7.30.14 Accounting For M&A - Accounting For Business Combinations Acquisition Method

9-108-067
REV: NOVEMBER 30, 2010
DAVID F. HAWKINS
F. ASÍS MARTÍNEZ JEREZ
Accounting for Business Combinations:

Acquisition Method
A business combination is a transaction or other event in which an acquirer obtains control of one
or more acquired businesses. Beginning in December 2008, following the issuance by the Financial
Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 141 (revised
2007), “Business Combinations” (SFAS 141 R), U.S. companies were required to use the acquisition
method to account for business combinations. SFAS 141 R is a revision of FASB Statement of
Financial Accounting Standards No. 141, “Business Combinations” (SFAS 141), issued in June 2001.
SFAS 141 required the use of the purchase method to account for business combinations. While
retaining much of its characteristics, SFAS 141 R renamed the purchase method to the acquisition
method. Prior to SFAS 141, a second method of accounting for business combinations referred to as
the pooling-of-interests method, was required under certain conditions.1 It was eliminated with the
issuance of SFAS 141.2
Effective for interim and annual financial reporting periods ending after September 15, 2009, the
FASB issued “Accounting Standards Codification” (ASC). Henceforth, ASC was the single source of
authoritative non-governmental U.S. Generally Accepted Accounting Principles (US GAAP). It
superseded all previously issued US GAAP. FAS 141 (R) in its entirety was incorporated in the
FASB’s ASC as Topic 805, “Business Combinations” (“Topic 805”).
The International Accounting Standards Board (IASB) has issued an almost identical in principles
and language standard to Topic 805, International Financial Reporting Standards No. 3, “Business
Combinations (Revised)” (IFRS 3R).3,4
1 Under the pooling-of-interests method, certain forms of business combinations were thought of as the uniting of two or more
different entities to form a new entity. In these cases, there is no acquirer or acquiree but a grouping/uniting of business
interests to continue activities. Under this accounting method the balance sheet and income statement of the combined entity is
essentially the sum of the existing balance sheets and income statements of the combining entities.
2 In its FAS 141 deliberations, the FASB rejected a proposal that it adopt the “fresh-start method” to account for business
combinations. Under this method both the acquirer and acquiree would restate their balance sheets to a fair value basis
following a business combination.
3 “IFRS 3 (Revised): Impact on earnings”, PriceWaterhouseCooper, 2008.
________________________________________________________________________________________________________________
Professors David F. Hawkins and F. Asís Martínez Jerez prepared this note as the basis for class discussion.
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108-067 Accounting for Business Combinations: Acquisition Method
Applying the acquisition method requires:
1. Identifying the acquirer
2. Determining the acquisition date
3. Measuring the consideration paid
4. Recognizing and measuring the identifiable assets acquired, the liabilities assumed, and any
non-acquired noncontrolling interest in the acquiree5
5. Recognizing and measuring goodwill6
6. Recognizing a gain from a bargain purchase.7
Identification of the Acquirer

Identifying the acquirer is crucial because only the acquiree’s assets and liabilities will be adjusted
to fair value as a consequence of the acquisition transaction.
The acquirer is the entity that obtains control of one or more businesses in a business
combination.8 In some acquisitions, the corporate form of the transaction may suggest one
corporation is the acquirer, but a closer examination of the substance of the business combination
may indicate the acquiree is in substance the acquirer. These transactions are referred to as “reverse
acquisitions”. In a reverse acquisition, the acquiree is accounted for as the acquirer.
Acquisition Date
Determining the acquisition date is an important step in applying the acquisition method, since all
of the fair valuation measurements must be made as of that date. The acquisition date is the date on
which the acquirer obtains control of the acquiree. Generally, but not necessarily, this is the date on
which the acquirer legally transfers the consideration, acquires the acquiree’s assets, and assumes the
liabilities of the acquiree.
4 This technical note covers the acquisition method and the post acquisition accounting for goodwill and various intangible
assets commonly acquired through business acquisitions. ASC Topic 350 “Intangibles – Goodwill and Other” (“Topic 350”),
IAS 3.
(goodwill only), and IAS 38 “Intangible Assets” (“IAS 38”) cover the post acquisition accounting for acquired and internally
generated other intangible assets.
5 A noncontrolling interest in the acquiree is an ownership interest in the acquiree not acquired by the acquirer who by
definition controls the acquiree subsequent to its acquisition.
6 Goodwill is an asset acquired by the acquirer in a business combination transaction representing the future economic benefits
arising from other assets acquired in a business combination that are not individually identified and separately recognized by
the acquirer.
7 A bargain purchase is an acquisition where the fair value of the identifiable net assets acquired is greater than the fair value
of the consideration transferred plus the fair value of any noncontrolling interest in the acquiree.
8 “Control” means the possession, direct or indirect, of the power to direct or cause the direction of the management and
policies of an entity, whether through the ownership of voting shares, by contrast, or otherwise.
Accounting for Business Combinations: Acquisition Method 108-067
Consideration Transferred
Determining the consideration transferred or paid to the acquiree is important for accounting and
a variety of other purposes. The shareholders of the acquirer need to know how much was paid in
order to assess management’s use of resources invested by the company. Moreover, in countries
outside the United States, often the approval procedures for an acquisition are a function of the size
of the acquisition, as special voting majorities are sometimes mandated for larger acquisitions.
The consideration paid is the sum of (1) the cash payment, (2) the fair value of any securities or
assets distributed as consideration, and (3) the fair value of any contingent consideration. Direct and
general expenses related to the business combination such as fees paid to lawyers, investment
bankers, finder’s fees, and acquisition department costs are expensed as incurred.
Cash payments do not present major valuation problems. If they are deferred for more than a
year, they should be measured at their present value.
Securities issued as part or all of the consideration should be recorded at their fair value as of the
acquisition date.
In some cases, business combination agreements involve future payments to the seller upon the
occurrence of future events. Such contingent consideration is recognized by the acquirer on the
acquisition date at its fair value.
Recognition of Identifiable Assets Acquired, Liabilities Assumed and

Noncontrolling Interests in the Acquiree
As of the acquisition date, the acquirer must recognize, separately from goodwill, the identifiable
assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. The
acquirer’s application of the acquisition method may result in the acquirer recognizing some assets
and liabilities that the acquiree had not previously recognized as assets and liabilities. For example,
an acquirer may recognize an identifiable intangible asset, such as a patent or trademark, that the
acquiree had developed internally and expensed the related costs as incurred.
The following text presents selected measurement rules applicable under Topic 805 and IFRS 3R
for acquired tangible and intangible assets other than goodwill, assumed liabilities, and
noncontrolling interests in the acquiree.
Tangible Assets
The following is general guidance for assigning amounts to tangible assets acquired:
1. Marketable securities should be recorded at their current net realizable values.
2. Receivables should be recorded at the present value of amounts to be received, determined at

appropriate current interest rates.
3. Inventories:
a. Finished goods and merchandise should be recorded at their selling price less the sum of
(1) cost of disposal and (2) a reasonable profit allowance for the selling effort of the
acquiring entity.
b. Work in process should be valued at the estimated selling price of finished goods less the
sum of (1) costs to complete, (2) costs of disposal, and (3) a reasonable profit allowance
for the completing and selling effort of the acquiring entity based on profit for similar
finished goods.
c. Raw materials should be recorded at their current replacement cost.
4. Plant and equipment (a) to be used should be stated at current replacement cost for similar
capacity unless the expected future use of the assets indicates a lower value to the acquirer; (b)
to be sold must be recorded at its fair value less cost of disposal.
5. Other assets, including land, natural resources, and nonmarketable securities, given that their
markets may not very liquid, should be recorded at their appraised value.
For accounting purposes acquired intangible assets fall into one of three categories: Those with
limited lives, those with indefinite lives, and goodwill.
Intangible Assets Other than Goodwill

Topic 805 and IFRS 3R require the recognition and measurement at fair value limited life and
indefinite life - intangible assets acquired that (1) arise from contractual or other legal rights or (2) are
separable.9 An intangible asset is separable if it is capable of being separated or divided from the
acquired enterprise and sold, transferred, licensed, or exchanged. Intangible assets that meet the
criteria for recognition apart from goodwill include trademarks, customer lists, musical works,
standstill agreements, employment contracts, and unpatented technology that meets the definition of
an asset. Because intangible assets tend to be singular and specific, their fair value is normally
assessed by professional appraisers, who use comparables and discounted cash flow based methods
to determine their worth.
The fair value of acquired limited life intangible assets should be amortized over their useful life.
For instance, the value of a patent should be amortized over its remaining legal life or for the period
the firm expects to benefit from its use, whichever is shorter.
Acquired intangible assets with indefinite lives, should not be amortized until their useful life is
determined to be finite.
Indefinite does not mean infinite. If legal, regulatory, contractual, competitive, economic, or other
factors do not limit the life of an intangible asset, the useful life should be considered indefinite. For
example, a five-year broadcast license acquired as part of a business combination that may be
renewed indefinitely at little cost is an indefinite life intangible asset if cash flows related to the
license are expected to continue indefinitely and there is evidence that the acquirer has both the
resources and intent to renew the license into the foreseeable future.
The carrying amount of intangible assets with indefinite lives should be tested for impairment
annually or when events indicate that they may be impaired. For intangible assets with finite lives,
impairment tests should be undertaken only if there is an indication that they may be impaired. An
impairment loss is recognized when the carrying amount of an intangible asset is not recoverable and
its carrying value exceeds its fair value.
9 Intangible assets are nonmonetary assets that lack physical substance.
The impairment test for intangible assets with finite lives is a two-stage process. First, the sum of
the undiscounted future net cash flows excluding interest costs that the intangible asset is expected to
generate over its useful life is determined. This is the recoverable amount. If this undiscounted
amount is less than the intangible asset’s carrying amount, the intangible asset is considered
impaired. Next, the fair value of the intangible asset is determined and its carrying amount is written
down to its fair value with a corresponding charge to earnings equal to the write-down.10
In the case of intangible assets with indefinite lives, the impairment test is more straightforward.
An indefinite-life intangible asset is impaired when its fair value falls below its carrying amount.11
The journal entry for a $100 impairment loss on an impaired intangible asset other than goodwill
(“A”) with a fair value of $200 and a book value of $300 would be the following:
Dr. Asset write-down (expense account) $100
Cr. Intangible asset A (asset account) $100
Goodwill
Goodwill may be an asset acquired by the acquirer in a business combination transaction. If
acquired, it represents the future economic benefits arising from other assets acquired in a business
combination that are not individually identified and separately recognized by the acquirer. Goodwill
is recognized by an acquirer as of the acquisition date and measured as the sum of the fair value of
the consideration transferred to the acquiree plus the fair value of any noncontrolling interest in the
acquiree in excess of the net acquisition-date fair value of the identifiable assets acquired (fair value
of identifiable assets acquired minus fair value of liabilities assumed).
Goodwill is an integral part of a business and cannot be regarded as an asset that is saleable or
independent of the business: that is, it is not a separable intangible asset.
An acquiring corporation should not record as a separate asset any goodwill previously recorded
by an acquired company.
Goodwill can only be recognized through a business combination transaction; thus, internally
developed goodwill may not be recorded as an asset.
Goodwill must be tested annually for impairment or when there is an indication that it may be
impaired. The goodwill impairment test is performed at the reporting-unit level. As a result,
goodwill should be assigned using a reasonable, supportable, and consistent method to the reporting
units that are expected to benefit from any related business combination’s synergies.
A reporting unit is the same as an operating segment or, in some cases, a component of an
operating segment. Operating segments are the basis for the segment disclosures in annual reports.12
An operating segment of an enterprise:
10 The impairment test and accounting for impaired tangible assets is similar to the impairment test and accounting for
impaired finite-life intangible assets.
11 IFRS applies the same impairment test to finite and indefinite lived intangible assets. Under IAS No. 36, “Impairment of
Assets,” an asset is impaired if its carrying amount is more than its recoverable amount. The recoverable amount of an asset is
the higher of its fair value less costs to sell and its value in use. Value in use is the present value of the future cash flows
expected to be derived from an asset. Impaired assets are written down to their recoverable amount through a change to
earnings. Unlike US-GAAP, IAS No. 36, under certain conditions, permits reversal of previously recognized intangible asset
(other than goodwill) impairment losses.
1. Engages in revenue-generating and expense-incurrence business activities

2. Has its operating results reviewed regularly by the enterprise’s chief executive officer for
performance evaluation and resource allocation decisions
3. Has discrete financial information prepared for it

A component of an operating segment is one level below an operating segment. It has essentially
the same characteristics as an operating segment, except that its operating results are reviewed by
operating segment management.
The goodwill impairment test is a two-step process:
1. First, to identify a potential goodwill impairment, the fair value of a reporting unit is
calculated and compared to its carrying amount, including goodwill. Ideally, the fair value of
a reporting unit would be the market price to acquire a similar entity in an active market.
However, because this value is often unavailable, it can be calculated using the multiples
method (if comparables are available) or the discounted cash flow method.13 If the reporting
unit’s fair value is less than its carrying amount, the reporting unit’s goodwill must be tested
for impairment, and a second step needs to be performed to determine the impairment loss, if
any.
2. If the reporting unit’s fair value is less than its carrying amount, the second step must be
performed as follows:
(a) The fair value of the reporting unit’s net assets, excluding goodwill but including
intangible assets other than goodwill, is determined in the same way as described
above.
(b) The fair value of the reporting unit’s net assets determined in (a) is deducted from the
reporting entity’s total fair value estimated in step 1 to determine the reporting entity’s
so-called implied goodwill.
(c) If the fair value of the reporting unit’s implied goodwill is less than the carrying amount
of its goodwill, the entity’s goodwill must be written down to its implied fair value and
a charge to operating earnings equal to the write-down recognized.
If in this valuation process some other tangible or intangible asset is also deemed impaired, it
should be written down prior to performing the goodwill impairment test.
To illustrate the above methodology, assume:
The ABC Company has six reporting units. Management believes that the goodwill of one of
these reporting units might be impaired. Management reviews the public sale prices of companies
comparable to this reporting unit and concludes that the reporting unit’s fair value is $100 million.
The reporting unit’s carrying amount is $110 million, which includes $75 million of goodwill. Next,
management calculates that the fair value of the reporting unit’s net assets excluding goodwill is $35
million.
12 Segment disclosures are governed by ASC Topic 280, “Segment Reporting (“Topic 280”).
13 The multiples method determines the fair value of an entity based on an examination of the price-earnings ratio of
comparable publicly-traded companies and recent comparable business acquisition transactions. The cash-flow method
determines the fair value of an entity based on the present value of its future net cash flows.
The first step in the goodwill impairment methodology suggests that the reporting unit’s goodwill
might be impaired. The fair value of the reporting unit ($100 million) is less than its carrying amount
($110 million). As a result, the second step of the impairment test methodology must be performed.
The application of the second step indicates that the reporting unit’s implied goodwill is $65
million, which is the difference between the reporting unit’s fair value and the fair value of its net
assets excluding goodwill ($100 million minus $35 million). Since the goodwill carrying amount ($75
million) is higher than the fair value of the implied goodwill ($65 million), the reporting unit’s
goodwill should be written down to $65 million, and a $10 million ($75 million minus $65 million)
charge to earnings recognized. The journal entry would be:
Goodwill write-down (expense account) $10
Goodwill (asset account) $10
Acquisition Accounting Example

In January 2009 Widgets Inc. acquires Toys Corp. A total of 100,000 Widgets Inc. shares are
exchanged for all of Toys Corp.’s outstanding common stock, as a result there is no noncontrolling
interest remaining in Toys Corp. The CEO of Widgets will be the CEO of the combined companies,
and the majority of the board of directors will be existing Widget directors.
At the time of the transaction Widgets Inc.’s shares are trading at $8 per share. The balance sheets
of the two companies at the acquisition date are shown below. Toys Corp. owns a valuable patent
that is not recognized on its balance sheet.
Widgets Inc. Toys Corp.
Net current assets $200,000 $100,000

Fixed tangible assets 450,000 300,000
Patent -- 0
Total $650,000 $400,000
Liabilities $50,000 $100,000

Capital stock 300,000 100,000
Retained earnings 300,000 200,000
Total $650,000 $400,000
The fair values of Toys Corp.’s assets and liabilities acquired by Widgets Inc. are shown below:
Toys Corp.
Net current assets $90,000

Fixed tangible assets 450,000
Patent 135,000
Liabilities 80,000
Toys Corp.’s patent is for a software package called Adaptive Converser that performs a
contextual analysis of a child’s words and then selects the sentences that a talking doll will say in
response. The patent was awarded to Toys Corp. in December 2008 it was expected effectively to
protect the Adaptive Converser from competitors for five years from the acquisition date. Intangible
Appraisals Ltd., a consulting firm specializing in patent valuations, valued the patent at $135,000.
To account for this transaction, the four fundamental questions listed earlier must be answered:
1. Which company is the acquirer?
Widgets Inc. is the acquirer. It has obtained control of Toys Corp.
2. What is the fair value of the consideration transferred?
The sum of the fair value of Widget Inc.’s shares issued as consideration is $800,000
($800,000=100,000 shares x $8). There is not a noncontrolling interest in the acquiree.
3. What is the fair value of the identifiable assets acquired, the liabilities assumed and any noncontrolling
interest in the acquire?
The fair value of the individual identifiable assets acquired and liabilities assumed is (there is no
noncontrolling interest and this is not a bargain purchase):
Net current assets $90,000

Fixed tangible assets 450,000
Patent 135,000
Liabilities 80,000
An important intangible asset is the software patent. Even though it is not recognized on Toys
Corp.’s books, it must be recognized at its fair value by Widgets Inc. Legal rights protect the patent,
and it can be sold independently of the firm. That is, it is separable.
4. Should a goodwill asset be recognized and how should it be measured?
Yes. There is an excess on the acquisition date of the fair value of the consideration transferred
over the fair value of the net assets acquired. The $205,000 goodwill is determined as follows:
Consideration transferred $800,000

Net current assets (90,000)
Fixed tangible assets (450,000)
Patent (135,000)
Liabilities 80,000
Goodwill $205,000
The equality of the fundamental accounting equation is maintained as a result of the accounting
entries Widgets Inc. will make to reflect the acquisition:
Balance Sheet Adjustments

Account Assets = Liabilities + Owners’ Equity
Net current assets +$90,000

Fixed tangible assets +450,000
Patent +135,000
Goodwill +205,000
Liabilities +$80,000
Capital stock ________ _______ +$800,000
Total $880,000 = $80,000 + $800,000
Post-Acquisition Accounting
Immediately following the acquisition, Widgets Inc. must adjust its balance sheet to reflect the
acquisition as shown above. As a result of these adjustments, Widgets Inc.’s balance sheet at the
acquisition date is:
Widgets Inc.’s Balance Sheet

Valuation of Toys
Acquisition Date Corp Acquired Acquisition Date
(Before Toys Corp Assets (After Toys Corp
acquisition and Assumed acquisition
adjustments) Liabilities adjustments)
Net current assets $200,000 $90,000 $290,000

Fixed tangible assets 450,000 450,000 900,000
Patent -- 135,000 135,000
Goodwill -- 205,000 205,000
Total $650,000 $880,000 $1,530,000
Liabilities $50,000 $80,000 $130,000

Capital stock 300,000 800,000 1,100,000
Retained earnings 300,000 ________ 300,000
Total $650,000 $880,000 $1,530,000
It is important to note that only the assets and liabilities acquired are remeasured to their fair
value. Widgets Inc.’s assets and liabilities are not revalued as a result of the business combination. In
addition, the acquired company’s retained earnings and capital stock balances are not carried
forward to the combined company’s balance sheet, and the acquired patent, which did not appear on
Toys Corp.’s balance sheet, is recognized by Widgets Inc.
Under the acquisition method, the acquired company’s revenues, expenses, and profits are
included in the combined company’s income statement only from the acquisition date. These
expenses will include depreciation charges, patent amortization charges, interest charges, and any
subsequent impairment charges based on the fair value of acquired assets and liabilities recognized at
the acquisition date.
Noncontrolling Interests
Sometimes the acquirer in a business combination acquires a controlling interest that is less than
100 per cent of the acquiree. A principle difference between IFRS 3R and Topic 805 is in the
measurement of noncontrolling interests for the purpose of calculating goodwill and recording the
transaction. IFRS 3R permits the acquirer to measure this item at either its fair value or on the basis
of the noncontrolling intersts proportional interest in the precombination carrying amounts of the
identifiable net assets of the acquiree. In contrast, Topic 805 requires the acquirer to value the
noncontrolling interest at its fair value as of the acquisition date an alternative measurement
approach is not permitted.
To illustrate, using the fair value of the noncontrolling interest approach to measuring goodwill,
assume 1) A acquires 80 per cent of B, 2) the fair value the consideration paid $12,000, 3) the fair value
of recognized identifiable assets and liabilities assumed is $6,000 and $2,000, respectively, and 4) the
fair value of the 20 per cent noncontrolling interest in the acquiree is $1,000. Goodwill is calculated as
follows:
Consideration $12, 000
Identifiable Assets (6,000)
Identifiable liabilities 2,000
Noncontrolling interest 1,000
Goodwill $9,000
The accounting entries are:
Dr. Assets $6,000
Goodwill $9,000
Cr. Consideration $12,000
Liabilities 2,000
Noncontrolling Interest 1,000
The noncontrolling interest is included in the equity section of the acquirer’s balance sheet under
the caption “noncontrolling interest”.
Bargain Purchase
Occasionally an acquirer will make what accountants refer to as a “bargain purchase.” This is a
business combination in which the sum of the fair values of the identifiable assets less the fair values
of assumed liabilities is greater than the fair value of the consideration transferred to the acquire plus
the fair value of the noncontrolling interest, if any. In this case, the acquirer must recognize the excess
as a gain in earnings at the acquisition date.
10
Financial Analysis
Business combination accounting creates many problems for statement users when evaluating
companies individually or on a comparative basis. The comments below relate to the questions
statement users should always ask when they encounter a business combination:
• How will the business acquisition influence the combined company’s future growth rates?
Are these rates sustainable?
• How reliable are the fair valuations assigned to the acquired assets and liabilities? Are
there signs that the fair value assignments might be biased? How do the assigned fair
values impact the combined company’s future earnings?
• What does goodwill represent? Is it representative of real value or is it the result of an

acquisition consideration over-payment? How did the fair value assignment’s influence
the measurement of goodwill?
• Between the time when an acquisition was first proposed and ultimately recognized for
accounting purposes, did the acquiree and acquirer agree to undertake certain acquiree
business actions that would favorably impact the combined company’s post acquisition
date results?
The act of accounting for a business combination can influence a company’s current and future
growth rate. Statement users must distinguish this accounting source of growth. It may be a onetime
earnings boost that cannot be sustained by future operations. For example, a company with flat
earnings acquiring another company with flat earnings for cash in a purchase transaction will include
in its statements the acquiree’s profits from the date of acquisition. The addition of these profits will
cause the acquiring company’s profits to rise relative to the period before acquisition. For example,
the simple act of accounting for a business combination as an acquisition can inflate operating
earnings and operating cash flows for as long as two years after the acquisition date. In the case of a
company acquired at mid-year, only the last 6 months of the acquired company’s operating profit
and cash flow are included in the acquirer’s acquisition year financial statements. However, during
the subsequent year, a full 12 months of the acquiree’s operating profits and cash flow are included in
the acquirer’s financial statements. All too often, companies with weak underlying operations
seeking growth through acquisitions find themselves so dependent on this source of growth that they
increasingly acquire overpriced marginal companies to maintain their growth rate. Eventually, the
weight of these marginal acquisitions causes the corporate structure to crumble. Statement users
must be wary of such companies, particularly since their stock is often “hyped” by interested parties.
When it comes to evaluating the appropriateness of the fair values assigned to an acquiree’s assets
and liabilities, statement users have to rely heavily on management’s judgment and the quality of the
appraisals performed by the appraisers. This can be a problem for statement users, particularly in the
case of serial acquirers. Serial acquirers tend to use the same group of acquirers repeatedly. When
this occurs, there is a possibility that these appraisers, out of the range of possible appraisal values,
will settle on fair values that are the most favorable to the acquirer. For example:
• Low fair values might be assigned to depreciable assets. (This lowers the related periodic
depreciation expense.)
• Low fair values might be assigned to amortizable finite life intangible assets. (This lowers
the periodic intangible asset amortization expense.)
11
• High fair values might be assigned to non-amortizable indefinite life intangible assets.
(This reduces the amount assigned to goodwill and the probability of a future goodwill
impairment charge.)
• Low fair values might be assigned to the acquired inventory. (This helps to record higher
gross margins when the inventory is sold by the acquirer.)
In some acquisitions, the acquirer’s management may influence the acquiree’s management to
take certain actions prior to the acquisition date that will boost the acquirer’s post acquisition date
results. For example, during the acquisition process, the acquirer may induce the acquiree’s
management to:
• Reduce in-channel inventories.
• Delay shipping product.
• Build up on hand inventories.
• Pay down accounts payable whether due or not.
• Pre-pay some operating costs that will be incurred after the acquisition.
• Slow down collection of accounts receivable.
These pre-acquisition date actions by the acquired company’s management jump start in the post
acquisition period the results achieved by the acquirer as follows:
• The channels are reloaded and the delayed orders are fulfilled. (This boosts sales beyond
their normal level.)
• The built up of onhand inventory, which the acquirer wrote down, is shipped. (This
increases the gross margin and profit percentages, as well as profits beyond their normal
level.)
• The collection of old accounts receivable is sped up, prepaids are drawn down and
accounts payable are allowed to build up to their normal level. (This improves operating
cash flow.)14
These acquirer induced actions by acquirees are difficult for statement users to detect. For
example, the acquired company’s acquisition date financial statements may be blended in with those
of other acquirers and disclosed as a group. Or, the acquiree may be a private company.
Goodwill is a difficult item for statement users to evaluate. It relates to the potential value to the
acquirer of acquired unrecognized intangibles that were never clearly identified. This makes it
difficult for statements users to evaluate whether the goodwill balance is overstated, understated, or
due for an impairment charge. Negative goodwill is seldom regarded as a stock value enhancing
income item since it is a one-time item that has no positive cash flow attached to it and often arises
from the purchase of troubled companies who must sell out for less than their net asset’s fair value.
14 David F. Hawkins, “How Serial Acquirers Turn No-Growth into Growth, Accounting Bulletin no. 108, Merrill Lynch July 9,
2002.
12
Business combination accounting can be abused by unscrupulous managements to mislead

unwary statement users. The best protection for statement users is to know the relevant accounting
rules, carefully analyze the accounting results of the acquisition deal, and be wary of managements
that appear to be using acquisition accounting to puff up current results.
13

7.30.14 Accounting For M&A - Accounting For Business Combinations Acquisition Method

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9-108-067

REV: NOVEMBER 30, 2010

F. ASÍS MARTÍNEZ JEREZ

Accounting for Business Combinations:

Applying the acquisition method requires:

1. Identifying the acquirer

2. Determining the acquisition date

3. Measuring the consideration paid

5. Recognizing and measuring goodwill6

6. Recognizing a gain from a bargain purchase.7

Identification of the Acquirer

Recognition of Identifiable Assets Acquired, Liabilities Assumed and

1. Marketable securities should be recorded at their current net realizable values.

2. Receivables should be recorded at the present value of amounts to be received, determined at

c. Raw materials should be recorded at their current replacement cost.

Intangible Assets Other than Goodwill

9 Intangible assets are nonmonetary assets that lack physical substance.

Dr. Asset write-down (expense account) $100

Cr. Intangible asset A (asset account) $100

1. Engages in revenue-generating and expense-incurrence business activities

3. Has discrete financial information prepared for it

The goodwill impairment test is a two-step process:

To illustrate the above methodology, assume:

Goodwill write-down (expense account) $10

Goodwill (asset account) $10

Acquisition Accounting Example

Widgets Inc. Toys Corp.

Net current assets $200,000 $100,000

Liabilities $50,000 $100,000

Net current assets $90,000

1. Which company is the acquirer?

Widgets Inc. is the acquirer. It has obtained control of Toys Corp.

2. What is the fair value of the consideration transferred?

Net current assets $90,000

4. Should a goodwill asset be recognized and how should it be measured?

Consideration transferred $800,000

Balance Sheet Adjustments

Net current assets +$90,000

Widgets Inc.’s Balance Sheet

Net current assets $200,000 $90,000 $290,000

Liabilities $50,000 $80,000 $130,000

Consideration $12, 000

Identifiable Assets (6,000)

Identifiable liabilities 2,000

Noncontrolling interest 1,000

The accounting entries are:

Dr. Assets $6,000

Cr. Consideration $12,000

Noncontrolling Interest 1,000

• What does goodwill represent? Is it representative of real value or is it the result of an

• Reduce in-channel inventories.

• Delay shipping product.

• Build up on hand inventories.

• Pay down accounts payable whether due or not.

• Slow down collection of accounts receivable.

Business combination accounting can be abused by unscrupulous managements to mislead

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