Concepts of Bus. Combin

2-1 Concepts of Bus. Combin.
- 1
Business Combinations
“A business “A business
combination occurs combination occurs
when two or more when an enterprise
companies join under acquires net assets that
common control, constitute a business or
meaning the ability to equity interests of one
direct policies and or more other
management.” enterprises and obtains
control over that
- - BAKER, et.al. enterprise or
enterprises.”
- - SFAS No. 141
Concepts of Bus. Combin. - 2
MOTIVATION FOR BUSINESS

COMBINATIONS
 Growth
– New markets
– Increase in market share
 Reduction in operating costs
 Diversification
 Tax reasons
 Management incentives
BUSINESS COMBINATIONS
Economic Substance
 Horizontal combinations
 Vertical combinations (integration)
 Conglomerates
Legal Form
 Merger
 Consolidation (Statutory)
 Acquisition
 Variable interests
Types of Business Combinations
Merger
P Company
P Company
S Company
Statutory
Consolidation
P Company
X Company
S Company
Stock Acquisition
P Company P Company
&
S Company S Company
2-8 Concepts of Bus. Combin. Exh.
- 8
2-2
Type of Business Combinations

Action of Acquiring Action of Acquired
Combination Company Company
Statutory merger Acquires assets & Dissolves and goes out of
through asset often liabilities. business.
acquisition
Statutory merger Acquires all stock and Dissolves as a separate
through capital then transfers assets corporation, often
stock acquisition & liabilities to its own remaining as a division of
books the acquiring company
Statutory Newly created to Original companies may
consolidation receive assets or dissolve while remaining as
through capital capital stock of separate divisions of newly
stock or asset original companies created company.
acquisition.
Continued
2-9 Concepts of Bus. Combin. Exh.
- 9
2-2
Business
Type of
Combination
Combinations
Action of Acquiring
Company
– Continued
Action of Acquired
Company
Acquisition of more Acquires stock that is Remains in existence as a
than 50% of the recorded as an legal corporation, although
voting stock. investment. Controls now a subsidiary of the
decision making of acquiring company.
acquired company.
Control though A sponsoring firm Remains in existence as a
ownership of creates an entity - separate legal entity - often
variable interests. often referred to as a trust or partnership.
Risks and rewards an SPE - to engage in
often flow to a a specific activity.
sponsoring firm
rather than the
equity holders.
2-10 Concepts of Bus. Combin. - 10
A Control Issue – SPE’s
 Special Purpose Entities (a popular type of “variable

interest entity”) were misused to hide debt and
manipulate earnings
 As a result, the FASB (in FIN 46R) expanded the definition
of “control” beyond just the holding of a majority share
position.
 The following indicate a controlling financial interest in a
variable interest entity:
– Direct or indirect ability to make decisions about the
entity’s activities
– Obligation to absorb any expected losses of the entity
– The right to receive any expected residuals of the
entity
What is to be consolidated?
 If dissolution occurs:
All account balances are actually
consolidated in the financial records of the
survivor.
 If separate incorporation maintained:

Financial statement information is consolidated on
work papers and not in the actual records
When does consolidation occur?
– Permanent consolidation occurs at the
combination date

– Consolidation (on work papers, not in the actual records!!)
occurs regularly, whenever financial statements are
prepared
How does consolidation affect the

accounting records?
– Dissolved company’s records are closed out.
– Surviving company’s accounts are adjusted to include all
balances of the dissolved company

– Each company continues to maintain its own records
Method of Accounting
 Acquisition
 Purchase
 Pooling of interests
Accounting for Combinations

June 30, 2001 Calendar 2009
Purchase Purchase Acquisition

OR only only
Pooling (Not retroactive) (Not retroactive)
Selection based on All new combinations All new combinations

specific criteria must use Purchase must use Acquisition
for Pooling (no adjustment of (no adjustment of
older results) older results)
Pooling
Purchase
Acquisition
Horizontal
Vertical
Conglomerate
Merger Statutory Stock

Consolidation Acquisition
The Acquisition Method
 A replacement for the Purchase Method

 Requires measurement of fair value of
the acquired business as a whole
 Requires measurement and recognition
of the fair values of the separately
identified assets acquired and liabilities
assumed
Acquisition Methods – Key Changes
 Adopts a “business fair value” measurement

approach as opposed to the traditional “cost-based”
measure
 Direct combination costs will be expensed as incurred
 Contingent consideration obligations are recognized
as part of the purchase price
 With bargain purchases, no assets will be recorded at
less than fair value, which will produce recognized
gains on purchase
 Allows for capitalization of Purchased In-Process
Research and Development (IPR&D)
Capitalization of In-Process Research and

Development Costs (IPR&D)
 To be recognized and measured at fair

value on the acquisition date
 Reported as intangible assets with
indefinite lives
 Subject to periodic “impairment
reviews”
Related Costs of Business Combinations

(Acquisition Method)
 Costs incurred for outside services (attorneys,

appraisers, accountants, investment bankers,
etc.) related to the combination are NOT
considered part of the fair value received,
and so are immediately expensed
 Internal costs of acquisition (secretarial and
management time) are expensed as incurred.
 Costs to register and issue securities related
to the acquisition reduce their fair value
Acquisition Method - Summary

Consideration transferred Assets acquired and liabilities
equals fair values of net assumed are recorded at
assets acquired their fair values
Consideration transferred is Assets acquired and liabilities

greater than the fair values of assumed are recorded at
net assets acquired their fair values. Excess
consideration recorded as
goodwill
Consideration transferred is Assets acquired and liabilities
less than the fair values of assumed are recorded at
net assets acquired their fair values. Excess of
fair value over consideration
is recorded as gain on
bargain purchase
Purchase Method – SFAS 141
 Employed when there is a

change in ownership
When the
resulting in control of one acquisition is made
enterprise by another. by issuing stock,
 The appropriate valuation the cost of the
basis for any purchase acquisition equals
transaction is “cost”. the MARKET
(Total value assigned to the VALUE of the stock
net assets received issued.
equals the total cost of
the acquisition.)
Accounting Challenge!!!
 Allocation of “cost of acquisition” among the

various assets and liabilities obtained.
 Allocation depends on the relation between
total cost and “fair value” of the acquired
firm’s assets and liabilities.
FASB defines fair value as “the price that would be
received to sell an asset or paid to transfer a liability
in an orderly transaction of market participants at the
measurement date.” (FASB, Statement of Financial
Accounting Standards No. 157, Fair Value
Measurements)
“Direct Costs” of Combination
 Typically includes fees to the following

for advising services in arranging and
structuring the combination:
– Investment bankers
– Accountants
– Attorneys
These must be included in determining the

purchase “cost.”
Purchase Method Situations
 Dissolution of the acquired

company:
Purchase Price = Fair Value
Purchase Price > FV
Purchase Price < FV
 Separate incorporation
maintained.
Purchase Method - Dissolution

Purchase Price = Fair Value
 Ignore the Equity and Nominal
accounts of the acquired
company.
 Determine fair value of the
acquired company’s assets and
liabilities.
 Prepare a journal entry to
– recognize the cost of acquisition
– incorporate the FV of the acquired
company’s assets and liabilities into
the acquiring company’s books.

Purchase Price > Fair Value
 FV of acquired company’s Note: Goodwill

assets and liabilities is added should be viewed
as a residual
to acquiring company’s books. amount
remaining after
all other
 Difference between identifiable and
Acquisition Cost and FV of separable
acquired assets and liabilities intangible assets
is allocated to identifiable have been
recognized.
intangible assets and to
goodwill.

Purchase Price < Fair Value
 When fair value exceeds cost,

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

 According to SFAS 141, the following non-
current assets are exceptions to the
proportionate reduction, and should be
recorded at assessed fair values:
– Financial assets other than equity method

investments
– Assets to be disposed of by sale
– Deferred tax assets
– Prepaid assets related to pension or other post-
retirement benefit plans

In the event that the difference is

substantial enough to eliminate all
the non-current asset balances of
the acquired company . . .
. . . The remainder is to be
reported as an extraordinary gain
(SFAS 141)
Accounting for Additional Costs

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

(additional internal costs
such as secretarial or
managerial time)
Costs to register and issue Reduce the value assigned

securities to the fair value of the
securities issued (typically
as a debit to APIC)
Let’s see what happens

when the acquired company
is not dissolved.
Purchase Method - No Dissolution
 The acquired company continues as a

separate entity.
– Reported on Parent’s books as the
Investment in Subsidiary account.
 Separate records for each company are still
maintained.
 The adjusted balances for the Parent and
the Subsidiary are consolidated using a
worksheet (no formal journal entries!)
Steps for Consolidation

1. Record the financial information for
both Parent and Sub on the worksheet.
2. Remove the Investment in Sub balance.
3. Remove the Sub’s equity account

balances.
4. Adjust the Sub’s net assets to FV.
5. Allocate any excess of cost over BV to
identifiable, separable intangible assets
or goodwill.
6. Combine all account balances.
Purchase Price Allocations -

Additional Issues, SFAS No. 141
 Intangibles
– Current and noncurrent assets
that lack physical substance.
– Do not include financial
instruments.
 When should an Intangible be
recognized?
– Does it arise from contractual
or other legal rights?
– Can it be sold or otherwise
separated from the acquired
enterprise?
2-36 Concepts of Bus. Combin. -Exh.
36
2-7

Intangible Asset Examples
 Databases
 Customer Base
 Technological know-
 Trademarked Brand Names how
 Customer Routes  Patents & Copyrights
 Effective Advertising  Strong labor relations
Programs
 Assembled, trained
 Covenants workforce
 Rights (broadcasting,  Favorable government
development, use, etc.) relations

 In-Process R&D
– Should be expensed immediately
upon acquisition (unless there
are alternative future uses.)
 IPR&D that has reached
technological feasibility, may be
“capitalized”.
– Determination of fair value is
critical.
Unconsolidated Subsidiaries
When can a Parent exclude a 50%
owned subsidiary from consolidation?
When control does not

actually rest with the 50%
owners.
SFAS No. 94
Pooling of Interests
Historically, many business

combinations were accounted
for as “Pooling of Interests.”
In SFAS 141, “Business
Combinations”, the FASB
stated that all business
combinations should be
accounted for using the
“Purchase Method”.
Pooling of Interest
POOLING OF INTERESTS
What is essential
for a combination to
be viewed as a
An exchange of
pooling of interest?
common stock.
Pooling of Interests
According to SFAS No. 141, the purchase

method is not to be applied to past
“Poolings of Interest.”
Past poolings of interests are left intact by
SFAS No. 141.
Therefore, it is important to understand
how to account for PAST poolings.
Historical Review of Pooling of

Interests
In a pooling, one  The ownership interests of
company obtained two, or more, companies
essentially “all” of the were combined into one new
other company’s company.
stock.  No single company was
dominant.
 Precise cost figures were
The transaction
difficult to obtain.
involved the
exchange of common  To use pooling of interests,
stock. No exchange 12 strict criteria had to be
of cash was allowed. met.
CRITERIA FOR POOLING
APB No. 16
 Attributes of combining companies
- Autonomous
- Independent of one another
 Manner of achieving combination
- Single transaction
- Common stock for Common stock
- For “substantially all” common stock (90%)
 Absence of planned transactions
- Planned spin-off of assets
- Contingent agreements
Historical Review of Pooling of

Interests
The Book Values of the two

combining companies were
joined. No Goodwill was
recorded.
Revenues and expenses were

combined retroactively for the
two companies.
Accounting Considerations
 Combination of ownership interests
- NOT AN ACQUISITION
 NO TRANSACTION by the corporate entities

- No new basis of accountability
- Total combined net assets unchanged
 NO CHANGE in total combined stockholders’ equity

Reallocation of individual accounts may be required
 Retained earnings accounts combined
 Earnings - combined for entire year of pooling
 Direct combination expenses = period expenses

Assets
+ Assets = Assets Par
RE
Liab. + Liab. = Liabilities Par

OCC
Par Par RE
Stockholders’
OCC + OCC = Equity
RE RE Par
OCC
RE
Total par issued vs. Total par exchanged

Summary
 Consolidation of financial information is required

when one organization gains control of another.
 If dissolution occurs, this consolidation is carried out
at the date of acquisition and a single set of
accounting records is maintained.
 If separate identities are maintained, consolidation is
a periodic “worksheet” process not involving journal
entries. Separate accounting records are maintained.
 The purchase method is currently GAAP, although the
FASB has proposed changing to the Acquisition
Method
Possible Criticisms
 The proposed “business fair value”

measurement approach involves a
departure from traditional “cost-based”
measurement. This violates the Historic
Cost Principle.
 The proposed capitalization of IPR&D
departs from the traditional SFAS 2
approach of expensing R&D as incurred.
WHAT DO YOU THINK?

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2-1 Concepts of Bus. Combin.

MOTIVATION FOR BUSINESS

 Vertical combinations (integration)

Type of Business Combinations

A Control Issue – SPE’s

 Special Purpose Entities (a popular type of “variable

 If separate incorporation maintained:

When does consolidation occur?

 If separate incorporation maintained:

How does consolidation affect the

 If separate incorporation maintained:

Accounting for Combinations

Purchase Purchase Acquisition

Selection based on All new combinations All new combinations

Merger Statutory Stock

The Acquisition Method

 A replacement for the Purchase Method

Acquisition Methods – Key Changes

 Adopts a “business fair value” measurement

Capitalization of In-Process Research and

 To be recognized and measured at fair

Related Costs of Business Combinations

 Costs incurred for outside services (attorneys,

Acquisition Method - Summary

Consideration transferred is Assets acquired and liabilities

Purchase Method – SFAS 141

 Employed when there is a

 Allocation of “cost of acquisition” among the

“Direct Costs” of Combination

 Typically includes fees to the following

These must be included in determining the

Purchase Method Situations

 Dissolution of the acquired

Purchase Method - Dissolution

Purchase Method - Dissolution

 FV of acquired company’s Note: Goodwill

Purchase Method - Dissolution

 When fair value exceeds cost,

Purchase Method - Dissolution

– Financial assets other than equity method

Purchase Method - Dissolution

In the event that the difference is

Accounting for Additional Costs

Indirect combination costs Expense as incurred

Costs to register and issue Reduce the value assigned

Let’s see what happens

Purchase Method - No Dissolution

 The acquired company continues as a

Steps for Consolidation

2. Remove the Investment in Sub balance.

3. Remove the Sub’s equity account

Purchase Price Allocations -

Purchase Price Allocations -

Purchase Price Allocations -

When control does not

Historically, many business

According to SFAS No. 141, the purchase

Historical Review of Pooling of

Historical Review of Pooling of

The Book Values of the two

Revenues and expenses were

 NO TRANSACTION by the corporate entities

 NO CHANGE in total combined stockholders’ equity