Buyer beware! New international accounting standards to have significant impact on future company acquisitions.
New international accounting requirements affecting company acquisitions will impact the amount of goodwill arising and lead to greater performance volatility warns leading professional services provider Ernst & Young – and may result in some other surprises if they are not understood before entering into future transactions.
The International Accounting Standards Board recently announced new accounting requirements for business combinations and transactions with non-controlling interests (NCIs, formerly ‘minority interests’). The revisions will have far-reaching consequences. Although the changes do not come into effect until 1 July 2009, any transactions negotiated prior to this date need to be carefully evaluated – particularly if they are not expected to be complete until after that date.
Will Rainey, Global Director of IFRS Services at Ernst & Young explains, “Having a clear understanding of the effect of the new requirements before entering into a business acquisition will be essential because it is highly likely that changes will also be needed to debt covenants, management remuneration and other performance measures in place. Some of the consequences can also be avoided by carefully structuring the arrangements during the negotiations.”
Of particular concern to many is the fact that all transaction costs (e.g. lawyers’ and advisers’ fees) will be expensed. Also, where former owners remain employees of the business after acquisition, a bright-line test has been introduced, that in many cases will result in payments made after the acquisition being treated as compensation not consideration. Management will need to think carefully about the terms of any such payments to avoid unintended consequences.
“It is quite common for acquisitions to have an element of contingent consideration payable in the future,” explains Rainey. “Under these new requirements, its fair value will need to be determined at acquisition – which can be a time-consuming and expensive exercise. The resulting liability will probably be a financial liability to be carried at fair value subsequent to the acquisition, thereby introducing greater volatility into future results. Management will therefore need to consider how any contingent consideration is structured.”
Garth Coppin, the National Director of Accounting for Ernst & Young in South Africa, is concerned about the effect of these changes. He states “If companies have to expense costs they previously capitalised, they might be resistant to incur costs to ensure all areas of an acquisition are adequately considered and could suffer the consequences of this in later years when unexpected surprises arise. In addition, companies might be tempted to overstate contingent consideration seeing that downward adjustments to the consideration could be used to boost profits in later years. Users of financial statements will need to be aware of these risks when the new requirements are applied in practice.”
The most controversial change arises when, after gaining control, less than 100% interest is held. The new requirements include a choice as to how the non-controlling interest (NCI) is measured. If management measures NCI at its fair value, it will effectively result in goodwill relating to the entire business (not just the percentage acquired) being recognised. If management stays with today’s method, and measures NCI at the share of the fair value of the net assets acquired, goodwill will be significantly lower.
“On the face of it, this doesn’t appear to be a big deal,” says Rainey. However, if management later acquires the outstanding minority interest, no additional goodwill can be recorded. Therefore, if management do intend to gain a 100% ownership, they will be better off fair valuing NCI when they gain control. This can also be a time-consuming and expensive exercise.
Rainey concludes “But this will require management to consider their longer-term objectives of the transaction, which will then be obvious to the market. These changes will affect the way acquisitions are negotiated. Disclosures will also be more extensive and managers will need to ensure that sufficient information is given without having an adverse impact on future operations.”
