What is Acquisition Accounting?
Acquisition accounting is a set of formal guidelines describing how assets, liabilities, non-controlling interest (NCI) and goodwill of a purchased company must be reported by the buyer on its consolidated statement of financial position.
The fair market value (FMV) of the acquired company is allocated between the net tangible and intangible assets portion of the balance sheet of the buyer. Any resulting difference is regarded as goodwill. Acquisition accounting is also referred to as business combination accounting.
- Acquisition accounting is a set of formal guidelines describing how assets, liabilities, non-controlling interest and goodwill of an acquired company must be reported by the purchaser.
- The fair market value of the acquired company is allocated between the net tangible and intangible assets portion of the balance sheet of the buyer. Any resulting difference is regarded as goodwill.
- All business combinations must be treated as acquisitions for accounting purposes.
How Acquisition Accounting Works
International Financial Reporting Standards (IFRS) and International Accounting Standards (IAS) require all business combinations to be treated as acquisitions for accounting purposes, meaning that one company must be identified as an acquirer and one company must be identified as an acquiree even if the transaction creates a new company.
The acquisition accounting approach requires everything to be measured at FMV, the amount a third-party would pay on the open market, at the time of acquisition — the date that the acquirer took control of the target company. That includes the following:
- Tangible assets and liabilities: Assets that have a physical form, including machinery, buildings, and land.
- Intangible assets and liabilities: Nonphysical assets, such as patents, trademarks, copyrights, goodwill, and brand recognition.
- Non-controlling interest: Also known as minority interest, this refers to a shareholder owning less than 50% of outstanding shares and having no control over decisions. If possible, the fair value of non-controlling interest can be derived from the share price of the acquiree.
- Consideration paid to the seller: The buyer can pay in many ways, including cash, stock or a contingent earnout. Calculations must be provided for any future payment obligations.
- Goodwill: Once all those steps have been taken, the purchaser must then calculate if there is any goodwill. Goodwill is recorded in a situation when the purchase price is higher than the sum of the fair value of all identifiable tangible and intangible assets bought in the acquisition.
Fair value analysis is often conducted by a third-party valuation specialist.
History of Acquisition Accounting
Acquisition accounting was introduced in 2008 by the major accounting authorities, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB), to replace the previous method, known as purchase accounting.
Acquisition accounting was preferred because it strengthened the concept of fair value. It focuses on prevailing market values in a transaction and includes contingencies and non-controlling interests, which were not accounted for under the purchase method.
Another difference between the two techniques is how bargain acquisitions are treated. Under the purchase method, the difference between the acquired company's fair value and its purchase price was recorded as negative goodwill (NGW) on the balance sheet that was to be amortized over time. In contrast, with acquisition accounting, NGW is immediately treated as a gain on the income statement.
Complexities of Acquisition Accounting
Acquisition accounting improved the transparency of mergers and acquisitions (M&A) but did not make the process of combining financial records easier. Each component of assets and liabilities of the acquired entity has to be adjusted for fair value in items ranging from inventory and contracts to hedging instruments and contingencies, to name just a few.
The amount of work needed to adjust and integrate the books of the two companies is one main reason for the long period between agreement on a deal by the respective boards of directors and the actual deal closing.