If a company uses the purchase method to account for a merger, which of the following is true?
I. Prior year's statements must be restated as if merged companies had always been one company.
II. Net income of combined companies will probably be lower than net income of two separate companies added together.
III. Goodwill is never recorded.
IV. Assets of acquired company will be recorded on acquirer's books at their fair value.

Question

Quizplus · Accepted Answer

-I. This statement is not true regarding the purchase method. Prior year's statements are not required to be restated.
-II. This statement is true. Combining companies can result in duplicate expenses and reduced efficiencies, leading to lower net income than if the companies were separate.
-III. This statement is not true. Goodwill is recorded when the purchase method is used to account for a merger.
-IV. This statement is true. The assets of the acquired company are recorded on the acquirer's books at their fair value.

In terms of the offer, for every two shares of Target Company, shareholders will receive one share of Acquirer Corp. This means that for the 1 million outstanding shares of Target Company, shareholders would receive 500,000 shares of Acquirer Corp. (1 million divided by 2).

To calculate the purchase price, we need to multiply the number of shares of Acquirer Corp. issued by the market price per share of Acquirer Corp.:

500,000 shares x $50 per share = $25 million

The excess of the purchase price over the book value of Target Company's net assets is recorded as goodwill. The excess in this case is $15M fair value - $12M book value = $3M.

The total assets of the combined company will be:
- Target Company's Fair Value Net Assets ($15M)
- Acquirer Corp.'s Fair Value Net Assets ($48M)
- Amount Paid to Acquire Target Company ($25M)

Total Assets = $15M + $48M + $25M = $88M

The total earnings of the combined company will be the sum of earnings of both companies:
$5M (Acquirer Corp.) + $2M (Target Company) = $7M

Therefore, the price-to-earnings (P/E) ratio would be:
Price / Earnings = $25M / $7M = 3.57

If a Company Uses the Purchase Method to Account for a Merger