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Despite mergers and acquisition (M&A) activity coming down from 2021’s record highs, companies and private equity firms flush with cash have still been snapping up acquisitions at a rapid pace.
But as the dust settles on a new transaction, end-of-year accounting looms, bringing with it a new hurdle: minimizing potential challenges from outside auditors or the SEC related to accounting for a recently completed acquisition.
“Companies made a lot of deals in the first half of the year while the economy was still relatively strong – multiples were good, it was a frothy market,” said Gregory Watts, co-senior managing director of CBIZ Valuation Group. “It’s usually about now that companies start their purchase price allocations to capitalize these transactions on their balance sheets and perform impairment testing on prior transactions. They’ve got to have the right processes and people in place to do so accurately.”
The stakes are high, especially in a volatile and fast-moving economy, where fair value valuations and accounting tied to deals may be particularly vulnerable to challenge. In what follows, we’ll provide guidance and highlight new regulations that executives should be aware of as they account for this year’s transactions.
Completing a purchase price allocation – whereby the acquirer assigns fair values to the acquired company’s assets – is no small feat. In essence, it means attaching a price tag to everything from physical holdings, such as real estate or machinery, to intangible assets that can be trickier to value.
Companies must account for all of the acquired identifiable assets (all tangible and intangible assets) and liabilities; note increases to the book values of assets when their carrying value is less than their fair value (as determined by an independent valuation specialist) and record goodwill (i.e., the amount paid in excess of the target company’s net value).
The first step alone can present novel accounting challenges, especially as businesses increasingly rely on intangible assets, like intellectual property and customer relationships. Watts and Deepa Menon, also co-senior managing director of CBIZ’s Valuation Group, recall several unusual intangibles that they only discovered through smart questioning: a technology firm’s content library, for instance, as well as a grocery chain’s influencer network.
Given the intensive nature of this exercise, Menon says that starting early is key.
“The real issue isn’t so much execution – it’s about lining up the pieces,” she said. “There are any number of different people and departments that need to get involved, and it can sometimes be difficult to get the information needed to do a thorough valuation – especially for intangibles, where you need qualitative information to support quantitative data. Establishing clear lines of communication with the target company’s audit team early on in the exercise to align on logistics and process can help.”
As part of an organization’s successful audit planning, several types of assets will need to be tested for impairment at various times to see if their value has decreased. For companies engaged in M&A, a key example is goodwill – that is, intangible factors such as reputation that influence the decision to pay more for an acquisition than the fair value of a company’s assets.
Pursuant to Accounting Standards Codification 350, goodwill, particularly for public companies, is typically not amortized and, therefore, must periodically undergo impairment tests: at the beginning of a fiscal year if certain “trigger events” (e.g., adverse changes in the business climate) occur, and annually, in the case of public companies. When it comes to goodwill, impairment tests involve first comparing an asset’s fair value to its carrying value; then, if impairment is indicated, an organization will need to enlist the help of a valuation specialist to adequately quantify the impairment.
“Public companies have it relatively easy – they can just look at their stock price,” said Watts. “Private companies, however, have to do a little more work, especially during periods of economic uncertainty.”
Impairment also needs to be considered when disposing of certain assets, which is increasingly likely in times of economic uncertainty.
Typical impairment steps include:
- Determine if a trigger event has occurred
- Classify assets or asset groupings as to be held and used or to be disposed of
- Determine if testing the carrying amounts of assets is needed
- Test long-lived assets for recoverability and impairment
- Determine the fair value of applicable assets
- Measure and recognize an impairment loss
Big drops in a company’s stock price and volatility in foreign exchange rates are just some of the issues that can lead to a triggering event. During the pandemic, for example, companies across sectors from energy to tourism booked goodwill impairment charges, citing COVID-19 and the resulting impact on their business.
Lease Accounting: A New Risk Area
The deal landscape has shifted this year, as have the types of companies being bought and sold. In the manufacturing industry, for instance, deals used to be heavy on hard assets like machinery and real estate; now, they increasingly involve service-focused and technology-driven intangibles.
But that’s not the only evolution underway. “Just as transactions are changing, so too are regulations and standards that impact accounting for them,” says Menon.
For example, private companies this year must adapt to new lease accounting standards, which essentially state that organizations must now account for leases as an intangible asset – that is, as the right to use an actual asset stated in a lease rather than the actual asset itself. As such, all leases longer than 12 months must be documented as assets and liabilities on a company’s balance sheet. The rules are part of a broader effort to boost financial transparency around leases, by including all types – not just capital leases but also operating leases, which were previously listed as expenses – on a company’s books.
This change presents new challenges, especially in today’s volatile interest rate environment. To calculate a lease liability, lessees must use the interest rate “implicit” in a lease to find the present value of future lease payments. Unfortunately, this rate tends not to be available, necessitating the use of an “incremental borrowing rate,” or the rate a lessor would have charged if they had financed the asset in question instead of leasing it.
As we enter a downturn, new acquisitions can help accelerate needed business transformations and provide growth-stage companies with alternative sources of capital – particularly amid an IPO slowdown.
Yet, in all the hubbub surrounding a new transaction, companies can’t forget the importance of preparing for potential audits or challenges from the SEC or other regulatory bodies. Focusing on these critical areas – and getting in touch with an independent valuation specialist – can help.
Copyright © 2022, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.
CBIZ MHM is the brand name for CBIZ MHM, LLC, a national professional services company providing tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies. CBIZ MHM, LLC is a fully owned subsidiary of CBIZ, Inc. (NYSE: CBZ).