1. Business Combinations
Chapter 1:
Business Combinations
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2. 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 record fair values of assets and liabilities in an acquisition.
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3. 1: Economic Motivations
Business Combinations
1: Economic Motivations
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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
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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
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6. 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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7. 2: Forms of Business Combinations
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8. 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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10. 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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11. 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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12. 3: Accounting for Business Combinations
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13. 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 ]
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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14. 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, [FASB ACS ]
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15. 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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16. 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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17. 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)
1,600
Common stock, $10 par (+SE)
1,000
Additional paid-in-capital (+SE)
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) 80
Additional paid-in-capital (-SE) 40
Cash (-A)
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)
XXX
Inventories (+A)
Plant assets (+A)
Goodwill (+A)
Accounts payable (+L)
Notes payable (+L)
Investment in Son Corp. (-A)
1,600
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21. 4: Recording fair value Using the Acquisition Method
Business Combinations
4: Recording fair value Using the Acquisition Method
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22. 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
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23. 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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24. 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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26. 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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27. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall
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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Book Val.
Fair Val.
Cash
$50
Net receivables
150
140
Inventory
200
250
Land 50
100
Buildings, net
300
500
Equipment, net
350
Patents
Total assets
$1,000
$1,440
Accounts payable
$60
Notes payable
135
Other liabilities 40 45
Total liabilities
$250
$240
Net assets
$750
$1,200
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29. 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: $1,200 Goodwill $ 200
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Entries with Goodwill
The entry to record the acquisition of the net assets: The entry to record Sad’s assets directly on Pit’s books:
Investment in Sad Co. (+A)
1,400
Cash (-A)
400
Common stock, $10 par (+SE)
500
Additional paid-in-capital (+SE)
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31. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall
Cash (+A) 50
Net receivables (+A)
140
Inventories (+A)
250
Land (+A)
100
Buildings (+A)
500
Equipment (+A)
350
Patents (+A)
Goodwill (+A)
200
Accounts payable (+L) 60
Notes payable (+L)
135
Other liabilities (+L) 45
Investment in Sad Co. (-A)
1,400
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32. 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)
$1,200
Total consideration at fair value (40 shares x $20) + $200
$1,000
Gain from bargain purchase
$200
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33. Entries with Bargain Purchase
The entry to record the acquisition of the net assets: The entry to record Sad’s assets directly on Pit’s books:
Investment in Sad Co. (+A)
1,000
10% Note payable (+L)
200
Common stock, $10 par (+SE)
400
Additional paid-in-capital (+SE)
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34. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall
Cash (+A) 50
Net receivables (+A)
140
Inventories (+A)
250
Land (+A)
100
Buildings (+A)
500
Equipment (+A)
350
Patents (+A)
Accounts payable (+L) 60
Notes payable (+L)
135
Other liabilities (+L) 45
Investment in Sad Co. (+A)
1,000
Gain from bargain purchase (G, +SE)
200
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35. 5: Other issues: Impairments, disclosures, and the sarbanes-oxley act
Business Combinations
5: Other issues: Impairments, disclosures, and the sarbanes-oxley act
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36. 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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37. 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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38. 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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39. 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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40. 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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