ASC 805, Business Combinations, consists of six subtopics:
ASU 2014-17. In November 2014, the FASB issued Pushdown Accounting. The Accounting Standards Update is a consensus of the FASB's Emerging Issues Task Force.
Effective date. The ASU became effective for change in control events upon issuance—on November 18, 2014. For financial statements already issued, pushdown accounting can be applied retrospectively as a change in accounting policy. Once applied, pushdown accounting cannot be undone. In addition, the SEC rescinded SAS Topic 5.J. Topic 5.J included the staff views on applying pushdown accounting. All entities, including public, will not apply. (ASU 2014-17)
Guidance. The changes affect the separate financial statements of an acquired entity and its subsidiaries that are a business or nonprofit activity upon the occurrence of an event in which an acquirer obtains control of the acquired entity. The subsidiaries may be public or nonpublic, and the acquirer may be a business entity or an individual. The ASU makes pushdown accounting optional for an entity each time an acquirer obtains control of the entity, i.e., a change in control event. The acquirer must still apply business combination accounting.
Entities should weigh the costs/benefits and the needs of the financial statement users when deciding whether or not to apply pushdown accounting. Some private entities may opt to apply pushdown accounting in order to eliminate separate bases of accounting between parent and subsidiary or to report the fair value, rather than the historical basis, of assets and liabilities. Other private entities may choose not to use pushdown accounting to avid dragging down earnings as a result of the stepped-up value associated with acquisition accounting.
ASU 2014-18. In December 2014, the FASB issued Business Combinations (Topic 805): Accounting for Identifiable Intangible Assets in a Business Combination. The ASU is a consensus of the Private Company Council and applies to all entities except public and not-for-profit entities.
Effective date. Entities must decide whether or not to adopt the accounting alternative in the ASU upon the occurrence of the first transaction within the scope of this accounting alternative in fiscal years beginning after December 15, 2015. The effective date of adoption depends on the timing of that first in-scope transaction. The elective adoption is effective for the fiscal year's first in-scope adoption annual financial reporting and all interim and annual periods thereafter. If the first in-scope transaction occurs in fiscal years beginning after December 15, 2016, the elective adoption will be effective in the interim period that includes the date of that first in-scope transaction and subsequent interim and annual periods thereafter. Early application is permitted for any interim and annual financial statements that have not yet been made available for issuance.
Guidance. If an entity adopts this alternative, it should no longer recognize and measure (and instead subsume into goodwill):
This issue was brought to the Private Company Council by entities concerned that the cost/benefit effect of the current guidance was not justified. The ASU changes are designed to reduce the costs and complexity of measuring these assets by decreasing the number of intangible assets that need to be recognized separately without diminishing decision-useful information for users of private company financials.
Adopting this alternative will result in a higher goodwill balance at acquisition. An entity that elects the accounting alternative in this Update must adopt the private company alternative to amortize goodwill as described in FASB Accounting Standards Update No. 2014-02, Intangibles—Goodwill and Other (Topic 350): Accounting for Goodwill. However, an entity that elects the accounting alternative in Update 2014-02 is not required to adopt the amendments in this Update.
ASU 2015-08. In May 2015, the FASB issued ASU 2015-08, Business Combinations (Topic 805): Pushdown Accounting—Amendments to SEC Paragraphs Pursuant to Staff Accounting Bulletin No. 115. The ASU removes Securities and Exchange Commission (SEC) staff guidance on pushdown accounting from the Accounting Standards Codification. In Staff Accounting Bulletin (SAB) No. 115, the SEC had rescinded its guidance when the FASB issued its own pushdown accounting guidance with the issuance of ASU 2014-07 in November 2014. (See above.)
Transactions or other events that meet the definition of a business combination are subject to ASC 805. Excluded from the scope of ASC 805, however, are:
Historically, one of the most daunting problems facing accountants has been the determination of when it is more informative and meaningful to present the financial statements of multiple enterprises together, as if they were a single economic unit. A closely related issue was that of how to account for the acquisition of one enterprise by another, or other combination of two or more formerly unrelated entities, into one new enterprise.
Regarding this last-named concern, US GAAP had traditionally permitted two distinct methods of accounting for business combinations. The purchase accounting method (now known as the acquisition method) required that the actual cost of the acquisition be recognized, including any excess over the amounts allocable to the fair value of identifiable net assets, commonly known as goodwill. The pooling of interest method, available only when a set of stringent criteria were all met, resulted in combining the book values of the merging entities, without any adjustment to reflect the fair values of acquired assets and liabilities, and without any recognition of goodwill. Since pooling of interests accounting required that the mergers be achieved by means of exchanges of common stock, the use of this method was largely restricted to publicly held acquirers, which greatly preferred poolings since this averted step-ups in the carrying value of depreciable assets and goodwill recognition, the amortization of which would reduce future reported earnings.
Pooling accounting was widely seen as not being indicative of economic reality, since mergers that were true “marriages of equals” rarely, if ever, occurred, notwithstanding that this was the theoretical basis for using this method of accounting. Ultimately, the pooling method was eliminated, but gaining support for this change required a significant compromise by the FASB on the related matter of goodwill accounting: under the rules established in Accounting Standards Codification (ASC) 350, Intangibles—Goodwill and Other, goodwill would no longer be amortized, and the impact of business combinations on reported income would often more closely resemble that of the now-banned pooling method than the traditional purchase accounting method. Although periodic amortization is no longer reported, goodwill must be tested annually for impairment and, when impairment is found to have occurred, goodwill must be written down to fair value, with the adjustment reflected as a charge against the operating income of that period. (See the chapter on ASC 350 for a technical update on ASU 2014-02, Intangibles—Goodwill and Other (Topic 350): Accounting for Goodwill. The ASU introduces an alternative for private companies that allows for amortization over a period not to exceed ten years.)
The major accounting issues in business combinations and in the preparation and presentation of consolidated or combined financial statements are:
The accounting for the assets and liabilities of entities acquired in a business combination is largely dependent on the fair values assigned to them at the transaction date. ASC 820, Fair Value Measurements, provides a framework for measuring fair value and important guidance when assigning values as part of a business combination. In essence, it favors valuations determined on the open market, but allows other methodologies if open market valuation is not practicable.
Source: ASC 805. For more definitions related to this topic, see the Definition of Terms Appendix: Acquiree, Acquirer, Acquisition by a Not-for-Profit Entity, Business, Business Combination, Contract Asset, Defensive Intangible Asset, Fair Value, Financial Statements are Available to be Issued, Goodwill, Intangible Asset, Lease, Market Participants, Noncontrolling Interest, Nonprofit Activity, Not-for-Profit Entity, Public Business Entity, Public Entity, Variable Interest Entity.
Acquisition Date. The date on which control of the acquiree is obtained by the acquirer.
Collateralized Financing Entity. A variable interest entity that holds financial assets, issues beneficial interests in those financial assets, and has no more than nominal equity. The beneficial interests have contractual recourse only to the related assets of the collateralized financing entity and are classified as financial liabilities. A collateralized financing entity may hold nonfinancial assets temporarily as a result of default by the debtor on the underlying debt instruments held as assets by the collateralized financing entity or in an effort to restructure the debt instruments held as assets by the collateralized financing entity. A collateralized financing entity also may hold other financial assets and financial liabilities that are incidental to the operations of the collateralized financing entity and have carrying values that approximate fair value (for example, cash, broker receivables, or broker payables).
Contingency. An existing condition, situation, or set of circumstances involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) to an entity that will ultimately be resolved when one or more future events occur or fail to occur.
Contingent Consideration. Usually an obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are met. However, contingent consideration also may give the acquirer the right to the return of previously transferred consideration if specified conditions are met.
Contingent consideration might also arise when the terms of the business combination provide a requirement that the acquiree's former owners return previously transferred assets or equity interests to the acquirer under certain specified conditions.
Equity Interests. Used broadly to mean ownership interests of investor-owned entities; owner, member, or participant interests of mutual entities; and owner or member interest in the net assets of not-for-profit entities.
Identifiable Asset. Assets (not including financial assets) that lack physical substance. (The term intangible assets is used to refer to intangible assets other than goodwill.)
Merger of Not-for-Profit Entities. A transaction or other event in which the governing bodies of two or more not-for-profit entities cede control of those entities to create a new not-for-profit entity.
Nonfinancial Asset. An asset that is not a financial asset. Nonfinancial assets include land, buildings, use of facilities or utilities, materials and supplies, intangible assets, or services.
Owners. Used broadly to include holders of ownership interests (equity interests) in investor-owned mutual entities, or not-for-profit entities. Owners include shareholders, partners, proprietors, or members, or participants of mutual entities. Owners also include owner and member interests in the net assets of not-for-profit entities.
Reverse Acquisition. An acquisition in which the entity that issues securities (the legal acquirer) is identified as the acquiree for financial accounting purposes, based on application of the guidance in ASC 805-10-55-11 through 55-15. The entity whose equity interests are acquired (the legal acquiree) must be the acquirer for accounting purposes in order for the transaction to be considered a reverse acquisition.
Reverse Spin-off. A spin-off transaction in which the nominal or legal spinnor is to be accounted for as the spinnee, in order to reflect the economic reality of the spin-off transaction.
A business combination results from the occurrence of a transaction or other event that results in an acquirer obtaining control of one or more businesses. This can occur in many different ways that include the following examples individually or, in some cases, in combination:
ASC 805 provides a definition of a business. Further, it clarifies that the initial consolidation of a VIE that is a business is considered to be a business combination. This effectively provides parity between the accounting for business combinations and any related noncontrolling interests involving voting interest entities and those involving variable interest entities.
To be considered a business, an integrated group of activities and assets must be capable of being conducted and managed to provide a return directly to investors, or other owners, members, or participants. The return can be in the form of dividends, reduced costs, or other economic benefits. The word capable emphasizes the fact that the definition does not preclude a development stage entity from qualifying as a business.1 “Other owners, members, or participants” were included to emphasize the applicability of ASC 805 to mutual entities that previously used the pooling-of-interests method of accounting for business combinations and to noncorporate entities.
The definition and related guidance elaborate further that a business consists of inputs and processes applied to those inputs that have the ability to create outputs. While outputs are usually present in a business, they are not required to qualify as a business. There simply must be the ability to create them.
An input is an economic resource that creates or has the ability to create outputs when one or more processes are applied to it. Examples of inputs include fixed assets, intangible rights to use fixed assets, intellectual property or other intangible assets, and access to markets in which to hire employees or purchase materials.
A process is a system, protocol, convention, or rule with the ability to create outputs when applied to one or more inputs. Processes are usually documented; however, an organized workforce with the requisite skills and experience may apply processes necessary to create outputs by following established rules and conventions. In evaluating whether an activity is a process, ASC 805 indicates that functions such as accounting, billing, payroll, and other administrative systems do not meet the definition. Thus, processes are the types of activities that an entity engages in to produce the products and/or services that it provides to the marketplace, rather than the internal activities it follows in operating its business.
An output is simply the by-product resulting from applying processes to inputs. An output provides, or has the ability to provide, the desired return to investors, members, participants, or other owners.
In analyzing a transaction or event to determine whether it is a business combination, it is not necessary that the acquirer retain, postcombination, all of the inputs or processes used by the seller in operating the business. Using the “market participant” approach to analyzing the facts, as defined in ASC 820, if market participants could, for example, acquire the business in an arm's-length transaction and continue to produce outputs by integrating the business with their own inputs and processes, then that subset of remaining inputs and processes still meets the definition of a business from the standpoint of the acquirer.
The guidance in ASC 805 provides additional flexibility by providing that it is not necessary that a business have liabilities, although that situation is expected to be rare.
If a business is not producing outputs, the acquirer must determine whether the enterprise constitutes a business by considering whether it:
(ASC 805-10-55-7)
It is important to note, however, that it is not required that all of these factors be present for a given set of activities and assets to qualify as a business. Again, the relevant question to ask is whether a market participant would be capable of conducting or managing the set of activities and assets as a business irrespective of whether the seller did so or the acquirer intends to do so.
Finally, ASC 805 provided what it acknowledged was circular logic in asserting that, absent evidence to the contrary, if goodwill is included in a set of assets and activities, it can be presumed to be a business. The circularity arises from the fact that, in order to apply GAAP to determine whether to initially recognize goodwill, the accountant would be required to first determine whether there had, in fact, been an acquisition of a business. Otherwise, it would not be permitted to recognize goodwill. It is not necessary, however, that goodwill be present in order to consider a set of assets and activities to be a business.
A business combination can be structured in a number of different ways that satisfy the acquirer's strategic, operational, legal, tax, and risk management objectives. Some of the more frequently used structures are:
The acquirer accounts for a business combination using the acquisition method. This term represents an expansion of the now-outdated term, “purchase method.” The change in terminology was made to emphasize that a business combination can occur even when a purchase transaction is not involved.
The following steps are required to apply the acquisition method:
ASC 805 strongly emphasizes the concept that every business combination has an acquirer. In the “basis for conclusions” that accompanies FASB 141 (R), FASB asserted that:
…“true mergers” or “mergers of equals” in which none of the combining entities obtain control of the others are so rare as to be virtually nonexistent…
The determination of the acquirer is based on application of the provisions of ASC 810 regarding the party that possesses a controlling financial interest in another entity. In general, ASC 810 provides that direct or indirect ownership of a majority of the outstanding voting interests in another entity “. . . is a condition pointing toward consolidation.” However, this is not an absolute rule to be applied in all cases. In fact, ASC 810 explicitly provides that majority owned entities are not to be consolidated if the majority owner does not hold a controlling financial interest in the entity. Exceptions to the general majority ownership rule include, but are not limited to, the following situations:
If applying the guidance in ASC 810 does not clearly indicate the party that is the acquirer, ASC 805-10-55-10 through 15 provides factors to consider in making that determination under different facts and circumstances:
(ASC 805-10-55-12)
By definition, the acquisition date is that on which the acquirer obtains control of the acquiree. As discussed previously, this concept of control (or, more precisely, controlling financial interest) is not always evidenced by voting ownership. Thus, control can be obtained contractually by an acquirer absent that party holding any voting ownership interests.
The general rule is that the acquisition date is the date on which the acquirer legally transfers consideration, acquires the assets, and assumes the liabilities of the acquiree. This date, in a relatively straightforward transaction, is referred to as the closing date. Not all transactions are that straightforward, however. All pertinent facts and circumstances are to be considered in determining the acquisition date. The parties to a business combination might, for example, execute a contract that entitles the acquirer to the rights and obligates the acquirer with respect to the obligations of the acquiree prior to the actual date of the closing. (ASC 805-10-35-7) Thus, in evaluating economic substance over legal form, the acquirer will have contractually acquired the target on the date it executed the contract.
ASC 805 provides a basic recognition principle that, as of the acquisition date, the acquirer is to recognize, separately from goodwill, the identifiable assets acquired (whether tangible or intangible), the liabilities assumed, and, if applicable, any noncontrolling interest (previously referred to as “minority interest”) in the acquiree.
In applying the recognition principle to a business combination, the acquirer may recognize assets and liabilities that had not been recognized by the acquiree in its precombination financial statements. ASC 805 continues to permit recognition of acquired intangibles (e.g., patents, customer lists) that would not be granted recognition if they were internally developed.
ASC 805 elaborates on the basic principle by providing that recognition is subject to the following conditions:
Restructuring or exit activities. Frequently, in a business combination, the acquirer's plans include the future exit of one or more of the activities of the acquiree or the termination or relocation of employees of the acquiree. Since these exit activities are discretionary on the part of the acquirer and the acquirer is not obligated to incur the associated costs, the costs do not meet the definition of a liability and are not recognized at the acquisition date. Rather, the costs will be recognized in postcombination financial statements in accordance with ASC 420.
Boundaries of the exchange transaction. Preexisting relationships and arrangements often exist between the acquirer and acquiree prior to beginning negotiations to enter into a business combination. Furthermore, while conducting the negotiations, the parties may enter into separate business arrangements. In either case, the acquirer is responsible for identifying amounts that are not part of the exchange for the acquiree. Recognition under the acquisition method is only given to the consideration transferred for the acquiree and the assets acquired and liabilities assumed in exchange for that consideration. Other transactions outside the scope of the business combination are to be recognized by applying other relevant GAAP.
The acquirer is to analyze the business combination transaction and other transactions with the acquiree and its former owners to identify the components that comprise the transaction in which the acquirer obtained control over the acquiree. This distinction is important to ensure that each component is accounted for according to its economic substance, irrespective of its legal form.
The imposition of this condition was based on an observation that, upon becoming involved in negotiations for a business combination, the parties may exhibit characteristics of related parties. In so doing, they may be willing to execute agreements designed primarily for the benefit of the acquirer of the combined entity that might be designed to achieve a desired financial reporting outcome after the business combination has been consummated. Thus, the imposition of this condition is expected to curb such abuses.
In analyzing a transaction to determine inclusion or exclusion from a business combination, consideration should be given to which of the parties will reap its benefits. If a precombination transaction is entered into by the acquirer, or on behalf of the acquirer, or primarily to benefit the acquirer (or to benefit the to-be-combined entity as a whole) rather than for the benefit of the acquiree or its former owners, the transaction most likely would be considered to be a “separate transaction” outside the boundaries of the business combination and for which the acquisition method would not apply.
The acquirer should consider the following factors, which FASB indicates “are neither mutually exclusive nor individually conclusive,” in determining whether a transaction is a part of the exchange transaction or recognized separately:
(ASC 805-10-55-18)
ASC 805 provides the following presumption after analyzing the economic benefits of a precombination transaction:
Primarily for the benefit of | Transaction is likely to be |
Acquirer or combined entity | Separate transaction |
Acquiree or its former owners | Part of the business combination |
ASC 805 provides three examples of separate transactions that are not to be included in applying the acquisition method, each of which will be discussed in further detail:
Acquisition-related costs. Acquisition-related costs are charged to expense of the period in which the costs are incurred and the related services received. Examples of these costs include
Accounting fees | Internal acquisitions department |
Advisory fees | Legal fees |
Consulting fees | Other professional fees |
Finder's fees | Valuation fees |
ASC 805 makes an exception to the general rule with respect to costs to register and issue equity or debt securities. These costs are to be recognized in accordance with other applicable GAAP. Stock issuance costs are normally charged against the gross proceeds of the issuance. Debt issuance costs are, under CON 6, either to be treated as a reduction of the amount borrowed or treated as an expense of the period in which they are incurred; however, some reporting entities have treated these costs as deferred charges and amortized them to income during the term of the debt.
Settlements of preexisting relationships between acquirer and acquiree. Prior to pursuing a business combination, business may have been transacted between the parties. The nature of the transactions may have been contractual, such as the purchase of goods and/or services, or the licensing of intellectual property. On the other hand, the parties may have had an adversarial relationship whereby they were plaintiff and defendant in pending litigation. If, in effect, a business combination settles such a preexisting relationship, the acquirer recognizes a gain or loss measured in the following manner:
If 2b is less than 2a, the difference is included as part of the accounting for the business combination.
In determining whether a contract is favorable or unfavorable to a party, the terms of the contract are compared to current market terms. It is important to note that a contract can be unfavorable to the acquirer and yet not result in a loss.
The amount of the gain or loss measured as a result of settling a preexisting relationship will, of course, depend on whether the acquirer had previously recognized related assets or liabilities with respect to that relationship.
Contingent payments to employees or former owners of the acquiree. The acquirer assesses whether arrangements to make contingent payments to employees or selling owners of the acquiree represent contingent consideration that is part of the business combination transaction or represent separate transactions to be excluded from the application of the acquisition method to the business combination. In general, the acquirer considers:
When those considerations do not provide clarity regarding whether the transaction is separate from the business combination, the acquirer considers the following indicators:
To facilitate the combined entity's future application of GAAP in its postcombination financial statements, management is required to make decisions on the acquisition date relative to the classification or designation of certain items. These decisions are based on contractual terms, economic and other conditions, and the acquirer's operating and accounting policies as they exist on the acquisition date. Examples include, but are not limited to, the following:
In applying Step 4, specific exceptions are provided for lease contracts and insurance contracts. Generally, these contracts are classified by reference to the contractual terms and other factors that were applicable at their inception rather than at the acquisition date. If, however, the contracts were modified subsequent to inception and those modifications would change their classification at that date, then the accounting for the contracts is determined by the modification date facts and circumstances. Under these circumstances, the modification date could be the same as the acquisition date.
In general, the acquirer measures the identifiable tangible and intangible assets acquired, liabilities assumed, and, if applicable, noncontrolling interest at fair value on the acquisition date. The following guidance is followed in applying the recognition and measurement principles (subject to certain specified exceptions).
Operating leases. Irrespective of whether the acquiree is the lessee or lessor, the acquirer evaluates, as of the acquisition date, each of the acquiree's operating leases to determine whether its terms are favorable or unfavorable compared to the market terms of leases of identical or similar items. If the lease terms are favorable, the acquirer recognizes an intangible asset; if the lease terms are unfavorable, the acquirer recognizes a liability.
Even when the lease is considered to be at market terms, there nevertheless may be an identifiable intangible associated with it. This would be the case if market participants would be willing to pay to obtain it (i.e., to obtain the rights and privileges associated with it). Examples of this situation are leases for favorably positioned airport gates, and prime retail space in an economically favorable location. If, from the perspective of marketplace participants, acquiring the lease would entitle them to future economic benefits that qualify as identifiable intangible assets (discussed later in this chapter), the acquirer would recognize, separately from goodwill, the associated identifiable intangible asset.
Operating lease assets owned by an acquiree/lessor. The fair value of assets owned by the acquiree that are subject to operating leases with the acquiree being the lessor are measured separately from the underlying lease to which they are subject.
Assets with uncertain cash flows. Since fair value measurements take into account the effects of uncertainty regarding the amounts and timing of future cash flows, the acquirer does not recognize a separate valuation allowance for assets subject to such uncertainties.
Assets the acquirer plans to idle or to use in a manner that is not their highest and best use. The measurement of the identifiable assets acquired at fair value is to be made in accordance with the requirements of ASC 820. One of those requirements is that the measurement is to assume the highest and best use of the asset by market participants. In applying this requirement to assets that are acquired in a business combination, this assumption is to be used even if it differs from the manner in which the acquiree was using the assets or the manner in which the acquirer intends to use the assets. Thus, even if the acquirer intends to protect its competitive position or for other business reasons to idle an acquired asset or use it in a manner that is not its highest and best use, the acquirer is still required to initially measure the fair value of that asset using the assumption of its highest and best use and to continue to use that assumption for the purposes of subsequently testing the asset for impairment. (ASC 805-20-30-6)
Identifiable intangibles are recognized separately from goodwill. ASC 350 addresses the accounting for all intangibles and how to distinguish between separately identifiable intangibles having finite lives, those having indefinite lives, and goodwill, which is unique in being “unidentifiable” and having an indeterminate life (which makes periodic amortization impossible, in the FASB's view). CON 5, Recognition and Measurement in Financial Statements of Business Enterprises, states that an asset is recognized if it meets the definition of an asset (found in CON 6, Elements of Financial Statements), has a relevant attribute measurable with sufficient reliability, and the information about it is representationally faithful, verifiable, neutral (i.e., it is reliable), and capable of making a difference in user decisions (i.e., it is relevant). In a business acquisition, any acquired identifiable intangible asset (e.g., patents, customer lists, etc.) must be recognized separately from goodwill when it meets these CON 5 asset recognition criteria, and additionally meets either of the following two criteria:
ASC 805-20-55 contains a listing of intangible assets that FASB believes have characteristics that meet one of these two criteria (legal/contractual or separability). A logical approach in practice would be for the acquirer to first consider whether the intangibles specifically included on the FASB list are applicable to the particular acquiree and then to consider whether there may be other unlisted intangibles included in the acquisition that meet one or both of the criteria for separate recognition.
ASC 805-20-55 organizes groups of identifiable intangibles into categories related to or based on:
These categorizations are somewhat arbitrary. Consequently, some of the items listed could fall into more than one of the categories. All intangible assets acquired—whether singly, in groups, or as part of a business combination—are initially recognized and measured based on their respective fair values. Under the provisions of ASC 350, serious effort must be directed to identifying the various intangibles acquired, thus minimizing the amount of goodwill to be recognized.
Examples of identifiable intangibles included in each of the categories are as follows:
One commonly cited intangible asset deliberately omitted by the FASB from its list of identifiable intangibles is an assembled workforce. FASB decided that the replacement cost technique that is often used to measure the fair value of an assembled workforce is not a representationally faithful measure of the fair value of the intellectual capital acquired. It was thus decided that an exception to the recognition criteria would be made, and that the fair value of an acquired assembled workforce would remain part of goodwill.
Useful economic life. Reliably measurable identifiable intangible assets, with the exception of those meeting the criteria for nonamortization (explained below), must be amortized over their respective useful economic lives. Useful economic life is the period over which the asset is expected to contribute (whether directly or indirectly) to cash flows into the entity. Factors to be considered in estimating the useful economic life of an intangible asset to an enterprise include:
In those instances where an intangible asset is determined to have an indefinite useful economic life, it will not be amortized until its life is determined to be finite at a later date. An example of such an asset would be a broadcast license, expiring in five years, but which may be renewed indefinitely at little cost. If the acquirer intends to renew the license indefinitely, and there is evidence to support its ability to do so, and the cash flows related to that license are expected to continue indefinitely, then no amortization would be recognized until such time as these criteria are no longer met.
Residual value. Typically, the entire fair value assigned to an intangible asset will be subject to amortization, although in some instances a residual value may be determined, which reduces the asset's amortizable basis. The residual value of an amortizable intangible is assumed to be zero unless the useful life to the acquiring enterprise is shorter than the intangible asset's useful economic life, and either (1) the acquiring enterprise has a commitment from a third party to purchase the asset at the end of its useful life, or (2) the residual value can be determined by reference to an observable market for that asset and that market is expected to exist at the end of the asset's useful life. The method of amortization is to reflect the pattern in which the economic benefits of the intangible asset are to be consumed; absent the ability to ascertain this, straight-line amortization is applied. However, if impairment (determined by application of the ASC 360 criteria) is later determined to have occurred, the carrying amount will be written down to the impaired amount.
Research and development assets. ASC 805 requires the acquirer to recognize and measure all tangible and intangible assets used in research and development (R&D) activities acquired individually or in a group of assets as part of the business combination. This prescribed treatment is to be followed even if the assets are judged to have no alternative future use. These assets are measured at their acquisition-date fair values. Fair value measurements, consistent with ASC 820, must be made based on the assumptions that would be made by market participants in pricing the asset. Assets that the acquirer does not intend to use or intends to use in a manner that is not their highest and best use are, nevertheless, required to be measured at fair value.
Intangible R&D assets. Upon initial recognition, the intangible R&D assets are classified as indefinite-lived assets until the related R&D efforts are either completed or abandoned. In the reporting periods during which the R&D intangible assets are classified as indefinite-lived, they are not amortized. Instead, they are tested for impairment in the same manner as other indefinite-lived intangibles. Upon completion or abandonment of the related R&D efforts, management determines the remaining useful life of the intangibles and amortize them accordingly. In applying these requirements, assets that are temporarily idled are not to be considered abandoned.
Tangible R&D assets. Tangible R&D assets acquired in a business combination are accounted for according to their nature (e.g., supplies, inventory, depreciable assets).
Exceptions to the recognition and/or measurement principles. ASC 805 provides certain exceptions to its general principles for recognizing assets acquired and liabilities assumed at their acquisition date fair values. These can be summarized as follows:
Nature of exception | Recognition | Measurement |
1. Assets held for sale | x | |
2. Contingent assets and liabilities of the acquiree | x | x |
3. Indemnification assets | x | x |
4. Reacquired rights | x | |
5. Employee benefits | x | x |
6. Share-based payment awards | x | |
7. Income taxes | x | x |
In postacquisition periods, long-lived assets classified as held for sale are not to be depreciated or amortized. If the assets are part of a disposal group, interest and other expenses related to the liabilities included in the disposal group are to continue to be accrued.
In determining fair value less cost to sell, it is important to differentiate costs to sell from expected future losses associated with the operation of the long-lived asset or disposal group to which it belongs.
Costs to sell are defined as the incremental direct costs necessary to transact a sale. To qualify as costs to sell, the costs must result directly from the sale transaction, incurring them needs to be considered essential to the transaction, and the costs would not have been incurred by the entity absent the decision to sell the assets. Examples of costs to sell include brokerage commissions, legal fees, title transfer fees, and closing costs necessary to effect the transfer of legal title. Costs to sell are expressly not permitted to include any future losses expected to result from operating the assets (or disposal group) while it is classified as held for sale. If the expected timing of the sale exceeds one year from the date of the statement of financial position, which is permitted in limited situations by ASC 360-10-45, the costs to sell are to be discounted to their present value.
If a loss is recognized in subsequent periods because of declines in the fair value less cost to sell, such losses are permitted to be restored by future periods' gains only to the extent to which the losses have been recognized cumulatively from the date the asset (or disposal group) was classified as held for sale.
Acquisition-date considerations. To determine whether to recognize a contingent asset or liability of the acquiree, the acquirer is to evaluate information available during the measurement period about the facts and circumstances as they existed at the measurement date. As a result of that evaluation, the acquirer is to conclude as to whether or not the acquisition-date fair value (ADFV) of a contingent asset acquired or contingent liability assumed can be determined during the measurement period.
The acquirer is required, however, to initially recognize the ADFV of any preexisting contingent consideration arrangements of the acquiree that the acquirer assumes in the business combination.
Postacquisition considerations. Management of the acquirer is to develop a “systematic and rational” basis for subsequently measuring and accounting for assets and liabilities arising from contingencies based on the nature of the contingency.
With respect to contingent consideration arrangements of the acquiree that are assumed by the acquirer in the business combination, these are subsequently accounted for in the same manner as contingent consideration arrangements entered into between the acquirer and acquiree as a part of the business combination:
Acquisition-date considerations. ASC 805 requires the acquirer to recognize and measure the indemnification asset using the same measurement basis it uses to measure the indemnified obligation.
In measuring an indemnification asset, management is to take into account any uncertainty in the amounts or timing of expected future cash flows. If the asset is measured at acquisition-date fair value, those effects are included in the measure of fair value and, therefore, a separate valuation allowance is not recognized.
Some indemnifications relate to assets or liabilities that are exceptions to the recognition or measurement principles. Indemnifications may, for example, be related to contingencies that do not meet the previously discussed criteria for recognition in the acquisition-date financial statements. Other indemnifications may be related to uncertain income tax positions that are measured, under ASC 740, as the maximum amount that is estimated to be more likely than not of being sustained upon examination by the relevant taxing jurisdiction. In cases such as these, the indemnification asset is to be recognized and measured using assumptions consistent with those used to measure the item being indemnified. Since uncertainty with respect to the collectibility of the indemnification asset is not directly included in its measurement, collectibility is considered separately and, to the extent necessary, reflected in a valuation allowance to reduce the carrying amount of the indemnification asset.
Postacquisition considerations. At each reporting date subsequent to the acquisition date, the acquirer is to measure an indemnification asset recognized as part of the business combination using the same basis as the indemnified item, subject to any limitations imposed contractually on the amount of the indemnification. If an indemnification asset is not subsequently measured at fair value (because to do so would be inconsistent with the basis used to measure the indemnified item), management is to assess the collectibility of the asset and, to the extent necessary, a valuation allowance should be established or adjusted. An indemnification asset is derecognized only when the asset is collected, the rights to receive the asset are sold, or the acquirer otherwise loses its right to receive it.
Acquisition-date considerations. Upon consummation of the business combination, the acquirer may reacquire a previously granted right. Upon reacquisition, the acquirer is to account for the right as an identifiable, amortizable intangible asset separate from goodwill.
If the terms of the contract that give rise to the reacquired right are either favorable or unfavorable to the acquirer compared to current market transactions for identical or similar rights, the acquirer is to recognize a gain or loss computed as the lesser of:
If item b is less than item a, the difference is to be included as part of the accounting for the business combination.
Postacquisition considerations. Reacquired rights recognized at the acquisition date are amortized, postcombination, on the basis of the remaining, unexpired term of the related contract. The remaining contractual term is to be used for this purpose even if market participants would consider potential future contract renewals in determining the fair value of the contract.
Should the acquirer subsequently sell the reacquired right to a third party, the carrying amount of the intangible asset is to be included in the determination of gain or loss on the sale.
Types of benefits | Applicable GAAP |
Deferred compensation contracts including postretirement benefit aspects of split-dollar life insurance arrangements | ASC 710-10-25 ASC 715-60 |
Compensated absences and sabbatical leaves | ASC 710-10-15 ASC 710-10-25 |
Pensions, plan curtailments, and termination benefits | ASC 715-30 ASC 715-20 |
Postretirement benefits other than pensions, including postretirement benefit aspects of split-dollar life insurance arrangements | ASC 715-60 ASC 715-20 |
Postemployment benefits (benefits provided to inactive or former employees, their beneficiaries, and covered dependents after employment but before retirement) including, but not limited to:
|
ASC 712 |
Onetime termination benefits | ASC 420 |
In researching the application of these pronouncements, it is important to consider the changes to them made by ASC 805. For example:
The discussion that follows uses concepts and terminology from ASC 718, Compensation—Stock Compensation.
If the acquirer is not obligated to replace the acquiree awards, all of the fair-value-based measure (FVBM)4 of the replacement awards is recognized as compensation cost in the postcombination financial statements.
Acquirer obligated to replace acquiree awards. If the acquirer is obligated to replace the awards of the acquiree, either all or a portion of the FVBM of the replacement awards is included in measuring the consideration transferred by the acquirer in the business combination. To the extent a portion of the replacement awards is not allocated to consideration transferred, it is accounted for as compensation for postcombination services in the acquirer's consolidated financial statements.
For the purposes of illustrating the allocation computations, the following conventions and abbreviations are used:
FVBMRA | Acquisition date fair-value-based measure of acquirer replacement award |
FVBMAA | Acquisition date fair-value-based measure of acquiree award that is being replaced by the acquirer |
RSPAA | Original requisite service period 5 of acquiree awards at their grant date |
RSPRA | Requisite service period of the acquirer replacement awards at acquisition date |
CRSPAA | Portion of requisite service period completed at the acquisition date by employees under the acquiree awards |
TSP | Total service period—the service period already satisfied by the employees at the acquisition date under the acquiree awards plus the requisite service period, if any, required by the acquirer replacement awards |
PRE | Portion of FVBMRA attributable to precombination services performed by the employees of the acquiree |
PCC | Postcombination compensation cost |
TSP = CRSPAA + RSPRA
The following steps are followed to determine the portion of the FVBM of the replacement award to be included as part of the consideration transferred by the acquirer:
PCC = FVBMRA – PRE
This amount is to be recognized as compensation cost in the postcombination financial statements since, at the acquisition date, the requisite service conditions had not been met.
The following examples are adapted from the implementation guidance for ASC 805.
Although not illustrated in the preceding examples, ASC 805 requires the acquirer to estimate the number of its replacement awards for which the requisite service is expected to occur. To the extent that service is not expected to occur due to employees terminating prior to meeting the replacement award's requisite service requirements, the portion of the FVBM of the replacement awards included in consideration transferred in the business combination is reduced accordingly.
If the replacement award is subject to a graded vesting schedule, the acquirer is to recognize the related compensation cost in accordance with its policy election for other awards in accordance with ASC 718-10-35. Compensation cost is either:
If option (2) is elected, compensation cost at any date must equal at least the amount attributable to options that actually vested on or before that date.
Finally, it is important to note that the same requirements for apportioning the replacement award between precombination and postcombination service apply to replacement awards that are classified as equity or as liabilities. All post-acquisition-date changes in the FVBM of liability awards (and their related income tax effects) are recognized in the acquirer's postcombination financial statements in the periods in which the changes occur.
The remainder of this section is devoted to describing the provisions of those standards and other related interpretive guidance related to accounting for income taxes in connection with business combinations.
Basic principle. The basic principle that applies to income tax accounting in a business combination (carried forward without change by ASC 805) is that the acquirer is to recognize, as of the acquisition date, deferred income tax assets or liabilities for the future effects of temporary differences and carryforwards of the acquiree that either:
ASC 805 also clarifies ASC 740's applicability to business combinations as follows:
Valuation allowances. To the extent applicable, deferred income tax assets are to be reduced by a valuation allowance for the portion of the asset not deemed MLTN to be realized.
On the acquisition date, any benefits of future deductible temporary differences or net operating loss carryforwards (NOLs) of an acquired entity are to be recognized if the acquirer is permitted to utilize those benefits on a consolidated income tax return under the existing income tax law. The income tax benefits will be recorded gross with an offsetting valuation allowance if it is more likely than not that the deferred income tax asset will not be realized by the reporting entity (for example, if it is estimated that there will not be sufficient future taxable income to utilize the NOL prior to its expiration).
Some jurisdictions restrict the future use of income tax benefits of the acquiree and only permit those benefits to be applied to subsequent taxable income generated by the acquiree even though the entities are permitted to file a consolidated income tax return. When this is the case, or when the acquiree is expected to file a separate income tax return, management of the consolidated reporting entity is to assess the need for a valuation allowance for those benefits based only on the acquiree's separate past and expected future taxable income.
As a result of the acquisition and the permissibility of filing a consolidated income tax return in a particular jurisdiction, the acquirer may be able to use future taxable income generated by the acquiree to obtain the tax benefits of its own NOLs for which the acquirer had previously recognized a valuation allowance. If, based on the weight of available evidence, management of the acquirer concludes that its previously recognized valuation allowance can be reduced or eliminated, the adjustment is not considered part of the accounting for the business combination. Instead, the benefit is recognized as a component of income tax expense in the period of the acquisition.
Post-acquisition-date changes in a valuation allowance with respect to an acquiree's deferred income tax asset are to be recognized as follows:
Goodwill. Historically, amortization of goodwill was not an allowable deduction for US federal income tax purposes. To the extent that goodwill amortization is nondeductible in any applicable taxing jurisdiction, the nondeductible goodwill does not represent a temporary difference between GAAP and tax and consequently does not give rise to deferred income taxes.
The 1993 Tax Reconciliation Act amended US federal income tax law to permit the amortization of goodwill and other specified acquired intangibles over a statutory 15-year period (IRC §197). The method of determining the amount of goodwill to recognize for income tax purposes, however, differs from the method prescribed by ASC 805 for financial reporting purposes. Further complicating matters, other taxing jurisdictions to which the reporting entity is subject may not recognize goodwill amortization as deductible. This can result in onerous recordkeeping of book/tax differences in the carrying amounts of goodwill in each of the major jurisdictions in which the reporting entity is taxed.
When goodwill amortization is tax-deductible in a particular jurisdiction, it does result in a temporary difference between the income tax basis and GAAP carrying amount of the goodwill. GAAP goodwill is only written off if it becomes partially or fully impaired whereas tax goodwill is subject to periodic amortization until its income tax basis is reduced to zero.
Since goodwill represents a residual amount after considering all identifiable assets acquired and liabilities assumed in the business combination, any deferred income tax asset associated with goodwill would necessarily have to be computed in order to determine the residual. Thus, FASB prescribed the use of a simultaneous equation method to compute goodwill net of the deferred income tax asset associated with it. To operationalize this requirement, ASC 805-74-55 describes and illustrates it.
The term noncontrolling interest replaces the term minority interest to refer to the portion of the acquiree, if any, that is not controlled by the parent. The term “minority interest” had become, in some cases, an inaccurate descriptor, because under ASC 805 and ASC 810, an entity can possess a controlling financial interest in another entity without possessing a majority of the voting interests of that entity. Thus it would be inaccurate, in many cases, to refer to the party that does not possess a controlling financial interest as a “minority,” since that party could, in fact, hold a majority of the voting equity of the acquiree.
ASC 805 requires the noncontrolling interest in the acquiree to be measured at fair value on the basis of a quoted price in an active market at the acquisition date. If the acquirer is not acquiring all of the shares in the acquiree and there is an active market for the remaining outstanding shares in the acquiree, the acquirer may be able to use the market price to measure the fair value of the noncontrolling interest. Otherwise, the acquirer would measure fair value using other valuation techniques.
In applying the appropriate valuation technique to determine the fair value of the noncontrolling interest, it is likely that there will be a difference in the fair value per share of that interest and the fair value per share of the controlling interest. This difference arises from what has been referred to as a “minority interest discount” applicable to the noncontrolling shares. Obviously, an investor would be unwilling to pay the same amount per share for equity shares in an entity that did not convey control of that entity than it would pay for shares that did convey control. (ASC 805-20-6 through 8)
In general, consideration transferred by the acquiree is measured at its acquisition-date fair value. Examples of consideration that could be transferred include cash, other assets, a business, a subsidiary of the acquirer, contingent consideration, common or preferred equity instruments, options, and warrants. The aggregate consideration transferred is the sum of the following elements measured at the acquisition date:
To the extent the acquirer transfers consideration in the form of assets or liabilities with carrying amounts that differ from their fair values at the acquisition date, the acquirer is to remeasure them at fair value and recognize a gain or loss on the acquisition date. If, however, the transferred assets or liabilities remain within the consolidated entity postcombination with the acquirer retaining control of them, no gain or loss is recognized, and the assets or liabilities are measured at their carrying amounts to the acquirer immediately prior to the acquisition date. This situation can occur, for example, when the acquirer transfers assets or liabilities to the entity being acquired rather than to its former owners.
The structure of the transaction may involve the exchange of equity interests between the acquirer and either the acquiree or the acquiree's former owners. If the acquisition-date fair value of the acquiree's equity interests is more reliably measurable than the equity interests of the acquirer, the fair value of the acquiree's equity interests is used to measure the consideration transferred.
Contingent consideration. Contingent consideration arrangements in connection with business combinations can be structured in many different ways and can result in the recognition of either assets or liabilities under ASC 805. In either case, the acquirer is to include contingent assets and liabilities as part of the consideration transferred, measured at acquisition-date fair value.
If the contingent consideration includes a future payment obligation, that obligation is to be classified as either a liability or equity under the provisions of:
The acquirer is to carefully consider information obtained subsequent to the acquisition-date measurement of contingent consideration. Additional information obtained during the measurement period that relates to the facts and circumstances that existed at the acquisition date result in measurement period adjustments to the recognized amount of contingent consideration and a corresponding adjustment to goodwill or gain from bargain purchase. Changes that result from events occurring after the acquisition date, such as meeting a specified earnings target, reaching a specified share price, or reaching an agreed-upon milestone on a research and development project, do not constitute measurement period adjustments. Changes in the fair value of contingent consideration that do not result from measurement period adjustments are to be accounted for as follows:
The last step in applying the acquisition method is the measurement of goodwill or a gain from a bargain purchase. Goodwill represents an intangible that is not specifically identifiable. It results from situations when the amount the acquirer is willing to pay to obtain its controlling interest exceeds the aggregate recognized values of the net assets acquired, measured following the principles of ASC 805. Goodwill's elusive nature as an unidentifiable, residual asset means that it cannot be measured directly but rather can only be measured by reference to the other amounts measured as a part of the business combination:
GW | = | Goodwill |
NG | = | Negative goodwill |
NI | = | Noncontrolling interest in the acquiree, if any, measured at fair value |
CT | = | Consideration transferred, generally measured at acquisition-date fair value |
PE | = | Fair value of the acquirer's previously held interest in the acquiree if the acquisition was achieved in stages |
NA | = | Net assets acquired at the acquisition date—consisting of the identifiable assets acquired and liabilities assumed, measured as described in this chapter |
(CT + NI + PE) – NA = GW or (NG) |
Thus, when application of the formula yields an excess of the consideration transferred, noncontrolling interest, and fair value of previously held interests over the net assets acquired, the acquirer has paid a premium for the acquisition and that premium is characterized as goodwill.
When the opposite is true, that is, when the formula yields a negative result, sometimes referred to as negative goodwill, the acquirer has, in fact, obtained a bargain purchase, as the value the acquirer obtained in the exchange exceeded the fair value of what it surrendered.
In a business combination in which no consideration is transferred, the acquirer is to use one or more valuation techniques to measure the acquisition-date fair value of its interest in the acquiree and substitute that measurement in the formula for CT, the consideration transferred. The techniques selected require the availability of sufficient data to properly apply them and are to be appropriate for the circumstances. If more than one technique is used, management of the acquirer is to evaluate the results of applying the techniques including the extent of data available and how relevant and reliable the inputs (assumptions) used are. Guidance on the use of valuation techniques is provided in ASC 820.
Bargain purchases. If the computation above results in negative goodwill, this constitutes a bargain purchase. Under ASC 805, a bargain purchase is recognized in net income as an acquisition-date gain. The gain is not characterized as an extraordinary gain. Rather, it is considered part of income from continuing operations.
Given the complexity of the computations involved, FASB prescribes a verification protocol for management to follow if the computation preliminarily results in a bargain purchase. If the computation initially yields a bargain purchase, management of the acquirer is to perform the following procedures before recognizing a gain on the bargain purchase:
Measurement period. More frequently than not, management of the acquirer does not obtain all of the relevant information needed to complete the acquisition-date measurements in time for the issuance of the first set of interim or annual financial statements subsequent to the business combination. If the initial accounting for the business combination has not been completed by that time, the acquirer is to report provisional amounts in the consolidated financial statements for any items for which the accounting is incomplete. ASC 805 provides for a “measurement period” during which any adjustments to the provisional amounts recognized at the acquisition date are to be retrospectively adjusted to reflect new information that management obtains regarding facts and circumstances existing as of the acquisition date. Information that has a bearing on this determination must not relate to postacquisition events or circumstances. The information is to be analyzed to determine whether, if it had been known at the acquisition date, it would have affected the measurement of the amounts recognized as of that date.
In evaluating whether new information obtained is suitable for the purpose of adjusting provisional amounts, management of the acquirer is to consider all relevant factors. Critical in this evaluation is the determination of whether the information relates to facts and circumstances as they existed at the acquisition date or instead, the information results from events occurring after the acquisition date. Relevant factors include:
Obviously, information received shortly after the acquisition date has a higher likelihood of relevance to acquisition-date circumstances than information received months later.
In addition to adjustments to provisional amounts recognized, the acquirer may determine during the measurement period that it omitted recognition of additional assets or liabilities that existed at the acquisition date. During the measurement period, any such assets or liabilities identified are also to be recognized and measured on a retrospective basis.
In determining adjustments to the provisional amounts assigned to assets and liabilities, management should be alert for interrelationships between recognized assets and liabilities. For example, new information that management obtains that results in an adjustment to the provisional amount assigned to a liability for which the acquiree carries insurance could also result in an adjustment, in whole or in part, to a provisional amount recognized as an asset representing the claim receivable from the insurance carrier. In addition, changes in provisional amounts assigned to assets and liabilities frequently will also affect temporary differences between the items' income tax basis and GAAP carrying amount, which in turn will affect the computation of deferred income assets and liabilities.
Adjustments to the provisional amounts that are made during the measurement period are recognized retrospectively as if the accounting for the business combination had actually been completed as of the acquisition date. This will result in the revision of comparative information included in the financial statements for prior periods including any necessary adjustments to depreciation, amortization, or other effects on net income or other comprehensive income related to the adjustments.
The measurement period ends on the earlier of:
After the end of the measurement period, the only revisions that are permitted to be made to the initial acquisition date accounting for the business combination are restatements for corrections of prior period errors in accordance with ASC 250, Accounting Changes and Error Corrections.
Due to the complexity of many business combinations and the varying structures used to effect them, ASC 805 provides supplemental guidance to aid practitioners in their application.
A step acquisition is a business combination in which the acquirer held an equity interest in the acquiree prior to the acquisition date on which it obtained control.
ASC 805 requires the acquirer to remeasure its previous holdings of the acquiree's equity at acquisition date fair value. Any gain or loss on remeasurement is recognized in earnings on that date.
If the acquirer had previously recognized changes in the carrying amount of the acquiree's equity in other comprehensive income (e.g., because the investment was classified as available for sale), that amount is to be reclassified and included in the computation of the acquisition date gain or loss from remeasurement.
Subsequent to a business combination, the parent may increase or decrease its ownership percentage in the acquiree/subsidiary, which may or may not affect whether the parent continues to control the subsidiary.
Changes not affecting control. The parent company may purchase or sell shares of the subsidiary after the acquisition date without affecting the determination that it controls the subsidiary. In addition, the subsidiary may issue new shares or repurchase some of its own shares as treasury stock or for retirement.
Changes in the parent's ownership interest that do not affect the determination that the parent retains a controlling financial interest in the subsidiary are accounted for as equity transactions with no gain or loss recognized in consolidated net income or in other comprehensive income. The carrying amount of the noncontrolling interest in the subsidiary is to be adjusted to reflect the change in ownership interest. Any difference between the fair value of the consideration received or paid in the transaction and the amount by which the noncontrolling interest is adjusted is to be recognized in equity attributable to the parent.
In the case of a subsidiary that has accumulated other comprehensive income (AOCI), if there is a change in the parent's ownership interest, the carrying amount of AOCI is to be adjusted through a corresponding charge or credit to equity attributable to the parent.
Changes resulting in loss of control. If a parent company ceases to have a controlling financial interest in a subsidiary, the parent is required to deconsolidate the subsidiary as of the date on which its control ceased. Examples of situations that can result in a parent being required to deconsolidate a subsidiary include:
If a parent effects a deconsolidation of a subsidiary through a nonreciprocal transfer to owners, such as through a spin-off transaction, the transaction is accounted for under ASC 845. Otherwise, the parent is to account for the deconsolidation by recognizing, in net income, a gain or loss attributable to the parent. The gain or loss is measured as follows:
FVCR | = | Fair value of consideration received, if any |
FVNIR | = | Fair value of any noncontrolling investment retained by the former parent at the deconsolidation date |
CVNI | = | Carrying value of the noncontrolling interest in the former subsidiary on the deconsolidation date, including any accumulated other comprehensive income attributable to the noncontrolling interest |
CVAL | = | Carrying value of the former subsidiaries assets and liabilities at the deconsolidation date. |
(FVCR + FVNIR + CVNI) – CVAL = Deconsolidation Gain (Loss) |
Should the parent's loss of controlling financial interest occur through two or more transactions, management of the former parent is to consider whether the transactions should be accounted for as a single transaction. In evaluating whether to combine the transactions, management of the former parent is to consider all of the terms and conditions of the transactions as well as their economic impact. The presence of one or more of the following indicators may lead to management concluding that it should account for multiple transactions as a single transaction:
Obviously, this determination requires the exercise of sound judgment and attention to economic substance over legal form.
This guidance does not apply to sales of real estate or the conveyance of oil and gas mineral rights. Refer to ASC 360-20 and 976-605 for the appropriate guidance for real estate, and to ASC 932-360 for oil and gas mineral rights.
In preparing consolidated financial statements, the parent eliminates 100% of the intercompany income or loss. This elimination is not affected by the existence of a noncontrolling interest since the consolidated financial statements purport to present the financial position and economic performance of a single economic entity. The elimination of the intercompany income or loss may be allocated between the parent and noncontrolling interests.
Revenues, expenses, gains, losses, net income or loss, and other comprehensive income are reported in the consolidated financial statements at the consolidated amounts that include amounts attributable to the owners of the parent company and the noncontrolling interest. Net income or loss, and other comprehensive income or loss, are allocated to the parent and the noncontrolling interest.
Losses allocated to the parent and to the noncontrolling interest may exceed their respective interests in the equity of the subsidiary. When this occurs, and if it continues to occur in subsequent periods, the excess as well as any further losses continue to be allocated to the parent and noncontrolling interest, even if this allocation results in a deficit balance in noncontrolling interest.
Under new basis (or push-down) accounting, the amounts allocated to various assets and liabilities can be adjusted to reflect the arm's-length valuation reflected in a significant transaction, such as the sale of a majority interest in the entity. For example, the sale of 90% of the shares of a company by one shareholder to a new investor—which under the entity concept would not alter the accounting by the company itself—would, under new basis accounting, be “pushed down” to the entity. The logic is that, as under accounting for business combinations, the most objective gauge of “cost” is that arising from a recent arm's-length transaction.
Traditionally, GAAP has not permitted new basis accounting, in part because of the practical difficulty of demonstrating that the reference transaction was indeed arm's-length in nature. (Obviously, the risk is that a series of sham transactions could be used to grossly distort the “cost” and hence carrying values of the entity's assets, resulting in fraudulent financial reporting.) Also heavily debated has been where the threshold should be set (a 50% change in ownership, an 80% change, etc.) to denote when a significant event had occurred that would provide valid information on the valuation of the entity's assets and liabilities for financial reporting purposes.
Many of the more general issues of push-down accounting (those applicable to traditional business acquisitions) have yet to be dealt with. For example, proponents of push-down accounting point out that in a business combination a new basis of accounting is established, and that this new basis should be pushed down to the acquired entity and should be used when presenting that entity's own, separate financial statements. However, practical problems remain: For example, while push-down makes some sense in the case where a major block of the investee's shares is acquired in a single free-market transaction, if new basis accounting were to be used in the context of a series of step transactions, continual adjustment of the investee's carrying values for assets and liabilities would be necessary. Furthermore, the price paid for a portion of the ownership of an investee may not always be meaningfully extrapolated to a value for the investee company as a whole.
The SEC's position (ASC 805-50-S99-2) has been that push-down accounting would be required if 95% or more of the shares of the company have been acquired (unless the company has outstanding public debt or preferred stock that may impact the acquirer's ability to control the form of ownership of the company); that it would be permitted, but not mandated, if 80% to 95% has been acquired; and it would be prohibited if less than 80% of the company is acquired. The SEC also requires push-down accounting if any entity becomes substantially wholly owned by a group of investors who act together, subject to several restrictions in ASC 805-50-S99-2 relating to such matters as their independence, risk of ownership, and subsequent collaboration.
While there is no requirement under GAAP to apply this push-down concept, the SEC position is considered to be substantial authoritative support and can be referenced even for nonpublic company financial reporting. It would be defensible in any instance where there is a change in control and/or a change in ownership of a majority of the common shares, when separate financial statements of the subsidiary are to be presented. Full disclosure is to be made of the circumstances whenever push-down accounting is applied.
The foregoing entry would only be made for purposes of preparing separate financial statements of Pushdown Co. If consolidated financial statements of Pullup Corp. are also presented, essentially the same result will be obtained. The additional paid-in capital account would be eliminated against the parent's investment account, however, since in the context of the consolidated financial statements this would be a cash transaction rather than a mere accounting revaluation.
There is also a body of opinion holding that the separate financial statements of Pushdown Co. in this example should be “grossed up” for the imputed premium that would have been achieved on the transfer of the remaining 10% ownership interest. This is less appealing, however, given the absence of a “real” transaction involving that last 10% ownership stake, making the price at which it would have traded somewhat speculative.
The foregoing example obviously also ignored the tax effects of the transaction. Since the step-ups in carrying value would not, in all likelihood, alter the corresponding tax bases of the assets and liabilities, deferred income tax effects would also require recognition. This would be done following the procedures set forth at ASC 740. See the chapter on ASC 740 for additional information.
Another complex issue that arises in practice is the determination of the appropriate accounting treatment for a leveraged buyout (sometimes referred to as a bootstrap transaction or simply abbreviated as an LBO).
An LBO results from a highly leveraged single transaction or series of transactions in which all of the previously outstanding common stock in a target entity, “OLDCO,” is acquired from the target's shareholders by “NEWCO,” a financial sponsor entity often organized as a private equity limited partnership.
The source of the financing for the LBO transaction is nonrecourse debt collateralized by the underlying assets of OLDCO, the acquiree. Thus, the acquiree's own assets provide the underlying collateral to enable the acquirer to execute the transaction. The postacquisition operating cash flows expected to be generated by the acquiree are intended to provide the funding necessary to meet the debt service requirements.
When an LBO meets its initial expectations, it can provide an attractive return on the relatively minimal initial investment required by the sponsor/acquirer's investors. However, when the acquiree's postacquisition financial performance falls short of expectations, the potential for a default on the acquisition indebtedness is substantial and the previously successful business that made the target company an attractive acquisition candidate can end up in bankruptcy reorganization or in outright liquidation.
At the center of the accounting issue is the question of whether a new basis of accounting has been created by the execution of the LBO transaction notwithstanding the fact that the change in ownership occurred outside of the target entity through the purchase of shares from the target's existing owners. Generally, under GAAP, such a transaction does not affect the reporting entity since that entity was not a party to the transaction.
However, it could be argued conceptually that the change in control of the target/acquiree is economically similar to the results that would be achieved if the sponsor/acquirer were to obtain control through a business combination transaction. Proponents of this economic substance over form argument hold that the execution of the LBO transaction would warrant a step-up in the reported amounts of the target/acquiree's assets and/or liabilities. If a step-up is not recognized, the carryforward bases of the predecessor entity assets and liabilities continue to be reported in its financial statements.
The Emerging Issues Task Force (EITF) had addressed leveraged buyouts in several pre-Codification Consensuses (EITF 88-16, Basis in Leveraged Buyout Transactions, and EITF 90-12, Allocating Basis to Individual Assets and Liabilities for Transactions within the Scope of Issue No. 88-16). However, both of these Consensuses were nullified in December 2007 by the issuance of FAS 141(R), Business Combinations, subsequently codified as Topic ASC 805.
Since FAS 141(R) was not required to be applied to transactions that preceded its effective date, the nullified EITF consensuses represent grandfathered guidance applicable to those transactions that were within their scope.
The EITF concluded that full or partial new basis accounting is appropriate only when the transaction results in a change in control of voting interests. EITF 88-16 established a series of mechanical tests by which this change in interest was to be measured. Three groups of interests were identified: (1) shareholders in the newly created company; (2) management; and (3) shareholders in the old company (who may or may not also have an interest in the new company). Depending upon the relative interests of these groups in the old entity (OLDCO) and in the new enterprise (NEWCO), there will be either (1) a finding that the transaction was a business combination (new basis accounting applies), or (2) a finding that it was a recapitalization or a restructuring (carryforward basis accounting applies).
Among the tests that the EITF decreed to determine proper accounting for any given LBO transaction is the monetary test. This test required that at least 80% of the net consideration paid to acquire OLDCO interests must have been monetary. In this context, monetary means cash, debt, and the fair value of any equity by securities given by NEWCO to selling shareholders of OLDCO. Loan proceeds provided OLDCO to assist in the acquisition of NEWCO shares by NEWCO shareholders were excluded from this definition. If the portion of the purchase effected through monetary consideration was less than 80%, but other criteria of EITF 88-16 were satisfied, there would be a step-up. This step-up was limited to the percentage of the transaction represented by monetary consideration.
EITF 88-16 presented an extensive series of examples illustrating the circumstances that would and would not meet the former purchase accounting criteria to be employed in an LBO.
A reverse acquisition is a stock transaction that occurs when one entity (the legal acquirer) issues so many of its shares to the former owners of another entity (the legal acquiree) that those former owners become the majority owners of the resultant consolidated enterprise. As a result of the transaction, the legal and accounting treatments will differ, with the legal acquiree being treated as the acquirer for financial reporting purposes. While often the legal acquirer will adopt the acquiree's name, thus alerting users of the financial statements to the nature of the organizational change, this does not necessarily occur, and, in any event, it is critical that the financial statements contain sufficient disclosure so that users are not misled. This is particularly important in the periods immediately following the transaction, and especially when comparative financial statements are presented that include periods prior to the acquisition, since comparability will be affected.
A typical reverse acquisition (see diagram on next page) involves a public company and a nonpublic operating company. The objective is for the nonpublic entity to “go public” without the usual time-consuming and expensive registration process involved in a formal initial public offering (IPO). However, reverse acquisitions are not limited to such situations, and such transactions have occurred involving two public or two nonpublic companies.
It had become popular for private companies to use this technique by locating a public shell (a publicly held company that is dormant or inactive) to serve as the legal acquirer/accounting acquiree. The staff of the SEC Division of Corporate Finance provided the following interpretive guidance in March 2001 that effectively ended the use of reverse acquisition accounting when a public shell is involved:
The merger of a private operating company into a nonoperating public shell corporation with nominal net assets typically results in the owners and management of the private company having actual or effective operating control of the combined company after the transaction, with shareholders of the former public shell continuing only as passive investors. These transactions are considered by the staff to be capital transactions in substance, rather than business combinations. That is, the transaction is equivalent to the issuance of stock by the private company for the net monetary assets of the shell corporation, accompanied by a recapitalization. The accounting is identical to that resulting from a reverse acquisition, except that no goodwill or other intangible should be recorded.7
In addition to the foregoing SEC guidance, ASC 805-40-25-1 imposed a requirement that, in transactions occurring after its effective date, the legal acquirer meet the definition of a business. Thus, the use of a public shell entity would not give rise to goodwill and should be accounted for as described in the SEC guidance.
The reverse acquisition is effected when the shareholders of the legal acquiree obtain control of the postacquisition consolidated enterprise, and most commonly this results from a stock-for-stock exchange. The public entity issues shares of newly registered common stock (the legal acquirer) to the shareholders of the nonpublic company in exchange for their ownership interests.
Based on the application of ASC 805-10-55-11 through 55-15, and as a result of the change in control effected by the exchange of stock, the legal acquiree entity is identified as the accounting acquirer of the legal acquirer/accounting acquiree.
Following a reverse acquisition, just as in any business combination, consolidated financial statements are to be presented. Although the financial statements will be identified as being those of the legal acquirer (which will be the legal owner of the legal acquiree), in substance these will be a continuation of the financial statements of the legal subsidiary/GAAP acquirer, with the assets, liabilities, revenues, and expenses of the legal acquirer being consolidated effective with the acquisition date. Put another way, the consolidated entity will be presented as a continuation of the business of the legal subsidiary, notwithstanding the formal structure of the transaction or the name of the successor enterprise.
Comparative financial statements for earlier periods, if presented, are to be consistent, meaning that in order for them to be comparable to the postacquisition financial statements, these would also need to represent the financial statements of the legal acquiree. Since in some instances the acquiree's name is different than that shown in the heading, care must be taken to fully communicate with the readers. The fact that the prior period's financial information, identified as being that of the legal parent, is really that of the legal acquiree is obviously extremely pertinent to a reader's understanding of the financial statements.
If the legal parent/accounting subsidiary does not change its name to that of the accounting parent, it is essential that the financial statement titles be captioned in a way that clearly communicates the substance of the transaction to the readers. For example, the statements may be headed “ABC Company, Inc.—successor to XYZ Corporation.”
Structure of Typical Reverse Acquisition
One adjustment to the financial statements is unique to a reverse acquisition. Management is to retroactively adjust the capital of the legal acquiree/GAAP acquirer to reflect the legal capital of the legal acquirer/GAAP acquiree. The adjustment is necessary in order for the consolidated statement of financial position to reflect the capital of the legal parent/GAAP subsidiary. Information presented for comparative purposes in the consolidated financial statements is also to be retroactively adjusted to reflect the legal parent's legal capital.
The consolidated financial statements present the continuation of the financial statements of the legal subsidiary with the exception of its capital structure. Thus, those postcombination consolidated financial statements will reflect, per ASC 805-40-45-2:
An issue that has concerned accountants and the SEC is the popularity of what have been called non-sub subsidiaries. This situation arises when an entity plays a major role in the creation and financing of what is often a start-up or experimental operation, but does not take an equity position at the outset. For example, the sponsor might finance the entity by means of convertible debt or debt with warrants entitling it to the later purchase of common shares. The original equity in such arrangements is often provided by the creative or managerial talent engaged in the new entity's operations, who generally exchange their talents for an equity interest. If the operation prospers, the sponsor will exercise its rights and obtain a majority voting stock position; if the operation fails, the sponsor presumably avoids reflecting the losses in its financial statements.
While this strategy may seem to avoid the requirements of equity method accounting or consolidation based on majority voting ownership, the economic substance of the arrangement clearly suggests that the operating results of the sponsored entity be reflected as a subsidiary in the consolidated financial statements of the sponsor who, in substance, is fulfilling the customary role of a parent, even absent ownership of voting stock.
The entities described above are often similar in structure and purpose to what were formerly called “special-purpose entities” or “special-purpose vehicles” and which have now been identified as “variable interest entities.”
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