Purchase accounting is the practice of revising the assets and liabilities of an acquired business to their fair values at the time of the acquisition. This treatment is required under the various accounting frameworks, such as GAAP and IFRS. Common revisions of asset and liability values include:
- Recording inventory at its fair value
- Recording fixed assets at their fair values
- Recording intangible assets at their fair values
In particular, intangible assets (such as customer lists and non-compete agreements) were not recorded on the books of the acquiree at all, so their recordation as assets is entirely new.
These changes have an impact on the books of the acquirer, which are known as purchase accounting adjustments. The adjustments are caused by the altered values of the assets and liabilities. For example:
- An increase in the valuation of inventory means that the acquirer will record an increased amount of cost of goods sold when the inventory is eventually sold.
- An increase in the valuation of fixed assets requires an increased amount of depreciation over time.
- The presence of new intangible assets requires the recognition of amortization over time.
Given the nature of these examples, it can be seen that purchase accounting adjustments frequently increase the recognized amount of expenses for a company in future periods, though these expenses are of the non-cash variety.
In particular, the amount of amortization expense can be substantial (if not overwhelming), so that this particular purchase accounting adjustment can cause the acquirer to record substantial losses until such time as the intangible assets have been fully amortized.
A business frequently explains the impact of purchase accounting adjustments in the notes accompanying its financial statements, so that readers can understand how acquisitions have skewed the results reported by the business.