It is no secret that 2021 was a historic year for mergers and acquisitions (M&A). Harvard Law School Forum on Corporate Governance recently noted that records were broken in M&A volume and the number of M&A transactions both in the U.S. and globally. These, along with private equity transactions, SPAC transactions, IPOs, etc., contributed to the highest total deal volume to date with over $5.8 trillion in deals. Though SPAC transactions have slowed in 2022, other forms of business combination activity continue, especially in the technology, software, and life sciences sectors. This is a good opportunity to provide a few helpful reminders for acquisition accounting and instances of accounting topics that can be problematic in practice.
The Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) Topic 805, Business Combinations addresses the accounting for acquisitions. If you are working through an acquisition (or might be in the near future), be mindful of the following common pitfalls:
1. Not identifying all consideration
Determining the aggregate consideration paid can be more difficult than simply using the purchase price amount in the offer letter or purchase agreement. This is because many purchase agreements include transfers of more than a simple cash value, including transfers of other assets, payments made on behalf of the sellers, contingent payment arrangements after the initial wire transfer as well as issuance of equity interests in the new entity. Consideration is the fair value of all assets transferred plus liabilities incurred to the seller and equity interest issued by the acquirer. For instance, transaction costs such as legal or due diligence expenses or liabilities paid for the benefit of the seller should be included in total consideration.
In contrast, items that settle previous relationships or payments for the benefit of the purchaser should not be included in total consideration. For example, the following transactions are considered to be separate, and not included in the acquisition accounting:
- A transaction that, in effect, settles a pre-existing relationship
- A transaction that, in effect, compensates employees or former owners for future service
- A transaction that, in effect, reimburses the seller for paying the purchaser’s acquisition related costs
2. Capitalizing acquirer transaction costs
This pitfall typically occurs from analogizing acquisition accounting to the purchases of property, plant, and equipment, where all costs are capitalized to have the asset in place. This could also be continued fallout from the former standard that permitted capitalization of these costs. In either case, capitalization of transaction costs is not permissible in business combination or acquisition accounting. Transaction costs incurred by the purchaser are recognized as period expenses. However, there is one exception in which the costs to issue debt or equity securities shall be recognized in accordance with other applicable guidance.
3. Failing to determine appropriate fair value or need for third-party specialists
Fair value determinations are not solely limited to determining total consideration. Acquisition accounting is a “fresh start” accounting concept whereby the purchaser is required to measure all identified assets acquired and liabilities assumed at fair value based upon the principle of highest and best use. In many instances, organizations dismiss the importance of the fair value adjustments in attempts to “save money” or belief that their companies have the capabilities to perform these valuations on their own. We do not discredit that many companies are capable to perform these assessments. However, we have experienced that the money saved by not hiring third-party specialists is often limited, or at least mitigated to some extent, due to complexities and difficultly of performing the valuations (particularly when completed from scratch) and the opportunity cost of not focusing on their core competencies. At a minimum, there may be a perception of lost savings as a result of increased “headaches” during the audit process as well as additional time spent auditing these calculations.
While not intended to be a comprehensive list, the following are rules and accounting requirements that purchasers should keep in mind in performing their own fair value assessments for assets acquired and liabilities assumed at fair value. At the acquisition date, the purchaser should consider doing the following:
- Not recognize a separate valuation allowance for assets with uncertainty about future cash flows (including accounts receivable and inventory). In contrast, these assets are adjusted to new carrying values that incorporate this adjustment to stay consistent with presenting at fair value. Any adjustments reducing their value at the acquisition are akin to impairment accounting guidance and cannot be restored after the opening balance sheet (and provisional period). Additionally, if these amounts are not paid or written off during the period between the acquisition date and reporting date, then the assets should be tracked separately to ensure proper calculation of subsequent allowance estimates.
- Adjust raw material, work-in-process, and finished good inventory to fair value. Fair value for accounting purposes is considered to be the exit price, meaning the price that would be received to sell an asset or paid to transfer a liability. In applying the fair value concepts to inventory, raw materials are recognized at the market prices for which they could be sold in their current state (which may be book balance if held under the first in, first out method). Work-in-process is (1) the selling price for the eventual finished goods less the costs to complete to finished state, (2) less costs of selling efforts, i.e., marketing, and (3) less a reasonable profit margin (which should be higher than a finished goods profit margin).
- Account for revenue contracts acquired as if they had originated the contracts in accordance with ASC 606. The FASB issued Accounting Standards Update 2021-08 (“ASU 2021-08”) in October 2021, which changed the way in which deferred revenue and contract liabilities acquired in a business combination are accounted for. Under ASU 2021-08, purchasers no longer have to recognize contract assets and contract liabilities acquired as part of a business combination at fair value. This change will generally result in the acquirer recognizing contract assets and contract liabilities acquired at amounts consistent with those recorded by the acquiree immediately before the acquisition date. There may be circumstances in which the acquirer cannot rely on the acquiree’s ASC 606 accounting including, but not limited to:
- The acquiree’s revenue recognition policies are different from those applied by the acquirer, and the acquirer elects to conform the acquiree’s accounting to their policy at the acquisition date
- The acquiree does not follow US GAAP
- There are errors identified in the acquiree’s accounting under ASC 606
In these cases, an independent assessment of the acquired contract balances should be performed as of the acquisition date utilizing the guidance as found in ASC 606.
- Recognize contingent consideration arrangements at fair value in the opening balance sheet. These arrangements are often based upon some form of performance metric (EBITDA, revenue, performance goal, etc.), so their uncertainty makes it difficult to develop a fair value. The valuation approach will depend largely on the nature of the arrangement and structure of consideration to be paid. Subsequent re-measurement adjustments to the fair value, until final settlement, are recognized in earnings after the opening balance sheet at each reporting period.
- Evaluate contracts for favorable or unfavorable terms with current market conditions and pricing. Any contracts that have committed purchase prices that differ from the current values readily available, including lease agreements, will result in intangible assets or liabilities.
- Recognize separately from goodwill any identifiable intangible assets if they are either contractual or legal rights, or if they are capable of being separated from the acquired company. These assets may include, but are not limited to, customer lists, non-compete agreements, tradenames, and patents. However, as further discussed below, the acquired company may adopt the Private Company Council (PCC) accounting alternatives that provide some relief for the recognition and fair value for intangibles. Calculations of fair value for these assets are where an acquirer will most often utilize a third-party specialist. Note that all assets (of significance) should be recorded at fair value or the exit price regardless of whether management intends to use them.
- Not assume that the transaction was only for certain assets and fail to apply full business combination accounting. Most transactions result in applying business combination accounting. A strong indicator that a business was purchased is the existence of goodwill.
4. Improper accounting for in-process research and development
Some organizations struggle with acquired in-process research and development (IPR&D) costs and how they should be accounted for in the opening balance sheet. Previous business combination accounting, as well as current research and development accounting guidance, may be root causes for some of the recent confusion. In any case, IPR&D is capitalized regardless of whether there is an alternative future use, and any uncertainty would be reflected in the assigned fair value. After acquisition, the IPR&D is considered to have an indefinite life until the IPR&D is complete or the project is abandoned, at which point it is assessed for potential impairment and useful life.
5. Insufficient accounting personnel time
Acquiring a business is often a very time intensive process that requires learning the prior entity’s processes. This creates additional complexity in evaluating and deciding the most advantageous integration plan. Integrating the entities could mean either running separate systems, e.g., accounting package, payroll, etc., or converting over to one of the acquirer’s applications. In addition, especially for public companies, there should be consideration of the control environment and whether the acquirer should push down its internal control infrastructure. This process often takes an inordinate amount of time, which places additional pressure on accounting personnel who would be applying the complicated and unfamiliar business combination accounting. Without sufficient staffing, or an investment in the integration plan, there is risk of inaccurate accounting records and exhausted staff. Obtaining temporary help may help mitigate these issues.
6. Unaware of the measurement period simplification
Legacy guidance requires that measurement period adjustments (and their associated disclosures) are made within one year retrospectively to the opening balance sheet for facts and circumstances that existed as of the balance sheet date. While that does not seem burdensome in principle, acquisition disclosures are complex, and modifying the information in subsequent filings can be cumbersome. For this reason, relief on a retrospective basis and associated subsequent disclosures can result in significant savings for public companies (and other organizations that provide interim information). To ease this complexity and burden, the FASB provided relief in September 2015 with an update that requires a purchaser recognize adjustments to estimated amounts that are identified during the measurement period in the reporting period in which the adjustment amounts are determined, rather than retrospective adjustment to amounts previously reported. In essence, the update eliminates the need to retrospectively adjust previously reported information and disclosures, and merely provide and recognize the adjustments as they are identified during the one-year measurement period.
7. Unaware of Private Company Council alternatives/relief
Many nonpublic companies are still unaware of the PCC and their alternative accounting simplification and relief efforts. To simplify some of the fair value considerations in acquisition accounting the PCC guidance provides relief for identifying intangible assets whereby companies no longer must recognize separately from goodwill customer-related intangible assets not capable of being sold or licensed independently. However, non-compete agreements and certain customer-related intangibles, such as mortgage servicing rights, commodity supply contracts, core deposits, and customer lists would continue to be separately recognized if they are able to be sold or licensed. While this relief seems minor, it can save companies extensive time, effort, and expense in applying acquisition accounting. In addition, it can reduce the time and expense of valuation experts in determining opening balance sheet fair value accounting. The relief does have some fine print to adoption, and companies who elect to adopt the intangible simplification must also adopt the goodwill simplification which requires amortization of goodwill over a ten-year period or less. In reducing the complexity for companies to identify intangible assets, organizations are essentially recording more finite-lived assets into goodwill with its adoption. To mitigate this accounting result in the long term, the PCC requires the amortization of goodwill. If you were not aware of PCC alternatives and feel you may have missed an opportunity to elect them in sufficient time, do not fret. During 2016, FASB provided additional relief and removed the original effective dates for the PCC alternatives, thereby allowing companies to adopt the accounting alternatives in later periods. In addition, this update also permits private companies to forgo the preferability assessment for the first-time election of these PCC alternatives, which is generally required for changes in accounting policies.
8. Not performing due diligence
While this pitfall is not a technical accounting matter, it can be costly to companies who are in midst of an acquisition. Sellers often believe their business is more valuable than buyers desire to pay. To reconcile the two opinions in the negotiation, many purchase agreements will include a final net settlement for the transaction using a calculation based upon performance after the acquisition, which is often based upon net working capital, earnings, EBITDA, or a negotiated contingent payment arrangement based upon an agreed upon metric. These payments can often be substantial cash settlements between the parties. As such, companies who have not performed due diligence can be blindsided by large payments after paying the initial acquisition price. Buyers perform due diligence in an effort to better understand what they are buying and to minimize the uncertainty of these final settlements. In a less technical sense, it is similar to a home inspection before purchasing a home. Continuing with the analogy, the costs expended in legal and accounting fees, much like home inspectors, can save prospective buyers expense and potential headaches, or at a minimum provide better clarity of what the company is buying. Potential buyers should consider performing sufficient due diligence on acquisitions before closing as well as having an audit of the acquiree if not already performed.
How FORVIS Can Help
While the examples above are by no means a comprehensive list of pitfalls in applying acquisition accounting, they are meant to illustrate that the challenges and complexity of business combinations extend beyond the initial negotiation, making the subsequent accounting and fair value considerations potentially difficult. FORVIS has experience in performing buy-side and sell-side due diligence, as well as proficiency in helping clients with associated assurance and tax services for acquisitions.
Reach out to a professional at FORVIS or submit the Contact Us form below if you have questions.