The Purchase Method is an accounting technique employed primarily in the United States for recording business combinations. It involves the allocation of cash, other assets, or incurring liabilities to acquire a company. This method is utilized when specific criteria for the pooling-of-interests method are not satisfied.
Types
There are primarily two methods to account for business combinations:
- Purchase Method: Involves recognizing assets and liabilities at fair market value and recording any excess purchase price as goodwill.
- Pooling-of-Interests Method: Combines the book values of the two companies without recognizing any goodwill or fair value adjustments (now largely obsolete).
Detailed Explanations
Under the Purchase Method, the acquiring company must:
- Identify the Acquirer: The entity that gains control of another entity.
- Determine the Acquisition Date: The date when the acquirer effectively gains control.
- Recognize and Measure Identifiable Assets and Liabilities: At fair value.
- Calculate Goodwill: Any excess of the purchase price over the fair value of identifiable net assets.
Goodwill Calculation:
$$ \text{Goodwill} = \text{Purchase Price} - (\text{Fair Value of Assets Acquired} - \text{Fair Value of Liabilities Assumed}) $$
Importance
The Purchase Method ensures transparency by recording acquired companies’ assets and liabilities at their true economic value, providing investors and stakeholders with accurate information.
Applicability
Used in scenarios where a company takes over another company by purchasing its net assets or shares. It is critical in mergers and acquisitions (M&A) accounting.
- Fair Value: An estimate of the market value of an asset or liability.
- Goodwill: An intangible asset representing the excess purchase price over the fair value of identifiable net assets.
- Acquirer: The company that gains control over another entity in a business combination.
- Impairment Testing: Assessing whether the carrying amount of an asset exceeds its recoverable amount.
FAQs
What happens to the target company's revenue after acquisition?
The target company’s revenue is included in the acquiring company’s financial statements from the acquisition date onward.
How is goodwill treated after acquisition?
Goodwill is not amortized but is tested annually for impairment.
Is the Purchase Method still used?
Yes, it is the standard method for accounting for business combinations under GAAP and IFRS.