Chapter

1-1

11
Introduction to Business
Combinations and the
Conceptual Framework

Advanced Accounting, Third Edition

Chapter
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 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.

Chapter
1-3

Learning
Learning Objectives
Objectives
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).

Chapter
1-4

Nature
Nature of
of the
the Combination
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) - results when the board of
directors of a company targeted for acquisition resists
the combination.

Chapter
1-5

Nature
Nature of
of the
the Combination
Combination
Defense Tactics
1. Poison pill: Issuing stock rights to existing
shareholders.

2. Greenmail: Purchase of 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.

Chapter
1-6

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: Sale of valuable assets to

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

6. Leveraged buyouts: Purchase of a controlling

interest in the target firm by its managers and thirdparty investors, who usually incur substantial debt.

Chapter
1-7

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

Chapter
1-8

a.

poison pill.

b.

pac-man defense.

c.

greenmail.

d.

white knight.

Business
Business Combinations:
Combinations: Why?
Why? Why
Why Not?
Not?
Internal Expansion vs. External Expansion
Business combinations (external have several
advantages)
1. Operating synergies
2. International marketplace
3. Financial synergy
4. Diversification
5. Divestitures
Chapter
1-9

LO 2 Reasons firms combine.

Business
Business Combinations:
Combinations: Historical
Historical Perspective
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).

1945 to the present, many of the mergers that

occurred from the 1950s through the 1970s were
conglomerate mergers.
Chapter
1-10

LO 1 Describe historical trends in types of business combinations.

Terminology
Terminology and
and Types
Types of
of Combinations
Combinations
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 assets

of the other firm.
Stock acquisition, control may be obtained by purchasing
50% or more of the voting common stock (or possibly less).
Chapter
1-11

LO 5 Distinguish between an asset and a stock acquisition.

Terminology
Terminology and
and Types
Types of
of Combinations
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.
Chapter
1-12

LO 5 Distinguish between an asset and a stock acquisition.

Terminology
Terminology and
and Types
Types of
of Combinations
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.

Chapter
1-13

LO 5 Distinguish between an asset and a stock acquisition.

Terminology
Terminology and
and Types
Types of
of Combinations
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.
Chapter
1-14

LO 5 Distinguish between an asset and a stock acquisition.

Terminology
Terminology and
and Types
Types of
of Combinations
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.
Chapter
1-15

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

Chapter
1-16

a.

acquisition.

b.

combination.

c.

consolidation.

d.

merger

LO 5 Distinguish between an asset and a stock acquisition.

Takeover
Takeover Premiums
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.
Chapter
1-17

LO 5 Distinguish between an asset and a stock acquisition.

Avoiding
Avoiding the
the Pitfalls
Pitfalls Before
Before the
the Deal
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.
Chapter
1-18

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:

Chapter
1-19

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

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 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.

Chapter
1-20

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
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.

Chapter
1-21

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.

Chapter
1-22

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.

6.

Chapter
1-23

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.

Add the estimated goodwill (step 5) to the fair value of

the firms net identifiable assets to arrive at a possible
offering price.
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

Chapter
1-24

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.

LO 6 Factors affecting price and method of payment.

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.
Chapter
1-25

LO 7 Estimating goodwill.

Determining
Determining Price
Price and
and Method
Method of
of Payment
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)

960,000
50,000
300,000
250,000

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

Chapter
1-26

LO 7 Estimating goodwill.

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

Chapter
1-27

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

Chapter
1-28

8,800,000
Fair value of net assets

LO 7 Estimating goodwill.

Determining
Determining Price
Price and
and Method
Method of
of Payment
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%)

$ 1,200,000
(288,000)

Targets adjusted earnings, 2005

Pretax income of Condominiums, Inc., 2006
Subtract: Additional depreciation on building

$
1,500,000
(288,000)

Targets adjusted earnings, 2006

1,212,000

Pretax income of Condominiums, Inc., 2007

950,000

Add: Extraordinary loss

300,000

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)
Chapter
1-29

912,000

(288,000)
962,000
3,086,000
$ 1,028,667

LO 7 Estimating goodwill.

Determining
Determining Price
Price and
and Method
Method of
of Payment
Payment
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
Chapter
1-30

LO 7 Estimating goodwill.

Determining
Determining Price
Price and
and Method
Method of
of Payment
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
$6,200,000
Chapter
1-31

Estimated goodwill
LO 7 Estimating goodwill.

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

Chapter
1-32

LO 7 Estimating goodwill.

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

$
x
$

98,667
2.28323
225,279
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.
Chapter
1-33

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.
Chapter
1-34

LO 8 Economic entity and parent company concepts.

Alternative
Alternative Concepts
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.
Chapter
1-35

LO 8 Economic entity and parent company concepts.

Alternative
Alternative Concepts
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.
Chapter
1-36

LO 8 Economic entity and parent company concepts.

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

Chapter
1-37

a.

majority stockholders.

b.

minority stockholders.

c.

creditors.

d.

both majority and minority stockholders.

LO 8 Economic entity and parent company concepts.

Alternative
Alternative Concepts
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.
Chapter
1-38

LO 8 Economic entity and parent company concepts.

Conceptual
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

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)
Provides definitions
of key components
of financial statements

SFAC No. 5 & 7

PRINCIPLES
Recognition
and Measurement

Objectives

Fundamental

Operational

1. Historical
cost
ASSUMPTIONS
PRINCIPLES
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
Chapter
1-39

LO 8 Economic entity and parent company concepts.

FASBs
FASBs Conceptual
Conceptual Framework
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).

Chapter
1-40

LO 8 Economic entity and parent company concepts.

FASBs
FASBs Conceptual
Conceptual Framework
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.
A shift to the economic entity concept seems to be
consistent with the assumptions laid out by the FASB
for GAAP (SFAC No. 5).

Chapter
1-41

LO 8 Economic entity and parent company concepts.

FASBs
FASBs Conceptual
Conceptual Framework
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
Chapter
1-42

LO 9 Statements of Financial Accounting Concepts.

FASBs
FASBs Conceptual
Conceptual Framework
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.
Chapter
1-43

LO 9 Statements of Financial Accounting Concepts.

FASBs
FASBs Conceptual
Conceptual Framework
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).
Chapter
1-44

LO 9 Statements of Financial Accounting Concepts.

Copyright
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Copyright 2008 John Wiley & Sons, Inc. All rights reserved.
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Chapter
1-45