Business Combinations: Valuation and Accounting Considerations

When a business changes hands, understanding the intricacies of valuation and financial reporting becomes critical. This article examines four key aspects of business combination accounting: measuring assets and liabilities, the valuation process, alternative methods for private companies, and considerations for asset impairment. This serves as a guide tailored for professionals with financial reporting responsibilities in relation to mergers and acquisitions, particularly in the context of private equity.

Measurement of Assets Acquired, Liabilities Assumed, Contingent Considerations, Rollover Equity, and Noncontrolling Interests

Fair Value as the Guiding Principle

Under ASC 805, assets acquired and liabilities assumed in a business combination must be measured and recorded on a new, opening balance sheet at fair value as of the acquisition date. This includes tangible assets (e.g., inventory, PP&E), intangible assets (e.g., customer relationships, trademarks), and liabilities, including contingent considerations.

Opening Balance Sheet Review

A common tool used in the transition from closing to opening balance sheet is the walk across schedule, which reclassifies historical cost data to fair value. Key adjustments include:

• Equity Elimination: Wiping historical equity (retained earnings, common stock) and replacing it with new consideration.
• Asset and Liability Revaluation: Tangible assets like machinery and equipment, and inventory are restated at fair value. For inventory, this includes a profit allocation, not just cost.
• Intangible Asset Recognition: Many intangible assets are identified and valued only through purchase accounting, including trademarks, patents, franchise agreements, software, and trade secrets.
• Non-Cash Consideration: Purchase price elements, including contingent consideration, rollover equity, and seller notes, are measured at fair value, taking into account subordination and market interest rates.

Non-Cash Consideration

Components like rollover equity, earnouts, and seller notes must be evaluated for fair value:

• Rollover Equity: Private equity transactions often include the selling shareholders agreeing to “roll over” part of their ownership into the new entity instead of taking all cash. Valuation methods and assumptions, including relevant discounts, are used to substantiate the fair value of the portfolio company.
• Earnouts: Contractual agreements, where part of the purchase price is contingent on the acquired company achieving future performance targets (e.g., revenue, EBITDA, or milestone achievements), must be measured at fair value to capture the full expected value of the deal. The earnout’s value isn’t its maximum payout — it’s the probability-weighted expected present value of future payments.
• Seller Notes: The interest rates on seller notes are evaluated to determine if they are above or below market rates based on credit default risk and subordination. Fair value measurement ensures that the purchase price reflects the true economic cost of the transaction.

Noncontrolling and Previously Held Interests

• Noncontrolling Interests: Also known as minority interests, these represent the portion of equity ownership in a subsidiary that is not owned by the parent company. When a parent owns less than 100% of a subsidiary but still controls it (typically by owning more than 50%), the remaining ownership held by third parties is recognized as NCI and is recorded on the opening balance sheet at fair value in the equity section.
• Step Acquisitions: When a previously held minority stake becomes a controlling interest, the prior investment must be remeasured at fair value, with any resulting gains or losses recorded.

The Valuation Process

Collaborative Approach

Valuation for purchase price allocation (PPA) involves close coordination among:

• Management and sponsors
• Technical accounting consultants (for journal entries and compliance)
• Independent valuation professionals (for fair value analysis)
• External auditors and legal advisors

Typical Timeline and Deliverables

An efficient valuation process spans approximately 4–5 weeks, including:

1. Scoping: Define what needs to be valued (inventory, intangibles, liabilities, etc.).
2. Data Gathering: Use a secure cloud storage service or virtual data room to facilitate data sharing including historical financials, deal models, customer data, and purchase agreements.
3. Kickoff Calls: Align with all parties on responsibilities and timelines, and discuss complex issues with auditors to obtain buy-in.
4. Analysis and Reporting: Perform fair value calculations and deliver reports.
5. Audit Review: Address auditor inquiries to finalize the purchase price allocation report.

Private Company Alternatives

Private companies have certain U.S GAAP alternatives that simplify post-acquisition accounting:

ASU 2014-02 – Goodwill Amortization

• Allows amortization of goodwill on a straight-line basis over up to 10 years.
• Reduces the need for annual impairment testing, although tests are still required upon triggering events.

ASU 2014-18 – Intangible Asset Subsumption

• Permits non-contractual customer relationships and non-compete agreements to be subsumed into goodwill, avoiding separate valuation.
• You do not need to have adopted it from inception. If you’ve done business combinations in the past without using ASU 2014-18, you can still adopt it for a new acquisition and apply it only to that and future acquisitions.
• Adoption requires concurrent adoption of ASU 2014-02.

These alternatives do not eliminate the need for a full ASC 805 purchase price allocation, but they reduce future reporting burdens.

Asset Impairment Issues

Post-transaction, companies must monitor the recoverability of recognized assets under two key accounting standards:

ASC 350 – Indefinite-Lived Intangibles (e.g., goodwill & trademarks)

• Requires annual impairment testing unless the private company election has been made.
• Focuses on qualitative and quantitative (discounted cash flow, guideline company and transaction methods) assessments of fair value.

ASC 360 – Long-Lived Tangible and Finite-Lived Intangible Assets

• Tests triggered by events (e.g., economic downturns, obsolescence).
• Requires a two-step impairment test: first, companies compare the sum of the undiscounted cash flows generated by the asset group to its carrying amount to test for recoverability. Failing that test necessitates a fair value measurement and write-down of the asset group.

Conclusion

The accurate and compliant valuation of assets and liabilities in business combinations is critical for financial transparency and audit readiness. ASC 805 provides a rigorous framework, and private company elections can offer meaningful relief. However, these processes demand coordination across finance, legal, and valuation teams, supported by clear documentation and robust professional judgment.

Rebecca McElwain is a Director at Prairie Capital Advisors, Inc. She can be contacted at 614.768.7302 or by email at rmcelwain@prairiecap.com.