The acquisition method of financial accounting for business combinations under FASB Statement no. 141(R), Business Combinations, requires the acquiring company to recognize and measure all identifiable assets acquired, liabilities assumed and any noncontrolling interest in the acquired company as of the acquisition date at their respective fair values. The assets acquired may include assets that are not included on the acquiree’s balance sheet because they were expensed or written off before the acquisition date. Additionally, the acquirer may record liabilities arising from contingencies at the acquisition date that were not recorded by the acquiree. This article suggests a method for management to forecast the effects of a business combination on reported earnings.
Due to numerous possible factors, the effect of recording the business combination under Statement no. 141(R) on postcombination earnings can be significant. The following examples illustrate the potential magnitude of this effect:
- Assuming adequate inventory turnover, the entire difference between the acquisition-date fair value and previously recorded book value of inventory (valued on a FIFO basis) of the acquired company could be charged to cost of sales in the first few months following the business combination.
- The excess of acquisition-date fair values over recorded net book values for plant and equipment would result in higher depreciation charges over the remaining useful lives of the assets after the business combination.
- Intangible assets not previously recorded in the financial statements by the acquired company would be recorded at their respective acquisition-date fair values and amortized over the respective remaining useful economic lives of the intangible assets. An example would be a license (with substantial renewal costs) that was not recognized as an asset by the acquiree before the acquisition because the development costs of the license were internal and charged to expense. Acquired in-process research and development would be recorded at fair value by the acquirer and would be subject to post-combination impairment but would not be amortized.
- If the terms of an acquiree’s operating lease are favorable in relation to market terms for a similar lease at the acquisition date, the acquirer would record an intangible asset (in most cases) for the difference between contract terms and market terms.
Because of the potential effect of the recorded business combination on postacquisition earnings, the acquiring company should develop an acquisition accounting forecast to estimate the future income statement effects. Discussed below is a suggested approach for developing this acquisition accounting forecast (which is for internal management analysis purposes). Due to the enormous complexity and variability of accounting, tax and other considerations, the comments and acquisition example in this article are intended to be illustrative rather than all-inclusive. The sample business combination assumes a single transaction (that is, not a “step” acquisition), the absence of a noncontrolling interest (that is, 100% equity interest acquired), no previously held equity interest in the acquiree, and does not include deferred income tax considerations. Specific applications of this approach should obviously be customized to the substance and details of the transaction.
The process for developing the acquisition accounting forecast is shown in Exhibit 1.
The first step is to estimate the total fair value of consideration to be transferred to the seller. It is assumed that the purchase price has already been determined, based on projected revenue, earnings and/or cash flows of the acquiree and numerous other factors. In addition to the expected consideration to be paid to the seller at closing (cash payments, fair value of equity interests issued by the acquirer and/or liabilities incurred by the acquirer to sellers), many business combinations also include contingent consideration (for example, earnouts based on achievement of post-acquisition earnings or other objectives). Statement no. 141(R) requires that the acquiring company recognize the acquisitiondate fair value of contingent consideration as part of the total consideration transferred.
In preparing the acquisition accounting forecast, the expected value of the contingent consideration should also be included. One possible method for determining this value is to assign expected probabilities to the range of consideration values. In the example, management estimated a 60% probability that the acquiree’s earnings would result in additional consideration of $2 million and a 40% probability of $1.5 million, and the acquisition accounting forecast included contingent consideration of $1.8 million [($2.0 million × 60%) + ($1.5 million × 40%)]. Other techniques for estimating the acquiree’s expected earnings could also be used.
In addition to consideration, incremental acquisition-related costs such as legal costs, finder fees, appraisal fees, environmental study costs, and accounting costs should be estimated and included in the acquisition accounting forecast. The acquiring company should be able to reasonably estimate such costs based on normal finder fee and appraisal fee ranges and discussions with lawyers, accountants, valuation professionals, engineers and other consultants. Statement no. 141(R) requires that direct costs of the acquisition be expensed by the acquirer when incurred and not be included in the cost of the business combination. Acquisition-related costs that are expensed should include any reimbursements to the acquiree or sellers for paying the acquirer’s acquisition costs.
Once the consideration and acquisition- related costs have been estimated, the next step is to develop a pro forma balance sheet as of the anticipated acquisition date. This balance sheet would be on a historical cost basis and could be developed by adjusting the latest reported balance sheet with forecasted changes in financial position up to the expected acquisition date.
In some cases, this balance sheet will already have been developed in conjunction with the initial analysis of the acquisition. In other cases, the forecasted balances can be derived (using the latest reported balance sheet) via analysis of trended financial ratios such as DSO (days sales outstanding) and inventory turnover, expected capital expenditures up to the acquisition date, and other factors.
The forecasted balance sheet should then be converted from a historical cost basis to a fair value basis. This step is the most important as well as the most difficult task. The comments below reference the forecasted balance sheet in Exhibit 2. As noted above, the example in Exhibit 2 excludes deferred income tax considerations.
- Trade accounts receivable. The forecasted historical cost of trade receivables in the acquisition example was derived by applying the acquiree’s historical DSO ratio to forecasted sales before the acquisition date. The fair value of receivables should be determined as the present value of amounts to be received using an appropriate interest rate, less estimated uncollectible accounts and collection costs. In this example, the acquiree’s low DSO precluded the necessity for present values, but it was estimated that an additional $300,000 of receivables at the acquisition date would be uncollectible (based on a bankruptcy filing by one of the acquiree’s customers).
- Inventory. Fair value guidelines are summarized as follows: raw materials should be valued at current replacement costs; finished goods should be valued at estimated selling prices less selling costs and reasonable profit allowance for selling effort; and work in process inventory should be valued similarly to finished goods except that the cost to complete should also be deducted. The first step in estimating the fair value of inventory is to estimate the amount of inventory by category on a historical cost basis. This can be accomplished by reviewing the trend of inventory by category—that is, if the relative proportions of inventory categories to total inventory have remained stable, the historical percentages can be applied to total inventory on the forecasted balance sheet. Other estimating techniques would be needed, of course, if historical experience was more variable. After the inventory amounts by category have been estimated, the selling prices, costs to complete, and so on should be estimated and applied as outlined above to the appropriate inventory categories. In the acquisition example, the entire process resulted in a net increase for inventory (valued at FIFO) at the acquisition date of $800,000.
- Property, plant and equipment. For purposes of developing the acquisition accounting forecast, the actual appraisals by a valuation professional, if already performed, could be used. If the appraisals have not yet taken place, the fair values could be estimated via: appropriate cost indexes; real estate market comparables; replacement cost data Web sites; discussions with construction, insurance and equipment specialists; and other methods. The net adjustments in the acquisition example were an increase in land of $100,000 and an increase in plant and equipment of $5.8 million, with a 10-year expected remaining life.
- Intangible assets. Statement no. 141(R) also requires the acquirer to recognize all identifiable intangible assets acquired in a business combination. In many cases, the intangible assets of the acquiree are not included in the acquiree’s pre-combination financial statements. Possible reasons for this include the asset development costs were expensed or written off, or market conditions changed from when a lease or contract was executed to the acquisition date. A valuation professional can help the acquiring company to identify intangible assets and determine their respective fair values.
In the example, the acquiring company identified a royalty agreement intangible asset that was not recorded by the acquiree before the business combination, with an economic useful life and fair value of two years and $200,000, respectively. A favorable lease was also identified, for which the present value of the favorable lease terms (relative to market conditions at the acquisition date) amounted to $120,000 and the remaining life of the lease was three years. The acquirer also identified and recognized the fair value of the acquiree’s customer contracts and the related customer relationships. The appraisal firm valued this intangible asset at $500,000 and the estimated useful life at two years.
- Pre-acquisition goodwill of acquiree. In the example shown, the acquiree’s recorded goodwill of $1 million was not an identifiable asset and would be written off at the acquisition date.
- Contractual contingency liability. In the example, the acquiring company determined that a contractual contingency as of the acquisition date should be recorded as a liability and the fair value of the liability was determined to be $400,000.
After all identifiable assets and liabilities acquired have been assigned fair values, the excess of the total acquisition consideration over the acquisitiondate fair values of assets acquired and liabilities assumed should be recognized as goodwill. In the example in Exhibit 2, estimated goodwill amounted to $2.38 million.
To forecast the effect of the fair value adjustments on post-combination earnings, the acquiring company needs to estimate the economic useful lives of the assets acquired and liabilities assumed (that is, the time periods over which economic benefits are consumed or otherwise used up and the fair value adjustments are charged or credited to operating results). Valuation professionals can assist the acquiring company in this process. The acquiring company should also estimate the incremental effects of the acquisition for costs other than direct acquisition costs. (Examples include post-combination restructuring costs expected but which the acquirer is not obligated to incur and the amortization of deferred financing costs that will be included in post-combination earnings.) In the example, expected restructuring expense was $500,000. The pretax income effects of the business combination (excluding unforeseen post-combination asset impairment losses) are summarized at the bottom of Exhibit 2.
The acquisition method accounting required by Statement no. 141(R) for business combinations is a financial accounting task that occurs subsequent to the acquisition, and may result in combined earnings substantially different from those anticipated due to the recognition of previously unrecorded assets and/or liabilities, the effect of fair value adjustments for assets acquired and liabilities assumed, and the expensing of incremental acquisition-related costs.
To lessen the probability of major unexpected income effects of the acquisition, the acquiring company’s management should consider using an acquisition accounting forecast as discussed above before the acquisition transaction. By integrating the impact of the acquisition accounting forecast and other effects of the business combination with the forecasted operating results (using carrying values) for the acquired company, the acquirer can obtain a more complete picture of post-combination earnings.
“A New Day for Business Combinations,” June 08, page 34
“Refining Fair Value Measurement,” Nov. 07, page 30
“Intangible Value: Delineating Between Shades of Gray,” May 07, page 66
The AICPA’s Guide to Business Combinations, Goodwill and Other Consolidation Issues, a CPE self-study course (#735161)
What You Need to Know About Accounting for Business Combinations, a CPE self-study course (#182000)