Financial Reporting & Accounting

Business Combination Accounting & ASC 805: 5 Avoidable Mistakes

During the record-breaking 10+ year bull run, U.S. companies saw a massive amount of M&A deals both in number of transactions and deal value. However, 2019 saw a double-digit percentage drop in the number of deals compared to 2018, and now with the COVID-19 pandemic, many companies have temporarily paused their M&A activity. Even though the past two years have seen a downward trend in M&A activity, this trend is unlikely to continue. Once the country recovers from this pandemic, most dealmakers expect M&A activity to recover rapidly, especially with the environment of low interest rates, high stock prices and large amounts of cash on the sidelines. Companies going through or contemplating a deal would be wise to look out for these five common business combination accounting mistakes.

1. Asset vs. Business Acquisition

Many accounting professionals who are inexperienced with business combination accounting will try to account for a deal as an asset acquisition. You really can’t blame them: most purchase agreements state that the transaction is an asset purchase rather than a purchase of a business. These purchase agreements are not written to benefit GAAP accounting, rather they are written for IRS and legal purposes. The FASB defines a “business” as an integrated set of activities and assets capable of performing activities for the purpose of providing a return to owners, achieving lower costs or offering other economic benefits to the owners. ASC 805 states that there are three elements of a business:

  1. Inputs: Economic resources that create (or can contribute to the creation of) outputs when one or more processes are applied to it
  2. Processes: Systems, standards, protocols, conventions or rules that, when applied to inputs, create the ability to contribute to the creation of outputs
  3. Outputs: The results of inputs and processes applied to inputs that provide goods or services to customers

According to ASC 805, if an entity is missing one of these elements, it is likely not a business. Assessing each of these elements and considering all the facts and circumstances in a transaction can be very complex and highly judgmental.

2. Identifying and Fair Valuing All Assets

In accordance with ASC 805, the acquirer must record the assets acquired in an acquisition at the fair value on the acquisition date. This process seems straightforward when the assets received are tangible assets like property, plant, and equipment and inventory. However, the complexity of the transaction increases significantly when intangible assets are put into the deal. Assets like trademarks, customer relationships, in-process research and development, and internet domain names are very difficult to fair value. Certain intangible assets may not even be considered assets on the acquiree’s books, but they may be on yours (e.g., favorable lease agreements, customer relationships, employment agreements and others). Considerable analysis must be made regarding all the benefits the acquirer will receive in the deal.

3. Including All Consideration

Many companies will simply account for the acquisition based upon the price stated in the purchase agreement. However, further analysis is needed to determine if there was additional consideration paid for the acquisition (e.g., transfer of assets, contingent payments, payments made on the behalf of the seller, issuance of new equity and others). The consideration in an acquisition is calculated as the fair value of all assets transferred, plus liabilities incurred to the acquiree, plus any equity issued to the acquiree. Additional analysis must be made for transaction costs related to legal, accounting and due diligence activities. As such, it’s rare that the total consideration is the amount stated on the purchase agreement and significant analysis must be done just for calculating consideration.

4. Identifying and Fair Valuing Contingent Consideration

Generally, identifying the contingent consideration is straightforward as it is specified in the purchase agreement. However, an acquirer may assume the pre-existing contingent consideration of the acquiree. As such, a deep understanding of the transaction and the acquired business is necessary to identify all the contingent consideration. ASC 805 requires companies to identify and record the fair value of the contingent consideration at the acquisition date, not the expected payout at the settlement date. Companies will need to estimate the fair value of the contingent consideration by calculating the probabilities of payment and time value of money… which is no small feat. Then the company must remeasure the contingent consideration during each reporting period. This requires significant complex work that many entities are not prepared for.

5. Relying Solely on Existing Accounting Staff

There are many more issues in business combination accounting than those mentioned above. Yet many companies will go the route of having their own accounting staff fair value the assets and record the business combination entries – all to save money!

Even if your company has a very capable accounting staff, very few accountants have the experience to fair value complex intangible assets.

Our experience is that companies who use their own accounting staff for fair valuing assets did not end up saving money when factoring in the added stress, diverting resources away from day-to-day operations and focusing on the business combination accounting rather than integrating new staff and financial systems.

Additionally, the company’s auditors will significantly scrutinize the business combination accounting and valuation of assets acquired because you did not use specialists.

Except in dealing with the largest companies, auditors do not believe that their client’s internal accounting staff has the expertise to fair value assets and will heavily review the business combination accounting, resulting in increased audit fees. Using a specialist to assist your company in accounting for business combinations will end up saving the organization money, time and stress.

Need Support With Business Combination Accounting, ASC 805 or Other Technical Accounting?

8020 Consulting’s team of finance and accounting consultants offer a wide range of support to companies in need of financial project execution or interim financial management. If you’d like to chat with us about bringing in one or more of our 90+ consultants, then contact us!

We also offer focused services specific to the economic impacts of the pandemic. For more information, you can download our services sheet:

business stabilization and contingency planning

About the Author

Brandon is a finance and accounting specialist with more than 15 years of experience. His career started as an auditor with the “Big 4” assisting and leading audit engagements in a wide range of industries including consumer products, financial services, and biotechnology. He then went on to The Walt Disney Company’s Transaction Support team where he was responsible for providing expertise in M&A transactions, due diligence, divestiture, technical accounting and restructuring to Disney and all of its subsidiaries. After The Walt Disney Company, Brandon led year-end audits, month-end close, and financial reporting in the retail apparel industry at levels of Senior Manager and then Director. Brandon is a CPA and holds a Bachelor of Science in accounting with a minor in economics from the University of Massachusetts Amherst.

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