An acquisition is a corporate transaction in which one company buys another company through the purchase of its assets or shares. A surefire way for a company to grow quickly is by acquiring other companies. This is normally what drives an acquisition.

Although growth is often the overarching goal, businesses may acquire certain companies for specific reasons, such as gaining access to more advanced technologies, opening up new distribution channels, synchronizing systems for more efficient operations and gaining ownership of undervalued assets.

Financial statements are the usual records and summaries of a company's financial activities. Acquisition accounting, on the other hand, is a term that defines a specific, formal set of guidelines that police how a buying company records the assets, liabilities, non-controlling interest and goodwill of a target company in its consolidated statement of financial position.

As you can imagine, it is important for companies to know how these transactions should be recorded on their balance sheets.

Purpose of Financial Statements

Although financial statements as a whole give the overall picture of a company's financial standing and health, these statements are divided into three parts that give different insights into various aspects of the business.

The three types of financial statements are income statements, balance sheets and cash flow statements.

The Income Statement

An income statement shows a company's profits or losses over a particular period of time. This statement presents the company's total revenues, costs, gross profit, net profit, administrative expenses, operation expenses and taxes paid.

The Balance Sheet

A balance sheet is a financial statement that gives insights into a company's financial condition. It shows how much the company has in assets, how they paid for those assets, the amount they have in liabilities, the total remaining after a company covers its liabilities and the amount of equity owned by its shareholders.

Assets can fall into one of two categories – current or fixed (long-term) – with current assets being those that can be converted into cash quickly (in less than a year) and fixed assets being assets that companies use in production and have for long-term use.

Liabilities are also divided into two groups – current and long-term – with current liabilities being debts that are due within one year and long-term liabilities being debts with due dates longer than one year away.

The Cash Flow Statement

The cash flow statement is the third piece to the financial statement trio. Cash flow represents the money coming in and going out of a business, and a cash flow statement is a way to present these activities in a summarized document. By looking at a cash flow statement, you can know how much money is incoming and outgoing, where it is coming from (or will come from) and where it went (or will go), and the overall financial health of a company.

This type of data is crucial when it comes to budgeting and planning business activities, such as ordering inventory.

Initial Effect on Financial Statements

A company's balance sheet is the only financial statement initially affected by an acquisition.

For example, let us imagine Company A purchases Company B for $100,000 in cash. Since cash was used, $100,000 would be subtracted from Company A's cash asset account on the balance sheet. If Company A went to the bank to borrow $100,000 to purchase Company B, $100,000 would be added to Company A's liabilities on the balance sheet.

Once Company A purchases Company B, all of the assets and liabilities from the acquired company's financial statements get added to Company A's balance sheet.

If Company B had $60,000 in assets and $30,000 in liabilities, then company A adds $60,000 its assets and $30,000 to its liabilities. The net value of the assets – which can be found by subtracting liabilities from assets – is $30,000.

The $70,000 difference between the net value of Company B's assets and the $100,000 that Company A paid for it goes on the balance sheet as goodwill.

Goodwill is a miscellaneous category on a company's balance sheet that consists of intangible assets. These assets are hard to measure and are often unquantifiable. Brand reputation and customer loyalty are two examples of assets that count as goodwill.

Costs vs. Expenses

To get an idea of how acquisitions affect an income statement, it is important to get a grasp on the difference between what company's define as a cost versus what they define as an expense. Although they are similar in nature, there is a fundamental difference between them.

The cost of a transaction is any amount of money that is paid for an asset, while an expense is any amount of money that leaves the company.

For example, if a construction company buys a dump truck, that would go down as a cost; however, the money that the construction company pays to cover their utility bills is considered an expense.

When it comes to acquisition accounting, any costs a business incurs during the acquisition process is considered part of its purchasing price. In addition to the cost of the company itself, the additional costs associated with the acquisition process include any legal fees paid to complete the transaction, any regulatory fees, potential commission fees and severance paid to released employees of the acquired company.

Because this money is considered a cost for the acquiring company, it goes on the company's balance sheet as a cost, but not on its income statement as an expense. However, if a business took out a loan to purchase the company, the interest they pay back on the loan will go on the company's income statement as an expense.

Amortization and Depreciation

Amortization is the process of transferring the cost of intangible assets over to expenses over an extended period of time. Intangible assets are classified as nonphysical assets that are assigned monetary value. By expensing the cost of these assets over time, the company gradually shifts the amount from its balance sheet over to its income statement.

Depreciation follows the same process as amortization, except it is used in reference to tangible assets. Since businesses also acquire a company's tangible assets – such as equipment, buildings, vehicles and land – during an acquisition, these costs must be expensed over to the income statement through depreciation.

Purchase Accounting Adjustment

General Accepted Accounting Principles (GAAP) require that the assets and liabilities of an acquired company be revised to their fair value at the time of the acquisition. If there is a change in the value of the acquired company's assets or liabilities, it is known as purchase accounting adjustments, and these changes must be reflected in the acquiring company's books.

In particular, inventory and all assets – fixed or intangible – should be recorded at their fair value.

Purchase accounting adjustments often result in increased future expenses for the acquiring company.

For example, an increase in the value of fixed assets would increase cost and increase the amount that must be depreciated over time. The same goes for intangible assets – which are not often recorded, initially – which increases the amount that must be expensed through amortization over time.