CHAPTER 1 1 Business Combinations: America’s Most Popular Business Activity, Bringing an End to the Controversy Fundamentals of Advanced Accounting 1st Edition Fischer, Taylor, and Cheng

Business Combinations All acquisitions of one firm by another Two categories of business combinations: Merger Consolidation Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Merger vs. Consolidation Existing company acquires another company Acquired company’s operations are merged with its own. Consolidation Two or more previously separate firms are combined into one new company. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Economic Advantages of Combinations Combinations utilize economies of scale Horizontal combinations – firms with similar functions Vertical combinations – firms at different levels in marketing chain Conglomerates – dissimilar businesses Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. 1 1

Economic Advantages of Combinations (continued) Defer capital gains on sale of stock Owner accepts Purchaser’s stock in exchange for their stock Structure combination as “tax-free” reorganization New shares are at basis of old shares Taxable to owner when new shares are sold Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Economic Advantages of Combinations (continued) Additional tax benefits: Tax losses are transferable in a business combination. Combined operations may reduce taxable income. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Obtaining Control Two methods to obtain control of another company: Purchase assets of an existing company May assume liabilities as well Purchase > 50% of outstanding voting stock of another company Parent/subsidiary relationship Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Accounting for Control Purchase of “net assets” Acquiring firm records assets/liabilities purchased in its own ledger. Acquisition of stock Acquiring firm (parent) records a single “investment” account Parent and subsidiary remain separate legal entities Parent/subsidiary financial statements are combined (consolidated). Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Basic Issues in Combinations (continued) Purchase versus pooling Purchase is group asset acquisition at market values Pooling was merging of accounts at book value Pooling not allowed after July 1, 2001 Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. 1 1

Purchase Method - Valuation All assets and liabilities are recorded at Fair Market Value. First identify and value tangible assets Next identify and value intangible assets Goodwill - Price paid in excess of Fair Market value of the net assets. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Basic Purchase: Example with Goodwill Acquisitions, Inc. purchases net assets of Johnson Company: Net assets (per books) = $148,000 Purchase price = $350,000 cash Direct acquisition costs = $10,000 Fair value (current appraisal) of net assets = $297,000 Goodwill = $63,000 Cost $360,000 less $297,000 fair value Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Example: Johnson, Inc. Net Asset Values Assets Book Value Fair Value Accounts receivable 28,000 28,000 Inventory 40,000 45,000 Land 10,000 50,000 Buildings (net) 40,000 80,000 Equipment (net) 20,000 50,000 Patent 15,000 30,000 Copyright - 40,000 Goodwill 20,000 0 Total Assets 173,000 323,000 Liabilities & Equity Current liabilities 5,000 5,000 Bonds payable 20,000 21,000 Total liabilities 25,000 26,000 Net assets 148,000 297,000 Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Entry to Record Purchase Accounts Receivable 28,000 Inventory (fair value) 45,000 Land (fair value) 50,000 Building (fair value) 80,000 Equipment 50,000 Patent 30,000 Copyright 40,000 Goodwill (based on current price) 63,000 Current liabilities 5,000 Bonds payable 20,000 Bonds payable premium (to fair value) 1,000 Cash 360,000 Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Basic Purchase: Example with Goodwill Purchased with Stock Assume same facts as in prior example. Acquisitions, Inc. issues $1 par value common stock for the $350,000 purchase price. Calculation of shares required: Fair value of shares = $50 Shares required = 7,000 ($350,000 / $50) Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Entry to Record Purchase Accounts Receivable 28,000 Inventory (fair value) 45,000 Land (fair value) 50,000 Building (fair value) 80,000 Equipment 50,000 Patent 30,000 Copyright 40,000 Goodwill (based on current price) 63,000 Current liabilities 5,000 Bonds payable 20,000 Bonds payable premium (to fair value) 1,000 Cash 10,000 Common Stock (7,000 x $1) 7,000 Paid-in Capital in Excess of Par 343,000 Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Required Disclosures Schedule of fair value of accounts Name and description of firm purchased Reason for purchase Cost of acquisition Valuation of stock (If payment method) Contingent payment agreements Pro Forma income disclosure Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Entry for Johnson, Inc. (Seller) Investment in Acquisitions, Inc. Stock 350,000 Current liabilities 5,000 Bonds payable 20,000 Accounts receivable 28,000 Inventory 40,000 Land 10,000 Buildings 40,000 Equipment 20,000 Patent 15,000 Goodwill 20,000 Gain on Sale of Business 202,000 Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Accounting for Acquired Assets Tangible assets and liabilities – normal depreciation and amortization procedures. Intangible assets amortized over useful lives. Goodwill is not amortized Subject to impairment Tested on an annual basis Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Goodwill Impairment Test: Goodwill is impaired if estimated value of business unit is less than remaining book value of net assets (including goodwill). New goodwill estimate: Estimated value of business unit – New estimate of identifiable net assets at fair value = New goodwill estimate Impairment Loss: Book value of goodwill – New goodwill estimate = Impairment loss Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Recording a Bargain Purchase Bargain purchase – price of acquisition is less than Fair Value of Net Assets No Goodwill exists (none recorded) Cost of acquisition is allocated to individual asset and liability accounts. Priority accounts – always recorded at fair value Non-priority accounts – discounted Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Priority Accounts All current assets All liabilities All investments (exception- controlled entities) Excess assets included in purchase Deferred tax assets and liabilities Prepaid assets relating to postretirement benefits Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Price Zone Analysis Fair Value Group Total Cum. Total Price zone analysis – guides assignment of price paid. Example: Johnson Company Calculate the market value net assets: Fair Value Group Total Cum. Total Priority Accounts receivable 28,000 Inventory 45,000 Current liabilities (5,000) Bonds payable (21,000) 47,000 47,000 Non-priority Land 50,000 Buildings (net) 80,000 Equipment (net) 50,000 Patent (net) 30,000 Copyright 40,000 250,000 297,000 Total Market Value = $297,000 Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Price Zone Analysis (continued) Determine the 3 price zones: Premium: Over $297,000 All accounts at fair value; goodwill for price over $297,000 Bargain: $47,000 [priority] to $297,000 Priority accounts at fair value; balance allocated to nonpriority accounts Extraordinary Gain: Below $47,000 Priority accounts at fair value; other accounts not recorded; extraordinary gain for excess of priority accounts over price paid Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Purchase Allocation Bargain Price: $210,000 $47,000 for priority accounts; $163,000 allocated to fixed and identifiable intangible assets Allocation Table Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Purchase Entry Bargain Price: $210,000 Accounts Receivable 28,000 Inventory (fair value) 45,000 Land (allocation) 32,600 Building (allocation) 52,160 Equipment (allocation) 32,600 Patent (allocation) 19,560 Copyright (allocation) 26,080 Current liabilities 5,000 Bonds payable (face value) 20,000 Bonds payable premium (to fair value) 1,000 Cash 10,000 Common Stock (4,000 shares x $1) 4,000 Paid-in Capital in Excess of Par 196,000 Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Purchase Entry Extraordinary Gain: $30,000 Purchase Price Price is below $47,000; there is no value to assign to fixed and identifiable intangible assets Accounts receivable 28,000 Inventory (fair value) 45,000 Extraordinary gain 7,000 Current liabilities 5,000 Bonds payable 20,000 Bonds pay premium (to fair value) 1,000 Cash 10,000 Common Stock (600 shares x $1) 600 Paid-In Capital in Excess of Par 29,400 Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Purchase Complications May have to calculate market value of debt issues Leases retain classification; related accounts recorded at market value Deferred tax liability (DTL) goes with assets in nontaxable exchange Tax loss carryover is usually recorded as an asset; if realization is uncertain, it is not recorded and is buried in goodwill Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. 8 8

Purchase Complications (continued) There may be contingent goodwill payment Added goodwill is recorded Price guarantees cover decline in value of securities issued in purchase If issued, value assigned to securities is adjusted Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. 8 8

Purchase: Some Fine Points Direct acquisition costs are paid to outside parties; include them in the price paid Indirect acquisition costs are internally incurred; they are expensed Issue costs are to issue bonds or stock; they are subtracted from the value assigned to the securities Stocks and bonds issued are always recorded at fair value in a purchase Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Example of Tax-Free Exchange The price paid for a company is $431,000 $6,000 in direct costs 8,500 shares of $10 par value common stock with a fair value of $40 per share Priority Accounts: Fair Value Inventory 50,000 Liabilities (80,000) Non-priority Accounts: Land: Book Value = $100,000 100,000 Building: Book Value = $200,000 300,000 Deferred tax liability – Bldg. (30,000) Total $340,000 Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Example of Tax-Free Exchange - Continued The tax rate is 30% A $30,000 DTL goes with the machine ($100,000 x 30%) $91,000 is available for goodwill (net of a 30% DTL) ($431,000 – 340,000) Goodwill = $130,000 $39,000  (1.0 – .3) Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Tax-Free Exchange: Journal Entry Inventory 50,000 Land (fair value) 100,000 Building (fair value) 300,000 Goodwill (gross value) 130,000 Liabilities 80,000 Deferred tax liability* 69,000 Cash 6,000 Common Stock ($10 par, 8500 shares) 85,000 Paid-in Capital in Excess of Par 340,000 *$30,000 on Building and $39,000 on goodwill The DTLs are amortized over the same life (and by the same method) as the assets to which they attach Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.