Business Combinations: Don’t Fall in the GAAP
Author: Brian West
There are many issues on a buyer’s mind when closing an acquisition—but properly accounting for a business combination often isn’t one of them. There are several potential accounting issues in a business combination that require advance preparation and communication. In this article, we’ll look at some potential pitfalls and issues often encountered when accounting for a business combination. This isn’t intended to be a full guide on accounting for business combinations; detailed accounting research always should be reviewed when going through a transaction.
Know Your Acquisition Date
Determining your acquisition date isn’t always as easy as it sounds; it may be before or after the closing date. Accounting guidance defines the acquisition date as the date on which the acquirer obtains control; this usually is the point at which consideration, assets acquired and liabilities assumed are transferred to the buyer.
Legal documents often are drafted with the closing date scheduled to occur at month-end, as this usually is the easiest time to cut off financial statements. However, transactions don’t always close at month-end for various reasons. Based on current accounting guidance, accounting cannot be backdated to month-end only based on the legal document. Further consideration must be given to the actual date a change in control occurs.
A close not occurring at month-end can present accounting departments with several financial statement concerns. The primary issue: Most accounting departments aren’t set up to close in the middle of a month. Systems may not be prepared to provide reports for this period. There are also other issues, including adjusting controls over the cutoff of receivables and payables or the counting of inventory.
In most circumstances, closing at month-end is advisable. If this is not possible or there are circumstances that cause delays, it’s important to include your accounting department and audit firm in these discussions early, so they can make necessary adjustments and preparations.
Make the Inventory Count Count
The acquisition date also is important when considering accounting for acquired inventory. The existence and cutoff of inventory are significant risks to consider. You can work to ensure proper cutoff and existence of acquired inventory by completing an inventory count. A full physical inventory count may be required in the absence of a reliable perpetual inventory system. Physical inventory may require testing by independent auditors in connection with the financial statement audit. This requires early communication between the buyers, accounting department and audit firm to understand the inventory control environment and procedures to be performed.
If an audit firm determines testing of inventory quantities is required but is not coordinated before the closing date, this can lead to additional complications during the auditor’s testing, including the requirement to roll back the inventory to the closing date.
Inventory at Fair Value
Current accounting guidance requires all acquired inventory to be recorded at fair value. The accounting literature discusses accounting for different types of inventory. Acquired manufactured finished goods inventory should approximate net realizable value. Work-in-process (WIP) inventory also can cause further difficulties, since it must include an estimate of the potential selling price of the inventory as a finished product along with adjustments for future costs. Margins earned pre-acquisition are intended to remain with the seller, with the buyer earning profit only on the completion of the WIP. Purchased materials typically are the easiest to value at approximate replacement cost, though this can be more difficult if those materials are potentially affected by inflation or significant price changes.
Increasing inventory to record at fair value often triggers issues with gross profit and income on future sales. Accounting guidance suggests the only profit that should be recognized on acquired inventory is typically the company’s future efforts to sell the inventory. This means gross profit recognized on acquired inventory will be less than historic gross profit earned prior to the acquisition.
This can cause issues when companies provide comparable financial statements pre- and post-acquisition. This can cause unexpected decreases to gross profit that the buyers, accounting department and lenders did not originally consider. It also can lead to immediate debt covenant concerns, as this can decrease the company’s net income in the period after acquisition. Prior to the acquisition, the company should inform any debt or equity holders of the accounting treatment and subsequent impact.
Property & Equipment Valuation
Many times, third-party valuation specialists value these assets during the acquisition, often as required by the lenders in connection with the financing. A key item to consider is the nature and scope of the appraisal for financial reporting, i.e., whether the acquired asset will be valued at fair value as opposed to orderly liquidation value. Real estate also should be included in the appraisal to help determine the best estimate of fair value. One procedure most third-party valuation specialists are required to complete in an appraisal is a review of the condition of the property and equipment. Valuation specialists can be engaged to review all property and equipment and provide evidence of existence.
Purchase contracts sometimes include an agreed-upon purchase price for property and equipment between buyer and seller. The purchase price may not reflect the fair value of the property and equipment for financial reporting. Property and equipment usually require a third-party valuation specialist to obtain the estimated fair value. Accounting and management should have this discussion with their audit firm early in the process.
Identifying & Valuing Intangible Assets
Almost all acquisitions will involve the assignment of value to intangible assets—separate from goodwill—at fair value. This is often a difficult process that requires a fair value specialist. New private company accounting alternatives allow for simplification in the process, which will not be covered in this article. However, all private companies should consider the simplification allowed in Accounting Standards Update (ASU) 2014-18, Accounting for Identifiable Intangible Assets in a Business Combination and ASU 2014-02, Intangibles – Goodwill and Other, as they can save time and money.
Best practice is to begin identifying intangible assets when performing the acquisition’s due diligence. Values of potential intangible assets often will be discussed by the buyer and seller; the accounting department should be informed throughout this process, and everyone should understand and identify the intangible asset.
Intangible assets must meet the contractual agreement or separability criterion as defined in accounting guidance. The contractual agreement criterion primarily refers to an asset having value that’s legally contracted, such as noncompete agreements or trademarks and trade name. The separability criterion refers to the fact that the asset could be marketed independently of the company, such as customer lists. Buyers, management and the accounting department should discuss to ensure all intangible assets are identified. Once intangible assets have been identified, fair value must be estimated. In almost all circumstances, the use of a third-party valuation specialist should be considered when significant separately recognizable intangibles are acquired. .
Accounting for Acquisition Transaction Costs
Accounting teams often struggle with accounting for acquisition transaction costs and knowing what to capitalize or expense. The buyer, management and accounting department all should understand the importance of accumulating all acquisition costs. It’s important to have a detailed listing of all costs with a detailed explanation. This list should include costs paid prior to, during and after the transaction. This can help accounting, the audit firm and tax preparers in the future. In many circumstances, the treatment of acquisition between book and tax will not be the same.
The majority of buyer transaction costs, other than those related to the issuance of debt or equity, are an expense in the period incurred. These include legal costs, accounting and valuation services, due diligence fees, consulting fees and advisory fees. In some transactions, these expenses are paid during the closing and funds are not disbursed from the company’s bank account. This can lead to the expenses not being properly reflected in the company’s financial statements. The accounting department should ensure it has properly collected all expenses and that those expenses are recorded in the company’s financial statements.
Payment of seller fees by the buyer should not be expensed or capitalized. These fees usually are consideration paid to the seller and should be included in the purchase price. Payment of fees by the seller on behalf of the buyer should not be included in consideration; these costs should be expensed by the buyer in the period incurred.
Primarily, the only transaction costs to capitalize are those for the issuance of debt or equity in an acquisition. Accounting guidance distinguishes these costs from other acquisition-related costs because they are components of obtaining financing for the acquisition. These costs should be capitalized and amortized to interest expense if related to the issuance of debt or charged to equity if related to an equity raise.
Cover Your Covenants
It’s important to consider the impact of the acquisition accounting on financial covenants that may have been established based on the target’s historic earnings and financial statements. It’s also important to consider the due date of audited financial statements during the year after the acquisition. Many financial institutions require audited financial statements 90 days after year-end. Even if the company being acquired has been previously audited by an audit firm and has a strong accounting department, this still can be a challenge due to the accounting issues related to the business combination. If the acquired company never has had an audit and there are significant expected accounting changes, a 90-day timeline can be impractical. It’s often helpful to request 120 or 150 days for the initial audit delivery date as companies work through post-acquisition transition matters.
Communication Is Key
The buyer, management, accounting department and audit firm all must be aware of accounting issues surrounding the business combination. The earlier these groups begin to discuss these issues, the more successful accounting for the business combination will be.
Accounting for business combinations is often difficult, but all can be made easier and smoother during the post-close period by working with experienced advisors who are engaged early in the acquisition process.
For more information about accounting best practices during and after an acquisition, contact your BKD advisor.