Chapter 1: Business Combinations Beams, Advanced Accounting 10e, Ch.1 11/6/2018 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 © Pearson Education, Inc. publishing as Prentice Hall 1-1 (c) Pearson Education Inc., publishing as Prentice Hall 1

Business Combinations: Objectives Understand 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. © Pearson Education, Inc. publishing as Prentice Hall 1-2

1: Economic Motivations Business Combinations 1: Economic Motivations © Pearson Education, Inc. publishing as Prentice Hall 1-3

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 © Pearson Education, Inc. publishing as Prentice Hall 1-4

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 © Pearson Education, Inc. publishing as Prentice Hall 1-5

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 © Pearson Education, Inc. publishing as Prentice Hall 1-6

2: Forms of Business Combinations © Pearson Education, Inc. publishing as Prentice Hall 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. © Pearson Education, Inc. publishing as Prentice Hall 1-8

Mergers: A + B = A 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. 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. © Pearson Education, Inc. publishing as Prentice Hall 1-9

Consolidations: E + F = “D” 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. 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. © Pearson Education, Inc. publishing as Prentice Hall 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). 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. © Pearson Education, Inc. publishing as Prentice Hall 1-11

3: Accounting for Business Combinations © Pearson Education, Inc. publishing as Prentice Hall 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…” [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. © Pearson Education, Inc. publishing as Prentice Hall 1-13

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] © Pearson Education, Inc. publishing as Prentice Hall 1-14

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] © Pearson Education, Inc. publishing as Prentice Hall 1-15

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. © Pearson Education, Inc. publishing as Prentice Hall 1-16

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. © Pearson Education, Inc. publishing as Prentice Hall 1-17

Example: Poppy Corp. (1 of 3) 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) Investment in Sunny Corp. 1,600 Common stock, $10 par 1,000 Additional paid-in-capital 600 © Pearson Education, Inc. publishing as Prentice Hall 1-18

Example: Poppy Corp. (2 of 3) 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. Investment expense 80 Additional paid-in-capital 40 Cash 120 © Pearson Education, Inc. publishing as Prentice Hall 1-19

Example: Poppy Corp. (3 of 3) Receivables XXX Inventories Plant assets Goodwill Accounts payable Notes payable Investment in Sunny Corp. 1,600 © Pearson Education, Inc. publishing as Prentice Hall 1-20

4: Cost Allocations Using the Acquisition Method Business Combinations 4: Cost Allocations Using the Acquisition Method © Pearson Education, Inc. publishing as Prentice Hall 1-21

Identify the Net Assets Acquired 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 © Pearson Education, Inc. publishing as Prentice Hall 1-22

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 observable measures Other internally derived estimations © Pearson Education, Inc. publishing as Prentice Hall 1-23

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. © Pearson Education, Inc. publishing as Prentice Hall 1-24

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. © Pearson Education, Inc. publishing as Prentice Hall 1-25

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 © Pearson Education, Inc. publishing as Prentice Hall 1-26

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. © Pearson Education, Inc. publishing as Prentice Hall 1-27

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): © Pearson Education, Inc. publishing as Prentice Hall 1-28

Book Val. Fair Val. Cash $ 50 $ 50 Net receivables 150 140 Inventory 200 250 Land 50 100 Buildings, net 300 500 Equipment, net 250 350 Patents 0 50 Total assets $1,000 $1,440 Accounts payable $ 60 $ 60 Notes payable 150 135 Other liabilities 40 45 Total liabilities $ 250 $ 240 Net assets $ 750 $1,200 © Pearson Education, Inc. publishing as Prentice Hall 1-29

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 © Pearson Education, Inc. publishing as Prentice Hall 1-30

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 © Pearson Education, Inc. publishing as Prentice Hall 1-31

Cash 50 Net receivables 140 Inventories 250 Land 100 Buildings 500 Equipment 350 Patents Goodwill 200 Accounts payable 60 Notes payable 135 Other liabilities 45 Investment in Seed Co. 1,400 © Pearson Education, Inc. publishing as Prentice Hall 1-32

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 © Pearson Education, Inc. publishing as Prentice Hall 1-33

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 © Pearson Education, Inc. publishing as Prentice Hall 1-34

Gain from bargain purchase 200 Cash 50 Net receivables 140 Inventories 250 Land 100 Buildings 500 Equipment 350 Patents Accounts payable 60 Notes payable 135 Other liabilities 45 Investment in Seed Co. 1,000 Gain from bargain purchase 200 © Pearson Education, Inc. publishing as Prentice Hall 1-35

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. © Pearson Education, Inc. publishing as Prentice Hall 1-36

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). © Pearson Education, Inc. publishing as Prentice Hall 1-37

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. © Pearson Education, Inc. publishing as Prentice Hall 1-38

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 © Pearson Education, Inc. publishing as Prentice Hall 1-39

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