Accounting Best Practice Considerations for Business Combinations
Author: Matt Gootee
With U.S. corporate cash balances at record levels and interest rates staying low, BKD has observed high volumes of acquisition activity across many industries. Aggregate deal volume in the U.S. for the 12 months ended March 2017 topped $2 trillion based on recent data published by FactSet Research Systems Inc. Given the continued interest by many manufacturers to grow through acquisition, BKD sees this as a good opportunity to provide a few reminders that could help avoid unwanted surprises after closing and better position a company to account for an acquisition.
The Financial Accounting Standards Board recently clarified the definition of a business and effectively raised the bar for what qualifies for business combination accounting within Accounting Standards Codification (ASC) Topic 805, Business Combinations. These changes aren’t effective for public companies until 2018 (2019 for other entities), although early adoption is permitted. Early adoption could be beneficial to many since the changes likely will result in more acquisitions being accounted for as asset purchases instead of business combinations.
Asset acquisitions don’t generate goodwill and aren’t subject to the more rigorous accounting requirements of
ASC 805. The revised definition includes an upfront screen such that when substantially all of the fair value in the acquisition is concentrated in one asset or a similar group of assets, the transaction should be accounted for as an asset acquisition instead of a business combination. Additional clarifications also have been provided for when acquisitions of early stage companies—that may not have any sales—should be accounted for as a business combination. If the early stage company has an organized workforce and one or more inputs the workforce could eventually develop into a product or service, then it could meet the revised business definition and qualify for business combination accounting if all other criteria are met.
If management has determined an acquisition will be accounted for as a business combination, all of the acquired assets and liabilities should be measured at their fair values for generally accepted accounting principles (GAAP) accounting purposes. The fair value accounting for various items, such as property, equipment and inventory, could pose unique challenges for many manufacturers.
For acquisitions involving large amounts of real estate, equipment and other long-lived assets, assessing the fair value of the assets acquired can be challenging, especially if located in an unfamiliar market or if the equipment is highly specialized. Although it could sometimes make sense to forgo an independent appraisal or valuation based on a cost-benefit analysis, not giving adequate consideration to fair value accounting upfront could cause additional difficulties and require additional resources to be expended during an audit. If an appraisal already is being obtained to satisfy a lender’s financing requirements, management should consider discussing with the appraiser upfront if the report can be structured to also provide information on the GAAP fair value of the assets being acquired. Many appraisals include valuations based on non-GAAP measurements such as orderly liquidation value or forced liquidation value that may provide minimal benefit to management in determining fair value for reporting. So it’s important to discuss which valuation criteria will be needed for all interested parties.
Depending on the type of property acquired, the quality of the accounting records and materiality, many appraisers can forgo a site visit to perform a more cost-efficient desktop appraisal by using a listing of acquired assets. For transactions involving smaller amounts of real estate or equipment, management should consider the desktop appraisal or whether consulting local real estate agents (for land and buildings) or industry dealers, resellers or trade publications (for equipment) would provide adequate information to support fair values recorded. This process can provide an ideal time to scrub the listing of items with little or no value to minimize unnecessary property tax liability and ensure the useful lives of all items acquired have been adjusted to reflect the remaining useful life as of the acquisition date, which could be significantly shorter than the original useful life.
Acquisitions involving inventory pose their own unique challenges management should consider. It’s crucial to establish the existence of the acquired inventory and obtain an accurate cutoff as of the transaction date. If the financial statements are being audited, your auditor likely will ask to observe and perform test counts of the inventory at or near the closing date, and even if the statements aren’t audited, management should strongly consider whether a full physical inventory count at or near the closing date is needed.
For transactions structured with delivered working capital targets or excluding certain liabilities like accounts payable, a physical inventory count can help detect quantity errors before closing and provide comfort that one isn’t overpaying for the inventory. Give particular attention to any consigned inventory arrangements, inventory stored off site and inventory expected to be in transit at the acquisition date as these quantities may be based on third-party reporting that also should be evaluated for accuracy.
In addition, it’s crucial to understand the condition and valuation of the acquired inventory. Even if the financial statements aren’t audited, management should consider one or more site visits, discussions and procedures with the target company’s management to inspect the inventory’s condition and discuss and test for excess and slow-moving inventory, so that adjustments to the purchase price and adequate fair value allocation for the acquisition accounting can be established. Management also should consider obtaining information such as inventory write-off history, whether any inventory is being held to support service, maintenance or warranty agreements, what procedures the target company’s management uses to determine if inventory is obsolete and whether the acquired inventory values are supported by future sales projections.
Finally, it’s important to understand potential differences between the inventory’s book cost and fair value to avoid surprises when reporting post-close. For raw materials, the fair value is typically based on current replacement cost, which could be different from historical cost. For manufactured inventory, the fair value will be based on the inventory’s selling price, less a normal profit margin, selling cost and any remaining costs to complete. Oftentimes, this results in an inventory step-up over book value recorded for finished goods and work in process that will be charged to cost of goods sold during the post-close period as the acquired inventory is sold. This has the effect of lowering gross profit in the post-close period, so management should consider working with advisors and lenders to understand any potential effect on reported financial results.
Growth through acquisition can provide many opportunities as well as challenges. Because each transaction is unique, we recommend you consult your BKD advisor early in the process to discuss your needs.