The following report is from the BNA Accounting Policy & Practice Report. To see the full report and take a trial to the BNA Tax and Accounting Center, visit this site.
ACCOUNTING POLICY & PRACTICE SPECIAL REPORT
By John Formica, partner in the national professional services group of PricewaterhouseCoopers, specializing in business combinations. He can be reached at John.R.Formica@us.pwc.com. This article is adapted from an earlier version published in 2007 in Accounting Policy & Practice Report.
Several years ago, the Financial Accounting Standards Board launched a project on accounting for business combinations. At that time, business combinations were accounted for using the purchase method, but the FASB had determined that the purchase method was too narrow; it didn't encompass many transactions that should be within the definition of a business combination. The broader, so-called acquisition method was more suitable. Under the acquisition method, transactions other than the purchase of net assets or equity interests can be business combinations. For example, a transaction can be considered a business combination in which a buyer obtains control of a business without purchasing its net assets or equity interests. So is a situation in which an entity gains control over a business as a result of the lapsing of participating rights held by other investors.
Having decided on the acquisition method, the FASB then focused on clarifying the underlying principles and their application as a means of increasing the transparency of information reported under that method. The project resulted in an exposure draft issued in June 2005, and a final standard issued in December 2007, effective for business combinations completed after Jan. 1, 2009. The widely spaced timing of these milestones demonstrates how deliberately and cautiously the FASB has proceeded.
Implications for Companies Planning Deals
The anticipated changes to accounting practices for business combinations are significant, with critical implications for companies planning deals. Most notably, the new accounting will introduce greater volatility into companies' financial statements following a business combination. Why? Consider these key changes.
- Acquisitions, including “consideration exchanged” (i.e., the purchase price), will be recorded at fair value, and essentially all acquired assets and liabilities will be carried at fair value. And fair values—that is, estimated market values at a given date—tend to fluctuate.
- More types of assets and liabilities will be recognized as part of an acquisition.
- Transaction costs and restructuring charges generally will be expensed as incurred.
- Contingent consideration (amounts that may or may not be paid, depending on future events) will be recorded at fair value.
- In partial business combinations, the holder of a controlling interest in a business (i.e., more than 50 percent) will record 100 percent of the assets and liabilities of the business at fair value.
Impact of Fair Value
Almost all assets acquired and liabilities assumed will be measured at fair value, as of the date the buyer obtains control over the acquired business—typically, the closing date. At that time, the buyer will have to determine the fair value of (1) all components of the purchase price and (2) substantially all assets acquired and liabilities assumed. Certain of those assets and liabilities will continue to be recognized at their fair values in future financial statements, thereby introducing volatility into the financial statements in years following the acquisition.
If equity securities are part of the purchase price, their value will be measured as of the acquisition date (not the announcement date, as in the past). Therefore, changes in the shares' market value between the date a deal is announced and the closing date will affect the valuation of the transaction. In particular, this change is likely to have implications on the amount of goodwill recorded, that is, the excess of the purchase price of the acquired business over the amounts of identifiable assets acquired and liabilities assumed. Goodwill is significant because in future periods the buyer will have to demonstrate that the recorded amount is recoverable (i.e., not impaired) or will have to write it off.
Recognizing More Types of Assets and Liabilities
Companies will have to recognize assets and liabilities they typically have not recognized in past deals. This will add visibility to those assets and liabilities, and almost inevitably make them of greater interest to analysts. For example, in-process research and development (IPR& D) acquired in a business combination will be capitalized, not expensed at acquisition as in the past. In some industries, such as pharmaceuticals and high technology, which tend to have large amounts of IPR& D, the new accounting will have a significant impact on the financial statements.
With the new accounting, IPR& D will be treated as an indefinite-lived intangible asset, meaning that at some future date it will be written off through amortization if it is completed or through impairment if it is abandoned. Impairment analysis of IPR& D assets will be challenging because IPR& D is quite fluid by nature. Research projects evolve and change over time and may be combined with other projects of the buyer, the acquired business, or other future targets, thereby losing or blurring their individual identities.
Acquired contingencies—for example, indemnification provisions, litigation, environmental issues, or possible product recalls—will be recorded in the financial statements at fair value if certain conditions are met. The new standard applies a lower threshold for the recognition of acquired contingencies at the acquisition date than is currently required when companies account for contingencies outside a business combination, and it introduces new complexities as acquiring companies determine the nature of the contingency (that is, whether the contingency is contractual or noncontractual) and the likelihood of occurrence. [Editor's Note: FASB voted to issue a proposed staff position to amend the accounting for assets and liabilities arising from contingencies in a business combination in FAS 141(R). Please see box, “FASB Vto Issue FSP Proposing Changes on Acquired Contingencies” below for more information.]
Transaction Costs and Restructuring Charges
Until now, fees and other acquisition-related costs paid to third parties, such as attorneys, accountants, brokers, and investment bankers, have been capitalized as part of the purchase price. Believing that these costs do not affect the fair value of an acquired business, the FASB determined that they should be expensed as incurred (unless they relate to the issuance of debt and/or equity). Thus, under the new accounting, “consideration exchanged” is limited to what the buyer pays to the seller. Similarly, restructuring charges of the acquired business, which generally have also been included as part of the acquisition accounting, will generally be expensed in post-acquisition income statements. Among the consequences of these changes will be lower net income in pre- and post-combination periods and a lower purchase price, resulting in the recording of lower amounts of goodwill. And because transaction costs will have to be disclosed as they are incurred, companies will disclose some of these costs prior to a deal, perhaps tipping their hand to the marketplace.
Contingent Consideration
In keeping with the FASB's principle of recording acquisitions at fair value, contingent consideration (such as additional amounts payable, based on future earnings) may be recorded at the acquisition date as a liability and measured at fair value, in contrast to the previous practice of deferring recognition until the contingency was resolved. In subsequent periods, the liability will be remeasured at fair value, and any changes will be reflected in the income statement. Contingent considerations classified as equity will be recorded at fair value at the acquisition date but will not be remeasured subsequently.
Goodwill will almost always be recognized when contingent consideration is recorded. In subsequent periods, if the targeted performance milestones are not met, the liability for contingent consideration will be reduced. This may suggest that the value of the acquired business has decreased subsequent to the acquisition date and thus may trigger an impairment analysis of goodwill. To the extent that goodwill is found to be impaired, it will be written off by a charge to the income statement—an ironic result because the contingent consideration was intended to help the buyer avoid overpaying for the target in the first place.
Partial Business Combinations
In a partial, or step, business combination—in which a company acquires more than 50 percent but less than 100 percent of another company—the acquirer will record 100 percent of the target's assets, including goodwill, and liabilities at fair value at the date control is obtained. This applies to acquisitions of a controlling interest in a single step as well as to multiple acquisitions over time. In the latter case, any pre-existing ownership interest on the date when control is obtained will be remeasured at fair value, with gains and losses recognized in earnings. The FASB's rationale for this accounting is that the owner of a controlling interest in a business can control all of the business' assets and liabilities and thus should record 100 percent of them at fair value.
Therefore, on the date control is obtained, all of the target's net assets will be recorded at fair value, and the buyer will recognize the full goodwill of the acquired business. This will eliminate previous mixed-attribute accounting practices, in which only the net assets acquired by the controlling interest were recorded at fair value, the net assets owned by other equity holders (noncontrolling or minority interests) were not remeasured, and goodwill was recognized for the acquired interest only.
Under a related standard on consolidated financial statements, once a company obtains a controlling interest—typically greater than 50 percent ownership interests of a business—subsequent transactions between the company and the noncontrolling interests would be considered transactions among owners, provided they do not result in a change of control. Thus, they would be accounted for as equity transactions and would not flow through the income statement. This contrasts with the current accounting, in which a gain or loss is recognized on the sale of a portion of the parent company's interest in a subsidiary irrespective if control is retained.
In addition, under the standard on consolidated financial statements, noncontrolling interests would be classified as equity of the parent company, even if the noncontrolling interests were third parties that lacked an ownership interest in the parent company. At present, noncontrolling interests are presented either as a liability or in a “mezzanine” section of the balance sheet (i.e., between liabilities and equity).
The new accounting may have significant effects on a company's operating metrics. For example, there will be an increase in depreciation and amortization charges, which will affect performance measures. In addition, certain debt covenant measurements may be affected by the additional charges or by changes in the components of equity. The company will have to be careful to ensure that this doesn't put it in default of debt covenants.
Due Diligence
More than before, deal makers will have to do their homework if they want to avoid or minimize adjustments to previously filed financial statements. They'll have to spend more time on due diligence to identify all assets acquired and liabilities assumed and to determine appropriate valuations. Otherwise, in the end they may have to revise their financial statements.
Companies will continue to be allowed to adjust initial or provisional amounts recorded to account for an acquisition. These adjustments should reflect only new information about facts that existed and were knowable at the acquisition date and which, had they been known, would have affected the measurement of the amounts recognized as of that date. The adjustment period ends as soon as the company obtains needed information about the facts or learns that the facts are unobtainable, but may not exceed one year from the acquisition date.
However, the new accounting requires adjustments to provisional amounts to be accounted for as of the acquisition date. This means that if the amounts are material, the company will have to revise previously issued financial statements presented for comparative purposes (such as in a filing with the SEC), including footnote disclosures of the nature of and reasons for the adjustments.
Companies will want to be sure that their due diligence process is robust enough to identify all relevant assets and liabilities and that they have determined the appropriate method of measuring fair value. This process should cover forecasting the effects of the acquisition on the company, including the inherent drag on earnings in the post-combination period introduced by the amortization and possible impairment of new assets and periodic adjustments to fair value of certain liabilities.
In particular, given the inherent uncertainty of contingencies, companies will want to pay close attention to acquired contingencies in the due diligence process.
Valuation Expertise
The new accounting will create challenging valuation issues both at the time of acquisition and subsequently. Companies generally will have a greater need for valuation expertise, either in-house or through outsourcing arrangements. This need for valuations will be ongoing. At the time of acquisition, companies will have to value consideration exchanged and net assets acquired, while in subsequent periods they will need to determine the fair value for certain assets and liabilities(e.g., contingent consideration) and to assess goodwill impairment charges.
Measuring contingencies at fair value, including contingent consideration, will require more complex valuation techniques and greater third-party involvement than at present. This may lead companies to decrease the use of contingent consideration in transactions or to increase the use of equity-based contingent consideration, even if the effects dilute earnings-per-share numbers.
Communications to Stakeholders
Communications to stakeholders will need to be tailored to explain the financial impact of the deal. Companies will want to explain the nature of the deal-related costs that will now directly impact the bottom line. Changes in the purchase price based on the closing-date value of equity securities issued in a deal may require explanation. Fair value measures will likely require greater explanation, and the potential need for recasting prior-period financial statements will be an area of focus. The new consolidation standard will also bring a host of new disclosures around transactions with minority shareholders and certain nonrecurring gains or losses.
Clearly, accounting should not drive the economics of deals. But neither should deal makers let themselves be blindsided by these significant accounting changes. Companies negotiating or contemplating deals—and audit committees and boards asked to approve them—will want to understand the FASB's new rules for business combinations. They will need to consider the effects of these changes and related implications for transaction structure, timing, and cost. Failure to track the shifting road map could end up in wrong turns and detours that waste time and resources—and turn “the art of the deal” into a frustrating experience.
Editor's Introduction: The new standard on business combinations from the Financial Accounting Standards Board—Statement of Financial Accounting Standard 141(R)—takes effect at the beginning of 2009 for calendar year companies. The standard imposes significant changes from current accounting in a number of areas. The following two articles summarize key issues for companies considering mergers and acquisitions.
Since these articles were written, FASB Oct. 29 agreed to propose an amendment to FAS 141(R) to delay one aspect of the standard regarding accounting for assets and liabilities arising from contingencies in a business combination. The proposal, which had not been released by press time, will carry an effective date that would coincide with FAS 141(R), according to FASB. Please see separate box on page 8 in this report for more information on that proposal.
4 APPRSR 8
FASB to Issue FSP Proposing Changes on Acquired Contingencies
In an Oct. 29 meeting, the Financial Accounting Standards Board decided to add to its agenda a project to amend accounting for assets and liabilities arising from contingencies in a business combination under Statement of Financial Accounting Standard 141(R), Business Combinations (4 APPR 951, 10/31/08).
The impact of the yet-to-be-published proposal is that accounting for acquired contingencies would continue to be treated in generally the same manner as they are treated under the existing version of FAS 141 and FAS 5, Accounting for Contingencies.
At its Oct. 29 meeting, FASB agreed to issue a proposed FASB staff position—before the end of 2008—to amend FAS 141 (R), the revised version of FASB's business combinations rule that takes effect for mergers and acquisitions starting in 2009. The FASB expects to finalize the FSP in the first quarter of 2009, and plans for the new guidance to take effect along with FAS 141(R).
FASB decided to act in part because it had already agreed to delay action on revisions to disclosures for contingencies under FAS 5 and FAS 141(R) (4 APPR 861, 10/3/08).
The following is the text of FASB's summary of its discussion in its Nov. 6 Action Alert:
Assets and liabilities arising from contingencies in a business combination. The Board reached the following decisions on a proposed FSP to amend current requirements for accounting for assets and liabilities arising from contingencies in a business combination in FASB Statement No. 141 (revised 2007), Business Combinations.
The Board agreed not to include contingent consideration in the scope of the project. The Board determined that initial recognition and measurement of assets and liabilities arising from contingencies should follow a model similar to the one in FASB Statement No. 141, Business Combinations, with additional clarification of situations under which fair value is “reasonably estimable,” similar to the requirements in FASB Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations.
The Board agreed to retain the subsequent measurement and accounting guidance in Statement 141 (R) for assets and liabilities initially recognized at fair value, with additional clarification to address derecognition.
The Board determined that disclosures should include the nature of the contingency, the measurement attribute applied, and, if not measured at fair value, the reason that fair value could not be reasonably estimated. Additional disclosures would depend on the initial measurement attribute applied.
The effective date of this FSP will be the same as Statement 141 (R).
4 APPRSR 11
New Requirements in Business Combinations
By Mark L. Zyla, CPA/ABV, CFA, ASA. Mark Zyla is a managing director with Acuitas Inc., a business valuation and litigation services firm based in Atlanta. He formerly was with PricewaterhouseCooper's Corporate Finance Consulting Group. He can be reached at 404 898 1137, or mzyla@acuitasinc.com. This report was excerpted from upcoming revisions to BNA Tax & Accounting Portfolio 5115, Business Combinations: Goodwill and Other Intangible Assets, Accounting Policy & Practice Series.
Problems with accounting for goodwill in business combinations helped spur the Financial Accounting Standards Board to develop both the newly revised business combinations standard, Statement of Financial Accounting Standard 141(R), Business Combinations and the new and controversial FAS 157, Fair Value Measurement.
During the Internet boom in the late 1990s’, FASB began a project to update Accounting Principles Board 16 which was the standard at that time for accounting for acquisitions. What the project determined was that the value of intangible assets had dramatically increased, particularly when compared to the value of tangible assets.
The FASB determined that under the old APB 16, companies had too much leeway in reporting the value of intangible assets in acquisitions and that financial statements were not fairly representing the allocation of the acquisition price to the assets acquired. Under the old accounting rules, most of the value in allocation of purchase price was being recorded as goodwill, which could then be amortized for up to forty years.
In 1996, the FASB formally opened a project to revamp accounting for business combinations. In 2001, FASB adopted FAS 141, the original standard on business combinations. In 2007, wrapping up its first joint project with the International Accounting Standards Board, FASB issued FAS 141(R), which placed stricter requirements on the financial statements of the acquirer for the recognition of intangible assets acquired in a transaction.
Improving Accounting for Business Combinations
The reasons for issuing FAS 141(R) were essentially captured in an announcement by the FASB. In the announcement, the FASB listed three main objectives in revising the guidance for accounting for business combinations:
- Improve the transparency of financial reporting and provide investors with “greater consistency” in the accounting for business combinations.
- Improve the comparability of financial statements world wide. (The IASB adopted a similar statement on accounting for business combinations early in 2008.)
- The revised standard continues the shift in measurements from historic cost based accounting to the fair value measurement standard.
Revised Definition. FAS 141(R) defines a “business combination” as, “a transaction or other event in which an acquirer obtains control of one or more businesses. Transactions sometimes referred to as ‘true mergers' or ‘mergers of equals' also are business combinations as that term is used in this Statement.”1 The modification of the definition of a business combination expands the types of transactions that may qualify as a business combination. Previously certain types of acquisitions that were classified as asset acquisition may now be classified as business combinations under the new statement.
1 FAS 141(R), ¶ 3(e).
FAS 141(R) applies to all transactions in which one entity gains control over another.2 The revised standard will apply to all entities including mutual entities. However, it will not apply to joint ventures, true asset acquisitions, combinations already under common control and not for profit entities.3
2 See FAS 141(R), ¶ ¶ 2, 3(e).
3 FAS 141(R), at Summary.
Significant Changes. Among key changes imposed by the standard, it generally requires measurement at fair value of the business acquired. Transaction related costs will be expensed rather than capitalized. Contingent consideration will be recognized as of the date of the acquisition. Assets and liabilities that are of a contingent nature will be recorded at their relative fair values which will change the way the acquisition price is calculated. In-process research and development would be recognized as an asset in a business combination rather than expensed under existing accounting treatment.
Asset values also will be no longer reduced from their fair value in a “bargain purchase.” The difference between the sum of the fair value of the assets acquired and the fair value of the consideration given will result in recognition of a gain in earnings rather than a pro rata reduction of values recorded on the balance sheet.
The Acquisition Method
FAS 141(R) revises accounting for a business combination from purchase method to the acquisition method. The steps in the application of the acquisition method described by the standard require: identifying the acquirer; determining the acquisition date; recognizing and measuring the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree; and recognizing and measuring goodwill or a gain from a bargain purchase.4
4 FAS 141(R), ¶ 7.
Identifying the Acquirer. A difference between FAS 141(R) and its predecessor is that under FAS 141, there was not definitive guidance as to the need to identify the acquirer. A key concept in the revised standard is that a business combination occurs when one business entity gains control over another business entity. As such, the business entity gaining control is termed as the acquirer.5
5 FAS 141(R), ¶ 9.
Acquisition Date. The acquisition date is the date on which the acquirer obtains control of the acquiree. Change of control is typically demonstrated when the acquirer transfers the consideration and obtains responsibly over the assets acquired and liabilities assumed. Often this occurs on the closing date of the transaction.6
6 FAS 141(R), ¶ 11.
Recognizing and Measuring the Identifiable Assets acquired, the Liabilities Assumed, and Any Noncontrolling Interest in the Acquiree. A significant change in FAS 141(R) from current practice is that in acquisitions involving stages or steps, the acquirer under the revised standard will have to recognize the full fair value of acquired identified intangible assets. FAS 141(R) requires noncontrolling interest in the acquiree to be measured at fair value resulting in a recognition of the goodwill attributable to the noncontrolling interest in addition to the goodwill attributable to the acquirer.7
7 FAS 141(R), at (iii).
Recognizing and Measuring Goodwill or a Gain from a Bargain Purchase. FAS 141(R) defined a bargain purchase as, “a business combination in which the total acquisition–date fair value of the identifiable net assets acquired exceeds the fair value of the consideration transferred plus any noncontrolling interest n the acquiree.”8 One result of this change is that bargain purchases will be recognized as gains on the income statement rather than a pro rata reduction in the fair value of assets recognized on the balance sheet.
8 FAS 141(R), at(iv).
Fair Value of the Business Acquired
The acquisition price under FAS 141(R) is generally the fair value of the consideration paid for its interest in the acquiree. This consideration can include cash and other assets, equity interests, and contingent consideration; all of these are measured at fair value at the acquisition date. Transaction costs are excluded from the acquisition accounting. They are measured under the applicable standards for the specific consideration.9
9 FAS 141(R), ¶ 39; FAS 141(R), ¶ 59.
The revised statement will change how the fair value is to be allocated from current practice. Currently, the costs of the acquisitions are added to the total purchase price. Under the revised standard, acquisition and restructuring costs would be expensed as of the acquisition date.10
10 FAS 141(R), ¶ 59.
In many instances, the acquirer of a business may agree to transfer additional consideration such as additional equity interests, cash or other assets to the former owners of the business, if the business meets certain specified targets after the acquisition. The purpose of this contingent consideration is beneficial to both parties in that in helps ensure a smoother transition to the new owner of the business. The former owner benefits from this structure in that contingent consideration (earn outs) will be recorded at fair value on the acquisition date, with changes in fair values generally being recorded through earnings each reporting period thereafter.
Previously, any value associated with contingent consideration was treated as goodwill.11
11 FAS 141(R), ¶ 41.
Bargain purchase occurs when the fair value of the assets of the business acquired exceeds the fair value of the consideration paid. The excess is first used to reduce goodwill, and then any additional excess beyond the reduction of goodwill would be recorded as a gain on the income statement. This differs from current treatment which reduces noncurrent assets pro ratably.
Contingent Assets and Liabilities
Editor's Note: Since this article was written, FASB Oct. 29 agreed to propose an amendment to FAS 141(R) to delay one aspect of the standard regarding accounting for assets and liabilities arising from contingencies in a business combination. The proposal, which had not been released by press time, will carry an effective date that would coincide with FAS 141(R), according to FASB. Please see separate article in this report for more information on that proposal.
Under FAS 141(R), assets and liabilities that are of a contingent nature are to be recorded at their fair values as of the acquisition date. Under current accounting standards as promulgated in FAS 5, contingencies that are classified as either assets or liabilities only have to record the fair value of the contingency if both of two conditions are met:
(1) It is probable that an asset had been impaired or a liability had been incurred; and
(2) The amount of loss can be reasonably estimated.
Under FAS 141(R), contingencies are to be measured at their respective fair values. FAS 141(R) indicates that the FASB recognizes concerns about difficulties in measuring contingencies that are classified as either assets or liabilities, yet the FASB has decided to address this concern through the FAS 157 which “provides relevant guidance for measuring the fair values of assets and liabilities.”12
12 FAS 141(R), ¶ B126.
One interesting aspect of this provision will be estimating the fair value of any potential lawsuits that the acquired company may be exposed to as of the date of acquisition. One way to measure the fair value of this contingency would be to estimate the range of likely outcomes. In order to estimate the fair value of the contingency, management of the acquirer would have to estimate and possibly disclose their estimate of range of possible outcomes and the probability of each outcome. There may be a concern by some that this sort of disclosure could possibly hinder any settlement negotiations.
In-Process Research and Development (IPR& D)
One interesting change under FAS 141(R) would be the treatment of in-process research and development (IPR& D) in a business combination. IPR& D is technology that, as of the date of acquisition, is not currently feasible nor is there any alternative future use.
Since the potential viability of any technology under development is somewhat speculative, the current accounting treatment is to expense research & development costs as they are incurred. This philosophy has carried over to the allocation of any in process technology acquired in a business combination. As such under this treatment the fair value of in-process research and development under FAS 141 is currently expensed as of the date of the acquisition.
Under FAS 141(R), the acquirer will be required to recognize the fair value of research and development assets as an asset apart from goodwill. The revision from current accounting however may leave some accounting inconsistencies in the treatment of IPR& D which will have to be addressed in the future. Specifically, while IPR& D acquired in a business combination would be recognized as an asset apart from goodwill, subsequent expenditures for research and development would still be expensed. Also if IPR& D is purchased as an asset apart from a business combination, the acquisition price for the IPR& D would still be expensed.13
13 FAS 141(R), ¶ ¶ B149-B156
There is also some other seemingly conflicting accounting treatment of IPR& D when fair value is capitalized in a business combination. Current accounting of capitalized IPR& D provides that IPR& D is an indefinite lived intangible asset until the project has been completed or abandoned. Consequently, any test for impairment is based on IPR& D’s fair value (FAS 142). However, once IPR& D becomes “developed,” then a life is assigned. The IPR& D would then be tested for impairment under FAS 144.
The following report is from the BNA Accounting Policy & Practice Report. To see the full report and take a trial to the BNA Tax and Accounting Center, visit this site. |
