Convergence: The Case of Accounting for Business Combinations
Nina T. Dorata and Ibrahim M. Badawi
APRIL 2008 - On
June 30, 2005, FASB and the International Accounting Standards Board
(IASB) each issued exposure drafts dealing with both business combinations
and consolidation procedures. FASB’s exposure drafts included
“Business Combinations” and “Consolidated Financial
Statements, Including Accounting and Reporting of Noncontrolling
Interests in Subsidiaries.” The
IASB’s related exposure drafts included proposed amendments
to International Financial Reporting Standard (IFRS) 3, Business
Combinations; proposed amendments to International Accounting
Standard (IAS) 27, Consolidated and Separate Financial Statements;
and proposed amendments to IAS 37, Provisions, Contingent Liabilities
and Contingent Assets, and IAS 19, Employee Benefits.
and IASB exposure drafts on business combinations were developed
jointly, and contain virtually the same accounting concepts. They
represent a major joint convergence project between these two
boards. The objectives of this project are twofold: to provide
a single high-quality standard for accounting for business combinations
that could be used for both domestic and international financial
reporting; and to promote the international convergence of accounting
developed standards for business combinations were a product of
two phases. During the first phase, FASB and the IASB separately
deliberated the issue of accounting for business combinations.
FASB concluded the first phase in June 2001 by issuing SFAS 141,
Business Combinations, and SFAS 142, Goodwill and
Other Intangible Assets. The IASB concluded its first phase
in March 2004 by issuing IFRS 3, Business Combinations.
In these standards, both boards required the use of the purchase
method as the single method of accounting for business combinations.
second phase, FASB and the IASB simultaneously addressed the guidance
for applying the acquisition method, and decided to conduct this
phase as a joint effort with the objective of reaching the same
conclusions and similar standards for accounting for business
combinations. Accordingly, the joint standards replace the existing
requirements of SFAS 141 and IFRS 3. Furthermore, FASB requires
simultaneous adoption of SFAS 160, Noncontrolling Interests
in Consolidated Financial Statements, an amendment of Accounting
Research Bulletin (ARB) 51, Consolidated Financial Statements,
issued in August 1959.
the IASB believe that the new standards will help users and preparers
by improving the comparability and transparency of financial information
reported by companies that engage in business combinations and
issue consolidated financial statements in accordance with either
U.S. GAAP or the IFRS.
standards for business combinations retain the fundamental requirement
of SFAS 141 and of IFRS 3, which is to account for all business
combinations using a single method (acquisition), where one party
(the acquirer) is always identified as acquiring the other entity
(the acquiree). However, the revised standards include procedures
that drastically alter previous guidance, including considerably
altering immediate and future charges to the income statement
in connection with business combinations. The following discusses
the revisions to accounting procedures and financial statement
presentations for business combinations. The Exhibit
presents the highlights of the revised standards and disclosures.
Method, Goodwill, and Noncontrolling Interest
in SFAS 141(R) applies to transactions in which an acquirer obtains
control of one or more businesses. Business combinations must
be accounted for using the acquisition method, where the acquirer
measures and recognizes the acquiree as a whole, and the assets
acquired and liabilities assumed (including all identifiable contingent
assets and liabilities) are recognized at their fair values as
of the acquisition date. The acquisition date is the date the
acquirer obtains control of the acquired business (the closing
date). No longer may an acquirer designate an effective date of
the business combination to the beginning of the period and avoid
the presentation of preacquisition earnings of the acquiree.
value as a whole is measured as the aggregate of: 1) the fair
value of the consideration transferred; 2) the fair value of any
noncontrolling interest in the acquiree; and 3) the fair value
of the acquirer’s previously held equity interest in the
acquiree. Excluded from the fair value measurement are assets
held for sale, deferred taxes, indemnification assets, employee
benefit plans, reacquired rights, share-based payment awards,
and goodwill. For business combinations where control is achieved
in stages, any previously held equity interest must be remeasured
to fair value as of the acquisition date; together with any prior
periods’ other comprehensive income, any resulting gains
or losses are included in earnings.
is still an unidentifiable residual value but is computed as the
excess of the fair value of the acquiree as a whole over the fair
value of the identifiable net assets acquired. The goodwill measurement
differs from the measurement prescribed by the purchase method,
in which goodwill equals the difference between the cost of acquisition
and the acquirer’s share of the fair values of the identifiable
net assets acquired. Any negative goodwill created in a bargain
purchase must be recognized as a gain in income from continuing
operations following a reassessment of fair value measurements
used in the computation.
requires the use of provisional amounts for the acquisition if
the accounting is incomplete by the end of the reporting period.
During the measurement period, the acquirer may retrospectively
adjust provisional amounts previously reported. The measurement
period may not exceed one year from the acquisition date. Any
revisions to the acquisition accounting beyond the measurement
period require an adjustment to retained earnings in accordance
with SFAS 154, Accounting Changes and Error Corrections.
FASB and the IASB did not jointly write the exposure drafts on
accounting for noncontrolling interests, their respective exposure
drafts propose similar guidance. Specifically, SFAS 160 requires
the presentation of a noncontrolling interest within equity, separately
from the parent’s shareholders’ equity. IAS 27 already
requires presentation of a noncontrolling interest in equity.
The boards did not, however, achieve convergence with regard to
the measurement of noncontrolling interests. FASB requires measurement
of a noncontrolling interest at fair value; the IASB permits measurement
at either fair value or book value of net assets acquired.
requires business combinations that were exempt from SFAS 141
(e.g., cooperatives and mutual entities) to use the acquisition
method. Moreover, valuation specialists may need to be more involved
in order to measure the fair value of an acquiree as a whole in
a partial acquisition that qualifies as a business combination.
When including the portion attributable to a noncontrolling interest,
the recognition of full goodwill may result in larger amounts
of goodwill that will be subject to annual impairment testing.
for Acquisition Transaction and Restructuring Costs
required that the purchase price include direct acquisition transaction
costs, such as payments made by the acquirer to third parties
for legal and consulting fees, banking fees, accounting fees,
and fees for valuation services. SFAS 141(R) requires that transaction
costs be accounted for separately from the business combination,
because they do not represent assets acquired and liabilities
assumed. Accordingly, these costs are expensed as incurred rather
than capitalized as part of the business combination cost.
from the acquisition accounting are costs the acquirer incurs
to achieve synergies through exiting acquiree activities or through
relocation or termination of acquiree employees. The acquirer
accounts for restructuring costs using the guidance of SFAS 146,
Accounting for Costs Associated with Exit or Disposal Activities,
which requires expense treatment. Collectively, the guidance for
acquisition-related costs incurred not only in the year of the
business combination but also in subsequent years will improve
transparency of the transactions at a cost of lower and more volatile
aspect of SFAS 141(R) is its treatment of contingent assets and
liabilities. Contingencies are identifiable assets acquired or
liabilities assumed whose ultimate benefit or settlement is contingent
or conditional on the outcome of some future event. Contractual
contingencies are recognized at the acquisition date, separately
from goodwill, and at fair value. The acquirer must use the “more
likely than not” criterion found in Statement of Financial
Concepts 6, Elements of Financial Statements, to recognize
noncontractual contingencies as part of the acquisition. Otherwise,
noncontractual contingencies that do not meet the “more
likely than not” criterion follow the guidance of SFAS 5,
Accounting for Contingencies.
difficulty in measuring the fair value of contingent assets and
liabilities is the quality and availability of information as
of the acquisition date. The fair value estimate of contingent
assets and liabilities will be based on certain assumptions, such
as the probability of payment, and will likely require significant
input from external parties, such as environmental experts or
attorneys. In periods subsequent to the business combination,
contingent assets will be measured at the lower of their fair
value at the acquisition date or their estimated realizable amount.
For contingent liabilities, SFAS 141(R) requires use of the higher
of their fair value at the acquisition date or their amount determined
under existing guidance for liability measurement. Any resulting
gains or losses from changes in the fair value of contingent assets
and liabilities are classified as a component of income from continuing
consideration is an obligation of the acquirer to transfer assets
or equity interests to former owners if future events occur or
certain conditions are met. A significant challenge that acquirers
may face is how to measure, on the acquisition date, the fair
value of contingent liabilities associated with earnout arrangements.
Earnouts typically include payments to acquiree shareholders that
are contingent upon the achievement of financial or other performance
goals following the closing date of the business combination.
Earnout arrangements under SFAS 141(R) require specific measurement
on the acquisition date. This measurement may create unintended
consequences of future performance, particularly with regard to
managing the acquirer’s risk and retaining key target firm
requires that changes in the fair value of contingent considerations
resulting from additional information about facts and circumstances
that existed at the acquisition date are measurement period changes.
Otherwise, changes in the fair value of contingent considerations
that come from events following the business combination, such
as achieving an earnings target or subsequent price levels, are
classified as a component of income from continuing operations
for liability consideration or as part of equity for equity consideration.
for Research and Development Costs
141 requires expensing and fair value measurement of acquired
in-process research and development (IPR&D), SFAS 141(R) requires
that acquired IPR&D be measured at fair value and capitalized
with an indefinite life. As with other indefinite-life assets,
acquired IPR&D must be tested regularly for impairment but
not amortized. When its life becomes determinable (e.g., upon
project completion), acquired IPR&D will be amortized over
its expected remaining life. In addition, there is separate recognition
on the acquisition date of all identifiable R&D assets, tangible
and intangible, including those with no alternative future use.
and the IASB’s joint project on business combinations represents
a major effort to converge the relevant accounting standards while
continuing the evolution toward fair value accounting. Both boards
have concluded that the revised standards improve financial reporting
and enhance the transparency and comparability of accounting for
business combinations. SFASs 141(R) and 160 require extensive
disclosures for business combinations and apply to acquisitions
on or after December 15, 2008. Earlier application of SFASs 141(R)
and 160 is not permitted. IFRS 3(R), Business Combinations,
and IAS 27(R), Consolidated and Separate Financial Statements,
apply to acquisitions occurring after July 1, 2009, with earlier
T. Dorata, PhD, CPA, is an assistant professor, and Ibrahim
M. Badawi, PhD, CPA, is a professor, both in the department
of accounting and taxation at the Peter J. Tobin College of Business
of St. John’s University, Queens, N.Y.