- New Accounting Rules Affect Business Combinations
- September 28, 2008 | Authors: James J. Gatziolis; Anneke A. Diem
- Law Firm: Quarles & Brady LLP - Chicago Office
On December 4, 2007, the Financial Accounting Standards Board (FASB) issued a revised version of Financial Accounting Standard No. 141 (“FAS 141(R)”), which addresses accounting for business combinations. The FASB issued the revised statement in an attempt to improve the representativeness and comparability of financial reports related to business combinations. FAS 141(R) implements a move toward fair value accounting in connection with business combinations, which in practice makes the financial records of an acquirer more reflective of the value of the business it acquired. For purposes of this update, “fair value” means an estimate of the potential market price of an asset or liability of an entity. The following is a summary of a few of the key changes in accounting practices resulting from the issuance of FAS 141(R).
Application of FAS 141(R)
FAS 141(R) applies to all transactions or events in which an entity obtains control of one or more businesses through a merger, consolidation, step acquisition or a combination resulting from contract. Specifically excepted from the rule are transactions involving the creation of a joint venture and transactions involving the combination of entities under common control, among others. FAS 141(R) applies prospectively to business combinations with an acquisition date (the date on which the acquiring entity obtains control of the target) occurring in fiscal years beginning on or after December 15, 2008. Entities may not elect to be governed by FAS 141(R) prior to this time period.
Accounting for Transaction Costs
Historically, the costs of an acquisition — such as legal, consulting, banking and other professional fees related to an acquisition — were treated as part of the purchase price of the transaction. In practice this translated into the Buyer writing-up the value of the assets it acquired from a Seller on its balance sheet in order to take these expenses into account. As a result, the book value of the assets acquired by the Buyer contained certain non-business-related expenses and therefore may not have been reflective of the true value of those assets or of the value of the business acquired.
FAS 141(R) abandons this approach and instead provides that the assets and liabilities acquired by the Buyer must be recorded at their fair value as of the acquisition date, and transaction-related costs must be expensed by the Buyer during the period in which they are incurred, with certain exceptions. By eliminating a Buyer’s ability to capitalize transaction costs, FAS 141(R) arguably causes the financial statements of a Buyer to more accurately reflect the actual value of the business acquired. One significant implication of this change is that, in the past, given that transaction costs were treated as part of the purchase price, a Buyer did not realize these expenses until the transaction had been consummated. Now, however, with FAS 141(R), a Buyer must recognize these costs as incurred, and as a result a Buyer’s earnings will likely be reduced during and after any period in which an acquisition is pursued.
Accounting for Contingent Consideration
In connection with an acquisition, the Buyer and Seller often negotiate provisions in the purchase agreement that allow for future payments based upon the occurrence of certain events. This is often referred to as “contingent consideration” and is commonly in the form of an “Earnout,” whereby payments to the Seller are contingent upon changes in the Seller’s stock price over a period of time, the value of the gross profits of the Seller for a given period of time or some other measure. Typically, such contingent consideration (generally classified as an asset to the Seller or as a liability to the Buyer) was not recognized until the contingency was actually resolved or paid out. Once the contingency was resolved, it was treated as an adjustment to the purchase price such that, on the date upon which the contingent consideration was actually paid by the Buyer, the Buyer would alter the value of the assets acquired from the Seller on its balance sheet to take into account the value of the contingency.
With the advent of FAS 141(R), contingent consideration must be measured and recorded at fair value as of the acquisition date. In practice, this means that a Buyer will have to make an estimate as to the amount of consideration it will be liable for when the contingency is resolved in the future. After the Buyer makes this initial estimate, it will then be required to re-measure the fair value of the contingency at each reporting date until the contingency is resolved. Any changes in the fair value of the contingency must be either credited or charged, as applicable, to its earnings during the period in which such change occurred, and the value of the contingency must be adjusted accordingly. If, however, the contingency is in the form of an equity interest, the Buyer will not be permitted to make any subsequent measurements of the value of the contingent consideration, and the resolution of the contingency will be reflected in the equity of the Buyer rather than its earnings.
The rationale behind this change in accounting practices is that, even though contingent consideration is often not paid out until some future date, the Buyer incurs an obligation related to the acquisition as of the acquisition date, and therefore that obligation should be accounted for as it is incurred.
Accounting for Bargain Purchases
A “bargain purchase” is one in which the fair value of the assets of the business acquired by the Buyer as of the acquisition date exceeds the fair value of the consideration paid by the Buyer. In other words, a bargain purchase occurs when the Buyer pays less than what the assets of the Seller are actually worth. The amount by which the fair value of the assets exceed the consideration paid by the Buyer is often referred to as “negative goodwill,” and historically the Buyer was required to reduce the value of the assets acquired on its balance sheet on a pro-rata basis in an amount equal to such negative goodwill. In effect, this meant that the assets acquired by the Buyer in a bargain purchase were recorded on the Buyer’s balance sheet at the value for which they were actually purchased. Under FAS 141(R), however, the Buyer must record the assets acquired on its balance sheet at their fair values regardless of the amount paid for such assets and must recognize the excess of the fair value of the assets over the consideration transferred in its earnings as an extraordinary gain during the period in which it acquired the assets.
In summary, FAS 141(R) implements significant changes to accounting practices related to business combinations. This update discusses significant aspects of FAS 141(R) but is not a comprehensive analysis of the new accounting practices.