Purchase accounting is a methodology prescribed and governed by ASC 805, Business Combinations, which outlines the process for recognizing, measuring, and presenting assets acquired and liabilities assumed in a business combination.
Despite the fairly prescriptive nature of the guidance in ASC 805 (its detailed rules and illustrative examples), companies often make mistakes or overlook critical areas. These oversights sometimes lead to misstatements in financial reports that can trigger restatements, auditor-identified material weaknesses, regulatory scrutiny, and loss of investor and creditor confidence in the CFO’s ability to produce reliable financial information useful for economic decision-making.
The most material numbers in terms of the relative magnitude in the context of an affected company’s financial statements include acquisition consideration, goodwill, and newly recognized intangible assets (even for small acquisitions, these assets can measure in the millions or dozens of millions of dollars). That’s why we’re focusing on the most commonly overlooked elements of purchase accounting and ASC 805—and breaking down how CFOs can get it right:
The valuation process of purchase accounting: Why CFOs should own it
While assisting corporate clients with various aspects of purchase accounting, we encounter situations where incorrect valuation conclusions (luckily, often caught at the preliminary valuation report draft stage, and thus correctable early) lead to inaccurate goodwill calculations, or even turn goodwill into a bargain purchase gain (for example, when incorrect assumptions or unsupportable forecasts were used in a technology valuation). Many audit firms have in-house valuation experts who proactively scrutinize the completeness and key assumptions used by third-party valuation firms—often challenging conclusions that management endorsed without sufficient diligence.
One of the challenging aspects of purchase accounting is the full identification and valuation of intangible assets. Such assets (e.g., customer lists, developed technology, non-compete agreements, tradenames, and one-off items like a “landfill permit”) usually do not appear on the balance sheet of the acquired company. Because they have never existed in the acquiree’s accounting before the acquisition, the difficulty lies in both properly identifying all of them and then determining their fair values.
Intangible assets are usually classified as Level 3 inputs, meaning they are based on unobservable data and internal inputs. However, even though external appraisers prepare all calculations, it is the company’s management who, at the end of the day, will be held accountable for the identification of all required intangible assets, assignment of values (sometimes with a bifurcation by reporting units required), and selecting proper amortization periods.
Some CFOs of private companies erroneously think that if they elect to amortize goodwill, an impairment test is not required (which is still required upon the emergence of any triggering event). In addition, some believe that goodwill should not be tested for impairment in the first year of the acquisition (because they remember goodwill is tested for impairment annually). This is also incorrect: the impairment test is required after the acquisition, even during the first year, if there is a triggering event suggesting impairment (such as a loss of a key customer or major product defects that occurred a few months after the acquisition but before year-end). Companies that overlook the goodwill impairment test or do not apply it rigorously not only increase the likelihood of future restatements, but also risk failing to identify and quantify operational risks and potential.
In practice, CFOs often underestimate the level of judgment required and remove themself from the management of the valuation process—ultimately delegating too much responsibility to external appraisers and relying on their assumptions, calculations, and conclusions without retaining proper oversight. The following judgments and assumptions that need to be either provided, critically reviewed, or constructively challenged by the CFO include:
- Operations and cash flow forecasts
- Expected weighted average return on assets
- Normalization adjustments
- Economic and accounting lives of each class of assets (including considerations related to a planned abandonment or gradual sunsetting of the acquiree’s brand or technology (perhaps a couple of years in the case of a roll-up or tuck-in acquisition)
- Tax rates used
- Royalty rates (e.g., for trademarks)
- Various discount rates (internal rate of return and weighted average cost of capital)
- Remaining useful lives
Intangible assets: Where valuation meets judgment
When intangible assets are acquired, they generally must be amortized over their remaining useful lives. Many CFOs miscalculate the useful lives of these assets—and therefore misapply amortization—by accepting the estimates provided by valuation firms, without critically assessing the underlying economics. For example, they may overlook their own plans to sunset existing technology within a year or two in favor of emerging solutions already in development. The “thinning” of the amortization expense by spreading it over the unsupportable longer period can lead to an overstatement of earnings in the post-acquisition period and, subsequently, the need to restate earnings once the error is discovered.
Many tangible assets have factors that act in opposite directions; for example, inventory analysis may result in identifying additional obsolete or slow-moving inventory items requiring a “step-down”, while the calculation of net realizable value (less disposition costs) could yield an inventory “step-up”. Management is responsible for identifying all individual upward- and downward-impacting factors, even if they ultimately cancel each other out.
Many companies that rent their offices or manufacturing facilities may find that their rental rates differ from the market ones at the acquisition date. In terms of purchase accounting, this should result in the emergence of favorable and/or unfavorable lease terms. Under the previous lease guidance (ASC 840), such terms could be recognized on the balance sheet separately, as intangible assets or liabilities. However, with the adoption of ASC 842, such terms are included as an adjustment to the right-of-use asset—thereby making it different from the related lease liability at the acquisition date. Related-party leases require special attention, as they are sometimes entered into at above- or below-market rental rates even at inception.
Rollover equity and contingent consideration: The importance of classification
Rollover equity shares or membership units (for LLCs and LPs) are often issued to selling shareholders (representing equity interests in a parent entity that sits several tiers above the acquiree). It is important not to overlook scenarios when such shares represent a different class of equity; even a slight difference in voting rights, distribution thresholds, or other attributes/privileges can lead to significant differences between the fair value of rollover equity and its nominal value (at which it was issued to the sellers). Companies often overlook the need to reevaluate rollover equity—but auditors are likely to pick up on it.
Contingent consideration (including earnouts, or other future payments to the sellers contingent on anything other than the passage of time, which would be just a case of “deferred consideration”) can be an issue as well, as its valuation may require a use of complex Monte Carlo scenario simulations and related time value adjustments (that it, an in-house estimate of the payout at the settlement date is not an adequate figure).
What’s more, there’s the issue of distinguishing the equity-classified contingent consideration from the post-acquisition employment compensation (when selling shareholders are retained as top managers under the condition that they would stay for a certain number of years to promote and grow new business). It would be a mistake to include such time-vesting shares as part of the acquisition consideration, especially when the share agreement stipulates that “unvested” shares would be forfeited if the selling manager terminates their employment (that is, leaves the company before the end of the required service period).
Clearly, it is critical to distinguish between compensation for future services and consideration for the acquired company. Stock options or deferred bonuses granted to selling manager employees are sometimes misclassified as part of the acquisition consideration, inflating goodwill and leading to incorrect amortization schedules. This mistake can result in significant restatements down the road. The boundary between compensation and purchase consideration is sometimes blurred, especially when the acquiring company offers stock as part of the deal—and not correctly identifying these elements can cause substantial misstatements.
Opening balance sheet: Timing, clean-up, and oversights
Many liabilities assumed in a business combination should be fair valued, just like the majority of the acquiree’s assets (there are limited exceptions to fair value). In addition to unfavorable lease terms, commonly overlooked liabilities include legal contingencies, environmental liabilities, and recalculation of obligations under operating and finance leases (there are special rules for valuing leases acquired in a business combination, including the use of a new discount rate). If these liabilities are not identified and adequately measured, expenses will be understated and net income inflated in the periods following the acquisition (the opposite may occur as well, albeit more rarely).
For example, a failure to recognize (and/or properly measure) a cyber-incident (e.g., a client data breach), potential lawsuit liability, or an environmental liability may lead to future costs that were not accounted for in the purchase price allocation, distorting the financial performance of the acquirer.
A “regular” liability cut-off test at the acquisition date should be performed as well to ensure that the buyer is fully aware of all liabilities it will have to pay off after taking over the acquired business (in addition to often being required by the “final net working capital adjustment” clause in the purchase agreement).
Talking about the opening balance sheet (which is a critical part of the valuation because it is a starting point for the third-party appraisers), we should note that sometimes companies merely use the wrong date. In the majority of cases, control is legally transferred in the morning of the closing date (purchase agreements often have the “00:01 a.m.” or “10 a.m.” effective time clause). This means that the opening balance sheet should be prepared as of the end of the previous calendar day, but companies sometimes incorrectly prepare their “final” pre-acquisition balance sheet as of the end of the acquisition date itself. Differences could be material given the nature and magnitude of cash flows on the first day after a change in control of the business (e.g., many expenses contingent on the acquisition are paid on that very day).
Also with regard to the opening balance sheet, companies often forget to derecognize accumulated depreciation and amortization, allowance for bad debt, prepaid, deferred and accrued rent, capitalized sales commissions, preexisting goodwill and intangibles (unless they have to stay for some reason), unamortized debt issuance costs and original issue discounts and costs to fulfill a contract (as they are either already included in the fair value or do not meet the definition of identifiable asset or liability acquired in a business combination).
In addition, tax ramifications of “fair valuing” assets and liabilities are sometimes overlooked. This includes the recognition of deferred tax assets or liabilities related to the newly-arisen temporary differences (which should be computed separately at the federal and state levels and do not offset each other), as well as an analysis of the company’s ability to utilize (fully or partially) the carryforwards of previous tax losses and tax credits (especially in a setting of a merger or other legal entity restructuring). On the other hand, a CFO should remember that for some transactions that are legally formalized a “stock purchase”, a buyer (by itself or in some cases jointly with the seller) may make an election to treat the transaction as an “asset purchase” for tax purposes (in accordance with either Section 338(h) or Section 338(g) of the IRC) to therefore receive a step-up in the tax basis of assets.
Measurement missteps: Understanding limits in ASC 805
ASC 805 allows for a one-year “measurement period”, during which companies can make adjustments to their initial purchase accounting. However, this rule does not mean an unrestricted opportunity to keep making changes to financial statements. Only adjustments based on facts that existed at the acquisition date and were provisionally accounted for at that time are permitted. Many companies mistakenly believe they can adjust numbers at will within the “measurement period”, leading to auditor scrutiny, corrections, and potential restatements.
For example, we see in practice that some companies believe that a change in their estimate of contingent consideration (e.g., based on the revised sales forecast) should be accounted for as an adjustment to goodwill if made within one year from the acquisition date. In reality, such a change should flow through P&L (because the revised revenue forecast was a result of events subsequent to the acquisition date). On top of that, some companies neglect to reassess contingent consideration at subsequent reporting periods altogether, leading to incorrect measurement of the earnout liability (which should be fair valued at the end of each subsequent reporting period).
Another error we typically see arise from incorrectly classifying adjustments as “measurement-period adjustments” when they are actually correction of errors made in the course of initial purchase accounting. Such mistakes can lead to delays in finalizing financial reports, create problems with the auditors, and confuse investors and lenders.
Purchase accounting is fraught with complexities that require careful attention to detail. Common oversights include the lack of CFO guidance over a third-party valuation of intangible assets, improper classification of compensation, and mismanagement of the measurement period. These mistakes not only distort financial performance, but can also lead to restatements, a loss of confidence in the CFO, and issues with investors and creditors. By being aware of these pitfalls, CFOs can better navigate the intricacies of ASC 805 and ensure more accurate financial reporting.