Though the M&A market may have cooled, any private equity investor or strategic investor planning to purchase a company—especially those having the ability to close their deal before year-end while the current purchase accounting rules are in effect—should become familiar with Statement of Financial Accounting Standards No. 141 (revised 2007), Business Combinations (SFAS 141R) and the changes that will impact the accounting for future M&A transactions.
Last December, the Financial Accounting Standards Board (FASB) issued SFAS 141R, which changes accounting and reporting requirements for business acquisitions in fiscal years beginning on or after December 15, 2008. This date is just around the corner and, when it becomes effective, SFAS 141R will replace the original SFAS 141 in its entirety.
While there are numerous changes to the rules, there are six specific areas where SFAS 141R will change “acquisition method” accounting (currently known as purchase accounting) that I would like to focus on:
1) Transaction Costs
Under SFAS 141R, the direct costs incurred as a result of a business combination—such as payments to investment bankers, attorneys, accountants and consultants—will no longer be included as a component of the fair value of the business acquired. Instead, these amounts will be recognized as expenses in the period in which they are incurred. Accordingly, even a potential buyer’s income statement will be impacted right away. The implications of this change include the following :
o All other things being equal, the earnings reported in periods immediately prior to the closing will be reduced due to the expensing of transaction costs;
o Depending on the materiality of the costs incurred and the length of time to close the deal, the buyer may be forced to reveal its M&A activity to the market prior to closing; and
o Some entities may choose to delay the hiring of third parties to assist with due diligence until the probability of consummating the deal is very high, which could delay the closing process.
For those entities whose next fiscal year begins after December 15, 2008 (e.g. January 1, 2009) and who are currently conducting M&A activity, consideration should be given to the fact that direct costs can be capitalized if the transaction closes in 2008. Thereafter, such costs will have to be expensed.
2) Restructuring Costs
The new treatment of restructuring costs will set a very high bar to clear before an acquirer will be allowed to recognize a liability as part of acquisition accounting. The new standards are similar to those that must be met to recognize a liability for restructuring activities outside of an acquisition. That is, the acquirer’s restructuring plan must be in place on the date of acquisition—meaning the plan would need to be approved, the benefit arrangements communicated to employees, and the facilities abandoned—before a liability could be recorded. Given the amount of planning required in advance of closing an acquisition, such treatment will likely be rare. With the diminished ability of the acquirer to accrue for restructuring costs related to the acquiree’s business under the acquisition method, the implications are as follows:
o In terms of the accounting, there will no longer be a difference between whether it is the acquirer’s or the target’s operations that are being restructured (i.e. in either case the costs will be expensed as incurred); and
o Restructuring costs will receive increased scrutiny from shareholders and analysts, as the costs will be charged to earnings under acquisition method accounting (i.e. SFAS 141R) instead of creating more goodwill under purchase accounting (i.e. the current rules under SFAS 141).
3) Purchase Price
SFAS 141R requires that equity securities issued as consideration in a business combination be recorded at fair value as of the acquisition date. Currently, under Emerging Issues Task Force No. 99-12, Determination of the Measurement Date for the Market Price of Acquirer Securities Issued in a Purchase Business Combination, the acquirer’s equity securities are valued over the period a few days before and after the terms of the business combination are agreed to and announced. Because the value of securities may change dramatically between the announcement date and acquisition date, the new rules might result in substantially different amounts recorded as consideration (i.e. a significantly different purchase price at the acquisition date than what was expected at the announcement date).
4) In-Process Research & Development
In-process research & development (IPR&D) acquired in a business combination will no longer be written off to earnings immediately after the acquisition. IPR&D will continue to be measured at fair value but will be capitalized as an intangible asset on the acquisition date and will be subject to amortization (if completed), impairment (if diminished in value), or complete write-off (if abandoned).
The accounting for standard research and development (R&D) costs, however, has not changed, resulting in a hybrid method going forward as follows:
o R&D costs incurred after the acquisition generally will be expensed as incurred, including those for completing the acquired IPR&D that was capitalized; and
o IPR&D acquired as part of an asset purchase (as opposed to acquiring the business) will continue to be expensed rather than capitalized. So buyers that acquire assets, including IPR&D, rather than the business entity, will immediately expense the fair value of the IPR&D.
5) Pre-acquisition Contingencies
Contingencies qualifying as assets or liabilities are to be recorded under SFAS 141R at fair value when the probability of occurrence is more-likely-than-not (i.e. greater than 50 percent). This is a move away from Statement of Financial Accounting Standards No. 5, Accounting for Contingencies, which required high probabilities for liabilities and certainty for assets. Contractual contingencies are recorded at fair value on the acquisition date, while non-contractual contingencies follow the more-likely-than-not test. For example, a $1 million contingency with 80 percent probability would be recorded at $800,000, and later adjusted upward or downward as more information becomes available. Nothing would be recorded for probabilities less than or equal to 50 percent.
Measuring contingencies at fair value may require the use of complex valuation techniques that are highly subjective and based on a variety of assumptions. In subsequent periods:
o A contingent asset is re-measured to the lower of its fair value on acquisition date or the best estimate of its future settlement amount;
o A contingent liability is re-measured to the higher of fair value on acquisition date or the amount that would be recognized under SFAS 5; and
o Subsequent changes in measurement are included in income.
6) Contingent Consideration
Earn-outs and other forms of contingent consideration will be recorded at fair value on the acquisition date, regardless of the likelihood of payment. This is a departure from previous accounting, under which only earn-outs that were probable of payment or were incurred during the first year after the acquisition have generally been considered part of the cost of the acquisition, while any earn-out payments after the first year were expensed as incurred. Under SFAS 141R though, subsequent changes in the fair value of most contingent consideration will directly impact earnings. However, if the contingent consideration meets the requirements for classification as equity, then it will not be adjusted in subsequent accounting periods for changes in fair value.
Accordingly, buyers may want to consider alternative deal structures that would allow the contingent consideration to be treated as equity. However, buyers will need to consider the impact of equity dilution. To determine whether contingent consideration represents a liability or equity, a private equity or strategic buyer should consult the applicable accounting literature.
The implementation of SFAS 141R is just around the corner and will impact purchase accounting in many ways, some of which have been demonstrated above. The FASB’s movement toward fair value, principles-based standards, and international convergence involves significant policy and technical accounting changes. This statement is part of that movement. Accordingly, we recommend that you contact your financial advisor should you need any further assistance in understanding what these changes entail.
Sean Windsor is Senior Managing Director in the Transaction Advisory Services group of FTI Consulting’s Corporate Finance practice in New York City. The opinions, facts and conclusions contained herein are those of the author or the sources cited and not those of FTI Consulting Inc.