Deal Pros Fault Plan to Require Buyers to Break Out Results: But Some M&A Advisers Think the ProposalWill Prod Buyers Into Tougher Diligence

A proposed shakeup in acquisition accounting and reporting, dubbed by some commentators as the “Tyco response,” has triggered a barrage of criticism from deal accountants. The idea under consideration by the profession’s principal rule making body, the FASB, could require buyer companies to break out in their financial statements results and other data directly traceable to acquired businesses and those stemming from ongoing operations. Both critics and proponents agree that the proposal is investor friendly and is being pressed in the name of transparency. But good intentions aside, the critics maintain, it’s easier to talk about the breakout than to do it. In particular, they point to problems in segmenting figures when the acquirer, in line with good strategic practice, moves quickly to integrate the target into its operations and the purchased business effectively loses its identity. If enacted, they say, the proposed change could create a conflict between accounting rules and sound operational execution and, they add, it might not generate the information it’s intended to expose. “Obviously, this is sort of responsive to Tyco,” says Robert Willens, a managing director and tax expert at Lehman Brothers. “This is more or less the Tyco rule.” In the view of Mark McDade, a transaction services partner at PricewaterhouseCoopers, “One needs to be very, very careful in trying to set accounting standards to eliminate a particular perceived abuse because you don’t end up with conceptually sound standards and you get a significant amount of unintended consequences.” And John Malvisi, m&a services partner at Deloitte & Touche, fears that the breakout idea is another example of piling on rules that have too much influence on acquisition decisions. “In too many cases, accounting is driving the transactions rather than economics driving the transactions,” he states. “I think it’s backwards.” But Brian Hechler, a transaction services partner at KPMG, sees a potential benefit in that a breakout could pressure buyers to be more aggressive in examining the target and knowing what it’s buying before sealing a deal. “It could significantly increase the scrutiny on the quality of earnings in businesses acquired and place a more significant burden on sellers to ensure than there are systems in place to identify and create this information in the near term for the buyer,” he says. Willens and others attribute the breakout proposal to the accounting controversy that engulfed conglomerate Tyco International Ltd. Although none of the practices found to date at Tyco apparently broke any rules, many investors, accountants, and corporate governance activists have alleged that several contributed to opaque financial statements, rather than transparent results. Among the most controversial were pre-closing write-downs in the values of target businesses and not disclosing a large number of smallish, presumably nonmaterial, acquisitions. The breakout proposal exploded in August when the FASB added it to the board’s long-running and far-ranging business combination project that is weighing a series of significant shifts in acquisition accounting rules. It was one of two recent additions to the menu. The other was a review of the accounting for in-process research and development obtained during an acquisition, which has long been a controversial issue in m&a, especially in technology deals. The business combination project already had embraced several hot-button issues, such as expensing m&a advisory fees, rather than blending them into the purchase price; changing the accounting for reserves established in connection with acquisitions; and requiring periodic revaluations of contingent payments and earn-outs to reflect market and economic changes. Breaking out results might work in practice, Willens says, if the target were to be operated as an autonomous subsidiary but it presents real challenges in integration settings. “Frequently, if you merge acquired operations into existing operations to take advantage of synergies, I think it would be very difficult to break out the acquired operations,” he says. How, he asks, would a buyer allocate such entries as overhead and sales, general, and administrative (SG&A) expenses? “It’s going to be incredibly arbitrary,” he adds. “I don’t know that it’s going to produce meaningful numbers.” McDade notes that many of the postacquisition aspects of a deal are either extremely difficult or impossible. These might include exactly how much in sales resulted simply because the deal was struck or how many customers entered or left the fold because of the transaction. “It may look easy at a 10,000-foot macro level but when you start drilling down to the nitty-gritty, the buyer has to ask, would I have gotten this sale or not?'” “It becomes really murky in a hurry,” McDade adds. “I think it’s going to be very difficult to come up with clean numbers.” While Malvisi is all for intensive due diligence, he says, “You shouldn’t be doing diligence because you have to disclose anything. You should be doing diligence to understand the operation. You don’t want the tail wagging the dog.” Although Hechler agrees that acquirers may initially find it tough to adjust to a breakout, it will generate benefits in the form of disciplined managers and informed investors. “This proposal will shine a bright light on the quality of earnings and the quality of the management’s ability to integrate the business without losing value,” he says. “It will highlight what heretofore has been murky water in that once a business was acquired it was difficult to see how much of the top line or bottom line was saved in the process. The key thing in integration is not only to match value but protect value.” The breakout proposal springs from a shift in investor perception on how to evaluate companies in the wake of the Tyco case and even more scandalous collapses such as Enron Corp. and WorldCom Inc. One result is that some big-ticket equity investors will pay less for earnings banked from acquisitions than for profits directly traceable to organic growth. Serving up a supposedly clearer demarcation appears to be a driver behind the proposal. Inclusion of the in-process R&D issue in the business combination review generally surprised deals accountants, and opinion varied widely on where the FASB was going with it. Although the matter had been highly controversial a few years ago, when high-priced technology megadeals were in flower, they believed acquirers had gotten the regulatory message not to abuse the entry by a series of enforcement actions. The former firestorm was generated by the tendency of some buyers to gain huge benefits by expensing or allocating to the purchase price all or most of the target’s cost of financing R&D projects. It died down because more recent acquirers tempered the amounts they wrote off or allocated after peer companies suffered setbacks from the SEC or the IRS by pushing the envelope. Hechler again sees operational benefits from creating new rules. They could pressure buyer managements to determine which projects are truly valuable and will yield commercially viable and profitable products and which are going nowhere and should be scrapped. Copyright 2003 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com