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Good morning. Today I would like to share my thoughts on two subjects: the use of a NEWCO to effect a business combination, and bowling.
I'll begin with bowling and get right to the point. I do not believe that bowling is a sport. Nothing personal against bowlers; I've bowled a few times myself and admit I enjoyed it. Great game - yes; sport - no.
Back in college, some drinking buddies and I spent hours at the local sports bar watching football, baseball and basketball. These were the sports we loved. These were real sports. A time would come each year, however, when our favorite teams packed it up for the season. Into their places on ESPN would emerge the D-listers of the sports world, such as billiards, the world's strongest man and most annoying of all: bowling.
Unemployed twenty-two year old men do not normally wax philosophical, but having found a cause we cared about we set out to divine the true meaning of sport. One of us thought we should look to Merriam Webster, which defines sport as "an activity where something is tossed or driven about in or as if in play." Congratulations, bowling; better luck next time marathon. Another proposed his own test: in order for something to be a true sport, the outcome had to be objectively measurable. Congratulations again bowling; but too bad for gymnastics. Because I was determined to exclude bowling, when my turn came I decided to get creative. Only those activities that were official Olympic events could be considered true sports, but for obvious reasons we'd make a special scope exception for football. Being a Texan, I also would have liked to have made exceptions for bull-riding and NASCAR, but I did not want to risk damaging my theory's already shaky façade of legitimacy. Besides, sometimes you just have to make your best cut.
Perhaps I'll come back to bowling later, but I'd now like to offer my perspective on the related topic of whether and under what circumstances a newly-formed entity (or NEWCO) should be considered the accounting acquirer in a business combination. New basis is not a new topic at this conference, but one that I feel is worth revisiting in light of the new standards on business combinations and non-controlling interests.1
Let me provide some context for those who may not be as familiar with this issue. As we go, ask yourself three questions. First, has there been a business combination? Second, at what level has the business combination occurred? Finally, who is the accounting acquirer?
In the first example, Entity C issues new shares to Entity A in exchange for cash and then uses that cash to buy back shares from Entity B. From Entity A's perspective, a business combination has occurred. Entity A is (ordinarily) the accounting acquirer and Entity C the accounting acquiree. In its consolidated financial statements, Entity A will recognize and measure 100% of Entity C's assets and liabilities pursuant to the acquisition method.
What about Entity C's separate financial statements? From Entity C's perspective, there has been no business combination for which it is the accounting acquirer.2 Entity C accounts for the issuance and repurchase of shares as equity transactions. This is what most people would refer to as a recapitalization, although that term is not defined in GAAP.
In the next example, Entity A forms a new wholly-owned subsidiary to which it contributes cash. This NEWCO then merges with and into Entity C with Entity C surviving.3
There are probably a dozen other ways to structure the same transaction, but they all share something in common: the outcome is economically the same. I think most of us also would agree that a business combination has taken place at some level. The real question, and one with which practice has wrestled with for decades, is whether and when a NEWCO should be considered the accounting acquirer.
Codification Topic 805 deals with business combinations and provides some relevant guidance on how to evaluate a NEWCO.
"A new entity formed to effect a business combination is not necessarily the acquirer. If a new entity is formed to issue equity interests to effect a business combination, one of the combining entities that existed before the business combination shall be identified as the acquirer by applying the guidance in paragraphs 805-10-55-10 through 55-14. In contrast, a new entity that transfers cash or other assets or incurs liabilities as consideration may be the acquirer." [Codification 805-10-55-15]
Some interpret this last sentence to mean that a NEWCO that does something other than issue equity must always be evaluated along with all other combining entities to determine which one is the accounting acquirer. Others believe that the phrase "may be the acquirer" implies that the NEWCO must have substance. The latter look to various factors when determining substance, including but not limited to: (a) whether the NEWCO survives the transaction; (b) the pre-combination activities of the NEWCO; (c) who created the NEWCO; (d) the age of the NEWCO (or said another way - when does a NEWCO become an OLDCO); and (e) whether the elements of the transaction are integrated or are preconditioned upon each other. While these are some of the factors one might reasonably consider, I do have a few observations.
U.S. GAAP does not expressly address how to determine whether a NEWCO used to effect a business combination has substance. Many of the factors I just mentioned were borrowed from accounting standards that for most entities have been superseded.4 Others have evolved over many years in response to what practice perceives the Staff's views to be based on interpretations of speeches, informal discussions with individual staff and experiences interacting with the Staff on specific registrant matters. Absent a common standard, though, the reality is that two reasonable people could have very different notions about whether a NEWCO has substance, just as when I look at bowling, I see a great game but not a sport (I am sure others feel differently).
In many ways, trying to apply the concept of substance to a NEWCO makes me feel like I am back on that barstool debating whether bowling is a sport. That is because, good intentions aside, I have noticed that many of us, preparers, auditors and yes - even regulators, are at times willing to overlook form in favor of substance if the outcome suits our notions of what each believes represents better financial reporting. Recently, the bias amongst some preparers has been to avoid new basis whenever possible. These preparers generally prefer "recap" accounting because it avoids the revaluation of assets and generally results in higher earnings-based valuations. But people's motivations can and do change.5 In an environment of declining asset values, someone who previously avoided new basis might embrace it. If that were case, I wonder whether for the rest of us our well-intentioned substance-based arguments might lose some of their luster. I learned that lesson when curling was added to the Olympic roster in 1998. Seriously, curling is even less a sport than bowling; clearly my theory of sport was beginning to show cracks.
Back to the subject of bowling, have you ever wondered why in most places each frame of bowling consists of ten pins? Why not 11 or 12 pins? It turns out that we actually used to bowl with nine pins. Apparently, we also used to gamble a bit too much on the game because a number of cities and states - including Connecticut in 1841 - outlawed nine-pin bowling. And so bowlers did what any reasonable person would do - they started bowling with ten pins.6 For me, debating whether bowling with nine pins is substantively different than bowling with ten pins is pointless. In bowling, as in accounting, form sometimes does matter.
In terms of sorting out when substance should override form, I am afraid I just don't have the answers. The best I can do in the absence of standard-setting is encourage registrants and their auditors to continue to apply reasonable judgment and to emphasize that, as with all Staff speeches, my comments represent only my personal perspective.
Perhaps I can do one more thing. Since joining the Commission, I've been amazed by some of the mythology surrounding NEWCOs that is attributed - or more often than not misattributed - to the Staff. Since one of my guilty pleasures is to read the newspaper advice columns, I thought it would be fun to imagine what it might be like if Abigail Van Buren was answering registrant questions on new basis.
Dear SEC Staff:
I am the controller of a company that plans to sell one of its divisions. We'd like to do this by first forming a NEWCO, but neither we nor the buyers want new basis. How long does the NEWCO have to exist prior to the transaction in order for it not to be considered the accounting acquirer? I've heard that the Staff believes the cut-off is two months. However, my CFO "Dave" says he heard someone at a conference say the cut-off is a year. Why can't the Staff just be consistent? Please help, this debate is driving a wedge between us.
Sincerely,
Frustrated in Fargo
Dear Frustrated in Fargo:
I am so sorry that your structuring efforts are proving frustrating. We try to be consistent, but NEWCOs simply mature much more slowly than they used to. Some might say that NEWCOs are like fine wine in that they usually improve with age.
While the Staff has no bright line for determining when a NEWCO changes from being "new" to being "old and cold", perhaps a better question to ask is why this should even matter. To get you started, I suggest researching why we bowl with ten pins instead of nine.
Dear SEC Staff:
Our auditor is telling us the OCA Staff believes that a surviving NEWCO that does anything other than issue equity will always be the accounting acquirer in a business combination. I don't see that anywhere in the codification, so what gives?
Looking forward to your response,
Angry in Atlanta
Dear Angry in Atlanta:
Please do not be angry, either with us or your auditor. Anger is unhealthy and counterproductive.
For your information, the OCA Staff never speaks about accounting issues in terms of absolutes in speeches without regard to specific facts. So perhaps you misunderstood your auditor. Just so that we are clear, the Staff does not believe that a surviving NEWCO will always be the accounting acquirer in all circumstances. You will need to evaluate all applicable criteria in the Codification's Business Combinations Topic in light of specific facts to make this determination.7
Dear SEC Staff:
I read in some accounting firm publication that the SEC Staff "generally dislikes recap accounting". Is this true, and if so what does that mean?
Yours truly,
Confused in Connecticut
Dear Confused in Connecticut:
Whether I personally agree or disagree with some aspect of a particular accounting standard, I try my best to apply GAAP based on what I believe GAAP requires or permits, not based on whether I like or dislike the outcome in a particular circumstance. So while I do have views on when new basis makes sense, I won't presume to impose them on you.
I will offer this advice: be wary of sweeping generalizations.
* * *
Two thoughts in closing. I imagine that there are some folks out there who do not agree with me (probably the bowling contingent); I'm fine with that - robust debate is a good thing. Others, though, will attempt to divine some secret meaning from my speech. Please don't. Those who know me well also know my very strong view that speeches are not the place to make GAAP.
Finally, my theory of sport took yet another blow when someone recently reminded me that baseball was just cut from the Olympic roster this summer. Obviously, some serious introspection is order; who knows, conceding that bowling is a sport may not be so bad after all.
1 New basis accounting generally is understood to mean a specific transaction or other event that results in a reporting entity re-measuring the carrying amounts of all assets and liabilities, and in some cases recognizing additional assets and liabilities for the first time. New basis events are distinguished from recurring re-measurements (e.g., AFS securities) and non-recurring re-measurements that affect only certain assets or liabilities (e.g., goodwill impairments). New basis itself is not a "fair value" concept although existing standards on new basis require many assets and liabilities to be measured at fair value. In addition to business combinations, other new basis events include fresh start accounting [ASC 852-10, Reorganizations - Overall] and quasi-reorganizations [ASC 852-20, Quasi-Reorganizations].
2 If Entity C were a public company, one would have to consider whether push down accounting was appropriate; that is, whether Entity A's basis in Entity C's individual assets and liabilities should be reflected in Entity C's separate financial statements [ASC 805-50-S99-1 (SAB Topic 5.J), Push Down Basis of Accounting Required in Certain Limited Circumstances; and ASC 805-50-S99-2, SEC Staff Announcement: Push-Down Accounting]. Because the transaction did not result in Entity C becoming substantially wholly-owned, push down is neither permitted nor required.
3 There are several possible reasons why Entity A might use a NEWCO, including squeezing out minority shareholders, compliance with state laws and limiting potential shareholder liability. For these reasons, as a practical matter certain deals simply cannot get done without the use of a NEWCO.
4 For example, see EITF Issue No. 88-16, Basis in Leveraged Buyout Transactions, EITF Issue No. 90-13, Accounting for Simultaneous Common Control Mergers and FTB No. 85-5, Issues Relating to Accounting for Business Combinations.
5 During the heyday of leveraged buy-outs in the 1980s, many preparers considered "new basis" a good thing because it generally resulted in higher net asset values, higher capital and a correspondingly higher capacity for debt. Ironically, many auditors, regulators and even standard setters at the time sought to limit the application of new basis, in part because they were not comfortable with fair value measurements.
6 Nine-pin bowling (also known as ninepin bowling, nine-pins, and 9-pins) is still popular in parts of rural Texas and Europe, particular Germany where there are over 90,000 members on teams. The "bowling ball" is smaller and lighter than in ten-pin bowling, and may have two or no finger holes. Being smaller, the ball will actually roll, rather than slide, down most of the lane distance, which is shorter than that in ten-pin bowling (excerpted from Wikipedia; see http://en.wikipedia.org/wiki/Nine-pin_bowling).
7 See Paragraphs 805-10-25-5 and 805-10-55-10 through 805-10-55-15 of the Codification.