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2
Accounting for Business
Combinations
Advanced Accounting, Fourth Edition
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Learning Objectives
1.
Describe the major changes in the accounting for business combinations passed by the
FASB in December 2007, and the reasons for those changes.
2.
Describe the two major changes in the accounting for business combinations approved by
the FASB in 2001, as well as the reasons for those changes.
3.
Discuss the goodwill impairment test described in SFAS No. 142 [ASC 350–20–35], including
its frequency, the steps laid out in the new standard, and some of the likely implementation
problems.
4.
Explain how acquisition expenses are reported.
5.
Describe the use of pro forma statements in business combinations.
6.
Describe the valuation of assets, including goodwill, and liabilities acquired in a business
combination accounted for by the acquisition method.
7.
Explain how contingent consideration affects the valuation of assets acquired in a business
combination accounted for by the acquisition method.
8.
Describe a leveraged buyout.
9.
Describe the disclosure requirements according to SFAS No. 141R [ASC 805–10–50],
“Business Combinations,” related to each business combination that takes place during a
given year.
10. Describe at least one of the differences between U.S. GAAP and IFRS related to the
accounting for business combinations.
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Historical Perspective on Business Combinations
What’s New?
Issued on December 2007
SFAS No. 141R [ASC 805], “Business Combinations,”
would replace FASB Statement No. 141.
Continues to support the use of a single method.
Uses the term “acquisition method” rather than
“purchase method.”
The acquired business should be recognized at its fair
value on the acquisition date rather than its cost,
regardless of whether the acquirer purchases all or only
a controlling percentage.
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LO 1 FASB’s two major changes for business combinations.
Historical Perspective on Business Combinations
What’s New?
Issued on December 2007
[ASC 810], “Noncontrolling Interests In Consolidated
Financial Statements,” will replace Accounting Research
Bulletin (ARB) No. 51.
Establishes standards for the reporting of the
noncontrolling interest when the acquirer obtains control
without purchasing 100% of the acquiree.
Additional discussion in Chapter 3.
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LO 1 FASB’s two major changes for business combinations.
Historical Perspective on Business Combinations
Historically, two methods permitted: purchase and
pooling of interests.
Pronouncements in June 2001:
1. SFAS No. 141, “Business Combinations,” - pooling method
is prohibited for business combinations initiated after
June 30, 2001.
2. SFAS No. 142, “Goodwill and Other Intangible Assets,” Goodwill acquired in a business combination after June 30,
2001, should not be amortized.
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LO 2 FASB’s two major changes of 2001.
Perspective on Business Combinations
Goodwill Impairment Test
SFAS No. 142 [ASC 350-20-35] requires impairment be
tested annually.
All goodwill must be assigned to a reporting unit.
Impairment should be tested in a two-step process.
Step 1: If fair value is less than the carrying amount of
the net assets (including goodwill), then perform a second
step to determine possible impairment.
Step 2: Determine the fair value of the goodwill (implied
value of goodwill) and compare to carrying amount.
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LO 3 Goodwill impairment assessment.
Perspective on
Business
Combinations
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LO 3
Perspective on Business Combinations
E2-10: On January 1, 2010, 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:
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2-9
Year
Present Value
of Future
Cash Flows
Carry Value
of SAAB's
Net Assets
2011
$
400,000
$
330,000
2012
$
400,000
$
2013
$
350,000
$
* Not including goodwill
*
Fair Value
of SAAB's
Net Assets
$
340,000
320,000
$
345,000
300,000
$
325,000
LO 3 Goodwill impairment assessment.
Perspective on Business Combinations
E2-10: On January 1, 2010, the acquisition date, what was
the amount of goodwill acquired, if any?
Acquisition price
$450,000
Fair value of identifiable net assets
Recorded value of Goodwill
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375,000
$ 75,000
LO 3 Goodwill impairment assessment.
Perspective on Business Combinations
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
Carrying value of goodwill
330,000
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.
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LO 3 Goodwill impairment assessment.
Perspective on Business Combinations
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
Journal
Entry
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Impairment loss
Goodwill
$ 15,000
15,000
15,000
LO 3 Goodwill impairment assessment.
Perspective on Business Combinations
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
Carrying value of goodwill
320,000
60,000 *
Total carrying value of unit
Excess of fair value over carrying value
380,000
$ 20,000
Excess of fair value over carrying value means step 2 is not required.
* $75,000 (original goodwill) – $15,000 (prior year impairment)
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LO 3 Goodwill impairment assessment.
Perspective on Business Combinations
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
Carrying value of goodwill
300,000
60,000 *
Total carrying value of unit
Excess of carrying value over fair value
360,000
$ 10,000
Excess of carrying value over fair value means step 2 is required.
* $75,000 (original goodwill) – $15,000 (prior year impairment)
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LO 3 Goodwill impairment assessment.
Perspective on Business Combinations
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
Journal
Entry
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2-15
Impairment loss
Goodwill
$ 35,000
35,000
35,000
LO 3 Goodwill impairment assessment.
Perspective on Business Combinations
Review Question
The first step in determining goodwill impairment involves
comparing the
a. implied value of a reporting unit to its carrying amount
(goodwill excluded).
b. fair value of a reporting unit to its carrying amount
(goodwill excluded).
c. implied value of a reporting unit to its carrying amount
(goodwill included).
d. fair value of a reporting unit to its carrying amount
(goodwill included).
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LO 3 Goodwill impairment assessment.
Perspective on Business Combinations
Disclosures Mandated by FASB
SFAS No. 141R [ASC 805] requires:
1. Total amount of acquired goodwill and the amount
expected to be deductible for tax purposes.
2. Amount of goodwill by reporting segment (in accordance
with SFAS No. 131 [ASC 280], “Disclosures about
Segments of an Enterprise and Related Information”),
unless not practicable.
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LO 3 Goodwill impairment assessment.
Perspective on Business Combinations
Disclosures Mandated by FASB
SFAS No. 142 [ASC 350-20-45] specifies the
presentation of goodwill (if impairment occurs):
a. Aggregate amount of goodwill should be a separate line
item in the balance sheet.
b. Aggregate amount of losses from goodwill impairment
should be a separate line item in the operating section
of the income statement.
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LO 3 Goodwill impairment assessment.
Perspective on Business Combinations
Disclosures Mandated by FASB
When an impairment loss occurs, SFAS No. 142 [ASC
350-20-50-2] mandates note disclosure:
1.
Description of facts and circumstances leading to the
impairment.
2. Amount of impairment loss and method of determining the
fair value of the reporting unit.
3. Nature and amounts of any adjustments made to
impairment estimates from earlier periods, if significant.
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LO 3 Goodwill impairment assessment.
Perspective on Business Combinations
Other Required Disclosures
SFAS No. 141R [ASC 805-10-50-2] states that
disclosure should include:
The name and a description of the acquiree.
The acquisition date.
The percentage of voting equity instruments acquired.
The primary reasons for the business combination,
including a description of the factors that contributed to
the recognition of goodwill.
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LO 3 Goodwill impairment assessment.
Perspective on Business Combinations
Other Required Disclosures
SFAS No. 141R [para. 805-10-50-2] states that
disclosure should include:
The fair value of the acquiree and the basis for measuring
that value on the acquisition date.
The fair value of the consideration transferred.
The amounts recognized at the acquisition date for each
major class of assets acquired and liabilities assumed.
The maximum potential amount of future payments the
acquirer could be required to make.
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LO 3 Goodwill impairment assessment.
Perspective on Business Combinations
Other Intangible Assets
Acquired intangible assets other than goodwill:
Limited useful life
 Should be amortized over its useful economic life.
 Should be reviewed for impairment.
Indefinite life
 Should not be amortized.
 Should be tested annually (minimum) for impairment.
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LO 3 Goodwill impairment assessment.
Perspective on Business Combinations
Treatment of Acquisition Expenses
The Exposure Draft requires that:
both direct and indirect costs be expensed.
the cost of issuing securities also be 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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LO 4 Reporting acquisition expenses.
Perspective on Business Combinations
Acquisition Costs—an Illustration
Suppose that SMC Company acquires 100% of the net assets of Bee
Company (net book value of $100,000) by issuing shares of common
stock with a fair value of $120,000. With respect to the merger,
SMC incurred $1,500 of accounting and consulting costs and $3,000
of stock issue costs. SMC maintains a mergers department that
incurred a monthly cost of $2,000. Prepare the journal entry to
record these direct and indirect costs.
Professional Fees Expense (Direct)
Merger Department Expense (Indirect)
Other Contributed Capital (Security Issue Costs)
Cash
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1,500
2,000
3,000
6,500
LO 4 Reporting acquisition expenses.
Pro Forma Statements and Disclosure Requirement
Pro forma statements serve two functions in relation
to business combinations:
1) to provide information in the planning stages of
the combination and
2) to disclose relevant information subsequent to
the combination.
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LO 5 Use of pro forma statements.
Pro Forma Statements and Disclosure Requirement
P Company Pro Forma Balance Sheet
Giving Effect to Proposed Issue of Common Stock for All the
Net Assets of S Company January 1, 2009
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Illustration 2-1
LO 5 Use of pro forma statements.
Pro Forma Statements and Disclosure Requirement
If a material business combination occurred, notes to
financial statements should include on a pro forma basis:
1.
Results of operations for the current year as though the
companies had combined at the beginning of the year.
2. Results of operations for the immediately preceding
period as though the companies had combined at the
beginning of that period if comparative financial
statements are presented.
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LO 5 Use of pro forma statements.
Explanation and Illustration of Acquisition Accounting
Four steps in the accounting for a business
combination:
1. Identify the acquirer.
2. Determine the acquisition date.
3. Measure the fair value of the acquiree.
4. Measure and recognize the assets acquired and
liabilities assumed.
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LO 6 Valuation of acquired assets and liabilities assumed.
Explanation and Illustration of Acquisition Accounting
Value of Assets and Liabilities Acquired
 Identifiable assets acquired (including intangibles other
than goodwill) and liabilities assumed should be recorded at
their fair values at the date of acquisition.
 Any excess of total cost over the fair value amounts
assigned to identifiable assets and liabilities is recorded as
goodwill.
 SFAS No. 141R [ASC 805-20], states in-process R&D is
measured and recorded at fair value as an asset on the
acquisition date.
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LO 6 Valuation of acquired assets and liabilities assumed.
Explanation and Illustration of Acquisition Accounting
E2-1: Preston Company acquired the assets (except for cash) and
assumed the liabilities of Saville Company. Immediately prior to the
acquisition, Saville Company’s balance sheet was as follows:
Any
Goodwill?
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LO 6 Valuation of acquired assets and liabilities assumed.
Explanation and Illustration of Acquisition Accounting
E2-1: Preston Company acquired the assets (except for cash) and
assumed the liabilities of Saville Company. Immediately prior to the
acquisition, Saville Company’s balance sheet was as follows:
Fair value
of assets,
without cash
$1,824,000
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LO 6 Valuation of acquired assets and liabilities assumed.
Explanation and Illustration of Acquisition Accounting
E2-1: A. Prepare the journal entry on the books of Preston
Co. to record the purchase of the assets and assumption of
the liabilities of Saville Co. if the amount paid was
$1,560,000 in cash.
Calculation of Goodwill
Fair value of assets, without cash
Fair value of liabilities
Fair value of net assets
1,230,000
Price paid
1,560,000
Goodwill
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$1,824,000
594,000
$ 330,000
LO 6 Valuation of acquired assets and liabilities assumed.
Explanation and Illustration of Acquisition Accounting
E2-1: A. Prepare the journal entry on the books of Preston
Co. to record the purchase of the assets and assumption of
the liabilities of Saville Co. if the amount paid was
$1,560,000 in cash.
Receivables
Inventory
228,000
396,000
Plant and equipment
540,000
Land
660,000
Goodwill
330,000
Liabilities
Cash
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594,000
1,560,000
LO 6 Valuation of acquired assets and liabilities assumed.
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.
In the past, FASB required that most long-lived assets be
written down on a pro rata basis before recognizing a gain.
Current standards require:
 fair values be reconsidered and adjustments made as
needed.
 any excess of acquisition-date fair value of net assets
over the consideration paid is recognized in income.
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LO 6 Valuation of acquired assets and liabilities assumed.
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.
Under SFAS No. 141R:
Any previously recorded goodwill on the seller’s books is
eliminated (and no new goodwill recorded).
An ordinary gain is recorded to the extent that the fair value
of net assets exceeds the consideration paid.
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LO 6 Valuation of acquired assets and liabilities assumed.
Explanation and Illustration of Acquisition Accounting
E2-1: 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
Fair value of liabilities
Fair value of net assets
Price paid
1,230,000
990,000
Bargain purchase
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$1,824,000
594,000
$ 240,000
LO 6 Valuation of acquired assets and liabilities assumed.
Explanation and Illustration of Acquisition Accounting
E2-1: B. Repeat the requirement in (A) assuming that the
amount paid was $990,000.
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Receivables
Inventory
228,000
396,000
Plant and equipment
540,000
Land
660,000
Liabilities
594,000
Cash
990,000
Gain on acquisition
240,000
LO 6 Valuation of acquired assets and liabilities assumed.
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.
SFAS No. 141R [ASC 450] 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.
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LO 7 Contingent consideration and valuation of assets.
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 the contingency is expected to be met,
and 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
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150,000
LO 7 Contingent consideration and valuation of assets.
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
Income from Change in Estimate
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150,000
150,000
LO 7 Contingent consideration and valuation of assets.
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 postcombination 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
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150,000
LO 7 Contingent consideration and valuation of assets.
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
Common Stock ($1 par)
Paid-in-Capital in Excess of Par
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150,000
10,000
140,000
LO 7 Contingent consideration and valuation of assets.
Contingent Consideration in an Acquisition
Adjustments During the Measurement Period
SFAS No. 141R [ASC 805–10–25] defines the
measurement period as the period after the initial
acquisition date during which the acquirer may adjust the
provisional amounts recognized at the acquisition date.
The measurement period ends as soon as the acquirer has
the needed information about facts and circumstances,
not to exceed one year from the acquisition date.
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LO 7 Contingent consideration and valuation of assets.
Contingent Consideration in an Acquisition
Contingency Based on Outcome of a Lawsuit
Consideration contingently issuable may depend on both
 future earnings and
 future security prices.
In such cases, an additional cost of the acquired company
should be recorded for all additional consideration
contingent on future events, based on the best available
information and estimates at the acquisition date (as
adjusted by the end of the measurement period).
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LO 7 Contingent consideration and valuation of assets.
Contingent Consideration in an Acquisition
Review Question
Which of the following statements best describes the current authoritative
position with regard to accounting for contingent consideration?
a.
If contingent consideration depends on both future earnings and future
security prices, an additional cost of the acquired company should be
recorded only for the portion of consideration dependent on future
earnings.
b. The measurement period for adjusting provisional amounts always ends
at the year-end of the period in which the acquisition occurred.
c.
A contingency based on security prices has no effect on the
determination of cost to the acquiring company.
d. The purpose of the measurement period is to provide a reasonable time
to obtain the information necessary to identify and measure the fair
value of the acquiree’s assets and liabilities, as well as the fair value of
the consideration transferred.
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LO 7 Contingent consideration and valuation of assets.
Leveraged Buyouts
A leveraged buyout (LBO) occurs when a group of
employees (generally a management group) and third-party
investors create a new company to acquire all the
outstanding common shares of their employer company.
 The management group contributes the stock they hold
to the new corporation and borrows sufficient funds to
acquire the remainder of the common stock.
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
The old corporation is merged into the new corporation.

Leveraged buyout (LBO) transactions are to be viewed as
business combinations.
LO 8 Leverage buyouts.
IFRS Versus U.S. GAAP
The project on business combinations
 Was the first of several joint projects undertaken by
the FASB and the IASB.
 Complete convergence has not yet occurred.
 International standards currently allow a choice between
 writing all assets, including goodwill, up fully (100%
including the noncontrolling share), as required now
under U.S. GAAP, or
 continuing to write goodwill up only to the extent of
the parent’s percentage of ownership.
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LO 10 Differences between U.S. GAAP and IFRS .
IFRS Versus U.S. GAAP
Other differences and similarities:
Slide
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LO 10 Differences between U.S. GAAP and IFRS .
IFRS Versus U.S. GAAP
Other differences and similarities:
Slide
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LO 10 Differences between U.S. GAAP and IFRS .
IFRS Versus U.S. GAAP
Other differences and similarities:
Slide
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LO 10 Differences between U.S. GAAP and IFRS .
IFRS Versus U.S. GAAP
Other differences and similarities:
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LO 10 Differences between U.S. GAAP and IFRS .
IFRS Versus U.S. GAAP
Other differences and similarities:
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LO 10 Differences between U.S. GAAP and IFRS .
Deferred Taxes in Business Combinations
To the extent that the seller accepts
APPENDIX A
common stock rather than cash or debt
in exchange for the assets, the sellers may not have to pay
taxes until a later date when the shares accepted are sold.
When the acquirer has inherited the book values of the
assets for tax purposes but has recorded market values
for reporting purposes, a deferred tax liability needs to be
recognized.
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Deferred Taxes in Business Combinations
Illustration: Taxaware Company has net assets totaling
$700,000 (market value), including fixed assets with a market
value of $200,000 and a book value of $140,000. The book values
of all other assets approximate market values. Taxaware Company
is acquired by Blinko in a combination that qualifies as a
nontaxable exchange for Taxaware shareholders. Blinko issues
common stock valued at $800,000 (par value $150,000). First, if
we disregard tax effects, the entry to record the acquisition
would be:
Assets
Goodwill
Common Stock
Additional Contributed Capital
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2-54
700,000
100,000
150,000
650,000
Deferred Taxes in Business Combinations
Illustration: Now consider tax effects, assuming a 30% tax rate.
First, the excess of market value over book value of the fixed
assets creates a deferred tax liability because the excess
depreciation is not tax deductible. Thus, the deferred tax
liability associated with the fixed assets equals 30% $60,000
(the difference between market and book values), or $18,000.
The inclusion of deferred taxes would increase goodwill by
$18,000 to a total of $118,000. The entry to include goodwill is
as follow:
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Assets
Goodwill
Deferred Tax Liability
Common Stock
Additional Contributed Capital
700,000
118,000
18,000
150,000
650,000
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