Pre-existing relationships are relatively common in business combinations, and can result in gains and losses on the transaction. Watch Becky Bisesar explain the guidance associated with gains and losses on pre-existing relationships (specifically the important difference between contractual and non-contractual relationships) and share a few examples to put them in context.
Hi, I’m Becky Bisesar.
In an acquisition, it’s fairly common for there to be some pre-existing relationships between the buyer and seller. These relationships can be simple like receivables and payables for transactions in the normal course of business, or complex involving multiple provisions in a broad ranging contract. These relationships are effectively settled upon acquisition, since they are either terminated or become intercompany relationships that are eliminated in the post-combination financial statements. The effective settlements can sometimes result in a gain or loss being recognized.
In this video, I’ll share the guidance associated with gains and losses on pre-existing relationships and a few examples to put them in context. The first step is identifying all pre-existing relationships. The receivable and payable example is an easy one, as they will be eliminated post-combination, if the amounts agree. For the more complex relationships, the treatment will differ depending on whether the relationship is non-contractual or contractual. A non-contractual relationship could include instances when the parties are plaintiff and defendant. An example of a contractual relationship would be those between a vendor and customer or between a licensor and licensee.
Let’s start with non-contractual relationships, as these are generally more straightforward. Settlement gains and losses from non-contractual relationships should be measured at fair value on the acquisition date. For example, say Company A is a defendant in litigation relating to a patent infringement claim by Target. When Company A acquires Target for $50 million dollars, the lawsuit is effectively settled. Let’s assume the fair value of the settlement of the lawsuit is $5 million dollars. Based on these facts, Company A would record a loss of $5 million dollars, excluding the effect of income taxes. However, if Company A had a $3 million dollar litigation reserve established for the lawsuit before the acquisition, it would record a settlement loss of only $2 million, representing the difference between the $5 million dollar fair value of the settlement and the existing $3 million dollar reserve. On the other hand, if Company A had a reserve in excess of the $5 million dollar fair value, the difference between the fair value and the previously recognized reserve would be recorded as a gain. Keep in mind that while the accounting may seem straightforward, determining the fair value can be complex.
Now let’s discuss contractual relationships. Settlement gains and losses from contractual relationships are required to be measured at the lesser of: the favorable or unfavorable amount compared to market pricing, or the amount of any stated settlement provisions. Contractual relationships need to be evaluated to determine if the contract terms are favorable or unfavourable compared to market pricing. This should be assessed from the perspective of the acquirer. If favorable, settlement of the relationship will result in a gain. If unfavorable, the acquirer would record a loss.
Prior to recording a gain or loss, Companies should consider whether contracts contain settlement provisions, as this will impact the gain or loss to be recorded. Let me give you an example. Say Company A acquires Target for $100 million dollars. Company A provides services to Target under a multi-year, fixed price service contract. Since the inception of the service contract, the market price for the remaining service period has increased by $10 million dollars. The terms in the contract are therefore unfavorable to Company A as compared to current market transactions. Company A would recognize a settlement loss of $10 million dollars, excluding the effect of income taxes, for the unfavorable amount of the contract.
Now let’s use the same scenario, but include a settlement provision that allows Company A to terminate the contract at any time for $6 million dollars. Although the contract is unfavorable by $10 million dollars, Company A would recognize a settlement loss of $6 million dollars, excluding the effect of income taxes, because it is the lesser of the fair value of the unfavorable contract term and the contractual settlement provision. But remember, the contract itself is unfavorable by $10 million dollars. The difference of $4million dollars would be included as part of the business combination. So when completing a business combination, remember to identify all pre-existing relationships, determine if they are contractual or non-contractual, and use the appropriate model. When there are multiple contracts or agreements between the parties, the settlement of each contract and each preexisting relationship needs to be assessed separately.