1. Advanced Accounting by Debra Jeter and Paul Chaney
Chapter 2: Methods of Accounting for Business Combinations
Slides Authored by Hannah Wong, Ph.D.
Rutgers University

2. Accounting Methods for Business Combinations
Purchase Method
treats the combination as the purchase of one or more companies by another.
Pooling of Interests Method
(not allowed after June 30, 2001)
treats the combination as two or more groups
of stockholders uniting their ownership
interests by an exchange of
common stock.
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3. FASB Issues New Standards
APB 16, “Business Combinations” and APB 17, “Intangible Assets” were superceded by SFAS 142, “Goodwill and Other Intangible Assets” in June 2001.
SFAS 141 – prohibits the use of the pooling method in accounting for business combinations and in favor of the purchase method.
SFAS 142 – mandates that goodwill resulting from a business combination should be tested for impairment – annually rather than expensed over a year period.
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4. Comparison of Purchase and Pooling of Interests
Assets and liabilities acquired are recorded at their fair values.
Any excess of cost over fair value of net assets acquired is recorded as goodwill.
Pooling of Interests
Assets and liabilities are recorded at their precombination book values.
No excess of cost over book value exists, and no new goodwill is recorded
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5. Comparison of Purchase and Pooling of Interests
The acquired company’s retained earnings are added into the acquiring company’s retained earnings.
Equity shares issued are recorded at the book value of the acquired shares.
Purchase
The acquired company’s retained earnings are not added into the acquiring company’s retained earnings.
Equity securities issued are recorded at their fair market value.
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6. Comparison of Purchase and Pooling of Interests
There is no additional depreciation or amortization expense.
The issuer and combiner companies’ earnings are combined for the full fiscal year in which the combination occurs.
Purchase
The excess of cost over book value is depreciated or amortized to reduce future earnings.
The acquired company’s earnings are included with the acquiring firm’s only from the date of combination forward.
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7. Comparison of Purchase and Pooling of Interests
Direct costs are capitalized as part of the acquisition cost.
Indirect costs are expensed.
Security issuance costs are deducted from additional paid-in capital.
Pooling of Interests
Direct costs are expensed in the year in which incurred.
Indirect costs are expensed.
Security issuance costs are expensed.
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8. Goodwill Impairment Test
3 Step Process
Assign goodwill to a reporting unit (level at which management reviews performance – product, geographic, facility…).
Measure if difference between current FMV and purchase price still exists.
If goodwill has diminished, book. No upward adjustment allowed.
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9. Disclosure Requirements SFAS 141 – “Business Combinations”
Total amount of acquired
goodwill and amount to
be deductible for
tax purposes.
Amount of goodwill by
reporting segment.
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10. Disclosure Requirements SFAS 142 – “Goodwill & Other Intangible Assets”
Aggregate amount of goodwill should be reported as a separate line item on the face of the balance sheet.
Aggregate impairment loss should be reported as a separate line in the operating section of the income statement (unless from discontinued operations).
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11. SFAS Footnotes
Description of facts and circumstances leading to an impairment.
Amount of impairment loss and how fair value was determined.
Nature and amounts of any adjustments to impairment estimates from earlier periods.
Footnote or disclose on face the income before extra- ordinaries and net income adjusted to exclude amortization of goodwill no longer amortized under SFAS 142.
Reconciliation of adjusted net income to reported net income.
Adjusted EPS amounts.
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12. Acquisition Expenses
Direct Expenses – (accounting, legal & consulting) capitalize as part of assets acquired.
Indirect Expenses – (mergers dept., labor & overhead diverted to the merger) expense currently.
Security Issuance Costs – (legal, under-writing, banking) reduce additional paid-in capital on shares issued or adjust premium/discount on bonds.
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13. Acquisition Costs - An Illustration
Facts:
SMC Company acquires 100% of the net assets of Bee Company by issuing shares of common stock with a fair value of $120,000.
SMC incurred:
$1,500 of accounting and consulting costs
$3,000 of stock issue costs
$2,000 monthly overhead cost for its mergers department
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14. Acquisition Costs - An Illustration
Pooling Accounting:
Accounting and Consulting Expense (Direct) 1,500
Merger Department Expense (Indirect) 2,000
Securities Issue Expense (Security Issue Costs) 3,000
Cash ,500
Purchase Accounting:
Goodwill (Direct) 1,500
Merger Department Expense (Indirect) 2,000
Other Contributed Capital (Security Issue Costs) 3,000
Cash ,500
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15. Pro-forma “As-If” Financial Statements
SFAS 141 requires pro-forma financial statements (in notes) in year of material combination.
Pro-formas must include:
Revenue
Income before extraordinary items
Cumulative effect of changes in accounting principles
Net income
Earnings per share
Material nonrecurring items included
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16. Purchase Example - Facts
On January 1, 2003, P Company acquired the assets and assumed the liabilities of S Company.
P Company gave one of its $15 par value common shares for each share of S company common stock.
P Company common stock has a fair value per share of $48.
Refer to Illustration 2-3 for the companies’ balance sheet information.
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17. Purchase Example - Journal Entry
Cash and Receivables ,000
Inventories ,000
Land ,000
Buildings & Equipment (Net) 1,000,000
Discount on Bonds Payable ,000
Goodwill ,000
Current Liabilities ,000
Bonds Payable ,000
Common Stock ,000
Other Contributed Capital 990,000
Identifiable
net assets
acquired are
recorded at
their market
value on the
acquisition
date
Goodwill =
excess
cost over
fair value of
identifiable
assets
acquired
Common stock issued is recorded at
market value on the acquisition date
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18. Financial Statement Differences Purchase vs. Pooling
Purchase method causes assets to be restated at FMV.
Assets are higher on balance sheet.
Depreciation expense is higher in later years.
Cost of goods sold may be higher if inventories are increased in value and vice versa.
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19. Valuation of Net Assets Acquired:
Bargain Purchase
Bargain = Fair value of identifiable net assets acquired
Less: Purchase price
Valuation of Net Assets Acquired:
Current assets, long-term investments in marketable securities, liabilities = fair value
Previously recorded goodwill = 0
Long-term assets = fair value - bargain allocation
(The bargain is allocated to long-term assets in proportion to their fair value.)
Any remaining bargain is recorded as negative goodwill
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20. Bargain Purchase - Example
Bargain = Fair value of identifiable net assets ($23,000) Purchase price ($17,000)
= $6,000 Building $4,500
Land $1,500
Current Assets ,000
Buildings ($15,000-$4,500) 10,500
Land ($5,000-$1,500) ,500
Liabilities ,000
Cash ,000
Building and Land is recorded at
fair value minus allocated
bargain
Current assets and liabilities
are recorded at fair value
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21. Contingent Considerations
Contingencies based on earnings
Contingencies based on security prices
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22. Earnings Contingency Definition Accounting Treatment
additional consideration to be made if the combined company’s future earnings equal or exceed a threshold.
Accounting Treatment
as additional cost of acquisition
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23. Stock Price Contingency
Definition
additional consideration to be made if the future market value of shares issued is less than the guaranteed value
Accounting Treatment
no effect on acquisition cost
as an adjustment to Other Contributed Capital
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24. Leveraged Buyout (LBO)
A management group contributes stock it holds and borrows funds to create a new company, which acquires all the outstanding common shares of its employer company.
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25. Leveraged Buyout (LBO)
Borrowed Funds
Stock of employer
company held by
managers
New Company
acquires
Employer Company
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26. Leveraged Buyout (LBO)
Valuation of New Company
net assets acquired by borrowed funds
market value
net assets contributed by managers
book value
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27. Leveraged Buyout (LBO) Example
Valuation of Net Assets in New Company
Excess
of cost
over
book
value
Market Value
Excess cost applied to
plant assets = $13,500
Goodwill
$9,000
Book Value
$1,000
$9,000
10%
90%
Net assets
contributed
by managers
Net assets acquired
by borrowed fund
of $31,500
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28. Advanced Accounting by Debra Jeter and Paul Chaney
Copyright © 2001 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.
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29. Deleted Slides Follow
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30. Criteria for Pooling of Interests
Company Attributes
autonomous of any other companies
independent of other combining companies
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31. Criteria for Pooling of Interests
Exchange of Stock
single transaction
common stock for 90% common stock
no change in equity interest
no abnormal treasury stock transactions
same ratio of interest of individual stockholders
voting rights immediately exercisable
no provision for future issuance of stock
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32. Criteria for Pooling of Interests
Absence of Planned Transactions
no agreement to reacquire stock
no financial arrangements for shareholders
no unusual disposal of assets
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33. Disadvantages of Pooling Method
Values given and received are ignored in a negotiated transaction.
“Instant earnings” can result
from sale of newly pooled assets that are carried at their precombination low book values, and
from including precombination earnings of other companies in the year of combination.
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34. Disadvantages of Purchase Method
Subjective - appraisal of assets or stock values are necessary.
Inconsistent - accounting for one part of the combined company on a fair value and the other part of a historical basis.
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35. Financial statements “as if” the combination had been consummated.
Pro Forma Statements
Financial statements “as if” the combination had been consummated.
Functions
provide information in the planning stages of the combination
disclose relevant information subsequent to the combination
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36. Equity Allocation in Pooling of Interests - Case A
P issued shares with par value of $450,000
Other Contributed
Capital - S
$50,000
Retained Earnings
- S
$140,000
Common stock -S
$300,000
$300,000
$50,000
$140,000
Common Stock
- P
$750,000
Other Contributed
Capital - P
$400,000
Retained Earnings
- P
$350,000
$100,000
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37. Journal Entry - Case A Cash and Receivables 180,000
net assets
acquired
are carried
forward at
their book
value
Cash and Receivables ,000
Inventories ,000
Land ,000
Buildings & Equipment ,000
Other Contributed Capital ,000
Accumulated Depreciation 300,000
Current Liabilities ,000
Bonds Payable ,000
Common Stock ,000
Retained Earnings ,000
Total shareholders’ equity of S
Company ($490,000) is carried
forward to P Company
Par value of common stock issued
is recorded
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38. Equity Allocation in Pooling of Interests - Case B
P issued shares with par value of $800,000
Other Contributed
Capital - S
$50,000
Retained Earnings
- S
$140,000
Common stock -S
$300,000
$50,000
$50,000
$300,000
$90,000
Common Stock
- P
$750,000
Other Contributed
Capital - P
$400,000
Retained Earnings
- P
$350,000
$400,000
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39. Journal Entry - Case B Cash and Receivables 180,000
net assets
acquired
are carried
forward at
their book
value
Cash and Receivables ,000
Inventories ,000
Land ,000
Buildings & Equipment ,000
Other Contributed Capital ,000
Accumulated Depreciation 300,000
Current Liabilities ,000
Bonds Payable ,000
Common Stock ,000
Retained Earnings ,000
Total shareholders’ equity of S
Company ($490,000) is carried
forward to P Company
Par value of common stock issued
is recorded
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40. Equity Allocation in Pooling of Interests - Case C
P issued shares with par value of $330,000
Other Contributed
Capital - S
$50,000
Retained Earnings
- S
$140,000
Common stock -S
$300,000
$30,000
$20,000
$300,000
$140,000
Common Stock
- P
$750,000
Other Contributed
Capital - P
$400,000
Retained Earnings
- P
$350,000
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41. Journal Entry - Case C Cash and Receivables 180,000
net assets
acquired
are carried
forward at
their book
value
Cash and Receivables ,000
Inventories ,000
Land ,000
Buildings & Equipment ,000
Accumulated Depreciation 300,000
Current Liabilities ,000
Bonds Payable ,000
Common Stock ,000
Other Contributed Capital ,000
Retained Earnings ,000
Total shareholders’ equity of S
Company ($490,000) is carried
forward to P Company
Par value of common stock issued
is recorded
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42. Equity Allocation in Pooling of Interests - Case D
P issued shares with par value of $275,000
Other Contributed
Capital - S
$50,000
Retained Earnings
- S
$140,000
Common stock -S
$300,000
$25,000
$50,000
$275,000
$140,000
Common Stock
- P
$750,000
Other Contributed
Capital - P
$400,000
Retained Earnings
- P
$350,000
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43. Pooling Example - Case D
net assets
acquired
are carried
forward at
their book
value
Cash and Receivables ,000
Inventories ,000
Land ,000
Buildings & Equipment ,000
Accumulated Depreciation 300,000
Current Liabilities ,000
Bonds Payable ,000
Common Stock ,000
Other Contributed Capital ,000
Retained Earnings ,000
Total shareholders’ equity of S
Company ($490,000) is carried
forward to P Company
Par value of common stock issued
is recorded
Obj 9