Once upon a time, the mergers and acquisitions crowd argued that complicated new accounting rules going into effect in 2009 would spur a rush of deals to close by the end of 2008.
Then the stock market collapsed, and companies are struggling to close any M&A deal at all, whether it spills into next year or not—so financial reporting executives have a lot of hard work ahead as they try to value and report transactions correctly.
“The biggest issue out there right now is companies’ ability to finance transactions,” says Neil Dhar, a partner with PricewaterhouseCoopers. “At the end of the day, it’s an accounting standard. The underlying cash flows and the overall quality of assets is what’s going to drive transactions.”
The culprit is Financial Accounting Standard No. 141R, Business Combinations, due to take effect with the beginning of the 2009 reporting year. FAS 141R requires much more upfront reporting about the nature of business deals and the fair value of the assets and liabilities that are changing hands. At the same time, however, accounting executives must also grapple with FAS 157, Fair Value Measurements, which will change how those fair values are calculated.
That collision of rules has set the M&A world spinning over the implications. Transaction costs will no longer be capitalized, but expensed upfront and charged directly to earnings. Earnouts (the amounts paid after a deal closes based on how the business performs) must be assigned an upfront value and charged as a Day 1 liability, then adjusted through earnings over the life of the agreement. Restructuring reserves (the amounts set aside to cast off underperforming assets bundled into a transaction) represent another direct hit to earnings under FAS 141R.
Nicholas
The new accounting rule has prompted the M&A community to pay close heed to how a deal will affect the balance sheet. “A lot of companies are realizing there’s got to be much more consideration of what’s really going on with these transactions,” says Stamos Nicholas, a principal at Deloitte Financial Advisory Services. “They have to think ahead of time and draw in more people to look at these deals than before.”
Nicholas says deal teams now bring in accountants, attorneys, and tax experts into the conversation earlier and more frequently. “Historically, you saw the deal people do their thing and then pass it off to the accounting people to take care of it,” he says.
All that doesn’t necessarily mean accounting requirements are driving the transactions. In fact, the accounting rules have taken a distant backseat to market concerns, according to most M&A experts. “The economic issues are clearly more dominant right now,” Nicholas says.
“It’s no different than shopping. At the right time of year, at the right time of a cycle, you can get a lower price for the same value.”
— Dan Gary,
Partner, Transaction Services,
KPMG
Dhar said he’s not expecting a fourth-quarter spike in closing transactions to beat the effective date of FAS 141R, but “we do have clients that are thinking about transactions that have had long windows, where the due diligence started early in the year,” he says. “All things being equal, it’s good to get it done by Dec. 31.”
Ellis
Jeff Ellis, managing director with Huron Consulting, says dealmakers are sensitive to the implications of FAS 141R, but aren’t negotiating deals around it. “At this point I’m not seeing a lot of transactions structured with an eye toward the impact of FAS 141R,” he says. “People are aware it’s out there, but [generally] the deal is being structured currently based on what accounting rules are today.”
Dan Gary, a partner in transaction services for KPMG, says the terms of M&A deals don’t seem to be bending as a result of FAS 141R—at least not yet. The market isn’t even sure how it will value earnouts, for example, so deals aren’t necessarily changing in anticipation of the change in reporting.
Earnout Puzzles
A bit of a paradox surrounds the reporting change for earnouts. On the one hand, they must be valued and reported at the start of the transaction, yet in many transactions the purpose of an earnout is to bridge a gap in the value perception between buyers and sellers; buyers agree to make future payments to sellers based on some agreed performance metric as a way to settle up any difference in the upfront value equation. “It remains to be seen how these things will be valued,” Gary says.
Gary
Given the inherent uncertainty involving earnouts, public companies tend to avoid earnouts when selling operations, Gary explains, but they will still agree to them when buying units—and right now that habit doesn’t seem to be changing as a result of accounting rules. Instead, the bigger driver around transaction terms is the uncertain economy and the ability to finance a deal, he says.
CONTINGENCY QUESTIONS
Below are some of the worries FASB staffers have heard from members of the accounting community concerned about FAS 141(R) to pre-acquisition contingencies.
Assessing whether a contingency is more likely than not to give rise to a liability and determining the acquisition-date fair value: Members of the audit profession have raised concerns about the availability of audit evidence to support the recognition and measurement of liabilities related to certain loss contingencies assumed in a business combination under Statement 141(R). Additionally, concerns have been raised about determining the acquisition-date fair value of preacquisition contingencies related to litigation because of the significant number of noneconomic variables and assumptions involved in assessing the possible outcomes of a legal case.
Distinguishing between a contractual and noncontractual contingency: Statement 141(R) provides a different recognition threshold for contractual and noncontractual contingencies.
Accounting for expected settlement of a noncontractual contingency when the more-likely-than-not criterion has not been met: Some constituents have expressed concerns that a target entity may have determined that a loss contingency should be recognized in accordance with Statement 5 because the entity intends to settle, but the liability does not meet the more-likely-than-not threshold for recognition of a noncontractual contingency in Statement 141(R).
Derecognition of a liability arising from a contingency recognized as of the acquisition date: Constituents are concerned that the requirement to only derecognize a contingency when it is resolved, combined with the requirement to measure a liability at the higher of its acquisition-date fair value or the amount that would be recognized if applying Statement 5, could result in liabilities being recognized indefinitely when there is no clear resolution or settlement of the contingency.
Accounting for legal fees related to a liability arising from a contingency recognized as of the acquisition date: Constituents have questions about the accounting for legal fees incurred subsequent to the acquisition date that were considered in the acquisition date fair value of a liability.
Because of these implementation issues and a number of other factors, including the Board's project on loss contingency disclosures and the IASB's project on Liabilities (IAS 37), the Chairman announced his decision on 10/29/2008 to add a project to the Board's technical agenda to reconsider the guidance in Statement 141(R) related to preacquisition contingencies.
Source
FASB Project on FAS 141R Amendment Plans (Oct. 29, 2008).
“It’s tougher to sell a company today,” Gary says. “The volume of M&A is going down, and we’re seeing companies doing things like joint ventures and other creative structures where there is not an outright buyer.”
Quinlivan
Steve Quinlivan, an M&A lawyer with Minneapolis-based firm Leonard, Street and Deinard, agrees that accounting considerations are distant concerns compared with economic considerations when negotiating transactions. “In the near term, distressed M&A is going to be the game,” he says. “Sellers basically have little bargaining power, so I wouldn’t expect to see earnouts in those structures anyway. They’ll say, ‘Here’s your cash, use it to pay off your bills, and we’ll take it from here.’”
To some extent, M&A players believed new rules for restructuring reserves would also drive new ideas about how to structure deals, Gary says. There was talk earlier this year of whether buyers would expect sellers to cull the dead-weight assets before handing over a unit, to spare the buyer from the reporting headache and hit to earnings. “It’s yet to be seen whether sellers will be open to this,” he says. “I don’t see it happening with public companies,” where shareholders wouldn’t take kindly to being left holding a bag of worthless assets.
Ellis says the M&A sector is eager to see how the Financial Accounting Standards Board ultimately amends FAS 141R regarding contingent liabilities. The Board is working on a project to ease its disclosure expectations, promising to retreat back to requirements that look more like FAS 141 before it was revised. It has not agreed, however, to throttle back the earnout requirements.
Gary says companies fortunate enough to have cash—and believe it or not, they’re still out there—are snooping around for good deals. “It’s no different than shopping,” he says. “At the right time of year, at the right time of a cycle, you can get a lower price for the same value. There are companies that have their eyes on businesses or product lines from companies that are really hurting for the money. When you’ve got a motivated seller, it’s the best time to buy it.”
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