Advanced
Accounting
Jeter ● Chaney
Introduction to Business
Combinations and the
Conceptual Framework
1
Prepared by Sheila Ammons, Austin Community College
Learning Objectives
• Describe historical trends in types of business
combinations.
• Identify the major reasons firms combine.
• Identify the factors that managers should consider in
exercising due diligence in business combinations.
• Identify defensive tactics used to attempt to block
business combinations.
• Distinguish between an asset and a stock acquisition.
2
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Learning Objectives (continued)
• Indicate the factors used to determine the price and the
method of payment for a business combination.
• 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.
• Describe the two alternative views of consolidated
financial statements: the economic entity and the parent
company concepts.
• Discuss the Statements of Financial Accounting Concepts
(SFAC).
• Describe some of the current joint projects of the FASB
and the International Accounting Standards Board
(IASB), and their primary objectives.
3
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Introduction
• On December 4, 2007, FASB released two new standards,
– FASB Statement No. 141 R, Business Combinations, and
– FASB Statement No. 160, Noncontrolling Interests in
Consolidated Financial Statements.
• FASB ASC 805, “Business Combinations” and FASB
ASC 810, “Consolidations.
• These standards
– Became effective for years beginning after December 15,
2008, and
– Are intended to improve the relevance, comparability and
transparency of financial information related to business
combinations, and to facilitate the convergence with
international standards.
4
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Nature of the 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.
5
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Nature of the Combination
Defensive Tactics
– Poison pill: Issuing stock rights to existing
shareholders; exercisable only in the event of a
potential takeover.
– Greenmail: Purchasing shares held by the would-be
acquiring company at a price substantially in excess of
fair value.
– White knight: Encouraging a third firm, more
acceptable to the target company management, to
acquire or merge with the target company.
LO 4 Defensive tactics are used
6
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Nature of the Combination
Defensive Tactics (continued)
– Pac-man defense: Attempting an unfriendly
takeover of the would-be acquiring company.
– Selling the crown jewels: Selling valuable assets to
make the firm less attractive to the would-be
acquirer.
– Leveraged buyouts: Purchasing a controlling
interest in the target firm by its managers and thirdparty investors, who usually incur substantial debt
and subsequently take the firm private.
LO 4 Defensive tactics are used.
7
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Nature of the 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.
LO 4 Defensive tactics are used.
8
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Business Combinations: Why? Why
Not?
Advantages of External Expansion
– Rapid expansion
– Operating synergies
– International marketplace
– Financial synergy
– Diversification
– Divestitures
9
LO 2 Reasons firms combine.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Business Combinations: Historical
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).
10
LO 1 Historical trends in types of M&A.
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Business Combinations: Historical
Perspective
Three distinct periods (continued)
1945 to the present:
– This period started after World War II and has exhibited
rapid growth in merger activity since the mid-1960s.
– There was even more rapid growth since the 1980s.
– By 1996, the number of yearly mergers completed was
nearly 7,000, giving rise to the term merger mania.
– Most agreed that the mania had ending by mid-2002.
– By 2006, merger activity was soaring once more.
11
LO 1 Historical trends in types of M&A.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Business Combinations: Historical
Perspective
Three distinct periods (continued):
1945 to the present: Many of the mergers that occurred
from the 1950s through the 1970s were conglomerate
mergers.
• The primary motivation was often to diversify
business risk.
–In contrast, the 1980s were characterized by a relaxation in
antitrust enforcement and by the emergence of highyield junk bonds to finance acquisitions.
• Deregulation undoubtedly played a role in the
popularity of combinations in the 1990s.
12
LO 1 Historical trends in types of M&A.
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Terminology and Types of
Combinations
What Is Acquired?
Net assets of S Company
(Assets and Liabilities)
Common Stock
of S Company
What Is Given Up?
1. Cash
Illustration 1-3
2. Debt
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).
13
LO 5 Stock versus asset acquisitions.
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Terminology and Types of
Combinations
Possible Advantages of Stock Acquisition
– Lower total cost in many cases.
– Direct formal negotiations with the acquired firm’s
management 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.
– Regulations pertaining to one of the firms do not
automatically extend to the entire merged entity.
14
LO 5 Stock versus asset acquisition.
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Terminology and Types of
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.
15
LO 5 Stock versus asset acquisitions.
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Terminology and Types of
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 the acquired companies (A and B) become
stockholders in the new entity (C).
16
LO 5 Stock versus asset acquisitions.
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Terminology and Types of
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 parent–subsidiary relationship
results.
17
LO 5 Stock versus asset acquisitions.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Terminology and Types of
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
18
LO 5 Stock versus asset acquisitions.
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Takeover Premiums
Takeover Premium – the excess amount offered, or 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 or has assets not reported on the balance sheet.
– Acquirer may believe growth by acquisitions is essential and
competition necessitates a premium.
19
LO 5 Stock versus asset acquisitions.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Avoiding the Pitfalls Before the
Deal
Beware of the following factors:
– 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 have artificially or
temporarily boosted earnings.
– Look for recent changes in estimates, accrual levels, and
methods.
– Be careful of CEO egos.
20
LO 3 Factors to be considered in due diligence.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Avoiding the Pitfalls Before the
Deal
Review Question
When an acquiring company exercises due diligence in
attempting a business combination, it should:
a. be skeptical about accepting the target company’s 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
21
LO 3 Factors to be considered in due diligence.
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Determining Price and Method of Payment in Business 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
(generally defined as the number of shares of the
acquiring company to be exchanged for each share of
the acquired company).
– Each constituent makes two kinds of contributions to
the new entity—net assets and future earnings.
22
LO 6 Factors affecting price and method of payment.
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Determining Price and Method of Payment in Business Combinations
Net Asset and Future Earnings Contributions
• Determination of an equitable price for each constituent
company requires:
– The valuation of each company’s
• net assets and
• expected contribution to the future earnings of the
new entity.
23
LO 6 Factors affecting price and method of payment.
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Determining Price and Method of
Payment
Excess Earnings Approach to Estimate Goodwill
– Step 1:Identify a normal rate of return on assets for firms
similar to the company being targeted.
– Step 2: Apply the rate of return (step 1) to the net assets
of the target to approximate “normal earnings”.
– Step 3: Estimate the expected future earnings of the
target. Exclude any nonrecurring gains or losses.
– Step 4: Subtract the normal earnings (step 2) from the
expected target earnings (step 3). The difference is
“excess earnings”.
24
LO 6 Factors affecting price and method of payment.
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Determining Price and Method of
Payment
Excess Earnings Approach to Estimate Goodwill
(continued)
• Step 5: 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.
• Step 6: Add the estimated goodwill (step 5) to the fair value
of the firm’s net identifiable assets to arrive at a possible
offering price.
25
LO 6 Factors affecting price and method of payment.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Determining Price and Method of
Payment
Review Question
A potential offering price for a company is computed by
adding the estimated goodwill to the
a. book value of the company’s net assets.
b. book value of the company’s identifiable assets.
c. fair value of the company’s net assets.
d. fair value of the company’s identifiable net assets.
26
LO 6 Factors affecting price and method of payment.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Determining Price and Method of
Payment
Exercise 1-1: Plantation Homes Company is considering the
acquisition of Condominiums, Inc. early in 2015. 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.
27
LO 7 Estimating goodwill.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Determining Price and Method of
Payment
Exercise 1-1: (continued)
B. Condominiums, Inc.’s pretax incomes for the years 2012
through 2014 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)
960,000
Depreciation on equipment (each year)
50,000
Extraordinary loss (year 2014)
300,000
Sales commissions (each year)
250,000
C. The normal rate of return on net assets is 15%.
28
LO 7 Estimating goodwill.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Determining Price and Method of
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.
29
LO 7 Estimating goodwill.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Determining Price and Method of
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
Fair value of liabilities
Fair value of net assets
Normal rate of return
Normal earnings
$15,000,000
8,800,000
6,200,000
15%
$ 930,000
30
LO 7 Estimating goodwill.
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Determining Price and Method of
Payment
Step 3 Estimate the expected future earnings of the target. Exclude any
nonrecurring gains or losses.
Pretax income of Condominiums, Inc., 2012
Subtract: Additional depreciation on building ($960,000 x 30%)
Target’s adjusted earnings, 2012
$
Pretax income of Condominiums, Inc., 2013
Subtract: Additional depreciation on building
Target’s adjusted earnings, 2013
Pretax income of Condominiums, Inc., 2014
Add: Extraordinary loss
Subtract: Additional depreciation on building
Target’s adjusted earnings, 2014
Target’s three year total adjusted earnings
Target’s three year average adjusted earnings ($3,086,000 / 3)
1,200,000
(288,000)
$
912,000
1,500,000
(288,000)
1,212,000
950,000
300,000
(288,000)
$
962,000
3,086,000
1,028,667
31
LO 7 Estimating goodwill.
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Determining Price and Method of
Payment
Step 4 Subtract the normal earnings (step 2) from the expected target
earnings (step 3). The difference is “excess earnings.”
Expected target earnings
Less: Normal earnings
Excess earnings, per year
$1,028,667
930,000
$ 98,667
32
LO 7 Estimating goodwill.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Determining Price and Method of
Payment
Step 5
Compute estimated goodwill from “excess earnings.”
Present value of excess earnings (perpetuity) at 25%:
Excess earnings
$ 98,667
=
$394,668
25%
Estimated
Goodwill
Step 6 Add the estimated goodwill (step 5) to the fair value of the firm’s
net identifiable assets to arrive at a possible offering price.
Net assets
$6,200,000
Estimated goodwill
Implied offering price
394,668
$6,594,668
33
LO 7 Estimating goodwill.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Determining Price and Method of
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.
34
LO 7 Estimating goodwill.
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Determining Price and Method of
Payment
Part B
Excess earnings of target (same a Part A)
$
98,667
PV factor (ordinary annuity, 3 years, 15%)
x
2.28323
Estimated goodwill
$
225,279
Fair value of net assets
Implied offering price
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.
35
LO 7 Estimating goodwill.
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Alternative Concepts of Consolidated Financial Statements
Parent Company Concept - Primary purpose of consolidated
financial statements is to provide information relevant to the
controlling stockholders. Emphasis is placed on the needs of
the controlling stockholders.
– The noncontrolling interest is presented as a liability or
as a separate component before stockholders’ equity.
• Economic Entity Concept - Affiliated companies are a
separate, identifiable economic entity. Both controlling and
noncontrolling stockholders contribute to the economic
unit’s capital.
– The noncontrolling interest presented as a component of
stockholders’ equity.
36
LO 8 Economic entity and parent company concepts.
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Alternative 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 realized combined income of the
parent company and its subsidiaries. Total combined
income is then allocated proportionately to the
noncontrolling interest and the controlling interest.
37
LO 8 Economic entity and parent company concepts.
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Alternative 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
company’s 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.
38
LO 8 Economic entity and parent company concepts.
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Alternative 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.
39
LO 8 Economic entity and parent company concepts.
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Alternative Concepts
Intercompany Profit
• Two alternative points of view:
– Total (100%) elimination.
– 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 company’s
share of the unconfirmed intercompany profit is
eliminated.
40
LO 8 Economic entity and parent company concepts.
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Conceptual Framework
Illustration 1- 5
Conceptual
Framework for
Financial
Accounting and
Reporting
41
LO 8 Economic entity and parent company concepts.
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FASB’s Conceptual 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” or representationally faithful values
(SFAC No. 8).
LO 8 Economic entity and parent company concepts.
LO 9 Statements of Financial Accounting Concepts.
42
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FASB’s Conceptual Framework
Economic Entity vs. Parent Concept and the Conceptual
Framework
The economic entity assumption
 views a parent and its subsidiaries as one economic entity.
 can be argued to produce more relevant, if not necessarily
reliable, information for users.
 is an integral part of the FASB’s conceptual framework
(named in SFAC No. 5 as one of the basic assumptions in
accounting).
• The recent shift to the economic entity concept seems to be
entirely consistent with the assumptions laid out by the
FASB for GAAP.
LO 8 Economic entity and parent company concepts.
LO 9 Statements of Financial Accounting Concepts.
43
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FASB’s Conceptual Framework
Overview of FASB’s Conceptual Framework (SFAC)
The Statements of Financial Accounting Concepts issued by the
FASB include:
No.4 Objectives of Financial Reporting by Nonbusiness
Organizations
No.5 Recognition and Measurement in Financial Statements of
Business Enterprises
No.6 Elements of Financial Statements (replaces SFAC No. 3)
No.7 Using Cash Flow Information and Present Value in
Accounting Measurements
No.8 The Objective of General Purpose Financial Reporting and
Qualitative Characteristics of Useful Information
(replaces SFAC No. 1 and No. 2)
44
LO 9 Statements of Financial Accounting Concepts.
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FASB’s Conceptual 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 these gains and losses 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”.
45
LO 9 Statements of Financial Accounting Concepts.
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FASB’s Conceptual 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
entity’s 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.
46
LO 9 Statements of Financial Accounting Concepts.
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FASB Codification (Source of
GAAP)
On July 1, 2009, the FASB launched the FASB Accounting
Standards Codification.
– Single source of authoritative nongovernmental U.S.
GAAP, effective for interim and annual periods ending
after September 15, 2009.
– All existing accounting standards documents are
superseded as described in FASB Statement No. 168,
“The FASB Accounting Standards Codification and the
Hierarchy of Generally Accepted Accounting Principles.”
• All other accounting literature not included in the
Codification is nonauthoritative.
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FASB Codification (Source of
GAAP)
The Codification
•Is intended to simplify the classification of existing
and future standards by restructuring all
authoritative U.S. GAAP (other than that for
governmental entities) into one online database
under a common referencing system.
•Replaces the GAAP hierarchy.
Authoritative
Nonauthoritative
48
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FASB Codification (Source of
GAAP)
Structure of the Codification
– Roughly 90 accounting topics
– Contains four groupings of numbers:
topic, subtopic, section, and paragraph
•The code 450-20-25-2 refers to topic 450
(‘contingencies’); subtopic 20 ( loss
‘contingencies’); section 25 (recognition); and 2
(second paragraph).
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FASB Codification (Source of
GAAP)
a. Financial Accounting Standards Board (FASB)
1. Statements (FAS)
2. Interpretations (FIN)
3. Technical Bulletins (FTB)
4. Staff Positions (FSP)
5. Staff Implementation Guides (Q&A)
6. Statement No. 138 Examples
b. Emerging Issues Task Force (EITF)
1. Abstracts
2. Topic D
c. Derivative Implementation Group (DIG) Issues
d. Accounting Principles Board (APB) Opinions
e. Accounting Research Bulletins (ARB)
f. Accounting Interpretations (AIN)
g. American Institute of Certified Public Accountants (AICPA)
1. Statements of Position (SOP)
2. Audit and Accounting Guides (AAG)—only incremental accounting guidance
3. Practice Bulletins (PB), including the Notices to Practitioners elevated to Practice
Bulletin status by Practice Bulletin 1
4. Technical Inquiry Service (TIS)—only for Software Revenue Recognition
Literature
included in the
Codification
50
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FASB Codification (Source of
GAAP)
Standards issued by the SEC
To increase the utility of the Codification for public companies,
relevant portions of authoritative content issued by the SEC and
selected SEC staff interpretation and administrative guidance
have been included for reference in the Codification, such as:
– Regulation S-X (SX)
– Financial Reporting Releases (FRR)/Accounting Series
Releases (ASR)
– Interpretive Releases (IR)
– SEC Staff guidance in
• Staff Accounting Bulletins (SAB)
• EITF Topic D and SEC Staff Observer comments.
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FASB Codification (Source of
GAAP)
Changes to GAAP: Updating the FASB Standards
Updates to the Codification are called Accounting
Standards Updates and are referenced as ASU YYYYxx, where
– Ys indicate the year the update was approved and
– xx represents the number of the update for that year.
52
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