Deloitte's Roadmap: Business Combinations

As a result of the amendments made by ASU 2021-08, it is expected that an acquirer will generally recognize and measure acquired contract assets and contract liabilities in a manner consistent with how the acquiree recognized and measured them in its preacquisition financial statements. However, the Board acknowledges that:

Therefore, the Board notes that “the amendments may not always be as simple as recording the same contract assets and contract liabilities that were recorded by the acquiree before the acquisition and that there may be additional effort required to evaluate how the acquiree applied Topic 606.”

In addition, ASU 2021-08 indicates that the amendments “do not affect the accounting for other assets or liabilities that may arise from revenue contracts with customers in accordance with Topic 606, such as refund liabilities, or in a business combination, such as customer-related intangible assets and contract-based intangible assets. For example, if acquired revenue contracts are considered to have terms that are unfavorable or favorable relative to market terms, the acquirer should recognize a liability or asset for the off-market contract terms at the acquisition date.”

The ASU’s amendments are effective as follows:

• For public business entities — Fiscal years beginning after December 15, 2022, including interim periods within those fiscal years.
• For all other entities — Fiscal years beginning after December 15, 2023, including interim periods within those fiscal years.

The amendments should be applied prospectively to business combinations occurring on or after the effective date of the amendments.

The ASU clarifies that “[e]arly adoption of the amendments is permitted, including adoption in an interim period. An entity that early adopts in an interim period should apply the amendments (1) retrospectively to all business combinations for which the acquisition date occurs on or after the beginning of the fiscal year that includes the interim period of early application and (2) prospectively to all business combinations that occur on or after the date of initial application.” For example, assume that an entity with a calendar year-end had one business combination in the second quarter of 2020 and another business combination in the third quarter of 2021. If the entity adopts the amendments in the fourth quarter of 2021, it would apply the amendments retrospectively to the acquisition that occurred in the third quarter of 2021 but would not apply the amendments retrospectively to the acquisition that occurred in the second quarter of 2020 even if it had not yet issued financial statements for the year ended December 31, 2020.

The fourth and final step in applying the acquisition method is recognizing and measuring goodwill or a gain from a bargain purchase. The ASC master glossary, as amended by ASU 2023-05, defines goodwill as “[a]n asset representing the future economic benefits arising from other assets acquired in a business combination, acquired in an acquisition by a not-for-profit entity, or recognized by a joint venture upon formation that are not individually identified and separately recognized.” Because goodwill is not a separately identifiable asset, it cannot be measured directly. It is therefore measured as a residual and calculated as the excess of the sum of the following items over the net of the acquisition-date values of the identifiable assets acquired and the liabilities assumed: (1) the consideration transferred, (2) the fair value of any noncontrolling interest in the acquiree if a less than 100 percent interest in the acquiree is acquired, and (3) the fair value of the acquirer’s previously held equity interest in the acquiree if the acquirer had a noncontrolling equity interest in the acquiree before the acquisition. Occasionally, the sum of (1) through (3) above is less than the net of the acquisition-date fair values of the identifiable assets acquired and the liabilities assumed. In such a case, the acquirer recognizes a gain, referred to as a bargain purchase gain, in earnings on the acquisition date.

Because it may take time for an entity to obtain the information necessary to recognize and measure all the items exchanged in a business combination, the acquirer is allowed a period in which to complete its accounting for the acquisition. That period — referred to as the measurement period — ends as soon as the acquirer (1) receives the information it had been seeking about facts and circumstances that existed as of the acquisition date or (2) learns that it cannot obtain further information. However, the measurement period cannot be more than one year after the acquisition date. During the measurement period, the acquirer recognizes provisional amounts for the items for which the accounting is incomplete.

Under ASC 805-10-55-16, the acquirer is required to recognize any adjustments to the provisional amounts that were recognized during the measurement period “in the reporting period the adjustments are 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. Measurement-period adjustments may also affect the income statement. In accordance with ASC 805-10-25-17, 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.”

See Deloitte’s Roadmap SEC Reporting Considerations for Business Acquisitions for more information.

In other acquisitions, the acquirer obtains control of an asset or a group of assets, rather than a legal entity, and it must separately hire the employees of the seller after the acquisition if it seeks to obtain their services. We believe that in such a case, the determination of whether the acquired set includes those employees should be based on an evaluation of all relevant facts and circumstances and that such employees should not be presumptively excluded from the set on the basis of the legal form of the transaction. Employees of the seller are more likely to be included in the acquired set when hired in close proximity to the transaction date and when the seller is involved in facilitating the acquirer’s hiring of the employees, as might be the case if such hiring is a condition of the closing.

The FASB notes in paragraph BC24 of ASU 2017-01 that “[f]or ease of application, the Board decided that an entity should use the same unit of account when assessing the [screen] that it would use for identifying assets recognized in a business combination even if it results in some tangible assets and intangible assets being combined into a single asset.” The FASB reasoned that the assessment related to the screen should not result in significant incremental costs for acquisitions because entities must determine the fair value of each asset in both asset acquisitions and business combinations.

ASC 805 provides no specific guidance on determining the unit of account for identifiable assets, but it offers the following three examples of acquired assets that may be recognized as a single asset in financial reporting:

• “[A] group of complementary assets such as a trademark (or service mark) and its related trade name, formulas, recipes, and technological expertise.” (See ASC 805-20-55-18.)
• A license to operate a nuclear power plant and the power plant. (See ASC 805-20-55-2(b).)
• An artistic-related copyright “and any related assignments or license agreements.” (See ASC 805-20-55-30.)

In each example, the assets that are combined for financial reporting have similar useful lives. In addition, we believe that to be combined into a single unit of account, the assets should have similar methods of amortization, since this would ensure that they have a similar effect on financial reporting. Determining whether it is appropriate to combine assets into a single unit of account may require considerable judgment, particularly when it comes to combining tangible and intangible assets. See Section 4.10.3 for more information about determining the unit of account.

While entities should generally apply the same unit of account when both performing the evaluation required by the screen and recognizing assets in a business combination, ASC 805-10-55-5B provides two exceptions. The first exception requires entities to combine “[a] tangible asset that is attached to and cannot be physically removed and used separately from another tangible asset (or an intangible asset representing the right to use a tangible asset) without incurring significant cost or significant diminution in utility or fair value to either asset.” In paragraph BC23 of ASU 2017-01, the FASB notes that it permitted this exception because without it, “the [screen] could not be applied practically in certain circumstances, such as in the real estate industry where land and buildings are often transferred together.”

As indicated in ASC 805-10-55-5B(b), the second exception requires entities to combine “[i]n-place lease intangibles, including favorable and unfavorable intangible assets or liabilities, and the related leased assets.” This exception was primarily intended to increase consistency in the accounting for real estate transactions by reducing the likelihood that an acquisition would be accounted for as a business combination simply because a lease was in a sought-after location and had significant in-place value or because a lease had above- or below-market rents.

We do not believe that entities should combine other assets by analogy to these exceptions in ASC 805-10-55-5B. For example, it would not be appropriate to combine a hotel and its related brand name or to combine a wind or solar farm and a related power purchase agreement if the power purchase arrangement does not meet the definition of a lease.

Entities should combine identifiable assets that meet the exceptions (e.g., land and building or in-place lease intangible asset and the related leased assets) only when evaluating the screen; for other purposes, such assets typically should be recognized separately regardless of whether the acquired set is a business or a group of assets. For example, while a building and an in-place lease would be combined in the evaluation required by the screen, they would be recognized separately for financial reporting purposes.

As indicated in ASC 805-10-55-5B, a “single identifiable asset includes any individual asset or group of assets that could be recognized and measured as a single identifiable asset in a business combination.” After the adoption of ASC 842, right-of-use (ROU) lease assets are recognized as identifiable assets and, therefore, should be included in the performance of the screen test under ASC 805-10-55-5B. See Section 4.3.11 for additional considerations related to the accounting for leases acquired in a business combination.

In accordance with ASC 805-10-55-5C, if the acquired set includes multiple assets, entities should combine the assets that qualify for combination as similar assets. Paragraph BC28 of ASU 2017-01 states, in part:

Although the FASB does not define the term “similar” in ASC 805-10-55-5C, the guidance provides examples of assets that cannot be considered similar. For example, entities cannot combine financial assets with nonfinancial assets or tangible assets with intangible assets. However, assets that are combined under ASC 805-10-55-5B into a single identifiable asset can continue to be combined. For example, if entities combine a building and an in-place lease intangible asset into a single identifiable asset in step 1, they can continue to combine those assets in applying this step even though tangible and intangible assets cannot be combined into similar assets.

In addition, different major classes of the following asset types cannot be combined into similar assets:

• Identifiable intangible assets (e.g., customer-related intangibles, trademarks, and IPR&D).
• Financial assets (e.g., accounts receivable and marketable securities).
• Tangible assets (e.g., inventory, manufacturing equipment, and automobiles).

Entities may need to use judgment when determining whether financial assets, tangible assets, or intangible assets are in the same major class of asset. The ASC master glossary defines an intangible asset class as “[a] group of intangible assets that are similar, either by their nature or by their use in the operations of an entity,” and ASC 350-30-50-1 requires entities to provide disclosures about the amounts assigned to each major intangible asset class. Accordingly, while the FASB does not specifically define major classes of tangible assets and financial assets, we believe that an entity performing the screen should consider the definition of intangible asset class as well as its ASC 350-30 disclosures when assessing its major classes of assets.

Further, ASC 805-10-55-5C states that entities cannot combine identifiable assets within the same major asset class if the assets have “significantly different risk characteristics.” Paragraph BC31 of ASU 2017-01 states, in part:

Entities in different industries are typically affected by different types of risks. For example, in the real estate industry, entities may consider risk characteristics associated with the type of property (e.g., commercial vs. residential), size (e.g., single tenant vs. multitenant), geographic location (e.g., high-growth areas vs. low-growth areas), and class of customer (e.g., high default-risk tenants vs. low default-risk tenants). By contrast, in the life sciences industry, entities may evaluate risk characteristics associated with the stage of drug development (e.g., compounds in early development stages vs. later stages), class of customer (e.g., compounds that treat one medical condition vs. another medical condition), and market risk (e.g., products for use in the United States vs. outside the United States). Entities should consider all relevant facts and circumstances in making their determination.

The measurement of gross assets acquired excludes cash and cash equivalents (including restricted cash), deferred tax assets, and goodwill resulting from the effects of deferred tax liabilities. As stated in paragraph BC27 of ASU 2017-01:

In addition, as described in Section 2.4.1.4, entities should exclude any amounts related to transactions that are separate from the acquisition (e.g., arrangements that represent compensation for future services).

With the exception of unfavorable lease liabilities that are combined with the related leased asset under ASC 805-10-55-5B(b), the calculation of gross assets acquired excludes debt and other liabilities. Paragraph BC20 of ASU 2017-01 states that “[t]he Board reached this conclusion to avoid the existence of debt (for example, a building with a mortgage) or other liabilities affecting the analysis of whether the [screen] has been met. That could potentially result in a group of assets that would otherwise be subject to further evaluation under the model bypassing such evaluation solely because a transaction includes liabilities in addition to assets.”

The requirement to exclude liabilities also applies to asset retirement obligations (AROs) related to assets included in the acquired set. For example, assume that Company A acquires Company B, a utility, in a transaction that is accounted for as a business combination. Company A determines that an ARO exists related to B’s facility and estimates the ARO’s fair value to be $25 million. Company A estimates the fair value of the facility to be $100 million, meaning that the value of the facility would be $25 million higher if the costs associated with the ARO were ignored. Accordingly, in determining the single identifiable asset or similar assets and the gross assets acquired, A would use $125 million. See Section 4.8.1 for more information about assets subject to AROs.

ASC 805-10-55-5A states that gross assets “should include any consideration transferred . . . in excess of the fair value of net identifiable assets acquired,” but it does not address whether the screen should include any deficit (i.e., bargain purchase gains). We believe that bargain purchase gains should be excluded from the screen because their inclusion would distort the calculation in a manner similar to the inclusion of liabilities.

If the quantitative result is close to 90 percent, the presence of one or more of these indicators might warrant a determination that the screen is not met. In that case, entities should apply the framework to determine whether the set is a business.

Entities may be able to perform the screen qualitatively or bypass it in certain circumstances. See Section 2.4.2.6 for more information.

Therefore, entities may bypass the screen and proceed directly to the framework (see Section 2.4.3) as long as the set is determined not to be a business under the framework. However, entities may not bypass the screen and apply the framework to conclude that a set is a business since that determination may contradict the conclusion that would have been made by applying the screen.

Both a business and an asset or a group of assets possess one or more inputs. As indicated in ASC 805-10-55-4, what distinguishes a business from an asset or a group of assets is that “[a] business consists of inputs and processes applied to those inputs that have the ability to contribute to the creation of outputs.”

According to ASC 805-10-55-4(b), a process is “[a]ny system, standard, protocol, convention, or rule that when applied to an input or inputs, creates or has the ability to contribute to the creation of outputs.” Examples of processes include:

• Strategic management processes — for setting the overall strategy and direction of operations.
• Operational processes — for obtaining contracts or customers, or developing, fulfilling, or producing outputs.
• Resource management processes — for obtaining inventory and managing operational employees.

While processes are usually documented, they do not need to be. For example, employees are an input, but they may form an organized workforce whose knowledge and ability may be considered a process, even if that process is not documented.

Determining whether a substantive process is present in a set can be challenging. ASC 805-10-55 provides guidance for making that judgment in response to the practice issues that existed under the previous definition of a business. According to the revised guidance, only processes that are used in the creation of outputs should be considered substantive under the definition of a business. For example, accounting, billing, payroll, and other administrative systems typically are not used to create outputs.

While acquiring a contract that gives access to an organized workforce may represent the acquisition of a substantive process, ASC 805-10-55-5F states that assumed contracts that provide for a continuation of revenues — such as customer contracts, customer lists, and leases (from the lessor’s perspective) — should not be considered acquired processes and should be excluded from the analysis.

To help reduce the likelihood that a transaction is inappropriately accounted for as a business acquisition, the Board emphasized in paragraph BC35 of ASU 2017-01 that a process must be important to the ability to create outputs. While ASC 805-10-55-5 notes that a “business need not include all the inputs or processes that the seller used in operating that business . . . to be considered a business, the set must include, at a minimum, an input and a substantive process that together significantly contribute to the ability to create output.”

As indicated in ASC 805-10-55-4(c), outputs are “[t]he result of inputs and processes applied to those inputs that provide goods or services to customers, investment income (such as dividends or interest), or other revenues.” ASU 2017-01 narrowed the definition of outputs to align it with the ability to generate goods or services for customers and make it consistent with the description of outputs in ASC 606. However, as discussed in paragraph BC59 of the ASU, “the Board noted that not all entities have revenues within the scope of Topic 606 and therefore, decided to incorporate other types of revenues in the definition. For example, the Board decided to include the reference to investment income in the definition of outputs in the amendments . . . to ensure that the purchase of an investment company can still qualify as a business combination.”

Although outputs are not required for a set to be a business, ASC 805-10-55 provides different criteria for determining whether a set has one or more substantive processes, depending on whether the set has outputs (i.e., a continuation of revenues before and after the acquisition). Because outputs are usually a fundamental element of a business, the Board reasoned that if there are no outputs, the other elements should be more significant. Therefore, the guidance includes more stringent criteria on what is required for a set to have a substantive process when outputs are not present.

ASC 805-10-55 does not specify the amount of outputs an entity should consider when assessing whether to apply the criteria for a set without outputs rather than a set with outputs. We believe that when determining which criteria to apply, an entity may need to use judgment. For example, if an acquired set has only an insignificant amount of outputs (i.e., revenues), it may be appropriate for an entity to evaluate the criteria for a set without outputs to determine whether a substantive process exists. In addition, because the determination of whether a set is capable of being conducted and managed as a business is performed from a market participant perspective, we believe that an acquired set could still be considered as having outputs even if all its goods or services, or both, were previously being used internally through an intercompany revenue or transfer arrangement, provided that such goods or services, or both, will be recognized as third-party revenue (e.g., a carve-out transaction) after the transaction.

ASC 805-10-55-5D states that if a set does not have outputs, a substantive process can only be provided by employees that form an organized workforce with “the necessary skills, knowledge, or experience to perform an acquired process (or group of processes) that when applied to another acquired input or inputs is critical to the ability to develop or convert that acquired input or inputs into outputs.” ASC 805-10-55 does not provide guidance on determining whether employees are providing a “critical” process, except to say that “[a] process (or group of processes) is not critical if, for example, it is considered ancillary or minor in the context of all the processes required to create outputs.” Accordingly, entities will need to use judgment in determining whether a process is critical.

While an organized workforce is an input, it is the workforce’s ability to make the set active that must be evaluated as a substantive process. In paragraph BC41 of ASU 2017-01, the Board explained:

The determination of whether an organized workforce is performing a critical process requires judgment and varies from transaction to transaction and from industry to industry. Entities should evaluate whether the process (or group of processes) is critical in the context of all the processes required to create outputs. If the process (or group of processes) is considered ancillary or minor in that context, it is not critical. The following factors may be indicators that the acquired organized workforce has the necessary skills, knowledge, or experience to perform a critical process (none of the factors below are individually determinative):

• Composition and size of the workforce — Generally, the greater the number of employees in an organized workforce, the more likely the process (or group of processes) they perform is critical. However, the composition of the workforce also needs to be considered. That is, a large number of employees that perform ancillary or minor tasks may not have the requisite skills, knowledge, or experience to perform a critical process. By contrast, a small number of employees that have significant skills, knowledge, or experience may perform a process critical to the development of outputs.
• Ability for the set to operate independently — A set that includes an organized workforce that was operating independently before the acquisition may be an indicator that the organized workforce is performing a critical process (or group of processes).
• Significant amount of goodwill — A set that includes a significant amount of goodwill may be an indicator that the organized workforce has the necessary skills, knowledge, or experience to perform a critical process (or group of processes).
• Advanced stage of activities — A set that includes an organized workforce that is in advanced stages of converting acquired inputs into outputs (i.e., generating revenues) may be an indicator that the processes being performed by the employees are critical. For example, if an acquired set is close to generating revenues on a stand-alone basis and the acquirer does not anticipate the need to add a significant number of employees with requisite skills, knowledge, or experience, this may indicate that the organized workforce is performing a critical process (or group of processes).

When an entity obtains access to an organized workforce as a result of an acquired contractual arrangement, the entity cannot consider such workforce to be an acquired substantive process if outputs are not present. The Board indicated in paragraph BC47 of ASU 2017-01 that:

However, the management of service providers could be considered a critical process performed by employees. In paragraph BC48 of ASU 2017-01, the Board noted that “as an example, an entity should come to consistent conclusions when evaluating a set that has 100 employees and a set that has 20 employees with the equivalent of 80 employees replaced by outsourced service providers because the 20 employees would be responsible for the management and performance of the outsourced employees.” If a set without outputs includes both employees and an outsourced workforce, entities must use judgment to determine whether the employees represent an organized workforce that provides a substantive process.

Under ASC 805-10-55-5D(b), for a set without outputs to be a business, it must contain both an organized workforce performing a substantive process and “[i]nputs that employees who form an organized workforce could develop (or are developing) or convert into outputs.” The acquisition of an organized workforce alone is not sufficient to conclude that a set is a business.

Like a set without outputs, a set with outputs is a business if it includes, at a minimum, both an input and a substantive process that together significantly contribute to the ability to create outputs. A set has outputs if there is a continuation of revenue before and after the transaction. While the continuation of revenues alone does not mean that a set is a business, the Board concluded in paragraph BC51 of ASU 2017-01 that a set with outputs is more likely to include an input and substantive process than a set without outputs. Therefore, the criteria for determining whether a substantive process is present are less stringent than those for a set that is not producing outputs. According to ASC 805-10-55-5E, when a set has outputs, a substantive process may be provided by any of the following:

• “[E]mployees that form an organized workforce.”
• “[A]n acquired contract that provides access to an organized workforce.”
• A process (or group of processes) that, “when applied to an acquired input or inputs significantly contributes to the ability to continue producing outputs and cannot be replaced without significant cost, effort, or delay in the ability to continue producing outputs.”
• A process (or group of processes) that, “when applied to an acquired input or inputs significantly contributes to the ability to continue producing outputs and is considered unique or scarce.”

As indicated by the guidance in ASC 805-10-55-5D, an “organized workforce must have the necessary skills, knowledge, or experience to perform an acquired process (or group of processes) that when applied to another acquired input or inputs is critical to the ability to develop or convert that acquired input or inputs into outputs.”

The determination of whether an organized workforce is performing a critical process requires judgment and varies from transaction to transaction and from industry to industry. Entities should evaluate whether the process (or group of processes) is critical in the context of all the processes required to create outputs. If that process (or group of processes) is considered ancillary or minor in that context, it is not critical. We generally believe that entities should consider the same factors described in Section 2.4.3.2 to determine whether an organized workforce in a set with outputs has the necessary skills, knowledge, or experience to perform a critical process (or group of processes).

Many industries outsource operating activities that may not be significantly different from those that would be performed by employees (e.g., contract manufacturers or property managers). When a set has outputs, an entity must evaluate acquired contracts to determine whether they represent an acquired substantive process or, possibly, an input. Paragraph BC46 of ASU 2017-01 states:

Therefore, when a set has outputs, entities must use judgment in determining whether an acquired contract that provides access to an organized workforce also represents a substantive process. Entities should consider the substance of the contract, including:

• The nature of the activities performed by the outsourced workforce.
• The duration and the renewal terms of the contract.
• Whether the outsourced workforce is critical to the ability to continue producing outputs.
• Whether the outsourced workforce could be replaced without significant cost, effort, or delay in the ability to continue producing outputs.

Because the guidance in ASC 805-10-55-5E(b) specifically mentions an acquired contract, new contracts originating between the buyer and a third party on the acquisition date would not be considered part of the acquired set in the assessment of the definition of a business. Conversely, as part of an acquisition, the buyer and seller may agree that the seller will continue to provide services to the buyer after the acquisition by using the seller’s existing workforce. Such an arrangement, commonly referred to as a transition services agreement or a TSA, specifies the period of services and the fee to be paid by the buyer. While some believe that a TSA could be considered an acquired contract because of the continuation of services, we believe that a TSA typically does not give the acquirer access to an organized workforce that represents a substantive process because the services provided under a TSA are often limited in both duration and scope.

A substantive process may also be present without an organized workforce when a set has outputs. For example, a set may have one or more automated processes through acquired technology or infrastructure (e.g., automated technology, or a manufacturing or production line). In accordance with ASC 805-10-55-5E, for an automated process to be considered substantive, (1) it must significantly contribute “to the ability to continue producing outputs” when applied to an input or inputs and (2) the acquirer cannot have the ability to replace it “without significant cost, effort, or delay in the ability to continue producing outputs,” or it must be “unique or scarce.”

To help entities evaluate whether a set includes a substantive process, the FASB notes in ASC 805-10-55-9 that “the presence of more than an insignificant amount of goodwill may be an indicator that the acquired process is substantive.” That is, the presence of more than an insignificant amount of goodwill could be an indicator that an organized workforce is performing a critical process or that an acquired process in a set is substantive.

Paragraph B313 of the Basis for Conclusions of FASB Statement 141(R) describes components that are conceptually part of goodwill — the fair values of “the going-concern element of the acquiree’s existing business” and “the expected synergies and other benefits from combining the acquirer’s and acquiree’s net assets and businesses.” The guidance also lists elements that are captured in the measurement of goodwill in a business combination but are not conceptually part of goodwill — namely, “[o]vervaluation of the consideration paid by the acquirer stemming from [valuation] errors” and “[o]verpayment or underpayment by the acquirer.” We believe that while the nonrecognition of certain assets and liabilities and the measurement of certain assets or liabilities at amounts other than fair value are not conceptually part of goodwill, those components are captured in the measurement of goodwill. In evaluating goodwill as an indicator of a substantive process, entities should consider the reasons why they have calculated an excess and whether the excess is related to the elements that are conceptually part of goodwill.

Often, part of an excess is the result of an assembled workforce intangible asset that is subsumed into goodwill in a business combination. In such cases, entities should consider whether the employees represent an organized workforce as described in Section 2.4.3.2. That is, in accordance with ASC 805-10-55-5D, entities should assess whether the employees “have the necessary skills, knowledge, or experience to perform an acquired process (or group of processes) that when applied to another acquired input or inputs is critical to the ability to develop or convert that acquired input or inputs into outputs.” The presence of an assembled workforce that has significant fair value may be an indicator that the employees are performing a substantive process. Similarly, an excess may indicate that there is value in an acquired process that would not be captured in an identifiable asset.

In a business combination effected primarily by exchanging equity interests, the identification of the accounting acquirer is based on an evaluation of pertinent facts and circumstances, including the following:

• “The relative voting rights in the combined entity after the business combination” (ASC 805-10-55-12(a)) — see Section 3.1.2.2.1.
• “The existence of a large minority voting interest in the combined entity” (ASC 805-10-55-12(b)) — see Section 3.1.2.2.2.
• “The composition of the governing body of the combined entity” (ASC 805-10-55-12(c)) — see Section 3.1.2.2.3.
• “The composition of the senior management of the combined entity” (ASC 805-10-55-12(d)) — see Section 3.1.2.2.4.
• “The terms of the exchange of equity interests” (ASC 805-10-55-12(e)) — see Section 3.1.2.2.5.
• The relative size of the combining entities (ASC 805-10-55-13) — see Section 3.1.2.3.
• Other considerations — see Section 3.1.2.4.

When evaluating the relative size of the combining entities, entities should consider the specific asset, revenue, and earning measures determined to be pertinent, which may vary on the basis of the combining entities’ industry. Entities may also identify one or more additional pertinent measures, such as operating cash flows. Further, entities must use judgment to determine which period(s) to evaluate and whether to consider future budgeted amounts (when available).

When comparing the combining entities’ relative size, entities should evaluate the effects of any differences between their accounting policies, capitalization, or histories (i.e., organic growth versus acquisitions) and the existence of any items deemed to be nonrecurring.

Entities are expected to demonstrate the relevance of any other factors considered in the identification of the acquirer.

For indemnification assets recognized at fair value, no separate valuation allowance is recognized for concerns about collectibility before the adoption of ASU 2016-13. Entities should take into account collectibility concerns when measuring fair value since such concerns could result in a measurement of the indemnification asset that differs from that of the indemnified item. For indemnification assets measured at other than fair value, entities can establish a separate valuation allowance for collectibility concerns. Such an allowance would only affect presentation. We believe that after adoption of ASU 2016-13, if the indemnified item is a financial asset measured at amortized cost, the associated indemnification asset is within the scope of ASC 326-20 because ASC 805-20-25-27 requires indemnification assets to be “measured on the same basis as the indemnified item, subject to the need for a valuation allowance for uncollectible amounts.” See Deloitte’s Roadmap Current Expected Credit Losses for more information.

Acquisition agreements often include indemnification arrangements, but the parties to the business combination may instead establish such arrangements separately. In such cases, we believe that entities should consider analogizing to the factors in ASC 810-10-40-6 in determining whether to account for the acquisition agreement and the separate indemnification agreement as a single arrangement. Typically, we would expect that the application of those factors would lead an entity to conclude that the indemnification arrangement is part of the business combination agreement, in which case the acquirer would recognize, measure, and subsequently account for the indemnification assets by using the guidance in ASC 805.

When measuring an indemnification asset that was initially recognized as part of the accounting for a business combination, an entity should use assumptions that are consistent with those used to measure the indemnified item after the acquisition date, subject to any contractual limitations and considerations about the indemnifying party’s credit risk. If a change in the amount recognized for the indemnification asset is not the result of a qualifying measurement-period adjustment, the entity should recognize the change in earnings. An entity should use judgment in determining whether the changes to the indemnified item and the indemnification asset should be recognized in the same income statement line item so that they effectively offset one another.

If an indemnification asset only becomes recognizable after the measurement period for the indemnified item is closed, the recognition of the asset is subject to other GAAP rather than the guidance in ASC 805. In some cases, it may be appropriate to apply a loss recovery model to the recognition of the indemnification asset. The accounting framework underlying such a model is based on an analogy to the guidance on recognition of potential loss recoveries in ASC 410. Specifically, ASC 410-30-35-8, which provides subsequent measurement guidance related to environmental obligations, states, in part:

The recognition criteria for a loss recovery is different from that for a gain contingency. Provided that its collection is probable, a loss recovery is recognized in the period in which the loss is incurred (or the period in which collection becomes probable). However, a gain contingency is recognized on the earlier of when the gain is realized or is realizable. While not codified, paragraph 16 of EITF Issue 01-10 provides the EITF’s understanding of the distinction between a loss recovery and a gain contingency: a loss recovery represents the recovery of a loss already recognized in the financial statements, whereas a gain contingency represents the recovery of a loss not yet recognized in the financial statements or recovery of an amount that is greater than the loss recognized in the financial statements.

ASC 805-20-40-3 states that an acquirer only derecognizes an indemnification asset “when it collects the asset, sells it, or otherwise loses the right to it.” If there were no changes in the values of the recorded liability and associated indemnification asset after the acquisition date, both the asset and liability would be reversed upon derecognition, with no net effect on the income statement.

ASC 805 requires entities to perform two steps in determining whether an asset or liability arising from a contingency qualifies for recognition in a business combination. The first step is to evaluate whether the “fair value of the asset or liability arising from a contingency can be determined [at the acquisition date or] during the measurement period.” If so, the asset or liability is recognized as of its acquisition-date fair value as part of the accounting for the business combination.

Although ASC 805 does not provide specific guidance on whether the fair value of a contingency is determinable, it does state that “the acquisition-date fair value of a warranty obligation often can be determined.” However, in practice, the acquisition-date fair value of many contingencies, such as contingencies related to litigation, may not be determinable.

If an acquirer cannot determine the acquisition-date fair value of a contingency during the measurement period, it proceeds to the second step and recognizes the contingency at its estimated amount if (1) “it is probable that an asset existed or that a liability had been incurred at the acquisition date” and (2) “[t]he amount of the asset or liability can be reasonably estimated.” These requirements are similar to those in ASC 450 related to loss contingencies. However, in a business combination, both assets and liabilities arising from contingencies have the same recognition criteria, whereas under ASC 450 a gain contingency is not recognized until the earlier of when it is realized or it is realizable.

In some cases, an acquirer may not have identified the contingency either before or on the acquisition date. Although the contingency must have existed as of the acquisition date (i.e., it resulted from prior events), the acquirer is not limited to only recognizing items that were known at the time of acquisition. Contingencies identified during the measurement period that existed as of the acquisition date still qualify for recognition as part of the business combination accounting.

The fair value measurement of a contingent liability takes into account the time value of money. However, for contingent liabilities recognized at their estimated amounts, discounting is permitted, but not required, only if both the timing and amounts of future cash flows are fixed or reliably determinable on the basis of objective and verifiable information. Although ASC 410-30 specifically addresses environmental remediation liabilities, an entity may also find the guidance useful for evaluating whether discounting is appropriate for other contingencies arising from liabilities. ASC 410-30-35-12 states, in part, that the “measurement of the liability, or of a component of the liability, may be discounted to reflect the time value of money if the aggregate amount of the liability or component and the amount and timing of cash payments for the liability or component are fixed or reliably determinable.” However, because the timing and amounts of future cash flows of many contingencies are inherently subjective, it is often difficult for an entity to meet the criteria for discounting (e.g., in the early phases of litigation and environmental remediation efforts). In addition, if the timing and amounts of future cash flows are fixed or reliably determinable, the acquirer would likely be able to measure the contingency at fair value.

ASC 805 does not provide specific subsequent measurement guidance for contingencies recognized in a business combination, except to say that “[a]n acquirer shall develop a systematic and rational basis for subsequently measuring and accounting for assets and liabilities arising from contingencies depending on their nature.” The subsequent accounting depends on whether the contingency was measured at fair value or at its estimated amount.

For contingencies initially recognized at fair value, the acquirer must develop a “systematic and rational” subsequent measurement approach that is consistent with the nature of the asset or liability. In paragraph B20 of the Basis for Conclusions of FSP FAS 141(R)-1, the FASB suggested that the methods used to subsequently account for guarantees initially recognized at fair value under ASC 460-10 (formerly FASB Interpretation 45) could be applied to warranty obligations initially recognized at fair value. We believe that the guidance in ASC 460-10 for the subsequent accounting of guarantees would also be an acceptable approach to accounting for other contingencies recognized at fair value, not just warranty obligations. Another systematic and rational approach would be for entities to subsequently account for contingencies by applying the methods used for AROs under ASC 410. Entities should use judgment in assessing whether the subsequent accounting method they select is consistent with the nature of the asset or liability. Entities should also apply the same method to similar assets and liabilities.

However, we do not believe that the application of ASC 450 to contingencies recognized at fair value would be a systematic or rational approach. This is because it would not be appropriate for an entity to recognize a contingency at fair value on the acquisition date and then immediately recognize a gain or loss upon measuring the contingency at its estimated amount under ASC 450. In addition, subsequently measuring a contingency at fair value is not a systematic or rational approach unless fair value measurement is required by other GAAP.

For contingencies initially recognized in accordance with ASC 805-20-30-23 at the amount that can be reasonably estimated, acquirers should apply other GAAP, including ASC 450, in periods after the acquisition date. However, assets arising from contingencies should not be derecognized after the acquisition date because they do not meet the gain contingency recognition threshold in ASC 450.

Adjustments to the amounts recognized for a contingency should be accounted for as measurement-period adjustments (see Section 6.1) if they are (1) made within the measurement period and (2) based on the facts and circumstances that existed as of the acquisition date. If the adjustments resulted from facts or circumstances that did not exist as of the acquisition date, they should be recognized in the income statement. It can be particularly challenging for entities to determine whether adjustments to contingencies result from changes in facts or are related to facts that existed as of the acquisition date, especially in the case of litigation-related contingencies.

If a contingency does not qualify for recognition as part of the accounting for a business combination, the acquirer should recognize the asset or liability when it meets the recognition criteria in the applicable GAAP, such as ASC 450 for contingencies or ASC 410 for loss recoveries (see discussion in Section 4.3.4.2 for more information). Under ASC 450, gain contingencies are not recognized until the earlier of when they are realized or are realizable. Because an acquirer cannot adjust the acquisition accounting for the recognition of a contingency after the end of the measurement period, contingencies that qualify for recognition outside of the business combination accounting are recognized in the income statement. Also, contingencies for which the obligating event did not exist on the acquisition date, even those that arose before the end of the measurement period, do not qualify as measurement-period adjustments since they are not related to facts and circumstances that existed as of the acquisition date.

For more information, see Deloitte’s Roadmap Contingencies, Loss Recoveries, and Guarantees.

A reacquired right is an identifiable intangible asset that an acquirer recognizes separately from goodwill because it arises from contractual rights. However, reacquired rights are an exception to ASC 805’s measurement principle because ASC 805 requires entities to measure them on the basis of the related contract’s remaining term, regardless of whether market participants would consider potential contract renewals in determining the rights’ fair value. While market participants would generally reflect expected renewals of the term of a contractual right in their fair value estimate of a right traded in the market, the FASB has observed that an acquirer that controls a reacquired right could assume indefinite renewals of its contractual term, effectively making the reacquired right an indefinite-lived intangible asset. The Board has therefore concluded that a right reacquired from an acquiree is no longer a contract with a third party and, in substance, has a finite life. Accordingly, reacquired rights are measured only on the basis of the remaining contractual term.

However, complexities can arise when a contract has no stated term or is perpetual. In making reacquired rights an exception to the measurement principle, the FASB intended to limit the value attributed to a reacquired right by restricting the measurement to only the remaining contractual term. In this way, an acquirer could not assume that there would be unlimited renewals (since the reacquired right becomes a contract between the acquirer and itself as a result of the acquisition), classify the reacquired right as indefinite-lived, and measure it consistently with its classification. Accordingly, we would expect it to be unusual for a reacquired right to be classified as indefinite-lived. Before classifying a reacquired right as indefinite-lived and measuring it consistently with its classification, entities should consider consulting with experts, and SEC registrants should consider consulting with the SEC staff on a prefiling basis.

At the 2005 AICPA Conference on Current SEC and PCAOB Developments, then SEC OCA Professional Accounting Fellow Brian Roberson stated the following regarding the valuation of reacquired rights:

While a reacquired right is the result of a preexisting contractual relationship with the acquiree, not all preexisting relationships with an acquiree will result in the recognition of a reacquired right because not all preexisting relationships (e.g., a lawsuit) lead to the reacquisition of a right previously granted to the acquiree. If the terms of the preexisting contractual relationship giving rise to a reacquired right are favorable or unfavorable relative to the terms of current market transactions for the same or similar items, the acquirer must recognize a settlement gain or loss related to the preexisting contractual relationship separately from the accounting for the business combination. ASC 805-10-55-21 provides guidance on measuring that settlement gain or loss (see Section 6.2.2 for more information).

ASC 805-20-35-2 states that an entity amortizes a reacquired right “over the remaining contractual period of the contract in which the right was granted.” If an acquirer subsequently sells a reacquired right to a third party, the carrying amount of the intangible asset is included in the determination of the gain or loss on the sale. If the acquirer subsequently sells only a portion of the reacquired right to the third party, the acquirer will need to develop a reasonable allocation method for measuring the portion of the intangible asset’s carrying amount that it will include in determining the gain or loss on the sale. Such an allocation method would be necessary if, for example, an acquirer reacquires a franchise right to a specific geographic area and then subsequently subdivides that geographic area and sells only a portion of it to a third party.

Under ASC 805-20-30-15, when measuring the funded status of pension and other postretirement plans, an acquirer must exclude the effects of an entity’s planned but not executed amendments, terminations, and curtailments. Planned or expected amendments, terminations, and curtailments are not considered part of the liability assumed on the acquisition date. Such actions are recognized in the postcombination financial statements in accordance with ASC 715.

Upon an acquisition or a change in control, an acquirer may be obligated to modify an existing plan. The acquirer should assess the modification to determine whether it is part of the business combination or whether it should be accounted for outside of the business combination in accordance with ASC 805-10-55-18. If the modification is determined to be part of the business combination, the acquirer should include the effect of the modification on the existing plan in measuring the plan’s funded status.

The measurement of the projected benefit obligation for pensions or accumulated postretirement benefit obligation for other postretirement benefits and the fair value of the plan assets on the acquisition date should reflect any other necessary changes in discount rates or other assumptions that are based on the acquirer’s assessment of relevant future events.

In addition, ASC 805-20-55-51 addresses the accounting for contractual termination benefits and curtailment losses in an acquiree’s preacquisition financial statements. It states that “[t]he liability for the contractual termination benefits and the curtailment losses under employee benefit plans that will be triggered by the consummation of the business combination shall not be recognized when it is probable that the business combination will be consummated; rather it shall be recognized when the business combination is consummated.”

As indicated in ASC 842-10-55-11, an acquirer in a business combination should retain the acquiree’s classification of its leases unless “there is a lease modification and that modification is not accounted for as a separate contract.”

The ASC master glossary defines a lease modification as:

As part of a business combination, a lease might also be changed in ways that do not qualify as a lease modification. For example, a lease may be changed to reflect the new owner of the acquiree. Such a change in the name of one of the parties identified in the contract would not qualify as a lease modification without a change in the scope of or consideration for the lease.

If the terms of a lease are modified as part of a business combination such that there is a lease modification, the acquirer should use the guidance in ASC 842 to determine whether to account for that modification as a separate contract. ASC 842-10-25-8 states that a lease modification should be considered a separate contract (i.e., “separate from the original contract”) if both of the following conditions exist:

Therefore, a lease modification that meets the conditions in ASC 842-10-25-8 effectively results in two separate contracts: (1) the original unmodified contract and (2) a separate contract for the additional right of use. Accordingly, if the lease modification is considered a separate contract, the classification of the original lease is not reconsidered as part of the business combination and the additional right of use added in the lease modification is accounted for, and classified as, a separate “new” lease in accordance with ASC 842 when that lease commences.

However, if the modification does not meet the conditions to be accounted for as a separate contract, the acquirer reconsiders the classification of the lease on the basis of modified terms and conditions that exist as of the acquisition date (i.e., the effective date of the modification) in accordance with ASC 842-10-25-9 and ASC 842-10-25-11 through 25-18.

ROU assets and lease liabilities arising from an acquiree’s operating or finance leases are exceptions to ASC 805’s recognition and fair value measurement principles. Instead, ROU assets and lease liabilities are recognized and measured in accordance with ASC 842. However, an acquirer should recognize and measure at fair value certain lease-related intangible assets or liabilities previously recognized by the acquiree (e.g., in-place lease intangible assets).

For acquired operating or finance leases in which the acquiree is the lessee, the acquirer measures the lease liability and ROU asset in accordance with the principles in ASC 842, and thus their measurement is an exception to ASC 805’s fair value measurement principle. (The acquirer may elect, as an accounting policy, not to recognize assets or liabilities as of the acquisition date for leases that, on the acquisition date, have a remaining lease term of 12 months or less; see Section 4.3.11.4.) The FASB considered whether to require an acquirer to apply the general measurement principle in ASC 805 and measure the acquiree’s ROU assets and lease liabilities at fair value as of the acquisition date but decided against it, as described in paragraph BC416 of ASU 2016-02:

Accordingly, ASC 805-20-30-24 requires an acquirer to measure “the lease liability at the present value of the remaining lease payments, as if the acquired lease were a new lease of the acquirer at the acquisition date.” The remaining lease payments are those expected to be received over the balance of the lease term and should be determined in accordance with the guidance in ASC 842-10-30-5, except that the commencement date for an acquired lease is the acquisition date. Paragraph BC415 of ASU 2016-02 clarifies that “[m]easuring the acquired lease as if it were a new lease at the date of acquisition includes undertaking a reassessment of all of the following:

1. The lease term
2. Any lessee options to purchase the underlying asset
3. Lease payments (for example, amounts probable of being owed by the lessee under a residual value guarantee)
4. The discount rate for the lease.”

We believe that the lease term should be assessed from the acquirer’s perspective. The acquirer should take into account any renewal or purchase options it expects to exercise (see Section 4.3.11.8) and use the discount rate that is implicit in the lease, if readily determinable; otherwise, the acquirer should use its incremental borrowing rate. In a manner consistent with how an entity would determine the incremental borrowing rate for a new lease, the acquirer should evaluate whether the incremental borrowing rate at the parent level (i.e., acquirer level) or the subsidiary level (i.e., acquiree level) would be appropriate on the basis of the terms and conditions of the lease arrangement. Regardless of this determination, the incremental borrowing rate used should be the rate determined as of the acquisition date. However, the acquirer would not reassess the acquiree’s lease classification solely on the basis of differences between the acquirer’s and acquiree’s assessment of the lease term or likelihood of purchase option exercise by the lessee. In other words, the acquirer will retain the lease classification of the acquiree’s leases, regardless of whether the acquirer’s and acquiree’s conclusions differ regarding lease term or purchase options, as long as the acquisition does not result in a lease modification that is not accounted for as a separate contract. (See Chapter 7 of Deloitte’s Roadmap Leases for additional information about the determination of the discount rate and measurement of a new lease under ASC 842 and Section 8.3.5.1.2 of Deloitte’s Roadmap Leases for subsequent accounting considerations for an acquirer that is reasonably certain to exercise a purchase option in an acquired operating lease.

ASC 805-20-30-24 also requires the acquirer to measure the “right-of-use asset at the same amount as the lease liability as adjusted to reflect favorable or unfavorable terms of the lease when compared with market terms.” Accordingly, an acquirer would not recognize a separate intangible asset or liability if an acquired lease in which the acquiree is a lessee is favorable or unfavorable relative to market terms as of the acquisition date. Thus, the acquirer will first measure the ROU asset in accordance with ASC 842 and then adjust the ROU asset for any off-market terms in accordance with ASC 805.

 

Connecting the Dots

ASC 842-10-55-12 states, in part, that “[l]eases between related parties should be classified in accordance with the lease classification criteria applicable to all other leases on the basis of the legally enforceable terms and conditions of the lease.” In addition, ASC 842-10-15-3A, which was added by ASU 2023-01, states, in part, that "as a practical expedient, an entity that is not a public business entity . . . may use the written terms and conditions of a related party arrangement between entities under common control to determine whether that arrangement is or contains a lease.” Therefore, under ASC 842, there are no circumstances in which entities would adjust the accounting for related-party leases for off-market terms or conditions. However, an ROU asset acquired in a business combination is adjusted for any off-market terms. We believe that even though it is not explicitly required to do so, an acquirer should, in a manner consistent with the measurement guidance in ASC 805 for all acquired ROU assets, adjust the carrying amount of an ROU asset acquired in a business combination for any off-market terms in a related-party lease. Otherwise, the off-market portion would be captured in goodwill (or possibly a bargain purchase gain) rather than through the amortization of the ROU asset.

In addition to the ROU asset and lease liability, when the acquiree is the lessee, an acquirer should recognize separately:

• Leasehold improvements owned by the acquiree (see Section 4.3.11.9).
• An intangible asset for the value associated with an in-place lease even if the lease is at market terms if market participants would place value on an at-the-money contract (see Section 4.3.11.10).

The ASC master glossary defines a short-term lease as “[a] lease that, at the commencement date, has a lease term of 12 months or less and does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise.” Lessees may elect an accounting policy (by class of underlying asset to which the right of use relates) to not recognize on the balance sheet lease liabilities or ROU assets of short-term leases (i.e., the “short-term lease exemption”). Rather, a lessee that makes this accounting policy election recognizes (1) fixed lease payments as an expense on a straight-line basis over the lease term and (2) variable lease payments that do not depend on an index or rate as an expense in the period in which achieving the specified target that triggers the variable lease payments becomes probable. See Deloitte’s Roadmap Leases for further discussion.

ASC 842 amended ASC 805 to allow a similar exemption for leases acquired in a business combination on the basis of a remaining lease term of 12 months or less on the acquisition date. ASC 805-20-25-28B states, in part:

ASC 805-20-25-28B clarifies that the recognition exemption, when elected, also applies to intangible assets or liabilities for favorable or unfavorable terms of acquired operating leases. We also believe that this exception may be applied to in-place lease intangible assets.

The lessor in an operating lease continues to report the assets subject to the lease on its balance sheet. In a business combination in which the acquiree is a lessor, the assets subject to the lease are recognized by the acquirer and measured at their acquisition-date fair values. The fair value measurement of the assets does not take into consideration the terms of the lease arrangement. That is, ASC 805-20-30-5 clarifies that “the fair value of the asset shall be the same regardless of whether it is subject to an operating lease.”

In addition to the asset subject to the lease, an acquirer may recognize the following separately when the acquiree is the lessor in an operating lease:

• An intangible asset or a liability if the terms of the lease are favorable or unfavorable compared with the market terms of leases of the same or similar items as of the acquisition date (see Section 4.3.11.7), including favorable or unfavorable renewal or termination options (see Section 4.3.11.8).
• Leasehold improvements owned by the acquiree (see Section 4.3.11.9).
• An intangible asset for the value associated with an in-place lease, including a lease that is at current market terms if market participants would place value on an at-the-money contract (see Section 4.3.11.10).
• An intangible asset for the value of the existing customer relationship between the acquiree and its lessee (see Section 4.3.11.11).

ASC 805-20-30-25 requires that when the acquiree is a lessor in a sales-type or direct financing lease, the acquirer must recognize the net investment in the lease — measured as the sum of the present value of the lease receivable and the unguaranteed residual asset — which should approximate fair value. The ASC master glossary defines a lease receivable as “[a] lessor’s right to receive lease payments arising from a sales-type lease or a direct financing lease plus any amount that a lessor expects to derive from the underlying asset following the end of the lease term to the extent that it is guaranteed by the lessee or any other third party unrelated to the lessor, measured on a discounted basis.” In the measurement of a lease receivable, it is assumed that the acquirer entered into the lease on the acquisition date under the terms in effect on that date. The measurement should include assessment of the lease term, any lessee options to purchase the underlying asset, lease payments, and the discount rate for the lease as described in paragraph BC415 of ASU 2016-02. See Deloitte’s Roadmap Leases for discussion about the measurement of a new lease under ASC 842.

The ASC master glossary defines an unguaranteed residual asset as “[t]he amount that a lessor expects to derive from the underlying asset following the end of the lease term that is not guaranteed by the lessee or any other third party unrelated to the lessor, measured on a discounted basis.” Such an asset is measured as “the difference between the fair value of the underlying asset at the acquisition date and the carrying amount of the lease receivable, as determined in accordance with [ASC 805-20-30-25(a)], at that date.” Because the measurement of the acquisition-date fair value of the underlying asset takes into account the terms and conditions of the existing lease arrangement, including any favorable or unfavorable terms, the acquirer does not recognize a separate intangible asset or liability for such off-market terms.

As described in paragraph BC417 of ASU 2016-02, the Board considered requiring an acquirer to apply the general principle in ASC 805 and measure the acquiree’s lease receivable and unguaranteed residual asset at fair value as of the acquisition date but ultimately decided against such an approach:

The net investment in the lease is subsequently accounted for in accordance with ASC 842. See Deloitte’s Roadmap Leases for more information on the subsequent accounting for the net investment in a sales-type or direct financing lease.

In addition to the net investment in the lease, an acquirer may recognize the following separately when the acquiree is the lessor in a sales-type or direct financing lease:

• An intangible asset for the value associated with an in-place lease, including a lease that is at current market terms if market participants would place value on an at-the-money contract (see Section 4.3.11.10).
• An intangible asset for the value of the existing customer relationship between the acquiree and its lessees (see Section 4.3.11.11).

 

Connecting the Dots

The above guidance on the recognition of favorable or unfavorable terms in a lease arrangement also applies to sublease transaction scenarios in which the lessee (i.e., intermediate lessor) is not relieved of its primary obligation under the head lease arrangement. For example, if the acquiree is the lessee in a sublease transaction, it would adjust the measurement of its ROU asset for any off-market terms as if it were the lessee in a normal lease arrangement. Likewise, if the acquirer is the intermediate lessor in a sublease transaction, it would account for the off-market terms as if it were the lessor in a normal lease arrangement. Thus, it would either recognize a separate intangible asset or liability or recognize an adjustment to the measurement of the underlying asset, depending on the classification of the sublease as either an operating lease or a sales-type or direct financing lease. See Deloitte’s Roadmap Leases for more information about sublease arrangements.

Acquired leasehold improvements that are owned by the acquiree are measured at their acquisition-date fair values. ASC 805-20-35-6 requires such improvements, once recognized, to be amortized over the shorter of the remaining lease term or the useful life of those assets, as determined by the acquirer, unless (1) “the lease transfers ownership of the underlying asset to the lessee” or (2) “the lessee is reasonably certain to exercise an option to purchase the underlying asset,” in which case the acquirer is required to amortize the leasehold improvements to the end of their useful life.

The existence of leasehold improvements owned by the acquiree can affect the acquirer’s determination of the lease term (and thus of the acquirer’s measurement of lease assets and lease liabilities). As discussed in Sections 4.3.11.3 and 4.3.11.6, the acquirer measures the acquired lease as if it were a new lease on the acquisition date, which includes undertaking a reassessment of the lease term (and other inputs). For example, if, as of the acquisition date, the acquiree/lessee has significant leasehold improvements, the acquirer may be likely to exercise a renewal option if failing to do so would result in the loss of those improvements with a remaining useful life.

For additional information about the accounting for leasehold improvements (including the importance of determining which party owns the improvements and the issuance of ASU 2023-01 related to the accounting for leasehold improvements in common-control arrangements), see Deloitte’s Roadmap Leases.

An in-place lease intangible asset represents the price that a market participant would be willing to pay for an at-market lease. The value associated with an in-place lease reflects, for example, the value associated with avoiding (1) the costs of originating an acquired lease (such as the costs to execute the lease, including marketing costs, sales or leasing commissions, and legal and other related costs) and (2) costs that would be incurred if an asset that was intended to be leased was acquired without a lessee.

An intangible asset for an in-place lease should be recognized separately in the financial statements and not combined with other lease-related assets or liabilities (e.g., not combined with lessee ROU assets, lessor net investments in leases, intangible assets for favorable lease terms, or liabilities for unfavorable lease terms).

The interrelationship of various types of intangible assets associated with the same lessee can pose challenges in the recognition and measurement of a customer-related intangible asset. The values assigned to other assets and liabilities — such as lease receivables, off-market contracts, and in-place lease intangible assets — may also affect the valuation of customer-related intangible assets.

When an entity enters into a lease, the terms of the lease are presumed to be at market even if the arrangement includes up-front or deferred payments (i.e., the total amount of the payments is presumed to reflect the market rate). However, if a lease with prepaid or deferred payments is acquired in a business combination, the remaining lease payments may be more or less than they would be for a new lease of the property with the same remaining term. As a result, the lease may be above or below market as of the acquisition date. See Section 4.3.11.7 for the accounting for off-market terms, which depend on whether the acquiree is the lessee or the lessor and the classification of the lease.

On the adoption date of ASC 842, leases that were previously classified as leveraged leases under ASC 840 are subject to the guidance in ASC 842-50, which is generally consistent with the accounting requirements for leveraged leases in ASC 840 and effectively carries forward that guidance. However, if a leveraged lease is modified after the entity adopts ASC 842, it is accounted for as a new lease in accordance with ASC 842 (i.e., classification is reassessed and leveraged lease accounting would no longer be available). Entities are not permitted to account for any new lease arrangements as leveraged leases after the adoption of ASC 842.

If a leveraged lease is acquired in a business combination after the adoption of ASC 842, the acquirer does not reassess the lease’s classification (unless it is modified on or after the date of acquisition) and must apply the recognition, measurement, presentation, and disclosure guidance for leveraged leases in ASC 842-50. If the acquired leveraged lease is modified as part of the business combination, it should be reclassified in accordance with the lease classification guidance in ASC 842. As discussed in Section 4.3.11.1, a modification is a change in the scope of or consideration for a lease. Changing the parties identified in a lease contract would not change the classification of a leveraged lease because such a change does not alter the scope of or consideration for the lease.

If the acquiree is a lessor in a leveraged lease that is not modified as part of the business combination, the acquirer measures the net investment on the basis of the remaining net future cash flows and gives appropriate recognition to the estimated future tax effects of such cash flows. The net investment is then broken down into its component parts (i.e., net rentals receivable, estimated residual value, and unearned income, including the discount to adjust the other components to present value), which are recognized as of the acquisition date. After the acquisition, the acquirer accounts for the investment in the leveraged lease in accordance with ASC 842-50.

Example 4 in ASC 842-50-55-27 through 55-33 illustrates the accounting for a leveraged lease acquired in a business combination. Also, see Deloitte’s Roadmap Leases for more information about the accounting for leveraged leases.

If the initial transfer of the asset is determined to be a sale in accordance with ASC 842-40 and ASC 606, the transaction is accounted for as a sale and leaseback under ASC 842-40. The seller/lessee derecognizes the underlying asset, recognizes any gain or loss on the sale, and accounts for the leaseback as it would any other operating lease. The buyer/lessor recognizes the underlying asset and accounts for the lease as it would any other operating or direct financing lease. If the seller/lessee or buyer/lessor in a sale-and-leaseback transaction is subsequently acquired in a business combination, the acquirer should account for the leaseback as described in Sections 4.3.11.1 through 4.3.11.14.

If the initial transfer does not meet the criteria to be a sale in accordance with ASC 842-40 and ASC 606 (i.e., it is a “failed” sale and leaseback), the seller/lessee and the buyer/lessor account for the transaction as a financing transaction. The seller/lessee continues to report the property on its balance sheet as if it were its owner and recognizes a financial liability (i.e., debt). The buyer/lessor does not recognize the property on its balance sheet and instead recognizes a financial asset (i.e., a loan receivable). If the seller/lessee or buyer/lessor in a failed sale-and-leaseback transaction is subsequently acquired in a business combination, the acquirer should not reassess the transaction. For example, the acquirer may continue to use the acquiree’s accounting for the failed sale-and-leaseback transaction until the transaction meets the requirements in ASC 842-40 and ASC 606 for the transfer to be accounted for as a sale. The assets and liabilities related to the arrangement should be measured at their acquisition-date fair values.

In addition, there may be situations in which a third party acquires an asset directly from the acquiree before or concurrently with the business combination and subsequently leases the asset back to the acquirer after the acquisition. In substance, such arrangements may represent sale-and-leaseback transactions if it is determined that the acquirer or future lessee controls the asset before or concurrently with the acquisition. See Chapter 10 of Deloitte’s Roadmap Leases for more information.

In addition, the acquirer should consider whether it has recognized any assets or liabilities related to the lease that should be derecognized as part of the effective settlement of the arrangement. The carrying amounts of the recognized assets or liabilities, if any, would adjust the amount of the gain or loss recognized for the settlement of the preexisting relationship, as illustrated in Example 3 in ASC 805-10- 55-33 (reproduced in Section 6.2.2.3).

ASC 805-20-25-8(b) requires an acquirer to carry forward the classification of an acquired contract as an insurance or a reinsurance contract (rather than a deposit) that the acquiree made at the inception of the contract on the basis of its terms and any related contracts or agreements. If the terms of those contracts or agreements were modified in a way that would change their classification, the acquirer determines the classification of the contract on the basis of its terms and other pertinent factors on the modification date, which may be the acquisition date. When assessing whether a contract qualifies as insurance or reinsurance, an entity must consider related contracts and arrangements because they can significantly affect the amount of risk transferred.

The assets and liabilities arising from the rights and obligations of insurance and reinsurance contracts acquired in a business combination are recognized on the acquisition date and measured at their acquisition-date fair values. That recognition and measurement might include a reinsurance recoverable, a liability to pay future contractual claims and claim expenses on the unexpired portions of the acquired contracts, and a liability to pay incurred contractual claims and claim expenses. However, those assets acquired and liabilities assumed would not include the acquiree’s insurance and reinsurance contract accounts, such as deferred acquisition costs and unearned premiums that do not represent future cash flows.

Although insurance and reinsurance contracts are measured at fair value, the FASB noted in paragraph B192 of Statement 141(R) that an acquirer should be able to subsequently report the acquired business on the same basis as its written business. However, rights and obligations related to insurance and reinsurance contracts are not measured at fair value under existing GAAP. Thus, in ASC 944-805, the Board provided specific measurement and recognition guidance that requires an acquirer to separate the fair value of the insurance and reinsurance contracts it acquires into (1) insurance and reinsurance GAAP accounting balances, in keeping with the acquirer’s accounting policies, and (2) an intangible asset (or, infrequently, another liability) for the difference between the fair value of the insurance and reinsurance contracts and the amount recognized in accordance with the acquirer’s existing accounting policies. As a result, the acquirer is permitted to subsequently report the acquired business on the same basis as its written business since the intangible asset is amortized separately. However, while the total value of an insurance contract represents its fair value, the elements of a contract do not (i.e., the rights and obligations related to insurance and reinsurance contracts are measured under existing GAAP, and the intangible asset (or liability) is calculated as a residual).

Other contracts that provide third-party contingent commissions are accounted for in the same manner as other contingencies, and contracts that provide guarantees of the adequacy of claims liabilities are accounted for as indemnifications.

ASC 805 refers to the subsequent measurement guidance for insurance contracts in ASC 944. Under that guidance, the insurance contract intangible asset (or liability) is measured on a basis consistent with the related insurance or reinsurance liability. Specifically, ASC 944-805-35-1 through 35-3 provide the following guidance:

As explained in paragraph BC35 of the ASU, the first expedient “provides relief for contracts that have been previously modified before the acquisition date” by allowing an acquirer to reflect the aggregate effect of all modifications as of the acquisition date. The second expedient provides “relief for situations in which the acquirer does not have the appropriate data or expertise to analyze the historical periods in which the contract was entered into” by allowing an acquirer to determine the stand-alone selling price as of the acquisition date. Under ASC 805-20-30-30, any practical expedients used by the acquirer should be applied (1) “on an acquisition-by-acquisition basis” and (2) “consistently to all contracts acquired in the same business combination.” Entities are also required to provide certain disclosures if they elect to use any of the practical expedients. See Section 7.3.6 for more information.

While we do not believe that the acquirer should recognize a separate asset for those up-front payments in its postcombination financial statements, we do believe that the up-front payments to customers could affect the value of another asset, such as a customer relationship intangible asset or an off-market component of a customer contract.

Many intangible assets arise from rights conveyed by contract, statute, or similar means. As stated in paragraph B156 of the Background Information and Basis for Conclusions of FASB Statement 141, “franchises are granted to automobile dealers, fast-food outlets, and professional sports teams. Trademarks and service marks may be registered with the government. Contracts are often negotiated with customers or suppliers. Technological innovations are often protected by patent.” Therefore, the fact that an intangible asset arises from contractual or other legal rights distinguishes it from goodwill. Such an intangible asset must be recognized separately from goodwill even if the acquirer is legally or contractually restricted from selling, transferring, or otherwise exchanging it. Restrictions on selling or otherwise transferring an intangible asset arising from contractual rights do not affect its recognition; however, such restrictions may affect its fair value measurement.

ASC 805-20-55-2 provides the following examples of intangible assets arising from contractual or other legal rights:

Some intangible assets that meet the contractual-legal criterion may also meet the separability criterion, but only one criterion must be met for an intangible asset to be identifiable. Similarly, an intangible asset that meets the separability criterion is identifiable even if it does not arise from a contractual or legal right.

In contrast to goodwill, which cannot be separated from an entity, some intangible assets do not arise from contractual or other legal rights but are capable of being separated from the acquiree and exchanged for something else of value. Therefore, identifiable assets can also be distinguished from goodwill on the basis of separability.

An acquired intangible asset meets the separability criterion if there is evidence of exchange transactions for the asset or similar assets, even if such exchanges occur infrequently and the acquirer has not participated and does not intend to participate in such exchanges. It is the acquirer’s ability to separate the asset from the combined entity that makes an intangible asset separable. ASC 805-20-55-4 provides the following example of customer-related intangible assets that meet the separability criterion:

Therefore, even if an intangible asset that is related to a contract, identifiable asset, or liability cannot be separated individually from that contract, identifiable asset, or liability, it will still meet the separability criterion if it can be transferred together with that related contract, identifiable asset, or liability. ASC 805-20-55-5 provides examples of intangible assets that, while not individually separable, are separable when combined with other assets or liabilities.

Unlike the contractual-legal criterion, restrictions on the sale, transfer, or exchange of an intangible asset may preclude the asset from meeting the separability criterion. If agreements, laws, or statutes prohibit the sale, transfer, license, rent, or exchange of an intangible asset, that asset does not meet the separability criterion, although it could still meet the contractual-legal criterion.

An acquirer might identify certain intangible assets acquired in a business combination that may have value but do not meet either the separability or contractual-legal criterion. Thus, such assets are subsumed into goodwill.

FASB Statement 141 includes the following examples of intangible assets that are not identifiable (while ASC 805 did not carry forward all of these examples, they continue to be relevant):

• Potential contracts that an acquiree is negotiating with prospective new customers as of the acquisition date, which is specifically addressed in ASC 805-20-55-7.
• Customer base or unidentifiable customers — a group of customers that are not known or identifiable to the entity (e.g., customers of a fast-food franchise).
• Assembled workforce, which is specifically addressed in ASC 805-20-55-6.
• Customer service capacity.
• A presence in geographic markets or in certain locations.
• Status as a nonunion, or strong labor relations.
• Training that is ongoing.
• Recruitment programs.
• Outstanding credit ratings.
• Access to capital markets.
• Favorable governmental relationships.

ASC 805-20-55-7 acknowledges that while potential contracts do not meet the criteria for separate recognition as of the acquisition date and cannot be subsequently reclassified from goodwill for events that occur after the acquisition date, the acquirer should “assess the facts and circumstances surrounding events occurring shortly after the acquisition to determine whether a separately recognizable intangible asset existed at the acquisition date.”

In a business combination, an intangible asset must be identifiable according to the specific criteria in ASC 805 to be recognized, but in an asset acquisition, it must only meet the asset recognition criteria in FASB Concepts Statement 5 to be recognized in accordance with ASC 350-30-25-4. (See Section C.3.4 for more information.)

ASC 805-20-55-29 provides the following examples of artistic-related intangible assets:

As stated in ASC 805-20-55-31, “[c]ontract-based intangible assets represent the value of rights that arise from contractual arrangements.” Contracts with terms that are favorable relative to market terms give rise to contract-based intangible assets, and contracts with terms that are unfavorable relative to market terms give rise to a liability assumed in the business combination (see additional discussion in Section 4.10.4.4.5).

ASC 805-20-55-31 also provides the following examples of contract-based intangible assets:

An acquirer recognizes tangible and intangible assets that result from, or are to be used in, R&D activities as assets regardless of whether the acquired assets have an alternative future use. Acquired IPR&D assets must be measured at their acquisition-date fair values. Uncertainty about the outcome of an individual project does not affect the recognition of IPR&D but does affect its fair value measurement. Even though the guidance describes R&D as a single asset, ASC 730 defines the terms “research” and “development” separately, as follows:

ASC 730-10-55-1 lists examples of activities that are within the scope of ASC 730, and ASC 730-10-55-2 notes those that are not.

R&D activities are only considered to be within the scope of ASC 730 if they are not “conducted for others under a contractual arrangement.” If R&D activities are conducted for others under a contractual arrangement, the costs should not be recognized as part of the acquired IPR&D.

If an entity acquires IPR&D in a business combination that it intends to use in a manner other than its highest and best use (e.g., it has plans to discontinue the R&D project after the acquisition even though a marketplace participant would continue the R&D efforts), it would still be required to recognize an intangible asset at fair value for the IPR&D (see Section 4.9).

The guidance in ASC 805 does not affect the accounting for R&D expenditures incurred outside of a business combination. Therefore, if R&D costs related to an acquired IPR&D project are incurred after the acquisition date, an acquirer would expense them in accordance with ASC 730, unless they have an alternative future use.

Also, see Section C.3.4.2 for information about accounting for IPR&D acquired in an asset acquisition.

Once complete, R&D projects may become other identifiable assets such as patents, formulas, trade secrets, or blueprints.

The AICPA Accounting & Valuation Guide Assets Acquired to Be Used in Research and Development Activities (the “guide”) outlines best practices for the recognition and measurement of IPR&D assets acquired in a business combination or an asset acquisition. While the guide focuses primarily on the software, electronic devices, and pharmaceutical industries, it is a useful reference for recognizing and measuring acquired IPR&D assets in all industries. The guide indicates that both of the following conditions must be met for an IPR&D asset to be recognized in a business combination:

• The acquired asset (whether tangible or intangible) meets the definition of an asset on the acquisition date and is part of what the acquirer and acquiree exchanged in the business combination.
• There is persuasive evidence that the specific IPR&D project has substance and is incomplete.

If the acquired IPR&D asset does not meet both of those criteria, it does not qualify for recognition. However, even if the acquired asset does not qualify as IPR&D, it may still be recognized in the business combination. For example, if a project has substance but is complete, the IPR&D may represent another identifiable intangible asset such as a patent, formula, trade secret, or blueprint.

Sometimes, an entity may acquire an asset that it either does not intend to use or intends to use in a manner other than its highest and best use. Such an asset is commonly called a defensive intangible asset, which the ASC master glossary defines as “[a]n acquired intangible asset in a situation in which an entity does not intend to actively use the asset but intends to hold (lock up) the asset to prevent others from obtaining access to the asset.” For example, an entity may decide not to use the acquired trade name of a competitor but intend to keep the name (rather than sell it) solely to prevent others from using it. In this case, the asset is determined to have value to the acquirer albeit in a defensive manner (i.e., by denying others access to its use). When measuring the fair value of a defensive intangible asset in accordance with ASC 820, an acquirer should assume its highest and best use by market participants.

The implementation guidance in ASC 350-30-55 provides examples of defensive intangible assets:

 

Changing Lanes

In December 2023, the FASB issued ASU 2023-08, which addresses the accounting and disclosure requirements for certain crypto assets. The new guidance requires entities to subsequently measure certain crypto assets at fair value, with changes in fair value recorded in net income in each reporting period. In addition, entities are required to provide additional disclosures about the holdings of certain crypto assets. Before the adoption of ASU 2023-08, entities (other than those within the scope of the investment-company guidance in ASC 946 or certain types of broker-dealers) accounted for crypto assets as indefinite-lived intangible assets in accordance with ASC 350 (i.e., the assets were measured at historical cost less impairment). The FASB anticipates that the guidance in the ASU will better reflect the economics of certain crypto assets held by entities as well as reduce the complexity and cost of complying with a historical-cost-less-impairment model under the existing requirements in ASC 350. The amendments in ASU 2023-08 are effective for all entities for fiscal years beginning after December 15, 2024, including interim periods within those years. Early adoption is permitted.

As described in ASC 606-10-45-1, the existence of a contract asset depends “on the relationship between the entity’s performance and the customer’s payment.” For example, a contract asset exists when an entity has a contract with a customer for which revenue has been recognized (i.e., goods or services have been transferred to the customer) but the customer’s payment is contingent on a future event (e.g., billed on an agreed-upon future schedule or only along with completion of additional performance obligations). Such an asset might be referred to as an unbilled receivable or as a progress payment to be billed. If the entity’s right to consideration is contingent only on the passage of time, the right represents a receivable.

An acquiree’s contract assets and receivables are both recognized at fair value in a business combination and are similar in that they both represent an entity’s right to consideration for the transfer of goods or services, but there are different risks associated with each. The fair value of a receivable takes into account the time value of money and the customer’s credit risk (see Section 4.5), whereas the fair value of a contract asset incorporates the same risks as receivables as well as other risks (e.g., risks associated with additional performance obligations or price variability). Contract assets should be presented separately from receivables in the financial statements.

As described in ASC 606-10-45-1, the existence of a contract liability depends “on the relationship between the entity’s performance and the customer’s payment.” A contract liability exists when an entity has received consideration but has not yet transferred the promised goods or services to the customer. Such a liability might be referred to as deferred revenue or unearned revenue.

An acquirer recognizes an assumed contract liability when the acquiree has received consideration under a revenue contract but still retained a performance obligation (even if partially satisfied) as of the acquisition date. The ASC master glossary (pending content) defines a performance obligation as:

ASC 606-10-25-14 through 25-22 provide guidance on identifying performance obligations. In accordance with ASC 606-10-25-19, a promised good or service is distinct (and therefore a performance obligation) if it is both of the following:

• Capable of being distinct — “The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer.”
• Distinct within the context of the contract — “The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract.”

Under ASC 606, a performance obligation may be created not only on the basis of the terms of a contract but also on a customer’s reasonable expectations and may include promises that are implied by an entity’s customary business practices or industry norms.

If the acquirer determines that it has assumed an unsatisfied (or partially satisfied) performance obligation, it recognizes a contract liability at its acquisition-date fair value, which is the amount the acquirer would have to pay a third party to assume the liability. Under ASC 606, the contract liability recognized on the acquiree’s preacquisition balance sheet typically represents the consideration the acquiree received in advance from the customer, less the amount recognized for services performed to date. Therefore, the amount recognized by the acquiree before the business combination is unlikely to equal its fair value. After the acquisition, the acquirer recognizes revenue and derecognizes the contract liability as it satisfies its obligation by transferring the promised goods or services to the customer under the contract.

In practice, there are two methods for measuring a contract liability at fair value in accordance with ASC 820. Under one method, sometimes called the cost build-up method, the liability is measured as the direct incremental cost of fulfilling the remaining performance obligation, plus a reasonable profit margin. Such a margin should take into account the level of effort required or risk assumed by the acquirer after the acquisition date but should not include any profit related to the selling, marketing, or other efforts completed by the acquiree before the acquisition.

Under the other method, the liability is measured by using market data about the amount of revenue that an entity would earn in a transaction to provide the remaining performance obligation in the contract, less the cost of the selling effort that was already performed by the acquiree before the acquisition date, plus a reasonable profit margin on that effort. This method is less common since relevant market data are often unavailable.

Regardless of the method used, entities should perform the fair value measurement from the perspective of a market participant.

In some cases, there may be a short administrative delay (i.e., one or two days) in the acquirer’s repayment of the acquiree’s debt when such repayment is required. We believe that in such cases, the cash paid to settle the acquiree’s debt might also be reported as consideration transferred if the acquirer is deemed to not have assumed the risks inherent in the debt.

Regardless of whether the repayment of the acquiree’s debt is presented as consideration transferred or as a liability assumed, the amount of goodwill reported will not change (see Examples 4-8 and 4-9), but the acquirer should ensure that its financial statements are presented consistently throughout. That is, if the acquirer concludes that it did not assume the acquiree’s debt, the amount paid to settle the debt should be accounted for and disclosed as part of the consideration transferred. In addition, in such a case, the acquirer should present the repayment as an investing cash outflow in a manner consistent with how it would present cash consideration paid in a business combination.

By contrast, if the acquirer concludes that it assumed the acquiree’s debt, the debt should be accounted for and disclosed as a liability assumed in the acquisition accounting. The acquirer would present the repayment as a financing cash outflow in a manner consistent with how it would present the repayment of its own debt obligations outside of a business combination. See Deloitte’s Roadmap Statement of Cash Flows for more information about cash flow presentation.

 

SEC Considerations

Under ASC 805, an acquirer’s conclusion about whether it assumed the acquiree’s debt affects the amount of the consideration transferred in the business combination. In accordance with SEC Regulation S-X, Rule 3-05, a registrant must perform three tests to determine (1) the significance of the business acquisition or probable business acquisition and (2) whether the registrant should file the acquiree’s separate annual and interim financial statements and, if so, for how many periods. The three tests are the investment test, the asset test, and the income test.

When an entity performs the investment test, the registrant’s “investment in” the acquiree is the consideration transferred under ASC 805. Debt that the acquirer assumes from the acquiree is not included as part of the consideration transferred. However, debt that is not assumed by the acquirer and is included as part of the consideration transferred would be included in the investment test.

The entity’s determination of whether the contingent arrangement contains one or multiple units of account may affect whether the arrangement qualifies as equity in whole or in part. If an entity determines that an arrangement includes multiple payment conditions, triggers, or targets that are independent of one another and that would, if met, result in the issuance of specified consideration regardless of whether any other targets were met, each target-based payment is treated as a separate unit of account (contract) that must be assessed for classification. If the payment conditions or targets are cumulative or not independent of one another, the arrangement is considered one contract that requires delivery of a variable number of shares.

For more information about determining the unit of account for contingent consideration arrangements, see Deloitte’s Roadmap Contracts on an Entity’s Own Equity.

Contingent consideration arrangements are often evaluated under the third item above because they involve instruments that require delivery of the acquirer’s shares, and the value of the obligation is solely or predominantly based on whether certain contingencies or target thresholds are met. If an arrangement varies on the basis of the extent to which contingencies or metrics are met (e.g., the number of shares delivered depends on how much EBITDA exceeds a target), we believe that a determination of whether it is within the scope of ASC 480 depends on whether its monetary value, at inception, is based solely or predominantly on the exercise contingency (e.g., EBITDA or revenue target) or share price. If the monetary value is based solely or predominately on the exercise contingency, the arrangement is likely to be classified as a liability under ASC 480. If, however, the monetary value is based solely or predominately on the share price, the arrangement is likely to be outside the scope of ASC 480, but entities would need to consider the guidance in ASC 815. Further, we believe that the determination of whether an arrangement’s monetary value, at inception, is based solely or predominately on the exercise contingency or share price depends on the entity’s particular facts and circumstances.

ASC 480 discusses the underlying in a contingent consideration arrangement and notes that instruments that “solely or predominantly” vary on the basis of something other than the entity’s shares do not qualify for equity treatment.

Since ASC 805 specifically addresses the subsequent measurement of contingent consideration, the subsequent measurement guidance in ASC 480 does not apply. See Section 5.7.3 for more information about subsequent measurement of the contingent consideration.

A contingent consideration arrangement that is a derivative is classified as a liability unless the arrangement meets a scope exception that allows equity classification. ASC 815-10-15-74(a) provides a scope exception for an entity’s contracts that are both (1) indexed to the entity’s own shares and (2) classified in equity in the entity’s statement of financial position.

A contingent consideration arrangement that is not precluded from equity classification under ASC 480-10 and ASC 815-40-15 may be classified in equity only if it meets all of the following conditions in ASC 815-40-25:

• It is required to be physically settled in shares or net share settled or the acquirer has a choice of net cash settlement or settlement in shares (either net share settlement or physical settlement).
• If an event could trigger net cash settlement that is outside the issuer’s control, the arrangement requires net cash settlement only in specific circumstances in which holders of shares underlying the contract also would receive cash in exchange for their shares.
• It permits the acquirer to settle in unregistered shares (however, see Changing Lanes discussion below).
• The acquirer has sufficient authorized and unissued shares to settle the contract. In making that determination, the acquirer must consider all other commitments or potentially dilutive instruments (e.g., options, warrants, convertible arrangements) that may require the issuance of shares during the maximum period the arrangement could remain outstanding.
• The arrangement contains an explicit limit on the number of shares to be delivered in a share settlement.
• There are no required cash payments to the seller in the event the acquirer fails to make timely filings with the SEC.
• There are no cash-settled top-off or make-whole provisions.
• There are no provisions in the arrangement that indicate that the seller has rights that rank higher than those of a holder of the shares underlying the contract (however, see Changing Lanes discussion below).
• There is no requirement in the contract to post collateral at any point or for any reason (however, see Changing Lanes discussion below).

These conditions are discussed in detail in ASC 815-40-25, and entities should consider them carefully in determining whether an arrangement would be classified in equity. In addition, entities must reassess a contingent consideration arrangement as of each reporting date. If equity classification is no longer appropriate, the arrangement must be reclassified as a liability. Similarly, if equity classification becomes appropriate, the arrangement must be reclassified as equity as of the date of the event that caused the reclassification. For additional discussion, see Deloitte’s Roadmap Contracts on an Entity’s Own Equity.

 

Changing Lanes

In August 2020, the FASB issued ASU 2020-06, which simplifies the accounting for certain financial instruments with characteristics of liabilities and equity, including convertible instruments and contracts on an entity’s own equity. ASU 2020-06 amends ASC 815-40-25 to remove the following three conditions for equity classification related to an entity’s ability to settle a contract on its own equity by delivering shares:

• Settlement permitted in unregistered shares; however, the ASU clarifies that if a contract explicitly states that cash settlement is required if registered shares are unavailable, the contract will not qualify as equity.
• There are no provisions in the arrangement that indicate that the seller has rights that rank higher than those of a holder of the shares underlying the contract.
• There is no requirement in the contract to post collateral at any point or for any reason.

For more information about ASU 2020-06, see Deloitte’s August 5, 2020, Heads Up.

Before the acquisition date, an acquiree may have completed a prior business combination in which it was the acquirer and had issued contingent consideration to the seller. Consequently, at the time of the new acquisition, the acquiree may have a liability (or asset) recognized for the contingent consideration. The nature of contingent consideration does not change because of the subsequent acquisition of the acquirer. Therefore, if an acquirer assumes a preexisting contingent consideration liability (or asset) in a business combination, the acquirer measures and recognizes that arrangement at fair value and classifies it in the same manner as if it had entered into that arrangement at the same time as the current business combination.

After initial recognition, such contingent consideration arrangements are accounted for in accordance with the requirements for acquirer contingent consideration in ASC 805-30-35-1. However, acquiree contingent consideration arrangements are assumed liabilities (or acquired assets) rather than part of the consideration transferred in the business combination because they are payable to (or receivable from) parties other than the sellers in the current business combination.

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.

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:

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.

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:

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.

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:

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.

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

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.

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).

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 agreements and issues — see Section 6.2.4.

According to ASC 805-10-55-24, “whether arrangements for contingent payments to employees or selling shareholders are contingent consideration in the business combination or are separate transactions depends on the nature of the arrangements.” While ASC 805-10-55-25(a) (i.e., the continuing employment factor — see Section 6.2.3.3.1) 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.

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.