Purchase accounting adjustment definition
/What is the Purchase Accounting Adjustment?
Purchase accounting is the practice of revising the assets and liabilities of an acquired business to their fair values at the time of the acquisition. This treatment is required under the various accounting frameworks, such as GAAP and IFRS. Common revisions of asset and liability values include recording inventory, fixed assets, and intangible assets at their fair values.
Types of Purchase Accounting Adjustments
There are several areas in which purchase accounting adjustments may arise. In particular, intangible assets (such as customer lists and non-compete agreements) were not recorded on the books of the acquiree at all, so their recordation as assets is entirely new. These changes have an impact on the books of the acquirer, which are known as purchase accounting adjustments. The adjustments are caused by the altered values of the assets and liabilities. For example:
An increase in the valuation of inventory means that the acquirer will record an increased amount of cost of goods sold when the inventory is eventually sold.
An increase in the valuation of fixed assets requires an increased amount of depreciation over time.
The presence of new intangible assets requires the recognition of amortization over time.
Given the nature of these examples, it can be seen that purchase accounting adjustments frequently increase the recognized amount of expenses for a company in future periods, though these expenses are of the non-cash variety.
In particular, the amount of amortization expense can be substantial (if not overwhelming), so that this particular purchase accounting adjustment can cause the acquirer to record substantial losses until such time as the intangible assets have been fully amortized.
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Presentation of Purchase Accounting Adjustments
A business frequently explains the impact of purchase accounting adjustments in the notes accompanying its financial statements, so that readers can understand how acquisitions have skewed the results reported by the business.
Example of a Purchase Accounting Adjustment
As an example of the purchase accounting adjustment concept, Company A acquires Company B for $500 million. The net book value of Company B’s assets and liabilities is $400 million. The resulting adjustments are noted below:
Step 1. Purchase price allocation. Company A must adjust Company B’s assets and liabilities to their fair market value (FMV) on the acquisition date, using the following adjustments:
Tangible assets such as property, plant, and equipment (PPE) are appraised and revalued.
Intangible assets like patents, trademarks, and customer relationships are recognized if they meet accounting criteria, even if they were not on Company B’s books.
This results in the following adjustments:
Fixed assets: The fair value of Company B’s machinery is $50 million higher than its book value, so it is adjusted upward.
Intangible assets: Company B has customer relationships valued at $30 million that weren’t previously recorded.
Liabilities: Company B has warranty obligations whose fair value is $10 million higher than their recorded amount.
Step 2: Calculate goodwill. If the purchase price exceeds the fair market value of the identifiable net assets, the excess is recorded as goodwill. This calculation is as follows:
Fair value of assets: $400M + $50M (fixed asset adjustment) + $30M (intangible assets) = $480M
Fair value of liabilities: $100M (original) + $10M (adjusted warranty obligations) = $110M
Net assets (adjusted): $480M - $110M = $370M
Purchase price: $500M
Goodwill: $500M - $370M = $130M
Step 3. Record adjustments. Company A’s financial statements will reflect the following:
Adjusted fixed assets of $50M
Newly recognized intangible assets of $30M
Adjusted liabilities of $10M
Goodwill of $130M
These adjustments ensure that Company A’s financial statements provide a fair representation of the economic reality post-acquisition, reflecting the true value of the acquired business.