What it means
When one company buys another, the buyer's accounts must show what it got for its money. The acquisition method answers that question by breaking the purchase into its parts.
The acquirer first confirms that what it bought is a business (an integrated set of activities and assets capable of producing outputs) rather than merely a collection of assets; buying a factory with its workforce, contracts and processes is a business combination, buying an empty building is not. The distinction matters because asset purchases are recorded at cost with no goodwill, while business combinations require fair value measurement of everything acquired.
Next the acquirer measures the consideration: cash paid, shares issued at their market value on the acquisition date, liabilities assumed, and any contingent consideration (earn-outs) at fair value. Transaction costs such as advisers' fees are expensed, not added to the price.
Then it identifies and values what it acquired. Tangible assets and liabilities are measured at fair value rather than at the target's book value, so property may be revalued upwards and inventory may be marked to selling price less costs to complete.
More significantly, intangible assets that the target never recorded, because it built them internally, are recognised at fair value: brands, customer relationships, technology, licences, order backlogs and non-compete agreements. Contingent liabilities that meet the recognition criteria are recorded.
Deferred tax is recognised on the differences between these fair values and their tax bases. Goodwill is the residual: consideration transferred (plus any non-controlling interest and the fair value of any previously held stake) minus the fair value of net identifiable assets.
It represents the value of things that cannot be separately identified, such as the assembled workforce, expected synergies and the going-concern premium. Goodwill is not amortised under IFRS and US GAAP for public companies but is tested for impairment at least annually.
If the net identifiable assets exceed the consideration, the difference is a bargain purchase gain, recognised immediately in profit after the acquirer has re-checked its figures. The acquirer has up to twelve months (the measurement period) to finalise provisional values as information comes in.
After that, the fair values are fixed and adjustments go through profit or loss. The consequences run for years.
Acquired intangibles with finite lives are amortised, which reduces reported profit relative to the target's own historical accounts. Goodwill sits on the balance sheet until impaired, and an impairment charge is a public admission that the acquirer overpaid or that the business has deteriorated.
Analysts often strip out amortisation of acquired intangibles to compare acquisitive companies with organic ones.
In practice
Real-world examples.
Example
A software company buys a competitor for shares and records $40 million of acquired technology and customer contracts, amortised over five to ten years.
Example
A retailer buys a chain of 30 shops; because the shops come with staff, stock, leases and systems, the purchase is a business combination, not an asset purchase.
Example
A pharmaceutical group acquires a company whose only asset is a licensed drug candidate and concludes it is an asset acquisition, since there are no substantive processes.
Think of it
“A business combination is when companies join through merger or acquisition-accounting for becoming one.
Formula
Calculation
Goodwill = Consideration transferred + Non-controlling interest + Fair value of previously held interest minus Fair value of net identifiable assets acquired
Worked example. Alpha acquires 100% of Beta for $50,000,000 in cash plus 1,000,000 Alpha shares worth $12 each on the acquisition date, plus an earn-out with a fair value of $6,000,000. Alpha incurs $1,500,000 of adviser fees.
- Consideration = $50,000,000 + $12,000,000 + $6,000,000 = $68,000,000 (fees expensed separately)
Beta's balance sheet shows net assets of $30,000,000 at book value. Fair value work identifies:
- Property carried at $8,000,000, fair value $11,000,000: plus $3,000,000
- Customer relationships, not on Beta's books: $9,000,000
- Developed technology: $6,000,000
- Brand: $4,000,000
- A lawsuit disclosed but not provided by Beta, fair value of the obligation: minus $1,500,000
- Deferred tax liability on the fair value uplifts at 25%: ($3,000,000 + $9,000,000 + $6,000,000 + $4,000,000 minus $1,500,000) x 25% = minus $5,125,000
Fair value of net identifiable assets = $30,000,000 + $3,000,000 + $9,000,000 + $6,000,000 + $4,000,000 minus $1,500,000 minus $5,125,000 = $45,375,000
Goodwill = $68,000,000 minus $45,375,000 = $22,625,000
Effect on Alpha's future profits: customer relationships amortised over 8 years ($1,125,000 a year), technology over 5 years ($1,200,000 a year), brand indefinite life (impairment tested). Annual amortisation of $2,325,000 reduces reported profit compared with Beta's standalone results, although the deferred tax liability unwinds alongside, reducing the after-tax effect to about $1,744,000. Goodwill of $22.6 million is tested annually; if Beta's performance falls short of the plan that justified $68 million, an impairment will follow.Case study
Seen in the real world.
A listed engineering group acquired a specialist instrumentation company for $120 million, roughly nine times its operating profit, on the strength of its customer base and a proprietary sensor technology. The purchase price allocation identified $35 million of customer relationships (amortised over ten years), $20 million of technology (seven years), $5 million of brand and $48 million of goodwill after deferred tax. In the first year the group's reported operating profit rose by only $2 million despite the acquired company contributing $13 million, because $6.4 million of amortisation and $2 million of transaction costs were charged, and the chief executive spent an uncomfortable results presentation explaining that the deal was performing as planned.
Three years later, a competitor launched a cheaper sensor, the acquired company's revenue fell 25%, and the annual impairment test, which compared the carrying value of the unit ($100 million including remaining intangibles and goodwill) with the present value of its revised cash flows ($70 million), produced a $30 million impairment charge, entirely against goodwill. The group's audit committee subsequently required every acquisition proposal to include the projected purchase price allocation, the resulting amortisation and the earnings threshold below which impairment would follow, so that the board saw the accounting consequences of a price before agreeing to it.
Watch out
Common mistakes.
- Treating the target's book values as the acquired values. Everything is remeasured at fair value, and unrecorded intangibles must be identified.
- Capitalising transaction costs into the purchase price. Under current standards they are expensed.
- Forgetting deferred tax on fair value adjustments, which typically increases goodwill.
Questions
People also ask.
What is the difference between a merger and an acquisition in accounting?
None in substance. Every business combination has an acquirer, even if the deal is called a merger, and the acquisition method applies.
Why is goodwill not amortised?
Standard setters concluded that its useful life cannot be reliably estimated and that annual impairment testing gives more relevant information. Private companies in the US may elect to amortise it.
What happens to the target's own goodwill?
It is eliminated. Only the goodwill arising on this acquisition is recognised.
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