During the negotiations to acquire a business, the buyer may enter into or modify an arrangement with employees or sellers of the target. To the extent one of these types of arrangements arises or exists, the buyer must determine whether any payments to be made in conjunction with the arrangement should be: (a) included within the accounting for the business combination (possibly as consideration transferred or an assumed liability) or (b) accounted for separate from the business combination (possibly as compensation or another cost). When such arrangements will or may result in payments that are forfeited by a recipient upon termination of employment, then the accounting is straightforward and the payment should be accounted for separate from the business combination as compensation. If, however, the payments that will or may be made by the buyer are not forfeited upon termination of employment, the buyer will need to determine whether it or the combined entity receives the primary benefit from the arrangement. If it is the buyer or the combined entity that receives the primary benefit from the arrangement, then that suggests the arrangement should be accounted for separate from the business combination (e.g., as compensation). Financial Accounting Standards Board Accounting Standards Codification paragraph 805-10-55-25 provides a variety of indicators to consider in making this determination. The following two examples illustrate the application of this guidance in certain scenarios. Assume that in both cases a CEO was hired as the Chief Executive Officer of Target on January 1, 20X1. Buyer acquires 100% of Target on December 31, 20X4. On the acquisition date, Buyer transfers $500 million to the sellers.
Example 1 – Preexisting employment arrangement
Target enters into an employment arrangement with CEO on January 1, 20X1. The arrangement specifies that if Target is acquired while CEO is employed by Target, then CEO would be entitled to a payment of $2 million, but only if Buyer terminates CEO’s employment within one year after the acquisition date.
Because the payment is not forfeited upon termination, Buyer must consider the following questions (and additional assumed facts) when determining who receives the primary benefit from the arrangement (i.e., whether the potential termination payment should be accounted for as part of, or separate from, the business combination):
- Why did Target and CEO enter into the employment arrangement?
It was in CEO’s best interests to enter into the arrangement because it would provide him with financial protection in the event Target was acquired at any point during his employment and his employment was subsequently terminated within one year. It was also in Target’s best interests to enter into the arrangement because CEO was their first choice to fill the Chief Executive Officer position and CEO would not agree to fill the position unless Target agreed to the arrangement.
- Who initiated the arrangement? CEO initiated the arrangement.
- When was the arrangement entered into? The arrangement was entered into on January 1, 20X1, which was before Buyer contemplated acquiring Target.
Although Target receives some benefit from this arrangement, because payment from the arrangement would only occur as a result of activities within Buyer’s control (i.e., Buyer terminates CEO’s employment within one year of the acquisition), Buyer would receive the primary benefit (e.g., future costs avoided). As a result, we believe the arrangement should be accounted for separate from the business combination. That is, we believe the payment to CEO if terminated within one year of the acquisition date should be recorded as a period expense.
In this example, if the termination payment was automatically due to CEO on the date of the change of control of Target, then Target would be considered to receive the primary benefit from the arrangement. As such, the arrangement would be accounted for as part of the business combination (i.e., part of the purchase price consideration). 3 FINANCIAL REPORTING INSIGHTS | DECEMBER 5, 2023
Example 2 – Continuing employment required except in limited circumstances
Buyer enters into an employment arrangement with CEO on December 31, 20X4, which is the same date that Buyer acquires 100% of Target. The arrangement specifies that if CEO is employed by the combined entity one year after the acquisition date, then CEO is entitled to a payment of $2 million at that point in time. CEO is also entitled to receive this payment if no longer employed by the combined entity one year after the acquisition date due to either being terminated by Buyer or resigning due to a significant reduction in pay or responsibilities. However, if CEO voluntarily resigns for other reasons or is terminated for cause within one year, CEO will not receive this payment.
Although payment may be made to CEO even if CEO is no longer employed by the combined entity one year after the acquisition date, this would only occur as a result of activities within Buyer’s control (i.e., Buyer either terminates CEO or significantly reduces CEO’s pay or responsibilities) for which Buyer would receive the primary benefit. As a result, we believe the arrangement should be accounted for separate from the business combination as compensation expense.
For additional guidance on this topic and other issues that arise when accounting for a business combination, refer to our publication, A guide to accounting for business combinations.
