The march toward fair-value accounting took another notable step in December when the Financial Accounting Standards Board revised FAS 141, its rule on business combinations. The new FAS 141(R) requires companies that acquire assets or assume liabilities in a deal to record the items at their acquisition-date fair value rather than at historical costs.
Greg Rogers, president of consulting firm Advanced Environmental Dimensions, warns that while fair-value accounting may provide a much-needed dose of accounting reality, it will also result in short-term pain for companies and their auditors as they come to grips with the new policies regarding contingent liabilities.
A contingent liability is an obligation to make payments based on the outcome of future events, such as lawsuits or so-called earnouts. As companies grapple with, for example, environmental-cleanup liabilities, FAS 141(R) replaces the long-standing “probable and reasonably estimable” criteria (stipulated under FAS 5) with fair-value measurement. “As a result, buyers in M&A transactions should expect to book many more contingent liabilities and at significantly higher cost estimates than reported by sellers,” Rogers says.
Jay Hanson, national director of accounting for audit firm McGladrey & Pullen, also expects a “significant change” in the way companies record M&A transactions that feature earnouts. Consider a paper producer that buys 70 percent of a forest-products operation for $100 million, promising to add $25 million to the purchase price if the forest-products company hits certain profitability milestones over the next two years. The $25 million earnout is a contingent consideration. Under the old FAS 141 it would not be recorded on the balance sheet of the acquiring company until it was paid out, but under FAS 141(R) the paper company 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. When (and if) the payout is finally made, the paper producer must record the difference between the estimated fair value and the actual payout as an expense or gain.
The advent of FAS 141(R) comes on the heels of last November’s FAS 157, which provides a framework for assessing the fair value of a range of assets and liabilities. The matter is a contentious one among companies, auditors, standard-setters, and regulators, with plenty of disagreement regarding the practical impact of such a move. Indeed, expect the year ahead to feature several debates about how fair value is applied to pensions, employee benefits, operating leases, sales contracts, and M&A transactions.
The International Accounting Standards Board finalized its revised business-combination rule last month. As expected, the rules are largely in lockstep but diverge on some details regarding income taxes, operating leases, and employee benefits. FASB and the IASB plan to iron out the kinks over the next year or so.
Combination Transformation
While FAS 141(R) will change the way companies account for contingent liabilities as part of business combinations, the revised standard, and a new companion rule on minority interests (FAS 160), will affect other line items as well.
Negative goodwill:
Companies must 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 did in the past.
Merger-related transactions:
These expenses, which include fees charged by investment banks, attorneys, and valuation specialists, can no longer be lumped into the price of an acquisition.
R&D assets:
R&D assets acquired in business combinations will be recognized separately from goodwill at their acquisition-date fair values (this supersedes their treatment under FAS 4).
Deferred tax benefits:
DTBs must now be recorded either in income from continuing operations in the period the acquisition took place or directly in contributed capital (thus amending the provisions of FAS 109).
FAS 160:
The new rule, which is effective for fiscal years beginning on or after December 15, 2008, clarifies that a noncontrolling or minority interest in a subsidiary is considered an ownership interest, and therefore is recorded as equity in the financial statement of the acquiring company.
