 Hello and welcome to this session in which we'll discuss the acquisition method and business combination. This topic is covered on the CPA exam. This lecture specifically is designed for CPA candidate. Why am I emphasizing this point? It's because I do cover the acquisition method much more in depth in my advanced accounting course. If you are a CPA candidate and you understand the acquisition method, this is a review similar to your Becker, Roger, Wiley, Gleam review. If you want more in depth explanation or if you are lacking basic knowledge about the acquisition method, which I will explain, but not as much as in depth as I will do it in my advanced accounting course. So for the acquisition method, we're gonna be covering the following topics. Let's go ahead and get started. What is a business combination? A business combination is any event when one company called the acquirer obtain another company or more than one company acquires. So you have one company called somebody, someone is buying another company. Usually we're gonna call it P parent and acquiring the subsidiaries. There is a wide variety of business combination. So there's more than one way you can combine with another company. And there are basically three. And let's take a look at all three because you might be asked what is a statuary merger is? What is that statuary consolidation? What is consolidated financial statement? So we need to know what all these three are. When company A buys company B or company B buys company A when one company buys another company and let's assume A by B and B is absorbed in A. So the only surviving company is A. We call this a statuary merger is where the acquirer in the situation A acquires all the asset and liabilities of the acquiree B. The acquirer survive while the acquiree cease to exist. A case in point is Bank of America. Bank of America bought Merrill Lynch. Well, Merrill Lynch is gone and what survive is Bank of America. Statuary consolidation is where the acquirer is created to acquire two or more separate acquires in their entirety. Simply put, if a case in point is Daimler, Daimler Chrysler is a new company that absorbed Daimler which is a German company and Chrysler which is a U.S. company and they form a new company called Daimler Chrysler. So a new company is created. The old two companies are basically gone. They cease to exist as a separate legal entities. And the third one is the consolidated financial statement or acquisition and this is what we really need to know. The other two just make sure you know the definition is when we have a parent subsidiary relationship is one one company called the parent company buys 50% or more of the sub. 50% or more means what? It means you have control over the subsidiary. Under those circumstances, what's gonna happen is this. Company A will stay independent. Company B will stay independent and they will keep their own books. However, because company A, let's assume company A purchased company B. Company A is called the parent company. Company B is the subsidiary. Now they basically form the same company. So what we do is when we prepare financial statement, we prepare consolidated financial statement that shows the financial statements of A and B together. A case in point is the GAP company. GAP, the GAP stores. The GAP stores for example, they own Old Navy as well as other companies as well as Banana Republic. GAP is an independent company. Old Navy is an independent company. However, since GAP controls Old Navy, when GAP report their financial statement, they consolidate, they include Old Navy because what we need to know is GAP is since they own the company, they're part of the company, they are one company. Therefore, you have to show everything in one part. And this is what we need to focus on, which is the consolidated financial statement. When do we consolidate? It's when we have control. How do we determine we have control if we have more than 50% of the other company stocks? Now this is called the voting model. Well, we have another model to determine control and that's called the VIE, variable interest entity. So sometime you might have to consolidate because you have control, not because you own more than 50% of the stock, it's because you have what's called variable interest entity in the company. VIE is variable interest entity and see the lectures for VIE because I kept it as a separate lesson because it's important to appreciate to emphasize the VIE model. Now, acquisition method. What happened is this? Again, you own between 50 to 100, between 50 it means 50 plus to 100%. Under those circumstances, this is where you would have to use what's called the acquisition method. Not any other method, not pooling, not purchase, those are old methods. So you would use the acquisition method to prepare consolidated financial statement. As a result of the acquisition, the parent acquire the total assets and total liabilities at their fair value on the acquisition date. So certain terms we need to be familiar with. When do we determine the fair value of the company that we are buying at the acquisition date, not the announcement date, not the announcement date. So the acquisition date is also known as the value date. The acquisition date is sometimes called to as the measurement or the value date at which the acquired identifiable assets and liabilities assumed are measured at fair value. So this is the acquisition date, important. And this is where we start to count revenues and expenses of the acquiree in the consolidated financial statement at the acquisition date, not announcement date. Acquisition cost. Well, we purchased the company. We're gonna have to incur cost. How do we account for that cost? In an acquisition where we buy more than 50% of the stocks of the other company and where we have control, legal fees and other acquisition costs are expensed, which is different than the fair value method, different than the equity method. So you have to be aware of this. However, I'm gonna highlight this in yellow to point it out. Issuing cost. Issuing cost and registration fee associated with any stocks. Those are a reduction. They are deducted from additional paid in capital. Don't worry, we're gonna work an example. But you need to know legal fees and other acquisition costs expensed. Those are, those are expensed. However, fees associated with issuing stocks, issuing costs of securities, registration fees, reduction paid in capital. It's also worth noting the difference between the accounting treatment of the equity security issuance cost because you need to incur cost to issue those stocks versus the debt issuing cost. Also, when you issue debt, when you issue bond, there's a cost as well. The debt issuing cost are directly reduced from the carrying value of the debt. Just make sure you know the difference because there could be questions where they trick you about this. Let's take a look at the initial journal entry when you make an investment and you buy more than 50% of the other company stocks. The cost of the investment, obviously you incur the cost is the total fair value of the consideration paid by the acquirer, which is the investor in exchange for the investment. Well, when you buy a company, what would you pay, how would you pay for it? Well, you can pay with cash, cash equivalent, other assets, you could incur reliability, you can issue securities, issue stocks, or a combination of all the listed alternative. So if you wanna buy something, you can give them some cash, some, I don't know, inventory if they want to, well, not likely, but the point is you can give them anything, any asset. You might have stocks of other companies. You might issue your own stocks. Give them stocks of your own company. You may issue that. So simply put, the typical journal entry would look something like this. When you buy the investment, the investment is recorded at consideration paid if you incur any legal expense. Remember, legal expense are not added to the investment, which is that's different than the fair value method, different than the equity method where the expenses, those costs incurred like legal expenses are added. That's not the case. That's not the case under the acquisition method. Then if you issue stocks, you credit common stock, credit paid in capital for the stock issued. Remember, you credit common stock, number of shares, number of shares times the par value. This is how much you credit common stock. And remember, additional paid in capital. This is a plug. We keep this for last. If you paid cash, we credit cash or credit other assets that you paid. And if you incur a liability, or if you credit the liability, if the liability were assumed or incurred, sometimes you're gonna carry the liability from the other company. Some of the asset that you buy, they might be the carrying value of those assets are below the fair value. Well, they should be adjusted to fair value before it can be transferred to the acquiree. The adjustment result in a gain that's recognized in the income statement. Basically, you increase the asset and you credit the gain that's called gain on asset revaluation. Sometime what happened when you buy a company, there might be some contingent consideration. What is a contingent consideration? It's some condition that if something happened in the future, we will agree to make additional payment or we'll agree to give you something else. So in some cases, the parent company agree to transfer assets or equity to the former shareholder at a later date provided some conditions are met. Now, why do we do that? Let's think about it from a business perspective. The people who are selling their company, they want like a million dollar. Let's assume they want a million dollar. You'll tell them, your company is only worth 800,000. Well, they would say, okay, you pay us $800,000 now, but in the future, we're gonna be making more income. We can add more value to you. And as a result, you're gonna have more value as a parent company. You would say, okay, I'll pay $800,000 now. And if that event realized was realized if I obtain a certain income as a result of acquiring you, I'll pay you more at a later date. So this is what contingent consideration is. Those conditions might be related to the achievement of a specific target. Usually it's the realization of a certain income. In such circumstances, what's gonna happen is this. The transfer is considered a contingent consideration and the estimated value of the probable consideration is added to the investment. So you have to issue, you have to value a number for that consideration. Okay, for example, it's $300,000. What's the possibility of that consideration happening? 50%, well, 300,000 times 50%, well, that's $150,000 more in your cost. So you have to add it to the investment. Don't worry, we'll work an example and credit a liability because now you have a contingency. After the acquisition date, there could be changes to the estimated value of the consideration. And those are reported in the income statement with an adjustment to the associated liability. So that contingent liability might go up, that contingent liability might go down. That's fine. Bear in mind the investment in the subsidiary account, in the subsidiary account does not change. So the investment does not change. Once you record the investment, it does not change. Any changes in that contingency will increase or decrease your liability and the corresponding entry, if it's a gain or a loss, it goes on the income statement. Another thing we need to be aware of when we buy another company is indemnification asset. What does that mean? Sometime when you buy a company, they might have, for example, a contingent liability. A contingent liability could be a lawsuit. What's gonna happen is this. If the subsidiary loses the lawsuit, guess what? Now, since you're the parent company, you are responsible for the loss. So what happened is this. What is an indemnification asset represent a guarantee from the inquiry to the acquirer? So now you're scared. You don't want to buy the company. They will tell you, look, don't worry about this lawsuit. Whatever happened, you are only your losses as a new owner of the company are limited to 5 million. Let's assume 5 million. So they will guarantee this. So it doesn't matter. Let's assume the lawsuit settled and it's 7 million. Well, the parent company is only responsible for five. They know how much they are paying. Simply put, they want to limit their losses, especially with the lawsuit. You don't know how much the total losses will be. This asset is reported in the financial statement on the same basis as the identified item, which is the fair value at the acquisition date and they recognize upon the settlement or expiration. And what's gonna happen once it's settled, it's done. Non-controlling interest. What is a non-controlling interest? Remember what I said. To consolidate, you have to own more than 50 up to 100. So anything above 50% up to 100, you cannot own more than 100, you have control. Let's assume you own 80%. Well, if you own 80%, what's missing is 20%. Well, that 20%, that's 20% that you don't own, it's called non-controlling interest. Used to be called the minority interest. It's called the non-controlling interest. You would, in your CPA review course, they refer to it as NCI. So when the parent company acquires less than 100% of the subsidiaries' equity, the difference between the sub-total equity and the share acquired by the parent company is attributed to shareholders that would not have controlling interest in the subsidiary. Those now, they have no controlling interest, but they still, they don't want to sell their position. They like to keep owning that 20%. At the acquisition date, you have to compute NCI, which we'll see how do we do it, is computed as the total fair value of the subsidiaries at the date times the percentage of the non-controlling interest. So what's gonna happen is we're gonna look at the fair value of the asset, of the value of the subsidiary, and multiplied by the percentage. If the fair value of the subsidiary is a million and there's 20% ownership, then NCI is $200,000. And NCI is reported as a separate line in the consolidated financial statement. So we're gonna have a separate line for NCI. We're gonna have to keep track of NCI. The fair value of the subsidiary, bear in mind, the fair value of the subsidiary equal to the parent acquisition cost, which may include the contingent liability plus the fair value of the non-controlling interest. So we have those two together is the fair value of the subsidiary, because 80% is one piece, 20% is the other piece. Both of those represent the fair value of the subsidiary. Now bear in mind, the value of the NCI non-controlling interest goes up and goes down to account for the proportionate share of the subsidiary's income and dividend. Again, we'll work a quick example. Just a few things I want to kind of remind you, a few things you need to be aware of. Acquisition method legal and other acquisition costs are expensed. Stock issuing costs and registration are a reduction in additional paid in capital. I know we talked about this. Bear in mind, they're not expensed nor capitalized because that's how they try to trick you. None of these costs is capitalized in the investment. You don't add to the investment account. And do not use the fair value at the announcement date, use the fair value at the acquisition date, okay? When the transaction occur at the transaction date. The best is to look at an example to start to illustrate everything that we went over in this session thus far. On February 2nd, year one, company X announced its decision to acquire 90% of company Y. So we have X buying Y. By issuing 20,000 shares of its $15 power value common stock at $40. How are they buying it? Well, they're issuing shares. The value of their share is $40 per share. They're issuing 20,000 share. The acquisition took place March 15 year two when the fair value of the company's X common stock was $45. They announced it on February 2nd. It took place March 15. So we have to account for everything as of the date of March 15. In addition, company X incurred and paid in cash all the following cost. They incur legal cost for $75,000. What do we do with legal cost? We expense it. Stock issuing cost. What do we do with stock issuing cost? It's a reduction of additional paid in capital. Registration fee of $44,000. Reduction in paid in capital. Moreover, company X agreed to pay $30,000 to company Y former shareholder on March 15 year four if the average net income over years three and year four exceed $275,000 and there's a probability of 30% of that happening. Now we're gonna learn how to record the journal entry for this acquisition. Well, let's take a look at break it down. Well, the value of the stock that we are acquiring we're buying 20,000 shares and the value of the stock is 45,000. Therefore, the cost of this company, the cost of the investment is 900,000 because we're buying 20,000 shares. Remember the legal fees, we expense. This could be just by itself could be a simulation or could be a series of multiple choice. The stock is showing cost 66 and 44, deduction and additional paid in capital. The estimated value of the probable consideration which is we're gonna have to pay them 30,000. There's a 30% chance we have to add $9,000 to our investment and create a $9,000 liability. Now let's take a look at the journal entry to see how this all fits together. The investment is 909 which is 900,000 which is the cost of the stocks 20,000 shares times $45 and $9,000 for the contingent liability. We expense the 75, we issued common stock which is number of shares times the par value. Number of shares we are issuing is 20,000 times the par value times the par value 20,000 times 15 times 15. We paid cash 179. We have to credit the contingent liability which has a corresponding debit here. And what's left is additional paid in capital which is 496. Now it's worth pointing out how reduction and additional paid in capital work. Remember we issued 20,000 shares at $45 that's $900,000. Well, how do we book this $900,000? Let's assume we are issuing stocks and we received cash in this situation we debited investment. But let's debit the investment. So the investment was debited $900,000. The common stock is credited for $300,000 which is how do we compute the $300,000 which is 20,000 shares times $15 par value is $300,000 and what's left is additional paid in capital which should be $600,000. Now bear in mind that we had to incur, we had to incur, what did we had to incur? We had to incur $60 in registration cost and $44 in issuing cost 66 and registration is 44. We have to incur $104,000. That's gonna be a reduction in paid in, sorry, this will be 300, not 600. 300, I'm sorry, 600 it is, 600 it is, 600 additional paid in capital, dose registration and issuing cost will reduce it by 104. So when we reduce it by 104, it will be 496 and this is how 496 is the plug. Initially additional paid in capital 600 but what we did is we reduced it by that issuing cost and registration fees. Compute the value of the non-controlling interests at the acquisition date. Remember what we're doing here is we are buying only, we bought only 90% of the company. It means we have a non-controlling interest of 10%. How do we do so? Non-controlling interest is computed as the total fair value of the subsidiaries at the acquisition date times the percentage of the non-controlling interests with the fair value of the subsidiary equal to the parent acquisition plus the non-controlling interest fair value. In this example, the parent acquisition cost equal to 909. This is what we paid for the company 909. Well, if the company is worth 909 and this is 90% of the company, we divide this by 90%, it means the total company is worth $1 million and $10,000. Well, the minority owners or the non-controlling interests own 10%, therefore NCI is how much? 100 and 1000. Simply put, here's what we're saying. You paid, we don't know how much you own 90% of the company. So we don't know what's the total value of the company, but if we take the total value of the company times 90%, you paid 909. This is how much you paid for the company. Well, what is the total value of the company? X equal 909 divided by 0.9. If you watch that show Shark Tank on CNBC, for example, if they tell them, we want you to invest 90% for 909, they would say, okay, they will take 909 divided by 90%, and they will tell the entrepreneur, your company is worth $1 million and $10,000. Say, how do you come up with that valuation? And they will start the negotiation, but this is how you find the value of the company. How much did you pay for the company and you got 90% take this amount divided by the percentage? We'll give you the total. Then you will take the total multiplied by the non-minority interest. Now, assume during their period, March 15, year two, for that December 31st year two company, why earned 270,000 and distribute a 210,000 of dividend? Compute the non-controlling interest, okay? And why did we say March 15 year two? Because this is when the period started. This is when the transaction took place. Well, what's gonna happen is this, the value of the non-controlling interest at year end is affected by the non-controlling shareholder share of the subsidiary's income and dividend. In this question, we have a 10% ownership for NCI. Well, what's gonna happen is this. We're starting NCI at 101. Well, 10% of 270 is 27,000. That's gonna be an addition. And 10% of 210 will be 21,000. That's gonna be a subtraction. And by doing so, we can find the fair value of NCI, which is 107. What should you do now? In the next session, I'm gonna work some few multiple questions, multiple choice questions, but what you should do, go to farhatlectures.com, subscribe. And if you need more help, as I told you, if I went too fast or not in depth enough, please go to my advanced accounting course. This is a review for CPA candidate who are looking to kind of move on, be able to answer questions. But if you want explanation, please go to my advanced accounting course. Invest in yourself, good luck. 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