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Remarks by

Paul R. Kepple

Professional Accounting Fellow, Office of the Chief Accountant
U.S. Securities & Exchange Commission

27th Annual National AICPA Conference on Current SEC Developments

December 7, 1999

As a matter of policy, the Commission disclaims responsibility for any private publications or statements by any of its employees. The views expressed are those of the author, and do not necessarily represent the views of the Commission or the author's colleagues on the staff.

Good morning. I thought I would start off my discussion by cleaning up a bit of open business from last year's conference related to contractual asset dispositions in a pooling transaction. I will then move on to a few new issues related to application of the equity method of accounting, identification of an accounting acquirer, and accounting for deferred revenue in a purchase business combination.

Contractual Asset Dispositions in a Pooling

As some may recall from last year's conference, I had discussed an issue dealing with the impact that a contractually triggered asset disposition may have on a pooling of interests transaction.1 To highlight the fact pattern again:

The registrant had entered into a number of joint ventures with another independent company. These ventures included the contribution of significant net assets of both companies. As part of the venture agreements, certain change in control and noncompete provisions were included. Specifically, in the event that either venture partner participated in a change in control event, as defined, the other venture partner would have a contractual call on the "change in control" party's interests in the joint ventures. For example, if the registrant was acquired in a change in control event, the other venture partner would have a unilateral right to call the registrant's interests in the joint ventures for fair value. The converse would also be true.

Separately, a noncompete provision required the venture partners to sell competing assets acquired in any transactions to either the joint ventures, at the discretion of the other venture partner, or to another third party. For example, if the registrant acquired Target Co. and Target Co. had operations that competed with the joint ventures, the other venture partner would have the unilateral right to decide if the joint ventures should acquire Target Co.'s competing assets. If the joint ventures did not acquire the competing assets, the registrant would still be required to sell those assets to another third party.

Both of the provisions could only be triggered in a business combination transaction entered into by one of the venture partners. Assuming that the joint venture agreement had not been entered into in contemplation of the business combination transaction, the issue was whether the contractually required asset disposition, triggered by the business combination, would preclude use of the pooling of interests method of accounting to the extent that such asset disposition would be significant.

The staff's final conclusion was consistent with the preliminary conclusion discussed at last year's conference. The staff believes that a company should not be able to accomplish through a contractual provision what it would otherwise not be permitted to do in a pooling transaction, even if the contractual provision had been put in place over two years ago. As a result, the staff believes that such provisions would preclude pooling to the extent that they trigger a significant asset disposition as a result of a business combination.

In the past year, the staff has also addressed a scenario where the call provisions described above are triggered by a business combination and are exercisable for some period of time after consummation. In one registrant fact pattern, upon a change in control the other joint venture party had up to three months after the date of the business combination to exercise its call on the "change in control" party's interest in the ventures. In this instance, the staff concluded that the mere existence of the open call at consummation date, triggered by the business combination, would preclude the use of the pooling of interests method if such a disposition would be significant. The staff believes that this conclusion is consistent with APB 16,2 paragraph 48(c), which requires that there be no intent or plan to dispose of significant assets within two years after the combination. To state the conclusion another way, it is the existence of the call at consummation, the exercisability of which is triggered by the business combination, and not the subsequent exercise of the call, that precludes pooling.

The staff has also addressed another fact pattern in which the call provisions, which would have been triggered by a business combination, were waived for that transaction by the other joint venture party for no consideration prior to consummation of the pooling transaction. In this instance, the staff did not object to the registrant's conclusion that the potential pooling violation had been eliminated as a result of the waiver received for no consideration.

Application of the Equity Method of Accounting

The staff continues to receive and address questions regarding the application of the equity method of accounting. Many of these questions revolve around whether the equity method or cost method of accounting is appropriate in a given set of circumstances. In particular, fact patterns such as an investment in common stock just under the 20 percent threshold established in APB 183 regarding a presumption of significant influence, or an investment in common stock of less than 20 percent coupled with one or more contractually provided board of directors seats, give rise to questions of whether the staff applies "bright line" tests to the application of APB 18.

In short, the staff does not apply a bright line test to the application of APB 18. When considering whether the application of the equity method of accounting is required for an investment in common stock, the staff has evaluated:

  • The nature and significance of the investments, in any form, made in the investee. The staff does not consider the difference between a 20 percent common stock investment versus a 19.9 percent investment to be substantive, as some have asserted in applying APB 18. In addition, the staff will consider whether the investor has other forms of investments or advances, such as preferred or debt securities, in the investee in determining whether significant influence results.

  • The capitalization structure of the investee. The analysis would consider whether the investee effectively is being funded by common or non-common stock investments and how critical the investments made by the investor are to the investee's capitalization structure (e.g., is the investor the sole funding source).

  • Voting rights, veto rights, and other protective and participating rights4 held by the investor. The greater the ability of the investor to participate in the financial, operating, or governance decisions made by the investee, via any form of governance rights, the greater the likelihood that significant influence exists.

  • Participation on the investee's board of directors (or equivalent), whether through contractual agreement or not. The staff will consider, in particular, whether any representation is disproportionate to the investment held. For example, an investor that is contractually granted 2 of 5 board seats, coupled with a 15 percent common stock investment, will likely be viewed to have significant influence over the investee.

  • Other factors as described in full in FIN 35.5

In summary, evaluating the existence of significant influence is often a judgment call. While the starting point in any evaluation of significant influence is the investor's common stock ownership level in the investee, the staff does not believe that a "bright line" approach is appropriate and will consider and weigh all of the factors noted above in concluding on any given set of facts and circumstances.

Identification of an Accounting Acquirer

The staff recently addressed an issue involving the identification of an accounting acquirer in a three-way purchase business combination between Companies A, B, and C. Company A was a registrant, as is the combined company. What makes this transaction particularly interesting, however, is that one party (Shareholder X), who is also a registrant, held an interest in each of the three combining companies; a cost investment6 in Company A, an equity method investment in Company B, and a 100 percent interest in Company C. The financial ownership and voting percentages held by the combining companies' shareholder groups in the combined company were as follows:

Company A Shareholders40%
Company B Shareholders36%
Company C Shareholder24%

As a result of the combination, Shareholder X would own 47% in the combined company, but did not have a controlling interest that would result in an ability to consolidate the combined company.

In evaluating the above fact pattern, the combined company registrant concluded that the accounting acquirer should be identified based upon the shareholder group of a combining company that receives the largest voting percentage, consistent with the guidance in APB 16 and SAB 97.7 Specifically, the registrant considered the staff's response to Question 2 of SAB Topic 2.A.2, which states:

"When more than two entities are involved in a purchase business combination, the identification of the acquiring entity may require rigorous analysis when no single former shareholder group obtains more than 50 percent of the outstanding shares of the new entity following the transaction. APB Opinion 16 states, "presumptive evidence of the acquiring company in combinations effected by an exchange of stock is obtained by identifying the former common shareholder interests of a combining company which either retain or receive the larger portion of the voting rights in the combined corporation." Thus, even when no single former shareholder group of the combining entities individually obtains more than a 50 percent ownership interest in the new combined entity, the staff believes that the shareholder group receiving the largest ownership interest in the combined company should be presumed to be the acquirer unless objective and verifiable evidence rebuts that presumption and supports the identification of a different shareholder group as the acquirer for accounting purposes."

In this instance, application of the above guidance would result in Company A, whose shareholders received the largest voting percentage in the combined company, being viewed as the accounting acquirer rather than either of the other combining companies or Shareholder X. The staff believes that the combined company had appropriately interpreted the guidance provided in APB 16 and SAB 97, which focuses on identifying former shareholder groups of combining companies rather than on individual members in common among those groups. As a result, the staff did not object to the identification of Company A as the accounting acquirer.

Deferred Revenue in a Purchase Business Combination

The last subject I would like to cover is one that appears to be arising with increasing frequency, particularly in the software industry. The issue deals with the appropriate accounting for deferred revenue in a purchase business combination. Given the requirements necessary for revenue recognition under SOP 97-2,8 it is not unusual for companies in the software industry to have deferred revenue recorded on their balance sheets. The issue is not, however, limited to the software industry. For example, Company A, a registrant in the health club industry, has recorded significant levels of deferred revenue resulting from the receipt of nonrefundable membership initiation fees. In addition, Company A receives monthly dues from its customers which are in excess of any costs necessary to service the membership contracts and which provide a market return on such services. Company A is acquired in a purchase business combination by Company B. The issue is how Company B should consider Company A's deferred revenue balance in its allocation of acquisition cost under APB 16.

APB 16, paragraph 88(i), states that other liabilities and commitments assumed in a purchase business combination should be recorded at the present values of the amounts to be paid to settle the obligations using appropriate current interest rates. A target company's deferred revenue balance at the date of acquisition is generally not the amount that would be required to settle the underlying contractual performance obligation. The staff believes that an acquirer should record a liability for the fair value of the contractual performance obligation at the date of acquisition based upon the nature of the activities to be performed, and the related costs to be incurred, after consummation. The fair value should consider the current market rates for performing the remaining services or providing the remaining products, if any, and also any proceeds yet to be received under the arrangement. The ultimate result of the purchase accounting should be that the acquirer will record a current market profit margin on the assumed obligation to perform services or provide products after the consummation of the business combination.

In determining the fair value of an assumed contractual performance obligation, no margin may be included for elements of the service or production process, such as the selling effort, that are completed prior to consummation. In addition, the current market profit margin must be just that - a market based profit margin - and not a profit margin based on entity or buyer specific attributes. The current market profit margin must take into account what the "market" as a whole would charge to assume the obligation to perform the remaining services or provide the remaining products.9 For example, while a software company may experience an 80 or 90 percent profit margin on software packages sold in bundled arrangements, it would likely not have an 80 or 90 percent profit margin on telephone support services, or shipping and handling, that may remain to be performed after consummation date. In addition, revenue that has been deferred under SOP 97-2 solely due to extended payment terms will not represent an assumed obligation to the acquirer. In no case should the deferred revenue balance of the target company simply be carried over to the accounts of the acquirer.

It should be noted that a target company's deferred revenue may also not represent an assumed liability if the additional fees to be received for the performance obligation represent fair value for the services to be rendered or the products to be delivered. In addition, APB 16 does not require that vendor specific objective evidence exist to support the fair value of the performance obligation, as contrasted with the requirements in SOP 97-2 for revenue recognition.

In the case of Company A, the staff observed that the ongoing monthly dues for club membership were sufficient to provide at least a fair market return on those services. As a result, the staff believes a liability did not exist at the acquisition date for the underlying performance obligation.


That concludes my prepared remarks. I will be glad to respond to any questions at the conclusion of this session.


1 See "Current Accounting Projects" – Remarks of Paul R. Kepple, Professional Accounting Fellow, Office of the Chief Accountant, Securities and Exchange Commission, at the 1998 Twenty-Sixth Annual National Conference on Current SEC Developments, Washington, DC, December 8, 1998, available at www.sec.gov/news/speeches/spch234.htm.
2 Accounting Principles Board Opinion No. 16, Business Combinations.
3 Accounting Principles Board Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock.
4 See Emerging Issues Task Force Issue No. 96-16, Investor's Accounting for an Investee When the Investor Has a Majority of the Voting Interest but the Minority Shareholder or Shareholders Have Certain Approval or Veto Rights, for further discussion and description of participating and protective rights.
5 FASB Interpretation No. 35, Criteria for Applying the Equity Method of Accounting for Investments in Common Stock.
6 Subject to the accounting guidance in FASB Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities.
7 Staff Accounting Bulletin No. 97, The inappropriate application of Staff Accounting Bulletin No. 48, "Transfers of Nonmonetary Assets by Promoters or Shareholders," to purchase business combinations consummated just prior to or concurrent with an initial public offering, and the identification of an accounting acquirer in accordance with APB Opinion No. 16, "Business Combinations," for purchase business combinations involving more than two entities, codified in SAB Topic 2.A.2 and 2.A.8.
8 AICPA Statement of Position 97-2, Software Revenue Recognition, as amended.
9 Consistent with the definition of fair value in FASB Statements of Financial Accounting Standards Nos. 107, 121, 123 and 133.


Modified: 07/07/2005