Business combinations: convergence and fair value.

Abstract

The exposure drafts issued by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are considered a major joint project on business combinations. This paper discusses the significant proposed accounting changes, which include the application of the acquisition method, recognition of full goodwill in partial business combinations, use of fair value measurements, and expense treatment for certain acquisition-related costs.

Introduction

On June 30, 2005, the U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) each issued a number of exposure drafts (EDs) dealing with both business combinations and consolidation procedures. The FASB issued two EDs, which include Business Combinations and Consolidated Financial Statements, Including Accounting and Reporting of Noncontrolling Interests in Subsidiaries. The IASB issued three related EDs, which include: proposed amendments to International Financial Reporting Standard No. 3, Business Combinations (IFRS 3); proposed amendments to International Accounting Standard No. 27, Consolidated and Separate Financial Statements (IAS 27), proposed amendments to IAS No. 37, Provisions, Contingent Liabilities and Contingent Assets (IAS 37), and IAS No. 19, Employee Benefits (IAS 19).

Most importantly, the FASB and the IASB EDs on business combinations are jointly developed and contain virtually the same accounting concepts, and therefore represent a major joint convergence project between these two Boards. The objectives of this joint project are twofold. The first is to provide a single high-quality standard for accounting for business combinations that could be used for both domestic and international financial reporting; and the second is to promote the international convergence of accounting standards.

The jointly developed EDs on business combinations are a product of two phases. During the first phase, the FASB and the IASB deliberated the issue of accounting for business combinations separately. The FASB concluded the first phase in June 2001 by issuing Statement of Financial Accounting Standards No. 141, Business Combinations (SFAS 141), and Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (SFAS 142). The IASB concluded their first phase in March 2004 by issuing IFRS 3, Business Combinations. In these standards, both Boards required the use of the purchase method as one method of accounting for business combinations.

During the second phase of the project, FASB and the IASB simultaneously addressed the guidance for applying the acquisition method, and decided to conduct this phase as a joint effort, with the objective of reaching the same conclusions and similar standards for accounting for business combinations. Accordingly, the new joint proposed standard would replace the existing requirements of the SFAS 141 and IFRS 3. Furthermore, the proposed standard requires simultaneous adoption of the FASB proposed statement Consolidated Financial Statements, Including Accounting and Reporting of Non-Controlling Interests in Subsidiaries, which would replace the existing requirements of Accounting Research Bulletin 51, Consolidated Financial Statements, dated August 1959.

The FASB and the IASB believe that the new proposed standard will help users and preparers by improving the comparability of financial information reported by companies around the world that issue consolidated financial statements in accordance with either U.S. generally accepted accounting principles (GAAP) or the IFRS. Both Boards expect to issue final standards for business combinations and non-controlling interests during the third quarter of 2007. The Boards will probably defer the effective dates of the proposed standards to sometime in 2008 or even beyond.

FASB/IASB EDs--Significant Changes

The accounting proposals in both exposure drafts on business combinations retain the fundamental requirement of SFAS 141 and of IFRS 3, which is to account for all business combinations using a single method (acquisition method), where one party (the acquirer) is always identified as acquiring the other entity (the acquiree). However, the EDs propose significant accounting changes that would drastically alter current accounting practices for business combinations. The proposed accounting changes could result in considerably more immediate charges to the income statement in connection with business combinations. The following are the significant accounting changes, and explanations of their accounting implications.

1. Acquisition Method, Goodwill, and Noncontrolling Interest

The proposed business combination rules in the EDs would apply to transactions in which an acquirer obtains control of one or more businesses. The EDs require that all business combinations be accounted for by applying the acquisition method, where the acquirer measures and recognizes the acquiree, as a whole, and the assets acquired and liabilities assumed, including all identifiable contingent assets and liabilities, are recognized at their fair values at the acquisition date. The EDs revise the acquisition date to the date that the acquirer obtains control of the acquired business (the closing date). The EDs recognize that in the absence of evidence to the contrary, the consideration transferred is the best evidence of the fair value. However, in some business combinations, where either no consideration is transferred on the acquisition date or the consideration transferred is not the best indicator of the acquisition's fair value, the acquirer would need to determine the fair value of the acquiree. Excluded from the fair value measurement are assets held for sale, deferred taxes, operating leases, employee benefit plans, and goodwill.

According to the EDs, goodwill is still an unidentifiable residual value and is computed as the difference between the fair value of the acquiree as a whole and the fair value of the net assets acquired. The residual measurement according to the EDs differ from the measurement prescribed by the purchase method, which computes goodwill as the difference between the cost of acquisition and the acquirer's share of the fair values of the net assets acquired. The significant differences in the computation are as follows: (1) goodwill computed according to the EDs includes the share or portion attributable to the noncontrolling interest, and (2) goodwill computed according to the EDs focuses on fair value of the acquiree.

Business combinations presently exempt from SFAS 141 (e.g., cooperatives and mutual entities), will be required to use the acquisition method under the proposed rules. Furthermore, there may be a requirement for greater involvement of valuation specialists to measure the fair value of an acquiree as a whole, in a partial acquisition that qualifies as a business combination. The recognition of full goodwill, including the noncontrolling interest's portion, would result in higher amounts of goodwill that will be subject to annual impairment testing.

2. Accounting for Acquisition Transaction Costs

Under SFAS 141, direct acquisition transaction costs, such as payments made by the acquirer to third parties for legal and consulting fees, banking fees, accounting fees, and fees for valuation services all associated with acquisition, are included in the purchase price. The EDs now require that these transaction costs to be accounted for separately from the business combination, as they do not represent assets acquired and liabilities assumed. Accordingly, these costs are expensed as incurred rather than capitalized as part of the business combination cost under current practice. Hence, the proposed accounting of acquisition-related costs will be more transparent and may result in lower earnings in the year of acquisition.

3. Accounting for Contingencies

One of the most controversial proposed changes in the EDs relate to the accounting for contingent assets and liabilities. They are identifiable assets acquired or liabilities assumed, whose ultimate benefit or settlement is contingent or conditional on the outcome of some future event. Such contingencies are recognized at the acquisition date, separately from goodwill, and at fair value. The inherent difficulty in measuring the fair value of contingent assets and liabilities is the quality and availability of information as of the acquisition date. The fair value estimate of contingent assets and liabilities will be based on certain assumptions, such as the probability of an occurrence that would result in payment of the contingency, and will likely require significant input from external parties, such as environmental experts or attorneys.