New M&A Accounting Contains Important Changes

April 2008

In December 2007, the Financial Accounting Standards Board (FASB) issued SFAS 141R, "Business Combinations". The statement is the first major result of the joint convergence agreement between the FASB and the International Accounting Standards Board (IASB). The IASB’s comparable financial reporting standard (Standard 3) was issued in January 2008. Having a common set of standards improves the comparability of financial information around the world.

Consistent with other recently issued financial accounting and reporting standards, fair value is the centerpiece of SFAS 141R. The dramatic changes in accounting for mergers and acquisitions require a purchaser to:

1. Recognize an acquired business at its fair value as of the closing date. This is a change from recording such transactions at cost as of the deal negotiation date .
2. Determine the fair value of the individual assets acquired and liabilities assumed, and then record all such values on the balance sheet. Previously, some items included as part of the acquisition were not allowed to be recorded.
3. No longer determine carrying of assets based on the acquirer’s expectations about how the acquired assets will be used. To the extent that the acquirer’s ideas are different than what the marketplace would consider, the accounting treatment will be different than what the acquirer considered in arriving at the purchase price.

The measurement date for all these valuations is now the closing date of the deal, as opposed to (under the old rules) the date the agreement was struck. In mergers that take a while to complete for regulatory or other reasons, the difference between the valuations can be large.

These seemingly simple changes will have important impacts, as follows:

1. Contingent assets and contingent liabilities that are “more likely than not” (more than 50%) to exist are recorded at their fair value, and not under SFAS 5 (“Accounting for Contingencies”) requirements. These potential gains (assets) and losses (liabilities) will be recorded on the balance sheet, even if they do not otherwise meet the existing accounting rules specified in SFAS 5. Each subsequent accounting period, these estimates will be reassessed and recorded as part of earnings in the subsequent periods.

   Impact on Lawyers - Contingent losses and contingent gains from lawsuits will now need to be measured if they impact the purchase price. Because contingent gains and losses from acquired companies will now be on the balance sheet and reassessed each year, lawyers' confirmation letters to auditors will request information regarding a larger number of lawsuits. Expect these confirmation letters to have a heightened importance and scrutiny.

2. Acquisition-related costs of the acquirer (such as for lawyers and investment bankers) will now be treated as an immediate expense, rather than capitalized as part of the acquisition cost. The rationale is that acquisition costs are not part of the consideration to the seller and could not be recovered in a re-sale. Because the transaction is recorded at fair value (rather than cost), the closing costs must be written off when incurred.

   Impact on Lawyers - The costs of acquisitions, including legal fees, used to be recorded on the balance sheet and written off over time. Now, these costs will be an immediate charge against the client's reported earnings. Although the legal fees would cost resources under either accounting treatment, a public company that is focused on immediately-reported earnings may become a bit more fee sensitive than before.

3. Costs associated with restructuring activities will be expensed by the combined entity when incurred, rather than allowed to be accrued as a liability under the existing rules. An exception allows obligations to be treated as part of the acquisition if the restructuring plan existed as an obligation of the entity being acquired as of the closing date. During the period between the negotiation and closing, the acquired entity can implement such obligations that will allow the restructuring efforts to be part of the acquisition accounting.

   Impact on Lawyers - Because restructuring costs are often significant, an acquirer concerned with reported earnings would prefer to include these costs as part of the acquisition accounting. To accomplish this, legal efforts must be accelerated, since such restructuring plans will need to be formalized before the closing.

4. Contingent consideration (for example, an "earnout") is recorded at fair value at the closing date. Subsequent adjustments in the estimated or actual payment that are to be paid in cash (vs. those paid in equity) are recorded through earnings. Previously, these subsequent changes altered goodwill, and affected earnings only through the goodwill accounting.

   Impact on Lawyers - Acquiring businesses will want to limit their exposure to earnings swings based on differences between the original estimate, and what subsequently occurs. Accordingly, expect buyers to be less enthusiastic about agreeing to an earnout that is payable in cash.

5. Acquired research and development that is in-process previously needed to be valued, but then was immediately written off as an expense. This immediate write-off was not faithful to the economics of the transaction. Accordingly, in-process research will now be recorded on the balance sheet as an indefinite-life asset. In subsequent periods, this recorded fair value will be tested to determine whether there has been a subsequent fair value decline, and/or converted to an amortizable asset once a known life is established.
6. In contrast, post-acquisition R&D will generally continue to be expensed as incurred, thus causing an inconsistency between two otherwise identical assets that are acquired under different circumstances.

   Impact on Lawyers - Additional intellectual property assets will now be recorded on the balance sheet, and then retested each year for their ongoing value. To do this well, clients will likely consult their IP lawyers more frequently regarding their legal protection and alternatives.

Acquisition accounting is now more complicated. The substantially greater use of fair value means increased use of outside valuation specialists, both at the time of the original accounting, and afterwards. This need for outside valuation assistance will persist long after the transaction occurs. Because subsequent differences between the valuation estimates and what later occurs will cause earnings volatility, the need for quality, thoughtful valuation assistance is much greater than what previously existed.

SFAS 141R is required in the first annual reporting period that begins after December 15, 2008. Businesses wishing to avoid these complicated new rules will push for a 2008 closing of their acquisition.

Fulcrum Inquiry is an accounting firm that performs business and intellectual property valuations as one of its primary service lines.