ASC 805: Accounting for Business Combinations

When one company acquires another, the financial reporting is governed by the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) Topic 805, Business Combinations. This standard provides the framework for mergers and acquisitions, ensuring consistent and transparent financial statements. The primary goal of ASC 805 is to improve the relevance and comparability of financial information by mandating the use of a single “acquisition method” for all business combinations.

Scope and Foundational Principles

ASC 805 applies to all transactions where an entity obtains control over one or more businesses. A determination must be made as to whether the acquired assets and activities constitute a “business,” as this accounting is different from a simple asset acquisition. To clarify this, a screening test is used. If the fair value of the gross assets acquired is concentrated in a single identifiable asset or group of similar assets, the transaction is an asset acquisition. If it fails this screen, it is a business only if it includes both an input and a substantive process that together can create outputs.

Before applying the acquisition method, two principles must be established. The first is identifying the acquirer, which is the entity that obtains control, often determined by majority ownership or the ability to direct management. The second principle is determining the acquisition date, which is the date the acquirer obtains control of the acquiree. This date, usually the closing date of the deal, serves as the single point in time for measuring all aspects of the transaction.

Determining the Consideration Transferred

All forms of consideration transferred by the acquirer must be measured at their fair value on the acquisition date. This includes cash, other assets like property or equipment, and equity interests, such as common or preferred stock issued by the acquirer.

A more complex component is contingent consideration, which involves future payments dependent on certain events or conditions being met. For example, an acquirer might agree to pay an additional amount if the acquired business achieves specific earnings targets. This potential future payment must be estimated at its fair value on the acquisition date and included in the total consideration. The fair value of contingent consideration is recorded as a liability or an asset and is remeasured at fair value in each subsequent reporting period, with changes in value recognized in the income statement.

Acquisition-related costs, such as legal, advisory, and valuation fees, are not included in the consideration transferred. These costs are treated as expenses in the period they are incurred.

Recognizing and Measuring Acquired Assets and Liabilities

The acquirer must identify and measure all assets acquired and liabilities assumed in the business combination. The guiding principle of ASC 805 is that these items should be recognized at their fair value as of the acquisition date. The acquirer must recognize all identifiable assets, including those that may not have been previously recorded on the acquiree’s balance sheet, such as tangible assets and intangible assets.

Examples of identifiable intangible assets that must be recognized separately from goodwill include:

• Patents
• Trademarks
• Customer relationships
• Franchise agreements

The acquirer must also recognize all liabilities assumed from the acquiree at their fair value, including items such as debt, lease obligations, and employee benefit plans. There are some exceptions to the fair value principle. For instance, contract assets and liabilities from revenue contracts are measured in accordance with the revenue recognition standard, rather than at fair value.

Calculating Goodwill or a Bargain Purchase Gain

The final step is to determine if there is any goodwill or a gain from a bargain purchase, which is a residual calculation that reconciles the purchase price with the value of the net assets acquired. Goodwill is recognized when the consideration transferred is greater than the fair value of the net identifiable assets acquired. It represents the intangible value of the acquired business that is not separately identifiable, such as its brand reputation, customer loyalty, and expected synergies. For public companies, goodwill is recorded as an intangible asset, is not amortized, and is tested for impairment annually.

Private companies have an accounting alternative and can elect to amortize goodwill on a straight-line basis for up to 10 years. If this option is chosen, goodwill is tested for impairment only when a specific event suggests its value may have declined. In rare cases, the fair value of the net assets acquired may exceed the consideration transferred, resulting in a bargain purchase gain recognized in the acquirer’s income statement. Before recognizing a gain, ASC 805 requires the acquirer to reassess the identification and measurement of all assets and liabilities to ensure no items were misvalued.

Post-Acquisition Measurement and Disclosures

The accounting for a business combination does not end on the acquisition date. ASC 805 provides for a “measurement period,” not to exceed one year from the acquisition date, during which the acquirer can adjust the provisional amounts recorded for the transaction. This allows for refinement of initial estimates as new information becomes available about facts and circumstances that existed at the time of the acquisition. If new information is obtained during this period, the acquirer must retrospectively adjust the provisional amounts. Any adjustments made after the measurement period are recognized in the current period’s earnings.

ASC 805 also mandates extensive disclosures to help financial statement users understand the effect of a business combination. The acquirer must disclose information such as a breakdown of the purchase price, the fair value of the assets and liabilities acquired, and the amount of goodwill recognized. If the initial accounting is incomplete, the acquirer must disclose the reasons why and the items for which the accounting is still provisional.