Under Accounting Standards Codification (“ASC”) 805, Business Combinations, a business combination occurs when an entity obtains control of a business by acquiring its net assets, or some or all of its equity interests. It may sound straightforward, but in reality, the close of a deal is just the beginning of the journey.
Under ASC 805, once control of a business is obtained, the acquirer recognizes the assets acquired and liabilities assumed at 100% of their fair value on the acquisition date even if less than 100% of the equity interests are acquired. Business combinations involving construction and real estate (“CRE”) have many industry-specific complexities to take into consideration. Prior to even getting into the debits and credits of recording the acquisition, however, management should be asking the following questions:
Does the Transaction Constitute an Acquisition of a Business or an Asset Acquisition?
Prior to assessing whether a business combination has occurred, ASC 805 states that the entity being evaluated must meet the definition of a business. Under US GAAP, an initial screening test is required to assist in the determination. If substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset, then the acquisition should in fact be accounted for as an asset acquisition as opposed to a business combination, which results in significantly different accounting. However, if that screen test is not met, then further analysis is needed to determine if the acquired set of assets and activities meets the definition of a business because it consists of inputs and processes applied to those inputs that have the ability to contribute to the creation of outputs.
While this test may seem simple, it is important to remember that you may be required to follow business combination accounting even in instances where an entire business is not acquired. Business combination accounting rules may apply to transactions that are not a full acquisition of another company.
If Deemed a Business Combination, Which Entity in the Business Combination is the Accounting Acquirer?
ASC 805 indicates that for each business combination, one of the combining entities is to be identified as the acquirer for accounting purposes. The process of identifying the acquirer begins with the determination of the party that obtains control based on guidance in the consolidation standards in ASC 810. According to ASC 810, Consolidation, the general rule is that the party that holds directly or indirectly greater than 50% of the voting shares of the combined entity has control. This analysis may seem relatively straightforward, and a lot of times it is. However, determining the accounting acquirer can be difficult when the combining entities are of nearly equal value or the shareholders of one entity do not clearly control the combined entity based on voting interests. In these circumstances, judgment will be required.
What is the Acquisition Date for Purposes of Applying ASC Topic 805?
According to ASC 805, the acquisition date is the date on which the acquirer obtains control of the acquiree. This generally coincides with the closing date when assets are received and other assets are given, liabilities are assumed, or equity interest are issued. However, if control of the acquiree transfers to the acquirer through a written agreement, the acquisition date could be before or after the closing date.
What is the Nature & Amount of Consideration Paid?
The consideration transferred in a business combination is measured at fair value and represents the sum of the acquisition-date fair values of the assets transferred by the acquirer, the liabilities incurred by the acquirer to former owners of the acquiree, and the equity interests issued by the acquirer. Certain exceptions apply for any portion of the acquirer’s share-based payment awards exchanged for awards held by the acquiree’s employees. Examples of potential forms of consideration include cash, other assets, a business/subsidiary of the acquirer, contingent consideration, common or preferred shares, options, warrants or member interests. Careful analysis is needed for payments to former owners who enter into continuing employment relationships with the acquirer post-acquisition to determine if the payments represent consideration transferred or compensation expense. In addition, transaction expenses will need to be evaluated to ensure whether they can be included in consideration transferred or expensed as incurred.
What is the Fair Value of the Assets Acquired & Liabilities Assumed?
The acquirer generally records tangible assets and liabilities assumed at their acquisition-date fair values. This may require adjustments to historical recorded amounts based on specific account analysis or valuations to be performed under ASC 820. In addition, there are certain exceptions to this fair value recognition principle, including assets and liabilities arising from contingencies, income taxes, employee benefits, indemnification assets, leases and contract assets and contract liabilities.
ASC 805 also requires acquired identifiable intangible assets to be recognized separately from goodwill if the subject intangible asset is either contractual or separable. Intangible assets are assets, other than financial instruments, that lack physical substance. Assets like trademarks, tradenames, customer lists, and patented technology are all examples of potential intangible assets. Specifically for CRE entities, easements, leases, licenses and permits are additional items that may need to be recognized as intangible assets. Identifiable intangible assets could include both indefinite-lived and definite-lived intangible assets. Useful lives of definite-lived intangible assets will then need to be determined based on the period over which the asset is expected to contribute directly or indirectly to the future cash flows of that entity. Given the potential complexity involved, third party valuation specialists might be required to perform valuations specific to the intangible assets identified.
US GAAP includes an accounting alternative (the “intangible assets accounting alternative”) that allows a private company or not-for-profits (“NFPs”) to limit the customer-related intangibles it recognizes in a business combination or acquisition by an NFP to those that are capable of being sold or licensed independently from the other assets of the business. The application of this accounting alternative, however, is limited to those entities that also adopt the goodwill accounting alternative described below.
What is the Resulting Amount of Goodwill to Record in the Transaction?
Goodwill is measured as the residual value remaining after the subtracting the net tangible and intangible assets acquired from the fair value of the entity. This requires an assessment of the fair value of the consideration transferred plus the fair value of any remaining noncontrolling interest. The measurement occurs on the acquisition-date and, other than qualifying measurement period adjustments, no adjustments are made to goodwill recognized as of the acquisition date until and unless it becomes impaired. To the extent the fair value of the net assets acquired in a business combination exceeds the amount of the consideration transferred (a “bargain purchase”), further assessment and analysis would be required as these situations are expected to be rare.
Under US GAAP, if a private company/NFP entity elects the accounting alternative to amortize goodwill (“goodwill alternative”), the entity may amortize goodwill on a straight-line basis over ten years, or less than ten years if the company demonstrates that another useful life is more appropriate. Goodwill would only then need to be assessed for impairment upon the occurrence of a triggering event. Otherwise, subsequent accounting, including annual impairment considerations, would need to be considered under the provisions of ASC 350.
What are Common Items Involved in Business Combinations that CRE Entities Should Consider?
One of the more common items included in an acquisition involving CRE are real estate holdings and other machinery and equipment (collective, property, plant and equipment). Acquired property, plant and equipment to be used by the acquirer is recognized at fair value, which would represent the estimated price that would be realized upon sale to a market participant. Depending on the uniqueness and magnitude of acquired assets, third party valuation specialists might be required to perform valuations specific to assets acquired. The recorded carrying amount of the asset is the net value, which also means that no accumulated depreciation is recorded on day 1. For depreciation purposes, estimated useful lives of acquired property, plant and equipment should be established based on the expected remaining useful life. This useful life is an entity-specific estimate that would not necessarily be consistent with the useful life of the life previously assigned.
Another more common item for CRE entities involves leases. While the rules around lease accounting in business combinations and beyond is too broad to cover within this article, a few things to consider are the initial valuation of the asset and liability, consideration of favorable/unfavorable leases and in place leases and leases with a remaining lease term of 12 months or less. Under ASC 842, the existing lease classification is not changed unless the lease is modified, and the modification is not accounted for as a separate contract. When the acquiree in a business combination is a lessee, the acquirer initially measures the lease liability and right-of-use asset for acquired finance and operating leases as if the leases are new at the acquisition date (i.e. as calculated under ASC 842, not fair value). When the acquiree in a business combination is a lessor in a sales-type or direct financing lease, the acquirer recognizes and measures the net investment in the lease, which includes the lease receivable and the unguaranteed residual asset at the acquisition date. Also, when an acquiree is a lessor, an underlying asset subject to an operating lease is recognized and initially measured at its acquisition-date fair value, as the underlying assets subject to the lease remain on the lessor’s balance sheet.
Regardless of whether the acquiree is the lessee or the lessor, the acquirer also needs to assess whether the terms of acquired operating leases are favorable or unfavorable compared with the market terms of leases of the same or similar items at the acquisition date. If the acquiree is a lessor, an intangible asset should be recognized if the terms of an operating lease are favorable relative to market terms and a liability if the terms are unfavorable relative to market terms. If the acquiree is a lessee, the measurement of the acquired right-of-use asset should be adjusted for any favorable or unfavorable terms.
Some lease contracts may have value for reasons other than terms that are favorable relative to market prices. In-place leases acquired with an asset (e.g., tenant leases associated with an acquired building) should be recognized apart from the acquired asset as they also meet the recognition criteria under ASC 805. Generally, the useful life of an in-place lease is shorter than the remaining life of the underlying asset and thus separate recognition and amortization will affect the net earnings of the acquiring entity.
If the acquiree is a lessee, the acquirer can apply a policy election to not recognize assets and liabilities for leases that at the acquisition date have a remaining lease term of 12 months or less. This election includes not recognizing an intangible asset if the terms of an operating lease are favorable relative to market terms or a liability if the terms are unfavorable relative to market terms.
Looking Ahead
Given the complexity of business combinations, the considerations above are not all encompassing of the factors that should be evaluated to ensure proper accounting under the standards. If you need further guidance or have any questions on this topic, we are here to help. Please do not hesitate to reach out to discuss your specific situation.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.
