Speed Bumps For Dealmakers
Corporate honchos have lots of reasons to pass on acquisitions, from clashing cultures to adverse Wall Street reaction to high costs. Soon they may have a new one: proposed accounting rules that could hurt their results, make earnings more volatile, and turn a spotlight on high deal fees charged by investment bankers and lawyers. "These are big changes," says Colleen Cunningham, president and CEO of Financial Executives International, an association of corporate finance officers and controllers.
Cunningham and other executives aren't happy about many of the changes, which have been more than four years in the making. One proposal would radically alter how companies account for the value of research and development at a company they're buying. Another might discourage the common practice of buyers promising extra payments to sellers depending on how well the acquisition performs. Significant as they are, the changes are unlikely to stop M&A in its tracks. Deals will need more preparation and become more complicated to execute, says Tomer Regev, an investment banker at Morgan Stanley (MWD ), but people "will learn to live with the accounting."
The Financial Accounting Standards Board, which has posted its proposals for public comment, seems to agree. It seems set on an unswerving course now, regardless of whether the changes make earnings look worse or better. "We're trying to create high-quality information," says G. Michael Crooch, the FASB member overseeing the effort. The Norwalk (Conn.)-based board, which usually gets its way as the U.S. keeper of generally accepted accounting principles, says it expects the rules to take effect at the end of next year.
If adopted, the decision would be a milestone in the drive for consistent accounting around the world, making it easier for investors to compare companies based in various countries. That's because these are the first standards proposed simultaneously by FASB and the London-based International Accounting Standards Board, whose code has been adopted in Europe and elsewhere.
The new rules put great emphasis on fair value accounting. Under this, assets and liabilities are reported at their estimated current values rather than their historical cost. As the estimates change, companies report the ups and downs as profits and losses, even though no cash changes hands. For example, some buyers would have to estimate purchase prices based on the probability that an acquisition will do well and thus trigger a bonus payment to the seller. The FEI's Cunningham frets that earnings volatility from updating estimates could discourage buyers from offering performance incentives. "It would be a shame to see some of that go away," she says. Worse, she fears that investors could become suspicious of management. "It is going to look like companies are managing their earnings even though they are following the rules," she says.
The new rules also could depress earnings for months, even years, if the purchased company has a lot of research and development on the verge of yielding saleable products -- often the bulk of what buyers of biotech companies acquire. The buying company would have to subtract the value of such R&D from earnings as its products generate revenue. Current rules allow buyers to write off this R&D all at once when they close on a deal, potentially goosing profit margins for years. Last year, Eli Lilly & Co. (LLY ) wrote off such R&D valued at $362 million, or 82% of what it paid for Applied Molecular Evolution. Accounting analyst Chris Senyek of Bear, Stearns & Co. (BSC ) predicts pharma companies will rush to buy biotech outfits before the rule takes effect.
Accounting for restructuring costs would also change significantly. Now they are estimated up front and rolled into the acquisition price. FASB's proposals would end that free pass by making companies expense restructuring costs as they are incurred. "It is a drag on earnings," says Raymond J. Beier, a U.S. partner at PricewaterhouseCoopers.
Investment bankers may suffer some collateral damage. Buyers would no longer be able to bury their fees in the price of what they're buying. Instead, they would have to subtract the fees from earnings when they fall due. The hit in a single quarter could be substantial. If that had been the case when Harrah's Entertainment Inc. bought Caesars Entertainment Inc. in June, its second quarter pre-tax income would have been slashed by $52 million, or more than a third. One result could be more pressure on bankers to cut deal fees. No doubt the bankers will say investors should ignore the expense because it isn't recurring.
Another proposal -- that buyers should book purchases (HET )when they close deals instead of when they announce them -- seems innocuous but will add uncertainty to dealmaking. Buyers, particularly those paying with stock, will be less sure of how much they'll have to report paying for a takeover. As a result, says Morgan Stanley's Regev, more deals will include "collars" to limit how much purchase prices can change before closing.
Dealmaking may be less fun in the future. But investors should get a much clearer view of what it's costing them.
By David Henry in New York