FASB Eases Requirement to Account for Contingent Assets Acquired and Liabilities Assumed in a Business Combination
On April 1, 2009, the Financial Accounting Standards Board (FASB) issued FASB Staff Position 141R (FSP 141R or Staff Position) that makes it easier for companies to account for contingent assets and liabilities such as litigation claims acquired in business combinations without having to disclose prejudicial information about these claims in their financial statements. Before this amendment, Financial Accounting Standards No. 141 (revised 2007) (FAS 141R), which became effective for business combinations occurring on or after December 15, 2008, required financial statement issuers to recognize contingent assets and liabilities at their acquisition-date fair value if the contingency was “contractual” or if it was “non-contractual” and was “more likely than not” to give rise to an asset or liability, even if the likelihood of the contingency occurring was not probable and/or the amount of the contingency was not reasonably estimable. Besides not knowing how to quantify contingent assets or liabilities that were not reasonably estimable, financial statement issuers were concerned with having to disclose information about contingent liabilities that could provide claimants with a roadmap that would not otherwise be available absent a business combination.
Background
When it released FAS 141R, the FASB stated that to faithfully represent the acquirer’s economic circumstances at the acquisition date resulting from a business combination, all identifiable assets acquired and liabilities assumed should be recognized at their acquisition-date fair value. To achieve this goal, the FASB deemed it necessary to expand the recognition of contingent assets acquired and liabilities assumed in business combinations, unless the contingency was non-contractual in nature and did not meet the “more likely than not” standard. Such assets and liabilities were previously recognized only if they were both probable and reasonably estimable under the guidance of FAS 5. Thus, FAS 141R required recognition of contingencies that, outside the context of business combinations, are not ordinarily recognized.
Upon the release of FAS 141R, companies, auditors, and attorneys voiced concerns about the impact of increasing the recognition and disclosure of contingent assets acquired and liabilities assumed in business combinations. After considering these concerns, the FASB scaled back the provisions of FAS 141R that relate to the recognition of contingent assets and liabilities, bringing the criteria for recognition more in line with FAS 5. The FASB considers the change to be a temporary solution and will revisit the issue in the context of its consideration of changes to accounting for all contingencies under FAS 5.
Concerns Raised
The issuance of FAS 141R prompted companies, auditors, and attorneys to raise a number of concerns regarding the application of the provisions FAS 141R relating to the recognition, measurement, and disclosure of contingent assets and liabilities acquired in a business combination. The most vital and commonly expressed concerns involved:
- Making the more likely than not determination, which is a lower threshold than FAS 5’s probable threshold
- Determining the acquisition-date fair value of a litigation-related contingency if it was not reasonably estimable
- Distinguishing between a contractual and non-contractual contingency, e.g., where a lawsuit asserts claims for both breach of contract and a tort such as breach of fiduciary duty1
- Supporting the recognition and measurement of liabilities arising from legal contingencies without disclosing attorney-client privileged information to the company’s auditor and potentially waiving the company’s privilege by making such disclosure2
- Disclosing potentially prejudicial information in financial statements such as management’s assessment of the viability of and possible range of outcomes for a contingent claim without compromising the company’s position in litigation
FASB’s Solution: FSP 141R and a Reasonably Determined Standard
In response to the concerns outlined above, FSP 141R essentially reduces the recognition of contingent assets acquired and liabilities assumed in business combinations to such assets and liabilities that can be reasonably determined. By limiting recognition of contingent assets and liabilities, the new Staff Position reduces the information related to such contingencies that is required to be disclosed in the footnotes to the financial statements. The FASB noted in Appendix B to FSP 141R that it considers the change to be a temporary solution until it determines whether to separately address the accounting for all contingencies by reconsidering FAS 5 or by participating in the International Accounting Standard Board’s project on their contingency Exposure Draft.
Criteria for Recognition
The new Staff Position eliminates FAS 141R’s distinction between a contractual and non-contractual contingency and the more-likely-than-not threshold for the recognition of non-contractual contingencies. Instead, the new Staff Position requires an issuer to recognize the acquisition-date fair value of an asset acquired or liability assumed in a business combination that arises from a contingency only if the acquisition-date fair value of the asset or liability can be determined during the measurement period (the time after the acquisition and before the date of the financial statements). However, if the acquisition-date fair value of such assets and liabilities cannot be determined at the acquisition date, the asset or liability is only recognized if:
- The acquisition-date fair value of the asset or liability can be determined during the measurement period, or
- Both (i) information available before the end of the measurement period indicates that it is probable that an asset existed or a liability had been incurred at the acquisition date and (ii) the amount of the asset or liability can be reasonably estimated. The probable and reasonably estimable criteria are similar to the criteria in FAS 5, and the Staff Position provides that the guidance in FAS 5 and the interpretations issued under FAS 5 should be used in applying the criteria.
Scaled Back Disclosure
Under both FAS 141R and the new Staff Position, if a contingency is recognized in the financial statements, a company must disclose the amount recognized at the acquisition date and the nature of the contingency. However, because many contingencies that would be recognized under FAS 141R are not required to be recognized under FSP 141R, the amount of disclosure also will be greatly reduced. For contingencies that are not required to be recognized under the new Staff Position, companies are only required to make the disclosures required by FAS 5. FAS 5 requires disclosure of an estimate of the range of outcomes if an estimate can be made, or, if no such estimate can be made, companies are required to disclose that fact.
Limiting the recognition of contingent assets acquired and liabilities assumed in business combinations to those that can be reasonably determined effectively serves to greatly reduce the amount of footnote disclosure related to such contingencies. If a contingency is not recognized and an estimate of the range of loss cannot be made, minimal disclosure is required. Limiting the recognition and disclosure of contingent liabilities should serve to greatly alleviate many of the concerns with FAS 141R.
1 In FAS 141R, the FASB acknowledged that, in some situations, determining whether a contingency is contractual or non-contractual may require the exercise of judgment based on the facts and circumstances of the specific contingency.
2 Not only were concerns expressed about management sharing potentially privileged information with auditors, but the FASB also took note of the concern that the ethical duties of attorneys may prevent them from sharing certain information with auditors in audit letters. Specifically, the FASB took note of the fact that the American Bar Association’s Statement of Policy Regarding Lawyers’ Responses to Auditors’ Requests for Information does not require a client’s attorney to comment on whether it is more likely than not that a contingency arising from litigation gives rise to a liability. Attorneys indicated to the FASB that they could not reconcile fulfilling their professional responsibilities to their clients and providing auditors with audit evidence that states their client is more likely than not liable in a given case.
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If you have any questions about this alert or would like to discuss the topic further, please contact your Foley attorney or the following individuals:
Mark T. Plichta
Milwaukee, Wisconsin
414.297.5670
[email protected]
Timothy H. Shea
Milwaukee, Wisconsin
414.319.7054
[email protected]
