Understanding ASC 805: Essential Insights for Business Combinations

Companies engage in merger and acquisition activity for a multitude of reasons such as strategically aligning with a complementary entity or increasing market prominence. 

Given the significant investment involved in executing a merger or acquisition, companies expend a great deal of resources on the front end of a transaction to mitigate the risks that come with acquiring an entity. With all of the attention that the pre-transaction process garners, companies can easily overlook the accounting complexities that arise post-transaction and the additional technical and workload burden undertaken by the accounting department. The Financial Accounting Standards Board (FASB) established Accounting Standards Codification Topic 805 (ASC 805) to provide guidance on how an entity should account for the acquisition of another entity. Despite the exhaustive guidance of ASC 805, there are inherent complexities due to uniquely negotiated deal terms. BDO’s Blueprint on Business Combinations Under ASC 805 provides essential guidance that can help organizations navigate the complexities of accounting for a business combination. 

Scope of ASC 805, Business Combinations

Before navigating the guidance of ASC 805, it is important to note that certain transactions are outside the scope of the business combination guidance in ASC 805 such as formations of joint ventures, mergers and acquisitions between not-for-profit entities, and transactions between commonly controlled entities to name a few. 

However, joint ventures that meet the FASB’s definition of a joint venture are outside the scope of the business combination guidance in ASC 805-10 through ASC 805-30. ASC 805-60 provides guidance for the accounting by a joint venture upon its initial formation, which is similar to business combination accounting. Other mergers and acquisitions (sometimes loosely referred to as joint ventures) are not scoped out of the business combination guidance.

If the transaction is in the scope of ASC 805, companies begin by identifying the acquirer.

Identifying the Acquirer and the Acquisition Date

Often, the identity of the acquirer in a business combination is clear. For example, this is the case when one entity acquires all the equity instruments of another entity in exchange for cash proceeds paid to the sellers. However, the determination can become far more complex when only a portion of the equity instruments is being acquired or the consideration exchanged between parties consists solely of equity instruments. In these cases, companies may find that the legal acquirer as defined in the purchase agreement may differ from the accounting acquirer based on the provisions of ASC 805, resulting in what is commonly referred to as a “reverse acquisition.”

Additionally, if it is determined that the legal acquiree is a variable interest entity (VIE), determining the acquirer would involve a VIE analysis under the guidance of Accounting Standards Codification Topic 810, Consolidation (ASC 810).

Once the acquirer is identified, the assets acquired, the liabilities assumed, and any non-controlling interests will be measured at the acquisition date. Further, this is the date the acquirer must begin to consolidate the acquiree. Generally, this date corresponds with the  effective date of the purchase agreement when consideration is transferred. However, in certain circumstances, the acquirer may have obtained control before the closing of the transaction or, alternatively, the transfer of control is delayed until sometime after the transaction closing date.

Definition of a Business

A critical analysis in the journey through ASC 805 is determining if the acquired group of assets and liabilities meets the definition of a business. ASC 805 establishes that a business must have inputs and processes that are capable of generating outputs. Further, ASC 805 also includes an additional required analysis, referred to as the “screen test.” Under the screen test, the acquired assets and liabilities may not be deemed a business in the context of ASC 805, even if the acquired assets and liabilities include inputs and processes that generate or are capable of generating outputs. Determining whether the acquired assets and liabilities are a business is critical because the accounting for a business combination is significantly different that the accounting for an asset acquisition or recapitalization.

Recognizing Assets Acquired, Liabilities Assumed, and Noncontrolling Interests

Under the guidance of ASC 805, the acquirer recognizes the acquired assets, liabilities assumed, and noncontrolling interest at fair value considering the guidance of Accounting Standards Codification Topic 820, Fair Value Measurement (ASC 820). There are exceptions to the fair value concept for certain assets acquired and liabilities assumed. For example, contract assets and liabilities recognized in accordance with Accounting Standards Codification Topic 606, Revenue from Contracts with Customers (ASC 606) are not measured at fair value but should continue to be accounted in accordance with the guidance of ASC 606.  

Quite often, significant time and effort is required by the purchaser’s accounting team to identify these assets, determine the appropriate values, and account for and disclose them in the financial statements.

Recognizing Goodwill or Bargain Purchase Gain

Most business combinations result in the recognition of goodwill, which represents a premium paid in excess of the value of the acquired net assets. Less often, there are bargain purchase gains (for example, if the consideration transferred is less than the values assigned to the identifiable assets acquired and liabilities assumed). ASC 805 requires entities to reevaluate the completeness of the assets acquired and liabilities assumed, as well as the value ascribed to said assets and liabilities if it is determined that a bargain purchase gain results from the acquisition.

Determining the amount of goodwill or bargain purchase gain is fairly straightforward, as it is generally the difference in consideration compared to the acquired assets, assumed liabilities, and noncontrolling interest. However, complexities often arise in determining the consideration transferred, especially when earnout provisions are present, the acquiree has employee stock compensation awards that are replaced in conjunction with the acquisition, the sellers are retained as employees, or seller transaction costs are being paid by the acquirer.

Separate Transactions

It is common for a business combination to be accompanied by other transactions between the buyer and seller. Because these transactions may be negotiated in connection with the business combination, it is not always clear what is and what isn’t part of the business combination. As a result, ASC 805 provides a framework for evaluating whether transactions should be accounted for apart from the business combination. 

Other Topics

ASC 805 also addresses accounting for the following topics:

• Pushdown accounting: the recognition of the acquirer’s new basis in the acquiree’s standalone financial statements. 
• Common control transactions: transfers of assets or businesses between entities that are controlled by the same ultimate parent.
• Asset acquisitions and recapitalizations: the acquisition of a group of assets that is not a business combination.
• Joint venture formations: the initial accounting by a joint venture at its formation date.

Presentation and Disclosures

ASC 805 establishes robust, detailed disclosure requirements for material business combinations, as well as for immaterial business combinations that, in the aggregate, are material to the financial statements.

Business Combinations Are Challenging. We Can Help.

As a result of the infrequency of merger and acquisition activity for most companies, there is increased risk of materially misstated financial statements relating to inappropriate accounting treatment of business combinations. Entities that frequently engage in merger and acquisition activity also face increased risks of material misstatements due to the uniqueness of negotiated terms and conditions of each business combination. 

The road to appropriately determining and applying the applicable accounting for a business combination requires careful analysis and in-depth knowledge of complicated accounting standards. Our Blueprint offers comprehensive guidance on the application of ASC 805. BDO’s professional advisors can walk you through the complicated process of choosing the most appropriate financial reporting for your business and help supplement the needs of your accounting team during the increased workload associated with these transactions, operating seamlessly with your team to meet both internal and regulatory deadlines for accurately evaluating and reporting such meaningful transactions.