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Chapter 4
Business Combinations
Business Combinations
Definition:
• Business combinations are events or transactions
in which two or more business enterprises, or their
net assets, are brought under common control in a
single accounting entity.
• Business combinations are often referred to as
MERGERS AND ACQUISITIONS.
Cont’d
• The Financial Accounting Standards Board has suggested
the following definitions for terms used in business
combinations:
• Combined Enterprise: The accounting entity that results
from a business combination.
• Constituent Companies: The business enterprises that
enter into a combination.
• Combinor :A constituent company entering into a
combination whose owners as a group ends up with
control of the ownership interests in the combined
enterprise.
• Combinee: a constituent company other than the
combinor in a business combination. The term acquired,
acquiree and combinee can be used interchangeably.
• Control: Ownership by one company, directly or
indirectly.
Cont’d
The following are the assertions relating to business
combinations as per SFAS No.141
1. In Business combination an acquirer obtains
control of one or more businesses.
2. An acquirer can be identified in every business
combination.
3. The business combination acquisition date is the
date the acquirer obtains control of the acquiree.
4. By obtaining control of an acquiree, an acquirer
becomes responsible and accountable for all of the
acquiree’s assets, liabilities, and activities regardless
of the percentage of its ownership in the acquiree.
Types of Business Combinations
There are Three types of business combinations: Horizontal
Combination, Vertical Combination, and Conglomerate
Combination:
1. Horizontal Combination: is a combination involving enterprises
in the same industry.
2. Vertical Combination: A Combination involving an enterprise
and its customers or suppliers. It is a combination involving
companies engaged in different stages of production or
distribution. It is classified into two: Backward Vertical
Combination – combination with supplier and Forward Vertical
Combination – combination with customers. E.g.1: A Tannery
Company acquiring a Shoes Company - Forward
E.g.2: Weaving Company acquiring both Ginning and Spinning
Company – Backward
3. Conglomerate (Mixed) Combination: is a combination involving
companies that are neither horizontally nor vertically integrated. It
is a combination between enterprises in unrelated industries or
markets.
Methods of Arranging Business
Combinations
The four common methods for carrying out a
business combination are:
1. Statutory Merger
2. Statutory Consolidation,
3. Acquisition of Common Stock, and
4. Acquisition of Assets
1. STATUTORY MERGER
• A business combination in which one company
(the survivor) acquires all the outstanding
common stock of one or more other companies
that are then dissolved and liquidated, with their
net assets owned by the survivor.
• The survivor can effect the transaction by
exchanging voting common stock or preferred
stock, cash, or long-term debt ( or a combination
of these) for all of the outstanding voting
common stock of the acquired company or
companies.
Cont’d
• In a statutory merger, one or more of
the combinee companies are liquidated
and thus cease to exist as separate
legal entities.
2. STATUTORY CONSOLIDATION
Statutory consolidation can be summarized in the
following main points
1. The boards of directors of the constituent companies work
out the terms of the consolidation.
2. Stockholders of the constituent companies approve the
terms of the consolidation in accordance with applicable
corporate bylaws and state laws.
3. A new corporation is formed to issue its common stock to
the stock holders of the constituent companies in exchange
for all their outstanding voting common stock of those
companies.
4. The new corporation dissolves and liquidates the
constituent companies, receiving in exchange for its
common stock investment in the net assets of those
companies.
3. Acquisition of Common stock
• One corporation (the investor) may issue common stock, preferred,
cash, debt or a combination there of to acquire from present
stockholders a controlling interest in the voting common stock of
another corporation (the investee).
• This stock acquisition program may be accomplished through
direct acquisition in the stock market, or through tender offer.
• The price per share stated in the tender offer usually is well above
the prevailing market price of the combinees’ common stock.
• If a controlling interest in the combinees voting common stock is
acquired, that corporation becomes affiliated with the combiner
(parent company) as a subsidiary, but is not dissolved and
liquidated and remains a separate legal entity.
4. Acquisition of Assets
• A business enterprise may acquire from another
enterprise all or most of the gross asset or net
assets of other enterprise for cash, debt, preferred
or common stock or a combination thereof.
• The transaction generally must be approved by
the board of directors and stockholders of the
constituent companies.
• The selling enterprise may continue its existence
as separate entity or may be dissolved and
liquidated; it does not become on affiliate of the
combiner.
Cont’d
Determination of Cost of Acquisition
The Cost of combinee includes also some other costs as discussed
below.
• The cost of a combine on a BC accounted for by purchase method
is the total of
a. The amount of consideration paid by the combiner,
b. The combiners DIRECT “out of pocket” costs of the combination&
c. Any contingent consideration that is determinable on the date of
the business combination.
Amount of Consideration:
• This is the total amount of
a. Cash paid,
b. The Current fair value of other assets distributed,
c. The present value of debt securities issued &
d. The Current fair value (Market) value of equity security issued by
the combiner.
Direct out of pocket costs
Out of pocket costs are classified as direct and indirect.
Direct out of pocket costs
This includes
• Legal fees,
• Accounting, &
• Finder fees.
Finder fee- An amount paid to the investment banking
firm or other organizations or individuals that
investigated the combinee, assisted in determining the
price of the business combination & other wise
rendered service to bring about the combination.
INDIRECT COSTS
BOND ISSUE COSTS- refers to cost of registering
(with the SEC) and issuing DEBT SECURITIES in a
Business combination is debited to bond issue
costs. They are not part of the cost of the
combine.
Cost of registering with SEC & issuing equity
securities are not direct costs of the business
combination but are offset against the proceeds
from the issuance of the securities.
Cont’d
• Indirect out-of-pocket costs of the
combination, such as salaries of officers
involved in the combination, are expensed
as incurred by the constituent companies.
• Direct out-of-Pocket Costs are added to the
Cost of Acquisition of Combinee where as
indirect out of-pocket costs are
immediately expensed by the constituent
companies.
Cont’d
Determination of Goodwill Goodwill frequently
is recorded in purchase-type business
combinations because the total acquisition cost
of the combinee exceeds the current fair value
of identifiable net assets of the combinee.
• That is, goodwill is the difference between the
total acquisition costs less current fair value of
the net assets (the current fair value of the
assets less current fair value of liabilities).
Cont’d
Recording the Acquisition – the transaction is
recorded on the date of the business
combinations.
• Both the combinor and combinee record
transactions relating to the business combination.
• The combinee that is dissolved and liquidated
passed the following journal entries:
Cont’d
Investment in xxx Stock ---------xxx
Current Liabilities -------------------xxx
Accumulated Depreciation -------xxx
Loss on sale of Net Asset-----------xxx
Cash and Receivables -----------------xxx
Inventory ----------------------------------xxx
Land -----------------------------------------xxx
Buildings and Equipment --------------xxx
Gain on Sale of Net Assets --------------xxx
Illustration on Purchase Accounting
for Statutory Merger
Given: on January 1, 2018, Point corporation
purchases all assets and liabilities of Sharp
company in a statutory merger by issuing to
Sharp 10,000 shares of $ 10 par common stock.
The shares issued have a total market value of
$600,000. Point incur legal and appraisal fees of
40,000 in connection with the combination and
stock issue costs of 25,000.
Sharp co. balance sheet information, Dec 31, 2018
Assets, liabilities and equity BV CFV
Cash and Receivables 45, 000 45, 000
Inventory 65, 000 75,000
Land 40,000 70,000
Buildings and equipment 400,000 350,000
Acc. Depn. (150,000)
Patent - 80,000
Total assets 400,000 620,000
Current liabilities. 100,000 110,000
Common stock, (par) 100,000
Additional paid in capital 50,000
Retained earnings 150,000
Total liabilities and equities 400,000
Cont’d
Required
Record what is necessary journal entry by both
companies for the above business combination
using purchase accounting.
Steps
1. Purchase Consideration
Amount paid to Sharp Co. (10,000*60) 600,000
+ Direct Out of Pocket Costs (legal and finders fees) 40,000
Total cost of the business combination 640,000
Cont’d
2. Current fair values of net assets acquired
Current Fair Values of Assets
Cash and Receivables 45, 000
Inventory 75,000
Land 70,000
Buildings and equipment 350,000
Patent 80,000
CFV of Total asset 620,000
Less: Current Fair Values of Current liabilities 110,000
Current Fair Values of Net assets acquired 510,000
Cont’d
3. Goodwill
Purchase Consideration 640,000
Less: Current Fair Values acquired 510,000
Goodwill 130,000
4. Recording amount paid to the acquired company
Investment in the net assets of Sharp Co. 600,000
Common Stock(10,000*10) 100,000
Paid in Capital in Excess of Par 500,000
5. Recording security related costs
Investment in the net assets of Sharp Co. 40,000
Paid in Capital in excess of Par 25,000
Cash 65,000
Cont’d
6. Recording individual assets and liabilities acquired by Point
Corporation (Allocation)
Cash and Receivables 45, 000
Inventory 75,000
Land 70,000
Buildings and equipment 350,000
Patent 80,0 00
Goodwill 130,000
Liabilities 110,000
Investment in the net assets of Sharp Co. 640,000
7. Recording dissolution of the acquired company (Company
Sharp)
a) sale of net assets to Point Corp.
Investment in the c.s of Point Co. 600,000
Current Liabilities 100,000
Acc. Dep. 150,000
Cash and Receivables 45, 000
Inventory 65, 000
Land 40,000
Buildings and equipment 400,000
Gain on sale of net assets to Point Co.300,000
Cont’d
b) Closing of Stockholders equity accounts, gain on sale and
investment account and distribution of common stock
investment will be made.
Common stock, (par) 100,000
Additional paid in capital 50,000
Retained earnings 150,000
Gain on sale of net assets to Point Corp. 300,000
Inv’t in the c.s of Point Co. 600,000
2. Illustration on Purchase Accounting for
Statutory Consolidation
• Because a new corporation issues common stock to
effect a statutory consolidation, one of the constituent
companies must be identified as the combinor, under
the criteria described to identify combinor.
• Once the combinor has been identified, the new
corporation recognizes net assets acquired from the
combinor at their carrying amount in the combinor’s
accounting records; however, net assets acquired from
the combinee are recorded by the new corporation at
their current fair values.
• To illustrate, assume the following condensed balance
sheets of the constituent companies involved in a
purchase-type statutory consolidation on December
31, Year 1999:
Lamson Corporation and Donald Company Balance Sheet(Prior to
Business Combination)
December 31, 1999
Asset Lamson Co. Donald Co.
Current assets ..................................................... Br.600,000 400,000
Plant asset (net) .................................................. 1,800,000 1,200,000
Other assets ........................................................ 400,000 300,000
Total assets ......................................................... 2,800,000 1,900,000
Liabilities & Shareholders Equity
Current liabilities ................................................ 400,000 300,000
Long-term debt ................................................... 500,000 200,000
Common stock, Br10 .......................................... 430,000 620,000
Paid in capital ..................................................... 300,000 400,000
Retained Earning ................................................ 1,170,000 380,000
Total ................................................................... 2,800,000 1,900,000
Cont’d
• The current fair values of both companies’
liabilities were equal to carrying amounts.
• Current fair values of identifiable assets were as
follows for Lamson and Donald, respectively:
current assets, Br 800,000 and Br 500,000; plant
assets, Br 2,000,000 and Br 1,400,000; other
assets, Br 500,000 and Br 400,000.
• On December 31, Year 1999, in a statutory
consolidation approved by shareholders of both
constituent companies, a new corporation,
LamDon Corporation, issued 74,000 shares of no
stated value common stock with an agreed value
of Br 60 a share, based on the following valuations
assigned to the two constituent companies’
identifiable net assets and goodwill.
cont’d
Lamson Donald
Current fair value of identifiable net assets:
Lamson: Br 800,000 + 2,000,000+500,000-400,000-500,000 = 2,400,000
Donald: Br 500,000 +1,400,000+400,000-300,000 -200,000 ....... 1,800,000
Goodwill assigned to determine number of shares to be issued= 180,000 60,000
Net assets’ current fair value ...................................................... 2,580,000 1,860,000
Number of shares of LamDon to be issued to constituent companies’
Stockholders, at Br 60 a share agreed value ....................................43,000 31,000
58% 42%
Cont’d
• Because the former shareholders of Lamson
Corporation receive the largest interest in the
common stock of LamDon Corporation (43/74,
or 58%), Lamson is the combinor in the
purchase-type business combination.
• Assuming that LamDon paid Br 200,000 out-of-
pocket costs which comprises Br 110,000 direct
and Br 90,000 indirect for the statutory
consolidation after it was consummated on
December 31, Year 1999; LamDon’s journal
entries would be as follows:
Cont’d
To record consolidation of Lamson corporation and Donald
company as a purchase
Inv’t in Lamson and Donald Co Common Stock (74,000 @ 60) ..... 4,440,000
Common stock, no par .................................................................. 4,440,000
To record payment of costs incurred in consolidation of Lamson
Corporation and Donald Company. Accounting legal and finder’s
fee in connection with the consolidation are recorded as
investment cost; other out-of-pocket costs are recorded as a
reduction in the proceeds received from the issuance of common
stock.
Investment in Lamson and Donald Co. common stock .............. 110,000
Common stock, no par ....................................................................... 90,000
Cash .................................................................................... 200,000
Cont’d
To allocate total cost of investment to identifiable
assets and liabilities, at carrying mount for combinor
Lamson corporation’s net assets and at current fair
value for combinee Donald company’s net assets.
Assume Lamson Corporation was identified as Combinor
and valued Current Assets at Br 500,000; Plant assets at Br
1,400,000; and Other assets at Br 400,000 of Donald
Company:
Current assets (600,000 + 500,000) .............................................................. 1,100,000
Plant assets (1,800,000 +1,400,000) .............................................................. 3,200,000
Other assets ((400,000 +400,000) ..................................................................... 800,000
Goodwill ......................................................................................................... ..... 850,000
Current liabilities (400,000 +300,000) ........................................................... 700,000
Long-term Debt (500,000+ 200,000) ............................................................ 700,000
Inv’t in Lamson & Donald Co cs (4,440,000+110,000) ………………... 4,550,000
Cont’d
Note in the foregoing journal entry that because of the
combinor’s net assets’ being recorded at carrying amount
and because of the Br 110,000 direct costs of the
business combination, the amount of goodwill is Br
850,000, rather than Br 240,000 (Br 180,000+Br
60,000=Br 240,000), the amount assigned by the
negotiating directors to goodwill in the determination of
the number of shares of common stock to be issued in
the combination.
Amount of Goodwill is computed as follows:
Total cost of investment (4,440,000 + 110,000) ....................................... Br 4,550,000
Less: Carrying amount of Lamson’s Identifiable net Assets ..................... (1,900,000)
Current Fair Value of Donald’s Identifiable net assets ............................. (1,800,000)
Amount of Goodwill .................................................................................. Br 850,000
.
The End
