Let's now consider some slightly more advanced purchase price allocation (PPA) topics related to the fair valuation of assets acquired and liabilities assumed in a business combination. Recall from our previous lesson FAS 141r supercedes FAS 141 on January 1, 2009.
Existing Goodwill and Deferred Tax Items
Any goodwill or deferred tax items existing on the target's balance sheet at the time of acquisition are written off in the purchase price allocation (PPA) since their fair values (FVs) are zero.
In-Process Research & Development (IPR&D)
A portion of the purchase price may be allocated to acquired IPR&D. FAS 141 and 141r differ significantly in their treatment of acquired IPR&D as follows:
- FAS 141 – Expense immediately upon completion of the transaction if the acquired IPR&D has no alternate future use
- FAS 141r – Do not expense, regardless of whether or not the acquired IPR&D has an alternate future use
Under FAS 141r, acquired IPR&D is an intangible asset classified as an indefinite-lived until the completion or abandonment of the associated R&D effort. Intangible IPR&D is not amortized during the period that it is considered indefinite-lived but rather tested for impairment.
Tax and FAS 141r accounting methods for acquired IPR&D are similar in that the asset is not expensed.
Example A – IPR&D
On December 14, 2008, A acquires 100% of T's assets, including intangible IPR&D fairly valued at $100. A's tax rate is 30%. What journal entries will A make related to the acquired IPR&D on the acquisition date?
|Record Expense of IPR&D|
|Record Deferred Tax Asset|
|cr. Income Tax Expense||$30|
We need to create a DTA of $35 (= 35% × $100) because A's cash taxes actually payable in each of the next 15 years will be lower than A's income tax expense since IPR&D is amortized over 15 years under Section 197 for tax purposes, but not for accounting purposes.
What journal entry will A make in each year of the IPR&D tax amortization period to record the reversal of this DTA?
|Record Deferred Tax Asset Reversal|
The DTA will reverse over the tax amortization period of 15 years (recall that the acquired IPR&D is a Section 197 intangible asset).
You might imagine that, under the old FASB rules requiring that IPR&D be expensed immediately, allocating as much of the purchase price as possible to IPR&D would be favorable, since doing so would minimize assets on the balance sheet whose amortization, depreciation, or impairment would adversely affect future operating results. However, the SEC has strict requirements and guidelines for allocating and measuring IPR&D, and requires lengthy disclosure on the progress of IPR&D in subsequent filings.
Contingent consideration is usually an obligation of an acquirer to transfer assets or equity interests to the target's sellers conditioned on the outcome of future events, such as achieving specific performance benchmarks. FAS 141 and 141r differ in their treatment of contingent consideration as follows:
- FAS 141 – Usually recognize when the contingency is resolved and the consideration is issued or becomes issuable
- FAS 141r – Recognize as a liability or equity on the acquisition date at FV on such date
Contingent consideration arrangements can also be structured to give the acquirer the right to the return of previously transferred consideration if specified conditions are met. For example, an acquisition agreement may require the sellers to forfeit some proceeds from the sale of their business if a pending lawsuit against the target is later ruled unfavorably. In such cases, FAS 141r requires the contingent consideration to be recognized as an asset, rather than a liability or equity, at the acquisition date. As you can imagine, structuring contingent consideration arrangements in this manner is rare when the target is a public company with many shareholders from whom it would be difficult to reclaim the contingent consideration.
Example B – Applying FAS 141 and 141r
A acquires 100% of T's assets for $125 on December 14, 2008, and will pay another $15 to T's shareholders if T's revenues grow at least 10% in the coming year. The contingent payment is valued at $12 at the acquisition date. Transaction and advisory fees total $6. A's tax rate is 25%. T's book and tax balance sheets are identical and as shown in part (A).
(A) How much goodwill will A record on its balance sheet?
Note that the DTA resulting from acquired IPR&D is not included in the purchase price allocation because the journal entries described in Example A are made separately and immediately after the purchase price is allocated when the IPR&D is expensed. Also, note that goodwill is a whopping 83% of the purchase price! While this is a rather high percentage, it is certainly not unprecedented in the annals of M&A.
(B) Now suppose that the transaction is a stock deal rather than an asset deal. How much goodwill will A recognize on its balance sheet?
The DTL created in the acquisition is a function only of the write-ups of PP&E and identifiable intangibles because IPR&D will be expensed immediately and will therefore not give rise to any difference between taxable income for book and tax purposes in the future (book basis = tax basis = $0).
(C) Now suppose that the stock deal from part (B) was completed on December 16, 2008. How much goodwill will A recognize on its balance sheet?
Since we are not required to expense acquired IPR&D after December 15, 2008, the IPR&D will give rise to a DTL in the same manner as PP&E and other identifiable intangibles.
In the purchase price allocation for the stock acquisition in the example above, note that no DTL is recognized for goodwill. Goodwill is thus a permanent difference for taxable deals with no step-up in tax basis.
Whether we account for contingent payment arrangements in the business combination or as separate transactions depends on the nature of the arrangements. Understanding the reasons why the acquisition agreement includes a provision for contingent payments, who initiated the arrangement, and when the parties entered into the arrangement may be helpful in assessing the nature of the arrangement. See FAS 141r for additional guidance on assessing the nature of the arrangements.
Example C – Contingent Payment to an Employee
T hired a new CEO under a 5-year contract that required T to pay the candidate $10 if T upon a change in control before the contract expires. A acquires T 3 years later, triggering the $10 payment to the CEO under the existing contract.
In this example, T entered into the employment agreement before the negotiations of the combination began, and the purpose of the agreement was to retain the CEO's services. Thus, there is no evidence that the agreement was arranged primarily to provide benefits to A or the combined entity. Therefore, the liability to pay $10 is recognized at acquisition.
In other circumstances, T might enter into a similar agreement with CEO at the suggestion of A during the negotiations for the business combination. If so, the primary purpose of the agreement might be to provide severance pay to CEO, and the agreement may primarily benefit A or the combined entity rather than T or its former owners. In that situation, A accounts for the $10 liability separately in its post-combination financial statements.
FAS 141 and 141r differ in their treatment of restructuring costs the acquirer expects but is not obligated to incur as follows:
- FAS 141 – Recognize as a liability at the acquisition date
- FAS 141r – Expense separately from the transaction as incurred
Examples of such restructuring costs are plans to exit business activities of the target or terminate or relocate the target's employees. FAS 146 (FASB) and IAS 37 (IASB) provides more detailed guidance on accounting for costs associated with exit or disposal activities.
Compensation for Past Services
Payments to Target's employees for services performed in the past which have no future benefit are added to the purchase price because they are considered assumed liabilities. Examples include severance payments to Target's former managers and stock options that vest upon a change of control.
If Acquirer is obligated to replace share-based payment awards (e.g. stock options) held by Target's employees with its own, either all or a portion of the FV of Acquirer's replacement awards is included as part of the purchase price. Such an obligation might arise from:
- The terms of the acquisition agreement
- The terms of T's awards
- Applicable laws or regulations
The portion of the FV of the replacement award that is included in the purchase price equals the portion of the Target award that is attributable to past service.
In some cases, Target's awards may expire rather than vest upon a change in control. If Acquirer replaces Target's awards without obligation to do so, the FV of all such replacement awards is recognized as a compensation expense in the post-combination financial statements rather than added to the purchase price.
Acquirer must attribute a portion of a replacement award to future service if it requires future service, regardless of whether Target's employees had rendered all of the service required by their Target awards before the acquisition date. The portion of a nonvested replacement award attributable to future service equals the total FV of the replacement award less the amount attributed to past service. Therefore, Acquirer must attribute any excess of the FV of the replacement award over the FV of the T award to future service.
Example D – A Replacement Awards That Require No Future Services Exchanged for T Awards for Which Employees Have Rendered the Required Services as of the Acquisition Date
A issues replacement awards fairly valued at $110 on the acquisition date for T's awards similarly valued at $100. No future services are required for the replacement awards, and T's employees have rendered all of the required service for the T awards as of the acquisition date.
The amount attributable to past service is the FV of T's awards ($100) at the acquisition date; that amount is included in the purchase price. The amount attributable to future service is $10, which is the difference between the total value of the replacement awards ($110) and the portion attributable to past service ($100). Because no future service is required for the replacement awards, A immediately recognizes $10 as compensation cost in its post-combination financial statements.
Example E – A Replacement Awards That Require Future Services Exchanged for T Awards for Which Employees Have Rendered the Requisite Service as of the Acquisition Date
A exchanges replacement awards that require 1 year of future service for share-based payment awards of T for which employees had completed the requisite service period before the business combination. The FV of both awards is $100 at the acquisition date. When originally granted, T’s awards had a requisite service period of 4 years. As of the acquisition date, the T employees holding unexercised awards had rendered a total of 7 years of service since the grant date.
Even though T employees had already rendered all of the requisite service, A attributes a portion of the replacement award to future compensation cost because the replacement awards require one year of future service. The total service period is 5 years—the requisite service period for the original T awards completed before the acquisition date (4 years) plus the requisite service period for the replacement award (1 year). The portion attributable to past services equals the FV of the T awards ($100) multiplied by the ratio of the past service period (4 years) to the total service period (5 years). Thus, $80 ($100 × 4 ÷ 5 years) is attributed to the past service period and therefore included in the purchase price. The remaining $20 is attributed to the future service period and therefore is recognized as compensation cost in A’s post-combination financial statements.
Example F – A Replacement Awards That Require Future Services Exchanged for T Awards for Which Employees Have Not Rendered All of the Requisite Service as of the Acquisition Date
A exchanges replacement awards that require 1 year of future service for share-based payment awards of T for which employees had not yet rendered all of the required services as of the acquisition date. The FV of both awards is $100 at the acquisition date. When originally granted, T's awards had a requisite service period of 4 years. As of the acquisition date, T's employees had rendered 2 years’ service, and they would have been required to render 2 additional years of service after the acquisition date for their awards to vest. Accordingly, only a portion of the T awards is attributable to past service.
The replacement awards require only 1 year of future service. Because employees have already rendered 2 years of service, the total requisite service period is 3 years. The portion attributable to past services equals the FV of the T awards ($100) multiplied by the ratio of the past service period (2 years) to the greater of the total service period (3 years) or the original service period of T's award (4 years). Thus, $50 ($100 × 2 ÷ 4 years) is attributable to past service and therefore included in the purchase price. The remaining $50 is attributable to future service and therefore recognized as compensation cost in A's post-combination financial statements.
Example G – A Replacement Awards for Which No Future Services Are Required Exchanged for T Awards for Which Employees Have Not Rendered All of the Requisite Service as of the Acquisition Date
Assume the same facts as in Example 1.5, except that A exchanges replacement awards that require no future service for share-based payment awards of T for which employees had not yet rendered all of the requisite service as of the acquisition date. The terms of the replaced T awards did not eliminate any remaining requisite service period upon a change in control (if the T awards had included a provision that eliminated any remaining requisite service period upon a change in control, the guidance in Example 1.3 would apply). The FV of both awards is $100.
Because employees have already rendered 2 years of service and the replacement awards do not require any future service, the total service period is 2 years. The portion of the FV of the replacement awards attributable to past services equals the FV of the T award ($100) multiplied by the ratio of the past service period (2 years) to the greater of the total service period (2 years) or the original service period of T’s award (4 years). Thus, $50 ($100 × 2 ÷ 4 years) is attributable to past service and therefore included in the purchase price. The remaining $50 is attributable to future service. Because no future service is required to vest in the replacement award, A recognizes the entire $50 immediately as compensation cost in its post-combination financial statements.