3
Business Combinations
Slide
1-1
Nature of the Combination
Business Combination – is a process whereby operations of
two or more companies are brought under common control.
It refers to a transaction or other event in which an
acquirer obtains control over one or more businesses, i.e.
Creating a Single Economic Entity
Slide
1-2
Nature of the Combination
Business growth. Can occur internally – adding facilities
and expanding markets or externally – by acquiring other
companies.
• Business combinations represent accounting transactions
in which two or more accounting entities (or companies or
groups of net assets that constitute a going concern) are
brought together under common control in a single
accounting entity.
• Doesn't include combination of entities or businesses
Slide
1-3
under the same control
Nature of the Combination

Control over other companies can be obtained by
acquiring all of the target company’s assets or by
acquiring more than 50% of the target company’s
outstanding voting common stock.

Purchase of a group of idle assets or control over a
defunct/shell corporation (i.e. not an operating
business) is not a business combination and dissolution
of legal entities is unnecessary within the accounting
concept.
Slide
1-4
Nature of the Combination
= Combined Enterprise
•In form-one or more legal entity(ies)
Combinor/
Combinee/
Acquiror
Acquiree/
Target
•In substance- only one & single
=
accounting entity
•Substance over form
•Dissolution of legal entities
Constituent
Companies
unnecessary within the accounting
concept
Slide
1-5
Business Combinations: Why?
Advantages of External Expansion: Reasons firms
combine.
1. Rapid expansion
2. Operating synergies
 Revenues
• Increase market power
• Better/more efficient marketing efforts
• Strategic benefits such as entry into new markets
Operating costs (cost advantage or saving)
• Economies of scale (marketing, management,
production, distribution)
• Complementary resources (avoid duplicate efforts)
• Eliminate operating or management inefficiencies
Slide
1-6
Business Combinations: Why?
3. International marketplace
4. Financial synergy
• Income tax-tax gain (savings) through accumulated tax
losses
• Utilization of unused debt capacity
• Reinvestment of surplus funds (free cash flows) as an
alternative to paying dividends or repurchasing stock
5. Diversification: through conglomerate operations
Slide
1-7
Terminology and Types of Combinations
A business combination may be classified as follows:
1.
Nature of the combination
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.
Slide
1-8
Terminology and Types of Combinations
Defensive Tactics against Hostile takeover
1. Poison pill: Issuing stock rights to existing
shareholders; exercisable only in the event of a
potential takeover.
2. Greenmail: Purchasing (own)shares held by acquiring
company at a price substantially in excess of fair value.
The stocks then acquired are kept at treasury or
retired
3. White knight: Encouraging a third firm to acquire or
merge with the target company.
Slide
1-9
Terminology and Types of Combinations
Defensive Tactics (continued)
4. Pac-man defense: Attempting an unfriendly takeover
of the would-be acquiring company.
5. Selling the crown jewels/Scorched Earth: Selling
valuable assets to make the firm less attractive to the
would-be acquirer.
Slide
1-10
Terminology and Types of Combinations
Defensive Tactics (continued)
6. Shark repellent: An acquisition of substantial amounts
of outstanding common stocks for treasury or for
retirement, or the incurring of substantial long-term
debt in exchange for outstanding common stock.
7. Leveraged buyouts: Purchasing a controlling interest
in the target firm by its managers and third-party
investors, who usually incur substantial debt.
Slide
1-11
Terminology and Types of Combinations
2. Economic Structure of Combination
•Horizontal Integration -Combination between companies that are
competitors, within the same industry. For example, two airline
companies combine or two computer software companies combine.
•Vertical Integration - Combination between companies in different
but successive stages of production or distribution. For example, a
manufacturing company merges with a mining company or an
automobile company acquires automobile dealerships.
Slide
1-12
Terminology and Types of Combinations
Conglomerate-
Combination
between
companies
in
unrelated industries or markets. This is a procedure for
companies that want to diversify.
For example, a
manufacturing company acquires a financial services
company.
Slide
1-13
Terminology and Types of Combinations
3. Method of Acquisition/Legal Form
A. Statutory Merger
A Company
A Company
B 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.
Slide
1-14
Terminology and Types of Combinations
B.Statutory Consolidation
A Company
C Company
B 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.
Slide
1-15
Terminology and Types of Combinations
C. Stock Acquisition
A Company
A Company
B Company
B Company
•The
stock acquisition can be made at stock market or
through bid but not statutory
•If
a company acquires a controlling interest in the voting
stock of another company, a parent–subsidiary relationship
results.
Slide
1-16
•
This is the Common means of hostile takeover
Accounting for Business Combinations
Acquisition Method
• Record the combination using the historical-cost principle.
• The general approach for business combinations, whether
a direct purchase of net assets or a purchase of control,
requires determination of:
1.
The acquirer
2. Acquisition date: closing date
3. The consideration transferred on acquisition date.
4. Measure the fair value of the acquiree.
5. Measure and recognize the assets, including goodwill
Slide
1-17
acquired and liabilities assumed at FV.
Accounting for Business Combinations
The acquisition method follows the same GAAP
for recording a business combination as we follow
in recording the purchase of other assets and
the incurrence of liabilities.
We record the combination using the fair value
principle. In other words, we measure the cost to
the purchasing entity of acquiring another
company in a business combination by the amount
of cash disbursed or by the fair value of other
assets distributed or securities issued.
Slide
1-18
Accounting for Business Combinations
•We expense the direct costs of a business combination
(such as accounting, legal, consulting, and finders’ fees)
other than those for the registration or issuance of equity
securities.
•We charge registration and issuance costs of equity
securities issued in a combination against the fair value of
securities issued, usually as a reduction of additional
paid-in capital.
•We expense indirect costs such as management salaries.
We also expense indirect costs incurred to close duplicate
facilities.
Slide
1-19
Accounting for Business Acquisition
To determine the combinor(Acquirer):
a. If cash or other assets are distributed or liabilities
are incurred: In a business combination effected
solely through the distribution of cash or other assets
or by incurring liabilities, the entity that distributes
cash or other assets or incurs liabilities is generally
the acquiring entity.
Slide
1-20
Accounting for Business Acquisition
b. If stock is exchanged: In a business combination
effected through an exchange of equity interests, the
entity that issues the equity interests or receive
larger share of voting rights in the combined
enterprise is generally the acquiring entity.
Slide
1-21
Accounting for Business Acquisition
Determining the Purchase Price, i.e. the Total
Cost of the Acquired Business (Combinee) include:
a. Fair value of the consideration given: Cash or
other assets, Debt, Equity securities
b. Fair value of any contingent consideration given
after acquisition date (Contingencies based on
securities prices do not affect the cost of the
investment above what was recorded at the
acquisition date, but instead represent
Slide
1-22
adjustments to additional paid in capital
Accounting for Business Acquisition
• Contingencies based on other than securities
prices (the current value of the additional
consideration is added to the acquiring company’s
cost of the acquired business)
c. Incidental/Out-of-Pocket Costs incurred in
connection with acquisition
Slide
1-23
Accounting for Business Acquisition
Acquisition expenses
Direct Expenses (Legal, Investment banker consulting
fees Accounting fees such as for a purchase investigation,
Finders’ fees, Travel costs
Indirect Expenses Labor and overhead of internal
acquisitions or merger department & General expenses
diverted to the merger (costs of closing duplicate
facilities, salary for officers involved in the negotiation &
completion of the combination)
Securities Issuance Costs
(legal, under-writing, banking) Such costs are merely
related to the mode of financing
Slide
1-24
Perspective on Business Combinations
Treatment of Acquisition Expenses
both direct and indirect costs are expensed
the cost of issuing securities is also excluded
from the consideration.
Security issuance costs are assigned to the
valuation of the security, thus reducing the
additional contributed capital for stock issues or
adjusting the premium or discount on bond issues.
Slide
1-25
Terminology and Types of Combinations
What Is Acquired?
Net assets of S Company
(Assets and Liabilities)
Statutory Merger
Common Stock
of S Company
Stock Aquisisiton
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. Both assets and liability of acquire are recorded at FV
on the book of acquirer including GW if any.
Slide
1-26
Stock acquisition, control may be obtained by purchasing >50% of
the voting common stock (or possibly less). Investment is recorded
on the book of acquirer at a cost of Business Combination.
Explanation and Illustration of Acquisition Accounting
Example 1: Galaxy Company acquired the assets and assumed the
liabilities of Axis Company. Immediately prior to the acquisition, Axis
Company’s balance sheet was as follows:
Any
Goodwill?
Slide
1-27
Explanation and Illustration of Acquisition Accounting
Example 1 Statutory Merger : Galaxy Company acquired the
assets and assumed the liabilities of Axis Company. Immediately
prior to the acquisition, Axis Company’s balance sheet was as
follows:
Slide
1-28
Explanation and Illustration of Acquisition Accounting
Example 1: A. Prepare the journal entry on the books of
Galaxy Co. to record the purchase of the assets and
assumption of the liabilities of Axis Co. if the amount paid
was $1,680,000 in cash.
Calculation of Goodwill
Fair value of assets
Fair value of liabilities
Fair value of net assets
1,350,000
Price paid
1,680,000
Goodwill
Slide
1-29
$1,944,000
594,000
$ 330,000
Explanation and Illustration of Acquisition Accounting
Example 1: A. Prepare the journal entry on the books of
Galaxy Co. to record the purchase of the assets and
assumption of the liabilities of Axis Co. if the amount paid
was $1,680,000 in cash.
Cash
Receivables
Inventory
120,000
228,000
396,000
Plant and equipment
540,000
Land
660,000
Goodwill
330,000
Liabilities
Cash
Slide
1-30
594,000
1,680,000
Explanation and Illustration of Acquisition Accounting
Bargain Purchase
When the fair values of identifiable net assets (assets
less liabilities) exceeds the total cost of the acquired
company, the acquisition is a bargain.
Current standards require:
 fair values be considered carefully and
adjustments made as needed.
 any excess of acquisition-date fair value of
net assets over the consideration paid is
recognized in income.
Slide
1-31
Explanation and Illustration of Acquisition Accounting
Bargain Acquisition Illustration
When the price paid to acquire another firm is lower
than the fair value of identifiable net assets (assets
minus liabilities), the acquisition is referred to as a
bargain.
Any previously recorded goodwill on the seller’s
books is eliminated (and no new goodwill recorded).
A gain is reflected in current earnings of the
acquirer to the extent that the fair value of net
Slide
1-32
assets exceeds the consideration paid.
Explanation and Illustration of Acquisition Accounting
Example 1: B. Repeat the requirement in (A) assuming that
the amount paid was $1,110,000.
Calculation of Goodwill or Bargain Purchase
Fair value of assets
Fair value of liabilities
Fair value of net assets
Price paid
Gain on Bargain purchase
Slide
1-33
$1,944,000
594,000
1,350,000
1,110,000
$ 240,000
Explanation and Illustration of Acquisition Accounting
Example 1: B. Repeat the requirement in (A) assuming that
the amount paid was $1,110,000.
Cash
Receivables
Inventory
120,000
228,000
396,000
Plant and equipment
540,000
Land
660,000
Liabilities
Cash
Gain on acquisition
Slide
1-34
594,000
1,110,000
240,000
Explanation and Illustration of Acquisition Accounting
Example 2: Stock Acquisition
On January 1, Year 1, Big Company exchanged 10,000 shares
of $10 par value common stock with a fair value of $415,000
for 100% of the outstanding stock of Sub Company in a
business combination properly accounted for as an
acquisition. After combination , both company continue to be
separate legal entity. In addition Big Co. paid $35,000 in
legal fees. At the date of acquisition, the fair value of Sub
Co.'s net assets totaled $300,000 [=600,000-300,000].
Registration fees were $20,000. Journal entry to record the
acquisition:
Investment in Sub net asset…415,000
Legal expense……………………………....35,000
Common stock……………………………………………………….100,000
Additional paid-in capital [315,000-20,000]…………295,000
Slide
1-35
Cash [=35,000 + 20,000]…………………………………..…55,000

Slide
1-36
End