to accompany Advanced Accounting, 11th edition by Beams, Anthony, Bettinghaus, and Smith Chapter 1: Business Combinations Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-1

1: ECONOMIC MOTIVATIONS Business Combinations Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-2

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 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-3

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 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-4

2: FORMS OF BUSINESS COMBINATIONS Business Combinations Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-5

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. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-6

3: ACCOUNTING FOR BUSINESS COMBINATIONS Business Combinations Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-7

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. [GAAP] A parent-subsidiary relationship is formed when:  Less than 100% of the firm is acquired, or  The acquired firm is not dissolved. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-8

Methods  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. [FASB ASC 805]  Firms now use the acquisition method for business combinations. This began with combinations in fiscal periods beginning after December 15, [FASB ACS ] Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-9

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. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-10

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. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-11

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. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-12

Example: Pop Corp. (1 of 3) Investment in Son Corp. (+A)1,600 Common stock, $10 par (+SE) 1,000 Additional paid-in-capital (+SE) 600 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-13 Pop Corp. issues 100,000 shares of its $10 par value common stock for Son Corp. Pop’s stock is valued at $16 per share. (in thousands)

Example: Pop Corp. (2 of 3) Investment expense (E, -SE)80 Additional paid-in-capital (-SE)40 Cash (-A) 120 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-14 Pop Corp. pays cash for $80,000 in finder’s and consulting fees and for $40,000 to register and issue its common stock. (in thousands) 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.

Example: Pop Corp. (3 of 3) Receivables (+A)XXX Inventories (+A)XXX Plant assets (+A)XXX Goodwill (+A)XXX Accounts payable (+L) XXX Notes payable (+L) XXX Investment in Son Corp. (-A) 1,600 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-15

4: RECORDING FAIR VALUE USING THE ACQUISITION METHOD Business Combinations Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-16

Identify the Net Assets Acquired Identify:  Tangible assets acquired,  Intangible assets acquired, and  Liabilities assumed  Goodwill on the books of the acquired firm is assigned no value. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-17

Assign Fair Values to Net Assets Use fair values determined, in preferential order, by:  Established market prices  Present value of estimated future cash flows, discounted based on an observable measure, such as the prime interest rate  Other internally derived estimations Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-18

Contingent Consideration The fair value of contingent consideration is determined or estimated at the acquisition date and it is included along with other consideration given as part of the combination. Classifying contingencies:  Contingent share issuances are equity  Contingent cash payments are liabilities Estimated contingencies are revalued to fair value at each subsequent reporting date. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-19

Example – Pit Corp. Data Pit Corp. acquires the net assets of Sad Co. in a combination consummated 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): Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-20

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-21 Book Val.Fair Val. Cash$50 Net receivables Inventory Land50100 Buildings, net Equipment, net Patents 0 50 Total assets$1,000$1,440 Accounts payable$60 Notes payable Other liabilities4045 Total liabilities$250$240 Net assets$750$1,200

Acquisition with Goodwill Pit Corp. pays $400,000 cash and issues 50,000 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): $400 + (50 shares x $20) $1,400 Fair value of net assets acquired: $1,200 Goodwill$ 200 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-22

Entries with Goodwill The entry to record the acquisition of the net assets: The entry to record Sad’s assets directly on Pit’s books: Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-23 Investment in Sad Co. (+A)1,400 Cash (-A) 400 Common stock, $10 par (+SE) 500 Additional paid-in-capital (+SE) 500

Cash (+A)50 Net receivables (+A)140 Inventories (+A)250 Land (+A)100 Buildings (+A)500 Equipment (+A)350 Patents (+A)50 Goodwill (+A) 200 Accounts payable (+L) 60 Notes payable (+L) 135 Other liabilities (+L) 45 Investment in Sad Co. (-A) 1,400 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-24

Acquisition with Bargain Purchase Pit Corp. 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 Sad Co. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-25 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

Entries with Bargain Purchase The entry to record the acquisition of the net assets: The entry to record Sad’s assets directly on Pit’s books: Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-26 Investment in Sad Co. (+A)1,000 10% Note payable (+L) 200 Common stock, $10 par (+SE) 400 Additional paid-in-capital (+SE) 400

Cash (+A)50 Net receivables (+A)140 Inventories (+A)250 Land (+A)100 Buildings (+A)500 Equipment (+A)350 Patents (+A)50 Accounts payable (+L) 60 Notes payable (+L) 135 Other liabilities (+L) 45 Investment in Sad Co. (+A) 1,000 Gain from bargain purchase (G, +SE) 200 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-27

5: OTHER ISSUES: IMPAIRMENTS, DISCLOSURES, AND THE SARBANES-OXLEY ACT Business Combinations Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-28

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 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-29

Goodwill Impairment Testing Firms must test for the impairment of goodwill at the business unit reporting level.  Step 1: Compare the unit’s net book value to its fair value to determine if there has been a loss in value.  Step 2: Determine the implied fair value of the goodwill, in the same manner used to originally record the goodwill, and compare that to the goodwill on the books. Record a loss if the implied fair value is less than the carrying value of the goodwill. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1-30