The staff of the Securities and Exchange Commission recently took a subtle but significant swipe at an accounting practice now steadily falling out of vogue: structuring business mergers and other transactions so they look pretty on financial statements.
In this case, the SEC staff focused on application of new rules for business mergers that took effect in 2009 and are poised to be even more important in 2010. The new rules ended some long-held conventions about how to account for common transactions among unrelated business entities. And SEC staff has sent an important signal that they expect companies and their auditors to abandon rigid, form-over-substance practices of the past.
Stacey
“It’s a brave new world,” says Carol Stacey, vice president for training firm SEC Institute and a former SEC staffer herself. “With these new standards you have to use judgment and apply it.”
The standards in question were adopted as Financial Accounting Statement No. 141R, Business Combinations and FAS 160, Non-controlling Interests in Consolidated Financial Statements. They took effect in 2009 and have since been housed in the Accounting Standards Codification as Topic 805, Business Combinations, and Topic 810, Consolidation.
While merger and acquisition activity dropped off amid the recession last year, M&A deals are expected to revive in 2010, says Stacey, so the issue is likely to crop up for any number of companies as the year progresses.
At a recent national conference of the American Institute of Certified Public Accountants, Doug Parker, a professional accounting fellow for the SEC, took up the question that burns the phone lines at the Commission: whether a new company established to cement a business combination should always be viewed as the acquiring company. It’s an important distinction, because it has implications for whether assets and liabilities that change hands in a transaction will be measured at fair value (referred to as “new basis” accounting) or whether values will be carried over as they are currently reflected on the target company’s books (“carryover” basis).
Using a tongue-in-cheek analogy, Parker compared that question to one he and his college beer buddies used to ponder: whether bowling is actually a sport. The best they could figure was that it depends on how you define “sport”—and likewise, he wouldn’t expect sweeping agreement among the financial reporting world on whether a “newco,” as accountants call it, should always be deemed the acquirer in a business merger.
“It’s a brave new world. With these new standards you have to use judgment and apply it.”
—Carol Stacey,
Vice President,
SEC Institute
Parker said he’s seen a bias among financial-statement preparers lately to avoid interpretations that would lead to new basis accounting. Under current market conditions, that generally would result in higher earnings-based valuations, he said.
Adam Brown, a partner with BDO Seidman, says practice under old Generally Accepted Accounting Principles was fairly well established that a newco surviving a business combination would be deemed the acquirer, and therefore assets and liabilities would be measured at fair value. But, he adds, “You can’t find any of this written down anywhere. These are just informal practice views.”
At the AICPA conference, Parker cautioned against applying the absolutes of past practices to reach accounting conclusions today just because those old habits lock down a favorable interpretation. “The staff does not believe that a surviving ‘newco’ will always be the accounting acquirer in all circumstances,” he said. “You will need to evaluate all the applicable criteria in the Codification’s Business Combinations topic in light of specific facts to make this determination.”
Parker’s remarks “tend to soften the perception that in 100 percent of cases you’re going to do new basis,” Brown says. “For some people, that is a fairly significant change.”
BUSINESS COMBO EXAMPLES
Below are some examples from SEC Professional Accounting Fellow Douglas Parker’s speech of business combinations and circumstances in which the newco should be considered the accounting acquirer:
In the first example, Entity C issues new shares to Entity A in exchange for cash and then uses that cash to buy back shares from Entity B. From Entity A’s perspective, a business combination has occurred. Entity A is (ordinarily) the accounting acquirer and Entity C the accounting acquiree. In its consolidated financial statements, Entity A will recognize and measure 100% of Entity C’s assets and liabilities pursuant to the acquisition method.
What about Entity C’s separate financial statements? From Entity C’s perspective, there has been no business combination for which it is the accounting acquirer. Entity C accounts for the issuance and repurchase of shares as equity transactions. This is what most people would refer to as a recapitalization, although that term is not defined in GAAP.
In the next example, Entity A forms a new wholly-owned subsidiary to which it contributes cash. This NEWCO then merges with and into Entity C with Entity C surviving.
There are probably a dozen other ways to structure the same transaction, but they all share something in common: the outcome is economically the same. I think most of us also would agree that a business combination has taken place at some level. The real question, and one with which practice has wrestled with for decades, is whether and when a NEWCO should be considered the accounting acquirer.
Codification Topic 805 deals with business combinations and provides some relevant guidance on how to evaluate a NEWCO.
“A new entity formed to effect a business combination is not necessarily the acquirer. If a new entity is formed to issue equity interests to effect a business combination, one of the combining entities that existed before the business combination shall be identified as the acquirer by applying the guidance in paragraphs 805-10-55-10 through 55-14. In contrast, a new entity that transfers cash or other assets or incurs liabilities as consideration may be the acquirer.” [Codification 805-10-55-15]
Parker Speech on SEC/PCAOB Developments (Dec. 7, 2009)
Out With the Old
Schnurr
Jim Schnurr, senior national professional practice director for Deloitte & Touche, says the remarks seek to deter the structuring of transactions in ways that produce a predetermined, desired outcome on the balance sheet. While the practice of structuring transactions once was considered strategic in the merger and acquisition arena, in today’s environment of sharp skepticism it can be considered potentially deceptive or abusive.
Under the new rules, some folks in the M&A world may have been seeking to develop new practices based on old GAAP and old guidance, Schnurr says. “The SEC essentially nipped it in the bud.”
Pounder
Using basis accounting for a newco can result in a significant difference when valuing a deal, says Bruce Pounder, president of accounting education firm Leveraged Logic, especially when depreciated assets are involved.
If fair values are significantly higher than current book values, that makes the balance sheet considerably stronger, Pounder explains. If fair values are lower, new basis accounting makes the balance sheet weaker. That, in turn, has significant implications for financial leverage, risks, return on assets, borrowing capacity, and other important operational metrics, he says.
“If you do new basis accounting, you can dramatically rewrite an acquired entity’s balance sheet,” he says. “Whoever is responsible for managing that entity all of a sudden is seeing a balance sheet that looks completely different than it did the day before.”
In a separate speech on a related issue, the SEC’s Joshua Forgione, an associate chief accountant, said questions may also be forming about how the new business combination rules affect the use of new basis accounting in joint ventures. Like Parker, Forgione said preparers and auditors should ignore previous guidance and bright lines.
“I’m not going to roll out a new model for new basis in joint venture formation transactions,” he said. “This is an area that requires a significant amount of analysis, and you should carefully evaluate the facts and circumstances surrounding the transaction to determine whether you believe new basis of accounting will result in decision-useful information to investors.”
Formica
John Formica, a partner with PricewaterhouseCoopers, says SEC staff remarks are consistent with the approach that generally applies to any complex accounting issue these days: Preparers will be expected to apply reasonable judgment and provide robust documentation and transparent disclosure.
“The staff didn’t come out with any silver bullets or clear answers,” he says. “I think there may be more deliberation around whether or not a company in a particular transaction should use new basis or continue with carryover basis.”
Fox
Bert Fox, a partner with Grant Thornton, says Parker’s remarks give preparers more flexibility to call a transaction what it is, but it could also lead to some confusion and tension with auditors. “There’s always a fine line between judgment and structuring transactions,” he says.
No comments yet