A combined effort

New rules on accounting for mergers and acquisitions will make it harder for companies to hide deals that turn sour.


The international accountancy profession has spent years trying to harmonise its myriad financial reporting rules, so that investors can compare statements produced under one code with those produced under another. The rule-makers have now produced their first common standard, one that covers the thorny issue of accounting for mergers and takeovers. Many of the new provisions look like a simple tidy-up of existing rules, but there are important changes, particularly for US companies, experts say.

The world of accounting standards is dominated by two bodies. The London-based International Accounting Standards Board (IASB) produces International Financial Reporting Standards (IFRS), which are used in most countries around the world. The New York-based Financial Accounting Standards Board (FASB) is responsible for the generally accepted accounting principles (GAAP) that US companies use. It’s a highly charged political issue, but an increasing number of US companies are opting to produce their financial statements under IFRS, rather than their domestic rules.

The two bodies have been working for years on efforts to bring their standards into line with each other. But they have just published the first new standard that they have worked on together. The aim of the so-called business combinations project is to develop a single, high-quality accounting standard that would ensure that the accounting for business combinations is the same whether a business is applying IFRSs or US GAAP.

For the IASB, completion of the project entailed revising two of its existing standards: IFRS 3 Business Combinations and IAS 27 Consolidated and Separate Financial Statements. Its new requirements take effect on 1 July 2009. The FASB, meanwhile, issued FASB Statements 141 Business Combinations, and 160, Non-controlling Interests in Consolidated Financial Statements. These are effective for financial years beginning after December 15, 2008.

It might sound confusing, but the upshot is that the accounting requirements in IFRSs and US GAAP will be substantially the same. This is thanks largely to the changes that the FASB has made to US GAAP; the changes to IFRSs have, in contrast, been relatively small.

Capital markets
Standard-setters say the effort taken to get this far should deliver important benefits. Business combinations are an important feature of the capital markets. Over the past decade the average annual value of corporate acquisitions worldwide has been the equivalent of 8-10 percent. “Investors and their advisers have a difficult enough job assessing how the activities of the acquirer and its acquired business will combine.

But comparing financial statements is more difficult when acquirers are accounting for acquisitions in different ways, whether those differences are a consequence of differences between US GAAP and IFRSs or because IFRSs or US GAAP are not being applied on a consistent basis,” said Sir David Tweedie, IASB chairman.

The completion of the joint project is “a significant convergence milestone,” said FASB member Michael Crooch. The common approach will eliminate some of the most “significant and pervasive” differences between the two accounting regimes, he said. The new US rules should improve reporting by creating “greater consistency in the accounting and financial reporting of business combinations, resulting in more complete, comparable, and relevant information for investors and other users of financial statements.”

US companies have been able to use a range of legitimate tricks in the past to ensure that the way they accounted for an acquisition or merger put the deal in a good light. Now they will have to recognize all – and only – the assets acquired and liabilities assumed in the transaction. The date used to determine the value of the assets and liabilities will be the date of the acquisition, not some other one. And the company making the acquisition will have to disclose to investors all the information they need to evaluate and understand the nature and financial effect of the deal.

Other changes should make the US rules less complex. And amendments to Statement 160 will improve the “relevance, comparability, and transparency” of financial information provided to investors by requiring all companies to report non-controlling interests in subsidiaries in the same way – as equity in the consolidated financial statements.

Mary Tokar, head of the international financial reporting group at accountants KPMG, said the fact that the international and US standards are very similar is a further step towards greater consistency. “Although not 100 percent identical, the two boards worked to reach agreement not just on concepts and principles, but also on using the same wording,” she said. Progress on convergence is one of the factors supporting the recently published changes to the US Securities and Exchange Commission (SEC) rules, which allow the use of IFRS as published by the IASB in financial reports filed by foreign private issuers that are registered with the SEC without having to reconcile those results to US GAAP.

Tokar agreed that the international standards require less change for IFRS users than for entities reporting under US GAAP. Partly this is due to the option that is available in the international standards, but not in the U.S. standards, to limit the recognition of goodwill to the controlling interest acquired. It is also because the boards drew on the IASB’s current business combinations standard, which was issued after the comparable US standard. In several areas existing IFRS requirements were the starting point for the two boards.

Tokar also warned that the limited changes to existing international standards should not lull companies into complacency. “Companies applying IFRS are advised to look carefully at the new requirements. In particular, the new standards require purchases and sales of non-controlling shareholdings when control is retained to be accounted for fully as equity transactions, which will reduce the current diversity in accounting for such transactions,” she said.

Several other changes mean that business combinations are likely to have an immediate impact on reported profits, she added. For example, any pre-existing interests in the acquired company will be remeasured to fair value at the acquisition date, with any gain or loss recognised in the income statement rather than directly in equity. Additionally, many transaction costs that currently are capitalised will be required to be recognised as an expense instead.

Cause for consideration
Another area of significant change is contingent consideration – when the buyer agrees to a possible adjustment to the purchase price, often based on post-acquisition performance. Contingent consideration will be measured at fair value at the acquisition date, with subsequent changes recognised in the income statement if the contingent consideration is classified as a liability, rather than as adjustments to the purchase price.

While the IASB says the changes to the international rules are less significant than the changes to US GAAP, accountants Ernst & Young have warned companies to tread with caution. The new rules will affect the amount of goodwill arising and lead to greater performance volatility, said the firm, and may result in some other surprises if they are not understood before entering into future transactions.

And while the international changes do not come into effect until July 1, 2009, any transactions negotiated prior to this date need to be carefully evaluated – particularly if they are not expected to be complete until after that date, the firm said.

“Having a clear understanding of the effect of the new requirements before entering into a business acquisition will be essential because it is highly likely that changes will also be needed to debt covenants, management remuneration and other performance measures in place,” said Will Rainey, global director of IFRS services at Ernst & Young. “Some of the consequences can also be avoided by carefully structuring the arrangements during the negotiations.”

Of particular concern to many is the fact that all transaction costs (such as lawyers’ and advisers’ fees) will be expensed. Also, where former owners remain employees of the business after acquisition, a bright-line test has been introduced, that in many cases will result in payments made after the acquisition being treated as compensation, not consideration. “Management will need to think carefully about the terms of any such payments to avoid unintended consequences,” said E&Y.

“It is quite common for acquisitions to have an element of contingent consideration payable in the future,” explains Rainey. “Under these new requirements, its fair value will need to be determined at acquisition – which can be a time-consuming and expensive exercise. The resulting liability will probably be a financial liability to be carried at fair value subsequent to the acquisition, thereby introducing greater volatility into future results. Management will therefore need to consider how any contingent consideration is structured.”

Rainey said the most controversial change arises when, after gaining control, a company holds less than 100 percent interest equity. The new requirements include a choice as to how the non-controlling interest (NCI) is measured. If management measures NCI at its fair value, it will effectively result in goodwill relating to the entire business – not just the percentage acquired – being recognised. If management stays with today’s method, and measures NCI at the share of the fair value of the net assets acquired, goodwill will be significantly lower.

Minority interest
“On the face of it, this doesn’t appear to be a big deal,” says Rainey. However, if management later acquires the outstanding minority interest, no additional goodwill can be recorded. Therefore, if management do intend to gain a 100 percent ownership, they will be better off fair valuing NCI when they gain control. This can also be a time-consuming and expensive exercise. “But this will require management to consider their longer-term objectives of the transaction, which will then be obvious to the market.”

Tokar said that the US standards requires companies to measure a non-controlling interest at fair value, which effectively means that an acquirer will recognise the full goodwill of the acquirer, including goodwill relating to non-controlling shareholders. The international standards allow the full fair value method, but companies also have an option to follow the current IFRS model whereby goodwill relating to non-controlling shareholders is not recognised. The IASB decided on this option during the Boards’ debates of the comments they received after exposing their proposals.

More widely, says Rainey, the changes will affect the way companies negotiate acquisitions. “Disclosures will also be more extensive and managers will need to ensure that sufficient information is given without having an adverse impact on future operations.”

The greater clarity should also make it easier for investors to work out whether a deal has been a success or not, as it will be easier to untangle the financial statements. That makes this particular accounting reform especially interesting. Normally, the effect of a new accounting rule is apparent when it is introduced, but the real impact of the business combinations standards will be seen in a few years time – that’s when investors will be able to look back on the deals reported under the new rules to see whether the financial returns have lived up to management’s promises, or not. In the past, it’s been easy for unscrupulous companies to fudge the issue. In the future, if the new rules work, that should be a lot harder.