The Role of ASC 805 in M&A Accounting

Every corporate acquisition that qualifies as a business combination is governed by ASC 805, Business Combinations. This standard prescribes the acquisition method – the only acceptable method for recording a business combination under US GAAP – and addresses everything from identifying the acquirer to measuring goodwill to handling complex contingent consideration structures.

For finance teams at companies that acquire regularly, ASC 805 is not an occasional reference – it is a core competency. For teams encountering their first acquisition, this guide provides the roadmap to navigate the accounting from deal announcement through measurement period close.

Asset Acquisition vs. Business Combination

Before applying ASC 805, determine whether the transaction is a business combination or an asset acquisition. The distinction matters because:

  • Business combination – Assets acquired and liabilities assumed are measured at fair value. Goodwill is recognized. Transaction costs are expensed.
  • Asset acquisition – The cost of the acquisition is allocated to assets based on relative fair values. No goodwill is recognized (any excess is allocated to the assets). Transaction costs are capitalized.

The Screen Test

ASU 2017-01 introduced a practical screen: if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or group of similar identifiable assets, the transaction is an asset acquisition. If not, apply the more detailed definition of a business.

A “business” requires inputs and a substantive process that together have the ability to create outputs. The evaluation considers whether the acquired set includes an organized workforce and whether the inputs and processes are sufficient to produce outputs.

Why It Matters

The classification can have a dramatic impact on the financial statements. In a business combination, transaction costs (legal, advisory, due diligence fees) are expensed immediately, which reduces earnings in the acquisition period. In an asset acquisition, those same costs are capitalized, reducing current-period expense but increasing the carrying amount of the acquired assets.

The Acquisition Method: Detailed Walkthrough

Identifying the Acquirer

The acquirer is the entity that obtains control. In most cases, this is the entity that transfers cash or issues equity to acquire the other entity. However, for reverse acquisitions (where the legal acquiree is the accounting acquirer), the analysis can be more complex. Factors to evaluate include:

  • Relative voting rights after the combination
  • Composition of the governing body
  • Composition of senior management
  • Relative size of the entities
  • Which entity initiated the transaction

Determining the Acquisition Date

The acquisition date is the date on which the acquirer obtains control of the acquiree. This is almost always the closing date, when legal title transfers, regulatory approvals are finalized, and the acquirer begins directing the operations of the acquiree.

Measuring Consideration Transferred

Total consideration includes:

  • Cash at face value
  • Equity instruments at acquisition-date fair value (which may differ from the announcement-date value)
  • Contingent consideration at acquisition-date fair value (discussed in detail below)
  • Replacement awards – When the acquirer issues replacement equity awards for the acquiree’s outstanding awards, a portion of the replacement award’s fair value may be allocated to purchase consideration (the portion attributable to pre-combination service) with the remainder recognized as post-combination compensation expense

Recognizing Identifiable Assets and Liabilities

The acquirer recognizes, separately from goodwill, the identifiable assets acquired and liabilities assumed, measured at acquisition-date fair values. This includes:

Tangible assets – Property, plant, equipment, inventory, and other physical assets.

Intangible assets – The acquirer must recognize intangible assets that meet either the contractual-legal criterion or the separability criterion, even if the acquiree did not previously recognize them. Common categories include:

  • Customer relationships
  • Developed technology and patents
  • Trade names and trademarks
  • In-process research and development (IPR&D)
  • Non-compete agreements
  • Favorable and unfavorable contracts (above- or below-market leases, supply agreements)

Contingent liabilities – Recognized at fair value if the acquisition-date fair value can be determined, even if the amount is not yet probable and estimable under ASC 450.

Deferred tax assets and liabilities – Recognized for the tax effects of differences between the fair values of assets acquired (and liabilities assumed) and their tax bases.

Pre-existing relationships – If the acquirer and acquiree had a pre-existing relationship (e.g., a supply agreement or a licensing arrangement), it is effectively settled as part of the business combination and accounted for separately from the acquisition.

Goodwill Calculation

Goodwill equals:

Consideration transferred + Fair value of any noncontrolling interest + Fair value of any previously held equity interest - Net identifiable assets at fair value = Goodwill

If the net identifiable assets exceed the consideration (a “bargain purchase”), the acquirer first reassesses whether all assets and liabilities have been identified and measured correctly. If a bargain purchase gain remains after reassessment, it is recognized in earnings.

Contingent Consideration: A Deeper Look

Contingent consideration (earn-outs) is one of the most complex areas of ASC 805 because it requires fair value measurement at the acquisition date and, if classified as a liability, ongoing remeasurement.

Classification

  • Equity – Contingent consideration is classified as equity if it is settled by issuing a fixed number of shares for a fixed contingency. This is relatively rare.
  • Liability – Most contingent consideration is classified as a liability because it involves variable payments of cash or variable numbers of shares. Liability-classified contingent consideration is remeasured to fair value each reporting period, with changes flowing through earnings.

Valuation Approaches

  • Scenario-based (probability-weighted) – Assign probabilities to different payout scenarios and calculate the expected present value.
  • Option pricing (Monte Carlo simulation) – For earn-outs with path-dependent payoff structures (e.g., revenue milestones with caps and floors), Monte Carlo simulation is often the most appropriate technique.

Ongoing Remeasurement

Each quarter, the entity must update the fair value of liability-classified contingent consideration. This requires revisiting the underlying assumptions (revenue forecasts, probability of milestone achievement, discount rates) and can create significant earnings volatility. Proactive communication with investors about the non-operational nature of these remeasurement gains and losses is important.

The Measurement Period

The measurement period allows the acquirer up to 12 months from the acquisition date to finalize the purchase price allocation. During this period:

  • Provisional amounts may be adjusted as new information is obtained about facts and circumstances that existed at the acquisition date.
  • Adjustments are retrospective – Prior periods presented are adjusted as if the revised amounts had been recorded at the acquisition date.
  • New information vs. new events – Only information about conditions that existed at the acquisition date qualifies for measurement period adjustments. Events occurring after the acquisition date (e.g., loss of a customer post-close) do not.

Practical Tips

  • Set a clear timeline for finalizing each component of the purchase price allocation. Intangible asset valuations, working capital true-ups, and contingent consideration valuations each have their own workstreams.
  • Maintain a measurement period log that tracks all provisional items, the status of each, and the expected completion date.
  • Communicate the measurement period timeline to your auditors at the outset to avoid surprises during the year-end audit.

Transaction Costs

Under ASC 805, acquisition-related costs (investment banking fees, legal fees, due diligence costs, and advisory fees) are expensed as incurred. This includes costs related to deals that are ultimately not consummated.

The one exception: costs of issuing debt or equity securities are accounted for under their respective standards (e.g., debt issuance costs are deferred and amortized; equity issuance costs are charged against the equity proceeds).

Pushdown Accounting

When an entity becomes substantially wholly owned (usually 95% or more), the acquiree may elect to apply pushdown accounting – reflecting the acquirer’s new basis of accounting (fair values) in the acquiree’s standalone financial statements. This is an election, not a requirement.

When Pushdown Accounting Makes Sense

  • The acquiree issues standalone financial statements to lenders or regulators who benefit from seeing the fair value basis.
  • The acquiree’s debt covenants reference standalone financial metrics that are more meaningful on a fair value basis.
  • Simplification of intercompany accounting and consolidation entries.

Common Challenges and How to Address Them

Challenge 1: Working Capital True-Ups

Most acquisition agreements include a purchase price adjustment for differences between estimated and actual working capital at closing. Track these adjustments carefully and determine whether they qualify as measurement period adjustments (most do) or represent post-combination events.

Challenge 2: Retention and Compensation Arrangements

Payments to selling shareholders who become employees of the acquirer must be evaluated to determine whether they are purchase consideration or post-combination compensation. Factors include whether the payments are contingent on continued employment, whether they are forfeitable, and whether the payment amounts are consistent with arm’s-length compensation.

Challenge 3: Indemnification Assets

The seller may indemnify the acquirer for certain pre-acquisition contingencies (e.g., tax exposures, litigation). The acquirer recognizes an indemnification asset measured on the same basis as the related indemnified item, subject to any contractual limits.

Challenge 4: Integration Costs

Costs incurred to integrate the acquired business (systems migration, facility consolidation, severance for redundant employees) are post-combination expenses, not purchase consideration. They are recognized in the periods incurred, consistent with the applicable accounting standards.

A Checklist for Day 1 Accounting

Use this checklist for every acquisition:

  • [ ] Determine whether the transaction is a business combination or asset acquisition
  • [ ] Identify the acquirer and the acquisition date
  • [ ] Measure total consideration transferred (including contingent consideration)
  • [ ] Identify and measure all tangible assets at fair value
  • [ ] Identify and measure all intangible assets at fair value
  • [ ] Measure assumed liabilities at fair value (including contingent liabilities)
  • [ ] Calculate deferred tax assets and liabilities on fair value adjustments
  • [ ] Evaluate pre-existing relationships for settlement
  • [ ] Calculate goodwill (or bargain purchase gain)
  • [ ] Classify contingent consideration as equity or liability
  • [ ] Evaluate replacement equity awards for purchase consideration vs. compensation allocation
  • [ ] Establish the measurement period tracking log
  • [ ] Prepare Day 1 journal entries and validate the opening balance sheet

Final Thoughts

Business combination accounting is among the most consequential work a finance team performs. The Day 1 balance sheet, once finalized, drives goodwill impairment testing, intangible asset amortization, and contingent consideration remeasurement for years. Getting it right requires close coordination among accounting, tax, valuation, legal, and the business unit. Establish a repeatable playbook, engage specialists early, and treat the measurement period as a rigorous process rather than a grace period.