Abdu Y.

Advanced Financial Accounting

Unit 1
Business Combination

MEANING OF BUSINESS COMBINATION

Business Combination
A business combination is defined in International Financial Reporting Standard 3 (IFRS 3) as a
transaction or other event in which an acquirer obtains control of one or more businesses. This
definition has two key aspects: control and businesses. A business is defined as an integrated set
of activities and assets that is capable of being conducted and managed for the purpose of
providing a return in the form of dividends, lower costs, or other economic benefits directly to
investors or other owners, members, or participants. A business consists of inputs and processes
applied to those inputs that have the ability to create outputs. An input is any economic resource
that creates, or has the ability to create, outputs when one or more processes are applied to it.

IFRS 10 states that an investor controls an investee when it is exposed or has rights to variable
returns from its involvement with the investee, and it has the ability to affect those returns
through its power over the investee. This definition contains the following three elements:
i. The investor has power over the investee.
ii. The investor has exposure, or rights, to variable returns from its
involvement with the investee.
iii. The investor has the ability to use its power over the investee to affect the
amount of the investor’s returns.

All three elements must be met for the investor to have control. If the investor does have control
over the investee, the investor is called the parent and the investee is called the subsidiary.

WHY BUSINESS COMBINATION?

If expansion is a proper goal of business enterprise, why would a business expand through
combination rather than by building new facilities? Among the many possible reasons are the
following:

Cost Advantage. It is frequently less expensive for a firm to obtain needed facilities through
combination than through development. This is particularly true in periods of inflation.
Lower Risk. The purchase of established product lines and markets is usually less risky than
developing new products and markets. The risk is especially low when the goal is diversification.
Scientists may discover that a certain product provides an environmental or health hazard. A
single-product, non-diversified firm may be forced into bankruptcy by such a discovery; while a
multiproduct, diversified company is more likely to survive. For companies in industries already

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plagued with excess manufacturing capacity, business combinations may be the only way to
grow.
Fewer Operating Delays. Plant facilities acquired in a business combination are operative and
already meet environmental and other governmental regulations. The time to market is critical,
especially in the technology industry. Firms constructing new facilities can expect numerous
delays in construction, as well as in getting the necessary governmental approval to commence
operations. Environmental impact studies alone can take months or even years to complete.
Avoidance of Takeovers. Many companies combine to avoid being acquired themselves.
Smaller companies tend to be more vulnerable to corporate takeovers; therefore, many of them
adopt aggressive buyer strategies to defend against takeover attempts by other companies.

Acquisition of Intangible Assets. Business combinations bring together both intangible and
tangible resources. The acquisition of patents, mineral rights, research, customer databases, or
management expertise may be a primary motivating factor in a business combination.

Other Reasons. Firms may choose a business combination over other forms of expansion for
business tax advantages (for example, tax-loss carry forwards), for personal income and estate-
tax advantages, or for personal reasons.

Growth
In recent years Growth has been main reason for business enterprises to enter into a business
combination. Firms can achieve growth through external and internal methods. The external
(e.g. business combination) method of achieving growth is more rapid than growth through
internal methods, as per advocates of external method. There is no question that expansion and
diversification of product lines, or enlarging the market share for current products, is achieved
readily through a business combination with another enterprise. Combinations enable
satisfactory and balanced growth of an enterprise. The company can cross many stages of growth
at one time through combination. Growth through combination is also cheaper and less risky. By
acquiring other enterprises, a desired level of growth can be maintained by an enterprise. When
an enterprise tries to enter new line of activities, it may face a number of problems in production,
marketing, purchasing. Business combination enables to acquire or merge with an enterprise
already operating indifferent lines that have crossed many obstacles and difficulties.
Combination will bring together experiences of different persons in varied activities. So
combination will be the best way of Growth.

Economies of Scale
A combined enterprise will have more resources at its command than the individual enterprises.
This will help in increasing the scale of operations so that economies of large scale will be
availed. The economies of scale will occur as a result of more intensive utilization of production

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facilities, distribution network, research and development facilities, etc. The economies of scale
will lead to financial synergies.

Operating Economies
A number of operating economies will be available with the combination of two or more
enterprises. Duplicating facilities in accounting, purchasing, marketing, etc will be eliminated.
Operating inefficiencies of small concerns will be controlled by superior management emerging
from the combinations. The acquiring company will be in a better position to operate than the
acquired companies individually. Whether the horizontal or vertical business combinations, it
may provide operating synergies when the duplicated facilities are eliminated

Better Management
Combinations results in better management. Combinations result running the large scale
enterprises. A large enterprise can offer to use the service of expertise. Various managerial
functions can be efficiently managed by those persons who are qualified for such jobs. This is
not possible for small individual enterprises.

Monopolistic Ambitions
One of the important reasons behind business combination is monopolistic ambitions. The
combined enterprises try to control more and more enterprises in the same line so that they may
be able to detect their terms (E.g. set their price). But, the antitrust law is against such type of
business combination.

Diversification of Business Risk

When one company involves business combination, it can diversify risks of operations. A
Company involving business combination can minimize risks as the enterprise is diversifying
operation or line of their activity. Since different companies are already dealing in their
respective lines, there will be risk diversification.

Tax Advantages
When an enterprise with accumulated losses merges with a profit making enterprise, it is able to
utilize tax shields (benefits). An enterprise having losses will not be able to set-off losses against
future profits, because it is not a profit earning unit. On the other hand, if it merges with an
enterprise earning profits then the accumulated losses of one unit will be set-off against future
profit of the other unit. In this way, combinations will enable an enterprise to avail tax benefits.
The tax law that permits setting off losses is either Loss Carry Forward or Loss Carry Back.

Elimination of Fierce Competition

Combination of two or more enterprises will eliminate competition among them. The enterprises
will be able to save their advertising expenses. This enables the combined enterprise to reduce
prices. The consumer will also benefit in the form cheaper goods being made available to them.

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Better Financial Planning

A combined enterprise will be able to plan their resources in a better way. The collective finance
of merged enterprises will be more and their utilization may be better than in separate
enterprises. It may happen that one of the merging enterprises has short Gestation period (A
period of time from making investment to collecting the returns) while the other has longer
Gestation period. The profits with short gestation period will be utilized to finance the other
enterprise with long gestation period. When the enterprise with longer gestation period starts
earning profits then it will improve financial position as a whole.

Getting Financial Gains

Critics have alleged that the foregoing reasons attributed to the ―urge to merge‖ (business
combinations) do not apply to unfriendly takeovers. These critics complain that the ―Sharks‖
who engage in unfriendly takeovers need financial benefits after assessing the prospect of
substantial gains resulting from the sale of business segments of a combine following the
business combination.

TYPES OF BUSINESS COMBINATION

There are three types of business combinations: Horizontal Combination, Vertical Combination,
and Conglomerate Combination:
1. Horizontal Combination: is a combination involving enterprises in the same industry.
E.g. assume combination of BEDELE Brewery and HARAR Brewery
2. Vertical Combination: A Combination involving an enterprise and its customers or
suppliers. It is a combination involving companies engaged in different stages of
production or distribution. It is classified into two: Backward Vertical Combination –
combination with supplier and Forward Vertical Combination – combination with
customers. E.g.1: A Tannery Company acquiring a Shoes Company - Forward
E.g.2: Weaving Company acquiring both Ginning and Spinning Company - Backward
3. Conglomerate (Mixed) Combination: is a combination involving companies that are
neither horizontally nor vertically integrated. It is a combination between enterprises in
unrelated industries or markets.

FORMS OF BUSINESS COMBINATION

The three primary legal forms of business combinations are:
 Statutory Merger,
 Statutory Consolidation, and
 Stock Acquisition.

A statutory merger is a type of business combination in which only one of the combining
companies survives and the other loses its separate identity. The acquired company's assets and
liabilities are transferred to the acquiring company, and the acquired company is dissolved, or

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liquidated. The operations of the previously separate companies are carried on in a single legal
entity following the merger.

A statutory consolidation is a business combination in which both combining companies are

dissolved and the assets and liabilities of both companies are transferred to a newly created
corporation. The operations of the previously separate companies are carried on in a single legal
entity, and neither of the combining companies remains in existence after a statutory
consolidation. In many situations, however, the resulting corporation is new in form only, and in
substance it actually is one of the combining companies reincorporated with a new name.

A stock acquisition occurs when one company acquires the voting shares of another company
and the two companies continue to operate as separate, but related, legal entities. Because neither
of the combining companies is liquidated, the acquiring company accounts for its ownership
interest in the other company as an investment. In a stock acquisition, the acquiring company
need not acquire all the other company's stock to gain control.

The relationship that is created in a stock acquisition is referred to as a parent–subsidiary

relationship. A parent company is one that controls another company, referred to as a
subsidiary, usually through majority ownership of common stock. For general-purpose financial
reporting, a parent company and its subsidiaries present consolidated financial statements that
appear largely as if the companies had actually merged into one.

A stock acquisition occurs when one company acquires a majority of the voting stock of another
company and both companies remain in existence as separate legal entities following the
business combination. Statutory mergers and consolidations may be effected through acquisition
of stock as well as through acquisition of net assets. To complete a statutory merger or
consolidation following an acquisition of stock, the acquired company is liquidated and only the
acquiring company or a newly created company remains in existence.

The legal form of a business combination, the substance of the combination agreement, and the
circumstances surrounding the combination all affect how the combination is recorded initially
and the accounting and reporting procedures used subsequent to the combination.

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Summary: Schematic Diagram of Business Combination Form

A Company invests in B Company

Acquires Net Assets A quires Stock

Yes
Acquired Company Liquidated?

No

Record as Statutory Record as Stock

Merger or Statutory Acquisition and Operate
Consolidation as Subsidiary

METHODS OF EFFECTING BUSINESS COMBINATION

Business combinations can be characterized as either friendly or unfriendly. In a friendly

combination, the managements of the companies involved come to agreement on the terms of the
combination and recommend approval by the stockholders. Such combinations usually are
effected in a single transaction involving an exchange of assets or voting shares. In an unfriendly
combination, or ―hostile takeover,‖ the managements of the companies involved are unable to
agree on the terms of a combination, and the management of one of the companies makes a
tender offer directly to the shareholders of the other company. A tender offer invites the
shareholders of the other company to ―tender,‖ or exchange, their shares for securities or assets
of the acquiring company. If sufficient shares are tendered, the acquiring company gains voting
control of the other company and can install its own management by exercising its voting rights.
The specific procedures to be used in accounting for a business combination depend on whether
the combination is effected through an acquisition of assets or an acquisition of stock.

Acquisition of Assets
Sometimes one company acquires another company's assets through direct negotiations with its
management. The agreement also may involve the acquiring company's assuming the other
company's liabilities. Combinations of this sort take forms of statutory merger or consolidation.
The selling company generally distributes to its stockholders the assets or securities received in
the combination from the acquiring company and liquidates, leaving only the acquiring company
as the surviving legal entity.

The acquiring company accounts for the combination by recording each asset acquired, each
liability assumed, and the consideration given in exchange.
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Acquisition of Stock

A business combination effected through a stock acquisition does not necessarily have to involve
the acquisition of all of a company's outstanding voting shares. For one company to gain control
over another through stock ownership, a majority (i.e., more than 50 percent) of the outstanding
voting shares usually is required unless other factors lead to the acquirer gaining control. The
total of the shares of an acquired company not held by the controlling shareholder is called the
noncontrolling interest, previously referred to as the minority interest.

In those cases when control of another company is acquired and both companies remain in
existence as separate legal entities following the business combination, the stock of the acquired
company is recorded on the books of the acquiring company as an investment and subsequently
is accounted for as an intercorporate investment. Alternatively, the acquired company may be
liquidated and its assets and liabilities transferred to the acquiring company or a newly created
company. To do so, all or substantially all of the acquired company's voting stock must be
obtained. An acquisition of stock and subsequent liquidation of the acquired company is
equivalent to an acquisition of assets.

Acquisition by Other Means

Occasionally, a business combination may be effected without an exchange of assets or equities

and without a change in ownership. In some cases, control might be acquired through agreement
alone, or in rare cases, by some other means.

ACCOUNTING METHODS OF BUSINESS COMBINATION

ACQUISITION METHOD OF ACCOUNTING

IFRS 3 requires a business combination to be accounted for by applying the acquisition method.
Applying the acquisition method involves the following steps:
a) Identifying an acquirer;
b) Determining the acquisition date;
c) Recognizing and measuring the identifiable assets acquired, the liabilities assumed, and
any non-controlling interest in the acquiree; and
d) Recognizing and measuring goodwill or a gain in a bargain purchase.

Under the acquisition method, the acquirer recognizes all assets acquired and liabilities assumed
in a business combination and measures them at their acquisition-date fair values. If less than
100 percent of the acquiree is acquired, the noncontrolling interest also is measured at its
acquisition date fair value. Note that a business combination does not affect the amounts at
which the assets and liabilities of the acquirer are valued.

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Fair Value Measurements

Because accounting for business combinations is now based on fair values, the measurement of
fair values takes on added importance. The acquirer value at fair value
1) the consideration it exchanges in a business combination,
2) each of the individual identifiable assets and liabilities acquired, and
3) any noncontrolling interest in the acquiree.

IFRS 3 provides the acquirer with a choice of two methods to measure noncontrolling interests at
the acquisition date arising in a business combination:
1. To measure the noncontrolling interest at fair value (also recognizing the acquired business at
fair value); or
2. To measure the noncontrolling interest at the present ownership instruments’ share in the
recognized amounts of the acquiree’s identifiable net assets (under this approach the only
difference is that, in contrast to the approach of measuring the noncontrolling interest at fair
value, no portion of imputed goodwill is allocated to the noncontrolling interest). (We will
discuss this situation in detail in chapter 4)

Applying the Acquisition Method

For all business combinations, an acquirer must be identified, and that party is the one gaining
control over the other. In addition, an acquisition date must be determined. That date is usually
the closing date when the exchange transaction actually occurs. However, in rare cases control
may be acquired on a different date or without an exchange, so the circumstances must be
examined to determine precisely when the acquirer gains control.

Under the acquisition method, the full acquisition-date fair values of the individual assets
acquired, both tangible and intangible, and liabilities assumed in a business combination are
recognized. This is true regardless of the percentage ownership acquired by the controlling
entity. If the acquirer acquires all of the assets and liabilities of the acquiree in a merger, these
assets and liabilities are recorded on the books of the acquiring company at their acquisition date
fair values. If the acquiring company acquires partial ownership of the acquiree in a stock
acquisition, the assets acquired and liabilities assumed appear at their full acquisition date fair
values in a consolidated balance sheet prepared immediately after the combination.

All indirect costs of bringing about and consummating a business combination are charged to an
acquisition expense as incurred. Examples of traceable, indirect costs include finders’ fees,
consulting fees, travel costs, and so on. The costs of issuing equity securities used to acquire the
acquiree are treated in the same manner as stock issues costs are normally treated, as a reduction
in the paid-in capital associated with the securities.

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Goodwill
Conceptually, goodwill as it relates to business combinations consists of all those intangible
factors that allow a business to earn above-average profits. From an accounting perspective,
goodwill ―is an asset representing the future economic benefits arising from other assets acquired
in a business combination that are not individually identified and separately recognized.‖An
asset is considered to be identifiable, and therefore must be separately recognized, if it is
separable (can be separated from the business) or arises from a contractual or other right.

Under the acquisition method, an acquirer measures and recognizes goodwill from a business
combination based on the relationship between the total fair value of the acquired company and
the fair value of its net identifiable assets. However, for several reasons, not to focus directly on
the total fair value of the acquiree, but rather on the components that provide an indication of that
fair value. The FASB identified three components that should be measured and summed for the
total amount to be used in determining the amount of goodwill recognized in a business
combination:

A. The fair value of the consideration given by the acquirer.

B. The fair value of any interest in the acquiree already held by the acquirer.
C. The fair value of the noncontrolling interest in the acquiree, if any.
The total of these three amounts, all measured at the acquisition date, is then compared with the
acquisition-date fair value of the acquiree's net identifiable assets, and the difference is goodwill.

Example of the Computation of Goodwill

Assume that Albert Company acquires all of the assets of Zanfor Company for $400,000 when
the fair value of Zanfor’s net identifiable assets is $380,000. Goodwill is recognized for the
$20,000 difference between the total consideration given and the fair value of the net identifiable
assets acquired. If, instead of an acquisition of assets, Albert acquires 75 percent of the common
stock of Zanfor for $300,000, and the fair value of the noncontrolling interest is $100,000,
goodwill is computed as follows:

Fair value of consideration given by Albert $300,000

+ Fair value of noncontrolling interest 100,000
Total fair value of Zanfor Company $400,000
– Fair value of net identifiable assets acquired (380,000)
Goodwill $ 20,000

Note that the total amount of goodwill is not affected by whether 100 percent of the acquiree or
less than that is acquired. However, the fair value of the noncontrolling interest does have an
effect on the amount of goodwill recognized. In the example given, the fair values of the
controlling and noncontrolling interests are proportional (each is valued at an amount equal to its
proportionate ownership share of the total) and imply a total fair value of the acquired company

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of $400,000. This is frequently the case and will always be assumed throughout the text unless
indicated otherwise. However, that may not always be the case in practice. Situations might arise
in a stock acquisition, for example, where the per-share value of the controlling interest is higher
than that of the noncontrolling interest because of a premium associated with gaining control.

COMBINATION EFFECTED THROUGH ACQUISITION OF NET ASSETS

When one company acquires all the net assets of another in a business combination, the acquirer
records on its books the individual assets acquired and liabilities assumed in the combination and
the consideration given in exchange. Each identifiable asset and liability acquired (with minor
exceptions) is recorded by the acquirer at its acquisition-date fair value. Any excess of the fair
value of the consideration exchanged over the fair value of the net identifiable assets is recorded
by the acquiree as goodwill.

Example 1: Goodwill

Assume P stands for Point Corporation and S stands for Sharp Company.

On January 1, 2009, P Corporation acquires all assets and liabilities of S company in a statutory
merger by issuing to S 10,000 shares of $10 Par common stock. The shares issued have a total
market value of $610,000. P Corporation incurs legal and appraisal fees of $40,000 in connection
with the combination and stock issue costs of $25,000.

Assume the book value and fair value of the individual assets and liabilities of S company are
given below.

S company Balance Sheet as of December 31, 2008

Assets, Liabilities, and Equities Book Value Fair Value
Cash and Receivable $45,000 $45,000
Inventory 65,000 75,000
Land 40,000 70,000
Building & Equipment 400,000 350,000
Accumulated depreciation (150,000)
Patent . 80,000
Total Assets $400,000 $620,000

Current Liabilities $100,000 $110,000

Common Stock ($5 Par) 100,000
Additional Paid in Capital 50,000
Retained Earnings 150,000
Total Liabilities & Equity $400,000 .
Fair Values of Net Assets $510,000

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Required:
A. Determine the Acquisition price of the acquired company and
B. The recorded amount of stock issued to effect the combination by P Corporation.
C. Record the necessary journal entries on the books of acquiring Company.
D. Record the necessary journal entries on the books of acquired Company.
Solution: A., B., C. and D. Refer the class discussion for the solution
Entries Recorded by Acquiring Company

The total difference at the acquisition date between the fair value of the consideration exchanged
and the book value of the net identifiable assets acquired is referred to as the differential. In more
complex situations, the differential is equal to the difference between (1) the acquisition-date fair
value of the consideration transferred by the acquirer, plus the acquisition-date fair value of any
equity interest in the acquiree previously held by the acquirer, plus the fair value of any
noncontrolling interest in the acquiree and (2) the acquisition-date book values of the identifiable
assets acquired and liabilities assumed.

In the Point/Sharp merger, the total differential of $310,000 reflects the difference between the
total fair value of the shares issued by Point and the carrying amount of Sharp's net assets
reflected on its books at the date of combination. A portion of that difference ($210,000) is
attributable to the increased value of Sharp's net assets over book value. The remainder of the
difference ($100,000) is considered to be goodwill.
 The $40,000 of acquisition costs incurred by Point in bringing about the combination with
Sharp are expensed as incurred and recorded as it has been demonstrated in the class.
 Portions of the $25,000 of stock issue costs related to the shares issued to acquire Sharp
may be incurred at various times. To facilitate accumulating these amounts before
recording the combination, Point may record them in a separate temporary ―suspense‖
account as incurred recorded as it has been demonstrated in the class.

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 On the date of combination, Point records the acquisition of Sharp as it has been
demonstrated in the class.

This entry records all of Sharp's individual assets and liabilities, both tangible and intangible, on
Point's books at their fair values on the date of combination. The fair value of Sharp's net assets
recorded is $510,000 ($620,000–$110,000). The $100,000 difference between the fair value of
the shares given by Point ($610,000) and the fair value of Sharp's net assets is recorded as
goodwill. In recording the business combination, Sharp's book values are not relevant to Point;
only the fair values are recorded. Because a change in ownership has occurred, the basis of
accounting used by the acquired company is not relevant to the acquirer. Consistent with this
view, accumulated depreciation recorded by Sharp on its buildings and equipment is not relevant
to Point and is not recorded.

The stock issue costs incurred by Point in connection with Sharp's acquisition are initially
recorded in a temporary account as incurred. They then are treated in the normal manner as a
reduction in the proceeds received from the issuance of the stock. Thus, these costs are
transferred from the temporary account to Additional Paid-In Capital as a reduction. Point
records the $610,000 of stock issued at its value minus the stock issue costs, or $585,000. Of this
amount, the $100,000 par value is recorded in the Common Stock account and the remainder in
Additional Paid-In Capital.

Entries Recorded by Acquired Company

 On the date of the combination, Sharp records entry to recognize receipt of the Point
shares and the transfer of all individual assets and liabilities to Point as demonstrated in the class
room.
 Sharp recognizes the fair value of Point Corporation shares at the time of the exchange
and records a gain of $310,000. The distribution of Point shares and the liquidation of Sharp are
recorded on Sharp's books with similar to the demonstration in the class.

Example 2: Bargain Purchase

Assume P stands for Point Corporation and S stands for Sharp Company.

On January 1, 2009, P Corporation acquires all assets and liabilities of S company in a statutory
merger by paying cash of $500,000. P Corporation incurs legal and appraisal fees of $40,000 in
connection with the combination. Assume the book value and fair value of the individual assets
and liabilities of S company are given below.

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S company Balance Sheet as of December 31, 2008

Assets, Liabilities, and Equities Book Value Fair Value
Cash and Receivable $45,000 $45,000
Inventory 65,000 75,000
Land 40,000 70,000
Building & Equipment 400,000 350,000
Accumulated depreciation (150,000)
Patent . 80,000
Total Assets $400,000 $620,000

Current Liabilities $100,000 $110,000

Common Stock ($5 Par) 100,000
Additional Paid in Capital 50,000
Retained Earnings 150,000
Total Liabilities & Equity $400,000 .
Fair Values of Net Assets $510,000

Required:
A. Determine the Acquisition price of the acquired company and
B. Record the necessary journal entries on the books of acquiring Company.
C. Record the necessary journal entries on the books of acquired Company.

Solution:
A., B. and C. Refer the class discussion for the solution

Bargain Purchase

Occasionally, the fair value of the consideration given in a business combination, along with the
fair value of any equity interest in the acquiree already held and the fair value of any
noncontrolling interest in the acquiree, may be less than the fair value of the acquiree's net
identifiable assets, resulting in a bargain purchase. This might occur, for example, with a forced
sale.

When a bargain purchase occurs (rarely), the acquirer must take steps to ensure that all
acquisition-date valuations are appropriate. If they are, the acquirer recognizes a gain at the date
of acquisition for the excess of the amount of the net identifiable assets acquired and liabilities
assumed over the sum of the fair value of the consideration given in the exchange, the fair value
of any equity interest in the acquiree held by the acquirer at the date of acquisition, and the fair
value of any noncontrolling interest. The amount of the gain must be disclosed, along with where
the gain is reported and the factors that led to the gain.

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To illustrate accounting for a bargain purchase, assume that in the previous example of Point and
Sharp, Point is able to acquire Sharp for $500,000 cash even though the fair value of Sharp's net
identifiable assets is estimated to be $510,000. In this simple bargain-purchase case without an
equity interest already held or a noncontrolling interest, the fair value of Sharp's net identifiable
assets exceeds the consideration exchanged by Point, and, accordingly, a $10,000 gain
attributable to Point is recognized. In accounting for the bargain purchase (for cash) on
Point's books, the entry is demonstrated in the class room (Refer class Example 2).

This treatment is rather unusual because it recognizes a gain on an acquisition and, thus,
represents an exception to the realization concept.

Acquirers do not knowingly overpay for an acquisition. Any overpayment presumably would be
the result of misinformation, and the overpayment would not be discovered until a later time.
The FASB avoided this issue by basing the computation of goodwill on the consideration given
by the acquirer rather than the acquiree's total fair value. Thus, any overpayment would be
included in goodwill and presumably eliminated in future periods by testing for goodwill
impairment.

COMBINATION EFFECTED THROUGH ACQUISITION OF STOCK

Many business combinations are effected by acquiring the voting stock of another company
rather than by acquiring its net assets. In such a situation, the acquired company continues to
exist, and the acquirer records an investment in the common stock of the acquiree rather than its
individual assets and liabilities. The acquirer records its investment in the acquiree's common
stock at the total fair value of the consideration given in exchange. (Refer to the demonstration
given in the class, Example 3)
When a business combination is effected through a stock acquisition, the acquiree may continue
to operate as a separate company, or it may lose its separate identity and be merged into the
acquiring company. The accounting and reporting procedures for intercorporate investments in
common stock when the acquiree continues in existence are discussed in the next chapters. If the
acquired company is liquidated and its assets and liabilities are transferred to the acquirer, the
dollar amounts recorded are identical to those in entry of Example 1, as illustrated in the class.

Example 3: Assume P stands for Point Corporation and S stands for Sharp Company.
On January 1, 2009, P Corporation exchanges its 10,000 shares of $10 Par common stock for all
outstanding shares of S company. The shares issued have a total market value of $610,000. P
Corporation incurs legal and appraisal fees of $40,000 in connection with the combination and
stock issue costs of $25,000. Assume the book value and fair value of the individual assets and
liabilities of S company are given below.

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S company Balance Sheet as of December 31, 2008

Assets, Liabilities, and Equities Book Value Fair Value
Cash and Receivable $45,000 $45,000
Inventory 65,000 75,000
Land 40,000 70,000
Building & Equipment 400,000 350,000
Accumulated depreciation (150,000)
Patent . 80,000
Total Assets $400,000 $620,000

Current Liabilities $100,000 $110,000

Common Stock ($5 Par) 100,000
Additional Paid in Capital 50,000
Retained Earnings 150,000
Total Liabilities & Equity $400,000 .
Fair Values of Net Assets $510,000

Required:
Case 1: - Assume the form of the business combination is a statutory merger;
A. Determine the Acquisition price of the acquired company and
B. The recorded amount of stock issued to effect the combination by P Corporation.
C. Record the necessary journal entries on the books of acquiring Company.
D. Record the necessary journal entries on the books of acquired Company.

Case 2: - Assume the form of the business combination is a stock acquisition; record the
necessary journal entries on the books of acquiring Company.

Solution:

Case 1 and Case 2. Refer the class discussion for the solution.

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Part I: Multiple-Choice Questions

Select the correct answer for each of the following questions.
1. Lead Corporation established a new subsidiary and transferred to it assets with a cost of
$90,000 and a book value of $75,000. The assets had a fair value of $100,000 at the time of
transfer. The transfer will result in
A. A reduction of net assets reported by Lead Corporation of $90,000.
B. A reduction of net assets reported by Lead Corporation of $75,000.
C. No change in the reported net assets of Lead Corporation.
D. An increase in the net assets reported by Lead Corporation of $25,000.
2. Tear Company, a newly established subsidiary of Stern Corporation, received assets with an
original cost of $260,000, a fair value of $200,000, and a book value of $140,000 from the
parent in exchange for 7,000 shares of Tear’s $8 par value common stock. Tear should record
A. Additional paid-in capital of $0.
B. Additional paid-in capital of $84,000.
C. Additional paid-in capital of $144,000.
D. Additional paid-in capital of $204,000.
3. Grout Company reports assets with a carrying value of $420,000 (including goodwill with a
carrying value of $35,000) assigned to an identifiable reporting unit purchased at the end of
the prior year. The fair value of the net assets held by the reporting unit is currently
$350,000, and the fair value of the reporting unit is $395,000. At the end of the current
period, Grout should report goodwill of
A. $45,000.
B. $35,000.
C. $25,000.
D. $10,000.
4. Twill Company has a reporting unit with the fair value of its net identifiable assets of
$500,000. The carrying value of the reporting unit’s net assets on Twill’s books is $575,000,
which includes $90,000 of goodwill. The fair value of the reporting unit is $560,000. Twill
should report impairment of goodwill of
A. $60,000.
B. $30,000.
C. $15,000.
D. $0.

Part II: Workout

1. Sun Corporation concluded the fair value of Tender Company was $60,000 and paid that
amount to acquire its net assets. Tender reported assets with a book value of $55,000 and fair
value of $71,000 and liabilities with a book value and fair value of $20,000 on the date of
combination. Sun also paid $4,000 to a search firm for finder’s fees related to the acquisition.

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Required: Give the journal entries to be made by Sun to record its investment in Tender and
its payment of the finder’s fees.

2. Samper Company reported the book value of its net assets at $160,000 when Public
Corporation acquired 100 percent of its voting stock for cash. The fair value of Samper’s net
assets was determined to be $190,000 on that date.
Required: Determine the amount of goodwill to be reported in consolidated financial
statements presented immediately following the combination and the amount at which Public
will record its investment in Samper if the amount paid by Public is
a. $310,000.
b. $196,000.
c. $150,000.

3. Pit Corporation acquires the net assets of Sad Company in a combination consummated on
December 27, 2011. Sad Company is dissolved. The assets and liabilities of Sad Company on
this date, at their book values and at fair values, are as follows (in thousands):

Book Value Fair Value

Assets
Cash $ 50 $ 50
Net receivables 150 140
Inventories 200 250
Land 50 100
Buildings—net 300 500
Equipment—net 250 350
Patents — 50
Total assets $1,000 $1,440
Liabilities
Accounts payable $ 60 $ 60
Notes payable 150 135
Other liabilities 40 45
Total liabilities $ 250 $ 240

REQUIRED:

Prepare the necessary journal entries on the books of acquiring company under the following
cases.

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Case 1: Pit Corporation pays $400,000 cash and issues 50,000 shares of Pit Corporation $10 par
common stock with a market value of $20 per share for the net assets of Sad Company.
Case 2: Pit Corporation issues 40,000 shares of its $10 par common stock with a market value of
$20 per share, and it also gives a 10 percent, five-year note payable for $200,000 for the net
assets of Sad Company.

4. On January 2, 2011, Par Corporation issues its own $10 par common stock for all the
outstanding stock of Sin Corporation in an acquisition. Sin is dissolved. In addition, Par pays
$40,000 for registering and issuing securities and $60,000 for other costs of combination.
The market price of Par’s stock on January 2, 2011, is $60 per share. Relevant balance sheet
information for Par and Sin Corporations on December 31, 2010, just before the
combination, is as follows (in thousands):

Par Sin Sin

Historical Cost Historical Cost Fair Value
Cash $ 240 $ 20 $ 20
Inventories 100 60 120
Other current assets 200 180 200
Land 160 40 200
Plant and equipment—net 1,300 400 700
Total assets $ 2,000 $700 $1,240
Liabilities $ 400 $ 100 $ 100
Capital stock, $10 par 1,000 200
Additional paid-in capital 400 100
Retained earnings 200 300
Total liabilities and owners’ equity $2,000 $700

REQUIRED
1. Assume that Par issues 25,000 shares of its stock for all of Sin’s outstanding shares.
a. Prepare journal entries to record the acquisition of Sin.
b. Prepare a balance sheet for Par Corporation immediately after the acquisition.

2. Assume that Par issues 15,000 shares of its stock for all of Sin’s outstanding shares.
a. Prepare journal entries to record the acquisition of Sin.
b. Prepare a balance sheet for Par Corporation immediately after the acquisition.

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