Acquisition Accounting

Checklist
This checklist explores the principles of accounting for a business combination under the acquisition method
of accounting.

Definition
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.

Advantages
• 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.

Disadvantages
• 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.

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Action Checklist
• 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

Do
• 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
• 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.

More Info
Books:
• Lajoux, Alexandra Reed. The Art of M&A Integration: A Guide to Merging Resources, Processes, and
Responsibilities. New York: McGraw-Hill Professional, 2005.
• Lewis, Richard, and David Pendrill. Advanced Financial Accounting. London: Pearson Education,
2004.
• Siegel, Joel G., Nick Dauber, and Jae K. Shim. The Vest Pocket CPA.. Hoboken, NJ: Wiley, 2005.

Articles:
• Dos Santos, M. B., V. R. Errunza, and D.P. Miller. “Does corporate international diversification destroy
value? Evidence from cross-border mergers and acquisitions.” Journal of Banking and Finance 32:12
(2008): 2716–2724.
• James, K., J. How, and P. Verhoeven. “Did the goodwill accounting standard impose material
economic consequences on Australian acquirers?” Accounting and Finance 48:4 (2008): 625–647.
• Pasiouras, F., C. Gaganis, and C. Zopounidis. “Regulations, supervision approaches and acquisition
likelihood in the Asian banking industry” Asia Pacific Financial Markets 15:2 (2008): 135–154.

Wesbite:
• International Accounting Standards Board: www.iasb.org

See Also
Checklists
• Structuring M&A Deals and Tax Planning
• Using IRR for M&A Financing
• Using the Market-Value Method for Acquisitions

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