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ASC 805-20-25-1 provides the recognition principle for assets acquired, liabilities assumed, and any noncontrolling interest in the acquiree.

Excerpt from ASC 805-20-25-1

As of the acquisition date, the acquirer shall recognize, separately from goodwill, the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. Recognition of identifiable assets acquired and liabilities assumed is subject to the conditions specified in paragraphs 805-20-25-2 through 25-3.

An acquirer should recognize the identifiable assets acquired and the liabilities assumed on the acquisition date if they meet the definitions of assets and liabilities in FASB CON 6, Elements of Financial Statements. For example, costs that an acquirer expects to incur but is not obligated to incur at the acquisition date (e.g., restructuring costs) are not liabilities assumed under ASC 805-20-25-2. An acquirer may also recognize assets and liabilities that are not recognized by the acquiree in its financial statements prior to the acquisition date, due to differences between the recognition principles in a business combination and other US GAAP. This can result in the recognition of intangible assets in a business combination, such as a brand name or customer relationship, which the acquiree would not recognize in its financial statements because these intangible assets were internally generated.
Certain assets acquired and liabilities assumed in connection with a business combination may not be considered part of the assets and liabilities exchanged in the business combination and will be recognized as separate transactions in accordance with other US GAAP.
ASC 805-20-30-1 provides the principle with regard to the measurement of assets acquired and liabilities assumed and any noncontrolling interest in the acquiree.

Excerpt from ASC 805-20-30-1

The acquirer shall measure the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at their acquisition-date fair values.

The measurement of the identifiable assets acquired and liabilities assumed is at fair value, with limited exceptions as provided for in ASC 805. Fair value is based on the definition in ASC 820-10-20 as the price that would be received from the sale of an asset or paid to transfer a liability in an orderly transaction between market participants. See FV 7 for a discussion of the valuation techniques and issues related to the fair value measurement of the identifiable assets acquired and liabilities assumed.
The recognition and measurement of particular assets acquired and liabilities assumed are discussed in BCG 2.5.1 through BCG 2.5.19. The following table provides a summary of the exceptions to the recognition and fair value measurement principles in ASC 805, along with references to where these exceptions are discussed.
Summary of exceptions to the recognition and fair value measurement principles
Measurement principle
• Reacquired rights (BCG 2.5.6)
• Assets held for sale (BCG 2.5.8)
• Share-based payment awards (BCG 2.6.3.1)
• Purchased financial assets with credit deterioration (subsequent to adoption of ASC 326) (BCG 2.5.2)
Recognition and measurement principles
• Income taxes (BCG 2.5.9)
• Employee benefits (BCG 2.5.10)
• Contingencies (BCG 2.5.13)
• Indemnification assets (BCG 2.5.14)
• Leases (subsequent to adoption of ASC 842) (BCG 4.3.3.7)
In some instances, the SEC has expressed the view that significant differences between the acquired entity’s historical carrying value and the acquiring entity's estimated fair value could call into question whether the fair value determined by the acquiring entity and/or the carrying value reported by the acquired entity before the acquisition is appropriate. If it is determined that the pre-acquisition carrying value was not accurate in the acquired entity’s financial statements, the pre-acquisition financial statements may require adjustment.

2.5.1 Assets that the acquirer does not intend to use

An acquirer, for competitive or other reasons, may not use an acquired asset or may intend to use the asset in a way that is not its highest and best use (i.e., different from the way other market participants would use the asset). ASC 805 specifies that the intended use of an asset by the acquirer does not affect its fair value. See BCG 4.5 for further information on the subsequent measurement of assets that the acquirer does not intend to use.

2.5.1.1 Defensive intangible assets (business combinations)

A company may acquire intangible assets in a business combination that it has no intention to actively use but intends to hold (lock up) to prevent others from obtaining access to them (defensive intangible assets). Defensive intangible assets may include assets that the entity will never actively use, as well as assets that will be actively used by the entity only during a transition period. In either case, the company will lock up the defensive intangible assets to prevent others from obtaining access to them for a period longer than the period of active use. Examples of defensive intangible assets include brand names and trademarks whereby the acquirer obtains market share by removing a competitor’s brand name/trademark from the market. A company should utilize market-participant assumptions, not acquirer-specific assumptions, in determining the fair value of defensive intangible assets.
Determining the useful life of defensive intangible assets can be challenging. The acquirer’s intention or subsequent use of the asset might affect the asset’s useful life after the acquisition date. The value of defensive intangible assets will likely diminish over a period of time as a result of the lack of market exposure or competitive environment or other factors. Therefore, the immediate write-off of defensive intangible assets would not be appropriate. It would also be rare for such assets to have an indefinite life. See BCG 4.5 and BCG 8.4 for further information on the initial and subsequent measurement of defensive intangible assets.

2.5.2 Valuation allowances (business combinations) after ASU 2016-13

As described in ASC 805-20-30-4, separate valuation allowances are not recognized for acquired non-financial assets that are measured at fair value, as any uncertainties about future cash flows are included in their fair value measurement.
Upon adoption of ASU 2016-13, Financial Instruments—Credit Losses, the accounting for acquired financial assets within the scope of ASC 326 will depend on whether the financial assets are purchased with credit deterioration. Purchased financial assets without credit deterioration will be recorded at the acquisition date fair value. Additionally, an allowance is recorded with a corresponding charge to credit loss expense in the reporting period in which the acquisition occurs. Purchased financial assets with credit deterioration will no longer be recognized at fair value. They are an exception to the measurement principle in ASC 805. Instead, the acquirer will recognize an allowance with a corresponding increase to the amortized cost basis of the financial asset as of the acquisition date.

Excerpt from ASC Master Glossary

Purchased financial assets with credit deterioration: Acquired individual financial assets (or acquired groups of financial assets with similar risk characteristics) that, as of the date of acquisition, have experienced a more-than-insignificant deterioration in credit quality since origination, as determined by an acquirer’s assessment.

The revised guidance is effective for public business entities that are SEC filers, excluding entities eligible to be smaller reporting companies (SRCs) as currently defined by the SEC, for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. For SRCs and all other entities, the revised guidance will be effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. Early adoption is permitted for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. For additional information on the effective dates of ASU 2016-13, refer to LI 13.1 (Figure LI 13-2).
See LI 9 for additional information on purchased financial assets with credit deterioration.

2.5.2A Valuation allowances (business combinations) before ASU 2016-13

Separate valuation allowances are not recognized for acquired assets that are measured at fair value, as any uncertainties about future cash flows are included in their fair value measurement, as described in ASC 805-20-30-4. This precludes the separate recognition of an allowance for doubtful accounts or an allowance for loan losses. Companies may need to separately track contractual receivables and any valuation losses to comply with certain disclosure and other regulatory requirements in industries such as financial services. In accordance with ASC 805-20-50-1(b), in the reporting period in which the business combination occurs, the acquirer should disclose the fair value of the acquired receivables, their gross contractual amounts, and an estimate of cash flows not expected to be collected.
The use of a separate valuation allowance is permitted for assets that are not measured at fair value on the acquisition date (e.g., certain indemnification assets). Consequently, a valuation allowance for deferred income tax assets is allowed.

2.5.3 Inventory acquired in a business combination

Acquired inventory can be in the form of finished goods, work in process (WIP), and/or raw materials. ASC 805 requires inventory acquired in a business combination to be measured at its fair value on the acquisition date in accordance with ASC 820. Ordinarily, the amount recognized for inventory at fair value by the acquirer will be higher than the amount recognized by the acquiree before the business combination. See FV 7.3.3.1 for further information.

2.5.4 Contracts acquired in a business combination

Contracts (e.g., sales contracts, supply contracts) assumed in a business combination may give rise to assets or liabilities. An intangible asset or liability may be recognized for contract terms that are favorable or unfavorable compared to current market transactions or related to identifiable economic benefits for contract terms that are at market. See BCG 4 for further discussion of the accounting for contract-related intangible assets.

2.5.5 Intangible assets acquired in a business combination

All identifiable intangible assets that are acquired in a business combination should be recognized at fair value on the acquisition date. Identifiable intangible assets are recognized separately if they arise from contractual or other legal rights or if they are separable (i.e., capable of being sold, transferred, licensed, rented, or exchanged separately from the entity). This includes research and development acquired in a business combination, which is recognized at fair value and capitalized as an indefinite-lived intangible asset. See BCG 4 for guidance on the recognition and measurement of intangible assets.

2.5.6 Reacquired rights in a business combination

An acquirer may reacquire a right that it had previously granted to the acquiree to use one or more of the acquirer’s recognized or unrecognized assets. Examples of such rights include a right to use the acquirer’s trade name under a franchise agreement or a right to use the acquirer’s technology under a technology licensing agreement. Such reacquired rights generally are identifiable intangible assets that the acquirer separately recognizes from goodwill in accordance with ASC 805-20-25-14. The reacquisition must be evaluated separately to determine if a gain or loss on the settlement should be recognized. See BCG 2.7.2.1 for further information.
Understanding the facts and circumstances, including those surrounding the original relationship between the parties prior to the business combination, is necessary to determine whether the reacquired right constitutes an identifiable intangible asset. Some considerations include:
  • How was the original relationship structured and accounted for? What was the intent of both parties at inception?
  • Was the original relationship an outright sale with immediate revenue recognition, or was deferred revenue recorded as a result? Was an up-front, one-time payment made, or was the payment stream ongoing? Was the original relationship an arm’s-length transaction, or was the original transaction set up to benefit a majority-owned subsidiary or joint venture entity with off-market terms?
  • Was the original relationship created through a capital transaction, or was it created through an operating (executory) arrangement? Did it result in the ability or right to resell some tangible or intangible rights?
  • Has there been any enhanced or incremental value to the acquirer since the original transaction?
  • Is the reacquired right exclusive or nonexclusive?
Contracts giving rise to reacquired rights that include a royalty or other type of payment provision should be assessed for contract terms that are favorable or unfavorable when compared to pricing for current market transactions. A settlement gain or loss should be recognized and measured at the acquisition date for any favorable or unfavorable contract terms identified. A settlement gain or loss related to a reacquired right should be measured consistently with the guidance for the settlement of preexisting relationships. See BCG 2.7.2.1 for further information. The amount of any settlement gain or loss should not impact the measurement of the fair value of any intangible asset related to the reacquired right.
The acquisition of a reacquired right may be accompanied by the acquisition of other intangibles that should be recognized separately from both the reacquired right and goodwill. For example, a company grants a franchise to a franchisee to develop a business in a particular country. The franchise agreement includes the right to use the company’s trade name and proprietary technology. After a few years, the company decides to reacquire the franchise in a business combination for an amount greater than the fair value of a new franchise right. The excess of the value transferred over the franchise right is an indicator that other intangibles, such as customer relationships, customer contracts, and additional technology, could have been acquired along with the reacquired right.

2.5.6.1 Determining value and useful life of reacquired rights

Reacquired rights are identified as an exception to the fair value measurement principle, because the value recognized for reacquired rights is not based on market-participant assumptions. In accordance with ASC 805-20-30-20, the value of a reacquired right is determined based on the estimated cash flows over the remaining contractual life, even if market-participants would reflect expected renewals in their measurement of that right. The basis for this measurement exception is that a contractual right acquired from a third party is not the same as a reacquired right under FAS 141(R).B309. Because a reacquired right is no longer a contract with a third party, an acquirer that controls a reacquired right could assume indefinite renewals of its contractual term, effectively making the reacquired right an indefinite-lived intangible asset.
Assets acquired and liabilities assumed, including any reacquired rights, should be measured using a valuation technique that considers cash flows after payment of a royalty rate to the acquirer for the right that is being reacquired because the acquiring entity is already entitled to this royalty. The amount of consideration that the acquirer would be willing to pay for the acquiree is based on the cash flows that the acquiree is able to generate above and beyond the royalty rate that the acquirer is already entitled to under the agreement.
The FASB concluded that a right reacquired from an acquiree in substance has a finite life (i.e., the contract term); a renewal of the contractual term after the business combination is not part of what was acquired in the business combination.
Therefore, consistent with the measurement of the acquisition date value of reacquired rights, the useful life over which the reacquired right is amortized in the postcombination period should be based on the remaining contractual term without consideration of any contractual renewals. In the event of a reissuance of the reacquired right to a third party in the postcombination period, any remaining unamortized amount related to the reacquired right should be included in the determination of any gain or loss upon reissuance in accordance with ASC 805-20-35-2.
In some cases, the reacquired right may not have any contractual renewals and the remaining contractual life may not be clear, such as with a perpetual franchise right. An assessment should be made as to whether the reacquired right is an indefinite-lived intangible asset that would not be amortized, but subject to periodic impairment testing. A conclusion that the useful life is indefinite requires careful consideration and is expected to be infrequent. If it is determined that the reacquired right, such as a perpetual franchise right, is not an indefinite-lived intangible asset, then the reacquired right should be amortized over its economic useful life. See PPE 4.2.1 for guidance on identifying the useful life of an intangible asset.
Example BCG 2-7 illustrates the recognition and measurement of a reacquired right in a business combination.
EXAMPLE BCG 2-7
Recognition and measurement of a reacquired right
Company A owns and operates a chain of retail coffee stores. Company A also licenses the use of its trade name to unrelated third parties through franchise agreements, typically for renewable five-year terms. In addition to on-going fees for cooperative advertising, these franchise agreements require the franchisee to pay Company A an up-front fee and an on-going percentage of revenue for continued use of the trade name.
Company B is a franchisee with the exclusive right to use Company A’s trade name and operate coffee stores in a specific market. Pursuant to its franchise agreement, Company B pays to Company A a royalty rate equal to 6% of revenue. Company B does not have the ability to transfer or assign the franchise right without the express permission of Company A.
Company A acquires Company B for cash consideration. Company B has three years remaining on the initial five-year term of its franchise agreement with Company A as of the acquisition date. There is no unfavorable/favorable element of the contract.
What should Company A consider when recognizing the reacquired right?
Analysis
Company A will recognize a separate intangible asset at the acquisition date related to the reacquired franchise right, which will be amortized over the remaining three-year period. The value ascribed to the reacquired franchise right under the acquisition method should exclude the value of potential renewals. The royalty payments under the franchise agreement should not be used to value the reacquired right, as Company A already owns the trade name and is entitled to the royalty payments under the franchise agreement. Instead, Company A’s valuation of the reacquired right should consider Company B’s applicable net cash flows after payment of the 6% royalty. In addition to the reacquired franchise rights, other assets acquired and liabilities assumed by Company A should also be measured using a valuation technique that considers Company B’s cash flows after payment of the royalty rate to Company A.

2.5.7 Property, plant, and equipment acquired in a business combination

Property, plant, and equipment acquired in a business combination intended to be held and used should be recognized and measured at fair value. Accumulated depreciation of the acquiree is not carried forward in a business combination. See FV 7.3.3.2 for further information on the measurement of property, plant, and equipment. See BCG 4.3.3.7 for the recognition and measurement of right-of-use assets and lease liabilities of an acquiree in a business combination. Also, see BCG 2.5.8 for the recognition and measurement of long-lived assets acquired in a business combination classified by the acquirer as held for sale.

2.5.7.1 Government grants acquired in a business combination

Assets acquired with funding from a government grant should be recognized at fair value without regard to the government grant. Similarly, if the government grant provides an ongoing right to receive future benefits, that right should be measured at its acquisition-date fair value and separately recognized. For a government grant to be recognized as an asset, the grant should be uniquely available to the acquirer and not dependent on future actions. The terms of the government grant should be evaluated to determine whether there are on-going conditions or requirements that would indicate that a liability exists. If a liability exists, the liability should be recognized at its fair value on the acquisition date.

2.5.7.2 AROs in a business combination

An acquirer may obtain long-lived assets, such as property, plant, and equipment, that upon retirement require the acquirer to dismantle or remove the assets and restore the site on which it is located (i.e., asset retirement obligations (AROs)). If an ARO exists at the acquisition date, it must be recognized at fair value (using market-participant assumptions), which may be different than the amount previously recognized by the acquiree. Long-lived assets and any associated AROs acquired in a business combination should be recorded on a gross basis. In other words, the acquired long-lived assets should be recorded at fair value, unencumbered by future cash flows associated with the settlement of the asset retirement obligation. Separately, an ARO should be recorded at fair value on the acquisition date. The long-lived asset and ARO are separate units of account.
For example, a nuclear power plant is acquired in a business combination. The acquirer determines that an ARO of $100 million (fair value) associated with the power plant exists at the acquisition date. The appraiser has included the expected cash outflows of the ARO in the cash flow model, establishing the value of the plant at $500 million (i.e., the appraised value of the power plant would be $100 million higher if the ARO were disregarded). The acquirer would record the power plant and the ARO as two separate units of account. The acquirer would record the power plant at its fair value of $600 million (i.e., on an unencumbered basis) and an ARO of $100 million.

2.5.8 Acquired assets held for sale in a business combination

Assets held for sale are an exception to the fair value measurement principle, because they are measured at fair value less costs to sell. A long-lived asset or group of assets (disposal group) may be classified and measured as assets held for sale at the acquisition date if, from the acquirer’s perspective, the classification criteria in ASC 360-10, Property, Plant, and Equipment, are met.
ASC 360-10-45-12 provides specific criteria which, if met, would require the acquirer to present newly-acquired assets as assets held for sale. The criteria require a plan to dispose of the assets within a year and that it be probable that the acquirer will meet the other held for sale criteria within a short period of time after the acquisition date (generally within three months). The other criteria in ASC 360-10-45-9 include (1) management having the authority to approve an action commits to sell the assets; (2) assets are available for immediate sale in their present condition, subject only to sales terms that are usual and customary; (3) an active program to locate a buyer and actions to complete the sale are initiated; (4) assets are being actively marketed; and (5) it is unlikely there will be significant changes to, or withdrawal from, the plan to sell the assets. If the criteria are not met, those assets should not be classified as assets held for sale until all applicable criteria have been met. See PPE 5.3 for further information on accounting for assets held for sale under US GAAP.
If the acquired disposal group is a business that upon acquisition meets the held for sale criteria, it must be presented as a discontinued operation. See FSP 27.3.1.1 for further information on this requirement.

2.5.9 Income taxes related to business combinations

Income taxes are identified as an exception to the recognition and fair value measurement principles. The acquirer should record all deferred tax assets, liabilities, and valuation allowances of the acquiree that are related to any temporary differences, tax carryforwards, and uncertain tax positions in accordance with ASC 740, Income Taxes.
Deferred tax liabilities are not recognized for nontax-deductible goodwill under US GAAP. However, deferred tax liabilities should be recognized for differences between the book and tax basis of indefinite-lived intangible assets.
Subsequent changes to deferred tax assets, liabilities, valuation allowances, or liabilities for any income tax uncertainties of the acquiree will impact income tax expense in the postcombination period unless the change is determined to be a measurement period adjustment. See BCG 2.9 for further information on measurement period adjustments.
Adjustments or changes to the acquirer’s deferred tax assets or liabilities as a result of a business combination should be reflected in earnings or, if specifically permitted, charged to equity in the period subsequent to the acquisition. See TX 10 for further information on the recognition of income taxes and other tax issues. Alternatively, if the tax change is not a part of the business combination, it should be accounted for as a separate transaction.
New guidance
In December 2019, the FASB issued ASU 2019-12, Income Taxes (ASC 740): Simplifying the Accounting for Income Taxes. ASU 2019-12 clarifies when a step up in the tax basis of goodwill should be considered part of the business combination in which the book goodwill was originally recognized and when it should be considered a separate transaction. In situations when the step-up in the tax basis of goodwill relates to the business combination, a deferred tax asset should be recorded only to the extent that the new tax basis exceeds the book basis in goodwill. If it is determined that the step-up in tax basis relates to a separate transaction, a deferred tax asset should be recorded since there is a tax basis with no corresponding book basis in the goodwill. Refer to TX 10.5.6 for additional information.
For public business entities, the guidance is effective for fiscal years beginning after December 15, 2020, and interim periods within those fiscal years. For all other entities, the guidance is effective for fiscal years beginning after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022. Early adoption is permitted. This amendment should be applied on a prospective basis.

2.5.10 Employee benefit plans acquired in a business combination

Employee benefit plans are an exception to the recognition and fair value measurement principles. In accordance with ASC 805-20-25-23, employee benefit plan obligations are recognized and measured in accordance with the guidance in applicable US GAAP, rather than at fair value. Applicable guidance under US GAAP includes:
  • ASC 420, Exit or Disposal Cost Obligations
  • ASC 710, Compensation—General
  • ASC 712, Compensation—Nonretirement Postemployment Benefits
  • ASC 715, Compensation—Retirement Benefits
Under ASC 712, some employers may apply the recognition and measurement guidance in ASC 715 to nonretirement postemployment benefit plans (e.g., severance arrangements). In these situations, the ASC 712 plans of an acquiree should be accounted for by the acquirer in a manner similar to the accounting for ASC 715 plans in a business combination.
ASC 805 requires recognition of a pension asset or liability of a single-employer defined benefit pension plan in connection with recording assets and liabilities of a business combination. A pension liability is recorded for the excess of the projected benefit obligation over the fair value of the plan assets. A pension asset is recorded if the fair value of the plan assets exceeds the projected benefit obligation. The projected benefit obligation and the fair value of plan assets should be measured at the acquisition date using current discount rates and assumptions established by the acquirer. Unlike annual and interim remeasurements, there is no practical expedient to measure the plan assets and obligations as of the closest calendar month-end date in a business combination.
The amount recorded for the pension asset or liability in a purchase transaction essentially represents a "fresh start" approach; there are no amounts recorded in accumulated other comprehensive income that are carried over from the acquired company. Accordingly, subsequent net periodic pension cost should not include amortization of the acquired company's prior service cost/credit, net gain or loss, or transition amount. If a calculated "market-related value" is used, it is also appropriate to restart the calculation for the plan assets (i.e., use fair value at the acquisition date and phase into a new computed market-related value prospectively) at acquisition. Consistent with ASC 715-30-55-37, the methodology used to compute market-related value of the acquired plan should generally be consistent with the acquiring company's methodology.
When determining the funded status of the plan at the acquisition date, the acquiring entity should exclude the effects of expected plan amendments, terminations, or curtailments that it has no obligation to make at the acquisition date.
If the acquirer is not obligated to amend the plan in connection with the business combination, a post-acquisition amendment to the plan that gives rise to prior service cost or credit would be accounted for by the acquirer in the post-acquisition period. As a result, the impact of such an amendment would be recognized in the income statement of the acquirer in future periods. On the other hand, if the acquirer is obligated to make the amendment (e.g., for legal or regulatory requirements), the impact of a plan amendment would generally be incorporated into the initial measurement of the plan in acquisition accounting.
ASC 805-20-55-50 and ASC 805-20-55-51 state that a liability for contractual termination benefits and for curtailment losses under employee benefit plans that will be triggered by consummation of a business combination should be recognized when the combination is consummated, even if consummation (and therefore the liabilities) are probable at an earlier date.
If the business combination is consummated, but the pension assets are to be transferred from the seller's pension trust at a later date (i.e., based on a final valuation as of the merger date), the acquirer should estimate the amount to be received and record this as part of acquisition accounting, similar to a working capital adjustment. The acquirer then must determine if this receivable meets the definition of plan assets. If the pension assets will be transferred from the seller's pension trust directly to the acquirer's pension trust, we believe that this receivable would be a plan asset and result in a net presentation within the opening net pension asset or liability. If the pension assets will be transferred to the acquirer (rather than directly to the acquirer's pension trust), they would not meet the definition of plan assets and the acquirer would record a receivable separate from the opening net pension liability, resulting in gross presentation. Companies should consider disclosing both situations if material.
In some transactions, the seller agrees to reimburse the buyer for payments made under the plan to retired participants of the plan at the date of the business combination. If the payment is made directly to the acquirer (and not the acquirer’s pension trust), this reimbursement should be presented gross, with the recognition of a receivable and a pension liability. The receivable would be based on the corresponding actuarially determined pension liability. The receivable should also reflect the credit risk of the seller.
If enhanced pension benefits are offered as part of a voluntary termination program that is not contingent upon the acquisition, ASC 715 should take precedence over ASC 805. Therefore, the effects should only be included in the determination of the pension liability (asset) at the acquisition date to the extent the voluntary termination offer is accepted before that date.
For a multiemployer plan in which the acquired company's employees participate, an obligation to the plan for a portion of its unfunded benefit obligations should not be established at the acquisition date unless withdrawal from the multiemployer plan is probable. The FASB acknowledged in the Basis for Conclusions in FAS 141(R) that the provisions for single-employer and multiemployer plans are not necessarily consistent.
Question BCG 2-1 considers whether modifications to defined benefit pension plans may be included as part of acquisition accounting if the modifications are written into the acquisition agreement as an obligation of the acquirer.
Question BCG 2-1
Can modifications to defined benefit pension plans be included as part of the acquisition accounting in a business combination if the modifications are written into the acquisition agreement as an obligation of the acquirer?
PwC response
ASC 805 generally requires employee compensation costs for future services, including pension costs, to be recognized in earnings in the postcombination period. Modifications to defined benefit pension plans are usually done for the benefit of the acquirer. A transaction that primarily benefits the acquirer is likely to be a separate transaction. Additionally, modifications to a defined benefit pension plan would typically relate to future services of the employees. It is not appropriate to analogize this situation to the exception in ASC 805 dealing with share-based compensation arrangements. That exception allows the acquirer to include a portion of the fair value based measure of replacement share-based payment awards as consideration in acquisition accounting through an obligation created by a provision written into the acquisition agreement. Such an exception should not be applied to modifications to defined benefit pension plans under the scenario described.
ASC 805-10-55-18 provides further interpretive guidance of factors to consider when evaluating what is part of a business combination, such as the reason for the transaction, who initiated the transaction and the timing of the transaction. See BCG 3.2 for further information on accounting for compensation arrangements.

2.5.11 Payables and debt assumed in a business combination

An acquiree’s payables and debt assumed by the acquirer are recognized at fair value in a business combination. Short-term payables are generally recorded based on their settlement amounts since the settlement amounts would be expected to approximate fair value. However, the measurement of debt at fair value may result in an amount different from what was recognized by the acquiree before the business combination. See FV 7.3.3.5 for further discussion of the measurement of debt at fair value. Unamortized revolving line of credit debt issuance costs of the acquiree do not meet the definition of an asset and, therefore, would not be recognized by the acquirer in a business combination.
An acquirer may settle (i.e., pay-off) some or all of the outstanding debt of the acquiree on, or in close proximity to, the date of the business combination. In these situations, it is important to determine whether the cash paid to settle the acquiree’s debt should be recognized (1) as a component of consideration transferred or (2) as the acquirer’s settlement of an assumed liability of the acquiree post-acquisition.
Cash paid by the acquirer to settle the acquiree’s outstanding debt on, or in close proximity to, the date of the business combination is generally recognized as a component of consideration transferred if the acquirer does not legally assume the outstanding debt. In this scenario, an assumed liability for the outstanding debt of the acquiree would not be recognized in acquisition accounting. However, if the acquirer legally assumes the acquiree’s outstanding debt through the business combination, an assumed liability should be recognized at fair value on the acquisition date. Any subsequent repayment of the debt is a separate transaction from the business combination and would not be a component of consideration transferred.
In other situations, an acquirer may incur new debt with a third party to fund a business combination. The new debt incurred by the acquirer to fund the business combination is not an assumed liability and is not considered part of consideration transferred in the business combination.

2.5.12 Guarantees assumed in a business combination

All guarantees made by the acquiree and assumed by the acquirer in a business combination are recognized at fair value on the acquisition date. An assumed guarantee would be accounted for under ASC 460, Guarantees, and the acquirer should relieve the guarantee liability through earnings using a systematic and rational manner as it is released from risk.

2.5.13 Contingencies: recognition and measurement

ASC 805-20-20 defines contingencies as existing conditions, situations, or sets of circumstances resulting in uncertainty about a possible gain or loss that will be resolved if one or more future events occur or fail to occur. ASC 805-20-25-19 through ASC 805-20-25-20A include a framework that acquirers should follow in recognizing preacquisition contingencies.
An acquirer should first determine whether the acquisition-date fair value of the asset or liability arising from the preacquisition contingency can be determined as of the acquisition date or during the measurement period. If the acquisition-date fair value of the contingency can be determined, the corresponding asset or liability should be recognized at fair value as part of acquisition accounting. For example, an acquirer will often have sufficient information to determine the fair value of warranty obligations assumed in a business combination. Generally, an acquirer also has sufficient information to determine the fair value of other contractual contingencies assumed in a business combination, such as penalty provisions in a supply agreement. In contrast, the fair value of legal contingencies assumed in a business combination may not be determinable.
If the acquisition-date fair value of assets or liabilities arising from the preacquisition contingency cannot be determined as of the acquisition date or during the measurement period, the acquirer should recognize the estimated amount of the asset or liability as part of the acquisition accounting if both of the following criteria are met:
  • It is probable that an asset existed or a liability had been incurred at the acquisition date based on information available prior to the end of the measurement period. It is implicit in this condition that it must be probable at the acquisition date that one or more future events confirming the existence of the asset or liability will occur.
  • The amount of asset or liability can be reasonably estimated.
The above recognition criteria should be applied using guidance provided in ASC 450 for the application of the similar criteria in ASC 450-20-25-2. In a business combination, this guidance applies to both assets and liabilities arising from preacquisition contingencies.
Contingencies identified during the measurement period that existed as of the acquisition date qualify for recognition as part of acquisition accounting. However, if the above criteria are not met based on information that is available as of the acquisition date or during the measurement period about facts and circumstances that existed as of the acquisition date, the acquirer should not recognize an asset or liability as part of acquisition accounting. In periods after the measurement period, the acquirer should account for such assets or liabilities in accordance with other GAAP, including ASC 450, as appropriate.
Example BCG 2-8, Example BCG 2-9, and Example BCG 2-10 illustrate the initial recognition and measurement of acquired contingencies.
EXAMPLE BCG 2-8
Recognition and measurement of a warranty obligation: fair value can be determined on the acquisition date
On June 30, 20X1, Company A purchases all of Company B’s outstanding equity shares for cash. Company B’s products include a standard three-year warranty. An active market does not exist for the transfer of the warranty obligation or similar warranty obligations. Company A expects that the majority of the warranty expenditures associated with products sold in the last three years will be incurred in the remainder of 20X1 and in 20X2 and that all will be incurred by the end of 20X3. Based on Company B’s historical experience with the products in question and Company A’s own experience with similar products, Company A estimates the potential undiscounted amount of all future payments that it could be required to make under the warranty arrangements.
Should Company A recognize a warranty obligation as of the acquisition date?
Analysis
Company A has the ability to estimate the expenditures associated with the warranty obligation assumed from Company B as well as the period over which those expenditures will be incurred. Company A would generally conclude that the fair value of the liability arising from the warranty obligation can be determined at the acquisition date and would determine the fair value of the liability to be recognized at the acquisition date by applying a valuation technique prescribed by ASC 820. In the postcombination period, Company A would subsequently account for and measure the warranty obligation using a systematic and rational approach. A consideration in developing such an approach is Company A’s historical experience and the expected value of claims in each period as compared to the total expected claims over the entire period.
EXAMPLE BCG 2-9
Recognition and measurement of a litigation related contingency: fair value cannot be determined on the acquisition date
In a business combination, Company C assumes a contingency of Company D related to employee litigation. Based upon discovery proceedings to date and advice from its legal counsel, Company C believes that it is reasonably possible that Company D is legally responsible and will be required to pay damages. Neither Company C nor Company D have had previous experience in dealing with this type of employee litigation, and Company C’s attorney has advised that results in this type of case can vary significantly depending on the specific facts and circumstances of the case. An active market does not exist to transfer the potential liability arising from this type of lawsuit to a third party. Company C has concluded that on the acquisition date, and at the end of the measurement period, adequate information is not available to determine the fair value of the lawsuit.
Should Company C recognize a contingent liability for the employee litigation?
Analysis
A contingent liability for the employee litigation is not recognized at fair value on the acquisition date. Company C would not record a liability by analogy to ASC 450-20-25-2, because it has determined that an unfavorable outcome is reasonably possible, but not probable. Therefore, Company C would recognize a liability in the postcombination period when the recognition and measurement criteria in ASC 450 are met.
EXAMPLE BCG 2-10
Recognition and measurement of a litigation related contingency: decision to settle on the acquisition date
In a business combination, Company C assumes a contingency of Company D related to employee litigation. Based upon discovery proceedings to date and advice from its legal counsel, Company C believes that it is reasonably possible that Company D is legally responsible and will be required to pay damages. Neither Company C nor Company D have had previous experience in dealing with this type of employee litigation, and Company C’s attorney has advised that results in this type of case can vary significantly depending on the specific facts and circumstances of the case. An active market does not exist to transfer the potential liability arising from this type of lawsuit to a third party. Company C has decided to pay $1 million to settle the liability on the acquisition date to avoid damage to its brand or further costs associated with the allocation of resources and time to defend the case in the future.
Should Company C recognize a contingent liability for the employee litigation?
Analysis
Company C would record the liability to settle the litigation on the acquisition date applying the guidance of ASC 805-20-25-20 (i.e., by analogy to ASC 450-20-25-2). Company C’s decision to pay a settlement amount indicates that it is probable that Company C has incurred a liability as of the acquisition date and that the amount of the liability can be reasonably estimated.

Question BCG 2-2 considers whether future costs to defend litigation assumed in a business combination should be recognized in acquisition accounting.
Question BCG 2-2
Should an accounting acquirer that has an accounting policy to expense legal fees as incurred accrue future costs to defend litigation assumed in a business combination as of the acquisition date if the fair value of the litigation contingency cannot be determined?
PwC response
No. Given that the accounting acquirer has historically elected an accounting policy to expense legal fees as incurred, it would not be appropriate to accrue future legal costs as of the acquisition date, even though the related litigation existed as of the acquisition date. Instead, such future legal costs should be expensed as incurred consistent with the acquirer’s policy.
However, if the litigation contingency was recognized at fair value on the acquisition date (i.e., if the fair value was determinable at the acquisition date), future legal fees would be included in the fair value measurement.

2.5.13.1 Contingencies: subsequent measurement

The acquirer should develop a systematic and rational approach for subsequently measuring and accounting for assets and liabilities arising from contingencies that were recognized at fair value on the date of acquisition. The approach should be consistent with the nature of the asset or liability. Although ASC 805 does not provide guidance on subsequent accounting for contingencies, we believe the acquirer should consider the initial recognition and measurement of the contingency when developing the systematic and rational basis. For example, the method developed for the subsequent accounting for warranty obligations may be similar to methods that have been used in practice to subsequently account for guarantees that are initially recognized at fair value under ASC 460-10-35-2. For other contingencies initially recognized at fair value, we believe that a systematic and rational approach may consider accretion of the liability as well as changes in estimates of the cash flows (e.g., an accounting model similar to asset retirement obligations under ASC 410-20 may be an acceptable method). Judgment is required to determine the method for subsequently accounting for assets and liabilities arising from contingencies.
It would not be appropriate to recognize an acquired contingency at fair value on the acquisition date and then in the immediate subsequent period value the acquired contingency in accordance with ASC 450, with a resulting gain or loss for the difference. In addition, subsequently measuring an acquired asset or liability at fair value is not considered to be a systematic or rational approach, unless required by other GAAP.
Companies will need to develop policies for transitioning from the initial fair value measurement of assets or liabilities arising from contingencies on the acquisition date to subsequent measurement and accounting at amounts other than fair value, in accordance with other GAAP.
If the acquirer recognized an asset or liability under ASC 450 on the acquisition date, the acquirer should continue to follow the guidance in ASC 450 in periods after the acquisition date.
If the acquirer did not recognize an asset or liability at the acquisition date because none of the recognition criteria are met, the acquirer should account for such assets or liabilities in the periods after the acquisition date in accordance with other GAAP, including ASC 450, as appropriate.

2.5.14 Indemnification assets (business combinations)

Indemnification assets are an exception to the recognition and fair value measurement principles because indemnification assets are recognized and measured differently than other contingent assets. Indemnification assets (sometimes referred to as seller indemnifications) may be recognized if the seller contractually indemnifies, in whole or in part, the buyer for a particular uncertainty, such as a contingent liability or an uncertain tax position.
The recognition and measurement of an indemnification asset is based on the related indemnified item. That is, the acquirer should recognize an indemnification asset at the same time that it recognizes the indemnified item, measured on the same basis as the indemnified item, subject to collectibility or contractual limitations on the indemnified amount. Therefore, if the indemnification relates to an asset or a liability that is recognized at the acquisition date and measured at its acquisition-date fair value, the acquirer should recognize the indemnification asset at its acquisition-date fair value on the acquisition date. If an indemnification asset is measured at fair value, a separate valuation allowance is not necessary because its fair value measurement will reflect any uncertainties in future cash flows resulting from collectibility considerations. Indemnification assets recognized on the acquisition date (or at the same time as the indemnified item) continue to be measured on the same basis as the related indemnified item subject to collectibility and contractual limitations on the indemnified amount until they are collected, sold, cancelled, or expire in the postcombination period.
Question BCG 2-3 considers how a buyer should account for an indemnification from the seller when the indemnified item has not met the criteria to be recognized on the acquisition date.
Question BCG 2-3
How should a buyer account for an indemnification from the seller when the indemnified item has not met the criteria to be recognized on the acquisition date?
PwC response
ASC 805 states that an indemnification asset should be recognized at the same time as the indemnified item. Therefore, if the indemnified item has not met the recognition criteria as of the acquisition date, an indemnification asset should not be recognized. If the indemnified item is recognized subsequent to the acquisition, the indemnification asset would then also be recognized on the same basis as the indemnified item subject to management’s assessment of the collectibility of the indemnification asset and any contractual limitations on the indemnified amount. This accounting would be applicable even if the indemnified item is recognized outside of the measurement period.

Question BCG 2-4 discusses whether an indemnification arrangement needs to be specified in the acquisition agreement to achieve indemnification accounting.
Question BCG 2-4
Does an indemnification arrangement need to be specified in the acquisition agreement to achieve indemnification accounting?
PwC response
No. Indemnification accounting can still apply even if the indemnification arrangement is the subject of a separate agreement. Indemnification accounting applies as long as the arrangement is entered into on the acquisition date, is an agreement reached between the acquirer and seller, and relates to a specific contingency or uncertainty of the acquired business, or is in connection with the business combination.

Question BCG 2-5 considers the accounting related to acquisition consideration held in escrow for the seller’s satisfaction of general representations and warranties.
Question BCG 2-5
Should acquisition consideration held in escrow for the seller’s satisfaction of general representation and warranties be accounted for as an indemnification asset?
PwC response
General representations and warranties would not typically relate to any contingency or uncertainty related to a specific asset or liability of the acquired business. Therefore, in most cases, the amounts held in escrow for the seller’s satisfaction of general representations and warranties would not be accounted for as an indemnification asset. See BCG 2.6.3.3 for further information on consideration held in escrow for general representation and warranty provisions.

Example BCG 2-11 provides an example of the recognition and measurement of an indemnification asset.
EXAMPLE BCG 2-11
Recognition and measurement of an indemnification asset
As part of an acquisition, the seller provides an indemnification to the acquirer for potential losses from an environmental matter related to the acquiree. The contractual terms of the seller indemnification provide for the reimbursement of any losses greater than $100 million. There are no issues surrounding the collectibility of the arrangement from the seller. A contingent liability of $110 million is recognized by the acquirer on the acquisition date using similar criteria to ASC 450-20-25-2 because the fair value of the contingent liability could not be determined during the measurement period. At the next reporting period, the amount recognized for the environmental liability is increased to $115 million based on new information.
How should the seller indemnification be recognized and measured?
Analysis
The seller indemnification should be considered an indemnification asset and should be recognized and measured on a similar basis as the related environmental contingency. On the acquisition date, an indemnification asset of $10 million ($110 million less $100 million), is recognized. At the next reporting period after the acquisition date, the indemnification asset is increased to $15 million ($115 million less $100 million), with the $5 million adjustment offsetting the earnings impact of the $5 million increase in the contingent liability.

2.5.15 Liabilities related to restructurings or exit activities

Liabilities related to restructurings or exit activities of the acquiree should only be recognized at the acquisition date if they are preexisting liabilities of the acquiree and were not incurred for the benefit of the acquirer. Including a plan for restructuring or exit activities in the purchase agreement does not in itself create an obligation for accounting purposes to be assumed by the acquirer at the acquisition date. Liabilities and the related expense for restructurings or exit activities that are not preexisting liabilities of the acquiree should be recognized through earnings in the postcombination period when all applicable criteria of ASC 420 have been met. Liabilities related to restructuring or exit activities that were recorded by the acquiree after negotiations to sell the company began should be assessed to determine whether such restructurings or exit activities were done in contemplation of the acquisition for the benefit of the acquirer. If the restructuring activities were done for the benefit of the acquirer, the acquirer should account for the restructuring activities as a separate transaction. Refer to ASC 805-10-55-18 for more guidance on separate transactions.
Example BCG 2-12 and Example BCG 2-13 illustrate the recognition and measurement of liabilities related to restructuring or exit activities.
EXAMPLE BCG 2-12
Restructuring efforts of the acquiree vs. restructuring efforts of the acquirer
On the acquisition date, an acquiree has an existing liability/obligation related to a restructuring that was initiated one year before the business combination was contemplated. In addition, in connection with the acquisition, the acquirer identified several operating locations to close and selected employees of the acquiree to terminate to realize certain anticipated synergies from combining operations in the postcombination period. Six months after the acquisition date, the recognition criteria under ASC 420 for this restructuring are met.
How should the acquirer account for the two restructurings?
Analysis
The acquirer would account for the two restructurings as follows:
  • Restructuring initiated by the acquiree: The acquirer would recognize the previously recorded restructuring liability at fair value as part of the business combination, since it is an obligation of the acquiree at the acquisition date.
  • Restructuring initiated by the acquirer: The acquirer would recognize the effect of the restructuring in earnings in the postcombination period, rather than as part of the business combination. Since the restructuring is not an obligation at the acquisition date, the restructuring does not meet the definition of a liability and is not a liability assumed in the business combination.
EXAMPLE BCG 2-13
Seller’s reimbursement of acquirer’s postcombination restructuring costs
The sale and purchase agreement for a business combination contains a provision for the seller to reimburse the acquirer for certain qualifying costs of restructuring the acquiree during the postcombination period. Although it is probable that qualifying restructuring costs will be incurred by the acquirer, there is no liability for restructuring that meets the recognition criteria at the combination date.
How should the reimbursement right be recorded?
Analysis
The reimbursement right is a separate arrangement and not part of the business combination because the restructuring action was initiated by the acquirer for the future economic benefit of the combined entity. The purchase price for the business must be allocated (on a reasonable basis such as relative fair value) to the amount paid for the acquiree and the amount paid for the reimbursement right. The reimbursement right should be recognized as an asset on the acquisition date with cash receipts from the seller recognized as settlements. The acquirer should expense postcombination restructuring costs in its postcombination consolidated financial statements.

2.5.16 Acquired revenue contracts with customers

The acquiree in a business combination may have revenue contracts with customers for which it had recognized contract assets and liabilities in its precombination financial statements. Contract assets and liabilities acquired in a business combination should be recognized and measured by the acquirer at their acquisition date fair values, which may be different from the amounts that the acquiree had previously recognized under ASC 606.
The unit of account for the recognition and measurement of contract assets and liabilities in a business combination should be the customer contract. However, there may be acquired intangible assets or liabilities associated with customer contracts that meet the contractual-legal or the separability criterion, in which case separate recognition of these intangible assets would be required. For example, acquired contract-related intangible assets such as off-market contracts, customer relationships, or contract backlogs may require separate recognition. See BCG 4.3.5.1 for further discussion of the accounting for customer contract-related intangible assets.
The fair value of acquired customer contracts is not impacted by the acquiree’s method of accounting for the contracts before the acquisition or the acquirer’s planned accounting methodology in the postcombination period (i.e., the fair value is determined using market-participant assumptions).
For performance obligations satisfied over time, the acquirer will need to determine the measure of progress to recognize revenue during the post-acquisition period. The measure of progress should be based on the acquirer’s estimate of the remaining post-acquisition performance and should be determined in accordance with ASC 606. For example, if the “cost-to-cost” (i.e., input) method is used, the acquirer should measure progress based on the estimated cost to complete the contract as of the acquisition date as opposed to the estimated cost to complete the contract from inception. In other words, the acquired contract is effectively viewed as a new performance obligation that is 0% complete as of the acquisition date.

2.5.16.1 Acquired customer contract assets

ASC 606 distinguishes between a contract asset and a receivable based on whether receipt of the consideration is conditional on something other than the passage of time.

Definition from ASC Master Glossary

Contract asset: An entity’s right to consideration in exchange for goods or services that the entity has transferred to a customer when that right is conditioned on something other than the passage of time (for example, the entity’s future performance).

Excerpt from ASC 606-10-45-4

A receivable is an entity’s right to consideration that is unconditional. A right to consideration is unconditional if only the passage of time is required before payment of that consideration is due…An entity shall account for a receivable in accordance with ASC 310.

An acquiree’s contract assets and receivables are recognized and measured by the acquirer at their acquisition date fair values. Although contract assets and receivables are similar in nature in that both represent the right to consideration from a customer, the measurement of each at fair value may be different. Since contract assets are conditioned on something other than the passage of time, such as the performance of future performance obligations, the fair value of these assets may need to incorporate assumptions regarding other factors, such as the satisfaction of future performance obligations . The fair value of receivables, however, generally incorporates only the time value of money and the customers’ credit risk. In certain situations, the fair value of acquired receivables may approximate their carrying value if the receivables are short term in nature and customer credit risk is not material. See BCG 2.5.2 and BCG 2.5.2A for information on recognizing asset valuation allowances for receivables. Additionally, see FSP 33.3.1 for information on distinguishing between contract assets and receivables, including the separate presentation of these assets in the financial statements.

2.5.16.2 Acquired customer contract liabilities

Under ASC 606, an entity should recognize a contract liability if the customer’s payment of consideration precedes the entity’s performance (e.g., payment of an upfront payment or a deposit) or when an entity has an unconditional right to consideration in advance of performance. Examples of contract liabilities include deferred or unearned revenue.

ASC 606-10-45-2

If a customer pays consideration or an entity has a right to an amount of consideration that is unconditional (that is, a receivable), before the entity transfers a good or service to the customer, the entity shall present the contract as a contract liability when the payment is made or the payment is due (whichever is earlier). A contract liability is an entity’s obligation to transfer goods or services to a customer for which the entity has received consideration (or an amount of consideration is due) from the customer.

The acquirer in a business combination recognizes an assumed contract liability at the acquisition date fair value when the contract liability represents a legal obligation assumed by the acquirer. The fair value of a contract liability recognized by the acquirer in acquisition accounting may be different from the contract liability recognized in the acquiree’s precombination financial statements. See FV 7.3.3.6 for further information on measuring deferred or unearned revenue (i.e., contract liabilities) at fair value.
Subsequent to the acquisition date, the acquirer should derecognize the contract liability and recognize revenue when or as the performance obligations are satisfied.

2.5.16.3 Costs to obtain/fulfill customer contract (business combinations)

Costs to obtain or fulfill contracts with customers may be recognized as assets in the acquiree’s precombination financial statements under ASC 340-40. Similar to other types of deferred costs (e.g., debt issuance costs), unamortized contract acquisition and fulfilment costs of the acquiree do not meet the definition of an asset to the acquirer and therefore would not be recognized by the acquirer in a business combination. However, the fair value of these costs may be measured in the value of certain customer-related intangible assets recognized in acquisition accounting. See BCG 4.3.5.1 for further information on recognizing and measuring intangible assets relating to customer contracts and relationships.

2.5.16.4 Loss contracts acquired in a business combination

A loss contract occurs if the unavoidable costs of meeting the obligations under a contract with a customer exceed the expected future economic benefits to be received. However, unprofitable operations of an acquired business do not necessarily indicate that the contracts of the acquired business are loss contracts.
A loss contract should be recognized as a liability at fair value if the contract is a loss contract to the acquiree at the acquisition date, which may be different from any loss accrual that the acquiree had previously recognized. Amortization of the loss contract is usually recognized as revenue. An acquirer should have support for certain key assumptions, such as market price and the unavoidable costs to fulfil the contract (e.g., manufacturing costs, service costs), if a liability for a loss contract is recognized. For example, Company A acquires Company B in a business combination. Company B is contractually obligated to fulfil a previous fixed-price contract to produce a fixed number of components for one of its customers. However, Company B’s unavoidable costs to manufacture the component exceed the sales price in the contract. As a result, Company B has incurred losses on the sale of this product and the combined entity is expected to continue to do so in the future. Company B’s contract is considered a loss contract that is assumed by Company A in the acquisition. Therefore, Company A would record a liability for the loss contract assumed in the business combination.
When measuring a loss contract, an acquirer should consider whether the amount to be recognized should be adjusted for any intangible assets or liabilities already recognized for contract terms that are favorable or unfavorable compared to current market terms. A contract assumed in a business combination that becomes a loss contract as a result of the acquirer’s actions or intentions should be recognized through earnings in the postcombination period based on the applicable framework in US GAAP.

2.5.17 Deferred charges arising from leases (acquiree is a lessor)

The balance sheet of an acquiree that is a lessor before the acquisition date may include deferred rent related to an operating lease, resulting from the accounting guidance in ASC 840 or ASC 842 to generally recognize operating lease income on a straight-line basis if lease terms include decreasing or escalating lease payments. The acquirer should not recognize the acquiree’s deferred rent using the acquisition method because it does not meet the definition of an asset or liability. The acquirer may record deferred rent starting from the acquisition date in the postcombination period based on the terms of the assumed lease.
Although deferred rent of the acquiree is not recognized in a business combination, the acquirer may recognize an intangible asset or liability related to the lease, depending on its nature or terms. See BCG 4 for additional guidance on the accounting for leases in a business combination.
Example BCG 2-14 illustrates the recognition of deferred rent in a business combination.
EXAMPLE BCG 2-14
Recognition of deferred rent when the acquiree is a lessor
On the acquisition date, Company A assumes an acquiree’s operating lease. The acquiree is the lessor. The terms of the lease are:
  • Four-year lease term
  • Lease payments are:
    • Year 1: $400
    • Year 2: $300
    • Year 3: $200
    • Year 4: $100
On the acquisition date, the lease had a remaining contractual life of two years, and the acquiree had recognized a $200   liability for deferred rent. For the purpose of this example, other identifiable intangible assets and liabilities related to the operating lease are ignored.
How should Company A account for the deferred rent?
Analysis
Company A does not recognize any amounts related to the acquiree’s deferred rent liability on the acquisition date. However, the terms of the acquiree’s lease will give rise to deferred rent in the postcombination period. Company A will record a deferred rent liability of $50 at the end of the first year after the acquisition.

2.5.18 Classifying or designating identifiable assets and liabilities

ASC 805-20-25-6 provides the principle with regard to classifying or designating the identifiable net assets acquired.

Excerpts from ASC 805-20-25-6

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

The acquirer must classify or designate identifiable assets acquired, liabilities assumed, and other arrangements on the acquisition date, as necessary, to apply the appropriate accounting in the postcombination period. As described in ASC 805-20-25-6, the classification or designation should be based on all pertinent factors, such as contractual terms, economic conditions, and the acquirer’s operating or accounting policies, as of the acquisition date. The acquirer’s designation or classification of an asset or liability may result in accounting different from the historical accounting used by the acquiree. For example:
  • Classifying assets as held for sale: As discussed in BCG 2.5.8, the classification of assets held for sale is based on whether the acquirer has met, or will meet, all of the necessary criteria.
  • Classifying investments in debt securities: Debt securities are classified based on the acquirer’s investment strategies and intent in accordance with ASC 320, Investments—Debt Securities.
  • Re-evaluation of the acquiree’s contracts: The identification of embedded derivatives and the determination of whether they should be recognized separately from the contract is based on the facts and circumstances existing on the acquisition date.
  • Designation and redesignation of the acquiree’s precombination hedging relationships: The decision to apply hedge accounting is based on the acquirer’s intent and the terms and value of the derivative instruments to be used as hedges on the acquisition date.
See BCG 2.5.19 for further information on the classification or designation of derivatives on the acquisition date.
ASC 805 provides two exceptions to the classification or designation principle:
  • Classification of leases as operating or capital in accordance with ASC 840. Subsequent to adoption of ASC 842, the exception pertains to the classification of a lease of an acquiree in accordance with ASC 842-10-55-11. See BCG 4.3.3.7 for further information.
  • Classification of contracts as an insurance or reinsurance contract or a deposit contract within the scope of ASC 944, Financial Services—Insurance. The classification of these contracts is based on either the contractual terms and other factors at contract inception or the date (which could be the acquisition date) that a modification of these contracts triggered a change in their classification in accordance with the applicable US GAAP. See PwC’s Insurance contracts guide for further information.

2.5.19 Classification or designation of financial instruments and hedges

An acquiree may have a variety of financial instruments that meet the definition of a derivative instrument. The type and purpose of these instruments will typically depend on the nature of the acquiree’s business activities and risk management practices. These financial instruments may have been (1) scoped out of ASC 815, Derivatives and Hedging, (2) used in hedging relationships, (3) used in an “economic hedging relationship,” or (4) used in trading operations. Generally, the precombination accounting for the acquiree’s financial instruments is not relevant to the postcombination accounting by the acquirer. Several issues could arise with respect to an acquiree’s financial instruments and hedging relationships and the subsequent accounting by the acquiring entity. The key issues are summarized below:
  • Re-evaluation of the acquiree’s contracts: All contracts and arrangements of the acquiree need to be re-evaluated at the acquisition date to determine if any contracts are derivatives or contain embedded derivatives that need to be separated and accounted for as financial instruments. This includes reviewing contracts that qualify for the normal purchases and sales exception and documenting the basis for making such an election. The determination is made based on the facts and circumstances at the date of the acquisition.
  • Designation and redesignation of the acquiree’s precombination hedging relationships: To obtain hedge accounting for the acquiree’s precombination hedging relationships, the acquirer will need to designate hedging relationships anew and prepare new contemporaneous documentation for each. The derivative instrument may not match the newly designated hedged item as closely as it does the acquiree’s item.
  • Potential inability to apply the short-cut method: Previous hedging relationships may not be eligible for the short-cut method because, upon redesignation of the hedging relationship, the derivative instrument will likely have a fair value other than zero (positive or negative) on the acquisition date, which will prevent the hedge from qualifying for the short-cut method.

1Section 4014 of the Coronavirus Aid, Relief, and Economic Security (CARES) Act includes optional deferral of the effective date of ASU 2016-13 for insured depository institutions, bank holding companies, and their affiliates. The relief period begins on March 27, 2020 and ends on the earlier of (1) the date the national emergency related to COVID-19 ends or (2) December 31, 2020.

2Deferred rent of the acquiree: straight-line income of $500 ((($400 + $300 + $200 + $100) / 4) × 2 years) less cash receipts of $700 ($400 + $300).

3Deferred rent of the acquirer: straight-line income of $150 ((($200 + $100) / 2) × 1 year) less cash receipts of $200 (year 3 of lease).

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