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June 26, 2018

 

Background

Despite being introduced in 2014, the management teams of many private companies, private equity (PE) funds and other investment firms still wrestle with whether or not to adopt a private company accounting alternative[1] when accounting for identifiable intangible assets in a business combination. The decision to adopt this guidance can have a significant effect on a company’s future reported earnings and asset balances, as well as impact management’s efforts to execute a financing or exit transaction. While in certain instances the decision-making process to adopt this guidance may be straightforward, in many cases, it is not. 

This article provides an overview of this “simplified” accounting alternative for private companies, and provides insights to companies and management teams regarding the pros and cons of adoption. Making the wrong choice can result in costly restatements which might also delay a transaction.

 

Introduction

Through the accounting alternative for identifiable intangibles and another private company alternative related to goodwill impairment testing[2], the Financial Accounting Standards Board (FASB) has allowed private companies to adopt potentially simplified accounting alternatives to the prevailing authoritative guidance on accounting related to business combinations and the impairment testing of goodwill and other indefinite-lived intangible assets within FASB Accounting Standards Codification (ASC) 805 and ASC 350, respectively.

The intent of introducing this accounting alternative was to reduce “the cost and complexity associated with the measurement of certain identifiable intangible assets without significantly diminishing decision-useful information to users of private company financial statements.”[3] While the simplification of the accounting for business combinations and goodwill impairment testing was viewed as a relief for many private companies, there is still confusion regarding the implications of adopting this accounting alternative.

 

Implications Related to Business Combinations

One significant way in which this guidance simplifies purchase accounting is through eliminating the requirement to perform a purchase price allocation on a reporting unit basis. The private company alternative allows a business combination to be accounted for on a consolidated basis, removing the need for private companies to allocate value to multiple reporting units. This change can significantly reduce the complexity of a purchase price allocation. As we will discuss later in this article, eliminating the business combination accounting for reporting units also impacts the requirements of goodwill impairment testing.

Under ASC 805, all identifiable intangible assets are valued and recognized separately from goodwill if the asset meets either of the following criteria:

  1. 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; and
  2. 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.

The private company alternative simplifies the process of accounting for a business combination through the removal of the requirement to recognize most customer-related intangible assets and noncompetition agreements separately from goodwill.

Customer-related assets typically valued in a business combination include: customer lists, order or production backlog, customer contracts[4] and non-contractual customer relationships. With adoption of the private company alternative, only customer-related assets that are capable of being sold or licensed independent of the business or other assets need to be valued. 

When evaluating whether a customer-related asset can be sold or licensed, management should consider whether there are any restrictions on selling the asset. For example, a customer-related asset is not considered capable of being sold or licensed if the asset’s sale or licensure requires any customer action or prior approval. Examples of customer-related assets that could potentially be sold independently include, but are not limited to: mortgage servicing rights, commodity supply contracts, core deposits and customer information. Each of these customer-related assets has significant market evidence of transacting independently from other assets associated with a business.

The accounting alternative focused on noncompetition agreements and customer-related assets, in part, because these assets are generally viewed to be incapable of being sold or licensed independently from the other assets of a business. In addition, the value of these assets is viewed by some to be subjective, and difficult to accurately estimate.

 

Implications Related to Impairment Testing

Normally in a business combination, goodwill is not amortized; but it is tested for impairment at the reporting unit level. This testing is performed at least annually, or upon the occurrence of a triggering event. If a private company elects the accounting alternative for certain intangible assets, it must also adopt the goodwill-related alternative, which only requires the impairment testing of goodwill and other indefinite lived assets to be performed upon a triggering event and only at an entity level, as opposed to a reporting unit level. While annual goodwill impairment testing is not required under this alternative, goodwill is amortized over a period of no more than 10 years, on a straight-line basis.

 

Benefits of Adopting the Private Company Alternatives

The benefits of adopting this alternative can include:

  • Potential cost savings related to business combinations from a reduced number of assets being valued as well being able to perform the analysis on a consolidated basis (not at a reporting unit level). Significant potential cost savings can be recognized in instances where ASC 350 would have otherwise required the business combination to be reported on a multiple reporting unit basis. 
  • Potential cost savings from not having to perform annual impairment testing on a reporting unit basis. Favorable macroeconomic conditions, including the robust U.S. stock markets, have alleviated impairment testing requirements for many companies that have adopted the private company alternatives. The likelihood of recognizing goodwill impairment is reduced for companies that adopt the private company alternative because the subsequent carrying value of the business is lowered by the annual amortization of goodwill.

It is important to note that while not having to value certain intangible assets undoubtedly results in reduced efforts for the purchase price allocation, it often does not result in large cost savings for many private companies. While the number of assets to be valued is reduced, the purchase price allocation process still requires valuing all the other acquired assets including, but not limited to: inventory, real and personal property, marketing and artistic-related intangible assets, contract and technology-based intangible assets and assumed liabilities such as deferred revenue and contingent consideration (as the case may be). 

 

Disadvantages of Adopting the Private Company Alternatives

Disadvantages of adopting this alternative can include:

  • Adopting the private company alternative for business combinations tends to result in companies reporting lower profits and total asset balances.  This results from having to amortize goodwill over a period of no longer than 10 years. Under ASC 805, absent the alternatives, goodwill remains on a company’s balance sheet unless impairment is recognized through the goodwill impairment testing process.
  • The biggest risk of adopting these alternatives occurs when a private company goes public, issues public debt or is acquired by a public company. Such an occurrence would require a company to discontinue the use of the accounting and reporting under the alternatives and retroactively restate its previously issued financial statements utilizing U.S. GAAP applicable to public companies. Therefore, a private company would need to reverse previously amortized goodwill, while recognizing customer-related assets and noncompetition agreements previously subsumed into goodwill. The process of valuing customer-related and noncompetition assets is particularly challenging because the fair value of these assets needs to be determined as of the original acquisition date of the applicable business combination.
  • Private companies that adopt the alternatives and go public, issue public debt or are acquired by a public company are also required to perform historical impairment tests on a reporting unit basis. Retrospectively performing impairment tests on a reporting unit basis can present significant information challenges for a company’s management to address while they are trying to prepare for a capital market or M&A transaction.

 

Summary of Benefits and Disadvantages

Based on the discussion above, the decision-making process is quite clear for companies that have no intention of going public or being acquired by a public company. In such instances, the cost savings and reduced effort resulting from the simplification provided by the private company alternatives will likely outweigh any potential negative impacts. Conversely, companies having a reasonable likelihood of going public, issuing public debt or being acquired by a public company would not want to adopt these alternatives to avoid the significant cost of restating its financials. Companies that are uncertain about their exit strategy have a more difficult decision to make. Management of such companies should consider adopting a hybrid approach to address their business combinations and goodwill impairment testing requirements.

 

Hybrid Approach

Under a hybrid approach, private companies would perform business combination valuations in accordance with existing, non-private company guidance under ASC 805 and ASC 350, including valuing customer-related assets or noncompetition agreements at a reporting unit level.  However, for accounting purposes, companies would apply the private company alternatives and subsume any customer-related assets and noncompetition agreements into goodwill and amortize the goodwill over a period of no more than 10 years.

By taking this approach, companies would likely reduce the cost of performing impairment testing on an annual basis.  However, if such companies had to restate their financial statements retroactively, they would already possess the information required to reverse previously amortized goodwill for customer-related assets and noncompetition agreements.[5]

We believe that by using this hybrid approach, companies can recognize cost savings, but at the same time be better prepared for the possibility of going public or being acquired by a public company.  By adopting this approach, private companies can avoid incurring the substantial costs of having to retrospectively perform purchase price allocations.

 

Conclusion

The private company alternatives for business combinations were part of a broader effort by FASB to address the cost and complexity of preparing financial statements for private companies and their stakeholders without significantly diminishing “decision-useful” information.  When considering whether to adopt these alternatives, companies must carefully assess their strategic growth options and future financing requirements.  Furthermore, management should seek feedback from the users of its financial statements including lenders, investors, and regulators. 

For private companies that are highly unlikely to go public, issue public debt or to be acquired by a public company, the cost savings and reduced effort associated with adopting the alternatives can be appealing.  Conversely, if there is a high likelihood that an entity may go public, issue public debt or get acquired by a public buyer, a company should not adopt the private company alternatives.  For companies which are uncertain about their exit strategy, the hybrid approach discussed earlier can be a practical solution for private companies to avoid unnecessary complexities and distractions during a financing or exit event.

 

[1] Financial Accounting Standards Board Accounting Standards Update (ASU) 2014-18, Accounting for Identifiable Intangible Assets in a Business Combination (a Consensus of the Private Company Council)

[2] ASU 2014-02, Accounting for Goodwill (a Consensus of the Private Company Council)

[3] ASU 2014-18, page 1.

[4] It is important to note that contract assets, as discussed in ASC 606, Revenue from Contracts from Customers, that are related to contracts with customers are not considered to be customer-related intangible assets under the private company alternative. Therefore, such assets are not eligible to be subsumed into goodwill and should be recognized separately. Also, favorable customer contracts can be subsumed into goodwill, while unfavorable customer contracts cannot.  This distinction is because the alternative only relates to customer-related assets, and not liabilities. Furthermore, leases are not viewed to be customer-related intangible assets. As such, favorable/unfavorable leases must be recognized separately consistent with current practice under ASC 805.

[5] It is important to note that after making these adjustments, companies are required to perform retrospective goodwill impairment testing per ASC 350 to ensure there was no impairment during the restated periods.