Understanding ASC 805: What PE Firms and CFOs Need to Know Ahead of Transactions

July 11, 2023

Merger and acquisition (M&A) activity started off strong in 2022 but by the end of the year tailed off significantly and was slow to start 2023, however, activity is expected to potentially pick back up as 2023 progresses. Traditional credit markets are tight but private equity (PE) firms continue to have dry powder to deploy. As they seek out new acquisitions, both PE firms and CFOs of target companies should have a robust understanding of ASC 805 – Business Combinations (ASC 805) – to streamline accounting and avoid unintended risks.

Using ASC805 to Chart a Path Forward

ASC 805 establishes a framework for assessing whether an M&A transaction should be accounted for as a business combination or an asset purchase. The standard further discusses significant considerations required for a business combination, including determining:

The acquiring entity.
The acquisition date.
The transaction price.
The identification and valuation of the assets acquired and liabilities assumed.
The accounting treatment for concurrent arrangements entered between the buyer and seller and for the various costs associated with the transaction.
Certain elections to simplify purchase accounting afforded to privately owned companies.

In addition, the standard discusses the accounting treatment for transactions that do not meet the criteria to be a business combination and therefore must be accounted for as an asset purchase.

An asset purchase is when substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or group of similar identifiable assets or if the acquired set lacks an input and a substantive process to apply to the input.

ASC 805 Purchase Price Allocation

A key component of purchase accounting under ASC 805 is identification of the assets acquired and liabilities assumed and the determination of their respective fair values, often referred to as the ASC 805 purchase price allocation. This ASC 805 purchase price allocation aims to provide investors with increased transparency into the assets acquired and liabilities assumed in order to better quantify the value of the entire deal and understand how the transaction will impact their portfolios.

The standard references ASC 820 – Fair Value Measurements (ASC 820) – to provide a framework for determining fair value pursuant to US GAAP. Certain components of working capital may have carrying values on the closing balance sheet, which are representative of their fair value. Other components of working capital, as well as long-term assets and liabilities, may require complex analysis and valuation techniques to determine their respective fair values. Beyond this, consideration is required to identify potential unrecorded assets (generally, intangible assets).

Although the application of ASC 805 and ASC 820 may seem straightforward, below the surface complexities arise. Both PE buyers and CFOs of target companies should familiarize themselves with these complexities before engaging in an M&A transaction. Financial statement errors resulting from a misunderstanding of how to apply these accounting standards can lead to costly consequences like delayed filings and restatements.

Addressing Key Considerations That Affect Buyer & Seller

To address the nuances associated with ASC 805, we’ve listed six M&A considerations relevant to both PE companies and target company CFOs — and broken down how these considerations can affect a deal.

Consideration	Impact
Does the transaction qualify as a business combination, or should it be accounted for as an ASC 805 asset acquisition?	This determination has an impact on the underlying accounting for the transaction. Specifically related to: -Whether or not the transaction can result in the recognition of goodwill or a bargain purchase. -The treatment of transaction-related expenses.
Has the acquirer taken control of the company before or after the closing of the transaction?	If the acquiring entity obtains control of the target company prior to the transaction closing, the acquisition date may be prior to the closing date, which can have accounting implications. -An interim date may require rollforward or rollback steps for accounting purposes -Establishing rollforward or rollback processes can be cumbersome if not considered in advance
The transaction price may not be limited to the cash transferred at closing.	Consideration is not limited to cash exchanged — it can take other forms such as other assets, contingent consideration, common or preferred equity instruments, options, warrants, etc. -All forms of consideration must be measured at fair value -Certain forms of consideration might require complex valuation exercises -Results from said valuation exercises can impact conclusions related to goodwill and/or bargain purchases
Do the parties have preexisting relationships? Did they enter other arrangements during the negotiations?	Preexisting relationships and other arrangements require an evaluation to determine whether they should be accounted for as -Part of the business combination, likely impacting the transaction consideration, or -As separate transactions, that may require an evaluation to determine the proper accounting
Have both parties taken the necessary steps to recognize and measure identifiable assets and liabilities?	The acquirer must determine the fair value of the assets acquired, liabilities assumed and any noncontrolling interests in the target company. -Determining the fair market value of all assets and liabilities often requires complex valuation techniques -Consideration must be given to items that did not qualify for recognition on the historic financial statements/balance sheet at closing
Will the company apply the accounting alternatives afforded by the FASB through the Private Company Council (“PCC”)?	The company should determine if FASB’s PCC accounting alternatives will be applied. The FASB alternatives are: -ASU 2014-18 allows private companies the option to not recognize certain intangible assets separately from goodwill, most commonly customer relationships. If not adopted, the intangible assets are required to be recognized separately from goodwill. -ASU 2014-02 allows private companies to amortize goodwill for a period of up to 10 years. Companies who elect ASU 2014-18 are required to apply ASU 2014-02, however, companies may opt only to apply ASU 2014-02. An important consideration when determining whether or not to apply the PCC elections discussed above is the PE’s long-term exit plan. If a public offering is being contemplated, caution should be exercised in applying the PCC elections.

Diving Deeper into the PCC Elections

ASU 2014-18 allows private companies the option to not recognize separately from goodwill customer-related intangible assets, unless they can be sold or licensed independently from other assets of a business and noncompetition agreements. As noted in the table above, customer relationship intangible assets would generally qualify to be subsumed into goodwill, whereas customer contracts are generally able to be sold or licensed independently from other assets of a business.

ASU 2014-02 provides private companies a simplified alternative for the subsequent accounting for goodwill, including impairment testing. This ASU allows private companies to choose one of the following options in an effort to simplify the accounting and reduce costs associated with performing annual impairment tests:

Amortize goodwill on a straight-line basis over a useful life of up to 10 years
Test goodwill for impairment only when a triggering event occurs instead of annually
Test goodwill for impairment at either the entity level or the reporting unit level

ASU 2014-02 also eliminated step two of the goodwill impairment test.

As noted in the table above, a PE firm’s long-term exit strategy with respect to its investment in the portfolio company should be considered prior to applying the PCC elections. As these elections are not afforded to public business entities (PBE), these elections may have to be unwound, and prior period financial statements restated in the future in the event of a public exit. Companies may be required to retroactively determine the acquisition-date fair value of customer relationships and noncompetition agreements. Further, retroactive goodwill impairment analysis may be required to support goodwill recorded at the acquisition date, without the subsequent amortization permitted pursuant to the PCC election. As such, the short-term cost savings realized from the initial election may prove to be more costly in the event they must be unwound in the future.

Navigating Dealmaking in 2023

M&A transactions have inherent complexities, as do subsequent accounting policy elections made by PE companies and management. Planning and preparation as transactions are being contemplated can alleviate unintended accounting consequences, streamline reporting considerations and reduce the risk of financial statement restatements in future periods.

A third-party professional can help PE firms and CFOs of target companies manage the ASC 805 implications of a potential or upcoming deal. To increase transparency and improve accounting accuracy, consider engaging industry professionals who can break down the nuances and next steps.