The rationale for Mergers and Acquisitions
Generally accepted accounting principles regarding mergers and acquisitions continue to evolve. The Financial Accounting Standards Board, or FASB, issued Statement (141R) in 2001 to replace the pooling method with the purchase method. The pooling method relied on book values, whereas the purchase method allocated costs to acquired assets and liabilities. In 2007, FASB issued an update, Statement 141R, which evolves the purchase method into the acquisition method.
Fair value is the price a buyer would freely pay for a purchase. Under the purchase method, the acquirer assigns values to acquired assets and liabilities based on the cost of the acquisition. If the acquirer makes the purchase at a bargain price, the buyer must mark down the values of assets and liabilities so the total does not exceed the purchase price. Unfortunately; this often results in balance sheet values that differ from fair value. FASB put this right in Statement 141R by requiring the acquirer to use fair values for all acquired assets and liabilities.
A contingent asset or liability is one that a company may recognize based on future events. The purchase method requires no acknowledgment of contingencies arising from a merger or acquisition. In contrast, the acquisition method obliges the acquirer to recognize contingencies, whether contractual or otherwise, at fair value. The fair value is the best estimate of the contingency as of the acquisition date. When new information becomes available, the acquirer may raise the value of the contingent liabilities and lower the value of contingent assets.
An acquirer may pay more or less than fair value for its acquisition. Under both methods, excess payment creates the intangible asset “goodwill.” If instead, the acquirer scores a bargain purchase, the purchase method treats the bargain savings as negative goodwill that creates prorated reductions in asset .and liability values. This treatment does not affect the acquirer’s income statement. Under the acquisition method, the acquirer simply recognizes the bargain savings as a gain on its income statement.
Research and Development
The two methods differ in their treatment of acquired in-process research and development, or IPRD, projects. Under the purchase method, the acquirer must measure at fair value IPRD that has no alternative future use and to immediately expense this amount. The acquisition method also measures IPRD projects at fair value on the acquisition date, but it treats these amounts as noncurrent assets. If a project proves to be successful, the acquirer amortizes the asset over its estimated lifetime. If the IPRD project flops, the acquirer writes off the impaired asset and books a loss.