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Chapter 3 Business
Combinations

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 Business Combinations
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 Separate organizations tied together through

common control
 Financial statements which represent more than one
corporation are known as “consolidated” financial
statements.
 The company which exerts control is known as the
“parent.”
 The separate controlled companies whose
information is consolidated are known as
“subsidiaries.”

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 2.1. LEGAL FORMS OF BUSINESS COMBINATIONS
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the three primary legal forms of business
combinations.
1. A statutory merger is a type of business
combination in which only one of the combining
companies survives and the other loses its separate
identity. (AA +BB=AA)
➢ The acquired company’s assets and liabilities are
transferred to the acquiring company, and the acquired
company is dissolved, or liquidated.
➢ The operations of the previously separate companies
are carried on in a single legal entity following the
merger.
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 cont’d
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2. A statutory consolidation is a business combination
in which both combining companies are dissolved
and the assets and liabilities of both companies are
transferred to a newly created corporation. ( AA
+BB=CC)
➢ The operations of the previously separate companies are
carried on in a single legal entity, and neither of the
combining companies remains in existence after a
statutory consolidation.
➢ In many situations, however, the resulting corporation is
new in form only, and in substance it actually is
one of the combining companies reincorporated
with a new name.

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 cont’d
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3. A stock acquisition occurs when one company

acquires the voting shares of another company and the
two companies continue to operate as separate,
but related, legal entities. (AA+BB=AA +BB)
➢ Because neither of the combining companies is liquidated,
the acquiring company accounts for its ownership interest
in the other company as an investment.
➢ In a stock acquisition, the acquiring company need not
acquire all the other company’s stock to gain control

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 cont’d
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➢ The relationship that is created in a stock acquisition is

referred to as a parent– subsidiary relationship.
➢ A parent company is one that controls another company,
referred to as a subsidiary, usually through majority
ownership of common stock.
➢ For general-purpose financial reporting, a parent company
and its subsidiaries present consolidated financial statements
that appear largely as if the companies had actually merged
into one.
➢ The legal form of a business combination, the substance of the
combination agreement, and the circumstances surrounding
the combination all affect how the combination is recorded
initially and the accounting and reporting procedures used
subsequent to the combination.

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Figure 2–1 Types of Business Combinations

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 Why do Firms Combine?
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 Vertical integration
 Cost savings
 Quick access to new markets
 Economies of scale
 More attractive financing opportunities
 Diversification of business risk

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 The Consolidation Process
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“The purpose of consolidated financial statements is to present,
primarily for the benefit of the owners and creditors of the parent,
the results of operations and the financial position of a parent
company and all its subsidiaries as if the consolidated group were a
single economic entity with one or more branches or divisions.”
- - SFAS 160 (December 2007)

Why Consolidated Statements?

 They are presumed to be more meaningful than
separate statements.
 They are considered necessary for fair
presentation.

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 Business Combinations
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There is a presumption that consolidated financial statements
are more meaningful than separate financial statements and
that they are usually necessary for a fair presentation when one
of the entities in the consolidated group directly or indirectly
has a controlling financial interest in the other entities (SFAS
160).

The usual condition for a controlling financial interest is

ownership of a majority voting interest, and, therefore, as a
general rule ownership by one entity, directly or indirectly, of
more than 50 per cent of the outstanding voting shares of
another entity is a condition pointing toward consolidation
(SFAS 160).

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 Consolidation of Financial Information
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Parent Subsidiary

The parent does not Consolidated The Sub still prepares

prepare separate financial statements separate financial
financial statements are prepared. statements
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Reminder: GAAP Accounting Methods
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Level of
Influence Method of Accounting

Minor Fair Value Method (SFAS 115)

Equity Method (APB 18 and
Significant
SFAS 142)
Acquisition Method (SFAS
Control
141R, 142, and 160)
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 A Control Issue – SPE’s
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 Special Purpose Entities (a popular type of “variable

interest entity”) were misused to hide debt and manipulate
earnings
 As a result, the FASB (in FIN 46R) expanded the definition
of “control” beyond just the holding of a majority share
position.
 The following indicate a controlling financial interest in a
variable interest entity:
 Direct or indirect ability to make decisions about the entity’s
activities
 Obligation to absorb any expected losses of the entity
 The right to receive any expected residuals of the entity

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 What is to be consolidated?
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 If dissolution occurs:
All account balances are actually consolidated in the financial
records of the survivor.

 If separate incorporation maintained:

Financial statement information is

consolidated on work papers and not in the
actual records

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When does consolidation occur?
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 If dissolution occurs:
Permanent consolidation occurs at the
combination date

 If separate incorporation maintained:

Consolidation (on work papers, not in the
actual records) occurs regularly, whenever
financial statements are prepared

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 How does consolidation affect the accounting
records?
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 If dissolution occurs:
Dissolved company’s records are closed out.
Surviving company’s accounts are adjusted to
include all balances of the dissolved company

 If separate incorporation maintained:

Each company continues to maintain its own
records

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Acquisition Method – SFAS 141R (effective for all
combinations beginning in 2009)
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 Employed when there is a change in
ownership resulting in control of one
enterprise by another.
 The valuation basis for most acquisitions is
the fair value of the “consideration
transferred” by the acquirer at the date of
acquisition.
 Consideration transferred includes
 Cash paid or fair value of stock issued
 Fair value of any contingent consideration
 Fair value of any other property transferred

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 Accounting Challenges
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 Allocation of “acquisition-date fair value” among the various assets and

liabilities obtained.

 Allocation depends on the relation between the total fair value of the
acquired business and the collective amount of the individual “fair
values” of the acquired firm’s assets and liabilities.

FASB defines fair value as “the price that would be received to sell an
asset or paid to transfer a liability in an orderly transaction of market
participants at the measurement date.”
(FASB, “Statement of Financial Accounting Standards No. 157,” Fair
Value Measurements)

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 “Direct Costs” of Combination
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 The fees to the following for advising services in

arranging and structuring the combination:
 Investment bankers
 Accountants
 Attorneys

These amounts are considered expenses of the period in which

the combination takes place. They are NOT consider an
element of the fair value received by the acquirer.

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Acquisition Method Situations
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 Dissolution of the acquired company:

 Consideration transferred =

Collective fair values of the individual asset acquired

and liabilities assumed (FV)
 Consideration transferred = FV

 Consideration transferred > FV

 Consideration transferred < FV

 Separate incorporation maintained.

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 Acquisition Method: Dissolution
Consideration transferred = Fair value
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 Ignore the equity and nominal accounts of the
acquired company.
 Determine fair values of the acquired company’s
assets and liabilities.
 Prepare a journal entry to
 recognize the fair value of the consideration
transferred in the acquisition
 incorporate the fair value of the acquired
company’s identifiable assets and liabilities into the
acquiring company’s books.

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 Acquisition Method: Dissolution
Consideration transferred = Fair value
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BigNet agrees to pay $2,550,000 (cash of

$550,000 and 20,000 unissued shares of its
$10 par value common stock that is
currently selling for $100 per share) for all
of Smallport’s assets and liabilities.

Smallport then dissolves itself as a legal

entity. As is typical, the $2,550,000 fair
value of the consideration transferred by
BigNet represents the fair value of the
acquired Small port business. 11/4/2021
INFORMATION FOR CONSOLIDATION
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 Acquisition Method: Dissolution
Consideration transferred = Fair value
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 Acquisition Method: Dissolution
Consideration transferred > Fair value
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 FV of acquired company’s assets

and liabilities is added to
acquiring company’s books. Note: Goodwill
should be
viewed as a
 Difference between consideration residual amount
remaining after
transferred and FV of identifiable all other
assets acquired and liabilities identifiable
assumed is allocated to assets acquired
goodwill. and liabilities
assumed are
recognized.

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 ILLUSTRATIVE EXAMPLE
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 If in the previous example, BigNet transfers to the

former owners of Smallport consideration of $1,000,000
in cash plus 20,000 shares of common stock with a fair
value of $100 per share.

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 Acquisition Method: Dissolution
Consideration transferred > Fair value
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 Acquisition Method: Dissolution
Consideration transferred < Fair value
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 In rare circumstances, the FV of the

identifiable assets acquired and liabilities
assumed may exceed the consideration
transferred.
 This excess FV is recognized as an ordinary
gain on a bargain purchase.
 The FV of the of identifiable assets acquired
and liabilities assumed then becomes the
valuation basis of the acquisition.

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 Acquisition Method: Dissolution
Consideration transferred < Fair value
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At acquisition date, each

subsidiary asset and liability is
reported at its fair value. . .

. . . The remainder is to be
reported as an ordinary gain on
bargain purchase (SFAS 141R)

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 Example for bargain purchase
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 If BigNet transferring consideration of $2,000,000 to

the owners of Smallport in exchange for their business.
BigNet conveys no cash and issues 20,000 shares of
common stock having a $100 per share fair value.

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 Accounting for Additional Costs Associated
with Business Combinations (SFAS 141R)
Direct combination costs Expense as incurred
(Accounting, legal,
investment banking and
appraisal fees, etc.)

Indirect combination costs Expense as incurred

(additional internal costs
such as secretarial or
managerial time)

Costs to register and issue Reduce the value assigned

securities to the fair value of the
securities issued
 Illustrative example for related costs
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 assume the following in connection with BigNet’s
acquisition of Smallport BigNet issues 20,000 shares of
its $10 par common stock with a fair value of
$2,600,000 in exchange for all of Smallport’s assets and
liabilities. BigNet pays an additional $100,000 in
accounting and attorney fees. Internal secretarial and
administrative costs of $75,000 are indirectly
attributable to BigNet’s combination with Smallport
Cost to register and issue BigNet’s securities issued in
the combination total $20,000.

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34

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Acquisition Method - No Dissolution
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 The acquired company continues as a separate entity.
 Reported on Parent’s books as the Investment in Subsidiary
account.
 Separate records for each company are still
maintained.
 The adjusted balances for the Parent and the
Subsidiary are consolidated using a worksheet (no
formal journal entries!)

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Steps for Consolidation
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1. Record the financial information for

both Parent and Sub on the worksheet.

2. Remove the Investment in Sub balance.

3. Remove the Sub’s equity account

balances.
4. Adjust the identifiable assets acquired
and liabilities assumed to FV.
5. Allocate any remaining excess of
consideration transferred over BV to
goodwill.
6. Combine all account balances.
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 Assume that BigNet acquires Smallport Company on
December 31 by issuing 26,000 shares of $10 par value
common stock valued at $100 per share (or $2,600,000 in
total). BigNet pays fees of $40,000 to a third party for its
assistance in arranging the transaction. Then to settle a
difference of opinion regarding Smallport’s fair value, BigNet
promises to pay an additional $83,200 to the former owners if
Smallport’s earnings exceed $300,000 during the next annual
period. BigNet estimates a 25 percent probability that the
$83,200 contingent payment will be required. A discount rate
of 4 percent (to represent the time value of money) yields an
expected present value of $20,000 for the contingent liability
($83,200 *25% * 0.961538). The fair-value approach of the
acquisition method views such contingent payments as part of
the consideration transferred.

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According to this view, contingencies have value to those who
receive the consideration and represent measurable
obligations of the acquirer. Therefore, the fair value of the
consideration transferred in this example consists of the
following two elements: This allocation procedure is helpful
but not critical if dissolution occurs. The asset and liability
accounts are simply added directly into the parent’s books at
their acquisition-date fair value with any excess assigned to
goodwill as shown in the previous sections of this chapter.

Fair value of securities issued by BigNet ………….$2,600,000

Fair value of contingent performance liability ………..20,000
Total fair value of consideration transferred ……….$2,620,000

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Acquisition Method—Subsidiary Is Not Dissolved
(BigNet Company’s Financial Records—December 31)

Investment in Small port Company . . . . . . .. 2,620,000

Contingent Performance Liability . . . . . . . . ……..20,000
Common Stock ……………………………………………260,000
Additional Paid-In Capital……….. . . . . ………….2,340,000

Professional Services Expense . . . . . . . . . . .40,000

Cash (paid for third-party fees) . . . . . . . . . . . . . . . . .40,000

To record acquisition of Small port Company, which maintains

its separate legal identity.

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44

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 Acquisition Fair Value Allocations: Additional
Issues, SFAS No. 141R
45

Intangible Asset Examples

 Databases
 Brand Names  Technological know-how
 Trademarks  Patents & Copyrights
 Customer Routes  Franchise agreements
 Royalty agreements  Noncompetition
 Internet domain names agreements
 Rights (broadcasting,  Many, many, more
development, use, etc.)

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Acquisition Fair Value Allocations: Additional
Issues, SFAS No. 141R
46
 In-Process R&D
 Should be recognized at acquisition
date as an ASSET.
 Determination of fair value is critical.

 Subsequent to acquisition, the IPR&D

assets are tested for impairment at
least annually.

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 Unconsolidated Subsidiaries
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When can a Parent exclude a 50%

owned subsidiary from consolidation?

When control does not

actually rest with the 50% owners,
e.g., bankruptcy, substantive minority rights, etc.

SFAS No. 94

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LEGACY ACCOUNTING METHODS FOR
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BUSINESS COMBINATIONS

Prior to the SFAS 141R

acquisition method (effective
2009), the FASB required either
the
▪ Purchase method (GAAP
through 2008, SFAS 141)

▪ Pooling of interests method

(GAAP through 6/30/02, APB
16)
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 Purchase Method Situations:
GAAP for new combinations through 2008
49

 Dissolution of the
acquired company:
Purchase Price = Fair
Value
Purchase Price > FV
Purchase Price < FV
 Separate
incorporation
maintained.
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 Purchase Method: Dissolution
Purchase Price > or = Fair Value
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 Ignore the equity and nominal
accounts of the acquired company.
 Determine fair value of the acquired
company’s assets and liabilities.
 Prepare a journal entry to
 recognize the cost of acquisition
 incorporate the FV of the acquired
company’s assets and liabilities into the
acquiring company’s books.
 Recognize goodwill as the excess of cost over
FV of the net assets acquired.
 Record any acquired in-process research and
development as an expense

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Purchase Method: Dissolution
Purchase Price > Fair Value
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Archer agrees to pay $1,200,000 (10,000
unissued shares of its $1 par value common stock
that is currently selling for $120 per share) for all
of Baker’s assets and liabilities. Archer also paid
$25,000 cash for legal and accounting fees
directly related to the acquisition.

Baker then dissolves itself as a legal entity. Under

the purchase method both the fair value of the
stock issued and the direct acquisition costs are
included in the cost-based valuation of the
combination.
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Purchase Method: Dissolution
Purchase Price > Fair Value
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Acquisition-date information for Baker Co.

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Purchase Method: Dissolution
Purchase Price < Fair Value
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 When fair value exceeds cost, full

allocation of fair value is not possible.
 Current assets and liabilities should be
consolidated at their fair value.
 Non-current assets should be
proportionately reduced in value (with
some exceptions)

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Assume Adams Co. paid $520,000 for Brook Co. in 2008.
Brook has the following assets with appraised fair values:

Accounts receivable . . . . . . . . . . . . . $ 15,000

Land . . . . . . . . . . . . . . . . . . . . . . . . .. 200,000
Building . . . . . . . . . . . . . . . . . . . . . . .. 400,000
Accounts payable . . . . . . . . . . . . . . . . (5,000)
Total net fair value . . . . . . . . . . . . . . …. $610,000

The purchase method reduce the valuation assigned to the

acquired long-term assets (land and building) proportionately
by $90,000 ($610,000 - $520,000). The total fair value of the
long-term assets, in this case $600,000, provided the basis for
allocating the reduction. Thus, Adams would reduce the
acquired land by (2/6 *$90,000) = $30,000 and the building
by $60,000.
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Accounts receivable . . . . . . . . . . . . . . . . 15,000
Land ($200,000 -$30,000) . . . . . . .. . . . . 170,000
Building ($400,000 -$60,000) .. . . . . . . . . 340,000
Accounts payable . . . . . . . . . . . . . . . . . . . 5,000
Cash . . . . . . . . . . . . . . . . . . .. . . . . . ……. . 520,000

Adams’ journal entry to record the combination using the

purchase method

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 Purchase Method - Dissolution
Purchase Price < Fair Value
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 According to SFAS 141, the following
non-current assets are exceptions to the
proportionate reduction, and should be
recorded at assessed fair values:
 Financial assets other than equity method
investments
 Assets to be disposed of by sale

 Deferred tax assets

 Prepaid assets related to pension or other

post-retirement benefit plans
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Purchase Method - Dissolution
Purchase Price < Fair Value
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In the event that the difference is

substantial enough to eliminate all
the non-current asset balances of
the acquired company . . .

. . . The remainder is to be
reported as an extraordinary gain
(SFAS 141)

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 Accounting for Additional Costs Associated
with Business Combinations (SFAS 141)
Direct combination costs Include in the purchase
(Accounting, legal, price of the acquired firm
investment banking and
appraisal fees, etc.)

Indirect combination costs Expense as incurred

(additional internal costs
such as secretarial or
managerial time)

Costs to register and issue Reduce the value assigned

securities to the fair value of the
securities issued (typically
as a debit to APIC)
 Summary
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 Consolidation of financial information is required when one

organization gains control of another.
 If dissolution occurs, this consolidation is carried out at the date of
acquisition and a single set of accounting records is maintained.
 If separate identities are maintained, consolidation is a periodic
“worksheet” process not involving journal entries. Separate accounting
records are maintained.
 The acquisition method is GAAP beginning in 2009.

 Legacy effects for the purchase method (for combinations occurring

through 2008) and the pooling method (through 6/30/2002) remain in
subsequent year’s financial reports.

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END OF CHAPTER THREE

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