CHAPTER
2
Accounting for Business Combinations
BRIEF OUTLINE
2.1
2.2
2.3
2.4
2.5
2.6
Introduction to the Method
Goodwill Impairment Test
Other Intangible Assets
Did Firms Prefer Pooling?
Treatment of Acquisition Expenses
Pro Forma Statements
2.7
2.8
2.I.9
2.10
Explanation of Purchase Accounting
Financial Statement Differences
Contingent Consideration in a Purchase
Leveraged Buyouts
INTRODUCTION
This chapter introduces you to the new technique for recording a business combination. It also
gives you some background on how the new rules evolved, and what was done before the recent
changes. There are some important illustrations in the book concerning the techniques.
CHAPTER OUTLINE
2.1 Introduction to the Method
A. Historically, there were two methods
1. Purchase
2. Pooling of interests – restricted by APB Opinion No. 16 in 1970
B. New rules
1. SFAS No. 141 discontinues poolings
2. SFAS No. 142 changes the way goodwill is accounted for
C. Why the change?
1. Before 1970, pooling was commonly used
a. Pooling allowed assets to carry forward at original cost
b. Poling usually resulted in higher consolidated net income
2. In 1970 the APB issued Opinion No. 16, which severely reduced the number
of combinations that could be considered poolings
3. In 1997, FASB expressed concerns about lack of comparability
4. In 1999, FASB issued an Exposure Draft
a. Prohibit pooling
b. Reduce maximum amortization of goodwill from 40 to 20 years
5. Lots of controversy concerning the exposure draft caused 2001 modifications
a. No pooling after June 39, 2001
b. No goodwill amortization after June 30, 3001, even goodwill from prior
acquisitions
6. Positive aspects of new ruling
1
a. Enhanced comparability between companies
b. Higher reported earnings might help stock prices
2.2 Goodwill Impairment Test
A. Each year goodwill must be tested to see if its value has permanently declined
1. For “new” goodwill, the loss is current
2. For goodwill from acquisitions prior to the new ruling, the loss is treated as a
change in accounting principle
B. Technique
1. Goodwill is assigned to a reporting unit
2. There is a two-step process
a. Step 1. Fair value of the unit is compared to its carrying (book) value,
including goodwill
i. Fair value can be market prices, comparison prices, present value, etc.
ii. If FV < CV, step 2 is necessary
b.
Step 2. Carrying value of goodwill is compared to “implied fair value”
i. Same as original value calculation on date of acquisition
ii. Purchase price – FV of identifiable net assets = goodwill
3. When the loss is recognized, goodwill has a new carrying value which can’t be
written up
4. Other assets should be revalued first
C. Disclosures mandated by FASB
1. SFAS No. 141 disclosure for goodwill
a. Total amount of goodwill acquired and amount expected to be tax deductible
b. Amount of goodwill divided by reporting segment
2. SFAS No. 142
a. Presentation in financial statements
i. Aggregate goodwill on a separate line on the balance sheet
ii. Aggregate impairment loss in operating section of the income statement
b. Included in notes to the financial statements
i. Description of the circumstances
ii. Amount of loss
iii. Nature and amounts of losses
C. Transitional disclosure is required until all statements presented reflect the
new ruling
2.3
Other Intangible Assets
A. Acquired intangibles other than goodwill should be amortized over their economic
lives, as per SFAS No. 121
B. Other intangibles with indefinite lives should not be amortized until their economic
lives are determined
2.4
Did Firms Prefer Pooling; and If So, Why?
A. The two methods resulted in substantially different financial statements
B. Basis of pooling
1. Neither firm was dominant – a “combination,” not an “acquisition”
2. Assets. Liabilities and Retained Earnings were carried forward at their original
amounts – no “acquisition,” no revaluation
2
2.5
2.6
2.7
3. Operating results combined as if the two companies had been together all year –
no “purchased income”
C. Income statement perspective
1. Income often higher in pooling – no goodwill amortization
2. Also – there is lower depreciation on assets which aren’t revalued
3. Return on assets is higher because income is higher and assets are lower
D. Balance sheet perspective
1. Pooling leaves assets further from current value
2. Pooling combines the retained earnings of both companies
Treatment of acquisition expenses
A. With a purchase, each category of expense is treated separately
1. Direct expenses of purchase are capitalized
2. Indirect expenses are written off
3. Security issue costs are assigned to valuation of the securities
Pro Forma Statements and Disclosure Requirement
A. Pro forma statements serve two functions
1. To provide information when planning the combination
2. To disclose relevant information after the combination
B. Planning function
1. To estimate purchase price
2. To explain combination to stockholders
3. Must be clearly labeled pro forma
C. Disclosure function
1. Notes to the financial statements should include
a. Results of operations as if the companies had been together all year
b. Results of operations of the prior year as if the companies had been together
2. Minimum information must include:
a. Revenue
b. Income before extraordinary items
c. Cumulative effect of changes in accounting principle
d. Net income
e. Earnings per share
f. Nature and amounts of any material, nonrecurring items
Explanation and Illustration of Purchase Accounting
A. This method treats the combination as a purchase of one company by another
1. The cost of the acquisition is cash and debt given
2. Assets by issuing stock
a. Valued at fair value of stock issued or fair value of asset acquired
b. Quoted market price of stock is preferred fair value
c. Closely held stock issues use the fair value of assets
3. Cost is allocated to identifiable assets acquired and liabilities assumed, using fair
values
4. Any excess of cost over the sum of the fair values of the net assets is recorded as
goodwill, which is not amortized but can be adjusted for impairment
a. This avoids creative manipulation in the valuation of assets
b. R & D was often used as a tool for manipulating goodwill
3
2.8
2.9
5. If the fair values of the net assets exceed the cost, the buyer has a “bargain
purchase”
B. Income Tax Consequences in Business Combinations Accounted for by the Purchase
Method
1. Fair values of net assets might be different from income tax valuations of those
same assets
2. SFAS No. 109 requires deferred taxes be recorded for those differences
Financial Statement Differences Between Accounting Methods
A. The financial statements of two similar combinations could be very different under
purchase and pooling
1. Poolings recorded before SFAS Nos. 141 and 142 will not be changed, so
statements might continue to be different for some time to come.
2. Purchase accounting
a. Higher asset values – assets valued at their fair value rather than original cost,
and goodwill recorded
b. Lower earnings – lower depreciation from assets revalued, and no
amortization of goodwill
3. Pooling accounting
a. Lower asset values – assets recorded at their original costs, no goodwill
b. Higher earnings – lower depreciation, no amortization of goodwill
c. Future sale of capital assets will provide a higher gain (or smaller loss) since
the “cost” is lower
d. Lower stockholder’s equity is the result of using original cost
e. Higher income and lower equity cause a higher return on stockholders’ equity
B. Bargain purchase
1. Purchase price is below the fair value of identifiable net assets
2. Some of the acquired assets must be recorded below their fair values
a. Current assets, long-term investments, assets to be disposed of by sale,
deferred tax assets, prepaid pension assets, and assumed liabilities are always
recorded at fair value
b. Any previously recorded goodwill on the seller’s books is eliminated
c. Long-lived assets are recorded at fair value less an adjustment for the bargain
d. An extraordinary gain is recorded only if all long-lived assets are reduced to
zero
3. The excess of fair value over cost should be allocated to long-lived assets in
proportion to their fair values
Contingent Consideration in a Purchase
A. Sometimes a purchase agreement includes a contingency in the contract
1. The purchasing company might have to give more cash or securities if certain
events happen
2. There’s usually a stated contingency period, which should be disclosed
B. Contingency based on earnings
1. If the combined company’s earnings exceed estimates, the purchaser might have
to give the sellers additional cash or securities
2. Sometimes shareholders may be provided with compensation for services, use of
property, or profit sharing
4
2.10
a. A decision must be made as to whether the compensation is part of the
purchase price or is actually compensation
b. To be compensation
i. There must be a “linkage” of continuing employment with the contingency
ii. The duration of employment must be for the contingent period
iii.If the compensation is above that offered to other employees, the payments
are additional purchase price.
c. Compensation is expensed
3. If the compensation is determined to be additional purchase price
a. Compensation can be added to goodwill already recorded
b. If there is an excess of fair value over cost, the cost must be restated to include
the compensation
C. Contingency based on security prices
1. A contingency where the buyers guarantee a certain price for stock issued to
sellers as a part of the acquisition
2. The cost of the acquisition does not change
3. The buyers pay stockholders of the acquired company if the stock price on a
certain date does not meet a predetermined level.
a. Payment can be cash or other assets
b. Payment can be issuance of additional shares of stock
4. The amount paid reduces other contributed capital
D. Contingency based on both future earnings and stock prices – a combination of both
methods
Leveraged Buyouts (LBOs)
A. Leveraged buyouts occur when management and outside investors buy all the
outstanding shares of stock and the old corporation becomes a new, closely-held
corporation
1. The management group gives some of their stock
2. Large amounts of money are borrowed (the “leverage”)
B. How should the new company be accounted for?
1. Only net assets acquired with borrowed funds have been purchased and should be
recorded at their fair values.
2. Net assets acquired with donation of stock by managers should be recorded at
their original cost
5
MULTIPLE CHOICE QUESTIONS
Choose the BEST answer for the following questions.
_____ 1.
The currently acceptable method(s) of accounting for a business combination is (are):
a. statutory merger
b. pooling of interests
c. purchase
d. both purchase and pooling
_____ 2.
The general idea of a pooling of interests is the:
a. acquiring company is buying an asset.
b. acquiring and the acquired companies are joining as if they were always together.
c. acquisition always results in parent-subsidiary relationship.
d. assets of the acquired company are recorded at their fair market values.
_____ 3.
The advantages of a purchase include:
a. one company acquires another and control passes.
b. the transaction is based on book values given and received.
c. the companies report as if they had always been together.
d. earning per share are generally higher than in a pooling.
_____ 4.
What is P’s cost in a purchase?
a. The par value of the stock issued
b. The fair value of the net assets acquired
c. The book value of the net assets acquired
d. The cash, debt, or fair value of stock given up
_____ 5.
What is goodwill?
a. The excess of cost over fair value of net assets acquired
b. The excess of cost over book value of net assets acquired
c. The excess of fair value of net assets acquired over cost
d. The amortized excess of fair value of assets acquired over their book value
_____ 6.
What is the current technique for the disposition of goodwill acquired in a business
combination?
a. Amortized over some period not to exceed 40 years
b. Amortized over some period not to exceed 20 years
c. Expensed in the year of combination
d. Capitalized at original value unless impairment occurs
_____ 7.
What is a bargain purchase?
a. When P’s cost is far above the fair value of S’s net assets acquired
b. When P cannot determine a fair value of its stock issued in the acquisition
c. When P purchases S for less than the fair market value of the net assets acquired
d. When P increases the value of the long-lived assets to reflect its excess cost
6
_____ 8. If P offers a contingency based on earnings:
a. P’s original stockholders might be entitled to additional payments
b. S’s original stockholders might be entitled to additional payments
c. the amounts determined are always added to the purchase price of the acquisition
d. there is concern from S’s original stockholders that the purchase price offered by
P might be too high
_____ 9. Impairment of goodwill
a. causes the asset account to be decreased.
b. is the only time goodwill from a business combination is expensed.
c. cannot ever be reclaimed in future periods.
d. all of the above.
_____10. Which of the following is NOT a drawback of the purchase method?
a. Both return on assets and earnings can be smaller than under a pooling
b. P’s books reflect both historical cost and fair market values.
c. P can use a variety of resources to acquire S.
d. Fair values are sometimes difficult to objectively determine.
_____11. A leveraged buyout includes:
a. a group of employees and their party investors making a tender offer for all the
common stock of a corporation.
b. most of the capital for the new corporation comes from debt.
c. some assets are recorded at cost and some at book value.
d. all of the above.
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MATCHING
Match the terms in the list to the definitions below. Each term may be used only once.
a.
b.
c.
d.
e.
f.
Pooling of interests
Purchase
Contingent purchase
Goodwill
Pro forma statements
Impairment
g.
h.
i.
j.
k.
Bargain purchase
Leverage buyout
Fair value
Book value
P’s cost
_____ 1.
The value recorded by S for its net assets before its acquisition by P
_____ 2.
An agreement to modify the price paid for a company for events that happen after the
acquisition date
_____ 3.
The amount determined by what P gives up in its acquisition of S
_____ 4. A combination technique which assumes the businesses have always been together
_____ 5.
A purchase where P pays less than the fair market value of S’s net assets
_____ 6.
The excess of cost over the fair value of S’s net assets
_____ 7.
A condition where P’s purchased goodwill is determined to be less than originally
calculated
_____ 8.
A combination where P buys the net assets of S
_____ 9.
A combination often financed by large amounts of debt
_____10. The value of net assets recorded in a purchase
_____11. Statements prepared to reflect the impact of a business combination in the year of
acquisition
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EXERCISES
1. Proust Corporation is considering a merger with Seville Company. After considerable
negotiations, the two companies determined that two shares of each Seville Company stock
would be replaced with one share of Proust stock. The balance sheets of the two companies
are below, along with the fair value of Seville’s identifiable net assets. At this time, Proust’s
stock is selling for $50 a share, and Seville’s stock is selling for $25.
___Proust
Cash
$ 50,000
Receivables
20,000
Inventories
15,000
Plant and equipment (net) 150,000
Total assets
$ 235,000
Seville
$ 30,000
15,000
20,000
80,000
$ 145,000
Liabilities
Common Stock, $10 par
Other cont. capital
Retained earnings
Total equities
$ 10,000
75,000
20,000
40,000
$ 145,000
$ 25,000
100,000
50,000
60,000
$ 235,000
Seville’s
Fair Values
$ 30,000
14,000
23,000
95,000
Required:
A. Assume the merger will be accounted for as a purchase. Determine the value of the stock
issued and the resulting cost of the merger to Proust. Determine any goodwill.
9
B. Prepare journal entries for the Proust Company after the merger.
10
SOLUTIONS
MULTIPLE CHOICE
1. c
2. b
3. a
4. d
5. a
6. d
7.
8.
9.
c
b
d
10. b
11. d
4. a
5. g
6. d
7.
8.
9.
f
b
h
10. i
11. e
MATCHING
1. j
2. c
3. k
EXERCISES
1. a. Seville’s net assets at fair value:
Cash
$ 30,000
Receivables
14,000
Inventory
23,000
Plant & Equip
95,000
Total assets
$162,000
Liabilities
10,000
Fair value of S’s net assets $152,000
Proust’s stock issued:
Seville’s stock = $75,000/$10 par value = 7,500 shares
Proust issues 7,500/2 = 3,750 new shares x $50 market price = $187,500
Goodwill:
Proust’s cost
$187,500
Fair value of S’s assets 152,000
Goodwill
$ 35,500
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b.
To record Proust’s purchase of Seville
Cash
Receivables
Inventory
Plant and equipment
Goodwill
Liabilities
Common stock [3,750 x $10 par]
Other contributed capital [3,750 x $40]
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30,000
14,000
23,000
95,000
35,500
10,000
37,500
150,000