Chapter 6 — Other Acquisition Method Guidance

6.2 Assessing Whether a Transaction Is Separate From the Business Combination

ASC 805-10

Determining What Is Part of the Business Combination Transaction

25-20 The acquirer and the acquiree may have a preexisting relationship or other arrangement before negotiations for the business combination began, or they may enter into an arrangement during the negotiations that is separate from the business combination. In either situation, the acquirer shall identify any amounts that are not part of what the acquirer and the acquiree (or its former owners) exchanged in the business combination, that is, amounts that are not part of the exchange for the acquiree. The acquirer shall recognize as part of applying the acquisition method only the consideration transferred for the acquiree and the assets acquired and liabilities assumed in the exchange for the acquiree. Separate transactions shall be accounted for in accordance with the relevant generally accepted accounting principles (GAAP).

25-21 A transaction entered into by or on behalf of the acquirer or primarily for the benefit of the acquirer or the combined entity, rather than primarily for the benefit of the acquiree (or its former owners) before the combination, is likely to be a separate transaction. The following are examples of separate transactions that are not to be included in applying the acquisition method:

A transaction that in effect settles preexisting relationships between the acquirer and acquiree (see paragraphs 805-10-55-20 through 55-23)
A transaction that compensates employees or former owners of the acquiree for future services (see paragraphs 805-10-55-24 through 55-26)
A transaction that reimburses the acquiree or its former owners for paying the acquirer’s acquisition-related costs (see paragraph 805-10-25-23).

As part of its accounting for an acquisition, an acquirer must assess whether the items exchanged include amounts that are separate from the business combination. In some cases, an acquirer and seller (or acquiree) may have an arrangement or relationship — such as a supply, distribution, franchise, or licensing agreement; lease contracts; or potential or ongoing litigation — that arose before the negotiations for the acquisition began. ASC 805 refers to such arrangements as preexisting relationships. In other cases, an acquirer and seller (or acquiree) may enter into agreements or arrangements in close proximity to the business combination. ASC 805 provides guidance for assessing whether particular transactions or arrangements are part of the business combination or should be accounted for separately from the business combination accounting.

6.2.1 Determining What Should Be Accounted for Separately From a Business Combination

To determine what is or is not part of a business combination, an entity must consider the relevant facts and circumstances of the arrangement. ASC 805-10-25-20 states, in part, that “[t]he acquirer shall recognize as part of applying the acquisition method only the consideration transferred for the acquiree and the assets acquired and liabilities assumed in the exchange for the acquiree. Separate transactions shall be accounted for in accordance with the relevant generally accepted accounting principles (GAAP).” Specifically, ASC 805-10-55-18 provides three factors, which “are neither mutually exclusive nor individually conclusive,” for an entity to consider when making this determination:

The reasons for the transaction. Understanding the reasons why the parties to the combination (the acquirer, the acquiree, and their owners, directors, managers, and their agents) entered into a particular transaction or arrangement may provide insight into whether it is part of the consideration transferred and the assets acquired or liabilities assumed. For example, if a transaction is arranged primarily for the benefit of the acquirer or the combined entity rather than primarily for the benefit of the acquiree or its former owners before the combination, that portion of the transaction price paid (and any related assets or liabilities) is less likely to be part of the exchange for the acquiree. Accordingly, the acquirer would account for that portion separately from the business combination.
Who initiated the transaction. Understanding who initiated the transaction may also provide insight into whether it is part of the exchange for the acquiree. For example, a transaction or other event that is initiated by the acquirer may be entered into for the purpose of providing future economic benefits to the acquirer or combined entity with little or no benefit received by the acquiree or its former owners before the combination. On the other hand, a transaction or arrangement initiated by the acquiree or its former owners is less likely to be for the benefit of the acquirer or the combined entity and more likely to be part of the business combination transaction.
The timing of the transaction. The timing of the transaction may also provide insight into whether it is part of the exchange for the acquiree. For example, a transaction between the acquirer and the acquiree that takes place during the negotiations of the terms of a business combination may have been entered into in contemplation of the business combination to provide future economic benefits to the acquirer or the combined entity. If so, the acquiree or its former owners before the business combination are likely to receive little or no benefit from the transaction except for benefits they receive as part of the combined entity.

Determining what is or is not part of a business combination requires judgment, particularly when both the acquirer and acquiree may benefit from a particular transaction.

ASC 805-10-25-21 specifies that “[a] transaction entered into by or on behalf of the acquirer or primarily for the benefit of the acquirer or the combined entity, rather than primarily for the benefit of the acquiree (or its former owners) before the combination, is likely to be a separate transaction.” However, it also states that the following are transactions that must be accounted for separately from the business combination:

“A transaction that in effect settles preexisting relationships between the acquirer and acquiree” — see ASC 805-10-55-20 through 55-23 and Section 6.2.2.
“A transaction that compensates employees or former owners of the acquiree for future services” — see ASC 805-10-55-24 through 55-26 and Section 6.2.3.
“A transaction that reimburses the acquiree or its former owners for paying the acquirer’s acquisition-related costs” — see ASC 805-10-25-23 and Section 5.4.1.1.

These are examples only. Acquirers must assess whether other transactions with the acquiree should be accounted for separately from the business combination.

6.2.2 Effective Settlement of Preexisting Relationships Between the Acquirer and Acquiree

ASC 805-10

Effective Settlement of a Preexisting Relationship Between the Acquirer and Acquiree in a Business Combination

55-20 The acquirer and acquiree may have a relationship that existed before they contemplated the business combination, referred to here as a preexisting relationship. A preexisting relationship between the acquirer and acquiree may be contractual (for example, vendor and customer or licensor and licensee) or noncontractual (for example, plaintiff and defendant).

55-21 If the business combination in effect settles a preexisting relationship, the acquirer recognizes a gain or loss, measured as follows:

For a preexisting noncontractual relationship, such as a lawsuit, fair value
For a preexisting contractual relationship, the lesser of the following:
1. The amount by which the contract is favorable or unfavorable from the perspective of the acquirer when compared with pricing for current market transactions for the same or similar items. An unfavorable contract is a contract that is unfavorable in terms of current market terms. It is not necessarily a loss contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it.
2. The amount of any stated settlement provisions in the contract available to the counterparty to whom the contract is unfavorable. If this amount is less than the amount in (b)(1), the difference is included as part of the business combination accounting.

55-22 Examples 2 and 3 (see paragraphs 805-10-55-30 through 55-33) illustrate the accounting for the effective settlement of a preexisting relationship as a result of a business combination. As indicated in Example 3 (see paragraph 805-10-55-33), the amount of gain or loss recognized may depend in part on whether the acquirer had previously recognized a related asset or liability, and the reported gain or loss therefore may differ from the amount calculated by applying paragraph 805-10-55-21.

55-23 A preexisting relationship may be a contract that the acquirer recognizes as a reacquired right in accordance with paragraph 805-20-25-14. If the contract includes terms that are favorable or unfavorable when compared with pricing for current market transactions for the same or similar items, the acquirer recognizes, separately from the business combination, a gain or loss for the effective settlement of the contract, measured in accordance with paragraph 805-10-55-21.

A preexisting relationship between an acquirer and acquiree may be contractual (e.g., a lease contract or a supply, distribution, franchise, licensing, or debt agreement) or noncontractual (e.g., a dispute or litigation between the acquirer and the seller or acquiree). Such a relationship is considered effectively settled as part of the business combination even if it is not legally cancelled since, upon the acquisition date, it becomes an “intercompany” relationship that is eliminated in consolidation in the postcombination financial statements. A reacquired right is also a preexisting relationship (see Section 4.3.7). When there is more than one contract or agreement between the parties to the business combination, the effective settlement of each preexisting relationship should be assessed separately. ASC 805 provides guidance on measuring any gain or loss from the effective settlement of a preexisting relationship. The measurement depends on whether the relationship is contractual or noncontractual, as discussed below.

6.2.2.1 Effective Settlement of a Noncontractual Preexisting Relationship

If a business combination results in the effective settlement of a noncontractual preexisting relationship such as a lawsuit, threatened litigation, or dispute, the gain or loss should be recognized and measured at fair value in accordance with the guidance in ASC 805-10-55-21. However, measuring the fair value of the effective settlement of such a noncontractual preexisting relationship may be challenging, and the gain or loss may differ from the amount the acquirer previously recognized, if any. For example, the fair value of the settlement of a lawsuit would most likely differ from the amount the acquiree would have recognized under ASC 450.

In his remarks at the 2007 AICPA Conference on Current SEC and PCAOB Developments, then SEC OCA Associate Chief Accountant Eric West discussed the accounting for litigation settlements that occur in combination with other arrangements. He stated, in part:

[W]e believe that it would be acceptable to value each element of the arrangement and allocate the consideration paid to each element using relative fair values. To the extent that one of the elements of the arrangement just can’t be valued, we believe that a residual approach may be a reasonable solution. In fact, we have found that many companies are not able to reliably estimate the fair value of the litigation component of any settlement and have not objected to judgments made when registrants have measured this component as a residual. In a few circumstances companies have directly measured the value of the litigation settlement component.

These remarks indicate that if an entity cannot measure the fair value of an element of a transaction, such as litigation, it can measure the element as a residual. However, we believe that the measurement of the fair value of the acquiree should exclude any preexisting relationships. That is, while a market participant would include the preexisting relationship in its measurement of the acquiree, the guidance requires the acquirer to account for that preexisting relationship separately from the business combination. Therefore, the acquirer’s measurement of the acquiree should be exclusive of any relationships that are effectively settled as part of the combination.

While Mr. West’s speech was delivered before FASB Statement 141(R) was issued, we believe that the guidance continues to be relevant under ASC 805.

Example 6-4

Effective Settlement of a Lawsuit in a Business Combination

Company A files a lawsuit against Company B for unauthorized use of A’s intellectual property. Company A concludes that any potential settlement with B would be a contingent gain and therefore does not recognize an asset in its financial statements. Likewise, B does not recognize a liability in its financial statements for the contingent loss related to the lawsuit because it believes that no amount of loss is probable. Company A acquires B and accounts for the acquisition as a business combination.

As part of the accounting for the acquisition, A determines that a gain exists related to the effective settlement of the lawsuit. Company A should measure that gain at fair value and recognize it separately from the accounting for the acquisition. If A cannot directly determine the lawsuit’s fair value, A can measure it as the difference between the amount paid for the acquisition and the fair value of B without the lawsuit. While a market participant would include the lawsuit in its measurement of B, we believe that A’s exclusion of it is consistent with the requirement to account for preexisting relationships separately from the business combination.

6.2.2.2 Effective Settlement of a Contractual Preexisting Relationship

When a business combination results in the effective settlement of a preexisting contractual relationship, entities should recognize and measure the resulting gain or loss in accordance with the guidance in ASC 805-10-55-21(b). That guidance requires that the settlement gain or loss for a contractual preexisting relationship be measured as the lesser of the following:

“The amount by which the contract is favorable or unfavorable from the perspective of the acquirer when compared with pricing for current market transactions for the same or similar items. An unfavorable contract is a contract that is unfavorable in terms of current market terms. It is not necessarily a loss contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it.”
“The amount of any stated settlement provisions in the contract available to the counterparty to whom the contract is unfavorable. If this amount is less than the amount in (b)(1), the difference is included as part of the business combination accounting.”

If a contractual preexisting relationship is cancelable by either party without penalty, the stated settlement provision is zero and no settlement gain or loss should be recognized regardless of whether the contract is favorable or unfavorable to the acquirer. However, if there are no stated settlement provisions and the contract is not cancelable, entities should recognize a settlement gain or loss on the basis of the amount by which the contract is favorable or unfavorable to the acquirer (i.e., on the basis of the settled contract’s acquisition-date fair value). ASC 805 provides the following example to illustrate the accounting for the effective settlement of a preexisting relationship when an acquirer does not have an amount previously recognized related to the contract:

ASC 805-10

Example 2: Effective Settlement of a Supply Contract as a Result of a Business Combination

55-30 This Example illustrates the guidance in paragraphs 805-10-55-20 through 55-21. Acquirer purchases electronic components from Target under a five-year supply contract at fixed rates. Currently, the fixed rates are higher than rates at which Acquirer could purchase similar electronic components from another supplier. The supply contract allows Acquirer to terminate the contract before the end of the initial 5-year term only by paying a $6 million penalty. With 3 years remaining under the supply contract, Acquirer pays $50 million to acquire Target, which is the fair value of Target based on what other market participants would be willing to pay.

55-31 Included in the total fair value of Target is $8 million related to the fair value of the supply contract with Acquirer. The $8 million represents a $3 million component that is at-market because the pricing is comparable to pricing for current market transactions for the same or similar items (selling effort, customer relationships, and so forth) and a $5 million component for pricing that is unfavorable to Acquirer because it exceeds the price of current market transactions for similar items. Target has no other identifiable assets or liabilities related to the supply contract, and Acquirer has not recognized any assets or liabilities related to the supply contract before the business combination.

55-32 In this Example, Acquirer recognizes a loss of $5 million (the lesser of the $6 million stated settlement amount and the amount by which the contract is unfavorable to the acquirer) separately from the business combination. The $3 million at-market component of the contract is part of goodwill.

6.2.2.3 Settlement of a Preexisting Relationship if the Acquirer Had Previously Recognized an Asset or Liability

If an acquirer has recognized an asset or liability related to the preexisting relationship before the acquisition, it should include that amount in calculating the settlement gain or loss. The scenario in Example 2 in ASC 805-10-55-30 through 55-32 is continued below in Example 3, which illustrates the accounting for the effective settlement of a preexisting relationship when an acquirer has an amount previously recognized related to the contract.

ASC 805-10

Example 3: Effective Settlement of a Contract Between the Acquirer and Acquiree in Which the Acquirer Had Recognized a Liability Before the Business Combination

55-33 This Example illustrates the guidance in paragraphs 805-10-55-20 through 55-21. Whether Acquirer had previously recognized an amount in its financial statements related to a preexisting relationship will affect the amount recognized as a gain or loss for the effective settlement of the relationship. In Example 2 (see paragraph 805-10-55-30), generally accepted accounting principles (GAAP) might have required Acquirer to recognize a $6 million liability for the supply contract before the business combination. In that situation, Acquirer recognizes a $1 million settlement gain on the contract in earnings at the acquisition date (the $5 million measured loss on the contract less the $6 million loss previously recognized). In other words, Acquirer has in effect settled a recognized liability of $6 million for $5 million, resulting in a gain of $1 million.

Example 6-4A

Company A acquires all of the outstanding shares of Company B in a business combination by paying $1 million in cash to the former owners of B. On the acquisition date, A has a $50,000 account receivable from B, and B has an equal account payable to A.

As a result of the acquisition of B, the account receivable and payable is effectively settled between the parties. Accordingly, the consideration transferred for B is $1,050,000 (i.e., $1 million in cash plus the forgiveness of the accounts receivable). Because there is no off-market amount or stated settlement provisions, A does not recognize a gain or loss upon the settlement.

6.2.2.3.1 Effective Settlement of Debt Between the Parties to a Business Combination

A business combination may result in the effective settlement of debt between an acquirer and an acquiree. If the acquirer was the issuer of the debt and it is settled as a result of the business combination, the acquirer would apply the guidance in ASC 470-50 to account for the debt extinguishment. An extinguishment gain or loss would be recognized if the reacquisition price (fair value or stated settlement amount) differs from the net carrying amount of the debt. Any settlement gain or loss would be recognized separately from the business combination.

Example 6-4B

On January 1, 20X2, Company A issued $50,000 in debt securities to Company B. On June 30, 20X3, A acquires all of the outstanding shares of B in a business combination by paying $1 million in cash to the former owners of B. On the acquisition date, the carrying amount of the debt is $40,000 and its fair value is $41,000.

As a result of the acquisition of B, A would recognize a $1,000 loss related to the settlement of the debt securities with B, calculated as the amount by which the fair value of the debt exceeds its carrying amount. The consideration transferred for B is $959,000, calculated as the cash paid to the former owners of B less the fair value of the debt.

If the acquiree was the issuer of the debt and it is settled as a result of the business combination, the acquirer would be effectively settling a receivable and would apply the guidance in ASC 805-10-55-21 related to the settlement of preexisting relationships in a business combination. See the next section for more information.

6.2.2.4 Settlement of a Preexisting Relationship if the Acquirer Is a Customer of the Acquiree

If an entity acquires one of its vendors (i.e., the acquirer was a customer of the acquiree) in a business combination, the acquirer should recognize a settlement gain or loss in accordance with ASC 805-10- 55-21 for the effective settlement of any contractual arrangements. However, even though the parties have a preexisting relationship, the acquirer would not recognize a customer-relationship intangible asset for its relationship with its former vendor because the customer relationship no longer exists after the acquisition (i.e., the acquirer would not record a customer relationship with itself as a result of the business combination). The guidance in ASC 805-10-55-32 (see above) demonstrates that the acquirer should not recognize a separate intangible asset for the customer relationship; instead, that amount should be part of goodwill.

6.2.2.5 Settlement of a Preexisting Relationship When Less Than 100 Percent of the Acquiree Is Acquired

The SEC staff has discussed the accounting for a preexisting relationship in a less than 100 percent acquisition. In prepared remarks at the 2005 AICPA Conference on Current SEC and PCAOB Developments, then SEC OCA Professional Accounting Fellow Brian Roberson discussed preexisting relationships between parties to a business combination in a partial acquisition:

One issue that has arisen is whether this issue applies to other than 100 percent acquisitions and, if so, how it is applied. The answer is that it applies anytime you have something that qualifies as a business combination. The harder part of the question is how to value the preexisting relationship and that is where facts and circumstances come into play.

For instance, assume you own 40 percent of an entity and another party owns 60 percent and that you have an unfavorable supply contract with the entity. If you buy an additional 15 percent interest in the entity and you, as the new controlling shareholder, have the ability to cancel the supply contract, you would likely have to pay the other shareholder its entire portion of the value of the supply contract since it will be giving up its favorable position in the contract. If, on the other hand, you buy the same 15 percent interest but cannot cancel the contract, you would likely only pay the other shareholder the value of the 15 percent interest in the contract as the other shareholder will still realize value for the 45 percent interest it retained. I do not mean to imply that all valuations will be this straightforward, but the important point is that determining the settlement gain or loss in a partial acquisition is not a simple mathematical exercise - you need to step back and consider all of the facts and circumstances and the impact they would have on the value lost or gained by the other interest holders.

While the SEC staff made these remarks before the FASB issued Statement 141(R), we believe that they continue to be relevant.

6.2.2.6 Reacquired Rights

ASC 805-10

A preexisting relationship may represent a reacquired right of the acquirer — for example, a “right to use the acquirer’s trade name under a franchise agreement or a right to use the acquirer’s technology under a technology licensing agreement.” All reacquired rights are preexisting relationships, even though all preexisting relationships are not reacquired rights. If a preexisting relationship represents a reacquired right, the acquirer recognizes a settlement gain or loss, if any, separately from the business combination measured in accordance with ASC 805-10-55-21.

The acquirer also recognizes a reacquired right as an identifiable intangible asset separately from goodwill because it arises from contractual rights. However, reacquired rights are an exception to the measurement principle in ASC 805 because such rights must be measured on the basis of the remaining contractual term of the related contract, regardless of whether market participants would consider potential contractual renewals in determining the fair value of those rights. See Section 4.3.7 for more information about the measurement of reacquired rights.

6.2.2.7 Reimbursement of the Acquirer’s Acquisition-Related Costs

ASC 805-10-25-21(c) specifies that “[a] transaction that reimburses the acquiree or its former owners for paying the acquirer’s acquisition-related costs” is a separate transaction that should not be included in the application of the acquisition method. That is, if the acquirer and acquiree enter into an arrangement in which the acquiree pays the acquirer’s acquisition-related costs and the acquirer agrees to reimburse the acquiree either as part of the consideration transferred or otherwise, such costs must be accounted for separately from the business combination in accordance with their nature and not as part of the consideration transferred. See Section 5.4.1 for guidance on the accounting for the acquirer’s acquisition-related costs.

6.2.3 Compensation Arrangements

An acquiree in a business combination may have agreements in place to provide specified employees with additional compensation that is predicated on a change in control of the acquiree. Such arrangements could have been established either before or after the negotiations began for the business combination. When determining whether the acquirer should account for these arrangements as part of the business combination or separately as compensation, entities must use judgment and consider the specific facts and circumstances as discussed below. However, if a business combination results in additional compensation arrangements that include payments to the acquirer’s employees, such payments are always compensation.

6.2.3.1 Arrangements to Pay an Acquiree’s Employee Upon a Change in Control

Arrangements may be established with the objective of retaining one or more of the acquiree’s employees until the acquisition date and possibly for a defined period thereafter. Such arrangements — often referred to in practice as “stay bonuses,” “change in control payments,” or “golden parachutes” — may also provide additional compensation for performance related to the business combination or compensate employees who are terminated after the combination. An entity should account for these arrangements on the basis of their substance. In assessing the substance of an arrangement, an entity should consider the factors listed in ASC 805-10-55-18 (i.e., “[t]he reasons for the transaction,” “[w]ho initiated the transaction,” and “[t]he timing of the transaction”). See Section 10.7.1 of Deloitte’s Roadmap Share Based Payment Awards for more information.

ASC 805-10-55-34 through 55-36 provide the following example of a contingent payment to an acquiree’s employee:

ASC 805-10

Example 4: Arrangement for Contingent Payment to an Employee

55-34 This Example illustrates the guidance in paragraphs 805-10-55-24 through 55-25 relating to contingent payments to employees in a business combination. Target hired a candidate as its new chief executive officer under a 10-year contract. The contract required Target to pay the candidate $5 million if Target is acquired before the contract expires. Acquirer acquires Target eight years later. The chief executive officer was still employed at the acquisition date and will receive the additional payment under the existing contract.

55-35 In this Example, Target entered into the employment agreement before the negotiations of the combination began, and the purpose of the agreement was to obtain the services of the chief executive officer. Thus, there is no evidence that the agreement was arranged primarily to provide benefits to Acquirer or the combined entity. Therefore, the liability to pay $5 million is included in the application of the acquisition method.

55-36 In other circumstances, Target might enter into a similar agreement with the chief executive officer at the suggestion of Acquirer during the negotiations for the business combination. If so, the primary purpose of the agreement might be to provide severance pay to the chief executive officer, and the agreement may primarily benefit Acquirer or the combined entity rather than Target or its former owners. In that situation, Acquirer accounts for the liability to pay the chief executive officer in its postcombination financial statements separately from application of the acquisition method.

In accounting for the acquisition, the acquirer will need to assess whether to recognize amounts that have been determined to be part of the business combination as part of the consideration transferred or as a liability assumed.

If the acquirer issues cash, other assets, or its equity instruments to settle the acquiree’s awards that were equity-classified in the acquiree’s precombination financial statements, the portion determined to be part of the business combination represents consideration transferred since the acquiree’s employees were owners of (or increased their ownership in) the acquiree as a result of the arrangement.

By contrast, if the acquirer issues cash, other assets, or its equity instruments to settle a bonus arrangement (e.g., stay bonus) with the acquiree’s employees or to settle the acquiree’s awards that were liability-classified in the acquiree’s precombination financial statements, the portion determined to be part of the business combination would be treated in the acquisition accounting as a liability assumed.

If arrangements to pay an acquiree’s employees upon a change in control are settled in cash or in other assets after the acquisition date rather than at the closing of the business combination, the acquirer would recognize a liability in its acquisition accounting for the portion determined to be part of the business combination. In the acquisition accounting, the nature of that liability as either consideration transferred or a liability assumed should be determined on the basis of the analysis described above.

6.2.3.2 Dual- or Double-Trigger Arrangements

An employment agreement entered into before negotiations began for the business combination may include terms that require a payment or accelerate vesting upon (1) a change of control and (2) a second defined event or “trigger,” which is why such provisions are commonly called “dual trigger” or “double trigger” arrangements. The second defined event is generally the separation of the employee from the acquirer and might be limited to involuntary terminations or might also include resignation of the employee in specified conditions (sometimes referred to as “good reasons”) such as:

A demotion or significant reduction in the employee’s duties or responsibilities after the acquisition date.
A significant reduction in the employee’s salary after the acquisition date.
The relocation of the employee’s job site beyond a specified radius after the acquisition date.

The objective of such employment agreements, which are typically entered into before negotiations have begun for a business combination, is generally to obtain the employee’s services. While the three factors in ASC 805-10-55-18 (i.e., “[t]he reasons for the transaction,” “[w]ho initiated the transaction,” and “[t]he timing of the transaction”) might indicate that the payments should be accounted for as part of the business combination, such arrangements are generally accounted for separately from the business combination. This is because the decision to effect the second trigger (i.e., the employee’s involuntary termination or voluntary termination for “good reason”) is under the control of the acquirer and is therefore presumed to be made primarily for the acquirer’s benefit (e.g., to reduce cost by eliminating the unneeded employee).

Example 6-5

Dual- or Double-Trigger Arrangement Involving the Termination of Employment

Company A acquires Company B in a transaction accounted for as a business combination. Company B has an existing employment agreement with its CEO that was put in place before negotiations began for the combination. Under the agreement, all of the CEO’s unvested awards will fully vest upon (1) a change in the control of B and (2) the involuntary termination of the CEO’s employment within one year after the acquisition date.

Before the closing, A determines that it will not offer employment to the CEO after the combination has been completed. Thus, both conditions are triggered, and the vesting of the CEO’s awards is accelerated upon the closing of the acquisition.

The decision not to employ B’s former CEO was under A’s control and was made for A’s benefit (i.e., to reduce costs). Therefore, A should recognize the compensation cost related to the acceleration of the unvested portion of the awards in its postcombination financial statements and not as part of the business combination.

Example 6-6

Dual- or Double-Trigger Arrangement in Which Employee Resigns for “Good Reason”

As in the example above, Company A acquires Company B in a transaction accounted for as a business combination, and B has an existing employment agreement with its CEO. However, in this example, the agreement provides that all of the CEO’s unvested awards will fully vest upon (1) a change in the control of B and (2) either the involuntary termination of the CEO or the voluntary departure of the CEO for “good reason” within one year after the acquisition date. The agreement specifies that a significant reduction in job responsibilities would be a good reason. After the acquisition date, B’s CEO will not assume the role of CEO of the combined entity but instead will be assigned a position with significantly reduced responsibilities. In response, B’s CEO will resign upon the change in control.

The decision to significantly reduce the responsibilities of B’s former CEO after the acquisition date is within A’s control. Therefore, A should recognize the compensation cost related to the acceleration of the unvested portion of the awards in its postcombination financial statements and not as part of the business combination.

6.2.3.3 Arrangements for Contingent Payments to Employees or Selling Shareholders

ASC 805-10

55-24 Whether arrangements for contingent payments to employees or selling shareholders are contingent consideration in the business combination or are separate transactions depends on the nature of the arrangements. Understanding the reasons why the acquisition agreement includes a provision for contingent payments, who initiated the arrangement, and when the parties entered into the arrangement may be helpful in assessing the nature of the arrangement.

During negotiations of the business combination, an acquirer may agree to a provision for contingent payments to employees or selling shareholders after the acquisition date. Such payments may be in cash, other assets, the acquirer’s equity instruments, or a combination thereof. The acquirer must evaluate any contingent payments (i.e., payments that include conditions other than the passage of time) to the acquiree’s former shareholders to determine whether they represent (1) consideration transferred (i.e., contingent consideration), which is part of the business combination, or (2) compensation, which is a transaction separate from the business combination. Payments to individuals who were not shareholders or owners of the acquiree before an acquisition should be accounted for as transactions that are separate from the business combination in accordance with the nature of the payment. Accordingly, contingent payments to individuals who were not the acquiree’s owners but become employees of the combined entity should be accounted for as compensation in the acquirer’s postcombination financial statements.

When deciding whether a contingent payment to a shareholder of the acquiree who becomes an employee of the combined entity is part of the consideration transferred or a transaction that is separate from the business combination, the acquirer should first consider the factors in ASC 805-10-55-18. Specifically, by applying the factors in ASC 805-10-55-18(a) and (b) to determine the reason for the payment and who initiated it, the acquirer may gain insight into the nature and intent of an arrangement. In addition, we note that in practice, the only time an acquirer would negotiate a payment to a shareholder of the acquiree that is contingent on the shareholder’s becoming an employee of the combined entity would be during the period leading up to the acquisition; thus, the guidance in ASC 805-10-55-18(c) on the timing of a transaction suggests that such a payment would be a separate transaction. However, the factors in ASC 805-10-55-18 are not intended to be a checklist, and no one factor is determinative.

Further, an acquirer should consider the following indicators in ASC 805-10-55-25 “[i]f it is not clear whether an arrangement for payments to employees or selling shareholders is part of the exchange for the acquiree or is a transaction separate from the business combination”:

Continuing employment — see Section 6.2.3.3.1.
Duration of continuing employment — see Section 6.2.3.3.2.
Level of compensation — see Section 6.2.3.3.3.
Incremental payments to employees — see Section 6.2.3.3.4.
Number of shares owned — see Section 6.2.3.3.5.
Linkage to valuation — see Section 6.2.3.3.6.
Formula for determining compensation — see Section 6.2.3.3.7.
Other arrangements and issues — see Section 6.2.4.

According to ASC 805-10-55-24, “whether arrangements for contingent payments to employees or selling shareholders are contingent consideration in the business combination or are separate transactions depends on the nature of the arrangements.” While ASC 805-10-55-25(a) (i.e., the continuing employment factor — see Section 6.2.3.3.1) states that “a contingent consideration arrangement in which the payments are automatically forfeited if employment terminates is compensation for postcombination services” (emphasis added), the other indicators in ASC 805-10-55-25 are not as conclusive. Thus, in the absence of the automatic forfeiture condition described in ASC 805-10-55-25(a), an acquirer must use judgment to determine the nature of an arrangement, especially if not all indicators point to the same conclusion.

6.2.3.3.1 Continuing Employment

ASC 805-10

55-25(a) Continuing employment. The terms of continuing employment by the selling shareholders who become key employees may be an indicator of the substance of a contingent consideration arrangement. The relevant terms of continuing employment may be included in an employment agreement, acquisition agreement, or some other document. A contingent consideration arrangement in which the payments are automatically forfeited if employment terminates is compensation for postcombination services. Arrangements in which the contingent payments are not affected by employment termination may indicate that the contingent payments are additional consideration rather than compensation.

If an arrangement requires a contingent payment to a selling shareholder who becomes an employee of the combined entity to be forfeited upon the termination of the shareholder’s employment, the acquirer must account for the arrangement as compensation in its postcombination financial statements. Such a determination cannot be overcome by consideration of the other indicators in ASC 805-10-55-25.

Example 6-7

Payment Contingent on Continuing Employment

Because the future payment for each shareholder of B is contingent on continued employment with A after the acquisition, A should recognize each arrangement as compensation in the postcombination period and not as contingent consideration in the business combination.

Assume the same facts as those above, except that under the terms of the acquisition agreement, each of the three shareholders would be entitled to the additional payment if they are no longer employed by A at the end of three years because of death, disability, or involuntary termination. If the shareholders are no longer employed by A at the end of three years because of voluntary resignation or because they were terminated for cause, they would not be entitled to the additional payment. Even though there are situations in which the shareholders could receive the additional payment without being employed by A at the end of three years, we believe that the future payment for each shareholder of B is contingent on continued employment with A after the acquisition. Therefore, A should recognize each arrangement as compensation in the postcombination period and not as contingent consideration in the business combination.

Example 6-8

Contingent Payment Reverts to Nonemployee Shareholder if Employment Terminates

Company A acquires Company B from a single selling shareholder in a transaction accounted for as a business combination. Company A hires B’s top salesperson and agrees to pay the individual a percentage of sales above a specified amount at the end of each year for three years provided the individual is employed by A at the end of each year. If the individual is not employed at a year-end, any amount due under the arrangement will instead be paid to B’s selling shareholder.

Even though A is required to make the payments regardless of whether the salesperson remains employed by A, we believe that the substance of the arrangement is to induce the individual to remain employed. Therefore, A should account for the payments as compensation in its postcombination financial statements and not as part of the consideration transferred for the acquiree.

Arrangements with a shareholder of the acquiree who becomes an employee of the combined entity may contain some elements that are linked to continuing employment and some that are not. Because ASC 805-10-55-25(a) specifies that “a contingent consideration arrangement in which the payments are automatically forfeited if employment terminates is compensation for postcombination services,” a question arises regarding whether linking any portion of the arrangement to continuing employment causes the entire arrangement to be compensation for postcombination services. We believe that if arrangements involve a single shareholder of the acquiree who becomes an employee of the combined entity, an acquirer should separately account for each element.

Example 6-9

Contingent Payment Affected in Part by Continuing Employment

Company A acquires Company B in a transaction accounted for as a business combination. One of B’s shareholders (Shareholder Y) is an executive officer of B and agrees to become an employee of A after the acquisition. Under the terms of the acquisition agreement, all selling shareholders of B are entitled to an additional payment at the end of the first year after the acquisition date if certain performance targets have been met for that year; however, any amount due to Y will be paid at the end of the first year only if Y is then employed by A. If Y is not employed by A at that time, any contingent amount due under the acquisition agreement will be distributed at the end of the fifth year after the acquisition date.

Since it is possible for the executive officer to receive a payment even if he or she is no longer employed by A, we believe that it is appropriate for A to isolate the element that is contingent on continuing employment and account for that element as compensation in its postcombination financial statements. In this example, A is likely to measure the compensatory element of the arrangement as the value of receiving the amount that is due in one year rather than in five years.

Arrangements such as this might be viewed as containing a “floor” amount that is not affected by continued employment, and thus that amount is appropriately accounted for as contingent consideration in the business combination as long as it satisfies the other criteria for contingent consideration in ASC 805-10-55-25.

In general, if more than one shareholder of the acquiree becomes an employee of the combined entity and one or more of those individuals are required to continue employment, the arrangement is compensatory and not part of the exchange for the acquiree. However, there may be diversity in practice related to these arrangements.

Example 6-10

Payment Contingent on the Continued Employment of a Specific Employee

Company A acquires Company B in a transaction accounted for as a business combination. One of B’s three shareholders, its CEO, agrees to become A’s employee after the acquisition. The terms of the acquisition agreement require A to make an additional payment if B’s CEO is employed by A at the end of three years. The payment, if due, would be divided among the three shareholders on the basis of their relative ownership percentages in B. However, if B’s CEO is not employed by A for the full three-year period, none of the shareholders will receive their portion of the payment.

We believe that Company A should account for the entire payment as compensation in the postcombination period because all of the payment is contingent on continued employment, albeit on only one person’s employment.

We are also aware of an alternative view in which only the payments to the CEO would be considered contingent on continued employment and therefore be compensation. Under that view, the payments to the other two shareholders should be evaluated in accordance with the other factors in ASC 805-10-55-25.

The guidance in ASC 805-10-55-25(a) requires contingent consideration arrangements to be accounted for as compensation if the payments would be automatically forfeited upon the termination of employment. We believe that when evaluating a provision for forfeiture in the event of employment termination, an entity should assess the substance of any defined stay period. Accordingly, we believe that on the basis of an evaluation of the other indicators in ASC 805-10-55-25, an entity could conclude in unusual circumstances that payments that are contingent on a nonsubstantive stay period are eligible to be accounted for as consideration transferred. We expect such circumstances to be rare.

Example 6-11

Postcombination Service Requirement Might Be Viewed as Nonsubstantive

Company A acquires Company B in a transaction accounted for as a business combination. Company B’s three shareholders are executive officers of B and agree to become employees of A after the acquisition. The terms of the acquisition agreement require that A pay B’s shareholders (1) 50 percent of the consideration at the closing of the acquisition and (2) 50 percent of the consideration if the employees are employed by A one month after the closing of the acquisition. The payment will be divided among the shareholders on the basis of their relative ownership percentages in B. The amount of the contingent payment far exceeds the salary and benefits that the employees would earn in a one-month period.

We believe that before determining that the 50 percent payable one month after the closing is consideration transferred, entities should evaluate the reason for the agreed-upon employment period, the nature of the employees’ activities, and other evidence to assess whether the required stay period is substantive. If it is determined to be nonsubstantive, further analysis of the specific facts and circumstances and the other factors in ASC 805-10-55-25 is necessary.

Example 6-12

Conditional Payment Disproportional to Payment at Closing

Company A acquires Company B, a manufacturing company, in a transaction accounted for as a business combination. Company B is a substantive operating company with revenues, expenses, inventory, PP&E, customers and customer contracts, and liabilities. Company A determines that B’s fair value on the acquisition date is $20 million. Company B’s three shareholders are executive officers of B and agree to become employees of A after the acquisition.

The terms of the acquisition agreement require A to pay B’s shareholders (1) $1 million in cash consideration at the closing of the acquisition and (2) $25 million in three years from the acquisition date if the shareholders/employees remain employed by A. The conditional payment would be divided among those shareholders on the basis of their relative ownership percentages in B.

While the future payment is contingent on the executive officers’ continuing employment with A after the acquisition, we believe that it is not clear whether the guidance in ASC 805-10-55-25(a) is applicable because of the insignificant amount of the consideration paid at closing compared with B’s fair value.

For example, if A accounts for the contingent payment as compensation on the basis of applying ASC 805-10-55-25(a), it will be expected to recognize a bargain purchase gain (the difference between the $1 million in consideration transferred and the fair value of the net assets acquired as of the acquisition date) and compensation over the next five years. We believe that such facts might indicate that a portion of the future payments (i.e., the portion representing B’s fair value) should be accounted for as consideration transferred and the remainder should be accounted for as compensation in the postcombination period. Further analysis of the specific facts and circumstances is warranted.

6.2.3.3.1.1 Arrangements to Reallocate Forfeited Awards or Amounts

An acquirer may issue share-based payment awards to a group of shareholders of the acquiree, all of whom become employees of the combined entity with such awards subject to vesting based on continued employment. The awards may be placed in a trust by the acquirer on the acquisition date. Such arrangements are sometimes referred to as “last man standing” arrangements if any forfeited awards must be reallocated to the remaining participants in the group. Some arrangements may not specify what happens if none of the participants are still employed by the acquirer at the end of the term; however, since these arrangements typically encompass many employees, it would be unlikely that none remain. Other arrangements may specify that the amounts revert to the acquiree’s former shareholders if none of the participants are still employed at the end of the term.

In his remarks at the 2000 AICPA Conference on Current SEC Developments, then SEC OCA Professional Accounting Fellow R. Scott Blackley provided the following example of such an arrangement:

For illustration, consider an example business combination where a company acquires another enterprise, XYZ Company, for cash and stock. All of the shareholders of XYZ Company are also employees. The acquiring company expects and desires to have the employee shareholders of XYZ Company continue as employees of the combined companies. Accordingly, of the shares issued to the shareholders of XYZ Company, a portion is held in an irrevocable trust, subject to a three year vesting requirement (“forfeiture shares”).

The forfeiture provision requires that if, prior to vesting, a shareholder resigns from employment or is terminated for cause, the shares held in the trust allocable to the employee shareholder be forfeited. Additionally, any shares actually forfeited are reallocated to the remaining employee shareholders based on their remaining ownership interests such that all of the forfeiture shares in the trust will ultimately be issued.

Mr. Blackley said that in this scenario, the SEC staff concluded that “the forfeiture shares must be accounted for as a compensation arrangement.” He noted that the staff placed “significant weight” on the shares’ vesting on the basis of continued employment even though the amount of consideration was fixed because it would not be returned to the acquirer under any circumstances. Although Mr. Blackley made these remarks before Statement 141(R) was issued, we believe that they remain relevant.

Therefore, in an arrangement in which share-based payment awards are issued to a group of shareholders of the acquiree, all of whom become employees of the combined entity on the basis of a requirement to continue employment, the forfeiture and subsequent redistribution of the awards are accounted for as (1) the forfeiture of the original award and (2) the grant of a new award. That is, the acquirer would reverse any compensation previously recognized for the forfeited award (on the basis of the original grant-date fair-value-based measure) and then recognize compensation for the new award (on the basis of the fair-value-based measure on the date the award is redistributed) over the remaining requisite service period.

Example 6-13

Arrangement to Reallocate Forfeited Awards to Remaining Shareholders/Employees

On January 1, 20X1, Company A acquires Company B and, as part of the acquisition agreement, grants each of B’s 10 shareholders/employees 100 new share-based payment awards that vest at the end of five years of service (cliff vesting). The grant-date fair-value-based measure of each award as of the acquisition date is $10. The terms of the award state that if employment is terminated before the end of five years (i.e., the vesting date), the employee’s awards are forfeited and redistributed among the remaining employees within the group.

The total grant-date fair-value-based measure of the awards as of the acquisition date is $10,000 (10 employees × 100 awards × $10 grant-date fair-value-based measure), which A recognizes in the postcombination financial statements as compensation cost over the five-year service period ($2,000 per year). On December 31, 20X3, two employees in the group terminate their employment and forfeit their awards, which are then redistributed to the eight remaining group members. The fair-value-based measure of each redistributed (i.e., new) award is $12 on the date the awards are redistributed.

On December 31, 20X3, A should reverse $1,200 of previously recognized compensation cost (2 employees × 100 awards × $10 grant-date fair value × 60% for 3 out of 5 years of services rendered) corresponding to the forfeited awards. Company A should continue to recognize $1,600 in annual compensation cost (8 employees × 100 awards × $10 grant-date fair value ÷ 5 years) over each of the remaining two years of service for the original awards provided to the remaining employees. In addition, A should recognize $1,200 in additional annual compensation cost (200 awards × $12 grant-date fair value ÷ 2 years of remaining service) over each of the remaining two years of service for the redistributed awards.

In some cases, payments to the shareholders/employees may be made in cash rather than forfeitable shares. We do not believe that the form of the payment affects the conclusion that such arrangements are based on continued employment and therefore should be accounted for as compensation and not as part of the exchange for the acquiree.

6.2.3.3.1.2 Refundable Payments or Forgiveness of Loans to Selling Shareholders Who Become Employees of the Combined Entity

An acquirer may structure a contingent consideration arrangement such that payments to selling shareholders who become employees of the combined entity are distributed in advance but must be returned if specified conditions are not met. Such amounts might be characterized as refundable payments or loans subject to forgiveness and should be evaluated in accordance with the guidance in ASC 805-10-55-25(a). Accordingly, if the selling shareholders must remain employed by the combined entity for the amount to not become refundable or for the loan to be forgiven, the acquirer should account for the arrangement as compensation rather than contingent consideration.

6.2.3.3.2 Duration of Continuing Employment

ASC 805-10

55-25(b) Duration of continuing employment. If the period of required employment coincides with or is longer than the contingent payment period, that fact may indicate that the contingent payments are, in substance, compensation.

ASC 805-10-55-25(b) states, in part, that “[i]f the period of required employment coincides with or is longer than the contingent payment period, that fact may indicate that the contingent payments are, in substance, compensation” (emphasis added). In evaluating this indicator, the acquirer should consider any employment and noncompetition agreements with a selling shareholder who becomes an employee of the combined entity and whether such agreements create a “requirement” to remain employed with the acquirer.

6.2.3.3.3 Level of Compensation

ASC 805-10

55-25(c) Level of compensation. Situations in which employee compensation other than the contingent payments is at a reasonable level in comparison to that of other key employees in the combined entity may indicate that the contingent payments are additional consideration rather than compensation.

As indicated in ASC 805-10-55-25(c), if the compensation, excluding the contingent payment to the selling shareholder who becomes an employee of the combined entity, “is at a reasonable level in comparison to that of other key employees in the combined entity,” the contingent payment may represent contingent consideration. However, assessing the compensation may be difficult because the responsibilities of such an employee may not be readily comparable to those of the acquirer’s other key employees, and levels of compensation may vary significantly within the combined entity on the basis of other factors.

6.2.3.3.4 Incremental Payments to Employees

ASC 805-10

55-25(d) Incremental payments to employees. If selling shareholders who do not become employees receive lower contingent payments on a per-share basis than the selling shareholders who become employees of the combined entity, that fact may indicate that the incremental amount of contingent payments to the selling shareholders who become employees is compensation.

There may be differences between the per-share contingent payments made to selling shareholders who become employees of the combined entity and the payments made to those who do not. Such differences may be indicators that a portion or all of the payments are compensation. For example:

The selling shareholders who become employees of the combined entity may be entitled to receive higher contingent payments on a per-share basis than selling shareholders who do not become the entity’s employees. Such a scenario may be an indicator that the incremental portion paid to the selling shareholders/employees is compensation.
Only selling shareholders who become employees of the combined entity may be entitled to receive the contingent payments. Such a scenario may be an indicator that the contingent payments are compensation.

Example 6-14

Incremental Contingent Payment to Shareholder Who Becomes an Employee

Company A acquires Company B in a transaction accounted for as a business combination. Company B is owned equally by three shareholders. One of those shareholders, B’s CEO, agrees to become A’s employee after the acquisition. The terms of the acquisition agreement require A to pay B’s shareholders a fixed amount upon the closing of the acquisition. In addition, A must pay (1) the two shareholders who do not become employees 5 percent of B’s EBITDA above $1 million for each of the next five years and (2) B’s CEO/shareholder 12 percent of B’s EBITDA above $1.5 million for each of the next five years.

The fact that B’s CEO received a higher contingent payment and is employed by A after the business combination indicates that the incremental amount paid (12 percent of B’s EBITDA above $1.5 million less 5 percent of B’s EBITDA above $1 million) is compensation in A’s postcombination financial statements, whereas the remainder of the payments should be accounted for as contingent consideration provided that they qualify as such on the basis of the other factors in ASC 805-10-55-25.

6.2.3.3.5 Number of Shares Owned

ASC 805-10

55-25(e) Number of shares owned. The relative number of shares owned by the selling shareholders who remain as key employees may be an indicator of the substance of the contingent consideration arrangement. For example, if the selling shareholders who owned substantially all of the shares in the acquiree continue as key employees, that fact may indicate that the arrangement is, in substance, a profit-sharing arrangement intended to provide compensation for postcombination services. Alternatively, if selling shareholders who continue as key employees owned only a small number of shares of the acquiree and all selling shareholders receive the same amount of contingent consideration on a per-share basis, that fact may indicate that the contingent payments are additional consideration. The preacquisition ownership interests held by parties related to selling shareholders who continue as key employees, such as family members, also should be considered.

The proportion of shares owned by selling shareholders who become employees of the combined entity may be an indicator of whether a contingent payment is a profit-sharing arrangement. For example, if the owners of substantially all of the acquiree’s shares become key employees of the combined entity, the contingent payments may be profit-sharing arrangements (i.e., compensation). However, if such shareholders owned only a small number of the acquiree’s shares, and all selling shareholders received the same amount of contingent consideration on a per-share basis, the conditional payments may be contingent consideration.

When evaluating whether selling shareholders who become employees of the combined entity owned substantially all of the shares in the acquiree, entities also should consider preacquisition ownership interests held by parties related to the selling shareholders, such as family members. Entities may need to use judgment in determining which parties are considered “related to selling shareholders.”

6.2.3.3.6 Linkage to the Valuation

ASC 805-10

55-25(f) Linkage to the valuation. If the initial consideration transferred at the acquisition date is based on the low end of a range established in the valuation of the acquiree and the contingent formula relates to that valuation approach, that fact may suggest that the contingent payments are additional consideration. Alternatively, if the contingent payment formula is consistent with prior profit-sharing arrangements, that fact may suggest that the substance of the arrangement is to provide compensation.

Entities should consider whether the sum of the consideration transferred on the acquisition date and any anticipated contingent payments is consistent with the acquirer’s estimate of the acquiree’s fair value or whether that total exceeds the estimate. For example, an acquirer and acquiree may disagree on the specific fair value of the acquiree but agree on a related range of value. In such a scenario, the acquirer may agree to pay the seller (1) a fixed amount at the closing that would represent the low end of the range and (2) a contingent amount if earnings exceed a certain target that would represent the higher end of the range, in which case the contingent payments might be viewed as additional consideration. By contrast, if the sum of the fixed amount at the closing and any anticipated contingent payments exceeds the higher end of the range of the acquiree’s estimated fair value, the substance of the arrangement might be to provide compensation.

6.2.3.3.7 Formula for Determining Contingent Consideration

ASC 805-10

55-25(g) Formula for determining consideration. The formula used to determine the contingent payment may be helpful in assessing the substance of the arrangement. For example, if a contingent payment is determined on the basis of a multiple of earnings, that might suggest that the obligation is contingent consideration in the business combination and that the formula is intended to establish or verify the fair value of the acquiree. In contrast, a contingent payment that is a specified percentage of earnings might suggest that the obligation to employees is a profit-sharing arrangement to compensate employees for services rendered.

Payments based on multiples of earnings (e.g., EBITDA, EBIT, net income, or revenues) may be more likely to be contingent consideration than payments based on percentages of earnings, which are more likely to be profit-sharing arrangements that should be accounted for as compensation.

6.2.4 Other Arrangements

ASC 805-10

55-25(h) Other agreements and issues. The terms of other arrangements with selling shareholders (such as noncompete agreements, executory contracts, consulting contracts, and property lease agreements) and the income tax treatment of contingent payments may indicate that contingent payments are attributable to something other than consideration for the acquiree. For example, in connection with the acquisition, the acquirer might enter into a property lease arrangement with a significant selling shareholder. If the lease payments specified in the lease contract are significantly below market, some or all of the contingent payments to the lessor (the selling shareholder) required by a separate arrangement for contingent payments might be, in substance, payments for the use of the leased property that the acquirer should recognize separately in its postcombination financial statements. In contrast, if the lease contract specifies lease payments that are consistent with market terms for the leased property, the arrangement for contingent payments to the selling shareholder may be contingent consideration in the business combination.

The acquirer and the selling shareholders may enter into other arrangements simultaneously with, or in close proximity to, the acquisition. If so, the acquirer should determine whether to attribute some or all of the contingent payments under the acquisition agreement to such other arrangements (e.g., in circumstances in which the other arrangement provides for no payment or a below-market payment). Amounts attributable to other arrangements should be accounted for separately from the business combination in accordance with their nature.

In addition, ASC 805-10-55-25(h) states that “the income tax treatment of contingent payments may indicate that contingent payments are attributable to something other than consideration for the acquiree.” When assessing the substance of an arrangement, entities should evaluate any lack of symmetry between the accounting treatment and the tax treatment of contingent payments.

6.2.5 Selling Shareholders Share Proceeds With Specified Employees of the Acquiree

In some acquisitions, one or more of the selling shareholders may decide to share some of the proceeds that they are entitled to receive with one or more of the acquiree’s nonshareholder employees. Such arrangements may be structured in various ways. For example, the selling shareholders may decide to share a portion of the consideration that they are entitled to receive on the acquisition date or to share a portion of any future contingent payments that they are entitled to receive, or both. The selling shareholders may direct the acquirer to deliver the amounts directly to the specified employees or may pay the specified employees directly from their proceeds.

On the basis of the guidance in ASC 718-10-15-4, unless the amount “is clearly for a purpose other than compensation,” the framework described in Section 6.2.3 should be used to determine whether the compensation is for precombination or postcombination services.

6.2.6 Disputes Arising From the Business Combination

After the completion of a business combination, a dispute may occur between an acquirer and the acquiree’s sellers that sometimes results in payments between the parties after the acquisition date. Alternatively, an acquirer’s shareholders may bring a claim against the acquirer for various reasons (e.g., overpayment for the acquiree — see discussion in Section 6.2.6.2).

6.2.6.1 Settlement of Disputes With the Sellers Over a Business Combination

When a dispute between the acquirer and the seller results in a transfer of amounts between the parties after the acquisition date, questions may arise about whether the acquirer, when accounting for such subsequent payments, should reflect the amount paid or received either (1) as an adjustment to the consideration transferred for the acquiree or (2) in its postacquisition income statement. At the 2003 AICPA Conference on Current SEC Developments, then SEC OCA Professional Accounting Fellow Randolph Green indicated in prepared remarks that the SEC has “generally concluded that legal claims between an acquirer and the former owners of an acquired business should be reflected in the income statement when settled.” This view is based on the general belief that contingencies related to litigation about the business combination itself are not preacquisition contingencies. However, Mr. Green noted that an acquirer may be able to treat such payments as an adjustment to the consideration transferred for the acquisition if there is a “clear and direct link to the purchase price.” He gave the following example:

[A]ssume a purchase agreement explicitly sets forth the understanding that each “acquired customer” is worth $1,000, that not less than one thousand customers will be transferred as of the consummation date, and subsequent litigation determines that the actual number of acquired customers was only nine hundred. The effects of the litigation should properly be reflected as part of the purchase price. In contrast, if the purchase agreement obligates the seller to affect its best efforts to retain customers through the consummation date and litigation subsequently determines that the seller failed to do so, the effects are not clearly and directly linked to the purchase price and, accordingly, should be reflected in the income statement.

Even when an acquirer is able to establish “a clear and direct link” to the consideration transferred, we believe that it is only appropriate to adjust the consideration transferred if the measurement period is still open. If it is closed, entities should recognize such amounts in the income statement. In an alternative example, Mr. Green noted that “claims that assert one party [misled] the other or that a provision of the agreement is unclear are not unique to business combination agreements.” Therefore, such claims do not generally establish a clear and direct link to the consideration transferred and should be reflected in the income statement.

Mr. Green also noted that “[f]requently, claims seeking enforcement of an escrow or escrow-like arrangement also include claims of misrepresentation or otherwise constitute a mixed claim.” He went on to say that “[i]n order to reflect some or all of the settlement of such a [mixed] claim as an adjustment of the purchase price of the acquired business, the acquirer should be able to persuasively demonstrate that all or a specifically identified portion of the mixed claim is clearly and directly linked to the purchase price.”

Although not stated by Mr. Green, neither the acquirer’s legal costs to settle the dispute nor any settlement amounts used to reimburse the sellers for legal costs or other damages are clearly and directly linked to the consideration transferred. Thus, they should be reflected in the income statement.

While this SEC staff speech was given before FASB Statement 141(R) was issued, we believe that the views expressed in it continue to apply.

6.2.6.2 Settlement of Disputes With the Acquirer’s Shareholders Over a Business Combination

An acquirer’s shareholders may bring a claim against the acquirer after the acquisition date for various reasons, such as the shareholders’ assertion that the acquirer overpaid for the acquiree. The acquirer should recognize costs incurred for such disputes, including any settlement amounts if paid, in the income statement and not as part of the consideration transferred to the acquiree. This view is consistent with an additional statement by Mr. Green that, in reference to settlements of litigation over the consideration transferred, “the cost of litigation brought by the acquirer’s shareholders should always be reflected in the income statement.”

Confidential and Proprietary — for Use Solely by Authorized Personnel

This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.