LBO frontiers in the 1990s: can accounting keep pace? LBO-type transactions aren't dead, and their accounting issues still are unresolved.

LBO FRONTIERS IN THE 1990s: CAN ACCOUNTING KEEP PACE?

LBO-type transactions aren't dead, and their accounting issues still are unresolved.

The fall of 1989 brought troubles for leveraged buyouts. Problems developed at Campeau, Integrated Resources, Hillsborough Holdings (Jim Walter Corp.) and Resorts International. The potentially lucrative United Airlines and American Airlines buyout schemes never got off the ground. And the investment community now is waiting to see what happens when reset bonds get reset and payment-in-kind bonds begin to require payments in cash.

Nevertheless, the entrepreneurial spirit still exists and companies always will want to divest themselves of unneeded businesses--so the LBO phenomenon will survive and continue. Buyers will become more selective and LBOs of the 1990s will feature tighter loan covenants and more achievable financial projections. These developments will force the dealmakers to design new and more complex LBO-like transactions--custom-tailored for each situation.

This article discusses the current state of accounting rules in one alternative to an LBO transaction and the challenges faced by the accounting profession in keeping pace with LBO innovations.

LBO ALTERNATIVES

As the classic LBO loses its luster, alternative vehicles for divestiture and acquisition include joint ventures and other forms of spin-offs that resemble LBOs but whose economics are markedly different. The accounting issues associated with these transactions are an uncharted frontier for CPAs. The Financial Accounting Standards Board emerging issues task force (EITF) has answered some questions but many more remain. Let's examine one type of common transaction recently studied by the EITF and consider some of the questions that were left unanswered.

Example: An operating company contributes assets and a financial partner invests equity capital in a newly formed entity. The contributed assets typically are underperforming and their true value may be realized only with the help of a new management team and/or an infusion of capital. The financial partner sees an opportunity to invest in a business with significant potential; the operating company is happy to reduce its investment but hedges its bet by keeping a noncontrolling equity interest. To equalize values, the operating company may receive or make a cash payment as well as contribute assets. Both parties can leverage the contributed assets, with the proceeds going to one or both or used to finance the new entity's operations. An initial public stock offering also is possible.

THE ACCOUNTING CONSIDERATIONS

Some accounting questions raised by these types of transactions were discussed, but only partially resolved, in EITF Issue no. 89-7, Exchange of Assets or Interest in a Subsidiary for a Noncontrolling Equity Interest in a New Entity.

Assume: Operatingco is a diverse manufacturing company that has a trucking subsidiary with a carrying value of $8 million and a fair value of $60 million. Over the years, Operatingco's reliance on its trucking company has declined and it believes the investment is no longer warranted.

Operatingco agrees to partially divest itself of the trucking company by transferring it to a new and revitalized entity, Truckco, in exchange for a 40% equity interest valued at $60 million, which it will account for using the equity method. It seeks a financial partner that believes Truckco can be turned into an independent profitable company. Financeco, an investment company, contributes $90 million in cash to Truckco for a 60% interest in Truckco. Assume Operatingco has no ongoing commitment to support any of Truckco's operations.

The accounting entries for this transaction are shown in exhibit 1 Operatingco divests Truckco. Financeco's accounting is easy: It has a subsidiary with a 40% minority interest. Consolidation accounting normally would be required but many investment companies carry acquisitions at cost until their value clearly is impaired or there's substantial evidence it has increased. Typically, this would occur if Truckco's stock became publicly traded.

Operatingco's accounting: No gain recognition. Operatingco's accounting, however, is somewhat controversial and was the subject of a recent EITF debate in which no consensus was reached. The majority of EITF members believed that since Operatingco's transfer of trucking assets brings in no cash, the company should not recognize gain. Thus, Operatingco should record its $8 million Truckco investment by reclassifying its net trucking assets to an "Investment in Truckco" account. Under this line of thinking, the exchange is a nonmonetary transaction in which the "culmination of the earnings process," as described by Accounting Principles Board Opinion no. 29, Nonmonetary Transactions, has not occurred. In other words, Operatingco has exchanged one productive asset--its net trucking assets--for an equity investment in another--Truckco. This view is backed by the American Institute of CPAs Statement of Position no. 78-9, Accounting for Investments in Real Estate Ventures, which describes analogous real estate transactions. This SOP does not permit gain recognition on the formation of a joint venture unless the transferor receives cash.

Operatingco's accounting: Partial gain recognition. One also could argue that at least 60% (the interest transferred) of the potential gain by Operatingco should be recognized. That is 60% of $52 million (the difference between the fair market value of net assets transferred by Operatingco and their carrying value) or $31.2 million. Some gain recognition by the parent is allowed by Securities and Exchange Commission Staff Accounting Bulletins (SABs) nos. 51 and 84, Accounting for Sales of Stock by a Subsidiary. To use these SEC pronouncements for support, however, the transaction would have to be structured differently and would require Truckco's accounting to remain on Operatingco's historical cost basis.

EITF Issue no. 86-29, Nonmonetary Transactions: Magnitude of Boot and the Exceptions to the Use of Fair Value, requires partial gain recognition if Operatingco receives, as part of the exchange, enough equity to control Truckco. It seems inconsistent not to allow any gain recognition if control is surrendered. In surrendering control over $60 million in assets for the noncontrolling equity interest in Truckco, it appears Operatingco is placing at least equivalent economic value on its Truckco investment. The loss of control of the business and the different form of ownership suggest an economic event has occurred that should be recognized.

It's understandable why full gain recognition would not be acceptable because of Operatingco's continuing interest but partial gain recognition seems appropriate--especially since Financeco's equity was purchased for cash.

Truckco's accounting: Historical or fair value? Truckco's opening balance sheet accounting isn't clear either. A CPA working for Truckco might take the opportunity to record all asset values at fair value. There's surely economic evidence supporting this position because 60% of Truckco's equity was bought for cash. One can assume that Financeco wouldn't have paid $90 million for its 60% equity investment unless it believed the trucking assets were worth $60 million. Given this objective evidence of value by independent companies dealing at arm's length, recording the fair value of Truckco's assets seems to be one reasonable alternative.

Recording an entity's net assets at fair value raises an interesting possibility. Does the benefit from recording net assets at fair value offset the burden higher future depreciation and amortization costs will place on operating results? Over time, step-up in basis, unless allocated to land, will offset (via charges to the income statement) the additional equity established in fair valuation. Having alternatives in accounting can be very convenient. If a borrowing is planned, a healthy balance sheet with lots of equity could facilitate getting a loan. If a stock offering is planned two or three years ahead, minimizing asset step-up can help establish a high earnings trend and increase the perceived value of the equity being offered to investors.

Truckco's accounting: Predecessor basis. Using the concept of predecessor basis set forth in EITF Issue no. 88-16, Basis for Leveraged Buyout Transactions, one could value Truckco's assets at predecessor cost to the extent of Operatingco's 40% continuing interest. This would be the required accounting if Truckco was formed in a leveraged buyout with Operatingco retaining a 40% residual interest in Truckco. Using these principles under our scenario, Truckco's assets would be valued at $39.2 million, whereby only 60% of the step-up in basis would be allowed in valuing the transferred assets. See exhibit 2 Accounting for Truckco's assets.

Some observers would use the concept of pushdown accounting set forth in SAB no. 54, "Pushdown" Basis of Accounting in Financial Statements of Subsidiaries, to support the partial step-up of Truckco's assets. SAB no. 54 discusses a scenario in which the parent sells "substantially all" of the stock of a subsidiary at greater than the subsidiary's book value. The SEC believes when a purchase results in the entity becoming a substantially wholly owned subsidiary of another entity, a new basis of accounting should be established. That is, the new parent's cost basis should be reflected in the subsidiary's separate financial statements.

If a 60% interest in Operatingco's truck business was acquired in a straight purchase acquisition for $90 million, the buyer would step up the acquired assets by 60%. Using the concept of pushdown accounting, this step-up would be recorded on the books of Truckco and the offset credited to Truckco's paid-in capital. However, pushdown accounting is required only when the acquired company is public and substantially all--approximately 80% to 90%--of its stock has been acquired. In addition, the SEC staff recognizes the existence of outside public debt, preferred stock or a significant minority interest may affect the new parent's ability to control the form of the subsidiary's ownership. In these circumstances, the SEC does not insist on pushdown accounting, although it encourages its use.

Thus, our example isn't directly analogous to the classic pushdown scenario but those favoring at least a partial step-up in basis nonetheless can use these principles to support their view that the cost basis of the parents should be considered only partially in the subsequent financial reporting of a new subsidiary.

Obviously, there are at this time no definitive accounting answers to many of the questions raised by this relatively straight-forward transaction. One can get an idea of how they will be answered from an accounting consensus on a similar transaction in which the newly formed subsidiary leverages its assets and pays the proceeds to one of its parents.

LEVERAGING THE NEWLY FORMED ENTITY

The EITF addressed the accounting when the newly formed entity is leveraged and reached a consensus on Transportco's accounting in EITF Issue no. 89-7. The consensus was very specific and will have practical application only when no contingencies or recourse to the transferor exists.

Assume: Transportco is a diverse transportation company that has a railroad subsidiary with a carrying value of $10 million and a fair value of $80 million. Transportco needs cash to expand its core businesses and wants to divest the railroad. To do so, it transfers the railroad to a new entity, Railco, in exchange for a 40% equity interest valued at $8 million and $72 million of redeemable preferred stock. An investment company, Investco, contributes $12 million in cash for a 60% interest in Railco. Later, Railco borrows $72 million and uses the proceeds to redeem the Transportco preferred stock. The Railco debt is nonrecourse to Transportco and Transportco has no commitment to support Railco's operations or guarantee its debt or any other liability.

The accounting entries used to record the initial investment in Railco are shown in exhibit 3 Transportco divests Railco.

The unresolved accounting issues. The accounting alternatives faced by Investco and Railco are the same as those discussed in the previous example. Investco's accounting is similar to Financeco's. Investco carries its investment at cost until circumstances indicate this value should change. The accounting questions about Railco's opening balance sheet are the same as those for Truckco--and these were not addressed by the EITF. There's no controversy about Railco's accounting for leveraging its assets because Railco merely replaces the preferred equity of Transportco with a liability to lenders.

Transportco's accounting: No gain recognition. Although it received cash from Railco without contingencies or a commitment to support operations via the redemption of preferred stock, some EITF members believed Transportco shouldn't recognize a gain because a borrowing does not culminate an earnings process. Instead, they would credit the Transportco investment account with the proceeds of the Railco preferred stock redemption--establishing a negative investment account for Railco on Transportco's books.

Transportco's accounting: 100% gain recognition. Other EITF members supported recognizing 100% of the gain. They argued that Transportco should not be required to maintain a negative Railco investment account (which is effectively a liability account) if it's not obligated to support Railco, make good on any present or contingent liability or return the proceeds of the borrowing at any time in the future.

EITF Issue no. 86-29 says an exchange of nonmonetary assets that would otherwise be based on recorded amounts but also involves boot should be considered monetary if the boot is significant (more than 25% of the fair value). Since Transportco received more than 25% of the consideration for its railroad assets in cash (it actually received 90% in cash), some believe 100% of the $70 million gain should be recorded (that is, $80 million value received, $72 million in cash and $8 million in Railco stock, less $10 million book value of the railroad assets surrendered).

Transportco's accounting: Partial gain recognition. Some observers would limit the gain to the percentage of control surrendered over the exchanged business--in this example that would amount to $42 million gain (60% of $70 million). They believe Transportco in substance continues to own 40% of the railroad assets and should not recognize more than 60% of the gain until either the remainder is sold by Railco, or Transportco sells its investment in Railco. Notwithstanding this argument, some observers would use the principles of SOP no. 78-9 and limit the gain recognized to cash received. If the cash received is more than the gain calculated in this manner, the difference would be recorded on Transportco's balance sheet as a deferred credit.

EITF Issue no. 89-7 on Transportco's accounting allows gain recognition in the situation described above such that the ongoing investment by the operating company, Transportco, not be less than zero. The consensus and the SEC observer emphasized that, to permit this gain recognition treatment, there can't be any contingencies or actual or implied commitment, financial or otherwise, to support the operations of the new entity (Railco) in any manner. In the case above, this means a $62 million gain should be recognized. See exhibit 4 Accounting for Transportco's gain using EITF Issue no. 89-7.

SETTLING THE FRONTIER

The guidance of EITF Issue no. 89-7 does not cover all the questions that can arise in these transactions. For example, what if the equity interest in Railco is such that equity accounting in Railco isn't permitted by Transportco? Would the cash proceeds from the borrowing be credited against the investment account? Or what if part of Investco's investment is in the form of a note, mandatorily redeemable or convertible preferred stock or a nonmonetary asset? What would be the impact on the accounting?

If the Railco loan is nonrecourse to Transportco, guidance on Transportco's accounting can be found in SAB no. 81, Gain Recognition on the Sale of a Business or Operating Assets to a Highly Leveraged Entity. In this pronouncement, the SEC cautions that gains should not be recognized when significant uncertainties exist about the seller's ability to realize noncash proceeds or when circumstances may require the seller to infuse cash into the LBO. In our case, if Transportco is contingently liable for the Railco borrowing, no gain recognition would be permitted.

Merger, acquisition, joint venture and LBO transactions now are structured to meet the specific needs and objectives of the situations. Accordingly, there are numerous deviations from the basic "plain vanilla" transactions common in the late 1980s. Not surprisingly, accounting rule makers haven't been able to keep pace. Consequently, CPAs must search the literature not necessarily for an exact answer on how to account for a specific transaction but for clues on precedents.

Development of the LBO carryover basis principles took more than three years. Rule makers of the 1990s should try to speed up the accounting standard-making process to help ultimate the diversity that has arisen in accounting practice.

Some CPAs are scratching their heads over the unique and innovative accounting featured in the recent merger of the Merrell division of Dow Chemical and the Marion Corporation. The new entity, which combines Merrell and Marion, was able to limit the amount of goodwill by having Dow obtain control of Marion before the combination was completed. Though some goodwill was established when Dow acquired such control, as a combination of entities under common control, the remainder of the merger was recorded at book value. CPAs are waiting to see if the EITF will examine the accounting issue this raised. Thus far, EITF Issue no. 90-5, Exchanges of Ownership Interests Between Entities Under Common Control, touches only some aspects of the accounting.

The availability of accounting alternatives can be a luxury for those creating new transactions but it becomes confusing for those who rely on financial statements to make investments using comparisons among companies. There may be fewer LBOs in the 1990s but other transactions will take their place and the accounting profession should be ready to meet the accounting challenges they offer.

EXHIBIT 2

Accounting for Truckco's assets

Here's how Operatingco uses predecessor basis to account for the transaction to the extent of its continuing interest in Truckco.

Fair value of Truckco's assets                   60%
Predecessor basis of Truckco's assets            40%
                                                100%
Fair value: 60% of $60 million (fair value)            $36.0 million
Predecessor basis: 40% of $8 million                     3.2 million
Truckco basis of valuation                             $39.2 million

Alternatively, these amounts may be computed:

Fair value                                             $60.0 million
Predecessor basis                                        8.0 million
Difference                                             $52.0 million
Amount of fair valuation                                         60%
"Partial step-up in basis"*                            $31.2 million
Predecessor cost                                       $ 8.0 million
Truckco basis of valuation                             $39.2 million

(*) This is the partial gain that some observers believe should be recognized by Operatingco. [Exibit 1, 3 and 4 Omitted]

JERRY GORMAN, CPA, is a partner in the mergers and acquisitions group of Ernst & Young, New York. He is a member of the American Institute of CPAs and the New York State Society of CPAs.