Mergers and acquisitions (M&A) provide growth opportunities. But these transactions also introduce accounting complexities. Here’s a closer look at the rules for reporting business combinations under U.S. Generally Accepted Accounting Principles (GAAP). Getting it right is essential to managing stakeholder expectations and providing a solid foundation for future financial reporting.

Breaking down the purchase price

Accounting Standards Codification Topic 805, Business Combinations, requires a buyer to allocate the purchase price to all acquired assets and liabilities based on their fair values. This process begins by estimating a cash-equivalent purchase price.

If a buyer pays 100% cash up front, the purchase price is already at a cash-equivalent value. But it’s less clear if a seller accepts noncash terms, such as an earnout contingent on the acquired entity’s future performance or stock in the newly formed entity.

The next step is to identify all tangible and intangible assets and liabilities acquired in the business combination. The seller’s presale balance sheet will usually report most tangible assets and liabilities, including inventory, equipment and payables. However, intangibles are reported only if the seller previously purchased them. Most intangibles are generated in-house, so they’re rarely included on the seller’s balance sheet.

Allocating value to acquired assets and liabilities

Acquired assets and liabilities are then added to the buyer’s balance sheet, based on their fair values on the acquisition date. Determining fair value can require significant judgment, particularly when valuing intangible assets. In some cases, buyers engage valuation specialists to assist with the process. The difference between the sum of these fair values and the purchase price is reported as goodwill.

Acquired identifiable intangible assets — such as customer lists, noncompete agreements and certain technology assets — are amortized over their estimated useful lives. As a result, purchase price allocation decisions can affect future earnings and other key financial metrics.

Goodwill and other indefinite-lived intangibles — such as brand names and in-process research and development — usually aren’t amortized under GAAP. Instead, companies generally must test goodwill for impairment annually. Impairment testing may also be necessary when certain triggering events occur. Examples of triggering events include the loss of a major customer or the enactment of unfavorable government regulations. If a business reports an impairment loss, it may indicate that the acquisition hasn’t delivered the expected economic benefits or that business conditions have changed since the transaction closed.

Rather than test for impairment, private companies may elect to amortize goodwill on a straight-line basis, generally over 10 years. However, companies that elect this alternative method must still test for impairment when certain triggering events occur.

In rare instances, a buyer negotiates a bargain purchase. Here, the fair value of the net assets exceeds the fair value of the consideration transferred (the purchase price). Rather than recognizing negative goodwill, the buyer reports a gain on the income statement.

Why post-deal accounting matters

The rules for reporting M&A transactions are complex and can sometimes have unexpected effects on a buyer’s financial statements. Accurate purchase price allocations are essential for reliable post-deal financial reporting and reducing future adjustments and restatements. Contact us for guidance on accounting for business combinations and subsequent testing for goodwill impairment.

For many businesses, inventory is one of the largest and most expensive assets to maintain. Beyond the cost of purchasing goods, businesses incur ongoing expenses related to storage, labor, insurance, transportation, obsolescence, depreciation and shrinkage. Excess inventory can also tie up cash that you could otherwise use to fund growth initiatives or other operational priorities. Here are two supply chain approaches that may help reduce inventory carrying costs, improve cash flow and enable a more efficient response to changes in customer demand.

1. JIT inventory management

Under the just-in-time (JIT) approach, a business plans shipments of raw materials to arrive just before they’re required for production or fulfillment. This reduces the amount of inventory on hand — and the associated carrying costs. It also increases production responsiveness and flexibility. Elements of this approach include:

Small lot sizes. This allows the business to be more flexible and adapt more quickly to changes in market demand. It can also decrease inventory cycle time, lead times and pipeline inventory. Because lot sizes are smaller, businesses that use this approach can achieve more consistent workflows.

Tight set-up times. By reducing equipment set-up times and the associated costs, a business can afford to produce smaller lot sizes. In addition, the business can avoid lengthy or inefficient set-up processes, which may discourage frequent product changeovers and reduce operational agility.

Workforce flexibility. A flexible workforce can quickly shift responsibilities and resources during bottlenecks or unplanned spikes in demand.

Strong supplier relationships. Suppliers must provide frequent, on-time deliveries of high-quality materials. So, close ties with them are vital to this approach. Long-term relationships with suppliers promote loyalty and improved overall quality.
Regular maintenance schedules. For operations with a high degree of automation, preventive maintenance is critical. Unplanned downtime can be disruptive and costly.

Quality control. JIT systems are designed to control quality at the source, rather than later in the process. For that reason, production workers are responsible for their own work, and if a defective unit is discovered, it’s returned to the area where the defect occurred. This makes employees accountable and empowers them to produce higher-quality products.

JIT can reduce carrying costs and improve efficiency. However, it hinges on having a reliable supply chain. Delays, shortages and other disruptions can adversely affect sales and customer satisfaction when inventory levels are kept low.

2. Accurate response inventory management

While JIT focuses on minimizing inventory levels, the accurate response approach tries to match inventory levels to customer demand. This approach can be particularly useful for seasonal products and items with unpredictable demand because it helps reduce excess inventory and minimize stockouts. However, it requires timely sales and inventory data, demand forecasting capabilities, flexible production processes and shorter replenishment cycles.

The accurate response approach begins with an initial forecast of customer demand, which helps management determine how much inventory to produce or purchase. Then management monitors actual sales and uses that information to adjust inventory levels. That way, the business carries more high-demand products and limits its investment in slower-moving items.

Find the right fit

There’s no one-size-fits-all approach to inventory management. The most effective system depends on your business’s products, supply chain, customer expectations and operating model. Contact us to help assess your current inventory management processes and identify opportunities to improve cash flow and operational efficiency.

Persistent inflation, elevated interest rates and volatile energy costs continue to squeeze profit margins for many small and midsize businesses. While implementing price increases may seem like the simplest response, that’s not always necessary — and, in today’s competitive markets, price increases can even cause some of your customers to search for lower-cost providers. Sustainable pricing decisions start with disciplined cost controls. One broad area to target for operational inefficiencies is overhead expenses.

Learn what counts as overhead

Overhead costs are a part of every business. These accounts frequently serve as catch-alls for any expense that can’t be directly tied to revenue-generating activities, including:

• Equipment maintenance and depreciation,
• Rent and building maintenance,
• Administrative and executive salaries,
• Insurance, and
• Utilities.

These are sometimes called indirect costs because they support your operations as a whole. Generally, these costs are fixed over the short run, meaning they won’t change appreciably as your revenue ebbs and flows. However, some overhead costs can rise with increased activity levels, energy usage or staffing demands.

For many small businesses, overhead grows gradually over time. And, because it isn’t directly tied to a single product, job or service, you may underestimate how much these costs affect your overall profitability.

Choose an allocation method that fits your business

The key to controlling overhead — and unlocking hidden profit potential — lies in allocating these costs to your products, services, projects or clients. Overhead allocations are typically associated with manufacturers. But a thoughtful approach, even if it’s informal, can help many businesses evaluate profitability. For instance, construction companies can assign equipment, supervision and office expenses to projects, restaurants can assign operating costs across menu items or locations, and professional service firms can assign administrative costs across client engagements.

The challenge is deciding how to allocate these costs using a relevant overhead rate. The rate is typically determined by dividing estimated overhead expenses by estimated totals in the allocation base (for example, direct labor hours) for a future time period. Then you multiply the rate by the actual number of direct labor hours for each product, project or service line to determine the amount of overhead to apply.

In some businesses, the rate is applied across all products. But if your operations are more complex, you may use multiple overhead rates to allocate costs more accurately. If one department is machine-intensive and another is labor-intensive, for example, multiple rates may be appropriate. In some situations, activity-based costing methods can improve accuracy by assigning overhead to activities that drive costs, such as machine setups, shipping volume or employee time supporting clients.

Cost allocations provide insight into which customers, services or business segments are the most profitable. This can help you identify underperforming products or services, evaluate expansion opportunities and make better-informed pricing decisions.

Review overhead regularly

There’s one problem with accounting for overhead costs: Variances from actual costs are almost certain. Fortunately, you can reduce the chance of overhead anomalies and improve the reliability of your financial reporting by:

• Conducting independent reviews of adjustments to overhead accounts,
• Studying significant overhead adjustments over different periods of time to spot anomalies, and
• Evaluating your existing overhead allocation methods and updating them when needed.

Allocating costs more accurately won’t guarantee that you make a profit. However, it can provide a stronger foundation for planning and budgeting.

You should also periodically revisit allocation assumptions as labor costs, supply chain expenses, technology investments and business operations evolve. Allocation methods that worked several years ago may no longer be relevant for your current operations.

Need guidance?

Accurate overhead allocation can provide valuable insight into profitability, pricing and operational efficiency. We can help you evaluate your current costing methods, strengthen internal controls and develop practical strategies to manage rising expenses. Contact us to learn more.