The Financial Accounting Standards Board (FASB) has been kicking around new rules for business combinations and intangible assets for more than two years. Finally, after revisions and re-revisions to the proposed changes, which originally surfaced in February 1999, the FASB plans to issue a final statement by June 30, 2001.
At issue is accounting for goodwill. When the changes pass, as expected, companies can say goodbye to the amortization of goodwill. Instead, goodwill will be tested for impairment on an “events and circumstances” basis using a proposed impairment model. While hardly anyone will shed a tear over this move, private equity professionals are trying to grasp the different ways their lives will be affected come July 1.
For the most part, the changes will benefit GPs, sources say.
“This structure is going to provide more flexibility and less need to go through structural contortions when we acquire companies,” says Saul Fox, chief executive officer of Foster City, Calif.-based Fox Paine & Co.
And while it is the general consensus among those in the know that the positives of this rule change currently outweigh the negatives, sources are quick to add that more negatives may be revealed as time goes by.
The overall push behind the FASB’s decision to focus on accounting for goodwill is three-fold. According to the FASB, its objective was to improve the transparency of the accounting for business combinations. Additionally, international harmonization is at stake since the U.S. generally accepted accounting principles (GAAP) are unique compared with other countries. And lastly, the FASB saw it fit to make accounting for goodwill less arbitrary, at least in theory. Many believe it is somewhat of a fictional number and doesn’t match well to reality.
Bring It On
Topping GPs’ list of favorable side effects of the proposed changes is flexibility, or having the opportunity to explore alternative deal structures. Under the current rules, it benefits buyout firms to structure deals as recapitalizations despite the less than optimal tax results. Although none of the new rules will change recap accounting, in which buyers avoid amortizing any dollars, they give financial buyers some wiggle room when they are not able to structure a buy as a recap.
With goodwill amortization taken out of the mix, fewer assets have to be evaluated and the effect on earnings will be less. For example, if a firm is buying Company A, which has a book value of $70, for $150, there is an $80 premium signifying goodwill and fixed intangibles that is not reflected on the books. In a leveraged recap neither of those classes of assets would be stepped up and amortized on the acquiring company’s books. But beginning July 1, if a recap is not an option, and a purchase transaction is performed, the fixed intangibles would be stepped up and amortized. But the premium associated with the goodwill piece would not be amortized (although it would be subject to impairment tests).
However, when held up against the FASB’s new rules, a number of things either become obvious or move into question in the aforementioned scenario. First of all, accounting sources warn GPs against putting less thought into recaps just because of the upcoming rule change. This change does not eliminate financial buyers’ need to consider qualifying their transactions as leveraged recaps, says Ray Beier, a partner in the transaction services group of PricewaterhouseCoopers. They should not be led to think that they won’t suffer dilution under the new rules.
“They will still suffer dilution, although it won’t be as much depending upon the allocation between the fixed intangibles and the goodwill, but it will still be a dilution amount nonetheless,” Beier says.
Let’s go back to the purchase of Company A. Say the $80 premium was broken down into $20 worth of intangible assets and $60 worth of goodwill. Under a recap transaction, the $60 would not be amortized and the $20 would. So a recap benefits the buyer by avoiding $20 of future amortization that goes with a purchase transaction. Additionally, as part of the new pronouncement, there will be a greater focus on identifying or determining identifiable intangibles.
“As a practical matter those intangibles like contracts, franchises, trademarks and patents a lot of times have been rolled into goodwill because everybody knew they would get amortized anyway,” says Cliff Braly, a national M&A partner with Deloitte & Touche. “Now the FASB is calling for people to spend time identifying these separate from goodwill. Technically it was always mandatory, but it seemed arbitrary and not worth the effort of breaking down.”
The subject of how the new accounting rules will affect earnings and valuations remains to be seen. However, theoretically, with less cost premium or less of the amortization on the books, one assumes a company would have higher earnings. Currently, a cash acquirer can’t use the pooling method, and the mandated writing up of assets leads to greater depreciation. That has to be written off against earnings and therefore reduces them, making a company’s earnings look smaller compared with a company that has not done an acquisition. Lower earnings mean an acquirer pays less for a company that could be equal in value to its counterpart.
Enter the new rules. Over time, the FASB change will make companies’ GAAP books and records a better reflection of reality. As companies go through acquisitions they will have a chance to clean up old books and records as assets are rated up to fair market value. This, in effect, could bring multiples down because the earnings of companies will start to look more like after-tax cash flow. Bringing cash flow and earnings into closer alignment makes sense, sources say.
Earnings, however, are still a vital part of how companies are viewed and evaluated in the marketplace, especially during the process of an initial public offering. If the new rules are expected to increase companies’ earnings, then multiples will be affected and exiting through an IPO could generate a higher return.
“Earnings do not reflect how much a company is worth, and people don’t look for them to. They make computations from multiples of earnings, but they don’t buy a company based on its book value,” says Jay Abrams, an economist at Abrams Valuation Group in San Diego.
It’s no secret that the FASB rule change may affect deal flow. While some GPs predict a positive outcome, others are wary of possible future repercussions. One thing is for sure, corporate buyers who are no longer subject to the pooling rules being eliminated by the FASB will become more active in the same areas where private equity firms look for deals.
Bob Filek, also a partner at PricewaterhouseCoopers, says this benefits financial buyers who will soon have more opportunities to mingle with corporate buyers, teaming up on deals or spinning off assets to each other.
Fox, on the other hand, says the new rules give corporate buyers the ability to participate in cash transactions, making them more of a competitor to financial buyers.
“It has always been an advantage to financial buyers that corporate buyers could not do cash deals,” Fox says. “Now that the corporate buyer doesn’t have to use stock, we will see more competition from them as buyers.”
One other concern on the minds of financial buyers and the business community is the way in which accountants interpret the new rules. While the push behind the rule change is to put companies on a more level playing field, sources say subjectivity will be an issue for a while. “Changes like this, whether it’s in tax law, SEC rules or GAAP rules, they are bound to have non-intuitive side effects that can only become understood over time,” Fox says. “While this change is primarily beneficial and will help companies’ records reflect reality over time, only time will tell if there are some unintended side effects that negate some of the positive effects.”