The Purchase Method

The purchase accounting method of reporting acquisitions requires that the assets of the target firm be reported at their fair market value on the books of the bidder. With this method, an asset called goodwill is created for accounting purposes. Goodwill is the difference between the purchase price and the estimated fair market value of the net assets (assets less liabilities) acquired.

To illustrate, suppose Firm A acquires Firm B, thereby creating a new firm, AB. The balance sheets for the two firms on the date of the acquisition are shown in Table 25.1. Suppose Firm A pays $18 million in cash for Firm B. The money is raised by borrowing the full amount. The net fixed assets of Firm B, which are carried on the books at $8 million, are appraised at $14 million fair market value. Because the working capital is $2 million, the balance sheet assets are worth $16 million. Firm A thus pays $2 million in excess of the estimated market value of these net assets. This amount is the goodwill.3 The last balance sheet in Table 25.1 shows what the new firm looks like under purchase accounting. Notice that:

1. The total assets of Firm AB increase to $38 million. The fixed assets increase to $30 million. This is the sum of the fixed assets of Firm A and the revalued fixed assets of Firm B ($16 million + 14 million = $30 million).

2. The $2 million excess of the purchase price over the fair market value is reported as goodwill on the balance sheet.4

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