Accounting for Business Combinations

7-1704 Accounting for Business Combinations

7-1704.1 Introduction and Use

FASB Statement No. 141 requires that all business combinations initiated after June 30, 2001 must be accounted for using the purchase method. Prior to this date the pooling of interest method was acceptable under certain circumstances. (See editions of CAM prior to July 2003 for discussion of the pooling of interest method.)

7-1704.2 Purchase Method

a. The purchase method reflects the acquisition of one company by another. The excess, if any, of the fair value of the identifiable assets purchased over the fair value of the liabilities assumed and the amount paid is recorded as goodwill. Goodwill is an expressly unallowable cost. Also, goodwill is an unallowable element of the facilities capital employed base used to compute cost of money.

b. The effect of using the purchase method on the valuation of acquired assets is stated in paragraph 7 of FASB Statement No. 141. It requires that the cost of each individual asset be determined based on its estimated fair value at the date of acquisition. Any excess of the price paid for the acquired business over the sum of the amounts assigned to all recognized assets acquired less liabilities assumed is assigned to unidentified assets, including goodwill.

c. In a business combination, a write-up (or write-down) of the asset values can occur when the fair value of the assets acquired is more (or less) than the book value of the assets (7-1705.1). Costs assigned to intangible assets should reasonably reflect their fair market value (7-1705.2).

d. For more specific guidance relating to the valuation or write-up of assets under the purchase accounting method, see 7-1705 below.

7-1705 Asset Valuation and Revaluation Resulting from Business Combinations

7-1705.1 GAAP for Write-ups (or Write-downs)

a. The GAAP for determining the value of an acquired company's assets and liabilities are principally provided in Statement of Financial Accounting Standards No. 141. Five paragraphs are restated below.

(1) Paragraph 7 - Allocating cost.

Acquiring assets in groups requires not only ascertaining the cost of the asset (or net asset) group but also allocating that cost to the individual assets (or individual assets and liabilities) that make up the group. The cost of such a group is determined using the concepts described in paragraphs 5 and 6. A portion of the cost of the group is then assigned to each individual asset (or individual assets and liabilities) acquired on the basis of its fair value. In a business combination, an excess of the cost of the group over the sum of the amounts assigned to the tangible assets, financial assets, and separately recognized intangible assets acquired less liabilities assumed is evidence of an unidentified intangible asset or assets.

(2) Paragraphs 35 and 36 - Allocating the Cost of an Acquired Entity to Assets Acquired and Liabilities Assumed

Following the process described in paragraphs 36-46 (commonly referred to as the purchase price allocation), an acquiring entity shall allocate the cost of an acquired entity to the assets acquired and liabilities assumed based on their estimated fair values at date of acquisition (refer to paragraph 48). Prior to that allocation, the acquiring entity shall:

(a) review the purchase consideration if other than cash to ensure that it has been valued in accordance with the requirements in paragraphs 20-23 and

(b) identify all of the assets acquired and liabilities assumed, including intangible assets that meet the recognition criteria in paragraph 39, regardless of whether they had been recorded in the financial statements of the acquired entity. Among other sources of relevant information, independent appraisals and actuarial or other valuations may be used as an aid in determining the estimated fair values of assets acquired and liabilities assumed. The tax basis of an asset or liability shall not be a factor in determining its estimated fair value.

(3) Paragraphs 37 and 38 - Assets acquired and liabilities assumed, except goodwill.

The following is general guidance for assigning amounts to assets acquired and liabilities assumed, except goodwill:

(a)' Marketable securities at fair values.

(b)' Receivables at present values of amounts to be received determined at appropriate current interest rates, less allowances for uncollectibility and collection costs, if necessary.

(c) Inventories - Finished goods and merchandise at estimated selling prices less the sum of

• (i) costs of disposal and

• (ii) a reasonable profit allowance for the selling effort of the acquiring entity.

- Work in process at estimated selling prices of finished goods less the sum of :

• (i) costs to complete,

• (ii) costs of disposal, and

• (iii) a reasonable profit allowance for the completing and selling effort of the acquiring entity based on profit for similar finished goods.

- Raw materials at current replacement costs.

(d) Plant and equipment.

- To be used, at the current replacement cost for similar capacity unless the expected future use of the assets indicates a lower value to the acquiring entity (Note - Replacement cost may be determined directly if a used-asset market exists for the assets acquired. Otherwise, the replacement cost should be estimated from the replacement cost new less estimated accumulated depreciation.)

- To be sold, at fair value less cost to sell.

(e) Intangible assets that meet the criteria in paragraph 39 at estimated fair values.

(f) Other assets, including land, natural resources, and nonmarketable securities, at appraised values.

(g) Accounts and notes payable, long-term debt, and other claims payable, at present values of amounts to be paid determined at appropriate current interest rates. An acquiring entity shall not recognize the goodwill previously recorded by an acquired entity, nor shall it recognize the deferred income taxes recorded by an acquired entity before its acquisition. A deferred tax liability or asset shall be recognized for differences between the assigned values and the tax bases of the recognized assets acquired and liabilities assumed in a business combination in accordance with paragraph 30 of FASB Statement No. 109, Accounting for Income Taxes.

7-1705.2 Intangible Assets

a. Intangible assets such as patents, trademarks, and franchises are referred to as “identifiable.”

Other intangible assets lack specific identity. The excess amount paid for an acquired company over the sum of identifiable net assets, usually termed goodwill, is the most common unidentifiable intangible asset. The most significant distinction between “identifiable” and “unidentifiable” intangible assets is separability. Identifiable intangible assets may be acquired singly, as part of a group of assets, or as part of an entire company.

Unidentifiable intangible assets are inseparable from the entity.

b. Costs should be assigned to all identifiable assets, normally based on the fair values of the individual assets; costs of identifiable assets should not be included in goodwill or any other type of unidentifiable assets (see FASB Statement No. 141 Paragraph 39). The cost of unidentifiable intangible assets is measured by the difference between the cost of the group of assets or enterprise acquired and the sum of the assigned costs of individual tangible and identifiable intangible assets acquired, less liabilities assumed.

c. The assets of the acquired company are appraised and fair values established. Usually, outside appraisers perform the appraisal. They may take several different approaches in arriving at their estimated fair values. While:

• (1) the accounting processes prescribed by FASB Statement No. 141 require the assignment of costs to identifiable assets, and

• (2) GAAP prescribes recognition of the assigned cost, the auditor should not automatically conclude that the resulting costs are reasonable and reimbursable.

d. The auditor needs to evaluate the contractor's categorization of each identifiable intangible asset to determine whether or not the fair value assigned to such asset is reasonable and commensurate with economic reality or substance of the asset in review. The allowability of identified assets should be limited to fair market values subject to allocability and reasonableness tests.

7-1705.3 Allowability of Asset Valuation Write-ups

a. Contracts subject to TINA awarded after February 27, 1995 incorporate a contract clause (FAR 52-215.19) which specifically requires the contractor to notify the Government of any changes in contractor ownership which would impact asset valuations. The clause also expressly requires maintenance of the records and calculation of the expense amounts which are required in order to comply with the cost principle at 31.205-52. For business combinations that use the purchase method of accounting, FAR 31.205-52 (Asset Valuation Resulting from Business Combinations) limits the amount of allowable amortization, depreciation, and cost of money to the total amount that would have been allowable had the combination never taken place. This provision became effective July 23, 1990. Simply stated, the Government will not recognize for cost allowability purposes any costs resulting from the increase in the value of acquired assets (or the creation of new assets) as a result of business combinations. FAR 31.205-52 applies to contracts awarded on or after July 23, 1990. For purposes of pricing and costing contracts entered into after July 22, 1990, this FAR provision also applies to preexisting business combinations that predate the effective date of the cost principle. However, the contracting officer may need to separately address the costs of past asset write-ups on a case-by-case basis to achieve equity or to protect the Government's interest in special situations (see 7-1705.3.c.).

b. The April 15, 1996 revision to CAS 404 goes beyond the FAR concept of “no step-up” and provides “no step-up, no step-down” of asset values. Consequently, under the provisions of the revised CAS 404, the net book value of the tangible capital asset in the seller’s accounting records will be used as the capitalized value of the asset for the buyer (see 8-404.2b). The contractor is responsible for maintaining the proper documentation to demonstrate that the proposed or claimed costs do not exceed the amounts calculated based on the book values of the acquired assets (but see 8-404.2b). This becomes particularly important in those business combinations when one company purchases another company and the acquired company is dissolved.

c. Auditors who encounter the following situations should advise the contracting officer that an advance agreement, while not required, may be beneficial to provide equitable treatment to both the Government and the contractor and to minimize future disputes:

(1) (2) when the acquired company had no or little Government business before being acquired so that no material credit exists for excess depreciation and amortization previously recognized, and the acquiring company subsequently entered Government business with the asset valuations established by the combination.

(3) when an extensive period of time has elapsed between a prior business combination and the effective date of the cost principle. A reasonable period of time may need to be considered in applying the limits of FAR 31.205-52 when the acquired company’s asset values prior to the business combination are no longer available and it is not practical or cost beneficial to reconstruct these costs.

d. Gains and losses on the disposition of assets resulting from a business combination are not allowable as specified at FAR 31.205-16(a) (but see 8-409.1g.(5) and (6) for the measurement of gains and losses under the April 15, 1996 revision to CAS 409).

e. For contracts awarded on or after April 24, 1998, whether or not the contract is subject to CAS, FAR 31.205-52 allows costs calculated based on the seller’s net book value (no step-up, no step-down) if the assets generated depreciation expense or cost of money charged to Government contracts in the most recent accounting period prior to a business combination. If tangible capital assets did not generate depreciation expense or cost of money charged to Government contracts in the most recent year, such costs calculated based on the purchase method (step-up or step-down) of accounting would be allowable.

f. The asset values determined in accordance with CAS (or GAAP) are used in the three-factor formula for distributing home office costs. Likewise, depreciation and amortization costs assigned in accordance with CAS will be included in any allocation base which normally includes such costs (e.g., the total cost input base). FAR 31.203(d) requires that the full amount of such costs be included in allocation bases so as to cause the unallowable portion of the costs to absorb a portion of overhead cost or G&A expense (see 8-410.1a(2) and 8-405.1g(1)). However, on September 29, 1999, a class deviation from this requirement was issued for DoD contracts and subcontracts, effective through September 30, 2002. This deviation was extended on September 9, 2002, effective through September 30, 2005, also on September 26, 2005, effective through September 30, 2008 and on February 18, 2009, effective through September 30, 2011. Under this DoD deviation, the indirect costs allocable to the step-up asset value under the prior CAS 404 requirements will not be disallowed.

7-1705.4 Unallowable Costs

===a.Goodwill=== FAR 31.205-49 defines goodwill as an unidentifiable intangible asset. It originates from use of the purchase method of accounting for a business combination. Goodwill arises when the price paid by the acquiring company exceeds the sum of the identifiable individual assets acquired less liabilities assumed, based upon their fair values. Goodwill may arise from the acquisition of a company as a whole or in part. Any costs for amortization, expensing, write-off, or write-down of goodwill (however represented) are unallowable.

b. Cost of Money

The cost of money resulting from including goodwill (however represented) in the facilities capital employed base is unallowable (see FAR 31.205-10(b)(2)).

7-1705.5 Summary of Audit Guidelines for Write-ups

a. For contracts awarded after July 22, 1990, the auditor should verify that contracts do not receive increased costs flowing from asset revaluation resulting from business combinations. This would also apply to preexisting business combinations that predate the contracts being entered into. The auditor may have to advise the contracting officer of the need to separately address the costs of past asset write-ups on a case-by-case basis to achieve equity or to protect the Government's interest in special situations.

b. For contracts awarded on or after April 15, 1996, the auditor should verify whether the contracts are subject to the revised CAS 404 and 409, effective April 15, 1996 (8404.b and 8-409.b). If the revised CAS 404 and 409 apply, the auditor should verify whether the acquired tangible capital assets generated depreciation or cost of money charges on Federal Government contracts or subcontracts negotiated on the basis of cost during the most recent cost accounting period. For tangible capital assets that generated such depreciation expense or cost of money charges, no write-up and no write-down of asset values is permitted and no gain or loss is recognized on asset disposition. For tangible capital assets that did not generate such depreciation or cost of money charges, asset values are written-up or written-down in accordance with CAS 404.50(d)(2). However, tangible capital assets meeting the requirements of CAS 404.50(d)(2) must still comply with the requirements of FAR 31.205-10, 31.205-11, 31-205-16, and 31.205-52 (i.e., costs resulting from asset write-ups are unallowable).

c. For contracts awarded on or after April 24, 1998, whether or not the contract is subject to CAS, the allowable depreciation and cost of money would be based on capitalized asset values measured in accordance with CAS 404.50(d). (See 8-404.2 and 8-409.2)