Acquiring a company can come with many twists and turns to navigate. One of those being the accounting involved in combining businesses. To help simplify purchase accounting for business combinations involving private companies, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-18 back in December 2014. While it’s been several years since the update, many private companies and some investment and private equity firms still don’t fully understand or struggle with the application and implications of ASU 2014-18. To help make sense of the update and its impact on acquisitions, we’re taking a deep dive into the details below.
An Accounting Alternative to Save Time and Money
ASU 2014-18 provides an important accounting alternative for private companies related to the identifiable intangible assets recognized as part of the accounting for a business combination. This accounting alternative can offer a simpler, less costly and more straightforward accounting process for measuring certain intangible assets. According to the FASB, the alternative is intended to “reduce cost and complexity without significantly diminishing decision-useful information for users of private company financial statements.”
Since its issuance in 2014, for most private companies, election of this alternative results in the recognition of few intangible assets other than goodwill, reducing the third-party appraisal expense for the acquiror and the complexity of the business combination accounting for the auditor and company.
ASC 805 vs ASU 2014-18 (Private Company Alternative)
To provide some context, under traditional GAAP and Accounting Standards Codification (“ASC”) 805, all identifiable intangible assets are valued and recognized separately from goodwill if the asset meets either of the following criteria:
- It arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the acquired entity or from other rights and obligations; or
- It is separable, that is, capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, asset, or liability, regardless of whether the entity intends to do so.
Under ASU 2014-18, a private company can choose to elect an accounting policy that does not require them to separately recognize, or value, the following intangible assets in its accounting for a business combination:
- Assets arising from non-compete agreements (“NCAs”), and
- Customer-related intangible (“CRI”) assets that cannot be separately sold or licensed.
Under the alternative election, these assets are effectively considered goodwill.
The private company alternative also eliminates the requirement to perform a purchase price allocation on a reporting unit basis. It allows a business combination to be accounted for on a consolidated, entity-level basis, eliminating the need to allocate value across multiple reporting units and reducing the complexity of a purchase price allocation.
Impact of ASU 2014-18 on the Scope of a Purchase Price Allocation
Even with the adoption of ASU 2014-18, the purchase price allocation process still requires the consideration and potential valuation of a range of assets in accordance with ASC 805, including:
- Real and personal property
- Favorable and unfavorable leases
- Trade names and trademarks
- Technology-based intangible assets
- Franchise agreements
- Assumed liabilities, such as deferred revenue and contingent consideration
Interestingly, there are several customer-related assets, such as customer lists and contracts, see ASC 606, that, despite being customer-driven, may meet the criteria for recognition and valuation.
The determining factor as to whether an intangible asset must be separately recognized is whether the asset is capable of “being sold or licensed independently from the other assets of the business,” and, if so, they cannot be subsumed into goodwill under ASU 2014-18.
With NCAs and, in many cases, non-contractual CRIs, the assets are generally viewed as incapable of being sold or licensed independently from the rest of the business. In addition, some consider the value of these assets to be subjective and difficult to accurately estimate.
Alternatively, assets like trade names, technology, patents and others, are capable of being licensed or sold and are considered separable under ASC 2014-18. When evaluating whether a customer-related asset can be sold or licensed, management and their appraiser should consider whether there are any restrictions on selling the asset, such as a required customer action or prior approval.
Contract-assets, which according to ASU 2014-18 are “an entity’s right to consideration in exchange for goods or services that the entity has transferred to a customer when that right is conditioned on something other than the passage of time (for example, the entity’s future performance),” are not subsumed into goodwill under ASC 2014-18 and must be valued separately.
Finally, pre-existing CRI and NCA assets that were on the balance sheet at the beginning of the period of adoption of ASU 2014-18 are not included in the election and such existing balance sheet assets may not be subsumed into goodwill.
Relationship Between ASU 2014-18 and ASU 2014-02 (Goodwill Accounting Alternative)
It’s important to remember that a private company may only elect ASU 2014-18 if it also elects, or has elected, the private company goodwill accounting alternative, ASU 2014-02. However, the opposite is not true. A company that elects ASU 2014-02 is not required to adopt ASU 2014-18.
Election of ASU 2014-02 provides private companies with the ability to amortize goodwill on a straight-line basis over a period not to exceed 10 years, or less than 10 years if another useful life is demonstrated to be more appropriate. The Private Company Council (“PCC”) found that the goodwill impairment test provided limited decision-useful information, as many private company stakeholders disregarded goodwill and impairment losses in their analysis of company financial statements. Under ASU 2014-02, private companies can elect to amortize goodwill rather than carry it on the books at its original value and testing it for impairment annually. However, the companies are still required to test goodwill and other indefinite-lived assets for impairment when a “triggering event” occurs.
Examples of triggering events include:
- The loss of a key customer
- Unanticipated competition, or
- Negative cash flows from operations
Impairment may also occur after an acquisition if there has been a stock market or economic downturn causing the acquiror or acquired business to lose material value.
Additional Option – Adopt ASU 2014-02 But Not ASU 2014-18
While it will not necessarily drive the same time and cost savings resulting from full adoption of ASU 2014-18, some private companies unsure as to whether to adopt ASU 2014-18 pursue an additional option – valuing all intangible assets prescribed by standard GAAP, but then amortizing goodwill as prescribed under ASU 2014-02. Under this scenario, if the company later pursues an initial public offering, is acquired by a public company, or issues public debt, the purchase price allocation performed will already meet the requirements of ASC 805, thereby simplifying the extent of the adjustments, time and cost required to amend previous financial statements to reflect standard GAAP.
Implications of the Private Company Alternative
It appears the FASB was successful in its effort to simplify the accounting process in an acquisition. However, some investment firms and private equity funds struggle with whether to adopt this private company alternative when accounting for the intangible assets. The election can have a significant impact on a company’s future earnings and balance sheet, as well as its ability to complete an exit transaction or new financing. In some cases, the decision to elect this accounting alternative is an easy one, in other cases, it’s not so straightforward. Making the wrong decision can lead to costly and time-consuming restatements, which could also delay a transaction.
Potential Drawbacks of ASU 2014-18 and 2014-02
In considering ASU 2014-18 or ASU 2014-02 elections, a few possible drawbacks should be considered:
- If the private company ever decides to pursue an initial public offering (IPO), is acquired by a public company, or issues publicly traded debt, the company will have to discontinue use of the accounting under the private company alternative and revise its past financial statements to comply with traditional GAAP. The implication is a restatement of previous financial results to (1) reverse previously amortized goodwill, (2) recognize and separately value CRIs and NCAs previously subsumed into goodwill, and (3) correspondingly restate goodwill. This is a daunting and costly prospect.
- There may be time and expense incurred to adjust accounting systems to record the appropriate entries under the private company alternative.
- Financial statements prepared under the private company alternative accounting will not be directly comparable to those prepared under traditional GAAP standards, which may otherwise be used by the company for benchmarking purposes. For example, a private company reporting under ASC 2014-18 may show lower earnings and total assets due to the amortization of goodwill.
Is the Private Company Alternative Right For You?
There are many factors, both positive and negative, for private companies and investment and private equity firms to consider in deciding whether to adopt ASC 2014-18, and whether it is the right decision can change over time.
- For private companies with no intention of ever going public or being acquired by a public company, the decision-making process is generally quite clear. In these cases, the cost savings and reduced effort due to the simplification provided by the private company alternative will likely outweigh any negative impact.
- Alternatively, companies that may go public, be acquired by a public company, or issue public debt, would generally not adopt these alternatives to avoid the risk of incurring the cost of restating financials at some future date.
- Caught in the middle, and with a more challenging decision to make, are companies unsure about their ultimate exit strategy.
To ensure you have fully weighed the costs, benefits and future risks, we advise consulting with your auditor and other advisors. Anders has audit advisors and valuation professionals experienced in business combinations, private company accounting and the valuation of assets for purchase price allocation and goodwill impairment testing that can provide important insight to ensure you make an informed decision. Contact an Anders advisor below to discuss how we can assist with your next business combination.
Katie A. Holtgrave, CPA/ABV/CFF, Supervisor + Forensic, Valuation and Litigation, is a contributor to this post.All Insights