CHAPTER FOUR

Business Combinations

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Business Combination
It refers to a transaction in which an acquirer obtains
control over one or more businesses.
Business Combination has two key aspects(characteristics):
control and businesses
 Control:
Control is the power to direct the relevant activities of the investee.
It requires that the investor has the ability to use its power over the
investee to affect the amount of the investor’s returns.
Owning more than 50% of the voting shares usually, but not always,
indicates control
A company could have control with less than 50% of the voting shares
when contractual agreements give it control.

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 Business Combination
A business :
The acquiree has to be a business
Business consists of inputs and processes applied to those
inputs that have the ability to create outputs
Buying a group of assets that do not constitute a business
is a basket purchase, not a business combination

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Business Combination

 Control over other companies can be obtained by

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

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

combination .

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 Nature of the Combination

Combinor/ Combinee/
Acquirer Acquiree/
Target

Constituent
Companies

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Business Combinations: Why?

1. Rapid expansion
• Business growth Can occur internally – adding facilities and
expanding markets or externally – by acquiring other companies.

2. Operating synergies
 Revenues
• Increase market power/eliminate competition
• Better/more efficient marketing efforts
• Strategic benefits such as entry into new markets
Operating costs (cost advantage or saving)
• Economies of scale (marketing, management, production,
distribution)
• Complementary resources (avoid duplicate efforts)
• Eliminate operating or management inefficiencies

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 Business Combinations: Why?
3. International marketplace
4. Financial synergy
• Income tax-tax gain (savings) through accumulated tax
losses
• Utilization of unused debt capacity
• Reinvestment of surplus funds (free cash flows) as an
alternative to paying dividends or repurchasing stock
5. Diversification: through conglomerate operations

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Types of Combinations

A business combination may be classified as follows:

1. Nature of the combination
Friendly - the boards of directors of the potential
combining companies negotiate mutually agreeable
terms of a proposed combination.
Unfriendly (hostile) - the board of directors of a
company targeted for acquisition resists the
combination.

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 Types of Combinations

Defensive Tactics against Hostile takeover

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

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

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

3. White knight: Encouraging a third firm to acquire or

merge with the target company.

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 Types of Combinations

Defensive Tactics (continued)

4. Pac-man defense: Attempting an unfriendly takeover
of the would-be acquiring company.

5. Selling the crown jewels/Scorched Earth: Selling

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

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Types of Combinations

Defensive Tactics (continued)

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

7. Leveraged buyouts: Purchasing a controlling interest in

the target firm by its managers and third-party
investors, who usually incur substantial debt.

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 Types of Combinations

2. Economic Structure of Combination

Horizontal Integration -Combination between companies that are

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

companies combine or two computer software companies combine.

Vertical Integration - Combination between companies in different

but successive stages of production or distribution. For example, a

manufacturing company merges with a mining company or an automobile

company acquires automobile dealerships.

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 Types of Combinations

Conglomerate- Combination between companies in

unrelated industries or markets. This is a procedure for
companies that want to diversify. For example, a
manufacturing company acquires a financial services
company.

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 Types of Combinations

3. Method of Acquisition/Legal Form

A. 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.
The acquired company’s assets and liabilities are transferred to the
acquiring company, and the acquired company is dissolved, or liquidated .
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 Terminology and Types of Combinations

B.Statutory Consolidation

A Company
C Company

B Company

Is a business combination in which both combining companies are

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

C. Stock Acquisition

A Company A Company

B Company B Company

•The stock acquisition can be made at stock market or

through bid but not statutory
•Ifa company acquires a controlling interest in the voting
stock of another company, a parent–subsidiary relationship
results.

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• This is the Common means of hostile takeover
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 Accounting for Business Combinations

Acquisition Method of Accounting

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

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Acquisition Method of Accounting

1. Determine the combinor(acquirer):

a. If cash or other assets are distributed or liabilities are
incurred as consideration for the aquiree, the entity
that distributes cash or other assets or incurs
liabilities is generally the acquiring entity.
b. If stock is exchanged, the entity that issues the equity
interests or receive larger share of voting rights in the
combined enterprise is generally the acquiring entity.

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Acquisition Method of Accounting
2. Determining the Purchase Price of aquireee
 The Total Cost of Combinee ( Fair value of consideration
transferred) include:
Any cash paid by acquirer
 Fair value of non cash assets transferred by the acquirer
Present value of any liability incurred by acquirer
Fair value of any shares issued by acquirer
Fair value of contingent consideration

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Contingent consideration
 Contingent consideration is an add-on to the acquisition
price that is based on events occurring or conditions
being met some time after the purchase takes place.
 The amount of contingent consideration can be based on
a number of factors, such as:
 The profitability of acquired company;
 Market price for the acquirer’s shares
 Fair value of any contingent consideration based on
securities prices do not affect the cost of the
investment above what was recorded at the acquisition
date, but instead represent adjustments to additional
paid in capital

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Incidental/Out-of-Pocket Costs incurred in connection
with acquisition
Acquisition expenses
Direct Expenses (Legal, Investment banker consulting fees
Accounting fees such as for a purchase investigation, Finders’
fees, Travel costs

Indirect Expenses Labor and overhead of internal

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

What Is Acquired? What Is Given Up?

Net assets of S Company 1. Cash
(Assets and Liabilities)
2. Debt Figure 1-1
Statutory Merger
3. Stock
Common Stock
of S Company 4. Combination of
Stock Aquisisiton above

Asset acquisition, a firm must acquire 100% of the assets of the

other firm. Both assets and liability of acquire are recorded at FV
on the book of acquirer including GW if any.
Stock acquisition, control may be obtained by purchasing >50% of
the voting common stock (or possibly less). Investment is recorded
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1-23 on the book of acquirer at a cost of Business Combination.
Explanation and Illustration of Acquisition Accounting

Example 1 Statutory Merger : Galaxy Company acquired the assets and

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

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Explanation and Illustration of Acquisition Accounting
Example 1: A. Prepare the journal entry on the books of Galaxy
Co. to record the purchase of the assets and assumption of the
liabilities of Axis Co. if the amount paid was $1,680,000 in cash.

Calculation of Goodwill
Fair value of assets $1,944,000
Less: Fair value of liabilities (594,000)
Fair value of net assets 1,350,000
Less: Price paid (1,680,000)

Goodwill $ 330,000

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Entry to record business combination

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

The acquiring company’s own assets and liabilities are not

revalued when it purchases the net assets of the acquired
company.
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The selling company( Axis Company) records the transfer of
its asset and liability to galaxy company on its books as
follows:

Cash 1,680,000
Liability 540,000
Cash 120,000
Receivable 192,000
Inventory 360,000
Plant and Equipment 480,000
Land 420,000
Gain on sale 648,000

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After this entry Axis Company will have
Cash 1,680,000 Common Stock 480,000
Retained earning (420+648) 1,068,000
Other capital 132,0000
Total 1,680,000 1,680,000

When it is subsequently dissolved and cash is distributed to the

shareholders:

Common Stock 480,000

Retained earning 1,068,000
Other capital 132,0000
Cash 1,680,000

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Explanation and Illustration of Acquisition Accounting

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

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Explanation and Illustration of Acquisition Accounting

Bargain Acquisition -Illustration

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

Any previously recorded goodwill on the seller’s books is

eliminated (and no new goodwill recorded).

A gain is reflected in current earnings of the acquirer to

the extent that the fair value of net assets exceeds the
consideration paid.

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Explanation and Illustration of Acquisition Accounting

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

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

Calculation of Goodwill or gain on bargain Purchase

Fair value of assets $1,944,000
Fair value of liabilities 594,000
Fair value of net assets 1,350,000
Price paid 1,110,000
Gain on Bargain purchase $ 240,000

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Explanation and Illustration of Acquisition Accounting

Example 2: Entry: Galaxy Book

Cash 120,000
Receivables 228,000
Inventory 396,000
Plant and equipment 540,000
Land 660,000
Liabilities 594,000
Cash 1,110,000
Gain on acquisition 240,000

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The selling company( Axis Company) records the transfer of
its asset and liability to galaxy company on its books as
follows:

Cash 1,110,000
Liability 540,000
Cash 120,000
Receivable 192,000
Inventory 360,000
Plant and Equipment 480,000
Land 420,000
Gain on sale 78,000

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After this entry Axis Company will have
Cash 1,110,000 Common Stock 480,000
Retained earning (420+78) 498,000
Other capital 132,0000
Total 1,110,000 1,110,000

When it is subsequently dissolved and cash is distributed to the

shareholders :

Common Stock 480,000

Retained earning 498,000
Other capital 132,0000
Cash 1,110,000

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Example 3: What if Galaxy Company purchased 100% net
asset of Axis Company in exchange for its 10,000
common shares , $68 par value , $168 selling price per
share instead of cash
Galaxy Company Entry
Cash 120,000
Receivables 228,000
Inventory 396,000
Plant and equipment 540,000
Land 660,000
Goodwill 330,000
Liabilities 594,000
Common stock 680,000
Premium Capital - Common stock 1,000,000

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The selling company( Axis Company) records the transfer
of its asset and liability to galaxy company on its books as
follows:

Investment in Galaxy 1,680,000

Liability 540,000
Cash 120,000
Receivable 192,000
Inventory 360,000
Plant and Equipment 480,000
Land 420,000
Gain on sale 648,000

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After this entry Axis Company will have
Investment in Galaxy 1,680,000 Common Stock 480,000
Retained earning (420+648) 1,068,000
Other capital 132,0000
Total 1,680,000 1,680,000

When it is dissolved and galaxy share is transferred to individual

shareholders of Axis :

Common Stock 480,000

Retained earning 1,068,000
Other capital 132,0000
Investment in Galaxy 1,680,000

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