EXECUTIVE SUMMARY
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FASB outlined a major
overhaul of GAAP related to mergers and
acquisitions when it issued
Statement no. 141 (revised), Business
Combinations , in December 2007.
The standard is effective for fiscal years
beginning after Dec. 15, 2008.
A fundamental concept
at the core of Statement no. 141(R) is
that the reporting entity is the entire
economic enterprise created by the
combination. As such, the
consolidated statement of financial
position will describe 100% of the
acquired assets and liabilities. Any
minority interest—called a
noncontrolling interest —will
be considered to be stockholders’ equity.
The new approach will
use the full fair values for both the
debits and credits to record
transactions , even to the
point of recognizing a gain from bargain
purchase in rare cases in which the
acquired value exceeds the purchase price.
Statement no. 141(R)
won’t abandon the residual cost approach
to goodwill measurement.
However, its implementation will
be improved because acquirers will have to
value and record many additional assets
and liabilities, including R&D and
contingencies. In addition, the
acquisition entry credits will include the
fair value of previous holdings and any
noncontrolling interest.
Paul B.W. Miller , CPA,
Ph.D., and Brian P. McAllister
, CPA, Ph.D., are accounting
professors at the University of Colorado
at Colorado Springs. Paul R.
Bahnson , CPA, Ph.D., is an
accounting professor at Boise State
University. Their e-mail addresses,
respectively, are pmiller@uccs.edu
, bmcallis@uccs.edu
and pbahnson@boisestate.edu
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After 25 years of work on business combination
standards, FASB rolled out a major overhaul of
GAAP related to mergers and acquisitions when it
issued Statement no. 141(R), Business
Combinations , in December 2007. In
its joint project with the International
Accounting Standards Board, FASB’s overall goal
was to produce more complete statements of
financial position and income to help users make
better decisions. The approach continues the shift
away from historical costs to reliance on fair
value. In addition, Statement no. 141(R) and
Statement no. 160, Noncontrolling Interests in
Consolidated Financial Statements, call for
recognizing certain assets and liabilities that
previously escaped recognition. The standards also
alter income statements by introducing new items,
eliminating some old ones and providing a new
structure. This article discusses the
conceptual foundation for Statement no. 141(R),
which is effective for fiscal years beginning
after Dec. 15, 2008, and explains nine significant
changes created by the revised standard. It also
ponders how the new train of thought behind
Statement no. 141(R) may drive behaviors and
attitudes.
THE CONCEPTUAL FOUNDATION
Combination accounting has long been
controversial because of divergent views on how to
provide the most useful information. In addition,
many implementation problems arise from specific
and often unique features of individual
combinations. The accounting profession’s
struggles with these challenges are reflected in
diverse and often inconsistent practices. Debate
has swirled around goodwill and other intangibles.
Minority interests have also been reported in
several ways. These inconsistencies diminished the
usefulness of the information to the point that
new standards were needed. The most
fundamental concept expressed in Statement no.
141(R) is that the reporting entity is the entire
economic enterprise created by the combination. As
such, the consolidated statement of financial
position will describe 100% of the acquired assets
and liabilities. Any minority interest—called a
noncontrolling interest —will be
considered stockholders’ equity instead of a
liability or mezzanine item that is not
specifically classified as a liability or equity.
Income statements will present results for
the entire enterprise with the bottom line
followed by a schedule that divides income into
portions attributable to the controlling and
noncontrolling interests. Notably, displayed
earnings-per-share results will be based only on
income attributable to controlling interest
stockholders. Cash flow and equity statements will
be reconfigured to describe the whole enterprise
so users can see more of what is under the
parent’s management. The new approach will
use the full fair values for both the debits and
credits to record transactions, even to the point
of recognizing a gain from bargain purchase in
uncommon situations in which the acquired value
exceeds the purchase price.
NINE KEY CHANGES
This article describes what we consider the
nine most significant features of Statement no.
141(R). The changes are listed in Exhibit 1, along
with their effects on the statements. This list is
not meant to be exhaustive; rather it is intended
to show readers why they need to learn more before
preparing consolidated financial statements for
fiscal years beginning after Dec. 15, 2008.
(1) ACQUISITION EXPENSES
Acquirers may incur millions in direct and
indirect costs finding targets, gathering and
analyzing information, seeking funds and
negotiating deals. The question is how to report
these costs.
Current GAAP . These costs are
deferred by adding them to the purchase price. In
all likelihood, they increase recorded goodwill,
where they remain until and unless impairment is
recognized.
Deficiency . Although
pre-transaction costs are necessary, they don’t
add value to acquired assets (including goodwill)
and they are not assets on their own. It’s
questionable whether putting them on a balance
sheet is useful.
New standard . Statement no.
141(R) follows the tenet that only real assets
should be recorded for a combination. Because
acquisition-related costs are not assets, they
will be charged to expense. Exhibit 1 shows them
being moved off the statement of financial
position and onto the income statement. (See the
sidebar “141 vs. 141(R)” for examples.)
(2) BARGAIN PURCHASE GAIN
In rare circumstances, an acquirer strikes a
favorable deal and pays less than the aggregate
fair value of purchased net assets. These
transactions raise two issues—at what amounts
should individual assets and liabilities be
recorded, and is it useful to recognize a bargain
purchase gain?
Current GAAP. The excess value
is considered “negative goodwill.” Because of its
focus on cost, current practice selectively
reduces certain asset carrying values until the
aggregate total equals the purchase price. (In
very rare circumstances, any unallocated
difference is treated as an extraordinary
gain.)
Deficiency. The balance sheet
underreports the value at hand and available to
management for earning returns. In addition,
management’s successful negotiation is not
immediately reflected in reported income.
New standard. Acquired assets
and liabilities will be recorded at fair value and
any excess over the purchase price will be
credited to a gain that flows to the income
statement, net of deferred taxes. The outcome will
likely be more complete and useful statements of
financial position and income. (See Scenario B in
the sidebar “141 vs. 141(R)” for an example.)
(3) CONTINGENT CONSIDERATION
In major transactions such as combinations,
sizable spreads initially exist between amounts
buyers and sellers offer to pay and accept. One
way to close that gap is contingent consideration
arrangements in which, depending on future events,
a buyer agrees to pay an additional amount or a
seller agrees to refund part of the purchase
price. Because contingencies can be difficult to
pin down, many issues have been raised about their
financial statement effects.
Current GAAP. Most contingent
consideration arrangements are ignored in
determining the recorded price. When additional
payments based on earnings targets occur, their
amounts are added to goodwill. If payments are
tied to stock price changes, paid-in capital is
credited. If refunds are received, the buyer
reduces goodwill or paid-in capital.
Deficiency. In these
circumstances, not immediately recognizing the
contingent assets or liabilities reduces the
managers’ accountability for what they’ve
negotiated. Statements that ignore these potential
cash flows are not adequately informative.
New standard. Consistent with
getting more assets and liabilities on
consolidated balance sheets, Statement no. 141(R)
will require buyers to book estimated fair values
of contingent consideration agreements as assets
or liabilities. The items will be marked to market
until the contingencies are resolved, with each
year’s gain or loss flowing to the income
statement. Once settlement occurs, a gain or loss
will be recognized for the difference between the
carrying value and the amount received or paid. If
contingent consideration involves shares, the
difference between the initial and final fair
values will be recorded in paid-in capital. (See
Scenario C in the sidebar “ 141 vs. 141(R)” for an
example.).
(4) IN–PROCESS R&D
Many acquired companies have valuable
intellectual property embedded in incomplete but
promising research and development results.
Acquisitions enable acquirers to use R&D to
create or improve products and services. At issue
is how to reflect these potential future cash
flows in financial statements.
Current GAAP. Statement no.
142, Goodwill and Other Intangible Assets
, requires buyers to assign values to
in-process R&D assets for recording the
acquisition but then immediately write them off.
Deficiency. The balance
sheet omits relevant information about significant
assets that help justify the acquisitions. In
addition, income reported in the transaction year
may be misstated.
New standard. In-process
R&D results will be classified as intangible
assets with indefinite lives until the R&D
phase is complete or the project is abandoned, and
subsequent expenditures won’t be capitalized.
These recorded assets won’t be written off or
amortized but will be subject to impairment tests.
The result will likely be more useful income
statements that don’t include spurious losses and
more complete balance sheets that include more
assets. Although R&D asset values are
uncertain, their approximate amounts are more
representative than reporting nothing at all. (See
Scenario C in the sidebar “ 141 vs. 141(R)” for an
example.)
(5) OTHER CONTINGENCIES
In combinations, buyers virtually always
acquire some contingent items subject to
uncertainty. The question arises whether they
should be included in balance sheets alongside
other assets and liabilities.
Current GAAP. Consistent
with FASB Statement no. 5, Accounting for
Contingencies , the consolidated entity’s
statements recognize only loss contingencies
deemed probable and reasonably estimable at the
time of acquisition. Other loss contingencies are
either disclosed or ignored; gain contingencies
are never considered.
Deficiency. The
consolidated financial statements are initially
incomplete by not including all assets
and liabilities passing to buyers. Omitting
contingent liabilities understates the total cost
and produces smaller debits to goodwill. Omitting
contingent assets inflates debits to goodwill.
Consequently, statement readers may be left
uninformed about possible future outcomes.
New standard. Statement
no. 141(R) will change practice by exempting most
acquired contingencies from Statement no. 5
requirements. Specifically, acquirers will be
required to record all contractual contingent
assets and liabilities at estimated fair value.
Other contingencies will be recorded at fair value
if it is more likely than not that an
asset or liability exists under the element
definitions in Concepts Statement no. 6,
Elements of Financial Statements. This
provision is ground-breaking because it uses a
concepts statement to create GAAP rather than
guide standard setters in the due process.
Recognized amounts would be subsequently
remeasured conservatively until the contingencies
are resolved. That is, contingent assets would be
revalued at the lower of their original or
later value and contingent liabilities would be
revalued at the higher of their original or
later value calculated, in both cases, with the
guidance in Statement no. 5
(6) STEP ACQUISITIONS
It is not unusual for an acquirer to gain
control by beginning with smaller noncontrolling
purchases on the way to achieving a majority
position. A key question is how to account for the
combination when control is reached through a
“step acquisition.”
Current GAAP. The acquirer
preserves original book value (cost, market, or
equity method balance) of each investment in the
series that culminated in control. In effect,
total consideration is built up, layer by layer.
Once control is achieved, each layer’s book value
is used to determine the total consideration, even
if that sum isn’t close to the aggregate fair
value at the acquisition date.
Deficiency. This cost-based
measure lacks usefulness because it is partially
based on irrelevant market conditions existing
when past transactions occurred, not when control
was gained.
In addition, this undervalued consideration
may allocate less cost to goodwill than its
apparent fair value. If the original investments
are really old, this measure could even fall below
the acquired net assets’ fair value, causing them
to be booked at amounts that don’t reflect their
cash flow potential. In fact, FASB concluded the
old approach “led to many … inconsistencies and
deficiencies in financial reporting.” (See
paragraph B386 of the revised standard.)
New standard. Once control is
achieved through a step acquisition, the acquirer
will mark each incremental investment to fair value
as of the acquisition date. The date of interest is
the date on which the acquirer gains control. Gains
and losses from revaluing those holdings will be
included in current earnings. The outcome will be
greater likelihood that all recorded assets and
liabilities are stated at fair value.
(7) GOODWILL MEASUREMENT
A perennial issue concerns the excess paid
over the net asset value received in a
combination. Tension exists between the
possibilities that (1) the full excess describes a
real asset and (2) the acquirer paid more than it
should have.
Current GAAP. The acquirer
compares the consideration with the aggregated
fair values of its proportionate share of acquired
identifiable assets and liabilities. The excess is
recognized as goodwill. No goodwill is attributed
to the noncontrolling interest.
Deficiency. This approach
doesn’t independently assess the existence or real
value of goodwill. Rather, it throws the residual
into the goodwill account without regard to how
much value actually exists. It is unlikely to
recognize the full amount of goodwill inherent in
the enterprise.
New standard. Statement no.
141(R) won’t abandon the residual cost approach to
goodwill measurement. However, its implementation
will likely be improved because acquirers will
have to value and record many additional assets
and liabilities, including R&D and
contingencies. In addition, the acquisition entry
credits will include the fair value of previous
holdings and any noncontrolling interest.
(8) SUPPLEMENTAL DISCLOSURES
Because financial statements cannot fully
inform on their own, Statement no. 141(R) requires
many new supplemental disclosures to provide users
with relevant details, showing how a combination
affects the financial statements and the entity’s
cash flow potential.
Current GAAP. Disclosures are
limited to describing the acquisition’s impact on
reported earnings and the allocation of the
purchase price among the acquired assets and
liabilities.
Deficiency. Over time,
compliance has become perfunctory, with a tendency
for many managers to provide only the minimum
required disclosures.
New standard. Statement no.
141(R) will mandate extensive disclosures about
the acquisition’s quantitative and qualitative
effects. The list fills more than four pages of
the standard. Two requirements are especially
noteworthy. First, management will have to
describe economic factors that validate the
recorded goodwill, including other unrecognized
intangibles and synergies expected from the
combination. The goal is to prevent assigning a
residual to goodwill that doesn’t reflect its real
value. Second, Statement no. 141(R) moves
toward principles-based accounting by mandating
that acquirers disclose “whatever additional
information is necessary” to ensure users are
fully informed about new combinations or
adjustments to previous combinations. (See
paragraph 73 of the revised standard.)
(9) MEASUREMENT PERIOD
Acquirers can seldom estimate fair
values for all acquired items at the acquisition
date because due diligence processes simply cannot
generate those details.
Current GAAP. Acquirers assign
provisional values up through the first financial
statement date after the acquisition. They may be
adjusted for up to a year after the acquisition.
Statement no. 141 is silent on whether equity
changes created by these adjustments should be
reported as current income or applied
retroactively to equity.
Deficiency. Without clear
guidance on how to report equity adjustments, FASB
found practice was inconsistent. (See paragraph
B396 of the revised standard.) And, without
retroactive adjustment of prior balance sheets,
users are not provided a complete and reliable
description of the combination as of the
acquisition date.
New standard. To help management
cope with uncertainty in preparing consolidated
statements, Statement no. 141(R) allows them a
measurement period of up to one year to fix fair
values as of the acquisition date. Significantly,
adjustments to initially reported provisional
amounts will be reflected in restated comparative
statements, just as if the revised amounts had been
known on the acquisition date.
BEHAVIORAL IMPLICATIONS OF THE NEW TRAIN
OF THOUGHT
The adage that people manage what gets
measured suggests that Statement no. 141(R) will
cause acquirers to be more judicious. At the very
least, more careful measurement and more inclusive
reporting may trigger more painstaking front
frontend research and negotiations. Because more
assets and liabilities will be reported at fair
value, with buyers’ mistakes laid out for all to
see, we’re confident more homework will precede
acquisition offers. While some may worry that
these requirements might chill takeovers, we think
that could be a good outcome if it stimulates more
discipline and eliminates unprofitable
transactions.
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