The New M&A Accounting

The FASB has rolled out the results of its first major joint project with the International Accounting Standards Board: two new standards, which the board claims will “improve, simplify, and converge internationally the accounting for business combinations.”

Converge, certainly; improve, maybe. But simplify?

John Formica, partner in PricewaterhouseCoopers’ National Professional Services Group, believes that certain aspects of the accounting will indeed be simpler under FAS 141(R), Business Combinations, and FAS 160, Noncontrolling Interests in Consolidated Financial Statements, which will take effect for fiscal years beginning after Dec. 15, 2008. “The FASB has made an effort to consolidate the accounting literature for business combinations into this new standard, so the guidance will be all together now,” he notes.

“Having said that, I do think that there are some complexities that have been introduced into the standard, largely due to the movement toward expanded use of fair value measures,” Formica adds. “Valuation in particular will be an area that, at least in the beginning, will add some complexity to the process.”

Fair value measures are a key feature of 141(R) in particular. The FASB’s approach here takes the view that an acquired business, as well as all underlying assets and liabilities, should be recorded at fair value. In the previous accounting, some assets and liabilities were recorded at fair value, while others were not.

“The big impact is going to come in the analysis of what the fair value is and who’s going to set that value,” says Murray Beach, president of investment banking firm Boston Corporate Finance. “The auditors have an interest in setting that number, but there are probably very few reliable mathematical formulas that really are going to give you much guidance for this. It’s a very difficult concept.” The difficulties will need to be ironed out by the accounting industry and the appraisal industry, he adds. “Essentially, there’s going to be a lot of money paid and made trying to sort it out.”

There’s no question but that the valuation of some assets will involve a considerable degree of subjectivity. This doesn’t bother Greg Forsythe, a director in Deloitte Financial Advisory Services’ valuation practice and a member of the FASB’s valuation resource group. “Valuation has a lot of subjective aspects to it; this is the reason, to a large degree, why the stock market goes up and down every day,” he points out. “Valuation is a range game. If anyone says, ‘X is worth a certain number of dollars and that’s it,’ he’s making an erroneous statement. There’s a lot of subjectivity and a lot of variables. People who are having to deal with this accounting will have to deal with those subjective aspects.”

Transaction expenses and restructuring charges will no longer be capitalized as part of the acquisition. Under the new rules, these items are not regarded as part of the fair value of the acquired asset, but rather as part of the cost of the acquisition, and will be expensed. “I certainly expect increased volatility to earnings as a result of the standard because restructuring costs generally are going to be hitting earnings after the transaction, acquisition costs will be hitting earnings prior to the transaction, and other adjustments as well will also be going through earnings, consistent with the fair value principle underlying the standards,” says Formica.

Forsythe is more guarded. Volatility in earnings “is a possibility,” he says. “Some of the accounting is changing such that there will be a need to have another look at value estimates subsequent to an acquisition. And if these estimates change, this could well lead to an expense flowing through earnings and causing earnings to fluctuate more than they might have done in the past.”

The accounting for earn-outs will likely be trickier, too. Under the current rules, performance-based contingent payments are considered part of the cost of the deal and don’t have to be accounted for until they are paid. Under 141(R), they will be recorded at fair value on the acquisition date, and changes in that value will be recorded in earnings.

As businesses review their growth plans for the coming year, they should be taking a hard look at the new regulations. “It’s a call to action for companies to think about the impact of the standards and to get themselves ready to go before the standards become effective next year,” says Formica. Forsythe agrees: “Any company that’s out there performing acquisitions is going to have to be really on top of this,” he observes.

Investment bankers will have their work cut out for them, too. “I’m going to be reading a lot of articles over the next year,” says Beach.