Advanced Accounting

Thirteenth Edition, Global Edition

Chapter 1
Business Combinations

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Business Combinations: Objectives
1.1 Understand the economic motivations underlying
business combinations.
1.2 Learn about the alternative forms of business
combinations, from both the legal and accounting
perspectives.
1.3 Introduce accounting concepts for business
combinations, emphasizing the acquisition method.
1.4 See how firms record fair values of assets and
liabilities in an acquisition.
1.5 Appendix: (exclude) Review accounting concepts for
a pooling of interests.

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1.1: Economic Motivations
Business Combinations

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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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Reasons for Combinations
– Cost advantage
– Lower risk
– Fewer operating delays
– Avoidance of takeovers
– Acquisition of intangible assets
– Other: business and tax advantages, personal
reasons

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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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1.2: Forms of Business Combinations
Business Combinations

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Legal Forms of Combination
Merger
– One corporation takes over all the operations of
another business entity and that other entity is
dissolved.
Consolidation
– 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
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.

Example: Office Depot acquired Office Max. Office

Depot issued 2.69 share of its stock to Office Max
shareholders.

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Consolidations:
E+F=D
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.

Consolidation had a large effect on banks. Banks

with assets of less than $100 million declined by
85% between 1985 and 1993, while banks with
assets over $10 billion nearly tripled in number.

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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). Other scenarios will be
explored 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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1.3: Accounting for Business
Combinations
Business Combinations

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Business Combination (definition)

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 805-10, IFRS 3]

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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U.S. GAAP for Business Combinations
– Since the 1950s both the pooling of interests
method and the purchase method of accounting
for business combinations became acceptable.
– Combinations initiated after June 30, 2001 use the
purchase method. [FASB ASC 805]
– GAAP requires that all business combinations
initiated after Dec 15, 2008 be accounted using
the acquisition method. [FASB ACS 810-10-5-2]

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International Accounting and IFRS 3

– 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.
– Elimination of pooling in the US made GAAP more
consistent with international accounting standards.
– US GAAP and IFRS 3 are essentially the same
regarding business combination.

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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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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,
then a gain on the bargain purchase is recorded in
current income.

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Example: Pizza.com (1 of 3)
Sept.6, Peter starts an online pizza delivery company
called pizza.com. On the first day, Pizza.com has the
following transactions:
1) Peter transfers $100,000 his personal money into the corporate account.
2) Borrow $100,000 from HSBC.
3) Purchase 5 electric ovens for $100,000.
At the end of first day, the Balance Sheet of Pizza.com:
Assets Liability and Equity
Cash 100,000 Bank loan 100,000
Equipment-oven 100,000 Owner’s equity 100,000
Total assets $200,000 Total L&SE $200,000

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Example: Pizza.com (2 of 3)
Sept.7, Pepsico Inc. talks with Peter about acquiring
Pizza.com. Questions for students:
1) Which part of the balance sheet is acquired by Pepsico? What if Pizza.com
was started by Peter and David
Answer: ownership, or shareholder’s equity is being acquired.
2) If acquired, does Pepsico own the assets and assume the bank loan after
the acquisition?
Answer: Yes.
3) How much should Pepsico pay, or should Peter ask for, in the acquisition?
Where to start the acquisition price?
Answer: The book value of shareholder’s equity=$100,000
Do Pepsico and Peter care for fair value of assets and liability?
Answer: Yes. In this case, FV=BV more likely, but in general, FV≠BV, FV will
be used in acquisition.

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Example: Pizza.com (3 of 3)
4) What about the trademark Pizza.com?
Answer: Yes. The value of trademark, if determined, is an intangible asset
acquired in the transaction.

5) Assuming that Pepsico pays $200,000 to acquire 100% of Pizza.com,

FV=BV. What is the amount of goodwill?
Goodwill = acquisition cost-FV of net assets
= acquisition cost-BV of net assets
=200,000-100,000
=$100,000

6) After the acquisition, Peter receives $200,000 for his ownership with initial
investment $100,000. Peter makes a capital gain or investment income of
$100,000.

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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 blank

Common stock, $10 par (+SE) blank 1,000
Additional paid-in-capital (+SE) blank 600

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Example: Pop Corp. (2 of 3)
Pop Corp. pays cash of $80,000 in finder’s and
consulting fees and $40,000 to register and issue its
common stock (in thousands).

Investment expense (E, -SE) 80 blank

Additional paid-in-capital (-SE) 40 blank
Cash (-A) blank 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 blank
Inventories (+A) XXX blank
Plant assets (+A) XXX blank
Goodwill (+A) XXX blank
Accounts payable (+L) blank XXX
Notes payable (+L) blank XXX
Investment in Son Corp. (-A) blank 1,600

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1.4: Recording Values in an Acquisition
Business Combinations

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Identify the Net Assets Acquired
Identify:
– 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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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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Exceptions to Fair Value Rule
Use normal guidance for:
– Deferred tax assets and liabilities
– Pensions and other benefits
– Operating and capital leases

Goodwill on the books of the acquired firm is

assigned no value. (because all assets and liabilities
are re-valued at the acquisition)

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Goodwill
Goodwill is the excess of the investment cost over
the fair value of net assets received.

Goodwill includes 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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Contingent Consideration
The fair value of contingent consideration is
determined or estimated at the acquisition date, and
it is included along with other considerations 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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Example – Pam Corp. Data
Pam Corp. acquires the net assets of Sun Co. in a
combination consummated on 12/27/2016.
The assets and liabilities of Sun Co. on this date at
their book values and fair values are as follows (in
thousands):

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Example – Sun Co. Data (continued)
Blank Book Value Fair Value
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

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Acquisition with Goodwill
Pam Corp. pays $400,000 cash and issues 50,000
shares of $10 par common stock with a market value
of $20 per share for the net assets of Sun 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:

Investment in Sun Co. (+A) 1,400 blank

Cash (-A) blank 400
Common stock, $10 par (+SE) blank 500
Additional paid-in-capital (+SE) blank 500

The entry to record Sun’s assets directly on Pam’s

books:

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Entries with Goodwill (continued)
Cash (+A) 50 blank
Net receivables (+A) 140 blank
Inventories (+A) 250 blank
Land (+A) 100 blank
Buildings (+A) 500 blank
Equipment (+A) 350 blank
Patents (+A) 50 blank
Goodwill (+A) 200 blank
Accounts payable (+L) blank 60
Notes payable (+L) blank 135
Other liabilities (+L) blank 45
Investment in Sun Co. (-A) blank 1,400

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Acquisition with Bargain Purchase
Pam 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 Sun 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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Entries with Bargain Purchase
The entry to record the acquisition of the net assets:
Investment in Sun Co. (+A) 1,200 blank
10% Note payable (+L) blank 200
Common stock, $10 par (+SE) blank 400
Additional paid-in-capital (+SE) blank 400
Gain on bargain purchase (+E,
+SE) 200
The entry to record Sun’s assets directly on Pam’s
books:

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Entries with Bargain Purchase (continued)
Cash (+A) 50 blank
Net receivables (+A) 140 blank
Inventories (+A) 250 blank
Land (+A) 100 blank
Buildings (+A) 500 blank
Equipment (+A) 350 blank
Patents (+A) 50 blank
Accounts payable (+L) blank 60
Notes payable (+L) blank 135
Other liabilities (+L) blank 45
Investment in Sun Co. (+A) 1,200
blank

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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 or IFRS standards, like U.S. GAAP,
– Capitalize goodwill,
– Do not amortize it, and
– Test it for impairment.

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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 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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When to Test for Impairment
Goodwill should be tested for impairment at least
annually.
More frequent testing may be needed if:
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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Business Combination Disclosures
Business combination disclosures include, but are
not limited to, the following:
– General information including company names
and description
– Reason for combination
– Nature and amount of consideration
– Allocation of purchase price among assets and
liabilities
– Pro-forma results of operations
– Goodwill or gain from bargain purchase

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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 (Public Company Accounting
Oversight Board)
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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