New England Biz Law Update
Over the past few years, the scope of responsibilities of the
in-house general counsel has grown immensely. Much of the change is a result of
the passage of the now well-known Sarbanes-Oxley Act of 2002 (“SOX”).
Understandably, general counsel have scrambled to comprehend SOX’s prohibitions
and formalistic reporting requirements and its impact on auditors, issuers and
boards of directors.
In the mad dash of press and publicity, however, certain new
rules governing financial statement presentation have been enacted somewhat
more quietly. The Financial Accounting Standards Board, the primary financial
standards rule making body in the United States (“FASB”), issued FASB
Statements 141 and 142, which dramatically impact the way U.S. companies
account for business combinations and goodwill and other intangible assets. In
addition to financial reporting issues, these rule changes may have significant
impact on the general counsel’s office.
Accountants and CFOs have historically grappled with the
proper treatment of goodwill – the premium paid in an acquisition of a business
or assets over the fair market value of the assets purchased. Their treatment
of goodwill and other intangibles on the financial statements has been loudly
criticized and maligned, such treatment earning the pejorative moniker
“goodwill games.”
Ill-defined rules allowed for the massive accumulation of
“assets” on the financial statements, many of which assets no longer held any
value to the company. In an era shaped by revelations of scandalous financial
reporting, the FASB issued Statements 141 (Business Combinations) and 142
(Goodwill and Other Intangible Assets) to tighten the rules and improve
financial statement disclosure.
In general, these FASB Statements ushered in a new reporting
regime by:
use of the “pooling of interests” method of accounting for all business
combinations occurring after June 30, 2001; and
annual test for impairment of intangible assets and goodwill for all fiscal
years beginning after Dec. 15, 2003, effectively ending the arbitrary amortization
of such assets over seemingly indefinite periods.
These rule changes significantly impact corporations’
financial planning and reporting methodology surrounding business combinations
and intangible assets. Each is discussed briefly below.
FASB 141 – Business Combinations
When a corporation acquires a business, the premium paid in
excess of the fair market value, net of associated liabilities, of the
specific, identifiable assets purchased is accounted for as goodwill, an
intangible asset.
The pooling of interests method allowed entities to account
for business combinations without recognizing goodwill. By eliminating pooling,
the FASB directed corporations to account for such combinations using the
“purchase” method and recognize goodwill.
FASB 141 also established a heightened level of financial
disclosure concerning business combinations. Among other things, under the new
regime, acquiring corporations must clearly disclose (i) the primary reason for
the acquisition, including a description of the factors that contributed to a
purchase price that resulted in the recognition of goodwill, and (ii) the
actual allocation of the purchase price paid to specific assets and liability
categories as of the acquisition date.
FASB 142 – Goodwill and Intangible Assets
Having announced the closing of the “goodwill games,” FASB
142 set forth the accounting regimen for all purchased goodwill and intangible
assets that are acquired, whether individually or as a group, in connection
with a transaction other than a business combination. It also addressed the
ongoing process of accounting for goodwill after its initial recognition.
Before FASB 142, goodwill could have been carried on the
financial statements and slowly written off over periods of up to 40 years.
Although the process was slow and predictable (therefore not upsetting the
earnings apple cart), much of the goodwill represented as an “asset” had been
impaired and had little or no actual value to the enterprise.
The new regimen ushered in with Statements 141 and 142
requires that entities now test at least annually for asset impairment and
formalize the asset appraisal process.
Each company-operating segment or “reporting unit” must
review the values at which it carries intangible assets and goodwill by testing
for impairment at least annually. The reporting unit determines impairment by
ascertaining the fair market value of its assets and comparing the fair market
value to the book value. If the fair market value of the goodwill and
intangible assets is lower than the book value, the difference is deemed the
impairment and must be written off in the current period.
Such additional scrutiny has led to significant goodwill
write-offs and loan covenant concerns. Companies are now faced with dramatic
uncertainty and market risk. Industries experiencing tough economic times are
forced to write down the value of their goodwill and intangible assets and
incur significant offsets against revenues. Once the carrying value of goodwill
and intangible assets has been reduced though write-offs, it cannot be written
up, even if the fair market value of those assets increases.
While these new accounting measures may initially appear to
only impact the financial statements, the CFO and her direct reports, when
combined with the increased disclosure transparency called for by SOX, the new
accounting rules, including the annual determination of fair market value, have
a direct impact on the in-house legal function.
Impairment Recognition
Specifically, as counselor and an advisor to the company,
the in-house attorney must have a basic understanding of the new accounting
rules and the facts and circumstances that may indicate impairment of goodwill
and intangible assets, such as:
protection;
regulatory changes;
new technology by a competitor;
write-off at the operating unit level;
of a key member of management; or
unit for less than its book value.
This knowledge is necessary to ensure appropriate financial
statement treatment and disclosure. Inaccurate or misleading disclosure could
expose the company and its officers to civil and criminal penalties.
General Counsel’s Role
The general counsel’s understanding will allow him to successfully
negotiate with banks and other lenders to determine appropriate entity-specific
loan covenants and to navigate the minefield of revised loan qualification
standards.
When negotiating strategic transactions, such as mergers and
acquisitions, general counsel must insist upon the utilization of appropriate
valuation methodologies and negotiate accurate valuations to avoid the
accumulation of significant goodwill and the risk of future write-offs. The
acquisition negotiation process must also focus on appropriate and efficient
allocation of purchase price.
After an acquisition and as part of ongoing operations, the
general counsel must continue to work with the finance team and operating unit
management to ensure proper treatment and reporting, specifically in connection
with senior management certifications, and to minimize the potential
company-wide impact of capital impairments at the operating unit level.
Although the impact of FASB 141 and 142 and the associated
revised treatment of goodwill and intangible assets seems to be primarily a
financial issue, in the new environment of increased corporate scrutiny and
disclosure transparency, the impact can quickly become a company-wide legal
matter focused on valuation, operations and strategic planning, in addition to
reporting.
Donald P. Ricklefs is a partner in Perkins Smith &
Cohen LLP ‘s Boston office and chairs the firm’s Corporate Group. His practice
focuses on corporate transactions, including mergers and acquisitions,
financing, venture capital and tax and estate planning. Don is also a CPA. He
can be reached at [email protected]
or 617.854.4250.
John C. Cushing is an associate in the firm’s Corporate
Group. His practice focuses on corporate and securities law, including mergers
and acquisitions, private placements o fdebt and equity securities, SEC
compliance and corporate governance. Perkins Smith & Cohen is a premier
mid-size law firm headquartered in Boston, with offices in Providence, R.I. and
Washington, D.C. For more information, please visit the firm’s website, www.pscboston.com.
