Acquisition of a strategic partner usually makes good business sense but can cause accounting and financial headaches if not calculated correctly. The problem is that accounting rules in effect require the buyer to treat the acquisition and the wind-up of the old relationship as separate transactions, which can result in significant one-time gains or losses at the bottom line. Both squaring away the impact and explaining it to investors can be tricky business, warns PricewaterhouseCoopers. In a recent Deal Flash, the firm’s Transaction Services Group noted that the issue is not new, but its potential for causing trouble has multiplied because of an increased number of deals between members of strategic alliances. These include acquisitions by strategic acquirers of their distributors, licensees, and franchisees. The general advisory for doing these integrative deals is to thoroughly comb the contracts during due diligence and inform surprise-averse investors of any major effects on earnings. The issue is rooted in a rule (EITF Issue No. 04-1) promulgated in 2004 to harmonize accounting treatment in deals linking business affiliates. The question is whether the buyer “settles a preexisting relationship with a target” and the rule orders that the accounting for that matter be handled separately from the acquisition. In addition, PricewaterhouseCoopers says, the rule addresses cases in which the buyer reacquires rights previously granted to the target, such as the right to use a trade name or a technology. According to the Deal Flash, prepared by Jeff Kotowitz, Jonathan Isler, and John Vanosdall, the rule centers on these three aspects: Settlement – If a contract or relationship is settled, the buyer records a gain or loss on its income statement “equal to the favorable or unfavorable terms of the contract.” Impact – The gain or loss should be either the stated contractual settlement provisions or the amount by which the contract is favorable or unfavorable based on current market terms, depending on which is lower. Reacquisition of rights – Any reacquired rights should be valued as an intangible asset, separate from goodwill, through an appropriate method, such as discounted cash flow. In view of the rule, the authors say, the buyer of an affiliated firm must examine the contracts to determine how “settlement” will impact post-acquisition results. “The impact potential one-time gains or losses can have on purchase accounting or dilution arising from the amortization of reacquired rights should not be overlooked,” the Deal Flash advises. The requirements were cited as an example of the increasing convergence of accounting and valuation, and the Deal Flash notes that the rule offers no guidance on how to determine gains or losses to value reacquired rights. While common valuation techniques can be used, the process can be complex. “If the contract doesn’t specify settlement terms, the buyer could apply a discounted cash flow model that considers the settlement amount to be the difference between relevant terms and market rates,” the authors say. “A similar model is widely accepted for valuing other acquired assets, such as favorable or unfavorable lease arrangements,” they add. Finally, Kotowitz, Isler, and Vanosdall advise that the partners should have the rule in mind when negotiating the original affiliation. Specifying settlement and payment terms in case the agreement is terminated is a good idea. (c) 2006 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com

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