FASB Emerging Issues Task Force. Issue No Title: Accounting for Preexisting Relationships between the Parties to a Business Combination

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1 EITF Issue No FASB Emerging Issues Task Force Issue No Title: Accounting for Preexisting Relationships between the Parties to a Business Combination Document: Issue Summary No. 1, Supplement No. 1 Date prepared: June 16, 2004 FASB Staff: Munro (ext. 350)/McBride (ext. 384) Date previously discussed: March 17 18, 2004 Previously distributed EITF materials: Issue Summary No. 1, dated March 1, 2004 References: FASB Statement No. 45, Accounting for Franchise Fee Revenue (FAS 45) FASB Statement No. 141, Business Combinations (FAS 141) FASB Statement No. 142, Goodwill and Other Intangible Assets (FAS 142) EITF Issue No. 98-3, "Determining Whether a Nonmonetary Transaction Involves Receipt of Productive Assets or of a Business" (Issue 98-3) The alternative views presented in this Issue Summary Supplement are for purposes of discussion by the EITF. No individual views are to be presumed to be acceptable or unacceptable applications of Generally Accepted Accounting Principles until the Task Force makes such a determination. EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 1

2 Background 1. This Issue was originally referred by the EITF Agenda Committee to the FASB's project team on Business Combinations: Purchase Method Procedures. Since the FASB's joint project with the IASB on Purchase Method Procedures is not expected to specifically address this Issue in the near term, it was added to the EITF agenda. 2. This Issue applies when two parties that have a preexisting relationship enter into a business combination. Specifically, the Issue is whether a consummation of a business combination between two parties that have a preexisting relationship should be evaluated to determine if a settlement of a preexisting relationship exists, thus requiring accounting separate from the business combination. Issues 3. The following issues were included in Issue Summary No. 1: Issue 1 Whether a consummation of a business combination between two parties that have a preexisting relationship should be evaluated to determine if a settlement of a preexisting relationship may exist, thus requiring accounting separate from the business combination. Issue 2 If separate accounting is required for the settlement of a preexisting relationship between two parties to a business combination, the measurement of the settlement amount. Issue 3 If it is determined that assets of the acquired entity that are related to a preexisting relationship with the acquiring entity should be recognized as part of the business combination, whether the acquirer should recognize those assets as intangible assets apart from goodwill. EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 2

3 Previous Discussion 4. At the March 17 18, 2004 EITF meeting, the Task Force reached a tentative conclusion on Issue 1 that consummation of a business combination between two parties that have a preexisting relationship should be evaluated to determine if a settlement of a preexisting relationship exists. In reaching its tentative conclusion on Issue 1, the Task Force observed that a business combination between two parties that have a preexisting relationship could be viewed as a multielement transaction with one element being the business combination and the other element being the settlement of the preexisting relationship. 5. The Task Force also discussed Issue 2 but was not asked to reach a consensus. The Task Force directed the FASB staff to further explore alternative views on the recognition and measurement of the settlement of the preexisting relationship. The Task Force did not discuss Issue 3. Current Discussion 6. The purpose of this Issue Summary is to address the recognition and measurement of a settlement of a preexisting relationship (included in "Proposed Model") and whether certain reacquired rights should be recognized as intangible assets apart from goodwill (included in "Classification"). Proposed Model 7. While exploring alternative views on the recognition and measurement of a settlement of a preexisting relationship in a business combination, the FASB staff considered the various types of settlements discussed by the Task Force, including debt settlements, settlements of lawsuits, and settlements of off-market (favorable/unfavorable) executory contracts. The FASB staff proposes the following three step model to address the recognition and measurement of a settlement of a preexisting relationship in a business combination, which reflects two general principles: (a) the recognition and measurement of the fair value of the identifiable assets and liabilities of the acquired entity should be based on a marketplace participant view (as if acquired by a third party), and (b) the accounting for an item(s) should generally be the same whether within a business combination or absent a business combination. Therefore, it may be EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 3

4 appropriate for an entity to recognize a settlement gain or loss in conjunction with a business combination. Step 1: Allocate the cost of the acquired entity to the identifiable assets acquired and liabilities assumed (including any identifiable assets and liabilities related to the preexisting relationship) based on their estimated fair values at the date of the acquisition with any residual recognized as goodwill in accordance with FAS 141. Step 2: Segregate the identifiable assets and liabilities related to the preexisting relationship. Step 3: For each asset (liability) identified in Step 2, determine how the amount allocated to each asset (liability) in Step 1 would be recognized had that amount been paid (incurred) absent the business combination. 8. Under Step 1, the cost of the acquired entity should be allocated to the identifiable assets acquired and liabilities assumed based on what their estimated fair values would be if they were to be acquired by an unrelated third party. 9. For purposes of Step 2, assets and liabilities are "related" if they exist as a result of the acquired entity's preexisting relationship with the acquiring entity. 10. In Step 3, for each asset and liability identified in Step 2, the acquirer should determine how the amount allocated to each asset and liability in Step 1 would be recognized had that amount been paid (incurred) absent a business combination. That is, it could be either capitalized as an asset (recognized as a liability) or recognized as a settlement loss (or gain). 1 Because the accounting for each item identified in Step 2 depends on specific facts and circumstances, the 1 Some Task Force members are troubled by the recognition of a gain in conjunction with a business combination between parties with a preexisting relationship. However, those Task Force members acknowledge that there are conceptual inconsistencies between allowing the recognition of settlement losses but not gains. In response, some Task Force members have suggested that the proposed model include certain disclosure requirements regarding any settlement losses or gains recognized in conjunction with a business combination between parties with a preexisting relationship. Those disclosures could include information such as a discussion of nature of the settlement item and the methods used for measuring the amount of the settlement loss or gain. EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 4

5 FASB staff recommends that the Task Force not provide specific guidance as to how amounts paid (incurred) for these types of items would be recognized absent the business combination. 11. For certain intangible assets that the acquirer determines should be capitalized in Step 3 of the proposed model, there are divergent views as to the classification of those assets by the acquiring entity. That issue is addressed below under "Classification." 12. Examples 1-3 in Exhibit 04-1A demonstrate the application of the proposed model. Classification 13. Questions have been raised as to whether the acquirer should recognize, apart from goodwill, an acquired entity's intangible asset identified in Step 3 of the proposed model that, prior to the business combination, arose solely from the acquired entity's contractual right to use the acquirer's existing recognized or unrecognized intangible assets. Examples of intangible assets that arise solely from contractual rights include rights to the acquirer's tradename under a franchise agreement or rights to the acquirer's technology under a technology licensing agreement. 14. After the business combination, the acquirer has, in effect, reacquired the right previously granted to the acquired entity (hereinafter referred to as "reacquired right"). However, when the two entities are combined, the contract previously granting those rights is, in effect, terminated so that there is no longer a contractual-based intangible asset. Therefore, in order for the reacquired right to be recognized as an intangible asset apart from goodwill, it must meet either the legal or the separability criteria in FAS 141. There is little debate about how to interpret the FAS 141 legal criterion. There are, however, divergent views as to how to interpret the FAS 141 separability criterion. Those views are as follows: View A: The reacquired right should be considered an intangible asset apart from goodwill. 15. View A proponents believe that the reacquired right should be considered an intangible asset apart from goodwill under the separability criterion because there is evidence of an exchange EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 5

6 transaction for the asset (the acquirer had granted the right previously). View A proponents note that paragraph A11 of FAS 141 states (in part): Exchange transactions provide evidence that an intangible asset is separable from the acquired entity and might provide information that can be used to estimate its fair value. An acquired intangible asset meets the separability criterion if there is evidence of exchange transactions for that type of asset or an asset of a similar type (even if those exchange transactions are infrequent and regardless of whether the acquiring entity is involved in them). 16. View A proponents note that recognizing the reacquired right as an intangible asset apart from goodwill is consistent with the objective of FAS 141 to distinguish intangible assets from goodwill. They observe that subsuming the reacquired right into goodwill could result in nonamortization of a finite-lived intangible asset. 17. View A proponents also note that Step 3 of the proposed model requires the acquirer to determine how the item would have been accounted for had it been paid for absent a business combination. Because goodwill cannot be recognized absent a business combination, it would be inappropriate to classify the acquisition of an intangible asset as goodwill. 18. Opponents of View A observe that paragraph A11 of FAS 141 indicates "an acquired intangible asset meets the separability criterion if there is evidence of exchange transactions for that kind of asset or an asset of a similar type" (emphasis added). Considering an example in which Fast Food Company X acquires Fast Food Company Y (an unrelated entity), View A opponents note that the application of View A would require Fast Food Company X to assign value to franchise rights intangibles for every location in the region where a Fast Food Company Y franchise agreement could potentially be established in the future. View A opponents also observe that the same rationale would apply when performing Step 2 of the goodwill impairment test because FAS 142 requires an entity to allocate the fair value of a reporting unit to its individual assets and liabilities as if the reporting unit had been acquired in a business combination. In other words, there is potentially no limit to the number of intangible assets that would be required to be recognized under View A. EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 6

7 View B: The reacquired right should not be considered an intangible asset apart from goodwill. 19. View B proponents agree with View A proponents that, when applying the separability criterion in FAS 141, evidence of an exchange transaction provides evidence of separability. However, View B proponents do not believe that the guidance in paragraph A11 of FAS 141 is applicable to assets that arise solely from contractual or legal rights. They note that the first sentence of paragraph A11 of FAS 141 states (in part): If an acquired intangible asset does not arise from contractual or other legal rights, paragraph 39 requires that it be recognized as an asset apart from goodwill only if it is separable. [Emphasis added.] 20. View B proponents note that a granted right (for example, a franchise right) is an example of a contractual-based intangible asset in paragraph A14 of FAS 141 because it arises from contractual rights. View B proponents observe that paragraph A11 of FAS 141 is only applicable for intangible assets that do not arise from contractual or legal rights. View B proponents also believe that the reacquired right does not "fit" in any other example categories of intangible assets listed in paragraph A14 of FAS 141 (that is reacquired rights are not "marketing-related," "customer-related," "artistic-related," or "technology-based"). Therefore, View B proponents believe that since the reacquired right no longer meets the contractual criterion (when the contract is, in effect, terminated in conjunction with the business combination) and also does not meet the legal criterion, the reacquired right cannot be considered an intangible asset apart from goodwill. 21. View B proponents also believe that reclassifying the reacquired right as goodwill is not inconsistent with Step 3 of the proposed model. Proponents of View B believe that the purpose of principle (b) of the proposed model (paragraph 7) is to identify any settlement gain or loss. They believe that once the acquirer determines that a reacquired right should be capitalized (that is, included as part of the business combination) in Step 3 of the proposed model, the issue of how to classify that reacquired right becomes a business combinations issue that is unrelated to any settlement element of the transaction. EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 7

8 22. Example 4 in Exhibit 04-1A demonstrates the application of the alternative views to the classification issue. Transition 23. The FASB staff believes that any consensus on the "Proposed Model" should be applied prospectively to business combinations completed in reporting periods beginning after Board ratification of the consensus (standard EITF consensus). Early application should be permitted for business combinations completed in periods for which financial statement have not been issued. 24. The FASB staff notes that any consensus on the "Classification" issue may affect both an entity's recognized intangible assets or goodwill at the date the consensus is initially applied and an entity's goodwill impairment test. In Step 2 of a goodwill impairment test, FAS 142 requires an entity to allocate the fair value of a reporting unit to the individual assets and liabilities to determine the implied fair value of the goodwill. An entity should allocate the fair value as if the reporting unit had been acquired in a business combination. The "Classification" issue affects how purchase price is allocated in a business combination and, accordingly, it also affects the goodwill impairment test. For illustrative purposes, assume that the Task Force reaches a View A consensus and consider the following example: A franchisor acquires an operating franchisee's business in a business combination and does not allocate any purchase price to reacquired franchise rights (that is, it is subsumed in goodwill). After the ratification of the consensus, the entity performs its annual goodwill impairment test. If the fair value of a reporting unit is below its carrying amount, the entity is required to allocate the reporting unit's fair value to its assets and liabilities. Any value attributable to reacquired franchise rights (and other similar internally generated intangible assets) is required to be considered an intangible asset apart from goodwill. That is, a View A consensus will result in more fair value being allocated to intangible assets, which will result in less residual value attributed to goodwill. As a result, an entity may be required to recognize a goodwill impairment charge (or a larger goodwill impairment charge.) 25. The Task Force should consider whether it should provide a transition alternative to address this potential issue. Those transition alternatives are: EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 8

9 View A: No transition alternative. 26. An entity should apply the consensus prospectively. Any goodwill impairment as a result of the application of this consensus should be reported in operating income. Proponents of View A note that before an entity allocates fair value in Step 2 of the impairment test, the fair value of the reporting unit must be below its carrying amount. Accordingly, View A proponents believe that the recognition of a goodwill impairment charge in operating income is appropriate. View B: Cumulative effect. 27. Require a goodwill impairment test on the initial application of the consensus and any goodwill impairment charge should be recognized as a cumulative effect of a change in accounting principle. Alternatively, require an entity to identify and record as a cumulative effect adjustment the portion of the goodwill impairment charge that relates solely to the application of the consensus. If the entity is unable to isolate the effect of the consensus in its impairment charge, it should recognize the full amount in operating income. View C: Consistent application. 28. Require consistent application on an entity's purchase price allocation methodology for goodwill impairment testing purposes. That is, for assets and goodwill acquired before the application of this consensus, an entity would allocate the fair value based on the methodology that it used for the original purchase price allocation. For example, an entity that did not separately recognize reacquired franchise rights apart from goodwill would not allocate value to reacquired franchise rights (or other similar assets) for goodwill impairment testing purposes. View C may require an entity to allocate the value of a reporting unit differently for goodwill impairment testing purposes based on the methodology that originally was used to allocate the purchase price of a business combination. EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 9

10 View D: Restatement. 29. Require retroactive application of the consensus to previous business combinations and impairment tests. EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 10

11 Exhibit 04-1A ILLUSTRATION OF THE APPLICATION OF THE PROPOSED MODEL TO EXAMPLE FACT PATTERNS Example 1 Debtor/Creditor Relationship Company Y has an investment in debt securities of Company X. At the time of the initial investment, Company Y paid $100 million, which was equivalent to the face value of the debt (assume no discount or premium). Subsequently, the fair value of the debt has decreased to $95 million. Company X pays $900 million (net of liabilities assumed) to acquire Company Y (fair value of Company Y based on what marketplace participants would pay). The purchase price allocation for Company Y is as follows (in millions): Unrelated identifiable assets $ 1,200 Investment in debt securities of Co. X 95 Unrelated liabilities (500) Goodwill 105 Fair value of Co. Y $ 900 If Company X acquired its own debt for $95 million absent a business combination, it would recognize a debt extinguishment for the carrying amount of the debt ($100 million) and a debt extinguishment gain of $5 million as part of the transaction. Example 2 Plaintiff/Defendant Relationship Company Y is suing Company X for patent infringement. Company X pays $800 million (net of liabilities assumed) to acquire Company Y (fair value of Company Y based on what marketplace participants would pay). The purchase price allocation for Company Y is as follows (in millions): Unrelated identifiable assets $ 500 Contingent gain from lawsuit with Co. X 100 Unrelated liabilities (200) Goodwill 400 Fair value of Co. Y $ 800 If Company X paid Company Y $100 million to settle the lawsuit absent a business combination, any difference between the carrying amount of Company X's contingent liability related to the lawsuit and the amount paid would be recognized as a settlement gain or loss. EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 11

12 Example 3 Manufacturer/Distributor Relationship Company Y purchases electronic components from Company X under a supply contract at stated list rates. Currently, the stated list rates are lower than rates that Company X charges other third party distributors. Company X pays $50 million (net of liabilities assumed) to acquire Company Y (fair value of Company Y based on what marketplace participants would be willing to pay). The purchase price allocation for Company Y is as follows (in millions): Unrelated identifiable assets $ 45 Favorable supply contract with Co. X 5 Unrelated liabililities (20) Goodwill 20 Fair value of Co. Y $ 50 If Company X paid Company Y $5 million to settle the supply contract absent a business combination, any difference between the carrying amount of Company X's liability, if any, related to its unfavorable supply contract and the amount paid would be recognized as a settlement gain or loss. Example 4 Reacquisition of Franchise Right Fast Food Company X acquires the business of its operating franchisee, Franchise A. Fast Food Company X pays $100 million (net of liabilities assumed) to acquire Franchise A (fair value of Franchise A based on what marketplace participants would be willing to pay). The purchase price allocation for Franchise A is as follows (in millions): Unrelated identifiable assets $ 125 Franchise agreement (with Fast Food Company X) 40 Unrelated liabililities (75) Goodwill 10 Fair value of Franchise A $ 100 Alternatives Under View A, the $40 million paid to reacquire the franchise right would be capitalized as an intangible asset apart from goodwill. Under View B, the $40 million paid to reacquire the franchise right would be subsumed in goodwill resulting in Fast Food Company X recognizing $50 million of goodwill related to the acquisition of Franchise A. EITF Issue No Issue Summary No. 1, Supplement No. 1, p. 12