Advanced Accounting

Thirteenth Edition, Global Edition

Chapter 1
Business Combinations

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 Business Combinations
Learning Objectives
1.1 Understand the economic motivations underlying
business combinations.
1.2 Learn about the alternative forms of business
combinations, from both the legal and accounting
perspectives.
1.3 Introduce accounting concepts for business
combinations, emphasizing the acquisition method.
1.4 See how firms record fair values of assets and
liabilities in an acquisition.

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Introduction
Business Combinations

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Types of Business Combinations

–Horizontal integration
–Vertical integration
–Conglomeration

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Horizontal integration
– same business lines and markets
– It may be seeking to increase its size, diversify its
product offerings or services, achieve economies of
scale, reduce competition, or gain access to new
customers or markets.
 Facebook's 2012 acquisition of Instagram (social
media)
 Disney's 2006 acquisition of Pixar (entertainment
media).

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Vertical integration
– It may be seeking to strengthen its supply chain,
reduce production costs, capture upstream or
downstream profits, or access new distribution
channels.
Google's 2011 acquisition of smart phone producer
Motorola
Ikea's 2015 purchase of forests in Romania to supply
its own raw materials

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Conglomeration
• – unrelated and diverse products or services

• Firms may diversify to reduce the risk associated

with a particular line of business, such as might
occur in a utility’s acquisition of a manufacturing
company.
• Several utilities combined with telephone
companies after the 1996 Telecommunications Act
allowed utilities to enter the telephone business.

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1.1 Reasons for Combinations

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Reasons for Combinations
– Cost advantage
frequently less expensive to acquire rather than
build facilities or develop R&D
– Lower risk
usually less risky to acquire product lines or
markets rather than develop new products,
particularly if the goal is diversification
– Fewer operating delays
facilities are already in place, which shortens
the time to market
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Reasons for Combinations
– Avoidance of takeovers
some businesses, especially small ones,
combine to prevent takeovers
– Acquisition of intangible assets
acquiring patents, mineral rights, research,
databases, or management expertise can be a
primary factor
– Other: business and tax advantages, personal
reasons

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Potential Prohibitions / Obstacles
Antitrust
– Federal Trade Commission prohibited Staples’
acquisition of Office Depot
Regulation
– Federal Reserve Board
– Department of Transportation
– Department of Energy
– Federal Communications Commission
Some states have antitrust exemption laws to allow
hospitals to pursue cooperative projects.
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Disney wins antitrust approval to acquire
21st Century Fox
• Jun 27, 2018
• Disney has cleared a key hurdle in its bid to
acquire 21st Century Fox: the company has
won antitrust approval from the Justice
Department, albeit with one condition. The
Justice Department required that Disney divest
Fox’s regional sports networks, as they would
create anti-competitive conflicts due to Disney’s
ownership of ESPN, according to Variety.
Disney has agreed to the conditions.
1.2: Legal Forms of Combination
Business Combinations

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 consolidation
merger

acquisitions
 Acquisition:

1. One corporation acquires the productive assets of

another business entity and integrates those assets into
its own operations; or
2. One corporation obtains operating control over the
productive facilities of another entity by acquiring a
majority of its outstanding voting stock.

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 Merger:

One corporation takes over all the operations of
another business entity and that other entity is
dissolved.

Company A acquires the net assets of Company B
for cash, other assets, or Company A securities.
Company B is dissolved.

A+ B =A

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 Consolidation

A new corporation is formed to take over the
assets and operations of two or more separate
business entities and dissolves the previously
separate entities.

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 Accounting Concept of Business Combinations
 

• GAAP define the accounting concept of a

business combination as:
• 『 A transaction or other event in which an
acquirer obtains control of one or more
businesses. 』
• Although one or more of the companies
may lose its separate legal identity,
dissolution of the legal entities is not
necessary within the accounting concept.
 Accounting Concept of Business Combinations
 

• Previously separate businesses are brought together

into one entity when their business resources and
operations come under control of a single
management team. That control is established when:
•   1 One or more corporations become
subsidiaries
•  2 One company transfers its net assets to
another; or
•  3 Each company transfers its net assets to a
newly formed corporation.
 Accounting Concept of Business Combinations
 

• A corporation becomes a subsidiary when

another corporation acquires a majority (more
than 50%) of its outstanding voting stock;

• The term "consolidation" also refers to the

accounting process of combining a parent
company’s financial statements with those of
its subsidiaries.
Introduction
Parent-Subsidiary Relationship
Company B Group
Subsidiary
nt rol
Co

Consolidation:
Company A
Company C Process of preparing
Parent Control and presenting
Subsidiary
(Controlling financial statements of
entity) parent and subsidiary
as if they were one
Co economic entity
nt rol
Company D
Subsidiary
Consolidated FS:
Artificial creations
more than 50%of its outstanding voting stock. 21
 Background on Business Combination Accounting 

The pooling of interests method of

accounting was eliminated for all
transactions initiated after June 30, 2001.
All subsequent combinations must use the
acquisition method.
 1.3: Accounting for Combinations As
Acquistions
Business Combinations

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 How much would it cost
to own the company
Apple?

https://investor.apple.com/investor-relations/default.aspx
 Acquisition Method
• Cost is measured by the cash
disbursed, the fair value of other assets
distributed, or the fair value of securities
issued (fair value principle).
• Direct costs
• Indirect costs
 Direct Costs of Acquisition
registering Be charged against additional
and issuing paid-in
securities capital

the excess paid by an investor over and above the par-value

price of a stock issue and is often included in the contributed
surplus account in the shareholders' equity section of a
company's balance sheet.

accounting,
consulting, expense
and legal fees
 Indirect Costs of Acquisition

management salaries,
expense
closing a duplicate facility
Example: Pop Corp. P29
Pop Corp. issues 100,000 shares of its $10 par
value common stock for Son Corp on July 1,2016.
The market price of Pop’s stock on this date is $16
per share.
Additional direct costs of the combination consist of
SEC fees of $5,000, accountants’ fees in
connection with the SEC registration statement of
$10,000, costs for printing and issuing the common
stock certificates of $25,000 and finder’s and
consulting fees of $80,000.

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Example: Pop Corp. (1 of 3) P29
Pop Corp. issues 100,000 shares of its $10 par
value common stock for Son Corp on July 1,2016.
The market price of Pop’s stock on this date is $16
per share.

Investment in Son Corp. (+A) 1,600 blank

Common stock, $10 par (+SE) blank 1,000
Additional paid-in-capital (+SE) blank 600

(in thousands)

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Example: Pop Corp. (2 of 3)
Additional direct costs of the combination consist of
SEC fees of $5,000, accountants’ fees in
connection with the SEC registration statement of
$10,000, costs for printing and issuing the
commmon stock certificates of $25,000 and finder’s
and consulting fees of $80,000.
Investment expense (E, -SE) 80 blank
Additional paid-in-capital (-SE) 40 blank
Cash (-A) blank 120

Registration and issuance costs of $40, as a reduction of the fair value

of the stock issued and charge these costs to Additional paid-in capital.

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Example: Pop Corp. (3of 3)
Son Corp. is assumed to have been dissolved. So,
Pop Corp. allocates the investment’s cost to the fair
value of the identifiable assets acquired and
liabilities assumed. The excess cost is goodwill.

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Son Corp. is assumed to have been
dissolved
Investment in Son Corp. (+A) 1,600 blank
Common stock, $10 par (+SE) blank 1,000
Additional paid-in-capital (+SE) blank 600

Receivables (+A) XXX blank

Inventories (+A) XXX blank
Plant assets (+A) XXX blank
Goodwill (+A) XXX blank
Accounts payable (+L) blank XXX
Notes payable (+L) blank XXX
Investment in Son Corp. (-A) 1,600

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1.4: Recording Fair Values in an
Acquisition
Business Combinations

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 Fair Values
• Determine the fair values of all
identifiable tangible and intangible
assets acquired and liabilities assumed
in the combination.
• This is often done before the
combination by independent appraisers
and valuation experts.
 Fair Values
• All identifiable assets and liabilities are
valued regardless of whether they are
recorded on the books of the acquired
company.
• For example, an acquired company may have
expensed the costs of developing patents.
• However , we assign fair values to such
identifiable intangible assets of an acquired
company in a business combination
accounted for as an acquisition.
Example – Pam Corp. Data (continued)
Blank Book Value Fair Value
Cash $ 50 $ 50
Net receivables 150 140
Inventory 200 250
Land 50 100
Buildings, net 300 500
Equipment, net 250 350
Patents 0 50
Total assets $1,000 $1,440
Accounts payable $60 $60
Notes payable 150 135
Other liabilities 40 45
Total liabilities $250 $240
Net assets $750 $1,200

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 Goodwill
• No value is assigned to goodwill
recorded on the books of the acquired
company because such goodwill is an
unidentifiable asset and because we
value the goodwill resulting from the
business combination directly.
 Steps to Record an Acquisition
• First, fair values are assigned to all
identifiable tangible and intangible
assets acquired and liabilities assumed.
• Second, compare the investment cost
with the total fair value of identifiable
assets less liabilities(net fair value)
 Steps to Record an Acquisition
• investment cost > net fair value
 the excess cost is assigned to goodwill.
• investment cost < net fair value
 the gain is a bargain purchase and is
recognized as an ordinary gain by
acquirer
• investment cost = net fair value
Example – Pam Corp. Data
Pam Corp. acquires the net assets of Sun Co. in a
combination consummated on 12/27/2016. Sun
Company is dissolved.
The assets and liabilities of Sun Co. on this date at
their book values and fair values are as follows (in
thousands):

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 net fair value =?
Example – Pam Corp. Data (continued)
Blank Book Value Fair Value
Cash $ 50 $ 50
Net receivables 150 140
Inventory 200 250
Land 50 100
Buildings, net 300 500
Equipment, net 250 350
Patents 0 50
Total assets $1,000 $1,440
Accounts payable $60 $60
Notes payable 150 135
Other liabilities 40 45
Total liabilities $250 $240
Net assets $750 $1,200

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 Acquisition with Goodwill
• Pam Corp. pays $400,000 cash and issues
50,000 shares of $10 par common stock with
a market value of $20 per share for the net
assets of Sun Co.
• investment cost =?
• $400 + (50 shares x $20)=$1,400
(Total consideration at fair value )(in thousands)
Fair value of net assets acquired: $1,200
Goodwill $ 200
Entries with Goodwill
The entry to record the acquisition of the net assets:

Investment in Sun Co. (+A) 1,400 blank

Cash (-A) blank 400
Common stock, $10 par (+SE) blank 500
Additional paid-in-capital (+SE) blank 500

The entry to record Sun’s assets directly on Pam’s

books:

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Entries with Goodwill (continued)
Cash (+A) 50 blank
Net receivables (+A) 140 blank
Inventories (+A) 250 blank
Land (+A) 100 blank
Buildings (+A) 500 blank
Equipment (+A) 350 blank
Patents (+A) 50 blank
Goodwill (+A) 200 blank
Accounts payable (+L) blank 60
Notes payable (+L) blank 135
Other liabilities (+L) blank 45
Investment in Sun Co. (-A) blank 1,400

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Acquisition with Bargain Purchase
Pam Corp. issues 40,000 shares of its $10 par
common stock with a market value of $20 per share,
and it also gives a 10%, five-year note payable for
$200,000 for the net assets of Sun Co.
• investment cost =?
• $200 + (40 shares x $20)=$1,000
Fair value of net assets
acquired (in thousands) $1,200
Total consideration at fair value
(40 shares x $20) + $200 $1,000
Gain from bargain purchase $200

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Entries with Bargain Purchase
The entry to record the acquisition of the net assets:
Investment in Sun Co. (+A) 1,000 blank
10% Note payable (+L) blank 400
Common stock, $10 par (+SE) blank 400
Additional paid-in-capital (+SE) blank 200

The entry to record Sun’s assets directly on Pam’s

books:

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Entries with Bargain Purchase (continued)
Cash (+A) 50 blank
Net receivables (+A) 140 blank
Inventories (+A) 250 blank
Land (+A) 100 blank
Buildings (+A) 500 blank
Equipment (+A) 350 blank
Patents (+A) 50 blank
Accounts payable (+L) blank 60
Notes payable (+L) blank 135
Other liabilities (+L) blank 45
Investment in Sun Co. (+A) blank 1,000
Gain from bargain purchase (G, +SE) 200

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Exercise Q1,Q2,Q3
Contingent Consideration in
an Acquisition
• For example, if a buyer thinks the business is
worth 10 million dollars, but the seller says it’s
worth 15 million, the deal could fall apart. This is
when contingent consideration may come into
play.
• The buyer may say, I’ll pay you 10 million dollars
now, and if the business performs like you say it
will, I’ll pay you the extra 5 million dollars later. At
first glance, it seems like this 5 million dollar
payment would be additional purchase price.
• Contingent consideration is an additional payment
made to the previous stockholders of the acquired
company contingent on future events or transactions.
• The contingent consideration may include the
distribution of cash, other assets, or the issuance of
debt or equity securities.
• Contingent consideration must be measured and
recorded at fair value as of the acquisition date as
part of the consideration transferred in the acquisition.
 Liability
• If the contingent consideration is to be
paid in cash to the acquiree.
• Then, the the contingent consideration is
in the form of a liability.
• At the date of the acquisition, the
Investment and Liability accounts are
increased by the fair value of the
contingent consideration.
 Equity
• If the contingent consideration is to be
paid in additional shares to the acquiree, it
is in the form of equity, and the Investment
and Paid-in-Capital accounts are
increased by the fair value of the
contingent consideration.
 Subsequent changes in fair value of
contingent consideration

• If equity, then do not remeasure fair value

at each reporting date until contingency is
resolved.
• If liability, acquirer measures fair value at
each reporting date until resolved.
Goodwill Controversies
 GoodwilI

net fair value

investment cost

Goodwill is the excess of the investment

cost over the fair value of net assets
received.
• Goodwill is no longer amortized for
financial reporting purposes.
• annual impairment tests
• Impairment occurs when the recorded
value of goodwill is greater than its fair
value.
Disclosure Requirements
 Financial statement disclosures for a
business combination
• 1 The name and a brief description of the
acquired company, acquisition date, the portion of
voting stock acquired, reason for the acquisition,
and the manner in which acquirer obtained control;
• 2 Information about goodwill or a gain from a
bargain purchase;
• 3 Nature, terms, and fair value of consideration
transferred;
• 4 Details about assets acquired, liabilities
assumed, and any noncontrolling interests;
•5 Reduction in acquirer’s pre-existing
deferred tax asset valuation allowance due to
the business combination;
•6 Information about transactions with the
acquiree accounted for separately from the
business combination;
•7 Details about step acquisitions;
•8 In the case of a public company acquirer, pro-
forma information.
 Homework
• Q1~Q4
• deadline ： 10/21