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 first to determine the total cost of the acquisition. 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 difficult. 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 different value for the issued stock from the value obtained from the current market price. For private enterprises and enterprises that have limited stock trading, placing a value on the shares can be difficult. The buyer and seller must agree on the share price as it affects both their tax positions. Having 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
• Determining the date used to report the acquisition
• Determining the cost of the acquired entity. This includes:
  
  • Valuing the consideration paid or in some cases, the net  assets acquired
  • Accounting for the direct costs of the business combination
  • Accounting for contingent consideration

• Identifying the assets acquired and liabilities assumed
• Allocating the purchase price –that is, allocating the cost of the acquired entity to the assets acquired and the liabilities assumed
• Accounting subsequent to the business combination

Questionnaire:

• What is purchase method of accounting?
• What are the applications of purchase method of accounting?