Business Combinations

Chapter 5
Business Combinations
ACCT 501
Objectives of the Chapter
1. To discuss the general view of

business combinations.
2. To learn accounting for business
combinations (purchase versus
pooling methods) on date of
combination for statutory merger
type of business combinations.
Business Combinations 2
3. To discuss the development of

two alternatives for business
combinations from a historical
perspective.
4. Preparing financial statements
following a business
combination for statutory merger
type of business combination.
5. To learn accounting for statutory

consolidation (using purchase
method).
6. To discuss the current
development on business
combination standards.
 Business combinations: events

and transactions in which two or
more business enterprises, or
their net assets, are combined to
be under the control of a single
business entity.
Business Combinations (contd.)
 FASB’s terms for the business
entities involved in the business
combination:
a.Constituent companies : all business
entities enter into a business
combination.
b.Combined enterprise: the business
entity that results from a business
combination.
c.Combinor : a constituent company

whose owners end up to have control
of the ownership interest of the
combined enterprise.
d.Combinee : all other constituent
companies other than the combinor
in a business combination.
Types of Business Combinations
 Friendly takeovers
 Hostile takeovers
Reasons for Business Combinations
 For the combination in a friendly

takeover:
a.Growth.
Through the business combinations,
the product lines can be expanded and
diversified. Also, the market shares
can be enlarged.
Reasons for Business Combinations
(contd.)
b.Obtaining new management strength or
better use of existing management.
c.For the income tax advantages
 For hostile takeovers:

Substantial gains may result from the
sale of business segments of a
combinee following the business
combination.
Four Methods for Carrying Out
1.Statutory Merger
Procedures of statutory merger:
a. The board of directors of the
constituent companies work out the
terms of merger.
b. Stockholders of the constituent
companies approve the terms of the
merger.
c. the survivor issues its common stock
or other consideration to stockholders
of the other constituent companies to
exchange for all their outstanding
voting common shares.
d. The survivor dissolves and liquidates
the other constituent companies.
2. Statutory Consolidation:
a new corporation is formed to issue
its common stock for the outstanding
common stock of all constituent
corporations.
Procedures of statutory consolidation:
a. similar to the statutory merger.
b. similar to the statutory merger.
c. a new corporation is formed to issue
its common stock to the stockholders
of all the constituent companies in
exchanger for all their outstanding
voting common stock.
d. the new corporation dissolves and
liquidates the constituent companies.
3.Acquisition of Common Stock (a
method for most of hostile
takeovers)
Procedures:
a. the combinor received the approval
from its board of directors to acquire
common stock of the prospective
target firm.
b. acquiring target firm’s common stock
in an open market, or through a
tender offer to stockholders of a
publicly owner corporation.
c. When acquiring enough shares to
have the controlling interest in the
combinee’s voting common
shares,the target firm becomes
affiliated with the combinor (the
parent company) as a subsidiary.
The target firm remains as a
separate legal entity.
4. Acquisitions of Assets:
Business entity acquires all or most of
net assets of the other entity (using
cash, debt, stock ……..)
Establishing the Price for a
Business Combination
1. Capitalization of expected average
annual earnings of the combinee at a
desired rate of return.
2. Determination of current fair value of
the combinee’s net assets (including
goodwill).
Methods of Accounting for
 Pooling of Interest Accounting versus
Purchase Accounting
 Definitions:
Accounting Acquisition Premium
(AAP)
= purchase price – book value of the
combinee.
Purchased Goodwill
= AAP – combinee’s assets step-up.
Assets step up
= the fair market value of net assets
of the combinee – the book value of
these net assets.
 Two accounting methods for business
combinations are allowed under APB
Opinion No. 16:
 Pooling-of-interests method (pooling

accounting) :
The acquired firm’s net assets are
consolidated at their existing book
value and any accounting acquisition
premium (AAP) is ignored.
 Purchase method (purchase
accounting):
The acquired net assets are recorded at
their fair market value and the excess of
AAP over the assets step-up is
recognized as goodwill.
In order to adopt the pooling of interests

method to account for the business
combination, 12 conditions must be met
(detailed later).
 Impact of these two accounting
methods on the financial numbers:
 Earnings:
the depreciation associated with any
assets step-up and the amortization of
any purchased goodwill will result in
purchase earnings, in general, to be
less than pooling earnings (i.e., E purchase
< E pooling).
 Book Value:
the book value of the accounting
consolidated net assets under pooling
accounting will typically be less than
those reported under purchase
accounting (i.e., B pooling < Bpurchase ).
Purchase Accounting
 Cost of a Combinee including:
1.the amount of consideration paid by
the combinor to a combinee.
2.the combinor’s direct “out-of-
pocket” costs of the combination,
and
3.contingent consideration which is
determinable on the business
combination date.
Cost of A Combinee (contd.)
 Direct out-of-pocket costs include legal
fees, accounting fees, and finder’s fees.
 Costs of registering with the SEC and
issuing debt securities in a business
combinations are debited to Bond Issue
Costs.
Cost of A Combinee (contd.)
 Cost of registering with the SEC and
issuing equity securities are offset
against the proceeds from the
issuance of the securities.
 Contingent consideration: cash,other
assets,or securities that may be
issuable in the future.
Accounting Treatment for
Contingent Consideration
a.Contingent consideration which is
determinable on the combination
date:
recorded as part of the cost of the
combination.
Accounting Treatment for
Contingent Consideration(contd.)
b.Contingent consideration that is not
determinable on the combination
date:
the contingent amount is recorded
as goodwill when the contingency is
resolved.
Assigning Values to a Purchased Combinee’s
Identifiable Assets and Liabilities (Based on
APB Opinion No. 16)
1. Present value: receivables and
liabilities;
2. Net realizable values : marketable
securities, finished goods, goods in
process inventories, plant assets held
for sale or temporary use;
Assigning Values to a Purchased Combinee’s
Identifiable Assets and Liabilities (Based on
APB Opinion No. 16) (contd.)
3. Appraised value: intangible assets,
land, natural resources and
nonmarketable securities;
4. Replacement cost: material and

plant assets held for long-term use.
Goodwill Computation under
Purchase Accounting
 Purchased Goodwill
=purchase price (total cost of the
combinee) –
the current fair values of identifiable
net assets of the combinee.
Goodwill Computation under
Purchase Accounting (contd.)
 Negative Goodwill:
The excess amount is applied to
reduce proportionally the amounts
initially assigned to noncurrent assets
(other than long-term investments.)
 If this procedure does not extinguish
the excess, a Negative Goodwill
account would be credited for the
remaining excess.
Example I: Purchase Accounting For
Statutory Merger, with Goodwill
 On December 31,1999, Mason
Company (the combinee) was merged
into Saxon Corporation (the combinor
or survivor).
 Both companies used the same
accounting principles for assets,
liabilities, revenue, and expenses and
both had a December 31 fiscal year.
Example I: Purchase Accounting For
Statutory Merger, with Goodwill (contd.)
 Saxon issued 150,000 shares of its $10
par common stock (current fair value
$25 a share) to Mason’s stockholders
for all 100,000 issued and outstanding
shares of Mason’s no-par, $10 stated
value common stock.
 In addition, Saxon paid the following
out-of-pocket costs associated with
business combination:
Example I (contd.): Out of Pocket Costs
Accounting fees:
 For investigation of Mason
Company as prospective combinee $ 5,000

 For SEC registration statement for
Saxon common stock 60,000

Legal fees:
 For the business combination 10,000
 For SEC registration statement for
Saxon common stock 50,000
Example I (contd.): Out of Pocket Costs
(contd.)
Finder’s fee 51,250

Printer’s charges for printing
securities and SEC registration
statement 23,000
SEC registration statement fee 750
Total out-of-pocket costs of
business combination $200,000
 There was no contingent consideration in the
merger contract.
Example I (contd.): Mason Company’s
Condensed B/S Prior to The Merger
MASON COMPANY (combinee)
Balance Sheet (prior to business combination)
December 31,1999
Assets
Current assets $1,000,000
Plant assets (net) 3,000,000
Other assets 600,000
Total assets 4,600,000
(Continued)
Example I (contd.): Mason Company’s
Condensed B/S Prior to The Merger (contd.)
MASON COMPANY
Balance Sheet (contd.) , 12/31/1999
Liabilities & Stockholders’ Equity

Current Liabilities $ 500,000
Long-term debt 1,000,000
Common stock, no-par,$10 stated
value 1,000,000
Additional paid-in capital 700,000
Retained earnings 1,400,000
Total liabilities & stockholders’
equity $4,600,000
Example I (contd.):
 Using the guidelines in APB Opinion
No. 16, “Business Combinations”, the
board of directors of Saxon Corporation
determined the current fair values of
Mason Company’s identifiable assets
and liabilities (identifiable net assets)
as follows:
Example I (contd.): Fair Value of
Identifiable Net Assets of Combinee
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
Example I (contd.): Combinor’s Journal
Entries for Business Combination
 Saxon uses an investment ledger
account to accumulate the total cost of
Mason Company prior to assigning the
cost to identifiable net assets and
goodwill.
Entries for Business Combination (contd.)
 Journal Entries for Saxon Corp. 12/31/1999
Investment in Mason
Company Common
Stock (150,000 x $25) 3,750,000
Common stock
(150,000 x $10) 1,500,000
Paid-in Capital in
Excess of Par 2,250,000
To record merger with Mason
Company as a purchase.
(Continued)
 12/31/1999 (contd.)
Investment in Mason
Company Common Stock
($5,000+$10,000+$51,250) 66,250
Paid-in Capital in Excess of
Par ($60,000+$50,000 +
$23,000+750) 133,750
Cash 200,000
To record payment of out-of-pocket
costs incurred in merger with
Mason Company.
(Continued)
 12/31/1999 (contd.)
Current Assets 11,500,000
Plant Assets 3,400,000
Other Assets 600,000
Discount on Long-Term Debt 50,000
Goodwill 116,250
Current Liabilities 500,000
Long-Term Debt 1,000,000
Investment in Mason
Company Common
Stock ($3,750,000+$66,250) 3,816,250
To allocate total cost of liquidated Mason Company to
identifiable assets and liabilities, with the reminder to goodwill.
(Income tax effects are disregarded.)
Example I (contd.): Combinee’s J.E. for The
Dissolution of the Company after Statutory
Merger
 Mason Company (the combinee)
prepares the condensed journal entry
below to record the dissolution and
liquidation of the company on
December 31, 1999.
Example I (contd.): Combinee’s J.E. for The
Dissolution of The Company after Statutory
Merger (contd.)
 Journal Entries for Mason Corp.12/31/1999
Long-Term Debt 1,000,000
Common Stock , $10 stated
value 1,000,000
Paid-in Capital in Excess of
Stated Value 700,000
Retained Earnings 1,400,000
Plant Assets (net) 3,000,000
Example II: Purchase Accounting for
Acquisition of Net Assets, with Negative
Goodwill (Bargain-Purchase Excess)
 On December 31, 1999, Davis
Corporation acquired the net assets of
Fairmont Corporation directly from
Fairmont Corp. for $400,000 cash, in a
purchase-type business combination.
 Davis paid legal fees of $40,000 in
connection with the combination.
Example II: Purchase Accounting
with Negative Goodwill
 The condensed balance sheet
statement of Fairmont Corp. prior to the
business combination, with related
current fair value data, is presented
below:
Example II (contd.):Combinee’s B/S
Prior to Statutory Merger
FAIRMONT CORPORATION (combinee)
Balance Sheet (prior to business combination)
December 31, 1999
Assets Carrying Current Fair
Amounts Values
Current assets $ 190,000 $ 200,000
Investment in marketable debt
securities (held to maturity) 50,000 60,000
Plant assets (net) 870,000 900,000
Intangible assets (net) 90,000 100,000
Total assets $1,200,000 $1,260,000
Business Combinations (Continued)51
Example II (contd.):Combinee’s B/S
Prior to Statutory Merger (contd.)
FAIRMONT CORPORATION B/S (contd.)
Liabilities and Carrying Current Fair

Stockholders’ Equity Amounts Values
Current liabilities $ 240,000 $ 240,000
Long-term debt 500,000 520,000
Total Liabilities $ 740,000 $ 760,000
Common stock, $1 par $ 600,000
Deficit (140,000)
Total stockholders’ equity $ 460,000
Total liabilities &
stockholders’ equity $1,200,000
Example II (contd.) : Computing the
Negative Goodwill
 Thus, Davis acquired identifiable net
assets with a current fair value of $
500,000a for a total cost of $440,000b.
 a. $ 1,260,000 - $760,000= $500,000

 b. $ 400,000 +$40,000= $440,000
Example II (contd.) : Computing the
Negative Goodwill (contd.)
 The $60,000 excess of current fair
value of the net assets over their cost to
Davis ($500,000 - $440,000 = $60,000)
is prorated to the plant assets and
intangible assets in the ratio of their
respective current fair values, as
follows:
Example II (contd.) : Allocation of
Negative Goodwill
To plant assets:
$60,000 x $900,000
($900,000 +$100,000) =$54,000
To intangible assets:
$60,000 x $900,000
($900,000 +$100,000) =$6,000
Total excess of current fair
value of identifiable net
assets over combinor’s cost $60,000
Example II (contd.)
 Notes: No part of the $60,000 bargain-
purchase excess is allocated to current
assets or to the investment in
marketable securities.
 The journal entries on pages 54 and 55

record Davis Corporation’s acquisition
of the net assets of Fairmont
Corporation and payment of $40,000
legal fees:
Example II (contd.) : Combinor’s J.E. for
The Acquisition of Net Assets
 Journal Entries of Davis Corp. 12/31/1999
Investment in Net Assets of
Fairmont Corporation 400,000
Cash 400,000
To record acquisition of net assets
of Fairmont Corporation
Fairmont Corporation 40,000
Cash 40,000
To record payment of legal fees
incurred in acquisition of net assets
of Fairmont Corporation
Business Combinations (Continued)57
Example II (contd.) : Combinor’s J.E. for the
Acquisition of Net Assets (contd.)
 12/31/1999 (contd.)
Current Assets 200,000
Investments in Marketable Debt
Securities 60,000
Plant Assets ($900,000 - $54,000) 846,000
Intangible Assets ($100,000 - $6,000) 94,000
Long-Term Debt 500,000
Premium on Long-Term Debt
($520,000 - $500,000) 20,000
Fairmont Corporation
($400,000 + $40,000) Business Combinations 440,00058
Example II (contd.): Note to the
Journal Entries
 Note to the above journal entries:
To allocate total cost of net assets
acquired to identifiable net assets, with
excess of current fair value of the net
assets over their cost prorated to
noncurrent assets other than
investments in marketable debt
securities.
Pooling-of-Interests Accounting
 The idea behind this accounting
method is that the business
combination is simply an exchange of
common stock between an issuer and
the stockholders of a combinee.
 Thus, this method is appropriated to be
used in the case of business
combinations involving only common
stock exchanges between companies
of approximately equal size.
(contd.)
 Because neither party can be
considered as the combinor (as
previously defined), the combined
assets, liabilities and retained earnings
of the constituent companies are
recorded at their carrying amounts.
(contd.)
 Both the market value of the common
stock issued for the combination and
the fair value of the combinee’s net
assets are disregarded in this method.
 The term “issuer” identifies the
corporation that issues its common
stock to accomplish the combination.
Example III: Pooling-of-Interests
Accounting for Statutory Merger
 Applying the pooling-of interests
accounting method on the Example I
(the business combination of Saxon
and Manson) illustrated on page 32-45,
the following journal entries would be
prepared in Saxon Corporation’s
accounting records:
Example III : Pooling-of-Interests
Accounting for Statutory Merger (contd.)
 Journal Entries for Saxon Corp. 12/31/1999
Plant Assets (net) 3,000,000
Long-term Debt 1,000,000
Common Stock, $10 par 1,500,000
Paid-in Capital in Excess
of Par 200,000
To record merger with Mason
Company as a pooling of interests.
Example III : Pooling-of-Interests
Accounting for Statutory Merger (contd.)
 12/31/1999 (J. E. contd.)
Expenses of Business
Combination 200,000
Cash 200,000
To record payment of out-of-
pocket costs incurred in
merger with Mason Company
Example III (contd.): Notes to the example
 Notes:
1. An Investment in Mason’s Company
Common Stock account is not used in the
pooling-of-interests method.
2. Mason’s assets, liabilities and retained
earnings are recorded at their carrying
amounts in Mason’s premerger balance
sheet.
3. The common stock issued by Saxon for the
business combination is recorded at par
value.
(contd.)
 Notes (contd.)
4. The Paid-in-Capital in Excess of Par equals
the total premerger paid-in-capital of Mason
minus the par value of Saxon's stock issued
for the business combination.
5. If the par value of Saxon’s common stock
issued for the combination exceeds the
premerger paid-in capital of Mason,
Saxon’s Paid-in Capital in Excess of Par
account should be debited for the excess
amount. (contd.)
(contd.)
 Notes (contd.)
5. (contd.)If this account is not sufficient to
absorb the excess amount, Saxon’s
Retained Earnings account should be
debited.
6. The entire out-of-pocket costs were
expensed and are not tax deductible.
Advantage of Using Pooling Accounting on
Financial Numbers
1.Advantage on the Post-Merger
Earnings:
The following exhibit shows the balance
sheet statement accounts of pooling
accounting versus purchase accounting
using the example of Saxon and
Mason:
Financial Numbers (contd.)
Purchase Accounting Pooling Accounting

Current Assets 1,150,000 1,000,000
Plant Assets 3,400,000 3,000,000
Other Assets 600,000 600,000
Discount on
Good will 116,250
Expense of Business 200,000
Combination
(Continued)
Purchase Accounting Pooling Accounting

Current Liabilities 500,000 500,000
Long-Term Debt 1,000,000 1,000,000
Common Stock,
$ 10 par 1,500,000 1,500,000
Paid-in Capital in
Excess of Par 2,116,250 200,000
Cash 200,000 200,000
To record merger with
Mason Company.
 The difference on the net assets of these
two methods is:
Purchase accounting
net assets $3,616,250
Pooling accounting
net assets 2,900,000
Difference $ 716,250
 The composition of the $716,250 is
summarized as follows:
Excess of purchase asset values over
pooling asset values:
Current assets ($1,150,000-$1,000,000) $150,000
Plant assets ($3,400,000- $3,000,000) 400,000
Goodwill 116,250
Excess of pooling liability values over
purchase liability values:
Long-term debt
[$1,000,000-($1,000,000- $50,000) ] 50,000
Excess of purchase net assets values
over pooling net assets values $716,250
 Assuming:
a.The $150,000 difference in current assets is

attributable to inventories which will be
allocated to CGS on FIFO basis in the
following year.
b.The $400,000 difference in plant assets is
attributable to depreciable assets, and
assuming an average economic life for these
plant assets is 10 years.
c.Goodwill will be amortized in 40 years.
d.The long-term debt has a remaining 5 years

to maturity.
 Based on the above information, Saxon’s pre-tax
income for the year ended 12/31/2000 would be
$202,906 less under purchase accounting than
under pooling accounting. Calculation is as
follows:
Cost of goods sold $150,000
Depreciation expense ($400,000 x 1/10) 40,000
Amortization expense ($116,250 x 1/40) 2,960
Interest expense ($50,000 x 1/5) 10,000
Excess of year 2000 pre-tax income under
pooling accounting rather than under
purchase accounting $202,906
 Thus, pooling accounting, in general,
results in a more favorable post-merger
earnings than the purchase accounting.
As a result, it is preferred by mangers
who would like to present a higher post-
merger earnings.
2.Advantage on the Retained
Earnings
The retained earnings under the
pooling method is $1,400,000 greater
than that of the purchase method.
This outcome also provides the
managers with a greater flexibility in
dividend distribution when using the
pooling accounting.
3.Advantage on the Price-Earnings
Ratios on the Merger Year
Assume Saxon and Mason had the
following financial information prior to
the business combination:
Saxon Mason
Corporation Company
Year ended Dec. 31, 1999:
Net income $500,000* $375,000
Basic earnings per share of
common stock $0.50 $3.75
On Dec. 31, 1999:
Number of shares of
common stock outstanding 1,000,000+ 100,000+
Market price per share $25 $30
Price-earnings ratio 50 8
* Net of $200,000 expenses of business combination.
+ Outstanding during entire year.
 Using the pooling method, Saxon would
report the combined enterprise’s net
income as $875,000 for the year ended
12/31/1999 (as if these two companies
were pooled as of 1/1/1999) and the EPS
for Saxon would be increased from $0.50
to $0.76.
 Calculated as :
$875,000/(1,000,000+150,000).
Historical Perspective of Accounting
for Business Combinations
 Due to lack of accounting
pronouncement in providing clear
guidance in determining the appropriate
method for business combination prior
to the issuance of Accounting Principle
Board Opinion No. 16 “Business
Combinations” in August 1970 (effective
for business combinations initiated after
October 31, 1970),
for Business Combinations (contd.)
 a substantial number of business
combinations arranged in the 1950s
and 1960s were accounted for using
pooling accounting despite the absence
of the assumption for using pooling
accounting .
 The pooling accounting was first
sanctioned by the AICPA in its
Accounting Research Bulletin No. 40,
“Business Combinations”. This
pronouncement provides very little
guidance for identifying the business
combinations that qualified for pooling
method.
 ARB No. 40 was subsequently replaced
by ARB No. 48, “Business
Combinations” which continued to allow
pooling method to be used for most
business combinations involving an
exchange of common stock.
Past Abuses of Pooling Accounting
 The advantages of pooling accounting
in post-merger earnings, retained
earnings, and in the P/E ratio of the
merger year with the lack of clear
guidelines for pooling in ARB No. 48 led
to serious abuses of pooling method.
(contd.)
 Consequently, a substantial number of
business combinations arranged in the
1950s and 1960s were accounted for
using pooling accounting despite the
absence of the assumption for using
pooling accounting – the combination of
existing stockholders’ interests.
(contd.)
 Among these abuses are:
a. Retroactive Pooling
b. Retrospective Pooling
c. Part-Pooling, Part-Purchase
Accounting
d. Treasure Stock Issuance
(contd.)
 Contd.:
e.Issuance of Unusual Securities
f. Creation of “instant Earnings”
g.Contingent Payouts
h.“Burying” the Costs of Pooling-Type
Past Abuses of Purchase Accounting
(in the period of 1950-1960)
 The most common abuses of purchase
accounting is the failure to allocate the
cost of a combinee to the identifiable
net assets acquired and to goodwill.
Action by the AICPA to Curtail The
Abuses
 The Accounting Principles Board
reacted to the abuses by issuing APB
opinion No. 16 in which pooling
accounting standards are tightened
and the range of situations allowed
for pooling accounting is substantially
limited.
Conditions Requiring Pooling Accounting
in APB Opinion No. 16
1.Attributes of the combining
companies (2 conditions).
These conditions were to assure that
the pooling combination was truly a
combining of two or more entities whose
common stockholder interests were
previously independently of each other.
in APB Opinion No. 16) (contd.)
2.Manner of combining ownership
interests (7 conditions).
the exchange of voting common stock
actually took place in substance and in
form.
in APB Opinion No. 16) (contd.)
3.Absence of planned transactions (3
conditions).
no planned transactions, which are
inconsistent with the combining of
entire existing interests of common
stockholders, could be arranged prior to
the combination.
APB Opinion No. 16
 A business combination that meets 12

conditions of APB of Opinion No.16
accounting for as a pooling regardless
of the legal form of the combination.
 These conditions specified in APB

Opinion No. 16 are:
APB Opinion No. 16 (contd.)
1.Attributes of the constituent
companies (2 conditions)
a. Each of the constituent companies is
autonomous and has not been a
subsidiary or division of another
corporation within two years before the
plan of combination is initiated.
b. Each of the constituent companies is
independent of the other.
2.Manner of combining ownership
interests (7 conditions)
b. A corporation offers and issues only
common stock with rights identical to
those of the majority of its outstanding
voting common stock in exchange for
substantially all the voting common
stock interest of another company on the
date the plan of combination is
consummated.
3.Absence of planned transactions (3
conditions)
a. The combined entity does not agree to
retire or acquire all or part of the common
stock issued to effect the combination.
b. The combined entity does not enter
agreement for the benefit of the former
stockholder of a constituent company.
c. The combined entity does not plan to sell
a significant part of the assets of the
constituent companies within two years
after the combination.
 APB stated that both purchase and
pooling methods are acceptable in
accounting for business combination,
but not as alternatives in accounting for
the same business combination.
 By tightening the conditions for
adopting pooling accounting, many
previous abuse of pooling were
eliminated or reduced.
Discussion of Four Conditions
1.Independence of Constituent
Companies
On the dates of initiation and
consummation of a business
combination, no constituent company
may have more than 10% ownership of
the outstanding voting common stock of
another constituent company.

(contd.)
2.Substantially All Voting Common
Stock of Combinee’s Company Are
Exchanged
The condition requires that at least 90%
of the combinee’s outstanding voting
common stock be exchanged for the
issuer’s voting common stock.
The following are excluded from the
computation of the number of shares
exchanged:
(contd.)
1) Shares acquired before the initiation
date of combination and held by
either the issuer or its subsidiaries.
2) Share acquired by either the issuer
or its subsidiaries after the
combination is initiated, other than in
exchange for the issuer’s voting
common stock.

(contd.)
3) shares of the combinee still
outstanding on the date the
combination is consummated.
4) any voting common stock of the
issuer owner by the combinee before
the business combination must be
converted to equivalent shares of the
combinee for the 90% test.

discussion of Four Conditions
(contd.)
Example to illustrate the independence and
90% of voting common stock tests
 On March 13, 1999, Patton Corporation and
Sherman Company initiated a plan of
business combination.
 Under the Plan, 1.5 shares of Patton’s voting
common stock (1,000,000 shares issued and
outstanding prior to March 13, 1999) were to
be exchanged for each outstanding share of
Sherman’s common stock (100,000 shares
issued and 99,500 shares outstanding prior
to March 13,1999).
Discussion of Four Conditions (contd.)
90% of voting common stock tests (contd.)
 At this time, Patton owned 7,500 shares
of Sherman’s common stock, and
Sherman owned 6,000 shares of
Patton’s voting common stock; in
addition, 500 shares of Sherman’s
common stock were in Sherman’s
treasury.

 Neither Patton’s ownership of 7.54% of
Sherman’s outstanding common stock
(7,500/ 99,500 = 7.54%) nor Sherman’s
ownership of 0.6% of Patton’s
outstanding common stock (6,000/
1,000,000 = 0.6%) exceeds the 10%
limitation of the independence of
constituent companies requirement.

 On March 26, 1999, Patton acquired in
the open market for cash 1,000 shares
(1.005%) of Sherman’s outstanding
common stock.
 On June 30, 1999, Patton issued
136,500 shares of its voting common
stock in exchange for 91,000
outstanding shares of Sherman’s
common stock to complete the
 Computation of the 90% requirement follows:
Total Sherman Company shares issued,
June 30, 1999 100,000
Less: Shares in Sherman’s treasury 500
Total Sherman shares outstanding,
June 30, 1999 99,500
Less:
Sherman shares owned by Patton
Corporation, Mar. 13, 1999 7500
Sherman shares acquired by
Patton for cash, Mar. 26, 1999 1000
(Continued)
Equivalent number of Sherman
shares represented by Patton’s
common stock owned by
Sherman, Mar. 13, 1999
(6,000÷ 1 ½) 4,000 12,500
Effective number of Sherman shares
acquired June 30, 1999 in exchange for
Patton’s common stock 87,000
Application of 90% requirement
(99,500 x 90%) 89,550
 Thus, the 91,000 shares of Sherman
Company common stock actually
exchanged on June 30, 1999, are in
effect restated to 87,000 shares.
Because the restated amount is less
than 90% of Sherman’s 99,500 shares
outstanding, the business combination
does not qualify for pooling accounting.

(contd.)
3.Restrictions on Treasury Stock
Only the treasury stock purchased
under a systematic purchase plan
(referred to as untainted treasury stock)
can be accounted for as issuance of
common stock in a pooling
combination.

(contd.)
4.No Pending Provisions
No additional common stock can be
contingently issuable to former
stockholders of a combinee after a
combination has been initiated.
And, no common stock can be issued to
an escrow agent pending the resolution
of a contingency.
Financial Statements Following a
Business Combination
 The assets, liabilities, and retained earnings
in a balance sheet statement following a
business combination are reported as follow:
Assets & Lia. Retained earnings
Purchase- Carrying amount Reported
combinor
Purchase- Fair value Not reported
combinee
Pooling- Carrying amount Reported
combinor
Pooling- Carrying amount Reported
combinee
Business Combination (contd.)
 The combined income statement
following a business combination
depends on the accounting method:
 Purchase Accounting:
The income statement of the combined
entity for the period in which the
business combination occurred include
the operating results of the combinee
after the date of the combination
only.
 Pooling Accounting
The income statement of the combined
entity for the period in which the
business combination occurred
includes the results of operations of the
constituent companies as though the
combination had been completed at the
beginning of the period regardless
when the combination consummated.
 Comparative financial statements for
preceding periods are restated for
comparative purposes.
 Intercompany transactions prior to the
combination must be eliminated from
the combined income statements in a
manner comparable with that described
in Chapter 4 for branches.

Financial Statements Following a Business
Combination (contd.)
Example IV:
 To illustrate, assume that the income
statements of Saxon Corporation and Mason
Company for the year ended December 31,
1999 (prior to completion of their pooling-
type merger described on page 60-65
example III), were as shown below.
 Assume also that Mason’s interest expense
includes $25,000 paid to Saxon on a loan
that was repaid prior to December 31, 1999,
and that Saxon’s revenue includes $25,000
interest received from Mason.
Example IV (contd.)
SAXON CORPORATION AND MASON COMPANY
Separate Income Statements
For Year Ended December 31, 1999
Saxon Mason
Corporation Company
Sales and other revenue $10,000,000 $5,000,000
Costs and expenses:
Costs of goods sold $ 7,000,000 $3,000,000
Operating expenses 1,883,333* 1,274,500
Interest expense 150,000 100,500
Income taxes expense 466,667 250,000
Total costs and
expenses $ 9,500,000 $4,625,000
Net income $ 500,000 $ 375,000
*Includes $200,000 expenses of business combination.
Example IV (contd.)
 The working paper for the postmerger
income statement of Saxon Corporation
under pooling accounting is illustrated
below.
 The amounts in the Combined column
are reported in Saxon’s published
postmerger income statement for the
year ended December 31,1999.

Example IV (contd.)
SAXON CORPORATION
Working Paper for Combined Income Statement (Pooling of Interests)
For Year Ended December 31, 1999
Saxon Mason Eliminations Combined
Corporation Company
Sales and other
revenue 10,000,000 5,000,000 (a) 25,000 14,975,000
Cost and expenses:
Cost of goods sold 7,000,000 3,000,000 10,000,000
Operating expenses 1,883,333 1,274,500 3,157,833
Interest expense 150,000 100,500 (a) (25,000) 225,500
Income taxes
expense 466,667 250,000 716,667
Total costs and
expenses 9,500,000 4,625,000 (25,000) 14,100,000
Net income 500,000 375,000 -0- 875,000
(a) To eliminate intercompany interest received by Saxon Corporation from Mason
Company. Business Combinations 121
Notes to Financial Statements
Following a Business Combination
 Extensive disclosure is required for
business combinations in the period they
occur.
 Required Disclosure for Purchase
Accounting: (textbook p194)
 1. Name and brief description of the
combinee; also the accounting method
used for the business combination;

Notes to Financial Statements Following a
2.period for which combinee’s operating
results are included in the income
statement of the combined enterprise;
3.cost of the combinee, including number
of shares and value per share of
common stock issued and nature of
and accounting treatment for contingent
consideration;
4. amortization policy for goodwill;

5.pro forma operating results for the
combined enterprise for the current
and preceding accounting periods as if
the combination had occurred at the
beginning of the preceding period.
Note: The FASB waived the proforma

disclosures for nonpublic enterprises.

 Required Disclosure for Pooling
Accounting
1. Name and brief description of the
combinee; the accounting method used
for the business combination;

2. number of shares of common stock
issued in the combination;
3. separate operating results of the
constituent companies for the period
prior to the combination that were
included in the operating results of the
combined entity for the combination
year.

Comparison of Purchase and
Pooling Accounting
 The following table summarizes the
principal aspects of purchase
accounting and pooling-of-interests
accounting for business combinations:

Pooling Accounting (contd.)
Aspect Purchase Pooling-of-
Accounting Interests
Accounting
Underlying Acquisition of Combining of
premise assets stockholder
interests
Applicability Combinations Combinations
not meeting all meeting all 12
12 criteria for criteria for
pooling pooling
accounting accounting
(Continued)
Aspect Purchase Pooling-of-Interests
Accounting Accounting
Accounting At cost, including At carrying amount
recognition of amount of of combinee’s net
investment in consideration, direct assets (all out-of-
combinee out-of-pocket costs, pocket costs are
and determinable recognized as
contingent expenses of the
consideration issuer)
Valuation of At current fair values At carrying amounts
combinee’s net on date of on date of
assets in combined combination combination
enterprise
Business Combinations (Continued) 129
Goodwill recognition Yes, if combinor’s No
cost exceeds current
fair value of
combinee’s
identifiable net assets
Retained earnings NO YES
of constituent
companies
combined on date
of business
combination
(Continued) 130
Financial
statements and
notes for period of
business
combination:
Balance sheet Combinor’s net Both issuer’s and
assets at carrying combinee’s net
amount; combinee’s assets at carrying
net assets at current amount
fair value
(Continued)
Aspect Purchase Accounting Pooling-of-Interests
Accounting
Income Combinor’s operations Both issuer’s and
statement for entire period; combinee’s operations
combinee’s operations for entire period as
from date of though combination
combination to end of took place at beginning
period of period; prior periods
restated comparably
Disclosure of Pro forma for combined Separately for
operations in enterprise for current constituent companies
notes and preceding period for period prior to
as though combination combination
took place at beginning
of preceding period
Purchase-Type Statutory
Consolidation
 Due to a new corporation is formed to
issue common stock to all constituent
companies in this type of business
combination, a combinor needs to be
identified for the accounting treatment.
 The assets and liabilities of the
identified combinor will be accounted
for by the new corporation at the
carrying amount while those of the
combinee will be accounted for at the
fair value.
Purchase-Type Statutory Consolidation (contd.)
Example V :
 To illustrate, assume the following
balance sheet statements of the
constituent companies involved in a
purchase-type statutory consolidation
on December 31, 1999 (p196-199 of
textbook):

Example V (contd.):
LAMSON CORPORATION AND DONALD COMPANY
Separate Balance Sheets (prior to business combination)
December 31,1999
Assets Lamson Donald

Corporation Company
Current assets $ 600,000 $ 400,000
Plant assets (net) 1,800,000 1,200,000
Other assets (net) 400,000 300,000
Total assets $ 2,800,000 $1,9,00,000
(Continued)
Example V (contd.):
LAMSON CORPORATION AND DONALD COMPANY
Separate Balance Sheets (contd.), 12/31/1999
Liabilities & Lamson Donald

Stockholders’ Equity Corporation Company
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 liabilities &
stockholders’
equity $ 2,800,000 $1,9,00,000
Example V (contd.):
 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.
Example V (contd.):
 On December 31, 1999, in a statutory
consolidation approved by shareholders of
both constituent companies, a new
corporation, LamDon Corporation, issued
74,000 shares of no-par, no-stated-value
common stock with an agreed value of $60 a
share, based on the following valuations
assigned by the negotiating directors to the
two constituent companies’ identifiable net
assets and goodwill:
Example V(contd.):
Lamson Donald
Corporation Company
Current fair value of identifiable net
assets:
Lamson: $800,000+$2,000,000
+$500,000- $400,000-$500,000 $2,400,000
Donald: $500,000+ $1,400,000
+ $400,000 -$300,000-$200,000 $1,800,000
Goodwill 180,000 60,000
Net assets’ current fair value $2,580,000 $1,860,000
Number of shares of LamDon
common stock to be issued to
constituent companies’
stockholders, at $60 a share
agreed value 43,000 31,000
Example V (contd.):
 Because the former stockholders of
Lamson Corporation receive the larger
interest in the common stock of
LamDon Corporation (43/74, or 58%),
Lamson is the combinor in the
purchase-type statutory consolidation

Example V (contd.):
 Assuming that LamDon paid $200,000
out-of-pocket costs of the consolidation
after it was consummated on December
31, 1999, LamDon’s journal entries
would be as follows:

Example V (contd.):
 Journal Entries of Lamdon Corp., 12/31/1999
Investment in Lamson
Corporation and Donald
Company Common Stock
(74,000 x $60) 4,440,000
Common Stock, no par 4,440,000
To record consolidation of Lamson
Corporation and Donald Company
as a purchase
(Continued)
Example V (contd.):
 12/31/1999 (contd.)
Company Common Stock 110,000
Common Stock, no par 90,000
Cash 200,000
To record payment of costs incurred in
consolidation of Lamson Corporation and
Donald Company. Accounting, legal, and
finder’s fees in connection with the
consolidation are recorded as investment
cost; other out-of-pocket costs are recorded
as a reduction in the proceeds received
from the issuance of common stock.
(Continued)
Example V (contd.):
 12/31/1999 (contd.)
Current Assets ($600,000+$500,000) 1,100,000
Plant Assets ($1,800,000+$1,400,000) 3,200,000
Other Assets ($400,000+$400,000) 800,000
Goodwill 850,000
Company Common
Stock 4,550,000
Business Combinations (Continued) 144

Example V (contd.):
 12/31/1999 (contd.)
Amount of goodwill is
computed as follows:
Total cost of investment
($4,400,000+$110,00) 4,550,000
Less: Carrying amount of
Lamson’s identifiable
net assets ($430,000+
$300,000+1,170,000) (1,900,000)
Current fair fair value of
Donald’s identifiable net
assets (1,800,000)
Amount of goodwill $ 850,000
Subsequent Issuance of Contingent
Consideration
 Example of Contingent Consideration
(p176 and p198 of text book)
Norton Company agrees to pay

$800,000 cash for Robinson’s net
assets (not including Robinson’s slow-
moving products which have been
written down to scrap value by
Robinson prior to the business
combination).
Consideration
 Example (contd.) These purchased net
assets of Robinson will be included in
the Rob Division of Norton Company.
 In addition, the following contingent
consideration was included in the

contract:
1. Norton will pay Robinson $100 a unit
for all sales by Robb Division of the
slow-moving product.

Consideration (contd.)
(contd.)
2.Norton will pay Robinson 25% of any
pre-tax financial income in excess of
$500,000 (excluding income from sale
of the slow-moving product) of Robb
Division for each of the four years
subsequent to the business
combination.

 Assuming that by 12/31/x2, the end of the
first year following Norton’s acquisition of the
net assets, another 300 units of the slow-
moving product had been sold, and Norton’s
Rob Division had pre-tax income of
$580,000 (excluding the sale of the slow-
moving product).
 On 12/31/x2, Norton prepares the following
journal entry to record the resolution of
contingent consideration:
Goodwill 50,000*
Cash (or payable to 50,000
Robinson Company)
* $100 x 300 =$30,000

+ (580,000-500,000) x 25% = 20,000
$50,000

IAS 22, “Accounting for Business
Combinations”
 International Accounting Standards
Committee requires purchase
accounting to be used for all business
combinations except for united-of-
interests –type combinations.

The Current Development on the Business
Combination Standards (Excerpts from News
Release of the FASB dated 7/20/01)
 On July 20, 2001, FASB issued
Statement No. 141, Business
Combinations and Statement No. 142,
Goodwill and Other Intangible Assets.

Release of the FASB dated 7/20/01) (contd.)
 Statement 141:
Use of the pooling-of-interests method
is not permitted. All business
combinations should be accounted for
using the purchase method. This
statement is effective for business
combinations initiated after June 30,
2001.

 Statement 142:
Requires that goodwill no longer to be
amortized as expense but subject to
annual review for impairment.

 Reasons of issuing SFAS No. 141:
(Source: summary of SAFS No. 141
published by the FASB):
 Due to the 12 criteria for pooling
accounting failed to distinguish
economically dissimilar transactions,
similar business combinations were
accounted for using different
accounting methods.
 Therefore, different financial statements
were produced for similar business
combinations.
 The following are some of the reasons
stated by the FASB:

1.Lack of Comparability on the financial
statements when different method is
adopted.
2.Criticism on the amortization of
goodwill when purchase method is
used.
3.Criticism from mangers on the impact
of these two methods on the
competition in markets for mergers and
acquisitions.
Summary of Statement No. 142:
(source: FASB Publication of Summary of
Statement No. 142)
 Intangible assets have become an
important economic resource for many
entities.
 Thus, better information for the
intangible assets is needed.
 Some empirical studies indicate that the
goodwill amortization expense is not
reflected in firm value
Statement No. 142) (contd.)
 APB Opinion No. 17 assumed that
goodwill and all other intangible assets
were assets with finite lives and thus
should be amortized, not to exceed 40
years.

 Statement No. 142 assumed that
goodwill and other intangible assets

have indefinite lives and will not be
amortized but rather will be tested on
annual basis for impairment.
 Intangible assets that have finite useful
lives will continue to be amortized over

their useful lives, but without the
arbitrary ceiling of 40 years.
 Statement 142 provides guidance for
the two-step process of review of the
potential impairment:
 Consequence of SFAS No. 142:
Earnings may be more volatile due to
the impairment losses are likely to
occur irregularly and in varying
amounts.

 Disclosure requirements of Statement
142:
a. Information about the changes in the
carrying amount of goodwill from
period to period (in the aggregate
and by reportable segment);

b. The carrying amount of intangible
assets by major intangible asset
class for those assets subject to
amortization and for those not
subject to amortization;
c. The estimated intangible assets
amortization expense for the next
five years.

 FASB indicates that this statement can
improve the financial reporting on these
assets (goodwill and other intangible
assets) because this treatment will
result values of these assets better
reflect the underlying economic values
of these assets.

Business Combinations

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Business Combinations

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Chapter 5

1. To discuss the general view of

3. To discuss the development of

5. To learn accounting for statutory

 Business combinations: events

c.Combinor : a constituent company

 For the combination in a friendly

 For hostile takeovers:

 Pooling-of-interests method (pooling

In order to adopt the pooling of interests

4. Replacement cost: material and

Company as prospective combinee $ 5,000

Saxon common stock 60,000

Saxon common stock 50,000

Finder’s fee 51,250

Liabilities & Stockholders’ Equity

Current assets $ 1,150,000

Liabilities and Carrying Current Fair

 a. $ 1,260,000 - $760,000= $500,000

 The journal entries on pages 54 and 55

Purchase Accounting Pooling Accounting

Purchase Accounting Pooling Accounting

a.The $150,000 difference in current assets is

c.Goodwill will be amortized in 40 years.

d.The long-term debt has a remaining 5 years

 A business combination that meets 12

 These conditions specified in APB

Business Combinations 101

Business Combinations 103

Business Combinations 104

Business Combinations 106

Business Combinations 107

Business Combinations 111

Business Combinations 112

Business Combinations 117

Business Combinations 120

Business Combinations 122

Business Combinations 123

Note: The FASB waived the proforma

Business Combinations 124

Business Combinations 125

Business Combinations 126

Business Combinations 127

Business Combinations 134

Assets Lamson Donald

Liabilities & Lamson Donald

Business Combinations 140

Business Combinations 141

Business Combinations (Continued) 144

Norton Company agrees to pay

consideration was included in the

Business Combinations 147

Business Combinations 148

* $100 x 300 =$30,000

Business Combinations 150

Business Combinations 151

Business Combinations 152

Business Combinations 153

Business Combinations 154

Business Combinations 156

Business Combinations 159

goodwill and other intangible assets

lives will continue to be amortized over