PWC New M&a Accounting 2009

8/4/2019 PWC New M&a Accounting 2009

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What you need to know

about the new accountingstandards aecting M&A deals*

*connectedthinking


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What you need to know about the newaccounting standards aecting M&A deals

Executive summary

1 The standards represent the rst joint eort by the FASB and the IASB to develop converged standards. FAS 141(R) is the U.S. standard on M&A; FAS 160 is the U.S. standard

on consolidations.

For many companies, mergers and acquisitions (M&A) area key strategic driver o shareholder value. While, in theory,accounting considerations should not aect the decision tobuy or sell a business, accounting and reporting concernsoten impact many decisions made in the evaluation o adeal, including decisions about how to communicate thetransaction to a companys stakeholders.

Important changes in the accounting or M&A transactionshave occurred. In the ourth quarter o 2007, the U.S.Financial Accounting Standards Board (FASB) released newstandards dealing with the accounting and reporting or M&Aand the related topic o consolidations.1 The International

Accounting Standards Board (IASB) is expected to issueits related standards in the rst quarter o 2008. Becausemost companies use either the standards o the FASB or theIASB or nancial reporting, the accounting or M&A will beimpacted worldwide.

The last time standard setters changed the accounting orM&A, the immediate impact was dramaticno more pooling-o-interests, no more goodwill amortization. Those changessignicantly altered how some acquisitions were structured.In comparison, the new standards may seem less dramatic.But they will infuence deal negotiations and deal structures,aect how companies model and evaluate the impact o an

acquisition, and change how companies communicate withstakeholders about deals.

While certain aspects o the accounting or M&A will besimpler, the new standards introduce new accountingconcepts and create certain accounting complexities. Further,the expanded use o air value accounting will inherentlycreate valuation complexities. Several o the changeshave the potential to generate greater earnings volatility inconnection with and ater an acquisition.Here are just some o the key changes:

Transaction costs and restructuring charges will beexpensed. The accounting or certain assets acquired and liabilities

assumed in an acquisition will change signiicantly. Somenotable examples: acquired in-process research anddevelopment (IPR&D) assets will now be capitalized; certaincontingent assets and liabilities will be recognized at airvalue; and allowances or loan losses on the acquisition datewill be eliminated.

Earn-out arrangements (contingent consideration),depending on how they are structured, will be measured aair value until settled, with changes in air value recognizeeach period in earnings.

In partial acquisitions, when control is obtained, theacquiring company will recognize and measure at air valu100 percent o the assets and liabilities, including goodwillas i the entire target company had been acquired.

Companies will no longer recognize gains or losses onthe sale o shares o a subsidiary when control is retained.

Companies will be under increased pressure to inalizethe acquisition accounting in the irst reporting periodater the deal. Material adjustments made during the

measurement period to the initial acquisition accountingwill be recorded back to the acquisition date. This will causcompanies to revise previously iled inancial statementswhen reporting comparative period inancial inormation insubsequent ilings.

Even companies with no merger activity on the horizon mabe aected by the new standards as the nancial reportingor minority interests will undergo a major change. This willlikely cause perormance measures, nancial ratios, andconsolidated equity balances to change, and companies wneed to evaluate the impact o these changes particularlyon existing contractual arrangements, such as debt

covenant calculations.

The changes in these standards are pervasive. Managementwill need to revisit the customary practices it uses to evaluatpotential acquisitions and to communicate to stakeholdersits perormance and nancial results subsequent to anacquisition. In doing so, companies should note that the newstandards are to be applied to acquisitions that close in yearbeginning ater December 15, 2008 (2009 or calendar-year-end companies). Although early adoption o the standardsis prohibited, we recommend that companies assess thebroader impact o the standards now, as it could aect their

thinking on potential transactions.

This publication highlights and explores the major provisiono the standards and their implications. A summary o howthese provisions compare with parallel provisions o priorstandards is presented in the appendix.

Overview


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We do not anticipate that the new standards will impact dealfow. That dynamic is infuenced by broader macro-economicactors. However, the changes introduced by the newstandards will aect how companies account or and reportM&A activity.

The new standards will:Inuence acquisition negotiations and deal structures

The use o earn-outs may become less requent due tothe earnings volatility that results rom changes in their airvalue, while obtaining seller indemniications may become agreater part o the negotiation process.

The use o equity securities to pay or deals may be viewed

as less attractive, as the new standards require the value othe securities to be measured at the close o the transactionrather than when the transaction is announced. Thus,pricing o deals or accounting purposes will not be knownuntil closing.

Acquirers will need to consider the accounting implicationso strategies involving acquisitions o less than 100 percento the target company.

The greater use o air value measures and other estimatesinherent in acquisition accounting may have the unintendedconsequence o causing the timing o deals to change.Closing a transaction early in a quarter will provide moretime to reine acquisition accounting estimates and thus

reduce the possible need to revise previous inancialstatements.

Aect the fnancial projections used to model the

acquisition

Private equity investors and corporate management willneed to modiy their exit strategy and accretion/dilutionmodels to relect the earnings impact that will result rom thenew standards.

Pervasive changes in a number o areas, including theexpensing o deal costs and restructuring charges, willimpact earnings and aect other modelling considerations.

2 PricewaterhouseCoop

The impact on deals

Operating metrics such as gross margins, operatingearnings, EBITDA, and debt/equity ratios will change,particularly or partial acquisitions.

Inuence how, when, and what companies communicat

to stakeholders

Companies may need to explain the nature o deal-relatedcosts that will now directly impact the bottom line, as wellas changes in the purchase price based on the closing-datvalue o equity securities issued in a deal.

The rationale and assumptions supporting the air valuemeasures or certain balance sheet items will likely need tobe discussed.

The reasons or the revision o prior-period inancialstatements or material adjustments to the acquisitionaccounting will need to be clearly communicated tostakeholders.

Finally, the new consolidation standard will result in ahost o new disclosures about transactions with minorityshareholders and certain non-recurring gains or losses.


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The impact o air value

The standard setters approached revising the accountingor business combinations with the view that an acquiredbusiness, as well as the underlying assets and liabilities,should be recorded at air value. Under the previous standard,certain assets and liabilities o an acquired business wererecorded at air value, while others were not.

The use o air value in the new standards will change currentpractice in the ollowing ways: Transaction costs, such as deal costs and restructuring

charges, will no longer be capitalized as part o theacquisition. The principle behind the change is that thesecosts are not part o the fair value o the business acquired,

but rather a cost o acquiring the business. Most assets and liabilities will be recorded at their air values

on the date o acquisition. This would include contingenciesand earn-out arrangements (contingent consideration). Mostasset reserves will be eliminated, as the acquired assets willbe recorded at their air values. Acquisitions that result in abargain purchase rom an accounting standpoint will nolonger reduce asset values and will result in an operatinggain under the new standards.

Even in a partial acquisition, the acquiring company willrecognize and measure at air value 100 percent o theassets and liabilities o the target, including 100 percento goodwill. This means that minority interests will also be

recorded at air value rather than historical cost. Similarly, in a step acquisition, once control is obtained the

entire business will also be recorded at air value on thatdate. This includes the investors prior investment in thesubsidiary, resulting in a gain or loss on the transaction date.Subsequent transactions with minority shareholders will notresult in a gain or loss, or a change in the recorded amounto assets and liabilities, unless control is lost.

The measurement principles or applying air value to assetsand liabilities are also changing. No longer will buyers be abto determine the air value o acquired assets by reerenceto the intended use o an asset. The standard requires thatthe buyer value assets by using marketplace assumptionsrather than the assumptions the acquirer used to arrive at thpurchase price. As a result, higher values could be placedon assets that the buyer might have no intention o using orplans to phase out. This would cause higher depreciation anamortization (or impairment) charges in uture periods.

These changes have many practical implications. Clearly,valuation issues will be in the oreront, particularly or

assets and liabilities that require more subjective valuationtechniques. The valuation o more complex items, suchas contingencies and earn-out arrangements, is new,and valuation models and practices are likely to evolveover time. The application o the marketplace approachto air value will also require modications in traditionalvaluation practices. Lastly, the use o air value measureswill aect the comparability o nancial inormation amongcompanies and may make it more dicult to predict earningin uture periods.

What you need to know about the new accounting standards aecting M&A deals


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Discussing the implications

The new nancial reporting relationship

Partial acquisitions and noncontrolling interests

Stepping back to see the bigger picture


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Discussing the implications

The ollowing provides more detail on the implications o the new standards or M&A deals.

Deal costsDeal costs typically include direct payments to investment bankers, advisors, attorneys, appraisers, and accountants. Underprevious accounting, such costs were capitalized as part o the purchase price. These costs will now be expensed as incurred

As a result, reported earnings in periods prior to the closing will be reduced. Beyond this immediate impact on earnings, thereare several urther implications:

In the uture, some companies may want to delay initiating thorough due diligence and incurring related deal costs until thereis a higher degree o certainty that the transaction will actually occur.

High deal costs in the period preceding an acquisition could warrant an explanation to the market, which would signal theexistence o ongoing M&A activity.

Companies will need to careully assess the accounting or deal costs or acquisitions that are in process in late 2008. I thedeal closes in 2008, these costs will be capitalized as part o the acquisition. I the deal does not close in 2008, the costs willneed to be expensed.

Restructuring activitiesThe new standards generally preclude acquirers rom recording a liability related to a planned restructuring o the acquiredcompanys operations. As a result, the cost o these restructurings will be charged to earnings in the post-acquisition period.Under previous accounting, the cost o an acquirers planned restructuring o the acquired companys operations was recordas a liability, as part o the accounting or the acquisition, resulting in higher goodwill.

Under the new standards, the cost to restructure the operations o the acquired company as a result o the deal can berecognized as part o acquisition accounting only i certain conditions are met. These conditions are similar to those thatmust be met to recognize a liability or restructuring activities outside an acquisition. That is, the acquirers restructuring plan

must be in place on the date o the acquisition. For example, the plan would need to be approved, the benet arrangementscommunicated to employees, and the acilities abandoned beore a liability could be recorded.

For most acquisitions, these conditions set a very high hurdle or an acquirer to clear on the acquisition date, and we expectsuch situations to be rare. As a result, the costs or these restructuring activities will be recorded in earnings ater thetransactions closing date.

This treatment eliminates the anomaly that arose under the previous accounting, whereby the accounting or restructuringcosts depended on whether the restructuring was o the acquirers or the acquired companys operations. From an accountinstandpoint, it will now make no dierence which acilities will be shuttered or whose employees will be severed (those o theacquired company or those o the buyer) to achieve the synergies expected rom the transaction.

Because these restructuring costs will now be charged to earnings, they may receive increased scrutiny rom stakeholders.Companies may, thereore, come under increased pressure to demonstrate the link between the restructuring activity andanticipated synergies; thus management will want to ensure that the benet o the acquisition is communicated clearly tostakeholders.



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Acquired contingenciesIn a signicant change rom prior practice, acquired contingent assets and liabilities (e.g., litigation, environmental issues, or

possible product recalls) will be recorded at air value as o the acquisition date, i certain conditions are met. The guidanceintroduces new complexities, as acquiring companies must determine the nature o the contingency (that is, whether thecontingency is contractual or non-contractual) and the likelihood o occurrence. Under the new standards, the thresholdor recognizing acquired contingencies on the acquisition date is lower than is required when companies account orcontingencies outside an acquisition.

Subsequent changes in the recorded amount o an acquired contingent liability will not be recognized unless there is newinormation about its outcome, and the amount determined under other applicable accounting guidance is higher than theoriginal air value amount. I so, an adjustment to increase the liability will be recorded in earnings. Similarly, subsequentchanges in the recorded amount o a contingent asset will not be recognized unless there is new inormation about itsoutcome, and the best estimate o its uture settlement amount will be lower than the original air value. In this case, a chargeto earnings will be recorded to decrease the asset.

Acquisition date Subsequent accounting periods

Contractual All at air value No change in the recorded amounts, unlessthere is new inormation about its outcome, andamounts under existing standards would behigher (liabilities) or the estimated settlementamount would be lower (assets), until resolved

Non-contractual I more likely than not, record at air value;otherwise do not recognize

The accounting by the buyer or seller indemnications has also changed. I the buyer is able to obtain seller indemnicationsor certain contingencies (e.g., environmental matters or tax exposures), the indemnication will be recognized and measuredas a contingent asset in the same way as the related contingent liability. This means that these accounts will generally move intandem and any impact on earnings will be oset, although not always within the same income statement caption.

Recording contingencies at air value will entail a highly complex valuation process. Further, companies will need to trackacquired contingencies separately rom other contingencies to eectively assess whether the amount o the contingencyunder other applicable accounting standards would be higher (or a liability) or lower (or an asset) than the air value amountdetermined on the acquisition date. In addition, the new standards require companies to provide more disclosures aboutacquired contingencies, including the nature and amount o the contingencies as well as the potential range o outcomes.While the new standards will not change the acquirers economic exposure to contingencies, companies will want to ensurethat the legal and nancial due diligence processes appropriately consider the existence and nature o acquired contingencieFurther, the representations and warranties provisions o the purchase and sale document may be expanded to minimizeexposures to contingencies.



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Earn-outs (contingent consideration)Under the previous accounting, earn-outs were generally considered part o the cost o the acquisition and did not need to

be accounted or until the contingency was resolved. Under the new standards, earn-outs and other orms o contingentconsideration will be recorded at air value on the acquisition date, regardless o the likelihood o payment. Subsequentchanges in the air value o most contingent consideration arrangements will be recorded in earnings. However, i thecontingent consideration meets the requirements or classication as equity, it would not be adjusted in subsequentaccounting periods or changes in air value.

The impact o the new requirements is worth illustrating. Assume that a buyer agrees to pay the seller additional cashconsideration i certain perormance targets are met in the three years ollowing the acquisition. Upon acquisition, the buyerrecords a liability representing the air value o the obligation to make the additional payment. In each reporting period duringthe three-year earn-out, the air value o the obligation is adjusted through earnings until the commitment is settled. As thelikelihood o meeting the perormance targets increases, the air value o the contingent consideration also increases, resultinin an additional liability and additional expense. The reverse is also true: Failure to meet the targeted perormance milestonesunder an earn-out will result in income, but may also trigger the need or an impairment analysis o goodwill. Many believe tha

these results are counter-intuitive.

Given the impact on earnings, the buyer may want to consider alternative deal structures, including one that would allow thecontingent consideration to be treated as equity. I this is the preerred alternative, buyers will also need to consider the dilutivimpact o the equity earn-out arrangement. In certain circumstances, however, buyers may seek to avoid earn-outs altogetheand settle the nal purchase price when the deal closes. This strategy will likely aect deal negotiations.

In-process research & development (IPR&D)In-process research and development will continue to be measured at air value on the acquisition date; however, these assetswill no longer be written o to earnings immediately ater the acquisition. Instead, they will be capitalized and recorded asintangible assets on the acquisition date, subject to impairment until completion. I the projects are completed, the IPR&D assewill be amortized through earnings. I the projects are abandoned, the IPR&D assets will be written o. The new standards havenot changed the accounting or research and development expenditures that are incurred ater the acquisition, including those

or completing the acquired IPR&D projects. These costs generally continue to be expensed as incurred.

Heres an example: Under previous accounting, a pharmaceutical companys acquisition o a biotech company with new drugsunder development would likely have resulted in the recording o an immediate, non-recurring, and easily explainable write-oo the value ascribed to the IPR&D. Under the new accounting, the value o the drugs under development will be capitalizedon the acquisition date and reported as intangible assets. I the drugs to which the IPR&D relates are successul, the assetswill be amortized in uture periods. The IPR&D assets associated with unsuccessul drugs will need to be written o in periodssubsequent to the acquisition. Further, assessing IPR&D assets or impairment will be a challenge because research anddevelopment projects evolve over time and may be combined with other projects, thereby losing or blurring their individualidentities and complicating valuation.

The accounting or IPR&D in an acquisition o assets or accounting purposes has not changed. In some circumstances, itmay be worthwhile or companies to consider acquiring just the desired assets rather than the entire business. The FASB isconsidering amending the accounting or IPR&D purchased in an asset acquisition to conorm it to the accounting or IPR&Dacquired in an acquisition o a business. Until then, buyers that acquire just the desired IPR&D asset, rather than the entirebusiness, will immediately write o the asset.



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Effective tax rate volatilityIn the past, adjustments to acquisition-related tax reserves were generally made by adjusting goodwill. Those adjustments

were made irrespective o the time that had elapsed since the acquisition. For example, i ater the acquisition, the IRSexamined tax periods o the target company preceding its acquisition, the results o the examination would almost always berecorded as an adjustment to goodwill, regardless o when the examination was completed. Under the new standards, suchadjustments will generally be recorded in earnings subsequent to the acquisition, directly impacting a companys eectivetax rate.

Further, the new accounting or changes in tax reserves will apply to all acquisitions, including those consummated in periodsprior to the eective date o the standard. Thereore, adjustments made to these accounts ater the eective date o thestandard will be charged to earnings, while adjustments made to these accounts prior to the eective date will aect goodwil

The new standards require similar changes in the accounting or post-acquisition adjustments to deerred tax valuationallowances o the acquired company, which could also impact a companys eective tax rate. This provision will also applyto previous acquisitions. In the past, when a valuation allowance o the acquired company established in the acquisition

accounting was released, the adjustment reduced goodwill (possibly other non-current intangible assets). Under the newstandards, the subsequent reduction o a valuation allowance o the acquired company recorded in the acquisition accountinwill typically be reported in earnings.

There may also be instances when an acquisition results in a change in assessment o the recoverability o the buyerspre-existing deerred tax assets. For example, i income o an acquired company is expected to oset the buyers existingoperating losses, the corresponding reduction in the buyers previously recorded valuation allowance will be reported inearnings. Previously, the reduction o the buyers valuation allowance reduced goodwill as part o the acquisition accountingThereore, irrespective o whether a reduction o the valuation allowance o the buyer is recorded at the date o the acquisitionor in post-acquisition periods, the reduction will be reported in earnings.

Post-acquisition eective tax rates may also be impacted by other provisions in the standards. For example, in the acquisitioo stock o another company (a non-taxable transaction), deal costs and earn-outs will oten be treated as part o the cost

o the acquired entity or tax purposes. This means that these costs will become part o the tax basis o the shares, and theywill not result in a tax deduction until or unless the shares o the entity are subsequently sold. Thus, no current or deerred taxbenet would be recognized or those payments. The pre-tax expenses or these items without a related tax benet will resultin an increase in the companys eective tax rate or that reporting period. That is, the charge to earnings or an increase inthe value o an earn-out arrangement ater the acquisition will create an expense or nancial reporting purposes that is notdeductible or tax purposes.

Companies may want to enhance their due diligence procedures to more precisely identiy and measure the signicant taxuncertainties o the target at the acquisition date to mitigate the potential or signicant volatility in its eective tax rate inthe uture.



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Valuation dateThe standards introduce a new accounting consideration or companies that plan to issue equity as a component o the

purchase price. The value o equity securities issued as part o the purchase price will be measured on the closing date othe transaction, rather than on the announcement date. Fluctuations in the acquirers stock ater the announcement dateand beore the closing date will thereore impact the amount o the purchase price or accounting and reporting purposes.Companies may eel pressure to compress the period between the announcement date and the closing date to limit the risk omajor variations in the stock price. In addition, while most deal structures include price protections in the event o wide swingin stock price, management may want to consider negotiating eatures in the acquisition agreement to narrow the range ostock price variability that would trigger the protection provisions.

Adjustments to acquisition accountingAnother signicant change rom prior nancial reporting practices relates to adjustments made to the acquisition accountingater the transaction. Companies will have a period o time ater the acquisition (similar to the time permitted under previousrequirements) to true-up acquisition accounting estimates. However, the new standards require the revision o prior-periodnancial statements to record material adjustments o estimated amounts in the acquisition accounting as o the acquisition da

This contrasts with previous accounting in which these types o adjustments were generally refected in the period o change.

Nearly every organization will be impacted by this requirement, due to the pervasive use o estimates. The requirement islikely to increase the pressure on due diligence to provide the inormation necessary to make accurate estimates and therebyminimize the need to revise prior-period nancial statements in subsequent lings. Further, management may want to givecareul consideration to the timing o a deals closing date. A closing date in the beginning o a quarter will provide more time nalize the accounting or the transaction prior to reporting quarterly results.



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The new nancial reporting relationship

The new standards change the nature o the nancial reporting relationship between the parent and minority shareholders in aconsolidated subsidiary (the standards reer to minority shareholders as noncontrolling interests).

The standard setters have adopted the view that the consolidated nancial statements should be presented as i the parentcompany investors and the other minority investors in partially owned subsidiaries have similar economic interests in a singleentity. Thereore, minority shareholders are now viewed as having an interest in the consolidated reporting entity. As a result,the investments o these minority shareholders, previously recorded between liabilities and equity (the mezzanine), will nowbe reported as equity in the parent companys consolidated nancial statements. The ollowing exhibit illustrates this change

The reporting entity: view o consolidated fnancial statements

Since the noncontrolling interests are now considered equity o the entire reporting entity, transactions between the parentcompany and the noncontrolling interests will be treated as transactions between shareholders, provided that the transactiondo not create a change in control. This means that no gains or losses will be recognized in earnings or transactions betweenthe parent company and the noncontrolling interests, unless control is achieved or lost. These new principles undamentallychange not only the presentation, but also the accounting or noncontrolling interests in the consolidated nancial statements

Although the change makes certain aspects o the accounting or transactions between shareholders simpler, like step-acquisition accounting, other aspects o the new nancial reporting relationship will be highly complex, or example,determining the air value o the noncontrolling interests on the acquisition date.


s

Old view

Consolidatedinancial statement

Liabilities

Assets

EquityParent Companyinvestors

Mezzaninenoncontrolling interests

New view

Consolidatedinancial statements

Liabilities

Assets

EquityParent Companyinvestors andnoncontrolling interests


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Another implication o reporting noncontrolling interests as a component o equity is that companies that have been reportingmore than their proportionate share o a partially owned subsidiarys losses will now report higher earnings because the

noncontrolling interests will be allocated their share o the losses even i their equity balance is in a decit position.

This new accounting will be required or all companies that have partially owned subsidiaries on the eective date o thestandard. This means that there will be dierent accounting or these transactions beore and ater January 1, 2009. Forexample, i management was contemplating acquiring additional equity interests in a partially-owned subsidiary, the acquisitiowould be accounted or as an additional cost o the subsidiary (i.e., a step acquisition) beore January 1, 2009. Ater that date,the same transaction would be accounted or as an equity transaction, with the dierence between air value and carrying valurecorded in equity. Likewise, i management is considering the sale o an interest that would not result in a change o control,it may want to complete the transaction beore the eective date o the standards. In doing so, the company would record again or loss, rather than recording it as an equity transaction. Communications to stakeholders will need to be clear about theimplications o these types o transactions.

Partial acquisitions and noncontrolling interests

The ollowing provides more detail on the implications o the new nancial reporting relationship.

Goodwill on partial acquisitionsIn a partial acquisition, or step acquisition in which a company acquires a controlling interest through a series o transactionsthe acquirer will generally record all assets, including 100 percent o goodwill, and all liabilities at air value on the date controobtained. This applies to single-step acquisitions o a controlling interest, as well as to transactions in which acquiring controrequires multiple steps over time. Under the previous accounting, the buyer would have recorded the acquired portion o thenet assets at air value (including goodwill on a pro rata basis) and retained the book value or the noncontrolling (minority)interests. This approach resulted in goodwill being recorded or the acquired interest only.



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Transactions with minority shareholdersAcquiring minority shareholder interests when there is no change in control

The purchase o additional interests in a partially owned subsidiary will be treated as an equity transaction i there is no changin control. I the parent company purchases additional shares o stock in the partially owned subsidiary, and the air value o thinterest acquired exceeds its carrying value, the adjustment will reduce the parent companys equity. This in turn may impactthe equity-based operating metrics and nancial ratios o the parent company.

For example, lets assume that a parent company that owns 60 percent o the voting equity interests o a subsidiary acquiresan additional 10 percent rom the minority shareholders or $100 million. Further, assume that the carrying value o that intereis $65 million. Since there was no change in control, the parent company would record an adjustment (in this case a decreaseto its equity or the dierence between the air value o that interest o $100 million and the related carrying value o $65million, or $35 million. Under previous accounting guidance, this dierence would have been recorded as an additional costo the acquisition, likely resulting in more goodwill. Thus, i a company is assessing its strategic alternatives concerning theoutstanding interests o minority shareholders, it should consider the impact o the new accounting on balance sheet ratios aperormance metrics.

Transactions Previous accounting New accounting

Holds 60% Fair-value 60% and consolidate;minority interest o 40% recorded atcarryover basis on the acquisitiondate

Fair-value 100% o assets andliabilities and consolidate on theacquisition date

Acquires additional 10% (now 70%) Fair-value additional 10% Equity transaction

Parent company sale to third parties (or its interests are diluted) when there is no change in control

Transactions such as the sale o subsidiary stock by the parent or the issuance o stock by the partially owned subsidiary,which under previous accounting generally resulted in gains or losses, will now be recorded in stockholders equity as long as

there is no change in control o the subsidiary.

I a company is contemplating the sale in the near term o a portion o an existing subsidiary that would not result in a changeo control, management may want to consider the timing o the transaction, since gains or losses will no longer be recognizedater the eective date o the standard.


Holds 80% Fair-value 80% and consolidate;minority interest o 20% recorded atcarryover basis on the acquisitiondate

Fair-value 100% o assets andliabilities and consolidate on theacquisition date

Dispose o 20% (now 60%) Record gain or loss on disposition Equity transaction



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Step acquisitions: acquiring shareholder interests when there is a change in control

I the parent company obtains control by increasing its ownership rom, say, 40 percent to 65 percent, the parent would

adjust its initial investment (i.e., the 40 percent) to air value by recording a gain or loss based on the dierence between thair value and the carrying value o the investment. The remeasurement guidance is likely to have more o an impact on therecognition o gains, since companies are required to periodically evaluate their investments or impairment. The acquiringcompany will need to consider the earnings impact o recording the investment at air value and the manner in which thetransaction is communicated to stakeholders. For example, i there had been a diminution in the value o the shares o theinvestment, management might believe its the right time to take a larger stake in the company, even though doing so couldtrigger a loss (i the loss was not previously recognized) on its current holdings.


Holds 40% Equity method investment recorded atcost on the acquisition date

Equity method investment recorded acost on the acquisition date

Acquires additional 25% (now 65%) Fair-value additional 25% and

consolidate; minority interest o 35%recorded at carryover basis

Fair-value 100% o assets

and liabilities and consolidate; recordholding gain or loss on original 40%

Parent company sale to third parties (or its interests are diluted) when there is a change in control

Transactions between the parent company and third parties (noncontrolling interests) that result in a change o control willgenerate gains or losses to be recorded in earnings. I a company sells shares o its subsidiary such that it no longer controthe subsidiary, the company would (i) recognize a gain or loss in earnings on the shares sold and (ii) adjust the retained equinvestment to air value, with any dierence rom its carrying value recognized as a gain or loss in earnings. Transparentreporting o these transactions will be required through robust disclosures in the nancial statements.


Holds 80% Fair-value 80% and consolidate;

minority interest o 20% recordedat carryover basis on theacquisition date

Fair-value 100% o assets and

liabilities and consolidate on theacquisition date

Dispose o 60% (now 20%) Record gain/loss on shares sold Record gain/loss on shares sold andgain/loss to revalue remaining interest(i.e., the 20%) to air value



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New look for the income statementIn addition to the changes in the balance sheet, there is also a change in what is presented in the income statement. Net

income will include both the parents and the minority shareholders share o earnings. That diers rom todays presentatioin which net income represents only the parents share. To provide consistency with past reporting, there is a new categorycalled net earnings attributable to the parent company, which will be similar to net income under the prior standards.Despite this change, earnings per share will still be determined on the basis o net earnings attributable to the parentcompanys shareholders, consistent with previous calculations.

Although not a new look, the presentation o gross margins and operating earnings or companies that enter into a partialacquisition is likely to look dierent in amount when compared to amounts determined under previous practice, due to therecording o 100 percent o the acquired assets at air value.

Stepping back to see the bigger picture

The eective dates o the new standards on accounting or M&A and on consolidations provide companies time to assessthe strategic implications or a variety o signicant issues. These issues encompass the impact o the new standards on deastructure, deal assessment, nancial modelling, and post-transaction nancial reporting and communications, as well as theearnings impact that will occur both beore and ater an acquisition.

Management will need to provide additional inormation to investors so that they may clearly understand the impact oacquisitions on reported results. This will be more important under the new accounting standards because the reporting o prand post- acquisition expenses, transactions with minority shareholders, and the inormation in nancial statements will dierom what investors are used to seeing.

In light o the very real impact that these new standards have on acquisition strategy and nancial reporting, the message isclear. The changes are ar reachingthey will aect old deals, deals in the pipeline that are expected to close both beore and

ater 2009, and the presentation o consolidated nancial statements. Senior executives and directors need to understand thkey eatures o the new standards and will want to assess their impact now on deal strategies.

We welcome the opportunity to dialogue with you on any o the matters discussed here.

For urther inormation, please contact:

Raymond J. BeierStrategic Analysis Group LeaderTel. [email protected]

Michael J. Burwell

U.S. Transaction Services LeaderTel. [email protected]



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Appendix: A quick look at key eatures o the new standards


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A quick look at key eatures o the new standards

Deal costs and restructuring costs

New accounting

Transaction costs and costs to restructure the acquired companywill generally be expensed.

Previous accounting

Transaction and costs to restructure the acquired company weretypically recorded as part o the cost o the acquisition.

ImpactThese costs will now aect earnings.

Acquired contingencies

New accounting

Upon acquisition, certain contingent liabilities o the target (e.g.,

litigation, environmental issues, or possible product recalls) will bemeasured at air value. Ater the acquisition, i new inormation isavailable, contingent liabilities will be measured at the higher otheir acquisition-date air value or the amount determined underexisting guidance or non-acquired contingencies.

Previous accounting

Contingent liabilities were typically recorded when payment was

deemed to be probable and the amount was estimable.

Certain acquired contingent assets will be measured at air value.In subsequent periods, i new inormation is available, contingentassets will be measured at the lower o their acquisition-date airvalue or the estimated amount to be realized.

Contingent assets typically did not meet the recognition criteriaand were seldom recorded.

Impact

The recognition criteria have been changed and, as a result, more contingent assets and liabilities will be recorded.

Earn-outs (contingent consideration)

New accounting

Earn-outs and other orms o contingent consideration (i.e.,additional payments dependent on the outcome o uture events)will be recorded at air value on the acquisition date, regardlesso the likelihood o payment. Subsequent changes in air value orcertain earn-outs will directly impact earnings.

Previous accounting

Earn-outs were recorded when the contingency was resolved andwere considered part o the cost o the acquisition.

Impact

Previously recorded as adjustments to goodwill, changes in the air value o these arrangements will now aect earnings.

In-process research and development (IPR&D)

New accounting

Acquired IPR&D will be measured at air value and recorded as anasset on the acquisition date.

Previous accounting

IPR&D was measured at air value and expensed immediatelyupon acquisition as a one-time charge to earnings.

Impact

Post-deal earnings will be aected by either the amortization or the impairment o the IPR&D asset.



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Accounting or tax adjustments

New accountingChanges to acquisition-related deerred tax asset and income taxreserves made ater the acquisition will generally impact incometax expense.

Previous accountingThese adjustments were commonly treated as an adjustment togoodwill.

ImpactThese tax items will now aect earnings.

Valuation date

New accounting

Equity securities issued as part o the purchase price will bemeasured on the closing date o the transaction.

Previous accounting

Equity securities were generally measured when the deal wasannounced.

ImpactThe purchase price will be impacted by movements in stock price between the announcement date and the closing date.

Partial acquisition and minority interests

New accounting

Noncontrolling interests will be recorded in equity in theconsolidated nancial statements.

Previous accounting

Called minority interests, these amounts were generallyrecorded on the balance sheet between liabilities and equity (themezzanine).

ImpactNo gains or losses will be recognized in earnings or transactions between the parent company and the noncontrolling interests, unless

control is achieved or lost.

Goodwill on partial acquisitions

New accounting

Even when less than a 100% controlling interest is acquired,100% o the net assets o the acquired business, including 100%o goodwill, will be recorded at air value.

Previous accounting

Only the acquired controlling interest was recorded at air value,while the remaining interests retained their pre-acquisition bookvalues.

ImpactThis change will likely result in higher asset values and aect uture operating metrics and nancial ratios, although net incomeattributable to the parent company remains unchanged.

Adjustments to acquisition accounting

New accounting

Adjustments to acquisition-date accounting estimates will beaccounted or as adjustments to prior-period nancial statements.

Previous accounting

These types o adjustments were refected in the period ochange; previous nancial statements were not reopened.

ImpactEnhanced due diligence procedures may be needed to obtain greater assurance about the accuracy o accounting estimates on theacquisition date to avoid changes to previously released nancial inormation.


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Documents

PWC New M&a Accounting 2009