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ACCOUNTING CONSIDERATIONS FOR INSURANCE ACQUISITIONS Paul Medini, CPA, Partner, PricewaterhouseCoopers LLP William Lowry, CPA, CLU, FLMI, Capital Decision Services LLC April 2000. Discussions Topics. Business Combinations -- Purchase vs. Poolings Purchase Accounting Overview

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Paul Medini, CPA, Partner, PricewaterhouseCoopers LLP

William Lowry, CPA, CLU, FLMI, Capital Decision Services LLC

April 2000

discussions topics
Discussions Topics
  • Business Combinations -- Purchase vs. Poolings
    • Purchase Accounting
      • Overview
      • Purchase accounting adjustments
      • Financial statement impact of purchase accounting
      • FASB’s view of useful life and Goodwill
      • Reserve covers
      • Reserve adjustments
    • Pooling of Interest Accounting
      • Overview
      • Pooling transactions in the Insurance Industry
      • Future of pooling
  • Restructuring Charges
purchase vs pooling accounting
Purchase vs Pooling Accounting

Purchase Pooling

Theory Acquisition Merger

Accounting Fair Value Book Value

EPS Impact Bad Good

Structuring Flexibility Yes Limited *

* Limited flexibility refers to restrictions on certain transactions such as asset dispositions, the issuance of options, and treasury stock repurchases.

purchase accounting overview
Purchase Accounting Overview
  • Determine the acquirer
    • General rule:
      • Payer of cash and monetary securities is the acquirer
    • Exceptions:
      • Stock for stock transactions, consider:
        • Shareholder group ownership
        • Composition of top management and board of directors
        • Relative values
        • Imposed restricting conditions
    • The determination of the “acquirer” can potentially be different depending on legal or accounting definitions
purchase accounting overview cont
Purchase Accounting Overview, cont.
  • Determine the purchase price

Cash and monetary securities

+ Non-monetary consideration paid

+ Direct acquisition costs

+ Contingent consideration

= Purchase price

purchase accounting overview cont1
Purchase Accounting Overview, cont.
  • Allocation of the purchase price
    • Purpose:
      • To create a new balance sheet stated at fair value. Consider it as if acquirer purchased or assumed a group of individual assets or liabilities
    • Assets and liabilities are valued using various techniques depending on their nature:
      • Net realizable value
      • Present value
      • Fair value
balance sheet impact of purchase accounting
Balance Sheet Impact of Purchase Accounting

 Other assets/liabilities Revaluation of office buildings or

reflection of favorable/unfavorable


Deferred Taxes Restated for tax effect of difference

between purchase accounting basis

and tax basis

Goodwill  Differences between purchase price

and allocated value to tangible net


Equity Restated to reflect purchase price

p l and equity impact of purchase accounting
P&L and Equity Impact of Purchase Accounting


Investment Income Effect of amortization/depreciation of

purchase accounting adjustments to

invested assets

Interest expense Effect of acquisition debt, if any

Other expenses  Amortization of Goodwill


 Current Deduction of Goodwill amortization,

if any, and adjustments to taxable

investment income

 Deferred Reflects change in differences between

purchase accounting and tax bases


Unrealized gain/loss onReflects difference between historical

investments and purchase accounting basis

fasb s emerging view of useful life
FASB’s Emerging View of Useful Life
  • The FASB is moving toward a view that it will no longer accept a useful life of Goodwill over 20 years
  • FASB has made it clear that it prefers 10 years or less
  • Entities will have to carefully evaluate the expected useful life
potential disclosures
Potential Disclosures

The FASB has proposed that Goodwill be shown separately on the financial statements, as exemplified below:

Income before Goodwill charges and taxes $xxxx

Income tax expense xxxx

Income before Goodwill charges xxxx

Goodwill charges (net of $__tax benefit) xxxx

Net income xxxx

EPS before Goodwill charges xx

Goodwill charges per share xx

EPS (basic) xx

Issues and Implications

  • The impact on M&A activity, shareholder value, and deal pricing is uncertain. Preliminary reaction ranges from “little impact” to “severe adverse impact.” Impact may be lessened due to the separate disclosure of goodwill amortization on the face of the financial statements. However, amortization of other intangibles will not be segregated.
  • Additional disclosures bring FASB closer to cash flow EPS as a performance measure. However, it only partially addresses on difference between net income and cash flow.
  • This proposal would not change the existing life of goodwill.
  • New reporting style favors consolidated investment over minority interests since the embedded Goodwill associated with minority investments will not be included in the Goodwill line item.
reserve adjustments
Reserve Adjustments
  • Insurance Industry has similar rules to Banking
  • Reserves should not be adjusted in Purchase Accounting
  • Large adjustments should be reflected as an error in prior years financial statements, not as adjustments to Goodwill
reserve covers
Reserve Covers
  • Insurance Companies are allowed to guarantee the loss reserves of an acquired entity
  • Applying normal insurance rules would yield a result that would not benefit acquiror -- retroactive accounting
  • GAAP provides for a solution
reserve covers cont gaap solution
Reserve Covers, cont. -- GAAP Solution
  • Provided the seller guarantees the reserves, the Buyer can off-set adverse development with recoveries from guarantee
  • Recovery must be shown gross in the balance sheet along with increase in losses
taxes in a business combination purchase
Taxes in a Business Combination -- Purchase
  • Stock deals -- Goodwill is not tax deductible
  • Asset deals -- Goodwill generally is deductible
  • There are provisions in the tax code that allow stock deals to have deductible Goodwill (e.g., 338 (h)10 )
pooling accounting
Pooling Accounting
  • Accounts for a business combination as the uniting of ownership interests
    • Reported as if the merger occurred in the beginning of the year
    • Restate historical financial statements
  • Pooling is typically the preferable acquisition strategy from an earnings perspective
    • No step-up in target’s assets and liabilities
    • No Goodwill
    • Restate historical financial statements
  • The SEC staff for years has been increasingly scrutinizing pooling of interests accounting
    • SEC staff views are provided on a “piece-meal” basis
    • FASB business combinations project
why so few poolings in the insurance industry
Why So Few Poolings in the Insurance Industry?
  • Greater Flexibility
  • Purchase accounting allows the seller to guarantee the loss reserves
  • No benefit of pooling under SAP
fasb legislative action
FASB Legislative Action
  • FASB is contemplating a new standard that would eliminate pooling of interest accounting as early as 2001
  • Why?
    • Many pooling deals are economically not mergers
    • Pooling creates an uneven playing field
    • Eliminate comparative advantage
potential impact of eliminating pooling
Potential Impact of Eliminating Pooling
  • EPS will be substantially diluted
  • Deals may be rejected because of EPS decreases driven by Goodwill
  • Valuation: No difference from a cash flow or EBITDA multiple perspective
restructuring charges
Restructuring Charges
  • Accounting regulators do not want to allow one time charges that relate to expense for future periods
  • Expenses must be recognized in the period accrued
  • Entities should not expense items that have future benefits to the enterprise
restructuring charges1
Restructuring Charges
  • Restructuring charges are expenses commonly reported in connection with business combinations and existing activity
  • Some examples include:
    • Termination and severance benefits
    • Loss recognition for leases and other commitments
    • Write-off of related intangibles
      • Capitalized software costs