Most of us involved in transactions remember the old (APB Opinion 16) accounting rules where, depending on the facts and circumstances, each transaction was accounted for as either a pooling or a purchase. This resulted in a situation where similar acquirers could perform comparable acquisitions with very different accounting results. The Financial Accounting Standards Board (FASB) believed that this inconsistency reduced the usefulness of financial statements, and SFAS 141 (effective June 30, 2001) addressed the potential inconsistency by eliminating the pooling of interests method and made significant revisions to the purchase method. Recently, SFAS 141 was revised, and the new rules are a significant break from those that existed in the 1990s.
For reporting periods beginning after December 15, 2008, FASB requires the use of the acquisition method of accounting for business combinations. The acquisition method replaces the purchase method, which is no longer used. The acquisition method of accounting for business combinations is explained in ASC 805 Business Combinations (SFAS 141(R)). The acquisition method consists of four general steps:
- Identify the acquirer.
- Determine the acquisition date.
- Calculate the fair values of the identifiable assets acquired, the fair values of the liabilities assumed, and the fair value of any non-controlling interest in the acquired entity.
- Recognize any goodwill associated with the transaction or the gain from a bargain purchase.
In addition, the consideration transferred to the seller in a business combination is measured at fair value. The fair value of the consideration transferred to the seller is equal to the sum of the fair values of all the assets transferred by the acquirer, plus the sum of the fair values of the liabilities assumed by the acquirer, plus the fair value of any equity securities issued by the acquirer.
Other key differences from previous practice include:
- Contingent consideration is explicitly considered at fair value on the acquisition date.
- Costs related to the transaction are expensed by the acquirer in the period incurred rather than being capitalized.
- Anticipated restructuring costs are expensed in the period incurred rather than capitalized as part of the transaction price.
- Acquired research and development assets are recorded on the balance sheet at fair value.
- Certain portions of FASB Statement 109, Accounting for Income Taxes, are modified so that certain tax items which had previously been accounted for by reducing goodwill are now recognized as income tax expense.
Because acquirers generally think of transaction prices in total (“We paid $2.0 million for ABC Company”) rather than thinking of their acquisitions as collections of assets (“We paid $1.0 million for the tangible assets, plus $150 thousand for the customer list, plus $100 thousand for trade dress, plus …”), the new accounting rules often result in the need for appraisers to opine on the value of particular acquired assets in order to allocate the purchase price among the assets. These purchase price allocation projects assist management in determining the opening balance sheet for the acquisition. In practice, the process typically involves the following steps, although the specific process varies from engagement to engagement:
- Determine a market participant weighted average cost of capital for the acquired entity and, if appropriate, the business enterprise value of the acquired entity (BEV is the value of total invested capital or the value of the equity plus the value of the debt).
- Arrive at the fair value of the consideration paid in the transaction (the acquisition price). In a cash deal, this might be simple; in deals with complex and/or contingent consideration, this can be a significant undertaking. Ideally, the fair value of the consideration paid in the transaction will approximate the business enterprise value of the acquired entity. If the acquisition price is less than the net fair values of the assets acquired and liabilities assumed, a bargain purchase occurred, and the acquirer will recognize a gain on the transaction. If the acquisition price is significantly greater than the net fair values of the assets acquired and liabilities assumed, there might be goodwill impairment issues.
- Using a market participant forecast, calculate the internal rate of return (IRR) implied by the transaction. If this differs significantly from the market participant weighted average cost of capital (WACC), the difference should be discussed and reconciled.
- Identify the tangible and intangible assets acquired and determine their fair values. The identification of the intangible assets acquired will normally require discussions with management of the acquirer regarding the motives behind the transaction. It also sometimes involves a more in-depth analysis of the cash flows associated with the acquired intangibles than many acquirers are accustomed to performing.
- The excess of the fair value of the consideration paid in the transaction over the sum of the fair values of the identified tangible and intangible assets acquired is recognized as goodwill.
- Determine the market returns on the various assets acquired in the transaction, and determine the implied weighted average return on assets.
- Assess the reasonableness of the concluded asset allocation by comparing the implied returns on the various assets to each other (assets with more risk should require higher returns) and by comparing the implied weighted average return on assets to the market participant WACC and/or the transaction IRR.
Once the fair value of the consideration paid in the transaction is allocated to the various tangible and intangible assets, the opening balance sheet for the acquired entity can be created. For most intangible assets identified in a transaction, the fair value of the assets will be amortized over their useful lives. Assets whose useful lives cannot be determined (such as goodwill) are not amortized, but instead are tested for impairment under certain circumstances.
Decosimo Advisory Services has performed a number of purchase price allocation projects for acquisitions both simple and complex. We work with our clients’ auditors to determine a scope of work that makes sense for all involved, and our opinions of fair value have been accepted by auditors from local, regional and Big 4 firms.
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If you have a purchase price allocation question, please feel free to call us in confidence at 800.782.8382.