How does purchase accounting affect inventory and COGS after an acquisition?

Purchase accounting requires revaluing the acquired company's inventory to fair value at the acquisition date. This creates a temporary distortion in reported margins.

The Mechanics:

When Company A acquires Company B, B's inventory is marked up from its book value (cost) to its fair value on A's consolidated balance sheet. This fair value typically includes a profit margin that B would have earned on selling the inventory.

Example -- Granite Holdings acquires Beacon Manufacturing:

Beacon's inventory:

• Book value (cost to Beacon): $20 million
• Fair value at acquisition: $28 million
• Markup: $8 million

Impact in the First Quarter After Acquisition:

When Beacon's inventory is sold to third-party customers, COGS reflects the fair value ($28M), not the original cost ($20M).

This is a one-time effect. After the acquired inventory is sold (usually within 1-2 quarters), subsequent inventory is recorded at the acquirer's actual cost and margins normalize.

Analytical Adjustments:

Analysts should:

1. Identify the inventory step-up from acquisition footnotes
2. Add back the step-up to calculate "organic" gross margin
3. Exclude the period from trend analysis or clearly mark it as distorted
4. Compare normalized margins quarter-over-quarter to assess underlying performance

Cash Flow Consideration:

The higher COGS reduces taxable income, creating a temporary tax benefit. However, the cash paid to acquire the inventory (as part of the purchase price) is classified as investing activity, not operating. This can make CFO appear misleadingly strong.

Exam Tip: Level II item sets may provide post-acquisition financials and ask you to identify why margins dropped or to calculate normalized earnings excluding the purchase accounting effect.

Practice acquisition adjustments in our CFA Level II question bank.