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Managements may want to tweak deal structures and due diligence in light of new accounting rules.
Marie Leone, CFO.com | US
January 14, 2008
New accounting rules may affect the structure and timing and timing of mergers. As a result, companies will have to rethink how much equity or cash to plow into a deal, what kinds of share-price restrictions to apply, and when's the best time to close a transaction.
The rules, two released by the Financial Accounting Standards Board in December, and two companion mandates issued by the International Accounting Standards Board last week, affect companies both in the United State and abroad. But American companies using U.S. generally accepted accounting principles will likely be affected to a greater extent because the most sweeping changes were made to the American body of rules.
For example, under FAS 141(R), Business Combinations, which will be in effect for acquisitions that close in fiscal years that start after December 15, 2008, buyers must value the amount paid for a target company on the day the transaction closes, rather than the day of the deal announcement, which is current practice. That includes recording the value of stock the buyer may use to pay for all or part of an acquisition.
But transactions can take months, or even a full year, to finalize, and a lot can happen to a buyer's share price during that time, says John Formica, a partner with PricewaterhouseCoopers. In the absence of any price protections, the new accounting treatment could make the use of equity in an M&A deal less attractive, Formica told CFO.com.
If stock is used to pay for the acquisition, the final purchase price, as well as its potential affect on earnings, will not be fully known until the deal is inked. "From a measurement perspective, [dealmakers] will want to sign and close as quickly as possible" unless a collar is put in place to assure that more money is not being spent on the deal than is necessary, says Barry Smith, managing director of SMART Business Advisory and Consulting.
Consider a transaction in which the buyer's stock price rises, increasing the value of the shares allocated to the deal. That could result in more goodwill and, therefore, more goodwill impairment risk in future periods. For example, say that a large food conglomerate with a stock price of $25 per share announces a deal to buy a small ice cream producer for $30 million, or 1.2 million shares. Nine months later—in a typical deal timeframe—the transaction closes when the buyer's share price is $26.
So although the same number of shares will be used to complete the transaction, the buyer is paying a $1.2 million premium for the target, which will typically be accounted for as goodwill."The goodwill could be in excess of what is [considered market value], and that could mean a hit to your profit and loss statement," says Smith. For instance, there would be pressure to perform a goodwill impairment assessment, which at some point may force the buyer to write down the $1.2 million premium and take a hit to earnings.
Conversely, if the food conglomerate's stock dropped by $1, the company would have a $1.2 million "bargain" purchase, which results in an immediate operating gain under FAS 141(R). That so-called "negative goodwill" may help the income statement, "but it is not a gain that you can spend," Jack Ciesielski, editor and publisher of the Analyst's Accounting Observer newsletter told CFO.com.
One way to curb the stock-market uncertainty is to structure the deal so it contains share price protections that are more narrow than usual, suggested Formica. While most deals set price ceilings and floors to help manage wide swings in stock prices, dealmakers may want to negotiate more narrow ranges so protection, which usually comes in the form of puts or price caps, would be triggered sooner.
Further, Formica suggests that buyers may also want to "compress" the amount of time between the deal announcement and closing, as a way to manage share-price swings. That would require that dealmakers put more time and resources into due-diligence efforts before the merger is announced.
Another big timing issue concerns the post-acquisition, true-up period. Similar to the current rule, the new standard allows companies to make accounting adjustments to their deal estimates after the transaction is finalized. However, FAS 141(R) requires those post-period adjustments to be recorded as of the closing date, rather than in the period they are changed, as is the current practice. Since fair-value estimates will be pervasive, Formica expects most deals to be affected by these such adjustments.
The problem with adjusting older financials, adds Formica, is that current and potential investors would likely view the revision in the same way as they would any restatement: with suspicion. With the specter of a restatement in full sight, management will work to minimize any post-deal accounting changes, which again means ramping up due-diligence efforts. And that will require more access to target-company data before the close and solid accounting around the transaction before the close.
The upshot of the new M&A rules may be that some companies will "be racing to do deals" before the compliance deadline, asserted Smith. He also advised companies to start looking at potential deals in light of the new rules now, even though the deadline is still a year away. "They should be thinking about whether to employ cash or equity, and should start rethinking the whole acquisition process" to factor in new valuation impacts.
Nevertheless, Smith insists: "If it's a good deal, and a deal that is good for the company, it will get done."