Chapter 1: Business Combinations

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

Edited by: Erlinda J. Hipolito, CPA, MBM

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.
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
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).
Mergers and consolidations will involve only 100%
acquisitions with the dissolution of the acquired firm(s).
Philippine Law- above 50% acquistion
“Consolidation” is also an accounting term used to
describe the process of preparing consolidated
financial statements for a parent and its subsidiaries.
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.
 Forms of Business Combinations

• There are three primary forms of business

combinations:

• Statutory Merger

• Statutory Consolidation

• Stock Acquisition

© Pearson Education, Inc. publishing as Prentice Hall

Statutory Merger
• A statutory merger occurs when one company
acquires another company and the assets and
liabilities of the acquired company are transferred
to the acquiring company.

• In a statutory merger, the acquired company is

liquidated and the acquiring company continues to
exist.

1-14
Statutory Consolidation
• A statutory consolidation occurs when a new
company is formed to acquire the assets and
liabilities of two combining company.

• In a statutory consolidation, the combining

companies are dissolved and the new company is
the only surviving entity.

1-15
Stock Acquisition
• A stock acquisition occurs when one company
acquires a majority of the common stock of another
company and the acquired company is not
liquidated.

• In a stock acquisition, both companies continue to

operate as separate but related corporations (i.e.,
affiliated corporations).

1-16
Stock Acquisition:
Parent-Subsidiary Relationship
• A subsidiary is a corporation that is controlled
(through common stock ownership) by another
corporation, that is, the parent corporation.
• Controlling Interest: The parent owns a
majority of the common stock of the subsidiary.
• Wholly-Owned Subsidiary: The parent owns
all of the common stock of the subsidiary.
• Given that a subsidiary is a separate legal entity,
the parent’s risk associated with the subsidiary’s
activities is limited.

1-17
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]
Chapter 1 Important Terms
– Cost of Investment (Purchase Price)
– Goodwill – when the purchase price exceeds FV of
identifiable assets & liabilities
– Fair Value – amount needed to buy an asset or refinance a
liability today
– Book Value – historical cost or monetary amount owed for
liabilities (adjusted for premium or discounts)
– Identifiable Assets – assets other than goodwill
– Identifiable Liabilities – known liabilities
– Net Identifiable Assets – net identifiable assets less net
identifiable liabilities
– Differential: difference between cost of the investment and
book value of the net identifiable assets.

1-20
 Acquistion Method of Accounting
for Bus. Combination
Page 7
1. Identify the acquirer
2. Determine the acquistion date
3. Determine the consideratin given (Price Paid)
by the acquirer
4. Recognize and measure the idenfiable assets
acquired, the liabilities assumed nad any non-
controlling interest in the acquireee. any resulting
goodwill or gain from abargain purchase should
be recognized
© Pearson Education, Inc. publishing as Prentice Hall
Recording Guidelines
• 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.
• Acquisition-related cost or Charge other direct
combination costs (e.g., legal fees, finders’ fees)
• And indirect combination costs (e.g.,
management salaries) to expense.
Purchase Price
--Direct Costs
• All direct costs associated with purchasing another
company are expensed
• Examples:
• Finders’ fees
• Accounting fees
• Legal fees
• Appraisal fees

1-23
Purchase Price
--Costs of Issuing Securities
• Costs incurred in issuing equity securities in
connection with the purchase of a company should
be treated as a reduction in Additional-Paid-In
Capital. Examples include: Listing fees; Audit and
legal fees related to the registration; and, Brokers’
commissions.

• Costs incurred in issuing bonds payable in

connection with the purchase of a company should
be accounted for as bond issue costs and amortized
over the term of the bonds.

1-24
Purchase Price
--Indirect and General Costs
• All indirect and general costs related to a business
combination or to the issuance of securities in a
combination should be expensed as incurred.

• For example, the salary costs of accountants on the

staff of the acquiring company in a business
combination would be expensed, even though some
of their time was spent on matters related to the
combination.

1-25
Goodwill
• Any amount of the purchase price in excess of the
fair value of the identifiable assets and liabilities
acquired is viewed as the price paid for goodwill.

• In theory, goodwill is the excess earnings power of

the of the acquired company.

• In practice, goodwill represents the premium paid

to acquire control.

1-26
 Record and Measure the Acquiree’s
and Liabilities that are assume
Price paid/Acquisition cost 100
less FV of NA 90
Goodwil 10

Price paid/Acquisition cost 100

less FV of NA 130
gain on acquisition 30

© Pearson Education, Inc. publishing as Prentice Hall

Example: Poppy Corp. (1 of 3)
Poppy Corp. issues 100,000 shares of its $10 par
value common stock for Sunny Corp. Poppy’s
stock is valued at P16 per share. (in thousands)

Investment in Sunny Corp. 1,600

Common stock, P10 par 1,000
Additional paid-in-capital 600
Example: Poppy Corp. (2 of 3)
Poppy Corp. pays cash for P80,000 in finder’s fees
and consulting fees and for P40,000 to register
and issue its common stock. (in thousands)
Investment expense 80
Additional paid-in-capital 40
Cash 120
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
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
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
Entries with Goodwill
The entry to record the acquisition of the net
assets:
Investment in Seed Co. 1,400
Cash 400
Common stock, $10 par 500
Additional paid-in-capital 500
The entry to record Seed’s assets directly on Pitt’s
books:
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:
Investment in Seed Co. 1,000
10% Note payable 200
Common stock, $10 par 400
Additional paid-in-capital 400
The entry to record Seed’s assets directly on Pitt’s
books:
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.
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
 END

© Pearson Education, Inc. publishing as Prentice Hall