In accounting, something that looks like a duck and quacks like a duck isn’t necessarily one of our fine feathered friends. Nothing proves that point better than the subtle but crucial differences between an asset acquisition and a business combination. And needless to say, it behooves you to understand those oh-so-important differences when there’s a transaction on the horizon.
But because you have a business to run and there’s only so much time in the day, we thought it best to give you the low-down on accounting treatments for asset acquisitions and business combinations, how they differ, and some handy best practices to boot. So let’s dive right in.
Defining Businesses, Asset Acquisitions, and Business Combinations
We’ll begin with a look at the business combinations guidance under US GAAP. According to ASC 805 from the good folks at the FASB (Financial Accounting Standards Board), a business combination is “a transaction or other event in which an acquirer obtains control of one or more businesses.”
Note our added emphasis on control in that definition. The concept of control is front and center in this discussion, pivoting around the financial interest an acquirer has in a business. It’s essentially the same concept you use to evaluate control in ASC 810, where control can fall into one of two frameworks – the variable interest entity (VIE) or the voting interest entity (VOE).
Granted, we’re painting with pretty broad strokes in this case since there are instances when a transaction doesn’t result in a business combination according to US GAAP standards, including:
- The formation of joint ventures
- Combinations involving entities under common control or not-for-profit organizations
- Acquisitions of assets that don’t constitute a business
- Financial assets and financial liabilities of a consolidated VIE that is a collateralized financing entity
For our purposes, it’s that third bullet point that can make such a dramatic difference in your transaction accounting. Therefore, we need to establish what constitutes a business in the first place. That’s where an overhauled definition enters the fold, providing two criteria to evaluate whether a transaction results in a business:
1. The Screen Test
In this first criteria, an entity must evaluate if substantially all the fair value of the gross assets acquired are concentrated in a single asset or a group of similar assets. In other words, once you identify the acquired set, you must determine if that acquired set is not a business by applying the screen included in ASC 805. And you accomplish this by applying a four-step process:
- Combine the identifiable assets into a single identifiable asset, if applicable
- Combine any other assets into groups of assets similar in character, if applicable
- Measure the fair value of the gross assets acquired in the set, excluding cash & cash equivalents, deferred tax assets, and goodwill resulting from the effects of deferred tax assets
- Determine whether substantially all of the fair value of the gross assets is concentrated in a single identifiable asset or group of similar identifiable assets
Although GAAP does not explicitly define substantially all, 90% is the typical benchmark. Therefore, excluding any assumed liabilities or debt, you can stop and rest for a bit if you satisfy this screen test because the guidance automatically considers the transaction an asset acquisition. If you don’t meet the criteria, however, then you proceed to a more detailed framework to assess the definition of a business.
In certain cases, you may also be able to determine qualitatively that the screen has been met when assets acquired are a large single asset or where other assets would have limited fair value assigned to them. On the other hand, an entity may be able to qualitatively determine the screen has not been met and proceed to evaluating the definition of a business if there is obvious significant value in assets acquired that are not similar.
2. The Definition of a Business
This is the second and more robust step from ASC 805 – and updated in Accounting Standards Update (ASU) 2017-01 – that revolves around the definition of a business from the guidance by evaluating three specific elements:
- Inputs: Economic resources – including long-lived assets and other tangible assets, identifiable intangible assets, certain non-financial assets like intellectual property, and employees, to name a few – that create or can create outputs.
- Processes: Any system, standard, protocol, or rule that, when applied to an input, creates or can create outputs. This would include management and operational processes but not administrative processes like billing and payroll as they typically don’t create outputs.
- Outputs: The result of inputs and substantive processes that create goods or services to customers, investment income, or other revenues.
A business, by definition, will consist of an integrated set of activities and set of assets that work together and contribute to the ability to create outputs. However, such outputs aren’t necessarily required for a transaction to still meet the definition of a business.
For example, an early-stage or pre-revenue company might not create outputs yet but can still represent a business if it includes:
- Employees that form an organized workforce, and;
- An input that the organized workforce could use to create outputs.
In this example, the organized workforce must include active company employees, not just outsourced contract workers, and possess the necessary skills and knowledge to create outputs.
Thankfully, once you get to the end of this accounting criteria gauntlet, you’ll know if your transaction constitutes a business combination or not. Going back to a previous point – acquisitions of assets that don’t constitute a business – if your transaction does not satisfy the definition of a business, then it’s obviously an asset acquisition.
Most importantly, that determination, business combination or asset acquisition, will direct which route your accounting takes, either a fair value model or a cost accumulation model, respectively.
Accounting for Business Combinations
Let’s assume you determined your transaction is a business combination. From here, the acquisition method from ASC 805 requires you to follow four specific steps:
1. Identify the Acquirer
ASC 805 says one of the combining entities must be the acquirer. The trick, however, is figuring out exactly who that is, a process that comes down to our old friend control once again.
In many cases, identifying the acquirer is obvious because one legal entity is exchanging cash or other assets for another legal entity. It’s not always that straightforward, though, especially when the exchange of equity interests are involved. Thankfully, ASC 805 provides additional guidance for murkier situations like certain mergers or when a company creates an entirely new company – commonly referred to as a “NewCo” – to consummate the transaction.
2. Determine the Acquisition Date
This one, at least on the surface, is pretty simple. The acquisition date is generally the closing date of the transaction when the acquirer gains control. However, there are certain situations where an acquirer might obtain control before or after the closing date, depending on the facts and circumstances.
Also, some entities might use a “convenience date” when accounting for a business combination to simplify matters, assuming it doesn’t materially impact the financial statements. Typically, the convenience date is a few days different or less from the actual closing or acquisition date, and always in the same reporting period.
3. Recognize and Measure Identifiable Assets Acquired, Liabilities Assumed
This is the step where the bulk of the heavy lifting occurs, particularly when you’re acquiring or assuming numerous assets and liabilities. More often than not, you want to bring in outside valuation specialists for this step since the exercise itself can become quite complex.
Basically, you recognize all the identifiable assets and liabilities on the acquisition date that meet the definition of an asset or liability, including any non-controlling interest. Also, don’t be surprised if you dig up additional assets that the acquiree didn’t previously recognize. For example, intangible assets like brand names, trademarks, technology, or customer relationships often fall into this category because the acquiree generated them internally.
After identifying all the assets and liabilities, you then generally measure them at fair value – with certain exceptions – on the acquisition date according to the fair value standard in ASC 820.
To reiterate, this process can quickly become complex and overwhelming, so don’t hesitate to reach out to experienced outside valuation specialists. Oh, and we just happen to know of a team of experts that will hit it out of the park for you.
4. Recognize and Measure Goodwill or Bargain Purchase Gain
Goodwill is an asset that reflects the acquired future economic benefits of a company that aren’t separately identifiable. A common example of goodwill is the synergies generated between two business entities after the transaction.
While not all business combinations result in goodwill, keep in mind that you need to allocate any residual purchase consideration from the transaction once you know the fair value of the other identified assets and liabilities. People often refer to steps three and four as a purchase price allocation, or PPA for short.
The Measurement Period
Granted, there can be a lot more involved in accounting for a business combination than these four steps – transaction-related costs to third parties, contingent consideration, and purchase price adjustments, amongst others.
In some cases, the acquirer may not have the information necessary to complete the accounting for a business combination by the end of their reporting period, especially when the acquisition date occurs right before the end of it. That’s why ASC 805 provides a period of time for companies to finalize their acquisition accounting, allowing them to initially report provisional amounts if incomplete.
The guidance provides some relief to an acquirer to obtain the information it needs to identify and measure the consideration transferred, assets acquired, and liabilities assumed, as well as any previously held or noncontrolling interests. This relief is often referred to as the measurement period and cannot exceed one year from the acquisition date. Keep in mind, you must record any adjustments you identify as measurement period adjustments in the same period you determined they’re adjustments to the initial acquisition accounting.
Likewise, such adjustments must only relate to the events or circumstances existing at the acquisition date. And while this is skipping ahead just a bit, a measurement period does not apply for asset acquisitions so, on that front, you really have to hit the ground running.
Accounting for Asset Acquisitions
Believe it or not, that was only one-half of the conversation. Because there are plenty of times when a transaction doesn’t meet the criteria for a business combination and, thus, is an asset acquisition on your books.
Rather than just saying an asset purchase is a transaction that doesn’t meet the business combination requirements, though, ASC 805-50 provides specific guidance on accounting for an asset acquisition. But to put it in simple terms, assets acquired and liabilities assumed are recognized at cost, which is the consideration the acquirer transfers to the seller, including direct transaction costs, on the acquisition date. In an asset acquisition, no goodwill is recognized.
And while we sincerely detest bursting anyone’s accounting bubble, asset acquisitions aren’t always going to involve less work than a business combination – at least from a valuation perspective – as many believe. In fact, you’re usually going to need fair value measures, regardless of whether it’s an asset acquisition or a business combination. So it’s really just a matter of how you use the information in your subsequent accounting.
The Cost Accumulation Model
All that said, let’s just assume you’ve performed the screen test, looked at the definition of a business, and concluded your transaction is an asset acquisition. Once again, this means your accounting falls under the jurisdiction of the cost accumulation model, where you recognize, at cost, any assets you acquired or liabilities you assumed.
Put another way, this is the consideration you, as the acquirer, transfer to the seller on the acquisition date, which could include:
- Cash consideration paid
- Non-cash consideration paid
- Direct acquisition costs incurred
- Contingent consideration
- Previously held interest
- Non-controlling interest
Of course, if some or all of the transferred consideration involves non-cash assets, liabilities incurred to the seller, or equity interest issued to the seller, you should first see if the transaction falls under other guidance like ASC 845 or ASC 610-20. In addition, reporting entities should peruse ASC 718 when the transaction involves equity interest issued to the seller.
Afterward, you allocate the total costs to the assets you acquired based on their relative fair values. Keep in mind this method could very well result in the total cost of the acquisition either exceeding or falling short of an acquired asset’s actual fair value.
Now, if there are significant differences between the acquisition cost and the fair value, it could suggest you haven’t recognized all of the acquired net assets. Similarly, it could also mean there are transactions you should recognize separately from the asset acquisition.
Think of it like this – when you’re putting together a piece of furniture and you’re left with either too many or too few parts, something is probably up. Aside from the obvious – a dining room chair that could very well send you to the ER – it also means you likely skipped some steps or might have taken the wrong accounting road at some point. Whatever the cause, judgment is required to evaluate the difference properly.
Beware of Fair Value Impairment Testing
As a slight but essential side note, remember that an asset acquisition doesn’t result in the recognition of any goodwill. Therefore, you must still allocate any excess costs over fair value on a relative fair value basis to the acquired assets.
However, don’t forget about any acquired assets that may be subject to recurring fair value impairment testing such as indefinite-lived intangible assets. You should avoid allocating any excess consideration on a relative fair value basis for these assets since, otherwise, you risk an immediate impairment. In other words, you should not allocate any excess consideration to these assets above their actual fair value on the acquisition date.
Other Insights and Best Practices
We just finished a pretty high-level look at accounting for business combinations versus asset acquisitions. Naturally, there can be a lot more nuance to your transaction accounting, so we also want to provide some insights and tips we’ve collected from the M&A accounting frontlines.
Just keep in mind, however, that unique circumstances often mean greater complexities, so even an exhaustive list of insights and best practices probably won’t answer every question. If you find yourself in such circumstances, we urge you to either do some additional research or reach out to us so we can, at the very least, point you in the right direction.
Contingent consideration for an asset acquisition mirrors the guidance we see in ASC 450. Thus, you recognize what’s probable and what you can estimate on the acquisition date. After that initial recording, you adjust your initial estimate according to new facts or circumstances that arise.
That’s not to say that accounting for contingent consideration will remain the same down the road as that’s a matter the accounting gods have yet to officially settle on. For now, however, anytime there’s a change to the initial contingent consideration– which you capitalize into the cost of the assets – it’s really just a matter of changing the cost basis of the assets.
But what happens, you ask, when you’re adjusting the cost basis to fixed assets you’ve been depreciating over the old cost basis? Well, although there’s no explicit GAAP guidance on this, in practice, you generally use a cumulative catchup entry for depreciation or amortization.
Also, note that this is a very different approach than contingent consideration for a business combination, where you determine the fair value of the contingent consideration on the acquisition date.
From there, depending on its classification, you may have to do subsequent remeasurements each reporting period until settled with changes in fair value running through your earnings. However, with an asset acquisition, you’re capitalizing the consideration into costs so it impacts your income statement through normal depreciation or amortization of those assets.
Leases are rarely easy. And by rarely we mean practically never. Therefore, it shouldn’t come as a surprise that the new lease accounting guidance in ASC 842 might have some unsavory treats in store for you.
For lessees, there are a couple of key areas you will want to focus on – classification and measurement. Regarding classification, if you acquire a lease through a business combination, you simply keep the same classification as the acquiree and do not reassess. However, for an asset acquisition, there are two viewpoints used in practice:
- Reassess the lease, including classification, as if it's considered a new lease on the acquisition date, or;
- Where the change to the lease is only the leasing parties and not the terms of the lease, do not reassess lease classification similar to acquired leases in a business combination.
Whichever path you take, you should apply it consistently for all leases in the asset acquisition.
Also, from a lessee measurement perspective, lessees will view an acquired lease as a new lease for both business combinations and asset acquisitions. For acquirees who were lessees in a lease, you base the measurement on the remaining lease payments, treating it as a new lease and discounting it back.
One key difference relates to any favorable or unfavorable lease terms. For business combinations, you record this intangible as an adjustment to the right of use asset. However, in an asset acquisition, you account for that intangible separately from your right of use assets.
Transaction costs are pretty straightforward in a business combination, where you generally expense almost all types of transaction costs. Yes, there are limited exceptions, like when you’re paying on behalf of people but, far and away, you’re simply expensing those costs. However, It’s different with an asset acquisition since the transaction costs are a component of the acquisition itself. Therefore, you capitalize and allocate the costs to the assets acquired.
Although this may only apply to certain industries like life sciences, many research or technology-oriented companies conduct unique R&D projects. And as you probably guessed, the accounting for business combinations and asset acquisitions are vastly different for an acquired entity with in-process research and development (IPR&D).
For an asset acquisition, an acquirer almost always expenses R&D, with very few exceptions like alternative future uses. In those rare cases, you could theoretically capitalize it. However, it’s still a very high hurdle to meet since the guidance says R&D that’s not completely ready to roll cannot have an alternative use from an accounting perspective. So, for the most part, whatever you acquire through an acquisition of an asset, you’re acquiring it in its current state.
On the flip side, you generally recognize an IPR&D asset at fair value with a business combination, even when an asset has no alternative future use. You generally characterize this asset as an indefinite-lived intangible asset until the R&D is either completed or abandoned.
Finally, when it comes to financial reporting – disclosures, in particular – there really aren’t any prescribed disclosures for an asset acquisition. Instead, other areas of GAAP may require you to disclose elements of the asset acquisition within their requirements, namely ASC 360 for depreciable assets, ASC 350 for intangible assets, and ASC 450 for loss contingencies. Obviously, this is not the case for business combinations since they have a metric ton of robust disclosures that you must include – usually in great detail – regarding the transaction under ASC 805.
Therefore, when it comes to reporting on an acquisition of a business, be ready to wax poetic about purchase price allocations and fair value, while also breaking out different considerations.
Now, given the fluid nature of the accounting standards codification these days, keep in mind that everything we just discussed could very well change in coming years. And, once again, since you have a business to run, you might not have the time to stay on the cutting edge of M&A accounting. That’s why a team of experts like Embark, from transaction advisory to valuation specialists, can be such an asset for your finance organization. Simply put, let us worry about your transaction accounting so you can focus on steering the organizational ship.