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.

Contingent consideration is an obligation of the acquirer to transfer assets or equity interests if future events occur or certain conditions are met. A significant challenge acquirers may face is to measure, on the acquisition date, the fair value of contingent liabilities associated with earnout arrangements. Earnouts typically include payments to acquiree shareholders that are contingent on the achievement of financial or other performance goals following the closing date of the business combination. Earnout arrangements under the EDs require specific measurement on the acquisition date, and it is that measurement that may create unintended consequences of future performance, particularly associated with managing the acquirer's risk and retaining key target firm managers. Changes in the values of contingent assets and liabilities (that are not financial instruments) will be adjusted to fair value in each reporting period, with changes in fair value recorded in the income statement.

4. Accounting for Acquired In-Process Research and Development

Under SFAS 141, in-process research and development (IPR & D) acquired is measured at fair value and expensed. Under the EDs, the acquirer recognizes separately from goodwill an acquiree's intangible asset if it meets the definition of a separately identifiable intangible asset. The EDs propose that IPR & D acquired be measured at fair value, and capitalized with an indefinite life. As is the case with other indefinite-life assets, acquired IPR & D will be tested regularly for impairment but not amortized. When its life becomes determinable (e.g., upon project completion), acquired IPR & D will be amortized over its expected remaining life.

The implications are that there are only limited circumstances in which the fair value of the asset cannot be reliably measured, and that uncertainty enters into the measurement of the asset's fair value rather than demonstrating an inability to measure fair value reliably. These restrictive recognition requirements for intangible assets would result in a re-allocation from goodwill to intangible assets, and consequently, amortization charges would lower earnings in years following the acquisition.

Fair Value and the EDs

A. Criticisms of the EDs

The EDs define fair value of the target firm as the fair value of the consideration transferred on the acquisition date, unless it can be demonstrated otherwise that the consideration transferred is not the best measurement of fair value. Fair value measurement of the consideration exchanged is sufficiently supported for a 100 percent acquisition.

The major criticisms of the EDs requirement to use fair value measurements focus on the lack of guidance in fair value measurement in partial and step-acquisitions that ultimately require business combinations. Paragraph A11 of the FASB's ED states that for partial acquisitions that require business combination accounting, the fair value of the consideration given up is not representative of the fair value of the target firm as a whole. As an example, the consideration given up in a 100% acquisition may include control premiums paid to acquiree shareholders having significant equity interests. The payment of control premiums allows the acquirer to direct the strategy and policies of an acquired firm. The acquisition of a series of minority positions, taken individually, may not include control premiums, but could ultimately result in a majority ownership that meets the requirement for business combination procedures. The value of the control premium leading to the majority ownership may be considered to measure the fair value of the acquiree as a whole. The EDs do not provide guidance for imputing control premiums. Paragraph A11 of the FASB ED requires that in these types of situations, the acquirer of partial acquisitions that qualify as a business combination must use the fair value of the consideration given with any other available information to estimate the fair value of the acquiree as a whole.

In certain circumstances, such as non-transfer of consideration, transactions under duress or through related parties, the fair value of the consideration given cannot be reliably used to measure the fair value of the acquiree. In these circumstances, the FASB's ED recommends the use of the market or income valuation techniques which are consistent with measurement guidance found in SFAS No. 157, Fair Value Measurements (SFAS 157).

Certain respondents criticized the EDs for providing too much fair value measurement guidance, which could mislead preparers into thinking they possess valuation expertise. These respondents caution of undesirable outcomes that could result in highly unreliable financial reporting.

Those respondents who supported the EDs proposal to measure contingent consideration at fair value based their support for the use of the acquisition date fair value as the best evidence of fair value of the target firm. Any adjustment to the fair value of the consideration given is evidence to review for goodwill impairment in later periods, because the acquirer will have the benefit of hindsight in acquiree valuation. Those respondents who criticized the EDs suggested that the use of contingent consideration is evidence that fair value is not completely determinable on the acquisition date. Some respondents even suggest that requiring fair value measurement for contingencies on acquisition date motivate managers to engage in earnings management by overstating contingent liabilities, so any lower settlement results in income in future periods.

The EDs prohibit the inclusion of acquisition-related transaction costs incurred by the acquirer in the measurement of the business combination. Transaction costs would be expensed, or would reduce the fair value of equity securities transferred as part of the consideration given. The thrust of the argument lies in the irrelevancy of transaction costs in assessing the future performance of the target firm, and thus do not provide any future economic benefit. This argument is consistent with paragraph 9 of SFAS 157, which states that transaction costs do not possess attributes of assets; but rather are specific to the transaction and will differ depending on how the reporting entity transacts.

Most respondents to the EDs disagree with the proposed treatment of acquisition-related costs, citing the proposal as a significant departure from current accounting standards that base the measurement of the business combination on a cost-accumulation model.

B. SFAS 141 and SFAS 157

SFAS 157, issued in September 2006, establishes a framework for measuring fair value in GAAP and expands disclosures about fair value measurements. The standard provides guidance on how to measure fair value where it is permitted or required under more than 60 other accounting pronouncements.

Paragraph 35 of SFAS 141 requires that the acquiring entity allocates the cost of an acquired entity to assets and liabilities acquired, except goodwill and deferred income taxes, based on their estimated fair values at the date of acquisition. Sources of information to be used to estimate fair values include independent appraisals, actuarial or other valuations. Paragraph 37 provides general guidance specific to the elements. This list includes the following measurements:

1. Marketable securities -- fair value;

2. Receivables -- present value of amounts expected to receive;

3. Inventories -- use of lower-of-cost-or-market (LCM) or current replacement cost;

4. Plant and Equipment -- current replacement cost;

5. Intangible assets other than goodwill -- fair value;

6. Other assets such as land, natural resources, and nonmarketable securities -- appraised values;

7. Liabilities, accruals and commitments -- present values of amounts to be paid;

8. Pension and other postretirement benefit obligations -- actuarial determined present values; and

9. Preacquisition contingencies -- fair value if determinable.

SFAS 157 provides a single definition of fair value. Paragraph 5 states that fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. SFAS 157, paragraph 16, states that the transaction price represents the price paid to acquire the asset or received to assume the liability (an entry price). In contrast, the fair value of the asset or liability represents the price that would be received to sell the asset or paid to transfer the liability (an exit price, which is conceptually different from an entry price). In many cases, the transaction price will equal the exit price and, therefore, represent the fair value, but not always, as discussed in paragraph 16 of SFAS 157. Therefore, SFAS 157 provides detailed guidance on how fair value measurements should be attained, which includes a hierarchal structure for ranking the inputs that should be used in valuations techniques for measuring fair values.

Valuation techniques to measure fair value under SFAS 157 include three approaches: (1) market approach--measurement comes from market transactions involving identical or comparable assets or liabilities, (2) income approach--measurement comes from the conversion of future amounts (earnings and cash flows) to a single discounted value through the use of present value techniques and pricing models, and (3) cost approach--measurement comes from current replacement cost of an asset.

Although broad approaches to fair value measurements in SFAS 157 (market, income, and replacement cost) seem to coincide with the guidance found in paragraph 37 of SFAS 141, the FASB acknowledges the practical exceptions to fair value measurements in SFAS 141, but does not resolve in SFAS 157 its inconsistencies with SFAS 141.

Concluding Remarks

The FASB and IASB joint exposure drafts, when approved, may be considered a major attempt to converge accounting standards for business combinations. The Boards conclude that the proposed standard would make several improvements to financial reporting that would enhance the transparency of accounting for business combinations. The Boards also sought to reduce costs of implementation by requiring prospective application of the guidance and maintaining consistency with current standards for the measurement of certain assets and liabilities acquired through business combinations.

References

1. FASB. Statement of Financial Accounting Standards No. 141 Business Combinations June 2001.

2. FASB. Exposure Draft. Proposed Statement of Financial Accounting Standards Business Combinations--a replacement of FASB Statement No. 141. June 30, 2005, found at http://www.fasb.org/draft/index.shtml.

3. FASB. Exposure Draft-Business Combinations, Comment Letter Summary. 2006.

4. FASB. Statement of Financial Accounting Standards No. 157. Fair Value Measurements. September 2006.

5. FASAC. Business Combinations: Applying the Acquisition Method. Materials addressed at the March 23, 2006 FASAC Meeting.

6. Leaders' Edge. IASB/FASB First Joint Proposals on Business Combinations. July/August 2005, found at http://leadersedge.michcpa.org/JulAug05/fg_p-fasb.asp

Ibrahim M. Badawi, The Peter J. Tobin College of Business, St. John's University

Nina T. Dorata, The Peter J. Tobin College of Business, St. John's University