On December 23, 2014, the Financial Accounting Standards Board (FASB) issued ASU No. 2014-18, Business Combinations (Topic 805): Accounting for Identifiable Intangible Assets in a Business Combination (ASU 2014-18). A proposal from the Private Company Council (PCC), ASU 2014-18 provides a qualifying private company an election to record certain intangible assets as part of goodwill rather than as separately identified intangible assets, when applying the acquisition method in transactions such as business combinations.
ASU 2014-18 permits qualifying private companies an election to account for customer-related intangible assets that cannot be sold or licensed independently and noncompetition agreements as part of goodwill in transactions accounted for under the acquisition method, such as a business combination.
Private companies electing the option may reduce the costs of compliance when accounting for these transactions, but must carefully weigh whether adoption is best for their circumstances.
A private company electing this guidance must also elect to amortize goodwill as provided by ASU No. 2014-02 Accounting for Goodwill.
The election is available upon the first qualifying transaction that occurs after the beginning of the first annual period starting after December 15, 2015, but may be adopted early for any financial statements not yet made available for issuance. See the summary of Significant Changes for the key provisions of ASU 2014-18.
The basic premise of ASU 2014-18 is to allow a qualifying private company to identify fewer intangible assets which must be separately accounted for, in order to potentially reduce the cost of compliance associated with the fair value measurement and subsequent accounting that result from qualifying transactions.
Effect of the Election
If a qualifying private company elects the accounting alternative under ASU 2014-18 it is excluded from the requirement to account for, and therefore recognize at fair value, intangible assets that meet one of two requirements:
- Customer-related intangible assets unless they are capable of being sold or licensed independently from other assets of a business, and
- Noncompetition agreements.
Entities within the scope of ASU 2014-18 are limited to certain private companies. A private company in this context is any entity that does not meet the definition of a public business entity, the definition of which was issued by the FASB in December of 2013. The definition of a private company also excludes not-for-profit entities and employee benefit plans.
The types of transactions that are within the scope of the alternative that may be elected under ASU 2014-18 are:
- Business combinations accounted for under the acquisition method under ASC Topic 805 Business Combinations,
- Investments in an entity accounted for under the equity method under ASC Topic 323 Investments - Equity Method and Joint Ventures, and
- Reorganizations in which the guidance on fresh-start accounting under ASC Topic 852 Reorganizations is applied.
Applicability to stand alone financial statements of a subsidiary:
A not-for-profit entity or public business entity may have a subsidiary or equity method investment in a for-profit private company within the scope of ASU 2014-18. In these circumstances, the subsidiary/investee may elect to apply ASU 2014-18 to its stand alone financial statements. However, the parent/investor entity that is not within the scope of ASU 2014-18 would be required to reverse the effects of the election in preparing its consolidated financial statements or recording the earnings from the equity method investee.
An entity that reports to a parent company or investor with significant influence will therefore want to discuss the application of ASU 2014-18 with the parent or investor prior to adoption to avoid potential increased costs and reducing the usefulness of its financial statements.
A business combination occurs when an entity acquires control of a business, that is an integrated set of activities and assets that consists of inputs, processes and outputs that can be operated for the benefit of the investor or participants. The change in control that results in a business combination can occur in many ways including one entity purchasing the equity, assets or group of assets that constitutes a business from another entity, the issuance or purchase of equity interests that results in a change in control of a business, a change in contractual terms that transfers control of a business, and a change resulting in an entity becoming the primary beneficiary of a variable interest entity.
The acquisition method does not apply when one entity obtains control of another entity if both entities were previously under common control; therefore ASU 2014-18 would not apply to common control transactions. However, an entity that experiences a change in control that adopts the guidance on pushdown accounting and therefore applies the acquisition method to its stand alone financial statements, would able to elect this accounting alternative if it is a qualifying private company.
Equity method investments
When an entity (investor) acquires an equity interest in another entity (investee) that provides it with significant influence, but not control over the investee the investor accounts for its ownership interest under the equity method. Often the purchase price of the equity interest is different than the historical cost basis as reported on the investee's financial statements. As a result, the investor accounts for the difference between the amount paid and its proportionate share of the book value of the equity interest as reported on the investee's historical cost basis financial statements by applying the acquisition method. The results of the fair value determination under the acquisition method are compared to the book value of the net assets; this basis difference is tracked by the investor in order to determine its reported earnings in the equity method investment.
Example of a qualifying equity method transaction:
Corporation A pays $1,000,000 to the owner of Corporation B for a 20% equity interest in Corporation B. The book value of equity as reported in Corporation B's financial statements at the time of the purchase is $3,500,000; therefore the book value of the 20% interest acquired by Corporation A is $700,000. Corporation A applies the acquisition method to allocate the additional $300,000 of its investment to differences in the fair value and reported carrying value of Corporation B's underlying assets and liabilities acquired, including intangible assets acquired as a result of the transaction.
Fresh start accounting
Fresh start accounting is applicable to entities emerging from bankruptcy that meet two criteria:
- The reorganization value of the assets of the emerging entity immediately before the date the reorganization plan is confirmed is less than the total of all post-petition liabilities and allowed claims, and
- Holders of existing voting shares immediately before confirmation of the bankruptcy plan substantively, and not temporarily, receive less than 50 percent of the voting shares of the emerging entity.
When adopting fresh start accounting an entity applies the acquisition method and therefore the reorganization qualifies for election of the provisions of ASU 2014-18.
Acquisition Accounting Requirements
Application of the acquisition method requires that the identifiable assets, liabilities and noncontrolling interest in the acquiree to be measured at fair value (as determined in accordance with ASC Topic 820 Fair Value Measurement).
An identifiable asset is defined as an asset that meets one of the following two criteria:
- it arises from a contractual or other legal right, regardless of whether it is transferable or separable from the entity or other rights and obligations, or
- it is capable of being sold, transferred, licensed, rented or exchanged either individually or together with other assets
Fair Value under Topic 820
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
Refer to our substance of the standard discussing fair value measurements (see Substance of the Standard: FASB Statement No. 157: Fair Value Measurements) for additional information.
These two criteria result in the identification of tangible assets of the entity as well as numerous intangible assets which may include customer lists, in-place customer contracts and leases, customer relationships, noncompete agreements and more, all of which are required to be reported at fair value on the acquisition date.
As discussed earlier, if an entity elects the provisions under ASU 2014-18 they are excluded from the requirement to determine fair value of the customer-related intangible assets that cannot be sold separately and noncompetition agreements that would otherwise be required to be measured under the acquisition method.
An entity making this election may not choose to recognize certain customer-related intangibles or noncompetition agreements that meet the criteria and not recognize others. Once elected, the accounting alternative must be applied to all qualifying intangible assets associated with the transaction and for each business combination or other qualifying transaction that occurs subsequent to the election to apply the alternative in ASU 2014-18.
Customer-related intangible assets
Evaluating the applicability of the alternative to customer-related intangible assets that are not capable of being sold or licensed independently is the more difficult to apply than the guidance on noncompetition agreements. Certain types of intangible assets are explicitly excluded from the election, (e.g., lease agreements, mortgage servicing rights, and contract assets under ASC Topic 606 Revenue from Contracts with Customers). In addition, accounts or contracts receivable, unbilled earnings on contracts, and notes receivable with customers would not qualify for the election and must continue to be recorded at fair value under the acquisition method.
Contract Assets under Topic 606
Topic 606 is the new guidance on revenue recognition issued as ASU No. 2014-09 Revenue from Contracts with Customers. A contract asset under Topic 606 is an entity's right to receive payment (consideration) in exchange for goods or services for which control has not yet been transferred. Topic 606 is first applicable for public business entities in the annual period, and interim periods within, beginning after December 15, 2016, and the annual period beginning after December 15, 2017 for all other entities.
Refer to our revenue recognition serial for more information about ASU 2014-09.
The primary challenge of the alternative is properly identifying the types of customer-related intangible assets that can be sold or licensed independently and therefore are required to be recognized separately. The following table lists common types of customer-related intangible assets that may qualify to not be separately recognized at fair value by an entity electing the alternative common types of customer-related intangible assets.
|Commonly Qualify to Not be Recognized ||Commonly Do Not Qualify to Not be Recognized |
|Customer relationships ||Customer lists |
|Backlog || |
|Favorable Contracts with Customers |
Customer-related Intangible Assets: Customer Relationships
A customer relationship represents the existing information an entity has about a customer when the entity has regular contact with the customer and the customer can directly contact the entity. Since the nature of the customer relationship means that it generally cannot be sold or transferred to another entity in the way that some contracts might be, it meets the exemption criteria in ASU 2014-18.
Customer relationships can be the result of a contract, but usually are a separate intangible asset that is distinct from a contractual relationship with a customer. When a contract exists, the analysis of whether the contract itself is an intangible asset that should be recognized is more complex. The in-place customer contracts are discussed in a separate section below.
Customer-related Intangible Assets: Customer Lists
A customer list represents information about a customer that an entity obtains, including names associated with the customer, contact information and historical purchasing activity. Unlike a customer relationship, this information may be compiled and sold to third parties. As a result the customer list will normally not meet the criteria for the election, and will continue to be separately identified and initially recorded at fair value.
In some instances the customer list may not be transferrable. Certain industries may be restricted by regulation or law from providing information to third parties. In addition, other entities may include terms in their contractual relationships that prevent the reselling of customer information. In these circumstances the customer list would not be capable of being sold independently of the other assets of the business and therefore would not be required to be separately identified for an entity electing the provisions of ASU 2014-18.
Customer-related Intangible Assets: Backlog
Backlog is the result of orders and contracts that are received but for which no performance has occurred prior to the date the acquisition method is applied. Under the acquisition method a backlog will meet the criteria for recognition even if the orders are cancellable because they are contractual-legal rights. However, backlogs typically cannot be sold or transferred because the entity is contractually obligated to perform. As the obligation is not transferrable to a third party, the backlog in those circumstances typically meets the scope of the exception and an entity electing ASU 2014-18 would not be required to separately report the backlog intangible asset.
In some cases, depending on industry, it may be possible to sell or transfer the obligation to another entity. In those cases the backlog would not be scoped out of the acquisition method for an entity adopting ASU 2014-18. The types of backlogs that are most likely to be transferable are those related to commodities; commodity contracts are discussed further in the section on contracts with customers.
Customer-related Intangible Assets: Contracts with Customers
In order to establish the fair value of contracts with customers, an entity must compare the pricing contained in the contract for the products or services to be delivered to the current market rate for the same products or services delivered on the same terms. Typically in a business combination in which the contracts are short term in nature, the contracts do not have significant differences between the current market prices and the contractual price; therefore the fair value of the contracts is at or near zero.
In some instances however, significant changes in prices may have occurred between the date the contract was entered into and the date the acquisition method is applied. When this occurs the contract may contain either favorable or unfavorable pricing terms. An unfavorable contract term is one where the contracted price is less than the current market price resulting in a negative fair value. An unfavorable contract is presented as a liability in the financial statements of the acquirer. These types of contracts are excluded from the scope of the election because they are not assets and are still required to be recognized at fair value on the date of acquisition.
In contrast favorable contracts may be within scope of ASU 2014-18. A favorable contract occurs when the contracted price is greater than the current market price. Under the election, favorable contracts are excluded from the requirement to record at fair value under the acquisition method when they are not capable of being sold or licensed independently from other assets. In many cases an entity is not able to sell its contracts because as part of the contract terms, it is the party required to perform and it does not have the ability to transfer its obligation independently from its other assets. However, there are circumstances in which the contracts can be sold to third parties without input from the customer or the customer's agreement to the transfer. The FASB identified the following three examples that may commonly be transferred in this way and may not be eligible for the accounting alternative:
- Servicing Rights - Servicing rights are the result of contracts where an entity assumes responsibilities and the rights of collecting, escrowing funds, and managing the administrative responsibilities for the holder of a financial instrument, such as a loan, in exchange for a fee. In the context of an acquisition these rights typically arise as either separate assets or liabilities when the entity they are acquired from does not also own the underlying financial asset.
- Commodity Supply Contracts - Typically long term agreements which specify amounts and the basis for pricing of commodities.
- Core deposits - Deposits placed in a banks natural market. These deposits are viewed by banks as a stable source of funding.
The other type of intangible asset that qualifies under the election is a noncompetition agreement. These agreements restrict a person or a business's ability to compete with another business, commonly through restrictions on activities performed in a geographic region, industry area or with certain customers. These agreements are commonly associated with business combinations and are normally considered to be part of the assets acquired because they are a legal right, and therefore meet the first criteria of an identifiable asset under the acquisition method.
Entities that elect the provisions of ASU 2014-18 will not recognize any noncompetition agreements when applying the acquisition method.
If the provisions of ASU 2014-18 are adopted, an entity is also required to adopt the provisions associated with the amortization of goodwill as provided in ASU No. 2014-02 Intangibles - Goodwill and Other (ASU 2014-02) (see our Substance of the Standard: Changes in Accounting for Goodwill). Depending on the nature of the transaction, a significant amount of the resulting goodwill may be from fair value of the customer relationships that were subsumed into goodwill. The effect of subsuming the customer relationships may allow an entity to demonstrate that an amortization period for goodwill shorter than the ten year maximum period is appropriate.
ASU 2014-18 does not require additional disclosure within the financial statements when a qualifying transaction occurs, however, adoption of the accounting policy should be disclosed in the summary of accounting policies. An entity continues to be required to provide the applicable disclosures under the acquisition method as prescribed by ASC Topic 805 Business Combinations.
Required disclosures when applying the acquisition method include information about goodwill, including a qualitative description of the factors that make up goodwill, such as intangible assets that do not qualify for separate recognition. Therefore, the existence and nature of the customer-related and noncompete intangible assets that are subsumed into goodwill because of the election of ASU 2014-18 must be described in the notes to the financial statements in the year the acquisition method is applied to a business combination or when applying fresh start accounting. There is no requirement to disclose the fair value of the intangible assets subsumed into goodwill.
When the accounting alternative is applied to a qualifying transaction related to an equity method investment there is not a requirement to describe the differences that gave rise to the basis difference between the amount invested and the book value of the equity of the investee. In these circumstances disclosure is not required about those assets that were subsumed into goodwill within the basis difference when applying the equity method.
Transition and Effective Date
An entity electing the alternative in ASU 2014-18 must apply the accounting policy prospectively to qualifying intangible assets in all future transactions and cannot apply the election retroactively to intangible assets already recognized in the financial statements. If elected, an entity applies the alternative to all future qualifying transactions.
The determination to adopt the accounting alternative provided by ASU 2014-18 becomes effective upon the first qualifying transaction that occurs subsequent to the annual period beginning after December 15, 2015. For an entity that reports on the calendar year basis, the election to apply or not apply the alternative is required on the first transaction occurring after January 1, 2016.
Depending on when the transaction occurs the election is effective either (1) at the beginning of the year in which the transaction occurs and all future periods, or (2) for the interim period the transaction occurs and all future periods. If the transaction occurs in the first annual period beginning after December 15, 2015 the accounting alternative is effective as of the beginning of the year, and if it occurs in a subsequent year it is effective at the beginning of the respective interim period. Thus, for a calendar-year entity if a qualifying transaction occurs between January 1, 2016 and December 31, 2016 the election to apply or not apply the alternative in ASU 2014-18 is effective on January 1st. If the first qualifying transaction occurs anytime after January 1, 2017, the election to apply or not apply the alternative in ASU 2014-18 is effective at the beginning of the interim period in which the transaction occurred.
An entity may also elect to early adopt the alternative provided by ASU 2014-18 for any annual or interim period that has not yet been made available to be issued.
Available to be issued:
Financial statements are available to be issued when they are complete and all approvals have been obtained to issue them. These approvals generally mean management, board of directors and owners, as applicable. It is common for audited financial statements of private companies to be available for issuance at the auditors' report date.
The effective date of adoption is significant because an entity that elects to apply the provisions of ASU 2014-18 is also required to adopt ASU 2014-02 which requires the amortization of goodwill. We believe an entity with existing goodwill that subsequently adopts ASU 2014-18 and had not previously adopted ASU 2014-02 would begin the amortization of goodwill at the beginning of the annual period or the interim period as determined by the effective date of ASU 2014-18.
An entity that does not elect to adopt the accounting alternative during the first eligible transaction after the effective date may not be able to adopt the alternative during a future transaction. Future adoption of the accounting alternative would need to be assessed in accordance with the guidance on changes to accounting principles, which provides that the change in policy must be preferable.
U.S. generally accepted accounting principles (GAAP) presumes that an accounting principle, once adopted, should not be changed for similar events or transactions because consistency from one period to another enhances the usefulness of financial statements. A change in accounting principle after the effective date, in this case after the first qualifying transaction is completed, is allowed if either 1) the transaction or event is clearly different from the previous transactions, or 2) the new principle is preferable.
The narrowness of the scope of ASU 2014-18 indicates that it is unlikely that two qualifying transactions would be clearly different; therefore it is unlikely that a change would qualify under the first condition discussed above.
The requirement to be preferable under the second condition is not clearly defined in U.S. GAAP for a private company. It may be difficult to establish that a change in the decision to apply the alternative in ASU 2014-18 is preferable. A case for preferability would likely include the needs of the financial statement users, regulatory requirements, or a significant financial reporting benefit that did not previously exist.
If an entity does qualify for a change in accounting principle, when that change occurs U.S. GAAP requires that the change is applied retrospectively to all prior periods unless impractical. Therefore, a change in accounting principle for the election of ASU 2014-18 would require recasting prior periods to reflect the impact of the accounting alternative. The retrospective application would be particularly costly in cases where transactions had been previously accounted for under the alternative provided by ASU 2014-18 and therefore valuation information about the intangible assets that would now be required to be separated from goodwill is not readily available. In this situation an entity would need to perform additional valuation work on previous transactions.
An example of a situation where this additional cost may be incurred is when an entity qualifies as a private company and in a subsequent period becomes a public business entity, for instance through a public offering. The resulting restatement of prior period financial statements would result in increasing the costs of the public offering because of the need for management to establish estimates for historical transactions, obtain new valuations for the intangible assets in those transactions, and to have the new estimates and valuation work audited.
Impacts on Valuation
In order to properly account for the transaction many entities obtain a valuation report from a qualified valuation specialist upon completion of a significant business combination, investment in an equity method investment with a large basis difference, or when applying fresh start accounting. Whether a valuation report is obtained, or management determines fair value on its own, the amount of effort required may be reduced by electing the alternative in ASU 2014-18. The reduction in effort and cost may result from reducing the amount of information gathering necessary to complete the valuation, reducing the amount of computations necessary to determine fair value of the identified intangible assets, and by reducing the amount of auditing required for those estimates and computations.
The fair value of the customer relationship is often a significant intangible asset in a business combination and one of the most costly to evaluate that may be within the scope of the accounting alternative of ASU 2014-18. In order to estimate the fair value, information is needed about the existing customer base, the past history of the life of customer relationships and the expected future benefit from the existing customer relationships.
The elimination of other customer related intangibles may also reduce the amount of effort required for the valuation, but may initially add additional effort to determine if they are capable of being sold separately.
In addition to the customer related intangibles, some effort may be saved in connection with the noncompetition agreements. While noncompetition agreements are often an asset acquired in connection with a business combination, they are not always significant.
However, benefits associated with a reduction in time and costs to complete an analysis of the fair value of acquired intangible assets may be mitigated due to valuation methodologies used. For instance, use of a multiple period excess earnings model to determine the fair value of other intangible assets may require substantially the same amount of effort.
When the FASB endorsed the PCC proposal on amortization of goodwill they also started work on a project to consider the accounting for goodwill for public business entities and not-for-profit entities. This project agenda includes consideration of changes to goodwill, including simplification of the impairment model and amortization. During November 2014, the Board decided they would begin outreach on a new project on the accounting for identifiable intangible assets in a business combination. The initial intent of this project is to consider whether certain intangible assets should be subsumed into goodwill for all entities similar to the alternative available under ASU 2014-18.
The FASB Staff is currently performing outreach and research to determine the best path for future deliberations. The outcomes of these projects may impact an entity's decisions about electing the amortization of goodwill and the election under ASU 2014-18.
Considerations before Electing to Adopt
When considering any accounting election, the decision on which accounting principle to use should be carefully considered. The decision to elect to apply the alternative allowed by ASU 2014-18 is no different. Some considerations include the nature of the assets that are typically identified for qualifying transactions in the entity's industry, expectations of financial statement users, expected cost savings from adoption, impacts on covenants and contracts, reduction in comparability to other entities within the industry, and the future plans of the reporting entity. The more common concerns to evaluate include:
- Is the value for purposes of acquiring entities or investing in entities heavily reliant on customer-related intangibles that would be subsumed into goodwill? If yes, does electing the alternative result in less useful information, or inadequately explain the purpose for an acquisition or investment?
- Do the owners, lenders, bonding companies or other users of the financial statements expect to see customer-related intangible assets that result from a transaction?
- Does the election of the alternative impact the computation or compliance with financial covenants, or compliance with non-financial covenants?
- Does the election of the alternative on goodwill amortization as required when electing ASU 2014-18 result in negative impact to the financial statement's usefulness, user expectations or contractual arrangements of the entity?
- Does the entity have plans that will cause it to no longer qualify as a private company that may result in retroactively determining the fair value for customer-related intangibles and noncompetition agreements?
When evaluating covenant compliance with non-financial covenants, it is important to note the financial statements prepared using the alternative permitted in ASU 2014-18 result in financial statements that are in compliance with U.S. GAAP, as long as the reporting entity is a qualifying private company and all qualifying transactions are accounted for correctly under the provisions of the update.
If a private company applying the accounting alternative is acquired by a registrant or registers with the Securities and Exchange Commission (SEC), it may be required by the regulator, or acquirer, to restate prior financial statements as if the private company had not made the election to apply this accounting alternative. If restatement were required by the SEC, or the acquirer, it may be necessary to re-audit prior periods.
Every implementation of ASU 2014-18 will be unique, but the following steps can be used to assist in designing an implementation plan:
Step 1: Ensure the entity qualifies to make the election in ASU 2014-18
- The entity is only eligible to adopt the provisions of ASU 2014-18 if it does not meet the definition of a public business entity provided by ASU No. 2013-12 Definition of a Public Business Entity-An Addition to the Master Glossary (see MHM Messenger: Private Company Decision Making Framework & Definition of a Public Business Entity). Additionally, the alternative is not available to not-for-profit entities or employee benefit plans.
Step 2: Identify the transactions that qualify
- Depending on the entity, qualifying transactions may occur frequently and a process or control may be necessary to identify and properly apply the election to business combinations and acquisition of equity method investments.
- The election is made upon the first qualifying transaction, which may not occur for several years.
Step 3: Evaluate the identifiable intangible assets that may qualify for the accounting alternative
- In general customer related intangible assets qualify to be subsumed into goodwill if they are not capable of being sold or licensed independently from other assets of a business.
- Exceptions to general rule are the exclusion of lease agreements and contracts assets from the accounting alternative. In addition, accounts and contracts receivable, unbilled earnings on contracts, and notes receivable with customers would still be separately recognized at fair value by an entity electing the accounting alternative.
- All non-competition agreements that are part of a qualifying transaction are within the scope of the accounting alternative.
Step 4: Ensure the transition requirements are applied properly
- Upon the election to apply the accounting alternative the entity must also adopt, if not previously adopted, the policy to amortize goodwill.
- The standard is applied prospectively and previously existing contract-related intangibles and noncompetition agreements should be retained.
Step 5: Ensure financial statement presentation and disclosures are appropriate
- ASU 2014-18 does not exempt the entity from the qualitative disclosures required to explain what intangibles are subsumed into goodwill. Without electing this alternative those intangibles typically consist of expected synergies, potential future contracts and the in-place workforce. With the adoption of this alternative additional components will include various customer-related intangibles and noncompetition agreements qualifying under the exception.
For More Information
If you have any specific questions or concerns regarding the application of the accounting alternative under ASU 2014-18, please contact James Comito, Mike Loritz or Mark Winiarski of MHM's Professional Standards Group or your MHM or CBIZ Valuation service professional.
Published on February 23, 2015