Chapter 1: Business Combinations by Jeanne M David, Ph.D., Univ of Detroit Mercy to accompany Advanced Accounting, 10th edition by Floyd A Beams, Robin P Clement, Joseph H Anthony, and Suzanne Lowensohn © Pearson Education, Inc publishing as Prentice 1-1 Business Combinations: Objectives Understand the economic motivations underlying business combinations Learn about the alternative forms of business combinations, from both the legal and accounting perspectives Introduce concepts of accounting for business combinations, emphasizing the acquisition method See how firms make cost allocations in an acquisition method combination © Pearson Education, Inc publishing as Prentice 1-2 Business Combinations 1: Economic Motivations © Pearson Education, Inc publishing as Prentice 1-3 Types of Business Combinations Business combinations unite previously separate business entities • Horizontal integration – same business lines and markets • Vertical integration – operations in different, but successive stages of production or distribution, or both • Conglomeration – unrelated and diverse products or services © Pearson Education, Inc publishing as Prentice 1-4 Reasons for Combinations • • • • • • Cost advantage Lower risk Fewer operating delays Avoidance of takeovers Acquisition of intangible assets Other: business and other tax advantages, personal reasons © Pearson Education, Inc publishing as Prentice 1-5 Potential Prohibitions/ Obstacles • Antitrust – Federal Trade Commission prohibited Staples’ acquisition of Office Depot • Regulation – Federal Reserve Board – Department of Transportation – Federal Communications Commission • Some states have antitrust exemption laws to protect hospitals © Pearson Education, Inc publishing as Prentice 1-6 Business Combinations 2: Forms of Business Combinations © Pearson Education, Inc publishing as Prentice 1-7 Legal Form of Combination • Merger – Occurs when one corporation takes over all the operations of another business entity and that other entity is dissolved • Consolidation – 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 © Pearson Education, Inc publishing as Prentice 1-8 Mergers: A + B = A 1) Company A purchases the 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 2) Company A purchases Company B stock from its shareholders for cash, other assets, or Company A debt/equity securities Company B is dissolved Company A survives with Company B’s assets and liabilities © Pearson Education, Inc publishing as Prentice 1-9 Consolidations: E + F = “D” 1) Company D is formed and acquires the 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 2) Company D is formed acquires Company E and F stock from their respective shareholders by issuing Company D stock Companies E and F are dissolved Company D survives with the assets and liabilities of both firms © Pearson Education, Inc publishing as Prentice 1-10 Contingent Consideration • If the fair value of contingent consideration is determinable at the acquisition date, it is included in the cost of the combination • If the fair value of the contingent consideration is not determinable at that date, it is recognized when the contingency is resolved • Types of consideration contingencies: – Future earnings levels – Future security prices © Pearson Education, Inc publishing as Prentice 1-26 Recording Contingent Consideration • Contingencies based on future earnings increase the cost of the investment • Contingencies based on future security prices not change the cost of the investment Additional consideration distributed is recorded at its fair value with an offsetting write-down of the equity or debt securities issued In some cases the contingency may involve a return of consideration © Pearson Education, Inc publishing as Prentice 1-27 Example – Pitt Co Data Pitt Co acquires the net assets of Seed Co in a combination consummated on 12/27/2008 The assets and liabilities of Seed Co on this date, at their book values and fair values, are as follows (in thousands): © Pearson Education, Inc publishing as Prentice 1-28 Cash Net receivables Inventory Land Buildings, net Equipment, net Patents Total assets Accounts payable Notes payable Other liabilities Total liabilities Net assets Book Val $ 50 150 200 50 300 250 $1,000 $ 60 150 40 $ 250 $ 750 © Pearson Education, Inc publishing as Prentice Fair Val $ 50 140 250 100 500 350 50 $1,440 $ 60 135 45 $ 240 $1,200 1-29 Acquisition with Goodwill Pitt Co pays $400,000 cash and issues 50,000 shares of Pitt Co $10 par common stock with a market value of $20 per share for the net assets of Seed Co Total consideration at fair value (in thousands): $400 + (50 shares x $20) $1,400 Fair value of net assets acquired: $1,200 Goodwill $ 200 © Pearson Education, Inc publishing as Prentice 1-30 Entries with Goodwill The entry to record the acquisition of the net assets: Investment in Seed Co 1,400 Cash 400 Common stock, $10 par 500 Additional paid-in-capital 500 The entry to record Seed’s assets directly on Pitt’s books: © Pearson Education, Inc publishing as Prentice 1-31 Cash Net receivables Inventories Land Buildings Equipment Patents Goodwill Accounts payable Notes payable Other liabilities Investment in Seed Co © Pearson Education, Inc publishing as Prentice 50 140 250 100 500 350 50 200 60 135 45 1,400 1-32 Acquisition with Bargain Purchase Pitt Co 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 Seed Co Fair value of net assets acquired (in thousands): $1,200 Total consideration at fair value: (40 shares x $20) + $200 $1,000 Gain from bargain purchase $ 200 © Pearson Education, Inc publishing as Prentice 1-33 Entries with Bargain Purchase The entry to record the acquisition of the net assets: Investment in Seed Co 1,000 10% Note payable 200 Common stock, $10 par 400 Additional paid-in-capital 400 The entry to record Seed’s assets directly on Pitt’s books: © Pearson Education, Inc publishing as Prentice 1-34 Cash Net receivables Inventories Land Buildings Equipment Patents Accounts payable Notes payable Other liabilities Investment in Seed Co Gain from bargain purchase © Pearson Education, Inc publishing as Prentice 50 140 250 100 500 350 50 60 135 45 1,000 200 1-35 Goodwill Controversies • Capitalized goodwill is the purchase price not assigned to identifiable assets and liabilities – 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 – Capitalize goodwill, – Do not amortize it, and – Test it for impairment © Pearson Education, Inc publishing as Prentice 1-36 Impairments • Firms must test annually for the impairment of goodwill at the business unit reporting level – If the unit’s book value exceeds its fair value, additional tests must be performed to determine the impairment of goodwill and/or other assets • More frequent testing for goodwill impairment may be needed (e.g., loss of key personnel, unanticipated competition, goodwill impairment of subsidiary) © Pearson Education, Inc publishing as Prentice 1-37 Business Combination Disclosures • FASB Statement No 141R and 142 prescribe disclosures for business combinations and intangible assets This includes, but is not limited to: – Reason for combination, – Allocation of purchase price among assets and liabilities, – Pro-forma results of operations, and – Goodwill or gain from bargain purchase © Pearson Education, Inc publishing as Prentice 1-38 Sarbanes-Oxley Act of 2002 • Establishes the PCAOB • Requires – Greater independence of auditors and clients – Greater independence of corporate boards – Independent audits of internal controls – Increased disclosures of off-balance sheet arrangements and obligations – More types of disclosures on Form 8-K • SEC enforces SOX and rules of the PCAOB © Pearson Education, Inc publishing as Prentice 1-39 All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher Printed in the United States of America Copyright © 2009 Pearson Education, Inc   Publishing as Prentice Hall © Pearson Education, Inc publishing as Prentice 1-40 ... to Fair Value Rule • Deferred tax assets and liabilities [FASB Statement No 109 and FIN No 48] • Pensions and other benefits [FASB Statement No 158] • Operating and capital leases [FASB Statement... “Consolidation” is also an accounting term used to describe the process of preparing consolidated financial statements for a parent and its subsidiaries © Pearson Education, Inc publishing as Prentice... Record assets acquired and liabilities assumed using the fair value principle • If equity securities are issued by the acquirer, charge registration and issue costs against the fair value of