💠Complex Financial Structures Unit 1 – Business Combinations: Accounting Standards

What's This Unit About?

• Focuses on the accounting standards and methods used when two or more businesses combine to form a single reporting entity
• Covers the different types of business combinations (mergers, acquisitions, consolidations) and their accounting implications
• Explores the acquisition method, which is the primary method used to account for business combinations under current accounting standards
• Discusses the concept of goodwill and how it arises in business combinations when the purchase price exceeds the fair value of the acquired company's net assets
• Examines the impact of business combinations on the acquiring company's financial statements, including the balance sheet, income statement, and cash flow statement
• Provides real-world examples and case studies to illustrate the application of accounting standards in various business combination scenarios

Key Concepts and Definitions

• Business combination: A transaction or event in which an acquiring company obtains control of one or more businesses (the acquiree)
• Acquirer: The entity that obtains control of the acquiree in a business combination
• Acquiree: The business or businesses that the acquirer obtains control of in a business combination
• Acquisition date: The date on which the acquirer obtains control of the acquiree
• Fair value: The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date
• Goodwill: An intangible asset that represents the excess of the purchase price over the fair value of the acquired company's net assets
• Bargain purchase: A business combination in which the fair value of the acquired company's net assets exceeds the purchase price, resulting in a gain for the acquirer

Accounting Standards for Business Combinations

• In the United States, business combinations are accounted for under Accounting Standards Codification (ASC) Topic 805, "Business Combinations"
  • ASC 805 was introduced by the Financial Accounting Standards Board (FASB) in 2007 and has been subsequently updated
• Internationally, business combinations are accounted for under International Financial Reporting Standard (IFRS) 3, "Business Combinations"
  • IFRS 3 was issued by the International Accounting Standards Board (IASB) in 2004 and has been subsequently revised
• Both ASC 805 and IFRS 3 require the use of the acquisition method to account for business combinations
  • The acquisition method involves identifying the acquirer, determining the acquisition date, and recognizing and measuring the identifiable assets acquired, liabilities assumed, and any non-controlling interest in the acquiree
• The standards also provide guidance on the recognition and measurement of goodwill or a gain from a bargain purchase
• Consistency in accounting for business combinations is essential for comparability of financial statements across companies and jurisdictions

Types of Business Combinations

• Merger: A transaction in which two or more companies combine to form a single entity, with one company's shareholders exchanging their shares for shares in the new combined entity
• Acquisition: A transaction in which one company (the acquirer) obtains control of another company (the acquiree) by purchasing its assets, shares, or a combination of both
  • Stock acquisition: The acquirer purchases the outstanding shares of the acquiree, and the acquiree becomes a subsidiary of the acquirer
  • Asset acquisition: The acquirer purchases the assets and assumes the liabilities of the acquiree, and the acquiree ceases to exist as a separate entity
• Consolidation: A transaction in which two or more companies combine to form a new entity, with the shareholders of the combining companies exchanging their shares for shares in the newly formed entity
• Reverse acquisition: A transaction in which the legal acquiree is determined to be the accounting acquirer, often due to the relative size or ownership structure of the combining entities

Acquisition Method: Step-by-Step

1. Identify the acquirer: Determine which entity obtains control of the acquiree based on factors such as relative voting rights, composition of the governing body, and relative size of the combining entities
2. Determine the acquisition date: Establish the date on which the acquirer obtains control of the acquiree, which is generally the closing date of the transaction
3. Recognize and measure the identifiable assets acquired, liabilities assumed, and any non-controlling interest in the acquiree:
   • Measure the identifiable assets and liabilities at their acquisition-date fair values, with limited exceptions
   • Measure any non-controlling interest in the acquiree at either fair value or the proportionate share of the acquiree's identifiable net assets
4. Recognize and measure goodwill or a gain from a bargain purchase:
   • Goodwill = Purchase price - Fair value of net assets acquired
   • Bargain purchase gain = Fair value of net assets acquired - Purchase price
5. Disclose information that enables users of the financial statements to evaluate the nature and financial effect of the business combination

Goodwill and Bargain Purchases

• Goodwill arises when the purchase price in a business combination exceeds the fair value of the acquired company's net assets
  • Goodwill is an intangible asset that represents the expected synergies and future economic benefits of the combination
  • Goodwill is not amortized but is instead tested for impairment at least annually or more frequently if events or changes in circumstances indicate that it might be impaired
• A bargain purchase occurs when the fair value of the acquired company's net assets exceeds the purchase price
  • In this case, the acquirer recognizes a gain in the income statement equal to the difference between the fair value of the net assets and the purchase price
  • Bargain purchases are less common than goodwill and may result from factors such as a distressed sale or a strategic decision by the seller
• The accounting treatment of goodwill and bargain purchases can have a significant impact on the acquirer's financial statements and key ratios (return on assets, earnings per share)

Financial Statement Impact

• Balance sheet: A business combination affects the acquirer's balance sheet by adding the acquired assets and liabilities at their fair values, as well as any goodwill or gain from a bargain purchase
  • The acquirer's total assets and liabilities will increase, and the composition of its assets may change significantly (more intangible assets, such as goodwill and customer relationships)
• Income statement: The acquirer's income statement will include the acquiree's results of operations from the acquisition date forward
  • The acquirer may experience changes in revenue, expenses, and profitability due to the combined entity's operations and any synergies or integration costs
  • In the case of a bargain purchase, the acquirer will recognize a one-time gain in the income statement
• Cash flow statement: The cash flow statement will reflect the cash outflows associated with the purchase price and any transaction costs, as well as the cash inflows or outflows related to the acquired company's operations
• Disclosures: The acquirer must provide extensive disclosures about the business combination, including the purchase price allocation, goodwill or bargain purchase gain, and pro forma financial information as if the combination had occurred at the beginning of the reporting period

Real-World Examples and Case Studies

• Microsoft's acquisition of LinkedIn (2016): Microsoft acquired LinkedIn for $26.2 billion, resulting in significant goodwill on Microsoft's balance sheet and an expanded presence in the professional networking and social media space
• Amazon's acquisition of Whole Foods Market (2017): Amazon acquired Whole Foods Market for $13.7 billion, allowing the e-commerce giant to expand into the brick-and-mortar grocery industry and leverage Whole Foods' brand and store network
• Disney's acquisition of 21st Century Fox (2019): Disney acquired 21st Century Fox for $71.3 billion, significantly increasing its content library and production capabilities, particularly in the streaming services market
• AbbVie's acquisition of Allergan (2019): AbbVie acquired Allergan for $63 billion, creating a diversified pharmaceutical company with a strong presence in immunology, oncology, and aesthetics
• These case studies demonstrate the various strategic, financial, and accounting implications of business combinations and how they can transform the competitive landscape of entire industries