Valuation Critical Under New M&A Rules

Sweeping changes to the accounting rules for mergers and acquisitions (M&A) will start affecting many companies that are closing deals this year. Statement of Financial Accounting Standards (SFAS) No. 141(R), Business Combinations, was issued by the Financial Accounting Standards Board (FASB) in late 2007, but it applies to deals closing on or after the first day of the first annual reporting period beginning after Dec. 15, 2008. Many of the changes prescribed in this 358-page document increase the importance of having accurate valuations.

Shift to a Fair Value Approach

The purpose of the revised standard is to increase consistency and transparency in financial reporting and to clarify inconsistencies in previous pronouncements. To that end, the standard requires more fair value reporting. Here are a few of the key items that are affected:

• Acquired assets and assumed liabilities. Purchasers are now required to recognize acquired assets and assumed liabilities at their acquisition-date fair values rather than at cost. In addition, any stock or other equity securities the purchaser issues as consideration must be measured by its fair value on the closing date, rather than the date the deal is announced, which was the previous practice.
  
• Goodwill. Goodwill is calculated by totaling the fair value of: 1) the consideration for the purchase, 2) any noncontrolling interests in the target company, and 3) any equity interests in the target already held by the purchaser, and subtracting the net fair value of identifiable acquired assets and assumed liabilities. This is particularly significant in acquisitions of less than 100% of the target’s stock because goodwill is measured based on the fair value of the entire company, not just the piece being acquired.
  
• Contingent assets and liabilities. Purchasers are now required to record contractual contingencies (such as warranties) at their acquisition-date fair value. Noncontractual contingencies (such as lawsuits) are recorded at their acquisition-date fair value if it’s more likely than not that they will result in an asset or liability.
  
  This is a significant departure from previous rules, under which contingencies were recognized only if they were probable and reasonably estimable. Under the new rules, contingencies must be reevaluated in subsequent accounting periods and earnings adjusted as appropriate.
  
• Contingent consideration. Purchasers are now required to recognize contingent consideration, such as an earnout provision, at its fair value on the acquisition date rather than waiting until after the contingency is settled. In subsequent accounting periods, changes in the estimated fair value of contingent consideration are recorded on the company’s income statement.
  
• Transaction costs. Transaction costs — such as legal, accounting and investment banking fees — are now expensed as incurred rather than capitalized as part of the purchase price. The immediate impact of these costs on earnings may cause some clients to become more fee-sensitive.

The Role of Business Valuation

By shifting to a fair value approach to M&A accounting, SFAS 141(R) increases the need for valuations in connection with business combinations and makes the valuation process more complex.

Valuations are particularly important with regard to contingent assets and liabilities, contingent consideration, and other items that are subject to uncertainty. Although there’s no way to eliminate this uncertainty, a thorough, well-reasoned valuation up front will minimize the earnings volatility that can result if frequent adjustments to fair value are required in the future.