CHAPTER TWO

BUSINESS COMBINATION

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 Outline
 BUSINESS COMBINATION

The Development of Complex Business Entities

Business Expansion and Forms of Organizational
Structure
Concepts of Business Combination
Methods of Accounting for Business Combinations
Appraisal of Accounting Standards for Business
Combinations

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The Development of Complex Business Entities

Today’s business environment is complex that

arises because of
 Business across different states and
countries, each with its own laws and risks,
 The intricacies of tax provisions,

 The myriad of exceedingly complex business

transactions, and financial instruments, and

other factors
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 Cont’d…

 Most business enterprises seek to expand as a means of

survival and profitability
 Both the owners and managers of a business enterprise
have an interest in seeking a company grow in size
 Why corporate management often finds it advantageous
to increase company size?
* Because as company size increases management is
rewarded with higher salaries
* Prestige frequently increases with the size of a
company and with a reputation for the successful
08/04/22acquisition of other companies
 Cont’d…

For example:
Boeing, a company very strong in commercial
aviation, acquired McDonnell Douglas, a company
weak in commercial aviation but very strong in
military aviation and other defense and space
applications.
When orders for commercial airliners plummeted
following a precipitous decline in air travel,
increased in defense spending, partially related to
the war in Iraq, helped level out Boeing’s earnings
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Business Expansion and Forms of Organizational Structure

 Complex organizational structures often evolve to help

achieve a business’s objectives, such as increasing
profitability or reducing risk.
Eg; Many companies establish subsidiaries to
undertake certain business activities.
◙
A.Internal Expansion (Expansion from Within)
B.External Expansion

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 Cont’d…
A. Internal Expansion (Expansion from Within)
 By building its own facilities
 When companies expand from within, they often find it
advantageous to conduct their expanded operations through new
subsidiaries or other entities, such as partnerships, joint ventures, or
special entities (created for a single specified purpose).
 In most of these situations, an identifiable segment of the
company’s existing assets is transferred to the new entity, and, in
exchange, the transferring company receives equity ownership.
A spin-off vs. A split-off
►A spin-off: occurs when the ownership of a newly created or existing
subsidiary is distributed to the parent’s stockholders without their
surrender of any of their stock in the parent company.
►A split-off: occurs when the subsidiary’s shares are exchanged for
shares of the parent, thereby leading to a reduction in the
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outstanding shares of the parent company.
 Cont’d…
B. External Expansion
- By acquiring control of other firms through business combinations
Expansion through business combinations:
A business combination occurs when two or more
companies join under common control.
The concept of control relates to the ability to direct
policies and management
Traditionally, control over a company has been gained by
acquiring a majority of the company’s common stock.
However, the diversity of financial & operating
arrangements employed in recent years also raises the
possibility of gaining control with less than majority
ownership
08/04/22 or, in some cases, with no ownership at all.
Concept of business combination
What is business combination?
An event under which two or more companies
net asset brought under common control in a
single accounting entity
When business combination Occurs?
when one party gain control over others
How business combination acquired?
 through * Paying cash
* Transferring asset
* Issuing securities
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Common terminologies
Combined enterprise
* An accounting entity that results from business combination
Constituent companies
* A business entity that enter in to a business combination
Combiner( transferee) / purchaser company/investor/acquiring
* A constituent company that have controlling interest over combinee
Combinee (combined ) or acquiree/investee/Transferor
Parent company
* A company that own a majority of subsidiaries' com. stock.
Subsidiary
* is a corporation that is controlled by another corporation, referred
to as a parent company
Purchase consideration:
* An amount payable by purchasing co.
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Reasons for business combination
1. An external method of growth than internal
2. To get managerial strength and better use of existing management
3. To take advantage of income tax available for two or more
companies in business combination
4. To gain - control over other companies
- new technology
- economic association
5. Existence of – less competition(monopolistic ambitions)
- limited risk
6. To ensure – supply of raw material
- customers operation
7. Cost advantage e.g. Advertisement cost
8. Fewer operating delays
9. Avoidance of takeovers
10. Acquisition of intangible assets
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Types of Business Combinations
Based on their nature: Methods of Effecting
I. Friendly takeovers
 In a friendly combination, the management(BOD)
of the companies involved come to agreement on the
* terms of the combination and
* recommend approval by the stockholders
The proposal is submitted to share holders of all
constituent companies for approval.
Such combinations are usually effected in a single
transaction involving an exchange of assets or voting
shares
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 Cont’d…
II. Unfriendly combination (hostile takeover)
In which the managements of the companies involved are
* unable to agree on the terms of a combination &
* 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”(exchange) their shares for securities or assets of the
acquiring company.
If sufficient shares are tendered, the acquiring Co. gains voting
control of the other co. & can install its own mgt by exercising its
voting rights.
In this type of takeovers, the target combinee typically resists the
proposed business combination.

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 Cont’d…
I. Horizontal integration – Combination of firms in the same business
lines and markets
E.g. Assume combination of St. George Brewery and Zebider
Beer under BGI
II. Vertical integration
* Combination of firms in different business operation , but
successive stages of production or distribution, or both
* it can be either backward – combination with supplier or
forward - combination with customer
Exercise: * A Tannery Company acquiring a Shoes Company
* A Shoes Company acquired a tannery company
What types of business combination
formed between Heineken and Bedele
beer, Harar beer?
III. Conglomeration – unrelated and diverse products or services
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 Legal Form of Combination
1. Statutory Merger( Abor vision)
 Occurs when one company takes over all the operations of
another entity and that the acquired entity is dissolved.
A+B=A
 Here the acquired company’s assets & liabilities are
transferred to the acquiring company & the acquired
company is dissolved
 The operations of the previously separate companies are
carried on in a single legal identity following the merger.
Eg; Company A purchases the assets/stock of Company B for
cash, other assets, or Company A debt/equity securities. Company B
is dissolved; Company A survives with Company B’s assets and
liabilities.
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 Cont'd…
2. Statutory Consolidation(Amalgamation)
 Occurs when a new corporation is formed to take over
the assets and operations of two or more separate
business entities
 In which the combined (acquired) companies dissolved
and the assets and liabilities of the companies are
transferred to a newly created corporation.
E + F = “D”
 The operations of dissolved companies are carried on in
a single legal entity
 Eg;Company D acquired the assets (stock from their
respective shareholders) of Companies E and F by
issuing Company D stock. Companies E and F are
dissolved. Company D survives, with the assets and
liabilities of both dissolved firms.
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 Cont'd…
3. Acquisition of Common Stock
When one company acquires the majority of outstanding
voting shares of another company, which leads to a parent-
subsidiary relationship.
A parent – subsidiary relationship is formed when:
* Less than 100% of the firm is acquired, or
* The acquired firm is not dissolved
A parent company is the one that controls another company
referred to as a subsidiary through majority ownership of CS
Here neither of the combining companies is liquidated rather
the two companies continue to operate as separate, but related,
legal entities.
No need acquire all shares to gain control
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 Cont'd…
 The acquiring company accounts for its ownership
interest in the other company as an investment
E.g. Suppose Company A acquires over 50% of the
voting stock of Company B, Company B is now a
subsidiary of Company A
 An acquisition of less than a majority of the
outstanding voting shares typically is not regarded
as a business combination
 When a single shareholder holds a majority of the
voting shares, the remaining shares are referred to
as the minority interest or non-controlling interest.

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 Cont'd…

• Accounting standards normally require that the

financial statements of the parent and subsidiary
be consolidated for general purpose reporting so
the companies appear as a single company.

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 Cont'd…
4. Acquisition of Assets
when one corporation acquires all or most of the
gross assets or net assets of another enterprise for
cash, debt, preferred or common stock, or a
combination thereof.
There is a parent–subsidiary relationship
do not involve the liquidation of the combinee
The combining company accounts for
* asset taken over
* Labilities assumed
* purchase consideration paid
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Degree of influence over ‘investees
What is control?
IFRS 10: An investor controls an investee when the investor:
* has power over the investee;
* is exposed, /has rights, to variable returns from its
involvement with the investee; and
* has the ability to affect those returns through its power
over the investee.

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Methods of Accounting for Business Combinations

U.S. GAAP for Business Combinations(BC)

 Since the 1950s both pooling-of-interests & purchase
method of accounting for business combinations were
acceptable. [ARB 40, APB Opinion 16]
 Combinations initiated after June 30, 2001, use
the purchase method. [FASB Statement No. 141]
Firms should use the acquisition method for
business combinations occurring in fiscal periods
beginning after December 15, 2008 [FASB
Statement No. 141R]
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 Cont’d…

International Accounting Standards Board(IASB)

 Most major economies prohibit the use of the
pooling method.
 The IASB prohibits the pooling method and
requires the acquisition method. [IFRS 3]

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 Cont’d…
1. Pooling of interests Method
It is preferable method to use because it doesn't result in
the creation of goodwill
FASB unanimously voted to eliminate pooling of interests
as an acceptable method of accounting for BC
The purchase of an ongoing business is essentially the
same as the purchase of any other assets or group of assets.
When an asset is purchased, consideration is given in
exchange for the ownership rights to the items acquired.
Similarly, when a business is purchased, consideration is
given in exchange for the ownership rights relinquished by
the owners of the acquired company.

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2. Purchase Accounting method
•A widely used approach prior to the increase in popularity of pooling-
of-interests accounting
•principles should be used for applying Purchase
Recognition Principle - the acquirer should recognize all of the
* assets acquired and
* liabilities assumed
Fair Value Measurement Principle - the acquirer should measures
* Each asset acquired &
* Liability assumed and at its acquisition date
* any non-controlling interests CFV but not BV
Disclosure Principle – the acquirer should include the information
* in its financial statement
* so as to help users of financial statements evaluate the nature and
financial effect of BC recognized by the acquirer
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 Cont’d…
 Any amount of the purchase price in excess of the
fair value of the identifiable assets and liabilities
acquired is considered as the price paid for goodwill
If purchase price > CFV(of asset ac. & lia ass.) - GW
 In theory, goodwill is
* the excess earning power of the acquired company
 In practice, goodwill represents
* the premium paid to acquire control

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 Cont’d…
Parameters Poling interest method Purchase method

1. Applicability Mostly statutory merger In nature of purchase(acquisition)

2.Involve Exchange of stock Acquision of asset and stock

b/n equal size corporation

3. Recognition of At carrying amount At cost

investment in (out of pocket not part of PC + out of pocket cost
combinee purchase consideration (out of pocket considered as
rather as expense BC investment if related with BC )
neither Acquision of asset
nor raise of capital )
4.Recognition of At carrying amount At CFV
net asset, Lia…..

5. Recognition of No Yes if PC > CFV (AA & LA)

goodwill of
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combinee
Determining the Purchase Price
 In accounting for a business combination, the purchasers
considers all costs associated with acquiring the other
company’s net assets or stock as part of the total purchase
price.
 The value of the consideration given to the owners of the
acquired company normally constitutes the largest part of
the total cost, but other costs may also be important.
 There are three types of other costs that may be incurred in
effecting a business combination:
* Direct costs
* Costs of issuing securities, and
* Indirect and general costs
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 Cont’d…
A. Direct Costs:
 All direct costs associated with purchasing another Co.
are treated as part of the total cost of the acquired Co.
Example: finders fees for locating companies, legal,
accounting,& appraisal fees
 All of these costs are capitalized as part of the total
purchase price of the acquired company

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 Cont’d…
B. Costs of issuing securities
Those costs incurred in issuing CS /PS in
connection with a BC should be treated as a
reduction in the issue price of the securities
rather than as an addition to the purchase
price of the acquired company :
* listing fees
* audit & legal fees related to stock
registration, and
* brokers’ commissions
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 Cont’d…
C. Indirect Costs:
All indirect and general costs related to a BC or to the
issuance of securities in a combination should be
expensed as incurred.
Example: salary costs of accountants on
the acquiring company’s staff.

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 Cont’d…
Illustration 1
Assume that on June 1, Year 2, Shark Corporation
purchases all the assets and liabilities of Dolphin Company
in a statutory merger by issuing to Dolphin 100,000 shares
of $10 par common stock. The shares issued have a total
market value of $1.8 million. Shark Corporation incurred
legal and appraisal fees of $120,000 in connection with the
combination and stock issue costs of $50,000.
What is the value of purchase price?
The total purchase price is equal to the value of the shares
issued by Shark plus the additional costs incurred related to
the acquisition of assets.
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 Cont’d…
Fair Value of Stock issued $1,800,000
Other Acquisition Costs 120,000
Total Purchase Price $1,920,000
And the stock issued by Shark to effect the combination
is valued at its fair value minus the issue costs:
Fair Value of stock issued $1,800,000
Less: Stock Issue Costs (50,000)
Recorded Amount(value) of Stock $1,750,000

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Combination Effected through Purchase of Net Assets

Once the purchase price of an acquisition has

been determined, it must be assigned to the
individual assets and liabilities acquired
Each identifiable asset and liability acquired is
valued at its fair value at the date of
combination
Any amount of the purchase price in excess of
the fair value of the identifiable assets and
liabilities acquired is considered as the price
paid for goodwill
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 Cont’d…

Illustration 2
In the case of Dolphin co. acquisition, the total
purchase price was computed to be $1,920,000.
Assume the book values and fair values of
Dolphin’s individual assets and liabilities given
in table below:

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 Cont’d…
Assets, liabilities, and Equities Book Value Fair Value
Cash and Receivables $95,000 $95,000
Inventory 470,000 510,000
Furniture &Equipment 500,000 380,000
Accumulated Depreciation (F&E) (120,000)
Building 600,000 450,000
Accumulated Depreciation (Building) (150,000)
Land 100,000 210,000
Patent 75,000
Total Assets $1,495,000 $1,720,000
Total current Liabilities 135,000 150,000
Common Stock, ($6 par) 600,000
Additional paid-In capital 400,000
Retained earnings 360,000
Total liabilities and Equities $1,495,000
Fair Value of Net Assets $1,570,000
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 Cont’d…

Journal Entries Related to the Acquisition by the Acquiring Co.,

1. Deferred Merger Costs 120,000
Cash 120,000
To record costs related to purchase of Dolphin co.
2. Deferred Stock Issue Costs 50,000
Cash 50,000
To record costs related to issuance of Common Stock

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 Cont’d…
On the date of the combination, Shark Corporation
records the combination with the following entry:
(3) Cash & Receivables 95,000
Inventory 510,000
Equipment &Furniture 380,000
Building 450,000
Land 210,000
Patent 75,000
Goodwill 350,000
Current Liabilities 150,000
Common Stock 1,000,000
Additional Paid-In Capital 750,000
Deferred Merger Costs 120,000
Deferred Stock Issue Costs 50,000
to records all Dolphin Company’s individual assets and liabilities, both tangible
and intangible, on Shark’s books at their fair values on the date of combination.
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 Cont’d…
 The fair value of Dolphin Company’s net assets
recorded is $1,570,000 ($1,720,000-$150,000).
 The $350,000 difference between the total purchase
price of $1,920,000 ($1,800,000 + $120,000), as
computed earlier, and the fair value of Dolphin’s net
assets is recorded as goodwill.
 In recording the business combination, Dolphin’s
book values are not relevant to Shark; only the fair
values are recorded.
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 Cont’d…
 Because a change in ownership has occurred, the basis of
accounting used by the acquired company is not relevant to
the purchaser.
 Consistent with this view, accumulated depreciation
recorded by Dolphin Co. on its equipment and furniture and
building is not relevant to Shark and is not recorded.
 The costs incurred in bringing about the merger are
recorded in a separate temporary account entitled:
“Deferred Merger Costs” until the transfer of assets to
Shark is recorded.
 Because the merger costs are considered part of the total
purchase price, the temporary account must be closed with
entry (#3) and these costs assigned, along with the remainder
of08/04/22
the purchase price, to the net assets recorded.
 Cont’d…
 Similarly, the stock issue costs are recorded in a
temporary account and then treated as a
reduction in the proceeds received from the
issuance of the stock by reducing the amount of
additional paid –in capital recorded.
 Merger costs incurred after a business
combination is
* recorded may be debited directly to
goodwill, and
 stock issue costs incurred subsequently are
charged against additional paid-in capital

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 Cont’d…

Entries Recorded by the Acquired Company:

Dolphin records the following entry, on the date of the combination, to
record the receipt of Shark shares and the transfer of all individual assets
and liabilities to Shark Co.
(4) Investment in Shark Common Stock 1,800,000
Current Liabilities 135,000
Accumulated Depreciation (E&F) 120,000
Accumulated Depreciation (Building) 150,000
Cash 95,000
Inventory & Receivables 470,000
Equipment &Furniture 500,000
Building 600,000
Land 100,000
Gain on sale of net assets 440,000
08/04/22 To record the transfer of Assets to Shark Corp.
 Cont’d…
 Dolphin recognizes the fair value of Shark
Corporation’s shares at the time of the exchange and
records a gain on sale of Net Assets of $440,000.
 The liquidation of Shark’s shares and the liquidation
of Dolphin are recorded on Dolphin’s books as shown
below:
(5) Common Stock 600,000
Additional Paid-In Capital 400,000
Retained Earnings 360,000
Gain on sale of Net Assets 440,000
Investment in Shark’s Common Stock 1,800,000
To record distribution of Shark Corporation’s Stock

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 Cont’d…
Goodwill
Goodwill is viewed in accounting as the total of all those
factors that permit a Company to earn above-average profits.
As with any asset, goodwill is valued based on its original
cost to the purchaser when objectively determinable.
Because “self-developed” goodwill often are not
distinguishable from the current operating costs, such
expenditures are always expensed as incurred.
When goodwill is purchased in connection with a business
combination, however, the amount of the expenditure is
viewed as objectively determinable and is capitalized.
The cost of goodwill purchased is measured as the excess of
the total purchase price over the fair value of the net
identifiable assets acquired.
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 Subsequent Accounting for Goodwill

 Goodwill is carried forward at the original

amount, without amortization, unless it becomes
impaired
 Goodwill must be tested for impairment at least
annually.
 To test for the impairment of goodwill, the fair
value of the reporting unit is compared with its
carrying amount.
Fair value > carrying amount – unimpaired
Fair value < carrying amount – impaired GW
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 Cont’d…
 Thus, the amount of the reporting unit’s goodwill
impairment is measured as the excess of the
carrying amount of the unit’s goodwill over the
implied value of its goodwill.
 The implied value of its goodwill is determined as
the excess of the fair value of the reporting unit
over the fair value of its net assets excluding
goodwill.
 Goodwill impairment losses are recognized in
income from continuing operations or income
before extraordinary gains or losses.
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 Cont’d…
Illustration 3
Assume that reporting Unit X is assigned $150,000 of goodwill
arising from a recent business combination. The following assets
and liabilities are assigned to reporting unit X.
Item Book Value Fair Value
Cash and Receivables $ 85,000 $ 85,000
Inventory 570,000 590,000
Equipment & Furniture 350,000 375,000
Building 750,000 780,000
Land 50,000 75,000
Goodwill 150,000
Total Assets $1, 955,000 $1,905,000
Current Liabilities (205,000) (205,000)
Net Assets $1,750,00 $1,700,000
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 Cont’d…
 In the above illustration, the carrying value of the
reporting unit X including the goodwill is
determined to be $1,750,000.
 If the fair value of the reporting unit is
$1,800,000, no impairment of goodwill is
indicated.
 However, if the fair value of the reporting unit is
estimated to be $1,725,000; a second comparison
should be made to determine the amount of any
impairment loss.

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 Cont’d…
• The implied value of Reporting Unit X’s goodwill is
determined by deducting the $1,700,000 fair value of
the net asset, excluding goodwill, from the unit’s
$1,725,000 fair value.
Implied GW = FV exc. GW- FV
• The $25,000 difference ($1,725,000-$1,700,0000
represents Reported Unit X’s implied goodwill.
☻Therefore, the impairment loss is measured as the
excess of carrying value of the unit’s goodwill
($150,000) over the implied value of the goodwill
($25,000), or $125,000
Impairment loss = carrying value of GW- Implied value
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 Cont’d…
Negative Goodwill
Sometimes the purchase price of an acquired
company is less than the fair value of the net
identifiable assets acquired.
This difference often is referred to as negative
goodwill.
The existence of negative goodwill might be viewed
as implying that the acquired company should be
liquidated because the assets and liabilities are worth
more individually than together as an ongoing
concern.

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 Cont’d…

Item BV FV Reduction Amount

Recorded
Cash & Receivables $ 95,000 $ 95,000 $ 95,000
Inventory 470,000 510,000 510,000
Equip & Furniture 380,000 380,000 (380/1115*$70,000) 356,144
Building (net) 450,000 450,000 (450/1115*$70,000) 421,749
Land 100,000 210,000 (210/1115*$70,000) 196,816
Patent 75,000 (75/1115*$70,000) 70,291
Total Identifiable Assets $1,495,000 $1,720,000 $70,000 $1,650,000
Current Liabilities 135,000 150,000 150,000
Net Ident. Assets $1,360,000 $1,570,000 $1,500,000

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 Combination Effected through Purchase of Stock

 Business combination can also be effected by purchasing the

voting stock of another company rather than acquiring its net
assets. In such cases, the acquired company continues to exist,
and the purchasing company records an investment in the
common stock of the acquired company rather than the
individual assets and liabilities.
 As with the purchase of the assets and liabilities, the cost of the
investment is based on the total value of the consideration given
in purchasing the shares, together with any additional costs
incurred in bringing about the combination.

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 Cont’d…
Illustration 2.6:
Suppose Shark Corporation (a) exchanges 100,000
shares of its $10 par shares with a total market value
of $1,800,000 for all of Dolphin corporation’s shares
and (b) incurs merger costs of $120,000 and stock
issue costs of $50,000. Shark Corporation records its
investment in Dolphin Corporation up on receipt of
Dolphin stock.
Entry to record the purchase of Dolphin Company’s Stock:
Investment in Dolphin Stock 1,920,000
Common Stock 1,000,000
Additional Paid-In Capital 750,000
Deferred Merger Costs 120,000
08/04/22 Deferred Stock Issue Costs 50,000
 Cont’d…

• When a business combination is effected through

an acquisition of stock, the acquired company
may continue to operate as a separate entity,
or it may lose its separate identity and be
merged into the acquiring company.

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Financial Reporting Subsequent to a Business Combination

 Financial statements prepared subsequent to a business

combination reflect the combined entity only from the
date of combination.
 When a business combination occurs during a fiscal
period, income earned by the acquired company prior to
the combination is not reported in the income statement of
the combined enterprise.
 If the combined company presents comparative financial
statements that include statements for periods before the
combination, those statements include only the activities
and financial position of the acquiring company, not those
of the acquired company

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 Cont’d…
Illustration 2.7:
To illustrate the financial reporting subsequent to a business
combination, assume the following information for Shark Corporation
and Dolphin Company:
Year 1 Year 2
Shark Corporation:
Separate income (excluding any income
from Dolphin) $800,000 $900,000
Shares Outstanding, Dec. 31. 200,000
300,000
Dolphin Company:
Net Income $200,000 $300,000

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 Cont’d…
 Shark Corporation acquired Dolphin’s stock at book value on June 1,
Year 2, by issuing 100,000 shares of common stock. Subsequently,
Shark Corporation presents comparative financial statements for the
years Year 1 and Year 2.
 The Net Income and earning per share that Shark presents in its
comparative financial statements for the two years are as follows:
Year 1:
Net Income $ 800,000
Earning per Share ($800,000/200,000) $4.00
Year 2:
Net Income ($900,000+$300,000) $1,200,000
Earning per Share ($1,200,000/300,000) $4.00

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Appraisal of Accounting Standards for
Business Combinations
Individual assignment 3: compare and
contrast
* Accounting Standards for Business
Combinations under GAAP and IFRS

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