SFAS 141(R) Key Issues for In-house Counsel. Thomas White Stephanie Evans October 2008

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1 SFAS 141(R) Key Issues for In-house Counsel Thomas White Stephanie Evans October 2008

2 Overview Background of new accounting standard for business combinations Focus on aspects of standard most likely to raise issues for in-house counsel Comparison of old and new standards and identification of areas of potential impact 2

3 Background Since 2001, accounting for business combinations governed by Statement of Financial Accounting Standards 141 Abolished pooling of interests method Prescribed purchase method as sole method No change to purchase method as such Determine cost paid for acquired entity Allocate cost to assets acquired and liabilities assumed Difference between cost paid and identifiable assets and liabilities recorded as goodwill 3

4 SFAS 141(R) Adopted by Financial Accounting Standards Board in December 2007 Replaces SFAS 141 Developed jointly with International Accounting Standards Board and parallels International Financial Reporting Standard 3, with some exceptions Effective for acquisitions closed in fiscal years beginning after December 15, 2008 (i.e., 2009 for most companies) 4

5 Overview of SFAS 141(R) Retains fundamental requirement that purchase accounting (now called acquisition accounting) be used for business combinations However, underlying philosophy is changed: Former SFAS 141 reflected a cost-allocation process, i.e., determine cost of acquisition and allocate it to assets acquired and liabilities assumed New SFAS 141(R) uses fair value approach which focuses on values of assets and liabilities acquired as of acquisition date (usually closing) 5

6 Scope All transactions or events in which an entity obtains control of one of more businesses Broader definition of business so more acquisitions covered 6

7 Deal expenses Old: Deal expenses (advisory, legal, accounting, diligence, valuation, etc.) capitalized as part of purchase price and allocated to assets and liabilities New: Deal expenses (including internal costs) recognized separately and charged to P&L as of acquisition date Impact: Increased scrutiny of deal expenses due to P&L impact 7

8 Earnouts Old: Payments under an earnout recognized only when they became payable, treated as an adjustment to the accounting for the business combination New: Fair value of earnout must be recognized as of the acquisition date, changes in value of earnout over time can result in P&L charges (depending on form of consideration) Impact: Valuation issues and P&L impact likely to make earnouts less attractive 8

9 Step transactions A step transaction is one in which control is acquired by more than one transaction over time Old: Each purchase in the step treated as a separate purchase New: Transaction resulting in control triggers revaluation of all assets, liabilities and noncontrolling interest, record to P&L if difference from prior carrying value Impact: P&L impact could affect structuring of step transactions 9

10 Stock consideration Old: Value of stock consideration measured at date of agreement New: Value of stock consideration measured as of acquisition date (closing) Impact: Look carefully at structure of stock deals due to potential uncertainty regarding value of purchase price paid and goodwill, possible future impairment charges 10

11 Employee equity awards Old: If vested options exchanged for unvested options, fair value included in purchase price consideration New: If vested options exchanged for unvested options, portion attributable to post-combination services are accounted for as compensation Impact: Potential P&L impact of treated portion of exchanged options as compensation expense 11

12 Contingencies Old: Contingencies (e.g., litigation) not recognized as of closing unless standards of FAS 5 met (i.e., liability was probable and reasonably estimable) New: Contractual contingencies (e.g., warranty claims) recognized at fair value at closing (regardless of probability) and marked to market quarterly 12

13 Contingencies (cont.) New: Non-contractual contingencies (e.g., litigation) measured at fair value at closing if it is more likely that not that there is liability; special rules for remeasuring liability when there is new information about possible outcome; changes recognized in P&L Impact: Difficulties of assessing probability of loss from contingency and valuation; prejudicial impact of disclosures; increased diligence 13

14 Measurement period Old: One-year period to complete allocations to assets and liabilities New: Up to one-year period to complete accounting for the business combination; however, must recognize adjustments and make disclosure requirements for impact of changes from provisional valuations Impact: Due diligence may be required at earlier stages to mitigate impact of post-closing adjustments 14

15 Disclosure Old: Enumerated general disclosures about the acquisition and certain specified financial information New: General requirement to disclose information to enable users to evaluate nature and financial effect of combination (including post-period acquisitions), plus detailed disclosure rules Impact: Disclosure process will have to include procedures to ensure full and timely development of required information 15

16 Key implications Valuation issues fair value accounting (particularly litigation) Potential increased earnings volatility Expanded disclosures Covenant impact 16