FASB Changes the Rules on Accounting for Business Acquisitions
In its ongoing focus towards fair value accounting, the Financial Accounting Standards Board (FASB) issued FAS 141R in December 2007, which set forth new rules on accounting for business acquisitions. As a result, for “business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008,” valuation experts and auditors need to understand and correctly apply key changes to the standard. The key changes are summarized below.
In the past, under FAS 141, the purchase price was allocated as of the acquisition date but contingent consideration was recorded when the contingency was resolved and as an adjustment to goodwill. FAS 141R requires that the fair value of all assets and liabilities be recorded at the acquisition date.IMPACT: For valuation experts, contingent assets and liabilities (specifically earn-out or other contingent consideration) need to be fair valued as of the date of acquisition. The primary method for estimating this contingent value is a probability approach that looks at the upper limit of the contingent consideration stream over the agreed upon term and applies a probability of success based on qualitative discussions with management or the forecasted financial statements that were applied in the valuation.
In the past, the definition of “fair value” had several sources including FAS 141, FAS 142, and FAS 144. In addition, the terms “business” and “business combination” were defined by various statements and EITFs. FAS 141R now defines these terms as follows:
- Fair Value. “Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” (FASB Statement No. 157, Fair Value Measurements, paragraph 5).IMPACT: This definition assumes that fair value is determined in accordance with highest and best use by other market participants, regardless of the acquirer’s intended use of the asset.
- Business and Business Combination
- Business. “A business is an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members, or participants.”
- Business Combination. “A business combination is a transaction or other event in which an acquirer obtains control of one or more businesses. Transactions sometimes referred to as ‘true mergers’ or ‘mergers of equals’ also are business combinations as that term is used in this Statement.”IMPACT: Based on these definitions, more transactions will qualify as business combinations that will require fair value assessment under this standard. For example, a step acquisition whereby an acquirer purchases an additional 10% interest of a previous 40% owned company is now considered a business combination.
In the past, the announcement date was used to assess value. The new standard pushes that date to the acquisition or closing date.IMPACT: Business valuation experts and auditors will now have a shorter window in which to complete and review these valuation reports, which may increase fees for both parties to complete the work in an accelerated timeframe.
Acquisition and Restructuring Costs
In the past, these costs were capitalized and recorded as part of the purchase price. Now, they need to be treated separately from the business combination and expensed as occurred prior to or subsequent to the acquisition.IMPACT: While timing changes look to increase potential valuation and audit fees, acquirers see added pressure to lower these fees in order to minimize the impact on their pre-acquisition financial performance or disclose additional detail for non-recurring fees.
In-Process Research and Development (IPR&D)
In the past, the fair value of IPR&D was expensed if there was no alternative future use. The new standard continues to look at the fair value of IPR&D but treats them as indefinite-lived assets subject to amortization upon completion, impairment, or abandonment.IMPACT: Valuation experts will have a more difficult time assessing the value of IPR&D and the need to amortize these assets will impact the acquirer’s future earnings.
Other Changes that Impact Financial Reporting
- Negative Goodwill. Excess fair value of net assets was previously recorded as negative goodwill. Under 141R, this excess is booked as a gain on the income statement.
- Deferred Tax. Similar to other assets and liabilities, changes in these deferred tax items will not reduce goodwill as an adjustment to the purchase price, but will be expensed.
Under the new rules, we don’t see tremendous changes to our approach and methodologies in valuing intangible assets. Instead, in addition to accelerated timing on turnaround, we see increased pressure on due diligence to qualify and quantify contingent liabilities, specifically contingent consideration. These increased responsibilities transfer over to the audit side in their review. In response and reaction to these changes, we anticipate that buyers will at the least reconsider deal structure and possibly move away from contingent consideration to minimize the complexity of the purchase price allocation and ongoing tax and amortization expense impact to their financial statements. As with most new pronouncements, we expect the market to adjust to these changes over the next two to three years. In the short-term, we expect to see more deals that will fall under FAS 141R and result in increased fees for the valuation and to sort out, translate, and reconcile these issues to the prior standard.