Purchase Method of Accounting

The more frequently encountered method of accounting for a business

combination is the purchase method of accounting. Under the purchase method
of accounting, the acquisition is recorded in the same manner as the acquisition of
any single asset-that is , at its fair market value.
To account for a combination by the purchase method, it is necessary frst to
determine the total cost of theacquisition. If the purchase consideration consist
solely of cash the total amount of cash will be the cost acquired enterprise. If the
enterprise issues its own stock as part of the cost in an acquisition, determination of
the total price may prove to be more dicult. If the stock is actively traded, the
market price of the stock is probably the most reliable indicator of value. If the
buyer places restrictions on the subsequent resale of the stock by the seller,
however, that might indicate a di!erent value for the issued stock from the value
obtained from the current market price. "or private enterprises and enterprises that
have limited stock trading, placing a value on the shares can be dicult. The
buyer and seller must agree on the share price as it a!ects both their ta# positions.
$aving determined the total cost of the acquired enterprise, the purchaser must
mark the assets and liabilities acquired at their fair value.
Application of the purchase method of accounting involves:
Identifying the acquiring company
%etermining the date used to report the acquisition
%etermining the cost of the acquired entity. This includes&
o 'aluing the consideration paid or in some cases, the net assets
acquired
o (ccounting for the direct costs of the business combination
o (ccounting for contingent consideration
Identifying the assets acquired and liabilities assumed
(llocating the purchase price )that is, allocating the cost of the acquired
entity to the assets acquired and the liabilities assumed
(ccounting subsequent to the business combination
Questionnaire:
What Is Consolidation in Accounting
*usiness consolidations are an advanced accounting concept.
Business combinations are when a company takes another company's fnancial
statement and brings it together with its own. Consolidations allow companies to
disclose all of their fnancial information from all of their properties to their
investors. This gives a more accurate description of a company and the company's
results for the year.
+ther ,eople (re -eading
.onsolidation (ccounting Tutorial
$ow to .onsolidate (ccounts
/. 0ethods
o There are three di!erent methods of consolidation in accounting& cost,
equity and acquisition method. (ccountants use the cost method when a parent
owns between 1ero percent and 23 percent of a company. (ccountants use the
equity method when a parent owns between 23 percent and 43 percent of a
company. (ccountants use the acquisition method when a parent owns more than
43 percent of a company.
.ost 0ethod
o The cost method will record the acquisition of the subsidiary at the
amount it cost the parent to purchase ownership in the subsidiary. (t the end of
each year, the accountant must ad5ust the investment in the subsidiary account to
fair value. This creates an unreali1ed gain or loss. %ividends from the subsidiary are
reported as income on the income statement.
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7quity 0ethod
o The equity method records the acquisition of a subsidiary at the cost to
purchase ownership in the subsidiary. 7arnings from the subsidiary increase the
ownership account of the subsidiary by the parent company;s percent of ownership
in the subsidiary. "or e#ample, if a subsidiary had </33,333 in income and a parent
owns =3 percent, then the ownership account will increase by <=3,333 on the
parent;s fnancial statements. %ividends decrease the ownership account.
(cquisition 0ethod
o 'alue the investment at the fair value of the amount given. "or
e#ample, if a company pays </33,333 and provides a <24,333, the ownership is
valued at </24,333. >hen consolidating, the accountant must eliminate the
stockholder;s equity section of the subsidiary, revalue assets to fair value, eliminate
the ownership in the subsidiary account, create a non-controlling interest account
and record goodwill or gain.
Inter-company Transactions
o +nly eliminate inter-company transactions when the accountant
consolidates the two fnancial statements. ?enerally, the fnancial statements will
only be consolidated under the acquisition method.
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$ow the 7quity 0ethod -elates to .onsolidated
"inancial 6tatements
If a company acquires more than 43G of the voting stock of another
company, it;s said to have a controlling interest, because by voting those
shares, the investor actually can control the company acquired. The
investor is referred to as the parent; the investee is termed
the subsidiary. "or reporting purposes Halthough not legallyI, the parent and
subsidiary are considered to be a single reporting entity, and their fnancial
statements are consolidated. *oth companies continue to operate as
separate legal entities and the subsidiary reports separate fnancial
statements. $owever, because of the controlling interest, the parent
company reports consolidated fnancial statements.
p. B=4
Consolidated #nancial statementscombination of
the separate f nancial statements of the parent and
subsidiary each period into a single aggregate set of f
nancial statements as if there were only one
company. combine the separate fnancial statements of
the parent and the subsidiary each period into a single
aggregate set of fnancial statements as if there were
only one company. This entails an item-by-item
combination of the parent and subsidiary statements
Hafter frst eliminating any amounts that are shared by
the separate fnancial statementsI.
2C
"or instance, if the
parent has <C million cash and the subsidiary has <J
million cash, the consolidated balance sheet would report
<// million cash.
Consolidated
fnancial
statements co
mbine the
individual
elements of
the parent and
subsidiary
statements$

Two aspects of the consolidation process are of particular interest to us in
understanding the equity method. "irst, in consolidated fnancial
statements, the acquired company;s assets are included in the fnancial
statements at their fair values as of the date of the acquisition, rather than
their book values on that date. 6econd, if the acquisition price is more than
the sum of the separate fair values of the acquired net assets Hassets less
liabilitiesI, that di!erence is recorded as an intangible assetK
goodwill.
2L
>e;ll return to the discussion of these two aspects when we
reach the point in our discussion of the equity method where their inMuence
is felt. (s we;ll see, the equity method is in many ways a partial
consolidation.
>e use the equity method when the investor can;t control the investee
but can e#ercise signifcant inMuence over the operating and fnancial
policies of an investee.