Acquisitions

Far greater deal transparency and unpredictable results will arise from new the International Financial Reporting Standard 3 (IFRS 3) for Business Combinations, issued on 31 March 2004 by the IASB. This should be of interest as the new rules apply to all acquisitions in 2004, including deals (for UK institutions) that have already been completed. European institutions already applying IAS will need to comply from 1 April 2004.

The changes should transform the way companies plan and execute their acquisition strategies as there are major changes to the way transactions are recorded, evaluated and communicated. Understanding the implications of the new standards before making an acquisition, and specifically whether a deal will be earnings-enhancing or not will be critical as, in some cases, the acquisition may cause reduced earnings per share (EPS). The successful communication of the rationale for the deal, and the likely impact on earnings, will be vital for listed companies. This is clearly not just an issue for finance directors but for all senior management involved in acquisitions.

The major changes introduced by IFRS 3 are as follows:

• no more merger accounting - instead all business combinations are acquisitions
• more intangible assets will be identified and recognised on acquisition
• goodwill is not amortised but subject to an annual impairment test
• restructuring costs are charged to income
• contingent liabilities are recognised at fair value, and
• detailed disclosures about transactions and impairment testing are required.

Historically, in the majority of acquisitions, the excess purchase price over the fair value of the tangible fixed assets has all been allocated to goodwill rather than attributing value to acquired intangible assets. Under the new IFRS, when a deal is completed, the purchase price must first be allocated to all the acquired tangible and intangible assets before any excess is allocated to goodwill. The intangible assets such as brands, patents and even customer relationships, that were often part of 'goodwill', are now required to be identified separately, valued and carried on the balance sheet. This is part of the 'purchase price allocation' process and will lead to greater transparency over what companies have acquired and may throw up a few surprises on what the potential financial impact of the deal could be.

Expert valuation assistance may be needed to establish values for items such as acquired intangible assets and contingent liabilities. Key challenges in the accounting requirements include the identification of the acquirer - which is not always that clear. In addition, companies unfamiliar with these changes may need assistance to ensure that all relevant intangibles have been identified and valued appropriately. This may be challenging as the valuation of such assets is a complex task and there is limited guidance available to companies to perform the valuation effectively.

Under the IFRS, which closely follows US GAAP in this respect, goodwill and indefinite-lived intangible assets will no longer be amortised but reviewed for impairment at least annually. Any impairments will be taken to the profit and loss account which increases the risk of unwelcome surprises. As a result, poorly performing acquisitions will be highlighted sooner rather than later. In addition, the impairment tests themselves are not straightforward and present challenges (and opportunities) to allocate the acquired assets and liabilities to reduce the prospect of a future impairment for companies.

More rigorous evaluation of targets and structuring of deals will be required in order to withstand greater market scrutiny from now on. In addition, all acquisitions in 2004 will need to be recorded using the new rules and the acquisition process will need to become even more rigorous from planning to execution, with much greater emphasis on market communication. Companies will need to clarify to shareholders and analysts the impact of the new standards and, on future acquisitions, what they are buying and why. While mindful of the risks of disclosure of commercially sensitive information, institutions need to provide analysts and investors with a full understanding of the acquisition and its strategic rationale.

Nick Rea is director in the valuation & strategy practice at PricewaterhouseCoopers.