how will valuation changes affect m&a deals?

13
I n late 2007 and early 2008, both the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued separate statements on business combina- tions. Statement of Financial Accounting Standards (SFAS) 141(R), issued by the FASB, and Interna- tional Financial Reporting Standard (IFRS) 3R, issued by the IASB, represent concerted efforts on the part of both standard-setting boards to make the accounting for busi- ness combinations more consis- tent in both the United States and internationally. 1 The two standards provide guidance in terms of defining what a business combination is and how companies should account for the business combi- nation. There are a number of similarities between the two new standards, but differences do exist that could lead to dramatically different results in terms of the valuation of the assets acquired and the liabili- ties assumed in the business combination. These differences in valuation will impact the amounts of and types of assets and liabilities recorded as part of the business combination, impact investor perceptions of the business combination, and potentially alter the acquirer’s earnings going forward. Those involved with merger- and-acquisition work should be aware of how SFAS 141(R), IFRS 3R, and other related stan- dards will affect the val- uation of specific assets and liabilities included as part of the business combination. This understanding will be important for those deciding how to best structure the acquisition and also for those charged with accounting for the effects of the business combination— both currently and into the future. MEASUREMENT AND VALUATION DIFFERENCES: SFAS 141(R) AND IFRS 3R Both SFAS 141(R) and IFRS 3R provide guidance in terms of valuing a business combination. For the most part, this guidance is the same or quite similar under both standards. However, there are differences between the two standards that could affect the valuation of the specific assets/liabilities accounted for as part of a business combination. Specifically, the new U.S. and international standards that will In late 2007 and early 2008, both the Financial Accounting Standards Board and the International Accounting Standards Board issued separate statements on business combinations. There are a number of similarities between the two new standards, but differences do exist that could lead to dramatically different valuations of assets and liabilities in a merger-and-acquisition (M&A) deal. Deal makers must understand the differences in the two standards to decide how to structure any new deal. The authors take an in-depth look at the issues involved. © 2009 Wiley Periodicals, Inc. f e a t u r e a r t i c l e 49 © 2009 Wiley Periodicals, Inc. Published online in Wiley InterScience (www.interscience.wiley.com). DOI 10.1002/jcaf.20500 How Will Valuation Changes Affect M&A Deals? Peter Woodlock and Gang Peng

Upload: peter-woodlock

Post on 11-Jun-2016

215 views

Category:

Documents


0 download

TRANSCRIPT

Page 1: How will valuation changes affect M&A deals?

In late 2007 andearly 2008, boththe Financial

Accounting StandardsBoard (FASB) andthe InternationalAccounting StandardsBoard (IASB) issuedseparate statementson business combina-tions. Statement ofFinancial AccountingStandards (SFAS)141(R), issued by theFASB, and Interna-tional FinancialReporting Standard (IFRS) 3R,issued by the IASB, representconcerted efforts on the part ofboth standard-setting boards tomake the accounting for busi-ness combinations more consis-tent in both the United Statesand internationally.1

The two standards provideguidance in terms of definingwhat a business combination isand how companies shouldaccount for the business combi-nation. There are a number ofsimilarities between the twonew standards, but differencesdo exist that could lead to

dramatically different results interms of the valuation of theassets acquired and the liabili-ties assumed in the businesscombination. These differencesin valuation will impact theamounts of and types of assetsand liabilities recorded as partof the business combination,impact investor perceptions ofthe business combination, andpotentially alter the acquirer’searnings going forward.

Those involved with merger-and-acquisition work should beaware of how SFAS 141(R),IFRS 3R, and other related stan-

dards will affect the val-uation of specific assetsand liabilities includedas part of the businesscombination. Thisunderstanding will beimportant for thosedeciding how to beststructure the acquisitionand also for thosecharged with accountingfor the effects of thebusiness combination—both currently and intothe future.

MEASUREMENT ANDVALUATION DIFFERENCES:SFAS 141(R) AND IFRS 3R

Both SFAS 141(R) and IFRS3R provide guidance in terms ofvaluing a business combination.For the most part, this guidanceis the same or quite similarunder both standards. However,there are differences between thetwo standards that could affectthe valuation of the specificassets/liabilities accounted for aspart of a business combination.Specifically, the new U.S. andinternational standards that will

In late 2007 and early 2008, both the FinancialAccounting Standards Board and the InternationalAccounting Standards Board issued separatestatements on business combinations. There area number of similarities between the two newstandards, but differences do exist that could leadto dramatically different valuations of assets andliabilities in a merger-and-acquisition (M&A) deal.Deal makers must understand the differences inthe two standards to decide how to structure anynew deal. The authors take an in-depth look atthe issues involved. © 2009 Wiley Periodicals, Inc.

featur

e artic

le

49

© 2009 Wiley Periodicals, Inc.Published online in Wiley InterScience (www.interscience.wiley.com).DOI 10.1002/jcaf.20500

How Will Valuation Changes

Affect M&A Deals?

Peter Woodlock and Gang Peng

JCAF20-4_20500.qxp 4/8/09 8:56 PM Page 49

Page 2: How will valuation changes affect M&A deals?

govern the accounting for businesscombinations differ in terms of:

• the definition of what consti-tutes a business combination,

• the definition of fair value,• whether contingent assets

and contingent liabilitiesshould be valued as part ofthe business combination,and how these will be valued,

• the valuation alternatives fornoncontrolling interests, and

• the value assigned to theacquired entity’s employeebenefit arrangements.

These differences are sum-marized in Exhibit 1 and dis-cussed in more detail below.2

Definition of a BusinessCombination3

Under rules promulgated inSFAS 141, a merger or acquisi-tion was accounted for as a busi-ness combination when “votingcontrol over a business wasobtained through a transaction

that resulted in the acquisition ofnet assets or equity interests.”Control as defined by SFAS141(R) has been expandedbeyond SFAS 141’s definition toinclude both “voting controlover an entity’s operations andinstances where the acquiringentity becomes the primarybeneficiary in the transaction,”where primary beneficiary iscurrently defined in terms ofprofit-and-loss (P&L) exposuresin accordance with FASB Inter-pretation 46(R), Consolidationof Variable Interest Entities.

Under IFRSs, control isdefined as in InternationalAccounting Standard (IAS) 27R,which states that control repre-sents “the power to govern thefinancial and operating policiesof an entity so as to obtain bene-fits from its activities.” In con-trast to the FASB’s definition ofcontrol, which is based on votingcontrol or the level of benefits/losses gained by the acquirer, theIASB’s definition avoids defin-ing control in quantitative terms.

Instead, it is the “power to gov-ern” and “the ability to obtainbenefits” that determine whencontrol exists.

These differences in howcontrol is defined will mostlikely result in situations inwhich the entity identified asthe acquirer will vary under U.S.and international accountingstandards.

Example: Suppose thatABC holds 51 percent ofthe stock of X Companyand that DCF owns 1 percent of X. Alsosuppose that DCF entersinto an agreement withABC in which ABCagrees to vote its stockin favor of a slate ofboard members thatfavor DCF’s interest.Following this vote,DCF clearly has thepower to govern X Com-pany if it so chooses.Also, DCF has the abilityto obtain benefits from

50 The Journal of Corporate Accounting & Finance / May/June 2009

DOI 10.1002/jcaf © 2009 Wiley Periodicals, Inc.

Differences in the Initial Accounting for Business Combinations: U.S. GAAP vs. IFRS

Item U.S. GAAP IFRS

Definition of When a Business Voting control/primary beneficiary Power to govern/ability to obtain Combination Occurs govern when a business benefits govern when a business

combination occurs combination occursNotion of Fair Value Exit value Arm’s-length transaction (entry value)Contingent Assets and Contingent assets/contingent Only contingent liabilities that are

Liabilities liabilities are valued present obligations are recognized and recognized and valued

Value Assigned to Noncontrolling NCI is valued at its proportionate NCI can be valued in one of two ways.Interests (NCIs) share of acquiree’s total assets The choice can be varied for each

(including goodwill) acquisitionValue Assigned to Employee Amounts assigned are based on Amounts assigned are based on

Benefit Arrangements relevant U.S.-based accounting relevant international standardsstandards

Exhibit 1

JCAF20-4_20500.qxp 4/8/09 8:56 PM Page 50

Page 3: How will valuation changes affect M&A deals?

X Company. But DCFdoes not have votingcontrol over X, nor isDCF the primary benefi-ciary of the gains andlosses of X Company.Instead, ABC enjoysboth of these distinc-tions. Under FASB rulesthen, ABC would clearlybe viewed as the acquirerof X Company andwould need to combineits operations with X. Incontrast, under IFRSstandards, an argumentcould be made that DCFhas control of X.

Notion of Fair Value

U.S. generallyaccepted accounting prin-ciples (GAAP; specifically,SFAS 157) define fairvalue using an exchange-price notion (where fairvalue is measured by theprice you would receive forthe asset at the time of dis-posal), while IFRSs viewfair value more from anarm’s-length transactionview (where fair value ismeasured by the price someonewould pay to acquire the asset).In applying U.S. GAAP’s fairvalue definition to assets, con-sideration must be given to theasset’s highest and best use,either on a stand-alone basis orin combination with other assets.In addition, U.S. GAAP requirethe valuator to consider the prin-cipal or most favorable marketfor the sale of these assets. Incontrast, IFRSs require the com-putation of asset values on astand-alone basis under theassumption that an unrelatedwilling buyer and willing sellerwould act in their own respectiveself-interests. These differencesin fair value definitions will

most likely lead to differencesin the values assigned to theacquiree’s assets and liabilitiesunder U.S. and internationalaccounting standards.

Example: Suppose thatA Company is going toacquire B Company for$200 million. B has apatent that is redundant—that is, A currently alsohas a patent that makesB’s patent unnecessaryand therefore essentiallyworthless to A.

B’s patent could be soldto external parties for$50 million in an arm’s-length transaction, with

the remainder of B’sidentifiable assets thenbeing worth $100 millionon a stand-alone basis.Alternatively, B’s identi-fiable assets could besold as a group for $175 million—$5 millionfor the patent and $170million for the otherassets. Under IFRSs, thepatent would be valuedat $50 million, its stand-alone value, and the otheridentifiable assets wouldbe valued at $100 millionon a stand-alone basis.In contrast, under SFAS141(R), the patent wouldbe valued at $5 million,

and the other net identi-fiable assets would bevalued at $170 million.This occurs because thecombined value of theassets (the patent andthe other assets) repre-sents their highest andbest use.

The above example illustratesthat the patent’s value is notaffected by whether A willobtain value from B’s patent.That is, under the new standards,value is not a function of whetherA finds B’s patent useful or not.Rather, fair value, regardless ofwhether it is being measuredusing U.S. or international GAAP,is based on either an entry or

existing value for the asset.While the above exam-

ple focuses on valuationissues for an intangibleasset (a patent), the fairvalue definition used mayalso lead to differing val-ues being assigned to theacquiree’s other assets andliabilities as well. The dis-cussion below reinforcesthis idea by extending theabove discussion to the

values assigned to the acquiree’sworking capital and tangibleassets.

Valuing Working Capital Items

The main elements of work-ing capital that would need to bevalued as part of a businesscombination include accountsreceivable, inventory, andaccounts payable. When valuinginventory and accounts receiv-able under U.S. GAAP, acquirerswould need to consider theassets’ highest and best use andthe principal market for the salesof such assets. Because largercompanies sell many types ofproducts to customers in many

The Journal of Corporate Accounting & Finance / May/June 2009 51

© 2009 Wiley Periodicals, Inc. DOI 10.1002/jcaf

In applying U.S. GAAP’s fair valuedefinition to assets, considerationmust be given to the asset’s highestand best use, either on a stand-alone basis or in combination withother assets.

JCAF20-4_20500.qxp 4/8/09 8:56 PM Page 51

Page 4: How will valuation changes affect M&A deals?

different industries, accountsreceivable and inventory repre-sent assets whose value is mostlikely affected by the variousmarkets in which these assets aretraded (in the case of inventory)or originate (in the case ofaccounts receivable). Because ofthis, these assets probably cannotbe properly valued without someconsideration of these issues.

In contrast, as stated above,IFRS 3R computes asset valueon a stand-alone basis under theassumption that an unrelatedwilling buyer and willing sellerwould act in their own respectiveself-interests when entering intoa buy-sell agreement. The fairmarket values of bothinventory and accountsreceivable are an artifact ofbuyer and seller negotia-tions, which should allowcompanies to value both ofthese items more on anaggregate basis, possiblyusing some market-specificaverages to establish values.

Example: The acquiredcompany sells twoproducts to a given cus-tomer and discounts theprice of the secondproduct as a way of sell-ing the first product tothe customer. The sec-ond product is part ofthe acquired company’sinventory on the date ofacquisition. Under IFRS,the value assigned to thesecond product shouldrepresent what a willingbuyer would be willingto pay a willing sellerfor the product. Underthis view, it is not totallyclear whether the currentpricing scenario with thecustomer should be con-sidered when setting avalue for the acquiree’s

inventory. Should theneed to discount thesecond product to sellthe first product affectthe value assigned to theinventory?

The valuation of inven-tory under SFAS 141(R)’srequirements is also notstraightforward. SFAS141(R) requires thatinventory be valued atthe highest and best useeither on a stand-alonebasis or in combinationwith other assets. Itcould be easily envi-sioned that in certain

circumstances the highestand best use for a secondproduct would be to sellit in conjunction withthe first product, eventhough the principalmarket for the secondproduct would allow fora stand-alone valuationapproach.

Similar to accounts receiv-able and inventory, the valueassigned to accounts payablemay also be affected by the fairvalue definition adopted.Because accounts payable arisespredominantly from transactionswith suppliers, the amount that

the acquiring firm would payto settle the payables of theacquired firm will be affectedby economic differencesbetween suppliers. These eco-nomic differences include sup-plier differences in paymentterms, rights of return, andother contractually mandatedpurchaser-supplier actions thatcould either increase ordecrease settlement amounts.Since IFRS 3R requires liabili-ties to be valued at their settle-ment amount, consideration ofsupplier-specific differenceswill be necessary when assign-ing a value to the acquiree’spayables.

In contrast to IFRS’sview that payables shouldbe valued at their settle-ment amount, U.S. GAAP,specifically SFAS 157,mandate that payables bevalued at an amount thatwould allow the debtor totransfer the liability to athird party withoutrecourse. Because thetransfer concept assumesthat the debtor is relievedof all obligations aftertransfer, valuing the liabil-ity under U.S. GAAP will

necessitate the consideration ofthe creditworthiness of thedebtor—something that may ormay not be considered whenarriving at a defined settlementamount under IFRS 3R.

Valuing Tangible Assets

As is the case with mostorganizations, tangible assetswill most likely have greatervalue when they are combinedwith other tangible and intangi-ble assets. For example, some-one who might pay $100 for arestaurant booth to be used inhis/her existing restaurantwould most likely pay more

52 The Journal of Corporate Accounting & Finance / May/June 2009

DOI 10.1002/jcaf © 2009 Wiley Periodicals, Inc.

The fair market values of bothinventory and accounts receivable arean artifact of buyer and sellernegotiations, which should allowcompanies to value both of theseitems more on an aggregate basis,possibly using some market-specificaverages to establish values.

JCAF20-4_20500.qxp 4/8/09 8:56 PM Page 52

Page 5: How will valuation changes affect M&A deals?

for that booth if he/she werebuying the booth as part of theacquisition of a going-concernrestaurant.

U.S. GAAP requires thatthose valuing tangible assetsconsider both their value on astand-alone basis and in combi-nation with other assets, whileIFRSs are more focused on astand-alone valuation. This dif-ference between U.S. GAAP andIFRS could lead to substantialdifferences in valuing tangibleassets, including those restaurantbooths found in your favoritelocal restaurant.

Measurement of ContingentLiabilities and Assets

U.S. GAAP separates con-tingencies into those thatare contractual and thosethat are noncontractual. Acontractual contingency isone that arises from a con-tract, while a noncontrac-tual contingency includesall other contingencies. Anacquiree’s contractual con-tingencies (assets and liabil-ities) are recognized based onU.S. GAAP notions of fairvalue. An acquiree’s noncontrac-tual contingencies are recog-nized under SFAS 141(R) onlyin instances when the contin-gency is more likely than not tooccur.4

The IFRSs do not providefor separate recognition stan-dards for those loss contingen-cies that arise from contractualas opposed to noncontractualrelationships. Instead, IFRS 3Rseparates contingencies intothose that are possible and thosethat are present obligations. Pos-sible obligations are obligationsthat arise from “past events whoseexistence will be confirmed onlyby the occurrence or nonoccur-rence of one or more uncertain

future events” that are not “withinthe control of the entity.” Presentobligations are “legal or con-structive obligations that resultfrom a past event.” Under IFRS3R, an acquirer must recognize,at fair value on the acquisitiondate, present obligations that canbe reliably measured. This recog-nition of the present obligationoccurs regardless of its probabil-ity of occurrence. In contrast,contingent assets and possibleobligations are not recognizedunder IFRS 3R.

Example: Suppose thatX Company is facedwith a lawsuit related toa product liability claimthat is noncontractual innature and which is

expected to be settledone year from today.Also assume that Y isbuying a 100 percentinterest in X and that therelevant cost of capital is10 percent. Based onmanagement’s analysisand discussion withcounsel, it is expectedthat X will need to payout $100 million toclaimants 25 percent ofthe time and that X willpay out nothing to theclaimants otherwise.Since it is expected thatpayments will occur 25 percent of the timeand the contingency isnoncontractual from aU.S. GAAP standpoint,

Y would not place avalue on the contingencyfor purposes of SFAS141(R).

In contrast, Y wouldvalue the contingent lia-bility at $22.73 million(the present value of theexpected cost of the con-tingency) under IFRSswhen X’s contingency isconsidered possible innature.

Valuing NoncontrollingInterests

Noncontrolling interests(NCIs) can be valued underIFRSs at either the NCI’s pro-portionate share of the fair

value of the acquiree’s netassets (including good-will) or at the NCI’s pro-portionate share of the fairvalue of the acquired com-pany’s identifiable netassets. U.S. GAAPrequires that the NCI bemeasured as the NCI’sproportionate share of the

fair value of the acquired com-pany’s identifiable assets(including goodwill).

Example: Suppose thatY Company enters intoan agreement with XCompany to acquire 80 percent of X’s out-standing stock for $300million. As part of theaccounting for the acqui-sition, Y determines thatthe fair value of X’sidentifiable assets is$350 million and thatthe fair value of X’sidentifiable liabilities is$25 million.

Based on the abovefacts, the fair value of

The Journal of Corporate Accounting & Finance / May/June 2009 53

© 2009 Wiley Periodicals, Inc. DOI 10.1002/jcaf

Under IFRS 3R, an acquirer mustrecognize, at fair value on theacquisition date, present obligationsthat can be reliably measured.

JCAF20-4_20500.qxp 4/8/09 8:56 PM Page 53

Page 6: How will valuation changes affect M&A deals?

X’s net identifiableassets is $325 million—with 80 percent of thesenet assets owned by Yafter Y’s acquisition and20 percent of theseassets being owned bythe noncontrollinginterest. As alluded toabove, under IFRS 3R,the NCI can be valuedat either a proportionateshare of the fair valueof X’s implied netassets including good-will (20 percent of $375million, or $75 mil-lion) or at the NCI’sproportionate share ofthe fair value of X’sidentifiable net assets(20 percent of $325million, or $65 mil-lion) exclusive ofgoodwill. Although thedifference in the NCI’svalue is not large ($10million), the differencein value will impacthow Y accounts forfuture purchases of X’sstock and will alsoaffect the extent towhich the NCI canabsorb any future lossesgenerated by X.

Measuring the AcquiredEntity’s Employee Benefits

Both IFRS 3R and SFAS141(R) require the liabilitiesand assets related to theacquired company’s employeebenefit arrangements to berecognized and be measured inaccordance with the appropriateinternational or U.S.-basedaccounting standards. Since the standards governing theaccounting for employee benefitarrangements differ domesti-cally and internationally, thevalue assigned to the acquiree’s

employee benefit arrangementswill also differ.

MEASUREMENT ANDVALUATION SIMILARITIES:IFRS 3R AND SFAS 141(R)

Even though differences doexist between IFRS 3R andSFAS 141(R), IFRS 3R andSFAS 141(R) do share a numberof similarities. From a valuationperspective, both of these newpronouncements provide similarguidance along a number ofdimensions. Specifically, these

pronouncements provide similarguidance in terms of:

• values assigned to reacquiredrights,

• the accounting for acquisitioncosts,

• the valuation date used tovalue the acquirer’s stock,

• whether and how contingentconsideration is valued, and

• the types of intangible assetsthat are valued as part of thebusiness combination.

Each of these items is dis-cussed below in more detail andsummarized in Exhibit 2.

Valuing Reacquired Rights

As part of the acquisition, anacquirer may reacquire certain

rights that it had previouslytransferred to a company it isnow acquiring. For instance,suppose that X Company isgoing to acquire Y Company.Further suppose that just prior toacquiring Y, X Company enteredinto an agreement with Y thatprovided Y with an exclusivelicense to X’s technology for aperiod of ten years in return foran end-of-year fee of $200,000.As part of the agreementbetween X and Y, the two partiesincluded a renewal option for upto 20 years beyond the current

agreement period.The acquisition of Y

Company by X Companyinvolves the reacquisitionof the license for which Ycurrently pays X $200,000a year. This reacquisitionof the license is referred toas a reacquired rightbecause X is now reacquir-ing from Y, as part of itsacquisition of Y, a right tolicense technology to othercompanies.

Under SFAS 141(R)and IFRS 3R, the reacquiredright is considered an identifiableintangible asset that X Companymust recognize separately fromgoodwill. The value assigned tothe reacquired right under bothSFAS 141(R) and IFRS 3Requals the value of the dis-counted cash flows generatedfrom the license over the remain-ing ten-year term of the originallicensing contract. In assigningvalue to the license under SFAS141(R) and IFRS 3R, renewaloptions are ignored, as would beany market notions of what thislicense might be worth. As such,both the FASB and the IASBhave made an exception to itsfair value notions when assigningvalue to reacquired rights. Suchexceptions to market valuationswould also extend to Y’s deferred

54 The Journal of Corporate Accounting & Finance / May/June 2009

DOI 10.1002/jcaf © 2009 Wiley Periodicals, Inc.

Both IFRS 3R and SFAS 141(R)require the liabilities and assetsrelated to the acquired company’semployee benefit arrangements to berecognized and be measured inaccordance with the appropriateinternational or U.S.-based accountingstandards.

JCAF20-4_20500.qxp 4/8/09 8:56 PM Page 54

Page 7: How will valuation changes affect M&A deals?

taxes (and valuation accountsunder FIN 48, Accounting forUncertainty in Income Taxes),and any assets held by Y at theacquisition date that met theclassification criteria of assetsheld for resale under eitherSFAS 144 (Accounting for theImpairment or Disposal of Long-Lived Assets) or IFRS 5 (Non-current Assets Held for Sale andDiscontinued Operations).

Example: If it is assumedthat X’s cost of capital is12 percent, the techno-logy rights obtained by Xfrom Y as part of theacquisition of Y would bevalued at $1,130,045—the present value of a$200,000, ten-yearannuity, discounted at a

12 percent annual rate.The $1.13 million reac-quired rights would beincluded as one of theassets obtained as partof X’s acquisition of Y.Subsequent to acquisi-tion, the reacquired rightswould need to be testedfor impairment.

The Accounting forAcquisition Costs

Under both SFAS 141 andIFRS 3, acquisition costs wereallocated to the various assetsacquired as part of the businesscombination. SFAS 141(R) andIFRS 3R now require that thesecosts be expensed as incurred.The valuation implication ofthis change is that acquisition

costs will no longer impact thevalue assigned to the acquiree’sgoodwill.

Example: Assume that YCompany is acquiring a100 percent interest in ZCompany for $50 mil-lion. The fair value ofZ’s assets (exclusive ofgoodwill) at the date ofacquisition totals $40million. To acquire Z, Yincurs $5 million inacquisition costs in addi-tion to the $50 millionpaid to Z’s shareholders.

Under SFAS 141 andIFRS 3, the amountassigned by Y to Z’sassets (inclusive ofgoodwill) would equal

The Journal of Corporate Accounting & Finance / May/June 2009 55

© 2009 Wiley Periodicals, Inc. DOI 10.1002/jcaf

Similarities Between IFRS 3R and SFAS 141(R)

Item Accounting/Valuation Requirements

Reacquired Rights Reacquired rights are recognized as assets acquired in the business combination.

Reacquired rights are valued at their respective discounted cash flows.Acquisition Costs Acquisition costs are expensed as incurred and not used to step up the

value of the assets acquired as part of the business combination.Valuation Date of Acquirer’s Stock The acquirer’s stock issued as consideration is valued at the acquisition

date. The acquisition date is defined as the date when the change incontrol occurs. The acquisition date is to be considered as thevaluation/measurement date for both the assets received and theconsideration provided as part of the business combination.

Contingent Consideration Contingent consideration provided as part of the business combination is to be valued as of the acquisition date. Subsequent changes in the value ofthe contingent consideration are charged to earnings in the year thechange occurs.

Intangible Assets Intangible assets are recognized and valued as part of the business combination when they meet the separability or contractually legalcriterion. If either condition is met, the value of the intangible is assumedto be able to be reliably measured. All intangibles must be valued basedon relevant fair value measures.

Exhibit 2

JCAF20-4_20500.qxp 4/8/09 8:56 PM Page 55

Page 8: How will valuation changes affect M&A deals?

$55 million—the $50million paid to Z’sshareholders and the $5 million incurred by Yto acquire Z. Thedifference between the$40 million in assetsacquired and the $55 million paid forthese assets, $15 millionin total, would becharged to goodwill.

Under SFAS 141(R) andIFRS 3R, the amountassigned by Y to Z’sassets (inclusive ofgoodwill) would total$50 million. Thedifference between the$40 million in assetsacquired and the $50 million assignedto Z’s assets, $10 mil-lion in total, wouldbe viewed as theacquiree’s goodwill. In contrast to pastaccounting for acquisi-tion costs, the newpronouncementsrequire the $5 millionin acquisition costs tobe expensed in theperiod incurred and notbe considered part of thegoodwill calculation.

Valuation Date of Acquirer’s Equity

Under SFAS 141(R), IFRS3R, and IFRS 3, shares of theacquiring company issued aspart of the acquisition are to bevalued as of the acquisition date.For purposes of IFRS 3, IFRS3R, and SFAS 141(R), theacquisition date is defined asthe date on which the acquirerobtains control over the acquiredcompany. Under previous U.S.GAAP, specifically SFAS 141,

equity securities issued to effectan acquisition were valued a fewdays before or a few days afterthe announcement of the busi-ness combination. These differ-ences in valuation dates mayhave profound effects on thevaluation of the equity sharesissued as part of the businesscombination.

Example: Suppose XCompany is acquiringY Company in an all-stock deal, under whicheach of the 1 millionshares of Y will beexchanged for 1.5 sharesof X Company. Theacquisition wasannounced on December31, 2008, with X

assuming control of Yon February 1, 2009.On December 31, 2008,X’s stock was trading at$10 per share, while X’sstock was trading at $9per share on February 1,2009.

Under SFAS 141(R),IFRS 3, and IFRS 3R, Xwould assign a value of$13.5 million to theshares of stock trans-ferred to Y shareholders.Under SFAS 141, theequity would have beenvalued at $15 million, itsvalue on the date thecombination wasannounced.

Valuing ContingentConsideration

Acquisitions often includecontingent consideration,defined as consideration that ispayable only when certain con-ditions are met. A sale of anaccounting practice, forinstance, often includes acontingent consideration clause,whereby the buyer of the prac-tice pays the seller an amountequal to some multiple of theacquired practice’s next year’sbillings.

Under current accountingstandards, contingent considera-tion is generally not valued aspart of the acquisition price.Under SFAS 141(R) and IFRS3R, however, any contingent

consideration included aspart of the acquisition willneed to be valued at theacquisition date and willneed to be counted as partof the acquisition price. Bymaking this change, theaccounting standard settershave eliminated a com-pany’s ability to use contin-gent consideration to mask

the full amount paid for theacquired company.

Example: Suppose thatY Company purchasesX Company at time zerofor $100 million cashand contingent consider-ation equal to X’s Year 3earnings before interest,taxes, depreciation, andamortization (EBITDA).Currently, X’s EBITDAtotals $50 million. It isexpected that X’sEBITDA will grow at arate of 4 percent in eachof the next three years.As part of its due dili-gence, Y has also deter-mined that X’s cash

56 The Journal of Corporate Accounting & Finance / May/June 2009

DOI 10.1002/jcaf © 2009 Wiley Periodicals, Inc.

Under SFAS 141(R), IFRS 3R, andIFRS 3, shares of the acquiring com-pany issued as part of the acquisi-tion are to be valued as of theacquisition date.

JCAF20-4_20500.qxp 4/8/09 8:56 PM Page 56

Page 9: How will valuation changes affect M&A deals?

flows should be dis-counted at a weightedaverage cost of capital(WACC) equal to 12percent to account forX’s unsystematic riskand debt capacity.

Under the scenariodescribed above, X’sYear 3 EBITDA wouldequal $56.2 million.When discounted to the present, Year 3’sEBITDA would approxi-mate $40 million. UnderSFAS 141, the presentvalue of Year 3’s contin-gent payout would notbe considered part of theacquisition price and Ywould be viewed asacquiring X for $100million. Under the newbusiness combinationstandards, Y wouldconsider the presentvalue of the contingentconsideration, the $40million, as part of theacquisition price for X.Under the new account-ing standards, Y wouldtherefore be viewed aspaying $140 million forX Company, not $100million.

Measuring Intangible Assets

Under IFRS 3R and SFAS141(R), intangible assets that areacquired as part of a businesscombination and meet the sepa-rability criterion or the contrac-tually legal criterion are sepa-rately recognized from goodwillat their respective fair value asof the acquisition date. Anintangible asset is assumed tomeet the contractually legal cri-terion when it arises from con-tractual or other legal rights. Anintangible asset is assumed to

meet the separability criterion ifthe company is capable of sell-ing, licensing, renting, orexchanging the intangible assetto a third party either by itself orin combination with a relatedcontract, asset, or liability.

Past accounting practice,specifically IFRS 3 and SFAS141, included similar require-ments for when intangiblesshould be recognized. However,IFRS 3 allowed companies toexclude certain intangibles fromthe business combination basedon the company’s inability toreliably measure the value of theintangible. In addition, SFAS141 did not require valuation ofthe intangibles under their high-est and best use, and, therefore,certain intangible assets might

not have been booked as part of the business combinationbecause the acquired intangiblehad little or no value to the com-pany acquiring them. IFRS 3Reliminates the reliability excep-tion found in IFRS 3, and SFAS141(R) requires that intangiblesacquired in the business combi-nation be valued at their highestand best use.

The added guidance foundin SFAS 141(R) and IFRS 3R asto when to recognize an intangi-ble should increase the numberand types of intangibles recordedas part of the business combina-tion and cause commensuratereductions in recognized good-will. A specific case in point ofthis is the acquiree’s in-processresearch and development. Under

SFAS 141(R), the acquiree’s in-process research and develop-ment costs are to be included aspart of the acquiree’s assets andnot expensed, as would havebeen the case under SFAS 141.

It also should be noted thatwhile both SFAS 141(R) andIFRS 3R both use similar criteriato determine when an intangibleasset should be recognized,neither standard mandates whatmethod to use in valuing theseintangibles. Currently, businessvaluators use one of threemethods when valuing an asset:the cost approach, the incomeapproach, and the marketapproach. As would be expected,the valuation method used tovalue the intangibles will affectboth the value assigned to the

asset and any futureamortization/impairmentamounts associated withthe asset.

SUBSEQUENT EFFECTS(AFTER ACQUISITION) ONTHE INCOME STATEMENT/BALANCE SHEET ANDIMPLICATIONS ON DEAL

STRUCTURE: U.S. ANDINTERNATIONAL ACQUISITIONS

It is our expectation that theamount paid for an acquisitionwould be unaffected by thechanges in the accounting stan-dards for business combina-tions. After all, what someonewill pay for a business shouldbe unaffected by the accountingfor the transaction. However, itis possible that the changes inthe standards could affect thestructure of the deal andwhether the deal actually takesplace. The reason for this is thatthe changes in the accountingfor business combinations, asoutlined in SFAS 141(R) andIFRS 3R, will affect the finan-cial statements of the combined

The Journal of Corporate Accounting & Finance / May/June 2009 57

© 2009 Wiley Periodicals, Inc. DOI 10.1002/jcaf

An intangible asset is assumed tomeet the contractually legal criterionwhen it arises from contractual orother legal rights.

JCAF20-4_20500.qxp 4/8/09 8:56 PM Page 57

Page 10: How will valuation changes affect M&A deals?

entity in terms of the initialaccounting for the businesscombination and the subsequentaccounting for the combinedcompany. Because of this, wewould anticipate that companieswould consider these changesand take the steps necessary tomitigate any adverse financialeffects that might be associatedwith the new standards govern-ing the accounting for businesscombination.

A recent Deloitte FinancialAdvisory Services poll supportsthis conclusion. The results ofthe Deloitte poll indicate that40 percent of 1,850 respondingexecutives feel that “FAS 141(R),Business Combinations, wouldcause them to ‘rethink’ dealstrategy and would affectplanned deal activity.”5

Since IFRS 3R and SFAS141(R) are fairly consistentin many ways, we feel thatthe survey’s conclusionsprobably hold as well forthose companies needingto comply with IFRS 3R.

Underlying these pollresults is the fact that anumber of the changesmandated by the newaccounting standards will lead tomore variability in the futurereported financial results of thecombined entity. Some of themore significant changes in thebusiness combinations standardsthat will contribute to this earn-ings variability include thepostacquisition accounting for:

• contingent assets andliabilities,

• noncontrolling interests,• contingent consideration,

and• intangible assets.

Each of these items is dis-cussed below in terms of theirimpact on the combined entity’s

future earnings, with theseeffects being summarized inExhibit 3.

Subsequent Accounting forContingent Liabilities andContingent Assets

Under the new standards,yearly changes in the valuesassigned to the contingentassets and liabilities will bereflected in the income state-ment. Under U.S. GAAP,losses/gains associated withrevaluing contingent assets andliabilities will need to be recog-nized only when new informa-tion suggests that the contingentasset or liability has changed invalue. When this information

becomes available, the contin-gent asset will be revalued tothe lower of its acquisition-datefair value or the best estimate ofits future value. For liabilities,U.S. GAAP will require theacquirer to measure the contin-gent liability at the higheramount of its acquisition fairvalue or the amount recognizedunder SFAS 5. In contrast,under IFRS 3R, any new infor-mation regarding the acquiree’scontingent liabilities will beused to revalue the contingencyto an amount equal to the higherof its acquisition fair value orthe best estimate of the amountneeded to settle the contingentliability.

Potential Impact on DealStructure

Earnings volatility may wellincrease because of the need toadjust contingent liabilities andassets on a yearly basis. Compa-nies should anticipate this andinclude in their valuation modelsthe potential volatility created bythese contingencies. Companiesshould also take steps (eitherpreacquisition or postacquisi-tion) to minimize the financialeffects of the contingent liabilityor to enhance the value of thecontingent asset.

Subsequent Accounting forNoncontrolling Interests

Subsequent to acquisition,the noncontrolling interestwill be assigned its share ofthe acquiree’s profits andlosses even if the lossesresult in a deficit value forthe noncontrolling interest.Further, if the noncontrollinginterest is later acquired bythe controlling interest, anyshortfall between the bookvalue of the noncontrollinginterest and the amount paid

for the noncontrolling interest willreduce the controlling interest’sequity. Such reductions in equitycould negatively affect certain ofthe acquirer’s key financial performance ratios, includingreturn on equity and debt-to-equityratios.

Potential Impact on DealStructure/Valuation

If the acquirer plans onacquiring the noncontrollinginterest in the future and wantsto avoid dilution of debt/equityrelationships to the extent possi-ble, it should value the NCI atthe highest possible amount atacquisition. For companies

58 The Journal of Corporate Accounting & Finance / May/June 2009

DOI 10.1002/jcaf © 2009 Wiley Periodicals, Inc.

Under U.S. GAAP, losses/gains associ-ated with revaluing contingent assetsand liabilities will need to be recog-nized only when new informationsuggests that the contingent asset orliability has changed in value.

JCAF20-4_20500.qxp 4/8/09 8:56 PM Page 58

Page 11: How will valuation changes affect M&A deals?

adopting IFRSs, this wouldrequire valuing the noncontrollinginterest at amounts that includethe noncontrolling interest’s pro-portionate share of goodwill.

Subsequent Accounting forContingent Considerations

Because contingent consider-ation is valued at its acquisition-date fair values, any changes in

the value of the contingent con-sideration post-acquisition willlead to income-statement effects.If better-than- anticipated per-formance occurs, the acquiringfirm will have greater expensesrelated to the contingent consid-eration. In contrast, lower-than-anticipated performance shouldresult in lower payouts and lowerexpenses for the acquiring company.

Potential Impact on DealStructure

Companies that wish to avoidthe earnings volatility created bycontingent consideration maychoose to denominate the contin-gent consideration in terms of afixed number of the acquirer’sequity shares. Any changes inthe value of the shares would nothave income-statement effects,

The Journal of Corporate Accounting & Finance / May/June 2009 59

© 2009 Wiley Periodicals, Inc. DOI 10.1002/jcaf

Impact of New Business Combination Standards on Future Firm Performance/Deal Structure

U.S. GAAP IFRS

Accounting for Contingent Contingent assets/liabilities may Contingent liabilities may need to be Assets/Contingent Liabilities need to be revalued on a revalued on a yearly basis.

yearly basis.

Impact on Deal Structuring Revaluation of a contingent asset or liability will result in an offset to the income statement, potentially increasing earnings volatility. Acquirersshould consider how to minimize these effects.

Accounting for Contingent Contingent consideration may need to be revalued on a yearly basis.Consideration

Impact on Deal Making Any revaluation of contingent consideration viewed as debt will result in an offset to the Income statement. The revaluation of contingent considerationviewed as equity will not have income-statement effects. However, the useof equity-based contingent consideration may impact earnings-per-sharecalculations because of its impact on weighted shares outstanding. Acquirersshould consider both of these issues when deciding whether to includeeither debt- or equity-based contingent consideration in their offers.

Valuation of Noncontrolling Alternatives for valuing Noncontrolling interests are valued in Interests noncontrolling interests are one of two ways under IFRSs

not available.

Impact on Deal Making Acquiring firms that anticipate future acquisitions of the acquiree’s noncontrolling interest and follow IFRSs should carefully consider which ofthe two valuation methodologies for NCIs to use when initially accountingfor the noncontrolling interest.

Valuation of Intangible Assets IFRS 3R and SFAS 141(R) will result in the recognition of more intangible assets,which will contribute to higher amortization costs on the income statement.

Impact on Deal Making Depending on the amounts and timing of any additional amortization costs,firms that justified acquisitions in the past based on earnings metrics maywant to justify the acquisition more on a cash-flow basis and use share valueaccretion or the acquisition’s internal rate of return to justify the acquisition.

Exhibit 3

JCAF20-4_20500.qxp 4/8/09 8:56 PM Page 59

Page 12: How will valuation changes affect M&A deals?

since the consideration would beconsidered an equity interest inthe acquirer. There is no freelunch here, however, because theuse of equity-based considera-tion should result in increases inthe acquirer’s weighted sharesoutstanding and commensuratereductions in current and futureearnings per share.

Acquisition teams shouldtherefore determine the income-statement effects of using eitherequity-based or debt-based con-tingent consideration when per-forming their due diligencework. By doing this, the acqui-sition team can better determinehow contingent considerationmight be best structured toreflect the economics of theacquisition.

Subsequent Accounting for Intangible Assets

Intangible assets with indef-inite lives will need to be testedfor impairment on a yearlybasis. Intangible assets withdefinite lives will also need tobe tested for impairment, andthe yearly amortization expensefrom these intangibles will bereflected in the company’sincome statement. Since IFRS3R and SFAS 141(R) will mostlikely lead to the recognition ofmore intangibles, reported earn-ings post-acquisition under thesenew standards will probably bebelow those reported undercurrent standards.

Impact on Deal Structure

Deals that were justified inthe past based on earnings accre-tion may still make economicsense. However, because of theearnings volatility issues associ-

ated with the new standards, themetrics used to measure the accre-tive nature of the deal may need tobe altered to be more reflective ofthe underlying cash flows gener-ated from the acquisition. Futuredeals may therefore need to besold more on cash-flow accretionthan on earnings accretion.

SIGNIFICANT CHANGES AHEAD

Both IFRS 3R and SFAS141(R) include significantchanges in the accounting forbusiness combinations. Thesestandards will alter the valuesassigned to the acquiree’s assetsand liabilities from those cur-rently assigned under existingbusiness combination standards.Because of these changes, com-panies that plan on merger-and-acquisition activity in 2009should familiarize themselveswith both IFRS 3R and SFAS141(R) prior to performing anyacquisition-related activities.These efforts will allow thoseinvolved with merger-and-acquisition activities to beproactive in structuring thebusiness combination in waysthat will assure that futurefinancial performance reflectsthe economic benefits associ-ated with the acquisition.

IFRS 3R is to be appliedprospectively to mergers andacquisitions occurring in the firstaccounting period beginning onor after July 1, 2009. Earlieradoption, for business combina-tions occurring on or after June30, 2007, is permissible underIFRS 3R. SFAS 141(R) is effec-tive prospectively for mergersand acquisitions occurring incalendar year 2009. In contrastto IFRS 3R, early adoption ofSFAS 141(R) is not permitted.

NOTES

1. SFAS 141(R), Business Combinations,was issued by the Financial AccountingStandards Board in December 2007.IFRS 3R, Business Combinations, wasissued by the International AccountingStandards Board in January 2008. Tworelated standards, one issued by theFASB and one by the IASB, govern theaccounting for minority interests andprovide guidance as to when separateand consolidated statements should beissued. These two standards are SFAS160, Non-controlling Interests inConsolidated Financial Statements, AnAmendment of ARB No. 51, and IAS27R, Consolidated and SeparateFinancial Statements.

2. For more detail into other accountingdifferences between U.S. and interna-tional GAAP, interested readers shouldconsult A Global Guide to Accountingfor Business Combinations and Noncon-trolling Interests: Application of the U.S.GAAP and IFRS Standards (New York:PricewaterhouseCoopers, 2008).

3. The definition of a business combina-tion as found in SFAS 141(R) willlikely be affected by the FASB’s projecttitled “Reconsideration of FIN 46(R)Consolidation of Variable InterestEntities,” which was last updated onAugust 7, 2008. Interested readersshould consult the FASB’s Web site,www.fasb.org, for additionalinformation.

4. U.S. accounting regulators are consider-ing changes in when noncontractual con-tingencies will need to be recognized aspart of the business combination. Thesechanges may include a movement awayfrom the “more-likely-than-not” recogni-tion requirement and the inclusion of areliably measurable requirement for con-tingent assets and liabilities. More infor-mation about these changes can be had byreviewing the proposed FASB Staff Posi-tion No. FAS 141(R), Accounting forAssets Acquired and Liabilities Assumedin a Business Combination That AriseFrom Contingencies.

5. See Leone, M. (2008, June 13). Rulemakes execs think twice aboutdealmaking—A Deloitte survey saysFASB’s new merger rule will put thekibosh on transactions that untilrecently would have gone forward.Retrieved February 19, 2009, fromhttp://www.cfo.com/article.cfm/11562484?f=related.

60 The Journal of Corporate Accounting & Finance / May/June 2009

DOI 10.1002/jcaf © 2009 Wiley Periodicals, Inc.

JCAF20-4_20500.qxp 4/8/09 8:56 PM Page 60

Page 13: How will valuation changes affect M&A deals?

The Journal of Corporate Accounting & Finance / May/June 2009 61

© 2009 Wiley Periodicals, Inc. DOI 10.1002/jcaf

Peter Woodlock, PhD, is a professor of accounting and finance in the Williamson College of BusinessAdministration in Youngstown, Ohio. Gang Peng is an assistant professor of management in the WilliamsonCollege of Business Administration in Youngstown, Ohio.

JCAF20-4_20500.qxp 4/8/09 8:56 PM Page 61