Mergers & acquisitions a snapshot Change the way you think about tomorrows deals

Stay ahead of the accounting and reporting standards for M&A1

December 14, 2011

Did I buy a group of assets or a business? Why should I care?

Determining whether an acquired group of assets is a business has proven to be one of the more challenging aspects of applying the current M&A accounting guidance. For many transactions, the determination will be straightforward. However, the current guidance will cause many transactions that are "on the edge," and previously would have been accounted for as asset acquisitions, to be accounted for as business combinations. Why is this determination important? While the measurement of assets and liabilities in both types of transactions will yield similar results, several differences can arise that can have a significant impact on a company's earnings, financial ratios, and business metrics. This edition of Mergers & acquisitions a snapshot, identifies relevant considerations in determining whether a business has been acquired and why it matters not only upon acquisition but also for disposals and public company reporting.

What's inside Why does it matter? What is a business? Industry-specific considerations Disposal transactions Public company reporting Conclusion

Accounting Standards Codification 805 is the US standard on M&A, and Accounting Standards Codification 810 is the US standard on noncontrolling interests.

M&A snapshot

Why does it matter?

Determining whether a business has been acquired has far reaching business and accounting implications. To illustrate, the table below outlines some of the key areas where the accounting treatment can differ.
Area Measurement of assets and liabilities Transaction costs Contingent consideration Business combination Fair value Asset acquisition Allocate purchase consideration based on relative fair values Capitalize

What is a business?
The M&A standards contain a definition of a business that can result in a broad range of transactions qualifying as business acquisitions. A business is an integrated set of assets and activities capable of being managed to provide a return to its owners. Businesses consist of assets/resources, and systems, standards, or protocols applied to those assets/resources, that have the ability to create economic benefits, such as revenues or lower costs. In many transactions, the asset or business determination will be straightforward. For example, the acquisition of an operating company active in the marketplace will qualify as a business, whereas the purchase of a single machine will be accounted for as an asset acquisition. However, in other instances, this assessment can become more complex and judgmental. In making this determination, it is important to: 1) identify the elements in the acquired group (i.e., the assets purchased and processes transferred); 2) assess the capability of those elements to generate economic benefits; and 3) assess the impact of any missing elements on a market participant's ability to generate economic benefits. The table below outlines some factors that may distinguish business combinations from asset acquisitions.
Business combination Key business processes acquired A market participant could manage the assets to provide a return to its owners Key elements are missing but can be easily replicated or obtained Key employees hired Able to produce "Day 1" outputs Presence of liabilities and/or goodwill Asset acquisition No processes acquired or only administrative processes acquired A market participant could not manage the assets to provide a return to its owners without combining them with other assets Key elements are missing and cannot be easily replicated or obtained No employees hired Not able to create economic benefits No goodwill present

Expense

Generally record at fair Generally record when value; mark to market probable and through P&L postreasonably estimable close if a liability Capitalize as an Expense assuming no indefinite lived asset alternative future use until project completed or abandoned Recognize as standalone asset Recognize at fair value if determinable; otherwise, when probable and reasonably estimable Subsumed within goodwill Cannot be recognized Generally record when probable and reasonably estimable

IPR&D

Goodwill Acquired contingencies

Assembled workforce

Recognize as standalone asset

M&A snapshot

Industry-specific considerations
Determining whether a business has been acquired can be particularly challenging in certain industries. Considerations relevant to some of these industries are discussed below. Oil and gas industry In the oil and gas industry, properties acquired for extractive activities vary significantly in terms of their stage of development and viability. Properties may be completely unexplored and undeveloped on one extreme, and may be actively producing on the other. Due to the differing stages of development and exploration, judgment is required to determine whether many properties are businesses or assets. An example of a transaction in this industry is described below.

Real estate industry Acquired properties vary as to the level of business processes that are needed to yield a return and the degree to which those processes are present at acquisition. For example, the nature of tenant solicitation, maintenance, and property management can vary significantly in the purchase of an empty building versus a building with multiple tenants. This concept is highlighted in the following example.

Example 2 acquisition of commercial properties Facts: Company W, a real estate investment entity, owns
and manages a group of commercial properties across the United States. Company W decides to purchase a commercial office property in San Francisco. The existing property is 90% occupied, and Company W will become a party to the lease agreements upon acquisition. Company W will replace existing security, cleaning, and maintenance contracts with new contracts. However, the existing property management agreement will be terminated and Company W will undertake all property management functions, such as collecting rent and supervising maintenance work. In connection with the transaction, Company W will also hire leasing managers and other management personnel involved with the operations of the property.

Example 1 acquisition of oil and gas exploration company Facts: Company K is an oil and gas exploration company.
Company K owns a proven but undeveloped property. Company K has performed enough exploration activities to determine that the property is proven, but has not yet begun to extract the mineral reserves from the property. Additionally, Company K has constructed transportation infrastructure that will be used to transport the mineral reserves. However, this infrastructure has not yet been placed into operation. Company L is an oil and gas production company that operates a large portfolio of producing properties. Company L acquires Company K.

Analysis: In the past, this transaction may have been

Analysis: In the past, this transaction may have been

treated as the acquisition of property. However, under the current guidance it is likely a business has been acquired. The acquisition includes assets (property and transportation infrastructure) and systems/protocols (supporting exploration activities). While there are missing elements (other infrastructure and developed reserves), Company L determined that likely market participants would have, or could easily obtain, the necessary operational processes to manage the acquired group in a way that would provide a return to investors.

treated as the acquisition of real estate. However, under the current guidance, it is likely a business has been acquired. Company W acquired assets (commercial property, lease agreements, and other contracts) and hired key leasing and management personnel. Further, rental income is present immediately after the acquisition. Company W concluded that other market participants would have existing property management expertise.

Technology industry In the technology industry, IPR&D and contingent consideration arrangements are prevalent, making the stakes particularly high for determining what constitutes a business. In making this determination, it is important to consider the stage of development of IPR&D and the level of expertise of any employees hired in connection with the transaction.

M&A snapshot

Outsourcing arrangements are common in the technology industry because they allow companies to lower their fixed costs. An example illustrating the application of this guidance to an outsourcing arrangement is presented below.

Example 4 acquisition of research and development company

Facts: Development Inc. owns the right to several product (drug compound) candidates. Its only activities consist of research and development that is being performed on the product candidates. Development Inc. employs management and administrative personnel as well as scientists that are vital to performing the R&D. Big Pharma Co. acquires the rights to certain of the product candidates as well as testing and development equipment from Development Inc. Big Pharma Co. also hires the scientists formerly employed by Development Inc. who are developing the acquired candidates. Analysis: This transaction would likely have been accounted for as an asset acquisition in the past (acquisition of a pre-revenue development company). However, under the current guidance, it is likely a business has been acquired. Big Pharma acquired assets (product candidates, testing, and development equipment) and the operating protocols and procedures established by the scientists. While Big Pharma Co. did not acquire a manufacturing facility or a sales force, it determined that the likely market participants are other large pharmaceutical companies that already have these items or could easily replicate them.

Example 3 outsourcing arrangement Facts: Company O is in the business of providing

information technology outsourcing services. It offers to provide services to Firm P under a 20 year agreement. As part of the agreement, Company O acquires a building, computer equipment, and certain intellectual property ("IP") held by Firm P. While all employees of Firm P working in this area have been hired by Company O in the transaction, Company O plans to initiate a restructuring, which will eliminate headcount and improve efficiency.

Analysis: In the past, this arrangement may have been

treated as an executory contract. Now, it is likely a business has been acquired. Company O acquired assets (building, computer equipment, IP) and systems/protocols (computer systems, knowledge resident in employees). Further, the acquired group is capable of providing a return to its owners.

Pharmaceutical & life sciences industry Similar to the technology sector, IPR&D and contingent consideration arrangements can constitute a significant portion of a transaction in the pharmaceutical and life sciences industry. Some relevant factors to consider in determining whether a business has been acquired include the stage of development of any drug compounds acquired and any processes attached to the acquired assets. In most cases, there are likely to be more processes associated with later stage drug compounds than those in earlier stages. In addition, certain licensing arrangements, such as some worldwide perpetual licenses in which employees, processes, or other assets have been acquired, may be business acquisitions. The following example illustrates the application of this guidance in the pharmaceutical industry.

Disposal transactions
The business versus asset determination is also relevant for disposal transactions. A key difference between an asset sale and a business sale is that in the latter case goodwill needs to be allocated to the business sold. This allocation could have a significant impact on the gain or loss recognized from the sale. Allocation of goodwill to the business sold would also trigger the need for an impairment assessment of the remaining goodwill in the reporting unit. The following example highlights these considerations for a disposal transaction.

M&A snapshot

Example 5 disposal of a plant Facts: Company V is a diversified manufacturing

company that has a widget reporting unit. The widget reporting unit comprises two plants - one that sources US subsidiaries and one that sources European subsidiaries. Company V decides to sell the plant in Europe for $2,000. Financial information for the widget reporting unit and its two plants prior to the disposal is provided in the table below.
US Fair value Net assets (excluding goodwill) Goodwill Total book value $3,000 $1,500 Europe $2,000 $1,000 Total $5,000 $2,500

In summary
There are no "bright lines" that can be used in determining whether a business has been acquired. Often times, this determination is judgmental and can have a significant impact on a buyer's financial reporting. Making these judgments will not be easy but buyers will want to avoid post-deal "surprises" by addressing this issue early in the deal process. For more information on this publication please contact one of the following individuals: John Glynn Valuation Services Leader (646) 471-8420 john.p.glynn@us.pwc.com Henri Leveque Accounting Advisory Services Leader (678) 419-3100 h.a.leveque@us.pwc.com Principal authors: Lawrence N. Dodyk US Business Combinations Leader (973) 236-7213 lawrence.dodyk@us.pwc.com Kevin McManus Assurance Senior Manager (704) 344-4320 kevin.m.mcmanus@us.pwc.com John Vanosdall National Professional Services Group Director (973) 236-4030 john.p.vanosdall@us.pwc.com

$500 $3,000

Analysis: The plant in Europe likely qualifies as a

business because it has tangible and intangible assets and processes, such as manufacturing protocols and knowledgeable employees. The plant is also currently producing widgets. Company V would allocate a portion of the total widget reporting unit goodwill upon disposal based on the relative fair values of the US and European plants. This results in an allocation of 40% ($2,000/$5,000) of the total widget reporting unit goodwill to the European plant, or $200. As a result, the book value of the European plant is $1,200 and Company V will record a gain of $800 based on a sales price of $2,000. Absent the allocation of goodwill to the European plant, Company V would have recorded a gain of $1,000. In addition, Company V will test the remaining amount of goodwill for impairment.

Public company reporting

For public companies, the asset versus business determination can also impact SEC reporting requirements. While the SEC's rules are different from the M&A rules, what constitutes a business will, for the most part, be the same for both. Specifically, the SEC rules require financial statements for acquired businesses that are considered significant. In contrast, there is no such requirement for asset acquisitions.

M&A snapshot

PwC has developed the following publications related to business combinations and noncontrolling interests, covering topics relevant to a broad range of constituents. 10Minutes on Mergers and Acquisitionsfor chief executive officers and board members What You Need to Know about the New Accounting Standards Affecting M&A Dealsfor senior executives and deal makers Mergers & acquisitionsa snapshota series of publications for senior executives and deal makers on emerging M&A financial reporting issues Business Combinations and Consolidationsthe new accounting standardsan executive brochure on the new accounting standards A Global Guide to Accounting for Business Combinations and Noncontrolling Interests: Application of U.S. GAAP and IFRS Standardsfor accounting professionals and deal makers Dataline 2008-01: FAS 141(R), Business Combinationsfor accounting professionals and deal makers Dataline 2008-02: FAS 160, Noncontrolling Interests in Consolidated Financial Statementsfor accounting professionals and deal makers Dataline 2008-30: Key Considerations for Implementing FAS 141(R) and FAS 160for accounting professionals and deal makers Dataline 2008-35: Nonfinancial Asset Impairment Considerationsfor accounting professionals and deal makers Dataline 2009-08: Revisions to EITF Topic D-98, Classification and Measurement of Redeemable Securitiesfor accounting professionals and deal makers Dataline 2009-16: New Guidance for Acquired Contingenciesfor accounting professionals and deal makers

Dataline 2009-34: Accounting for Contingent Consideration Issued in a Business Combinationfor accounting professionals and deal makers Dataline 2011-20: Goodwill ImpairmentFASB proposes changes to impairment testfor accounting professionals and deal makers Dataline 2011-28: FASB issues guidance that simplifies goodwill impairment test and allows early adoptionfor accounting professionals and deal makers PwC clients who would like to obtain any of these publications should contact their engagement partner. Prospective clients and friends should contact the managing partner of the nearest PwC office, which can be found at www.pwc.com.

This publication has been prepared for general information on matters of interest only, and does not constitute professional advice on facts and circumstances specific to any person or entity. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. The information contained in this material was not intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. PwC, its members, employees and agents shall not be responsible for any loss sustained by any person or entity who relies on this publication. 2011 PwC. All rights reserved. "PwC" refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.