CONTESTANT: Tim Cummins, Managing Director, Valuation &
Financial Opinions Group, Stout Risius Ross.
THE CHALLENGE:
The evolution of Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS 157”), combined with the impact of recent market forces, led to tremendous debate this year on the issue of fair value measurements for portfolio investments. Given the amount of focus on this vigorous debate, is it safe to assume that remaining issues related to valuation of private equity investments are more straightforward and require less investigation?
TIM CUMMINS’ ANSWER:
No. While the debate over the implications of SFAS 157 has raged, the economic environment has resulted in fewer closed deals and thus fewer instances where acquirers have had to deal with the intricacies of other valuation issues, such as the new purchase accounting guidance. Though the Financial Accounting Standard Board (“FASB”) released SFAS 141(R) on 7 December 2007, it applied prospectively to all business combinations for which the acquisition date is on or after the beginning of the first annual accounting period which begins on or after 15 December 2008. (For more on SFAS 141(R) see Earnout ennui, p.4) As a result, changes in the application of purchase accounting are just beginning to be encountered. When the deal market heats up again, these issues will become more apparent and it will be useful to be familiar with them when contemplating the structure of a new deal.
In addition, as of 1 July 2009 the language of accounting has changed. The FASB launched the FASB Accounting Standards Codification effective for interim and annual periods ending after 15 September 2009. The Codification reorganises thousands of US GAAP pronouncements into roughly 90 accounting topics using a consistent structure. What does this mean? In short, the terms SFAS 157 and SFAS 141(R) no longer have meaning. When addressing these issues in the future, it will be necessary to think in terms of FASB Accounting Standards Codification Topic 820, Fair Value Measurements and Disclosures (“FASB ASC 820”) and FASB Accounting Standards Codification Topic 805, Business Combinations (“FASB ASC 805”).
FASB ASC 805 presents numerous conceptual and practical valuation issues to contend with as compared to the prior SFAS 141, several of which are addressed below.
MEASURING THE FAIR VALUE OF THE ACQUIREE
One of the primary changes resulting from FASB ASC 805 is that business combinations are to be measured and recognised at the fair value of the acquiree as of the acquisition date (rather than the accumulated cost of the acquisition), even if the business combination is achieved in stages, or if less than 100 percent of the equity interests in the acquiree are owned at the acquisition date. In addition, any costs the acquirer incurs in connection with the business combination will be accounted for separately and expensed, rather than included in the cost of the acquiree.
CONTINGENT CONSIDERATION
Under SFAS 141, any expected contingent consideration was not recognised or measured at the acquisition date. Rather, the contingent consideration was recognised when incurred (resulting in an increase to goodwill). Under FASB ASC 805, the expected contingent consideration is measured at fair value and recognised at the acquisition date as part of the purchase price. Further, the fair value of an earnout is to be re-measured annually up to the point at which all potential payments are made, and any corresponding changes in fair value will result in a gain or loss recorded on the acquirer’s income statement.
It is important to note that when accounting for expected earn-out payments, there will be an inconsistency between the entry at closing and the actual payments made to the seller regardless of whether or not the earnout payments are estimated with exact precision. This difference results from the present value factor associated with the fair value calculation. To the extent the initial measurement is greater than (or less than) the actual earnout payment, the company will subsequently recognise a gain (or loss) on its income statement for the difference. There could also be potential goodwill impairment implications involved, as an overestimation in the value of an earnout will likely result in a greater amount of goodwill on the balance sheet than is supported by the financial performance of the company. However, the impairment loss may be partially mitigated by the reduced value of the contingent earn-out.
STEP AND PARTIAL ACQUISITIONS
It is possible for an acquirer to gain control of the target company through a series of smaller, non-controlling acquisitions known as step acquisitions. Similarly, any acquisition of less than 100 percent of the target company’s equity is considered a partial acquisition. For both step and partial acquisitions, FASB ASC 805 represents a significant change from prior promulgations, requiring that the acquirer recognise the acquiree’s identifiable assets, liabilities, and any non-controlling interests at 100 percent of their acquisition date fair values regardless of the percentage of the target that was acquired. Prior to FASB ASC 805, the assets and liabilities of the acquiree were measured at a mixture of current fair value exchange prices and historical book values. FASB ASC 805 requires that the non-controlling interest be measured at fair value and recorded as a component of equity separate from the parent shareholder’s equity. The critical valuation issue to highlight in this regard is that the fair values of the respective interests in the acquiree may differ on a per-share basis for the controlling and non-controlling interests. This per-share value difference is due to the fact that it may be appropriate to include a discount for a lack of control in the valuation of the non-controlling interest(s).
IN-PROCESS RESEARCH AND DEVELOPMENT
Under SFAS 141, research and development assets acquired in a business combination that had no alternative future use were measured at their fair value and expensed at the acquisition date. Now, under FASB ASC 805, in-process research and development assets will be classified as indefinite-lived assets until the project is either completed or abandoned and will also be tested annually for impairment. Once the project is deemed to be commercially feasible and proven, the asset is to be amortised over its expected economic useful life.
BARGAIN PURCHASE
In some circumstances, the fair value of the acquirer’s interest in the acquiree exceeds the fair value of the consideration transferred for that interest (as might be the case in a transaction that is a forced sale in which the seller is acting under compulsion). This type of business combination is referred to as a “bargain purchase.” The previous requirement to allocate negative goodwill as a pro rata reduction to other tangible and intangible assets was eliminated by FASB ASC 805. Now an extraordinary gain shall be recognised in any bargain purchase transaction with negative goodwill. The gain is calculated as the fair value of the net assets acquired less the sum of the consideration paid and the fair value of any non-controlling interests. It should also be noted that this revision reflects a shift towards IFRS procedures.
CONCLUSION
The valuation issues associated with purchase price allocation procedures are becoming much more complex and integrated with respect to other accounting promulgations. Understanding this conceptual framework and the practical reality of what is acceptable from an SEC and FASB perspective is critical from a planning standpoint to ensure that more effective purchase agreements are structured and that management correctly understands issues relating to accretion and dilution and the potential capital markets impact of the financial reporting requirements.
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