Mergers & acquisitions — a snapshot Change the way you think about tomorrow’s deals Stay ahead of the accounting and reporting standards for M&A1
June 9, 2014
What's inside Overview ................................. 2 Segment reporting ................. 2 Foreign currency matters ..... 2 Goodwill implications ........... 3 Disposal considerations — Parent’s accounting for CTA ................................. 4 Multi-GAAP requirements ..... 5 In summary ............................ 5
Cross-border acquisitions Post-acquisition considerations Months of hard work have paid off and the deal is closed. The buyer has performed its due diligence, navigated the SEC reporting requirements, and assessed the potential tax effects of the transaction. The rest should be easy, right? Not so fast! Generally, buyers underestimate the other aspects of a transaction that require attention post-acquisition and the amount of effort needed to navigate the accounting and financial reporting considerations. This edition of Mergers & acquisitions — a snapshot is the fourth and final edition in our series focused on navigating the waters of a cross-border acquisition. The first three editions have looked at various aspects along the deal continuum prior to closing as well as potential tax considerations. This edition focuses on some of the other post-acquisition accounting and reporting issues that need to be considered in relation to cross-border deals, including US and international reporting requirements, foreign currency matters, and impairment testing.
Accounting Standards Codification 805 is the US standard on business combinations, and Accounting Standards Codification 810 is the US standard on noncontrolling interests (collectively the "M&A Standards").
Overview It might not seem like it at first glance, but the accounting and reporting issues faced during the post-acquisition period can be as complex as those encountered in the preacquisition period in a cross-border deal. Segment reporting, foreign currency matters, goodwill implications, disposal considerations, and multi-GAAP requirements are just a few specific post-acquisition accounting and financial reporting issues that can be particularly challenging. Let’s take a look at each of these areas.
Segment reporting Accurate segment reporting hinges on the proper identification of operating segments. Generally, identification of operating segments begins by understanding how management views the business, including considering what information management regularly uses to allocate resources and assess performance. Understanding how a buyer anticipates integrating a newly acquired business is a focal point of this analysis and key in assessing how an acquisition impacts segment reporting. When integrating a cross-border acquisition, the buyer must consider many factors in determining what its segment reporting will be, including: i)
What risks and opportunities are inherent in running the newly expanded company? Did the buyer enter a new geographical market or sector or expand in an existing market or sector?
ii) How will the acquired business be integrated into the buyer’s existing operation? Does the buyer’s existing operation have the capacity needed to serve the newly acquired market or will the buyer need to maintain both operations? iii) How will the acquisition affect the information that management uses to assess performance and to make resource allocation decisions? Will management monitor the newly acquired business separately from the existing operation or integrate the reporting of the two operations? iv) What will be the impact on the buyer’s internal and external reporting? What information will management need and receive on a regular basis to monitor the expanded operations and make effective strategic decisions? And will two or more operating segments meet the accounting criteria for aggregation?
Ultimately, the decision on how to integrate an overseas acquisition into the information provided to management will be driven by business considerations. However, it is helpful to have a timely understanding of the financial reporting implications of such business considerations. The buyer will want to ensure that the proper processes and controls are in place to assess and document the identification of operating segments and whether they can be aggregated for reporting purposes, especially in light of the SEC’s continued focus in this area.
Foreign currency matters Cross-border buyers will need to deal with numerous accounting issues created by having transactions denominated in currencies that are different from the buyer’s reporting currency. The most common of these issues relate to the concepts of functional currency, foreign currency transactions, and foreign currency translation.
Determination of foreign entity and functional currency A foreign entity is an operation whose transactions are executed and reported in a functional currency that is different than the reporting currency of the buyer and is distinct and separable from other foreign entities. An entity’s functional currency is the currency in which the entity primarily generates and expends cash. In practice most foreign entities are also legal entities. However, it is possible for a foreign entity to comprise several legal entities. Less commonly, a single legal entity could comprise several foreign entities. For a foreign entity whose operations are relatively selfcontained and integrated within a particular country, its functional currency is typically the local currency of that country. However, a foreign entity that is an extension of the parent company’s operations, for example, could have the parent’s currency as its functional currency, i.e., the dollar for a US buyer. Exchange gains and losses may arise from executing transactions in foreign currencies as well as translating the financial statements of foreign entities. However, there are significant differences in the accounting for each.
Foreign currency transactions Transactions denominated in a currency other than the foreign entity’s functional currency are considered a foreign currency transaction. A change in exchange rates between the functional currency and the currency in which a transaction is denominated alters the expected amount of cash flows upon settlement of the transaction. Such a change is considered a foreign currency transaction gain or loss that generally should be included in determining net income of the foreign entity. For example, on January 1, a foreign entity with a Euro (EUR) functional currency borrows US Dollar (USD)500 from its US parent when the exchange rate is USD1/ EUR1.25 and records a EUR625. If on March 31 the foreign exchange rate is USD1/EUR1.5, the foreign entity would have suffered a EUR125 foreign currency transaction loss that would be reflected in its net income because the future settlement of the USD500 liability is now expected to require EUR750. This loss would not be eliminated in the parent’s consolidated earnings.
Foreign currency translation As it is not possible to consolidate financial statements expressed in different currencies, it is necessary to translate the financial statements of foreign entities into a single reporting currency. Assets and liabilities are translated at the exchange rate as of the balance sheet date; income statement items are translated either with the exchange rate at the dates the transactions were recognized or at an appropriately weighted average exchange rate for the period; equity accounts are translated at their appropriate historical exchange rates. The process of translating financial statements results in translation adjustments which are recorded as cumulative translation adjustments (CTA) in other comprehensive income (OCI), a component of equity (not earnings) in the parent’s consolidated financial statements. Translation adjustments primarily originate from the effects of the difference between prior period-end exchange rates and current period-end exchange rates. In a cross-border acquisition that includes foreign entities with different functional currencies, the assets acquired (including goodwill) and liabilities assumed are allocated on the acquisition date to each foreign entity using the acquisition date exchange rate. Subsequently, these amounts are translated into the buyer’s reporting currency when preparing the consolidated financial statements. This is true even if the buyer only intends to account for acquisition adjustments at the parent company level. Example 1 illustrates the concept of translating assets and liabilities denominated in a foreign currency.
Example 1 — Translation of assets and liabilities denominated in a foreign currency Facts: Company A acquired Business X, which is
considered a foreign entity and whose functional currency is the Euro. On the acquisition date, the net assets of Business X were valued at EUR100 million, which was the equivalent of USD150 million. At period-end, the EUR/USD exchange rate is 1.25 (EUR1 for USD1.25). Assume breakeven operations and net assets remain EUR100 million at period-end.
Analysis: In translating Business X’s net assets at periodend for the purpose of preparing Company A’s consolidated financial statements, the EUR100 million net assets determined at the acquisition date would be measured at USD125 million, with a CTA loss of USD25 recorded in OCI.
Goodwill implications Goodwill arising from the synergies of an acquisition must be assigned to one or more reporting units, the level at which goodwill is tested for impairment. In the simplest of acquisitions, a new reporting unit will be created and the assets and liabilities of the target, including goodwill, will be assigned to the new reporting unit. Frequently, however, the specific assets and liabilities of a target, including goodwill, will be assigned to one or more of the buyer’s existing reporting units and, perhaps, new reporting units that are created in connection with the acquisition. Example 2 illustrates one acceptable method to assign goodwill to new and existing reporting units upon an acquisition.
Example 2 — Assignment of goodwill Facts: Company X acquires Company Y for USD1,500.
The fair value of the identifiable net assets acquired is USD1,000. The buyer includes the entire acquired business in a new reporting unit—Reporting Unit D. Although existing Reporting Unit C has not been assigned any of the acquired assets or assumed liabilities, the buyer expects Reporting Unit C to benefit from synergies related to the acquisition (e.g., Reporting Unit C is expected to realize higher sales of its products because of access to the Company Y’s distribution channels).
Example 2 — Assignment of goodwill (continued) Analysis: Even though Company Y may be a foreign entity, goodwill is assigned for impairment testing to Reporting Units C and D as follows: Reporting unit C
Fair value of acquired company
Total acquisition USD1,500
Fair value of identifiable net assets (excluding goodwill)
Fair value of unit C with acquisition
Fair value of unit C without acquisition
Subsequent to the acquisition and the for the purpose of performing impairment testing, it is best practice to perform the test in the functional currency of the foreign entity prior to translation.
Disposal considerations — Parent’s accounting for CTA Many buyers that acquire a business may dispose all or a portion of the acquired business at a later date because, for example, the business no longer meets the buyer’s strategic vision. The release of CTA into earnings will depend on whether the buyer is selling all or substantially all of its investment in the foreign entity or simply disposing of one or more businesses within the foreign entity. Examples 3 and 4 illustrate these concepts.
Example 3 — Sale of an investment “in” a foreign entity Facts: Company X, whose reporting currency is the USD, consolidates its wholly owned subsidiary, Subsidiary Y, a business whose functional currency is the Euro. In 20X4, Company X sells its interest in Subsidiary Y to a third party. Subsidiary Y is considered the entire foreign entity.
Analysis: When the sale occurs, Company X would
include all CTA associated with Subsidiary Y from accumulated OCI when computing the gain or loss on the sale. If Company X had only sold a portion of its interest while maintaining a controlling interest in Subsidiary Y, no CTA would be included in the gain or loss computation. Conversely, if Company X sold a controlling interest in Subsidiary Y and retained a noncontrolling investment, all of the CTA related to the Subsidiary Y would be included in the gain or loss computation.
Example 4 — Sale of a business “within” a foreign entity Facts: Company X, whose reporting currency is the USD,
consolidates its wholly owned subsidiary, Subsidiary Y, a business whose functional currency is the Euro. Subsidiary Y owns all of Subsidiary Z, a business whose functional currency is also the Euro. Subsidiary Y and Z, together meet the definition of a foreign entity. In 20X4, Subsidiary Y sells its entire interest in Subsidiary Z to a third party.
Analysis: As Subsidiary Y is a business that holds other
substantive assets besides its investment in Subsidiary Z, the sale of Subsidiary Z would not constitute a substantially complete liquidation of the foreign entity. Therefore, when Subsidiary Z is sold, none of the CTA associated with the foreign entity (including amounts historically related to Subsidiary Z) is included in the gain or loss computation in Company X's consolidated financial statements.
Multi-GAAP requirements As noted in the first edition of this series, cross-border targets in 2013 came from almost every part of the world. Following a cross-border acquisition, it is essential to understand the interaction between group reporting requirements (under US GAAP) and any local reporting requirements that may necessitate use of IFRS or local GAAP (e.g., statutory, regulatory, tax, or other reporting reasons). Typically, in a cross-border deal, each territory will be required to maintain its books and records in a manner that allows reporting under multiple GAAPs and/or regulatory frameworks. In addition, internal management accounts may be on a different basis, to allow management to monitor certain metrics or key performance indicators. All of these accounting bases must be reconciled and understood in order to effectively manage the business, comply with regulatory requirements, and effectively communicate with shareholders and other stakeholders. As an example, a cross-border target in Europe may have local statutory reporting requirements for each country it operates in (e.g., tax reporting in Italy, France, etc.) as well as consolidated reporting requirements that may continue after the acquisition (e.g., for debt covenant purposes). The following diagram illustrates these various multi-GAAP reporting considerations.
IFRS, foreign group reporting
need to be trained to understand and evaluate the differences between the various reporting requirements. Robust and clearly written group accounting policies and internal controls documentation are needed to ensure knowledge and guidance is properly shared. Knowledge of IFRS and overseas reporting requirements held by the existing finance team should be leveraged for strategic conversion to group reporting principles. There may also be opportunities to align local reporting and group reporting post-acquisition through policy choices made at the acquired subsidiary level.
In summary In this series on cross-border acquisitions, we have looked at various aspects along the deal continuum that may be particularly challenging for a buyer, including preacquisition due diligence and strategies, SEC reporting requirements, tax implications, and finally postacquisition considerations. We have highlighted only a few matters, which if not appropriately considered could diminish a deal’s value. While significant planning for an acquisition is always needed, the added complexities of a cross-border acquisition makes it even more critical for a buyer to develop its action plan early in the due diligence process to address the various accounting, valuation, reporting, and tax implications arising before and after a deal is consummated. Buyers that are mindful of these matters will be best positioned to maximize the value from their cross-border deals.
US GAAP consolidated reporting
For more information on this publication please contact:
Reconcile and understand differences
John Glynn Valuation Services Leader (646) 471-8420 [email protected]
Henri Leveque Capital Markets & Accounting Advisory Services Leader (678) 419-3100 [email protected]
Principal authors: Local GAAP, local subsidiary reporting
Implementing systems, processes, and controls that will allow such complex reporting requirements to be met can be a time-consuming, costly, and difficult task – however, planning, investment, and training can greatly minimize the pain. Staff at both parent and subsidiary levels will
Lawrence N. Dodyk US Business Combinations Leader (973) 236-7213 [email protected]
Elly Barrineau National Professional Services Group Senior Manager (973) 236-7039 [email protected]
PwC has developed the following publications related to business combinations and noncontrolling interests, covering topics relevant to a broad range of constituents.
Noncontrolling interests—why minority shareholder
How timing your transactions in light of the new
Did I buy a group of assets or a business? Why should I
standards will impact your business and communication with stakeholders Goodwill impairment testing: What's old is new again Deal or no deal: Why you should care about the new
M&A standards Even your tax rate will change Accounting for partial acquisitions and disposals—it's
not so simple! Doing a deal? Be careful about employee compensation
decisions Acquired assets not intended to be used: You may need
to record them, even if you don't use them! Accounting for contingent consideration—Don't let
earnouts lead to earnings surprises The Consolidation Standard—determining who
consolidates is just the beginning Carve-out Financial Statements—A challenging process
rights matter Market participants: how their views impact your values
care? Don't let push-down accounting push you around Financial risk management considerations in an
acquisition We’re in the process of acquiring a company with
significant in-process research and development (IPR&D) activities. What's next? Cross-border acquisitions – Due diligence and pre-
acquisition risk considerations Cross-border acquisitions – Navigating SEC reporting
requirements Cross-border acquisitions – Accounting considerations
relating to income taxes PwC clients who would like to obtain any of these publications should contact their engagement partner. Prospective clients and friends should contact the managing partner of the nearest PwC office, which can be found at www.pwc.com.
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