Accounting for Business Acquisition Using Purchase Method

 

In brief, a business acquisition, from the accounting standpoint, is a transaction in which both the acquiring and acquired company are still left standing as separate entities at the end of the transaction. If the acquiring company spreads the acquisition price over the assets being bought at their fair market value, with any remaining portion of the acquisition price being recorded in a goodwill account, the “purchase method” is used to account the transaction. So, how do you account transaction of a business acquisition using purchase method?

This post provides you with step-by-step guide on how to account transaction of business acquisition using purchase method.

There are three primary steps involved on the accounting for business acquisition using purchase method.

Step-1. Determine the Purchase Price

How do you determine the purchase price? You would determine purchase value based on fair market value. For example:

• If the purchase is made with stock, the stock must be valued at its fair market value.
• If treasury stock is used as part of the consideration, then this must also be valued at its fair market value.
• If the buyer’s stock is thinly traded or closely held, then it may be necessary to obtain the services of an investment banker or appraiser, who can use various valuation models and industry surveys to derive a price per share.

Step-2. Allocate Price Among the Various Assets of the Company Being Purchased

The second step in the purchase method is to allocate the purchase price among the acquired company’s assets and liabilities, which are then recorded in the buyer’s accounting records.
The main issue on the second step is that the method of valuation varies by line item on the acquired company’s balance sheet. Here are the key valuation rules:
1. Accounts Receivable – Record A/R at its present value, less the allowance for bad debts. For example, if present value of the A/R is $250,000 with $5000 bad debt allowance sitting underneath, then the value of the A/R is 245,000. Given the exceedingly short time frame over which the A/R is outstanding, there is generally no need to discount this valuation, unless there are receivables with very long collection terms. Also, since the acquisition transaction is generally not completed until several months after the acquisition date (given the effort required to make the accounting entry), the amount of the allowance for bad debts can be very precisely determined as of the acquisition date.
2. Marketable Securities – You would record marketable securities at their FAIR MARKET VALUE. If you are under the U.S jurisdiction, this could be an opportunity for the buyer to mark up a security to its fair market value (if such is the case)—since the GAAP normally only allows for the recognition of reductions in market value. For this reason, this is an area in which there is some opportunity to allocate an additional portion of the purchase price beyond the original cost of the asset. However, since most companies only invest in short-term, highly liquid securities, it is unlikely that there will be a large amount of potential appreciation in the securities.
3. Inventory—Raw Materials – You would record raw material inventories at their REPLACEMENT COST. Though, this can be a problem if the acquiree is in an industry, such as computer hardware, where inventory costs drop at a rapid pace as new products rapidly come into the marketplace. Consequently, the buyer may find itself with a significantly lower inventory valuation as a result of the purchase transaction than originally appeared on the accounting records of the acquiree.
4. Inventory—Finished Goods – You would record FG inventories at their SELLING PRICE, less their AVERAGE PROFIT MARGIN + DISPOSITION COSTS. This can be a difficult calculation to make, though, if the finished goods have variable prices depending upon where or in what quantities they are sold—in such cases, the determination of selling price should be based on a history of the most common sales transactions. For example, if 80% of all units sold are in purchase quantities that result in a per-unit price of $1.50, then this is the most appropriate price to use.

Note: The above rule can be avoided if the acquiree has firm sales contracts as of the date of the acquisition with specific customers that can be used to clearly determine the prices at which the finished goods will actually be sold.

5. Inventory—Work-In-Process – You would record WIP inventories by using the same valuation treatment as finished goods, except that the cost of conversion into finished goods must also be subtracted from their eventual sale price.
6. Property, Plant, and Equipment (PP&E) – You would record PP&Es at their REPLACEMENT COST. This can be a difficult task that lengthens the interval before the acquisition journal entry is completed, because some assets may be so old that there is no equivalent product currently on the market, or equipment may be so specialized that it is difficult to find a reasonable alternative on the market. This valuation step frequently calls for the services of an appraiser.
7. PP&E to be Sold – If buyer intends to sell off assets as of the acquisition date, then these assets should be recorded at their FAIR MARKET VALUE. This most accurately reflects their disposal value as of the acquisition date.
8. Capital Leases – If the acquiree possesses assets that were purchased with capital leases, then you would value the asset at its FAIR MARKET VALUE, while valuing the associated lease at its NET PRESENT VALUE.
9. Research and Development Assets (R&D) – If any assets associated with specific R&D projects are part of the acquiree, you would then charge the R&D assets off to expense if there is no expectation that they will have an alternative future use once the current R&D project has been completed. The precise allocation of assets to expense or asset accounts can be difficult, though, since the existing projects may be expected to last well into the future, or the future use of the assets may not be easy to determine. Consequently, one should carefully document the reasons for the treatment of R&D assets.
10. Intangible Assets – You would record intangible assets at their APPRAISED VALUES. If the buyer cannot reasonably assign a cost to them or identify them, you would then assign no cost.
11. Accounts and Notes Payable – You can typically record A/P at their CURRENT AMOUNTS as listed on the books of the acquiree. However, if the A/Ps are not to be paid for some time, you would then record them at their DISCOUNTED PRESENT VALUES. The same logic applies to notes payable; since all—but the shortest-lived notes—will have a significantly different present value, they should be discounted and recorded as such. Note, however, that this treatment is used on the assumption that the buyer would otherwise be purchasing these liabilities on the date of the acquisition, not on a variety of dates stretching out into the future, and so must be discounted to show their value on the acquisition date.
12. Accruals – Accruals are fall under the short-term (or current) liabilities. These liabilities are typically very short-term ones that will be reversed shortly after the current accounting period. Accordingly, they are to be valued at their PRESENT VALUE (discounting is rarely necessary).
13. Pension Liability – If there is an unfunded pension liability, even if not recognized on the books of the acquiree, it must be recognized by the buyer as part of the purchase transaction.
14. Stock Option Plan (SOP) – If the buyer decides to take over an existing stock option plan of the acquiree, then it must allocate part of the purchase price to the incremental difference between the price at which shares may be purchased under the plan and the market price for the stock as of the date of the acquisition. However, if the buyer forced the acquiree to settle all claims under the option plan prior to the acquisition, then this becomes a compensation expense that is recorded on the books of the acquiree.

The company being purchased can be bought with any form of consideration, such as stock, cash, or property.

Let’s construct a case example:
Lie Dharma Corporation acquires Robinson Ma Corporation by spreading the acquisition price over the assets being bought at their fair market value—with any remaining portion of the acquisition price being recorded in a goodwill account, so we use purchase method for the case.
If the acquiring company (Lie Dharma Corporation) buys the acquiree’s (Robinson Ma Corporation) stock with $500,000 of cash, the entry on Lie Dharma’s books would be:
[Debit]. Investment in Robinson Ma Corporation = $500,000
[Credit]. Cash = $500,000
Alternatively, if Lie Dharma were to make the purchase using a mix of 20% cash and 80% for a note, the entry would be:
[Debit]. Investment in Robinson Ma Corporation = $500,000
[Credit]. Cash = $100,000
[Credit]. Note payable = $400,000
Another approach would be to exchange 5,000 shares of Lie Dharma’s $1 par value stock for that of Robinson Ma as a form of payment. Under this method, the entry would be:
[Debit]. Investment in Robinson Ma Corporation = $500,000
[Credit]. Common stock—par value = $ 5,000
[Credit]. Common stock—additional paid-in capital = $495,000
The result of all the preceding valuation rules is shown below—where I show the calculation that would be required to adjust the books of an acquiree in order to then consolidate it with the results of the acquiring company:

The above table shows the initial book cost of each account on the acquiree’s balance sheet, followed by a listing of the required valuation of each account under the purchase method, the adjustment required, and the new account valuation. The new account valuation on the right side of the table can then be combined directly into the records of the acquiring company.
Note, under the “Purchase Method Valuation” column, that:

• a designation of “NPV” means that the net present value of the line item is shown,
• a designation of “FMV” means that the fair market value is shown (less any costs required to sell the item, if applicable)
• “RC” designates the use of replacement cost
• “SLM” designates the use of sale price less the gross margin
• “AV” designates an asset’s appraised value.

In the above table, debits and credits are specified for each adjusting entry listed in the “Required Adjustment” column.
The amount of goodwill shown in the “Required Adjustment” column is derived by subtracting the purchase price of $15,000 from the total of all fair market and other valuations shown in the “Purchase Method Valuation” column. In this case, we have a fair market valuation of $18,398 for all assets, less a fair market valuation of $8,075 for all liabilities, which yields a net fair market value for the acquiree of $10,323. When this fair market value is subtracted from the purchase price of $15,000, we end up with a residual of $4,677, which is listed in the goodwill account.
Please note that the “Adjusted Acquiree Records” column on the right side of the table still must be added to the acquirer’s records to arrive at a consolidated financial statement for the combined entities.

Step-3. Account for the First Year Partial Results of the Purchased Entity

The third step in the acquisition process is to account for the first year partial results of the acquired company on the buyer’s financial statements. Here the rules of thumb:

• Only the income of the acquiree that falls within its current fiscal year, but after the date of the acquisition, should be added to the buyer’s accounting records.
• The buyer must charge all costs associated with the acquisition to current expense—they cannot be capitalized. These acquisition costs should be almost entirely for outside services, since any internal costs charged to the acquisition would likely have been incurred anyway, even in the absence of the acquisition.
• The only variation from this rule is the costs associated with issuing equity to pay for the acquisition; these costs can be recorded as an offset to the additional paid-in capital account.
• An additional item is that a liability should be recognized at the time of the acquisition for any plant closings or losses on the dispositions of assets that are planned as of that date; this is not an expense that is recognized at a later date, since we assume that the buyer was aware at the purchase date that some asset dispositions would be required.
• If the acquirer chooses to report its financial results for multiple years prior to the acquisition, it does not report the combined results of the two entities for years prior to the acquisition.

A reverse acquisition is one in which the company issuing its shares or other payment is actually the acquiree, because the acquiring company’s shareholders do not own a majority of the stock after the acquisition is completed. Though rare, this approach is sometimes used when a shell company with available funding buys an operating company, or when a publicly held shell company is used to buy a non-public company, thereby avoiding the need to go through an initial public offering (IPO) by the non-public company. In this case, the assets and liabilities of the shell corporation are revalued to their fair market value and then recorded on the books of the company being bought.

If you are an accountant, your main interest in your company’s merger and acquisition activities is how to account for the transactions. The main approach you would use probably is the purchase method, which has been described on this post. An alternative is the pooling of interests method, however, the FASB is continually reviewing the need for this method, and was close to eliminating it as of I made this post. The IASB has prohibited the use of pooling of interest method, completely.
There are also many situations in which a company merely makes a small investment in another company, rather than making a big and outright purchase. This requires three possible types of accounting—depending upon the size of the investment and the degree of control attained over the subject company—which are: the cost method, equity method, and consolidation method, I would plan to discuss on the coming post, one-by-one.