M&A Rule Is the First to Go Global

FASB issues FAS 141(R) and FAS 160, and hails the standards as the first significant convergence milestones. Now companies have to deal with the fallout.

The Financial Accounting Standards Board took one giant leap for global accounting convergence on Tuesday when it issued a revision to its rule on business combinations and a new rule on how to account for minority interests. The new standards “represent completion of FASB’s first major joint project with the International Accounting Standards Board,” noted FASB member G. Michael Crooch.

But while the respective accounting boards move forward to harmonize international standards with U.S. generally accepted accounting principles, corporate accountants will have their hands full dealing with the fallout. Indeed, the new rules — FAS 141(R), Business Combinations, and FAS 160, Noncontrolling Interests in Consolidated Financial Statements — represent a major departure from the historical cost accounting that many companies use now. “The most difficult part of implementing FAS 141(R) is coming to grips with fair value principles that were never required before,” opined Jay Hanson, national director of accounting for audit firm McGladrey & Pullen.

Financial statement users and preparers talked about FAS 141 and fair value with “a wink and a nudge,” says accounting expert Jack Ciesielski, editor and publisher of the Analyst’s Accounting Observer newsletter. “But under FAS 141(R), you are required to recognize [assets and liabilities] at fair value.”

The FASB standards will take effect for fiscal years beginning after December 15, 2008. IASB is due to release its versions of the new rules early next year, which are said to be very similar in principle but diverge on some details, according to Jay Hanson, national director of accounting for audit firm McGladrey & Pullen. Those disparities include provisions that deal with income taxes, operating leases, and employee benefits.

A “significant change” is set to occur with the way companies record M&A transactions in which the acquiring company buys less than 100 percent of a target company, Hanson told CFO.com. In those cases, contingent considerations will be accounted for differently under FAS 141(R) than they currently are. A contingent consideration is an obligation to make payments based on the outcome of future events, such as a payouts tied to lawsuits or so-called earnouts.

For instance, consider a situation in which a large turbine manufacturer offers an earnout to close a deal with a small pipe fabricator. The manufacturer offers to buy 60 percent of the pipe fabrication company for $70 million, and promises to add $10 million to the purchase price if the pipe company hits certain profitability milestones over the next two years. The $10 million earnout offer is a contingent consideration that under the current FAS 141 is not recorded on the balance sheet of the acquiring company until the payout is made.

However, under FAS 141(R), the turbine maker must determine the estimated fair value of the future payout and record it as part of the purchase price on the day of the sale. In addition, when the payout is finally made, the turbine company must record the difference between the estimated fair value and the actual payout as an expense or gain.

The valuation of future assets and liabilities will likely cause tension between companies and their auditors, said Hanson, because companies may aim high with their estimates in order to get a bump in earnings when the payout is made. What’s more, Hanson points out that the auditing industry’s watchdog, the Public Company Accounting Oversight Board, has criticized accounting firms for not doing enough work to verify the calculations provided by valuation specialists that work up fair-value estimates. The PCAOB has cited audit firms for not testing the numbers, models, and management’s assumptions to their liking, which probably means heightened scrutiny by auditors as they review corporate fair value estimates.

FAS 141(R) also addresses negative goodwill,
which is the gain created when a company buys an asset — including another company — for less than the asset’s current fair value, or current market price. The revised rule forces companies to carry negative goodwill as an immediate gain on the day of the sale, rather than write down the gain to zero through a series of allocations, as they currently do.

“The negative goodwill may help the income statement, but it is not a gain that you can spend,” asserted Ciesielski, who noted that buying a company at a bargain price is rare.

Merger-related transaction costs will also be tossed out of purchase prices under FAS 141(R). The new rule does not allow, for example, fees charged by investment banks, attorneys, and valuation specialists to be lumped into the price of an acquisition, as is currently allowed, said Ciesielski.

FASB also approved the release of FAS 160, which affects how companies record minority interests of a subsidiary. The new rule was passed as a prerequisite to FAS 141(R), to make sure overarching principles remain consistent. FAS 160 clarifies that a noncontrolling or minority interest in a subsidiary is considered an ownership interest for purposes of the consolidated financial statements. As a result, when FAS 160 goes into effect in two years, all companies that report minority interests in subsidiaries will record that interest as equity.

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