Thinking of acquiring a competitor to expand market share or achieve economies of scale? Or maybe you want to merge with a supplier to become more vertically integrated and lower supply chain risks. A business combination is one of the most important transactions a business owner or CFO will ever engage in. Significant attention typically is focused on negotiating deal terms and integrating two entities with divergent corporate cultures after closing. But adequate consideration should also be given to financial reporting. If such consideration isn’t given, it can lead to disappointing financial results, restatements and potential lawsuits.
Here’s guidance on how to correctly account for business combinations under U.S. Generally Accepted Accounting Principles (GAAP), including some potential pitfalls.
Identify the Seller’s Assets
A seller’s balance sheet tells only part of the story. Various intangible assets and contingencies may be excluded from the financial statements, such as internally developed brands, patents and customer lists, along with environmental claims and pending lawsuits. Overlooking identifiable assets and liabilities often results in inaccurate reporting of goodwill from the sale.
Private companies can, however, elect to combine noncompete agreements and customer-related intangibles with goodwill. If this alternative is used, it specifically excludes customer-related intangibles that can be licensed or sold separately from the business.
It’s also important to determine whether the terms of the deal include arrangements to compensate the seller (or existing employees) for future services. These payments, along with payments for pre-existing arrangements, aren’t part of the business combination.
In addition, acquisition-related costs (such as finder’s fees or professional fees) shouldn’t be capitalized as part of the business combination. Instead, they generally should be accounted for separately and expensed as incurred.
The buyer should also evaluate the tax implications of the deal, because there may be differences in the book and tax bases of acquired deferred tax assets and assumed tax liabilities. Under GAAP, business combinations may trigger complex rules regarding goodwill and replacement awards classified as equity. For example, goodwill may be taxable in certain jurisdictions, resulting in deferred taxes.
Determine the Purchase Price
When the buyer pays in cash, the purchase price (also called the fair value of consideration transferred) is obvious. But other types of consideration muddy the waters. Consideration transferred may include stock, stock options, replacement awards and contingent payments.
For example, the seller may be required to provide replacement awards for employees’ existing stock options. If the stock options relate to the employees’ past service (before the combination), they should be included in the fair value of consideration transferred.
It can also be challenging to assign fair value to contingent consideration, such as earnouts payable only if the acquired entity achieves predetermined financial benchmarks. Contingent consideration may be reported as a liability or equity (if the buyer will be required to pay more if it achieves the benchmark) or as an asset (if the buyer will be reimbursed for consideration already paid). Contingent consideration that’s reported as an asset or liability may need to be measured each period, if new facts are obtained during the measurement period or for events that occur after the acquisition date.
The income approach is often used to value contingent consideration. The buyer may, for example, use a discounted cash flow analysis to calculate the amount and timing of contingent consideration. Under this technique, the best estimate of contingent payments is discounted to present value using a rate that reflects the risks that the contingent event won’t happen.
Alternatively, some experts use a probability-weighted payout or an option-pricing model to value contingent consideration. All of these methods require judgment that should be supported by market evidence and thorough documentation.
Divvy Up Fair Value
The next step is to split up the fair value of consideration (minus any noncontrolling interests retained by the seller or held by other investors) among the assets acquired and liabilities assumed. This requires you to estimate the fair value of each individual asset and liability.
Fair value is the price an entity would receive to sell an asset — or pay to transfer a liability — in a transaction that’s orderly, takes place between market participants and occurs at the acquisition date.
If quoted market prices and other observable inputs aren’t available, the valuator may turn to unobservable inputs to estimate fair value. It’s important to use assumptions that a market participant would use — based on an asset’s highest and best use — rather than assumptions based on the buyer’s intended use. Intangible assets are often hard to value, because they’re unique and there’s limited comparable market data to support their values.
Assign Remainder to Goodwill
Once the fair value of consideration has been divvied up among the acquired company’s identifiable assets and liabilities, what’s leftover is assigned to goodwill. Essentially, goodwill is the premium the buyer is willing to pay above the fair value of the net assets acquired for expected synergies and growth opportunities.
In rare instances, a buyer negotiates a bargain purchase. Here, the fair value of the net assets exceeds the fair value of consideration transfer (the purchase price). Rather than book negative goodwill, the buyer reports a gain on the purchase.
Before settling on an amount for goodwill, step back and ask if the amount makes sense. Large amounts of goodwill relative to the overall purchase price might indicate that the buyer overlooked a key asset or understated the fair value of an identifiable asset. Likewise, bargain purchases typically occur only when the seller is financially distressed and forced to sell.
Inaccurate fair value measurements may come back to haunt buyers. That’s because goodwill must be tested for impairment annually and when triggering events occur. Impairment losses flow through to the income statement, and stakeholders often view these write-offs unfavorably.
However, the accounting rules allow private businesses to elect to amortize goodwill over a period not to exceed 10 years, in lieu of annual impairment testing. They must still test for impairment if a triggering event — such as the loss of a major customer or the enactment of an adverse government regulation — occurs.
Anticipate Financial Reporting Issues before Closing
Accounting for business combinations requires forethought. So, while you’re still conducting due diligence, contact our business valuation professionals to help you understand the accounting rules and the fair value of the seller’s assets and liabilities. Waiting until the deal closes could lead to surprises and delays in financial reporting. We are happy to talk to you about your M&A options!