CHAPTER 2

Accounting for Business Combinations

BRIEF OUTLINE
2.1 Accounting Standards on Business Combinations 2.5 Contingent Consideration in an Acquisition
2.2 Pro Forma Statements and Disclosure Requirements 2.6 Leveraged Buyouts
2.3 Explanation and Illustration of Acquisition Accounting 2.7 IFRS versus U.S. GAAP
2.4 Other Intangible Assets Appendix 2A: Deferred Taxes in Business Combinations

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 Accounting Standards on Business Combinations: Background

A. Historically, there were two methods
1. Purchase
2. Pooling of interests – restricted by APB Opinion No. 16 in 1970
B. Major changes made in 2007
1. SFAS No. 141 discontinued the “pooling method” and allows for the “purchase method”
only.
2. SFAS No. 141R replaced SFAS 141. Only one method is allowed, the “acquisition
method”.
3. SFAS No. 141R requires that fair values of all assets and liabilities on the acquisition
date, defined as the date the acquirer obtains control of the acquire, be reflected in
financial statements.
4. These topics are now codified in FASB ASC Topic 805 [Business Combinations].
5. SFAS No. 142, now included in FASB ASC Topic 810 [Consolidations], changes the
way goodwill is accounted for at acquisition and FASB ASC Topic 350 how goodwill is
accounted for subsequent to acquisition.
6. FASB ASC Topic 810 [Consolidations] on reporting for non-controlling interests is
covered in Chapter 3.
7. These standards try to overcome criticisms that have haunted the accounting for some
time:
a. Differences between U.S. GAAP and International Financial Reporting Standards
b. Lack of consistency, understandability and usefulness in accounting for step
acquisitions
8. The essence of the changes is that the acquired business should be recognized at its fair
value on the acquisition date (defined as the date when control is obtained), rather than its
cost.
C. Goodwill for public companies is assigned to a reporting unit.
A. Assess qualitative factors to determine if fair value of reporting unit is less than its carrying
amount. If a likelihood greater than 50 percent that the fair value of the reporting unit is less than
its carrying amount, there is a two-step process:
1. Determine whether the carrying value of the reporting unit is greater than zero
Study Guide to accompany Jeter and Chaney, Advanced Accounting

a. If CV < zero and circumstances suggest that it is more likely than not that
goodwill has been impaired, step 2 is necessary
b. Such circumstances include unanticipated competition, loss of key personnel,
and adverse regulatory action
2. Compare the carrying value of goodwill to its “implied fair value” (calculated as FV of
reporting unit – FV of identifiable net assets)
a. Same as original value calculation on date of acquisition
b. Acquisition 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 tested for impairment first
D. Disclosures Mandated by FASB
1. FASB ASC paragraph 805-30-50-1 includes 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. FASB ASC paragraph 350-20-45-1
a. Presentation in financial statements (if impairment occurs)
i. Aggregate goodwill on a separate line on the balance sheet
ii. Aggregate impairment loss in operating section of the income statement
b. FASB ASC paragraph 350-20-50-2 included in notes to the financial statements
i. Description of the circumstances
ii. Amount of loss and method of determining FV of reporting unit
iii. Nature and amounts of losses
c. Transitional disclosure is required until all statements presented reflect the
new ruling
3. FASB ASC paragraph 805-10-50-2 includes other required disclosures
a. Name and description of acquiree
b. The acquisition date
c. The percentage of voting equity acquired
d. The primary reasons for the business combination
e. The fair value of acquiree and the basis of measuring the fair value
f. The fair value of consideration transferred
g. The amounts recognized for each major class of asset and liabilities
h. The maximum potential amount of future payments
E. Other Intangible Assets
1. Acquired intangibles other than goodwill should be amortized over their limited economic
lives and be reviewed for impairment in accordance with FASB ASC Section 350-30-35
[Intangibles – Subsequent Measurement]
2. Other intangibles with indefinite lives should not be amortized until their economic
lives are determined. Instead it should be tested annually for impairment.
F. FASB ASC paragraph 805-10-25-23 treatment of acquisition expenses
1. Excluded from measurement of consideration paid
a. Direct and indirect expenses are expensed
b. Security issue costs are assigned to valuation of the securities
2.2 Pro Forma (as if) 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

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C. Notes to the financial statements should include

1. Results of operations as if the companies had been together all year
2. Results of operations of the prior year as if the companies had been together all year
2.3 Explanation of Acquisition Accounting
A. This method treats the combination as an acquisition 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, whichever is more
clearly evident
b. Quoted market price of stock is preferred fair value, if stock is actively traded
c. For issued stock from new or closely held companies use the fair value of assets
3. Value implied by the purchase price is allocated to identifiable assets acquired and
liabilities assumed, using fair values
4. Any excess of value implied by the purchase price exceeding 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. In-process R&D that is acquired as part of a business combination is capitalized
5. If the fair values of the net assets exceed the value implied by the purchase price, the
buyer has a “bargain acquisition.” This amount is recognized in income.
B. Income Tax Consequences in Business Combinations Accounted for by the Acquisition
Method
1. Fair values of net assets might be different from income tax valuations of those assets
2. Current GAAP requires deferred taxes be recorded for those differences
C. Bargain Acquisition
1. Value implied by the purchase price is below the fair value of identifiable net assets
2. Any previously recorded goodwill on the seller’s books is eliminated
3. An ordinary gain is recorded to the extent that the fair value of net assets exceeds the
consideration paid.
2.4 The Measurement Period (and Measurement Period Adjustments)
A. Measurement period is the period after the acquisition date during which the
acquirer may adjust the provisional amounts recognized to identify and measure
any of the following as of the acquisition date:
1. The identifiable assets acquired, liabilities assumed, and any noncontrolling interest in
the acquiree
2. Any consideration transferred to the acquiree
3. In a business combination achieved in stages, any previous equity interest held by the
acquirer
4. The amount recognized as goodwill or the gain from a bargain purchase
B. 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
2.5 Contingent Consideration in an Acquisition
A. Sometimes a purchase agreement includes a contingency in the contract
1. The purchaser might have to give more cash or securities if certain events happen
2. There’s usually a stated contingency period, which should be disclosed
3. All contingent consideration must be measured and recognized at fair value on the
acquisition date
4. Subsequent adjustments usually result from events or changes in circumstances that take
place after the acquisition date and, thus, should not be treated as adjustments to the
consideration paid.

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5. Contingent consideration classified as equity shall not be remeasured

B. Contingency based on both future earnings and stock prices – all additional contingent
consideration is recorded
2.6 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 whatever stock they hold
2. Large amounts of money are borrowed (the “leverage”)
B. LBOs are viewed as business combinations.
2.7 IFRS versus U.S. GAAP
A. Project on business combinations was the first of several joint projects to move converge
standards.
B. Significant difference is that IFRS allows user choice of writing all assets including goodwill
up fully (U.S. GAAP) or write goodwill up only to the extent of the parent’s percentage of
ownership
Appendix 2A: Deferred Taxes in Business Combinations (Available at www.wiley.com/college/jeter)
A. To the extent that the seller accepts 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
B. In a non-taxable exchange, where the goodwill is not subject to amortization on either the tax
return or the books, there is no obvious temporary difference
C. In a taxable exchange, the excess amount of tax-deductible goodwill over the goodwill
recorded in the books does meet a definition of temporary difference
D. Changes in valuation allowance on deferred tax assets shown as income or expense in the
period of the combination

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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. acquisition
d. both acquisition and pooling

_____ 2. The general idea of the acquisition method 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 an acquisition 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. earnings per share are generally higher than in a pooling.

_____ 4. What is parent’s cost in an acquisition?

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 acquisition?

a. When parent’s cost is far above the fair value of S’s net assets acquired
b. When parent cannot determine a fair value of its stock issued in the acquisition
c. When parent purchases S for less than the fair market value of the net assets acquired
d. When parent increases the value of the long-lived assets to reflect its excess cost

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_____ 8. If parent offers a contingency based on earnings:

a. parent’s original stockholders might be entitled to additional payments
b. subsidiary’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 subsidiary’s original stockholders that the purchase price offered by
parent 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 a drawback of an asset acquisition compared to a stock

acquisition?
a. Since the target company does not persist as a separate entity, its liability and its
regulated status, if any, may extend to the parent.
b. The consolidated statements reflect both historical cost and fair market values.
c. Parent can use a variety of resources to acquire subsidiary.
d. Fair values are sometimes difficult to objectively determine.

_____11. A leveraged buyout includes:

a. a group of employees and third 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. treatment as business combination.
d. all of these.

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MATCHING

Match the terms in the list to the definitions below. Each term may be used only once.

A. Business combinations E. Pro forma statements I. Fair value

B. Asset acquisition F. Impairment J. Book value
C. Contingent acquisition G. Bargain acquisition K. P’s cost
D. Goodwill H. Leveraged buyout

_____ 1. The value recorded by S for its net assets before its acquisition by parent

_____ 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. Convergence project by FASB and IASB

_____ 5. An acquisition 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 acquired 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 an acquisition

_____11. Statements prepared to reflect the impact of a business combination in the year of acquisition

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EXERCISE

1. Proust Corporation is considering a merger with Seville Company. After considerable negotiations,
the two companies determined that two shares of 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.

Seville’s
___Proust Seville Fair Values
Cash $ 50,000 $ 30,000
$ 30,000
Receivables 20,000 15,000 14,000
Inventories 15,000 20,000 23,000
Plant & Equipment (Net) 150,000 80,000 95,000
Total Assets $ 235,000 $ 145,000

Liabilities $ 25,000 $ 10,000 $ 10,000

Common Stock, $10 par 100,000 75,000
Other Contributed Capital 50,000 20,000
Retained Earnings 60,000 40,000
Total Lia & Equities $ 235,000 $ 145,000

Required:

A. Assume the merger will be accounted for as an acquisition. Determine the value of the stock
issued and the resulting cost of the merger to Proust. Determine any goodwill.

B. Prepare journal entries for the Proust Company after the merger.

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SOLUTIONS

MULTIPLE CHOICE
1. C 4. D 7. C 10. A
2. D 5. A 8. B 11. D
3. A 6. D 9. D

MATCHING

1. J 4. A 7. F 10. I
2. C 5. G 8. B 11. E
3. K 6. D 9. H

EXERCISE

1. a. Seville’s net assets at fair value:

Cash $ 30,000
Receivables 14,000
Inventory 23,000
Plant & Equipment 95,000
Total Assets $162,000
Liabilities 10,000
Fair value of Seville’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 × $50 market price = $187,500

Goodwill:
Proust’s cost $187,500
Fair value of Seville’s net assets 152,000
Goodwill $ 35,500

b.

To record Proust’s purchase of Seville

Cash 30,000
Receivables 14,000
Inventory 23,000
Plant & Equipment 95,000
Goodwill 35,500
Liabilities 10,000
Common Stock [3,750 × $10 par] 37,500
Other Contributed Capital [3,750 × $40] 150,000

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