The Effect of Change in Control Transactions on Financial Reporting
M&A activity reached record levels in 2015 with deal volume reaching $4.9 trillion—and the momentum shows no signs of slowing. Within the restaurant industry, it seems much of this M&A activity is driven by the market’s saturation and private equity investors turning their attention toward established concepts with strong EBITDA and increased same-store-sales.
Auditing and accounting for business transactions in accordance with the FASB’s ASC 805, Business Combinations
, presents a number of complexities. As deal-making continues at a frenzied pace, we have identified the top 5 issues to keep in mind:
- Asset purchases vs. business combinations
Many companies prefer the transaction be classified as an asset acquisition rather than a business combination for tax purposes, particularly the simplicity of asset purchase transactions, as opposed to business combination transactions.
Thus, purchase agreements often stipulate the transaction is an asset purchase agreement rather than the acquisition of a business. But don’t let the wording fool you—if what is being acquired meets the definition of a business, it is a business combination for accounting purposes.
- Identification and valuation of intangible assets and favorable/unfavorable lease arrangements
The acquirer is required to identify all the assets acquired and liabilities assumed, regardless of whether they were previously recorded by the entity being acquired. Assets acquired not only includes tangible assets, such as property, plant and equipment, but also intangible assets.
Accounting principles generally accepted in the U.S. (GAAP) require intangible assets to be separately recognized apart from goodwill if they are separable or arise from contractual or legal rights. There are intangible assets like brands, trademarks and patents, however, some other, more surprising, intangible assets such as trade dress, jingles and customer relationships (both contractual and noncontractual) are also included.
It’s not easy to value a customer list, brand or customer relationship, since the valuations typically involve sophisticated models using inputs that are unobservable (i.e. Level 3 fair value measurements). Thus, management typically engages specialists to value these assets. Remember, although they are using a specialist, this does not relieve them of their overall responsibility for properly accounting for the business combination transaction.
U.S. GAAP also requires lease agreements that were not negotiated within the previous 12 months from the acquisition date to be considered for favorable or unfavorable lease treatment. Because each property is unique, companies will likely need to work with a broker or other real estate professional in the markets where the properties are located to establish what represents market rates when determining the favorable or unfavorable lease treatment for the location.
- Management review controls
Although business combinations are non-routine transactions, this characteristic does not preclude a company from establishing controls over the transactions. Auditors may find that controls in place around business combinations are less robust or more challenging for management to apply. The Public Company Accounting Oversight Board (PCAOB) has found several instances of management review controls put in place but not adequately audited. For example, auditors documented and observed a management review control had taken place, but failed to ascertain that the control was operating with sufficient precision to prevent against material misstatements in the financial statements.
- Contingent consideration
Any contingent consideration included in the purchase agreement should be included in the purchase price. The amount to be included is measured at fair value at the acquisition, which may not equal the expected payout at the settlement date. This estimate of fair value should consider the probabilities of payment and the time value of money.
As the fair value of the contingent consideration increases, so does the purchase price and thus, any eventual goodwill recorded at acquisition date. However, this is not a one-time consideration. Each reporting period, this contingent consideration needs to be remeasured at fair value with the corresponding entry made to current period earnings.
Most contingent consideration is based on the future earnings of the company being acquired. This estimate involves significant management judgment, especially as the period of the contingency increases.
- Measurement-period adjustments
Many companies falsely believe they have up to one year to finalize the purchase price allocation. While they do have one year to make certain adjustments, it is not a blank check. Only items that existed at the acquisition date and were provisionally accounted for at that time qualify.
This has been an area of concern for the SEC as they remind filers that it is only appropriate to characterize an adjustment to the assets acquired or liabilities assumed in a business combination as a measurement-period adjustment (as opposed to a correction of an error) if:
- The acquirer obtains new information about facts and circumstances that existed at the time of the acquisition that, if known then, would have impacted the amounts recognized;
- The company’s initial disclosures indicate that the accounting for the acquired assets and liabilities assumed is incomplete; and
- The measurement period has not ended.
In the past, measurement period adjustments were made retrospectively by “recasting” prior periods presented in the financial statements. Luckily, the FASB recently published ASU 2015-16
, making the accounting for measurement period adjustments a bit easier.
If you are mindful of these five areas when accounting for or auditing a business combination, you’ll be well on your way to properly applying ASC 805.
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