New M&A Accounting Rules that Every Investment Banker Should Know - June 2010

By now, you should be aware that there were some significant changes in M&A accounting last year. If you are not, then you will certainly see the effects of these changes in annual reports for the year to 2009 which are now being published.

Here is a summary of some of the key changes:

Advisory fees should be expensed in the first year post deal

This is in contrast to the previous treatment of adding them to the purchase price and hence also to goodwill.

No doubt analysts will treat them as non-recurring items for the purposes of cleaning EBIT, EBITDA and net income numbers.

Accounting for Earn Outs in transactions such as LBOs

Contingent consideration now has to be recognized at “fair value” at the deal date. This means it must be a probability-weighted estimate of alternative outcomes. So even if the payment is unlikely to happen, some of it will still be recognized at the deal date, as a financial liability or as equity depending on the nature of the consideration.

If the amount estimated changes, this liability needs to be adjusted and the corresponding gain or loss will be taken through the income statement rather than correspondingly adjusting the goodwill, as under previous rules*.

Noncontrolling interests (NCIs)

This is the new name for “minority interests”.

Why the name change? Given the flexibility of accounting rules in defining control, it is now possible that the NCI could hold a majority of the voting equity of a company but not have control; hence it could be misleading to refer to them as “minority” shareholders.

Classification of NCIs

US GAAP has come into line with IFRS and NCIs are now classified as part of equity rather than as a separate category between liabilities and equity. So be careful when selecting the equity for return on equity calculations – group vs. common shareholders only?

The fair value method for NCIs

Under US GAAP new NCIs are now shown in the balance sheet at fair value and NOT at % of net assets acquired.

IFRS allows companies a choice of either method for new NCIs.

Thereafter, the NCI is not marked to market, but adjusted by the NCI% of the subsidiary company’s equity, exactly as under the previous rules.

What are the implications?

If recorded at fair value, the NCI now includes their share of goodwill in the subsidiary company.

Consequently, the NCI value in the balance sheet is normally higher than under the % of net assets method. The goodwill in the consolidated balance sheet is also higher by the same amount.

How do you find the fair value of the NCI?

Ideally it is based on the share price of the relevant subsidiary, if there is one. Otherwise any standard valuation method (trading comparables, DCF etc) can be used. The company has to disclose the method it used in the notes in the annual report.

Conclusion

Make sure you know the basics of the M&A accounting rule changes, and start using the term “noncontrolling interests” rather than “minorities” if you want to impress your colleagues.

* With exceptions