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Fair Value Accounting & Its Role Post Merger Or Acquisition

Executive Summary: Fair value accounting plays a key role after an acquisition or merger. It can help you determine the worth of your target company’s assets and liabilities, not based on historical costs, but using the context of their current market worth. We’ll review the hierarchy you can use to calculate it, some examples of it in use, and the pros and cons to consider with using this method.

What Is Fair Value Accounting According To GAAP?

Put simply, it’s what you’d receive according to the current market conditions if you were to sell an asset or pay to transfer a liability at the given date you’re measuring. This is how it’s defined by both GAAP and IFRS. However, there are some differences between how fair value is applied between the two standards.

Fair value can help you report on assets like nonpublic entity securities, long-lived assets, and acquired goodwill assets, but not items like transaction costs or special synergies between buyer and seller. It’s also not synonymous with market value.

To illustrate, imagine you’re at an auction and a famous painting is listed for sale at $20K. That’s the current price tag of it, so you could consider this the market value of the item. However, say you’re an expert and knowing the artist’s works, you know it’s potentially worth more. 

Say that after you’ve bought it, you know a willing buyer would be willing to pay more to acquire it. You’re referencing factors like the price it sold at, the art market, and estimated pricing a willing buyer would pay, leading you to estimate its fair value is closer to $40K.

At its core, fair value considers what something is really worth based on all the surrounding factors. This is particularly important after an M&A transaction, because the financial statements need to show the full impact of the deal. This is valuable information for investors or management who need to evaluate its long-term success.

How Is Fair Value Calculated: The Fair Value Hierarchy

ASC 820-10-35-37 was created to establish a fair value hierarchy that increases consistency in how companies handle measuring fair value. Level one is the highest priority and three is the lowest, so you should work through them in that order based on the details you have.

Level 1: Look for an identical item.

At this step, you should try to find an exact item actively for sale on the market at the date you’re reporting.

Level 2: Rely on observable inputs.

If you can’t calculate fair value through the prior level, move on and use observable inputs you can gather aside from quoted prices. These can be directly or indirectly observable at the time you’re reporting. Use items like:

• Price-to-earnings ratio
• Quoted prices for similar items in an active or inactive market
• Market-derived valuation models (with inputs like interest rates, yield curves, credit spreads, and volatility)

It’s important to note that this level necessitates using more judgment and analysis.

Level 3: Use unobservable methods.

After running through prior steps, this is the last resort. It relies on pricing inputs that can’t be observed or validated by market data. Fair value becomes more subjective at this level and may involve more complex calculations.

Steps To Begin Fair Value Accounting

1. Identify all the assets and liabilities of the company you just acquired or merged with. Make sure to include intangible ones like property, equipment, inventory, trademarks, etc. You should also compile liabilities like accounts payable, long-term debt, and any contingencies
2. Next, work through valuing each asset and liability using the hierarchy above. Remember, use the most objective level possible.
3. After you’ve assessed each item on your list, record the impact of this new M&A on your financials and make sure they reflect what you’ve uncovered from this process.

How Do Fair Value & Hedge Accounting Work Together?

Hedge accounting can help manage the risk of uncertainty and volatility that can come with fair value accounting. Your decision to use it will hinge on your company’s risk management strategy and if you meet the criteria for hedge accounting. (That criteria is the ASC 815 or IFRS 9 financial instruments depending on which standards you follow.)

If you are you’ll likely rely on:

• Fair value hedges
  • This helps offset any changes in the fair value of an asset or liability. The gains and losses on the hedged instrument and item are recognized on your income statement in the same period.
• Cash flow hedges
  • These help hedge against changes in cash flow from an existing asset or liability. This is reported in other comprehensive income (OCI) until the hedged transaction has an effect on earnings. Anything that’s ineffective is recognized on the income statement.
• Net investment hedges
  • This helps if you’ve made an investment in a foreign organization where you’re dealing with multiple currencies and fluctuations between them. It’s recognized in OCI as well during the cumulative translation adjustment period.

Hedge accounting can become complex. If your team needs more guidance, consider working with an advisor who can ensure you’re compliant and taking the right steps.

Historical Cost Accounting vs Fair Value

While fair value accounting is important, historical cost accounting still has its place too. Many companies will use both, for example leaning into historical costs for property, plant, and equipment. Below, we’ve broken down some considerations when you’re deciding whether to incorporate it.

Examples Of Fair Value Accounting

Property
Say your business purchased land for $600,000 several years ago, but an appraiser is saying it’s valued at $850,000 now. Using fair value accounting, you’d adjust the land’s value to $850,000. Whereas the historical method would keep it at $600,000 until the land is sold.

Company Vehicle(s)

Say that you acquired a company with a fleet of work vehicles, valued at $20,000 each when they were first bought. Using fair value accounting, you could assess their worth today based on the current state of the cars and the market, averaging the value of similar used trucks.

Equipment

Say you’ve merged with another manufacturing company. You’ll need to assess the fair value of their equipment, which involves looking at the assets’ condition, remaining lifespan, and current market prices of similar assets. If the fair value exceeds book value, your company has a gain. But if the fair value is lower, you’ll need to count this as an impairment loss on your financials.

Goodwill

Say after you’ve purchased a business, the market value declines significantly. You need to do impairment testing on goodwill to assess if its value has been reduced. If you find goodwill is impaired, that will need recording and it will affect your earnings.

Pros & Cons Of Fair Value Accounting

Here are a few considerations to keep in mind as you begin understanding the financial impact of your recent transaction.

Looking for a partner who can help you navigate your accounting post transaction? Reach out to our experts to see how we can support you.

Maxwell B. Heller

Managing Director | M&A Advisory Practice Leader

Max is a Managing Director at Centri Business Consulting and the leader of the firm’s M&A Advisory Practice. He has more than 20 years of merger and acquisition consulting experience and provides M&A advisory services to private equity firms, venture capital firms, family offices, and strategic/corporate clients. View Maxwell B. Heller's Full Bio