Chapter 1

Business Combination

Aprilia Beta Suandi

Faculty of Economics and Business
Universitas Gadjah Mada
 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
 Reasons for Combinations

– Cost advantage
– Lower risk
– Fewer operating delays
– Avoidance of takeovers
– Acquisition of intangible assets
– Other: business and tax advantages, personal
reasons
 Potential Prohibitions / Obstacles

Antitrust
– Federal Trade Commission prohibited Staples’
acquisition of Office Depot
Regulation
– Federal Reserve Board
– Department of Transportation
– Department of Energy
– Federal Communications Commission
 Forms of Combination

Acquisition
– One corporation acquires the productive assets of another business
entity and integrates those assets into its own operations. Both
companies can still exist.
– A + B = A + B or A + B = A or A + B = B
Merger
– One corporation takes over all the operations of another business
entity and that other entity is dissolved.
– A + B = A or A + B = B
Consolidation
– 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.
–A + B = C
 Keeping the Terms Straight
● In Chapter 1, mergers and consolidations will
involve only 100% acquisitions with the
dissolution of the acquired firm(s). Other
scenarios will be explored 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.
 Business Combination (definition)

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:

– Less than 100% of the firm is acquired, or
– The acquired firm is not dissolved.
 Accounting Method for Business
Combinations
– Since the 1950s both the pooling of interests
method and the purchase method of
accounting for business combinations became
acceptable.
– GAAP requires that all business combinations
initiated after Dec 15, 2008 be accounted using
the acquisition method. [FASB ACS 810-10-5-
2]
• The International Accounting Standards Board
specifically prohibits the pooling method and
requires the acquisition method.
 Recording Guidelines (1 of 2)

– 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 the securities issued, usually a
reduction in additional paid-in-capital.
– Charge other direct combination costs (e.g., legal
fees, finders’ fees) and indirect combination costs
(e.g., management salaries) to expense.
 Recording Guidelines (2 of 2)
Consideration transferred = Acquisition cost
Net assets (NA) = Asset – Liabilities = Equity

Acquisition cost > FV net assets acquired

– The excess of cash, other assets, debt, and equity
securities transferred over the fair value of the net
assets acquired is recorded as goodwill.

Acquisition cost < FV net assets acquired

– If the net assets acquired exceeds the cash, other
assets, debt, and equity securities transferred, then a
gain on the bargain purchase is recorded in current
income.
 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. (+A) 1,600 blank

Common stock, $10 par (+SE) blank 1,000
Additional paid-in-capital (+SE) blank 600
 Example: Pop Corp. (2 of 3)

Pop Corp. pays cash of $80,000 in finder’s and

consulting fees and $40,000 to register and issue its
common stock (in thousands).

Investment expense (E, -SE) 80 blank

Additional paid-in-capital (-SE) 40 blank
Cash (-A) blank 120
 Example: Pop Corp. (3 of 3)
Son Corp. is assumed to have been dissolved.
Pop Corp. allocates the investment’s cost to the fair value of
the identifiable assets acquired and liabilities assumed.
Fair value of Son’s total assets: $1,440
Fair value of Son’s total liabilities: $240

Receivables (+A) XXX blank

Inventories (+A) XXX blank
Plant assets (+A) XXX blank
Goodwill (+A) XXX
Accounts payable (+L) blank XXX
Notes payable (+L) blank XXX
Investment in Son Corp. (-A) blank 1,600
 Identify the Net Assets Acquired
Identify:
– Tangible assets acquired,
– Intangible assets acquired, and
– Liabilities assumed
Include:
– Identifiable intangibles resulting from legal or
contractual rights, or separable from the entity
– Research and development in process
– Contractual contingencies
– Some noncontractual contingencies
 Assign Fair Values to Net Assets

Use fair values determined in preferential order by:

– Established market prices
– Present value of estimated future cash flows,
discounted based on an observable measure,
such as the prime interest rate
– Other internally derived estimations
 Exceptions to Fair Value Rule
Use normal guidance for:
– Deferred tax assets and liabilities
– Pensions and other benefits
– Operating and capital leases

[FASB ASC 740]

Goodwill on the books of the acquired firm is
assigned no value.
 Contingent Consideration

The fair value of contingent consideration is determined or

estimated at the acquisition date, and it is included along
with other considerations given as part of the combination.

Classifying contingencies:
– Contingent share issuances are equity.
– Contingent cash payments are liabilities.

Contingent consideration in the form of:

– Liability: remeasured to fair value at each subsequent
reporting date.
– Equity: no remeasurement
 Example – Pam Corp. Data

Pam Corp. acquires the net assets of Sun Co. in a

combination consummated on 12/27/2016.
The assets and liabilities of Sun Co. on this date at
their book values and fair values are as follows (in
thousands):
 Example – Pam Corp. Data (continued)

Blank Book Value Fair Value

Cash $ 50 $ 50
Net receivables 150 140
Inventory 200 250
Land 50 100
Buildings, net 300 500
Equipment, net 250 350
Patents 0 50
Total assets $1,000 $1,440
Accounts payable $60 $60
Notes payable 150 135
Other liabilities 40 45
Total liabilities $250 $240
Net assets $750 $1,200
 Acquisition with Goodwill

Pam Corp. pays $400,000 cash and issues 50,000

shares of $10 par common stock with a market
value of $20 per share for the net assets of Sun 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
 Entries with Goodwill

The entry to record the acquisition of the net assets:

Investment in Sun Co. (+A) 1,400 blank

Cash (-A) blank 400
Common stock, $10 par (+SE) blank 500
Additional paid-in-capital (+SE) blank 500

The entry to record Sun’s assets directly on Pam’s

books:
 Entries with Goodwill (continued)
Cash (+A) 50 blank
Net receivables (+A) 140 blank
Inventories (+A) 250 blank
Land (+A) 100 blank
Buildings (+A) 500 blank
Equipment (+A) 350 blank
Patents (+A) 50 blank
Goodwill (+A) 200 blank
Accounts payable (+L) blank 60
Notes payable (+L) blank 135
Other liabilities (+L) blank 45
Investment in Sun Co. (-A) blank 1,400
 Acquisition with Bargain Purchase

Pam 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 Sun 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
 Entries with Bargain Purchase

The entry to record the acquisition of the net assets:

Investment in Sun Co. (+A) 1,000 blank
10% Note payable (+L) blank 200
Common stock, $10 par (+SE) blank 400
Additional paid-in-capital (+SE) blank 400

The entry to record Sun’s assets directly on Pam’s books:

 Entries with Bargain Purchase (continued)
Cash (+A) 50 blank
Net receivables (+A) 140 blank
Inventories (+A) 250 blank
Land (+A) 100 blank
Buildings (+A) 500 blank
Equipment (+A) 350 blank
Patents (+A) 50 blank
Accounts payable (+L) blank 60
Notes payable (+L) blank 135
Other liabilities (+L) blank 45
Investment in Sun Co. (+A) blank 1,000
Gain from bargain purchase (G, +SE) blank 200
 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.
 Goodwill Impairment Testing
Firms must test for the impairment of goodwill at
the business unit reporting level.
– Step 1: Compare the unit’s net book value to
its fair value to determine if there has been a
loss in value.
– Step 2: Determine the implied fair value of the
goodwill in the same manner used to originally
record the goodwill, and compare to the
goodwill on the books.
Record a loss if the implied fair value is less than
the carrying value of the goodwill.
 When to Test for Impairment
Goodwill should be tested for impairment at least
annually.
More frequent testing may be needed if:
Significant adverse change in business
– Adverse action by regulator
– Unanticipated competition
– Loss of key personnel
Impairment or expected disposal losses of:
– Reporting unit or part of one
– Significant long-lived asset group
– Subsidiary
 Business Combination Disclosures
Business combination disclosures include, but are
not limited to, the following:
– General information including company names
and description
– Reason for combination
– Nature and amount of consideration
– Allocation of purchase price among assets and
liabilities
– Pro-forma results of operations
– Goodwill or gain from bargain purchase
 Intangible Asset Disclosures
Specific disclosures are needed
– In the fiscal period when intangibles are acquired,
– Annually, for each period presented, and
– In the fiscal period that includes an impairment.

Disclosures are needed for:

– Intangibles which are amortized,
– Intangibles which are not amortized,
– Research & development acquired, and
– Intangibles with renewal or extension terms.
 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.
 Tugas
• E1-4
P1-3