Department of Accounting and Information Systems

MBA 2nd Semester

AIS: 5201 Advanced Financial Accounting
Course Teacher: Md. Shahbub Alam, Lecturer, Dept. of AIS, I.U, Kushtia.

Chapter-02
Interoperate Acquisition and Investment in other Entities

1. Reasons for the Development of Complex Business Structures

Today’s business environment is complex. The complexity arises from doing business across
different states and countries, each with its own laws and risks. A simple business setting in
which one company has two or more manufacturing plants and produces products for a local
or regional market. As companies grow in size and as a response to the complex business
environment, they often develop complex organizational and ownership structure.

i) Enterprise Expansion: Most business enterprises seek to expand over time in order to
survive and become profitable. Both the owners and managers of a business enterprise have an
interest in seeing a company grow in size. Increased size often allows economies of scale in
both production and distribution. By expanding into new markets or acquiring other companies
already in those markets, companies can develop new earning potential and those in cyclical
industries can add greater stability to earnings through diversification.

ii) Business Objectives: Complex organizational structures often evolve to help achieve a
business’s objectives, such as increasing profitability or reducing risk.

iii) Frequency of Business Combinations: Very few major companies function as single legal
entities in our modern business environment. Virtually all major companies have at least one
subsidiary, with more than a few broadly diversified companies having several hundred
subsidiaries. In some cases, subsidiaries are created to incorporate separately part of the
ongoing operations previously conducted within the parent company. Other subsidiaries are
acquired through business combinations.

iv) Ethical Considerations: Acquisitions can sometimes lead to ethical challenges for
managers. Corporate managers are often rewarded with higher salaries as their companies
increase in size. In addition, prestige frequently increases with the size of a company and with
a reputation for the successful acquisition of other companies.
2. Sample Question-What types of circumstances would encourage management to
establish a complex organizational structure?
Complex organizational structures often result when companies do business in a complex
business environment. New subsidiaries or other entities may be formed for purposes such as
extending operations into foreign countries, seeking to protect existing assets from risks
associated with entry into new product lines, separating activities that fall under regulatory
controls, and reducing taxes by separating certain types of operations.

3. Define Subsidiary Company and Parent Company. Why a parent company create
subsidiary.
A subsidiary is a corporation that another corporation, referred to as a parent company,
controls, usually through majority ownership of its common stock. Because a subsidiary is a
separate legal entity, the parent’s risk associated with the subsidiary’s activities is limited.
There are many reasons for creating or acquiring a subsidiary. For example, companies often
transfer their receivables to subsidiaries or special-purpose entities that use the receivables as
collateral for bonds issued to other entities (securitization). External parties may hold partial or
complete ownership of those entities, allowing the transferring company to share its risk
associated with the receivables. In some situations, companies can realize tax benefits by
conducting certain activities through a separate entity. Bank of America, for example,
established a subsidiary to which it transferred bank-originated loans and was able to save $418
million in quarterly taxes.

4. Methods of Business Expansion.

Historically, businesses have expanded by internal growth through new product development
and expansion of existing product lines into new markets. In recent decades,
however, many companies have chosen to expand by combining with or acquiring other
companies. Either approach may lead to a change in organizational structure.

i) Internal Expansion: Creating a Business Entity: As companies expand from within, they
often find it advantageous to conduct their expanded operations through new subsidiaries or
other entities such as partnerships, joint ventures, or special entities. In most of these situations,
an identifiable segment of the company’s existing assets is transferred to the new entity, and,
in exchange, the transferring company receives equity ownership. Companies may be
motivated to establish new subsidiaries or other entities for a variety of reasons. In some cases,
an entity that specializes in a particular type of activity or has its operations in a particular
country may qualify for special tax incentives. Companies also might establish new
subsidiaries or other entities, not as a means of expansion, but as a means of disposing of a
portion of their existing operations through outright sale or a transfer of ownership to existing
shareholders or others.
ii) External Expansion: Business Combinations Many time’s companies find that entry into
new product areas or geographic regions is more easily accomplished by acquiring or
combining with other companies than through internal expansion. For example, SBC
Communications, a major telecommunications company and one of the “Baby Bells,”
significantly increased its service area by combining with Pacific Telesis and Ameritech, later
acquiring AT&T (and adopting its name), and subsequently combining with BellSouth. A
business combination occurs when “. . . an acquirer obtains control of one or more businesses.”
The concept of control relates to the ability to direct policies and management. Traditionally,
control over a company has been gained by acquiring a majority of the company’s common
stock. However, the diversity of financial and operating arrangements employed in recent years
also raises the possibility of gaining control with less than majority ownership or, in some
cases, with no ownership at all through other contractual arrangements. This types of business
combinations found in today’s business environment and the terms of the combination
agreements are as diverse as the firms involved. Companies enter into various types of formal
and informal arrangements that may have at least some of the characteristics of a business
combination.

5. When Spin-off and Split-off occurs?

A spin-off occurs when the ownership of a newly created or existing subsidiary is distributed
to the parent’s stockholders without the stockholders surrendering any of their stock in the
parent company. Thus, the company divests itself of the subsidiary because it is owned by the
company’s shareholders after the spin-off. A split-off occurs when the subsidiary’s shares are
exchanged for shares of the parent, thereby leading to a reduction in the parent company’s
outstanding shares. Although the two divestiture types are similar, the split-off could result in
one set of the former parent shareholders exchanging their shares for those of the divested
subsidiary. Although a transfer of ownership to one or more unrelated parties normally results
in a taxable transaction, properly designed transfers of ownership to existing shareholders
generally qualify as nontaxable exchanges.

6. Sample Question: How would the decision to dispose of a segment of operations using
a split-off rather than a spinoff impact the financial statements of the company
making the distribution?
The split-off and spin-off result in the same reduction of reported assets and liabilities. Only
the stockholders’ equity accounts of the company are different. The number of shares
outstanding remains unchanged in the case of a spin-off and retained earnings or paid-in
capital is reduced. Shares of the parent are exchanged for shares of the subsidiary in a split-
off, thereby reducing the outstanding shares of the parent company.

7. Types Organizational Structure and Financial Reporting

When companies expand or change organizational structure by acquiring other companies or
through internal division, the new structure must be examined to determine the
appropriate financial reporting procedures. Several approaches are possible, depending on the
circumstances:
i) Merger: A merger is a business combination in which the acquired company’s assets and
liabilities are combined with those of the acquiring company. Thus, two companies are merged
into a single entity. In essence, the acquiring company “swallows” the acquired company.

ii) Controlling ownership: A business combination in which the acquired company remains
as a separate legal entity with a majority of its common stock owned by the purchasing
company leads to a parent–subsidiary relationship. Accounting standards normally require that
the financial statements of the parent and subsidiary be consolidated for general-purpose
reporting so the companies appear as a single company. The treatment is the same if the
subsidiary is created rather than purchased. The treatment is also the same when the other entity
is unincorporated (independent) and the investor company has control and majority ownership.

iii) Non-controlling ownership: The purchase of a less-than-majority interest in another

corporation does not usually result in a business combination or controlling situation.
A similar situation arises when a company creates another entity and holds less than a
controlling position in it or purchases a less-than-controlling interest in an existing partnership.
In its financial statements, the investor company reports its interest in the investee as an
investment with the specific method of accounting for the investment dictated by the
circumstances.

iv) Other beneficial interest: One company may have a beneficial interest in another entity
even without a direct ownership interest. The beneficial interest may be defined by the
agreement establishing the entity or by an operating or financing agreement. When the
beneficial interest is based on contractual arrangements instead of majority stock ownership,
the reporting rules may be complex and depend on the circumstances. In general, a company
that has the ability to make decisions significantly affecting the results of another entity’s
activities or is expected to receive a majority of the other entity’s profits and losses is
considered to be that entity’s primary beneficiary. Normally, that entity’s financial statements
would be consolidated with those of the primary beneficiary.

8. HISTORY OF THE DEVELOPMENT OF ACCOUNTING FOR BUSINESS

COMBINATIONS (Self- Study).
9. ACCOUNTING FOR INTERNAL EXPANSION: CREATING BUSINESS
ENTITIES (Practical Problem)
i) As an illustration of a created entity, assume that Allen Company creates a subsidiary,
Blaine Company, and transfers the following assets to Blaine in exchange for all 100,000
shares of Blaine’s $2 par common stock:

Item Cost Book

Cash - 70,000
Inventory 50,000 50,000
Land 75,000 75,000
Building 100,000 80,000
Equipment 250,000 160,000
435,000
Allen records the transfer with the following entry:

Investment in Blaine Company Common Stock 435,000

Accumulated Depreciation* 110,000
Cash 70,000
Inventory 50,000
Land 75,000
Building 100,000
Equipment 250,000
Record the creation of Blaine Company.
*$110,000 = ($100,000 - $80,000) + ($250,000 - $160,000)

Blaine Company records the transfer of assets and the issuance of stock (at the book value of
the assets) as follows:

Cash 70,000
Inventory 50,000
Land 75,000
Building 100,000
Equipment 250,000
Accumulated Depreciation 110,000
Common Stock, $2 par 200,000
Additional Paid-In Capital 235,000
Record the receipt of assets and the issuance of $2 par common stock

ii) Asset Transfer to Subsidiary

Pale Company was established on January 1, 20X1. Along with other assets, it immediately
purchased land for $80,000, a building for $240,000, and equipment for $90,000. On January
1, 20X5, Pale transferred these assets, cash of $21,000, and inventory costing $37,000 to a
newly created subsidiary, Bright Company, in exchange for 10,000 shares of Bright’s $6 par
value stock. Pale uses straight-line depreciation and useful lives of 40 years and 10 years for
the building and equipment, respectively, with no estimated residual values.

Required:
a) Give the journal entry that Pale recorded when it transferred the assets to Bright.

b) Give the journal entry that Bright recorded for the receipt of assets and issuance of common
stock to Pale.

a. Journal entry recorded by Pale Company for transfer of assets to Bright Company:
Investment in Bright Company Common Stock 408,000
Accumulated Depreciation – Buildings 24,000
Accumulated Depreciation – Equipment 36,000
Cash 21,000
 Inventory 37,000
Land 80,000
Buildings 240,000
Equipment 90,000

b. Journal entry recorded by Bright Company for receipt of assets from Pale Company:
Cash 21,000
Inventory 37,000
Land 80,000
Buildings 240,000
Equipment 90,000
Accumulated Depreciation – Buildings 24,000
Accumulated Depreciation – Equipment 36,000
Common Stock 60,000
Additional Paid-In Capital 348,000

[N.B: Also Solve Problem from Text book: i;e E1-6, Creating new subsidiaries,p1-24, p1-
25, p1-26.]

10. Forms/ Types of Business Combinations

The three primary legal forms of business combinations.

i) A statutory merger is a type of business combination in which only one of the combining
companies survives and the other loses its separate identity. The acquired company’s assets
and liabilities are transferred to the acquiring company, and the acquired company is dissolved,
or liquidated. The operations of the previously separate companies are carried on in a single
legal entity following the merger.

ii) A statutory consolidation is a business combination in which both combining companies

are dissolved and the assets and liabilities of both companies are transferred to a newly created
corporation. The operations of the previously separate companies are carried on in a single
legal entity, and neither of the combining companies remains in existence after a statutory
consolidation. In many situations, however, the resulting corporation is new in form only, and
in substance it actually is one of the combining companies reincorporated with a new name.

iii) A stock acquisition occurs when one company acquires the voting shares of another
company and the two companies continue to operate as separate, but related, legal entities.
Because neither of the combining companies is liquidated, the acquiring company accounts
for its ownership interest in the other company as an investment. In a stock acquisition, the
acquiring company need not acquire all the other company’s stock to gain control. The
relationship that is created in a stock acquisition is referred to as a parent– subsidiary
relationship. A parent company is one that controls another company, referred to as a
subsidiary, usually through majority ownership of common stock.

Figure: From Text

11. ACQUISITION ACCOUNTING (Definition and application)
As of the end of 2007, the FASB significantly changed the method of accounting for business
combinations, requiring the use of the acquisition method. Under the acquisition method, the
acquirer recognizes all assets acquired and liabilities assumed in a business combination and
measures them at their acquisition-date fair values. If less than 100 percent of the acquiree is
acquired, the non-controlling interest also is measured at its acquisition-date fair value. Note
that a business combination does not affect the amounts at which the assets and liabilities of
the acquirer are valued.

Fair Value Measurements Because accounting for business combinations is now based on fair
values, the measurement of fair values takes on added importance. The acquirer must value at
fair value (1) the consideration it exchanges in a business combination, (2) each of the
individual identifiable assets and liabilities acquired, and (3) any non-controlling interest in the
acquiree.

Applying the Acquisition Method For all business combinations, an acquirer must be
identified, and that party is the one gaining control over the other. In addition, an acquisition
date must be determined. That date is usually the closing date when the exchange transaction
actually occurs.

However, in rare cases control may be acquired on a different date or without an exchange, so
the circumstances must be examined to determine precisely when the acquirer gains control.
Under the acquisition method, the full acquisition-date fair values of the individual assets
acquired, both tangible and intangible, and liabilities assumed in a business combination are
recognized. All indirect costs of bringing about and consummating a business combination are
charged to an acquisition expense as incurred. Examples of traceable, indirect costs include
finders’ fees, consulting fees, travel costs, and so on.

12. Definition of Goodwill with example (Required for practical problem)

Conceptually, goodwill as it relates to business combinations consists of all those intangible
factors that allow a business to earn above-average profits. From an accounting perspective,
the FASB has stated that goodwill “is an asset representing the future economic benefits arising
from other assets acquired in a business combination that are not individually identified and
separately recognized” (ASC 805-10-65-1). Under the acquisition method, an acquirer
measures and recognizes goodwill from a business combination based on the difference
between the total fair value of the acquired company and the fair value of its net identifiable
assets.
However, the FASB decided, for several reasons, not to focus directly on the total fair value
of the acquiree, but rather on the components that provide an indication of that fair value. The
FASB identified three components that should be measured and summed for the total amount
to be used in determining the amount of goodwill recognized in a business combination:
1. The fair value of the consideration given by the acquirer.
2. The fair value of any interest in the acquiree already held by the acquirer, if any.
3. The fair value of the non-controlling interest in the acquiree, if any.

The total of these three amounts, all measured at the acquisition date, is then compared with
the acquisition-date fair value of the acquiree’s net identifiable assets, and any excess is
goodwill.

As an example of the computation of goodwill, assume that Albert Company acquires all of
the assets of Zanfor Company for $400,000 when the fair value of Zanfor’s net identifiable
assets is $380,000. Goodwill is recognized for the $20,000 difference between the total
consideration given and the fair value of the net identifiable assets acquired. If,
instead of an acquisition of assets, Albert acquires 75 percent of the common stock of Zanfor
for $300,000, and the fair value of the non-controlling interest is $100,000, goodwill is
computed as follows:
Fair value of consideration given by Albert 300,000
+ Fair value of non-controlling interest 100,000
Total fair value of Zanfor Company 400,000
-Fair value of net identifiable assets acquired (380,000)
Goodwill 20,000

13. Combination Effected through the Acquisition of Net Assets (Practical Problem)
When one company acquires all the net assets of another in a business combination, the
acquirer records on its books the individual assets acquired and liabilities assumed in the
combination and the consideration given in exchange. Each identifiable asset and liability
acquired is recorded by the acquirer at its acquisition-date fair value. The acquiring company
records any excess of the fair value of the consideration exchanged over the fair value of the
acquiree’s net identifiable assets as goodwill.
To illustrate the application of the acquisition method of accounting to a business combination
effected through the acquisition of the acquiree’s net assets, assume that Point Corporation
acquires all of the assets and assumes all of the liabilities of Sharp Company in a statutory
merger by issuing 10,000 shares of $10 par common stock to Sharp. The shares issued have a
total market value of $610,000. Point incurs legal and appraisal fees of $40,000 in connection
with the combination and stock issue costs of $25,000. In below shows the book values and
fair values of Sharp’s individual assets and liabilities on the date of combination.
 Balance sheet of Sharp Co

Assets, Liabilities and Equities Book -Value Fair-Value

Cash & Receivables $ 45,000 $45,000
Inventory 65,000 75,000
Land 40,000 70,000
Buildings & Equipment 400,000 350,000
Accumulated Depreciation (150,000) -
Patent - 80,000
Total Assets $400,000 $620,000
Current Liabilities $100,000 110,000
Common Stock ($5 par) 100,000 -
Additional Paid-In Capital 50,000 -
Retained Earnings 150,000 -
Total Liabilities & Equities $400,000
Fair Value of Net Assets $510,000

The relationships among the fair value of the consideration exchanged, the fair value of
Sharp’s net assets, and the book value of Sharp’s net assets are illustrated in the following
diagram:

Goodwill=Fair value of consideration-Fair value of net identifiable assets= (6, 10,000-5,

10,000)=1,00,000.
Excess fair value of net identifiable=Fair value of net identifiable assets-Book value of net
identifiable assets= (5,10,000-3,00,000) = 2,10,000.
Total differential=Goodwill + Excess fair value of net identifiable = (1,00,000+2,10,000) =
3,10,000.

The $40,000 of acquisition costs incurred by Point in carrying out the acquisition are expensed
as incurred:

Acquisition Expense 40,000

Cash 40,000
Record costs related to acquisition of Sharp Company.

Portions of the $25,000 of stock issue costs related to the shares issued to acquire Sharp may
be incurred at various times. To facilitate accumulating these amounts before recording the
combination, Point may record them in a separate temporary “suspense” account as incurred:

Deferred Stock Issue Costs 25,000

Cash 25,000
Record costs related to issuance of common stock.
On the date of combination, Point records the acquisition of Sharp with the following entry
Cash and Receivables 45,000
Inventory 75,000
Land 70,000
Buildings and Equipment 350,000
Patent 80,000
Goodwill 100,000
Current Liabilities 110,000
Common Stock 100,000
Additional Paid-In Capital 485,000
Deferred Stock Issue Costs 25,000
Record acquisition of Sharp Company.

On the date of the combination, Sharp records the following entry to recognize receipt of the
Point shares and the transfer of all individual assets and liabilities to Point:
Investment in Point Stock 610,000
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 310,000
Record transfer of assets to Point Corporation.

Sharp recognizes the fair value of Point Corporation shares at the time of the exchange and
records a gain of $310,000. The distribution of Point shares to Sharp shareholders and the
liquidation of Sharp are recorded on Sharp’s books with the following entry:

Common Stock 100,000

Additional Paid-In Capital 50,000
Retained Earnings 150,000
Gain on Sale of Net Assets 310,000
Investment in Point Stock 610,000
Record distribution of Point Corporation stock.

17. Differential
The total difference at the acquisition date between the fair value of the consideration
exchanged and the book value of the net identifiable assets acquired is referred
to as the differential. In more complex situations, the differential is equal to the difference
between (1) the acquisition-date fair value of the consideration transferred by the acquirer, plus
the acquisition-date fair value of any equity interest in the acquire previously held by the
acquirer, plus the fair value of any non-controlling interest in the acquiree and (2) the
acquisition-date book values of the identifiable assets acquired and liabilities assumed.
14. Acquisition Accounting ( Practical Problem)
Acquisition of Net Assets

E1-08: Sun Corporation concluded the fair value of Tender Company was $60,000 and paid
that amount to acquire its net assets. Tender reported assets with a book value of $55,000 and
fair value of $71,000 and liabilities with a book value and fair value of $20,000 on the date of
combination. Sun also paid $4,000 to a search firm for finder’s fees related to the acquisition.

Required
Give the journal entries to be made by Sun to record its investment in Tender and its payment
of the finder’s fees.
Sun Corporation will record the following journal entries:
1. Assets 71,000
Goodwill 9,000
Liabilities 20,000
Cash 60,000
2. Merger Expense 4,000
Cash 4,000

[Also Solve Problem from Text book: i;e E1-9,10,11,12,21, 22. p1-27, 28, 29,30.]

Assignment-p1-26,30.