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CHAPTER
Business Combinations: America’s Most Popular
Business Activity, Bringing an End to the Controversy
Fundamentals of Advanced Accounting 1st Edition
Fischer, Taylor, and Cheng
11
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #2
• All acquisitions of one firm by another
• Two categories of business combinations:
1) Merger
2) Consolidation
Business Combinations
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #3
Merger vs. Consolidation
Merger
• Existing company acquires another company
• Acquired company’s operations are merged with its own.
Consolidation
• Two or more previously separate firms are combined into one new company.
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #4
Economic Advantages of Combinations
Combinations utilize economies of scale
• Horizontal combinations – firms with similar functions
• Vertical combinations – firms at different levels in marketing chain
• Conglomerates – dissimilar businesses
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #5
Economic Advantages of Combinations(continued)
Defer capital gains on sale of stock• Owner accepts Purchaser’s stock in
exchange for their stock• Structure combination as “tax-free”
reorganization• New shares are at basis of old shares• Taxable to owner when new shares are
sold
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #6
Economic Advantages of Combinations(continued)
Additional tax benefits:
• Tax losses are transferable in a business combination.
• Combined operations may reduce taxable income.
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #7
Obtaining Control
Two methods to obtain control of another company:
• Purchase assets of an existing company– May assume liabilities as well
• Purchase > 50% of outstanding voting stock of another company– Parent/subsidiary relationship
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #8
Accounting for Control
• Purchase of “net assets”– Acquiring firm records assets/liabilities
purchased in its own ledger.
• Acquisition of stock– Acquiring firm (parent) records a single
“investment” account– Parent and subsidiary remain separate
legal entities– Parent/subsidiary financial statements are
combined (consolidated).
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #9
Basic Issues in Combinations(continued)
• Purchase versus pooling
– Purchase is group asset acquisition at market values
– Pooling was merging of accounts at book value
• Pooling not allowed after July 1, 2001
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #10
Purchase Method - Valuation
• All assets and liabilities are recorded at Fair Market Value.– First identify and value tangible assets– Next identify and value intangible assets
• Goodwill - Price paid in excess of Fair Market value of the net assets.
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #11
Basic Purchase: Example with Goodwill
Acquisitions, Inc. purchases net assets of Johnson Company:
• Net assets (per books) = $148,000• Purchase price = $350,000 cash• Direct acquisition costs = $10,000• Fair value (current appraisal) of net
assets = $297,000• Goodwill = $63,000
– Cost $360,000 less $297,000 fair value
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #12
Assets Book Value Fair Value
Accounts receivable 28,000 28,000Inventory 40,000 45,000Land 10,000 50,000Buildings (net) 40,000 80,000Equipment (net) 20,000 50,000Patent 15,000 30,000Copyright - 40,000Goodwill 20,000 0Total Assets 173,000 323,000
Liabilities & EquityCurrent liabilities 5,000 5,000Bonds payable 20,000 21,000Total liabilities 25,000 26,000
Net assets 148,000 297,000
Example: Johnson, Inc. Net Asset Values
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #13
Accounts Receivable 28,000
Inventory (fair value) 45,000Land (fair value) 50,000Building (fair value) 80,000Equipment 50,000Patent 30,000Copyright 40,000Goodwill (based on current price) 63,000
Current liabilities 5,000Bonds payable 20,000Bonds payable premium (to fair value) 1,000Cash 360,000
Entry to Record Purchase
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #14
Basic Purchase: Example with GoodwillPurchased with Stock
• Assume same facts as in prior example.
• Acquisitions, Inc. issues $1 par value common stock for the $350,000 purchase price.
Calculation of shares required:
Fair value of shares = $50
Shares required = 7,000 ($350,000 / $50)
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #15
Accounts Receivable 28,000
Inventory (fair value) 45,000Land (fair value) 50,000Building (fair value) 80,000Equipment 50,000Patent 30,000Copyright 40,000Goodwill (based on current price) 63,000
Current liabilities 5,000Bonds payable 20,000Bonds payable premium (to fair value) 1,000Cash 10,000Common Stock (7,000 x $1) 7,000Paid-in Capital in Excess of Par 343,000
Entry to Record Purchase
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #16
Required Disclosures
• Schedule of fair value of accounts
• Name and description of firm purchased
• Reason for purchase
• Cost of acquisition– Valuation of stock (If payment method)
• Contingent payment agreements
• Pro Forma income disclosure
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #17
Entry for Johnson, Inc. (Seller)
Investment in Acquisitions, Inc. Stock 350,000Current liabilities 5,000Bonds payable 20,000
Accounts receivable 28,000Inventory 40,000Land 10,000Buildings 40,000Equipment 20,000Patent 15,000Goodwill 20,000Gain on Sale of Business 202,000
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #18
Accounting for Acquired Assets
• Tangible assets and liabilities – normal depreciation and amortization procedures.
• Intangible assets amortized over useful lives.
• Goodwill is not amortized– Subject to impairment – Tested on an annual basis
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #19
Test: Goodwill is impaired if estimated value of business unit is less than remaining book value of net assets (including goodwill).
New goodwill estimate:Estimated value of business unit
– New estimate of identifiable net assets at fair value= New goodwill estimate
Impairment Loss:Book value of goodwill
– New goodwill estimate= Impairment loss
Goodwill Impairment
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #20
Recording a Bargain Purchase
• Bargain purchase – price of acquisition is less than Fair Value of Net Assets
• No Goodwill exists (none recorded)• Cost of acquisition is allocated to
individual asset and liability accounts.– Priority accounts – always recorded at fair
value– Non-priority accounts – discounted
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #21
Priority Accounts
• All current assets• All liabilities• All investments (exception- controlled
entities)• Excess assets included in purchase• Deferred tax assets and liabilities• Prepaid assets relating to
postretirement benefits
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #22
Price zone analysis – guides assignment of price paid.
Example: Johnson CompanyCalculate the market value net assets:
Fair Value Group Total Cum. Total
Priority Accounts receivable 28,000Inventory 45,000Current liabilities (5,000)Bonds payable (21,000) 47,000 47,000
Non-priority Land 50,000Buildings (net) 80,000Equipment (net) 50,000Patent (net) 30,000Copyright 40,000 250,000 297,000
Total Market Value = $297,000
Price Zone Analysis
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #23
2. Determine the 3 price zones:• Premium: Over $297,000
All accounts at fair value; goodwill for price over $297,000
• Bargain: $47,000 [priority] to $297,000Priority accounts at fair value; balance allocated to nonpriority accounts
• Extraordinary Gain: Below $47,000Priority accounts at fair value; other accounts not recorded; extraordinary gain for excess of priority accounts over price paid
Price Zone Analysis (continued)
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #24
$47,000 for priority accounts; $163,000 allocated to fixed and identifiable intangible assets
Land 50,000 20% 163,000 32,600
Building 80,000 32% 163,000 52,160
Equipment 50,000 20% 163,000 32,600
Patent 30,000 12% 163,000 19,560
Coyright 40,000 16% 163,000 26,080
Allocation Table
Purchase Allocation Bargain Price: $210,000
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #25
Accounts Receivable 28,000
Inventory (fair value) 45,000Land (allocation) 32,600Building (allocation) 52,160Equipment (allocation) 32,600Patent (allocation) 19,560Copyright (allocation) 26,080
Current liabilities 5,000Bonds payable (face value) 20,000Bonds payable premium (to fair value) 1,000Cash 10,000Common Stock (4,000 shares x $1) 4,000Paid-in Capital in Excess of Par 196,000
Purchase Entry Bargain Price: $210,000
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #26
Price is below $47,000; there is no value to assign to fixed and identifiable intangible assets
Accounts receivable 28,000Inventory (fair value) 45,000
Extraordinary gain 7,000Current liabilities 5,000Bonds payable 20,000Bonds pay premium (to fair value) 1,000Cash 10,000Common Stock (600 shares x $1) 600Paid-In Capital in Excess of Par 29,400
Purchase Entry Extraordinary Gain: $30,000 Purchase Price
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #27
• May have to calculate market value of debt issues
• Leases retain classification; related accounts recorded at market value
• Deferred tax liability (DTL) goes with assets in nontaxable exchange
• Tax loss carryover is usually recorded as an asset; if realization is uncertain, it is not recorded and is buried in goodwill
Purchase Complications
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #28
• There may be contingent goodwill payment – Added goodwill is recorded
• Price guarantees cover decline in value of securities issued in purchase – If issued, value assigned to securities is
adjusted
Purchase Complications (continued)
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #29
• Direct acquisition costs are paid to outside parties; include them in the price paid
• Indirect acquisition costs are internally incurred; they are expensed• Issue costs are to issue bonds or stock; they are subtracted from the
value assigned to the securities• Stocks and bonds issued are always recorded at fair value in a purchase
Purchase: Some Fine Points
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #30
• The price paid for a company is $431,000– $6,000 in direct costs– 8,500 shares of $10 par value common stock with a
fair value of $40 per share
Priority Accounts: Fair Value
Inventory 50,000Liabilities (80,000)Non-priority Accounts:Land: Book Value = $100,000 100,000Building: Book Value = $200,000 300,000Deferred tax liability – Bldg. (30,000)
Total $340,000
Example of Tax-Free Exchange
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #31
Example of Tax-Free Exchange - Continued
• The tax rate is 30%• A $30,000 DTL goes with the machine
($100,000 x 30%)
• $91,000 is available for goodwill (net of a 30% DTL)
($431,000 – 340,000)
• Goodwill = $130,000$39,000 (1.0 – .3)
Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 1, Slide #32
Inventory 50,000Land (fair value) 100,000Building (fair value) 300,000Goodwill (gross value) 130,000
Liabilities 80,000Deferred tax liability* 69,000Cash 6,000Common Stock ($10 par, 8500 shares) 85,000Paid-in Capital in Excess of Par 340,000
*$30,000 on Building and $39,000 on goodwill
The DTLs are amortized over the same life (and by the same method) as the assets to which they attach
Tax-Free Exchange: Journal Entry