Purchase accounting is another term for acquisition accounting and refers to the process of changing the book value of the assets of an acquired company into the market value of those assets for the purchasing company. Companies use purchase accounting in acquisitions or mergers. Acquisition is the purchase of a company; merger is a combination of two companies to form a new company.

The fair market value (FMV) is what a willing buyer would pay and what a willing seller would accept in payment. A company may be purchased for more than the fair market value. In that case, the amount paid must be allocated, or divided, among the various assets being purchased.

Any excess of the cost will be allocated to goodwill. Goodwill is an intangible asset that encompasses the value or trust customers place on the company. Purchase accounting determines the difference between the fair market value of the company and the cost of acquiring it.

When the purchase is a stock purchase only, the entire cost is allocated to the cost of the stock. In a non-stock purchase, however, the assets of the company are taken over by the purchasing company. The allocation will include the value of land, buildings, and other physical assets, such as equipment and furniture, as well as inventory, accounts receivable, and customer lists.

A next step in purchase accounting is the allocation of value to intangible assets, such as licenses, covenants not to compete, copyrights, patents, and goodwill. The total value assigned to the assets is equal to the total purchase price. If the value of the physical assets of a purchased company is less than the purchase price, then the remainder must be allocated to goodwill.

For example, if Company A is purchasing Company B for $25 million US Dollars (USD) and the book value of tangible assets of Company B is listed at $8 million USD and the fair market value of these assets are $10 million USD, Company A will list those assets at $10 million USD on Company A’s books. Then, Company A will allocate an amount to the intangible assets. If it was decided that the intangible assets are valued at an additional $10 million USD, then the remaining $5 million USD would be considered goodwill.

It is also possible that the fair market value is less than the listed book value. The rules of purchase accounting would then require that the purchasing company write down, or decrease, the listed value of the assets that are being acquired. A calculation is made to determine the percentage each classification of asset is of the total book value. Then, the fair market value is allocated by the same percentages.