Rule Makes Execs Think Twice About Dealmaking

A Deloite survey says FASB's new merger rule will put the kibosh on transactions that until recently would have gone forward.
Marie LeoneJune 13, 2008

Just six months after the Financial Accounting Standards Board issued its revised rule on business combinations, corporate executives are saying the technical pronouncement will change the way they do business.

In a recent survey, 40 percent of 1,850 executives said FAS 141(R), Business Combinations, would cause them to “rethink” deal strategy and affect planned deal activity, according to Deloitte Financial Advisory Services, which conducted the online poll.

Only 4 percent of the respondents said their companies have already finished assessing the valuation impact of the new rule.

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“The finance and accounting, business development, tax and legal departments of companies are working to understand the implications of Statement 141(R), as the process for how a deal is consummated and reported will require significant preliminary and ongoing analyses,” noted Stamos Nicholas, Deloitte’s national business valuation leader.

FAS 141(R) is the first global standard to be issued since FASB and its overseas counterpart, the International Accounting Standards Board, began their joint rulemaking convergence project in 2002. One aim of the project is to harmonize international standards with U.S. generally accepted accounting principles to better meet the demands of global investors. It’s also intended to cut complexity and costs from the financial reporting process, particularly for multinationals that are forced to record results using several different local standards.

However, the launch of the maiden rule has created controversy, mainly because FAS 141(R) is a major departure from the historical cost accounting that many companies use. To the chagrin of many companies, the new rule mandates the use of FAS 157, Fair Value Measurement, which introduces a standardized way to measure financial assets and liabilities at fair value using a three-level hierarchy based on risk-related criteria.

As always, acquiring companies value the target company’s assets and liabilities, identifiable intangible assets, and some previously unrecognized contingencies at fair value at the time of the sale. But under the new measurement system, unobservable assets and liabilities, such as contingent liabilities that are measured using estimates, must be valued on what the company believes a hypothetical third party would pay for them, rather than rely on in-house models. “The most difficult part of implementing FAS 141(R) is coming to grips with fair-value principles that were never required before,” Jay Hanson of McGladrey & Pullen told CFO.com in an earlier interview.

For example, Hanson opined on potential problems related to the way companies record merger-and-acquisition transactions in which the acquiring company buys less than 100 percent of a target company.

In those cases, the contingent consideration — which include future payouts such as lawsuit settlements or earnouts — must be estimated if they are determinable. Then the acquirer records the estimated payout as part of the sale price on the day the deal closes. In addition, when the payout is eventually made, the company records the difference between the estimated fair value and the actual payout as an expense or gain. Currently, contingent considerations are not recorded on the balance sheet until the payout is made.

The problem with that process is that the valuation of future assets and liabilities will likely cause tension between companies and their auditors, because companies may aim high with their estimates with an eye toward boosting earnings when the payout is made.

Further, FAS 141(R) tightens some loopholes, but widens others. For instance, the revised rule makes it harder for buyers to manage earnings because the standard restricts the use of restructuring reserves and in-process research and development writeoffs. So companies that acquire incomplete R&D projects in a merger will have to capitalize — and eventually amortize — the assets rather than follow the current practice of expensing them. The change will likely boost company earnings in the year of the acquisition and, in some cases, help companies swing reported losses into a profit, according to a study published last month by the Georgia Institute of Technology’s Financial Analysis Lab.

At the same time, FAS 141(R) leaves room for management discretion and potential abuse, according to another study, “Acquisition Accounting: New Rules & Shenanigans,” issued by research consultant RiskMetrics Group.

In addition, the revised rule may create near-term headaches for companies that picked up assets at bargain prices, because it changes the way companies book a gain known as negative goodwill. Negative goodwill is created when a company buys an asset for less than its current fair value.

Currently, companies write down such a gain to zero through a series of allocations. But under FAS 141(R), companies will have to carry negative goodwill as an immediate gain on the day of the sale. That, in turn, may cause an increase in reported assets, net income, and shareholders’ equity, which would skew performance ratios tied to those underlying items, asserts another report form the Georgia Tech Lab.

Another consideration: It is possible that FAS 141(R) will prompt acquiring companies to plow more cash into M&A deals. That’s because the rule affects the structure and timing of mergers, which is likely to cause companies to reconsider how much equity or cash to put into a deal, and when is the best time to close. Consider that transactions can sometimes take a year to close, and that much can happen to a buyer’s share price during that time.

For example, if a buyer’s stock price rises, increasing the value of the shares allocated to the transaction, more goodwill and, therefore, more goodwill impairment risk will be created. So although the same number of shares will be used to complete the transaction, the buyer is paying a premium for the target, which will typically be accounted for as goodwill, John Formica of PricewaterhouseCoopers explained in an earlier interview.

That becomes a problem if the goodwill exceeds what is considered the fair value of the target company. In that case, the acquirer’s earnings takes a hit because the premium has to be written down. Conversely, if the acquirer’s stock price drops significantly before the deal closes, the company would have made a so-called bargain purchase, which generates a negative goodwill gain. And while negative goodwill may produce an income statement gain, “it is not a gain that you can spend,” Jack Ciesielski, editor and publisher of the Analyst’s Accounting Observer newsletter, told CFO.com.

Less controversal is the rule’s provision that prohibits companies from lumping merger-related transaction costs into the purchase price. Starting next year, fees charged by investment banks, attorneys, and valuation specialists will be exorcised from the purchase price.