1
What is a Business Combination?
 Occurs when one company obtains control
over another company
 Referred to as
 Merger
 Acquisition
 Takeover
 Sought out when the acquiring firm’s
management believes it can accomplish its
objectives more efficiently and at lower cost
©Cambridge Business Publishing, 2010
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Motivations for Acquisitions
 To facilitate relationships with other
companies as suppliers, subcontractors,
customers
 To add new facilities and capabilities
 To control a source of supply
 To add production or distribution facilities
 To achieve customer relationships
 To expand into new geographic markets
 To diversify into new lines of business
©Cambridge Business Publishing, 2010
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Advantages of Acquiring a Company
 Going concern is less costly
 Eliminates the need to start from scratch
 Avoids duplication of efforts that exist from
growth from within
 Competition is often reduced
 Complementary products or services can
lead to increased overall sales
©Cambridge Business Publishing, 2010
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Top M&A Deals Worldwide, 2000-2007
Exhibit 2.1
©Cambridge Business Publishing, 2010
5
Types of Combinations
Statutory merger
Statutory consolidation
Asset acquisition
Stock acquisition
©Cambridge Business Publishing, 2010
Stock
transactions
governed by
State laws
All assets
acquired and
liabilities
assumed are
recorded directly
on the books of
the acquiring
company
6
Statutory Merger Example
IBM pays $10 million in cash to acquire DataFile, Inc. on January
1, 2010. The fair values of DataFile’s assets and liabilities are:
Account
Current assets
Equipment
Patents and copyrights
Current liabilities
Long-term debt
Fair Value
$ 5,000,000
45,000,000
10,000,000
15,000,000
35,000,000
To record the acquisition of DataFile, Inc:
Current assets
Equipment
Patents and copyrights
Current liabilities
Long-term debt
Cash
©Cambridge Business Publishing, 2010
5,000,000
45,000,000
10,000,000
15,000,000
35,000,000
10,000,000
7
Statutory Merger Results
 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
 Acquired assets and liabilities
 Recorded at fair value at the date of
acquisition
 Acquiring company’s net assets are not
revalued
©Cambridge Business Publishing, 2010
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Statutory Consolidation
 New corporation absorbs both companies
 Identify one of the companies as the
acquirer
 Only the acquired company’s assets and
liabilities are reported by the new
corporation at fair value on date of
acquisition
©Cambridge Business Publishing, 2010
9
Stock Acquisition
 Occurs when a company acquires most or all
of the voting stock of another company
 Each firm continues as a separate legal entity
 Investment in the acquired firm treated as an
intercorporate investment
 Consolidation working paper used to combine
the two companies’ results
To record the investment in stock:
Investment in DataFile, Inc. 10,000,000
Cash
10,000,000
©Cambridge Business Publishing, 2010
10
Goodwill
Goodwill exists if price paid by acquirer exceeds the
total fair value of the specific net assets acquired.
 Excess price paid occurs due to value attributable
 To a company’s reputation, and
 To a company’s competitive strengths
 Amount is capitalized as goodwill, an intangible
asset
©Cambridge Business Publishing, 2010
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Calculating Goodwill
IBM pays $10 million in cash to acquire DataFile, Inc. on January
1, 2010. The fair value of DataFile’s assets and liabilities are:
Current assets
$ 5,000,000 Current liabilities $15,000,000
Equipment
45,000,000 Long-term debt
35,000,000
Patents and copyrights 10,000,000
Goodwill is the excess of amount paid over the fair value
of net assets acquired:
Acquisition cost
$10,000,000
Fair value of identifiable net assets acquired:
Current assets
$ 5,000,000.
Equipment
45,000,000.
Patents and copyrights
2,000,000.
Current liabilities
(15,000,000)
Long-term debt
(35,000,000) 2,000,000
Goodwill
$ 8,000,000
©Cambridge Business Publishing, 2010
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Recording an Acquisition with Goodwill
To record the acquisition with goodwill at $8,000,000.
Current assets
Equipment
Patents and copyrights
Goodwill
Current liabilities
Long-term debt
Cash
©Cambridge Business Publishing, 2010
5,000,000
45,000,000
2,000,000
8,000,000
15,000,000
35,000,000
10,000,000
Evolution of Reporting Business
Combinations
From 1970 to 2001, two accounting methods
existed:
Purchase Method
Pooling Method
Viewed as an
acquisition of one
business by
another
Viewed as a union
of two previously
separate
companies
©Cambridge Business Publishing, 2010
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Current U.S. GAAP for Business
Combinations
Exhibit 2.3
©Cambridge Business Publishing, 2010
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Business Combinations Defined
 Occurs when control is obtained over one
or more businesses
 When is control obtained?
 Direct acquisition of the assets and liabilities of
the acquired company
 Statutory merger
 Consolidation
 Asset acquisition
Control is
obvious
 Obtaining a controlling interest in the voting
shares of the acquired company
 Stock acquisition
©Cambridge Business Publishing, 2010
Control must
be evaluated
Transactions Excluded as Business
Combinations
Not covered under SFAS 141(R)
 Formation of a joint venture by existing
companies
 Establishing a new business as a separate
subsidiary
 Combining companies already under
common control
©Cambridge Business Publishing, 2010
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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, 2010
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Identifying the Acquiring Company
 Acquiring company distributes cash or
other assets and/or incurs liabilities
 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, 2010
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Measuring Assets and Liabilities
Acquisition
cost
Greater
Than
Acquisition
cost
©Cambridge Business Publishing, 2010
Less
Than
Fair value of
the net assets
acquired
Report
goodwill
Fair value of
the net assets
acquired
A bargain
purchase
exists.
Report a
gain.
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Estimation of Fair Values
Exhibit 2.4
©Cambridge Business Publishing, 2010
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Identification of Previously Unreported
Intangibles
 Two criteria leading to separate recognition
as an 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
Separability Criterion
©Cambridge Business Publishing, 2010
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Examples of Identifiable Intangible Assets
Contract-based
intangible
assets
Marketingrelated
intangible
assets
©Cambridge Business Publishing, 2010
• Lease, franchise, licensing
agreements
• Construction permits
• Employment contracts
• Broadcast rights
• Mineral rights
•
•
•
•
•
Brand names
Trademarks
Internet domain names
Newspaper mastheads
Non-competition agreements
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Examples of Identifiable Intangible Assets
Customer-related
intangible assets
• Customer lists
• Order backlogs
• Customer contracts
Technology-based
intangible assets
•
•
•
•
Artistic-based
intangible assets
©Cambridge Business Publishing, 2010
•
•
•
•
•
Patent rights
Computer software
Databases
Trade secrets
Television programs
Motion pictures and videos
Recordings
Books and photographs
Advertising jingles
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Goodwill
 Excess of acquisition cost over fair value of
identifiable net assets acquired
 Included as goodwill under SFAS 141(R)
 Assembled workforce
 Employees in place and able to run the business
 Potential contracts
 Being negotiated with prospective customers
 Long-standing customer relationships
 Favorable locations
 Business reputation
©Cambridge Business Publishing, 2010
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Valuation of Intangibles
 General measurement rules of SFAS 157
apply
 Level 1: Quoted prices in an active market for
identical assets
 Level 2: Quoted market prices for similar
assets, adjusted for the attributes of the assets
in question
 Level 3: Valuation based on unobservable
estimated attributes
Always valued in the context of highest and best use
©Cambridge Business Publishing, 2010
Three Approaches to Valuation
(SFAS 157)
 Market
 Quoted market prices of identical or similar
assets
 Income
 Valuation models used to calculate the present
value of future cash flows or earnings
 Cost
 Estimation of replacement cost of the services
provided by the asset
©Cambridge Business Publishing, 2010
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Illustration of Reporting Assets Acquired
and Liabilities Assumed
27
IBM pays $25 million in cash to acquire DataFile Inc. on July 1,
2010. Fair value of DataFile’s reported assets and liabilities are:
Current assets
Equipment
Patents and copyrights
$ 2,000,000
60,000,000
5,000,000
Current liabilities
Long-term debt
$10,000,000
40,000,000
Identified and valued unreported intangible assets are:
Brand names
$1,000,000
Favorable lease agreements
600,000
Assembled workforce
5,000,000
In-process contracts with potential customers 2,000,000
Contractual customer relationships
3,000,000
Identifiable
intangibles
Unreported intangible assets
©Cambridge Business Publishing, 2010
Illustration of Reporting Assets Acquired
and Liabilities Assumed
continued
Determining goodwill for the acquisition of DataFile Inc. for
$25 million cash:
Acquisition cost
$25,000,000
Fair value of identifiable net assets acquired:
Current assets
$2,000,000.
Plant and equipment
60,000,000.
Patents and copyrights
5,000,000.
Brand names
1,000,000.
Favorable lease agreements
600,000.
Contractual customer relationships
3,000,000.
Current liabilities
(10,000,000)
Long-term debt
(40,000,000) 21,600,000
Goodwill
$3,400,000
©Cambridge Business Publishing, 2010
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Illustration of Reporting Assets Acquired
and Liabilities Assumed
29
continued
Recording the acquisition of DataFile Inc for $25 million cash:
Current assets
Plant and equipment
Patents and copyrights
Brand names
Favorable lease agreements
Contractual customer relationships
Goodwill
Current liabilities
Long-term debt
Cash
©Cambridge Business Publishing, 2010
2,000,000
60,000,000
5,000,000
1,000,000
600,000
3,000,000
3,400,000
10,000,000
40,000,000
25,000,000
30
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
 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, 2010
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Earnings Contingency
 Derives from the beliefs of the former
shareholders that they are entitled to more
consideration given their company will bolster
postcombination earnings
 Also known as earnouts
 Expected payments increase the acquisition
cost
 Often based on performance goals for
 Revenue
 Cash from operations
©Cambridge Business Publishing, 2010
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Out-of-Pocket Acquisition-Related Costs
 Not included with acquisition costs
 Why? Do not increase the value of the
acquired business
 Examples of out-of-pocket costs
 Outside consulting fees and advisory services
 Lawyers
 Accountants
 Security registration costs
 Reduce the net value of the equity accounts
affected
 Do not increase total acquisition costs
©Cambridge Business Publishing, 2010
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Acquisition-Related Restructuring Costs
 Must be expensed as incurred under SFAS
141(R)
 Do not affect acquisition costs
 Costs included
 Shutting down departments
 Reassigning or eliminating jobs
 Changing supplier or production practices in
connection with the combination
©Cambridge Business Publishing, 2010
Reporting Consideration Given in an
Acquisition Example
34
IBM pays acquires DataFile Inc. on July 1, 2010. The deal is
structured as:
Cash paid to former owners of DataFile
Fair value of stock issued to former owners of DataFile:
1,000,000 shares, par value $.50
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
$3,000,000
20,000,000
600,000
1,200,000
1,500,000
800,000
Fair value of DataFile’s reported assets and liabilities are:
Current assets
Plant and equipment
Patents and copyrights
Current liabilities
Long-term debt
©Cambridge Business Publishing, 2010
$ 2,000,000
60,000,000
5,000,000
10,000,000
40,000,000
Brand Names
Favorable lease agreements
Assembled workforce
In-process contracts with potential customers
Contractual customer relationships
$1,000,000
600,000
5,000,000
2,000,000
3,000,000
Reporting Consideration Given in an
Acquisition Example
continued
IBM calculates goodwill for the acquisition of DataFile Inc. as:
Acquisition cost
Cash to former owners of DataFile
$3,000,000
Cash paid for registration fees
600,000
Fair value of stock issued, net
19,400,000
Fair value of earnout
1,500,000
Fair value of stock contingency
800,000
Fair value of identifiable net assets acquired:
Current assets
$2,000,000
Plant and equipment
60,000,000
Patents and copyrights
5,000,000
Brand names
1,000,000
Favorable lease agreements
600,000
Contractual customer relationships
3,000,000
Current liabilities
(10,000,000)
Long-term debt
(40,000,000)
Goodwill
©Cambridge Business Publishing, 2010
$25,300,000
21,600,000
$3,700,000
35
Reporting Consideration Given in an
Acquisition Example
continued
IBM records the acquisition of DataFile Inc. as:
Current assets
2,000,000
Plant and equipment
60,000,000
Patents and copyrights
5,000,000
Brand names
1,000,000
Favorable lease agreements
600,000
Contractual customer relationships
3,000,000
Goodwill
3,700,000
Merger expenses
1,200,000
Current liabilities
Long-term debt
Earnout liability
Common stock, $.50 par
Additional paid-in-capital--stock issue
Additional paid-in-capital--stock contingency
Cash
©Cambridge Business Publishing, 2010
10,000,000
40,000,000
1,500,000
500,000
18,900,000
800,000
4,800,000
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37
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, 2010
38
Measurement Period
 Defined as the period during which value
changes may be reported as corrections to
the initial acquisition entry (SFAS 141(R))
 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, 2010
Reporting Subsequent Changes in Asset
and Liability Values
IBM pays acquires DataFile Inc. on July 1, 2010. Three months
after acquisition, new information reveals that equipment not
belonging to DataFile was mistakenly included in the original
valuation and the actual equipment fair value was $40 million
instead of $60 million.
IBM’s journal entry to correct the original acquisition:
Goodwill
Plant and equipment
20,000,000
20,000,000
If the equipment dropped in value after the date of
acquisition, the decline in value would be recognized
as a loss on equipment with no change to the original
equipment cost.
©Cambridge Business Publishing, 2010
39
40
Bargain Purchases
 Occurs when the acquisition cost is less
than the fair value of the acquired net
assets at acquisition date
 May be the results of a forced sale
 Seller is attempting to avoid bankruptcy or
other financial losses
 Report a gain on the bargain purchase
 Ensures accurate reporting of asset and
liability balances
©Cambridge Business Publishing, 2010
41
Bargain Purchase Example
IBM acquires DataFile Inc. for $20 million cash with the following
fair values of assets acquired and liabilities assumed:
Current assets
$ 2,000,000 Brand names
Plant and equipment
60,000,000 Favorable lease agreements
Patents and copyrights
5,000,000 Assembled workforce
Current liabilities
10,000,000 In-process contracts with potential customers
Long-term debt
40,000,000 Contractual customer relationships
$1,000,000
600,000
5,000,000
2,000,000
3,000,000
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
Contractual customer relationships
Current liabilities
Long-term debt
Gain on bargain purchase
©Cambridge Business Publishing, 2010
$20,000,000
$2,000,000
60,000,000
5,000,000
1,000,000
600,000
3,000,000
(10,000,000)
(40,000,000)
21,600,000
$1,600,000
42
Bargain Purchase Example
continued
IBM acquires DataFile Inc. for $20 million cash with the following
fair values of assets acquired and liabilities assumed:
Current assets
$ 2,000,000 Brand names
Plant and equipment
60,000,000 Favorable lease agreements
Patents and copyrights
5,000,000 Assembled workforce
Current liabilities
10,000,000 In-process contracts with potential customers
Long-term debt
40,000,000 Contractual customer relationships
$1,000,000
600,000
5,000,000
2,000,000
3,000,000
To record the bargain purchase:
Current assets
Plant and equipment
Patents and copyrights
Brand names
Favorable lease agreements
Contractual customer relationships
Current liabilities
Long-term debt
Cash
Gain on bargain purchase
©Cambridge Business Publishing, 2010
2,000,000
60,000,000
5,000,000
1,000,000
600,000
3,000,000
10,000,000
40,000,000
20,000,000
1,600,000