If you’re conducting, or considering, a business combination, you may be wondering how to handle an important step—determining the fair value of assets, liabilities, and noncontrolling interests. If so, look no further than Accounting Standards Codification (ASC) 805, Business Combinations, issued by the Financial Accounting Standards Board (FASB). This essential guidance provides the framework for this type of valuation and provides investors with a more accurate picture of the value of assets purchased and liabilities assumed in a merger or acquisition.
Fair value versus fair market value
ASC 805 requires your company to ascertain the fair value of all acquired assets and assumed liabilities as of the acquisition date. But what exactly is fair value? According to ASC 820, Fair Value Measurement, it represents the price you would obtain if you were to sell an asset or the price you would pay to transfer a liability in an orderly transaction between market participants. Fair value is calculated based on best use of the asset or liability by “market participants”—that is, buyers and sellers in the asset’s or liability’s principal market—distinguishing it from fair market value, which considers all hypothetical buyers.
How to determine fair value in accordance with ASC 805
Now, let’s delve into the process of determining fair value in accordance with ASC 805. Whenever your company gains control of or merges with another business, you must perform a purchase price allocation (PPA) for financial reporting purposes. This exercise allocates the purchase price among all the acquired assets and assumed liabilities. You’ll need to consider both tangible assets, such as property, plant, and equipment (PP&E), and intangible assets, like patents, trademarks, and customer relationships. The liabilities you’ve assumed might include contractual obligations, debt, or contingent liabilities.
Once you’ve identified all the assets and liabilities, you must determine their fair value as of the transaction date. Remember, fair value is determined based on the highest and best use of the asset or liability by market participants. You can choose from among several valuation methods, including market approaches, income approaches, and cost approaches, to determine fair value. Although there are several valuation methods to choose from, there are certain methods that are commonly used and widely accepted for certain types of assets. Moreover, when determining the fair value of the primary asset in a business combination, guidance suggest that appraisers consider a very specific type of valuation methodology. It is important to consult with valuation experts and your accounting professionals for best practices in all circumstances.
After the fair value of each asset and liability is calculated, any residual value between the total consideration paid and the sum of the net assets acquired is allocated to goodwill. Goodwill is an asset representing future economic benefits like synergies. Depending on the circumstances, you might not amortize goodwill, but you’ll need to test for impairment annually.
Purchase price allocation for business combinations
But how do you determine the purchase price in dollars and cents, since cash is often not the only payment form used in acquiring businesses and their assets? The crucial first step in any PPA exercise is to ascertain the fair value of all forms of consideration paid. That means you’ll tally not only cash paid, but all other elements of payment as well, such as contingent consideration, promissory notes, equity instruments (common or preferred), options, and warrants.
Furthermore, the FASB mandates that the consideration transferred to the seller must be recorded at its acquisition-date fair value, regardless of its form. Determining the cash value of all elements of payment at that date entails meticulous analysis and, often, complex valuation models. However, it’s worth doing right; starting out with the correct consideration paid is vital to ensuring accuracy in your company’s financial statements.
Private companies and the GAAP alternative
If your business is a private company, you can explore a compelling alternative to the extensive, costly PPA process. Many business owners and investors have questioned whether this long, complex process is justified. In response, in December 2014, the FASB issued ASU 2014-18 – Business Combinations, which offers an accounting alternative to traditional GAAP (generally accepted accounting principles) standards for private companies. This alternative aims to reduce costs and complexity associated with measuring certain intangible assets without compromising the usefulness of financial statements.
Under ASU 2014-18, if you opt for the private company accounting alternative, you will not need to separately recognize customer-related assets (unless they can be sold or licensed independently) or noncompetition agreements. Instead, most, if not all, of these assets will be subsumed into goodwill. Keep in mind that if you adopt the private company accounting alternative, you must also use the private company alternative to amortize goodwill (ASU 2014-02). (On the other hand, selecting ASU 2014-02 does not necessarily mandate the adoption of ASU 2014-18.)
In conclusion, performing an ASC 805 valuation is a complex endeavor requiring specialized knowledge and expertise in valuation and accounting. To ensure compliance with ASC 805 and to obtain accurate and reliable valuations, consider the benefits of consulting with accounting professionals or valuation experts. Doing so will enable you to unlock the secrets of ASC 805 valuations, navigate the intricate world of fair value determination with confidence, and make informed business decisions, all while knowing your financial reporting is accurate and transparent.