Highlights of CCH Seminar: FAS 141(R) Business Combinations
What is the purpose of FAS 141(R)?
While the Financial Accounting Standards Board and the International Accounting Standards Board are closely aligned, there is still some adjustment needed to create "global harmonization." FAS 141(R) adds details to the purchase method of accounting for business combinations, designed to ensure that financial statements reflect more useful information including accurate predictors of future cash flows.
What did not change with FAS 141(R)?
- All business combinations are required to be accounted for as acquisitions.
- Each acquisition will name an "acquirer."
- Intangible assets will be accounted for as separate from goodwill. The amount allocated to goodwill needs to be for the entire entity, not just the parent, on the measurement date.
What did change with FAS 141(R)?
- The most significant change is the requirement to use the acquisition method of accounting for business combinations.
- Under the new rules, more transactions will qualify as business combinations.
- "Step acquisition" is no longer allowed for non-controlling interests.
- Value is measured on the full acquisition date, even for non-controlling interests and step acquisitions.
Key definitions clarified by FAS 141(R)
Total value is the consideration transferred, fair value of the equity interest previously acquired, and the fair value of the non-controlling interest.
Goodwill is the excess of total value over the fair value of identifiable assets acquired and liabilities assumed. Excess value is "negative goodwill," and results in a credit to gain by the acquirer.
Business is defined in details in FAS 141(R) as an integrated set of assets and activities capable of being conducted and managed for the purpose of providing return in the form of dividends, lower costs, increased share prices, or other economic benefits to investors, owners, or participants. The key wording there is "capable of," since profit may not happen. A business has inputs and processes with the ability to produce outputs. Admin systems, such as payroll, that do not produce outputs do not meet the definition of business. Other considerations, if there are assets that can be conducted and managed, and if there is goodwill, chances are, the entity qualifies as a business.
Excluded from the definition of a business is, the admin processes listed above, a joint venture combining entities under common control, acquisition of assets not used for business, and post-combination acquisitions of non-controlling interests.
Business combination, is “a transaction or other event in which an acquiring entity obtains control of one or more businesses” – which includes mergers of equals
The Acquisition Method
Using the acquisition method, more transactions will qualify as business combinations. This is true because it recognizes that purchase is not the only way that control can be obtained. For example, control can be gained by the expiration of a minority interest. In the case of a variable interest entity, control is assumed for the primary beneficiary. VIEs require special measurement principles.
The acquisition method includes four steps.
1. Identify the acquirer. The acquirer is generally assumed to be the entity that gives up consideration and gains control.
2. Determine the acquisition date. This may be the closing date that the assets and liabilities are assumed, or another date, such as the date consideration is transferred. The accompanying revenues and expenses are captured on that date, not before, and the fair value of the assets are determined on the acquisition date, not the offer date.
3. Measure the fair value of the acquired entity. This may be one of the most significant changes of FAS 141(R). The best method for measuring fair value of the acquired is the amount of consideration given on the acquisition date.
4. Measure the fair value of any non-controlling interest in the acquired that is held by the acquirer immediately before the acquisition date.
The Measurement Period
The measurement period allows for retrospective adjustment of the business combination for one year from the acquisition date, or when all necessary information for the adjustment is available. After the measurement period, there is no revision allowed for subsequent information that is unrelated to the facts and circumstances existing at the time of the acquisition, except for error correction.
What Qualifies as Consideration?
Combination costs need to be counted separately in order to determine consideration. Only the amount transferred to the acquiree, as well as the assets acquired and the liabilities assumed or incurred, are consideration.
The direct costs of completing the business combination are no longer capitalized. Instead, they are expensed as they are incurred. As for debt and equity issue costs, normal GAAP rules apply. This change could have a major impact on near-term income for those planning to consolidate.
Business combination costs do not include the cost of employing the former owner (these must be expensed). If you retain the former owner as a consultant, that fee is generally part of the consideration rather than compensation (though it depends to some degree on whether there was a pre-existing relationship with the former owner. The settlement of a pre-existing relationship as part of a business combination must be accounted for independently from the business combination).
Basic Recognition Principles
The acquirer must recognize assets acquired and liabilities assumed as part of a business combination (if the definitions of assets and liabilities are met) as well as non-controlling interests, at their fair value on the date of acquisition.
The fair value is not determined by the intended use by the acquirer, but by the highest and best use of the person having an interest in the asset. This is true for the initial recognition of value as well as for subsequent impairment testing. Example: One of the assets purchased in a business combination is a sign, which you do not intend to use. Your intention has no effect on the value of the sign.
Contingencies of the Acquiring Company
Virtually all business combinations include some contingencies that may or may not require special treatment.
- Acquirers must record contractual contingent assets and liabilities at their estimated fair values.
- Contingencies that are not contractual must be recorded if it is more likely than not that an asset or liability exists, according to the elements defined in Concepts Statement No. 6, Elements of Financial Statements.
- Contingent values that are recognized must be conservatively remeasured until their contingent status is resolved. Contingent assets should be revalued at the lower of their original or later value, and liabilities should be revalued at the higher of their original or later value when recalculated (in both cases, based on FAS 5).
- Derecognition of a contingency is only to occur after resolution, such as when the asset is sold or the right to use it is lost, or when a contingent amount is collected, a liability is settled or there is no longer an obligation to settle it.
- When recognition of contingencies occurs, it must be at fair value on the acquisition date.
- Retrospective adjustments to contingent values are permitted within the one year measurement period.
CCH calls the new treatment of contingencies a "bombshell change," since under the old method, contingencies and contingent consideration frequently escaped initial measurement and would later result in changes to goodwill that had previously been recorded.
Asset Valuation Points
- Long-lived assets that are held for sale are to be valued at fair value, less cost to sell them.
- Accounts receivable are valued at fair value, not full value minus an allowance. Since fair value usually includes an implicit allowance for uncollectability, this could represent a significant change for companies that buy substantial receivables.
- However, deferred taxes, which will not be measured at fair value may involve an allowance.
Employee Benefits of the Acquiree
Most employee benefits are not affected by a business combination, which the exception of defined benefit pension plans. Otherwise, the existing GAAP rules apply.
For defined benefit plans (single employer) the acquirer must recognize the asset or liability for the funded status of the plan.
For a multi-employer plan, if it's possible for the acquirer to withdraw from the plan, a withdrawal liability needs to be recorded. The acquirer needs to disclose when a different set of assumptions is used, such as a different interest rate. The applicable closing date is the date of acquisition.
Tax Deductible Goodwill
This is a calculation which CCH admits can be confusing. If tax deductible goodwill exceeds accounting goodwill, there is a temporary difference that requires recording of an adjustment.
Example given by CCH:
- Tax-deductible goodwill – book goodwill (before adjustment below)
– Deferred income tax asset
- (Tax rate ÷ (1 – tax rate)) X preliminary temporary
– Goodwill recognized for financial reporting
- Book goodwill (before adjustment ) – Deferred income tax adjustment (above)
CCH provides this simple numerical example:
Assume goodwill is the only asset and is valued at $70.
Debit goodwill $70
Credit Cash $70
In examining the goodwill, you discover that the tax basis is $100, which gives you $30 temporary difference. You must book a deferred income tax asset.
Assume a tax rate of 40 percent.
The adjustment is: the tax rate divided by one minus the tax rate, and the result is multiplied by the temporary difference.
40/60 x $30 = $20
To record the adjustment
Debit Deferred income tax asset $20
Debit Goodwill $50
Credit cash $70
Changes in Acquiree’s Deferred Income Tax Valuation
If new information about facts and circumstances at the measurement date changes the value of goodwill, goodwill needs to be adjusted. If goodwill is reduced to zero, a gain results.
Other adjustments of the acquiree's deferred income tax valuation are taken into income.
If an indemnified liability is not more likely than not to materialize, you can ignore it. Otherwise, you must record the liability and related indemnified assets. Record the pending claim along with the asset for indemnification, taking into account the collectability of the asset
Operating leases. Depending on whether the terms of the lease were favorable or unfavorable compared to the market, the acquirer will need to recognize an intangible asset or a liability.
The intangible asset or liability is recorded separate from the recording of the fair value of the leased asset.
Capital leases. The acquirer, who becomes the lessee, must record the asset at fair value and the lease obligation at fair value (the components are decoupled and recorded separately).
In Process Research and Development
This is perhaps the biggest change in FAS 141(R). Previously, purchasers of in-process R&D were expected to assign values to these assets and then immediately expense them. This was determined to result in an inaccurate picture of assets and income.
Now in-process R&D will be classified as an intangible asset with an indefinite life until the project is complete or the R&D is abandoned. Subsequent expenditures will not be capitalized. And the recorded assets won't be written off or capitalized, but instead will be subject to impairment testing.
The expected result of this important change is more accurate, less questionable losses, and balance sheets that better reflect the true assets.
If the acquirer expects but is not obligated to pay restructuring costs, those costs are not considered part of the business combination. Instead costs are accounted for as incurred and no adjustment to the acquisition cost is necessary.
Acquisition Date Value
To determine the fair value on the acquisition date, add
- the value transferred on the acquisition date
- the fair value of equity already held on the acquisition date
- and the fair value of the remaining interest on the acquisition date
Valuing Non-controlling Interests
The value to be assigned to NCI is fair value, including goodwill, taking into consideration minority discounts and control premiums. Because of these, the NCI per share may be different than the per share value of the controlling interest. In other words, it may cost more per share to control than to just own.
Subsequent changes in NCI share are not recorded as gains or losses, because they are now considered equity transactions.
NCI shares are recorded as equity, and the value of NCI share of income should be subtracted from net income and identified on the income statements.
Valuing Transferred Consideration
--The acquirer must recognize a gain or loss when the value on the acquisition date and the carrying value of assets transferred and liabilities assumed differ.
Date of Measurement, Gains and Losses
The fair value on the acquisition date includes the fair value of contingent consideration given... which could be an asset or a liability. On subsequent reporting dates, assets other than cash that are contingencies will need to be remeasured, marking them to fair value with an earnings adjustment. Contingent equity does not need to be remeasured.
The acquirer must disclose any information that helps the users of the financial statements evaluate the effect that a business combination has on the current reporting period or after the reporting date but before the financial statement date.
The acquirer must also disclose any information that assists the financial statement users in evaluating the effects of adjustments recognized in the reporting period, relating to the business combination that took place in the current or previous reporting period.
The Overall Impact of FAS 141(R)
More assets and liabilities will be reported at fair value, so it will be easier for a buyer to determine when an acquisition is sound. Increased accuracy of measurement and more inclusive reporting should help reduce the number of unprofitable transactions.
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