Chapter 1: Business Combinationsby Jeanne M. David, Ph.D., Univ. of Detroit Mercy

to accompany Advanced Accounting, 10th editionby Floyd A. Beams, Robin P. Clement, Joseph H. Anthony, and Suzanne Lowensohn

Business Combinations: ObjectivesUnderstand the economic motivations underlying business combinations.Learn about the alternative forms of business combinations, from both the legal and accounting perspectives.Introduce concepts of accounting for business combinations, emphasizing the acquisition method.See how firms make cost allocations in an acquisition method combination.

1: Economic MotivationsBusiness Combinations

Types of Business CombinationsBusiness combinations unite previously separate business entities.Horizontal integration same business lines and marketsVertical integration operations in different, but successive stages of production or distribution, or bothConglomeration unrelated and diverse products or services

Reasons for CombinationsCost advantageLower riskFewer operating delaysAvoidance of takeoversAcquisition of intangible assetsOther: business and other tax advantages, personal reasons

Potential Prohibitions/ ObstaclesAntitrustFederal Trade Commission prohibited Staples acquisition of Office DepotRegulationFederal Reserve BoardDepartment of TransportationFederal Communications CommissionSome states have antitrust exemption laws to protect hospitals

2: Forms of Business CombinationsBusiness Combinations

Legal Form of CombinationMergerOccurs when one corporation takes over all the operations of another business entity and that other entity is dissolved.ConsolidationOccurs 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.

Mergers: A + B = ACompany 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 Bs assets and liabilities.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 Bs assets and liabilities.

Consolidations: E + F = DCompany 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.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.

Keeping the terms straightIn 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.

3: Accounting for Business CombinationsBusiness Combinations

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, orThe acquired firm is not dissolved.

U.S. GAAP for Business CombinationsSince 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]

International AccountingMost 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]

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.

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 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 and equity securities transferred, a gain on the bargain purchase is recorded in current income.

Example: Poppy Corp. (1 of 3)Poppy Corp. issues 100,000 shares of its $10 par value common stock for Sunny Corp. Poppys stock is valued at $16 per share. (in thousands)

Example: Poppy Corp. (2 of 3)Poppy Corp. pays cash for $80,000 in finders fees and consulting fees and for $40,000 to register and issue its common stock. (in thousands)

Sunny Corp. is assumed to have been dissolved. So, Poppy Corp. will allocate the investments cost to the fair value of the identifiable assets acquired and liabilities assumed. Excess cost is goodwill.

Example: Poppy Corp. (3 of 3)

4: Cost Allocations Using the Acquisition MethodBusiness Combinations

Identify the Net Assets AcquiredIdentify: Tangible assets acquired,Intangible assets acquired, andLiabilities assumedInclude:Identifiable intangibles resulting from legal or contractual rights, or separable from the entityResearch and development in processContractual contingenciesSome noncontractual contingencies

Assign Fair Values to Net AssetsUse fair values determined, in preferential order, by:Established market pricesPresent value of estimated future cash flows, discounted based on observable measuresOther internally derived estimations

Exceptions to Fair Value RuleDeferred 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.

GoodwillThe excess ofThe sum of:Fair value of the consideration transferred, Fair value of any noncontrolling interest in the acquiree, andFair value of any previously held interest in acquiree, Over the net assets acquired.

Contingent ConsiderationIf 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 levelsFuture security prices

Recording Contingent ConsiderationContingencies 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.

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):

Book Val.Fair Val.Cash$ 50$ 50Net receivables 150 140Inventory 200 250Land 50 100Buildings, net 300 500Equipment, net 250 350Patents 0 50 Total assets$1,000$1,440Accounts payable$ 60$ 60Notes payable 150 135Other liabilities 40 45 Total liabilities$ 250$ 240Net assets$ 750$1,200

Acquisition with GoodwillPitt Co. pays $400,000 cash and issues 50,000 shares of Pitt Co. $10 par common stock with a market value of $20 per share for the net assets of Seed Co. Total consideration at fair value (in thousands):$400 + (50 shares x $20) $1,400Fair value of net assets acquired: $1,200Goodwill$ 200

Entries with GoodwillThe entry to record the acquisition of the net assets:

The entry to record Seeds assets directly on Pitts books:

Investment in Seed Co.1,400 Cash 400 Common stock, $10 par 500 Additional paid-in-capital 500

Cash50 Net receivables140 Inventories250 Land100 Buildings500 Equipment350 Patents50 Goodwill200 Accounts payable 60 Notes payable 135 Other liabilities 45 Investment in Seed Co. 1,400

Acquisition with Bargain PurchasePitt Co. issues 40,000 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 $200,000 for the net assets of Seed Co. Fair value of net assets acquired (in thousands): $1,200Total consideration at fair value: (40 shares x $20) + $200 $1,000Gain from bargain purchase$ 200

Entries with Bargain PurchaseThe entry to record the acquisition of the net assets:

The entry to record Seeds assets directly on Pitts books:

Investment in Seed Co.1,000 10% Note payable 200 Common stock, $10 par 400 Additional paid-in-capital 400

Cash50 Net receivables140 Inventories250 Land100 Buildings500 Equipment350 Patents50 Accounts payable 60 Notes payable 135 Other liabilities 45 Investment in Seed Co. 1,000 Gain from bargain purchase200

Goodwill ControversiesCapitalized 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. GAAPCapitalize goodwill,Do not amortize it, andTest it for impairment.

ImpairmentsFirms must test annually for the impairment of goodwill at the business unit reporting level.If the units 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).

Business Combination DisclosuresFASB 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, andGoodwill or gain from bargain purchase.

Sarbanes-Oxley Act of 2002Establishes the PCAOBRequires Greater independence of auditors and clientsGreater independence of corporate boardsIndependent audits of internal controlsIncreased disclosures of off-balance sheet arrangements and obligationsMore types of disclosures on Form 8-KSEC enforces SOX and rules of the PCAOB

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