The M&A game will not be the same after FRS 7.
'Accounting for acquisitions has long been seen as fertile ground for manipulating figures.' So said Sir David Tweedie, chairman of the Accounting Standards Board, at the introduction of new accounting standard, FRS 7. David Peerless, also of the ASB, was slightly less damning about the previous standard: 'The old method unfairly penalised businesses growing organically rather than by acquisitions.' FRS 7 will surely curb abuses associated with accounting for acquisitions, but is it too draconian?
Up to now, an acquirer has been able to provide - at the time of acquisition - against future losses that it expected to be incurred by a newly acquired company. Reasonably enough, it could be argued. A business can't be turned around overnight, so any such loss can be viewed as a liability of the acquired company. Reorganisation costs, such as redundancies, could also be provided against, which commonly had the effect of increasing the element of goodwill in a transaction. Goodwill being usually written-off against reserves, these costs and losses never needed to go through the acquirer's profit and loss account. Thus, given adequate provisions, a newly acquired company - even though trading unprofitably and spending heavily on reorganisation - could nevertheless make a healthy contribution to the acquirer's earnings per share.
Never again, it seems. Under FRS 7, fair values must be attributed to the assets and liabilities of the acquired company. These values 'should not reflect either the acquirer's intention or events subsequent to the acquisition'. In other words, any losses expected to be made by an acquired company - and all reorganisation costs - must be charged to the acquirer's profit and loss account.
The new standard has received support from many quarters. Paul Richards, a council member of the Institute of Investment Management & Research believes that it closes a loophole. 'Some companies abused the old system, over-provisioning at the time of an acquisition to bolster subsequent years' accounts'. With FRS 7, it will be up to anyone who is interested to look into the accounts and discover what's going on. Where reorganisation costs are disclosed, analysts will be able to make their own interpretations. John Kellas of KPMG Peat Marwick believes that: 'FRS 7 should lead to greater clarity and greater consistency - which must be a good thing. It will also encourage companies to explain the effects and longer term strategic consequences of their deals.' Such enthusiasm is far from universal. Nigel Stapleton, finance director of Reed-Elsevier and chairman of the 100 Group of UK Finance Directors, feels that those who drafted the standard have gone too far. 'There needs to be a distinction between revenue items and capital items. While provisioning against future losses should not be permissible, restructuring costs are a capital item and should be treated as such. It's like spending money on a dilapidated house which has been bought cheaply because of its poor condition.' Some chairmen and finance directors must be hoping fervently that analysts prove themselves equal to the task of picking out the underlying performance of their businesses. In the case of smaller quoted companies, with few City followers focusing on underlying earnings per share, FRS 7 may prove decidedly unhelpful. As the chief executive of an FT-SE stock observes: 'Buying a loss-making business which may have strong strategic rationale for us could easily knock our earning per share completely off target. While we can explain what's happening to our major institutional shareholders, our reported eps will unsettle many of our less sophisticated investors. We like to buy underperformers, but FRS 7 may well hamstring us.' This could be to the advantage of potential acquirers who don't have to worry about reporting earnings. Andrew Joy, at venture capitalists CINVen, reckons that: 'Where a venture capital company is competing with a smaller quoted company to acquire an underperforming business, the venture capitalist will probably have an edge.' FRS 7 will certainly lead to greater disclosure in accounts, as acquirers strive to explain why their earning per share have been temporarily and artificially depressed by their latest deals. It may also focus some people's minds on whether the earnings per share criterion gets too much attention. Meanwhile, those who want to sell (or buy) an underperforming business would be well advised to move quickly. FRS 7 is being applied to all accounting periods beginning after 23 December 1994.