Chapter 6 — Other Acquisition Method Guidance
Chapter 6 — Other Acquisition Method Guidance
This chapter discusses other aspects of the acquisition method,
including the measurement period, assessing whether a transaction is separate from
the business combination (e.g., a compensation arrangement), business combinations
achieved in stages (i.e., step acquisitions), partial acquisitions, and reverse
acquisitions.
6.1 Measurement Period
ASC 805-10
25-15 The measurement period is the period after the acquisition date during which the acquirer may
adjust the provisional amounts recognized for a business combination. The measurement period provides
the acquirer with a reasonable time to obtain the information necessary to identify and measure any of the
following as of the acquisition date in accordance with the requirements of this Topic:
- The identifiable assets acquired, liabilities assumed, and any noncontrolling interest in the acquiree (see Subtopic 805-20)
- The consideration transferred for the acquiree (or the other amount used in measuring goodwill in accordance with paragraphs 805-30-30-1 through 30-3)
- In a business combination achieved in stages, the equity interest in the acquiree previously held by the acquirer (see paragraph 805-30-30-1(a)(3))
- The resulting goodwill recognized in accordance with paragraph 805-30-30-1 or the gain on a bargain purchase recognized in accordance with paragraph 805-30-25-2.
30-1 Paragraph 805-10-25-15 establishes that the measurement period provides the acquirer with a
reasonable time to obtain the information necessary to identify and measure various items in a business
combination.
An acquirer may not have the information necessary to complete the accounting for a business
combination by the end of the reporting period after the acquisition, especially when the business
combination closes shortly before the end of the acquirer’s reporting period or when the acquiree’s
operations are significant or complex. Thus, ASC 805-10-25-15 provides a measurement period during
which an acquirer can obtain the information it needs to identify and measure the consideration
transferred, assets acquired, and liabilities assumed, as well as any previously held or noncontrolling
interests. The objective of the measurement period is to give the acquirer a reasonable period in which
to obtain the information necessary to complete the accounting for the business combination while
maintaining normal reporting schedules.
The measurement period for a particular asset, liability, or equity instrument
ends once the acquirer determines that either (1) the necessary information has been
obtained or (2) the information is not available. However, the measurement period
for all items is limited to one year from the acquisition date. See Section 7.11 for a discussion
of the specific disclosure requirements for situations in which the accounting for a
business combination has not been completed by the end of the acquirer’s reporting
period.
6.1.1 Recognition of Provisional Amounts
ASC 805-10
25-13 If the initial accounting for a business combination is incomplete by the end of the reporting period in
which the combination occurs, the acquirer shall report in its financial statements provisional amounts for the
items for which the accounting is incomplete. During the measurement period, in accordance with paragraph
805-10-25-17, the acquirer shall adjust the provisional amounts recognized at the acquisition date to reflect
new information obtained about facts and circumstances that existed as of the acquisition date that, if known,
would have affected the measurement of the amounts recognized as of that date.
25-14 During the measurement period, the acquirer also shall recognize additional assets or liabilities if new
information is obtained about facts and circumstances that existed as of the acquisition date that, if known,
would have resulted in the recognition of those assets and liabilities as of that date. The measurement period
ends as soon as the acquirer receives the information it was seeking about facts and circumstances that
existed as of the acquisition date or learns that more information is not obtainable. However, the measurement
period shall not exceed one year from the acquisition date.
55-16 Paragraphs 805-10-25-14 through 25-19 and 805-10-30-2 through 30-3 discuss requirements related
to the measurement period in a business combination. If the initial accounting for a business combination is
incomplete at the end of the financial reporting period in which the combination occurs, paragraph 805-10-25-13 requires that the acquirer recognize in its financial statements provisional amounts for the items for
which the accounting is incomplete. During the measurement period, the acquirer recognizes adjustments
to the provisional amounts needed to reflect new information obtained about facts and circumstances that
existed as of the acquisition date that, if known, would have affected the measurement of the amounts
recognized as of that date. Paragraph 805-10-25-17 requires the acquirer to recognize such adjustments with
a corresponding adjustment to goodwill in the reporting period the adjustments are determined. The effects
of adjustments to provisional amounts to periods after the acquisition date are included in the earnings of the
adjustment period.
If the acquirer does not have the information necessary to complete the accounting for the business
combination by the next reporting date, it must recognize provisional amounts for those items for which
the accounting is incomplete by using its best estimates of their fair value (or other measurement as
required by ASC 805) on the basis of the information available. See Section 7.11 for a discussion of the
specific disclosure requirements for provisional measurements.
When the accounting for a business combination is incomplete at the end of the reporting period,
the acquirer must not knowingly understate or overstate an asset or liability, as might be the case if
no amount, a nominal amount, or the acquiree’s carrying amount were to be used as the provisional
amount until the measurement has been completed. Instead, the acquirer must determine provisional
amounts by using the best information available. If the acquirer becomes aware of new information
during the measurement period related to conditions that existed as of the acquisition date, it must
make subsequent adjustments to the provisional amounts, and additional assets acquired or liabilities
assumed might be identified for recognition and measurement.
6.1.2 Adjustments Identified During the Measurement Period
ASC 805-10
25-16 The acquirer recognizes an increase (decrease) in the provisional amount recognized for an identifiable
asset (liability) by means of a decrease (increase) in goodwill. However, new information obtained during
the measurement period sometimes may result in an adjustment to the provisional amount of more than
one asset or liability. For example, the acquirer might have assumed a liability to pay damages related to an
accident in one of the acquiree’s facilities, part or all of which are covered by the acquiree’s liability insurance
policy. If the acquirer obtains new information during the measurement period about the acquisition-date fair
value of that liability, the adjustment to goodwill resulting from a change to the provisional amount recognized
for the liability would be offset (in whole or in part) by a corresponding adjustment to goodwill resulting from a
change to the provisional amount recognized for the claim receivable from the insurer.
25-17 During the measurement period, the acquirer shall recognize adjustments to the provisional amounts
with a corresponding adjustment to goodwill in the reporting period in which the adjustments to the
provisional amounts are determined. Thus, the acquirer shall adjust its financial statements as needed,
including recognizing in its current-period earnings the full effect of changes in depreciation, amortization, or
other income effects, by line item, if any, as a result of the change to the provisional amounts calculated as
if the accounting had been completed at the acquisition date. Paragraph 805-10-55-16 and Example 1 (see
paragraph 805-10-55-27) provide additional guidance.
25-18 Paragraphs 805-10-30-2 through 30-3 require consideration of all pertinent factors in determining
whether information obtained after the acquisition date should result in an adjustment to the provisional
amounts recognized or whether that information results from events that occurred after the acquisition date.
30-2 The acquirer shall consider all pertinent factors in determining whether information obtained after
the acquisition date should result in an adjustment to the provisional amounts recognized or whether that
information results from events that occurred after the acquisition date. Pertinent factors include the time
at which additional information is obtained and whether the acquirer can identify a reason for a change to
provisional amounts.
30-3 Information that is obtained shortly after the acquisition date is more likely to reflect circumstances that
existed at the acquisition date than is information obtained several months later. For example, unless an
intervening event that changed its fair value can be identified, the sale of an asset to a third party shortly after
the acquisition date for an amount that differs significantly from its provisional fair value determined at that
date is likely to indicate an error in the provisional amount.
In September 2015, the FASB issued ASU 2015-16, which amended the guidance in ASC 805 on
the accounting for measurement-period adjustments. As described in paragraph BC3 of the ASU,
an acquirer must “recognize adjustments to provisional amounts that are identified during the
measurement period in the reporting period in which the adjustment amount is determined.” The
adjustments are calculated as if the accounting had been completed on the acquisition date. When an
acquirer adjusts a provisional amount, the offsetting entry generally increases or decreases goodwill but
may also result in adjustments to other assets and liabilities. For example, if an acquirer recognizes a
liability for a contingency and has an offsetting indemnification asset, an adjustment to the liability may
result in an offsetting increase or decrease in the indemnification asset.
Measurement-period adjustments may also affect the income statement. In
accordance with the guidance in ASU 2015-16, an acquirer must recognize, in the
reporting period in which the adjustment amounts are determined (rather than
retrospectively), the “effect on earnings of changes in depreciation,
amortization, or other income effects, if any, as a result of the change to the
provisional amounts, calculated as if the accounting had been completed at the
acquisition date.” For example, if a measurement-period adjustment increases the
value of fixed assets or finite-lived intangible assets, the acquirer should
recognize any catch-up depreciation or amortization in the reporting period in
which the adjustment is determined.
According to ASU 2015-16, acquirers must also “present separately on the face of
the income statement or disclose in the notes the portion of the amount recorded
in current-period earnings by line item that would have been recorded in
previous reporting periods if the adjustment to the provisional amounts had been
recognized as of the acquisition date.” See Section 7.11 for more information about
the disclosure requirements for measurement-period adjustments.
ASC 805-10 provides the following example illustrating the accounting for
measurement-period adjustments:
ASC 805-10
Example 1: Appraisal That Is Incomplete at the Reporting Date
55-27 This Example
illustrates the measurement period guidance in paragraph
805-10-55-16. Acquirer acquires Target on September 30,
20X7. Acquirer seeks an independent appraisal for an
item of property, plant, and equipment acquired in the
combination, and the appraisal was not complete by the
time Acquirer issued its financial statements for the
year ended December 31, 20X7. In its 20X7 annual
financial statements, Acquirer recognized a provisional
fair value for the asset of $30,000. At the acquisition
date, the item of property, plant, and equipment had a
remaining useful life of five years. Six months after
the acquisition date, Acquirer received the independent
appraisal, which estimated the asset’s acquisition-date
fair value as $40,000.
55-28 In its interim financial statements for the quarter ended March 31, 20X8, Acquirer adjusts the provisional
amounts recorded and the related effects on that period’s earnings as follows:
- The carrying amount of property, plant, and equipment as of March 31, 20X8, is increased by $9,000. That adjustment is measured as the fair value adjustment at the acquisition date of $10,000 less the additional depreciation that would have been recognized had the asset’s fair value at the acquisition date been recognized from that date ($1,000 for 6 months’ depreciation).
- The carrying amount of goodwill as of March 31, 20X8, is decreased by $10,000.
- Depreciation expense for the period ended March 31, 20X8, is increased by $1,000 to reflect the effect on earnings as a result of the change to the provisional amount recognized.
55-29 In accordance with paragraph 805-20-50-4A, Acquirer discloses both of the following:
- In its 20X7 financial statements, that the initial accounting for the business combination has not been completed because the appraisal of property, plant, and equipment has not yet been received
- In its March 31, 20X8 financial statements, the amounts and explanations of the adjustments to the provisional values recognized during the current reporting period. Therefore, Acquirer discloses that the increase to the fair value of the item of property, plant, and equipment was $10,000, with a corresponding decrease to goodwill. Additionally, the change to the provisional amount resulted in an increase in depreciation expense and accumulated depreciation of $1,000, of which $500 relates to the previous quarter.
The measurement period is not intended to allow for subsequent adjustments of the amounts
recognized as part of the business combination that result from the uncertainties and related risks
the acquirer assumed in the combination. Adjustments that are due to decisions made by the
combined company or changes in facts and circumstances or economic conditions that occurred
after the acquisition date are not measurement-period adjustments; rather, they are included in the
determination of net income in the period in which they are made. For example, if acquired equipment
is damaged after the acquisition date, the decrease in the equipment’s value is the result of changes in
facts and circumstances after the acquisition date and should not be recognized as a measurement-period
adjustment.
Determining whether an adjustment to an item’s value is a measurement-period adjustment or is
due to a change in fact or circumstance after the acquisition date may require significant judgment.
New information received soon after a business combination is more likely to reflect facts and
circumstances that existed as of the acquisition date than information received later during an open
measurement period; however, before reaching a conclusion, an acquirer must consider all pertinent
factors to determine whether information it obtained after the acquisition date is related to facts and
circumstances that existed as of the acquisition date or occurred after the acquisition date. For example,
deferred taxes recognized in a business combination should reflect the structure of the combined entity
as it existed on the acquisition date. Generally, the tax effects of subsequent transaction steps that may
be considered acquisition-related integration steps are not measurement-period adjustments and are
accounted for separately from the business combination.
Example 6-1
Potential Litigation Known as of the Acquisition Date
On January 1, 20X9, Company A acquires Company B in a transaction accounted for as a business combination.
As a result of due diligence activities associated with the acquisition, A was aware of a potential liability related
to a claim that B had breached a contract with a customer before the business combination. On the basis of
its understanding of the claim as of the acquisition date, A recognizes a provisional liability of $500,000 as part
of its initial accounting for the acquisition and asks its legal counsel to fully evaluate the claim. On April 1, 20X9,
A’s legal counsel confirms to A’s management that the claim does have merit since it appears that B breached
the contract. On the basis of this legal analysis, A determines that it should increase the provisional liability it
recognized to $750,000.
Because the new information became available during the measurement period and
is related to a circumstance that existed on the
acquisition date, A should recognize an increase of
$250,000 to the liability, with a corresponding
adjustment to goodwill.
Example 6-2
Potential Litigation Not Known as of the Acquisition Date
Assume the same facts as in the example above, except that Company A did not
know about Company B’s breach of contract as of the
acquisition date. Therefore, in the initial accounting
for the acquisition of B, A did not recognize a
liability. On March 1, 20X9, A becomes aware of B’s
potential breach of contract and asks its legal counsel
to evaluate the claim. On May 1, 20X9, A’s legal counsel
notifies A’s management that the claim does have merit
and that B may have breached the contract. Company A
determines that it should have recognized a liability of
$750,000 as part of the initial accounting for the
acquisition.
The breach of contract was a circumstance that existed as of the acquisition date, even though A was not aware
of it on that date. Because the new information became available during the measurement period and was
related to a circumstance that existed as of the acquisition date, A should recognize a liability for $750,000 as
part of the business combination accounting with a corresponding adjustment to goodwill.
6.1.2.1 Settlement of Litigation Shortly After the Acquisition Date
An acquiree may have ongoing litigation at the time of the business combination.
We believe that, by analogy to the subsequent-events guidance in ASC 855, if
the litigation is settled shortly after the acquisition date during an open
measurement period, the acquirer should consider whether that settlement
provides evidence about facts and circumstances that existed as of the
acquisition date. ASC 855-10-25-1 states, in part, that “[a]n entity shall
recognize in the financial statements the effects of all subsequent events
that provide additional evidence about conditions that existed at the date
of the balance sheet” (i.e., recognized subsequent events). ASC 855-10-55-1
provides the following example of a recognized subsequent event:
If the events that gave rise to litigation had taken
place before the balance sheet date and that litigation is settled after
the balance sheet date but before the financial statements are issued or
are available to be issued, for an amount different from the liability
recorded in the accounts, then the settlement amount should be
considered in estimating the amount of liability recognized in the
financial statements at the balance sheet date.
If an adjustment results from a settlement that occurs after the measurement
period — either because it occurs after the one-year anniversary of the
acquisition or because the acquirer concludes that it is no longer waiting
for information about that item — the change should be recognized in the
income statement. In addition, if the event that gives rise to the claim
takes place after the acquisition date, settlement of litigation does not
result in a measurement-period adjustment and should be recognized in the
income statement.
6.1.3 Adjustments Identified After the Measurement Period Has Ended
ASC 805-10
25-19 After the measurement period ends, the acquirer shall revise the accounting for a business combination
only to correct an error in accordance with Topic 250.
ASC 805-10-25-19 states that “[a]fter the measurement period ends, the acquirer shall revise the
accounting for a business combination only to correct an error in accordance with Topic 250”
(emphasis added). ASC 250-10-45-23 requires that an “error in the financial statements of a prior period
discovered after the financial statements are issued or are available to be issued . . . shall be reported as
an error correction, by restating the prior-period financial statements.” If an adjustment identified after
the measurement period is not the result of an error, it must be recognized in current-period earnings.
Entities must use judgment in determining whether an identified adjustment should be considered an
error correction or the result of events occurring after the acquisition date that require prospective
treatment in a manner consistent with a change in estimate.
ASC 250-10-20 defines an error in previously issued financial statements (an
“error”) as follows:
An error in recognition,
measurement, presentation, or disclosure in financial statements
resulting from mathematical mistakes, mistakes in the application of
generally accepted accounting principles (GAAP), or oversight or misuse
of facts that existed at the time the financial statements were
prepared. A change from an accounting principle that is not generally
accepted to one that is generally accepted is a correction of an
error.
When considering whether a change is a correction of an error, an entity should
use judgment to determine (1) whether the correct information was or should
have been “reasonably knowable” or was “readily accessible” from the
acquiree’s books and records in a prior reporting period and (2) whether use
of that information at that time would have resulted in different
reporting.
Connecting the Dots
In his remarks at the 2016 AICPA Conference on Current SEC and PCAOB Developments,
then SEC OCA Associate Chief Accountant Jonathan Wiggins noted that although ASU 2015-16
eliminated the requirement to retrospectively account for measurement-period adjustments,
it “does not change the measurement period or apply when an adjustment represents the
correction of an accounting error.” He also reminded registrants that they “should ensure they
have sufficient internal control over financial reporting to identify and account for measurement
period adjustments appropriately and separately identify accounting errors.”
Example 6-3
Accounting for an Adjustment Outside the Measurement Period
Company A acquires Company B on November 30, 20X1, in a nontaxable business combination accounted for
under ASC 805. Company A sought an independent valuation for several of the intangible assets it acquired in
the combination, but the valuation has not been completed as of the time A issues its financial statements for
the year ended December 31, 20X1. Thus, A includes a provisional measurement of the intangible assets and
the related deferred tax liabilities in its annual financial statements.
In June 20X2, A receives the final independent valuation of the intangible assets, which increases the fair
value it recorded as a provisional amount. Because this information pertained to the facts and circumstances
that existed as of the acquisition date, A adjusts its intangible-asset balances and recognizes any catch-up
amortization to account for this updated information in its interim financial statements for the quarter ended
June 30, 20X2. Company A then concludes that the measurement period has closed because it is not waiting
for any additional information regarding the provisional amounts.
In January 20X3 (i.e., after the measurement period has ended), A discovers that
although the financial statements were adjusted for
the change in fair value of its acquired intangible
assets, the related deferred tax liability was not
adjusted accordingly. Company A concludes that in
accordance with ASC 250, this was an error in the
accounting for the business combination.
6.2 Assessing Whether a Transaction Is Separate From the Business Combination
ASC 805-10
Determining What Is Part of the Business Combination Transaction
25-20 The acquirer and the
acquiree may have a preexisting relationship or other
arrangement before negotiations for the business combination
began, or they may enter into an arrangement during the
negotiations that is separate from the business combination.
In either situation, the acquirer shall identify any amounts
that are not part of what the acquirer and the acquiree (or
its former owners) exchanged in the business combination,
that is, amounts that are not part of the exchange for the
acquiree. The acquirer shall recognize as part of applying
the acquisition method only the consideration transferred
for the acquiree and the assets acquired and liabilities
assumed in the exchange for the acquiree. Separate
transactions shall be accounted for in accordance with the
relevant generally accepted accounting principles
(GAAP).
25-21 A transaction entered into by or on behalf of the acquirer or primarily for the benefit of the acquirer
or the combined entity, rather than primarily for the benefit of the acquiree (or its former owners) before the
combination, is likely to be a separate transaction. The following are examples of separate transactions that are
not to be included in applying the acquisition method:
- A transaction that in effect settles preexisting relationships between the acquirer and acquiree (see paragraphs 805-10-55-20 through 55-23)
- A transaction that compensates employees or former owners of the acquiree for future services (see paragraphs 805-10-55-24 through 55-26)
- A transaction that reimburses the acquiree or its former owners for paying the acquirer’s acquisition-related costs (see paragraph 805-10-25-23).
As part of its accounting for an acquisition, an acquirer must assess whether the items exchanged
include amounts that are separate from the business combination. In some cases, an acquirer
and seller (or acquiree) may have an arrangement or relationship — such as a supply, distribution,
franchise, or licensing agreement; lease contracts; or potential or ongoing litigation — that arose
before the negotiations for the acquisition began. ASC 805 refers to such arrangements as preexisting
relationships. In other cases, an acquirer and seller (or acquiree) may enter into agreements or
arrangements in close proximity to the business combination. ASC 805 provides guidance for assessing whether particular transactions or arrangements are part of the business combination or should be
accounted for separately from the business combination accounting.
6.2.1 Determining What Should Be Accounted for Separately From a Business Combination
To determine what is or is not part of a business combination, an entity must
consider the relevant facts and circumstances of the arrangement. ASC
805-10-25-20 states, in part, that “[t]he acquirer shall recognize as part of
applying the acquisition method only the consideration transferred for the
acquiree and the assets acquired and liabilities assumed in the exchange for the
acquiree. Separate transactions shall be accounted for in accordance with the
relevant generally accepted accounting principles (GAAP).” Specifically, ASC
805-10-55-18 provides three factors, which “are neither mutually exclusive nor
individually conclusive,” for an entity to consider when making this
determination:
-
The reasons for the transaction. Understanding the reasons why the parties to the combination (the acquirer, the acquiree, and their owners, directors, managers, and their agents) entered into a particular transaction or arrangement may provide insight into whether it is part of the consideration transferred and the assets acquired or liabilities assumed. For example, if a transaction is arranged primarily for the benefit of the acquirer or the combined entity rather than primarily for the benefit of the acquiree or its former owners before the combination, that portion of the transaction price paid (and any related assets or liabilities) is less likely to be part of the exchange for the acquiree. Accordingly, the acquirer would account for that portion separately from the business combination.
-
Who initiated the transaction. Understanding who initiated the transaction may also provide insight into whether it is part of the exchange for the acquiree. For example, a transaction or other event that is initiated by the acquirer may be entered into for the purpose of providing future economic benefits to the acquirer or combined entity with little or no benefit received by the acquiree or its former owners before the combination. On the other hand, a transaction or arrangement initiated by the acquiree or its former owners is less likely to be for the benefit of the acquirer or the combined entity and more likely to be part of the business combination transaction.
-
The timing of the transaction. The timing of the transaction may also provide insight into whether it is part of the exchange for the acquiree. For example, a transaction between the acquirer and the acquiree that takes place during the negotiations of the terms of a business combination may have been entered into in contemplation of the business combination to provide future economic benefits to the acquirer or the combined entity. If so, the acquiree or its former owners before the business combination are likely to receive little or no benefit from the transaction except for benefits they receive as part of the combined entity.
Determining what is or is not part of a business combination requires judgment, particularly when both
the acquirer and acquiree may benefit from a particular transaction.
ASC 805-10-25-21 specifies that “[a] transaction entered into by or on behalf of
the acquirer or primarily for the benefit of the acquirer or the combined
entity, rather than primarily for the benefit of the acquiree (or its former
owners) before the combination, is likely to be a separate transaction.”
However, it also states that the following are transactions that must be
accounted for separately from the business combination:
-
“A transaction that in effect settles preexisting relationships between the acquirer and acquiree” — see ASC 805-10-55-20 through 55-23 and Section 6.2.2.
-
“A transaction that compensates employees or former owners of the acquiree for future services” — see ASC 805-10-55-24 through 55-26 and Section 6.2.3.
-
“A transaction that reimburses the acquiree or its former owners for paying the acquirer’s acquisition-related costs” — see ASC 805-10-25-23 and Section 5.4.1.1.
These are examples only. Acquirers must assess whether other transactions with
the acquiree should be accounted for separately from the business
combination.
6.2.2 Effective Settlement of Preexisting Relationships Between the Acquirer and Acquiree
ASC 805-10
Effective Settlement of a Preexisting Relationship Between the Acquirer and Acquiree in a Business
Combination
55-20 The acquirer and
acquiree may have a relationship that existed before
they contemplated the business combination, referred to
here as a preexisting relationship. A preexisting
relationship between the acquirer and acquiree may be
contractual (for example, vendor and customer or
licensor and licensee) or noncontractual (for example,
plaintiff and defendant).
55-21 If the business combination in effect settles a preexisting relationship, the acquirer recognizes a gain or
loss, measured as follows:
- For a preexisting noncontractual relationship, such as a lawsuit, fair value
- For a preexisting contractual relationship, the lesser of the following:
- 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.
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
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 may represent a reacquired right of the acquirer — for example, a “right to
use the acquirer’s trade name under a franchise agreement or a right to use the acquirer’s technology
under a technology licensing agreement.” All reacquired rights are preexisting relationships, even
though all preexisting relationships are not reacquired rights. If a preexisting relationship represents a
reacquired right, the acquirer recognizes a settlement gain or loss, if any, separately from the business
combination measured in accordance with ASC 805-10-55-21.
The acquirer also recognizes a reacquired right as an identifiable intangible
asset separately from goodwill because it arises from contractual rights.
However, reacquired rights are an exception to the measurement principle in
ASC 805 because such rights must be measured on the basis of the remaining
contractual term of the related contract, regardless of whether market
participants would consider potential contractual renewals in determining
the fair value of those rights. See Section 4.3.7 for more information
about the measurement of reacquired rights.
6.2.2.7 Reimbursement of the Acquirer’s Acquisition-Related Costs
ASC 805-10-25-21(c) specifies that “[a] transaction that reimburses the acquiree or its former owners
for paying the acquirer’s acquisition-related costs” is a separate transaction that should not be
included in the application of the acquisition method. That is, if the acquirer and acquiree enter into an
arrangement in which the acquiree pays the acquirer’s acquisition-related costs and the acquirer agrees
to reimburse the acquiree either as part of the consideration transferred or otherwise, such costs must be accounted for separately from the business combination in accordance with their nature and
not as part of the consideration transferred. See Section 5.4.1 for guidance on the accounting for the
acquirer’s acquisition-related costs.
6.2.3 Compensation Arrangements
An acquiree in a business combination may have agreements in place to provide specified employees
with additional compensation that is predicated on a change in control of the acquiree. Such
arrangements could have been established either before or after the negotiations began for the
business combination. When determining whether the acquirer should account for these arrangements
as part of the business combination or separately as compensation, entities must use judgment and
consider the specific facts and circumstances as discussed below. However, if a business combination
results in additional compensation arrangements that include payments to the acquirer’s employees,
such payments are always compensation.
6.2.3.1 Arrangements to Pay an Acquiree’s Employee Upon a Change in Control
Arrangements may be established with the objective of retaining one or more of
the acquiree’s employees until the acquisition date and possibly for a
defined period thereafter. Such arrangements — often referred to in practice
as “stay bonuses,” “change in control payments,” or “golden parachutes” —
may also provide additional compensation for performance related to the
business combination or compensate employees who are terminated after the
combination. An entity should account for these arrangements on the basis of
their substance. In assessing the substance of an arrangement, an entity
should consider the factors listed in ASC 805-10-55-18 (i.e., “[t]he reasons
for the transaction,” “[w]ho initiated the transaction,” and “[t]he timing
of the transaction”). See Section 10.7.1 of Deloitte’s Roadmap Share Based Payment
Awards for more information.
ASC 805-10-55-34 through 55-36 provide the following example of a contingent
payment to an acquiree’s employee:
ASC 805-10
Example 4: Arrangement for Contingent Payment to an Employee
55-34 This Example
illustrates the guidance in paragraphs 805-10-55-24
through 55-25 relating to contingent payments to
employees in a business combination. Target hired a
candidate as its new chief executive officer under a
10-year contract. The contract required Target to
pay the candidate $5 million if Target is acquired
before the contract expires. Acquirer acquires
Target eight years later. The chief executive
officer was still employed at the acquisition date
and will receive the additional payment under the
existing contract.
55-35 In this Example, Target entered into the employment agreement before the negotiations of the
combination began, and the purpose of the agreement was to obtain the services of the chief executive
officer. Thus, there is no evidence that the agreement was arranged primarily to provide benefits to Acquirer
or the combined entity. Therefore, the liability to pay $5 million is included in the application of the acquisition
method.
55-36 In other circumstances, Target might enter into a similar agreement with the chief executive officer at the
suggestion of Acquirer during the negotiations for the business combination. If so, the primary purpose of the
agreement might be to provide severance pay to the chief executive officer, and the agreement may primarily
benefit Acquirer or the combined entity rather than Target or its former owners. In that situation, Acquirer
accounts for the liability to pay the chief executive officer in its postcombination financial statements separately
from application of the acquisition method.
In accounting for the acquisition, the acquirer will need to assess whether to
recognize amounts that have been determined to be part of the business
combination as part of the consideration transferred or as a liability
assumed.
If the acquirer issues cash, other assets, or its equity instruments to settle
the acquiree’s awards that were equity-classified in the acquiree’s
precombination financial statements, the portion determined to be part of
the business combination represents consideration transferred since the
acquiree’s employees were owners of (or increased their ownership in) the
acquiree as a result of the arrangement.
By contrast, if the acquirer issues cash, other assets, or its equity
instruments to settle a bonus arrangement (e.g., stay bonus) with the
acquiree’s employees or to settle the acquiree’s awards that were
liability-classified in the acquiree’s precombination financial statements,
the portion determined to be part of the business combination would be
treated in the acquisition accounting as a liability assumed.
If arrangements to pay an acquiree’s employees upon a change in control are
settled in cash or in other assets after the acquisition date rather than at
the closing of the business combination, the acquirer would recognize a
liability in its acquisition accounting for the portion determined to be
part of the business combination. In the acquisition accounting, the nature
of that liability as either consideration transferred or a liability assumed
should be determined on the basis of the analysis described above.
6.2.3.2 Dual- or Double-Trigger Arrangements
An employment agreement entered into before negotiations began for the business
combination may include terms that require a payment or accelerate vesting
upon (1) a change of control and (2) a second defined event or
“trigger,” which is why such provisions are commonly called “dual trigger”
or “double trigger” arrangements. The second defined event is generally the
separation of the employee from the acquirer and might be limited to
involuntary terminations or might also include resignation of the employee
in specified conditions (sometimes referred to as “good reasons”) such as:
-
A demotion or significant reduction in the employee’s duties or responsibilities after the acquisition date.
-
A significant reduction in the employee’s salary after the acquisition date.
-
The relocation of the employee’s job site beyond a specified radius after the acquisition date.
The objective of such employment agreements, which are typically entered into
before negotiations have begun for a business combination, is generally to
obtain the employee’s services. While the three factors in ASC 805-10-55-18
(i.e., “[t]he reasons for the transaction,” “[w]ho initiated the
transaction,” and “[t]he timing of the transaction”) might indicate that the
payments should be accounted for as part of the business combination, such
arrangements are generally accounted for separately from the business
combination. This is because the decision to effect the second trigger
(i.e., the employee’s involuntary termination or voluntary termination for
“good reason”) is under the control of the acquirer and is therefore
presumed to be made primarily for the acquirer’s benefit (e.g., to reduce
cost by eliminating the unneeded employee).
Example 6-5
Dual- or Double-Trigger Arrangement Involving the Termination of Employment
Company A acquires Company B in a transaction accounted for as a business combination. Company B has
an existing employment agreement with its CEO that was put in place before negotiations began for the
combination. Under the agreement, all of the CEO’s unvested awards will fully vest upon (1) a change in the
control of B and (2) the involuntary termination of the CEO’s employment within one year after the acquisition
date.
Before the closing, A determines that it will not offer employment to the CEO after the combination has been
completed. Thus, both conditions are triggered, and the vesting of the CEO’s awards is accelerated upon the
closing of the acquisition.
The decision not to employ B’s former CEO was under A’s control and was made for
A’s benefit (i.e., to reduce costs). Therefore, A
should recognize the compensation cost related to
the acceleration of the unvested portion of the
awards in its postcombination financial statements
and not as part of the business combination.
Example 6-6
Dual- or Double-Trigger Arrangement in Which Employee Resigns for “Good Reason”
As in the example above, Company A acquires Company B in a transaction accounted
for as a business combination, and B has an existing
employment agreement with its CEO. However, in this
example, the agreement provides that all of the
CEO’s unvested awards will fully vest upon (1) a
change in the control of B and (2) either the
involuntary termination of the CEO or the voluntary
departure of the CEO for “good reason” within one
year after the acquisition date. The agreement
specifies that a significant reduction in job
responsibilities would be a good reason. After the
acquisition date, B’s CEO will not assume the role
of CEO of the combined entity but instead will be
assigned a position with significantly reduced
responsibilities. In response, B’s CEO will resign
upon the change in control.
The decision to significantly reduce the responsibilities of B’s former CEO
after the acquisition date is within A’s control.
Therefore, A should recognize the compensation cost
related to the acceleration of the unvested portion
of the awards in its postcombination financial
statements and not as part of the business
combination.
6.2.3.3 Arrangements for Contingent Payments to Employees or Selling Shareholders
ASC 805-10
55-24 Whether arrangements for contingent payments to employees or selling shareholders are contingent
consideration in the business combination or are separate transactions depends on the nature of the
arrangements. Understanding the reasons why the acquisition agreement includes a provision for contingent
payments, who initiated the arrangement, and when the parties entered into the arrangement may be helpful
in assessing the nature of the arrangement.
During negotiations of the business combination, an acquirer may agree to a provision for contingent
payments to employees or selling shareholders after the acquisition date. Such payments may be
in cash, other assets, the acquirer’s equity instruments, or a combination thereof. The acquirer
must evaluate any contingent payments (i.e., payments that include conditions other than the
passage of time) to the acquiree’s former shareholders to determine whether they represent
(1) consideration transferred (i.e., contingent consideration), which is part of the business combination,
or (2) compensation, which is a transaction separate from the business combination. Payments to
individuals who were not shareholders or owners of the acquiree before an acquisition should be
accounted for as transactions that are separate from the business combination in accordance with the
nature of the payment. Accordingly, contingent payments to individuals who were not the acquiree’s owners but become employees of the combined entity should be accounted for as compensation in the
acquirer’s postcombination financial statements.
When deciding whether a contingent payment to a shareholder of the acquiree who
becomes an employee of the combined entity is part of the consideration
transferred or a transaction that is separate from the business combination,
the acquirer should first consider the factors in ASC 805-10-55-18.
Specifically, by applying the factors in ASC 805-10-55-18(a) and (b) to
determine the reason for the payment and who initiated it, the acquirer may
gain insight into the nature and intent of an arrangement. In addition, we
note that in practice, the only time an acquirer would negotiate a payment
to a shareholder of the acquiree that is contingent on the shareholder’s
becoming an employee of the combined entity would be during the period
leading up to the acquisition; thus, the guidance in ASC 805-10-55-18(c) on
the timing of a transaction suggests that such a payment would be a separate
transaction. However, the factors in ASC 805-10-55-18 are not intended to be
a checklist, and no one factor is determinative.
Further, an acquirer should consider the following indicators in ASC
805-10-55-25 “[i]f it is not clear whether an arrangement for payments to
employees or selling shareholders is part of the exchange for the acquiree
or is a transaction separate from the business combination”:
-
Continuing employment — see Section 6.2.3.3.1.
-
Duration of continuing employment — see Section 6.2.3.3.2.
-
Level of compensation — see Section 6.2.3.3.3.
-
Incremental payments to employees — see Section 6.2.3.3.4.
-
Number of shares owned — see Section 6.2.3.3.5.
-
Linkage to valuation — see Section 6.2.3.3.6.
-
Formula for determining compensation — see Section 6.2.3.3.7.
-
Other arrangements and issues — see Section 6.2.4.
According to ASC 805-10-55-24, “whether arrangements for contingent payments to
employees or selling shareholders are contingent consideration in the
business combination or are separate transactions depends on the nature of
the arrangements.” While ASC 805-10-55-25(a) (i.e., the continuing
employment factor — see Section 6.2.3.3.1) states that “a contingent consideration
arrangement in which the payments are automatically forfeited if employment
terminates is compensation for postcombination
services” (emphasis added), the other indicators in ASC 805-10-55-25 are not
as conclusive. Thus, in the absence of the automatic forfeiture condition
described in ASC 805-10-55-25(a), an acquirer must use judgment to determine
the nature of an arrangement, especially if not all indicators point to the
same conclusion.
6.2.3.3.1 Continuing Employment
ASC 805-10
55-25(a) Continuing employment. The terms of continuing employment by the selling shareholders who
become key employees may be an indicator of the substance of a contingent consideration arrangement.
The relevant terms of continuing employment may be included in an employment agreement, acquisition
agreement, or some other document. A contingent consideration arrangement in which the payments are
automatically forfeited if employment terminates is compensation for postcombination services. Arrangements
in which the contingent payments are not affected by employment termination may indicate that the
contingent payments are additional consideration rather than compensation.
If an arrangement requires a contingent payment to a selling shareholder who
becomes an employee of the combined entity to be forfeited upon the
termination of the shareholder’s employment, the acquirer must account
for the arrangement as compensation in its postcombination financial
statements. Such a determination cannot be overcome by consideration of
the other indicators in ASC 805-10-55-25.
Example 6-7
Payment Contingent on Continuing Employment
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. Under the
terms of the acquisition agreement, each
shareholder of B is entitled to an additional
payment at the end of three years after the
acquisition date if a specified revenue target is
met and the individual is
still employed by A.
Because the future payment for each shareholder of B is contingent on continued
employment with A after the acquisition, A should
recognize each arrangement as compensation in the
postcombination period and not as contingent
consideration in the business combination.
Assume the same facts as those above, except that under the terms of the acquisition agreement, each of the three shareholders would be entitled to the additional payment if they are no longer employed by A at the end of three years because of death, disability, or involuntary termination. If the shareholders are no longer employed by A at the end of three years because of voluntary resignation or because they were terminated for cause, they would not be entitled to the additional payment. Even though there are situations in which the shareholders could receive the additional payment without being employed by A at the end of three years, we believe that the future payment for each shareholder of B is contingent on continued employment with A after the acquisition. Therefore, A should recognize each arrangement as compensation in the postcombination period and not as contingent consideration in the business combination.
Example 6-8
Contingent Payment Reverts to Nonemployee Shareholder if
Employment Terminates
Company A acquires Company B from a single selling shareholder in a transaction
accounted for as a business combination. Company A
hires B’s top salesperson and agrees to pay the
individual a percentage of sales above a specified
amount at the end of each year for three years
provided the individual is employed by A at the
end of each year. If the individual is not
employed at a year-end, any amount due under the
arrangement will instead be paid to B’s selling
shareholder.
Even though A is required to make the payments regardless of whether the salesperson remains employed by
A, we believe that the substance of the arrangement is to induce the individual to remain employed. Therefore,
A should account for the payments as compensation in its postcombination financial statements and not as
part of the consideration transferred for the acquiree.
Arrangements with a shareholder of the acquiree who becomes an employee of the combined entity
may contain some elements that are linked to continuing employment and some that are not. Because
ASC 805-10-55-25(a) specifies that “a contingent consideration arrangement in which the payments
are automatically forfeited if employment terminates is compensation for postcombination services,” a
question arises regarding whether linking any portion of the arrangement to continuing employment
causes the entire arrangement to be compensation for postcombination services. We believe that if
arrangements involve a single shareholder of the acquiree who becomes an employee of the combined
entity, an acquirer should separately account for each element.
Example 6-9
Contingent Payment Affected in Part by Continuing Employment
Company A acquires Company B in a transaction accounted for as a business combination. One of B’s
shareholders (Shareholder Y) is an executive officer of B and agrees to become an employee of A after the
acquisition. Under the terms of the acquisition agreement, all selling shareholders of B are entitled to an
additional payment at the end of the first year after the acquisition date if certain performance targets have
been met for that year; however, any amount due to Y will be paid at the end of the first year only if Y is then
employed by A. If Y is not employed by A at that time, any contingent amount due under the acquisition
agreement will be distributed at the end of the fifth year after the acquisition date.
Since it is possible for the executive officer to receive a payment even if he or she is no longer employed by A,
we believe that it is appropriate for A to isolate the element that is contingent on continuing employment and
account for that element as compensation in its postcombination financial statements. In this example, A is
likely to measure the compensatory element of the arrangement as the value of receiving the amount that is
due in one year rather than in five years.
Arrangements such as this might be viewed as containing a “floor” amount that is
not affected by continued employment, and thus
that amount is appropriately accounted for as
contingent consideration in the business
combination as long as it satisfies the other
criteria for contingent consideration in ASC
805-10-55-25.
In general, if more than one shareholder of the acquiree becomes an employee of the combined
entity and one or more of those individuals are required to continue employment, the arrangement
is compensatory and not part of the exchange for the acquiree. However, there may be diversity in
practice related to these arrangements.
Example 6-10
Payment Contingent on the Continued Employment of a Specific Employee
Company A acquires Company B in a transaction accounted for as a business combination. One of B’s three
shareholders, its CEO, agrees to become A’s employee after the acquisition. The terms of the acquisition
agreement require A to make an additional payment if B’s CEO is employed by A at the end of three years.
The payment, if due, would be divided among the three shareholders on the basis of their relative ownership
percentages in B. However, if B’s CEO is not employed by A for the full three-year period, none of the
shareholders will receive their portion of the payment.
We believe that Company A should account for the entire payment as compensation in the postcombination
period because all of the payment is contingent on continued employment, albeit on only one person’s
employment.
We are also aware of an alternative view in which only the payments to the CEO
would be considered contingent on continued
employment and therefore be compensation. Under
that view, the payments to the other two
shareholders should be evaluated in accordance
with the other factors in ASC 805-10-55-25.
The guidance in ASC 805-10-55-25(a) requires contingent consideration arrangements to be accounted
for as compensation if the payments would be automatically forfeited upon the termination of
employment. We believe that when evaluating a provision for forfeiture in the event of employment
termination, an entity should assess the substance of any defined stay period. Accordingly, we believe
that on the basis of an evaluation of the other indicators in ASC 805-10-55-25, an entity could conclude
in unusual circumstances that payments that are contingent on a nonsubstantive stay period are eligible
to be accounted for as consideration transferred. We expect such circumstances to be rare.
Example 6-11
Postcombination Service Requirement Might Be Viewed as Nonsubstantive
Company A acquires Company B in a transaction accounted for as a business combination. Company B’s
three shareholders are executive officers of B and agree to become employees of A after the acquisition. The
terms of the acquisition agreement require that A pay B’s shareholders (1) 50 percent of the consideration at
the closing of the acquisition and (2) 50 percent of the consideration if the employees are employed by A one
month after the closing of the acquisition. The payment will be divided among the shareholders on the basis of
their relative ownership percentages in B. The amount of the contingent payment far exceeds the salary and
benefits that the employees would earn in a one-month period.
We believe that before determining that the 50 percent payable one month after
the closing is consideration transferred, entities
should evaluate the reason for the agreed-upon
employment period, the nature of the employees’
activities, and other evidence to assess whether
the required stay period is substantive. If it is
determined to be nonsubstantive, further analysis
of the specific facts and circumstances and the
other factors in ASC 805-10-55-25 is
necessary.
Example 6-12
Conditional Payment Disproportional to Payment at Closing
Company A acquires Company B, a manufacturing company, in a transaction accounted for as a business
combination. Company B is a substantive operating company with revenues, expenses, inventory, PP&E,
customers and customer contracts, and liabilities. Company A determines that B’s fair value on the acquisition
date is $20 million. Company B’s three shareholders are executive officers of B and agree to become
employees of A after the acquisition.
The terms of the acquisition agreement require A to pay B’s shareholders (1) $1
million in cash consideration at the closing of
the acquisition and (2) $25 million in three years
from the acquisition date if the
shareholders/employees remain employed by A. The
conditional payment would be divided among those
shareholders on the basis of their relative
ownership percentages in B.
While the future payment is contingent on the executive officers’ continuing
employment with A after the acquisition, we
believe that it is not clear whether the guidance
in ASC 805-10-55-25(a) is applicable because of
the insignificant amount of the consideration paid
at closing compared with B’s fair value.
For example, if A accounts for the contingent payment as compensation on the
basis of applying ASC 805-10-55-25(a), it will be
expected to recognize a bargain purchase gain (the
difference between the $1 million in consideration
transferred and the fair value of the net assets
acquired as of the acquisition date) and
compensation over the next five years. We believe
that such facts might indicate that a portion of
the future payments (i.e., the portion
representing B’s fair value) should be accounted
for as consideration transferred and the remainder
should be accounted for as compensation in the
postcombination period. Further analysis of the
specific facts and circumstances is warranted.
6.2.3.3.1.1 Arrangements to Reallocate Forfeited Awards or Amounts
An acquirer may issue share-based payment awards to a group of shareholders of the acquiree, all
of whom become employees of the combined entity with such awards subject to vesting based on
continued employment. The awards may be placed in a trust by the acquirer on the acquisition date.
Such arrangements are sometimes referred to as “last man standing” arrangements if any forfeited
awards must be reallocated to the remaining participants in the group. Some arrangements may not
specify what happens if none of the participants are still employed by the acquirer at the end of the
term; however, since these arrangements typically encompass many employees, it would be unlikely
that none remain. Other arrangements may specify that the amounts revert to the acquiree’s former
shareholders if none of the participants are still employed at the end of the term.
In his remarks at the 2000 AICPA Conference on Current SEC Developments, then SEC OCA Professional
Accounting Fellow R. Scott Blackley provided the following example of such an arrangement:
For illustration, consider an example business combination where a company acquires another enterprise,
XYZ Company, for cash and stock. All of the shareholders of XYZ Company are also employees. The acquiring
company expects and desires to have the employee shareholders of XYZ Company continue as employees of
the combined companies. Accordingly, of the shares issued to the shareholders of XYZ Company, a portion is
held in an irrevocable trust, subject to a three year vesting requirement (“forfeiture shares”).
The forfeiture provision requires that if, prior to vesting, a shareholder resigns from employment or is
terminated for cause, the shares held in the trust allocable to the employee shareholder be forfeited.
Additionally, any shares actually forfeited are reallocated to the remaining employee shareholders based on
their remaining ownership interests such that all of the forfeiture shares in the trust will ultimately be issued.
Mr. Blackley said that in this scenario, the SEC staff concluded that “the
forfeiture shares must be accounted for as a compensation
arrangement.” He noted that the staff placed “significant weight” on
the shares’ vesting on the basis of continued employment even though the amount of consideration was fixed because it would not be returned to the acquirer under any circumstances. Although Mr. Blackley made these remarks before Statement 141(R) was issued, we
believe that they remain relevant.
Therefore, in an arrangement in which share-based payment awards are issued to a
group of shareholders of the acquiree, all of whom become employees
of the combined entity on the basis of a requirement to continue
employment, the forfeiture and subsequent redistribution of the
awards are accounted for as (1) the forfeiture of the original award
and (2) the grant of a new award. That is, the acquirer would
reverse any compensation previously recognized for the forfeited
award (on the basis of the original grant-date fair-value-based
measure) and then recognize compensation for the new award (on the
basis of the fair-value-based measure on the date the award is
redistributed) over the remaining requisite service period.
Example 6-13
Arrangement to Reallocate Forfeited Awards to Remaining Shareholders/Employees
On January 1, 20X1, Company A acquires Company B and, as part of the acquisition agreement, grants each
of B’s 10 shareholders/employees 100 new share-based payment awards that vest at the end of five years of
service (cliff vesting). The grant-date fair-value-based measure of each award as of the acquisition date is $10.
The terms of the award state that if employment is terminated before the end of five years (i.e., the vesting
date), the employee’s awards are forfeited and redistributed among the remaining employees within the group.
The total grant-date fair-value-based measure of the awards as of the acquisition date is $10,000
(10 employees × 100 awards × $10 grant-date fair-value-based measure), which A recognizes in the
postcombination financial statements as compensation cost over the five-year service period ($2,000 per year).
On December 31, 20X3, two employees in the group terminate their employment and forfeit their awards,
which are then redistributed to the eight remaining group members. The fair-value-based measure of each
redistributed (i.e., new) award is $12 on the date the awards are redistributed.
On December 31, 20X3, A should reverse $1,200 of previously recognized
compensation cost (2 employees × 100 awards × $10
grant-date fair value × 60% for 3 out of 5 years
of services rendered) corresponding to the
forfeited awards. Company A should continue to
recognize $1,600 in annual compensation cost (8
employees × 100 awards × $10 grant-date fair value
÷ 5 years) over each of the remaining two years of
service for the original awards provided to the
remaining employees. In addition, A should
recognize $1,200 in additional annual compensation
cost (200 awards × $12 grant-date fair value ÷ 2
years of remaining service) over each of the
remaining two years of service for the
redistributed awards.
In some cases, payments to the shareholders/employees may be made in cash rather than forfeitable
shares. We do not believe that the form of the payment affects the conclusion that such arrangements
are based on continued employment and therefore should be accounted for as compensation and not
as part of the exchange for the acquiree.
6.2.3.3.1.2 Refundable Payments or Forgiveness of Loans to Selling Shareholders Who Become Employees of the Combined Entity
An acquirer may structure a contingent consideration arrangement such that payments to selling
shareholders who become employees of the combined entity are distributed in advance but must be
returned if specified conditions are not met. Such amounts might be characterized as refundable payments or loans subject to
forgiveness and should be evaluated in accordance with the guidance in ASC
805-10-55-25(a). Accordingly, if the selling shareholders must remain employed by the combined entity
for the amount to not become refundable or for the loan to be forgiven, the acquirer should account for the arrangement as compensation rather
than contingent consideration.
6.2.3.3.2 Duration of Continuing Employment
ASC 805-10
55-25(b) Duration of
continuing employment. If the period of required
employment coincides with or is longer than the
contingent payment period, that fact may indicate
that the contingent payments are, in substance,
compensation.
ASC 805-10-55-25(b) states, in part, that “[i]f the period of required employment coincides with or is longer
than the contingent payment period, that fact may indicate that the
contingent payments are, in substance, compensation” (emphasis added).
In evaluating this indicator, the acquirer should consider any
employment and noncompetition agreements with a selling shareholder who
becomes an employee of the combined entity and whether such agreements
create a “requirement” to remain employed with the acquirer.
6.2.3.3.3 Level of Compensation
ASC 805-10
55-25(c) Level of
compensation. Situations in which employee
compensation other than the contingent payments is
at a reasonable level in comparison to that of
other key employees in the combined entity may
indicate that the contingent payments are
additional consideration rather than
compensation.
As indicated in ASC 805-10-55-25(c), if the compensation, excluding the contingent payment to the
selling shareholder who becomes an employee of the combined entity, “is at a reasonable level in
comparison to that of other key employees in the combined entity,” the contingent payment may
represent contingent consideration. However, assessing the compensation may be difficult because the
responsibilities of such an employee may not be readily comparable to those of the acquirer’s other key
employees, and levels of compensation may vary significantly within the combined entity on the basis of
other factors.
6.2.3.3.4 Incremental Payments to Employees
ASC 805-10
55-25(d) Incremental payments
to employees. If selling shareholders who do not
become employees receive lower contingent payments
on a per-share basis than the selling shareholders
who become employees of the combined entity, that
fact may indicate that the incremental amount of
contingent payments to the selling shareholders
who become employees is compensation.
There may be differences between the per-share contingent payments made to selling shareholders
who become employees of the combined entity and the payments made to those who do not. Such
differences may be indicators that a portion or all of the payments are compensation. For example:
- The selling shareholders who become employees of the combined entity may be entitled to receive higher contingent payments on a per-share basis than selling shareholders who do not become the entity’s employees. Such a scenario may be an indicator that the incremental portion paid to the selling shareholders/employees is compensation.
- Only selling shareholders who become employees of the combined entity may be entitled to receive the contingent payments. Such a scenario may be an indicator that the contingent payments are compensation.
Example 6-14
Incremental Contingent Payment to Shareholder Who Becomes an Employee
Company A acquires Company B in a transaction accounted for as a business combination. Company B is
owned equally by three shareholders. One of those shareholders, B’s CEO, agrees to become A’s employee
after the acquisition. The terms of the acquisition agreement require A to pay B’s shareholders a fixed amount
upon the closing of the acquisition. In addition, A must pay (1) the two shareholders who do not become
employees 5 percent of B’s EBITDA above $1 million for each of the next five years and (2) B’s CEO/shareholder
12 percent of B’s EBITDA above $1.5 million for each of the next five years.
The fact that B’s CEO received a higher contingent payment and is employed by A after the business
combination indicates that the incremental amount paid (12 percent of B’s EBITDA above $1.5 million less
5 percent of B’s EBITDA above $1 million) is compensation in A’s postcombination financial statements, whereas
the remainder of the payments should be accounted for as contingent consideration provided that they qualify
as such on the basis of the other factors in ASC 805-10-55-25.
6.2.3.3.5 Number of Shares Owned
ASC 805-10
55-25(e) Number of shares
owned. The relative number of shares owned by the
selling shareholders who remain as key employees
may be an indicator of the substance of the
contingent consideration arrangement. For example,
if the selling shareholders who owned
substantially all of the shares in the acquiree
continue as key employees, that fact may indicate
that the arrangement is, in substance, a
profit-sharing arrangement intended to provide
compensation for postcombination services.
Alternatively, if selling shareholders who
continue as key employees owned only a small
number of shares of the acquiree and all selling
shareholders receive the same amount of contingent
consideration on a per-share basis, that fact may
indicate that the contingent payments are
additional consideration. The preacquisition
ownership interests held by parties related to
selling shareholders who continue as key
employees, such as family members, also should be
considered.
The proportion of shares owned by selling shareholders who become employees of the combined entity
may be an indicator of whether a contingent payment is a profit-sharing arrangement. For example, if
the owners of substantially all of the acquiree’s shares become key employees of the combined entity,
the contingent payments may be profit-sharing arrangements (i.e., compensation). However, if such
shareholders owned only a small number of the acquiree’s shares, and all selling shareholders received
the same amount of contingent consideration on a per-share basis, the conditional payments may be
contingent consideration.
When evaluating whether selling shareholders who become employees of the combined entity owned
substantially all of the shares in the acquiree, entities also should consider preacquisition ownership
interests held by parties related to the selling shareholders, such as family members. Entities may need
to use judgment in determining which parties are considered “related to selling shareholders.”
6.2.3.3.6 Linkage to the Valuation
ASC 805-10
55-25(f) Linkage to the
valuation. If the initial consideration
transferred at the acquisition date is based on
the low end of a range established in the
valuation of the acquiree and the contingent
formula relates to that valuation approach, that
fact may suggest that the contingent payments are
additional consideration. Alternatively, if the
contingent payment formula is consistent with
prior profit-sharing arrangements, that fact may
suggest that the substance of the arrangement is
to provide compensation.
Entities should consider whether the sum of the consideration transferred on the acquisition date and
any anticipated contingent payments is consistent with the acquirer’s estimate of the acquiree’s fair
value or whether that total exceeds the estimate. For example, an acquirer and acquiree may disagree
on the specific fair value of the acquiree but agree on a related range of value. In such a scenario, the
acquirer may agree to pay the seller (1) a fixed amount at the closing that would represent the low
end of the range and (2) a contingent amount if earnings exceed a certain target that would represent
the higher end of the range, in which case the contingent payments might be viewed as additional
consideration. By contrast, if the sum of the fixed amount at the closing and any anticipated contingent
payments exceeds the higher end of the range of the acquiree’s estimated fair value, the substance of
the arrangement might be to provide compensation.
6.2.3.3.7 Formula for Determining Contingent Consideration
ASC 805-10
55-25(g) Formula for
determining consideration. The formula used to
determine the contingent payment may be helpful in
assessing the substance of the arrangement. For
example, if a contingent payment is determined on
the basis of a multiple of earnings, that might
suggest that the obligation is contingent
consideration in the business combination and that
the formula is intended to establish or verify the
fair value of the acquiree. In contrast, a
contingent payment that is a specified percentage
of earnings might suggest that the obligation to
employees is a profit-sharing arrangement to
compensate employees for services rendered.
Payments based on multiples of earnings (e.g., EBITDA, EBIT, net income, or revenues) may be more
likely to be contingent consideration than payments based on percentages of earnings, which are more
likely to be profit-sharing arrangements that should be accounted for as compensation.
6.2.4 Other Arrangements
ASC 805-10
55-25(h) Other agreements and issues. The terms of other arrangements with selling shareholders (such as
noncompete agreements, executory contracts, consulting contracts, and property lease agreements) and
the income tax treatment of contingent payments may indicate that contingent payments are attributable
to something other than consideration for the acquiree. For example, in connection with the acquisition, the
acquirer might enter into a property lease arrangement with a significant selling shareholder. If the lease
payments specified in the lease contract are significantly below market, some or all of the contingent payments
to the lessor (the selling shareholder) required by a separate arrangement for contingent payments might be,
in substance, payments for the use of the leased property that the acquirer should recognize separately in
its postcombination financial statements. In contrast, if the lease contract specifies lease payments that are
consistent with market terms for the leased property, the arrangement for contingent payments to the selling
shareholder may be contingent consideration in the business combination.
The acquirer and the selling shareholders may enter into other arrangements simultaneously with, or
in close proximity to, the acquisition. If so, the acquirer should determine whether to attribute some or
all of the contingent payments under the acquisition agreement to such other arrangements (e.g., in
circumstances in which the other arrangement provides for no payment or a below-market payment).
Amounts attributable to other arrangements should be accounted for separately from the business
combination in accordance with their nature.
In addition, ASC 805-10-55-25(h) states that “the income tax treatment of
contingent payments may indicate that contingent payments are attributable to
something other than consideration for the acquiree.” When assessing the
substance of an arrangement, entities should evaluate any lack of symmetry
between the accounting treatment and the tax treatment of contingent
payments.
6.2.5 Selling Shareholders Share Proceeds With Specified Employees of the Acquiree
In some acquisitions, one or more of the selling shareholders may decide to share some of the proceeds
that they are entitled to receive with one or more of the acquiree’s nonshareholder employees. Such
arrangements may be structured in various ways. For example, the selling shareholders may decide
to share a portion of the consideration that they are entitled to receive on the acquisition date or to
share a portion of any future contingent payments that they are entitled to receive, or both. The selling
shareholders may direct the acquirer to deliver the amounts directly to the specified employees or may
pay the specified employees directly from their proceeds.
On the basis of the guidance in ASC 718-10-15-4, unless the amount “is clearly
for a purpose other than compensation,” the framework described in Section 6.2.3 should be
used to determine whether the compensation is for precombination or
postcombination services.
6.2.6 Disputes Arising From the Business Combination
After the completion of a business combination, a dispute may occur between an acquirer and the
acquiree’s sellers that sometimes results in payments between the parties after the acquisition date.
Alternatively, an acquirer’s shareholders may bring a claim against the acquirer for various reasons
(e.g., overpayment for the acquiree — see discussion in Section 6.2.6.2).
6.2.6.1 Settlement of Disputes With the Sellers Over a Business Combination
When a dispute between the acquirer and the seller results in a transfer of
amounts between the parties after the acquisition date, questions may arise
about whether the acquirer, when accounting for such subsequent payments,
should reflect the amount paid or received either (1) as an adjustment to
the consideration transferred for the acquiree or (2) in its postacquisition
income statement. At the 2003 AICPA Conference on Current SEC Developments,
then SEC OCA Professional Accounting Fellow Randolph Green indicated in
prepared remarks that the SEC has “generally concluded that
legal claims between an acquirer and the former owners of an acquired
business should be reflected in the income statement when settled.” This
view is based on the general belief that contingencies related to litigation
about the business combination itself are not preacquisition contingencies.
However, Mr. Green noted that an acquirer may be able to treat such payments
as an adjustment to the consideration transferred for the acquisition if
there is a “clear and direct link to the purchase price.” He gave the
following example:
[A]ssume a purchase agreement
explicitly sets forth the understanding that each “acquired customer” is
worth $1,000, that not less than one thousand customers will be
transferred as of the consummation date, and subsequent litigation
determines that the actual number of acquired customers was only nine
hundred. The effects of the litigation should properly be reflected as
part of the purchase price. In contrast, if the purchase agreement
obligates the seller to affect its best efforts to retain customers
through the consummation date and litigation subsequently determines
that the seller failed to do so, the effects are not clearly and
directly linked to the purchase price and, accordingly, should be
reflected in the income statement.
Even when an acquirer is able to establish “a clear and direct link” to the
consideration transferred, we believe that it is only appropriate to adjust
the consideration transferred if the measurement period is still open. If it
is closed, entities should recognize such amounts in the income statement.
In an alternative example, Mr. Green noted that “claims that assert one
party [misled] the other or that a provision of the agreement is unclear are
not unique to business combination agreements.” Therefore, such claims do
not generally establish a clear and direct link to the consideration
transferred and should be reflected in the income statement.
Mr. Green also noted that “[f]requently, claims seeking enforcement of an escrow
or escrow-like arrangement also include claims of misrepresentation or
otherwise constitute a mixed claim.” He went on to say that “[i]n order to
reflect some or all of the settlement of such a [mixed] claim as an
adjustment of the purchase price of the acquired business, the acquirer
should be able to persuasively demonstrate that all or a specifically
identified portion of the mixed claim is clearly and directly linked to the
purchase price.”
Although not stated by Mr. Green, neither the acquirer’s legal costs to settle the dispute nor any
settlement amounts used to reimburse the sellers for legal costs or other damages are clearly and
directly linked to the consideration transferred. Thus, they should be reflected in the income statement.
While this SEC staff speech was given before FASB Statement 141(R) was issued,
we believe that the views expressed in it continue to apply.
6.2.6.2 Settlement of Disputes With the Acquirer’s Shareholders Over a Business Combination
An acquirer’s shareholders may bring a claim against the acquirer after the acquisition date for
various reasons, such as the shareholders’ assertion that the acquirer overpaid for the acquiree. The
acquirer should recognize costs incurred for such disputes, including any settlement amounts if paid,
in the income statement and not as part of the consideration transferred to the acquiree. This view
is consistent with an additional statement by Mr. Green that, in reference to settlements of litigation
over the consideration transferred, “the cost of litigation brought by the acquirer’s shareholders should
always be reflected in the income statement.”
6.3 Accounting for Arrangements Entered Into Concurrently With the Business Combination
An acquirer and seller may enter into one or more other agreements in close proximity to, or
simultaneously with, the business combination. For example, an acquirer and seller may enter into a
business combination transaction as well as execute an ongoing supply, distribution, collaboration,
or licensing agreement. Such agreements may be transitional (e.g., for a few months) or more long
term. The acquirer should account for individual agreements in accordance with their nature and
should specifically consider whether each agreement’s stated price reflects an amount that would be
expected in the absence of a concurrent business combination. For example, the consideration for the
business could be overstated while the pricing for the supply agreement could be understated or vice
versa. Therefore, an entity may need to adjust the stated contractual amounts when recognizing each
arrangement.
Example 6-15
Supply Agreement Entered Into Simultaneously With the Acquisition
Company B enters into an agreement with Company C to acquire C’s subsidiary,
Subsidiary S. Subsidiary S has been supplying a specific raw
material to C, and C wants to continue to receive it after
the acquisition. Company B agrees to pay a fixed amount on
the acquisition date and to provide a predetermined amount
of raw materials to C at no cost for one year after the
closing date.
In determining the consideration transferred in the business combination, B
should include the value related to the amount of raw
materials to be provided to C for no cost, because an
arrangement to provide no-cost materials would be unexpected
in the absence of the business combination.
6.4 Partial Acquisitions
A “partial acquisition” is a business combination in which an entity acquires a controlling interest,
but less than 100 percent of the voting interests, in an entity. The ASC master glossary defines a
noncontrolling interest (also known as a minority interest) as “[t]he portion of equity (net assets) in a
subsidiary not attributable, directly or indirectly, to a parent.” Therefore, the portion of equity in the
acquiree held by other parties is presented as a noncontrolling interest in the acquirer’s consolidated
financial statements.
An underlying premise of ASC 805 is that obtaining control of a business makes
the acquirer accountable and responsible for all of the acquiree’s assets and liabilities,
regardless of the acquirer’s ownership percentage. Therefore, in a partial acquisition, the
acquirer recognizes in its consolidated financial statements the assets acquired,
liabilities assumed, and noncontrolling interest at 100 percent of their values, measured in
accordance with ASC 805 (generally at fair value). That is, even if the acquirer obtains a
less than 100 percent interest in the acquiree, all of the assets and liabilities, including
goodwill, are measured at 100 percent of their values, as calculated in accordance with ASC
805.
On the acquisition date of a partial acquisition, the acquirer only transfers
consideration for the portion of the equity interests acquired in that transaction.
Therefore, to determine the amounts to recognize for the assets acquired (including
goodwill), liabilities assumed, and any noncontrolling interests, the acquirer must include
in the calculation “the fair value of any noncontrolling interest,” in accordance with ASC
805-30-30-1. That guidance requires entities to measure goodwill in business combinations,
including partial acquisitions, as follows:
The acquirer shall
recognize goodwill as of the acquisition date, measured as the excess of (a) over (b):
-
The aggregate of the following:
-
The consideration transferred measured in accordance with this Section, which generally requires acquisition-date fair value (see paragraph 805-30-30-7)
-
The fair value of any noncontrolling interest in the acquiree
-
In a business combination achieved in stages, the acquisition-date fair value of the acquirer’s previously held equity interest in the acquiree.
-
-
The net of the acquisition-date amounts of the identifiable assets acquired and the liabilities assumed measured in accordance with this Topic. [Emphasis added]
Once an entity has control of a subsidiary, any subsequent acquisitions of some
or all of the noncontrolling interests in that subsidiary are accounted for as equity
transactions under ASC 810-10, as long as the acquirer maintains control. For more
information about acquisitions of noncontrolling interests, see Deloitte’s Roadmap Consolidation — Identifying a Controlling
Financial Interest.
Example 6-16
Measuring Goodwill in a Partial Acquisition
Company A acquires 80 percent of the equity interests in, and control of,
Company B for $1,600. Company A had no prior ownership in B. The transaction
meets the definition of a business combination. The fair value of the
noncontrolling interest is $380. The fair value of B’s identifiable net assets
as of the acquisition date is $1,500.
Company A should measure goodwill as follows:
6.4.1 Measuring the Fair Value of a Noncontrolling Interest
ASC 805-20
Measuring the Fair Value of a Noncontrolling Interest in an Acquiree
30-7 Paragraph 805-20-30-1 requires the acquirer to measure a noncontrolling interest in the acquiree at its
fair value at the acquisition date. An acquirer sometimes will be able to measure the acquisition-date fair value
of a noncontrolling interest on the basis of a quoted price in an active market for the equity shares (that is,
those not held by the acquirer). In other situations, however, a quoted price in an active market for the equity
shares will not be available. In those situations, the acquirer would measure the fair value of the noncontrolling
interest using another valuation technique.
30-8 The fair values of the acquirer’s interest in the acquiree and the noncontrolling interest on a per-share
basis might differ. The main difference is likely to be the inclusion of a control premium in the per-share fair
value of the acquirer’s interest in the acquiree or, conversely, the inclusion of a discount for lack of control
(also referred to as a noncontrolling interest discount) in the per-share fair value of the noncontrolling interest
if market participants would take into account such a premium or discount when pricing the noncontrolling
interest.
ASC 805 requires an acquirer to determine the acquisition-date fair value of any noncontrolling interest
in the acquiree. If there is an active market for the noncontrolling interest, it must be measured “on the
basis of a quoted price in an active market for the equity shares (that is, those not held by the acquirer).”
However, ASC 805 does not provide detailed guidance on valuing the noncontrolling interest when
an active market does not exist, except to say that “the acquirer would measure the fair value of the
noncontrolling interest using another valuation technique” and that the “main difference [in valuing the
noncontrolling interests] is likely to be . . . the inclusion of a discount for lack of control.” The valuation
techniques used by entities to measure the noncontrolling interest should be consistent with the fair
value measurement principles in ASC 820.
Example 6-17
Impact of a Control Premium on the Fair Value of the Noncontrolling Interest
Company A acquires 60 percent (600,000 shares) of Company B for $6 million (or
$10 per share). However, on the acquisition date, B’s shares are trading at
$9.00 per share. The acquirer acknowledges that it is paying a premium over
the market because it believes that it will derive synergies from integrating
B with its own business.
Because A paid a premium over B’s market value per share, it may not be
reasonable to conclude that the fair value of each share held by
noncontrolling shareholders is $10.00.
Example 6-18
Determining the Fair Value of the Noncontrolling Interest
Company C acquired 75 percent (750,000 shares) of Company D, a privately held
entity, for $15 million in cash (or $20 per share). An independent third-party
valuation firm calculates the fair value of D as a whole (i.e., 100 percent)
as $19 million by using valuation techniques in accordance with the guidance
in ASC 820.
It may be appropriate for C to derive the fair value of the noncontrolling
interest as $4 million (or $16 per share), calculated as the fair value of the
entire business ($19 million) less the fair value of the consideration
transferred by C ($15 million), which includes a control premium.
6.5 Business Combinations Achieved in Stages
ASC 805-10
A Business Combination Achieved in Stages
25-9 An acquirer sometimes obtains control of an acquiree in which it held an equity interest immediately
before the acquisition date. For example, on December 31, 20X1, Entity A holds a 35 percent noncontrolling
equity interest in Entity B. On that date, Entity A purchases an additional 40 percent interest in Entity B, which
gives it control of Entity B. This Topic refers to such a transaction as a business combination achieved in stages,
sometimes also referred to as a step acquisition.
25-10 In a business combination
achieved in stages, the acquirer shall remeasure its
previously held equity interest in the acquiree at its
acquisition-date fair value and recognize the resulting gain
or loss, if any, in earnings. In prior reporting periods,
with respect to its previously held equity method
investment, the acquirer may have recognized amounts in
other comprehensive income in accordance with paragraph
323-10-35-18. If so, the amount that was recognized in other
comprehensive income shall be reclassified and included in
the calculation of gain or loss as of the acquisition date.
If the business combination achieved in stages relates to a
previously held equity method investment that is a foreign
entity, the amount of accumulated other comprehensive income
that is reclassified and included in the calculation of gain
or loss shall include any foreign currency translation
adjustment related to that previously held investment. For
guidance on derecognizing foreign currency translation
adjustments recorded in accumulated other comprehensive
income, see Section 830-30-40.
As described in ASC 805-10-25-9, in a business combination achieved in stages, an acquirer “obtains
control of an acquiree in which it held an equity interest immediately before the acquisition date.” Such
transactions are also commonly called “step acquisitions.” Because, as stated previously, an acquirer is
accountable and responsible for all of the acquiree’s assets and liabilities regardless of the ownership
percentage acquired on the acquisition date, the acquirer in a step acquisition recognizes in its
consolidated financial statements the assets acquired, liabilities assumed, and noncontrolling interest at
100 percent of their values, measured in accordance with ASC 805 (generally at fair value).
However, on the acquisition date of a business combination achieved in stages,
the acquirer only transfers consideration for the portion of the equity interests
acquired in that transaction. Therefore, to determine the amounts to recognize for
the assets acquired (including goodwill), liabilities assumed, and any
noncontrolling interests, the acquirer must determine the fair value of the acquiree
as a whole. To do so, the acquirer must remeasure its previously held equity
interest in the acquiree as of its acquisition-date fair value and recognize the
resulting gain or loss, if any, in earnings. The acquirer then measures the goodwill
in accordance with the guidance in ASC 805-30-30-1 and accounts for the acquisition
as if it had sold the previously held interest, recognized any gain or loss in
current-period earnings, and then acquired a controlling interest in the acquiree. Paragraph B384 of the Basis for Conclusions of Statement 141(R) explains the FASB’s
rationale for the accounting treatment:
The Boards concluded
that a change from holding a noncontrolling investment in an entity to obtaining
control of that entity is a significant change in the nature of and economic
circumstances surrounding that investment. That change warrants a change in the
classification and measurement of that investment. Once it obtains control, the
acquirer no longer is the owner of a noncontrolling investment asset in the
acquiree. As in present practice, the acquirer ceases its accounting for an
investment asset and begins reporting in its financial statements the underlying
assets, liabilities, and results of operations of the acquiree. In effect, the
acquirer exchanges its status as an owner of an investment asset in an entity
for a controlling financial interest in all of the underlying assets and
liabilities of that entity (acquiree) and the right to direct how the acquiree
and its management use those assets in its operations.
In prior periods, the previously held interest may have been remeasured to fair value, with changes
recognized in other comprehensive income. Alternatively, the investment may have been in a foreign
entity for which the acquirer had recognized cumulative translation adjustments. In such cases, any
amounts in accumulated comprehensive income related to the previously held interest should be
reclassified and included in the calculation of the gain or loss.
Once the acquirer obtains control of the acquiree, subsequent increases or
decreases in its ownership interest are accounted for as equity transactions in
accordance with ASC 810-10 as long the acquirer retains control. For more
information about acquisitions of noncontrolling interests, see Deloitte’s Roadmap
Consolidation — Identifying
a Controlling Financial Interest.
Example 6-19
Business Combination Achieved in Stages (Step Acquisition)
Company A purchases a 35 percent interest in Company B, a publicly traded
entity, for $2,000 on January 1, 20X8. (The deferred tax
accounting implications are ignored in this example.)
Company A accounts for its 35 percent interest in B by using
the equity method of accounting.
On December 31, 20X9, A purchases the remaining 65 percent interest for $6,500
and obtains control of B. Company A accounts for the
transaction as a business combination. Company B’s
identifiable net assets are recognized at $8,000 under ASC
805, and the fair value of A’s 35 percent interest in B is
$3,500. The book value of that interest is $2,500.
Company A should account for the acquisition of B as follows:
6.5.1 Measuring the Fair Value of a Previously Held Interest
ASC 805 does not specify how to measure a previously held equity interest. For publicly traded interests,
entities should measure fair value by using the market price on the acquisition date. However, some
have questioned whether a previously held interest that is not publicly traded should be remeasured
with or without a control premium.
Some have looked to ASC 805-30-30-1, which describes how to measure goodwill, as
support for remeasuring a previously held interest without a control premium.
That paragraph states:
The acquirer shall recognize goodwill
as of the acquisition date, measured as the excess of (a) over (b):
-
The aggregate of the following:
-
The consideration transferred measured in accordance with this Section, which generally requires acquisition-date fair value (see paragraph 805-30-30-7)
-
The fair value of any noncontrolling interest in the acquiree
-
In a business combination achieved in stages, the acquisition-date fair value of the acquirer’s previously held equity interest in the acquiree.
-
-
The net of the acquisition-date amounts of the identifiable assets acquired and the liabilities assumed measured in accordance with this Topic.
Proponents of this view believe that this guidance indicates that a previously
held interest is its own unit of account. That is, in measuring the fair value
of the acquiree, entities should separately measure (1) the consideration
transferred for the interest that gave the acquirer control, (2) the fair value
of any noncontrolling interest, and (3) the fair value of any previously held
interest. Because there are three separate units of account, each is measured
individually, and possibly differently, from the others. Entities should then
look to ASC 805-20-30-8, which clarifies how a noncontrolling interest in a
partial acquisition should be measured:
The fair values of
the acquirer’s interest in the acquiree and the noncontrolling interest on a
per-share basis might differ. The main difference is likely to be the
inclusion of a control premium in the per-share fair value of the acquirer’s
interest in the acquiree or, conversely, the inclusion of a discount for
lack of control (also referred to as a noncontrolling interest discount) in
the per-share fair value of the noncontrolling interest if market
participants would take into account such a premium or discount when pricing
the noncontrolling interest.
ASC 805-20-30-8 clarifies that a noncontrolling interest is a separate unit of
account that should be measured differently from the acquirer’s controlling
interest. Thus, if the previously held interest is also a separate unit of
account, it must also be measured independently, which suggests that no control
premium should be included in the value of the previously held interest.
Alternatively, others believe that the acquirer’s entire ownership interest
(both the newly acquired and the previously held interest) in the acquiree
should be measured as a single unit of account. This view could result in the
inclusion of a control premium in the remeasurement of the previously held
interest.
Supporters of this view also look to the guidance in ASC 805-20-30-8, but they interpret the words
“the fair values of the acquirer’s interest in the acquiree and the noncontrolling interest” to indicate
that there are two units of account in the measurement of the acquiree’s fair value: the acquirer’s total
interest (both the newly acquired and the previously held interest) and the noncontrolling interest, if any.
They then read the words “inclusion of a control premium in the per-share fair value of the acquirer’s
interest in the acquiree” to indicate that the valuation of the acquirer’s interest (both the newly acquired
and the previously held interest) should include a control premium.
We understand that members of both the FASB’s and IASB’s staffs discussed this
issue at the September 23, 2008, FASB Valuation Resource Group meeting. At that
meeting, two staff members, one from each staff, expressed their belief that
measuring a previously held interest without a control premium is consistent with both boards’ intent in jointly developing Statement 141(R) (now ASC 805)
and IFRS 3. However, we note that there has been no additional standard setting
in response to the staff discussions. We also note that sometimes, such as in
the case of a publicly traded acquiree, it would be appropriate to measure at
the same per-share amount both the interest that gives the acquirer control and
the previously held interest, which may include a control premium. We therefore
believe that measuring a previously held interest requires the use of judgment
and that different approaches may be reasonable under different
circumstances.
6.5.2 Call Options to Acquire a Controlling Interest in a Business
An entity may hold a freestanding call option that, when exercised, will result in
the acquisition of a controlling financial interest in a business. In some cases,
the entity may have no previous equity ownership in the business, while in others,
the entity may have held a noncontrolling interest in the business before exercising
the call option. The call option may not be measured at fair value on a recurring
basis under applicable U.S. GAAP; for example, it may not meet the definition of a
derivative in ASC 815 as a result of the net settlement criterion. Accordingly, we
believe that if the entity exercises the call option and obtains a controlling
financial interest in the business, the acquirer should account for the call option
as a previously held equity interest and remeasure the call option to its
acquisition-date fair value, with any resulting gain or loss recognized in earnings
in accordance with ASC 805-10-25-10. See Section
6.5 for more information about previously held equity interests and
business combinations achieved in stages.
6.6 Business Combinations Achieved Without the Transfer of Consideration
ASC 805-10
25-11 An acquirer sometimes obtains control of an acquiree without transferring consideration. The acquisition
method of accounting for a business combination applies to those combinations. Such circumstances include
any of the following:
- The acquiree repurchases a sufficient number of its own shares for an existing investor (the acquirer) to obtain control.
- Minority veto rights lapse that previously kept the acquirer from controlling an acquiree in which the acquirer held the majority voting interest.
- The acquirer and acquiree agree to combine their businesses by contract alone. The acquirer transfers no consideration in exchange for control of an acquiree and holds no equity interests in the acquiree, either on the acquisition date or previously. Examples of business combinations achieved by contract alone include bringing two businesses together in a stapling arrangement or forming a dual-listed corporation.
25-12 In a business combination achieved by contract alone, the acquirer shall attribute to the equity holders
of the acquiree the amount of the acquiree’s net assets recognized in accordance with the requirements of
this Topic. In other words, the equity interests in the acquiree held by parties other than the acquirer are a
noncontrolling interest in the acquirer’s postcombination financial statements even if the result is that all of the
equity interests in the acquiree are attributed to the noncontrolling interest.
ASC 805-30
55-2 In a business combination achieved without the transfer of consideration, the acquirer must substitute the
acquisition-date fair value of its interest in the acquiree for the acquisition-date fair value of the consideration
transferred to measure goodwill or a gain on a bargain purchase (see paragraphs 805-30-30-1 through 30-4).
Subtopic 820-10 provides guidance on using valuation techniques to measure fair value.
An acquirer may obtain control of an acquiree without transferring any consideration on the acquisition
date. Even though no consideration is transferred, the acquirer must still account for the transaction
by using the acquisition method. ASC 805-30-55-2 states that “[t]he acquirer must substitute the
acquisition-date fair value of its interest in the acquiree for the acquisition-date fair value of the
consideration transferred to measure goodwill or a gain on a bargain purchase.”
ASC 805-10-25-11 provides three examples of business combinations achieved
without the transfer of consideration:
-
The acquiree repurchases a sufficient number of its own shares for an existing investor (the acquirer) to obtain control [see Section 6.6.1].
-
Minority veto rights lapse that previously kept the acquirer from controlling an acquiree in which the acquirer held the majority voting interest [see Section 6.6.2].
-
The acquirer and acquiree agree to combine their businesses by contract alone [see Section 6.6.3].
These are examples only, and there may be other transactions or events that
qualify as business combinations achieved without the transfer of
consideration.
6.6.1 Share Repurchases
A business combination can occur when an entity repurchases a sufficient number of its own shares
from existing investors and another existing investor obtains control of the entity. In such cases, the
acquiree transfers consideration to buy back its own shares, but the acquirer does not transfer any
consideration to obtain control of its investee.
Example 6-20
Share Repurchase
Company A holds a 48 percent interest in Company B and accounts for it by using
the equity method of accounting. The remaining 52
percent interest in B is widely held. Company B
announces a share buyback program. Company A does
not sell any of its interest. As a result of B’s
share buybacks, A’s percent interest in B
increases to greater than 50 percent of the
outstanding shares, and A obtains control of
B.
Company A should account for this event as a business combination (i.e., an
acquisition achieved in stages, since A had a
previously held interest). While A did not
transfer consideration to obtain control of B, it
did obtain control as a result of B’s repurchase
of its own shares.
6.6.2 Lapse of Minority Veto Rights or Substantive Participating Rights
A business combination can occur when minority veto rights or substantive
participating rights held by one or more shareholders lapse, giving a majority
shareholder control over an entity. While it is presumed under the guidance in
ASC 810-10 that a voting interest entity is controlled by the holder of more
than 50 percent of an entity’s voting interest, noncontrolling interest holders
sometimes have the right to either participate in or block certain significant
financial and operating decisions that an entity makes in the ordinary course of
business. In such situations, the majority investor cannot control the entity.
However, if those minority veto rights or substantive participating rights
lapse, the holder of the majority interest may obtain control of the entity and
would account for that event as a business combination. For more information
about minority veto rights and substantive participating rights, see Deloitte’s
Roadmap Consolidation —
Identifying a Controlling Financial Interest.
Example 6-21
Lapse of Minority Veto Rights
Company A holds a majority interest in Company X, and Company D holds both a noncontrolling interest and
minority veto rights in X. The minority veto rights preclude A from exercising control over X, so A accounts for its
interest in X by using the equity method of accounting. On the date that D’s veto rights expire, A gains control
over X.
Once A obtains control of X, it should account for this event as a business
combination.
6.6.3 Control by Contract
A business combination can occur when an acquirer and acquiree agree to combine their businesses
by contract alone (e.g., a stapling arrangement or dual-listed corporations). In such cases, one of the
entities must be identified as the acquirer for accounting purposes, and the assets and liabilities of the
entity determined to be the acquiree for accounting purposes are recognized by using the acquisition
method, generally at the acquisition-date fair values. ASC 805-10-25-12 states, in part, that for business
combinations achieved by contract alone, “the acquirer shall attribute to the equity holders of the
acquiree the amount of the acquiree’s net assets recognized.” In other words, the acquirer should
consolidate the acquiree even if the acquirer owns little or none of the acquiree’s outstanding equity.
The acquirer should recognize in its postcombination financial statements a noncontrolling interest for the equity in the acquiree owned by other parties even if the result is that the noncontrolling interest
represents 100 percent of the acquiree’s net assets.
With the introduction of the VIE model, the relevance of the control by contract
model has diminished. This is because a legal entity
controlled by contract would most likely be a VIE since one
of the conditions for exemption from the VIE model is that
the equity investors at risk must control the legal entity’s
most significant activities. However, in the rare instances
in which such a legal entity is not a VIE, the guidance in
ASC 810-10-15-20 through 15-22 applies. See Deloitte’s
Roadmap Consolidation — Identifying a Controlling
Financial Interest for more
information about the control-by-contract model.
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.
6.8 Reverse Acquisitions
As discussed in Chapter
3, a reverse acquisition occurs when the entity that issues its
shares or gives other consideration to effect the transaction is determined for
accounting purposes to be the acquiree (also called the accounting acquiree or legal
acquirer), while the entity whose shares are acquired is for accounting purposes the
acquirer (also called the accounting acquirer or legal acquiree). The accounting
acquiree/legal acquirer generally continues in existence as the legal entity whose
shares represent the outstanding common shares of the combined company. While the
accounting acquiree/legal acquirer continues to issue its own financial statements,
those statements are often in the name of the accounting acquirer/legal acquiree
because the legal acquirer often adopts the name of the legal acquiree. The
financial reporting reflects the accounting acquirer’s/legal acquiree’s financial
information, except for its equity, which is retroactively adjusted to reflect the
equity of the accounting acquiree/legal acquirer.
Example 6-23
Reverse Acquisition
Company A, a public company with substantive operations and a December 31
year-end, has one million common shares outstanding as of
June 30, 20X9. On July 1, 20X9, in a transaction accounted
for as a business combination, A issues four million of its
newly registered common shares to Company B, a private
entity, in exchange for all of B’s two million outstanding
common shares (an exchange rate of 2:1). After the
transaction, B controls A’s voting rights through its 80
percent ownership interest (four million common shares held
÷ five million total common shares outstanding) and its
ability to elect the majority of the combined entity’s board
members.
Although A issued common shares to effect the business combination, B would be
considered the accounting acquirer under ASC 805, provided
that there are no other existing pertinent facts and
circumstances to the contrary after consideration of the
factors in ASC 805-10-55-12 through 55-14.
6.8.1 Accounting Acquiree Must Meet the Definition of a Business
ASC 805-40
25-1 For a business combination transaction to be accounted for as a reverse acquisition, the accounting
acquiree must meet the definition of a business. All of the recognition principles in Subtopics 805-10, 805-20,
and 805-30, including the requirement to recognize goodwill, apply to a reverse acquisition.
ASC 805-40-25-1 states that the guidance in ASC 805-40 on reverse acquisitions only applies if the
accounting acquiree/legal acquirer meets the definition of a business in ASC 805 (see Section 2.4).
Otherwise, the transaction is accounted for as either a reverse asset acquisition or a capital transaction, depending on the substance of the transaction.
See Appendix C for more information about accounting for asset acquisitions.
6.8.2 Measuring Consideration Transferred
ASC 805-40
30-2 In a reverse acquisition, the accounting acquirer usually issues no consideration for the acquiree. Instead,
the accounting acquiree usually issues its equity shares to the owners of the accounting acquirer. Accordingly,
the acquisition-date fair value of the consideration transferred by the accounting acquirer for its interest in the
accounting acquiree is based on the number of equity interests the legal subsidiary would have had to issue
to give the owners of the legal parent the same percentage equity interest in the combined entity that results
from the reverse acquisition. Example 1, Case A (see paragraph 805-40-55-8) illustrates that calculation. The
fair value of the number of equity interests calculated in that way can be used as the fair value of consideration
transferred in exchange for the acquiree.
In a reverse acquisition, the accounting acquiree/legal acquirer typically
issues its shares to the owners of the accounting acquirer/legal acquiree as
consideration in the transaction. However, to apply the acquisition method of
accounting, the accounting acquirer/legal acquiree must calculate the
hypothetical amount of consideration that it would have transferred to acquire
the accounting acquiree/legal acquirer and obtain the same percentage of
ownership interest in the combined entity that results from the transaction.
Accordingly, the fair value of the consideration transferred is determined on
the basis of the number of equity interests that the accounting acquirer/legal
acquiree would have had to issue to the accounting acquiree’s/legal acquirer’s
owners to provide the same ratio of ownership of equity interests in the
combined entity as a result of the reverse acquisition. Generally, the fair
value of the consideration transferred equals the fair value of the accounting
acquiree/legal acquirer.
In some reverse acquisitions, the accounting acquiree/legal acquirer may issue
cash or other consideration, as well as shares, to acquire the shares of the
accounting acquirer/legal acquiree. The payment of cash to the shareholders of
the accounting acquirer/legal acquiree should be considered a distribution of
capital and, accordingly, a reduction of shareholders’ equity of the accounting
acquirer/ legal acquiree.
For reverse acquisitions between a public company and a private company in which
the public company is the legal acquirer but is determined to be the accounting
acquiree, the fair value of the public company’s shares generally is more
reliably determinable than the fair value of the private company’s shares. Thus,
the determination of the consideration transferred might be based on the fair
value of the legal acquirer’s shares rather than the fair value of the legal
acquiree’s shares.
6.8.3 Measuring the Accounting Acquiree’s Assets and Liabilities, Including Goodwill
ASC 805-40
30-1 All of the measurement principles applicable to business combinations in Subtopics 805-10, 805-20, and
805-30 apply to a reverse acquisition.
In a reverse acquisition accounted for as a business combination, the accounting acquiree’s/legal
acquirer’s assets and liabilities are measured in accordance with the guidance in ASC 805 on business
combinations. ASC 805-40-55-12 clarifies that an entity should measure goodwill in a reverse acquisition
“as the excess of the fair value of the consideration effectively transferred” (emphasis added) by the
accounting acquirer/legal acquiree divided by the fair value of the accounting acquiree’s/legal acquirer’s
identifiable assets and liabilities. The consideration effectively transferred is calculated as described in
Section 6.8.2.
In some reverse acquisitions, the accounting acquirer/legal acquiree owns shares
of the accounting acquiree/legal acquirer before the transaction. To calculate
the amount of goodwill to recognize, the accounting acquirer/legal acquiree must
remeasure its previously held interest in the accounting acquiree/legal acquirer
at its acquisition-date fair value and add it to the consideration transferred.
See Section 6.5 for
more information about the accounting for previously held interests.
If the accounting acquiree/legal acquirer does not meet the definition of a business and the acquisition
is accounted for as a reverse asset acquisition, the accounting acquiree’s assets and liabilities are
measured in accordance with the subsections in ASC 805-50 on the acquisition of assets rather than a
business. See Appendix C for more information about accounting for asset acquisitions.
6.8.4 Noncontrolling Interests
ASC 805-40
25-2 In a reverse acquisition, some of the owners of the legal acquiree (the accounting acquirer) might not
exchange their equity interests for equity interests of the legal parent (the accounting acquiree). Those owners
are treated as a noncontrolling interest in the consolidated financial statements after the reverse acquisition.
That is because the owners of the legal acquiree that do not exchange their equity interests for equity interests
of the legal acquirer have an interest in only the results and net assets of the legal acquiree ― not in the
results and net assets of the combined entity. Conversely, even though the legal acquirer is the acquiree for
accounting purposes, the owners of the legal acquirer have an interest in the results and net assets of the
combined entity.
30-3 The assets and liabilities of the legal acquiree are measured and recognized in the consolidated financial
statements at their precombination carrying amounts (see paragraph 805-40-45-2(a)). Therefore, in a reverse
acquisition the noncontrolling interest reflects the noncontrolling shareholders’ proportionate interest in the
precombination carrying amounts of the legal acquiree’s net assets even though the noncontrolling interests in
other acquisitions are measured at their fair values at the acquisition date.
In some reverse acquisitions, some shareholders of the accounting acquirer/legal acquiree may
not exchange their interests for interests in the accounting acquiree/legal acquirer, which results
in noncontrolling interests in the combined entity. Because the noncontrolling interest holders
own ownership interests in the entity determined to be the acquirer for accounting purposes,
“the noncontrolling interest reflects the noncontrolling shareholders’ proportionate interest in the precombination carrying amounts of the legal acquiree’s net assets even though the noncontrolling
interests in other acquisitions are measured at their fair values at the acquisition date.”
6.8.5 Presentation of the Combined Entity’s Financial Statements
In a reverse acquisition, the financial statements of the newly combined entity represent a continuation
of the financial statements of the accounting acquirer/legal acquiree. As a result, the assets and
liabilities of the accounting acquirer/legal acquiree are presented at their historical carrying values in
the consolidated financial statements of the newly combined entity and the assets and liabilities of the
accounting acquiree/legal acquirer are recognized on the acquisition date and measured by using the
acquisition method. The results of the accounting acquiree’s/legal acquirer’s results of operations are
included in the combined company’s financial statements beginning on the acquisition date.
ASC 805-40
30-4 Paragraph 805-40-45-1 provides guidance on required adjustments to the accounting acquirer’s legal
capital to reflect the legal capital of the legal parent (accounting acquiree) in the consolidated financial
statements following a reverse acquisition.
45-1 Consolidated financial statements prepared following a reverse acquisition are issued under the
name of the legal parent (accounting acquiree) but described in the notes as a continuation of the financial
statements of the legal subsidiary (accounting acquirer), with one adjustment, which is to retroactively adjust
the accounting acquirer’s legal capital to reflect the legal capital of the accounting acquiree. That adjustment is
required to reflect the capital of the legal parent (the accounting acquiree). Comparative information presented
in those consolidated financial statements also is retroactively adjusted to reflect the legal capital of the legal
parent (accounting acquiree).
45-2 Because the consolidated financial statements represent the continuation of the financial statements
of the legal subsidiary except for its capital structure, the consolidated financial statements reflect all of the
following:
- The assets and liabilities of the legal subsidiary (the accounting acquirer) recognized and measured at their precombination carrying amounts.
- The assets and liabilities of the legal parent (the accounting acquiree) recognized and measured in accordance with the guidance in this Topic applicable to business combinations.
- The retained earnings and other equity balances of the legal subsidiary (accounting acquirer) before the business combination.
- The amount recognized as issued equity interests in the consolidated financial statements determined by adding the issued equity interest of the legal subsidiary (the accounting acquirer) outstanding immediately before the business combination to the fair value of the legal parent (accounting acquiree) determined in accordance with the guidance in this Topic applicable to business combinations. However, the equity structure (that is, the number and type of equity interests issued) reflects the equity structure of the legal parent (the accounting acquiree), including the equity interests the legal parent issued to effect the combination. Accordingly, the equity structure of the legal subsidiary (the accounting acquirer) is restated using the exchange ratio established in the acquisition agreement to reflect the number of shares of the legal parent (the accounting acquiree) issued in the reverse acquisition.
- The noncontrolling interest’s proportionate share of the legal subsidiary’s (accounting acquirer’s) precombination carrying amounts of retained earnings and other equity interests as discussed in paragraphs 805-40-25-2 and 805-40-30-3 and illustrated in Example 1, Case B (see paragraph 805-40-55-18).
The table below summarizes the presentation of
the combined entity’s financial statements at the time of a reverse
acquisition.
Statement of Financial
Position Balance(s) | Presentation |
---|---|
Assets and liabilities | Sum of (1) the accounting acquiree’s/legal acquirer’s assets and liabilities,
measured by using the acquisition method under ASC 805, and (2) the
accounting acquirer’s/legal acquiree’s assets and liabilities, measured at their
carrying values. |
Retained earnings and other
equity balances | The accounting acquirer’s/legal acquiree’s precombination carrying amount,
proportionately reduced by any noncontrolling interests. |
Issued equity | Sum of (1) the accounting acquirer’s/legal acquiree’s issued equity immediately
before the reverse acquisition, proportionately reduced
by any noncontrolling interests, and (2) the fair value
of the accounting acquiree/legal acquirer (i.e., the
hypothetical consideration transferred). The equity
structure (i.e., the number and type of equity interests
issued) reflects the accounting acquiree’s/legal
acquirer’s equity structure. However, the balance is
adjusted to reflect the par value of the outstanding
shares of the accounting acquiree/legal acquirer,
including the number of shares issued in the reverse
acquisition. Any difference is recognized as an
adjustment to the APIC account. |
APIC | The historical APIC account of the accounting acquirer/legal acquiree
immediately before the reverse acquisition is carried forward and increased to
reflect the additional fair value of the accounting acquiree/legal acquirer less
the par value of the shares held by its preacquisition shareholders. |
Noncontrolling interest | The noncontrolling interest’s proportionate share of the accounting acquirer’s/legal acquiree’s precombination retained earnings, issued equity, and other
equity balances. |
Prior-period presentation | For periods before the reverse acquisition, the shareholders’ equity of
the combined entity presented on the basis of the historical equity of the
accounting acquirer/legal acquiree before the acquisition, retroactively recast to
reflect the number of shares received in the acquisition. |
6.8.6 EPS Calculation
In a reverse acquisition, the financial statements of the combined entity reflect the equity of the
accounting acquiree/legal acquirer, including the equity interests issued as part of the reverse
acquisition. As a result, EPS is calculated on the basis of the capital structure of the accounting acquiree/legal acquirer.
ASC 805-40
45-3 As noted in (d) in the preceding paragraph [ASC 805-40-45-2(d)], the equity structure in the consolidated financial statements
following a reverse acquisition reflects the equity structure of the legal acquirer (the accounting acquiree),
including the equity interests issued by the legal acquirer to effect the business combination.
45-4 In calculating the weighted-average number of common shares outstanding (the denominator of the
earnings-per-share [EPS] calculation) during the period in which the reverse acquisition occurs:
- The number of common shares outstanding from the beginning of that period to the acquisition date shall be computed on the basis of the weighted-average number of common shares of the legal acquiree (accounting acquirer) outstanding during the period multiplied by the exchange ratio established in the merger agreement.
- The number of common shares outstanding from the acquisition date to the end of that period shall be the actual number of common shares of the legal acquirer (the accounting acquiree) outstanding during that period.
45-5 The basic EPS for each comparative period before the acquisition date presented in the consolidated
financial statements following a reverse acquisition shall be calculated by dividing (a) by (b):
- The income of the legal acquiree attributable to common shareholders in each of those periods
- The legal acquiree’s historical weighted-average number of common shares outstanding multiplied by the exchange ratio established in the acquisition agreement.
6.8.7 Illustrative Example
ASC 805-40-55-2 through 55-23 illustrate the guidance on accounting for reverse acquisitions:
ASC 805-40
55-2 The following Cases illustrate the guidance in this Subtopic on accounting for a reverse acquisition:
- A reverse acquisition if all the shares of the legal subsidiary are exchanged (Case A)
- A reverse acquisition if not all of the shares of the legal subsidiary are exchanged and a noncontrolling interest results (Case B).
55-3 In these Cases, Entity B, the legal subsidiary, acquires Entity A, the entity issuing equity instruments and
therefore the legal parent, on September 30, 20X6. These Cases ignore the accounting for any income tax
effects. Cases A and B share all of the following information and assumptions.
55-4 The statements of financial position of Entity A and Entity B immediately before the business combination
are as follows.
55-5 On September 30, 20X6, Entity A issues 2.5 shares in exchange for each common share of Entity B. All
of Entity B’s shareholders exchange their shares in Entity B. Therefore, Entity A issues 150 common shares in
exchange for all 60 common shares of Entity B.
55-6 The fair value of each common share of Entity B at September 30, 20X6, is $40. The quoted market price
of Entity A’s common shares at that date is $16.
55-7 The fair values of Entity A’s identifiable assets and liabilities at September 30, 20X6, are the same as their
carrying amounts, except that the fair value of Entity A’s noncurrent assets at September 30, 20X6, is $1,500.
Case A: All the Shares of the Legal Subsidiary Are Exchanged
55-8 This Case illustrates the accounting for a reverse acquisition if all of the shares of the legal subsidiary,
the accounting acquirer, are exchanged in a business combination. The accounting illustrated in this Case
includes the calculation of the fair value of the consideration transferred, the measurement of goodwill and the
calculation of earnings per share (EPS).
55-9 The calculation of the fair value of the consideration transferred follows
55-10 As a result of the issuance of 150 common shares by Entity A (legal parent, accounting acquiree), Entity
B’s shareholders own 60 percent of the issued shares of the combined entity, that is, 150 of 250 issued
shares. The remaining 40 percent are owned by Entity A’s shareholders. If the business combination had
taken the form of Entity B issuing additional common shares to Entity A’s shareholders in exchange for their
common shares in Entity A, Entity B would have had to issue 40 shares for the ratio of ownership interest
in the combined entity to be the same. Entity B’s shareholders would then own 60 of the 100 issued shares
of Entity B — 60 percent of the combined entity. As a result, the fair value of the consideration effectively
transferred by Entity B and the group’s interest in Entity A is $1,600 (40 shares with a per-share fair value of
$40). The fair value of the consideration effectively transferred should be based on the most reliable measure.
In this Case, the quoted market price of Entity A’s shares provides a more reliable basis for measuring
the consideration effectively transferred than the estimated fair value of the shares in Entity B, and the
consideration is measured using the market price of Entity A’s shares ― 100 shares with a per-share fair value
of $16.
55-11 Goodwill is measured as
follows.
55-12 Goodwill is measured as the excess of the fair value of the consideration effectively transferred (the
group’s interest in Entity A) over the net amount of Entity A’s recognized identifiable assets and liabilities, as
follows.
55-13 The consolidated statement of financial position immediately after the business combination is as
follows.
55-14 In accordance with paragraph 805-40-45-2(c) through (d), the amount recognized as issued equity
interests in the consolidated financial statements ($2,200) is determined by adding the issued equity of the
legal subsidiary immediately before the business combination ($600) and the fair value of the consideration
effectively transferred, measured in accordance with paragraph 805-40-30-2 ($1,600). However, the equity
structure appearing in the consolidated financial statements (that is, the number and type of equity interests
issued) must reflect the equity structure of the legal parent, including the equity interests issued by the legal
parent to effect the combination.
55-15 The calculation of EPS follows.
55-16 Entity B’s earnings for the annual period ended December 31, 20X5, were $600, and the consolidated
earnings for the annual period ended December 31, 20X6, are $800. There was no change in the number of
common shares issued by Entity B during the annual period ended December 31, 20X5, and during the period
from January 1, 20X6, to the date of the reverse acquisition on September 30, 20X6. EPS for the annual period
ended December 31, 20X6, is calculated as follows.
55-17 Restated EPS for the annual period ending December 31, 20X5, is $4.00 (calculated as the earnings of
Entity B of 600 divided by the 150 common shares Entity A issued in the reverse acquisition).
Case B: Not All the Shares of the Legal Subsidiary Are Exchanged
55-18 This Case illustrates the accounting for a reverse acquisition if not all of the shares of the legal subsidiary,
the accounting acquirer, are exchanged in a business combination and a noncontrolling interest results.
55-19 Assume the same facts as in Case A except that only 56 of Entity B’s 60 common shares are exchanged.
Because Entity A issues 2.5 shares in exchange for each common share of Entity B, Entity A issues only 140
(rather than 150) shares. As a result, Entity B’s shareholders own 58.3 percent of the issued shares of the
combined entity (140 of 240 issued shares). The fair value of the consideration transferred for Entity A, the
accounting acquiree, is calculated by assuming that the combination had been effected by Entity B’s issuing
additional common shares to the shareholders of Entity A in exchange for their common shares in Entity A.
That is because Entity B is the accounting acquirer, and paragraphs 805-30-30-7 through 30-8 require the
acquirer to measure the consideration exchanged for the accounting acquiree.
55-20 In calculating the number of shares that Entity B would have had to issue, the noncontrolling interest
is ignored. The majority shareholders own 56 shares of Entity B. For that to represent a 58.3 percent equity
interest, Entity B would have had to issue an additional 40 shares. The majority shareholders would then own
56 of the 96 issued shares of Entity B and, therefore, 58.3 percent of the combined entity. As a result, the fair
value of the consideration transferred for Entity A, the accounting acquiree, is $1,600 (that is, 40 shares each
with a fair value of $40). That is the same amount as when all 60 of Entity B’s shareholders tender all 60 of
its common shares for exchange. The recognized amount of the group’s interest in Entity A, the accounting
acquiree, does not change if some of Entity B’s shareholders do not participate in the exchange.
55-21 The noncontrolling interest is represented by the 4 shares of the total 60 shares of Entity B that are
not exchanged for shares of Entity A. Therefore, the noncontrolling interest is 6.7 percent. The noncontrolling
interest reflects the noncontrolling shareholders’ proportionate interests in the precombination carrying
amounts of the net assets of Entity B, the legal subsidiary. Therefore, the consolidated statement of financial
position is adjusted to show a noncontrolling interest of 6.7 percent of the precombination carrying amounts of
Entity B’s net assets (that is, $134 or 6.7 percent of $2,000).
55-22 The consolidated statement of financial position at September 30, 20X6, reflecting the noncontrolling
interest is as follows.
55-23 The noncontrolling interest of $134 has 2 components. The first component is the reclassification
of the noncontrolling interest’s share of the accounting acquirer’s retained earnings immediately before
the acquisition ($1,400 × 6.7% or $93.80). The second component represents the reclassification of the
noncontrolling interest’s share of the accounting acquirer’s issued equity ($600 × 6.7% or $40.20).
6.8.8 Public Shell Corporations and SPACs
ASC 805-40
05-2 As one example of a reverse acquisition, a private operating entity may want to become a public entity
but not want to register its equity shares. To become a public entity, the private entity will arrange for a public
entity to acquire its equity interests in exchange for the equity interests of the public entity. In this situation,
the public entity is the legal acquirer because it issued its equity interests, and the private entity is the legal
acquiree because its equity interests were acquired. However, application of the guidance in paragraphs
805-10-55-11 through 55-15 results in identifying:
- The public entity as the acquiree for accounting purposes (the accounting acquiree)
- The private entity as the acquirer for accounting purposes (the accounting acquirer).
In some cases, a nonoperating public shell company legally
acquires a private operating company by using cash, other assets, equity, or a
combination thereof. A nonoperating public shell company is a registrant that
has no or nominal operations and no or nominal assets (other than possibly
cash). The owners and management of the private company generally have actual or
effective operating control of the combined company after the transaction, and
the private company gains access to the public market without going through an
IPO. The SEC staff considers the acquisition of a private operating company by a
nonoperating public shell company to be, in substance, a capital transaction
rather than a business combination (or asset acquisition). That is, the
transaction is a reverse recapitalization, equivalent to the issuance of shares
by the private operating company for the net monetary assets of the public shell
company accompanied by a recapitalization. The accounting is similar to that
resulting from a reverse acquisition, except that no goodwill or other
intangible assets are recognized.
In other cases, a SPAC, sometimes also called a “blank check”
company, legally acquires a private operating company. A SPAC is a newly formed
company that raises cash in an IPO and uses that cash or the equity of the SPAC,
or both, to fund the acquisition of a target. After a SPAC IPO, the SPAC’s
management looks to complete an acquisition of a target (the “transaction”)
within the period specified in its governing documents (e.g., 24 months). In
many cases, the SPAC and target may need to secure additional financing to
facilitate the transaction. For example, they may consider funding through a
private investment in public equity (PIPE), which will generally close
contemporaneously with the consummation of the transaction. If an acquisition
cannot be completed within the required time frame, the cash raised by the SPAC
in the IPO must be returned to the investors and the SPAC is dissolved (unless
the SPAC extends its timeline via a proxy process).
Before completing an acquisition, SPACs hold no material assets
other than cash; therefore, they are nonoperating public “shell companies,” as
defined by the SEC (see paragraph 1160.2 of the SEC Division of Corporation
Finance’s Financial Reporting Manual [FRM]). However, SPACs engage in
significant precombination activities (e.g., raising cash in public markets,
identifying investment opportunities). Therefore, entities must analyze
transactions in which a SPAC acquires an operating company to determine whether
the SPAC or the operating company is the acquirer for accounting purposes
(“accounting acquirer”).
The ASC master glossary defines an acquirer as follows:
The entity that
obtains control of the acquiree. However, in a business combination in which
a variable interest entity (VIE) is acquired, the primary beneficiary of
that entity always is the acquirer.
Entities must first consider the guidance in ASC 805-10-25-5,
which states, in part, that “in a business combination in which a [VIE] is
acquired, the primary beneficiary of that entity always is the acquirer. The
determination of which party, if any, is the primary beneficiary of a VIE shall
be made in accordance with the guidance in the Variable Interest Entities
Subsections of Subtopic 810-10, not by applying either the guidance in the
General Subsections of that Subtopic, relating to a controlling financial
interest, or in paragraphs 805-10-55-11 through 55-15.” Consequently, entities
must consider whether the legal acquiree (i.e., the operating company) is a VIE
on the basis of the guidance in ASC 810-10-15-14.
To qualify as a VIE, a legal entity needs to have only one of the following characteristics:
- The legal entity does not have sufficient equity investment at risk (see Section 5.2 of Deloitte’s Roadmap Consolidation — Identifying a Controlling Financial Interest).
- The equity investors at risk, as a group, lack the characteristics of a controlling financial interest (see Section 5.3 of Deloitte’s Roadmap Consolidation — Identifying a Controlling Financial Interest). In this assessment, there are specific requirements for entities that are limited partnerships or similar legal entities such as limited liability companies with managing members. Some of these entities may be VIEs depending on what voting rights are provided to limited partners in a limited partnership or to nonmanaging members for certain limited liability corporations (see Section 5.3.1.2 of Deloitte’s Roadmap Consolidation — Identifying a Controlling Financial Interest).
- The legal entity is structured with disproportionate voting rights, and substantially all of the activities are conducted on behalf of an investor with disproportionately few voting rights (see Section 5.4 of Deloitte’s Roadmap Consolidation — Identifying a Controlling Financial Interest).
If the legal acquiree is a voting interest entity rather than a
VIE, entities should identify the acquirer by first considering the guidance in
the general subsections of ASC 810-10 related to determining the existence of a
controlling financial interest. If they cannot identify the acquirer on the
basis of that guidance, they should consider the factors in ASC 805-10-55-11
through 55-15.
ASC 805-10-55-11 states that in an acquisition “effected primarily by
transferring cash or other assets or by incurring liabilities, the acquirer
usually is the entity that transfers the cash or other assets or incurs the
liabilities.” Therefore, if the acquisition is effected primarily by the SPAC’s
transfer of cash or other assets rather than its equity, the SPAC will usually
be identified as the accounting acquirer.
ASC 805-10-55-12 states that in an acquisition “effected primarily by exchanging
equity interests, the acquirer usually is the entity that issues its equity
interests. However, in some business combinations, commonly called reverse
acquisitions, the issuing entity is the acquiree.” That is, if the acquisition
is effected primarily by exchanging equity interests, the SPAC is the entity
that issues its equity interests to effect the transaction and is therefore the
“legal acquirer.” Sometimes, the SPAC may also be identified as the accounting
acquirer. However, in certain transactions, the operating company whose equity
interests are acquired and is therefore the “legal acquiree” is determined to be
the accounting acquirer. Entities should consider the following factors in ASC
805-10-55-12 and 55-13 when identifying the accounting acquirer in business
combinations effected primarily by exchanging equity shares:
- “The relative voting rights in the combined entity after the business combination” (ASC 805-10- 55-12(a)).
- “The existence of a large minority voting interest in the combined entity” (ASC 805-10-55-12(b)).
- “The composition of the governing body of the combined entity” (ASC 805-10-55-12(c)).
- “The composition of the senior management of the combined entity” (ASC 805-10-55-12(d)).
- “The terms of the exchange of equity interests” (ASC 805-10-55-12(e)).
- The “relative size (measured in, for example, assets, revenues, or earnings)” of the combining entities (ASC 805-10-55-13).
See Section 3.1 for more information about
identifying the acquirer.
If the SPAC is determined to be the accounting acquirer, the entities must
determine whether the operating company meets the definition of a business (see
Section 2.4). If it does, the
transaction is a business combination and the SPAC recognizes the operating
company’s assets and liabilities in accordance with the guidance in ASC 805-10,
ASC 805-20, and ASC 805-30, generally at fair value. If the operating company is
determined to be a group of assets that does not meet the definition of a
business, the transaction is an asset acquisition and the SPAC recognizes the
operating company’s assets and liabilities in accordance with the guidance in
ASC 805-50 at relative fair value (see Appendix
C). By contrast, if the operating company is determined to be the
accounting acquirer, generally the SPAC’s only precombination asset is the cash
raised from its investors and the substance of the transaction is a
recapitalization of the operating company (i.e., a reverse recapitalization).
Accordingly, the accounting for the transaction is similar to that of an
acquisition of a private operating company by a nonoperating public shell
company (as described above).
Because a reverse recapitalization is equivalent to the issuance
of shares by the private operating company for the net monetary assets of the
public shell company, the transaction costs incurred to effect the
recapitalization may represent costs related to issuing equity and raising
capital that are recognized as a reduction to the total amount of equity raised
(i.e., reduction of APIC) rather than expensed as incurred.
See Section
5.7 of Deloitte’s Roadmap Initial Public Offerings for more
information about offering costs. Also, for further discussion of reporting
considerations related to acquisitions by public shell companies and SPACs, see
SAB Topic 5.A and Deloitte’s October 2, 2020 (updated April 11, 2022), Financial Reporting
Alert.