Chapter 4: Business Combinations

1. Understand the economic motivations

underlying business combinations.
2. Learn about the alternative forms of
business combinations, from both the
legal and accounting perspectives.
3. Introduce concepts of accounting for
business combinations, emphasizing the
acquisition method.
4. See how firms make cost allocations in an
acquisition method combination.

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 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
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 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

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 Potential Prohibitions/ Obstacles
• Potential adverse effect of regulation
• Some states may impose high tax
• Complexity of combination process and
revaluation of assets
• Controversy of goodwill

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 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.

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 Mergers: A + B = A

1) Company A purchases the 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.
2) Company A purchases Company B stock from
its shareholders for cash, other assets, or
Company A debt/equity securities. Company B
is dissolved. Company A survives with
Company B’s assets and liabilities.
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 Consolidations: E + F = “D”
1) Company D is formed and acquires the 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.
2) Company D is formed acquires Company E
and F stock from their respective
shareholders by issuing Company D stock.
Companies E and F are dissolved. Company D
survives with the assets and liabilities of both
firms.
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 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.
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 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…” [FASB Statement No. 141,
para. 3.e.]
A parent – subsidiary relationship is formed
when:
– Less than 100% of the firm is acquired, or
– The acquired firm is not dissolved.
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 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. [IFRS 3]
• Firms should use the acquisition method for
business combinations.

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 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.
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 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 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 and equity securities transferred, a gain on
the bargain purchase is recorded in current
income.
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 Example: Poppy Corp. (1 of 3)
Poppy Corp. issues 100,000 shares of its $10 par
value common stock for Sunny Corp. Poppy’s
stock is valued at $16 per share. (in thousands)

Investment in Sunny Corp. 1,600

Common stock, $10 par 1,000
Additional paid-in-capital 600

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 Example: Poppy Corp. (2 of 3)
Poppy Corp. pays cash for $80,000 in finder’s fees and
consulting fees and for $40,000 to register and issue
its common stock. (in thousands)

Investment expense 80
Additional paid-in-capital 40
Cash 120
Sunny Corp. is assumed to have been dissolved. So,
Poppy Corp. will allocate the investment’s cost to the
fair value of the identifiable assets acquired and
liabilities assumed. Excess cost is goodwill.
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 Example: Poppy Corp. (3 of 3)

Receivables XXX
Inventories XXX
Plant assets XXX
Goodwill XXX
Accounts payable XXX
Notes payable XXX
Investment in Sunny Corp. 1,600

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Identify the Net Assets Acquired
Identify:
1. Tangible assets acquired,
2. Intangible assets acquired, and
3. Liabilities assumed
Include:
• Identifiable intangibles resulting from legal or
contractual rights, or separable from the entity
• Research and development in process
• Contractual contingencies
• Some noncontractual contingencies

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 Assign Fair Values to Net Assets
Use fair values determined, in preferential order,
by:
1. Established market prices
2. Present value of estimated future cash flows,
discounted based on observable measures
3. Other internally derived estimations

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 Exceptions to Fair Value Rule
• Deferred tax assets and liabilities [FASB
Statement No. 109 and FIN No. 48]
• Pensions and other benefits [FASB Statement
No. 158]
• Operating and capital leases [FASB Statement
No. 13 and FIN. No. 21]
• Goodwill on the books of the acquired firm is
assigned no value.

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 Goodwill
The excess of
• The sum of:
– Fair value of the consideration transferred,
– Fair value of any noncontrolling interest in the
acquiree, and
– Fair value of any previously held interest in
acquiree,
• Over the net assets acquired.

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 Contingent Consideration
• If the fair value of contingent consideration is
determinable at the acquisition date, it is
included in the cost of the combination.
• If the fair value of the contingent consideration is
not determinable at that date, it is recognized
when the contingency is resolved.
• Types of consideration contingencies:
– Future earnings levels
– Future security prices

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Recording Contingent Consideration
• Contingencies based on future earnings increase the
cost of the investment.
• Contingencies based on future security prices do not
change the cost of the investment. Additional
consideration distributed is recorded at its fair value
with an offsetting write-down of the equity or debt
securities issued.

In some cases the contingency may involve a return of

consideration.

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 Example – Pitt Co. Data
Pitt Co. acquires the net assets of Seed Co. in a
combination consummated on 12/27/2008.
The assets and liabilities of Seed Co. on this
date, at their book values and fair values, are
as follows (in thousands):

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 Book Val. Fair Val.
Cash $ 50$ 50
Net receivables 150 140
Inventory 200 250
Land 50 100
Buildings, net 300 500
Equipment, net 250 350
Patents 0 50
Total assets $1,000 $1,440
Accounts payable $ 60$ 60
Notes payable 150 135
Other liabilities 40 45
Total liabilities $ 250 $ 240
Net assets $ 750 $1,200
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 Acquisition with Goodwill
Pitt Co. pays $400,000 cash and issues 50,000
shares of Pitt Co. $10 par common stock with
a market value of $20 per share for the net
assets of Seed Co.
Total consideration at fair value (in thousands):
$400 + (50 shares x $20) $1,400
Fair value of net assets acquired: $1,200
Goodwill $ 200
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 Entries with Goodwill
The entry to record the acquisition of the net
assets:
Investment in Seed Co. 1,400
Cash 400
Common stock, $10 par 500
Additional paid-in-capital 500
The entry to record Seed’s assets directly on Pitt’s
books:

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Cash 50
Net receivables 140
Inventories 250
Land 100
Buildings 500
Equipment 350
Patents 50
Goodwill 200
Accounts payable 60
Notes payable 135
Other liabilities 45
Investment in Seed Co. 1,400
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Acquisition with Bargain Purchase
Pitt Co. issues 40,000 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 $200,000 for the net assets of Seed
Co.
Fair value of net assets acquired (in thousands):
$1,200
Total consideration at fair value:
(40 shares x $20) + $200 $1,000
Gain from bargain purchase $ 200
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 Entries with Bargain Purchase
The entry to record the acquisition of the net
assets:
Investment in Seed Co. 1,000
10% Note payable 200
Common stock, $10 par 400
Additional paid-in-capital 400
The entry to record Seed’s assets directly on Pitt’s
books:

Advanced Financial
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Accounting 2024
Cash 50
Net receivables 140
Inventories 250
Land 100
Buildings 500
Equipment 350
Patents 50
Accounts payable 60
Notes payable 135
Other liabilities 45
Investment in Seed Co. 1,000
Gain from bargain purchase 200
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 Goodwill Controversies
• 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.

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 Impairments

• Firms must test annually for the impairment of

goodwill at the business unit reporting level.
– If the unit’s book value exceeds its fair value,
additional tests must be performed to determine
the impairment of goodwill and/or other assets.
• More frequent testing for goodwill impairment
may be needed (e.g., loss of key personnel,
unanticipated competition, goodwill
impairment of subsidiary).
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INVESTMENTS LESS THAN 100% OWNERSHIP

Equity investment represents ownership of ordinary,

preference, or other capital shares.
 Cost includes price of the security.
 Broker’s commissions and fees are recorded as
expense.

The degree to which one corporation (investor) acquires an

interest in the common stock of another corporation
(investee) generally determines the accounting treatment for
the investment subsequent to acquisition.

LO 5
EQUITY INVESTMENTS

Holdings of Less Than 20%

Under IFRS, the presumption is that equity investments are
held-for-trading but it can be also non-trading.

General accounting and reporting rule:

 Investments valued at cost or alternatively fair value.
 Record gains and losses in net income when investment
is sold.
 Dividend income recognized when declared or paid

LO 5
Equity Investments—Trading (Income)

Illustration: November 3, 2015, Republic Corporation

purchased ordinary shares of three companies, each
investment representing less than a 20 percent interest. These
shares are held-for-trading.

Republic records these investments as follows:

LO 5
Equity
Investments
—Trading

Republic records these investments as follows:

Equity Investments 718,550
Cash
718,550
On December 6, 2015, Republic receives a cash dividend of
€4,200 on its investment in the ordinary shares of Nestlé.

Cash 4,200
Dividend Revenue
4,200
LO 5
 Equity Investments—Trading (Income)

At December 31, 2015, Republic’s equity investment portfolio has

the carrying value and fair value shown.

ILLUSTRATION 17-17
Computation of Fair Value Adjustment—
Equity Investment Portfolio (2015)

LO 5
 Equity Investments—Trading (Income)

ILLUSTRATION 17-17

Unrealized Holding Gain or Loss—Income 35,550

Fair Value Adjustment
35,550 LO 5
Equity Investments—Trading (Income)

On January 23, 2016, Republic sold all of its Burberry ordinary

shares, receiving €287,220. ILLUSTRATION 17-18
Computation of Gain on Sale of Burberry Shares

Cash 287,220
Equity Investments
259,700
Gain on Sale of Equity Investment
27,520
LO 5
Equity Investments—Non-Trading (OCI)

The accounting entries to record non-trading equity

investments are the same as for trading equity investments,
except for recording the unrealized holding gain or loss.

Report the unrealized holding gain or loss as other

comprehensive income.

LO 5
Holdings Between 20% and 50%

An investment (direct or indirect) of 20 percent or more of the

voting shares of an investee should lead to a presumption that
in the absence of evidence to the contrary, an investor has the
ability to exercise significant influence over an investee.

In instances of “significant influence,” the investor must

account for the investment using the equity method.

LO 6
Holdings Between 20% and 50%

Equity Method
Record the investment at fair value or alternatively cost
and subsequently adjust the amount each period for
 the investor’s proportionate share of the earnings
(losses) and
 dividends received by the investor.

If investor’s share of investee’s losses exceeds the carrying

amount of the investment, the investor ordinarily should discontinue
applying the equity method.

LO 6
Holdings of More Than 50%

Controlling Interest - When one corporation acquires a voting

interest of more than 50 percent in another corporation.
 Investor is referred to as the parent.
 Investee is referred to as the subsidiary.
 Investment in the subsidiary is reported on the parent’s
books as a long-term investment.
 Parent generally prepares consolidated financial
statements.

LO 6
Business Combination Disclosures
– Reason for combination,
– Allocation of purchase price among assets and
liabilities,
– Pro-forma results of operations, and
– Goodwill or gain from bargain purchase.

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