Business combinations: Soon we will see the ‘new’ standard’s effects

It feels like a long time (approaching two years) since my posting on the subject of the IASB’s revised business combinations standard. It was probably the most controversial accounting topic of its day; but now, of course, the debate has moved on, and subjects such as fair value and financial instruments are taking centre stage.

There have been few high-profile deals since the revised versions of IFRS 3 on business combinations and IAS 27 on consolidated financial statements were issued in January 2008. However, there are signs in some parts of the world that M&A activity is starting to pick up, and the timing could not be better as the revised standards are effective for years beginning on or after 1 July 2009. Although many companies with calendar years will not apply the revised standards until 2010, some of the potential deals currently attracting media attention may not be completed until next year, and these may fall to be accounted for under the new approach. This could have an impact on earnings and may influence the way in which deals are structured

Here’s a reminder, at a very high level, of some of the revised standards’ implications:

• The cost of a business combination includes cash paid, shares issued and any payments that are contingent on future events. Items traditionally considered as part of the cost of the business combination may no longer be so. In particular, transaction costs, such as legal and accountants’ fees, will be written off as incurred.
• The consideration also, in effect, includes any previously held interest in the acquired business. When control is obtained, the previously held interest will in future have to be re-measured to fair value and a gain or loss recognised in the income statement. The converse is also true: when control is lost – for example, when a former subsidiary becomes an associate – the remaining interest is also fair valued through the income statement.
• Many acquisitions are made with an element of the payments being contingent on, for example, the future performance of the acquired business. Previously, contingent payments were accrued only when probable, and they were added to and adjusted against goodwill. Under the new approach, all contingent payments are measured at fair value at the time of the acquisition. They are subsequently re-measured to fair value through the income statement. So, if an acquired business does better than originally assumed and the fair value of the liability increases, it may, paradoxically, result in a debit in the income statement; on the other hand, if the opposite occurs it would be a credit.

Most companies follow a ‘parent-company’ approach to consolidation, which means that a purchase of a minority interest (or non-controlling interest, as it is now known) leads to goodwill, while a sale of shares to a minority results in a gain or loss. The new standards take the 'economic entity' view (a concept in my view that has yet to have the benefit of an adequate debate), whereby minorities are viewed in the same way as the parent shareholders, as just another class of equity. This means that transactions with them under the new standards will not result in goodwill or gains: all effects will be recorded in equity.

These are just some of the ways in which earnings may be impacted by the revised standards. There are many reasons why an acquisition makes economic sense, but will the potential for increased volatility in the income statement influence decisions? Good deals will remain good deals, but will the structure of transactions change?

As always, I am interested to hear your views, either by commenting here or by email.

Comments

[Muhammad Ali]

Ever since the IASB took on its agenda the topic on business combination phase-II and culminated the project in revised IFRS 3, people from business community hold the stance that reporting / accounting frame work has never and will never dictate the way deals are structured. Business people think reporting as peripheral to the main activity instead of essential buiness function. Don't think it will affect the way deals are structured. Though it has many aspects to be considered, the accounting for such will be taken care of by the accountant / auditors. Deals never contemplated with a view of accounting consequences but with business and strategic fit are taken into consideration. Never the less the accountant division of corporate sector has to understand it so that appropriate accounting could be done.

[Eran Meishar]

Dear Richard,

As always, thank you.

Bullet point #3 - "all contingent payments are measured at fair value at the time of the acquisition. They are subsequently re-measured to fair value through the income statement."

I don’t know why the Board insists on this “counter-intuitive” treatment of changes in FV on contingent payments through P&L, this sounds awfully similar to the “own-credit” issue, which is now being re-visited. I would think changes in FV of contingent payments should be recorded in OCI until the contingency is satisfied, in a similar rational as with Cash-Flow hedges.

As you mentioned, the increase in earnings volatility, without mirror cash flow movement, may impact decision making.

Best regards,
-Eran