ASC 805-10, Overall, which provides guidance on transactions accounted for under the acquisition method
ASC 852-20, Identifiable Assets and Liabilities, and Any Noncontrolling Interest, deals with specific aspects of the acquisition method
ASC 805-30, Goodwill or Gain from Bargain Purchase, Including Consideration Transferred, like ASC 805-20, 805-30 deals with specific aspects of the acquisition method
ASC 805-40, Reverse Acquisitions, provides guidance on business combinations that are reverse acquisitions
ASC 805-50, Related Issue, which offers guidance two items that are similar, but not the same, as a business combination: acquisition of assets and transactions between entities under common control
ASC 805-740, Income Taxes, which provides “incremental guidance” on business combinations or acquisitions by a not-for-profit entity.

Scope and Scope Exceptions

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:

Formation of a joint venture
Acquisition of an asset or group of assets that does not represent a business or a nonprofit activity
Combinations between entities or businesses under common control
An acquisition by a not-for-profit entity for which the acquisition date is before December 15, 2009, or a merger of not-for-profit entities (NFPs).

Overview

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 Financial Accounting Standards Board (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.

Under ASC 350, all business combinations, except for those involving not-for-profit entities and combinations of entities under common control (e.g., parent/subsidiary and brother/sister mergers), were required to be accounted for as purchases. Goodwill arising from earlier purchase business combinations already amortized was not to be restored, but the unamortized balance as of the effective date of the new standards was no longer subject to amortization. Poolings completed before the December 15, 2008 effective date of FAS 141, Business Combinations, did not, however, need to be restated—and, as a practical matter, developing fair value information about long-ago combinations accounted for as poolings would have been an impossible task.

While goodwill impairment must be regularly assessed, the actual application of ASC 350 results in recognizing goodwill created by the reporting entity subsequent to the purchase combination, to the extent that this replaces or offsets impaired goodwill, so in many cases impairments will not be recognized even when the value of the acquired operations has declined. This approach—which effectively reverses the longstanding ban on recognizing internally created (as opposed to purchased) goodwill—was necessitated by the virtual impossibility of separately identifying elements of goodwill having alternative derivations. Even with this simplified approach, measurement of goodwill impairment is a fairly complex task, often requiring the services of independent valuation consultants.

This chapter addresses in detail, the application of the acquisition method of accounting for business combinations, and the accounting for goodwill to a lesser extent.

DEFINITIONS OF TERMS

Source: ASC 805

Acquiree. The business or businesses that the acquirer obtains control of in a business combination. This term also includes a nonprofit activity or business that a not-for-profit acquirer obtains control of in an acquisition by a not-for-profit entity.

Acquirer. An entity that obtains control over one or more businesses in a business combination. When the acquiree is a variable interest entity (VIE), the primary beneficiary of the VIE is always the acquirer.

Acquisition by a not-for-profit entity. A transaction or other event in which a not-for-profit acquirer obtains control of one or more nonprofit activities or businesses and initially recognizes their assets and liabilities in the acquirer's financial statements. When applicable guidance in Topic 805 is applied by a not-for-profit entity, the term business combination has the same meaning as it has for a not-for-profit entity. Likewise, a reference to business combinations in guidance that links to Topic 805 has the same meaning as a reference to acquisitions by not-for-profit entities.

Acquisition date. The date on which control of the acquiree is obtained by the acquirer.

Business. An integrated set of assets and activities capable of being conducted and managed for the purpose of providing a return directly to investors or other owners, members, or participants. The return can be in the form of dividends, lower costs, or other economic benefits. A development stage enterprise (ASC 915) is not precluded from qualifying as a business under this definition and the guidance that accompanies it in ASC 805.

Business combination. A transaction or event that results in an acquirer obtaining control over one or more businesses. It is important to note that transactions that are sometimes referred to as “mergers of equals” or as “true mergers” are nevertheless considered to be business combinations with an acquirer and one or more acquirees.

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.

Defensive intangible asset. An acquired intangible asset in a situation in which an entity does not intend to actively use the asset but intends to hold (lock up) the asset to prevent others from obtaining access to the asset.

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.

Fair value. The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Goodwill. An asset representing the future economic benefits arising from other assets acquired in a business combination or an acquisition by a not-for-profit entity that are not individually identified and separately recognized. For ease of reference, this term also includes the immediate charge recognized by not-for-profit entities in accordance with ASC 958-805-25-29.

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.)

Intangible asset. A nonfinancial asset that lacks physical substance. (The term intangible assets is used to refer to intangible assets other than goodwill.)

Market participants. Buyers and sellers in the principal (or most advantageous) market for the asset or liability that have all of the following characteristics:

They are independent of each other, that is, they are not related parties, although the price in a related-party transaction may be used as an input to a fair value measurement if the reporting entity has evidence that the transaction was entered into at market terms
They are knowledgeable, having a reasonable understanding about the asset or liability and the transaction using all available information, including information that might be obtained through due diligence efforts that are usual and customary
They are able to enter into a transaction for the asset or liability
They are willing to enter into a transaction for the asset or liability, that is, they are motivated but not forced or otherwise compelled to do so.

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.

Noncontrolling interest. The equity or net assets in a subsidiary not directly or indirectly attributable to its parent. Noncontrolling interests were formerly referred to in accounting literature as minority interests.

Nonprofit activity. An integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing benefits other than goods or services at a profit or profit equivalent, as a fulfillment of an entity's purpose or mission (for example, goods or services to beneficiaries, customers, or members). As with a not-for-profit entity, a nonprofit activity possesses characteristics that distinguish it from a business or a for-profit business entity.

Not-for-profit entity. A legal entity that, in varying degrees, possesses the following characteristics that differentiate it from a business entity:

It receives significant amounts of resources in the form of contributions where the contributors do not expect a reciprocal monetary return,
It operates for purposes other than providing goods or services at a profit.
It does not have ownership interests similar to those of business entities.

Among the entities that are clearly not included in this definition are

All investor-owned entities
Entities that provide dividends, lower costs, or other economic benefits directly and proportionately to their owners, members, or participants, such as mutual insurance entities, credit unions, farm and rural electric cooperatives, and employee benefit plans.

See ASC 958-10-15 for a discussion of this definition and for application guidance.

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.

Public entity. A business entity or a not-for-profit entity that meets any of the following conditions:

It has issued debt or equity securities or is a conduit bond obligor for conduit debt securities that are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional markets),
It is required to file financial statements with the Securities and Exchange Commission (SEC),
It provides financial statements for the purpose of issuing any class of securities in a public market.

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.

Variable interest entity. A legal entity subject to consolidation according to the provisions of the Variable Interest Entities Subsections of Subtopic 810-10.

CONCEPTS, RULES, AND EXAMPLES

Transactions and Events Accounted for as Business Combinations

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:

Transfer of cash, cash equivalents, or other assets, including the transfer of assets of another business of the acquirer
Incurring liabilities
Issuance of equity instruments
Obtaining variable interests in an acquiree variable interest entity (VIE) that is a business, resulting in the acquirer becoming the VIE's primary beneficiary/parent, under the provisions of ASC 810,
By contract alone without the transfer of consideration, such as when
1. An acquiree business repurchases enough of its own shares to cause one of its existing investors (the acquirer) to obtain control over it
2. There is a lapse of minority veto rights that had previously prevented the acquirer from controlling an acquiree in which it held a majority voting interest
3. An acquirer and acquiree contractually agree to combine their businesses without a transfer of consideration between them.

Qualifying as a Business

ASC 805 substantively revised the previous 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 (as defined in the Master Glossary) from qualifying as a business. “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. Clarification is provided that, while outputs are usually present in a business, they are not required to qualify as a business as long as there is 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.

As discussed previously, development stage entities are not precluded from meeting the criteria to be a business. This is true even if they do not yet produce outputs. If there are no outputs being produced, the acquirer is to determine whether the enterprise constitutes a business by considering whether it:

Has started its planned principal activities,
Has hired employees,
Has obtained intellectual property,
Has obtained other inputs,
Has implemented processes that could be applied to its inputs,
Is pursuing a plan to produce outputs,
Will have the ability to obtain access to customers that will purchase the outputs.

It is important to note, however, that it is not required that all of these factors be present for a given set of development stage 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.

Techniques for Structuring Business Combinations

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:

One or more businesses become subsidiaries of the acquirer. As subsidiaries, they continue to operate as legal entities.
The net assets of one or more businesses are legally merged into the acquirer. In this case, the acquiree entity ceases to exist (in legal vernacular, this is referred to as a statutory merger and normally the transaction is subject to approval by a majority of the outstanding voting shares of the acquiree).
The owners of the acquiree transfer their equity interests to the acquirer entity or to the owners of the acquirer entity in exchange for equity interests in the acquirer.
All of the combining entities transfer their net assets (or their owners transfer their equity interests into a new entity formed for the purpose of the transaction). This is sometimes referred to as a roll-up or put-together transaction.
A former owner or group of former owners of one of the combining entities obtains control of the combined entities collectively.
An acquirer might hold a noncontrolling equity interest in an entity and subsequently purchase additional equity interests sufficient to give it control over the investee. These transactions are referred to as step acquisitions or business combinations achieved in stages.
A business owner organizes a partnership, S corporation, or LLC to hold real estate. The real estate is the principal location of the commonly owned business and that business entity leases the real estate from the separate entity.

Accounting for Business Combinations under the Acquisition Method

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:

Identify the acquirer.
Determine the acquisition date.
Identify the assets and liabilities, if any, requiring separate accounting because they result from transactions that are not part of the business combination, and account for them in accordance with their nature and the applicable GAAP.
Identify assets and liabilities that require acquisition date classification or designation decisions to facilitate application of GAAP in postcombination financial statements and make those classifications or designations based on (a) contractual terms, (b) economic conditions, (c) acquirer operating or accounting policies, and (d) other pertinent conditions existing at the acquisition date.
Recognize and measure the identifiable tangible and intangible assets acquired and liabilities assumed.
Recognize and measure any noncontrolling interest in the acquiree.
Measure the consideration transferred.
Recognize and measure goodwill or, if the business combination results in a bargain purchase, recognize a gain.

Step 1—Identify the acquirer.

ASC 805 strongly emphasizes the concept that every business combination has an acquirer. In the “basis for conclusions” that accompanies ASC 805, 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:

An entity that is in legal reorganization or bankruptcy
An entity subject to uncertainties due to government-imposed restrictions, such as foreign exchange restrictions or controls, whose severity casts doubt on the majority interest owner's ability to control the entity
If the acquiree is a variable interest entity (VIE), the primary beneficiary of the VIE is always considered to be the acquirer.

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:

Relative size—Generally, the acquirer is the entity whose relative size is significantly larger than that of the other entity or entities. Size can be compared by using measures such as assets, revenues, or net income.
Initiator of the transaction—When more than two entities are involved, another factor to consider (beside relative size) is which of the entities initiated the transaction.
Roll-ups or put-together transactions—When a new entity is formed to issue equity interests to effect a business combination, one of the preexisting entities is to be identified as the acquirer. If, instead, a newly formed entity transfers cash or other assets, or incurs liabilities as consideration to effect a business combination, that new entity may be considered to be the acquirer.
Nonequity consideration—In business combinations accomplished primarily by the transfer of cash or other assets, or by incurring liabilities, the entity that transfers the cash or other assets, or incurs the liabilities is usually the acquirer.
Exchange of equity interests—In business combinations accomplished primarily by the exchange of equity interests, the entity that issues its equity interests is generally considered to be the acquirer. One notable exception that occurs frequently in practice is sometimes referred to as a reverse acquisition, discussed in detail later in this chapter. In a reverse acquisition, the entity issuing equity interests is legally the acquirer, but for accounting purposes is considered the acquiree. There are, however, other factors that should be considered in identifying the acquirer when equity interests are exchanged. These include:
1. Relative voting rights in the combined entity after the business combination—Generally, the acquirer is the entity whose owners, as a group, retain or obtain the largest portion of the voting rights in the consolidated entity. This determination must take into consideration the existence of any unusual or special voting arrangements as well as any options, warrants, or convertible securities.
2. The existence of a large minority voting interest in the combined entity in the event no other owner or organized group of owners possesses a significant voting interest—Generally, the acquirer is the entity whose owner or organized group of owners holds the largest minority voting interest in the combined entity.
3. The composition of the governing body of the combined entity—Generally, the acquirer is the entity whose owners have the ability to elect, appoint, or remove a majority of members of the governing body of the combined entity.
4. The composition of the senior management of the combined entity—Generally the acquirer is the entity whose former management dominates the management of the combined entity.
5. Terms of the equity exchange—Generally, the acquirer is the entity that pays a premium over the precombination fair value of the equity interests of the other entity or entities.

Step 2—Determine the acquisition date.

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. Thus, in evaluating economic substance over legal form, the acquirer will have contractually acquired the target on the date it executed the contract.

Step 3—Identify assets and liabilities requiring separate accounting.

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. Under ASC 805, GAAP continues to permit recognition of acquired intangibles (e.g., patents, customer lists) that would not be granted recognition if they were internally developed.

The pronouncement elaborates on the basic principle by providing that recognition is subject to the following conditions:

At the acquisition date, the identifiable assets acquired and liabilities assumed must meet the definitions of assets and liabilities as set forth in CON 6.¹
The assets and liabilities recognized must be part of the exchange transaction between the acquirer and the acquiree (or the acquiree's former owners) and not part of a separate transaction or transactions.

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 is to 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:

Purpose of the transaction—Typically, there are many parties involved in the management, ownership, operation, and financing of the various entities involved in a business combination transaction. Of course, there are the acquirer and acquiree entities, but there are also owners, directors, management, and various parties acting as agents representing their respective interests. Understanding the motivations of the parties in entering into a particular transaction potentially provides insight into whether or not the transaction is a part of the business combination or a separate transaction.
Initiator of the transaction—Identifying the party that initiated the transaction may provide insight into whether or not it should be recognized separately from the business combination. FASB believes that if the transaction was initiated by the acquirer, it would be less likely to be part of the business combination and, conversely, if it were initiated by the acquiree or its former owners, it would be more likely to be part of the business combination.
Timing of the transaction—Examining the timing of the transaction may provide insight into whether, for example, the transaction was executed in contemplation of the future business combination in order to provide benefits to the acquirer or the postcombination entity. FASB believes that transactions that take place during the negotiation of the terms of a business combination may be entered into in contemplation of the eventual combination for the purpose of providing future economic benefits primarily to the acquirer of the to-be-combined entity and, therefore, should be accounted for separately.

ASC 805 provides the following presumption after analyzing the economic benefits of a precombination transaction:

images

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:

Reimbursement to the acquiree or its former owners for paying the acquirer's acquisition-related costs,
A settlement of a preexisting relationship between acquirer and acquiree, and
Compensation to employees or former owners of the acquiree for future services

Acquisition-related costs. In a departure from the previous US GAAP for business combinations, acquisition-related costs under ASC 805 are to be charged to expense of the period in which the costs are incurred and the related services received. Examples of these costs include

images

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, to be either 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 the relationship is noncontractual (e.g., litigation), measure at fair value
If the relationship is contractual, measure at the lesser of
1. The amount by which, from the acquirer's perspective, the contract is favorable or unfavorable, or
2. The amount of any settlement provisions stated in the contract that are available to the counterparty for which the contract is unfavorable.

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.

Example of settlement of preexisting contractual supplier relationship; contract unfavorable to acquirer

Meyer Corporation (MC) and Henning, Inc. (HI) are parties to a 3-year supply contract that contains the following provisions:

MC is required to annually purchase 3,000 flat-panel displays from HI at a fixed price of $400 per unit for an aggregate purchase price of $1,200,000 for each of the three years.
MC is required to pay HI the annual $1,200,000 irrespective of whether it takes delivery of all 3,000 units and the required payment is nonrefundable.
The contract contains a penalty provision that would permit MC to cancel it at the end of the second year for a lump sum payment of $500,000.
In each of the first two years of the contract, MC took delivery of the full 3,000 units.

At December 31, 2011, the supply contract was unfavorable to MC because MC would be able to purchase flat-panel displays with similar specifications and of similar quality from another supplier for $350 per unit. Therefore, in accordance with ARB 43, MC accrued a loss of $150,000 (3,000 units remaining under the firm purchase commitment × $50 loss per unit).

On January 1, 2012, MC acquires HI for $30 million, which reflects the fair value of HI based on what other marketplace participants would be willing to pay. On the acquisition date, the $30 million fair value of HI includes $750,000 related to the contract with MC that consists of

images

HI has no other identifiable assets or liabilities related to the supply contract with MC. MC would compute its gain or loss on settlement of this preexisting relationship as follows:

images

Since MC had already recognized an unrealized loss on the firm purchase commitment as of December 31, 2011, upon its acquisition of HI, its loss of $150,000 from recognizing the lesser of items 1 and 2 in the preceding list would be offset by the elimination of the liability for the unrealized loss on the firm purchase commitment in the same amount of $150,000. Thus, under these circumstances, MC would have neither a gain nor a loss on the settlement of its preexisting relationship with HI. The entries to record these events are not considered part of the business combination accounting. It is important to note that, from the perspective of MC, when it applies the acquisition method to record the business combination, it will characterize the $600,000 “at-market” component of the contract as part of goodwill and not as identifiable intangibles. This is the case because of the obvious fallacy of MC recognizing customer-relationship intangible assets that represent a relationship with itself.

Example of settlement of preexisting contractual supplier relationship; contract favorable to acquirer

Using the same facts as the MC/HI example above, assume that, instead of the contract being unfavorable to the acquirer MC, it was unfavorable to HI in the amount of $150,000 and that there was a cancellation provision in the contract that would permit HI to pay a penalty after year two of $100,000 to cancel the remainder of the contract.

On the acquisition date, the $30 million fair value of HI, under this scenario would include $450,000 related to the contract with MC that consists of

images

Under these changed assumptions, MC would not have incurred or recorded an unrealized loss on the firm purchase commitment with HI since the contract terms were favorable to MC. The determination of MC's gain or loss would be as follows:

images

Under this scenario, unless HI believed that the market would change in the near term, it would be economically advantageous, absent a business combination, for HI to settle the remaining contract at the acquisition date by paying the $100,000 penalty because HI would be able to sell the remaining 3,000 units covered by the contract for an aggregate price of $150,000 more than it was committed to sell those units to MC.

At the acquisition date, MC would record a gain of $100,000 to settle its preexisting relationship with HI. The entry to record the gain is not considered part of the business combination accounting.

In addition, however, since item 2 is less than item 1, the $50,000 difference is included in the accounting for the business combination, since economically, postcombination, the combined entity will not benefit from that portion of the acquisition date favorability of the contract.

As was the case in the first example, the portion of the purchase price allocated to the contract in the business combination accounting would be accounted for as goodwill for the same reason.

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:

The reasons why the terms of the acquisition include the payment provision,
The party that initiated the arrangement, and
When (at what stage of the negotiations) the arrangement was entered into by the parties.

When those considerations do not provide clarity regarding whether the transaction is separate from the business combination, the acquirer considers the following indicators:

Postcombination employment—Consideration is to be given to the terms under which the selling owners will be providing services as key employees of the combined entity. The terms may be evidenced by a formal employment contract, by provisions included in the acquisition documents, or by other documents. If the arrangement provides that the contingent payments are automatically forfeited upon termination of employment, the consideration is to be characterized as compensation for postcombination services. If, instead, the contingent payments are not affected by termination of employment, this would be an indicator that the contingent payments represent additional consideration that is part of the business combination transaction and not compensation for services.
Duration of postcombination employment—If the employee is contractually bound to remain employed for a period that equals or exceeds the period during which the contingent payments are due, this may be an indicator that the contingent payments represent compensation for services.
Amount of compensation—If the amount of the employee's compensation that is not contingent is considered to be reasonable in relation to other key employees of the combined entity, this may indicate that the contingent amounts represent additional consideration and not compensation for services.
Differential between amounts paid to employees and selling owners who do not become employees of the combined entity—If, on a per-share basis, the contingent payments due to former owners of the acquiree that did not become employees are lower than the contingent payments due to the former owners that did become employees of the combined entity, this may indicate that the incremental amounts paid to the employees are compensation.
Extent of ownership—The relative ownership percentages (e.g., number of shares, units, percentage of membership interest) owned by the selling owners who remain employees of the combined entity serve as an indicator of how to characterize the substance of the contingent consideration. If, for example, the former owners of substantially all of the ownership interests in the acquiree are continuing to serve as key employees of the combined entity, this may be an indicator that the contingent payment arrangement is substantively a profit-sharing vehicle designed with the intent of providing compensation for services to be performed postcombination. Conversely, if the former owners that remained employed by the combined entity collectively owned only a nominal ownership interest in the acquiree and all of the former owners received the same amount of contingent basis on a per-share basis, this may be an indicator that the contingent payments represent additional consideration. In considering the applicability of this indicator, care must be exercised to closely examine the effects, if any, of transactions, ownership interests, and employment relationships, precombination and postcombination, with respect to parties related to the selling owners of the acquiree.
Relationship of contingent arrangements to the valuation approach used—The payment terms negotiated in many business combinations provide that the amount of the acquisition date transfer of consideration from acquirer to acquiree (or the acquiree's former owners) is computed near the lower end of a range of valuation estimates the acquirer used in valuing the acquiree. Furthermore, the formula for determining future contingent payments is derived from or related to that valuation approach. When this is the case, it may be an indicator that the contingent payments represent additional consideration. Conversely, if the formula for determining future contingent payments more closely resembles prior profit-sharing arrangements, this may be an indicator that the substance of the contingent payment arrangement is to provide compensation for services.
Formula prescribed for determining contingent consideration—Analyzing the formula to be used to determine the contingent consideration may provide insight into the substance of the arrangement. Contingent payments that are determined on the basis of a multiple of earnings may be indicative of being, in substance, contingent consideration that is part of the business combination transaction. Alternatively, contingent consideration that is determined as a prespecified percentage of earnings would be more suggestive of a routine profit-sharing arrangement for the purposes of providing additional compensation to employees for postcombination services rendered.
Other considerations—Given the complexity of a business combination transaction and the sheer volume of legal documents necessary to affect it, the financial statement preparer is charged with the daunting, but unavoidable task of performing a comprehensive review of the terms of all of the associated agreements. These can take the form of noncompete agreements, consulting agreements, leases, guarantees, indemnifications, and, of course, the formal agreement to combine the businesses. Particular attention should be paid to the applicable income tax treatment afforded to the contingent payments. The income tax treatment of these payments may be an indicator that tax avoidance was a primary motivator in characterizing them in the manner that they are structured. An acquirer might, for example, simultaneous to a business combination, execute a property lease with one of the key owners of the acquiree. If the lease payments were below market, some or all of the contingent payments to that key owner/lessor under the provisions of the other legal agreements might, in substance, be making up the shortfall in the lease and thus, should be recharacterized as lease payments and accounted for separately from the business combination in the combined entity's postcombination financial statements. If this were not the case, and the lease payments were reflective of the market, this would be an indicator pointing to a greater likelihood that the contingent payment arrangements actually did represent contingent consideration associated with the business combination transaction.

Step 4—Classify or designate identifiable assets acquired and liabilities assumed.

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:

Classification of investments in certain debt and equity securities as trading, available for sale, or held to maturity under ASC 320, Investments—Debt and Equity Securities
Designation of a derivative instrument as a hedging instrument under the provisions of ASC 815, Derivatives and Hedging
Assessment of whether an embedded derivative is to be separated from the host contract under ASC 815.

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.

Step 5—Recognize and measure the identifiable tangible and intangible assets acquired and liabilities assumed.

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:

Separability criterion—The intangible asset is capable of being separated or divided from the entity that holds it, and sold, transferred, licensed, rented, or exchanged, regardless of the acquirer's intent to do so. An intangible asset meets this criterion even if its transfer would not be alone, but instead would be accompanied or bundled with a related contract, other identifiable asset, or a liability.
Legal/contractual criterion—The intangible asset results from contractual or other legal rights. An intangible asset meets this criterion even if the rights are not transferable or separable from the acquiree or from other rights and obligations of the acquiree.

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

Marketing
Customers or clients
Artistic works
Contractual
Technological.

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:

Marketing-related intangible assets.

Newspaper mastheads. The unique appearance of the title page of a newspaper or other periodical.
Trademarks, service marks, trade names, collective marks, certification marks. A trademark represents the right to use a name, word, logo, or symbol that differentiates a product from products of other entities. A service mark is the equivalent of a trademark for a service offering instead of a product. A collective mark is used to identify products or services offered by members affiliated with each other. A certification mark is used to designate a particular attribute of a product or service such as its geographic source (e.g., Colombian coffee or Florida orange juice) or the standards under which it was produced (e.g., ISO 9000 Certified).
Trade dress. The overall appearance and image (unique color, shape, or package design) of a product.
Internet domain names. The unique name that identifies an address on the Internet. Domain names must be registered with an Internet registry and are renewable.
Noncompetition agreements. Rights to assurances that companies or individuals will refrain from conducting similar businesses or selling to specific customers for an agreed-upon period of time.

Customer-related intangible assets.

Customer lists. Names, contact information, order histories, and other information about a company's customers that a third party, such as a competitor or a telemarketing firm, would want to use in its own business.
Customer contracts and related customer relationships. When a company's relationships with its customers arise primarily through contracts and are of value to buyers who can “step into the shoes” of the sellers and assume their remaining rights and duties under the contracts, and which hold the promise that the customers will place future orders with the entity or relationships between entities and their customers for which:
1. The entities have information about the customers and have regular contacts with the customers, and
2. The customers have the ability to make direct contact with the entity.
Noncontractual customer relationships. Customer relationships that arise through means such as regular contacts by sales or service representatives, the value of which are derived from the prospect of the customers placing future orders with the entity.
Order or production backlogs. Unfilled sales orders for goods and services in amounts that exceed the quantity of finished goods and work-in-process on hand for filling the orders.

Artistic-related intangible assets.

Plays, operas, ballets.
Books, magazines, newspapers, and other literary works.
Musical works such as compositions, song lyrics, and advertising jingles.
Photographs, drawings, and clip art.
Audiovisual material including motion pictures, music videos, television programs.

Contract-based intangible assets.

License, royalty, standstill agreements. License agreements represent the right, on the part of the licensee, to access or use property that is owned by the licensor for a specified period of time at an agreed-upon price. A royalty agreement entitles its holder to a contractually agreed-upon portion of the income earned from the sale or license of a work covered by patent or copyright. A standstill agreement conveys assurances that a company or individual will refrain from engaging in certain activities for specified periods of time.
Advertising contracts. A contract with a newspaper, broadcaster, or Internet site to provide specified advertising services to the acquiree.
Lease agreements. (Irrespective of whether the acquiree is the lessee or lessor)
Construction permits. Rights to build a specified structure at a specified location
Construction contracts. Rights to become the contractor responsible for completing a construction project and benefit from the profits it produces, subject to the remaining obligations associated with performance (including any past-due payments to suppliers and/or subcontractors).
Construction management, service, or supply contracts. Rights to manage a construction project for a fee, procure specified services at a specified fee, or purchase specified products at contractually agreed-upon prices.
Broadcast rights. Legal permission to transmit electronic signals using specified bandwidth in the radio frequency spectrum, granted by the operation of communication laws.
Franchise rights. Legal rights to engage in a trade-named business, to sell a trademarked good, or to sell a service-marked service in a particular geographic area.
Operating rights. Permits to operate in a certain manner, such as those granted to a carrier to transport specified commodities.
Use rights. Permits to use specified land, property, or air space in a particular manner, such as the right to cut timber, expel emissions, or to land airplanes at specified gates at an airport.
Servicing contracts. The contractual right to service a loan. Servicing entails activities such as collecting principal and interest payments from the borrower, maintaining escrow accounts, paying taxes and insurance premiums when due, and pursuing collection of delinquent payments.
Employment contract. The right to succeed the acquiree as the employer under a formal contract to obtain an employee's services in exchange for fulfilling the employer's remaining duties, such as payment of salaries and benefits, as specified by the contract.

Technology-based intangible assets.

Patented or copyrighted software. Computer software source code, program specifications, procedures, and associated documentation that are legally protected by patent or copyright.
Mask works. Software permanently stored on a read-only memory chip as a series of stencils or integrated circuitry. Mask works may be provided statutory protection in some countries.
Unpatented technology. Access to knowledge about the proprietary processes and workflows followed by the acquiree to accomplish desired business results.
Databases. Databases are collections of information generally stored digitally in an organized manner. A database can be protected by copyright (e.g., the database contained on the CD-ROM version of this publication). Many databases, however, represent information accumulated as a natural by-product of a company conducting its normal operating activities. Examples of these databases are plentiful and include title plants, scientific data, and credit histories. Title plants represent historical records with respect to real estate parcels in a specified geographic location.
Trade secrets. Trade secrets are proprietary, confidential information, such as a formula, process, or recipe.

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

Legal, regulatory, or contractual provisions that may limit the maximum useful life;
Legal, regulatory, or contractual provisions that may enable renewal or extension of the asset's legal or contractual life (provided there is evidence to support renewal or extension without substantial cost and without materially modifying the original terms);
The effects of obsolescence, demand, competition, and other economic factors (such as the stability of the industry, the rate of technological change, expected changes in distribution channels, and the existence of uncertainty over future legal and/or regulatory changes);
The expected useful life of assets or groups of assets of the enterprise that the useful life of the asset may parallel (such as mineral rights to depleting assets);
The expected use of the intangible asset by the enterprise; and
The level of maintenance expenditures required to be made in order to obtain the expected future economic benefits from the asset.

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:

images

Assets held for sale. Assets classified as held for sale individually or as part of a disposal group are to be measured at acquisition date fair value less cost to sell consistent with ASC 360.
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.
Contingent assets and liabilities of the acquiree. A gain or loss contingency is defined as an existing, unresolved condition, situation, or set of circumstances that will eventually be resolved by the occurrence or nonoccurrence of one or more future events. A potential gain or loss to the reporting entity can result from the contingency's resolution.
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.
1. If ADFV is considered determinable during the measurement period, the acquirer recognizes the asset or liability at its ADFV.
2. If ADFV is not considered determinable during the measurement period, an asset or liability is recognized at the acquisition date if both of the following criteria are met, following the application guidance in ASC 450 and ASC 450-20.
  - Information available prior to the end of the measurement period indicates that it is probable that an asset existed or that a liability had been incurred at the measurement date, and
  - The amount of the asset or liability can be reasonably estimated
3. If neither criterion a nor b is met, no asset or liability is recognized at the measurement date and the contingencies are subject to the same ASC 450 considerations as any other contingencies of the ongoing consolidated reporting entity.
  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:
  1. If additional information is obtained during the measurement period that pertains to facts and circumstances that existed at the acquisition date and affects the ADFV of the contingency, the acquirer is to reflect the effects of the new information on ADFV as a measurement period adjustment.
  2. Changes in the fair value of the contingency resulting from postacquisition events, such as meeting a targeted level of earnings, reaching a specified stock price, or successfully meeting a milestone of a research and development project, are not to be reflected as measurement period adjustments. These are accounted for as follows:
    - (1) If the contingent consideration was classified as equity, it is not remeasured and, when subsequently settled, it is accounted for in equity.
    - (2) If the contingent consideration was classified as an asset or liability, it is remeasured at fair value in each reporting period until the contingency is resolved. Changes in fair value are charged or credited to net income unless the contingent arrangement is a hedging instrument for which ASC 15, Derivatives and Hedging, requires changes to be recognized initially in other comprehensive income.
Indemnification assets. Indemnification provisions are usually included in the voluminous closing documents necessary to effect a business combination. Indemnifications are contractual terms designed to fully or partially protect the acquirer from the potential adverse effects of an unfavorable future resolution of a contingency or uncertainty that exists at the acquisition date. Frequently the indemnification is structured to protect the acquirer by limiting the maximum amount of postcombination loss that the acquirer would bear in the event of an adverse outcome. A contractual indemnification provision results in the acquirer obtaining, as a part of the acquisition, an indemnification asset and simultaneously assuming a contingent liability of the acquiree.
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.
Reacquired rights. An acquirer and acquiree may have engaged in preacquisition business transactions such as leases, licenses, or franchises that resulted in the acquiree paying consideration to the acquirer to use tangible and/or intangible assets of the acquirer in the acquiree's business.
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:
1. The amount by which, from the acquirer's perspective, the contract is favorable or unfavorable, or
2. The amount of any settlement provisions stated in the contract that are available to the counterparty for which the contract is unfavorable.
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.
Employee benefits. Liabilities (and assets, if applicable), associated with acquiree employee benefit arrangements are to be recognized and measured under other GAAP, as applicable.

images

In researching the application of these pronouncements, it is important to consider the amendments to them made by ASC 805. For example,

ASC 715-30 and ASC 715-60 are amended to clarify that:
- (1) The acquirer is to recognize, as part of the business combination, an asset or liability that represents the funded status of a single-employer defined benefit pension plan and/or a single-employer defined benefit postretirement plan. In determining the funded status, the acquirer is to disregard the effects of expected plan amendments, terminations, or curtailments that it has no obligation to make at the acquisition date.
- (2) The projected benefit obligation assumed for a single-employer defined benefit pension plan or the accumulated postretirement benefit obligation assumed for a single-employer defined benefit postretirement plan are to reflect any other necessary changes in assumptions based on an assessment by the acquirer of relevant future events.
- (3) If the acquiree participates in a multiemployer-defined benefit pension or postretirement plan, and at the acquisition date it is probable that the acquirer will withdraw from that plan, the acquirer is to recognize a withdrawal liability as of the acquisition date under ASC 450.
ASC 420 is amended to expand its scope to cover exit activities associated with entities that are acquired in a business combination.

6a. Acquirer share-based payment awards exchanged for acquiree awards held by its employees. In connection with a business combination, the acquirer often awards share-based payments to the employees of the acquiree in exchange for the employees' acquiree awards. Obviously, there are many valid business reasons for the exchange, not the least of which is ensuring smooth transition and integration as well as retention of valued employees.
The discussion that follows uses concepts and terminology from ASC 718, Compensation—Stock Compensation.
6b. Acquirer not obligated to exchange. Accounting for the replacement awards under ASC 805 is dependent on whether the acquirer is obligated to replace the acquiree awards. The acquirer is obligated to replace the acquiree awards if the acquiree or its employees can enforce replacement through rights obtained from the terms of the acquisition agreement, the acquiree awards, or applicable laws or regulations.
If the acquirer is not obligated to replace the acquiree awards, all of the fair-value-based measure (FVBM)³ of the replacement awards is recognized as compensation cost in the postcombination financial statements.

Example of acquirer replacing acquiree awards without the obligation to do so

New Parent, Inc. (NP) acquired New Subsidiary, Inc. (NS) on January 1, 2012. Because of the business combination, the share-based payment awards that had been previously granted by NS to its employees expired on the acquisition date.

Although NP was not obligated, legally or contractually, to replace the expired awards, its Board of Directors approved a grant of NP awards designed so that the employees of NS would not be financially disadvantaged by the acquisition transaction.

Since the replacement awards were voluntary on the part of NP, the FVBM of the replacement award is attributed wholly to the postcombination consolidated financial statements of NP and Subsidiary.

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:

images

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:

Compute both FVBM_RA and FVBM_AA by following the provisions of ASC 718.
Compute the portion of the replacement award that is attributable to precombination services rendered by the acquiree's employees as follows:
Compute the portion of the nonvested replacement award attributable to postcombination service as follows:

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.

Example of acquirer replacement awards requiring no postcombination services exchanges for fully vested acquiree awards where the employees have rendered all required services by the acquisition date

New Parent, Inc. (NP) acquired New Subsidiary, Inc. (NS) on January 1, 2012. In accordance with the acquisition agreement, NP agreed to replace share-based awards that had previously been issued by NS. Details are as follows:

images

Since the acquiree's employees had completed all of the services required under the prior awards, applying the formula yields a result that attributes 100% of the fair value of the acquiree award that is being replaced to precombination services rendered.

images

The $100 result, attributed to precombination services, is included by the acquirer in its computation of the consideration transferred in exchange for control of the acquiree.

The final step in the computation is to account for the difference between the acquisition date fair values of the replacement awards and the acquiree awards as follows:

images

This result illustrates the basic principle in ASC 805 that any excess of FVBMRA over the FVBM_AA is to be attributed to postcombination services and recognized as compensation cost in the postcombination financial statements.

The acquisition agreement referred to in the previous example governing the NP acquisition of NS that occurred on January 1, 2012, contained the following provisions regarding exchange of outstanding NS awards at acquisition date for NP replacement awards:

images

Even though the acquiree's employees had completed all of the requisite service required by the acquiree's awards three years prior to the acquisition, the imposition of an additional year of required service by the acquirer's replacement awards results in an allocation between precombination compensation cost and postcombination compensation cost as follows:

images

The $80 result, attributed to precombination services, is included by the acquirer in its computation of the consideration transferred in exchange for control of the acquirer.

The $20 difference between the $100 fair value of the replacement awards and the $80 allocated to precombination services (and included in consideration transferred) is accounted for as compensation cost in the postcombination consolidated financial statements of NP and Subsidiary under the provisions of ASC 718.

Example of acquirer replacement awards requiring performance of postcombination services exchanged for acquiree awards with remaining unsatisfied requisite service period as of the acquisition date

The acquisition agreement referred to in the previous examples governing the NP acquisition of NS that occurred on January 1, 2012, contained the following provisions regarding exchange of outstanding NS awards at acquisition date for NP replacement awards:

images

The portion of the FVBM of the replacement awards attributable to precombination services already rendered by the acquiree employees is computed as follows:

images

Based on the computation above, at the acquisition date, NP, the acquirer, includes $50 as consideration transferred to obtain control of NS, the acquiree. The remaining $50 is attributed to postcombination services and, accordingly, recognized as compensation cost in the consolidated postcombination financial statements of NP and Subsidiary.

images

Under this scenario, the terms of the awards previously granted by NS, the acquiree, did not contain a change-in-control provision that would have fully vested them upon the acquisition by NP. If this had been the case, the outcome would be the same as the example above where neither the acquiree awards nor the replacement rewards required the completion of any service on the part of the acquiree's employees.

Since, at the acquisition date, the acquiree employees had completed only two out of the four years of required services and the replacement awards do not extend the duration of services required postcombination, the total service period (TSP) in 5b is the 2 years already completed by the acquiree's employees under their original awards in 3a (CRSP_AA).

The portion of the FVBM of the replacement awards attributable to precombination services already rendered by the acquiree employees is computed as follows:

images

Consequently, $50 of the FVBM of the replacement awards is attributable to precombination services already performed by the acquiree employees and is, therefore, included in computing the consideration transferred in exchange for obtaining control of the acquiree.

The remaining $50 of the FVBM of the replacement awards is attributable to postcombination service. However, since the acquiree's employees are not required to provide any postcombination services under the terms of the replacement awards, the entire $50 is immediately recognized by NP, the acquirer, in its postcombination consolidated financial statements.

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 (1) recognized using the graded vesting attribution method that separates the award into tranches according to the year in which they vest and treats each tranche as if it had been a separate award, or (2) recognized using a straight-line attribution method over the graded vesting period. 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.

7. Income taxes. The final exception to the general fair-value-based recognition and measurement provisions of ASC 805 is the accounting for income taxes. Since recognition and measurement of income tax assets and liabilities under US GAAP has not historically used fair value measurement or discounted present value techniques, FASB was loath to make fundamental changes to this complex area of accounting.

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

Exist on the acquisition date or
Are generated by the acquisition itself

ASC 805 also amends ASC 740 to clarify its applicability to business combinations as follows:

In computing the acquisition date amount of currently payable or refundable income taxes from a particular taxing jurisdiction, management is to apply the recognition and measurement provisions of ASC 740 to evaluate the amounts to record relative to prior income tax positions taken by the acquiree.
As a result of management's evaluation of prior tax positions and the amounts recognized in item 1, management is to adjust the income tax bases used in computing the deferred income tax assets and liabilities associated with the business combination at the acquisition date.
New information regarding the facts and circumstances that existed at the acquisition date that comes to the attention of management regarding those income tax positions is treated as follows:
- (1) If the information results in a change during the measurement period, the adjustment is made to goodwill. If goodwill is reduced to zero, any remaining portion of the adjustment is recorded as a bargain purchase gain.
- (2) If the information results in a post-measurement-period change, the change is accounted for in the same manner as any other ASC 740 changes.

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:

If the change in judgment occurs during the measurement period (as defined in ASC 805) that is not to exceed one year from the acquisition date, and results from new information bearing on facts and circumstances that existed at the acquisition date, the change is to be recognized as an adjustment to goodwill. Should the adjustment reduce goodwill to zero, the acquirer is to recognize any further reduction in the valuation allowance as a gain from a bargain purchase.
If the change in judgment occurs subsequent to the measurement period, it is reported as an increase or decrease in income tax expense or benefit of the period in which the judgment changed. Exceptions to this treatment are provided for changes attributable to dividends on unallocated shares of an employee stock ownership plan (ESOP), employee stock options, and certain quasi reorganizations. Accounting for these exceptions results in adjustments directly to contributed capital rather than to income tax expense.

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.

Step 6—Recognize and measure any noncontrolling interest in the acquiree.

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)

Example of fair value of noncontrolling interest adjusted for noncontrolling interest discount

Shirley Corporation (SC) is considering acquiring an 80% interest in Jake Industries Inc. (JI), a privately held corporation. SC engages a valuation specialist to determine the fair value of JI whose shares do not trade in an active market.

The specialist's findings with respect to JI as a whole were as follows:

images

In valuing the noncontrolling interest, however, the specialist made the following additional assumptions:

images

It is important to note from this analysis that, from the perspective of the acquirer, the computation of the acquisition-date fair value of the noncontrolling interest in the acquiree is not computed by simply multiplying the same fair value per share that the acquirer used to value the entity by the percentage voting interest retained collectively by the noncontrolling stockholders. Such a simplistic calculation would have yielded a different result:

$15 million aggregate fair value × 20% noncontrolling shares = $3 million

If this method had been used, the noncontrolling interest would be overvalued by $750,000 (the difference between $3 million and $2,250,000).

Step 7—Measure the consideration transferred.

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:

The fair value of the assets transferred by the acquirer,
The fair value of the liabilities incurred by the acquirer to the former owners of the acquiree, and
The fair value of the equity interests issued by the acquirer subject to the measurement exception discussed earlier in this chapter for the portion, if applicable, of acquirer share-based awards exchanged for awards held by employees of the acquiree that is included in consideration transferred.

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:

ASC 480,
ASC 815-40, or
Other applicable GAAP.

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:

If the contingent consideration is classified as equity, it is not to be remeasured and subsequent settlement of the contingency is to be reflected within equity.
If the contingent consideration is classified as an asset or liability, it is to be remeasured at fair value at each reporting date until resolution of the contingency. Changes in the fair value between reporting dates are to be recognized in net income unless the arrangement is a hedging instrument for which ASC 815, as amended by ASC 805 requires the changes to be initially recognized in other comprehensive income.

Step 8—Recognize and measure goodwill or gain on a bargain purchase.

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:

images

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:

Perform a completeness review of the identifiable tangible and intangible assets acquired and liabilities assumed to reassess whether all such items have been correctly identified. If any omissions are found, recognize the assets and liabilities that had been omitted.
Perform a review of the procedures used to measure all of the following items. The objective of the review is to ensure that the acquisition-date measurements appropriately considered all available information available at the acquisition date:
1. Identifiable assets acquired
2. Liabilities assumed
3. Consideration transferred
4. Noncontrolling interest in the acquiree, if applicable
5. Acquirer's previously held equity interest in the acquiree for a business combination achieved in stages.

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

The timing of the receipt of the additional information, and
Whether management of the acquirer can identify a reason that a change is warranted to the provisional amounts.

Obviously, information received shortly after the acquisition date has a higher likelihood of relevance to acquisition-date circumstances than information received months later.

Example of consideration of new information obtained during the measurement period

Krupp Industries, Inc. (KI) acquired Miller Motor Works Corp. (MMW) on January 2, 2012. In the first quarter 2012 consolidated financial statements of Krupp Industries and Subsidiary, it assigned a provisional fair value of $40 million to an asset group consisting of a factory and related machinery that manufactures engines used in large trucks and sport utility vehicles (SUVs).

As of the acquisition date, the average cost of gasoline in the markets served by the customers of MMW was $4.30 per gallon. For the first four months subsequent to the acquisition, the per-gallon price of gasoline was relatively stable and only fluctuated slightly up or down on any given day. Upon further analysis, management was able to determine that during that four-month period, the production levels of the asset group and related order backlog did not vary substantially from the acquisition date.

In May, 2012, however, due to an accident on May 3, 2012, at a large US refinery, the average cost per gallon skyrocketed to more than $6.00 a gallon. As a result of this huge spike in the price of fuel, MMW's largest customers either canceled orders or sharply curtailed the number of engines they had previously ordered.

Scenario 1: On April 15, 2012, management of KI signed a sales agreement with Joshua International (JI) to sell the asset group for $30 million. Given the fact that management was unable to identify any changes that occurred during the measurement period that would have accounted for a change in the acquisition-date fair value of the asset group, management determines that it will retrospectively reduce the provisional fair value assigned to the asset group to $30 million.

Scenario 2: On May 15, 2012, management of KI signed a sales agreement with Joshua International (JI) to sell the asset group for $30 million. Given the intervening events that affected the price of fuel and the demand for MMW's products, management determines that the $10 million decline in the fair value of the asset group from the provisional fair value it was originally assigned resulted from those intervening changes and, consequently does not adjust the provisional fair value assigned to the asset group at the acquisition date.

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:

The date management of the acquirer receives the information it seeks regarding facts and circumstances as they existed at the acquisition date or learns that it will be unable to obtain any additional information, or
One year after the acquisition date.

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.

Application Guidance

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.

Business combinations achieved in stages (step acquisitions).

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.

Example of a step acquisition

On 12/31/2012, Finestone Corporation (FC) owned 5% of the 30,000 outstanding voting common shares of Kitzes Industries (KI). On FC's 12/31/2012 statement of financial position, it classified its investment in KI as available for sale. On 3/31/2013, FC acquired additional equity shares in KI sufficient to provide FC with a controlling interest in KI and, thus, became KI's parent company.

The following table summarizes FC's initial holdings in KI, the subsequent increase in those holdings, and the computation of the gain on remeasurement at the acquisition date of 3/31/2013:

images

Changes in the parent's ownership interest in a subsidiary.

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:

Sale by the parent of all or a portion of its ownership interest in the subsidiary resulting in the parent no longer holding a controlling financial interest,
Expiration of a contract that granted control of the subsidiary to the parent,
Issuance by the subsidiary of stock that reduces the ownership interest of the parent to a level not representing a controlling financial interest,
Loss of control of the subsidiary by the parent because the subsidiary becomes subject to control by a governmental body, court, administrator, or regulator.

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:

images

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:

The transactions are entered into simultaneously or in contemplation of one another,
The transactions, when considered in tandem, are in substance a single transaction designed to achieve an overall commercial objective,
The occurrence of one transaction depends on the occurrence of at least one other transaction.
One transaction, when considered on its own merits, does not make economic sense, but when considered together with the other transaction or transactions would be considered economically justifiable.

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.

Allocation of net income and other comprehensive income to the parent and noncontrolling interest.

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.

Push-Down Accounting

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 pushdown 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.

Example of push-down accounting

Assume that Pullup Corp. acquires, in an open market arm's-length transaction, 90% of the common stock of Pushdown Co. for $464.61 million. At that time, Pushdown Co.'s net book value was $274.78 million (for the entire company). Book and fair values of selected assets and liabilities of Pushdown Co. as of the transaction date are summarized as follows ($000,000 omitted):

images

Assuming that “new basis” accounting is deemed to be acceptable and meaningful, since Pushdown Co. must continue to issue separate financial statements to its creditors and holders of its preferred stock, and also assuming that a revaluation of the share of ownership that did not change hands (i.e., the 10% noncontrolling interest in this example) should not be revalued based on the majority transaction, the entries by the subsidiary (Pushdown Co.) for purposes only of preparing stand-alone financial statements would be as follows:

images

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, as described fully in Chapter 23.

Accounting for Leveraged Buyouts

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) 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.

Reverse Acquisitions

Introduction.

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.

Structure of the transaction.

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.⁵

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.

Continuation of the business of the legal 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.

images

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.”

Equity structure adjustments.

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.

Consolidation procedures.

The consolidated financial statements will 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

The assets and liabilities of the legal subsidiary/accounting parent recognized and measured at their precombination carrying amounts.
The assets and liabilities of the legal parent/accounting subsidiary recognized and measured as a business combination under ASC 805.
The retained earnings and other equity balances of the legal subsidiary/accounting parent prior to the business combination.
The consolidated equity structure (i.e., the number and type of equity interests issued) is to be adjusted to reflect the equity structure of the legal parent/accounting subsidiary, including the equity interests issued by the legal parent in order to effect the combination. To operationalize this adjustment, the legal subsidiary's equity structure is to be restated to reflect the number of shares of the legal parent issued in the reverse acquisition using the exchange ratio prescribed by the acquisition agreement.
The noncontrolling interest's proportionate share of the legal subsidiary's precombination carrying amounts of retained earnings and other equity interests as discussed in ASC 805-40-25-2 and ASC 805-40-30-3.

Spin-offs and Reverse Spin-offs

Spin-offs.

One method that is used as a means of reorganizing an entity's operations is through the use of a spin-off. This can involve the transfer of assets that constitute a business, by their holder referred to as the spinnor, into a new legal entity (spinnee), the shares of which are distributed to the spinnor's shareholders. The distribution is nonreciprocal in that the shareholders of the spinnor are not required to surrender any of their stock in the spinnor in exchange for the shares of the spinnee.

Besides facilitating a reorganization of the reporting entity, a spin-off may also qualify as a nontaxable reorganization with the distribution not being treated as a taxable gain by the spinnor or its shareholders. In addition, if the spinnee stock is subsequently sold by the shareholders, they avoid the effect of the double taxation that would occur if the company sold the company directly and distributed the net proceeds to the stockholders in a taxable cash dividend.

The accounting rules governing spin-offs and reverse spin-offs are found in ASC 505-60 and ASC 845-10-30.

In accordance with ASC 505-60-25-2, the distribution of shares of a wholly owned or consolidated subsidiary that constitutes a business to an entity's shareholders is to be recorded based on the carrying value of the subsidiary. Irrespective of whether the spun-off operations are to be sold immediately following the spin-off, management is not to account for the transaction as a sale of the spinnee followed by a distribution of the proceeds.

Further, in accordance with ASC 845-10-30-10, a pro rata distribution to owners of an entity of shares of a subsidiary or other investee entity that has been or is being consolidated or accounted for under the equity method is to be considered the equivalent of a spin-off.

Reverse spin-offs.

Under certain circumstances, a spun-off subsidiary/spinnee will function as the continuing entity post-spin-off. When the spin-off of a subsidiary is structured in such a way that the legal form of the transaction does not represent its economic substance, this will be accounted for as a reverse spin-off whereby the legal spinnee is treated as if it were the spinnor for financial reporting purposes.

The determination of whether reverse spin-off accounting is appropriate is a matter of professional judgment that depends on a careful analysis of all relevant facts and circumstances. ASC 505-60-25-8 provides indicators to be considered in determining whether a spin-off should be accounted for as a reverse spin-off. No one indicator is to be considered presumptive or determinative.

The sizes of the legal spinnor and the legal spinnee. If all other factors are equal, in a reverse spin-off, the legal spinnee/accounting spinnor is larger than the legal spinnor/accounting spinnee. This comparison is to be based on assets, revenues, and earnings of the two entities with no established bright lines that should be applied.
The fair value of the legal spinnor and the legal spinnee. All other factors being equal, in a reverse spin-off, the fair value of the legal spinnee/accounting spinnor is greater than the fair value of the legal spinnor/accounting spinnee.
Senior management. All other factors being equal, in a reverse spin-off, the legal spinnee retains the senior management of the formerly consolidated entity. Senior management is generally understood to include the chairman of the board of directors, chief executive officer, chief operating officer, chief financial officer, the divisional heads that report directly to them, or the executive committee, if applicable.
Length of holding period. All other factors being equal, in a reverse spin-off, the legal spinnee is held for a longer period than the legal spinnor. A proposed or approved plan of sale for one of the separate entities concurrent with the spin-off transaction may assist in the identification of the entity to be sold as the spinnee for accounting purposes.

The determination of the accounting spinnor and spinnee, respectively, has significant implications. In a spin-off, the net book value of the spinnee is treated, in effect, as a dividend distribution to the shareholders of the spinnor. Since the net book value of these entities will differ from each other, the amount of the reduction to retained earnings of the surviving reporting entity (the accounting spinnor) will be affected by this determination. ASC 505-60 offers several examples of fact patterns which support spin-off or reverse spin-off determinations.

Finally, the accounting for a reverse spin-off is further complicated by the fact that the determination of the accounting spinnor and spinnee significantly affects the reporting of discontinued operations in accordance with ASC 360. The accounting spinnee is reported as a discontinued operation by the accounting spinnor if the spinnee is a component of an entity and meets the conditions for such reporting contained in ASC 360.

Non-Sub Subsidiaries

Another 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.”

Goodwill Impairment

Unlike tangible fixed assets, goodwill is impossible to separately identify and, if the ongoing business is successful, will tend to regenerate itself or be replaced by new internally generated goodwill. Historically, of course, goodwill could only achieve financial statement recognition in the limited situation of when it was purchased (i.e., internally generated goodwill was not recognizable for financial reporting purposes). However, any strategy for testing for impairment will inevitably be confounded by the existence, along with the purchased goodwill, of internally generated goodwill created subsequent to the date of the business combination. FASB concluded that it would be impossible to track “acquisition-specific” goodwill for impairment testing purposes and accordingly endorsed a major departure from the traditional prohibition against recognition of internally generated intangibles. This approach still results in an inconsistency, however, since only entities that have purchased goodwill in the past will be permitted to recognize the internally generated replacement goodwill to avoid impairment write-downs. Entities that internally generate goodwill but that have not entered into prior business combinations are still prohibited from capitalizing that new goodwill and from presenting it as an asset on their statement of financial position.

The impairment testing approach prescribed by ASC 350 reasons that “anomalies that result from the differences in how acquired goodwill and internally generated goodwill are accounted for . . . justify a departure from the current model of accounting.” Thus, it concluded, as long as the total goodwill identifiable with the reporting unit to which acquisition-based goodwill was assigned can be shown to have a fair value exceeding the book value of the goodwill arising from the acquisition (which means apples are to be compared with oranges), no impairment will be found. This represents a major departure from prior accounting practice.

A reporting unit is defined in ASC 350 as an operating segment or a component of an operating segment that is one level below the operating segment as a whole. In order for a component to be considered a reporting unit, it must:

Constitute a business, and
Have available discrete financial information regarding its operating results that is regularly reviewed by segment management.

A reporting unit is defined by reference to an operating segment, which is a term used in ASC 280. This definition applies equally to publicly held and privately held companies, even though nonpublic entities are exempted from reporting segment information.

Chapter 16, in the section entitled, “Alternative Statement of Financial Position Segmentation,” provides a diagram of how an organizational structure could be analyzed to determine its reporting units and provides definitional guidance regarding terminology used in the authoritative GAAP literature.

Initial assessment of goodwill's fair value and documentation requirement.

To facilitate periodic assessments of possible impairment, it is necessary that a benchmark assessment be made. This benchmark assessment is performed in conjunction with most significant acquisitions, regardless of how much goodwill arises from that acquisition. Similarly, a benchmark assessment is performed in conjunction with a reorganization of an entity's reporting structure.

The benchmark assessment involves identifying the valuation model to be used, documenting key assumptions, and measuring the fair value of the reporting unit. In determining how goodwill is to be assigned to reporting units, a reasonable and supportable approach must be adopted. In general, goodwill is assigned consistent with previous recognition of goodwill and with the reporting units to which the acquired assets and liabilities had been assigned. Goodwill assigned to a reporting unit is measured by the difference between the fair value of the entire reporting unit and the collective sum of the fair values of the reporting unit's assets, net of its liabilities.

In practice, consideration of the synergistic effects of business acquisitions may also be necessary (i.e., if other reporting units are expected to benefit from an acquired reporting unit, some or all of the acquired goodwill might be assignable to the other units). For example, a purchase may give a division of the acquirer access to a market niche benefiting one of its existing operating units, even if all the tangible and other intangible assets are assigned to other parts of the enterprise. If the goodwill allocation is based on the existence of such synergies, a “with and without” calculation is then used (i.e., it will be necessary to compare the fair value of the reporting unit before the acquisition to that after it).

Goodwill may also be split among two or more reporting units of the acquirer. Any allocation method used is to be consistently applied and the logic for doing so documented.

While it may be costly to accomplish, this benchmark assessment is necessary to ensure that the entity has identified and documented all key assumptions and tested the outputs of the selected valuation model for reasonableness prior to actually testing goodwill for impairment. Furthermore, measuring the fair value of the reporting unit as part of the benchmark assessment will provide management with a “reality check” on whether the amount of goodwill assigned to the reporting unit is reasonable, by comparing the fair value of the reporting unit with its carrying (book) value. If the fair value of the reporting unit is found to be less than its carrying amount, the goodwill allocation methodology should be reassessed, and the selected valuation model and the assumptions underpinning the initial valuation critically reexamined. In those cases where the indicated fair value of the reporting unit is still less than its carrying amount, goodwill would be tested for impairment.

At the acquisition date, management of the acquirer is required to document the basis for and method of determining the fair value of the acquiree as well as other related factors, such as the underlying rationale for making the acquisition and management's expectations with respect to dilution, synergies, and other financial measurements.

Display of goodwill and of goodwill impairment.

The aggregate amount of goodwill is to be presented as a separate line item in the statement of financial position. Traditionally, in classified statements, goodwill is an “other” noncurrent asset, distinguished from property, plant, and equipment.

The aggregate amount of goodwill impairment losses is generally to be presented as a separate line item in the operating section of the income statement. The exception to this rule is when the goodwill impairment loss is associated with a discontinued operation, in which case the impairment loss will be included, on a net-of-tax basis, within the results of discontinued operations. The portion of goodwill associated with net assets to be disposed of is recognized as part of the gain or loss on disposal and is not included in the calculation of impairment loss.

Disclosures about business combinations are to include the primary reason for the acquisition, including a description of the factors that contributed to a purchase price that reflects a premium that results in recognition of goodwill or a discount that results in recognition of an extraordinary gain (negative goodwill). If goodwill is material in relation to the total cost of a business acquisition, disclosure is required of the amount of acquired goodwill. The amount of acquired goodwill related to each segment (only for those entities that are required to report segment information) and the amount of acquired goodwill that is deductible for income tax purposes must also be disclosed.

¹ Assets are defined as “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events” (CON 6, par. 25). Liabilities are defined as “probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events” (CON 6, par. 35).

² In computing the valuation of HI, these amounts would represent such identifiable customer-related intangible assets as customer contract, related customer relationship, production backlog, and the like.

³ Although the accompanying guidance uses the term “fair-value-based measure” to refer to the measurement of share-based awards, the guidance also applies to awards of both the acquirer and acquiree that are measured using either the calculated value method or intrinsic value method.

⁴ The term “requisite service period” includes explicit, implicit, and derived service periods during which employees are required to provide services in exchange for the award. These terms are defined in ASC 71.

⁵ “Frequently Requested Accounting and Financial Reporting Interpretations and Guidance”; Accounting staff members of the Division of Corporation Finance, US SEC; Washington, D.C.; March 31, 2001; www.sec.gov/divisions/corpfin/guidance/cfactfaq.htm

..................Content has been hidden....................

You can't read the all page of ebook, please click here login for view all page.

Table of Contents for 45 ASC 805 BUSINESS COMBINATIONS

Create new playlist

Sign In

Sign Up

45 ASC 805 BUSINESS COMBINATIONS

PERSPECTIVE AND ISSUES

Subtopics

Scope and Scope Exceptions

Overview

DEFINITIONS OF TERMS

CONCEPTS, RULES, AND EXAMPLES

Transactions and Events Accounted for as Business Combinations

Qualifying as a Business

Techniques for Structuring Business Combinations

Accounting for Business Combinations under the Acquisition Method

Step 1—Identify the acquirer.

Step 2—Determine the acquisition date.

Step 3—Identify assets and liabilities requiring separate accounting.

Step 4—Classify or designate identifiable assets acquired and liabilities assumed.

Step 5—Recognize and measure the identifiable tangible and intangible assets acquired and liabilities assumed.

Step 6—Recognize and measure any noncontrolling interest in the acquiree.

Step 7—Measure the consideration transferred.

Step 8—Recognize and measure goodwill or gain on a bargain purchase.

Application Guidance

Business combinations achieved in stages (step acquisitions).

Changes in the parent's ownership interest in a subsidiary.

Allocation of net income and other comprehensive income to the parent and noncontrolling interest.

Push-Down Accounting

Accounting for Leveraged Buyouts

Reverse Acquisitions

Introduction.

Structure of the transaction.

Continuation of the business of the legal acquiree.

Equity structure adjustments.

Consolidation procedures.

Spin-offs and Reverse Spin-offs

Spin-offs.

Reverse spin-offs.

Non-Sub Subsidiaries

Goodwill Impairment

Initial assessment of goodwill's fair value and documentation requirement.

Display of goodwill and of goodwill impairment.

Table of Contents for
45 ASC 805 BUSINESS COMBINATIONS