In December 2007, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards 141 (Revised) to implement a number of major modifications and additional refinements in how to account for business combinations. Among them is a new treatment of a relatively rare transaction, the "bargain purchase" of a controlled entity.
FASB's earnest (and overdue, we think) embrace of fair-value measurement principles dramatically changes how combinations will be accounted for going forward. Nowhere are the implications of this shift more evident than for these bargain situations.
TURNING A CORNER?
In effect, the board has turned a corner by putting teeth into its oft-repeated verbal commitment to improve financial reporting by using the Conceptual Framework. This gain provision in SFAS 141R was not about theory for theory's sake, but about putting more useful information in financial statements.
To use another figure of speech, the change is another nail in the coffin for matching, and a major boost for the asset/liability approach to measuring income.
Suppose that Company A acquires Company X by paying $400 million dollars in cash and assuming debt with a fair value of $230 million, thus producing a total purchase price of $630 million. In return, because of management's negotiating skills, Company A acquires assets with a fair value of $710 million, thus creating a bargain purchase price.
Under matching, accountants focus on cost because it is the amount sacrificed to acquire the assets. In this case, Company A would record Company X's assets at the combined total cost of only $630 million, even though their value is reliably known to be $80 million greater. To accomplish this result, the journal entry for the acquisition would knock back the debits to selected asset accounts to make their total equal to the $630 million cost.
The reported amounts for the trimmed assets knowingly misrepresent their economic power, thereby diminishing the usefulness of the balance sheet, as well as that of current and future income statements. Further, management is not allowed to reveal in the statements the $80 million coup that it pulled off in its negotiations. All in all, matching produces poor information.
Back in the early 1980s, FASB made a key decision to put assets and liabilities in the prime position among the financial statement elements. Specifically, the board defined these elements first and placed them in precedence to revenues and expenses, which it defined as changes in assets and liabilities.
The consequence of applying this theory to the Company X acquisition is that the buyer would record the assets at $710 million, which is their reliably known market value, not their cost. The sum of these debits is larger than the $630 million of credits, as before. In contrast to matching, the asset-liability theory leaves the debits intact and balances the entry with a gain on purchase of $80 million. This practice is now required by SFAS 141R.
This difference has three impacts. First, the balance sheet presents the assets at a number that reflects their cash-flow potential of $710 million, thus enabling more useful predictions of future cash flows. Second, the income statement provides a direct measure of management's success in negotiating a favorable price. Third, future income statements will not be biased, because the asset values are not artificially depressed.
The outcome is that all the financial statements contain useful and up-to-date information. Users' interests (and the broader public's interest) are served ahead of auditors' worries about the defensibility of the numbers. This result is surely better for everyone.
IS THERE A PRECEDENT?
Some may think this acquisition gain is unprecedented in GAAP. As a matter of fact, it is not. According to longstanding tradition, finally codified in SFAS 116, donated assets are not recorded at their cost, but are brought onto the books at their estimated fair values. The offsetting credit is to donations revenue (or donated capital, if the donor is a government entity), thus reflecting the fact that the donee is better off by the amount of the gift in the year it's received.
This is obviously value-based accounting. Why didn't practitioners and FASB require donations to be recorded at their zero cost? Because this extreme case makes it so evident that cost doesn't usefully capture the asset's potential contribution to the company's future cash flows.
This relatively obscure use of market value at acquisition stood alone until SFAS 141R was issued. This new standard means the literature now clearly states that it's useful to record and report acquired assets at their fair value as of the acquisition date, instead of the purchase price.
This new practice has at least three implications for practice in other areas, all of which could lead to improved reporting. We consider them to be small, medium and large.
* A small implication. If it's useful to record a gain on the purchase of a business, why wouldn't it be useful to do the same for asset purchases in other situations? Although these transactions are specifically excluded from SFAS 141R, the same bargain purchase approach could just as easily be applied to all asset purchases.
If management were to pay a price less than prevailing market value, a gain would be recorded. And if management were to pay more than market, it would acknowledge that its hasty shopping produced a loss. Of course, the same things could happen with liabilities.
* A medium implication. Next, suppose that the practice of recording gains and losses on purchases were to be extended to acquired goodwill, such that it would be recorded at its estimated fair value, instead of merely being plugged in as the debit needed to balance the acquisition entry.
Undoubtedly, this estimate requires careful analysis of the underlying economic circumstances that create what is lumped together in goodwill (e.g., superior locations, management, etc.). For those who would claim that this analysis creates extra effort and expense for the acquirer, our response is that management should already have prepared these estimates in performing their pre-transaction due diligence leading up to setting the final price.
Under the traditional GAAP plugging method, the recorded debit to goodwill surely covers up losses from paying too much. It would help statement users to have goodwill reported at its estimated fair value, instead of just using it to make the debits equal the credits.
If managers know that they are subject to reporting losses on purchases, instead of just throwing the excess cost into goodwill, we think they'll be inclined to conduct more careful negotiations. If they understand that sweetening an offer would drive their reported earnings down immediately, perhaps they would be more cautious in deciding what they lay on the table.
* A large implication. The third implication has been staring accountants in the face for years, and SFAS 141R makes it hard to pretend it doesn't exist. In particular, if information about assets' fair value at the time of purchase is more useful than cost, then it must also be true that their fair value at all subsequent dates is more useful than their cost or book value.
In other words, the bargain purchase provision implies that users and everyone else would be helped if the balance sheet and income statement were to be based on fair values at every date and for every asset and liability, not just those acquired by buying another firm. The same common sense that supports reporting fair value at the purchase date supports marking assets and liabilities to their fair value at every statement date.
It's one thing to have an isolated breakthrough, but another, entirely different, thing to have an upheaval. Although we're very pleased, and feeling more than a little vindicated by this provision of SFAS 141R, we know it won't be easy to force everyone to abandon costs and book values cold turkey.
That's why we're enamored by SFAS 157, which spells out how to measure fair value, and SFAS 159, which gives progressive managers the freedom to use fair value for their financial assets and liabilities without making them do it. These may be baby steps, but they are far better than no steps at all.
As the fair-value reporting revolution continues its ponderous but deliberate forward march, we're convinced that it's an exciting time to be alive and to be an accountant.
Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authors' views are not necessarily those of their institutions. Reach them at firstname.lastname@example.org.
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