Effects of Non-Compliance of ASC 805 or IFRS 3

Financial Accounting Standard (FAS) 141 was first implemented in 2001. It is now codified as ASC 805, Business Combinations. Business combinations mean the acquisition of one company by another. They play a significant role in shaping the corporate landscape. Accounting standards, such as Accounting Standards Codification (ASC) standard 805 (U.S. GAAP) or International Financial Reporting Standards (IFRS 3), provide guidelines on how to account for these transactions. In this article, the potential impact of non-compliance with these guidelines is explored. Furthermore, the importance of adhering to these standards from multiple points of view is highlighted.

Understanding ASC 805 and IFRS 3

ASC 805 and IFRS 3 are accounting standards that show us how to account for business combinations. ASC 805 is applicable under U.S. GAAP, whereas IFRS 3 is used in jurisdictions that follow international financial reporting standards.

Both standards aim at improving transparency and comparability in financial reporting.

Purchase Price Allocation explained

One important aspect of these standards is purchase price allocation (PPA). PPA is related to the acquired assets and liabilities. It helps assign fair value of assets (tangible and intangible) acquired and liabilities assumed in a business combination.

This process allows accurate recognition of the acquired company's assets, liabilities, and goodwill in the financial statements of the purchasing company.

PPA requires a detailed analysis of the fair value of tangible and intangible assets. These include important intangible assets such as customer relationships, developed technology/software, patents, and trademarks.

The Impact of Non-Compliance

Companies must comply with the said accounting standards. Compliance is important for accurate financial reporting and transparency. However, non-compliance with ASC 805 or IFRS 3 can have a substantial impact on companies.

The consequences are particularly severe if the companies involved in business combinations do not present a proper PPA. 

1. Inaccurate financial statements

• Failure to comply with PPA requirements can lead to presenting wrong information in financial statements which may, in turn, lead to incorrect assessment of assets and liabilities of the Company.
• This can mislead investors, creditors, and other stakeholders. Hence, inaccurate financial information can hamper a company's ability to attract new investors, especially institutional investors and lenders, as they often conduct due diligence on a company's financial statements to assess its creditworthiness and risk profile. Non-compliance can raise red flags and deter potential investors or lenders from providing capital.

2. Faulty decision-making

• Non-compliance can hinder management’ and stakeholders’ decision-making
• Assessing the financial impact of the business combination without accurate and transparent information on the acquired company's assets, liabilities, and goodwill is difficult as the incorrect financial information may distort key valuation metrics, such as earning per share (EPS), return on equity (RoE) or price-to-book (P/B) ratio, leading to sub-optimal decisions regarding allocation of resources in future.

3. Lack of consistency and standardization

• Compliance with global accounting standards ensures consistency and standardization across different entities.
• Non-compliance can affect the ability to compare financial statements of businesses involved in business combinations
• Investors and stakeholders could find it difficult to accurately assess the performance and value of the combined entity.

4. Regulatory and legal implications

• Non-compliance with accounting standards can lead to regulatory scrutiny and legal consequences
• Companies that fail to adhere to ASC 805 or IFRS 3 requirements could face fines or penalties. In April 2014, the Securities and Exchange Commission (SEC) charged CVS Caremark Corp. with misleading investors by failing to disclose financial setbacks and using improper purchase price allocation accounting which artificially boosted its financial performance. In another case, the SEC charged DXC Technology, an information technology services company, with making misleading disclosures about non-GAAP financial performance from 2018 until early 2020 and imposed an $8 million penalty.
• According to Cornerstone Research, number of enforcement actions involving accounting and auditing enforcement initiated by the SEC in FY 2022 increased 55% from FY 2021, and the number of actions relating to announced restatements or material control weaknesses was the highest the SEC initiated in recent years.
• Non-compliance may raise suspicions of fraudulent reporting. This can lead to investigations and damage to the company's reputation.
• Non-compliance may also present a wrong estimate of the cost of integrating the acquired company due to adjustments pertaining to changes in legal entities, reporting requirements, risk mitigation or quality standards might not be accounted appropriately for the business combination.

5. Impact on shareholder value

• Investors rely on transparent and reliable financial statements to assess the value of their investments. Inaccurate reporting because of non-compliance can lower investor confidence. This can reduce share prices and potential shareholder lawsuits.
• Stakeholders may see non-compliance as a lack of commitment to ethical business practices and corporate governance.

6. Reputational damage

• In today's interconnected world, news spreads rapidly. Negative publicity can have an adverse impact on organization's brand and corporate image.
• Legal battles can be time-consuming and may result into unforeseen liabilities for the company.
• Reputational damage can lead to decreased customer loyalty, difficulties in attracting and retaining top talent, strained relationships with business partners and untimely resignation of statutory auditors.

Importance of compliance

Compliance with ASC 805 or IFRS 3 is vital for several reasons:

1. Transparency and accountability
2. Improved investor confidence
3. Enhanced comparability
4. Adherence to regulatory requirements

Conclusion

Non-compliance with ASC 805 or IFRS 3 can have several major consequences for companies involved in business combinations. This is especially true in terms of neglecting proper PPA.

Companies must recognize the significance of PPA and allocate sufficient resources and expertise to ensure compliance.

Non-compliance with accounting standards can lead to inaccurate financial statements and faulty decision-making..

Compliance increases trust, allows correct decision-making, and helps build a strong financial foundation for successful business combinations in today's global marketplace.

Businesses must allocate adequate resources, implement effective internal controls, and seek professional guidance to ensure compliance with these accounting standards. This will help companies safeguard their reputation, maintain stakeholder trust, and make well-informed business decisions based on accurate financial information.

Professional corporations like Aranca can help organizations understand and comply with these regulatory standards. Aranca has extensive experience in PPA engagements globally, handing US GAAP and IFRS financial reporting compliance.