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Business Combinations
ACCT 501
Objectives of the Chapter
Business Combinations 2
Objectives of the Chapter
Business Combinations 3
Objectives of the Chapter
Business Combinations 4
Business Combinations
Business Combinations 5
Business Combinations (contd.)
FASB’s terms for the business
entities involved in the business
combination:
a.Constituent companies : all business
entities enter into a business
combination.
b.Combined enterprise: the business
entity that results from a business
combination.
Business Combinations 6
Business Combinations (contd.)
Business Combinations 7
Types of Business Combinations
Friendly takeovers
Hostile takeovers
Business Combinations 8
Reasons for Business Combinations
Business Combinations 9
Reasons for Business Combinations
(contd.)
b.Obtaining new management strength or
better use of existing management.
c.For the income tax advantages
Business Combinations 12
Four Methods for Carrying Out
Business Combinations (contd.)
2. Statutory Consolidation:
a new corporation is formed to issue
its common stock for the outstanding
common stock of all constituent
corporations.
Procedures of statutory consolidation:
a. similar to the statutory merger.
b. similar to the statutory merger.
Business Combinations 13
Four Methods for Carrying Out
Business Combinations (contd.)
c. a new corporation is formed to issue
its common stock to the stockholders
of all the constituent companies in
exchanger for all their outstanding
voting common stock.
d. the new corporation dissolves and
liquidates the constituent companies.
Business Combinations 14
Four Methods for Carrying Out
Business Combinations (contd.)
3.Acquisition of Common Stock (a
method for most of hostile
takeovers)
Procedures:
a. the combinor received the approval
from its board of directors to acquire
common stock of the prospective
target firm.
Business Combinations 15
Four Methods for Carrying Out
Business Combinations (contd.)
b. acquiring target firm’s common stock
in an open market, or through a
tender offer to stockholders of a
publicly owner corporation.
Business Combinations 16
Four Methods for Carrying Out
Business Combinations (contd.)
c. When acquiring enough shares to
have the controlling interest in the
combinee’s voting common
shares,the target firm becomes
affiliated with the combinor (the
parent company) as a subsidiary.
The target firm remains as a
separate legal entity.
Business Combinations 17
Four Methods for Carrying Out
Business Combinations (contd.)
4. Acquisitions of Assets:
Business entity acquires all or most of
net assets of the other entity (using
cash, debt, stock ……..)
Business Combinations 18
Establishing the Price for a
Business Combination
1. Capitalization of expected average
annual earnings of the combinee at a
desired rate of return.
2. Determination of current fair value of
the combinee’s net assets (including
goodwill).
Business Combinations 19
Methods of Accounting for
Business Combinations
Pooling of Interest Accounting versus
Purchase Accounting
Definitions:
Accounting Acquisition Premium
(AAP)
= purchase price – book value of the
combinee.
Business Combinations 20
Methods of Accounting for
Business Combinations
Purchased Goodwill
= AAP – combinee’s assets step-up.
Assets step up
= the fair market value of net assets
of the combinee – the book value of
these net assets.
Business Combinations 21
Methods of Accounting for
Business Combinations (contd.)
Two accounting methods for business
combinations are allowed under APB
Opinion No. 16:
Earnings:
the depreciation associated with any
assets step-up and the amortization of
any purchased goodwill will result in
purchase earnings, in general, to be
less than pooling earnings (i.e., E purchase
< E pooling).
Business Combinations 24
Methods of Accounting for
Business Combinations (contd.)
Book Value:
the book value of the accounting
consolidated net assets under pooling
accounting will typically be less than
those reported under purchase
accounting (i.e., B pooling < Bpurchase ).
Business Combinations 25
Purchase Accounting
Cost of a Combinee including:
1.the amount of consideration paid by
the combinor to a combinee.
2.the combinor’s direct “out-of-
pocket” costs of the combination,
and
3.contingent consideration which is
determinable on the business
combination date.
Business Combinations 26
Cost of A Combinee (contd.)
Direct out-of-pocket costs include legal
fees, accounting fees, and finder’s fees.
Costs of registering with the SEC and
issuing debt securities in a business
combinations are debited to Bond Issue
Costs.
Business Combinations 27
Cost of A Combinee (contd.)
Cost of registering with the SEC and
issuing equity securities are offset
against the proceeds from the
issuance of the securities.
Contingent consideration: cash,other
assets,or securities that may be
issuable in the future.
Business Combinations 28
Accounting Treatment for
Contingent Consideration
a.Contingent consideration which is
determinable on the combination
date:
recorded as part of the cost of the
combination.
Business Combinations 29
Accounting Treatment for
Contingent Consideration(contd.)
b.Contingent consideration that is not
determinable on the combination
date:
the contingent amount is recorded
as goodwill when the contingency is
resolved.
Business Combinations 30
Assigning Values to a Purchased Combinee’s
Identifiable Assets and Liabilities (Based on
APB Opinion No. 16)
1. Present value: receivables and
liabilities;
2. Net realizable values : marketable
securities, finished goods, goods in
process inventories, plant assets held
for sale or temporary use;
Business Combinations 31
Assigning Values to a Purchased Combinee’s
Identifiable Assets and Liabilities (Based on
APB Opinion No. 16) (contd.)
3. Appraised value: intangible assets,
land, natural resources and
nonmarketable securities;
Business Combinations 32
Goodwill Computation under
Purchase Accounting
Purchased Goodwill
=purchase price (total cost of the
combinee) –
the current fair values of identifiable
net assets of the combinee.
Business Combinations 33
Goodwill Computation under
Purchase Accounting (contd.)
Negative Goodwill:
The excess amount is applied to
reduce proportionally the amounts
initially assigned to noncurrent assets
(other than long-term investments.)
If this procedure does not extinguish
the excess, a Negative Goodwill
account would be credited for the
remaining excess.
Business Combinations 34
Example I: Purchase Accounting For
Statutory Merger, with Goodwill
On December 31,1999, Mason
Company (the combinee) was merged
into Saxon Corporation (the combinor
or survivor).
Both companies used the same
accounting principles for assets,
liabilities, revenue, and expenses and
both had a December 31 fiscal year.
Business Combinations 35
Example I: Purchase Accounting For
Statutory Merger, with Goodwill (contd.)
Saxon issued 150,000 shares of its $10
par common stock (current fair value
$25 a share) to Mason’s stockholders
for all 100,000 issued and outstanding
shares of Mason’s no-par, $10 stated
value common stock.
In addition, Saxon paid the following
out-of-pocket costs associated with
business combination:
Business Combinations 36
Example I (contd.): Out of Pocket Costs
Accounting fees:
For investigation of Mason
Business Combinations 37
Example I (contd.): Out of Pocket Costs
(contd.)
Assets
Current assets $1,000,000
Plant assets (net) 3,000,000
Other assets 600,000
Total assets 4,600,000
(Continued)
Business Combinations 39
Example I (contd.): Mason Company’s
Condensed B/S Prior to The Merger (contd.)
MASON COMPANY
Balance Sheet (contd.) , 12/31/1999
Business Combinations 41
Example I (contd.): Fair Value of
Identifiable Net Assets of Combinee
Business Combinations 42
Example I (contd.): Combinor’s Journal
Entries for Business Combination
Saxon uses an investment ledger
account to accumulate the total cost of
Mason Company prior to assigning the
cost to identifiable net assets and
goodwill.
Business Combinations 43
Example I (contd.): Combinor’s Journal
Entries for Business Combination (contd.)
Journal Entries for Saxon Corp. 12/31/1999
Investment in Mason
Company Common
Stock (150,000 x $25) 3,750,000
Common stock
(150,000 x $10) 1,500,000
Paid-in Capital in
Excess of Par 2,250,000
To record merger with Mason
Company as a purchase.
(Continued)
Business Combinations 44
Example I (contd.): Combinor’s Journal
Entries for Business Combination (contd.)
12/31/1999 (contd.)
Investment in Mason
Company 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 payment of out-of-pocket
costs incurred in merger with
Mason Company.
(Continued)
Business Combinations 45
Example I (contd.): Combinor’s Journal
Entries for Business Combination (contd.)
12/31/1999 (contd.)
Current Assets 11,500,000
Plant Assets 3,400,000
Other Assets 600,000
Discount on Long-Term Debt 50,000
Goodwill 116,250
Current Liabilities 500,000
Long-Term Debt 1,000,000
Investment in Mason
Company 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 reminder to goodwill.
(Income tax effects are disregarded.)
Business Combinations 46
Example I (contd.): Combinee’s J.E. for The
Dissolution of the Company after Statutory
Merger
Mason Company (the combinee)
prepares the condensed journal entry
below to record the dissolution and
liquidation of the company on
December 31, 1999.
Business Combinations 47
Example I (contd.): Combinee’s J.E. for The
Dissolution of The Company after Statutory
Merger (contd.)
Journal Entries for Mason Corp.12/31/1999
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
Business Combinations 48
Example II: Purchase Accounting for
Acquisition of Net Assets, with Negative
Goodwill (Bargain-Purchase Excess)
On December 31, 1999, Davis
Corporation acquired the net assets of
Fairmont Corporation directly from
Fairmont Corp. for $400,000 cash, in a
purchase-type business combination.
Davis paid legal fees of $40,000 in
connection with the combination.
Business Combinations 49
Example II: Purchase Accounting
with Negative Goodwill
The condensed balance sheet
statement of Fairmont Corp. prior to the
business combination, with related
current fair value data, is presented
below:
Business Combinations 50
Example II (contd.):Combinee’s B/S
Prior to Statutory Merger
FAIRMONT CORPORATION (combinee)
Balance Sheet (prior to business combination)
December 31, 1999
Assets Carrying Current Fair
Amounts Values
Current assets $ 190,000 $ 200,000
Investment in marketable debt
securities (held to maturity) 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
Business Combinations (Continued)51
Example II (contd.):Combinee’s B/S
Prior to Statutory Merger (contd.)
FAIRMONT CORPORATION B/S (contd.)
Business Combinations 53
Example II (contd.) : Computing the
Negative Goodwill (contd.)
The $60,000 excess of current fair
value of the net assets over their cost to
Davis ($500,000 - $440,000 = $60,000)
is prorated to the plant assets and
intangible assets in the ratio of their
respective current fair values, as
follows:
Business Combinations 54
Example II (contd.) : Allocation of
Negative Goodwill
To plant assets:
$60,000 x $900,000
($900,000 +$100,000) =$54,000
To intangible assets:
$60,000 x $900,000
($900,000 +$100,000) =$6,000
Total excess of current fair
value of identifiable net
assets over combinor’s cost $60,000
Business Combinations 55
Example II (contd.)
Notes: No part of the $60,000 bargain-
purchase excess is allocated to current
assets or to the investment in
marketable securities.
Business Combinations 59
Pooling-of-Interests Accounting
The idea behind this accounting
method is that the business
combination is simply an exchange of
common stock between an issuer and
the stockholders of a combinee.
Thus, this method is appropriated to be
used in the case of business
combinations involving only common
stock exchanges between companies
of approximately equal size.
Business Combinations 60
Pooling-of-Interests Accounting
(contd.)
Because neither party can be
considered as the combinor (as
previously defined), the combined
assets, liabilities and retained earnings
of the constituent companies are
recorded at their carrying amounts.
Business Combinations 61
Pooling-of-Interests Accounting
(contd.)
Both the market value of the common
stock issued for the combination and
the fair value of the combinee’s net
assets are disregarded in this method.
The term “issuer” identifies the
corporation that issues its common
stock to accomplish the combination.
Business Combinations 62
Example III: Pooling-of-Interests
Accounting for Statutory Merger
Applying the pooling-of interests
accounting method on the Example I
(the business combination of Saxon
and Manson) illustrated on page 32-45,
the following journal entries would be
prepared in Saxon Corporation’s
accounting records:
Business Combinations 63
Example III : Pooling-of-Interests
Accounting for Statutory Merger (contd.)
Journal Entries for Saxon Corp. 12/31/1999
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 interests.
Business Combinations 64
Example III : Pooling-of-Interests
Accounting for Statutory Merger (contd.)
12/31/1999 (J. E. contd.)
Expenses of Business
Combination 200,000
Cash 200,000
To record payment of out-of-
pocket costs incurred in
merger with Mason Company
Business Combinations 65
Example III (contd.): Notes to the example
Notes:
1. An Investment in Mason’s Company
Common Stock account is not used in the
pooling-of-interests method.
2. Mason’s assets, liabilities and retained
earnings are recorded at their carrying
amounts in Mason’s premerger balance
sheet.
3. The common stock issued by Saxon for the
business combination is recorded at par
value.
Business Combinations 66
Example III (contd.): Notes to the example
(contd.)
Notes (contd.)
4. The Paid-in-Capital in Excess of Par equals
the total premerger paid-in-capital of Mason
minus the par value of Saxon's stock issued
for the business combination.
5. If the par value of Saxon’s common stock
issued for the combination exceeds the
premerger paid-in capital of Mason,
Saxon’s Paid-in Capital in Excess of Par
account should be debited for the excess
amount. (contd.)
Business Combinations 67
Example III (contd.): Notes to the example
(contd.)
Notes (contd.)
5. (contd.)If this account is not sufficient to
absorb the excess amount, Saxon’s
Retained Earnings account should be
debited.
6. The entire out-of-pocket costs were
expensed and are not tax deductible.
Business Combinations 68
Advantage of Using Pooling Accounting on
Financial Numbers
1.Advantage on the Post-Merger
Earnings:
The following exhibit shows the balance
sheet statement accounts of pooling
accounting versus purchase accounting
using the example of Saxon and
Mason:
Business Combinations 69
Advantage of Using Pooling Accounting on
Financial Numbers (contd.)
(Continued)
Business Combinations 70
Advantage of Using Pooling Accounting on
Financial Numbers (contd.)
Business Combinations 71
Advantage of Using Pooling Accounting on
Financial Numbers (contd.)
The difference on the net assets of these
two methods is:
Purchase accounting
net assets $3,616,250
Pooling accounting
net assets 2,900,000
Difference $ 716,250
Business Combinations 72
Advantage of Using Pooling Accounting on
Financial Numbers (contd.)
The composition of the $716,250 is
summarized as follows:
Excess of purchase asset values over
pooling asset values:
Current assets ($1,150,000-$1,000,000) $150,000
Plant assets ($3,400,000- $3,000,000) 400,000
Goodwill 116,250
Excess of pooling liability values over
purchase liability values:
Long-term debt
[$1,000,000-($1,000,000- $50,000) ] 50,000
Excess of purchase net assets values
over pooling net assets values $716,250
Business Combinations 73
Advantage of Using Pooling Accounting on
Financial Numbers (contd.)
Assuming:
Business Combinations 74
Advantage of Using Pooling Accounting on
Financial Numbers (contd.)
b.The $400,000 difference in plant assets is
attributable to depreciable assets, and
assuming an average economic life for these
plant assets is 10 years.
Business Combinations 75
Advantage of Using Pooling Accounting on
Financial Numbers (contd.)
Based on the above information, Saxon’s pre-tax
income for the year ended 12/31/2000 would be
$202,906 less under purchase accounting than
under pooling accounting. Calculation is as
follows:
Cost of goods sold $150,000
Depreciation expense ($400,000 x 1/10) 40,000
Amortization expense ($116,250 x 1/40) 2,960
Interest expense ($50,000 x 1/5) 10,000
Excess of year 2000 pre-tax income under
pooling accounting rather than under
purchase accounting $202,906
Business Combinations 76
Advantage of Using Pooling Accounting on
Financial Numbers (contd.)
Thus, pooling accounting, in general,
results in a more favorable post-merger
earnings than the purchase accounting.
As a result, it is preferred by mangers
who would like to present a higher post-
merger earnings.
Business Combinations 77
Advantage of Using Pooling Accounting on
Financial Numbers (contd.)
2.Advantage on the Retained
Earnings
The retained earnings under the
pooling method is $1,400,000 greater
than that of the purchase method.
This outcome also provides the
managers with a greater flexibility in
dividend distribution when using the
pooling accounting.
Business Combinations 78
Advantage of Using Pooling Accounting on
Financial Numbers (contd.)
3.Advantage on the Price-Earnings
Ratios on the Merger Year
Assume Saxon and Mason had the
following financial information prior to
the business combination:
Business Combinations 79
Advantage of Using Pooling Accounting on
Financial Numbers (contd.)
Saxon Mason
Corporation Company
Year ended Dec. 31, 1999:
Net income $500,000* $375,000
Basic earnings per share of
common stock $0.50 $3.75
On Dec. 31, 1999:
Number of shares of
common stock outstanding 1,000,000+ 100,000+
Market price per share $25 $30
Price-earnings ratio 50 8
* Net of $200,000 expenses of business combination.
+ Outstanding during entire year.
Business Combinations 80
Advantage of Using Pooling Accounting on
Financial Numbers (contd.)
Using the pooling method, Saxon would
report the combined enterprise’s net
income as $875,000 for the year ended
12/31/1999 (as if these two companies
were pooled as of 1/1/1999) and the EPS
for Saxon would be increased from $0.50
to $0.76.
Calculated as :
$875,000/(1,000,000+150,000).
Business Combinations 81
Historical Perspective of Accounting
for Business Combinations
Due to lack of accounting
pronouncement in providing clear
guidance in determining the appropriate
method for business combination prior
to the issuance of Accounting Principle
Board Opinion No. 16 “Business
Combinations” in August 1970 (effective
for business combinations initiated after
October 31, 1970),
Business Combinations 82
Historical Perspective of Accounting
for Business Combinations (contd.)
a substantial number of business
combinations arranged in the 1950s
and 1960s were accounted for using
pooling accounting despite the absence
of the assumption for using pooling
accounting .
Business Combinations 83
Historical Perspective of Accounting
for Business Combinations (contd.)
The pooling accounting was first
sanctioned by the AICPA in its
Accounting Research Bulletin No. 40,
“Business Combinations”. This
pronouncement provides very little
guidance for identifying the business
combinations that qualified for pooling
method.
Business Combinations 84
Historical Perspective of Accounting
for Business Combinations (contd.)
ARB No. 40 was subsequently replaced
by ARB No. 48, “Business
Combinations” which continued to allow
pooling method to be used for most
business combinations involving an
exchange of common stock.
Business Combinations 85
Past Abuses of Pooling Accounting
The advantages of pooling accounting
in post-merger earnings, retained
earnings, and in the P/E ratio of the
merger year with the lack of clear
guidelines for pooling in ARB No. 48 led
to serious abuses of pooling method.
Business Combinations 86
Past Abuses of Pooling Accounting
(contd.)
Consequently, a substantial number of
business combinations arranged in the
1950s and 1960s were accounted for
using pooling accounting despite the
absence of the assumption for using
pooling accounting – the combination of
existing stockholders’ interests.
Business Combinations 87
Past Abuses of Pooling Accounting
(contd.)
Among these abuses are:
a. Retroactive Pooling
b. Retrospective Pooling
c. Part-Pooling, Part-Purchase
Accounting
d. Treasure Stock Issuance
Business Combinations 88
Past Abuses of Pooling Accounting
(contd.)
Contd.:
e.Issuance of Unusual Securities
f. Creation of “instant Earnings”
g.Contingent Payouts
h.“Burying” the Costs of Pooling-Type
Business Combinations
Business Combinations 89
Past Abuses of Purchase Accounting
(in the period of 1950-1960)
The most common abuses of purchase
accounting is the failure to allocate the
cost of a combinee to the identifiable
net assets acquired and to goodwill.
Business Combinations 90
Action by the AICPA to Curtail The
Abuses
The Accounting Principles Board
reacted to the abuses by issuing APB
opinion No. 16 in which pooling
accounting standards are tightened
and the range of situations allowed
for pooling accounting is substantially
limited.
Business Combinations 91
Conditions Requiring Pooling Accounting
in APB Opinion No. 16
1.Attributes of the combining
companies (2 conditions).
These conditions were to assure that
the pooling combination was truly a
combining of two or more entities whose
common stockholder interests were
previously independently of each other.
Business Combinations 92
Conditions Requiring Pooling Accounting
in APB Opinion No. 16) (contd.)
2.Manner of combining ownership
interests (7 conditions).
These conditions were to assure that
the exchange of voting common stock
actually took place in substance and in
form.
Business Combinations 93
Conditions Requiring Pooling Accounting
in APB Opinion No. 16) (contd.)
3.Absence of planned transactions (3
conditions).
These conditions were to assure that
no planned transactions, which are
inconsistent with the combining of
entire existing interests of common
stockholders, could be arranged prior to
the combination.
Business Combinations 94
APB Opinion No. 16
Business Combinations 95
APB Opinion No. 16 (contd.)
1.Attributes of the constituent
companies (2 conditions)
a. Each of the constituent companies is
autonomous and has not been a
subsidiary or division of another
corporation within two years before the
plan of combination is initiated.
b. Each of the constituent companies is
independent of the other.
Business Combinations 96
APB Opinion No. 16 (contd.)
2.Manner of combining ownership
interests (7 conditions)
b. A corporation offers and issues only
common stock with rights identical to
those of the majority of its outstanding
voting common stock in exchange for
substantially all the voting common
stock interest of another company on the
date the plan of combination is
consummated.
Business Combinations 97
APB Opinion No. 16 (contd.)
3.Absence of planned transactions (3
conditions)
a. The combined entity does not agree to
retire or acquire all or part of the common
stock issued to effect the combination.
b. The combined entity does not enter
agreement for the benefit of the former
stockholder of a constituent company.
Business Combinations 98
APB Opinion No. 16 (contd.)
c. The combined entity does not plan to sell
a significant part of the assets of the
constituent companies within two years
after the combination.
Business Combinations 99
APB Opinion No. 16 (contd.)
APB stated that both purchase and
pooling methods are acceptable in
accounting for business combination,
but not as alternatives in accounting for
the same business combination.
By tightening the conditions for
adopting pooling accounting, many
previous abuse of pooling were
eliminated or reduced.
Business Combinations 100
Discussion of Four Conditions
1.Independence of Constituent
Companies
On the dates of initiation and
consummation of a business
combination, no constituent company
may have more than 10% ownership of
the outstanding voting common stock of
another constituent company.
(Continued)
Business Combinations 135
Purchase-Type Statutory Consolidation (contd.)
Example V (contd.):
LAMSON CORPORATION AND DONALD COMPANY
Separate Balance Sheets (contd.), 12/31/1999
Investment in Lamson
Corporation and Donald
Company Common Stock
(74,000 x $60) 4,440,000
Common Stock, no par 4,440,000
To record consolidation of Lamson
Corporation and Donald Company
as a purchase
(Continued)
Business Combinations 142
Purchase-Type Statutory Consolidation (contd.)
Example V (contd.):
12/31/1999 (contd.)
Investment in Lamson
Corporation and Donald
Company Common Stock 110,000
Common Stock, no par 90,000
Cash 200,000
To record payment of costs incurred in
consolidation of Lamson Corporation and
Donald Company. Accounting, legal, and
finder’s fees in connection with the
consolidation are recorded as investment
cost; other out-of-pocket costs are recorded
as a reduction in the proceeds received
from the issuance of common stock.
(Continued)
Business Combinations 143
Purchase-Type Statutory Consolidation (contd.)
Example V (contd.):
12/31/1999 (contd.)
Current Assets ($600,000+$500,000) 1,100,000
Plant Assets ($1,800,000+$1,400,000) 3,200,000
Other Assets ($400,000+$400,000) 800,000
Goodwill 850,000
Current Liabilities 700,000
Long-Term Debt 700,000
Investment in Lamson
Corporation and Donald
Company Common
Stock 4,550,000