A business combination occurs before a consolidation. Business combinations must be accounted for under the purchase method. Accounting and reporting requirements, and disclosures must be considered for the purchase method as required by FASB Statement No. 141 (Accounting for Business Combinations). A purchase typically involves either the payment of assets or incurrence of liabilities for the other business. To effect a purchase, more than 50 percent of voting common stock has to be acquired. What Else? Read on…
Accounting Followed for a Business Purchase
The accounting followed for a purchase is:
. Net assets of the acquired company are brought forth at fair market value. Guidelines in assigning values to individual assets acquired and liabilities assumed (except goodwill) follow:
- Marketable securities—Current net realizable values
- Receivables—Present value of net receivables using
present interest rates
- Inventories—Finished goods at estimated net realizable value less a reasonable profit allowance (lower limit). Work-in-process at estimated net realizable value of finished goods less costs to complete and profit allowance. Raw materials at current replacement cost
- Plants and equipment—If to be employed in operations, show at replacement cost. If to be sold, reflect at net realizable value. If to be used temporarily, show at net realizable value, recognizing depreciation for the period
- Identifiable intangibles—At appraisal value
- Other assets (including land and noncurrent securities)—At appraised values
- Payables—At estimated present value
- Liabilities and accruals—At estimated present value
- Other liabilities and commitments—At estimated present value. However, a deferred income tax credit account of the acquired company is not brought forth.\
. The excess of cost paid over book value of assets acquired is attributed to the identifiable net assets. The remaining balance not attributable to specific assets is of an unidentifiable nature and is assigned to goodwill. The identifiable assets are depreciated. Goodwill is subject to an annual impairment test.
Requirements for Purchase Method
(1). Goodwill of the acquired company is not brought forth.
(2). None of the equity accounts of the acquired business (e.g., retained earnings) appear on the acquirer’s books. Ownership interests of the acquired company stockholders are not continued subsequent to the merger.
(3). Net income of the acquired company is brought forth from the date of acquisition to year-end.
(4). Direct costs of the purchase are a deduction from the fair value of the securities issued; indirect costs are expensed as incurred:
- When stock is issued in a purchase transaction, the quoted market price of stock is typically a clear indication of asset cost. Consideration should be given to price fluctuations, volume, and issue price of stock.
- If liabilities are assumed in a purchase, the difference between the fixed rate of the debt securities and the present yield rate for comparable securities is reflected as a premium or discount.
When Control Isn’t Established on The Initial Purchase
When control is not established on the first initial purchase, the following step-by-step acquisition procedure is followed:
- If control is not accomplished on the initial purchase, the subsidiary cannot be included in consolidation until control has been accomplished.
- Once the parent owns in excess of 50 percent of the subsidiary, a retroactive restatement should be made including all of the subsidiary’s earnings in consolidated retained earnings in a “step-by-step” fashion commencing with the initial investment.
- The subsidiary’s earnings are included for the ownership years at the appropriate ownership percentage.
- After control is accomplished, fair value and adjustments for goodwill will be applied retroactively on a “step-by-step” basis. Each acquisition is separately determined.
The acquiring company generally cannot record a net operating loss carryforward of the acquired company, since there is no assurance of realization. However, if realized in a later year, recognition will be a retroactive adjustment of the purchase transaction allocation, causing the residual purchase cost to be reallocated to the other assets acquired. In effect, there will be a reduction of goodwill or the other assets.
Pre-Acquisition Contingencies and Its Accounting Treatment
A pre-acquisition contingency is a contingency of a business that is acquired with the purchase method and that exists prior to the consummation date.
Example: A contingent asset, a contingent liability, or a contingent impairment of an asset.
FASB 38 provides guidelines for recording pre-acquisition contingencies during the allocation period as a part of allocating the cost of an investment in an enterprise acquired under the purchase method.
The allocation period is the one required to identify and quantify the acquired assets and liabilities assumed. This period ceases when the acquiring company no longer needs information it has arranged to obtain and that is known to be available. Hence, the existence of a pre-acquisition contingency for which an asset, a liability, or an impairment of an asset cannot be estimated does not, of itself, extend the allocation period.
Note: Although the time required depends on the circumstances, the allocation period typically is not greater than one year from the consummation date.
Pre-acquisition contingencies (except for tax benefits of net operating loss carryforwards) must be included in the allocation of purchase cost. The allocation basis is determined by the fair value of the pre-acquisition contingency, assuming a fair value can be determined during the allocation period.
If fair value is not determinable, the following criteria are used:
- Information available before the termination of the allocation period indicates that it is probable that an asset existed, a liability had been incurred, or an asset had been impaired at the consummation date. It must be probable that one or more future events will occur confirming the existence of the asset, liability, or impairment.
- The amount of the asset or liability can be reasonably estimated.
Adjustments necessitated by a pre-acquisition contingency occurring after the end of the allocation period must be included in income in the year the adjustment is made.
Footnote Disclosures Under Purchase Method
Footnote disclosures under the purchase method include:
- Name and description of companies combined
- A statement that the purchase method is being used
- The period in which the earnings of the acquired company are included
- Cost of the acquired company including the number and value of shares issued, if any
- Contingencies arising under the acquisition agreement
- Earnings for the current and prior periods as if the companies were combined at the beginning of the period
- Major reasons for the acquisition
- Percentage of voting interest acquired
- Amount of purchase price assigned to each major intangible asset class
- Amount of any significant residual value, in total and by major intangible asset class
- Total goodwill and the amount of goodwill by reportable segment
- Impairment information with respect to goodwill
- Amount of goodwill deductible on the tax return
- Unresolved issues
- Commitments made
- Summarized financial data about the acquired company
- Description of the exit plan, including exit costs (e.g., relocation, employee termination)
Advantage and Disadvantage of the Purchase Method
Fair value is used to recognize the acquired company’s assets just as in the case of acquiring a separate asset.
Difficulty in determining fair value; mixing fair value of acquired company’s assets and historical cost for the acquiring company’s assets.