Novelty was the theme of the consultation trends panel at the Conference on Wednesday morning. The panel was moderated by Susan Mercier, Grant Thornton partner, and comprised several accounting firm professionals, including KPMG Department of Professional Practice partner Nick Burgmeier.
"The economic pressures from rising interest rates and general economic uncertainty have affected business combination activity, capital formation and other transactions. These structures often raise accounting issues where the solutions are not obvious."
— Nick Burgmeier, KPMG Partner
Panelists reported consulting on many recent, complex transactions involving nontraditional structures – and they shared a tremendous amount of information about how to analyze similar transactions. They discussed five recurring types of transactions.
Trend #1: Paying vendors with equity
A common theme in 2023 has been using equity (either shares or warrants) to pay vendors. Angela Fergason, PwC partner, noted two reasons for this trend: issuing companies (customers) wanting to conserve cash, and vendors wanting to make strategic investments. Panelists discussed the accounting models that apply to both the customer and vendor when warrants are issued.
Customer’s accounting (issuing equity to a vendor)
Aaron Shaw, Deloitte partner, noted that the warrants typically are measured and classified (as equity or a liability) as a nonemployee award under ASC 718 (stock compensation) but recognized as a cost as if the company paid cash.
The financial instruments guidance becomes relevant only if the warrants are modified after vesting and the vendor is no longer providing goods or services.
Vendor’s accounting (receiving equity from a customer)
Angela Newell, BDO principal, observed that generally the warrants are treated as noncash consideration under ASC 606 (revenue). However, Rahim Ismail, Ernst & Young partner, noted that the accounting is more challenging when the warrants are more complex – e.g. when they vest based on future performance.
There is some diversity in practice, with different perspectives on how vendors navigate the intersection of ASC 606 and other topics such as ASC 815 (derivatives) and 321 (investments).
Panelists have also been seeing transactions in which vendors make equity payments to customers – e.g. to incentivize future purchases. They discussed both the vendor and customer accounting in these transactions.
Vendor’s accounting (issuing equity to a customer)
Fergason explained that the warrants are measured and classified as nonemployee awards under ASC 718. However, the attribution and recognition provisions of ASC 606 also apply, meaning:
the grant date fair value of the warrants reduces the transaction price if the warrants are not related to a distinct good or service;
once the transaction price is reduced, the net amount is recognized under the ASC 606 model, which is not necessarily the same timing as when vesting occurs under ASC 718; and
companies need to evaluate whether an asset should be recorded if the warrants are issued before a committed revenue contract is entered into.
Customer’s accounting (receiving equity from a vendor)
Shaw noted that ASC 705-20 (accounting for consideration) applies to reduce the purchase price of goods or services received from the vendor unless the payments are for distinct goods or services provided to the vendor. For example, if the customer provides advertising services to the vendor, the customer has to determine whether those advertising services are distinct.
Trend #2: Business combinations
Burgmeier observed that deal volumes were down, particularly in late 2022 and early 2023, with the deals completed having complex structures. These transactions typically involve a number of accounting issues.
Burgmeier indicated that when two companies are combining, the accounting acquirer is not always obvious.
ASC 805 (business combinations) lists several indicators, each of which can require a deep level of analysis.
ASC 805 states that a primary beneficiary of a variable interest entity (VIE) is always the accounting acquirer – which can upend the normal analysis and result in the VIE guidance overriding the factors pointing to a transaction being a reverse acquisition. The VIE issue has been prevalent in SPAC transactions and is becoming more prevalent in other combinations.
Newell reported seeing several deals in which contingent consideration is paid to selling shareholders who become the acquirer’s employees, raising the issue of whether this contingent consideration is compensation instead of part of the purchase price.
Under ASC 805, such consideration is compensation if it is automatically forfeited upon voluntary termination, which is a common arrangement in many recent deals.
Additional 'compensation' scenarios
Burgmeier mentioned that compensation issues also arise outside of traditional contingent consideration arrangements. Two examples are when a selling shareholder either (1) transfers its equity but that equity becomes forfeitable upon voluntary termination or (2) sets aside money as a bonus pool for employees that is linked to the employees’ continued service and the selling shareholder is responsible for covering these payments.
Such links to employment require equity payments to be accounted for separately as compensation arrangements.
Trend #3: Royalty monetization
Monetizing future royalties has become a more common mechanism for generating cash. The panel discussed monetizing future royalties associated with intellectual property (IP).
Fergason set the stage by explaining a common scenario in which a biotech company licenses its FDA-approved IP to a pharmaceutical company for an upfront payment and future royalties. In that case, the future royalties qualify for the sales or usage-based royalty exception under ASC 606 to recognize revenue as the subsequent sale or usage occurs.
Ismail reported that to monetize future revenue streams, many companies are entering into a separate arrangement with a finance company to sell the future revenue stream. This arrangement potentially touches several Codification Topics, including ASC 815 (derivatives) and ASC 470-10 (debt) on the sale of future revenues.
The sale of future revenue guidance in ASC 470-10 lists factors to determine whether to characterize the cash received as financing (debt) or deferred revenue. Meeting any one of the factors creates a presumption that the transaction is financing, but in practice it is a high bar to not be considered a financing.
Fergason also noted that when the transaction with the finance company is debt, the biotech continues to account for the royalties from the pharmaceutical company as revenue.
Trend #4: Embedded leases
Fergason discussed a ‘sleeper’ issue that has become prevalent – identifying embedded leases in service contracts that include use of a specific asset. A common example is a contract manufacturing arrangement using equipment customized to the customer’s specifications, but several types of contracts can contain embedded leases – e.g. infrastructure as a service/server hosting arrangements and virtual nursing contracts.
Fergason and Newell discussed four accounting questions relevant to these transactions that will drive the accounting outcome.
Is there an identified asset in the contract or can the service provider provide the service using different assets? Also, what is the service being provided – the use of an asset or the output of that asset?
Does the customer have the right to direct the use of that identified asset and does it obtain substantially all of the economic benefits of that asset?
If there is a lease, can one or both parties elect a practical expedient under ASC 842 (leases) to not separately recognize the embedded lease?
If there is a lease, are there multiple lease components? What if the lease term is longer than the useful lives of certain components?
Trend #5: Virtual power purchase agreements
Another popular transaction in 2023 has been virtual power purchase agreements (VPPAs), which can allow a purchaser to meet clean energy goals without altering its power structure.
Shaw explained that unlike in a traditional power purchase agreement, the purchaser in a VPPA doesn’t take delivery of power. Instead, it pays a fixed price per unit of power and receives a floating price. This power component is settled monthly, similar to a fixed-for-floating swap. The fixed price provides the right to receive renewable energy credits (RECs). The power component and the number of RECs is based on actual production during the settlement period.
Ismail explored the ASC 815 implications, noting that in most instances the contract is not a derivative. If the contract is not a derivative, the buyer evaluates whether the REC should be recorded as an asset or immediately expensed and the accounting for the cash settlement component. Shaw noted there is diversity in practice, but that the FASB has a related project on its technical agenda.
"The complexity of today’s deals often requires companies to navigate multiple Codification Topics to determine the appropriate accounting. A single transaction could involve an analysis of Codification Topics related to business combinations, consolidation, share-based compensation, revenue recognition, leases and more."
— Angie Storm, KPMG Deputy Chief Accountant