Editors Note: Amalie L. Tuffin is a member of the Research Triangle Park law firm of Daniels Daniels & Verdonik, P.A. TechLaw is a regular feature in LTW.
_______________________________________________________________________________________Corporate deal making has been on an upswing in the past year, with activity higher in 2005 than in any year since 2000. Accounting changes that have been proposed by the Financial Accounting Standards Board (FASB) may, once effective, slow down the recent rapid pace of deal-making.

In June, the FASB, which is the organization that sets U.S. accounting standards, issued a set of proposed changes to FASB Statement 141, Business Combinations. A number of the changes are expected to have a significant negative effect on reported earnings. In addition, some of the changes are likely to affect deal structure. The changed standards are intended to make the true costs of deals much more apparent to investors.

What are the Major Changes?

A major focus of the new rules is fair value accounting. Under fair value accounting principles, a business combination is treated as an exchange of equal values at the time of the transaction, with that value measured based on the value of the consideration transferred, or the value of the business (net assets) acquired, depending on which side of the transaction is more reliably measurable. Fair value accounting also mandates that the acquirer report acquired assets and liabilities at their estimated current values, instead of their historical cost as is done now.

This means that as these estimates change, companies will be required to report the changing estimates as profits and losses on their financial statements. This will lead to increased earnings volatility as estimates change over time. A particular casualty of this type of accounting may be earn-out payments, where the selling party is eligible to receive bonus payments based on the performance of the acquired party over time.

Under fair value accounting, the acquirer will have to estimate this payment amount at the time of the acquisition and make adjustments to its estimates as time goes on, which would then affect its profits and losses. This could make acquirers less willing to structure transactions with performance incentives and thus could lead to overall smaller deals.

Another significant change relates to accounting related to research and development. Under the proposed changes, if the acquired company has significant research and development that is close to generating saleable products, the acquirer would be required to subtract the value of the R&D from its earnings as these products generate revenue. This has the potential of depressing earnings for years. Under current accounting standards, the acquirer is able to write off all of the R&D value at the time the acquisition closes, taking one hit and then reporting higher profits going forward. This issue could have a major impact on the entire technology industry, and especially on the biotech market.

A third significant change relates to accounting for the costs of restructuring the acquired company, e.g., employee severance payments, employee relocations and office closings. Under present rules, these costs are estimated up front and included in the costs of the acquisition. Under the proposed standards, restructuring costs will be expensed as they are incurred and will thus lower earnings for as long as it takes the acquirer to complete the restructuring. In major transactions, this could take a significant amount of time.

A similar issue applies to investment banking fees, legal fees, due diligence expenses, and other deal-related costs. Presently, acquirers are able to include these costs as part of the overall cost of the company being acquired, rather than breaking them out separately. Under the new standards, investment banking fees will be a separate expense that will negatively impact earnings for the period in which the fees are paid.

Finally, the proposed standards would require companies to book purchases at the time of closing rather than the time the pending acquisition is announced. This creates significant potential uncertainty, particularly in stock deals where the value of the stock could change substantially between the time of announcement and the time of closing. Investment bankers are predicting that more deals will be structured with “collars” to rein in how much the purchase price can change between announcement and closing, in order to reduce uncertainty.

Major Milestone in Move to Consistent Worldwide Standards

The proposed new standards do represent an important event in the ongoing push to make accounting standards consistent around the world. For the first time, the FASB and the International Accounting Standards Board (IASB) simultaneously proposed a new set of accounting standards. Assuming both sets are adopted, accounting for business combinations would become substantially the same in the U.S and Europe, as well as other parts of the world where IASB standards are used. This will allow investors to much more readily compare the financial consequences of U.S. and international transactions.

Changes Are Expected To Be Effective in Late 2006

The revised standards were issued by the FASB as an exposure draft, which is the way the FASB seeks public comment on its proposals. The public comment period ends on October 28, 2005, and the FASB is expected to issue final standards in the middle of 2006. If this timetable is kept, the standards would be effective for fiscal years beginning after December 15, 2006 and so would impact all mergers and acquisitions from 2007 forward. This may act as an impetus for companies to get deals announced and closed in 2006. For example, some commentators expect a rush to complete biotech transactions before the new rules become effective. In any event, dealmakers need to be aware of the coming changes, make sure that they understand the consequences of the proposed standards, and watch to see when they become effective.

Daniels Daniels & Verdonik, P.A. has been serving the legal needs of entrepreneurial and high technology clients for more than 20 years. Amalie L. Tuffin concentrates her practice in the representation of entrepreneurial and technology-based businesses, focusing on corporate, taxation and securities matters. Questions or comments can be sent to atuffin@d2vlaw.com