In 2007-2008, accounting rule-makers changed the way that companies are required to account for the merger or acquisition of businesses from the existing "purchase method" to a new "acquisition method." The differences between the two methods are subtle, but they are important to understand the implications for both the acquiring and the selling company in a merger or acquisition.

Big-picture differences between the purchase method and the acquisition method.
Philosophically, the purchase method accounted for an acquisition as the sum of the assets and liabilities being acquired. The acquisition method differs in that it views the purchase as the whole firm, not just the sum of its parts.

That difference is subtle, yes, but it has implications for both the balance sheet and income statement of both companies in the transaction. For example, the acquisition method requires accountants to disclose contingencies -- potential assets or liabilities that the company may or may not recognize in the future. The purchase method did not require these to be disclosed at the time of the acquisition. Some contingencies, like lawsuits, product warranties, or off balance sheet financial obligations, can have a material impact on the future of the company. Viewing the firm as a whole brings those possibilities into the picture, while only considering the component parts keeps these contingencies out of the equation.

Another major difference is how the two methods treat so-called "bargain prices." A bargain price is when the acquiring company pays less than the fair value of the company being acquired. Under the purchase method, the difference between the acquired company's fair value and its purchase price would be accounted for as negative goodwill on the balance sheet. That amount would then be amortized over time, trickling through to the income statement with minimal impact. Under the acquisition method, however, the negative goodwill is treated as a gain on the income statement immediately with the acquisition.

Both rely on the concept of fair value.
Despite their differences, both the purchase method and acquisition method are built upon the "fair value" concept. Fair value is defined as the value that a third party would freely pay for the assets and liabilities involved in the acquisition. Fair value could be higher than the actual purchase price, as would be the case in a bargain price transaction like the example above. Likewise though, fair value could be lower than the purchase price, resulting in a company carrying an intangible asset called goodwill on its books to account for the difference.

The accounting for major acquisitions is extremely complex, but having a strong fundamental understanding of the concepts behind these transactions will help any analyst understand how any potential deal will impact the financial statements of the new company immediately and over time.

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