Chapter 1

Business
Combinations
 Business Combinations: Objectives

1. Understand the economic motivations

underlying business combinations.
2. Learn about the alternative forms of
business combinations, from both the
legal and accounting perspectives.
3. Introduce concepts of accounting for
business combinations, emphasizing the
acquisition method.
4. See how firms record fair values of assets
and liabilities in an acquisition.

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 Business Combinations

1: ECONOMIC
MOTIVATIONS

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 Types of Business Combinations

– Business combinations unite previously

separate business entities.
– Horizontal integration – same business lines
and markets
– Vertical integration – operations in different,
but successive stages of production or
distribution, or both
– Conglomeration – unrelated and diverse
products or services

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 Reasons for Combinations

– Cost advantage
– Lower risk
– Fewer operating delays
– Avoidance of takeovers
– Acquisition of intangible assets
– Other: business and other tax advantages,
personal reasons

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 Potential Prohibitions / Obstacles

Antitrust
– Federal Trade Commission prohibited Staples’
acquisition of Office Depot
Regulation
– Federal Reserve Board
– Department of Transportation
– Department of Energy
– Federal Communications Commission
Some states have antitrust exemption laws
to allow hospitals to pursue cooperative
projects.
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 Business Combinations

2: FORMS OF BUSINESS
COMBINATIONS

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 Legal Form of Combination

Merger
– Occurs when one corporation takes over all the
operations of another business entity and that
other entity is dissolved.

Consolidation
– Occurs when a new corporation is formed to
take over the assets and operations of two or
more separate business entities and dissolves
the previously separate entities.

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 Mergers:
A+B=A X+Y=X
Company A acquires the net assets of
Company B for cash, other assets, or
Company A debt/equity securities. Company
B is dissolved; Company A survives with
Company B’s assets and liabilities.

Company X acquires the stock of Company

Y from its shareholders for cash, other
assets, or Company X debt/equity
securities. Company Y is dissolved.
Company X survives with Company Y’s
assets and liabilities.
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 Consolidations:
E + F = “D” K + L = “J”
Company D is formed and acquires the net
assets of companies E and F by issuing
Company D stock. Companies E and F are
dissolved. Company D survives with the
assets and liabilities of both dissolved firms.

Company J is formed and acquires the stock

of companies K and L from their respective
shareholders by issuing Company J stock.
Companies K and L are dissolved. Company J
survives with the assets and liabilities of both
firms.

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 Keeping the Terms Straight

In the general business sense, mergers and

consolidations are business combinations and
may or may not involve the dissolution of the
acquired firm(s).
In Chapter 1, mergers and consolidations will
involve only 100% acquisitions with the
dissolution of the acquired firm(s). These
assumptions will be relaxed in later chapters.
“Consolidation” is also an accounting term used
to describe the process of preparing
consolidated financial statements for a parent
and its subsidiaries.

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 Business Combinations

3: ACCOUNTING FOR
BUSINESS
COMBINATIONS

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 Business Combination (def.)

A business combination is “a transaction or

other event in which an acquirer obtains
control of one or more businesses.
Transactions sometimes referred to as true
mergers or mergers of equals also are
business combinations. [FASB ASC 805-10]

A parent-subsidiary relationship is formed

when:
– Less than 100% of the firm is acquired, or
– The acquired firm is not dissolved.

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 U.S. GAAP for Business
Combinations

– Since the 1950s both the pooling-of-interests

method and the purchase method of accounting
for business combinations were acceptable.
– Combinations initiated after June 30, 2001 use
the purchase method. [FASB ASC 805]
– Firms now use the acquisition method for
business combinations. This began with
combinations in fiscal periods beginning after
December 15, 2008. [FASB ACS 810-10-5-2]

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 International Accounting

– Most major economies prohibit the use of the

pooling method.

– The International Accounting Standards Board

specifically prohibits the pooling method and
requires the acquisition method.

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 Recording Guidelines (1 of 2)

– Record assets acquired and liabilities assumed

using the fair value principle.
– If equity securities are issued by the acquirer,
charge registration and issue costs against the
fair value of the securities issued, usually a
reduction in additional paid-in-capital.
– Charge other direct combination costs (e.g.,
legal fees, finders’ fees) and indirect
combination costs (e.g., management salaries)
to expense.

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 Recording Guidelines (2 of 2)

– When the acquiring firm transfers its assets

other than cash as part of the combination,
any gain or loss on the disposal of those
assets is recorded in current income.
– The excess of cash, other assets, debt, and
equity securities transferred over the fair value
of the net assets (A – L) acquired is recorded
as goodwill.
– If the net assets acquired exceeds the cash,
other assets, debt, and equity securities
transferred, a gain on the bargain purchase is
recorded in current income.

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 Example: Pop Corp. (1 of 3)

Pop Corp. issues 200,000 shares of its

$10 par value common stock for Son
Corp. Pop’s stock is valued at $16 per
share. (in thousands)

Investment in Son Corp. (+A) 3,200

Common stock, $10 par (+SE) 2,000

Additional paid-in-capital (+SE) 1,200

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 Example: Pop Corp. (2 of 3)

Pop Corp. pays cash for $160,000 in finder’s and

consulting fees and for $80,000 to register and
issue its common stock. (in thousands)
Investment expense (E, -SE) 160

Additional paid-in-capital (-SE) 80

Cash (-A) 240

Son Corp. is assumed to have been dissolved. So,

Pop Corp. allocates the investment’s cost to the fair
value of the identifiable assets acquired and
liabilities assumed. The excess cost is goodwill.

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 Example: Pop Corp. (3 of 3)

Receivables (+A) XXX

Inventories (+A) XXX

Plant assets (+A) XXX

Goodwill (+A) XXX

Accounts payable (+L) XXX

Notes payable (+L) XXX

Investment in Son Corp. (-A) 3,200

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 Business Combinations

4: RECORDING FAIR
VALUES IN AN
ACQUISITION

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 Identify the Net Assets Acquired

Identify:
– Tangible assets acquired,
– Intangible assets acquired, and
– Liabilities assumed
Include:
– Identifiable intangibles resulting from legal or
contractual rights, or separable from the entity
– Research and development in process
– Contractual contingencies
– Some noncontractual contingencies

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 Assign Fair Values to Net Assets

Use fair values determined, in preferential

order, by:
– Established market prices
– Present value of estimated future cash flows,
discounted based on an observable measure,
such as the prime interest rate
– Other internally derived estimations

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 Exceptions to Fair Value Rule

Use normal guidance for:

– Deferred tax assets and liabilities
– Pensions and other benefits
– Operating and capital leases
[FASB ASC 740]

Goodwill on the books of the acquired firm is

assigned no value.

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 Goodwill

Goodwill is the excess of

The sum of:
– Fair value of the consideration transferred,
– Fair value of any noncontrolling interest in the
acquiree, and
– Fair value of any previously held interest in
acquiree,
Over the net assets acquired.

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 Contingent Consideration

The fair value of contingent consideration is

determined or estimated at the acquisition
date and it is included along with other
consideration given as part of the
combination.
Classifying contingencies:
– Contingent share issuances are equity
– Contingent cash payments are liabilities
Estimated contingencies are revalued to fair
value at each subsequent reporting date.

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 Example – Pit Corp. Data

Pit Corp. acquires the net assets of Sad Co.

in a combination consummated on
12/27/2011.

The assets and liabilities of Sad Co. on this

date, at their book values and fair values,
are as follows (in thousands):

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 Book Val. Fair Val.
Cash $100 $100
Net receivables 300 280
Inventory 400 500
Land 100 200
Buildings, net 600 1.000
Equipment, net 500 700
Patents 0 100
Total assets $2,000 $2,880
Accounts payable $120 $120
Notes payable 300 270
Other liabilities 80 90
Total liabilities $500 $480
Net assets $1,500 $2,400

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 Acquisition with Goodwill

Pit Corp. pays $800,000 cash and issues 100,000

shares of Pit Corp. $10 par common stock with a
market value of $20 per share for the net assets of
Sad Co.

Total consideration at fair value (in thousands):

$800 + (100 shares x $20) $2,800

Fair value of net assets acquired: $2,400

Goodwill $ 400

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 Entries with Goodwill

The entry to record the acquisition of the net

assets:
Investment in Sad Co. (+A) 2,800
Cash (-A) 800
Common stock, $10 par (+SE) 1,000
Additional paid-in-capital (+SE) 1,000

The entry to record Sad’s assets directly on

Pit’s books:

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 Cash (+A) 100
Net receivables (+A) 280
Inventories (+A) 500
Land (+A) 200
Buildings (+A) 1,000
Equipment (+A) 700
Patents (+A) 100
Goodwill (+A) 400
Accounts payable (+L) 120
Notes payable (+L) 270
Other liabilities (+L) 90
Investment in Sad Co. (-A) 2,800

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 Acquisition with Bargain Purchase

Pit Corp. issues 80,000 shares of its $10 par

common stock with a market value of $20
per share, and it also gives a 10%, five-year
note payable for $400,000 for the net assets
of Sad Co.
Fair value of net assets
$2,400
acquired (in thousands)
Total consideration at fair value
$2,000
(80 shares x $20) + $400
Gain from bargain purchase $400

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 Entries with Bargain Purchase

The entry to record the acquisition of the net

assets:
Investment in Sad Co. (+A) 2,000

10% Note payable (+L) 400

Common stock, $10 par (+SE) 800

Additional paid-in-capital (+SE) 800

The entry to record Sad’s assets directly on

Pit’s books:

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 Cash (+A) 100

Net receivables (+A) 280

Inventories (+A) 500

Land (+A) 200

Buildings (+A) 1,000

Equipment (+A) 700

Patents (+A) 100

Accounts payable (+L) 120

Notes payable (+L) 270

Other liabilities (+L) 90

Investment in Sad Co. (+A) 2,000

Gain from bargain purchase (G, +SE) 400

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 Business Combinations

5: OTHER ISSUES:
IMPAIRMENTS,
DISCLOSURES, AND THE
SARBANES-OXLEY ACT

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 Goodwill Controversies

Capitalized goodwill is the purchase price not

assigned to identifiable assets and liabilities.
– Errors in valuing assets and liabilities affect the
amount of goodwill recorded.
Historically goodwill in most industrialized
countries was capitalized and amortized.
Current IASB standards, like U.S. GAAP
– Capitalize goodwill,
– Do not amortize it, and
– Test it for impairment

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 Goodwill Impairment Testing

Firms must test for the impairment of

goodwill at the business unit reporting level.
– Step 1: Compare the unit’s net book value to its
fair value to determine if there has been a loss
in value.
– Step 2: Determine the implied fair value of the
goodwill, in the same manner used to originally
record the goodwill, and compare that to the
goodwill on the books.
Record a loss if the implied fair value is less
than the carrying value of the goodwill.

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 When to Test for Impairment

Goodwill should be tested for impairment at

least annually.
More frequent testing may be needed:
Significant adverse change in business
– Adverse action by regulator
– Unanticipated competition
– Loss of key personnel
Impairment or expected disposal losses of:
– Reporting unit or part of one
– Significant long-lived asset group
– Subsidiary

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 Business Combination Disclosures

Business combination disclosures include, but

are not limited to:
– Reason for combination,
– Nature and amount of consideration,
– Allocation of purchase price among assets and
liabilities,
– Pro-forma results of operations, and
– Goodwill or gain from bargain purchase

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 Intangible Asset Disclosures

Specific disclosures are needed:

– In the fiscal period when intangibles are
acquired,
– Annually, for each period presented, and
– In the fiscal period that includes an impairment

Disclosures are needed for:

– Intangibles which are amortized,
– Intangibles which are not amortized,
– Research & development acquired, and
– Intangibles with renewal or extension terms
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 Sarbanes-Oxley Act of 2002

Establishes the PCAOB

Requires:
– Greater independence of auditors and clients
– Greater independence of corporate boards
– Independent audits of internal controls
– Increased disclosures of off-balance sheet
arrangements and obligations
– More types of disclosures on Form 8-K

SEC enforces SOX and rules of the PCAOB

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