Business combinations: convergence and fair value.

Contingent consideration is an obligation of the acquirer to transfer assets or equity interests if future events occur or certain conditions are met. A significant challenge acquirers may face is to measure, on the acquisition date, the fair value of contingent liabilities associated with earnout arrangements. Earnouts typically include payments to acquiree shareholders that are contingent on the achievement of financial or other performance goals following the closing date of the business combination. Earnout arrangements under the EDs require specific measurement on the acquisition date, and it is that measurement that may create unintended consequences of future performance, particularly associated with managing the acquirer's risk and retaining key target firm managers. Changes in the values of contingent assets and liabilities (that are not financial instruments) will be adjusted to fair value in each reporting period, with changes in fair value recorded in the income statement.

4. Accounting for Acquired In-Process Research and Development

Under SFAS 141, in-process research and development (IPR & D) acquired is measured at fair value and expensed. Under the EDs, the acquirer recognizes separately from goodwill an acquiree's intangible asset if it meets the definition of a separately identifiable intangible asset. The EDs propose that IPR & D acquired be measured at fair value, and capitalized with an indefinite life. As is the case with other indefinite-life assets, acquired IPR & D will be tested regularly for impairment but not amortized. When its life becomes determinable (e.g., upon project completion), acquired IPR & D will be amortized over its expected remaining life.

The implications are that there are only limited circumstances in which the fair value of the asset cannot be reliably measured, and that uncertainty enters into the measurement of the asset's fair value rather than demonstrating an inability to measure fair value reliably. These restrictive recognition requirements for intangible assets would result in a re-allocation from goodwill to intangible assets, and consequently, amortization charges would lower earnings in years following the acquisition.

Fair Value and the EDs

A. Criticisms of the EDs

The EDs define fair value of the target firm as the fair value of the consideration transferred on the acquisition date, unless it can be demonstrated otherwise that the consideration transferred is not the best measurement of fair value. Fair value measurement of the consideration exchanged is sufficiently supported for a 100 percent acquisition.

The major criticisms of the EDs requirement to use fair value measurements focus on the lack of guidance in fair value measurement in partial and step-acquisitions that ultimately require business combinations. Paragraph A11 of the FASB's ED states that for partial acquisitions that require business combination accounting, the fair value of the consideration given up is not representative of the fair value of the target firm as a whole. As an example, the consideration given up in a 100% acquisition may include control premiums paid to acquiree shareholders having significant equity interests. The payment of control premiums allows the acquirer to direct the strategy and policies of an acquired firm. The acquisition of a series of minority positions, taken individually, may not include control premiums, but could ultimately result in a majority ownership that meets the requirement for business combination procedures. The value of the control premium leading to the majority ownership may be considered to measure the fair value of the acquiree as a whole. The EDs do not provide guidance for imputing control premiums. Paragraph A11 of the FASB ED requires that in these types of situations, the acquirer of partial acquisitions that qualify as a business combination must use the fair value of the consideration given with any other available information to estimate the fair value of the acquiree as a whole.

In certain circumstances, such as non-transfer of consideration, transactions under duress or through related parties, the fair value of the consideration given cannot be reliably used to measure the fair value of the acquiree. In these circumstances, the FASB's ED recommends the use of the market or income valuation techniques which are consistent with measurement guidance found in SFAS No. 157, Fair Value Measurements (SFAS 157).

Certain respondents criticized the EDs for providing too much fair value measurement guidance, which could mislead preparers into thinking they possess valuation expertise. These respondents caution of undesirable outcomes that could result in highly unreliable financial reporting.

Those respondents who supported the EDs proposal to measure contingent consideration at fair value based their support for the use of the acquisition date fair value as the best evidence of fair value of the target firm. Any adjustment to the fair value of the consideration given is evidence to review for goodwill impairment in later periods, because the acquirer will have the benefit of hindsight in acquiree valuation. Those respondents who criticized the EDs suggested that the use of contingent consideration is evidence that fair value is not completely determinable on the acquisition date. Some respondents even suggest that requiring fair value measurement for contingencies on acquisition date motivate managers to engage in earnings management by overstating contingent liabilities, so any lower settlement results in income in future periods.

The EDs prohibit the inclusion of acquisition-related transaction costs incurred by the acquirer in the measurement of the business combination. Transaction costs would be expensed, or would reduce the fair value of equity securities transferred as part of the consideration given. The thrust of the argument lies in the irrelevancy of transaction costs in assessing the future performance of the target firm, and thus do not provide any future economic benefit. This argument is consistent with paragraph 9 of SFAS 157, which states that transaction costs do not possess attributes of assets; but rather are specific to the transaction and will differ depending on how the reporting entity transacts.

Most respondents to the EDs disagree with the proposed treatment of acquisition-related costs, citing the proposal as a significant departure from current accounting standards that base the measurement of the business combination on a cost-accumulation model.

B. SFAS 141 and SFAS 157

SFAS 157, issued in September 2006, establishes a framework for measuring fair value in GAAP and expands disclosures about fair value measurements. The standard provides guidance on how to measure fair value where it is permitted or required under more than 60 other accounting pronouncements.

Paragraph 35 of SFAS 141 requires that the acquiring entity allocates the cost of an acquired entity to assets and liabilities acquired, except goodwill and deferred income taxes, based on their estimated fair values at the date of acquisition. Sources of information to be used to estimate fair values include independent appraisals, actuarial or other valuations. Paragraph 37 provides general guidance specific to the elements. This list includes the following measurements:

1. Marketable securities -- fair value;

2. Receivables -- present value of amounts expected to receive;

3. Inventories -- use of lower-of-cost-or-market (LCM) or current replacement cost;

4. Plant and Equipment -- current replacement cost;

5. Intangible assets other than goodwill -- fair value;

6. Other assets such as land, natural resources, and nonmarketable securities -- appraised values;

7. Liabilities, accruals and commitments -- present values of amounts to be paid;

8. Pension and other postretirement benefit obligations -- actuarial determined present values; and

9. Preacquisition contingencies -- fair value if determinable.

SFAS 157 provides a single definition of fair value. Paragraph 5 states that fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. SFAS 157, paragraph 16, states that the transaction price represents the price paid to acquire the asset or received to assume the liability (an entry price). In contrast, the fair value of the asset or liability represents the price that would be received to sell the asset or paid to transfer the liability (an exit price, which is conceptually different from an entry price). In many cases, the transaction price will equal the exit price and, therefore, represent the fair value, but not always, as discussed in paragraph 16 of SFAS 157. Therefore, SFAS 157 provides detailed guidance on how fair value measurements should be attained, which includes a hierarchal structure for ranking the inputs that should be used in valuations techniques for measuring fair values.

Valuation techniques to measure fair value under SFAS 157 include three approaches: (1) market approach--measurement comes from market transactions involving identical or comparable assets or liabilities, (2) income approach--measurement comes from the conversion of future amounts (earnings and cash flows) to a single discounted value through the use of present value techniques and pricing models, and (3) cost approach--measurement comes from current replacement cost of an asset.