Cost of acquisition

What Is Cost of Acquisition?

Cost of acquisition refers to the total expense incurred to purchase or obtain an asset or a controlling interest in a business. This concept is fundamental in Corporate Finance and accounting, as it establishes the initial book value of an asset on a company's Balance Sheet. It includes not only the purchase price but also all direct and necessary expenditures made to prepare the asset for its intended use. Understanding the cost of acquisition is crucial for accurate financial reporting, tax calculations, and investment analysis.

History and Origin

The concept of capitalizing acquisition costs has evolved alongside accounting principles and tax regulations. Historically, various costs associated with acquiring an asset or a business, such as legal fees, due diligence expenses, and integration costs, were often capitalized and added to the asset's or business's initial cost. This practice reflected the view that these expenses were necessary to bring the acquired entity or asset into operational readiness.

However, accounting standards, particularly in the realm of Mergers and Acquisitions (M&A), have shifted over time. For instance, prior to 2009, many M&A transaction costs were capitalized as part of the purchase price. A significant change occurred with the issuance of FASB 141-Revised (now codified primarily in ASC 805, Business Combinations), which generally requires direct M&A-related transaction costs to be expensed as incurred rather than capitalized. This change was implemented to provide a more accurate depiction of a company's financial performance by separating operational costs from the valuation of the acquired entity itself. A staff paper from the SEC details some of the historical shifts in business combination accounting⁸, ⁹. Despite these changes, the fundamental principle that the cost of acquisition forms the basis for an Asset remains a cornerstone of financial accounting.

Key Takeaways

• The cost of acquisition includes the purchase price of an asset or business, plus all direct and necessary costs incurred to prepare it for its intended use.
• This cost forms the initial book value of an asset on a company's financial statements.
• It is critical for calculating depreciation, amortization, and determining capital gains or losses for tax purposes.
• Accounting standards distinguish between costs that are capitalized (added to the asset's basis) and those that are expensed immediately.
• For business acquisitions, certain transaction-related costs (e.g., legal and advisory fees) are generally expensed rather than capitalized into the acquired entity's value.

Formula and Calculation

The formula for the cost of acquisition is generally:

Where:

• Purchase Price: The amount paid to the seller for the asset or business.
• Directly Attributable Costs: These are expenses necessary to get the asset ready for its intended use. Examples include:
  • Sales taxes and duties.
  • Freight and handling costs.
  • Installation and assembly costs.
  • Testing costs (less net proceeds from selling items produced during testing).
  • Professional fees (e.g., legal fees for property transfer, broker commissions).

For an individual asset, the Internal Revenue Service (IRS) provides detailed guidance on what constitutes the basis of property, which is often its cost of acquisition. According to IRS Publication 551, the basis of property you buy is usually its cost, including the purchase price plus certain other costs related to buying or producing the property, such as sales tax, freight charges, and installation fees⁵, ⁶, ⁷.

Interpreting the Cost of Acquisition

Interpreting the cost of acquisition involves understanding its implications for a company's financial health and future profitability. For individual assets, the cost establishes the depreciable base, affecting future Income Statement figures through Depreciation or Amortization expenses. A higher cost of acquisition, when legitimate, reflects the true economic outlay and should ideally correspond to a higher value or greater utility of the asset.

In the context of business combinations, the cost of acquisition of an entire company includes the fair value of consideration transferred. This amount is then allocated to the identifiable assets and Liability acquired, with any excess recorded as Goodwill. Interpreting this cost involves assessing whether the price paid aligns with the value received and the strategic benefits expected from the acquisition. Analysts often scrutinize the amount of goodwill generated, as it represents the premium paid over the fair value of net identifiable assets.

Hypothetical Example

Imagine TechCorp decides to acquire a new manufacturing robot.
The details are as follows:

• Purchase Price of Robot: $500,000
• Sales Tax: $25,000
• Shipping and Freight Charges: $10,000
• Installation and Setup Costs: $15,000
• Training for Operators (ongoing expense): $5,000
• Routine Maintenance Contract (ongoing expense): $3,000

To calculate the cost of acquisition for the robot, TechCorp includes the purchase price and all direct costs necessary to get the robot ready for its intended use:

• Purchase Price: $500,000
• Sales Tax: $25,000
• Shipping and Freight: $10,000
• Installation and Setup: $15,000

The training for operators and the routine maintenance contract are considered ongoing operating Expenses and are not capitalized into the cost of acquisition.

Therefore, the cost of acquisition for the robot is:

This $550,000 will be recorded as the initial value of the robot, a Capital Expenditure, on TechCorp's balance sheet.

Practical Applications

The cost of acquisition is a critical metric across various financial domains:

• Financial Reporting: Companies record assets at their cost of acquisition, forming the basis for subsequent accounting treatments like depreciation, impairment testing, and the calculation of gains or losses upon sale. This impacts a company's reported assets and equity on its balance sheet.
• Taxation: For tax purposes, the cost of acquisition (often referred to as "basis") is used to determine taxable gains or losses when an asset is sold or disposed of. It also influences deductions such as depreciation. Accurate record-keeping of acquisition costs is essential for tax compliance.
• Investment Analysis: Investors and analysts use the cost of acquisition to evaluate a company's asset base and assess the efficiency of its capital deployment. Understanding how a company accounts for its acquisition costs can reveal insights into its financial strategy and its adherence to accounting standards.
• Due Diligence in M&A: In business acquisitions, prospective buyers perform extensive due diligence to ascertain the true cost of acquiring and integrating a target company. This includes identifying all direct and indirect costs, which informs the overall deal structure and pricing. The accounting treatment for these costs, specifically whether they are capitalized or expensed, can significantly impact the acquirer's post-acquisition financial statements², ³, ⁴.
• Legal Disputes: Disputes can arise concerning the true cost or valuation of an acquired asset or business, leading to legal battles where precise accounting of acquisition costs becomes paramount. Such cases highlight the complexities and potential ambiguities in assigning a definitive value to an acquisition¹.

Limitations and Criticisms

While the concept of cost of acquisition is fundamental, it faces several limitations and criticisms:

• Subjectivity in Allocating Costs: Determining which costs are "directly attributable" versus "operating expenses" can sometimes be subjective, particularly for complex acquisitions or the development of new assets. This subjectivity can lead to inconsistencies in financial reporting across different companies or even within the same company over time. The Journal of Accountancy highlights how determining what constitutes an acquisition cost can be complex and sometimes not intuitive from a strict accounting perspective.
• Impact of Non-Cash Considerations: When assets are acquired through non-cash means, such as the exchange of other assets or equity, determining the fair value of the consideration transferred can be challenging. This introduces complexity and potential for differing interpretations in establishing the true cost of acquisition.
• Hidden or Contingent Costs: The initial cost of acquisition may not always reflect all future costs associated with an asset or acquired business. These can include unforeseen integration costs, contingent liabilities, or post-acquisition adjustments, which can significantly alter the true economic cost over time.
• Outdated Book Value: Over time, the historical cost of acquisition, while important for accounting, may not reflect an asset's current market value or its true economic worth. This is particularly relevant in periods of inflation or rapid technological change, where the book value of older assets might significantly diverge from their replacement cost or market value.
• Distortion of Financial Performance: For business combinations, the requirement to expense many direct acquisition-related costs can lead to significant charges against earnings in the period of acquisition, potentially obscuring underlying operational performance. This treatment is a specific accounting standard but can lead to a less favorable initial appearance on the Income Statement.

Cost of Acquisition vs. Cost of Goods Sold

While both the cost of acquisition and Cost of Goods Sold (COGS) are critical financial metrics, they represent distinct aspects of a company's expenditures.

The cost of acquisition is a one-time capitalization event that brings an asset onto the books, whereas COGS is an ongoing operational expense directly tied to sales volume and reported on the Income Statement as goods are sold.

FAQs

What is included in the cost of acquisition for a business?

For a business acquisition, the cost of acquisition generally includes the fair value of the consideration transferred (e.g., cash paid, stock issued, or liabilities assumed). Professional fees, such as advisory, legal, and accounting fees, incurred by the acquirer to effect a business combination are typically expensed as incurred rather than capitalized into the cost of the acquired business.

Why is the cost of acquisition important?

The cost of acquisition is important because it establishes the initial book value of an asset for accounting purposes, forms the basis for calculating depreciation and amortization, and determines the taxable gain or loss upon the asset's sale or disposal. It is a foundational element for financial reporting, tax planning, and investment analysis, providing insight into a company's asset base and capital deployment.

How does cost of acquisition differ from market value?

Cost of acquisition is the historical cost paid to acquire an asset, plus all directly attributable costs to prepare it for its intended use. Market value, conversely, is the current price at which an asset could be bought or sold in the open market. The cost of acquisition is a fixed, historical figure recorded on a company's books, while market value fluctuates based on supply, demand, and other market conditions.

Is the cost of acquisition always capitalized?

No, not all costs associated with an acquisition are always capitalized. While the purchase price of an asset and directly attributable costs to make it ready for use are capitalized, certain costs, particularly those related to the acquisition of an entire business (e.g., legal fees, Due Diligence fees), are typically expensed in the period they are incurred under current accounting standards.

How does the cost of acquisition affect a company's financial statements?

The cost of acquisition initially increases the value of assets on the Balance Sheet. Over time, for depreciable assets, this cost is expensed through Depreciation or Amortization on the Income Statement, reducing reported profit. For tax purposes, it serves as the basis for calculating capital gains or losses. Additionally, cash outlays for acquisitions are reflected in the investing activities section of the Cash Flow Statement.