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There's been a pickup in corporate acquisitions lately. While that should be cause for celebration, it's not surefire evidence that companies are getting back to business despite the current financial and economic woes.
Instead, upcoming changes in accounting rules may be the catalyst as they make business combinations more expensive. Some companies may be rushing to get deals done by year end before the new bookkeeping requirements potentially put a bigger dent in their bottom line.
In recent months, there has been a noticeable rise in announced deals. While still not anywhere near the record-setting pace seen in the first half of last year, volume in July jumped to nearly $187 billion, the fifth straight month of growth and the highest total since a year ago, according to Dealogic.
The reason for that gain can be partially attributed to foreign companies taking advantage of the weak dollar, which gives them more purchasing power when bidding for U.S. firms. The slump in U.S. stocks over the last year also makes some companies' valuations look cheaper than in the recent past.
But that's not all that's behind the recent rise.
Accounting expert Robert Willens says time is of the essence for those companies trying to beat the deadline before changes come in deal-making accounting. Under Statement of Financial Accounting Standards No. 141, which was revised last year, the less restrictive "purchase method" will be replaced by the "acquisition method" for companies with fiscal years beginning on or after Dec. 15.
The switch is particularly troublesome for acquirers buying companies with large research and development components, like those in the drug and technology sectors. Willens cites Bristol-Myers Squibb Co.'s $60-per-share bid for ImClone Systems Inc. as a deal that would be better off happening sooner rather than later because of the potential hit to earnings for the acquiring company.
Under the current rules, the R&D being acquired - this is known as in-process R&D - is given a value at the time of purchase, which is then deducted from the acquirer's earnings through a one-time charge.
The new rules will require the in-process R&D to be capitalized, which means it is put on the acquirer's balance sheet as an asset. At the point the product is ready for use, the value will then be amortized over its estimated shelf life. If it is abandoned, it will be written off.
For instance, an acquirer buys a company with $100 million of in-process R&D. Under current accounting rules, it takes a one-time charge to earnings. The new rules require that $100 million to hit the balance sheet, and once the product is ready to use, it would be expensed over a certain number of years, let's say $10 million over 10 years.
"The profits will now be hurt by the constant expense," said Zhen Deng, a research analyst at RiskMetrics Group, which provides risk management and corporate governance services.
A recent study by the College of Management at the Georgia Institute of Technology looked at what would have happened to earnings if the in-process R&D had to be capitalized and amortized in previous years. In 2006, that would have knocked down pretax earnings at a sample of 50 pharmaceutical and medical companies by a median 4.18 percent. A sample of 151 computer and electronics companies in the study saw a similar median decrease.
That's not the only spot where the rule change could muck up earnings. Willens, who runs a consulting firm bearing his name, also points to the fuller disclosure of costs pertaining to an acquisition, such as the fees going to all the advisers on a given deal.
Previously, those costs had been added to the purchase price and generally became part of goodwill.
Goodwill is a noncash item on the balance sheet that reflects the amount by which the purchase price exceeds the value of the tangible assets. The new accounting rules will require those costs to be expensed from earnings as they are incurred, which could reduce earnings even before the deal closes.
"We will get to see in all of its splendor what the banking and legal fees are," Willens said.
Companies also won't be able to bundle restructuring costs into goodwill. The new rules will deduct costs for such things as exiting businesses or closing factories out of earnings as post-acquisition operating expenses.
Given how all this could damage earnings, there could be many deals happening in the coming months. Investors have to remember why.
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