Chapter 5
Business
Combinations
McGraw-Hill/Irwin
©The McGraw-Hill Companies, Inc. 2006
Scope of the Chapter
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Definition of “Business Combinations.”
Reasons for the popularity of business
combinations.
Techniques for arranging a business
combination.
The accounting method for business
combinations.
Definitions
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According to the FASB, a business
combination is an event or a procedure, in
which, an entity acquires net assets that
constitute a business or acquires equity
interests of one or more other entities and
obtains control over that entity or entities.
Commonly, business combinations are often
referred to as mergers and acquisitions.
Definitions
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Combined Enterprise: The accounting entity that
results from a business combination.
Constituent Companies: The business enterprises
that enter into a business combination.
Combinor: A constituent company entering into a
purchase-type business combination whose owners as
a group end up with control of the ownership interests
in the combined enterprises.
Combinee: A constituent company other than the
combinor in a business combination.
Classes of Business Combinations
Business Combinations
Friendly Takeover
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Hostile Takeover
Friendly Takeovers
Board of Directors of all constituent
companies amicably determine the
terms of the business combination.
 Proposal is submitted to share holders
of all constituent companies for
approval.
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Hostile Takeovers
Target combinee typically resists the
proposed business combination.
 Target combinee uses one or more of
the several defensive tactics.
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Tactics for Defense Used in
Hostile Takeovers
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Pac-man Defense: A threat to undertake a
hostile takeover of the prospective
combinor.
White Knight: A search for a candidate to
be the combinor in a friendly takeover.
Scorched Earth: The disposal, by sale or
by spin-off to stockholders, of one or more
profitable business segments.
Tactics for Defense Used in
Hostile Takeovers
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Shark Repellent: An acquisition of
substantial amounts of outstanding
common stock for the treasury or for
retirement, or the incurring of substantial
long-term debt in exchange for
outstanding common stock.
Tactics for Defense Used in
Hostile Takeovers
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Poison Pill: An amendment of the articles of
incorporation or bylaws to make it more difficult
to obtain stockholder approval for a takeover.
Green Mail: An acquisition of common stock
presently owned by the prospective combinor
at a price substantially in excess of the
prospective combinor’s cost, with the stock
thus acquired placed in the treasury or retired.
Business Combinations:
Why And How?
In recent years Growth has been main
reason for business enterprises to
enter into a business combination.
 There could be many more reasons.
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Business Combinations:
Why And How?
The external method of achieving
growth is more rapid than growth
through internal methods.
 Obtaining new management strength
or better use of existing management.
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Business Combinations:
Why And How?
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Achieving manufacturing or other operating
economies.
A business combination may be undertaken for
income tax advantages.
Hostile takeovers are mostly motivated by the
prospect of substantial gain resulting from the
sale of business segments.
Antitrust Considerations
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Antitrust litigations is a one obstacle faced by large
corporations that undertake business combinations.
The U.S. Government on occasion has opposed
concentration of economic power in large business
enterprises.
Business combinations have been challenged by the
Federal Trade Commission or the Antitrust Division of
the Department of Justice, under the provisions of
Section 7 of the Clayton Act.
Types of Business Combinations
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Horizontal: A combination involving
enterprises in the same industry.
Vertical: A Combination involving an enterprise
and its customers or suppliers.
Conglomerate: A combination between
enterprises in unrelated industries or markets.
Methods for Arranging Business
Combinations
Statutory Merger
 Statutory Consolidation
 Acquisition of Common Stock
 Acquisition of Assets
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Statutory Merger
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It is executed under provisions of applicable
state laws.
The boards of directors of the constituent
companies approve a plan for the exchange of
voting common stock (and perhaps some
preferred stock, cash or long-term debt) of one
of the corporations (the survivor) for all the
outstanding voting common stock of the other
corporations.
Statutory Merger
Stockholders of all constituent companies
must approve the terms of the merger.
 Some states require approval by a twothirds majority of stockholders, thus
acquiring ownership of those
corporations.
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Statutory Merger
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Company “A” acquires Company “B” then
dissolves “B” and liquidates “B”
Company “B” cease to exist as separate legal
entities
Company “B” (dissolved) often continues as a
division of the survivor (“A”)
, which now owns the net assets, rather than
the outstanding common stock, of the
liquidated corporations.
Statutory Consolidation
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Is consummated in accordance with applicable state
laws.
A new corporation is formed to issue its common
stock for the outstanding common stock of two or more
existing corporations, which then go out of existence.
The new corporation thus acquires the net assets of
the defunct corporations, whose activities may be
continued as divisions of the new corporation.
Acquisition of Common Stock
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One corporation (the investor) may issue
preferred or common stock, cash, debt or
a combination thereof to acquire from
present stockholders a controlling
interest in the voting common stock of
another corporation (the investee).
Acquisition of Common Stock
Stock acquisition program may be
accomplished through
 Direct acquisition in the stock market
 Negotiations with the principal
stockholders of a closely held corporation
 Tender offer to stockholders of a publicly
owned corporation.
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Acquisition of Common Stock
A tender offer is a publicly announced
intention to acquire common stock
 For a stated amount of consideration
 A maximum number of shares of the
combinee’s common stock “tendered” by
holders thereof to an agent
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Acquisition of Common Stock
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Price per share stated in the tender offer
usually is a premium to prices prior to the
announcement
A controlling interest in the combinee’s voting
common stock is acquired,
Corporation becomes affiliated with the
combinor parent company as a subsidiary
but is not dissolved and liquidated and remains
a separate legal entity.
Acquisition of Common Stock
Business combination through this
method, requires authorization by the
combinor’s board of directors and may
require ratification by the combinee’s
stockholders.
 Most hostile takeovers are accomplished
by this means.
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Acquisition of Assets
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Business enterprise may acquire from another
enterprise all or most of the gross assets or net assets
of the other enterprise for cash, debt, preferred or
common stock, or a combination thereof.
The transaction must be approved by the boards of
directors and stockholders or other owners of the
constituent companies.
The selling enterprise may continue its existence as a
separate entity or it may be dissolved and liquidated, it
does not become an affiliate of the combinor.
Establishing the Price for A
Business Combination
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This is a very important early step in planning
a business combination.
The price for a business combination
consummated for cash or debt generally is
expressed in terms of the total dollar amount
of the consideration issued.
Establishing the Price for A
Business Combination
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Common stock is issued by the combinor in a
business combination
Price is expressed as a ratio of the number of
shares of the combinor’s common stock to be
exchanged for each share of the combinee’s
common stock
Establishing the Price for A
Business Combination
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Amount of cash or debt securities, or the
number of shares of common or preferred
stock, to be issued in a business combination
generally is determined by variations of two
methods:
1.
2.
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Capitalization of expected average annual earnings
of the combinee at a desired rate of return.
Determination of current fair value of the
combinee’s net assets (including goodwill).
Purchase Method Of Accounting
For Business Combinations
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Initial Recognition: Assets are commonly
acquired in exchange transactions that trigger
the initial recognition of the assets acquired
and any liabilities assumed.
Initial Measurement: Like other exchange
transactions, acquisitions are measured on the
basis of the fair values exchanged.
Purchase Method Of Accounting
For Business Combinations
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Allocating Cost: Acquiring assets in groups
requires not only ascertaining the cost of the
asset (or net asset) group but also allocating
that cost to the individual assets (or individual
assets and liabilities) that make up the group.
Accounting after Acquisition: The nature of
an asset and not the manner of its acquisitions
determines an acquiring entity’s subsequent
accounting for the asset.
Determination of the Combinor
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Because the carrying amounts of the net
assets of the combinor are not affected by a
business combination, the combinor must be
accurately identified.
The FASB stated that in a business
combination effected solely by the distribution
of cash or other assets or by incurring
liabilities, the combinor is the distributing or
incurring constituent company.
Determination of the Combinor
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For combinations effected by the issuance of equity
securities, consideration of all the facts and
circumstances is required to identify the combinor.
Common theme is that the combinor is the constituent
company whose stockholders as a group retain or
receive the largest portion of the voting rights of the
combined enterprise and thereby can elect a majority
of the governing board of directors or other group of
the combined enterprise.
Computation of Cost of a Combinee
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The cost of a combinee in a business
combination accounted for by the purchase
method is the total of:
1.
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The amount of consideration paid by the combinor.
The combinor’s direct out-of-pocked costs of the
combination.
Any contingent consideration that is determinable
on the date of the business combination.
Amount of Consideration
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This is the total amount of cash paid, the
current fair value of other assets distributed,
the present value of debt securities issued, and
the current fair (or market) value of equity
securities issued by the combinor.
Direct Out-Of-Pocket Costs
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Included in this category are some legal fees,
some accounting fees and finder’s fees.
A finder’s fee is paid to the investment banking
firm or other organization or individuals that
investigated the combinee, assisted in
determining the price of the business
combination, and otherwise rendered services
to bring about the combination.
Direct Out-Of-Pocket Costs
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Costs of registering with SEC and issuing debt
securities are not direct costs of the business
combination but are offset against the proceeds from
the issuance of the securities.
Indirect out-of-pocket costs of the combination, such
as salaries of officers of constituent companies
involved in negotiation and completion of the
combination, are recognized as expenses incurred by
the constituent companies.
Contingent Consideration
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Contingent consideration is additional cash,
other assets, or securities that may be issuable
in the future
Contingent on future events such as a
specified level of earnings or a designated
market price for a security that had been
issued to complete the business combination.
Contingent Consideration
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Contingent consideration that is determinable
on the consummation date of a combination is
recorded as part of the cost of the combination.
Contingent consideration not determinable on
the date of the combination is recorded when
the contingency is resolved and the additional
consideration is paid or issued (or becomes
payable or issuable).
Allocation Of Cost Of A Combinee
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The cost of a combinee in a business
combination must be allocated to assets
(other than goodwill) acquired and liabilities
assumed based on their estimated fair values
on the date of the combination.
Any excess of total costs over the amounts
thus allocated is assigned to goodwill.
Allocation Of Cost Of A Combinee
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Methods for determining fair values included
present values for receivables and most
liabilities
Net realizable value less a reasonable profit
for work in process and finished goods
inventories;
Appraised values for land, natural resources,
and non-marketable securities.
Allocation Of Cost Of A Combinee
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The following combinee intangible assets
were to be recognized individually and valued
at fair value:
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Assets arising from contractual or legal rights, such
as patents, copyrights, and franchises
Other assets that are separable from the combinee
entity and can be sold, licensed, exchanged, and
the like, such as customer lists and non-patented
technology
Allocation Of Cost Of A Combinee
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Other matters involved in the allocation of the cost of a
combinee in a business combination are:
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A part of the cost of a combinee is allocable to identifiable
tangible and intangible assets that resulted from research and
development activities of the combined enterprise
Subsequently, such assts are to be expensed, as required by
FASB, unless they may be used for other than research and
development activities in the future.
Allocation Of Cost Of A Combinee
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In a business combination, leases of the combineelessee are classified by the combined enterprise as
they were by the combinee unless the provisions of
the lease are modified to the extent it must be
considered a new lease.
Unmodified capital leases of the combinee are
treated as capital leases by the combined
enterprise, and the leased property and related
liability are recognized in accordance with the
guidelines of FASB statement No. 141.
Allocation Of Cost Of A Combinee
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A combinee in a business combination may have
pre-acquisition contingencies, which are contingent
assets (other than potential income tax benefits of a
loss carry forward), contingent liabilities, or
contingent impairments of assets, that existed prior
to completion of the business combination.
An allocation period, generally not longer than one
year from the date the combination is completed,
may be used to determine the current fair value of a
pre-acquisition contingency.
Goodwill
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Goodwill is recognized in business combination
because the total cost of the combinee
exceeds the current fair value of identifiable net
assets of the combinee.
The amount of goodwill recognized on the date
the business combination is consummated
may be adjusted subsequently when
contingent consideration becomes issuable.
Negative Goodwill
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In some purchase-type business combinations
(known as bargain purchases), the current fair
value assigned to the identifiable net assets
acquired exceed the total cost of the combinee.
A bargain purchase is most likely to occur for a
combinee with a history of losses or when
common stock prices are extremely low.
Negative Goodwill
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Excess of the current fair values over total cost is
applied pro rata to reduce (but not below zero) the
amounts initially assigned to financial assets
Other than investments accounted for by the equity
method;
Assets to be disposed of by sale; deferred tax assets;
prepaid assets relating to pension or other
postretirement benefits; and any other current assets
Negative Goodwill
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Excess of current fair values over cost of the
combinee’s net assets remains after the
foregoing reduction
Is recognized as an extraordinary gain by the
combinor