Accounting for business combinations is a complex area of U.S. generally accepted accounting principles (U.S. GAAP). Acquirers' accountants and auditors often have questions about business combination accounting. Questions have also been raised because of recent standards issued the Financial Accounting Standards Board (FASB) addressing the accounting for goodwill, the definition of a business, pushdown accounting, and a private company accounting alternative that impacts which intangible assets are recognized as part of a business combination. Below are some of the questions that most frequently arise when a business combination occurs.
Did I Really Acquire a Business?
In order for there to be a business combination, there must first be an acquisition of a set of assets that meets the definition of a business. Earlier this year the FASB released Accounting Standards Update 2017-01, Business Combinations (Topic 805) Clarifying the Definition of a Business (ASU 2017-01), which clarifies what constitutes a business. ASU 2017-01 establishes a screen, clarifies the definition of an output and requires the acquisition to have inputs and processes that are significant in order to be considered a business. Prior to the adoption ASU 2017-01, entities will continue to follow U.S. GAAP and interpret he definition of a business broadly. For instance, the acquisition of a single hotel or rental property would generally qualify as a business, even if the acquirer and investors think of the acquisition as the purchase of an asset.
Prior to and after the adoption of the new standard, whether a business is acquired does not depend on the terminology used to legally document the acquisition (i.e., it is not relevant if the contract is titled "Asset Purchase") or whether a legal entity was acquired. Once adopted, ASU 2017-01 will require additional effort in evaluating whether a business was acquired. If it is determined that a business is not acquired, the assets acquired are accounted for as an asset acquisition. A critical difference between an asset acquisition and a business combination is that in an asset acquisition, the assets acquired are measured at cost basis instead of fair value. Cost basis includes the transaction costs. Another characteristic of an asset acquisition is that goodwill or bargain gains are not recognized. Rather, the cost is allocated amongst the assets acquired based on relative fair value.
How Much Was Paid for the Acquisition?
Consideration transferred is the amount paid to the selling (former) owners of the business acquired. The term transaction price, which is more commonly used in valuation techniques, is often used interchangeably with the term "consideration transferred." From an accounting perspective, consideration transferred includes only amounts paid or owed to the seller, such as assets transferred, liabilities incurred (including contingent consideration) to the former owners, and equity interests issued by the acquirer. The consideration transferred does not include liabilities that are assumed from the target nor the noncontrolling interests in the target retained by former owners. The consideration transferred is used in determining goodwill or gain on the acquisition and can include cash, other assets, a business, contingent consideration, common preferred equity interests, options, warrants, and members' interest in mutual entities. All of the above examples are measured at fair value. The consideration transferred is also the amount of that is used to prepare disclosures in the financial statements.
In some cases a valuation expert may determine the amount paid for the acquisition will include long-term debt assumed or other liabilities that are not part of consideration transferred from an accounting perspective. Care is often necessary when utilizing a valuation report to prepare the measurement of goodwill and disclosures to ensure the amount of consideration transferred is correctly disclosed under U.S. GAAP.
Is There More Than One Transaction?
Sometimes part of a transaction is excluded from the business combination and accounted for separately. Examples can include employment agreements, settlement of pre-existing relationships, and reimbursement to the acquiree for the acquirer's acquisition costs. These types of transactions are evaluated to determine if they are part of the business combination or a separate transaction. The evaluation involves considering whether these transactions are primarily entered into for the benefit of the acquiree (part of the business combination) or by the acquirer, or primarily for the benefit of the acquirer or combined entity (separate transaction).
What Assets and Liabilities Need to be Recognized?
Assets and liabilities are measured and recognized as part of a business combination when they are identifiable. Identifiable assets have probable future economic benefits obtained or controlled as part of the transaction. Liabilities are identifiable if there are probable future sacrifices of economic benefits arising from present obligations to transfer assets or provide services to other entities in the future as part of the transaction. A typical challenge is the determination of which intangible assets should be recognized in the financial statements as amounts separate from goodwill.
Intangible assets should be separated from goodwill when they arise from contractual or legal rights, or they can be separated from the business (sold or transferred independently in exchange for value). Some common examples of contractual intangible assets include franchise rights, customer and supplier contracts, patents, leases and customer relationships, while those that are separable may include customer lists and unpatented technology.
Customer relationships are considered to meet the contractual or legal rights characteristic if the target has a practice of entering into contracts with its customers. When this practice exists, whether it is through service contracts, sales/purchase orders, supply agreements or similar arrangements, the customer relationship is recognized and measured as a separate intangible asset. Existing in-place contracts, including backlog, may also exist and be measured as a separate asset. If there is not a past practice of establishing customer arrangements through contracts, then the customer relationship would be subsumed into goodwill.
A customer list is a different type of intangible assets from a customer relationship. A customer list may meet the criterion of being separable from the acquired business in order to be recognized separately from goodwill. This occurs when information, such as names, addresses, phone numbers of customers exist, the information is not restricted from being sold to third parties, and third parties would exchange value to purchase the list on its own. The value of a customer list can vary greatly depending on the industry, and in some cases may not be material to the financial statements.
A common question of private companies is whether to elect the private company accounting alternative for the recognition of intangible assets. Under the alternative they do not recognize customer-related intangible assets and noncompetition agreements that are not capable of being sold or licensed separately from other business assets. The value of any non-recognized assets will be subsumed into goodwill. Customer relationships and in-place contracts often qualify for the accounting alternative and would not need to be valued; however separable customer lists and contracts that are unfavorable (liabilities) do not qualify for the accounting alternative.
How Are the Assets and Liabilities Measured?
Almost all identifiable assets and liabilities acquired as part of the business combination are measured at fair value at the date of the acquisition. Fair value is the price that would be received to sell the asset or transfer the liability in an orderly transaction between market participants. The determination of fair value is done in compliance with accounting standard contained in ASC Topic 820, Fair Value. Although the use of a valuation expert is not required by U.S. GAAP, most companies choose to use a valuation expert to assist in measuring long-term or hard-to-value assets and liabilities (such as intangibles) because they require sophisticated valuation models and the careful selection of inputs into those models. Three approaches exist to value assets and liabilities: market, income, and cost. Considering each approach and valuation technique in order to select the best one for each type of asset can be a complex, time consuming, and a difficult task.
In contrast, most companies find that they are able to measure working capital assets and liabilities internally due to their short duration and simpler valuation techniques. Keep in mind that whatever valuation technique is used, the determination of fair value results in a new basis for the asset and there should be no allowance or contra accounts, such as an allowance for bad debts for accounts receivable or accumulated depreciation for property, plant, and equipment, reported in the financial statements as of the date of acquisition.
Some assets and liabilities are not measured at fair value. Depending on the nature of the asset, they may be measured as computed in other accounting guidance, use specified valuation techniques, or use techniques that are similar to fair value but exclude components of the contracts. Assets and liabilities not measured at fair value include:
- Income taxes
- Employee benefit obligations
- Share-based payments
- Pre-acquisition contingencies
- Reacquired rights
- Assets held for sale
What Is Pushdown Accounting?
It may be desirable to use pushdown accounting. With pushdown accounting, the acquiree applies the step-up in basis that would have resulted from the acquisition method being applied to the standalone statements of the acquiree. The advantages of pushdown accounting include a more accurate reflection of assets and liabilities in the stand alone financial statements of the acquired business and easier accounting for consolidating entries. The election applies to each change-in-control event, such as cash transfers, contracts and changes in the primary beneficiary of variable interest entities.
The election also requires that goodwill be pushed down and bargain purchase gains not be recognized by the acquiree. The acquiree may also recognize acquisition-related liabilities of the acquirer if the liabilities are also the acquiree's obligation.
Once the pushdown accounting policy is elected, it cannot be reversed. If it is not elected when a change in control event has occurred, it can be applied in a later period as a change in accounting principles.
Should Goodwill be Amortized?
U.S. GAAP includes two different models for accounting for goodwill. The standard model is to test goodwill for impairment at least annually. The second model, an accounting alternative available only to private companies, requires goodwill to be amortized over a period not exceeding 10 years and only requires impairment tests when a triggering event occurs. If a private company elects the accounting alternative for the recognition of intangible assets, it is required to amortize goodwill.
Considerations for companies that have the opportunity to choose their accounting model for goodwill include the expected annual cost of testing for impairment and the preferences of their financial statement users.
Importantly, the standard impairment model is due for a significant change. An accounting standard update issued this year simplified the required annual goodwill impairment test. Once adopted the revision eliminates the computation of implied fair value (formerly "Step 2" of the impairment process). The revised model will continue to include an optional qualitative assessment (formerly "step 0") and a quantitative test (formerly "Step 1"). The elimination of Step 2 will result in a decrease in costs related to the testing of impairment for those entities that previously failed the Step 1 test.
The new simplified test for goodwill is effective for SEC filers for fiscal years beginning after Dec. 15, 2019. Other public business entities adopt the new impairment test after Dec. 15, 2020, and private entities must adopt it by Dec. 15, 2021. Early adoption is permitted after Jan. 1, 2017. Preferability analysis is required to switch from the Private Company Council accounting alternative to amortize goodwill.
For More Information
If you have specific comments, questions or concerns about business combinations, please contact Mark Winiarski or Brad Hale of MHM's Professional Standards Group. Mark can be reached at 816.945.5614 or email@example.com. Brad can be reached at 727.572.1400 or firstname.lastname@example.org.
Published on September 05, 2017