This checklist explores the principles of accounting for a business combination under the acquisition method of accounting.
Acquisition accounting relates to the accounting procedure following the takeover of one company by another. The resulting entity is often known as a business combination. Exact standards may vary from one country to another so it is important to obtain professional advice on the procedures relating to acquisition accounting in the country in which the business combination will be operating. In the UK, for example, the Accounting Standards Board FRS 7 Standard sets out the principles of accounting for a business combination under the acquisition method of accounting. In the USA, the Financial Accounting Standard Board’s Statement No 141 sets out what a reporting entity should provide in its financial reports in relation to a business combination and its effects. However, there is a process of convergence taking place across the globe, led by the International Accounting Standards Board (IASB). Its standards: IFRS 3 Business Combinations and of IAS 27 Consolidated and Separate Financial Statements are increasingly recognized by governments around the world.
Prior to June 2001, two accounting methods could be used when a merger or acquisition took place. They were the purchase method and the pooling of interests method. However, the purchase method is now compulsory in the USA and the EU and wherever else the IFRS standard issued by the IASB is recognized. Under the purchase method, the assets and liabilities of the merged company are presented at their market values as on the date of acquisition. The acquisition must be estimated at fair value and the difference between the purchase price and the fair value should be recognized as goodwill. Under the pooling of interests method, transactions are considered as exchange of equity securities. The assets and liabilities of the two firms are combined according to their book value on the acquisition date.
The increasing use of the purchase method means that it is easier to compare potential acquisition targets around the world in accountancy terms at least.
Under the purchase method, a company cannot create a restructuring provision to provide for future losses or restructuring costs as a result of an acquisition. Such costs must be treated as post acquisition costs. Consequently, it is easier to gauge the impact of restructuring costs on profits, and prevent the use of provisions to exaggerate the immediate impact of an acquisition on profits, while boosting reported profits in subsequent years.
One of the main drawbacks of the purchase method is that it may overrate depreciation charges because the book value of assets used in accounting is generally lower than the fair value if the economy is experiencing relatively high inflation.
If the amount paid for a company is greater than fair market value - the difference is reflected as goodwill. Since goodwill must be written off against future earnings, the pooling of interests method is preferable to the purchase method.
Check which acquisition accounting standards apply in the country in which you are undertaking an acquisition.
If you can use either the purchase method or the pooling of interests method take professional advice on which is the most advantageous.
Dos and Don’ts
Obtain advice from legal and accounting professionals before proceeding with any acquisition.
Remember that, the purchase method, of accounting must identify the acquirer (the entity that obtains control over the other entity).
Don’t forget that, under the purchase method, investors are likely to disregard the impact of goodwill.
Don’t forget that, under the purchase method, the elimination of provisions creates extra visibility and helps prevent abuses.