Accounting for a Business Combination: A CFO’s Guide

Understanding the complexities of a business combination can be daunting for any CFO. The process involves numerous detailed steps, each requiring careful attention to ensure compliance with ASC 805: Business Combinations. This high-level guide provides CFOs with a comprehensive overview of the key considerations and challenges they may encounter when accounting for business combinations.

At its core, a business combination occurs when one entity gains control over another, resulting in a need to accurately recognize and measure the assets, liabilities, and noncontrolling interests involved. The following sections break down the critical steps in this process, from identifying the acquirer to addressing noncontrolling interests.

Key Steps in Accounting for a Business Combination

1. Determine the Acquirer

• Identify the entity that has gained control of the acquiree. Control is typically evidenced by majority ownership or significant influence over decision-making.

2. Establish the Acquisition Date

• The acquisition date is the date the acquirer gains control of the acquiree, often the closing date of the transaction.

3. Assessing What is Part of a Business Combination Transaction

• The transfer of consideration may be accompanied by other transactions in a business combination. Identifying those transactions that should be accounted for separately from the acquisition can require significant judgment and analysis.
• If the consideration transferred to the acquiree includes equity, determining the fair value of the equity transferred can be complex and may often require a separate third-party valuation.
• The acquirer may issue its own share-based payment awards (replacement awards) in exchange for awards held by grantees of the acquiree. The purpose may be to keep the grantees “whole” after the acquisition (i.e., preserve the value of the original awards at the acquisition date) or to provide further incentive for recipients to remain with the combined entity. Therefore, replacement awards may represent consideration for precombination vesting, postcombination vesting, or a combination of both.

4. Recognize and Measure Identifiable Assets and Liabilities

• Assets acquired and liabilities assumed are generally measured at their fair values on the acquisition date, with only a few exceptions.
• This includes tangible assets (e.g., property, inventory) and intangible assets (e.g., trademarks, patents, customer relationships).

5. Measure Goodwill or Bargain Purchase

• Goodwill is the excess of the purchase consideration over the fair value of net assets acquired.
• If the purchase price is less than the net assets’ fair value, a bargain purchase gain is recognized in earnings.

6. Record Contingent Consideration

• Any contingent payments (e.g., earnouts) are measured at fair value and recorded as part of the purchase consideration. Adjustments to contingent liabilities post-acquisition often affect earnings.

7. Address Noncontrolling Interests (NCI)

• Noncontrolling interests are measured at their proportionate share of the fair value of net assets or at fair value.
• Each reporting period, a reporting entity should attribute net income and comprehensive income of a consolidated subsidiary to the controlling interest and NCI.

Common Pitfalls and Challenges

1. Fair Value Measurement Complexity

• Pitfall: Determining fair value for equity consideration transferred (which may not necessarily be equal to the implied value in the purchase agreement), equity instruments exchanged and intangible assets (e.g., technology, brand equity) can be subjective and requires significant judgment.
• Mitigation: Engage third-party valuation experts to ensure compliance and accuracy.

2. Identifying Intangible Assets

• Pitfall: Failing to identify all intangible assets, leading to misstated goodwill.
• Mitigation: Perform a thorough assessment of the acquiree’s operations and contracts.

3. Contingent Consideration

• Pitfall: Misestimating the fair value of contingent payments, failing to account for changes in earnout estimates or classifying payments as contingent consideration instead of future compensation expense.
• Mitigation: Regularly reassess contingent consideration and document changes in assumptions. Carefully analyze any contingent payments to determine whether they are, in fact, contingent consideration or compensation agreements.

4. Accounting for Pre-existing Relationships

• Pitfall: Overlooking the settlement of pre-existing arrangements, such as supplier agreements or litigation, which can impact the purchase price allocation.
• Mitigation: Analyze all pre-existing relationships for proper treatment.

5. Integration Challenges Impacting Financial Reporting

• Pitfall: Post-acquisition integration issues, including different systems and processes, can lead to control and financial reporting breakdowns.
• Mitigation: Strengthen internal controls and align accounting systems, policies, and processes early in the process.

6. Tax Implications

• Pitfall: Misaligning deferred tax accounting with the fair value adjustments in the purchase price allocation.
• Mitigation: Collaborate with tax experts to understand the implications of deferred taxes and uncertain tax positions.

7. Impairment Risk for Goodwill and Intangibles

• Pitfall: Goodwill and intangibles impairment due to overestimated synergies or underperformance of the acquired business.
• Mitigation: Conduct regular goodwill impairment testing in line with ASC 350 requirements.

8. Share-based payment awards

• Pitfall: Overlooking contractual terms in share-based payment award agreements (e.g., pre- and post-combination vesting conditions, replacement awards, accelerated vesting, etc.), which can result in misstatements in purchase price or pre/post-combination expense recognition.
• Mitigation: Ensure a complete understanding of the terms and conditions of share-based awards, related vesting conditions, and related accounting implications.
• Pitfall: Companies paying certain legal and transaction costs without a complete picture of what those costs relate to or for whom they benefit.
• Mitigation: Identifying and understanding who is responsible for paying legal and other transaction costs to ensure such costs are properly accounted for.

9. Legal and other transaction costs

Talk to an Expert

There are many complex factors to consider when accounting for a business combination. Due to the intricacies of these processes, it is advisable to consult with your CBIZ Financial Accounting & Advisory Services (FAAS) professional early in the transaction. They can help you avoid pitfalls and ensure all aspects of the transaction are accurately recorded, enabling informed decisions that meet accounting requirements.