Business Combinations

Most organizations, large and small, hold

ownership in other companies.

FASB Accounting Standards Codification

(ASC) Business Combinations (Topic 805)
and Consolidation (Topic 810) provide
guidance using the acquisition method.

The acquisition method embraces the fair

value measurement for measuring and
assessing business activity.
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Business Combinations

Financial statements that represent a parent

and its subsidiaries as a SINGLE ENTITY are
known as consolidated financial statements.

Ownership can exist through a majority

voting interest or with a lesser percentage of
ownership through governance contracts,
leases, or agreements with other stockholders.

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LO 1

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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LO 2

The Consolidation Process

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(810-10-10-1)

Consolidated financial statements provide more

meaningful information than separate statements.

Consolidated financial statements more fairly

present the activities of the consolidated companies.

Yet, consolidated companies may retain their legal

identities as separate corporations.
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LO 3

Business Combinations
Business combinations . . .
can be achieved through transactions or
events in which an acquirer obtains control
over one or more businesses.

Create single economic entities.

Can be formed by a variety of events but can

differ widely in legal form.

Require consolidated financial statements.

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Business Combinations

2-6

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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2-8

Consolidation of Financial
Information
Parents
financial data

Subsidiaries
financial data

brought together
To report the financial position, results of operations,
and cash flows for the combined entity.

Reciprocal accounts and intra-entity transactions

are adjusted or eliminated to. . .
Prepare a single set of consolidated financial statements.
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What is to be consolidated?
If dissolution occurs:
All account balances are actually consolidated
in the financial records of the survivor.

If separate incorporation maintained:

Financial statement information (on work
papers, not the actual records) is

consolidated.

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2-10

When does consolidation occur?

If dissolution occurs:

Permanent consolidation occurs at the

combination date.

If separate incorporation maintained:

Consolidation occurs at regular intervals,

whenever financial statements are prepared.

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How does consolidation affect the

accounting records?
If dissolution occurs:
Dissolved companys records are closed out.
Surviving companys accounts are adjusted
to include all balances of the dissolved
company.
If separate incorporation is maintained:
Each company continues to retain its own
records.
worksheets facilitates the periodic
consolidation process without disturbing
individual accounting systems.
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LO 4

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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LO 5

Fair Value

Asset valuations established using

The Market Approach fair value can be
estimated referencing similar market trades.

The Income Approach fair value can be

estimated using the discounted future cash
flows of the asset.

The 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 Smallports 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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LO 6

Consideration Transferred =
Net Identified Asset Fair Values
Dissolution of Subsidiary
BigNet Companys Financial RecordsDecember 31
Current Assets . . . . . . . . . . . . . . . . . . . . . . . 300,000
Computers and Equipment . . . . . . . . . . . . . 600,000
Capitalized Software . . . . . . . . . . . . . . . . .1,200,000
Customer Contracts . . . . . . . . . . . . . . . . . . . 700,000
Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000
Cash (paid by BigNet) . . . . . . . . . . . . . . . . . . . . . . . . . . 550,000
Common Stock (20,000 shares issued at $10 par value) 200,000
Additional Paid-In Capital . . . . . . . . . . . . . . . . . . . . . . 1,800,000
To record acquisition of Smallport Company. Assets acquired
and liabilities assumed are recorded at fair value.
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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 Smallports 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 Companys Financial RecordsDecember 31
Current Assets . . . . . . . . . . . . . . . . . . . . . 300,000
Computers and Equipment . . . . . . . . . . . 600,000
Capitalized Software . . . . . . . . . . . . . . .1,200,000
Customer Contracts . . . . . . . . . . . . . . . . . 700,000
Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . .450,000
Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000
Cash (paid by BigNet) . . . . . . . . . . . . . . . . . . . . . . 1,000,000
Common Stock (20,000 shares at $10 par value) . . . . 200,000
Additional Paid-In Capital . . . . . . . . . . . . . . . . . . . . 1,800,000
To record acquisition of Smallport Company. Assets acquired
and liabilities assumed are recorded at fair value.
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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
Smallports 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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Acquisition Method Example

Purchase Price < Fair Value
Dissolution of Subsidiary
BigNet Companys Financial RecordsDecember 31
Current Assets . . . . . . . . . . . . . . . . . . . . . . . 300,000
Computers and Equipment . . . . . . . . . . . . . 600,000
Capitalized Software . . . . . . . . . . . . . . . . .1,200,000
Customer Contracts . . . . . . . . . . . . . . . . . . . 700,000
Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000
Common Stock (20,000 shares issued at $10 par value) 200,000
Additional Paid-In Capital . . . . . . . . . . . . . . . . . . . . . . 1,800,000
Gain on Bargain Purchase . . . . . . . . . . . . . . . . . . . . . . 550,000
To record acquisition of Smallport Company. Assets acquired and
liabilities assumed are recorded at fair value.
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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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LO 7

Acquisition Method
Separate Incorporation Maintained
Dissolution

does not occur.

Consolidation

process is similar to previous example.

Fair value

is the basis for initial consolidation of

subsidiarys net assets.

Subsidiary

is a legally incorporated separate entity.

Consolidation

of financial information is simulated.

Acquiring

company does not physically record the

transaction.
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LO 7

The Consolidation Worksheet

Consolidation worksheet entries (adjustments and
eliminations) are entered on the worksheet only.
Steps in the process:
1.Prior to

constructing a worksheet, the parent prepares

a formal allocation of the acquisition date fair value
similar to the equity method procedures.
2.Financial information for Parent and Sub is recorded
in the first two columns of the worksheet (with Subs
prior revenue and expense already closed).

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The Consolidation Worksheet

continued. . .
3. Remove the Subs equity account balances.
4.

Remove the Investment in Sub balance.

5.

Allocate Subs Fair Values, including any excess of

cost over Book Value to identifiable assets or
goodwill.

6.

Combine all account balances and extend into the

Consolidated totals column.

7.

Subtract consolidated expenses from revenues to

arrive at net income.

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Acquisition Method
Consolidation Workpaper Example

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LO 8

Acquisition Date Fair-Value

Allocations Additional Issues

Intangibles are assets that:

Lack physical substance (excluding financial
instruments)
Arise from contractual or other legal rights
Can be sold or otherwise separated from the acquired
enterprise

Preexisting goodwill recorded in the acquired companys

accounts is ignored in the allocation of the purchase
price.

IPR&D that has reached technological feasibility is

capitalized as an intangible asset at fair value with an
indefinite life that is reviewed for impairment.

Ongoing R&D is expensed as incurred.

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