After the acquisition is completed the financials of the acquired company have to be recorded into the buyers financials. What values do you take, how do you record the transaction and what happens if the purchase price is higher than the fair value of the acquired company? When is there goodwill?
When the acquisition is completed and the Buyer has obtained control, the acquired company has to be consolidated into the financials of the purchaser. The global accounting standards largely follow the same methodology for this and are referred to as purchase accounting or acquisition method. Purchase accounting follows four steps:
- Identify the purchaser.
- Determine the acquisition date.
- Identify and quantify the acquired assets and assumed liabilities.
- Recognize and record goodwill.
Identify the purchaser
In all business combinations or acquisitions there has to be one company to be identified as the acquirer. For accounting purposes this is the company that obtains control of the other entity. Control is defined as the “power to govern the financial and operating policies of an entity or business in order to obtain benefits from its activities”. The general rule is the entity that directly or indirectly holds greater than 50% of the voting shares has control.
If based on the above it is not clear which entity is the acquirer further guidance is provided:
- In a business combination effected primarily by transferring cash or other assets or by incurring liabilities, the acquirer usually is the entity that transfers the cash or other assets or incurs the liabilities.
- In a business combination effected primarily by exchanging equity interests, the acquirer usually is the entity that issues its equity interests.
The key thing here is that the acquirer is the company that obtains control over the acquired company. This does not always need to be the larger entity in terms of assets or revenues.
Determine acquisition date
The next step is to identify the exact acquisition date. This is determined as the date on which the purchaser obtains control. Generally, this will be at closing and when proceeds are transferred to the Seller.
Identify and quantify acquired assets
On the acquisition date, the purchaser has to determine the fair market value of:
- the identifiable assets acquired; and
- the liabilities assumed.
The assets and liabilities to be identified need to be recorded if they match the definition of assets and liabilities under generally accepted accounting principles (GAAP), which means that:
(i) for an asset it is probable that future economic benefits will flow to the company and its fair market value can be measured reliably.
(ii) for a liability it is probably that a future outflow of resources is required to settle an existing obligation and that its fair market value can be measured reliably.
This means that a buyer can record assets which the acquired entity could not. For example, an acquired brand and customer base, which the acquired entity could not record because it is internally generated.
Under GAAP the fair market value is defined as the price that would be received from the sale of an asset or paid to transfer a liability in an orderly transaction between knowledgeable market participants. As such, the assets on the acquired company’s balance sheet will change. For example, tangible fixed assets need to be revalued to its market price (not taking into account accumulated depreciation of the acquired company) and inventories need to be revalued to its selling price. Trade receivables and trade payables will likely remain the same as these already present the amount needed to settle the open amount.
The allocation of the paid purchase price to the fair market values of the assets acquired and liabilities assumed is a process called a Purchase Price Allocation (or PPA). A PPA is often performed by financial valuation specialists.
Recognize and record goodwill
A Buyer often pays more than the total fair market value of the assets of the acquired company. This is because the Buyer expects additional value as result of synergies or increased growth from future customers.
The residual value that remains after deducting the amount of all identifiable assets from the purchase price paid is goodwill. Under GAAP this goodwill is capitalized and recorded on the balance sheet. The thinking behind this is that even though the amount cannot be separately identified it holds value as a purchaser is willing to pay for it.
Under IFRS and US GAAP, goodwill is not amortized but subject to periodic impairment testing. At least on an annual basis this goodwill needs to be tested to see if it is recoverable by the business. If not fully recoverable, the goodwill needs to be impaired (written off) to the recoverable amount.
Whether or not goodwill needs to be amortized depends on the accounting principles followed. In some countries under local GAAP goodwill needs to be yearly amortized following its useful life.
Negative goodwill (or sometimes referred to as badwill or a purchase bargain) occurs when the purchase price paid is less than the fair market value of the identified assets acquired. This negative goodwill is added to equity.
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