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1
Introduction to Business Combinations and the Conceptual Framework

Advanced Accounting, Fourth Edition

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Learning Objectives
1. Describe historical trends in types of business combinations. 2. Identify the major reasons firms combine. 3. Identify the factors that managers should consider in exercising due diligence in business combinations. 4. Identify defensive tactics used to attempt to block business combinations. 5. Distinguish between an asset and a stock acquisition. 6. Indicate the factors used to determine the price and the method of payment for a business combination. 7. Calculate an estimate of the value of goodwill to be included in an offering price by discounting expected future excess earnings over some period of years. 8. Describe the two alternative views of consolidated financial statements: the economic entity and the parent company concepts. 9. List and discuss each of the seven Statements of Financial Accounting Concepts (SFAC). 10. Describe some of the current joint projects of the FASB and the International Accounting Standards Board (IASB), and their primary objectives.
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Introduction
On December 4, 2007, FASB released two new standards,

FASB Statement No. 141 R, Business Combinations, and

FASB Statement No. 160, Noncontrolling Interests in Consolidated Financial Statements.

These standards
Became effective for years beginning after December 15, 2008, and Are intended to improve the relevance, comparability and transparency of financial information related to business combinations, and to facilitate the convergence with international standards.

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Nature of the Combination

Business Combination - operations of two or more companies are brought under common control. A business combination may be:
Friendly - the boards of directors of the potential combining companies negotiate mutually agreeable terms of a proposed combination. Unfriendly (hostile) - the board of directors of a company targeted for acquisition resists the combination.

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Nature of the Combination

Defense Tactics
1. Poison pill: Issuing stock rights to existing
shareholders.

2. Greenmail: Purchasing shares held by acquiring

company at a price substantially in excess of fair value.

3. White knight: Encouraging a third firm to acquire or

merge with the target company.

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Nature of the Combination

Defense Tactics
4. Pac-man defense: Attempting an unfriendly takeover
of the would-be acquiring company.

5. Selling the crown jewels: Selling of valuable assets

to make the firm less attractive to the would-be acquirer.

6. Leveraged buyouts: Purchasing a controlling interest

in the target firm by its managers and third-party investors, who usually incur substantial debt.
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Nature of the Combination

Review Question
The defense tactic that involves purchasing shares held by the would-be acquiring company at a price substantially in excess of their fair value is called a. poison pill.
b. pac-man defense. c. greenmail. d. white knight.

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Business Combinations: Why? Why Not?

Advantages of External Expansion
1. Rapid expansion
2. Operating synergies 3. International marketplace 4. Financial synergy 5. Diversification 6. Divestitures

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LO 2 Reasons firms combine.

Business Combinations: Historical Perspective

Three distinct periods
1880 through 1904, huge holding companies, or trusts, were
created to establish monopoly control over certain industries (horizontal integration). 1905 through 1930, to bolster the war effort, the government encouraged business combinations to obtain greater standardization of materials and parts and to discourage price competition (vertical integration).

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LO 1 Describe historical trends in types of business combinations.

Business Combinations: Historical Perspective

Three distinct periods
1945 to the present, many of the mergers that occurred
from the 1950s through the 1970s were conglomerate mergers. In contrast, the 1980s were characterized by a relaxation in antitrust enforcement and by the emergence of high-yield junk bonds to finance acquisitions. Deregulation undoubtedly played a role in the popularity of combinations in the 1990s.

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LO 1 Describe historical trends in types of business combinations.

Terminology and Types of Combinations

What Is Acquired?
Net assets of S Company (Assets and Liabilities)

What Is Given Up?

1. Cash
2. Debt 3. Stock
Figure 1-1

Common Stock of S Company

4. Combination of above

Asset acquisition, a firm must acquire 100% of the assets of the other firm. Stock acquisition, control may be obtained by purchasing 50% or more of the voting common stock (or possibly less).
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LO 5 Distinguish between an asset and a stock acquisition.

Terminology and Types of Combinations

Possible Advantages of Stock Acquisition
Lower total cost. Direct formal negotiations may be avoided.

Maintaining the acquired firm as a separate legal

entity. Liability limited to the assets of the individual

corporation.
Greater flexibility in filing individual or consolidated tax returns.
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LO 5 Distinguish between an asset and a stock acquisition.

Terminology and Types of Combinations

Classification by Method of Acquisition

Statutory Merger
A Company + B Company = A Company

One company acquires all the net assets of another company. The acquiring company survives, whereas the acquired company ceases to exist as a separate legal entity.

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LO 5 Distinguish between an asset and a stock acquisition.

Terminology and Types of Combinations

Classification by Method of Acquisition

Statutory Consolidation
A Company + B Company = C Company

A new corporation is formed to acquire two or more other corporations through an exchange of voting stock; the acquired corporations then cease to exist as separate legal entities. Stockholders of A and B become stockholders in C.
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LO 5 Distinguish between an asset and a stock acquisition.

Terminology and Types of Combinations

Classification by Method of Acquisition

Consolidated Financial Statements

Financial Statements of A Company

Financial Statements of B Company

Consolidated Financial Statements of A Company and B Company

When a company acquires a controlling interest in the voting stock of another company, a parentsubsidiary relationship results.
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LO 5 Distinguish between an asset and a stock acquisition.

Terminology and Types of Combinations

Review Question
When a new corporation is formed to acquire two or more other corporations and the acquired corporations cease to exist as separate legal entities, the result is a statutory a. acquisition.
b. combination. c. consolidation. d. merger

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LO 5 Distinguish between an asset and a stock acquisition.

Takeover Premiums
Takeover Premium the excess amount agreed upon in an acquisition over the prior stock price of the acquired firm. Possible reasons for the premiums:
Acquirers stock prices may be at a level which makes it attractive to issue stock in the acquisition. Credit may be generous for mergers and acquisitions. Bidders may believe target firm is worth more than its current market value.

Acquirer may believe growth by acquisitions is essential and competition necessitates a premium.

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LO 5 Distinguish between an asset and a stock acquisition.

Avoiding the Pitfalls Before the Deal

The factors to beware of include the following:
Be cautious in interpreting any percentages.
Do not neglect to include assumed liabilities in the assessment of the cost of the merger. Watch out for the impact on earnings of the allocation of expenses and the effects of production increases, standard cost variances, LIFO liquidations, and byproduct sales. Note any nonrecurring items that may boost earnings. Be careful of CEO egos.

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LO 3 Factors to be considered in due diligence.

Avoiding the Pitfalls Before the Deal

Review Question
When an acquiring company exercises due diligence in attempting a business combination, it should:
a. be skeptical about accepting the target companys stated percentages

b. analyze the target company for assumed liabilities as well as assets

c. look for nonrecurring items such as changes in estimates d. all the above

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LO 3 Factors to be considered in due diligence.

Determining Price and Method of Payment in Business Combinations

When a business combination is effected by a stock swap, or exchange of securities, both price and method of payment problems arise.
The price is expressed as a stock exchange ratio. Each constituent makes two kinds of contributions to the new entitynet assets and future earnings.

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LO 6 Factors affecting price and method of payment.

Determining Price and Method of Payment in Business Combinations

Net Asset and Future Earnings Contributions
Determination of an equitable price for each
constituent company requires:
The valuation of each companys net assets.

Each companys expected contribution to the future

earnings of the new entity.

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LO 6 Factors affecting price and method of payment.

Determining Price and Method of Payment

Excess Earnings Approach to Estimate Goodwill
1. Identify a normal rate of return on assets for firms similar to the company being targeted.

2. Apply the rate of return (step 1) to the net assets of the target to approximate normal earnings. 3. Estimate the expected future earnings of the target. Exclude any nonrecurring gains or losses. 4. Subtract the normal earnings (step 2) from the expected target earnings (step 3). The difference is excess earnings.
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LO 6 Factors affecting price and method of payment.

Determining Price and Method of Payment

Excess Earnings Approach to Estimate Goodwill
5. Compute estimated goodwill from excess earnings.
If the excess earnings are expected to last indefinitely, the present value may be calculated by dividing the excess earnings by the discount rate. For finite time periods, compute the present value of an annuity.

6. Add the estimated goodwill (step 5) to the fair value of the firms net identifiable assets to arrive at a possible offering price.
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LO 6 Factors affecting price and method of payment.

Determining Price and Method of Payment

Review Question
A potential offering price for a company is computed by adding the estimated goodwill to the a. book value of the companys net assets.

b. book value of the companys identifiable assets.

c. fair value of the companys net assets. d. fair value of the companys identifiable net assets.

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LO 6 Factors affecting price and method of payment.

Determining Price and Method of Payment

Exercise 1-1: Plantation Homes Company is considering the acquisition of Condominiums, Inc. early in 2008. To assess the amount it might be willing to pay, Plantation Homes makes the following computations and assumptions. A. Condominiums, Inc. has identifiable assets with a total fair value of $15,000,000 and liabilities of $8,800,000. The assets include office equipment with a fair value approximating book value, buildings with a fair value 30% higher than book value, and land with a fair value 75% higher than book value. The remaining lives of the assets are deemed to be approximately equal to those used by Condominiums, Inc.
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LO 7 Estimating goodwill.

Determining Price and Method of Payment

Exercise 1-1: (continued)
B. Condominiums, Inc.s pretax incomes for the years 2005 through 2007 were $1,200,000, $1,500,000, and $950,000, respectively. Plantation Homes believes that an average of these earnings represents a fair estimate of annual earnings for the indefinite future. The following are included in pretax earnings:

Depreciation on buildings (each year) Depreciation on equipment (each year) Extraordinary loss (year 2007) Sales commissions (each year)
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960,000 50,000 300,000 250,000

LO 7 Estimating goodwill.

C. The normal rate of return on net assets is 15%.

Determining Price and Method of Payment

Exercise 1-1: (continued)
Required: A. Assume further that Plantation Homes feels that it must earn a 25% return on its investment and that goodwill is determined by capitalizing excess earnings. Based on these assumptions, calculate a reasonable offering price for Condominiums, Inc. Indicate how much of the price consists

of goodwill. Ignore tax effects.

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LO 7 Estimating goodwill.

Determining Price and Method of Payment

Exercise 1-1: (Part A)

Excess Earnings Approach

Step 1 Identify a normal rate of return on assets for firms similar to the company being targeted.

15%

Step 2 Apply the rate of return (step 1) to the net assets of the target to approximate normal earnings. Fair value of assets Fair value of liabilities Fair value of net assets Normal rate of return Normal earnings
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$15,000,000 8,800,000 6,200,000 15% $ 930,000

LO 7 Estimating goodwill.

Determining Price and Method of Payment

Step 3 Estimate the expected future earnings of the target. Exclude any nonrecurring gains or losses.
Pretax income of Condominiums, Inc., 2005 Subtract: Additional depreciation on building ($960,000 x 30%) Targets adjusted earnings, 2005 Pretax income of Condominiums, Inc., 2006 Subtract: Additional depreciation on building Targets adjusted earnings, 2006 Pretax income of Condominiums, Inc., 2007 Add: Extraordinary loss Subtract: Additional depreciation on building Targets adjusted earnings, 2007 Targets three year total adjusted earnings Targets three year average adjusted earnings ($3,086,000 / 3)
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$ 1,200,000 (288,000) $ 1,500,000 (288,000) 1,212,000 950,000 300,000 (288,000) 962,000 3,086,000 $ 1,028,667 912,000

LO 7 Estimating goodwill.

Determining Price and Method of Payment

Step 4 Subtract the normal earnings (step 2) from the expected target earnings (step 3). The difference is excess earnings. Expected target earnings Less: Normal earnings Excess earnings, per year $1,028,667 930,000 $ 98,667

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LO 7 Estimating goodwill.

Determining Price and Method of Payment

Step 5 Compute estimated goodwill from excess earnings. Present value of excess earnings (perpetuity) at 25%: Excess earnings $ 98,667 25% = $394,668 Estimated Goodwill

Step 6 Add the estimated goodwill (step 5) to the fair value of the firms net identifiable assets to arrive at a possible offering price.

Net assets
Estimated goodwill Implied offering price
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$6,200,000
394,668 $6,594,668
LO 7 Estimating goodwill.

Determining Price and Method of Payment

Exercise 1-1 (continued)
Required: B. Assume that Plantation Homes feels that it must earn a 15% return on its investment, but that average excess earnings are to be capitalized for three years only. Based on these assumptions, calculate a reasonable offering price for Condominiums, Inc. Indicate how much of the price consists of goodwill. Ignore tax effects.

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LO 7 Estimating goodwill.

Determining Price and Method of Payment

Part B Excess earnings of target (same a Part A) PV factor (ordinary annuity, 3 years, 15%) Estimated goodwill $ x $ 98,667 2.28323 225,279

Fair value of net assets

Implied offering price

6,200,000
$ 6,425,279

The types of securities to be issued by the new entity in exchange for those of the combining companies must be determined. Ultimately, the exchange ratio is determined by the bargaining ability of the individual parties to the combination.
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LO 7 Estimating goodwill.

Alternative Concepts of Consolidated Financial Statements

Parent Company Concept - primary purpose of consolidated financial statements is to provide information relevant to the controlling stockholders.
The noncontrolling interest presented as a liability or as a separate component before stockholders equity.

Economic Entity Concept - affiliated companies are a separate, identifiable economic entity.
The noncontrolling interest presented as a component of stockholders equity.
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LO 8 Economic entity and parent company concepts.

Alternative Concepts
Consolidated Net Income
Parent Company Concept, consolidated net income consists of the combined income of the parent company and its subsidiaries after deducting the noncontrolling interest in income as an expense in determining consolidated net income. Economic Entity Concept, consolidated net income consists of the total combined income of the parent company and its subsidiaries. Total combined income is then allocated proportionately to the noncontrolling interest and the controlling interest.
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LO 8 Economic entity and parent company concepts.

Alternative Concepts
Consolidated Balance Sheet Values
Parent Company Concept, the net assets of the subsidiary are included in the consolidated financial statements at their book value plus the parent companys share of the difference between fair value and book value on the date of acquisition. Economic Entity Concept, on the date of acquisition, the net assets of the subsidiary are included in the consolidated financial statements at their book value plus the entire difference between their fair value and their book value.
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LO 8 Economic entity and parent company concepts.

Alternative Concepts

Review Question
According to the economic unit concept, the primary purpose of consolidated financial statements is to provide information that is relevant to a. majority stockholders. b. minority stockholders. c. creditors.

d. both majority and minority stockholders.

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LO 8 Economic entity and parent company concepts.

Alternative Concepts
Intercompany Profit
Two alternative points of view: 1. Total (100%) elimination 2. Partial elimination
Under total elimination, the entire amount of unconfirmed intercompany profit is eliminated from combined income and the related asset balance. Under partial elimination, only the parent companys share of the unconfirmed intercompany profit is eliminated.
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LO 8 Economic entity and parent company concepts.

Conceptual
Figure 1-2 Conceptual Framework for Financial Accounting and Reporting

SFAC Nos. 1 & 2 Objectives: Provide Information: 1. Usefulness in investment and credit decisions 2. Usefulness in future cash flows 3. About enterprise resources, claims to resources, and changes

Framework
Objectives

SFAC No. 2 Qualitative Characteristics 1. Relevance 2. Reliability 3. Comparability 4. Consistency Also:Usefulness,Understandability

SFAC No. 6 (replaced SFAC No. 3) Elements of Financial Statements Provides definitions of key components of financial statements

Fundamental

SFAC No. 5 & 7 Recognition and Measurement

PRINCIPLES

Operational

1. Historical cost Assumptions Principles Constraints 1. Economic entity 1. Historical cost 1. Cost-benefit 2. Revenue recognition 2. Going concern 2. Revenue recognition 2. Materiality 3. Matching 3. Monetary unit 3. Matching 3. Industry practice 4. Full disclosure 4. Periodicity 4. Full disclosure 4. Conservatism SFAC No. 7: Using future cash flows & present values in accounting measures
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LO 8 Economic entity and parent company concepts.

FASBs Conceptual Framework

Economic Entity vs. Parent Concept and the Conceptual Framework
The parent concept is tied to the historical cost principle, which would suggest that the net assets related to the noncontrolling interest remain at their previous book values. This approach might be argued to produce more reliable values (SFAC No. 2).

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LO 8 Economic entity and parent company concepts.

FASBs Conceptual Framework

Economic Entity vs. Parent Concept and the Conceptual Framework
The economic entity assumption views a parent and its subsidiaries as one economic entity even though they are separate legal entities. The economic entity concept is an integral part of the FASBs conceptual framework and is named specifically in SFAC No. 5 as one of the basic assumptions in accounting.

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LO 8 Economic entity and parent company concepts.

FASBs Conceptual Framework

Overview of FASBs Conceptual Framework
The Statements of Financial Accounting Concepts issued by the FASB include:
SFAC No.1 - Objectives of Financial Reporting

SFAC No.2 - Qualitative Characteristics of Accounting Information

SFAC No.3 - Elements of Financial Statements (superceded by SFAC No. 6) SFAC No.4 - Nonbusiness Organizations SFAC No.5 - Recognition and Measurement in Financial Statements SFAC No.6 - Elements of Financial Statements (replaces SFAC No. 3) SFAC No.7 - Using Cash Flow Information and Present Value in Accounting Measurements
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LO 9 Statements of Financial Accounting Concepts.

FASBs Conceptual Framework

Distinguishing Between Earnings and Comprehensive Income
Earnings is essentially revenues and gains minus expenses and losses, with the exception of any losses or gains that bypass earnings and, instead, are reported as a component of other comprehensive income.

SFAC No. 5 describes them as principally certain

holding gains or losses that are recognized in the period but are excluded from earnings such as some changes in market values of investments... and foreign currency translation adjustments.
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LO 9 Statements of Financial Accounting Concepts.

FASBs Conceptual Framework

Asset Impairment and the Conceptual Framework
SFAC No. 5 provides guidance with respect to expenses
and losses:
Consumption of benefit. Earnings are generally recognized when
an entitys economic benefits are consumed in revenue earnings activities (Example: amortization of limited-life intangibles); or

Loss or lack of benefit. Expenses or losses are recognized if it

becomes evident that previously recognized future economic benefits of assets have been reduced or eliminated, or that liabilities have increased, without associated benefits (Example: review for impairment for indefinite-life intangibles).
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LO 9 Statements of Financial Accounting Concepts.

Appendix: FASB Codification Project

On July 1, 2009, the FASB launched the FASB Accounting Standards Codification.
Single source of authoritative nongovernmental U.S. generally accepted accounting principles (GAAP).

Codification is effective for interim and annual periods ending after September 15, 2009.
All existing accounting standards documents are integrated into the new codification, as described in FASB Statement No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles.

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LO 10 Describe some of the current joint projects of the FASB and the International Accounting Standards Board (IASB), and their primary objectives.

Appendix: FASB Codification Project

Structure of the Codification
Roughly 90 accounting topics Contains four groupings of numbers.
1) the topic, 2) the subtopic, 3) the section, and 4) the paragraph The code 450-20-25-2 refers to topic 450 (which is contingencies); subtopic 20 (which is loss contingencies); section 25 (which is recognition); and 2 (refers to the second paragraph).
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LO 10 Describe some of the current joint projects of the FASB and the International Accounting Standards Board (IASB), and their primary objectives.

Appendix: FASB Codification Project

a. Financial Accounting Standards Board (FASB) 1. Statements (FAS) 2. Interpretations (FIN) 3. Technical Bulletins (FTB) 4. Staff Positions (FSP) 5. Staff Implementation Guides (Q&A) 6. Statement No. 138 Examples b. Emerging Issues Task Force (EITF) 1. Abstracts 2. Topic D c. Derivative Implementation Group (DIG) Issues d. Accounting Principles Board (APB) Opinions e. Accounting Research Bulletins (ARB) f. Accounting Interpretations (AIN) g. American Institute of Certified Public Accountants (AICPA) 1. Statements of Position (SOP) 2. Audit and Accounting Guides (AAG)only incremental accounting guidance 3. Practice Bulletins (PB), including the Notices to Practitioners elevated to Practice Bulletin status by Practice Bulletin 1 4. Technical Inquiry Service (TIS)only for Software Revenue Recognition
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Literature included in the Codification

LO 10 Describe some of the current joint projects of the FASB and the International Accounting Standards Board (IASB), and their primary objectives.

Appendix: FASB Codification Project

Additional SEC literature included in the Codification for reference
(a) Regulation S-X (SX) (b) Financial Reporting Releases (FRR)/Accounting Series Releases (ASR) (c) Interpretive Releases (IR) (d) SEC Staff guidance in 1. Staff Accounting Bulletins (SAB) 2. EITF Topic D and SEC Staff Observer comments.

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LO 10 Describe some of the current joint projects of the FASB and the International Accounting Standards Board (IASB), and their primary objectives.

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