The Differences Between the Acquisition Method and the Purchase Method in Accounting
The biggest difference between the acquisition and purchase method of accounting for mergers is that accounting dropped the purchase method more than a decade ago. It joined an earlier standard, the "pooling of interests" approach, which was thrown out by the accounting industry back in 2001.
There are several technical details that differentiate the acquisition method from the purchase method of accounting. The big-picture difference is that the acquisition method acknowledges that there are many methods of taking control of a business, not just purchases.
Like purchasing a business, mergers are just one way for two companies to combine. Modern acquisition accounting covers purchases, mergers and all forms of what are called "business combinations".
In the accounting world, every combination is an acquisition. To get your merger accounting journal entries right, you have to define which company is the acquiring party. That's simple if one company buys another, but sometimes, it's not that obvious.
The acquiring party is the company with power to govern the financial and operating policies of the other business. If, for example, Company A is spending money to buy a controlling interest in Company B's stock, that's a clear sign that Company A is the acquiring party. The acquirer is often the larger company, but that isn't always the case.
Up until 2001, the preferred method for handling acquisitions was known as "pooling of interests". Accountants using this method for business combinations simply pooled the assets and liabilities on the companies' balance sheets. This was a popular approach for several reasons.
- Pooling of interests didn't recognize or acknowledge goodwill, which is any purchase price paid above the value of the assets. Goodwill had to be amortized over 20 years, which reduced the combined company's earnings.
- Merger accounting journal entries in this method reported assets at their book value rather than their market value, which was often less.
- The pooling of interests approach doesn't report acquisition costs. Like not amortizing goodwill, this makes the combined company's finances look better.
The Financial Accounting Standards Board killed pooling of interests in 2001. FASB based its decision on the same factors that made pooling of interests attractive to businesses: It presented a rosier view of the financial picture than what was realistic.
Up until 2001, the purchase method was an alternative to the pooling of interests. Mergers used pooling of interests; if one company simply bought another, then the purchase price method was preferred. Confusingly, both the acquisition and purchase methods may be referred to as "purchase accounting", but they're distinct approaches.
- In the purchase method, you value assets at their fair market value. You do the same for the liabilities you assume when you buy the company.
- The purchase method of accounting doesn't worry about the assets and liabilities of the acquiring party, only the company being acquired.
- Under the revised 2001 rules for the purchase method of accounting, FASB introduced new criteria for recognizing intangible assets.
- FASB eliminated the amortization of goodwill, which had been objectionable to so many businesses.
In 2007, the purchase method joined pooling of interests in the trash can of accounting history. The acquisition method was now top dog.
The transition to the acquisition method wasn't just a whim. The purchase method of accounting was designed for when one company buys another. The rules for the acquisition method cover purchases but also any other form of business combination.
Underlying the switch is a conceptual difference between the two types of accounting. If Company A combines with Company B, it becomes accountable for all of B's assets and liabilities. This holds true whether A buys the entire company or simply takes over 51% of the stock, so the accounting for the combination should reflect that.
Two principles distinguish the acquisition method from the purchase method: the recognition principle and the measurement principle.
- Under the acquisition method's recognition principle, the acquiring party must recognize not only the assets and liabilities acquired but any noncontrolling interest in the company. If the acquiring party buys 60% of a company's stock, for instance, the other 40% is a noncontrolling interest.
- The measurement principle requires the acquiring party to set a value on assets, liabilities and the noncontrolling interest. FASB has rules on how to recognize the values, but if the rules don't fit the situation, the acquiring company still has to make the measurement.
The FASB rules do include some exceptions allowing you to waive the recognition and measurement principles. If you're not covered by a specific exemption, however, the principles apply.
The acquisition method works in five steps.
- Measure tangible assets and liabilities. Your accounting journal entries should record the fair market value at the date you acquired control of the other company. A few exceptions, such as lease contracts, are measured by their inception date.
- Measure intangible assets and liabilities. You use the fair market value at the acquisition date here too. As intangibles aren't always written into the balance sheet, setting a value on them is tougher.
- Measure the value of the noncontrolling interest. If the stock is publicly traded, you can base the value on the amount of stock you don't own.
- Measure the consideration. Whatever you paid to gain control of the other company, whether it's cash, stock, stock options or something else, you record the fair market value.
- Measure goodwill. Suppose you paid $250,000 for a company with $225,000 in assets, $25,000 in liabilities and $15,000 in noncontrolling interest. Adding the consideration, the liabilities and the noncontrolling interest and then subtracting the assets gives you $65,000. That's your goodwill.
The acquisition method isn't one of the insanely complicated accounting formulas, but that doesn't mean it's easy. Unlike updating accounts payable or bad debts, merger accounting journal entries come along once in a blue moon at most firms. That makes it harder than more routine accounting tasks.
- Setting a fair market value on liabilities and assets can be difficult. It takes judgment, and the judgment needs supporting evidence. Many companies outsource this to experts.
- It's not always possible to complete all the valuation and journal entries in the same accounting period when your company acquired Company B. If the facts are going to be late, you have to put down a best estimate and then adjust them later when you know more.
- FASB still issues periodic updates and rules changes. If you haven't used the acquisition method in a while, you may face a new set of accounting standards.
- Your financial statements will need a lot of disclosure statements explaining your accounting assumptions.
- If you wait too long after the deal closes to update all your assumptions and estimates, your company could be charged with making material misstatements.
- If you don't understand the reasons for the deal and what assets the acquiring company wanted, it'll be harder to value them correctly.
You'll also have to deal with a lot of accounting issues outside the acquisition method itself. Deals often involve complex funding and tax considerations. After the deal, you have to merge the accounting systems, records and methods of two firms so they can function smoothly together.