Business Combinations

1 - 1©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn

Business Combinations

Chapter 1


Learning Objective 1

Understand the economic

motivations underlying

business combinations.


Business Combinations

A business combination occurs whentwo or more separate businesses join

into a single accounting entity.


Reasons for Business Combinations

Cost advantage

Lower risk

Fewer operating delays

Avoidance of takeovers

Acquisition of intangible assets

Other reasons



Learn about the alternative

forms of business combinations,

from both the legal and

accounting perspectives.


The Legal Form ofBusiness Combinations

Business Combination

Merger

Acquisitions

Consolidation



A B

AMerger



A B

CConsolidation


The Accounting Concept ofBusiness Combinations

The concept emphasizes the creation of asingle entity and the independence of thecombining companies before their union.

Dissolution of the legal entity is notnecessary within the accounting concept.



Single management



One or more corporations become subsidiaries.

One company transfers its net assets to another.

Each company transfers its net assetsto a newly formed corporation.


Background on Accounting forBusiness Combinations

Much of the controversy concerning accountingrequirements for business combinations historically

involved the pooling of interest method.

ARB No. 40 introduced an alternative method:the purchase method.



Until 2001, accounting requirements for businesscombinations were found in APB Opinion No. 16.

APB No. 16 recognized both the poolingand purchase methods.



FASB Statement No. 141 eliminated thepooling of interest method for transactions

initiated after June 30, 2001.

Combinations initiated after this datemust use the purchase method.

Prior combinations will be grandfathered.



Understand alternative

approaches to the financing

of mergers and acquisitions.


Pooling Method

Pooling uses historical book values to recordcombinations rather than recognizing fairvalues of net assets at the transaction date.

Most of the detailed issues related to poolingsconcern the original recording of the combination.


Purchase Method

Purchase accounting requires the recordingof assets acquired and liabilities assumed attheir fair values at the date of combination.



Introduce concepts of accounting

for business combinations

emphasizing the purchase method.


Accounting for Business Combinations

Under the Purchase Method

Poppy Corporation issues 100,000 shares of$10 par common stock for the net assets of

Sunny Corporation in a purchase combinationon July 1, 2003.

Poppy Corporation issues 100,000 shares of$10 par common stock for the net assets of

Sunny Corporation in a purchase combinationon July 1, 2003.

The market price of Poppy is $16 per shareThe market price of Poppy is $16 per share



Under the Purchase MethodAdditional direct costs:Additional direct costs:

SEC fees $ 5,000Accounting fees $10,000Printing and issuing $25,000

Finder and consulting $80,000

SEC fees $ 5,000Accounting fees $10,000Printing and issuing $25,000

Finder and consulting $80,000

How is the issuance recorded?How is the issuance recorded?



Under the Purchase MethodInvestment in Sunny 1,600,000

Common Stock, $10 par 1,000,000Additional Paid-in Capital 600,000

To record issuance of 100,000 shares of $10 parcommon stock with a market value of $16 per sharein a purchase business combination with Sunny.

Investment in Sunny 1,600,000Common Stock, $10 par 1,000,000Additional Paid-in Capital 600,000

To record issuance of 100,000 shares of $10 parcommon stock with a market value of $16 per sharein a purchase business combination with Sunny.

How are the additional direct costs recorded?How are the additional direct costs recorded?



Under the Purchase Method

Investment in Sunny 80,000Additional Paid-in Capital 40,000

Cash (other assets) 120,000To record additional direct costs of combiningwith Sunny: $80,000 finder’s and consultants’fees and $40,000 for registering and issuingequity securities.

Investment in Sunny 80,000Additional Paid-in Capital 40,000

Cash (other assets) 120,000To record additional direct costs of combiningwith Sunny: $80,000 finder’s and consultants’fees and $40,000 for registering and issuingequity securities.



Under the Purchase MethodThe total cost to Poppy of acquiring

Sunny is $1,680,000.The total cost to Poppy of acquiring

Sunny is $1,680,000.

This is the amount entered into theinvestment in the Sunny account.This is the amount entered into theinvestment in the Sunny account.


Goodwill

Goodwill is an intangible asset that ariseswhen the purchase price to acquire asubsidiary company is greater thanthe sum of the market value of the

subsidiary’s assets minus liabilities.



See how firms make cost

allocations in a purchase

method combination.


Cost Allocation in a PurchaseBusiness Combination

Determine the fair values of all identifiabletangible and intangible assets acquired

and liabilities assumed.

FASB Statement No. 141 provides guidelines for assigning amounts to specific categories

of assets and liabilities.


Cost Allocation in a PurchaseBusiness Combination

No value is assigned to goodwill recordedon the books of an acquired subsidiary.

Such goodwill is an unidentifiable asset.

Goodwill resulting from thecombination is valued directly.


Recognition and Measurement ofIntangible Assets Other than

Goodwill

Recognizable intangibles

Separabilitycriterion

Contractual-legal criterion


Contingent Consideration in aPurchase Business Combination

Contingent consideration that is determinableat the date of acquisition is recorded as

part of the cost of combination.

Future earningslevel

Security prices


Cost and Fair Value Compared

Investment costTotal fair value ofidentifiable assets

less liabilities



Investment cost Net fair value>

Goodwill

2

Identifiable netassets accordingto their fair value

1


Illustration of a PurchaseCombination

Pitt Corporation acquires the net assets ofSeed Company on December 27, 2003.

Pitt Seed



BookValue

AssetsCash $ 50 $ 50Net receivables 150 140Inventories 200 250Land 50 100Buildings, net 300 500 Equipment, net 250 350Patents 50

Total assets $1,000 $1,440

FairValue



BookValue

LiabilitiesAccounts payable $ 60 $ 60 Notes payable 150 135Other liabilities 40 45

Total liabilities $250 $ 240Net assets $ 50 $1,200

FairValue



Pitt pays $400,000 cash and issues 50,000shares of Pitt Corporation $10 par commonstock with a market value of $20 per share.

50,000 × $10 = $500,000


Investment in Seed 1,400,000Cash 400,000Common Stock 500,000Additional Paid-in Capital 500,000

To record issuance of 50,000 shares of $10 parcommon stock plus $400,000 cash in a purchasebusiness combination with Seed Company




Cash 50Net receivable 140Inventories 250Land 100Buildings, net 500Equipment, net 350Patents 50

Accounts payable 60Notes payable 135Other liabilities 45Investment in Seed Company 1,400

$1640 – 1,440 = 200

Goodwill 200



Pitt issues 40,000 shares of its $10 par commonstock with a market value of $20 per share and

also gives a 10%, five-year note payable for$200,000 for the net assets of Seed Company.

40,000 × $10 = $400,000


Investment in Seed 1,000,000Common Stock 400,000Additional Paid-in Capital 400,00010% Note Payable 200,000

To record issuance of 40,000 shares of $10 parcommon stock plus $200,000, 10% note in apurchase business combination with Seed Company




Cash 50Net receivable 140Inventories 250Land 80Buildings, net 400Equipment, net 280Patents 40

Accounts payable 60Notes payable 135Other liabilities 45Investment in Seed Company 1,000



$1,200,000 fair value is greater than $1,000,000purchase price by $200,000.

Amounts assignable to assets are reduced by 20%.


The Goodwill Controversy

Under FASB Statement No. 142, goodwill is nolonger amortized for financial reporting purposes.

– income tax controversies– international accounting issues


The Goodwill Controversy

Under FASB Statements No. 141 and No. 142, the FASB requires that firms periodically assess

goodwill for impairment of its value.

An impairment occurs when the recorded value of goodwill is less than its fair value.


Recognizing and MeasuringImpairment Losses

Carrying values

Compare

Fair values



Fair value Carrying amount <

Measurement of theimpairment loss


Amortization versusNonamortization

Firms must amortize intangible assets witha finite useful life over that life.

Firms will not amortize intangible assets with an indefinite useful life that cannot be estimated.


End of Chapter 1

Business Combinations

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