What it means
When a purchase completes, the buyer cannot just bolt the target's existing balance sheet onto its own. Accounting standards require a purchase price allocation, in which every identifiable asset and liability is remeasured at fair value on the acquisition date.
Two kinds of adjustment come out of that exercise. Assets already on the target's books are written up or down, and assets never recorded before, such as brands, customer lists and internally developed software, are recognised for the first time.
Whatever the buyer paid above the restated net assets becomes goodwill, an intangible standing for reputation, assembled workforce and expected synergies. If the buyer paid less than fair value, the difference is a bargain purchase gain and goes straight to the profit and loss account.
These adjustments matter to future profits, not only to the opening balance sheet. Written up plant carries higher depreciation and newly recognised intangibles are amortised, so reported earnings after a deal are often lower than the two businesses would have produced separately.
Buyers normally get a measurement window, commonly up to twelve months, to refine provisional figures as valuations are completed. Analysts watch how much of the price lands in goodwill, because a very large slice suggests the buyer paid for expectations rather than for assets.
In practice
Real-world examples.
Example
A packaging group buys a competitor whose factory sits on land bought in 1978. The acquisition adjustment writes the land up by $3,200,000 to current market value, which lifts the acquired net assets and reduces the goodwill recorded on the deal.
Example
A software business acquires a smaller rival with almost no assets on its balance sheet. Almost the entire price becomes an acquisition adjustment, split between a newly recognised technology intangible and a large residual goodwill figure.
Example
An auditor challenges a buyer that allocated 95% of a $60,000,000 price to goodwill. The revised allocation recognises customer contracts and a trade name separately, which increases annual amortisation and cuts reported operating profit for the next five years.
Formula
Calculation
Acquisition adjustment (premium over book value) = purchase price - target net book value
Goodwill = purchase price - fair value of net identifiable assets
A distributor is bought for $9,000,000. Its net book value is $5,000,000. The valuation exercise writes the freehold property up by $1,500,000 and recognises a customer list, never previously on the books, at $700,000.
Fair value of net identifiable assets = $5,000,000 + $1,500,000 + $700,000 = $7,200,000
Goodwill = $9,000,000 - $7,200,000 = $1,800,000
Total acquisition adjustment over book value = $9,000,000 - $5,000,000 = $4,000,000, made up of $2,200,000 of fair value step ups and $1,800,000 of goodwill.
The adjustments then feed the income statement. The customer list is amortised over seven years at $700,000 / 7 = $100,000 a year, and the property write up is depreciated over 25 years at $1,500,000 / 25 = $60,000 a year, adding $160,000 of annual charges that the target never reported on its own.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Ardenmoor Group, an invented facilities services company, paid $14,000,000 for Loxton Cleaning Services, whose accounts showed net book value of $6,000,000. The board told shareholders it had bought $6,000,000 of net assets for $14,000,000 and that the $8,000,000 difference was simply the price of buying a good business.
The purchase price allocation told a more precise story. The freehold depot was worth $2,000,000 more than its carrying value, an internally built scheduling system was recognised at $1,000,000, the trade name at $1,500,000, and an onerous lease added a $500,000 liability, giving net identifiable assets of $10,000,000 and goodwill of $4,000,000 rather than $8,000,000.
The sting arrived in the following year's accounts. Amortising the software over five years, the trade name over ten and depreciating the property write up over twenty added $450,000 of annual charges, so the fictional group's reported operating profit fell even though cash generation had improved. Management had to explain the difference between accounting profit and cash to a board that had not been warned.
Watch out
Common mistakes.
- Assuming the whole premium over book value is goodwill, when a large part of it is usually a fair value step up on identifiable assets.
- Forgetting that acquisition adjustments create extra depreciation and amortisation, which makes post deal earnings look worse than the underlying trading does.
- Treating the first allocation as final, when the measurement window allows provisional figures to be revised as valuations are finished.
Questions
People also ask.
Is goodwill amortised?
Under current international and US standards goodwill is not amortised but tested for impairment at least annually, although some regimes for private companies permit amortisation.
What happens if the buyer pays less than fair value?
The excess is a bargain purchase gain, recognised immediately in profit or loss after the allocation has been double checked.
Does an acquisition adjustment affect tax?
Usually only where tax rules follow the accounts, since many jurisdictions keep separate tax base values that are unaffected by the accounting restatement.
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