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1-1

11
Introduction to Business
Combinations and the
Conceptual Framework

Advanced Accounting, Fourth Edition

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1-2

Learning
Learning Objectives
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
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1-3

acquisition.

between an asset and a stock

Learning
Learning Objectives
Objectives
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).

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Introduction
Introduction

In 2003, the IASB initiated a project on reporting

consolidated financial statement.

These statements present an entitys assets, liabilities,

equity, revenues, and expenses with those of other
entities it controls as if they were a single economic
entity.

The projects objective is to publish a single (IFRS) on

the topic of consolidation.

The project is intended to : (1) revise the definition of

control in an effort to apply the same criteria to all
entities with a focus on (but not limited to) the
consolidation of structured entities, and (2) to enhance
the disclosure about consolidated and non-consolidated
entities.

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Introduction
Introduction
The IASB proposed the following definition of
control of an entity:
A reporting entity controls another entity when
the reporting entity has the power to direct the
activities of that other entity to generate returns
for the reporting entity

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Introduction
Introduction
On December 4, 2007, FASB released two new
standards,

FASB Statement No. 141 R, Business Combinations, and

FASB Statement No. 160, Non-controlling Interests in

Consolidated Financial Statements.

These two standards have altered the accounting for

business combination dramatically.

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1-7

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.

Introduction
Introduction
The new standard (141R) re-defines a business
combination
combination as a transaction or other event in
which an acquiring entity obtains control of one
or more businesses.

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Nature
Nature of
of the
the Combination
Combination
Business Combination occurs when the 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
Nature of
of the
the Combination
Combination
- In case, unfriendly position, a formal tender
offer enables the acquiring firm to deal with
individual shareholders.
-The

tender offer, usually published in a

newspaper, typically provides a price higher than
the current market price for shares made available
by certain date.
-If

a sufficient number of shares are not made

available, the acquiring company may reserve the
right to withdraw the offer.
Notes:- most tender offer are friendly ones.
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- a set of tactics have emerged to resist

takeover.

Nature
Nature of
of the
the Combination
Combination
Defense Tactics
Resistance often involves various moves by the
target firm as the following:
1.Poison pill: Issuing stock rights to existing

shareholders (only exercisable in the event of a takeover).

2.Greenmail: Purchasing any shares held by acquiring

company at a price substantially in excess of fair value.

3.White knight/White squire: Encouraging a third firm

more acceptable to the target firm to acquire or merge
with the target company.
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Nature
Nature of
of the
the Combination
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
Nature of
of the
the Combination
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
Business Combinations:
Combinations: Why?
Why? Why
Why Not?
Not?
A company may expand in two ways:
1.Internal expansion
By engaging in product development

1.External expansion
By acquiring one or more other firms.

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LO 2 Reasons firms combine.

Business
Business Combinations:
Combinations: Why?
Why? Why
Why Not?
Not?
Advantages of External Expansion
1. Rapid expansion
2. Operating synergies ()
- Combinations with an existing company provides the
acquirer with an establishing operating unit, regular
supplier, productive facilities and distribution channels.
- The combination may be Vertical (a merger between a
supplier and a customer) or Horizontal (a merger between
competitors).

3. International marketplace
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Combination may enable a company to compete more

effectively in the marketplace.

LO 2 Reasons firms combine.

Business
Business Combinations:
Combinations: Why?
Why? Why
Why Not?
Not?
Advantages of External Expansion
4.Financial synergy \
Business combinations are sometimes entered to benefit
from the tax laws in different countries. Because tax
laws vary from year to year and from country to country.

5.Diversification \
To achieve more protection from the competitors.

6.Divestitures
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Shedding divisions that are not part of a companys core

business.
LO 2 Reasons firms combine.

Business
Business Combinations:
Combinations: Historical
Historical Perspective
Perspective
Three distinct periods
In the United States there have been three distinct periods
characterized by many business mergers, consolidations and
other forms of combinations:
1.1880 through 1904, huge holding companies, or trusts,
were created to establish monopoly control over certain
industries (horizontal integration).
2.1905 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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Business
Business Combinations:
Combinations: Historical
Historical Perspective
Perspective
Three distinct periods
3. 1945 to the present, many of the mergers that occurred
from the 1950s through the 1970s were conglomerate
mergers (to diversify business risk)
In contrast, the 1980s were characterized by a
relaxation in antitrust enforcement and by the
emergence of high-yield junk bonds to finance
acquisitions.

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LO 1 Describe historical trends in types of business combinations.

Terminology
Terminology and
and Types
Types of
of Combinations
Combinations
An
An asset
asset and
and aa stock
stock acquisition
acquisition
What Is Acquired?
Net assets of S Company
(Assets and Liabilities)
Common Stock
of S Company

What Is Given Up?

1. Cash
2. Debt

Figure 1-1

3. Stock
4. Combination of
above

Asset acquisition, a firm must acquire 100% of the net 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
Terminology and
and Types
Types of
of Combinations
Combinations
Notes:
-In

case of an asset acquisition:

the books of the acquired company are closed

out.

and its assets and liabilities are transferred

to the books of acquirer.

-In

case of a stock acquisition:

The

books of the acquired company remain

intact and consolidated financial statements are
prepared periodically in this case.
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LO 5 Distinguish between an asset and a stock acquisition.

Terminology
Terminology and
and Types
Types of
of Combinations
Combinations

Advantages of Stock Acquisition

Lower total cost.
Direct formal negotiations may be avoided.
Maintaining the acquired firm as a separate
legal entity.
limited Liability to the assets of the
individual corporation and greater flexibility
in filing individual or consolidated tax
returns.
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LO 5 Distinguish between an asset and a stock acquisition.

Business combination are sometimes

classified by method of combination
into three types:

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1-22

Statutory merger

Statutory consolidation

Stock acquisition

LO 5 Distinguish between an asset and a stock 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.

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 two 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.

Stock acquisition: a stock acquisition occurs when one

company pays cash or issues debt for all or part of the
voting stock of another company and the acquired
company remains intact as a separate legal entity.

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
Terminology and
and Types
Types of
of Combinations
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
Takeover Premiums
Premiums
Takeover Premium the excess of the amount offered or
agreed upon in an acquisition over the prior stock price
of the acquired firm.
Possible reasons for the premiums:
Stock prices of acquirer 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.

reasons for the premiums:

Possible

.




.
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Avoiding
Avoiding the
the Pitfalls
Pitfalls Before
Before the
the Deal
Deal
The factors to beware of include the following:
1.

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Be cautious in interpreting any percentages

presented by the selling company. (say. At 60%
of capacity, while the company is already at
That are on the
books of the
100% capacity).
acquired
company

2.

Do not neglect to include assumed liabilities in

the assessment of the cost of the merger.

3.

Be aware of possibility of less obvious liabilities.

LO 3 Factors to be considered in due diligence.

Avoiding
Avoiding the
the Pitfalls
Pitfalls Before
Before the
the Deal
Deal

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4.

Accounting Standards require an acquiring firm

to recognize at fair value all assets acquired
and liabilities assumed.

5.

Note any nonrecurring items that may boost

earnings. looking at recent changes in estimates,
accruals levels and methods.

.
LO 3 Factors to be considered in due diligence.

Avoiding
Avoiding the
the Pitfalls
Pitfalls Before
Before the
the Deal
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
Determining Price
Price and
and Method
Method of
of Payment
Payment
in
in Business
Business Combinations
Combinations
-When a business combination is effected through
open-market acquisition of stock, no problems arise
related to determine price or method of payment (the
price is determined by the normal functioning of the stock market,
and payment is generally in cash).

-When it is effected by a stock swap, or exchange of securities,

both price and method of payment problems arise.

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The number of shares of

the acquiring company to
be exchange for each
share of the acquired
company

The price is expressed as a stock exchange ratio.

It is important to understand that each combination makes two kinds of

contributions to the new entitynet assets and future earnings.

LO 6 Factors affecting price and method of payment.

Determining
Determining Price
Price and
and Method
Method of
of Payment
Payment
in
in Business
Business Combinations
Combinations
To determine an equitable price for each company and of the
resulting exchange ratio requires:
Evaluate net assets of each company (that is by assessing
for example: the expected collectability of accounts
receivable, current replacement cost for inventories and
some fixed assets such as goodwill and the current value of
long term liabilities).
Evaluate expected contribution of each company to the
future earnings of the new entity.

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LO 6 Factors affecting price and method of payment.

Determining
Determining Price
Price and
and Method
Method of
of Payment
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
Determining Price
Price and
and Method
Method of
of Payment
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 assets to arrive at a possible
offering price.
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LO 6 Factors affecting price and method of payment.

Determining
Determining Price
Price and
and Method
Method of
of Payment
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.

Excess Earnings Approach

Exercise: W company is considering acquiring H

company and is wondering how much it should offer.
W company makes the following computations and
assumptions to help in the decision.

A.

H companys identifiable assets have a total fair

value of $7,000,000. H company has liabilities
totalling $ 3,200,000. The assets include patents
and copyrights with a fair value approximating book
value, building with a fair value 50% higher than
book value and equipment with a fair value 25%
lower than the book value. The remaining lives of
the assets are deemed to approximately equal to
those used by H company.

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B.H

companys pretax income for the year 2006 was $

1,059,000,
which is believed by W company to be more
indicative of future expectations than any of the preceding
years. The net income of $ 1,059,000 included the following
items, among others:
Amortization of patents & copyright
$50000
Depreciation on buildings
$360000
Depreciation on equipment
$ 80000
Extraordinary gain
$ 250000
Loss from discounted operations
$ 175000
Pension expense
$59000
C.The normal rate of return on net assets for industry is 14%.
D.W company believes that any excess earning will continue for
seven years (ordinary annuity) and that a rate of return of
15% is required on the investment.
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Required: calculate a reasonable offering price

for H company. Ignore tax effects.

Solution on page 24.

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Determining
Determining Price
Price and
and Method
Method of
of Payment
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.

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) 960,000
Depreciation on equipment (each year) 50,000
Extraordinary loss (year 2007)
300,000
Sales commissions (each year)
250,000
C. The normal rate of return on net assets is 15%.
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LO 7 Estimating goodwill.

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.
Ignore tax effects.
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LO 7 Estimating goodwill.

Determining
Determining Price
Price and
and Method
Method of
of Payment
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
$15,000,000
Fair value of liabilities

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8,800,000
Fair value of net assets

LO 7 Estimating goodwill.

Step 3 Estimate the expected future earnings of the target.

(Exclude any nonrecurring gains or losses).

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LO 7 Estimating goodwill.

Step 4 Subtract the normal earnings (step 2) from the

expected target earnings (step 3). The difference is excess
earnings.
Expected target earnings
$1,028,667
Less: Normal earnings
930,000
Excess earnings, per year
$ 98,667
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LO 7 Estimating goodwill.

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
$6,200,000
Estimated goodwill
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LO 7 Estimating goodwill.

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.

Part B
Excess earnings of target (same a Part A)
PV factor (ordinary annuity, 3 years, 15%)
Estimated goodwill
Fair value of net assets
Implied offering price

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$
x
$

98,667
2.28323
225,279
6,200,000

$ 6,425,279

LO 7 Estimating goodwill.

Alternative
Alternative Concepts
Concepts of
of Consolidated
Consolidated
Financial
Financial Statements
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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Non-controlling Interest
Under the economic entity concept, a noncontrolling
interest is part of the ownership equity. Thus it has the
same general nature and is accounted in the same way as
the controlling interest (i.e., component of owners
equity).
Under the parent company concept, the nature and
classification are unclear, the consolidated financial
statement are viewed as those of the parent company,
therefor, the noncontrolling interest is similar to a
liability. Consequently, the parent company concept
supports reporting the noncontrolling interest below
liabilities.
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The economic entity concept

Liabilities and stockholders
Accounts payable

$ 91000

Liabilities

$ 115000

Total liabilities

$ 206000

owners equity:
Non-controlling interest

$ 500000

Controlling interest

$ 1000000

Total Stockholders equity

1500000

The parent company concept

Liabilities and stockholders

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1-51

Accounts payable

$ 91000

Noncontrolling interest

$ 500000

Total liabilities

$ 591000

Stockholders equity

$1000000

Controlling interest

Consolidated Net Income

Under 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, that is, the noncontrolling interest in
income is deducted as an expense in determining
consolidated net income. (because parent company
stockholders are interested only in the results of their
share in income).

Under Economic Entity Concept, consolidated net income

consists of the total combined income of the parent
company and its subsidiaries.
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Consolidated Balance Sheet Values

Example: Suppose P company acquired 60% interest in S company for
960000$, while the book value of the net assets was 1000000$.
The implied fair value of net assets of S company will be
(960000/60%) = 1600000$.
Thus the difference between the fair value and the book value is
(1600000-1000000) = 600000, for the presentation in the
consolidated financial statements, should the net assets of S company
be presented by 600000$ or by 60% of 600000$?
Parent Company Concept, the net assets of the subsidiary are
included in the consolidated financial statements at their book value
plus the parent companys share of the difference between fair value
and book value (the book value + companys share of the difference
between fair value and book value)
Net assets = 1000000 + 600000*60% = 1360000$
Noncontrolling interest of S company 1000000 *40% = 400000$
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Economic Entity Concept: The book value of the net

assets at (1000000$), plus the entire difference
between their fair value and their book value
(600000$).
Then, the net assets that must be reported in the
consolidated financial statements is 1600000$.
Noncontrolling interest is reported as its percentage
in the fair value of the net assets of S company
(0.40*1600000) = 640000$.

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Alternative
Alternative Concepts
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.

Conceptual
Conceptual
Figure 1-2
Conceptual
Framework for
Financial
Accounting and
Reporting by
(FASB)

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

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

Framework
Framework

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

SFAC No. 5 & 7

PRINCIPLES
Recognition
and Measurement

Objectives

Fundamental

Operational

1. Historical
Assumptions
Principlescost
Constraints
1. Economic entity 2. 1.
Historical
cost
1. Cost-benefit
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.

Copyright
Copyright
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