CHAPTER Business Combinations: America’s Most Popular Business Activity, Bringing an End to the...

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


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.


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


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


Economic Advantages of Combinations(continued)

Additional tax benefits:

• Tax losses are transferable in a business combination.

• Combined operations may reduce taxable income.


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


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).


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


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.


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


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


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


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)



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


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


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


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


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


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


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


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


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)


$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



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


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


• 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


• 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)


• 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


• 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


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)


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

CHAPTER Business Combinations: America’s Most Popular Business Activity, Bringing an End to the...

Documents

Transcript of CHAPTER Business Combinations: America’s Most Popular Business Activity, Bringing an End to the...