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— Industry Insight —
You have probably heard that the new M&A accounting standards increase the potential for dilution and volatility to be reported in post-acquisition results. Sophisticated dealmakers who plan to be active in an M&A rebound have been preparing their teams to factor the impact of the new standards into their deal processes. Accretion-dilution analyses have been modified, planning process and systems changes have been made, and important stakeholder communications are ready to go. While the new accounting standards are not deterring dealflow -- the turbulent markets, credit crunch and overall economy are responsible for that -- it is beneficial for companies to become acquainted now with how the new standards could affect them when the deal market inevitably returns. When this happens, companies may have to work harder to achieve M&A accretion, or communicate with stakeholders to set expectations about dilution. In the interim, there are many aspects of the new standards already in effect and can therefore affect companies, with or without a deal.
Let's revisit the sources of dilution and volatility that may be reflected in a post-deal income statement. There is potential for increased dilution because the new standards require certain charges to be expensed in the income statement as opposed to capitalized in the purchase price. Transaction fees and restructuring charges are two prominent examples. There is also potential for volatility because there are certain assets and liabilities that will be included in the acquisition opening balance sheet that also must be adjusted, up or down, through the post-deal income statement. Contingent consideration ("earnouts") and income tax estimates both may require adjustment through the income statement after an acquisition. Did you realize that the new M&A accounting standards could affect your company regardless of whether you plan to close a deal? In this economy, understanding the new M&A standards may not be a priority for many companies, particularly if M&A activity is not on the horizon in the foreseeable future. Still, companies should not overlook the new standards, as they can affect results, deal or no deal. Companies that are acquisitive nearly always have goodwill assets on their balance sheet stemming from past acquisitions. For financial reporting purposes, goodwill must be tested annually, sometimes more frequently, for potential impairment. Where impairment is determined to exist, it is then charged through the income statement by writing off the goodwill. In performing impairment assessments of their goodwill, companies are required to use a two-step process. Part of the test requires companies to re-estimate the value of their goodwill at the reporting date, using a process similar to that used to record an opening acquisition balance sheet. Because companies are required to follow the new M&A standards in their impairment testing, they may need to use techniques that could differ from those in use under the old M&A standards. In this case, it is possible to either trigger a goodwill impairment charge that would not have existed under the old standards, or to increase the amount of a charge that would have resulted under the old standards. A formerly acquisitive company should be aware of this potential outcome, even if they are no longer doing deals today. In the past, adjustments to tax uncertainty reserves and reductions in valuation allowances from acquisitions were generally recorded as adjustments to goodwill and did not affect earnings unless an impairment charge was required. Under the new standards, adjustments to tax uncertainty reserves and reductions in valuation allowances that do not relate to facts that existed at the close of the deal will be reported in the income statement, even for those acquisitions pre-dating the new standards. Companies with significant tax reserves and valuation allowances from past deals will want to study this aspect of the new standards even if they are not active in the M&A market today. Many companies are positioning to sell groups of noncore assets to shore up their cash holdings in these uncertain times. There is an expanded definition of a business in the new standards that means more of these sales will now qualify as sales of businesses. This may affect the gain or loss companies report on those sales and may even result in goodwill impairment unrelated to the assets being sold. A key difference between an asset sale and a business sale is that with the latter, goodwill often needs to be allocated to the business sold. Such an allocation could significantly reduce a gain or significantly increase a loss that a company expected to report on a sale. And any remaining goodwill that is not sold may then need to be assessed for impairment, potentially resulting in another charge to continuing operations. Companies looking to rationalize their balance sheet by selling noncore assets should be especially careful in calculating and announcing the related expected gains and losses. The new standards also change the nature of the financial reporting for parent and minority shareholders (now termed "noncontrolling interests" in a consolidated subsidiary). The changes affect both the balance sheet and income statement, and can have a significant impact on whether a company is in compliance with debt covenants and other contractual arrangements. Investments by minority shareholders, which were previously presented between the liabilities and equity sections of the parent company's consolidated financial statements (the "mezzanine"), will generally now be reported as equity in the consolidated financial statements. Net income will now include earnings attributable to both the controlling and noncontrolling interests. That differs from today's presentation, in which net income represents only the parent's share. Despite this change, earnings per share will still be determined on the basis of net earnings that are attributable only to the parent company's shareholders, consistent with previous calculations. Notwithstanding the mechanical changes described above, there is another key difference that affects the way income is allocated between the parent and noncontrolling interests. In the past, losses generally were not allocated to the noncontrolling interests if allocating them would reduce the noncontrolling interest balance to a deficit position. The new M&A standards repeal this limit. This has the potential to increase net earnings and earnings per share attributable to the parent company shareholders as compared to the treatment required under the old standards. These new noncontrolling interest requirements are likely to change performance measures, financial ratios and consolidated equity balances. Companies will need to evaluate the impact of these changes, particularly in the case of existing contractual arrangements, such as debt covenant calculations. The changes resulting from the new M&A accounting standards are
far-reaching. They will affect old deals, new deals and the
presentation of the consolidated financial statements. Senior
executives and directors need to understand the key features of the new
standards even if they are currently inactive in the M&A markets.
If you haven't done so already, consider assessing their impact now,
regardless of your planned M&A activity in the future. It's not too
late to get ahead of the new M&A standards. Donna Coallier is a transaction services partner with PricewaterhouseCoopers who specializes in a variety of complex transactions, including mergers and acquisitions, joint ventures, divestitures and financing deals. |
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