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Business Combinations

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1-1
Nature of the Combination

Business Combination – is a process whereby operations of

two or more companies are brought under common control.

It refers to a transaction or other event in which an

acquirer obtains control over one or more businesses, i.e.

Creating a Single Economic Entity

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1-2
Nature of the Combination

Business growth. Can occur internally – adding facilities


and expanding markets or externally – by acquiring other
companies.

• Business combinations represent accounting transactions


in which two or more accounting entities (or companies or
groups of net assets that constitute a going concern) are
brought together under common control in a single
accounting entity.
• Doesn't include combination of entities or businesses
Slide

under the same control


1-3
Nature of the Combination

 Control over other companies can be obtained by


acquiring all of the target company’s assets or by
acquiring more than 50% of the target company’s
outstanding voting common stock.

 Purchase of a group of idle assets or control over a


defunct/shell corporation (i.e. not an operating
business) is not a business combination and dissolution
of legal entities is unnecessary within the accounting
concept.
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1-4
Nature of the Combination

 Constitute Company: The business enterprises that


entered into a business combination.

 Target Company: The co. whose business is being


sought after.

 Acquiring Company/Combinor: Constitute the Co.


attempting to acquire the target Co. business.

 Acquired Company/Combinee: A constitutes co. other


than the combiner in a business combination.

 Combined enterprise: The accounting entity that


Slide
1-5
results from a business combination.
Nature of the Combination

= Combined Enterprise
•In form-one or more legal entity(ies)
•In substance- only one & single
Combinor/ Combinee/
=
Acquiror Acquiree/ accounting entity
Target •Substance over form
•Dissolution of legal entities
Constituent
Companies unnecessary within the accounting
concept

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1-6
Business Combinations: Why?
Advantages of External Expansion: Reasons firms
combine.
1. Rapid expansion
2. Operating synergies
 Revenues
• Increase market power
• Better/more efficient marketing efforts
• Strategic benefits such as entry into new markets
Operating costs (cost advantage or saving)
• Economies of scale (marketing, management,
production, distribution)
• Complementary resources (avoid duplicate efforts)
• Eliminate operating or management inefficiencies
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1-7
Business Combinations: Why?
3. International marketplace
4. Financial synergy
• Income tax-tax gain (savings) through accumulated tax
losses
• Utilization of unused debt capacity
• Reinvestment of surplus funds (free cash flows) as an
alternative to paying dividends or repurchasing stock
5. Diversification: through conglomerate operations
6. Divestitures
• spin off instead of selling off (less break up value/selling
individual assets)
Slide
1-8
Business Combinations: Historical Perspective

Three distinct periods


1880 through 1904, huge holding companies, or trusts, were
created to establish monopoly control over certain industries
(horizontal integration).

1905 through 1930, to bolster the war effort, the


government encouraged business combinations to obtain
greater standardization of materials and parts and to
discourage price competition (vertical integration).

Slide
1-9
Business Combinations: Historical Perspective

Three distinct periods: Historical trends in types of


business combinations.

1945 to the present, many of the mergers that occurred


from the 1950s through the 1970s were conglomerate
mergers.

In contrast, the 1980s were characterized by a relaxation in


antitrust enforcement and by the emergence of high-yield
junk bonds to finance acquisitions.

Deregulation undoubtedly played a role in the popularity of


combinations in the 1990s.
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1-10
Terminology and Types of Combinations
A business combination may be classified as follows:
1. Nature of the combination
Friendly - the boards of directors of the potential
combining companies negotiate mutually agreeable
terms of a proposed combination.
Unfriendly (hostile) - the board of directors of a
company targeted for acquisition resists the
combination.

Slide
1-11
Terminology and Types of Combinations

2. Economic Structure of Combination

•Horizontal Integration -Combination between companies that are

competitors, within the same industry. For example, two airline

companies combine or two computer software companies combine.

•Vertical Integration - Combination between companies in different

but successive stages of production or distribution. For example, a

manufacturing company merges with a mining company or an

automobile company acquires automobile dealerships.

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1-12
Terminology and Types of Combinations

Conglomerate- Combination between companies in


unrelated industries or markets. This is a procedure for
companies that want to diversify. For example, a
manufacturing company acquires a financial services
company.

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1-13
Terminology and Types of Combinations

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1-14
Terminology and Types of Combinations

3. Method of Acquisition/Legal Form

A. Statutory Merger

A Company
A Company

B Company

One company acquires all the net assets of another company.


The acquiring company survives, whereas the acquired
company ceases to exist as a separate legal entity.
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1-15
Terminology and Types of Combinations

B.Statutory Consolidation

A Company
C Company

B Company

A new corporation is formed to acquire two or more other


corporations through an exchange of voting stock; the acquired
corporations then cease to exist as separate legal entities.
Stockholders of A and B become stockholders in C.

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1-16
Terminology and Types of Combinations

C. Stock Acquisition

A Company A Company

B Company B Company

•The stock acquisition can be made at stock market or


through bid but not statutory
•Ifa company acquires a controlling interest in the voting
stock of another company, a parent–subsidiary relationship
results.

Slide
• This is the Common means of hostile takeover
1-17
Terminology and Types of Combinations

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1-18
Accounting for Business Combinations
Acquisition Method
The acquisition method follows the same GAAP for
recording a business combination as we follow in recording
the purchase of other assets and the incurrence of
liabilities.
We record the combination using the fair value principle.
In other words, we measure the cost to the purchasing
entity of acquiring another company in a business
combination by the amount of cash disbursed or by the
fair value of other assets distributed or securities
issued.
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1-19
Accounting for Business Combinations
•We expense the direct costs of a business combination
(such as accounting, legal, consulting, and finders’ fees)
other than those for the registration or issuance of equity
securities.
•We charge registration and issuance costs of equity
securities issued in a combination against the fair value of
securities issued, usually as a reduction of additional
paid-in capital.
•We expense indirect costs such as management salaries,
depreciation, and rent under the acquisition method. We
also expense indirect costs incurred to close duplicate
facilities.
Slide
1-20
Accounting for Business Acquisition

To determine the combinor:

a. If cash or other assets are distributed or liabilities


are incurred: In a business combination effected
solely through the distribution of cash or other assets
or by incurring liabilities, the entity that distributes
cash or other assets or incurs liabilities is generally
the acquiring entity.

Slide
1-21
Accounting for Business Acquisition

b. If stock is exchanged: In a business combination


effected through an exchange of equity interests, the
entity that issues the equity interests or receive
larger share of voting rights in the combined
enterprise is generally the acquiring entity.

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1-22
Accounting for Business Acquisition
Determining the Purchase Price, i.e. the Total
Cost of the Acquired Business (Combinee) include:
a. Fair value of the consideration given: Cash or
other assets, Debt, Equity securities
b. Fair value of any contingent consideration given
after acquisition date (Contingencies based on
securities prices do not affect the cost of the
investment above what was recorded at the
acquisition date, but instead represent

Slide
adjustments to additional paid in capital
1-23
Accounting for Business Acquisition

• Contingencies based on other than securities


prices (the current value of the additional
consideration is added to the acquiring company’s
cost of the acquired business)

c. Incidental/Out-of-Pocket Costs incurred in


connection with acquisition

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1-24
Accounting for Business Acquisition
Acquisition expenses
Direct Expenses (Legal, Investment banker consulting
fees Accounting fees such as for a purchase investigation,
Finders’ fees, Travel costs
Indirect Expenses Labor and overhead of internal
acquisitions or merger department & General expenses
diverted to the merger (costs of closing duplicate
facilities, salary for officers involved in the negotiation &
completion of the combination)

Securities Issuance Costs


(legal, under-writing, banking) Such costs are merely
related to the mode of financing

Slide
1-25
Perspective on Business Combinations

Treatment of Acquisition Expenses

both direct and indirect costs are expensed

the cost of issuing securities is also excluded


from the consideration.

Security issuance costs are assigned to the


valuation of the security, thus reducing the
additional contributed capital for stock issues or
adjusting the premium or discount on bond issues.
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1-26
Terminology and Types of Combinations

What Is Acquired? What Is Given Up?

Net assets of S Company 1. Cash


(Assets and Liabilities) 2. Debt Figure 1-1

3. Stock
Common Stock 4. Combination of
of S Company above

Asset acquisition, a firm must acquire 100% of the assets of the


other firm.
Stock acquisition, control may be obtained by purchasing >50%
of the voting common stock (or possibly less).
Slide
1-27
Explanation and Illustration of Acquisition Accounting

Example 1: Galaxy Company acquired the assets (except for cash)


and assumed the liabilities of Axis Company. Immediately prior to the
acquisition, Axis Company’s balance sheet was as follows:

Any
Goodwill?

Slide
1-28
Explanation and Illustration of Acquisition Accounting

Example 1: Galaxy Company acquired the assets (except for cash)


and assumed the liabilities of Axis Company. Immediately prior to
the acquisition, Axis Company’s balance sheet was as follows:

Fair value
of assets,
without cash
$1,824,000

Slide
1-29
Explanation and Illustration of Acquisition Accounting

Example 1: A. Prepare the journal entry on the books of


Galaxy Co. to record the purchase of the assets and
assumption of the liabilities of Axis Co. if the amount paid
was $1,560,000 in cash.

Calculation of Goodwill
Fair value of assets, without cash $1,824,000
Fair value of liabilities 594,000
Fair value of net assets 1,230,000
Price paid 1,560,000
Goodwill $ 330,000

Slide
1-30
Explanation and Illustration of Acquisition Accounting

Example 1: A. Prepare the journal entry on the books of


Galaxy Co. to record the purchase of the assets and
assumption of the liabilities of Axis Co. if the amount paid
was $1,560,000 in cash.

Receivables 228,000
Inventory 396,000
Plant and equipment 540,000
Land 660,000
Goodwill 330,000
Liabilities 594,000
Cash 1,560,000
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1-31
Explanation and Illustration of Acquisition Accounting

Bargain Purchase
When the fair values of identifiable net assets (assets
less liabilities) exceeds the total cost of the acquired
company, the acquisition is a bargain.
Current standards require:
 fair values be considered carefully and
adjustments made as needed.
 any excess of acquisition-date fair value of
net assets over the consideration paid is
recognized in income.
Slide
1-32
Explanation and Illustration of Acquisition Accounting

Bargain Acquisition Illustration


When the price paid to acquire another firm is lower
than the fair value of identifiable net assets (assets
minus liabilities), the acquisition is referred to as a
bargain.

Any previously recorded goodwill on the seller’s


books is eliminated (and no new goodwill recorded).

A gain is reflected in current earnings of the


acquiror to the extent that the fair value of net
assets exceeds the consideration paid.
Slide
1-33
Explanation and Illustration of Acquisition Accounting

Example 1: B. Repeat the requirement in (A) assuming that


the amount paid was $990,000.

Calculation of Goodwill or Bargain Purchase


Fair value of assets, without cash $1,824,000
Fair value of liabilities 594,000
Fair value of net assets 1,230,000
Price paid 990,000
Bargain purchase $ 240,000

Slide
1-34
Explanation and Illustration of Acquisition Accounting

Example 1: B. Repeat the requirement in (A) assuming that


the amount paid was $990,000.

Receivables 228,000
Inventory 396,000
Plant and equipment 540,000
Land 660,000
Liabilities 594,000
Cash 990,000
Gain on acquisition (ordinary) 240,000

Slide
1-35
Explanation and Illustration of Acquisition Accounting
Example 2: On January 1, Year 1, Big Company exchanged
10,000 shares of $10 par value common stock with a fair
value of $415,000 for 100% of the outstanding stock of Sub
Company in a business combination properly accounted for as
an acquisition. After combination Sub company liquidates. In
addition Big Co. paid $35,000 in legal fees. At the date of
acquisition, the fair value of Sub Co.'s net assets totaled
$300,000 [=600,000-300,000]. Registration fees were
$20,000. Journal entry to record the acquisition:
Assets (various)…………………………600,000
Goodwill……………………………..………...115,000
Legal expense……………………………....35,000
Liabilities (Various)………………………………..………….…300,000
Common stock………………………………………………………...100,000
Additional paid-in capital [315,000-20,000]…………295,000
1-36 Cash [=35,000 + 20,000]……………………………………..…55,000
Slide
Acquisition Method: Dissolution
Illustration: Given

Slide
1-37
Acquisition Method: Dissolution
Consideration transferred = Fair value
BigNet agrees to pay $2,550,000 (cash of
$550,000 and 20,000 unissued shares of its
$10 par value common stock that is
currently selling for $100 per share) for all
of Small port's assets and liabilities.

Smallport then dissolves itself as a legal


entity. As is typical, the $2,550,000 fair
value of the consideration transferred by
BigNet represents the fair value of the
acquired Small port business.
Slide
1-38
Acquisition Method: Dissolution
Consideration transferred = Fair value

Slide
1-39
Acquisition Method: Dissolution
Consideration transferred > Fair value

2. BigNet agrees 1000000 cash and 20,000


$10 par shares of $100 price a share.

Slide
1-40
Acquisition Method: Dissolution
Consideration transferred > Fair value:

 FV of acquired company’s
assets and liabilities is
added to acquiring
company’s books. Note: Goodwill
should be
viewed as a
 Difference between residual amount
remaining after
consideration transferred all other
and FV of identifiable assets identifiable
acquired and liabilities assets acquired
assumed is allocated to and liabilities
assumed are
goodwill. recognized.
Slide
1-41
Acquisition Method: Dissolution
Consideration transferred > Fair value

Slide
1-42
Acquisition Method: Dissolution
Consideration transferred < Fair value

3.BigNet conveys no cash and issues 20,000


$10 par shares of common stock that has a
$100 per share fair value.

Slide
1-43
Acquisition Method: Dissolution
Consideration transferred < Fair value
• In rare circumstances, the FV of the
identifiable assets acquired and liabilities
assumed may exceed the consideration
transferred.
• This excess FV is recognized as an ordinary
gain on a bargain purchase.
• The FV of the of identifiable assets acquired
and liabilities assumed then becomes the
valuation basis of the acquisition.

Slide
1-44
Acquisition Method: Dissolution
Consideration transferred < Fair value…

Slide
1-45
Acquisition Method: Dissolution
Consideration transferred < Fair value

At acquisition date, each subsidiary asset


and liability is reported at its fair value. . .

. . . The remainder is to be reported as an


ordinary gain on bargain purchase (SFAS
141R)

Slide
1-46
Contingent Consideration in an Acquisition

Purchase agreements may provide that the purchasing


company will give additional consideration to the seller
if certain future events or transactions occur.

The contingency may require


 the payment of cash (or other assets) or
 the issuance of additional securities.

Current GAAP requires that all contractual contingencies, as well


as non-contractual liabilities for which it is more likely than not
that an asset or liability exists, be measured and recognized at
fair value on the acquisition date.

Slide
1-47
Contingent Consideration in an Acquisition

Illustration: P Company acquired all the net assets of S


Company in exchange for P Company’s common stock. P Company
also agreed to pay an additional $150,000 to the former
stockholders of S Company if the average post-combination
earnings over the next two years equaled or exceeded
$800,000. Assume that goodwill was recorded in the original
acquisition transaction. To complete the recording of the
acquisition, P Company will make the following entry:

Goodwill 150,000
Liability for Contingent Consideration 150,000

Slide
1-48
Contingent Consideration in an Acquisition

Illustration: Assuming that the target is met, P Company will


make the following entry:

Liability for Contingent Consideration 150,000


Cash 150,000

On the other hand, assume that the target is not met. The
adjustment will flow through the income statement
in the subsequent period, as follows:

Liability for Contingent Consideration 150,000


Income from Change in Estimate 150,000

Slide
1-49
Contingent Consideration in an Acquisition

Illustration: P Company acquired all the net assets of S


Company in exchange for P Company’s common stock. P Company
also agreed to issue additional shares of common stock to the
former stockholders of S Company if the average post-
combination earnings over the next two years equalled or
exceeded $800,000. Assume that the contingency is expected
to be met, and goodwill was recorded in the original acquisition
transaction. Based on the information available at the
acquisition date, the additional 10,000 shares (par value of $1
per share) expected to be issued are valued at $150,000. To
complete the recording of the acquisition, P Company will make
the following entry:
Goodwill 150,000
Paid-in-Capital for Contingent Consideration 150,000
Slide
1-50
Contingent Consideration in an Acquisition

Illustration: Assuming that the target is met, but the stock


price has increased from $15 per share to $18 per share at
the time of issuance, P Company will not adjust the original
amount recorded as equity. Thus, P Company will make the
following entry

Paid-in-Capital for Contingent Consideration 150,000


Common Stock ($1 par) 10,000
Paid-in-Capital in Excess of Par 140,000

Slide
1-51
Assume that BigNet acquires Smallport Company on
December 31 by issuing 26,000 shares of $10 par
value common stock valued at $100 per share (or
$2,600,000 in total). BigNet pays fees of $40,000 to a
third party for its assistance in arranging the
transaction. Then to settle a difference of opinion
regarding Smallport’s fair value, BigNet promises to
pay an additional $83,200 to the former owners if
Smallport’s earnings exceed $300,000 during the next
annual period. BigNet estimates a 25 percent
probability that the $83,200 contingent payment will
be required. Take a discount rate of 4 percent (to
represent the time value of money).

Slide
1-52
What is the total consideration
transferred?

Slide
1-53
According to this view, contingencies have value to those who
receive the consideration and represent measurable
obligations of the acquirer. Therefore, the fair value of the
consideration transferred in this example consists of the
following two elements: This allocation procedure is helpful but
not critical if dissolution occurs. The asset and liability
accounts are simply added directly into the parent’s books at
their acquisition-date fair value with any excess assigned to
goodwill as shown in the previous sections of this chapter.

Fair value of securities issued by BigNet ………….$2,600,000


Fair value of contingent performance liability ………..20,000*
Total fair value of consideration transferred ……….$2,620,000

* ($83,200 *25% * 0.961538).

Slide
1-54
Goodwill Impairment Test

Goodwill Impairment Test


GAAP/iGAAP requires impairment on goodwill be tested
annually whether there are indicators or not.
All goodwill must be assigned to a reporting unit/CGU(
reporting unit could be segment of the company or the
company itself).
Impairment should be tested in a two-step process.
Step 1: Does potential impairment exist? Assessment of
circumstances indicating existence of impairment.

Step 2: What is the amount of goodwill impairment?


Making actual test
Slide
1-55
Slide
1-56
Goodwill Impairment Test

E2-10: On January 1, 2011, Porsche Company acquired the net


assets of Saab Company for $450,000 cash. The fair value of
Saab’s identifiable net assets was $375,000 on this date.
Porsche Company decided to measure goodwill impairment using
the present value of future cash flows to estimate the fair
value of the reporting unit (Saab). The information for these
subsequent years is as follows:

Present Value Carry Value Fair Value


of Future of SAAB's of SAAB's
Year Cash Flows Net Assets * Net Assets
2011 $ 400,000 $ 330,000 $ 340,000
2012 $ 400,000 $ 320,000 $ 345,000
2013 $ 350,000 $ 300,000 $ 325,000

Slide * Not including goodwill


1-57
Goodwill Impairment Test

E2-10: On January 1, 2011, the acquisition date, what was


the amount of goodwill acquired, if any?

Acquisition price $450,000


Fair value of identifiable net assets 375,000
Recorded value of Goodwill $ 75,000

Slide
1-58
Goodwill Impairment Test

E2-10: Part A&B: For each year determine the amount of


goodwill impairment, if any, and prepare the journal entry
needed each year to record the goodwill impairment (if any).

Step 1 - 2011
Fair value of reporting unit $400,000
Carrying value of unit:
Carrying value of identifiable net assets 330,000
Carrying value of goodwill 75,000
Total carrying value of unit 405,000
Excess of carrying value over fair value $ 5,000

Excess of carrying value over fair value means step 2 is required.


Slide
1-59
Goodwill Impairment Test

E2-10: Part A&B (continued)

Step 2 - 2011
Fair value of reporting unit $400,000
Fair value of identifiable net assets 340,000
Implied value of goodwill 60,000
Carrying value of goodwill 75,000
Impairment loss $ 15,000

Journal Impairment loss 15,000


Entry Goodwill 15,000

Slide
1-60
Goodwill Impairment Test

E2-10: Part A&B (continued)

Step 1 - 2012
Fair value of reporting unit $400,000
Carrying value of unit:
Carrying value of identifiable net assets 320,000
Carrying value of goodwill 60,000 *
Total carrying value of unit 380,000
Excess of fair value over carrying value $ 20,000

Excess of fair value over carrying value means step 2 is not required.
* $75,000 (original goodwill) – $15,000 (prior year impairment)
Slide
1-61
Goodwill Impairment Test

E2-10: Part A&B (continued)

Step 1 - 2013
Fair value of reporting unit $350,000
Carrying value of unit:
Carrying value of identifiable net assets 300,000
Carrying value of goodwill 60,000 *
Total carrying value of unit 360,000
Excess of carrying value over fair value $ 10,000

Excess of carrying value over fair value means step 2 is required.


* $75,000 (original goodwill) – $15,000 (prior year impairment)
Slide
1-62
Goodwill Impairment Test

E2-10: Part A&B (continued)

Step 2 - 2013
Fair value of reporting unit $350,000
Fair value of identifiable net assets 325,000
Implied value of goodwill 25,000
Carrying value of goodwill 60,000
Impairment loss $ 35,000

Journal Impairment loss 35,000


Entry Goodwill 35,000

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1-63
Goodwill Impairment Test
Example

Slide
1-64
Goodwill Impairment Test
Example

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1-65
Goodwill Impairment Test
Example

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1-66
Exercises-1

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1-67
Exercises-2

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1-68
Exercise 2- cont…

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1-69