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Insights for the investment community from assurance professionals

Mergers and acquisitions

What are the key auditor concerns for M&A disclosures this year end?
IFRS 3 (revised), Business combinations, was effective for the first time for 2010 year-ends. The standard wont affect the underlying economics of a deal, but it might make it harder for investors to understand the complete picture of any acquisition. PwCs Dave Walters looks at some of the potential challenges that investors may encounter as the new standard takes effect.

The cost of the deal

Transaction costs including fees paid to professionals (such as to fees paid to investment banks or to lawyers for legal agreements) will now be expensed rather than capitalised. However, IFRS 3 (revised) does require entities to disclose the amount of transaction costs that have been incurred. This may have an impact on the calculations investors need to make when evaluating performance. Some investors may argue that these are cash costs and so it is right that they should be treated as any other expense; others might believe they represent part of the cost of an acquisition and so need to be included in any assessment of deal value.

Dave Walters

Muddy waters
Investors need to be aware of some of the effects on the income statement that IFRS 3 (revised) will bring. These range from a change in the way in which some expenses are treated, to some perhaps counter-intuitive impacts as changes in fair value estimates flow through the income statement. We have seen that, in some cases, concerns about some aspects of the accounting treatment of transactions will change the way in which management structures deals with some commensurate shift in the way in which risk is shared between buyer and seller.

Increasing the size of stake

Investors should be alert to potentially confusing income statement signals where companies increase their holdings.

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Example Entity A owns a stake in entity B; entity A then increases its stake in B so it now controls the entity. Under the revised standard, the increase in holding is treated as (a) a sale of the original stake at fair value, and (b) a purchase of the new combined stake in the entity at fair value. This will result in the gain or loss on the sale of the original holding being recognised in the income statement.

paying C10m has risen to 80%. This would result in additional costs of C2m going through the income statement. It is therefore possible that strong performance could lead to increased contingent costs turning a profit to a loss. As a result, management might find itself in the curious position of having to explain that the reason for an apparently bad year is because the acquired business performed better than expected.

Contingent consideration
Contingent consideration has long been used as a way for the acquirer to share the risk with the seller. IFRS 3 (revised) may make the use of contingent arrangements less desirable for management. Example A buyer agrees to pay C20m to acquire a business, with a further C10m contingent upon profit doubling in three years. The buyer has to estimate the fair value of that potential C10m. It might conclude that there is a 60% chance of paying out the C10m, and a 40% chance of paying nothing. The fair value is therefore C6m. This would be included in the consideration on acquisition. Under IFRS 3 (revised), management has to re-measure that contingent consideration at each reporting period, with any change taken through the income statement, rather than goodwill. In the example above, if at the end of year 1 the acquired business is doing better than expected, management might estimate that the chance of

Earn-outs
It is common particularly in the acquisition of professional services firms for the acquiring entity to make a portion of the total consideration contingent upon some of the key employees continuing to work for the combined entity for a predefined period. If these key employees resign early, the seller forfeits some part of the total consideration. Under IFRS 3 (revised), any portion of the total consideration that is automatically forfeited if employees leave isnt treated as part of the consideration for the acquisition; it is treated as an employee cost, which is taken as an expense through the income statement over the required retention period. We think it is likely that deals involving contingent consideration and earn-outs will become less common as a result of these changes.

Pre-existing relationships
IFRS 3 (revised) also has guidance on acquisitions where the acquirer has a pre-existing relationship with the entity that it is buying.
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Example Two years ago, an entity entered into a five-year distribution agreement with its distributor, fixing the margin the distributor gets. Now the entity has become a more significant player in the market and has more negotiating power. So, if the entity had negotiated the agreement today, it could demand that the distributor accept a smaller margin. This contract is therefore considered unfavourable. When management acquires an entity with whom it had a pre-existing relationship, it is considered to be (a) buying an entity and (b) settling a distribution agreement.

In the example above, the acquirer estimates that the distribution contract was C50m unfavourable and takes a C50m loss through the income statement at acquisition, despite the overall acquisition still making good commercial sense. In the past, acquisition accounting has been balance sheet focused (as one might expect); but the new business combinations standard can result in considerable income statement volatility, much of which is counterintuitive. This wont make directors jobs in explaining performance any easier, and investors should expect many more adjusted measures of earnings to work out.

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