IFRS – Hidden dangers of acquisition

Link: Detailed info on acquisitions

The reason being that international financial reporting standards have irrevocably changed the landscape for company acquisitions.

‘It will make people think very hard. People will have to consider much more carefully what they are buying,’ says Nick Rea, director of valuation and strategy at PricewaterhouseCoopers Corporate Finance.

The key standard for those considering a buying spree is IFRS3, though the good news is that nobody believes the new standard will put a break on deals.

That will come as good news for those who have ruled out organic growth as a route to major expansion in the near future. But deal makers need to be aware that things will not be the same. Accounts, in many cases, will not look as bouyant as they once might have done.

Indeed results may be harder to forecast and the onus will be on increased transparency. In short IFRS3 means there will be much more work attached to knowing the benefits a deal will bring.

What you should be aware of already is that under IFRS3 mergers are no longer possible. When this was raised as a proposal the issue caused much debate among technical experts.

The standard setters decided, however, that genuine mergers were so rare that a change was in order. Some still believe in the old split, but the deed has been done, mergers are now history and acquisitions are the only accounting option on the table.

One thing that all the parties involved in an acquisition have to be very clear about is who is identified as the ‘acquirer’. Oddly, this is sometimes not as easy as it sounds, so caution is needed. Factors such as relative size and voting rights will have to be taken into account.

If you’re not entirely up to date with the details of IFRS3 the next issue may come as a bit of shock. Buyers are no longer permitted to smoothly amortise goodwill over time. This, according many who watched the standard’s development closely, came about because of the realisation that some very ‘mechanical’ figures were appearing in accounts.

As amortisation goes it is replaced with a new regime of impairment testing on an annual basis. And there’s a bit of a sting in the tale. Firstly, extra work will be needed, under the standard’s detailed demands for transparency, to test all the intangible assets that may not have been recognised in the past. Many assets that may have remained in the shadows will have to come out into the open to be recognised.

Secondly, impairment testing also takes place at the level of these individual assets. This means that where once under-performing goodwill may well have been concealed as part of a much larger unit for measurement, it no longer will. Everything will have to be revealed in the cold light of day.

There’s one more possible blow in this area, identifying and testing all those intangible assets – trademarks, brands, customer lists, royalty agreements, franchise arrangements and usage rights – means a greater recognition of their financial performance.

If they’re not doing well, and many of them perhaps won’t be, it will become obvious in the first set of accounts after the deal is done.

The immediate boost to revenues that an acquisition used to bring becomes a little less likely under IFRS3 as the financial impact of all those newly recognised intangibles is felt on the balance sheet.

But that doen’t mean that the deal was not a good one. Research will be crucial. Richard Winter, a PwC partner, says acquirers will have to understand their target purchases ‘in a way that didn’t happen before’.

Understanding will be necessary to the next big task that the new standard will give executives – explaining their acquisition decisions to stakeholders, investors and analysts. Because of the likely volatility IFRS3 will cause in accounts immediately after a deal, company bosses will need to take much greater care when explaining the benefits of a deal to analysts and investors. Glancing at cashflow statements will no longer be enough.

‘People now have to get below cashflow as a way of understanding the business and intangible assets that are driving the value of the business,’ says Winter.

Ian Smart, managing partner of Grant Thornton Corporate Finance, calls it a ‘communication challenge’ while Ken Wild at Deloitte insists that ‘you need everyone to be speaking the same language’.

There’s been much discussion about the likely overall effects of IFRS on company accounts. Some companies will clearly see their asset values increase. Other commentators are concerned that there may be too little communication going on between corporates and analysts. One thing is for sure, if you are in the market to buy, IFRS3 is going to make a difference. Start talking to the analysts and your investors now.

Avoid nasty surprises
While much of the talk has been about how standards such as IAS39 and IFRS3 will affect a company’s accounts, the new suite of accounting rules contains a few more surprises that may catch some businesses out, writes Paul Grant.

Take IAS17, the standard on leasing, for instance. Those used to working with UK GAAP when it comes to property leases may find a few shocks await them, if they are not prepared for it. Despite tighter tests on operating leases, which is likely to cost companies a good deal of time and money, there is still thought to be a great deal of uncertainty over how to interpret what type of a lease many will be classified as.

Observers believe that many commercial leases will eventually have to be reclassified as finance leases, which will significantly affect a company’s initial profit and loss account.

But even those that remain as operating leases are going to see significant changes in how the leases are depreciated.

In essence this means taking a much larger hit in terms of depreciation at the start of the lease rather than being able to spread it out more evenly across the life of the lease.

For some, this will mean the deals that are struck will make losses for the first few years of existence, a situation that could be very difficult to justify economically.

Then you have IFRS2, which deals with the treatment of share options. Companies that rely heavily on share incentives to reward employees, a scheme particularly prevalent in the technology sector, are going to have to make big changes in their financial records.

As of now, options will have to be treated in the same way as other more direct payments to employees, such as salary.

This will mean a significant increase in staffing costs in the profit and loss account and may cause some companies to rethink their incentive schemes. Many of the other new and improved standards could have more of a bite than at first anticipated, with some industries likely to be more affected by certain standards than others.

Companies need to ensure that they fully understand the impact of the switch themselves before they communicate this to others.

Link: PwC’s dedicated IFRS Resource Centre

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