Legal as well as accounting distinctions divide business combinations into at least four separate categories.
To facilitate the introduction of consolidation accounting, we present the various procedures utilized in this process according to the following sequence:
1. Acquisition method when dissolution takes place.
2. Acquisition method when separate incorporation is maintained.
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As a basis for this coverage, assume that Smallport Company owns computers, telecommunications equipment, and software that allow its customers to implement billing and ordering systems through the Internet. Although the computers and equipment have a book value of $400,000, they have a current fair value of $600,000. The software developed by Smallport has only a $100,000 value on its books; the costs of developing it were primarily expensed as incurred.
The software’s observable fair value, however, is $1,200,000. Similarly, although not reflected in its financial records, Smallport had several large ongoing customer contracts. BigNet estimated the fair value of the customer contracts at $700,000. Smallport also has a $200,000 note payable incurred to help finance the software development. Because interest rates are currently low, this liability (incurred at a higher rate of interest) has a present value of $250,000.
BigNet Company owns Internet communications equipment and other business software applications that complement those of Smallport. BigNet wants to expand its operations and plans to acquire Smallport on December 31. Exhibit 2.3 lists the accounts reported by both BigNet and Smallport on that date. In addition, the estimated fair values of Smallport’s assets and liabilities are included.
Smallport’s net assets (assets less liabilities) have a book value of $600,000 but a fair value of $2,550,000. Only the assets and liabilities have been appraised here; the capital stock, retained earnings, dividend, revenue, and expense accounts represent historical measurements rather than any type of future values. Although these equity and income accounts can give some indication of the organization’s overall worth, they are not property and thus not transferred in the combination.
1. Acquisition Method when Dissolution takes Place:
At the date control is obtained with complete ownership, the acquisition method typically records the combination recognizing:
i. The fair value of the consideration transferred by the acquiring firm to the former owners of the acquire, and
ii. The assets acquired and liabilities assumed at their individual fair values.
However, the entry to record the combination further depends on the relation between the consideration transferred and the net amount of the fair values assigned to the assets acquired and liabilities assumed. Therefore, we initially provide three illustrations that demonstrate the procedures to record a business combination, each with different amounts of consideration transferred relative to the acquired asset and liability fair values. Each example assumes a merger takes place and therefore, the acquired firm is dissolved.
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Consideration Transferred Equals Net Fair Values of Assets Acquired and Liabilities Assumed:
Assume that after negotiations with the owners of Smallport, BigNet agrees to pay $2,550,000 (cash of $550,000 and 20,000 unissued shares of its $10 par value common stock that is currently selling for $100 per share) for all of Smallport’s assets and liabilities. Smallport then dissolves itself as a legal entity. As is typical, the $2,550,000 fair value of the consideration transferred by BigNet represents the fair value of the acquired Smallport business.
The $2,550,000 consideration transferred will serve as the basis for recording the combination in total. BigNet also must record all of Smallport’s identified assets and liabilities at their individual fair values. These two valuations present no difficulties because BigNet’s consideration transferred exactly equals the $2,550,000 collective net fair values of the individual assets and liabilities acquired.
Because Smallport Company will be dissolved. BigNet (the surviving company) directly records a consolidation entry in its financial records. Under the acquisition method, BigNet records Smallport’s assets and liabilities at fair value ignoring original book values. Revenue, expense, dividend, and equity accounts cannot be transferred to a parent and are omitted in recording the business combination.
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Acquisition Method- Consideration Transferred Equals Net Asset Fair Values—Subsidiary Dissolved:
BigNet’s financial records now show $1,900,000 in the Computers and Equipment account ($1,300,000 former balance + $600,000 acquired), $1,700,000 in Capitalized Software ($ 500,000 + $1,200,000), and so forth. Note that the customer contracts, despite being unrecorded on Small- port’s books, are nonetheless identified and recognized on BigNet’s financial records as part of the assets acquired in the combination. These items have been added into BigNet’s balances (see Exhibit 2.3) at their fair values.
Conversely, BigNet’s revenue balance continues to report the company’s own $1,000,000 with expenses remaining at $800,000 and dividends of $110,000. Under the acquisition method, only the subsidiary’s revenues, expenses, dividends, and equity transactions that occur subsequent to the takeover affect the business combination.
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Consideration Transferred Exceeds Net Amount of Fair Values of Assets Acquired and Liabilities Assumed:
BigNet agrees to pay $3,000,000 in exchange for all of Smallport’s assets and liabilities. BigNet transfers to the former owners of Smallport consideration of $1,000,000 in cash plus 20,000 shares of common stock with a fair value of $100 per share. The resulting consideration paid is $450,000 more than the $2,550,000 fair value of Smallport’s net assets.
Several factors may have affected BigNet’s $3,000,000 acquisition offer. First, BigNet may expect its assets to act in concert with those of Smallport, thus creating synergies that will produce profits beyond the total expected for the separate companies. In our examples, Google, Procter & Gamble, and Sprint all clearly expect substantial synergies from their acquisitions.
Other factors such as Smallport’s history of profitability, its reputation, the quality of its personnel, and the economic condition of the industry in which it operates may also enter into acquisition offers. In general, if a target company is projected to generate unusually high profits relative to its asset base, acquirers are frequently willing to pay a premium price.
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When the consideration transferred in an acquisition exceeds total net fair value of the identifiable assets and liabilities, the excess is allocated to an unidentifiable asset known as goodwill. Unlike other assets, we consider goodwill as unidentifiable because we presume it emerges from several other assets acting together to produce an expectation of enhanced profitability. Goodwill essentially captures all sources of profitability beyond what can be expected from simply summing the fair values of the acquired firm’s assets and liabilities.
Returning to BigNet’s $3,000,000 consideration, $450,000 is in excess of the fair value of Smallport’s net assets. Thus, goodwill of that amount is entered into BigNet’s accounting system along with the fair value of each individual asset and liability.
BigNet makes the following journal entry at the date of acquisition:
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Acquisition Method- Consideration Transferred Exceeds Net Asset Fair Values- Subsidiary Dissolved:
Once again, BigNet’s financial records now show $1,900,000 in the Computers and Equipment account ($1,300,000 former balance + $600,000 acquired), $1,700,000 in Capitalized Software ($500,000 + $1,200,000), and so forth. As the only change, BigNet records goodwill of $450,000 for the excess consideration paid over the identifiable net asset fair values.
Bargain Purchase—Consideration Transferred is less than Net Amount of Fair Values of Assets Acquired and Liabilities Assumed:
Occasionally, the fair value received in an acquisition will exceed the fair value of the consideration transferred by the acquirer.
The Boards observed that an economic gain is inherent in a bargain purchase. At the acquisition date, the acquirer is better off by the amount by which the fair value of what is acquired exceeds the fair value of the consideration transferred (paid) for it.
To demonstrate accounting for a bargain purchase, our third illustration begins with BigNet transferring consideration of $2,000,000 to the owners of Smallport in exchange for their business. BigNet conveys no cash and issues 20,000 shares of common stock having a $100 per share fair value.
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In accounting for this acquisition, at least two competing fair values are present. First, the $2,000,000 consideration transferred for Smallport represents a negotiated transaction value for the business. Second, the net amount of fair values individually assigned to the assets acquired and liabilities assumed produces a net fair value of $2,550,000.
Additionally, based on expected synergies with Smallport, BigNet’s management may believe that the fair value of the business exceeds the net asset fair value. Nonetheless, because the consideration transferred is less than the net asset fair value, a bargain purchase has occurred.
The acquisition method records the assets acquired and liabilities assumed at their individual fair values. In a bargain purchase situation, this net asset fair value effectively replaces the consideration transferred as the acquired firm’s valuation basis for financial reporting. The consideration transferred serves as the acquired firm’s valuation basis only if the consideration equals or exceeds the net amount of fair values for the assets acquired and liabilities assumed.
In this case, however, the $2,000,000 consideration paid is less than the $2,550,000 net asset fair value indicating a bargain purchase. Thus, the $2,550,000 net asset fair value serves as the valuation basis for the combination. A $550,000 gain on bargain purchase results because the $2,550,000 recorded value is accompanied by a payment of only $2,000.000. The acquirer recognizes this gain on its income statement in the period the acquisition takes place.
Acquisition Method: Consideration Transferred is Less Than Net Asset Fair Values, Subsidiary Dissolved:
A consequence of implementing a fair-value concept to acquisition accounting is the recognition of an unrealized gain on the bargain purchase. A criticism of the gain recognition is that the acquirer recognizes profit from a buying activity that occurs prior to traditional accrual measures of earned income (i.e., selling activity). Nonetheless, SFAS 141R requires an exception to the general rule of recording business acquisitions at fair value of the consideration transferred in the rare circumstances of a bargain purchase. Thus, in a bargain purchase, the fair values of the assets received and all liabilities assumed in a business combination are considered more relevant for asset valuation than the consideration transferred.
Related Expenses of Business Combinations:
Three additional categories of expenses typically accompany business combinations. First, firms often engage attorneys, accountants, investment bankers, and other professionals for services related to the business combination. The acquisition method does not consider such expenditures as part of the fair value received by the acquirer. Therefore, professional service fees are expensed in the period incurred. The second category of expenses concerns an acquiring firm’s internal costs.
Examples include secretarial and management time allocated to the acquisition activity. SFAS 141R considers such indirect expenditures as current year expenses, too. Finally, amounts incurred to register and issue securities in connection with a business combination simply reduce the otherwise determinable fair value of the securities. Exhibit 2.4 summarizes the three categories of related payments that accompany a business combination and their respective accounting treatments under SFAS 141R.
To illustrate the accounting treatment of these expenditures that frequently accompany business combination, assume the following in connection with BigNet’s acquisition of Small- port (also see Exhibit 2.3):
i. BigNet issues 20,000 shares of its $10 par common stock with a fair value of $2,600,000 in exchange for all of Smallport’s assets and liabilities.
ii. BigNet pays an additional $100,000 in accounting and attorney fees.
iii. Internal secretarial and administrative costs of $75,000 are indirectly attributable to BigNet’s combination with Smallport.
iv. Cost to register and issue BigNet’s securities issued in the combination total $20,000.
Summary of the Acquisition Method:
For combinations resulting in complete ownership, the fair value of the consideration transferred by the acquiring firm provides the starting point for recording a business combination at the date of acquisition. With few exceptions, the separately identifiable assets acquired and liabilities assumed are recorded at their individual fair values.
Goodwill is recognized if the fair value of the consideration transferred exceeds the net identifiable asset fair value. If the net identifiable asset fair value of the business acquired exceeds the consideration transferred, a gain on a bargain purchase is recognized and reported in current income of the combined entity. Exhibit 2.5 summarizes possible allocations using the acquisition method.
2. The Acquisition Method when Separate Incorporation is Maintained:
When each company retains separate incorporation in a business combination, many aspects of the consolidation process are identical. Fair value, for example, remains the basis for initially consolidating the subsidiary’s assets and liabilities.
Several significant differences exist in combinations in which each company remains a legally incorporated entity. Most noticeably, the consolidation of the financial information is only simulated; the acquiring company does not physically record the acquired assets and liabilities. Because dissolution does not occur, each company maintains independent recordkeeping. To facilitate the preparation of consolidated financial statements, a worksheet and consolidation entries are employed using data gathered from these separate companies.
A worksheet provides the structure for generating financial reports for the single economic entity. An integral part of this process involves consolidation worksheet entries. These adjustments and eliminations are entered on the worksheet and represent alterations that would be required if the financial records were physically united. Because no actual union occurs neither company ever records consolidation entries in its journals. Instead, they appear solely on the worksheet to derive consolidated balances for financial reporting purposes.
To illustrate using the Exhibit 2.3 information, assume that BigNet acquires Smallport Company on December 31 by issuing 26,000 shares of $10 par value common stock valued at $100 per share (or $2,600,000 in total). BigNet pays fees of $40,000 to a third party for their assistance in arranging the transaction.
Then to settle a difference of opinion regarding Smallport’s fair value, BigNet promises to pay an additional $83,200 to the former owners if Smallport’s earnings exceed $300,000 during the next annual period. BigNet estimates a 25 percent probability that the $83,200 contingent payment will be required.
A discount rate of 4 percent (to represent the time value of money) yields an expected present value of $20,000 for the contingent liability ($83,200 × 25% × 0.961538). The fair- value approach of the acquisition method views such contingent payments as part of the consideration transferred. According to this view, contingencies have value to those who receive the consideration and represent measurable obligations of the acquirer.
Therefore, the fair value of the consideration transferred in this example consists of the following two elements:
To facilitate a possible future spinoff, BigNet maintains Smallport as a separate corporation with its independent accounting information system intact. Therefore, whenever financial statements for the combined entity are prepared, a worksheet is utilized in simulating the consolidation of these two companies. Although the assets and liabilities are not transferred, BigNet must still record the payment made to Smallport’s owners.
When the subsidiary remains separate, the parent establishes an investment account that initially reflects the acquired firm’s acquisition-date fair value. Because Smallport maintains its separate identity, BigNet prepares the following journal entries on its books to record the business combination.
As demonstrated in Exhibit 2.6, a worksheet can be prepared on the date of acquisition to arrive at consolidated totals for this combination. The entire process consists of seven steps.
Prior to constructing a worksheet, the parent prepares a formal allocation of the acquisition- date fair value similar to the equity method procedures.
Thus, the following schedule is-appropriate for BigNet’s acquisition of Smallport:
Note that this schedule initially subtracts Smallport’s acquisition-date book value. The resulting $2,020,000 difference represents the total amount needed on the Exhibit 2.6 worksheet to adjust Smallport’s individual assets and liabilities from book value to fair value (and to recognize goodwill). Next, the schedule shows how this $2,020,000 total is allocated to adjust each individual item to fair value. The fair-value allocation schedule thus effectively serves as a convenient supporting schedule for the Exhibit 2.6 worksheet and is routinely prepared for every consolidation.
No part of the $2,020,000 excess fair value is attributed to the current assets because the book value equals fair value. The Notes Payable account shows a negative allocation, because the debt’s present value exceeds its book value. An increase in debt decreases the fair value of the company’s net assets.
Step 2:
The first two columns of the worksheet (see Exhibit 2.6) show the separate companies’ acquisition- date financial figures (see Exhibit 2.3). BigNet’s accounts have been adjusted for the investment entry recorded earlier. As another preliminary step, Smallport’s revenue, expense, and dividend accounts have been closed into its Retained Earnings account. The subsidiary’s operations prior to the December 31 takeover have no direct bearing on the operating results of the business combination. These activities occurred before Smallport was acquired; thus, the new owner should not include any pre-combination subsidiary revenues or expenses in the consolidated statements.
Step 3:
Consolidation Entry S eliminates Smallport’s stockholders’ equity accounts (S is a reference to beginning subsidiary Stockholders’ equity). These balances (Common Stock, Additional Paid-in Capital, and Retained Earnings) represent ownership accounts held by the parent in their entirety and thus no longer are outstanding. By removing these accounts, only Small- port’s assets and liabilities remain to be combined with the parent company figures.
Step 4:
Worksheet Entry S also removes the $600,000 component of the Investment in Smallport Company account that equates to the book value of the subsidiary’s net assets. For external reporting purposes, BigNet should include each of Smallport’s assets and liabilities rather than a single investment balance. In effect, this portion of the Investment in Smallport Company account is deleted and replaced by the specific assets and liabilities that it represents.
Step 5:
Entry A removes the $2,020,000 excess payment in the Investment in Smallport Company and assigns it to the specific accounts indicated by the fair-value allocation schedule. Consequently, Computers and Equipment is increased by $200,000 to agree with Smallport’s fair value- $1,100,000 is attributed to Capitalized Software, $700,000 to Customer Contracts, and $50,000 to Notes Payable.
The unexplained excess of $70,000 is allocated to goodwill. This entry is labeled Entry A to indicate that it represents the Allocations made in connection with Smallport’s acquisition-date fair value. It also completes the Investment in Smallport account balance elimination.
Step 6:
All accounts are extended into the Consolidated Totals column. For accounts such as Current Assets, this process simply adds Smallport and BigNet book values. However, when applicable, this extension also includes any allocations to establish the acquisition-date fair values of Smallport’s assets and liabilities. Computers and Equipment, for example, is increased by $200,000. By increasing the subsidiary’s book value to fair value, the reported balances are the same as in the examples when dissolution occurred. The use of a worksheet does not alter the consolidated figures but only the method of deriving those numbers.
Step 7:
We subtract consolidated expenses from revenues to arrive at a $160,000 net income. Note that because this is an acquisition-date worksheet, we consolidate no amounts for Smallport’s revenues and expenses. Having just been acquired, Smallport has not yet earned any income for BigNet owners. Consolidated revenues, expenses, and net income are identical to BigNet’s balances. Subsequent to acquisition, of course, Smallport’s income accounts will be consolidated with BigNet’s.
Worksheet Mechanics:
In general, totals (such as Net Income and Ending Retained Earnings) are not directly consolidated across on the worksheet. Rather, the components (such as revenues and expenses) are extended across and then combined vertically to derive the appropriate figure. Net income is then carried down on the worksheet to the statement of retained earnings and used (along with beginning retained earnings and dividends paid) to compute the December 31 Retained Earnings balance.
In the same manner, ending Retained Earnings of $920,000 is entered into the balance sheet to arrive at total liabilities and equities of $5,730,000, a number that reconciles with the total of consolidated assets.
The balances in the final column of Exhibit 2.6 are used to prepare consolidated financial statements for the business combination of BigNet Company and Smallport Company. The worksheet entries serve as a catalyst to bring together the two independent sets of financial information. The actual accounting records of both BigNet and Smallport remain unaltered by this consolidation process.