Understanding business combinations and the acquisition method is critical, yet complex for many professionals.
This article will clearly explain the key concepts and steps in applying the acquisition method to account for business combinations, using real-world examples to demonstrate the calculations and disclosures required.
We will define what constitutes a business combination, overview the acquisition method and its applicability, outline the key valuation and recognition steps, provide an example of calculating goodwill and bargain purchase gains, summarize the extensive disclosure requirements, and share insightful business combination accounting examples from high-profile acquisitions.
Introduction to Business Combinations and the Acquisition Method
This section provides an overview of business combinations and the acquisition method of accounting. It defines key terms and explains when the acquisition method applies.
Defining Business Combinations
A business combination occurs when one company acquires another entire business or gains control over its operations. This involves consolidating the acquired company's assets, liabilities, and operations into the acquiring company.
Some key points about business combinations:
- They require one company (acquirer) to gain control over another company (acquiree)
- The acquiree's net assets are consolidated into the acquirer's financial statements
- It results in the two companies becoming a single reporting entity
Overview of the Acquisition Method
The acquisition method is an accounting approach under US GAAP and IFRS for recording business combinations. The key steps include:
- Identifying the acquirer and acquisition date
- Recognizing identifiable assets acquired and liabilities assumed at their fair values
- Recognizing goodwill, which represents the excess value of consideration paid over the net fair value of assets/liabilities
- Recognizing any non-controlling interest in the acquiree
The acquisition method aims to accurately reflect the market value of assets/liabilities acquired and provide transparency into the valuation process.
Applicability of the Acquisition Method
The acquisition method applies when:
- The transaction meets the definition of a business combination
- The acquirer obtains control over the operations of the acquiree
Control typically means the acquirer has the power to govern policies, ability to appoint/remove management, and entitlement to variable returns.
So in summary, the acquisition method is used to account for transactions that result in one company gaining control over another business. It provides principles for valuating, recording, and reporting acquired assets and liabilities.
What are the methods of business combination?
There are two main methods for accounting for business combinations:
- Acquisition Method
- Pooling of Interests Method
The acquisition method is used much more commonly nowadays. Under this method:
- The acquiring company is identified as the acquirer
- The acquisition date is determined as the date control passes to the acquirer
- Identifiable assets, liabilities, and non-controlling interests of the acquired company are recognized and measured at fair value
- Goodwill is recognized as any excess of purchase consideration over net assets
- Comparative financial statements are not restated (acquisition accounting method)
Some key examples of the acquisition method in practice:
- Valuing assets and liabilities at fair value often increases depreciation and amortization expenses
- Any goodwill is capitalized and subject to impairment testing
- Transaction costs are usually expensed as incurred
- Deferred taxes are recognized for any temporary differences created
The pooling of interests method is rarely used today. Under this method:
- Assets and liabilities are combined at historical cost
- No goodwill is recognized
- Financial statements are restated as if the companies were combined from the beginning
Overall, the acquisition method provides more accurate information for the combined company going forward, while the pooling method provides better comparability to financial statements of prior periods. Most standard-setters globally have coalesced around requiring the acquisition method.
What is a business combination vs acquisition?
A business combination refers to when one company acquires another company and establishes control over it. This is different from an asset acquisition, where a company only buys some of the assets of another company.
The key differences between a business combination and an asset acquisition are:
- Business Combination: The acquirer obtains control over the acquired company by acquiring its net assets, operations, and management. This results in the acquired company becoming either a subsidiary or part of the acquiring company.
- Asset Acquisition: The acquirer purchases only some of the assets of the selling company, not the entire business. The selling company still retains control over its remaining assets and operations.
In a business combination, the acquirer must apply the acquisition method of accounting. This involves measuring all of the identifiable assets and liabilities acquired at their fair values on the date of acquisition.
In contrast, for an asset acquisition, the acquirer accounts for the transaction based on the cost accumulation and allocation method. This means assets and liabilities are recorded based on the amounts paid, rather than at fair value.
So in summary, a business combination results in a change of control and use of the acquisition method, while an asset acquisition is only a transfer of certain assets with no change of control or application of acquisition accounting.
What is step acquisition in business combination?
Step acquisition refers to business combinations achieved in stages, where an entity gains control of a business over multiple transactions.
In this case, we are focusing on an associate becoming a subsidiary - where an entity starts with a minority stake in another business and later acquires a controlling interest.
Some key points on step acquisitions:
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They are treated similarly to acquiring 100% control upfront. The prior ownership stake is remeasured to fair value at the acquisition date.
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Any gain or loss from remeasuring the prior interest is recognized in profit or loss.
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The assets, liabilities, and goodwill of the acquired business are recognized at 100% of their acquisition-date fair values - including the portion previously held by the acquirer.
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Comparative financial statements are restated as if 100% control was always held.
So in summary, previous ownership in an associate is discarded when control is obtained. The business combination accounting is approached as if the acquirer started with a 0% stake at the acquisition date. This simplifies things by avoiding partial goodwill recognition over multiple periods.
What are the methods of business combination valuation?
There are three key steps in valuing a business combination:
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Identifying the acquirer: This involves determining which entity is the acquirer and which is the acquiree. The acquirer is usually the entity that gains control and consolidates the acquiree into its financial statements.
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Determining the acquisition date: The acquisition date is when the acquirer legally transfers the consideration, acquires the assets and assumes the liabilities of the acquiree. This is usually the closing date of the acquisition.
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Recognizing and measuring the identifiable assets acquired, liabilities assumed, and noncontrolling interests: The identifiable assets and liabilities of the acquiree need to be recognized and measured at their fair values as of the acquisition date. This includes things like property, plant and equipment, intangible assets, accounts receivable, inventory, accounts payable, debt etc. Any noncontrolling interest in the acquiree also needs to be measured and recognized at fair value.
The key methods for valuing these items are:
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Market approach: Uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities.
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Income approach: Converts future cash flows or income to a single present value amount using discount rates.
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Cost approach: Reflects the amount that would currently be required to replace the asset (often referred to as current replacement cost).
The business combination valuation aims to establish the fair value of all acquired assets and liabilities. This forms the accounting basis for the transaction.
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Key Steps in Applying the Acquisition Method
This section outlines the key steps an acquirer must take to account for a business combination using the acquisition method.
Identify the Acquirer
The acquirer is the company that gains control over the operations of the acquired business. Some key points:
- The acquirer is usually the entity that transfers consideration and acquires the larger share of the voting rights
- In complex cases, other factors like board control may determine the acquirer
- Identifying the acquirer is critical for properly applying acquisition accounting
Determine the Acquisition Date
The acquisition date is the date on which the acquirer legally transfers consideration, acquires assets and assumes liabilities. Specifically:
- The date control passes, usually when legal title passes or consideration is transferred
- Assets acquired and liabilities assumed are recognized at their fair values on this date
- A critical date for valuation and recognition of all acquisition elements
Recognize and Measure Consideration Transferred
The consideration transferred in exchange for control over the acquiree should be measured at fair value and recognized on the acquisition date. Key points:
- Consideration may include cash, assets transferred, liabilities incurred, equity interests issued
- Contingent consideration is also usually part of the exchange and should be measured at fair value
- All consideration elements should be identified and measured accurately as of acquisition date
Identify and Classify Assets Acquired and Liabilities Assumed
The identifiable acquired assets and assumed liabilities must be measured at their acquisition date fair values and classified appropriately. Specifically:
- Recognize and measure identifiable acquired assets like IA, property plant and equipment
- Recognize and measure assumed liabilities like accounts payable, warranties
- Classify and designate the assets and liabilities based on contractual terms, policies etc.
- Appropriate identification and classification is critical for subsequent accounting
Properly executing these key steps allows the acquirer to account for the business combination based on the acquisition method, providing investors transparency into the acquired business.
Acquisition Method Example: Recognizing and Measuring Goodwill or Bargain Purchase Gains
This section explains how goodwill and bargain purchase gains are recorded under the acquisition method, illustrated with an acquisition accounting example.
Calculating Goodwill
Goodwill represents the excess of consideration transferred over the net fair value of identified assets acquired and liabilities assumed.
For example, Company A acquires Company B for $50 million. The fair value of Company B's net assets is determined to be $40 million. The difference of $10 million between the purchase price and fair value of net assets is recorded as goodwill.
The goodwill calculation would be:
Purchase price: $50 million
Fair value of net assets: $40 million
Goodwill = Purchase price - Fair value of net assets
= $50 million - $40 million
= $10 million
The $10 million goodwill is recognized as an intangible asset on Company A's balance sheet.
Identifying a Bargain Purchase
A bargain purchase happens when the net fair value of assets and liabilities exceeds the acquisition cost, resulting in negative goodwill.
Using the example above, if Company B had net assets with a fair value of $60 million rather than $40 million, the goodwill calculation would be:
Purchase price: $50 million
Fair value of net assets: $60 million
Goodwill = Purchase price - Fair value of net assets
= $50 million - $60 million
= -$10 million (negative $10 million)
The negative $10 million implies Company A acquired Company B for less than the fair value of its net assets, indicating a bargain purchase occurred.
Recording a Gain from a Bargain Purchase
The acquirer recognizes the resulting gain in profit or loss immediately on the acquisition date after reassessing values.
In the bargain purchase example above, Company A would record a $10 million gain on its income statement. This directly increases net income in the period when the acquisition occurs.
To summarize, under the acquisition method goodwill and bargain purchase gains are calculated as the difference between consideration paid and the fair value of net assets obtained in the transaction. Goodwill increases assets while bargain purchases boost net income.
Disclosure Requirements for Business Combinations
Companies must provide detailed disclosures regarding business combination transactions, including specifics on assets, liabilities, noncontrolling interests, goodwill and more.
Disclosures in the Period a Business Combination Occurs
When a business combination occurs, companies are required to disclose significant details regarding the acquisition in the period it occurs, including:
- The name and description of the acquiree
- The acquisition date
- The percentage of voting equity interests acquired
- The primary reasons for the business combination and a description of how control was obtained
- A qualitative description of the factors that make up goodwill recognized
- The acquisition-date fair value of the total consideration transferred and the fair value of each major class of consideration, such as:
- Cash
- Equity instruments
- Debt instruments
- Contingent consideration arrangements
- Other forms of consideration
- The amounts recognized as of the acquisition date for each major class of assets acquired and liabilities assumed
- For contingencies required to be recognized at the acquisition date - the amounts recognized at the acquisition date and the measurement basis applied (e.g. fair value)
- The total amount of goodwill that is expected to be deductible for tax purposes
- For transactions that are recognized separately from the business combination:
- A description of each transaction
- How the acquirer accounted for each transaction
- The amounts recognized for each transaction and the line item in the financial statements in which each amount is recognized
- If the transaction is the effective settlement of a preexisting
Real-world Examples of the Acquisition Method in Business Combinations
This section will explore various business combinations the acquisition method examples to demonstrate how the principles are applied in practice.
Acquisition Method of Accounting for Business Combinations Example
Here is an example of how the acquisition method was applied in a business combination between Company A (the acquirer) and Company B (the acquiree):
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Company A purchased 100% of Company B's shares for $50 million. This purchase price represented the fair value consideration transferred by Company A.
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On the acquisition date, Company B's balance sheet showed net identifiable assets with a fair value of $30 million.
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To account for the business combination, Company A compared the fair value of consideration transferred ($50 million) to the fair value of net assets acquired ($30 million).
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The difference of $20 million was recognized by Company A as goodwill. This goodwill represents the future economic benefits that Company A expects from assets that do not qualify for separate recognition such as an assembled workforce or synergies.
By following the acquisition method, Company A was able to accurately recognize and measure the assets acquired and liabilities assumed in this business combination transaction. The $20 million goodwill also reflects what Company A was willing to pay above the fair value of identifiable net assets.
Analyzing a Complex Acquisition Accounting Example
Let's analyze a more complex acquisition accounting example involving Company X (acquirer) purchasing Company Y (acquiree):
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Purchase price was $250 million, made up of $200 million cash and $50 million shares in Company X.
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Company Y's balance sheet on acquisition date showed assets with a fair value of $150 million and liabilities assumed of $80 million.
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Additionally, there was a contingent consideration clause requiring Company X to pay an extra $30 million if Company Y's profits exceed $10 million in the next 2 years.
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Some of Company Y's equipment was obsolete, so the fair value was estimated to be $5 million less than book value.
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An intangible brand asset valued at $20 million was also identified that was not previously on Company Y's books.
To apply acquisition accounting, Company X had to carefully analyze all components:
- The consideration transferred was $250 million + $30 million contingent consideration = $280 million
- Net identifiable assets acquired were $150 million assets + $80 million liabilities + $5 million write-down of equipment + $20 million brand asset = $95 million
- Goodwill was $280 million consideration - $95 million identifiable net assets = $185 million
By following the acquisition method even for a complex transaction, Company X was able to account for all aspects of the business combination appropriately.
Goodwill Calculation in a Notable Acquisition
The acquisition method was critical in LinkedIn's $26.2 billion purchase by Microsoft in 2016. This involved several goodwill calculations:
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The purchase price was made up of $26.2 billion cash consideration transferred by Microsoft.
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LinkedIn's identifiable net assets were valued at $3.2 billion total on the acquisition date, primarily consisting of cash, accounts receivable, property & equipment, and intangible assets.
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A portion of the intangible assets included $2.2 billion of developed technology and $1.5 billion in customer relationships that Microsoft specifically valued as part of LinkedIn.
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Goodwill was therefore calculated as the $26.2 billion purchase price minus the $3.2 billion in identifiable net assets, resulting in $23 billion goodwill.
This sizable goodwill reflects Microsoft's view that LinkedIn has earning potential that far exceeds just the identifiable assets. Factors like LinkedIn's user base, brand recognition, and future innovations contributed to Microsoft's willingness to pay the high premium.
Carefully applying the acquisition method was essential for Microsoft to account for this mega acquisition appropriately and justify the $23 billion goodwill with expected synergies.
Conclusion and Key Takeaways
In summary, the acquisition method is a complex accounting approach for consolidating one business into the acquirer's financial statements during a business combination resulting in control gained. Following the key steps and providing transparent disclosures are critical.
The Acquisition Method Involves Fair Value Measurements
A core tenet is measuring acquired assets/liabilities assumed at their acquisition-date fair values. This ensures the most accurate valuation is reflected on the acquirer's books after the transaction.
Goodwill Represents an Excess Payment for the Business
Goodwill typically arises in an acquisition when the price paid exceeds the net fair value of tangible and intangible assets obtained. It reflects intangibles like workforce, reputation, and expected future cash flows.
Extensive Disclosures Are Required
Transparent reporting on acquisition details, fair value methods, bargains, and more is necessitated under the acquisition method. This provides investors and regulators insight into the transaction and valuation assumptions.
