Beams, Advanced Accounting 10e, Ch.

1 11-Sep-11

Business Combinations: Objectives

Chapter 1: Business Combinations
by Jeanne M. David, Ph.D., Univ. of Detroit Mercy
to accompany
Advanced Accounting, 10th edition
by Floyd A. Beams, Robin P. Clement,
Joseph H. Anthony, and Suzanne Lowensohn
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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 make cost allocations in an
acquisition method combination.
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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,
Business Combinations but successive stages of production or
1: Economic Motivations distribution, or both
• Conglomeration – unrelated and diverse
products or services

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Reasons for Combinations Potential Prohibitions/ Obstacles

• Cost advantage • Antitrust
• Lower risk – Federal Trade Commission prohibited
• Fewer operating delays Staples’ acquisition of Office Depot
• Avoidance of takeovers • Regulation
• Acquisition of intangible assets – Federal Reserve Board
• Other: business and other tax advantages, – Department of Transportation
personal reasons – Federal Communications Commission
• Some states have antitrust exemption laws to
protect hospitals

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

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Beams, Advanced Accounting 10e, Ch.1
Mergers: A + B = A
1) Company A purchases the 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.
2) Company A purchases Company B stock from
its shareholders for cash, other assets, or
Company A debt/equity securities. Company B
is dissolved. Company A survives with
Company B’s assets and liabilities.
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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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Consolidations: E + F = “D”
1) Company D is formed and acquires the 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.
2) Company D is formed acquires Company E
and F stock from their respective shareholders
by issuing Company D stock. Companies E and
F are dissolved. Company D survives with the
assets and liabilities of both firms.
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Business Combinations
3: Accounting for Business
Combinations
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Beams, Advanced Accounting 10e, Ch.1
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 Statement No. 141, para. 3.e.]
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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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. [IFRS 3]
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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. [ARB 40,
APB Opinion 16]
• Combinations initiated after June 30, 2001, use the
purchase method. [FASB Statement No. 141]
• Firms should use the acquisition method for
business combinations occurring in fiscal periods
beginning after December 15, 2008 [FASB Statement
No. 141R]
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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) Example: Poppy Corp. (1 of 3)

• When the acquiring firm transfers its assets other Poppy Corp. issues 100,000 shares of its $10 par
than cash as part of the combination, any gain or value common stock for Sunny Corp. Poppy’s
loss on the disposal of those assets is recorded in stock is valued at $16 per share. (in thousands)
current income.
• The excess of cash, other assets and equity securities Investment in Sunny Corp. 1,600
transferred over the fair value of the net assets Common stock, $10 par 1,000
(A – L) acquired is recorded as goodwill. Additional paid-in-capital 600
• If the net assets acquired exceeds the cash, other
assets and equity securities transferred, a gain on
the bargain purchase is recorded in current income.
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Example: Poppy Corp. (2 of 3) Example: Poppy Corp. (3 of 3)

Poppy Corp. pays cash for $80,000 in finder’s fees
and consulting fees and for $40,000 to register Receivables XXX
and issue its common stock. (in thousands)
Inventories XXX
Investment expense 80
Plant assets XXX
Additional paid-in-capital 40
Goodwill XXX
Cash 120
Accounts payable XXX
Sunny Corp. is assumed to have been dissolved. So, Notes payable XXX
Poppy Corp. will allocate the investment’s cost to
Investment in Sunny Corp. 1,600
the fair value of the identifiable assets acquired
and liabilities assumed. Excess cost is goodwill.
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Beams, Advanced Accounting 10e, Ch.1
Business Combinations
4: Cost Allocations Using the
Acquisition Method
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Assign Fair Values to Net Assets
Use fair values determined, in preferential order,
by:
1. Established market prices
2. Present value of estimated future cash
flows, discounted based on observable
measures
3. Other internally derived estimations
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Identify the Net Assets Acquired
Identify:
1. Tangible assets acquired,
2. Intangible assets acquired, and
3. 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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Exceptions to Fair Value Rule
• Deferred tax assets and liabilities [FASB
Statement No. 109 and FIN No. 48]
• Pensions and other benefits [FASB Statement No.
158]
• Operating and capital leases [FASB Statement
No. 13 and FIN. No. 21]
• Goodwill on the books of the acquired firm is
assigned no value.
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Beams, Advanced Accounting 10e, Ch.1
Goodwill
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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Recording Contingent Consideration
• Contingencies based on future earnings
increase the cost of the investment.
• Contingencies based on future security prices
do not change the cost of the investment.
Additional consideration distributed is recorded
at its fair value with an offsetting write-down of
the equity or debt securities issued.
In some cases the contingency may involve a
return of consideration.
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Contingent Consideration
• If the fair value of contingent consideration is
determinable at the acquisition date, it is
included in the cost of the combination.
• If the fair value of the contingent consideration
is not determinable at that date, it is recognized
when the contingency is resolved.
• Types of consideration contingencies:
– Future earnings levels
– Future security prices
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Example – Pitt Co. Data
Pitt Co. acquires the net assets of Seed Co. in a
combination consummated on 12/27/2008. The
assets and liabilities of Seed Co. on this date, at
their book values and fair values, are as follows
(in thousands):
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Beams, Advanced Accounting 10e, Ch.1 11-Sep-11

Book Val. Fair Val.

Cash $ 50 $ 50
Net receivables 150 140
Acquisition with Goodwill
Inventory 200 250
Pitt Co. pays $400,000 cash and issues 50,000
Land 50 100
Buildings, net 300 500
shares of Pitt Co. $10 par common stock with a
Equipment, net 250 350 market value of $20 per share for the net assets
Patents 0 50 of Seed Co.
Total assets $1,000 $1,440 Total consideration at fair value (in thousands):
Accounts payable $ 60 $ 60 $400 + (50 shares x $20) $1,400
Notes payable 150 135 Fair value of net assets acquired: $1,200
Other liabilities 40 45 Goodwill $ 200
Total liabilities $ 250 $ 240
Net assets $ 750 $1,200
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Cash 50
Net receivables 140
Entries with Goodwill Inventories 250
The entry to record the acquisition of the net Land 100
assets: Buildings 500
Investment in Seed Co. 1,400 Equipment 350
Cash 400 Patents 50
Common stock, $10 par 500 Goodwill 200
Additional paid-in-capital 500 Accounts payable 60
The entry to record Seed’s assets directly on Pitt’s Notes payable 135
books: Other liabilities 45
Investment in Seed Co. 1,400
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Acquisition with Bargain Purchase Entries with Bargain Purchase

Pitt Co. issues 40,000 shares of its $10 par The entry to record the acquisition of the net
common stock with a market value of $20 per assets:
share, and it also gives a 10%, five-year note Investment in Seed Co. 1,000
payable for $200,000 for the net assets of Seed 10% Note payable 200
Co.
Common stock, $10 par 400
Fair value of net assets acquired (in thousands):
$1,200 Additional paid-in-capital 400
Total consideration at fair value: The entry to record Seed’s assets directly on Pitt’s
(40 shares x $20) + $200 $1,000 books:
Gain from bargain purchase $ 200
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Cash 50
Net receivables 140
Goodwill Controversies
Inventories 250
Land 100 • Capitalized goodwill is the purchase price not
Buildings 500 assigned to identifiable assets and liabilities.
Equipment 350 – Errors in valuing assets and liabilities affect
the amount of goodwill recorded.
Patents 50
• Historically goodwill in most industrialized
Accounts payable 60 countries was capitalized and amortized.
Notes payable 135 • Current IASB standards, like U.S. GAAP
Other liabilities 45 – Capitalize goodwill,
Investment in Seed Co. 1,000 – Do not amortize it, and
Gain from bargain purchase 200 – Test it for impairment.
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Beams, Advanced Accounting 10e, Ch.1
Impairments
• Firms must test annually for the impairment of
goodwill at the business unit reporting level.
– If the unit’s book value exceeds its fair value,
additional tests must be performed to
determine the impairment of goodwill and/or
other assets.
• More frequent testing for goodwill impairment
may be needed (e.g., loss of key personnel,
unanticipated competition, goodwill
impairment of subsidiary).
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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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Business Combination Disclosures
• FASB Statement No. 141R and 142 prescribe
disclosures for business combinations and
intangible assets. This includes, but is not
limited to:
– Reason for combination,
– Allocation of purchase price among assets
and liabilities,
– Pro-forma results of operations, and
– Goodwill or gain from bargain purchase.
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