Ch.1 Business Combinations

Chapter 1
Business Combinations
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Business Combinations: Objectives
1. Understand the economic motivations

underlying business combinations.
2. Learn about the alternative forms of
business combinations.
3. Introduce concepts of accounting for
business combinations, emphasizing the
acquisition method.
4. See how firms record fair values of assets
and liabilities in an acquisition.

Types of Business Combinations
– Business combinations unite previously separate
business entities.
– Horizontal integration – same business lines and

markets
– Vertical integration – operations in different, but

successive stages of production or distribution,
or both
– Conglomeration – unrelated and diverse products

or services

Reasons for Combinations
– Cost advantage
– Lower risk
– Fewer operating delays
– Avoidance of takeovers
– Acquisition of intangible assets
– Other: business and other tax advantages,

personal reasons

Legal Form of Combination
Merger
– Occurs when one corporation takes over all the
operations of another business entity and that
other entity is dissolved.
Consolidation
– Occurs when a new corporation is formed to take
over the assets and operations of two or more
separate business entities and dissolves the
previously separate entities.

Mergers:
A+B=A X+Y=X
Company A acquires the net assets of Company
B for cash, other assets.
Or:
Company A debt/equity securities. Company B
is dissolved; Company A survives with Company
B’s assets and liabilities.
Company X acquires the stock of Company Y
from its shareholders for cash, other assets.
or:
Company X debt/equity securities. Company Y
is dissolved. Company X survives with Company
Y’s assets and liabilities.

Consolidations:
E + F = “D” K + L = “J”
Company D is formed and acquires the net
assets of companies E and F by issuing
Company D stock. Companies E and F are
dissolved. Company D survives with the assets
and liabilities of both dissolved firms.
Company J is formed and acquires the stock of

companies K and L from their respective
shareholders by issuing Company J stock.
Companies K and L are dissolved. Company J
survives with the assets and liabilities of both
firms.

Keeping the Terms Straight
In the general business sense, mergers and
consolidations are business combinations and
may or may not involve the dissolution of the
acquired firm(s).
In Chapter 1, mergers and consolidations will
involve only 100% acquisitions with the
dissolution of the acquired firm(s). These
assumptions will be relaxed in later chapters.
“Consolidation” is also an accounting term used
to describe the process of preparing consolidated
financial statements for a parent and its
subsidiaries.

Business Combinations
ACCOUNTING FOR BUSINESS COMBINATIONS

Business Combination (def.)
A business combination is “a transaction or

other event in which an acquirer obtains
control of one or more businesses.
Transactions sometimes referred to as true
mergers or mergers of equals also are
business combinations.
A parent-subsidiary relationship is formed
when:
– Less than 100% of the firm is acquired, or
– The acquired firm is not dissolved.

U.S. GAAP for Business Combinations
– Since the 1950s both the pooling-of-interests

method and the purchase method of accounting
for business combinations were acceptable.
– Combinations initiated after June 30, 2001 use

the purchase method.
– Firms now use the acquisition method for

business combinations. This began with
combinations in fiscal periods beginning after
December 15, 2008.

International Accounting
– Most major economies prohibit the use of the

pooling method.
– The International Accounting Standards Board

specifically prohibits the pooling method and
requires the acquisition method.

Recording Guidelines (1 of 2)
– Record assets acquired and liabilities assumed
using the fair value principle.
– If equity securities are issued by the acquirer,

charge registration and issue costs against the
fair value of the securities issued, usually a
reduction in additional paid-in-capital.
– Charge other direct combination costs (e.g.,

legal fees, finders’ fees) and indirect
combination costs (e.g., management salaries)
to expense.

Recording Guidelines (2 of 2)
– When the acquiring firm transfers its assets
other than cash as part of the combination, any
gain or loss on the disposal of those assets is
recorded in current income.
– The excess of cash, other assets, debt, and

equity securities transferred over the fair value
of the net assets (A – L) acquired is recorded as
goodwill.
– If the net assets acquired exceeds the cash,

other assets, debt, and equity securities
transferred, a gain on the bargain purchase is
recorded in current income.

Example: Pop Corp. (1 of 3)
Pop Corp. issues 200,000 shares of its $10

par value common stock for Son Corp.
Pop’s stock is valued at $16 per share.
Investment in Son Corp. 3,200,000
Common stock, $10 par 2,000,000
Additional paid-in-capital 1,200,000

Pop Corp. pays cash for $160,000 in finder’s and
consulting fees and for $80,000 to register and issue
its common stock.
Investment expense 160,000
Additional paid-in-capital 80,000
Cash 240,000
Son Corp. is assumed to have been dissolved. So,

Pop Corp. allocates the investment’s cost to the fair
value of the identifiable assets acquired and
liabilities assumed. The excess cost is goodwill.

Receivables XXX
Inventories XXX
Plant assets XXX
Goodwill XXX
Accounts payable XXX
Notes payable XXX
Investment in Son Corp. 3,200,000

Goodwill
Goodwill is the excess of fair value of the

consideration assets transferred Over the net
assets acquired.
Goodwill on the books of the acquired firm is

assigned no value.

Example – Pit Corp. Data
Pit Corp. acquires the net assets of Sad Co.

in a combination on 12/27/2011.
The assets and liabilities of Sad Co. on this

date, at their book values and fair values, are
as follows (in thousands):

Book Val. Fair Val.
Cash $100 $100
Net receivables 300 280
Inventory 400 500
Land 100 200
Buildings, net 600 1.000
Equipment, net 500 700
Patents 0 100
Total assets $2,000 $2,880
Accounts payable $120 $120
Notes payable 300 270
Other liabilities 80 90
Total liabilities $500 $480
Net assets $1,500 $2,400

Acquisition with Goodwill
Pit Corp. pays $800,000 cash and issues 100,000

shares of Pit Corp. $10 par common stock with a
market value of $20 per share for the net assets of
Sad Co.
Total consideration at fair value (in thousands):

$800 + (100 shares x $20) $2,800
Fair value of net assets acquired: $2,400

Goodwill $ 400

Entries with Goodwill
The entry to record the acquisition of the net

assets:
Investment in Sad Co. (+A) 2,800
Cash (-A) 800
Common stock, $10 par (+SE) 1,000
Additional paid-in-capital (+SE) 1,000
The entry to record Sad’s assets directly on

Pit’s books:

Cash (+A) 100
Net receivables (+A) 280
Inventories (+A) 500
Land (+A) 200
Buildings (+A) 1,000
Equipment (+A) 700
Patents (+A) 100
Goodwill (+A) 400
Accounts payable (+L) 120
Notes payable (+L) 270
Other liabilities (+L) 90
Investment in Sad Co. (-A) 2,800

Acquisition with Bargain Purchase
Pit Corp. issues 80,000 shares of its $10 par

common stock with a market value of $20
per share, and it also gives a 10%, five-year
note payable for $400,000 for the net assets
of Sad Co.
Fair value of net assets
$2,400
acquired (in thousands)
Total consideration at fair value
$2,000
(80 shares x $20) + $400
Gain from bargain purchase $400

Entries with Bargain Purchase
The entry to record the acquisition of the net

assets:
10% Note payable (+L) 400
Common stock, $10 par (+SE) 800
Additional paid-in-capital (+SE) 800
The entry to record Sad’s assets directly on

Pit’s books:

Cash (+A) 100
Net receivables (+A) 280
Inventories (+A) 500
Land (+A) 200
Buildings (+A) 1,000
Equipment (+A) 700
Patents (+A) 100
Accounts payable (+L) 120
Notes payable (+L) 270
Other liabilities (+L) 90
Gain from bargain purchase (G, +SE) 400

Goodwill
Capitalized goodwill is the purchase price not assigned to
identifiable assets and liabilities.
– Errors in valuing assets and liabilities affect the amount of
goodwill recorded.
Historically goodwill in most industrialized countries was
capitalized and amortized.
Current IASB standards, like U.S. GAAP
– Capitalize goodwill,
– Do not amortize it, and
– Test it for impairment
Record a loss if the implied fair value is less than the carrying
value of the goodwill.

When to Test for Impairment
Goodwill should be tested for impairment at

least annually.
More frequent testing may be needed:

Significant adverse change in business
– Adverse action by regulator

– Unanticipated competition
– Loss of key personnel

Intangible Asset Disclosures
Specific disclosures are needed:

– In the fiscal period when intangibles are
acquired,
– Annually, for each period presented, and
– In the fiscal period that includes an impairment
Disclosures are needed for:

– Intangibles which are amortized,
– Intangibles which are not amortized,
– Research & development acquired, and
– Intangibles with renewal or extension terms

Ch.1 Business Combinations

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Chapter 1

Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-1

1. Understand the economic motivations

Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-2

– Horizontal integration – same business lines and

– Vertical integration – operations in different, but

– Conglomeration – unrelated and diverse products

Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-3

– Fewer operating delays

– Acquisition of intangible assets

– Other: business and other tax advantages,

Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-4

Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-5

Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-6

Company J is formed and acquires the stock of

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Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-8

ACCOUNTING FOR BUSINESS COMBINATIONS

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A business combination is “a transaction or

Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-10

– Since the 1950s both the pooling-of-interests

– Combinations initiated after June 30, 2001 use

– Firms now use the acquisition method for

Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-11

– Most major economies prohibit the use of the

– The International Accounting Standards Board

Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-12

– If equity securities are issued by the acquirer,

– Charge other direct combination costs (e.g.,

Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-13

– The excess of cash, other assets, debt, and

– If the net assets acquired exceeds the cash,

Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-14

Pop Corp. issues 200,000 shares of its $10

Investment in Son Corp. 3,200,000

Common stock, $10 par 2,000,000

Additional paid-in-capital 1,200,000

Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-15

Investment expense 160,000

Additional paid-in-capital 80,000

Son Corp. is assumed to have been dissolved. So,

Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-16

Plant assets XXX

Accounts payable XXX

Notes payable XXX

Investment in Son Corp. 3,200,000

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Goodwill is the excess of fair value of the

Goodwill on the books of the acquired firm is

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Pit Corp. acquires the net assets of Sad Co.

The assets and liabilities of Sad Co. on this

Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-19

Copyright ©2015 Pearson Education, Inc. All rights reserved. 1-20

Pit Corp. pays $800,000 cash and issues 100,000

Total consideration at fair value (in thousands):

Fair value of net assets acquired: $2,400

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The entry to record the acquisition of the net

The entry to record Sad’s assets directly on

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Pit Corp. issues 80,000 shares of its $10 par