Structuring a Successful Cross-Border M&A Transaction US Accounting Considerations

1. Structuring a Successful Cross-Border M&A Transaction US Accounting Considerations Moshe Peress, Partner & Head of the Professional Department PwC Israel Kesselman & Kesselman March 2005

2. M&A Transactions – US Accounting ConsiderationsThe general framework • Business Combinations: • Acquisition of a Target company • Acquisition of net assets which constitute a “business” • EITF 98-3 (inputs – processes - outputs) • Development stage company generally is not a “business” • Identifying the Acquirer (in a share-swap transaction) • The legal Acquirer is not always the Acquirer for accounting purposes – “reverse acquisition” (e.g., acquisition of a shell company) • Acquisition of a group of assets (which does not constitute a “business”) • No goodwill arises • The accounting basis – Fair values • Main current USM&Aaccounting pronouncements: • FAS 141("Business Combinations ") • FAS 142("Goodwill and Other Intangible Assets") • FASB Project on Business Combinations • Expected to introduce significant changes to current US M&A accounting 2

3. Frequent ExpressionsRegarding M&A Transactions

4. “We acquired the company in a share-swap transaction on October 31, 2005. For the sake of simplicity, we will start consolidating the company’s financial statements, determine purchase price and the fair value of the assets acquired (tangible and intangible), as of the closest balance sheet date (September 30, 2005)" • Determining the purchase price, starting to consolidate and allocating and determining the value of net assets acquired – can occur at different dates ! • Determining the purchase price when marketable securities are issued • The Measurement Date - a reasonable period of time before and after the terms of the acquisition are agreed upon and announced (EITF 99-12) • Expected to be changed under the FASB’s project on business combinations (“acquisition/closing date” instead of “announcement date”) • The “acquisition date” • The date assets are received and other assets are given, liabilities are assumed or incurred, or equity interests are issued • The amounts assigned to the assets acquired and liabilities assumed shall be determined as of the date of acquisition 4

5. “We signed an understanding agreement with a shareholder (X) concerning the purchase of all of his shares in company Y. Company Y is a privately held company that prepares its F/S in conformity with Israeli GAAP (we prepare our F/S in conformity with U.S. GAAP). Our goal is to shorten the process as much as possible, and to have the “closing” at the earliest possible date. Hence, we will deal with all GAAP issues and the required adjustments immediately after the closing" • Most important ! Ensure the availability of the needed financial information before closing the transaction, as part of the acquisition agreement • GAAP requirements: • FAS 141 – pro forma combined information • Consolidation basis - same GAAP and accounting policies • SEC requirements: • Rule 3-05 (businesses acquired or to be acquired) - historical F/S of the Target company • Article 11 - pro forma combined information 5

6. “In order to reduce the future impact of the acquisition on our P&L, we preferred allocating most of the excess of the acquisition cost over net tangible assets acquired to goodwill – which, as you all know - is no longer amortized" • The Acquirer should identify all of the intangible assets acquired, which should be recognized apart from goodwill, if they meet one of the following separate recognition criteria: • Contractual-Legal Criterion • Separability Criterion • Determine the useful life of intangible assets acquired: • Definite useful life • Indefinite useful life • While goodwill is no longer amortized, it should be tested for impairment at least annually • Impairment charge could have negative consequences • Use of valuation models: • Purchase price allocation • Subsequent impairment tests 6

7. "OK, so if allocation of the excess of the acquisition cost to goodwill will likely cause a future impairment, let’s allocate as high an amount as possible to IPR&D (In Process Research and Development), which is immediately charged to expense, and thus we will achieve two goals: (1) there will be no asset on the balance sheet to affect the company’s future operating results (by amortization or impairment); (2) IPR&D, in itself, is indicative of a good acquisition" • Strict instructions about allocating and measuring IPR&D • SEC requirements and guides • Frequently reviewed by the SEC • Quantitative" limitation” • AICPA Practice AIDs • Extended disclosure and subsequent analysis about the progress of the IPR&D projects after acquisition (mainly in the MD&A) • Under FASB’s project on business combinations - IPR&D will be capitalized as an asset 7

8. “In order to decrease our “risks” in the transaction, and in order to ensure that the representations we received about the acquired company’s expected future performance can be realized, let’s condition part of the purchase price consideration on the actual future performance of the acquired company " • Contingent consideration based on “earnings” • Contingent on maintaining/achieving specified earnings levels in future periods • Fair value of the additional consideration will be recognized as an additional acquisition cost of the Target, once the contingency is resolved • Contingent consideration based on “securities price” • The purchaser agrees to pay additional consideration if the securities issued to effect the combination are not worth a specified amount at some future date • Generally, the issuance of additional securities or distribution of other consideration upon resolution of contingencies based on security prices does not change the recorded cost of an acquired entity • These rules are expected to be changed under FASB’s project on business combinations • Contingent consideration will be recognized at fair value on acquisition date; contingent consideration will be marked to fair value through earnings in subsequent reporting periods 8

9. Contingent Consideration - Cont. • Contingent consideration - compensation arrangements • If the substance of the contingent consideration is to provide compensation for services or use of property or profit sharing, the additional consideration shall be recognized as an expense in the appropriate periods • Under EITF 95-8 - determination of whether contingent consideration should be accounted for as an adjustment of the purchase price or as compensation is a matter of judgment that depends on facts and circumstances • When continued employment is necessary for payment of the contingent consideration – it is a strong indicator that the payment is for services (i.e., compensation expense) 9

10. “The acquired business is very similar to our existing businesses. Nevertheless, there are duplicated facilities that we don’t need in the long-run. Let’s create a provision in respect of such costs, which will be credited against the acquisition cost (i.e., goodwill). In that way, we could also “decrease” our P&L effect, after the acquisition, with respect to such future costs” • Restructuring costs at the Target level (EITF 95-3), as opposed to restructuring costs at the Acquirer level (FAS 146) • Restructuring costs at the Target level • Exit, employee termination and relocation costs may be considered liabilities assumed in a business combination • Entities would need to meet certain requirements and would be permitted time to collect relevant data and finalize the plan • The plan must be finalized as soon as possible, but in no event later than one year after the combination date  • Liabilities accrued that are not expended must be reversed as a reduction of the cost of the acquired entity. Amounts expended in excess of original estimates would increase the cost of the acquired entity within one year of consummation, and would be included in net income if determined after the one-year window • Under FASB’s project on business combinations - expense all acquisition related restructuring costs in accordance with FAS 146, unless previously recognized by the Target company 10

11. “In relation to the acquisition, we had some direct and indirect costs, including legal advice, accountants’ work, management air fares, and costs of our M&A department. Those costs will be part of the acquisition cost – meaning, they will increase the goodwill (which is not amortized), and thus, will not affect our P&L " • The cost of an acquired entity includes direct costs of acquisition - which are external"out-of-pocket" and incremental costs - rather than internal recurring costs • Examples - finder's fees and fees paid to outside consultants for accounting, legal, or engineering investigations or for appraisals • All "internal" costs associated with a business combination (e.g., salaries, commissions, bonuses, employee benefits, travel costs, etc.) are expensed as incurred, even if those costs are incremental, nonrecurring, and directly associated with the business combination • Under FASB’s project on business combinations - immediately expense all transaction costs 11

12. “As part of our due diligence, we discovered that the Target has carryforward tax losses amounting to $XXX, and, in addition, there are some outstanding claims against the Target, that have been lodged by former employees. As part of the acquisition negotiations, we agreed to pay $XXX for the Target, based on the likelihood that we will succeed in using part of the carryforward tax losses, and we ignored the outstanding claims, since we concluded, that their success is very remote. The goodwill resulting from the acquisition is $XXX” • Goodwill amount is not final - it can be changed in the future as a result of utilizing acquired carryforward tax losses or settlement of contingencies existing at acquisition date • Carryforward tax losses • The tax effect of the Target’s carryforward tax losses are recorded as deferred tax assets at acquisition date. At that date, the need for a valuation allowance is assessed • If subsequently recognized - first reduce goodwill and then reduce other certain non-current assets. Once those assets are reduced to zero, the benefit is included in income as a reduction of income tax expense • Goodwill could potentially be reduced with no time limitation 12

13. Cont. • Pre-acquisition contingencies of the Target • Should be included in the purchase price allocation based on the fair value as determined during the allocation period • The allocation period should usually not exceed one year from the consummation of a business combination (time limitation!) • Adjustments made after the end of the allocation period - should be included in net income • Under FASB’s project on business combinations: • Carryforward tax losses • Subsequent release of a valuation allowance, recognized at the acquisition date, istreated as a reduction of income tax expense, unless within the first year • Pre-acquisition contingencies • Recognize all contingent assets and liabilities at fair value on acquisition date • Mark contingent assets and liabilities to fair value through earnings in subsequent reporting periods 13

14. “Part of the Target’s employees hold stock options (vested and unvested). We are willing to buy and hold 100% of the Target’s shares. What can we do?” Two alternatives: • Acquire the employees’ stock options for cash, at their fair value • The cash paid is part of the Target’s purchase price • Disadvantage – no incentive for the Target’s employees to stay after acquisition • Replace the Target employees’ stock options with the Acquirer’s stock options • The fair value of the stock options issued (vested and unvested) is part of the Target’s purchase price • To the extent that future service is required (the Acquirer has granted the Target’s employees unvested company’s stock options), a portion of the intrinsic value (if any) of the unvested awards shall be allocated to unearned compensation and recognized as compensation cost over the remaining future vesting period 14

15. Hence:Possible accounting consequences of M&A transactions are critical and need to be identified and analyzed in advance!