Purchase Accounting

Definition of Purchase Accounting

Purchase Accounting, according to the International Financial Reporting Standards (IFRS), also referred to as Acquisition Accounting, is the process of recognizing and measuring the identifiable assets acquired, liabilities assumed, and any non-controlling interest in the acquired business in the financial statements of the acquiring entity. This revaluation is done at their fair values as of the acquisition date.

In this method:

The acquirer measures the identifiable assets acquired and liabilities assumed at their fair values.
Any excess of the aggregate of the consideration transferred, the amount of any non-controlling interests, and the fair value of the acquirer’s previously held equity interest in the acquiree over the net of the acquisition-date amounts of the identifiable assets acquired and the liabilities assumed is recognized as goodwill.
If the cost of acquisition is less than the fair value of the identifiable net assets, the difference is recognized in the profit or loss as a gain on bargain purchase.

Examples

Example of Purchase Accounting:
- Company A acquires Company B. At the acquisition date, the fair value of Company B’s identifiable net assets is $5 million, and Company A pays $7 million for the acquisition.
- Purchase consideration: $7 million
- Fair value of identifiable net assets: $5 million
- Calculation of goodwill: $7 million - $5 million = $2 million
- Therefore, Company A will recognize $2 million as goodwill.
Example of a Bargain Purchase:
- Company X acquires Company Y. At the date of acquisition, the fair value of Company Y’s identifiable net assets is $8 million, and Company X pays $6 million for the acquisition.
- Purchase consideration: $6 million
- Fair value of identifiable net assets: $8 million
- Calculation of bargain purchase gain: $8 million - $6 million = $2 million
- Company X will recognize a $2 million gain on bargain purchase in its profit or loss.

Frequently Asked Questions (FAQs)

Q1. What is the main objective of purchase accounting?
A1. The main objective of purchase accounting is to provide a transparent and fair representation of the value of assets and liabilities obtained by the acquiring company, ensuring that the financial statements reflect the true financial position post-acquisition.

Q2. How is goodwill calculated in purchase accounting?
A2. Goodwill is calculated as the excess of any consideration paid over and above the fair value of the identifiable net assets acquired.

Q3. Can goodwill be negative?
A3. No, when the purchase consideration is less than the fair value of the identifiable net assets acquired, the excess is recognized as a gain on bargain purchase, not negative goodwill.

Q4. How are acquisition-related costs treated in purchase accounting?
A4. Acquisition-related costs (e.g., legal fees, advisory fees) are expensed as incurred and are not included in the consideration transferred in a business combination.

Q5. What is the fair value in purchase accounting?
A5. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Fair Value: The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
Goodwill: An intangible asset that represents the excess of the purchase price over the fair value of the identifiable net assets acquired in a business combination.
Bargain Purchase: Occurs when the purchase price is less than the fair value of the net identifiable assets acquired, resulting in a gain recognized in profit or loss.
Consolidation: The process of combining the financial statements of two or more entities that are controlled by one entity.
Acquired Entity: The company that is being purchased or merged in a business combination.

Online References

Suggested Books for Further Studies

“Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
A comprehensive guide delving deep into the principles and practices of accounting, including purchase accounting.
“International Financial Reporting: A Practical Guide” by Alan Melville
A practical and accessible guide to IFRS and its applications in real-world scenarios.
“Advanced Accounting” by Floyd A. Beams, Joseph H. Anthony, Bruce Bettinghaus, and Kenneth Smith
A detailed text offering insights into complex accounting topics, including consolidations and mergers.

Accounting Basics: “Purchase Accounting” Fundamentals Quiz

### When one company takes over another, which method is used to consolidate their financial statements? - [x] Purchase Accounting - [ ] Equity Accounting - [ ] Cost Accounting - [ ] Fund Accounting > **Explanation:** Purchase accounting is used to consolidate financial statements when one company acquires another, recognizing assets and liabilities at fair value and potentially recognizing goodwill. ### What is the result if the purchase consideration is higher than the fair value of identifiable net assets? - [ ] Bargain Purchase - [x] Goodwill - [ ] Discount on Purchase - [ ] Premium Amortization > **Explanation:** If the purchase consideration is higher than the fair value of identifiable net assets, the excess amount is recognized as goodwill. ### How is a 'bargain purchase' gain recognized? - [ ] As an asset - [ ] As goodwill - [ ] As a liability - [x] In profit or loss > **Explanation:** A bargain purchase gain occurs when the purchase price is less than the fair value of identifiable net assets and is recognized in profit or loss. ### What does IFRS stand for? - [x] International Financial Reporting Standards - [ ] International Financial Regulations Standard - [ ] International Financial Reporting System - [ ] International Fiscal Reporting Standards > **Explanation:** IFRS stands for International Financial Reporting Standards, which set the guidelines for global accounting practices, including purchase accounting. ### Which of the following is not expensed as incurred in purchase accounting? - [ ] Legal Fees - [ ] Advisory Fees - [x] Acquisition-related purchase price - [ ] Valuation Fees > **Explanation:** Acquisition-related purchase price forms part of the consideration transferred, while other costs such as legal, advisory, and valuation fees are expensed as incurred. ### What happens to the assets and liabilities of the acquired company in purchase accounting? - [ ] They are combined without any adjustments - [x] They are revalued to fair value - [ ] They are removed from records - [ ] They are kept unchanged > **Explanation:** In purchase accounting, the assets and liabilities of the acquired company are revalued to their fair values as of the acquisition date. ### Which method is used for interpreting and registering the financial effects of a company acquisition? - [ ] Cash Accounting - [ ] Accrual Accounting - [ ] Tax Accounting - [x] Purchase Accounting > **Explanation:** Purchase accounting is the method used for recognizing and measuring the financial effects of a company acquisition. ### Goodwill arising from an acquisition is classified under which category? - [ ] Liabilities - [x] Intangible Assets - [ ] Current Assets - [ ] Reserves & Surplus > **Explanation:** Goodwill is classified as an intangible asset on the balance sheet. ### What term is used when the cost of acquisition is less than the fair value of net assets acquired? - [ ] Excess Purchase - [ ] Amortization Surplus - [x] Bargain Purchase - [ ] Net Acquisition Gain > **Explanation:** When the cost of acquisition is less than the fair value of net assets acquired, it is termed a bargain purchase. ### How are non-controlling interests measured in purchase accounting? - [ ] Using historical cost - [x] At fair value or the proportionate share of the acquiree's identifiable net assets - [ ] At book value - [ ] Using intrinsic value > **Explanation:** In purchase accounting, non-controlling interests are measured at either fair value or the proportionate share of the acquiree's identifiable net assets as chosen by the acquirer.

Thank you for exploring purchase accounting, also known as acquisition accounting. Continue deepening your understanding of accounting principles for a successful career in finance!