Chapter 1

Intercorporate
Acquisitions and
Investments in
Other Entities

McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
 Intercorporate Acquisitions and
Investments in Other Entities

• This chapter provides an overview of complex

organizational arrangements (or structures).
• Complex organization structures often result
from complex business strategies such as:
• Extending operations into foreign countries.
• Initiating new product lines.
• Separating activities that fall under
regulatory controls.
• Reducing taxes by separating certain types
of operations.
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Intercorporate Acquisitions and
Investments in Other Entities

• Several accounting transactions may be

required to initiate a complex organization
structure.
• Additionally, unlike most of your previous
accounting courses, you will need to analyze
multiple transactions for multiple companies
simultaneously—not just one transaction for
one company.
• Thus you will need to “deal with” more than
one set of books in analyzing questions,
cases, exercises, and problems.
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Intercorporate Acquisitions and
Investments in Other Entities
Generally speaking, the accounting
procedures in this chapter are driven
by such questions as:
• Did the company acquire the
common stock of another company
or the assets of another company ?
• Was the company dissolved (i.e.,
liquidated) or did the company
continue to exist (i.e., survive) ?
• Was a new company formed ?
• Was there a change in ownership control ?
• Is the acquired company wholly-owned ?
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Bad News--Good News

Bad News: Numerous complex organization

arrangements are discussed in this chapter.
(Hint: Look for similarities in the various
complex organization arrangements.)

Good News: The next nine chapters focus on

one complex organization arrangement--
stock acquisitions.

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 Creating Business Entities
--Basic Transactions
• Complex business structures are routinely
grounded in the following basic transactions:
• Transfer (Sale) of Assets/Entity Dissolved
• Receipt of Assets from Dissolved Entity
• Transfer (Sale) of Assets/Entity Survives
• Receipt of Assets from Surviving entity
NOTE: Assume that Book Values (BV) equal
Fair Values (FV) for these transactions (i.e., the
next four slides). Also, assume that cash was
paid for the assets. The significance of both of
these assumptions will be discussed later.

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 Transfer of Assets/Entity Dissolved
• Entries Recorded By Seller Company:
– To transfer net assets to Purchaser Company.
Cash (from Purchaser) ???
Current Liabilities BV
Accumulated Depreciation BV
Cash and Receivables BV
Inventory BV
Fixed Assets BV
[Continued on next slide.]

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 Transfer of Assets/Entity Dissolved

• Entries Recorded By Seller Company:

– To distribute remaining assets to shareholders
of Seller Company.

Common Stock BV
Additional Paid-In Capital BV
Retain Earnings BV
Cash ???

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Receipt of Assets from Dissolved Entity
• Entry Recorded By Purchaser Company:
– To record net assets purchased
from Seller Company.
Cash and Receivables BV
Inventory BV
Fixed Assets (net) * BV
Cash (to Seller) ???
Current Liabilities BV
* Fixed Assets are recorded net
of Accumulated Depreciation.
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 Transfer of Assets/Entity Survives

• Entries Recorded By Seller Company:

– To transfer net assets to Purchaser Company.
Cash (from Purchaser) ???
Current Liabilities BV
Accumulated Depreciation BV
Cash and Receivables BV
Inventory BV
Fixed Assets BV
[Continued on next slide.]
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 Transfer of Assets/Entity Survives
• Entries Recorded By Seller Company:

– To distribute remaining assets to shareholders

of Seller Company.

??????????????????????????

NO ENTRY REQUIRED—Seller Company

was not dissolved. Thus the shareholders
of Seller Company may reinvest the Cash
(from Purchaser) as they wish.

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 Receipt of Assets from Surviving Entity

• Entry Recorded By Purchaser Company:

– To record net assets purchased from Seller
Company. [Continued on next slide.]
Cash and Receivables BV
Inventory BV
Fixed Assets (net) * BV
Cash (to Seller) ???
Current Liabilities BV
• Fixed Assets are recorded net of Accumulated
Depreciation.

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Receipt of Assets from Surviving Entity

NOTE: Since this was a purchase of the net

assets of Seller Company (and not the
common stock of Seller Company),
dissolution or non-dissolution of Seller
Company does not involve Purchaser
Company. Thus Purchaser Company
records the same entry as was previously
done when Seller Company was dissolved.

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 Additional Thoughts
• Seller Company would have recorded a “GAIN
ON SALE” if their net assets would have been
sold for an amount greater than book value. In
turn, Seller Company would have recorded a
“LOSS ON SALE” if their net assets would have
been sold for an amount less than book value.

• In either case, Purchaser Company would have

recorded the various assets and liabilities at
their individual fair value (not book value).

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Forms of Business Combinations
• There are three primary forms
of business combinations:

• Statutory Merger

• Statutory Consolidation

• Stock Acquisition

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Statutory Merger
• A statutory merger occurs when one
company acquires another company
and the assets and liabilities of the
acquired company are transferred to
the acquiring company.

• In a statutory merger, the acquired

company is liquidated and the
acquiring company continues to exist.

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 Statutory Consolidation
• A statutory consolidation occurs when a
new company is formed to acquire the
assets and liabilities of two combining
company.

• In a statutory consolidation, the combining

companies are dissolved and the new
company is the only surviving entity.

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Stock Acquisition
• A stock acquisition occurs when one
company acquires a majority of the
common stock of another company
and the acquired company is not
liquidated.

• In a stock acquisition, both companies

continue to operate as separate but
related corporations (i.e., affiliated
corporations).

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Stock Acquisition:
Parent-Subsidiary Relationship
• A subsidiary is a corporation that is controlled
(through common stock ownership) by another
corporation, that is, the parent corporation.
• Controlling Interest: The parent owns a
majority of the common stock of the
subsidiary.
• Wholly-Owned Subsidiary: The parent
owns all of the common stock of the
subsidiary.
• Given that a subsidiary is a separate legal
entity, the parent’s risk associated with the
subsidiary’s activities is limited.
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 Valuation of Business Entities

• Assessing the overall value of a

company often includes:

• Valuation of Individual Assets and Liabilities

• Valuation of Potential Earnings

• Valuation of Consideration Exchanged

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 Valuation of Individual
Assets and Liabilities

• The value of a company’s individual assets is

usually determined by appraisal.

• Current liabilities are often viewed as having fair

values equal to their book values because they
will be paid at face amount within a short time.

• Long-term liabilities must be valued based

on current interest rates if different from the
effective rates at the issue dates of the
liabilities.
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 Valuation of Potential Earnings
• Synergy occurs when assets operated together
have a value that exceeds the sum of their
individual values.
• This “going concern value” makes it desirable to
operate the assets as an ongoing entity rather
than sell them individually.
• Possible approaches to measuring the value of
a company’s future earnings include:
• Multiples of current earnings.
• Present value of anticipated future new
cash flows generated by the company.
• Sophisticated financial models.
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Valuation of Consideration Exchanged

• When one company acquires another, a value

must be placed on the consideration given in
the exchange.

• Little difficulty is encountered when cash is

used in an acquisition, but valuation may be
more difficult when securities are exchange,
particularly illiquid or privately held securities
or securities with unusual features (e.g.,
convertible or callable securities).

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Accounting and Reporting Methods:
SFAS No. 141, “Business Combinations”

• Prior to SFAS No. 141, there were two

acceptable methods for reporting business
combinations--the Purchase Method and
the Pooling Method.
• SFAS No. 141 disallowed the use of the
Pooling Method.
• Thus, the Purchase Method for reporting
business combinations is currently the only
allowable method under Generally Accepted
Accounting Principles (GAAP).
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Purchase Method (Current GAAP)

• The central idea underlying the purchase

method is the same idea underlying the
purchase of any asset or group of assets
—there is a change in ownership control.

• That is, since there is a change in ownership

control, the purchaser’s accounting is based
on the fair value of the assets and liabilities
—not the seller’s book values.

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 Pooling Method (Not Current GAAP)
• The central idea underlying the pooling method
was opposite that of the purchase method—a
continuity of interest.
• That is, the owners of the combining companies
became the owners of the combined company.
• Thus, the book values of both companies were
carried forward since there was not a change in
ownership control (i.e., there was no arm’s
length transaction to determine a “fair” fair
value).
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Purchase Method—
Critical Concepts and Terms
• Cost of Investment (a.k.a. Cost or
Investment Cost or Purchase Price)
• Goodwill
• Fair Value of Net Identifiable Assets
• Book Value of Net Identifiable Assets
• Excess of Cost over Fair Value of
Net Identifiable Assets
• Excess of Fair Value over Book
Value of Net Identifiable Assets
• Total Differential
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Cost of Investment (a.k.a. Cost or
Investment Cost or Purchase Price)

• The value of the consideration given to the

owners of the acquired company normally
constitutes the largest part of the total cost.
• There are three types of other costs that
may be incurred in effecting a business
combination:
• Direct costs
• Costs of issuing securities
• Indirect and general costs
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Purchase Price
--Direct Costs

• All direct costs associated with purchasing

another company are capitalized as part of
the total cost of the acquired company.
• Examples:
• Finders’ fees
• Accounting fees
• Legal fees
• Appraisal fees

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 Purchase Price
--Costs of Issuing Securities

• Costs incurred in issuing equity securities in

connection with the purchase of a company
should be treated as a reduction in the issue
price of the equity securities issued. Examples
include: Listing fees; Audit and legal fees related
to the registration; and, Brokers’ commissions.

• Costs incurred in issuing bonds payable in

connection with the purchase of a company
should be accounted for as bond issue costs
and amortized over the term of the bonds.
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Purchase Price
--Indirect and General Costs

• All indirect and general costs related to a

business combination or to the issuance of
securities in a combination should be
expensed as incurred.
• For example, the salary costs of accountants
on the staff of the acquiring company in a
business combination would be expensed,
even though some of their time was spent
on matters related to the combination.

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Goodwill

• Any amount of the purchase price in

excess of the fair value of the identifiable
assets and liabilities acquired is viewed
as the price paid for goodwill.

• In theory, goodwill is the excess earnings

power of the of the acquired company.

• In practice, goodwill represents the

premium paid to acquire control.
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Subsequent Accounting for Goodwill

• Goodwill is carried forward to subsequent

accounting periods at the original amount,
without amortization, unless it becomes
impaired.

• Goodwill must be evaluated for impairment

at least annually, at the same time each year,
and more frequently if events occur that are
likely to impair the value of goodwill.

1-33
 Bargain Purchase Price
(a.k.a. Negative Goodwill)
• Negative goodwill is said to exist when a
purchaser pays less than the fair value of the
identifiable net assets of another company in
acquiring its ownership.
• Negative goodwill is allocated as a pro rata
reduction of the amounts that otherwise would
have been assigned to all of the acquired
assets with certain exceptions (e.g., current
assets or deferred tax assets to name a few).
Any amount remaining after reducing these
acquired assets to zero would be recognized as
an extraordinary gain.
1-34
Fair Value of Net Identifiable Assets and
Book Value of Net Identifiable Assets

• Generally speaking, fair value is the amount

that would be required to buy an asset (or
refinance a liability) at the date of the business
combination.

• Generally speaking, book value is the “GAAP

historical cost” of the asset (or the monetary
amount owed for liabilities—adjusted for
premiums and discounts, if applicable).

1-35
Fair Value of Net Identifiable Assets and
Book Value of Net Identifiable Assets-Cont’d

• Identifiable Asset: Generally speaking,

assets other than Goodwill are considered
identifiable.

• Identifiable Liability: Generally speaking,

liabilities that are known (or, if probable,
can be reasonably estimated) are
considered identifiable.

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“Excess Cost over Fair Value” and
“Excess Fair Value over Book Value”
• Excess of Cost over Fair Value of Net
Identifiable Assets EQUALS Cost of
Investment LESS Fair Value of Net
Identifiable Assets
• Excess of Fair Value over Book Value
of Net Identifiable Assets EQUALS
Fair Value of Net Identifiable Assets
LESS Book Value of Net Identifiable
Assets

1-37
Total Differential
• Two Possible Views:
• Total Differential EQUALS Cost of
Investment LESS Book Value of Net
Identifiable Assets
• Total Differential EQUALS Cost (of
Investment) over Fair Value Net
Identifiable Assets PLUS Fair Value
over Book Value of Net Identifiable
Assets

1-38
 Example: Combination Effected
through Purchase of Net Assets

• Point acquires the net assets of Sharp in a

statutory merger by issuing Sharp 10,000
shares of $10 par common stock. The
shares have a total market value of $600,000.
• Point incurs $40,000 in legal and appraisal
fees and $25,000 in stock issuance costs.
• The net assets of Sharp have a total fair value
of $510,000. (Do not worry about the individual
fair values for now.)

1-39
 Example: Combination Effected
through Purchase of Net Assets (Cont’d.)

• Entries Recorded By Acquiring Company (Point)

• NOTE: All amounts on this slide (and the next
slide) are actual amounts incurred by Point.
– To record costs related to purchase of
Acquired Company (Sharp).
Deferred Merger Costs $40,000
Cash $40,000

1-40
 Example: Combination Effected
through Purchase of Net Assets (Cont’d.)

• Entries Recorded By Acquiring Company (Point)

– To record costs related to issuance of Point
common stock to Sharp.
Deferred Stock Issue Costs $25,000
Cash $25,000

1-41
Example: Combination Effected
through Purchase of Net Assets (Cont’d.)
• Entries Recorded By Acquiring Company (Point).
– To record the combination of Sharp by Point.
Cash and Receivables $45,000 #
Inventory 75,000 #
Land, Buildings and Equipment 420,000 #
Patent 80,000 #
Goodwill 130,000 *
Current Liabilities $110,000 #
Common Stock 100,000
Additional Paid-In Capital 475,000
Deferred Merger Costs 40,000 **
Deferred Stock Issue Costs 25,000 **
* See next slide. **See previous two slides.
# Fair Market Value

1-42
Example: Combination Effected
through Purchase of Net Assets (Cont’d.)

• Calculation of Goodwill
• Investment Cost:
Fair value of stock issued $600,000
PLUS: Other acquisition costs 40,000
_________________________

Total purchase price $640,000

• LESS:
Fair value of net assets 510,000
• __________________________

• Goodwill $130,000

1-43
 Example: Combination Effected
through Purchase of Net Assets (Cont’d.)

Entries Recorded By Acquired Company (Sharp).

• To record the transfer of net assets to Point.
Investment in Point Stock $600,000
Current Liabilities 100,000
Accumulated Depreciation 150,000
Cash and Receivables $45,000
Inventory 65,000
Land 40,000
Buildings and Equipment 400,000
Gain on sale of Net Assets 300,000
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 Example: Combination Effected
through Purchase of Net Assets (Cont’d.)

Entries recorded by acquired company (Sharp).

• To record the liquidation of Sharp.
Common Stock $100,000
Additional Paid-In Capital 50,000
Retained Earnings 150,000
Gain on Sale of Net Assets 300,000
Investment in Point Stock $600,000

1-45
 Example: Combination Effected
through Purchase of Stock
• Point acquires the all of the common stock of
Sharp issuing the shareholders of Sharp 10,000
shares of $10 par common stock. The shares
have a total market value of $600,000.
• Sharp continues to operate as a separate entity
after the business combination transaction.
• Point incurs $40,000 in legal and appraisal
fees and $25,000 in stock issuance costs.
• Do not worry about fair values for now.

1-46
 Example: Combination Effected
through Purchase of Stock

• Entries Recorded By Acquiring Company (Point)

• NOTE: All amounts on this slide (and the next
slide) are actual amounts incurred by Point.
– To record costs related to purchase of
Acquired Company (Sharp).
Deferred Merger Costs $40,000
Cash $40,000

1-47
 Example: Combination Effected
through Purchase of Stock

• Entries Recorded By Acquiring Company (Point)

– To record costs related to issuance of Point
common stock to Sharp.
Deferred Stock Issue Costs $25,000
Cash $25,000

1-48
 Example: Combination Effected
through Purchase of Stock (Cont’d.)
• Entries Recorded By Acquiring Company (Point)
– To record the combination of Sharp by Point.
Investment in Sharp Stock $640,000 *
Common Stock $100,000
Additional Paid-In Capital 475,000
Deferred Merger Costs 40,000 **
Deferred Stock Issue Costs 25,000 **
* $640,000 = $600,000 Fair Value of Point Common
Stock PLUS $40,000 Merger Costs
** See previous two slides.
1-49
Example: Combination Effected
through Purchase of Stock (Cont’d.)

• NOTE: With respect to the previous

slide, identifiable assets and liabilities
are not recorded at the date of the
business combination since Sharp is
not dissolved.

1-50
Additional Thoughts

• As previously stated, Sharp is not dissolved

and continues to operate as a separate entity
after the business combination transaction.
• The accounting and reporting procedures for
intercorporate investments in common stock
where the acquired company continues in
existence are discussed in the next nine
chapters.

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 Financial Reporting
Subsequent to a Purchase

• When a combination occurs during a fiscal year,

income earned by the acquired company prior to
the combination is not reported in the income
statement of the combined entity.

• If the combined entity reports comparative

financial statements that include statements for
periods before the combination, those
statements include only the activities and
financial statements of the acquiring company
and not those of the acquired company.
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 Disclosure Requirements
(a.k.a. Notes to the Financial Statements)

• A number of disclosures are required to provide

financial statement readers with information
about the combination. Examples include:
• A description of the acquired entity.
• The percentage voting interests acquired.
• The primary reason for the acquisition.

[Continued on next slide.]

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Disclosure Requirements
(a.k.a. Notes to the Financial Statements)

• A description of the factors that contributed

to the recognition of goodwill.
• Contingent payments, options, or
commitments.
• Purchased research and development
assets acquired and written off.

1-54
You Will Survive This Chapter !!!

ALWAYS ASK THESE QUESTIONS:

– Did the company acquire the common stock
of another company or the assets of another
company ?
– Was the company dissolved (i.e., liquidated)
or did the company continue to exist (i.e.,
survive) ?
– Was a new company formed ?
– Was there a change in ownership control ?
– Is the acquired company wholly-owned ?
1-55
 Chapter 1

End of Chapter

McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.