Updated July 2023

M&A isn’t a sprint. It’s a coordinated marathon for your company, team, and group of advisors. And like most things in life, all it takes is a single weak link to throw a wrench into everything, particularly your accounting squad. Drilling even deeper into the M&A accounting core, if your team isn’t up-to-speed on the ASC 805 front – FASB’s business combinations gospel – trouble might be lurking just up the road.

Long story short – purchase accounting for M&A isn’t for the faint of heart. But if you hitch your business combination wagon to the right advice and advisors, M&A can be an incomparable growth driver for your company. So, on that note, let’s take a closer look at purchase accounting adjustments, the guidance in ASC 805, and a few tips and best practices to ensure your acquisitions are nothing but blue skies and value.

Mergers & Acquisitions: It Takes a Village

Before we take a deep dive into the purchase accounting pool, it only makes sense to step back for a moment and look at the broader acquisition picture. Because, as we said up top, a single weak link is more than enough to throw the entire process into complete chaos. And as you know, successful mergers and acquisitions don’t have much of an appetite for chaos, not to mention your opening balance sheet.

Therefore, although purchase accounting is obviously essential to the total equation, it's all for naught if haphazard due diligence – think a sloppy, incomplete, or irrelevant QofE – or an inaccurate, unreliable valuation process leads into your purchase accounting. The same goes with your integration efforts on the back end – insufficient integration breeds inferior results. With so many moving parts and dependencies involved, it’s no wonder why most studies peg acquisition failure rates – falling short of initial financial objectives for the combination – between 70% and 90%.

So how can you avoid joining such a miserable statistical club with your acquisitions? Well, that’s a big question with an even bigger answer. But because valuation data is such a critical foundation to your purchase accounting – which happens to be the topic du jour – we’re going to hone in on a few valuation best practices before proceeding.

Valuation Best Practices for Acquisitions

• Start early: Begin the valuation process either immediately or soon after the transaction closes. Remember, time isn’t your friend, and the farther you get away from the transaction, the fuzzier memories get. Loss of talent and knowledge in the interim certainly doesn’t help, either.
• Cadence: Don’t try to cram an 805 valuation into two scant weeks. But try not to let the process drag on for three months or more, either. The sweet spot is somewhere in the 4-6 week range for discovery and thorough analysis.
• Consideration: On day one, determine what the consideration involved is, including the type – cash, stock, cash plus stock, earn-outs, and contingent consideration all potentially playing a role. Pay particular attention to distinguishing consideration from compensation.
• Auditor involvement:  Keep your auditors informed, including them throughout the valuation process for financial reporting and tax compliance purposes. Auditors can provide valuable insights and opinions on the scope of work and the required level of detail.
• Accounting policies: Understand how certain accounting policies might impact the valuation process, including the private company election. Such an understanding will be an invaluable guide later in the process, helping ensure you stay on the right side of US GAAP or IFRS.

Purchase Accounting Adjustments: Intangible Assets and Beyond

We put start early at the top of our best practices for a reason – you’re on a strict clock. Yes, the FASB gives you – at most, but more on that in a bit – 12 months to make your purchase accounting adjustments within the acquisition method of US GAAP. Thus, in most cases, you have time to revise the acquiree’s assets and liabilities to fair value, including inventory, fixed assets, and intangible assets.

But intangible assets can be a slippery slope, especially since items like customer lists and non-compete agreements never made it to the acquiree's books in the first place. Therefore, when you, as the acquiring company, record them in your books, it's the first time those assets are seeing the light of day on a balance sheet. Naturally, this will impact your financials, amongst other things.

Collectively, these adjusted values of the acquiree's assets and liabilities are known as purchase accounting adjustments, and they include things like:

• A change in the valuation of inventory that impacts the amount of cost of goods sold when an acquirer sells that inventory
• A change in the value of fixed assets that impacts the amount of depreciation on an acquirer's books
• The identified intangible assets from the acquiree, not including goodwill, that an acquiring company may amortize over its useful life.

As you can see, many of these purchase accounting adjustments will impact the recognizable non-cash expenses for an acquirer in the future. In fact, those expenses can generate significant losses until you’ve fully amortized the underlying intangible assets.

Thus, it's important to explain these losses in the financial statement disclosures to give investors some context behind them. Otherwise, they'll think the C-suite is either asleep at the wheel, incompetent, or both. And neither of those is any good at all.

Sorting Through the Guidance: ASC 805

Up until this point, we've spoken in generalities about the acquisition method and purchase accounting, the role that valuations and adjustments play, and their potential impact on an acquiring company's financials. Now we want to zero in on the guidance and discuss what ASC 805, Business Combinations, has to say about accounting for such transactions.

The Basics: What's a Business Combination?

Naturally, when zooming in on the guidance for business combinations, it helps to understand how the ol’ Generally Accepted Accounting Principles define the term business in the first place. We won't belabor the subject since we've already discussed it at length but, to borrow our own words:

At the very least, a business must include both an input and a substantive process that, together, significantly contribute to the ability to create outputs. The guidance on this corner of acquisition accounting – updated with ASU 2017-01 – relies on best judgment to evaluate when an input and substantive process work together to significantly contribute to the ability to produce outputs, including businesses without current outputs.

But why is it so important to define a business according to the guidance? Because, for a business combination to occur, the acquiring company must first determine if the target company is a business or a group of assets.

If a company determines the acquired assets and liabilities don't meet the definition of a business according to ASC 805, then there's no need to continue reading this financial prose. That is, unless you happen to appreciate a good turn of phrase and some handy insights that might be useful for you down the road. To that point, ASC 805-50, Business Combinations – Related Issues, will tell you how to account for the transaction as an asset acquisition.

The Acquisition Method

Since you’re still here, we assume your transaction meets the criteria for a business combination in the standard. So, let’s proceed by walking through the four basic steps the guidance uses for the acquisition method of accounting.

1. Identify the Acquirer

You would think this one would be obvious, but, as you already know, there's an awful lot of nuance in the accounting standards. For example, when two remarkably similar companies decide to merge, it's often called a "merger of equals." But while that term might look fancy and sophisticated in a press release, the truth is, there's really no such thing.

The guidance is very clear when it says that, in a business combination, one company is the acquiree and the other is the acquirer. But when you're dealing with, as we said, two remarkably similar organizations, how do you determine who's who? By control, that's how.

The acquiring company gains control of the other, as defined by ASC 810-10 – the direct or indirect ability to determine the direction of management and policies through ownership, contract, or otherwise. Further, an acquirer obtains control by:

• A single purchase of a controlling equity interest
• An acquisition of a controlling equity interest achieved in stages
• Acquisitions through other means, including through the VIE model discussed in ASC 810, the voting interest model, or industry-specific guidance

If the guidance from ASC 810, Consolidation, isn't sufficient to ascribe control, then it's time to consider the factors in ASC 805-10-55-11 through 55-15. Needless to say, identifying the acquirer can require a lot of judgment in certain circumstances.

2. Determine the Acquisition Date

As you might've guessed, the acquisition date is critical for several reasons. First and foremost, it signifies the exact date an acquirer obtained control of the acquiree, providing a baseline to calculate the fair value of the different assets it acquired, liabilities it assumed, and is key to determine goodwill created by the transaction. In other words, it’s the gravitational center of the entire valuation process.

Measurement Period Adjustments

The acquisition date also establishes the beginning of the measurement period we spoke of earlier, giving an acquiring company up to 12 months to adjust initial accounting for the transaction. During the measurement period, you can gather the information you need to properly account for the business combination, as outlined in ASC 805-10.

However, we urge you to proceed with caution regarding the measurement period since many companies fall prey to a number of common issues.

• Don’t assume the measurement period lasts for a full 12 calendar months. Remember, 12 months is the maximum allotted time and is not automatic. The guidance provides the time so an acquirer can obtain information necessary to evaluate the economic conditions on the acquisition date and not after, so be efficient and get it right the first time.
• Many companies fail to provide the required disclosures discussing the outstanding provisional items. Such a failure could mean a prior period error in the disclosure or that the acquirer can't record an adjustment to goodwill but, instead, can only recognize the adjustment through earnings.

Acquiring entities should not record corrections of errors or events occurring after the acquisition date as measurement period adjustments since the guidance doesn't allot the time for such purposes.  The acquirer should evaluate these errors under the premise of ASC 250.

3. Recognize & Measure the Assets, Liabilities, and Non-Controlling Interest

Once the acquiring company has determined the acquisition date, it's then time to recognize, measure, and allocate the identifiable assets it acquired in the transaction as well as the liabilities it assumed. Note our emphasis on "identifiable." This step only includes the assets and liabilities the acquirer and acquiree exchanged in the combination. In other words, it doesn't encompass anything stemming from separate transactions, as outlined in GAAP.

It's also important for the acquirer to remember that, more often than not, the process will include recognition and allocation of certain assets and liabilities that never made it to the acquiree's financials like, for instance, the aforementioned intangible assets. Further, the acquiring company must measure all of the identifiable assets and liabilities at fair value – with limited exceptions – as of the acquisition date, including net assets where a different entity retains a non-controlling interest.

For reference, fair value is the price the acquirer would receive if it were to sell an asset or the price paid to transfer a liability in an orderly transaction taking place on the acquisition date between market participants. Most companies will use one of two common approaches to calculating fair value:

1. A market approach based on something like a quoted market price, or;
2. An income or cash flow approach that might rely on a present value calculation.

In certain instances, a company may also utilize the cost approach as permitted under ASC 820 for some assets.

No matter what approach you use, however, you should rely on observable inputs to calculate fair value whenever possible, minimizing your reliance on unobservable inputs. Further, regardless of whether you, as the acquiring company, base your judgment on observable or unobservable inputs, the assumptions you use should be consistent with those that a market participant would use. Again, ASC 820, Fair Value Measurement, is the guidance for such situations, and is quite hefty in its own right.

Sidenote: Post-Closing Purchase Price Adjustments

Oftentimes, months can go by between the time two entities agree on a purchase price and actually seal the deal. In the meantime, plenty of things can go sideways, exposing an acquirer to fluctuations that could negatively impact any benefits from the transaction.

Take net working capital (NWC), for instance. If you see an acquiree’s actual working capital plummet below the target NWC, you could very well be staring at an increased investment just to fund post-closing working capital needs. However, a post-closing adjustment could protect you from such fluctuations by adjusting the purchase price to account for the lower NWC.

Likewise, if the acquiree's NWC comes in above its target, then you might pay the seller the amount in excess of the target as a price adjustment. Both entities can use similar adjustments based on things like assets and liabilities, income, and expense as well. Ultimately, you devote too much work, time, and resources into a transaction only to see things go south at closing or shortly thereafter.

4. Recognize & Measure Any Goodwill or Gain from a Bargain Purchase

Finally, the last step in the acquisition method discussed in ASC 805 outlines how the acquiring company must calculate any goodwill created by the transaction. Although it's not nearly as simple as a single equation, this step essentially has an acquirer subtracting the fair value of the assets acquired and liabilities assumed from the amount it paid for the acquiree.

If, after calculating the goodwill, an acquirer finds itself with a negative balance, then the transaction might be considered a bargain purchase. This essentially means you bought the acquiree’s net assets at a discount.

If you believe you have a bargain purchase gain to record, you should first reevaluate the net assets acquired to ensure you’ve identified and recognized all the assets acquired and liabilities assumed, including any additional items not previously considered.  While bargain purchases are the exception and not the rule, they're certainly common enough to keep in the back of your mind, especially if the acquiree is in financial distress and is selling just to keep the doors open.  

Going forward, as the acquiring company, you must stay mindful of any goodwill generated by the transaction, accounting for it according to the guidance from ASC 350. That's a topic we've discussed at length in the past, particularly goodwill impairment testing procedures, so make sure to familiarize yourself with this post-acquisition doozy to stay compliant.

A Final Word from Embark

We understand that, between valuation, simply understanding the guidance, and the four steps we just discussed, acquisition accounting can be a lot to take in, even if you have a fleet of talented CPAs at your disposal. But the good news is this – you’re not in it alone. Whether for valuation services or the meat and potatoes of purchase price accounting, Embark has you covered. So let’s talk and make sure your acquisition is nothing but rocket fuel for your company’s growth.