Reform for M&A accounting

Accounting rules around merger and acquisition (M&A) activity are ‘poorly applied’ by businesses, resulting in costly and difficult accounting for such deals and confusion for investors, according to the Financial Reporting Council (FRC). The findings come as M&A activity is expected to increase in 2010 after a barren two years.

The FRC recently undertook a study of accounting for acquisitions looking at whether there is a need for improvement. Ian Wright, its director of corporate reporting, believes there is. “A step change is needed in the quality of the information about M&A transactions given in annual reports and accounts,” he says.

Traditionally, companies give an account of their most significant M&A activity in the front of their annual reports to help investors and other annual report users to understand the impact of such transactions.

Impact of acquisitions
However, under the Companies Act 2006, directors of publicly-quoted companies now have to report explicitly on the main factors likely to affect the company’s future development, such as the impact of major acquisitions.

The FRC found that almost all the companies “explained well the rationale for their material acquisitions during the period and set out” in their business reviews, detailing potential future benefits that they expected to arise from M &A transactions, including revenue synergies expected from cross-selling products, access to forward order books and improved distribution networks, strengthened market positions including the acquisition of brand names, achieving critical mass in particular locations and cost savings from elimination of duplication.

International financial reporting standards (IFRS) prohibit the recording of most internally developed intangible resources. However, IFRS 3 Business Combinations, which was published in 2004 and came into effect for listed companies in 2005, contains specific accounting requirements to be applied to all business combinations.

However, it now seems that many UK companies are still unfamiliar with the standard’s requirements.

The most significant difference between IFRS 3 2004 and previous UK financial reporting requirements is that all business combinations, whether mergers or acquisitions, must be accounted for as acquisitions. Changes to the definition of an intangible asset also mean that more of them – such as brands, trademarks, customer and supplier contracts, licences and intellectual property – are likely to have to be recorded separately from goodwill under IFRS.

During 2008 and early 2009, the FRC conducted a series of interviews with investors and company finance teams to understand the factors that make the preparation and use of corporate reports complex. One element of the feedback received was that companies find M&A accounting costly and difficult to perform. Moreover, investors said they did not find the resulting information useful.

In the sample of 20 acquisitions carried out during 2008 that the FRC reviewed (before the current version of IFRS 3 Business Combinations came into effect, as noted by accounting standards chief Sir David Tweedie in an early January 2010 letter to the Financial Times), the aggregate value of intangible assets and goodwill recorded ranged from 30% to 180% of the purchase price for the transactions selected.

David Tweedie’s letter to the Financial Times, in response to an article the newspaper ran about the FRC report, said: “The revised standard addresses many of the application challenges referred to by the FRC study. Indeed, page 11 of the FRC report acknowledges this, stating that the revised standard ‘should lead to a step-change in the recording of intangible assets in future audited accounts’.”

Aggregation of intangible assets
The FRC says that companies seem to find it difficult to establish meaningful groups of intangible assets to aggregate as classes in the audited accounts, sometimes simply recognising a category of intangible assets by labelling them as ‘other’ – while it found three companies had combined a range of intangibles in this category, from combined purchased and acquired patents, licences and trademarks, software rights and licences, and order backlog.

“This level of aggregation does not satisfy the requirement that any grouping of reported assets should be ‘of a similar nature and use in an entity’s operations’,” the FRC says. “Greater care is needed to ensure compliance with the disclosure requirements in a meaningful manner.”

The significance of the aggregate values of intangible assets and goodwill found should lead the companies – and their external auditors – to take particular care to ensure that the business review is comprehensive and that the IFRS reporting requirements for acquisitions were met in full.

Indeed, the FRC found that, overall, the results of its study were disappointing in terms of the understanding and execution of these standards. In some cases, says the regulator, it was difficult to identify the required accounts disclosures, while in other cases the information provided in the business review and the audited accounts was either insufficient or inconsistent.