Should the accounting treatment of business combinations have an effect on future merger and acquisition activity?

Johannesburg, 26 January 2006: The accounting treatment of intangible assets in terms of International Financial Reporting Standard 3 (IFRS 3) and International Accounting Standard 38 (IAS 38) may put a dampener on future merger and acquisition activity, cautions Dave Thayser, Ernst & Young corporate finance and advisory services partner. “But should it?” he asks.

IFRS 3 applies to all business combinations agreed to on or after 31 March 2004. It does away with the highly controversial system of "merger accounting" that has been a feature of some significant UK and US merger and takeover situations. In terms of the new standard, the difference between the acquisition price and the fair value of assets acquired and liabilities assumed must be carefully analysed and first allocated to identifiable intangible assets, with the residual component being goodwill which is no longer amortised. Intangible assets might include brands, copyright, customer lists, licences, franchises and customer relationships. IAS 38 prescribes the accounting treatment for all intangible assets that are not dealt with by other standards.

Thayser, who is editor of the annual benchmark publication Ernst & Young Mergers & Acquisitions: A Review of Activity, explains that the impact of IFRS 3 and IAS 38 in combination may have repercussions on future merger and acquisition activity. Management may be wary of the impact of the new standards on the acquiring company’s income statement.

All acquisition deals, Thayser notes, must now be accounted for using the ‘purchase method’, which views the business combination from the perspective of the acquirer. IFRS 3 further requires companies to recognise intangible assets if it is probable that future economic benefits attributable to the asset will flow to the company, and that its cost at acquisition can be reliably measured.

“Internally generated goodwill, brands, mastheads, publishing titles and similar items are now recognised as assets acquired. The process of allocating value to intangible assets can be extremely complex,” he says.

Thayser points out that companies must also settle on whether such an asset has an indefinite life, which means that there is no foreseeable limit to the period of time over which the asset is expected to generate net cash flows for the company, or has a finite life, which means it has a limited period of benefit. (It is worth noting that an indefinite life does not mean an infinite life.)

In terms of IAS 38, if the intangible asset has a finite life, the depreciable amount of the asset is amortised on a systematic basis over its useful life. If it has an indefinite life, it must be tested for impairment at least annually, as is the case with goodwill as well as considering whether the intangible still has an indefinite life. “Observers believe that this system will be more complex than the existing one because of the difficulty of valuing intangible assets. Moreover, having to carry out regular impairment reviews could be an additional cause of volatility in the income statement,” says Thayser.

“So should management of the acquiring company pay much attention to the accounting implications of the deal?” asks Thayser. “After all, the decision to proceed with an acquisition is usually made on the basis of cash flows to be generated, rather than accounting earnings. If the deal makes sense from a cash flow perspective, then surely it should be proceeded with?”

This assumes, of course, that the analyst community is of a like mind. Research on the introduction of previous accounting standards impacting accounting earnings but not cash flows showed that share prices were unaffected. More recently, Lewis Stores’ share price showed no ill effects after the company announced results that were 10.8% down on what they might have been had IFRS not been introduced. If this holds true for other companies, it would appear that analysts have not changed their outlook, but there is still an onus on acquiring management to clarify the accounting implications of a transaction to the market.

One positive aspect of IFRS 3 is that it brings accounting for an acquisition more closely into line with economic reality. In the 1990s in South Africa it was very common for goodwill on acquisition to be written off against the acquiring company’s reserves. The effect was to understate the acquirer’s investment and, by implication, to overstate the return on that investment. IFRS 3 makes it more difficult for management to hide behind this sort of artifice.

Thayser concludes that the golden rule is still to do deals that make sense in terms of the company’s own investment criteria, but to make the market aware as soon as possible of any adverse accounting consequences. “It would be a pity”, he says, “to see good deals being turned down for the wrong reasons. The new accounting standards represent one more planning hurdle on the road to the successful conclusion of a deal, but it is not an insurmountable one.”

Ends

Click here for more information about Ernst & Young South Africa

Issued by:
Fathima Kolia
Ernst & Young
Tel: +27-11-772-3151
Cell: +27-76-662 -2842
Fathima Kolia

On behalf of:
Dave Thayser
Ernst & Young
Tel: +27-11-772-3000
Dave Thayser