REFERENCE GUIDE TO VALUING ASSETS IN BUSINESS COMBINATIONS
Combinations of businesses necessitate specific financial reporting methods. Companies that use GAAP-based financial statements must follow the guidance in FASB Accounting Standards Codification (ASC) 805: Business Combinations, formerly SFAS 141R, when recognizing and allocating all identifiable assets acquired, liabilities assumed, and non-controlling interests in a merger.
This guide is designed to be a quick reference for the ASC 805 allocation of total consideration transferred in a business combination. It goes over business combinations, fair value assumptions, valuation of tangible and intangible assets, and allocating consideration to identifiable assets purchased, liabilities undertaken, and non-controlling interests in an acquisition.
Overview of ASC 805: Business Combinations
The FASB ASC 805: Business Combinations standard explains how an acquirer should account for a business combination. 805 ASC:
- This rule applies to business combinations that occur on or after the start of the first annual reporting period, which begins on or after December 15, 2008. (Dec. 15, 2009, for acquisitions by not-for-profit entities)
- Gives a broader definition of what a company is.
- Requires the acquisition method to be used.
- Assumes fair value for assets bought and obligations assumed, as defined by ASC 820: Fair Value Measurement.
ASC 805-10-20 defines a Business Combination as:
An acquisition is a transaction or other event in which a buyer gains control of one or more businesses.
The usual rule under US GAAP is that one reporting entity has control over another if it directly or indirectly owns more than 50% of the outstanding voting shares of that other firm (ASC 810-10-15-8). With a smaller percentage of ownership, control can be exercised through a contract, lease, agreement with other stockholders, or a court order.
ASC 805-10-20 defines a Business as:
An integrated set of activities and assets that can be done and managed with the goal of generating a profit.
Inputs, processes, and outputs make up a business. A business uses procedures to transform its inputs into marketable outputs. When determining if a collection of assets and activities is a business, one must first determine whether the collection of assets can be run and managed as a business. If market players are capable of acquiring the business and continuing to produce outputs (for example, by integrating the firm with their own inputs and processes), the business does not need to contain all of the inputs or processes that the seller employed in operating the business.
Each business combination must be accounted for using the acquisition technique. Using the acquisition method necessitates:
- Identifying the acquirer
- Determining the acquisition date
- Determining the consideration transferred
- Recognizing and quantifying the identifiable assets purchased, liabilities taken, and any non-controlling stake in the acquire
Within a measurement period of typically less than one year, the acquirer must receive the essential information to identify and measure the above information. Adjustments to goodwill are done during the measuring period. Adjustments should only be performed after the measurement period to fix a mistake. The acquisition date is the day on which the acquirer takes ownership of the acquiree, which is usually the closing date.
Allocation of Assets and Liabilities
All identifiable assets and liabilities acquired, including identifiable intangible assets, must be assigned a share of the purchase price based on their fair valuations, according to ASC 805-20-25-1.
The sum of the acquisition-date values (measured at fair value with a few exceptions) of the following is commonly used to determine the worth of the business acquired:
- Transferred consideration for the acquiree
- The acquirer’s equity interests in the acquiree just prior to the acquisition date (for an acquisition achieved in stages, also known as a step acquisition)
- Third-party non-controlling interests in the acquiree (in a partially owned subsidiary)
Business Combination Elements
Acquisition Price (ASC 805-30-30-7):
– Equity Securities
– Debt Securities
– Complex Transaction
– debt or convertible debt securities with detachable warrants
– contingent considerations
– liabilities assumed
Acquisition Related Costs:
To be expensed:
– investment banking
– valuation services
– finder fees
Not to be expensed:
– registering and issuing securities
– charged to APIC
Overview of ASC 820: Fair Value Measurement
Under FASB ASC 820, fair value is defined as: Fair Value Measurement is defined as:
At the measurement date, the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market players.
– For transactions involving such assets or liabilities, fair value assumes an orderly transaction that anticipates market exposure for a period previous to the measurement date to allow for typical and customary marketing activity.
– The goal is to calculate the seller’s exit price, which is defined as “the price that would be received to sell an asset or paid to transfer a liability” in the principal or most beneficial market.
– It’s possible that the pricing will differ from the admission fee (the price paid to acquire the asset or received to assume the liability)
Highest and best use – A fair value measurement considers the asset’s highest and best use by market players at the measurement date, taking into account the use of the item that is physically practicable, legally permissible, and financially practical. In general, highest and best use refers to how market participants use an asset to maximize the value of the asset or the group of assets in which the item is employed.
Even if the reporting entity’s intended use of the asset is different, the highest and best use is decided based on how the asset is used by market participants. The asset’s value must be determined by whether it is “in use” or “in exchange.”
- In use — The asset’s highest worth is when it is combined with other assets.
- In exchange — On a stand-alone basis, the asset’s maximum value is reached.
Synergies — Buyer-specific synergies are omitted from the computation of value under fair value principles unless they can be sustained at the market participant level. In such instance, they’d be factored into the equation.
Market participants assumptions — Market participants, according to ASC 820, are purchasers and sellers in the major (or most beneficial) market for an asset or liability who meet all of the following criteria:
- Regardless of the reporting organization (that is, they are not related parties)
- Knowledgeable, with a fair grasp of the asset or obligation and the transaction based on all available information, including data gathered through ordinary and customary due diligence efforts
- Having the ability to transact for an asset or a liability
- Willing to make a deal in exchange for the asset or liabilities (that is, they are motivated but not forced or otherwise compelled to do so)
Fair Value of Tangible Assets
Market or income approaches are appropriate for valuing tangible assets. If sufficient data is not available to obtain an indication of value using these approaches, an appraiser can utilize the replacement cost method, which adjusts the original cost for price changes to establish its replacement cost new (RCN). The RCN is then updated to account for physical wear and tear as well as functional obsolescence.
For current capacity, property, plant, and equipment (PP&E) must be recognized at fair value. Depreciation that has accumulated is not carried forward. A market participant would not pay more for an asset than the amount required to replace it to produce at current capacity, according to the cost method.
Valuation Allowances: For acquired assets valued at fair value, such as allowance for doubtful accounts and allowance for loan losses, separate valuation allowances are not recognized. Future cash flow uncertainties are factored into their fair prices.
Enterprise Valuation: The fair worth of the acquired entity’s interest bearing debt and shareholder equity is represented by Enterprise Valuation. It’s a crucial instrument for determining the fair value of assets and liabilities undertaken. The enterprise value of the purchased firm is determined using prospective financial information (PFI).
The valuation specialist would also look at the estimated internal rate of return (IRR) by the purchase (in the event of a business acquisition) to get an extra indicator of the entire entity’s return as a helpful diagnostic. The IRR is calculated by matching the sum of the prospective cash flows on a present-value basis to the consideration transferred, assuming that the amount paid represents fair value, after the market participant PFI has been determined (that is, entity-specific synergies have been excluded). Because the PFI normally represents the cash flows projected from the acquiree’s operational assets and liabilities, the IRR must be adjusted when non-operating assets or liabilities are involved.
It may be difficult to utilize the IRR computation as a diagnostic in the case of an acquisition of assets that do not represent a business. The IRR can also be used to evaluate the correctness of the weighted average cost of capital computation (WACC). However, valuation specialists should be cautious about using it alone to change the WACC calculation because IRR and WACC can diverge in some situations, such as bargain acquisitions.
Prospective Financial Information
PFI begins with the cash flows utilized to determine the transaction’s acquisition price. These cash flows have been updated to reflect market participants’ estimations, including any synergies that other corporations would expect if they bought the acquiree. Any entity-specific synergies between the acquirer and acquiree must likewise be removed from financial predictions.
IRR and WACC Reconciliation
The IRR and the WACC should be conceptually compatible. All varieties of PFI, including conditional, probability-weighted, and PFI with “mixed” features, should follow this rule. If the indicated IRR and WACC diverge, it could mean that the PFI includes entity-specific synergies, that cash flows are not in line with market expectations, or that the price paid for the business was not representative of its fair worth. If such a scenario existed, the valuation specialist would review the PFI assumptions to ensure that only market participant assumptions are reflected (i.e., entity-specific synergies or biased PFI are not included) in order to calculate predicted cash flows for the total business and asset. If the price does not reflect fair value, the valuation specialist must infer fair value for the acquisition if the imputed value is to be used in WACC, IRR, and Weighted Average Return on Assets (WARA) comparisons.
The WARA analysis is used to calculate the implied rate of return on goodwill based on the IRR using the fair value of the assets. The WARA analysis is used to examine if the returns on identifiable intangible assets and the inferred return on goodwill are acceptable.
The following table highlights the link between the IRR and the WACC, as well as the consequences for choosing PFI in the event of a business merger:
- IRR = WACC — Indicates that the PFI is likely to reflect market participant assumptions accurately, and that the transaction consideration is likely to be representative of the fair value.
- IRR > WACC — Indicates whether the PFI includes some or all of the impact of entity-specific synergies, whether it reflects an optimistic bias, whether it reflects a bargain acquisition, or whether it reflects all three.
- IRR < WACC — Indicates that the PFI may ignore some or all market participant synergies, show a conservative bias, reflect an overpayment, or all three.
Fair Value of Intangible Assets
Apart from goodwill, an intangible asset is recognized if it comes from contractual or legal rights or if it may be separated from the purchased entity and transferred. Methods for valuing intangible assets include:
- Relief from Royalty Method — Patents and trademarks
- Multi-period Excess Earnings Method — Customer relationships, in process research and development
- With and Without Method — Non-compete agreements
- Replacement Cost Method — Assembled work force
- Greenfield Method — Federal Communications Commission license
Intangible assets are usually valued after they have been taxed. As part of the valuation, an amortization tax benefit is applied to each intangible asset. The amortization tax benefit represents the asset’s increased value as a result of the ability to deduct the asset’s amortization over its 15-year tax life. The present value of the tax shield (annual amortization multiplied by the tax rate) created over the next 15 years is used to compute the amortization tax benefit. (The amortization advantage refers to acquisitions made in the United States. Readers should be aware that assumptions for overseas market participants may differ.)
Common Intangible Asset Valuation Methods
Relief From Royalty Method
The method of Relief From Royalty is classified as an income-based method. This method calculates the share of a firm’s earnings that can be attributed to an asset based on the royalty rate the company would have paid if it didn’t own it.
The main input for this strategy is the hypothetical royalty rate.
- Observable — Rates of royalty in negotiated licenses
- Market-based — Royalty rates for licensing involving similar assets identified in publicly available market data
Multi-Period Excess Earnings Mode
The value of an intangible asset is equal to the present value of the incremental after-tax cash flows attributable only to the intangible asset, according to the Multi-period Excess Earnings Model. The after-tax cash flows related to the intangible asset in question are then discounted to present value.
The corporation estimates the predicted net income of a certain group of assets to use this strategy. The entire net after-tax cash flows are subsequently subtracted from the contributionary asset charges (explained on the following page). The remainder represents the intangible asset’s residual or “extra” earnings.
With and Without Method
The with and without approach compares the PFI calculated with and without the presence and ownership of an intangible asset to the PFI calculated without the presence and ownership of the intangible asset. The PFI attributable to the intangible asset after taxes is then discounted to its present value.
The With and Without Method is also known by the following terms:
- Income Increment/Cost Decrement Method
- Comparative Business Valuation Method
- The Differential Value Method
In a non-compete, consider the following factors when using the With and Without Method:
- Willingness of individual to compete
- Importance to business
- Business model
- Skill set, etc.
The worth of an asset now is equal to what it would cost to purchase a substitute item of equivalent utility today, according to the replacement cost technique.
The Greenfield technique posits that a firm is founded from the ground up and only owns the asset in question. As a result, the corporation must invest, either directly through asset purchases or indirectly through start-up costs and losses, to construct an operation comparable to the one in which the subject asset is used as of the current measurement date. Investing during the start-up era, in theory, recreates the other assets needed to support the business.
The term “contingent consideration,” sometimes known as a “earn-out,” refers to the acquirer’s obligation if certain future events or criteria are met. In business combination accounting, all contingent consideration is included and quantified at fair value as of the purchase date.
Typically, the fair value of contingent consideration is assessed by using a Monte Carlo simulation model or another risk-simulation tool to probability weight certain well-supported scenarios.
Specific, Relevant Projections — Multiple projections based on independent future outcomes should be prepared by management. These projections are weighted to find the best probability-weighted outcome for the contingent payment that will be paid. Changes after the acquisition date, such as hitting an earnings target, attaining a defined share price, or reaching a milestone on a research and development project, are not considered measurement period adjustments, according to ASC 805-30-35-1.
Changes in the fair value of contingent consideration that are not measurement period adjustments must be accounted for as follows:
- Contingent consideration that is categorized as equity is not re-measured, and its subsequent settlement is accounted for as equity.
- At each reporting date, contingent consideration categorized as an asset or a liability must be re-measured to fair value until the contingency is addressed. Changes in fair value must be accounted for in earnings.
Contributory Asset Charges
Contributory asset charges are fees for using contributory assets to support and produce revenue for the subject asset. Working capital, fixed assets, labor, and other intangible assets are all examples of these. Then, for each contributory asset, return rates are calculated.
The asset’s fair value multiplied by its rate of return yields the contributing asset charge.
Allocation of Assets and Liabilities
The fair value of the identifiable tangible and intangible assets and liabilities assumed is allocated among the total consideration transferred.
Goodwill: Goodwill is a residual sum that indicates future economic advantages emanating from other assets acquired in a business combination that do not meet the requirements for being identified and recognized separately. The difference between the fair value of acquired net assets and the entire payment paid for the purchased firm is recorded as goodwill.
GOODWILL = Consideration transferred + fair value of non-controlling interest + acquisition date fair value of the acquirer’s previously held equity interest – net amount of acquisition-date amounts of assets acquired and liabilities assumed
Bargain Purchase: An acquirer may make a bargain purchase in some situations, which is defined as a business combination in which the acquisition-date amounts of identified net assets acquired, excluding goodwill, exceed the sum of the price transferred. This criterion necessitates the identification of a profit on a bargain purchase.
Before recognizing a gain on a bargain purchase, the acquirer must examine whether it has correctly recognized all of the assets bought and all of the liabilities incurred, according to ASC 805-30-25-4. The acquirer shall then review the techniques used to measure the amounts this topic requires to be recognized at the acquisition date for all of the following as part of that reassessment:
- The identifiable assets acquired and liabilities assumed
- The noncontrolling interest in the acquiree, if any
- For a business combination achieved in stages, the acquirer’s previously held equity interest in the acquire
- The consideration transferred
The goal of the evaluation is to make sure that the measurements accurately reflect all relevant information at the time of capture.
The FASB and the IASB consider bargain purchases to be unusual transactions since business organizations and their owners rarely sell assets or enterprises for less than their fair value. Bargain purchases, on the other hand, have occurred and are likely to continue to occur. A forced liquidation or distress sale (e.g., after the death of a founder or key manager), in which owners need to sell a business quickly, may result in a price that is less than fair value, are examples of situations where they occur. These should, in general, be the exception rather than the rule.
Once the calculation is finished, take a step back. Examine each assumption, paying special attention to the PFI and overall WACC. To a market participant, the Enterprise Value and Fair Values of the assets and liabilities should appear reasonable.