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Creative accounting can thrive on gaps in M&A standards
March, 15th 2007
In India, at present, there is no accounting standard corresponding to IFRS-3 dealing with acquisition of an entity as a subsidiary on day zero, leaving some significant issues un-addressed. MR PAUL ALVERAS, A SENIOR PROFESSIONAL IN A MEMBER FIRM OF ERNST & YOUNG GLOBAL.

The Tata-Corus deal was a landmark in Indian corporate history. Consummated amid high drama, the acquisition drove home the message that our industry captains are on the prowl, in their journey to scale up.

"Deals like Tata-Corus may seem large today, but considering the aspirations of Indian companies to go global, these deal sizes may only get bigger and more complex. These complexities involve significant financial implications and hence need robust and evolving accounting guidance which ensures that these get appropriately reflected on the financial statements," observes Mr Paul Alveras, a senior professional in a member firm of Ernst & Young Global. "Indian GAAP (generally accepted accounting principles) does not have much accounting guidance supporting the complexities of deals done today, which does give Indian companies a clear flexibility to window-dress their numbers."

Mr Paul, who has earlier worked in CA firms such as S. B. Billimoria & Co and BSR & Co, has rich audit experience; his expertise lies in IPOs and real-estate entity audits. Currently, Mr Paul manages clients across sectors such as renewable energy, real-estate, FMCG, and manufacturing.

And his deliverables cover audits as per IFRS (International Financial Reporting Standard), US GAAP and Indian GAAP. Mr Paul was a member of the Study Group formed by the ICAI (Institute of Chartered Accountants of India) for revision of the Auditing Standard-19 on `Subsequent Events'.

Here is his take on a few questions from Business Line.

Why is it necessary to talk about Accounting Standards in the context of M&As?

Cross-border acquisitions from India have been increasing at a rapid pace. According to Bloomberg, the total value of inbound, outbound and domestic M&A (merger and acquisition), and `fairness opinion' deals was $40 billion during calendar 2006. Many, if not most, of these deals have involved Indian companies acquiring companies few times their size through LBO (leveraged buy-out) routes. The LBO route involves creation of an SPV, which funds the acquisition of a target (subsidiary), by securing the funding against the assets of the target acquired.

With so much activity happening on the acquisition front by Indian companies in cross-border markets, which when combined with the activity in the domestic markets gains even further proportions, it is an opportune time for us in India to evaluate whether the accounting profession in India has kept pace with these developments and whether the accounting standards reflect these business realities.

What are the standards governing M&A deals?

In the international context, accounting standards that are extremely relevant today, particularly in the light of cross border and domestic deals, are the standards on `business combinations' and `consolidated financial statements'.

IFRS-3, on `Business Combinations', deals with acquisition of an entity on the date of its acquisition (i.e., day zero); and IAS (International Accounting Standard) 27, on `Consolidated and Separate Financial Statements', deals with consolidation of the acquired entity on subsequent days.

In India, at present, there is no accounting standard corresponding to IFRS-3 dealing with acquisition of an entity as a subsidiary on day zero, leaving some significant issues un-addressed.

But we have Accounting Standard-14 (AS-14), don't we?

We do. Let's not forget, though, that AS-14, `Accounting for Amalgamations', of the ICAI was issued more than 12 years ago. It deals only with the acquisitions where the acquired company goes out of existence. The standard does not cover acquisitions of entities through acquisition of shares, which is the structure in most of the LBO deals currently.

Apart from one minor amendment, AS-14 continues to be the same as it was originally issued. As compared to this, to cover the peculiarities of acquisition deals, the corresponding international standard has been revised more than once the last major revision being in 2003, and the standard is again under revision.

The ICAI has issued an AS to deal with consolidations...

Yes, but the accounting treatment prescribed for consolidation in India is significantly different from its IFRS-equivalent and this difference has a significant impact on the results and the EPS (earnings per share) shown by companies and, consequently, the price. Further, deals done today are not plain vanilla deals, but ones involving various complexities.

The absence of IFRS-3 in India requires such complexities to be dealt with in accordance with the accounting standard on consolidation. Even though the IFRS-equivalent of consolidation in India covers many of these complexities, still it does not contain any prescriptive guidance on some of the issues, which arise particularly on day zero, and this may encourage companies to indulge in creative accounting.

How do we deal with consolidations?

In India, consolidation is dealt with by the AS-21, `Consolidated Financial Statements'. In simple terms, this standard prescribes, among other things, how to account for the consideration paid for the company whose equity has been acquired. It prescribes that the book values of the assets and liabilities of the acquired company should be added to the book values of the acquiring company, and the excess consideration paid over the net assets of the acquired company should be treated as goodwill.

Going by a plain vanilla interpretation, suppose a company, A Limited, paid $14 billion for a company X Limited, whose net assets are, say, $8 billion, then A Limited will need to show approximately $6 billion on its balance sheet as goodwill, which is a cool Rs 27,000 crore. And this goodwill will not be charged to the profit and loss, even though it will be tested for impairment.

Have assumptions of AS-21 become irrelevant?

AS-21 probably assumes that business deals are done on book values. Historical book value methods were in vogue and made some sense when businesses were acquired for their manufacturing facilities and physical assets had more importance in the acquisition than anything else. Brands, intangibles, patents, etc., were not even heard of earlier. Not anymore, when future profits, intangibles, people, supply contracts, etc., have a significant role to play in the deal value.

Today when a business is acquired, the owner pays for the physical assets, whose value in most cases would be much higher than the book value, but in addition he also pays for the intangible elements, like patents, designs, copyrights, customer arrangements, etc., which do not have any stated value on the balance-sheet. Further, he also pays for future profits, which also do not get reflected on the balance sheet of the company being acquired. For example, if Company A acquires Company B and Company B has a 15-year committed sole-supply arrangement with its customers, this arrangement will not have any stated value in the balance sheet of Company B, but will get a designated value, when Company A acquires Company B.

How does IFRS handle such a situation?

IFRS-3, on `Business Combinations', which deals with acquisition of entities on day zero, requires that the business combinations should be accounted based on the fair values. Even though there are some arguments around what is fair value, IFRS-3 is built on the premise that a company makes acquisitions based on the fair values and that, in many cases, book value may not be equal to fair value. Further, it also recognises and assigns values to assets and liabilities which may not be reflected on the balance sheet of the company being acquired.

Hence, the value of goodwill in most cases would get reduced to a much lower number in all subsequent financial statements. This lower number of goodwill is definitely a more appropriate representation of the fact that goodwill is payment made by the acquirer in anticipation of future economic benefits, unlike the Indian scenario where goodwill also includes the effects of under-valuation/overvaluation of assets/liabilities, or valuation of assets/liabilities not disclosed on the balance sheets of the acquired company.

On the likely impact that should concern investors...

The treatments under both IFRS and Indian standards can have significantly different impacts on the financials of companies and maybe even their stock prices. Under the IFRS, a higher portion gets allocated to individual depreciable assets and the goodwill (not depreciable) is generally lower. Hence, the charge to the profit and loss account under IFRS is much higher than under Indian GAAP, which means that in deals where the premiums are significant, the Indian consolidated financials may disclose a picture which could be significantly rosier than that computed under IFRS.

Even though goodwill is an important aspect, not adequately addressed by AS-21, there are many other important aspects in cross-border and domestic deals done currently, for which Indian Accounting Standards do not contain any prescriptive guidance.

Such as...

Some of these could be, treatment of:

Contingent considerations in acquisition deals.

Stepped-up acquisitions, where the controlling interest in entities is stepped up over a period of time.

Deferred taxes.

Reverse acquisitions, etc.

This highlights a need for significant revamp of the existing standards on acquisition and consolidation in India to bring them on a par with their IFRS equivalents, so that they are more tuned to the transactions and complexities of deals, both domestic and cross border, being done today.

So, what is your suggestion to the ICAI?

Though AS-21 itself was a landmark standard when introduced in 2001, many companies still are outside the scope of AS-21 and it has definitely outlived its usefulness to industry in terms of reflecting business reality of the deals done today. Maybe the time has come for us to relook the standard and make it more practical, relevant and reflective of business reality. This apart, there is also a need to bring new accounting standard on business combinations to capture the peculiarities of such deals on day zero.

D. Murali

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