Accounting for business combinations

The first step of applying the acquisition method is identifying the acquirer. ASC 805-10-25-4 requires entities to identify an acquirer in every business combination. The ASC master glossary defines an acquirer as follows:

The entity that obtains control of the acquiree. However, in a business combination in which a variable interest entity (VIE) is acquired, the primary beneficiary of that entity always is the acquirer.

The entity identified as the acquirer for accounting purposes usually is the entity that transfers the consideration (e.g., cash, other assets, or its equity interests) to effect the acquisition. However, in some business combinations, the entity that issues its equity interests (the “legal acquirer”) is determined for accounting purposes to be the acquiree (also called the “accounting acquiree”), while the entity whose equity interests are acquired (the “legal acquiree”) is for accounting purposes the acquirer (also called the “accounting acquirer”). Such transactions are commonly called reverse acquisitions.

In many acquisitions, the identification of the acquirer is straightforward, but in others, it can require significant judgment. If the entity identified as the accounting acquiree meets the definition of a business, the accounting acquirer accounts for the acquisition as a business combination in accordance with ASC 805. If the accounting acquiree does not meet the definition of a business, an entity must assess the nature of the assets and operations acquired. If the accounting acquiree has substantive assets (other than cash and investments), the acquisition generally is accounted for as a reverse asset acquisition. However, if the entity identified as the accounting acquiree has no substantive assets other than cash and investments, the nature of the transaction may be a reverse recapitalization rather than an acquisition.

In special-purpose acquisition company (SPAC) transactions, private operating companies (“targets”) raise capital by merging with SPACs rather than using traditional IPOs or other financing activities. A SPAC is a newly formed company that raises cash in an IPO and uses that cash or the equity of the SPAC, or both, to fund the acquisition of a target. A transaction in which a SPAC acquires an operating company target must be analyzed to determine whether the SPAC or the target is the accounting acquirer. An entity should consider all pertinent facts and circumstances in its evaluation.

In situations in which the target is determined to be the accounting acquirer, typically, the SPAC’s only precombination assets are cash and investments, and the SPAC does not meet the definition of a business in ASC 805. Therefore, the substance of the transaction is a recapitalization of the target (i.e., a reverse recapitalization) rather than a business combination or an asset acquisition. In such cases, the transaction would be accounted for as though the target issued its equity for the net assets of the SPAC and, since a business combination has not occurred, no goodwill or intangible assets would be recorded.

On January 24, 2024, the SEC issued a final rule on financial reporting and disclosures for SPACs that aims to “enhance investor protections in [IPOs] by [SPACs] and in subsequent business combination transactions between SPACs and [target] companies.”

The second step of applying the acquisition method is determining the acquisition date. The acquisition date is the date on which control of the business transfers to the acquirer and generally coincides with the date on which the acquirer legally transfers the consideration to the seller, receives the assets, and incurs or assumes the liabilities (i.e., the closing date). However, in unusual circumstances, the acquisition date can be before or after the closing date.

Determining the acquisition date is important because on this date:

● The consideration transferred is measured at fair value as the sum of (1) the assets transferred by the acquirer, (2) the liabilities incurred by the acquirer to former owners of the acquiree (e.g., contingent consideration), and (3) the equity interests issued by the acquirer.

● The assets acquired, liabilities assumed, and any noncontrolling interests are identified and measured.

● The acquirer begins consolidating the acquiree, if required.

The third step of applying the acquisition method is recognizing and measuring the identifiable assets acquired, liabilities assumed, and any noncontrolling interests in the acquiree. Step three is based on two key principles, which ASC 805 calls the recognition principle and the measurement principle. Under the recognition principle in ASC 805-20-25-1, an acquirer must “recognize, separately from goodwill, the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree.” As a result of applying the recognition principle, an acquirer may recognize certain assets and liabilities that were not previously recognized in the acquiree’s financial statements, such as certain intangible assets.

Under the measurement principle in ASC 805-20-30-1, an acquirer is required to measure “the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at their acquisition-date fair values.” Thus, most assets and liabilities and items of consideration are measured at fair value in accordance with the principles of ASC 820.

Recently issued guidance

In October 2021, the FASB issued ASU 2021-08, which amends ASC 805 to add contract assets and contract liabilities to the list of exceptions to the recognition and measurement principles that apply to business combinations and to “require that an entity (acquirer) recognize and measure contract assets and contract liabilities acquired in a business combination in accordance with Topic 606.” While primarily related to contract assets and contract liabilities that were accounted for by the acquiree in accordance with ASC 606, “the amendments also apply to contract assets and contract liabilities from other contracts to which the provisions of Topic 606 apply, such as contract liabilities from the sale of nonfinancial assets within the scope of Subtopic 610-20.” Before adopting the amendments, an acquirer generally recognizes contract assets and contract liabilities at fair value on the acquisition date.

As a result of the amendments made by ASU 2021-08, it is expected that an acquirer will generally recognize and measure acquired contract assets and contract liabilities in a manner consistent with how the acquiree recognized and measured them in its preacquisition financial statements. However, the Board acknowledges that:

“[T]here may be circumstances in which the acquirer is unable to assess or rely on how the acquiree applied Topic 606, such as if the acquiree does not follow GAAP, if there were errors identified in the acquiree’s accounting, or if there were changes identified to conform with the acquirer’s accounting policies. In those circumstances, the acquirer should consider the terms of the acquired contracts, such as timing of payment, identify each performance obligation in the contracts, and allocate the total transaction price to each identified performance obligation on a relative standalone selling price basis as of contract inception (that is, the date the acquiree entered into the contracts) or contract modification to determine what should be recorded at the acquisition date.”

Therefore, the Board notes that “the amendments may not always be as simple as recording the same contract assets and contract liabilities that were recorded by the acquiree before the acquisition and that there may be additional effort required to evaluate how the acquiree applied Topic 606.”

In addition, ASU 2021-08 indicates that the amendments “do not affect the accounting for other assets or liabilities that may arise from revenue contracts with customers in accordance with Topic 606, such as refund liabilities, or in a business combination, such as customer-related intangible assets and contract-based intangible assets. For example, if acquired revenue contracts are considered to have terms that are unfavorable or favorable relative to market terms, the acquirer should recognize a liability or asset for the off-market contract terms at the acquisition date.”

The ASU’s amendments are effective as follows:

● For public business entities — Fiscal years beginning after December 15, 2022, including interim periods within those fiscal years.

● For all other entities — Fiscal years beginning after December 15, 2023, including interim periods within those fiscal years.

The amendments should be applied prospectively to business combinations occurring on or after the effective date of the amendments.

The ASU clarifies that “[e]arly adoption of the amendments is permitted, including adoption in an interim period. An entity that early adopts in an interim period should apply the amendments (1) retrospectively to all business combinations for which the acquisition date occurs on or after the beginning of the fiscal year that includes the interim period of early application and (2) prospectively to all business combinations that occur on or after the date of initial application.” For example, assume that an entity with a calendar year-end had one business combination in the second quarter of 2020 and another business combination in the third quarter of 2021. If the entity adopts the amendments in the fourth quarter of 2021, it would apply the amendments retrospectively to the acquisition that occurred in the third quarter of 2021 but would not apply the amendments retrospectively to the acquisition that occurred in the second quarter of 2020 even if it had not yet issued financial statements for the year ended December 31, 2020.

The fourth and final step in applying the acquisition method is recognizing and measuring goodwill or a gain from a bargain purchase. The ASC master glossary, as amended by ASU 2023-05, defines goodwill as “[a]n asset representing the future economic benefits arising from other assets acquired in a business combination, acquired in an acquisition by a not-for-profit entity, or recognized by a joint venture upon formation that are not individually identified and separately recognized.” Because goodwill is not a separately identifiable asset, it cannot be measured directly. It is therefore measured as a residual and calculated as the excess of the sum of the following items over the net of the acquisition-date values of the identifiable assets acquired and the liabilities assumed: (1) the consideration transferred, (2) the fair value of any noncontrolling interest in the acquiree if a less than 100 percent interest in the acquiree is acquired, and (3) the fair value of the acquirer’s previously held equity interest in the acquiree if the acquirer had a noncontrolling equity interest in the acquiree before the acquisition. Occasionally, the sum of (1) through (3) above is less than the net of the acquisition-date fair values of the identifiable assets acquired and the liabilities assumed. In such a case, the acquirer recognizes a gain, referred to as a bargain purchase gain, in earnings on the acquisition date.

Because it may take time for an entity to obtain the information necessary to recognize and measure all the items exchanged in a business combination, the acquirer is allowed a period in which to complete its accounting for the acquisition. That period—referred to as the measurement period—ends as soon as the acquirer (1) receives the information it had been seeking about facts and circumstances that existed as of the acquisition date or (2) learns that it cannot obtain further information. However, the measurement period cannot be more than one year after the acquisition date. During the measurement period, the acquirer recognizes provisional amounts for the items for which the accounting is incomplete.

Under ASC 805-10-55-16, the acquirer is required to recognize any adjustments to the provisional amounts that were recognized during the measurement period “in the reporting period the adjustments are determined.” The adjustments are calculated as if the accounting had been completed on the acquisition date. When an acquirer adjusts a provisional amount, the offsetting entry generally increases or decreases goodwill but may also result in adjustments to other assets and liabilities. Measurement-period adjustments may also affect the income statement. In accordance with ASC 805-10-25-17, an acquirer must recognize, in the reporting period in which the adjustment amounts are determined (rather than retrospectively), the “effect [on earnings] of changes in depreciation, amortization, or other income effects . . . if any, as a result of the change to the provisional amounts calculated as if the accounting had been completed at the acquisition date.”