LECTURE 1

INTRODUCTION TO BUSINESS
COMBINATIONS AND THE
CONCEPTUAL FRAMEWORK

2
 Introduction
• In January 2008, the International Accounting Standards Board (the
IASB) issued a revised IFRS 3 Business Combinations and a revised
IAS 27 Consolidated and Separate Financial Statements. In doing
so, the Board completed phase II of its business combinations
project, and achieved substantial convergence between International
Financial Reporting Standards (IFRSs) and US Generally Accepted
Accounting Principles (US GAAP) on these topics.

• These standards are intended to improve the relevance,

comparability and transparency of financial information related to
business combinations, and to facilitate the convergence with
international standards.

3
 Nature of the Combination
Business Combination - operations of two or more
companies are brought under common control.
– A business combination may be:
• 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.

4
 Nature of the Combination
Defensive Tactics
– Poison pill: Issuing stock rights to existing shareholders;
exercisable only in the event of a potential takeover.
– Greenmail: Purchasing shares held by the would-be
acquiring company at a price substantially in excess of
fair value.
– White knight: Encouraging a third firm, more
acceptable to the target company management, to
acquire or merge with the target company.

5
 Nature of the Combination
Defensive Tactics (continued)
– Pac-man defense: Attempting an unfriendly
takeover of the would-be acquiring company.
– Selling the crown jewels: Selling valuable assets to
make the firm less attractive to the would-be acquirer.
– Leveraged buyouts: Purchasing a controlling
interest in the target firm by its managers and third-
party investors, who usually incur substantial debt
and subsequently take the firm private.

6
 Business Combinations: Why? Why
Not?
Advantages of External Expansion
– Rapid expansion
– Operating synergies
– International marketplace
– Financial synergy
– Diversification
– Divestitures

7
 Terminology and Types of
Combinations
What Is Acquired? What Is Given Up?

Net assets of S Company 1. Cash

(Assets and Liabilities) Illustration 1-3
2. Debt
3. Stock
Common Stock
of S Company 4. Combination of Above

• Asset acquisition, a firm must acquire 100% of the assets of the other
firm.
• Stock acquisition, control may be obtained by purchasing 50% or more
of the voting common stock (or possibly less).

8
 Terminology and Types of
Combinations
Possible Advantages of Stock Acquisition
– Lower total cost in many cases.
– Direct formal negotiations with the acquired firm’s
management may be avoided.
– Maintaining the acquired firm as a separate legal entity.
– Liability limited to the assets of the individual corporation.
– Greater flexibility in filing individual or consolidated tax
returns.
– Regulations pertaining to one of the firms do not
automatically extend to the entire merged entity.

9
 Terminology and Types of
Combinations
Classification by Method of Acquisition
Statutory Merger

A Company + B Company = A Company

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.

10
 Terminology and Types of
Combinations
Classification by Method of Acquisition
Statutory Consolidation

A Company + B Company = C Company

A new corporation is formed to acquire two or more other

corporations through an exchange of voting stock; the acquired
corporations then cease to exist as separate legal entities.

Stockholders of the acquired companies (A and B) become

stockholders in the new entity (C).

11
 Terminology and Types of
Combinations
Classification by Method of Acquisition
Consolidated Financial Statements

Consolidated
Financial Financial Financial
Statements of A + Statements of B = Statements of A
Company Company Company and B
Company

When a company acquires a controlling interest in the voting

stock of another company, a parent–subsidiary relationship
results.
12
 Takeover Premiums
Takeover Premium – the excess amount offered, or agreed upon, in
an acquisition over the prior stock price of the acquired firm.

Possible reasons for the premiums:

– Acquirers’ stock prices may be at a level which makes it
attractive to issue stock (rather than cash) in the acquisition.
– Credit may be generous for mergers and acquisitions.
– Bidders may believe target firm is worth more than its current
market value or has assets not reported on the balance sheet.
– Acquirer may believe growth by acquisitions is essential and
competition necessitates a premium.

13
 Avoiding the Pitfalls Before the
Deal
Beware of the following factors:
– Be cautious in interpreting any percentages.
– Do not neglect to include assumed liabilities in the assessment of
the cost of the merger.
– Watch out for the impact on earnings of the allocation of expenses
and the effects of production increases, standard cost variances,
LIFO liquidations, and byproduct sales.
– Note any nonrecurring items that may have artificially or
temporarily boosted earnings.
– Look for recent changes in estimates, accrual levels, and
methods.
– Be careful of CEO egos.

14
 Determining Price and Method of
Payment in Business Combinations
When a business combination is effected by a stock swap,
or exchange of securities, both price and method of
payment problems arise.
– The price is expressed as a stock exchange ratio
(generally defined as the number of shares of the
acquiring company to be exchanged for each share of
the acquired company).
– Each constituent makes two kinds of contributions to
the new entity—net assets and future earnings.

15
 Determining Price and Method of Payment
in Business Combinations
Net Asset and Future Earnings Contributions
• Determination of an equitable price for each constituent
company requires:
– The valuation of each company’s
• net assets and
• expected contribution to the future earnings of the
new entity.

16
 Determining Price and Method of
Payment
Excess Earnings Approach to Estimate Goodwill
– Step 1:Identify a normal rate of return on assets for
firms similar to the company being targeted.
– Step 2: Apply the rate of return (step 1) to the net assets
of the target to approximate “normal earnings”.
– Step 3: Estimate the expected future earnings of the
target. Exclude any nonrecurring gains or losses.
– Step 4: Subtract the normal earnings (step 2) from the
expected target earnings (step 3). The difference is
“excess earnings”.
17
 Determining Price and Method of
Payment
Excess Earnings Approach to Estimate Goodwill (continued)
• Step 5: Compute estimated goodwill from “excess earnings”.
– If the excess earnings are expected to last indefinitely, the
present value may be calculated by dividing the excess
earnings by the discount rate.
– For finite time periods, compute the present value of an
annuity.
• Step 6: Add the estimated goodwill (step 5) to the fair value of
the firm’s net identifiable assets to arrive at a possible
offering price.

18
 Determining Price and Method of
Payment
Exercise 1-1: Plantation Homes Company is considering the
acquisition of Condominiums, Inc. early in 2020. To assess the
amount it might be willing to pay, Plantation Homes makes the
following computations and assumptions.

A. Condominiums, Inc. has identifiable assets with a total fair value

of $15,000,000 and liabilities of $8,800,000. The assets include
office equipment with a fair value approximating book value,
buildings with a fair value 30% higher than book value, and land with
a fair value 75% higher than book value. The remaining lives of the
assets are deemed to be approximately equal to those used by
Condominiums, Inc.

19
 Determining Price and Method of
Payment
Exercise 1-1: (continued)
B. Condominiums, Inc.’s pretax incomes for the years 2017 through
2019 were $1,200,000, $1,500,000, and $950,000, respectively.
Plantation Homes believes that an average of these earnings
represents a fair estimate of annual earnings for the indefinite
future. The following are included in pretax earnings:
Depreciation on buildings (each year) 960,000
Depreciation on equipment (each year) 50,000
Extraordinary loss (year 2019) 300,000
Sales commissions (each year) 250,000
C. The normal rate of return on net assets is 15%.

20
 Determining Price and Method of
Payment
Exercise 1-1: (continued)

Required:
A. Assume further that Plantation Homes feels that it must
earn a 25% return on its investment and that goodwill is
determined by capitalizing excess earnings. Based on
these assumptions, calculate a reasonable offering price
for Condominiums, Inc. Indicate how much of the price
consists of goodwill. Ignore tax effects.

21
 Determining Price and Method of
Payment
Exercise 1-1: (Part A) Excess Earnings Approach

Step 1 Identify a normal rate of return on assets for firms

similar to the company being targeted. 15%

C. The normal rate of return on net assets is 15%.

22
Step 2 Apply the rate of return (step 1) to the net assets of the target to
approximate “normal earnings.”
A. Condominiums, Inc. has identifiable assets with a total fair value of $15,000,000 and
liabilities of $8,800,000. The assets include office equipment with a fair value
approximating book value, buildings with a fair value 30% higher than book value, and
land with a fair value 75% higher than book value. The remaining lives of the assets are
deemed to be approximately equal to those used by Condominiums, Inc.

Fair value of assets

$15,000,000
Fair value of liabilities

8,800,000
Fair value of net assets 23
 Step 3 Estimate the expected future earnings of the target. Exclude any
nonrecurring gains or losses.

B. Condominiums, Inc.’s pretax incomes for the years 2017 through 2019 were
$1,200,000, $1,500,000, and $950,000, respectively. Plantation Homes believes that an
average of these earnings represents a fair estimate of annual earnings for the indefinite
future. The following are included in pretax earnings:
Depreciation on buildings (each year) 960,000
Depreciation on equipment (each year) 50,000
Extraordinary loss (year 2019) 300,000
Sales commissions (each year) 250,000

24
 Determining Price and Method of
Payment
Step 3 Estimate the expected future earnings of the target. Exclude any
nonrecurring gains or losses.

25
 Determining Price and Method of
Payment
Step 4 Subtract the normal earnings (step 2) from the expected target
earnings (step 3). The difference is “excess earnings.”

Expected target earnings

$1,028,667
Less: Normal earnings

930,000
Excess earnings, per year

$ 98,667

26
 Determining Price and Method of
Payment
Step 5 Compute estimated goodwill from “excess earnings.”

Present value of excess earnings (perpetuity) at 25%:

Excess earnings $ 98,667 Estimated
= $394,668
25% Goodwill

Step 6 Add the estimated goodwill (step 5) to the fair value of the firm’s
net identifiable assets to arrive at a possible offering price.

Net assets

$6,200,000
Estimated goodwill
27
 Determining Price and Method of
Payment
Exercise 1-1 (continued)

Required:
B. Assume that Plantation Homes feels that it must earn a
15% return on its investment, but that average excess
earnings are to be capitalized for three years only. Based
on these assumptions, calculate a reasonable offering price
for Condominiums, Inc. Indicate how much of the price
consists of goodwill. Ignore tax effects.

28
 Determining Price and Method of
Payment
Part B
Excess earnings of target (same a Part A) $ 98,667
PV factor (ordinary annuity, 3 years, 15%) x 2.28323
Estimated goodwill $ 225,279
Fair value of net assets 6,200,000
Implied offering price $ 6,425,279

The types of securities to be issued by the new entity in exchange for those of
the combining companies must be determined. Ultimately, the exchange ratio
is determined by the bargaining ability of the individual parties to the
combination.

29
 Alternative Concepts of Consolidated
Financial Statements
Parent Company Concept - Primary purpose of consolidated
financial statements is to provide information relevant to the
controlling stockholders. Emphasis is placed on the needs of the
controlling stockholders.
– The noncontrolling interest is presented as a liability or as a
separate component before stockholders’ equity.
• Economic Entity Concept - Affiliated companies are a separate,
identifiable economic entity. Both controlling and noncontrolling
stockholders contribute to the economic unit’s capital.
– The noncontrolling interest presented as a component of
stockholders’ equity.

30
 Alternative Concepts
Consolidated Net Income
• Parent Company Concept: Consolidated net income
consists of the realized combined income of the parent
company and its subsidiaries after deducting the
noncontrolling interest in income (noncontrolling interest in
income is an expense item).
• Economic Entity Concept: Consolidated net income consists
of the total realized combined income of the parent company
and its subsidiaries. Total combined income is then allocated
proportionately to the noncontrolling interest and the
controlling interest.
31
 Alternative Concepts
Consolidated Balance Sheet Values
• Parent Company Concept: The net assets of the
subsidiary are included in the consolidated financial
statements at their book value plus the parent company’s
share of the difference between fair value and book value
on the date of acquisition.
• Economic Entity Concept: On the date of acquisition, the
net assets of the subsidiary are included in the consolidated
financial statements at their book value plus the entire
difference between their fair value and their book value.

32
 Alternative Concepts
Intercompany Profit
• Two alternative points of view:
– Total (100%) elimination.
– Partial elimination.
• Under total elimination, the entire amount of
unconfirmed intercompany profit is eliminated from
combined income and the related asset balance.
• Under partial elimination, only the parent company’s
share of the unconfirmed intercompany profit is
eliminated.
33
 Conceptual Framework
Illustration 1- 5
Conceptual
Framework for
Financial
Accounting and
Reporting

LO 8 Economic entity and parent company concepts.

34
 Conceptual Framework
Economic Entity vs. Parent Concept and the
Conceptual Framework
• The parent concept is tied to the historical cost
principle, which would suggest that the net assets
related to the noncontrolling interest remain at their
previous book values.
• This approach might be argued to produce more
“reliable” or representationally faithful values .

35
 Conceptual Framework
Economic Entity vs. Parent Concept and the
Conceptual Framework
The economic entity assumption
 views a parent and its subsidiaries as one economic
entity.
 can be argued to produce more relevant, if not
necessarily reliable, information for users.

36
 Conceptual Framework
Overview of FASB’s Conceptual Framework (SFAC)
The Statements of Financial Accounting Concepts issued by the FASB
include:
No.4 Objectives of Financial Reporting by Nonbusiness Organizations
No.5 Recognition and Measurement in Financial Statements of
Business Enterprises
No.6 Elements of Financial Statements (replaces SFAC No. 3)
No.7 Using Cash Flow Information and Present Value in Accounting
Measurements
No.8 The Objective of General Purpose Financial Reporting and
Qualitative Characteristics of Useful Information (replaces SFAC No. 1
and No. 2)

37
 Conceptual Framework
Distinguishing Between Earnings and Comprehensive
Income
• Earnings is essentially revenues and gains minus expenses
and losses, with the exception of any losses or gains that
bypass earnings and, instead, are reported as a component of
other comprehensive income.
• SFAC No. 5 describes these gains and losses as “principally
certain holding gains or losses that are recognized in the
period but are excluded from earnings such as some changes
in market values of investments... and foreign currency
translation adjustments”.
38
 FASB’s Conceptual Framework
Asset Impairment and the Conceptual Framework
• SFAC No. 5 provides guidance with respect to expenses and losses:
• Consumption of benefit. Earnings are generally recognized when
an entity’s economic benefits are consumed in revenue earnings
activities (or matched to the period incurred or allocated
systematically).
– Example: amortization of limited-life intangibles. OR
• Loss or lack of benefit. Expenses or losses are recognized if it
becomes evident that previously recognized future economic benefits
of assets have been reduced or eliminated, or that liabilities have
increased, without associated benefits.
– Example: review for impairment for indefinite-life intangibles.

39
 Historical Perspective on
Business Combinations
What Changed?
• IFRS 3 “Business Combinations,” supports the use of a
single method.
– Uses the term “acquisition method” rather than
“purchase method.”
– The fair values of all assets and liabilities on the
acquisition date, defined as the date the acquirer
obtains control of the acquiree, are reflected on the
financial statements.

40
 Historical Perspective on
Business Combinations
What Changed?
• “Noncontrolling Interests In Consolidated
Financial Statements”,
• Established standards for the reporting of the
noncontrolling interest when the acquirer obtains
control without purchasing 100% of the acquiree.
– Additional discussion in Chapter 3.

41
 Historical
AccountingPerspective on Business
Standards on
Business Combinations
Combinations: Background
• Historically, two methods permitted in the U.S.:
purchase and pooling of interests.
• Pronouncements in June 2001:
– SFAS No. 141, “Business Combinations,” - pooling
method is prohibited for business combinations
initiated since June 30, 2001. [FASB ASC 805]
– SFAS No. 142, “Goodwill and Other Intangible
Assets,” - Goodwill acquired in a business
combination since June 30, 2001, should not be
amortized. [FASB ASC 350]
 Accounting Standards on Business
Combinations: Background
Goodwill Impairment Test
• For public companies, goodwill is no longer amortized.
– Goodwill of each reporting unit is tested for impairment on an
annual basis.
• All goodwill must be assigned to a reporting unit.
• Impairment should be tested in a two-step process.
– Step 1: Does potential impairment exist?
– Step 2: What is the amount of goodwill impairment?

• Private companies can elect an alternative model: amortize goodwill

over a period not to exceed 10 years and utilize a simplified impairment
model.

43
Perspective on
Business
Combinations

44
LO 3
 Goodwill Impairment
Goodwill Impairment Test
Test
E2-10: On January 1, 2017, Porsche Company acquired the net assets of
Saab Company for $450,000 cash. The fair value of Saab’s 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:

* Goodwill is not included

45
 Goodwill Impairment Test
E2-10: On January 1, 2017, the acquisition date, what was the amount
of goodwill acquired, if any?
Acquisition price $450,000
Fair value of identifiable net assets 375,000
Recorded value of Goodwill $ 75,000

46
 Goodwill Impairment Test
E2-10: 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 - 2018
Fair value of reporting unit $400,000
Carrying value of unit:
Carrying value of identifiable net assets
Carrying value of goodwill
330,000
Total carrying value of unit
75,000
Excess of carrying value over fair value $ 5,000
405,000
Excess of carrying value over fair value means step 2 is required.
47
 Goodwill Impairment Test
E2-10: Part A&B (continued)
Step 2 - 2018
Fair value of reporting unit $400,000
Fair value of identifiable net assets 340,000
Implied value of goodwill 60,000
Carrying value of goodwill 75,000
Impairment loss

$ 15,000
Journal Impairment Loss Goodwill 15,000
Entry Goodwill

15,000 48
 Goodwill Impairment Test
E2-10: Part A&B (continued)
Step 1 - 2019
Fair value of reporting unit $400,000
Carrying value of unit:
Carrying value of identifiable net assets
Carrying value of goodwill *
320,000
Total carrying value of unit
60,000
Excess of fair value over carrying value $ 20,000
380,000
Excess of fair value over carrying value means step 2 is not required.
* $75,000 (original goodwill) – $15,000 (prior year impairment)
49
 Goodwill Impairment Test
E2-10: Part A&B (continued)
Step 1 - 2020
Fair value of reporting unit $350,000
Carrying value of unit:
Carrying value of identifiable net assets
Carrying value of goodwill *
300,000
Total carrying value of unit
60,000
Excess of carrying value over fair value $ 10,000
360,000

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

* $75,000 (original goodwill) – $15,000 (prior year impairment)
50
 Goodwill Impairment Test
E2-10: Part A&B (continued)
Step 2 - 2020
Fair value of reporting unit $350,000
Fair value of identifiable net assets 325,000
Implied value of goodwill 25,000
Carrying value of goodwill 60,000
Impairment loss

$ 35,000
Journal Impairment Loss Goodwill 35,000
Entry Goodwill

35,000 51
 Goodwill Impairment Test
Disclosures
• Total amount of acquired goodwill and the amount
expected to be deductible for tax purposes.
– Amount of goodwill by reporting segment (if the
acquiring firm is required to disclose segment
information), unless not practicable.

52
 Goodwill Impairment Test
Disclosures
• Specifies the presentation of goodwill (if impairment
occurs):
– Aggregate amount of goodwill should be a separate
line item in the balance sheet.
– Aggregate amount of losses from goodwill
impairment should be a separate line item in the
operating section of the income statement unless
some of the impairment is associated with a
discontinued operation.
53
 Goodwill Impairment Test
Disclosures
• When an impairment loss occurs mandates note
disclosure:
– Description of facts and circumstances leading to the
impairment.
– Amount of impairment loss and method of determining
the fair value of the reporting unit.
– Nature and amounts of any adjustments made to
impairment estimates from earlier periods, if
significant.
54
 Perspective on Business
Combinations
Other Required Disclosures
• 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.

55
 Perspective on Business
Combinations
Other Required Disclosures
• 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.

56
 Perspective 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 (at a minimum) for
impairment.
57
 Perspective on Business
Combinations
Treatment of Acquisition Expenses
• Exclude acquisition-related from measurement of consideration paid.
– Both direct and indirect costs are expensed
– The cost of issuing securities is 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.
– Expected restructuring costs (with no obligation at the acquisition
date) are accounted for separately from the business combination.

58
 Perspective on Business
Combinations
Acquisition Costs—an 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.
Prepare the journal entry to record these costs.

Professional Fees Expense (Direct) 1,500

Merger Department Expense (Indirect) 2,000
Other Contributed Capital (Security Issue Costs) * 3,000
Cash 6,500
*Costs to issue debt or equity securities shall be recognized in
accordance with other applicable GAAP - FASB ASC 805-10-25-23:
59
 Pro Forma Statements and
Disclosure Requirement
Pro forma statements (as-if statements) serve two
functions in relation to business combinations:
– to provide information in the planning stages of the
combination and
– to disclose relevant information subsequent to the
combination.

60
 Pro FormaStatements
Pro Forma Statements
and and
Disclosure
Disclosure Requirement
Requirement

Illustration 2-2 61
 Pro Forma Statements and
Disclosure Requirement
• If a material business combination occurred during the
year, notes to financial statements should include on a
pro forma basis:
– Results of operations for the current year as though
the companies had combined at the beginning of the
year.
– 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.
62
 Explanation and Illustration of
Acquisition Accounting
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.

63
 Explanation andIllustration
Explanation and Illustrationofof
Acquisition Accounting
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 sum of amounts assigned
to identifiable assets and liabilities is recorded as goodwill.
Goodwill should not be amortized but should be adjusted
downward only when it is impaired (discussed earlier).
• Under current GAAP, in-process R&D is measured and
recorded at fair value as an asset on the acquisition date.

64
 Explanation and Illustration 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
Company’s balance sheet was as follows:

Any
Goodwill?

65
 Explanation and Illustration 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
Company’s balance sheet was as follows:

Fair value of
assets, without
cash
$1,824,000

66
 Explanation and Illustration 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 $1,824,000
Fair value of liabilities 594,000
Fair value of net assets 1,230,000
Price paid 1,560,000
Goodwill $ 330,000

67
 Explanation and Illustration 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 (net) 228,000

Inventory 396,000
Plant and equipment (net) 540,000
Land 660,000
Goodwill 330,000
Liabilities 594,000
Cash 1,560,000

68
 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.
– In the past, FASB required that most long-lived assets be written
down on a pro rata basis before recognizing any gain.
– Current requirements, Acquirer must
• reassess whether it has correctly identified all of the assets
acquired and all of the liabilities assumed before recognizing a
gain on bargain purchases and
• review procedures used to measure the amounts recognized at
the acquisition date.

69
 Explanation and Illustration of
Acquisition Accounting
Bargain Acquisition
• 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 acquiree
to the extent that the fair value of net assets exceeds
the consideration paid.
70
 Explanation and Illustration 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 $1,824,000
Fair value of liabilities 594,000
Fair value of net assets 1,230,000
Price paid 990,000
Bargain purchase $ 240,000

71
 Explanation and Illustration of
Acquisition Accounting
E2-1: B. Repeat the requirement in (A) assuming that the amount paid
was $990,000.
Receivables (net) 228,000
Inventory 396,000
Plant and equipment (net) 540,000
Land 660,000
Liabilities 594,000
Cash 990,000
Gain on acquisition (ordinary) 240,000

72
 Measurement Period
The Measurement Period
 Period after the acquisition date during which the
acquirer may adjust the provisional amounts recognized
for a business combination.
 Ends as soon as the acquirer receives the information it
was seeking about the facts and circumstances that
existed at the acquisition date, or learns that more
information is not available
 Shall not exceed one year from the acquisition date.

73
 Measurement Period
The Measurement Period
 Provides the acquirer with a reasonable time to obtain the
information necessary to identify and measure any of the
following as of the acquisition date:
a. Identifiable assets acquired, liabilities assumed, and any
noncontrolling interest in the acquiree.
b. Any consideration transferred to the acquiree.
c. In a business combination achieved in stages, any previous
equity interest held by the acquirer.
d. The amount recognized as goodwill or the gain from a
bargain purchase.
74
 Measurement Period Adjustments
Measurement Period Adjustments
If initial accounting is incomplete by the end of the first
reporting period:
– Acquirer should use provisional amounts in the
financial statements for any item in which the
accounting is incomplete.

75
 Measurement Period Adjustments
Measurement Period Adjustments
During the measurement period, acquirer:
 Required to retrospectively adjust the provisional amounts
recognized at the acquisition date to reflect new
information obtained about facts and circumstances that
existed at the acquisition date.
 Recognizes additional assets or liabilities if new
information is obtained about facts and circumstances that
existed at the acquisition date which, if known, would have
resulted in the recognition of those assets and liabilities.

76
 Measurement Period Adjustments
Measurement Period Adjustments
After the measurement period ends:
– The acquirer only revises the accounting for a
business combination to correct an error.

77
 Contingent Consideration in an
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.
• Current GAAP requires that all contractual contingencies,
as well as non-contractual liabilities for which it is more
likely than not that an asset or liability exists, be measured
and recognized at fair value on the acquisition date.

78
 Contingent Consideration in an
Acquisition

 Changed the accounting for earnouts (contingencies based on

earnings) both on the measurement and subsequent dates.
 Requires the acquirer to recognize contingent consideration and to
measure the fair value of the consideration at the acquisition date.
 Potential methods for estimating the fair value of contingent
consideration are quite varied.
 For instance, the income approach involves estimating
expected cash flows under various scenarios and discounting
these using some appropriate discount rate and levels of
probability for each.

79
 Contingent Consideration in an
Acquisition
Contingent consideration classified as a liability:
Illustration: Assume that P Company acquired all the net assets of S
Company (current assets of $20,000, buildings for $400,000, and
liabilities of $50,000 for cash of $510,000. P Company also agreed to
pay an additional $150,000 to the former stockholders of S Company if
the post combination revenues over the next two years equaled or
exceeded $800,000. The fair value of the contingent consideration was
estimated to be $60,000.

80
 Contingent Consideration in an
Acquisition
Contingent consideration classified as a liability:
Illustration: P Company will make the following entry on the date of
acquisition:
Current Assets 20,000
Buildings 400,000
Goodwill 200,000
Liabilities 50,000
Contingent Consideration 60,000
Cash 510,000

81
 Contingent Consideration in an
Acquisition
Contingent consideration classified as a liability:
Since the contingent consideration is classified as a liability, P Company
must remeasure the contingent consideration each quarter and recognize
the change in income
Illustration: If at the end of the first year, the likelihood has increased
that the revenue target will be met, P Company should assess an increase
in the fair value of the contingent consideration. If the fair value at the
end of year one increased to $100,000 P Company would make the
following entry:
Increase in Liability:
Loss from Contingent Consideration 40,000
Contingent Consideration 40,000

82
 Contingent Consideration in an
Acquisition
Contingent consideration classified as a liability:
Illustration: If on the other hand, it has become unlikely that either
target will be met, P Company should remove the liability altogether,
and would make the following entry:

Decrease in Liability:
Contingent Consideration 60,000
Gain from Contingent Consideration 60,000

83
 Contingent Consideration in an
Acquisition
Contingent consideration classified as equity:
Illustration: Suppose that in the previous example, P Company agreed
to issue an additional 10,000 shares of $1 par value common stock to the
former stockholders of S Company if the post combination revenues over
the next two years equaled or exceeded $800,000. The fair value of the
contingent consideration was estimated to be $40,000.

84
 Contingent Consideration in an
Acquisition
Contingent consideration classified as equity:
Illustration: P Company will make the following entry on the date of
acquisition:
Current Assets 20,000
Buildings 400,000
Goodwill 180,000
Liabilities 50,000
Paid In Capital Contingent Consideration 40,000
Cash 510,000

85
 Contingent Consideration in an
Acquisition
Contingent consideration classified as equity:
Illustration: P Company would not remeasure the paid in capital
balance based on changes in the fair value of the common stock.
Suppose that the contingent consider was paid. P Company would make
the following entry:

Consideration is paid:
Paid in Capital Contingent Consideration 40.000
Common Stock (10,000 shares at $1 par) 10,000
Paid in Capital – Common Stock 30,000

86
 Contingent Consideration in an
Acquisition
Contingent consideration classified as equity:
Illustration: P Company would not remeasure the paid in capital
balance based on changes in the fair value of the common stock.
Suppose it became unlikely that the target would be met. P Company
would make the following entry:

Consideration is not paid:

Paid in Capital Contingent Consideration 40.000
Paid in Capital –
From Unsatisfied Targets 40,000

87
 Leveraged 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.
– The essence of the change suggests that the economic entity
concept should be applied; thus (LBO) transactions are to be
viewed as business combinations.

88
 IFRS Versus U.S. GAAP
• The project on business combinations
– Was the first of several joint projects undertaken by the
FASB and the IASB.
– Complete convergence has not yet occurred.
– International standards currently allow a choice between
• writing all assets, including goodwill, up fully (100%
including the noncontrolling share), as required now
under U.S. GAAP, or
• continuing to write goodwill up only to the extent of
the parent’s percentage of ownership.
89
 IFRS Versus U.S. GAAP
Other differences and similarities:

90
 IFRS Versus U.S. GAAP
Other differences and similarities:

91
 IFRS Versus U.S. GAAP
Other differences and similarities:

92
 IFRS Versus U.S. GAAP
Other differences and similarities:

93
 IFRS Versus U.S. GAAP
Other differences and similarities:

94