Mergers & acquisitions a snapshot Change the way you think about tomorrow s deals

Mergers & acquisitions a snapshot Change the way you think about tomorrow s deals Stay ahead of the accounting and reporting standards for M&A 1 March 6, 2014 Cross-border acquisitions Due diligence and pre-acquisition risk considerations What's inside Outbound cross-border activity in 2013... 2 GAAP differences and the impact on purchase price... 2 Risk exposures... 3 In summary... 5 In today s global economy, companies do not hesitate to look beyond their borders to find the right acquisition to grow their business. As a result, overseas expansion through cross-border acquisitions is increasing in volume. Buyers of foreign businesses need to have a comprehensive understanding of global accounting differences, regulatory requirements, foreign and domestic tax considerations, and the impact the acquisition will have on its financial reporting. A lack of knowledge in these areas could cause last-minute surprises that delay a deal s timing and result in a buyer over- or under-valuing the target. As a result, it is critical to understand how these areas impact deal valuation. This edition of Mergers & acquisitions a snapshot is the first in a series focused on navigating the waters of a cross-border acquisition. The series will look at various aspects along the deal continuum, including pre-acquisition due diligence and strategies, financial reporting requirements, tax implications, and post-acquisition considerations. This edition focuses on the pre-acquisition phase, including how GAAP differences can impact valuation and how a company can manage the financial risk exposure that arises from a cross-border acquisition. 1 Accounting Standards Codification 805 is the U.S. standard on business combinations, and Accounting Standards Codification 810 is the U.S. standard on noncontrolling interests (collectively the "M&A Standards"). M&A snapshot 1

Outbound cross-border activity in 2013 The diagram below shows the relative volume of global outbound deals by U.S. buyers based on the number of closed transactions in 2013. of the key differences between U.S. GAAP and IFRS are discussed below. Revenue recognition Revenue recognition differences can vary industry to industry. U.S. GAAP tends to have highly detailed guidance and is often industry specific. IFRS has broad principles that are generally applied without further guidance or exceptions for specific industries. For example, U.S. GAAP for software revenue recognition looks to vendor-specific-objective evidence (VSOE) to determine fair value, whereas IFRS does not have a similar concept. In addition, revenue recognition guidance may vary between the two frameworks regardless of industry. For example: Outbound 2013 Cross-border targets in 2013 came from almost every part of the world with the most significant activity concentrated in four locations. Canadian targets in 2013 were mostly in the real estate sector. In Europe, the United Kingdom had the most targets followed closely by Germany. Brazil had the most targets in South America. Australian targets were mostly in the real estate, utilities, and energy sectors. Acquisitions of foreign companies by U.S. buyers are expected to increase in 2014 as economic uncertainty in parts of the world continues to subside. GAAP differences and the impact on purchase price In theory, differences in accounting rules and principles should not impact a target s underlying valuation. However, buyers may focus on different metrics in applying valuation techniques to estimate a target s value. For example, private equity buyers and some corporate buyers may focus on a multiple of a target s EBITDA, whereas other corporate buyers may focus on postacquisition earnings per share. In both cases, differences between buyer and target accounting rules and policies may have a significant impact on a buyer s financial reporting and the target s valuation, and should be appropriately considered. Buyers also need to understand which differences may impact a target s cash flows. And, understanding the significant non-cash accounting impacts will be important for the buyer s deal model and will enable a buyer to make any necessary adjustments to the inputs for the metrics used to develop its purchase price. Differences between U.S. GAAP and a target s local GAAP, as well as differences with IFRS, can be significant. Some Residual method When a transaction has multiple deliverables, U.S. GAAP has a hierarchy for determining the selling price of each. Companies must first look to VSOE if available, third-party evidence (TPE) if VSOE is not available, or estimated selling price if neither VSOE nor TPE is available. The residual method (i.e., allocating the amount of consideration left over after determining the aggregate fair value of the other deliverables) is precluded (except under software industry guidance). Under IFRS, no explicit guidance regarding a hierarchy exists and the residual method is acceptable to allocate consideration across multiple-element arrangements. This could lead to differences in the timing of revenue recognition. Contingent pricing Under U.S. GAAP, contingent amounts are often not recorded until the contingency is resolved. IFRS looks to the probability of receiving an economic benefit when measuring revenue that would include any contingent revenue. This may lead to revenue being recognized earlier under IFRS. Percentage-of-completion (POC) accounting U.S. GAAP prohibits use of POC accounting for most service transactions and allows use of the completed contract method. IFRS requires use of POC accounting for most service contracts and prohibits use of the completed contract method. This may result in more deferred revenue under U.S. GAAP that must be recognized in purchase accounting, often at significantly lower values. Expense recognition Expense recognition can also vary between the two frameworks. For example: Development costs U.S. GAAP prohibits the capitalization of development costs with limited exceptions, whereas these costs are capitalized under IFRS if certain criteria are met. This can result in a target M&A snapshot 2

company having higher EBITDA and EPS under IFRS. Differences also exist in areas such as software developments costs where U.S. GAAP prescribes detailed guidance based on whether the software is for internal use or for sale, while under IFRS there is no such distinction. Employee benefits expense Significant differences exist between U.S. GAAP and IFRS in the areas of accounting for pension and other employee benefits. For example, actuarial gains and losses are permanently recognized in other comprehensive income under IFRS. U.S. GAAP requires that these items be expensed immediately or recycled from other comprehensive income through the income statement, creating additional earnings volatility. Under IFRS, the financing component of net pension cost may be classified as interest expense, whereas all components of net pension cost must be shown together under U.S. GAAP. This can increase EBITDA for a target company applying IFRS. Differences between the two frameworks related to the discount rate can also impact EBITDA. Additionally, the accounting for stock compensation is different between the two frameworks due to differing determinations of the grant date, different classifications of awards within equity or liabilities, different expense recognition for awards that vest ratably over time, and different tax treatments. Contingencies IFRS and U.S. GAAP have different recognition and measurement thresholds for contingencies that could result in different expense recognition patterns. For example, a contingent liability may be recorded under IFRS when it is more likely than not that a liability has been incurred, whereas under U.S. GAAP the loss must be probable. Additionally, differences in the frameworks related to discounting contingencies and determining the amount of a liability when a range of possible outcomes exist can result in different expense recognition patterns. Leases Form-based rules under U.S. GAAP drive lease classification, whereas IFRS focuses on the substance of the transaction. Lease classification can impact not only the amount of lease expense recognized but also the geography within a company s income statement, possibly impacting key metrics such as EBITDA. Impairment and inventory In general, impairments are recognized earlier under IFRS than under U.S. GAAP. Additionally, IFRS permits the reversal of previous impairment and inventory write-downs, which can create earnings volatility. Reversal of impairment and inventory write-downs is prohibited under U.S. GAAP. Also, LIFO inventory accounting is precluded under IFRS, which may result in IFRS companies having a higher EBITDA. The following example highlights the impact on a target company s EBITDA due to IFRS and U.S. GAAP differences and the potential impact on the purchase price of a cross-border acquisition. Example 1 How GAAP differences could impact acquisition price Facts: Buyer A, a large domestic U.S corporation, is looking to expand its business overseas by acquiring a subsidiary of a public conglomerate in Europe that applies IFRS (Target B). Target B produces customized machines for equipment manufacturers and has significant research and development activities for new products. Target B s contracts often contain contingent pricing based on agreed upon milestones and completion dates. Target B also has a defined benefit plan for its employees and records the financing component of its pension cost within interest expense. Buyer A is assessing the impact of IFRS and U.S. GAAP differences as the purchase price for Target B will be ten times Target B s prior year EBITDA. This multiple is based on recent transactions of U.S companies involving targets comparable to Target B. Analysis: Since Buyer A is purchasing Target B based on a multiple of EBITDA, it needs to understand how GAAP adjustments will impact its quality of earnings analysis. Target B s business of producing customized machines and its contingent pricing arrangements may lead to recognizing revenue earlier under IFRS than it would have under U.S. GAAP. Also, Target B s capitalized development costs would likely have been expensed under U.S. GAAP. Lastly, all components of Target B s pension costs would have reduced EBITDA under U.S. GAAP. If Buyer A does not appropriately consider the accounting differences between U.S. GAAP and IFRS, it may overvalue Target B as indicated below. Adjustments (millions) EBITDA Purchase price EBITDA (IFRS) $100 $1,000 Revenue recognition (20) Development costs (10) Employee benefits (5) EBITDA (U.S. GAAP) $65 $650 A buyer in a cross-border acquisition will likely want to be transparent about significant GAAP differences with the users of its financial statements as well. These GAAP differences may impact a buyer s key performance metrics and financial ratios differently than investors may be anticipating in their models or lenders may be considering for covenants in debt arrangements. Additionally, buyers in regulated industries will want to understand how GAAP differences will impact regulatory requirements. Risk exposures The acquisition of a business can have a significant impact on a buyer s risk exposures and risk management strategies. PwC s M&A Snapshot: Financial risk management considerations in an acquisition, discusses M&A snapshot 3

considerations for risks that arise subsequent to an acquisition. Buyers should also consider financial risk exposures that arise prior to an acquisition (the preacquisition phase ). A common financial risk that arises during the pre-acquisition phase of a cross-border transaction that companies will often plan to manage is foreign currency risk. Although not unique to cross-border acquisitions, buyers are often exposed to movements in interest rates as well as other financial risk considerations. Foreign currency risk Cross-border acquisitions with a purchase price denominated in a foreign currency will expose the buyer to foreign currency movements during the pre-acquisition phase. Foreign currency forward contracts and foreign currency option contracts are two derivative instruments commonly used to mitigate foreign currency risk. Foreign currency forward contracts lock in the functional-currency equivalent cash flows expected to arise upon an acquisition and therefore provide certainty to the buyer regarding the purchase price. However, buyers are contractually committed to exchange currencies as agreed to in the forward contract, whether or not the acquisition is ultimately consummated. Alternatively, buyers may enter into foreign currency option contracts to mitigate the risk of movements in foreign currency rates during the pre-acquisition phase. Options provide one-sided protection against adverse changes in foreign currency rates while allowing buyers to participate in any favorable movements in foreign currency rates. There is a cost associated with executing options that is not incurred when entering into a foreign currency forward contract. As a result, buyers will want to consider whether to lock in a foreign currency rate upfront by using a forward contract or to pay for one-sided protection against adverse movements in foreign currency rates by using an option contract. Interest rate risk While not unique to cross-border deals, buyers often fund acquisitions through the issuance of debt. As a result, buyers are exposed to increases in interest rates during the pre-acquisition phase. Buyers may mitigate this risk by entering into derivative instruments such as forwardstarting interest rate swaps, treasury rate locks, or swaptions. Forward-starting interest rate swaps or treasury rate locks are often executed to lock in the LIBOR or treasury rate component of the interest rate to be paid on forecasted debt issuances. These instruments help protect against increases in LIBOR or treasury rates, but result in a contractual commitment, whether or not an acquisition is ultimately consummated. Consequently, buyers executing these instruments will typically want to have a high degree of certainty that the transaction will be consummated. Moreover, buyers will typically want to know both the amount of debt to be issued and the timing of the debt issuance as these factors influence the terms of the derivative instruments. Swaptions are options to enter into interest rate swaps. Swaptions provide one-sided protection against adverse changes in interest rates while allowing companies to participate in any favorable interest rate movements. However, there is a cost associated with executing swaptions that does not exist when entering into forwardstarting interest rate swaps or treasury rate locks. As a result, buyers will want to consider whether to lock in an interest rate upfront or to pay for one-sided protection against movements in interest rates by using a swaption. The following example illustrates managing interest rate risk with a forward-starting interest rate swap. Example 2 Hedging pre-acquisition interest rate risk Facts: On January 1, 2014, Company A forecasts the acquisition of 100% of Company B and does not believe there are any significant contingencies or regulatory hurdles that would prevent the acquisition from being consummated. Company A is planning to issue 5-year fixed rate debt on March 31 to fund the acquisition. In an effort to mitigate its exposure to rising interest rates between January 1 and the date of the borrowing on March 31, Company A enters into a forward-starting interest rate swap to receive a variable rate (e.g., 6-month LIBOR) and pay 3%. The effective date of the swap is March 31, 2014, and the maturity date of the swap is March 31, 2019. Analysis: The forward-starting interest rate swap executed by Company A locks in the LIBOR component of the interest rate at 3%. Therefore, if interest rates rise from 3% to 4% between January 1, 2014 and March 31, 2014, Company A will have to pay its debt holders an additional 1% interest (assuming no changes in credit during the three-month period). However, the increase in interest payments will be offset by an increase in the net cash receipts from the counterparty to the swap. These swaps are typically terminated at fair value on the effective date when companies issue fixed rate debt, because the company s cash flows are no longer exposed to rising interest rates. While Company A is fairly certain the acquisition will be consummated, if it does not, Company A is still obligated under the terms of its forward-starting interest rate swap. This obligation could represent a liability if interest rates have declined since the derivative was executed. M&A snapshot 4

Other considerations Deal-contingent derivative contracts can also be used to hedge risks that arise during the pre-acquisition stage. These contracts are cancelled in the event that the anticipated acquisition is not consummated by a predetermined date. These products provide greater flexibility to buyers because they are cancelled without further obligation by either party if the acquisition does not occur. However, these derivatives can be more expensive, as the counterparty will require compensation for its cost to hedge the exposure assumed under the derivative contract. The exposure assumed can be difficult for the counterparty to hedge because it is contingent upon the deal being consummated, which is typically dependent on a variety of subjective factors. During the pre-acquisition phase, buyers should also consider the risks inherent in the target company and the impact of those risks to the potential combined entity. In some cases, the target s exposure to foreign currency risk, interest rate risk, and commodity price risk may naturally offset the current risk exposures of the buyer. These natural offsets may negate the need to enter into derivative instruments to achieve the buyer s risk management objectives. Buyers may also decide not to actively manage these risk exposures at all, depending on the degree of certainty that the anticipated transaction will close, the magnitude of the forecasted acquisition, and the buyer s tolerance for risk. Don t forget the accounting The risk management strategies discussed above involve the use of derivative financial instruments, which are required to be carried on the balance sheet at fair value with changes in fair value recorded in earnings, unless those derivatives qualify for hedge accounting. Therefore, derivatives that do not qualify for hedge accounting potentially result in income statement volatility. In theory, the forecasted interest rate risk associated with debt to be issued solely to fund an acquisition and foreign currency risk associated with a target s forecasted sales or purchases could be hedged prior to consummation of the deal, if they are probable of occurring. However, these cash flow exposures are contingent upon the consummation of the acquisition, which typically includes many substantive contingencies prior to closing, such as regulatory approvals, shareholder approvals, completion of due diligence, material adverse change provisions, etc. In practice, companies are unable to assert that the forecasted acquisition is probable of occurring due to the presence of these contingencies. In addition, buyers are precluded from applying hedge accounting to hedges of foreign currency risk associated with the purchase price. Thus, entities wishing to undertake risk management strategies associated with an acquisition should do so with the understanding that they will likely experience income statement volatility from the derivative instruments used. In summary Cross-border acquisitions are increasing in frequency and bring with them additional considerations that even the most acquisitive buyers of domestic companies may not have considered. This edition of M&A Snapshot highlights only a few of the issues that a company will want to consider in the pre-acquisition phase. GAAP differences, if not appropriately considered, may adversely impact the buyer s purchase price. Risk exposures, if not appropriately mitigated, may leave the buyer exposed to significant risks. Companies will want to consider developing an action plan early in the due diligence process to address accounting and valuation implications and to appropriately manage risk exposures arising from a cross-border acquisition. Stay tuned for future editions in our series on cross-border acquisitions focusing on financial reporting requirements, tax implications and post-acquisition considerations. For more information on this publication please contact: John Glynn Valuation Services Leader (646) 471-8420 john.p.glynn@us.pwc.com Henri Leveque Capital Markets & Accounting Advisory Services Leader (678) 419-3100 h.a.leveque@us.pwc.com Principal authors: Lawrence N. Dodyk US Business Combinations Leader (973) 236-7213 lawrence.dodyk@us.pwc.com Matthew Naro National Professional Services Group Director (973) 236-5824 matthew.naro@us.pwc.com Paul Moran National Professional Services Group Director (973) 236-5548 paul.d.moran@us.pwc.com M&A snapshot 5

PwC has developed the following M&A Snapshot publications related to business combinations and noncontrolling interests, covering topics relevant to a broad range of constituents. How timing your transactions in light of the new 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 Doing a deal? Be careful about employee compensation decisions Accounting for partial acquisitions and disposals it's not so simple! 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 Noncontrolling interests why minority shareholder rights matter Market participants: how their views impact your values Did I buy a group of assets or a business? Why should I 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? 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. 2014 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.