11

Introduction to Business
Combinations and the
Conceptual Framework

Advanced Accounting, Fifth Edition

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Learning
Learning Objectives
Objectives

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1-2

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 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.

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) - 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
Defensive Tactics
1. Poison pill: Issuing stock rights to existing

shareholders; exercisable only in the event of a

potential takeover.

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
Nature of
of the
the Combination
Combination
Defensive Tactics (continued)
4. Pac-man defense: Attempting an unfriendly takeover
of the would-be acquiring company.

5. Selling the crown jewels: Selling 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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Types
Types of
of Business
Business Combination
Combination
Business combinations unite previously separate
business entities.
Horizontal integration same business lines and
markets
Vertical integration operations in different, but
successive stages of production or distribution,
or both
Conglomeration unrelated and diverse
products or services

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1-7

Reasons
Reasons for
for Combination
Combination
Cost

advantage
Lower risk
Fewer operating delays
Avoidance of takeovers
Acquisition of intangible assets
Other: business and other tax advantages,
personal reasons

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1-8

Business
Business Combinations:
Combinations: Why?
Why? Why
Why Not?
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
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).

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LO 1 Describe historical trends in types of business combinations.

Business
Business Combinations:
Combinations: Historical
Historical Perspective
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
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).
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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.
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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.

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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

New corporation is formed to take over the assets and

operations of two or more separate business entities and
dissolves the previously separate 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
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.
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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 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 (rather than cash) 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
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.

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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.

Examples
Examples (1
(1 of
of 3)
3)
Poppy Corp. issues 100,000 shares of its $10 par
value common stock for Sunny Corp. Poppys stock
is valued at $16 per share.
(in thousands)

Investment in Sunny Corp.

Common stock, $10 par
Additional paid-in-capital

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1,600
1,000
600

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Examples
Examples (2
(2 of
of 3)
3)
Poppy Corp. pays cash for $80,000 in finders fees
and consulting fees and for $40,000 to register
and issue its common stock. (in thousands)

Investment expense
Additional paid-in-capital
Cash

80
40
120

Sunny Corp. is assumed to have been dissolved. So,

Poppy Corp. will allocate the investments cost to
the fair value of the identifiable assets acquired
and liabilities assumed. Excess cost is goodwill.
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Examples
Examples (3
(3 of
of 3)
3)

Receivables
Inventories
Plant assets
Goodwill
Accounts payable
Notes payable
Investment in Sunny Corp.
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XXX
XXX
XXX
XXX
XXX
XXX
1,600
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Identify
Identify the
the Net
Net Assets
Assets Acquired
Acquired
Identify:
1.
2.
3.

Tangible assets acquired,

Intangible assets acquired, and
Liabilities assumed

Include:

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Identifiable intangibles resulting from legal or

contractual rights, or separable from the entity
Research and development in process
Contractual contingencies
Some noncontractual contingencies
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Assign
Assign Fair
Fair Values
Values to
to Net
Net Assets
Assets
Use fair values determined, in preferential order,
by:
1.Established

market prices
2.Present value of estimated future cash flows, discounted
based on observable measures
3.Other internally derived estimations

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1-25

Exceptions
Exceptions to
to Fair
Fair Value
Value Rule
Rule
Deferred

tax assets and liabilities [FASB

Statement No. 109 and FIN No. 48]
Pensions and other benefits [FASB Statement
No. 158]
Operating and capital leases [FASB Statement
No. 13 and FIN. No. 21]

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Examples
Examples Pitt
Pitt Co.
Co.
Pitt Co. acquires the net assets of Seed Co. in a
combination consummated on 12/27/2008. The
assets and liabilities of Seed Co. on this date, at
their book values and fair values, are as follows (in
thousands):

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Cash
Net receivables
Inventory
Land
Buildings, net
Equipment, net
Patents
Total assets
Accounts payable
Notes payable
Other liabilities
Total liabilities
Net assets
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Book Val.
$ 50
150
200
50
300
250
0
$1,000
$ 60
150
40
$ 250
$ 750

Fair Val.
$ 50
140
250
100
500
350
50
$1,440
$ 60
135
45
$ 240
$1,200
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Acquisition
Acquisition with
with Goodwill
Goodwill
Pitt Co. pays $400,000 cash and issues 50,000
shares of Pitt Co. $10 par common stock with a
market value of $20 per share for the net assets of
Seed Co.

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Acquisition
Acquisition with
with Goodwill
Goodwill
Pitt Co. pays $400,000 cash and issues 50,000
shares of Pitt Co. $10 par common stock with a
market value of $20 per share for the net assets of
Seed Co.
Total consideration at fair value (in thousands):
$400 + (50 shares x $20)
$1,400
Fair value of net assets acquired: $1,200
Goodwill
$ 200

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Entries
Entries with
with Goodwill
Goodwill
The entry to record the acquisition of the net
assets:
Investment in Seed Co.
Cash
Common stock, $10 par
Additional paid-in-capital

1,400
400
500
500

The entry to record Seeds assets directly on Pitts

books:
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1-31

Cash
Net receivables
Inventories
Land
Buildings
Equipment
Patents
Goodwill
Accounts payable
Notes payable
Other liabilities
Investment in Seed Co.
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50
140
250
100
500
350
50
200
60
135
45
1,400
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Acquisition
Acquisition with
with Bargain
Bargain Purchase
Purchase
Pitt Co. issues 40,000 shares of its $10 par
common stock with a market value of $20 per
share, and it also gives a 10%, five-year note
payable for $200,000 for the net assets of
Seed Co.

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Acquisition
Acquisition with
with Bargain
Bargain Purchase
Purchase
Pitt Co. issues 40,000 shares of its $10 par
common stock with a market value of $20 per
share, and it also gives a 10%, five-year note
payable for $200,000 for the net assets of Seed
Co.
Fair value of net assets acquired (in thousands):
$1,200
Total consideration at fair value:
(40 shares x $20) + $200 $1,000
Gain from bargain purchase
$ 200
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1-34

Entries
Entries with
with Bargain
Bargain Purchase
Purchase
The entry to record the acquisition of the net
assets:

Investment in Seed Co.

10% Note payable
Common stock, $10 par
Additional paid-in-capital

1,000
200
400
400

The entry to record Seeds assets directly on Pitts

books:
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1-35

Cash
Net receivables
Inventories
Land
Buildings

50
140
250
100
500

Equipment
350
Patents
50
Accounts payable
Notes payable
Other liabilities
Investment in Seed Co.
Gain from bargain purchase
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60
135
45
1,000
200
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Goodwill
Goodwill Controversies
Controversies
Capitalized

goodwill is the purchase price not

assigned to identifiable assets and liabilities.
Errors

in valuing assets and liabilities affect the

amount of goodwill recorded.

Historically

goodwill in most industrialized

countries was capitalized and amortized.
Current IASB standards, like U.S. GAAP
Capitalize

goodwill,
Do not amortize it, and
Test it for impairment.
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Impairments
Impairments
Firms

must test annually for the impairment of

goodwill at the business unit reporting level.
If

the units book value exceeds its fair value,

additional tests must be performed to determine the
impairment of goodwill and/or other assets.

More

frequent testing for goodwill impairment

may be needed (e.g., loss of key personnel,
unanticipated competition, goodwill impairment
of subsidiary).

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Business
Business Combination
Combination Disclosures
Disclosures
FASB

Statement No. 141R and 142 prescribe

disclosures for business combinations and
intangible assets. This includes, but is not
limited to:
Reason

for combination,
Allocation of purchase price among assets and
liabilities,
Pro-forma results of operations, and
Goodwill or gain from bargain purchase.

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Sarbanes-Oxley
Sarbanes-Oxley Act
Act of
of 2002
2002
Establishes

the PCAOB

Requires
Greater

independence of auditors and clients

Greater independence of corporate boards
Independent audits of internal controls
Increased disclosures of off-balance sheet
arrangements and obligations
More types of disclosures on Form 8-K
SEC

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enforces SOX and rules of the PCAOB

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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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LO 8 Economic entity and parent company concepts.

Alternative
Alternative Concepts
Concepts
Consolidated Net Income
Parent Company Concept, consolidated net income
consists of the realized combined income of the parent
company and its subsidiaries after deducting the
noncontrolling interest in income (noncontrolling interest
in income is an expense item).
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
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.
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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
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
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.
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LO 8 Economic entity and parent company concepts.

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

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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. 8).

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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.
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
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.
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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 (or matched to the period incurred or allocated
systematically) (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.

Copyright
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