Big Accounting changes likely with release of ED on Business Combinations.

While not being heralded as exactly a "landmark," a recent announcement denotes an event that's ushering in the new era of converging global accounting standards. On June 30, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) concurrently released two Exposure Drafts (EDs) related to what is broadly known in the U.S. as Phase II of the Business Combinations project. Internationally, it's known as IFRS 3 Business Combinations.

The ED will be open for 120 days, allowing ample time for comments from both sides of the pond on what is likely to be a contentious ED in the U.S. During the comment period, roundtables will be held in both the U.S. and London.

In an interview, Michael Crooch, the FASB board member and collaborator for the project, stressed the importance of the joint project. "The fact that we were able to get this done gives us encouragement that we will be be able to do that again going forward," he says.

The EDs deal with accounting for business combinations and noncontrolling interests. One of the FASB EDs revises FASB Statement No. 141, Business Combinations--now FASB 141(R). The second is a proposed new standard that would incorporate consolidation guidance contained in Accounting Research Bulletin No. 51, Consolidated Financial Statements, and aims to provide new guidance on accounting for minority interests (now known as "noncontrolling" interest).

FASB Chairman Robert H. Herz, commenting in the press release, said, "A common standard on the very important area of accounting for business combinations will help users and preparers by improving the comparability of financial information reported by companies around the world that issue financial statements in accordance with either International Financial Reporting Standards [IFRS] or U.S. GAAP [generally accepted accounting principles]."

Also in the press release, IASB Chairman Sir David Tweedie expressed delight with the first major joint project's progress. "The development of a single standard demonstrates the ability of the IASB and FASB to work together. By focusing on fundamental principles and avoiding exceptions, the proposals aim to eliminate many of the inconsistencies in the existing guidance for accounting for business combinations," Tweedie said.

"Both boards have a long-standing commitment to convergence--they've certainly gotten encouragement from the Securities and Exchange Commission (SEC) and some of our leading politicians," said David L. Holman in an interview. Holman is a partner with Ernst & Young in New York and national director of Accounting Standards. He says it's "commendable that both boards were able to come to the same conclusion," albeit coming from different points within their existing standards to produce a standard that is virtually identical. Further, he says, "This is an example that they can and will continue to do it."

Officially known in the U.S. as Business Combinations and Consolidated Financial Statements, Including Accounting and Reporting of Noncontrolling Interests in Subsidiaries, the target effective date for both Statements is for fiscal years beginning on or after Dec. 15, 2006.

So, what are the significant differences from the former standards, and how will preparers and users be affected by the changes?

In earlier documents, the FASB said it "plans to revise the existing guidance on the application of the purchase method (developed over 30 years ago) in ways that will improve the completeness, relevance and comparability of financial information about business combinations that is reported in financial statements." It aims to:

1. eliminate existing inconsistencies in the guidance for measuring assets acquired and liabilities assumed in a business combination,

2. develop guidance for determining the assets and liabilities that should be recognized in the initial accounting for the business combination (such as liabilities associated with contingent consideration arrangements and planned exit activities),

3. determine whether a transaction or event, other than a purchase of net assets or equity interests that results in a reporting entity obtaining control over a business, should be accounted for by the purchase method; and

4. undertake the project jointly with the IASB with the goal of developing a single high-quality accounting standard that could be used for both cross-border and domestic financial reporting.

FASB Project Director Stefanie Tamulis said in an interview that the intent was not to change the decisions in Statement 141. However, she says certain changes in wording were made in order to be consistent with the IASB version (the changes can be found paragraph-by-paragraph in the "guidance" section of the EDs), and she cites several significant difference from Statement 141.

First is the area of step acquisitions (partial purchases). Previously, if a company acquired less than 100 percent, it recorded 80 percent fair value and 20 percent carry-over basis. She explains that since those numbers aren't particularly relevant to anybody, the way it is now, if less than 100 percent is acquired, the business combination is recorded at 100 percent of the assets and liabilities, including goodwill. Tamulis says, "That provides numbers that are much more relevant to users because they can understand what that number means."

Another substantial difference relates to transaction costs. Previously, the practice was to capitalize transaction costs as part of the business combination, and those low costs generally ended up in goodwill. Now, she says "this is not part of the fair value of what you are acquiring, and you would generally expense those costs as occurred."

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A third change of significance, notes Tamulis, relates to contingent consideration and contingent gains and losses. "If you're acquiring an entity, you measure all items of consideration on the acquisition date, and that would include contingent considerations. "Previously, users had the option of not recognizing contingent consideration until they knew what the settlement amount was going to be. "With that option eliminated, on the date of acquisition, you would have to recognize a liability for it [the acquisition] at fair value, and that liability is most likely not going to be your settlement value," she says.

Another change is for contingencies. People used to follow a FAS 5 approach to reporting contingencies--you didn't record a liability until you knew that the amount was going to be an asset, until you basically had the asset. Now, Tamulis explains, "you have to recognize those contingencies as part of the business combination at fair value."

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The biggest change in the classification of minority interest to "noncontrolling interest ED," explains Tamulis, is that noncontrolling interest would now be required to be classified as equity, and any changes in noncontrolling interest--acquisitions or sales of noncontrolling interest--would be recognized as capital transactions rather than a gain or loss recognition on the income statement.

Controversy, Changes, Comments

Holman opines that in the new EDs, "certain things appear to be very controversial, especially from the preparer community." Specific areas he highlights are the requirement to record contingent consideration at fair value, expensing acquisition-related expenses, pre-acquisition contingencies, dealing with contingent assets and contingent liabilities--all of which, he argues, go back to fair value exchange.

"At least in the ED, the board is trying to be consistent with that basic principle," he says. But he believes this will create controversy because it introduces more fair value, as well as items that have to be valued, that didn't have to be valued in the past. Such additional work could cause companies to require more outside help, in addition to incurring higher auditor costs.

"Whenever you get a large change to an existing practice, those tend to be more controversial, and [are] the ones that draw the most commentary from users and preparers," says Jeffrey Scott, a partner with Ernst & Young. Indeed, he notes, the result of the revised standards will cause changes to both the balance sheet and income statement.

Holman-says it will be interesting to see this play out and how the boards respond, especially if there were to be divergence in the comments from their various constituencies.

"Controversy usually leads to some rather strong comments," he says. "If there would be major changes, it would probably be better if they went back and re-addressed the basic principles of what they will be dealing with versus again putting a list of exceptions in. In my mind, it's always the exceptions that add to the complexity."

Bottom line, Holman says that before commenting, he'd advise clients to focus on the basic premise of the standard, and not just a piece of the whole thing. He indicates that page 72 of the ED talks about the fundamental principles. "People really need to focus on that. Try to understand it, and then try to comment on that, possibly starting with do you believe that is an appropriate premise or not, before going in and picking apart your own particular pet peeve."

It's difficult, he says, in cases where individuals don't like a particular piece, for the board to assess whether you don't like the basic premise, or whether you really are concerned with how a particular aspect is supported by the basic premise, or, is it consistent with the basic premise? As part of his job responsibilities, he'll be crafting the comment letter from E & Y.

Crooch says FASB has had some preview of the kinds of comments it can expect. One relates to the model change with regard to business combinations from the old purchase method approach (described earlier by Tamulis). "It's a different model, and one that says once you get control of your target, that you control all of the assets, and, therefore, all of the assets have to be fair valued at the date of acquisition, including goodwill," he explains, which means that the consolidated financial statements will have fair values of all of the assets that you have acquired, including that which is owned by the noncontrolling interest.

Another area in which Crooch expects a great deal of comments relates to the parent-company approach. This, he explains, is a method that is aimed specifically at getting information to the parent company's shareholders. "We have, in fact, put in some disclosures that mitigate the differences," he states. Tamulis had mentioned that contingent consideration is going to be fair-valued at the date of acquisition, and that changes in those fair values would go through income. Regardless, however, he still expects this area to be hotly contested.

Crooch believes there is great value in the upcoming roundtables, as opposed to "hearings." At roundtables, he says, everybody is at the table, and standard-setters moderate the discussion so that they get input from everybody. He believes this format significantly increases the amount of information transfer, since the moderator (likely himself in the U.S.) "has the ability to cut people off if they get redundant, and move into areas that we are interested in to get their opinions."

The Complexity Issue

So what is Holman expecting around October 28? Will this go through smoothly or be derailed because of the complexity and waiting for comments from both sides of the Atlantic? He says it depends on both the amount and level of comments, particularly in areas that the boards haven't thought about.

Before calling the new standards "complex," Holman advises that companies study the standards to see what associated literature gets eliminated from which is basically being put in one place. "The basic standards are particularly long," he says, "but they're effectively amending a lot of existing guidance--in the U.S., at least."

Holman believes much of the complexity in U.S. accounting standards generally is due to the mixed-attribute model in current practice. Complexity, he notes, is largely due to the exceptions to the basic principles put into the standards. He says the IASB issues more principles-based standards than FASB.

Crooch concedes it's easier to explain why the FASB has changed the rule than it is to explain the ensuing complexity. The standard was changed, he says, "because we believe that the new standard provides better and higher quality financial information for users." On the other hand, he says, complexity is a tougher issue.

"Some accounting is complex because the issues are complex, and some of the complexity comes from the desire on the part of our constituency to want increased amounts of guidance with regard to how to apply certain aspects of this." Thus, he explains, "the trade-off between less complexity and the ability of our constituents to apply these things in the manner that is intended, is a difficult task, and we try to balance those two."

The business combinations statement, he concedes, has a lot of complexity in it; it has a lot of places where people want to be sure they understand what the guidance is, and "we try to be sure that they could, in a manner that is not more complex than necessary."

Crooch emphasizes his belief that 141(R) is an improvement over the former standard, and that those involved worked very hard to be sure that they made it useful and understandable. Further, he hopes it is received well. "We recognize, however, that every time there is a change, there is going to be someone who is not going to appreciate that. We'll work with those people and try to make sure that the process works."

When asked about the expense involved in making these changes, Crooch says, "We have to issue accounting standards that we believe have a benefit in terms of better financial reporting, over the cost of change, [and] we try our best to come up with an equation that says, "yes, we believe the benefits are better than the cost."

Crooch believes, however, that he will hear from constituents--about how much additional effort this is going to take, how much outside help they think they are going to have to have, etc. And, he says, that's exactly the reason why we have Exposure Drafts.

FEI/FASB Webcast

Business Combinations and Non-Controlling Interests

September 20, 2005

featuring FASB Project Director Stefanie Tamulis

Register at www.fei.org/tc/