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Publication: Healthcare Financial Management

Date published: January 1, 2011

Language: English

PMID: 17804

ISSN: 07350732

CODEN: HFMAD7

Journal code: HFM

The healthcare sector is poised to undergo radical changes due to new regulatory regimes, political, and economic pressures. To withstand these powerful forces and operate in this highly competitive environment, entities have recognized a need to achieve greater economies of scale. As senior executives contemplate various growth scenarios, one avenue that continues to be of significant interest is mergers and acquisitions. Not since the mid1990s has the healthcare sector experienced such a significant number of consolidations. For years, guidance on accounting for mergers and acquisitions in the not-for-profit healthcare arena had been stagnant. However, as consolidation is once again a real possibility, it is time to revisit the recent changes in not-for-profit accounting guidance that will impact business combinations.

In April 2009, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 164, Not-for-ProfIt Entitles: Mergers and Acquisitions (ASU 2010-17), which fundamentally changed the accounting not only for mergers and acquisitions but also for goodwill, intangible assets, and noncontrolling interests (NCIs).a Along with changes in accounting practices, the new guidance is forcing entities to consider whether to expand internal resources or to engage external valuation specialists to comply with the new generally accepted accounting principles (GAAP) requirements.

What is the effect of this change, and to what type of organizations does it apply?

Although the scope of ASU 2010-17 is limited to not-for-profit entities, it is more than a transaction-specific standard. ASU 2010-17 also impacts the accounting for goodwill, intangible assets, and noncontrolling interests by removing the not-for-profit exemption from other accounting literature. The transaction-specific guidance is limited to combinations in which a not-for-profit is the acquirer or, in the case of a merger, two or more not-for-profit entities come together. Note that if the acquirer is a for-profit entity or a for-profit subsidiary to a not-for-profit, then for-profit acquisition guidance should be followed.

Is there a difference between a merger and an acquisition?

Yes. A determination must be made at the outset as to whether a transaction is a merger, an acquisition, or something else. The sole criterion for identifying a merger is that the combining entities cede control to a new entity. Conversely, in an acquisition, one entity cedes control to another entity. Accounting for a transaction within the scope of ASU 2010-17 is dependent on whether the transaction qualifies as a merger oran acquisition.

Generally, combinations have fallen into two broad categories: combinations in which consideration was exchanged (e.g. a hospital purchases an MRI center for $1 million) or combinations in which no consideration was exchanged (e.g. two stand-alone hospitals come together to form a larger system). For years, there were no changes in the prevailing guidance that not-for-prof its applied for mergers and acquisitions. Entities either applied the purchase method or the pooling-of-interests method.

Historically, when entities entered into a combination transaction, the accounting was often dictated by whether consideration had been paid. In circumstances in which consideration had not been paid, as is often the case when not-f or-profits merge, these transactions were accounted for as a pooling-of-interests. In simplest terms, the two organizations combined their assets, liabilities, and results of operations retroactive to the beginning of the year as if the entities had always been a combined organization.

Under the new GAAP, the days of applying the pooling-of-interest method for combining the two entities’ financial information are gone. Many of these historical pooling transactions will qualify as acquisitions and require the use of the acquisition method, which requires the acquirer to determine the fair value of all identifiable assets and liabilities of the acquiree- something not previously done under the pooling approach. Determining the fair value of certain acquired assets (e.g. cash, marketable securities) may not require much judgment, but some assets (e.g. buildings, land, intangibles) may require extensive management judgment. For the more complex areas, it is likely that management will need to consider engaging an outside valuation specialist to assist by preparing valuations of such assets.

What does this change mean?

For entities that were accustomed to the pooling-of-interest method of accounting, the acquisition method is a fundamental change. Consistent with the recent overall direction of the FASB, ASU 2010-17 relies heavily on fair value measures at initial recognition. Management will need to focus on determining the fair value of each asset and of each liability rather than on the overall enterprise value. This approach may result in a step-up in basis for existing assets and recognition of previously unrecognized assets (i.e. intangible assets).

For example, assume Hospital A acquires Hospital B. Hospital B’s main campus is on land that was bought more than 100 years ago and is carried at a nominal book value. As part of the acquisition method, Hospital A will determine the fair value of the acquired land in accordance with the fair value framework embodied in GAAP.

Under the new accounting model, the difference between the fair value of assets acquired and the fair value of liabilities plus consideration paid, if any, will either be contribution income, goodwill, or contribution expense. Determination of whether goodwill or contribution expense is recognized is based on how the acquiree’s operations are supported. If the acquiree is predominately supported by contributions and investment income, contribution expense is recognized. If not, goodwill is recognized.

Why is this issue important?

Recognizing and determining the fair value of previously unrecognized intangible assets will involve significant management judgment. A more thorough analysis of what has been acquired must be performed to identify acquired intangible assets that meet either the separability or contractual-legal criterion. Although not an exhaustive list, common examples of intangible assets include patient/customer lists, donor lists, trademarks, and/or trade names. The fair value of these assets can be determined using various valuation techniques (e.g. discounted cash flow analysis, relief from royalty). In addition to valuing intangible assets, management will also need to determine whether the intangible asset has a finite or infinite useful life, as these assets are no longer bound by an arbitrary 40-year limit. Certain intangible benefits such as assembled workforce, donor relationships, and conditional promises to give are specifically precluded from being recognized using the acquisition method.

What if I want to increase my ownership percentage from 20 to 80 percent or even 100 percent? Does this standard affect me?

Yes. Not-for-profits follow the voting interest, rather than the variable interest model, for determining when to consolidate another entity. Although ASU 2010-17 does not change the not-for-profit consolidation criteria, it does trigger changes in GAAP that may impact the accounting for changes in ownership percentages. Some entities facilitate acquisitions in stages rather than all at once (step acquisitions). An important factor to understand is that when more than 50 percent ownership interest is achieved, control is obtained and consolidation is required.

For example, Entity A owns 40 percent of an MRI practice and accounts for it on the equity method of accounting. Each reporting period, Entity A adjusts its equity method investment based on the earnings of the MRI practice. Entity A then decides to purchase an additional 40 percent ownership interest in the MRI practice. As a result, Entity A now owns 80 percent of this practice and must consolidate the entire entity and reflect a 20 percent noncontrolling interest (NCI)- formerly a minority interest. Because the purchase of the additional ownership percentage is considered an acquisition, Entity A must estimate a fair value for the entire MRI practice. The fair value is then allocated as if Entity A owns 100 percent of the entity with a 20 percent NCI based on the estimated fair value, which may result in immediate recognition of a gain or loss within Entity A’s financial statements. The NCI will now be reflected as a component of net assets and no longer displayed within the mezzanine section of the balance sheet.

What other concerns should be addressed?

Other matters that require attention include contingencies, contingent consideration, financial reporting, internal reporting, acquisition costs, and subsequent adjustments.

Contingencies. Operating in a highly complex ana regulated environment poses many issues for entities when trying to determine whether to recognize possible contingencies in the normal course of business. Attempting to determine the possible contingencies of an acquiree adds another layer of complexity that must be addressed as part of applying the acquisition method. If a contingency is identified during the measurement period that existed as of the acquisition date, it must be recognized at fair value as of the acquisition date. If, during the measurement period, the acquirer is unable to determine the fair value of an acquired contingency due to lack of information, then the acquirer cannot recognize an asset or liability. Such contingencies would be measured and disclosed in accordance with other GAAP, such as contingencies accounting.

Contingent consideration. When consideration is exchanged, many entities tie a portion of the purchase price to other future factors to align the acquiree’s interests with the acquirer. This action is known as contingent consideration. Common examples of contingent consideration include attaining future earnings targets and continuing to work for the acquirer for some period after the acquisition. Historically, the acquirer would not have accounted for contingent consideration at the time of initial purchase accounting, but would have added subsequent contingent payments to goodwill as the metric was achieved. Contingent consideration was not typically part of combinations accounting for under the pooling method.

Under ASU 2010-17, contingent consideration involves a radically different approach. The acquirer needs to consider the form of contingent consideration used because it will dictate the appropriate accounting treatment on the acquisition date. For example, for contingent consideration linked to earnings, the acquirer must estimate the fair value of the contingent consideration as of the acquisition date. This amount will be factored into the total consideration paid for the acquisition. The acquirer will remeasure the fair value of the contingent feature each reporting period and any adjustments will be reflected in that period’s earnings. If the contingent feature is linked to continued employment, the resulting charge is to be recognized as post-combination compensation expense.

Financial reporting. Similar to the previous purchase method and different from the previous pooling-of interest method, the acquisition method requires the acquirer to recognize the operations of the acquiree from the acquisition date forward. As a result, for those entities accustomed to pooling-of-interest accounting, financial statements will lack comparability for the first year following an acquisition.

Another question to consider is how management will reflect the acquiree within the consolidated financial statements. This question is particularly important if standalone reporting is required for any subsidiaries. For example, is it better to keep the acquiree as a separate entity or to blend it in to the acquirer? Should push down accounting be applied? The answers to these questions will depend on the individual circumstances and long-term strategic plan for each organization.

An additional area management should be aware of is transactions entered into in contemplation of the acquisition. These types of transactions are usually on behalf or for the benefit of the acquirer but are not part of what is exchanged in the acquisition. They also are subject to existing GAAP.

For example, the acquiree is asked to undertake a restructuring and record the expense in its statements just before the acquisition date or the acquiree is asked to reimburse the acquirer’s acquisition expenses. These types of transactions would be considered in contemplation of the acquisition and would be reversed when applying the acquisition method. The resulting expense for the restructuring or acquisition costs would be recognized within the operations of the acquirer subsequent to the acquisition.

Internal reporting. Management should consider the impact of additional depreciation and amortization as a result of the new basis of assets and liabilities into future projections and budgets. For example, if intangible assets with finite lives are identified, has amortization expense been considered? Another comparability issue in the year of acquisition is the possible recognition of contribution revenue or expense related to the combination, which, in turn, could distort the financial results for the year.

Acquisition costs. Entities often incur significant expenses when analyzing whether to consummate an acquisition for due diligence as well as during the accounting for an acquisition for valuation specialists and accountants. These expenses are no longer permitted to be capitalized and must be expensed as incurred, even if incurred in the period before adoption of ASU 2010-17.

Subsequent adjustments. Management should attempt to finalize its purchase price allocation as soon as is practical, but no later than one year from the acquisition date. This period, known as the measurement period, gives management time to prepare the necessary valuations. However, if the measurement period crosses reporting periods and an adjustment is identified, the adjustment needs to be recognized as of the acquisition date, and the previously issued financial statements need to be adjusted. Because of this provision, it is expected that more due diligence will take place in advance of the acquisition date so that purchase price allocations can be completed shortly after consummation of the acquisition and management can avoid revising previously issued financial statements.

In Summary

The accounting for mergers and acquisitions has radically changed with the effective date of ASU 2010-17. (In general, for acquisitions, the guidance is effective for annual periods beginning after Dec. 15, 2009.) Applying the acquisition method will present unique challenges to not-f or-prof its, and due to the many valuation issues associated with the guidance, it may require skill sets not currently possessed by internal resources. For this reason, management may have to look to external resources to assist with valuations when considering a merger. If these considerations are regarded as merely accounting issues and put off until the acquisition is complete, there may be unintended consequences. It is better to consider the changes in accounting now to avoid unwelcome surprises.

a. Subsequently codified by Accounting Standards Update 2010-17, Not-(or-Profit Entities: Mergers and Acquisitions.