Acquisition Accounting: Definition, How It Works, Requirements
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Acquisition Accounting
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Acquisition Accounting
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An acquisition cost, also referred to as the cost of acquisition, is the total cost that a company recognizes on its books for property or equipment after adjusting for discounts, incentives, closing costs and other necessary expenditures, but before sales taxes. An acquisition cost may also entail the amount needed to take over another firm or purchase an existing business unit from another company. Additionally, an acquisition cost can describe the costs incurred by a business in relation to the efforts involved in acquiring a new customer.
Acquisition costs provide a reflection of the true amount paid for fixed assets before sales tax is applied, for expenses related to the acquisition of a new customer, or for the takeover of other firms. Acquisition costs are useful because they recognize a more realistic cost on a company’s financial statements than using other measures. For instance, the acquisition cost of property, plant, and equipment (PP&E) recognizes any discounts or additional costs that the company will experience and is often referred to as the original book value of the asset in question.
Besides the price paid for the asset itself, additional costs may also be considered part of acquisition when these costs are directly tied to the acquisition process. For example, if the asset in question requires legal assistance to complete the transaction, legal and regulatory fees are also included. Commissions associated with the purchase may also be included, such as those paid to a real estate agent when dealing with a property transaction, to a staffing company for placing an employee, to a marketing firm for acquiring customers, or to an investment bank for brokering a merger.
With regard to manufacturing or production equipment, any costs associated with bringing the equipment to an operational state may also be included in the cost of acquisition. This includes the cost of shipping & receiving, general installation, mounting, and calibration.
Customer acquisition costs are those funds that are used to introduce new customers to the company’s products and services in hopes of acquiring the customer’s business. The customer acquisition cost is calculated by dividing total acquisition costs by total new customers over a set period.
Understanding customer acquisition costs is helpful in planning future capital allocations for marketing budgets and sales discounts. Costs traditionally associated with customer acquisition include marketing and advertising, incentives and discounts, the staff associated with those business areas, and other sales staff or contracts with external advertising firms. Incentives may be expressed in various formats, such as buy-one-get-one-free deals, receiving another product free with purchase, upgraded service at no additional cost to the customer, gift cards, or bill credits.
One business sector with a high occurrence of promotions directed at new customers is the wireless and cellular industry. Wireless companies often extend deals to new customers such as increased data packages, additional family phone lines for free, and discounts on the newest cellular phones. The purpose of these offerings is to entice customers to choose their business over their competitors.
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An acquisition is when one company purchases most or all of another company’s shares to gain control of that company. Purchasing more than 50% of a target firm’s stock and other assets allows the acquirer to make decisions about the newly acquired assets without the approval of the company’s other shareholders. Acquisitions, which are very common in business, may occur with the target company’s approval, or in spite of its disapproval. With approval, there is often a no-shop clause during the process.
We mostly hear about acquisitions of large well-known companies because these huge and significant deals tend to dominate the news. In reality, mergers and acquisitions (M&A) occur more regularly between small- to medium-size firms than between large companies.
Companies acquire other companies for various reasons. They may seek economies of scale, diversification, greater market share, increased synergy, cost reductions, or new niche offerings. Other reasons for acquisitions include those listed below.
If a company wants to expand its operations to another country, buying an existing company in that country could be the easiest way to enter a foreign market. The purchased business will already have its own personnel, a brand name, and other intangible assets, which could help to ensure that the acquiring company will start off in a new market with a solid base.
Perhaps a company met with physical or logistical constraints or depleted its resources. If a company is encumbered in this way, then it’s often sounder to acquire another firm than to expand its own. Such a company might look for promising young companies to acquire and incorporate into its revenue stream as a new way to profit.
If there is too much competition or supply, companies may look to acquisitions to reduce excess capacity, eliminate the competition, and focus on the most productive providers.
Sometimes it can be more cost-efficient for a company to purchase another company that already has implemented a new technology successfully than to spend the time and money to develop the new technology itself.
Officers of companies have a fiduciary duty to perform thorough due diligence of target companies before making any acquisition.
Although technically, the words “acquisition” and “takeover” mean almost the same thing, they have different nuances on Wall Street.
In general, “acquisition” describes a primarily amicable transaction, where both firms cooperate; “takeover” suggests that the target company resists or strongly opposes the purchase; the term “merger” is used when the purchasing and target companies mutually combine to form a completely new entity. However, because each acquisition, takeover, and merger is a unique case, with its own peculiarities and reasons for undertaking the transaction, the exact use of these terms tends to overlap in practice.
Friendly acquisitions occur when the target firm agrees to be acquired; its board of directors (B of D, or board) approves of the acquisition. Friendly acquisitions often work toward the mutual benefit of the acquiring and target companies. Both companies develop strategies to ensure that the acquiring company purchases the appropriate assets, and they review the financial statements and other valuations for any obligations that may come with the assets. Once both parties agree to the terms and meet any legal stipulations, the purchase proceeds.
Unfriendly acquisitions, commonly known as “hostile takeovers,” occur when the target company does not consent to the acquisition. Hostile acquisitions don’t have the same agreement from the target firm, and so the acquiring firm must actively purchase large stakes of the target company to gain a controlling interest, which forces the acquisition.
Even if a takeover is not exactly hostile, it implies that the firms are not equal in one or more significant ways.
As the mutual fusion of two companies into one new legal entity, a merger is a more-than-friendly acquisition. Mergers generally occur between companies that are roughly equal in terms of their basic characteristics—size, number of customers, the scale of operations, and so on. The merging companies strongly believe that their combined entity would be more valuable to all parties (especially shareholders) than either one could be alone.
Before making an acquisition, it is imperative for a company to evaluate whether its target company is a good candidate.
In corporate America, the 1990s will be remembered as the decade of the internet bubble and the megadeal. The late 1990s, in particular, spawned a series of multi-billion-dollar acquisitions not seen on Wall Street since the junk bond fests of the roaring 1980s. From Yahoo!’s 1999 $5.7-billion purchase of Broadcast.com to AtHome Corporation’s $7.5-billion purchase of Excite, companies were lapping up the “growth now, profitability later” phenomenon. Such acquisitions reached their zenith in the first few weeks of 2000.
AOL Inc. (originally America Online) was the most publicized online service of its time, and had been extolled as “the company that brought the internet to America.” Founded in 1985, by the year 2000 AOL had grown to become the United States’ largest internet provider. Meanwhile, the legendary media conglomerate, Time Warner, Inc. was being labeled an “old media” company, given its range of tangible businesses like publishing, and television, and an enviable income statement.
In 2000, in a masterful display of overweening confidence, the young upstart AOL purchased the venerable giant Time Warner (TWX) for $165 billion; this dwarfed all records and became the biggest merger in history. The vision was that the new entity, AOL Time Warner, would become a dominant force in the news, publishing, music, entertainment, cable, and Internet industries. After the merger, AOL became the largest technology company in America.
However, the joint phase lasted less than a decade. As AOL lost value and the dot-com bubble burst, the expected successes of the merger failed to materialize, and AOL and Time Warner dissolved their union:
Then, in October 2016, AT&T (NYSE: T) and Time Warner (TWX) announced a deal in which AT&T will buy Time Warner for $85.4 billion, morphing AT&T into a media heavy-hitter. In June 2018, after a protracted court battle, AT&T completed its acquisition of Time Warner.
Certainly, the AT&T-Time Warner acquisition deal of 2018 will be as historically significant as the AOL-Time Warner deal of 2000; we just can’t know exactly how yet. These days, 18 years equals numerous lifetimes—especially in media, communications, and technology—and much will continue to change. For the moment, however, two things seem certain:
Often, a business combination like an acquisition or merger can be categorized in one of four ways:
Acquiring other companies can serve many purposes for the parent company. First, it can allow the company to expand its product lines or offerings. Second, it can cut down costs by acquiring businesses that feed into its supply chain. It can also acquire competitors in order to maintain market share and reduce competition.
The main difference is that in an acquisition, the parent company fully takes over the target company and integrates it into the parent entity. In a merger, the two companies combine, but create a brand new entity (e.g., a new company name and identity that combines aspects of both).
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An acquisition premium is a figure that’s the difference between the estimated real value of a company and the actual price paid to acquire it. An acquisition premium represents the increased cost of buying a target company during a merger and acquisition (M&A) transaction.
There is no requirement that a company pay a premium for acquiring another company; in fact, depending on the situation, it may even get a discount.
In an M&A scenario, the company that pays to acquire another company is known as the acquirer, and the company to be purchased or acquired is referred to as the target firm.
Typically, an acquiring company will pay an acquisition premium to close a deal and ward off competition. An acquisition premium might be paid, too, if the acquirer believes that the synergy created from the acquisition will be greater than the total cost of acquiring the target company. The size of the premium often depends on various factors such as competition within the industry, the presence of other bidders, and the motivations of the buyer and seller.
In cases where the target company’s stock price falls dramatically, its product becomes obsolete, or if there are concerns about the future of its industry, the acquiring company may withdraw its offer.
When a company decides that it wants to acquire another firm, it will first attempt to estimate the real value of the target company. For example, the enterprise value of Macy’s, using data from its 2017 10-K report, is estimated at $11.81 billion. After the acquiring company determines the real value of its target, it decides how much it is willing to pay on top of the real value so as to present an attractive deal to the target firm, especially if there are other firms that are considering an acquisition.
In the example above an acquirer may decide to pay a 20% premium to buy Macy’s. Thus, the total cost it will propose would be $11.81 billion x 1.2 = $14.17 billion. If this premium offer is accepted, then the acquisition premium value will be $14.17 billion – $11.81 billion = $2.36 billion, or in percentage form, 20%.
You also may use a target company’s share price to arrive at the acquisition premium. For instance, if Macy’s is currently trading at $26 per share, and an acquirer is willing to pay $33 per share for the target company’s outstanding shares, then you may calculate the acquisition premium as ($33 – $26)/$26 = 27%.
However, not every company pays a premium for an acquisition intentionally.
Using our price-per-share example, let’s assume that there was no premium offer on the table and the agreed-upon acquisition cost was $26 per share. If the value of the company drops to $16 before the acquisition becomes final, the acquirer will find itself paying a premium of ($26 – $16)/$16 = 62.5%.
In financial accounting, the acquisition premium is known as goodwill—the portion of the purchase price that is higher than the sum of the net fair value of all of the assets purchased in the acquisition and the liabilities assumed in the process. The acquiring company records goodwill as a separate account on its balance sheet.
Goodwill factors in intangible assets like the value of a target company’s brand, solid customer base, good customer relations, healthy employee relations, and any patents or proprietary technology acquired from the target company. An adverse event, such as declining cash flows, economic depression, increased competitive environment and the like can lead to an impairment of goodwill, which occurs when the market value of the target company’s intangible assets drops below its acquisition cost. Any impairment results in a decrease in goodwill on the balance sheet and shows as a loss on the income statement.
An acquirer can purchase a target company for a discount, that is, for less than its fair value. When this occurs, negative goodwill is recognized.
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