Time’s Up: New M&A Rules in Effect

Potential buyers began 2008 worried about new M&A rules, effective this week, but ended the year with much bigger concerns.
Sarah JohnsonDecember 15, 2008

Accounting rule changes going into effect today were expected to speed up M&A activity in 2008. Other factors came into play, of course, prompting dealmakers to put the brakes on their fast-track plans.

Standard-setters approved the revisions last December, giving companies at least one year to push deals through to avoid the new requirements. Effective for fiscal years beginning after Dec. 15, 2008, the new rules change the date when acquisitions are valued, incorporate more fair-value accounting into merger valuations, alter how negative goodwill is recorded, and require buyers to capitalize the acquiring companies’ incomplete R&D projects.

Rather than letting the changes to the M&A accounting standard FAS 141, Business Combinations, affect their deal strategies, buyers had a more immediate worry: their ability to get financing in a faltering U.S. economy. “The provisions of 141 (R) took a back seat to discussions on how to finance the deal,” says Barry Smith, managing director of SMART Business Advisory and Consulting.

Still, accounting experts say the rules are transformative for the financial reporting of mergers. They will give investors a better view into the true worth of a deal and will likely make acquiring companies more diligent during the negotiation process.

Fair-value accounting is one reason the FAS 141 revisions stopped some deals from moving forward this year. FAS 141(R) calls on acquiring companies to value target companies’ financial assets and liabilities based on the fair-value rule FAS 157 as of the acquisition date, when traditionally they were measured at historical cost. Key Bank officials have said that change killed a deal after they applied fair value to another bank’s loans.

Under the new rules, acquiring companies will also have to apply FAS 157 to unobservable assets and liabilities, such as contingent liabilities that are measured using estimates. Buyers will estimate future payouts, such as lawsuit settlements or earnouts, when calculating the total sale price of a deal on the day it closes. Then, when the payout is later made, the acquiring company will record 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 changes affecting future deals make it ever more important to include any affected departments early on in the dealmaking process, say deal experts. In-house tax and accounting experts should be included in the initial conversations with the CEO, CFO, and lawyers to avoid problems later on, advises Stamos Nicholas, national business valuation leader for Deloitte Financial Advisory Services. “Initially, a lot of companies are going to be surprised as to how much they have to consider in order to estimate what this deal will look like,” he adds.

Among other changes: Buyers will estimate the value of their acquisitions at the closing date rather than when they make the deal announcement. Acquiring companies can no longer include merger-related fees — such as those charged by investment banks and attorneys — in the total purchase price. Rather, they have to expense those costs as they are incurred, even if the impending deal hasn’t been announced publicly.

Moreover, ccompanies 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. Also, companies will record negative goodwill — the gain created when a company buys an asset for less than its fair value — on the sale date, rather than writing down such a gain to zero through a series of allocations as they currently do.

The new merger rules are noteworthy for being the first completed joint project between U.S. and global rule-makers. The changes move U.S. GAAP closer to international financial reporting standards, say accounting experts.

To be sure, while the new rules will have an effect on the deal-making process, don’t expect them to have a long-term impact on deal volume. “If the deal makes sense, the deal is going to get done, whether there is 141(R) or no 141(R),” Smith says. “But given the current state of the credit markets, it’s very soft out there right now.”