Business Combination
Two or more independent
business entities combined into
one larger accounting entity,
with one firm acquiring control
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Reasons Firms Combine
Vertical Integration
Cost Savings
Quick Entry into New Markets
Economies of Scale
More Attractive Financing Opportunities
Diversification of Business Risk
Business Expansion
Increasingly Competitive Environment
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Recent Notable Business Combinations
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Advantages of Combinations
• Structural
– Horizontal Combination
– Vertical Combination
– Conglomerate
• Possible Tax Advantages
– Accept stock to create a tax free reorganization
– Transferable carry-forward feature of net operating
losses
– Net taxable income reported for the consolidated
company
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Consolidation Process
The consolidation of financial information into a
single set of statements becomes necessary
whenever a single economic entity is created by
the business combination of two or more
companies. - - ARB No. 51
Why Consolidated Statements?
– Presumed to be more meaningful than
separate statements.
– Considered necessary for a fair presentation.
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Types of Combinations
• Merger
• Consolidation
• Acquisition of Controlling Interest
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Business Combinations
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Business Combinations
A business combination occurs
when one enterprise acquires
either the (1) net assets that
constitute a business or (2) the
equity interests of one or more
enterprises - - SFAS No. 141
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FASB Control Model
 The FASB provides guidance and defines
control when accounting for business
combinations with this control model:
 “A reporting entity has the power to direct the
activities of another entity when it has the
current ability to direct the activities of the
entity that significantly affect the entity's
returns.”
 The power criterion defines control both
operationally through “majority voting shares”
and conceptually through contractual rights.
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Acquisition of Control
• Acquire “Net Assets”
– Acquire directly from target company
– Assume liabilities
– Payment in cash, debt, or equity
• Acquire Controlling Interest
–
–
–
–
Greater than 50% target’s voting common stock
Creates parent/subsidiary relationship
Separate legal and operating entities remain
External reporting --- single set of financial statements
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Acquisition of Control
• Accounting Ramifications – Asset Acquisition
– Acquiring company records assets and liabilities
– Subsequent accounting procedures are same as for
any single accounting entity
• Accounting Ramifications – Stock Acquisition
– Parent records an investment
– Parent and sub remain separate legal entities with
their own separate sets of accounts and separate
financial statements
– Consolidated financial statements reflect presence of
one economic entity (on workpapers only, not in the
actual records!!)
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The Acquisition Method
 Used to account for business combinations.
 Requires recognizing and measuring at fair
value:
 Consideration transferred for the acquired
business
 Noncontrolling interest
 Separately identified assets and liabilities
 Goodwill or gain from a bargain purchase
 Any contingent considerations.
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Fair Value Approaches
 Market Approach – fair value can be
estimated referencing similar market
trades.
 Income Approach – fair value can be
estimated using the discounted future cash
flows of the asset.
 Cost Approach – estimates fair values by
reference to the current cost of replacing
an asset with another of comparable
economic utility.
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Acquisition Method
What if the consideration transferred does
NOT EQUAL the Fair Value of the Assets
acquired?
If the consideration is MORE than the
Fair Value of the Assets acquired, the
difference is attributed to GOODWILL
If the consideration is LESS than the
Fair Value of the Assets acquired, we
got a BARGAIN!! And we will record a
GAIN on the acquisition!!
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Acquisition Method Example
Purchase Price = Fair Value
Dissolution of Subsidiary
BigNet pays $2,550,000 ($550,000 cash and 20,000
unissued shares of its $10 par value common stock
that is currently selling for $100 per share) for all
of Smallport’s assets and liabilities.
Smallport then dissolves 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 Smallport business.
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Acquisition Method Example
Purchase Price > Fair Value
Dissolution of Subsidiary
BigNet pays $3,000,000 ($1,000,000 cash and
20,000 unissued shares of its $10 par value
common stock that is currently selling for $100
per share) for all of Smallport’s assets and
liabilities.
Smallport then dissolves as a legal entity. The
$3,000,000 fair value of the consideration
transferred by BigNet is greater than the fair
value of the acquired Smallport business.
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Acquisition Method Example
Purchase Price < Fair Value
Dissolution of Subsidiary
BigNet pays $2,000,000 by issuing 20,000 unissued
shares of its $10 par value common stock that is
currently selling for $100 per share for all of
Smallport’s assets and liabilities.
Smallport then dissolves as a legal entity. The
$2,000,000 fair value of the consideration
transferred by BigNet is less than the fair value of
the acquired Smallport business.
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Related Costs of Business Combinations
 Direct Costs of the acquisition (attorneys,
appraisers, accountants, investment bankers,
etc.) are NOT part of the fair value received, and
are immediately expensed.
 Indirect or Internal Costs of acquisition (secretarial
and management time) are period costs
expensed as incurred.
 Costs to register and issue securities related to
the acquisition reduce their fair value.
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Acquisition Method –
Consolidation Workpaper Example
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Consolidation of Financial
Information
Parent
Subsidiary
The parent does not
Consolidated
The Sub still prepares
prepare separate financial statements
separate financial
financial statements
are prepared.
statements
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Steps in Acquisition Process
1. Identify the acquirer (buyer)
2. Determine the acquisition date
– Date used to establish fair value of the company
acquired
3. Measure the fair value of the acquiree (seller)
4. Record the acquiree’s (seller) assets and
liabilities that are assumed
– Net assets = excess of assets over liabilities
– Fair values are determined per FASB Statement 157
– Identifiable assets never include pre-existing
goodwill
– Only “new” goodwill is recorded in an acquisition
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Valuation of Identifiable
Assets and Liabilities
• Current assets recorded at fair value
– Valuation accounts are not used
• Existing liabilities recorded at fair value
• Property, plant, and equipment recorded at fair
value
– Accumulated depreciation is not recorded
• Assets scheduled for sale record at net
realizable value
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Valuation of Identifiable
Assets and Liabilities
• Acquiree was lessor of assets in use
– Leases retain their definition if terms are not modified
– Operating leases
• Recognize an intangible asset if terms are favorable
• Record an estimated liability if the terms are unfavorable
Example:
Excess of current payment over
contractual amount
Remaining term of lease (months)
Discount (annual rate)
Asset (present value beginning mode)
$300
60
8%
$14,894
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Valuation of Identifiable
Assets and Liabilities
• Acquiree acted as lessor
– Leases retain their definition if terms are not modified
– Operating lease
• Asset under lease is on books of acquiree
• Record at fair value
• Evaluate terms; record asset (liability) if favorable (unfavorable) to
the acquiree/lessor
• Intangible assets not separately recorded
– Arises from contractual or other legal rights or is separable
– Identify and record separately
– Allows for recognition that acquiree was barred from recognizing
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Intangible Asset - Examples
• Customer Base
• Trademarked Brand
Names
• Customer Routes
• Effective Advertising
Programs
• Covenants
• Rights (broadcasting,
development, use, etc.)
•
•
•
•
•
Databases
Technological know-how
Patents & Copyrights
Strong labor relations
Assembled, trained
workforce
• Favorable government
relations
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Valuation of Identifiable
Assets and Liabilities
• Research and Development
– Fair values of tangible and intangible assets are recorded
• Contingent Assets and Liabilities
– Possessed by acquiree on the acquisition date
• Liabilities Associated with Restructuring or Exit
Activities
– Existing liabilities to other entities
• Employee Benefit Plans
– Asset if projected benefit obligation > plan assets
– Liability if projected benefit obligation < plan assets
• Deferred Taxes
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Recording the Acquisition
• Record all accounts at fair value
• If Price Paid > Fair Value --- Recognize
Goodwill
• If Price Paid < Fair Value ---Recognize
Gain on Acquisition
• Expense all acquisitions costs
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Accounting by the Acquiree
• Record receipt of consideration
• Remove assets and liabilities at their book
values
• Recognize gain or loss on sale of business
• Typical final step
– Distribute consideration received to shareholders
– Cease operations
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Changes in Value
During Measurement Period
• Values recorded on the acquisition date are considered
provisional
• During the measurement period values assigned to
accounts recorded during purchase may be adjusted to
better reflect the value as of the acquisition date
• Note: Changes in value caused by events that occur
after the acquisition date are not a part of this adjustment
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Recording Contingent
Consideration
• Acquirer agrees to additional consideration if identified
triggers are met
• Contingent consideration that is payable in any form
other than additional stock
– Measure based on probability of achieving target
– Include as part of consideration for determining goodwill or gain
– Record as a contingent liability in acquisition entry
• Revalue consideration in measurement period
– Adjust Goodwill and Liability
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Recording Contingent
Consideration
• Contingent consideration is additional stock
– Treat as a change in estimate
• No liability is recorded on acquisition date
• When triggers are met reassign the original
consideration assigned to the stock to a greater
number of shares
– Reduce additional paid-in capital
– Record additional shares issued at par
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Steps for Consolidation
1. Record the financial information for
both Parent and Sub on the worksheet.
2. Remove the Investment in Sub balance.
3. Remove the Sub’s equity account
balances.
4. Adjust the Sub’s net assets to FV.
5. Allocate any excess of cost over BV to
identifiable, separable intangible assets
or goodwill.
6. Combine all account balances.
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Pooling of Interests
According to SFAS No. 141, the purchase
method is not to be applied to past “Pooling of
Interest.”
Past Pooling of interests are left intact by SFAS
No. 141.
Therefore, it is important to understand how to
account for PAST Pooling.
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Historical Review of Pooling of Interests
In a pooling, one
company
obtained
essentially “all”
of the other
company’s stock.
The transaction
involved the
exchange of
common stock.
No exchange of
cash was
allowed.
• The ownership interests of
two, or more, companies
were combined into one new
company.
• No single company was
dominant.
• Precise cost figures were
difficult to obtain.
• To use pooling of interests,
12 strict criteria had to be
met.
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Historical Review of Pooling of Interests
The Book Values of the two
combining companies were
joined. No Goodwill was
recorded.
Revenues and expenses were
combined retroactively for the
two companies.
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Historical Review of Pooling of Interests
• Both companies continued to
exist.
• An Investment in Sub account
was recorded on one company’s
books (usually the larger).
• No Goodwill was recorded.
• Both companies were combined
at BV.
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Historical Review of Pooling of Interests
• Prior Period Adjustments were
made to account for differences
in the ways the two companies
accounted for income.
• A journal entry was recorded to
recognize the Investment in
Subsidiary.
• The BV’s for both companies
were entered on a consolidation
worksheet.
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Accounting for Pooling of Interests in
Subsequent Periods
• The Investment in Sub account
must be eliminated.
– Also eliminate the Sub’s Equity
accounts to prevent double
recording.
(They have already been included
in the original Investment in Sub
entry.)
• Add together the BV’s of the
remaining accounts.
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End of Chapter 2
I can’t take
much
more of
this!
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