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In connection with its persistent efforts to “harmonize” accounting principles wherever possible, the Financial Accounting Standards Board has proposed to alter the manner in which business combinations are accounted for. It, in conjunction with its international counterpart, the International Accounting Standards Board, has issued an exposure draft entitled “Business Combinations” that will replace, should it be adopted, FASB Statement No. 141. Several rather radical changes in the manner in which business combinations are accounted for animate the exposure draft. In general, the exposure draft provides that all business combinations shall be accounted for by applying a method entitled the “acquisition method.” Thus, the venerable term “purchase method” (of accounting for a business combination) will be expunged. In the acquisition method, a business combination is defined as a transaction or event in which an acquirer obtains control of one or more businesses. The exposure draft acknowledges that an acquirer may obtain control of an acquiree without a transaction involving the acquirer — for example, if the acquiree redeems a sufficient amount of its stock (from shareholders other than the acquirer) to place the acquirer in control of the acquiree or where there is a lapse of minority veto rights that, previously, prevented the acquirer from exercising control over the acquiree. The heart of the exposure draft is its discussion of the acquisition method of accounting for a business combination. Under this method, the acquirer measures and recognizes the acquiree, as a whole, and the assets acquired and liabilities assumed, at their fair-market values as of the acquisition date. The draft provides that the acquisition method entails four distinct steps: � Identify the acquirer. In a business combination effected through an exchange of equity interests, the entity that issues the equity securities is, normally, the acquirer. However, the exposure draft acknowledges the notion of “reverse acquisitions”; transactions in which the issuing entity is, in fact, the acquiree. Further, in a business combination effected through the exchange of equity interests, the acquirer is, generally, the entity whose owners retained or received the largest portion of the voting rights and, in cases where this guideline is not decisive in determining the identity of the acquirer, the exposure draft goes on to say that the acquirer, “all things being equal,” is the entity that pays a premium. � Determine the acquisition date. This date is, generally, the “closing” date: the date on which the acquirer transfers the consideration, acquires the assets and assumes the acquiree’s liabilities. � Measure the fair-market value of the acquiree. The acquirer shall measure the fair-market value of the acquiree, as a whole, as of the acquisition date. For this purpose, the consideration transferred on the acquisition date is presumed to be the fair-market value of the acquirer’s interest in the acquiree. The consideration transferred consists of the acquisition-date fair value of the assets transferred and liabilities assumed as well as the equity interests that are issued and the acquisition-date fair-market value of any noncontrolling equity investment in the acquiree that the acquirer owned immediately before the acquisition date. In a departure from the purchase method of accounting, the acquisition-date fair value of contingent consideration is also considered to be part of the consideration transferred and, in cases where the contingent consideration is properly classified as a liability and such liability is not within the scope of FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities,” the contingent consideration shall, after its initial recognition, be measured at fair value with changes in such fair value recognized in income. Moreover, the excess of the fair value over the carrying amount of the noncontrolling equity owned immediately before the acquisition date shall be recognized in income in the period in which the acquisition date falls. This, too, is a departure from previous accounting conventions. Importantly, costs that are incurred “in connection with the business combination” (including legal fees, accounting fees, consulting fees and banking fees) are not part of the consideration transferred and, hence, must be accounted for separately. In virtually every case, these fees will be charged to expense in the period in which the acquisition date falls. � The acquirer shall then measure and recognize, as of the acquisition date, the assets acquired and the liabilities assumed. The identifiable assets (including “in-process R&D”) and liabilities assumed shall be measured at fair-market value and recognized separately from goodwill. For this purpose, an asset is identifiable when it is either “separable” or it arises from contractual or other legal rights. The often-criticized practice of capitalizing costs associated with restructuring or exit activities is summarily eliminated: To the extent those costs do not meet the recognition criteria in FASB Statement No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” (they rarely will), such costs will not be regarded as liabilities and, therefore, will be recognized separately from the business combination. These costs, therefore, will be expensed, in the post-combination financial statements, as they are incurred. The acquirer shall measure and recognize goodwill, as of the acquisition date, using the “residual” method — goodwill, therefore, will equal the excess of the fair-market value of the acquiree as a whole over the net amount of the identifiable assets acquired and liabilities assumed. Goodwill shall not be amortized but, instead, shall be “tested,” no less frequently than annually, for “impairment.” What if the acquisition-date fair-market value of the acquirer’s interest in the acquiree is greater than the consideration transferred? How does one account for such a bargain purchase? The excess, in those rare instances where one exists, is first applied to reduce goodwill and, once goodwill is reduced to zero, any remaining excess (of acquisition date fair value over the consideration transferred) shall be recognized as a gain. This exposure draft, should it be adopted, shall apply to business combinations for which the acquisition date is on or after the beginning of the first annual period beginning on or after December 15, 2006. Until that time, FASB Statement No. 141 remains in full force and effect. Robert Willens is a tax and accounting specialist at Lehman Brothers Inc. He is also an adjunct professor of finance at Columbia Business School. Copyright �2005 TDD, LLC. All rights reserved.

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