Chapter 1 Business Combinations to accompany Advanced Accounting

Business Combinations: Objectives 1. Understand the economic motivations underlying business combinations. 2. Learn about the alternative forms of business combinations, from both the legal and accounting perspectives. 3. Introduce concepts of accounting for business combinations, emphasizing the acquisition method. 4. See how firms record fair values of assets and liabilities in an acquisition. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 1 -2

Business Combinations 1: ECONOMIC MOTIVATIONS Copyright © 2012 Pearson Education, Inc. Publishing as Prentice

Types of Business Combinations v Business combinations unite previously separate business entities. v Horizontal integration – same business lines and markets v Vertical integration – operations in different, but successive stages of production or distribution, or both v Conglomeration – unrelated and diverse products or services Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 1 -4

Reasons for Combinations v v v Cost advantage Lower risk Fewer operating delays Avoidance of takeovers Acquisition of intangible assets Other: business and other tax advantages, personal reasons Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 1 -5

Potential Prohibitions / Obstacles Antitrust v Federal Trade Commission prohibited Staples’ acquisition of Office Depot Regulation v Federal Reserve Board v Department of Transportation v Department of Energy v Federal Communications Commission Some states have antitrust exemption laws to allow hospitals to pursue cooperative projects. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 1 -6

Business Combinations 2: FORMS OF BUSINESS COMBINATIONS Copyright © 2012 Pearson Education, Inc. Publishing

Legal Form of Combination Merger v Occurs when one corporation takes over all the operations of another business entity and that other entity is dissolved. Consolidation v Occurs when 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. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 1 -8

Mergers: A+B=A X+Y=X Company A acquires the net assets 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. Company X acquires the stock of Company Y from its shareholders for cash, other assets, or Company X debt/equity securities. Company Y is dissolved. Company X survives with Company Y’s assets and liabilities. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 1 -9

Consolidations: E + F = “D” K + L = “J” Company D is formed and acquires the net assets 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. Company J is formed and acquires the stock of companies K and L from their respective shareholders by issuing Company J stock. Companies K and L are dissolved. Company J survives with the assets and liabilities of both firms. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 1 -10

Keeping the Terms Straight In the general business sense, mergers and consolidations are business combinations and may or may not involve the dissolution of the acquired firm(s). In Chapter 1, mergers and consolidations will involve only 100% acquisitions with the dissolution of the acquired firm(s). These assumptions will be relaxed in later chapters. “Consolidation” is also an accounting term used to describe the process of preparing consolidated financial statements for a parent and its subsidiaries. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 1 -11

Business Combinations 3: ACCOUNTING FOR BUSINESS COMBINATIONS Copyright © 2012 Pearson Education, Inc. Publishing

Business Combination (def. ) A business combination is “a transaction or other event in which an acquirer obtains control of one or more businesses. Transactions sometimes referred to as true mergers or mergers of equals also are business combinations. [FASB ASC 805 -10] A parent-subsidiary relationship is formed when: v Less than 100% of the firm is acquired, or v The acquired firm is not dissolved. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 1 -13

U. S. GAAP for Business Combinations v Since the 1950 s both the pooling-ofinterests method and the purchase method of accounting for business combinations were acceptable. v Combinations initiated after June 30, 2001 use the purchase method. [FASB ASC 805] v Firms now use the acquisition method for business combinations. This began with combinations in fiscal periods beginning after December 15, 2008. [FASB ACS 810 Copyright © 2012 Pearson Education, 1 -14 10 -5 -2] Inc. Publishing as Prentice Hall

International Accounting v Most major economies prohibit the use of the pooling method. v The International Accounting Standards Board specifically prohibits the pooling method and requires the acquisition method. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 1 -15

Recording Guidelines (1 of 2) v Record assets acquired and liabilities assumed using the fair value principle. v If equity securities are issued by the acquirer, charge registration and issue costs against the fair value of the securities issued, usually a reduction in additional paid-in-capital. v Charge other direct combination costs (e. g. , legal fees, finders’ fees) and indirect combination costs (e. g. , management salaries) to expense. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 1 -16

Recording Guidelines (2 of 2) v When the acquiring firm transfers its assets other than cash as part of the combination, any gain or loss on the disposal of those assets is recorded in current income. v The excess of cash, other assets, debt, and equity securities transferred over the fair value of the net assets (A – L) acquired is recorded as goodwill. v If the net assets acquired exceeds the cash, other assets, debt, and equity securities transferred, a gain on the bargain purchase is recorded in current © 2012 Pearson Education, 1 -17 income. Copyright Inc. Publishing as Prentice Hall

Example: Pop Corp. (1 of 3) Pop Corp. issues 100, 000 shares of its $10 par value common stock for Son Corp. Pop’s stock is valued at $16 per share. (in thousands) Investment in Son Corp. 1, 600 (+A) Common stock, $10 par (+SE) Additional paid-in-capital (+SE) Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 1, 000 600 1 -18

Example: Pop Corp. (2 of 3) Pop Corp. pays cash for $80, 000 in finder’s and consulting fees and for $40, 000 to register and issue its common stock. (in thousands) Investment expense (E, -SE) 80 Additional paid-in-capital (40 SE) Cash (-A) 120 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 Copyright © 2012 Pearson Education, 1 -19 excess cost is goodwill. Inc. Publishing as Prentice Hall

Example: Pop Corp. (3 of 3) Receivables (+A) Inventories (+A) Plant assets (+A) Goodwill (+A) Accounts payable (+L) Notes payable (+L) Investment in Son Corp. (A) Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall XXX XXX XXX 1, 600 1 -20

Business Combinations 4: RECORDING FAIR VALUE USING THE ACQUISITION METHOD Copyright © 2012 Pearson

Identify the Net Assets Acquired Identify: v Tangible assets acquired, v Intangible assets acquired, and v Liabilities assumed Include: v Identifiable intangibles resulting from legal or contractual rights, or separable from the entity v Research and development in process v Contractual contingencies v Some noncontractual contingencies Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 1 -22

Assign Fair Values to Net Assets Use fair values determined, in preferential order, by: v Established market prices v Present value of estimated future cash flows, discounted based on an observable measure, such as the prime interest rate v Other internally derived estimations Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 1 -23

Exceptions to Fair Value Rule Use normal guidance for: v Deferred tax assets and liabilities v Pensions and other benefits v Operating and capital leases [FASB ASC 740] Goodwill on the books of the acquired firm is assigned no value. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 1 -24

Goodwill is the excess of The sum of: v Fair value of the consideration transferred, v Fair value of any noncontrolling interest in the acquiree, and v Fair value of any previously held interest in acquiree, Over the net assets acquired. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 1 -25

Contingent Consideration The fair value of contingent consideration is determined or estimated at the acquisition date and it is included along with other consideration given as part of the combination. Classifying contingencies: v Contingent share issuances are equity v Contingent cash payments are liabilities Estimated contingencies are revalued to fair value at each subsequent reporting date. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 1 -26

Example – Pit Corp. Data Pit Corp. acquires the net assets of Sad Co. in a combination consummated on 12/27/2011. The assets and liabilities of Sad Co. on this date, at their book values and fair values, are as follows (in thousands): Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 1 -27

Cash Net receivables Inventory Land Buildings, net Equipment, net Patents Total assets Accounts payable Notes payable Other liabilities Total liabilities Net assets Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall Book Fair Val. $50 150 140 200 250 50 100 300 500 250 350 0 50 $1, 000 $1, 440 $60 150 135 40 45 $250 $240 $750 $1, 200 1 -28

Acquisition with Goodwill Pit Corp. pays $400, 000 cash and issues 50, 000 shares of Pit Corp. $10 par common stock with a market value of $20 per share for the net assets of Sad Co. Total consideration at fair value (in thousands): $400 + (50 shares x $20) $1, 400 Fair value of net assets acquired: Goodwill Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall $1, 200 $ 200 1 -29

Entries with Goodwill The entry to record the acquisition of the net assets: Investment in Sad Co. (+A) 1, 400 Cash (-A) 400 Common stock, $10 par 500 (+SE) Additional paid-in-capital 500 The entry to record Sad’s assets directly on (+SE) Pit’s books: Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 1 -30

Cash (+A) Net receivables (+A) Inventories (+A) Land (+A) Buildings (+A) Equipment (+A) Patents (+A) Goodwill (+A) Accounts payable (+L) Notes payable (+L) Other liabilities (+L) Investment in Sad Co. (A) Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 50 140 250 100 500 350 50 200 60 135 45 1, 400 1 -31

Acquisition with Bargain Purchase Pit 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 Sad Co. Fair value of net assets acquired (in thousands) Total consideration at fair value (40 shares x $20) + $200 Gain from Copyright bargain © 2012 Pearson Education, Inc. Publishing as Prentice Hall $1, 200 $1, 000 $200 1 -32

Entries with Bargain Purchase The entry to record the acquisition of the net assets: Investment in Sad Co. (+A) 1, 000 10% Note payable (+L) 200 Common stock, $10 par 400 (+SE) Additional paid-in-capital 400 The entry to record Sad’s assets directly on (+SE) Pit’s books: Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 1 -33

Cash (+A) 50 Net receivables (+A) 140 Inventories (+A) 250 Land (+A) 100 Buildings (+A) 500 Equipment (+A) 350 Patents (+A) 50 Accounts payable (+L) Notes payable (+L) Other liabilities (+L) Investment in Sad Co. (+A) Gain from Copyright bargain purchase © 2012 Pearson Education, Inc. Publishing as Prentice Hall 60 135 45 1, 000 200 1 -34

Business Combinations 5: OTHER ISSUES: IMPAIRMENTS, DISCLOSURES, AND THE SARBANES-OXLEY ACT Copyright © 2012

Goodwill Controversies Capitalized goodwill is the purchase price not assigned to identifiable assets and liabilities. v Errors in valuing assets and liabilities affect the amount of goodwill recorded. Historically goodwill in most industrialized countries was capitalized and amortized. Current IASB standards, like U. S. GAAP v Capitalize goodwill, v Do not amortize it, and v Test it for impairment Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 1 -36

Goodwill Impairment Testing Firms must test for the impairment of goodwill at the business unit reporting level. v Step 1: Compare the unit’s net book value to its fair value to determine if there has been a loss in value. v Step 2: Determine the implied fair value of the goodwill, in the same manner used to originally record the goodwill, and compare that to the goodwill on the books. Record a loss if the implied fair value is less than the carrying value of the goodwill. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 1 -37

When to Test for Impairment Goodwill should be tested for impairment at least annually. More frequent testing may be needed: Significant adverse change in business v Adverse action by regulator v Unanticipated competition v Loss of key personnel Impairment or expected disposal losses of: v Reporting unit or part of one v Significant long-lived asset group v Subsidiary Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 1 -38

Business Combination Disclosures Business combination disclosures include, but are not limited to: v Reason for combination, v Nature and amount of consideration, v Allocation of purchase price among assets and liabilities, v Pro-forma results of operations, and v Goodwill or gain from bargain purchase Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 1 -39

Intangible Asset Disclosures Specific disclosures are needed: v In the fiscal period when intangibles are acquired, v Annually, for each period presented, and v In the fiscal period that includes an impairment Disclosures are needed for: v Intangibles which are amortized, v Intangibles which are not amortized, v Research & development acquired, and Copyright © 2012 Pearson Education, v Intangibles with renewal Inc. Publishing as Prentice Hall or extension 1 -40

Sarbanes-Oxley Act of 2002 Establishes the PCAOB Requires: v Greater independence of auditors and clients v Greater independence of corporate boards v Independent audits of internal controls v Increased disclosures of off-balance sheet arrangements and obligations v More types of disclosures on Form 8 -K SEC enforces SOX and rules of the PCAOB Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 1 -41

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