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acquisition, there is no immediate tax liability. He will owe tax only if and when he sells the Pave-Rite
shares. Of course in this latter case, Sarni assumes the risk that Pave-Rite‟s shares may fall in value.
Purchase Accounting
Since 2001, only the purchase method of accounting has been accepted for acquisitions; the pooling of
interests method is no longer permitted. 16 The purchase method requires the acquiring corporation to
allocate the purchase price to the assets and liabilities it acquires. All identifiable assets and liabilities
are assigned a value equal to their fair market value at the date of acquisition. The difference between
the sum of these fair market values and the purchase price paid is called goodwill. Goodwill appears
on the acquirer‟s books as an intangible asset and is amortized, or written off as a noncash expense for
book purposes over a period of not more than 40 years. The amortization of purchased goodwill is
deductible for tax purposes and is taken over 15 years, although it must be evaluated annually for a
loss in fair value or impairment. If the value of the goodwill has fallen, it is written down or impaired
by the amount of the decrease. Time-Warner AOL‟s 2002 loss of $98.7 billion—the largest in
corporate history—included $45 billion write-down of goodwill and was a clear admission that the
merger two years earlier had been a dismal financial failure.
To illustrate the basics of purchase accounting, we offer the following simple example:
Example 7: Consider the predeal balance sheets for B.B. Lean Inc. and Dead End Inc., both clothing
retailers (see Exhibit 17.9).
Now assume that B.B. Lean offers to purchase Dead End for $18 million worth of its stock. Assume
further that Dead End‟s building has appreciated and has a current market value of $12 million. Under
purchase accounting, B.B. Lean‟s balance sheet after the deal appears as shown in Exhibit 17.10.
Note that the acquired building has been written up to reflect its market value of $12 million and
that the difference between the acquisition price ($18 million) and the market value of the assets
acquired ($15 million) is booked as goodwill. B.B.
Exhibit 17.9 Predeal balance sheets.
Exhibit 17.10 B.B. Lean Inc.: Postmerger balance sheet.