Coming to a Financial Statement Near You: CHANGE – It’s Not Just for Politicians Anymore
By Brooks W. Binder

As if the 2008 presidential race is not exciting enough, we now also have change and drama in the opaque world of accounting policies. On August 27, 2008, the Securities and Exchange Commission voted unanimously to adopt a proposed Roadmap that could lead to abandonment of GAAP in favor of International Financial Reporting Standards by 2014. GAAP is such an integral part of American business that it is hard to believe that we may face a future when GAAP is referred to only in the past tense. Under the Roadmap, the SEC would not finally decide to abandon GAAP in favor of IFRS until 2011 and, theoretically, the switch would only apply to public companies. Nonetheless, the pendency of the change and the debate over the pros and cons should have an impact on American commerce for a long time to come.

Of more immediate concern, the implementation of SFAS 141R later this year will result in significant changes to the accounting policies and procedures applicable to business combinations. As explained below, SFAS 141R will have a substantive impact on accounting for mergers and acquisitions and other business combinations.

In December of 2007, the FASB issued Statement of Financial Accounting Standard No. 141 (revised 2007) (“SFAS 141R”), which will supersede SFAS 141 (Accounting for Business Combinations) for fiscal years beginning after December 15, 2008. The current purchase method accounting guidelines under SFAS 141 measure the purchase price of the target at the announcement date, but measures the assets and liabilities of the combined entity as of the acquisition date. In contrast, SFAS 141R mandates that the acquirer must determine the entire fair value of the target’s business as of the acquisition date, which is defined as “the date on which [the acquirer] obtains control of the [target].” Note that this will not be the same date as the closing date if the acquirer obtains control either before or after closing.

The major changes included in SFAS 141R can be divided into five categories:

1. accounting for transaction costs;
2. contingent considerations (“earn-outs”);
3. in-process research and development (“IPR&D”);
4. pre-acquisition contingencies; and
5. partial or step acquisitions.

First, SFAS 141R will resolve inconsistencies in accounting for transaction costs. Under SFAS 141 certain direct costs are considered a component of the purchase price, while other indirect costs are expensed as incurred. However, under the revisions, transaction costs such as legal fees, consulting fees, accounting fees, and banking fees will no longer be included in purchase price when accounting for a business combination. Since these acquisition-related costs do not add value to the acquired assets, they will be recognized as expenses of the period in which they were incurred. So, for example, when an acquiring company incurs a multi-million investment banking fee, 100% of that fee will impact earnings in the year in which the transaction is recognized, rather than having the expense spread over several accounting periods. For highly acquisitive companies, transaction costs are a normal and recurring expense and the immediacy of the expense under SFAS 141R will not likely pose a challenge to the financial reporting of those companies. However, for companies that only occasionally play the role of acquirer, immediate expensing of transaction costs could result in significant volatility in earnings.

The second major change under SFAS 141R affects earn-outs. Earn-outs generally include payments to the target’s shareholders that are contingent upon achievement of certain financial goals or performance goals that will occur after the acquisition date. SFAS 141R requires that an acquirer include the fair value of any contingent consideration in the consideration for the target at the acquisition date. This is in stark contrast to SFAS 141, which generally prohibited recognition of any contingent consideration until the contingency was resolved and the consideration was issued.

A third change will alter the method of capitalization of in process research and development (“IPR&D”). Currently, the acquirer must immediately expense acquired IPR&D assets. SFAS 141R requires IPR&D to be capitalized as indefinite-lived intangible assets at fair market value, even before IPR&D reaches the point of feasibility. When the research and development project is either completed or abandoned, then the useful life will be reconsidered. If the project reaches completion, it will be accounted for as an intangible asset with an assumed finite life and amortized over the related product’s estimated useful life. However, if the project is abandoned and has no feasible alternative use, it must be expensed.

Fourth, SFAS 141R will solidify the measurement date for pre-acquisition contingencies, such as obligations related to product warranties and product defects, guarantees of the indebtedness of others and pending or threatened litigation. Currently, acquirers do not recognize pre-acquisition contingencies until recognition criteria are met, and as a result pre-acquisition contingencies may be measured and accounted for at different times. However, under SFAS 141R contractual pre-acquisition contingencies must be recognized at fair value on the acquisition date. Moreover, non-contractual pre-acquisition contingencies will be recognized at fair value if they will “more likely than not” meet the definition of an asset or a liability. If the “more likely than not” threshold is not met, then the non-contractual contingency is not recognized in the accounting of the business combination.

Finally, the revisions of SFAS 141 will alter the method of measurement for partial acquisitions and step acquisitions. Under SFAS 141R, if an acquirer obtains less than 100 percent of a target or achieves control in stages, the acquirer must record 100 percent of the fair values of all of the target’s assets and liabilities at the acquisition date. This means that the acquirer must recognize full fair value of any non-controlling interests, so that the goodwill attributable to the non-controlling interest is represented. This is in contrast with the purchase method where each purchase is accounted for separately, and the historical costs are intermingled. For example, in a step acquisition under SFAS 141R, if a company acquires 30 percent of the target’s stock at $100 million, and subsequently purchases an additional 30 percent for $150 million, the acquirer must revalue its original 30 percent position at $150 million and report a $50 million gain on its original 30 percent position, causing the entire 60 percent position to be carried on its books at $300 million. Under SFAS 141, there is no step up in the value of the original 30 percent position as a result of the subsequent transaction and the aggregate 60 percent position would be carried at $250 million.

Most of us do not live in the arcane world of accounting policies and procedures. Even so, the significant changes in policy represented in the near term by SFAS 141R and in the longer term by the move to International Financial Reporting Standards will have wide-ranging impacts on American commerce for generations to come.

[Attribution: The author wishes to acknowledge the assistance of Ms. Jennifer Stutte in the preparation of this Article]

Brooks Binder is a partner in the firm’s Corporate and Securities Practices. He concentrates in the areas of mergers and acquisitions, strategic investments, recapitalizations, venture capital financings, leveraged buyouts, debt offerings including mezzanine loans, equipment leasing and other commercial lending transactions. Brooks received his bachelor’s degree from the University of North Carolina at Chapel Hill and his law degree from Emory University.

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