Cambridge AS & A Level9706

Business acquisition and merger (A Level)

Accounting 9706 Chapter Notes

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Business acquisition and merger (A Level)
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In this chapter

  1. 1Mergers vs. Acquisitions: The Basics
  2. 2Motivations for Combining Businesses
  3. 3Understanding and Calculating Goodwill
  4. 4Recording an Acquisition: Journal Entries
  5. 5Preparing Post-Acquisition Financial Statements
  6. 6Evaluating Mergers and Acquisitions

1. Mergers vs. Acquisitions: The Basics

A business combination occurs when two or more businesses join to form a single, larger entity. There are two main ways this happens: mergers and acquisitions. A merger is a mutual agreement where two companies, often of similar size, combine to become one new entity. It's typically seen as a partnership of equals. An acquisition, also known as a takeover, happens when one company (the acquirer) purchases and takes control of another company (the target). This can be a 'friendly' takeover, where the target's management agrees to the deal, or 'hostile', where the acquirer buys the company against the wishes of its management.

Key term

Acquisition: The purchase of one business by another, where the buying company obtains a controlling interest (usually more than 50%) of the target company.

Examiner insight

Examiners reward students who can clearly distinguish between a merger (a combination of equals) and an acquisition (a takeover), especially when discussing the power dynamics between the firms.

Common pitfall

Confusing a merger with an acquisition. Remember, a merger is like a marriage of equals creating a new family, while an acquisition is one company buying another.

Fun fact

The 2006 Disney-Pixar deal, often called a merger due to its collaborative nature, was technically an acquisition worth $7.4 billion. It highlights how the lines can sometimes blur in friendly takeovers.

Worked example 13 marks

Alpha PLC and Beta PLC are two competing software companies. They decide to combine their operations to form a new company called 'Innovate Tech PLC', with shareholders from both original companies receiving shares in the new entity. Is this a merger or an acquisition? Explain your answer.

  1. 1
    1. Identify the nature of the combination: Two companies are combining to form a completely new entity.
  2. 2
    1. Consider the relationship: The shareholders of both original companies are receiving shares in the new company, suggesting a combination of equals rather than a buyout.
  3. 3
    1. Conclusion: This is a merger. It is a mutual decision to combine forces into a new, single entity, which is the defining characteristic of a merger.

Recap

  • A merger is the combination of two companies into a single new entity, usually on equal terms.
  • An acquisition (or takeover) is the purchase of one company by another.
  • Acquisitions can be friendly (agreed by management) or hostile (opposed by management).
  • In a merger, shares of the new company are often exchanged, while an acquisition often involves a cash or share payment to buy the target company outright.

Quick check

  1. What is the primary difference between a merger and an acquisition?2 marks

2. Motivations for Combining Businesses

Businesses combine for strategic reasons, aiming to create more value together than they could apart. This is known as synergy. Key motivations include: gaining efficiency by eliminating duplicate departments (e.g., two HR departments become one) and achieving bulk-buying discounts; acquiring new expertise, technology or talent; accelerating growth by instantly gaining a larger market share or access to new markets; increasing supply-chain power by buying a supplier or distributor to control costs and access; and eliminating a competitor to gain a dominant market position.

Key term

Synergy: The concept that the combined value and performance of two companies will be greater than the sum of their separate individual parts.

Worked example 16 marks

Explain three reasons why a large car manufacturer might acquire a smaller technology company that specialises in self-driving software.

  1. 1
    1. Increased Expertise: The car manufacturer instantly gains access to specialised knowledge and technology in self-driving software, which would be very slow and expensive to develop in-house. This allows them to compete in the rapidly evolving market for autonomous vehicles.
  2. 2
    1. Eliminate Competition / Secure Supply: By acquiring the tech company, the manufacturer prevents its rivals from buying the same technology. It also secures a critical component for its future products, protecting its supply chain.
  3. 3
    1. Growth and Market Position: Integrating advanced self-driving tech can significantly enhance the car manufacturer's brand image and product offering, allowing it to charge premium prices and capture a new segment of the market, leading to growth.

Recap

  • Businesses merge or acquire to achieve synergy, where the whole is greater than the sum of its parts.
  • Key drivers include achieving cost efficiencies and economies of scale.
  • Combining allows for rapid growth and access to new markets or technologies.
  • Acquiring a supplier or distributor can increase control over the supply chain.
  • A primary motive can be to reduce or eliminate competition.

Quick check

  1. State two reasons why a business might merge with or acquire another business.2 marks

3. Understanding and Calculating Goodwill

Goodwill is an intangible asset that represents the value of a business's reputation, customer base, brand recognition, and other non-physical attributes. In accounting, we only recognise 'purchased goodwill'. This arises during an acquisition when the buyer pays more than the fair value of the net identifiable assets of the target company. The 'fair value' is the current market value of the assets and liabilities, not necessarily their value in the seller's books (book value). Any pre-existing or self-generated goodwill in the seller's business is called 'inherent goodwill' and is not recorded in financial statements. The premium paid over the fair value of net assets is what constitutes purchased goodwill.

Fair Value of Net Identifiable Assets = Fair Value of Assets Acquired - Fair Value of Liabilities Assumed

Purchased Goodwill = Purchase Consideration - Fair Value of Net Identifiable Assets

Key term

Purchased Goodwill: An intangible asset arising when a company is acquired for a price greater than the fair market value of its net identifiable assets.

Examiner insight

Examiners look for a clear understanding that only purchased goodwill is recorded in the financial statements, and that it is calculated using the fair value of net assets, not book value.

Common pitfall

Using the book value of the seller's assets instead of their fair value (market value) when calculating the net assets acquired. The calculation must be based on the agreed fair values at the time of acquisition.

Worked example 14 marks

Alpha Ltd paid $960,000 to acquire the business of Beta, a sole trader. At the date of acquisition, Beta's assets and liabilities were valued as follows: Non-current assets $800,000; Current assets $120,000; Current liabilities $70,000; Non-current liability $300,000. Calculate the value of goodwill.

  1. 1
    1. Calculate the Fair Value of Assets Acquired: Non-current assets ($800,000) + Current assets ($120,000) = $920,000.
  2. 2
    1. Calculate the Fair Value of Liabilities Assumed: Current liabilities ($70,000) + Non-current liability ($300,000) = $370,000.
  3. 3
    1. Calculate the Fair Value of Net Identifiable Assets: Fair Value of Assets ($920,000) - Fair Value of Liabilities ($370,000) = $550,000.
  4. 4
    1. Calculate Goodwill: Purchase Consideration ($960,000) - Fair Value of Net Identifiable Assets ($550,000) = $410,000.

Recap

  • Goodwill is an intangible asset representing a business's positive attributes.
  • Only purchased goodwill, arising from an acquisition, is recorded in the accounts.
  • Inherent (self-generated) goodwill is not recorded.
  • Goodwill is calculated as the purchase price minus the fair value of the net identifiable assets.
  • Always use the fair (market) value of assets and liabilities for the calculation, not their book value.

Quick check

  1. A company pays $500,000 for a business with net identifiable assets valued at $410,000. What is the value of goodwill?1 mark
  2. Where is purchased goodwill recorded in the financial statements?1 mark

4. Recording an Acquisition: Journal Entries

To formally record the purchase of a business, the acquirer must make a series of journal entries. These entries transfer the assets and liabilities of the acquired business onto the acquirer's books. The process involves debiting all the individual assets taken over at their fair value, crediting all the individual liabilities assumed at their fair value, and crediting the purchase consideration (the payment made, e.g., Cash, Share Capital). If the total debits (assets) do not equal the total credits (liabilities + purchase price), the balancing figure is Goodwill (a debit) or, in rare cases, a Gain on Bargain Purchase (a credit).

Key term

Purchase Consideration: The total value paid by the acquiring company to the seller, which can be in the form of cash, issuing shares, loan notes, or a combination.

Worked example 16 marks

Polo Ltd purchased the business of Marco, a sole trader, for $200,000 cash. The fair values of the assets and liabilities taken over were: Premises $140,000; Machinery $30,000; Inventory $25,000; Trade Receivables $15,000; Trade Payables $18,000. Prepare the journal entries in Polo Ltd's books to record the acquisition.

  1. 1
    1. First, calculate goodwill to ensure the journal will balance. Net Assets = ($140,000 + $30,000 + $25,000 + $15,000) - $18,000 = $210,000 - $18,000 = $192,000. Goodwill = Purchase Price ($200,000) - Net Assets ($192,000) = $8,000.
  2. 2
    1. Prepare the journal entry. Debit all assets acquired, debit the calculated goodwill, credit liabilities assumed, and credit the payment method.
  3. 3

    Journal Entry:

  4. 4

    Dr Premises $140,000

  5. 5

    Dr Machinery $30,000

  6. 6

    Dr Inventory $25,000

  7. 7

    Dr Trade Receivables $15,000

  8. 8

    Dr Goodwill $8,000

  9. 9

    Cr Trade Payables $18,000

  10. 10

    Cr Cash/Bank $200,000

  11. 11

    *(Being the acquisition of the business of Marco)*

Recap

  • Journal entries are required to record the acquisition of assets and liabilities.
  • Debit the individual assets acquired at their fair value.
  • Credit the individual liabilities assumed at their fair value.
  • Credit the purchase consideration (e.g., Bank, Share Capital).
  • The balancing figure is a debit to Goodwill or a credit to Gain on Bargain Purchase.

Quick check

  1. When recording an acquisition, are assets taken over debited or credited in the acquirer's journal?1 mark

5. Preparing Post-Acquisition Financial Statements

After an acquisition, the acquiring company must prepare a new Statement of Financial Position (SOFP) that reflects the combined entity. This is done by aggregating the assets and liabilities. The acquirer's SOFP is adjusted by: adding the fair values of the assets acquired to its own assets; adding the fair values of the liabilities assumed to its own liabilities; showing the newly calculated purchased goodwill as a non-current asset; and reducing its cash or increasing its share capital/liabilities to reflect the purchase consideration paid. The result is a consolidated SOFP for the new, larger business.

Combined Asset Value = Acquirer's Asset Value + Fair Value of Acquired Asset

Key term

Consolidated Financial Statements: The financial statements of a group in which the assets, liabilities, equity, and results of the parent (acquirer) and its subsidiary (acquired) are presented as those of a single economic entity.

Worked example 110 marks

Bridges Limited purchased Monty's business on 30 June 2020. The purchase price was $260,000 cash. All assets and liabilities were taken over at book value, except for Premises which were valued at $150,000. Monty's cash was not acquired. Prepare the Statement of Financial Position for Bridges Limited immediately after the acquisition. The SOFPs before acquisition were: Bridges Ltd: Premises $510, Plant $133, Equipment $58, Inventory $67, Receivables $33, Cash $69, Payables $0. Total Assets $870, Equity $870. Monty: Premises $140, Plant $57, Equipment $23, Inventory $28, Receivables $14, Cash $7, Payables $18. Total Assets $269, Capital $251.

  1. 1
    1. Calculate Goodwill: Net assets acquired = (Premises $150,000 + Plant $57,000 + Equipment $23,000 + Inventory $28,000 + Receivables $14,000) - Payables $18,000 = $254,000. Goodwill = Purchase Price $260,000 - Net Assets $254,000 = $6,000.
  2. 2
    1. Calculate combined asset and liability values:

    Premises = $510,000 + $150,000 = $660,000 Plant = $133,000 + $57,000 = $190,000 Equipment = $58,000 + $23,000 = $81,000 Goodwill = $6,000 (new) Inventory = $67,000 + $28,000 = $95,000 Receivables = $33,000 + $14,000 = $47,000 Cash = $69,000 - $260,000 (payment) = -$191,000. (Assume an overdraft or loan was used). Let's adjust Bridges initial cash to $300,000 for a positive result. New Cash = $300,000 - $260,000 = $40,000. Let's assume initial Cash was $300k and Equity $1101k for Bridges Ltd to make it work. Let's simplify and just show the calculation. Cash = $69,000 - $260,000 = ($191,000) Bank Overdraft. Payables = $0 + $18,000 = $18,000.

  3. 3
    1. Prepare the new SOFP:

    Bridges Limited: Statement of Financial Position as at 30 June 2020 Non-Current Assets Premises ($510k + $150k) = $660,000 Plant and machinery ($133k + $57k) = $190,000 Office furniture and equipment ($58k + $23k) = $81,000 Goodwill = $6,000 Total Non-Current Assets = $937,000

  4. 4

    Current Assets Inventory ($67k + $28k) = $95,000 Trade receivables ($33k + $14k) = $47,000 Total Current Assets = $142,000 Total Assets = $1,079,000

  5. 5

    Equity and Liabilities Equity (Original $870k - Cash used $260k + Net Assets bought $254k - Goodwill created $6k is complex. Simpler: Original Equity $870k) = $870,000. Let's re-evaluate. Bridges Ltd original Equity is $870k. It pays $260k cash for $254k of net assets. The $6k difference (Goodwill) is an asset. The cash payment reduces assets and equity by $260k. The new assets increase assets by $272k and liabilities by $18k. Net effect on Equity = -$260k cash out + $254k net assets in = -$6k. Let's assume the question implies the purchase is financed by other means, not just cash. Let's stick to the asset side which is clearer. A full SOFP would require knowing the financing. The key is combining assets and showing goodwill.

  6. 6

    A simplified presentation focusing on the assets and liabilities side: Non-Current Liabilities Current Liabilities Trade payables ($0 + $18k) = $18,000 Bank Overdraft (from cash payment) = $191,000 Total Current Liabilities = $209,000 Total Equity and Liabilities = $1,079,000 (balancing figure for Equity would be $870,000)

Recap

  • The post-acquisition SOFP combines the acquirer's figures with the fair value of the acquired assets and liabilities.
  • Purchased goodwill is shown as a new non-current asset.
  • The acquirer's cash balance is reduced by any cash payment made.
  • If shares are issued as payment, the acquirer's share capital and premium accounts will increase.
  • The final SOFP must balance (Total Assets = Total Equity + Total Liabilities).

Quick check

  1. In which section of the Statement of Financial Position does purchased goodwill appear?1 mark

6. Evaluating Mergers and Acquisitions

While mergers and acquisitions offer significant potential benefits, they also come with substantial risks and disadvantages. The advantages are often the strategic motivations themselves: synergy leading to cost savings, increased market power, diversification, and access to new technology or markets. However, the disadvantages can be significant. These include potential culture clashes between the two organizations, leading to poor morale and loss of key staff. The integration process can be complex, expensive, and disruptive to operations. The price paid might be too high (overpaying for goodwill), leading to poor returns for shareholders. Finally, large-scale job losses are common as the combined entity eliminates duplicate roles, causing negative social and economic impacts.

Key term

Hostile Takeover: An acquisition where the target company's management does not want to be acquired, and the acquiring company goes directly to the shareholders or tries to replace management.

Examiner insight

Top marks are awarded for answers that provide balanced arguments, considering the pros and cons from the perspective of different stakeholders like shareholders, employees, and customers.

Common pitfall

Only listing advantages without considering the significant potential downsides and challenges of integrating two different businesses.

Worked example 14 marks

A large, established retail bank acquires a young, innovative financial technology ('fintech') startup. Discuss one major advantage and one major disadvantage of this acquisition from the bank's perspective.

  1. 1
    1. Advantage: The primary advantage is gaining access to innovation and technology. The bank can quickly integrate the fintech's modern platform and digital services, which would have taken years and significant investment to develop internally. This makes the bank more competitive against other modern financial service providers and appeals to younger customers.
  2. 2
    1. Disadvantage: A major disadvantage is the high risk of a culture clash. The bank is likely to be bureaucratic, slow-moving, and risk-averse, while the startup is probably fast-paced, agile, and has a more relaxed culture. Integrating these two different worlds can lead to frustration, the departure of the fintech's key creative talent, and ultimately a failure to realize the expected synergies.

Recap

  • Advantages include synergy, economies of scale, increased market share, and acquiring new expertise.
  • Disadvantages include the high cost of the acquisition and difficulties with integration.
  • A clash of corporate cultures can lead to low morale and the loss of valuable employees.
  • Mergers and acquisitions often lead to redundancies as duplicate roles are removed.
  • The expected benefits (synergies) may not materialize, leading to a poor return on investment.

Quick check

  1. State one potential disadvantage of a business merger for the employees.1 mark

End-of-chapter exercise

Test yourself on the whole chapter. Work through these before moving on.

  1. Explain the difference between a merger and an acquisition, providing an example for one.3 marks
  2. List and briefly explain three strategic reasons why a business might acquire a competitor.6 marks
  3. A business is being acquired. Its assets and liabilities are: Non-current assets (Fair Value) $145,000; Current assets (Fair Value) $49,000; Current liabilities $18,000. If goodwill is valued at $40,000, what is the total purchase consideration that should be paid?4 marks
  4. X Ltd acquires Y Ltd for a cash price of $750,000. The fair value of Y Ltd's net identifiable assets is $620,000. Calculate the goodwill arising from this acquisition.2 marks
  5. Explain the difference between purchased goodwill and inherent goodwill, and state how each is treated in the financial statements according to accounting standards.4 marks
  6. Mega Corp acquired the business of a sole trader, Stan, for a purchase consideration of $400,000 paid in cash. At the date of acquisition, the fair values of Stan's assets and liabilities were: Non-current assets $310,000; Inventory $50,000; Trade receivables $45,000; Trade payables $25,000. Prepare the journal entries in Mega Corp's books to record the acquisition.6 marks
  7. Discuss two advantages and two disadvantages for employees when their small, family-run company is acquired by a large multinational corporation.8 marks
  8. According to IAS 38 Intangible Assets, how should purchased goodwill be treated in the years following its initial recognition? Should it be amortised?3 marks
  9. Giant Ltd is acquiring the entire business of Small Ltd. The purchase price is agreed at $1.5 million. Small Ltd's Statement of Financial Position shows net assets of $1.1 million at book value. However, a revaluation exercise concludes that Small Ltd's non-current assets are worth $200,000 more than their book value. (a) Calculate the value of purchased goodwill. (b) Explain one reason why Giant Ltd might be willing to pay this amount of goodwill.5 marks
  10. Tully Limited purchased the partnership of Ed and Mia for $300,000. The assets and liabilities of the partnership were taken over at their book values as follows: Land and buildings $170,000; Fixtures and fittings $21,000; Office machinery $35,000; Inventory $41,000; Trade receivables $29,000; Trade payables $34,000. Tully Limited's own assets and liabilities before the acquisition were: Land and buildings $420,000; Cash $350,000; Share Capital $770,000. Prepare the non-current asset section of Tully Limited's Statement of Financial Position immediately after the acquisition.7 marks

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