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 6.2.3.6.
“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 Share-Based Payment Awards in a Business Combination

6.2.3.1 Replacement of Acquiree Awards

In a business combination, share-based payment awards held by grantees of the acquiree are often exchanged for share-based payment awards of the acquirer. ASC 805 refers to the new awards as “replacement awards.” The acquirer must analyze the terms of both the preexisting and the replacement awards to determine what portion of the replacement awards is related to precombination vesting (i.e., past goods or services) and therefore part of the consideration transferred in the business combination. The portion of replacement awards that is related to postcombination vesting (i.e., future goods or services) should be recognized as compensation cost in the postcombination period.

ASC 718-20

Equity Restructuring or Business Combination

35-6 Exchanges of share options or other equity instruments or changes to their terms in conjunction with an equity restructuring or a business combination are modifications for purposes of this Subtopic. An entity shall apply the guidance in paragraph 718-20-35-2A to those exchanges or changes to determine whether it shall account for the effects of those modifications. Example 13 (see paragraph 718-20-55-103) provides further guidance on applying the provisions of this paragraph. See paragraph 718-10-35-10 for an exception.

ASC 805-30

Acquirer Share-Based Payment Awards Exchanged for Awards Held by the Acquiree’s Grantees

30-9 An acquirer may exchange its share-based payment awards for awards held by grantees of the acquiree. This Topic refers to such awards as replacement awards. Exchanges of share options or other share-based payment awards in conjunction with a business combination are modifications of share-based payment awards in accordance with Topic 718. If the acquirer is obligated to replace the acquiree awards, either all or a portion of the fair-value-based measure of the acquirer’s replacement awards shall be included in measuring the consideration transferred in the business combination. The acquirer is obligated to replace the acquiree awards if the acquiree or its grantees have the ability to enforce replacement. For example, for purposes of applying this requirement, the acquirer is obligated to replace the acquiree’s awards if replacement is required by any of the following:

The terms of the acquisition agreement
The terms of the acquiree’s awards
Applicable laws or regulations.

Exchanges of share-based payment awards in a business combination are considered modifications under ASC 718. An acquirer must assess whether the replacement awards are (1) part of the consideration transferred, (2) recognized as compensation cost in the postcombination financial statements, or (3) a combination of both in accordance with ASC 805. Before it can make its determination, the acquirer must assess whether it is “obligated” to replace the acquiree’s awards. If so, the acquirer must include all or a portion of the fair-value-based measure1 of the replacement awards in its measurement of the consideration transferred in the business combination. The portion not included in the measurement of consideration transferred is included in postcombination compensation cost.

ASC 805-30-30-9 notes that the acquirer is obligated to replace the acquiree’s share-based payment awards “if the acquiree or its grantees have the ability to enforce replacement.” It further indicates that the acquirer is obligated to replace the awards if replacement is required by (1) the terms of the acquisition agreement, (2) the terms of the acquiree’s awards, or (3) applicable laws or regulations.

Accordingly, an entity should consider the original terms of the acquiree’s awards (as well as applicable laws or regulations) and whether the acquirer was obligated to issue replacement awards in the event of a change in control. While some awards may contractually expire upon a change in control (see Section 6.2.3.8), it is more common for the terms of the acquiree’s awards to be silent on the matter or give the acquiree discretion regarding the awards’ treatment upon a change in control event such as a business combination. In these circumstances, if the acquiree’s awards are replaced under the terms of the acquisition agreement, an entity generally accounts for the replacement awards as if the replacement obligation exists. Acquirers may wish to consult with legal counsel for assistance in assessing the terms of award agreements and their requirements under applicable laws and regulations.

See Section 6.2.3.2 for additional information about allocating replacement awards between consideration transferred and postcombination compensation cost.

In addition, Section 10.9 of Deloitte’s Roadmap Share-Based Payment Awards discusses situations in which the acquiree’s share-based payment awards are not modified but remain outstanding after the business combination. For discussion of the guidance that applies when the acquiree’s share-based payment awards expire as a result of the business combination, see Section 6.2.3.8.

6.2.3.2 Allocating Replacement Awards Between Consideration Transferred and Postcombination Compensation Cost

ASC 805-30

30-11 To determine the portion of a replacement award that is part of the consideration transferred for the acquiree, the acquirer shall measure both the replacement awards granted by the acquirer and the acquiree awards as of the acquisition date in accordance with Topic 718. The portion of the fair-value-based measure of the replacement award that is part of the consideration transferred in exchange for the acquiree equals the portion of the acquiree award that is attributable to precombination vesting.

30-12 The acquirer shall attribute a portion of a replacement award to postcombination vesting if it requires postcombination vesting, regardless of whether grantees had rendered all of the service or delivered all of the goods required in exchange for their acquiree awards before the acquisition date. The portion of a nonvested replacement award attributable to postcombination vesting equals the total fair-value-based measure of the replacement award less the amount attributed to precombination vesting. Therefore, the acquirer shall attribute any excess of the fair-value-based measure of the replacement award over the fair value of the acquiree award to postcombination vesting.

30-13 Paragraphs 805-30-55-6 through 55-13, 805-740-25-10 through 25-11, 805-740-45-5 through 45-6, and Example 2 (see paragraph 805-30-55-17) provide additional guidance and illustrations on distinguishing between the portion of a replacement award that is attributable to precombination vesting, which the acquirer includes in the consideration transferred in the business combination, and the portion that is attributed to postcombination vesting, which the acquirer recognizes as compensation cost in its postcombination financial statements.

Replacement Share-Based Payment Awards

35-3 Topic 718 provides guidance on subsequent measurement and accounting for the portion of replacement share-based payment awards issued by an acquirer that is attributable to future goods or services.

Acquirer Share-Based Payment Awards Exchanged for Awards Held by the Grantees of the Acquiree

55-6 If the acquirer is obligated to replace the acquiree’s share-based payment awards, paragraph 805-30-30-9 requires the acquirer to include either all or a portion of the fair-value-based measure of the replacement awards in the consideration transferred in the business combination. Paragraphs 805-30-55-7 through 55-13, 805-740-25-10 through 25-11, 805-740-45-5 through 45-6, and Example 2 (see paragraph 805-30-55-17) provide additional guidance on and illustrate how to determine the portion of an award to include in consideration transferred in a business combination and the portion to recognize as compensation cost in the acquirer’s postcombination financial statements.

55-7 To determine the portion of a replacement award that is part of the consideration exchanged for the acquiree and the portion that is compensation for postcombination vesting, the acquirer first measures both the replacement awards and the acquiree awards as of the acquisition date in accordance with the requirements of Topic 718. In most situations, those requirements result in use of the fair-value-based measurement method, but that Topic permits use of the calculated value method or the intrinsic value method in specified circumstances. This discussion focuses on the fair-value-based method, but the guidance in paragraphs 805-30-30-9 through 30-13 and the additional guidance cited in the preceding paragraph also apply in situations in which Topic 718 permits use of either the calculated value method or the intrinsic value method for both the acquiree awards and the replacement awards.

55-8 The portion of an employee replacement award attributable to precombination vesting is the fair-value-based measure of the acquiree award multiplied by the ratio of the precombination employee’s service period to the greater of the total service period or the original service period of the acquiree award. (Example 2, Cases C and D [see paragraphs 805-30-55-21 through 55-24] illustrate that calculation.) The total service period is the sum of the following amounts:

The part of the employee’s requisite service period for the acquiree award that was completed before the acquisition date
The postcombination employee’s requisite service period, if any, for the replacement award.

55-9 The employee’s requisite service period includes explicit, implicit, and derived service periods during which employees are required to provide service in exchange for the award (consistent with the requirements of Topic 718).

55-9A The portion of a nonemployee replacement award attributable to precombination vesting is based on the fair-value-based measure of the acquiree award multiplied by the percentage that would have been recognized had the grantor paid cash for the goods or services instead of paying with a nonemployee award. For this calculation, the percentage that would have been recognized is the lower of:

The percentage that would have been recognized calculated on the basis of the original vesting requirements of the nonemployee award
The percentage that would have been recognized calculated on the basis of the effective vesting requirements. Effective vesting requirements are equal to the services or goods provided before the acquisition date plus any additional postcombination services or goods required by the replacement award.

55-10 The portion of a nonvested replacement award (for employee and nonemployee) attributable to postcombination vesting, and therefore recognized as compensation cost in the postcombination financial statements, equals the total fair-value-based measure of the replacement award less the amount attributed to precombination vesting. Therefore, the acquirer attributes any excess of the fair-value-based measure of the replacement award over the fair value of the acquiree award to postcombination vesting and recognizes that excess as compensation cost in the postcombination financial statements.

55-13 The same requirements for determining the portions of a replacement award attributable to precombination and postcombination vesting apply regardless of whether a replacement award is classified as a liability or an equity instrument in accordance with the provisions of paragraphs 718-10-25-6 through 25-19A. All changes in the fair-value-based measure of awards classified as liabilities after the acquisition date and the related income tax effects are recognized in the acquirer’s postcombination financial statements in the period(s) in which the changes occur.

Illustrations

Example 2: Acquirer Replacement of Employee Awards

55-17 The following Cases illustrate the guidance referred to in paragraph 805-30-55-6 for replacement awards that the acquirer was obligated to issue. The Cases assume that all awards are classified as equity and that the awards have only an explicit service period. As discussed in paragraphs 805-30-55-8 through 55-9, the acquirer also must take any implicit or derived employee’s service periods into account in determining the employee’s requisite service period for a replacement award. In these Cases, the acquiring entity is referred to as Acquirer and the acquiree is referred to as Target:

Awards that require no postcombination vesting that are exchanged for acquiree awards for which employees:
1. Have rendered the required service as of the acquisition date (Case A)
2. Have not rendered all of the required service as of the acquisition date (Case D).
Awards that require postcombination vesting that are exchanged for acquiree awards for which employees:
1. Have rendered the required service as of the acquisition date (Case B)
2. Have not rendered all of the required service as of the acquisition date (Case C).

Case A: No Required Postcombination Vesting, All Requisite Service for Acquiree Awards Rendered as of Acquisition Date

55-18 Acquirer issues replacement awards of $110 (fair-value-based measure) at the acquisition date for Target awards of $100 (fair-value-based measure) at the acquisition date. No postcombination vesting is required for the replacement awards, and Target’s employees had rendered all of the required service for the acquiree awards as of the acquisition date.

55-19 The amount attributable to precombination vesting is the fair-value-based measure of Target’s awards ($100) at the acquisition date; that amount is included in the consideration transferred in the business combination. The amount attributable to postcombination vesting is $10, which is the difference between the total value of the replacement awards ($110) and the portion attributable to precombination vesting ($100). Because no postcombination vesting is required for the replacement awards, Acquirer immediately recognizes $10 as compensation cost in its postcombination financial statements.

Case B: Postcombination Vesting Required, All Requisite Service for Acquiree Awards Rendered as of Acquisition Date

55-20 Acquirer exchanges replacement awards that require one year of postcombination vesting for share-based payment awards of Target for which employees had completed the requisite service period before the business combination. The fair-value-based measure of both awards is $100 at the acquisition date. When originally granted, Target’s awards had a requisite service period of four years. As of the acquisition date, the Target employees holding unexercised awards had rendered a total of seven years of service since the grant date. Even though Target employees had already rendered all of the requisite service, Acquirer attributes a portion of the replacement award to postcombination compensation cost in accordance with paragraphs 805-30-30-12 through 30-13 because the replacement awards require one year of postcombination vesting. The total service period is five years — the requisite service period for the original acquiree award completed before the acquisition date (four years) plus the requisite service period for the replacement award (one year). The portion attributable to precombination vesting equals the fair-value-based measure of the acquiree award ($100) multiplied by the ratio of the precombination vesting period (4 years) to the total vesting period (5 years). Thus, $80 ($100 × 4 ÷ 5 years) is attributed to the precombination vesting period and therefore included in the consideration transferred in the business combination. The remaining $20 is attributed to the postcombination vesting period and therefore is recognized as compensation cost in Acquirer’s postcombination financial statements in accordance with Topic 718.

Case C: Postcombination Vesting Required, All Requisite Service for Acquiree Awards Not Rendered as of Acquisition Date

55-21 Acquirer exchanges replacement awards that require one year of postcombination vesting for share-based payment awards of Target for which employees had not yet rendered all of the required services as of the acquisition date. The fair-value-based measure of both awards is $100 at the acquisition date. When originally granted, the awards of Target had a requisite service period of four years. As of the acquisition date, the Target employees had rendered two years’ service, and they would have been required to render two additional years of service after the acquisition date for their awards to vest. Accordingly, only a portion of Target’s awards is attributable to precombination vesting.

55-22 The replacement awards require only one year of postcombination vesting. Because employees have already rendered two years of service, the total requisite service period is three years. The portion attributable to precombination vesting equals the fair-value-based measure of the acquiree award ($100) multiplied by the ratio of the precombination vesting period (2 years) to the greater of the total service period (3 years) or the original service period of Target’s award (4 years). Thus, $50 ($100 × 2 ÷ 4 years) is attributable to precombination vesting and therefore included in the consideration transferred for the acquiree. The remaining $50 is attributable to postcombination vesting and therefore recognized as compensation cost in Acquirer’s postcombination financial statements in accordance with Topic 718.

Case D: No Required Postcombination Vesting, All Requisite Service for Acquiree Awards Not Rendered as of Acquisition Date

55-23 Assume the same facts as in Case C, except that Acquirer exchanges replacement awards that require no postcombination vesting for share-based payment awards of Target for which employees had not yet rendered all of the requisite service as of the acquisition date. The terms of the replaced Target awards did not eliminate any remaining requisite service period upon a change in control. (If the Target awards had included a provision that eliminated any remaining requisite service period upon a change in control, the guidance in Case A would apply.) The fair-value-based measure of both awards is $100. Because employees have already rendered two years of service and the replacement awards do not require any postcombination vesting, the total service period is two years.

55-24 The portion of the fair-value-based measure of the replacement awards attributable to precombination vesting equals the fair-value-based measure of the acquiree award ($100) multiplied by the ratio of the precombination vesting period (2 years) to the greater of the total service period (2 years) or the original service period of Target’s award (4 years). Thus, $50 ($100 × 2 ÷ 4 years) is attributable to precombination vesting and therefore included in the consideration transferred for the acquiree. The remaining $50 is attributable to postcombination vesting. Because no postcombination vesting is required to vest in the replacement award, Acquirer recognizes the entire $50 immediately as compensation cost in the postcombination financial statements.

Example 3: Acquirer Replacement of Nonemployee Awards

55-25 The following Cases illustrate the guidance referred to in paragraph 805-30-55-6 for replacement awards that the acquirer was obligated to issue and the attribution guidance for a nonemployee replacement award to precombination and postcombination vesting referenced in paragraph 805-30-55-9A.

55-26 In these Cases, the acquiring entity is referred to as Acquirer and the acquiree is referred to as Target:

Awards that require no postcombination vesting that are exchanged for acquiree awards for which grantees:
1. Have met the vesting condition as of the acquisition date (Case A)
2. Have not met the vesting condition as of the acquisition date (Case D).
Awards that require postcombination vesting that are exchanged for acquiree awards for which grantees:
1. Have met the vesting condition as of the acquisition date (Case B)
2. Have not met the vesting condition as of the acquisition date (Case C).

55-27 The Cases assume the following:

All awards are classified as equity.
The only vesting condition included in the awards, if any, involves the delivery of engines.
Target and Acquirer typically pay cash as each engine is delivered to their suppliers.

Case A: No Required Postcombination Vesting and the Vesting Condition for Acquiree Awards Has Been Met as of Acquisition Date

55-28 Acquirer issues replacement awards of $110 (fair-value-based measure) at the acquisition date for Target awards of $100 (fair-value-based measure) at the acquisition date. No postcombination vesting is required for the replacement awards, and Target’s grantee has delivered all the engines necessary for the acquiree awards as of the acquisition date.

55-29 The amount attributable to precombination vesting is the fair-value-based measure of Target’s awards ($100) at the acquisition date; that amount is included in the consideration transferred in the business combination. The amount attributable to postcombination vesting is $10, which is the difference between the total value of the replacement awards ($110) and the portion attributable to precombination vesting ($100). Because no postcombination vesting is required for the replacement awards, Acquirer immediately recognizes $10 as compensation cost in its postcombination financial statements.

Case B: Postcombination Vesting Required and the Vesting Condition for Acquiree Awards Has Been Met as of Acquisition Date

55-30 Acquirer exchanges replacement awards that require the delivery of another 10 engines postcombination for share-based payment awards of Target for which the grantee had met the necessary vesting condition to deliver 40 engines before the business combination. The fair-value-based measure of both awards is $100 at the acquisition date. Even though the grantee already had met the vesting condition for the acquiree’s award, Acquirer attributes a portion of the replacement award to postcombination compensation cost in accordance with paragraphs 805-30-30-12 through 30-13 because the replacement awards require the delivery of an additional 10 engines.

55-31 The portion attributable to precombination vesting equals the fair-value-based measure of the acquiree award ($100) multiplied by the percentage that would have been recognized for the award. The percentage that would have been recognized is the lower of the calculation on the basis of the original vesting requirements and the percentage that would have been recognized on the basis of the effective vesting requirements as described in paragraph 805-30-55-9A. The percentage that would have been recognized on the basis of the original vesting requirements equals 100 percent, which is calculated as 40 engines delivered divided by 40 engines required to be delivered. The percentage that would have been recognized on the basis of the effective vesting requirements equals 80 percent, which is calculated as 40 engines delivered divided by 50 engines (the sum of 40 engines delivered plus 10 engines required postcombination). Thus, $80 ($100 × 80%) is attributed to the precombination vesting period and therefore is included in the consideration transferred in the business combination. The remaining $20 is attributed to the postcombination vesting period and therefore is recognized as compensation cost in Acquirer’s postcombination financial statements in accordance with Topic 718.

Case C: Postcombination Vesting Required and the Vesting Condition for Acquiree Awards Has Not Been Met as of Acquisition Date

55-32 Acquirer exchanges replacement awards that require the delivery of 10 engines postcombination for share-based payment awards of Target for which the grantee had not met the necessary vesting condition to deliver 40 engines before the business combination. The fair-value-based measure of both awards is $100 at the acquisition date. As of the acquisition date, Target grantee has delivered 20 engines, and Target grantee would have been required to deliver an additional 20 engines after the acquisition date for its awards to vest. Accordingly, only a portion of Target’s awards is attributable to precombination vesting.

55-33 The portion attributable to precombination vesting equals the fair-value-based measure of the acquiree award ($100) multiplied by the percentage that would have been recognized on the award. The percentage that would have been recognized is the lower of the percentage that would have been recognized on the basis of the original vesting requirements and the percentage that would have been recognized on the basis of the effective vesting requirements as described in paragraph 805-30-55-9A. The percentage that would have been recognized on the basis of the original vesting requirements equals 50 percent, which is calculated as 20 engines delivered divided by 40 engines required to be delivered. The percentage that would have been recognized on the basis of the effective vesting requirements equals 66.67 percent, which is calculated as 20 engines delivered divided by 30 engines (the sum of 20 engines delivered plus 10 engines required postcombination). Thus, $50 ($100 × 50%) is attributed to precombination vesting and therefore is included in the consideration transferred in the business combination. The remaining $50 is attributed to the postcombination vesting and therefore is recognized as compensation cost in Acquirer’s postcombination financial statements in accordance with Topic 718.

Case D: No Postcombination Vesting Required and the Vesting Condition for Acquiree Awards Has Not Been Met as of Acquisition Date

55-34 Assume the same facts as in Case C, except that Acquirer exchanges replacement awards that require no postcombination vesting for share-based payment awards of Target for which the grantee had not met the necessary vesting condition to deliver 40 engines before the business combination. The terms of the replaced Target awards did not eliminate the vesting condition upon a change in control. (If the Target awards had included a provision that eliminated the vesting condition upon a change in control, the guidance in Case A [see paragraph 805-30-55-28] would apply.) The fair-value-based measure of both awards is $100.

55-35 The portion attributable to precombination vesting equals the fair-value-based measure of the acquiree award ($100) multiplied by the percentage that would have been recognized on the award. The percentage that would have been recognized is the lower of the percentage that would have been recognized on the basis of the original vesting requirements and the percentage that would have been recognized on the basis of the effective vesting requirements as described in paragraph 805-30-55-9A. The percentage that would have been recognized on the basis of the original vesting requirements equals 50 percent, which is calculated as 20 engines delivered divided by 40 engines required to be delivered. The percentage that would have been recognized on the basis of the effective vesting requirements equals 100 percent, which is calculated as 20 engines delivered divided by 20 engines (the sum of 20 engines delivered plus zero engines required postcombination). Thus, $50 ($100 × 50%) is attributed to the precombination vesting and is therefore included in the consideration transferred in the business combination. The remaining $50 is attributed to the postcombination vesting. Because no postcombination vesting is required to vest in the replacement award, Acquirer recognizes the entire $50 immediately as compensation cost in the postcombination financial statements.

Replacement share-based payment awards issued by the acquirer may represent consideration transferred in a business combination if the award is related to precombination vesting (past goods or services provided), postcombination compensation cost for future vesting (future goods or services provided), or both.

Entities should carefully analyze any modifications to or replacements of acquiree awards to determine whether they are part of, or separate from, the business combination. ASC 805-10-25-20 states, in part, that 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 [GAAP].” In addition, ASC 805-10-25-21 states, in part, 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.”

Further, as shown below, ASC 805-10-55-18 provides three factors for entities to consider in determining whether a transaction is part of a business combination or should be accounted for separately (these factors are not mutually exclusive or individually conclusive).

ASC 805-10

55-18 Paragraphs 805-10-25-20 through 25-22 establish the requirements to identify amounts that are not part of the business combination. The acquirer should consider the following factors, which are neither mutually exclusive nor individually conclusive, to determine whether a transaction is part of the exchange for the acquiree or whether the transaction is separate from the business combination:

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.

Understanding the business purpose of a modification will help an acquirer assess which party benefits from the modification. The acquirer should particularly consider terms that accelerate vesting upon a change in control (see Section 6.2.3.4), cash settlement upon a change in control (see Section 6.2.3.5), and other compensation arrangements affected by a change in control (see Section 6.2.3.6).

6.2.3.2.1 Allocation Steps

The diagram below illustrates the steps in an entity’s determination of the amount to recognize as consideration transferred in a business combination and as postcombination compensation cost. Sections 6.2.3.2.1.1 through 6.2.3.2.1.3 discuss the steps in detail. If the acquirer is not obligated to replace the acquiree’s awards, but replacement awards are issued, the entire replacement award is generally accounted for as postcombination compensation cost (see Section 6.2.3.1).

6.2.3.2.1.1 Considerations Related to Step 1

The acquirer must determine the fair-value-based measure of both the acquirer’s replacement awards and the acquiree’s replaced awards as of the acquisition date, in accordance with the guidance in ASC 718.

ASC 805 requires acquirers to use the guidance in ASC 820, with limited exceptions, to measure the consideration transferred, the assets acquired, and any liabilities assumed in a business combination at their acquisition-date fair values. One of the exceptions is share-based payment awards, which are measured by using the guidance in ASC 718. Unlike a fair value measure, a fair-value-based measure under ASC 718 excludes certain considerations such as vesting conditions (i.e., service or performance conditions). However, a market condition is directly factored into the fair-value-based measure of an award and should be taken into consideration in the calculation of the fair value-based measure of the acquiree’s replaced awards and the acquirer’s replacement awards. In certain circumstances, ASC 718 also permits the use of a calculated value and an intrinsic value. If either is used, the acquirer’s replacement awards and the acquiree’s replaced awards are measured on such a basis.

See Deloitte’s Roadmap Share-Based Payment Awards for additional discussion of the measurement methods prescribed in ASC 718.

6.2.3.2.1.2 Considerations Related to Step 2

If there is an excess of the fair-value-based measure of the acquirer’s replacement awards over the fair-value-based measure of the acquiree’s replaced awards as of the acquisition date, incremental value is recognized as compensation cost in the acquirer’s postcombination financial statements in accordance with ASC 805-30-30-12. Such cost is recognized over the period from the acquisition date through the end of the employee’s requisite service period or nonemployee’s vesting period of the replacement awards. If there is no postcombination vesting requirement, all of the excess is generally recognized immediately in the postcombination financial statements (i.e., on day 1). This is illustrated in Case A of Example 2 in ASC 805-30-55-18 and 55-19, which addresses employees, and Case A of Example 3 in ASC 805-30-55-28 and 55-29, which addresses nonemployees.

6.2.3.2.1.3 Considerations Related to Step 3

6.2.3.2.1.3.1 Allocation to Precombination Vesting

The portion of the replacement share-based payment awards that is attributable to precombination vesting, and therefore included in the consideration transferred, is calculated as follows:

The practical effect of requiring the use of the greater of the total vesting period or the original vesting period of the acquiree’s replaced awards is that an acquirer will always reflect at least the proportion of the compensation cost in the postcombination financial statements, as it would have under the original terms of the award. In a scenario in which the acquirer accelerates vesting, this “greater of” calculation is consistent with the accounting for an acceleration of vesting that is determined to primarily benefit the acquirer, as described in Section 6.2.3.4.1. An acquirer’s decision to immediately accelerate vesting of replacement awards does not decrease its proportion of compensation expense in the postcombination financial statements but merely accelerates the timing of recognition. This is illustrated in Case D of Example 2 in ASC 805-30-55-23 and 55-24, which addresses employee awards, and Case D of Example 3 in ASC 805-30-55-34 and 55-35, which addresses nonemployee awards.

The total vesting period is calculated as follows:

For employee awards, the requisite service period (i.e., the vesting period) may be explicit, implicit, or derived and will depend on the terms of the share-based payment awards. For nonemployee awards, the vesting period is calculated on the basis of the percentage that would have been recognized had the grantor paid cash for the goods or services instead of paying with a nonemployee award. For more information, see Deloitte’s Roadmap Share-Based Payment Awards.

If the acquirer decides to extend the vesting period rather than accelerate vesting, use of the “greater of” calculation would result in a greater share of the compensation cost attributed to the postcombination period and is consistent with the increase in grantee services to be provided to the acquirer. For acquiree awards that were fully vested before the acquisition date and replaced by new awards for which an additional future vesting period is required, the total vesting period is the sum of the vesting periods of (1) the acquiree-replaced awards and (2) the replacement awards. It excludes the period from the precombination vesting date of the acquiree-replaced awards to the acquisition date. This is illustrated in Case B of Example 2 in ASC 805-30-55-20, which addresses employee awards, and Case B of Example 3 in ASC 805-30-55-30 and 55-31, which addresses nonemployee awards.

The examples below illustrate how to determine the total service period for employee awards.

Example 6-5

Determining the Total Service Period of a Replacement Award When the Replaced Award Is Fully Vested

An employee is awarded 100 options on Entity B’s common stock that became fully vested on June 30, 20X1. A three-year service period was originally associated with this award, but the options have not been exercised. On January 1, 20X2, Entity A acquires B in a transaction accounted for as a business combination and is obligated to replace the employee’s options. As part of the acquisition, A is obligated to replace B’s fully vested options with A’s new options that require an additional three years of service.

The total service period of the replacement award is six years, which is the sum of the service period of B’s original award (the replaced award) plus the service period of A’s new award (the replacement award). The total service period does not include the period from the original vesting date (i.e., June 30, 20X1) to the acquisition date (i.e., January 1, 20X2).

Example 6-6

Determining the Total Service Period of Replacement Awards When the Service Period Is the Same as That for the Replaced Awards

On January 1, 20X1, Entity B grants 100 share-based payment awards to an employee that vest at the end of the fourth year of service (cliff vesting). On January 1, 20X3, Entity A acquires B in a transaction accounted for as a business combination and is obligated to replace the employee’s awards with 100 new awards that have the same service terms as B’s original award (i.e., the replacement awards will vest at the end of two additional years).

The total service period of the replacement awards is four years, which is equal to the service period of B’s original awards. In the calculation of the portion attributable to precombination service, the precombination service period is two years (January 1, 20X1, to January 1, 20X3).

6.2.3.2.1.3.2 Allocation to Postcombination Vesting

The portion of the replacement awards attributable to postcombination vesting, and therefore included in postcombination compensation cost, is calculated as follows:

The example below illustrates how to allocate the replacement awards between consideration transferred and postcombination compensation cost for an employee award.

Example 6-7

Allocation of Consideration

On January 1, 20X1, Entity B grants 100 share-based payment awards to an employee that vest at the end of the third year of service (cliff vesting).

On January 1, 20X2, Entity A acquires B in a transaction accounted for as a business combination and is obligated to replace the employee’s awards with 100 new awards that have the same service terms as B’s original awards (i.e., the replacement awards will vest at the end of two additional years). On January 1, 20X2, the fair-value-based measure of both A’s replacement awards and B’s replaced awards is $10 per award.

The total fair-value-based measure of the replacement awards as of the acquisition date is $1,000 (100 awards × $10 fair-value-based measure), of which (1) $333 (one of three years) is attributable to precombination service, and therefore included in the consideration transferred, and (2) $667 (two of three years) is attributable to postcombination service, and therefore is recognized as compensation cost by A as the service is rendered by the employee (i.e., from January 1, 20X2, to December 31, 20X3). Note that the grant-date fair-value-based measure assigned to the awards issued by B is not relevant as of the acquisition date.

See Section 6.2.3.9 for an example of how to allocate the replacement awards between consideration transferred and postcombination compensation cost for a nonemployee award.

6.2.3.2.2 Forfeitures

ASC 805-30

55-11 Regardless of the accounting policy elected in accordance with paragraph 718-10-35-1D or 718-10-35-3, the portion of a nonvested replacement award included in consideration transferred shall reflect the acquirer’s estimate of the number of replacement awards for which the service is expected to be rendered or the goods are expected to be delivered (that is, an acquirer that has elected an accounting policy to recognize forfeitures as they occur in accordance with paragraph 718-10-35-1D or 718-10-35-3 should estimate the number of replacement awards for which the service is expected to be rendered or the goods are expected to be delivered when determining the portion of a nonvested replacement award included in consideration transferred). For example, if the fair-value-based measure of the portion of a replacement award attributed to precombination vesting is $100 and the acquirer expects that the service will be rendered for only 95 percent of the instruments awarded, the amount included in consideration transferred in the business combination is $95. Changes in the number of replacement awards for which the service is expected to be rendered or the goods are expected to be delivered are reflected in compensation cost for the periods in which the changes or forfeitures occur — not as adjustments to the consideration transferred in the business combination. If an acquirer’s accounting policy is to account for forfeitures as they occur, the amount excluded from consideration transferred (because the service is not expected to be rendered or the goods are not expected to be delivered) should be attributed to the postcombination vesting and recognized in compensation cost over the employee’s requisite service period or the nonemployee’s vesting period. Recognition of compensation cost for nonemployees should consider the recognition guidance provided in paragraph 718-10-25-2C. That is, recognition of the fair value of the nonemployee share-based payment award should be recognized in the same manner as if the grantor had paid cash for the goods or services instead of paying with or using the share-based payment awards.

ASC 718 allows an entity to make an entity-wide accounting policy election to either (1) estimate forfeitures when the awards are granted and update its estimate when information becomes available indicating that actual forfeitures will differ from previous estimates or (2) account for forfeitures when they occur. In addition, ASC 718 permits an entity to make an entity-wide policy election for all nonemployee awards to either (1) estimate forfeitures or (2) recognize forfeitures when they occur. This policy election can be different from the entity’s policy election for employee awards.

Regardless of the accounting policy elected for forfeitures, ASC 805-30-55-11 requires that the portion of the fair-value-based measure of the replacement share-based payment awards included in consideration transferred (i.e., the amount attributable to precombination vesting) reflect the acquirer’s forfeiture estimate as of the acquisition date. If the acquirer’s accounting policy is to account for forfeitures when they occur, the amount that is excluded from consideration transferred on the basis of the acquirer’s estimate of forfeitures as of the acquisition date should be attributed to postcombination vesting and recognized in compensation cost over the employee’s requisite service period or nonemployee’s vesting period. Changes in the forfeiture estimate or actual forfeitures (i.e., an increase or decrease in the number of awards expected to vest or awards that actually vest) are recorded in postcombination compensation cost and not as adjustments to the consideration transferred in the business combination. There is diversity in practice regarding how such changes should be reflected in the financial statements (see Section 6.2.3.3).

6.2.3.2.3 Employee Awards With a Graded Vesting Schedule

ASC 805-30

55-12 Similarly, the effects of other events, such as modifications or the ultimate outcome of awards with performance conditions, that occur after the acquisition date are accounted for in accordance with Topic 718 in determining compensation cost for the period in which an event occurs. If the replacement award for an employee award has a graded vesting schedule, the acquirer shall recognize the related compensation cost in accordance with its policy election for other awards with graded vesting in accordance with paragraph 718-10-35-8.

Graded vesting awards are awards that are split into multiple tranches, each of which legally and separately vests as service is provided. For example, an entity may grant an employee 100 share-based payment awards, 25 of which legally vest at the end of each of the four years of service provided. Under ASC 718-10-35-8, the entity can make an accounting policy election about whether to recognize compensation cost for its employee awards with only service conditions that have a graded vesting schedule on either (1) an accelerated basis as though each separately vesting portion of the award was, in substance, a separate award or (2) a straight-line basis over the requisite service period for the entire award (i.e., over the requisite service period of the last separately vesting portion of the award).2 An acquiree may have made an accounting policy election regarding the recognition of the compensation cost for an award with a graded vesting schedule (i.e., as a single award or as in-substance multiple awards) that is different from the election made by the acquirer. Regardless of how the acquiree elected to account for its replaced share-based payment awards with a graded vesting schedule, the acquirer applies its existing accounting policy election for similar awards with a graded vesting schedule to recognize compensation cost for the replacement awards.

The guidance in ASC 805 is silent on how replacement awards with graded vesting schedules affect the determination of the portion of the fair-value-based measure of the replacement award that is attributable to (1) precombination service and therefore included in consideration transferred and (2) postcombination service and therefore included in postcombination compensation cost.

One acceptable approach for awards with only service conditions is that the acquirer determines its attribution of compensation cost on the basis of its accounting policy election. If it has elected to treat an award with a graded vesting schedule as a single award, the determination of the total service period and the original service period will be based on a single award (e.g., a single award with four years of required service). Conversely, if it has elected to treat an award with a graded vesting schedule as, in substance, multiple awards, the determination of both the total service period and the original service period will be based on each tranche of the award as though the award is, in substance, multiple awards (e.g., four separate awards with required service of one, two, three, and four years, respectively). The examples below illustrate this guidance.

Note that if the accounting policy elections of the acquiree and the acquirer differ, compensation cost that is presented on a combined basis (i.e., in the acquiree’s financial statements and the acquirer’s financial statements) (1) may not be recorded in either the acquiree’s precombination financial statements or the acquirer’s postcombination financial statements or (2) may be recorded in both the acquiree’s precombination financial statements and the acquirer’s postcombination financial statements. This concept is illustrated in Example 6-9. Other approaches may also be acceptable.

Example 6-8

Single-Award Approach for Replacement Awards With Graded Vesting and Only a Service Condition

On January 1, 20X1, Entity B grants 1,000 employee share-based payment awards. The awards vest in 25 percent increments each year over the next four years (i.e., a graded vesting schedule) and have only a service condition. On December 31, 20X3, Entity A acquired B in a transaction accounted for as a business combination and is obligated to replace B’s awards with new awards that have the same terms and conditions. (Section 6.2.3.1 discusses how to determine when an acquirer is obligated to exchange an acquiree’s awards.) Both A and B have chosen, as their policy election, to recognize compensation cost on a straight-line basis over the requisite service period for the entire award (i.e., as though the award is a single award).

Entity B determines the allocation between consideration transferred and compensation cost for awards with only a service condition and graded vesting schedules.

As of the acquisition date, the total fair-value-based measure of both awards (i.e., the replaced awards and the replacement awards) is $10,000 (1,000 × $10 per award), which is allocated as follows:

The portion attributable to (1) precombination service, and therefore included in consideration transferred, is $7,500 ($10 fair-value-based measure of the replaced award × 1,000 awards × 75% for three of four years of services rendered).
The portion attributable to postcombination service, and therefore included in postcombination compensation cost, is $2,500 ($10 fair-value-based measure of the replacement award × 1,000 awards × 25% for one of four years of services rendered).

Example 6-9

Multiple-Award Approach for Replacement Awards With Graded Vesting

Assume the same facts as in the example above, except that the acquirer has elected to determine the allocation between consideration transferred and compensation cost for each separately vesting portion of the award (i.e., as though the award is, in substance, multiple awards). The table below summarizes the attribution of the fair-value-based amount of the replaced awards ($10,000 = 1,000 awards × $10 fair-value-based measure of the replaced award) over each of the first three years of service and the related amount attributable to precombination service and therefore included in consideration transferred.

The total fair-value-based measure of the replacement awards is allocated as follows:

The portion attributable to precombination service, and therefore included in consideration transferred, is $9,375 (even though the acquiree would have only recognized $7,500 in compensation cost because of the difference in policies).
The portion attributable to postcombination service, and therefore included in postcombination compensation cost, is $625.

6.2.3.3 Changes Reflected in Postcombination Compensation Cost

ASC 805-30

Replacement Share-Based Payment Awards

6.2.3.3.1 Changes in Forfeiture Estimates or Actual Forfeitures in the Postcombination Period

ASC 805-30-55-11 (see Section 6.2.3.2.2) requires an acquirer to reflect changes in (1) the acquirer’s forfeiture estimate (if the acquirer’s accounting policy is to estimate forfeitures) or (2) actual forfeitures (if the acquirer’s accounting policy is to account for forfeitures when they occur) in the postcombination period in compensation cost for the period in which the changes occur. If the acquirer’s accounting policy is to account for forfeitures when they occur, it should attribute to postcombination vesting, and recognize in compensation cost over the employee’s requisite service period or the nonemployee’s vesting period, the amount excluded from consideration transferred (i.e., attributable to precombination vesting) on the basis of the acquirer’s estimate of forfeitures as of the acquisition date. However, views differ on whether the acquirer should reflect changes in its forfeiture estimate or actual forfeitures (i.e., a decrease in the number of awards expected to vest or awards that actually vest) in postcombination compensation cost.

The following are two acceptable views on accounting for circumstances in which the forfeiture estimate or actual forfeitures have increased since the acquisition-date forfeiture estimate (in the event of a decrease, only View B would apply):

View A — An increase in an acquirer’s forfeiture estimate or actual forfeitures (i.e., a decrease in the number of awards expected to vest or that actually vest) should result in the reversal of compensation cost associated with the acquisition-date fair-value-based measure of the awards not expected to vest or that do not actually vest that was solely attributed to postcombination vesting as of the acquisition date.
View B — An increase in the acquirer’s forfeiture estimate or actual forfeitures (i.e., a decrease in the number of awards expected to vest or that actually vest) should result in the reversal of compensation cost associated with the acquisition-date fair-value-based measure of the awards not expected to vest or that do not actually vest, regardless of whether that measure was attributed to precombination or postcombination vesting as of the acquisition date. This reversal of compensation cost may exceed the amounts previously recognized as compensation cost in the acquirer’s postcombination financial statements. View B is consistent with the guidance in ASC 805-30-55-13, which states that the acquirer must recognize, in its postcombination financial statements, “[a]ll changes in the fair-value-based measure of awards classified as liabilities after the acquisition date . . . in the period(s) in which the changes occur.”

An acquirer may elect either view as an accounting policy.

Regardless of the view selected, however, the acquirer must recognize in the current-period income tax provision the reversal of the corresponding deferred tax asset (DTA) related to the acquisition-date fair-value-based measure attributed to both precombination and postcombination vesting. ASC 805-740 provides specific income tax accounting guidance on replacement awards. For a discussion of this guidance, see Deloitte’s Roadmap Income Taxes.

The examples below illustrate the accounting for an increase in the acquirer’s forfeiture estimate or actual forfeitures under View A and View B. In the examples, it is assumed that the acquirer recognizes a DTA in purchase accounting in accordance with the guidance in ASC 805-740 and (for the portion of the award that vests postcombination) ASC 718-740.

Example 6-10

View A — Entity Elects to Estimate Forfeitures

On January 1, 20X1, Entity D grants employees 100 nonqualified (tax-deductible) stock options that vest at the end of the fifth year of service (cliff vesting). On December 31, 20X4, Entity C acquires D in a transaction accounted for as a business combination and is obligated to replace the employees’ awards with 100 replacement awards that have the same service terms as D’s original awards (i.e., the replacement awards will vest at the end of one additional year of service). The fair-value-based measure of each award on the acquisition date is $10. Accordingly, the fair-value-based measure of both C’s awards (the replacement awards) and D’s awards (the replaced awards) is $1,000 as of the acquisition date. Entity C attributes $800 of the acquisition-date fair-value-based measure of the replacement awards to precombination service and the remaining $200 to postcombination service. The $200 attributed to the postcombination service is recognized as postcombination compensation cost over the replacement awards’ remaining one-year service period. On the acquisition date, C estimates that 25 percent of the replacement awards granted will be forfeited. Entity C’s applicable tax rate is 25 percent and its policy is to estimate forfeitures.

During the third quarter, C goes through a restructuring, and many of D’s former employees terminate their employment before their replacement awards vest. Accordingly, C changes its forfeiture estimate for the replacement awards from 25 percent to 80 percent.

There were no additional changes to the forfeiture estimate in the fourth quarter; therefore, 20 of the 100 replacement awards vested.

Example 6-11

View B — Entity Elects to Estimate Forfeitures

Assume the same facts as in the example above, except that Entity C elects to estimate forfeitures under View B. There are no differences in the accounting under View A and View B as of the acquisition date and for the first two quarters of service in the postcombination period (i.e., the journal entries are the same). However, Entity C’s accounting in the third quarter for the change in forfeiture estimate will differ from that under View A.

Because C’s forfeiture estimate has increased to 80 percent in the third quarter, only $200 of the $1,000 acquisition-date fair-value-based measure of the replacement awards should be allocated between the precombination and postcombination service periods. Accordingly, C recognizes an adjustment in postcombination compensation cost for the sum of (1) the amount of the acquisition-date fair-value-based measure of the replacement awards that was originally included in consideration transferred but that is associated with replacement awards of $440 that are no longer expected to vest — ($800 acquisition-date fair-value-based measure allocated to precombination service × 20% revised awards expected to vest) – $600 previously recognized as consideration transferred — and (2) the amount of the acquisition-date fair-value-based measure of the replacement awards that was originally included in postcombination compensation cost but that is associated with replacement awards of $45 that are no longer expected to vest: ($200 acquisition-date fair-value-based measure allocated to postcombination service × 20% revised awards expected to vest × 75% service rendered) – $75 previously recognized as compensation cost.

With respect to the income tax adjustments, the offsetting entry for the reversal of the DTA associated with the amount that was previously recorded in consideration transferred would be recorded in the income tax provision along with the offsetting entry for the reversal of the DTA associated with the amount that was previously recorded in postcombination compensation cost.

As in the example above, there were no additional changes to the forfeiture estimate in the fourth quarter; therefore, 20 of the 100 originally issued awards vested.

Example 6-12

View A — Entity Elects to Account for Forfeitures as They Occur

Assume the same facts as in Example 6-10, except that Entity C elects to account for forfeitures as they occur, and all forfeitures (80 awards) occur in the quarter ended September 30, 20X5. Entity C is still required to estimate the number of awards that will vest in calculating the portion of the fair-value-based measure of the replacement awards included in consideration transferred (i.e., attributable to precombination service). In addition, in a manner consistent with its accounting policy election, C recognizes compensation cost of $200 for the portion of all outstanding awards attributable to postcombination service. However, C is also required to include the amount ($200) excluded from consideration transferred (on the basis of C’s estimate of forfeitures as of the acquisition date) as compensation cost attributed to postcombination service ($800 acquisition-date fair-value-based measure initially allocated to precombination service × 25% awards not expected to vest).

There is no difference in the accounting as of the acquisition date (i.e., the journal entries are the same) because C is still required to estimate forfeitures to determine the portion of the acquisition-date fair-value-based measure of the replacement awards attributed to precombination service.

Since C’s accounting policy is to account for forfeitures as they occur, and it was required to recognize as compensation cost the amount excluded from consideration transferred related to its estimate of forfeitures as of the acquisition date, it also makes an adjustment to recognize an increase in actual forfeitures related to the amount it would have recognized as consideration transferred if the acquisition-date estimate of forfeitures were equal to actual forfeitures. Because C’s actual forfeitures are 80 percent in the third quarter, it should allocate only $200 of the $1,000 acquisition-date fair-value-based measure of the replacement awards between the precombination and postcombination service periods. Accordingly, C recognizes an adjustment in postcombination compensation cost for the sum of (1) the amount of the acquisition-date fair-value-based measure of the replacement awards that was initially allocated to precombination service and is associated with replacement awards of $540 that are forfeited — ($800 acquisition-date fair-value-based measure initially allocated to precombination service × 20% of awards outstanding) – $600 previously recognized as consideration transferred – $100 previously recognized as compensation cost for the amount excluded from consideration transferred — and (2) the amount of the acquisition-date fair-value-based measure of the replacement awards that was originally included in postcombination compensation cost but that is associated with replacement awards of $70 that are now forfeited: ($200 acquisition-date fair-value-based measure allocated to postcombination service × 20% of awards outstanding × 75% service rendered) – $100 previously recognized as compensation cost. However, under View A, the adjustment is limited to the $100 previously recognized as compensation cost (based on the amount excluded from consideration transferred related to A’s estimate of forfeitures at the acquisition date). In addition, an adjustment related to the DTA previously recorded in purchase accounting (attributable to precombination service) is recognized because actual forfeitures during the third quarter exceeded the amount of forfeitures estimated as of the acquisition date.

Because all the forfeitures occurred in the third quarter, there are no additional adjustments, and 20 of the 100 replacement awards vested.

Example 6-13

View B — Entity Elects to Account for Forfeitures as They Occur

Assume the same facts as in the previous example, except that Entity C elects to account for forfeitures under View B. There are no differences in the accounting under View A and View B as of the acquisition date and for the first two quarters of service in the postcombination period (i.e., the journal entries are the same). However, in the third quarter, C’s accounting for the change in actual forfeitures will differ from the accounting under View A because the adjustment is not limited to the amount previously recognized as compensation cost.

As in the previous example, because all the forfeitures occurred in the third quarter, there are no additional adjustments, and 20 of the 100 replacement awards vested.

6.2.3.3.2 Changes in the Probability of Meeting a Performance Condition in the Postcombination Period

ASC 805-30-55-12 states that “the effects of other events, such as . . . the ultimate outcome of awards with performance conditions, that occur after the acquisition date are accounted for in accordance with Topic 718 in . . . the period in which an event occurs.” However, views differ on how an acquirer should reflect a change in the expected outcome of a performance condition that results in a decrease in the number of awards expected to vest (e.g., a performance condition that was deemed probable as of the acquisition date that is subsequently considered improbable) in postcombination compensation cost.

The following are two acceptable views on accounting for circumstances in which the achievement of a performance condition is deemed probable as of the acquisition date and is subsequently considered improbable:

View A — A change in the expected outcome of a performance condition from probable to improbable should result in the reversal of compensation cost associated with the acquisition-date fair-value-based measure that was solely attributed to postcombination vesting as of the acquisition date.
View B — A change in the expected outcome of a performance condition from probable to improbable should result in the reversal of compensation cost associated with the acquisition-date fair-value-based measure of all awards not expected to vest, regardless of whether that acquisition-date fair-value-based measure was attributed to precombination or postcombination vesting as of the acquisition date. This reversal of compensation cost may exceed the amounts previously recognized as compensation cost in the acquirer’s postcombination financial statements. As discussed previously, View B is consistent with the guidance in ASC 805-30-55-13, under which the acquirer must recognize in its postcombination financial statements “[a]ll changes in the fair-value-based measure of awards classified as liabilities after the acquisition date . . . in the period(s) in which the changes occur.”

An acquirer may elect either view as an accounting policy.

Regardless of the view selected, the acquirer must recognize in the current-period income tax provision the reversal of the corresponding DTA related to the acquisition-date fair-value-based measure attributed to both precombination and postcombination vesting. ASC 805-740 provides specific income tax accounting guidance on replacement awards. For a discussion of this guidance, see Deloitte’s Roadmap Income Taxes.

If the achievement of a performance condition is deemed improbable as of the acquisition date for either the acquiree’s awards or the acquirer’s replacement awards, no amount is recognized as either precombination or postcombination services. However, if the performance conditions subsequently become probable for the replacement awards, an approach similar to View B would apply. For example, if the performance condition changes from improbable to probable for the replacement awards, the acquirer would recognize compensation cost in the postcombination financial statements on the basis of the acquisition-date fair-value-based measure of the replacement awards. No adjustments would be made to the consideration transferred in the business combination.

The examples below illustrate the accounting for a change in the expected outcome of a performance condition from probable to improbable under View A and View B. In the examples, it is assumed that the acquirer recognizes a DTA in purchase accounting in accordance with the guidance in ASC 805-740 and (for the portion of the award that vests postcombination) ASC 718-740.

Example 6-14

View A

On January 1, 20X1, Entity D grants employees 100 nonqualified (tax-deductible) stock options that vest only if D’s cumulative net income over the succeeding five years is greater than $5 million. On the grant date, it is deemed probable that the performance condition will be met. Accordingly, D begins to recognize compensation cost on a straight-line basis over the five-year service period.

On December 31, 20X4, Entity C acquires D in a transaction accounted for as a business combination and is obligated to replace the employees’ awards with 100 new awards that have the same terms as D’s original awards (i.e., the replacement awards will vest at the end of one additional year of service if the performance condition is met). The fair-value-based measure of each award on the acquisition date is $10. Accordingly, the fair-value-based measure of both C’s awards (the replacement awards) and D’s awards (the replaced awards) is $1,000 as of the acquisition date.

Entity C attributes $800 of the acquisition-date fair-value-based measure of the replacement awards to precombination service and the remaining $200 to postcombination service. The $200 attributed to the postcombination service is recognized as postcombination compensation cost over the replacement awards’ remaining one-year service period. On the acquisition date, it is still probable that the performance condition will be met. Assume that C’s applicable tax rate is 25 percent.

During the third quarter, C loses one of its largest customers and no longer believes that meeting the performance condition is probable.

Entity C ultimately did not meet the performance condition. Therefore, none of the awards vested, and no additional journal entries were necessary.

Example 6-15

View B

Assume all the same facts as in the previous example, except that Entity C elects to account for performance conditions under View B. There are no differences in the accounting under View A and View B as of the acquisition date and for the first two quarters of service in the postcombination period (i.e., the journal entries are the same). However, in the third quarter, C’s accounting for the change in the expected outcome of the performance condition from probable to improbable will differ from its accounting under View A.

Because C has now determined that meeting the performance condition is no longer probable, it recognizes an adjustment to postcombination compensation cost for the sum of (1) the amount of the acquisition-date fair-value-based measure of the replacement awards that was originally included in consideration transferred but that is associated with replacement awards of $800 that are no longer expected to vest and (2) the amount of the acquisition-date fair-value-based measure of the replacement awards that was originally included in postcombination compensation cost but that is associated with replacement awards of $100 that are no longer expected to vest ($200 acquisition-date fair-value-based measure allocated to postcombination service × 50% of service rendered).

As in the example above, C ultimately did not meet the performance condition. Therefore, none of the awards vested, and no additional journal entries were necessary.

6.2.3.4 Acceleration of Vesting Upon a Change in Control

In some cases, the vesting of an acquiree’s share-based payment awards is accelerated upon a change in control of the acquiree. The accounting for the accelerated vesting of an award upon a change in control depends on which party initiated the acceleration as well as on whether the acceleration is a preexisting provision in the terms of the acquiree’s awards.

6.2.3.4.1 Acquirer Accelerates Vesting

An acquirer’s decision to immediately vest or reduce the future vesting period of awards held by grantees of the acquiree does not affect the portion of the fair-value-based measure of the replacement awards that is attributable to postcombination vesting and therefore included in postcombination compensation cost; rather, it affects the timing of the recognition of postcombination compensation cost. This is because the allocation of compensation expense to precombination and postcombination periods is based on the greater of (1) the total vesting period or (2) the original vesting period of the replaced awards (see Section 6.2.3.2.1.3). Therefore, in instances in which the acquirer accelerates vesting, the allocation will still be based on the original vesting period of the replaced awards. For example, if the acquirer decides to immediately vest the replacement awards, the portion of the fair-value-based measure of the awards attributable to postcombination vesting would be immediately recognized as compensation cost in the acquirer’s postcombination financial statements. The amount of the compensation cost would not be affected.

Example 6-16

Acquirer Accelerates Vesting Upon the Acquisition Date

On January 1, 20X1, Entity B issues 100 share-based payment awards to an employee that vest at the end of the third year of service (cliff vesting). On January 1, 20X2, Entity A acquires B in a transaction accounted for as a business combination and is obligated to replace the employee’s awards with 100 new awards that have the same service terms as B’s original awards. On January 1, 20X2, the fair-value-based measure of both A’s replacement awards and B’s replaced awards is $10 per award. Entity A then immediately vests all of the outstanding replacement awards on the date of the business combination.

The total fair-value-based measure of the replacement awards as of the acquisition date is $1,000 (100 awards × $10 fair-value-based measure), of which (1) $333 (one of three years) is attributable to precombination service, and therefore included in the consideration transferred, and (2) $667 (two of three years) is attributable to postcombination service, and therefore recognized as compensation cost by A in the postcombination financial statements immediately upon the business combination.

If the fair-value-based measure of the replacement awards had been greater than the acquisition-date fair-value-based measure of B’s replaced awards, any excess would have been recognized immediately as compensation cost in A’s postcombination financial statements.

6.2.3.4.2 Acceleration of Vesting Included in the Original Terms of the Awards

If share-based payment awards of the acquiree become immediately vested on the acquisition date because of a preexisting provision in the awards’ terms that accelerates their vesting (commonly referred to as a “change-in-control” provision), the portion of the replacement awards that is attributable to precombination vesting and therefore included in consideration transferred would be affected. As noted in Section 6.2.3.2, the portion of the replacement awards attributable to precombination vesting is the acquisition-date fair-value-based measure of the replaced awards multiplied by the ratio of the precombination vesting period to the greater of the (1) total vesting period or (2) original vesting period of the replaced awards. Since (1) all of the goods or services have been provided in the precombination period, (2) there is no requirement for future vesting, and (3) the original vesting period is complete, the entire fair-value-based measure of the replaced awards would be attributable to precombination vesting and therefore included in consideration transferred. If the fair-value-based measure of the replacement awards is the same as that of the replaced awards, there is no postcombination compensation cost recognized. If, however, the fair-value-based measure of the replacement awards is greater than that of the replaced awards, the excess is recognized as postcombination compensation cost.

Note that there is diversity in practice related to the acquiree’s recognition of the remaining unrecognized compensation cost. One view is that any remaining unrecognized compensation cost associated with the original grant-date fair-value-based measure of the awards should be recognized in the acquiree’s precombination financial statements. Under another view, the compensation cost may not be presented in either the acquiree’s precombination financial statements or the combined entity’s postcombination financial statements (i.e., it is recognized on the “black line”). See Section A.16.1 for information about the presentation of certain acquiree expenses triggered by the consummation of a business combination.

Example 6-17

Acceleration of Vesting Included in the Original Terms of the Award

Assume the same facts as in Example 6-16, except that the original terms of Entity B’s awards included a preexisting provision that accelerates their vesting upon B’s acquisition. Since (1) all of the service has been rendered in the precombination period, (2) there is no requirement for future vesting, and (3) the original vesting period is complete, the entire $1,000 would be attributable to precombination service and therefore included in consideration transferred.

6.2.3.4.3 Modification to the Original Terms of the Awards to Add a Change-in-Control Provision in Contemplation of a Business Combination

In some instances, share-based payment awards are modified to add a change-in-control provision in contemplation of a business combination. A modification could also result from the decision to exercise a discretionary change-in-control provision that was part of the original terms of the award (or was added in contemplation of the business combination). Such modifications may be initiated by the acquiree or requested by the acquirer. As discussed in Section 6.2.3.2, entities should carefully analyze a modification to determine whether it is part of, or separate from, the business combination. A transaction that is entered into either (1) by or on behalf of the acquirer or (2) primarily for the benefit of the acquirer or the combined entity is likely to be a separate transaction.

Under ASC 805-10-55-18, factors for entities to consider in determining whether a transaction primarily benefits the acquirer or the acquiree include the reason for the transaction, which party initiated it, and when it occurred. Understanding the business purpose of a modification will help an acquirer assess which party benefits from it. It is generally presumed that the acquirer benefits when an award’s original terms are modified to (1) add a change-in-control provision during the negotiation of a business combination with the acquirer or (2) exercise a discretionary change-in-control provision. On the other hand, the acquirer is generally not presumed to benefit if an acquiree, before entering into negotiations with the acquirer, modifies the award’s original terms as part of actively exploring exit strategies. Given the high degree of judgment involved in these determinations, discussion with accounting advisers is encouraged.

When a modification to accelerate the vesting of awards upon a change in control is determined to be primarily for the benefit of the acquirer, the modification is accounted for in accordance with ASC 718 (i.e., compensation cost is recognized over the remaining portion of the modified requisite service period). The acceleration of vesting upon the consummation of the business combination would be considered a transaction that is separate from the business combination and would be accounted for as though the acquirer had decided to accelerate the vesting of the replacement awards immediately upon the acquisition. That is, the acquirer’s decision to accelerate the vesting of the awards would affect the timing of the recognition of postcombination compensation cost — any remaining unrecognized compensation cost associated with the modified awards would not be recognized as compensation cost in the acquiree’s precombination financial statements; instead, it would be recognized as compensation cost immediately in the postcombination financial statements (i.e., on day 1). The acceleration of vesting would not affect the determination of the portion of the awards that is attributable to (1) precombination vesting and therefore included in the consideration transferred and (2) postcombination vesting and therefore included in postcombination compensation cost.

Example 6-18

Modification to Add a Change-in-Control Provision

Assume the same facts as in Example 6-16, except that to retain the employee until at least the acquisition date, Entity B modified the employee’s existing awards during the negotiations of the business combination so that they automatically vest upon a change in control. It was also determined that the modification was made to benefit Entity A as it was initiated and discussed between the parties as part of the negotiations. The modification is therefore, in substance, the acceleration of the vesting of the awards by the acquirer and is accounted for as a transaction that is separate from the business combination.

This accounting treatment is the same as that in Example 6-16; that is, one-third of the awards are attributable to precombination service and two-thirds are attributable to postcombination service (which is immediately recognized). As indicated above, acceleration of the vesting of awards by the acquirer does not affect the portion of the fair-value-based measure of the replacement awards that is attributable to postcombination service and therefore included in postcombination compensation cost (i.e., $667); rather, it affects the timing of the recognition of postcombination compensation cost (i.e., immediate).

Example 6-19

Modification as a Result of Exercising a Discretionary Change-in-Control Provision

Assume the same facts as in Example 6-16, except that the original awards included a discretionary change-in-control provision that allowed Entity B to elect whether upon a change in control the awards would (1) be replaced or (2) vest in full (i.e., accelerated vesting). Entity B elected to accelerate vesting and further determined that exercise of the discretionary provision benefited A because it was initiated and discussed between the parties as part of the negotiations.

As in Example 6-16 and the example above, the modification is, in substance, the acceleration of the vesting of the awards by the acquirer and is accounted for as a transaction that is separate from the business combination. The amount attributable to (1) precombination service (i.e., included in consideration transferred) and (2) postcombination service (i.e., recognized as postcombination compensation cost by the acquirer) is determined in a manner consistent with that described in Example 6-16 and the example above.

6.2.3.5 Cash Settlement Upon a Change in Control

In some business combinations, acquirers may, upon a change in control, cash settle share-based payment awards instead of either accelerating the awards’ vesting provisions or replacing the awards. Like vesting provisions that are accelerated upon a change in control (see Section 6.2.3.4), cash settlement provisions should be analyzed carefully in the determination of whether they are part of, or separate from, the business combination. ASC 805-10-25-20 states, in part, that 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 [GAAP].” In addition, ASC 805-10-25-21 states, in part, 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.” As noted in Section 6.2.3.2, ASC 805-10-55-18 also provides three factors to help entities determine whether the transaction primarily benefits the acquirer or the acquiree: “[t]he reasons for the transaction,” “[w]ho initiated the transaction,” and “[t]he timing of the transaction.”

6.2.3.5.1 Acquirer Cash Settles the Acquree’s Awards (Cash-Settlement Provision Is Not Included in the Original Terms of the Award)

If there is no preexisting change-in-control cash settlement provision in the original terms of awards (but the acquirer is obligated to issue replacement awards) and the acquirer decides to cash settle the acquiree’s awards, the cash settlement is treated in the same manner as if the acquirer was required to replace the awards with share-based payment awards of the acquirer.

An acquirer’s decision to cash settle the acquiree’s share-based payment awards does not affect the portion of the fair-value-based measure of the replacement awards (i.e., cash) that is attributable to postcombination vesting and therefore included in postcombination compensation cost; rather, it affects the timing of the recognition of postcombination compensation cost (i.e., if the acquiree’s awards were previously unvested, the cash settlement would effectively accelerate vesting in such a manner that postcombination compensation cost would be recognized immediately). Further, cash settlement does not affect the classification of the acquiree’s replaced awards because there was no preexisting change-in-control cash settlement provision in the original awards’ terms.

6.2.3.5.1.1 Fully Vested Awards That Are Cash Settled Upon a Change in Control

Rather than issuing replacement shares, an acquirer may choose to settle the acquiree’s awards with cash or a promissory note. If awards are fully vested as of the acquisition date, the fair value of the settlement amount should be included in consideration transferred unless it exceeds the fair-value-based measure of the settled acquiree awards. If the fair value of the settlement amount exceeds the fair-value-based measure of the settled acquiree awards, the excess would be immediately recognized as compensation cost in the acquirer’s postcombination financial statements.

6.2.3.5.1.2 Partially Vested Awards That Are Cash Settled Upon a Change in Control

If awards are partially vested as of the acquisition date, the acquirer has effectively accelerated the vesting of the unvested portion of the award and settled the entire award. The amount of the fair-value-based measure of the acquiree’s replaced award that is attributable to precombination vesting and therefore included in consideration transferred is based on the ratio of precombination vesting to the original vesting period of the acquiree’s replaced award (see Section 6.2.3.2.1.3.1). The amount recognized as compensation cost in the postcombination financial statements represents (1) any excess of the cash settlement over the fair-value-based measure of the vested replaced awards plus (2) the portion of the fair-value-based measure attributable to the postcombination period.

6.2.3.5.2 Cash-Settlement Provision Is Included in the Original Terms of the Award

In some circumstances, an acquiree’s share-based payment awards must be cash settled as a result of a change in control because of a preexisting provision in the awards’ original terms.

In such a case, as long as all other criteria for equity classification have been met, the awards would be classified as equity until it becomes probable that the change in control will occur (i.e., when it is probable that the awards will be cash settled). A change in control is generally not considered probable until the event has occurred (i.e., when the business combination has been consummated).

Contemporaneously with the closing of the business combination (when it is probable that the awards will be cash settled), the awards will become a share-based liability. As a result of the change in the probable settlement outcome, an entity would account for the awards in accordance with ASC 718-10-35-15; that is, the entity would account for them in a manner similar to a modification from equity awards to liability awards. Because the awards are liability-classified in the acquiree’s financial statements at the time of the acquisition (i.e., the cash settlement triggers a modification from equity to liability in the acquiree’s financial statements upon the acquisition), the awards would be accounted for as an assumed liability by the acquirer in the business combination rather than as consideration transferred. See Section 6.2.3.6.1 for more information about determining whether amounts should be accounted for as consideration transferred or an assumed liability in the acquirer’s acquisition accounting.

There is diversity in practice related to the acquiree’s recognition of the associated compensation cost resulting from the modification. One acceptable view is that all of the acquiree’s acquisition expenses, even those that are contingent on a change in control, should be recognized in the period in which they were incurred (i.e., in the acquiree’s precombination financial statements). Another acceptable view is that the compensation costs should not be recognized in the acquiree’s financial statements but instead recognized on the “black line.” See Section A.16.1 for information about the presentation of certain acquiree expenses triggered by a business combination.

6.2.3.5.2.1 Fully Vested Awards That Are Cash Settled Upon a Change in Control

If awards are fully vested as of the acquisition date and include a cash settlement provision in their original terms, the acquirer assumes and recognizes a share-based liability (because it is now probable that the awards will be cash settled) for their fair-value-based measure on the acquisition date. If the fair-value-based measure of the share-based liability is greater than the original grant-date fair-value-based measure of the equity awards, the difference is recognized as additional compensation cost in the acquiree’s precombination financial statements or on the “black line.” Conversely, if the fair-value-based measure of the share-based liability is less than or equal to the original grant-date fair-value-based measure of the equity awards, the offsetting amount is recorded to APIC in the acquiree’s precombination financial statements.

Example 6-20

Fully Vested Unexercised Options That Are Cash Settled Upon a Change in Control

On January 1, 20X1, Entity B issues 1,000 options to its employees, each of which has a grant-date fair-value-based measure of $5 and vests at the end of the third year of service (cliff vesting). Under a preexisting provision in the original terms of the option award, cash settlement is required in the event of a change in control. Because a change in control is generally not considered probable until it occurs, B classifies the options as equity (as long as all other criteria for equity classification are met).

On January 1, 20X5, Entity A acquires B in a transaction accounted for as a business combination. On January 1, 20X5, the fair-value-based measure of B’s options is $6 per option.

Contemporaneously with the closing of the business combination, B (1) reclassifies the amount currently residing in APIC as a share-based liability (i.e., $5,000, or 1,000 options × $5 grant-date fair-value-based measure × 100% of service rendered) and (2) records the excess $1,000, or ($6 acquisition-date fair-value-based measure – $5 grant-date fair-value-based measure) × 1,000 options × 100% of service rendered, as additional compensation cost in the acquiree’s precombination financial statements or on the “black line” (if the acquiree elects to apply pushdown accounting) to record the share-based liability at its fair-value-based measure, with a corresponding adjustment to the share-based liability. Entity A accounts for the share-based liability as an assumed liability in the business combination rather than as consideration transferred.

6.2.3.5.2.2 Partially Vested Awards That Are Cash Settled Upon a Change in Control

If awards are partially vested as of the acquisition date, a preexisting cash settlement provision may immediately cause them to become fully vested because such provision accelerates vesting for any remaining unvested awards. Accordingly, any unrecognized compensation cost associated with the original equity awards is recognized as compensation cost in the acquiree’s precombination financial statements or on the “black line.” Since the awards are now fully vested, if the fair-value-based measure of the acquiree’s awards as of the acquisition date is greater than the awards’ original grant-date fair-value-based measure, the difference is recognized as additional compensation cost in the acquiree’s precombination financial statements or on the “black line.” Conversely, if the fair-value-based measure is less than the awards’ original grant-date fair-value-based measure, the offsetting amount is recorded to APIC in the acquiree’s precombination financial statements. In addition, the acquirer accounts for the share-based liability as an assumed liability in the business combination at an amount equal to the awards’ fair-value-based measure on the acquisition date (i.e., generally for the amount of cash that it would expect to settle the acquiree’s awards).

Example 6-21

Partially Vested Options That Are Cash Settled Upon a Change in Control

Assume the same facts as in Example 6-20, except that the options granted by Entity B vest at the end of the fifth year of service (cliff vesting) and cash settlement is required even if the awards are unvested.

Contemporaneously with the closing of the business combination, B (1) recognizes $1,000 (1,000 options × $5 grant-date fair-value-based measure × 20% of service remaining) for the remaining unrecognized compensation cost associated with the original equity options because the cash settlement provision immediately vests the remaining unvested options; (2) reclassifies the amount now residing in APIC as a share-based liability (i.e., $5,000, or 1,000 options × $5 grant-date fair-value-based measure × 100% of service rendered); and (3) records the excess $1,000, or ($6 acquisition-date fair-value-based measure – $5 grant-date fair-value-based measure) × 1,000 options × 100% of service rendered, as additional compensation cost in the acquiree’s precombination financial statements or on the “black line” (if the acquiree elects to apply pushdown accounting) to record the share-based liability at its fair-value-based measure, with a corresponding adjustment to the share-based liability.

6.2.3.6 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.

6.2.3.6.1 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.

To determine whether an arrangement to pay an acquiree’s employees upon a change in control should be accounted for as part of or separately from the business combination, an entity must assess the substance of the arrangement by considering 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 Sections 6.2.3.2 and 6.2.3.4.3). If an arrangement to pay an acquiree’s employees upon a change in control is determined to be separate from the business combination, it represents compensation cost of the acquirer. If no future service is required, the acquirer should recognize compensation cost on the acquisition date. There may also be circumstances in which a payment needs to be allocated between the portion attributable to precombination services and postcombination compensation cost. 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.

6.2.3.6.2 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 6-22

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 6-23

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.

6.2.3.6.3 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 6.2.3.6.3.1.
Duration of continuing employment — see Section 6.2.3.6.3.2.
Level of compensation — see Section 6.2.3.6.3.3.
Incremental payments to employees — see Section 6.2.3.6.3.4.
Number of shares owned — see Section 6.2.3.6.3.5.
Linkage to valuation — see Section 6.2.3.6.3.6.
Formula for determining compensation — see Section 6.2.3.6.3.7.
Other agreements 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 6.2.3.6.3.1) 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.

There may also be circumstances in which one or more of the selling shareholders decide to share some of the proceeds that they are entitled to receive with one or more of the acquiree’s nonshareholder employees. Payments made by selling shareholders to such nonshareholder employees that become employees of the acquirer should be carefully evaluated under SAB Topic 5.T, which refers to ASC 718-10-15-4 and discusses payments made by economic interest holders (e.g., selling shareholders) on behalf of an entity (see Section 6.2.5 for more information). Acquirers must evaluate conditional future payments (i.e., payments that include conditions other than the passage of time) to former shareholders of the acquiree and to individuals who become employees of the combined entity (or otherwise provide goods or services to the combined entity) to determine whether such payments represent (1) consideration transferred (i.e., contingent consideration) or (2) compensation cost that is separate from the business combination.

6.2.3.6.3.1 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 6-24

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 6-25

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 6-26

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 6-27

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. Given that diversity in practice may exist, discussion with accounting advisers is encouraged.

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 6-28

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 6-29

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.

6.2.3.6.3.1.1 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 6-30

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.

6.2.3.6.3.1.2 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.

6.2.3.6.3.2 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.

6.2.3.6.3.3 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.

6.2.3.6.3.4 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 6-31

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.

6.2.3.6.3.5 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.”

6.2.3.6.3.6 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.

6.2.3.6.3.7 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.

6.2.3.7 Tax Effects of Replacement Awards Issued in a Business Combination

See Chapter 11 of Deloitte’s Roadmap Income Taxes for guidance on the accounting for the tax effects of replacement awards issued in a business combination. In addition, see Section 6.2.3.3 for more information about determining the allocation of such awards.

6.2.3.8 Acquiree Awards That Expire as a Result of the Business Combination

ASC 805-30

30-10 In situations in which acquiree awards would expire as a consequence of a business combination and the acquirer replaces those awards even though it is not obligated to do so, all of the fair-value-based measure of the replacement awards shall be recognized as compensation cost in the postcombination financial statements. That is, none of the fair-value-based measure of those awards shall be included in measuring the consideration transferred in the business combination.

In accordance with ASC 805-30-30-10, if an acquiree’s share-based payment awards will expire as a result of a business combination under the terms of the original award but the acquirer issues replacement awards even though it is not obligated to do so, “all of the fair-value-based measure of the replacement awards shall be recognized as compensation cost in the postcombination financial statements. That is, none of the fair-value-based measure of those awards shall be included in measuring the consideration transferred in the business combination.”

In most cases, however, an acquirer is obligated to replace the acquiree’s awards or they remain outstanding after the acquisition.

6.2.3.9 Nonemployee Awards Exchanged in a Business Combination

ASC 805-30

The percentage that would have been recognized calculated on the basis of the original vesting requirements of the nonemployee award
The percentage that would have been recognized calculated on the basis of the effective vesting requirements. Effective vesting requirements are equal to the services or goods provided before the acquisition date plus any additional postcombination services or goods required by the replacement award.

When nonemployee awards are exchanged in a business combination, it is important for an entity to determine what portion of the replacement awards is attributed to “precombination vesting” (and therefore included in the consideration transferred) and what portion is attributed to “postcombination vesting” (and therefore recognized in the postcombination period). Unlike the computation of ratably recognized employee awards, the computation of the portion of the replacement awards attributed to the consideration transferred and the portion attributed to the postcombination period is based on the percentage of the cost of the awards that would have been recognized in each period if the grantor had paid cash. Below are examples from ASC 805 illustrating how an acquirer that has provided replacement awards to nonemployees of an acquiree would attribute such replacement awards to precombination vesting and postcombination vesting.

ASC 805-30
Example 3: Acquirer Replacement of Nonemployee Awards 55-25 The following Cases illustrate the guidance referred to in paragraph 805-30-55-6 for replacement awards that the acquirer was obligated to issue and the attribution guidance for a nonemployee replacement award to precombination and postcombination vesting referenced in paragraph 805-30-55-9A.
55-26 In these Cases, the acquiring entity is referred to as Acquirer and the acquiree is referred to as Target: Awards that require no postcombination vesting that are exchanged for acquiree awards for which grantees: Have met the vesting condition as of the acquisition date (Case A) Have not met the vesting condition as of the acquisition date (Case D). Awards that require postcombination vesting that are exchanged for acquiree awards for which grantees: Have met the vesting condition as of the acquisition date (Case B) Have not met the vesting condition as of the acquisition date (Case C).
55-27 The Cases assume the following: All awards are classified as equity. The only vesting condition included in the awards, if any, involves the delivery of engines. Target and Acquirer typically pay cash as each engine is delivered to their suppliers.
Case A: No Required Postcombination Vesting and the Vesting Condition for Acquiree Awards Has Been Met as of Acquisition Date 55-28 Acquirer issues replacement awards of $110 (fair-value-based measure) at the acquisition date for Target awards of $100 (fair-value-based measure) at the acquisition date. No postcombination vesting is required for the replacement awards, and Target’s grantee has delivered all the engines necessary for the acquiree awards as of the acquisition date.
55-29 The amount attributable to precombination vesting is the fair-value-based measure of Target’s awards ($100) at the acquisition date; that amount is included in the consideration transferred in the business combination. The amount attributable to postcombination vesting is $10, which is the difference between the total value of the replacement awards ($110) and the portion attributable to precombination vesting ($100). Because no postcombination vesting is required for the replacement awards, Acquirer immediately recognizes $10 as compensation cost in its postcombination financial statements.
Case B: Postcombination Vesting Required and the Vesting Condition for Acquiree Awards Has Been Met as of Acquisition Date 55-30 Acquirer exchanges replacement awards that require the delivery of another 10 engines postcombination for share-based payment awards of Target for which the grantee had met the necessary vesting condition to deliver 40 engines before the business combination. The fair-value-based measure of both awards is $100 at the acquisition date. Even though the grantee already had met the vesting condition for the acquiree’s award, Acquirer attributes a portion of the replacement award to postcombination compensation cost in accordance with paragraphs 805-30-30-12 through 30-13 because the replacement awards require the delivery of an additional 10 engines.
55-31 The portion attributable to precombination vesting equals the fair-value-based measure of the acquiree award ($100) multiplied by the percentage that would have been recognized for the award. The percentage that would have been recognized is the lower of the calculation on the basis of the original vesting requirements and the percentage that would have been recognized on the basis of the effective vesting requirements as described in paragraph 805-30-55-9A. The percentage that would have been recognized on the basis of the original vesting requirements equals 100 percent, which is calculated as 40 engines delivered divided by 40 engines required to be delivered. The percentage that would have been recognized on the basis of the effective vesting requirements equals 80 percent, which is calculated as 40 engines delivered divided by 50 engines (the sum of 40 engines delivered plus 10 engines required postcombination). Thus, $80 ($100 × 80%) is attributed to the precombination vesting period and therefore is included in the consideration transferred in the business combination. The remaining $20 is attributed to the postcombination vesting period and therefore is recognized as compensation cost in Acquirer’s postcombination financial statements in accordance with Topic 718.
Case C: Postcombination Vesting Required and the Vesting Condition for Acquiree Awards Has Not Been Met as of Acquisition Date 55-32 Acquirer exchanges replacement awards that require the delivery of 10 engines postcombination for share-based payment awards of Target for which the grantee had not met the necessary vesting condition to deliver 40 engines before the business combination. The fair-value-based measure of both awards is $100 at the acquisition date. As of the acquisition date, Target grantee has delivered 20 engines, and Target grantee would have been required to deliver an additional 20 engines after the acquisition date for its awards to vest. Accordingly, only a portion of Target’s awards is attributable to precombination vesting.
55-33 The portion attributable to precombination vesting equals the fair-value-based measure of the acquiree award ($100) multiplied by the percentage that would have been recognized on the award. The percentage that would have been recognized is the lower of the percentage that would have been recognized on the basis of the original vesting requirements and the percentage that would have been recognized on the basis of the effective vesting requirements as described in paragraph 805-30-55-9A. The percentage that would have been recognized on the basis of the original vesting requirements equals 50 percent, which is calculated as 20 engines delivered divided by 40 engines required to be delivered. The percentage that would have been recognized on the basis of the effective vesting requirements equals 66.67 percent, which is calculated as 20 engines delivered divided by 30 engines (the sum of 20 engines delivered plus 10 engines required postcombination). Thus, $50 ($100 × 50%) is attributed to precombination vesting and therefore is included in the consideration transferred in the business combination. The remaining $50 is attributed to the postcombination vesting and therefore is recognized as compensation cost in Acquirer’s postcombination financial statements in accordance with Topic 718.
Case D: No Postcombination Vesting Required and the Vesting Condition for Acquiree Awards Has Not Been Met as of Acquisition Date 55-34 Assume the same facts as in Case C, except that Acquirer exchanges replacement awards that require no postcombination vesting for share-based payment awards of Target for which the grantee had not met the necessary vesting condition to deliver 40 engines before the business combination. The terms of the replaced Target awards did not eliminate the vesting condition upon a change in control. (If the Target awards had included a provision that eliminated the vesting condition upon a change in control, the guidance in Case A [see paragraph 805-30-55-28] would apply.) The fair-value-based measure of both awards is $100.
55-35 The portion attributable to precombination vesting equals the fair-value-based measure of the acquiree award ($100) multiplied by the percentage that would have been recognized on the award. The percentage that would have been recognized is the lower of the percentage that would have been recognized on the basis of the original vesting requirements and the percentage that would have been recognized on the basis of the effective vesting requirements as described in paragraph 805-30-55-9A. The percentage that would have been recognized on the basis of the original vesting requirements equals 50 percent, which is calculated as 20 engines delivered divided by 40 engines required to be delivered. The percentage that would have been recognized on the basis of the effective vesting requirements equals 100 percent, which is calculated as 20 engines delivered divided by 20 engines (the sum of 20 engines delivered plus zero engines required postcombination). Thus, $50 ($100 × 50%) is attributed to the precombination vesting and is therefore included in the consideration transferred in the business combination. The remaining $50 is attributed to the postcombination vesting. Because no postcombination vesting is required to vest in the replacement award, Acquirer recognizes the entire $50 immediately as compensation cost in the postcombination financial statements.

6.2.4 Other Agreements and Issues

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 6.2.3.6.3.1 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.”

Footnotes

While the term “fair-value-based measure” is used in this chapter, ASC 718 permits the use of a calculated value or an intrinsic value in specified circumstances. Accordingly, the guidance in this chapter also applies in situations in which a calculated or an intrinsic value is used.

Note that regardless of an entity’s policy decision regarding the recognition of compensation cost, it may elect to value the awards as (1) a single award or (2) in-substance multiple awards. That is, even though each portion of the awards may directly or indirectly be treated by certain valuation techniques as individual awards, the entity is able to make a policy decision to recognize compensation cost as (1) a single award or (2) in-substance multiple awards.

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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.