Chapter 5 — Measurement of Goodwill or Gain From a Bargain Purchase, and Consideration Transferred in a Business Combination

Some have looked to the guidance in ASC 805-10-25-13 as support for recognizing a provisional bargain purchase gain in earnings of the reporting period. That guidance states that “[i]f the initial accounting for a business combination is incomplete by the end of the reporting period in which the combination occurs, the acquirer shall report in its financial statements provisional amounts for the items for which the accounting is incomplete.” Others have looked to the guidance in ASC 805-30-25-4 and ASC 805-30-30-5 as support for recognizing a deferred credit (i.e., a liability) rather than a provisional bargain purchase gain until the accounting for the acquisition is complete (i.e., the end of the measurement period). That guidance requires an acquirer to reassess whether it has correctly identified and measured all of the assets acquired and liabilities assumed before recognizing a gain.

We believe that either approach is acceptable. Entities should disclose (1) that the initial accounting is still provisional and the gain or deferred credit recognized may therefore be subject to future adjustments and (2) the amount of the gain or deferred credit, the line item in which it is recognized, and a description of why the acquisition may result in a gain in accordance with ASC 805-30-50-1(f). The acquirer should also provide the other disclosures required by ASC 805-20-50-4A when the initial accounting for a business combination is incomplete (see Section 7.11).

Some have suggested that a provisional gain should be recognized as a contra-asset if the acquirer believes that the gain may be related to the overstatement of a specific asset or assets, such as identifiable intangible assets, which would be confirmed once the valuations are complete. However, we believe that such an approach suggests that the acquirer’s estimates of fair value may not be appropriate, even provisionally.

The escrowed shares or other securities are a means for an acquirer to gain further assurance that the acquisition agreement’s representations and warranties are accurate and, if they are not, to readily obtain restitution. Representation and warranty provisions generally lapse within a short period after the acquisition date.

In the absence of evidence to the contrary, since the representations and warranties in an acquisition agreement are assumed to be accurate, release of the consideration from escrow is likely to occur. Accordingly, it is generally considered appropriate to include amounts held in escrow in the total consideration transferred as of the acquisition date. However, if the amount held in escrow is related to the outcome of an uncertain future event rather than to circumstances that existed as of the acquisition date, the acquirer should consider whether the amount is contingent consideration (see Section 5.7). The terms of each escrow arrangement must be evaluated individually.

An acquirer also should carefully evaluate the legal terms of the business combination agreement and escrow agreement to determine whether cash held in escrow should continue to be presented as an asset on the acquirer’s balance sheet (e.g., the cash is held in an account legally owned by the acquirer). If the escrowed cash still qualifies for presentation as an asset on its balance sheet, the acquirer should consider whether to recognize a corresponding liability to the seller, which would be a liability incurred to the seller and included as a component of the consideration transferred.

Excesses or shortfalls in working capital that result in the acquirer’s payment or receipt of amounts after the acquisition date should adjust the consideration transferred if the adjustment is made before the end of the measurement period. Working capital adjustments paid or received after the end of the measurement period should be recognized in earnings.

Occasionally, disputes may arise over a working capital provision (e.g., after the acquisition date, entities might question how working capital is defined or how to measure the inputs used in its calculation). In these cases, it is necessary to evaluate whether the nature of the settlement of any such disputes represents the operation of the working capital adjustment or the settlement, in whole or in part, of a dispute arising from the business combination (see Section 6.2.6).

Whether included in the acquisition agreement initially or added at a later date, ticking fees are generally accounted for as part of the consideration transferred, provided that the business combination closes. In other words, the consideration transferred increases if the provision is triggered. However, entities should consider whether any overpayment resulting from the triggered provision may indicate that the goodwill is not recoverable in subsequent goodwill impairment testing under ASC 350-20 or represents payment for something other than the business acquired. See Section 6.2 for more information about accounting for transactions separately from the business combination.

Accordingly, the costs of and proceeds from using these instruments (including subsequent gains and losses) are not part of the consideration transferred in a business combination and instead are accounted for in accordance with other applicable GAAP (e.g., ASC 815). For example, if a derivative is executed in connection with a business combination to economically hedge the foreign currency risk associated with the consideration to be transferred, the acquirer initially recognizes the derivative at fair value and records subsequent changes in the derivative’s fair value in earnings. See Section 2.2.1.3 of Deloitte’s Roadmap Hedge Accounting for more information.

 

Connecting the Dots

In a June 19, 2018, agenda request, the ISDA’s Accounting Committee asked the FASB to consider an agenda topic that “extends the ability to designate a fair value or cash flow hedge of foreign currency exposure” related to either a firmly committed or forecasted acquisition of a business. As of the date of the publication of this Roadmap, the FASB has not added this topic to its agenda.

While an entity cannot hedge an expected business combination or a firm commitment to enter into such a combination, it is not prohibited from designating a transaction that is contingent on a business combination (e.g., interest payments related to the acquirer’s forecasted issuance of debt to fund the business combination) as the hedged item in a qualifying cash flow hedging relationship. However, the hedging relationship would need to meet the criteria to qualify for cash flow hedge accounting, and it may be difficult to assert that the consummation of a business combination is probable. An entity should consider the many uncertainties involved in entering into a business combination, including the need to obtain shareholder and regulatory approvals. See Section 4.1.1.1 of Deloitte’s Roadmap Hedge Accounting for more information.

The acquirer’s acquisition-related costs are not part of the consideration transferred. ASC 805-10-25-23 states that “[t]he acquirer shall account for acquisition-related costs as expenses in the periods in which the costs are incurred and the services are received, with one exception. The costs to issue debt or equity securities shall be recognized in accordance with other applicable GAAP.” Therefore, the acquirer should account for the direct and indirect costs of the acquisition as expenses in the periods in which the costs are incurred and the services are received.

In SAB Topic 5.A, the SEC staff states that “[s]pecific incremental costs directly attributable to a proposed or actual offering of securities may properly be deferred and charged against the gross proceeds of the offering.” Therefore, the costs to issue equity securities are generally reflected as a reduction of the amount that would have otherwise been recognized in additional paid-in capital (APIC).

SAB Topic 5.A goes on to say:

If the acquirer incurs debt to fund the acquisition, it should present the debt issuance costs in the balance sheet as a direct deduction from the face amount of the debt and amortize the costs as interest expense in accordance with ASC 835-30-45.

SAB Topic 2.A.6 discusses a scenario in which an investment banker provides both advisory services and underwriting services associated with issuing debt or equity securities in connection with a business combination and the costs are billed to the acquirer as a single amount. The interpretative response to Question 1 of SAB Topic 2.A.6 states:

While SAB Topic 2.A.6 states that “the total fees incurred by an entity should be allocated between the services received on a relative fair value basis,” we believe that the amounts allocated to debt issuance costs should result in an effective interest rate on the debt that is consistent with an effective market interest rate. Likewise, we believe that the amounts allocated to equity issuance costs should be consistent with fees an underwriter would charge.

The interpretive response to Question 2 of SAB Topic 2.A.6 also addresses the amortization of debt issue costs related to interim “bridge financing.” It states:

Any debt issuance costs allocated to bridge financing should be amortized over the estimated term of the bridge financing. If the bridge financing is repaid before the end of the originally estimated term, the unamortized amount of the debt issuance costs of such financing is written off as interest cost in accordance with ASC 340-10-S99. When bridge financing consists of increasing-rate debt and term-extending debt (i.e., debt that can be extended upon maturity at the option of the issuer with specified interest rate increases each time the maturity is extended), acquirers should consider the guidance in ASC 470-10-35-1 and 35-2 and ASC 835-30 on the application of the effective interest method. They should also consider the guidance in ASC 815-15 and ASC 815-10-55-19 through 55-21 on determining whether to bifurcate embedded derivatives related to the option to extend.

We believe that the acquirer’s direct expenses for acquisition-related costs should not be recognized in the acquiree’s separate financial statements unless the acquirer incurred such costs on behalf of, or for the benefit of, the acquiree. The interpretive response to Question 1 of SAB Topic 1.B.1 states, in part, that “[i]n general, the staff believes that the historical income statements of a registrant should reflect all of its costs of doing business. Therefore, in specific situations, the staff has required the subsidiary to revise its financial statements to include certain expenses incurred by the parent on its behalf.” See Section A.12 for more information.

SAB Topic 5.T also discusses the concept of reflecting costs incurred by a shareholder on behalf of a company in the company’s financial statements. It states that a transaction in which “a principal stockholder pays an expense for the company, unless the stockholder’s action is caused by a relationship or obligation completely unrelated to his position as a stockholder or such action clearly does not benefit the company,” should be reflected as an expense in the company’s financial statements, with a corresponding credit to APIC. While the guidance in SAB Topics 1.B and 5.T pertains to public companies, we believe that private companies should also apply it when evaluating the recognition of acquisition-related costs.

If the success fee is the legal obligation of the acquirer, an entity recognizes it as an expense in the acquirer’s financial statements at the time of the business combination. See Section A.16.1 for guidance on accounting for expenses of the acquiree triggered by a business combination in the separate financial statements of an acquiree that applies pushdown accounting.

Contingent consideration is part of the consideration transferred for the acquiree and therefore must be measured and recognized at fair value as of the acquisition date, which can be challenging. Acquirers need to identify the key inputs of the arrangement and use market participant assumptions when determining the fair value of contingent consideration. Key inputs may include estimated timing and the probability that the conditions or milestones in the arrangement will be met. Acquirers also need to apply judgment when assessing the probability that each potential outcome will be achieved.

Not all payments to be made to the seller in the future should be classified as contingent consideration. For example:

• Consideration held in escrow, or payments related to working capital adjustments, are not contingent consideration because they are not contingent on a future event; such amounts are payable on the basis of facts and circumstances that existed as of the acquisition date (see Sections 5.3.1 and 5.3.2).
• A conditional future payment linked to continuing employment should be accounted for as compensation in the acquirer’s postcombination financial statements (see Section 6.2.3.3.1).
• Obligations to deliver consideration in the future that are not contingent on the occurrence of a future event (e.g., a seller note or a payment for the use of property) should be accounted for by using other applicable GAAP, depending on the nature of the obligation. Like contingent consideration, noncontingent obligations would generally be initially measured at fair value; however, the subsequent accounting may differ.

While ASC 805 specifies that contingent consideration must be recognized at its acquisition-date fair value, it refers to other GAAP for determining the classification of such consideration as of the acquisition date as a liability, as equity, or (less frequently) as an asset. How an acquirer classifies a contingent consideration arrangement determines the subsequent accounting for the arrangement.

The classification of many contingent consideration arrangements will be evident. For example, arrangements are classified as liabilities if they obligate the acquirer to deliver to the seller cash, other assets, or equity securities of a third party. Similarly, contingent consideration arrangements are classified as assets (or as equity if appropriate under ASC 815-40) if they require the seller to return previously transferred consideration to the acquirer if the contingency is met in the future.

Often, contingent consideration arrangements obligate the acquirer to deliver its own equity instruments (or the equity instruments of one of the acquirer’s substantive subsidiaries) to the seller. Determining the classification of a contingent consideration arrangement that is settleable in the acquirer’s own equity can be challenging. ASC 805 does not provide guidance on classifying such contingent consideration arrangements, but it refers to other accounting standards for guidance (generally ASC 480-10 and ASC 815). To determine the classification of a contingent consideration arrangement that is settleable in the acquirer’s own equity, an acquirer should consider the following guidance:

• ASC 480-10 on distinguishing liabilities from equity.
• ASC 815-10-15 on determining whether an arrangement meets the definition of a derivative instrument and is within the scope of ASC 815-10.
• ASC 815-40-15-5 through 15-8 on determining whether an arrangement is indexed to the acquirer’s own shares.
• ASC 815-40-25 on determining whether an arrangement is classified in equity in the acquirer’s statement of financial position.

Most contingent consideration arrangements will be classified as liabilities under the above guidance. However, entities should base their determination on their specific facts and circumstances. Depending on the complexity of the arrangement, they may decide to consult with a financial instruments specialist. The discussion below highlights some common contingent consideration scenarios but does not provide comprehensive guidance.

A contingent consideration arrangement that is classified as an asset or a liability is remeasured at fair value each reporting period until the contingency is resolved. The acquirer recognizes changes in fair value in earnings each period unless it designates the arrangement as a cash flow hedging instrument that is subject to ASC 815-10.

If the contingent consideration is classified as an equity instrument, it is not remeasured. The initial amount recognized for contingent consideration classified as equity is not adjusted even if the fair value of the arrangement changes. The subsequent settlement of the arrangement on the date the contingency is resolved is accounted for in equity.

Adjustments made during the measurement period that pertain to facts and circumstances that existed as of the acquisition date are recognized as adjustments to goodwill. The acquirer must consider all pertinent factors in determining whether information obtained after the acquisition date should result in an adjustment to the provisional amounts recognized or whether that information results from events that occurred after the acquisition date. Changes in fair value resulting from events that occur after the acquisition date are recognized in earnings and not as adjustments to goodwill.

ASC 350-20-35-30 requires entities to test a reporting unit’s goodwill for impairment between annual dates if an event occurs or circumstances change that would more likely than not reduce the reporting unit’s fair value below its carrying amount. The acquirer should consider whether a reduced likelihood that a contingent consideration payment will be made is an indicator of impairment for any reporting units to which the arrangement is related (e.g., the earnings targets specified in an arrangement are no longer expected to be achieved or the likelihood of achievement is significantly reduced).

For additional discussion of the effect of contingently issuable shares on EPS calculations, see Deloitte’s Roadmap Earnings per Share.

A mutual entity is a private company whose owners are also its customers. As owner-customers, they are entitled to receive the profits or income generated by the mutual entity. Such profits may be in the form of dividends or lower costs that are distributed pro rata on the basis of the amount of business each customer conducts with the mutual entity. Examples of mutual entities include mutual insurance companies, cooperatives, credit unions, and savings and loans.

As discussed in Section 2.2.2, acquisitions between mutual entities are within the scope of ASC 805. Accordingly, one of the combining entities must be identified as the acquirer on the basis of the factors in ASC 805-10-55-11 through 55-15 (see Section 3.1). Typically, no consideration is transferred in a combination between mutual entities. The combination is effected through the exchange of member interests. To apply the acquisition method, the entity must determine which is more reliably measurable, the fair value of the member interests transferred by the entity identified as the acquirer or the fair value of the member interests of the entity identified as the acquiree (i.e., the fair value of the acquiree as a whole). In some cases, because member interests of mutual entities are not publicly traded, the fair value of the entity identified as the acquiree is more reliably measurable. Therefore, the fair value of the acquiree as a whole would be used as a substitute for the consideration transferred. In a business combination between mutual entities, goodwill is measured on the basis of the amount by which the acquiree’s fair value as a whole exceeds the fair value of its net assets. The acquiree’s assets acquired, including identifiable intangible assets, and liabilities assumed must be measured in accordance with ASC 805, generally at their fair values. The fair value of the acquiree is added directly to the acquirer’s equity (e.g., generally APIC) and not to its retained earnings.