Accounting for asset acquisitions vs. business combinations
One of the key accounting determinations when dealing with an M&A transaction is whether the acquisition was of a business or a group of assets. It is critical to make the appropriate determination upfront, as the accounting model for asset acquisitions is significantly different from business combinations. While the determination of an asset acquisition or business acquisition may be straight-forward in some cases, you still need to go through the guidance. With the update to the guidance around the definition of a business, more transactions are now being classified as asset acquisitions than in the past. Keep in mind that the accounting determination may be different than the way the deal was structured for tax purposes. For example, if the acquisition was structured as an asset purchase, it could still be a business combination under ASC 805. If your company is particularly acquisitive, having good internal controls around acquisitions, including the accounting determinations, is extremely important.
Determining if an acquisition is a business combination or an asset acquisition
ASU 2017-01 clarified the definition of a business under ASC 805 and created an initial screen test (Step 1) to determine whether a set constitutes a business. If the screen is met, it is accounted for as an asset acquisition. If the screen is not met, an entity must determine whether there is an input and a substantive process that have the ability to create outputs (Step 2). As a result of the initial screen test, fewer transactions are expected to be business combinations.
Step 1: Screen test- Is substantially all of the fair value of the gross assets acquired concentrated in a single identifiable asset?
When applying the screen test, an entity should first identify all single identifiable assets in the acquired set. A group of identifiable assets may be considered a single identifiable asset if they are tangible assets that are physically attached to each other, or intangible assets that represent the right to use a tangible asset.
If the acquired set includes multiple identifiable assets, an entity should evaluate whether the assets are similar, and therefore aggregated for the purposes of applying the screen test. Once all single identifiable assets in the acquired set are identified, the acquirer should assess whether substantially all the fair value of the gross assets acquired is concentrated in a single identifiable asset.
In determining the fair value of gross assets acquired, an entity should include all types of consideration transferred. Cash and cash equivalents, deferred tax assets, and goodwill arising from the effects of deferred tax liabilities should be excluded from gross assets acquired. However, gross assets include goodwill that is not related to deferred tax liabilities.
The guidance does not provide a bright line for determining “substantially all.” Entities should consider how “substantially all” is applied in its existing accounting policies in other areas.
The screen test can be performed either using a qualitative or quantitative analysis. If the screen is met (the answer is yes), the acquired set is accounted for as an asset acquisition. If the screen is not met (the answer is no), an entity must continue to step 2 to determine whether it is a business combination.
Step 2: Does the set have an input and a substantive process that together significantly contribute to the ability to create outputs?
If an acquired set does not meet the screen, the entity should then apply the framework outlined in ASC 805-10-55 to determine whether the acquired set is a business. Under ASC 805-10-55, a business is an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return to investors or other owners. The three main elements of a business are inputs, processes, and outputs. To be considered a business under the framework, the acquired set must include an input and a substantive process that contribute to the acquired set’s ability to create output.
A set might lack outputs as the seller has not yet sold any products. A set does not require outputs to qualify as a business; however, outputs are an important element in any business. As a result, there is more stringent criteria for an acquired set without outputs to meet the definition of a business.
If the acquired set includes outputs, any one of the following is required in order for the set to have both an input and a substantive process that together significantly contribute to the ability to create outputs:
- Employees that have the skills and knowledge to perform a substantive process with the ability to convert acquired inputs into outputs.
- An acquired contract that gives access to an organized workforce with the ability to perform the substantive process.
- The acquired process significantly contributes to the ability to produce outputs, and cannot be replaced without significant cost, effort, or delay; or
- The acquired process significantly contributes to the ability to produce outputs, and the process is considered unique or scarce.
If the acquired set does not include outputs, both of the following are required in order for the set to have both an input and a substantive process that together significantly contribute to the ability to create outputs:
- An acquired set of activities includes an organized workforce that has the skills and knowledge to perform a substantive process with the ability to convert acquired inputs into outputs; and
- An acquired set includes an input that the organized workforce can convert into outputs.
When evaluating whether a set meets the criteria above, the presence of more than an insignificant amount of goodwill may also indicate that the acquired process is substantive. The more significant the goodwill, the more likely it is a business. However, a business does not need to have goodwill. Furthermore, determining whether a set of assets and activities is a business should be based on whether a market participant could conduct the integrated set and manage it as a business. How the acquirer intends to operate the set or how the seller operated the set is not relevant in the determination of whether the set is a business.
If step 2 is met, the acquired set is accounted for as a business combination. If step 2 is not met, the acquired set is accounted for as an asset acquisition.
Accounting Models
The fundamental accounting model for business combinations differs from asset acquisitions.
- Business combinations are accounted for using the acquisition method under ASC 805, whereby assets acquired and liabilities assumed are measured at fair value with limited exceptions.
- Asset acquisitions are accounted for using the cost accumulation and allocation model under subtopic 805-50. ASC 805-50 provides limited guidance on asset acquisitions, and therefore, in the absence of specific guidance, other guidance may be applied by reference.
The following table summarizes the key differences between the two accounting models:
Asset Acquisition | Business Combination | |
Initial Measurement | The cost of the acquisition is allocated to the assets acquired based on relative fair value | The assets acquired are generally measured at their fair values |
Direct acquisition-related costs | Capitalized as part of the purchase price | Expensed as incurred |
Contingent consideration | Recognized when it becomes probable and reasonably estimable unless it’s within the scope of ASC 815. | Recognized at the acquisition date based on fair value. Subsequent changes in fair value are reported in earnings. |
Intangible assets | Recognized if they meet the recognition criteria in FASB Concepts Statement No. 5, which is a lower threshold than for business combinations. | Recognized if they meet the contractual-legal or separability criterion. |
IPR&D | Expensed unless it has an alternative future use. | Measured at fair value and recognized as an indefinite-lived intangible until completion, then reclassified as a finite-lived intangible. |
Assembled workforce | Recognized as an intangible asset. | Recognized as part of goodwill. |
Goodwill | Not recognized. Any excess cost over the fair value of assets acquired is allocated to qualified acquired assets on a relative fair value basis. | Recognize any excess consideration transferred over the fair value of net assets acquired as goodwill. |
Bargain purchase | Not recognized. Bargain purchase amount is allocated to qualified assets acquired on a relative fair value basis. | Recognized immediately as a gain in earnings. |
Acquired contingencies | Accounted for under ASC 450. Loss contingencies are recognized if both probable and reasonably estimable. | Recognized at fair value if determinable at acquisition date. |
Measurement period | No measurement period. | Measurement period is up to one year after the acquisition date where the acquirer may adjust the provisional amounts recognized in a business combination. |
Pushdown accounting | No such election can be made. | An election can be made to “push down” an acquirer’s stepped-up basis in the separate financial statements of the acquiree, creating a new basis of accounting and new reporting entity |
For asset acquisitions, when the cost of the assets is greater than the fair value, the excess cost is allocated to the nonfinancial assets acquired. This causes each acquired asset to be recognized at an amount greater than its individual fair value. The following items are not allocated any of the excess cost:
- assets acquired that are classified as held-for-sale;
- other current assets (including inventory);
- deferred tax assets;
- indefinite-lived intangible assets;
- postretirement benefit plan assets;
- contract assets recorded under Topic 606; and
- indemnification assets.
No excess cost is allocated to financial assets or indefinite-lived intangibles because that would result in an immediate impairment loss for those assets. Indefinite-lived intangibles should be measured at their fair value since they are subject to the impairment testing under ASC 350. Long-lived assets are allocated the excess cost and recorded above their fair value because those assets are subject to impairment under ASC 360. Under ASC 360, long lived assets are first tested for recoverability based on future undiscounted cash flows at the asset grouping level. This makes it unlikely that a recently acquired asset group would fail the recoverability test that would cause an immediate impairment.
Disclosures
For acquisitions that qualify as business combinations, ASC 805 requires extensive disclosures for individually material business combinations, and limited disclosures for individually immaterial business combinations that are material collectively. The objectives under ASC 805 are for the acquirer to disclose information that enables financial statement users to evaluate:
- The nature and financial effect of business combinations that occur during the reporting period or after the balance sheet date but before the financial statements are issued; and
- The financial effects of adjustments to the amounts recognized in a business combination that occur in the current reporting period or in previous reporting periods.
ASC 805-10-50-1 through 50-5 provides specific, detailed disclosure requirements that are intended to facilitate meeting these disclosure objectives. These include:
- The name and a description of the acquiree
- The acquisition date
- The percentage of voting equity interests acquired
- The primary reasons for the business combination and how control was obtained
- The acquisition-date fair value of the total consideration transferred
- The amounts recognized for each major class of assets acquired and liabilities assumed as of the acquisition date
- The amount of any measurement period adjustments recognized during the period
- Which items the initial accounting is incomplete and why
- A qualitative description of the factors that make up the goodwill recognized
- The amount of acquisition-related costs and which line item in the income statement they are recognized.
Public companies are required to disclose additional information, including all the following:
- The amounts of revenue and earnings of the acquiree included in the consolidated income statement for the period.
- If comparative financial statements are not presented, the revenue and earnings of the combined entity as though the acquisition date for all business combinations that occurred during the year had been as of the beginning of the annual reporting period.
- If comparative financial statements are presented, the revenue and earnings of the combined entity as though the business combination had occurred as of the beginning of the comparable prior annual reporting period.
- The nature and amount of any material, nonrecurring pro forma adjustments included in the reported pro forma revenue and earnings.
Unlike business combinations, ASC 805-50 does not require specific disclosures related to asset acquisitions. Entities should consider relevant disclosure requirements in other Subtopics that may apply to the transaction, including but not limited to:
- ASC 350-30 on intangible assets;
- ASC 360-10 on property, plant and equipment;
- ASC 450-20 on loss contingencies;
- ASC 610-20 on gains and losses from the derecognition of nonfinancial assets
- ASC 730-10 on R&D costs; and
- ASC 845-10 on nonmonetary exchanges.