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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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 make cost allocations in an acquisition method combination.
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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 Federal Communications Commission Some states have antitrust exemption laws to protect hospitals
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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
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 Bs 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 Bs assets and liabilities.
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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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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 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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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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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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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 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.
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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)

Investment in Sunny Corp. Common stock, $10 par Additional paid-in-capital

1,600
1,000 600

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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) Investment expense 80 Additional paid-in-capital 40 Cash 120 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.
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Example: Poppy Corp. (3 of 3)

Receivables Inventories Plant assets Goodwill Accounts payable Notes payable Investment in Sunny Corp.
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XXX XXX XXX XXX XXX XXX 1,600

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Business Combinations

4: Cost Allocations Using the Acquisition Method

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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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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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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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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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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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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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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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Cash Net receivables Inventory Land Buildings, net Equipment, net Patents Total assets Accounts payable Notes payable Other liabilities Total liabilities Net assets
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Book Val. $ 50 150 200 50 300 250 0 $1,000 $ 60 150 40 $ 250 $ 750

Fair Val. $ 50 140 250 100 500 350 50 $1,440 $ 60 135 45 $ 240 $1,200
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Acquisition with Goodwill

Pitt 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) $1,400 Fair value of net assets acquired: $1,200 Goodwill $ 200

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Entries with Goodwill

The entry to record the acquisition of the net assets: Investment in Seed Co. 1,400 Cash 400 Common stock, $10 par 500 Additional paid-in-capital 500 The entry to record Seeds assets directly on Pitts books:
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Cash Net receivables Inventories Land Buildings Equipment Patents Goodwill Accounts payable Notes payable Other liabilities Investment in Seed Co.
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50 140 250 100 500 350 50 200 60 135 45 1,400

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Acquisition with Bargain Purchase

Pitt 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): $1,200 Total consideration at fair value: (40 shares x $20) + $200 $1,000 Gain from bargain purchase $ 200
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Entries with Bargain Purchase

The entry to record the acquisition of the net assets: Investment in Seed Co. 1,000 10% Note payable 200 Common stock, $10 par 400 Additional paid-in-capital 400 The entry to record Seeds assets directly on Pitts books:
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Cash Net receivables Inventories Land Buildings

50 140 250 100 500

Equipment 350 Patents 50 Accounts payable Notes payable Other liabilities Investment in Seed Co. Gain from bargain purchase
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60 135 45 1,000 200

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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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Impairments
Firms 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).
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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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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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