Acquisition and US business

As the year-end corporate reporting cycle comes to a close in the US, companies there are beginning to turn their minds to the new acquisition accounting standard passed in January - and they may be in for a surprise, says Lauren Keane

The new acquisition accounting standard represents a significant change in how businesses must measure and report the details of business combinations, and will likely change how companies approach the details of mergers and acquisitions in the coming years.

'There's no question these changes are pervasive,' says John Formica, a partner in the National Services Group at PwC, 'and there had been a lot of resistance to that, both globally and in the US. Right now, everybody's just trying to understand the provisions of the standards and the effect that the changes will have on their deal strategies, deal processes, accretion and dilution analysis, and the related accounting implications.'

Of the many changes that will require US companies to make adjustments, US financial reporting professionals in interviews consistently flagged two that will require the most adaptation. The first is a requirement to expense transaction and restructuring costs. Although that move will increase transparency in acquisition reporting, it will also dilute corporate earnings.

'If you're talking about a major acquisition, something headline-making, with a lot of legal and due-diligence costs to determine whether you want to go through with the deal, those costs could be huge,' said one global accounting vice president of a major US investment firm. 'You've got to recover those costs somewhere - so you'll likely lower your offer price.'

The second is a number of standard changes that represent a sweeping move towards fair value measurements. Under the new requirements, most assets and liabilities (even in partial or step-by-step acquisitions), as well as earn-outs and other forms of contingent consideration, must now be recorded at fair value on the acquisition date. That change will mean more income statement volatility as companies adjust fair value in subsequent periods, changes that will directly impact earnings.

'[Having to retroactively account for adjustments to the estimated accounting for an acquisition] could put into question the credibility of the buyer's financial reporting, even if the buyer does everything right,' says Formica. 'The question will be, "How material are the adjustments?" It depends on the company, but it's certainly not unusual to have significant adjustments when you have to finalise your accounting for the transaction.'

Sue Bielstein, the Financial Accounting Standard Board's (FASB) director of major projects, says the change is worth it. 'Previously, those measurements were made using a blend of fair value and historical cost, which no one really understood,' she says. 'We don't want to implement a standard where the cost of the information exceeds its benefits, so we're thinking about it from the company's perspective, too. But, at the end of the day, it's about investors getting good information.'

But while the new standards and their emphasis on fair value may benefit investors in the long run, Formica says it is a huge concern for acquiring companies. 'It can be challenging enough to have to calculate it on the acquisition date, but to have to do that every quarter for contingent consideration - well, we just don't yet have an established model on how to fair value these kinds of things.'

Adapt

The US financial reporting industry should expect an increase in demand for valuation experts and valuation services, Formica said, as companies try to adapt to a heavier emphasis on fair value, and in many cases need to re-calculate those measurements in future periods and make them retroactive. And companies will have to make systematic and process changes too, he said, reconsidering the timing of due diligence and the deal structure, including the impact on the accretion and dilution modelling of the deal.

That is just one example of how the new standards could change the way companies approach M&A deals. 'Some entities will be less apt to enter into contingent consideration or want to minimise them, to the extent that that's possible,' says Stuart Moss, a partner at Deloitte. They may also steer clear of equity in favour of cash because equity must now be recorded at fair value on the acquisition date, adding more uncertainty into the equation.

A further challenge in transitioning to the new standard will be how to 'manage shareholder expectations' - in other words, how to communicate to investors how and why a company's financial statement has changed because it is incorporating these structural reporting changes.

The new standard is part of a larger worldwide drive towards convergence to a single, high quality global accounting standard. While there is debate over what that standard will look like - particularly over how closely it will resemble the existing international standard - there is little doubt that the world's business community is headed towards convergence. PwC is calling convergence a 'near-inevitability' and advising its clients to expect full, mandatory convergence to IFRS around 2013-2015. It is also encouraging them to start preparing for the transition now. 'Preparing now accelerates benefits,' says one of its client presentations.

That 'near-inevitability' has touched nerves here and set off a debate over whether IFRS is sufficiently 'high quality' for use in the US. But that argument seems based more on a matter of national pride than anything else. Last year, the Securities and Exchange Commission solicited public comment on a proposal to allow US companies to use IFRS, on the heels of a move last year to drop its requirement that foreign companies registered in the US reconcile their IFRS-compliant financial statements to US GAAP. The proposals have generated a heated debate over which standard is more appropriate for the American regulatory system.

As Alan Texeira, IASB's senior project manager, sees it, with IFRS, 'there's more judgment required. Some people perceive that as being "lower quality". We think the opposite. With IFRS, you're required to exercise sufficient judgement to make sure the accounting reflects the economics of the transaction.'

The revised standard also represents a theoretical and controversial shift in the US from a rules-based standard to a principles-based standard. Bielstein said the FASB's revision eliminated 28 specific elements of US GAAP that arose in fairly narrow situations, replacing them instead with broader principles. While the rest of the world already works on a more principles-based platform, the change is sure to require further adjustments in the larger regulatory framework in the US as the new standard is incorporated here.

Concerns

Most executives interviewed said that they personally supported the general trend towards convergence to a single global standard for a globalised market, but that they worried in the short term about how such a widespread change for US companies would affect the bottom line. Although the IASB and FASB have stressed that this is a jointly-issued standard, with changes to both US GAAP and IFRS, the changes to the US side were significantly more extensive than to the international side.

But Bielstein disagreed that the changes were monumental. 'In the grand scheme of accounting standards, some are more refinements of existing standards and some are completely new models,' she says. 'This is not a completely different way of thinking about it. We've been using the purchase method since before 1970. We essentially did some tweaking around the edges.'

Regardless of how material the changes are, there is more such 'tweaking' on the way: the new business combinations standard is just the first of a wave of convergence projects on the FASB and IASB's agenda. Expect more changes to be announced in 2008. High on the agenda are accounting of financial instruments, revenue recognition and financial statement presentation. FASB and IASB expect to release joint discussion papers on these topics, and potentially others, around the middle of the year.

Lauren Keane is a journalist based in Washington DC.