Chapter Two

Business Combinations
& Consolidation
of Financial Information

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 Business Combinations

A business combination occurs when

two or more separate businesses join
into a single accounting entity.
3

Business Combinations

Separate organizations tied together through common control

Financial statements which represent more than one
corporation are known as “consolidated” financial
statements.
The company which exerts control is known as the “parent.”
The separate controlled companies whose information is
consolidated are known as “subsidiaries.”
 Reasons for Business Combinations
Cost advantage Finding New Facilities Human resources Side-
Research Development .

Lower risk _ purchase new products and markets less risky Than trying to
develops new market ,new products. This help Company to Reduce risk
by diversify their investment in different products
Fewer operating delays- Existing Business reduce delays operation_
Because Government regulation inspection , many things you have to do
In order to start your business. This will Minimize operation delays.
Avoidance of takeovers. small companies afraid big Companies .
Big companies are aggressive in buying other small business_
to defend their companies against takeover By big Companies

Acquisition of intangible assets _ Business combinations bring both

Tangible and intangible resources Patent, management Expertise research
customer data base Other reason_ tax Advantages saving.
The Legal Form of Business Combinations

Business Combination

Acquisitions

Merger Consolidation
The Legal Form of Business
Combinations

A B

A
Merger
The Legal Form of Business
Combinations

A B

C
Consolidation
 The Accounting Concept of
Business Combinations

The concept emphasizes

the creation of a single entity and the independence
of the combining companies before their union.
The Accounting Concept of
Business Combinations

Single management _Control

 The Accounting Concept of
Business Combinations

One or more corporations become subsidiaries.

One company transfers its net assets to another.
Each company transfers its net assets to a newly
formed corporation.
 Background on Accounting for Business Combinations

Accounting for Business Combination is one of the most important and

interesting topic Of accounting theory and practice and its complex topic.
Since 1950 Pooling of interest been generally accepted. Until 2001 accounting
requirements for business combination recognized Both pooling & purchase
methods.
In 1999 FASB issued a report supporting its proposed decision to eliminate
Pooling of interest for the following Reasons: Pooling provides less relevant
information to statement users & ignore economic value exchange in
the transaction. Pooling creates these problem because it uses Historical book
Value rather than Fair value of net assets at the transaction date.
GAAP requires recording asset Acquisitions at fair value. Gaap Eliminated the
pooling of interest method of accounting initiated after June 30, 2001.
Businesses must use the Acquisition Method because the new standard
prohibited use pooling method. IFRS also consistent with GAAP and requires
to use the purchase methods. Accounting for business combination was
a major joint project between FASB & IASB.
 Background on Accounting for
Business Combinations

FASB Statement No. 141

eliminated the pooling of interest method
for transactions initiated after June 30, 2001. Combinations
Initiated after this date must use the purchase method.
Prior combinations will be grandfathered.
Pooling uses historical book values to record combinations
rather than recognizing fair values of net assets at the
transaction date.
 The Acquisitions Method

Acquisitions Method requires the recording

of assets acquired and liabilities assumed at
their fair values at the date of combination.
 The Acquisitions Method

The Acquisitions Method requires that we Expense the direct

cost to business combination (accounting , legal Consulting
and finders fees) .
Registration and other issuance cost of equity securities Issued
reated as a reduction in the fair value of the stock issued and
charge these cost to additional paid In capital.

We expense indirect costs such as management Salaries,

Deprecation and rent. We also expense indirect costs incurred
o close duplicate
Facilities.
 Accounting for Business Combinations
Under the Acquisitions Method

Poppy
PoppyCorporation
Corporationissues
issues100,000
100,000shares
sharesofof$10
$10par
parcommon
commonstock
stock
for
forthe
thenet
netassets
assetsof
ofSunny
SunnyCorporation
Corporationininaapurchase
purchase Combination
Combinationon on
July
July1,
1,2003.
2003.The
Themarket
marketprice
priceof
ofPoppy
Poppyisis$16
$16per
pershare.
share.
Additional
Additionaldirect
directcosts:
costs:
SEC
SECRegistration
Registrationfees
fees $5,000
$5,000aareduction
reductionininPIC
PIC
SEC
SECAccounting
Accountingfees
fees $10,000
$10,000aareduction
reductionin
inPIC
PIC
SEC
SECPrinting
Printingand
andissuing
issuing $25,000
$25,000aareduction
reductionin
inPIC
PIC
Finder
Finderand
andconsulting
consulting $$80,000
80,000Investment
InvestmentExp.
Exp.

How
Howisisthe
theissuance
issuancerecorded?
recorded?
 Accounting for Business Combinations
Under the Acquisitions Method

Investment
Investment in
in Sunny
Sunny 1,600,000
1,600,000
Common
Common Stock,
Stock, $10
$10 par
par 1,000,000
1,000,000
Additional
Additional Paid-in
Paid-in Capital
Capital 600,000
600,000

To
To record
record issuance
issuance of
of 100,000
100,000 shares
shares of
of $10
$10 par
par
common
common stock
stock with
with aa market
market value
value of
of $16
$16 per
per share
share
in
in aa purchase
purchase business
business combination
combination with
with Sunny.
Sunny.

How
How are
are the
the additional
additional direct
direct costs
costs recorded?
recorded?
 Accounting for Business Combinations
Under the Acquisitions Method

Investment
Investment Expense
Expense $$ 80,000
80,000
Additional
Additional Paid-in
Paid-in Capital
Capital $$ 40,000
40,000
Cash
Cash (other
(other assets)
assets) $$ 120,000
120,000
To
To record
record additional
additional direct
direct costs
costs of
of combining
combining
with
with Sunny:
Sunny: $80,000
$80,000 finder’s
finder’s and
and consultants’
consultants’
fees
fees
$40,000
$40,000 for
for registering
registering and
and issuing
issuing equity
equity securities.
securities.
Accounting for Business Combinations
Under the Acquisitions Method

The
The total
total cost
cost to
to Poppy
Poppy of
of acquiring
acquiring
Sunny
Sunny isis $1,600,000.
$1,600,000.
This
This isis the
the amount
amount entered
entered into
into the
the
investment
investment in in the
the Sunny
Sunny account.
account.
 Goodwill

Goodwill is an intangible asset that arises

when the purchase price to acquire a
subsidiary company is greater than
the sum of the market value of the
subsidiary’s assets minus liabilities.
 Cost Allocation in a Purchase
Business Combination

Determine the fair values of all identifiable tangible

nd intangible assets Acquired & liabilities assumed.

FASB Statement No. 141 provides guidelines for assignin

amounts to specific categories of assets and liabilities.
 Cost Allocation in a Purchase
Business Combination

No value is assigned to goodwill recorded

on the books of an acquired subsidiary.

Such goodwill is an unidentifiable asset .

 Cost and Fair Value Compared

Total fair value of

Investment cost identifiable assets
less liabilities
Cost and Fair Value Compared

Investment cost
> Net fair value

1 Identifiable net
assets according
to their fair value

Goodwill
 Illustration of a Purchase
Combination

Pitt Corporation acquires the net assets of

Seed Company on December 27, 2013. seed is dissolved

Pitt Seed
Illustration of a Purchase Combination

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
 Illustration of a Purchase
Combination
Book Fair
Value Value

Liabilities
Accounts payable $ 60 $ 60
Notes payable 150 135
Other liabilities 40 45
Total liabilities $250 $ 240
Net assets $ 750 $1,200
 Illustration of a Purchase
Combination

Case 1____
Pitt pays $400,000 cash and issues 50,000
shares of Pitt Corporation $10 par common
stock with a market value of $20 per share.

50,000 × $10 = $500,000

 Illustration of a Purchase
Combination
Pitt will record following entries in his books :

Investment in Seed 1,400,000

Cash 400,000
Common Stock 500,000
Additional Paid-in Capital 500,000

To record issuance of 50,000 shares of $10 par

common stock plus $400,000 cash in a purchase
business combination with Seed Company
 Illustration of a Purchase Combination

Cash 50 Accounts payable 60

Net receivable 140 Notes payable 135
Inventories 250 Other liabilities 45
Land 100 Investment in
Buildings, net 500 Seed Company 1,400
Equipment, net 350
Patents 50
Goodwill 200 $1640 – 1,440 = 200

Goodwill 200
 Illustration of a Purchase Combination

Case 2_
Assume that Pitt issues 40,000 shares of its $10 par common
stock with a market value of $20 per share and
also gives a 10%, five-year note payable for
$200,000 for the net assets of Seed Company.

40,000 × $10 = $400,000

 Illustration of a Purchase Combination

Investment in Seed 1,000,000

Common Stock 400,000
Additional Paid-in Capital 400,000
10% Note Payable 200,000

To record issuance of 40,000 shares of $10 par

common stock plus $200,000, 10% note in a
purchase business combination with Seed Company
 Illustration of a Purchase Combination

Cash 50 Accounts payable 60

Net receivable 140 Notes payable 135
Inventories 250 Other liabilities 45
Land 100 Investment in
Buildings, net 500 Seed Company 1,000
Gain from bargain purchase 200
Equipment, net 350
Patents 50
 Illustration of a Purchase Combination

$1,200,000 fair value is greater than $1,000,000

purchase price by $200,000.
 The Goodwill Controversy

Under FASB Statement No. 142, goodwill is no

longer amortized for financial reporting purposes.

– income tax controversies

– international accounting issues
 The Goodwill Controversy

Under FASB Statements No. 141 and No. 142,

the FASB requires that firms periodically assess
goodwill for impairment of its value.

An impairment occurs when the recorded value

of goodwill is less than its fair value.
 Recognizing and Measuring Impairment
Losses

Compare

Carrying values Fair values

Cost and Fair Value Compared

Fair value < Carrying amount

Measurement of the impairment loss

 Amortization versus Non amortization

Firms must amortize intangible assets with

a finite useful life over that life.

Firms will not amortize intangible assets with an

indefinite useful life that cannot be estimated.
Steps for Consolidation
1.
1. Record
Recordthe
thefinancial
financialinformation
informationfor
for
both
bothParent
Parentand
andSub
Subon onthe
theworksheet.
worksheet.
2.
2. Remove
Removethe
the Investment
Investmentin
in Sub
Sub balance.
balance.
3.
3. Remove
Removethe the Sub’s
Sub’s equity
equityaccount
account
balances.
balances.
4.
4. Adjust
Adjustthe
theidentifiable
identifiableassets
assetsacquired
acquired
and
andliabilities
liabilitiesassumed
assumedto toFV.
FV.
5.
5. Allocate
Allocateany
anyremaining
remainingexcess
excessofof
consideration
considerationtransferred
transferredover
overBVBVto
to
goodwill.
goodwill.
6.
6. Combine
Combineall allaccount
accountbalances.
balances.
No Dissolution Example
41
42
43
 Summary
 Consolidation of financial information is required when one
organization gains control of another.
 If dissolution occurs, this consolidation is carried out at the
date of acquisition and a single set of accounting records is
maintained.
 If separate identities are maintained, consolidation is a periodic
“worksheet” process not involving journal entries. Separate
accounting records are maintained.
 The acquisition method is GAAP beginning in 2009.
 Legacy effects for the purchase method (for combinations
occurring through 2008) and the pooling method (through
6/30/2002) remain in subsequent year’s financial reports.