Frequently, two similar business enterprises merge into one as a way of making more money by reaching more customers at a lower cost. By creating one from two, total overhead costs are reduced and more efficient distribution channels are created. It’s called a merger.
Mergers come about in two ways: either through two owners combining their organizations or through one business acquiring the other. The latter happens frequently when a young operation grows by purchasing a mature business whose owner is retiring or moving. A tragic flaw in these promising arrangements is that the accounting for the merger is more often than not considered an afterthought.
Tangible assets and goodwill
Accountants refer to the bookkeeping system for assets as the “purchase method.” It’s best understood as allocating the purchase price to acquired assets, both tangible and intangible. Customer lists, business reputation, and seasoned staff are intangibles. This “goodwill” may have considerable value for the acquirer, but that comes 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 recorded at only their fair market values. Goodwill is therefore a catchall category of everything else.
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 when the purchase closes is adjusted for these items.
As an example, assume you are purchasing a business for $10,000. The equipment you’re buying is worth only $6,000, leaving $4,000 to the catchall category of goodwill. On the acquisition date, however, this business has accounts receivable of $500 and work in process (which will eventually become invoiced receivables) of $400. You have to pay for these items as additions to the $10,000 purchase price.
But the acquisition target has already conducted business that incurred $400 of payroll taxes and $100 of sales tax. You will remit those amounts in the future, along with such taxes incurred after the purchase.
So the seller must leave $500 of cash for you to pay these obligations created during operations from which the seller profited. In addition, you might assume $300 of debt that the seller owes on the equipment, and the seller also has to give you credit for those funds.
Amounts allocated to equipment and goodwill are still $6,000 and $4,000. But the purchaser has to pay $10,100.
The additional $100 arises from the circuitous route of credits. The purchase price is adjusted with $900 of credits to the seller ($500 + $400) but $800 of credits to the buyer ($400 + $100 + $300).
It’s clearly an accounting obstacle, but not an insurmountable one, providing you have professional accounting advice.