October 10, 2013
We would like to share with you our answers to frequently asked questions concerning the accounting treatment for business acquisitions. You should consult with your accountant since facts and circumstances may differ in your potential acquisitions.
FAQ 1: How do we account for acquisition related cost in a business acquisition?
Response: The FASB requires that acquisition related cost should be expensed and should not be capitalized as part of the acquisition with the only exception associated with cost to issue debt and equity securities. Refer to actual guidance below:
As per FASB ASC 958 "Business Combination", 958-10-25-23 Acquisition-related costs are costs the acquirer incurs to effect a business combination. Those costs include finder's fees; advisory, legal, accounting, valuation, and other professional or consulting fees; general administrative costs, including the costs of maintaining an internal acquisitions department; and costs of registering and issuing debt and equity securities. The acquirer shall account for acquisition-related costs as expenses in the periods in which the costs are incurred and the services are received, with one exception. The costs to issue debt or equity securities shall be recognized in accordance with other applicable GAAP.
FAQ 2: How do we account for earn-outs in a business acquisition?
Response: Generally contingency consideration of an acquiree assumed by the acquirer in a business acquisition should be recognized initially at fair value. This is the same for contingency arrangements such as earn-outs that occurs as part of an acquisition. During the initial recording of contingency consideration the company would record a liability at the date of the acquisition with an offset to either an intangible asset such as goodwill or another asset account. You will need to consult with your accountant since there may be instances when recording such contingencies may not be necessary.
Additionally, as noted in FASB 805-30-35, changes resulting from events after the acquisition date, such as meeting an earning target, reaching a specified share price, or reaching a mile stone shall be remeasured to fair value at each reporting date until the contingency is resolved. The changes in fair value shall be recognized in earnings.
Example of an earn-out calculation: As part of an acquisition, the buyer and seller agreed to an earn-out provision that requires the buyer to pay the seller $400K per year if revenues for each of those years are greater than $10M. The agreement is for the next five fiscal years. The company on the date of acquisition would need to perform projections and calculate the likelihood of meeting the earn-out requirements. Assume management has determined that they expect to achieve the $10M revenue targets only in years 3, 4 and 5. The company would have an undiscounted liability of $1.2M ($400K for each of years 3, 4 and 5). The company will then use a present value formula to calculate the present value of that liability which in this example would be $1M.
The company would then record at the date of acquisition $1M of intangibles and $1M in liabilities. Assume in year 2 the company realized that it will only meet the $10M revenue target in year five only. The company would adjust the liability in year 2 to reflect the updated liability and would record the adjustment into earnings.
FAQ 3: Can an asset purchase be considered a business acquisition?
Response: That depends if the asset purchase meets the definition of a business. A business per FASB 805-10-55-4 consists of inputs and processes applied to those inputs that have the ability to create outputs. Although businesses usually have outputs, outputs are not required for an integrated set to qualify as a business.
Here are some examples: (assume the purchase agreement indicates that individual A is only buying a store and its assets and not assuming any liabilities)
Example 1: Individual A purchased a store from a retail company. Individual A is expecting to enter the same type of industry as the retail company he or she is buying the store from. The store that individual A is buying has employees and he or she will most likely be using the same distributor that the retail company was using. Would you consider this a business acquisition or simply a purchase of assets? Under the FASB guidance, Individual A most likely has purchased a business because he or she would have the inputs which in this case would be the distributor. He or she is also obtaining the employees which would be instrumental for the business process. Finally, once he or she opens the store the store most likely will have a customer base since that store originally serviced the same industry as the buyer is entering into.
Now let's change the facts a little.
Example 2: Assume now individual A purchased a store from a retail company. However he or she is planning to enter into a different type of retail industry then the previous retail company. Assume also in this case the store was closed down for years and there were no employees. Additionally, due to the different type of industry individual A is entering into he or she will have a different type of distributor. In this case, there will be a strong indication that individual A is in fact not buying a business instead he or she is buying assets. The reason being, that this store appears not to have inputs and a process as compared to the first example above. Additionally, there will most likely be a different customer base since individual A's plan is to open a retail store in a different industry then the predecessor owner.
FAQ 4: What is the difference in the accounting between an asset purchase and a business acquisition?
Response: As asset purchase is exactly what the name states. It is a purchase of assets and you record the purchase on your financial statements as you do when you purchase your day to day assets except as noted below. In a business acquisition, you are purchasing a business and the accounting for this will be significantly different than an asset purchase. In a business acquisition you would fair value your intangibles, goodwill, record contingency liabilities and etc. These are significant differences. Consult with your accountant.