What is Acquisition Accounting?
Acquisition accounting is the way a company tracks money and other assets when it buys another company. It is important because it affects the company’s reported profit and worth.
Acquisition vs Merger
An acquisition occurs when one company buys most or all of another company’s shares to gain control of that company. A merger occurs when two companies agree to become one new company rather than remain separate. Acquisitions are much more common than mergers, but from an accounting standpoint, the difference is not important.
The Acquisition Method
Acquisitions use a special accounting method called the “acquisition method.” Under this method, the acquiring company puts the target company’s assets and liabilities on its balance sheet. The assets include tangible things like buildings and intangible things like brands.
Assets and Liabilities
The acquiring company records the target’s assets and liabilities at their fair value. Fair value estimates how much the assets are worth and how much the company would pay to settle the liabilities. This may differ from the “book value” of these assets and liabilities in the target company’s financial statements.
Goodwill
If the purchase price exceeds the fair value of the assets and liabilities, the difference is recorded as an intangible asset called “goodwill.” Goodwill represents the value of things that are hard to measure, like the skills of the target workforce, customer relationships, and brand reputation.
Impacts of Acquisition Accounting
How acquisition accounting is done can significantly affect the financial statements of the combined company after the deal.
Reported Earnings
How the assets are recorded affects expenses like depreciation and amortization, which reduces reported profits in future periods. Also, if the target had previously unrecognized liabilities, the combined company now has to recognize them, lowering profits.
Asset Valuations
Sometimes, the acquisition method assigns higher values to the target’s assets than their book value. This can create a deferred tax liability, reducing future reported profits.
Goodwill Impairment
If the value of the acquired assets (including goodwill) later significantly declines, the company has to write it down through a “goodwill impairment” charge. This expense directly reduces reported profits.
Impact on Financial Metrics
Acquisition accounting affects critical financial metrics investors use to evaluate a company’s performance.
Profitability Ratios
Metrics like return on assets (ROA) and return on equity (ROE) generally decrease after an acquisition because the increased asset base from the target doesn’t immediately generate increased profits. Over time, as the company realizes synergies from the deal, these ratios may improve.
Debt Ratios
If the acquiring company takes on debt to finance the purchase, debt-to-equity and interest coverage will weaken. This can affect the company’s credit rating and borrowing costs.
Earnings Per Share (EPS)
EPS is often negatively affected in the short term after an acquisition because the additional shares issued to pay for the deal increase the share count. At the same time, profits may not immediately rise to offset this dilution effect.
Financial Reporting and Disclosure
There are many financial reporting and disclosure requirements related to acquisitions.
Segment Reporting
Companies must disclose detailed information about significant acquisitions, including the purchase price, the assets acquired and liabilities assumed, and the amount of any goodwill recognized. They also have to report separate financial information for the acquired business if it is significant relative to the company’s other segments.
Pro Forma Information
Companies often provide “pro forma” financial information showing their results if the acquisition had occurred earlier. While this can help investors understand the deal’s impact, companies sometimes use pro forma numbers to paint an overly optimistic picture of the combined business.
Footnotes and MD&A
Detailed disclosures about acquisitions are required in the footnotes to the financial statements and in management’s discussion and analysis (MD&A). These give investors important information to evaluate the deal’s financial impact.
Challenges of Acquisition Accounting
Acquisition accounting is complex and requires many estimates and judgments.
Fair Value Estimates
Estimating the fair value of acquired assets and liabilities is complex and subjective. It often involves assumptions about future cash flows, discount rates, and other variables. Small changes in these assumptions can have a significant impact on the numbers.
Goodwill Impairment Tests
Goodwill from acquisitions must be tested for impairment at least annually. This involves forecasting future cash flows and determining an appropriate discount rate. If the test shows that the carrying amount of goodwill is too high, the company must record an impairment expense. This process is also very subjective.
Tax Impacts
Acquisition accounting can have complex tax implications, especially if the deal involves international operations. Companies must carefully analyze and plan for the tax impacts of the deal structure, the valuation of assets, and the financing arrangements.
