Mastering accounting for business combinations
Mergers and acquisitions present challenges that finance can overcome by staying involved with the deal and preparing in advance of the closing.
By Maria L. Murphy, CPA
When accountants face the prospect of a business combination, there will be many challenges to prepare for in the deal and the accounting for it.
One of the first challenges is the strategic decision-making about whether the deal is right from a business perspective.
"Statistically, acquisitions aren't successful a high percentage of the time," said Aaron Saito, CPA, CGMA, Capital Accounting controller at Intel Corp. "It's like a baseball batting average, where .300 to .400 is outstanding. If you're at this percentage for M&A, you're beating the average," he said.
There are deal activities usually led by those outside of finance, such as finding the right target, performing due diligence, setting the price, drafting a purchase agreement, and working with professionals to close the transaction.
"Much of the complexity in acquisitions results from stresses around negotiating the deal structure, like funding arrangements, tax considerations, and continuation or dismissal of the acquired entity's employees," said Susan Callahan, CPA, Ford Motor Co.'s director, Americas Accounting and Global Policy. "These are in addition to the technical complexity of financial reporting."
FASB ASC Topic 805, Business Combinations, is a specialized accounting area that has evolved over the years and continues to be the subject of simplification initiatives by FASB. It is complex and may require CPAs to face new issues and apply certain accounting principles for the first time (see the sidebar, "Accounting Quick Tips," below).
"Unless you work for a company that is a serial acquirer, you are not applying acquisition accounting day to day, like you are other GAAP areas like revenue recognition and inventory accounting," said Greg McGahan, CPA, a partner at PwC. "Most companies only do one acquisition every couple of years, as it is only one path of a company's growth agenda. You may have to crack the books open and deal with a new accounting model, to refresh what you remember but also to keep up with the changes," he said.
To help accountants better anticipate and prepare for the challenges in business combinations, here are some things to consider.
INVOLVEMENT WITH THE DEAL
Since finance may not be leading the acquisition process, it is critical that it has a seat at the table and a strong partnership with the business development team throughout the transaction life cycle. In that way, finance will understand the deal's rationale, critical contract terms, and where the value drivers are.
"In a typical case, the business development group has done their due diligence, analyzed the target, developed the price, and determined the value drivers. Then the deal is closed, and the torch is passed to finance to do the acquisition accounting," McGahan said.
He said that if there is a lack of communication with the deal team, and finance doesn't understand the value drivers — such as a business that was acquired for a customer list or a platform that was too difficult to build internally — it will be much harder to apply acquisition accounting and properly value assets acquired and liabilities assumed.
Saito agreed that it is very important to understand the accounting ramifications upfront. "Once the ink is dry on the contract, you don't have options," he said. "And it's not easy to read purchase contracts. They can be 400 to 500 pages long, so it's easy for even the best accountants to miss something."
Finance needs to ensure that it does not get left out of the due-diligence process, because it can add value to the negotiations and help determine the best accounting and tax outcomes.
"Being part of due diligence can help finance understand the business being acquired and uncover areas where things can go wrong. Otherwise, you may not know what you don't know," said Linnae Latessa, CPA, corporate controller and chief accounting officer of USI Insurance Services.
Finance can reduce risks and avoid surprises by advising the due-diligence team against doing things in the transaction based on the potential financial impacts post-close, Saito said.
Accounting for business combinations is complex and requires considering a number of areas, including the following:
Identifying business combination transactions.
Identifying the acquirer.
Determining the acquisition date.
Measuring the consideration transferred.Recognizing and measuring the identifiable assets acquired and liabilities assumed, and any noncontrolling interests in the acquiree.
Recognizing and measuring goodwill for a gain from a bargain purchase.
Topic 805 provides guidance on the accounting and reporting for business combinations to be accounted for under the transition method.
One of the biggest challenges in applying acquisition accounting is the requirement to estimate the fair value of assets acquired and liabilities assumed. Valuation is challenging and requires a lot of judgment, which needs to be supported. Irrespective of whether the valuation is performed internally within a company or by an outside third party, finance needs to be aware of fair value accounting requirements and involved in the valuation process.
"Fair value using the concept of what 'market participants' do in arm's-length transactions may be a foreign concept," said Saito. Also, things may need to go on the balance sheet that were never valued before, like internally developed intangibles, intellectual property, know-how, and brands.
Valuation is frequently based on cash flow models. "Does the company have cash flow models? If so, how do you adjust them to reflect market participant assumptions? Where are the cash flows associated with the valuation? How do you translate deal price of '10X EBITDA' into cash flows?" asked Saito.
Some companies may perform the valuation themselves internally. If they do, it is important for finance to have the necessary expertise and to work with the external auditors to make sure the documentation and support that finance develops for the acquisition accounting is adequate for the auditors' needs.
Many companies use third-party valuation firms for their fair value estimates. Latessa recommended that transactions over a determined dollar value have an outside valuation. If a third-party valuation firm is used, management must be comfortable with the outcome of its activities.
"The valuation firm works from the assumptions the company provides, such as revenues used to value trademarks, and specific customer revenues and attrition rates to value customer intangibles," said McGahan. "At the end of the day, the financial statements are the company's responsibility. Mistakes in valuation in the financial statements are on your watch."
McGahan also advised that successful companies have an integrated approach to the valuation process, which includes the business development team and finance. The valuation experts should be given the deal's model assumptions (discount rates, internal rate of return, hurdle rates, and cost of capital) and the final version of the deal model to use, and everyone on the team should review the valuation output for reasonableness.
"Work with a good quality valuation firm, ask a lot of questions, and understand how they come up with the values," Latessa said. "They know how to run models, but conceptually does the answer make sense? Should 50% of the deal value have gone to the customer list? They should be able to explain why it makes sense."
The amount attributed to goodwill should also be reasonable in relation to the purchase price.
"It's the residual, but accountants should be able to validate it," McGahan said. "If 40% of the purchase price is allocated to goodwill, does that make sense based on the deal or value drivers? Things like future customers, platform, and company-specific synergies all go to goodwill."
This approach will pay dividends in the end, especially since valuation is an area of high audit concern. Because of the prevalence of merger activity in recent years and the many subjective judgments and estimates involved in the business combination process, the PCAOB highlighted its concern about valuation risk in its August 2017 Staff Inspection Brief. The PCAOB also recently issued two new standards that affect auditing of valuations: Amendments to Auditing Standards for Auditor's Use of the Work of Specialists and Auditing Accounting Estimates, Including Fair Value Measurements, and Amendments to PCAOB Auditing Standards.
CHANGES TO GAAP
The fair value challenges aren't the only things that make business combination accounting complex. FASB is continuing to work on initiatives to simplify this area and improve comparability. In 2017, FASB issued guidance that clarified the definition of a business. FASB also has several projects on its agenda that may impact business combinations, including subsequent accounting for goodwill and accounting for certain identifiable intangible assets, as well as improving the accounting for business and asset acquisitions. The experts interviewed for this article all agreed that these efforts have been helpful and made things better operationally.
FASB has also developed private company alternatives related to accounting for business combinations (see "Private Company GAAP Alternatives: It's Not Too Late," page 32). However, the practical expedients for private companies should be used only if the company's financial statements stay in the private domain and the banks will accept this format. McGahan advised: "Most companies doing acquisitions will need to access capital markets to raise money, so financial statements may need to be SEC-compliant."
Financial statement disclosures for business combinations can be extensive, especially for larger transactions.
"The critical assumptions regarding opening day balance sheet values are important for financial statement users," said McGahan. "They need transparent disclosure of significant acquisition accounting assumptions and estimates that are not [derived based on] observable inputs, including how they were developed."
For SEC registrants, operating segments may change based on how the new business will be managed going forward. In addition to the financial statements, there are also management's discussion and analysis (MD&A) and description of business sections to develop and prepare within filing deadlines.
Latessa recommended that accountants look at disclosures of other companies that have done acquisitions, along with networking with peers and others in their network or industry to ask if they have had the same issues that may need to be disclosed. She also recommended getting the auditors comfortable with disclosures in advance, getting their guidance on the requirements, and asking them what their other clients have disclosed in specific situations.
AFTER THE TRANSACTION CLOSES
After the business combination closes, accountants must contend with financial reporting challenges. "You can't just mush the results of the target in with the existing business," said Saito. "Post-close, it's disruptive."
Hopefully, there have been operational discussions in advance about how the new business will be managed, whether as a stand-alone or integrated business. "There may also be challenges with 'operationalizing' the acquisition accounting after day one," McGahan said, "like whether to track acquisition accounting at the parent or push down to a subsidiary, and how to deal with international transactions' foreign currency and deferred tax issues."
The closing process may become very challenging. Accounting policies and practices may be different and may have to be conformed. This may be an opportunity to evaluate existing accounting methods and make changes. There can also be timing issues if the acquired company takes longer to close its books.
If there are different ledgers and enterprise resource planning systems, automatic consolidation may not be possible and manual processes may have to be used. There will likely be system integration issues, especially if the acquired company is smaller and uses QuickBooks. System conversions will require additional reconciliations and verification of data. McGahan recommended that companies' due diligence include IT due diligence upfront to understand the target's IT and financial reporting and plan for it. "The best companies have dedicated teams to integrate IT post-closing to get the target on the same systems," he said.
"The two companies' accounting and finance departments need to form a partnership," said Saito. "Workflows may need to change, and change doesn't happen overnight."
Latessa agreed. "You may need to retrain the acquired company's people," she said. "This results in operational risks that can manifest themselves in the financial statements, so you need to be diligent in reviewing the financial statements when there are new employees involved." She has also experienced situations where the finance staff did not transfer to the acquiring company, so legacy knowledge and experience were lost. She said that in cases where a company buys a portion of another company, the acquired company's accounting may have been done at the corporate level, and it can take six months to a year for the acquirer to understand the business it bought.
Since post-close accounting is difficult, GAAP allows up to a year post-acquisition to finalize acquisition accounting and measurement period adjustments. But in some cases, there may only be 30 to 60 days to do a working capital true-up.
"The further away from the close date it is, the harder it is to remember, and people get busy with other things," Saitosaid.
Material adjustments to the acquisition accounting made too late can be considered errors as well as deficiencies of internal controls that could require financial reporting disclosure. Saito suggested that acquisition accounting be run like a project, with finance as the project manager, providing all involved departments a calendar of key dates and activities up to the earnings release so that everyone is aware of what has to be done and who has to review it.
Beyond the book close, reporting needs to be in place, including metrics and dashboards for management about the acquired business. A cash flow process should be developed to support the business after the close.
This requires planning in advance. "CFOs and boards of directors do not like surprises," Saito said. "Management needs to be aligned with finance upfront about what to expect."
To address the issues related to business combinations, it is critical that companies implement internal controls over the integration process. "From my experience, the post-combination accounting is less an issue than is the integration of the acquired entity. Challenges associated with integrating a new company are often dependent on size and scale, but the acquirer may need to consider new systems, processes, and, most importantly, controls," Callahan said.
Another big challenge relates to the controls over the business combination process itself, especially in a company where this may not happen often.
"How robust your process is depends on the frequency of acquisitions. The harder part is that if they are infrequent, you may not know what you should be looking for," Saito said.
McGahan agreed: "Companies have spent their time and effort to develop controls around ongoing daily processes but may not have robust controls for business combinations and struggle with what these are. There is a set of specific controls and procedures that should be in place ... But companies don't spend sufficient time developing these if they are only doing a few transactions."
Post-acquisition, until there is one integrated process with combined controls, companies may struggle to comply with internal control frameworks and Sarbanes-Oxley (SOX) requirements.
"You will have to do more to get your auditors through their test work," Latessa said. "There may be extra work and cost for them to look at both companies' processes, sample sizes will likely be higher, and they will have to do more substantive work."
Under SOX Section 404, public companies must include an internal control report with management's assertions about the effectiveness of the company's internal control over financial reporting, and their auditors must attest to its effectiveness. There are SOX implications relating to the acquirer's internal controls over the acquisition accounting and financial statement consolidation processes, along with the acquired company's own internal controls over financial reporting. If it is not possible for the acquiring company to complete its assessment of internal control over financial reporting of the acquired entity between the acquisition date and the acquirer's year end, in order to assess and report on its own internal controls over financial reporting on a consolidated basis under SOX Section 404(b), there is a relief period of one year from the date of the acquisition during which it may exclude the acquisition from its assessment. Despite this relief, necessary controls should be designed and implemented as quickly as possible.
Another internal control issue is documentation. "If I think about controls that need to be in place, in my experience, substantively companies are doing the work that they need to do. They are not doing big transactions blindly, they have talked to their boards, and management time has been spent," McGahan said. "They do have support for what they've done, but they don't have the documentation all in one place. One of the biggest challenges auditors have is that companies have to go back and pull together documentation around what they've done so that auditors are able to reperform the control."
A company that is doing a material acquisition may wish to talk to its auditors in advance about what controls might be needed, Saito suggested. "This helps with the audit and also gets management comfortable that they have the right controls in place," he said. "No one wants to have an internal control issue down the line."