Financial Reporting for Taxes

Financial Reporting for Taxes

TEI May A&A Update Meeting

Acquisition accounting

May 8, 2012

Orlando, FL

Wendi Christensen— Deloitte Tax LLP

Agenda

Obtain an understanding

of the transaction Step 1 Record tax consequences

of fair value accounting adjustments

Step 2 Analyze uncertain

tax positions Step 3

Evaluate tax attributes Step 4

Consider costs of

the acquisition Step 5 Evaluate post-closing

adjustments Step 6 Disclosures and

Financial Reporting for Taxes

• Generally deferred taxes must be provided on the taxable and

deductible temporary differences that arise from a difference between the tax basis of an asset or a liability and its reported amount in the financial statements

Tax status of enterprise being acquired

Each company has an inventory of taxable and

deductible temporary differences that will result in

• No deferred taxes are recorded in the partnership’s financial statement since tax consequences are borne by its partners

• If a partner is a taxable enterprise, deferred taxes are provided on temporary differences associated with that partner's interest

Tax status of enterprise being acquired (cont.)

No deferred tax recorded in the partnership’s financial

statements

Deferred tax on temporary difference associated with the partnership investment

C Corp

Ptrshp

Investor 60%

40%

• Acquirer recognizes and measures each asset acquired and

each liability assumed and any non-controlling interest at its

acquisition date

fair value

• Record deferred taxes for estimated future tax effects attributable

to temporary differences and carryforwards

– A temporary difference exists when there is a taxable or deductible difference between (1) the carrying amount of an asset or liability for financial reporting purposes and (2) the tax basis of that asset or liability (must consider the recognition and measurement

requirements for tax positions when determining the tax basis) – The carrying amount for financial reporting purposes is the same,

regardless of the form of the business combination

– There is a difference in how the tax basis is determined depending on whether the business combination is taxable or nontaxable

• Acquirer “steps up” the target’s historical tax bases in the assets acquired and liabilities assumed to fair market value

• Includes asset acquisitions, stock acquisitions treated as asset acquisitions by election (e.g., §338 elections) and integrated transactions treated as asset acquisitions

Taxable business combinations

Section 1060

allocation class Description

Class I Cash and near-cash

Class II Actively traded property (e.g., publicly traded stock) Class III Mark-to-market assets

Class IV Inventory

• Acquirer assumes the historical or “carry over” tax basis of

the acquired assets and liabilities assumed

• FMV accounting for book purposes will result in book/tax

basis differences (in addition to the historical differences)

• Includes stock acquisitions (absent a Section 338 election)

and tax-free asset and stock reorganizations

(e.g.,§368(a)(1)(A) and §368(a)(1)(B))

Financial Reporting for Taxes

Step 2: record the tax

• USP buys Target assets for $1,500

• USP recognizes and measures each asset acquired and

each liability assumed at its acquisition date fair value for

both tax and financial reporting purposes

• Since tax and financial reporting basis will be the same,

no temporary differences are expected

Asset Book basis

Tax

Basis Difference Tax rate

Deferred asset (liability) PP&E $200 $200 — 40% — Intangibles $1,000 $1,000 — 40% — Goodwill $300 $300 — 40% — Total $1,500 $1,500 —

Example 1 — taxable asset purchase (cont.)

• No deferred taxes recorded — no basis differences

• Temporary differences could arise in the future if depreciation and/or amortization rates for book and tax are different

Debit Credit

PP&E $200

Intangibles $1,000

Goodwill $300

• USP issues its own shares to T shareholders in exchange

for their T shares

• For financial reporting purposes, USP recognizes and

measures each asset acquired and each liability assumed

at its acquisition date fair value

• For tax purposes, USP assumes the historical or “carry

over” tax basis of acquired assets and liabilities assumed

• The historical temporary differences will be adjusted on

account of the fair value accounting adjustments

Asset

Book basis

Tax

basis Difference Tax rate

Def tax asset (liability) PP&E $200 $150 $50 40% ($20) Intangibles $1,000 $0 $1,000 40% ($400) Goodwill $300(1) _{$0 300 NA —} Total $1,500 $150 $1,350 ($420)

Example 2 — nontaxable stock purchase (cont.)

Debit Credit PP&E $200 Intangibles $1,000 Goodwill $720 DTL $420 Equity $1,500

• Goodwill

• In-process R&D

• Contingent liabilities

• Deferred revenue

• Contingent consideration

• Compensation expenses

Goodwill

Book Goodwill

FV of identifiable net assets acquired

=

=

Tax Goodwill

=

Any difference

between tax and

book goodwill

• A deferred tax asset is recognized for the excess of tax deductible goodwill over book goodwill

• ASC 740-10-25-3(d) prohibits recording a deferred tax liability for the excess of the book over tax goodwill when difference is acquired

• Historical books may have deferred tax liability or deferred tax asset related to a basis difference in goodwill

• Any deferred taxes related to historical accounting for goodwill must be removed and reset

– Component 1 goodwill has no temporary difference on acquisition date

– Component 2 goodwill may have a DTA for tax goodwill over book goodwill, but no DTL can exist

Goodwill (cont.)

Tax Accounting for Component 2 Goodwill

Book Tax

Preliminary calculation:

Component 1 goodwill (pre-acquisition balance) $400 $200 Component 2 goodwill (pre-acquisition balance)

Component 2 goodwill (generated by acquisition) $600 0

Total goodwill $1,000 $200

Journal entry to reverse the existing DTL: DR CR

Deferred tax liability $80*

Goodwill $80 *DTL = .40 x $200 Book Tax Adjusted calculation: Component 1 goodwill $200 $200 Component 2 goodwill 720 0 Total goodwill $920 $200

Example 3 — goodwill

liabilities acquired

• Acquired IPR&D will be recognized as an indefinite-lived intangible asset separately from goodwill and recorded at fair value as of the acquisition date

• The asset will be amortized over the useful life when R&D is complete or expense upon abandonment of project

– Although it is considered an indefinite lived asset, IPR&D will be expensed over a relatively limited period of time

• The amount recorded for an IPR&D intangible asset must be compared with its tax basis to determine whether a temporary difference exists

• In nontaxable transactions tax basis will typically be zero and a DTL will be recorded for the basis difference

In-process R&D

Financial Reporting

• The acquirer recognizes and measures each liability assumed

• DTA recorded for liabilities deductible when paid or otherwise reduce book income for taxable income calculation (e.g., Sch M adjustment) • No DTA is recorded for liabilities that are not deductible when paid

(e.g., contingent liabilities assumed in an asset acquisition)

– Payment of these liabilities results in an increase in tax basis of acquired assets

• Accounting systems may not be able to separately track nondeductible payments on liabilities resulting in double deductions: one deduction upon payment and the second through amortization of acquired assets

Contingent liabilities

Financial Reporting

For Tax Purposes

• Revenue related to contracts which extend beyond one reporting period is deferred and taken into account over the life of the contract

• If deferred revenue represents a future performance obligation, record that obligation at fair value

• Deferral of income is only permitted in certain circumstances

• In a nontaxable business combination, the acquirer should record a DTA for the post purchase accounting balance of deferred revenue

• In a taxable business combination:

– Acquirer includes the actual cost to satisfy target’s deferred revenue contract in the tax basis of the acquired assets during the period in which the costs are incurred

– A DTA is recorded for the financial reporting profit margin that will never be

Deferred revenue

Financial Reporting

• Record at fair value (regardless of likelihood of payment) and classify as a liability or in equity

• Liability-classified earn-out arrangements will be re-measured to FV at each balance sheet date; changes are recognized in post-acquisition income statement

• In a nontaxable business combination, payment of contingency generally results in additional purchase price for target stock

– Several exceptions to recording deferred taxes on outside basis differences in the stock of a subsidiary

• In a taxable business combination, payment of contingency generally results in additional amortizable or depreciable tax basis in target assets

– The amount at closing would be expected to eliminate any initial basis differences in the target assets

Contingent consideration

Financial Reporting

• Acquirer recognizes and measures accrued liabilities for

compensation and benefits

• Some of the compensation may have accrued as a result of

the business combination

• Record a DTA for compensation expenses that will be

deductible when paid

• Accrued compensation expenses may not be deductible

– Tax deductions may be limited under Section 280G

– Additional analysis may be required to identify the tax

deductible payments in each period

Accrued compensation

Financial Reporting

Financial Reporting for Taxes

• A tax position is first evaluated for recognition based upon

its technical merits. Tax positions that meet a recognition

criterion are then measured to determine an amount to

recognize in the financial statements. ASC 740-10-05-6

• Acquirer can only change the recognition and measurement

of target’s historic tax positions based upon new information

and not from a new evaluation or new interpretation by

management of information that was available in a previous

financial reporting period. ASC 740-10-35 and 10-40

Uncertain tax positions — generally

Financial Reporting

Note: In order to make changes in recognition (e.g., new court

Changes in an acquired entity’s uncertain tax positions:

• After the acquisition date, all adjustments to an acquired entity’s

uncertain tax positions are recorded in income tax expense, with one exception:

– If the company is still finalizing its accounting during the measurement period, and an adjustment is required that is based on new information about facts and circumstances that existed as of the acquisition date, then the adjustment is recorded to goodwill

• It is important to:

– Finalize tax due diligence before measurement period ends – Refine UTB analysis before measurement period ends

– Document all information available and considered at the acquisition date

Financial Reporting for Taxes

• Acquirer’s removal (or reversal) of its valuation allowance or any adjustment to tax-related balances as a result of a business

combination is recorded as a component of income tax expense and not included as part of acquisition accounting

• Adjustments to the target’s historical valuation allowance for DTAs at the date of acquisition (to reflect the fact that the acquirer and target will be filing a consolidated tax return) are reflected as adjustments to goodwill

• See discussion of measurement period for subsequent changes

Valuation allowances

Acquirer

• Section 382 generally places a limitation on the amount of net operating losses and other tax attributes arising before a change in ownership that may be used to offset taxable income after such a change

• A business combination is an ownership change that typically results in a Section 382 limitation

1. What amount of DTA should be recorded for tax attributes subject to limitation?

• A DTA should be recorded for the maximum amount of net operating loss that is mathematically possible of being used (sum of annual limits and NUBIG)

2. How does the limitation affect the valuation allowance and uncertain tax benefits considerations?

• A valuation allowance should be used to reduce the above DTA to the amount of tax benefits from the net operating loss that is more likely than not to be realized

• The presentation of the DTA/UTPs may be affected by whether the acquiring

Valuation allowances — section 382 limitations

• Acquirer recognizes an indemnification asset (subject to

realizability) at the same time and on the same basis as the

indemnified item

• The indemnification receivable is usually not a temporary

difference because it is considered an adjustment to

purchase price and as such is not taxable

Indemnification by seller

Financial Reporting

• Acquirer purchases Target

• Target has an UTB liability (indemnified by a previous owner) of $100 related to a federal tax issue (not MLTN to be realized)

• Under the purchase agreement, Target’s prior owner indemnifies Acquirer against losses related to the UTB

Day 1 accounting DR CR Indemnification receivable $100 UTB liability $100 Settlement for $75 Indemnification expense $25 Indemnification receivable $25 UTB liability $100 Tax expense $25

Example 4 — indemnification and UTB

• Acquirer’s historical state tax “footprint” can be changed by the transaction – Assume an acquirer operating in Nevada with no deferred state taxes but

substantial temporary differences acquires a target company in California – Acquirer now required to file a combined California return with target

company

– Acquirer must record deferred taxes for California state tax (on its own historical temporary differences) even though no state taxes were

previously recognized

• Any change in the measurement of existing deferred tax items of the

acquirer as a result of the acquisition are recorded “outside” of the business combination accounting as a component of income tax expense

• Measurement of target’s deferred taxes must consider the expected state combined and consolidated filings and the period when the combined filings will commence

• Adjustments to target’s historical deferred taxes are accounted for as part of the business combination

Financial Reporting for Taxes

• Under ASC 805, transaction costs are expensed as

incurred

• Costs are either:

– Capitalized into asset or stock basis or

– Capitalized as a separate non-amortizable asset (for tax-free

acquisitions)

Transaction costs

Financial Reporting

• Pre-closing reporting period — record tax consequences assuming transaction won’t close (e.g., assume costs not yet deducted will eventually become deductible)

• Actual tax consequences are determined and recorded at closing

• Pre-closing reporting period — if transaction is more-likely-than-not (MLTN) to close, record expected tax consequences of transaction costs according to the MLTN form of the transaction (e.g., taxable or nontaxable business combination). If transaction is not MLTN to close, then record tax consequences assuming transaction won’t close (see View 1 above).

Transaction costs — pre-acquisition period

View 1 — Don’t Anticipate Closing

• During Q3 2010, Acquirer begins due diligence for acquisition of Target stock

• Acquisition is expected to be structured as a non-taxable business combination and expected to close in Q1 2011

• For financial reporting purposes, Acquirer expenses $10,000 of transaction costs during Q3 and Q4 of 2010

• A preliminary tax analysis of costs determines the following:

– Non-deductible costs = $6,000 (added to tax basis of Target stock)

– Deductible costs = $4,000 (deductible upon closing of the transaction) • Tax rate is 40%

DR DR

Transaction expense $10,000

Cash $10,000

Deferred tax asset $4,000

Deferred tax expense $4,000

Adjusting entry at closing

Deferred tax expense $4,000

Deferred tax asset $4,000

Current tax liability $1,600

Current tax expense $1,600

Example 5 — transaction costs (cont.)

DR CR

Transaction expense $10,000

Cash $10,000

Deferred tax asset $1,600

Deferred tax expense $1,600

At close

Deferred tax expense $1,600

Deferred tax asset $1,600

Current tax liability $1,600

Current tax benefit $1,600

Example 5 — transaction costs (cont.)

• During Q1 2010, Acquirer announces its intent to acquire Target and

expects to close in Q3 2010 (expected to be structured as a non-taxable transaction)

• In Q2, Acquirer determines that due to market conditions it does not expect to close the transaction

• In Q3, Acquirer acquires Target

• For financial reporting purposes, Acquirer estimates it will incur $10,000 of transaction costs in 2010

• A preliminary tax analysis of costs determines the following:

– Non-deductible costs = $6,000

– Deductible costs = $4,000 (deductible upon closing of the transaction)

• Assume 40% tax rate

View 1 Q1 Q2 Q3 Actual

Pre-tax income $100,000 $100,000 $100,000 $100,000 Nondeductible transaction costs 6,000 6,000 Net tax to be provided 40,000 40,000 42,400 42,400 Estimated effect on AETR(1) _{40% 40% 42.4% 42.4%}

View 2 Q1 Q2 Q3 Actual

Pre-tax income $100,000 $100,000 $100,000 $100,000 Nondeductible transaction costs 6,000 6,000 6,000 Net tax to be provided 42,400 40,000 42,400 42,400 Estimated effect on AETR(1) _{42.4% 40% 42.4% 42.4%}

(1) _{Assuming the transaction costs are not considered significant, unusual, or extraordinary…ASC 740-270-30-8}

Financial Reporting for Taxes

• Measurement period is the period after the acquisition date during

which the acquirer may adjust the provisional amounts recognized for a business combination to reflect new information obtained about facts and circumstances that existed as of the acquisition date

• Measurement period ends as soon as the acquirer receives the information it was seeking or learns that more information is not obtainable (should not exceed one year from the acquisition date)

• Acquirer revises comparative information for prior periods presented in financial statements as needed

• After the measurement period ends, the acquirer revises the accounting for a business combination only to correct an error

Example 7 — measurement period adjustments

• On January 1, 2009, Company X acquired 100% of Target

• Company X collects jurisdictional tax rate information and analyzes Target’s deferred tax assets and liabilities

• Company X closes FY 2009 Q1 with estimates for taxes and discloses in its business combination footnote that data is still being gathered to finalize the tax accounting • In June 2009, Company X gathers all information needed to finalize tax adjustments

associated with the transaction (for facts that existed as of the acquisition date) and records the entries in its June close

• In July 2009, Company X files its Form 10Q and discloses the tax accounting has been finalized for the acquisition of Target

Acquisition Closes Measurement Period Closes

Example 7 — measurement period adjustments

(cont.)

• In June 2009, in connection with finalizing tax accounting related to the acquisition, Company X management identifies new information

• New information (which existed at acquisition date) makes a portion of the acquired entity's deferred tax assets not MLTN of being realized

• Company X’s management concludes an adjustment is needed to increase the valuation allowance

(1) Additional Facts

What journal entry is necessary?

6/30/09 1/1/10 1/1/09 3/31/09 9/30/09 10Q includes tax estimates Tax acquisition accounting finalized

Example 7 — measurement period adjustments

(cont.)

• In September 2009, management reevaluates acquired entity’s DTA valuation allowance to consider new facts (dramatic downturn in business)

• Management concludes an increase in the acquired entity’s valuation allowance is needed since DTAs are not MLTN of being realized

6/30/09 1/1/10 1/1/09 3/31/09 9/30/09 10Q includes tax estimates Tax acquisition accounting finalized

Acquisition Closes Measurement Period Closes

(2) Additional Facts

Example 7 — measurement period adjustments

(cont.)

• In April 2010, management discovers errors in the tax basis used to measure deferred taxes in acquisition accounting

How should the adjustment be recorded?

• Error are corrected by adjusting misstated accounts (i.e., deferred taxes and goodwill) • If the correcting entry was recorded to income tax expense, tax expense would be either

over or understated and goodwill will remain recorded at an incorrect amount

• Entry to deferred taxes and goodwill may be recorded in the year the error is discovered (if amounts are material, restatement of prior periods may be necessary)

• Adjustment most likely will be go to goodwill even when goodwill has been impaired

6/30/09 1/1/10 1/1/09 3/31/09 9/30/09 10Q includes tax estimates Tax acquisition accounting finalized 4/30/10

Acquisition Closes Measurement Period Closes

• Acquirer purchases Target stock for $200 plus a contingent payment with a fair value of $50

• Fair value of the identifiable assets is $200 and the tax basis is $25 • Tax rate is 40%

Day 1 accounting DR CR

Assets $ 200

Goodwill $ 120

Cash $ 200

Contingent consideration liability $ 50

Deferred tax liability ($200-$25 × 40%) $ 70

Example 8 — contingent consideration

Scenario 1 — settle at the initial amount accrued: DR CR

Contingent consideration liability 50

Cash 50

Scenario 2 — settle at $50 greater than initial amount accrued:

Pre-tax expense 50

Contingent consideration liability 50

Cash 100

• In non-taxable business combinations, settlement of contingent consideration classified as a liability for an amount greater than the initial amount is recorded as an expense for book purposes and an increase in stock for tax purposes

• An unfavorable permanent difference is created since ASC 740-30-25-9

prohibits recognition of a DTA when tax basis exceeds book basis in the stock when the temporary difference will not be reversed in the foreseeable future

Scenario 3 — settle at $40 less than initial amount: DR CR

Contingent consideration liability $ 50

Income $ 40

Cash $ 10

• Settlement for an amount less than the initial amount is recorded as income for book purposes and as a decrease in the stock for tax purposes

• A favorable permanent difference may arise if (1) target is a domestic

corporation; (2) stock basis difference can be eliminated in a tax-free manner (e.g., liquidation) and (3) Acquirer intends to realize stock basis difference [ASC 740-30-25-7 exception to DTL applicable to domestic sub]

• Other exceptions might apply to a foreign target company

• Acquirer purchases Target’s assets for $200 plus a contingent payment with a fair value of $50 • Tax rate is 40% Day 1 accounting DR CR Assets $ 200 Goodwill $ 50 Cash $ 200

Contingent consideration liability $ 50

• At acquisition date, no temporary differences considered to exist in Target’s assets since payment of the contingent consideration (“expected”) results in additional amortizable/depreciable tax basis in goodwill

Example 9 — contingent consideration

Scenario 1 — settle at the initial amount accrued: DR CR

Contingent consideration liability $ 50

Cash $ 50

Scenario 2 — settle at $50 greater than initial amount accrued:

Expense $ 50

Contingent consideration liability $ 50

Cash $ 100

Deferred tax asset $ 20

Deferred tax provision $ 20

• In a taxable business combination, settlement of contingent consideration

classified as a liability for an amount greater than the initial amount is recorded as an expense for book purposes and an increase in asset basis for tax

Scenario 3 — settle at $40 less than initial amount: DR CR

Contingent consideration liability $ 50

Income $ 40

Cash $ 10

Deferred tax provision $ 16

Deferred tax liability $ 16

• In a taxable business combination, settlement of contingent consideration

classified as a liability for an amount less than the initial amount is recorded as income for book purposes and as decreased asset basis for tax purposes

• A deferred tax liability is recorded on the temporary difference resulting from the immediate deduction of “expected” tax basis

Financial Reporting for Taxes

• Under ASC 805-10-50-1, the acquirer shall disclose information that enables users of its financial statements to evaluate the nature and financial effect of a business combination that occurs either:

– During the current reporting period; or

– After the reporting date but before the financial statements are issued

• Paragraphs 2 through 8 detail specific disclosure requirements with respect to the initial accounting for a business combination

• Under ASC 805-10-50-6, if the initial accounting is incomplete, an acquirer shall disclose:

– The reasons why the initial accounting is incomplete

– The assets, liabilities, equity interests, or items of consideration for which the initial accounting is incomplete

– The nature and amount of any measurement period adjustments recognized during the reporting period

(Dollar amounts in millions) 2011 2010 2009

Balance at January 1 $114 $66 $52 Additions for tax positions of prior years 11 12 1

Reductions for tax positions of prior years -1 -2 -11 Additions based on tax positions related to current year 63 42 24 Lapse of statute of limitations — — —

Settlements -16 -7 —

Foreign exchange translation -3 3 — Positions assumed in ABC transaction 117 — —

Balance at December 31 $285 $114 $66

• The purchase accounting adjustments are preliminary and subject to revision. At this time, except for the items noted below, the Company does not expect material changes to the value of the assets acquired or liabilities assumed in conjunction with the transaction. Specifically, the following assets and liabilities are subject to change:

– Intangible management contracts were valued using preliminary December 1, 2009 AUM and assumptions. The value of such contracts may change,

primarily as the result of updates to AUM and those assumptions;

– As management receives additional information, deferred income tax assets and liabilities and other assets, due from and to related parties, and other liabilities may be adjusted as the result of changes in purchase accounting and applicable tax rates

• Internal controls

– Frequent and formal interaction between accounting and tax departments – Process and controls for tax effecting fair value adjustments — consider

technology used, resources involved, review procedures, etc.

– Analytical review of acquisition accounting (for instance, ETR on goodwill adjustments)

– Education of tax department personnel – Integration with tax provision calculations

– Other tools — work plans, process memos, etc.

• Technical analysis

– Obtain and review financial accounting documentation, which will often include technical memoranda

– Memorialize tax analysis of acquisition accounting issues and conclusions on tax provision and tax return treatment

• Data considerations

– Particularly in a nontaxable acquisition, fair value accounting may result in the loss of historic data that will still be required for tax purposes — e.g., historic debt discounts

– Identify such data needs during acquisition accounting and implement plans to maintain necessary data

• External audit

– Consider auditability of the acquisition accounting work product – Develop work papers for external auditor review (opening balance

sheet, tax effect of fair value adjustments, tax attribute analysis and adjustments, technical memos, process documentation)

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based on the experiences and research of Deloitte

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