Historically, much of the controversy conceming accounting requirements tbr busmess pombmatlons involved the pooling of int6rests method,

which became generally accepted in 1950 when the Committee on Accounting Procedure issued Accoznting Research Bulletin (ARB) No. 40. Although there are conceptual difficulties with the pooling method the underlying problem that arose withARB (pooling No. 40 was the infioduction of altemative methods of accounting for business combinations interests are involved in a business cornbination, and alternate versus purchase). Numerous financial accounting procedures may not be neutral with respect to different interests. That is, the individual financial interests and the final plan of combination may be affected by the method of accounting. Until 2001, accounting requirements for business combinations were found in APB Opinion No. l6,which recognizedLo*rthe pooling and purchase methods of accounting for business combinations. In August 1999, the FASB issued a report supporting its proposed decision to eliminate pooling. Principal reasons cited included the following:

I I r

Pooling provides less relevant information to statement users. Pooling ignores economic value exchanged in the transaction and makes subsequent performance evaluation impossible. Comparing firms using the alterriative methods is difficult for investors.

Pooling creates these problems because it uses historical book values to record combinations, .ather tlhan recosnizing fak values of net assets at the transaction date. Generally accepted accountingprinciples(GAAP)generallyrequirerecordingassetacquisitionsa.tfairvalues' Further, the FASB believes that the economiJnotion,of u pooling of interests rarely exists in business combinations. More realistically, virnrally all combinations are acquisitions, in which one firm gains control over another. FASB Statement No. 141 eliminated the pooling of interests method of accounting for all transactions initiated after June 30, 2001. Combinations initiated subsequent to that date must use the purchase method. The new standard also made other changes to accounting for business
combinations, which will be discussed in detail later. Because the new standard prohibits the use of the pooling method only for combinations initiated after the issuance of the revised stadar4 prior combinations accounted for under the pooling of interests method will be grandfathere( that is, both the purchase and pooling methods will continue to exist as acceptable financial repcting practices for past btlsiness combinations. Therefore, one cannot ignore the conditions fu and reporting requirements under the pooling approach. On the other hand, because no new poolings will be permitted. this discussion focuses on the acquisition method. Mdre-detailed coverage d tte gnoling of interests method is relegated to the Advanced Accounting Web site.
lHren1nnonn- AccouHnnc The

FASB eliminarion of

poling

to account for business combinations. The Interoatimal Accounting Standards Board (IASB) issued International Financial Reporting Snndad J (fRS 3), "Business Combinations,".on
March 31,2004, requiring business combinatioqs to be ronted for using the purchase methodIFRS 3 specifically prohibits the pooling of intere*s mclhod In introducing the new standard, IASB Chairman Sir David Tweedie noted:
Accounting business combinations diverged substantially &cross iurisdictions. IFRS 3 marks a significant step towardhigh quatiry* stodads inbusiness combination accounting, and in ultimately achieving international com'ergence in this area.

international accounting standards. Most

majr

ffiies

makes U.S. GAAP more consistent with prohibit the use of the pooling method

for

ACCOUNTING FOR BUSINESS COMBIilATIONS UNDER THE ACOUISITION METHOD

A11

business combinations initiated after December 15, 2008, must be accounted for as acquisitions under.EASB Statement No. l4IR.The new standard supersedes APB Opinion No. 16, "Business Combinations," and supersedes or amends the numerous interpretations of the former standard. However, the FASB retains much of APB Opinion No. 16 except the pooling of interests method

for business combinations.

23

NOTE TO THE STUDENT

Thetopicscoveredinthistextares0metimesc0mpleXandinvolvedetailedexhibitsandillustrative experience' illustrati0ns iS an integral part of the learnrng examples. Understanding tte r*n|blts and review the exhibits as they with the related text. Care{ully and y'u should study tf,rm'in"lonlunciion information and illustrations are designed to provide essential are intr'duced in the text. ixhibits'and

presented' exptanations {or understanding the concepts " "unor"tunoing transactions is an important the tinanciat statement impact of c0mplex business To assist you.in this learning endeav0r' ;;ounting topics element in the study ot uouunrtit*n;iai and the directional journal entries that include the typds oi accounts being affected this book depicts as f0llgws: A parenthetical reference the text are impact ol the event. conventions used thrgugh0ut e{tect of the ;y;iouinat intry indicates the tvpe 0f acc0unt and the "Accgunts added to each account accgunt' is denoted as rec;ivable, an asset entry. F0r example, an lncreiie rn aicounts "Accounts receivable (-A)." The symbol (+A)." A decrease in this account is denoted as receivable (E) for equity accounts, (R) for revenues, (A) stands for assets, tLr iriiiunitiii*, isr) tor stockholders' expenses, (Ga) for gains, and (Lo) for losses'

rfi;;il

in reiording other assets for recording a business combination as we follow the principle. In other words, we measure the cost to record the combination using ,t " fair value amount of cash by the another company in u blsiness combination
purchasing entity of acquiririg

same generally accepted accounting principles In general, the acquisition method follows the and liabilities'r We

under agement salaries, depreciation, and rent incuned to close duplicate facilities' cists stock for issues 100,000 shares of $10 pal common To illustrate, assume that Poppy corporation 2009 ' The market price of a business combination on July I ' the net assets of Sunny corporation in Additional direct costs of the business combi,,, poppy cornmon stock on this date is $16 per share. (SEC) fee^s of $5,000, accountants' fees in commission nation consist of securities and Exchange costs for printing and issuing the cor'nwith the SEC registration statement of $10,000' connection consultants' fees of $80'000' mon stock certiflcates of $Zi,OOO, and finder's'and (in thousands): shares on its books as follows Poppy records the issuance ofthe 100,000
Investment in SunnY (*A) Common stock, $10 Par (*SE) Additional Paid-in caPital (*SE) par To record issuance of 100,000 shares of $10 price of $16 per share common stock with a market in a business combination with Sunny Corporation' 1,600
1,000

disbursedorbytherairvatue-orotherassetsdistributedorsecuritiesissued. consulting' and finders' (such as accounting, legal' we expense the direct costs of combination or issuance of equity securities' We chargo registration fees) other than those for the registration of securities t"";nties issued in a combination against the fair value and issuance costs of such as mall"*t paid-in capital' we expense indirect costs issued, usually as a reduction of additional the acquisition method' we also expense indirect

600

of the business combination as follows: Poppy records additional direct costs 80 Investment expense fE' -SE) 40 Additiorral paid-in capitai {-SE) Cash'(or other net asstsl t-A)

r20

TorecordadditionaldirectcoslsofcombinilgwithSunny

Corporation: $80,000 for finder's and consultants'fees equiq securities' ana-$+O,OOO for registerilg and issuing

tu

-..{ssumethat"we''aretheparentcompanyi}ccountansresponsibleforpreparationolconsolidaledfinancialstatemen6for and business combinations'

combined reporting

"ntity.

iil;;;;;;;;;;p"-.,i*."gtt'"-i,tt..i,uptlers'on

consotidations

24

we accumulate the total cost incurreiin furcuasing another company in a single investment account' regardless of whether the other .oirpurry is oissot'veo or the combining companies continue to operate in a parent-subsidiary "o-Lioiog relationship. If we dissolve sunny corporation, we record its identifiable^net assets on Poppy's books at *reirialr values, and we record any excess of investment
cost over tair value

we treat registration and issuance costs of $40,000 as a reduction of the fair value of the stock issued and charge thes-e^:9s!s to Additional paid-in capital. w" other direct costs of the business combination ($90,000). The total ""p"nr" *r, ,o poppy of acquiring Sunny is $r,600,000, the amount entered in the lnvestment in Sunny account.

*t:ilHll

in sunny account by means of an enrry on poppy's books. Such

* g*d*itt. h

thtr

;;;;.

ar""","in"

balance recorded in the

an enrry mighr appear

(*A) Inventories (*A) Plant assets (*A) Goodwill (*A)

Receivables

XXX XXX XXX XXX

Accounts payable

(*L)

Notes payable (-r-L) Investment in Sunny (_A) To record allocation of the $1,600,000 cost of acquiring Sunny Corporarion to identifiable net assets according to their fair values and to goodwill.

XXX XXX
1,600

If we dissolve sunny corporation,

company and subsidiary poppy will not record the entry to allocate the Investment in Sunny balance. Inrt"uo, poppy will account for its inrrestment in Sunny by means of the Iavestment in Sunny account, and we will make the allocation of the investment cost to identifiable net assets required L the consolidation process. Because of the additional complications of accounting ro, f*"ot-robsidiary operations, the remainder of this chapter is limited to business combinations in which a single acquiring entity receives the net assets of the other combining companies. subsequent chapters cover parentsubsidiary operations and the preparation ofconsolidatedfinanciar
statements.
OBJECTIVE Z+

Sunny shareholders are now shareholders of poppy. If Poppy and Sunn,v-- corporations operate as parent

we formally retire the sunny corporation shares. The former

LEARNING A

La,tl

PV uaccd orr CrVata\istrcd ilroflq I

gslitrta}rd

t nl

2 N ot I

F$hxr c49^ Flous

gstinalr

to specific categories of assets received and liabilities assumed. we record identifiable assets acquired, liabiliti-es assumed and any noncontrolling interest using fair values at the acquisition date. we determine fair values for all assets and tiabilities, regardless of whether they are recorded on the books of the acquired company. For example, an acquired company may have expensed the costs of developing patents, blueprints, formulas, and the like under the provisions of E4sB statement No. 2,'iccounting for Research ;il;;;;;;;t;r;r.,, However' we assign fair values to such identifiable intangible assets of an acquired company in a business combination accounted for as an acquisition.

the total market value of the consideration transferred by the acquirer, unless otherwise noted. MSB statement No' 14.lR.otrers additional guidance for assigning'amounts

cash flows, discounted based on an observable measure such as the prime interest rate. Level 3 includes other intemallv derived estimations. Throughout rhis rexr, ;;;;il;t;;;" tlat totar fair varue is equar to

but much of the work is done before and during the negotiating process of the proposed merglr' compaaies generally_retain outside appraisers and valualion experts to determine tair values"FASB statement N9. 157 provides guid*." on the determinatioq of fair values..EA^gB smtement No' 157 provides three levels of"reliabiliry for fair value estimates. Level 1 is fair value based on established market prices.. Level2 uses the present-value of estimated future

tangible and intangible assets acquired and liabilities assumed ia the combination. This can be a monumental task'

Recording Fair values in an Acquisition Business Gombination The first step ir recordiag an acquisition is to defermine fhe fair values of all identifiable

f;-;;;;'"n.the acquisition dbte. isset or iiabilitv arises rrom Y:::f^{;i;z:i3::;::tr;:":::::1T:.y;'il#:,";"l?ore,ike,y,hanno,,ha,an the contingeri;1i;,1#J:ffi,il:ffTJ:ilitnJ""i$"j,ll
;;:ombination ,n;a be accounted for in accordance No. r09 and rfi-u"7 ii.-p",^r*i benefits shourd fo'ow n MSB statement No' 158 ana retatet standards. op".ffi'und itucruld be recorded based capital 1ease contracts on the guidanJ n"diu ,***ent Ni. ts anl.rt, wo. zl. \r"e assign no varue to gooowill.""*o"a J^fe b.o,oks.gf_ar q,tr

There are few exceptions to the use of fair values. Contractuar contingencies (contingencies -lared to specific contracrs).ur"

25

r""ognJ"d ur rt"i,

ryE#ff #:n:lTl,iff ;:Ln'r"'fi}?";::;;:i'i;f"?#",heacquirershou,daf Deferred tax andliabilities

os'
assers

p,y

starement

;il;

gni*lance

riJil;;ilree

ffi ffi r*i,1f f .,in:nxl,i:*1**,"f1;ffi

excess of (a)over (b) below;

ig*sB :::hdbecausew;;;il;"

acquired subsidiary under

The acquirer shall recognize goodwill as of the acquisition date, measured as the

a.

The aggregate of:

b'
*qremgx

The consideration transferred measured in accordance with this statement, i rei acq u i si r i on _da,, fr, r- r" t ii i pa ra g rap h 3 9 ) 2. Th e fa i r v a t u e of a i y non, o n r ro t t i n r, rrir',, r, ii2,i n u, 3' In a business combination achievei n ,rogr;,' ,n'J iiqursrtron_aatu of ,the acquirer,s previousty fair varue
w h i ch gen e ra I ty re q u

1'

ri)

n,

The ner o.f the

orrrrc acquired and the riab,ities assumed measured in accordance with this statement.a
nruo Mensungueilr

naa ,ir]'rr"i,ii),rr'i,iirt acquisirion-da,r"o**r,i ,j,n"

or lilrnNetsu Assers,0rxen

iarii'o'b'i,

*nu*""

Bemmizable intangibles

TnnH Gooow tt f..sB statement No. l4IR arso 'ttsifies the recognition of intangibl;;;;; business under the acquisition method. Ems should recognize intungiur!"t"parat" ";#;;;; u"'n

"irr'"rlr"p*"uility ffi ffil'liTl?;;ff 1l',Tililif ;:f,i:.ffi]i;ffi

tn*

tn""t

rgg.q*il onry iitrr"y iat inro

criterion or

i contractuar-regal crirerion. i'ii",,"o(exc,udingnnancia,

one of rwo categories.

''

The acquirer ,rr!!::::!:,r: .seryrarcty f:.m go.o.dwiil rhe identiJiabte intangibte assers acquired in a business combination' A'n"intangible asset is ideniifrabre i"f it meets either rtu separab,itv criterion or tt,, ,orrrornr;,r*r;;;;;;r* paragraph 3(k). _tccording to paragraph 3*) An asset is ictentifiable if it either:

illiirro

1' Isseparable'.thatis,capableofbeingseparated.ordividedfromtheentityandsold,
transferred, ricensed, rented, o,

f",ilii"ii|lii;
2'

,*iongrd, eitlter inaniiuitty or together with a identifiabte asset, or tiabitity, ,"ro,ra"rl,f whether the entity

Arises from contractuar or orher regar.rights,-regardress of whether those rights are transferabre or separabre the"entity or yroi, oinrr" rirrir, from ,ro obrigations.s ' Intangible assets that cannot be so identified should be included in gooa\Vru. For rq:uired firms will have a varuabte example, raed as an intangible separately r.om "*ptof"" *orkforce ,n p;"",;;; this asset cannot be recog_ gooa;iil.

in ffi.-J*?,:1"'J$",d?H::H*i'"'",,*'";""J;;;ff ;""ri,,"ri,i"igiJr".*o
corr,lstNnrrolr Some business combinations provide for x'ilrfil:Eal payments to the previorr r;;"-kh;;;rs of the acquired of, transactions' MsB ffiany, contingent on future statement No. trtn 'nroEi rn"r"o"ir""iiiii orlprovides guidance in rcns for contingent consideration in a businer,

Appendix A

Li'iroiirr,

uo. I4lR(reproduced

0mmgr

corustorRenou

tl n Puncxnse Busfirss

m-r lm:ltrie the distribution of cash ot o,rr"r

'F*iil
ju:r-nr*r,g-;

^J",s

"oiou'i*tio;.il contingent consideration or the issuance or a"t, or equity securities.

lF!,,iff .]lolrm.rem

-l :.

J-tiR
--r--&

i{

paragraph 34.

qagraphAlg.

26

lntangible Assets
That Meet the

Criteria for Recognition Apart from Goodwill

Source: FASB Statement No. 141 , AppendixA,

pp.27-28.

tion

We record the fair value of contingent consideration that is determjnable at the date of acquisias part of the cost of combination. When the contingency irvolves future earnings levels, we recognize the fair market value of the consideration distributed or issued as a transfer within the equity accounts. If the contingency is based on security prices, the recorded cost of the acquired company should not change. Instead, when the contingency is resolved, we record the additional consideration that is distributed at its fak market value. We should write down securities issued and recorded at the date of acquisition proportionately. When the acquiring entity issued capital stock, the write-down is usually to other paid-in capital. A write-down of debt securities would result in recording a discount on debt, which we must then amortize from the date of settlement of the contingency.
Gosr nno Fltn Vnue Coupnrco After assigning fair values to all identifiable assets acquired and liabilities assumed, we compare the investment cost with the total fair value of identifiable assets less liabilities. If the investment cost exceeds net fair value, we first allocate it to identifiable net asbets according to their fair values and then allocate the excess to goodwill.

27

In some business combinations, the total fair value of identifiable assets acquired over liabilities -.sumed may exceed the cost of the acquired company. Paragraph 36 of MSB Statement No. I4IR :'itrs accounting procedures to dispose of the excess fair value in this situation. The gain from

:a;b

a bargain purchase is recognized as a gain

for the acquirer.

lllustration of an Acquisition Combination Pem Corporation acquires the net assets of Seed Company in a combination consummated

on December 27,2008. The assets and liabilities of Seed Company on this date, at their book values at fair values, are as follows (in thousands):

':d

Book Value Assets Cash Net receivables

FairValue

$s0
150

s0.
140.

Inventories Land

200
50 300

250'
350

r00 .-

Buildings-net
Equipment-net
Patents

500'-

250 $1,09q

Total assets

50' Ei4q

Liabilities
Accounts payable Notes payable Other liabilities Total liabilities Net assets

$60
150

$60
135

$ $

40 2s0 750

45

z4o

$r,200

CASE 1: cooDwrrL Pin Corporation pays $400,000 cash and issues 50,000 shares of Pitt Corporation $10 par :ililrmon stock with a market value of $20 per share for the net assets of Seed Company. The :rilowing entries record the business combination on the books of Pitt Corporation on December

r-.

2008.
Investment in Seed Company
Cash

(*A)

1,400 400 500 500

(-A)

Common stock, $10 par (*SE) Additional paid-in capital (+SE)

To record issuance of 50,000 shares of $10 par cofilmon plus $400,000 cash in a business combination with Seed Company. Cash

(*A)
(*A)

50

\et
-

receivables

140 250
100

lf\entories (+A)
'nd 1*A)
'trmenr

3:idirgs (*A)

500
350

(+A)

:'--':s (*A)

50 200

-..,---ll

(+A.) Accounts payable

Notes payable Cther

(*L) (*L) liabilities (*L) (-A)

60"
135'
45'
1.400

L:.estment in Seed Company

l:

-t",,:r.:

-':

r.:;r::-:
lr-:i:

.li:r:

"l,:

;ost of Seed Company to identihable assets liabilities assumed on the basis of their fair
;.Urdg.ili.

n
We assign the amounts to the assets and liabilities based on fair values, except for goodwill. We determine goodwill by subtracting the $1,200,000 fair value of identifiable n"t urJ"t, acquired from the $1,400,000 purchase price for Seed Company's net assets.

CASE 2: FAIR vALUE ExcEEDs TNvESTMENT cosr (BAncilx RncHAsE) Pitt Corporation issues 40,000 shares of its $10 par common stock with a market value of $20 per share, and it also gives a lj%o, fle^year note payable for 5200,000 for the net assets of Seed Company. Pitt's books record the Pitt/Seed business combinarion on December 21 ,2}Og,with the following journal entries:
Investment in Seed Company

(*A)

1.000

Common stock, $10 par (*SE) Additional paid-in capital t*SE)

107o Note payable

400 400 200

(*L)

To record issuance of 40,000 shares of $10 par corlmon pius a $200,000,10Vo note in a business combinarion with Seed Company. Cash

(+A)

50

Net receivables Inventories Land (!, A)

(*A)

140

(*A)

250
100 500

(*{1 Equipment (*A)

Buildings
Patents

3s0
50

(+A)
Accounrs payable
Notes payable

(*L;

60
135

(*L)

Other liabilities In'estrnenr

(*L) (-A)

45 1,000

ir

Seed Company

Gain from bargain purchase (Ga, *SE)

To assign the cost of Seed Company to identifiable assets acquired and liabilities assumed on the basis of their

200

fair Vaiues.

ago9" "Pushed to the brink of coliapse by the mortgage crisis. Bss Sre rns Cos. agreed - after prodding by the federal govemmenr - to be sold to J.p. Morgan Ctwse & Co, forthe fire_sale price of $2 a share' in stock' or about 5236 million. Bear Sterns had a stmk-market

notable transactions related to the sub-prime mortgage crisis il U.S. financial markets were reported intheWall Street Journal in early 2008."&ank af America offered an all-stock deal valued at $4 billion for Countrl'wide - a fraction of the companl's Sl-l biliion market value a year

value of the identifiable net assets acquired exceeds the S1.000.rir-rl purchase price by $200,000, so Pitt recognizes a $200,000 gair from a bargain purchase. Bargain purchases are infuequent, but sometimes occru erer rbr very large

We assign fair values to the individual asset and liabiliry ilcounts in this entry in accordance with the provisions of FASB Statement No. I4lR for business ci_rnbiaations. The $1,200,000 fair

corporations. Two

lion

as

of Friday

and was q'orrh S20 billion in January 2A0l. ),:

value of about $3.5 bil-

The Goodwill Controversy

GAAP defines goodwill as the excess of the investment cost over the fair value of assets received. Theoretically, it is a measure
excess earnings over the normal earnings of a similar business. Estimatiag it requiies considerable

ire

7'T.P. Morgan Buys Bear in Fire Sale, As Fed Widens Credit to

6"Behind Bank of America's Big Gamble," wail s*eet Journar, January 12,200g, p. A1.

Avert Cisisl' Wall Street Joumal,March

17, 200g, p. A1.

n
::3;ulation. Therefore, the amount thaf we generally capitalize as goodwill is the portion of the :rr;hase price left over after all other identifiable tangible and intangible assets and liabilities .,'e been valued. Errors in the valuation of other assets will affect the amount capitalized as : -- rdrl iil. {,nder EASB Statement No. 142, goodwill is not amortizedfor financial reporting purposes. -:i;re are also income tax controversies relating to goodwill. In some cases, firms can deduct good'; ril amortization for tax purposes over a 15-year period. The tax consequences of goodwill are

.-'i.rssed in Chapter I0,

FoR GooDWLL U.S. companies had long complained that the accounting rule amortizing goodwill put them at a disadvantage in competing against foreign companies for ::.:ser pafiners. Some countries, for exampie, permit the immediate write-off of goodwill to stock,,-,Jers' equity. Even though the balance sheet of the combined company may show negative net .- :,rth. the company can begin showing income from the merged operations immediately. The new . .. '; dard should alleviate these competitive disadvantages. Companies in most other industrial countries historically capitalized and amortized goodwill .:-iired in business combinations. The amortization periods vary. For instance, the maximum .-:-,rrtization period in Australia and Sweden is 20 years; in Japan, it is 5 years. Some countries per--, deducting goodwill amortization for tax purposes, which makes short amortization periods

flmRuattou* Accouwnlc

::

::lar.

runting standards. The standard-setting bodies of the three trading partners are looking at ways -row the differences in accounting standards. Canadian companies no longer amortize good- " Canadian GA.A.P for goodwill is now consistent with the revised U.S. standards. Mexican - ::anies amortize intangibles over the period benefited, not to exceed 20 years. Negative good- -iom business combinations of Mexican companies is reported as a component of stockhold: -, :quity and is not amortized. -:e IASB is successor to the IASC, a private-sector organization formed il 1913 to develop =rational accounting standards and prornote harmonization of accounting standards worldwide. -,-:--ident with the issuance of 1FR.9 3 on March 31,2004, the iASB revised International ' . . .Lnring Standard (IAS) 36, "Impairment of Assets," and 1AS 38, "Intangible Assets." Under the :. -.:,i rules, goodwill and other intangible assets having indeterminate lives will no longer be : rtltilt but will be tested for value impairment. Impairment tests will be conducted annually, or : ,:= : .:.:ently if circumstances indicate a possible impairment. Firms may not reverse previously -:- :- -' -:rpairment losses for goodwill. These revisions make the IASB rules consistent with :' -: '- ! .- j Canadian GAAP. Although accounting organizations tiom all over the world are .: .r- -- = I \SB does not have the authority to require compliance. However, this situation is ' ".r ; - - *-',--i. The European Union requires IFRS in the financial reporting of all listed firms , 5. Many other countries are replacing, or considering replacing, their own GAAP
-

:::

The North American Free Trade Agreement (NAFIA) increased trade and investments between -.-ada, Mexico, and the United States and also increased the need for the harmonization of

r: ,

Jards.

.rd FASB are working to eliminate differences in accounting for business comLS and U.S. GAAP. The FASB is considering revising its standards to hamo:::*:r:ements" For example, under U.S. GAAP, amounts assigned to purchased :: C"^velopment must be expensed, whereas IFRS 3 permits capitaiization of and 160 were issued in 2001 , as the result of a joint project with the of /FRS 3 at the same time. Some differences still remain. For an acquirer to measure the noncontrolling interest at its fair value, -i:: *-: - ::rs to record noncontrolling interests at either fair value or a propor-

l'

. ::"'ision
':

-entifiable net as\ets.

-*^i l+l

$ A,sc,:rit ".; inr Goodwill and Other lntangible Assets r-r: - -,-::: ::,-ounting for goodwill in FASB Statement No. 142. They main-.,

": -'-- - -

.'-J-*ill.buttherevisedstandardsmitigatemanyof

theprevious

frt

. FASB Statement No. 141R provides clarification and more detailed guidance on when previously unrecorded intangibles should be recognized as assets, which can affect the amount ofloodwill that firms recognize. Under FASB Statements No. l41R and No. 142, firms record goodwill but do not amortize it. Instead, the FASB requires that firms periodically assess goodwill for impairment in its value. An impairment occurs when the recorded value of goodwill is greater than its fair value. We calculate the fair value of goodwill in &e same manner as in the original calculation at the date of the business combination. Should such impairment occur, firms will write down goodwill to a new estimated amount and will record an offsetting loss in calculating net income for the period.
FASB Statement No. 142 doesnot retroactively change treatment of goodwill, but firms will cease arnortization of previously recorded goodwill. In other-words, further imortization is not permitted, but firms may not write goodwill back up to reverse the impact of prior-period amortization charges. Firms no longer amortize goodwill or other intangible assets that have indefinite useful lives. Instead, firms will periodically review these assets (at least annually) and adjust for value impairment. The FASB provides detailed guidance for determining and measuring impairment of goodwill and other intangible assetS. FASB Starement No. 142 amends FASB Statement No. I2I, 'Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," to exclude goodwill and other nonamortizable intangible assqts. Firms must apply MSB Statement lio. 142 in all fiscal years beginning after December 15, 2001. The standard also redefines the reponing entity in accounting for intangible assets. Under APB Opinion No. 17, firms treated the acquired entity as a stand-alone reporting entity. The FASB recognized that many acquired entities are i,ntegrated into the operations of the acquirer. Under MSB Statement No' 142, firms will treat goodwill and other intangibles as assets of the business reporting unit, as defined under,EA,SB Statement No. 13l, "Disclosures About Segments of an Enterprise and Relaled Information." Firms will report intangible assets, other than those acquired in business combinations, based on their fair value at the acquisition date. Firms should allocate the cost of a group of assets acquired (which may include both tangible and intangible assets) to the individual assets based on relative fair values and "shall not give rise to goodnill" (paragraph 9). MSB Statement No- 142 (paragraph 10t retains A PB Opinion No. l7's accounting for internally developed intangible assets:

Costs of internally developing, maintaining, or restoring intantgible assets (inctuding goodwilt) that are not specificatty idenifiable, that haie indeleruninate lives,

are inherent in a continuing business and related to the entity as awhole, shall be recognized as an expense when incuned.

or that

Recoctltaue AffD MEASURII{G lupntnmru Losss The goodwill impairment test under MSB Statement No' 142 is a fwo-step process. Firms must firsi compare values (book values) to fair val"uoying ues at the business-reporting-unit level. Canl ing value includes the goodwill amount. If fair value

a current arm's-length transaction. The FASB considers quoted market prices as the best indicators of fair values, although these are often unavailable. When market prices are unavailable, firms may determine fair values using market prices of similar assets and tiaUitities or other commonly used

unit to all identifiable assets and liabilities as if they purchased the unit on the measur".n"rrt dut". Any excess fair value is the implied fair value of goodwill. Fair value of assets and liabilities is the value at which thel-could be sold, incurred, or settled in

not reverse previously recognized impairment losses. Firms should determine the implied fair value of goodnill ir rhe same manner used to originally record the goodwill at the business combination date. Firms allmare the fair value of the reiorting

for the difference. The loss amount cannot exceed the canlilg amount of the goodwiil. Firms can-

is less than the carrying amount, then firms u-ill proceed to the secJnd step, measurement of this impairment loss. The second step requires a comparison of the carn'ing amount of goodwill to its implied fair value. Firms should again make this comparison at the business-reporting-unit level. If the canying amount exceeds the implied fair value of the goodn-ill. the firm must recognize an impairmentioss

31

--ir"r:
Tt: ::

, i* :: .::r:raiies. For example, firms may employ present value techniques to value estimated - i: i--.-,s orearnings.Firmsmayalsoemploytechniquesbasedonmultiplesof earningsor

:r

r_- , - -,i conduct the impairment test for goodwill at least annually. MSB Statement No. 142 j-,-- : - - : iequires more-frequent impairment testing if any of the following events occurs:
.

-:i

adverse change in legal factors or in the business climqte .- ;.j'. erse action or (tssessment by a regulator -- -. ;.:- c ipate d comp etition

- . .:t:!-icant
-.

, -.:
--

- . .. c.f key personnel :, .: ,e-likely-than-not expectation

."

that a reporting unit or a significant portion of

asset Sroup

itirtg unit **ill be sold or othenttise disposed of

reporting unit

::sing for the recoverabitity under statement 121 of a significant

r,

5 :. - zilition of a goodwill impairment loss in the financial statements of a , : ';iiary that is a component of a reporting unit r: : , ,::;. : ,l impairment testing required under E4SB Statement No' 142 is complex and may * ,:r , :-- , =l l-rnancial statement impact. A whole industry has sprung up to assist companies in -l*j.r:

::"..,: a

--= ;:.:d$.i11 valuations.

hnwr;s:nil\ Vfisus

Firms must amortize intangible assets with a finite useful life r jr- _: The FASB defines usefut tife as estimated useful life to the reporting entity. Firms must ' *i *,._: - ... eible assets with an indefinite useful life over the best estimate of that life. The :ir,t , . , .:: tnization should reflect the expected pattern of consumption of the economic benefits
Nonnm0RTtzATtoN
1''

: _:.- -:ttie. It firms cannot determine a pattern, then they should use straight-line amortization. :i*_i i _ rot amortize intangible assets with an indefinite useful life that cannot be estimated. If should be amottized at that point. Firms fru:; ,:: r,:r;tle s later have a life that can be estimated, they
.i, , - :-,-.-,:ica11-rreview intangibles that are not being amortized for possible impairment loss'
Srl r-0SURE REQUIREMENTS

I
.:.

r:,r I - .; ,.counted for by the acquisition method. The notes also should provide the name and of the .. ir-:i :::::tpiion of the acquired company, the period for which results of operations

,;

::

must disclose that the business com---nancial statements of the acquiring corporation

r .i .rj:- - . =iun1 are included in the income statement, the cost of the acquired company and' if '-: number and vaiuation of shares of stock issued or issuable, and a description of any --j:l . -::,: I --::-. :.1 ments. Inforrnation relating to several minor acquisitions may be combined for
=:: -.=:-.1 acquisitions, the financial statement notes for the period of combination should *'- tr:: , --:,:inental information on a pro forma basis as follows: (1) the results of operations for (2) the :erod as though the companies had combined at the beginning of the period and ,, * -. -r .* u i::. . : -:,e:.irons for tie immediately preceding period as though the companies had combined _ t** :r-' l-,..g of that period, if the firm presents comparative financial statements. The FASB .! lr I l-. '-- disclosure of these pro forma results for nonpublic enterprises'8 .ii related to recognized _ l , -i 1.' t:t No. l4l R expands required disclosures, especially those
r: ,

,"- .

r-:::*:!OSeS.

- .;

the combination and the :r*:r ;. 1 ;:: ;ri:-*:. Firms must disclose the primary business reason for for assets acquired and liabilities ,.,. : --. : rrchase price by major balance sheet categories

\o. j42 requires firms to report material aggregate amounts of goodwill as a -rtl lire item. Likewise, firms must show goodwill impairment losses separately rirTr"ir::lr ! -r - r: : ..r r:* .-r i: u i;r;L=lr. as a component of income from continuing operations (unless the impair- 1r;. : .*.Ji ; - -..-ued operaiions;. FASB Statement No. 142 aTso provides increased disclos'ure

, ,ri
1r

,ir

rn,r-r

r: -

j::r-:a-*i

can be found

in paragraphs 6T through ?3 of MSB

Statevnents

No l4lR Under

.: -:.., :jated ircome statimeit *i11 include ', :- *'.'*iSd further in a latter chapter.

acquiree eamings only for the period subsequent

32

iequirements for intangible assets (FASB Statement No. 142, paragraphs 45 through 47, which are reproduced in Exhibit 1-3). Before completing the chapter, let's take a look at a summary example of required disclosures under ,E4SB Statements No. I4I and 142 from a real-world company.e In February 2006, Cisco Systems,lnc. completed its acquisition of Scientific-Atlanta, Inc. Cisco planned to use ScientificAtlanta's products and services to provide a more complete package of services for its customers. Exhibit 1-4 provides excerpts of Note 3 from Cisco's 200'7 annual report related to this acquisition.

lntangible Assets Disclosure

Requirements
Source: FASB Statement

No.142, pp.16-17.

''

:ir ::

:-

--:.;:

:.-.::

--.: i:'----j.,:,,: r::

: - .'

-:-

"

::. rs:, :isclosures under E4SB Statement No. I 4 I R are L "\ . :: :::::sr:::rr iurhg ilscal rears be,einning a1:et D:::::*,

33

Note 3-Business

Combinations (pp.56-57)
Saurce: Excerpt from Clsco Sysfems, /nc' 2007 Annual RePort'

\lre,

to purchased intangible in particular, that $1.9 billion of the $7.1 billion price tag relates million to in-process research and ..sets. Cisco allocates $3.8 billion to goodwill and another $88
::r'elopment.

THE SARBANES.OXLEY ACT OF 2OO2

why we haven't rnentioned have likely heard about Sarbannes-oxley and ale wondering and WorldCoru (among others) and the demise The financial collapse of Enron Corporation

lou

it yet'

of

Congress to initiate legislation :ublic accounting firm Arthur Anilirsen and Company spurrecl abuse' The result was the sarbutes:r:ended to pfevent future financial reporting and auditing palt, the new rules focus on corporate goveflIance, auditing ,-t.-;lt-., .\ct of 2002 (sox) For the most presenlaljt': ,:j :"i:nal-control issues, rather than the details of financial reporting and statement al1 t'' ::: -:e topic of this text. However, you should recognize that the law rvill impact --::: .-: a few of the imporlant areas covered b.v SOX: . , ::. _, : -::panies that we study. Here are

34

I r I I r

Requires greater independence and oversight responsibilities for corporate boards of directors, especially for members of audit committees Requires management (CEO and CFO) certification of financial statements and interna.l controls Requires independent auditor review and attestation on management's internalcontrol assessments Increases disclosures about off-balance sheet arrangements and contraclual obligations Increases types of items requiring disclosure on Form 8-K and shortens the filing period

Enforcement of Sarbanes-Oxley is under .the jurisdiction of the Securities and F.xchange Commission. The SEC treats violations of SOX or rules of the PCAOB the same as violations of the Securities Exchange Act of 1934. Congress has also increased the SEC's budget to permit improved review and enforcement activities. SEC enforcement.actions and investigations have increased considerably since the Enron collapse. One recent example is Krispy Kreme Doughnuts, Inc. AJanuary 4,2005,press release on the company's Web site announced that earnings for fiscal 2004 and the last three quarters would be restated. Apparently the company did not make as much "dough" as originally reported. Pre-tax income will be reduced by between $6.2 million and $8.1 million. Another example appeared in a Reuters Limited story on January 6,2005, which noted that former directors of WbrldCom agreed to a $54 million settlement in a class-action lawsuit brought by investors. This included $18 million from personal funds, with the remainder being covered by
insurance.

Exhibit 1-5 provides an example of the required management responsibilities under SOX from the 2006 annual report of Chevron Corporation (p. 49). Notice that management's statement reads much

Report of
Management
Source:2006 Chevron Corp. annual repod.

,-r4

W#t1'. *#;&E+?4?*.as ffiif;=:'wE Bwr:;ar rr* gret

@mm'r

.s

-5[,i:

,::+

r:r++

35
a traditronal independent auditor's report. Management takes responsibility for preparation of ::e inancial reports, explicitly notes compliance with GAAP, and declares amounts to be fairly :'r*ented. Management also takes explicit responsibility for designing and maintaining internal

3"e

a:r.nr,ls. Finally, the statement indicates the composition and functioning of the Audit Committee, rn:-;h is designed to comply with SOX requirements. The statement is signed by the CEO, CFO, stj s66p6sller of the company. tre will note other relevant material from Sarbanes-Oxley throughout the text, as applicable. F:r erample, transactions with related parties and variable interest entities are included in

iAater

11.

*rr:.. Lnder FASB Statement No. l4lR, all combinations initiated after December 15, 2008, must rr .uc-nurted for as acquisitions. Acquisition accounting requires the recording of assets acquired
nr.,'

{" :u.si-aess combination occurs when two or more separate businesses

join into

a single

accounting

-:Si,lities assumed at their fair values at the date of the combination, illustrations in this chapter are for business combinations in which there is only one survivng :nd.ry. Later chapters cover accounting for parent-subsidiary operations in which more than

lk

nnre

:r me combining companies continue to exist as separate legal entities.

'll,

-'i*ribe

the accounting concept of a business combination. necessary

:= i E-rplain. a;-: are the legal distinctions between a business combination, a merger, and a consolidation? I { a:br does goodwill result from a business combination? How does goodwill affect reported net income
rr-,= a business combination?

- i Ssolution of all but one of the separate legal entities

in order to have

a business combina-

in

?i

is a bargain purchase? Describe the accounting procedures necessary to record and account for
purchase.

r :*;ai-n

r-1
questions
1.,

ffi
{
ncr:

r.sas combination in which a new corporation is formed to take over the assets and operations of two or
separate business entities, with the previously separate entities being dissolved, is a/an:

e tamlidation b Hger

r ,

fuiing at interests lr4rbition

combination, the direct costs of registering and issuing equi$ securities are:

2.

h &Mged against other paid-in capital ot the combined entity c [t&sfud from income in the period of combination 6 tuE of the above

a M b lhe parenUinvestor company's

r : s..siness

investment account

f,[flMl
.T

flfnr d tre following

r ffies Eff rffi tfuE

accounts would be adjusted to its fair market value in a merger accounted for under the method, regardless of the price paid?

4 ffi ilmm mte -ix value of net assets acquired in a business

r ffiar t gfir from a bargain purchase i ffi h r ffiiaa af noncash assels before negative goodwill may be reported

combination over the price paid is:

36

t
d
5'

noncurrent assets other than marketabre securities to zero berore nesative goodwi, Appried to reduce goodwi, to zero before negative

Y:i;:::;:l:fr

Cork corporation acouires Dart corporation in a business combination. which of the following would from the process of assigning frir.-ritrrr;;;;;;l"e, be excluded of recording the acquisition?

goodwirt may be reported

'^
pavabte becaui

ii]i,'ii| ,*i,n*of
a

FASB srarement

,,

bv tand ' ';:;;#::t*' "i:"{::f::::'i::,r:,:;:::;;::;[:ijii;::,,::;i;;that has

i,;;;;;;;,'r*d

market vatue rar in excess or the

ii;::t;r;1,:::X! "^*rt

for over_ or undertunding of Dart,s defined-benetit pension ptan

E1-2
[AICPA adapted! Generat probtems
1

'

Fast corporation paid $50,000 cash for the net assets of Agge company, which consisted of the following:

Book Value

Fair Value
$14,000 s5,000 (e,000)
$60"00-o

Curent

assets

Plant and equipmenr

i0,000

Liabilities assumed

40,000 (10,000) T4030-n

.fhe prant and equipment acquired in

b $50,000 c $45,ilii9 d W,ooo

2'
0n April
'l

a $i5,000

ftis

business combination should "vv uv,',v,,rquuil biluutu be recorded 0e fecofded

at:

transacti'n properlv acc'unted to,. ui

Cash

'

Jack companv pajd s800,000 for all the issued and outstanding common stock of Ann corporation pri.r'arr.'inir.rororu in ffiiliii;! of Ann corporation on Aprir 1a

,r;;t;il

ln1'sntor/
Property and equipment (net

$
depreciation

80,000

.,ifiiill,r,"o

of$320,000)

of

240.000 480,000

0n Aprir it was determinedrhat the inventorv ment (net) had a fair value of g560'000.

$1e0 wrjriiJ tiJumornt ot good;iir ,.;rlriN'g ,rj

,,T;ii3:,,:Ir,rl:,f

d
E 1-3

b $50,000 c $150,000
$180,000

fi:::?, the
r,.o,n

properry and equip-

business combination?

Prepare stockholders' equity section

illt:ilto:li'otrs'

equities of Pillourcorporation and Sreep-bank corporation ai January 1 were as forows (in PiIlog' Capital stock, $10 oar Other paid-in capiul
Retained eamings
s

SIeep-bant $ 800 400

300

1,500

200
600

Stockholders, equity

$2300

sl Jo-0

s,eep.bank,s shares, ii,lft.i11iH:;:::fl,J;%?T;:$'.'fli:#',trgr[*x*^.1^q,-qp.er llli:f:j.illl#i.H1g,?.,.*;;;;; ;;;:jiiilt#f,i?:;3li;,.1,',,*1JffJ?J:#fJ$f,,ff:ffiTl ilAT;

or
R-E Q U I R E D

srrffiu

::-re:.e

L,usiness combinarion on

prepare the stockholders, eoui section equrty of

January,. fi*,1,r

r."0#;:jil#H#:l

pillow Corporation,s balance

sheet rmmediately

J7 E 1-4

.&o'urnal entries

d,ifferences

to record an acquisition with direct costs and fair valuelbook ualue

-::--

-'-'---i.ry l.DandersCorporationpays$400,000cashandalsoissueslS,000sharesofg20parcommonstockwith . -.".-. 'r'aiue of $660,000 for all the outstanding common shares of Harrison Corporation. ln addition, oanoeii pays :a: --:iorregisteringandissuingthelS,000sharesand$l40,000fortheotherdirectcostsof thebusinesscombi-"''hichHarrisonCorporationisdissolved.summarybalancesheetinformationforthecompaniesimmeOiatety
mei-ger is as follows (in thousands):

-,:---: :-3

Danders Book Value

Cash

Harrison
Book Value

Harrison
tr'air Value

700

Inr entories Other cuffeni assets

?1ant assets--net Toial assets

$Bo
160

244
60

$80
204
40

520

sl

;ro
320
160

40 360

s6m

560 s880

Current liabilities
Other iiabilities Common stock, 920 par Retained earnings Total liabiiities and

$60
100

$60
80

840 200

400
80

owners'equity

$_u?q

$!4q

: : : U I R E D: . -:::-:rn.

Prepare all journal entries on Danciers Corporation's books to account for the business

,tmfiurrral

entries to record husiness combination$ +*:; :_-oany issued 120,000 shares of $10 par common stock with a fair value of $2,550,000 **:-.:_r:kof JesterCompany. lnaddition,iceAgeincurredthefollowingcosts:
Legal fees to arrange the business combination Cost of SEC registration, including accounting and legal fees Cost ofprinting and issuing net stock certificates Indirect costs of combining, including allocated overhead and executive salaries
$25,000 12,000 3,000 20,000

for all the voting

- -*: : :. lefore the business combination ; i :: -- :,',,s {in thousancis):

in which Jester Company was dissolved, Jester,s assets and equities

Book Value

Fair Value

Current assets
PIant assets

Liabilities
Common stock
Retained earnings

1,000 1,500 300 2,000

$r,100
300

) )oo

200

; Ei :

Plepare alljournal entries on IceAge's books to record the business combination.

il

*,,,:

!'uwffifrfi

mffiriiftiltmlffiB

$het after busines$ connbination :.-,::n corporation enters into a business combination with Seabird ..: -: :: dissolved. Pelican pays $825,000 for Seabird, the consideration

38

consisting of 33,000 shares of Pelican $ l0 par common stock with a market value of $25 per share. In addition, Pelican pays the following expenses in cash at the time of the merger:
Finders'fee
Accounting and legal fees Registration and issuance costs of securities

35,000 65,000 40,000

$140,000

Balance sheet and fair value information for the rn'o companies on December before the merger, is as follows (in thousands r:
Pelican Book \alue
Cash

3 1,

2008, immediately
Seabird

Seabird BookValue

FairValue

150
:_10

$30
50 80
100

$30
40

Accounts receivable-net Inventories Land

{|0

5:0

120
150 300

Buildings-net
Equipment-net
Total assets Accounts pay4ble Note payable Capital stock, $10 par Other paid-in capital
Retained eamings

: u s_-5r s
,1m 600 800 600

1.1:{n 500

200
300 $i6-o

250
s8e-0

$40
200
300 50

$40
180

Total liabilities and

-im
5t,8qq

170
$760

owners'equity

RE0UIRED: nepare

abalance sheet l'arPelican Corporation as of January 2,zmg,immediately afterthe

merger, assuming the merger is treated as ar acquisition.

7-2

Prepare balance sheet

afbr hl$ness Gombination

Pine

Comparative balance sheets for Pine and Sain Corporations at December 31, 2008, are as follows (in thousands):
Sain

Current as:ers Land

Buildings---net
Equipment----aet

Total as-ts
Currenr liabilicies Capital srock- S10 par

$Z!!-s50 500 s700

50 100

$130 50 300 220

60

100 100

240 $5oo

s60
2a0
140 100 $-m0

Additional paid-in capital Retained eamitgs 'Iotal equiries

issues 30.000 shares of its stock w-ith a market value of g20 per share for all the outstanding shares of Sain Corporation in a bushess combination. Sain is dissolved. The recorded book values reflect fair values, except for the buildings of Pine, which have anetrealizable value of $400,000, and the current assets of Sain, which have a net realizable value of

on January 2,2009, Pine

$100,000. Pine pays the following expenses

il

connection with the business combination:

$15,000

Costs of registeriag and issuing securities

Other direct costs of combination

25,000

RE0U

IRED:

Prepare the balance sheet of Pine Corporation immediately afterthe business combination-

P 1-3

Journal entries and balance sheet for business combination stock for all the lJa January 2,zl}g,Persis Corporation issues its own $10 par common

outstand-

Sineco is dissolved' In addition' Persis ,r1s stock of Sineco Corporation in a business combination' The issuing securities and $30,000 for other costs of combination' ;ar s $20,000 for regist#ng and Relevant balance sheet inforper share. :rarket price of persis's stJck on January 2,200g,is $30 just before the business combiSineco corporations on December 31, 2008, radon for Persis and -arion. is as follows (in thousands):
Persis Sineco Sineco

Ilistorical Cost
Cash

Historical Cosl

Fair Value

120

$to
30 90 20

$10
60
100 100

Inventories Other current assets Land Plant and equiPment-net Total assets

50
100

80 650

200

350

$Io=do

s556

$6m

Liabilities
Capital stock, $10 Par Additional paid-in caPital
Retained earnings

200 500

$s0
100 50 150 $350

$s0

200
100

Total liabilities and owners'equitY

R

$1,000

EQUIRED
1

its stock for all of Sineco's outstanding shares' -\ssume that Persis issues 25,000 shares of

2, -\ssume
t,

a.PreparejoumalentriestorecordthebusinesscombinationofPersisandSineco. business combination' b, Prepare a balance sheet for Persis corporation immediately after the outstanding shares' that Persis issues 15,000 shares of its stock for all of Sineco's
Prepare

rr"p*"

journal entries to record the business combination of Persis Td lt"::l: after the business combination' u uutunce sheet for Persis corporation immediately

F 1.4

Allocation schedule and balance sheet

-

at December balance sheets of Phule Corporation and Sen corporation (in thousands): --:C together with fair value information as follows

-:

1, 2008' are summa-

Phule Corporation BookValue

-{-rsels

Sen CorPoration

Fair

Value
ls
40 150 100 300

Book

Value

Fair Value

Cash

$1 15

$1

Receivables-net
Inventories Land

40

120
45

ts:ildings-net
T.ial
assets

200
180 $700

-;,:ipment-net
l-- ":,- j (

245 Seso

$3oo
$30 60
100

$10 20 50 30 100 90

10

20 30
100

150 150 $469

.---,'--..payable ":,:- -.:lliiies - r-^ck. $10 Par -; ."..:.- :,, :-n capital
:-

$90
100

$e0 90

$30
70

300
100

.*

:;--:3\
- :>::-ted.

=.+incc

ll0
$Zqg

80 30

$igq

_--_.--]00g,PhuleCorporationacquiredallofSenCorporation'soutstandingstockfor

::-::.:dSl00,000cashandissuedafive-year'!2Tonoteforthebalance'Sen
-, : i::

40

REQUIRED
1, Prepare a schedule to show how the investment cost is allocated to identifiable assets and liabilities. 2, Prepare a balance sheet for Phule Corporation on January l,2009, immediately after the business
combination.

P 1-5

Journal entries and balance sheet tor a combination

Celistia Corporation paid $5,000,000 for Dawn Corporation's voting common stock on January 2, 2009, and Dawn was dissolved. The purchase price consisted of 100,000 shares of Celistia's common stock with a market value of $4,000,000, plus 1,000,000 cash' In addition, Celistia paid $50.000 for registering and issuing the 100,000 shares of common stock and $200,000 for other costs of combination. Balance sheet information for the companies immediately befbre the business combination is summarized as follows (in thousands):
Celistia Book Value
Cash Book Value

Dawn Fair Value

$
receivable-net

6,000

Accounts receivable-net
Notes

2,600
3,000 5,000 1,400 4,000 18,000

480 720
600 840 360

480

Inventories Other curent assets Land

720 600 1,000 400

200
1,200 1,600

Buildings-net
Equipment-net
Total assets Accounts payable Mortgage payable-|l%o Capital stock, $20 par Other paid-in capital
Retained earnings Total equities

400 2,400
1,200

20,000
$60,000

$6,000

$r2qa

2,000 10,000

20,000
16,000 12,000 $60,000

600 1,400 2,000 1,200 800

600 1,200

s6.000

REQUIRED
1, Prepare journal entries for Celistia Corporation to record its acquisition of Dawn Corporation, including all allocations to individual asset and liability accounts.

2, Prepare a balance

sheet for Celistia Corporation on January 2,2009, immediately after the acquisition and

dissolution o[ Dawn.

,1

{i .i

,,$

,d

'i

,:d

't p

ji

IrHAPTER

Business Combinations

In May 2004, citizens Finunci(tl Group, Inc., announced an agreement to acquire

10 largest U.S. commercial banks.

Charter One Finuncial, Inc., for $10.5 billion, making Citizens one of the

In october 200r, chevron and rexaco announced completion of their merger agreement valued in excess of $30 billion. In 199g, gasoline-producing rivals Exxon and,Mobit merged to formExxonMobil Corporaion in a deal valued at gg0 billion. Similar combinations had occurred in the industry including Bp Amoco's acquisition of Atlsntic Richfield. Bank of America acquired FleetBoston Finuncial Corporation for g47 billion in
2004
alnd

followed up with

a purchase

In November 2006, Freeport-McMoRan copper & GoId acquired rival copper

producer Phelps Dodge for $25.9 billion. Nestle purchased the medical-nutrition division December 2006.

of MBNA Corporation for $35 billion in 2005.

of

Novartis AG for $2.5 billion in

Japan Tobacco

Inc.

offered $14.8 billion

(a British tobacco maker) in December 2006. In 2001, America online (AoL) acquired conrrol of

to acquire Gallaher Group pLC

rime warner for $147 billion.

nmr:ir3':r1se1.
&n'nnms"si

elcome to the world of business combinations. The 1990s witnessed a period of unparalleled growth in merger and acquisition activities in both the United States and in m.tional markets (often referred to as merger mania), and the trend continues. ]l,[,eger activities slowed with the stock market downturn in 2001, but as the market recovered, the mrulx regan to pick up. The following firms announced combinations in Decemb er 2004. Symantec of the Norton antivirus software) acquired veritss software for $13.5 billion. veritas is 'mmmrr---nrrer e firf,rse-slstem and backup-program manufacturcr. Oracle Cotporation acquired PeopleSoft, Inc., drr $:,r,i billion. Johnson & Johnson acquired Guidant for $25.4 billion. Guidant produces pacenrw{{e . itfibrillators, heart stents, and other medical devices. Sprint announced plansio acquire rival ild C-tCIrsnznications for approximately $35 billion, creating anew Sprint Nextel. Management qs-i'iriletl operating-cost savings and network upgrades of over $12 billion as a major motiva_ '"q{rt

their shareholders. enmr n -r; 5p21sgy, expansion has long been regarded as a proper goal of business entities. t$. fiusiffiF gfoso5s to expand either internally (building its own facilities) or externally =ar
rr[m:]'I@mflmnng

frrms constantly strive to produce economic value added for

5:m:e, ot other firms in business combinations). The focus in this chapter will be on

,Hl"l1Hl:tft",ffi:";"1il:,T:i
riding objective of businesr
Horizontal integration

over internal expansion options and how financiar reporring reflects

f*T[n:U;:*ffiTiJ",3:T;*'Y.
it trt"
activity in banking and other

In general terms' business combinations unite previously separate business entities. The oyer-urt u" rn"r"uring p'ro?tuurhty;towever, "o-uinuiJ.r,

"' ""ni""'v-J,"i,iii,

many firms oo",u,rons or uv aive,',ryng

ar,e *he ree6 t:il::ffi#;i,1?, i:ffii:J::Xi*-i:$l''eo i:mpanies Novemberl;;;,",;:^utitities"";o;;;:::;:I"ftf#tr3:;:::';,;;;:Tr,i;;;:

and garden equipmenr. Disney u"q*ir"d;;a-ilLrxirduring rsgri; p-urde consumer iawn_and_ broadcasting markers toi orsney-pr"J*Jnr-r, ready access ro mass other Disney products. In advertising outret for March 200 i, borpo*tio, Rx,Inc.,merged to form cvs/caremqrk corporatian in a dealuutu"o ui szo uithor. itr" joined the natiJn,s largest pharmacy chain with one of the leading ;ealthcare/phu..u""uJ.urs service companies. In September 2006' computer processor maiufacture, Devicesbought graphics chipmaker ATI Technologiis for Interner p*,"i a,,'"rrca online,s media giant Time warner in acquisirion of 2001 prouo"Jior un oppoiu"il;;;;", electronic access ro Time warner's vast media content' warner's cable televisi"t rr"rJiig, AoL an opportunity to expand its Internet presence l with high-speed, broadband access "rr*ed through cable conglomeration is the combiniti";;;;;-r with unrerared unJ-diu"rr. products functions' or both' Firms or service diversify to reduce the risk lnay with a particular line of business or to even out^cyclical "r*"i","d earnings, ,;;h might occur in u .riitity,, acquisition of a man_ ",

i,ioi"rr"a significanr consoridarion *rt cno* Manhattun. Kimberlyclark acqutred' scott Pwr' u "t"uting "o"t"# y*"1-a."rirJ p."oucrs giant. paint manufacturers sherwin-williams and Pratt t"a i.*iiicombined in a $aoO iittln a"a. control of its rival Western Air Derta Air Lines took Lines, at a cost of $7g7 mlfion.Automakers chrysler corporation were consolidated Daimler_Benz and to tty nytlcii"l"r. o"r"gurarion natural gas utilities islikely to of erectric and generare combinariorr'#rh;;inoustry in the turure. vertical integration i" tnJ ";; offirms with stages of production or disrribution "o,oli*J"r-"r ";;;;;; in different, but successive, ot iort, In June zodi,-iriir, & announced an agreeme.nr ro stratton corporation acquire Simplicity,lonuyo"turfni, ,rri., ,., $22j.5million. Briggs & stratton is'the world's t*g.rt proau*. teader in design, manufacture, "?,-;il gurorin"_po,"J.J "n*rn"r, whereas Simplicity is a una .*t"trng

of firms in the same business rines business combinations of chevron "i*uir",l"n and markets. The *a Exxon and naouil, Citigroup, and one are examples of horizontal Citizens and charter

r""g."""*

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rrr";;r;;;" d

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ci;

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systems.

rii,n

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iili,l|,l.

diversify into a communicarions The earlv r990s saw business. iniii)'nrirri, food produce t Kraft in a combination that included over $11 biui;;#recorded goodwill atone. r"teptrone giant AT&T acquired computer maker NCR Corporiioo for 96.4 Uifh"" i"^rSii. artnougf, aI of us have probably purchased a light butb man'uia.i"r"i ut Generar u""iri" co*pany, rhe scope of rhe firm's operations goes well beyond ,rru, rrour"rrold product. Gen"rarirectric broadcasring when it ourchased ncA f"; $;.1 uinion ncA already owned made a move into the NBC network. t excerpts ri*" 2006 on irs major operaring

company' a local-exchang"

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t"t.pion"";;;;;t,ro

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c"*i"ry;"d"

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lrl

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-:4r:lflJ lt*i:

NEASOiIS FOR BUSINESS COMBINATIONS

new

*ffi mT:.T|i.:l'"*:::::nrerprise,*r'r*o'affi ffi raclitiest,i;;;g'; ;;,#Hil?:::llTJfr:1***, Ty"

,ffi [dtiim ftm ilmryli trreirfuil THs ic L-*i^-r^-r_-xr{,I r,' r*il@m: .uG {Frykuime'r

=7

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Segment Reporting at General Electric

Source; 2006 General Electric annual report.

Lower Risk. The purchase of established product lines and martets is usually less risky than developing new products and markets. The risk is especially low when the goal is diversification. Scientists may discover that a certain product provides an environmental or health bazwd.A single-product, nondiversified firm may be forced into bankruptcy by such a discovery, while a multiproduct, diversified company is more likely to survive. For companies in ildustries already plagued with excess manufacturing capacity, business combinations may be the only way to grow. When ?oys R Us decided to diversify its operations to include baby furnishings and other related products, it purchased retail chain Baby Superstore in February 1997 for $376 million. X'ewer Operating Delays. Plant facilities acquired through a business combination are operative

and already meet environmental and other governmental regulations. The time to market is critical, especially in the technology industry. Firms constructing new facilities can expect nqmerous delays in construction, as well as in getting the necessary govemmental approval to commence operations. Environmental impact studies alone can take months or even years to comillete.

Avoidance of lhkeovers; Many companies combine to avoid being acquired themsetves. S;niiler companies tend to be riiore vulnerable to corporate takeovers; therefore, many of them adopt aggressive buyer strategies as the best defense against takeover attempts by other companies. Acquisition of Intarigible Assets. Business combinations bring together both intangible and tangible resources. Thus, the acquisition of patents, mineral rights, research, customer databases, or management expertise may be a primary motivating factor in a partieular business combination. When IBM purchased Lotus Development Corporation, $1.84 billion of the total cost of $3.2 billion.was allocated to purchase research and development in process.
business tax advantages

Other Reasons. Ftms may choose a business combination over other forms of expansion for (for example, tax-loss carryforwards), for personal incomq.and estate-tax advantages, and for personal reasons. One of several motivating factors in the combination of Wheeling-pittsburgh Stcel,a subsidiary of WHX,andHandy & frarmanwas Hanb! & Harman'$ overfunded pqnsion plan. rx'hich virtually eliminated Wheeling-Pittsburgh Steel's unfunded pension liability. The egos of company management and takeover specialists may also play an
important role in some bushess combinations.

ATTITRUST CONSI DERATIO NS

Fsdsai mtitmst laws prohibit business combinations that restrain ffade or impair competition. The L-5 Deparment of Justice and the Federal Trade Commission (FTC) have primary responsibility for marnngfederal antitrust laws. For example. :m1997 the FTC blockedStaples's proposed $4.3 billion

ily

{iriqn of Afftce Depot, argtJingin federal court that the takeover would be anticompetitive.

20

On July 20,2004, The Wall Street Journql (p. 86) reported that the FTC had conditionally approved Sanoji-Synthelqbo SA's $64 billion takeover of Aventis SA, creating the world's thirdlargest drug manufacturer. Sanofi agreed to sell certain assets and royalty rights in overlapping markets in order to gain approval of the acquisition.
Business combinations in particular industries are subject to review by additional federal
agencies. The Federal Reserve Board reviews bank mergers, the Department of Transportation scrutinizes mergers of companies under its jurisdiction, the Department of Energy has jurisdiction over some electric utility mergers, and the Federal Comrnunications Commission (FCC) rules on the transfer of communication licenses. After the Justice Depafiment cleared a $23 billion merger between BelI Atlantic Corporation and Nynex Corporatinn, the merger was delayed by the FCC because of its concem that consumers would be deprived of competition. The FCC later approved the merger. Such disputes are settled in federal courts. In addition to federal antitrust laws, most states have some type of statutory takeover regulations. Some states try to prevent or delay hostile takeovers ofthe business enterprises incorporated within their borders. On the other hand, some states have passed antitrust exemption laws to protect hospitals from antitrust laws when they pursue cooperative projects. Interpretations of antitnrst laws vary from one administration to another, from department to department, and from state to state. Even the same department under the same administration can change its mind. A completed business combination can be reexamined by the FTC at any time. Deregulation in the banking, telecommunication, and utility industries permits business combinations that once would have been forbidden. In 1997, the Justice Department and the FTC jointly issued new guidelines for evaluating proposed business combinations that allow companies to argue that cost savings or better prodqcts could offset potential anticompetitive effects of a merger.

LEARNING
OBJECTIVE

THE LEGAL FORM OF BUSINESS GOMBINATIONS

Business combination is a.general term that encompasses all forms of comtining previously separate business entities. Such combinations are acquisitions when one corporation acquires the productive assets of another business entity and integrates those assets into its own operations. Business combi-

nations are also acquisitions when one corporation obtains operating control over the productive facilities of another entity by acquiring a maiorit]' of its outstanding voting stock. The acquired company need not be dissolved; that is, the acquired company does not have to go out of existence. The terms merger and consolidation are often used as synonyms for. acquisitions. However legally and in accounting there is a difference. e@tntails the dissolution of all but one of the

businessentitieSinvolved.Alffid[affia.n,lffi.dissolutiffis

involved and the formation of a new comorati occurs when one corporation talies over all the operations of another business entir,r-and that entity is dissolved. For example, Company A purchases the assets of Company B directl-v from Company B for cash, other assets, or Company A securities (stocks, bonds; or notes). This business combination is an acquisition, but it is not a merger unless Company B goes out of existence. Alternatively, Company A ma1, purchase the stock of Company B directly from Company B's stockholders for cash, other assets, or Company A securities. This acquisition wiltr give Company A operating control over Company B's assets. It will not give Company A legal ownership of the assets unless it acquires al1 the stock of Company B and elects to dissolre

---

Company B (again. a merger).

AmoccurSwhenanewcorporationisformedtotakeovertheassetsandoperations of two or more separate business entities and dissdlves the previously separate entities. Fcx
example, Company D, a newly formed corporation, may acquire the net assets of Companies E and F

by issuing stock directly to Companies E and F. In this case, Companies E and F may continue tc hold Company D stock for the benefit of their stockholders (an acquisition), or they may disritrm the Company D stock to their stockholders and go out of existence (a consolidation). In either ca*re" Company D acquires ownership of the assets of Companies E and F. Alternatively, Company D could issue its stock directly to the stockholders of Companies E ann F in exchange for a majority of their shares. In this case, Company D controls the assets of Compr,rr E and Company fl but it does not obtain legal title unless Companies E and F are dissoh-aCompany D must acquire all the stock of Companies E and F and dissolve those compnnies if

frer

business combination is to be a consolidation.

If Companies E and F are not dissolved, Company D

will operate

holding company, and Companies E and F will be its subsidiaries' business Future references in this chapter will use the term merger in the technical sense of a go out of existence. Similarly, the combination in which all but one of the combining companies in which all term consolidation willbeused in its technical serse to refer to a business combination is formed to take over their net the combining companies are dissolved and a new corporation process of combining assets. Consotidation is also used in accounting to refer to the accounting *principles ofconsolidation," parent and subsidiary financial statements, such as in the expressions iconsolidation procedures," alid "consolidated financial statements." In future chapters, the meanilgs of the terms will depend on the context in which they are found'
as a

and consolidations do not present special accounting problems or issues after the initial one combiriation, apart from those discussed in intermediate accounting texts. This is because only

-M"rg"r*

legal and accounting entity survives in a merger or consolidation'

THE AGCOUNTING CONCEPT OF A BUSINESS

In June 2001, the Financiai Accounting Standards Board (FASB) defined the accounting concept, issuing MSB StqtementNo. l4l: A business combination is a tansaction or other event in which an acquirer obtains control or "mergof one or more businesses. Transactions sometimes referred to as "true mergers"

irs

of equals" also are business combinations qs thnt term is used in this Statement.l

single Note that the accounting concept of a business combination emphasizes the creation of a before their union. Although one or more cmtity and the independence of the combining companies qrgfte combining companies may lose its separate legal identity, dissolution of the legal entities is

mt

Decessary within the accounting concept. Previously separate businesses are brought together into one entity when their business Such control within ;E5ources and operations come under the control of a single management team' in which: i, established in business combinations me business

"ntity 1. One or more corporations become subsidiaries' 2, One company transfers its net assets to another, or 3. Each company transfers its net assets to a newly formed corporation.2

a majority (more need noi acquire all the stock of stock. Thus, on" Tfum 50Vo) ofits outstanding voting "o.poruiion in which motrer corporation to .onro*-ui" a business combination. In business combinations

A corporation becomes a subsidiary when another corporation acquires

records even cnryanies necessarily retainltheir separate legal identities and separate accounting

liess

than l00zo of the voting stock of other combining companies is acquired, the combining
have become one entity for primary reporting purposes'

fuugh they

can be consumtsLiness combinations in which one company transfers its net assets to another company must acquire substantially all thelet assets d in a variety of ways, but the acquiring n mI case. Alternatively, each combining company can transfer its net assets to a newly formed its stock ,mpmation. Because the newly formed corporation has no net assets of its own, it issues stockholders or owners. m fre other combining companies or to their

n B*f Background on Accounting for Business combinations and interesting'topics of -e*smthg for business combinations is one of the most important combi-

mming theory and practice. At the same time, it is complex and controversial. Business stories resF involve financial transactions of enormous magniiudes, business empires, success the 5 FsCInal fortunes, executive genius, and management fiascos. By their nature, they affect
5c rr dnafue campanies.
Each is unique and must be evaluated in terms of its economic substance, mnuqqrycre of its legal form. *,,f,U -8mme,1,o-.1{/R, paragraph 3.e. Statement 141R (2007) reaffirms' Sq.S forms e cnnsolidarion policy based on control of another enterprise rather than majority owaership'

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