Purchase Accounting Adjustment
A purchase accounting adjustment refers to changes that are made to the financial statements of a company when it is acquired by another. This is often done to align the accounting methods of the two entities, revalue assets and liabilities to their fair market values, or account for goodwill and other intangibles that may arise from the acquisition.
When a company is purchased, the buying company must adjust the financials of the acquired company to reflect the purchase price and the fair market values of the acquired assets and liabilities.
For instance, let’s say Company A buys Company B for $500,000. If the fair market value of Company B’s net assets (assets – liabilities) is $300,000, there’s a $200,000 difference. This excess amount might be allocated to intangible assets like brand value, customer relationships, patents, or it might even be booked as goodwill in the financial statements of Company A.
So in this case, the purchase accounting adjustments would include:
- Increasing the book values of some of Company B’s assets to their fair market values.
- Recognizing new intangible assets, if any.
- Recognizing goodwill for the remaining unallocated portion of the purchase price.
These adjustments ensure that the post-acquisition financial statements accurately represent the financial position of the new combined entity. They are often complex and require significant judgment, and they are usually subject to audit and potentially to scrutiny from regulatory bodies as well.
Example of a Purchase Accounting Adjustment
Let’s say Company A purchases Company B for $2 million. Before the purchase, Company B’s balance sheet looked like this:
- Assets: $1.5 million
- Liabilities: $0.5 million
- Equity: $1 million (Assets – Liabilities)
In this case, the net assets (assets – liabilities) of Company B are $1 million. But Company A paid $2 million to purchase Company B, which is $1 million more than the value of the net assets.
The extra amount Company A paid over the net asset value is usually attributed to intangible assets like goodwill, brand value, customer relationships, etc.
So, after the acquisition, Company A’s accountants would adjust their balance sheet to reflect this. The adjustment might look like this:
- $1.5 million for Company B’s original assets
- $0.5 million for Company B’s original liabilities
- $1 million as goodwill (This is the extra amount Company A paid over the net asset value)
Now, Company A’s balance sheet would show assets of $2.5 million (original assets of $1.5 million + goodwill of $1 million), liabilities of $0.5 million, and equity of $2 million (purchase price).
This is a simplified example, but it shows the basic principle of a purchase accounting adjustment. In real-world scenarios, things could be more complex as adjustments might need to be made for fair values of assets and liabilities, deferred tax liabilities, contingent liabilities, and more.
