Recognition principles

In order to ensure consistency and resolve inconsistencies that existed in practice, the FASB concluded that the guidance in ASC 805 should provide guidance for applying its recognition principle. This guidance emphasizes two fundamental conditions. To recognize an asset or liability when applying the acquisition method, the item acquired or assumed must:

a. Meet the definition of an asset or liability at the acquisition date, and

b. Be part of the business combination rather than the result of a separate transaction.

3.4.1.1 Meaning of “An asset or liability at the acquisition date”

Excerpt from Accounting Standards Codification

Business Combinations — Identifiable Assets and Liabilities, and Any Noncontrolling Interest Recognition

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To qualify for recognition as part of applying the acquisition method, the identifiable assets acquired and liabilities assumed must meet the definitions of assets and liabilities in FASB Concepts Statement No. 6, Elements of Financial Statements, at the acquisition date. For example, costs the acquirer expects but is not obligated to incur in the future to affect its plan to exit an activity of an acquiree or to terminate the employment of or relocate an acquiree’s employees are not liabilities at the

acquisition date. Therefore, the acquirer does not recognize those costs as part of applying the acquisition method. Instead, the acquirer recognizes those costs in its postcombination financial statements in accordance with other applicable generally accepted accounting principles (GAAP).

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The acquirer’s application of the recognition principle and conditions may result in recognizing some assets and liabilities that the acquiree had not previously recognized as assets and liabilities in its financial statements. For example, the acquirer recognizes the acquired identifiable intangible assets, such as a brand name, a patent, or a customer relationship, that the acquiree did not recognize as assets in its financial statements because it developed them internally and charged the related costs to expense.

Concepts Statement No. 6 includes the following definitions of assets and liabilities:

Assets — Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

Liabilities — Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

In a business combination accounted for under the guidance in ASC 805, the phrase “a particular entity”

included in the definition of both assets and liabilities from Concepts Statement No. 6 should be interpreted as the target entity. As such, when determining what assets and liabilities should be recognized in a business combination, the Concepts Statement 6 definitions should be applied to the target entity (i.e., recognition is based solely on what exists within the target entity at the acquisition date). However, the definitions should not be interpreted to mean that assets or liabilities recognized in the business combination are required to have been recognized previously in the target entity. Often, a target will have assets (e.g., internally developed intangibles) and liabilities (e.g., contingent liabilities) that are not recognized in the predecessor financial statements, even though they meet the Concepts Statement 6 definitions, as a result of the application of authoritative literature that applies outside of a business combination (e.g., ASC 730, ASC 450).

3.4.1.2 Meaning of “Part of the business combination”

Excerpt from Accounting Standards Codification

Business Combinations — Identifiable Assets and Liabilities, and Any Noncontrolling Interest Recognition

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In addition, to qualify for recognition as part of applying the acquisition method, the identifiable assets acquired and liabilities assumed must be part of what the acquirer and the acquiree (or its former owners) exchanged in the business combination transaction rather than the result of separate

transactions. The acquirer shall apply the guidance in paragraphs 805-10-25-20 through 25-23 to determine which assets acquired or liabilities assumed are part of the exchange for the acquiree and which, if any, are the result of separate transactions to be accounted for in accordance with their nature and the applicable GAAP.

Business Combinations — Overall Recognition

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The acquirer and the acquiree may have a preexisting relationship or other arrangement before negotiations for the business combination began, or they may enter into an arrangement during the negotiations that is separate from the business combination. In either situation, the acquirer shall identify any amounts that are not part of what the acquirer and the acquiree (or its former owners) exchanged in the business combination, that is, amounts that are not part of the exchange for the acquiree. The acquirer shall recognize as part of applying the acquisition method only the

consideration transferred for the acquiree and the assets acquired and liabilities assumed in the exchange for the acquiree. Separate transactions shall be accounted for in accordance with the relevant GAAP.

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A transaction entered into by or on behalf of the acquirer or primarily for the benefit of the acquirer or the combined entity, rather than primarily for the benefit of the acquiree (or its former owners) before the combination, is likely to be a separate transaction. The following are examples of separate

transactions that are not to be included in applying the acquisition method:

a. A transaction that in effect settles preexisting relationships between the acquirer and acquiree (paragraphs 805-10-55-20 through 23)

b. A transaction that compensates employees or former owners of the acquiree for future services (paragraphs 805-10-55-24 through 55-26)

c. A transaction that reimburses the acquiree or its former owners for paying the acquirer’s acquisition-related costs (paragraph 805-10-25-23).

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Paragraphs 805-10-55-18 through 55-26, 805-30-55-6 through 55-13, 805-740-25-10 through 25-11, 805-740-45-5 through 45-6, and Example 2 (see paragraph 805-10-55-30) provide additional guidance for determining whether a transaction is separate from the business combination transaction.

Parties directly involved in the negotiations of an impending business combination may take on the characteristics of related parties. Therefore, they may be willing to enter into other agreements or include as part of the business combination agreement some arrangements that are designed primarily for the benefit of the acquirer or the combined entity; for example, to achieve more favorable financial reporting outcomes after the business combination. Because of concerns that such arrangements might be accounted for as part of the business combination, the FASB developed a principle to ensure each component of the transaction is accounted for in accordance with its economic substance; that is, to determine whether a particular transaction or arrangement entered into by the parties to the combination is part of what the acquirer and acquiree exchange in the business combination or is a separate transaction.

The ASC 805 principle is based on the concept of who receives the primary benefits from the transaction.

If the transaction is entered into by or on behalf of the acquirer or primarily for the benefit of the acquirer or the combined entity, rather than primarily for the benefit of the acquiree (or its former owners) before the combination, the transaction is likely a separate transaction that should be accounted for apart from

the business combination based on its economic substance. As the identification of these transactions often requires judgment, ASC 805-10-55-18 provides factors that should be considered in assessing whether a transaction is part of a business combination or should be accounted for separately. There is no hierarchy to the following factors. They should not be considered all inclusive and should be considered holistically.

The reasons for the transaction — Understanding the reasons why the parties to the combination (the acquirer, the acquiree, and their owners, directors, managers, and their agents) entered into a particular transaction or arrangement may provide insight into whether it is part of the consideration transferred and the assets acquired or liabilities assumed.

For example, assume Acquirer includes as part of the consideration transferred to Target’s shareholders a contingent consideration arrangement. The former shareholders of Target become employees of the combined entity and will receive a payout of the contingent consideration if certain earnings thresholds are met and they continue to be employed by Acquirer at a specified future date. In this scenario, although the contingent consideration arrangement was negotiated in connection with the business combination, the Acquirer likely entered into the arrangement for its own benefit; that is, in order to provide incentive to the former shareholders to remain as employees of the combined entity. As such, this contingent consideration arrangement would be accounted for separately from the business combination as a compensatory arrangement. See section 6.4 for further discussion of contingent consideration arrangements.

Who initiated the transaction — Understanding who initiated the transaction may also provide insight into whether it is part of the exchange for the acquiree.

For example, assume Acquirer, in its evaluation of a potential business combination with Target, has identified numerous facilities that would be redundant in the combined entity after the transaction.

During the negotiations, Acquirer requests that Target initiate certain restructuring activities in order to eliminate the redundancy. Target agrees to restructure certain activities before the consummation date, but only after receiving shareholder approval for the business combination. In this scenario, Acquirer initiated the transaction and is the recipient of the future economic benefits of the restructuring activities. The fact that Target initiated the restructuring is not substantive because it was done at the acquirer’s request and after the business combination was essentially assured of completion. As such, the restructuring activities should be accounted for separately from the business combination and will result in an expense to Acquirer pursuant to the guidance in ASC 420. See section 4.3.3 for further discussion on restructuring activities in a business combination.

In another example, assume that Acquirer enters into a noncompetition arrangement with the target company shareholders (who typically would have been employed by or involved in the management of the target but will not be employed by Acquirer). Because the noncompetition agreement was initiated by Acquirer to protect Acquirer’s interests, the noncompetition agreement generally will be accounted for as a transaction separate from the business combination. See section 4.2.5.3.1.1 for additional discussion of noncompetition arrangements.

The timing of the transaction — The timing of the transaction may also provide insight into whether it is part of the exchange for the acquiree.

For example, assume concurrent with the execution of the business combination agreement, Acquirer enters into a supply agreement with Target. Target agrees to supply Acquirer with the raw materials necessary for Acquirer’s manufacturing process after the transaction is complete. As this supply arrangement was agreed to concurrent with the business combination, the terms of the arrangement should be evaluated to determine if they are at market value, if the consideration transferred in the business combination was affected by the terms of the future supply arrangement, and if Acquirer is receiving future economic benefits as a result.

ASC 805-10-25-21 includes examples of transactions that require accounting apart from the business combination; however, the following examples should not be considered all inclusive:

a. A transaction that in effect settles preexisting relationships between the acquirer and acquiree (see section 4.5).

b. A transaction that compensates employees or former owners of the acquiree for future services (see section 6.4.5).

c. A transaction that reimburses the acquiree or its former owners for paying the acquirer’s acquisition-related costs (see section 6.2).

3.4.1.2.1 Allocating the consideration transferred to a transaction to be accounted for separate from the business combination

As discussed above, an acquirer must determine which assets acquired or liabilities assumed are part of the exchange for the acquiree and which, if any, are the result of separate transactions. However, ASC 805 does not provide guidance on how to allocate the consideration transferred between the various components (i.e., the business combination and the separate transaction(s)). Absent specific guidance, we believe that using a relative fair value approach to allocate the consideration transferred between the two (or more) components would be reasonable and acceptable. Other alternatives may also be acceptable.

3.4.1.3 Classification or designation of assets acquired and liabilities assumed Excerpt from Accounting Standards Codification

Business Combinations — Identifiable Assets and Liabilities, and Any Noncontrolling Interest Recognition

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At the acquisition date, the acquirer shall classify or designate the identifiable assets acquired and liabilities assumed as necessary to subsequently apply other GAAP. The acquirer shall make those classifications or designations on the basis of the contractual terms, economic conditions, its operating or accounting policies, and other pertinent conditions as they exist at the acquisition date.

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In some situations, GAAP provides for different accounting depending on how an entity classifies or designates a particular asset or liability. Examples of classifications or designations that the acquirer shall make on the basis of the pertinent conditions as they exist at the acquisition date include but are not limited to the following:

a. Classification of particular investments in securities as trading, available for sale, or held to maturity in accordance with Section 320-10-25

b. Designation of a derivative instrument as a hedging instrument in accordance with paragraph 815-10-05-4

c. Assessment of whether an embedded derivative should be separated from the host contract in accordance with Section 815-15-25 (which is a matter of classification as this Subtopic uses that term).

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This Section provides the following two exceptions to the principle in paragraph 805-20-25-6:

a. Classification of a lease contract as either an operating lease or a capital lease in accordance with the guidance in paragraph 840-10-25-27

b. Classification of a contract written by an entity that is in the scope of Subtopic 944-10 as an insurance or reinsurance contract or a deposit contract.

The acquirer shall classify those contracts on the basis of the contractual terms and other factors at the inception of the contract (or, if the terms of the contract have been modified in a manner that would change its classification, at the date of that modification, which might be the acquisition date) In a business combination, the target entity’s carrying value of the assets acquired and liabilities assumed are not relevant in the measurement that results from the application of the acquisition method of accounting by the acquiring entity. Similarly, except as noted in ASC 805-20-25-8, any prior classifications or designations of assets acquired and liabilities assumed are reconsidered in connection with their remeasurement. In addition to the examples listed in ASC 805-20-25-7, classification and designation should also be reconsidered for assets held for sale. The acquirer’s classification and designation should be based on all relevant factors at the acquisition date, including contractual terms, economic conditions, accounting policies of the acquirer, and any other relevant factors. See chapter 4 for further discussion of the recognition and measurement of specific assets, liabilities and any noncontrolling interests.