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ASC 805-10-25-20 provides the principle for determining what is part of a business combination transaction.

Excerpt from ASC 805-10-25-20

The acquirer and the acquiree may have a preexisting relationship or other arrangement before negotiations for the business combination began, or they may enter into an arrangement during the negotiations that is separate from the business combination. In either situation, the acquirer shall identify any amounts that are not part of what the acquirer and the acquiree (or its former owners) exchanged in the business combination, that is, amounts that are not part of the exchange for the acquiree. The acquirer shall recognize as part of applying the acquisition method only the consideration transferred for the acquiree and the assets acquired and liabilities assumed in the exchange for the acquiree. Separate transactions shall be accounted for in accordance with the relevant GAAP.

The transfer of consideration may be accompanied by other transactions in a business combination. A transaction is likely to be recognized and accounted for separately from a business combination if it is entered into by or on behalf of the acquirer and is primarily for the benefit of the acquirer or the combined entity rather than that of the acquiree or its former owners.
Identifying those transactions that should be accounted for separately from the acquisition can require significant judgment and analysis. ASC 805-10-55-18 provides three factors to consider that are neither mutually exclusive nor individually conclusive.

Excerpt from ASC 805-10-55-18

a. The reasons for the transaction. Understanding the reasons why the parties to the combination (the acquirer, the acquiree, and their owners, directors, managers, and their agents) entered into a particular transaction or arrangement may provide insight into whether it is part of the consideration transferred and the assets acquired or liabilities assumed. For example, if a transaction is arranged primarily for the benefit of the acquirer or the combined entity rather than primarily for the benefit of the acquiree or its former owners before the combination, that portion of the transaction price paid (and any related assets or liabilities) is less likely to be part of the exchange for the acquiree. Accordingly, the acquirer would account for that portion separately from the business combination.
b. Who initiated the transaction. Understanding who initiated the transaction may also provide insight into whether it is part of the exchange for the acquiree. For example, a transaction or other event that is initiated by the acquirer may be entered into for the purpose of providing future economic benefits to the acquirer or combined entity with little or no benefit received by the acquiree or its former owners before the combination. On the other hand, a transaction or arrangement initiated by the acquiree or its former owners is less likely to be for the benefit of the acquirer or combined entity and more likely to be part of the business combination transaction.
c. The timing of the transaction. The timing of the transaction may also provide insight into whether it is part of the exchange for the acquiree. For example, a transaction between the acquirer and the acquiree that takes place during the negotiations of the terms of a business combination may have been entered into in contemplation of the business combination to provide future economic benefits to the acquirer or the combined entity. If so, the acquiree or its former owners before the business combination are likely to receive little or no benefit from the transaction except for benefits they receive as part of the combined entity.

In accordance with ASC 805-10-25-21, transactions that are recognized separately from the business combination are accounted for based on the applicable guidance in US GAAP. Specific guidance is provided for the following transactions in connection with a business combination:
  • Reimbursement provided to the acquiree or former owners for paying the acquirer’s acquisition costs (see BCG 2.7.1.2)
  • Settlement of preexisting relationships between the acquirer and acquiree (see BCG 2.7.2)
  • Employee compensation arrangements (see BCG 3)
There may also be circumstances in which litigation arises between the acquirer and the former owners of the acquiree related to the business combination. In a speech at the 2003 AICPA Conference on Current SEC and PCAOB Developments, an SEC staff member stated that contingencies arising from a business combination are not preacquisition contingencies. Therefore, the settlement of such legal claims should generally be reflected by the acquirer as an expense in the postcombination financial statements unless there is a clear and direct link to the purchase price. As such, we believe such disputes will typically be accounted for separately from the business combination.

2.7.1 Acquisition-related costs in a business combination

Costs may be incurred by both the acquirer and the acquiree in effecting a business combination. ASC 805-10-25-23 discusses the accounting for acquisition-related costs.

ASC 805-10-25-23

Acquisition-related costs are costs the acquirer incurs to effect a business combination. Those costs include finders fees; advisory, legal, accounting, valuation, and other professional or consulting fees; general administrative costs, including the costs of maintaining an internal acquisitions department; and costs of registering and issuing debt and equity securities. The acquirer shall account for acquisition-related costs as expenses in the period in which the costs are incurred and the services are received, with one exception. The costs to issue debt or equity securities shall be recognized in accordance with other GAAP.

2.7.1.1 Acquirer’s acquisition-related costs in a business combination

An acquirer’s acquisition-related costs may include:
  • Direct costs: third-party costs, including finders’ fees, advisory, legal, accounting, valuation, and other professional or consulting fees
  • Indirect costs: general administrative costs, including the cost of maintaining an internal acquisitions department
  • Financing costs: costs of issuing debt or equity securities to finance the acquisition
As required by ASC 805-10-25-23, acquisition-related costs are considered separate transactions and should not be included as part of the consideration transferred. These costs are not considered part of the fair value of a business and, by themselves, do not represent an asset. Instead, acquisition-related costs represent services that have been rendered to and consumed by the acquirer. Direct and indirect acquisition-related costs are expensed as incurred when the service is received.
Financing costs relating to the issuance of debt are recorded as a reduction of the debt balance in accordance with ASC 835-30-45-1A. Financing costs relating to the issuance of equity securities reduce the proceeds received from the issuance.
Question BCG 2-6 discusses the accounting for fees paid to an investment banker to provide advisory services and also handle the financing of a business combination.
Question BCG 2-6
How should fees paid to an investment banker to provide advisory services and also handle the financing of a business combination be recognized?
PwC response
ASC 340-10-S99-2 indicates that fees paid to an investment banker in connection with a business combination, when the investment banker is also providing interim financing or underwriting services, must be allocated between direct costs of the acquisition and those related to financing or underwriting the securities issued to consummate the business combination.
For example, assume Company A acquired Company B for 70% cash and the balance in preferred shares and debt. Company A hired an investment banker to provide advisory services and also to handle the financing and underwriting of the transaction. The costs paid to the investment banker should be allocated between those that are related to the advisory services and those related to financing or underwriting the business combination on a relative fair value basis.
SAB Topic 5.A states that “specific incremental costs directly attributable to a proposed or actual offering of securities may properly be deferred and charged against the gross proceeds of the offering.” Accordingly, the equity issuance costs should generally be reflected as a reduction of the gross proceeds of the equity offering (typically, as a reduction to APIC). If debt-issuance costs are incurred to fund the acquisition, those costs should be recognized in the balance sheet as a reduction from the face amount of the debt and amortized as interest expense in accordance with ASC 835-30-45-3. Costs for all other direct and indirect expenses of the transaction should be expensed as incurred.

Question BCG 2-7 considers whether transaction costs incurred by the acquirer should be reflected in the separate financial statements of the acquiree in a business combination.
Question BCG 2-7
Should transaction costs incurred by the acquirer be reflected in the separate financial statements of the acquiree in a business combination accounted for under ASC 805?
PwC response
Generally, no. SAB Topic 1B (Questions 1-2) indicates that the separate financial statements of a subsidiary should reflect any costs of its operations that are incurred by the parent on its behalf. Acquisition-related costs incurred by the acquirer in acquiring the acquiree (e.g., acquisition due diligence fees to assist in determining the purchase price) generally would not benefit the acquiree nor represent part of the acquiree’s operations and would not be reflected as an expense in the separate financial statements of the acquiree.

2.7.1.2 Reimbursing acquiree for paying acquirer’s acquisition costs

ASC 805-10-25-21 includes “a transaction that reimburses the acquiree or its former owners for paying the acquirer’s acquisition-related costs” as an example of a separate transaction when applying the acquisition method. Under this guidance, acquisition costs embedded in the consideration transferred should be accounted for separately from the business combination. For example, consideration transferred by the acquirer may include amounts to reimburse the acquiree or its former owners for payments made on behalf of the acquirer for its acquisition-related costs. Such costs should be recognized in the acquirer’s financial statements based on the nature of the cost (see BCG 2.7.1.1).

2.7.1.3 Acquiree’s acquisition-related costs in a business combination

Acquirees often incur sell-side acquisition-related costs in a business combination. Examples of these costs may include sell-side due diligence fees, valuation costs, tax planning fees, investment banking fees, legal fees, and other advisory fees. Acquisition-related costs incurred by the acquiree in a business combination should be expensed as incurred or when the service is received in the acquiree’s separate, pre-combination financial statements. See BCG 2.7.1.5 for information on acquiree acquisition-related costs that are contingent on the closing of the business combination.

2.7.1.4 Reimbursing acquiree for sell-side acquisition-related costs

Consideration transferred by the acquirer that includes amounts to reimburse the acquiree for the acquiree’s costs incurred to sell the business would generally be accounted for by the acquirer as part of the consideration transferred, as illustrated in Example BCG 2-29.
In determining whether costs incurred are on behalf of the acquirer or acquiree, the reason for the transaction, who initiated it, and the timing should be considered in accordance with ASC 805-10-55-18.
EXAMPLE BCG 2-29
Accounting for assumed liabilities for transaction costs incurred by the seller in connection with a business combination
Company A acquired 100% of Company B. In connection with this transaction, Company B incurred costs to sell the business, including legal fees. As of the acquisition date, Company B had several outstanding invoices to the attorneys and other advisors that assisted with this sale recorded in its acquisition-date balance sheet. The costs incurred by the seller were not for the benefit of the buyer as contemplated in ASC 805-10-25-21.
Should Company A recognize the outstanding payables of Company B as assumed liabilities in acquisition accounting?
Analysis
Yes. The costs were incurred by the seller as a result of the sale. Therefore, as long as the outstanding payables do not include any of the acquirer’s acquisition-related costs (i.e., Company A and Company B did not negotiate for Company B to pay for Company A’s transaction costs), Company A should recognize the outstanding payables as assumed liabilities in acquisition accounting no different than Company A assuming Company B’s other accounts payable balances from normal operating activities.
However, if Company A and Company B had negotiated for Company B to pay the transaction costs of Company A, such costs would be outside of the business combination. Therefore, the reimbursement provided by Company A would not be consideration transferred and an expense would be recognized by Company A in the period the costs were incurred. See BCG 2.7.1.1 for further information.

2.7.1.5 Recognizing certain acquisition-related costs “on the line”

In situations when predecessor and successor financial statements are presented with a “blackline” resulting from the effects of pushdown accounting, a question often arises as to which period acquiree expenses should be recorded in if the amounts are contingent on the closing of a business combination (e.g., acquiree’s investment banker “success” fees, acquiree’s share-based awards with performance conditions vesting upon a change in control).
One view is that these costs should be recorded in the predecessor period, immediately prior to the closing of the transaction, because all the acquiree’s acquisition-related costs should be recognized in the period in which they are incurred. Since the predecessor financial statements present the results of operations for the acquiree up to the closing of the transaction and at the closing date it is known that the transaction has been consummated, then all expenses would have been incurred and thus should be recognized in the predecessor period.
However, in a speech at the 2014 AICPA Conference on Current SEC and PCAOB Developments, an SEC staff member stated that when certain expenses are contingent upon a change-in-control event, the SEC staff has not objected to the presentation of such items in neither the predecessor or successor periods (i.e., presented “on the line”), provided that transparent and disaggregated disclosure of the nature and amount of such expenses is made. This view is based on the premise that any expenses contingent on the closing of the business combination are not payable, and thus should not be recognized, until the transaction is consummated. The SEC stated that if such presentation is elected, registrants should ensure that only those amounts fully contingent on the consummation of the change-in-control event be included in the disclosure.
Separately, an acquirer’s costs that are contingent upon the closing of a business combination should be recognized in the acquirer’s financial statements in the period that includes the acquisition.

2.7.2 Settlement of preexisting relationships

A preexisting relationship can be contractual (e.g., vendor and customer, licensor and licensee) or it can be noncontractual (e.g., plaintiff and defendant). The acquirer should identify any preexisting relationships to determine which ones have been effectively settled. Typically, a preexisting relationship will be effectively settled, since such a relationship becomes an “intercompany” relationship upon the acquisition and is eliminated in the postcombination financial statements. Reacquired rights, which also arise from preexisting relationships, are discussed at BCG 2.5.6. The acquirer should recognize a gain or loss if there is an effective settlement of a preexisting relationship in accordance with ASC 805-10-55-21. When there is more than one contract or agreement between the parties with a preexisting relationship or more than one preexisting relationship, the settlement of each contract and each preexisting relationship should be assessed separately.
Example BCG 2-30 illustrates the settlement of a preexisting debtor/creditor relationship between an acquirer and acquiree.
EXAMPLE BCG 2-30
Settlement of a preexisting relationship recorded at current market rates
Company A has accounts payable of $100,000 to Company B and Company B has accounts receivable of $100,000 from Company A. Both the recorded payable and corresponding receivable approximate fair value. Company A acquires Company B for $2 million in a business combination.
How should the settlement of the preexisting relationship be recorded in acquisition accounting?
Analysis
As a result of the business combination, the preexisting relationship between Company A and Company B is effectively settled. No gain or loss was recognized on the settlement as the payable was effectively settled at the recorded amount. Company A should reduce the consideration transferred for the acquisition by $100,000 to account for the effective settlement of the payable to Company B.

2.7.2.1 Calculating gain/loss on settlement of preexisting relationships

The acquirer should recognize a gain or loss for the effective settlement of a preexisting relationship. Settlement gains and losses from noncontractual relationships should be measured at fair value on the acquisition date in accordance with ASC 805-10-55-21.
Settlement gains and losses from contractual relationships should be measured as the lesser of:
a. The amount the contract terms are favorable or unfavorable (from the acquirer’s perspective) compared to pricing for current market transactions for the same or similar items. If the contract terms are favorable compared to current market transactions, a settlement gain should be recognized. If the contract terms are unfavorable compared to current market transactions, a settlement loss should be recognized.
b. The amount of any stated settlement provisions in the contract available to the counterparty to whom the contract is unfavorable. The amount of any stated settlement provision (e.g., voluntary termination) should be used to determine the settlement gain or loss. Provisions that provide a remedy for events not within the control of the counterparty, such as a change in control, bankruptcy, or liquidation, would generally not be considered a settlement provision in determining settlement gains or losses.
If (b) is less than (a), the difference is included as part of the business combination in accordance with ASC 805-10-55-21. If there is no stated settlement provision in the contract, the settlement gain or loss is determined from the acquirer’s perspective based on the favorable or unfavorable element of the contract.
If the acquirer has previously recognized an amount in the financial statements related to a preexisting relationship, the settlement gain or loss related to the preexisting relationship should be adjusted (i.e., increasing or decreasing any gain or loss) for the amount previously recognized in accordance with ASC 805-10-55-21.
Example BCG 2-31 illustrates the accounting for settlement of a noncontractual relationship. Example BCG 2-32 illustrates the accounting for settlement of a contractual relationship that includes a settlement provision. Example BCG 2-33 illustrates the accounting for settlement of a contractual relationship that does not include a settlement provision. Additional examples are provided in ASC 805-10-55-30 through ASC 805-10-55-33.
EXAMPLE BCG 2-31
Settlement loss with a liability previously recorded on a noncontractual relationship
Company A is a defendant in litigation relating to a patent infringement claim brought by Company B. Company A pays $50 million to acquire Company B and effectively settles the lawsuit. The fair value of the settlement of the lawsuit is estimated to be $5 million, and Company A had previously recorded a $3 million litigation liability in its financial statements before the acquisition. The fair value of Company B’s net assets is $45 million, excluding the lawsuit.
How should the settlement loss related to a noncontractual relationship be recorded in acquisition accounting?
Analysis
Company A would record a settlement loss related to the litigation of $2 million, excluding the effect of income taxes. This represents the $5 million fair value of the settlement after adjusting for the $3 million litigation liability previously recorded by Company A. The consideration transferred for the acquisition of Company B and the effective settlement of the litigation are recorded as separate transactions (in millions):
Dr. Litigation liability
$3
Dr. Loss on settlement of lawsuit with Company B
$2
Dr. Acquired net assets of Company B
$45
Cr. Cash
$50
If, however, Company A had previously recorded a liability greater than $5 million, then a settlement gain would be recognized for the difference between the liability previously recorded and the fair value of the settlement.
EXAMPLE BCG 2-32
Settlement loss on a contractual relationship
Company C provides services to Company D. Since the inception of the contract, the market price for these services has increased. The terms in the contract are unfavorable compared to current market transactions for Company C in the amount of $10 million. The contract contains a settlement provision that allows Company C to terminate the contract at any time for $6 million. Company C acquires Company D for $100 million.
How should the settlement loss related to a contractual relationship be recorded in acquisition accounting?
Analysis
Company C would recognize a settlement loss of $6 million, excluding the effect of income taxes.
A settlement loss of $6 million is recognized because it is the lesser of the fair value of the unfavorable contract terms ($10 million) and the contractual settlement provision ($6 million). The $100 million in cash paid by Company C is attributed as $6 million to settle the services contract and $94 million to acquire Company D. The $4 million difference between the fair value of the unfavorable contract terms and the contractual settlement provision is included as part of consideration transferred for the business combination. The consideration transferred for the acquisition of Company D and the effective settlement of the services contract would be recorded as follows (in millions):
Dr. Loss on settlement of services contract with Company D
$6
Dr. Acquired net assets of Company D
$94
Cr. Cash
$100
EXAMPLE BCG 2-33
Settlement loss on a contractual relationship when the contract is silent on the amount of the settlement provision
Company E provides services to Company F. Since the inception of the services contract, the market price for these services has increased. The terms in the contract are unfavorable compared to current market transactions for Company E in the amount of $10 million. The services contract is silent on a settlement provision in the event that either party terminates the contract. Company E acquires Company F for $100 million.
How should the settlement loss related to a contractual relationship be recorded in acquisition accounting?
Analysis
Company E would recognize a $10 million settlement loss, excluding the effect of income taxes, for the unfavorable amount of the contract. The $100 million that Company E pays Company F’s shareholders is attributed $10 million to settle the preexisting relationship and $90 million to acquire Company F. The consideration transferred for the acquisition of Company F and the effective settlement of the services contract would be recorded by Company E as follows (in millions):
Dr. Loss on settlement of services contract with Company F
$10
Dr. Acquired net assets of Company F
$90
Cr. Cash
$100

2.7.3 Settlement of debt

If the preexisting relationship effectively settled is a debt financing issued by the acquirer to the acquiree, the guidance in ASC 470, Debt should be applied. If debt is settled (extinguished) prior to maturity, the amount paid upon reacquisition of debt may differ from the carrying amount of the debt at that time. An extinguishment gain or loss is recognized in earnings for the difference between the reacquisition price (fair value or stated settlement amount) and the carrying amount of the debt in accordance with ASC 470-50-40-2. For example, if the acquiree has an investment in debt securities of the acquirer with a fair value of $110 million and the carrying amount of the acquirer’s debt is $100 million, the acquirer would recognize a settlement loss of $10 million on the acquisition date (based on the assumption that the debt was settled at $110 million).
If the preexisting relationship effectively settled is a debt financing issued by the acquiree to the acquirer, the acquirer effectively is settling a receivable and would apply the guidance for settling a preexisting relationship. See BCG 2.7.2.1 for further information.

2.7.4 Financial instruments entered into by the acquirer

Financial instruments entered into by the acquirer to hedge certain risks in contemplation of a business combination generally should be accounted for as separate transactions apart from the business combination. These contracts are generally not eligible for hedge accounting, even though these contracts may effectively hedge various economic risks and exposures related to the transaction. Hedge accounting for a firm commitment to acquire a business is prohibited under ASC 815.
Hedges of other items in contemplation of a business combination (e.g., the forecasted interest expense associated with debt to be issued to fund an acquisition or the forecasted sales associated with the potential acquiree) generally do not qualify for hedge accounting and should be accounted for separately from the business combination. While it may be argued that hedge accounting should be acceptable theoretically, practically it may not be possible to achieve because a forecasted transaction can qualify for hedge accounting under ASC 815 only if it is probable of occurrence. The ability to support an assertion that a business combination is probable of occurrence and achieve hedge accounting for these types of hedges will be rare given the number of conditions that typically must be met before an acquisition can be consummated (e.g., satisfactory due diligence, no material adverse changes/developments, shareholder votes, regulatory approval). Accordingly, an evaluation of the specific facts and circumstances would be necessary if an entity asserts that a forecasted acquisition is probable of occurrence.

2.7.5 Transition service agreements

Transition service agreements (TSAs) are often entered into in connection with a business combination. The services are generally provided by the seller to the acquirer for a specified period of time following the acquisition and may be at no cost, at a cost below fair market value of the services, or at fair market value. In such cases, the acquirer should consider whether a portion of the consideration paid should be allocated to the services to be rendered in the future. See FSP 27.4.2.3 for guidance on the presentation of revenues and costs associated with TSAs.
Example BCG 2-34 illustrates the accounting for a TSA from the seller’s perspective (in an acquisition, the acquirer would account for the services similarly by evaluating whether a portion of the consideration paid should be allocated to the services to be rendered in the future).
EXAMPLE BCG 2-34
Transition service agreement
Company A agrees to sell a business for $100 million to Company B. Company A's net book value of the assets acquired and liabilities assumed by Company B is $70 million. The fair value of the business is $95 million. Concurrent with the acquisition agreement, Company A and Company B enter into a transition service agreement (TSA), under which Company A agrees to provide certain services to Company B for a period of one year after the acquisition at no cost to Company B. Company A estimates the fair value of the services to be provided under the TSA to be $5 million.
How should Company A account for the services to be provided under the TSA?
Analysis
On the date of sale of the business, Company A should allocate $5 million of the proceeds (the fair value of the services less the fee assessed, in this case zero) to the TSA. Company A would record a gain of $25 million representing the difference between the consideration received for the business ($95 million) and the book value of the net assets sold ($70 million).
Although the TSA agreement stipulates that the services will be performed by Company A at no cost to Company B, the substance of the transaction is that a portion of the consideration for the sale of the business relates to the transition services that will be provided in the future. Company B should recognize an asset for the prepayment of the services of $5 million to be realized as the services are provided.
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