BUSINESS COMBINATIONS

I. Basic Concepts
A. Business growth. Can occur internally – adding facilities and expanding markets or
externally – by acquiring other companies.
B. Business combinations represent accounting transactions in which two or more
accounting entities (or companies or groups of net assets that constitute a going concern)
are brought together under common control in a single accounting entity.
C. Control over other companies can be obtained by acquiring all of the target company’s
assets or by acquiring more than 50% of the target company’s outstanding voting
common stock.
D. Purchase of a group of idle assets or control over a defunct/shell corporation (i.e. not an
operating business) is not a business combination and dissolution of legal entities is
unnecessary within the accounting concept.
E. Parties to a business combination
Combinor/ Combinee/ = Combined Enterprise
Acquirer Acquired/Target - In form-one or more legal
entity(ies)
Constituent - In substance- only one & single
Companies accounting entity
- Substance over form
- Dissolution of legal entities
unnecessary within the accounting
concept
II. Reasons for Business Combinations
A. Internal Vs external expansion: Overall objective must be increasing profitability.
B. External growth advantages:
 International marketplace
 Operating synergies
 Revenues
 Increase market power
 Better/more efficient marketing efforts
 Strategic benefits such as entry into new markets
 Operating costs (cost advantage or saving)
 Economies of scale (marketing, management, production, distribution)
 Complementary resources (avoid duplicate efforts)
 Eliminate operating or management inefficiencies
 Income tax-tax gain (savings) through accumulated tax losses
 Financial synergy
 Utilization of unused debt capacity
 Reinvestment of surplus funds (free cash flows) as an alternative to paying
dividends or repurchasing stock
 Diversification-through conglomerate operations
 Divestitures-spin off instead of selling off (less break up value/selling individual
assets)
III. Classification: In general, business combinations can be categorized in the following
ways:

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A. Nature of Combination
1. Friendly Combinations-Boards of directors of both companies negotiate terms
of proposed combination.
2. Unfriendly (Hostile) Combinations-Board of directors of target company resists
the combination. The acquiring company deals directly with individual shareholders
through a tender offer.
B. Legal Form of Combination
1. Statutory Merger (or Absorption) – One company (the Combinor) acquires all
of the voting stock or all of the assets of one or more other companies (combinee or
combinees) such that only the Combinor survives as a separate legal entity. The
combinee or combinees may be liquidated or continue operating as a division of the
Combinor.
A Company + B Company = A Company

2. Statutory Consolidation (or Amalgamation) – A new company is formed from

the net assets of two or more old companies. Only the new company survives as a
separate legal entity. The old companies are dissolved.
A Company B Company C Company
+ =
3. Stock Acquisition – The acquiring company obtains a substantial amount or all
of the voting stock of one or more acquired companies. However, all companies
continue as separate legal entities following the business combination. The
investment in the acquired companies is carried as a long-term asset on the acquiring
company’s books. Acquiring company is referred to as the parent or holding, while
the acquired company (or companies) is referred to as a subsidiary (or subsidiaries).
For financial reporting purposes, the companies combine their information into what
is referred to as consolidated financial statement.
Financial Statements Financial Statements Financial Statements of
of A Company + of B Company = A & B Companies

C. Accounting Methods
1. Pooling (Uniting) of Interests – Record business combination
such that the accounting bases of combining companies are not changed.
 No new basis of accountability
 Continuity of ownership
 Basis of valuation of net assets of Combinor @ BV and
Combinee @ BV
2. Purchase – Record business combination such that the accounting basis of
Combinee(s) is changed to reflect fair market value (if it does not already).
 New basis of accountability
 Basis of valuation of net assets of Combinor @ BV and
Combinee @ MV
 SFAS 141 requires that only the purchase accounting method be used for
business combinations after June 1, 2001, i.e. pooling not allowed after June 1, 2001.

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  Business combinations recorded under the pooling of interests method
prior to FASB Statement No. 141 and 142 will continue to be accounted for by the
pooling of interests method, i.e. prior combinations will be grandfathered.
IV. Accounting for Business Acquisition under the Purchase Method
 Record the combination using the historical-cost principle.
 The general approach for business combinations, whether a direct purchase of net
assets or a purchase of control, is a four-step process:
1. Identification of the Combinor (acquiring entity)
2. Determination of the cost of Combinee
3. Determination of the fair values of the net assets acquired
4. Allocation of the cost on the basis of fair values
1. Determining the Combinee: To use the purchase method, one company must be designated
as the “acquiring company”. Here are the guidelines from FAS141:
A. If cash or other assets are distributed or liabilities are incurred: In a business
combination effected solely through the distribution of cash or other assets or by incurring
liabilities, the entity that distributes cash or other assets or incurs liabilities is generally
the acquiring entity. [FAS141, Par. 17]
B. If stock is exchanged: In a business combination effected through an exchange of
equity interests, the entity that issues the equity interests or receive larger share of voting
rights in the combined enterprise is generally the acquiring entity. [FAS141, Par. 18]
2. Determining the Purchase Price, i.e. the Total Cost of the Acquired Business (Combinee)
include:
a) Fair value of the consideration given: Cash or other assets, Debt, Equity securities
b) Fair value of any contingent consideration given after acquisition date (Contingencies
based on securities prices do not affect the cost of the investment above what was recorded
at the acquisition date, but instead represent adjustments to additional paid in capital
whereas contingencies based on other than securities prices (the current value of the
additional consideration is added to the acquiring company’s cost of the acquired business)
c) Incidental/Out-of-Pocket Costs incurred in connection with acquisition
Acquisition expenses Accounting treatment
Direct Expenses (Legal, Investment banker Capitalizable (Include)
consulting fees Accounting fees such as for
a purchase investigation, Finders’ fees,
Travel costs
Indirect Expenses Labor and overhead of merely expensed as incurred
internal acquisitions or merger department
& General expenses diverted to the merger
(costs of closing duplicate facilities, salary
for officers involved in the negotiation &
completion of the combination)
Securities Issuance Costs If an equity security, additional paid-in
(legal, under-writing, banking) Such costs capital is charged; if a debt security, debt
are merely related to the mode of financing issuance costs are charged (to be amortized
over the life of the debt)

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3. Cost Allocation based on Fair Values

 Computation and Allocation of Difference between Cost

(Purchase Price) and Book Value, i.e. Conceptual Analysis of
Purchase Price
Cost of Investment (Purchase Price) Xxx
Less: FMV of NA Acquired (NA X % Ownership Xxx
interest)
Difference: Excess Cost (FMV) Xxx
Allocated to Goodwill (Extraordinary Gain if FMV Xxx
Noncurrent & Nonfinancial Assets reduced to zero)
1. Record assets and liabilities at their fair values as of the acquisition date
2. If the cost of the acquired company exceeds the sum of the amounts assigned to the assets
and liabilities acquired, record the excess as goodwill.
3. If the values assigned to the assets acquired and the liabilities assumed exceeds the cost
of the acquired company:
a. Reduce by a proportionate amount the values assigned to the noncurrent
(nonfinancial) assets acquired (other than long-term investments in marketable
securities)
b. After the noncurrent assets have been reduced to zero, any excess of assigned values
over cost of the acquired company is recorded as an extraordinary gain at
acquisition.
c. Any goodwill is NOT amortized since it has an indefinite life. It is subject to
impairment test at least annually.
N.B. Negative goodwill arises because of a disagreement between the fair values of
identifiable assets and liabilities acquired and the investment cost. The Board
decided to allocate the difference among those assets having the most subjective fair
value estimates. The fair values of current assets, current liabilities, noncurrent
liabilities and long-term investments in marketable securities are generally
susceptible to objective measurement. This leaves other non-current assets, such as
plant assets and identifiable intangibles, whose fair values are often highly uncertain,
to be the "dumping ground" for negative goodwill.
OR
 Allocate Differences Between Purchase Price and Current Values
a. Purchase Price > Fair Market Values
If the cost of the acquired company exceeds the sum of the amounts assigned to the
assets and liabilities acquired, record the excess as goodwill. Such that:
• All assets, liabilities recorded at current values
• Goodwill recorded = Excess Purchase Price
b. Purchase Price = Fair Market Values
• All assets, liabilities recorded at current values
• No goodwill recorded
b. Purchase Price < Fair Market Values
If the values assigned to the assets acquired and the liabilities assumed exceeds the cost
of the acquired company:
a. Reduce by a proportionate amount the values assigned to the noncurrent nonfinancial
assets acquired (other than long-term investments in marketable securities)

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 b. After the noncurrent assets have been reduced to zero, any excess of assigned values
over cost of the acquired company is recorded as an extraordinary gain at acquisition
(SFAS 141). Such that:
• All current assets, all liabilities recorded at current values
• The negative goodwill (Excess Fair Market Values or the bargain purchase element
is allocated against all noncurrent assets
• If a negative balance still remains after all noncurrent assets are reduced to zero, the
remainder is reported as an extraordinary gain.
 Any goodwill is NOT amortized since it has an indefinite life. It is subject to
impairment test at least annually (SFAS 142).

V. Illustrations on Accounting for Purchase-Type Business Combinations

Case 1: Statutory Merger with Goodwill

On January 31, 1999, Combinor Company issued Br.700, 000 face amount of 6%, 20-year bonds
due January 31, 2024 with a present value of Br.625, 257 at a 77c yield, to Combinee Company
for its net assets. On January 31, 1999, except for the assets listed below, the current fair values
of Combinee’s net assets equaled their carrying amounts.

Current assets Br.320,000

Plant assets 680,000
Other Assets 120,000

Moreover, on January 31, 1999, Combinor paid out-of-pocket costs of the combination as
follows:
Accounting, legal, and finder’s fees incurred for combination Br 80,000
Costs of registering 6% bonds with SEC 110,000
Total out-of-pocket costs Br.190,000
There were no contingent considerations in the merger contract. Both companies were using the
same accounting principles and had same fiscal year that ends on December 31. The Combinee's
condensed balance sheet just before the merger was as follows:

Combinee Company
Balance Sheet (Prior to Business Combination)
January 31, 1999
Assets
Current Assets Br. 300,000
Plant Assets 600,000
Other Assets 100,000
Total assets Br. 1,000,000

Liabilities & Stockholders' Equity

Current liabilities Br. 200,000
Long-term debt 300,000
Common stock, no par 100.000
Retained earnings 400,000

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 Total liabilities & Stockholders' Equity Br. 1,000,000

 Journal Entries on Books of Combinor

A. Issuance Of Bonds
Investment in Combinee’s Net Assets (or Common stock) 625,257
Discount on Bonds Payable 74,743
Bonds Payable 700,000

B. Direct Additional Costs Of Business Combination

Investment in Combinee’s Net Assets (or Common stock) 80,000
Bond Issue Costs 110,000
Cash 190,000

C. Allocation Of Total Investment Cost

Current assets 320,000
Plant assets 680,000
Other assets 120,000
Goodwill 85,257
Current liabilities 200,000
Long-term debt 300,000
Investment in Combinee’s Net Assets (or Com. stock) 705,257

Note 1:
Total Cost of Combinor:
Direct out-of-pocket costs 80000
Present Value of Bond issued 625,257 705,257
Less: Fair value of net assets acquired:
Current Assets 320,000
Plant assets 680,000
Other assets 120,000 1,120,000
Less: Liabilities assumed:
Current Liabilities 200,000
Long-term debt 300,000 (500,000) (620,000)
Goodwill 85257
 Journal Entries on Books of Combinee (Dissolution/Liquidation)
Current liabilities 200,000
Long-term debt 300,000
Common stock 100,000
Retained earnings 400,000
Current assets 300,000
Plant assets 600,000
Other assets 100,000
Case 2: Statutory Merger with Negative Goodwill
On January 31, 1999, Combinor Company issued 10000, Br.10 par common stock with a market
price of Br. 63 per share for net assets of the Combinee. On January 31, 1999, the current fair
values of Combinee’s liabilities equaled their carrying amounts; however, current fair values of

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Combinee’s assets were as follows:
Current assets Br. 400, 000
Plant assets 800,000
Intangible assets 200,000
Moreover, on January 31, 1999, Combinor paid out-of-pocket costs of the combination as
follows:
Accounting, legal, and finder’s fees incurred for combination Br. 170,000
Costs of registering shares with SEC 110,000
Total out-of-pocket costs Br.280,000
There were no contingent considerations in the merger contract. Both companies were using the
same accounting principles and had same fiscal year that ends on December 31. The Combinee's
condensed balance sheet just before the merger was as follows:

Combinee Company
Balance Sheet (Prior to Business Combination)
January 31, 1999
Assets
Current Assets Br. 300,000
Plant Assets 600,000
Intangible Assets 100,000
Total assets Br. 1,000,000

Liabilities & Stockholders' Equity

Current liabilities Br. 200,000
Long-term debt 300,000
Common stock, no par 100.000
Retained earnings 400,000
Total liabilities & Stockholders' Equity Br. 1,000,000

 Journal Entries on Books of Combinor

A. Issuance Of Capital Stock
B.
Investment in Combinee’s Net Assets (or Common stock) 630,000
Common stock 100,000
APIC 530,000
Direct Additional Costs Of Business Combination
Investment in Combinee’s Net Assets (or Common stock) 170,000
APIC 110,000
Cash 280,000
C. Allocation Of Total Investment Cost
Current assets 400,000
Plant assets (Br. 800,000-Br. 80,000) 720,000
Intangible assets (Br. 200,000-Br. 20,000) 180,000
Current liabilities 200,000
Long-term debt 300,000
Investment in Combinee’s Net Assets (or Com. stock) 800,000
Note 1:
Total Cost of Combinor:

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 Out-of-pocket Costs Br.170,000
Fair value of Common stock 630,000 Br. 800,000
Less: Fair value of net assets acquired:
Current Assets Br. 400,000
Plant assets 800,000
Intangible assets 200,000 1,400,000
Less: Liabilities assumed:
Current Liabilities 200,000
Long-term debt 300,000 (500,000) (900,000
Negative Goodwill Br.100,000)
 Allocation of Negative Goodwill
To plant assets: Br. 100,000 x 800,000/ (800,000+200,000) = Br. 80,000
To intangible assets: Br. 100,000 x 200,000/(800,000+200,000) = Br. 20,000
 Journal Entries on Books of Combinee
Current liabilities 200,000
Long-term debt 300,000
Common stock 100,000
Retained earnings 400,000
Current assets 300,000
Plant assets 600,000
Intangible assets 100,000
VI. Additional Comprehensive Illustrations
Balance Sheets 01/01/07
(Prior Combination)
A Company(Combinor) B Company (Combinee)
@ BV @ BV @ FMV Differential
Assets
Cash Br. 30,000 Br. 37,400 Br. 37,400 Br. 0
Accounts receivable 34,200 9,100 9,100 0
Inventories 22,900 16,100 17,100 1,000
Equipment 200,000 50,000 48,000 8,000
Less: Acc. Dep. (21,000) (10,000) 3,000
Patents 0 10,000 13,000
Total assets Br. 267,000 Br. 112,600
Liabilities & S.Equity
Accounts payable 4,000 6,600 6,600 0
Bonds payable 100,000 0
Capital stock (Br. 10par) 100,000 50,000
Additional Paid-in capital 15,000 15,000
Retained earnings 48,000 41,000
Total liabilities & equity Br. 267,000 Br. 112,600 Br. 12,000

+Goodwill
Investment Cost FMV of NA BV of NA Differential (C-FMV)
Case A Br. 134,000 Br. 118,000 Br. 106,000 Br. 28,000 Br. 16,000
Case B 118,000 118,000 106,000 12,000 0

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Case C 106,000 118,000 106,000 0 (12,000)
Case D 100,000 118,000 106,000 (6,000) (18,000)

Assigned Values Excess of New

of NCA acquired Proportion FMV over Reallocation assigned
Item (S-1) Cost (Step 2) Value
Case C Equipment 48,000 48/61 (12,000) (9,443) 38,557
Patents 13,000 13/61 (12,000) (2,557) 10,443
61,000 (12,000)

Case D Equipment 48,000 48/61 (18,000) (14,164) 33,836

Patents 13,000 13/61 (18,000) (3,836) 9,164
61,000 (18,000)

Date of Combination Entries on Books of A Company for Purchase-Merger

Case A Case B Case C Case D
Cash 37,400 37,400 37,400 37,400
A/R 9,100 9,100 9,100 9,100
Inventories 17,100 17,100 17,100 17,100
Equipment 48,000 48,000 38,557 33,836
Patents 13,000 13,000 10,443 9,164
Goodwill 16,000 0 0 0
A/P 6,600 6,600 6,600 6,600
Cash 134,000 118,000 106,000 100,000

VII. Illustration on Contingencies Based on Earnings

Assume that P Company acquired all the net assets of S Company in exchange for P Company’s
common stock. P Company also agreed to issue additional shares of common stock with a fair
value of Br. 150,000 to the former stockholders of S company if the average post combination
earnings over the next two years equal or exceed Br. 800,000.
Assume that the contingency is met; P Company’s stock has a par value of Br. 5 per share and a
market value of Br. 25 per share at the end of the contingency period. Issuance of new 6,000
additional shares (Br. 150,000/Br. 25) to settle the contingency would be recoded as follows:
Case 1: If Goodwill was recorded in the original purchase transaction
Goodwill 150,000
Common Stock (6,000 X Br. 5) 30,000
Additional Paid-In Capital 120,000
Case 2: If Excess of FV over cost (negative goodwill) in the amount of Br. 50,000 was allocated
to reduce the fair values assigned to equipment (Br. 35,000) and land (Br. 15,000) in
the original purchase transaction

Equipment 35,000
Land 15,000
Goodwill 100,000
Common Stock 30,000
Additional Paid-In Capital 120,000

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VIII. Illustration on Contingencies Based on Security Prices
Assume that P Co. issues 50,000 shares of common stock with a par value of Br. 5 per share and
a market price of Br. 30 per share for the net assets of S Co. P Co. guarantees that the stock will
have a market price of at least Br. 30 per share one year later.
 At the original transaction date:
Net assets (50,000 X Br. 30) 1,500,000
Common Stock (50,000 X Br. 5) 250,000
APIC 1,250,000
 Assuming that the market price of P Co.’s stock at the end of the contingency period is
Br. 25 per share, P Co. must give additional consideration of Br. 250,000 (50,000 X Br. 5) to
the former stockholders of S Co. and will make the following entry:

Case 1: If the contingency is paid in cash;

APIC 250,000
Cash 250,000
Adjustment:
Total purchase price agreed on Br. 1,500,000
Less: Cash paid 250,000
Payment in common stock 1,250,000
Less: Par value of stock issued 250,000
APIC Br. 1,000,000

Case 2: If the contingency is satisfied by the issuance of additional shares of stock, P Co.
must issue 10,000 additional shares (Br. 250,000/Br. 25);
APIC 50,000
Common Stock (10,000 X Br. 5) 50,000

Total purchase price paid in stock Br. 1,500,000

Par value of stock issued (60,000 X Br. 5) 300,000
APIC Br. 1,200,000

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