September 2, 2009

Accounting for Change: New FASB Standards’ Ripple Effects on M&A

Below is a note from Watson Wyatt regarding the impact of FAS #141 on M&A activity:

We can count mergers and acquisitions activity as one more casualty of the credit crisis: During the last 12 months, deals have sharply declined in volume and size. As a result, an important change in the M&A landscape has not received the attention it would have attracted just a couple of years ago.

The new Statement of Financial Accounting Standards 141R, “Business Combinations,” and 160, “Noncontrolling Interests in Consolidated Financial Statements,” might have fallen below the radar screen of many corporate dealmakers so far, but they have significantly changed the way costs for M&A deals must be managed and reported. While driven by the desire to increase transparency of accounting for deal costs, the new rules are also likely to have significant implications for HR’s management of staff reduction and other integration issues.

These standards — the first to be developed jointly by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) — were published in late 2007. The FASB standards took effect on Dec. 15, 2008, and thus apply to most current deals, and the companion IASB standards — International Financial Reporting Standard 3R and International Accounting Standard 27R — took effect more recently on July 1, 2009. The new standards change the accounting for business combinations and will likely affect integration decisions by acquirers in M&A deals. Historically, companies have been able to adjust goodwill to absorb post-deal cost surprises, which allowed for more streamlined due diligence. Under the new rules, however, the financial impact of an M&A deal must be booked at the time of the acquisition. With no recourse to a retroactive adjustment based on later analyses or data, there is less margin for error or oversight in due diligence, which is thus likely to require more time and create pressure for accurate calculations to be completed earlier in the process.

Subsequent job reductions, previously rolled into deal accounting, might need to be recorded and accounted for as special events if details are not finalized until post-acquisition. Many M&A transactions are driven by the prospect of eliminating redundant jobs and consolidating operations. Relocating workers and reducing headcount incur short-term costs but deliver long-term savings. Historically, the anticipated severance and related costs were rolled into the deal costs. Under the new rules, if these expenses will be booked as deal costs, they must be specifically identified at the date of acquisition.

In addition to struggling with the employee relations issues triggered by the early announcement of staff reductions, companies might need to obtain agreements with works councils, labor unions or other outside parties before projecting cuts and closures. So the costs/benefits from such staff reductions will more likely need to be recorded in a later accounting period, after the company has obtained the necessary approvals. Given the intensified scrutiny from business units and shareholders on expenses incurred, relocation and restructuring plans formerly considered standard practice might need to be reconsidered.

In addition, deal expenses and fees from internal resources and external advisers — normally capitalized into goodwill — now must be expensed as a normal profit and loss (P&L) cost in the period incurred (before or after a deal is announced). For larger deals, these costs can be significant, and oversight will likely become more rigorous. An additional impact: Transaction costs might need to be publicly disclosed before the deal is completed, potentially accelerating the timing of negotiations and compromising confidentiality.

Deals that result in partial ownership or increase a company’s interest must be measured at fair value, regardless of whether the buyer attains a controlling or noncontrolling interest. The associated goodwill is measured only once — when the initial controlling interest is obtained. All subsequent adjustments to ownership or fair value will be to equity rather than to the regular P&L accounts or goodwill. The challenge for companies is that, for each additional interest acquired, the associated fair value must be assessed and accounted for. This will probably increase the number of small transactions for which fair value calculations need to be completed and could necessitate new valuation techniques for certain nontraditionally valued assets or liabilities.

In addition to calling for more thorough due diligence and triggering more rigorous oversight, the new reporting standards will likely require a response from HR at an earlier stage in the M&A process. Companies might need to communicate upcoming HR changes to employees sooner and negotiate agreements with groups representing workers. Increased scrutiny of relocation and restructuring plans could influence companies’ decision making.