The Financial Accounting Standards Board recently issued Staff Position No. 141(R)-1, Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies, which provides new guidance that changes the accounting treatment of contingent assets and liabilities in mergers and acquisitions and other business combinations under FASB Statement No. 141 (revised 2007), Business Combinations.  These changes will be welcome by many who felt that the prior rules were overly complicated and likely to result in the disclosure of confidential information regarding litigation and similar matters in the financial statements. 

This Update offers practical guidance for companies regarding FASB's new guidance.

Effective Date

FAS 141(R)-1 is effective for contingent assets and contingent liabilities acquired in business combinations consummated on or after the beginning of the first annual reporting period beginning on or after December 15, 2008.  For calendar year-end companies, these changes are effective for all business combinations with an acquisition date that is on or after January 1, 2009. 

Background

Since 2001, FASB has required companies to use the purchase price financial accounting method for business combinations, under which the cost of the acquired assets is recorded based on an allocation of the purchase price among the assets.  In December 2007, FASB substantially refined these requirements with the release of FAS 141(R), which required that companies recognize assets acquired and liabilities assumed in a business combination, including most contingent assets and contingent liabilities, at their relative fair values. 

FAS 141(R) reflects two important accounting trends with broad implications.

• Fair Value Recognition for Assets.  First, it reflects the move toward recording assets at their fair values, rather than their historical cost.
• Convergence of GAAP and IFRS.  Second, FAS 141(R) is driven in part by the planned convergence of United States GAAP (generally accepted accounting principles) and IFRS (International Financial Reporting Standards).  FAS 141(R) was issued as part of a joint project between FASB and the International Accounting Standards Board.

Concerns About Contingent Assets and Liabilities

Lawyers and others reacted strongly to the changes in FAS 141(R).  Many found the rules for contingent assets and liabilities particularly objectionable—feeling that they were overly complicated and likely to require the release of confidential information.

• Distinguishing "Contractual" and "Noncontractual" Contingencies.  FAS 141(R) placed substantial importance on distinguishing "contractual" assets and liabilities, which companies had to value in virtually all cases, and "noncontractual" assets and liabilities (e.g., litigation), which companies had to value only when they were "more likely than not" to give rise to an asset or liability.
• No Valuation Guidance.  FAS 141(R) required companies to value contingent assets and liabilities, but provided no material guidance on how companies should value these contingent assets and liabilities.
• Requiring Subsequent Measurement.  FAS 141(R) required companies to constantly revaluate contingent assets and liabilities when new information became available and provided a methodology for companies to recognize the changes in the value of those assets and liabilities.  Many feared this methodology would result in understating contingent assets and overstating contingent liabilities, potentially distorting subsequent financial statements.
• Risks of Disclosing Contingent Liabilities.  Many believed FAS 141(R) increased the likelihood that companies would have to disclose confidential and potentially damaging information regarding pending litigation in their financial statements or otherwise.  For example, disclosing litigation information to a third-party valuation expert for purposes of valuing the contingent liability might constitute a breach of the attorney-client privilege, which would open this information to full discovery.

FASB Response—FAS 141(R)-1

New Guidance Partially Reinstates FAS 141.  In response to the widespread criticism, FASB issued Staff Position No. 141(R)-1.  Although this new guidance purports to amend and clarify FAS 141(R), in many ways the guidance reinstates the guidance provided in FAS 141 for accounting for contingent assets and liabilities (prior to the 2007 amendments).  Specifically, the new guidance implemented the following changes:

• Eliminates Contractual Versus Noncontractual Distinction.  The new guidance eliminates the distinction between contractual and noncontractual contingencies.  
• "Probable" Standard for Recognizing Contingencies.  The new guidance replaced FAS 141(R)’s "more likely than not" standard with the "probable" standard for recording contingent assets and liabilities at their fair values.  Under the new standards, a company must recognize contingent assets and liabilities only if the acquisition-date fair values can be determined within the one-year period following the close of the transaction.  Otherwise, the company must recognize the asset or liability arising from a contingency only if
• it is probable that an asset existed or that a liability had been incurred and
• the amount of the asset or liability can be reasonably estimated.

This standard is expected to diminish the recording of contingent items. 

Preserves Some FAS 141(R) Guidance.  FASB preserved some of its prior guidance, specifically providing that the new guidance does not apply to assets or liabilities for which FAS 141(R) provides specific guidance (e.g., contingent consideration arrangements, indemnification assets, and the prohibition against separate valuation allowances for assets reflected at fair value).  See FASB Staff Position No. FAS 141(R)-1, Section 6.

Eliminates Subsequent Measurement.  FAS 141(R)-1 amended the FAS 141(R) requirements by eliminating the subsequent accounting requirements.  Instead, the new guidance mandates that the reporting company "develop a systematic and rational basis for subsequently measuring and accounting for assets and liabilities arising from contingencies depending on their nature," but does not provide any methodology by which this should occur. 

Reduces Required Disclosures.  FAS 141(R)-1 significantly reduces FAS 141(R)'s disclosure requirements for contingencies, under which a reporting company had to disclose the range of expected outcomes for contingencies and, when the company could not estimate a range, the reasons why it could not.  The new guidance more closely mirrors the standards currently in use under FAS 5, and FASB expects it will reduce the likelihood of disclosure of potentially prejudicial information. 

Additional Information

You can find a copy of the full text of FAS 141(R)-1 at http://www.fasb.org/pdf/fsp_fas141r-1.pdf.  You can find discussions of other recent cases, laws, regulations and rule proposals of interest to public companies on our website.