What is Purchase Accounting?

Purchase accounting is a form of business or corporate bookkeeping that basically sets a framework and guidelines for what to do with the financial records of a company that has been bought. Acquisitions and takeovers are relatively common in the corporate world, but it isn’t always easy to get the books of a purchased company in line with those of the new owner. Purchase accounting, which is also frequently referred to as “acquisition accounting,” is the general name given to the various processes companies use to make things simpler. Specific rules and regulations vary from place to place, though in most cases the field includes instructions for what to do with both intangible and tangible assets, and how to reconcile discrepancies and potential errors.

Companies use this process in acquisitions or mergers, which is basically any purchase of a company or a combination of two companies to form a new entity. The main goal is usually to determine the difference between the fair market value of the company being bought and the cost of acquiring it and, if the acquisition goes through, to provide a framework for bringing everything onto one set of books and financial spreadsheets.

As a result, the process typically has two parts: one looking prospectively, and one focused on immediacy. Companies often instruct their accountants to engage in preemptive purchase accounting during preliminary acquisition discussions to see if the finances make sense. If they don’t, the deal is sometimes called off. If they do, that’s when it becomes really important to bring the two companies into alignment so that things can function as a single financial entity moving into the future.

One of the biggest parts of this sort of accounting has to do with figuring out what specific assets there are and how they should be classified and valued. This normally starts with a candid identification, and then a determination of each thing’s fair market value. The fair market value is what a willing buyer would pay and what a willing seller would accept in payment. A company may be purchased for more than the fair market value and, in these cases, the amount paid must be allocated or divided among the various assets being purchased. Any excess of the cost will generally be allocated to what is known as “goodwill,” an intangible asset that encompasses the value or trust customers place in the company.

When the purchase is a stock or commodities purchase only, the entire cost is usually allocated to the cost of the stock. In a non-stock purchase, however, the assets of the company are taken over by the purchasing company. This normally includes the value of land, buildings, and other physical assets like equipment and furniture as well as inventory. Accounts receivable and customer lists can also be included when these things are valuable in their own rights.

Not everything that is important and valuable has a known, fixed price, though. Items like licenses, covenants not to compete, copyrights, and patents can fall within the category of “intangibles.” They don’t often have a significant monetary value in and of themselves, but in context they may actually be quite lucrative and important financially. Acquisition accounting accordingly has to take note of these things, too, and there is usually a system in place just for this purpose.

In most cases, the total value assigned to the assets as a whole, tangibles and intangibles. is equal to the total purchase price. If the value of the physical assets of a purchased company is less than the purchase price, then the remainder must be allocated to goodwill. For example, if Company A is purchasing Company B for $25 million US Dollars (USD) and the book value of tangible assets of Company B is listed at $8 million USD and the fair market value of these assets is $10 million USD, Company A will list those assets at $10 million USD on Company A’s books. Then, Company A will allocate an amount to the intangible assets. If it was decided that the intangible assets are valued at an additional $10 million USD, then the remaining $5 million USD would be considered goodwill.

It is also possible that the fair market value is less than the listed book value. In these cases, the rules of purchase accounting typically require that the purchasing company write down, which is to say “decrease,” the listed value of the assets that are being acquired. A calculation is made to determine the percentage each classification of asset is of the total book value, and the fair market value is allocated by the same percentages.