1-1 Chapter 1: Business Combinations

1-2 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.

1-3 1: Economic Motivations Business Combinations

1-4 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

1-5 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

1-6 2: Forms of Business Combinations Business Combinations

1-7 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.

1-8 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.

1-9 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.

1-10 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). “Consolidation” is also an accounting term used to describe the process of preparing consolidated financial statements for a parent and its subsidiaries.

1-11 3: Accounting for Business Combinations Business Combinations

1-12 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…” A parent – subsidiary relationship is formed when: –Less than 100% of the firm is acquired, or –The acquired firm is not dissolved.

1-13 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.

1-14 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.

1-15 Example: Poppy Corp. (1 of 3) Investment in Sunny Corp.1,600 Common stock, $10 par 1,000 Additional paid-in-capital 600 Poppy Corp. issues 100,000 shares of its $10 par value common stock for Sunny Corp. Poppy’s stock is valued at $16 per share. (in thousands)

1-16 Example: Poppy Corp. (2 of 3) Investment expense80 Additional paid-in-capital40 Cash 120 Poppy Corp. pays cash for $80,000 in finder’s 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 investment’s cost to the fair value of the identifiable assets acquired and liabilities assumed. Excess cost is goodwill.

1-17 Example: Poppy Corp. (3 of 3) ReceivablesXXX InventoriesXXX Plant assetsXXX GoodwillXXX Accounts payable XXX Notes payable XXX Investment in Sunny Corp. 1,600

1-18 4: Cost Allocations Using the Acquisition Method Business Combinations

1-19 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

1-20 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

1-21 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.

1-22 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

1-23 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.

1-24 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):

1-25 Book Val.Fair Val. Cash$ 50$ 50 Net receivables Inventory Land Buildings, net Equipment, net Patents 0 50 Total assets$1,000$1,440 Accounts payable$ 60$ 60 Notes payable Other liabilities Total liabilities$ 250$ 240 Net assets$ 750$1,200

1-26 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 $ 200 Goodwill$ 200

1-27 Entries with Goodwill The entry to record the acquisition of the net assets: The entry to record Seed’s assets directly on Pitt’s books: Investment in Seed Co.1,400 Cash 400 Common stock, $10 par 500 Additional paid-in-capital 500

1-28 Cash50 Net receivables140 Inventories250 Land100 Buildings500 Equipment350 Patents50 Goodwill200 Accounts payable 60 Notes payable 135 Other liabilities 45 Investment in Seed Co. 1,400

1-29 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

1-30 Entries with Bargain Purchase The entry to record the acquisition of the net assets: The entry to record Seed’s assets directly on Pitt’s books: Investment in Seed Co.1,000 10% Note payable 200 Common stock, $10 par 400 Additional paid-in-capital 400

1-31 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

1-32 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.

1-33 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).