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The Financial Accounting Standards Board’s (“FASB”) revision to its Statement of Financial Accounting Standards No. 141 (“FAS 141R”), changes how business combinations are treated under Generally Accepted Accounting Principles (“GAAP”). The changes in FAS 141R represent a step towards the international convergence of accounting standards by aligning US GAAP closer to the International Financial Reporting Standards (“IFRS”). However, in addition to changes to financial reporting, the changes in these accounting rules will impact how companies view their transaction strategy going forward. It is imperative that financial executives understand not only how FAS 141R will change purchase accounting but also how the initial treatment of an acquisition will affect financial reporting in the future.

FAS 141R requires a transition from the purchase method to the acquisition method. Previously, under FAS 141, the purchase price was allocated among all identifiable tangible and intangible assets and the remainder was considered goodwill. The acquisition method calls for the recognition of the fair value, as defined under Statement of Financial Accounting Standards No. 157 (“FAS 157”), of all of the assets acquired and liabilities assumed in the transaction. After the assets and liabilities have been recognized at fair value, the difference between the net of the assets and liabilities and the purchase price is categorized as either goodwill or a gain from a bargain purchase. The fundamental shift in the philosophy is that the assets are valued independent of, rather than based on, the purchase price. Fair value is the predominant standard used in business, tangible asset, and intangible asset valuation for financial reporting purposes.

Fair value is defined as the price that would be received to sell an asset or transfer a liability in an orderly transaction between market participants as of a specified date. The concept of the market participant means that any synergies from a specific buyer are not to be taken into consideration when valuing the asset or business. While FAS 157 and the application of mark-to-market accounting to value auction rate securities, mortgage backed securities and other financial products has been hotly contested over the last few months, the new fair value standard provides a clearer, more universal standard for valuing businesses and intangible assets.

Below we have highlighted the five key changes that will have the largest impact to financial executives who need to understand the new rules governing the accounting for business combinations. These rules take effect at the beginning of the first annual reporting period after December 15, 2008¹:

Contingent Consideration 

Contingent consideration that is paid for the target company, which includes earn-outs and other additional forms of consideration, will now be recorded at fair value as part of the purchase price at the time of the acquisition. Previously, when earn-out milestones were achieved, the payment resulted in an increase to the purchase price, which was generally allocated to goodwill. Now, the asset or liability associated with the contingent consideration is revalued each reporting date, with the change impacting earnings in the current period, until the contingency is resolved.

Pre-Acquisition Contingencies

This portion of FAS 141R has been updated since its issuance in December 2007. FAS 141R initially required recognition of all contractual and noncontractual contingencies, such as outstanding lawsuits, that are more likely than not to give rise to an asset or liability at their fair value as of the acquisition date. However, this has since been further revised by FSP FAS 141(R)-1 with the following guidance. The asset or liability arising from a contingency must be recognized if the acquisition-date fair value can be determined during the measurement period. If the fair value cannot be determined during the measurement period, then it is only recognized if it meets both of the following criteria: 

• The information available before the end of the measurement period indicates that it is probable that an asset or liability existed at the acquisition date.
• The amount can be reasonably estimated.

If either one of the criteria is not met, the acquirer shall account for the contingency in accordance with other applicable GAAP, including FAS 5, as appropriate². Going forward, the guidance for subsequent measurement and accounting for the contingencies that are recognized is limited to a “systematic and rational basis…depending on their nature.”³

Deal Costs

Under FAS 141, both transaction and anticipated restructuring costs were capitalized and included as part of the purchase price. However, one of the major changes under FAS 141R requires these costs to be expensed in the period incurred. This could lead to ripple effects outside of the context of financial reporting. Companies may alert the markets to potential acquisitions if they incur and report a significant increase in expenses related to investment bankers, attorneys, and other professional service providers.

In-process Research & Development 

FAS 141R takes the opposite approach to in-process research and development (“IPR&D”) when compared to transaction and restructuring costs. Whereas deal costs are now expensed versus being capitalized under FAS 141, IPR&D which was previously expensed, is now capitalized at fair value under FAS 141R. IPR&D is then tested annually for impairment. This will require potentially difficult judgments of impairment as these projects unfold, and if they are abandoned, then the asset must be written off.  

Definition of a Business 

FAS 141R also updates the definition of a business, which means that more transactions will be subject to the scope of the new standard than previously were under FAS 141. “Businesses must be capable of being conducted and managed to provide a return to investors (e.g. dividends, lower costs, increased share price or other economic benefits).”⁴ The previous definition and the new definition under FAS 141R are listed below:

Previous Definition: “A business is a self-sustaining integrated set of activities and assets managed for the purpose of providing a return to investors. A business consists of:

• Inputs
• Processes applied to those inputs
• Resulting outputs that are used to generate revenues⁵

FAS 141R Definition: “...an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members, or participants.”⁶ A business consists of:

• Inputs
• Processes applied to those inputs
• The ability to create outputs

The key distinction between the two definitions is actually having outputs verses the ability to create outputs. The old definition excluded development stage and some real estate entities that do not currently generate outputs. As a result, more entities will be considered businesses under FAS 141R, and therefore, will be treated as business combinations and accounted for at fair value. This change to the definition of a business is likely to lead to fewer acquisitions of select assets under FAS 141R because more groups of assets will be considered businesses. Previously, a business combination, by definition, was a transaction in which the acquirer obtained control through purchase of equity interests or net assets. FAS 141R only calls for a transaction or “other event” which can include the lapse of minority veto rights or an acquiree repurchasing a sufficient number of its own shares for an existing investor (the acquirer) to obtain control.

The first step in the planning process for acquiring companies involves becoming familiar with the important aspects of these new accounting rules and determining if a potential transaction will be subject to FAS 141R. After that initial step, it will be important for financial executives to understand the new rules in order to develop a strategy for structuring transactions and initially reporting acquisitions in order to minimize the impact on investors, lenders, and analysts. analysts. 

¹ If a Company’s fiscal year ends November 30, 2008, then FAS 141R would not take effect until the period beginning December 1, 2009. If the fiscal year ends December 31, 2008, then FAS 141R is already in effect and any transactions after that date would be subject to the updated rules.

² FASB Staff Position No. FAS 141(R)-1. April 1, 2009.

³ Ibid.

⁴ Paragraph A-4 of Statement of Financial Accounting Standards No. 141 (revised 2007).

⁵ Paragraph 6 of EITF No. 98-3. 6 Paragraph A-4 of Statement of Financial Accounting Standards No. 141 (revised 2007).

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