You are on page 1of 164

Chapter 5

Business Combinations

ACCT 501

Objectives of the Chapter


1. To discuss the general view of
business combinations.
2. To learn accounting for business
combinations (purchase versus
pooling methods) on date of
combination for statutory merger
type of business combinations.

Objectives of the Chapter


3. To discuss the development of

4.

two alternatives for business


combinations from a historical
perspective.
Preparing financial statements
following a business
combination for statutory merger
type of business combination.

Objectives of the Chapter


5. To learn accounting for statutory
6.

consolidation (using purchase


method).
To discuss the current
development on business
combination standards.

Business Combinations

Business combinations: events


and transactions in which two or
more business enterprises, or
their net assets, are combined to
be under the control of a single
business entity.

Business Combinations (contd.)


FASBs terms for the business
entities involved in the business
combination:
a.Constituent companies : all business
entities enter into a business
combination.
b.Combined enterprise: the business
entity that results from a business
combination.

Business Combinations (contd.)


c.Combinor : a constituent company
whose owners end up to have control
of the ownership interest of the
combined enterprise.
d.Combinee : all other constituent
companies other than the combinor
in a business combination.

Types of Business Combinations

Friendly takeovers

Hostile takeovers

Reasons for Business Combinations


For the combination in a friendly
takeover:
a.Growth.
Through the business combinations,
the product lines can be expanded and
diversified. Also, the market shares
can be enlarged.

Reasons for Business Combinations


(contd.)
b.Obtaining new management strength or
better use of existing management.
c.For the income tax advantages

For hostile takeovers:


Substantial gains may result from the
sale of business segments of a
combinee following the business
combination.

Four Methods for Carrying Out


Business Combinations
1.Statutory Merger
Procedures of statutory merger:
a. The board of directors of the
constituent companies work out the
terms of merger.
b. Stockholders of the constituent
companies approve the terms of the
merger.

Four Methods for Carrying Out


Business Combinations (contd.)
c. the survivor issues its common stock
or other consideration to stockholders
of the other constituent companies to
exchange for all their outstanding
voting common shares.
d. The survivor dissolves and liquidates
the other constituent companies.

Four Methods for Carrying Out


Business Combinations (contd.)
2. Statutory Consolidation:
a new corporation is formed to issue
its common stock for the outstanding
common stock of all constituent
corporations.
Procedures of statutory consolidation:
a. similar to the statutory merger.
b. similar to the statutory merger.

Four Methods for Carrying Out


Business Combinations (contd.)
c. a new corporation is formed to issue
its common stock to the stockholders
of all the constituent companies in
exchanger for all their outstanding
voting common stock.
d. the new corporation dissolves and
liquidates the constituent companies.

Four Methods for Carrying Out


Business Combinations (contd.)
3.Acquisition of Common Stock (a
method for most of hostile
takeovers)
Procedures:
a. the combinor received the approval
from its board of directors to acquire
common stock of the prospective
target firm.

Four Methods for Carrying Out


Business Combinations (contd.)
b. acquiring target firms common stock
in an open market, or through a
tender offer to stockholders of a
publicly owner corporation.

Four Methods for Carrying Out


Business Combinations (contd.)
c. When acquiring enough shares to
have the controlling interest in the
combinees voting common
shares,the target firm becomes
affiliated with the combinor (the
parent company) as a subsidiary.
The target firm remains as a
separate legal entity.

Four Methods for Carrying Out


Business Combinations (contd.)
4. Acquisitions of Assets:
Business entity acquires all or most of
net assets of the other entity (using
cash, debt, stock ..)

Establishing the Price for a


Business Combination
1. Capitalization of expected average
annual earnings of the combinee at a
desired rate of return.
2. Determination of current fair value of
the combinees net assets (including
goodwill).

Methods of Accounting for Business


Combinations

Pooling of Interest Accounting versus


Purchase Accounting
Definitions:
Accounting Acquisition Premium
(AAP)
= purchase price book value of the
combinee.

Methods of Accounting for Business


Combinations
Purchased

Goodwill
= AAP combinees assets step-up.

Assets

step up
= the fair market value of net assets
of the combinee the book value of
these net assets.

Methods of Accounting for Business


Combinations (contd.)

Two accounting methods for business


combinations are allowed under APB
Opinion No. 16:
Pooling-of-interests method (pooling
accounting) :
The acquired firms net assets are
consolidated at their existing book
value and any accounting acquisition
premium (AAP) is ignored.

Methods of Accounting for Business


Combinations (contd.)

Purchase method (purchase


accounting):
The acquired net assets are recorded at
their fair market value and the excess of
AAP over the assets step-up is recognized
as goodwill.
In order to adopt the pooling of interests
method to account for the business
combination, 12 conditions must be met
(detailed later).

Methods of Accounting for Business


Combinations (contd.)

Impact of these two accounting methods


on the financial numbers:
Earnings:
the depreciation associated with any
assets step-up and the amortization of any
purchased goodwill will result in purchase
earnings, in general, to be less than
pooling earnings (i.e., E purchase < E pooling).

Methods of Accounting for Business


Combinations (contd.)

Book Value:
the book value of the accounting
consolidated net assets under pooling
accounting will typically be less than
those reported under purchase
accounting (i.e., B pooling < Bpurchase ).

Purchase Accounting

Cost of a Combinee including:


1.the amount of consideration paid by
the combinor to a combinee.
2.the combinors direct out-ofpocket costs of the combination,
and
3.contingent consideration which is
determinable on the business
combination date.

Cost of A Combinee (contd.)

Direct out-of-pocket costs include legal


fees, accounting fees, and finders fees.
Costs of registering with the SEC and
issuing debt securities in a business
combinations are debited to Bond Issue
Costs.

Cost of A Combinee (contd.)

Cost of registering with the SEC and


issuing equity securities are offset
against the proceeds from the
issuance of the securities.
Contingent consideration: cash,other
assets,or securities that may be
issuable in the future.

Accounting Treatment for


Contingent Consideration
a.Contingent consideration which is
determinable on the combination
date:
recorded as part of the cost of the
combination.

Accounting Treatment for


Contingent Consideration(contd.)
b.Contingent consideration that is not
determinable on the combination
date:
the contingent amount is recorded
as goodwill when the contingency is
resolved.

Assigning Values to a Purchased Combinees


Identifiable Assets and Liabilities (Based on APB
Opinion No. 16)
1. Present value: receivables and
liabilities;
2. Net realizable values : marketable
securities, finished goods, goods in
process inventories, plant assets held
for sale or temporary use;

Assigning Values to a Purchased Combinees


Identifiable Assets and Liabilities (Based on APB
Opinion No. 16) (contd.)
3. Appraised value: intangible assets,
land, natural resources and
nonmarketable securities;
4. Replacement cost: material and
plant assets held for long-term use.

Goodwill Computation under


Purchase Accounting

Purchased Goodwill
=purchase price (total cost of the
combinee)
the current fair values of identifiable
net assets of the combinee.

Goodwill Computation under


Purchase Accounting (contd.)

Negative Goodwill:
The excess amount is applied to reduce
proportionally the amounts initially
assigned to noncurrent assets (other than
long-term investments.)
If this procedure does not extinguish the
excess, a Negative Goodwill account
would be credited for the remaining
excess.

Example I: Purchase Accounting For


Statutory Merger, with Goodwill

On December 31,1999, Mason


Company (the combinee) was merged
into Saxon Corporation (the combinor
or survivor).
Both companies used the same
accounting principles for assets,
liabilities, revenue, and expenses and
both had a December 31 fiscal year.

Example I: Purchase Accounting For


Statutory Merger, with Goodwill (contd.)

Saxon issued 150,000 shares of its $10


par common stock (current fair value $25
a share) to Masons stockholders for all
100,000 issued and outstanding shares of
Masons no-par, $10 stated value
common stock.
In addition, Saxon paid the following outof-pocket costs associated with business
combination:

Example I (contd.): Out of Pocket Costs


Accounting fees:
For investigation of Mason
Company as prospective combinee $ 5,000
For SEC registration statement for
Saxon common stock
60,000
Legal fees:
For the business combination
10,000
For SEC registration statement for
Saxon common stock
50,000

Example I (contd.): Out of Pocket Costs


(contd.)
Finders fee
Printers charges for printing
securities and SEC registration
statement

51,250

SEC registration statement fee


Total out-of-pocket costs of
business combination

750

23,000

$200,000

There was no contingent consideration in the


merger contract.

Example I (contd.): Mason Companys


Condensed B/S Prior to The Merger
MASON COMPANY (combinee)
Balance Sheet (prior to business combination)
December 31,1999
Assets
Current assets
Plant assets (net)
Other assets
Total assets

$1,000,000
3,000,000
600,000
4,600,000
(Continued)

Example I (contd.): Mason Companys


Condensed B/S Prior to The Merger (contd.)
MASON COMPANY
Balance Sheet (contd.) , 12/31/1999
Liabilities & Stockholders Equity
Current Liabilities
$ 500,000
Long-term debt
1,000,000
Common stock, no-par,$10 stated
value
1,000,000
Additional paid-in capital
Retained earnings
Total liabilities & stockholders

700,000
1,400,000

Example I (contd.):

Using the guidelines in APB Opinion


No. 16, Business Combinations, the
board of directors of Saxon Corporation
determined the current fair values of
Mason Companys identifiable assets
and liabilities (identifiable net assets)
as follows:

Example I (contd.): Fair Value of


Identifiable Net Assets of Combinee
Current assets
Plant assets
Other assets
Current liabilities
Long-term debt (present value)
Identifiable net assets of
combinee

$ 1,150,000
3,400,000
600,000
(500,000)
(950,000)
$3,700,000

Example I (contd.): Combinors Journal


Entries for Business Combination

Saxon uses an investment ledger


account to accumulate the total cost of
Mason Company prior to assigning the
cost to identifiable net assets and
goodwill.

Example I (contd.): Combinors Journal


Entries for Business Combination (contd.)

Journal Entries for Saxon Corp. 12/31/1999

Investment in Mason
Company Common
Stock (150,000 x $25)

3,750,000

Common stock
(150,000 x $10)

1,500,000

Paid-in Capital in
Excess of Par

2,250,000

To record merger with Mason


Company as a purchase.

(Continued)

Example I (contd.): Combinors Journal


Entries for Business Combination (contd.)

12/31/1999 (contd.)

Investment in Mason
Company Common Stock
($5,000+$10,000+$51,250)

66,250

Paid-in Capital in Excess of


Par ($60,000+$50,000 +
$23,000+750)

133,750

Cash
To record payment of out-of-pocket
costs incurred in merger with
Mason Company.

200,000
(Continued)

Example I (contd.): Combinors Journal


Entries for Business Combination (contd.)

12/31/1999 (contd.)

Current Assets
Plant Assets
Other Assets
Discount on Long-Term Debt
Goodwill
Current Liabilities
Long-Term Debt
Investment in Mason
Company Common
Stock ($3,750,000+$66,250)

11,500,000
3,400,000
600,000
50,000
116,250
500,000
1,000,000
3,816,250

Example I (contd.): Combinees J.E. for The


Dissolution of the Company after Statutory
Merger

Mason Company (the combinee)


prepares the condensed journal entry
below to record the dissolution and
liquidation of the company on
December 31, 1999.

Example I (contd.): Combinees J.E. for The


Dissolution of The Company after Statutory
Merger (contd.)

Journal Entries for Mason Corp.12/31/1999

Current Liabilities
Long-Term Debt
Common Stock , $10 stated
value
Paid-in Capital in Excess of
Stated Value
Retained Earnings
Current Assets
Plant Assets (net)

500,000
1,000,000
1,000,000
700,000
1,400,000
1,000,000
3,000,000

Example II: Purchase Accounting for


Acquisition of Net Assets, with Negative
Goodwill (Bargain-Purchase Excess)

On December 31, 1999, Davis


Corporation acquired the net assets of
Fairmont Corporation directly from
Fairmont Corp. for $400,000 cash, in a
purchase-type business combination.
Davis paid legal fees of $40,000 in
connection with the combination.

Example II: Purchase Accounting


with Negative Goodwill

The condensed balance sheet


statement of Fairmont Corp. prior to the
business combination, with related
current fair value data, is presented
below:

Example II (contd.):Combinees B/S


Prior to Statutory Merger
FAIRMONT CORPORATION (combinee)
Balance Sheet (prior to business combination)
December 31, 1999

Assets

Current assets
Investment in marketable debt
securities (held to maturity)
Plant assets (net)
Intangible assets (net)
Total assets

Carrying
Current Fair
Amounts
Values
$ 190,000 $ 200,000

50,000
870,000
90,000
$1,200,000

60,000
900,000
100,000
$1,260,000
(Continued)

Example II (contd.):Combinees B/S


Prior to Statutory Merger (contd.)
FAIRMONT CORPORATION B/S (contd.)

Liabilities and
Stockholders Equity
Current liabilities
Long-term debt
Total Liabilities
Common stock, $1 par
Deficit
Total stockholders equity

Carrying
Amounts
$ 240,000
500,000
$ 740,000
$ 600,000
(140,000)
$ 460,000

Current Fair
Values
$ 240,000
520,000
$ 760,000

Example II (contd.) : Computing the


Negative Goodwill

Thus, Davis acquired identifiable net


assets with a current fair value of $
500,000a for a total cost of $440,000b.
a. $ 1,260,000 - $760,000= $500,000
b. $ 400,000 +$40,000= $440,000

Example II (contd.) : Computing the


Negative Goodwill (contd.)

The $60,000 excess of current fair


value of the net assets over their cost to
Davis ($500,000 - $440,000 = $60,000)
is prorated to the plant assets and
intangible assets in the ratio of their
respective current fair values, as
follows:

Example II (contd.) : Allocation of


Negative Goodwill
To plant assets:
$60,000 x
$900,000
($900,000 +$100,000)

=$54,000

To intangible assets:
$60,000 x
$900,000
($900,000 +$100,000)

=$6,000

Total excess of current fair


value of identifiable net
assets over combinors cost $60,000

Example II (contd.)

Notes: No part of the $60,000 bargainpurchase excess is allocated to current


assets or to the investment in
marketable securities.
The journal entries on pages 54 and 55
record Davis Corporations acquisition
of the net assets of Fairmont
Corporation and payment of $40,000
legal fees:

Example II (contd.) : Combinors J.E. for


The Acquisition of Net Assets

Journal Entries of Davis Corp. 12/31/1999


Investment in Net Assets of
Fairmont Corporation

400,000

Cash

400,000

To record acquisition of net assets


of Fairmont Corporation

Investment in Net Assets of


Fairmont Corporation
Cash

To record payment of legal fees


incurred in acquisition of net assets
of Fairmont Corporation

40,000
40,000

(Continued)

Example II (contd.) : Combinors J.E. for the


Acquisition of Net Assets (contd.)

12/31/1999 (contd.)

Current Assets
Investments in Marketable Debt
Securities
Plant Assets ($900,000 - $54,000)
Intangible Assets ($100,000 - $6,000)
Current Liabilities
Long-Term Debt
Premium on Long-Term Debt
($520,000 - $500,000)

200,000
60,000
846,000
94,000
240,000
500,000
20,000

Example II (contd.): Note to the


Journal Entries

Note to the above journal entries:


To allocate total cost of net assets
acquired to identifiable net assets, with
excess of current fair value of the net
assets over their cost prorated to
noncurrent assets other than
investments in marketable debt
securities.

Pooling-of-Interests Accounting

The idea behind this accounting method


is that the business combination is
simply an exchange of common stock
between an issuer and the stockholders
of a combinee.
Thus, this method is appropriated to be
used in the case of business
combinations involving only common
stock exchanges between companies
of approximately equal size.

Pooling-of-Interests Accounting
(contd.)

Because neither party can be


considered as the combinor (as
previously defined), the combined
assets, liabilities and retained earnings
of the constituent companies are
recorded at their carrying amounts.

Pooling-of-Interests Accounting
(contd.)

Both the market value of the common


stock issued for the combination and
the fair value of the combinees net
assets are disregarded in this method.
The term issuer identifies the
corporation that issues its common
stock to accomplish the combination.

Example III: Pooling-of-Interests


Accounting for Statutory Merger

Applying the pooling-of interests


accounting method on the Example I
(the business combination of Saxon
and Manson) illustrated on page 32-45,
the following journal entries would be
prepared in Saxon Corporations
accounting records:

Example III : Pooling-of-Interests


Accounting for Statutory Merger (contd.)
Journal Entries for Saxon Corp. 12/31/1999
Current Assets
1,000,000
Plant Assets (net)
3,000,000
Other Assets
600,000
Current Liabilities
500,000
Long-term Debt
1,000,000
Common Stock, $10 par
1,500,000
Paid-in Capital in Excess
of Par
200,000

Retained Earnings

1,400,000

Example III : Pooling-of-Interests


Accounting for Statutory Merger (contd.)

12/31/1999 (J. E. contd.)

Expenses of Business
Combination
Cash
To record payment of out-ofpocket costs incurred in
merger with Mason Company

200,000
200,000

Example III (contd.): Notes to the example


Notes:
1. An Investment in Masons Company
Common Stock account is not used in the
pooling-of-interests method.
2. Masons assets, liabilities and retained
earnings are recorded at their carrying
amounts in Masons premerger balance
sheet.
3. The common stock issued by Saxon for the
business combination is recorded at par
value.

Example III (contd.): Notes to the example


(contd.)
Notes (contd.)
4. The Paid-in-Capital in Excess of Par equals the total
premerger paid-in-capital of Mason minus the par
value of Saxon's stock issued for the business
combination.
5. If the par value of Saxons common stock issued
for the combination exceeds the premerger paid-in
capital of Mason, Saxons Paid-in Capital in Excess
of Par account should be debited for the excess
amount. (contd.)

Example III (contd.): Notes to the example


(contd.)
Notes (contd.)
5. (contd.)If this account is not sufficient to
absorb the excess amount, Saxons
Retained Earnings account should be
debited.
6. The entire out-of-pocket costs were
expensed and are not tax deductible.

Advantage of Using Pooling Accounting on


Financial Numbers
1.Advantage on the Post-Merger
Earnings:
The following exhibit shows the balance
sheet statement accounts of pooling
accounting versus purchase accounting
using the example of Saxon and
Mason:

Advantage of Using Pooling Accounting on


Financial Numbers (contd.)
Purchase Accounting

Pooling Accounting

Current Assets

1,150,000

1,000,000

Plant Assets

3,400,000

3,000,000

Other Assets

600,000

600,000

Discount on
Long-Term Debt
Good will
Expense of Business
Combination

50,000
116,250
200,000
(Continued)

Advantage of Using Pooling Accounting on


Financial Numbers (contd.)
Purchase Accounting
Current Liabilities

Pooling Accounting

500,000

500,000

Long-Term Debt

1,000,000

1,000,000

Common Stock,
$ 10 par

1,500,000

1,500,000

Paid-in Capital in
Excess of Par

2,116,250

200,000

Retained Earnings
Cash
To record merger with
Mason Company.

1,400,000
200,000

200,000

Advantage of Using Pooling Accounting on


Financial Numbers (contd.)

The difference on the net assets of these two


methods is:
Purchase

accounting
net assets $3,616,250
Pooling accounting
net assets 2,900,000
Difference $ 716,250

Advantage of Using Pooling Accounting on


Financial Numbers (contd.)

The composition of the $716,250 is


summarized as follows:

Excess of purchase asset values over


pooling asset values:

Current assets ($1,150,000-$1,000,000)


Plant assets ($3,400,000- $3,000,000)
Goodwill
Excess
of pooling liability values over
purchase liability values:
Long-term debt
[$1,000,000-($1,000,000- $50,000) ]
Excess of purchase net assets values
over pooling net assets values

$150,000
400,000
116,250
50,000
$716,250

Advantage of Using Pooling Accounting on


Financial Numbers (contd.)

Assuming:

a.The $150,000 difference in current assets is


attributable to inventories which will be
allocated to CGS on FIFO basis in the
following year.

Advantage of Using Pooling Accounting on


Financial Numbers (contd.)
b.The $400,000 difference in plant assets is
attributable to depreciable assets, and
assuming an average economic life for
these plant assets is 10 years.
c.Goodwill will be amortized in 40 years.
d.The long-term debt has a remaining 5 years
to maturity.

Advantage of Using Pooling Accounting on


Financial Numbers (contd.)
Based on the above information, Saxons pre-tax
income for the year ended 12/31/2000 would be
$202,906 less under purchase accounting than
under pooling accounting. Calculation is as
follows:
Cost of goods sold
$150,000
Depreciation expense ($400,000 x 1/10)
40,000
Amortization expense ($116,250 x 1/40)
2,960
Interest expense ($50,000 x 1/5)
10,000
Excess of year 2000 pre-tax income under
pooling accounting rather than under
purchase accounting
$202,906

Advantage of Using Pooling Accounting on


Financial Numbers (contd.)

Thus, pooling accounting, in general,


results in a more favorable post-merger
earnings than the purchase accounting.
As a result, it is preferred by mangers
who would like to present a higher postmerger earnings.

Advantage of Using Pooling Accounting on


Financial Numbers (contd.)
2.Advantage on the Retained
Earnings
The retained earnings under the pooling
method is $1,400,000 greater than that
of the purchase method.
This outcome also provides the
managers with a greater flexibility in
dividend distribution when using the
pooling accounting.

Advantage of Using Pooling Accounting on


Financial Numbers (contd.)
3.Advantage on the Price-Earnings
Ratios on the Merger Year
Assume Saxon and Mason had the
following financial information prior to
the business combination:

Advantage of Using Pooling Accounting on


Financial Numbers (contd.)
Saxon
Corporation
Year ended Dec. 31, 1999:
Net income
Basic earnings per share of
common stock

Mason
Company

$500,000*

$375,000

$0.50

$3.75

1,000,000+

100,000+

Market
price per
shareof business combination.
$25
* Net of $200,000
expenses
+ Outstanding during
entire year.
Price-earnings
ratio
50

$30
8

On Dec. 31, 1999:


Number of shares of
common stock outstanding

Advantage of Using Pooling Accounting on


Financial Numbers (contd.)

Using the pooling method, Saxon would


report the combined enterprises net
income as $875,000 for the year ended
12/31/1999 (as if these two companies
were pooled as of 1/1/1999) and the EPS
for Saxon would be increased from $0.50
to $0.76.
Calculated as : $875,000/
(1,000,000+150,000).

Historical Perspective of Accounting


for Business Combinations

Due to lack of accounting


pronouncement in providing clear
guidance in determining the appropriate
method for business combination prior
to the issuance of Accounting Principle
Board Opinion No. 16 Business
Combinations in August 1970 (effective
for business combinations initiated after
October 31, 1970),

Historical Perspective of Accounting


for Business Combinations (contd.)

a substantial number of business


combinations arranged in the 1950s
and 1960s were accounted for using
pooling accounting despite the absence
of the assumption for using pooling
accounting .

Historical Perspective of Accounting


for Business Combinations (contd.)

The pooling accounting was first


sanctioned by the AICPA in its
Accounting Research Bulletin No. 40,
Business Combinations. This
pronouncement provides very little
guidance for identifying the business
combinations that qualified for pooling
method.

Historical Perspective of Accounting


for Business Combinations (contd.)

ARB No. 40 was subsequently replaced


by ARB No. 48, Business
Combinations which continued to allow
pooling method to be used for most
business combinations involving an
exchange of common stock.

Past Abuses of Pooling Accounting

The advantages of pooling accounting


in post-merger earnings, retained
earnings, and in the P/E ratio of the
merger year with the lack of clear
guidelines for pooling in ARB No. 48 led
to serious abuses of pooling method.

Past Abuses of Pooling Accounting


(contd.)

Consequently, a substantial number of


business combinations arranged in the
1950s and 1960s were accounted for
using pooling accounting despite the
absence of the assumption for using
pooling accounting the combination of
existing stockholders interests.

Past Abuses of Pooling Accounting


(contd.)

Among these abuses are:


a. Retroactive Pooling
b. Retrospective Pooling
c. Part-Pooling, Part-Purchase
Accounting
d. Treasure Stock Issuance

Past Abuses of Pooling Accounting


(contd.)

Contd.:
e.Issuance of Unusual Securities
f. Creation of instant Earnings
g.Contingent Payouts
h.Burying the Costs of Pooling-Type
Business Combinations

Past Abuses of Purchase Accounting


(in the period of 1950-1960)

The most common abuses of purchase


accounting is the failure to allocate the
cost of a combinee to the identifiable
net assets acquired and to goodwill.

Action by the AICPA to Curtail The


Abuses

The Accounting Principles Board


reacted to the abuses by issuing APB
opinion No. 16 in which pooling
accounting standards are tightened
and the range of situations allowed
for pooling accounting is substantially
limited.

Conditions Requiring Pooling Accounting


in APB Opinion No. 16
1.Attributes of the combining
companies (2 conditions).
These conditions were to assure that
the pooling combination was truly a
combining of two or more entities whose
common stockholder interests were
previously independently of each other.

Conditions Requiring Pooling Accounting


in APB Opinion No. 16) (contd.)
2.Manner of combining ownership
interests (7 conditions).
These conditions were to assure that
the exchange of voting common stock
actually took place in substance and in
form.

Conditions Requiring Pooling Accounting


in APB Opinion No. 16) (contd.)
3.Absence of planned transactions (3
conditions).
These conditions were to assure that
no planned transactions, which are
inconsistent with the combining of
entire existing interests of common
stockholders, could be arranged prior to
the combination.

APB Opinion No. 16

A business combination that meets 12


conditions of APB of Opinion No.16
accounting for as a pooling regardless
of the legal form of the combination.
These conditions specified in APB
Opinion No. 16 are:

APB Opinion No. 16 (contd.)


1.Attributes of the constituent
companies (2 conditions)
a. Each of the constituent companies is
autonomous and has not been a
subsidiary or division of another
corporation within two years before the
plan of combination is initiated.
b. Each of the constituent companies is
independent of the other.

APB Opinion No. 16 (contd.)


2.Manner of combining ownership
interests (7 conditions)
b. A corporation offers and issues only
common stock with rights identical to
those of the majority of its outstanding
voting common stock in exchange for
substantially all the voting common
stock interest of another company on the
date the plan of combination is
consummated.

APB Opinion No. 16 (contd.)


3.Absence of planned transactions (3
conditions)
a. The combined entity does not agree to
retire or acquire all or part of the common
stock issued to effect the combination.
b. The combined entity does not enter
agreement for the benefit of the former
stockholder of a constituent company.

APB Opinion No. 16 (contd.)


c. The combined entity does not plan to sell
a significant part of the assets of the
constituent companies within two years
after the combination.

APB Opinion No. 16 (contd.)

APB stated that both purchase and


pooling methods are acceptable in
accounting for business combination,
but not as alternatives in accounting for
the same business combination.
By tightening the conditions for
adopting pooling accounting, many
previous abuse of pooling were
eliminated or reduced.

Discussion of Four Conditions


1.Independence of Constituent
Companies
On the dates of initiation and
consummation of a business
combination, no constituent company
may have more than 10% ownership of
the outstanding voting common stock of
another constituent company.

Discussion of Four Conditions


(contd.)
2.Substantially All Voting Common
Stock of Combinees Company Are
Exchanged
The condition requires that at least 90%
of the combinees outstanding voting
common stock be exchanged for the
issuers voting common stock.
The following are excluded from the
computation of the number of shares
exchanged:

Discussion of Four Conditions


(contd.)
1) Shares acquired before the initiation
date of combination and held by
either the issuer or its subsidiaries.
2) Share acquired by either the issuer
or its subsidiaries after the
combination is initiated, other than in
exchange for the issuers voting
common stock.

Discussion of Four Conditions


(contd.)
3) shares of the combinee still
outstanding on the date the
combination is consummated.
4) any voting common stock of the
issuer owner by the combinee before
the business combination must be
converted to equivalent shares of the
combinee for the 90% test.

(contd.)

discussion of Four Conditions

Example to illustrate the independence and


90%
voting
stock
tests
On of
March
13,common
1999, Patton
Corporation
and

Sherman Company initiated a plan of business


combination.
Under the Plan, 1.5 shares of Pattons voting
common stock (1,000,000 shares issued and
outstanding prior to March 13, 1999) were to
be exchanged for each outstanding share of
Shermans common stock (100,000 shares
issued and 99,500 shares outstanding prior to
March 13,1999).

Discussion of Four Conditions (contd.)

Example to illustrate the independence and


90% of voting common stock tests (contd.)

At this time, Patton owned 7,500 shares


of Shermans common stock, and
Sherman owned 6,000 shares of
Pattons voting common stock; in
addition, 500 shares of Shermans
common stock were in Shermans
treasury.

Discussion of Four Conditions (contd.)

Example to illustrate the independence and


90% of voting common stock tests (contd.)

Neither Pattons ownership of 7.54% of


Shermans outstanding common stock
(7,500/ 99,500 = 7.54%) nor Shermans
ownership of 0.6% of Pattons
outstanding common stock (6,000/
1,000,000 = 0.6%) exceeds the 10%
limitation of the independence of
constituent companies requirement.

Discussion of Four Conditions (contd.)

Example to illustrate the independence and


90% of voting common stock tests (contd.)

On March 26, 1999, Patton acquired in


the open market for cash 1,000 shares
(1.005%) of Shermans outstanding
common stock.
On June 30, 1999, Patton issued
136,500 shares of its voting common
stock in exchange for 91,000 outstanding
shares of Shermans common stock to
complete the business combination.

Discussion of Four Conditions (contd.)

Example to illustrate the independence and


90%
of
voting
common
stock
tests
(contd.)

Computation of the 90% requirement follows:

Total Sherman Company shares issued,


June 30, 1999
Less: Shares in Shermans treasury
Total Sherman shares outstanding,
June 30, 1999
Less:
Sherman shares owned by Patton
Corporation, Mar. 13, 1999
Sherman shares acquired by
Patton for cash, Mar. 26, 1999

100,000
500
99,500

7500
(Continued)

1000

Discussion of Four Conditions (contd.)

Example to illustrate the independence and


90% of voting common stock tests (contd.)
Equivalent number of Sherman
shares represented by Pattons
common stock owned by
Sherman, Mar. 13, 1999
(6,000 1 )

4,000

12,500

Effective number of Sherman shares


acquired June 30, 1999 in exchange for
Pattons common stock

87,000

Application of 90% requirement


(99,500 x 90%)

89,550

Discussion of Four Conditions (contd.)

Example to illustrate the independence and


90% of voting common stock tests (contd.)

Thus, the 91,000 shares of Sherman


Company common stock actually
exchanged on June 30, 1999, are in
effect restated to 87,000 shares.
Because the restated amount is less
than 90% of Shermans 99,500 shares
outstanding, the business combination
does not qualify for pooling accounting.

Discussion of Four Conditions


(contd.)
3.Restrictions on Treasury Stock
Only the treasury stock purchased
under a systematic purchase plan
(referred to as untainted treasury stock)
can be accounted for as issuance of
common stock in a pooling
combination.

Discussion of Four Conditions


(contd.)
4.No Pending Provisions
No additional common stock can be
contingently issuable to former
stockholders of a combinee after a
combination has been initiated.
And, no common stock can be issued to
an escrow agent pending the resolution
of a contingency.

Financial Statements Following a


Business Combination

The assets, liabilities, and retained earnings


in a balance sheet statement following a
business combination are reported as follow:
Purchasecombinor

Assets & Lia.


Retained earnings
Carrying amount
Reported

Purchasecombinee

Fair value

Not reported

Poolingcombinor

Carrying amount

Reported

Poolingcombinee

Carrying amount

Reported

Financial Statements Following a


Business Combination (contd.)

The combined income statement


following a business combination
depends on the accounting method:
Purchase Accounting:
The income statement of the combined
entity for the period in which the
business combination occurred include
the operating results of the combinee
after the date of the combination
only.

Financial Statements Following a


Business Combination (contd.)

Pooling Accounting
The income statement of the combined
entity for the period in which the
business combination occurred
includes the results of operations of the
constituent companies as though the
combination had been completed at the
beginning of the period regardless
when the combination consummated.

Financial Statements Following a


Business Combination (contd.)

Comparative financial statements for


preceding periods are restated for
comparative purposes.
Intercompany transactions prior to the
combination must be eliminated from
the combined income statements in a
manner comparable with that described
in Chapter 4 for branches.

Financial Statements Following a Business


Combination (contd.)

Example IV:

To illustrate, assume that the income


statements of Saxon Corporation and Mason
Company for the year ended December 31,
1999 (prior to completion of their poolingtype merger described on page 60-65
example III), were as shown below.
Assume also that Masons interest expense
includes $25,000 paid to Saxon on a loan that
was repaid prior to December 31, 1999, and
that Saxons revenue includes $25,000
interest received from Mason.

Financial Statements Following a Business


Combination (contd.)

Example IV (contd.)

SAXON CORPORATION AND MASON COMPANY


Separate Income Statements
For Year Ended December 31, 1999
Saxon
Corporation

Mason
Company

$10,000,000

$5,000,000

Costs of goods sold

$ 7,000,000

$3,000,000

Operating expenses

1,883,333*

1,274,500

Interest expense

150,000

100,500

Income taxes expense

466,667

250,000

Sales and other revenue


Costs and expenses:

Total
costs and
*Includes $200,000
expenses
of business combination.
expenses

$ 9,500,000

$4,625,000

Financial Statements Following a Business


Combination (contd.)

Example IV (contd.)

The working paper for the postmerger


income statement of Saxon Corporation
under pooling accounting is illustrated
below.
The amounts in the Combined column
are reported in Saxons published
postmerger income statement for the
year ended December 31,1999.

Financial Statements Following a Business


Combination (contd.)

Example IV (contd.)
SAXON CORPORATION

Working Paper for Combined Income Statement (Pooling of Interests)


For Year Ended December 31, 1999
Saxon
Corporation

Sales and other


revenue

Mason
Company

Eliminations

Combined

10,000,000 5,000,000

(a) 25,000 14,975,000

Cost of goods sold

7,000,000 3,000,000

10,000,000

Operating expenses

1,883,333 1,274,500

3,157,833

Cost and expenses:

Interest expense

150,000

100,500

Income taxes
expense

466,667

250,000

716,667

9,500,000 4,625,000

(25,000) 14,100,000

Total costs and


expenses

(a) (25,000)

225,500

(a) To eliminate intercompany interest received by Saxon Corporation from Mason


Net income
500,000
375,000
-0875,000
Company.

Notes to Financial Statements


Following a Business Combination

Extensive disclosure is required for


business combinations in the period they
occur.
Required Disclosure for Purchase
Accounting: (textbook p194)
1. Name and brief description of the
combinee; also the accounting method
used for the business combination;

Notes to Financial Statements Following a


Business Combination (contd.)
2.period for which combinees operating
results are included in the income
statement of the combined enterprise;
3.cost of the combinee, including number
of shares and value per share of
common stock issued and nature of
and accounting treatment for contingent
consideration;
4. amortization policy for goodwill;

Notes to Financial Statements Following a


Business Combination (contd.)
5.pro forma operating results for the
combined enterprise for the current
and preceding accounting periods as if
the combination had occurred at the
beginning of the preceding period.
Note: The FASB waived the proforma
disclosures for nonpublic enterprises.

Notes to Financial Statements Following a


Business Combination (contd.)
Required Disclosure for Pooling
Accounting
1. Name and brief description of the
combinee; the accounting method used
for the business combination;

Notes to Financial Statements Following a


Business Combination (contd.)
2. number of shares of common stock
issued in the combination;
3. separate operating results of the
constituent companies for the period
prior to the combination that were
included in the operating results of the
combined entity for the combination
year.

Comparison of Purchase and


Pooling Accounting

The following table summarizes the


principal aspects of purchase
accounting and pooling-of-interests
accounting for business combinations:

Comparison of Purchase and


Pooling Accounting (contd.)
Aspect

Purchase
Accounting

Pooling-ofInterests
Accounting

Underlying
premise

Acquisition of
assets

Combining of
stockholder
interests

Applicability

Combinations
not meeting all
12 criteria for
pooling
accounting

Combinations
meeting all 12
criteria for
pooling
accounting
(Continued)

Comparison of Purchase and


Pooling Accounting (contd.)
Aspect

Purchase
Accounting

Pooling-of-Interests
Accounting

Accounting
recognition of
investment in
combinee

At cost, including
amount of
consideration, direct
out-of-pocket costs,
and determinable
contingent
consideration

At carrying amount of
combinees net
assets (all out-ofpocket costs are
recognized as
expenses of the
issuer)

Valuation of
combinees net
assets in combined
enterprise

At current fair values At carrying amounts


on date of
on date of
combination
combination
(Continued)

Comparison of Purchase and


Pooling Accounting (contd.)
Aspect

Purchase
Accounting

Pooling-of-Interests
Accounting

Goodwill recognition Yes, if combinors cost No


exceeds current fair
value of combinees
identifiable net assets
Retained earnings NO
of constituent
companies
combined on date of
business
combination

YES

(Continued)

Comparison of Purchase and


Pooling Accounting (contd.)
Aspect

Purchase
Accounting

Pooling-of-Interests
Accounting

Financial
statements and
notes for period of
business
combination:
Balance sheet

Combinors net assets


at carrying amount;
combinees net assets
at current fair value

Both issuers and


combinees net
assets at carrying
amount
(Continued)

Comparison of Purchase and


Pooling Accounting (contd.)
Aspect

Purchase Accounting

Income
statement

Combinors operations
for entire period;
combinees operations
from date of
combination to end of
period

Disclosure of
operations in
notes

Pro forma for combined


enterprise for current
and preceding period
as though combination
took place at beginning
of preceding period

Pooling-of-Interests
Accounting
Both issuers and
combinees operations
for entire period as
though combination
took place at beginning
of period; prior periods
restated comparably
Separately for
constituent companies
for period prior to
combination

Purchase-Type Statutory
Consolidation

Due to a new corporation is formed to


issue common stock to all constituent
companies in this type of business
combination, a combinor needs to be
identified for the accounting treatment.
The assets and liabilities of the
identified combinor will be accounted
for by the new corporation at the
carrying amount while those of the
combinee will be accounted for at the
fair value.

Purchase-Type Statutory Consolidation (contd.)

Example V :

To illustrate, assume the following


balance sheet statements of the
constituent companies involved in a
purchase-type statutory consolidation
on December 31, 1999 (p196-199 of
textbook):

Purchase-Type Statutory Consolidation (contd.)

Example V (contd.):

LAMSON CORPORATION AND DONALD COMPANY


Separate Balance Sheets (prior to business combination)
December 31,1999

Assets
Current assets
Plant assets (net)
Other assets (net)
Total assets

Lamson
Corporation

Donald
Company

600,000 $ 400,000
1,800,000
1,200,000
400,000
300,000
$ 2,800,000 $1,9,00,000
(Continued)

Purchase-Type Statutory Consolidation (contd.)

Example V (contd.):

LAMSON CORPORATION AND DONALD COMPANY


Separate Balance Sheets (contd.), 12/31/1999

Liabilities &
Stockholders Equity
Current liabilities
Long-term debt
Common stock,$10 par
Additional paid-in
capital
Retained earnings
Total liabilities &

Lamson
Donald
Corporation Company
$ 400,000 $ 300,000
500,000
200,000
430,000
620,000
300,000

400,000

1,170,000

380,000

Purchase-Type Statutory Consolidation (contd.)

Example V (contd.):

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, $800,000 and
$500,000; plant assets, $2,000,000 and
$1,400,000; other assets, $500,000 and
$400,000.

Purchase-Type Statutory Consolidation (contd.)

Example V (contd.):

On December 31, 1999, in a statutory


consolidation approved by shareholders of
both constituent companies, a new
corporation, LamDon Corporation, issued
74,000 shares of no-par, no-stated-value
common stock with an agreed value of $60 a
share, based on the following valuations
assigned by the negotiating directors to the
two constituent companies identifiable net
assets and goodwill:

Purchase-Type Statutory Consolidation (contd.)

Example V(contd.):

Lamson
Corporation

Donald
Company

Current fair value of identifiable net


assets:
Lamson: $800,000+$2,000,000
+$500,000- $400,000-$500,000

$2,400,000

Donald: $500,000+ $1,400,000


+ $400,000 -$300,000-$200,000
Goodwill
Net assets current fair value
Number of shares of LamDon
common stock to be issued to
constituent companies
stockholders, at $60 a share

$1,800,000
180,000

60,000

$2,580,000 $1,860,000

Purchase-Type Statutory Consolidation (contd.)

Example V (contd.):

Because the former stockholders of


Lamson Corporation receive the larger
interest in the common stock of
LamDon Corporation (43/74, or 58%),
Lamson is the combinor in the
purchase-type statutory consolidation
business combination.

Purchase-Type Statutory Consolidation (contd.)

Example V (contd.):

Assuming that LamDon paid $200,000


out-of-pocket costs of the consolidation
after it was consummated on December
31, 1999, LamDons journal entries
would be as follows:

Purchase-Type Statutory Consolidation (contd.)

Example V (contd.):

Journal Entries of Lamdon Corp., 12/31/1999

Investment in Lamson
Corporation and Donald
Company Common Stock
(74,000 x $60)
Common Stock, no par

4,440,000
4,440,000

To record consolidation of Lamson


Corporation and Donald Company
as a purchase
(Continued)

Purchase-Type Statutory Consolidation (contd.)

Example V (contd.):

12/31/1999 (contd.)

Investment in Lamson
Corporation and Donald
Company Common Stock
Common Stock, no par
Cash
To record payment of costs incurred in
consolidation of Lamson Corporation and
Donald Company. Accounting, legal, and
finders fees 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.

110,000
90,000
200,000

(Continued)

Purchase-Type Statutory Consolidation (contd.)

Example V (contd.):

12/31/1999 (contd.)
Current Assets ($600,000+$500,000) 1,100,000
Plant Assets ($1,800,000+$1,400,000) 3,200,000
800,000
Other Assets ($400,000+$400,000)

Goodwil
l

Current Liabilities
Long-Term Debt
Investment in Lamson
Corporation and Donald
Company Common
Stock

850,000
700,000
700,000

4,550,000

(Continued)

Purchase-Type Statutory Consolidation (contd.)

Example V (contd.):
12/31/1999 (contd.)
Amount of goodwill is
computed as follows:
Total cost of investment

($4,400,000+$110,00)

Less: Carrying amount of


Lamsons identifiable
net assets ($430,000+
$300,000+1,170,000)

4,550,000

(1,900,000)

Current fair fair value of


Donalds identifiable net
assets
(1,800,000)
Amount of goodwill

$ 850,000

Subsequent Issuance of Contingent


Consideration

Example of Contingent Consideration


(p176 and p198 of text book)

Norton Company agrees to pay


$800,000 cash for Robinsons net
assets (not including Robinsons slowmoving products which have been
written down to scrap value by
Robinson prior to the business
combination).

Subsequent Issuance of Contingent


Consideration

Example (contd.) These purchased net

assets of Robinson will be included in


the Rob Division of Norton Company.
In addition, the following contingent
consideration was included in the
contract:
1. Norton will pay Robinson $100 a unit
for all sales by Robb Division of the
slow-moving product.

Subsequent Issuance of Contingent


Consideration (contd.)
(contd.)
2.Norton will pay Robinson 25% of any
pre-tax financial income in excess of
$500,000 (excluding income from sale
of the slow-moving product) of Robb
Division for each of the four years
subsequent to the business
combination.

Subsequent Issuance of Contingent


Consideration (contd.)

Assuming that by 12/31/x2, the end of the first


year following Nortons acquisition of the net
assets, another 300 units of the slow-moving
product had been sold, and Nortons Rob
Division had pre-tax income of $580,000
(excluding the sale of the slow-moving
product).
On 12/31/x2, Norton prepares the following
journal entry to record the resolution of
contingent consideration:

Subsequent Issuance of Contingent


Consideration (contd.)
Goodwill

50,000*

Cash (or payable to


Robinson Company)
* $100 x 300
+ (580,000-500,000) x 25%

50,000

=$30,000
= 20,000
$50,000

IAS 22, Accounting for Business


Combinations

International Accounting Standards


Committee requires purchase
accounting to be used for all business
combinations except for united-ofinterests type combinations.

The Current Development on the Business


Combination Standards (Excerpts from News
Release of the FASB dated 7/20/01)
On July 20, 2001, FASB issued
Statement No. 141, Business
Combinations and Statement No. 142,
Goodwill and Other Intangible Assets.

The Current Development on the Business


Combination Standards (Excerpts from News
Release of the FASB dated 7/20/01) (contd.)
Statement 141:
Use of the pooling-of-interests method
is not permitted. All business
combinations should be accounted for
using the purchase method. This
statement is effective for business
combinations initiated after June 30,
2001.

The Current Development on the Business


Combination Standards (Excerpts from News
Release of the FASB dated 7/20/01) (contd.)
Statement 142:
Requires that goodwill no longer to be
amortized as expense but subject to
annual review for impairment.

The Current Development on the Business


Combination Standards (Excerpts from News
Release of the FASB dated 7/20/01) (contd.)

Reasons of issuing SFAS No. 141:


(Source: summary of SAFS No. 141
published by the FASB):
Due to the 12 criteria for pooling
accounting failed to distinguish
economically dissimilar transactions,
similar business combinations were
accounted for using different accounting
methods.

The Current Development on the Business


Combination Standards (Excerpts from News
Release of the FASB dated 7/20/01) (contd.)
Therefore, different financial statements
were produced for similar business
combinations.
The following are some of the reasons
stated by the FASB:

The Current Development on the Business


Combination Standards (Excerpts from News
Release of the FASB dated 7/20/01) (contd.)
1.Lack of Comparability on the financial
statements when different method is
adopted.
2.Criticism on the amortization of goodwill
when purchase method is used.
3.Criticism from mangers on the impact of
these two methods on the competition in
markets for mergers and acquisitions.

Summary of Statement No. 142:

(source: FASB Publication of Summary of


Statement No. 142)
Intangible assets have become an
important economic resource for many
entities.
Thus, better information for the
intangible assets is needed.
Some empirical studies indicate that the
goodwill amortization expense is not
reflected in firm value

Summary of Statement No. 142:

(source: FASB Publication of Summary of


Statement No. 142) (contd.)
APB Opinion No. 17 assumed that
goodwill and all other intangible assets
were assets with finite lives and thus
should be amortized, not to exceed 40
years.

Summary of Statement No. 142:

(source: FASB Publication of Summary of


Statement No. 142) (contd.)
Statement No. 142 assumed that
goodwill and other intangible assets
have indefinite lives and will not be
amortized but rather will be tested on
annual basis for impairment.
Intangible assets that have finite useful
lives will continue to be amortized over
their useful lives, but without the
arbitrary ceiling of 40 years.

Summary of Statement No. 142:

(source: FASB Publication of Summary of


Statement No. 142) (contd.)
Statement 142 provides guidance for
the two-step process of review of the
potential impairment:
Consequence of SFAS No. 142:
Earnings may be more volatile due to
the impairment losses are likely to
occur irregularly and in varying
amounts.

Summary of Statement No. 142:

(source: FASB Publication of Summary of


Statement No. 142) (contd.)
Disclosure requirements of Statement
142:
a. Information about the changes in the
carrying amount of goodwill from
period to period (in the aggregate
and by reportable segment);

Summary of Statement No. 142:

(source: FASB Publication of Summary of


Statement No. 142) (contd.)
b. The carrying amount of intangible
assets by major intangible asset
class for those assets subject to
amortization and for those not
subject to amortization;
c. The estimated intangible assets
amortization expense for the next
five years.

Summary of Statement No. 142:

(source: FASB Publication of Summary of


Statement No. 142) (contd.)
FASB indicates that this statement can
improve the financial reporting on these
assets (goodwill and other intangible
assets) because this treatment will
result values of these assets better
reflect the underlying economic values
of these assets.