On any acquisition process, once due diligence and valuation of acquiree is completed, the process continued to recording (accounting) the acquisition on the company’s book. And this task mostly be conducted by a general ledger specialist. Of course the Controller will want to review this area of accounting, since a mistake here can have a major impact on overall corporate results. The only allowable method used is the purchase method. There are also many situations where a company merely makes a small investment in another company, rather than making an outright purchase. This requires three possible types of accounting, depending on the size of the investment and the degree of control attained over the subject company—all three methods, which are the cost, equity, and consolidation methods.
This post deals with the purchase method of accounting for an acquisition, as well as the cost, equity, and consolidation methods, which are used to describe purchases of varying proportions of another entity. I also address how to account for intercompany transactions between the acquirer and acquiree after the purchase is completed. Enjoy!
Note: It is worth mentioning here, the terms merger and acquisition are not the same thing. An acquisition is when both the acquiring and acquired company are still left standing as separate entities at the end of the transaction.
Purchase Method Acquisition Accounting
This approach to accounting for a business combination assumes that the acquiring company spreads the acquisition price over the assets being bought at their fair market value, with any remaining portion of the acquisition price being recorded in a goodwill account. The company being purchased can be bought with any form of consideration, such as stock, cash, or property.
There are three primary steps involved in accounting for a purchase transaction: (1) determining the purchase price; (2) allocating this price among the various assets of the company being purchased; and (3) accounting for the first-year partial results of the purchased entity on the buyer’s financial statements. Let’s go into more detail of the steps. Read on…
Step-1. Determining the Purchase Price
The issue with the first step is that the purchase price is based on the fair market value of the consideration given to the seller. For example:
- If the purchase is made with stock, the stock must be valued at its fair market value.
- If treasury stock is used as part of the consideration, then this must also be valued at its fair market value.
- If the buyer’s stock is thinly traded or closely held, then it may be necessary to obtain the services of an investment banker or appraiser, who can use various valuation models and industry surveys to derive a price per share.
Step-2. Allocate Purchase Price Among Various Assets of The Company Being Purchased
The second step in the purchase method is to allocate the purchase price among the acquired company’s assets and liabilities, which are then recorded in the buyer’s accounting records. The method of valuation varies by line item on the acquired company’s balance sheet. Here are the key rules on how to allocate the purchase price among assets, liabilities and stock option of company being purchased:
Accounts Receivable – Record this asset at its present value, less the allowance for bad debts. Given the exceedingly short time frame over which this asset is outstanding, there is generally no need to discount this valuation, unless there are receivables with very long collection terms. Also, since the acquisition transaction is generally not completed until several months after the acquisition date (given the effort required to make the accounting entry), the amount of the allowance for bad debts can be very precisely determined as of the acquisition date.
Marketable Securities – These assets should be recorded at their fair market value. This is an opportunity for the buyer to mark up a security to its fair market value (if such is the case), since generally accepted accounting principles (GAAP) normally only allows for the recognition of reductions in market value. For this reason, this is an area in which there is some opportunity to allocate an additional portion of the purchase price beyond the original cost of the asset. However, since most companies only invest in short-term, highly liquid securities, it is unlikely that there will be a large amount of potential appreciation in the securities.
Inventory—raw Materials – These assets should be recorded at their replacement cost. This can be a problem if the acquiree is in an industry, such as computer hardware, where inventory costs drop at a rapid pace as new products come into the marketplace. Consequently, the buyer may find itself with a significantly lower inventory valuation as a result of the purchase transaction than originally appeared on the accounting records of the acquiree.
Inventory—finished Goods – These assets should be recorded at their selling prices, less their average profit margin and disposition costs. This can be a difficult calculation to make if the finished goods have variable prices depending on where or in what quantities they are sold; in such cases, the determination of selling price should be based on a history of the most common sales transactions. For example, if 80% of all units sold are in purchase quantities that result in a per unit price of $1.50, then this is the most appropriate price to use. This rule can be avoided, however, if the acquiree has firm sales contracts as of the date of the acquisition with specific customers that can be used to clearly determine the prices at which the finished goods will actually be sold. If the acquirer had been using a last-in, first-out (LIFO) inventory valuation system, then the newly derived valuation for the finished goods inventory shall be used as the LIFO base layer for all inventory obtained through the purchase transaction.
Inventory—work-in-process [WIP] – These assets receive the same valuation treatment as finished goods, except that the cost of conversion into finished goods must also be subtracted from their eventual sale price.
Property, Plant, and Equipment (PP&E) – These assets should be recorded at their replacement cost. This can be a difficult task that lengthens the interval before the acquisition journal entry is completed, because some assets may be so old that there is no equivalent product currently on the market, or equipment may be so specialized that it is difficult to find a reasonable alternative on the market. This valuation step frequently calls for the services of an appraiser.
Property, Plant, and Equipment To Be Sold – If the buyer intends to sell off assets as of the acquisition date, then these assets should be recorded at their fair market value. This most accurately reflects their disposal value as of the acquisition date.
Capital Leases – If the acquiree possesses assets that were purchased with capital leases, then the CFO should value the asset at its fair market value, while valuing the associated lease at its net present value.
Research and Development (R&D) Assets – If any assets associated with specific R&D projects are part of the acquiree, the CFO should charge these assets off to expense if there is no expectation that they will have an alternative future use once the current R&D project has been completed. The precise allocation of assets to expense or asset accounts can be difficult, since the existing projects may be expected to last well into the future, or the future use of the assets may not be easy to determine. Consequently, one should carefully document the reasons for the treatment of R&D assets.
Intangible Assets – These assets are to be recorded at their appraised values. If the buyer cannot reasonably assign a cost to them or identify them, then no cost should be assigned.
Accounts and Notes Payable – Accounts payable can typically be recorded at their current amounts as listed on the books of the acquiree. However, if the accounts payable are not to be paid for some time, then they should be recorded at their discounted present values. The same logic applies to notes payable; since all but the shortest-lived notes will have a significantly different present value, they should be discounted and recorded as such. This treatment is used on the assumption that the buyer would otherwise be purchasing these liabilities on the date of the acquisition, not on a variety of dates stretching out into the future, and so must be discounted to show their value on the acquisition date.
Accruals – These liabilities are typically very short-term ones that will be reversed shortly after the current accounting period. Accordingly, they are to be valued at their present value; discounting is rarely necessary.
Pension Liability – If there is an unfunded pension liability, even if not recognized on the books of the acquiree, it must be recognized by the buyer as part of the purchase transaction.
Stock Option Plan – If the buyer decides to take over an existing stock option plan of the acquiree’s, then it must allocate part of the purchase price to the incremental difference between the price at which shares may be purchased under the plan and the market price for the stock as of the date of the acquisition. However, if the buyer forced the acquiree to settle all claims under the option plan prior to the acquisition, then this becomes a compensation expense that is recorded on the books of the acquiree.
Let’s say the acquiring company (Lie Dharma Corporation) buys the acquiree’s (Putra Corporation’s) stock with $500,000 of cash, the entry on Lie Dharma’s books would be:
[Debt]. Investment in Putra Corporation = $500,000
[Credit]. Cash = $500,000
Alternatively, if Lie Dharma were to make the purchase using a mix of 20% cash and 80% for a note, the entry would be:
[Debt]. Investment in Putra Corporation = $500,000
[Credit]. Cash = $100,000
[Credit]. Note payable = $400,000
Another approach would be to exchange 5,000 shares of Lie Dharma’s $1 par value stock for that of Putra as a form of payment. Under this method, the entry would be:
[Debit]. Investment in Putra Corporation = $500,000
[Credit]. Common stock—par value = $5,000
[Credit]. Common stock—additional paid-in capital = $495,000
Next, still on the second step, let’s say the result of all valuation process shown as the following table, where it shows the calculation that would be required to adjust the books of an acquiree in order to then consolidate it with the results of the acquiring company.
The above table shows the initial book cost of each account on the acquiree’s balance sheet, followed by a listing of the required valuation of each account under the purchase method, the adjustment required, and the new account valuation. The new account valuation on the right side of the table can then be combined directly into the records of the acquiring company.
Under the “Purchase Method Valuation” column, a designation of “NPV” means that the net present value of the line item is shown, a designation of “FMV” means that the fair market value is shown (less any costs required to sell the item, if applicable), “RC” designates the use of replacement cost, “SLM” designates the use of sale price less the gross margin, and “AV” designates an asset’s appraised value.
In the table, debits and credits are specified for each adjusting entry listed in the “Required Adjustment” column. The amount of goodwill shown in the “Required Adjustment” column is derived by subtracting the purchase price of $15,000 from the total of all fair market and other valuations shown in the “Purchase Method Valuation” column. In this case, we have a fair market valuation of $18,398 for all assets, less a fair market valuation of $8,075 for all liabilities, which yields a net fair market value for the acquiree of $10,323. When this fair market value is subtracted from the purchase price of $15,000, we end up with a residual of $4,677, which is listed in the goodwill account. Note that the “Adjusted Acquiree Records” column on the right side of the exhibit still must be added to the acquirer’s records to arrive at a consolidated financial statement for the combined entities.
Step-3. Account for the First-Year Partial Results of the Purchased Entity on The Buyer’s Financial Statements
The third step in the acquisition process is to account for the first year partial results of the acquired company on its books. Only the income of the acquiree that falls within its current fiscal year, but after the date of the acquisition, should be added to the buyer’s accounting records.
In addition, the buyer must charge all costs associated with the acquisition to current expense—they cannot be capitalized. These acquisition costs should be almost entirely for outside services, since any internal costs charged to the acquisition would likely have been incurred anyway, even in the absence of the acquisition.
The only variation from this rule is the costs associated with issuing equity to pay for the acquisition; these costs can be recorded as an offset to the additional paid-in capital account. An additional item is that a liability should be recognized at the time of the acquisition for any plant closings or losses on the dispositions of assets that are planned as of that date; this is not an expense that is recognized at a later date, since we assume that the buyer was aware at the purchase date that some asset dispositions would be required.
If the acquirer chooses to report its financial results for multiple years prior to the acquisition, it does not report the combined results of the two entities for years prior to the acquisition.
A reverse acquisition is one where the company issuing its shares or other payment is actually the acquiree, because the acquiring company’s shareholders do not own a majority of the stock after the acquisition is completed.
As, I have mentioned at the preface of this post, there are cases that buyers only obtain another company’s stock that less than 50% where buyer’s does not have control right over it with various conditions. In those cases, there are: (1) cost method; (2) Equity Method; and (3) consolidation method. I am going to discuss these methods on the next paragraphs. Read on…
Cost Method Acquisition Accounting
The cost method is used to account for the purchase of another company’s stock when the buyer obtains less than 20% of the other company’s shares and does not have management control over it.
The buyer does not have control if it cannot obtain financial results from the other company that it needs to create entries under the equity method, or if it fails to obtain representation on the Board of Directors, is forced to relinquish significant shareholder rights, or the concentration of voting power is clearly in evidence among a different group of shareholders.
Under this method, the investing company records the initial investment at cost on its books. It then recognizes as income any dividends distributed by the investee after the investment date.
Equity Method Acquisition Accounting
The equity method of accounting for an investment in another company is used when the investor owns more than 20% of the investee’s stock, or less than 20% but with evidence of some degree of management control over the investee, such as control over some portion of the investee’s Board of Directors, involvement in its management activities, or the exchange of management personnel between companies. The method is only used when the investee is a corporation, partnership, or joint venture, and when both organizations remain separate legal entities.
Under the equity method, the acquirer records its initial investment in the investee at cost.
If the initial investment in Company ABC were $1,000,000 in exchange for ownership of 40% of its common stock, then the entry on the books of the investor would be:
[Debit]. Investment in Company ABC = $1,000,000
[Credit]. Cash = $1,000,000
After the initial entry, the investor records its proportional share of the investee’s income against current income.
If the investee has a gain of $120,000, the investor can recognize its 40% share of this income, which is $48,000. The entry would be:
[Debit]. Investment in Company ABC = $48,000
[Credit]. Investment income = $48,000
The credit in the last journal entry can more precisely be made to an Undistributed Investment Income account, since the funds from the investee’s income have not actually been distributed to the investor.
The investor should also record a deferred income tax expense based on any income attributed to the investee.
To continue with the preceding example, if the incremental tax rate for the investor is 38%, then it would record the following entry that is based on its $48,000 of Company ABC’s income:
[Debit]. Income tax expense = $18,240
[Credit]. Deferred taxes = $18,240
If the investee issues dividends, then these are recorded as an offset to the investment account and a debit to cash. Dividends are not recorded as income, since income was already accounted for as a portion of the investee’s income, even though it may not have been received.
If dividends of $25,000 are received from Company ABC, the entry would be:
[Debit]. Cash = $25,000
[Credit]. Investment in Company ABC = $25,000
If the market price of the investor’s shares in the investee drops below its investment cost, these are not normally any grounds for reducing the amount of the investment. However, if the loss in market value appears to be permanent, then a loss can be recognized and charged against current earnings. Evidence of a permanent loss in market value would be a long-term drop in market value that is substantially below the investment cost, or repeated and substantial reported losses by the investee, with no prospects for an improvement in reported earnings.
If the market price of the stock in Company ABC necessitated a downward adjustment in the investor’s valuation, the entry would be:
[Debit]. Loss on investments = $50,000
[Credit]. Investment in Company ABC = $50,000
If, after making a downward adjustment in its investment, the investor finds that the market price has subsequently increased, it cannot return the carrying amount of the investment to its original level. The new basis for the investment is the amount to which it has been written down. This will increase the size of any gain that is eventually recognized on the sale of the investment.
If the investee experiences an extraordinary gain or loss, the investor should record its proportional share of this amount as well. However, it is recorded separately from the usual investment accounts.
If Company ABC were to experience an extraordinary loss of $15,000, the entry would be:
[Debit]. Undistributed extraordinary loss = $15,000
[Credit]. Investment in Company ABC = $15,000
If the investee experiences such large losses that the investor’s investment is reduced to zero, the investor should stop recording any transactions related to the investment in order to avoid recording a negative investment. If the investee eventually records a sufficient amount of income to offset the intervening losses, then the investor can resume use of the equity method in reporting its investment.
If the investor loses control over the investee, then it should switch to the cost method of reporting its investment. When it does this, its cost basis should be the amount in the investment account as of the date of change. However, the same rule does not apply if the investor switches from the cost method to the equity method—in this case, the investor must restate its investment account to reflect the equity method of accounting from the date on which it made its initial investment in the investee.
When reporting the results of its investment in another company under the equity method, the investor should list the investment in a single Investment in Subsidiary line item on its balance sheet and in an Investment Income line item on its income statement.
When a company buys more than 50% of the voting stock of another company, but allows it to remain as a separate legal entity, then the financial results of both companies should be combined in a consolidated set of financial statements. However, if the companies are involved in entirely different lines of business, it may still be appropriate to use the equity method; otherwise, the combined results of the two enterprises could lead to misleading financial results. For example: if a software company with 90% gross margins combines with a steel rolling facility whose gross margins are in the 25% range (both being typical margins for their industries) the blended gross margin presents a misleading view of the gross margins of both entities.
Another case in which a 50%+ level of ownership might not result in the use of a consolidation is when the investing company only expects to have temporary control over the acquiree or if the buyer does not have control over the acquiree (perhaps because control is exercised through a small amount of restricted voting stock). In either case, the equity method should be used.
When constructing consolidated financial statements, the preacquisition results of the acquiree should be excluded from the financial statements. If there is a year of divestiture, the financial results of the acquiree in that year should only be consolidated up until the date of divestiture.
Post-Acquisition Intercompany Transactions
When the acquirer elects to report consolidated financial information, it must first eliminate all intercompany transactions. By doing so, it eliminates any transactions that represent the transfer of assets and liabilities between what are now essentially different parts of the same company. The transactions that should be eliminated are:
- Intercompany Sales, Accounts Receivable and Payable – The most common intercompany transaction is the account receivable or payable associated with the transfer of goods between divisions of the parent company. From the perspective of someone outside the consolidated company, these accounting transactions have not really occurred, since the associated goods or services are merely being moved around within the company and are not caused by a business transaction with an outside entity. Accordingly, for consolidation purposes, all intercompany accounts receivable, accounts payable, and sales are eliminated.
- Intercompany Bad Debts – A bad debt from another division of the same company cannot be recognized, since the associated sale and account receivable transaction must also be eliminated as part of the consolidation process. In short, if the sale never occurred, then there cannot be a bad debt associated with it.
- Intercompany Dividend Payments – This is merely a transfer of cash between different divisions of the corporate parent, and so should be invisible on the consolidated statement.
- Intercompany Loans and any Associated Discounts, Premiums, and Interest Payments – Though there are good reasons for using intercompany loans, such as the provision of funds to risky subsidiaries that might not be able to obtain funds by other means, this is still just a transfer of money within the company, as was the case for intercompany dividend payments. Thus, it must be removed from the consolidated financial statements.
- Intercompany Rent Payments – This is a form of intercompany payable, and so is not allowed.
- Fixed Asset Sale Transactions – When fixed assets are sold from one subsidiary to another, the selling company will eliminate the associated accumulated depreciation from its books as well as recognize a gain or loss on the transaction. These entries must be reversed, since the fixed asset has not left the consolidated organization.
- Intercompany Profits – A common issue for vertically integrated companies is that multiple subsidiaries recognize profits on component parts that are shipped to other subsidiaries for further work. On a consolidated basis, all of these intercompany profits must be eliminated, since the only profit gained from the consolidated perspective is when the completed product is finally sold by the last subsidiary in the production process to an outside entity.
- Intercompany Investments – The corporate parent’s investment in any subsidiaries is removed from the consolidation. For example, if a corporate parent created a subsidiary and invested a certain amount of equity in it, this investment would appear on the books of both the parent (as an investment) and the subsidiary (as equity). In a consolidation, both entries are removed.
All intercompany eliminations are recorded on a separate consolidation worksheet. They are not recorded on the books of any of the subsidiaries or the parent company. In essence, these transactions are invisible to all but the Controller, who is responsible for the consolidation reporting.