Implications of the Joint FASB and IASB Proposal on Accounting for Business Combinations
Conceptual Changes on the Path to Convergence

By Pamela A. Smith and Georgia Saemann

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[On June 30, 2005, FASB and the IASB also issued an ED, Consolidated Financial Statements, which addresses accounting after the date of acquisition. Descriptions and examples of the conceptual views of the post-acquisition entity are addressed in “Understanding the Different Views of Consolidation,” by Rebecca Toppe Shortridge and Pamela A. Smith, accessible by clicking here.]

Conceptual Changes

Although the IASB and FASB’s conceptual frameworks state that information is useful if it is relevant and reliable, there has been a deliberate focus recently on improving relevance at the expense of reliability, as demonstrated in recent pronouncements in the areas of pensions, investments in securities, impairment of long-lived assets, goodwill impairment, asset retirement obligations, derivatives, and cash flow (see FASB Concept Statement 7). SFAS 141(R) continues this course with a focus on fair valuation. Exhibit 1 summarizes the two conceptual changes proposed in the ED: the conceptual view of the combined entity and the determination of the acquisition value.

Parent View Versus Entity View

The conceptual difference between the parent and the entity views of a business combination is based on the way the fair value increment and goodwill are determined and allocated. The fair value increment is the excess of the fair value over the book value of the acquiree’s identifiable net assets. Goodwill is the amount paid by the acquirer in excess of the fair value of the identifiable net assets. For example, if the purchase price is $200, the fair value of the identifiable net assets is $160, and the book value of the net assets is $100, then the fair value increment would be $60 ($160 – $100) and goodwill would be $40 ($200 – $160).

At present, U.S. accounting standards are consistent with the parent view of the consolidated entity. Under the parent view, the parent company consolidates 100% of the book value of the acquiree’s net assets but only the parent’s percentage share of the fair value increment and goodwill. Therefore, the noncontrolling interest (NCI) share of the acquiree’s net assets is the acquiree’s original book value with no fair value increment or goodwill allocation. The rationale is that the consolidated entity should recognize only the percentage of the fair value increment and goodwill that was actually purchased by the acquiree.

SFAS 141(R) proposes that accounting for business combinations (and subsequent consolidation) follow the entity view, under which the parent company consolidates 100% of the book value of the acquiree’s net assets plus 100% of the fair value increment; goodwill is recognized and allocated between the controlling and noncontrolling interests. Note that this view requires a full fair value measurement of the goodwill associated with the acquisition. Goodwill will be the difference between the fair value of the acquiree as a whole and the fair value allocated to its identifiable assets and liabilities.

The entity view is appealing because it presumes that an acquisition results in the acquirer’s full control of the fair market value of the acquiree’s assets and liabilities, even if the acquisition is less than 100%. The rationale underlying the entity view is that if the acquired company is controlled, 100% of the net assets are controlled, and, accordingly, the acquired assets and liabilities should be reported at full fair value. In contrast, the parent view presumes control of 100% of the net assets, but recognizes only the parent’s share of the fair value increment.

The authors’ review of the comment letters on the ED revealed different perspectives on the proposed change to the entity view. Supporters noted that the entity view gives the reader more complete information than the parent view about the economic position of the consolidated entity. The most common concern expressed by opponents of the entity view was with the extension of goodwill to the NCI. The International Organization of Securities Commissions (IOSCO) argued that goodwill is too “hypothetical” to extrapolate its value and extend to NCI. Moreover, the French Society of Financial Analysts (FSFA) noted that users will not consider “full goodwill” in their analyses because it provides neither relevant nor reliable information. Historically, goodwill has been recorded only when paid for, because of its ambiguity and the associated difficulty of achieving a reliable measurement absent a transaction. Some commentators argued that if full goodwill is merely an extrapolation from the value of the goodwill paid by the acquiree, the extrapolated value is unreliable.

Although there is some merit to the concerns expressed by opponents of the entity view, the authors would like to point out that the application of the entity view must be evaluated in tandem with the ED’s proposed model for measuring acquisition value. Under SFAS 141(R)’s new model, the acquisition value would be the fair value of the acquiree as a whole, not the price paid in the acquisition. Therefore, goodwill would not be an extension of goodwill “paid for” but rather would be the excess of the fair value of the acquiree as a whole over the fair value of its identifiable net assets. Theoretically, this should provide a sounder base for measuring goodwill than one based on the residual payment. There should be no distortion associated with factors that affect the fair value of the purchase price, such as an embedded control premium.

Acquisition Value

Under the present accounting rules, an acquisition of a controlling interest in another company is recorded based on the cost of the acquisition. This approach is referred to as purchase method accounting and is consistent with accounting for any asset investment. The purchase method is based on the premise that cost is the most reliable measure of an asset’s fair value. Purchase method accounting also permits the capitalization of direct costs associated with consummation of the business combination, such as finders’ fees.

SFAS 141(R) proposes acquisition method accounting. Acquisition method accounting requires the purchaser to record the value of the acquiree at fair value. Absent evidence to the contrary, acquisition-date fair value of the consideration transferred is presumed to be the fair value of the acquirer’s interest in the acquiree. The ED recognizes that, although business combinations are usually arm’s-length transactions, there is often evidence that the exchange price is not the best basis for measuring the acquisition-date fair value of the acquiree. Such evidence arises in several situations: when there is an obvious control premium embedded in the purchase price, when no consideration is transferred on the acquisition date (e.g., control is obtained when the acquiree repurchases its own shares, causing an existing owner to obtain control), when the transaction is not an exchange of equal values because the seller is acting under duress, or when the fair value of the consideration transferred cannot be reliably measured.

Theoretically, fair value, as opposed to cost, is an appealing measurement of a business combination because, by definition, assets are future economic benefits and fair value better reflects future benefits than cost if the two values do not agree. Fair value that is not based on a transaction is difficult to determine, however, leading to questions of reliability and, accordingly, decision usefulness. The debate between cost and fair value is an excellent example of the trade-off between reliability and relevance. The position taken in the ED reflects standards setters’ recent focus on improving relevance over reliability.

The reaction to conceptual change embodied by the ED has been mixed. While many agree that fair value is more relevant than cost, many still oppose using fair value, arguing that the methodology needs to be clarified before it can be promulgated and applied to business combinations. Some commentators argue that the fair value of an acquiree in a business combination is idiosyncratic, determinable only in the context of the value to the acquirer (value-in-use). They also note that this characteristic conflicts directly with the underlying premise of SFAS 157, Fair Value Measurements, which presumes that fair value is not idiosyncratic to the intended purpose, but rather the result of a pure value-in-exchange.

Implications for Existing Literature

In addition to the conceptual shifts, the ED introduces accounting that differs from existing accounting standards unrelated to business combinations, such as those involving research and development (R&D), contingencies, and unrealized gains and losses. The adoption of accounting methods for business combinations that significantly differ from accounting methods not related to business combinations will result in different treatment, depending upon how the transaction originated. The accounting will not be based on the nature of the transaction, but on whether the transaction arose as part of a business combination. Financial statement preparers must explain the different accounting treatment in the footnotes, and financial statement users will have to sort out the differences. Moreover, the differences in accounting could provide an opportunity for the manipulation of transactions to obtain the desired accounting treatment.

Four major accounting differences that arise from the ED are presented in Exhibit 2: accounting for direct costs, in-process research and development costs (IPRD), acquisition date contingencies, and unrealized gains and losses on investments.

Direct Acquisition Costs

Currently, direct costs related to the purchase of an asset (e.g., inventory, fixed assets, and investments) are capitalized. The ED proposes the treatment of direct acquisition costs that is counter to this practice. According to the ED, acquisition costs are viewed as an expense for services rendered with no associated future economic value. Therefore, the costs meet the definition of an expense.

The ED seems to imply that if the purchase is a group of assets, direct acquisition costs can be capitalized; but if the purchase is a business, direct acquisition costs are expensed. [The ED states: “A business is defined as an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing either (a) a return to investors or (b) dividends, lower costs, or other economic benefits directly and proportionately to owners, members or participants” (paragraph A2).] Some commentators noted this distinction between a business acquisition and an asset acquisition and argued that in many cases purchasing a group of assets is essentially the same economic transaction as purchasing a business. They predicted that the distinction will encourage manipulation of the acquisition structure in order to meet the criteria for a business or asset purchase, depending on the preferred accounting outcome. Perhaps to separate the purchase of a business from other asset acquisitions, the ED should make the distinction between purchasing a group of assets and purchasing a business much clearer.

Research and Development Costs

SFAS 2, Accounting for Research and Development Costs, requires all R&D costs to be expensed. In accordance, FASB Interpretation (FIN) 4 required that IPRD acquired in a business combination also be expensed. If the R&D were obtained through a business combination, the proposed SFAS 141(R) would supersede FIN 4 and make an exception to the accounting for R&D in SFAS 2.

As previously discussed, the ED requires recognition of the business acquisition at fair value. In a consolidation, the value must be allocated to identifiable assets and liabilities of the acquiree, including those that have not been previously recognized. In this context, FASB views IPRD as an unrecorded asset and, accordingly, requires the allocation of fair value to IPRD. Under the ED, IPRD acquired as part of a business combination would be recorded as an asset, while R&D that is internally developed will be expensed. The source of the IPRD, rather than its substance, would determine whether the IPRD is reported as an asset or an expense.

The rationale behind the change in accounting for IPRD in a business combination is that part of the price paid for the acquiree may be attributable to its IPRD (common in pharmaceutical or technology acquisitions). If part of the purchase price is not assigned to the IPRD, there will be a greater value allocated to goodwill. That is, if part of the purchase price is attributed to the acquirer’s valuation of IPRD, then that value should be reflected in the financial statements as IPRD and not as goodwill.

Contingencies

According to SFAS 5, Accounting for Contingencies, a liability contingency is recorded only when probable and estimable. Asset contingencies are not recorded under any circumstances. The ED requires the recognition of contingencies obtained in a business combination, at fair value, if they meet the definition of an asset or liability. The probability and measurability criteria are excluded from the ED.

The proposed change in accounting for contingencies in a business combination introduces two distinct issues: the expanded recognition of contingencies, and the related valuation of contingencies. The second issue, valuation, was cited more frequently in comment letters, which noted that measures of contingencies are idiosyncratic to a specific issue, and rely too much on unverifiable views from the legal profession.

If adopted, SFAS 141(R) would introduce inconsistencies in accounting for contingencies. As a result of a business combination, companies would report contingent assets and liabilities that would not otherwise be reported.

Recognition of Unrealized Gains and Losses

Currently, investments such as trading and available-for-sale (AFS) investments are carried at fair value. The unrealized gains and losses on trading investments are recorded in income because the realization is presumed to be imminent. However, unrealized gains and losses on AFS investments are recorded in other comprehensive income (OCI) because the realization is uncertain. (It should be noted that the draft of SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, also proposed income statement recognition for all unrealized gains and losses, whether trading or AFS.)

SFAS 141(R) proposes that in a business combination achieved in stages, the acquirer would remeasure its noncontrolling equity investment to fair value at the stepped acquisition dates and recognize any unrealized gains or losses in income. Commentators did not seem to object to remeasurement of the equity investment to fair value. Many were, however, opposed to recording the unrealized gains or losses in income when realization is uncertain. Commentators noted that an acquirer often purchases additional shares of an acquiree to obtain more influence or control, making it highly unlikely that the investment would be sold and the gains and losses realized.

The consequences of adopting SFAS 141(R) would be that unrealized gains and losses in stepped acquisitions would be reflected on the income statement even though there is no imminent realization of these gains and losses. This is a direct contrast to the treatment of unrealized gains and losses for AFS securities, which are recorded in OCI until the security is sold.

Implications for Future Accounting Standards

The IASB and FASB reaffirmed the commitment made in the 2002 Norwalk Agreement in a Memorandum of Understanding dated February 27, 2006. It acknowledges that the development of “high-quality” accounting standards is more important than uniformity in efforts to achieve convergence in accounting standards. The SFAS 141(R) draft reflects this effort with its attention to underlying concepts long advocated by accounting standards setters and already evident in the convergence projects mapped out in the memorandum.

If adopted as proposed, SFAS 141 (R)’s implications for future accounting standards would include the following:

• Continued expansion of fair value accounting.
• More complete recognition of assets and liabilities.
• Increased inclusion of unrealized gains and losses in the income statement and correspondingly reduced use of other comprehensive income.

If the ED is adopted and the IASB and FASB follow the course it establishes, there could be both costs and benefits. The continued expansion of fair value accounting and more complete recognition of assets and liabilities will likely increase the cost of measuring and auditing financial information, but increase the relevance of the information provided. Increased inclusion of unrealized gains and losses in the income statement will produce more volatile income statements, but increase transparency. Even though the short-term effect of the ED will result in differences in accounting for similar transactions, if FASB follows the ED’s precedent, comparability issues will be lessened and a closer link between the conceptual framework and accounting standards will be established.

©2009 The New York State Society of CPAs. Legal Notices