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The New Accounting for M&A Deals

By Tammy Whitehouse — January 29, 2008

ccounting purists shiver at the notion that a new accounting rule would drive new behavior … but they acknowledge it often does. Now new rules for mergers and acquisitions are likely to have some far-reaching consequences for what such deals cost and how they get done.

RELATED RESOURCES Text of FAS 141R, Business Combinations (December 2007) Text of FAS 160, Noncontrolling Interests (December 2007) Related Coverage FASB Approves Merger Accounting Overhaul (Dec. 11, 2007) Merger Accounting Has Been Delayed (Dec. 4, 2007) Related Column What Comes Next for Merger Accounting (Nov. 27, 2007)

Gary

“I don’t ever really think accounting is going to kill a good deal,” says Dan Gary, a partner with KPMG’s transaction services practice. “Cash is always one of the most important factors in a deal, if not the most important. This is not going to alter cash flow, so it’s not going to deter or alter good deals.”

Still, there may be cases where marginal deals will get a pass, or certain provisions of a good deal will get more careful scrutiny, according to Gary and other M&A experts. In addition, the mechanics of how deals are negotiated may change.

Financial Accounting Standard No. 141R, Business Combinations, and FAS 160, Accounting for Noncontrolling Interests, are set to take effect in fiscal 2009 for calendar year-end companies. They generally require more recognition and measurement of acquired assets and liabilities at fair value, and more disclosure.

One of the biggest eyebrow-raisers is a requirement that transaction fees related to an acquisition be expensed as incurred and included on the income statement, rather than capitalized and amortized over time on the balance sheet. “Anytime you have something hitting the bottom line, it’s going to lead to more attention,” says David Zagore, a partner with the law firm Squire, Sanders & Dempsey.

While financing costs will continue to be capitalized, fees related to bankers, attorneys, accountants, valuation specialists, and others will be expensed each period as they are incurred—even if incurred before a prospective acquisition is announced publicly. “With significant public transactions, you may see some reordering of activity,” Zagore says. “Companies are not going to want to send a signal to the market. If the market sees a big jump in expenses, it will raise questions: Are they in the middle of a big transaction? Are they selling? Are they buying someone?”

Zagore

For example, Zagore says, in some transactions the due diligence process may be pursued differently; a buyer might do investigation and discovery on significant issues before a deal is signed, but shelve less critical issues for later scrutiny. A purchase agreement may leave more issues open to later negotiation depending on deferred due diligence. “It may delay initiating due diligence and incurring those related costs until there’s a higher degree of certainty that a transaction will occur,” he says.

While secrecy is often seen as important to negotiating the best deal, it may be difficult—especially for larger companies—to keep a deal quiet under new expensing and disclosure requirements, says Richard Quinlan, an M&A specialist at consulting firm Jefferson Wells. “There may be a limited number of parties of a magnitude that would be of interest,” he says. “With those types of transactions, there are only so many that a company can seriously be looking at that might fall into their strategy.”

It’s not clear whether the expensing requirement will result in fee pressure. “In the legal world, fees are pretty competitive already,” says Steve Quinlivan, of the law firm Leonard, Street and Deinard. “But it probably will become another reason why a company will ask upfront one more time, ‘How much is this really going to cost?’”

Quinlan

Quinlan says the rules may also create some room for bargaining. “Transaction expenses can range widely depending on the nature and the financing of a particular transaction,” he says. With financing costs capitalized, broker fees and legal feels will stand out as the biggest ticket items, he says.

“People are generally sensitive to legal expenses but there may be some pressure in the broker arena to become more competitive,” he says. “The board will have to look at those numbers, which are substantial, and shareholders may have questions, which may lead to some potential pressure.”

Gary says some fees may be more negotiable than others. “The people who find these deals and find others to invest—there’s a big premium for that service,” he says. “I don’t think they’re going to forego fees.”

Deal Structure

New rules around contingencies and contingent consideration also may drive some changes in how deals are done, experts say. The new accounting standards generally require more valuation and recognition around future projections, which may drive dealmakers to strike tighter terms.

STANDARD DETAILS From FAS 141R: Assets and Liabilities Arising from Contingencies This Statement improves the completeness of the information reported about a business combination by changing the requirements for recognizing assets acquired and liabilities assumed arising from contingencies. Statement 141 permitted deferred recognition of preacquisition contingencies until the recognition criteria for FASB Statement No. 5, Accounting for Contingencies, were met. This Statement requires an acquirer to recognize assets acquired and liabilities assumed arising from contractual contingencies as of the acquisition date, measured at their acquisition-date fair values. An acquirer is required to recognize assets or liabilities arising from all other contingencies (noncontractual contingencies) as of the acquisition date, measured at their acquisition-date fair values, only if it is more likely than not that they meet the definition of an asset or a liability in FASB Concepts Statement No. 6, Elements of Financial Statements. If that criterion is not met at the acquisition date, the acquirer instead accounts for a noncontractual contingency in accordance with other applicable generally accepted accounting principles, including Statement 5, as appropriate. This Statement provides specific guidance on the subsequent accounting for assets and liabilities arising from contingencies acquired or assumed in a business combination that otherwise would be in the scope of Statement 5. It requires that an acquirer continue to report an asset or a liability arising from a contingency recognized as of the acquisition date at its acquisition-date fair value absent new information about the possible outcome of the contingency. When new information is obtained, the acquirer evaluates that new information and measures a liability at the higher of its acquisition-date fair value or the amount that would be recognized if applying Statement 5, and measures an asset at the lower of its acquisition-date fair value or the best estimate of its future settlement amount. From FAS 161: Noncontrolling Interests in Consolidated Financial Statements This Statement shall be applied prospectively as of the beginning of the fiscal year in which this Statement is initially adopted, except for the presentation and disclosure requirements. The presentation and disclosure requirements shall be applied retrospectively for all periods presented, as follows: The noncontrolling interest shall be reclassified to equity in accordance with paragraph 26 of ARB 51, as amended by this Statement. Consolidated net income shall be adjusted to include the net income attributed to the noncontrolling interest. Consolidated comprehensive income shall be adjusted to include the comprehensive income attributed to the noncontrolling interest. The disclosures in paragraphs 38 and 39 of ARB 51, as amended by this Statement, shall be provided. Paragraph 31 of ARB 51, as amended by this Statement, requires that the noncontrolling interest continue to be attributed to its share of losses even if that attribution results in a deficit noncontrolling interest balance. Source Text of FAS 141R, Business Combinations (December 2007). Text of FAS 160, Noncontrolling Interests (December 2007).

Contingencies are uncertainties that may result in future assets or liabilities: potential legal claims, tax disputes, environmental hazards, and other events where the outcome and future cost may not be fully known at the time a deal is reached. Contingent consideration is a provision used in acquisition agreements that sets a current selling price along with future payments from the buyer to the seller contingent on certain performance hurdles being met.

Earlier and more specific recognition of contingencies, for example, is likely to lead to more clearly defined indemnification, or limits on liability in acquisitions, Zagore says. “Rather than having general indemnification, there may be more specific indemnification for specific issues,” he says. “In the end, you’re going to have more concentration on the details and a higher amount of scrutiny as to what constitutes the fair value of a contingency. It’s going to be a more cumbersome and detailed enterprise.”

Gary contends that heightened scrutiny and disclosure around contingencies could cause marginal deals to collapse. “People are going to look a lot harder at companies with a lot of contingencies,” he says. “Companies typically don’t have a big appetite for earnings volatility. This new accounting makes these contingencies hit earnings period to period. If there are a lot of contingencies that are difficult to estimate and the company has a low appetite for earnings volatility, those are the deals that will get a much harder look.”

As for contingent considerations, also called “earn-outs,” Quinlan says new rules are likely to compel buyers to push for shorter earn-out periods and explain them more clearly to assure shareholders understand them. “I don’t see the market moving away from them,” he says. “They’re a very effective means of bridging the gap in terms of buyers’ and sellers’ perception of value.”

The Fine Print

Other provisions requiring more upfront recognition and measurement are likely to drive decision making as well, Quinlivan says. For example, acquiring companies will be required to state more plainly when they’re eliminating product lines or closing facilities after an acquisition. “How is that going to look to investors?” he says.

Quinlivan

Deals involving in-process research and development—which cannot be written off as readily under new rules—also are likely to get a closer look, especially in certain sectors such as pharmaceuticals or technology where R&D is a big component of the business, Quinlivan says. “Technology companies that have rested acquisitions on those favorable provisions [of old rules] might be taking a second look at what deals they do and whether they’re still going to be accretive,” he says.

They’ll also have to look at how new rules around reflecting minority or non-controlling interest will affect contractual agreements. “Companies with large non-controlling interest need to check loan covenants to see if the changes will cause compliance problems,” he says.

Quinlivan and others say good deals will still get done under new accounting rules, but the new rules are certainly going to drive new sensitivity about how financials statements will be affected. “Companies don’t want to have to explain to investors quarter after quarter why costs are coming through the income statement,” he says.

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