The general principles of the purchase method under both pronouncements are similar to the general principles of accounting for acquisitions of assets and issuances of stock; The total cost of the acquisition is determined. Determining the cost of an acquisition and allocating the purchase price to assets acquired and liabilities assumed requires the application of specialized acquisition accounting concepts and procedures, which are discussed throughout this post. Various approaches to determine the cost of an acquisition: Stock Issued In Payment of Purchase Price, Direct Costs Of Acquisitions Other Than Purchase Price, Premium Or Discount, Assets Exchanged, Contingent Consideration, Pre-acquisition Contingencies, Stock Option Exchanges.
The general approach to determining the cost of a purchase acquisition follows three general principles for accounting for acquisitions of assets:
- An asset acquired in exchange for cash or other assets is recorded at cost (i.e., at the amount of cash disbursed or the fair value of other assets distributed).
- An asset acquired by incurring liabilities is recorded at cost (i.e., at the present value of the amounts to be paid).
- An asset acquired by issuing shares of stock of the acquiring corporation is recorded at the fair value of the asset (i.e., shares of stock issued are recorded at the fair value of the consideration received for stock). In cases where stock has a quoted price, one would, in fact, look first to the value of the stock for valuing the stock issued and assets received.
Stock Issued In Payment of Purchase Price
Many acquisitions are paid for by exchanging cash or incurring liabilities for the net assets or stock of another company. Alternatively, equity securities of an acquiring company are often issued in exchange for the assets or stock of an acquired company. The fair value of net assets acquired in exchange for stock that has determinable value is usually measured by the value of the stock at the date of acquisition. However, market prices for a reasonable period of time before and after the date an acquisition is agreed to and announced should be considered in establishing the value to be assigned to the securities to avoid volatility of stock prices unduly affecting accounting for the acquisition. If restricted securities are issued, an appraisal of value by qualified professionals, such as investment bankers, may be necessary to establish value. If the fair value of stock is not readily determinable, other indicators of value should be used, such as an estimate of the value of the assets received, including an estimate of goodwill.
Emerging Issues Task Force (EITF) Issue 95-19, Determination of the Measurement Date for the Market Price of Securities Issued in a Purchase Business Combination, considered conflicting guidance in paragraphs 74 and 93 of Opinion 16 with respect to the valuation of securities that are issued as consideration in a purchase-method acquisition. Paragraph 74 says:
The market price for a reasonable period before and after the date the terms of the acquisition are agreed to and announced should be considered in determining the fair value of securities issued.” The guidance of paragraph 93 would value securities as of the date of the acquisition, which is defined as “the date assets are received and other assets are given or securities are issued.
The EITF indicated that the guidance of paragraph 74 should be used. The “reasonable period of time” should be very short, such as a few days before and after an acquisition is agreed to and announced. Thus, the measurement date for the value of securities issued is not affected by the need for shareholder or regulatory approval.
EITF 95-19 also indicates that the measurement date for a hostile tender offer occurs when the proposed transaction is announced and enough shares have been tendered to make the offer binding. If a proposed hostile tender offer becomes non-hostile, the market price at that time would be used based on the acquiree’s agreement to the purchase price. EITF 95-19 also provides that a new measurement date for marketable equity securities occurs if a purchase price is changed. Changes in a purchase price can result from further negotiations or changes in the market price of the equity securities that could cause a change in the security’s exchange ratio or a change to a cash portion of a purchase price.
Some preferred share issues are similar to debt securities, while others are similar to common shares, with many gradations in between. Fair value of nonvoting, nonconvertible preferred shares that lack characteristics of common shares may be determined by comparing specified dividend and redemption terms with those of comparable securities and by assessing market factors. Thus, the cost of issuing senior equity securities may be determined in practice on the same basis as for debt securities.
Direct Costs Of Acquisitions Other Than Purchase Price
Acquisition cost includes all direct costs related to an acquisition, such as finders’ and directly related professional fees [e.g., legal, accounting, and appraisal fees] and incremental costs that were directly caused by and related to the acquisition. The fixed costs of an internal acquisitions department or of the officers and employees who work on acquisitions should not be included in acquisition cost, because they are not incremental. Costs of registering and issuing equity securities are a reduction of the otherwise determinable fair value of the securities.
Premium Or Discount
Purchase accounting requires recognition of the time value of money in computing total acquisition cost as well as in determining the fair market values of assets acquired and liabilities assumed. Premium or discount on a debt security that is issued or assumed should be imputed to adjust the liability to present value based on current market interest or yield rates if the stated interest or yield rates vary significantly from current market rates. Assigning fair value to individual assets and liabilities (generally receivables or payables) may require discounting to present value or assigning a premium allocation. After an acquisition, interest expense or income should be recorded by amortization of the premium or discount using the interest method.
Assets given to a seller as consideration should be included in the total acquisition cost at fair value. Any deferred taxes related to assets given up should be removed from the balance sheet and accounted for as a reduction of the total acquisition cost.
Consideration that is contingent on future earnings of an acquiree should be added to the acquisition cost when amounts are determinable beyond a reasonable doubt. Acquisition cost should be increased and the additional cost should be allocated to net assets acquired in accordance with the purchase method.
This often results in an adjustment to long-term assets or goodwill. The additional cost should be depreciated or amortized prospectively over the remaining useful lives of the assets to which the additional cost was assigned.
If stock has been given in consideration for an acquisition with a contingency requiring the issuance of additional shares or payment of cash dependent on future security prices, issuance of additional shares does not result in an adjustment of acquisition cost. The recorded amount of shares previously issued is reduced by an amount equal to the fair value of the additional consideration (cash, stock, or other) paid upon resolution of the contingency.
Interest and dividends paid to an escrow agent on contingently issuable debt or equity securities should not be accounted for as interest or dividends. Upon resolution of the contingency, if payment of the escrowed funds by the agent to the seller is required, the amounts should be recorded as additional acquisition costs if the contingency was based on earnings. If the contingency was based on security prices, the accounting is the same as for contingently issuable securities—the value of securities previously issued is reduced and there is no change to total acquisition cost.
In EITF Issue 97-8, Accounting for Contingent Consideration Issued in a Purchase Business Combination, the EITF addressed accounting for contingent consideration based on earnings or a guaranteed value of securities that is embedded in a security or in a separate financial instrument (which may trade in financial markets). The EITF determined that if the seller has the right to transfer the security or instrument and if it is publicly traded or indexed to a security that is publicly traded, the security or instrument should be recorded as part of the purchase price at fair value at the date of acquisition (using the basis for determining value discussed in EITF 95-19 [Section 6.2(b)]).
There is no later adjustment to the purchase price based on changes in value of the security or financial instrument. If the security or instrument is not publicly traded or indexed to a security that is publicly traded (the contingent consideration), the contingent consideration is not recorded at the acquisition date and when the contingency is resolved, the purchase price is adjusted. EITF Issue 96-13, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock, and EITF Issue 86-28, Accounting Implications of Indexed Debt Instruments, provide applicable subsequent accounting guidance for indexed securities or instruments.
EITF Issue 97-15, Accounting for Contingency Arrangements Based on Security Prices in a Purchase Business Combination, addresses situations where the acquirer agrees to pay cash or another form of consideration to the seller if securities issued as part of the purchase price do not have a specified value at a specified future date. These situations include a “below-market guarantee”, where an acquirer agrees to issue additional consideration if the securities issued do not have, at a future date, a specified value that is less than the value at the date the securities were issued.
If a below-market guarantee is given, the purchase price should be recorded based on the fair value of the consideration unconditionally given at the date of the acquisition.
Example: An acquisition is consummated with the acquirer issuing 100,000 shares with a value of $22 per share, for a total purchase price of $2.2 million. The acquirer gives a below-market guarantee at a specified future date of $18 per share, or $1.8 million. When the future date arrives, the market price of the stock is $15 per share, for a total value of $1.5 million. The acquirer must provide additional consideration of $300,000, which could be cash, additional shares of stock, or some other form of consideration. This does not result in a change in the purchase price. The value of the initial consideration given is reduced by the amount of the additional consideration.
Some contingency arrangements that are based on security prices do not guarantee a minimum value of total consideration. Instead, they require additional consideration if the value of the shares issued at the acquisition date is less than a “target” value at a specified future date. The target value is the lowest amount at which additional consideration would not have to be issued. The amount of additional consideration is limited and, therefore, the total value of all consideration is not known at the acquisition date. In this instance, the purchase price should be recorded at an amount equal to the maximum number of shares that could be issued, multiplied by the fair value per share at the acquisition date if that amount is limited, but no greater than the target value. Said another way, the purchase price should be recorded at an amount equal to the lower of either the target value or the maximum number of shares that could be issued, multiplied by the market price per share at the date of acquisition. The conveyance of additional consideration would not result in a change in the purchase price recorded at the date of acquisition.
EITF Issue 95-8, Accounting for Contingent Consideration Paid to the Shareholders of an Acquired Enterprise in a Purchase Business Combination, addresses situations in which contingencies are based on earnings or other performance measures where selling shareholders have positions that can affect the financial results of the acquiree after the acquisition. This could be as employees, officers, directors, consultants, or contractors. Issue 95-8 indicates criteria that should be used to determine whether the resolution of the contingency should be accounted for as an adjustment of the purchase price or as a compensation expense of the future period. These factors include:
- Is the contingent consideration forfeited if the employment terminates (which would indicate that the contingent consideration is compensation)?
- Does the length of time of requirements coincide with the contingent payment period?
- Is the employee compensation, excluding the contingent payments, reasonable in relation to that of comparable employees?
- Do the selling shareholders who become employees receive greater amounts of contingent payments than shareholders who do not become employees?
- Do the selling shareholders who become employees own substantially all, or only a minor amount, of the stock of the acquiree, and do all shareholders receive the same amount of contingent consideration on a per-share basis?
- Identify the reasons for the contingent consideration arrangement (e.g., if the initial purchase price is at the low end of a range established in a valuation study or if the contingent consideration formula is consistent with prior profit-sharing or bonus arrangements).
- Are there indications from the formula used to compute the contingent consideration?
- Identify the terms of other arrangements with the selling shareholders, including non-compete agreements, executory contracts, consulting contracts, and leases.
The effect of the assumption of a contingency, whether or not there was an identifiable adjustment to the purchase price, should result in an allocation to a liability assumed. Certain resolutions of contingencies after the acquisition can result in adjustments to acquisition costs.
If appreciated (fair value is higher than carrying value) non-monetary assets are given up as part of a purchase price, the acquirer would record a gain. This is necessary to achieve the Opinion 16 driving principle that assets given up should be included in the purchase price at fair value. When the author first encountered this in practice, he consulted with the FASB staff and confirmed that this is correct.
While gain recognition is not specifically addressed in Opinion 16, the FASB staff indicated that the requirement to include the assets in the purchase price at fair value (which is then allocated to the net assets acquired) requires the gain recognition.
An issue relating to operating assets being exchanged for other operating assets is addressed in EITF Issue 98-3, Determining Whether a Transaction Is an Exchange of Similar Productive Assets or a Business Combination. The situation deals with the interplay of Opinion 16 and APB Opinion 29, Accounting for Non-monetary Transactions. Opinion 29 indicates that it does not apply to business combinations. The opinion addresses the issues of when a transaction would be considered an exchange of similar productive assets that would be accounted for at historical cost under Opinion 29, and when it would be considered a business combination to be accounted for at fair value under Opinion 16.
The EITF members indicate that the answer lies in whether the assets exchanged are “businesses.” Some EITF members suggested that work be done on what characteristics indicate that the operating assets exchanged are a business, in which case accounting should be done under Opinion 16. Other EITF members indicated that they believe that even if similar businesses are exchanged, the accounting could be done under Opinion 29 at historical cost. They indicated that they believe the EITF should work on what characteristics indicate that groups of assets are similar. The Securities and Exchange Commission (SEC) observer to the EITF has indicated that the SEC staff believes that Opinion 16 should be used for exchanges of businesses, even if the businesses are similar.
Stock Option Exchanges
Options to purchase an acquiree’s stocks that are exchanged for options to purchase the acquirer’s stock should be considered part of the purchase price according to current practice and SEC guidance. The amount to be included in the purchase price is the fair value of the options of the acquirer that were exchanged, determined by using the Black-Scholes formula or another option valuation model.
In an exposure draft issued on March 31, 1999, Accounting for Certain Transactions Involving Stock Compensation, the FASB has proposed that only vested options should be included in the purchase price. Non-vested options would not be included in the purchase price. For non-vested options, the FASB would require a new measurement date if the exchange of options resulted in more than a deminimus increase in fair value. Compensation cost would be recognized by the acquirer to the extent that costs were not recognized by the acquiree for non-vested options. If there is a new measurement date, additional compensation cost would be recognized to the extent that the intrinsic value of the acquirer’s options exceeds the intrinsic value of the acquiree’s options immediately before the exchange.
In EITF Issue 85-45, Business Combinations of Stock Options and Awards, the EITF indicated that if a target company settles stock options voluntarily, at the direction of the acquirer or as part of the plan of acquisition, the acquiree should account for the settlement as compensation expense under APB Opinion 25, Accounting for Stock Issues to Employees.