Purchase Method

In the USA, a method of accounting for business combinations in which cash and other assets are distributed or liabilities incurred. The purchase method is used if the criteria are not met for the pooling-of-interests method.
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Detailed Definition

The purchase method is an accounting method used when a company acquires another business. Under this method, the acquired company’s assets and liabilities are recorded at their fair market value on the acquisition date. If the purchase price is higher than the aggregate fair value of the net identifiable assets acquired, the difference is recorded as goodwill. Crucially, the net income of the acquired company is recognized from the date of acquisition forward, not retrospectively.

Examples

  1. Example 1: Acquisition with Excess Purchase Price

    • Company A acquires Company B for $10 million.
    • Fair value of Company B’s identifiable net assets: $7 million.
    • Goodwill recorded: $10 million - $7 million = $3 million.

  2. Example 2: Acquisition at Fair Value

    • Company C acquires Company D for $5 million.
    • Fair value of Company D’s identifiable net assets: $5 million.
    • Goodwill recorded: $0.

Frequently Asked Questions (FAQs)

Q1: What happens if the purchase price is less than the fair value of net assets?

  • A1: If the purchase price is less than the fair value of the acquired net assets, the acquirer recognizes this difference as a bargain purchase gain, which affects the income statement immediately.

Q2: How is goodwill calculated in the purchase method?

  • A2: Goodwill is calculated as the excess of the purchase price over the fair market value of the acquired company’s identifiable net assets.

Q3: Are the results of the acquired company included prior to the acquisition date?

  • A3: No, under the purchase method, only the net income from the date of acquisition forward is included.

Q4: Can the purchase method be used for any business combination?

  • A4: The purchase method is used when specific criteria for other methods, such as the pooling-of-interests method, are not met.
  • Pooling-of-Interests Method: An accounting method for business combinations resembling mergers rather than acquisitions, which is no longer allowed under U.S. GAAP.
  • Fair Value: The price at which an asset could be bought or sold in a current transaction between willing parties.
  • Goodwill: An intangible asset that represents the excess of purchase price over the fair value of identifiable net assets.

Online References

Suggested Books for Further Studies

  • “Financial Accounting for MBAs” by Peter Easton: A comprehensive guide for MBA students that covers a variety of accounting practices, including business combinations and the purchase method.
  • “Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, Terry D. Warfield: An in-depth textbook widely used in accounting courses that offers extensive insights into advanced accounting topics, including business combinations.

Accounting Basics: “Purchase Method” Fundamentals Quiz

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