ADVANCED FINANCIAL

ACCOUNTING-I

By: Teshale Berhane (Ass.Prof.)

CHAPTER ONE
BUSINESS
COMBINATION
 Introduction
• Business combinations: are 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.
• Firms strive to produce economic value added for
shareholders. Related to this strategy, expansion has long
been regarded as a proper goal of business entities.
• A business may choose to expand either internally
(building its own facilities) or externally (acquiring
control of other firms in business combinations).
• The focus in this chapter will be on why firms
often prefer external over internal expansion
options and how financial reporting reflects
the outcome of these activities.
• In general terms, business combinations unite
previously separate business entities.
• The overriding objective of business
combinations must be increasing profitability;
however, many firms can become more
efficient by horizontally or vertically
integrating operations or by diversifying their
risks through conglomerate operations.
• Horizontal integration is the combination of firms
in the same business lines and markets.
• Vertical integration is the combination of firms with
operations in different, but successive, stages of
production or distribution, or both.
• Conglomeration is the combination of firms with
unrelated and diverse products or service functions,
or both. Firms may diversify to reduce the risk
associated with a particular line of business
 Reasons for Business
combinations
• If expansion is a proper goal of business
enterprise, why would a business expand
through combination rather than by building
new facilities? Among the many possible
reasons are the following:
• Cost Advantage:- It is frequently less expensive
for a firm to obtain needed facilities through
combination than through development.
• For E.g. If a company, having no facilities for
research and development, is combining with
another co. having the facility, the cost for the
establishment of the segment could be
reduced.
• Lower Risk:- The purchase of established
product lines and markets is usually less risky
than developing new products and markets.
The risk is especially low when the goal is
diversification.
• Fewer Operating Delays:- Plant facilities acquired in
a business combination are operative and already
meet environmental and other governmental
regulations.
• The time to market is critical, especially in the
technology industry.
• Firms constructing new facilities can expect
numerous delays in construction, as well as in getting
the necessary governmental approval to commence
operations
• Avoidance of Takeovers:- Many companies
combine to avoid being acquired themselves.
Smaller companies tend to be more
vulnerable to corporate takeovers; therefore,
many of them adopt aggressive buyer
strategies to defend against takeover attempts
by other companies.
• Acquisition of Intangible Assets:- Business
combinations bring together both intangible
and tangible resources.
• The acquisition of patents, mineral rights,
research, customer databases, or
management expertise may be a primary
motivating factor in a business combination.
• Other Reasons:- Firms may choose a business
combination over other forms of expansion
for business tax advantages (for example, tax-
loss carry forwards), for personal income and
estate-tax advantages, or for personal reasons.
 Legal form of Business combinations

• Business combination is a general term that

covers all forms of combining previously
separate business entities.
• Such combinations are acquisitions when one
corporation acquires the productive assets of
another business entity and integrates those
assets into its own operations.
• Business combinations are also acquisitions
when one corporation obtains operating
control over the productive facilities of
another entity by acquiring a majority of its
outstanding voting stock.
• The acquired company need not be dissolved;
that is, the acquired company does not have
to go out of existence.
• The terms merger and consolidation are often
used as synonyms for acquisitions.
• However, legally and in accounting there is a
difference.
• A merger entails the dissolution of all but one of
the business entities involved.
• A consolidation entails the dissolution of all the
business entities involved and the formation of a
new corporation.
• A merger occurs when one corporation takes over all
the operations of another business entity and that
entity is dissolved.
• For example, Company A purchases the assets of
Company B directly from Company B for cash, other
assets, or Company A’s securities (stocks, bonds, or
notes).
• This business combination is an acquisition, but it is
not a merger unless Company B goes out of
existence.
• A 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.
• For example, Company C, a newly formed
corporation, may acquire the net assets of
Companies A and B by issuing stock directly to
Companies A and B.
• In this case, Companies A and B may continue
to hold Company C stock for the benefit of
their stockholders (an acquisition), or they
may distribute the Company C stock to their
stockholders and go out of existence (a
consolidation).
• In either case, Company C acquires ownership
of the assets of Companies A and B.
Alternatively, Company C could issue its stock
directly to the stockholders of Companies A
and B in exchange for a majority of their
shares. In this case, Company C controls the
assets of Company A and Company B, but it
does not obtain legal title unless Companies A
and B are dissolved.
• Company C must acquire all the stock of
Companies A and B and dissolve those
companies if their business combination is to
be a consolidation.
• If Companies A and B are not dissolved,
Company C will operate as a holding company,
and Companies A and B will be its subsidiaries.
Ways of Business combinations

• A business combination can be undertaken

either in (1) Friendly takeovers or (2) Hostile
takeovers
• A friendly takeover occurs when one
corporation acquires another with both
boards of directors approving the transaction. 
• A hostile takeover occurs when one
corporation, the acquiring corporation,
attempts to take over another corporation,
the target corporation, without the agreement
of the target corporation’s board of directors.
• A hostile takeover is usually accomplished by a
tender offer or a proxy fight.
• In a tender offer, the corporation seeks to
purchase shares from outstanding
shareholders of the target corporation at a
premium to the current market price. 
• In a proxy fight, the acquiring corporation tries
to persuade shareholders to use their 
proxy votes to install new management or take
other types of corporate action.
• The acquiring corporation may highlight
alleged shortcomings of the target
corporation’s management. The acquiring
corporation seeks to have its own candidates
installed on the board of directors.
• By installing friendly candidates on the board
of directors, the acquiring corporation can
easily make the desired changes at the target
corporation.
 Accounting for combinations as acquisitions

• The four basic steps in the acquisition method are

as follows:
• STEP 1 — Determine the acquirer/combinor/.
• STEP 2 — Determine the acquisition date.
• STEP 3 — Recognize and measure the assets,
liabilities and noncontrolling interest.
• STEP 4 — Recognize and measure any goodwill
or gain from a bargain purchase.
 STEP 1 — Determine the acquirer

• The acquirer/combinor/ often is the party that

pays cash or other assets as part of the
acquisition transaction.
• Factors that may help identify the acquirer
include:
 Who pays cash or other assets as part of the
acquisition transaction
 Who has more voting rights in the combined
entity following the acquisition
 Who is able to elect, appoint or remove
members from the governing body of the
combined entity
 Who takes the lead in managing the combined
entity
 Who is larger (in terms of assets, revenues,
earnings or some other measure)
 Who initiated the acquisition
 STEP 2 — Determine the
acquisition date
• The acquisition date is the date on which the
acquirer obtains control of the
acquiree/combinee/ and the measurement
date for recording the assets acquired and
liabilities assumed in the transaction.
• An acquirer/combinor/ typically obtains
control over an acquiree by exchanging
consideration, such as:
 Transferring cash or other assets
 Incurring liabilities
 Issuing equity interests
 Performing a combination of these
• If an acquirer obtains control of the acquiree
over time, in stages, the business combination
is referred to as a step acquisition.
• For instance, an entity might have a 10%
interest in an investee, but no control, and
then purchase an additional 50% interest in
the investee, gaining control and resulting in a
business combination.
 STEP 3 — Recognize and measure
the assets, liabilities and
noncontrolling interest
• All assets acquired and liabilities assumed in a
business combination must be recognized by
the acquirer in its financial statements.
• This might result in the acquirer recognizing an
asset or liability that was not previously
recognized in the acquiree’s financial
statements, such as a brand name, patent,
customer relationship or other intangible asset
developed internally by the acquiree.
• The acquirer must recognize 100% of the
acquiree’s net assets, even when other parties
retain a noncontrolling interest.
• The general measurement principle for business
combinations is that all assets acquired and
liabilities assumed must be measured at fair
value as of the acquisition date.
• Fair value is the price an entity would receive to
sell an asset — or pay to transfer a liability — in
a transaction that is orderly, takes place
between market participants and occurs at the
acquisition date.
• In practice, entities often use a market approach
(such as a quoted market price) or an income
approach (such as a present value technique).
Regardless of the approach selected, an acquirer
must maximize the use of observable inputs and
minimize the use of unobservable inputs.
• Also, an acquirer must be careful to use
assumptions consistent with those that a market
participant would use.
• An acquirer might incur various transaction
costs related to a business combination.
Examples are finder’s fees, professional or
consulting fees (such as advisory, legal,
accounting or valuation costs), general and
administrative costs (such as those to run
internal departments dedicated to
acquisitions) and costs to register or issue
debt and equity securities.
• These costs are collectively called “acquisition-
related costs.”
• Except costs to register or issue debt and equity
securities, all acquisition-related costs must be
accounted for separately from the business
combination and expensed as incurred.
• In other words, they are not capitalized as part
of the business combination transaction.
• Registration and issuance costs of equity
securities issued in a combination are charged
against the fair value of securities issued,
usually as a reduction of additional paid-in
capital.
• Once an acquirer has identified all of the assets
acquired and liabilities assumed in the business
combination, the acquirer also must determine if a
noncontrolling interest exists.
• The noncontrolling interest represents the portion of
net assets not attributable to the acquirer. In other
words, the portion attributable to other investors.
• The acquirer must measure the noncontrolling
interest at fair value as of the acquisition date.
• The fair value of the noncontrolling interest
often is determined based on the number of
shares held by the noncontrolling interest and
the quoted market price of a share.
• Often, the per-share valuation of the acquirer’s
interest and the noncontrolling interest differ.
This is generally because the per-share
valuation of the acquirer’s interest includes a
control premium.
• The control premium reflects the fact that
market participants typically are willing to pay
more per share for the ability to have control
over an investee.
 STEP 4 — Recognize and measure
any goodwill or gain from
a bargain purchase
• Goodwill is defined as the future economic
benefits arising from the other assets purchased
in a business combination that are not identified
and recognized separately.
• The amount of goodwill is determined using the
fair value of the consideration transferred.
• The basic formula used to calculate goodwill is:
• Goodwill = FV of the consideration transferred +
Noncontrolling interest – FV of net assets acquired
• ILLUSTRATION:
• In a business combination, an acquirer pays
cash consideration of $400,500, acquires
assets with a fair value of $813,400 and
assumes liabilities with a fair value of
$478,020. The acquirer does not hold any
interest in the acquiree prior to the business
combination. Assume that the fair value of the
noncontrolling interest is $27,600.
• The acquirer calculates the amount of
goodwill as follows:
• Goodwill = FV of the consideration transferred
+ Noncontrolling interest — FV of net assets
acquired
• = $400,500 + $27,600 – ($813,400 - $478,020)
• = $92,720
• The acquirer records the following journal
entry to reflect the effects of the business
combination:
Identifiable assets $813,400
Goodwill $92,720
Cash $400,500
Liabilities $478,020
Noncontrolling interest $27,600
• The basic formula to calculate goodwill is
adjusted if a business combination has no
consideration (the case by which he acquirer
and the acquiree agree to combine their
businesses by contract alone) or if the
business combination is achieved in stages.
• For business combinations with no
consideration, the fair value of the acquirer’s
interest in the acquiree is used instead of the
fair value of consideration transferred, as
follows:
• Goodwill = FV of the acquirer’s interest in the
acquiree + Noncontrolling interest – FV of net
assets acquired
• For business combinations achieved in stages,
the fair value of the acquirer’s previously-held
equity interest in the acquiree is added to the
total before subtracting the fair value of net
assets acquired, as follows:
• Goodwill = FV of the consideration transferred +
Noncontrolling interest + FV of the acquirer’s
previously-held equity interest – FV of net assets
acquired
• If the calculation of goodwill results in a negative
balance, the transaction might be a bargain
purchase. In a bargain purchase, the acquirer
essentially buys the net assets of the acquiree at
a discount. Bargain purchases are rare.
• They do, however, arise occasionally. For
instance, a bargain purchase might happen if the
acquiree is under financial distress and must sell
its business to survive.
• Before concluding that a bargain purchase has occurred, an
acquirer is required to revisit steps 3 and 4 of the
acquisition method. Specifically, the acquirer must
reassess:
 Whether it properly identified all assets acquired and
liabilities assumed in the business combination.
 Whether these assets and liabilities were measured
appropriately.
 Whether the other amounts used to compute goodwill,
such as the fair value of the consideration transferred and
noncontrolling interest, were determined correctly.
• If, after this reassessment, the acquirer
concludes that a bargain purchase has taken
place, the acquirer recognizes a gain on the
bargain purchase.
• A gain from a bargain purchase is immediately
recognised in profit or loss.
 CONTINGENT CONSIDERATION IN AN ACQUISITION

• Contingent consideration exists if the consideration

transferred in the business combination is
contingent upon the occurrence of specific future
events or changes in circumstances.
• Contingent consideration must be included as part
of the consideration transferred in the business
combination.
• The contingent consideration is measured at its fair
value as of the acquisition date.
• In practice, this requires the acquirer to
estimate the amount of consideration it will be
liable for when the contingency is resolved in
the future.
• The contingent consideration can be classified
as equity or as a liability.
• An acquirer may agree to issue additional
shares of stock to the acquiree if the acquiree
meets an earnings goal in the future.
• Then, the contingent consideration is in the
form of equity. At the date of acquisition, the
Investment and Paid-in Capital accounts are
increased by the fair value of the contingent
consideration.
• Alternatively, an acquirer may agree to pay
additional cash to the acquiree if the acquiree
meets an earnings goal in the future.
• Then, the contingent consideration is in the
form of a liability. At the date of the
acquisition, the Investment and Liability
accounts are increased by the fair value of the
contingent consideration.
• The accounting treatment of subsequent changes in
the fair value of the contingent consideration
depends on whether the contingent consideration is
classified as equity or as a liability.
• If the contingent consideration is in the form of
equity, the acquirer does not remeasure the fair
value of the contingency at each reporting date until
the contingency is resolved. When the contingency
is settled, the change in fair value is reflected in the
equity accounts.
• If the contingent consideration is in the form
of a liability, the acquirer measures the fair
value of the contingency at each reporting
date until the contingency is resolved.
Changes in the fair value of the contingent
consideration are reported as a gain or loss in
earnings, and the liability is also adjusted.