A new day for business combinations: recognizing the whole enterprise.

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EXECUTIVE SUMMARY

* FASB outlined a major overhaul of GAAP related to mergers and acquisitions when it issued Statement no. 141 (revised), Business Combinations, in December 2007. The standard is effective for fiscal years beginning after DeG, 15, 2008.

* A fundamental concept at the core of Statement no. 141(R) is that the reporting entity is the entire economic enterprise created by the combination. As such, the consolidated statement of financial position will describe 100% of the acquired assets and liabilities. Any minority interest-called a noncontrolling interest-will be considered to be stockholders' equity.

* The new approach will use the full fair values for both the debits and credits to record transactions, even to the point of recognizing a gain from bargain purchase in rare cases in which the acquired value exceeds the purchase price.

* Statement no. 141 (R) won't abandon the residual cost approach to goodwill measurement. However, its implementation will be improved because acquirers will have to value and record many additional assets and liabilities, including R&D and contingencies. In addition, the acquisition entry credits will include the fair value of previous holdings and any noncontrolling interest.

After 25 years of work on business combination standards, FASB rolled out a major overhaul of GAAP related to mergers and acquisitions when it issued Statement no. 141(R), Business Combinations, in December 2007.

In its joint project with the International Accounting Standards Board, FASB's overall goal was to produce more complete statements of financial position and income to help users make better decisions. The approach continues the shift away from historical costs to reliance on fair value. In addition, Statement no. 141(R) and Statement no. 160, Noncontrolling Interests in Consolidated Financial Statements, call for recognizing certain assets and liabilities that previously escaped recognition. The standards also alter income statements by introducing new items, eliminating some old ones and providing a new structure.

This article discusses the conceptual foundation for Statement no. 141(R), which is effective for fiscal years beginning after Dec. 15, 2008, and explains nine significant changes created by the revised standard. It also ponders how the new train of thought behind Statement no. 141 (R) may drive behaviors and attitudes.

THE CONCEPTUAL FOUNDATION

Combination accounting has long been controversial because of divergent views on how to provide the most useful information. In addition, many implementation problems arise from specific and often unique features of individual combinations. The accounting profession's struggles with these challenges are reflected in diverse and often inconsistent practices. Debate has swirled around goodwill and other intangibles. Minority interests have also been reported in several ways. These inconsistencies diminished the usefulness of the information to the point that new standards were needed.

The most fundamental concept expressed in Statement no. 141(R) is that the reporting entity is the entire economic enterprise created by the combination. As such, the consolidated statement of financial position will describe 100% of the acquired assets and liabilities. Any minority interest--called a noncontrolling interest--will be considered stockholders' equity instead of a liability or mezzanine item that is not specifically classified as a liability or equity.

Income statements will present results for the entire enterprise with the bottom line followed by a schedule that divides income into portions attributable to the controlling and noncontrolling interests. Notably, displayed earnings-per-share results will be based only on income attributable to controlling interest stockholders. Cash flow and equity statements will be reconfigured to describe the whole enterprise so users can see more of what is under the parent's management.

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The new approach will use the full fair values for both the debits and credits to record transactions, even to the point of recognizing a gain from bargain purchase in uncommon situations in which the acquired value exceeds the purchase price.

NINE KEY CHANGES

This article describes what we consider the nine most significant features of Statement no. Ill(R). The changes are listed in Exhibit 1, along with their effects on the statements. This list is not meant to be exhaustive; rather it is intended to show readers why they need to learn more before preparing consolidated financial statements for fiscal years beginning after Dec. 15, 2008.

(1) ACQUISITION EXPENSES

Acquirers may incur millions in direct and indirect costs finding targets, gathering and analyzing information, seeking funds and negotiating deals. The question is how to report these costs.

Current GAAP These costs are deferred by adding them to the purchase price. In all likelihood, they increase recorded goodwill, where they remain until and unless impairment is recognized.

Deficiency. Although pre-transaction costs are necessary, they don't add value to acquired assets (including goodwill) and they are not assets on their own. It's questionable whether putting them on a balance sheet is useful.

New standard. Statement no. 141(R) follows the tenet that only real assets should be recorded for a combination. Because acquisition-related costs are not assets, they will be charged to expense. Exhibit 1 shows them being moved off the statement of financial position and onto the income statement. (See the sidebar "141 vs. 141(R)" for examples.)

(2) BARGAIN PURCHASE GAIN

In rare circumstances, an acquirer strikes a favorable deal and pays less than the aggregate fair value of purchased net assets. These transactions raise two issues--at what amounts should individual assets and liabilities be recorded, and is it useful to recognize a bargain purchase gain?

Current GAAP The excess value is considered "negative goodwill." Because of its focus on cost, current practice selectively reduces certain asset carrying values until the aggregate total equals the purchase price. (In very rare circumstances, any unallocated difference is treated as an extraordinary gain.)

Deficiency. The balance sheet underreports the value at hand and available to management for earning returns. In addition, management's successful negotiation is not immediately reflected in reported income.

New standard. Acquired assets and liabilities will be recorded at fair value and any excess over the purchase price will be credited to a gain that flows to the income statement, net of deferred taxes. The outcome will likely be more complete and useful statements of financial position and income. (See Scenario B in the sidebar "141 vs. 141(R)" for an example.)

(3) CONTINGENT CONSIDERATION

In major transactions such as combinations, sizable spreads initially exist between amounts buyers and sellers offer to pay and accept. One way to close that gap is contingent consideration arrangements in which, depending on future events, a buyer agrees to pay an additional amount or a seller agrees to refund part of the purchase price. Because contingencies can be difficult to pin down, many issues have been raised about their financial statement effects.

Current GAAP. Most contingent consideration arrangements are ignored in determining the recorded price. When additional payments based on earnings targets occur, their amounts are added to goodwill. If payments are tied to stock price changes, paid-in capital is credited. If refunds are received, the buyer reduces goodwill or paid-in capital.

Deficiency. In these circumstances, not immediately recognizing the contingent assets or liabilities reduces the managers' accountability for what they've negotiated. Statements that ignore these potential cash flows are not adequately informative.

New standard. Consistent with getting more assets and liabilities on consolidated balance sheets, Statement no. 141(R) will require buyers to book estimated fair values of contingent consideration agreements as assets or liabilities. The items will be marked to market until the contingencies are resolved, with each year's gain or loss flowing to the income statement. Once settlement occurs, a gain or loss will be recognized for the difference between the carrying value and the amount received or paid. If contingent consideration involves shares, the difference between the initial and final fair values will be recorded in paid-in capital. (See Scenano C in the sidebar "141 vs. 141(R)" for an example.)

(4) IN-PROCESS R&D

Many acquired companies have valuable intellectual property embedded in incomplete but promising research and development results. Acquisitions enable acquirers to use R&.D to create or improve products and services. At issue is how to reflect these potential future cash flows in financial statements.

Current GAAP. Statement no. 142, Goodwill and Other Intangible Assets, requires buyers to assign values to in-process R&D assets for recording the acquisition but then immediately write them off.

Deficiency. The balance sheet omits relevant information about significant assets that help justify the acquisitions. In addition, income reported in the transaction year may be misstated.

New standard. In-process R&D results will be classified as intangible assets with indefinite lives until the R&D phase is complete or the project is abandoned, and subsequent expenditures won't be capitalized.

These recorded assets won't be written off or amortized but will be subject to impairment tests.

The result will likely be more useful income statements that don't include spurious losses and more complete balance sheets that include more assets. Although R&D asset values are uncertain, their approximate amounts are more representative than reporting nothing at all. (See Scenario C in the sidebar "141 vs. 141(R)" for an example.)

(5) OTHER CONTINGENCIES

In combinations, buyers virtually always acquire some contingent items subject to uncertainty. The question arises whether they should be included in balance sheets alongside other assets and liabilities.

Current GAAP Consistent with FASB Statement no. 5, Accounting for Contingencies, the consolidated entity's statements recognize only loss contingencies deemed probable and reasonably estimable at the time of acquisition. Other loss contingencies are either disclosed or ignored; gain contingencies are never considered.

Deficiency. The consolidated financial statements are initially incomplete by not including all assets and liabilities passing to buyers. Omitting contingent liabilities understates the total cost and produces smaller debits to goodwill. Omitting contingent assets inflates debits to goodwill. Consequently, statement readers may be left uninformed about possible future outcomes.

New standard. Statement no. 141(R) will change practice by exempting most acquired contingencies from Statement no. 5 requirements. Specifically, acquirers will be required to record all contractual contingent assets and liabilities at estimated fair value. Other contingencies will be recorded at fair value if it is more likely than not that an asset or liability exists under the element definitions in Concepts Statement no. 6, Elements of Financial Statements. This provision is ground-breaking because it uses a concepts statement to create GAAP rather than guide standard setters in the due process.

Recognized amounts would be subsequently remeasured conservatively until the contingencies are resolved. That is, contingent assets would be revalued at the lower of their original or later value and contingent liabilities would be revalued at the higher of their original or later value calculated, in both cases, with the guidance in Statement no. 5.

(6) STEP ACQUISITIONS

It is not unusual for an acquirer to gain control by beginning with smaller noncontrolling purchases on the way to achieving a majority position. A key question is how to account for the combination when control is reached through a "step acquisition."

Current GAAP. The acquirer preserves original book value (cost, market, or equity method balance) of each investment in the series that culminated in control. In effect, total consideration is built up, layer by layer. Once control is achieved, each layer's book value is used to determine the total consideration, even if that sum isn't close to the aggregate fair value at the acquisition date.

Deficiency. This cost-based measure lacks usefulness because it is partially based on irrelevant market conditions existing when past transactions occurred, not when control was gained.

In addition, this undervalued consideration may allocate less cost to goodwill than its apparent fair value. If the original investments are really old, this measure could even fall below the acquired net assets' fair value, causing them to be booked at amounts that don't reflect their cash flow potential. In fact, FASB concluded the old approach "led to many... inconsistencies and deficiencies in financial reporting." (See paragraph B386 of the revised standard.)

New standard. Once control is achieved through a step acquisition, the acquirer will mark each incremental investment to fair value as of the acquisition date. The date of interest is the date on which the acquirer gains control. Gains and losses from revaluing those holdings will be included in current earnings. The outcome will be greater likelihood that all recorded assets and liabilities are stated at fair value.

(7) GOODWILL MEASUREMENT

A perennial issue concerns the excess paid over the net asset value received in a combination. Tension exists between the possibilities that (1) the full excess describes a real asset and (2) the acquirer paid more than it should have.

Current GAAP. The acquirer compares the consideration with the aggregated fair values of its proportionate share of acquired identifiable assets and liabilities. The excess is recognized as goodwill. No goodwill is attributed to the noncontrolling interest.

Deficiency. This approach doesn't independently assess the existence or real value of goodwill. Rather, it throws the residual into the goodwill account without regard to how much value actually exists. It is unlikely to recognize the full amount of goodwill inherent in the enterprise.

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New standard. Statement no. 141(R) won't abandon the residual cost approach to goodwill measurement. However, its implementation will likely be improved because acquirers will have to value and record many additional assets and liabilities, including R&D and contingencies. In addition, the acquisition entry credits will include the fair value of previous holdings and any noncontrolling interest.

(8) SUPPLEMENTAL DISCLOSURES

Because financial statements cannot fully inform on their own, Statement no. 141(R) requires many new supplemental disclosures to provide users with relevant details, showing how a combination affects the financial statements and the entity's cash flow potential.

Current GAAP. Disclosures are limited to describing the acquisition's impact on reported earnings and the allocation of the purchase price among the acquired assets and liabilities.

Deficiency. Over time, compliance has become perfunctory, with a tendency for many managers to provide only the minimum required disclosures.

New standard. Statement no. 141(R) will mandate extensive disclosures about the acquisition's quantitative and qualitative effects. The list fills more than four pages of the standard. Two requirements are especially noteworthy. First, management will have to describe economic factors that validate the recorded goodwill, including other unrecognized intangibles and synergies expected from the combination. The goal is to prevent assigning a residual to goodwill that doesn't reflect its real value.

Second, Statement no. 141(R) moves toward principles-based accounting by mandating that acquirers disclose "whatever additional information is necessary" to ensure users are fully informed about new combinations or adjustments to previous combinations. (See paragraph 73 of the revised standard.)

(9) MEASUREMENT PERIOD

Acquirers can seldom estimate fair values for all acquired items at the acquisition date because due diligence processes simply cannot generate those details.

Current GAAP. Acquirers assign provisional values up through the first financial statement date after the acquisition. They may be adjusted for up to a year after the acquisition. Statement no. 141 is silent on whether equity changes created by these adjustments should be reported as current income or applied retroactively to equity

Deficiency. Without clear guidance on how to report equity adjustments, FASB found practice was inconsistent. (See paragraph B396 of the revised standard.) And, without retroactive adjustment of prior balance sheets, users are not provided a complete and reliable description of the combination as of the acquisition date.

New standard. To help management cope with uncertainty in preparing

consolidated statements, Statement no. 141(R) allows them a measurement period of up to one year to fix fair values as of the acquisition date. Significantly, adjustments to initially reported provisional amounts will be reflected in restated comparative statements, just as if the revised amounts had been known on the acquisition date.

BEHAVIORAL IMPLICATIONS OF THE NEW TRAIN OF THOUGHT

The adage that people manage what gets measured suggests that Statement no. 141(R) will cause acquirers to be more judicious. At the very least, more careful I measurement and more inclusive reporting may trigger more painstaking front-end research and negotiations. Because more assets and liabilities will be reported at fair value, with buyers' mistakes laid out for all to see, we're confident more homework will precede acquisition offers. While some may worry that these requirements might chill takeovers, we think that could be a good outcome if it stimulates more discipline and eliminates unprofitable transactions.

AICPA RESOURCES

Jof A articles

* "Refining Fair Value MeasurementS' Nov. 07, page 30

* "Intangible Value: Delineating Between Shades of Gray," May 07, page 66

CPE 

The AICPA's Guide to Business Combinations, Goodwill and Other Consolidation Issues, a CPE self-study course (#735161)

Publications

Current Accounting Issues and Risks 2008-Strengthening Financial Management and Reporting, a Financial Reporting Alert (#029208)

Web seminar

See the AICPA Forensic and Valuation Services site for details on a Statement no. 141 (R) seminar on Sept. 18 for FVS Section members, http://fvs.aicpa.org/ Events/BVFLS+Web+Seminars.htm.

For more information or to place an order or register, go to www.cpa2biz.com or call the Institute at 888-777-7077.

Paul B.W. Miller, CPA, Ph.D., and Brian P. McAllister, CPA, Ph.D., are accounting professors at the University of Colorado at Colorado Springs. Paul R. Bahnson, CPA, Ph.D., is an accounting professor at Boise State University. Their e-mail addresses, respectively, are [e-mail], bmcallis@ uccs.edu and pbahnson@ boisestate.edu.

141 vs. 141(R)

This sidebar illustrates, through three business combination
scenarios, several of the nine key changes that Statement no. 141
(R) creates. Scenario A demonstrates the treatment of acquisition
expenses, Scenario B (next page) presents a bargain purchase, and
Scenario C (next page) describes contingent consideration and
in-process R&D. The assumed facts are:

Purchase Transaction
Information:                     Scenario A   Scenario B   Scenario C

Purchase price (cash)            $1,000,000     $725,000   $1,000,000
  Acquisition expenses (cash)        31,000       31,000       31,000
  Contingent consideration
    (based on future earnings)          --           --        82,000
  Percent of affiliate shares
    acquired                            100%         100%         100%

Acquired Net Assets
    (at fair value)
  Current assets                    415,000      415,000      415,000
  Tangible noncurrent assets     $1,200,000   $1,200,000   $1,200,000
  In-process R&D
    (with no alternative uses)          --           --        67,000
  Liabilities                      -780,000     -780,000     -780,000

  Acquired net assets              $835,000     $835,000     $902,000

To simplify the presentation, differences between Statement no. 141
and Statement no. 141 (R) are contrasted using journal entries to
record the acquirer's transactions as mergers.

Scenario A: Acquisition Expenses

Acquisition expenses increase total consideration under Statement
no. 141, but they are expensed under Statement costs

Scenario A (Acquisition-related costs)

                               Current GAAP            New Standard

Current assets              415,000                415,000
Tangible
  noncurrent assets       1,200,000              1,200,000
Goodwill                    196,000                165,000
Acquisition expense              --                 31,000
  Liabilities                          780,000                780,000
  Cash                               1,031,000              1,031,000

  Total cost incurred    $1,031,000             $1,031,000
  Acquisition expenses           --               (31,000)
  Net assets acquired
    at fair value         (835,000)              (835,000)
  Recorded cost of
    goodwill               $196,000               $165,000

Scenario B: Bargain Purchase

This example assumes a purchase price less than fair value of the
acquired net assets. Statement no. 141 reduces the initial recorded
cost of tangible noncurrent assets, but Statement no. 141 (R)
recognizes a gain on the bargain purchase.

Scenario B (Bargain purchase)

                              Current GAAP            New Standard

Current assets              415,000                415,000
Tangible noncurrent
  assets                  1,121,000              1,200,000
Acquisition expense              --                 31,000
  Liabilities                          780,000                780,000
  Gain on bargain
    purchase                                --                110,000
  Cash                                 756,000                756,000

  Total cost incurred      $756,000               $756,000
  Acquisition expenses           --               (31,000)
  Net assets acquired
    at fair value         (835,000)              (835,000)
  Gain on bargain
    purchase                     --             $(110,000)
  Negative adjustment
    to tangible assets     (79,000)
  Fair value of
    tangible assets       1,200,000
  Amount recorded for
    tangible assets      $1,121,000

Scenario C: Contingent Consideration and In-Process R&D

Under Statement no. 141, contingent consideration is excluded from
the purchase price. Although in-process R&D is included among the
acquired net assets at its fair value, it is then written off
immediately. Under Statement no. 141(R), the fair value of
contingent consideration increases the purchase price; in-process
R&D assets remain in the accounts, subject to impairment testing.

Scenario C (Contingent
  consideration
  and in-process R&D)         Current GAAP           New Standard

Current assets              415,000                415,000
Tangible noncurrent
  assets                  1,200,000              1,200,000
Intangible assets
  (in-process (R&D)          67,000                 67,000
Goodwill                    129,000                180,000
Acquisition expense              --                 31,000
  Liabilities                          780,000                780,000
  Contingent
    consideration
    liability                               --                 82,000
  Cash                               1,031,000              1,031,000

R&D expense                  67,000                     --
  Intangible assets
    (in-process R&D)                    67,000                     --

  Total cost incurred    $1,031,000             $1,113,000
  Acquisition expenses           --               (31,000)
  Net assets acquired
    at fair value         (902,000)              (902,000)
  Recorded cost of
    goodwill               $129,000               $180,000