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
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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.
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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.
Related Terms
- 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
- Investopedia: Purchase Method
- Financial Accounting Standards Board (FASB): Business Combinations and Goodwill
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
### What is recorded if the purchase price exceeds the fair market value of assets in a business combination using the purchase method?
- [ ] Net Income
- [ ] Discount
- [x] Goodwill
- [ ] Impairment
> **Explanation:** When the purchase price exceeds the fair market value of the identifiable net assets, the excess is recorded as goodwill.
### What does 'fair value' represent in the context of the purchase method?
- [x] The current market price of the asset.
- [ ] The historical cost of the asset.
- [ ] The book value of the asset.
- [ ] The original purchase price of the asset.
> **Explanation:** Fair value is the price at which an asset could be bought or sold in an arm's length transaction between willing and knowledgeable parties.
### Under the purchase method, from when is the net income of the acquired company recognized?
- [ ] From the beginning of the fiscal year.
- [ ] From the date of the announcement.
- [x] From the date of acquisition.
- [ ] Retrospectively from the previous fiscal year.
> **Explanation:** Net income of the acquired company is recognized from the date of acquisition forward.
### What is a potential consequence if the purchase price is less than the fair value of the identifiable net assets?
- [x] Bargain purchase gain.
- [ ] Additional goodwill.
- [ ] Deferred tax asset.
- [ ] Goodwill impairment.
> **Explanation:** If the purchase price is less than the fair value of the identifiable net assets, the difference is recognized as a bargain purchase gain.
### Which accounting standard governs the purchase method in the USA?
- [ ] Generally Accepted Auditing Standards (GAAS)
- [ ] Governmental Accounting Standards Board (GASB)
- [x] Financial Accounting Standards Board (FASB)
- [ ] Public Company Accounting Oversight Board (PCAOB)
> **Explanation:** The Financial Accounting Standards Board (FASB) governs the purchase method in the USA.
### What must be done with acquired assets under the purchase method?
- [x] They must be recorded at their fair market value.
- [ ] They must be recorded at the purchase price.
- [ ] They must be recorded at their historical cost.
- [ ] They must be recorded at their appraised value.
> **Explanation:** Acquired assets must be recorded at their fair market value in the purchase method.
### In which scenario is the purchase method applicable?
- [ ] When a business acquires another by issuing stocks.
- [x] When a business combination does not meet pooling-of-interests criteria.
- [ ] When all outstanding shares are acquired.
- [ ] When a business merger occurs.
> **Explanation:** The purchase method is used for business combinations that do not meet the criteria for the pooling-of-interests method.
### What happens to goodwill if it becomes impaired?
- [ ] It is revalued.
- [ ] It is written off over time.
- [ ] It is amortized.
- [x] It is written down.
> **Explanation:** If goodwill becomes impaired, it is written down to reflect its reduced value.
### How is a bargain purchase gain treated in financial statements?
- [x] It is immediately recognized in the income statement.
- [ ] It is deferred.
- [ ] It is amortized over several years.
- [ ] It increases equity.
> **Explanation:** A bargain purchase gain is recognized immediately in the income statement.
### Which of the following statements about the purchase method is false?
- [ ] It records assets at fair market value.
- [x] It records liabilities at their historical amounts.
- [ ] It can result in goodwill.
- [ ] It can recognize a bargain purchase gain.
> **Explanation:** Under the purchase method, liabilities are recorded at their fair market value, not their historical amounts.
Thank you for exploring the intricacies of the purchase method through this detailed content and our comprehensive quiz. Keep expanding your accounting expertise!
