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November 2008
NEW STANDARDS WILL SOON BRING SUBSTANTIAL CHANGE TO M&A ACCOUNTING
The U.S. Financial Accounting Standards Board (“FASB”) has issued new guidance on accounting for business combinations which becomes effective January 1, 2009 for calendar year end companies. These new standards will have a dramatic impact on accounting practices that have been in place for many years.
By placing a greater focus on fair value accounting, FASB Statement Number 141(R), Business Combinations, attempts to eliminate the inconsistencies that have historically resulted from the divergence of accounting application in this area.
FASB 141(R) continues the underlying movement away from the historical cost basis of accounting toward fair value accounting. The Statement requires an acquisition to be recorded based upon the estimated fair value of all assets acquired and liabilities assumed with those fair values being determined in accordance with FASB Statement Number 157, Fair Value Measurements.
Adoption of FASB 141(R) will likely have a more pervasive impact on business combinations than any previously issued pronouncements. In addition, the application of FASB 141(R) will create the potential for significant post-closing earnings volatility and will therefore result in changes to the way transactions are planned, negotiated, executed and ultimately recorded and disclosed in financial statements.
SUMMARY OF THE MOST SIGNIFICANT CHANGES
INTRODUCED BY FASB 141(R) |
Acquisition Costs
Historically, costs associated with an acquisition have been included as a component of the purchase price and, through the purchase price allocation process, often increase the recorded goodwill and other intangible assets. Since 141(R) values all assets and liabilities acquired or assumed at their fair value and compares that amount to the consideration paid to determine goodwill, including the costs of the acquisition, would theoretically result in a double counting when establishing the value of the goodwill.
As a result, and consistent with the movement toward fair value accounting, the new standards will require these costs to be expensed. This change will dramatically increase post-closing earnings volatility and will require the acquiring organization to have an in depth understanding of the impact these costs will have not only on operating results but also loan covenants. |
Earn-outs and Other Contingent Consideration
Earn-outs and other contingent consideration arrangements have become common components of acquisitions. Past accounting treatment only required the recognition of these events when it was considered more likely than not such contingencies will be resolved. Furthermore, once they became recordable transactions, they would generally be recognized as additional purchase price and result in additional goodwill.
FASB 141(R) requires earn-outs and other contingent consideration to be recorded, at the closing date, based on the estimated fair value of the contingency even if the likelihood of satisfying the contingency is remote. Once recorded, these items will be subject to remeasurement criteria, and any resulting changes in fair value will be adjusted through the company’s income statement. Again, there is the likelihood that earnings volatility will be created as a result of implementation of FASB 141 (R). |
Bargain Purchases
Changes to accounting for bargain purchase transactions will also create earnings volatility, but should enhance the balance sheet position of the acquired entity. Historically, if the net assets of the acquired entity were greater than the purchase price, accounting standards required the “negative goodwill” to be applied against certain asset categories. To the extent there remained a residual negative goodwill balance after reducing the value of these assets; the residual negative goodwill would be recognized as an extraordinary gain on the income statement of the acquired entity.
The revised standards will eliminate the process of allocating negative goodwill to certain asset categories, and will result in recognition of a gain for the entire difference between the fair value of the acquired net assets over the purchase price. However, the Standard indicates that the occurrence of a bargain purchase is anticipated to be rare and would require a reconsideration of the entire purchase price allocation prior to recognition of such a gain. |
In-Process Research and Development Costs (“IPR&D”)
Under FASB 141(R), acquirers will be required to identify and measure all IPR&D at fair value. Amounts identified as IPR&D will be capitalized and recorded on the opening balance sheet of the acquired entity.
Past practices required such items to be identified and valued. However, IPR&D was immediately expensed when undertaking the purchase price allocation and establishing the opening balance sheet of the acquired entity. |
Defensive Intangibles and IPR&D
Under FASB 141(R), all acquired assets are recorded at estimated fair value-regardless of the acquiring entity’s intention with respect to those assets. For example, an acquirer may purchase a brand name that it has no intention of utilizing in its ongoing business model. That brand name would still be required to be recognized by the acquiring entity at is fair value at the date of acquisition, and would then be subjected to an annual impairment testing.
In a similar manner, IPR&D that is acquired with the purpose of preventing a competitor from bringing a similar product to market but is not expected to be utilized by the acquirer will need to be recorded at its fair value at acquisition and subjected to annual impairment testing thereafter. Though this will initially enhance balance sheets, it will also likely introduce volatility to earnings after the acquisition date as acquired defensive assets lose their value in periods after the acquisition date. |
Other Acquisition Contingencies
Acquired contingent assets and liabilities will be recorded at their fair value if they meet the "more likely than not" threshold. Subsequent changes in the recorded amounts of an acquired contingent liability will not be recognized unless new information about its outcome is available and the amount determined under other applicable accounting guidance is higher than then original fair value amount.
Subsequent changes in the value of a contingent asset may be required if the asset is subsequently impaired, or if it is an asset that is subject to fair value accounting under other standards. This is a significant change from prior practice and may be one of the most complex aspects of implementation.
Generally, these contingencies will be considered either contractual or non-contractual in nature. Contractual contingencies include items such as product warranties and non-contractual items include lawsuits, environmental claims and other similar matters. |
Buyer Equity as Consideration
Equity securities issued as part of the purchase price have been measured based on the values at the transaction announcement date. The new Standard will require equity securities issued as part of the purchase price to be valued at the transaction closing date. This will result in significant uncertainties surrounding the ultimate value of the transaction. To mitigate transaction price volatility, we expect that floor and cap agreements will be incorporated into transactions which utilize equity as a component of the consideration. |
Restructuring Costs
Under FASB 141(R), acquirers would generally be precluded from recording a liability related to a planned restructuring of the acquired entity’s operations. As a result, such items will be charged to earnings in the post acquisition period. Past practices permitted acquirers to record restructuring liabilities as part of acquisition accounting. This typically resulted in recognition of higher goodwill. |
Tax Adjustments
Adjustments to acquisition related tax reserves have generally been made with corresponding adjustments to previously recorded goodwill. Under the new Standard, changes in accounting for tax reserves will be charged to earnings in the period of the change. It is important to note that changes to accounting for tax adjustments apply to all acquisitions, including those consummated in periods prior to the effective date of the standard. |
Adjustments to Acquisition Accounting
Another significant change from prior practice relates to adjustments made to acquisition accounting after initially recording the transaction. Companies will have a period of time after the acquisition to true-up acquisition estimates. However, the new Standard will require the revision of prior period financial statements to record material adjustments of estimated amounts in the acquisition accounting as of the acquisition date. This differs from prior practice which required these types of adjustments to be reflected in the period of change. |
Conclusion
The changes resulting from the issuance of this Standard will dramatically impact all transactions. As a result, acquirers will place a greater emphasis on the due diligence process to ensure information necessary to formulate many of these estimates are captured in the routine course of diligence thereby reducing the post closing risk of restatements to prior period financial statements and avoiding unexpected volatility in post acquisition earnings.
Please contact the Transaction Advisory Services specialists at CB&H to learn more about how FASB 141 (R) may impact your next transaction.
Scott Moss, Partner
Group Director, Transaction Advisory Services Group
smoss@cbh.com
1.800.849.4224
Mark Nelson, Partner
Assurance Practice
mnelson@cbh.com
1.800.849.4224
Scott Linch, Partner
Transaction Advisory Services Group
slinch@cbh.com
1.800.849.4224
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