International Convergence: The Case of Accounting for Business Combinations
Dorata, Nina T
On June 30, 2005, FASB and the International Accounting Standards Board (IASB) each issued exposure drafts dealing with both business combinations and consolidation procedures. FASB’s exposure drafts included “Business Combinations” and “Consolidated Financial Statements, Including Accounting and Reporting of Noncontrolling Interests in Subsidiaries.” The lASB’s related exposure drafts included proposed amendments to International Financial Reporting Standard (IFRS) 3, Business Combinations; proposed amendments to International Accounting Standard (IAS) 27, Consolidated and Separate Financial Statements; and proposed amendments to IAS 37, Provisions, Contingent Liabilities and Contingent Assets, and IAS 19, Employee Benefits.
The FASB and IASB exposure drafts on business combinations were developed jointly, and contain virtually the same accounting concepts. They represent a major joint convergence project between these two boards. The objectives of this project are twofold: to provide a single high-quality standard for accounting for business combinations that could be used for both domestic and international financial reporting; and to promote the international convergence of accounting standards.
Working Toward Convergence
The jointly developed standards for business combinations were a product of two phases. During the first phase, FASB and the IASB separately deliberated the issue of accounting for business combinations. FASB concluded the first phase in June 2001 by issuing SFAS 141, Business Combinations, and SFAS 142, Goodwill and Other Intangible Assets. The IASB concluded its first phase in March 2004 by issuing IFRS 3, Business Combinations. In these standards, both boards required the use of the purchase method as the single method of accounting for business combinations.
During the second phase, FASB and the IASB simultaneously addressed the guidance for applying the acquisition method, and decided to conduct this phase as a joint effort with the objective of reaching the same conclusions and similar standards for accounting for business combinations. Accordingly, the joint standards replace the existing requirements of SFAS 141 and IFRS 3. Furthermore, FASB requires simultaneous adoption of SFAS 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment of Accounting Research Bulletin (ARB) 51, Consolidated Financial Statements, issued in August 1959.
FASB and the IASB believe that the new standards will help users and preparers by improving the comparability and transparency of financial information reported by companies that engage in business combinations and issue consolidated financial statements in accordance with either U.S. GAAP or the IFRS.
The revised standards for business combinations retain the fundamental requirement of SFAS 141 and of IFRS 3, which is to account for all business combinations using a single method (acquisition), where one party (the acquirer) is always identified as acquiring the other entity (the acquiree). However, the revised standards include procedures that drastically alter previous guidance, including considerably altering immediate and future charges to the income statement in connection with business combinations. The following discusses the revisions to accounting procedures and financial statement presentations for business combinations. The Exhibit presents the highlights of the revised standards and disclosures.
Acquisition Method, Goodwill, and Noncontrolling Interest
The guidance in SFAS 141(R) applies to transactions in which an acquirer obtains control of one or more businesses. Business combinations must be accounted for using the acquisition method, where the acquirer measures and recognizes the acquiree as a whole, and the assets acquired and liabilities assumed (including all identifiable contingent assets and liabilities) are recognized at their fair values as of the acquisition date. The acquisition date is the date the acquirer obtains control of the acquired business (the closing date). No longer may an acquirer designate an effective date of the business combination to the beginning of the period and avoid the presentation of preacquisition earnings of the acquiree.
The fair value as a whole is measured as the aggregate of: 1) the fair value of the consideration transferred; 2) the fair value of any noncontrolling interest in the acquiree; and 3) the fair value of the acquirer’s previously held equity interest in the acquiree. Excluded from the fair value measurement are assets held for sale, deferred taxes, indemnification assets, employee benefit plans, reacquired rights, share-based payment awards, and goodwill. For business combinations where control is achieved in stages, any previously held equity interest must be remeasured to fair value as of the acquisition date; together with any prior periods’ other comprehensive income, any resulting gains or losses are included in earnings.
Goodwill is still an unidentifiable residual value but is computed as the excess of the fair value of the acquiree as a whole over the fair value of the identifiable net assets acquired. The goodwill measurement differs from the measurement prescribed by the purchase method, in which goodwill equals the difference between the cost of acquisition and the acquirer’s share of the fair values of the identifiable net assets acquired. Any negative goodwill created in a bargain purchase must be recognized as a gain in income from continuing operations following a reassessment of fair value measurements used in the computation.
SFAS 141(R) requires the use of provisional amounts for the acquisition if the accounting is incomplete by the end of the reporting period. During the measurement period, the acquirer may retrospectively adjust provisional amounts previously reported. The measurement period may not exceed one year from the acquisition date. Any revisions to the acquisition accounting beyond the measurement period require an adjustment to retained earnings in accordance with SFAS 154, Accounting Changes and Error Corrections.
Although FASB and the IASB did not jointly write the exposure drafts on accounting for noncontrolling interests, their respective exposure drafts propose similar guidance. Specifically, SFAS 160 requires the presentation of a noncontrolling interest within equity, separately from the parent’s shareholders’ equity. IAS 27 already requires presentation of a noncontrolling interest in equity. The boards did not, however, achieve convergence with regard to the measurement of noncontrolling interests. FASB requires measurement of a noncontrolling interest at fair value; the IASB permits measurement at either fair value or book value of net assets acquired.
SFAS 141(R) requires business combinations that were exempt from SFAS 141 (e.g., cooperatives and mutual entities) to use the acquisition method. Moreover, valuation specialists may need to be more involved in order to measure the fair value of an acquiree as a whole in a partial acquisition that qualifies as a business combination. When including the portion attributable to a noncontrolling interest, the recognition of full goodwill may result in larger amounts of goodwill that will be subject to annual impairment testing.
Accounting for Acquisition Transaction and Restructuring Costs
SFAS 141 required that the purchase price include direct acquisition transaction costs, such as payments made by the acquirer to third parties for legal and consulting fees, banking fees, accounting fees, and fees for valuation services. SFAS 141(R) requires that transaction costs be accounted for separately from the business combination, because they do not represent assets acquired and liabilities assumed. Accordingly, these costs are expensed as incurred rather than capitalized as part of the business combination cost.
Excluded from the acquisition accounting are costs the acquirer incurs to achieve synergies through exiting acquiree activities or through relocation or termination of acquiree employees. The acquirer accounts for restructuring costs using the guidance of SFAS 146, Accounting for Costs Associated with Exit or Disposal Activities, which requires expense treatment. Collectively, the guidance for acquisition-related costs incurred not only in the year of the business combination but also in subsequent years will improve transparency of the transactions at a cost of lower and more volatile earnings.
Accounting for Contingencies
A controversial aspect of SFAS 141(R) is its treatment of contingent assets and liabilities. Contingencies are identifiable assets acquired or liabilities assumed whose ultimate benefit or settlement is contingent or conditional on the outcome of some future event. Contractual contingencies are recognized at the acquisition date, separately from goodwill, and at fair value. The acquirer must use the “more likely than not” criterion found in Statement of Financial Concepts 6, Elements of Financial Statements, to recognize noncontractual contingencies as part of the acquisition. Otherwise, noncontractual contingencies that do not meet the “more likely than not” criterion follow the guidance of SFAS 5, Accounting for Contingencies.
The inherent difficulty in measuring the fair value of contingent assets and liabilities is the quality and availability of information as of the acquisition date. The fair value estimate of contingent assets and liabilities will be based on certain assumptions, such as the probability of payment, and will likely require significant input from external parties, such as environmental experts or attorneys. In periods subsequent to the business combination, contingent assets will be measured at the lower of their fair value at the acquisition date or their estimated realizable amount. For contingent liabilities, SFAS 141(R) requires use of the higher of their fair value at the acquisition date or their amount determined under existing guidance for liability measurement. Any resulting gains or losses from changes in the fair value of contingent assets and liabilities are classified as a component of income from continuing operations.
Contingent consideration is an obligation of the acquirer to transfer assets or equity interests to former owners if future events occur or certain conditions are met. A significant challenge that acquirers may face is how to measure, on the acquisition date, the fair value of contingent liabilities associated with earnout arrangements. Earnouts typically include payments to acquiree shareholders that are contingent upon the achievement of financial or other performance goals following the closing date of the business combination. Earnout arrangements under SFAS 141(R) require specific measurement on the acquisition date. This measurement may create unintended consequences of future performance, particularly with regard to managing the acquirer’s risk and retaining key target firm managers.
SFAS 141(R) requires that changes in the fair value of contingent considerations resulting from additional information about facts and circumstances that existed at the acquisition date are measurement period changes. Otherwise, changes in the fair value of contingent considerations that corne from events following the business combination, such as achieving an earnings target or subsequent price levels, are classified as a component of income from continuing operations for liability consideration or as part of equity for equity consideration.
Accounting for Research and Development Costs
While SFAS 141 requires expensing and fair value measurement of acquired in-process research and development (IPR&D), SFAS 141(R) requires that acquired IPR&D be measured at fair value and capitalized with an indefinite life. As with other indefinite-life assets, acquired IPR&D must be tested regularly for impairment but not amortized. When its life becomes determinable (e.g., upon project completion), acquired IPR&D will be amortized over its expected remaining life. In addition, there is separate recognition on the acquisition date of all identifiable R&D assets, tangible and intangible, including those with no alternative future use.
Progress Toward Convergence
FASB’s and the IASB’s joint project on business combinations represents a major effort to converge the relevant accounting standards while continuing the evolution toward fair value accounting. Both boards have concluded that the revised standards improve financial reporting and enhance the transparency and comparability of accounting for business combinations. SFASs 141(R) and 160 require extensive disclosures for business combinations and apply to acquisitions on or after December 15, 2008. Earlier application of SFASs 141(R) and 160 is not permitted. IFRS 3(R), Business Combinations, and IAS 27(R), Consolidated and Separate Financial Statements, apply to acquisitions occurring after July 1, 2009, with earlier application permitted.
Nina T. Dorata, PhD, CPA, is an assistant professor, and Ibrahim M. Badawi, PhD, CPA, is a professor, both in the department of accounting and taxation at the Peter J. Tobin College of Business of St. John’s University, Queens, N.Y.
Copyright New York State Society of Certified Public Accountants Apr 2008
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