Three financial reporting questions to ask with M&As

The accounting rules for mergers and acquisitions (M&As) can be complicated, depending on how a deal is structured. Here are three questions you should ask when recording these transactions under U.S. Generally Accepted Accounting Principles (GAAP).

1. Are you purchasing assets or a business?

The definition of a “business” was revised under Accounting Standards Update (ASU) No. 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business. Transactions that meet the definition of a business are generally subject to more complex financial reporting requirements than asset acquisitions.

The updated guidance was designed to reduce the number of transactions that qualify as business combinations vs. routine deals involving assets. It changed the minimum requirements for a set of assets to be considered a business. A set must, at minimum, include an “input” and a substantive process that together significantly contribute to create “outputs.”

Examples of inputs are people, intellectual property or raw materials. The standard provides guidance to determine whether both an input and a substantive process are present.

The standard also includes two sets of criteria to consider to determine whether a set has outputs. Outputs typically are considered goods or services for customers that provide (or have the ability to provide) a return to the business’s investors in the form of dividends, lower costs or other economic benefits.

In addition, the update provides a screen, or shortcut, to help make a quick call about when a set of assets isn’t a business. The screen requires that, when substantially all the fair value of the gross assets acquired (or disposed of) is concentrated in a single asset or a group of similar identifiable assets, the set isn’t a business.

2. What’s the purchase price?

The purchase price is generally straightforward when the sale of a business is paid with cash or financed by outside loans. However, some deals include noncash consideration, such as noncompete agreements, shares of stock or stock options in the newly merged company, and ongoing employment or consulting agreements for the seller. Likewise, a portion of the payments may be paid in annual installments or contingent on achieving future financial benchmarks, rather than paid upfront at closing. More complex deals also may include replacement awards, which require the buyer to compensate the seller’s employees for previously earned stock options.

In general, deal terms are converted to a cash-equivalent purchase price for financial reporting purposes. For example, a deal involving contingent earnout payments may call for a discounted cash flow analysis or option pricing models to estimate fair value. However, certain items — such as replacement awards for post-acquisition services and future employment or consulting agreements with the seller — are specifically excluded from the purchase price under GAAP.

3. What are the fair values of the items transferred?

Buyers usually hire business valuation experts to estimate the fair value of assets acquired and liabilities assumed in business combinations. This helps preserve auditor independence if the merged business will issue audited financial statements — or if noncontrolling owners are expected to contest the fairness of a transaction after closing.

The valuation process starts by identifying what the acquired company owns (assets) and owes (liabilities). However, some assets and liabilities — such as internally developed intangibles and contingent liabilities — may be missing from the balance sheet. So, it’s important to create a detailed list of all the items that will be included in the deal. ?

Next, the purchase price is allocated among the identified assets and liabilities based on their respective fair values. Accounting Standards Codification (ASC) Topic 820, Fair Value Measurements and Disclosures, defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly market transaction, as opposed to a fire sale or other unusual circumstance.”

Valuators use quantifiable market data and their own expertise to estimate fair value. Topic 820 identifies the following three-tiered hierarchy depending on the judgment used:

·??????Level 1: Public stock prices for the company’s stock,

·??????Level 2: Information based on publicly quoted prices, including older prices from inactive markets and prices of comparable stocks, and

·??????Level 3: Nonpublic information and management’s estimates.

After the purchase price is allocated to each identifiable asset and liability, any remaining fair value is assigned to goodwill. If the purchase price is less than the combined fair value of the seller’s net assets, the buyer records a gain on the income statement. These so-called “bargain purchases” are rare, however.

After closing, goodwill must be tested for impairment annually and when any “triggering” events happen that might adversely affect the company’s value. Examples of events that may trigger impairment testing include the loss of a major contract or a major lawsuit.

Important: Private companies can elect to combine noncompete agreements and customer-related assets with goodwill, if the latter can’t be licensed or sold separately from other assets. They can also elect to amortize goodwill over a period of up to 10 years in lieu of annual impairment testing.

Finding answers

The rules for recording M&A transactions are complex and can sometimes have unexpected effects on the buyers’ financial statements. Plus, inaccurate purchase price allocations can lead to financial restatements and impairment charges in the future, so it’s important to get it right from the start. DLA can simplify the financial reporting details and minimize post-acquisition headaches. ?