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Merger Mysteries

Accounting for business combinations

A weak economy has caused merger and acquisition activity to slow over the past two years, but business combinations may be on the verge of a comeback. If your company is contemplating M&A activity in the near future, now is a good time to review the applicable accounting standards.

Clarifying fair value
The measurement of fair value under Generally Accepted Accounting Principles has been widely discussed in recent months. The Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurements, in late 2006, but controversy over the new standard didn’t heat up until the economy cooled in 2008.

Many companies expressed concern that SFAS 157 (now covered under FASB Accounting Standards Codification™ (ASC) Topic 820, Fair Value Measurements and Disclosures) would require them to value assets at fire-sale prices, even in the absence of liquidation plans. To ease such concerns, FASB issued a series of FASB Staff Positions (FSPs) and Accounting Standards Updates (ASUs) clarifying that market prices need not be relied on in situations where the market for an asset is inactive and evidence exists that quoted prices reflect forced liquidations or distressed sales. In those cases, internal data, such as cash-flow projections, can be used.

Despite new guidance, measuring fair value can be challenging — particularly in an M&A context. For example, SFAS 142 (now found under ASC Topic 350, Intangibles — Goodwill and Other) requires companies to test acquired goodwill annually for impairment and to write goodwill down if its carrying amount exceeds its implied fair value. The implied fair value of goodwill is generally equal to a business unit’s fair value less the fair value of its net assets, including any unrecognized intangible assets.

Contingent consideration conundrum
SFAS 141(R) (now found under ASC Topic 805, Business Combinations), which took effect in 2009, requires companies to recognize acquired assets and assumed liabilities at fair value. This can significantly affect an acquiring company’s balance sheet and earnings.

The impact is particularly dramatic when contingent considerations, such as earnout agreements, are part of a transaction. In the past, the portion of the purchase price that was contingent on the acquired company achieving certain earnings targets wasn’t recognized until the contingency was resolved. Under current rules, however, payments tied to future performance are recognized at their acquisition-date fair value — despite uncertainty over whether they’ll be paid.

Suppose, for example, that a buyer agrees to increase the purchase price by $1 million if the seller meets its earnings targets for the two years following the acquisition. If the buyer’s management estimates the probability of meeting those targets at 50%, then 50% of the earnout payment, or $500,000, should be included in the acquired company’s fair value (discounted to present value). Postacquisition changes in fair value are then recognized in income, which creates earnings volatility.

Assets and liabilities
SFAS 141(R)’s rules regarding contingent assets and liabilities also have been controversial. Originally, the statement required companies to record contractual contingencies, such as warranties, at their acquisition-date fair value. Noncontractual contingencies, such as pending litigation, were to be recorded at fair value if they were more likely than not to result in an asset or liability. The statement also required companies to constantly revalue contingent assets and liabilities and follow a complex methodology for recognizing changes in their fair value.

Companies, however, criticized this treatment, claiming that it would force them to disclose confidential litigation information and possibly waive attorney-client privilege. FASB responded with FSP No. FAS 141(R)-1, which backs away from some of the changes made by SFAS 141(R).

FSP FAS 141(R)-1 makes several important changes, including:

• Eliminating the distinction between contractual and noncontractual contingencies,
• Requiring recognition of acquired contingent assets and liabilities if their acquisition-date fair value “can be determined during the measurement period,” noting that the fair value of a warranty obligation often can be determined,
• Providing for a contingent asset or liability whose value can’t be determined to be recorded if 1) it’s probable (as opposed to “more likely than not”) that an asset existed or a liability was incurred on the acquisition date, and 2) the amount can reasonably be estimated, and
• Eliminating the procedures for postacquisition measurement, instructing acquirers to “develop a systematic and rational basis for subsequently measuring and accounting for assets and liabilities arising from contingencies depending on their nature.”

In general, the FSP is expected to reduce the number of contingencies that must be recorded.

Stay tuned
FSP FAS 141(R)-1 is intended as only a temporary solution, and further developments can be expected in the months and years ahead. In the meantime, you may find that you need greater assistance from outside valuation and other financial professionals to ensure you’re accounting correctly for your acquisitions.
 

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.