6.7 Recapitalization Transactions
A recapitalization is a type of reorganization designed to change an entity’s capital structure (e.g., the
mix of debt and equity). Usually, these transactions involve new debt financing, issuing new shares, or
repurchasing outstanding shares. In a leveraged recapitalization, new debt is issued, and the proceeds
are used to redeem shares from existing shareholders as part of a series of steps that may also result
in the establishment of a new majority shareholder. If the transaction results in a change in control of
the entity undergoing the recapitalization, the new controlling entity would account for the entity that
underwent the recapitalization (if it meets the definition of a business) as an acquiree in a business
combination. In such a situation, an entity should evaluate all facts and circumstances in determining
whether it has obtained control of a business as a result of an investee undergoing a recapitalization
transaction.
Example 6-22
Recapitalization Transaction Without a Change in Control
Entities A, B, C, D, and E each own 20 percent of the issued and outstanding
shares of Company X. Company X meets the definition of a
business. None of the entities has control of X. Company X
buys back all of E’s shares, and the ownership of A, B, C,
and D increases to 25 percent each. However, no entity
obtains control of X and thus a business combination has not
occurred as a result of the recapitalization.
Recapitalization Transaction With a Change in Control
Entities A, B, and C own all of the issued and outstanding shares of Company X.
Company X meets the definition of a business. Entity A owns
45 percent, B owns 40 percent, and C owns 15 percent. None
of the entities has control of X. Company X buys back all of
C’s shares, and A’s ownership increases to 53 percent. In
the absence of evidence that A does not control X, a
business combination between A and X has occurred as a
result of the recapitalization.
6.7.1 Transaction Costs in a Recapitalization
Entities may incur costs related to structuring a recapitalization. An entity undergoing a recapitalization
should account for its costs on the basis of their nature. For example:
- Costs related to issuing debt are capitalized as debt issuance costs and amortized over the life of the debt by using the effective interest method.
- Costs related to issuing equity and raising capital are recognized as a reduction to the total amount of equity raised. (See Section 5.7 of Deloitte’s Roadmap Initial Public Offerings for more information about offering costs and SAB Topic 5.A.)
- Direct and incremental costs (e.g., costs related to advisory or legal services) should be expensed as incurred.
If the costs are billed to the entity as a single amount, we believe that the
entity should apply the guidance in the Interpretive Response to Question 1 of SAB Topic 2.A.6,
which states, in part:
When an investment banker provides
services in connection with a business combination or asset acquisition and
also provides underwriting services associated with the issuance of debt or
equity securities, the total fees incurred by an entity should be allocated
between the services received on a relative fair value basis. The objective
of the allocation is to ascribe the total fees incurred to the actual
services provided by the investment banker.
We believe that the amounts allocated to debt issuance costs should result in an
effective interest rate on the debt that is consistent with the effective market
interest rate and that the amounts allocated to equity issuance costs should be
consistent with the fees an underwriter would charge.
Further, we believe that if the fees are incurred by a new investor, those costs
should not be recognized in the financial statements of the entity undergoing
the recapitalization unless they were incurred by the investor on the entity’s
behalf. We believe that entities should consider the guidance in SAB Topic 1.B and SAB Topic 5.T in
determining whether such costs were incurred on behalf of, and for the benefit
of, the entity.