Chapter 1

Business
Combinations
 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 record fair values of assets
and liabilities in an acquisition.

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 Business Combinations

1: ECONOMIC
MOTIVATIONS

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 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

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 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

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 Potential Prohibitions / Obstacles

Antitrust
Federal Trade Commission prohibited Staples
acquisition of Office Depot
Regulation
Federal Reserve Board
Department of Transportation
Department of Energy
Federal Communications Commission
Some states have antitrust exemption laws
to allow hospitals to pursue cooperative
projects.
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 Business Combinations

2: FORMS OF BUSINESS
COMBINATIONS

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 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.

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 Mergers:
A+B=A X+Y=X
Company A acquires the net assets of Company
B for cash, other assets, or Company A
debt/equity securities. Company B is dissolved;
Company A survives with Company Bs assets
and liabilities.

Company X acquires the stock of Company Y

from its shareholders for cash, other assets, or
Company X debt/equity securities. Company Y is
dissolved. Company X survives with Company
Ys assets and liabilities.

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 Consolidations:
E + F = D K + L = J

Company D is formed and acquires the net

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.

Company J is formed and acquires the stock of

companies K and L from their respective
shareholders by issuing Company J stock.
Companies K and L are dissolved. Company J
survives with the assets and liabilities of both
firms.
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 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.

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 Business Combinations

3: ACCOUNTING FOR
BUSINESS
COMBINATIONS

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 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 ASC 805-
10]

A parent-subsidiary relationship is formed when:

Less than 100% of the firm is acquired, or
The acquired firm is not dissolved.

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 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.
Combinations initiated after June 30, 2001 use
the purchase method. [FASB ASC 805]
Firms now use the acquisition method for
business combinations. This began with
combinations in fiscal periods beginning after
December 15, 2008. [FASB ACS 810-10-5-2]

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 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.

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 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.

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 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, debt, 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, debt, and equity securities
transferred, a gain on the bargain purchase is
recorded in current income.

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 Example: Pop Corp. (1 of 3)

Pop Corp. issues 200,000 shares of its $10 par

value common stock for Son Corp. Pops stock
is valued at $16 per share. (in thousands)

Investment in Son Corp. (+A) 3,200

Common stock, $10 par (+SE) 2,000

Additional paid-in-capital (+SE) 1,200

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 Example: Pop Corp. (2 of 3)

Pop Corp. pays cash for $160,000 in finders and

consulting fees and for $80,000 to register and
issue its common stock. (in thousands)
Investment expense (E, -SE) 160

Additional paid-in-capital (-SE) 80

Cash (-A) 240

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

Pop Corp. allocates the investments cost to the fair
value of the identifiable assets acquired and
liabilities assumed. The excess cost is goodwill.

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 Example: Pop Corp. (3 of 3)

Receivables (+A) XXX

Inventories (+A) XXX

Plant assets (+A) XXX

Goodwill (+A) XXX

Accounts payable (+L) XXX

Notes payable (+L) XXX

Investment in Son Corp. (-A) 3,200

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 Business Combinations

4: RECORDING FAIR
VALUES IN AN
ACQUISITION

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 Identify the Net Assets Acquired

Identify:
Tangible assets acquired,
Intangible assets acquired, and
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

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 Assign Fair Values to Net Assets

Use fair values determined, in preferential

order, by:
Established market prices
Present value of estimated future cash flows,
discounted based on an observable measure,
such as the prime interest rate
Other internally derived estimations

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 Exceptions to Fair Value Rule

Use normal guidance for:

Deferred tax assets and liabilities
Pensions and other benefits
Operating and capital leases
[FASB ASC 740]

Goodwill on the books of the acquired firm is

assigned no value.

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 Goodwill

Goodwill is 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.

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 Contingent Consideration

The fair value of contingent consideration is

determined or estimated at the acquisition
date and it is included along with other
consideration given as part of the
combination.
Classifying contingencies:
Contingent share issuances are equity
Contingent cash payments are liabilities
Estimated contingencies are revalued to fair
value at each subsequent reporting date.

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 Example Pit Corp. Data

Pit Corp. acquires the net assets of Sad Co.

in a combination consummated on
12/27/2011.

The assets and liabilities of Sad Co. on this

date, at their book values and fair values,
are as follows (in thousands):

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 Book Val. Fair Val.
Cash $100 $100
Net receivables 300 280
Inventory 400 500
Land 100 200
Buildings, net 600 1.000
Equipment, net 500 700
Patents 0 100
Total assets $2,000 $2,880
Accounts payable $120 $120
Notes payable 300 270
Other liabilities 80 90
Total liabilities $500 $480
Net assets $1,500 $2,400

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 Acquisition with Goodwill

Pit Corp. pays $800,000 cash and issues 100,000

shares of Pit Corp. $10 par common stock with a
market value of $20 per share for the net assets of
Sad Co.

Total consideration at fair value (in thousands):

$800 + (100 shares x $20) $2,800

Fair value of net assets acquired: $2,400

Goodwill $ 400

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 Entries with Goodwill

The entry to record the acquisition of the net

assets:
Investment in Sad Co. (+A) 2,800
Cash (-A) 800
Common stock, $10 par (+SE) 1,000
Additional paid-in-capital (+SE) 1,000

The entry to record Sads assets directly on

Pits books:

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 Cash (+A) 100
Net receivables (+A) 280
Inventories (+A) 500
Land (+A) 200
Buildings (+A) 1,000
Equipment (+A) 700
Patents (+A) 100
Goodwill (+A) 400
Accounts payable (+L) 120
Notes payable (+L) 270
Other liabilities (+L) 90
Investment in Sad Co. (-A) 2,800

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 Acquisition with Bargain Purchase

Pit Corp. issues 80,000 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 $400,000 for the net assets of Sad
Co.
Fair value of net assets
$2,400
acquired (in thousands)
Total consideration at fair value
$2,000
(80 shares x $20) + $400
Gain from bargain purchase $400

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 Entries with Bargain Purchase

The entry to record the acquisition of the net

assets:
Investment in Sad Co. (+A) 2,000

10% Note payable (+L) 400

Common stock, $10 par (+SE) 800

Additional paid-in-capital (+SE) 800

The entry to record Sads assets directly on

Pits books:

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 Cash (+A) 100

Net receivables (+A) 280

Inventories (+A) 500

Land (+A) 200

Buildings (+A) 1,000

Equipment (+A) 700

Patents (+A) 100

Accounts payable (+L) 120

Notes payable (+L) 270

Other liabilities (+L) 90

Investment in Sad Co. (+A) 2,000

Gain from bargain purchase (G, +SE) 400

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 Business Combinations

5: OTHER ISSUES:
IMPAIRMENTS,
DISCLOSURES, AND THE
SARBANES-OXLEY ACT

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 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

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 Goodwill Impairment Testing

Firms must test for the impairment of

goodwill at the business unit reporting level.
Step 1: Compare the units net book value to its
fair value to determine if there has been a loss
in value.
Step 2: Determine the implied fair value of the
goodwill, in the same manner used to originally
record the goodwill, and compare that to the
goodwill on the books.
Record a loss if the implied fair value is less
than the carrying value of the goodwill.

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 When to Test for Impairment

Goodwill should be tested for impairment at least

annually.
More frequent testing may be needed:
Significant adverse change in business
Adverse action by regulator
Unanticipated competition
Loss of key personnel
Impairment or expected disposal losses of:
Reporting unit or part of one
Significant long-lived asset group
Subsidiary

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 Business Combination Disclosures

Business combination disclosures include, but

are not limited to:
Reason for combination,
Nature and amount of consideration,
Allocation of purchase price among assets and
liabilities,
Pro-forma results of operations, and
Goodwill or gain from bargain purchase

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 Intangible Asset Disclosures

Specific disclosures are needed:

In the fiscal period when intangibles are
acquired,
Annually, for each period presented, and
In the fiscal period that includes an impairment

Disclosures are needed for:

Intangibles which are amortized,
Intangibles which are not amortized,
Research & development acquired, and
Intangibles with renewal or extension terms

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 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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