CH 02

Chapter
2-1
22
Accounting for Business
Combinations
Advanced Accounting, Third Edition

Chapter
2-2
Learning
Learning Objectives
Objectives
1.
Describe the major changes in the accounting for

business combinations proposed by the FASB in June
2005, and the reasons for those changes.
2.
Describe the two major changes in the accounting for

business combinations approved by the FASB in 2001, as
well as the reasons for those changes.
3.
Discuss the goodwill impairment test described in SFAS

No. 142, including its frequency, the steps laid out in
the new standard, and some of the likely implementation
problems.
4.
Explain how acquisition expenses are reported.
5.
Describe the use of pro forma statements in business

combinations.
Chapter
2-3
Learning
Learning Objectives
Objectives
6.
Describe the valuation of assets, including goodwill, and

liabilities acquired in a business combination accounted
for by the acquisition method.
7.
Explain how contingent consideration affects the

valuation of assets acquired in a business combination
accounted for by the acquisition method.
8.
Describe a leveraged buyout.
9.
Describe the disclosure requirements according to the

Exposure Draft No. 1204-01 (June 2005), Business
Combinations, related to each business combination that
takes place during a given year.
Chapter
2-4
Historical
Historical Perspective
Perspective on
on Business
Business Combinations
Combinations
Historically,
Historically two distinct methods of accounting for
business combinations were permitted: purchase and
pooling of interests.
Two New Pronouncements in June 2001:
1. SFAS No. 141, Business Combinations, - pooling
method is prohibited for business combinations initiated
after June 30, 2001.
2. SFAS No. 142, Goodwill and Other Intangible Assets,
- Goodwill acquired in a business combination after June
30, 2001, should not be amortized.
Chapter
2-5
LO 2 FASBs two major changes of 2001.
Historical
Perspective on
on Business
Combinations
Whats New?
Issued on June 30, 2005,
Exposure Draft No. 1204-01, Business

Combinations, would replace FASB Statement No. 141.
Continues to support the use of a single method.
Uses the term acquisition method rather than
purchase method.
All assets and liabilities, on the date the acquirer
obtains control of the acquiree, will be reflected
in the financial statements at fair value.
Chapter
2-6
LO 1 New changes proposed by FASB in June 2005.
Historical
Perspective on
on Business
Combinations
Whats New?
Issued on June 30, 2005,
Exposure Draft No. 1205-001, Consolidated

Financial Statements, Including Accounting and
Reporting of Noncontrolling Interests in Subsidiaries,
will replace Accounting Research Bulletin (ARB) No. 51.
Establishes standards for the reporting of the
noncontrolling interest when the acquirer obtains
control without purchasing 100% of the acquiree.
Additional discussion in Chapter 3.
Chapter
2-7
LO 1 New changes proposed by FASB in June 2005.
Historical
Perspective on
on Business
Combinations
Goodwill Impairment Test
SFAS No. 142 requires impairment be tested annually.
All goodwill must be assigned to a reporting unit.
Impairment should be tested in a two-step process.
Step 1: If fair value is less than the carrying amount
of the net assets (including goodwill), then perform a
second step to determine possible impairment.
Step 2: Determine the fair value of the goodwill
(implied value of goodwill) and compare to carrying
amount.
Chapter
2-8
LO 3 Goodwill impairment assessment.
Historical
Perspective on
on Business
Combinations
E2-11 On January 1, 2007, Porsche Company acquired the
net assets of Saab Company for $450,000 cash. The fair
value of Saabs identifiable net assets was $375,000 on this
date. Porsche Company decided to measure goodwill
impairment using the present value of future cash flows to
estimate the fair value of the reporting unit (Saab). The
information for these subsequent years is as follows:
Year
2008
2009
2010
Chapter
2-9
Present Value
of Future
Cash Flows
$ 400,000
$ 400,000
$ 350,000
* Not including goodwill
Carry Value
of SAAB's
Net Assets *
$ 330,000
$ 320,000
$ 300,000
Fair Value
of SAAB's
Net Assets
$ 340,000
$ 345,000
$ 325,000
Historical
Perspective on
on Business
Combinations
E2-11 On January 1, 2007, the acquisition date, what was
the amount of goodwill acquired, if any?
Acquisition price
$450,000
Fair value of identifiable net assets

Recorded value of Goodwill
Chapter
2-10
375,000
$ 75,000
Historical
Perspective on
on Business
Combinations
E2-11 Part A&B: For each year determine the amount of
goodwill impairment, if any, and prepare the journal entry
needed each year to record the goodwill impairment (if any).
Step 1 - 2008
Fair value of reporting unit
$400,000
Carrying value of unit:

Carrying value of identifiable net assets
Carrying value of goodwill
330,000
75,000
Total carrying value of unit

Excess of carrying value over fair value
405,000
$ 5,000
Excess of carrying value over fair value means step 2 is required.

Chapter
2-11
Historical
Perspective on
on Business
Combinations
E2-11 Part A&B (continued)
Step 2 - 2008
$400,000
340,000
Implied value of goodwill
60,000
75,000
Impairment loss
Journal
Entry
Chapter
2-12
Impairment loss
Goodwill
$ 15,000
15,000
15,000
Historical
Perspective on
on Business
Combinations
Step 1 - 2009
$400,000

320,000
60,000 *

Excess of fair value over carrying value
380,000
$ 20,000
Excess of fair value over carrying value means step 2 is not required.
* $75,000 (original goodwill) $15,000 (prior year impairment)
Chapter
2-13
Historical
Perspective on
on Business
Combinations
Step 1 - 2010
$350,000

300,000
60,000 *

Excess of carrying value over fair value
360,000
$ 10,000
Excess of carrying value over fair value means step 2 is required.

* $75,000 (original goodwill) $15,000 (prior year impairment)
Chapter
2-14
Historical
Perspective on
on Business
Combinations
Step 2 - 2010
$350,000
325,000
Implied value of goodwill
25,000
60,000
Impairment loss
Journal
Entry
Chapter
2-15
Impairment loss
Goodwill
$ 35,000
35,000
35,000
Historical
Perspective on
on Business
Combinations
Review Question
The first step in determining goodwill impairment involves
comparing the
a. implied value of a reporting unit to its carrying
amount (goodwill excluded).
b. fair value of a reporting unit to its carrying amount
(goodwill excluded).
c. implied value of a reporting unit to its carrying
amount (goodwill included).
d. fair value of a reporting unit to its carrying amount
(goodwill included).
Chapter
2-16
Historical
Perspective on
on Business
Combinations
Disclosures Mandated by FASB
SFAS No. 141 requires:
1. The total amount of acquired goodwill and the amount
expected to be deductible for tax purposes.
2. The amount of goodwill by reporting segment (in
accordance with SFAS No. 131, Disclosures about
Segments of an Enterprise and Related Information),
unless not practicable.
Chapter
2-17
Historical
Perspective on
on Business
Combinations
SFAS No. 142 specifies the presentation of goodwill
(if impairment occurs) as follows:
a. The aggregate amount of goodwill should be a separate
line item in the balance sheet.
b. The aggregate amount of losses from goodwill
impairment should be shown as a separate line item in
the operating section of the income statement.
Chapter
2-18
Historical
Perspective on
on Business
Combinations
When an impairment loss occurs, SFAS No. 142
mandates the following disclosures in the notes:
1. A description of the facts and circumstances leading to
the impairment.
2. The amount of the impairment loss and the method of
determining the fair value of the reporting unit.
3. The nature and amounts of any adjustments made to
impairment estimates from earlier periods, if significant.
Chapter
2-19
Historical
Perspective on
on Business
Combinations
Other Required Disclosures
Exposure Draft (ED1204-001) states that disclosure
should include:
The name and a description of the acquiree.
The acquisition date.
The percentage of voting equity instruments acquired.
The primary reasons for the business combination,
including a description of the factors that contributed
to the recognition of goodwill.
Chapter
2-20
LO 9 New disclosure requirements for business combinations.
Historical
Perspective on
on Business
Combinations
Other Required Disclosures
Exposure Draft (ED1204-001) states that disclosure
should include:
The fair value of the acquiree and the basis for
measuring that value on the acquisition date.
The fair value of the consideration transferred.
The amounts recognized at the acquisition date for each
major class of assets acquired and liabilities assumed.
The maximum potential amount of future payments the
acquirer could be required to make.
Chapter
2-21
Historical
Perspective on
on Business
Combinations
Other Intangible Assets
Acquired intangible assets other than goodwill:
Limited useful life
Should be amortized over its useful economic life.
Should be reviewed for impairment.
Indefinite life
Should not be amortized.
Should be tested annually (minimum) for impairment.
Chapter
2-22
Historical
Perspective on
on Business
Combinations
Treatment of Acquisition Expenses
The Exposure Draft requires that:
both direct and indirect costs be expensed.
the cost of issuing securities also be excluded
from the consideration.
Security issuance costs are assigned to the valuation
of the security, thus reducing the additional
contributed capital for stock issues or adjusting the
premium or discount on bond issues.
Chapter
2-23
LO 4 Explain how acquisition expenses are reported.
Historical
Perspective on
on Business
Combinations
ACQUISITION COSTSAN ILLUSTRATION
Suppose that SMC Company acquires 100% of the net assets of Bee
Company (net book value of $100,000) by issuing shares of common
stock with a fair value of $120,000. With respect to the merger,
SMC incurred $1,500 of accounting and consulting costs and $3,000
of stock issue costs. SMC maintains a mergers department that
incurred a monthly cost of $2,000. The following illustrates how
these costs are recorded under proposed GAAP.
ACQUISITION ACCOUNTING:
Professional Fees Expense (Direct)
Merger Department Expense (Indirect)
Other Contributed Capital (Security Issue Costs)
Cash
Chapter
2-24
1,500
2,000
3,000
6,500
LO 4 Explain how acquisition expenses are reported.
Pro
Pro Forma
Forma Statements
Statements and
and Disclosure
Disclosure Requirement
Requirement
Pro forma statements serve two functions in relation
to business combinations:
1) to provide information in the planning stages of
the combination and
2) to disclose relevant information subsequent to
the combination.
Chapter
2-25
LO 5 Use of pro forma statements.
Pro
Pro Forma
Forma Statements
Statements and
and Disclosure
Requirement
P Company Pro Forma Balance Sheet
Giving Effect to Proposed Issue of Common Stock for All the
Net Assets of S Company January 1, 2007
Chapter
2-26
Illustration 2-1
Pro
Pro Forma
Forma Statements
Statements and
and Disclosure
Requirement
If a material business combination occurred, notes to
financial statements should include on a pro forma
basis:
1. Results of operations for the current year as though
the companies had combined at the beginning of the
year.
2. Results of operations for the immediately preceding
period as though the companies had combined at the
beginning of that period if comparative financial
statements are presented.
Chapter
2-27
Explanation
Explanation and
and Illustration
Illustration of
of Acquisition
Acquisition Accounting
Accounting
The Exposure Draft specifies four steps in the
accounting for a business combination:
1. Identify the acquirer.
2. Determine the acquisition date.
3. Measure the fair value of the acquiree.
4. Measure and recognize the assets acquired and
liabilities assumed.
Chapter
2-28
LO 6 Valuation of acquired asset and liabilities assumed.
Explanation
Explanation and
and Illustration
Illustration of
of Acquisition
Accounting
Value of Assets and Liabilities Acquired
Identifiable assets acquired (including intangibles other
than goodwill) and liabilities assumed should be recorded

at their fair values at the date of acquisition.
Any excess of total cost over the fair value amounts
assigned to identifiable assets and liabilities is recorded

as goodwill.
Standards require that R&D costs be expensed as
incurred, however, the Exposure Draft proposes that inprocess R&D that is acquired as part of a business
combination will be capitalized.
Chapter
2-29
Explanation
Explanation and
and Illustration
Illustration of
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.
In the past, FASB required that most long-lived assets be
written down on a pro rata basis before recognizing a gain.
The Exposure Draft advises that:
fair values be reconsidered and adjustments made as
needed.
any excess of acquisition-date fair value of net assets
over the consideration paid is recognized in income.
Chapter
2-30
Explanation
Explanation and
and Illustration
Illustration of
of Acquisition
Accounting
E2-1 Preston Company acquired the assets (except for cash) and
assumed the liabilities of Saville Company. Immediately prior to the
acquisition, Saville Companys balance sheet was as follows:
Any
Goodwill?
Chapter
2-31
Explanation
Explanation and
and Illustration
Illustration of
of Acquisition
Accounting
E2-1 Preston Company acquired the assets (except for cash) and
assumed the liabilities of Saville Company. Immediately prior to the
acquisition, Saville Companys balance sheet was as follows:
Fair value
of assets,
without cash
$1,824,000
Chapter
2-32
Explanation
Explanation and
and Illustration
Illustration of
of Acquisition
Accounting
E2-1 A. Prepare the journal entry on the books of Preston
Co. to record the purchase of the assets and assumption of
the liabilities of Saville Co. if the amount paid was
$1,560,000 in cash.
Calculation of Goodwill
Fair value of assets, without cash
Fair value of liabilities
Fair value of net assets
1,230,000
Price paid
1,560,000
Goodwill
Chapter
2-33
$1,824,000
594,000
$ 330,000
Explanation
Explanation and
and Illustration
Illustration of
of Acquisition
Accounting
E2-1 A. Prepare the journal entry on the books of Preston
Co. to record the purchase of the assets and assumption of
the liabilities of Saville Co. if the amount paid was
$1,560,000 in cash.
Receivables
Inventory
Plant and equipment
Land
Goodwill
Liabilities
Cash
Chapter
2-34
228,000
396,000
540,000
660,000
330,000
594,000
1,560,000
Explanation
Explanation and
and Illustration
Illustration of
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.
Under SFAS No. 141:
the excess of fair value over cost was allocated to
reduce long-lived assets (with certain exceptions).
if long-lived assets were reduced to zero, and still an
excess remained, an extraordinary gain was recognized.
The Exposure Draft, if adopted, will simplify this issue.
Chapter
2-35
Explanation
Explanation and
and Illustration
Illustration of
of Acquisition
Accounting
Bargain Acquisition Illustration

Exposure Draft, if adopted, would require the following:
Any previously recorded goodwill on the sellers books is
eliminated (and no new goodwill recorded).
An ordinary gain is recorded to the extent that the fair
value of net assets exceeds the consideration paid.
Chapter
2-36
Explanation
Explanation and
and Illustration
Illustration of
of Acquisition
Accounting
E2-1 B. Repeat the requirement in (A) assuming that the
amount paid was $990,000.
Calculation of Goodwill or Bargain Purchase

Fair value of assets, without cash
Fair value of liabilities
Fair value of net assets
Price paid
1,230,000
990,000
Bargain purchase
Chapter
2-37
$1,824,000
594,000
$ 240,000
Explanation
Explanation and
and Illustration
Illustration of
of Acquisition
Accounting
E2-1 B. Repeat the requirement in (A) assuming that the
amount paid was $990,000.
Plant and equipment

Land
Fair Value
(A)
$ 540,000
660,000
$ 1,200,000
Receivables
Inventory
Plant and equipment
Land
Liabilities
Cash
Chapter
2-38
Fair Value
Percent
(B)
45%
55%
100%
Bargain
Purchase
Allocation
(C)
$ 108,000
132,000
$ 240,000
228,000
396,000
432,000
528,000
Fair Value
Less
Allocation
(A-C)
$ 432,000
528,000
$ 960,000
594,000
990,000
Contingent
Contingent Consideration
Consideration in
in an
an Acquisition
Acquisition
Purchase agreements may provide that the purchasing
company will give additional consideration to the seller
if certain future events or transactions occur.
The contingency may require
the payment of cash (or other assets) or
the issuance of additional securities.
The Exposure Draft requires that all contingent
consideration in a business combination be measured
and recognized at fair value on the acquisition date.
Chapter
2-39
LO 7 Contingent consideration and valuation of assets.
Contingent
Consideration in
in an
an Acquisition
Acquisition
Adjustments During the Measurement Period
The Exposure Draft defines the measurement period as
the period after the acquisition date during which the
acquirer may adjust the provisional amounts recognized
at the acquisition date.
The measurement period ends as soon as the acquirer has
the needed information about facts and circumstances,
not to exceed one year from the acquisition date.
Chapter
2-40
Contingent
Consideration in
in an
an Acquisition
Acquisition
Contingency Based on Outcome of a Lawsuit
Consideration contingently issuable may depend on both
future earnings and
future security prices.
In such cases, an additional cost of the acquired company
should be recorded for all additional consideration
contingent on future events, based on the best available
information and estimates at the acquisition date (as
adjusted by the end of the measurement period).
Chapter
2-41
Contingent
Consideration in
in an
an Acquisition
Acquisition
Review Question
Which of the following statements best describes the Exposure
Draft with regard to accounting for contingent consideration?
Chapter
2-42
a.
If contingent consideration depends on both future earnings and

future security prices, an additional cost of the acquired company
should be recorded only for the portion of consideration dependent
on future earnings.
b.
The measurement period for adjusting provisional amounts always

ends at the year-end of the period in which the acquisition occurred.
c.
A contingency based on security prices has no effect on the

determination of cost to the acquiring company.
d.
The purpose of the measurement period is to provide a reasonable

time to obtain the information necessary to identify and measure
the fair value of the acquirees assets and liabilities, as well as the
fair value of the consideration transferred.
Leveraged
Leveraged Buyouts
Buyouts
A leveraged buyout (LBO) occurs when a group of
employees (generally a management group) and third-party
investors create a new company to acquire all the
outstanding common shares of their employer company.
The management group:
contributes the stock they hold to the new
corporation and
borrows sufficient funds to acquire the remainder of
the common stock.
The old corporation is merged into the new corporation.
Chapter
2-43
LO 8 Leverage buyouts.
Leveraged
Leveraged Buyouts
Buyouts
The consensus position is that only the portion of the
net assets acquired with the borrowed funds has
actually been purchased and should therefore be
recorded at their cost.
The portion of the net assets of the new corporation
provided by the management group is recorded at book
value since there has been no change in ownership.
Chapter
2-44
Leveraged
Leveraged Buyouts
Buyouts
E2-7 Managers of Bayco own 500 of its 10,000
outstanding common shares. Draco is formed by the
managers of Bayco to take over Bayco in a leveraged
buyout. The managers contribute their shares in Bayco, and
Draco then borrows $50,000 to purchase the remaining
9,500 outstanding shares of Bayco. Bayco is then merged
into Draco. Data relevant to Bayco immediately prior to the
leveraged buyout follow:
Chapter
2-45
Leveraged
Leveraged Buyouts
Buyouts
E2-7 Required: Complete the following schedule showing
the values to be reported in Dracos balance sheet
immediately after the leveraged buyout.
Current assets
$3,000
Plant assets
24,350
Goodwill
23,400
Debt
(1)
(2)
Stockholders equity$50,000
750
(3)
(1) $12,000 + [.95 x ($25,000 $12,000)] = $24,350

(2)
(3) .05 x $15,000 = = $750

Chapter
2-46
Copyright
Copyright
Copyright 2008 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted
in Section 117 of the 1976 United States Copyright Act
without the express written permission of the copyright owner
is unlawful. Request for further information should be
addressed to the Permissions Department, John Wiley & Sons,
Inc. The purchaser may make back-up copies for his/her own
use only and not for distribution or resale. The Publisher
assumes no responsibility for errors, omissions, or damages,
caused by the use of these programs or from the use of the
information contained herein.
Chapter
2-47

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Chapter

Advanced Accounting, Third Edition

Describe the major changes in the accounting for

Describe the two major changes in the accounting for

Discuss the goodwill impairment test described in SFAS

Explain how acquisition expenses are reported.

Describe the use of pro forma statements in business

Describe the valuation of assets, including goodwill, and

Explain how contingent consideration affects the

Describe a leveraged buyout.

Describe the disclosure requirements according to the

LO 2 FASBs two major changes of 2001.

Issued on June 30, 2005,

Exposure Draft No. 1204-01, Business

LO 1 New changes proposed by FASB in June 2005.

Issued on June 30, 2005,

Exposure Draft No. 1205-001, Consolidated

LO 1 New changes proposed by FASB in June 2005.

LO 3 Goodwill impairment assessment.

* Not including goodwill

LO 3 Goodwill impairment assessment.

Fair value of identifiable net assets

LO 3 Goodwill impairment assessment.

Carrying value of unit:

Total carrying value of unit

Excess of carrying value over fair value means step 2 is required.

LO 3 Goodwill impairment assessment.

Fair value of identifiable net assets

Implied value of goodwill

Carrying value of goodwill

LO 3 Goodwill impairment assessment.

Carrying value of unit:

Total carrying value of unit

LO 3 Goodwill impairment assessment.

Carrying value of unit:

Total carrying value of unit

Excess of carrying value over fair value means step 2 is required.

LO 3 Goodwill impairment assessment.

Fair value of identifiable net assets

Implied value of goodwill

Carrying value of goodwill

LO 3 Goodwill impairment assessment.

LO 3 Goodwill impairment assessment.

LO 3 Goodwill impairment assessment.

LO 3 Goodwill impairment assessment.

LO 3 Goodwill impairment assessment.

LO 9 New disclosure requirements for business combinations.

LO 9 New disclosure requirements for business combinations.

LO 9 New disclosure requirements for business combinations.

LO 4 Explain how acquisition expenses are reported.

LO 4 Explain how acquisition expenses are reported.

LO 5 Use of pro forma statements.

LO 5 Use of pro forma statements.

LO 5 Use of pro forma statements.

LO 6 Valuation of acquired asset and liabilities assumed.

Identifiable assets acquired (including intangibles other

than goodwill) and liabilities assumed should be recorded

Any excess of total cost over the fair value amounts

assigned to identifiable assets and liabilities is recorded

Standards require that R&D costs be expensed as

LO 6 Valuation of acquired asset and liabilities assumed.

LO 6 Valuation of acquired asset and liabilities assumed.

LO 6 Valuation of acquired asset and liabilities assumed.