Business Combination Accounting: Challenging Reporting Standards for Buyers
By Mike French, CPA, ABV, CFE, Managing Director
After an entity changes hands, the buyer must satisfy U.S. GAAP financial reporting standards defining whether the transaction is subject to business combination accounting. If the seller has done a good job of providing the information the buyer needs to know during the course of the transaction, the process of meeting the demands of business combination accounting will go more smoothly.
At its core, the question focuses on whether the transaction was solely a sale of a group of assets, or whether it was the transfer of assets that constitute a business. If the latter, it is subject to business combination accounting standards and, thus, a different level of scrutiny.
Users of financial statements, including bankers, investors and regulators, closely examine business combinations to understand the financial underpinnings of the transaction, particularly when deals swerve out of the standard lane with issues like a bargain purchase or a reverse merger. Buyers must be prepared to answer any questions that arise.
Is It a Business?
A business is defined, under U.S. GAAP, as a set of activities and assets that is both self-sustaining and managed to provide a return to investors. To be subject to business combination accounting rules, a transaction must involve an entity that has inputs and processes that contribute to the potential for outputs.
It may seem obvious to a buyer that an acquisition is either an asset transaction or a business transaction, but documenting it in the new entity’s financial statements is critical. Accounting treatment for business combinations and asset acquisitions have marked differences. For instance, in a business combination, an entity recognizes goodwill; no goodwill is recognized for an asset acquisition. Additionally, in a business combination, transaction costs are expensed as incurred. Transaction costs are capitalized for an asset acquisition.
Once the determination of a business combination is made, the buyer must account for it using the four basic steps of the acquisition method:
- Determine the acquirer
- Determine the acquisition date
- Recognize and measure the assets, liabilities and noncontrolling interest
- Recognize and measure any goodwill or gain from a bargain purchase
All assets acquired and liabilities assumed in a business combination must be recognized by the buyer in financial statements, and identifying assets and liabilities requires careful attention. A common pitfall is to overlook one or more of the items exchanged, such as an intangible asset or a contingency. Failing to identify and measure one of the items exchanged results in recording the wrong amount of goodwill. In addition, it results in improper accounting for the item in a future period.
A buyer may incur transaction costs related to a business combination such as finder’s fees, professional or consulting fees, administrative costs and costs to register or issue debt and equity securities. Acquisition-related costs generally must be accounted for separately from the business combination and expensed as incurred. An exception applies to the costs to issue debt or equity securities; these costs must be treated in accordance with applicable GAAP and the acquirer must disclose its accounting for these costs in the notes to its financial statements.
Business combination accounting rules around goodwill are extensive, and complexities can arise in particular if the seller(s) will stay on as employees of the combined entity. In this case, it may be difficult to determine whether amounts paid to the owners are consideration for the business, included in the fair value of consideration transferred in the business combination, or compensation for future service (accounted for separately from the business combination).
It’s important to remember that goodwill is only taxable in certain jurisdictions. Therefore, an acquirer must know the applicable tax law to determine if goodwill results in deferred taxes.
For more information about business combination accounting or assistance with preparing for a business sale, contact your PKF Advisory team member or:
Mike French, CPA, ABV, CFE