New Financial Reporting Rules will Simplify Accounting on Some Transactions
By Corey Fischer, CPA
After what seemed an endless flow of new accounting rules that have made the audits of micro and small cap companies more complex and difficult, the Financial Accounting Standards Board (“FASB”) has updated two areas of accounting that may offer reporting relief for micro and small cap companies.
Recently, the FASB simplified accounting requirements for companies that issue equity-linked financial instruments (e.g. convertible debt or convertible preferred stock, or warrants) with down round features, which will substantially reduce the number of derivative liability instruments that have become commonplace on the balance sheet of small cap companies. The FASB also narrowed the definition of a business, providing a new framework for making reasonable judgments about whether a transaction involves an asset or a business. This is important because it should simplify the accounting for certain acquisitions that were formerly considered a “business”.
Determining Derivative Liabilities
Under current Generally Accepted Accounting Principles (“GAAP”), when an equity-linked financial instrument with down round features is issued, the embedded conversion feature is usually required to be separated and recognized as a derivative liability, with changes in the fair value of the derivative recorded in earnings each reporting period, making the measurement of these derivatives complex and costly. In addition, many users of financial statements have suggested that this accounting does not reflect the true economics of a down round feature, and that the volatility in earnings caused by the change in the fair value of derivatives is inconsequential to most readers.
The FASB update will allow companies to exclude a down round feature when determining if a financial instrument (or embedded conversion feature) should be recorded as a derivative. Companies will instead recognize the value of the down round feature when it is triggered (that is, when the strike price has been reduced). This is great news as it now will eliminate one of the most complicated, and some will say most distortive, aspect of accounting currently faced by companies.
While some of the analysis required under current accounting will be eliminated, preparers will still be required to perform detailed analysis to determine if instruments are to be classified as equity or liabilities (e.g. sufficient authorized shares, fundamental transaction clauses, etc.).
Definition of a business clarified
This FASB change affects the definition of acquisitions, disposals, goodwill, and consolidation. Generally, in an acquisition of a business, assets and liabilities acquired are recorded at fair value and goodwill is recognized for any excess consideration. Assumed contingencies are typically recognized and measured at fair value. In an asset acquisition, the acquired asset is recorded at cost, goodwill is not recognized, and contingencies assumed are recorded only if probable.
In January 2017, the FASB narrowed the definition of a business and provided a new framework for making reasonable judgments about whether a transaction involves the acquisition of an asset or a business. FASB clarifies that when substantially all the fair value of the gross assets acquired (or disposed of) is concentrated in a single identifiable asset or a group of similar identifiable assets, the set is not a business. The new rule also requires that a set (of assets and activities) cannot be considered a business unless it includes, at a minimum, an input and a substantive process that together significantly contribute to the ability to create output.
This change to the definition of a business is likely to result in more acquisitions being accounted for as asset acquisitions in all industries. This is extremely important as it makes the accounting for these types of transactions much simpler. It could also eliminate the costly expense of employing an outside valuation firm in assisting with the purchase price allocation in recording the initial purchase, and also could eliminate the need for continuing impairment testing of the acquired goodwill and intangibles going forward that is required under the old rules.
One potential issue worth noting is that the SEC definition of a business is not affected by the change in the FASB’s definition of a business. An asset purchase under GAAP that is deemed a business by the SEC may require the company making the acquisition to submit past audited financial statements of the “business” in a Form 8-K, whereas if it were an acquisition of an asset, audited financial statements may not be required. It remains to be seen if the SEC will adopt the same position as the FASB. If it does, this may significantly reduce the need for the costly presentation of prior year audited financial statements of the acquired asset.
Accounting and disclosure rules are complex, cumbersome and often difficult in application. Please consult experienced auditors or consultants before entering into transactions.
Corey Fischer, CPA, is Firm Managing Partner of Weinberg & Company, a multi-office, PCAOB and CPAB-Registered firm specializing in the audit, assurance and tax needs of micro and small cap companies. He has more than 25 years of experience, having worked with the Big 4 accounting firms, and as an SEC reporting officer for a number of NASDAQ-listed companies. Based Los Angeles, he is an expert in financial reporting, SEC compliance, raising debt and equity, mergers and acquisitions and structuring accounting operations. E-mail: firstname.lastname@example.org or 310-601-2200.