A frequently deployed technique for attaining greater wealth by reaching more customers at lower cost is for two similar business enterprises to merge into one. This model for advancement arises from synergistic scale into a single entity. Total overhead costs are reduced and more efficient distribution channels are created.
Mergers can entail two entrepreneurs combining their organizations or one business acquiring another. The latter is a common occurrence for a young operation to grow by purchasing a mature business whose owner is retiring or moving. A tragic flaw in these promising arrangements is the afterthought status of accounting for the merger.
Tangible Assets & Goodwill
Accountants refer to the bookkeeping system used for business combinations as the purchase method. This scheme is best understood as allocating the purchase price to acquired assets – both tangible and intangible. Customer lists, business reputation, and seasoned staff are examples of intangibles. These items often have considerable value for an acquirer. But they come at a cost.
The purchase price of an acquired business typically exceeds the fair market value of tangible assets, such as equipment, computers, and desks. This excess cost is recorded as goodwill – a special type of other asset. Goodwill is almost always present in an acquisition because a purchased business is usually worth more than the sum of its tangible assets, which are only recorded at their fair market values. Goodwill is therefore a catchall category of everything else.
Purchase Adjustments
Accounting for an acquisition becomes especially challenging when the target company is transferring accounts receivable, customer deposits, work in process, and liability for sales tax or payroll taxes. The amount paid at closing of the purchase is adjusted for these items.
Take for example the purchase of a business for $10,000. The equipment bought is only worth $6,000 – leaving $4,000 to goodwill. On the acquisition date, however, the acquired company has accounts receivable of $500 and work in process (which will eventually become invoiced receivables) of $400. The buyer has to pay for these items as additions to the $10,000 purchase price.
Moreover, the acquisition target has already conducted business that incurred $400 of payroll taxes and $100 of sales tax. The buyer will remit those amounts in the future along with such taxes incurred after the purchase. Hence, the seller must leave $500 of cash for the purchaser to pay these obligations that were created during operation from which the seller profited. In addition, say the buyer assumes $300 of debt that the seller owes on the equipment. The seller has to give the buyer credit for those funds.
Allocated amounts to equipment and goodwill are still $6,000 and $4,000. But the purchaser has to pay $10,100. The purchase price is adjusted with $900 of credits to the seller ($500 + $400) but $800 of credits to the buyer ($400 + $100 + $300). The additional $100 arises from the circuitous route of credits. It’s all clearly an accounting obstacle, but not an insurmountable one if professional accounting advice is sought.
The Finance Writer 