Common accounting challenges in business combinations

Acquisitions are an increasingly popular way to fuel company growth. 

However, for those involved in preparing financial statements, they can be tricky to navigate.

These transactions introduce significant accounting and auditing complexities, which can impact the accuracy and reliability of financial statements. 

 Is it a business combination or an asset acquisition? 

To apply the correct accounting treatment, you must first determine if the transaction constitutes a business combination. The key question is whether the assets and assumed liabilities acquired form a business. If they do, the transaction is a business combination. If they do not, treat the transaction as an asset acquisition.

Business combinations and asset acquisitions are accounted for differently, and the distinction can have a significant impact on your financial statements. The classification affects areas such as deferred taxes, amortisation, and impairment testing. For this reason, it is essential to accurately identify the nature of the transaction from the outset.

What constitutes a business?

A business comprises inputs and processes that can generate outputs. The emphasis here is on the word, ‘can.’
While outputs are common, they are not necessary for an integrated set of activities and assets to qualify as a business. At a minimum, a business must include an input and a substantive process that together significantly contribute to the ability to create outputs.

Business combinations and AASB 3

In a business combination, the acquirer obtains control over the acquiree. Companies undertaking business combinations in Australia must comply with the standards laid out by the Australian Accounting Standards Board (AASB). This also ensures compliance with International Financial Reporting Standards (IFRS). 
AASB 3: Business Combinations mandates using the acquisition method as the principal approach for accounting for such transactions. This means:

• Finding out who the acquirer is.
• Deciding the acquisition date.
• Recognising the identifiable assets acquired, liabilities assumed and any non-controlling interest at their fair values. 

Note: Business combinations between entities under common control are scoped out of AASB 3. These transactions are accounted for differently. For more detail, see our article on Common Control Transactions.

The fair value treatment often results in the recognition of goodwill. Goodwill represents the excess of the purchase price over the fair value of the net identifiable assets. AASB 136: Impairment of Assets covers measuring goodwill.

When identifying and measuring intangible assets, you need to apply AASB 138: Intangible Assets.

Understanding how to account for business combinations in Australia can be complicated. It is important to grasp these standards and how they connect. This means careful record-keeping and clear financial reporting are essential.

Asset acquisition

In an asset acquisition, the transaction is recorded based on the cost of the acquired assets, and no goodwill is recognised.

 Examples of business combinations vs asset acquisitions 

For example, acquiring a junior mining explorer with only exploration permits and geological data is typically an asset acquisition, whereas acquiring a producing mine with operations and workforce is a business combination. Similarly, purchasing a software start-up with a prototype may be an asset acquisition, while acquiring an established SaaS provider with customers and support staff is a business combination. Including real-life examples helps clarify the distinction and supports accurate application of AASB 3. 

Additional examples:

 Financial reporting challenges in business combinations 

Business combinations may involve complex transactions and diverse stakeholders, presenting significant challenges for financial reporting Common errors in applying AASB 3 can significantly impact the accuracy of financial reports. These mistakes often stem from a lack of understanding of complex accounting standards or the details of specific transactions.

For example, a tech company may acquire a start-up and incorrectly record the entire purchase price as goodwill, overlooking identifiable intangibles such as proprietary algorithms, customer contracts, and software licenses. Due to these complexities, preparers must exercise heightened diligence.
Identifying and valuing intangible assets

A common challenge in business combinations is correctly identifying and valuing intangible assets. 
These assets lack physical form but can be quite valuable. Think brand recognition, customer relationships, and internal intellectual property. 

Because their valuation is subjective, specialised methods like discounted cash flow are often required. You may need to bring in an expert to perform an identified intangible asset valuation, which can be expensive.

Common intangible assets include:

• Customer contracts
• Customer relationships
• Brand names
• Supplier contracts
• Patented technology
• Non-compete agreements

It is important to distinguish these from goodwill to prevent misstatements.

Example: Acquiring a media company

Intangible assets might consist of:

• Broadcasting licenses
• Subscriber lists
• Program rights

All of these must be separately identified and valued.

Ensure these valuations are reasonable and reflect current market conditions and the specifics of the business combination. Confirm that intangible assets meet strict recognition criteria: identifiability, probable future economic benefits, and reliable measurability. 

Since many intangible assets have a tax base of zero, they often lead to significant deferred tax liabilities. Improper accounting for deferred tax impacts is common, which can result in material misstatements in financial statements.

Recognising and measuring goodwill

Goodwill, an intangible asset representing future economic benefits from unidentifiable assets, poses significant measurement challenges. It is calculated as the excess of the purchase price over the fair value of identifiable net assets acquired. 

Pay close attention to the allocation of the purchase price, ensuring accurate valuation of all identifiable assets and liabilities, with any residual amount allocated to goodwill. 

This process requires a deep understanding of the industry, the target company's business model, and the acquisition context.

Auditors will assess the reasonableness of assumptions used in fair value measurements, including future cash flows, discount rates, and expected synergies. Significant deviations from industry benchmarks or historical data warrant thorough investigation to ensure accurate goodwill measurement. Completeness is a major risk here to ensure all assets and liabilities have been appropriately included

Assessing fair value of acquired assets and liabilities

Accurate determination of the fair value of acquired assets and liabilities impacts goodwill calculation, deferred taxes, and the financial reporting of the combined entity. This process is particularly challenging for assets and liabilities not previously recognised by the acquiring company. 

Rigorously evaluate the methodologies and assumptions used in fair value measurements, ensuring compliance with accounting standards and consistency in valuation techniques. This involves assessing the qualifications of external valuers, verifying the reliability of data inputs, and scrutinising discount rates applied to future cash flows.

Fair value considerations include:

• Valuation methodology

Verify the appropriateness of the selected valuation method (e.g., market approach, income approach) relative to the industry and the specific asset or liability.

• Data inputs

Ensure the accuracy, completeness, and relevance of data used in the valuation model, including market data, comparable company information, and financial forecasts.

• Assumptions

Evaluate the reasonableness and support for key assumptions, such as growth rates, discount rates, and risk premiums.

Misinterpreting the nature of consideration transferred

Accurately determining the transaction price in a business combination is crucial. A common pitfall is misinterpreting what constitutes the consideration transferred, especially when it includes more than just cash. For instance, contingent consideration, which depends on future events, must be correctly recorded at fair value (discounted and probabilities applied where relevant).

Misclassifying or failing to recognise contingent consideration can distort the accounting for the acquisition. Similarly, transaction costs, which must be expensed separately under AASB 3, should not be included in the consideration transferred.

Non-cash payments, such as shares, must also be valued at their fair value on the acquisition date, which can involve complex calculations and estimates.

Ensure these valuations are accurate and reflect the true financial position of the transaction.

Overlooking contingent liabilities and asset impairments

Contingent liabilities, which are present obligations arising from past events with uncertain outcomes, require careful consideration during a business combination.

Failing to identify and report significant contingent liabilities can result in an understatement of liabilities and an overstatement of net assets.

Asset impairments can also be overlooked during transactions. The acquisition process may reveal that some assets are worth less than their recorded amounts,  for example recoverability of accounts receivable. Ignoring these impairments can lead to an overstatement of asset values and ultimately lead to an overstatement of the goodwill.

Additionally,  AASB 3 allows 12 months to finalise the accounting for the business combination namely called the measurement period, which allow for the finalisation of fair value measurements within one year of the acquisition date. This 12-month period allows entities to adjust provisional amounts as new information becomes available about conditions that existed at the acquisition date.