The McGraw-Hill Companies, Inc.

2006 McGraw-Hill/Irwin
Chapter 5
Business
Combinations
2
Definitions
According to the FASB, a business
combination is an event or a procedure, in
which, an entity acquires net assets that
constitute a business or acquires equity
interests of one or more other entities and
obtains control over that entity or entities.
Commonly, business combinations are often
referred to as mergers and acquisitions.
3
Definitions
Combined Enterprise: The accounting entity that
results from a business combination.
Constituent Companies: The business enterprises
that enter into a business combination.
Combinor: A constituent company entering into a
purchase-type business combination whose owners as
a group end up with control of the ownership interests
in the combined enterprises.
Combinee: A constituent company other than the
combinor in a business combination.
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Business Combinations:
Why And How?
In recent years Growth has been main
reason for business enterprises to
enter into a business combination.
There could be many more reasons.
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Business Combinations:
Why And How?
The external method of achieving
growth is more rapid than growth
through internal methods.
Obtaining new management strength
or better use of existing management.
6
Types of Business Combinations
Horizontal: A combination involving
enterprises in the same industry.
Vertical: A Combination involving an
enterprise and its customers or suppliers.
Conglomerate: A combination between
enterprises in unrelated industries or markets.
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Methods for Arranging Business
Combinations
Statutory Merger
Statutory Consolidation
Acquisition of Common Stock
Acquisition of Assets
8
Statutory Merger
The boards of directors of the constituent companies
approve a plan for the exchange of voting common
stock (and perhaps some preferred stock, cash or long-
term debt) of one of the corporations (the survivor) for
all the outstanding voting common stock of the other
corporations.
Stockholders of all constituent companies must
approve the terms of the merger.

9
Statutory Merger
Company A acquires Company B then
dissolves B and liquidates B
Company B cease to exist as separate legal
entities
Company B (dissolved) often continues as a
division of the survivor (A)
, which now owns the net assets, rather than
the outstanding common stock, of the
liquidated corporations.
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Statutory Consolidation
A new corporation is formed to issue its
common stock for the outstanding common
stock of two or more existing corporations,
which then go out of existence.
The new corporation thus acquires the net
assets of the defunct corporations, whose
activities may be continued as divisions of the
new corporation.
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Acquisition of Common Stock
One corporation (the investor) may issue
preferred or common stock, cash, debt or
a combination thereof to acquire from
present stockholders a controlling
interest in the voting common stock of
another corporation (the investee).
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Acquisition of Common Stock
Stock acquisition program may be
accomplished through
Direct acquisition in the stock market
Negotiations with the principal
stockholders of a closely held corporation
13
Acquisition of Common Stock
A controlling interest in the combinees voting
common stock is acquired,
Corporation becomes affiliated with the
combinor parent company as a subsidiary
but is not dissolved and liquidated and remains
a separate legal entity.
14
Acquisition of Assets
Business enterprise may acquire from another
enterprise all or most of the gross assets or net assets
of the other enterprise for cash, debt, preferred or
common stock, or a combination thereof.
The transaction must be approved by the boards of
directors and stockholders or other owners of the
constituent companies.
The selling enterprise may continue its existence as a
separate entity or it may be dissolved and liquidated, it
does not become an affiliate of the combinor.
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Computation of Cost of a Combinee
The cost of a combinee in a business
combination accounted for by the purchase
method is the total of:
1. The amount of consideration paid by the combinor.
2. The combinors direct out-of-pocked costs of the
combination.
3. Any contingent consideration that is determinable
on the date of the business combination.
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Amount of Consideration
This is the total amount of cash paid, the
current fair value of other assets distributed,
the present value of debt securities issued, and
the current fair (or market) value of equity
securities issued by the combinor.
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Direct Out-Of-Pocket Costs
Included in this category are some legal fees,
some accounting fees and finders fees.
A finders fee is paid to the investment banking
firm or other organization or individuals that
investigated the combinee, assisted in
determining the price of the business
combination, and otherwise rendered services
to bring about the combination.
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Direct Out-Of-Pocket Costs
Costs of registering with SEC and issuing debt
securities are not direct costs of the business
combination but are offset against the proceeds from
the issuance of the securities.
Indirect out-of-pocket costs of the combination, such
as salaries of officers of constituent companies
involved in negotiation and completion of the
combination, are recognized as expenses incurred by
the constituent companies.
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Contingent Consideration
Contingent consideration is additional cash,
other assets, or securities that may be issuable
in the future
Contingent on future events such as a
specified level of earnings or a designated
market price for a security that had been
issued to complete the business combination.
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Allocation Of Cost Of A Combinee
The cost of a combinee in a business
combination must be allocated to assets
(other than goodwill) acquired and liabilities
assumed based on their estimated fair values
on the date of the combination.
Any excess of total costs over the amounts
thus allocated is assigned to goodwill.
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Negative Goodwill
Excess of the current fair values over total cost
is applied pro rata to reduce (but not below
zero) the amounts initially assigned to financial
assets
Other than investments accounted for by the
equity method;
22
Example-1
Statutory Merger with Goodwill
On December 31, 2005, M. Company (the
combinee) was merged into S. Corporation
(the combinor or survivor). S. corporation
issued 150,000 shares of its $10 par common
stock (current fair value $25 a share) to M.
companys stockholders for all 100,000 issued
and outstanding shares of M. companys no-
par $10 stated value common stock.
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Example-1
Statutory Merger with Goodwill
In addition, S. corporation paid the following out-
of-pocket costs associated with the business
combination:
Direct out-of-pocket costs, $66,250
Indirect out-of-pocket costs, 133,750
Immediately, prior to the merger, M. Companys
condensed balance sheet was as follows:
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Example-1
Statutory Merger with Goodwill
Balance sheet
Assets Liabilities & S.H.E
Current asset$1,000,000 Current liabilities.$500,000
Plant asset (net).3,000,000 Long-term Debt..1,000,000
Other assets... 600,000 Common stock 1,000,000
Total assets..$4,600,000 Additional Paid-in 7,00,000
Retained Earnings.1,400,000
Total.$4,600,000
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Example-1
Statutory Merger with Goodwill
The board of directors of S. Corporation determined the
current fair values of M. Company s identifiable assets
and liabilities (identifiable net assets) as follows:

Current assets..$1,150,000
Plant assets 3,400,000
Other assets 600,000
Current liabilities (500,000)
Long-term Debt (present value). (950,000)
Identifiable net assets of combinee $3,700,000
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Example-1
Statutory Merger with Goodwill
Required
1. In the accounting records of S. Corporation, record
a) The merger with M. company
b) Out-of-pocket costs.
c) Allocate the total cost of liquidated M. Co to identifiable
assets, liabilities and goodwill.
2. In the accounting records of M. Company, record the
dissolution and liquidation of the company.
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Example-2
Acquisition of Net Assets
On December 31, 2005, Davis Corporation acquired all of
the net assets of Fairmont Corporation directly from
Fairmont for $400,000 cash in a business combination.
Davis paid legal fees of $40,000 in connection with the
business combination

Condensed balance sheet for Fairmont prior to the
business combination, with related current fair value
data, is presented below:
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Example-2
Acquisition of Net Assets

Carrying Current
Amount Fair Value
Assets
Current Asset. $190,000 .$200,000
Investment in Mkt Debt Sec 50,000 60,000
Plant asset (net) ,. 870,000 .. 900,000
Intangible assets (net) 90,000........100,000
Total assets .............$1,200,000...$1,260,000
Liabilities & Stockholders' equity
Current liabilities $240,000..$240,000
Long-term Debt..500,000.. 520,000
Total 740,000..$760,000
Common stock, $1 par..600,000
Deficit.(140,000)
Total $1,200,000
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Example-2
Acquisition of Net Assets
Required
1. Determine the amount of bargain purchase excess
(negative goodwill).
2. Prorate the bargain purchase excess to plant assets
and intangible assets
3. Prepare journal entries for Davis corporations
acquisition of net assets.
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Example-3
Statutory Consolidation
The new corporation recognizes net assets from
the combinor at their carrying amount in the
combinors accounting records, net assets
acquired from the combinee are recognized by
the new corporation at their current fair value.

Assume the following balance sheets of the
constituent companies involved in a statutory
consolidation on December 31, 2005.
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Example-3
Statutory Consolidation

Lamson Donald
Corporation Company
Assets
Current Asset. $600,000 .$400,000
Plant asset (net) , 1,800,000 1,200,000
Other assets 400,000.......300,000
Total assets .............$2,800,000..$1,900,000
Liabilities & Stockholders' equity
Current liabilities $400,000..$300,000
Long-term Debt..500,000.. 200,000
Common stock, $10 par 430,000..$620,000
Additional Paid-in capital..300,000 400,000
Retained Earnings 1,170,000... 380,000
Total $2,800,000 $1,900,000
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Example-3
Statutory Consolidation
The current fair values of both companies liabilities were equal to
carrying amounts. Current fair values of identifiable assets were
as follows for Lamson and Donald, respectively:
Current assets, $800,000 and $500,000; plant assets, $2,000,000
and $1,400,000; other assets, $500,000 and $400,000.
On December 31, 2005, in a statutory consolidation approved by
stockholder of both constituent companies, a new coporation,
LamDon corporation issued 74,000 shares of no-par, no-stated
value common stock with an agreed value of $60 a share. In
addition the board of directors assigned goodwill for each as
company as follows:
Lamson$180,000
Donald. $60,000

33
Example-3
Statutory Consolidation
Required
1. Compute the number of shares of commons stock
issued to each of the constituent company.
2. Record the consolidation of Lamson and Donald
3. Record the out-of-pocket costs paid:
Direct..$110,000
Indirect$90,000
4. Allocate the total cost of investment to identifiable
assets and liabilities of Lamson an Donald