Mergers and acquisitions (M&A) activity reached record levels in 2015 with deal volume reaching $4.9 trillion, beating the previous record set in 2007. According to a recent KPMG survey, acquisition momentum is expected to continue in 2016. That prediction proved to be true based on yesterday’s announcement that Microsoft will acquire LinkedIn for $26.2 billion in one of the largest deals for an internet company in history. This “deal making” has us wondering: Do accountants and auditors really know the requirements of accounting for business combinations in accordance with ASC 805?

What’s causing the frenzied activity in M&A? The survey of over 550 M&A executives by KPMG and FORTUNE Knowledge Group points to:

• Low interest rates
• Resilient stock prices
• Solid employment numbers
• Abundance of cash

Based on our knowledge of ASC 805 and years of experience auditing these transactions, we’ve identified the following Top 5 issues associated with accounting for and auditing business combinations.

          1. Asset purchases vs. business combinations

Many companies would rather the transaction be classified as an asset acquisition than a business combination because, frankly, the accounting is easier. Then, they can capitalize transaction costs; they don’t have to fair value all the assets acquired; and they don’t have to determine the fair value of contingent consideration. Best of all, they don’t have to bother with recording (and subsequently performing an annual impairment test on) goodwill!

Because of this, purchase agreements often stipulate the transaction is an asset purchase rather than the acquisition of a business. However, don’t let the wording fool you! If what is being acquired meets the definition of a business, it is a business combination, regardless of what the agreement says.

          2. Identification and valuation of intangible assets

Assuming the transaction qualifies as a business combination, the acquirer is required to identify all the assets acquired and liabilities assumed, regardless of whether or not they were previously recorded by the entity being acquired. With respect to the assets acquired, this includes not only tangible assets such as inventory and property, plant, and equipment, but also intangible assets.

U.S. GAAP requires intangible assets to be separately recognized apart from goodwill if they are separable or arise from contractual or legal rights. Let me tell you, the list of intangible assets that qualify for recognition would boggle your mind! Obviously, there are intangible assets like brands, trademarks, and patents. However, other intangible assets such as trade dress, jingles, and customer relationships (both contractual and noncontractual) are also included.

How do you value a customer list, a brand, or a customer relationship? It’s not easy since the valuations typically involve sophisticated models using inputs that are unobservable (i.e. Level 3 fair value measurements). This is why management typically engages specialists to value these assets. Remember that, although they are using a specialist, this does not relieve them of their overall responsibility for properly accounting for the business combination.

           3. Management review controls

Although business combinations are non-routine transactions, this characteristic does not preclude a company from establishing controls over the transactions. Auditors may find that controls in place around business combinations are less robust or more challenging for management to apply. The PCAOB found several instances of management review controls that had been put in place that were not adequately audited. For example, often auditors would document and observe a management review control had taken place but failed to ascertain that the control was operating with sufficient precision to prevent against material misstatements in the financial statements.

Also, it must be noted that when specialists are delegated to perform certain functions associated with a business combination (particularly third party valuation specialists), it does not excuse management from incorporating controls over the process and taking responsibility for the work of the specialist (including controls over the inputs and assumptions utilized by the specialist).

          4. 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 acquisition, not the expected payout at the settlement date. This estimate of fair value should take into consideration the probabilities of payment and the time value of money.

Obviously, as the fair value of the contingent consideration increases, so does the purchase price and, as a result, any eventual goodwill recorded at acquisition date. However, this is not a one-time consideration. Each reporting period, this contingent consideration needs to be remeasured at fair value, with the corresponding entry made to current period earnings.

Most contingent consideration is based on the future earnings of the company being acquired. This estimate involves significant management judgment, especially as the period of the contingency increases.

          5. Measurement-period adjustments

Many companies believe they have up to one year to finalize the purchase price allocation. This is not exactly true. While you do have one year to make certain adjustments, it is not a blank check to do whatever you want. Only items that existed at the acquisition date and were provisionally accounted for at that time qualify.

This has been an area of concern for the SEC. The SEC staff has reminded filers that it is appropriate to characterize an adjustment to the assets acquired or liabilities assumed in a business combination as a measurement-period adjustment (as opposed to a correction of an error) only if:

• The acquirer obtains new information about facts and circumstances that existed at the time of the acquisition that, if known then, would have impacted the amounts recognized;
• The company’s initial disclosures indicate that the accounting for the acquired assets and liabilities assumed is incomplete; and
• The measurement period has not ended.

In the past, measurement period adjustments were made retrospectively by “recasting” prior periods presented in the financial statements. Luckily, the FASB recently published ASU 2015-16, making the accounting for measurement period adjustments a bit easier.

And there you have it! If you are mindful of these five areas when accounting for or auditing a business combination, you’ll be well on your way to properly applying ASC 805. Over the next several weeks, we will be publishing a series of blog posts containing relevant examples covering each one of these issues in more depth. Stay tuned!