beams10e ch01 business combinations[1]
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Chapter 1: Business Combinations
Advanced Accounting, 10th edition
by Floyd A. Beams, Robin P. Clement,
Joseph H. Anthony, and SuzanneLowensohn
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1: ECONOMIC MOTIVATIONS
Business Combinations
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A BUSINESS COMBINATION IS THE UNION OFPREVIOUSLY SEPARATE BUSINESS ENTITIES
Horizontal integration is the combination offirms in the same business lines and markets.
Vertical integration is the combination of firms
with operations in different, but successive,stages of production and/or distribution.
Conglomeration is the combination of firms
with unrelated and diverse products and/orservice functions.
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Reasons for Combinations
Cost advantage
Lower risk
Fewer operating delays
Avoidance of takeovers
Acquisition of intangible assets
Other: business and other taxadvantages, personal reasons
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2: FORMS OF BUSINESSCOMBINATIONS
Business Combinations
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Legal Form of Combination
Merger
Occurs when one corporation takes over allthe operations of another business entityand that other entity is dissolved.
Consolidation
Occurs when a new corporation is formed
to take over the assets and operations oftwo or more separate business entities anddissolves the previously separate entities.
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A Stock acquisition
Occurs when one company acquires the votingshares of another company and the twocompanies continue to operate as separate, butrelated, legal entities.
The acquiring company need not acquire all the
other companys stock to gain control. The relationship that is created in a stock
acquisition is referred to as a parent-subsidiaryrelationship.
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Legal Form of Combination
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Business Combination
Merger
Acquisitions
Consolidation
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A
B
A
Merger
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AA Company
BB Company
Stock Acquisition
AA Company
BB Company
The Legal Form ofBusiness Combinations
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Consolidations: E + F = D
1) Company D is formed and acquires theassets of Companies E and F by issuingCompany D stock. Companies E and F are
dissolved. Company D survives, with theassets and liabilities of both dissolved firms.
2) Company D is formed acquires Company Eand F stock from their respectiveshareholders by issuing Company D stock.Companies E and F are dissolved. CompanyD survives with the assets and liabilities ofboth firms.
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3: ACCOUNTING FORBUSINESS COMBINATIONS
Business Combinations
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Much of the controversy concerning accountingrequirements for business combinations historicallyinvolved the pooling of interest method.
ARB No. 40introduced an alternative method:the purchase method.
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Major conclusions In May, 2001, the FASB issued Statement141 which reaffirmed the business combination concept withthe following exception:
The pooling of interest method of accounting was
eliminated for all transactions initiated after June 30,2001.
Prior combinations accounted for by the pooling ofinterests method will be allowed to continue as
acceptable financial reporting practice for past businesscombinations.
FASB Statement 141 makes U. S. GAAP more consistentwith international accounting standards. Most majoreconomies, including France, Japan, and Germany
prohibit the use of pooling of interests accounting
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International Accounting
Most major economies prohibit the use ofthe pooling method.
The International Accounting StandardsBoard issued IFRS3, on March 31, 2004,requiring business combination to be
accountedfor using the purchase
method.
IFRS3 specifically prohibits the pooling
of interest method.
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Application of the purchase method:
Cost in a purchase business combination is measuredby the cash disbursed, or the fair value of propertygiven up, or securities issued.
Direct costs of acquisition:1. Direct costs of registering and issuing securities are
charged against additional paid-in capital.
2. Other direct costs of combining are included in the
cost of the acquired company.3. Indirect costs and costs to close duplicate facilities
are expensed
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Recording Guidelines (1 of 2)
Record assets acquired and liabilitiesassumed using the fair value principle.
If equity securities are issued by the
acquirer, charge registration and issue costsagainst the fair value of the securities issued,usually a reduction in additional paid-in-capital.
Charge other direct combination costs (e.g.,legalfees, findersfees) and indirectcombination costs (e.g., managementsalaries) to expense.
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Recording Guidelines (2 of2)
When the acquiring firm transfers its assets otherthan cash as part of the combination, any gain orloss on the disposal of those assets is recorded
in current income. The excess of cash, other assets and equity
securities transferred over the fair value of the netassets (A L) acquired is recorded as goodwill.
If the net assets acquired exceeds the cash, otherassets and equity securities transferred, a gain onthe bargain purchase is recorded in currentincome.
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Example: Poppy Corp. (1 of3)
Investment in Sunny Corp. 1,600,000
Common stock, $10 par 1,000,000
Additional paid-in-capital 600,000
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Poppy Corp. issues 100,000 shares ofits $10 par value common stock for
Sunny Corp. Poppys stock is valued at$16 per share.
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Example: Poppy Corp. (2 of 3)
Investment expense 80,000
Additional paid-in-capital 40,000
Cash 120,000
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Poppy Corp. pays cash for $80,000 in finders feesand consulting fees and for $40,000 to registerand issue its common stock. (in thousands)
Sunny Corp. is assumed to have been dissolved.
So, Poppy Corp. will allocate the investments costto the fair value of the identifiable assets acquiredand liabilities assumed. Excess cost is goodwill.
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Example: Poppy Corp. (3 of 3)
Receivables XXX
Inventories XXX
Plant assets XXXGoodwill XXX
Accounts payable XXX
Notes payable XXX
Investment in Sunny Corp. 1,600,000
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4: COST ALLOCATIONS USINGTHE ACQUISITION METHOD
Business Combinations
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Determine the fair values of all identifiable
tangible and intangible assets acquiredand liabilities assumed.
FASB Statement No. 141 provides guidelinesfor assigning amounts to specific categories
of assets and liabilities.
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No value is assigned to goodwill recordedon the books of an acquired subsidiary.
Such goodwill is an unidentifiable asset.
Goodwill resulting from thecombination is valued directly.
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Investment cost
Total fair value ofidentifiable assets
less liabilities
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Investment cost Net fair value>
Goodwill
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Identifiable netassets accordingto their fair value
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Book Value.FairValue.Cash $ 50 $ 50
Net receivables 150 140Inventory 200 250Land 50 100Buildings, net 300 500
Equipment, net 250 350Patents 0 50
Total assets $1,000 $1,440Accounts payable $ 60 $ 60
Notes payable 150 135Other liabilities 40 45
Total liabilities $ 250 $ 240Net assets $ 750 $1,200
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Entries with Goodwill
The entry to record the acquisition of the netassets:
The entry to record Seeds assets directly onPitts books:
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Investment in Seed Co. 1,400,000
Cash 400,000
Common stock, $10 par 500,000
Additional paid-in-capital 500,000
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Illustration of a Purchase
Combination
Cash 50
Net receivable 140Inventories 250Land 100Buildings, net 500
Equipment, net 350Patents 50
Accounts payable 60
Notes payable 135
Other liabilities 45Investment inSeed Company 1,400
$1640 1,440 = 200
Goodwill 200
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Illustration of a Purchase
Combination
Pitt issues 40,000 shares of its $10 par commonstock with a market value of $20 per share andalso gives a 10%, five-year note payable for
$200,000 for the net assets of Seed Company.
40,000 $10 = $400,000
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Investment in Seed 1,000,000
Common Stock 400,000Additional Paid-in Capital 400,00010% Note Payable 200,000
To record issuance of 40,000 shares of $10 parcommon stock plus $200,000, 10% note in a
purchase business combination with Seed Company
Illustration of a Purchase
Combination
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Illustration of a Purchase
Combination
Cash 50
Net receivable 140Inventories 250Land 80Buildings, net 400
Equipment, net 280Patents 40
Accounts payable 60
Notes payable 135
Other liabilities 45Investment inSeed Company 1,000
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Illustration of a Purchase
Combination
Cash 50
Net receivable 140Inventories 250Land 80Buildings, net 400Equipment, net 280
Patents 40
Accounts payable 60
Notes payable 135
Other liabilities 45Investment inSeed Company 1,000
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Illustration of a Purchase
Combination
$1,200,000 fair value is greater than $1,000,000
purchase price by $200,000.
Amounts assignable to assets are reduced
by 20%.
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The goodwill controversy
GAAP defines goodwill as the excess of the investment cost
over the fair value of assets received.
Theoretically, is is a measure of the present value of the
combined companys projected future excess earnings over thenormal earnings of a similar business.
Therefore, the amount that generally capitalize as goodwill is
the portion of the purchase price left over after all other
identifiable tangible and intangible assets and liabilities have
been valued.
Error in the valuation of other assets will affect the amount
capitalize as goodwill.
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The Goodwill Controversy
UnderFASB Statements No. 141 and No. 142,
the FASB requires that firms periodically assessgoodwill for impairment of its value.
An impairment occurs when the recorded valueof goodwill is less than its fair value.
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Carrying values
Compare
Fair values
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Fair value Carrying amount