Business Combinations: Applying the Acquisition Method Board Meeting Handout. July 19, 2006

Transcription

1 Business Combinations: Applying the Acquisition Method Board Meeting Handout July 19, 2006 The purpose of this 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: Identifying the Components of a Business Combination Topic 2: Accounting for Restructuring Costs in a Business Combination Topic 3: Measurement Date for Equity Instruments Issued as Consideration TOPIC 1: IDENTIFYING THE COMPONENTS OF A BUSINESS COMBINATION Paragraph 69 of the business combinations Exposure Draft proposes that: The acquirer shall assess whether any portion of the transaction price (payments or other arrangements) and any assets acquired or liabilities assumed or incurred are not part of the exchange for the acquiree. Only the consideration transferred and the assets acquired or liabilities assumed or incurred that are part of the exchange for the acquiree shall be included in the business combination accounting. Any portion of the transaction price or any assets acquired or liabilities assumed or incurred that are not part of the exchange for the acquiree shall be accounted for separately from the business combination. [Emphasis omitted.] Objective of Guidance for Identifying the Components of a Business Combination A business combination might be comprised of several substantively separate yet related transactions or events (referred to as components of a business combination in this discussion). The guidance proposed in the Exposure Draft focuses on assessing whether the assets acquired and liabilities assumed in a business combination are part of the exchange for the acquiree. The staff believes the guidance should focus on identifying the components of a business combination to ensure that each of the components is accounted for in accordance with its economic substance. This objective will provide The staff prepares Board 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 users with relevant information about the financial effects of transactions and events entered into by the acquirer. For example, the acquirer should recognize and report any expenses incurred for acquisition-related services or for postcombination transactions or events in addition to reflecting the assets acquired and liabilities assumed that comprise the acquiree. The component of a business combination that involves acquiring the assets acquired and assuming the liabilities that comprise the acquiree and transferring consideration for those assets and liabilities is accounted for using the acquisition method. The other components of a business combination (such as the incurrence of acquisition related costs) are accounted for in accordance with other IFRSs or U.S. GAAP. It is important that all components of a business combination be identified and accounted for in accordance with their economic substance. Otherwise, consideration transferred in exchange for the acquiree might be overstated, which might result in goodwill being overstated or expenses that the acquirer is responsible for not being reflected in the acquirer s financial statements. Identifying the components of a business combination requires guidance because: 1. In some circumstances it might be difficult to determine which parts of a business combination transaction are substantively separate yet concurrent transactions. For example, if an acquirer exchanges its share-based payment awards (replacement awards) for awards held by employees of the acquiree, it might be difficult to assess the portion of the acquirer s replacement awards that is part of the consideration transferred for the assets and liabilities that comprise the acquiree and the portion, if any, that represents payment for future services. 2. Parties involved directly in the negotiations of an impending business combination could take on the characteristics of related parties. As a result, they might be willing to enter into other agreements or include conditions as part of the business combination agreement that are designed primarily to achieve favorable postcombination reporting outcomes (for example, shifting postcombination expenses of the acquirer into the accounting for the assets acquired and liabilities assumed that comprise the acquiree). 2

3 Comment Letter Responses Respondents generally agreed that acquirers should assess whether any portion of the transaction price and any assets acquired or liabilities assumed or incurred are not part of the exchange for the acquiree. They also generally agreed that only the consideration transferred and the assets acquired or liabilities assumed or incurred that are part of the exchange for the acquiree should be included in the accounting for the exchange for the acquiree and everything else should be accounted for separately. The majority of respondents comments were related to the specific guidance proposed for preexisting relationships, payments to employees, and exchanges of share-based payment awards. The staff does not plan to discuss those topics in detail at this meeting, but it will address any comments Board members have on its plans for those issues. In summary, the staff plans to analyze further and discuss the following issues raised by respondents at a future Board meeting: 1. Issues related to the accounting for preexisting relationships and reacquired rights, including (a) distinguishing between preexisting relationships and reacquired rights, (b) concerns that recognizing a reacquired right as a separately identifiable intangible asset is analogous to recognizing an internally generated intangible asset and, (c) whether a renewable reacquired right should be valued assuming renewal rights or not; 2. Whether a gain or loss for the effective settlement of preexisting relationships between the acquirer and acquiree should be recognized; and 3. Differences between contingent payments that are based on multiples of earnings and those that are based on percentages of earnings. At this meeting, the staff plans to focus on the overall principles and guidance for identifying the components of a business combination. Level of Detail and Need for Principles-Based Guidance Several respondents stated that identifying the components of a business combination will require judgment and must be based on the individual facts and circumstances of the 3

4 business combination. However, respondents views on the implications of that observation differed. 1. Some respondents stated that the guidance is appropriate, useful, and sufficient for identifying the components of a business combination. 2. Other respondents stated that the guidance is not sufficient and that the Board should provide additional examples from a variety of industries illustrating the application of the principle. 3. Other respondents stated that the guidance is too detailed and complex and should be based more on principles. Respondents views on the principles proposed in the business combinations Exposure Draft varied. Some respondents stated that the principle outlined in paragraphs 69, 70, and A88 is sufficient. Other respondents stated that the proposed guidance appears to lack a clear principle. Those respondents expressed concern that without a clear principle, the detailed guidance will be difficult to apply or might be viewed as a checklist for preparers to follow. Principles for Identifying the Components of a Business Combination The staff recommends that the following principles be included in the final business combinations Statement: The acquirer shall assess whether a business combination includes any transactions that are substantively separate from the acquisition of assets and assumption of liabilities that comprise the acquiree. Only the consideration transferred and the assets acquired or liabilities assumed that comprise the acquiree shall be accounted for using the acquisition method. Other transactions should be accounted for separately in accordance with other IFRS/U.S. GAAP. A transaction or event arranged by or on behalf of the acquirer and/or initiated primarily for the economic benefit of the acquirer or the combined entity (rather than for the benefit of the acquiree or its former owners prior to the business combination) is a substantively separate transaction. 4

5 In addition, the staff recommends that the following guidance proposed in the Exposure Draft be included in the implementation guidance to assist constituents in assessing whether a transaction is substantively separate from the acquisition of assets and assumption of liabilities that comprise the acquiree: The acquirer should consider the following factors, which are neither mutually exclusive nor individually conclusive, to determine whether a transaction or event is initiated primarily for the economic benefit of the acquirer or combined entity, rather than for the acquiree or its former owners prior to the business combination. a. The reasons for the transaction or event b. Who initiated the transaction or event c. The timing of the transaction or event. The staff also considered whether the final Statement should explicitly explain the abuses that the principle assessing whether a business combination consists of substantively separate transactions is trying to prevent. However, the staff believes that the principle should stand alone and be clear enough to prevent acquirers from circumventing the accounting for separate exchange transactions without having to state explicitly that it is the intention of the guidance. In addition, the staff does not believe that the guidance is only applicable to circumstances in which an acquirer is trying to circumvent the accounting guidelines. For example, the guidance might also be used in some circumstances in which it is difficult to determine which parts of a business combination transaction are substantively separate yet concurrent transactions (for example, exchanges of share-based payment awards). Therefore, the staff does not believe that such an explicit statement should be included in the final Statement. Examples Illustrating the Application of the Principles The staff tested the robustness of the principles and related guidance proposed for identifying the components of a business combination by applying the guidance to a variety of examples. Attachment A of this handout includes a table outlining several of the examples that the staff considered. 5

6 Question 1: Does the Board agree with the principles and additional implementation guidance proposed by the staff? TOPIC 2: ACCOUNTING FOR RESTRUCTURING COSTS IN A BUSINESS COMBINATION The business combinations Exposure Draft proposes that an acquirer recognize the acquisition date fair value of liabilities for restructuring or exit activities acquired in a business combination only if they meet the recognition criteria in FASB Statement No. 146, Accounting for Costs Associated with Exit or Disposal Activities. Costs associated with restructuring or exit activities that do not meet the recognition criteria in Statement 146 are not liabilities on the acquisition date and, thus, would be recognized as postcombination activities or transactions of the combined entity when incurred (paragraph 37, paraphrased). Principles Underlying the Accounting for Restructuring Costs The Board agreed to the following recognition principle in March 2006: In a business combination, the acquirer recognizes all of the assets acquired and all of the liabilities assumed. The staff believes the recognition principle provides the basis for determining whether restructuring costs should be recognized as liabilities assumed in the business combination or recognized when the costs are incurred after the acquisition date. That is, restructuring costs that do not meet the recognition criteria in Statement 146 at the acquisition date are not liabilities; therefore, the acquirer should not recognize those costs as liabilities assumed in a business combination. Comment Letter Responses Most respondents that commented on the proposed accounting for restructuring costs apply U.S. GAAP and disagreed with the proposal for the following reasons: 1. Acquirers factor restructuring costs into the amount they are willing to pay for an acquiree. As a result, those costs should be part of the initial business combination accounting. 6

7 2. The proposal is inconsistent with the Board s decisions regarding contingencies. That is, it is not clear why the Board decided that restructuring costs should not be recognized as liabilities assumed in the business combination when they are much more likely to be incurred than some remote contingencies that the Board proposes to recognize at fair value. 3. Capitalizing restructuring costs as part of the business combination is consistent with guidance for other assets (such as fixed assets) in which the amount capitalized is equal to the amount paid to acquire and place the asset in service. Restructuring Costs Are Factored into the Amount the Acquirers Are Willing to Pay for an Acquiree The staff agrees that any knowledgeable and willing buyer would factor a variety of costs into its decision to purchase a business. For example, a buyer would most likely consider acquisition-related costs, restructuring costs, and the price of the assets and liabilities of the acquiree as part of its purchase decision. That is, those factors will influence what the acquirer is prepared to pay for the acquiree. The staff also agrees that those costs would likely be viewed as part of the total investment in the acquired business. However, the acquirer does not pay the owner of the acquiree for such anticipated costs or activities and the acquirer s plans to undertake those activities do not give rise to an obligation and associated liability at the acquisition date. The liability associated with such costs is usually incurred by the acquirer after it gains control of the business. The staff notes that the Exposure Draft states that restructuring costs that are not liabilities at the acquisition date are generally recognized as postcombination expenses of the combined entity when incurred (paragraph 37). That statement suggests that the expenditure is presumptively an expense. However, restructuring activities could also lead to the recognition of assets in accordance with an entity s capitalization policies after the acquisition date when the costs are incurred. The staff believes that paragraph should clarify that the expenditure should be accounted for under other IFRSs or U.S. GAAP in the postcombination period. 7

8 The Proposed Accounting for Restructuring Costs Is Inconsistent with the Board s Decisions Regarding Contingencies Some respondents questioned why contingencies should be recognized at fair value (and therefore included as part of the exchange for the acquiree) while restructuring costs, which are more than likely to occur, would not be considered as part of the exchange. The staff believes the proposals for restructuring costs are consistent with the Board s decisions for contingencies because, in both cases, a liability is recognized when there is an obligation arising from either a contingency or restructuring activity that meets the definition of a liability at the acquisition date. Capitalizing Restructuring Costs as Part of the Business Combination Is Consistent with Guidance for Other Assets Some constituents might confuse anticipated costs with actual costs incurred. The restructuring costs that meet the criteria for capitalization under U.S. GAAP should be capitalized when the costs are incurred in the postcombination period. Structuring Opportunities Based on the proposed approach for recognizing restructuring liabilities, the staff notes that an acquirer could structure a business combination to recognize restructuring or exit costs as liabilities assumed. For example, the acquirer could require the acquiree to implement particular exit or disposal activities prior to the acquisition date so that the recognition criteria would be met and the acquirer would be able to recognize those costs as assumed liabilities in the business combination. The staff believes the proposed guidance for identifying components of a business combination and assessing their economic substance should reduce the risk of transactions being structured to make restructuring costs look like they are part of the liabilities assumed that comprise the acquiree at the acquisition date. Question 2: Does the Board affirm that an acquirer recognize restructuring or exit costs as liabilities assumed in a business combination only if those costs meet the recognition criteria in Statement 146 at the acquisition date? 8

9 TOPIC 3: MEASUREMENT DATE FOR EQUITY INSTRUMENTS ISSUED AS CONSIDERATION The business combinations Exposure Draft requires that consideration transferred in a business combination be measured at its fair value on the date control is achieved (the acquisition date). Therefore, the fair value of any equity securities issued as consideration in a business combination should be measured at the acquisition date and not at the agreement or closing date. The distinction between the agreement date, acquisition date, and closing date is as follows: 1. Agreement Date the date that the significant terms of the transaction are generally agreed upon. 2. Acquisition Date the date the acquirer obtains control of the acquiree. 3. Closing Date 1 the date that the acquirer transfers the consideration, acquires the assets, and assumes the liabilities of the acquiree. (The closing date often coincides with the acquisition date). FASB Statement No. 141, Business Combinations, and IFRS 3, Business Combinations, currently diverge on the measurement date for equity securities issued as consideration in a business combination. Paragraph 24 of IFRS 3 requires measuring equity instruments issued by the acquirer at the date of exchange. The current U.S. guidance is contradictory. Paragraph 22 of Statement 141 states that 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 the securities issued. However, paragraph 49 of Statement 141 states that the cost of an acquired entity could be determined at the acquisition date. Paragraph BC66 of the IASB s business combinations Exposure Draft (see also B71 B73 of the FASB s Exposure Draft) states: 1 The staff intends to clarify in the final Statement that the closing date is generally the date that legal transfer takes place. The fact that the date of legal transfer might be later than the date that economic control is achieved is the reason that the acquisition date might differ from the closing date. 9

10 The IASB and the FASB considered the agreement date and acquisition date models in their deliberations. Both Boards observed that there are valid conceptual arguments for measuring equity interests at the agreement date. However, the Boards concluded that reaching a converged answer on the measurement date was of primary importance. The FASB agreed to change, to require that equity interests issued should be measured at their fair value at the acquisition date. As a consequence, all consideration transferred by an acquirer is to be measured at its acquisition date fair value. Principles for Measuring Consideration Transferred In a Business Combination In March 2006, the Boards affirmed the recognition and measurement principles for applying the acquisition method: 1. In a business combination, the acquirer recognizes all of the assets acquired and all of the liabilities assumed. 2. In a business combination, the acquirer measures each recognized asset acquired and each liability assumed at its acquisition date fair value. Application of those principles means that the acquirer recognizes the assets acquired and liabilities assumed in a business combination at their fair values at the date control is achieved (the acquisition date). The acquisition date fair value of many assets acquired and liabilities assumed can be measured directly. However, goodwill is an exception to the measurement principle because it can only be measured indirectly as a residual. In a 100 percent acquisition, goodwill would generally be measured as the difference between the consideration paid and the fair value of assets acquired and liabilities assumed in a business combination. Thus, measuring the consideration paid has an important role in measuring goodwill. Comment Letter Responses Respondents views on the measurement date for equity securities issued as consideration in a business combination were mixed. Those respondents who supported the proposal stated that it makes sense to measure all forms of consideration and the assets and liabilities on the same date. Other respondents disagreed with the proposals for the following reasons: 10

11 1. There is a direct alignment between the fair value of consideration transferred and the fair value of the acquirer s interest in the acquiree at the agreement date. 2. Subsequent changes in the fair value of the acquirer s equity instruments between the agreement date and the acquisition date could be due to factors unrelated to the business combination and should not affect the fair value of the acquirer s interest in the acquiree. 3. Subsequent changes in the fair value of the acquirer s equity instruments between the agreement date and the acquisition date lead inappropriately to either bargain purchase or overpayment situations. The staff is concerned that constituents comments suggest that there is some confusion about what the consideration measured at the agreement date represents. Therefore, the staff will analyze the nature of consideration transferred in a business combination and then assess whether the agreement date or the acquisition date is the better measurement date for consideration transferred. What Consideration Has Been Negotiated at the Agreement Date? Fair Value of Cash Issued as Consideration In a business combination in which the acquirer pays cash, the fair value of the consideration being transferred by the acquirer is readily observable. In such circumstances, the Board tentatively decided that even if the agreement, acquisition, and closing dates coincided, the acquirer would not be able to reliably identify an overpayment. The Board also tentatively decided that in a bargain purchase transaction, the acquirer accounts for the excess of the acquirer s interest in the acquiree over the fair value of consideration transferred by reducing the amount of goodwill that would otherwise be recognized. 2 reliable basis for measuring goodwill. Thus, the consideration transferred is presumed to be a more If the agreement date is earlier than the acquisition date, 3 the staff believes that the consideration that the acquirer agrees to transfer on the acquisition or closing date is the 2 If the goodwill related to that business combination is reduced to zero, any remaining excess is recognized as a gain attributable to the acquirer. 3 Assume that the acquisition and closing dates are the same. 11

12 agreement date estimate of the fair value of the acquiree at the acquisition date. That amount presumably considers the acquirer s and the seller s expectations at the agreement date about any movements in the fair value of the acquiree between the agreement date and the acquisition date. The staff believes that the agreement date estimate of the fair value of the acquiree at the acquisition date is susceptible to an estimation error. The amount of cash consideration fixed at the agreement date will often not equal the acquisition date fair value of the interest in the acquiree. The question is whether the acquirer is able to measure that estimation error with sufficient reliability to be able to account for it separately or whether it would be appropriate to account for it separately if the estimation error could be identified. The staff believes that the estimation error will generally not be identifiable at the acquisition date. The Board already agreed that it is not likely that a bargain purchase, or overpayment, can be measured reliably even if the agreement and acquisition dates are the same. It seems incongruous to believe that the acquirer will be able to separate any bargain purchase or overpayment element that results from this estimation error from other causes of a bargain or overpayment. It is also not clear what would be the incremental information content of those separated components. Fair Value of the Equity Instruments Issued as Consideration The staff analyzed in the preceding section business combinations in which the consideration transferred is cash. In those situations, no estimation uncertainty existed with respect to the fair value of consideration transferred in the business combination. As a consequence, it does not matter whether the fair value of consideration transferred is fixed at the agreement or the acquisition date. In contrast, if the consideration transferred by the acquirer is equity instruments (or any other non-cash asset or liability), the fair value of those instruments issued is likely to change between the agreement date and the closing date. That means that the transaction price negotiated at the agreement date reflects assumptions by the acquirer and the seller about the acquisition date fair value of 12

13 the acquiree and the acquisition date fair value of equity instruments to be issued as consideration in the transaction. Any estimation error will affect the measurement of goodwill on acquisition. In the analysis of transactions involving cash consideration, the staff concluded that an acquirer is unlikely to be able to measure an estimation error related to the acquiree with sufficient reliability to separate it from goodwill. In the case of equity securities being issued as consideration, the acquisition date fair value of consideration transferred will not usually equal the acquisition date fair value of the acquired business because the value of the equity securities changed unexpectedly. An unexpected change in the value of the securities affects the measurement of goodwill on acquisition. Error in Estimating the Acquisition Date Fair Value of Consideration Transferred The estimation error occurs because of unexpected changes in the fair value of consideration transferred between the agreement date and the acquisition date. Unexpected changes in the fair value of equity instruments could be a consequence of: 1. A different market reaction to the business combination than was anticipated by the acquirer 2. Events that affect the fair value of the target and, therefore, also affect the fair value of the acquirer were not anticipated by the acquirer 4 3. The acquirer did not foresee events unrelated to the business combination that affect the value of the acquirer but do not relate to the acquisition date fair value of the acquirer s interest in the acquiree. In theory, some of the changes in the fair value of consideration transferred should be reflected in the measurement of goodwill while other changes should not. However, the staff believes that it generally will not be possible to isolate specific reasons for estimation errors with sufficient reliability. Hence, it will be necessary to account either for all or for none of the estimation errors associated with the acquisition date fair value of consideration transferred. 4 This would occur because the exchange ratio between the acquirer and target is fixed. Therefore, an increase in the value of the target could affect the value of the acquirer. 13

14 Measuring consideration based on share price at or around the agreement date excludes both the expected and unexpected portions of changes in the fair value of the consideration between the agreement and acquisition dates. On the other hand, measuring consideration transferred at the acquisition date will include both expected and unexpected changes. The latter approach is the one taken by the Exposure Draft. Should Consideration Transferred Be Measured at the Agreement Date or at the Acquisition Date? During initial deliberations, the Boards compared the measurement of consideration transferred in a business combination to: 1. Share-based payment transactions; and 2. Equity forward contracts. Measuring the fair value of consideration transferred at the acquisition date would be consistent with the measurement guidance given in IFRS 2, Share-based Payment. If in an equity-settled, share-based payment transaction the fair value of goods or services received cannot be estimated reliably, paragraph 10 of IFRS 2 requires measuring their fair value indirectly by reference to the fair value of the equity instruments granted. For transactions with parties other than employees, the fair value of the equity instruments granted is measured at the date the entity obtains the goods or the counterparty renders the service. Paragraph BC126 of IFRS 2 states: 5 The [IASB] Board considered whether the delivery (service) date fair value of the equity instruments granted provided a better surrogate 5 FASB Statement No. 123 (revised 2004), Share-Based Payment, does not specify a measurement date for share-based payment transactions with parties other than employees. EITF Issue No , Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, states: [The measurement date] is the earlier of the following: (a) The date at which a commitment for performance by the counterparty to earn the equity instruments is reached (a performance commitment ), or (b) The date at which the counterparties performance is complete. Therefore, in the context of share-based payment transactions with parties other than employees, the measurement date could be the vesting date or some other date between grant date and vesting date. 14

15 measure of the fair value of the goods or services received from parties other than employees than the grant date fair value of those instruments. For example, some argue that if the counterparty is not firmly committed to delivering the goods or services, the counterparty would consider whether the fair value of the equity instruments at the delivery date is sufficient payment for the goods or services when deciding whether to deliver the goods or services. This suggests that there is a high correlation between the fair value of the equity instruments at the date the goods or services are received and the fair value of those goods or services.... Paragraph BC128 of IFRS 2 states: The [IASB] Board therefore concluded that for transactions with parties other than employees in which the entity cannot measure reliably the fair value of the goods or services received at the date of receipt, the fair value of those goods or services should be measured indirectly, based on the fair value of the equity instruments granted, measured at the date the goods or services are received. However, those who believe that consideration transferred should be measured at the agreement date compare the purchase agreement to an equity forward contract. They argue that at the agreement date the parties are essentially committed to the transaction such that they normally cannot unilaterally terminate the transaction without the payment of a break-up fee or a high likelihood of litigation. Therefore, the acquirer s obligation to issue equity securities in exchange for the target s business has characteristics of a forward contract. As a consequence, the value of the transaction should not be revalued after the agreement date. The staff believes that there are valid reasons for and against either analogy. However, the acquisition date model would effectively align the measurement of consideration transferred with the measurement date of assets acquired and liabilities assumed in a business combination that are measured at the acquisition date. Measuring equity securities issued as consideration at the agreement date would misalign the measurement of consideration transferred with the measurement date of assets acquired and liabilities assumed in the business combination. Therefore, some staff members believe that a departure from the recognition and measurement principles adopted by both Boards is not conceptually justified and 15

16 recommend the Boards affirm that the fair value of equity instruments issued as consideration in a business combination is measured at the acquisition date. However, some staff members believe that the Boards should adopt a more practical approach regarding the measurement date for equity instruments. They emphasize that both measuring equity instruments at the agreement date as well as measuring equity instruments at the acquisition date are indirect measures and might not achieve the objective of measuring the acquisition date fair value of the acquirer s interest in the acquiree. Therefore, the measurement should be adopted because it will result in a better representation of the acquisition date fair value of the acquirer s interest in the acquiree. They believe that adoption of the agreement date will more often lead to a better measurement of the fair value of the acquirer s interest in the acquiree than adoption of the acquisition date as the measurement date for consideration transferred. Those staff members concede that measuring consideration transferred at the agreement date will often not meet the objective of measuring the fair value of the acquirer s interest in the acquiree. However, for a variety of cost-benefit, operationality, and consistency reasons they would accept measuring the fair value of consideration transferred at the agreement date as a practical expedient to measuring the fair value of the acquirer s interest in the acquiree. Thus, they recommend that equity instruments issued in a business combination should be measured at the agreement date. Question 3: Does the Board believe that the fair value of equity instruments issued as consideration in a business combination should be measured at the agreement date or at the acquisition date? 16

17 ATTACHMENT A EXAMPLES ILLUSTRATING THE APPLICATION OF THE PRINCIPLES The following table includes several examples that the staff used to test the robustness of the principles and related guidance proposed for identifying the components of a business combination. A B C D E F G Acquisition-Related Costs I Acquirer Co. acquires 100% of Sub Co. and incurs CU1 million of costs related to legal fees and due diligence associated with the deal. Acquisition-Related Costs II Acquirer Co. seeks to acquire Target Co., a subsidiary of Seller Co. Acquirer Co. would like to avoid recognizing CU1 million expense for its costs incurred related to legal fees and due diligence associated with the deal. Prior to the closing date, Acquirer Co. makes a deal with Seller Co. to pay an additional CU1 million in consideration for Target Co. if Seller Co. will assume the liabilities for Acquirer Co. s acquisition-related costs. Restructuring Costs I Acquirer Co. purchases 100% of Sub Co. Acquirer Co. plans to sell one of Sub Co. s divisions (Division A). Restructuring Costs II Acquirer Co. purchases 100% of Sub Co. Sub Co. planned to sell Division A and met the criteria under existing guidance to recognize a liability for certain exit costs associated with the planned sale (IAS 37 or Statement 146). The sale of Division A to another buyer is pending. Acquirer Co. agrees to assume Sub Co. s liability for the exit costs relating to the sale of Division A. Restructuring Costs III Acquirer Co. purchases 100% of Sub Co. from Trade Co. Sub Co. owns a fleet of trucks that are branded with Trade Co. s name. Because Trade Co. will continue to operate other similar truck fleets, it insists that its brand name be removed from Sub Co. s trucks as a condition of the combination. Restructuring Costs IV Acquirer Co. purchases Sub Co. from Trade Co. Sub Co. owns a fleet of trucks branded with its name. Acquirer Co. plans to brand the trucks using its own name. Trade Co. does not insist that the Sub Co. brand name on the trucks be removed. Golden Parachute I Target Co. seeks to hire a new CEO (Candidate). The highly desired and sought Candidate agrees to accept a position with Target provided that Target enters into a golden parachute agreement that requires Target Co. to pay the CEO CU1 million if Target Co. is acquired before the CEO s employment contract expires. Acquirer Co. acquires Target Co. eight years later. 17

18 H I J K L M Golden Parachute II Acquirer Co. is negotiating to acquire Target Co. Acquirer plans to terminate the CEO s employment contract as part of its restructuring of Target Co. after the business combination. However, Acquirer would like to avoid recognition of a postcombination expense for the restructuring. So prior to the closing date, Acquirer makes a quiet arrangement with the key directors of Target to set up a golden parachute agreement that effectively provides termination benefits to the CEO. The golden parachute agreement requires Target Co. to pay the CEO CU1 million if Target Co. is acquired before the CEO s employment contract expires. As part of that arrangement, Acquirer agrees that any increase in the liabilities of Target as a result of the golden parachute agreement will not be included in potential downward adjustments to the previously negotiated and agreed upon purchase price. Target agrees to enter into the golden parachute agreement in order to facilitate negotiations. Golden Parachute III Target Co. is the target of a much publicized hostile takeover bid by Acquirer Co. The CEO is concerned that the management of Acquirer Co. intends to replace the executives at Target with its own senior staff. Consequently, the CEO begins to seek employment elsewhere. Worried about its CEO s departure during a critical moment, Target s directors enter into a golden parachute agreement with the CEO that would provide reasonable compensation for the CEO s services in the event of an acquisition. The golden parachute agreement requires Target Co. to pay the CEO CU1 million if Target Co. is acquired before the CEO s employment contract expires. A few weeks later, Acquirer raises its tender offer and Target is acquired anyway. Employee Benefits I Acquirer Co. acquires 100% of Sub Co. Sub Co. has a preexisting contractual agreement that requires Sub Co. to make payments to its employees in the event that Sub Co. is acquired. Employee Benefits II Acquirer Co. acquires 100% of Sub Co. Sub Co. s owners require that, as a condition of the business combination, Acquirer Co. improve the postemployment benefit plan for Sub Co. s employees. Employee Benefits III Acquirer Co. acquires 100% of Sub Co. Acquirer Co. expects to change the terms of the acquiree s postemployment benefit plan. Those changes are not made before the acquisition date. Constructive Obligations As a result of a business combination, Acquirer Co. has a liability of CU16,000 that meets the definition of a constructive obligation. The constructive obligation arises because Acquirer Co. has a widely published policy that is historically honored. Under the policy, Acquirer Co. rectifies faults in its products and faults of acquired companies products even if those faults become apparent after the warranty period has expired. Sub Co. did not have a similar constructive obligation relating to product faults. 18

19 Board Meeting Handout Financial Statement Presentation July 19, 2006 The purpose of this Board meeting is to discuss application of some, but not all, of the project s working principles. (The project objectives and working principles are included in Attachment A.) The goal is for the Board to agree on a basic working format for the financial statements (the sections and categories for each financial statement) that will be included in the Preliminary Views document. Sample financial statements illustrating the proposed working format are included in Attachment B. Application of the working principles to the statement of changes in equity will not be addressed until the Board has reached decisions on the statement of earnings and comprehensive income (herein referred to as the comprehensive income statement), the statement of cash flows, and the statement of financial position (herein referred to as the balance sheet). Therefore, for purposes of this meeting, the financial statements refer to those three financial statements. Note: the paragraph and issue numbers in this handout correspond to paragraph numbers in the Board memorandum used as the basis for discussion. THE COHESIVENESS WORKING PRINCIPLE The first working principle states that financial statements should present information in a manner that portrays a cohesive financial picture of an entity. That working principle implies that the financial statements should be presented in a way in which interrelationships between financial statements are easily understood in other words, any relationship between items on different financial statements should be clear [ 3]. In developing its recommendations, the staff started with that cohesive working principle as the governing working principle and then looked to the working principle related to separating financing and business activities (the financing working principle) because it appeared it would be the driving force behind the categorization scheme. A very basic categorization scheme for each of the financial statements flowed from the combination of those two working principles [ 4]. The following table illustrates the sections, categories, and subcategories that are recommended by the staff [ 5]. The staff prepares Board 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.

20 Balance Sheet Business: Operating assets and liabilities o Operating working capital o Other operating assets and liabilities Treasury assets Financing: Financing liabilities Equity Statement of Comprehensive Income Business income: Operating income Treasury income Financing expenses Statement of Cash Flows Business cash flows: Operating cash flows Treasury cash flows Financing cash flows: Non-equity Equity Questions for the Board: Q1. Should cohesiveness be the governing working principle such that a. Changes in assets and liabilities are explained in the statement of cash flows and the comprehensive income statement [ 3] b. The sections and categories on each financial statement are similar, if not the same [ 3] c. The classification of an asset or liability (its placement in a section or category) drives the classification of the related changes in that asset or liability on the statement of cash flows and the comprehensive income statement. [ 52] Q2. Should the primary sections in each financial statement be Business and Financing? THE FINANCING SECTION The Board will discuss the following alternatives for deciding which liabilities should be included in the Financing section: a. Broad definition with flexible application (staff recommendation): The financing section should include only those liabilities for which accounting standards require the separate calculation of a financing component (e.g., interest income or expense); separate reporting of that component in the financial statements would not be required. An entity would be permitted to classify liabilities that meet that broad definition in the business section rather than the financing section if one or more of the following criteria are met: i. Initial recognition of the liability contains sufficient measurement uncertainty that the subsequent reporting of remeasurements as financing gains or losses would be misleading. ii. The source of financing in question is not viewed by the entity as interchangeable with other sources of financing. iii. The activity in question is viewed by the entity as part of its overall business, and not as only a financing activity. [ 37a] 2

21 b. Narrow definition with strict application: The financing section should include all liabilities that originate from an entity s capital-raising activities in capital markets. An entity would be required to include all liabilities that meet that definition in the financing section. [ 37b] c. Another narrow definition with strict application: The financing section should include all liabilities that provide an entity with funds for general use and that do not arise in connection with a specific business activity. An entity would be required to include all liabilities that meet that definition in the financing section. [New] Questions for the Board (Issues 1 and 2): Q3. How should financing liabilities be defined and should there be any flexibility in applying that definition for purposes of determining which liabilities get classified (included) in the financing section? If there is flexibility in application, what information should be disclosed in the notes to the financial statements? Q4. Should the Financing section include any assets; if so, which assets? [The staff recommends that it not include any assets.] Transactions with Owners Question for the Board (Issue 3): Q5. Does the Board agree that the statement of cash flows should separate cash flows from financing transactions with owners from cash flows from financing with nonowners [as recommended by the staff; 50]? THE BUSINESS SECTION Treasury Category The staff recommends that there be a treasury category in the Business section of each financial statement. The Board will discuss the following alternatives for deciding which assets should be classified as treasury assets in the treasury category: Alternative 1 Treasury assets are defined as those items currently classified as cash and cash equivalents [ 55]. Cash includes cash on hand and demand deposits. Cash equivalents include short-term, highly liquid investments that are readily convertible to known amounts of cash and that are so near their maturity that they present insignificant risk of changes in value because of changes in interest rates (generally, only investments with original maturities of three months or less). (Underscored words are excluded from the definition in Alternative 2.) Alternative 2 Treasury assets are defined as cash, and highly liquid investments that are readily convertible to known amounts of cash and that present insignificant risk of changes in value because of changes in interest rates [ 56]. Alternative 3 Treasury assets are defined as all financial assets [ 57]. 3

22 The current definitions of financial assets follow. [While a converged definition of financial assets is desirable, a change in the definition is beyond the scope of this project ( 66)]. FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities Cash, evidence of an ownership interest in an entity, or a contract that conveys to a second entity a contractual right (a) to receive cash or another financial instrument from a first entity or (b) to exchange other financial instruments on potentially favorable terms with the second entity. IAS 32, Financial Instruments: Disclosure and Presentation Cash; an equity instrument of another entity; a contractual right: (i) to receive cash or another financial asset from another entity or (ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity; or a contract that will or may be settled in the entity s own equity instruments and is: (i) a non-derivative for which the entity is or may be obliged to receive a variable number of the entity s own equity instruments or (ii) a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity s own equity instruments. For this purpose the entity s own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery of the entity s own equity instruments. [Emphasis omitted.] The staff recommends that treasury assets be defined as financial assets (as defined in the accounting literature) (Alternative 3) and that for presentation purposes an entity be permitted to exclude from the treasury category any assets that meet the treasury asset definition (other than cash and cash equivalents) that they believe should be classified as operating working capital assets in the Business section [ 68(a) and (b)]. Questions for the Board (Issue 4): Q6. How should treasury assets be defined and should there be any flexibility in applying that definition for purposes of determining which assets get classified (included) in the treasury category? If there is flexibility in application, what information should be disclosed in the notes to the financial statements? Q7. Does the Board agree that treasury assets should be separated from operating working capital assets? If so, should the treasury category be in the Business section (as recommended) or in the Financing section? Q8. Should cash and cash equivalents be presented as a separate line item (or as a subtotal if cash and cash equivalents are presented separately) in the treasury category (as recommended by the staff, 68 (h))? Q9. Does the Board agree that bank overdrafts should be excluded from the definition of cash and cash equivalents and classified as a financing liability [as recommended by the staff, 59 and 68(g)]? 4