In accounting, a business combination is a transaction that gives your company control of one or more businesses. The term applies to both mergers and to purchasing another company. Your company accounts have to record the new assets and any debts you acquired in the purchase. The accounting also has to track the goodwill gained from the purchase, and any extra money spent for purchase besides the purchase price.
Assets and Liabilities
When your company makes the purchase, it buys all the business's liabilities and assets. Your company's financial statements must recognize your new assets. The dollar amount you report for each new asset is the fair-market value at the time you bought the company. You do the same thing with liabilities and report them as your own.
If you acquire any of the company's assets or liabilities in separate transactions, record them separately in your accounts. In this case, they are not part of the company purchase.
Contingent/Uncertain Assets and Liabilities
Some assets or liabilities are contingent, depending on the outcome of a lawsuit or a contract. If, say, the business you take over is being sued, the possibility of losing the lawsuit is a contingent liability. You do not always recognize contingent liabilities or assets in the financial statements.
Only contingencies that are likely to occur happen go on the books, and only if you can estimate the probable value. If unrecorded contingencies come to pass, you recognize the gain or loss then.
How to Measure Goodwill
Goodwill is the value of the company minus the market value of the tangible assets acquired in the purchase. To figure out the value of the company, you add the price you paid for it to any previous ownership stake you had, plus the value of any other owners' non-controlling shares. Compare the result to the value of the assets.
If, say, you have $650,000 in assets and the company value is $875,000, the goodwill is usually worth $225,000. If the assets and non-controlling interest are worth more than your purchase price, you report the excess as a gain in earnings. For instance, if you buy a $650,000 company for $550,000, that is a $100,000 gain.
Accounting for Company Purchase Costs
Company purchase costs include more than what you paid for the business combination. They include finder's fees, legal and accounting fees, fees for appraising the business value, and consulting and advisory fees. It also includes general administrative costs, such as maintaining an acquisition department or registering bonds to finance the purchase.
Because these costs are not part of what you pay for the company, you report them separately, as expenses. You report these costs in the year you incur them.
Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com