Chapter 1: Business Combinations
by Jeanne M. David, Ph.D., Univ. of Detroit Mercy
to accompany
Advanced Accounting
, 10th editionby 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 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 2: Forms of Business Combinations
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 3: Accounting for Business
Combinations Combinations
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)
Example: Poppy Corp.
(2 of 3)Investment expense 80
Additional paid-in-capital 40
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.
Example: Poppy Corp. (3 of 3)
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 4: Cost Allocations Using the
Acquisition Method Acquisition Method
Business Combinations
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$ 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
Additional paid-in-capital 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
Investment in Seed Co. 1,400
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:
Investment in Seed Co. 1,000
10% Note payable 200
Common stock, $10 par 400
Additional paid-in-capital 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
Investment in Seed Co. 1,000 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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