Understanding Purchase Acquisition Accounting: Definition & Process

What Is Purchase Acquisition Accounting?

When another company acquires a company, the purchase is recorded using the purchase acquisition accounting method. It requires the acquiring company to report the target’s assets and liabilities at fair market value on its consolidated balance sheet, treating the deal as an investment rather than pooling assets.

If the purchase price exceeds the net fair value of those assets and liabilities, the difference is recorded as goodwill, which reflects intangible value like brand or customer relationships. Goodwill is tested annually for impairment. Also known as business combination accounting, this approach became the required standard after major updates in the late 2000s.

Understanding the Mechanics of Purchase Acquisition Accounting

Purchase acquisition accounting is a set of guidelines for recording the purchase of a company on the consolidated statements of financial position of the company that buys it. When a company acquires another, purchase acquisition accounting requires it to:

1. Measure all acquired assets and liabilities, including both tangible and intangible, at fair market value on the acquisition date.
2. Recognize goodwill if the purchase price exceeds the fair value of the net identifiable assets.
3. Incorporate these values into its consolidated financial statements.

This method helps provide a clear and realistic picture of what the acquiring company is getting, based on what an independent third party would pay for those assets in an open market. It enhances transparency for investors and regulators.

Example: If Company A acquires Company B and pays $50 million, but Company B’s net assets (fair value of assets minus liabilities) total only $40 million, the $10 million difference is recorded as goodwill on Company A’s balance sheet.

Exploring Alternative Accounting Methods

If the business combination is not a strict takeover of one company by another, then other methods of accounting are allowed. Pooling of interest or merger accounting may be allowed by FASB or the IASB.

For instance, if the companies are under common control and interests are pooled between the acquirer and the target, all assets and liabilities of the acquirer and target are netted using their book value. No goodwill results from the purchase transaction. Since there is no goodwill to write off, this can result in higher future earnings for the newly formed entity.

When the acquirer uses the acquisition accounting method, the target is treated as an investment. The target's assets and liabilities are netted using current fair market value and if the amount paid for the target is greater than that netted value, the difference is considered as goodwill.

Because goodwill must be written off against future earnings, this can reduce the future earnings of the entity.

How the Concept Has Evolved

The concept of purchase acquisition accounting was introduced in 2007 and 2008 by the major accounting authorities, the Financial Accounting Standards Board (FASB), and the International Accounting Standards Board (IASB). It replaces the previous method, known as purchase accounting.

Acquisition accounting was preferred because it strengthened the concept of fair market value at the time of a transaction. It also adds accounting for contingencies and non-controlling interests, which were not considered under the previous method.

It treats the target firm as an investment. There is no pooling of assets.

The Bottom Line

Purchase acquisition accounting is the standard for recording mergers and acquisitions, offering a transparent and market-based view of what the acquirer gains. By using fair market values and accounting for goodwill, it ensures the acquiring company’s financial statements reflect the true economic cost and value of a business combination.

While it can reduce future earnings due to potential goodwill impairments, the method improves comparability and accuracy, which are key goals in modern financial reporting.