What Is Purchase Accounting?

Purchase accounting is the process of recording a business combination under the acquisition method, as prescribed by ASC 805, Business Combinations. When one company acquires another, the acquirer must recognize and measure the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at their acquisition-date fair values. The difference between the total consideration transferred and the net fair value of identifiable assets and liabilities is recorded as goodwill.

This process is sometimes called “Day 1 accounting,” and it has far-reaching consequences for the balance sheet, income statement, and key financial metrics for years after the deal closes.

The Acquisition Method: Step by Step

Step 1: Identify the Acquirer

In most transactions, the acquirer is the entity that obtains control of the other entity. Control is typically evidenced by ownership of more than 50% of the voting interests, but ASC 805 requires consideration of other factors, including the composition of the governing body, the relative size of the entities, and which entity initiated the combination.

Step 2: Determine the Acquisition Date

The acquisition date is the date on which the acquirer obtains control of the acquiree. This is typically the closing date of the transaction, not the announcement date or the signing date.

Step 3: Measure the Consideration Transferred

Consideration can take many forms:

  • Cash – Measured at face value.
  • Equity instruments – Measured at fair value on the acquisition date (not the announcement date).
  • Contingent consideration – Measured at fair value on the acquisition date. This is one of the most complex areas of purchase accounting (discussed further below).
  • Assumed liabilities – Certain obligations assumed as part of the transaction may be part of the consideration transferred.

Step 4: Recognize and Measure Identifiable Assets and Liabilities

The acquirer recognizes, separately from goodwill, the identifiable assets acquired and liabilities assumed at their acquisition-date fair values. This includes assets and liabilities that the acquiree may not have previously recognized, such as:

  • Intangible assets – Customer relationships, technology, trade names, non-compete agreements, in-process research and development, and order backlog.
  • Contingent liabilities – Recognized at fair value if the acquisition-date fair value can be determined.
  • Deferred revenue – Measured at fair value, which is typically less than the carrying amount on the acquiree’s books (discussed below).
  • Deferred tax assets and liabilities – Recognized for the tax effects of fair value adjustments to assets and liabilities.

Step 5: Measure Goodwill

Goodwill is calculated as:

Consideration transferred + Noncontrolling interest + Previously held equity interest - Net identifiable assets acquired at fair value = Goodwill

Goodwill represents the future economic benefits arising from assets that are not individually identified and separately recognized – such as the assembled workforce, expected synergies, and the going-concern value of the business.

Fair Value Measurement: The Heart of Purchase Accounting

Fair value measurement under ASC 820 is central to purchase accounting. The fair value hierarchy applies:

  • Level 1 – Quoted prices in active markets for identical assets or liabilities.
  • Level 2 – Observable inputs other than Level 1 prices (e.g., comparable transactions, market multiples).
  • Level 3 – Unobservable inputs based on the entity’s own assumptions (e.g., discounted cash flow models).

Most assets acquired in a business combination are measured using Level 3 inputs, particularly intangible assets. This makes the valuation process inherently judgment-intensive and subject to scrutiny by auditors and regulators.

Common Valuation Approaches for Intangible Assets

Intangible Asset Common Valuation Method
Customer relationships Multi-period excess earnings method
Developed technology Relief from royalty method or cost approach
Trade names and trademarks Relief from royalty method
Non-compete agreements With-and-without method (differential cash flows)
In-process R&D Multi-period excess earnings or cost approach
Order backlog Discounted cash flow of expected profit from existing orders

Deferred Revenue: A Frequently Misunderstood Area

Acquired deferred revenue is measured at fair value, which reflects only the costs to fulfill the remaining performance obligations plus a reasonable profit margin on those costs. This is almost always less than the acquiree’s historical carrying amount.

The practical impact is significant: the acquirer will report lower revenue in the periods immediately following the acquisition because the “haircut” on deferred revenue reduces the amount available to be recognized. This effect is often called the “deferred revenue haircut” or “deferred revenue write-down.”

What to Watch For

  • Revenue guidance and analyst expectations – The deferred revenue haircut can depress reported revenue in the first few quarters post-acquisition. Proactively communicate this effect to investors and analysts.
  • Integration planning – If the acquired business has large deferred revenue balances (common in SaaS and subscription businesses), model the revenue impact during due diligence, not after close.

Contingent Consideration

Contingent consideration (earn-outs, milestone payments, etc.) is measured at fair value at the acquisition date and classified as either equity or a liability.

  • Liability-classified contingent consideration is remeasured at fair value each reporting period, with changes recognized in earnings. This can create significant income statement volatility.
  • Equity-classified contingent consideration is not remeasured after the acquisition date.

Practical Guidance

Most contingent consideration arrangements are classified as liabilities because they involve cash or variable share settlements. Option pricing models (e.g., Monte Carlo simulation) are commonly used to value earn-outs, particularly those with multiple performance thresholds.

The Measurement Period

The acquirer has up to one year from the acquisition date to finalize the purchase price allocation. During this measurement period, the acquirer may adjust the provisional amounts recognized at the acquisition date as new information is obtained about facts and circumstances that existed at the acquisition date.

Rules for Measurement Period Adjustments

  • Adjustments are recognized as if the revised amounts had been known at the acquisition date (retrospective adjustment).
  • Adjustments must relate to facts and circumstances that existed at the acquisition date, not events that occurred after.
  • Depreciation, amortization, and other effects are adjusted retrospectively as well.

Common Pitfalls in Purchase Accounting

  1. Incomplete intangible asset identification – Failing to identify and separately value all intangible assets inflates goodwill and may draw SEC comment letters.
  2. Incorrect discount rates – Using a single discount rate for all intangible assets rather than asset-specific rates that reflect the risk profile of each asset.
  3. Tax basis misalignment – Forgetting to record deferred tax liabilities on intangible assets that have no tax basis (e.g., in a stock deal) or misapplying the simultaneous equation for tax-amortizable goodwill.
  4. Post-combination expense vs. purchase price – Certain payments to selling shareholders (e.g., retention bonuses, above-market employment agreements) may be compensatory rather than purchase consideration. Misclassifying these items affects both goodwill and post-acquisition earnings.
  5. Contingent consideration remeasurement – Failing to update fair value estimates for liability-classified earn-outs each quarter.

A Framework for Managing Purchase Accounting

For companies that are active acquirers, consider establishing the following:

  • Standardized purchase accounting playbook – A checklist and timeline covering every step from deal signing through measurement period close.
  • Third-party valuation firm engagement – Engage a valuation specialist early in the process, ideally during due diligence, so that preliminary fair values are available at close.
  • Cross-functional deal team – Include accounting, tax, FP&A, legal, and the business unit from the start. Purchase accounting decisions affect financial models, integration plans, and tax structures.
  • Measurement period tracking log – Track all provisional amounts and the status of measurement period adjustments in a centralized document.
  • Post-close reconciliation – Within 60 days of close, reconcile the final closing balance sheet to the purchase price allocation model and resolve any differences.

Final Thoughts

Purchase accounting is one of the most technically demanding areas of financial reporting. It requires the intersection of accounting expertise, valuation skills, tax knowledge, and business judgment. The quality of the Day 1 accounting directly affects financial reporting for years – through amortization of intangibles, goodwill impairment testing, and the ongoing remeasurement of contingent consideration. Investing the time and resources to get it right at the outset is always more efficient than correcting it later.