Mergers and acquisitions (M&A) can create opportunities for business growth, expanded services, and stronger market positioning. They also bring complex financial reporting requirements that should be addressed early in the transaction process.
Under U.S. Generally Accepted Accounting Principles (GAAP), business combinations are generally accounted for under Accounting Standards Codification (ASC) Topic 805, Business Combinations. The buyer must identify the accounting acquirer, determine the acquisition date, measure consideration transferred, and recognize acquired assets and assumed liabilities at their acquisition-date fair values, subject to certain exceptions. The Financial Accounting Standards Board (FASB) Codification is the source of authoritative GAAP for nongovernmental entities, other than SEC guidance that applies to SEC registrants.
Breaking Down The Purchase Price
Accounting Standards Codification Topic 805, Business Combinations, requires a buyer to allocate the purchase price to all acquired assets and liabilities based on their fair values. This process begins by estimating a cash-equivalent purchase price.
If a buyer pays 100% cash up front, the purchase price is already at a cash-equivalent value. But it’s less clear if a seller accepts noncash terms, such as an earnout contingent on the acquired entity’s future performance or stock in the newly formed entity.
The next step is to identify all tangible and intangible assets and liabilities acquired in the business combination. The seller’s presale balance sheet will usually report most tangible assets and liabilities, including inventory, equipment, and payables. However, intangibles are reported only if the seller previously purchased them. Most intangibles are generated in-house, so they’re rarely included on the seller’s balance sheet.
Allocating Value To Acquired Assets And Liabilities
Acquired assets and liabilities are then added to the buyer’s balance sheet, based on their fair values on the acquisition date. Determining fair value can require significant judgment, particularly when valuing intangible assets. In some cases, buyers engage valuation specialists to assist with the process. The difference between the sum of these fair values and the purchase price is reported as goodwill.
Acquired identifiable intangible assets — such as customer lists, noncompete agreements, and certain technology assets — are amortized over their estimated useful lives. As a result, purchase price allocation decisions can affect future earnings and other key financial metrics.
Goodwill and other indefinite-lived intangibles — such as brand names and in-process research and development — usually aren’t amortized under GAAP. Instead, companies generally must test goodwill for impairment annually. Impairment testing may also be necessary when certain triggering events occur. Examples of triggering events include the loss of a major customer or the enactment of unfavorable government regulations. If a business reports an impairment loss, it may indicate that the acquisition hasn’t delivered the expected economic benefits or that business conditions have changed since the transaction closed.
Rather than test for impairment, private companies may elect to amortize goodwill on a straight-line basis, generally over 10 years. However, companies that elect this alternative method must still test for impairment when certain triggering events occur.
In rare instances, a buyer negotiates a bargain purchase. Here, the fair value of the net assets exceeds the fair value of the consideration transferred (the purchase price). Rather than recognizing negative goodwill, the buyer reports a gain on the income statement.
Why Post-Deal Accounting Matters
The rules for reporting M&A transactions are complex and can sometimes have unexpected effects on a buyer’s financial statements. Accurate purchase price allocations are essential for reliable post-deal financial reporting and reducing future adjustments and restatements. Contact us for guidance on accounting for business combinations and subsequent testing for goodwill impairment.
