Through a series of tentative decisions, the Financial Accounting Standards Board recently showed that it wants to require even more fair-value accounting in the merger-and-acquisition process. The proposed changes — which would extend elements of FAS 141, the July 2001 standard that ended most acquirers' use of pooling — would profoundly alter the way companies express the costs associated with M&A. But while the revisions in general have merger experts cheering, they have raised some concern that corporations may be tempted to spend less on due diligence and merger planning, a result that would be decidedly negative.
The FASB proposals have several features, all aimed at requiring companies to make merger costs more visible, and to place a value on deal-related assets or liabilities at the level that applies at the time they are obligated. One feature would prohibit acquirers from lumping the costs of merger-related legal fees, due diligence, and integration planning into the overall fair value of the deal. Another feature would bar buyers from estimating and recording expected merger-related restructuring costs — such as employee severance payments, relocations, and plant closings — as a one-time merger reserve liability when the deal is struck. The new rules require that both types of costs be expensed as incurred.
The latter move would further close the loophole that has permitted merger-accounting abuses such as those alleged to have been committed by Cendant Corp., among other companies. Part of the Cendant case has involved charges that it used amounts from its huge, one-time merger reserves to create fictitious revenues, thus helping boost earnings in future quarters. (At press time, former Cendant chairman Walter Forbes and former vice chairman E. Kirk Shelton were on trial for alleged abuses of this kind.)
In FASB's view, this extension of the fair-value standards is "pretty basic," says the board's senior project manager, Ronald Bossio. "What we're basically saying is that you can't recognize a liability until it's a liability. If you have the ability to record an asset or liability whenever you want, you can increase or reduce your net income whenever you want," he says. "We don't want people doing that."
Of course, what constitutes an obligating event that creates a liability may be anything but basic. On January 1, 2003, FAS 146 took effect, essentially banning companies from collecting the costs of exit and disposal activities into a large, one-time restructuring reserve, and requiring them to be accounted for as incurred. FAS 146 also describes how to determine when a liability is incurred. But experts say that those rules, which may soon apply to acquisition-related liabilities, left room for a great deal of interpretation.
Bossio concedes that courts dispute a lot of issues every day, and adds, "It's not always that clear whether or not a liability has been incurred at a certain point in time."
But what of the unintended consequence of the proposed rule change: that companies will feel pressure to hold down transaction costs associated with the merger, such as due diligence, planning, and legal fees? That worry relates largely to the requirement that acquirers break out such costs as separate and apart from the actual fair-value price of the target company, and record those costs, too, when incurred. Under the current FAS 141 guidelines, some of these costs are still allowed to be accounted for as part of the purchase price.
Some experts say this change simply flies in the face of traditional business practice — and may lead to an unhealthy reaction by some acquirers.
"I see a real risk that companies may be inclined to reduce spending on due diligence and other transaction-related costs as a way of reducing current-period expense charges," says Charles Mulford, professor of accounting at Georgia Institute of Technology's College of Management and director of its Financial Analysis Lab. "The fair value of an asset is what someone is willing to pay for it, which has traditionally included the transaction costs."
Adds Sam Rovit, head of the worldwide M&A practice at Bain & Co., "I think it would be very unfortunate if [the guidelines] put a damper on merger planning. The planning for a merger is crucial to its success." Rovit professes to be enthusiastic, however, about the general requirement that fair-value accounting be made to apply to acquisitions.
Expect Few Waves
Even though it may take time to work out ambiguities in the new provisions — an exposure draft and the associated comment period are expected in the first quarter of 2005 — Corporate America seems ready to accept what FASB has prepared. For one thing, the changes have far less impact than previous merger-accounting revisions, especially the elimination of pooling. And, of course, they follow the fair-value trend outlined by regulators years ago.
Indeed, in some quarters companies already are operating according to the guidelines, even before they become an official regulation. "We've done three recent deals," says Rovit, "and in each case, the company received advice to essentially implement the new rules before they come out."
Jordan Klear, managing partner at Washington, D.C., investment-banking boutique Gutman Group LLC, doesn't expect most merger-minded companies to scrimp on preplanning just to show better up-front numbers. And he sees the new proposals as good for both investors and businesses. "I believe that restructuring reserves, used in connection with mergers and acquisitions, have long been abused by the corporate community as a way to hide the lack of performance of companies that have been acquired," he says. "I view this move by FASB as a positive one that will only reinforce the integrity of proposed mergers."
While there may be some short-term negative effect on M&A, Klear believes that over time, the changes will force companies to take a more thoughtful approach to acquisitions from the very beginning. "We believe that long term, the primary tool used for corporate growth will always be M&A," he says. "This will be just another rule they'll have to abide by."
So far, CFOs also seem unfazed by the proposed changes. "When you evaluate M&A, you should look at the ultimate cash flow the combination will create, not the accounting treatment associated with certain charges," says Digitas Inc. finance chief Jeff Coté. "The question is, will the cash flow be positive and accretive to the existing business?" The new rules, he adds, would likely have little effect on acquisition activity at his Boston-based marketing-services firm.
"FASB has been doing a good job giving guidance on these matters," says Coté. "They are just continuing to refine the guidance to make reporting more comparable across companies. And that is absolutely a good thing."
What's Next? Commissions?
While the proposals may make abuses of merger reserves far less likely, they still leave plenty of room for faulty estimates — which may, of course, reflect a great deal of speculation, even after an "obligating event" has occurred. Severance payments, lawsuit-related liabilities, and other postmerger items generally must be estimated at the point when the layoffs are planned or the suits are filed, for example. But, unless U.S. businesses move fully away from accrual accounting, that's unlikely to change.
One major contribution of these latest changes, says FASB's Bossio, is that they will bring FASB rules into harmony with the International Accounting Standards Board requirements for business-combination accounting.
In advance of the official exposure draft, FASB has not yet received much push-back about the proposals. (It has already recorded objections, however, from member-owned companies and collaboratives, as well as mutually held insurance companies, all of which had been excluded from coverage under FAS 141's nonpooling rules.) If passed, the rules would take affect in fiscal years beginning after December 15, 2005.
How much further could the application of fair value extend? Some see it eventually affecting any asset purchase with hefty transaction-cost elements, such as delivery and setup charges. And not everyone agrees this would be good.
If regulators are going to change such a basic thing as merger-cost accounting, "we have to look at a lot of other transactions as well, like investments," says Georgia Tech's Mulford. "Are we going to start breaking out commission charges now?"
Kris Frieswick is a senior writer at CFO.