Acquisition method of accounting

What Is the Acquisition Method of Accounting?

The acquisition method of accounting is a fundamental principle in financial accounting that dictates how a company, known as the acquirer, accounts for a business combination. This method requires the acquirer to recognize and measure the assets acquired and liabilities assumed from the acquired entity at their respective fair value on the acquisition date. Any excess of the purchase price over the fair value of the identifiable net assets acquired is recognized as goodwill. This approach aims to provide a more transparent and accurate representation of the combined entity's financial position and performance following a merger or acquisition.

History and Origin

Prior to the widespread adoption of the acquisition method of accounting, U.S. Generally Accepted Accounting Principles (GAAP) allowed for two primary methods for business combinations: the purchase method and the pooling-of-interests method. The pooling-of-interests method, which treated combining companies as if they had always been together, avoided the recognition of goodwill and the revaluation of assets and liabilities to fair value. This often resulted in lower reported asset bases and higher subsequent earnings, making it a popular choice for companies seeking to avoid the impact of depreciation and amortization on revalued assets.

However, the pooling-of-interests method faced increasing scrutiny due to its lack of transparency and the potential for obscuring the true cost of an acquisition. Regulators and accounting standard-setters worldwide recognized the need for a more consistent and economically realistic approach. In the United States, this led the Financial Accounting Standards Board (FASB) to issue Statement of Financial Accounting Standards No. 141, Business Combinations (FAS 141), in 2001, effectively eliminating the pooling-of-interests method for business combinations initiated after June 30, 2001. FAS 141 (later revised as FAS 141(R) and codified into ASC 805) mandated the use of the acquisition method, aligning U.S. GAAP with international standards and enhancing comparability in financial reporting⁴.

Key Takeaways

• The acquisition method of accounting requires an acquirer to recognize assets and liabilities of an acquired entity at their fair value on the acquisition date.
• Any excess of the consideration transferred over the fair value of identifiable net assets acquired is recorded as goodwill.
• This method provides a more accurate representation of the economic value exchanged in a business combination.
• It replaced the pooling-of-interests method to enhance transparency and comparability in financial reporting.
• The application of the acquisition method is governed by accounting standards, such as ASC 805 in the United States.

Formula and Calculation

The core calculation in the acquisition method involves determining the amount of goodwill to be recognized. Goodwill arises when the purchase price paid for an acquired entity exceeds the fair value of its identifiable net assets.

The formula for goodwill is:

Where:

• Consideration Transferred: The total value of assets transferred by the acquirer, liabilities incurred by the acquirer, and equity interests issued by the acquirer to obtain control of the acquiree.
• Fair Value of Identifiable Net Assets Acquired: The sum of the fair values of the identifiable assets acquired (e.g., property, plant, equipment, intangible assets) minus the fair values of the liabilities assumed (e.g., debt, accounts payable).

Interpreting the Acquisition Method

Interpreting the acquisition method of accounting involves understanding how the recorded values impact the combined entity's financial statements. By recognizing assets and liabilities at their fair value at the time of acquisition, the method aims to present the financial position of the newly combined entity in a way that reflects current market conditions. This revaluation can significantly impact future depreciation or amortization expenses, as these are based on the newly recorded fair values rather than the acquiree's historical cost.

The goodwill recognized under the acquisition method is a key component of the combined entity's balance sheet. Goodwill represents unidentifiable assets such as reputation, customer relationships not separately recognized, or synergies expected from the business combination. Unlike identifiable assets, goodwill is not amortized over time but is subject to an annual impairment test. If the fair value of the reporting unit to which the goodwill is assigned falls below its carrying amount, an impairment loss must be recognized, affecting the income statement.

Hypothetical Example

Assume Company A decides to acquire Company B. Company A pays $500 million in cash for all of Company B's outstanding equity.

On the acquisition date, Company B's identifiable assets and liabilities are determined to have the following fair values:

• Cash: $20 million
• Accounts Receivable: $80 million
• Inventory: $100 million
• Property, Plant, and Equipment: $250 million
• Identifiable Intangible Assets (e.g., patents): $70 million
• Accounts Payable: ($50 million)
• Long-Term Debt: ($120 million)

Step 1: Calculate the fair value of identifiable net assets acquired.
Fair Value of Identifiable Assets = $20M + $80M + $100M + $250M + $70M = $520 million
Fair Value of Liabilities Assumed = $50M + $120M = $170 million
Fair Value of Identifiable Net Assets = $520M - $170M = $350 million

Step 2: Calculate goodwill.
Goodwill = Consideration Transferred - Fair Value of Identifiable Net Assets Acquired
Goodwill = $500 million (cash paid) - $350 million = $150 million

Under the acquisition method of accounting, Company A would record the individual assets and liabilities of Company B at their fair values, and also recognize goodwill of $150 million on its consolidated balance sheet.

Practical Applications

The acquisition method of accounting is universally applied in mergers and acquisitions that qualify as a business combination. It is essential for various stakeholders:

• Financial Reporting: Companies use this method to prepare their financial statements after an acquisition, providing investors and creditors with a clear picture of the combined entity's assets, liabilities, and equity. The Financial Accounting Standards Board (FASB) continues to issue updates and clarifications to the Accounting Standards Codification (ASC) Topic 805, which governs business combinations, ensuring that accounting practices remain relevant and address emerging complexities³.
• Valuation and Due Diligence: During the acquisition process, companies perform extensive due diligence to determine the fair value of the target's assets and liabilities. This valuation directly informs the application of the acquisition method and the eventual calculation of goodwill.
• Investor Analysis: Investors rely on financial statements prepared using the acquisition method to assess the financial impact and strategic rationale of an acquisition. They analyze the reported goodwill, its impairment risk, and the revaluation of assets to understand the true profitability and asset base of the combined entity. Regulatory bodies like the Securities and Exchange Commission (SEC) provide oversight to ensure that companies adhere to these accounting principles, enhancing investor confidence and market transparency.
• Compliance and Regulation: Publicly traded companies are required to adhere to specific accounting standards, such as U.S. GAAP (specifically ASC 805) or International Financial Reporting Standards (IFRS 3), when applying the acquisition method. These standards mandate specific disclosures that provide transparency regarding the details of the acquisition².

Limitations and Criticisms

Despite its advantages in promoting transparency, the acquisition method of accounting has certain limitations and has faced criticisms:

• Subjectivity in Fair Value Measurement: Determining the fair value of identifiable assets and liabilities, especially intangible assets like customer relationships or brands, can be highly subjective. This requires significant judgment and assumptions, which can lead to variations in reported values across different acquisitions or even different preparers. While professional standards aim to minimize this subjectivity, it remains a challenge.
• Goodwill Impairment Risk: The goodwill recorded in an acquisition is not amortized but must be tested for impairment annually, or more frequently if impairment indicators arise. A significant impairment charge can negatively impact the income statement and reduce reported equity, potentially surprising investors. This can be a volatile aspect of post-acquisition financial reporting.
• Acquisition-Related Costs: Under the acquisition method, costs directly associated with the acquisition, such as legal, accounting, and advisory fees, are generally expensed as incurred rather than being capitalized as part of the acquisition cost. This impacts the acquirer's current period earnings, which some argue does not fully reflect the long-term investment nature of these costs¹.
• Complexity: The detailed requirements for applying the acquisition method, particularly concerning the identification and measurement of all acquired assets and assumed liabilities, can be complex and resource-intensive for companies. This complexity can be particularly challenging for transactions involving intricate structures or novel forms of consideration.

Acquisition Method of Accounting vs. Pooling-of-interests Method

The acquisition method of accounting fundamentally differs from the historical pooling-of-interests method in how it records a business combination. Under the acquisition method, one entity is clearly identified as the acquirer, and the acquired entity's assets and liabilities are revalued to their fair value on the acquisition date. This often leads to the recognition of new goodwill on the acquirer's balance sheet, which must then be periodically tested for impairment. In contrast, the pooling-of-interests method, which is no longer permitted for most business combinations, treated the merging entities as if they had always been combined. It simply combined their historical carrying amounts of assets and liabilities, avoiding any revaluation to fair value and thus no recognition of goodwill. This difference in approach led to vastly different reported financial positions and income statements, with pooling-of-interests often resulting in higher post-combination earnings due to the absence of revalued assets subject to higher depreciation or amortization.

FAQs

What is the primary objective of the acquisition method of accounting?

The primary objective of the acquisition method is to provide relevant and reliable information about the effects of a business combination on the acquirer's financial statements. It aims to measure the acquired assets and liabilities at their fair value, reflecting the economic substance of the transaction.

How does the acquisition method impact goodwill?

The acquisition method requires the calculation and recognition of goodwill as the excess of the purchase price over the fair value of identifiable net assets acquired. This goodwill is then subject to annual impairment testing, rather than systematic amortization.

Is the acquisition method used internationally?

Yes, the acquisition method is largely converged globally. International Financial Reporting Standards (IFRS), specifically IFRS 3 Business Combinations, also mandates the use of the acquisition method, aligning with U.S. GAAP's ASC 805 in most key aspects. This convergence helps improve the comparability of financial statements for multinational companies.

What are identifiable intangible assets in the context of the acquisition method?

Identifiable intangible assets are non-physical assets that can be separated or arise from contractual or other legal rights. Examples include patents, trademarks, customer lists, brand names, and software. Under the acquisition method, these are recognized at their fair value separately from goodwill.