Tuesday, June 28, 2022

Business Combinations vs. Asset Acquisitions | The Accounting Matters Podcast

all right this is sarah cage and i'm joined again by my co-host adam olsen embark's national quality leader and we also have mac martinez and krista holland in the house they're here to provide some practical insight from their own experience as we dive into the difference between an asset acquisition.

And a business combination so as a company enters into any type of transaction to acquire this distinction is going to be super important so we're going to dive into all that adam will you kick us off with um knowing we've covered this in previous podcast the acquisition side for business combinations uh but can you set.

The stage about what exactly an asset acquisition is yeah yeah so asset acquisition basically in its simplest terms is the acquisition of assets and in some cases that could include liabilities as well that do not constitute a business under us gap so u.s usgap provides some.

Parameters and definitions for what what constitutes a business so it's a transaction that doesn't meet those requirements um asc 805 has a subsection 805.50 that does provide some of the guidance for how you would account for an asset acquisition so that's that's the 30 000 foot view of what an asset.

Acquisition would be and if you want to know more about business combinations go listen to that episode but we're going to talk more about the distinction here so adam could you tell us how an asset acquisition is a little different from a business combination yeah sure so um it is a real critical kind of fork in the road you know making sure that you.

Are heading down the right path whether or not your transaction is an asset acquisition or a business combination and that's that's primarily because the accounting frameworks that are used are completely different so an asset acquisition follows what's known as like a cost accumulation model where you know the cost used to pay for that for the.

Assets you acquire get allocated all those different assets and you know it's based on costs itself whereas a business combination really follows a fair value model where most items are accounted for at fair value and any excess consideration you paid will ultimately usually result in some type of goodwill so it is important that.

You kind of know which avenue you're going down because you are you know accounting for it in very different ways okay that makes sense and we'll probably talk through that accounting more throughout the podcast but mac could you give us an overview of where to start if you're trying to find the distinction between an asset acquisition or a.

Business combination for sure so the first step would be you know taking a look at the guidance at asc 805 you know determine whether you know acquired set of asset represents a business or not um so historically whenever you're evaluating uh a transaction you know you apply the traditional input.

Processes and outputs or you know ability to create outputs frame framework that the fasb has put in place but as part of the the fasbee's long-term business combination technical project they amended that definition back in 2017 through the issuance of.

Asu 2017-01 in phase one so those amendments introduce the the screen test um so that must be applied and requires an id to determine if substantially all the fair value of a uh.

Excuse me determine if substantially all the fair value of the gross assets acquired or concentrated in a single asset or a single subset of assets or a similar group of assets i guess so if that's the case then the acquired uh set is an asset acquisition and you don't have to further assess the.

Transaction definition of a business combination so our favorite little fasby quote is substantially all could you dig in a little more to what they mean by that sure um so the caveat here there's there's no real like bright lines the fazzy doesn't you know specifically define it away from him.

But uh in practice generally around 90 is presumed to mean substantially all quantitatively if there's kind of uncertainty uncertainty uncertainty about whether a single asset or a group of similar assets represents substantially all for example assume like an asset is 85 of the value.

Uh additional factors you know can be considered so you know some of those some of those other factors could be um you know other assets in included in the set are they complementary to each other or is it complementary to this to the primary single asset or i'm going to start over on that.

Go for it all right all right so for example let's assume an asset makes up 80 of the value additional factors uh should be considered um so like are there other assets included in the set that are complemented complementary to the single asset or group of similar assets.

Or they're distinct types on their own is there a presence of goodwill that's usually an indicator of a business or um if the acquired set operates independently you know acquired set of assets is is an operation or division so it's not it's not necessarily like a.

Checklist but it just kind of generally represents indicators uh the set is more like a business and wouldn't meet the screen test so it's kind of like looking at the set of facts as a whole right instead of you know just going through like a checklist yeah.

So you mentioned the screen test what's kind of the intent behind creating a screen test so the screen test was created um really to help simplify some of the burden of having to determine whether a certain transaction is an asset acquisition or a business combination.

Particularly in certain industries like real estate you know since the as adam mentioned as the accounting is really different between business combination or asset acquisition it's really just to kind of try to help simplify that that determination um and to make sure that it's applied correctly.

That makes sense they don't want to do too much work right everybody likes to save workload exactly krista in your experience what are some common challenges that we see companies have in applying the screen tests some of the common areas i've seen are determining what is considered a group.

Of similar assets and determining fair value of gross assets acquired yeah that sounds pretty challenging let's look at each of those one at a time how does an entity figure out if an acquired asset is part of a similar group and how do they apply that substantially all tests.

Entities should consider the nature of the assets and the risks associated with managing and creating outputs when determining if the assets should be grouped is similar if the risks are not similar the assets cannot be combined for the screen test ase 805 provides examples of assets that should not be considered similar and.

Combined as a group for applying the screen test these include things like a tangible asset and an intangible asset intangible assets across different classes of intangibles like customer relationships and technology a financial and non-financial asset different major classes of financial assets like ar versus equity securities.

And different major classes of tangible assets like inventory versus fixed assets this will require some judgment and vary based on facts and circumstances i will caveat that even for a single use uh single assay used in the screen test there can be instances where assets are combined into one single asset examples.

Of this would include a tangible asset attached to another tangible asset including instances where an intangible asset represents the right to use a tangible asset such as a building with a ground lease to be attached it cannot be removed without incurring significant costs like land and building would be.

So in this instance land and building would be combined into a single asset yeah because you're not going to go in and lift the building off the land right right another example is in-place lease intangibles and related lease assets those two would be considered a single asset as well.

This is different from the group of similar assets we previously discussed where these assets are considered more complementary to each other and should be viewed holistically that makes sense you know you tangible asset intangible asset those don't sound similar to me they sound pretty opposite and then those package deals so how does.

An entity come up with the gross assets acquired does everything get included here um or are there certain things that should be excluded this will include all the assets acquired in the transaction with limited exceptions this total should also include any consideration transferred in.

Excess of the fair value of the net assets acquired so what would otherwise be considered goodwill in a business combination however certain gross assets acquired are exclude excluded including cash and cash equivalents deferred tax assets and goodwill resulting from the effects of deferred tax assets.

I like the sound of that because i do not like deferred i feel like it's like a terrible word these items are excluded as the fafsa did not believe the tax form of the transaction and whether cash and cash equivalents were included should affect the determination of whether the set is a business.

Keep in mind the fair value of gross assets acquired is not necessarily the same as the consideration transferred this may be caused for example by liabilities assumed which are factored into the determination of purchase price but excluded from the gross assets in the denominator of the screen test the guidance does not address how to.

Treat a program purchase option uh gain and applying the screen in practice well not always common a bargain purchase gain is excluded from the denominator of gross assets acquired similar to liabilities assumed an entity may not need additional information in all transactions to evaluate whether the threshold is met.

Because it would need most of the information required like the fair value assessment for such an analysis regardless of whether the asset set is a business or a group of assets that is in an acquisition of a group of assets that does not constitute a business an entity must determine the fair value of all the assets acquired to.

Allocate consideration transferred to those assets on a relative fair value basis in accordance with asc 805-50-30-3 do you have that memorized no i think that's a good point to actually bring up is that i think a lot of people think an asset acquisition is always going to be less work from a valuation perspective and that's not.

Always the case you're generally going to need evaluation done regardless of whether it's a nasdaq which is asset acquisition or a business combination it's just how that information is used with the subsequent accounting got it yeah and i thought you've done a lot of that purchase price accounting.

Acquisition stuff mac what if a company thinks the answer to the screen test is blatantly obvious do they have to go through the entire exercise evaluating it or can they skip it so the screen test isn't optional but the guidance does not.

Require a quantitative evaluation of whether the threshold is met um so for example a set the assessment could be qualitative if the entity concludes that you know all the fair value is assigned to one element of the set you know for so just to give an example assume a company acquires a license for a drug candidate.

And an at market lease contract if the lease contract is quant qualitatively determined to have little or no fair value then based on the significant license it's clear the threshold was met asset acquisition contrast if an indian concludes that there is clearly significant value in assets that are not similar.

The entity may be able to qualitatively determine the threshold is not met you know keeping with a similar example uh assuming acquired set includes multiple licenses for very different drug types and candidates uh if each license were to have more than an insignificant fair value then the entity could qualitatively.

Determine that you know substantially all threshold for the screen test is not met kind of moving towards the business combination have to keep going down the screen test so if the screen test isn't met do we have to go back to the concept of whether the transaction meets the definition of a business.

And if so can you give us a little recap of how that all works sure so even if the initial screen test isn't met you could still end up concluding the transaction as an asset acquisition if all the required elements of a business are not met as outlined in asc 805 so ac 805 states that a business is an.

Integrated set of assets and activities that is capable of being conducted and managed for the purposes of providing return to investors or other owners members or participants so business typically has inputs processes and outputs they're used to generate a.

Return to investors the evaluation of whether outputs exist in the acquired set is an important step the guidance defines an output as the result of inputs and processes applied to those inputs that provide goods or services to customers investment income such as dividends or interest or other revenues if outputs are present the set must.

Include an acquired substantive process if outputs are not present the set must include an organized work for force who are capable of performing a substantive process by having a necessary experience and skills so if those those elements are not present the acquired set would be an asset acquisition so you know technically outputs aren't required.

But like quote unquote the ability to create outputs is required okay so we go through all that work we do all these tests let's say we land at an asset acquisition how does a company recognize and measure an asset acquisition if that's where we land crystal you take this one yeah so this follows a cost accumulation model.

In other words assets acquired and any liabilities assumed are recognized at cost which is the consideration the acquirer transfers to the seller on the acquisition date costs could include any of the following cash consideration paid non-cash consideration paid direct acquisition costs incurred consideration previously previously held.

Interest or non-controlling interest for asset acquisitions in which some or all of the consideration transferred consists of non-cash assets liabilities incurred to the seller or equity interest issued to the seller entities should first determine whether the transaction is within the scope of other u.s gaap.

The guidance suggests asc 845 and asc 610-20 as examples of other u.s gaap that may apply to these transactions additionally reporting entities may also need to consider whether asc 718 applies to asset acquisitions involving equity interest issued to the seller the cost of the acquisition is then allocated to the assets acquired based.

On their relative fair values an asset's acquisition cost or the consideration transferred by the acquiring entity is assumed to be equal to the fair value of the net assets acquired unless contra evidence exists okay so how does the cost allocation process work any key reminders here.

As we mentioned before after the cost of a group of assets in an asset acquisition is determined it is allocated to the assets acquired based on their relative fair values keep in mind this allocation method could result in the cost of the asset acquisition exceeding the fair value of the acquired asset or.

The cost of the asset acquisition being less than the fair value of the acquired asset if significant differences between the cost of an asset acquisition and the fair value of the assets acquired and liabilities assumed exists it could be evident to suggest that not all assets were acquired in liabilities assumed.

Have been recognized or that there are transactions that should be recognized separate from the asset acquisition judgment is required to evaluate it's like when i'm putting together furniture and like it's not fitting it means that i've probably missed something yeah yeah i had that experience recently i.

Was putting together a basketball goal and the thing wouldn't lift and it was because we missed a step and we didn't put the little spacers in so if you if your entry doesn't balance you maybe miss something smaller hoops easier to dunk on in many cases the cost of the asset.

Acquisition may still exceed the fair value of the individual individual assets acquired and liabilities assumed this may be due to synergies existing among the acquired assets as an asset acquisition does not result in the recognition of any goodwill any excess cost over the fair value is still required to be allocated to the acquired.

Assets on a relative fair value basis however entities should keep in mind any assets in the acquired set that may be subject to ongoing fair value impair impairment testing as any excess consideration should generally not be allocated to them on a relative fair value basis or they risk an immediate impairment.

Those assets should not be allocated any consideration in excess of their fair value on the asset acquisition date let's provide an example to help illustrate this last point assume that a company entered into an asset acquisition and paid 20 million in cash the fair value of the asset acquired on the acquisition.

Date consisted of the following property plans and equipment of 12 million inventory of 4 million and indefinite lived intangible assets of 3 million so the total for fair value of the assets acquired would be 19 million in this example because the cost of the assets exceeds its fair value the excess must still be allocated to the acquired.

Assets however the indefinite lived intangible asset should not be allocated to an amount greater than its fair value of 3 million because it's subject to an annual recurring fair value impairment test in doing so could result in an immediate impairment instead the allocation would work by taking the remaining 17 million in.

Consideration so 20 million less through the 3 million for the indefinite live asset and out allocate it on a relative fair value basis between the ppe and inventory okay i like the example that's really helpful um so we've touched on this at a high level the difference between asset.

Acquisition and business combinations but are there any specific accounting differences that we should maybe highlight to our listeners adam will you take this one yeah so i've got a list i guess of the more common ones that i see people have questions on or that they're surprised by some of the accounting and then this.

Is by like no means meant to be you know all-encompassing there's there's several others out there so if you have more unique circumstances i definitely recommend doing some of the research or reaching out to one of us we can help direct you in the right in the right direction to make sure you're.

Thinking about that correctly but contingent considerations a big area leases transaction costs in process r d is kind of a unique one but the accounting outcomes kind of surprising to a lot of people there so i always like to throw that one in measurement periods and then kind of.

Like the reporting side like what kind of disclosures are needed so those are kind of my top i guess six items um and we can talk through each of those as you see fit yeah you know i don't let you off with just a list you gotta dig into each one of those let's let's start with uh contingent consideration yeah so contingent consideration you.

Know i think when we were talking through what gets um included into the cost you know contentious consideration could be one of those items um the way it works for an asset acquisition it kind of mirrors the guidance that you see in asc 450 so it's whether it's probable and estimatable so trying to you know think about how much should we.

Recognize based on those criteria um at the date of acquisition and so that's what you would record and then obviously subsequent to that as you you know new facts or circumstances come about or you adjust that estimate there's always the question of like how would i handle this contingency consideration you know going down the.

Road it hasn't been settled yet but now i either think more is going to be paid out or maybe less is going to be paid out what do you do and so the way the accounting works is that any time there's a change in the um initial consent contingency consideration which would be capitalized right so it's all a cost accumulation.

Model so any contingent consideration just gets capitalized into the cost of the assets any changes to that is really just a change in the cost basis of those assets so you are just changing that cost basis the big question that comes up is what do you do you know if that cost basis let's say is an adjustment to fixed.

Assets for example what do you do with the depreciation expense that you were you know appreciating over you know an old cost basis what do you do now that you've trued up that cost basis and so generally there you know there is an explicit gap on this but in practice what's generally done is a cumulative.

Catch-up entry so any you know depreciation or amortization that you should have recorded had that been the cost basis originally you would catch that up through a catch-up entry and this is different obviously from a business combination which is why it's important that we distinguish between the two.

The two different models themselves because in a business combination you fair value contingent consideration and then depending on the classification of that contingent consideration so whether it's equity classified or liability classified you may have to do subsequent remeasurements so liability.

Classified contingent consideration gets revalued every reporting period any changes in that run through earnings so it's it's completely different because that one is obviously you know especially from like a liability perspective it's going to hit your p l whereas at an asset acquisition perspective it's.

All being capitalized into cost and it comes through the p l through your depreciation or amortization okay what about with leases so lisa's there's a lot um in here they're all never easy you know especially with like.

The new leasing guidance which is where we'll focus most of this discussion um and i'll talk more about on the less seaside there are some some nuances on the lessor side so definitely would suggest if you acquire you know if you acquire something that included leases where they were the less sore in.

You know definitely look at some of that guidance as well but from a lessee perspective there's a couple areas i like to focus on one is classification so normally um in a business combination if you acquire a lease you just keep the same classification of the inquiry.

So you don't reassess that and in asset acquisition you actually do reassess these classifications so completely different frameworks there so you would have to perform that classification test based on the information of that lease at the acquisition date and then from a measurement perspective um there are some differences there as well for.

Lessee so the you know both are going to view the acquired lease as a new lease so they're going to measure the right of us at least liability um lease liability rather based on the remaining lease payments as if it was a new lease you know discount that back the big difference is whether or not.

There's any favorable or unfavorable intangibles associated with that lease so you know if the lease is at you know below market or above market as far as lease rates or something there could be an intangible asset associated with it and an asset acquisition you have to account for that intangible separate.

From your right of use asset whereas in a business combination it would actually reduce the right of use or be an adjustment to the right of use asset depending on whether it's favorable or unfavorable so just a couple differences in how you account for write a few assets on that.

Acquisition date sounds like we could do a whole podcast on that one um what about transaction costs we've kind of talked about this a little bit throughout the podcast but what's maybe the main difference here yeah so this one i mean it's it's pretty straightforward um business combination.

You generally all you're going to be expensing almost all those transaction type costs and there's some limited exceptions if you're paying on behalf of people things like that but generally those are expensed whereas in an asset acquisition it's a you know it's a component of the acquisition itself so those actually get allocate or.

Capitalized and allocated to the assets so you know that was one of the big reasons that um when you know the fasb put into place kind of their definition of a business rework there was a lot of feedback particularly like in the real estate industry because there's a ton of cost that goes into.

Right trying to close real estate transactions and so people are like these are obviously like we're just buying an asset here we're not really buying a whole business and so you know under the old definition of a business a lot of times they were having a tough time kind of overcoming that hurdle to.

Say it wasn't a business and so they were having to expense all these costs and they weren't able to capitalize the cost you know for those that are able to meet the definition of an asset acquisition you know through the screen tests or failing that business definition then you know those costs can then be.

Capitalized into the transaction and then you know obviously it looks better on your balance sheet so yeah um you know so big difference there as well yeah and i think the next on your list was in process r d which isn't something that everybody deals with but it's also one of those things that makes our brains.

Hurt so could you kind of hit the highlights on what's going on there yeah so this is the one i think like kind of shocks people i mean it's obviously more prevalent like in life sciences you know you're doing drug research or maybe some technology type companies are also doing some unique research and development.

Type projects um but depending on whether the transaction you know has some in process research and development at the time you acquire um you know whether it's business versus asset acquisition the accounting is like completely different so asset acquisitions generally will always expense any of that.

In progress research and development so if you think about you know some of these pharmaceutical startup type companies they may only have research and development and so if that transaction ends up being like we're going to acquire this you know this drug company but it's.

Determined to be an asset acquisition like that research and development in most cases is always just going to be expense so you really have nothing to like record in a lot of cases in those transactions there are limited exceptions it's pretty rare that you could argue that the in.

Research or in progress research and development may have an alternative future use that exists in which case you could capitalize it but that that's a i guess that's a high hurdle to me because basically what the guidance you know in practice came out saying is that if there's.

Um if the use of that in process research and development requires like further development like it's not completely ready to go as it is it's not considered to have an alternative use so it's almost like whatever you acquired has to be able to be used in its current state it can't be.

Like you know we're going to take what's there and then continue to add on to it that would suggest that you know an asset doesn't exist and you've got to basically expense that on the flip side if it's a business combination um you you would capitalize or you know generally you'd recognize an asset um at fair value for that in.

Research in progress research and development and it's usually an indefinite live asset um you know sits on your books but you know it's not something that hits your it's your p l man they really like to have these things be treated differently all right so the last two items on your.

List were measurement periods and disclosures could you talk a little bit about both of those yeah so anyone that's been through you know a traditional sorry business combination under ac 805 is probably familiar with the concept of a measurement period which basically allows you.

Up to a year from the acquisition day to finalize your your purchase accounting so gather your information make adjustments you know fine-tune things based on information that existed on the acquisition date and an asset acquisition that doesn't exist so you don't have the luxury of.

Having a period of time to finalize that accounting you have to get that that ready the first time ready to record so there's no you know looking back and trying to to make adjustments there if there are changes to the asset acquisition accounting it's you know has to be evaluated as like are we.

Correcting an error in the initial accounting and kind of going through that framework so just something to keep in mind and then probably on the relief side so something that's maybe a little bit easier on the asset acquisition side is disclosures there really aren't any like prescribed disclosures for an asset.

Acquisition obviously business combinations have a ton of robust disclosures that you have to include a lot of details about the transaction um you know purchase price allocations breakouts of different consideration fair value type disclosures around that type of stuff asset acquisition accounting there isn't.

Any prescribed specific disclosures but there could be disclosures that are required just by you know being in in tandem with some of the types of assets acquired so if you acquired an intangible there's you know standard intangible disclosures you got to include and things like that so just kind of keeping in mind like depending.

On the nature of what you acquired you may have other areas of gaap that have applicable disclosures but there's nothing specific to like the transaction itself okay well we cover just a few of the differences and it sounds like there's a lot.

So given all these differences and the nuances between these is there any thought to try and bridge that gap between business combinations and asset acquisitions yeah yeah there is so you know we've mentioned you know earlier at the top of the podcast about the definition of a business was just like phase one of the.

Fazbeas project and they they worked through phase two which had to do with some of like de-recognition type stuff of certain non-financial assets and and things like that in asc-610 but there's actually a phase three that's underway and this is the part of the project that is looking at differences like key differences in asset acquisition.

Accounting versus business combination accounting and whether or not they could align some of those you know more closely together so that's something that's definitely in the works i think recently they kind of noted that they were going to be looking at contingent consideration that in.

Progress research and development and transaction costs and whether they should be treated similarly so there's more to come on that they haven't really given you know a ton of indication like where they're going to land but they they have kind of defined the scope of certain things they are looking at and obviously other things.

Could be added but definitely something to kind of keep a pulse on especially if you you know work for a company that makes a lot of transactions you kind of have to go through this drill you know pretty frequently just if they're if there are going to be something wide sweeping changes that you kind of stay current on.

That stuff so and i'm sure if there's changes we'll also probably have a little chat about that we'll go through it all um so just to bring us all the way through the the process here what about after the asset acquisition is there any guidance about subsequent measurement considerations.

Yeah not specific to like you know asset acquisitions you know if you think about like a business combination where you recorded goodwill you know subsequently then you're like testing that goodwill for impairment if you you aren't a private company that elected an alternative but for asset acquisitions there really isn't any like.

Specific subsequent you know recognition or measurement guidance for asset acquisitions as a whole you basically are just going to follow whatever applicable gap you know exists for those different assets or liabilities you brought onto your books through the transactions so you know you.

Got intangibles for example you're gonna amortize your intangibles and record that but you know there's there's no there's no specific you know guidance that you have to follow after the fact i like that and i think that is plenty for today's discussion unless you all want to go for another hour.

I'm good thank you i think accounting is like medicine it's best when taking in doses yes pause for laughter they could see myself if you'd like to learn more about this and or have any questions about today's discussion please find embark on linkedin we'd love to connect especially.

If you have suggestions for future podcast episodes uh we'd love to hear what topics you want to know more about thank you mac and krista for joining adam and i and for sharing your insights and thank you for listening and following along on another episode of accounting matters.



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