www.pwc.com American Gas Association Accounting Principles Committee Accounting and other issues related to M&A activity August 14, 2017
Accounting and other issues related to M&A activity David Humphreys Partner, PricewaterhouseCoopers LLP U.S. Power and Utilities Accounting Technical Leader 488 Almaden Boulevard, Suite 1800, San Jose, CA david.humphreys@pwc.com 2
Agenda Overview of general concepts Accounting implications for regulated utilities Navigating the new landscape Financial reporting and other considerations 3
Overview of general concepts 4
Overview of general concepts (ASC 805) Definition of a business combination A business combination is a transaction or other event in which the acquirer obtains control of one or more businesses: Business combinations may result from events or transactions that do not involve the acquisition of the net assets or equity interests in a business, such as: - Lapsing or removal of participating rights - An investee's repurchase of its own shares from other parties, causing the primary investor to obtain control - Newly consolidated Variable Interest Entities (VIEs) under ASC 810 Business combinations require the use of Acquisition Method accounting 5
Acquisition method Applying this method requires the following steps: 1. Identify the acquirer 2. Determine the acquisition date 3. Recognize and measure the identifiable assets acquired and liabilities assumed and any non-controlling interest in the acquiree; and* 4. Recognize and measure goodwill or a gain from a bargain purchase An acquirer in a business combination typically incurs acquisition-related costs, such as finder s fees; advisory, legal, accounting, valuation, other professional or consulting fees; and general and administrative costs. Acquisition-related costs are considered separate transactions and should not be included as part of the consideration transferred but, rather, expensed as incurred or when the service is received. These costs are not considered part of the fair value of a business and, by themselves, do not represent an asset. Acquisition-related costs represent services that have been rendered to and consumed by the acquirer *All assets acquired and liabilities assumed in a business combination should be recorded at their acquisition-date fair values (with fair value measured in accordance with the principles of ASC 820, Fair Value Measurement), except as specifically stated in ASC 805 (limited exceptions to the fair value measurement principles for acquired assets and liabilities are provided for in the Standards, which are covered later in this section). 6
Determining the accounting acquirer The party that obtains control based on the guidance in the consolidation standard (ASC 810) Factors to consider: - Who transfers cash or incurs liabilities? - Who issues equity interests? - Relative voting rights - Composition of governing body - Composition of senior management - Terms of exchange Challenges - New entity formed to effect a business combination - Reverse acquisition Accounting acquirer vs Legal acquirer - Acquirer/acquiree reporting under different accounting standards (i.e., US entity reporting under US GAAP acquired by foreign entity reporting under IFRS) 7
Fair value measurement exceptions The measurement of the identifiable assets acquired and liabilities assumed is at fair value, with limited exceptions as provided for in the Standards. Summary of exceptions to the recognition and fair value measurement principles Measurement principle Reacquired rights Assets held-for-sale Share-based payment awards Recognition and measurement Principles Income taxes Employee benefits Contingencies Indemnification assets 8
Post-acquisition accounting issues Determining the appropriate period and method to depreciate or amortize assets requires a certain amount of judgment and an understanding of the assets and their useful lives. The useful life of a long-lived tangible or intangible asset is the period over which the asset is expected to contribute directly or indirectly to the future cash flows of an entity. The useful life is dependent upon a number of factors, the assessment of which can require a significant amount of judgment. Developments and events after a business combination or an asset acquisition may result in a material and sustained decrease in the value of tangible and intangible assets, potentially leading to impairment. Measuring assets that an acquirer intends to use in a way other than their highest and best use may result in additional amortization expense and future impairment losses. Goodwill impairment testing (covered later as part of Navigating the new landscape ). Measurement period adjustments (covered later as part of Navigating the new landscape ). 9
Accounting implications for regulated utilities 10
Accounting implications for regulated utilities Regulated utility acquisition = Easy Just throw the difference between acquisition price and net assets into goodwill and DONE!!! Not so fast A business combination that involves a regulated utility may have certain unique issues as a result of the impact of regulation, including: Measuring the fair value of assets and liabilities arising from, or subject to, regulation Determining when regulatory offset of fair value adjustments is appropriate Accounting for merger credits Post-acquisition accounting for goodwill 11
Interaction of regulation and fair value in a business combination Regulation can impact the fair value of utility plant assets and it may be appropriate to offset certain fair value adjustments with regulatory assets and liabilities. However, regulation does not override other U.S. GAAP. ASC 805 and ASC 820 should be applied when accounting for a business combination. The interaction of regulation and fair value in a business combination is summarized on the following slide. 12
Interaction of regulation and fair value in a business combination (continued) Component Fair value considerations Regulatory considerations Utility plant assets Regulation is a characteristic of utility plant No separate regulatory accounting assets and as it would be considered by market participants, its effects should be incorporated in the valuation Regulatory assets and liabilities Assets that are earning higher or lower returns than market participants require for similar assets and liabilities should be adjusted to reflect fair value (i.e., a market participant s required return may differ from the current allowed rate of return) Nonperformance risk should be incorporated in the fair value measurement of liabilities Not applicable; the asset or liability being recorded is the regulatory asset or liability itself 13
Interaction of regulation and fair value in a business combination (continued) Component Fair value considerations Regulatory considerations Intangible assets and liabilities, Including contractual rights and Obligations Liabilities (including long-term Debt and environmental obligations) Identifiable intangible assets acquired should be recognized separately from goodwill All contracts should be recorded at their acquisition-date fair values (e.g., derivatives, executory contracts, land rights, leases, and others) Some licenses may be valued as part of related plant assets All liabilities, including long-term debt, should be recorded at their acquisition date fair values (except for pensions and tax liabilities, which follow specific guidance in ASC 805) Fair value should incorporate the reporting entity s own credit and current market conditions Regulatory offset may be appropriate in certain circumstances, depending on ratemaking and specific pass-through mechanisms Regulatory offset may be appropriate in certain circumstances 14
Determining when regulatory offset should be recorded Would the predecessor entity have recorded regulatory offset if the related asset or liability had been recorded on the balance sheet? Yes Are the ASC 980 criteria for recognition of a regulatory asset or liability met? No No Yes Record at fair value with no regulatory adjustment Record at fair value AND record regulatory offset 15
Merger credits Many regulated utility acquisitions include some provision for rate credits, merger credits, or other rate concessions for customers after the merger. Merger credits represent rate discounts negotiated by the acquirer with the regulator as part of obtaining the regulator s support for the transaction. The accounting for merger credits will be dependent upon the specific facts and circumstances and require both an evaluation of the substance and legal form of the credits. Merger credits may meet the definition of a liability and be recognized at the acquisition date separate from the accounting for the business combination. As the merger credits are not part of the exchange, no merger credit liability should be recorded as part of the business combination. Contrast: A. Merger credit of $25M. Recovery mechanism to be $0.002 per therm to all customers until the $25M credit has been satisfied (Projected to be two years) B. Merger credit of $0.002 per therm to all customers for a two year period (Projected at a cost of $25M) 16
Post-acquisition accounting for goodwill Goodwill often results from a business combination. ASC 980 specifically addresses the accounting for goodwill by a regulated utility. ASC 980-350-35-1 Topic 350 states that goodwill shall not be amortized and shall be tested for impairment in accordance with that Subtopic. For rate-making purposes, a regulator may permit an entity to amortize purchased goodwill over a specified period. In other cases, a regulator may direct an entity not to amortize goodwill or to write off goodwill. ASC 980-350-35-2 If the regulator permits all or a portion of goodwill to be amortized over a specific time period as an allowable cost for rate-making purposes, the regulator s action provides reasonable assurance of the existence of a regulatory asset (see paragraph 980-340- 25-1). That regulatory asset would then be amortized for financial reporting purposes over the period during which it will be allowed for rate-making purposes. Otherwise, goodwill shall not be amortized and shall be accounted for in accordance with Topic 350. 17
Navigating the new landscape (and making life easier ) 18
Clarifying the definition of a business executive summary Issued January 2017 What you need to know A set now needs to have an input and a substantive process that together significantly contribute to the ability to create outputs to be a business. A new screen test if substantially all of the fair value of the gross assets acquired are concentrated in a single asset or similar assets, the set is not a business. Definition of outputs narrowed to be consistent with the new revenue standard. Narrows the scope of transactions which will qualify as a business Looking forward Effective 2018 Early adoption allowed Prospective application 19
Comparison to existing guidance Screen Inputs and processes Existing guidance No screen Inputs and processes, if not included, could be replaced by market participant New guidance Not a business when substantially all of the fair value of the gross assets acquired is concentrated in a single asset or group of assets The set must include, at a minimum, an input and substantive process that together create outputs Organized workforce Organized workforce is not required. Evaluate certain factors to determine if a business When no outputs are present, a set must include an organized workforce Outputs Return in the form of dividends, lower costs, or other economic benefits Goods or services to customers, other revenues, or investment income, such as dividends or interest 20
Derecognition of nonfinancial assets executive summary Issued February 2017 What you need to know The standard defines the term in substance nonfinancial asset Scope exclusions added, such as equity method investments and certain subsidiaries Eliminates specific nonmonetary exchange guidance in order to apply ASC 610-20 Provides guidance for partial sales of nonfinancial assets, including partial sales of real estate (retained portion would now result in full gain or loss recognition) Impacts Clarifies guidance by defining in substance nonfinancial asset Provides guidance for partial sales of nonfinancial assets Looking forward Effective January 1, 2018 (must adopt at same time as revenue recognition) Early adoption permitted Choice of full or modified retrospective (can be different than revenue recognition) 21
Measurement period adjustments Issued September 2015 What you need to know Recognize the cumulative impact in the period in which the adjustment is identified Do not restate prior periods Amount to recognize = cumulative effect on earnings including prior period impact Disclose out-of-period impact (how much of the prior period effect is in the current period) Impacts Entities would no longer restate prior periods for measurement period adjustments Looking forward Effective in 2016 for calendar-year-end public companies. One additional year for nonpublic companies. Early adoption permitted To be applied prospectively. 22
Goodwill impairment simplification executive summary (ASU 2017-04) Issued January 2017 What you need to know Eliminates Step 2 of the quantitative impairment testing model Goodwill impairment is measured by the excess of the carrying value of a reporting unit over its fair value, up to the carrying value of goodwill in the reporting unit Same model is applied for all reporting units, including reporting units with negative or zero carrying value Impacts Intended to reduce cost and complexity Eliminates Step 2 from the goodwill impairment test Looking forward Effective 2020 Early adoption beginning 2017 Prospective transition 23
Comparison to existing guidance Number of steps Existing guidance Two-step approach with optional qualitative assessment (step 0) New guidance One-step approach with optional qualitative assessment Impairment calculation Negative reporting units Impairment measured by the excess of the carrying amount of goodwill to the implied fair value of goodwill For reporting units with zero or negative carrying amount, step 2 is required if mandatory step 0 test fails Impairment measured by the excess of the carrying amount of a reporting unit to its fair value (up to the carrying amount of goodwill) No separate model for reporting units with zero or negative carrying amount 24
Financial reporting and other considerations 25
Other financial reporting considerations (AKA things that can be a real pain ) An acquisition may close on a date other than period-end, which could result in: - An evaluation of system configuration for generating financial information at a date that does not coincide with the regular monthly reporting cycle - Additional auditing procedures being required at the acquisition date at the request of the acquiring entity Financial reporting integration between the acquirer and aquiree may be required: - Interfaces between existing financial reporting information - Chart of accounts mapping for presentation, disclosure and group reporting packages An acquiring entity may be an SEC Registrant. If so, additional reporting requirements may exist that require additional information relating to the acquired entity such as: - Pro forma disclosures - SOX Controls relating to the Business Combination transaction - Evaluation of SOX exemption at the acquired entity level 26
Other financial reporting considerations (continued) An exercise to align accounting policies with the acquired entity will need to be performed once an acquisition is consummated - Consideration of differences in the acquirer s and acquiree s approach to adopting new accounting standards such as revenue and leasing Year-end reporting timelines may change to align with the reporting deadlines of the acquired entity Evaluation of the accounting for one-off items arising at the date of the acquisition: - Assessment of what constitutes consideration e.g., employee compensation costs - Assessment of what is a cost of the acquire, the acquirer or part of purchase accounting e.g., restructuring costs - Push-down accounting elections Resource planning considerations - External resources (actuaries, auditors, valuation specialists) - Internal resource (steering committee, competing priorities, tax, HR, treasury coordination) 27
Pro forma financial information Regulation S-X article 11 Rule 11-01 of Regulation S-X requires pro forma financial statements for significant business combinations as defined in S-X 3-05 (which points to S-X 1-02(w) for determining significance). Such business acquisitions are treated differently than asset acquisitions. Under Article 11, a presumption exists that a separate entity, subsidiary, or division is a business. However, a lesser component such as a separate product line could be a business for the purpose of determining financial statement and pro forma requirements related to an acquisition or disposition. ASC 805 and IFRS 3 Business Combinations pro forma disclosures may be required even when Article 11 pro forma financial information is not required. Pro forma financial statements required: - Most recent interim period (P&L and BS) - Prior year (P&L) (requirements may differ for discontinued operations and reorganizations of entities under common control) Acquisition is required to be reported on Form 8-K within four business days of consummating the transaction. Historical financial statements of the acquired business and pro forma financial information must be filed as an amendment, no later than 71 calendar days after the initial Form 8-K due date. 28
Pro forma financial information Significance test Rule 11-01 of Regulation S-X requires the significant subsidiary test in Rule 1-02(w) to be applied to compute the significance of the acquired business using three tests: - Investment test sum of the registrant s investment in and advances to the acquired business, divided by the registrant s total assets as of the most recent audited fiscal year - Asset test registrant s proportionate interest in total assets of the acquired business, divided by the registrant s total assets as of the most recent audited fiscal year - Income test registrant s equity in income from continuing operations before income taxes, extraordinary items and cumulative effect of accounting changes, exclusive of amounts attributable to any noncontrolling interests, divided by the registrant s such consolidated income (certain circumstances may require the use of 5-year average income) The test with the highest significance determines the significance of the acquired business. The threshold for the requirement to file historical financial statements and related pro forma financial information is 20%. 29
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