Chapter 7 — Common Issues Related to Cash Flows

7.5 Business Combinations

Cash flows related to the purchases and sales of businesses, PP&E, and other productive assets are presented as investing activities in the statement of cash flows. In a business combination, all cash paid to purchase the business is presented as a single line item in the statement of cash flows, net of any cash and cash equivalents acquired (including acquired restricted cash and restricted cash equivalents after the adoption of ASU 2016-18). That is, changes in the individual assets acquired and liabilities assumed that occur on the acquisition date are no longer reflected as separate line items in the statement of cash flows. After an acquisition, the cash flows of the acquirer and acquiree are combined and presented in a consolidated statement of cash flows.

An entity may also need to consider other financial reporting implications of a business combination depending on the nature and terms of the transaction. For example, any noncash effects of a business combination, such as an acquisition involving noncash consideration (as described in Example 5-2), must be disclosed in a narrative format or summarized in a schedule.

For additional considerations related to an entity’s accounting for a business combination, see Deloitte’s Roadmap Business Combinations.

7.5.1 Presentation of Acquisition-Related Costs

When consummating a business combination, an acquirer frequently incurs acquisition-related costs such as advisory, legal, accounting, valuation, and professional and consulting fees. Except for certain debt and equity issuance costs, ASC 805 requires that an entity expense all such acquisition-related costs as incurred. The costs of issuing debt or equity securities as part of a business combination are recognized in accordance with other applicable accounting literature.

In the deliberations before the issuance of Statement 141(R) (codified in ASC 805), the FASB determined that acquisition-related costs are not considered part of the fair value exchange between the buyer and seller of the business; rather, they are separate transactions in which the buyer pays for services that it receives. Further, the definition of “operating activities” in the ASC master glossary states, in part, that “[c]ash flows from operating activities are generally the cash effects of transactions and other events that enter into the determination of net income.” Because acquisition-related costs accounted for under ASC 805 are expensed and affect net income, these costs should be reflected as operating cash outflows in the statement of cash flows.

7.5.2 Settlement of Acquired Liabilities After a Business Combination

After an acquisition, the acquirer may make payments to settle a liability legally assumed in a business combination. The cash outflow related to the settlement of the liability could be classified as an operating, investing, or financing activity depending on the nature of the payment. The payment should be classified as it would have been in the absence of the business combination. For example:

If the payment was for inventory purchased on account, it would represent an operating cash outflow.
If the payment was for PP&E that was purchased on account and was paid within three months of its original purchase date, it would represent an investing cash outflow.
If the payment was in connection with a debt obligation legally assumed in an acquisition that remained outstanding after the acquisition, it would represent a financing cash outflow. However, as described below, if the payment is related to debt extinguished in conjunction with a business combination, the entity must consider certain facts and circumstances of the business combination to determine the appropriate presentation in its statement of cash flows.

7.5.3 Debt in a Business Combination

An acquirer may sometimes use cash to settle debt of the acquiree on or close to the acquisition date. In such cases, it is necessary to determine whether the cash distributed should be reported as consideration transferred to effect the acquisition or as cash paid to settle the debt assumed in the acquisition. While cash paid on the acquisition date to settle debt of the acquiree is generally reported as consideration transferred, cash paid close to the acquisition date to settle debt of the acquiree might also be reported as consideration transferred if the acquirer is deemed not to have assumed the risks inherent in the debt (e.g., when the separation of the payment from the acquisition date is more administrative).

The classification in the statement of cash flows of cash paid to settle the acquiree’s debt in a business combination should be consistent with the acquirer’s treatment of the debt in acquisition accounting (i.e., whether the debt was treated as a liability assumed in acquisition accounting). If the acquirer concludes that it assumes the acquiree’s debt as part of the business combination, the acquirer will generally present the extinguishment as a financing activity (in a manner consistent with how it would present the repayment of a debt obligation outside of a business combination). Conversely, if the acquirer concludes that it does not assume the acquiree’s debt as part of the business combination that was subsequently extinguished, the acquirer will generally present the extinguishment as an investing activity (in a manner consistent with how it would present cash consideration paid in a business combination). The example below illustrates an acquisition in which the acquirer does not assume the acquiree’s debt.

Example 7-8

Company A acquires Company B in a business combination. Before the acquisition, B had $1 million in outstanding debt owed to a third-party bank. Company A pays the seller $5 million in cash and repays the $1 million debt upon the closing of the business combination. Company A concludes that it did not assume B’s debt (i.e., that it repaid the debt on B’s behalf). As of the acquisition date, B’s net assets recognized in accordance with ASC 805 are $4 million. Company A calculates the goodwill resulting from the acquisition of B as follows:

Because A did not assume B’s debt, the total consideration transferred is $6 million in cash. Therefore, A should present the $6 million as an investing outflow in its statement of cash flows.

In the example below, the acquirer has assumed the acquiree’s debt.

Example 7-9

Assume the same facts as in the example above, except that Company A concludes that it assumed Company B’s debt. As a result, B’s net assets recognized in accordance with ASC 805 are $3 million (i.e., $4 million less $1 million in debt). Company A calculates the goodwill resulting from the acquisition of B as follows:

Because A assumed B’s debt, the consideration transferred is $5 million in cash paid to the seller, and the $1 million to repay B’s debt is a liability assumed in the acquisition accounting. Therefore, A should present $5 million as an investing outflow and $1 million as a financing outflow in its statement of cash flows.

7.5.4 Contingent Consideration in a Business Combination

ASC 805 requires the acquirer to recognize the acquisition-date fair value of the contingent consideration arrangement as part of the consideration transferred in exchange for the acquiree. The contingent consideration arrangement is classified either as a liability or as equity in accordance with applicable U.S. GAAP.

7.5.4.1 Contingent Consideration Classified as a Liability

If the acquiring entity determines that the contingent consideration arrangement should be classified as a liability, the initial fair value of the contingent consideration as of the acquisition date should be reflected as a noncash investing activity. In accordance with ASC 230-10-50-3, this arrangement should be either disclosed narratively or summarized in a schedule because no cash consideration is transferred on the acquisition date. It should not be reflected in investing activities. In subsequent periods, the contingent consideration liability must be remeasured at fair value as of each reporting date until the contingency is resolved, with the changes recognized as an expense in the determination of earnings (unless the change is the result of a measurement-period adjustment or the arrangement is a hedging instrument for which ASC 815 requires changes to be recognized in OCI). Because the subsequent fair value adjustment enters into the determination of the acquiring entity’s net income and is a noncash item, it should be reflected as a reconciling item between net income and cash flows from operating activities in the statement of cash flows.

If the contingent consideration is satisfied in either cash or cash equivalents upon resolution of the contingency, the classification of payments made to settle the contingent consideration liability should be determined on the basis of when such payments are made in relation to the date of the business combination. Essentially, classification of the payments depends on whether they are made soon after the acquisition in a business combination transaction. While ASC 230 does not define the term “soon after,” we generally believe that this term would apply to payments made within three months or less of the acquisition date. This view is also consistent with paragraph BC16 of ASU 2016-15, which states that “some Task Force members believe that a payment for contingent consideration that was made soon after a business combination is an extension of the cash paid for the business acquisition (an investing activity), if that payment for contingent consideration was made within a relatively short period of time after the acquisition date (for example, three months or less).” Therefore, because a payment made on or soon after the business combination date (to settle the liability related to contingent consideration) is viewed as an extension of the business combination, such payments made soon after the date of the business combination are presented as investing activities in the acquirer’s statement of cash flows in accordance with ASC 230-10-45-13(d).

Conversely, contingent consideration payments that are not made on the acquisition date or soon after the business combination are not viewed as an extension of the business combination. Therefore, such payments should be separated and presented as:

Financing cash flows — The cash paid to settle the contingent consideration liability recognized at fair value as of the acquisition date (including measurement-period adjustments), less payments made soon after the business combination date, should be reflected as a cash outflow for financing activities in accordance with ASC 230-10-45-15(f).
Operating cash flows — The cash payments not made soon after the business combination date that exceed those classified as financing activities should be reflected as a cash outflow for operating activities in accordance with ASC 230-10-45-17(ee).

As indicated in paragraph BC14 of ASU 2016-15, the separation of contingent consideration payments not made soon after the business combination date is consistent with the approach most entities used before the ASU was issued. Paragraph BC14 further notes that this approach is the one that is most closely aligned with certain principles in ASC 230.

These principles include:

The cash paid to settle the contingent consideration liability recognized at fair value as of the acquisition date (including measurement-period adjustments) should be reflected as a cash outflow for financing activities in the statement of cash flows. Effectively, the acquiring entity financed the acquisition and the cash outflow therefore represents a subsequent payment of principal on the borrowing and should be reflected in accordance with ASC 230-10-45-15(f).
The remaining portion of the amount received/paid (i.e., the changes in fair value of the contingent consideration liability after the acquisition date) should be reflected as a cash inflow/outflow from operating activities because the fair value adjustments were recognized in earnings. If the amount paid to settle the contingent consideration liability is less than the amount recorded on the acquisition date (i.e., the fair value of the contingent consideration decreased), the entity would only reflect the portion of the liability that was paid as a cash outflow for financing activities. The difference between the liability and the amount paid is a fair value adjustment. This adjustment enters into the determination of the acquiring entity’s net income and is a noncash item, so it should be reflected as a reconciling item between net income and cash flows from operating activities in the consolidated statement of cash flows.

Example 7-10

On December 1, 20X2, Company A (a calendar-year-end private company) acquires 100 percent of Company B for $1 million. The purchase agreement includes a contingent consideration arrangement under which A agrees to pay additional cash consideration if the earnings of B (which will be operated as a separate subsidiary of A) exceed a specified target for the year ended December 31, 20X3. Company A classifies the contingent consideration arrangement as a liability and records the contingent consideration liability at its acquisition-date fair value amount, provisionally determined to be $500,000.

On April 15, 20X3, A finalizes its valuation of the contingent consideration liability. Therefore, A estimates the acquisition-date fair value of the contingent consideration liability to be $600,000 and records a measurement-period adjustment for $100,000 (the measurement-period adjustment related to facts and circumstances that existed as of the acquisition date), with an offsetting adjustment to goodwill.

Company B achieves the performance target for the year ended December 31, 20X3; accordingly, A determines that it must pay $750,000 to B’s former owners to settle the contingent consideration arrangement. For the year ended December 31, 20X3, A recognizes $150,000 ($750,000 – $600,000) in earnings to reflect the subsequent remeasurement of the contingent consideration liability to fair value. On January 31, 20X4, A settles the obligation.

No payments to settle the liability for contingent consideration were made soon after the business acquisition date.

Company A would present the following amounts in its statement of cash flows for the years ended:

December 31, 20X2 — The provisional accrual of $500,000 would be reflected as a noncash investing activity and would be either disclosed narratively or summarized in a schedule.
December 31, 20X3 — The adjustment to the provisional accrual of $100,000 would be reflected as a noncash investing activity and would be either disclosed narratively or summarized in a schedule. The subsequent remeasurement adjustment to the contingent consideration liability of $150,000 would be reflected as a reconciling item between net income and cash flows from operating activities.
December 31, 20X4 — Of the $750,000 paid, $600,000 represents the amount to settle the contingent consideration liability recognized at fair value as of the acquisition date (including measurement-period adjustments) and should be reflected as a cash outflow for financing activities. The remaining portion of the $750,000 paid (i.e., the $150,000 change in fair value of the contingent consideration liability after the acquisition date) should be reflected as a cash outflow for operating activities because the fair value adjustments were recognized in earnings.

Example 7-11

Assume the same facts as in the example above except that when B achieves the performance target for the year ended December 31, 20X3, A determines that it only needs to pay $550,000 to B’s former owners to settle the contingent consideration arrangement. For the year ended December 31, 20X3, A recognizes a credit of $50,000 ($550,000 – $600,000) in earnings to reflect the subsequent remeasurement of the contingent consideration liability to fair value.

Company A would present the same amounts as those in the example above in its statement of cash flows for the year ended December 31, 20X2. Company A would then present the following amounts for the years ended:

December 31, 20X3 — The adjustment to the provisional accrual of $100,000 would be reflected as a noncash investing activity and would be either disclosed narratively or summarized in a schedule. The subsequent remeasurement adjustment to the contingent consideration liability of $50,000 would be reflected as a reconciling item between net income and cash flows from operating activities.
December 31, 20X4 — The entire amount of the $550,000 paid represents the amount to settle the contingent consideration liability recognized at fair value as of the acquisition date (including measurement-period adjustments) and should be reflected as a cash outflow for financing activities.

7.5.4.2 Contingent Consideration Classified as Equity

If the acquiring entity determines that the contingent consideration arrangement should be classified as equity, it is not required to remeasure the amount recorded as of the acquisition date at fair value as of each reporting period after the acquisition date. The initial recognition of the contingent consideration arrangement as of the acquisition date (including measurement-period adjustments), as well as the issuance of shares to settle the contingent consideration arrangement on the date the contingency is resolved, should be reflected as noncash investing and financing activities and, in accordance with ASC 230-10-50-3, should be either disclosed narratively or summarized in a schedule.

7.5.4.3 Unit-of-Account Considerations

Contingent consideration arrangements in a business combination may contain multiple contingent payment triggers. With respect to the statement of cash flows, neither ASC 230 nor ASC 805 provides explicit guidance on the unit of account, including when multiple payments are specified in a contingent consideration arrangement; that is, neither contains authoritative guidance on whether such payment arrangements should be viewed as a single unit of account or multiple units of account. This determination could also affect whether the arrangement qualifies as equity or a liability (in whole or in part) and, accordingly, the presentation in the statement of cash flows (as discussed in Sections 7.5.4.1 and 7.5.4.2).

Given the lack of on-point guidance in ASC 230 and ASC 805, an entity may need to use significant judgment in determining the unit of account. We believe that for cash flow statement reporting, entities should use the same unit-of-account determination as that used to determine the classification of the contingent consideration arrangement as a liability or equity. This determination is made on the basis of the following definition of a freestanding financial instrument in the ASC master glossary:

A financial instrument that meets either of the following conditions:

It is entered into separately and apart from any of the entity’s other financial instruments or equity transactions.
It is entered into in conjunction with some other transaction and is legally detachable and separately exercisable.

Note that in applying this definition to a contingent consideration arrangement, an entity must use judgment and must consider both the form and substance of the arrangement. The following matters may be relevant to consider:

Whether the counterparty to the arrangement has the ability to transfer its rights and, if so, whether these rights may be transferred in discrete denominations or the entire arrangement must be transferred in totality.
The interdependency of the risks and payment triggers — that is, whether there are shared or independent risks and triggers, which could include whether future triggers (and therefore payments of contingent consideration) may change prior payments in such a way that the acquirer can recover or “claw back” previous amounts paid.

Connecting the Dots

In evaluating the interdependency of the risks and payment triggers, an entity should consider the duration of the measurement period for each contingent payment trigger to determine whether each measurement period represents a substantively discrete reporting period. Given the lack of other authoritative guidance defining what period would comprise a substantive discrete period, entities will need to carefully consider the relevant facts and circumstances. However, we believe that to have discrete periods, and therefore separate units of account, each discrete period needs to consist of a substantive period. For example, we believe that measurement periods of less than three months generally would not be substantive (on a basis consistent with interim reporting periods for an SEC registrant). Measurement periods of one year or more generally would be considered substantive. An entity must use judgment and consider the specific facts and circumstances in determining whether measurement periods between three months and one year are substantive.
Whether there is an economic need or a substantive business purpose for structuring payments of contingent consideration separately. Entities may find the guidance in ASC 815-10-15-8 and 15-9 useful in this evaluation.

Section 5.7.2.1 of Deloitte’s Roadmap Business Combinations provides additional guidance on the unit of account for contingent consideration arrangements and includes numerous examples. Because an entity may need to use significant judgment in determining the unit of account when there is more than one contingent payment trigger in a contingent consideration arrangement, we encourage entities to consider consultation with their accounting and financial advisers.

7.5.5 Acquired IPR&D Assets With No Alternative Future Use

In accordance with ASC 730, IPR&D assets acquired in an asset acquisition rather than in a business combination should be expensed as of the acquisition date unless such assets have an alternative future use, in which case they should be capitalized. All IPR&D assets acquired in a business combination should initially be capitalized regardless of whether they have an alternative future use. For more information, see Chapter 4 of Deloitte’s Life Sciences Industry Accounting Guide.

We have observed diversity in practice related to how up-front and subsequent milestone cash payments made for IPR&D assets acquired in an asset acquisition are reported in the statement of cash flows when such payments are expensed and the IPR&D does not have an alternative future use. While some entities classify the cash payments in operating activities, other entities classify them in investing activities. Given the lack of authoritative guidance on this matter and the diversity in practice, we believe that it is acceptable for an entity to present cash payments related to the IPR&D assets acquired in an asset acquisition that have no alternative use as either operating or investing activities. This election is an accounting policy matter that an entity should consistently apply to similar arrangements and disclose if material.

Considerations related to the classification as operating or investing activities include:

Operating activities — Classification in operating activities of cash outflows for IPR&D assets acquired in an asset acquisition that do not have an alternative future use is supported by the following:
- ASC 230 does not specifically define such cash outflows as investing or financing activities.
- Since such cash outflows are immediately expensed, they represent “the cash effects of transactions and other events that enter into the determination of net income” in a manner consistent with the definition of operating activities in the ASC master glossary.
Investing activities — Classification in investing activities of cash outflows for IPR&D assets acquired in an asset acquisition that do not have an alternative future use is supported by the following Q&A in paragraph 5.12 of the AICPA Accounting and Valuation Guide Assets Acquired to Be Used in Research and Development Activities:
Question 1: How should an acquiring entity classify in its statement of cash flows an R&D charge associated with the costs of IPR&D projects acquired as part of an asset acquisition that have no alternative future use?
Answer: Best practices suggest that an acquiring entity should report its cash acquisition of assets to be used in R&D activities as an investing outflow in its statement of cash flows. In this regard, an acquiring entity should treat assets acquired to be used in R&D activities similar to how it reports other acquired assets in the statement of cash flows. Although acquired IPR&D may lack an alternative future use and, therefore, would be expensed immediately, it is still an asset for cash flow statement purposes.
When arriving at cash flows from operating activities under the indirect method of reporting cash flows, best practices suggest that an acquiring entity should add back to net income the costs of assets acquired to be used in R&D activities that are charged to expense. That adjustment is necessary to eliminate from operating cash flows those cash outflows of assets acquired to be used in R&D activities that are reflected in investing activities.

In addition, if the cash outflows are treated as investing activities, the cash flow reporting of IPR&D assets acquired in a business combination would be aligned with that of IPR&D assets acquired in an asset acquisition.

7.5.6 Break-Up Fees Resulting From a Failed Business Combination

In a merger or other business combination, a terminating party may be required to pay a “break-up” fee or termination payment to the other party involved in the transaction. While ASC 230 does not address the classification of break-up or termination payments, we believe that the guidance in ASC 230-10-45-17(f) applies in such circumstances. ASC 230-10-45-17(f) states that cash outflows for operating activities include “[a]ll other cash payments that do not stem from transactions defined as investing or financing activities, such as payments to settle lawsuits, cash contributions to charities, and cash refunds to customers.” As a result, amounts paid or received in connection with a failed merger or business combination would be classified as operating cash flows.

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