The economy has continued to improve over the past few years and that has meant more transactions involving businesses being bought and sold. With that comes the need to properly account for those transactions. The rules under U.S. generally accepted accounting principles (GAAP) can sometimes be complex and application of those rules can often be a challenge. CEOs, CFOs and business owners are well advised to have adequate familiarity with the requirements under the applicable standards because proper application of such standards is critical to achieve correct reporting for acquired businesses.
Get to Know the Guidance
The first thing to understand is where to look for authoritative guidance. The rules that cover accounting for business combinations are codified in Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 805. This standard evolved from guidance that was originally issued in 1970 (APB Opinions 16 and 17), which then was replaced in 2001 by SFAS Nos. 141 and 142, both later revised and then codified under FASB ASC 805. The new guidance eliminated past practices of accounting for business combinations under various alternative methods (purchase, pooling, etc.) and the resulting inconsistencies that come with reporting different accounting for similar transactions.
Understand the Terminology
All business combinations must be reported using the acquisition method. The method requires the reporting entity to identify the acquirer for every business combination. Additionally, the reporting entity must recognize intangible assets separately from goodwill based on certain contractual or separability criteria.
At a high level, the acquisition method involves an acquirer recognizing and measuring at fair value, as of the acquisition date, all of the identifiable assets assumed, liabilities assumed and any non-controlling interest in the acquiree.
One of the most important concepts under ASC 805 is that the acquisition method only applies to the acquisition of a business. A business combination only occurs when (a) an entity obtains control and (b) acquires a business. Under ASC 805, a business is defined as an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return directly to investors and other owners. A business consists of (a) inputs, (b) processes and (c) the ability to create outputs (emphasis on ability). If the assets acquired and the liabilities assumed do not meet the definition of a business, then the transaction is simply an asset purchase and the fair value and other requirements under ASC 805 do not apply.
It's also important to recognize that consideration, generally thought of as what you pay to acquire a business, can come in a number of ways. Cash, other assets, a business or subsidiary of the acquirer, contingent consideration, common or preferred equity instruments, options, warrants, and member interests of mutual entities are all examples of consideration.
Applying the Acquisition Method
Proper application of the acquisition method involves some key steps, which are all requirements within the standard:
- Identifying the Acquirer
- Determining the acquisition date
- Recognizing and measuring at fair value the identifiable assets acquired, liabilities assumed and any non-controlling interests
- Measuring the consideration transferred (except in situations where control is obtained without consideration)
Other important considerations when applying ASC 805 to business combinations include the fact that certain transactions are outside the scope of ASC 805 because other guidance under GAAP apply to those transactions. Such transactions include:
- Formation of a joint venture;
- Acquisition of an asset or group of assets that does not meet the definition of a business;
- A combination between two entities under common control;
- A combination between not-for-profit entities, acquisitions of a for-profit business by a not-for-profit entity; and
- Public shell mergers.
These are all exempt from the requirements of ASC 805 and should not be accounted for as a business combination, as defined under this standard.
What to Do with Goodwill and Other Intangible Assets
A discussion of business combinations would not be complete without mentioning goodwill and other intangible assets. Without spelling out the technical definition as defined in the standard, which has several elements, goodwill can essentially be thought of as the excess consideration (plus some other items such as non-controlling interest or a previously held equity interest) less the fair value of the identifiable assets acquired and liabilities assumed as of the acquisition date. This excess consideration (goodwill) must be accounted for separately and should not include other identifiable intangible assets (such as patents or trademarks). Note, however, that under a recent Accounting Standards Update (ASU), private companies may now elect an accounting alternative that allows certain customer-related intangible assets and noncompetition agreements to be included with goodwill (ASU 2014-18).
When in Doubt, Turn to ASC 805
ASC 805 also contains guidance related to some other issues that are regularly encountered when accounting for business combinations. Combinations that occur in stages, control achieved without consideration, contingent consideration, measurement period issues, and acquisition-related costs are all areas that the guidance addresses. A discussion of these areas is outside the scope of this article, but nevertheless, it's important to recognize that guidance exists within a standard that is quite comprehensive.
Whether you represent a smaller private company that is looking to grow via a strategic acquisition or a larger company that regularly considers potential target companies to acquire, understanding the key concepts within the accounting guidance for business combinations is critical to achieve the proper accounting and reporting under GAAP. For companies that need to produce financial statements to outside/external users, it's almost always a good idea to involve your CPA firm early in the process to avoid potential restatements of financial statements that might have already been shared with an individual or management team who uses them.
For additional information about reporting and other information required for business combinations, please contact us.
Published on September 20, 2016