Merger Guide for the Perplexed

On the heels of launching its new merger rule on contingent losses, FASB slaps on a "Band-Aid" that raises questions with lawyers.

Practical issues outweighed deeper merger-accounting questions on Monday, as the Financial Accounting Standards Board issued a proposed “Band-Aid” rule fix for the standard that governs business combinations. The rule change solves a perplexing problem for corporate accountants who said defense attorneys refused to provide information to help them quantify potential losses linked to lawsuits.

The current rule, 141(R), which the FASB hopes to fix with its newest proposal, requires companies to estimate and recognize the fair value of contingent liabilities — such as losses related to lawsuits — in most situations. The proposed adjustment would give companies more leeway in determining whether those losses could be quantified using fair value accounting.

Ironically, Monday was also the day that FAS 141(R) went into effect for companies with fiscal years beginning after Dec. 15, 2008. “This is the first Band-Aid for FAS 141(R) — and there will be more,” asserted Jay Hanson, national director of accounting with McGladrey & Pullen.

The Band-Aid, known as 141(R)-a, affects acquiring companies that buy businesses that are embroiled in a lawsuit, and which eventually may be forced to shell out damages or settlement payments. The rule also applies to contingent assets — the future settlement payments a company may receive — but the controversy, as well as investors, are focused on the liability question.

The new proposal eliminates the need for companies to go through the exercise of determining whether a contingent liability is contractual or noncontractual in nature, which is something companies and auditors have complained about since the rule was announced a year ago. Critics argue that the criteria has never been clear in this area.

And while an acquirer still must recognize the fair value of a potential liability on the acquisition date, it must do so only if the contingent loss can be reasonably determined. If the acquirer lacks sufficient information with respect to determining the fair value estimate, the company may revert back to kinder, gentler rules: FAS 5 and the staff guidance contained in FIN 14.

Those rules have been applied liberally by companies who in some situations have low-balled estimates, or not recognized potential losses at all. Indeed, under FAS 5, if a future settlement amount is not probable, the acquirer does not have to recognize the potential loss on the acquisition date.

However, Hanson points out that the proposed rule revision sets up several testing hurdles for companies to clear before determining whether attaining a fair value estimate is an unreasonable quest. By Hanson’s lights, the proposal language makes it clear that FASB wants companies to “try hard” to determine the fair value of contingent liabilities.

The proposed fix was issued because acquiring companies ran into two major problems with FAS 141(R): categorizing contingent liabilities as contractual or noncontractual, and getting lawyers to reveal proprietary information related to lawsuits. The litigation-related provisions of the rule were “troubling” from a functional perspective because of the way FAS 141(R) was written, says Hanson. The rule had a “decision tree” that forced companies to make impractical assessments, he explains, noting that he was “glad” FASB took action to change the rule.

For example, “the first fork in the road” with respect to FAS 141(R) requires companies to make a judgment call regarding whether the contingent liability is contractual or noncontractual in nature. A potential contractual obligation must be recognized at fair value on the acquisition date. More testing is needed before a potential noncontractual liability is recognized, however. According to FAS 141(R), a fair value estimate is required of a noncontractual liability if it is “more likely than not” that the company would lose the suit or settle, and therefore incur a loss.

But most companies, auditors and lawyers had a hard time understanding the criteria laid out in FAS 141(R) to determine whether a liability was contractual or not. What’s more, even if companies got passed the categorization debate, the second fork in the FAS 141(R) road was to estimate the liability. To do that, attorneys had to release what they considered “prejudicial” information about the suit, and they flat out refused to comply fearing the release of the information would put defendants at a disadvantage.

Despite its good intentions, FAS 141(R)-a, which will be out for public review until Jan. 15, 2009, is likely to attract comments on the disparity between the proposal and its international counterpart, IFRS 3. To be sure, FASB and international standards setters have been working together since 2002 to converge the two sets of standards into one volume of rules that apply globally. FAS 141(R)-a could be a sticking point in that process.

The main problem is that current international accounting rules require companies to fair value contingent losses in all cases. So in theory, companies operating outside of the United States are making the fair value estimates, says Hanson.

But American lawyers argue that the U.S. is too litigious to make a rule like IFRS 3 practical, because they are not about to put their clients at a disadvantage by disclosing lawsuit information that would be damaging. Such information could include loss estimates and associated data that could be used by plaintiffs to determine monetary awards or guilt. Further, sharing data with third-party valuation experts could be seen as a breach of attorney-client privilege, which would open up the information to full discovery.

More puzzling, says Hanson, is that foreign companies that acquire lawsuit-laden U.S. subsidiaries claim that they are complying with the fair value rules in IFRS 3. Meanwhile, American attorneys insist that there are no U.S. companies — parent or subsidiary — that could comply with the international rule in the litigation area.

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