What might Warren Buffet contribute to the IFRS 3R post-implementation review?

This week’s guest blogger is Dave Walters, a partner in PwC UK’s Accounting Consulting Services.

I've never met Warren Buffett but I admire the man and our views on accounting seem to be aligned.  He’s one of the world's richest men and a fabulous source of quotations.  The Chairman's letter in Berkshire Hathaway’s annual report is an excellent read; it deals honestly with the company’s performance with the occasional nugget or two on accounting.  His comments on derivatives as "financial weapons of mass destruction" are peerless.   But this blog is not about derivative accounting; fortunate for both the author and readers.

As both a ‘user’ of financial reporting and a preparer of financial statements perhaps the IASB might seek his views as they move to the next phase of IFRS 3R post-implementation review.

Like me, Warren Buffett has a problem with acquisition accounting; broadly the same under IFRS and US GAAP. Two aspects of it draw his particular ire; transactions with non-controlling interests (NCI) and intangibles and their amortisation.  His complaint on NCI accounting is simple; if you buy out some of the minority, reported net assets are pretty likely to fall.  The more successful the company, the bigger the fall.  Last year, Berkshire Hathaway spent $3.5billion buying out NCI, adding $300m to earning power but reducing net assets by $1.8 billion.  This may be a painless way to increase future return on net assets but is it also an indicator that the accounting doesn’t make sense?

Berkshire Hathaway has identified purchased intangibles in business combinations and is properly amortising them.  Investors tend to add back amortisation. Plenty of hard work goes into those numbers and yet no-one seems to notice.  Is this the equivalent of spending 3 hours making yourself beautiful before going to a party in an unlit coal mine, as Warren Buffet might say?

Berkshire Hathaway acquisition structures tend to be straightforward, avoiding the intricacies of contingent consideration.  That could be to manage Mr Buffet’s blood pressure as acquisitions involving contingent consideration can produce some interesting accounting as well.

An acquirer measures contingent consideration at fair value on acquisition date.  Subsequently, contingent consideration is re-measured through earnings (it used to be taken to goodwill).  Consider this outcome: Company A acquires Company B for £40m today plus a possible £60m in year 3 based on an EBITDA target.  The fair value of contingent consideration is £30m at acquisition date. Assume the acquired business grows rapidly such that by the end of year 2 all the contingent consideration is expected to be paid.  The contingent consideration increases by £30m, all charged to earnings.  The contingent consideration liability might predict upcoming cash outflows but the related expense takes some explaining.  Is the information decision-useful?

Contingent payments linked to future service, that are forfeit if the selling shareholder leaves, are treated as employee remuneration and charged to post acquisition earnings. This is a rule, and sometimes the acquirer has bought some very expensive employees.  But does the rule always produce an accounting outcome that is consistent with the economics?

Go back to Company B.  If the contingent consideration was payable to a selling shareholder who is required to deliver future service, then total consideration would be £40m and the next 3 years’ earnings would include an additional charge of up to £60m for employee costs. It’s not just theoretical; I've seen a transaction with no consideration and all contingent payments linked to future service. It resulted in recording acquired intangibles - ‘negative goodwill’ that ends up in the income statement and substantial employee costs for the earn out period.

I can see why Mr Buffett is not a fan of acquisition accounting. The IASB is currently doing a post implementation review of the business combination standard.  Sadly, I don’t think the ‘Sage of Omaha’ or many other users and preparers commented during the initial phase.  Many companies are now using adjusted earnings measures to strip out the impact of purchase accounting.  If the impacts are routinely ‘adjusted’, is the standard really fit for purpose?

Meanwhile, I'm eagerly waiting for Warren Buffett to take aim on deferred taxes.

What do you think?