In 2014, FASB issued Accounting Standards Update 2014-18, Business Combinations (Topic 805): Accounting for Identifiable Intangible Assets in a Business Combination, a consensus of the Private Company Council. It enables private companies to use an accounting alternative that allows them to cease recognizing certain customer-related intangibles and noncompetition agreements separately from goodwill in a business combination and other specific transactions. This discussion examines the current accounting requirements for recognizing identifiable intangible assets acquired in a business combination and explores the accounting alternative available to private companies. Furthermore, it illustrates the application of the relevant provisions of the update and provides practical considerations for private company management when deciding whether to adopt this approach.
In December 2014, FASB issued the latest in a series of targeted efforts to address the needs of private companies and their stakeholders: Accounting Standards Update (ASU) 2014-18, Business Combinations (Topic 805): Accounting for Identifiable Intangible Assets in a Business Combination, a consensus of the Private Company Council. The Accounting Standards Codification (ASC) Master Glossary defines a private company as “an entity other than a public business entity, a not-for-profit entity, or an employee benefit plan within the scope of Topics 960 through 965 on plan accounting.” The Private Company Council (PCC) was formed in 2012 to make recommendations to FASB concerning accounting alternatives for private companies that would reduce the cost and complexity of particular accounting standards while preserving decision-useful information for users of such financial statements.
ASU 2014-18 permits a private company to elect an accounting alternative that would no longer recognize certain customer-related intangibles and non-competition agreements separately from goodwill in a business combination and other specific transactions. Private companies that adopt this accounting alternative must also adopt the accounting alternative to amortize goodwill over a period of not more than 10 years, as permitted in ASU 2014-02, Intangibles—Goodwill and Other (Topic 350): Accounting for Goodwill. Essentially, a private company electing the alternative in ASU 2014-18 will limit the customer-related intangibles it recognizes in a business combination to those that are capable of being sold or licensed independently from other intangible assets of the acquired business. As a result, private companies will subsume into goodwill many of the customer-related intangibles that have previously been recognized separately, as well as noncom-petition agreements.
Private companies that elect this alternative should realize lower valuation expenses and a reduction in the complexity inherent in accounting for a business combination. Yet, management must still examine customer-related intangibles to determine whether they are separable. The decision to adopt the accounting alternative must be made upon the occurrence of the first transaction within the scope of the alternative in fiscal years beginning after December 15, 2015 (though early adoption is permitted for any interim and annual financial statements that have not yet been issued). Any customer-related intangibles and noncompetition agreements recognized in business combinations prior to adoption of the accounting alternative would continue to be recognized and measured separately, without being subsumed into goodwill.
Private companies that elect this alternative should realize lower valuation expenses and a reduction in the complexity inherent in accounting for a business combination.
Recognition and Measurement of Identifiable Intangible Assets in a Business Combination
ASC Topic 805, “Business Combinations,” requires the use of the acquisition method of accounting for business combinations, in which one entity obtains control over one or more businesses. This method requires the following steps:
- Identifying the acquirer
- Determining the acquisition date
- Recognizing and measuring the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree
- Recognizing and measuring goodwill or a gain from a bargain purchase.
The recognition principle in the third step acknowledges that this process might result in the acquirer identifying and recognizing particular assets and liabilities that had not been previously recorded by the acquiree (ASC 805-20-25-4). The acquirer measures the identifiable assets acquired and liabilities assumed at their acquisition-date fair values (ASC 805-20-30-1). Goodwill is a residual amount, computed as the excess of the fair value of consideration transferred over the fair value of identifiable assets acquired, less the fair value of liabilities assumed.
Identifiable Assets Acquired in a Business Combination
Under the recognition requirements in ASC 805-20-25, an acquirer must recognize, separately from goodwill, the identifiable intangible assets acquired in a business combination. The ASC Master Glossary specifies that an asset is identifiable if it meets either of the following criteria:
- Separability criterion. The asset is separable—that is, capable of being separated or divided from the entity—and sold, transferred, licensed, rented, or exchanged (either individually or together with a related contract, identifiable asset, or liability), regardless of whether the entity intends to do so.
- Contractual-legal criterion. The asset arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations.
ASU 2014-18 allows private companies to make an accounting policy election to apply an accounting alternative for the recognition of identifiable intangible assets when applying the acquisition method in a business combination.
Five categories of intangible assets are specified as identifiable: marketing-related, customer-related, artistic-related, contract-based, and technology-based. Of particular interest with respect to ASU 2014-18 are customer-related intangibles, which include the following:
- Customer lists. These consist of information about customers and are frequently sold, leased, or exchanged. Customer lists generally do not arise from contractual or other legal rights but are usually separable.
- Order or production backlogs. These arise from purchase or sales orders (contracts) and therefore usually meet the contractual-legal criterion, even if cancellable.
- Customer contracts and related customer relationships. By definition, customer contracts and customer relationships established through contracts meet the contractual-legal criterion but are not generally separable; customer relationships also meet the contractual-legal criterion if they arise through regular contact by sales or service representatives.
- Noncontractual customer relationships. Though not contractual, these may be separable; for example, relationships with depositors and their related deposits are frequently exchanged.
ASC 805-20-55 designates the first and fourth items above as those that “do not arise from contractual or other legal rights but are [generally] separable,” and the second and third items above as those that do arise from contractual or other legal rights and are possibly separable.
Accounting Alternative for Customer-Related Intangibles and Noncompetition Agreements
ASU 2014-18 (codified in ASC Topic 805) allows private companies to make an accounting policy election to apply an accounting alternative for the recognition of identifiable intangible assets when applying the acquisition method in a business combination, as well as in the following two instances:
- When assessing the nature of the difference between the carrying amount of an investment and the amount of underlying equity in net assets of an investee when applying the equity method of accounting in accordance with ASC Topic 323, “Investments—Equity Method and Joint Ventures.”
- When adopting fresh-start reporting in accordance with ASC Topic 852, “Reorganizations.”
In addition to applying the recognition requirements discussed below, a private company must also adopt the accounting alternative in ASU 2014-02 to amortize goodwill over a period of 10 years or less. If this accounting alternative was not elected previously, it should be adopted on a prospective basis, along with the current accounting alternative. Note that the reverse is not true—the adoption of the goodwill accounting alternative available in ASU 2014-02 does not require the adoption of ASU 2014-18. (For a full discussion of ASU 2014-02, see “A New Era for Private Company Accounting Standards,” by Cary D. Lange, James M. Fornaro, and Rita J. Buttermilch, The CPA Journal, January 2015, pp. 28–36.)
As noted previously, the recognition principles in ASC 805-20-25-1 state that “as of the acquisition date, the acquirer shall recognize, separately from goodwill, the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree”; however, under the accounting alternative in ASU 2014-18, a private company shall not recognize the following identifiable intangible assets separately from goodwill:
- Customer-related intangible assets, unless they are capable of being sold or licensed independently from other assets of the business
- Noncompetition agreements.
The above criteria suggest that customer lists, which are generally capable of being sold or leased to third parties (unless restrictions apply), will not qualify for the election and will be reported separately. Backlogs arising from unfulfilled purchase and sales orders represent contractual obligations requiring performance and cannot generally be sold or transferred. Accordingly, backlogs will generally qualify for the accounting alternative and would be subsumed into goodwill. Customer contracts and related customer relationships (e.g., supply agreements and service contracts) are also not generally separable and would be subsumed into goodwill. ASU 2014-18 specifically identifies three customer-related intangibles that are likely to be separately recognized because they are generally capable of being sold or licensed independently of other assets: 1) mortgage servicing rights, 2) commodity supply contracts, and 3) core deposits (i.e., relationships between financial institutions and depositors).
Noncompetition agreements represent contracts with owners and other key employees of the acquired entity not to engage in certain business activities deemed to be in competition with the activities of the acquired entity for a specific period of time and specific geographic location. The ASU is applicable to noncompetition agreements entered into that are directly associated with the acquisition. FASB acknowledges, however, that many (if not most) noncom-petition agreements are separate and distinct from the acquisition transaction itself, and thus outside the scope of this guidance. The Exhibit illustrates the recognition of identifiable intangibles in a business combination and the application of the accounting alternative for private companies in ASU 2014-18.
Illustration of the Accounting Alternative Provisions in ASU 2014-18
Related Issues and Provisions
The PCC and FASB agreed that the provisions of ASU 2014-18 are consistent with the objectives in the Private Company Decision-Making Framework: A Guide for Evaluating Financial Accounting and Reporting for Private Companies. Issued in December 2013 by the PCC and FASB, the framework establishes criteria for determining whether and when exceptions or modifications to U.S. GAAP are warranted for private companies. Private company financial statement preparers, users, and auditors have indicated that the benefits of the current accounting for certain identifiable intangible assets acquired in a business combination might not justify the related costs. By providing an alternative treatment, ASU 2014-18 should reduce the cost and complexity involved in the recognition and measurement of certain identifiable intangible assets without significantly diminishing decision-useful information for users. As a result, the PCC and FASB believe that this update meets the overall objectives of the framework and addresses the needs of private company stakeholders. It is important to note that many respondents to the exposure draft expressed doubts about the ultimate benefit of this update.
The PCC and FASB concluded that noncompetition agreements rarely meet the criteria for recognition and chose not to require an assessment of whether such agreements are capable of being sold or licensed separately from the other assets of the acquiree.
The guidance in ASU 2014-18 also clarifies that contract assets, as defined in ASU 2014-09, Revenue from Contracts with Customers (Topic 606), and leases (both favorable and unfavorable) are not considered intangible assets eligible to be subsumed into goodwill and are, therefore, not within the scope of this update. The PCC and FASB noted that contract assets (the right to consideration from delivering goods or performing services that is conditional upon the satisfaction of another performance obligation) are not customer-related intangible assets because the contract asset will be reclassified as a receivable when all performance obligations are satisfied.
The basis for conclusions in ASU 2014-18 further addresses the treatment of favorable and unfavorable customer contracts acquired in a business combination. The PCC and FASB noted that most customer contracts are “at market” and generally do not include favorable or unfavorable terms. Yet, they concluded that customer contracts with favorable terms relative to market are generally not separable and are eligible to be subsumed into goodwill; those with unfavorable terms relative to market are recorded as liabilities and, therefore, do not fall under the ASU’s scope. The inclusion of contracts with favorable terms in goodwill would not necessarily create subsequent impairment issues, given the requirement to also adopt the goodwill amortization provisions in ASU 2014-02. In business combinations that include significant favorable contract assets, a shorter life for goodwill might be justified.
ASU 2014-18 also applies to new equity-method investments when the investor is assessing the nature of the difference between an investment’s cost and the underlying equity in the net assets of an investee. Note that a public business entity with an equity-method investment in a private company that adopts the accounting alternative for its stand-alone financial statements will recognize income or loss that differs from the amount that would have been recognized otherwise. In such cases, an investor must adjust its share of the investee’s income or loss in order to reverse the effects of the accounting alternative.
The PCC and FASB also concluded that noncompetition agreements rarely meet the criteria for recognition and chose not to require an assessment of whether such agreements are capable of being sold or licensed separately from the other assets of the acquiree (ASU 2014-18, para. BC19). Several private company financial statement preparers, users, and auditors indicated that many noncompetition agreements represent transactions separate from the business combination; therefore, the ASU would not result in significantly different financial reporting outcomes. If a non-competition agreement is acquired as part of a business combination, however, it would fall under the scope of this guidance.
The ASU stipulates that customer-related intangible assets and noncompetition agreements that exist as of the beginning of the adoption period should continue to be subsequently measured according to the guidance in ASC Topic 350, “Intangibles—Goodwill and Other.” In other words, existing customer-related intangible assets and noncompetition agreements should not be subsumed into goodwill upon adoption of the accounting alternative. This is a departure from the treatment ascribed to existing goodwill in ASU 2014-02, which requires the amortization of new and existing goodwill upon application of that alternative.
ASU 2014-18 states that the present disclosure requirements in ASC Topic 805 are sufficient and already require a qualitative description of intangible assets that do not qualify for separate recognition and the factors that comprise goodwill. Though no incremental disclosures are required, the change in accounting principle and its effect on the financial statements should be disclosed in the year of adoption, in accordance with ASC 250-10, “Accounting Changes and Error Corrections.”
Effective Dates and Transition Requirements
As previously noted, management’s decision to adopt the accounting alternative must be made upon the occurrence of the first in-scope transaction in fiscal years beginning after December 15, 2015 (i.e., January 1, 2016 for calendar-year companies), and must be applied to all subsequent transactions. The effective date of adoption depends upon the timing of that first transaction. If it occurs in the fiscal year beginning after December 15, 2015, the elective adoption will be effective for that fiscal year’s annual financial statements and all interim and annual periods thereafter; however, if the first transaction occurs in fiscal years beginning after December 15, 2016, the elective adoption will be effective in the applicable interim period and all subsequent interim and annual periods thereafter. Early adoption is permitted for any interim and annual financial statements that have not yet been made available for issuance (i.e., not yet complete or require approvals from management, the board of directors, or particular shareholders, depending upon the specific circumstances). As noted previously, implementation is prospective and all customer-related intangibles and noncompetition agreements that exist upon adoption will continue to be recognized and measured without being subsumed into goodwill. If an entity does not adopt the accounting alternative when the first in-scope transaction occurs, a subsequent adoption would be treated as a change in accounting principle in accordance with ASC 250-10.
Practical Considerations and Observations
Before electing the alternative treatment, management should consider whether it expects to engage in an initial public offering or might be acquired by a public business entity. Because neither FASB nor the SEC has provided specific transition guidance in these situations, it appears that private companies would have to retrospectively restate their financial statements to apply public company accounting and reporting requirements to all periods presented. Management should also ensure that key users will accept the financial statements reflecting the accounting alternative before making the election. Users should be informed of the accounting alternative’s expected impact on the financial statements. It would also be prudent to evaluate how the expected accounting results will affect existing loan covenants.
As mentioned earlier, the PCC and FASB believe that ASU 2014-18 offers private companies some relief from the costs and complexity associated with the valuation of identifiable intangible assets acquired in a business combination. It does not, however, obviate the need for the private company to perform a purchase-price allocation for income tax purposes. ASU 2014-18 does not change existing requirements to identify and measure identifiable intangible assets and goodwill for tax purposes. Given that much of the cost and complexity is still necessary for tax purposes, the benefits ultimately realized may be less than expected.
Finally, the overall objective of the guidance in ASC Topic 805 “is to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports about a business combination and its effects” (ASC 805-10-10-1). Unfortunately, the provisions of ASU 2014-18 will reduce comparability among private companies and between private and public companies. Concerning private companies, ASU 2014-18 notes, “For entities electing this alternative, the amendments generally will result in those entities separately recognizing fewer intangible assets in a business combination when compared to entities that do not elect or are not eligible for this alternative” (p. 2). With respect to comparability between public and private companies, dissenting FASB members have stated that “comparability is a vital qualitative characteristic of decision-useful information with differences in reporting for private and public entities only being justified by differences in the benefits and/or costs of the reported information for private versus public entities.” Absent these benefits, “the accounting for private and public entities should remain the same” (p. 11).
Given that much of the cost and complexity is still necessary for tax purposes, the benefits ultimately realized may be less than expected.
Many of the comment letters received in response to the ASU 2014-18 exposure draft suggested that the accounting alternatives for identifiable intangible assets should not be restricted to private companies. They supported expanding the scope of the accounting alternative to public companies and not-for-profit entities as well. Similar comments were received in response to the exposure draft for ASU 2014-02.
FASB currently has two related items on its technical agenda: 1) accounting for goodwill for public business entities and not-for-profit entities (added in November 2013), and 2) accounting for identifiable intangible assets in a business combination for public business entities and not-for-profit entities (added in November 2014). Both of these projects will explore the possibility of expanding the scope of the accounting alternatives available to private companies to these other types of entities, and they have no specific timetable.