chapter 1: business combinations

© Pearson Education, Inc. publishing as Prentice Hall 1-1

Chapter 1: Business Combinations

by Jeanne M. David, Ph.D., Univ. of Detroit Mercy

to accompany

Advanced Accounting, 10th edition

by Floyd A. Beams, Robin P. Clement,

Joseph H. Anthony, and Suzanne Lowensohn


Business Combinations: Objectives

1. Understand the economic motivations

underlying business combinations.

2. Learn about the alternative forms of business

combinations, from both the legal and

accounting perspectives.

3. Introduce concepts of accounting for business

combinations, emphasizing the acquisition

method.

4. See how firms make cost allocations in an

acquisition method combination.


1: Economic Motivations

Business Combinations


Types of Business Combinations

Business combinations unite previously separate

business entities.

• Horizontal integration – same business lines

and markets

• Vertical integration – operations in different,

but successive stages of production or

distribution, or both

• Conglomeration – unrelated and diverse

products or services


Reasons for Combinations

• Cost advantage

• Lower risk

• Fewer operating delays

• Avoidance of takeovers

• Acquisition of intangible assets

• Other: business and other tax advantages,

personal reasons


Potential Prohibitions/ Obstacles

• Antitrust

– Federal Trade Commission prohibited

Staples’ acquisition of Office Depot

• Regulation

– Federal Reserve Board

– Department of Transportation

– Federal Communications Commission

• Some states have antitrust exemption laws to

protect hospitals


2: Forms of Business Combinations



Legal Form of Combination

• Merger

– Occurs when one corporation takes over all

the operations of another business entity and

that other entity is dissolved.

• Consolidation

– Occurs when a new corporation is formed to

take over the assets and operations of two or

more separate business entities and dissolves

the previously separate entities.


Mergers: A + B = A

1) Company A purchases the assets of Company

B for cash, other assets, or Company A

debt/equity securities. Company B is dissolved;

Company A survives with Company B’s assets

and liabilities.

2) Company A purchases Company B stock from

its shareholders for cash, other assets, or

Company A debt/equity securities. Company B

is dissolved. Company A survives with

Company B’s assets and liabilities.


Consolidations: E + F = “D”

1) Company D is formed and acquires the assets

of Companies E and F by issuing Company D

stock. Companies E and F are dissolved.

Company D survives, with the assets and

liabilities of both dissolved firms.

2) Company D is formed acquires Company E

and F stock from their respective shareholders

by issuing Company D stock. Companies E and

F are dissolved. Company D survives with the

assets and liabilities of both firms.


Keeping the terms straight

In the general business sense, mergers and consolidations

are business combinations and may or may not involve

the dissolution of the acquired firm(s).

In Chapter 1, mergers and consolidations will involve

only 100% acquisitions with the dissolution of the

acquired firm(s). These assumptions will be relaxed in

later chapters.

“Consolidation” is also an accounting term used to

describe the process of preparing consolidated

financial statements for a parent and its subsidiaries.


3: Accounting for Business

Combinations



Business Combination (def.)

“A business combination is a transaction or other

event in which an acquirer obtains control of

one or more businesses. Transactions sometimes

referred to as ‘true mergers’ or ‘mergers of

equals’ also are business combinations…”

[FASB Statement No. 141, para. 3.e.]

A parent – subsidiary relationship is formed

when:

– Less than 100% of the firm is acquired, or

– The acquired firm is not dissolved.


U.S. GAAP for Business Combinations

• Since the 1950s both the pooling-of-interests

method and the purchase method of accounting for

business combinations were acceptable. [ARB 40,

APB Opinion 16]

• Combinations initiated after June 30, 2001, use the

purchase method. [FASB Statement No. 141]

• Firms should use the acquisition method for

business combinations occurring in fiscal periods

beginning after December 15, 2008 [FASB Statement

No. 141R]


International Accounting

• Most major economies prohibit the use of the

pooling method.

• The International Accounting Standards Board

specifically prohibits the pooling method and

requires the acquisition method. [IFRS 3]


Recording Guidelines (1 of 2)

• Record assets acquired and liabilities assumed

using the fair value principle.

• If equity securities are issued by the acquirer,

charge registration and issue costs against the

fair value of the securities issued, usually a

reduction in additional paid-in-capital.

• Charge other direct combination costs (e.g.,

legal fees, finders’ fees) and indirect combination

costs (e.g., management salaries) to expense.


Recording Guidelines (2 of 2)

• When the acquiring firm transfers its assets other

than cash as part of the combination, any gain or

loss on the disposal of those assets is recorded in

current income.

• The excess of cash, other assets and equity securities

transferred over the fair value of the net assets

(A – L) acquired is recorded as goodwill.

• If the net assets acquired exceeds the cash, other

assets and equity securities transferred, a gain on

the bargain purchase is recorded in current income.


Example: Poppy Corp. (1 of 3)

Investment in Sunny Corp. 1,600

Common stock, $10 par 1,000

Additional paid-in-capital 600

Poppy Corp. issues 100,000 shares of its $10 par

value common stock for Sunny Corp. Poppy’s

stock is valued at $16 per share. (in thousands)



Investment expense 80


Cash 120

Poppy Corp. pays cash for $80,000 in finder’s fees

and consulting fees and for $40,000 to register

and issue its common stock. (in thousands)

Sunny Corp. is assumed to have been dissolved. So,

Poppy Corp. will allocate the investment’s cost to

the fair value of the identifiable assets acquired

and liabilities assumed. Excess cost is goodwill.



Receivables XXX

Inventories XXX

Plant assets XXX

Goodwill XXX

Accounts payable XXX

Notes payable XXX

Investment in Sunny Corp. 1,600


4: Cost Allocations Using the

Acquisition Method



Identify the Net Assets Acquired

Identify:

1. Tangible assets acquired,

2. Intangible assets acquired, and

3. Liabilities assumed

Include:

• Identifiable intangibles resulting from legal

or contractual rights, or separable from the

entity

• Research and development in process

• Contractual contingencies

• Some noncontractual contingencies


Assign Fair Values to Net Assets

Use fair values determined, in preferential order,

by:

1. Established market prices

2. Present value of estimated future cash

flows, discounted based on observable

measures

3. Other internally derived estimations


Exceptions to Fair Value Rule

• Deferred tax assets and liabilities [FASB

Statement No. 109 and FIN No. 48]

• Pensions and other benefits [FASB Statement No.

158]

• Operating and capital leases [FASB Statement

No. 13 and FIN. No. 21]

• Goodwill on the books of the acquired firm is

assigned no value.


Goodwill

The excess of

• The sum of:

– Fair value of the consideration transferred,

– Fair value of any noncontrolling interest in

the acquiree, and

– Fair value of any previously held interest in

acquiree,

• Over the net assets acquired.


Contingent Consideration

• If the fair value of contingent consideration is

determinable at the acquisition date, it is

included in the cost of the combination.

• If the fair value of the contingent consideration

is not determinable at that date, it is recognized

when the contingency is resolved.

• Types of consideration contingencies:

– Future earnings levels

– Future security prices


Recording Contingent Consideration

• Contingencies based on future earnings

increase the cost of the investment.

• Contingencies based on future security prices

do not change the cost of the investment.

Additional consideration distributed is recorded

at its fair value with an offsetting write-down of

the equity or debt securities issued.

In some cases the contingency may involve a

return of consideration.


Example – Pitt Co. Data

Pitt Co. acquires the net assets of Seed Co. in a

combination consummated on 12/27/2008. The

assets and liabilities of Seed Co. on this date, at

their book values and fair values, are as follows

(in thousands):


Book Val. Fair Val.

Cash $ 50 $ 50

Net receivables 150 140

Inventory 200 250

Land 50 100

Buildings, net 300 500

Equipment, net 250 350

Patents 0 50

Total assets $1,000 $1,440

Accounts payable $ 60 $ 60

Notes payable 150 135

Other liabilities 40 45

Total liabilities $ 250 $ 240

Net assets $ 750 $1,200


Acquisition with Goodwill

Pitt Co. pays $400,000 cash and issues 50,000

shares of Pitt Co. $10 par common stock with a

market value of $20 per share for the net assets

of Seed Co.

Total consideration at fair value (in thousands):

$400 + (50 shares x $20) $1,400

Fair value of net assets acquired: $1,200

Goodwill $ 200


Entries with Goodwill

The entry to record the acquisition of the net

assets:

The entry to record Seed’s assets directly on Pitt’s

books:

Investment in Seed Co. 1,400

Cash 400

Common stock, $10 par 500



Cash 50

Net receivables 140

Inventories 250

Land 100

Buildings 500

Equipment 350

Patents 50

Goodwill 200

Accounts payable 60

Notes payable 135

Other liabilities 45



Acquisition with Bargain Purchase

Pitt Co. issues 40,000 shares of its $10 par

common stock with a market value of $20 per

share, and it also gives a 10%, five-year note

payable for $200,000 for the net assets of Seed

Co.

Fair value of net assets acquired (in thousands):

$1,200

Total consideration at fair value:

(40 shares x $20) + $200 $1,000

Gain from bargain purchase $ 200


Entries with Bargain Purchase

The entry to record the acquisition of the net

assets:

The entry to record Seed’s assets directly on Pitt’s

books:


10% Note payable 200

Common stock, $10 par 400



Cash 50

Net receivables 140

Inventories 250

Land 100

Buildings 500

Equipment 350

Patents 50

Accounts payable 60

Notes payable 135

Other liabilities 45


Gain from bargain purchase 200


Goodwill Controversies

• Capitalized goodwill is the purchase price not

assigned to identifiable assets and liabilities.

– Errors in valuing assets and liabilities affect

the amount of goodwill recorded.

• Historically goodwill in most industrialized

countries was capitalized and amortized.

• Current IASB standards, like U.S. GAAP

– Capitalize goodwill,

– Do not amortize it, and

– Test it for impairment.


Impairments

• Firms must test annually for the impairment of

goodwill at the business unit reporting level.

– If the unit’s book value exceeds its fair value,

additional tests must be performed to

determine the impairment of goodwill and/or

other assets.

• More frequent testing for goodwill impairment

may be needed (e.g., loss of key personnel,

unanticipated competition, goodwill

impairment of subsidiary).


Business Combination Disclosures

• FASB Statement No. 141R and 142 prescribe

disclosures for business combinations and

intangible assets. This includes, but is not

limited to:

– Reason for combination,

– Allocation of purchase price among assets

and liabilities,

– Pro-forma results of operations, and

– Goodwill or gain from bargain purchase.


Sarbanes-Oxley Act of 2002

• Establishes the PCAOB

• Requires

– Greater independence of auditors and clients

– Greater independence of corporate boards

– Independent audits of internal controls

– Increased disclosures of off-balance sheet

arrangements and obligations

– More types of disclosures on Form 8-K

• SEC enforces SOX and rules of the PCAOB


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Publishing as Prentice Hall

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chapter 1: business combinations

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