When new accounting standards are issued most CPAs don’t get overly excited until they are hired on an engagement that requires them to employ the standards. Acquisition disputes generally heat up a few years after the standards become effective. Currently, there is a new standard that provides forensic accountants with a great opportunity to be proactive with their contacts in the legal community — the transaction and litigating attorneys that work on merger and acquisition (M&A) deals and disputes.

The new standard is “Statement of Financial Accounting Standards No. 141 (revised 2007) Business Combinations” or “FAS 141 R” for short. This standard will be a game changer in many ways. Although the new standard becomes effective for transactions closed after January 1, 2009, it is imperative for professionals (including forensic accountants who perform valuations and handle M&A disputes) who operate in this space to be aware of the changes and the implications on structuring deals. Attorneys and their clients don’t like surprises.
 
Why FAS 141 R Was Issued

The Financial Accounting Standards Board (FASB) began revising the accounting for business combinations beginning in 1996.  At that time the recognition of two distinct methods of accounting for mergers (purchase accounting and pooling) was not sensible and also not aligned with international standards.  As a result, FASB’s initial guidance on business combinations (FAS 141) was issued in 2001, with the help of international standard setters.  At or around that time, FASB, along with the International Accounting Standards Board (IASB), jointly took up a project in an attempt to converge the two standards.  FAS 141 R was jointly issued in December 2007 and now both U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) are essentially identical with respect to business combinations.

FAS 141 R was issued “to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports about a business combination and its effects … this Statement establishes principles and requirements for how the acquirer”:

1. “Recognizes and measures financial statements, the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquiree.
2. “Recognizes and measures the goodwill acquired in the business combination or gain from a bargain purchase.
3. “Determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination.”

Important Tips for Attorneys and Forensic Accountants

Here are seven items that both attorneys and forensic accountants should look into.

• Definition of a Business — The new rules tighten the guidance substantially and will cause more transactions to be treated as business combinations, including acquisitions of development stage companies. Business is now defined as an integrated set of activities and assets that is capable of being managed to produce a return to owners. The new rules are now more likely to scope in more research and development (R&D) entities which were previously specifically scoped out in prior guidance. This could have a significant impact on the pharmaceutical, real estate and retail industries. This is important because in previous transactions scoped out of purchase accounting, there was no need to account for goodwill. Such transactions were previously accounted for as asset purchases and recorded at relative fair values.
• Transaction/Acquisition Costs — Transaction/acquisition costs must be expensed and recognized immediately as a period cost rather than capitalized as part of goodwill. No more capitalized costs as they now have to be recognized separately from the transaction.
• Restructuring Costs — Anticipated restructuring costs post-transaction cannot be recorded as a purchase liability. These cost may no longer be accrued which is a substantial change from previous practice. It used to be that certain restructuring costs could be recognized and capitalized as part of goodwill. Now such costs must be expensed in the post-acquisition period.
• Contingent Consideration — In the past such earn-outs were basically cash basis and recorded as an increase to goodwill (when paid). Now the earn-out liability must be measured at fair value and recorded as part of the transaction. The earn-out liability needs to measured annually until disposed of with gains and losses recognized in earnings (the “income statement”).
• Assets/Liabilities — All assets and liabilities acquired must be recognized at fair value using the requirements of the new standard. Contingent liabilities (including contractual liabilities) must now be recorded at fair value. Non-contractual items are recorded if it is more likely than not to meet the conceptual framework definition of a liability (meaning that there is a likely claim on assets). Contingent assets related to indemnification may now be recorded in the same manner as the potential liabilities. Changes in the contingent liability will have an equal change to the related contingent asset. Acquired assets held for sale shall be recognized at fair value less costs to sell, which is an exception to the general recognition principle. Guidance for intangible assets that are separate from goodwill has not changed from previous standards and still must meet the separable criteria or contractual criteria.
• Full Goodwill Recognition — FAS 141 R requires any interest retained by the seller (non-controlling interest) to be recorded at fair value with a corresponding increase to goodwill.
• Measurement Date — Stock deals are now valued at the closing date rather than the announcement date. This means the measurement date must be the change of control date and eliminates convenience dating.

Why It Matters?

• Definition of a Business — New rules for business accounting are more complex and therefore could be more expensive and the potential for recording larger goodwill balances increases.
• Transaction/Acquisition Costs — With transaction/acquisition costs having to be expensed as incurred this may cause companies to do less due diligence, delay the start of such work or cause them to put pressure on professionals to reduce fees – pre-acquisition expenses in financial statements could possibly telegraph potential deals.
• Restructuring Costs — Since these costs can no longer be accrued it makes no difference where the synergies are accomplished. For example, closures or layoffs at either the target or the buyer will have the same accounting answer — expensed as incurred. This could possibly create more volatility in earnings, surprises in earnings and potential covenant issues.
• Contingent Consideration — More risks of earnings volatility and cause for difficult measurements.
• Assets/Liabilities — With respect to contingent liabilities such as environmental or other litigation type items the degree of difficulty in measuring contingencies could increase. In addition, the need for periodic re-measurement of liabilities and assets could potentially increase volatility in earnings.
• Full Goodwill Recognition — This creates more potential for future impairment charges if more goodwill is recognized.
• Measurement Date — Volatility in stock prices between announcement date and closing date could impact the goodwill recognized and increase valuation issues. It may also cause more use of cash in the deals to eliminate uncertainties.

Overall, FAS 141 R is a good thing. However, it may cause more urgency to get more transactions closed during the fourth quarter of 2008 in advance of the impending deadline. The failure to close acquisitions could also lead to expensing of acquisition costs in 2008 and other significant surprises. Accordingly, the deal-making attorneys need to be aware of the new rules. Post-transaction modeling should account for potential volatility under the new rules. Moreover, bank covenants may need to be responsive to higher expenses running through the income statement. The impact of increased goodwill, non-controlling interests and fair value measurements on balance sheet covenants must be modeled to avoid surprises.

Robert P. Gray, CPA/ABV, CFE, FACFEI, Principal, Forensic & Litigation Services, Parente Randolph, LLC, Dallas, TX. Gray has an extensive background in financial/accounting analyses, business valuation, economic damages, forensic investigation and litigation. He is a member of the AICPA’s Forensic & Litigation Services Committee, which provides professional guidance to CPAs who perform fraud investigations and determine economic damages. Phillip J. Santarelli, CPA, MBA, is Director of Assurance Services and is responsible for Parente Randolph, LLC’s audit and accounting practice, risk management, quality assurance. He is an active member of the Technical Issues Committee of the Private Companies Practice Section of the AICPA. In this role he interfaces with accounting and auditing standards setters, providing comments and perspectives on the impact of accounting standards on private companies.