Earn-Outs Are Key in FASB’s Revisions for M&A Treatment: Accounting Rules Maker Proposes Changes That Could Cut Earnings, Stir Volatility

Sometimes a deal-saver, sometimes a flashpoint for hard feelings, the earn-out invariably is embraced by dealmakers only with trepidation. In theory, it’s an elegantly simple way to rescue a deal stalled by a seemingly unbridgeable gap in the seller’s asking price and the buyer’s bid. Mix in people, however, and the theory can go astray. So many earn-out agreements based on post-deal performance of the target company have wound up in litigation or arbitration that many dealmakers historically have considered attaching them to a deal structure only as a last resort. Nevertheless, the present m&a market – characterized by an enormous chasm in price perceptions between the buy and sell sides – has sparked a burst of popularity for the earn-out as a technique for getting transactions done, even among dealmakers aware of its potential for friction. But that newfound acceptance is being threatened by a proposal to change the way an acquirer must account for the earn-out. It is not only more complicated, says Jeff Kotowitz, a transaction services partner at PricewaterhouseCoopers, but it can cut into or roil the buyer’s earnings. “The earn-out has become relatively popular for a number of reasons related to the current market,” Kotowitz says. “But if the proposed change is adopted, it could reduce the number of earn-outs.” At present, the earn-out is recognized as an addition to the purchase when the contingency is settled or resolve – that is when the seller receives extra cash or stock for producing results outlined in the earn-out agreement. Under a proposed change issued by the FASB, the earn-out would be recognized at fair value and marked to market by adjusting post-deal earnings every quarter until the agreement expires or is settled. There would be an exception if the earn-out were considered equity. The revision not only would trigger volatility in the combined company’s earnings but challenge accountants to come up with a method for calculating and assigning fair value to the earn-out. It hasn’t been done before and nobody really knows how to do it, Kotowitz notes. The revised earn-out approach is one component in a package of m&a accounting changes – considered the second round of a shake-up that started with last year’s elimination of pooling-of-interest accounting – that the FASB has sketched for future action. An exposure draft, in effect a formal proposal that will be kicked around by the industry before a final decision, is expected in the spring of 2003. Although the earn-out was seen by Kotowitz and others as the plank that would have the most impact on dealmaking, the plan also packs significant revisions on accounting for acquired contingencies, acquisition costs, and restructuring costs, among others. An earn-out is a dealmaking technique that in effect states, “Put your money where your mouth is.” Say, a buyer refuses to pay the asking price because it lacks confidence that the selling company can keep up a stellar performance. If an earn-out is attached to the initial price, the seller will be paid more – perhaps even wiping out the price gap – if the target meets sales, earnings, or other goals hammered out at the negotiating table. It’s a risky proposition for both sides, often leading to disputes, and the proposed accounting change would exacerbate the potential for bad blood. “The FASB has proposed treating most earn-outs as liabilities and recognizing them at fair value on the closing date (of the deal), thereby generating incremental goodwill,” stated a PricewaterhouseCoopers analysis that Kotowitz helped prepare. “Changes in the fair value of most earn-outs would be recognized through earnings in each subsequent period until the earn-out is either paid or cancelled, causing earnings volatility.” That can have “paradoxical results,” according to Kotowitz. If the selling business performs well enough to get the earn-out, the buyer rolls up added costs that offset or reduce the benefits of the target’s performance, “thereby hurting its P&L.” But if the target’s performance doesn’t measure up and the earn-out isn’t paid, the buyer’s P&L will escape a hit but questions will emerge on whether the target’s value has slipped and related goodwill should be written down. One way out of the dilemma is arranging the earn-out so that it qualifies as equity. That can be tricky because the non-accounting definition of equity clashes with the accountants’ idea. To qualify as equity, Kotowitz points out, the earn-out must represent a residual interest in the company rather than an obligation. Warrants issued to selling shareholders that are exercisable if they meet sales or earnings goals may qualify as equity. But an earn-out that is to be paid as a flat dollar amount through a floating number of shares – among the most common of contingent payment approaches – would not be considered equity. Kotowitz suggests that acquirers weigh the trade-offs between the economic side – preventing overpayment – and the accounting side – proxied by more volatile earnings – before opting for an earn-out if the FASB change goes through as proposed. Among the other proposed changes outlined by Kotowitz and PricewaterhouseCoopers: Acquired contingencies – Future payments are generally recognized in the purchase price if they are likely to be met and can be estimated at the time of the acquisition. The FASB proposal would require immediate recognition of all contingent assets and liabilities at fair value and subsequent marking them to fair value in the combined company’s earnings – another source of potential earnings volatility. Kotowitz suggests tighter due diligence to identify and value the contingencies, include them in earnings dilution analyses, and disclose them in financial statements. Acquisition costs – The FASB would have all acquisition-related costs, including advisory fees, expensed immediately, causing increased short-term earnings dilution for the combined firm. At present, the buyer expenses indirect transaction costs and capitalizes direct costs in the purchase price. Kotowitz says that the primary impact may be to make the cost of doing a deal “more transparent” for investors and that some companies may try to segregate m&a fees in financial reports and note that they are non-recurring. Restructuring costs – Under the proposed rules revision, buyers would be forced to expense all costs of restructuring a newly acquired business, e.g., laying off excess workers, relocating facilities, etc., and take an immediate hit on profits. The current arrangement involves capitalizing the costs in the purchase price, thus stretching out the impact. The antidote is accelerating the restructuring and getting it over with as fast as possible. That could have a benefit, however, by prodding companies to act quickly so they can capture synergies as soon as possible. Effective dates – Changing the effective date for measuring the value of stock-swap deals to closing from announcement. The final price would reflect the stock market’s reaction. The shift also could reduce the likelihood of big goodwill write-offs through the annual impairment tests that the FASB mandated last year while knocking out goodwill in favor of uniform purchase accounting for all m&a transactions. Partial acquisitions – Minority interest investments would be recognized at fair value by the investor company.