The accounting rules for mergers and acquisitions can be complicated depending on how a deal is structured. Here are four questions to ask to help you record your transaction correctly under U.S. Generally Accepted Accounting Principles (GAAP).
1. What’s for sale?
There’s an important distinction between acquiring a business vs. an asset or a group of assets. The Financial Accounting Standards Board (FASB) recently updated the guidance to help make this determination.
A business combination is a transaction in which an acquirer gains control over a business. Accounting Standards Update (ASU) No. 2017-01, Business Combinations: Clarifying the Definition of a Business, revises the definition of “business.” As a result, fewer transactions are expected to be subject to the complex business combinations rules.
The new definition goes into effect in 2018 for public companies and 2019 for private ones, although some buyers are likely to apply it early.
The new definition lays out minimum requirements for a set of assets to be considered a business. A business includes:
- An input (such as people, intellectual property or raw materials), and
- A substantive process.
For a set of assets to be considered a business, these mandatory components must have the ability to contribute to the creation of outputs. Outputs are goods or services, investment income, or other revenues resulting from the application of the required processes to the required inputs.
Shortcut to determining what’s for sale
In addition, the updated standard provides a shortcut to help buyers quickly decide what’s for sale: A set of assets is not a business if substantially all the fair value of the acquired gross assets is concentrated in a single asset or a group of similar identifiable assets. A set of assets is considered a business as long as market participants are capable of buying the set and continuing to produce outputs, such as incorporating the set into their own inputs and processes.
Transactions that meet the definition of a business are subject to much more complex financial reporting rules than asset acquisitions. Key differences include the treatment of:
- Goodwill. The buyer recognizes goodwill in a business combination; no goodwill is recognized in an asset acquisition.
- Transaction costs. The buyer expenses transaction costs as incurred in a business combination; these costs are capitalized in an asset acquisition.
This distinction also affects how the buyer handles contingent payments and in-process research and development costs. If a sale involves a business (not just assets), the buyer must follow Accounting Standards Codification (ASC) Topic 805, Business Combinations. For business acquisitions, other parts of the FASB’s guidance — such as the standards on consolidation, fair value measurements, income taxes and share-based payments — may also apply to the transaction.
2. What’s the acquisition date?
For an acquisition that is indeed a business, under Topic 805, it’s important to establish the acquisition date. That’s the date on which the buyer obtains control of the business.
How does a buyer obtain control? Typically, control transfers at closing — when the buyer pays the seller, assumes debt and/or issues stock. But a buyer can sometimes gain control without exchanging any consideration (such as a stapling arrangement or lapse in minority veto rights) or control may be transferred in stages in a so-called “step” acquisition.
The acquisition date becomes the effective date for determining the fair value of assets and liabilities. (See No. 4.) It also starts the clock on the “measurement period.” During the measurement period, the buyer may adjust its initial accounting for the deal, based on information about conditions that existed on the acquisition date but that the buyer wasn’t yet aware of. The measurement period may extend for up to one year from the acquisition date.
In order to make any changes to goodwill, however, the buyer must clearly disclose in the financial statements any provisional items outstanding on the acquisition date. Additionally, measurement period adjustments can’t be made for errors or events happening after the acquisition date.
3. What’s the purchase price?
When the buyer pays cash up front for a business, the purchase price (known as the “fair value of consideration transferred” under U.S. GAAP) is obvious. But more complex deal structures may include the following forms of consideration:
- Shares of stock or stock options in the newly merged company,
- Installment payments,
- Contingent payments (such as earnouts based on revenue or earnings benchmarks),
- Replacement awards (for example, the buyer may be required to compensate the seller’s employees for previously earned stock options), and
- Ongoing employment or consulting agreements with the seller.
These forms of consideration must be analyzed to determine a cash-equivalent purchase price. Some items — such as replacement awards for postcombination services and future employment or consulting agreements with the seller — are specifically excluded from the purchase price under GAAP.
Estimating the fair value of consideration transferred from the buyer to the seller requires the use of estimates. For example, a deal involving contingent payments may call for a discounted cash flow analysis or option pricing models to accurately assess fair value. Buyers often hire outside experts to support these estimates, especially if the company’s financial statements are audited or management is worried about lawsuits from minority shareholders who dissent to the transaction.
4. What’s the fair value of assets acquired and liabilities assumed?
The seller’s balance sheet is a good starting point for identifying the assets acquired and liabilities assumed in a business combination. But some critical items may be missing. Examples include internally developed intangible assets (for example, customer lists, copyrights and patents) and contingent liabilities (for example, IRS inquiries and unemployment claims).
Buyers must identify all assets and liabilities and then allocate the purchase price to them. But there’s one exception: Under ASU No. 2014-18, Business Combinations: Accounting for Identifiable Intangible Assets in a Business Combination, private companies can elect to combine noncompetes and customer-related assets with goodwill, as long as the latter can’t be licensed or sold separately from other assets.
The next step is to measure the fair value of each asset and liability. This exercise can be especially difficult for intangibles (such as brands and trademarks) that tend to be unique and lack comparable market data to rely on. A valuation specialist can help estimate the fair values of these items using unobservable inputs.
After the purchase price is allocated to each identifiable asset and liability, any remaining fair value is assigned to goodwill. Goodwill represents the premium the buyer paid for expected synergies (in terms of, say, expected revenue-building and cost-saving opportunities).
If the purchase price is less than the combined fair value of the seller’s net assets, a bargain sale has occurred and the buyer records a gain on the income statement. Bargain purchases, however, are rare.
After closing, goodwill must be tested for impairment annually and when any “triggering” events occur that might adversely affect the company’s value (such as the loss of a major contract or a major lawsuit). Under ASU No. 2014-02, Intangibles — Goodwill and Other: Accounting for Goodwill, private companies can elect to amortize goodwill over a period of up to 10 years in lieu of annual impairment testing.
A proactive approach
As soon as you start thinking about merging with or acquiring a business, contact your Baker Tilly advisor to help you understand the relevant financial reporting issues and record the transaction with confidence. We can also assist with conducting due diligence and negotiating a deal that minimizes headaches and maximizes shareholder value.
For more information on business combinations and acquisition accounting, or to learn how Baker Tilly specialists can help, contact our team.