1. Introduction and summary

One small step for man
In December 2007 and January 2008 respectively, the Financial Accounting Standards Board (“FASB”) and the International Accounting Standards Board (“IASB”) issued revised standards on business combinations. These revised standards take significant steps toward the standard setters’ declared goal of convergence.

 

This achievement should not be underestimated, as a set of common global standards was always going to be the primary objective, whatever the shortcomings of those standards.  It seems to me that common sense has prevailed, with the best of both standards being adopted without either party stubbornly defending their existing standard. The two boards are to be applauded for their progress, and encouraged to go the ‘last mile’ to complete convergence urgently.  Only then, I suspect, will there be an appetite to address the shortcomings that remain.

 

Application of the revised international standard
The good news for companies reporting under the International Financial Reporting Standard 3, Business Combinations (“IFRS3”) is that the revised standard makes few changes and some of these are of limited application only.  Many business combinations will not involve contingent consideration or step acquisitions.  The only change which will affect all business combinations is that the costs of the acquisition must now be expensed instead of being included in the purchase price.

 

For those companies with a US listing, the changes to Statement of Financial Accounting Standards No. 141 Business Combinations (“FAS141”) are more substantial but all serve to eliminate differences of treatment between USGAAP and IFRS, and hence reduce workloads.

 

I would encourage more attention to better application of the existing standard, particularly to ensure that intangible assets are realistically valued and disclosed.  However, I believe that there is a need to monitor and enforce compliance, other than the external audit, as the SEC does in the United States.

 

The components of goodwill require disclosure in published accounts, a requirement widely ignored in the early days of IFRS3, and I believe that it should be good practice to prepare a full value analysis of the components of goodwill to support the amount reported in the purchase price allocation.  Ultimately, this should form part of the accounting standard.  This would require companies to be more open and realistic about the amount reported as goodwill.

 

2. The changes and remaining differences

The FASB issued FAS141, effective for all business combinations initiated after 30th June 2001.  IFRS 3 followed with an effective date of 31st March 2004, although in many jurisdictions, adoption of IFRS came later. In December 2007, the FASB issued a revised FAS141 (“FAS141R”) which is mandatory from the annual reporting period beginning on or after 15th December 2008.  Interestingly, entities are not permitted to apply the new standard early. The revised IFRS 3 (“IFRS3R”) was issued in January 2008 and is effective for accounting periods beginning on or after 1st July 2009.  Unlike FAS141R, IFRS3R may be applied earlier.

 

The Changes
Although the two original standards were broadly similar, there were a number of substantive differences, and these have now, for the most part, been addressed.  The tables below summarise the key changes; firstly those to FAS141 bringing it into line with IFRS3 and secondly changes to both standards. There are no changes affecting IFRS3 only.

 

Changes to FAS141
1. Recognition of all acquired assets and assumed liabilities at fair value at the acquisition date
2. Restructuring costs, expected but not obligated to incur, to be expensed
3. Recognition of the full fair values of acquired assets and assumed liabilities in a business combination achieved in stages
4. Assets and liabilities arising from contractual contingencies to be recognised at their fair value at the acquisition date
5. Negative goodwill resulting from a bargain purchase is taken to profit
6. Acquired R&D assets to be reported at fair value
7. Disclosure of the factors that make up goodwill

...and the previous treatment
1. Some assets and liabilities not recognised, and some not at fair value
2. Included in cost of acquisition
3. Only the proportion of assets attributable to the acquirer were fair valued, with minority interest based on book values
4. Deferred recognition was permitted
5. Fair values of acquired assets reduced pro rata
6. R&D assets with no alternative use immediately charged to expense
7. No disclosure required

 

Changes to IFRS3 & FAS141
1. Costs of acquisition to be expensed
2. Contingent consideration to be recognised at fair value at the acquisition date
3. Re-measure fair value of previously held equity interests in a step or partial acquisition

...and the previous treatment
1. Included in cost of acquisition
2. Only recognised when additional consideration became payable
3. Changes in fair value were treated as a revaluation

 

Remaining differences
Saint Augustine said “Give me chastity and continence, but not yet”, and the boards seem to have taken a similar approach.  While striving for convergence, the boards have decided to issue new standards which still have a number of differences although the two boards will consider most of these in future convergence projects. 

 

This is disappointing as, at best, it delays completion of the convergence process for standards on business combinations. Could the boards not have gone the extra mile to complete the job?

 

Having said that, the first major difference listed by the FASB  is in the definition of the acquirer and identifying the acquirer.  The reason cited for a continuing difference is the absence, in IFRS, of any guidance equivalent to that legend of obfuscation FASB Interpretation No. 46 (revised), Consolidation of Variable Interest Entities (“FIN46R”).  While the issues FIN46R attempts to address are only too real (off balance sheet vehicles beloved of Enron and others), the interpretation is the worst example I have ever seen of detailed accounting rules trying to corral the excesses of creative accounting.  You might as well try to nail blancmange to a wall.  If ever there was an area where principles based standards are required, this is it.  Agreement between FASB & IASB on this will need a lot of work. The other significant, remaining differences are summarised below:

FAS141R

• Minority interests: Must be measured at fair value
• Operating leases: Requires recognition of an intangible asset, or liability, if the lease terms are other than market terms
• Contingent assets and liabilities: Recognise contractual, and some non-contractual contingencies
• Goodwill disclosure: Disclosure by reportable segment for each business combination

IFRS3R

• Minority interests: May be measured at fair value or as a proportionate share of net assets
• Operating leases: No recognition required
• Contingent assets and liabilities: Recognise contingent liabilities for present obligations arising from past events, that can be measured reliably
• Goodwill disclosure: Not required

3. Where do we go from here?

Clearly there is a commitment to achieve further convergence, but this falls short of what should be the short term goal.  The next step must be a common standard for business combinations and the boards should say so unequivocally and set a target date for achieving this.

 

We need to stand back and take a good look at how business combinations are reported to stakeholders and how well their needs are served.  Frankly we must get past convergence in order to address two bigger issues, namely the shortcomings common to both standards and the effectiveness of application of standards. 

 

Effectiveness of application of standards
Our research, covering reporting by UK FTSE100 companies applying IFRS3 for the first time, and the largest US corporations in the first five years of reporting under FAS141, indicates that many companies have failed to identify and report intangible assets in acquired entities or have undervalued them.  This has resulted in a corresponding overstatement of goodwill.  For example, Standard Chartered Bank would have us believe that the combined value of the brand name and customer relationships of Korean First Bank was only £0.1 billion on acquisition in 2005, while the reported goodwill was £1.7 billion. This purchase price allocation seems to undervalue substantially the driving forces behind the acquisition.  In the same year Aviva acquired the RAC, and reported the values of brand and customer relationships at £0.4billion, with goodwill of £1.1billion.  Again I believe that the intangible assets were undervalued.

 

In the USA, company filings are subject to scrutiny by the SEC, which strikes fear into the heart of reporting entities and auditors alike, but there is no equivalent for companies reporting under IFRS.  With the Financial Reporting Review Panel, the auditors are the main safeguard of compliance.  This is clearly not enough as many UK companies were able to report business combinations without any explanation of the components of goodwill, in clear breach of the disclosure requirements of IFRS3.  If the rules are there, they must be applied.  Compliance needs to be monitored and enforced more strongly.

 

Shortcomings in existing standards
I make no apology for focusing mainly on intangible assets as these are so often the ‘elephant in the room’. They drive most of the value of businesses in many different sectors, but the only time their value is considered at all for reporting purposes is after a business combination. I believe that the standards could be strengthened to impose a higher level of realism in valuations on reporting entities and their auditors.

 

The inclusion, in FAS141R, of a requirement to disclose the factors which go to make up goodwill, such as synergies and intangible assets that cannot be separately recognised (like an assembled workforce) is very welcome.  I only hope it is complied with more rigorously than was the case for FTSE100 companies reporting under IFRS3 for the first time.  However, early indications are that reporting standards among the biggest UK companies are improving the second time around.

 

It may be inappropriate to beef up the disclosure requirements for goodwill any further because of commercial confidentiality considerations, but acquirers should be obliged to quantify the fair values of the identified elements of goodwill, which could then be audited.  This would give better information on the likelihood of material overpayment for acquisitions at a much earlier stage. 

 

This would be akin to an impairment test of the goodwill on each acquisition, and a much tougher test than the present, aggregated, impairment testing of goodwill.  The shareholders of eBay might have been glad of such a requirement before the acquisition of Skype.