Purchase method

Definition

The purchase method is an accounting approach used in mergers and acquisitions, where the acquiring company records the assets and liabilities of the target company at their fair market values on the acquisition date. This method requires that any excess payment over the fair value of the identifiable net assets is recognized as goodwill. Understanding this method is crucial for accurately reflecting the financial position of both companies involved in the transaction.

5 Must Know Facts For Your Next Test

1. Under the purchase method, all identifiable assets and liabilities of the acquired company must be measured at their fair values, leading to a comprehensive assessment of the acquired entity's worth.
2. Goodwill recognized from an acquisition under the purchase method can significantly impact the acquirer's financial statements, as it is subject to annual impairment testing.
3. The purchase method requires detailed documentation and valuation of each asset and liability involved in the acquisition to ensure compliance with accounting standards.
4. This method contrasts with the pooling-of-interests method, which was previously used but is no longer permitted under current accounting rules.
5. The purchase method provides clearer insights into how much a company has paid for its acquisitions, which can be essential for stakeholders evaluating corporate strategies.

Review Questions

• How does the purchase method influence the financial reporting of a company after an acquisition?
  • The purchase method impacts financial reporting by requiring that all assets and liabilities of the acquired company be recorded at their fair values. This means that upon acquisition, any excess payment over these values is recorded as goodwill on the balance sheet. This change can affect key financial ratios, earnings calculations, and overall financial health perception for stakeholders evaluating the company's performance post-acquisition.
• Discuss the implications of recognizing goodwill under the purchase method in terms of financial statement transparency and investor perception.
  • Recognizing goodwill under the purchase method adds complexity to financial statements, as it reflects future earning potential that may not be easily quantifiable. This can lead to concerns among investors regarding transparency since goodwill does not represent tangible assets. Investors may question whether future performance will justify the premium paid during acquisition, making it critical for companies to provide clear explanations and justifications related to their acquisition strategies.
• Evaluate how changes in accounting standards regarding mergers and acquisitions have affected the adoption of the purchase method in financial services.
  • Changes in accounting standards, particularly with FASB Statement No. 141, have mandated that the purchase method be used for all business combinations, eliminating alternative methods like pooling-of-interests. This shift has led to a more standardized approach in financial reporting across the financial services industry, enhancing comparability between companies. As firms navigate these changes, they must carefully assess fair values and ensure compliance with new regulations while effectively communicating these adjustments to stakeholders.

Related terms

goodwill:

Goodwill is an intangible asset that represents the excess amount paid over the fair value of a company's net identifiable assets during an acquisition.

fair value:

Fair value is the estimated price at which an asset or liability would trade in a current transaction between willing parties.

merger:

A merger is a business combination where two companies agree to combine their operations and form a single entity, typically involving one company acquiring another.