The Purchase Method is an accounting technique employed primarily in the United States for recording business combinations. It involves the allocation of cash, other assets, or incurring liabilities to acquire a company. This method is utilized when specific criteria for the pooling-of-interests method are not satisfied.
Historical Context
The Purchase Method emerged as a response to the need for a standardized accounting approach to reflect the fair market value of acquired companies. Historically, it replaced the pooling-of-interests method in many jurisdictions due to the latter’s less rigorous requirements for recording business combinations.
Types/Categories
There are primarily two methods to account for business combinations:
- Purchase Method: Involves recognizing assets and liabilities at fair market value and recording any excess purchase price as goodwill.
- Pooling-of-Interests Method: Combines the book values of the two companies without recognizing any goodwill or fair value adjustments (now largely obsolete).
Key Events
- FASB Statement No. 141 (2001): Mandated the use of the Purchase Method for all business combinations.
- IFRS 3 (2004): Adopted a similar approach internationally, reinforcing the method’s global importance.
Detailed Explanations
Under the Purchase Method, the acquiring company must:
- Identify the Acquirer: The entity that gains control of another entity.
- Determine the Acquisition Date: The date when the acquirer effectively gains control.
- Recognize and Measure Identifiable Assets and Liabilities: At fair value.
- Calculate Goodwill: Any excess of the purchase price over the fair value of identifiable net assets.
Mathematical Formula
Goodwill Calculation:
Charts and Diagrams
graph TD;
A[Acquiring Company] -->|Acquisition| B[Target Company];
B --> C{Assets};
B --> D{Liabilities};
C -->|Fair Value| E[Acquirer's Books];
D -->|Fair Value| E[Acquirer's Books];
E --> F[Goodwill];
F -->|Recognition| G[Balance Sheet];
Importance
The Purchase Method ensures transparency by recording acquired companies’ assets and liabilities at their true economic value, providing investors and stakeholders with accurate information.
Applicability
Used in scenarios where a company takes over another company by purchasing its net assets or shares. It is critical in mergers and acquisitions (M&A) accounting.
Examples
- Example 1: Company A acquires Company B for $1 million. The fair value of Company B’s net assets is $800,000. The goodwill recognized would be $200,000.
- Example 2: Company X purchases Company Y. The total purchase price is $5 million, and the fair value of Company Y’s identifiable assets is $4.5 million, leaving $500,000 as goodwill.
Considerations
- Regulatory Requirements: Must comply with GAAP or IFRS standards.
- Fair Value Measurement: Determining fair values can be complex and requires professional judgment.
- Goodwill Impairment: Regular testing of goodwill for impairment is necessary.
Related Terms with Definitions
- Fair Value: An estimate of the market value of an asset or liability.
- Goodwill: An intangible asset representing the excess purchase price over the fair value of identifiable net assets.
- Acquirer: The company that gains control over another entity in a business combination.
- Impairment Testing: Assessing whether the carrying amount of an asset exceeds its recoverable amount.
Comparisons
- Purchase Method vs. Pooling-of-Interests Method: The purchase method records fair values and goodwill, while the pooling method simply combines book values without recognizing goodwill or fair value adjustments.
Interesting Facts
- The transition to the Purchase Method was influenced by high-profile accounting scandals to increase financial transparency.
- Goodwill resulting from acquisitions has led to significant changes in the valuation of many companies.
Inspirational Stories
- The acquisition of Pixar by Disney utilized the Purchase Method, leading to a successful integration and the creation of many beloved animated movies.
Famous Quotes
- “Price is what you pay. Value is what you get.” - Warren Buffett
Proverbs and Clichés
- “You get what you pay for.” - Reflecting the importance of fair value in acquisitions.
Expressions
- “Buying a company” - Informally referring to a business combination using the Purchase Method.
Jargon and Slang
- M&A (Mergers and Acquisitions): General term for business combinations.
- Write-off: Accounting for the reduction in the book value of goodwill when its value is impaired.
FAQs
What happens to the target company's revenue after acquisition?
How is goodwill treated after acquisition?
Is the Purchase Method still used?
References
- Financial Accounting Standards Board (FASB) Statement No. 141.
- International Financial Reporting Standard (IFRS) 3.
- “Accounting for Business Combinations” by Kenneth W. Thompson, CPA Journal.
Summary
The Purchase Method of accounting for business combinations ensures that acquired assets and liabilities are recorded at their fair value, providing transparency and accurate representation of a company’s financial status. This method has been fundamental in transforming how mergers and acquisitions are reported, emphasizing the importance of fair value and the recognition of goodwill.
