Restatements related to business acquisitions have jumped in steady increments since the early part of the decade, in large part as a result of allocation and valuation issues, experts say.
In 2001 and in 2002, restatements resulting from business combinations hovered in the upper 80s, but by 2006 the number of such restatements hit 278, according to data from Audit Analytics.
Cheffers
Mark Cheffers, CEO of Audit Analytics, says the figure includes a host of restatements related to acquisitions, mergers, disposals, or other types of reorganization events. “It’s a fairly complex area that includes intangible asset considerations, valuations, unrecorded liabilities, unrecorded assets—restatements of that nature,” he says.
Accounting for business acquisitions is governed by Financial Accounting Standard No. 141, Business Combinations, and FAS 142, Goodwill and Other Intangible Assets. The Financial Accounting Standards Board is in the midst of a long project to rewrite business combination rules with a draft statement to replace FAS 141 and converge U.S. Generally Accepted Accounting Principles with international rules.
As written today, Statement 141 requires companies to allocate the total purchase price of an acquisition to its various assets and liabilities at fair value. For physical assets, that is usually straightforward enough, but things get trickier when valuing intangible assets, says Charles Mulford, director of the Georgia Tech Financial Reporting & Analysis Lab. “You have to identify all the assets, even assets not on the acquired company balance sheet,” he explains. That includes patents, trademarks, licenses, customer lists, noncompete agreements, and the like.
Often the price a company pays to acquire an entire business is greater than the sum of its collective assets, and that amount is allocated to goodwill, Mulford says. But that’s a sensitive figure to put on the balance sheet because all other acquired assets have finite lives and are amortized. Goodwill, on the other hand, is seen to have infinite life and is not amortized.
Mulford
“This is where companies will get tripped up in terms of acquisition accounting,” Mulford says. “It’s an important figure because it affects not only the balance sheet and income statement in the year of acquisition, but also future income statements, because you’re amortizing the finite-lived assets.” Mulford said the Securities and Exchange Commission looks carefully at goodwill in business acquisitions and has been known to call for restatements related to that issue.
In some cases, companies have been determined to have allocated too much of the upfront purchase price to in-process research and development, which enables the acquiring company to expense more of the purchase price upfront. On restatement, Mulford says, companies in that situation have shifted more of the purchase price to goodwill. “Companies would like to expense more at the time of acquisition,” he says. “It’s a nonrecurring charge and investors tend to ignore it.”
EXPOSURE DRAFT
An excerpt from the exposure draft on a replacement for FAS 141 follows.
This Exposure Draft proposes that in a business combination that is an exchange of
equal values, the acquirer should measure and recognize 100 percent of the fair value of
the acquiree as of the acquisition date. This applies even in business combinations in
which the acquirer holds less than 100 percent of the equity interests in the acquiree at that
date. In those business combinations, the acquirer would measure and recognize the
noncontrolling interest as the sum of the noncontrolling interest’s proportional interest in
the acquisition-date values of the identifiable assets acquired and liabilities assumed plus
the goodwill attributable to the noncontrolling interest.
…
This Exposure Draft proposes that a business combination is usually an arm’s-length
transaction in which knowledgeable, unrelated willing parties are presumed to exchange
equal values. In such transactions, the fair value of the consideration transferred by the
acquirer on the acquisition date is the best evidence of the fair value of the acquirer’s
interest in the acquiree, in the absence of evidence to the contrary. Accordingly, in most
business combinations, the fair value of the consideration transferred by the acquirer
would be used as the basis for measuring the acquisition-date fair value of the acquirer’s
interest in the acquiree. However, in some business combinations, either no consideration
is transferred on the acquisition date or the evidence indicates that the consideration
transferred is not the best basis for measuring the acquisition-date fair value of the
acquirer’s interest in the acquiree. In those business combinations, the acquirer would
measure the acquisition-date fair value of its interest in the acquiree and the acquisition-
date fair value of the acquiree using other valuation techniques.
This Exposure Draft proposes a presumption that the best evidence of the fair value
of the acquirer’s interest in the acquiree would be the fair values of all items of
consideration transferred by the acquirer in exchange for that interest measured as of the
acquisition date, including:
a. Contingent consideration
b. Equity interests issued by the acquirer
c. Any noncontrolling equity investment in the acquiree that the acquirer owned
immediately before the acquisition date.
This Exposure Draft proposes that after initial recognition, contingent consideration
classified as:
a. Equity would not be remeasured
b. Liabilities would be remeasured with changes in fair value recognized in income
unless those liabilities are in the scope of FASB Statement No. 133, Accounting for
Derivative Instruments and Hedging Activities. Those liabilities would be accounted
for after the acquisition date in accordance with that Statement.
…
This Exposure Draft proposes that the costs that the acquirer incurs in connection
with a business combination (also called acquisition-related costs) should be excluded
from the measurement of the consideration transferred for the acquiree because those
costs are not part of the fair value of the acquiree and are not assets. Such costs include
finder’s fees; advisory, legal, accounting, valuation, other professional or consulting fees;
the cost of issuing debt and equity instrument; and general administrative costs, including
the costs of maintaining an internal acquisitions department. The acquirer would account
for those costs separately from the business combination accounting.
Source
Proposed Statement Of FAS
Business Combinations A Replacement Of FASB Statement No. 141 (Financial Accounting Standards Board; June 30, 2005)
Taub
Scott Taub, managing director at Chicago-based Financial Reporting Advisers and former SEC deputy chief accountant, said the most common issue in business combinations is the allocation of purchase price to intangible assets. “If you have acquisitions where a large amount of the purchase price went to goodwill, someone looking at the financials is likely to ask questions,” he explains. “Have you identified all the intangible assets? And have you valued them appropriately?”
Other errors include failing to recognize liabilities for contingencies, Taub says, which means the liability only kicks in for the acquiring company if certain conditions are met or present.
Also, companies can incorrectly value the consideration issues related to the purchase, Taub says—especially prevalent where companies have issued exotic securities to finance the acquisition. “There are all kinds of valuation issues that come into play with regard to those securities,” he says.
Michael Mard and Steven Hyden, managing directors at the Financial Valuation Group and co-authors of a book that focuses on valuation for financial reporting purposes, say the turnover in auditors of recent years may also play a part in acquisition-related restatements.
Hyden
“There are certain due diligence procedures that have to be followed and each firm would look at valuation issues or valuation conclusions in a different way,” Hyden says. “A lot of times we see when a client changes audit firms our prior work is re-examined by the new auditor, so they can get themselves satisfied with what was done in the past.”
Mard
Mard says the growing use of fair value in accounting magnifies the effect of valuation on the financial-reporting process, causing valuations in general to get a closer look by everyone along the reporting chain. The give-and-take of establishing supportable valuations doesn’t necessarily result in overturned valuations, he says, but “it’s more like a taffy pull than a black-and-white rejection. Accomplished valuation people will disagree on the number, usually within a narrow range. They’re not looking to totally overturn valuation. They want to get comfortable with the assumptions.”
Taub says a change in the learning curve around fair value has definitely occurred, leading to more questions and discovery of errors. “People are becoming more knowledgeable about fair value and are paying more attention to whether things are being appropriately valued,” he contends. “Ten years ago, if you used a valuation specialist in doing your purchase price allocation, the specialist’s work likely would be accepted without any questions. Now accountants know this stuff, and investors know it as well. More questions are being asked and people are paying more attention to these issues.”
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