Is Your U.S. Asset Purchase Actually a Business Combination Under GAAP?

In Brief:

• The title of a purchase agreement does not determine how a deal is classified under U.S. GAAP. The assets, employees, processes, and activities transferred do.
• If acquired assets can keep operating and generating revenue with little effort from the buyer, you may have bought a business, not just assets.
• Business combinations can create goodwill and require acquisition costs to be expensed, while asset acquisitions generally capitalize those costs.
• Legal form, GAAP classification, and tax treatment are three separate questions, and accounting does not automatically follow tax.
• Cross-border buyers should resolve the accounting before closing, since U.S. GAAP, IFRS, and local reporting may all need to align.

For international buyers looking to purchase a business in the U.S., a transaction can be legally structured as a purchase of an asset or a group of assets but still qualify as a business combination (an acquisition of a business) under U.S. GAAP. Likewise, the purchase of a business’s stock does not automatically produce an asset-basis step-up for federal income tax purposes. Buyers therefore need to analyze three separate questions: the legal form of the transaction, its U.S. GAAP classification, and its tax treatment.

You Bought Assets But Did You Really Buy a Business?

Understanding the difference between an asset acquisition and a business combination in the U.S. requires an understanding of how U.S. accounting standards, tax laws, and business practices differ from those in other countries.

In the U.S., an asset acquisition involves buying specific assets of a company, such as machinery and equipment, without buying control of the business. A business combination involves acquiring control over an entire business, including its assets, liabilities and operations, and most likely the business stock, although this is not necessary.

Sometimes, the question of whether a transaction is an asset purchase or business combination is murky. For example, a transaction may be legally structured as an asset purchase, such as the purchase of a restaurant’s equipment, inventory, recipes, and vendor information. However, depending on the assets and activities transferred, the transaction may still qualify as a business combination under U.S. GAAP.

To avoid such confusion, the agreement should clearly identify the assets, liabilities, employees, contracts, processes and other activities transferred. Those facts, not the title of the agreement or the buyer’s stated intent, determine the U.S. GAAP classifications.

What is a Business?

In addition to hard assets, a business generally includes:

• Elements that generate revenue
• Processes or know-how
• Employees or workforce
• Customer relationships
• Systems and operations

In simple terms, if the acquired assets can continue operating and generating revenue with little effort from the buyer, you may have acquired a business instead of simply buying assets. This is determined by accounting standards that distinguish between a business combination and the purchase of standalone assets.

Why Does It Matter Whether It’s an Asset Purchase or a Business Combination?

Under U.S. accounting rules and tax regulations, asset purchases and business combinations are treated differently in several important ways:

• Purchase price allocation — For a GAAP asset acquisition, the total cost, including qualifying transaction costs, is generally allocated to the acquired assets based on their relative fair value. Federal income tax allocation follows separate rules. In a business combination, identifiable assets acquired and liabilities assumed generally are recognized at their acquisition date fair values, subject to specified exceptions.
• Goodwill —If you pay $10 million for the transaction, and the identifiable assets are valued at $8 million, the remaining $2 million may become goodwill, subject to other adjustments required by ASC 805 in a business combination. However, accounting guidance notes that asset purchases generally don’t create goodwill in the same manner that business combinations do. However, a taxable asset acquisition may result in taxable goodwill subject to the federal income tax rules under Section 197 intangibles. Goodwill is a residual asset representing future economic benefits that are not separately identifiable and recognizable, such as reputation, strong customer relationships, and established operations.
• Transaction costs — Costs for such items as legal fees, valuation fees, and due diligence are generally capitalized as part of a GAAP asset acquisition. In a business combination, acquisition-related costs are generally expensed as incurred, except for costs governed by separate guidance, such as debt or equity issuance costs.
• Future earnings can change — Different accounting treatments can affect depreciation, amortization, and future reported profits. Therefore, whether a deal is booked as an asset acquisition or a business combination can affect financial statements for many years after the transaction.

Common Transactions That Create Confusion

An investor has found a target company and is planning to buy its:

• Customer lists
• Employees
• Technology
• Contracts

This will likely be classified as a business combination if, when acquiring hard assets, the buyer retains the employees who form an organized workforce performing substantive processes that significantly contribute to producing or developing outputs.

A second investor is buying:

• One building
• Vacant land
• Equipment

This is most likely an asset acquisition if the acquired assets do not include a substantive process and outputs.

A third investor is acquiring and taking control of substantially all of the operating assets and activities of a foreign company’s subsidiary, but not its legal entity or shares. Many investors might consider this an asset acquisition, but that’s not necessarily the case. The specifics of the transaction must be analyzed to determine whether it must be treated as a business combination.

Special Challenges for Cross-Border Transactions

When the buyer and seller are from different countries, and one is subject to the tax regimes of both the U.S. and its home country, they may have different legal and tax objectives. The buyer may prefer one type of transaction, while the seller may prefer another.

Additionally, documentation maybe be an issue, as many international agreements focus on legal and tax outcomes, but do not address accounting issues.

Finally, multiple reporting frameworks must be aligned:

• U.S. GAAP
• IFRS
• Local statutory reporting

Common Mistakes Business Owners Make

Mistake #1

“The agreement says, ‘asset purchase,’ so it must be an asset purchase.”

The title of the agreement does not, by itself, determine the U.S. GAAP classification. The agreement’s substantive terms and the assets and activities transferred must be analyzed.

Mistake #2

“Accounting follows tax treatment.”

This is not always true.

Mistake #3

“We’ll determine the accounting after the closing.”

Depending on the nature and materiality of the acquired assets and liabilities, management may need a valuation specialist to support the purchase accounting analysis.

Summary

Whether a deal is treated as an asset purchase or a business combination can significantly affect purchase accounting, goodwill, transaction costs, and future earnings. Understanding the distinction early in the process can help avoid costly surprises after closing. Above all, don’t let the title at the top of a purchase agreement mislead you. A purchase agreement may legally be structured as an asset purchase while the acquired set of assets and activities is accounted for as a business combination under U.S. GAAP.

If the acquired assets, processes, employees and operations together constitute a business, the transaction may need to be accounted for as a business combination, potentially resulting in goodwill, different treatment of transaction costs and a more complex purchase accounting analysis.

We’re Here to Help

If you are considering a transaction, work with an advisor who understands the expected legal, tax, and financial reporting issues and who can help you evaluate the appropriate accounting based on the final terms.

For more information, contact your JLK Rosenberger team member, call 949-860-9902 or click here to contact us. We look forward to speaking with you soon.