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1 Financial reporting developments A comprehensive guide Business combinations October 2015

2 To our clients and other friends Companies that engage in business combinations face various financial reporting issues, including determining whether a transaction represents a business combination or an asset acquisition, accounting for consideration transferred in the transaction and measuring and recognizing the fair value of assets acquired and liabilities assumed. We have updated this Financial reporting developments publication to help you understand the financial reporting issues associated with business combinations. This publication includes excerpts from and references to the FASB s Accounting Standards Codification, interpretive guidance and examples. We have also updated this publication to provide insights from the SEC, updates on recent standard-setting activities and further clarifications and enhancements to our interpretative guidance. Refer to Appendix I for further detail on the updates provided. We hope this publication will help you understand and apply the accounting for business combinations. We are also available to answer your questions and discuss any concerns you may have. October 2015

3 Contents 1 Overview of accounting for business combinations Overview Background The overall principle in ASC 805: obtaining control results in a new basis Scope: identifying business combination transactions Definition of a business Control assessment Recognizing and measuring the identifiable assets acquired, the liabilities assumed and any noncontrolling interest in the acquiree Consideration transferred Recognizing and measuring goodwill or a gain from a bargain purchase Bargain purchases A business combination achieved in stages Measurement period Assessing what is part of the exchange for the acquiree Disclosure requirements Identifying business combination transactions What is a business combination? Control obtained without transferring consideration Lapse of participating rights held by minority shareholders Investee share repurchase transactions Control obtained by contract alone Control by contract Dual-listed corporation and stapling arrangements Multiple transactions that result in obtaining control Variable interest entities Definition of a business Capable of from the viewpoint of a market participant Development stage enterprises Presence of goodwill Application of the definition of a business Examples Application of the definition of a business Industry examples Application of the definition of a business Effect of the definition of a business on other GAAP Limitations in the scope of ASC Joint ventures The acquisition of an asset or group of assets that does not constitute a business or a nonprofit activity A combination between entities, businesses or nonprofit activities under common control Change of accounting basis in master limited partnerships Financial reporting developments Business combinations i

4 Contents Not-for-profit organizations Mutual entities Other scope considerations The acquisition method Overview Identifying the acquirer Identifying the acquirer if the acquiree is a VIE Identifying the acquirer if the acquiree is a voting interest entity Identifying the acquirer when the acquirer is not obvious Relative voting rights Size of single minority voting interest Composition of the governing body Composition of management Terms of the exchange of equity interests Size Reverse acquisitions Measuring the consideration transferred in a reverse acquisition Share-based payments in a reverse acquisition Noncontrolling interests in a reverse acquisition Financial statement presentation Transactions involving public shell companies Combinations of more than two entities Combinations involving a Newco Examples Combinations involving a Newco Determining the acquisition date Recognizing and measuring the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree Recognition principles Meaning of An asset or liability at the acquisition date Meaning of Part of the business combination Allocating the consideration transferred to a transaction to be accounted for separate from the business combination Classification or designation of assets acquired and liabilities assumed Measurement principles Exceptions to the recognition and measurement principles Recognizing and measuring goodwill or a gain from a bargain purchase Goodwill Bargain purchase Recognizing assets acquired, liabilities assumed, and any noncontrolling interest Overview Assets acquired Assets the acquirer does not intend to use to their highest and best use Subsequent accounting for assets the acquirer does not intend to use to their highest and best use Assets with uncertain cash flows (valuation allowances) Inventories Financial reporting developments Business combinations ii

5 Contents Finished goods Work-in-process Raw materials Supply inventories Acquired last-in, first-out (LIFO) inventories Effect on purchase accounting of LIFO election for income tax purposes Subsequent measurement considerations Plant and equipment Plant and equipment to be used Property and equipment to be sold Spare parts inventories Mineral rights Acquired assets to be abandoned Plant and equipment subject to retirement obligations Intangible assets Recognition of identifiable intangible assets Contractual-legal criterion Separability criterion Private Company Council alternative Examples of intangible assets that meet the recognition criteria Marketing-related intangible assets Customer-related intangible assets Artistic-related intangible assets Contract-based intangible assets Technology-based intangible assets Assembled workforce Reacquired rights Other examples of intangible assets Measurement of identifiable intangible assets Acquired intangible assets to be sold SEC observations on the recognition and measurement of intangible assets in a business combination Research and development assets R&D definitions and scope Research Development Examples of research and development costs Application of AICPA Accounting & Valuation Guide, Assets Acquired to Be Used in Research and Development Activities (the Guide) Attributes of an acquired IPR&D project Distinguishing between assets used in R&D activities and assets resulting from R&D activities Measurement Unit of account Recognition of an IPR&D asset acquired in a business combination with associated milestone and royalty obligations Financial reporting developments Business combinations iii

6 Contents Defensive IPR&D assets Subsequent accounting for IPR&D acquired in a business combination IPR&D acquired in an asset acquisition Acquired IPR&D assets to be sold Indemnification assets Subsequent accounting for indemnification assets Subsequent accounting for an indemnification asset recognized at the acquisition date as a result of a government-assisted acquisition of a financial of a financial institution Debt issue costs Equity method investments Liabilities assumed Pension and post retirement obligations Modifications to pension and OPEB obligations in connection with a business combination Effect of employee terminations on obligations for pension benefits, other postretirement benefits and postemployment benefits Multiemployer pension plans Accrued bonus Deferred revenue of an acquired company Unit of account when measuring the fair value of deferred PCS revenue in a business combination Cost of restructuring an acquired company Cost of restructuring initiated by the acquiree Guarantees Instruments indexed to or settled in shares and classified as liabilities Measuring the fair value of debt assumed Amounts that might be assets or liabilities Preacquisition contingencies What is considered a preacquisition contingency? Initial recognition and measurement guidance Fair value can be determined Fair value cannot be determined Subsequent accounting for preacquisition contingencies Preacquisition contingencies recognized at fair value Preacquisition contingencies recognized pursuant to the guidance in ASC Adjustment to preacquisition contingencies during the measurement period Preacquisition contingencies that are not recognized in a business combination Contingencies that are not considered preacquisition contingencies Escrow payments Working capital adjustments Income taxes Financial reporting developments Business combinations iv

7 Contents Long-term construction contracts Determining the unit of account for an acquired long-term contract Valuation considerations for an acquired long-term contract Completed-contract method Percentage-of-completion method Executory contracts Off-market element of fair value in executory contracts Inherent fair value in executory contracts Leases Lessee accounting Lessor accounting Lease modifications in connection with a business combination Acquired leasehold improvement Derivatives Employment contracts Preexisting relationships between parties to a business combination Settlements of contractual relationships in a business combination Examples of settlements of contractual relationships in a business combination Settlement provisions that are available only in the future Settlements of preexisting relationships for which an acquirer had previously recognized assets or liabilities Settlement of debt Settlement of a noncontractual relationship (e.g., a lawsuit) in a business combination Reacquired rights in a business combination Noncontrolling interests What is noncontrolling interest? Estimating the fair value of a noncontrolling interest Noncontrolling interest s share of goodwill Accounting for put options, call options or forward contracts entered over NCI in a business combination Accounting for noncontrolling interest after the business combination Acquisition of noncontrolling interest in connection with a business combination Subsequent accounting for assets acquired and liabilities assumed in a business combination Income tax considerations Consideration transferred Measurement of consideration transferred Items included in consideration transferred Equity instruments issued (including measurement date) Issuance of preferred shares as consideration Issuance of subsidiary shares as consideration Debt instruments issued Valuing convertible debt and debt issued with warrants Recognizing gains or losses on non-cash assets transferred Financial reporting developments Business combinations v

8 Contents Recognizing gains or losses on transfers of assets that remain under the acquirer s control Consideration transferred in a business combination achieved without the transfer of consideration Mutual entities Applying the acquisition method to combinations of mutual entities Acquisition-related costs Allocating transaction costs to the business combination and financing transactions Equity issuance costs Costs incurred by the sellers of an acquired company Costs incurred by the sellers of an acquired company on behalf of the acquirer Success fee related to a business combination Costs incurred in connection with asset acquisitions Exchange of share-based payment awards in a business combination Measurement of share-based payment awards Replacement of share-based payment awards Acquirer is obligated to replace acquiree s share-based payment awards Graded vesting Forfeiture estimates Acquiree awards with change-in-control provisions Acquirer accelerates vesting after the acquisition date Exchange of awards with performance conditions Exchange of awards with market conditions Acquirer does not replace acquiree s share-based payment awards (i.e., acquiree awards remain outstanding) Acquiree share-based payment awards expire as a result of the business combination Income tax effects of replacement awards classified as equity Cash settlement of acquiree share-based payment awards Last-man-standing arrangements Examples Accounting for share-based payments in a business combination No required postcombination service, all requisite service for acquiree awards rendered as of acquisition date Postcombination service required, all requisite service for acquiree awards rendered as of acquisition date Postcombination service required, all requisite service for acquiree awards not rendered as of a date No required postcombination service, all requisite service for acquiree awards not rendered as of acquisition date Contingent consideration Recognition and measurement of contingent consideration Consideration held in escrow for general representations and warranties Determining the unit of account of a contingent consideration arrangement Financial reporting developments Business combinations vi

9 Contents Classification of contingent consideration The roadmap of applicable sections of the Codification to consider in determining the appropriate classification of contingent consideration Application of ASC 480 to classification of contingent consideration Application of ASC 815 to classification of contingent consideration Determining if a contingent consideration arrangement is indexed to the acquirer s own stock Determining if a contingent consideration arrangement indexed to the acquirer s own stock should be classified in equity Examples illustrating principles when evaluating classification Determining the fair value of contingent consideration Selecting a deterministic or a probabilistic approach Estimating an appropriate discount rate Contingent payments to employees or selling shareholders Continuing employment Evaluating whether there is an in-substance service period Duration of continuing employment Level of compensation Incremental payments to employees Relative stock ownership Linkage to the valuation Formula for determining contingent consideration Other agreements and issues Examples of arrangements with contingent payments to employees or selling shareholders Accounting for contingent consideration after initial recognition Contingent consideration classified as equity Continuous analysis of contingent consideration classified as equity Contingent consideration classified as liabilities Changes to contingent consideration arrangements Dispute over the terms of a contingent consideration arrangement Modification to a contingent consideration arrangement Effect of contingent consideration classified as equity on earnings per share computations Basic earnings per share Diluted earnings per share Assumed contingent consideration obligations Seller accounting for contingent consideration in deconsolidation Other matters (including goodwill, measurement period and acquisitions achieved in stages) Recognizing and measuring goodwill Recognition Measurement Recognizing and measuring a gain from a bargain purchase Required reassessment of identification and measurement of all aspects of the transaction Financial reporting developments Business combinations vii

10 Contents Bargain purchase example Bargain purchase in an acquisition of less than 100% controlling interest Measurement period Measurement period defined Provisional amounts recognized Adjustments to provisional amounts during the measurement period Recognition of measurement-period adjustments Transition requirements Acquisition accounting subsequent to the measurement period Business combinations achieved in stages Accounting prior to obtaining control Accounting for a preexisting investment when control is obtained Remeasurement of previously held interest Presentation and disclosure Gain recognized in a bargain purchase Cash paid to acquire a business Other presentation matters Transaction costs Classification in the statement of operations Classification in the statement of cash flows Contingent consideration Contingent consideration classified as equity Remeasurement of contingent consideration classified as a liability or an asset General disclosure requirements Overview When to disclose a business combination Aggregation of immaterial business combinations Specific disclosure requirements Disclosure requirements for specific assets acquired, liabilities assumed and noncontrolling interest Disclosure requirements for goodwill, bargain purchase gains and consideration transferred Intangible assets disclosures in period of acquisition Additional pro forma disclosures required for public entities Definition of a public business entity for purposes of evaluating the requirement to provide pro forma disclosures Effect of measurement period adjustments on the pro forma disclosures Presentation of pro forma information for a business combination Article 10 pro forma information Computation and presentation in MD&A SEC reporting requirements for business combinations Financial statements of businesses acquired or to be acquired Pro forma financial information Business combinations after the balance sheet date In what periods are the disclosures required? Initial accounting for a business combination is incomplete Financial reporting developments Business combinations viii

11 Contents ASC 820 disclosure considerations Retention of an investment banker Disclosures related to acquired IPR&D assets Disclosure related the measurement of previously held equity interests Conforming accounting policies Effective date and transition Overview Transition considerations for prior business combinations Liabilities for certain restructuring activities Resolution of contingent consideration A Accounting for asset acquisitions... A-1 A.1 Scope... A-1 A.1.1 Summary of key differences between accounting for a business combination versus an asset acquisition... A-2 A.1.2 Settlements of preexisting relationships in asset acquisitions... A-3 A.2 Measurement of the cost of an asset acquisition... A-3 A.2.1 Transaction costs... A-4 A.2.2 Nonmonetary assets as consideration transferred... A-4 A.2.3 Fair value measurements... A-4 A.3 Allocation of consideration transferred in asset acquisitions... A-5 A.3.1 Cost assignment in asset acquisitions... A-5 A Intangible assets, including goodwill... A-5 A Assembled workforce... A-5 A In-process research and development... A-6 A Deferred income tax accounting... A-6 A Acquired contingencies... A-6 A Accounting for leases in asset acquisitions... A-6 A Asset Acquisition lessor... A-6 A Asset acquisition lessee... A-6 A.3.2 Excess of cost over the fair value of acquired assets... A-7 A.3.3 Excess of fair value of acquired assets over cost (bargain purchase)... A-9 A.3.4 Accounting for contingent consideration in asset acquisitions... A-10 A Excess of fair value over cost of acquired assets with contingent consideration and IPR&D... A-10 A.3.5 The acquisition of a controlling interest in an entity that does not constitute a business... A-10 A.4 Subsequent accounting... A-11 A.4.1 Subsequent accounting for assets recognized based on the settlement of a contingent consideration arrangement... A-11 A.4.2 Other considerations research and development assets... A-12 A.5 Disclosure considerations... A-12 A.5.1 Intangible assets... A-12 A.5.2 Tangible assets... A-13 A.5.3 Nonmonetary assets... A-13 A.5.4 Contingent consideration arrangements... A-13 Financial reporting developments Business combinations ix

12 Contents B Pushdown accounting and other new basis issues... B-1 B.1 Overview... B-1 B.1.1 Differences between ASU and the rescinded SEC staff guidance... B-1 B.2 Scope... B-3 B.3 Recognition... B-4 B.4 Measurement... B-7 B.4.1 Bargain Gain... B-8 B.4.2 Acquisition-related liabilities incurred by acquirer... B-9 B.4.3 Treatment of a contingent consideration asset or liability... B-9 B.4.4 Treatment of a parent s fair value option election in acquiree s financial statements... B-10 B.4.5 Acquisition-related costs... B-10 B.4.6 Subsequent accounting... B-10 B Pushdown of goodwill and testing for impairment... B-10 B.5 Disclosure... B-11 B.6 Transition... B-12 B.7 Financial reporting considerations... B-13 B.7.1 Financial statement presentation and disclosure... B-13 B Expenses related to the business combination... B-13 B.7.2 Effect on new registration statements when pushdown accounting is applied in an interim period... B-14 B.8 Other new basis considerations... B-14 B.8.1 Recapitalizations... B-14 B Recapitalization involving a new entity (Newco)... B-15 B Transaction costs in a recapitalization... B-15 C Accounting for common control transactions... C-1 C.1 Introduction... C-1 C.2 Defining common control... C-2 C.2.1 Determining whether common control exists... C-3 C.3 Nature of common control transactions... C-4 C.3.1 Transfer of financial assets... C-5 C.3.2 Transfer of inventory... C-6 C.4 Accounting and reporting by the receiving entity... C-6 C.4.1 VIE and primary beneficiary are under common control... C-7 C.4.2 Financial statement presentation by the receiving entity... C-8 C Considerations for applying pooling-of-interests... C-9 C Determining the predecessor entity in certain common control transactions... C-11 C.4.3 Noncontrolling interests in a common control transaction... C-12 C.5 Accounting and reporting by the transferring entity... C-14 C.5.1 Impairment considerations... C-15 C.5.2 Financial statement presentation by the transferring entity... C-16 C.6 Transactions involving common ownership... C-18 C.6.1 Transactions not involving identical common ownership... C-19 C.7 Income taxes... C-19 C.7.1 Deferred taxes... C-19 C.7.2 Tax basis differences... C-20 Financial reporting developments Business combinations x

13 Contents C.8 Disclosures... C-20 C.9 Reporting unit and goodwill impairment... C-21 C.10 IFRS considerations... C-21 D Accounting for puts, calls and forwards over NCI in a business combination... D-1 D.1 Overview... D-1 D.2 Roadmap for initial classification of equity contracts over NCI... D-2 D.3 Evaluating whether an equity contract is embedded or freestanding... D-3 D.4 Embedded call or put options... D-4 D.5 Embedded forward contracts and certain combinations of embedded options... D-5 D.5.1 Embedded forward contract... D-6 D.5.2 Combination of embedded call and put options that are similar to forward contracts... D-6 D.6 Redeemable NCI... D-7 D.7 Freestanding equity contracts... D-8 D.7.1 Accounting for freestanding put or call options... D-8 D.7.2 Accounting for a freestanding forward purchase contract... D-9 D.8 Effect of equity contracts on NCI on EPS... D-10 D.9 Illustrative examples of equity contracts on NCI... D-11 E Private Company Council alternatives... E-1 E.1 Overview... E-1 E.2 Definition of a private company and a public business entity... E-1 E.3 Goodwill accounting alternative... E-2 E.4 Intangible assets accounting alternative... E-3 E.4.1 Overview and scope... E-3 E Interaction with the goodwill alternative... E-4 E.4.2 Recognition... E-4 E Application of the intangible assets alternative to customerrelated intangible assets... E-5 E Off-market components... E-6 E Contract assets and leases... E-7 E Application of the intangible assets alternative to noncompetition agreements... E-7 E.4.3 Transition requirements... E-8 F Internal control over financial reporting in a business combination... F-1 F.1 Introduction... F-1 F.2 Management review controls... F-1 F.2.1 Assessing design effectiveness... F-2 F.3 Steps in a business combination... F-3 F.4 Internal control considerations for valuation analyses... F-5 F.5 Controls to consider that may be within other processes... F-7 G Business combination accounting and reporting considerations tool... G-1 G.1 Instructions and explanatory comments... G-1 H Flowchart for SEC Rule 3-05 and illustrative disclosure for ASC H-1 H.1 SEC Rule 3-05 flowchart... H-1 H.2 Illustrative disclosures for ASC H-3 H.2.1 Comprehensive ASC 805 disclosure... H-3 H.2.2 Adjustment to provisional amount disclosure... H-6 Financial reporting developments Business combinations xi

14 Contents I Summary of important changes... I-1 J Differences between ASC 805 and IFRS 3(R)... J-1 K Abbreviations used in this publication... K-1 L Glossary... L-1 M Index of ASC references in this publication... M-1 Financial reporting developments Business combinations xii

15 Contents Notice to readers: This publication includes excerpts from and references to the FASB Accounting Standards Codification ( the Codification or ASC ). The Codification is the single source of authoritative nongovernmental US generally accepted accounting principles (US GAAP), with the exception of guidance issued by the SEC, and is effective for interim and annual periods ending after 15 September The Codification comprises all US GAAP issued by a standard setter, excluding those standards for state and local governments, and supersedes previously issued accounting standards. The Codification uses a hierarchy that includes Topics, Subtopics, sections and Paragraphs. Each Topic includes an Overall Subtopic that generally includes pervasive guidance for the topic, and additional Subtopics, as needed, with incremental or unique guidance. Each Subtopic includes sections which in turn include numbered Paragraphs. Thus, a codification reference includes the Topic (XXX), Subtopic (YY), section (ZZ) and Paragraph (PP). Throughout this publication references to guidance in the codification are shown using these reference numbers. For example, references to specific Topics within the Codification are presented as ASC XXX, references to specific Subtopics are presented as ASC XXX-YY and references to specific Paragraphs are shown as ASC XXX-YY-ZZ-PP. Certain content from pre-codification standards (e.g., basis for conclusions) is excluded from the Codification. Throughout this publication, references are made to certain pre-codification standards (and specific sections or paragraphs of pre-codification standards) in situations in which the content being discussed is excluded from the Codification. We have included the following items as appendices to this publication: Appendix A Appendix B Appendix C Appendix D Appendix E Appendix F Appendix G Accounting for asset acquisitions Pushdown accounting and other new basis issues Accounting for common control transactions Accounting for puts, calls and forwards over NCI in a business combination Private Company Council alternatives Internal control over financial reporting in a business combination Business combinations accounting and reporting considerations tool Appendix H Flowchart for SEC Rule 3-05 and illustrative disclosures for ASC 805 Appendix I Appendix J Appendix K Appendix L Appendix M Summary of important changes Differences between ASC 805 and IFRS 3(R) Abbreviations used in this publication Glossary Index of ASC references in this publication Portions of FASB publications reprinted with permission. Copyright Financial Accounting Standards Board, 401 Merritt 7, P.O. Box 5116, Norwalk, CT , U.S.A. Portions of AICPA Statements of Position, Technical Practice Aids, and other AICPA publications reprinted with permission. Copyright American Institute of Certified Public Accountants, 1211 Avenue of the Americas, New York, NY , USA. Copies of complete documents are available from the FASB and the AICPA. Financial reporting developments Business combinations xiii

16 1 Overview of accounting for business combinations 1.1 Overview Excerpt from Accounting Standards Codification Business Combinations Overall General Background The Business Combinations Topic provides guidance on the accounting and reporting for transactions that represent business combinations to be accounted for under the acquisition method (as described in paragraph ). In addition, the Topic includes Subtopic , which provides guidance on transactions sometimes associated with business combinations but that do not meet the requirements to be accounted for as business combinations under the acquisition method. This Financial Reporting Developments ( FRD ) publication provides guidance and our observations on the application of the guidance in ASC 805. After the issuance of Statements 141 and 142, the FASB began deliberating the second phase of its business combinations project. The objectives of the second phase of the project were to reconsider the guidance on applying the purchase method of accounting that Statement 141 carried forward from APB 16 and Statement 38, and to address other related issues that were not considered in the first phase of the project, including business combinations that are achieved through means other than purchasing the net assets or equity interests in a business, acquisitions of less than 100% of the equity ownership interests in an acquiree (i.e., partial acquisitions) and the accounting for business combinations achieved in stages (commonly referred to as step acquisitions). The FASB partnered with the IASB on the second phase of the project to promote the international convergence of accounting and reporting standards for business combinations. The FASB and IASB developed common exposure drafts that incorporated the decisions reached in their joint project. The FASB and IASB concurrently deliberated and reached the same conclusions on the fundamental issues that were considered in the second phase of the project, with only limited exceptions. As a result, the final FASB and IASB standards on business combinations are substantially the same. Appendix J of this FRD summarizes the differences between ASC 805 and IFRS 3(R) as well as the differences between ASC 805 and Statement The overall principle in ASC 805: obtaining control results in a new basis ASC 805 reflects the overall principle that when an entity (the acquirer) takes control of another entity (the target), the fair value of the underlying exchange transaction is used to establish a new accounting basis of the acquired entity. Furthermore, because obtaining control leaves the acquirer responsible and Financial reporting developments Business combinations 1

17 1 Overview of accounting for business combinations accountable for all of the acquiree s assets, liabilities and operations, the acquirer recognizes and measures the assets acquired and liabilities assumed at their full fair values 1, 2 as of the date control is obtained, regardless of the percentage ownership in the acquiree or how the acquisition was achieved (e.g., a business combination achieved in stages, a single purchase resulting in control, or a change in control without a purchase of equity interests). ASC 805 refers to this method as the acquisition method. 1.4 Scope: identifying business combination transactions Under ASC 805, a business combination occurs when an entity obtains control of a business by acquiring its net assets, or some or all of its equity interests. The FASB believes that all transactions or events in which an entity obtains control of a business are economically similar and, therefore, the accounting for a change in control should not differ based on the means by which control is obtained. Thus, although a business combination typically occurs through the purchase of the net assets or equity interests of a business, a business combination could also occur without the transfer of consideration (e.g., through a contractual arrangement) Definition of a business As noted above, under ASC 805 a business combination occurs when an entity obtains control of a business. The new definition of a business under ASC 805 is broad, which has resulted in many more transactions qualifying as a business combination. The determination of whether the acquired activities and assets constitute a business is critical because the accounting for a business combination differs significantly from that of an asset acquisition. Because significant judgments are required to conclude whether an acquired set of activities and assets is a business, companies should carefully evaluate their specific facts and circumstances when applying the guidance in ASC 805. The FASB has a project to clarify certain aspects of the definition of a business and plans to issue a proposal in the second half of The expected proposal would provide a more robust framework to assist entities in their analysis of when a set of transferred assets and activities (set) is a business by: (1) requiring that a business include at least one substantive process, (2) clarifying that an acquisition in which substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets is not a business and (3) narrowing the definition of outputs. We encourage readers to monitor developments in this area Control assessment An acquirer in a business combination is the entity that obtains control over a business. When an acquirer obtains its interest through the acquisition of a legal entity (rather than through the acquisition of a group of assets and liabilities) it should consider the following guidance, as well as other applicable literature, to determine whether its interests represent a controlling financial interest that requires the investor to consolidate the entity under ASC 810: The investor assesses whether the entity should be consolidated under the provisions of ASC 810. This assessment would first include an evaluation to determine whether the investee is a variable interest entity (VIE), and if so, whether the investor is the VIE s primary beneficiary. See our FRD, Consolidation and the Variable Interest Model: Determination of a controlling financial interest, for guidance on this assessment. 1 The term fair value as used in ASC 805 has the same meaning as in ASC As discussed in section 3.4 of this FRD, ASC 805 provides certain exceptions to the fair value measurement principle. Financial reporting developments Business combinations 2

18 1 Overview of accounting for business combinations If the investor determines that the entity is not a VIE, it should evaluate whether it controls the entity pursuant to consolidation guidance for voting interest entities within ASC 810 (including control by contract). See Appendix C of our FRD, Consolidation and the Variable Interest Model: Determination of a controlling financial interest, for guidance on this assessment. The investor should consider industry-specific guidance, such as the real estate industry accounting provisions of ASC , which address consolidation. In February 2015, the FASB issued ASU , Consolidation (Topic 810): Amendments to the Consolidation Analysis. The ASU could affect the consolidation conclusions for all reporting entities. For public business entities, ASU is effective for annual and interim periods beginning after 15 December For nonpublic business entities, it is effective for annual periods beginning after 15 December 2016, and interim periods beginning after 15 December Early adoption is permitted, including adoption in an interim period. See our Technical Line publication, New consolidation guidance will require many entities to re-evaluate their conclusions, for more information. 1.5 Recognizing and measuring the identifiable assets acquired, the liabilities assumed and any noncontrolling interest in the acquiree ASC 805 requires that identifiable assets acquired, liabilities assumed and any noncontrolling interest in the acquiree be recognized and measured as of the acquisition date at fair value (with certain limited exceptions). The FASB observed that to fairly represent economic circumstances at the acquisition date, in principle, all assets acquired and liabilities assumed should be recognized at the acquisition date and measured at fair value. In addition, although the objectives of the business combinations project were not directly related to day 2 accounting3 for assets acquired and liabilities assumed, ASC 805 provides guidance on accounting for certain acquired assets and assumed liabilities after the business combination. Some of the most significant recognition and measurement exceptions included in ASC 805 are as follows: Income taxes are recognized and measured in accordance with ASC 740. Under ASC 740, (a) changes that result from a business combination transaction in an acquirer s existing deferred income tax asset valuation allowances and (b) changes in an acquired company s deferred income tax asset valuation allowances and income tax uncertainties that occur subsequent to the business combination, in most cases, are recognized as adjustments to income tax expense. If the fair value of a preacquisition contingency is not determinable during the measurement period, the preacquisition contingency still must be recognized if it meets the probable and reasonably estimable criteria in ASC 450. Assumed pension and postretirement benefit obligations are measured and recognized in accordance with the guidance in ASC 715. The effects of expected terminations, curtailments or amendments of an assumed acquiree benefit plan are not included in purchase accounting. Indemnification assets relating to liabilities recognized in the business combination are recognized and measured using assumptions consistent with those used to measure the liabilities to which they relate, subject to any contractual limitations as to the indemnification amount and management s assessment of collectability. A liability or equity instrument issued to replace the acquiree s share-based payment awards is measured in accordance with the guidance in ASC 718, which is a fair-value-based measure. 3 Day 2 accounting refers to the accounting for the acquired entity as part of the combined operations subsequent to the acquisition date of the business combination. Financial reporting developments Business combinations 3

19 1 Overview of accounting for business combinations 1.6 Consideration transferred ASC 805 requires that all consideration transferred (i.e., the purchase price) be measured at its acquisition-date fair value. Under ASC 805, consideration transferred is comprised of the acquisitiondate fair values of: Assets transferred, Liabilities incurred, 4 including contingent consideration obligations and Equity interests issued by the acquirer. Consideration transferred may take many forms, including cash, tangible and intangible assets, a business or subsidiary of the acquiring entity, securities of the acquiring entity (e.g., common stock, preferred stock, options, warrants and debt instruments) or other promised future payments of the acquiring entity, including contingent payments. Irrespective of the form, the fair value of all consideration transferred is recognized at the acquisition date. ASC 805 also provides guidance on the day 2 accounting for contingent consideration that is recognized as consideration transferred in the business combination. 1.7 Recognizing and measuring goodwill or a gain from a bargain purchase Under ASC 805, an acquirer in a business combination recognizes 100% of the fair value of the business acquired (i.e., the full fair value of the assets acquired, liabilities assumed and any noncontrolling interests) as of the acquisition date. This is referred to as the full-goodwill approach and is applicable without regard to the actual controlling ownership interest acquired. 5 This principle applies whether control is obtained by purchasing an acquiree s net assets, purchasing some (or all) of the acquiree s equity interests, by contract alone or by other means. The result under ASC 805 is that recognized goodwill will represent all of the goodwill of the acquired business, as opposed to just the acquirer s share Bargain purchases In rare circumstances, the acquirer s interest in the acquiree (i.e., the fair value of consideration transferred, the fair value of any noncontrolling interest in the acquiree and the fair value of any previously held equity interest in the acquiree) is less than the fair value (or other recognized value for the exceptions to fair value recognition) of the identifiable net assets acquired. Such a transaction results in an economic gain to the acquiring entity. Any such gain should not be classified as extraordinary 6, and is recognized in earnings only after a thorough reassessment of all elements of the accounting for the acquisition A business combination achieved in stages An acquirer may obtain control of an acquiree through a series of acquisitions of two or more different investments, which ASC 805 refers to as a business combination achieved in stages. If the acquirer holds a noncontrolling equity investment in the acquiree immediately before obtaining control, the acquirer remeasures that investment to fair value as of the acquisition date and recognizes any remeasurement gains or losses in earnings. 4 Liabilities incurred refers to obligations of the acquirer to former owners of a target company and not to liabilities of the acquiree assumed in a business combination by an acquirer. Liabilities assumed are not considered an element of consideration transferred. 5 Under IFRS 3(R), the IASB permits an alternative to the recognition of 100% of residual goodwill, allowing the acquirer to recognize components of noncontrolling interest that are present ownership interests and entitle their holders to a proportionate share of the acquiree s net assets in the event of liquidation at either full fair value or its proportionate share of the fair value of the identifiable net assets. 6 In January 2015, the FASB issued ASU , which eliminated the concept of extraordinary items (and the related presentation and disclosure requirements) from US GAAP. ASU is effective for annual periods, and interim periods within those annual periods, beginning after 15 December Financial reporting developments Business combinations 4

20 1 Overview of accounting for business combinations After taking control of a target company, further acquisitions of ownership interests (i.e., acquisitions of noncontrolling ownership interests) are accounted for as transactions among shareholders pursuant to the guidance in ASC Measurement period ASC 805 provides for a period of time during which the acquirer may adjust provisional amounts recognized at the acquisition date to their subsequently determined acquisition-date fair values, referred to as the measurement period. Adjustments during the measurement period are not limited to just those relating to assets acquired and liabilities assumed, but apply to all aspects of business combination accounting (e.g., the consideration transferred). In September 2015, the FASB issued ASU that eliminates the current requirement for an acquirer in a business combination to account for measurement-period adjustments retrospectively. Instead, acquirers must recognize measurement-period adjustments during the period in which they determine the amounts, including the effect on earnings of any amounts they would have recorded in previous periods if the accounting had been completed at the acquisition date. The guidance is effective in 2016 for calendar year end public business entities and a year later for other entities. Early adoption is permitted for all entities Assessing what is part of the exchange for the acquiree To distinguish elements that should be accounted for as part of the business combination from elements that should be accounted for outside of the business combination, ASC 805 requires an acquirer to assess if any assets acquired, liabilities assumed or portion of the transaction price are not part of the exchange for the acquiree. Exchanged values of any portion of the assets acquired, liabilities assumed or transaction price that is not part of the exchange for the acquiree are accounted for separately from the business combination and may increase or decrease the consideration transferred in the business combination. Examples of payments or other arrangements that would not be considered part of the exchange for the acquiree, and thus not part of the accounting for the business combination, include payments that effectively settle preexisting relationships between the acquirer and acquiree, payments to compensate employees or former owners of the acquiree for future services, acquirer share-based payments exchanged for acquiree awards that are determined not to be part of the consideration transferred, and costs incurred in connection with a business combination (i.e., transaction costs). 1.8 Disclosure requirements The FASB, like the IASB, developed overall objectives for disclosure of information related to a business combination. ASC 805 provides specific, detailed disclosure requirements that are intended to facilitate meeting these disclosure objectives. However, ASC states that if these specific disclosure requirements and those required by other GAAP do not meet the overall disclosure objectives of the standard, an acquirer should disclose any additional information necessary to meet those objectives. Financial reporting developments Business combinations 5

21 2 Identifying business combination transactions 2.1 What is a business combination? Excerpt from Accounting Standards Codification Business Combinations Overall Recognition An entity shall determine whether a transaction or other event is a business combination by applying the definition in this Subtopic, which requires that the assets acquired and liabilities assumed constitute a business. If the assets acquired are not a business, the reporting entity shall account for the transaction or other event as an asset acquisition. An entity shall account for each business combination by applying the acquisition method. Implementation Guidance and Illustrations Paragraph requires an entity to determine whether a transaction or event is a business combination. In a business combination, an acquirer might obtain control of an acquiree in a variety of ways, including any of the following: a. By transferring cash, cash equivalents, or other assets (including net assets that constitute a business) b. By incurring liabilities c. By issuing equity interests d. By providing more than one type of consideration e. Without transferring consideration, including by contract alone (see paragraph ) A business combination may be structured in a variety of ways for legal, taxation, or other reasons, which include but are not limited to, the following: a. One or more businesses become subsidiaries of an acquirer or the net assets of one or more businesses are legally merged into the acquirer. b. One combining entity transfers its net assets or its owners transfer their equity interests to another combining entity or its owners. c. All of the combining entities transfer their net assets or the owners of those entities transfer their equity interests to a newly formed entity (sometimes referred to as a roll-up or put-together transaction). d. A group of former owners of one of the combining entities obtains control of the combined entity. Financial reporting developments Business combinations 6

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