The FASB exposure draft on accounting for business combinations and intangible assets: An instructional assignment

TY - JOUR

T1 - The FASB exposure draft on accounting for business combinations and intangible assets

T2 - An instructional assignment

AU - Schoderbek, Michael P.

AU - Slaubaugh, Michael D.

N1 - Funding Information: The assignment was distributed as a group project to 89 and 68 students in an advanced accounting course at Rutgers University, New Brunswick during Spring Semester 2000 and Spring Semester 2001, respectively. Students were allowed to choose their own groups of four to five students each. Each question was given roughly equal weight in determining the total assignment score and the entire assignment was worth approximately ten percent of each student's final grade. The following sections contain the solutions and teaching notes for each question. Question 1: FASB standard setting process. The first part of the question requires students to outline the stages of due process followed by the FASB in developing a new standard. The document on the FASB website related to this topic should not take students long to read. Preparing a brief summary of the contents of the document, however, may prove more difficult for students unless the instructor sets parameters on the answer. 3 3 Students may wish to look at other sources for information on the FASB's standard setting process. Suggested readings include Reither (1997) and Miller (1998) . One objective of the due process followed by the FASB in developing a new standard is to have all proceedings open to the public for both observation and participation. For each major project on its technical agenda, the FASB appoints a task force of experts with a vested interest in the project. The task force plays an advisory role to both the Board and staff of the FASB in defining the project and its scope. The input of the task force aids the staff in preparing a discussion document that is disseminated for public comment. The discussion document should define the nature of the problem, specify the pertinent accounting and reporting issues, summarize any relevant research findings, present alternative solutions to the problem, and identify a deadline for written comments from the public. The Board and staff also holds a public hearing to address and receive additional input from the respondents to the discussion document. Based on the written and oral comments made by respondents, the staff analyzes the responses and submits a report to the Board. After assimilating the report and conducting further analysis, the Board directs the staff to prepare an initial Exposure Draft (ED), which may prompt further discussion and revision. The ED sets forth the proposed standard, the proposed effective date, method of transition, and a summary of the rationale behind the Board's conclusions. The public can express opinions on the ED through comment letters and position papers, which may prompt further modifications. The final version must receive at least five of the seven Board member votes to be adopted as a new standard. The second part of the question asks students to report on the current status of the ED used in the assignment. The ED was originally issued in September 1999 after a number of years on the FASB's agenda which included the dissemination of several discussion documents, numerous public hearings, and field tests. The Board also looked at hundreds of comment letters received from a broad constituency including the Securities and Exchange Commission. After the issuance of the Exposure Draft, constituents were again invited to comment which initiated a new series of meetings as well as testimony before the Committees of the House and Senate. At the time of the assignment, the FASB was still in the midst of that stage of the project. 4 4 Subsequently, the FASB issued a limited revision of the ED in February 2001 followed by the issuance of two separate standards in June 2001, Statement No. 141: Business Combinations , and Statement No. 142: Goodwill and Other Intangible Assets . Question 2 : Reasons the FASB Proposed Eliminating Pooling. The question serves several objectives. First, it requires students to critically examine the conceptual theory underlying pooling. Second, it demonstrates how changes in the business environment can affect the appropriateness of different accounting practices. Third, it looks at the influence of international practices on the standard setting process in the USA. Many of the FASB's reasons for eliminating the pooling of interests method in favor of the purchases method are found in the Introduction and Appendix B of the ED: 1. Concerns about the amount of time the SEC spends on determining if companies meet the 12 criteria for the pooling of interests method (ED, Introduction, para. 6). 2. Fairness: companies that cannot meet the stringent pooling of interests criteria believe they are at a competitive disadvantage due to lower earnings (ED, App. B, para. 84). 3. To achieve convergence with international standards and the standards employed by other countries such as Australia and New Zealand (ED, App. B, para. 86). 4. By recording net assets at fair market value, the purchase method provides more useful information about the ability of those net assets to generate cash (ED, App. B, para. 112). 5. Comparability: the differences that arise as a result of allowing two alternate accounting methods for recording business combinations makes comparability across firms difficult (ED, App. B, para. 113). 6. Because assets are combined at book values, the pooling of interests method masks the investment made in the combination and fails to hold management accountable for that investment (ED, App. B, para. 122). 7. The costs of maintaining two alternate accounting methods outweigh the benefits and only the purchase method can be applied to all business combinations (ED, App. B, para. 114, 116). Although pooling is less costly to apply than the purchase method, the cost is borne by the financial statement user who must complete additional analysis for those companies that use pooling ( FASB Status Report, 1999 ). 8. In recent years, the pooling of interest method has not been applied to the same circumstances for which it was originally intended. For example, the method has been historically used in combinations of regulated utility companies to keep the asset-basis down, thereby reducing the rates passed on to consumers (ED, App. B, para. 119–120). Apart from the ED, students are required to look at other sources to investigate alternative viewpoints of accounting for business combinations. The pooling of interests method in particular has long been a favorite target of the financial press. For example, Lowenstein (1996) argues that pooling puts accounting appearance before economic substance, and that the substantive (cash) difference between the purchase and pooling methods is negligible. Petersen (1998) suggests that pooling allows companies to make major acquisitions and yet report virtually no evidence of what may have been a dangerous move or an excessive price paid, because the purchase price is never recorded on the books. These views, at least according to the financial press, are additional reasons to eliminate pooling. With respect to international accounting perspectives, Reither (1997, p. 96) notes that the FASB communicates both formally and informally with the United Kingdom Accounting Standards Board, the Australian Accounting Research Foundation, the Canadian Institute of Chartered Accountants, and the International Accounting Standards Committee. The policies of these international entities have the potential to influence the standard setting process within the FASB. Thus, two references on the diversity of international accounting practices are provided to students. For example, Afterman (2000, Section B4.02) reports that: 1. The pooling of interests method is either prohibited or never used in several countries such as Australia, Mexico, South Africa, and Israel. 2. In Canada, New Zealand, and the Netherlands, pooling may only be applied when the combining companies are of equal size and it is not possible to identify the acquiring company. 3. In general, the criteria for pooling are much more stringent in most European and Pacific Rim countries than the USA. Question 3: Identifying the Acquired Company. There are two parts to the question on identifying the acquiring company in a purchase business combination affected by the exchange of stock. The student groups did very well on the first part of the question asking them to list the criteria used to identify the acquiring company. These criteria include: 1. The status of the voting rights of shareholder groups from former companies in the combined enterprise (ED, App. B, para. 164). 2. The composition of the Board of Directors and senior management in the combined enterprise (ED, App. B, para. 165). 3. The pre-combination market capitalization of the separate companies (ED, App. B, para. 166). 4. The existence of a premium payment (ED, App. B, para. 167). However, students did not fare as well on the second part of the question asking why it is necessary to identify the acquiring company, primarily because that topic is not clearly addressed in the ED. When the exchange of stock is involved in a business combination, the identity of the acquiring company is not always obvious when the combined enterprise takes the name of the acquired company (ED, Part I, para. 15). However, identifying the acquiring company under the purchase method is essential because the acquiring company's net assets will remain at book value whereas the acquired company's net assets will be recorded at fair market value. The designation of the acquiring company can also have a significant impact on the amount of goodwill and related amortization charges recorded on the combined company's books. As one student group correctly noted, if the FASB did not provide criteria to designate the acquiring firm, the combining companies could record net assets and goodwill in a way that is most beneficial to them, rather than reflecting the economic substance of the transaction. presents the journal entries students are required to record using the fresh-start method to account for the combination of Adams Corporation and Baker Corporation. Question 4: Fresh-start method. The “fresh-start” method of accounting for business combinations is discussed in the ED as a viable alternative to both the purchase and pooling of interests methods. However, many students are unfamiliar with this method. The question requires students to rely on their knowledge of accounting to apply the fresh-start method in a business combination setting. Table 3 The FASB has been criticised in recent years because the current reporting model allegedly fails to reflect innovative activities of the enterprise, thereby affecting the usefulness of financial statements ( Lev and Zarowin, 1999 , p. 354). Much of the criticism points to unrecorded intangible assets, suggesting that portions of the balance sheet are missing, especially for high-technology firms ( Francis and Schipper, 1999 , p. 342). The fresh-start method of accounting for business combinations attempts to address these concerns. Under the fresh-start method, the combined company is treated as a new entity with the net assets of both the acquiring company and the acquired company being restated to fair market value (ED, App. B, para. 89, note 29). Retained earnings is also reduced to zero and transferred to additional paid-in capital with a new history for that account commencing on the combination date ( Baker, Lembke, & King, 1999, p. 1236; Beams, Brozovsky, & Shoulders, 2000, p. 694; Hoyle, Schaefer, & Doupnik, 1998, p. 595 ). 5 5 The fresh-start method is closely related to push-down accounting, which is mandated by the SEC for wholly owned subsidiaries with no public debt or preferred stock. Under push-down accounting, the subsidiary is also treated as a new entity with retained earnings eliminated and transferred to additional paid-in capital. Because both the acquiring company and the acquired company are being treated the same as a purchase, there are two purchase prices (one for the acquired company and a “pseudo” purchase price for the acquiring company) and two goodwill calculations as illustrated in Table 3 . Note that the patent is classified as an intangible with no observable market. In the process of restating the net assets of both companies to fair market value, previously unrecorded intangibles will be capitalized such as goodwill, FCC licenses, patents, etc. This should assist investors in assessing the firms' risk, growth opportunities, and future cash flows. This question elicited great interest among the student groups, with about 60% handling it correctly. The rest submitted a myriad of solutions. Many problems stemmed from failure to compute the “pseudo” purchase price of Adams for $37,500,000. In one common variation, a group correctly recorded Baker's net assets (including goodwill of $2,300,000 based on a $12,500,000 purchase price) at fair market value and also wrote up Adams' net assets to fair market value, but failed to record goodwill of $10,500,000 for Adams. Note that because the “pseudo” purchase price for Adams is not obvious, the assignment offers some helpful hints for students. Question 5: Excess of the fair market value of acquired net assets over cost. There are two parts to the question. The first part focuses on the differences between APB Opinion No. 16 and the ED in accounting for business combinations where the fair market value of the net assets of the acquired company is more than the acquisition cost (i.e. “negative goodwill”). Under APB Opinion No. 16 (para. 91), negative goodwill should first be allocated on a pro rata basis to reduce nonfinancial, depreciable assets. If the allocation reduces these noncurrent assets to zero, the remainder should be classified as a deferred credit (such as “Excess of Market Value of Net Current Assets over Cost”) and amortized over a period not to exceed 40 years. In contrast, under the ED (Part I, para. 23–24), negative goodwill should first be allocated on a pro rata basis to reduce intangibles with no observable market when the fair market value of the acquired company exceeds the acquisition cost. If the allocation reduces these type of intangibles to zero, then both nonfinancial, depreciable assets and acquired intangible assets with an observable market should be reduced on a pro rata basis until their recorded value is zero. Any remaining difference should be recorded as an extraordinary gain. highlight the key differences between APB Opinion No. 16 and the ED under two different scenarios (Part A and Part B). 6 6 As an example of the evolving nature of standards, the FASB has recently revised its proposed treatment of negative goodwill. In a summary of the project dated 5 April 2001, the Board now recommends that negative goodwill should be “allocated as a pro rata reduction of the amounts that otherwise would be assigned to all of the acquired assets other than cash and cash equivalents, trade receivables, inventory, financial instruments that are required by US GAAP to be carried on the balance sheet at fair market value, assets to be disposed of by sale, and deferred taxes. If an excess remains after reducing those assets to zero, the remaining excess should be recognized as an extraordinary gain”. The required journal entries presented in Table 4 The second part of the question raises a more challenging issue for students: why would the cost of the acquired company be less than the fair market value of its net assets? Many current financial accounting textbooks do not adequately address this topic, but the ED posits several plausible explanations (ED, App. B, para. 291): 1. Measurement error resulting from undervaluing the consideration paid in the business combination (e.g. when an unlisted company acquires a company listed on a stock exchange in a “backdoor listing” transaction, the unlisted firm may give noncash assets whose fair market value may be difficult to determine; if the assets are undervalued, the acquisition cost might exceed the fair market value of the acquired company). 2. Measurement error resulting from overvaluation of assets recognized, particularly intangible assets without an observable market (e.g. the fair market value of intangible assets that do not have an observable market is difficult to determine; if the assets are overvalued, the acquisition cost might exceed the fair market value of the acquired company). 3. Recognition of deferred tax assets at book value that may not be realized for several years and/or deferred tax assets that have a greater value to the acquiring enterprise. 4. Failure to recognize liabilities that should be accounted for under generally accepted accounting principles (GAAP). 5. Liabilities that are not recognizable under GAAP because they are not measurable or they relate to contingencies not accounted for. Question 6: Financial statement presentation of goodwill . The question has three main parts. The answer to the first part involves a straightforward discussion of goodwill disclosures under the ED which requires a company to aggregate and present all amortization and impairment loses related to goodwill on the income statement, net of tax. This line item should appear after a descriptive subtotal such as “income before goodwill charges and extraordinary items” (ED, Part I, para. 52). A company may also elect to provide per share amounts for the goodwill charges and the subtotals that precede “income before goodwill charges and extraordinary items” (ED, Part I, para. 57). On the balance sheet, all goodwill should be aggregated and presented as a line item separate from other intangible assets (ED, Part I, para. 52). The ED also requires more extensive footnote disclosures. In the year of acquisition, a firm must report [ED, Part I, para. 60 (c)]: 1. Description of the elements that underlie goodwill. 2. Amortization period and how it was determined. 3. Amortization method. In subsequent years, a firm must report the following on their financial statements [ED, Part I, para. 61 (c)]: 1. Accumulated amortization. 2. Amortization method. The second part of the question asks students to discuss how the new reporting rules for goodwill will influence the way in which financial analysts and investors process accounting information and predict cash flows. Prior to the ED, firms often lumped goodwill charges with other expenses on the income statement. But the amortization of goodwill does not affect future cash flows and many financial analysts focus on earnings before interest, taxes, depreciation, and amortization (EBITDA). These analysts also typically adjust their forecasts for noncash charges similar to goodwill in predicting cash flows. Thus, separate disclosure of goodwill charges should provide financial analysts with more useful information for the prediction of future cash flows and also reduce their information processing costs. The enhanced footnote disclosures may also help analysts predict the frequency and amount of goodwill impairment losses. Furthermore, under APB (1970) Opinion No. 17, annual goodwill expense does not need to be disclosed unless the charges were material, which can be very subjective. As such, few companies actually report goodwill as a separate line item. Thus, the ED should aid investors in predicting future cash flows because they have more useful information on the goodwill component of firms' earnings. On the other hand, some students' answers reflected a belief in the strong form of market efficiency. Under this assumption, the new disclosures will not provide new information, but will only reduce the processing costs for financial analysts to collect that information. The third part of the question required the student groups to prepare the 1999 income statement for Coastal Corporation under the new goodwill reporting guidelines specified in the ED. Coastal Corporation was chosen because it is one of the few companies that reports the dollar amount of goodwill amortization in the footnotes. . 7 7 At Rutgers, half the student groups were required to prepare the income statement of Coastal Corporation under the provisions of the ED. The other half were assigned Baxter International, whose 1999 Form 10-K Annual Report is also available on the Edgar SEC website. Both companies reported annual goodwill charges either in the footnotes or on the face of their 1999 income statements. Additional representative companies that disclosed goodwill amortization charges in their 1999 annual reports include Metro Goldwyn Meyer, Milacron, and Safeway. Several instructions are also given to students in the assignment to simplify the question including (1) omitting comparative figures from prior years and (2) computing only basic earnings per share. The solution is presented in Table 5 Reporting special charges (credits) on the income statement is usually complicated by the disclosure of income taxes, and the ED requires the disclosure of goodwill net of tax. However, goodwill is deductible for tax purposes only in a very few cases. This caused some confusion among the student groups. Therefore, hints were also incorporated into the question to assist students in dealing with the tax issue, including an examination of the income tax footnotes. In Coastal Corporation's schedule reconciling income tax expense at the statutory rate to the income tax provision on the income statement, taxes related to goodwill are shown as nondeductible. Hence, the solution presented in Table 5 is much easier, albeit not as rich, because neither the goodwill charges nor income tax expense had to be adjusted. Question 7: Nonamortization of intangible assets. The last question asks students to present reasons both for and against the nonamortization of qualifying intangible assets. Three main reasons for the nonamortization of intangible assets can be found in the ED: 1. Some identifiable intangibles such as airport landing rights have indefinite useful lives and amortizing these assets would lack representational faithfulness (ED, App. B, para. 288). 2. Some identifiable intangible assets such as a hydroelectric plant have legal or contractual rights greater than 20 years (ED, App. B, para. 286). 3. To allow US firms to compete with firms in other countries (e.g. Great Britain) which do not require the amortization of intangible assets in certain situations (ED, App. B, para. 274). Although international accounting practices are mentioned as a reason for nonamortization, the FASB provides no specific references in the ED. As a result, many of the answers turned in by students lacked breadth. To address this deficiency, students are given three references on international accounting. Harris (1998, p. 7) examines the so-called “competitive advantage” enjoyed by British firms that are allowed to capitalize goodwill without amortization, and concludes that the future earnings charges associated with goodwill are the reasons many US mergers and acquisitions fail. Harris predicts that in upcoming years global accounting standards for goodwill will converge to the UK approach (p. 8). Both Choi (1997) and Afterman (2000) provide comparative analysis of international practices for “brands.” Brands encompass brand names, patents, trademarks, copyrights, and other intellectual property. Choi (Chapter 14.3) finds that many of the top companies in Australia capitalize brands without subsequent amortization on the grounds that the asset's lives are not finite or that the carrying value is less than the residual value. Under International Accounting Standards, Afterman (Section B6.05) reports that brands are recorded as assets and expensed only upon impairment in values. Thus, the ED's proposed nonamortization of intangibles assets is consistent with some of the practices currently used in other countries or jurisdictions. Although the FASB provides some reasons supporting the nonamortization of intangibles assets in the ED (see earlier), the Board does not openly discuss any arguments against nonamortization of intangibles in the ED. Therefore, this part of the question requires students to use their creativity and independent thought. To help them in this process, students are asked to revisit the FASB's conceptual framework found in many intermediate accounting textbooks and in its Statement of Financial Accounting Concepts No. 2: Qualitative Characteristics of Accounting Information . From those sources, several arguments against nonamortiazation can be posited including, but not limited to, the following: 1. Nonamortization would violate the matching principle. 2. Annual systematic charges to goodwill are more objective than periodic reviews for impairment. The latter would allow firms greater opportunities to manage their earnings. 3. Very few intangibles would actually satisfy the criteria for nonamortization, so the cost of implementing the new rule outweighs the benefits. 4. Consistency: applying nonamortization to newly acquired intangibles and amortization to intangibles acquired under old accounting rules could produce misleading results and/or be detrimental to the comparability of financial statements.

PY - 2001/12

Y1 - 2001/12

N2 - Accounting standards are constantly evolving to meet the needs of a rapidly changing business environment and changes in accounting theory. Accounting students need to be familiar with the content of Exposure Drafts, since these documents reflect the Financial Accounting Standards Board's (FASB) position on current financial reporting issues. Students are generally not well versed on the standard setting process and how contextual factors affect this process. The purpose of this instructional assignment is to enhance students' understanding of how contextual factors affect the standard setting process within the context of the Exposure Draft on "Business Combinations and Intangible Assets." The assignment requires that students examine the Exposure Draft and answer questions designed to elicit responses as to why the FASB is considering a new standard and the impact the standard would have on current accounting procedures and financial statements.

AB - Accounting standards are constantly evolving to meet the needs of a rapidly changing business environment and changes in accounting theory. Accounting students need to be familiar with the content of Exposure Drafts, since these documents reflect the Financial Accounting Standards Board's (FASB) position on current financial reporting issues. Students are generally not well versed on the standard setting process and how contextual factors affect this process. The purpose of this instructional assignment is to enhance students' understanding of how contextual factors affect the standard setting process within the context of the Exposure Draft on "Business Combinations and Intangible Assets." The assignment requires that students examine the Exposure Draft and answer questions designed to elicit responses as to why the FASB is considering a new standard and the impact the standard would have on current accounting procedures and financial statements.

KW - Business combinations

KW - Exposure draft

KW - Goodwill

KW - Intangible assets

KW - Pooling of interests

UR - https://www.scopus.com/pages/publications/0042239305

UR - https://www.scopus.com/pages/publications/0042239305#tab=citedBy

U2 - 10.1016/S0748-5751(01)00022-7

DO - 10.1016/S0748-5751(01)00022-7

M3 - Article

SN - 0748-5751

VL - 19

SP - 265

EP - 281

JO - Journal of Accounting Education

JF - Journal of Accounting Education

IS - 4

ER -