The application of purchase accounting can often involve difficult questions. One of these may be the proper basis for the measurement of the net assets acquired. This can be an issue when the acquired entity’s owners receive ownership interests of the acquiring entity as consideration (continuing ownership interest), or when the acquiring entity purchases less than 100% of the ownership interests of the acquired entity (e.g., there remains a minority or noncontrolling interest in the acquired entity).
However, before considering the application of purchase accounting, a determination must be made as to whether the accounting is being evaluated from the perspective of the acquiring entity or the acquired entity. If the focus is on the accounting by the acquired entity in its financial statements, this does not give rise to purchase accounting considerations. Instead, the only consideration for the acquired entity is whether it should apply push-down accounting (in some cases involving public entities, push-down accounting is required). This article will focus on accounting for an acquisition by the acquiring entity not involving entities under common control (e.g., the acquiring entity and acquired entity are not under the control of the same individual (or entity) or close family members).
Accounting for an acquisition of an entity is done in only one of two ways. One is the application of leveraged-buyout (LBO) accounting under EITF Issue No. 88-16, “Basis in Leveraged Buyout Transactions”. The other way is the application of FASB Statement No. 141, Business Combinations.
To apply LBO accounting, the following conditions must be met:
- A newly-formed company (NEWCO) acquires all of the outstanding shares of the acquired entity (OLDCO) in a single or series of related and anticipated transactions.
- NEWCO must have had no substantive prior operations.
- The acquisition must be highly leveraged.
- The acquisition must result in a change in control of OLDCO.
Only when these four conditions have been met may LBO accounting be applied. When LBO accounting cannot be applied, Statement No. 141 must be applied to all other acquisitions. The fundamental difference between the two accounting methods involves the measure of the net assets acquired when there is a continuing ownership interest in the acquiring entity by the owners of the acquired entity. The following examples will help illustrate this point:
Example 1
- NEWCO is formed to acquire 100 percent of the outstanding shares of OLDCO in a single transaction.
- The transaction is highly leveraged (e.g., 70 percent from proceeds of a bank loan and 30 percent from the proceeds of the sale of NEWCO stock).
- OLDCO shareholders will receive cash and 20 percent of the shares of NEWCO in exchange for their OLDCO shares.
In this example, the conditions of LBO accounting have been met. Accordingly, the transaction must be accounted for in accordance with Issue No. 88-16. LBO accounting results in a new basis for the 80 percent interest in OLDCO acquired by the new owners while the continuing ownership interest (20 percent) is recorded at the OLDCO shareholders’ historical carrying value.
Example 2
Assume the same transaction discussed in Example 1 except the transaction is not highly leveraged. In this case, the transaction is not in the scope of Issue No. 88-16, and Statement No. 141 must be applied. The application of Statement No. 141 to that transaction results in the acquisition being accounted for at full fair value. That is, the sum of the cash paid to acquire the 80 percent interest in OLDCO and the fair value of the 20 percent interest represented by the shares issued by NEWCO in exchange for OLDCO shares should be used to record the acquisition.
Example 3
- NEWCO acquires 80 percent of the shares of OLDCO for cash.
- The remaining 20 percent of OLDCO is retained by existing OLDCO shareholders and NEWCO is issuing consolidated financial statements.
In NEWCO’s consolidated financial statements, OLDCO is recorded based on the acquisition price paid for the 80 percent interest, and the 20 percent noncontrolling interest is recorded at the historical carrying value recorded by OLDCO (partial purchase method or step-acquisition accounting). The basis in OLDCO’s net assets recorded by NEWCO is the same as in Example 1. However, the accounting treatment does differ from Example 1 because there is a noncontrolling interest outstanding while in Example 1 there was no noncontrolling interest as 100 percent of the shares of OLDCO were acquired. As a result, a noncontrolling interest must be recorded by NEWCO in its financial statements in this example. Furthermore, in this example Issue No. 88-16 cannot be applied by NEWCO (regardless of whether the transaction is highly leveraged or not) as all of the shares of OLDCO were not acquired.
Future
If the transactions in Examples 1 and 3 were to occur in annual reporting periods beginning after December 15, 2008 (the effective date of FASB Statement No. 141 (revised 2007), Business Combinations, which replaces Statement No. 141 and nullifies Issue No. 88-16), the accounting treatment would differ. The accounting treatment for Example 1 would change to be consistent with that in Example 2. The accounting treatment for Example 3 would be at full fair value calculated using the fair value of the 80 percent acquired and the fair value of the 20 percent noncontrolling interest. |
