Chapter 7 BUSINESS COMBINATIONS

7.1 Nature of Business Combinations

Business combinations are events or transactions in which two or more
business enterprises, or their net assets, are brought under common
control in a single accounting entity. Other terms frequently applied to
business combinations are mergers and acquisitions.
Commonly used terms:
Combined enterprise: the accounting entity that results from business
combination.
Constituent companies: the business enterprises that enter into a
business combination.
Combinor: a constituent company entering into a purchase type
business combination whose owners as a group end up with control of
the ownership interest in the combined enterprise.
Combinee: a constituent company other than the combinor in a
business combination.
Business combinations may be friendly takeovers and hostile takeovers.
Friendly takeovers the boards of directors of the two constituent
companies generally work out the terms of the business combination
amicably and submit the proposal to stockholders of all constituent
companies for approval.
A target combinee in a hostile takeover typically resists the proposed
business combination by resorting to various defensive tactics.
Why do business enterprises enter into combinations? The overriding
reason for combinors in recent years has been growth. This is an
external method of achieving growth and mach more rapid than growth
through internal means. Expansion and diversification of product lines,
or enlarging the market share is achieved readily through a business
combination. However, the disappointing experiences of many combinors
suggest much may be said in favor of more gradual and reasoned growth

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through internal means, using available management and financial
resources.
Other reasons for business combinations are obtaining new management
strength or better use of existing management and achieving
manufacturing or other operating economies. A business combination
may be undertaken for income tax advantages available to one or more
parties to the combination.
The foregoing reasons do not apply to hostile takeovers. Critics complain
that the ‘sharks’ who engage in hostile takeovers, and investment
bankers and attorneys who counsel them, are motivated by the prospect
of substantial gains resulting from the sale of business segments of a
combinee following the business combination.
Methods for Arranging Business Combinations
The four common methods for carrying out a business combination are
statutory merger, statutory consolidation, common stock, and
acquisition of assets.
Statutory Merger
Procedures in a statutory merger
 The boards of directors of the constituent companies work out the
terms of the merger
 Stockholders of the constituent companies approve the terms of
the merger, in accordance with applicable corporate bylaws and
state laws
 The survivor dissolves and liquidates the other constituent
companies, receiving in exchange for its common stock
investments the net assets of those companies.
 Activities of the constituent companies are often continued as
divisions of the survivor

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Statutory Consolidation
Procedures in a statutory consolidation
 The boards of directors of the constituent companies work out the
terms of the merger
 Stockholders of the constituent companies approve the terms of
the merger, in accordance with applicable corporate bylaws and
state laws
 A new corporation is formed to issue common stock to the
stockholders of the constituent companies in exchange for all their
outstanding voting common stock of those companies.
 The new corporation dissolves and liquidates the other constituent
companies, receiving in exchange for its common stock
investments the net assets of those companies.
Acquisition of Common Stock
One corporation, the investor, may issue preferred or common stock,
cash, debt or a combination thereof to acquire from present stockholders
a controlling interest in the voting common stock of another corporation,
the investee. Stock acquisition may be accomplished through:
 Direct acquisition in the stock market
 Negotiation with the principal stockholders of a closely held
corporation
 Through a tender offer to stockholders of a publicly owned
corporation. The price per share state in the tender offer usually is
well above the prevailing market price
If a controlling interest in the combinee’s common stock is acquired, that
corporation becomes affiliated with the combinor parent company as a
subsidiary, but is not dissolved and liquidated and remains a separate
legal entity. Combinations arranged in this manner require authorization
by the combinor’s board of directors and require ratification by the

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combinee’s stockholders. Most hostile takeovers are accomplished by this
means.
Acquisition of Assets
A business enterprise may acquire from another enterprise all or most of
its gross assets or net assets for cash debt, preferred or common stock,
or a combination thereof. The transaction generally must be approved by
the boards of the constituent companies. The selling enterprise may
continue its existence as a separate or it may be dissolved and
liquidated; it does not become an affiliate of the combinor.
Establishing the Price for a Business Combination
The amount of cash or debt securities, or the number of shares of
preferred or common stock, to be issued in a business combination
generally is determined by variations of the following methods:
 Capitalization of expected annual earnings of the combinee at a
desired rate of return
 Determination of current fair value of combinee’s net assets
The price for a business combination consummated for cash or debt
generally is expressed in terms of the total dollar amount of the
consideration issued. When common stock is issued, the price is
expressed as a ratio of the number of shares of the combinor’s common
stock to be exchanged for each share of the combinee’s common stock.
7.2 Methods of Accounting for Business Combinations
Purchase Accounting
Accounting for a business combination by the purchase method follows
principles normally applicable under historical cost accounting to record
acquisition of assets and issuances of stock and to accounting for assets
and liabilities after acquisition.
 Assets (including goodwill) acquired for cash would be recognized
at the amount of cash paid

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  Assets acquired involving the issuance of debt, preferred stock, or
common stock would be recognized at the current fair value of the
asset, or the debt or the stock, whichever was more clearly evident.
Determination of the Combinor
Because the carrying assets of the combinor are not affected by a
business combination, the combinor must be accurately identified. The
Accounting Principles Board provided the following for identifying the
combinor:
 A corporation which distributes cash or other assets or incurs
liabilities to obtain the assets or stock of another company
 The company which either retains or receives the larger portion of
voting rights in the combined enterprise
Computation of Cost of a Combinee
The cost of a combinee in a business combination accounted for by the
purchase method is the total of:
 The amount of consideration paid by the combinor
 The combinor’s direct out of pocket costs
 Any contingent consideration that is determinable on the date of
the business combination
Amount of Consideration
This is the total amount of:
 cash paid
 the current fair value of other assets distributed
 the present value of debt securities issued, and
 the current fair/market value of equity securities issued by the
combinor.
Direct Out of Pocket Costs
Included in this category are:
 legal fees
 accounting fees

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  finder’s fees
A finder’s fee is paid to the investment banking firm or other organization
or individuals that investigated the combinee, assisted in determining
the price of the business combination, and otherwise rendered services
to bring about the combination.
Indirect out of pocket costs such as salaries of officers of the constituent
companies involved in negotiation and completion of the completion, are
recognized as expenses incurred by the constituent companies.
Contingent Considerations
Contingent consideration is additional cash, other assets, or securities
that may be issued in the future, contingent on future events such as a
specified level of earnings or a designated market price for a security that
has been issued to complete the business combination.
Contingent consideration that is determinable on the consummation date
of a combination is recorded as part of the cost of the combination while
that not determinable on the date of combination is recorded when the
contingency is resolved and the additional consideration is paid or issued
or becomes payable or issuable.
Allocation of Cost of a Combinee
APB Opinion No. 16 provides the following principles for allocating cost
of a combinee in a purchase type business combination.
 First, all identifiable assets acquired and liabilities assumed in a
business combination should be assigned a portion of the cost of
the acquired company, normally equal to their fair values at the
date of acquisition
 Second, the excess of the cost of the acquired company over the
sum of the amounts assigned to identifiable assets acquired less
liabilities assumed should be recorded as goodwill.

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Identifiable Assets and Liabilities
APB Opinion No. 16 provides guidelines for assigning values to a
purchased combinee’s identifiable assets and liabilities.
 Present values for receivables and liabilities
 Net realizable values for:
o marketable securities
o Finished goods and in process inventories
o Plant assets held for sale or temporary use
 Appraised values for:
o Intangible assets
o Land
o Natural resources
o Non marketable securities
 Replacement cost for:
o For inventories of material and plant assets held for long
term use.
Goodwill
Goodwill is recognized frequently because the total cost of the combinee
exceeds the current fair value of identifiable net assets. The amount of
goodwill recognized at the outset may be adjusted subsequently when
contingent considerations become issuable.
Negative Goodwill
Negative goodwill means an excess of current fair value of the combinee’s
identifiable net assets over their cost to the combinor.

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Illustration of Purchase Accounting for Statutory Merger, with Goodwill
On December 31, 1999, Mason Company (the combinee) was merged into
Saxon Corporation (the combinor or the survivor). Both companies used
the same accounting principles for assets, liabilities, revenue and
expenses and both had a December 31 fiscal year. Saxon issued 150,000
shares of its $10 par common stock (current fair value is $25 a share) to
Mason’s stockholders for all 100,000 issued and outstanding shares of
no-par, $10 stated value common stock. In addition, Saxon paid the
following out of pocket costs associated with the business combination:
Accounting fees:
For investigation of Mason as prospective combinee 5,000
For SEC registration statement for Saxon common stock 60,000
Legal fees:
For the business combination 10,000
For SEC registration statement for Saxon common stock 50,000
Finder’s fee 51,250
Printer’s charges for printing securities and SEC reg statement 23,000
SEC registration statement fee 750
Total out of pocket expenses 200,000
There was no contingent consideration in the merger contract.
Immediately prior to the merger, Mason Company’s condensed balance
sheet was as follows:
Mason Company (combinee)
Balance Sheet (prior to business combination)
December 31, 1999
Assets
Current assets 1,000,000
Plant assets (net) 3,000,000
Other assets 600,000
Total assets 4,600,000
Current liabilities 500,000
Long term debt 1,000,000
Common stock, no par, $10 stated value 1,000,000
Additional paid in capital 700,000
Retained earnings 1,400,000
Total liabilities and capital 4,600,000

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Using the guidelines in APB Opinion No. 16, the board of directors of
Saxon Corporation determined the current fair values of Mason
Company’s and liabilities (identifiable net assets) as follows:
Current assets 1,150,000
Plant assets 3,400,000
Other assets 600,000
Current liabilities (500,000)
Long term debt (present value) (950,000)
Identifiable net assets of combinee 3,700,000
The following are journal entries required by Saxon Corporation to record
the merger. Saxon uses the investment ledger to accumulate the total
cost prior to assigning the cost to identifiable net assets and goodwill.
Investment in Mason Co common stock
(150,000*25) 3,750,000
Common stock (150,000*10) 1,500,000
Paid in capital in excess of par 2,250,000
To record merger with Mason Company as purchase

Investment in Mason co common stock

(5,000+10,000+51,250) 66,250
Paid in capital in excess of par
(60,000+50,000+23,000+750) 133,750
Cash 200,000
To record out of pocket costs incurred with Mason company.
Accounting, legal, and finder’s fees are as investment cost; other
out of pocket costs are recorded as a reduction in the proceeds
received from issuance of common stock.

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 Current assets 1,150,000
Plant assets 3,400,000
Other assets 600,000
Discount on long term loan 50,000
Goodwill 116,250
Current liabilities 500,000
Long term debt 1,000,000
Investment in Mason co common stock
(3,750,000+66,250) 3,816,250
To allocate total cost of liquidated Mason company to identifiable
assets and liabilities, with the remainder to goodwill. (income tax
effects disregarded). Amount of goodwill is computed as follows:
Total cost of Mason company 3,816,250
Mason’s identifiable net assets
(4,600,000-1,500,000) 3,100,000
Excess (deficiency) of current fair
value over carrying amounts
Current assets 150,000
Plant assets 400,000
Long term debt 50,000 3,700,000

Amount of goodwill 116,250

No adjustments are made to reflect the current fair values of Saxon’s

identifiable net assets or goodwill as Saxon is the combinor.
Mason company records (the combinee) prepares the following condensed
journal entry to record the dissolution and liquidation of the company on
Dec 31,1999.

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 Current liabilities 500,000
Long term debt 1,000,000
Common stock, $10 stated value 1,000,000
Paid in capital in excess of stated value 700,000
Retained Earnings 1,400,000
Current assets 1,000,000
Plant assets (net) 3,000,000
Other assets 600,000
To record liquidation of company in conjunction with merger with
Saxon Corporation

Illustration of purchase accounting for acquisition of net assets,

with bargain purchase excess
On December 31,1999, Davis Corporation acquired the net assets of
Fairmont Corporation directly from Fairmont for 400,000 cash, in a
purchase type business combination. Davis paid legal fees of 40,000 in
connection with the combination.
The condensed balance sheet of Fairmont prior to the business
combination, with related current fair value data, is presented below:

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 FAIRMONT CORPORATION (combinee)
Balance Sheet (prior to business combination)
December 31,1999
Carrying Current
Amounts Fair Values
Assets
Current assets 190,000 200,000
Investment in marketable debt 50,000
60,000
Plant assets (net) 870,000 900,000
Intangible assets (net) 90,000 100,000
Total assets 1,200,000 1,260,000

Liabilities and Stockholders’ Equity

Current liabilities 240,000 240,000

Long term debt 500,000 520,000
Total liabilities 740,000 760,000
Common stock, $1 par 600,000
Deficit (140,000)
Total stockholders’ equity 460,000
Total liab & stockholders’ equity 1,200,000

Thus, Davis acquired identifiable net assets with current fair value of
500,000 (1,260,000-760,000) for a total cost of 440,000
(400,000+40,000). The 60,000 excess of the current fair value of the
assets over their cost is prorated to plant and intangible assets in ratio of
their respective current fair value.
To plant assets: 60000*900,000/900,000+100,000= 54,000
To intangible assets: 60,000*100,000/900,000+100,000= 6,000
Total 60,000
The journal entries below record Davis Corporation’s acquisition of the
net assets of Fairmont Corporation and payment of 40,000 legal fee.

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Investment in Net Assets of Fairmont Corp 400,000
Cash 400,000
To record acquisition of net assets of Fairmont Corporation

Investment in net assets of Fairmont Corp 40,000

Cash 40,000
To record legal fee paid in acquisition of net assets of Fairmont
Corporation

Current assets 200,000

Investment in Marketable Debt Securities 60,000
Plant assets (900,000-54000) 846,000
Intangible assets (100,000-6,000) 94,000
Current liabilities 240,000
Long term debt 500,000
Premium on long term debt (520,000-500,000) 20,000
Investment in net assets of Fairmont 440,000
To allocate total cost of net assets acquired to identifiable net assets,
with excess of current fair value of the net assets over cost allocated to
non current assets other than marketable securities

Pooling of Interest Accounting

The original premise of pooling of interest method was that certain
business combinations involving the exchange of common stock between
an issuer and the stockholders of a combinee were more in the nature of
a combining of existing stockholder interests than an acquisition of
assets or raising of capital.
Combining of existing stockholder interests was evidenced by
combinations involving common stock exchanges between corporations
of approximately equal size. The stockholders and managements of these

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corporations continue their relative interests and activities in the
combined enterprise as they previously did in the constituent companies.
Because neither of the equal sized companies could be considered the
combinor, the pooling of interest method of accounting provided for
carrying forward to the accounting records of the combined enterprise
the combined assets, liabilities, and retained earnings of the constituent
companies at their carrying amounts. The current fair value of the
common stock issued to effect the business combination and the current
fair value of the combinee’s net assets are disregarded in pooling of
interest accounting. Further, because there is no identifiable combinor,
the term issuer identifies the corporation that issues its common stock to
accomplish the combination.
Illustration of pooling of interest accounting for statutory merger
The Saxon Corporation-Mason Company merger business combination
would be accounted for as a pooling of interest by the following journal
entries in Saxon Corporation’s accounting records:
Current assets 1,000,000
Plant assets (net) 3,000,000
Other assets 600,000
Current liabilities 500,000
Long term debt 1,000,000
Common stock, $10 par 1,500,000
Paid in capital in excess of par 200,000
Retained earnings 1,400,000
To record merger with Mason Company as a pooling of interest

Expenses of Business Combination 200,000

Cash 200,000
To record payment out of pocket costs incurred in a merger with
Mason Company

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Because a pooling type business combination is a combining of existing
stockholder interest rather than an acquisition of assets, an investment
account is not used. Instead, Mason Company’s assets, liabilities, and
retained earnings are assigned their carrying amounts in Mason’s pre
merger balance sheet. The common stock issued by Saxon Corporation
must be recorded at par (150,000*10), the 200,000 credit to paid capital
in excess of par is a balancing account for the journal entry.
Total paid in capital of Mason prior to merger
(1,000,000+700,000) 1,700,000
Less: par value of Saxon common stock issued 1,500,000
Amount credit to Paid in Cap in excess of par 200,000
If the par value of common stock issued is in excess of total paid in
capital of Mason Company, Saxon’s paid in capital in excess of par would
have been debited. If the balance of Saxon’s Paid in Capital in Excess of
Par account were in sufficient to absorb the debit, Saxon’s Retained
Earnings account would be reduced.
All out of pocket costs of the business combination are recognized as
expense because a pooling type business combination is neither an
acquisition of assets nor a raising of capital. The expenses of business
combination are not deductible for tax purpose.
Mason’s journal entries to record the dissolution and liquidation of the
company would be identical to the journal entry illustrated under the
purchase method.
Comparison of Purchase and Pooling Accounting
The following table summarizes principal aspects of purchase accounting
and pooling of interest accounting for business combinations:

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7.3 Comparison of Purchase Accounting and Pooling of Interest Accounting for Business Combinations
Aspect Purchase Accounting Pooling of Interest Accounting
Underlying premise Acquisition of assets Combining of stockholder interests
Applicability Combinations not meeting all Combinations meeting all 12 criteria for
12 criteria for pooling accounting pooling accounting
Accounting recognition At cost, including amount of At carrying amount of combinee’s net assets
of investment in consideration, direct out of (all out of pocket costs are recognized as
combinee pocket costs, and determinable expenses of the issuer)
contingent consideration

Valuation of combinee’s At current fair values on date at carrying amounts on date of combination
net asset in combined of combination
enterprise
Goodwill recognition Yes, if combinor’s cost exceeds No
current fair value of combinee’s
identifiable net assets
Retained earnings of No Yes
constituent companies
combined on date of
business combination

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Financial statements
and notes for period
of business combin-
ation
Balance sheet Combinor’s net assets at carrying Both issuer’s and combinee’s net assets
amount, combinee’s net assets at carrying amount
current fair value
Income statement Combinor’s operations for entire Both issuer’s and combinee’s operations
period, combinee’s operations for entire period as though combination took
from date of combination to end place at beginning of period; prior periods
of period restated comparably
Disclosure of operation Pro forma for combined enterprise Separately for constituent companies for period
in notes for current and preceding period prior to combination
as though combination took place
at beginning of preceding period

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7.4 Appraisal of Accounting Standards for Business Combination
Criticism of Purchase Accounting
The principal criticism of purchase accounting is the residual basis for
valuing goodwill. These critics contend that part of the amounts thus
assigned to goodwill probably apply to other identifiable tangible assets.
Accordingly, goodwill in a business combination should be valued
directly and any remaining cost not directly allocated to all identifiable
assets including goodwill would be proportionately apportioned to those
assets or recognized as a loss.
Amortization of goodwill attributable to business combination is
considered inappropriate and the amount should be treated as a
reduction of stockholders’ equity of the combined enterprise.
Critics also argue that there is no theoretical support for the arbitrary
reduction of previously determined current fair values of assets by an
apportioned amount of purchase price excess. Rather an amortization of
the entire bargain purchase excess is suggested.
The fact that current fair values of the net assets of the combinee only
are reflected is also viewed as inconsistent.
Criticism of Pooling Accounting
The principal objections to pooling accounting are:
 The assumption that some business combinations involving
exchange of voting common stock result in a combining of existing
stockholder interests other than an acquisition of assets is difficult
to support in any accounting theory.
 The assets of the combinee are not accounted for at their cost to
the issuer. As a result, net income for each accounting period
subsequent to a pooling type business combination is misstated.
Assignments
Review questions
Exercises
5-1(except Q. # 3), 5-2, 5-3, 5-7, 5-8, 5-10; Problems 5-2 & 5-3.

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