Purchase Accounting
Purchase accounting, now called the acquisition method under ASC 805, is the required framework for recording business combinations under US GAAP, in which the acquirer measures all identifiable acquired assets and assumed liabilities at their acquisition-date fair values, with any excess of the purchase price recognized as goodwill.
ASC 805, Business Combinations, establishes that virtually all business combinations must be accounted for using the acquisition method. The standard requires identifying the acquirer — the entity that obtains control of the acquiree — and then applying a four-step process: (1) identify the acquiree, (2) determine the acquisition date, (3) recognize and measure the identifiable assets acquired, liabilities assumed, and any non-controlling interest in the acquiree, and (4) recognize and measure goodwill or a gain from a bargain purchase.
The acquisition-date fair value measurement requirement applies to all identifiable assets and liabilities, including items that were not previously recognized on the acquiree's balance sheet. This is particularly significant for intangible assets: under US GAAP, internally generated intangibles (customer relationships, trade names, technology, non-compete agreements) are generally not capitalizable as they are created, but in a business combination, these same assets must be identified and measured at fair value. This process — known as purchase price allocation (PPA) — often results in the recognition of substantial intangible assets that generate amortization expense over their useful lives, depressing reported GAAP earnings after the acquisition.
Goodwill arises when the aggregate purchase consideration (cash paid, equity issued, contingent consideration at fair value, and assumed liabilities) exceeds the net fair value of identifiable assets and liabilities. Under ASC 350, goodwill is not amortized but is tested for impairment at least annually (or more frequently if triggering events indicate potential impairment). If a bargain purchase occurs — where the purchase consideration is less than the fair value of net assets — a gain is recognized immediately in income, though FASB requires reassessment to confirm the measurement was correct before recording a bargain purchase gain.
Contingent consideration — earnouts paid to selling shareholders based on post-acquisition performance — is recognized at fair value on the acquisition date as part of the purchase consideration. Changes in the fair value of contingent consideration liabilities in subsequent periods flow through the acquirer's income statement, which can introduce earnings volatility tied to the acquiree's performance against targets.
For equity investors, purchase accounting effects are among the most important factors to understand when evaluating acquisitive companies. The amortization of acquired intangibles (customer relationships, technology, trade names) can create a persistent gap between GAAP net income and cash earnings, which is why many companies and analysts present adjusted earnings that add back acquisition-related amortization. Goodwill impairment charges, while non-cash, signal that the anticipated economic benefits of past acquisitions have not materialized.