Academic journal article Journal of Accountancy

LBO Frontiers in the 1990s: Can Accounting Keep Pace? LBO-Type Transactions Aren't Dead, and Their Accounting Issues Still Are Unresolved

Academic journal article Journal of Accountancy

LBO Frontiers in the 1990s: Can Accounting Keep Pace? LBO-Type Transactions Aren't Dead, and Their Accounting Issues Still Are Unresolved

Article excerpt

LBO FRONTIERS IN THE 1990s: CAN ACCOUNTING KEEP PACE?

LBO-type transactions aren't dead, and their accounting issues still are unresolved.

The fall of 1989 brought troubles for leveraged buyouts. Problems developed at Campeau, Integrated Resources, Hillsborough Holdings (Jim Walter Corp.) and Resorts International. The potentially lucrative United Airlines and American Airlines buyout schemes never got off the ground. And the investment community now is waiting to see what happens when reset bonds get reset and payment-in-kind bonds begin to require payments in cash.

Nevertheless, the entrepreneurial spirit still exists and companies always will want to divest themselves of unneeded businesses--so the LBO phenomenon will survive and continue. Buyers will become more selective and LBOs of the 1990s will feature tighter loan covenants and more achievable financial projections. These developments will force the dealmakers to design new and more complex LBO-like transactions--custom-tailored for each situation.

This article discusses the current state of accounting rules in one alternative to an LBO transaction and the challenges faced by the accounting profession in keeping pace with LBO innovations.

LBO ALTERNATIVES

As the classic LBO loses its luster, alternative vehicles for divestiture and acquisition include joint ventures and other forms of spin-offs that resemble LBOs but whose economics are markedly different. The accounting issues associated with these transactions are an uncharted frontier for CPAs. The Financial Accounting Standards Board emerging issues task force (EITF) has answered some questions but many more remain. Let's examine one type of common transaction recently studied by the EITF and consider some of the questions that were left unanswered.

Example: An operating company contributes assets and a financial partner invests equity capital in a newly formed entity. The contributed assets typically are underperforming and their true value may be realized only with the help of a new management team and/or an infusion of capital. The financial partner sees an opportunity to invest in a business with significant potential; the operating company is happy to reduce its investment but hedges its bet by keeping a noncontrolling equity interest. To equalize values, the operating company may receive or make a cash payment as well as contribute assets. Both parties can leverage the contributed assets, with the proceeds going to one or both or used to finance the new entity's operations. An initial public stock offering also is possible.

THE ACCOUNTING CONSIDERATIONS

Some accounting questions raised by these types of transactions were discussed, but only partially resolved, in EITF Issue no. 89-7, Exchange of Assets or Interest in a Subsidiary for a Noncontrolling Equity Interest in a New Entity.

Assume: Operatingco is a diverse manufacturing company that has a trucking subsidiary with a carrying value of $8 million and a fair value of $60 million. Over the years, Operatingco's reliance on its trucking company has declined and it believes the investment is no longer warranted.

Operatingco agrees to partially divest itself of the trucking company by transferring it to a new and revitalized entity, Truckco, in exchange for a 40% equity interest valued at $60 million, which it will account for using the equity method. It seeks a financial partner that believes Truckco can be turned into an independent profitable company. Financeco, an investment company, contributes $90 million in cash to Truckco for a 60% interest in Truckco. Assume Operatingco has no ongoing commitment to support any of Truckco's operations.

The accounting entries for this transaction are shown in exhibit 1 Operatingco divests Truckco. Financeco's accounting is easy: It has a subsidiary with a 40% minority interest. Consolidation accounting normally would be required but many investment companies carry acquisitions at cost until their value clearly is impaired or there's substantial evidence it has increased. …

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