Chapter 1: Business Combinations

Report
Chapter 1:
Business
Combinations
to accompany
Advanced Accounting, 11th edition
by Beams, Anthony, Bettinghaus, and Smith
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Inc. Publishing as Prentice Hall
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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 record fair values of assets
and liabilities in an acquisition.
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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
 Department of Energy
 Federal Communications Commission
Some states have antitrust exemption laws to
allow hospitals to pursue cooperative projects.
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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
X+Y=X
Company A acquires the net 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.
Company X acquires the stock of Company Y
from its shareholders for cash, other assets,
or Company X debt/equity securities.
Company Y is dissolved. Company X survives
with Company Y’s assets and liabilities.
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Consolidations:
E + F = “D”
K + L = “J”
Company D is formed and acquires the net
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 J is formed and acquires the stock of
companies K and L from their respective
shareholders by issuing Company J stock.
Companies K and L are dissolved. Company J
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 ASC 805-10]
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.
 Combinations initiated after June 30, 2001 use the
purchase method. [FASB ASC 805]
 Firms now use the acquisition method for business
combinations. This began with combinations in
fiscal periods beginning after December 15, 2008.
[FASB ACS 810-10-5-2]
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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.
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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, debt, 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, debt, and equity securities transferred, a
gain on the bargain purchase is recorded in current
income.
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Example: Pop Corp. (1 of 3)
Pop Corp. issues 100,000 shares of its $10 par
value common stock for Son Corp. Pop’s
stock is valued at $16 per share. (in
thousands)
Investment in Son Corp. (+A)
Common stock, $10 par (+SE)
Additional paid-in-capital (+SE)
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1,600
1,000
600
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Example: Pop Corp. (2 of 3)
Pop Corp. pays cash for $80,000 in finder’s and
consulting fees and for $40,000 to register and issue
its common stock. (in thousands)
Investment expense (E, -SE)
Additional paid-in-capital (-SE)
Cash (-A)
80
40
120
Son Corp. is assumed to have been dissolved. So, Pop
Corp. allocates the investment’s cost to the fair value
of the identifiable assets acquired and liabilities
assumed. The excess cost is goodwill.
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Example: Pop Corp. (3 of 3)
Receivables (+A)
Inventories (+A)
Plant assets (+A)
Goodwill (+A)
Accounts payable (+L)
Notes payable (+L)
Investment in Son Corp. (-A)
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XXX
XXX
XXX
XXX
XXX
XXX
1,600
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Business Combinations
4: RECORDING FAIR VALUE
USING THE ACQUISITION
METHOD
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Identify the Net Assets Acquired
Identify:
 Tangible assets acquired,
 Intangible assets acquired, and
 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:
 Established market prices
 Present value of estimated future cash flows,
discounted based on an observable measure, such
as the prime interest rate
 Other internally derived estimations
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Exceptions to Fair Value Rule
Use normal guidance for:
 Deferred tax assets and liabilities
 Pensions and other benefits
 Operating and capital leases
[FASB ASC 740]
Goodwill on the books of the acquired firm is
assigned no value.
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Goodwill
Goodwill is 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
The fair value of contingent consideration is
determined or estimated at the acquisition
date and it is included along with other
consideration given as part of the
combination.
Classifying contingencies:
 Contingent share issuances are equity
 Contingent cash payments are liabilities
Estimated contingencies are revalued to fair
value at each subsequent reporting date.
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Example – Pit Corp. Data
Pit Corp. acquires the net assets of Sad Co. in
a combination consummated on 12/27/2011.
The assets and liabilities of Sad 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
Pit Corp. pays $400,000 cash and issues 50,000
shares of Pit Corp. $10 par common stock
with a market value of $20 per share for the
net assets of Sad Co.
Total consideration at fair value (in thousands):
$400 + (50 shares x $20)
$1,400
Fair value of net assets acquired:
Goodwill
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$1,200
$ 200
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Entries with Goodwill
The entry to record the acquisition of the net
assets:
Investment in Sad Co. (+A)
Cash (-A)
Common stock, $10 par (+SE)
Additional paid-in-capital (+SE)
1,400
400
500
500
The entry to record Sad’s assets directly on
Pit’s books:
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Cash (+A)
Net receivables (+A)
Inventories (+A)
Land (+A)
Buildings (+A)
Equipment (+A)
Patents (+A)
Goodwill (+A)
Accounts payable (+L)
Notes payable (+L)
Other liabilities (+L)
Investment in Sad Co. (-A)
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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
Pit Corp. 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 Sad
Co.
Fair value of net assets acquired
(in thousands)
Total consideration at fair value
(40 shares x $20) + $200
Gain from bargain purchase
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$1,200
$1,000
$200
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Entries with Bargain Purchase
The entry to record the acquisition of the net
assets:
Investment in Sad Co. (+A)
10% Note payable (+L)
Common stock, $10 par (+SE)
Additional paid-in-capital (+SE)
1,000
200
400
400
The entry to record Sad’s assets directly on
Pit’s books:
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Cash (+A)
50
Net receivables (+A)
140
Inventories (+A)
250
Land (+A)
100
Buildings (+A)
500
Equipment (+A)
350
Patents (+A)
50
Accounts payable (+L)
Notes payable (+L)
Other liabilities (+L)
Investment in Sad Co. (+A)
Gain from bargain purchase (G, +SE)
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60
135
45
1,000
200
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Business Combinations
5: OTHER ISSUES:
IMPAIRMENTS,
DISCLOSURES, AND THE
SARBANES-OXLEY ACT
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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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Goodwill Impairment Testing
Firms must test for the impairment of goodwill
at the business unit reporting level.
 Step 1: Compare the unit’s net book value to its fair
value to determine if there has been a loss in value.
 Step 2: Determine the implied fair value of the
goodwill, in the same manner used to originally
record the goodwill, and compare that to the
goodwill on the books.
Record a loss if the implied fair value is less
than the carrying value of the goodwill.
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When to Test for Impairment
Goodwill should be tested for impairment at
least annually.
More frequent testing may be needed:
Significant adverse change in business
 Adverse action by regulator
 Unanticipated competition
 Loss of key personnel
Impairment or expected disposal losses of:
 Reporting unit or part of one
 Significant long-lived asset group
 Subsidiary
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Business Combination Disclosures
Business combination disclosures include, but
are not limited to:
 Reason for combination,
 Nature and amount of consideration,
 Allocation of purchase price among assets and
liabilities,
 Pro-forma results of operations, and
 Goodwill or gain from bargain purchase
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Intangible Asset Disclosures
Specific disclosures are needed:
 In the fiscal period when intangibles are acquired,
 Annually, for each period presented, and
 In the fiscal period that includes an impairment
Disclosures are needed for:
 Intangibles which are amortized,
 Intangibles which are not amortized,
 Research & development acquired, and
 Intangibles with renewal or extension terms
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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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