Another anti-recovery rule from FASB

Business combinations will be one of the drivers of the economy's emergence from recession. As relatively stronger companies absorb weaker ones, this merger and acquisition activity reallocates resources to better, more efficient acquirers. The acquirers' willingness to take risk in a down economy often provides important psychological stimulus indicating that business leaders see better days ahead. The recent spate of big pharmaceutical merger activity has been cited as a factor in the market's earlier rally.

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Yet a Financial Accounting Standards Board rule that went into effect on Dec. 15 penalizes merger activity. FASB 141(R) requires companies to reduce net income and operating earnings (Ebitda) by all expenses incurred in connection with an acquisition. Previously, these costs -- which can be hundreds of millions of dollars -- were capitalized on the acquirer's balance sheet and had no affect on its earnings.

This is a very meaningful accounting change with pernicious consequences, including loss of confidentiality, confusion in comparing earnings results period-over-period and, most importantly, potential loan defaults by acquiring companies. In a world where so few are willing to take risks, added concerns over the application of FASB 141(R) will likely chill acquisition activity at a time when we need it most.

Confidentiality, a necessary condition for effective merger negotiations, will be threatened under FASB 141(R). Mergers can take quarters to negotiate and complete, and confidentiality is crucial. If a firm contemplating a merger begins to incur significant expenses, those will appear on its income statement immediately, raising questions and opening the door to stock manipulation that could kill a transaction.

Secondly, at a time when investors need transparent comparable earnings results, the implementation of FASB 141(R) will serve to destroy meaningful period-over-period comparisons. If an acquirer makes an acquisition with significant costs in one year, but not in another, an investor will not be able to discern trends in the operating results of the reporting company. Investors are looking for indicators that a firm's core business is improving or deteriorating, but episodic and unpredictable earnings charges from lumpy deal costs will make it is impossible to measure profitability and underlying trends.

Most importantly, the new rule could cause the acquiring firm to breach existing bank and bond covenants, resulting in loan defaults and acceleration. These financial covenants are often computed based on operating earnings (Ebitda) compared to "fixed charges" (such as annual principal and interest payments) or total debt burden. The covenants may have been put in place years ago in bonds with terms of 10 or more years.

FASB's new rule would erode an acquiring company's margin of safety built up over time by positive earnings and, at worst, could cause the acquiring firm to breach its covenants and trigger acceleration of the loan. Headline statistics (such as debt-to-Ebitda ratios) published for a firm that often trigger short-selling and rating downgrades will also appear much worse under the new rule. In this "sell first, ask later" market, few investors will take the time to analyze "true" earnings results.

Here is a simple example: Assume a company is required to maintain debt-to-Ebitda of under 5 times, and must keep Ebitda to fixed charges above 1.75 times. Let's further assume the company has $600 million in annual Ebitda, debt of $2.4 billion and fixed annual payments of $300 million. The company would be passing all its tests comfortably. If that company saw a value-creating acquisition and expected to incur $150 million in costs to do so, it couldn't proceed. The firm's Ebitda -- calculated under FASB's new rule -- would be cut by 25% to $450 million, so its debt-to-Ebitda ratio would soar to 5.3 times and its fixed-charge coverage would decline to 1.5 times. The company would be in default of its loans, and its financial profile would look worse. No company can risk such an outcome, even for a wildly attractive acquisition opportunity.

In the current environment, short sellers and aggressive hedge funds are trolling for these kinds of easy chances to make money. They want to force borrowers -- even solid ones -- to repay debt, often with significant repayment penalties for early payments. Or they will want to short the stock, or push up the cost of insuring the company's debt in the credit default swap market, on the theory that lenders will trigger a damaging default scenario. Significant financial harm will be done to the shareholders of the borrower/acquiring company. Even worse, a loan default often can set off a cascade of "cross defaults" that can literally bring down an otherwise solid company.

So what did FASB find so compelling about the benefits of the new rule that overcame all of these objections from companies and accounting firms? The new rule brings U.S. accounting standards closer to the international standards FASB. And FASB believes "that all acquisitions of businesses be measured at the fair value of the business acquired." The second is surely wrong. An acquirer would normally take the costs of the transaction into account in deciding what price to pay for a target. So, analytically, the "fair value" of the acquired business must necessarily include these costs. Therefore, they should continue to be capitalized (reflected on the acquirer's balance sheet as part of the costs of the acquisition) as they were under FASB's prior rule that has worked well since 2001. FASB 141(R) provides no real benefit for those who rely on financial statements, yet the disadvantages are significant, immediate and real. If a CEO is deciding during a recession whether to acquire another company, he or she is already taking a risk that the merger won't work and that business conditions will continue to deteriorate. It is simply too much to ask that a company also give up its hard-won "margin of safety" under its bond and bank agreements when access to fresh capital is virtually nil and lenders are looking for any reason to call outstanding loans.

FASB 141(R) effectively penalizes business combinations just when our economy would benefit most from robust merger activity. FASB should revoke FASB 141(R) immediately to pave the way for increased acquisition activity that is essential to jump-starting our economy and markets. And Congress should ask FASB why it continues to force rules on business that provide no benefit to investors while imposing significant risks and burdens on businesses who play a vital role in bringing the U.S. economy out of its current recession.

Debra A. Cafaro is chairman, president and CEO of Ventas Inc., a healthcare real estate investment trust that owns a diversified portfolio of healthcare and senior housing assets.

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