Changing the Rules

ELT, Oct 2007 by Bober, John

Accounting for Acquisitions prepares for substantial change.

Accounting for acquisitions-known as business combinations in accounting literature-has been relatively stable for almost 40 years. While pooling-of-interests accounting and amortization of goodwill were eliminated a few years ago, guidance for purchase transactions was established in APB Opinion No. 16, Business Combinations, back in 1970, leaving almost a generation since those rules have been subjected to a major revision. This situation is about to end. The Financial Accounting Standards Board (FASB) is poised to issue two new standards that will revise the rules for purchase accounting and replace the existing accounting standard, SFAS No. 141, Business Combinations.

SFAS 141R, Business Combinations, together with the final standard on Consolidated Financial Statements, inciuding Accounting and Reporting of Noncontrouing Interests in Subsidiaries, will represent a significant departure from current practice. Proposed changes to the purchase method will require accountants, business development groups, auditors and investors to adjust their thought process around acquisitions and the impact these acquisitions have on the acquirer's financial statements.

On its website, FASB states it expects to issue the final statements in the third quarter of 2007, perhaps by the time this article is published. This article is, therefore, not based upon the final rules, but upon the author's understanding of the proposed statements as communicated by FASB's Board during its deliberations and upon the information publicly available on FASB's web site (www.fasb.org). Since the final rules, including subsequent interpretations, may differ from the current understanding, it is essential that readers of this article obtain the final rule when it becomes available and review its provisions in detail.

Background

FASB has been in the process of reconsidering business combination rules for more than ten years. Initial work led to the June 2005 publication of an exposure draft for SFAS 141R, which has been the subject of numerous discussions at FASB Board meetings for the past two years.

FASB hasn't undertaken the project in isolation. The business combination project is one of the joint projects undertaken by FASB and the London based International Accounting Standards Board (IASB) to further the international convergence of accounting standards. The boards have worked closely, and the result will be the adoption of similar-but not identical-standards by both bodies.

SFAS 141R will significantly change how accounting for acquisitions. The greatest changes from current practice are expected to result from FASB's fundamental revision of the concept of fair value, which is contained in SFAS No. 157, Fair Value Measurements, issued in September 2006. Acquisitions are fair value transactions; therefore, the new definition of fair value will have far reaching consequences in the accounting for business combinations.

Fair value, under SFAS 157, is now defined within generally accepted accounting principles (GAAP) as the amount at which an asset can be sold or a liability can be transferred-an "exit" value. This is very different from the purchase value or cost approach we are used to. In addition, fair value is no longer an entity or owner-specific concept. Fair value is dependent upon what market participants will value and not what the value of an asset or liability is to the acquiring company. This subtle shift in accounting thought causes a significant change in how assets and liabilities are valued in an acquisition.

The Expected Standard

We expect that, when SFAS 141R and its companion are issued, the rules will have two primary effects on financial statements. First, the standards will revise how acquired assets and liabilities are recognized and measured in financial statements. second, the standards will affect how elements of financial statements, principally minority interests, are calculated and displayed, and those impacts will affect the accounting for certain subsequent transactions.

Also expect SFAS 141R to be applicable to a larger universe of transactions than SFAS 141 and its predecessors. While only acquisitions of a business would be within the scope of SFAS 141R, as is the case under SFAS 141, the definition of what constitutes a business for accounting purposes is being expanded. To qualify as a business under SFAS 141R, an integrated set of activities and assets need only be capable of being managed and operated to provide a return to investors. Outputs would not be required. This is a lower threshold than exists under current GAAP, which provides that a business needs to be a self-sustaining set of activities and assets, which include inputs, processes and outputs.

Recognition and Measurement

The most immediate impact for acquirers, especially teams working to explain transactions to senior management, will be the elimination from purchase accounting of many costs incurred by the acquirer in connection with the purchase. These costs are not part of fair value using the exit price definition. Costs that were previously capitalized as part of the entry cost of the acquisition that will now be expensed include: