Business Combinations
Chapter 1
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Learning Objective 1
Understand the economic
motivations underlying
business combinations.
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Business Combinations
A business combination occurs when
two or more separate businesses join
into a single accounting entity.
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Reasons for Business Combinations
Cost advantage
Lower risk
Fewer operating delays
Avoidance of takeovers
Acquisition of intangible assets
Other reasons
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Learning Objective 2
Learn about the alternative
forms of business combinations,
from both the legal and
accounting perspectives.
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The Legal Form of
Business Combinations
Business Combination
Acquisitions
Merger
Consolidation
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The Legal Form of
Business Combinations
A
B
A
Merger
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The Legal Form of
Business Combinations
A
B
C
Consolidation
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The Accounting Concept of
Business Combinations
The concept emphasizes the creation of a
single entity and the independence of the
combining companies before their union.
Dissolution of the legal entity is not
necessary within the accounting concept.
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The Accounting Concept of
Business Combinations
Single management
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The Accounting Concept of
Business Combinations
One or more corporations become subsidiaries.
One company transfers its net assets to another.
Each company transfers its net assets
to a newly formed corporation.
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Background on Accounting for
Business Combinations
Much of the controversy concerning accounting
requirements for business combinations historically
involved the pooling of interest method.
ARB No. 40 introduced an alternative method:
the purchase method.
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Background on Accounting for
Business Combinations
Until 2001, accounting requirements for business
combinations were found in APB Opinion No. 16.
APB No. 16 recognized both the pooling
and purchase methods.
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Background on Accounting for
Business Combinations
FASB Statement No. 141 eliminated the
pooling of interest method for transactions
initiated after June 30, 2001.
Combinations initiated after this date
must use the purchase method.
Prior combinations will be grandfathered.
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Learning Objective 3
Understand alternative
approaches to the financing
of mergers and acquisitions.
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Pooling Method
Pooling uses historical book values to record
combinations rather than recognizing fair
values of net assets at the transaction date.
Most of the detailed issues related to poolings
concern the original recording of the combination.
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Purchase Method
Purchase accounting requires the recording
of assets acquired and liabilities assumed at
their fair values at the date of combination.
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Learning Objective 4
Introduce concepts of accounting
for business combinations
emphasizing the purchase method.
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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 combination
on July 1, 2003.
The market price of Poppy is $16 per share
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Accounting for Business Combinations
Under the Purchase Method
Additional direct costs:
SEC fees
Accounting fees
Printing and issuing
Finder and consulting
$ 5,000
$10,000
$25,000
$80,000
How is the issuance recorded?
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Accounting for Business Combinations
Under the Purchase Method
Investment in Sunny
1,600,000
Common Stock, $10 par
1,000,000
Additional Paid-in Capital
600,000
To record issuance of 100,000 shares of $10 par
common stock with a market value of $16 per share
in a purchase business combination with Sunny.
How are the additional direct costs recorded?
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Accounting for Business Combinations
Under the Purchase Method
Investment in Sunny
80,000
Additional Paid-in Capital
40,000
Cash (other assets)
120,000
To record additional direct costs of combining
with Sunny: $80,000 finder’s and consultants’
fees and $40,000 for registering and issuing
equity securities.
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Accounting for Business Combinations
Under the Purchase Method
The total cost to Poppy of acquiring
Sunny is $1,680,000.
This is the amount entered into the
investment in the Sunny account.
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Goodwill
Goodwill is an intangible asset that arises
when the purchase price to acquire a
subsidiary company is greater than
the sum of the market value of the
subsidiary’s assets minus liabilities.
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Learning Objective 5
See how firms make cost
allocations in a purchase
method combination.
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Cost Allocation in a Purchase
Business Combination
Determine the fair values of all identifiable
tangible and intangible assets acquired
and liabilities assumed.
FASB Statement No. 141 provides guidelines
for assigning amounts to specific categories
of assets and liabilities.
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Cost Allocation in a Purchase
Business Combination
No value is assigned to goodwill recorded
on the books of an acquired subsidiary.
Such goodwill is an unidentifiable asset.
Goodwill resulting from the
combination is valued directly.
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Recognition and Measurement of
Intangible Assets Other than Goodwill
Separability
criterion
Contractuallegal criterion
Recognizable intangibles
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Contingent Consideration in a
Purchase Business Combination
Contingent consideration that is determinable
at the date of acquisition is recorded as
part of the cost of combination.
Future earnings
level
Security prices
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Cost and Fair Value Compared
Investment cost
Total fair value of
identifiable assets
less liabilities
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Cost and Fair Value Compared
Investment cost
2
>
Net fair value
1
Identifiable net
assets according
to their fair value
Goodwill
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Illustration of a Purchase
Combination
Pitt Corporation acquires the net assets of
Seed Company on December 27, 2003.
Pitt
Seed
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Illustration of a Purchase
Combination
Book
Value
Assets
Cash
Net receivables
Inventories
Land
Buildings, net
Equipment, net
Patents
Total assets
$
50
150
200
50
300
250
$1,000
Fair
Value
$
50
140
250
100
500
350
50
$1,440
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Illustration of a Purchase
Combination
Book
Value
Liabilities
Accounts payable
Notes payable
Other liabilities
Total liabilities
Net assets
$ 60
150
40
$250
$ 50
Fair
Value
$
60
135
45
$ 240
$1,200
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Illustration of a Purchase
Combination
Pitt pays $400,000 cash and issues 50,000
shares of Pitt Corporation $10 par common
stock with a market value of $20 per share.
50,000 × $10 = $500,000
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Illustration of a Purchase
Combination
Investment in Seed
1,400,000
Cash
400,000
Common Stock
500,000
Additional Paid-in Capital
500,000
To record issuance of 50,000 shares of $10 par
common stock plus $400,000 cash in a purchase
business combination with Seed Company
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Illustration of a Purchase
Combination
Cash
Net receivable
Inventories
Land
Buildings, net
Equipment, net
Patents
50
140
250
100
500
350
50
Goodwill
200
Accounts payable
60
Notes payable
135
Other liabilities
45
Investment in
Seed Company 1,400
$1640 – 1,440 = 200
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Illustration of a Purchase
Combination
Pitt issues 40,000 shares of its $10 par common
stock 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
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Illustration of a Purchase
Combination
Investment in Seed
1,000,000
Common Stock
400,000
Additional Paid-in Capital
400,000
10% Note Payable
200,000
To record issuance of 40,000 shares of $10 par
common stock plus $200,000, 10% note in a
purchase business combination with Seed Company
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Illustration of a Purchase
Combination
Cash
Net receivable
Inventories
Land
Buildings, net
Equipment, net
Patents
50
140
250
80
400
280
40
Accounts payable
60
Notes payable
135
Other liabilities
45
Investment in
Seed Company 1,000
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Illustration of a Purchase
Combination
$1,200,000 fair value is greater than $1,000,000
purchase price by $200,000.
Amounts assignable to assets are reduced by 20%.
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The Goodwill Controversy
Under FASB Statement No. 142, goodwill is no
longer amortized for financial reporting purposes.
– income tax controversies
– international accounting issues
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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.
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Recognizing and Measuring
Impairment Losses
Compare
Carrying values
Fair values
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Cost and Fair Value Compared
Fair value
<
Carrying amount
Measurement of the
impairment loss
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Amortization versus
Nonamortization
Firms must amortize intangible assets with
a finite useful life over that life.
Firms will not amortize intangible assets with an
indefinite useful life that cannot be estimated.
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End of Chapter 1
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