Squeeze on a Buyer’s Credit From an Unlikely Source: Rules that tarnish balance sheets by turning some securities and guarantees into liabilities can make it hard to get deal funding

Thanks to newly issued accounting rules, large numbers of U.S. companies are facing a balance sheet shakeup with securities historically carried as equity shifting virtually overnight into the liabilities column. The rules also require clearer disclosure of financial guarantees and indemnifications that may commit a business to future payouts. Just another cosmetic accounting change? Hardly, warn transaction services experts at PricewaterhouseCoopers, who say the heavier liabilities load could curb a firm’s ability to obtain financing for acquisitions and other corporate projects and jack up the interest costs. The advice to acquirers is to line up the financing commitment, including such key elements as rates, terms, and covenants, early in the deal process and not wait until an acquisition agreement is at hand. PWC partners Donna Coallier and Jonathan Isler say that the ramifications of the reclassification are so complex that both acquirers and lenders will need more time to work through the impact on such key issues as the borrower’s ability to service the debt. “When you change the rules like this, it may change how the buyer will be screened by its lenders,” Coallier says. “And because the screen level changes, the pricing of debt changes.” The changeover also could impact a company’s credit caliber as judged by the rating agencies. A recent FASB pronouncement affects preferred stock, convertible shares, and trust preferred securities, among others, and requires them to be classified as liabilities if they contain mandatory redemption provisions, i.e., they must be retired at a specified date and for a specific amount. The theory is that they represent a required future payment and therefore should be treated as liabilities. A PWC paper that centers on how a barrage of recent accounting rule revisions will impact dealmaking, and which Collier and Isler helped prepare, points out that expanded disclosure of financial guarantees and indemnifications “represents a radical shift in accounting guidance.” “There is the possibility that many of the guarantees that the target provides will have to be recognized at fair value on either the target’s or the buyer’s financial statements, and this could affect recorded earnings,” the firm’s Deal Flash publication stated. The guarantees and indemnifications involve a broad range of transactions that a company undertakes with the potential of triggering future payments. They could, for example, involve guarantees proffered in the normal course of business, such as refunds to protect prices quoted a customer or to compensate a customer if product quality is less than promised or to accept returns if the product doesn’t sell. In the m&a arena, they could involve guarantees and indemnities provided to the buyer of a divested division. The comment underscored that the new rules swelling liabilities can fall on either or both sides of the deal when it comes to securing financing. A buyer showing an increased debt load could be considered a steeper credit risk by lenders. A seller with a less robust debt-to-equity ratio could be viewed as less valuable in terms of supporting a borrowing. Besides erecting possible new ground rules for getting the money in the first place, the new classifications could lead to more stringent terms for loans that are granted, Isler says. “Financial statement covenants, net worth covenants, and debt-to-equity ratio covenants would need to be reassessed given the potential change in the structure of the company’s balance sheet,” Isler adds. “The covenants may need to be changed to reflect the changes in accounting.” In recommending a priority for attending to financing during the deal process, Isler notes that dealmakers must accept two important realizations. One is that each financier has its own system for reevaluating credit risk. Second, the lenders are still working their way through the ramifications of the restructured balance sheets and will need time to adjust their screens to the changes. “The lenders and the rating agencies just don’t have the full insight into the evaluation process as yet,” says Isler. It is also essential for buying-company executives to work with accountants at the earliest point to understand how their financial picture will be affected by the new classifications. “The balance sheet may be different than originally expected,” Isler states. “They should also be aware that in the case of an instrument like preferred stock, any dividends associated with that are actually recorded as interest expense.” Coallier believes that the biggest marketplace upset will hit right after the new rules start to bite but that the reaction will cool as lenders and borrowers adjust. “I personally think it will be a learning experience,” she says. “You will see some reaction and some tightening early. But as people get more comfortable with the new rules and the new model that comes into play and it has been in place for a while, the uncertainty will go away and people will know what to do.” Isler points out that the new rules largely cover traditional types of securities that bridge the debt/equity line because of their features. More novel hybrids, such as the income deposit securities that combine debt and equity strips in the same instrument and pays both dividends and interest in tandem, have been left for another day. The reclassification-based increase in liabilities is one of the less publicized challenges forcing dealmakers to become more nimble as a result of a plethora of accounting and regulatory changes – many rooted in the recent wave of corporate scandals. Other tips offered by Deal Flash: Acquisition accounting *Perform a more rigorous purchase price allocation that estimates the value of intangible assets to be acquired and asses the impact of their amortization on earnings. *Mitigate future goodwill impairment by allocating goodwill among the targets reporting units. Off-balance sheet issues *If the target has off-balance sheet entities or is involved in joint ventures or partnerships, start at the earliest time to deal with the complex issues of whether these entries will have to be consolidated. Employee compensation *Be careful in constructing equity-based compensation plans, which may be key to retaining target employees, so that accounting rules on expensing don’t change an accretive transaction to a dilutive one. Sarbanes-Oxley *Buyers should carefully consider the risks at the target in addition to traditional financial and operational due diligence. Among the big proposed changes in deal treatment under review by the FASB are: *Expensing deal costs; *Fair value accounting for contingent payments, including deal earn-outs; *Capitalizing acquired in-process research and development; and *Basing the price of an equity transaction on the deal closing date rather than the announcement date. n Copyright 2004 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com