Slide1-2Introduction to BusinessCombinations and theConceptual FrameworkAdvanced Accounting, Fifth Edition1
Slide1-31. Describe historical trends in types of business combinations.2. Identify the major reasons firms combine.3. Identify the factors that managers should consider in exercising due diligence inbusiness combinations.4. Identify defensive tactics used to attempt to block business combinations.5. Distinguish between an asset and a stock acquisition.6. Indicate the factors used to determine the price and the method of payment for abusiness combination.7. Calculate an estimate of the value of goodwill to be included in an offering price bydiscounting expected future excess earnings over some period of years.8. Describe the two alternative views of consolidated financial statements: the economicentity and the parent company concepts.9. List and discuss each of the Statements of Financial Accounting Concepts (SFAC).10. Describe some of the current joint projects of the FASB and the InternationalAccounting Standards Board (IASB), and their primary objectives.Learning Objectives
Slide1-4On December 4, 2007, FASB released two new standards, FASB Statement No. 141 R, Business Combinations, and FASB Statement No. 160, Noncontrolling Interests inConsolidated Financial Statements. [ASC 805, ―BusinessCombinations‖ and ASC 810, ―Consolidations‖, based on FASB‘s newcodification system]These standards Became effective for years beginning after December 15,2008, and Are intended to improve the relevance, comparability andtransparency of financial information related to businesscombinations, and to facilitate the convergence withinternational standards.Introduction
Slide1-5Business Combination - operations of two or morecompanies are brought under common control.Nature of the CombinationA business combination may be:Friendly - the boards of directors of the potentialcombining companies negotiate mutually agreeableterms of a proposed combination.Unfriendly (hostile) - the board of directors of acompany targeted for acquisition resists thecombination.
Slide1-6Defensive TacticsNature of the Combination1. Poison pill: Issuing stock rights to existingshareholders; exercisable only in the event of apotential takeover.2. Greenmail: Purchasing shares held by acquiringcompany at a price substantially in excess of fair value.3. White knight: Encouraging a third firm to acquire ormerge with the target company.
Slide1-7Defensive Tactics (continued)Nature of the Combination4. Pac-man defense: Attempting an unfriendly takeoverof the would-be acquiring company.5. Selling the crown jewels: Selling valuable assets tomake the firm less attractive to the would-be acquirer.6. Leveraged buyouts: Purchasing a controlling interestin the target firm by its managers and third-partyinvestors, who usually incur substantial debt.
Slide1-8The defense tactic that involves purchasing shares heldby the would-be acquiring company at a pricesubstantially in excess of their fair value is calleda. poison pill.b. pac-man defense.c. greenmail.d. white knight.Review QuestionNature of the Combination
Slide1-10Three distinct periodsBusiness Combinations: Historical Perspective1880 through 1904, huge holding companies, or trusts, werecreated to establish monopoly control over certain industries(horizontal integration).1905 through 1930, to bolster the war effort, thegovernment encouraged business combinations to obtaingreater standardization of materials and parts and todiscourage price competition (vertical integration).LO 1 Describe historical trends in types of business combinations.
Slide1-11Three distinct periodsBusiness Combinations: Historical Perspective1945 to the present, many of the mergers that occurredfrom the 1950s through the 1970s were conglomeratemergers.In contrast, the 1980s were characterized by a relaxation inantitrust enforcement and by the emergence of high-yieldjunk bonds to finance acquisitions.Deregulation undoubtedly played a role in the popularity ofcombinations in the 1990s.LO 1 Describe historical trends in types of business combinations.
Slide1-12Asset acquisition, a firm must acquire 100% of the assets of theother firm.Stock acquisition, control may be obtained by purchasing 50% ormore of the voting common stock (or possibly less).Terminology and Types of CombinationsLO 5 Distinguish between an asset and a stock acquisition.What Is Acquired? What Is Given Up?Net assets of S Company(Assets and Liabilities)Common Stockof S Company1. Cash2. Debt3. Stock4. Combination ofaboveFigure 1-1
Slide1-13Possible Advantages of Stock AcquisitionLower total cost.Direct formal negotiations may be avoided.Maintaining the acquired firm as a separate legalentity.Liability limited to the assets of the individualcorporation.Greater flexibility in filing individual or consolidatedtax returns.Terminology and Types of CombinationsLO 5 Distinguish between an asset and a stock acquisition.
Slide1-14Classification by Method of AcquisitionTerminology and Types of CombinationsLO 5 Distinguish between an asset and a stock acquisition.A Company B Company A Company+ =Statutory MergerOne company acquires all the net assets of anothercompany.The acquiring company survives, whereas the acquiredcompany ceases to exist as a separate legal entity.
Slide1-15Classification by Method of AcquisitionTerminology and Types of CombinationsLO 5 Distinguish between an asset and a stock acquisition.A Company B Company C Company+ =Statutory ConsolidationA new corporation is formed to acquire two or more othercorporations through an exchange of voting stock; theacquired corporations then cease to exist as separate legalentities.Stockholders of A and B become stockholders in C.
Slide1-16Classification by Method of AcquisitionTerminology and Types of CombinationsLO 5 Distinguish between an asset and a stock acquisition.FinancialStatements ofA CompanyFinancialStatements ofB CompanyConsolidatedFinancialStatements ofA Company andB Company+ =Consolidated Financial StatementsWhen a company acquires a controlling interest in thevoting stock of another company, a parent–subsidiaryrelationship results.
Slide1-17When a new corporation is formed to acquire two ormore other corporations and the acquired corporationscease to exist as separate legal entities, the result is astatutorya. acquisition.b. combination.c. consolidation.d. mergerReview QuestionTerminology and Types of CombinationsLO 5 Distinguish between an asset and a stock acquisition.
Slide1-18Takeover Premium – the excess amount agreed upon in anacquisition over the prior stock price of the acquired firm.Possible reasons for the premiums:Acquirers‘ stock prices may be at a level which makes itattractive to issue stock (rather than cash) in theacquisition.Credit may be generous for mergers and acquisitions.Bidders may believe target firm is worth more than itscurrent market value.Acquirer may believe growth by acquisitions is essential andcompetition necessitates a premium.Takeover PremiumsLO 5 Distinguish between an asset and a stock acquisition.
Slide1-19The factors to beware of include the following:Be cautious in interpreting any percentages.Do not neglect to include assumed liabilities in theassessment of the cost of the merger.Watch out for the impact on earnings of the allocation ofexpenses and the effects of production increases, standardcost variances, LIFO liquidations, and byproduct sales.Note any nonrecurring items that may boost earnings.Be careful of CEO egos.Avoiding the Pitfalls Before the DealLO 3 Factors to be considered in due diligence.
Slide1-20When an acquiring company exercises due diligence inattempting a business combination, it should:a. be skeptical about accepting the target company‘sstated percentagesb. analyze the target company for assumed liabilities aswell as assetsc. look for nonrecurring items such as changes inestimatesd. all the aboveReview QuestionAvoiding the Pitfalls Before the DealLO 3 Factors to be considered in due diligence.
Slide1-21When a business combination is effected by a stockswap, or exchange of securities, both price and methodof payment problems arise. The price is expressed as a stock exchange ratio(generally defined as the number of shares of the acquiring company to beexchanged for each share of the acquired company). Each constituent makes two kinds of contributions tothe new entity—net assets and future earnings.Determining Price and Method of Paymentin Business CombinationsLO 6 Factors affecting price and method of payment.
Slide1-22Net Asset and Future Earnings ContributionsDetermining Price and Method of Paymentin Business CombinationsLO 6 Factors affecting price and method of payment.Determination of an equitable price for eachconstituent company requires:The valuation of each company‘s net assets andEach company‘s expected contribution to the futureearnings of the new entity.
Slide1-23Excess Earnings Approach to Estimate GoodwillLO 6 Factors affecting price and method of payment.Step 1:Identify a normal rate of return on assets for firmssimilar to the company being targeted.Step 2: Apply the rate of return (step 1) to the net assets ofthe 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 theexpected target earnings (step 3). The difference is―excess earnings.‖Determining Price and Method of Payment
Slide1-24Excess Earnings Approach to Estimate GoodwillLO 6 Factors affecting price and method of payment.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 theexcess earnings by the discount rate.For finite time periods, compute the present value of anannuity.Determining Price and Method of PaymentStep 6: Add the estimated goodwill (step 5) to the fair valueof the firm‘s net identifiable assets to arrive at apossible offering price.
Slide1-25A potential offering price for a company is computed byadding the estimated goodwill to thea. 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.Review QuestionLO 6 Factors affecting price and method of payment.Determining Price and Method of Payment
Slide1-26Exercise 1-1: Plantation Homes Company is considering theacquisition of Condominiums, Inc. early in 2008. To assess theamount it might be willing to pay, Plantation Homes makes thefollowing computations and assumptions.A. Condominiums, Inc. has identifiable assets with a total fairvalue of $15,000,000 and liabilities of $8,800,000. The assetsinclude office equipment with a fair value approximating bookvalue, buildings with a fair value 30% higher than book value,and land with a fair value 75% higher than book value. Theremaining lives of the assets are deemed to be approximatelyequal to those used by Condominiums, Inc.LO 7 Estimating goodwill.Determining Price and Method of Payment
Slide1-27Exercise 1-1: (continued)B. Condominiums, Inc.‘s pretax incomes for the years 2005through 2007 were $1,200,000, $1,500,000, and $950,000,respectively. Plantation Homes believes that an average ofthese earnings represents a fair estimate of annual earningsfor the indefinite future. The following are included in pretaxearnings:Depreciation on buildings (each year) 960,000Depreciation on equipment (each year) 50,000Extraordinary loss (year 2007) 300,000Sales commissions (each year) 250,000LO 7 Estimating goodwill.Determining Price and Method of PaymentC. The normal rate of return on net assets is 15%.
Slide1-28Exercise 1-1: (continued)Required:A. Assume further that Plantation Homes feels that it mustearn a 25% return on its investment and that goodwill isdetermined by capitalizing excess earnings. Based on theseassumptions, calculate a reasonable offering price forCondominiums, Inc. Indicate how much of the price consistsof goodwill. Ignore tax effects.LO 7 Estimating goodwill.Determining Price and Method of Payment
Slide1-29Exercise 1-1: (Part A)LO 7 Estimating goodwill.Determining Price and Method of PaymentStep 1 Identify a normal rate of return on assetsfor firms similar to the company being targeted.Excess Earnings Approach15%Step 2 Apply the rate of return (step 1) to the net assets ofthe target to approximate ―normal earnings.‖Fair value of assets $15,000,000Fair value of liabilities 8,800,000Fair value of net assets 6,200,000Normal rate of return 15%Normal earnings $ 930,000
Slide1-30Determining Price and Method of PaymentStep 3 Estimate the expected future earnings of the target.Exclude any nonrecurring gains or losses.Pretax income of Condominiums, Inc., 2005 1,200,000$Subtract: Additional depreciation on building ($960,000 x 30%) (288,000)Target’s adjusted earnings, 2005 912,000$Pretax income of Condominiums, Inc., 2006 1,500,000Subtract: Additional depreciation on building (288,000)Target’s adjusted earnings, 2006 1,212,000Pretax income of Condominiums, Inc., 2007 950,000Add: Extraordinary loss 300,000Subtract: Additional depreciation on building (288,000)Target’s adjusted earnings, 2007 962,000Target’s three year total adjusted earnings 3,086,000Target’s three year average adjusted earnings ($3,086,000 / 3) 1,028,667$LO 7 Estimating goodwill.
Slide1-31Determining Price and Method of PaymentStep 4 Subtract the normal earnings (step 2) from theexpected target earnings (step 3). The difference is ―excessearnings.‖LO 7 Estimating goodwill.Expected target earnings $1,028,667Less: Normal earnings 930,000Excess earnings, per year $ 98,667
Slide1-32Determining Price and Method of PaymentStep 5 Compute estimated goodwill from ―excess earnings.‖LO 7 Estimating goodwill.Excess earnings $ 98,667Present value of excess earnings (perpetuity) at 25%:25%= $394,668EstimatedGoodwillStep 6 Add the estimated goodwill (step 5) to the fair value ofthe firm‘s net identifiable assets to arrive at a possible offeringprice.Net assets $6,200,000Estimated goodwill 394,668Implied offering price $6,594,668
Slide1-33Exercise 1-1 (continued)Required:B. Assume that Plantation Homes feels that it must earn a 15%return on its investment, but that average excess earningsare to be capitalized for three years only. Based on theseassumptions, calculate a reasonable offering price forCondominiums, Inc. Indicate how much of the price consistsof goodwill. Ignore tax effects.LO 7 Estimating goodwill.Determining Price and Method of Payment
Slide1-34Determining Price and Method of PaymentPart BLO 7 Estimating goodwill.Excess earnings of target (same a Part A) $ 98,667PV factor (ordinary annuity, 3 years, 15%) x 2.28323Estimated goodwill $ 225,279Fair value of net assets 6,200,000Implied offering price $ 6,425,279The types of securities to be issued by the new entity in exchangefor those of the combining companies must be determined.Ultimately, the exchange ratio is determined by the bargainingability of the individual parties to the combination.
Slide1-35LO 8 Economic entity and parent company concepts.Parent Company Concept - primary purpose of consolidatedfinancial statements is to provide information relevant tothe controlling stockholders.The noncontrolling interest presented as a liability or as aseparate component before stockholders‘ equity.Alternative Concepts of ConsolidatedFinancial StatementsEconomic Entity Concept - affiliated companies are aseparate, identifiable economic entity.The noncontrolling interest presented as a component ofstockholders‘ equity.
Slide1-36Consolidated Net IncomeParent Company Concept, consolidated net incomeconsists of the realized combined income of the parentcompany and its subsidiaries after deducting thenoncontrolling interest in income (noncontrolling interestin income is an expense item).Economic Entity Concept, consolidated net incomeconsists of the total combined income of the parentcompany and its subsidiaries. Total combined income isthen allocated proportionately to the noncontrollinginterest and the controlling interest.Alternative ConceptsLO 8 Economic entity and parent company concepts.
Slide1-37Consolidated Balance Sheet ValuesParent Company Concept, the net assets of the subsidiaryare included in the consolidated financial statements attheir book value plus the parent company‘s share of thedifference between fair value and book value on the dateof acquisition.Economic Entity Concept, on the date of acquisition, thenet assets of the subsidiary are included in theconsolidated financial statements at their book value plusthe entire difference between their fair value and theirbook value.Alternative ConceptsLO 8 Economic entity and parent company concepts.
Slide1-38According to the economic unit concept, the primarypurpose of consolidated financial statements is toprovide information that is relevant toa. majority stockholders.b. minority stockholders.c. creditors.d. both majority and minority stockholders.Review QuestionAlternative ConceptsLO 8 Economic entity and parent company concepts.
Slide1-39Intercompany ProfitTwo alternative points of view:1. Total (100%) elimination2. Partial eliminationAlternative ConceptsLO 8 Economic entity and parent company concepts.Under total elimination, the entire amount of unconfirmedintercompany profit is eliminated from combined incomeand the related asset balance. Under partial elimination,only the parent company‘s share of the unconfirmedintercompany profit is eliminated.
Slide1-40Conceptual FrameworkLO 8 Economic entity and parent company concepts.Figure 1-2ConceptualFramework forFinancialAccounting andReporting
Slide1-41Economic Entity vs. Parent Concept and theConceptual FrameworkThe parent concept is tied to the historical costprinciple, which would suggest that the net assetsrelated to the noncontrolling interest remain at theirprevious book values.This approach might be argued to produce more―reliable‖ values (SFAC No. 8).LO 8 Economic entity and parent company concepts.FASB’s Conceptual Framework
Slide1-42Economic Entity vs. Parent Concept and theConceptual FrameworkThe economic entity assumption views a parent andits subsidiaries as one economic entity even thoughthey are separate legal entities.The economic entity concept is an integral part ofthe FASB‘s conceptual framework and is namedspecifically in SFAC No. 5 as one of the basicassumptions in accounting.LO 8 Economic entity and parent company concepts.FASB’s Conceptual Framework
Slide1-43Overview of FASB’s Conceptual FrameworkLO 9 Statements of Financial Accounting Concepts.FASB’s Conceptual FrameworkSFAC No.1- Objectives of Financial Reporting (replaced by SFACNo. 8)SFAC No.2 - Qualitative Characteristics of Accounting Information(replaced by SFAC No. 8)SFAC No.3 - Elements of Financial Statements (replaced bySFAC No. 6)The Statements of Financial Accounting Concepts issued bythe FASB include:
Slide1-44Overview of FASB’s Conceptual FrameworkLO 9 Statements of Financial Accounting Concepts.FASB’s Conceptual FrameworkSFAC No.4 - Objectives of Financial Reporting by NonbusinessOrganizationsSFAC No.5 - Recognition and Measurement in Financial StatementsSFAC No.6 - Elements of Financial Statements (replaces SFAC No. 3)SFAC No.7 - Using Cash Flow Information and Present Value inAccounting MeasurementsSFAC No.8 – The Objective of General Purpose Financial Reporting(replaces SFAC No. 1 and No. 2)The Statements of Financial Accounting Concepts issued bythe FASB include:
Slide1-45Distinguishing Between Earnings andComprehensive IncomeLO 9 Statements of Financial Accounting Concepts.FASB’s Conceptual FrameworkEarnings is essentially revenues and gains minusexpenses and losses, with the exception of any losses orgains that bypass earnings and, instead, are reported asa component of other comprehensive income.SFAC No. 5 describes them as ―principally certainholding gains or losses that are recognized in the periodbut are excluded from earnings such as some changes inmarket values of investments... and foreign currencytranslation adjustments.‖
Slide1-46Asset Impairment and the Conceptual FrameworkLO 9 Statements of Financial Accounting Concepts.FASB’s Conceptual FrameworkSFAC No. 5 provides guidance with respect to expensesand losses:Consumption of benefit. Earnings are generally recognized whenan entity‘s economic benefits are consumed in revenue earningsactivities (or matched to the period incurred or allocatedsystematically) (Example: amortization of limited-lifeintangibles); orLoss or lack of benefit. Expenses or losses are recognized if itbecomes evident that previously recognized future economicbenefits of assets have been reduced or eliminated, or thatliabilities have increased, without associated benefits (Example:review for impairment for indefinite-life intangibles).
Slide1-47LO 10 Describe some of the current joint projects of the FASB and the InternationalAccounting Standards Board (IASB), and their primary objectives.Appendix: FASB Codification ProjectOn July 1, 2009, the FASB launched the FASB AccountingStandards Codification. Single source of authoritative nongovernmental U.S.generally accepted accounting principles (GAAP). Codification is effective for interim and annual periodsending after September 15, 2009. All existing accounting standards documents aresuperseded as described in FASB Statement No. 168,―The FASB Accounting Standards Codification and theHierarchy of Generally Accepted Accounting Principles.‖
Slide1-48LO 10 Describe some of the current joint projects of the FASB and the InternationalAccounting Standards Board (IASB), and their primary objectives.Appendix: FASB Codification ProjectStructure of the Codification Roughly 90 accounting topics Contains four groupings of numbers.1) the topic,2) the subtopic,3) the section, and4) the paragraphThe code 450-20-25-2 refers to topic 450 (which is‗contingencies‘); subtopic 20 (which is loss ‗contingencies‘); section25 (which is recognition); and 2 (refers to the second paragraph).
Slide1-49a. 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 Examplesb. Emerging Issues Task Force (EITF)1. Abstracts2. Topic Dc. Derivative Implementation Group (DIG) Issuesd. Accounting Principles Board (APB) Opinionse. 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 guidance3. Practice Bulletins (PB), including the Notices to Practitioners elevated to PracticeBulletin status by Practice Bulletin 14. Technical Inquiry Service (TIS)—only for Software Revenue RecognitionLO 10 Describe some of the current joint projects of the FASB and the InternationalAccounting Standards Board (IASB), and their primary objectives.Appendix: FASB Codification ProjectLiteratureincluded in theCodification
Slide1-50(a) Regulation S-X (SX)(b) Financial Reporting Releases (FRR)/Accounting SeriesReleases (ASR)(c) Interpretive Releases (IR)(d) SEC Staff guidance in1. Staff Accounting Bulletins (SAB)2. EITF Topic D and SEC Staff Observer comments.LO 10 Describe some of the current joint projects of the FASB and the InternationalAccounting Standards Board (IASB), and their primary objectives.Appendix: FASB Codification ProjectAdditional SEC literature included in theCodification for reference
Slide1-51LO 10 Describe some of the current joint projects of the FASB and the InternationalAccounting Standards Board (IASB), and their primary objectives.Appendix: FASB Codification ProjectChanges to GAAP: Updating the FASB StandardsUpdates to the Codification are called AccountingStandards Updates and are referenced asASU YYYY-xx, where the Ys indicate the year ofUpdate and xx represents the number of the updateFor that year.