CHAPTER FOUR

Business Combinations
Business Combination
It refers to a transaction in which an acquirer obtains control over one or more
businesses.
Business Combination has two key aspects(characteristics):
control and

businesses

 Control:
Control is the power to direct the relevant activities of the investee.
It requires that the investor has the ability to use its power over the
investee to affect the amount of the investor’s returns.
Owning more than 50% of the voting shares usually, but not always,
indicates control
A company could have control with less than 50% of the voting shares
when contractual agreements give it control.
Business Combination
A business :
The acquiree has to be a business
Business consists of inputs and processes applied to those inputs
that have the ability to create outputs
Buying a group of assets that do not constitute a business is a
basket purchase, not a business combination
Business Combination

 Control over other companies can be obtained by

acquiring all of the target company’s assets or by
acquiring more than 50% of the target company’s
outstanding voting common stock.

 Purchase of a group of idle assets is not a business

combination .
Nature of the Combination

Combinor/ Combinee/
Acquirer Acquiree/
Target

Constituent
Companies
Business Combinations: Why?

1. Rapid expansion
• Business growth Can occur internally – adding facilities and expanding
markets or externally – by acquiring other companies.
2. Operating synergies
 Revenues
• Increase market power/eliminate competition
• Better/more efficient marketing efforts
• Strategic benefits such as entry into new markets
Operating costs (cost advantage or saving)
• Economies of scale (marketing, management, production, distribution)
• Complementary resources (avoid duplicate efforts)
• Eliminate operating or management inefficiencies
Business Combinations: Why?
3. International marketplace
4. Financial synergy
• Income tax-tax gain (savings) through accumulated tax losses
• Utilization of unused debt capacity
• Reinvestment of surplus funds (free cash flows) as an alternative to
paying dividends or repurchasing stock
5. Diversification: through conglomerate operations
Types of Combinations

A business combination may be classified as follows:

1. Nature of the combination

Friendly - the boards of directors of the potential

combining companies negotiate mutually agreeable terms
of a proposed combination.
Unfriendly (hostile) - the board of directors of a company
targeted for acquisition resists the combination.
Types of Combinations

Defensive Tactics against Hostile takeover

1. Issuing stock rights to existing shareholders; exercisable
Poison pill:
only in the event of a potential takeover.

2. Greenmail: Purchasing (own)shares held by acquiring company at a

price substantially in excess of fair value. The stocks then
acquired are kept at treasury or retired

3. White knight:
Encouraging a third firm to acquire or merge with the
target company.
Types of Combinations

Defensive Tactics (continued)

1. Pac-man defense: Attempting an unfriendly takeover

of the would-be acquiring company.

2. Selling the crown jewels/Scorched Earth: Selling

valuable assets to make the firm less attractive to
the would-be acquirer.
Types of Combinations

Defensive Tactics (continued)

6. Shark repellent: An acquisition of substantial amounts of
outstanding common stocks for treasury or for retirement, or the
incurring of substantial long-term debt in exchange for outstanding
common stock.

7. Leveraged buyouts: Purchasing a controlling interest in the target firm

by its managers and third-party investors, who usually incur
substantial debt.
Types of Combinations
2. Economic Structure of Combination

Horizontal Integration -Combination between companies that

are competitors, within the same industry. For example, two

airline companies combine or two computer software companies

combine.

Vertical Integration - Combination between companies in

different but successive stages of production or distribution. For

example, a manufacturing company merges with a mining

company or an automobile company acquires automobile

dealerships.
Types of Combinations

Conglomerate- Combination between companies in unrelated industries or markets. This

is a procedure for companies that want to diversify. For example, a manufacturing
company acquires a financial services company.
Types of Combinations

3. Method of Acquisition/Legal Form

A. Statutory Merger
One company acquires all the net assets of another company.
The acquiring company survives, whereas the acquired company
ceases to exist as a separate legal entity.
The acquired company’s assets and liabilities are transferred to the
acquiring company, and the acquired company is dissolved, or liquidated .

A Company

A Company
B Company
Terminology and Types of Combinations
B.Statutory Consolidation
Is a business combination in which both combining companies are
dissolved and the assets and liabilities of both companies are transferred to a
newly created corporation.
Neither of the combining companies remains in existence after a statutory
consolidation.
Stockholders of A and B become stockholders in C.

A Company

C Company

B Company
Terminology and Types of Combinations
C. Stock Acquisition

•The stock acquisition can be made at stock market or through bid

but not statutory
•Ifa company acquires a controlling interest in the voting stock of
another company, a parent–subsidiary relationship results.
• This is the Common means of hostile takeover

A Company A Company

B Company B Company
Accounting for Business Combinations

Acquisition Method of Accounting

Acquisition Method for business combinations requires determination of:
1. The acquirer
2. Acquisition date: closing date(The acquisition date is the date the
acquirer obtains control of the acquiree.)
3. The consideration transferred on acquisition date( cost of acquiree)
4. Measure the fair value of the acquiree.
5. Measure and recognize the assets, including goodwill acquired and
liabilities assumed at FV.
Acquisition Method of Accounting

1. Determine the combinor(acquirer):

b. If cash or other assets are distributed or liabilities are incurred as
consideration for the aquiree, the entity that distributes cash or
other assets or incurs liabilities is generally the acquiring entity.
c. If stock is exchanged, the entity that issues the equity interests or receive
larger share of voting rights in the combined enterprise is generally the
acquiring entity.
Acquisition Method of Accounting
1. Determining the Purchase Price of aquireee
 The Total Cost of Combinee ( Fair value of consideration transferred)
include:
Any cash paid by acquirer
 Fair value of non cash assets transferred by the acquirer
Present value of any liability incurred by acquirer
Fair value of any shares issued by acquirer
Fair value of contingent consideration
Contingent consideration
• Contingent consideration is an add-on to the acquisition
price that is based on events occurring or conditions
being met some time after the purchase takes place.
• The amount of contingent consideration can be based
on a number of factors, such as:
• The profitability of acquired company;
• Market price for the acquirer’s shares
• Fair value of any contingent consideration based on
securities prices do not affect the cost of the investment
above what was recorded at the acquisition date, but
instead represent adjustments to additional paid in
capital
Incidental/Out-of-Pocket Costs incurred in connection with
acquisition
Acquisition expenses
Direct Expenses (Legal, Investment banker
consulting fees Accounting fees such as for a
purchase investigation, Finders’ fees, Travel costs

Indirect Expenses Labor and overhead of internal

acquisitions or merger department & General
expenses diverted to the merger (costs of closing
duplicate facilities, salary for officers involved in the
negotiation & completion of the combination)
Securities Issuance Costs
(legal, under-writing, banking) Such costs are merely
related to the stock issued as consideration
Measurement of combinee’s assets and liablities
• All of the acquiree’s identifiable assets and liabilities must be
recognized and measured at fair value at the date of
acquisition.
• Goodwill is the excess of total consideration given over the
fair value of identifiable assets and liabilities
• Negative goodwill could result recorded as a gain on
purchase by the acquiring company
• Incidental costs incurred in relation to B.C are directly
expensed except those for the issuance of stock
• Issuance costs of stock issued in a combination recorded as
a reduction of additional paid-in capital( premium capital)
• indirect incidental costs such as management salaries.
incurred to close the B.C deal are also expensed.
Terminology and Types of Combinations

What Is Acquired? What Is Given Up?

Net assets of S Company

1. Cash
(Assets and Liabilities) Figure 1-1
Statutory Merger 2. Debt
Common Stock 3. Stock
of S Company 1. Combination of above
Stock Aquisisiton
Asset acquisition, a firm must acquire 100% of the assets of the other firm.
Both assets and liability of acquire are recorded at FV on the book of
acquirer including GW if any.
Stock acquisition, control may be obtained by purchasing >50% of the
voting common stock (or possibly less). Investment is recorded on the
book of acquirer at a cost of Business Combination.
Explanation and Illustration of Acquisition Accounting

Example 1 Statutory Merger : Galaxy Company acquired the assets and

assumed the liabilities( net asset) of Axis Company. Immediately prior to the
acquisition, Axis Company’s balance sheet was as follows:
Explanation and Illustration of Acquisition Accounting

Required : A. Prepare the journal entry on the books of Galaxy

Co. to record the purchase of the assets and assumption of the
liabilities of Axis Co. if the amount paid was $1,680,000 in cash.

Calculation of Goodwill

Fair value of assets $1,944,000

Less: Fair value of liabilities (594,000)
Fair value of net assets 1,350,000
Less: Price paid (1,680,000)

Goodwill $ 330,000
Entry to record business combination

Cash 120,000
Receivables 228,000
Inventory 396,000
Plant and equipment 540,000
Land 660,000
Goodwill 330,000
Liabilities 594,000
Cash 1,680,000

The acquiring company’s own assets and liabilities are not revalued when it
purchases the net assets of the acquired company.
The selling company( Axis Company) records the
transfer of its asset and liability to galaxy company on
its books as follows:

Cash 1,680,000
Liability 540,000
Cash 120,000
Receivable 192,000
Inventory 360,000
Plant and Equipment 480,000
Land 420,000
Gain on sale 648,000
After this entry Axis Company will have
Cash 1,680,000 Common Stock 480,000
Retained earning (420+648) 1,068,000
Other capital 132,0000
Total 1,680,000 1,680,000

When it is subsequently dissolved and cash is distributed to the shareholders:

Common Stock 480,000

Retained earning 1,068,000
Other capital 132,0000
Cash 1,680,000
Explanation and Illustration of Acquisition Accounting

Bargain Purchase
When the fair values of identifiable net assets (assets less liabilities)
exceeds the total cost of the acquired company, the acquisition is a
bargain.
Current standards require:
 fair values be considered carefully and adjustments made as
needed.
 any excess of acquisition-date fair value of net assets over
the consideration paid is recognized in income.
Explanation and Illustration of Acquisition Accounting

Bargain Acquisition -Illustration

When the price paid to acquire another firm is lower than the fair value of
identifiable net assets (assets minus liabilities), the acquisition is referred to as a
bargain.

Any previously recorded goodwill on the seller’s books is eliminated (and

no new goodwill recorded).

A gain is reflected in current earnings of the acquirer to the extent that the
fair value of net assets exceeds the consideration paid.
Explanation and Illustration of Acquisition Accounting

Example 2 Statutory Merger : Repeat the requirement in (A)

assuming that the amount paid was $1,110,000.

Calculation of Goodwill or gain on bargain Purchase

Fair value of assets $1,944,000

Fair value of liabilities 594,000
Fair value of net assets 1,350,000
Price paid 1,110,000
Gain on Bargain purchase $ 240,000
Explanation and Illustration of Acquisition Accounting

Example 2: Entry: Galaxy Book

Cash 120,000
Receivables 228,000
Inventory 396,000
Plant and equipment 540,000
Land 660,000
Liabilities 594,000
Cash 1,110,000
Gain on acquisition 240,000
The selling company( Axis Company) records the transfer
of its asset and liability to galaxy company on its books as
follows:

Cash 1,110,000
Liability 540,000
Cash 120,000
Receivable 192,000
Inventory 360,000
Plant and Equipment 480,000
Land 420,000
Gain on sale 78,000
After this entry Axis Company will have
Cash 1,110,000 Common Stock 480,000
Retained earning (420+78) 498,000
Other capital 132,0000
Total 1,110,000 1,110,000

When it is subsequently dissolved and cash is distributed to the

shareholders :

Common Stock 480,000

Retained earning 498,000
Other capital 132,0000
Cash 1,110,000
Example 3: What if Galaxy Company purchased 100% net
asset of Axis Company in exchange for its 10,000 common
shares , $68 par value , $168 selling price per share instead
of cash
Galaxy Company Entry
Cash 120,000
Receivables 228,000
Inventory 396,000
Plant and equipment 540,000
Land 660,000
Goodwill 330,000
Liabilities 594,000
Common stock 680,000
Premium Capital - Common stock 1,000,000
The selling company( Axis Company) records the transfer of its
asset and liability to galaxy company on its books as follows:

Investment in Galaxy 1,680,000

Liability 540,000
Cash 120,000
Receivable 192,000
Inventory 360,000
Plant and Equipment 480,000
Land 420,000
Gain on sale 648,000
After this entry Axis Company will have
Investment in Galaxy 1,680,000 Common Stock 480,000
Retained earning (420+648) 1,068,000
Other capital 132,0000
Total 1,680,000 1,680,000

When it is dissolved and galaxy share is transferred to individual

shareholders of Axis :

Common Stock 480,000

Retained earning 1,068,000
Other capital 132,0000
Investment in Galaxy 1,680,000
Explanation and Illustration of Acquisition Accounting
Example 4: Stock Acquisition
On January 1, Year 1, Big Company exchanged 10,000 shares of $10 par value
common stock with a fair value of $415,000 for 100% of the outstanding stock of
Sub Company in a business combination properly accounted for as an acquisition.
After combination , both company continue to be separate legal entity. In addition
Big Co. paid $35,000 in legal fees. At the date of acquisition, the fair value of Sub
Co.'s net assets totaled $300,000 [=600,000-300,000]. Stock registration fees were
$20,000. Journal entry to record the acquisition:

Investment in Sub net asset……………………….415,000

Legal expense……………………..……………....35,000
Common stock……………………………………………….100,000
Additional paid-in capital [315,000-20,000]………………295,000
Cash [=35,000 + 20,000]…………………………………..…55,000
 Exercise-1
On December 31, 20X5, purchase ltd. acquired all of the assets and liabilities of
target Ltd by issuing 40,000 common stock to target company share holders.
The market value of Purchase Ltd.’s shares is $30 each. The balance sheet of
the two companies before B.C is summarized below;
Required:
a. Compute Goodwill/ gain on bargain purchase
b. Record the purchase of target Ltd on the books of Purchase
Ltd.
c. Prepare post B.C balance sheet for Purchase Ltd.
d. Compute gain/loss for Target on sale of its asset and liability
e. Record sale of asset and liability for Target Company
f. What if Purchase Ltd. acquired 100% outstanding shares of
Target Ltd by issuing 40,000 common stock of its own?
• Exercise-2 Assume that on January 1, Year 2, A Company pays $95,000 in cash to B
Corporation for all of the net assets of that company, and that no other direct costs are
involved. The balance sheet before B.C is as follows:

a. Compute Goodwill/ gain on bargain purchase

b. Record the purchase of target Ltd on the books of Purchase Ltd.
c. Prepare post B.C balance sheet for A company Ltd.
Exercise-3 : On 1 July 20x1, Diamond Co and Gold Co concluded an agreement
that Gold Co will transfer its assets and liabilities to Diamond Co in exchange
for the following considerations:
1. Immediate payment of cash of $5,000,000.
2. Issue of 1,000,000 ordinary shares of Diamond Co to Gold Co on 1 July
20x1, the fair value per share of Diamond Co was $10 per share.
3. Transfer of land. The fair value of the land on 1 July 20x1 was $30,000,000
4. Additional contingent payment by Diamond Co to Gold Co if the business
achieves the following profit benchmarks during the financial year ending 31
December 20x2:
Benchmarks Payment Probability
Profit greater than $30,000,000 $6,000,000 0.60
Profit between $15,000,000 and $30,000,000 3,000,000 0.30
Profit below $15,000,000 0 0.1
The cost of capital of Diamond Co was 5% per annum

The balance sheet of Gold Co. is summarized in the next slide

Gold Company Balance sheet
Required:

a. Compute goodwill/ gain on bargain purchase

b. Record the purchase of gold company's asset and liability

on the books of diamond co:

c. What if Diamond company acquired 100% outstanding

shares of Gold company.

d. What if Gold segment under business unit of Diamond

company made a profit of $32,000,000 on December
31,20X2