Preferred Stock; Rethinking M&A; More

Brace for bigger liabilities on the balance sheet and a larger ratio of liabilities to equity if the Financial Accounting Standards Board stays the course in redefining preferred stock as a liability.

As complexity of financial engineering has blurred the line between liabilities and equities, FASB is working on a comprehensive project to help redefine where various items belong on the balance sheet. So far, the Board has stated its preference for a “basic ownership” approach. That would result in preferred stock, long regarded as equity, being reclassified as a liability, according to Charles Mulford, director of the Georgia Tech Financial Analysis Lab.

Mulford

“Under the basic ownership approach, they’re defining equity as the last claim, the essence of what ownership is,” Mulford says. “It’s the last in line if the company fails, but the first to reap the rewards of success.” Preferred stock would be seen as a liability instead of equity because it carries a required dividend payment.

A recent Georgia Tech study examined 746 companies with outstanding preferred stock and positive shareholder’s equity across 10 broad industry sectors, to see how the change might affect results. The study compared balance sheet and income statement measures of leverage, interest coverage, and pretax income to determine the likely effect of FASB’s plans.

In a report titled “FASB’s Basic Ownership Approach and a Reclassification of Preferred Stock as a Liability,” the lab determined that companies are likely to see an increase in overall liabilities, with an increase in the liabilities-to-equity ratio of 4.17 percent. The study found the median company would witness a 6.4 percent decline in pretax income and a 6 percent decline in times-interest-earned.

Mulford says those could be sobering changes for companies, with net income defined differently, because preferred dividends would be subtracted as an expense through earnings. He says companies likely will consider refinancing outstanding preferred stock with common equity or debt to offset the effects.

Merger Accounting May Inspire New M&A Strategies

The new changes in how to account for mergers and acquisitions are likely to prod a large number of dealmakers to revise their strategies.

That’s the finding of a recent Deloitte poll of 1,850 executives, where 40 percent of respondents said Financial Accounting Standard No. 141R, Business Combinations, would cause them to think more carefully about the deal strategy or the effect deal activity would have on financial statements.

Nicholas

Stamos Nicholas, head of Deloitte’s national business valuation practice, says the credit crunch and the accounting rule combined are squeezing the number of deals getting done and the nature of the deals themselves. M&A specialists are studying FAS 141R to assure they know how transactions will get reported and above all how a deal will affect earnings now that deal-making costs will be expensed when the deal closes.

FAS 141R is an early feather in the cap of accounting rulemakers—here and overseas—who are trying to converge U.S. and international rules onto a single common platform. FAS 141R makes a number of changes in how mergers, acquisitions, and other forms of business combinations are reported to investors, beginning with fiscal years ending after Dec. 15.

The Deloitte poll shows only 4 percent of companies consider themselves fully versed in the implications of FAS 141R for financial reporting going forward. That suggests companies still aren’t entirely certain how they’ll proceed, Nicholas says. “There are a lot of intricacies in these rules, and they have a lot of different implications and offsetting issues,” he says. “A lot of companies are still digesting what all the implications are.”

In addition to upfront expensing of deal costs, for example, companies are studying how best to structure “earnouts” given the new requirements for them to be remeasured over the life of the arrangement. An earnout is a purchase-price provision that establishes future payments based on an entity’s performance following a deal. “A company can be remeasuring a deal for many years down the line,” Nicholas says. “You can imagine the volatility that is going to occur.”

To aid implementation and facilitate comparison of U.S. and international rules, PricewaterhouseCoopers has prepared a guide that addresses business combination and non-controlling interest accounting under both U.S. Generally Accepted Accounting Principles and International Financial Reporting Standards. The guide clarifies the principles of the new standards and highlights areas where implementation may be tricky for companies preparing financial statements under GAAP or IFRS.

PwC’s guide also provides some focus to the challenges of accounting for intangible assets and goodwill after a merger or acquisition, areas that continue to be different in U.S. GAAP compared with IFRS.

No Good News on Auction Rate Securities

Holders of auction rate securities took a $1.85 billion writedown through the first quarter of 2008, and the second quarter likely will reflect even bigger writedowns, according to a recent analysis.

Of 402 public company filings studied by Pluris Valuation Advisers, only 185 ARS holders wrote down the value of those investments based on failed auctions in recent months and the collapse of the market for auction rates. Some 217 holders of such securities continued to account for the securities at full par value, even though auctions have ground to a halt for lack of willing buyers.

“Even with the same types of auction rate securities, we’re seeing very big differences in how companies are treating them,” says Espen Robak, president of Pluris. “We’re hearing informally through auditors and ARS holders that a lot of companies that didn’t take any impairments in the first quarter are going to do it in the second quarter.”

Given the timing of the market collapse (widespread auction failures began in mid-February) it’s not surprising to see widespread diversity in how companies are tagging their value, Robak says. The study notes that the valuation conundrum—whether to carry the securities at par value or to reflect deep writedowns—is compounded by investors’ views. It says for many investors the connection between liquidity and valuation is not entirely intuitive and that investors think of impairments as resulting from a decline in credit quality, not a reduction in liquidity.

Robak

“It’s reasonable given how new this phenomenon is and what a shock to the system it’s been,” he says.

Robak says Pluris will continue to look for more companies reporting their ARS holdings and will track how second-quarter numbers differ from the first. He says the firm is hoping to determine whether different types of auction rate securities—those backed by student loans, closed-end funds, collateralized debt obligations, or municipal bonds, for example—are being treated differently. Many filings lack the detail necessary, however, to perform such an analysis, he says.

“The surprising thing to us was not really that there was inconsistency, but that there seems to be a number of companies that didn’t take writedowns at all, and they were very skimpy in their disclosures about how they valued these securities,” he says. He predicted the Securities and Exchange Commission is likely to take an interest in such filings and ask for more information.