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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

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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.
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Business Combinations
1: Economic Motivations

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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 other 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
Federal Communications Commission
Some states have antitrust exemption laws to
protect hospitals

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Business Combinations
2: Forms of Business Combinations

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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
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 Bs 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 Bs assets and liabilities.
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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.
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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). 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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Business Combinations
3: Accounting for Business
Combinations

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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.
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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 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]
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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]

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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 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.
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Example: Poppy Corp. (1 of 3)
Poppy Corp. issues 100,000 shares of its $10 par
value common stock for Sunny Corp. Poppys
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

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Example: Poppy Corp. (2 of 3)
Poppy Corp. pays cash for $80,000 in finders fees
and consulting fees and for $40,000 to register
and issue its common stock. (in thousands)
Investment expense 80
Additional paid-in-capital 40
Cash 120
Sunny Corp. is assumed to have been dissolved. So,
Poppy Corp. will allocate the investments cost to
the fair value of the identifiable assets acquired
and liabilities assumed. Excess cost is goodwill.
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Example: Poppy Corp. (3 of 3)

Receivables XXX
Inventories XXX
Plant assets XXX
Goodwill XXX
Accounts payable XXX
Notes payable XXX
Investment in Sunny Corp. 1,600

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Business Combinations
4: Cost Allocations Using the
Acquisition Method

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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
Some noncontractual contingencies
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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

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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.

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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.

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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

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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.
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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):

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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
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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

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Entries with Goodwill
The entry to record the acquisition of the net
assets:
Investment in Seed Co. 1,400
Cash 400
Common stock, $10 par 500
Additional paid-in-capital 500
The entry to record Seeds assets directly on Pitts
books:

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Cash 50
Net receivables 140
Inventories 250
Land 100
Buildings 500
Equipment 350
Patents 50
Goodwill 200
Accounts payable 60
Notes payable 135
Other liabilities 45
Investment in Seed Co. 1,400
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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
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Entries with Bargain Purchase
The entry to record the acquisition of the net
assets:
Investment in Seed Co. 1,000
10% Note payable 200
Common stock, $10 par 400
Additional paid-in-capital 400
The entry to record Seeds assets directly on Pitts
books:

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Cash 50
Net receivables 140
Inventories 250
Land 100
Buildings 500
Equipment 350
Patents 50
Accounts payable 60
Notes payable 135
Other liabilities 45
Investment in Seed Co. 1,000
Gain from bargain purchase 200
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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 standards, like U.S. GAAP
Capitalize goodwill,
Do not amortize it, and
Test it for impairment.
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Impairments
Firms must test annually for the impairment of
goodwill at the business unit reporting level.
If the units 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).
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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.

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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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