Both ASC 805 and IFRS 3 require business combinations to be accounted for using the acquisition method.
The acquisition method requires all of the following steps:
Let’s briefly walk through each of these steps.
Step 1: Identifying the acquirer
The acquirer is the entity that obtains control of the acquiree. The acquiree is the business or businesses that the acquirer obtains control of in a business combination. Control is the direct or indirect ability to determine the direction of management and policies through ownership, contract, or otherwise.
Transactions sometimes referred to as “true mergers” or “merger of equals” are actually business combinations! In these situations, an acquirer would need to be identified using the guidance for a controlling financial interest in ASC 810 Consolidation or IFRS 10 Consolidated Financial Statements.
Step 2: Determining the acquisition date
The acquisition date is the date on which the acquirer obtains control over the acquiree. Often referred to as the “closing date,” generally, it’s the date when the acquirer:
- legally transfers the consideration;
- acquires the assets; and
- assumes the liabilities.
It’s the date the magic happens! Why? Because on this date the acquirer will:
- determine the fair value of what it purchased;
- recognize and measure goodwill; and
- consolidate the results of the acquiree into their financial statements.
Step 3: Recognizing and measuring identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree
As of the acquisition date, the acquirer will recognize, separately from goodwill, the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree.
The identifiable assets acquired, and liabilities assumed must:
- meet the definitions of assets and liabilities in FASB Concepts Statement No. 6; and
- be part of what the acquirer and acquiree exchanged in the combination, rather than as a result of separate transactions (e.g., settling pre-existing relationships).
Sounds easy, right? Well, this is probably the step where many of the “issues” associated with business combinations arise.
Step 4: Recognizing and measuring goodwill or a gain from a bargain purchase
In step 3 we determined the fair value of what we purchased. Now, in the final step, we have to determine what we paid for these net assets, or the consideration transferred. Obviously, this includes cash, but it also includes other assets, equity interests, and liabilities assumed, all of which are measured at fair value at the acquisition date. It also includes contingent consideration, which, as we discuss below, is one of our top 5 “issues” related to the accounting for business combinations.
We add to the consideration transferred the fair value of any noncontrolling interest in the acquiree, as well as the acquisition-date fair value of any of the acquirer’s previously held equity interest in the acquiree. This is the total purchase price. We then deduct from this amount the fair value of the net assets acquires to get goodwill.
And there you have it! A high-level overview of the acquisition method prescribed by both ASC 805 and IFRS 3. However, there are numerous accounting issues related to business combinations. We’ve summarized our top 5 issues related to accounting for business combinations under ASC 805 below.
Issue #1: Business Combinations vs. Asset Acquisitions
The first issue relates to determining what exactly was purchased. Did the entity purchase a business or just a bunch of assets? This determination matters because the accounting is vastly different as we discuss in this post.
Needless to say, the accounting for an asset acquisition is far easier than accounting for a business combination. Therefore, many purchase agreements often stipulate the transaction is an asset purchase. But, don’t let the wording fool you! If what is being acquired meets the definition of a business, then ASC 805 is applicable, regardless of what those pesky lawyers and tax accountants say!
According to ASC 805, to be considered a business, the acquired set needs to have an input and at least one substantive process that together significantly contribute to the ability to create outputs. The guidance, originally set out in ASU 2017-01 and summarized in this post, provides a framework to evaluate when an input and substantive process are present, as well as provides more stringent criteria for sets without outputs to be considered a business.
Issue #2: Identifying the Assets Acquired and Liabilities Assumed
The second issue relates identifying all the assets acquired and liabilities assumed. Obviously, we start with the assets and liabilities reported on the acquiree’s balance sheet, but we don’t stop there! It also includes intangible assets, if they are separable or arise from contractual or legal rights.
Included in the intangible assets acquired are in-process research and development projects and brands, even if the acquirer intends to “kill the brand” post-acquisition. Check out this post for more on identifying intangible assets acquired in a business combination.
Issue #3: Valuing the Assets Acquired and Liabilities Assumed
Now that we’ve identified the net asset acquired, ASC 805 requires us to determine the fair value of the assets and liabilities at fair value determined in accordance with ASC 820 Fair Value Measurements. This is the third issue relating to the accounting for business combinations.
Most of us didn’t go to school to learn how to value intangible assets. How do you measure the fair value of an in-process R&D project in the “monkey phase” of trails? Or the fair value of a brand that the acquirer intends to “kill” post-acquisition? Who knows? However, what we do know is that we need to consider market participant assumptions and, when you don’t know how to do something, ask for help! That’s why both preparers and auditors often rely on the work of specialists for such matters.
We briefly discuss the most common valuation methodologies used by valuation specialists in this post.
Issue #4: Accounting for Contingent Consideration
Any contingent consideration included in the purchase agreement should be included in the purchase price. The amount to be included is measured at fair value at the date of the acquisition, not the expected payout at settlement. The probability of payment should be considered when determining fair value, not whether to record contingent consideration or not. In addition, the fair value should include the time value of money and, like all fair value measurements in accordance with ASC 820, based on market participant assumptions.
As we discuss further in this post, the acquirer needs to remeasure the contingent consideration each reporting period. And, since this remeasurement is recorded through current period earnings, this can lead to an incentive for management to overestimate contingent consideration at the acquisition date. Auditors should be careful in this area!
Issue #5: Determining the Measurement Period
The final accounting issue relates to an area where a lot of people misinterpret the guidance. Many companies believe they have up to one year to finalize the purchase price allocation, with any adjustments being recorded by an adjustment to goodwill. This is not true! The FASB didn’t give entities a one-year “blank check” to get the accounting straight. First, entities have to document and disclose within the financial statements which items are accounted for provisionally at the acquisition date. Second, the measurement period is not always one year. Once you’ve got the information you need to determine fair value of an asset or liability initially recorded provisionally, the measurement period ends. Check out this post for more information on the measurement period.
Accounting Differences: ASC 805 vs. IFRS 3
The guidance within ASC 805 and IFRS 3 is largely converged. However, there are still differences in the accounting for business combinations under U.S. GAAP as compared to IFRS.
Although this is not an all-inclusive list, here are the top differences between U.S. GAAP and IFRS in the area of business combinations:
Accounting for Pre-acquisition Contingencies
Under ASC 805, all contingencies, including contingent assets, are recognized at fair value at the acquisition date, if fair value can be reasonably determined during the measurement period. If fair value cannot be reasonably determined, then such contingencies are measured using existing guidance. In other words, contingent liabilities that are probable would be measured at the best estimate of expected payment, while contingent assets would not be recorded.
Under IFRS 3, contingent liabilities, as defined in IAS 37, should be measured at fair value. However, entities are not permitted to recognize a contingent asset in a business combination.
Measurement of Noncontrolling Interest
Noncontrolling interest is the portion of equity (ownership interest) in a subsidiary not attributable directly or indirectly to the parent.
Under ASC 805, noncontrolling interest is measured at fair value.
Under IFRS 3, noncontrolling interests that are present ownership interests and entitle their holders to a proportionate share of the acquiree’s net assets in the event of liquidation may be measured at either:
- fair value; or
- the noncontrolling interest’s proportionate share of the fair value of the acquiree’s identifiable net assets.
This choice is available on a transaction-by-transaction basis. All other components of noncontrolling interest are measured at fair value unless another measurement basis is required by IFRS.
Measurement Period Adjustments
As noted above, the measurement period is the period during which adjustments can be made to amounts originally recorded at the acquisition date, with the corresponding entry to goodwill.
ASC 805 requires such adjustments to be made prospectively by adjusting amounts in the period in which the adjustment is determined.
IFRS 3 requires such adjustments to be made retrospectively by “recasting” prior periods.
Pushdown accounting refers to establishing a new basis of accounting in the separate financial statements of the acquired entity (or acquiree) after it is acquired by an acquirer. In other words, the cost of the acquisition is reflected in the separate financial statements of the acquired subsidiary, with the parent (acquirer) “pushing down” the fair values assigned to the assets and liabilities acquired, as well as goodwill.
ASC 805 gives entities the option to apply pushdown accounting and this election may be elected each time there is a change-in-control event in which an acquirer obtains control of the acquiree. If elected, pushdown accounting is irrevocable.
There is no equivalent guidance within IFRS 3 and, therefore, it is unclear whether pushdown accounting is acceptable under IFRS.
Combinations Involving Entities under Common Control
Combinations between entities or businesses under common control are outside the scope of ASC 805. A common example is when one subsidiary acquires another subsidiary, both of which are under the common control of the same parent entity. Generally, these transactions are recorded carrying forward the historical cost basis of the assets and liabilities of the parent.
IFRS 3 does not specifically address combinations between entities under common control. In practice, entities develop and consistently apply an accounting policy related to such transactions. In other words, they would either carry forward the historical cost basis of the parent, as required by U.S. GAAP, or apply acquisition accounting where the assets and liabilities acquired are recorded at fair value at the acquisition date.
Looking for more information on GAAP differences? Check out this post for more information on the differences between U.S. GAAP and IFRS related to accounting for business combinations. Alternatively, we encourage you to download the various GAAP differences books published by the Big 4 firms.
Our eLearning courses are designed to help accounting firms and companies, as well as individuals. We offer our eLearning courses through our online eLearning platform we call the Revolution. Check out our full library of U.S. GAAP and IFRS eLearning courses. Our courses are continually updated, and new content is constantly being added, so check back often!
These are not your typical eLearning courses. We try make them fun, like how we use celebrity couples as the theme for our accounting for business combinations eLearning courses. Check out the details of these courses below:
Business combinations eLearning courses
Business Combinations: Overview of ASC 805 (1.5 CPE) – Although it is common for a company to acquire a business, the accounting can be quite complex! Therefore, it is important to be familiar with the overall considerations when an acquisition falls within the scope of ASC 805. In this course, key concepts will be discussed, including the definition of a business, the recognition and measurement principles, and the calculation of goodwill. View Course Details!
Business Combinations: Advanced Issues and Disclosures (1.0 CPE) – Now that you are familiar with the basic accounting rules, this course dives deeper into more advanced business combination issues such as exceptions to general guidelines, noncontrolling interests, and measurement period adjustments. ASC 805 disclosure requirements will also be discussed. Learn more!
Business Combinations: Application of ASC 805 (0.5 CPE) – This is the third and final course in the three-part Business Combinations eLearning series. Now that you are familiar with the basic accounting rules and certain ASC 805 advanced issues, this course asks you to apply that knowledge by walking through an example acquisition and requiring you to identify the proper accounting treatment. Test your knowledge!
We’ve bundled all three business combinations eLearning courses into an ASC 805 collection for big savings!
There are numerous resources available related to the accounting for business combinations under both ASC 805 and IFRS 3. To save you time, we’ve compiled a list of resources below to assist you in your journey to learn more about this exciting topic!
Resources from GAAP Dynamics:
We’ve written several blog posts on a variety of topics related to the accounting for business combinations. Click on the links below to learn more.
Accounting for Business Combinations: An Overview of ASC 805
Struggling with accounting for business combinations? No worries. This post provides you with an overview of ASC 805 and links to helpful resources.
5 Issues Related to Accounting for Business Combinations under ASC 805
Accounting for and auditing business combinations under ASC 805 is tricky! This post talks about the top five issues associated with these transactions.
Navigating ASC Topic 805: Business Combination or Asset Purchase?
This post explores why determining whether the transaction is an asset purchase or business combination is a common issue under ASC 805.
Intangible Assets (ASC 350) and Business Combinations (ASC 805)
The next post in our series associated with business combinations: intangible assets (ASC 350) acquired in a business combination (ASC 805).
Business Combinations (ASC Topic 805) and Management Review Controls: Where Are We Going Wrong?
The next post in our series associated with business combinations: management review controls (MRCs) and business combinations (ASC 805).
Accounting for Business Combinations ASC 805: Contingent Consideration
Contingent consideration is one of the trickiest issues when accounting for business combinations under ASC 805. In this post, we explore this issue in further detail.
Business Combinations (ASC 805): Measurement Period Adjustments
This post explores an entity’s ability to record measurement period adjustments when accounting for business combinations under ASC 805.
Merger of Equals? Business Combinations Must Have an Acquirer!
Merger of equals? Not possible! Recent headlines forced me to write a post explaining how to identify the acquirer in a business combination (ASC 805 / IFRS 15).
Resources for Accounting for Business Combinations (ASC 805)
Accounting for business combinations under ASC 805 is not easy. This list of our top external and internal resources can help guide you through it.
Raising the Bar: New Definition of a Business under ASC 805
Under ASC 805, the definition of a business is changing. The FASB recently issued ASU 2017-01 with a better framework for applying this definition.
Is it a Business (ASC 805)? ASU 2017-01 Provides Clarity!
The definition of a business (ASC 805) was too broad. ASU 2017-01 clarified the situation and now it looks like the IASB has plans for IFRS 3 too!
Business Combinations: Accounting under ASC 805 versus IFRS 3!
Business combinations continue to be a hot accounting topic. This blog post summarizes the main differences between ASC 805 and IFRS 3.
IFRS 3: Is the Road to Convergence Really Paved with Good Intentions?
Is a clear road to convergence in sight amidst amendments to the guidance? Business combinations (IFRS 3, ASC 805) may be closer than you think!
Resources from Accounting Firms:
The Big 4 accounting firms have published informative and thorough guides related to the accounting for business combinations. To save you time, we’ve linked to the most recent versions below.
- Financial Reporting Developments – Business Combinations (EY) - EY’s FRD publication on business combinations has been updated to reflect recent standard setting activity and to further clarify and enhance their interpretive guidance in several areas. It also includes an updated appendix on accounting for asset acquisitions.
- Handbook: Business combinations (KPMG) - KPMG explains accounting for acquisitions of businesses and related issues with examples and analysis.
- A Roadmap to Accounting for Business Combinations (Deloitte) - This roadmap provides Deloitte’s insights into and interpretations of the guidance in ASC 805 on business combinations, pushdown accounting, common-control transactions, and asset acquisitions as well as an overview of related SEC reporting requirements.
- Accounting Guide: Business Combinations and Noncontrolling Interests (PwC) - PwC’s Business combinations and noncontrolling interests guide is a comprehensive resource for accounting for business combinations under ASC 805.
None of the Big 4 firms specifically publish guides or handbooks related to IFRS. However, all have web pages dedicated to IFRS 3 Business combinations. Here’s the links to those web pages: