Business Combinations: Applying the Acquisition Method Board Meeting Handout. October 18, 2006

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1 Business Combinations: Applying the Acquisition Method Board Meeting Handout October 18, 2006 The purpose of this Board meeting is to discuss the following topics as a part of the redeliberations of the FASB s and the IASB s joint Exposure Draft, Business Combinations: Topic 1: Assembled Workforce Topic 2: Research and Development (R&D) Assets Topic 3: Preexisting Relationships and Reacquired Rights Topic 4: Measurement Period TOPIC 1: ASSEMBLED WORKFORCE At the September 2006 Board meetings, the Boards tentatively decided that intangible assets that are identifiable (that is, arising from contractual-legal rights or separable) can be measured reliably and should be recognized separately from goodwill. The Business Combinations Exposure Draft (BC ED), however, proposes that an assembled workforce should not be recognized as an intangible asset separately from goodwill. Comment Letter Summary Although the BC ED did not specifically request comments on the proposal to preclude the recognition of an assembled workforce as an intangible asset separate from goodwill, several respondents did comment. Some respondents agreed that an assembled workforce should not be recognized separately from goodwill. Other respondents suggested that the Boards reconsider allowing an assembled workforce to be recognized if it is identifiable. Staff Analysis Characteristics of an assembled workforce An assembled workforce is not defined in either FASB Statement No. 141, Business Combinations, or IAS 38, Intangible Assets. As a result, there are inconsistencies in practice because preparers often have different interpretations, including: The staff prepares meeting handouts to facilitate the audience's understanding of the issues to be addressed at the Board meeting. This material is presented for discussion purposes only; it is not intended to reflect the views of the FASB or its staff. Official positions of the FASB are determined only after extensive due process and deliberations.

2 a. View 1: An assembled workforce is the intellectual capital of the skilled workforce of which the acquirer has obtained the benefit as a result of the acquisition. This view implies that the assembled workforce is the (specialized) knowledge and experience that the employees bring to their jobs (and appears to be the underlying premise of both Statement 141 and IAS 38). b. View 2: An assembled workforce is a collection of employees that allows the acquirer to continue to operate on Day One. That is, the acquirer does not need to go through the process of finding, hiring, and training the employees because they are already in place and operating on a continuous business as usual basis. It should be noted that training, in this context, refers to the cost that would be incurred (generally in terms of lost productivity and training course fees) to get a new employee that has experience in the job function for which he or she was hired to be sufficiently proficient in his or her new job (that is, to learn the systems and procedures for that particular company). This is not related to the knowledge and experience that are gained over time. The staff agrees with View 2. This is similar to the rationale that an existing customer relationship intangible asset meets the criteria to be recognized separately from goodwill; it is the fact that these relationships exist and allow the acquirer to operate functionally from Day One that gives the customer relationships their value. Under View 1, there is a potential to double count the intellectual capital of the employee and the know how reflected in the other intangible assets of the entity (for example, proprietary technologies and processes, customer relationships, and so forth). The staff believes that the intellectual capital can be separated from the assembled workforce because the related intellectual capital is captured in the fair value of the entity s other intangible assets. 1 This is the case when a process or methodology can be documented and followed to the extent that the business would not be affected materially should the employee leave the entity. In other words, the employees are relatively easy to replace without adversely affecting the fair value of the entity s other assets. This view assumes that an employee is replaceable with another person of similar background and experience. In most jurisdictions, the intellectual capital of an employee usually is owned by the employer. Most employment contracts stipulate that the employer retains the rights to 1 Examples include proprietary technologies and processes, in-process research and development (IPR&D), and customer contracts and related relationships (including some types of maintenance and consulting contracts). 2

3 and ownership of any intellectual property created by the employee. Accordingly, it seems inappropriate to allocate those rights to the fair value of the assembled workforce. The fair value of the assembled workforce is not related to the employee s knowledge as much as it relates to the fact that he or she is able to perform the job without having to be hired and trained on Day One. Question 1: Does the Board believe that an assembled workforce represents (a) the intellectual capital of the employees of an entity (View 1) or (b) the fact that the acquired entity has a collection of employees in place to operate the business on Day One (View 2)? Reliability of measurement Statement 141 was issued over five years ago. The staff agrees with the respondents who stated that it is appropriate to consider whether valuation techniques are now available to measure the fair value of an assembled workforce with sufficient reliability. The staff notes that the definition of fair value has developed and been clarified in the past five years, most recently in FASB Statement No. 157, Fair Value Measurements. Statement 157 includes the cost approach as a valuation technique that can be used to measure fair value. It states that valuation techniques consistent with the market approach, income approach, and/or cost approach shall be used to measure fair value. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (often referred to as current replacement cost) (paragraph 18; emphasis added). Therefore, the staff believes that the Board should consider whether the statement that replacement cost is not a representationally faithful measurement of the fair value of the intellectual capital acquired in a business combination is still valid. If the cost approach is an appropriate valuation approach for other assets required to be measured at fair value under U.S. GAAP, the staff sees no reason why the cost approach would not be a representationally faithful measure of the fair value of an assembled workforce. 3

4 Assembled workforces are valued for purposes of calculating a contributory asset charge when valuing other intangible assets. For this purpose, assembled workforces are often valued using a cost approach (based on the costs of hiring and training/lost productivity). Indeed, if the fair value of an assembled workforce cannot be measured reliably, the fair values of all intangible assets that include a contributory asset charge for assembled workforce (that is, any entity using an excess earnings income approach) are likely to be stated inappropriately. Furthermore, based on the view that an assembled workforce is a pool of employees in place on Day One, an appropriate valuation methodology would consider the cost of replacing an entity s workforce to be reflective of the fair value of the entity s assembled workforce. This clearly would imply that the fair value of an assembled workforce measured in this way would be lower than it would be if an intellectual capital component was included. However, it would not necessarily be an insignificant asset to the acquiring entity. The fair value of an assembled workforce that is a team of specialized employees (such as the technical partner in the example above) would reflect the higher costs associated with employing highly skilled employees (in the form of higher recruiting costs, higher salaries, better benefits packages, and higher training costs). This would result in a higher fair value per employee. Less skilled workers would have a lower assembled workforce value per employee because such employees are relatively easy to find and hire, have relatively lower salaries and benefits, and have lower training costs. Control An entity has control over an asset when it has the power to obtain the future economic benefits flowing from the underlying resource and to restrict the access of others to those benefits (IAS 38, paragraph 13). The staff points out that there is a difference between control and ownership. Although having ownership of an asset generally implies having control over the asset, it does not necessarily follow that having control over an asset can occur only through ownership. This difference applies to all assets that involve the behaviour of natural persons because, in most areas of the world, people cannot be owned. Such assets include those related to 4

5 employees and customers. The staff sees no difference between an at-will employment relationship and an at-will customer relationship. It seems inconsistent, therefore, to not allow the recognition of an assembled workforce. The staff recognizes that some employers do not have written employment contracts with their employees. This depends on the job function that is being performed and the jurisdiction in which the employer operates. The staff believes that the existence of a written contract is not necessary. An employee and employer are bound by the agreed-upon terms of employment even if they are in the form of an oral contract. The exchange of services in exchange for payment will, in many jurisdictions, qualify as a contract between the two parties. For this reason, most, if not all, employment arrangements would meet the contractual-legal criterion. The staff also believes that an assembled workforce meets the separability criterion because employees are often leased to other entities. This happens, for example, with employees on secondment 2 or with temporary employees. Finally, the staff believes that defining what is meant by assembled workforce and requiring separate recognition will prevent what is currently, in many cases, a misapplication of the standard. Preparers with the goal of maximizing the amount of goodwill simply need to assert that the intellectual capital of their employees is a very valuable asset of the business, thereby increasing the fair value of the assembled workforce (as interpreted). This increases the contributory asset charges for the other intangible assets, which reduces the fair value of those other assets. The result is a higher amount of goodwill. Question 2: Does the Board agree that an assembled workforce should be recognized as an intangible asset separate from goodwill? 2 A secondment is a temporarily transfer of an employee to another position, either within the same company (such as a transfer overseas) or to another company (such as a consulting firm leasing its employees to a client for the duration of a project). 5

6 TOPIC 2: ACCOUNTING FOR R&D ASSETS The accounting proposed in the BC ED for R&D assets would result in a significant change to current U.S. GAAP. FASB Interpretation No. 4, Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method, requires an acquirer to immediately expense tangible and intangible assets to be used in R&D that have no alternative future use. R&D assets that have alternative future uses are capitalized. The BC ED proposes that an acquirer recognize identifiable tangible and intangible assets acquired in a business combination to be used in R&D activities regardless of whether those assets have an alternative future use. 3 IFRS 3, Business Combinations, already requires that an acquirer recognize an intangible asset (including an in-process research and development (IPR&D) asset) separately from goodwill if it meets the criteria for recognition in accordance with IAS 38, Intangible Assets. Therefore, the proposals in the BC ED would not change the accounting for acquired R&D assets under IFRS. Respondents that apply IFRS did not raise any specific issues in applying the IFRS 3 guidance related to acquired R&D assets. Comment Letter Responses Few respondents commented on the proposed accounting for R&D assets, but those that did generally (a) apply U.S. GAAP and (b) disagree with the proposal. Generally, those respondents were accounting firms or preparers in the pharmaceutical or hightechnology industries. They disagreed for two reasons: 3 Interpretation 4 describes two types of R&D assets: a. Tangible and intangible assets resulting from R&D activities for example, patents, blueprints, formulas, and designs for new products or processes. Those examples are assets that would generally be considered intangible assets because they are no longer in-process. b. Tangible and intangible assets to be used in R&D activities for example, materials and supplies, equipment and facilities, and even a specific IPR&D project. At this meeting, the Board is addressing only R&D assets to be used in R&D activities. 6

7 a. IPR&D does not meet the definition of an asset since its low-likelihood of success does not represent probable future economic benefits. b. The fair value of IPR&D is not reliably measurable. Some respondents (both those that agreed with the proposals and those that did not) expressed concerns about the inconsistencies and mixed model this proposal would create. That is, the BC ED proposes that IPR&D acquired in a business combination be capitalized, while IPR&D acquired in an asset acquisition or internally generated IPR&D would continue to be expensed under FASB Statement No. 2, Accounting for Research and Development Costs. Also, subsequent expenditures on the projects acquired in the business combination would be expensed even though those subsequent costs are likely to be more valuable since they get the project closer to completion. Because of the concerns about inconsistent accounting treatment, some respondents suggested that the FASB address IPR&D accounting comprehensively rather than on a piecemeal basis. A few respondents raised issues about the impairment testing of IPR&D that would be required as a result of the Boards decision to capitalize those assets. Those concerns are about the difficulty and significant judgment required to perform an impairment test, including unit of account issues. Staff Analysis Issue 1: Initial Recognition and Measurement of IPR&D Acquired in a Business Combination Is an IPR&D Project an Asset? Some respondents disagreed with the proposal because they believe that at the acquisition date IPR&D does not meet the definition of an asset in FASB Concepts Statement No. 6, Elements of Financial Statements. Respondents believed that IPR&D acquired in a business combination does not meet the definition of an asset because they believe its low-likelihood of success does not represent probable future economic benefits. The staff believes that respondents are confusing the use of the term probable in Concepts Statement 6 with the use of that same term in other U.S. 7

8 GAAP, such as FASB Statement No. 5, Accounting for Contingences, or FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes. Footnote 18 of Concepts Statement 6 clarifies the use of the word probable in the definition of an asset: 4 Probable is used with its usual general meaning, rather than in a specific accounting or technical sense...and refers to that which can be reasonably be expected or believed on the basis of available evidence or logic but neither is certain or proved.... Its inclusion in the definition is intended to acknowledge that business and other economic activities occur in an environment characterized by uncertainty in which few outcomes are certain.... The staff acknowledges that there is uncertainty surrounding the amounts and timing of the future economic benefits that IPR&D will generate. However, the staff notes that the term probable was not intended to imply that a particular degree of certainty in obtaining the economic benefits is required before an item meets the definition of an asset. Uncertainty in the amounts or timing of future economic benefits does not determine whether or not an asset exists, but rather enters into the measurement of the asset. The term probable in the definition of an asset (or liability) has been misinterpreted by some constituents. In July 2006, the Boards discussed the following proposed working definition of an asset, which no longer uses the term probable: 4 The staff notes that IAS 38 also uses the term probable in determining whether an intangible asset should be recognized, but IAS 38 uses the term probable differently from Concepts Statement 6. Paragraph 21 of IAS 38 states that an intangible asset should be recognized if it is probable that the expected future economic benefits attributable to the asset will flow to the entity and the cost of the asset can be measured reliably. Paragraph 33 of IAS 38 explains that the fair value of an intangible asset reflects market expectations about the probability that the future economic benefits embodied in the asset will flow to the entity. In other words, the effect of probability is reflected in the fair value measurement of the intangible asset. Therefore, the probability recognition criterion in paragraph 21(a) is always considered to be satisfied for intangible assets acquired in business combinations (emphasis added). In the definition in Concepts Statement 6, the term probable is linked to the likelihood of obtaining the future benefits rather than the likelihood that the benefits will flow to the entity. That might be why some constituents believe that IPR&D does not meet the definition of an asset in the FASB s Conceptual Framework. 8

9 An asset is a present economic resource to which an entity has a present right or other privileged access. An asset of an entity has three essential characteristics: a. There is an economic resource. b. The entity has rights or other privileged access to the economic resource. c. The economic resource and the rights or other privileged access both exist at the financial statement date. The staff notes that IPR&D projects also would meet the conceptual framework project s proposed working definition of an asset. The staff believes that it is difficult to argue that IPR&D is not an asset. The next logical question is whether IPR&D can be measured reliably. Is the Fair Value of IPR&D Reliably Measurable? Some respondents opposed the FASB s proposal to capitalize IPR&D because they believe that the fair value of IPR&D cannot be reliably measured. The staff acknowledges that because of the uncertainty inherent in economic activities, judgments and estimates must often be used in financial reporting. Paragraph 23 of Concepts Statement 6 states: To be included in a particular set of financial statements, an item must not only qualify under the definition of an element but also must meet criteria for recognition and have a relevant attribute (or surrogate for it) that is capable of reasonably reliable measurement or estimate. [Emphasis added; footnote reference omitted.] The use of estimates and judgment does not mean information is unreliable. Paragraph 86 of the IASB s Framework states that in many cases, cost or value must be estimated; the use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability. In Statement 141, the FASB concluded that identifiability (that is, an intangible asset arises from contractual-legal rights or is separable) is the condition that establishes a 9

10 reliability of measurement threshold for the separate recognition of intangible assets. Therefore, the FASB concluded that if an intangible asset is identifiable, its fair value can be measured reliably. The staff believes that if IPR&D is identifiable (because it meets the separability criterion), it can be measured reliably. As a result, the staff believes that Level 1, 2, or 3 inputs will be available to measure identifiable intangible assets, including IPR&D. The staff notes that the fair value of IPR&D acquired in a business combination is currently estimated in practice but immediately expensed. Uncertainty and judgmental assumptions make it difficult to measure IPR&D. However, the difficulty in measuring IPR&D does not mean the measurement is unreliable. The staff also believes that relevance outweighs the concerns expressed about reliability for the reasons discussed in paragraph B60 of FASB Statement No. 123 (revised 2004), Share-Based Payment, which states: Without estimates, accrual accounting would not be possible. For example, financial statement amounts for loan loss reserves, valuation allowances for deferred tax assets, and pensions and other postretirement benefit obligations are based on estimates. For those and many other items in accounting that necessitate the use of estimates, companies are required to use appropriate measurement techniques, relevant data, and management judgment in the preparation of financial statements. Few accrual-based accounting measurements can claim absolute reliability, but most parties agree that financial statement recognition of estimated amounts is preferable to the alternative cash basis accounting. [Emphasis added.] Does Capitalizing IPR&D Acquired in a Business Combination Provide Decision- Useful Information? Some staff members believe that IPR&D acquired in a business combination should continue to be expensed in accordance with Interpretation 4 until the Board comprehensively reconsiders the accounting for R&D. That is, those staff members find it difficult to accept a model in which an entity would capitalize IPR&D that was acquired in a business combination but then subsequently expense any internal costs to complete the asset. The amount capitalized would represent the value of the asset only on the acquisition date. Immediately after the acquisition date, the entity would 10

11 incur costs that would presumably increase the value of the capitalized IPR&D asset, but those costs would be expensed. Therefore, those staff members believe that after the acquisition, the amount recorded for the IPR&D asset provides users with no more decision-useful information than if all R&D costs were expensed immediately. Proposed Clarification of Which IPR&D Assets Would Be Capitalized The staff believes that if the FASB Board decides to capitalize IPR&D acquired in a business combination, then it should be clear about its intent. The staff believes that the intent of the proposal is that if IPR&D is separable, then it should be capitalized as an intangible asset separate from goodwill. Therefore, separability would be the criterion for separate recognition. Question 3: Does the Board believe that R&D assets (including IPR&D projects) acquired in a business combination should be capitalized at the acquisition date and measured using a current exchange value? Question 4: If so, does the Board agree with staff s clarification that only those R&D assets to be used in R&D activities that are separable would be capitalized? Issue 2: Accounting for Subsequent Expenditures Related to IPR&D Acquired in a Business Combination One respondent questioned the FASB Board s rationale for proposing that subsequent expenditures related to IPR&D acquired in a business combination be expensed rather than capitalized. IPR&D, by nature, is different from other intangible assets in the sense that it is still in-process when it is acquired. This leads to the question of what to do with subsequent expenditures that get the project closer to completion. Under the proposals, the acquirer would be required to expense subsequent expenditures for R&D in accordance with Statement. 2. Those subsequent expenditures are not substantially different from subsequent expenditures incurred for other intangible assets. For example, after acquiring a brand, an entity incurs costs to maintain or improve the brand, which are expensed as incurred. The staff believes that the Board should not reconsider Statement 2 in the business combinations project. The intention of the business combinations project is to provide 11

12 guidance at the acquisition date rather than prescribe the accounting required subsequent to the business combination. Although the BC ED does provide some Day 2 guidance, the staff believes that reconsidering the accounting for subsequent internal R&D expenditures is outside the scope of the project. Therefore, the staff recommends that subsequent expenditures related to acquired IPR&D assets should be expensed. Question 5: Does the Board agree that subsequent expenditures related to acquired IPR&D should be expensed? Issue 3: Subsequent Accounting for IPR&D Acquired in a Business Combination If the Board affirms its decision in the BC ED to capitalize IPR&D acquired in a business combination, some constituents asked the Board to provide additional guidance for applying FASB Statement No. 142, Goodwill and Other Intangible Assets, to the capitalized IPR&D. The Board previously decided that providing some additional guidance was necessary because unlike the IASB s constituents, the FASB s constituents have no experience in accounting for capitalized IPR&D. Therefore, the Board decided to amend Statement 142 to clarify that IPR&D assets acquired in a business combination should be considered indefinite-lived until the completion or abandonment of the associated R&D efforts. Without that clarification, the Board was concerned that a preparer would likely conclude that an IPR&D asset acquired in a business combination is finite-lived and would test for impairment using the less stringent method required in FASB Statement No. 144, Accounting for the Disposal or Impairment of Long-Lived Assets. Because of the constantly evolving nature of IPR&D projects, several respondents expressed concern about the difficulty and significant judgment required for performing an impairment test of IPR&D assets. The staff considered whether impairment testing guidance for IPR&D is needed. The impairment testing process is different depending on whether an intangible asset is finite-lived or indefinite-lived: 12

13 a. Indefinite-lived intangible assets are tested for impairment under Statement 142. Statement 142 requires, at a minimum, an annual impairment test. To determine whether an indefinite-lived intangible asset is impaired, an entity compares the fair value (discounted) of the asset to its carrying value. b. Finite-lived intangible assets are amortized over their useful lives and tested for impairment under Statement 144. Statement 144 requires an impairment test whenever circumstances indicate that the carrying amount may not be recoverable. To determine whether a finite-lived intangible asset is not recoverable, an entity compares the expected undiscounted cash flows from the asset to its carrying value. If the undiscounted cash flows exceed the carrying amount, an impairment loss is recognized as the amount by which the carrying amount of the asset exceeds its fair value. Under the proposals, while an IPR&D project is classified as indefinite-lived, the entity would need to test the asset for impairment at least annually. The staff believes that as long as the entity is continuing to work on the IPR&D project, it would be unlikely that the asset would be impaired because subsequent internal expenditures on the project, which likely would increase its fair value, would be expensed and, therefore, would not increase the carrying value. The staff believes that the appropriate guidance for unit of account issues is already provided in EITF Issue No. 02-7, Unit of Accounting for Testing Impairment of Indefinite-Lived Intangible Assets. Paragraph 4 of that Issue states that separately recorded indefinite-lived intangible assets, whether acquired or internally developed, should be combined into a single unit of accounting for purposes of testing impairment if they are operated as a single asset and, as such, are essentially inseparable from one another. Example 3 of Exhibit 02-7A illustrates that consensus and the evolving nature of a brand, which the staff believes is analogous to an evolving IPR&D project. Entities are also currently required to estimate the fair value of IPR&D projects in performing the goodwill impairment test. Footnote 14 to paragraph 21 of Statement 142 states that: 13

14 The relevant guidance in paragraphs of Statement 141 shall be used in determining how to allocate the fair value of a reporting unit to the assets and liabilities of that unit. Included in that allocation would be R&D assets that meet the criteria in paragraph 32 of this Statement, even if Statement 2 or Interpretation 4 would require those assets to be written off to earnings when acquired. Thus, the staff believes that entities have experience with estimating the fair value of IPR&D for purposes of impairment testing. Once the project is completed, the acquirer would make a separate determination of the useful life of that asset in accordance with Statement 142. If the R&D asset is finite-lived (which is likely), it would be amortized and tested for impairment in accordance with Statement 144. If the R&D asset is indefinite-lived, it would not be amortized and would be tested for impairment in accordance with Statement 142. Once the IPR&D project is completed, the staff believes that the nature of the IPR&D asset changes, for example, it becomes technology or a patent (that is, tangible and intangible assets resulting from R&D activities). The staff believes that entities already have experience with testing those types of assets for impairment. Thus, the staff does not believe that any further guidance is needed. Question 6: Does the Board affirm the proposed guidance in the BC ED that would require IPR&D acquired in a business combination to be classified as indefinitelived until completion or abandonment of the project? Question 7: Does the Board want the staff to explore providing additional guidance for impairment testing IPR&D assets? One respondent was concerned with the determination of impairment when projects are shelved. The Boards decided at their separate September 2006 Board meetings to provide guidance in the final Statement on business combinations for (a) intangible assets that the acquirer does not intend to use in the traditional sense and (b) intangible assets that will be used for a period significantly less than their economic useful life. The staff believes that this type of guidance also should be considered for shelved or temporarily abandoned assets, including IPR&D assets. The staff notes 14

15 that Statement 144 provides guidance for long-lived assets to be abandoned, but it states that a long-lived asset that has been temporarily idled shall not be accounted for as if abandoned (paragraph 28). Question 8: Does the Board believe that guidance should be considered for IPR&D assets that are temporarily abandoned? Issue 4: Proposal Creates Inconsistent Accounting for R&D Respondents who disagreed with the proposed accounting for IPR&D were concerned with the mixed model that the proposal would create. That is, the BC ED would require capitalization of only IPR&D acquired in a business combination. In contrast, IPR&D that is internally generated or acquired in an asset acquisition with no alternative future use would continue to be expensed in accordance with Statement 2. To further complicate the mixed model, the BC ED would amend Statement 142 such that IPR&D acquired in a business combination would be classified as indefinite-lived until the project is completed or abandoned. Once the project is completed, the acquirer would make a separate determination of the useful life of that asset in accordance with Statement 142. If the R&D asset is finite-lived, it would be amortized and tested for impairment in accordance with Statement 144. If the R&D asset is indefinite-lived, it would not be amortized and would be tested for impairment in accordance with Statement 142. However, subsequent expenditures related to IPR&D acquired in a business combination would be expensed. Those respondents noted that R&D costs should be accounted for in the same manner because a mixed model would add complexity, decrease comparability, create confusion, and provide less useful information. Those respondents also noted that, in reality, R&D costs are no different, whether purchased pre- or postacquisition or internally generated, in nature or probability of success. Conceptually, IPR&D acquired in a business combination and IPR&D acquired in an asset acquisition are economically similar transactions; they are acquired in an arm slength transaction in the marketplace and that transaction provides the acquirer with evidence by which to value the IPR&D. In fact, IPR&D acquired in an asset 15

16 acquisition is likely easier to value if it is acquired standalone rather than as part of a multi-element transaction such as a business combination. The staff believes that, conceptually, economically similar transactions should be accounted for similarly. Question 9: Does the Board want to expand the proposals in the BC ED to include the accounting for R&D assets (including IPR&D projects) acquired in an asset acquisition? TOPIC 3: PREEXISTING RELATIONSHIPS AND REACQUIRED RIGHTS BC ED proposes to codify the guidance in EITF Issue No. 04-1, Accounting for Preexisting Relationships between the Parties to a Business Combination. Issue 04-1 addresses how the acquirer in a business combination should account for: a. The effective settlement of an executory contract or a lawsuit between the parties to the business combination (preexisting relationship)? b. The acquisition of a right that the acquirer had previously granted to the acquired entity to use the acquirer's recognized or unrecognized intangible assets (reacquired right)? Preexisting Relationships Paragraph A92 of the BC ED proposes the following guidance, which is based on the guidance in Issue 04-1, for accounting for the effective settlement of a preexisting relationships in a business combination: In general, the effective settlement of a preexisting relationship between the acquirer and acquiree should be accounted for in the same way whether it is settled as part of a business combination or separately from a business combination. Therefore, if the business combination results in the effective settlement of a preexisting relationship, the acquirer recognizes a gain or loss and measures it as follows: a. A noncontractual preexisting relationship (such as a lawsuit) should be measured at fair value. b. A contractual preexisting relationship should be measured as the lesser of the following: (1) The amount by which the contract is favorable or unfavorable from the perspective of the acquirer when compared with pricing for current market transactions for the same or similar items. 16

17 (2) Any stated settlement provisions in the contract available to the counterparty to whom the contract is unfavorable. To the extent that (2) is less than (1), the difference should be included as part of the business combination accounting. Also, an unfavorable contract is not necessarily a loss contract for the acquirer. The primary purpose of that guidance is to prevent an entity from avoiding income statement recognition for the effective settlement of an onerous contract or pending unfavorable litigation by acquiring the counterparty to the contract or the plaintiff. In July 2006, the Boards agreed that an acquirer should assess whether a business combination includes any transactions that are substantively separate from the acquisition of assets and assumption of liabilities that make up the acquiree...other transactions should be accounted for separately in accordance with other IFRS/U.S. GAAP (July 2006 Summary of Decisions Reached). The staff believes that the guidance for recognizing preexisting relationships is consistent with the principles for determining whether a business combination includes any transactions that are substantively separate from the acquisition of assets and assumption of liabilities that make up the acquiree. It, however, goes a step further than the principle by describing how to measure the effective settlement gain or loss since that measurement may not be intuitive from the principle alone. The EITF considered whether the settlement of a contractual preexisting relationship should be measured the same way as a noncontractual preexisting relationship, that is, at fair value. However, the EITF believed that a fair value measurement is not appropriate if the contract provides specific settlement terms or the contract is cancelable by the acquirer without penalty. Comment Letter Responses/Practice Issues The staff notes that few of the comment letters addressed the proposed accounting for preexisting relationships. Those comment letters that did address preexisting relationships generally disagreed that an acquirer should recognize a settlement gain or loss for the effective settlement of a preexisting relationship. They believed that the 17

18 preexisting relationship is inextricably linked to the business combination and, therefore, should not be separately recognized. The staff contacted resource group members to determine if there are issues in practice in applying the consensus in Issue 04-1 for preexisting relationships. Resource group members stated that they generally do not encounter issues in applying the consensus to preexisting relationships. They stated that they do sometimes encounter valuation issues, but they agreed that the final Statement on business combinations should not be the place to include valuation guidance. (They also agreed that the guidance in Statement 157 will be helpful in valuing those relationships, at least for the FASB s constituents). Question 10: Does the Board want to affirm the proposed guidance for accounting for preexisting relationships? Clarification Loss Contract Issue 04-1 and the BC ED stated that an unfavorable contract is not necessarily a loss contract for the acquirer. A few respondents asked for clarification about what that sentence means. The staff believes that the EITF only intended to highlight that an unfavorable contract is different from a loss (onerous) contract. An unfavorable contract is a contract in which the terms are unfavorable compared to the pricing an entity could get if it entered into the contract in the market today. However, that does not mean that the contract is onerous. The economic benefits that an entity expects to receive from an unfavorable contract could still outweigh the costs the entity expects to incur. On the other hand, a loss (onerous) contract is one in which the economic benefits that the entity expects to achieve are less than the costs the entity expects to incur. In that case, the entity might have a liability recorded for the loss contract (if permitted to accrue a liability for the loss contract under U.S. GAAP or IFRS). Unless Board members object, the staff plans to clarify this point in drafting. 18

19 Reacquired Rights Paragraph 41 of the BC ED provides the following guidance: As part of a business combination, an acquirer may reacquire a right that it had previously granted to the acquiree to use the acquirer s recognized or unrecognized intangible assets (such as 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 a right is an identifiable intangible asset that shall be recognized separately from goodwill as part of the business combination accounting. If the contract giving rise to the reacquired right includes pricing terms that are favorable or unfavorable when compared with pricing for current market transactions for the same or similar items, the acquirer shall recognize a settlement gain or loss. Paragraph A92 provides guidance for measuring that settlement gain or loss. After initial recognition, reacquired rights shall be amortized over the remaining contractual period of the precombination contract that granted those rights. 5 The IASB and FASB discussed the accounting for reacquired rights at their December 2004 and February 2005 Board meetings. At those meetings, the Boards agreed with the EITF s conclusion relating to reacquired rights and settlement gains or losses for any off-market component of the reacquired right. In addition, the Boards decided to provide some guidance for the subsequent accounting for reacquired rights. A few IASB members had expressed concern about determining the useful life of a 5 That guidance is based on the guidance provided in Issue In that Issue, the EITF concluded that: The Task Force reached a consensus on Issue 3 that the acquisition of a right that the acquirer had previously granted to the acquired entity to use the acquirer's recognized or unrecognized intangible assets (for example, rights to the acquirer's trade name under a franchise agreement or rights to the acquirer's technology under a technology licensing agreement, hereinafter referred to as a "reacquired right") should be included as part of the business combination. The Task Force observed that if the contract giving rise to the reacquired right includes terms that are favorable or unfavorable when compared to pricing (for example, royalty rates) for current market transactions for the same or similar items, an entity should measure a settlement gain or loss as the lesser of (a) the amount by which the contract is favorable or unfavorable to market terms from the perspective of the acquirer or (b) the stated settlement provisions of the contract available to the counterparty to which the contract is unfavorable... The Task Force reached a consensus on Issue 4 that a reacquired right (which would exclude the amount recognized as a settlement gain or loss as a result of the application of the consensus in Issue 3) should be recognized as an intangible asset apart from goodwill.... [Paragraphs 5 and 6; emphasis added.] 19

20 reacquired right, which Issue 04-1 did not address. Because the acquirer would control the right after the acquisition, the acquirer could assume an infinite number of renewals. That could result in the right being classified as indefinite-lived (not amortized). Therefore, the Boards decided that, subsequently, those rights should be amortized over the remaining contractual period of the precombination contract that granted those rights up until the first right of renewal. That is, the amortization period must be based on the contract terms and not include noncontractual renewals. Comment Letter Responses/Practice Issues The Boards did not specifically solicit input on reacquired rights in the Notice/Invitation; however, a few respondents raised this issue in their comment letters. Those who responded generally disagreed that an acquirer should recognize a reacquired right as a separately identifiable intangible asset because separate recognition would lead to the acquirer recognizing an internally generated intangible asset as part of the business combination. A few respondents believed that a reacquired right should be recognized as part of goodwill, whereas one respondent believed that a reacquired right should be recognized as a settlement of a preexisting relationship. Issue 1: Initial Recognition of a Reacquired Right The staff considered three alternatives for the initial recognition of reacquired rights in a business combination: a. b. c. Alternative One: Recognize a reacquired right as a settlement of a preexisting relationship (an expense). Alternative Two: Recognize a reacquired right as part of goodwill. Alternative Three: Recognize a reacquired right as a separately identified intangible asset. 20

21 Example Illustrating the Three Alternatives Consider the following example for accounting for reacquired rights in a business combination: Acquirer Co. grants a franchise right to Target Co. to operate under Acquirer Co. s name in the Northeast region. Two years later, Acquirer Co. decides to expand its business and enters into an agreement to acquire Target Co for $50,000. Target Co. s business consists of the franchise right (fair value $20,000), a customer list (fair value $10,000), some operating assets and liabilities (net fair value $15,000), an assembled workforce (recognized as part of goodwill), and processes. At the time of the acquisition, the franchise right is at market terms (therefore, Acquirer Co. would not recognize an off-market settlement gain or loss). Under each of the alternatives, Acquirer Co. would recognize the acquisition and the franchise right as follows: Alternative One Alternative Two Alternative Three Dr. Tangible net assets 15,000 15,000 15,000 Dr. Intangible assets 10,000 10,000 30,000 Dr. Goodwill 5,000 25,000 5,000 Dr. Expense 20, Cr. Cash (50,000) (50,000) (50,000) Analysis of Alternatives Alternative One Under Alternative One, the reacquired franchise right is recognized as an effective settlement of a preexisting relationship (an expense). Supporters of Alternative One believe that all preexisting relationships in a business combination should be accounted for the same way. A reacquired right is a type of preexisting relationship. Therefore, the acquirer is effectively settling the relationship by reacquiring that right. However, opponents of Alternative One believe that reacquired rights are different from lawsuits or other executory contracts that are effectively settled as part of a business combination. Therefore, they should be accounted for differently. Opponents of Alternative One believe that in the example described above, Acquirer Co. is not effectively settling the contract. The right to operate in the Northeast region 21

22 still exists and Acquirer Co. will continue to receive the benefits of that right in the form of cash flows; the only difference is that after the acquisition, Acquirer Co., rather than Target Co., controls the right. Therefore, Acquirer Co. has not incurred a loss. Opponents of Alternative One also note that if any other marketplace participant was to acquire that right, it would be recognized as an asset, not as a loss. Therefore, it seems inappropriate for Acquirer Co. to recognize an expense for the reacquired right. Supporters of Alternative One believe that the net result of this alternative is as if the accounting had been done correctly from Day 1. That is, when an entity issues a franchise right, the following entries are recorded under current practice: Franchisor Franchisee Dr. Asset (receivable) 100 Dr. asset (franchise right) 100 Cr. Income (100) Cr. Cash (100) However, conceptually, the franchisor has a performance obligation at the date the franchise is granted. So, the franchisor should recognize a liability instead of income, as follows: Franchisor Franchisee Dr. Asset (receivable) 100 Dr. asset (franchise right) 100 Cr. Liability (100) Cr. Cash (100) Supporters of Alternative One believe that if the franchisor initially recognizes a liability when it first issues the franchise, then the franchisor s liability and the franchisee s asset would eliminate in the business combination. However, because the franchisor recognized income instead of a liability initially, applying Alternative One would result in expensing the asset, which would eliminate against the previously recognized income (albeit likely in different reporting periods). Alternative Two Under Alternative Two, the reacquired franchise right is recognized as part of goodwill. Supporters of Alternative Two believe that from the perspective of Acquirer Co., the reacquired right is not the same as other acquired intangible assets. 22

23 In the above example, there is no longer a franchising relationship between Acquirer Co. (parent) and Target Co. (subsidiary). Therefore, the reacquired right cannot be accounted for as a franchising rights intangible asset because any franchising relationships no longer exist from the perspective of the combined entity. The initial accounting should not look to what was an asset of the acquiree before the business combination. Effectively, the acquirer reacquired its ability to enter into a franchising agreement in the Northeast region with another third party. The ability to enter into a franchising agreement with another party is not recognized as intangible assets under existing U.S. GAAP and IFRSs; they are in the nature of goodwill. Therefore, those types of assets should be subsumed in goodwill in a business combination. Supporters of Alternative Two agree that from the perspective of any other marketplace participant, the intangible right would meet the criteria for recognition as a separate intangible asset. However, from the perspective of the acquirer, the reacquired right is in the nature of goodwill or other internally generated intangible assets that are not recognized as intangible assets. Opponents of Alternative Two have three concerns. The first is that this alternative could not be applied to an asset acquisition. That is, if Target Co. did not meet the definition of a business, Alternative Two would not be operational because an entity cannot recognize goodwill in a transaction that does not qualify as a business combination. The staff notes that given the broad definition of a business combination, it may be unlikely that such a transaction in which a right and some other assets are acquired could qualify as an asset acquisition. However, it remains a possibility. The second concern is that by subsuming the value of the reacquired right into goodwill, Acquirer Co. is providing less decision-useful information to users of its financial statements than if the reacquired right was separately recognized. The third concern is that by subsuming the reacquired right into goodwill, the reacquired right could remain in goodwill indefinitely rather than be amortized over its useful life. 23