Accounting for Business Acquisition Using Purchase Method

In detail, a business acquisition, from the accounting viewpoint, is a transaction in which both the acquiring & acquired organization are still left standing as separate entities at the end of the transaction. If the acquiring organization spreads the acquisition cost over the assets being bought at their fair market price, with any remaining portion of the purchase acquisition cost being recorded in a consideration account, the “purchase method” is used to account the transaction. Hence, how do you account transaction of a business acquisition using purchase method? How to record stock purchase in quickbooks?

This post provides you with one step at a time  guide on how to account transaction of purchase acquisition using purchase method.

There are 3 primary steps involved on the accounting for business acquisition using purchase method.

Step-1. Determine the Purchase Cost

How do you determine the purchase cost? You would determine purchase cost based on fair market price. For example:

• If the purchase is made with stock, the stock must be priced at its fair market price.
• If treasury stock is used as part of the consideration, then this must also be priced at its fair market price.

• If the purchaser’s stock is thinly traded or closely held, then it may be mandatory to obtain the services of appraiser  or an investment banker, who can use several valuation models & industry surveys to derive a cost per share.

 

Step-2. Allocate cost Among the Several Assets of the organization Being Purchased

The 2nd step in the purchase method is to assign the purchase cost among the acquired company’s assets & liabilities, which are then recorded in the purchaser’s accounting records.

The main problem on the 2nd step is that the method of valuation differ by line product on the acquired company’s balance sheet. Here are the key valuation rules:

1. Accounts Receivable

   Record A/R at its present cost, less the allowance for bad debts. For instance, if present cost of the A/R is dollar 250,000 with dollar 5000 bad debt allowance sitting underneath, then the cost of the A/R is 245,000. Given the exceedingly short time frame over which the A/R is outstanding, there is generally nonessential to discount this valuation, unless there are receivables with very long collection terms. Also, since the acquisition transaction is normally not completed until specific months after the acquisition date (given the effort required to make the accounting entry), the amount of the allowance for bad debts can be very exactly find as of the acquisition date.

2. Marketable Securities

   You would record marketable securities at their FAIR MARKET PRICE. If you are under the U.S jurisdiction, this could be an chance for the purchaser to mark up a security to it is fair market cost (if such is the case)—since the GAAP generally only allows for the recognition of reductions in market price. For this reason, this’s an area in which there is some opportunity to allocate an additional portion of the purchase cost beyond the real cost of the asset. But, since most organizations only invest in short-term, highly liquid securities, it’s unlikely that there will be a large amount of potential appreciation in the securities.

3. Inventory—Raw Materials

   You would record raw material inventories at their REPLACEMENT COST. Even so, this can be a issue if the acquiree is in an industry, such as computer hardware, where inventory costs drop at a quick pace as new products fastly come into the marketplace. Accordingly, the purchaser may find itself with a significantly lower inventory valuation as a result of the purchase transaction than originally appeared on the accounting records of the acquiree.

4. Inventory—Finished Goods

   You would record FG inventories at their SELLING COST, less their AVERAGE PROFIT MARGIN + DISPOSITION COSTS. This can be a tough calculation to make, however, if the final products have variable costs depending upon where or in what quantities they are sold— in such situations, the determination of selling cost should be based on a history of the most common sales transactions. For instance, if 80% of all units sold are in purchase quantities that result in a per unit cost of dollar 1.50, then this is the most appropriate cost to use.

Note: The above rule can be avoided if the acquiree has company sales contracts as of the date of the acquisition with particular customers that can be used to clearly determine the costs at which the finished product will actually be sold.

5. Inventory—Work-In-Process

   You would record WIP inventories by using the same valuation treatment as finished product, except that the cost of conversion into finished products must also be subtracted from their eventual sale cost.

6. Property, Plant, & Equipment (PP&E)

   You would record PP&Es at their REPLACEMENT COST. This can be a tough task that lengthens the interval before the acquisition journal entry is completed, because some assets may be so old that there is no equivalent goods currently on the market, or equipment may be so generic that it is tough to detect a reasonable replacement on the market. This valuation step usually calls for the services of an appraiser.

7. PP&E to be Sold

   If purchaser intends to sell off assets as of the acquisition date, then these assets should be recorded at their FAIR MARKET COST. This most accurately reflects their disposal cost as of the acquisition date.

8. Capital Leases

   If the acquiree possesses assets that were purchased with capital leases, then you would cost the asset at its FAIR MARKET COST, while valuing the associated lease at its NET PRESENT COST.

9. Research & Development Assets (R&D)

   If some assets associated with particular R&D projects are part of the acquiree, you would then charge the R&D assets off to expense if there is no assumption that they will have replacement future use once the current R&D project has been completed. The precise allocation of assets to expense or asset accounts can be tough, however, since the existing projects may be expected to last well into the future, or the future use of the assets may not be easy to find. Thus, one should carefully document the reasons for the treatment of R&D assets.

10. Intangible Assets

    You would record intangible assets at their APPRAISED COST. If the purchaser cann’t reasonably assign a cost to them or identify them, you would then assign no cost.

11. Accounts & Notes Payable

    You can generally record A/P at their CURRENT AMOUNTS as listed on the books of the acquiree. However, if the A/Ps are not to be paid for ultimately, you would then record them at their DISCOUNTED PRESENT PRICES. The same logic applies to notes payable; since all—but the shortest-lived notes—will have a notably different present price, they should be discounted & recorded as such. Note, since, that this treatment is used on the assumption that the purchaser would apart from that be purchasing these liabilities on the date of the acquisition, not on a variety of dates stretching out into the future, & so must be discounted to show their cost on the acquisition date.

12. Accruals

    Accruals are fall under the short term (or current) liabilities. These liabilities are generally very short term ones that will be reversed shortly after the current accounting period. Therefore, they are to be priced at their PRESENT cost (discounting is rarely essential).

13. Pension Liability

    If there is an unfunded pension liability, even if not recognized on the books of the acquiree, it must be recognized by the purchaser as part of the purchase transaction.

14. Stock Option Plan (SOP)

    If the purchaser decides to take over an existing stock option plan of the acquiree, then it must allocate part of the purchase cost to the incremental difference between the cost at which shares may be purchased under the plan & the market cost for the stock as of the date of the purchase acquisition. Since, if the purchaser forced the acquiree to settle all claims under the option plan prior to the acquisition, then this becomes a compensation expense that is recorded on the books of the acquiree.

The organization being purchased can be bought with any form of consideration, like stock, cash, or property.

Let’s construct a case example:

Liee Dharma Corporation acquires Robinson Maa Corporation by spreading the acquisition cost over the assets being bought at their fair market cost with any remaining portion of the purchase acquisition cost being recorded in a goodness account, hence we use purchase method for the case.

If the acquiring organization (Liee Dharma Corporation) buys the acquiree’s (Robinson Maa Corporation) stock with $ 500,000 of cash, the entry on Liee Dharma’s books would be:

[Debit]. Investment in Robinson Maa Corporation = $ 500,000
[Credit]. Cash = $ 500,000

Alternatively, if Liee Dharma were to make the purchase using a mix of 20% cash & 80% for a note, the entry would be:

[Debit]. Investment in Robinson Ma Corporation = $ 500,000
[Credit]. Cash = $ 100,000
[Credit]. Note payable = $ 400,000

Another approach would be to exchange 5,000 shares of Lie Dharma’s dollar 1 par cost stock for that of Robinson Ma as a form of payment. Under this method, the entry would be:

[Debit]. Investment in Robinson Ma Corporation = $ 500,000
[Credit]. Common stock—par cost = $5,000
[Credit]. Common stock—additional paid-in capital = $ 495,000

The outcome of all the preceding valuation rules is given below where I show the calculation that would be required to adjust the reference books of an acquiree in order to then consolidate it with the outcome of the acquiring firm:

The above table shows the starting book cost of each account on the acquiree’s balance sheet, followed by a listing of the required valuation of each and every account under the purchase acquisition method, the adjustment required, & the new account valuation. The new account valuation on the right side of the table can then be combined directly into the records of the acquiring firm.

Note that, under the “Purchase Method Valuation”, that:

• “NPV” designates the net present cost of the line product is shown,
• “FMV” designates the fair market cost is shown (less any costs required to sell the product, if applicable)
• A designation of “RC” that the use of replacement cost
• “SLM” designates the use of sale cost less the gross margin
• An asset’s appraised cost means “AV”.

In the above table, credits & debits are defined for each modifing entry listed in the “Required Adjustment” column.

The amount of goodness shown in the “Required Adjustment” column is derived by subtracting the purchase cost of $ 15,000 from the overall of all fair market & other valuations given in the “Purchase Method Valuation” column. In such a situation, we have a fair market valuation of $ 18,398 for all assets, less a fair market valuation of $ 8,075 for all liabilities, which yields a net fair market cost for the acquiree of $ 10,323. When this fair market cost is subtracted from the purchase cost of $ 15,000, we end up with a residual of $ 4,677, which is listed in the goodness account.

Kindly note that the “Adjusted Acquiree Records” column on the right side of the table should be added to the acquirer’s records to arrive at a consolidated financial statement for the merged entities.

 

Step-3. Account for the First Year Partial Results of the Purchased Entity

The 3rd step in the acquisition process is to account for the 1st year partial outcome of the acquired organization on the purchaser’s financial statements. Given below the rules of thumb:

• Only the income of the acquiree that falls within its current fiscal year, but after the date of the acquisition, should be added to the purchaser’s accounting records.
• The puchaser must charge all costs associated with the acquisition to current expense they cann’t be capitalized. These acquisition costs must be almost totally for outside services, hence some internal costs charged to the acquisition would likely have been incurred anyway, even in the absence of the acquisition.
• The only variation from this rule is the costs associated with issuing equity to pay for the acquisition; these costs can be recorded as an offset to the additional paid in capital account.
• An additional product is that a liability must be recognized at the time of the acquisition for any plant closings or losses on the dispositions of assets that are planned as of that date; this is not an expense that is recognized at a later date, hence we assume that the purchaser was aware at the buy date that some asset dispositions would be required.
• If the acquirer chooses to report it is financial outcome for multiple years prior to the acquisition, it doesn’t report the combined outcome of the 2 entities for years prior to the acquisition.

A reverse acquisition is one in which the organization issuing its shares or other payment is actually the acquiree, because the acquiring firm’s shareholders don’t own a majority of the stock after the acquisition is completed. However rare, this approach is occasionally used when a shell organization with available funding purchase an operating firm, or when a publicly held shell organization is used to purchase a non public firm, So that avoiding the need to go through IPO ( an initial public offering ) by the non public firm. In this respect, the assets & liabilities of the shell corporation are re-priced to their fair market cost & then recorded on the books of the organization being bought.

If you are an accountant, your main interest in your firm’s combined & acquisition activities is how to account for the transactions. The main approach you should use probably is the purchase method, which has been described on this current post. An alternative is the pooling of interests method, since, the FASB is frequently reviewing the need for this method, & was close to eliminating it as of I made this current post. The IASB has prohibited the use of pooling of interest procedure, entirely.

There are also many situations in which a organization merely makes a small investment in another firm, rather than making a big & outright purchase. This requires 3 possible types of accounting base upon the size of the investment & the degree of control attained over the subject firm—which are: equity method,  the cost method & consolidation method.

 

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