Acquisition method

What Is Acquisition Method?

The acquisition method is an accounting standard used in financial accounting to record business combinations, specifically when one entity, the acquirer, gains control over another entity, the acquiree. This method dictates that the acquirer recognizes the identifiable assets acquired and liabilities assumed of the acquiree at their respective fair value on the date of acquisition. Any excess of the consideration transferred (such as cash, equity interests, or other assets) over the fair value of the identifiable net assets acquired is recognized as goodwill.

The acquisition method falls under the broader category of Generally Accepted Accounting Principles (GAAP) in the United States, primarily guided by ASC 805, Business Combinations. Its objective is to provide a more accurate and transparent representation of the economic substance of a business combination by reflecting current market values rather than historical costs.

History and Origin

The evolution of accounting for business combinations has seen significant changes, driven by the desire for greater transparency and comparability in financial reporting. Historically, various methods were used, most notably the pooling of interests method. Under this method, the financial statements of combining companies were simply added together at their book values, effectively treating the combination as a merger of equals and avoiding the recognition of goodwill or the revaluation of assets and liabilities to fair value.

However, the pooling of interests method faced increasing criticism for obscuring the true economics of acquisitions, especially when a clear acquirer existed. In response, the Financial Accounting Standards Board (FASB), the independent organization responsible for establishing accounting standards in the U.S., issued Statement No. 141, Business Combinations, in June 2001. This standard effectively eliminated the pooling of interests method for all business combinations initiated after June 30, 2001, mandating the use of the purchase accounting method⁸, ⁹.

The purchase accounting method was a significant step towards fair value accounting, requiring assets and liabilities to be recorded at their fair values. However, it still involved the amortization of goodwill over a period, which impacted reported earnings. Recognizing the need for further refinement, the FASB issued Statement No. 141 (revised), Business Combinations, in December 2007, effective for fiscal years beginning after December 15, 2008. This revision replaced the purchase accounting method with the modern acquisition method. The key change was the elimination of goodwill amortization, replacing it with an annual impairment test⁷. This shift aimed to provide a more accurate depiction of a company's financial health, reflecting the ongoing value of acquired intangible assets. A summary of FASB Statement No. 141 is available on the FASB website.⁶

Key Takeaways

• The acquisition method is the mandatory accounting approach for business combinations in which one entity obtains control over another.
• It requires the acquirer to measure all identifiable assets acquired and liabilities assumed at their fair values at the acquisition date.
• Goodwill is recognized as the difference between the total consideration transferred (plus any noncontrolling interest and previously held equity interest) and the fair value of the identifiable net assets acquired.
• Unlike prior methods, goodwill under the acquisition method is not systematically amortized but is instead subject to annual impairment tests.
• The method aims to provide a more transparent and economically relevant view of an acquisition's financial impact on the acquirer's balance sheet and future financial statements.

Formula and Calculation

While the acquisition method itself is a set of principles rather than a single formula, a core calculation within it is the determination of goodwill recognized in a business combination. Goodwill arises when the consideration paid for an acquiree exceeds the fair value of its identifiable net assets.

The basic "formula" for goodwill under the acquisition method is:

Where:

• Consideration Transferred: The fair value of the assets transferred by the acquirer, the liabilities incurred by the acquirer to former owners of the acquiree, and the equity interests issued by the acquirer.
• FV of NCI: Fair value of any existing noncontrolling interest in the acquiree. This represents the portion of the acquiree not acquired by the acquirer.
• FV of PHEI: Fair value of previously held equity interests in the acquiree. This applies to step acquisitions where control is gained in stages.
• FV of IANA: Fair value of the identifiable net assets acquired and liabilities assumed. This involves measuring each individual asset and liability at its fair value.

If the fair value of the identifiable net assets acquired exceeds the sum of consideration transferred, the fair value of noncontrolling interest, and the fair value of previously held equity interest, the difference is recognized as a bargain purchase gain, which is recorded in profit or loss.

Interpreting the Acquisition Method

Interpreting the outcomes of the acquisition method requires understanding its impact on a company's financial position and performance. The core principle is that the acquirer's financial statements should reflect the acquired business at its fair value at the acquisition date, providing a "fresh start" for the acquired entity's assets and liabilities within the acquirer's consolidated financials.

The recognition of goodwill under the acquisition method signifies the intangible value attributed to an acquired business that cannot be individually identified and valued. This often includes elements like strong brand reputation, skilled workforce, synergistic benefits, or customer relationships. Since goodwill is not amortized, its value remains on the balance sheet unless it is deemed to be impaired through an annual impairment test. Therefore, understanding the composition of recorded assets and the nature of goodwill is crucial for evaluating the true value and future earnings potential of the combined entity. Users of financial statements must assess whether the fair value adjustments and the goodwill recognized appropriately reflect the economic realities of the transaction.

Hypothetical Example

Consider TechSolutions Inc. acquiring InnovateCo, a software development firm, for $150 million in cash. On the acquisition date, InnovateCo's identifiable assets (such as cash, accounts receivable, property, plant, equipment, and intellectual property) have a collective fair value of $120 million. Its identifiable liabilities (such as accounts payable and deferred revenue) have a fair value of $30 million.

Here's how the acquisition method would be applied:

1. Identify Fair Value of Identifiable Net Assets:

   • Fair value of identifiable assets = $120 million
   • Fair value of identifiable liabilities = $30 million
   • Fair value of identifiable net assets = $120 million - $30 million = $90 million

2. Calculate Goodwill:

   • Consideration transferred (cash paid) = $150 million
   • Fair value of identifiable net assets = $90 million
   • Goodwill = Consideration Transferred - Fair Value of Identifiable Net Assets
   • Goodwill = $150 million - $90 million = $60 million

Upon acquisition, TechSolutions Inc. would record the identifiable assets and liabilities of InnovateCo at their fair values of $120 million and $30 million, respectively, on its consolidated balance sheet. Additionally, $60 million in goodwill would be recognized. This goodwill would then be subject to annual impairment tests.

Practical Applications

The acquisition method is fundamental to corporate finance and financial reporting, appearing in various contexts:

• Mergers and Acquisitions (M&A): This is the primary application. Any time one company acquires another, the acquisition method is used to integrate the acquired entity's financial position and results into the acquirer's consolidated financial statements.
• Financial Analysis: Investors and analysts rely on financial statements prepared using the acquisition method to assess the true cost of an acquisition, the value of acquired assets and liabilities, and the amount of goodwill recognized. This helps in evaluating the success of a business combination and its impact on future profitability.
• Regulatory Compliance: Public companies, in particular, must adhere strictly to accounting standards like ASC 805 for business combinations and the related disclosure requirements. The Securities and Exchange Commission (SEC) has detailed reporting requirements for business combinations to ensure transparency and protect investors. Companies must provide comprehensive financial information about acquired businesses in their regulatory filings.⁴, ⁵
• Valuation: The process of applying the acquisition method often involves extensive valuation efforts to determine the fair value of identifiable intangible assets (like patents, customer lists, brand names) separately from goodwill. This detailed valuation provides insights into the components of the acquisition premium.

Limitations and Criticisms

While the acquisition method aims for greater transparency and economic relevance, it is not without limitations and criticisms. A primary area of debate revolves around the accounting for goodwill.

One significant criticism concerns the subjectivity involved in the fair value measurement of acquired assets and liabilities, particularly intangible assets. Valuing these assets can be complex and relies on significant judgment and assumptions, which can introduce subjectivity into the financial statements.

Furthermore, the post-acquisition accounting for goodwill, specifically the reliance on an annual impairment test rather than systematic amortization, has been a contentious issue among academics and practitioners. Critics argue that impairment testing can be subjective, potentially allowing companies to delay or avoid recognizing reductions in the value of goodwill. Some academic research suggests that non-arbitrary goodwill impairment testing is challenging and has proposed a return to a systematic amortization approach, potentially with uniform amortization periods, to improve accounting quality and reduce arbitrariness¹, ², ³. Conversely, proponents of the impairment-only model argue that it better reflects the economic life of goodwill, which may not decline systematically over time, and that amortization could artificially reduce reported earnings.

Acquisition Method vs. Pooling of Interests Method

The acquisition method fundamentally differs from the historical pooling of interests method in its core principles and financial statement impact. Understanding these differences is crucial as the pooling of interests method, though no longer permitted for most new business combinations since 2001, shaped past financial reporting.

The shift from the pooling of interests method to the acquisition method represented a move towards reflecting the economic reality of an acquisition more accurately on the balance sheet, providing users of financial statements with a clearer picture of the value exchanged in a business combination.

FAQs

Q1: What is the main purpose of the acquisition method?

The main purpose of the acquisition method is to accurately reflect the economic substance of a business combination by valuing the acquired assets and assumed liabilities at their fair value at the date of acquisition. This provides a more transparent view of the transaction's impact on the acquirer's financial position.

Q2: How does the acquisition method handle goodwill?

Under the acquisition method, goodwill is recognized when the purchase price of an acquired company exceeds the fair value of its identifiable net assets. Once recognized, this goodwill is not systematically amortized over its useful life. Instead, it is subject to an annual impairment test to determine if its value has decreased, in which case an impairment loss is recorded.

Q3: What is the difference between the acquisition method and the purchase accounting method?

The acquisition method is essentially a refinement and replacement of the older purchase accounting method. While both methods required recognizing acquired assets and liabilities at fair value, a key distinction lies in the treatment of goodwill. The purchase method required goodwill to be amortized over its estimated useful life, whereas the acquisition method eliminated goodwill amortization in favor of periodic impairment testing.

Q4: Does the acquisition method apply to all types of mergers?

The acquisition method applies to all transactions or events in which an entity obtains control of one or more businesses. This includes traditional mergers where one company absorbs another, as well as situations sometimes referred to as "true mergers" or "mergers of equals" and combinations achieved without the transfer of consideration (e.g., by contract alone), provided that one entity can be identified as the acquirer.

Q5: Why is fair value measurement so important in the acquisition method?

Fair value measurement is critical because it ensures that the acquired assets and liabilities are recorded on the acquirer's balance sheet at their current market-based values. This provides a more relevant and up-to-date picture of the combined entity's financial position compared to using historical book values, which might not reflect current economic conditions.