Advanced accounting 10th by a beams athony ch01

Introduce concepts of accounting for business combinations, emphasizing the acquisition method.. Types of Business CombinationsBusiness combinations unite previously separate business

Chapter 1: Business Combinations

by Jeanne M David, Ph.D., Univ of Detroit Mercy

to accompanyAdvanced Accounting, 10 th edition

by Floyd A Beams, Robin P Clement, Joseph H Anthony, and Suzanne Lowensohn

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: Economic Motivations

Business Combinations

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

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

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

2: Forms of Business Combinations

Business Combinations

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.

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.

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.

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.

3: Accounting for Business

Combinations

Business Combinations

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.

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]

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.

• 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.

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)

Example: Poppy Corp (2 of 3)

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.

Example: Poppy Corp (3 of 3)

4: Cost Allocations Using the

Acquisition Method

Business Combinations

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

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

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

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.

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

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.

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):

Book Val Fair Val.

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

Entries with Goodwill

The entry to record the acquisition of the net

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

Entries with Bargain Purchase

The entry to record the acquisition of the net

• 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.

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

– 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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