Susan S.
Hamlen
Ronald J.
Huefner
James A.
Largay
Chapter 2:
Mergers and Acquisitions
2
What is a Business Combination?
 Occurs when one company obtains control
over another company
 Terms used:
 Merger
 Acquisition
 Takeover
©Cambridge Business Publishing, 2013
Business Strategies
Achieved Through Acquisitions
 Control a source of supply
 Acquire new technology, production or
distribution facilities
 Expand into new geographic markets,
acquire new customers
 Diversify into new lines of business
©Cambridge Business Publishing, 2013
3
4
Advantages of Acquisitions
 Acquiring a going concern is less costly
 Eliminates the need to start from scratch
 Avoids duplication of efforts
 Competition is often reduced
 Complimentary products or services can
lead to increased overall sales
©Cambridge Business Publishing, 2013
5
Top M&A Deals Worldwide, 2000-2010
Exhibit 2.1
©Cambridge Business Publishing, 2013
6
Types of Combinations
Acquiring
company
remains
Statutory merger
New
company
remains
Statutory consolidation
Asset acquisition
Stock acquisition
©Cambridge Business Publishing, 2013
All assets and
liabilities acquired are
recorded directly on
the books of the
acquiring company
Acquiring and acquired
companies remain
separate legal entities
7
Combination Example
An acquirer pays $25 million in cash to acquire another company.
The fair value of the other company’s assets and liabilities are:
Account
Current assets
Plant and equipment
Patents and copyrights
Current liabilities
Long-term debt
Fair Value
$ 2,000,000
93,000,000
5,000,000
15,000,000
60,000,000
To record the acquisition on the acquirer’s books:
Current assets
Plant and equipment
Patents and copyrights
Current liabilities
Long-term debt
Cash
©Cambridge Business Publishing, 2013
2,000,000
93,000,000
5,000,000
15,000,000
60,000,000
25,000,000
Fair
values,
NOT
book
values
8
Statutory Merger
 Acquired company ceases to exist as a
separate company
 Subsequent transactions of acquired firm
are reported on books of acquirer
 Assets and liabilities acquired are recorded
directly on acquiring company’s books
 At fair value at the date of acquisition
 ASC Topic 820 provides measurement
guidance
©Cambridge Business Publishing, 2013
9
Statutory Consolidation
 New corporation absorbs both companies
 One of the existing companies is the
acquirer, the other is the acquiree
 Acquiree’s assets and liabilities reported at
fair value at date of acquisition
 Acquirer’s assets and liabilities remain at book
value
 Same result as statutory merger
©Cambridge Business Publishing, 2013
10
Stock Acquisition
 Occurs when a company acquires the voting
stock of another company
 Each firm continues as a separate legal entity
 Acquirer treats investment in the acquired
firm as an intercorporate investment
 Consolidated working paper used to combine
the two companies’ results, with same result
as statutory merger or consolidation.
To record the investment in stock on acquirer’s books:
Investment in acquiree
Cash
©Cambridge Business Publishing, 2013
25,000,000
25,000,000
Reporting Standards
for Business Combinations
 ASC Topic 805
 Valuation of assets acquired and liabilities
assumed
 Valuation of consideration paid
 ASC Topic 350
 Valuation and subsequent reporting for
intangible assets acquired, including goodwill
 ASC Topic 810
 Consolidation criteria, procedures, and
consolidated financial statement format
©Cambridge Business Publishing, 2013
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12
Definition of Business Combination
 Control is obtained over one or more
businesses
 Definition of a business
An integrated set of activities and assets that is
capable of being conducted and managed for the
purpose of providing a return in the form of
dividends, lower costs, or other economic
benefits directly to investors or other owners,
members, or participants.
 ASC Topics 805 and 810 apply only to
business combinations
©Cambridge Business Publishing, 2013
13
Learning Objective 1
Measure and account for the various
assets and liabilities acquired in
mergers and acquisitions.
©Cambridge Business Publishing, 2013
14
Acquisition Method
 Used to report all business combinations
 Requires careful identification and valuation
of the
 Fair value of the assets acquired, and
 Fair value of the liabilities assumed
 At acquisition date
 The date the acquiring company obtains control of
the acquired company
 Normally date consideration is paid
©Cambridge Business Publishing, 2013
15
Identify Acquiring Company
 When no equity interests are exchanged, acquiring
company distributes cash or other assets and/or incurs
liabilities
 More difficult to identify the acquiring company when the
business combination involves an equity exchange
 Possible characteristics of acquiring company







Entity that issues the equity interests
Entity that is larger
Owners have larger voting interest
Prior owners constitute a large minority (<50%)
Entity selects a majority of the governing body
Dominates senior management
Entity’s stockholders did not receive a premium over market
value in the exchange
©Cambridge Business Publishing, 2013
16
Identify Acquiring Company
Why is it necessary to identify the acquiring
company?
 Acquired company’s assets and liabilities
are revalued to fair value at the date of
acquisition
 Acquiring company’s assets and liabilities
remain at book value
©Cambridge Business Publishing, 2013
17
Measuring Assets and
Liabilities Acquired
Acquisition
cost
Acquisition
cost
©Cambridge Business Publishing, 2013
>
Fair value of
net assets
acquired
Goodwill
<
Fair value of
net assets
acquired
Gain on
bargain
purchase
18
Estimation of Fair Values
Exhibit 2.3
©Cambridge Business Publishing, 2013
19
Identification of Previously
Unreported Intangibles
 Two criteria for separate recognition as an
identifiable intangible by acquiring entity
 Intangible arises from contractual or other legal
rights, or
 Intangible is separable
 Can be separated or divided from the acquired
entity and sold, rented, licensed, or otherwise
transferred
©Cambridge Business Publishing, 2013
Examples of Identifiable
Intangible Assets
Contract-based
Marketingrelated
©Cambridge Business Publishing, 2013
• Lease, franchise, licensing
agreements
• Construction permits
• Employment contracts
• Broadcast rights
• Mineral rights
•
•
•
•
•
Brand names
Trademarks
Internet domain names
Newspaper mastheads
Non-competition agreements
20
Examples of Identifiable
Intangible Assets
Customerrelated
• Customer lists
• Order backlogs
• Customer contracts
Technologybased
•
•
•
•
Patent rights
Computer software
Databases
Trade secrets
Artisticbased
•
•
•
•
•
Television programs
Motion pictures and videos
Recordings
Books and photographs
Advertising jingles
©Cambridge Business Publishing, 2013
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22
Valuation of Identifiable Intangibles
 Measurement guidelines of ASC Topic 820
 Fair value hierarchy
 Level 1: Quoted prices in an active market
 Level 2: Quoted prices for similar assets,
adjusted for attributes of acquired assets
 Level 3: Valuation based on unobservable
estimated attributes
 Discounted present value
 Earnings and book value multiples
©Cambridge Business Publishing, 2013
Intangibles Not Meeting Criteria as
Identifiable Intangibles
 Examples:





Assembled workforce
Potential contracts
Long-standing customer relationships
Favorable locations
Business reputation
 Consideration paid reflects these
intangibles
 Consideration paid > fair value of identifiable
net assets
©Cambridge Business Publishing, 2013
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24
Goodwill
Goodwill exists if the consideration paid exceeds the
total fair value of the net identifiable assets acquired.
 Excess consideration paid occurs due to value
attributed to intangible assets not meeting criteria
for capitalization as identifiable intangible assets
 Amount is capitalized as goodwill, an intangible
asset
©Cambridge Business Publishing, 2013
Calculating Goodwill
An acquirer pays $100 million in cash to acquire another
company. The fair value of the other company’s assets and
liabilities are:
Account
Current assets
Plant and equipment
Patents and copyrights
Current liabilities
Long-term debt
Fair Value
$ 3,000,000
42,000,000
5,000,000
4,000,000
40,000,000
Acquisition cost
$100,000,000
Fair value of identifiable net assets acquired:
Current assets
$ 3,000,000.
Plant and equipment
42,000,000.
Patents and copyrights
5,000,000.
Current liabilities
(4,000,000)
Long-term debt
(40,000,000)
6,000,000
Goodwill
$ 94,000,000
©Cambridge Business Publishing, 2013
25
Recording an Acquisition
with Goodwill
Current assets
Plant and equipment
Patents and copyrights
Goodwill
Current liabilities
Long-term debt
Cash
©Cambridge Business Publishing, 2013
3,000,000
42,000,000
5,000,000
94,000,000
4,000,000
40,000,000
100,000,000
26
Illustration of
Previously Unreported Assets
27
An acquirer pays $100 million in cash to acquire another
company. Fair value of the acquiree’s reported assets and
liabilities are:
Current assets
Plant and equipment
Patents and copyrights
$ 3,000,000
42,000,000
5,000,000
Current liabilities
Long-term debt
$ 4,000,000
40,000,000
Unreported intangible assets:
Brand names
Favorable lease agreements
Assembled workforce
Potential future contracts
Developed technology
$2,000,000
500,000
60,000,000
12,000,000
8,000,000
Identifiable
Intangibles
Not identifiable intangibles
©Cambridge Business Publishing, 2013
Illustration of Reporting Assets
Acquired and Liabilities Assumed
continued
Goodwill calculation:
Acquisition cost
$100,000,000
Fair value of identifiable net assets acquired:
Current assets
$ 3,000,000.
Plant and equipment
42,000,000.
Patents and copyrights
5,000,000.
Brand names
2,000,000.
Favorable lease agreements
500,000
Developed technology
8,000,000.
Current liabilities
(4,000,000)
Long-term debt
(40,000,000)
16,500,000
Goodwill
$ 83,500,000
©Cambridge Business Publishing, 2013
28
Illustration of Reporting Assets
Acquired and Liabilities Assumed
continued
Recording the acquisition:
Current assets
Plant and equipment
Patents and copyrights
Brand names
Favorable lease agreements
Developed technology
Goodwill
Current liabilities
Long-term debt
Cash
©Cambridge Business Publishing, 2013
3,000,000
42,000,000
5,000,000
2,000,000
500,000
8,000,000
83,500,000
4,000,000
40,000,000
100,000,000
29
30
Learning Objective 2
Measure and report the various types of
consideration paid.
©Cambridge Business Publishing, 2013
31
Measurement of Acquisition Cost
 Must be measured at fair value at the
acquisition date
 Acquisition cost includes
 Cash or other assets transferred to the former
owners by the acquirer
 Liabilities incurred by the acquirer and owed to
the former owners of the acquiree
 Stock issued by the acquirer to the former
owners of the acquiree
©Cambridge Business Publishing, 2013
32
Contingent Consideration
 Exists when the acquirer agrees to make
additional payments to the former owners of
the acquiree if certain events occur or
conditions are met
 Adds to acquisition cost
 Must be reported at date of acquisition
 Requires good faith estimates of
 Probability, and
 Timing
 Based on present value of the expected
payment
©Cambridge Business Publishing, 2013
33
Earnings Contingency
 The former shareholders believe they are
entitled to more consideration given their
company will bolster postcombination
earnings
 Acquirer makes an additional payment, in
cash or stock, if certain performance goals are
met
 Performance goals often based on
 Revenue
 Cash from operations
 EBITDA
 Also known as an earnout
©Cambridge Business Publishing, 2013
34
Earnings Contingency Example
X agrees to pay Y’s former shareholders $0.50 cash for every
dollar in cash from operations above $20 million reported in the
first year after acquisition. X expects 3 possible outcomes:
Cash from Operations
Probability
$15,000,000
0.30
25,000,000
0.50
35,000,000
0.20
Expected payment:
($25,000,000 - $20,000,000) x 50% =
$ 2,500,000
($35,000,000 - $20,000,000) x 20% =
3,000,000
$ 5,500,000
Using a 5% discount rate, the present value of expected payment is
approximately:
($5,500,000/(1 + 0.05) = $5,238,000
©Cambridge Business Publishing, 2013
35
Security Price Contingency
 Guarantee to the former shareholders of
the acquired company
 Guarantees that the market value of securities
issued to them in exchange for their stock does
not fall below a specified amount
 Acquiring company issues additional
shares or cash to the former shareholders
to bring the total consideration value to the
minimum level
©Cambridge Business Publishing, 2013
36
Security Price Contingency Example
X issues 1 million shares with a market price of $50 per share to
the former shareholders of Y. A agrees to issue additional shares
to maintain the value of the shares at $50 million at the end of the
first year after acquisition. X estimates the stock price at the end
of the year to be three possible outcomes:
Stock Price Per Share
$35
45
55
Probability
0.10
0.25
0.65
Expected obligation:
($50,000,000 - $35,000,000) x 10% =
($50,000,000 - $45,000,000) x 25% =
$1,500,000
1,250,000
$2,750,000
Using a 5% discount rate, the present value of expected payment
is approximately:
($2,750,000/(1 + 0.05) = $2,619,000
©Cambridge Business Publishing, 2013
37
Reporting Contingent Consideration
 Earnings contingencies are liabilities
 Security price contingencies are additional
paid-in capital
 Both increase the total acquisition price
©Cambridge Business Publishing, 2013
Recording Contingent Consideration
continued
 Use the previous acquisition information
and add the two contingent considerations:
Current assets
Plant and equipment
Patents and copyrights
Brand names
Favorable lease agreements
Developed technology
Goodwill
Current liabilities
Long-term debt
Cash
Earnings contingency liability
Additional paid-in capital:
security price contingency
©Cambridge Business Publishing, 2013
3,000,000
42,000,000
5,000,000
2,000,000
500,000
8,000,000
91,357,000
4,000,000
40,000,000
100,000,000
5,238,000
2,619,000
38
39
Acquisition-Related Costs
 Out-of-pocket costs
 Outside consulting fees and advisory services
 Lawyers
 Accountants
 Out-of-pocket costs are expenses
 Do not increase the value of the acquired business
 Security registration costs
 Reduce the net value of the equity accounts
affected (additional paid-in capital)
 Do not increase acquisition cost
©Cambridge Business Publishing, 2013
Acquisition-Related
Restructuring Costs
 Must be expensed as incurred
 Do not affect acquisition cost
 Examples
 Shutting down departments
 Reassigning or eliminating jobs
 Changing supplier or production practices in
connection with the combination
©Cambridge Business Publishing, 2013
40
41
Reporting Consideration Paid:
An Example
An acquirer pays the following consideration to acquire another
company:
Cash paid to former owners of the acquired company
Fair value of stock issued to former owners of the acquired
company:
1,000,000 shares, par value $1
Cash paid for registration fees on stock issued
Cash paid for outside merger advisory services
Expected present value of earnout agreement
Expected present value of stock price contingency agreement
$50,000,000
60,000,000
1,000,000
2,000,000
600,000
400,000
Fair value of acquirer’s assets and liabilities are:
Previously reported
Current assets
Plant and equipment
Patents and copyrights
Current liabilities
Long-term debt
©Cambridge Business Publishing, 2013
$ 3,000,000
42,000,000
5,000,000
4,000,000
40,000,000
Previously unreported
Brand names
Favorable lease agreements
Assembled workforce
Future potential contracts
Developed technology
$2,000,000
500,000
60,000,000
12,000,000
8,000,000
Reporting Consideration Paid:
An Example
continued
Goodwill calculation:
Acquisition cost
Cash paid to former owners
$50,000,000
Fair value of stock issued
60,000,000
Fair value of earnout
600,000
Fair value of stock contingency
400,000
Fair value of identifiable net assets acquired:
Current assets
$ 3,000,000
Plant and equipment
42,000,000
Patents and copyrights
5,000,000
Brand names
2,000,000
Favorable lease agreements
500,000
Developed technology
8,000,000
Current liabilities
(4,000,000)
Long-term debt
(40,000,000)
Goodwill
©Cambridge Business Publishing, 2013
$111,000,000
16,500,000
$ 94,500,000
42
Reporting Consideration Paid:
An Example
continued
Record the acquisition:
Current assets
3,000,000
Plant and equipment
42,000,000
Patents and copyrights
5,000,000
Brand names
2,000,000
Favorable lease agreements
500,000
Developed technology
8,000,000
Goodwill
94,500,000
Merger expenses
2,000,000
Current liabilities
Long-term debt
Earnout liability
Common stock, $1 par
Additional paid-in-capital--stock issue
Additional paid-in-capital--stock contingency
Cash
©Cambridge Business Publishing, 2013
4,000,000
40,000,000
600,000
1,000,000
58,000,000
400,000
53,000,000
43
44
Learning Objective 3
Account for changes in the values of
acquired assets and liabilities, and
contingent consideration.
©Cambridge Business Publishing, 2013
45
Subsequent Changes in Values
Value changes resulting
from clarification of
facts existing as of the
date of acquisition
Value changes caused
by events occurring
after the date of
acquisition
Treated as corrections
to the initial acquisition
entry
Reported in income
©Cambridge Business Publishing, 2013
46
Measurement Period
 Defined as the period during which value
changes may be reported as corrections to
the initial acquisition entry
 Ends when no more information can be
obtained concerning estimated values as of
the acquisition date
 Limited to one year after the acquisition date
©Cambridge Business Publishing, 2013
Reporting Subsequent Changes in
Asset and Liability Values
Refer to the previous acquisition illustration. Three months
after the acquisition, new information reveals that $15 million of
plant and equipment not belonging to the acquired company
was mistakenly included in the original valuation.
The acquirer’s journal entry to correct the original acquisition:
Goodwill
Plant and equipment
15,000,000
15,000,000
If the equipment dropped in value after the date of
acquisition, the decline in value would be recognized
in income as a loss on equipment.
©Cambridge Business Publishing, 2013
47
Reporting Subsequent Changes in
Contingent Consideration
For value changes caused by events
occurring after the date of acquisition
If contingent
consideration is
reported as equity
If contingent
consideration is
reported as a liability
• No value changes are
reported
• Final settlement
reported in equity
• Changes in value
reported in income at
each reporting date
until the contingency is
resolved
©Cambridge Business Publishing, 2013
48
Contingent Consideration Value
Example
The acquirer records an earnout agreement at $600,000 and a
stock price contingency at $400,000. Four months later, new
information is uncovered, causing the earnout agreement to
increase in value by $500,000.
To report the change in earnout value as a correction to the
original acquisition value:
Goodwill
Earnout liability
500,000
500,000
To report the change in earnout value due to an improvement
in business conditions since the acquisition:
Loss on earnout
Earnout liability
©Cambridge Business Publishing, 2013
500,000
500,000
49
50
Learning Objective 4
Account for bargain purchases.
©Cambridge Business Publishing, 2013
Bargain Purchases
 Occurs when the acquisition cost is less than the
fair value of the identifiable net assets at
acquisition date
 May be the results of a forced sale
 Seller is attempting to avoid bankruptcy or other
financial losses
 To ensure accurate reporting of asset and liability
balances
 Report a gain on the bargain purchase
 BUT double check acquired asset and liability
estimates first.
 Assets may be overvalued, liabilities undervalued
©Cambridge Business Publishing, 2013
51
52
Bargain Purchase Example
An acquirer pays $15 million cash for another company. Fair
values of assets acquired and liabilities assumed are:
Current assets
$ 3,000,000 Brand names
Plant and equipment
42,000,000 Favorable lease agreements
Patents and copyrights
5,000,000 Assembled workforce
Current liabilities
4,000,000 Future potential contracts
Long-term debt
40,000,000 Developed technology
$2,000,000
500,000
60,000,000
12,000,000
8,000,000
To calculate the gain:
Acquisition cost
Fair value of identifiable net assets acquired:
Current assets
Plant and equipment
Patents and copyrights
Brand names
Favorable lease agreements
Developed technology
Current liabilities
Long-term debt
Gain on bargain purchase
©Cambridge Business Publishing, 2013
$15,000,000
$ 3,000,000
42,000,000
5,000,000
2,000,000
500,000
8,000,000
(4,000,000)
(40,000,000)
16,500,000
$ 1,500,000
53
Bargain Purchase Example
continued
To record the bargain purchase:
Current assets
Plant and equipment
Patents and copyrights
Brand names
Favorable lease agreements
Developed technology
Current liabilities
Long-term debt
Cash
Gain on bargain purchase
©Cambridge Business Publishing, 2013
3,000,000
42,000,000
5,000,000
2,000,000
500,000
8,000,000
4,000,000
40,000,000
15,000,000
1,500,000
54
Learning Objective 5
Explain the reporting requirements and
issues related to in-process research and
development and preacquisition
contingencies.
©Cambridge Business Publishing, 2013
In-process
Research and Development
 If acquired in a business combination, must
be reported as an asset
 At fair value
 Regardless of whether there is an alternative
future use
 Reinforces focus on accurate measurement
of assets and liabilities acquired
Differs from internally generated R&D
costs that are expensed immediately.
©Cambridge Business Publishing, 2013
55
56
Preacquisition Contingencies
 An acquired entity has business situations
that will result in gains or losses if and
when a future event occurs
 Such as
 Lawsuits and warranty liabilities
 Result in contingent assets and liabilities
 If the entity is the plaintiff in a lawsuit, a
contingent asset may exist.
 If the entity is the defendant in a lawsuit, a
contingent liability may exist.
©Cambridge Business Publishing, 2013
57
Preacquisition Contingency Categories
 Known assets and liabilities with ‘determined’
or ‘determinable’ fair values
 Recognized at date of acquisition fair value when
that value can be determined during the
measurement period.
 Example: warranties
 Other contingencies
 Recognized at date of acquisition fair value when
these criteria are satisfied during the measurement
period:
 It is probable that a contingent asset or liability
exists on the acquisition date
 The value of the asset or liability can be
reasonably estimated
 Example: Unsettled lawsuit
©Cambridge Business Publishing, 2013
58
IFRS for Business Combinations
 IFRS 3(R) Business Combinations
 IAS 38 Intangible Assets
 IFRS and U.S. GAAP requirements for
business combinations are mostly
converged
 ASC Topic 805 requirements converged to
IFRS
©Cambridge Business Publishing, 2013
59
End of Chapter 2
©Cambridge Business Publishing, 2013