Advanced Accounting, 6th Edition

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PREFACE
Convergence with international accounting standards has
played an important role in virtually every project entered
into by the Financial Accounting Standards Board (FASB)
in recent years. Accounting for business combinations is no
exception. In the Sixth Edition of Advanced Accounting, we
compare and contrast U.S. standards and international prin-
ciples throughout the book, drawing the readers’ attention to
remaining differences with an IFRS icon. The reader is made
aware of important changes, both present and forecasted. We
also incorporate the FASB’s codification system for refer-
encing standards.
This book is designed for advanced courses dealing
with financial accounting and reporting in the following top-
ical areas: business combinations, consolidated financial
statements, international accounting, foreign currency trans-
actions, accounting for derivative instruments, translation of
financial statements of foreign affiliates, segment reporting
and interim reporting, partnerships, fund accounting and
accounting for governmental units, and accounting for non-
government—nonbusiness organizations. The primary
objective of this book is to provide a comprehensive treat-
ment of selected topics in a clear and understandable man-
ner. The changes related to FASB ASC Topics 805 and 810
(SFAS No. 141R and 160) are integrated throughout the edi-
tion. As in previous editions, we strive to maintain maxi-
mum flexibility to the instructor in the selection and breadth
of coverage for topics dealing with consolidated financial
statements and other advanced topics.
We have further expanded the number and variety of
exercises and problem materials at the end of each chapter.
We include codification exercises that require the student to
research the FASB’s Codification to determine the appropri-
ate GAAP for a variety of issues. In addition, we include
financial statement analysis exercises that relate to real com-
panies and practical applications in virtually every chapter.
All chapters have been updated to reflect the most recent
pronouncements of the Financial Accounting Standards
Board and the Governmental Accounting Standards Board
as of this writing.
vi
In teaching consolidation concepts, a decision must be
made about the recording method that should be empha-
sized in presenting consolidated workpaper procedures. The
three major alternatives for recording investments in sub-
sidiaries are the (1) cost method, (2) partial equity (or
simple equity) method, and (3) complete equity (or sophis-
ticated equity) method. A brief description of each method
follows.
1. Cost method. The investment in subsidiary is carried at
its cost, with no adjustments made to the investment
account for subsidiary income or dividends. Divi-
dends received by the parent company are recorded as
an increase in cash and as dividend income.
2. Partial equity method. The investment account is ad-
justed for the parent company’s share of the subsidiary’s
reported earnings or losses, and dividends received from
the subsidiary are deducted from the investment account.
Generally, no other adjustments are made to the invest-
ment in subsidiary account.
3. Complete equity method. This method is the same as the
partial equity method except that additional adjustments
are made to the investment in subsidiary account to reflect
the effects of (a) the elimination of unrealized intercom-
pany profits, (b) the amortization (depreciation) of the
difference between cost and book value, and (c) the addi-
tional stockholders’ equity transactions undertaken by the
subsidiary that change the parent company’s share of the
subsidiary’s stockholders’ equity.
We continue to present all three methods, using generic
icons to distinguish among the three methods. The instructor
has the flexibility to teach all three methods, or to instruct
the students to ignore one or two. If the student is interested
in learning all three methods, he can, even if the instructor
only focuses on one or two. Also, we believe this feature
makes the book an excellent reference for the student to keep
after graduation, so that he or she can adapt to any method
needed.
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Preface
WHAT’S NEW IN THE TEXT?
• Author-created online videos explain some of the
critical concepts of advanced accounting and walk
students through how to solve selected problems
throughout the book.
• A continuous consolidation problem is introduced in
Chapters 4 and 5. This allows students to build on con-
cepts learned in prior chapters.
• The coverage of certain topics has been expanded (such
as contingent consideration and bargain purchases) to
incorporate information gleaned from the FASB’s Post-
Implementation Review of FASB Statement No. 141R
and to include more realistic real-world issues.
• Chapter 11 on International Accounting has been updated
to reflect the current status of international financial
reporting standards (IFRS) around the world and the
SEC’s position with respect to U.S. adoption. In addition,
we pay particular attention to the remaining major joint
projects of the two boards (FASB and IASB), which
include revenue recognition, accounting for leases, insur-
ance contracts, and financial instruments.
• The chapters on fund accounting and governmental
accounting (Chapters 17 and 18) were updated to reflect
the latest GASB pronouncements, including changes in
the classification of the fund balance.
• An appendix to Chapter 1 has been posted online at
www.wiley.com/college/jeter. This appendix illustrates
a strategy or technique for analyzing a given company,
such as a potential acquisition target. This strategy may
be applied in some of the end-of-the-chapter Analyzing
Financial Statements (AFS) problems. Several addi-
tional online appendices (including coverage of
deferred taxes, as they pertain to individual topics
throughout the text) may also be found at www.wiley
.com/college/jeter.
OTHER HIGHLIGHTED FEATURES
OF THE TEXT
1. We include a feature that requires students to research
the FASB Codification in order to locate the current
standard that applies to various issues. These exercises
appear before the problems at the end of each chapter
and often, but not always, relate to topics addressed
in that chapter. (Similar questions appear on the
CPA exam.)
2. We include a discussion of international accounting
standards on each topic where such standards exist, and
compare and contrast U.S. GAAP and IFRS. An IFRS
icon appears in the margins where this discussion
occurs.
3. A discussion of the joint projects of the FASB and the
IASB is incorporated throughout the textbook where
appropriate, with an expanded discussion in Chapter 11.
vii
4. FASB’s conceptual framework is discussed as it relates
to Advanced Accounting in Chapter 1. We also include
marginal references to Related Concepts throughout
the book. The GASB’s conceptual framework is
discussed in Chapters 17 and 18.
5. Questions or problems related to Business Ethics are
included in the end-of chapter materials for every
chapter.
6. We include real-company annual reports or excerpts
from reports with related questions (Analyzing Finan-
cial Statements) in the end-of-chapter materials and/or
online for most chapters excluding Chapters 15 and 16.
7. In Chapter 9 of the 6th edition, the homework material
includes the effective interest, in addition to the straight-
line method for amortization of bond premiums and dis-
counts. The Sixth Edition also includes online appen-
dices on deferred taxes which are related to the topics in
Chapter 6 & 7. (Go to www.wiley.com/college/jeter.)
8. The in-the-news boxes that appear throughout the book
reflect recent business and economic events relevant to
the subject matter.
9. We have integrated goodwill impairment into some
illustrations in the body of Chapter 5, as well as in sev-
eral homework problems. We illustrate the goodwill
impairment test described in FASB ASC topic 350
(SFAS No. 142), discussing its frequency, the steps laid
out in the standard, and some of the likely implementa-
tion problems. The simplification of these tests for
smaller companies is also discussed along with the role
of qualitative factors for determining whether the steps
are necessary. There are exercises on this topic in
Chapters 2 and 5.
10. At the beginning of Chapter 4 we discuss three methods
of accounting for investments, depending on the level of
ownership and the presumption of influence or control.
We emphasize the importance of the complete equity
method for certain investments that are not consolidated,
or in the parent-only statements. In addition, online
materials include an expanded discussion of the account-
ing for investments. (See www.wiley.com/college/jeter.)
11. Learning objectives are included in the margins of the
chapters, and relevant learning objective numbers are
provided with end-of-chapter materials.
12. We continue the use of graphical illustrations, which
was introduced in prior editions.
13. A few short-answer questions (and solutions) are peri-
odically provided throughout each chapter to enable
students to test their knowledge of the content before
moving on.
14. The organization of the worksheets applies a format
that separates accounts to the income statement, the
statement of retained earnings, and the balance sheet in
distinct sections. The worksheets are placed near the
relevant text.
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viii
15. All illustrations are printed upright on the page and la-
beled clearly for convenient study and reference.
16. Entries made on consolidated statements workpapers
are presented in general journal form. These entries are
shaded in blue to distinguish them from book entries, to
facilitate exposition and study. To distinguish among
parent company entries and workpaper entries in the
body of the text, we present parent entries in gray and
workpaper entries in blue.
17. Summaries appear at the end of each chapter, and a
glossary of key terms is provided at the end of the
book.
18. Chapters 17 through 19 reflect the latest GASB and
FASB pronouncements related to fund accounting.
Clearly there are more topics in this text than can be cov-
ered adequately in a one semester or one-quarter course.
We believe that it is generally better for both students and
instructors to cover a selected number of topics in depth
rather than to undertake a superficial coverage of a larger
number of topics. Modules of material that an instructor
may consider for exclusion in any one semester or quarter
include the following:
• Chapters 7–9. An expanded analysis of problems in the
preparation of consolidated financial statements.
• Chapter 10. Insolvency—liquidation and reorganiza-
tion.
• Chapters 11–14. International accounting, foreign cur-
rency transactions and translation, and segment and in-
terim reporting.
• Chapters 15 and 16. Partnership accounting.
• Chapters 17 through 19. Fund accounting, accounting
for governmental units, and accounting for nongovern-
ment–nonbusiness organizations (NNOs).
SUPPLEMENTS
The following supplements are available on the book com-
panion web site: Study Guide, Excel Templates, Power-
Point Slides, Instructors’ Manual, Solutions Manual, Test
Bank, and videos. These materials are accessible form
www.wiley.com/college/jeter.
Preface
WileyPLUS
WileyPLUS is an online learning and assessment environ-
ment, where students test their understanding of concepts,
get feedback on their answers, and access learning materi-
als like the eText and multimedia resources. Instructors can
automate assignments, create practice quizzes, assess stu-
dents’ progress, and intervene with those falling behind.
ACKNOWLEDGMENTS
We wish to thank the following individuals for their sug-
gestions and assistance in the preparation of this edition.
Thank you goes to Anthony Abongwa (Monroe Col-
lege), Jonghyuk Bae Darius Fatemi (Northern Kentucky
University), Edward Julius (California Lutheran Univer-
sity), Ron Mano (Westminster College), Kevin Packard
(Brigham Young University – Idaho), Ashley Stark (Dick-
inson State University), Denise Stefano (Mercy College),
Deborah Strawser (Grand Canyon University Online),
Joseph Wall (Carthage College), and Sheila Reed (State of
Tennessee).
Thank you also goes to Sheila Ammons (Austin Com-
munity College) for preparing the Power- Point slides, to
TBD for preparing the Study Guide, to TBD for preparing
the Test Bank, and to TBD for their helpful textbook, solu-
tions manual, and test bank accuracy review comments.
Finally we would like to acknowledge a few individu-
als at Wiley who helped all this come together: Ellen Keo-
hane, Mary O’Sullivan, Christina Volpe, Beth Pearson,
Joel Hollenbeck, Tai Harris, Karolina Zarychta, Maddy
Lesure.
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CONTENTS

1 INTRODUCTION TO BUSINESS COMBINATIONS Questions 58

AND THE CONCEPTUAL FRAMEWORK 1 Analyzing Financial Statements 58
Exercises 64
Learning Objectives 1
ASC Exercises 70
1.1 Growth Through Mergers 1
Problems 71
1.2 Nature of the Combination 3
1.3 Business Combinations: Why? Why not? 4
1.4 Business Combinations: Historical Perspective 7 3 CONSOLIDATED FINANCIAL STATEMENTS—
1.5 Terminology and Types of Combinations 10 DATE OF ACQUISITION 75
1.6 Takeover Premiums 12 Learning Objectives 75
1.7 Avoiding the Pitfalls before the Deal 13 3.1 Definitions of Subsidiary and Control 77
1.8 Determining Price and Method of Payment 3.2 Requirements for the Inclusion of Subsidiaries in
in Business Combinations 14 the Consolidated Financial Statements 80
1.9 Alternative Concepts of Consolidated 3.3 Reasons for Subsidiary Companies 81
Financial Statements 18 3.4 Consolidated Financial Statements 81
1.10 FASB’s Conceptual Framework 22 3.5 Investments at the Date of Acquisition 82
1.11 FASB Codification (Source of GAAP) 27 3.6 Consolidated Balance Sheets: The Use of
Summary 31 Workpapers 83
Appendix 1A: Evaluating Firm Performance (Online only) 3.7 A Comprehensive Illustration—More than One
Questions 32 Subsidiary Company 97
Analyzing Financial Statements 33 3.8 Limitations of Consolidated Statements 100
Exercises 35 Summary 102
ASC Exercises 36 Appendix 3A: Deferred Taxes on the Date of Acquisition
(Online only)
Appendix 3B: Consolidation of Variable Interest Entities
2 ACCOUNTING FOR BUSINESS (Online only)
COMBINATIONS 37 Questions 103
Learning Objectives 37 Analyzing Financial Statements 104
2.1 Accounting Standards on Business Combinations: Exercises 105
Background 37 ASC Exercises 109
2.2 Pro Forma Statements and Disclosure Problems 109
Requirement 45
2.3 Explanation and Illustration of Acquisition
Accounting 47 4 CONSOLIDATED FINANCIAL STATEMENTS
2.4 The Measurement Period (and Measurement AFTER ACQUISITION 116
Period Adjustments) 50 Learning Objectives 116
2.5 Contingent Consideration in an Acquisition 51 4.1 Accounting for Investments by the Cost, Partial
2.6 Leveraged Buyouts 55 Equity, and Complete Equity Methods 117
2.7 IFRS versus U.S. GAAP 55 4.2 Consolidated Statements after Acquisition—Cost
Summary 57 Method 124
Appendix 2A: Deferred Taxes in Business Combinations 4.3 Recording Investments in Subsidiaries—Equity
(Online only) Method (Partial or Complete) 134

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x Contents
4.4 Elimination of Intercompany Revenue and Expense
Items 144
4.5 Interim Acquisitions of Subsidiary Stock 144
4.6 Consolidated Statement of Cash Flows 149
4.7 Illustration of Preparation of a Consolidated
Statement of Cash Flows—Year of
Acquisition 153
4.8 Compare U.S. GAAP and IFRS Regarding Equity
Method 156
Summary 157
Appendix 4A: Alternative Workpaper Format
(Online only)
Appendix 4B: Deferred Tax Consequences When
Affiliates File Separate Income Tax Returns—
Undistributed Income (Online only)
Questions 159
Analyzing Financial Statements 159
Exercises 161
ASC Exercises 167
Problems 167
5 ALLOCATION AND DEPRECIATION
OF DIFFERENCES BETWEEN
IMPLIED AND BOOK VALUES 186
Learning Objectives 186
5.1 Computation and Allocation of the Difference
Between Implied and Book Values to Assets and
Liabilities of Subsidiary—Acquisition Date 188
5.2 Effect of Differences Between Implied and Book
Values on Consolidated Net Income—Year
Subsequent to Acquisition 194
5.3 Consolidated Statements Workpaper—Using the
Cost Method 196
5.4 Controlling and Noncontrolling Interests in
Consolidated Net Income and Retained
Earnings—Using the Cost Method 205
5.5 Consolidated Statements Workpaper—Using
Partial Equity Method 207
5.6 Controlling and Noncontrolling Interests in
consolidated Net Income and Retained Earnings—
Using Partial Equity Method 214
5.7 Consolidated Statements Workpaper—Using
Complete Equity Method 216
5.8 Controlling Interest in Consolidated Net Income
and Retained Earnings—Using Complete Equity
Method 223
5.9 Additional Considerations Relating to Treatment
of Difference Between Implied and Book
Values 223
5.10 Push Down Accounting 231
5.11 IFRS vs U.S. GAAP on Research & Development
Costs 236
Summary 236
Questions 237
Analyzing Financial Statements 238
Exercises 240
ASC Exercises 245
Problems 245
6 ELIMINATION OF UNREALIZED PROFIT
ON INTERCOMPANY SALES
OF INVENTORY 263
Learning Objectives 263
6.1 Effects of Intercompany Sales of Merchandise
on the Determination of Consolidated
Balances 264
6.2 Cost Method: Consolidated Statements
Workpaper—Upstream Sales 272
6.3 Cost Method—Analysis of Consolidated Net
Income and Consolidated Retained
Earnings 277
6.4 Consolidated Statements Workpaper—Partial
Equity Method 279
6.5 Partial Equity Method—Analysis of Consolidated
Net Income and Consolidated Retained
Earnings 284
6.6 Consolidated Statements Workpaper—Complete
Equity Method 285
6.7 Complete Equity Method—Analysis of
Consolidated Net Income and Consolidated
Retained Earnings 290
6.8 Summary of Workpaper Entries Relating to Inter-
company Sales of Inventory 290
6.9 Intercompany Profit Prior To Parent–Subsidiary
Affiliation 290
Summary 291
Appendix 6A: Deferred Taxes and Intercompany Sales
of Inventory (Online only)
Questions 292
Analyzing Financial Statements 292
Exercises 294
ASC Exercises 296
Problems 296
7 ELIMINATION OF UNREALIZED GAINS
OR LOSSES ON INTERCOMPANY SALES
OF PROPERTY AND EQUIPMENT 309
Learning Objectives 309
7.1 Intercompany Sales of Land (Nondepreciable
Property) 310
7.2 Intercompany Sales of Depreciable
Property (Machinery, Equipment, And
Buildings) 312
7.3 Consolidated Statements Workpaper—Cost and
Partial Equity Methods 319
7.4 Calculation of Consolidated Net Income and
Consolidated Retained Earnings 327
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Contents xi

7.5 Consolidated Statements Workpaper—Complete 9.9 Dividends from Preacquisition Earnings 413
Equity Method 330 9.10 Subsidiary with both Preferred and Common
7.6 Calculation and Allocation of Consolidated Net Stock Outstanding 414
Income; Consolidated Retained Earnings: Complete 9.11 Consolidating a Subsidiary with Preferred Stock
Equity Method 336 Outstanding 417
7.7 Summary of Workpaper Entries Relating to Summary 427
Intercompany Sales of Equipment 336 Questions 428
7.8 Intercompany Interest, Rents, and Service Analyzing Financial Statements 428
Fees 336
Exercises 430
Summary 339
ASC Exercises 433
Appendix 7A: Deferred Taxes Consequences Related to
Problems 433
Intercompany Sales of Equipment (Online only)
Questions 340
Analyzing Financial Statements 341 10 INSOLVENCY—LIQUIDATION
Exercises 341 AND REORGANIZATION 433
ASC Exercises 344 Learning Objectives 433
Problems 344 10.1 Contractual Agreements 444
10.2 Bankruptcy 446
8 CHANGES IN OWNERSHIP INTEREST 355 10.3 Liquidation (Chapter 7) 449
10.4 Reorganization Under the Reform Act
Learning Objectives 355
(Chapter 11) 450
8.1 Changes in Ownership 355
10.5 Trustee Accounting and Reporting 460
8.2 Parent Acquires Subsidiary Stock Through Several
10.6 Realization and Liquidation Account 462
Open-Market Purchases—Cost Method 357
Summary 467
8.3 Parent Sells Subsidiary Stock Investment on the
Open Market—Cost Method 360 Questions 468
8.4 Equity Method—Purchases and Sales of Subsidiary Analyzing Financial Statements 469
Stock by the Parent 363 Exercises 469
8.5 Parent Sells Subsidiary Stock Investment on the ASC Exercises 475
Open Market—Cost Method 367 Problems 475
8.6 Subsidiary Issues Stock 368
Summary 376
Questions 376
11 INTERNATIONAL FINANCIAL REPORTING
STANDARDS 481
Analyzing Financial Statements 377
Exercises 377 Learning Objectives 481
ASC Exercises 380 11.1 The Increasing Importance of International
Accounting Standards 481
Problems 380
11.2 Historical Perspective: The Road to
Convergence 482
9 INTERCOMPANY BOND HOLDINGS AND 11.3 Similarities and Differences Between U.S. GAAP
MISCELLANEOUS TOPICS—CONSOLIDATED and IFRS 486
FINANCIAL STATEMENTS 388 11.4 GAAP Hierarchy—U.S. versus IFRS 486
11.5 Convergence Projects—FASB and IASB 495
Learning Objectives 388
11.6 International Convergene Issues 500
9.1 Intercompany Bond Holdings 389
11.7 American Depository Receipts: An Overview 503
9.2 Accounting for Bonds—A Review 390
Summary 506
9.3 Constructive Gain or Loss on Intercompany Bond
Holdings 391 Appendix 11A: List of Current International Financial
Reporting Standards Issued by IASC and IASB(Online
9.4 Accounting for Intercompany Bonds I
only)
llustrated 393
Questions 506
9.5 Book Entry Related to Bond Investment 394
Analyzing Financial Statements 507
9.6 Interim Purchase of Intercompany Bonds 409
Exercises 509
9.7 Notes Receivable Discounted 410
ASC Exercises 510
9.8 Stock Dividends Issued by a Subsidiary
Company 410 Problems 511
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xii Contents

12 ACCOUNTING FOR FOREIGN CURRENCY Summary 612

TRANSACTIONS AND HEDGING FOREIGN Appendix 14A: GE Segmental Disclosures 2013 Annual
EXCHANGE RISK 514 Report (Online only)
Questions 613
Learning Objectives 514
Analyzing Financial Statement 613
12.1 Exchange Rates—Means of Translation 515
Exercises 615
12.2 Measured versus Denominated 518
ASC Exercises 618
12.3 Foreign Currency Transactions 518
Problems 619
12.4 Using Forward Contracts as a Hedge 526
Summary 541
Questions 542 15 PARTNERSHIPS: FORMATION, OPERATION,
Analyzing Financial Statements 543
AND OWNERSHIP CHANGES 623
Exercises 543 Learning Objectives 623
ASC Exercises 550 15.1 Partnership Defined 624
Problems 550 15.2 Reasons for Forming a Partnership 625
15.3 Characteristics of a Partnership 625
15.4 Partnership Agreement 627
13 TRANSLATION OF FINANCIAL STATEMENTS 15.5 Accounting for a Partnership 629
OF FOREIGN AFFILIATES 556
15.6 Special Problems in Allocation of
Learning Objectives 556 Income and Loss 636
13.1 Accounting for Operations in Foreign 15.7 Financial Statement Presentation 637
Countries 557 15.8 Changes in the Ownership of the
13.2 Translating Financial Statements of Foreign Partnership 638
Affiliates 557 15.9 Section A: Admission of a New Partner 640
13.3 Objectives of Translation 559 15.10 Section B: Withdrawal of a Partner 646
13.4 Translation Methods 559 Summary 649
13.5 Identifying the Functional Currency 561 Questions 650
13.6 Translation of Foreign Currency Financial Exercises 650
Statements 561 ASC Exercises 656
13.7 Translation of Foreign Financial Statements Problems 656
Illustrated 565
13.8 Financial Statement Disclosure 574
13.9 Historical Developments of Accounting 16 PARTNERSHIP LIQUIDATION 663
Standards 575 Learning Objectives 663
Summary 576 16.1 Steps in the Liquidation Process 664
Appendix 13A: Accounting for a Foreign Affiliate and 16.2 Priorities of Partnership and Personal
Preparation of Consolidated Statements Workpaper Creditors 665
Illustrated (Online only) 16.3 Simple Liquidation Illustrated 668
Questions 577 16.4 Installment Liquidation 669
Analyzing Financial Statements 578 16.5 Incorporation of a Partnership 676
Exercises 579 Summary 678
ASC Exercises 585 Questions 679
Problems 585 Exercises 679
ASC Exercises 684
14 REPORTING FOR SEGMENTS AND FOR Problems 684
INTERIM FINANCIAL PERIODS 593
Learning Objectives 593 17 INTRODUCTION TO FUND
14.1 Need for Disaggregatd Financial Data 594 ACCOUNTING 690
14.2 Standards of Financial Accounting and Learning Objectives 690
Reporting 594 17.1 Classifications of Nonbusiness
14.3 International Accounting Standards Board (IASB) Organizations 691
Position on Segment Reporting 604 17.2 Distinctions Between Nonbusiness Organizations
14.4 Interim Financial Reporting 605 and Profit-Oriented Enterprises 691
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Contents xiii

17.3 Financial Accounting and Reporting Standards for Exercises 775

Nonbusiness Organizations 692
17.4 Fund Accounting 695
17.5 Comprehensive Illustration—General Fund 709
17.6 Reporting Inventory and Prepayments in the
Financial Statements 718
Summary 719
Appendix 17A: City of Atlanta Partial Financial
Statements (Online only)
Questions 720
Analyzing Financial Statements 720
Exercises 721
ASC Exercises 725
Problems 725
18 INTRODUCTION TO ACCOUNTING
FOR STATE AND LOCAL GOVERNMENTAL
UNITS 732
Learning Objectives 732
18.1 The History of Generally Accepted Governmental
Accounting Standards 734
18.2 The Structure of Governmental Accounting 736
18.3 Governmental Fund Entities 737
18.4 Proprietary Funds 754
18.5 Fiduciary Funds 757
18.6 Capital Assets and Long-Term Debt 757
18.7 External Reporting Requirements (GASB
Statement No. 34) 762
18.8 Government Fund-Based Reporting 762
18.9 Government-wide Reporting 765
18.10 Management’s Discussion and Analysis
(MD&A) 769
18.11 Interfund Activity 770
Appendix 18A: Government-wide Financial Statements
City of Atlanta (Online only)
Summary 772
Questions 774
Analyzing Financial Statements 774
ASC Exercises 781
Problems 782
19 ACCOUNTING FOR NONGOVERNMENT
NONBUSINESS ORGANIZATIONS: COLLEGES
AND UNIVERSITIES, HOSPITALS AND OTHER
HEALTH CARE ORGANIZATIONS 792
Learning Objectives 792
19.1 Sources of Generally Accepted Accounting
Standards for Nongovernment Nonbusiness
Organizations 793
19.2 Fund Accounting 796
19.3 Accrual Basis of Accounting 797
19.4 Accounting for Current Funds 798
19.5 Contributions 801
19.6 Accounting for Plant Funds 804
19.7 Accounting for Endowment Funds 808
19.8 Accounting for Investments 810
19.9 Accounting for Loan Funds 811
19.10 Accounting for Agency (Custodial) Funds 811
19.11 Accounting for Annuity and Life Income
Funds 812
19.12 Issues Relating to Colleges and
Universities 813
Appendix 19A: Sample Financial Statements for Private
Educational Institutions (Online only)
Summary 813
Questions 815
Analyzing Financial Statement 815
Exercises 816
ASC Exercises 822
Problems 823
Glossary 831
Appendix PV: Tables of Present Value 837
Index 839
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1
INTRODUCTION TO BUSINESS
COMBINATIONS AND THE
CONCEPTUAL FRAMEWORK
CHAPTER CONTENTS LEARNING OBJECTIVES
1.1 GROWTH THROUGH MERGERS 1 Describe historical trends in types of business
1.2 NATURE OF THE COMBINATION combinations.
2 Identify the major reasons firms combine.
1.3 BUSINESS COMBINATIONS: WHY? WHY NOT?
3 Identify the factors that managers should consider in
1.4 BUSINESS COMBINATIONS: HISTORICAL PERSPECTIVE exercising due diligence in business combinations.
1.5 TERMINOLOGY AND TYPES OF COMBINATIONS 4 Identify defensive tactics used to attempt to block
business combinations.
1.6 TAKEOVER PREMIUMS
5 Distinguish between an asset and a stock
1.7 AVOIDING THE PITFALLS BEFORE THE DEAL acquisition.
1.8 DETERMINING PRICE AND METHOD OF PAYMENT IN 6 Indicate the factors used to determine the price and
BUSINESS COMBINATIONS the method of payment for a business combination.
1.9 ALTERNATIVE CONCEPTS OF CONSOLIDATED FINAN- 7 Calculate an estimate of the value of goodwill to be
CIAL STATEMENTS included in an offering price by discounting expected
future excess earnings over some period of years.
1.10 FASB’S CONCEPTUAL FRAMEWORK
8 Describe the two alternative views of consolidated
1.11 FASB CODIFICATION (SOURCE OF GAAP) financial statements: the economic entity and the
parent company concepts.
9 Discuss the Statements of Financial Accounting
Concepts (SFAC).
10 Describe some of the current joint projects of the
FASB and the International Accounting Standards
Board (IASB), and their primary objectives.

1.1 GROWTH THROUGH MERGERS

The merger between American Airlines and US Airways in 2013 has been the latest in a string
of acquisitions in an industry described by Warren Buffett a few years earlier as typifying the
“worst” sort of business. He went on to describe such a business as one that grows fast, earns
next to nothing, and takes large amounts of capital to engender growth. Twenty-nine
bankruptcies in 30 years support Buffett’s allegations. Still, the belief is growing that maybe
now, at last, airlines have finally cut capacity sufficiently to earn profits in the long run.1
Growth through mergers and acquisitions (M&A) has become a standard in business
not only in America but throughout the world. In the new millennium, the most recent in a
series of booms in merger activity was sparked by cheaper credit and by global competition,

1
WSJ, “Airlines Haven’t Reached Escape Velocity,” by Justin Lahart, 4/1/2013.

1
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2 Chapter 1 Introduction to Business Combinations and the Conceptual Framework

in addition to the usual growth-related incentives predominant during the boom of the
1990s. By the end of 2008, however, uncertainty in the commercial credit markets had led
to anxiety about whether merger transactions could continue to be achieved successfully in
the current environment, and by the middle of 2009 M&A activity had nearly come to a halt.
With plunging market values and tightened credit, the mix and nature of the financing com-
ponents were clearly in flux, and major adaptations needed to consummate any new deals.
As the markets began to recover in the second half of 2009, however, merger transac-
tions picked up once more. Banks made capital available for bigger companies, such as
Kraft, who looked to acquire Cadbury, and corporate debt offerings soared. By 2010, sev-
eral huge deals were in the works.
Merger activity has historically been highly correlated with the movement of the
stock market. Increased stock valuation increases a firm’s ability to use its shares to
acquire other companies and is often more appealing than issuing debt. During the
merger cycle of the 1990s, equity values fueled the merger wave. The slowing of merger
activity in the early years of the 21st century provided a dramatic contrast to this preced-
ing period. Beginning with the merger of Morgan Stanley and Dean Witter Discover and
ending with the biggest acquisition to that date—WorldCom’s bid for MCI—the year
1997 marked the third consecutive year of record mergers and acquisitions activity. The
pace accelerated still further in 1998 with unprecedented merger activity in the banking
industry, the auto industry, financial services, and telecommunications, among others.
This activity left experts wondering why and whether bigger was truly better. It also left
consumers asking what the impact would be on service. A wave of stock swaps was
undoubtedly sparked by record highs in the stock market, and stockholders reaped bene-
fits from the mergers in many cases, at least in the short run. Regulators voiced concern
about the dampening of competition, and consumers were quick to wonder where the real
benefits lay. Following the accounting scandals of 2001 (WorldCom, Enron, Tyco, etc.),
merger activity lulled for a few years.
Also in 2001, the Financial Accounting Standards Board (FASB) voted in two major
accounting changes related to business combinations. The first met with vehement protests
that economic activity would be further slowed as a result and the second with excitement
that it might instead be spurred. Both changes are detailed in Chapter 2.
By the middle of 2002, however, these hopes had been temporarily quelled. Instead of
increased earnings, many firms active in mergers during the 1990s were forced to report
large charges related to the diminished value of long-lived assets (mainly goodwill).
Merger activity slumped, suggesting that the frenzy had run its course. Market reaction to
the mergers that did occur during this period typified the market’s doubts. When Northrop
Grumman Corp. announced the acquisition of TRW Inc. for $7.8 billion, the deal was
praised but no market reaction was noted. In contrast, when Vivendi Universal admitted
merger-gone-wrong woes, investors scurried.
By the middle of the first decade of the 21st century, however, the frenzy was return-
ing with steady growth in merger activity from 2003 to 2006. In 2005, almost 18% of all
M&A (mergers & acquisitions) deals were in the services sector. In a one-week period in
June of 2006, $100 billion of acquisitions occurred, including Phelps Dodge’s $35.4 bil-
lion acquisition of Inco Ltd. and Falconbridge Ltd. In addition, because of the economic
rise in China and India, companies there were looking to increase their global foothold
and began acquiring European companies. Thus cross-border deals within Europe
accounted for a third of the global M&A deals.
However, by the end of 2008, a decline in overall merger activity was apparent as the
U.S. economy slid into a recession, and some forecasters were predicting the next chapter
in mergers and acquisitions to center around bankruptcy-related activity. Data from
Thomson Reuters revealed that in 2008, bankruptcy-related merger activity increased for
the first time in the last six years. For example, the number of Chapter 11 M&A purchases
rose from 136 for the entire year of 2007 to 167 for the first ten months of 2008, with more
to come. Overall mergers, on the other hand, decreased from $87 billion in the United
States ($277 billion globally) during October 2007 to $78 billion in the United States
($259 billion globally) during October 2008, based on the Reuters data.
c01.qxd 9/16/14 3:30 PM Page 3

Nature of the Combination 3

On December 4, 2007, FASB released two new standards, FASB Statement No. 141
“If we are
going to ride R, Business Combinations, and FASB Statement No. 160, Noncontrolling Interests in
IN
the IASB and Consolidated Financial Statements [ASC 805, “Business Combinations” and ASC 810,
THE
NEWS the IFRS “Consolidations,” based on FASB’s new codification system]. These standards have
[International altered the accounting for business combinations dramatically.
Financial Both statements became effective for years beginning after December 15, 2008, and
Reporting Standards] horse, we are intended to improve the relevance, comparability and transparency of financial infor-
want to make sure that it’s as mation related to business combinations, and to facilitate the convergence with interna
good as it can be. We want to tional standards. They represent the completion of the first major joint project of the
make sure that the IASB is FASB and the IASB (International Accounting Standards Board), according to one
strong, is independent, is well
FASB member, G. Michael Crooch. The FASB also believes the new standards will
resourced, and is properly
funded in a broad-based and
reduce the complexity of accounting for business combinations. These standards are inte-
secure way.”2 grated throughout this text.

Planning M&A in a Changing Environment and Under

CHANGING Accounting Requirements

“By 2006, the

1. The timing of deals is critical. The number of days between agreement or announce-
percentage ment and deal consummation can make a huge difference.
IN
THE of the 2. The effects on reporting may cause surprises. More purchases qualify as business
NEWS mergers and combinations than previously. Income tax provisions can trigger disclosures.
acquisitions 3. Assembling the needed skill and establishing the needed controls takes time. The
market
use of fair values is expanded, and more items will need remeasurement or monitor-
accounted for by private-equity
ing after the deal.
firms had increased to
approximately 15 percent from 4. The impact on earnings in the year of acquisition and subsequent years will differ
around 4 percent in 1990.”4 from that in past mergers, as will the effects on earnings of step purchases or sales.
5. Unforeseen effects on debt covenants or other legal arrangements may be lurking in
the background, as a result of the changes in key financial ratios.3
After several Growth is a major objective of many business organizations. Top management often
IN lean years, lists growth or expansion as one of its primary goals. A company may grow slowly, gradu-
THE U.S. M&A ally expanding its product lines, facilities, or services, or it may skyrocket almost overnight.
NEWS volume
Some managers consider growth so important that they say their companies must “grow or
reached $1
die.” In the past hundred years, many U.S. businesses have achieved their goal of expansion
trillion in
2013. Scott Barshay of Cravath,
through business combinations. A business combination occurs when the operations of two
Swaine, & Moore, a major law or more companies are brought under common control.
firm, claims that this growth
was caused by “a stronger
economy, . . . Congress 1.2 NATURE OF THE COMBINATION
behaving more responsibly,
and . . . all appearances of A business combination may be friendly or unfriendly. In a friendly combination, the
stability at the Fed.”5 boards of directors of the potential combining companies negotiate mutually agreeable
terms of a proposed combination. The proposal is then submitted to the stockholders of
the involved companies for approval. Normally, a two-thirds or three-fourths positive
vote is required by corporate bylaws to bind all stockholders to the combination.
An unfriendly (hostile) combination results when the board of directors of a com-
pany targeted for acquisition resists the combination. A formal tender offer enables the
acquiring firm to deal directly with individual shareholders. The tender offer, usually
published in a newspaper, typically provides a price higher than the current market price
for shares made available by a certain date. If a sufficient number of shares are not made

2
“Change Agent: Robert Hertz discusses FASB’s priorities, the road to convergence and changes ahead for
CPAs,” Journal of Accountancy, February 2008, p. 31.
3
BDO Seidman, LLP, “Client Advisory,” No. 2008-1, January 31, 2008.
4
The New York Post, “Money to Burn,” by Suzanne Kapner, March 28, 2006, p. 33.
5
“Markets Buoyant, Merger Activity Picks Up,” by David Gelles, The New York Times, DealBook, January 1, 2014.
c01.qxd 9/16/14 3:30 PM Page 4
4 Chapter 1 Introduction to Business Combinations and the Conceptual Framework
Men’s
Wearhouse
IN
acquired all
THE
NEWS the
outstanding
shares of Jos.
A Bank with a per share offer
that represented a 56%
premium over Jos. A. Bank’s
closing share price. During a six
month period, Jos. A. Bank
made several offers to acquire
Men’s Wearhouse. At the end
of this six month period, Men’s
Wearhouse, using a Pac Man
strategy, made an offer to
acquire Jos. A Bank. No
rebranding of the companies
is expected and Men’s
Wearhouse shareholders hope
to benefit from $100 to
$150 million in synergies.6
LO 4 Defensive tactics are used.
1.3 BUSINESS COMBINATIONS: WHY? WHY NOT?
LO 2 Reasons firms combine.
available, the acquiring firm may reserve the right to withdraw the offer. Because they are
relatively quick and easily executed (often in about a month), tender offers are the pre-
ferred means of acquiring public companies.
Although tender offers are the preferred method for presenting hostile bids, most ten-
der offers are friendly ones, done with the support of the target company’s management.
Nonetheless, hostile takeovers have become sufficiently common that a number of mech-
anisms have emerged to resist takeover.
Defense Tactics
Resistance often involves various moves by the target company, generally with colorful
terms. Whether such defenses are ultimately beneficial to shareholders remains a contro-
versial issue. Academic research examining the price reaction to defensive actions has
produced mixed results, suggesting that the defenses are good for stockholders in some
cases and bad in others. For example, when the defensive moves result in the bidder (or
another bidder) offering an amount higher than initially offered, the stockholders benefit.
But when an offer of $40 a share is avoided and the target firm remains independent with
a price of $30, there is less evidence that the shareholders have benefited.
A certain amount of controversy surrounds the effectiveness, as well as the ultimate
benefits, of the following defensive moves:
1. Poison pill: Issuing stock rights to existing shareholders enabling them to purchase
additional shares at a price below market value, but exercisable only in the event of a
potential takeover. This tactic has been effective in some instances, but bidders may
take managers to court and eliminate the defense. In other instances the original share-
holders benefit from the tactic. Chrysler Corp. announced that it was extending a
poison pill plan until February 23, 2008, under which the rights become exercisable if
anyone announces a tender offer for 15% or more, or acquires 15%, of Chrysler’s
outstanding common shares. Poison pills are rarely triggered, but their existence
serves as a preventative measure.
2. Greenmail: The purchase of any shares held by the would-be acquiring company at a
price substantially in excess of their fair value. The purchased shares are then held as
treasury stock or retired. This tactic is largely ineffective because it may result in an
expensive excise tax; further, from an accounting perspective, the excess of the price
paid over the market price is expensed.
3. White knight or white squire: Encouraging a third firm more acceptable to the target
company management to acquire or merge with the target company.
4. Pac-man defense: Attempting an unfriendly takeover of the would-be acquiring company.
5. Selling the crown jewels: The sale of valuable assets to others to make the firm less
attractive to the would-be acquirer. The negative aspect is that the firm, if it survives,
is left without some important assets.
6. Leveraged buyouts: The purchase of a controlling interest in the target firm by its
managers and third-party investors, who usually incur substantial debt in the process
and subsequently take the firm private. The bonds issued often take the form of high-
interest, high-risk “junk” bonds. Leveraged buyouts will be discussed in more detail
in Chapter 2.
A company may expand in several ways. Some firms concentrate on internal expansion. A
firm may expand internally by engaging in product research and development. Hewlett-
Packard is an example of a company that relied for many years on new product
6
“Men’s Wearhouse Reaches $1.8 Billion Deal to Acquire Jos. A. Bank,” by Maggie McGrath, Forbes.com,
March 11, 2014.
c01.qxd 9/16/14 3:30 PM Page 5

Business Combinations: Why? Why Not? 5

development to maintain and expand its market share. A firm may choose instead to
emphasize marketing and promotional activities to obtain a greater share of a given market.
Although such efforts usually do not expand the total market, they may redistribute that
market by increasing the company’s share of it.
For other firms, external expansion is the goal; that is, they try to expand by acquiring
one or more other firms. This form of expansion, aimed at producing relatively rapid
growth, has exploded in frequency and magnitude in recent years. A company may achieve
significant cost savings as a result of external expansion, perhaps by acquiring one of its
major suppliers.
In addition to rapid expansion, the business combination method, or external expan-
sion, has several other potential advantages over internal expansion:
1. Operating synergies may take a variety of forms. Whether the merger is vertical
(a merger between a supplier and a customer) or horizontal (a merger between
competitors), combination with an existing company provides management of the
acquiring company with an established operating unit with its own experienced per-
sonnel, regular suppliers, productive facilities, and distribution channels. In the case of
Views on vertical mergers, synergies may result from the elimination of certain costs related to
IN whether negotiation, bargaining, and coordination between the parties. In the case of a horizon-
THE synergies are tal merger, potential synergies include the combination of sales forces, facilities, out-
NEWS real or simply
lets, and so on, and the elimination of unnecessary duplication in costs. When a private
a plug figure
to justify a
company is acquired, a plus may be the potential to eliminate not only duplication in
merger that shouldn’t happen costs but also unnecessary costs.
are diverse. Time Warner, for Management of the acquiring company can draw upon the operating history and
example, has fluctuated back the related historical database of the acquired company for planning purposes. A his-
and forth on this issue in recent tory of profitable operations by the acquired company may, of course, greatly reduce
years. President Jeffrey Bewkes the risk involved in the new undertaking. A careful examination of the acquired com-
recently was quoted as saying, pany’s expenses may reveal both expected and unexpected costs that can be eliminated.
“No division should subsidize On the more negative (or cautious) side, be aware that the term “synergies” is some-
another.” When queried about times used loosely. If there are truly expenses that can be eliminated, services that can
the message his predecessors
be combined, and excess capacity that can be reduced, the merger is more likely to
sent to shareholders, he said,
prove successful than if it is based on growth and “so-called synergies,” suggests
“It’s bull—”7
Michael Jensen, a professor of finance at the Harvard Business School.

GAINS FROM BULKING UP8

Industry Key Benefit of Consolidation

Antenna towers Frees up capital and management time for wireless
communications operators
Funeral homes Yields greater discounts on coffins, supplies, and
equipment
Health clubs Spreads regional marketing and advertising costs over
more facilities
Landfill sites Lets operators cope with the new environmental and
regulatory demands
Physician group practices Reduces overhead and costs of medical procedures

2. Combination may enable a company to compete more effectively in the international

marketplace. For example, an acquiring firm may diversify its operations rather
rapidly by entering new markets; alternatively, it may need to ensure its sources of sup-
ply or market outlets. Entry into new markets may also be undertaken to obtain cost sav-
ings realized by smoothing cyclical operations. Diminishing savings from cost-cutting

7
WSJ, “After Years of Pushing Synergy, Time Warner Inc. Says Enough,” by Matthew Karnitschnig,
6/2/06, p.A1.
8
Business Week, “Buy ’Em Out, Then Build ’Em Up,” by Eric Schine, 5/18/95, p. 84.
c01.qxd 9/16/14 3:30 PM Page 6

6 Chapter 1 Introduction to Business Combinations and the Conceptual Framework

More than a
IN third of
THE bankruptcy
NEWS merger
activity in
2008 took
place in financial services, with
the sale of assets by Lehman
Brothers (New York investment
bank) and the $2.8 billion
acquisition by a consortium of
Ashikaga Bank (Japan). Others
included Thornwood
Associates’ $900 million
purchase of Federal-Mogul,
Mendecino Redwood’s $600
million acquisition of Pacific
Lumber, and NBTY’s $371
million purchase of Leiner
Health Products.9
within individual companies makes combination more appealing. The financial crisis in
Asia accelerated the pace for a time as American and European multinationals com-
peted for a shrinking Asian market. However, a combination of growing competition,
globalization, deregulation, and financial engineering has led to increasingly complex
companies and elusive profits.
3. Business combinations are sometimes entered into to take advantage of income tax
laws. The opportunity to file a consolidated tax return may allow profitable corpora-
tions’ tax liabilities to be reduced by the losses of unprofitable affiliates. When an ac-
quisition is financed using debt, the interest payments are tax deductible, creating a fi-
nancial synergy or “tax gain.” Many combinations in the past were planned to obtain
the advantage of significant operating loss carryforwards that could be utilized by the
acquiring company. However, the Tax Reform Act of 1986 limited the use of operat-
ing loss carryforwards in merged companies. Because tax laws vary from year to year
and from country to country, it is difficult to do justice to the importance of tax effects
within the scope of this chapter. Nonetheless, it is important to note that tax implica-
tions are often a driving force in merger decisions.
4. Diversification resulting from a merger offers a number of advantages, including
increased flexibility, an internal capital market, an increase in the firm’s debt capacity,
more protection from competitors over proprietary information, and sometimes a more
effective utilization of the organization’s resources. In debating the tradeoffs between
diversification and focusing on one (or a few) specialties, there are no obvious
answers.
5. Divestitures accounted for 30% or more of the merger and acquisitions activity in each
quarter from 1995 into mid-1998 and from 2001 to 2010. Shedding divisions that are
not part of a company’s core business became common during this period. In some
cases the divestitures may be viewed as “undoing” or “redoing” past acquisitions. A
popular alternative to selling off a division is to “spin off” a unit. Examples include
AT&T’s spin-off of its equipment business to form Lucent Technologies Inc., Sears
Roebuck’s spin-off of Allstate Corp. and Dean Witter Discover & Co., and Cincinnati
Bell’s proposed spin-off of its billing and customer-management businesses to form
Convergys Corp.

Notwithstanding its apparent advantages, business combination may not always be the
best means of expansion. An overriding emphasis on rapid growth may result in the pyra-
miding of one company on another without sufficient management control over the result-
ing conglomerate. Too often in such cases, management fails to maintain a sound enough
financial equity base to sustain the company during periods of recession. Unsuccessful or
incompatible combinations may lead to future divestitures.
In order to avoid large dilutions of equity, some companies have relied on the use of
various debt and preferred stock instruments to finance expansion, only to find themselves
unable to provide the required debt service during a period of decreasing economic activ-
ity. The junk bond market used to finance many of the mergers in the 1980s had essentially
collapsed by the end of that decade.
Business combinations may destroy, rather than create, value in some instances. For
example, if the merged firm’s managers transfer resources to subsidize money-losing seg-
ments instead of shutting them down, the result will be a suboptimal allocation of capital. This
situation may arise because of reluctance to eliminate jobs or to acknowledge a past mistake.
Some critics of the accounting methods used in the United States prior to 2002 to
account for business combinations argued that one of the methods did not hold executives
accountable for their actions if the price they paid was too high, thus encouraging firms to
“pay too much.” Although opinions are divided over the relative merits of the accounting
alternatives, most will agree that the resulting financial statements should reflect the
economics of the business combination. Furthermore, if and when the accounting standards

9
“Water Cooler: What Players in the Mid Market Are Talking About,” Mergers & Acquisitions, December 2008.
c01.qxd 9/16/14 3:30 PM Page 7

Business Combinations: Historical Perspective 7

and the resulting statements fail even partially at this objective, it is crucial that the users of
financial data be able to identify the deficiencies. Thus we urge the reader to keep in mind
that an important reason for learning and understanding the details of accounting for busi-
ness combinations is to understand the economics of the business combination, which in
turn requires understanding any possible deficiencies in the accounting presentation.

1.4 BUSINESS COMBINATIONS: HISTORICAL PERSPECTIVE

LO 1 Historical trends in types of In the United States there have been three fairly distinct periods characterized by many busi-
M&A. ness mergers, consolidations, and other forms of combinations: 1880–1904, 1905–1930, and
1945–present. During the first period, huge holding companies, or trusts, were created by
investment bankers seeking to establish monopoly control over certain industries. This type of
combination is generally called horizontal integration because it involves the combination of
companies within the same industry. Examples of the trusts formed during this period are J. P.
Morgan’s U.S. Steel Corporation and other giant firms such as Standard Oil, the American
Sugar Refining Company, and the American Tobacco Company. By 1904, more than 300 such
trusts had been formed, and they controlled more than 40% of the nation’s industrial capital.
The second period of business combination activity, fostered by the federal govern-
ment during World War I, continued through the 1920s. In an effort to bolster the war
effort, the government encouraged business combinations to obtain greater standardization
of materials and parts and to discourage price competition. After the war, it was difficult to
reverse this trend, and business combinations continued. These combinations were efforts
to obtain better integration of operations, reduce costs, and improve competitive positions
rather than attempts to establish monopoly control over an industry. This type of combina-
tion is called vertical integration because it involves the combination of a company with
its suppliers or customers. For example, Ford Motor Company expanded by acquiring a
glass company, rubber plantations, a cement plant, a steel mill, and other businesses that
supplied its automobile manufacturing business. From 1925 to 1930, more than 1,200 com-
binations took place, and about 7,000 companies disappeared in the process.
The third period started after World War II and has exhibited rapid growth in merger
activity since the mid-1960s, and even more rapid growth since the 1980s. The total dollar
value of mergers and acquisitions grew from under $20 billion in 1967 to over $300 billion by
1995 and over $1 trillion in 1998, and $3.5 trillion by 2006. Even allowing for changes in the
value of the dollar over time, the acceleration is obvious. By 1996, the number of yearly merg-
ers completed was nearly 7,000. Some observers have called this activity merger mania, and
most agreed that the mania had ended by mid-2002. However, by 2006, merger activity was
soaring once more. Illustration 1-1 presents two rough graphs of the level of merger activity for
acquisitions over $10 million from 1972 to 2012 in number of deals, and from 1979 to 2012 in
dollar volume. Illustration 1-2 presents summary statistics on the level of activity for the year
2012 by industry sector for acquisitions with purchase prices valued in excess of $10 million.
This most recent period can be further subdivided to focus on trends of particular
decades or subperiods. For example, many of the mergers that occurred in the United States
from the 1950s through the 1970s were conglomerate mergers. Here the primary motivation
for combination was often to diversify business risk by combining companies in different
industries having little, if any, production or market similarities, or possibly to create value
by lowering the firm’s cost of capital. One conjecture for the popularity of this type of merger
during this time period was the strictness of regulators in limiting combinations of firms in
the same industry. One conglomerate may acquire another, as Esmark did when it acquired
Norton-Simon, and conglomerates may spin off, or divest themselves of, individual busi-
nesses. Management of the conglomerate hopes to smooth earnings over time by counter-
balancing the effects of economic forces that affect different industries at different times.
In contrast, the 1980s were characterized by a relaxation in antitrust enforcement dur-
ing the Reagan administration and by the emergence of high-yield junk bonds to finance
acquisitions. The dominant type of acquisition during this period and into the 1990s was the
strategic acquisition, claiming to benefit from operating synergies. These synergies may
arise when the talents or strengths of one of the firms complement the products or needs of
c01.qxd 9/16/14 3:30 PM Page 8

8 Chapter 1 Introduction to Business Combinations and the Conceptual Framework

the other, or they may arise simply because the firms were former competitors. An argument
can be made that the dominant form of acquisition shifted in the 1980s because many of the
conglomerate mergers of the 1960s and 1970s proved unsuccessful; in fact, some of the
takeovers of the 1980s were of a disciplinary nature, intended to break up conglomerates.
Deregulation undoubtedly played a role in the popularity of combinations in the
1990s. In industries that were once fragmented because concentration was forbidden, the

ILLUSTRATION 1-1 PART A

Number of Mergers and Acquisitions over $10 Million 1972 to 2012

12,000

10,000

8,000
Number

6,000

4,000

2,000

0
1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Year
Data source: Mergers and Acquisitions, February 2002, 2004, 2006, 2009, 2010, 2013 March/April 1999, May/June.

ILLUSTRATION 1-1 PART B

Value of Mergers and Acquisitions over $10 Million 1979 to 2012

$2,000

$1,800

$1,600

$1,400
Dollars Billions

$1,200

$1,000

$800

$600

$400

$200

$0
19 1

19 3

20 9

20 1

20 9
82

19 3

19 1

00

20 3
19 9
19 0

19 9

92

19 8

02

04

20 8

10
11
84

19 8

90

94
19 5

19 5
19 7

96

20 7
86

19 7

20 5
20 6
8

0
8

0
7
8

0
8
8

9
8

0
9

0
0
19

20
19

19

20
19

20
19

19
19

19

20

Year
Data source: Mergers and Acquisitions, February 2013, 2010, 2009, 2006, 2004, 2002, March/April 1999, May/June 1989, 1982 Almanac & Index.
c01.qxd 9/16/14 3:30 PM Page 9

Business Combinations: Historical Perspective 9

ILLUSTRATION 1-2

10 Most Active Industries (Domestic Deals) by Number and Value of Transactions in 2012
Number of Deals Value of Deals
Number % of All Value % of Total
Industry Rank of Deals M&A Deals Rank ($ billions) M&A Value
Business Services 1 957 18.8% 8 24.9 4.0%
Software 2 428 8.4% 7 28.8 4.6%
Real Estate 3 307 6.0% 4 35.7 5.7%
Health Services 4 300 5.9% 3 45.0 7.2%
Oil & Gas 5 210 4.1% 2 67.0 10.7%
Insurance 6 171 3.4% 10 41.6 6.6%
Commercial Banks 7 169 3.3% – 31.0 4.9%
Investment and Commodity Firms 8 146 2.9% 9 22.2 3.5%
Measuring, Medical & Photographic Equipment 9 140 2.7% 6 30.8 4.9%
Wholesale Trade—durable goods 10 139 2.7% – 25.8 4.1%
Drugs – 83 1.6% 5 32.6 5.2%
Electric, Gas, and Water Distributions – 83 1.6% 1 116.6 18.6%
Data source: Mergers & Acquisitions, February 2013, p. 37.

pace of mergers picked up significantly in the presence of deregulation. These industries

include banking, telecommunications, and broadcasting. Although recent years have
witnessed few deals blocked due to antitrust enforcement, an example of a major transac-
tion dropped in 1996 because of a planned FTC (Federal Trade Commission) challenge
was in the drugstore industry. The FTC challenged the impact of a proposed merger
between Rite Aid Corp. and Revco D.S. Inc. on market power in several sectors of the
East and Midwest. Nonetheless, subsequent deals in the industry saw both companies
involved: Rite Aid acquired Thrifty PayLess Holdings Inc., and CVS Inc. purchased
Revco in February 1997.
Later, the Justice Department sued to block Primestar’s acquisition of a satellite slot
owned by MCI and News Corp. Other deals were dropped in the face of possible interven-
tion, including a planned merger between CPA firms KPMG Peat Marwick and Ernst &
Young in 1998. Nonetheless, over time the group of large CPA firms once referred to as the
Big 8 has blended into the Big 4, raising concerns about a possible lack of competition in
the audit market for large companies. The Justice Department reached a settlement in 2013
with American Airlines and US Airways requiring them to sell facilities at seven airports
before being allowed to consummate the planned merger.10

Before the announcement of the merger between AT&T and T-Mobile, phone handset makers such
IN as˛HTC and Motorola had two major carriers (ATT and T-Mobile) who could buy their GSM-based
THE phones. They just lost any ability to control price and profits on handsets because now a single buyer
NEWS that can dictate what GSM phones come to market. Even with LTE becoming the standard for the 4G
world, it would essentially be a market dominated by three buyers, which would place handset
makers at the mercy of the giants.11

Virtually every deal in the 2010 Wall Street lineup of potential mega-mergers faced regulatory
IN challanges both in the United States and in Europe. Examples include Oracle and Sun; Exxon and XTO
THE Energy; Yahoo and Microsoft, Kraft and Cadbury.
NEWS

10
CNN Money, “US Air and American Airlines Reach Deal with Justice to Allow Merger,” by C. Isadore and
E.˛Perez, 11/12/2013.
11
Gigaom.com “In AT&T & T-Mobile Merger, Everybody Loses,” by Om Malik, 3/20/2011.
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10 Chapter 1 Introduction to Business Combinations and the Conceptual Framework

1.5 TERMINOLOGY AND TYPES OF COMBINATIONS

LO 5 Stock versus asset acquisitions. From an accounting perspective, the distinction that is most important at this stage is
between an asset acquisition and a stock acquisition. In Chapter 2, we focus on the acqui-
sition of the assets of the acquired company, where only the acquiring or new company sur-
vives. Thus the books of the acquired company are closed out, and its assets and liabilities
are transferred to the books of the acquirer. In subsequent chapters, we will discuss the
stock acquisition case where the acquired company and its books remain intact and consol-
idated financial statements are prepared periodically. In such cases, the acquiring company
debits an account “Investment in Subsidiary” rather than transferring the underlying assets
and liabilities onto its own books.
Note that the distinction between an asset acquisition and a stock acquisition does not
imply anything about the medium of exchange or consideration used to consummate the
acquisition. Thus a firm may gain control of another firm in a stock acquisition using cash,
debt, stock, or some combination of the three as consideration. Alternatively, a firm may
acquire the total assets of another firm using cash, debt, stock, or some combination of the
three. There are two independent issues related to the consummation of a combination:
what is acquired (assets or stock) and what is given up (the consideration for the combina-
tion). These are shown in Illustration 1-3.
In an asset acquisition, a firm must acquire 100% of the assets of the other firm. In a
stock acquisition, a firm may obtain control by purchasing 50% or more of the voting com-
mon stock (or possibly even less). This introduces one of the most obvious advantages of
the stock acquisition over the asset acquisition: a lower total cost in many cases. Also, in a
stock acquisition, direct formal negotiations with the acquired firm’s management may be
avoided. Further, there may be advantages to maintaining the acquired firm as a separate
legal entity. The possible advantages include liability limited to the assets of the individual
corporation and greater flexibility in filing individual or consolidated tax returns. Finally,
regulations pertaining to one of the firms do not automatically extend to the entire merged
entity in a stock acquisition. A stock acquisition has its own complications, however, and
the economics and specifics of a given situation will dictate the type of acquisition
preferred.
Other terms related to mergers and acquisitions merit mention. For example, business
combinations are sometimes classified by method of combination into three types—
statutory mergers, statutory consolidations, and stock acquisitions. However, the distinction
between these categories is largely a technicality, and the terms mergers, consolidations,
and acquisitions are popularly used interchangeably.
A statutory merger results when one company acquires all the net assets of one or
more other companies through an exchange of stock, payment of cash or other property, or
issue of debt instruments (or a combination of these methods). The acquiring company
survives, whereas the acquired company (or companies) ceases to exist as a separate
legal entity, although it may be continued as a separate division of the acquiring company.

ILLUSTRATION 1-3

What Is Acquired: What Is Given Up:

1. Cash
Net Assets of S Company
(Assets and Liabilities) 2. Debt

3. Stock
Common Stock of S Company 4. Combination of Above
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Terminology and Types of Combinations 11

Synergistic
Thus, if A Company acquires B Company in a statutory merger, the combination is often
IN deals may be expressed as
THE viable even in Statutory Merger
NEWS the current
environment, A Company 1 B Company 5 A Company
given
adequate flexibility and The boards of directors of the companies involved normally negotiate the terms of a
preparation. Although the
plan of merger, which must then be approved by the stockholders of each company
successful financing of large
involved. State laws or corporation bylaws dictate the percentage of positive votes required
deals depends largely on
capital markets, local middle for approval of the plan.
market deals—say, less than A statutory consolidation results when a new corporation is formed to acquire two or
$20 million—more often rely more other corporations through an exchange of voting stock; the acquired corporations
on a combination of then cease to exist as separate legal entities. For example, if C Company is formed to con-
commercial loans, seller solidate A Company and B Company, the combination is generally expressed as
financing, and equity from
Statutory Consolidation
private sources or a private
equity group.12 A Company 1 B Company 5 C Company

Stockholders of the acquired companies (A and B) become stockholders in the new

entity (C). The combination of Chrysler Corp. and Daimler-Benz to form Daimler-
Chrysler is an example of this type of consolidation. The acquired companies in a statutory
consolidation may be operated as separate divisions of the new corporation, just as they
may under a statutory merger. Statutory consolidations require the same type of stock-
holder approval as do statutory mergers.
A stock acquisition occurs when one corporation pays cash or issues stock or debt
for all or part of the voting stock of another company, and the acquired company remains
intact as a separate legal entity. When the acquiring company acquires a controlling
interest in the voting stock of the acquired company (for example, if A Company acquires
50% of the voting stock of B Company), a parent–subsidiary relationship results.

TEST YOUR KNOWLEDGE 1.1

NOTE: Solutions to Test Your Knowledge questions are found at the end of
each chapter before the end-of-chapter questions.
Short Answer
1. Name the following takeover defense tactics:
a. Issuing stock rights to existing shareholders, enabling
them to purchase additional shares at a price below
market value, but exercisable only in the event of a
potential takeover. ________
b. The purchase of a controlling interest in the target
firm by its managers and third-party investors, who
usually incur substantial debt in the process and sub-
sequently take the firm private. ________
c. Encouraging a third firm, more acceptable to the tar-
get company management, to acquire or merge with
the target company. ________
Multiple Choice
2. Which one of the following statements is incorrect?
a. In an asset acquisition, the books of the acquired
company are closed out, and its assets and liabilities
are transferred to the books of the acquirer.
b. In many cases, stock acquisitions entail lower total
cost than asset acquisitions.
c. Regulations pertaining to one of the firms do not
automatically extend to the entire merged entity in a
stock acquisition.
d. A stock acquisition occurs when one corporation
pays cash, issues stock, or issues debt for all or part
of the voting stock of another company; and the
acquired company dissolves and ceases to exist as a
separate legal entity.
3. Which of the following can be used as consideration in a
stock acquisition?
a. Cash
b. Debt
c. Stock
d. Any of the above may be used

12
“The Credit Puzzle,” by Lou Banach and Jim Gettel, Mergers & Acquisitions, December 2008.
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12 Chapter 1 Introduction to Business Combinations and the Conceptual Framework

Consolidated financial statements (explained in later chapters) are prepared and the
business combination is often expressed as
Consolidated Financial Statements

Financial Statements Financial Statements Consolidated Financial Statements of

1 5
of A Company of B Company A Company and B Company

1.6 TAKEOVER PREMIUMS

A takeover premium is the term applied to the excess of the amount offered, or agreed
During March
upon, in an acquisition over the prior stock price of the acquired firm. It is not unusual for
IN 2006, the
THE
the takeover premium to be as high as 100% of the target firm’s market share price before
Capital One
NEWS Financial
the acquisition, and the average hovered around 40% to 50% into the late 1990s. In the face
Corporation of the already high stock prices of this period, speculation was mixed as to the future of
agreed to takeover premiums. Some experts predicted the premiums would shrink, leading to “take-
acquire the North Fork unders” in some cases where companies are acquired below the listed stock prices. These
Bancorporation for about predictions found some subsequent fulfillment as premiums in 2006 declined to around 20%.
$14.6 billion in cash and stock. Possible reasons acquirers are willing to pay high premiums vary. One factor is that the
North Fork shareholders acquirers’ own stock prices may be at a level which makes it attractive to issue stock (rather
received a mix of cash and than cash) to consummate the acquisition. Another factor is the availability of relatively
Capital One shares, cheap credit for mergers and acquisitions.
representing a 22.8% premium
Bidders may have private information about the target firm suggesting that it is worth
over the closing price of North
more than its current market value or has assets not reported on the balance sheet (such as in-
Fork shares.13
process research and development). Alternatively, companies desperate to boost earnings may
believe that growth by acquisitions is essential to survive in the global marketplace and that the
competition necessitates the premiums. At the other end of the spectrum, a final possibility,
which cannot be entirely ruled out, is that managers eager for growth may simply pay too much.
One research study presented evidence that higher premiums were offered for firms with
high cash flows, relatively low growth opportunities, and high tax liabilities relative to their
equity values.14 Another study suggested that the bigger the ego of the acquiring firm’s CEO,
the higher the takeover premium, while still another suggested that any premium over 25% is
extremely risky.15 Some compensation analysts argue that the massive options payouts to
executives combined with golden parachutes provide an unhealthy incentive for executives
to negotiate mergers, citing Chrysler’s merger with Daimler-Benz as an example.16
Takeover premiums have attracted so much attention that some strategists (e.g., Paine
Some Webber’s Edward Kerschner) have advised clients looking for investments to choose stocks
IN statistics that might get taken over. Cautious financial advisors point out that lofty stock prices are a
THE suggest that double-edged sword for financial buyers because they mean high prices for both companies’
NEWS of “6000 stocks and costlier acquisitions. Also, when stock prices fluctuate, the agreed-upon purchase
acquisitions, price may suddenly appear more or less attractive than it did at the time of agreement. For
only 900 example, a proposed acquisition of Comsat Corp. by Lockheed Martin Corp. was announced
return the cost of capital. It is in September 1998, with the acquisition valued at $2.6 billion, of which 49% was to be paid
easy to do deals. It is very in cash and the rest in Lockheed stock. When Lockheed Martin’s stock price subsequently
difficult to make them
faltered enough to suggest a 16% drop in the total value of the transaction, Comsat sharehold-
succeed.”18
ers questioned whether the consideration for the transaction was fairly priced.17

13
The New York Times, “Capital One Reported in Deal for North Fork,” by Andrew Ross Sorkin and Eric Dash,
March 13, 2006, p. A18.
14
The study, entitled “Free Cash Flow and Stockholder Gains in Going Private Transactions,” was conducted by
Lehn and Poulsen (Journal of Finance, July 1989, pp. 771–787). Also see “The Case against Mergers,” by Phillip
Zweig, Business Week, 10/30/95, pp. 122–130.
15
“Acquisition Behavior, Strategic Resource Commitments and the Acquisition Game: A New Perspective on Per-
formance and Risk in Acquiring Firms,” by Mark Sirower, doctoral dissertation, Columbia University, 1994.
16
WSJ, “Chrysler Executives May Reap Windfall,” by Gregory White, 5/13/98, p. A3.
17
WSJ, “Lockheed Bid for Comsat Hits Obstacles,” by Anne Marie Squeo, 6/11/99, p. A3.
18
M&A, “How Acquirers Can Be Blindsided by the Numbers,” May/June 1997, p. 29.
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Avoiding the Pitfalls before the Deal 13

1.7 AVOIDING THE PITFALLS BEFORE THE DEAL

In a survey of 101 corporations that completed a merger or acquisition transaction of at least $100
IN million, KPMG found that 93% of companies queried believed that their deal enhanced shareholder
THE value and over a third said they would not do anything different in subsequent deals. However,
NEWS KPMG’s objective examination of the deals showed that only 31% of these deals improved value.
KPMG concluded that many companies may not be prepared to make an honest assessment of the
success of their deals in order to avoid making mistakes in future deals.19

LO 3 Factors to be considered in due To consider the potential impact on a firm’s earnings realistically, the acquiring firm’s
diligence. managers and advisors must exercise due diligence in considering the information
presented to them. The factors to beware of include the following:

1. Be cautious in interpreting any percentages presented by the selling company. For

example, the seller may be operating below capacity (say, at 60% of capacity), but the
available capacity may be for a product that is unprofitable or that is concentrated at a
specific location, while the desirable product line (which the acquirer wishes to
expand) is already at capacity.
2. Don’t neglect to include assumed liabilities in the assessment of the cost of the
merger. The purchase price for a firm’s assets is the sum of the cash or securities is-
sued to consummate the merger plus any liabilities assumed. This is equivalent to
viewing the purchase price for a firm’s net assets (assets minus liabilities assumed)
as the sum of the cash or securities issued to consummate the merger.

An important part of a buyer’s preparation involves the development of a due diligence report
IN (sometimes by a public accounting firm) for the purpose of uncovering “skeletons in the closet” (like
THE vendor reliance or customer concentrations). These reports offer a fairly objective perspective of the
NEWS business, so sharing them with potential lenders is one way of building trust and confidence in the
collateral and cash flow. Most lenders prefer a 1-to-1 loan-to-collateral ratio in any deal, and regular
monitoring through a monthly borrowing base. A lot of the scrutiny by senior lenders gets directed to
the buyer’s credentials and familiarity with the industry.20

In addition to liabilities that are on the books of the acquired firm, be aware of the
possibility of less obvious liabilities. FASB ASC Section 805–20–25 [recognition]
requires an acquiring firm to recognize at fair value all assets acquired and liabilities
assumed, whether or not shown in the financial statements of the acquired company.21
Furthermore, FASB ASC paragraph 805–30–25–5 states that any contingent assets
or liabilities that are acquired or assumed as part of a business combination must be
measured and recognized at their fair values (provided they satisfy the definition of
assets or liabilities), even if they do not meet the usual recognition criteria for
recording contingent items (FASB ASC paragraph 450–20–25–2).22
FASB ASC Topic 805 [Business Combinations] also states that any costs associated
with restructuring or exit activities should not be treated as liabilities at the acquisition

19
KPMG Transaction Services, “The Morning After—Driving for Post Deal Success,” January 31, 2006.
20
“The Credit Puzzle,” by Lou Banach and Jim Gettel, Mergers & Acquisitions, December 2008.
21
See the section later in the chapter on the FASB Codification.
22
FASB ASC paragraph 450–20–25–2 (FASB Statement No. 5) states that, in general, contingent liabilities (and
related losses) should be accrued if they are both probable and reasonably estimable while contingent assets (and
gains) should usually not be reflected to avoid misleading implications about their realizability. These conditions
still apply for noncontractual contingent liabilities unless it is more likely than not that an asset or liability exists.
The number of deals with contingent payments nearly doubled between 1997 and 2006, while the dollar value of
those deals more than doubled (with the earn-out value portion rising from 3.3 billion dollars in 1997 to a high of
6.1 billion dollars in 2001 and leveling back to 5.3 billion dollars in 2006). See Chapter 2 for further details.
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14 Chapter 1 Introduction to Business Combinations and the Conceptual Framework

ILLUSTRATION 1-4

Mode of Payment in M&A Deals

% of all Deals
Cash Only Stock Only Earnouts
Year # % # % # %
2010 968 61.1% 352 22.2% 145 9.2%
2011 1093 61.3% 379 21.3% 189 10.6%
2012 1143 66.2% 292 16.9% 139 8.0%
2013 965 65.0% 286 19.3% 118 7.9%
2014* 65 60.7% 23 21.5% 7 6.5%
Source: Thomas SDC Platinum
*Partial Year in 2014.

date unless they meet the criteria for recognition laid out in FASB ASC paragraph 420-
10-15-2.23 Instead, costs not meeting these criteria should be expensed in the period in
which they are incurred. For example, future costs expected with regard to exiting an
activity of the target, terminating the employment of the acquiree’s employees, or relo-
cation of those employees are not accounted for as part of the business combination.24
3. Watch out for the impact on earnings of the allocation of expenses and the effects of
production increases, standard cost variances, LIFO liquidations, and by-product
sales. For example, a firm that is planning to be acquired may grow inventory levels in
“While order to allocate its fixed costs over more units, thus decreasing the cost of goods sold
IN everything in and increasing the bottom line. However, the inventory level that is acquired may be
THE the offering excessive and ultimately costly.
NEWS memorandum
4. Note any nonrecurring items that may have artificially or temporarily boosted earn-
may very well
be true,
ings. In addition to nonrecurring gains or revenues, look for recent changes in esti-
although not necessarily, the mates, accrual levels, and methods. While material changes in method are a required
facts are designed to make the disclosure under GAAP, the rules on materiality are fuzzy, and changes in estimates and
company look better than it accruals are frequently not disclosed (See Illustration 1–4).
would if an analyst were to dig 5. Be careful of CEO egos. Striving to be number one may make business sense, but
into those facts.”25 not everyone can hold that spot. One CEO drew both praise and criticism with his
deal-of-the-month style. He stated, “There are the big dogs, there are the ankle-biters,
and then there are those caught in the middle.” The midsize firms have to combine, he
claimed.26

1.8 DETERMINING PRICE AND METHOD OF PAYMENT

IN BUSINESS COMBINATIONS
Whether an acquisition is structured as an asset acquisition or a stock acquisition, the
LO 6 Factors affecting price and
acquiring firm must choose to finance the combination with cash, stock, or debt (or some
method of payment.
combination). The cash-only financed portion of acquisition prices dropped approximately
10% from the early 2000s to an average of 63% between 2010 to 2014. The number of
deals financed with stock-only increased by 6% to an average of 20% between 2010 and
2014. Earnouts were used in approximately 9% of acquisitions.

23
FASB ASC paragraph 420–10–25–2 (FASB Statement No. 146) reiterates the definition of a liability and states
that only present obligations to others are liabilities. It clarifies by specifying that an obligation becomes a present
obligation when a past transaction or event leaves little or no discretion to avoid settlement, and that an exit or dis-
posal plan, by itself, does not create a present obligation.
24
FASB’s new Codification system, referenced here, is discussed near the end of Chapter 1.
25
M&A, “How Acquirers Can Be Blindsided by the Numbers,” May/June 1997, p. 29.
26
WSJ, “In the New Mergers Conglomerates Are Out, Being No. 1 Is In,” by Bernard Wysocki Jr., 12/31/97,
p. A1.
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Determining Price and Method of Payment in Business Combinations 15

The mode of payment also affects the number of days it takes to complete the merger
(from the announcement date to the effective date). The following schedule provides the
average days to complete a merger for various modes of payment in an acquisition.
Mode of Payment* Days to Complete Acquisition

Public Targets Private Targets

Common stock 158 days 90 days
Cash only 84 days 67 days
Earnout 75 days 48 days
* SDC Platinum (2010 to 2013).

As can be seen, if earnouts are used as part of the consideration, the time to complete the
merger is significantly shorter (especially for private acquisitions, with an average of
48 days). Acquisitions using stock generally take much longer to complete. Information on
the mode of payment in mergers and acquisitions is provided in Illustration 1-4.
The trends are often explained by fluctuating stock valuations. The higher the acquir-
ing firm’s stock valuation, the fewer shares are needed to pay for the acquisition. This
means less dilution to existing shareholders, a frequent concern in the planning stages of a
proposed acquisition. When stock prices slumped in the middle of 2001, merger activity
slowed as well. But by the middle of the decade, both were booming once more. Then,
merger activity rose steadily from 2002 to 2006, remained approximately the same in 2007
as in 2006, and then fell off by the end of 2008 as stock prices plunged and the economy
slid into a recession. By 2010, many of the mega-mergers in the making were once again
looking to use all (or mostly) stock, as the market moved up.
When a business combination is effected through an open-market acquisition of stock,
In the merger no particular problems arise in connection with determining price or method of payment.
IN run in 2005,
Price is determined by the normal functioning of the stock market, and payment is gener-
THE the number
NEWS
ally in cash, although some or all of the cash may have to be raised by the acquiring com-
of deals
using stock
pany through debt or equity issues. Effecting a combination may present some difficulty if
decreased to there are not enough willing sellers at the open-market price to permit the acquiring com-
about 11% of total deals, while pany to buy a majority of the outstanding shares of the company being acquired. In that
in 2000, the percentage of event, the acquiring company must either negotiate a price directly with individuals hold-
deals using all stock averaged ing large blocks of shares or revert to an open tender offer.
around 27%. Stock-for-stock When a business combination is effected by a stock swap, or exchange of securities, both
swaps are more common when price and method of payment problems arise. In this case, the price is expressed in terms of
stock prices are increasing.27 a stock exchange ratio, which is generally defined as the number of shares of the acquiring
company to be exchanged for each share of the acquired company, and constitutes a negoti-
ated price. It is important to understand that each constituent of the combination makes two
kinds of contributions to the new entity—net assets and future earnings. The accountant
often becomes deeply involved in the determination of the values of these contributions.
Some of the issues and the problems that arise are discussed in the following section.
In addition, it is not unusual, in an acquisition, for the acquiree to retain all cash as well
as the responsibility for paying any interest bearing debt. A potential issue that can arise
prior to the transaction close is that the acquiree has incentives to delay payments and col-
lect large receivable balances. Thus acquisitions often include net working capital adjust-
ments (true-up). The acquirer will receive additional consideration if net working capital is
below agreed-upon target levels while the acquiree will receive additional consideration if
the target amounts exceed the agreed-upon target amounts.

Net Asset and Future Earnings Contributions

Determination of an equitable price for each constituent company, and of the resulting
exchange ratio, requires the valuation of each company’s net assets as well as their expected
contribution to the future earnings of the new entity. The accountant is often called upon to

27
WSJ, “Year-End Review of Markets & Finance 2005,” by Dennis Berman, 1/3/06, p. R1.
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16 Chapter 1 Introduction to Business Combinations and the Conceptual Framework

EXCESS EARNINGS APPROACH TO ESTIMATING GOODWILL

1. Identify a normal rate of return on assets for firms similar to the company being targeted. Statistical
services are available to provide averages, or a normal rate may be estimated by examining annual
reports of comparable firms. The rate may be estimated as a return on either total assets or on net
identifiable assets (assets other than goodwill minus liabilities).
2. Apply the rate of return identified in step 1 to the level of identifiable assets (or net assets) of the
target to approximate what the “normal” firm in this industry might generate with the same level of
resources. We will refer to the product as “normal earnings.”
3. Estimate the expected future earnings of the target. Past earnings are generally useful here and pro-
vide a more objective measure than management’s projections, although both should be considered.
Exclude any nonrecurring gains or losses (extraordinary items, gains and losses from discontinued
operations, etc.) from past earnings if they are used to estimate future earnings.
4. Subtract the normal earnings calculated in step 2 from the expected target earnings from step 3. The
difference is “excess earnings.” If the normal earnings are greater than the target’s expected earn-
ings, then no goodwill is implied under this approach.
5. To compute estimated goodwill from “excess earnings,” we must assume an appropriate time period
and a discount rate. The shorter the time period and the higher the discount rate, the more conserv-
ative the estimate. If the excess earnings are expected to last indefinitely, the present value of a per-
petuity may be calculated simply by dividing the excess earnings by the discount rate. For finite
time periods, use present-value tables or calculations to compute the present value of an annuity.
Because of the assumptions needed in step 5, a range of goodwill estimates may be obtained simply
by varying the assumed discount rate and/or the assumed discount period.
6. Add the estimated goodwill from step 5 to the fair value of the firm’s net identifiable assets to arrive
at a possible offering price.

aid in determining net asset value by assessing, for example, the expected collectibility of
accounts receivable, current replacement costs for inventories and some fixed assets, and the
current value of long-term liabilities based on current interest rates. To estimate current
replacement costs of real estate and other items of plant and equipment, the services of
appraisal firms may be needed.
Estimation of the value of goodwill to be included in an offering price is subjective.
A number of alternative methods are available, usually involving the discounting of
expected future cash flows (or free cash flows), earnings, or excess earnings over some
period of years. Generally, the use of free cash flows or earnings yields an estimate of the
entire firm value (including goodwill), whereas the use of excess earnings yields an esti-
mate of the goodwill component of total firm value. We next describe the steps in the
excess earnings approach and then follow with an illustration.

Estimating Goodwill and Potential Offering Price Wanna Buy Company is consid-
LO 7 Estimating goodwill.
ering acquiring Hot Stuff Inc. and is wondering how much it should offer. Wanna Buy
makes the following computations and assumptions to help in the decision.
a. Hot Stuff’s identifiable assets have a total fair value of $7,000,000. Hot Stuff has lia-
bilities totalling $3,200,000. The assets include patents and copyrights with a fair
value approximating book value, buildings with a fair value 50% higher than book
value, and equipment with a fair value 25% lower than book value. The remaining lives
of the assets are deemed to be approximately equal to those used by Hot Stuff.
b. Hot Stuff’s pretax income for the year 2006 was $1,059,000, which is believed by
Wanna Buy to be more indicative of future expectations than any of the preceding
years. The net income of $1,059,000 included the following items, among others:
Amortization of patents and copyrights $50,000
Depreciation on buildings 360,000
Depreciation on equipment 80,000
Extraordinary gain 250,000
Loss from discontinued operations 175,000
Pension expense 59,000

c. The normal rate of return on net assets for the industry is 14%.
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Determining Price and Method of Payment in Business Combinations 17

d. Wanna Buy believes that any excess earnings will continue for seven years and that a
rate of return of 15% is required on the investment.
Based on the assumptions above and ignoring tax effects, we will first calculate an
estimation of the implied goodwill, and then use that estimate to arrive at a reasonable
offering price for Hot Stuff.
Normal earnings for similar firms: ($7,000,000 2 $3,200,000) 3 14% 5 $532,000
Expected earnings of target:
Pretax income of Hot Stuff $1,059,000
Add: Losses on discontinued operations 175,000
Reduced depreciation on equipment 20,000 195,000
Subtotal
1,254,000
Subtract: Additional depreciation on building 180,000
Extraordinary gain 250,000 430,000

Target’s expected future earnings 824,000

Excess earnings of target: $824,000 2 $532,000 5 $292,000 per year

Present value of excess earnings (ordinary annuity) for seven years at 15% (see Table A2
in Appendix PV at back of textbook):
Estimated goodwill: $292,000 3 4.16042 5 $1,214,843
Implied offering price = Fair value of assets - Fair value of liabilities + Estimated goodwill
= $7,000,000 - $3,200,000 + $1,214,843 = $5,014,843.

Upon the
IN agreement to
THE purchase
NEWS Creo Inc. for
$900 million
in cash,
Eastman Kodak Company’s CEO
Daniel Carp stated that the
“acquisition will result in some
modest earnings dilution for
the remainder of 2005.”
However, Carp expects that the
Creo transaction will be
accretive in 2006, adding “at
least 5 cents to per-share
operational earnings, driven by
cost savings and revenue
growth available to the
combined entity.”28
In the illustration above, in arriving at the target’s expected future earnings, we ignored
the items that are expected to continue after the acquisition, such as the amortization of the
patents and copyrights and the pension expense. We backed out nonrecurring gains and
losses on extraordinary items or discontinued operations. We adjusted the prior reported
earnings for the expected increase in depreciation on the building (50% higher than in the
past), leading to a decrease in projected earnings. In contrast, we increased projected earn-
ings for the decrease in equipment depreciation (25% lower than in the past). In practice,
more specific information should be available as to which components of earnings are
expected to continue at the same level, which might be reduced because of economies or
cost-cutting plans, and which might increase because of transition costs. The better the
information used in the computation, the better the estimate of goodwill and offering price.
Where the constituent companies have used different accounting methods, the accoun-
tant will often need to reconstruct their financial statements on the basis of agreed-upon
accounting methods in order to obtain reasonably comparable data. Once comparable data
have been obtained for a number of prior periods, they are analyzed further to project future
contributions to earnings. The expected contributions to future earnings may vary widely
among constituents, and the exchange ratio should reflect this fact. The whole process of
valuation, of course, requires the careful exercise of professional judgment. Ultimately,
however, the exchange ratio is determined by the bargaining ability of the individual par-
ties to the combination.
Once the overall values of relative net asset and earnings contributions have been
agreed on, the types of securities to be issued by the new entity in exchange for those of the
combining companies must be determined. In some cases a single class of stock will be
issued; in other cases equity may require the use of more than one class of security.
The concepts of earnings dilution and accretion are critical to the valuation of a
merger. Does the merger increase or decrease expected earnings performance of the acquir-
ing institution? From a financial and shareholder perspective, the price paid for a firm
is hard to justify if earnings per share declines. When this happens, the acquisition is

28
Business Wire, “Kodak Announces Agreement to Acquire Creo Inc,” 1/31/05.
c01.qxd 9/16/14 3:31 PM Page 18

18 Chapter 1 Introduction to Business Combinations and the Conceptual Framework

considered dilutive. Conversely, if the earnings per share increases as a result of the acqui-
Build-A-Bear
IN Workshop, sition, it is referred to as an accretive acquisition.
THE the teddy- Many deals lower earnings per share initially but add significantly to value in later
NEWS bear-stuffing years. While initial dilution may not be a deal killer, however, many managers feel that they
retailer, cannot afford to wait too long for a deal to begin to show a positive return. Opinions are
purchased divided, however, on what drives the market in relation to mergers and acquisitions, nor do
U.K.-based rival Bear Factory research studies offer conclusive evidence on the subject. Bart Madden, a partner in a
for $41.4 million in cash to help valuation advisory firm in Chicago, remarked, “I totally disagree that the market is EPS
solidify Build-A-Bear’s global driven. From the perspective of the owner or manager of capital, what matters is cash in,
position. Build-A-Bear expected cash out, not reported earnings.”29 He acknowledges, however, that CFOs, who “live in a
the acquisition to be accretive
world of accounting rules,” are concerned about reported earnings.
to earnings per share by
2007.30
Evaluating Firm Performance In Appendix 1A (online at www.wiley.com/college/jeter),
we provide a structured approach using ratios to evaluate the performance of a firm. This
approach could be used to evaluate the financial performance of a potential target or in evalu-
ating the strength of an acquirer. The ratio approach begins by analyzing the change in return
on equity (ROE). This ratio is then decomposed into a return on asset (ROA) and a leverage
ratio (total assets divided by equity). These ratios are further decomposed into other relevant
combinations of variables. This structured approach allows the user to zero in on areas that
have changed or that need to be examined in more detail.

1.9 ALTERNATIVE CONCEPTS OF CONSOLIDATED FINANCIAL STATEMENTS

LO 8 Economic entity and parent As mentioned previously, business combinations may take the form of asset acquisitions or
company concepts. stock acquisitions. When the combination is consummated as an asset acquisition, the
books of the acquired company are closed out and the accounting takes place on the books
of the acquirer, as illustrated in Chapter 2. When the combination is consummated as a
stock acquisition, both companies continue to prepare journal and ledger entries separately
through future periods. Periodically the two sets of books are combined into one through a
procedure sometimes referred to as the consolidating process to produce a set of consoli-
dated financial statements. Chapters 3 through 9 deal with many of the technical proce-
dures needed to carry out this process. Here we present a brief introduction to the more
theoretical concepts involved in accounting for the consolidated entity. The question that
arises relates to the primary purpose of the consolidated financial statements and to the
relationships between the affiliated companies and their shareholders, keeping in mind that
a certain group of shareholders may own a portion of the acquired company (often referred
to as the subsidiary) but none of the acquiring company (or parent).
Historically, practice in the U.S. has reflected a compromise between two general con-
cepts of consolidation given various designations in the accounting literature. However, in
FASB ASC topics 805 [Business Combinations] and 810 [Consolidation] (formerly FASB
Statements No. 141-R and No. 160), the FASB indicates that the economic entity concept
is now to be embraced more fully. Next, let us review the basic differences between the
alternative concepts. For our purposes, we will refer to them as the parent company con-
cept and the economic entity concept (sometimes called the economic unit concept). A
third concept, proportionate consolidation, was rejected by the FASB.
Although only one of these—the economic entity concept—is embraced by current
GAAP and thus integrated throughout this text, the two more popular concepts are
described below (as defined by the Financial Accounting Standards Board).31

29
CFO, “Say Goodbye to Pooling,” by Ian Springsteel, February 1997, p. 79.
30
MSNBC.com, “When Bears Collide,” by Rick Aristotle Munarriz, 3/6/06.
31
FASB Discussion Memorandum, “Consolidation Policy and Procedures” FASB (Norwalk, CT: September 10,
1991), pars. 63 and 64.
c01.qxd 9/16/14 3:31 PM Page 19

Alternative Concepts of Consolidated Financial Statements 19

Parent Company Concept

The parent company concept emphasizes the interests of the parent’s shareholders. As a
result, the consolidated financial statements reflect those stockholder interests in the
parent itself, plus their undivided interests in the net assets of the parent’s subsidiaries.
The consolidated balance sheet is essentially a modification of the parent’s balance
sheet with the assets and liabilities of all subsidiaries substituted for the parent’s invest-
ment in subsidiaries. Similarly, the consolidated income statement is essentially a mod-
ification of the parent’s income statement with the revenues, expenses, gains, and losses
of subsidiaries substituted for the parent’s income from investment in subsidiaries.
These multi-line substitutions for single lines in the parent’s balance sheet and income
statement are intended to make the parent’s financial statements more informative about
the parent’s total ownership holdings.

Economic Entity Concept

The economic entity concept emphasizes control of the whole by a single management.
As a result, under this concept, consolidated financial statements are intended to provide
information about a group of legal entities—a parent company and its subsidiaries—
operating as a single unit. The assets, liabilities, revenues, expenses, gains, and losses of
the various component entities are the assets, liabilities, revenues, expenses, gains, and
losses of the consolidated entity. Unless all subsidiaries are wholly owned, the business
enterprise’s proprietary interest (assets less liabilities) is divided into the controlling
interest (stockholders or other owners of the parent company) and one or more noncon-
trolling interests in subsidiaries. Both the controlling and the noncontrolling interests
are part of the proprietary group of the consolidated entity. Under this concept, the
entirety of subsidiaries assests, liabilities, revenues, and expenses are reflected in the
consolidated financial statements. Noncontrolling interest in equity and in income
serves to capture the portion not controlled by the parent.

The parent company concept represents the view that the primary purpose of consoli-
dated financial statements is to provide information relevant to the controlling stockhold-
ers. The parent company effectively controls the assets and operations of the subsidiary.
Noncontrolling stockholders do not exercise any ownership control over the subsidiary
company or the parent company. Thus, the parent company concept places emphasis on the
needs of the controlling stockholders, and the noncontrolling interest is essentially rele-
gated to the position of a claim against the consolidated entity. Thus, the noncontrolling, or
minority, interest should be presented as a liability in the consolidated statement of finan-
cial position under the parent company concept or, as described in the next section, as a
separate component before stockholders’ equity.
The economic entity concept represents the view that the affiliated companies are a
separate, identifiable economic entity. Meaningful evaluation by any interested party of the
financial position and results of operations of the economic entity is possible only if the
individual assets, liabilities, revenues, and expenses of the affiliated companies making up
the economic entity are combined. The economic entity concept treats both controlling and
noncontrolling stockholders as contributors to the economic unit’s capital. Thus, the non-
controlling, or minority, interest should be presented as a component of equity in the con-
solidated financial statement under the economic entity concept.
The FASB stated that it had considered and rejected the concept of proportionate con-
solidation for subsidiaries. This concept, although not used in current or past practice, has
been advocated by some as an alternative to full consolidation. Under proportionate con-
solidation, the consolidated statements would include only a portion, based on the parent’s
ownership interest, of the subsidiary’s assets, liabilities, revenues, expenses, gains, and
losses. The FASB stated that because the consolidated entity has the power to direct the use
of all the assets of a controlled entity, omitting a portion of those assets from the statements
would not be representationally faithful. Similarly, omitting part of the revenues and
expenses from the consolidated income statement would not be representationally faithful.
Another random document with
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 DANCE ON STILTS AT THE GIRLS’ UNYAGO, NIUCHI

Newala, too, suffers from the distance of its water-supply—at least

the Newala of to-day does; there was once another Newala in a lovely
valley at the foot of the plateau. I visited it and found scarcely a trace
of houses, only a Christian cemetery, with the graves of several
missionaries and their converts, remaining as a monument of its
former glories. But the surroundings are wonderfully beautiful. A
thick grove of splendid mango-trees closes in the weather-worn
crosses and headstones; behind them, combining the useful and the
agreeable, is a whole plantation of lemon-trees covered with ripe
fruit; not the small African kind, but a much larger and also juicier
imported variety, which drops into the hands of the passing traveller,
without calling for any exertion on his part. Old Newala is now under
the jurisdiction of the native pastor, Daudi, at Chingulungulu, who,
as I am on very friendly terms with him, allows me, as a matter of
course, the use of this lemon-grove during my stay at Newala.
 FEET MUTILATED BY THE RAVAGES OF THE “JIGGER”
(Sarcopsylla penetrans)

The water-supply of New Newala is in the bottom of the valley,

some 1,600 feet lower down. The way is not only long and fatiguing,
but the water, when we get it, is thoroughly bad. We are suffering not
only from this, but from the fact that the arrangements at Newala are
nothing short of luxurious. We have a separate kitchen—a hut built
against the boma palisade on the right of the baraza, the interior of
which is not visible from our usual position. Our two cooks were not
long in finding this out, and they consequently do—or rather neglect
to do—what they please. In any case they do not seem to be very
particular about the boiling of our drinking-water—at least I can
attribute to no other cause certain attacks of a dysenteric nature,
from which both Knudsen and I have suffered for some time. If a
man like Omari has to be left unwatched for a moment, he is capable
of anything. Besides this complaint, we are inconvenienced by the
state of our nails, which have become as hard as glass, and crack on
the slightest provocation, and I have the additional infliction of
pimples all over me. As if all this were not enough, we have also, for
the last week been waging war against the jigger, who has found his
Eldorado in the hot sand of the Makonde plateau. Our men are seen
all day long—whenever their chronic colds and the dysentery likewise
raging among them permit—occupied in removing this scourge of
Africa from their feet and trying to prevent the disastrous
consequences of its presence. It is quite common to see natives of
this place with one or two toes missing; many have lost all their toes,
or even the whole front part of the foot, so that a well-formed leg
ends in a shapeless stump. These ravages are caused by the female of
Sarcopsylla penetrans, which bores its way under the skin and there
develops an egg-sac the size of a pea. In all books on the subject, it is
stated that one’s attention is called to the presence of this parasite by
an intolerable itching. This agrees very well with my experience, so
far as the softer parts of the sole, the spaces between and under the
toes, and the side of the foot are concerned, but if the creature
penetrates through the harder parts of the heel or ball of the foot, it
may escape even the most careful search till it has reached maturity.
Then there is no time to be lost, if the horrible ulceration, of which
we see cases by the dozen every day, is to be prevented. It is much
easier, by the way, to discover the insect on the white skin of a
European than on that of a native, on which the dark speck scarcely
shows. The four or five jiggers which, in spite of the fact that I
constantly wore high laced boots, chose my feet to settle in, were
taken out for me by the all-accomplished Knudsen, after which I
thought it advisable to wash out the cavities with corrosive
sublimate. The natives have a different sort of disinfectant—they fill
the hole with scraped roots. In a tiny Makua village on the slope of
the plateau south of Newala, we saw an old woman who had filled all
the spaces under her toe-nails with powdered roots by way of
prophylactic treatment. What will be the result, if any, who can say?
The rest of the many trifling ills which trouble our existence are
really more comic than serious. In the absence of anything else to
smoke, Knudsen and I at last opened a box of cigars procured from
the Indian store-keeper at Lindi, and tried them, with the most
distressing results. Whether they contain opium or some other
narcotic, neither of us can say, but after the tenth puff we were both
“off,” three-quarters stupefied and unspeakably wretched. Slowly we
recovered—and what happened next? Half-an-hour later we were
once more smoking these poisonous concoctions—so insatiable is the
craving for tobacco in the tropics.
Even my present attacks of fever scarcely deserve to be taken
seriously. I have had no less than three here at Newala, all of which
have run their course in an incredibly short time. In the early
afternoon, I am busy with my old natives, asking questions and
making notes. The strong midday coffee has stimulated my spirits to
an extraordinary degree, the brain is active and vigorous, and work
progresses rapidly, while a pleasant warmth pervades the whole
body. Suddenly this gives place to a violent chill, forcing me to put on
my overcoat, though it is only half-past three and the afternoon sun
is at its hottest. Now the brain no longer works with such acuteness
and logical precision; more especially does it fail me in trying to
establish the syntax of the difficult Makua language on which I have
ventured, as if I had not enough to do without it. Under the
circumstances it seems advisable to take my temperature, and I do
so, to save trouble, without leaving my seat, and while going on with
my work. On examination, I find it to be 101·48°. My tutors are
abruptly dismissed and my bed set up in the baraza; a few minutes
later I am in it and treating myself internally with hot water and
lemon-juice.
Three hours later, the thermometer marks nearly 104°, and I make
them carry me back into the tent, bed and all, as I am now perspiring
heavily, and exposure to the cold wind just beginning to blow might
mean a fatal chill. I lie still for a little while, and then find, to my
great relief, that the temperature is not rising, but rather falling. This
is about 7.30 p.m. At 8 p.m. I find, to my unbounded astonishment,
that it has fallen below 98·6°, and I feel perfectly well. I read for an
hour or two, and could very well enjoy a smoke, if I had the
wherewithal—Indian cigars being out of the question.
Having no medical training, I am at a loss to account for this state
of things. It is impossible that these transitory attacks of high fever
should be malarial; it seems more probable that they are due to a
kind of sunstroke. On consulting my note-book, I become more and
more inclined to think this is the case, for these attacks regularly
follow extreme fatigue and long exposure to strong sunshine. They at
least have the advantage of being only short interruptions to my
work, as on the following morning I am always quite fresh and fit.
My treasure of a cook is suffering from an enormous hydrocele which
makes it difficult for him to get up, and Moritz is obliged to keep in
the dark on account of his inflamed eyes. Knudsen’s cook, a raw boy
from somewhere in the bush, knows still less of cooking than Omari;
consequently Nils Knudsen himself has been promoted to the vacant
post. Finding that we had come to the end of our supplies, he began
by sending to Chingulungulu for the four sucking-pigs which we had
bought from Matola and temporarily left in his charge; and when
they came up, neatly packed in a large crate, he callously slaughtered
the biggest of them. The first joint we were thoughtless enough to
entrust for roasting to Knudsen’s mshenzi cook, and it was
consequently uneatable; but we made the rest of the animal into a
jelly which we ate with great relish after weeks of underfeeding,
consuming incredible helpings of it at both midday and evening
meals. The only drawback is a certain want of variety in the tinned
vegetables. Dr. Jäger, to whom the Geographical Commission
entrusted the provisioning of the expeditions—mine as well as his
own—because he had more time on his hands than the rest of us,
seems to have laid in a huge stock of Teltow turnips,[46] an article of
food which is all very well for occasional use, but which quickly palls
when set before one every day; and we seem to have no other tins
left. There is no help for it—we must put up with the turnips; but I
am certain that, once I am home again, I shall not touch them for ten
years to come.
Amid all these minor evils, which, after all, go to make up the
genuine flavour of Africa, there is at least one cheering touch:
Knudsen has, with the dexterity of a skilled mechanic, repaired my 9
× 12 cm. camera, at least so far that I can use it with a little care.
How, in the absence of finger-nails, he was able to accomplish such a
ticklish piece of work, having no tool but a clumsy screw-driver for
taking to pieces and putting together again the complicated
mechanism of the instantaneous shutter, is still a mystery to me; but
he did it successfully. The loss of his finger-nails shows him in a light
contrasting curiously enough with the intelligence evinced by the
above operation; though, after all, it is scarcely surprising after his
ten years’ residence in the bush. One day, at Lindi, he had occasion
to wash a dog, which must have been in need of very thorough
cleansing, for the bottle handed to our friend for the purpose had an
extremely strong smell. Having performed his task in the most
conscientious manner, he perceived with some surprise that the dog
did not appear much the better for it, and was further surprised by
finding his own nails ulcerating away in the course of the next few
days. “How was I to know that carbolic acid has to be diluted?” he
mutters indignantly, from time to time, with a troubled gaze at his
mutilated finger-tips.
 Since we came to Newala we have been making excursions in all
directions through the surrounding country, in accordance with old
habit, and also because the akida Sefu did not get together the tribal
elders from whom I wanted information so speedily as he had
promised. There is, however, no harm done, as, even if seen only
from the outside, the country and people are interesting enough.
The Makonde plateau is like a large rectangular table rounded off
at the corners. Measured from the Indian Ocean to Newala, it is
about seventy-five miles long, and between the Rovuma and the
Lukuledi it averages fifty miles in breadth, so that its superficial area
is about two-thirds of that of the kingdom of Saxony. The surface,
however, is not level, but uniformly inclined from its south-western
edge to the ocean. From the upper edge, on which Newala lies, the
eye ranges for many miles east and north-east, without encountering
any obstacle, over the Makonde bush. It is a green sea, from which
here and there thick clouds of smoke rise, to show that it, too, is
inhabited by men who carry on their tillage like so many other
primitive peoples, by cutting down and burning the bush, and
manuring with the ashes. Even in the radiant light of a tropical day
such a fire is a grand sight.
Much less effective is the impression produced just now by the
great western plain as seen from the edge of the plateau. As often as
time permits, I stroll along this edge, sometimes in one direction,
sometimes in another, in the hope of finding the air clear enough to
let me enjoy the view; but I have always been disappointed.
Wherever one looks, clouds of smoke rise from the burning bush,
and the air is full of smoke and vapour. It is a pity, for under more
favourable circumstances the panorama of the whole country up to
the distant Majeje hills must be truly magnificent. It is of little use
taking photographs now, and an outline sketch gives a very poor idea
of the scenery. In one of these excursions I went out of my way to
make a personal attempt on the Makonde bush. The present edge of
the plateau is the result of a far-reaching process of destruction
through erosion and denudation. The Makonde strata are
everywhere cut into by ravines, which, though short, are hundreds of
yards in depth. In consequence of the loose stratification of these
beds, not only are the walls of these ravines nearly vertical, but their
upper end is closed by an equally steep escarpment, so that the
western edge of the Makonde plateau is hemmed in by a series of
deep, basin-like valleys. In order to get from one side of such a ravine
to the other, I cut my way through the bush with a dozen of my men.
It was a very open part, with more grass than scrub, but even so the
short stretch of less than two hundred yards was very hard work; at
the end of it the men’s calicoes were in rags and they themselves
bleeding from hundreds of scratches, while even our strong khaki
suits had not escaped scatheless.

NATIVE PATH THROUGH THE MAKONDE BUSH, NEAR

MAHUTA

I see increasing reason to believe that the view formed some time
back as to the origin of the Makonde bush is the correct one. I have
no doubt that it is not a natural product, but the result of human
occupation. Those parts of the high country where man—as a very
slight amount of practice enables the eye to perceive at once—has not
yet penetrated with axe and hoe, are still occupied by a splendid
timber forest quite able to sustain a comparison with our mixed
forests in Germany. But wherever man has once built his hut or tilled
his field, this horrible bush springs up. Every phase of this process
may be seen in the course of a couple of hours’ walk along the main
road. From the bush to right or left, one hears the sound of the axe—
not from one spot only, but from several directions at once. A few
steps further on, we can see what is taking place. The brush has been
cut down and piled up in heaps to the height of a yard or more,
between which the trunks of the large trees stand up like the last
pillars of a magnificent ruined building. These, too, present a
melancholy spectacle: the destructive Makonde have ringed them—
cut a broad strip of bark all round to ensure their dying off—and also
piled up pyramids of brush round them. Father and son, mother and
son-in-law, are chopping away perseveringly in the background—too
busy, almost, to look round at the white stranger, who usually excites
so much interest. If you pass by the same place a week later, the piles
of brushwood have disappeared and a thick layer of ashes has taken
the place of the green forest. The large trees stretch their
smouldering trunks and branches in dumb accusation to heaven—if
they have not already fallen and been more or less reduced to ashes,
perhaps only showing as a white stripe on the dark ground.
This work of destruction is carried out by the Makonde alike on the
virgin forest and on the bush which has sprung up on sites already
cultivated and deserted. In the second case they are saved the trouble
of burning the large trees, these being entirely absent in the
secondary bush.
After burning this piece of forest ground and loosening it with the
hoe, the native sows his corn and plants his vegetables. All over the
country, he goes in for bed-culture, which requires, and, in fact,
receives, the most careful attention. Weeds are nowhere tolerated in
the south of German East Africa. The crops may fail on the plains,
where droughts are frequent, but never on the plateau with its
abundant rains and heavy dews. Its fortunate inhabitants even have
the satisfaction of seeing the proud Wayao and Wamakua working
for them as labourers, driven by hunger to serve where they were
accustomed to rule.
But the light, sandy soil is soon exhausted, and would yield no
harvest the second year if cultivated twice running. This fact has
been familiar to the native for ages; consequently he provides in
time, and, while his crop is growing, prepares the next plot with axe
and firebrand. Next year he plants this with his various crops and
lets the first piece lie fallow. For a short time it remains waste and
desolate; then nature steps in to repair the destruction wrought by
man; a thousand new growths spring out of the exhausted soil, and
even the old stumps put forth fresh shoots. Next year the new growth
is up to one’s knees, and in a few years more it is that terrible,
impenetrable bush, which maintains its position till the black
occupier of the land has made the round of all the available sites and
come back to his starting point.
The Makonde are, body and soul, so to speak, one with this bush.
According to my Yao informants, indeed, their name means nothing
else but “bush people.” Their own tradition says that they have been
settled up here for a very long time, but to my surprise they laid great
stress on an original immigration. Their old homes were in the
south-east, near Mikindani and the mouth of the Rovuma, whence
their peaceful forefathers were driven by the continual raids of the
Sakalavas from Madagascar and the warlike Shirazis[47] of the coast,
to take refuge on the almost inaccessible plateau. I have studied
African ethnology for twenty years, but the fact that changes of
population in this apparently quiet and peaceable corner of the earth
could have been occasioned by outside enterprises taking place on
the high seas, was completely new to me. It is, no doubt, however,
correct.
The charming tribal legend of the Makonde—besides informing us
of other interesting matters—explains why they have to live in the
thickest of the bush and a long way from the edge of the plateau,
instead of making their permanent homes beside the purling brooks
and springs of the low country.
“The place where the tribe originated is Mahuta, on the southern
side of the plateau towards the Rovuma, where of old time there was
nothing but thick bush. Out of this bush came a man who never
washed himself or shaved his head, and who ate and drank but little.
He went out and made a human figure from the wood of a tree
growing in the open country, which he took home to his abode in the
bush and there set it upright. In the night this image came to life and
was a woman. The man and woman went down together to the
Rovuma to wash themselves. Here the woman gave birth to a still-
born child. They left that place and passed over the high land into the
valley of the Mbemkuru, where the woman had another child, which
was also born dead. Then they returned to the high bush country of
Mahuta, where the third child was born, which lived and grew up. In
course of time, the couple had many more children, and called
themselves Wamatanda. These were the ancestral stock of the
Makonde, also called Wamakonde,[48] i.e., aborigines. Their
forefather, the man from the bush, gave his children the command to
bury their dead upright, in memory of the mother of their race who
was cut out of wood and awoke to life when standing upright. He also
warned them against settling in the valleys and near large streams,
for sickness and death dwelt there. They were to make it a rule to
have their huts at least an hour’s walk from the nearest watering-
place; then their children would thrive and escape illness.”
The explanation of the name Makonde given by my informants is
somewhat different from that contained in the above legend, which I
extract from a little book (small, but packed with information), by
Pater Adams, entitled Lindi und sein Hinterland. Otherwise, my
results agree exactly with the statements of the legend. Washing?
Hapana—there is no such thing. Why should they do so? As it is, the
supply of water scarcely suffices for cooking and drinking; other
people do not wash, so why should the Makonde distinguish himself
by such needless eccentricity? As for shaving the head, the short,
woolly crop scarcely needs it,[49] so the second ancestral precept is
likewise easy enough to follow. Beyond this, however, there is
nothing ridiculous in the ancestor’s advice. I have obtained from
various local artists a fairly large number of figures carved in wood,
ranging from fifteen to twenty-three inches in height, and
representing women belonging to the great group of the Mavia,
Makonde, and Matambwe tribes. The carving is remarkably well
done and renders the female type with great accuracy, especially the
keloid ornamentation, to be described later on. As to the object and
meaning of their works the sculptors either could or (more probably)
would tell me nothing, and I was forced to content myself with the
scanty information vouchsafed by one man, who said that the figures
were merely intended to represent the nembo—the artificial
deformations of pelele, ear-discs, and keloids. The legend recorded
by Pater Adams places these figures in a new light. They must surely
be more than mere dolls; and we may even venture to assume that
they are—though the majority of present-day Makonde are probably
unaware of the fact—representations of the tribal ancestress.
 The references in the legend to the descent from Mahuta to the
Rovuma, and to a journey across the highlands into the Mbekuru
valley, undoubtedly indicate the previous history of the tribe, the
travels of the ancestral pair typifying the migrations of their
descendants. The descent to the neighbouring Rovuma valley, with
its extraordinary fertility and great abundance of game, is intelligible
at a glance—but the crossing of the Lukuledi depression, the ascent
to the Rondo Plateau and the descent to the Mbemkuru, also lie
within the bounds of probability, for all these districts have exactly
the same character as the extreme south. Now, however, comes a
point of especial interest for our bacteriological age. The primitive
Makonde did not enjoy their lives in the marshy river-valleys.
Disease raged among them, and many died. It was only after they
had returned to their original home near Mahuta, that the health
conditions of these people improved. We are very apt to think of the
African as a stupid person whose ignorance of nature is only equalled
by his fear of it, and who looks on all mishaps as caused by evil
spirits and malignant natural powers. It is much more correct to
assume in this case that the people very early learnt to distinguish
districts infested with malaria from those where it is absent.
This knowledge is crystallized in the
ancestral warning against settling in the
valleys and near the great waters, the
dwelling-places of disease and death. At the
same time, for security against the hostile
Mavia south of the Rovuma, it was enacted
that every settlement must be not less than a
certain distance from the southern edge of the
plateau. Such in fact is their mode of life at the
present day. It is not such a bad one, and
certainly they are both safer and more
comfortable than the Makua, the recent
intruders from the south, who have made USUAL METHOD OF
good their footing on the western edge of the CLOSING HUT-DOOR
plateau, extending over a fairly wide belt of
country. Neither Makua nor Makonde show in their dwellings
anything of the size and comeliness of the Yao houses in the plain,
especially at Masasi, Chingulungulu and Zuza’s. Jumbe Chauro, a
Makonde hamlet not far from Newala, on the road to Mahuta, is the
most important settlement of the tribe I have yet seen, and has fairly
spacious huts. But how slovenly is their construction compared with
the palatial residences of the elephant-hunters living in the plain.
The roofs are still more untidy than in the general run of huts during
the dry season, the walls show here and there the scanty beginnings
or the lamentable remains of the mud plastering, and the interior is a
veritable dog-kennel; dirt, dust and disorder everywhere. A few huts
only show any attempt at division into rooms, and this consists
merely of very roughly-made bamboo partitions. In one point alone
have I noticed any indication of progress—in the method of fastening
the door. Houses all over the south are secured in a simple but
ingenious manner. The door consists of a set of stout pieces of wood
or bamboo, tied with bark-string to two cross-pieces, and moving in
two grooves round one of the door-posts, so as to open inwards. If
the owner wishes to leave home, he takes two logs as thick as a man’s
upper arm and about a yard long. One of these is placed obliquely
against the middle of the door from the inside, so as to form an angle
of from 60° to 75° with the ground. He then places the second piece
horizontally across the first, pressing it downward with all his might.
It is kept in place by two strong posts planted in the ground a few
inches inside the door. This fastening is absolutely safe, but of course
cannot be applied to both doors at once, otherwise how could the
owner leave or enter his house? I have not yet succeeded in finding
out how the back door is fastened.

MAKONDE LOCK AND KEY AT JUMBE CHAURO

 This is the general way of closing a house. The Makonde at Jumbe
Chauro, however, have a much more complicated, solid and original
one. Here, too, the door is as already described, except that there is
only one post on the inside, standing by itself about six inches from
one side of the doorway. Opposite this post is a hole in the wall just
large enough to admit a man’s arm. The door is closed inside by a
large wooden bolt passing through a hole in this post and pressing
with its free end against the door. The other end has three holes into
which fit three pegs running in vertical grooves inside the post. The
door is opened with a wooden key about a foot long, somewhat
curved and sloped off at the butt; the other end has three pegs
corresponding to the holes, in the bolt, so that, when it is thrust
through the hole in the wall and inserted into the rectangular
opening in the post, the pegs can be lifted and the bolt drawn out.[50]

MODE OF INSERTING THE KEY

With no small pride first one householder and then a second

showed me on the spot the action of this greatest invention of the
Makonde Highlands. To both with an admiring exclamation of
“Vizuri sana!” (“Very fine!”). I expressed the wish to take back these
marvels with me to Ulaya, to show the Wazungu what clever fellows
the Makonde are. Scarcely five minutes after my return to camp at
Newala, the two men came up sweating under the weight of two
heavy logs which they laid down at my feet, handing over at the same
time the keys of the fallen fortress. Arguing, logically enough, that if
the key was wanted, the lock would be wanted with it, they had taken
their axes and chopped down the posts—as it never occurred to them
to dig them out of the ground and so bring them intact. Thus I have
two badly damaged specimens, and the owners, instead of praise,
come in for a blowing-up.
The Makua huts in the environs of Newala are especially
miserable; their more than slovenly construction reminds one of the
temporary erections of the Makua at Hatia’s, though the people here
have not been concerned in a war. It must therefore be due to
congenital idleness, or else to the absence of a powerful chief. Even
the baraza at Mlipa’s, a short hour’s walk south-east of Newala,
shares in this general neglect. While public buildings in this country
are usually looked after more or less carefully, this is in evident
danger of being blown over by the first strong easterly gale. The only
attractive object in this whole district is the grave of the late chief
Mlipa. I visited it in the morning, while the sun was still trying with
partial success to break through the rolling mists, and the circular
grove of tall euphorbias, which, with a broken pot, is all that marks
the old king’s resting-place, impressed one with a touch of pathos.
Even my very materially-minded carriers seemed to feel something
of the sort, for instead of their usual ribald songs, they chanted
solemnly, as we marched on through the dense green of the Makonde
bush:—
 “We shall arrive with the great master; we stand in a row and have
no fear about getting our food and our money from the Serkali (the
Government). We are not afraid; we are going along with the great
master, the lion; we are going down to the coast and back.”
With regard to the characteristic features of the various tribes here
on the western edge of the plateau, I can arrive at no other
conclusion than the one already come to in the plain, viz., that it is
impossible for anyone but a trained anthropologist to assign any
given individual at once to his proper tribe. In fact, I think that even
an anthropological specialist, after the most careful examination,
might find it a difficult task to decide. The whole congeries of peoples
collected in the region bounded on the west by the great Central
African rift, Tanganyika and Nyasa, and on the east by the Indian
Ocean, are closely related to each other—some of their languages are
only distinguished from one another as dialects of the same speech,
and no doubt all the tribes present the same shape of skull and
structure of skeleton. Thus, surely, there can be no very striking
differences in outward appearance.
 Even did such exist, I should have no time
to concern myself with them, for day after day,
I have to see or hear, as the case may be—in
any case to grasp and record—an
extraordinary number of ethnographic
phenomena. I am almost disposed to think it
fortunate that some departments of inquiry, at
least, are barred by external circumstances.
Chief among these is the subject of iron-
working. We are apt to think of Africa as a
country where iron ore is everywhere, so to
speak, to be picked up by the roadside, and
where it would be quite surprising if the
inhabitants had not learnt to smelt the
material ready to their hand. In fact, the
knowledge of this art ranges all over the
continent, from the Kabyles in the north to the
Kafirs in the south. Here between the Rovuma
and the Lukuledi the conditions are not so
favourable. According to the statements of the
Makonde, neither ironstone nor any other
form of iron ore is known to them. They have
not therefore advanced to the art of smelting
the metal, but have hitherto bought all their
THE ANCESTRESS OF
THE MAKONDE
iron implements from neighbouring tribes.
Even in the plain the inhabitants are not much
better off. Only one man now living is said to
understand the art of smelting iron. This old fundi lives close to
Huwe, that isolated, steep-sided block of granite which rises out of
the green solitude between Masasi and Chingulungulu, and whose
jagged and splintered top meets the traveller’s eye everywhere. While
still at Masasi I wished to see this man at work, but was told that,
frightened by the rising, he had retired across the Rovuma, though
he would soon return. All subsequent inquiries as to whether the
fundi had come back met with the genuine African answer, “Bado”
(“Not yet”).
 BRAZIER

Some consolation was afforded me by a brassfounder, whom I

came across in the bush near Akundonde’s. This man is the favourite
of women, and therefore no doubt of the gods; he welds the glittering
brass rods purchased at the coast into those massive, heavy rings
which, on the wrists and ankles of the local fair ones, continually give
me fresh food for admiration. Like every decent master-craftsman he
had all his tools with him, consisting of a pair of bellows, three
crucibles and a hammer—nothing more, apparently. He was quite
willing to show his skill, and in a twinkling had fixed his bellows on
the ground. They are simply two goat-skins, taken off whole, the four
legs being closed by knots, while the upper opening, intended to
admit the air, is kept stretched by two pieces of wood. At the lower
end of the skin a smaller opening is left into which a wooden tube is
stuck. The fundi has quickly borrowed a heap of wood-embers from
the nearest hut; he then fixes the free ends of the two tubes into an
earthen pipe, and clamps them to the ground by means of a bent
piece of wood. Now he fills one of his small clay crucibles, the dross
on which shows that they have been long in use, with the yellow
material, places it in the midst of the embers, which, at present are
only faintly glimmering, and begins his work. In quick alternation
the smith’s two hands move up and down with the open ends of the
bellows; as he raises his hand he holds the slit wide open, so as to let
the air enter the skin bag unhindered. In pressing it down he closes
the bag, and the air puffs through the bamboo tube and clay pipe into
the fire, which quickly burns up. The smith, however, does not keep
on with this work, but beckons to another man, who relieves him at
the bellows, while he takes some more tools out of a large skin pouch
carried on his back. I look on in wonder as, with a smooth round
stick about the thickness of a finger, he bores a few vertical holes into
the clean sand of the soil. This should not be difficult, yet the man
seems to be taking great pains over it. Then he fastens down to the
ground, with a couple of wooden clamps, a neat little trough made by
splitting a joint of bamboo in half, so that the ends are closed by the
two knots. At last the yellow metal has attained the right consistency,
and the fundi lifts the crucible from the fire by means of two sticks
split at the end to serve as tongs. A short swift turn to the left—a
tilting of the crucible—and the molten brass, hissing and giving forth
clouds of smoke, flows first into the bamboo mould and then into the
holes in the ground.
The technique of this backwoods craftsman may not be very far
advanced, but it cannot be denied that he knows how to obtain an
adequate result by the simplest means. The ladies of highest rank in
this country—that is to say, those who can afford it, wear two kinds
of these massive brass rings, one cylindrical, the other semicircular
in section. The latter are cast in the most ingenious way in the
bamboo mould, the former in the circular hole in the sand. It is quite
a simple matter for the fundi to fit these bars to the limbs of his fair
customers; with a few light strokes of his hammer he bends the
pliable brass round arm or ankle without further inconvenience to
the wearer.
SHAPING THE POT

SMOOTHING WITH MAIZE-COB

CUTTING THE EDGE

 FINISHING THE BOTTOM

LAST SMOOTHING BEFORE

BURNING

FIRING THE BRUSH-PILE

 LIGHTING THE FARTHER SIDE OF
THE PILE

TURNING THE RED-HOT VESSEL

NYASA WOMAN MAKING POTS AT MASASI

Pottery is an art which must always and everywhere excite the
interest of the student, just because it is so intimately connected with
the development of human culture, and because its relics are one of
the principal factors in the reconstruction of our own condition in
prehistoric times. I shall always remember with pleasure the two or
three afternoons at Masasi when Salim Matola’s mother, a slightly-
built, graceful, pleasant-looking woman, explained to me with
touching patience, by means of concrete illustrations, the ceramic art
of her people. The only implements for this primitive process were a
lump of clay in her left hand, and in the right a calabash containing
the following valuables: the fragment of a maize-cob stripped of all
its grains, a smooth, oval pebble, about the size of a pigeon’s egg, a
few chips of gourd-shell, a bamboo splinter about the length of one’s
hand, a small shell, and a bunch of some herb resembling spinach.
 Nothing more. The woman scraped with the
shell a round, shallow hole in the soft, fine
sand of the soil, and, when an active young
girl had filled the calabash with water for her,
she began to knead the clay. As if by magic it
gradually assumed the shape of a rough but
already well-shaped vessel, which only wanted
a little touching up with the instruments
before mentioned. I looked out with the
MAKUA WOMAN closest attention for any indication of the use
MAKING A POT. of the potter’s wheel, in however rudimentary
SHOWS THE a form, but no—hapana (there is none). The
BEGINNINGS OF THE embryo pot stood firmly in its little
POTTER’S WHEEL
depression, and the woman walked round it in
a stooping posture, whether she was removing
small stones or similar foreign bodies with the maize-cob, smoothing
the inner or outer surface with the splinter of bamboo, or later, after
letting it dry for a day, pricking in the ornamentation with a pointed
bit of gourd-shell, or working out the bottom, or cutting the edge
with a sharp bamboo knife, or giving the last touches to the finished
vessel. This occupation of the women is infinitely toilsome, but it is
without doubt an accurate reproduction of the process in use among
our ancestors of the Neolithic and Bronze ages.
There is no doubt that the invention of pottery, an item in human
progress whose importance cannot be over-estimated, is due to
women. Rough, coarse and unfeeling, the men of the horde range
over the countryside. When the united cunning of the hunters has
succeeded in killing the game; not one of them thinks of carrying
home the spoil. A bright fire, kindled by a vigorous wielding of the
drill, is crackling beside them; the animal has been cleaned and cut
up secundum artem, and, after a slight singeing, will soon disappear
under their sharp teeth; no one all this time giving a single thought
to wife or child.
To what shifts, on the other hand, the primitive wife, and still more
the primitive mother, was put! Not even prehistoric stomachs could
endure an unvarying diet of raw food. Something or other suggested
the beneficial effect of hot water on the majority of approved but
indigestible dishes. Perhaps a neighbour had tried holding the hard
roots or tubers over the fire in a calabash filled with water—or maybe
an ostrich-egg-shell, or a hastily improvised vessel of bark. They
became much softer and more palatable than they had previously
been; but, unfortunately, the vessel could not stand the fire and got
charred on the outside. That can be remedied, thought our
ancestress, and plastered a layer of wet clay round a similar vessel.
This is an improvement; the cooking utensil remains uninjured, but
the heat of the fire has shrunk it, so that it is loose in its shell. The
next step is to detach it, so, with a firm grip and a jerk, shell and
kernel are separated, and pottery is invented. Perhaps, however, the
discovery which led to an intelligent use of the burnt-clay shell, was
made in a slightly different way. Ostrich-eggs and calabashes are not
to be found in every part of the world, but everywhere mankind has
arrived at the art of making baskets out of pliant materials, such as
bark, bast, strips of palm-leaf, supple twigs, etc. Our inventor has no
water-tight vessel provided by nature. “Never mind, let us line the
basket with clay.” This answers the purpose, but alas! the basket gets
burnt over the blazing fire, the woman watches the process of
cooking with increasing uneasiness, fearing a leak, but no leak
appears. The food, done to a turn, is eaten with peculiar relish; and
the cooking-vessel is examined, half in curiosity, half in satisfaction
at the result. The plastic clay is now hard as stone, and at the same
time looks exceedingly well, for the neat plaiting of the burnt basket
is traced all over it in a pretty pattern. Thus, simultaneously with
pottery, its ornamentation was invented.
Primitive woman has another claim to respect. It was the man,
roving abroad, who invented the art of producing fire at will, but the
woman, unable to imitate him in this, has been a Vestal from the
earliest times. Nothing gives so much trouble as the keeping alight of
the smouldering brand, and, above all, when all the men are absent
from the camp. Heavy rain-clouds gather, already the first large
drops are falling, the first gusts of the storm rage over the plain. The
little flame, a greater anxiety to the woman than her own children,
flickers unsteadily in the blast. What is to be done? A sudden thought
occurs to her, and in an instant she has constructed a primitive hut
out of strips of bark, to protect the flame against rain and wind.
This, or something very like it, was the way in which the principle
of the house was discovered; and even the most hardened misogynist
cannot fairly refuse a woman the credit of it. The protection of the
hearth-fire from the weather is the germ from which the human
dwelling was evolved. Men had little, if any share, in this forward
step, and that only at a late stage. Even at the present day, the
plastering of the housewall with clay and the manufacture of pottery
are exclusively the women’s business. These are two very significant
survivals. Our European kitchen-garden, too, is originally a woman’s
invention, and the hoe, the primitive instrument of agriculture, is,
characteristically enough, still used in this department. But the
noblest achievement which we owe to the other sex is unquestionably
the art of cookery. Roasting alone—the oldest process—is one for
which men took the hint (a very obvious one) from nature. It must
have been suggested by the scorched carcase of some animal
overtaken by the destructive forest-fires. But boiling—the process of
improving organic substances by the help of water heated to boiling-
point—is a much later discovery. It is so recent that it has not even
yet penetrated to all parts of the world. The Polynesians understand
how to steam food, that is, to cook it, neatly wrapped in leaves, in a
hole in the earth between hot stones, the air being excluded, and
(sometimes) a few drops of water sprinkled on the stones; but they
do not understand boiling.
To come back from this digression, we find that the slender Nyasa
woman has, after once more carefully examining the finished pot,
put it aside in the shade to dry. On the following day she sends me
word by her son, Salim Matola, who is always on hand, that she is
going to do the burning, and, on coming out of my house, I find her
already hard at work. She has spread on the ground a layer of very
dry sticks, about as thick as one’s thumb, has laid the pot (now of a
yellowish-grey colour) on them, and is piling brushwood round it.
My faithful Pesa mbili, the mnyampara, who has been standing by,
most obligingly, with a lighted stick, now hands it to her. Both of
them, blowing steadily, light the pile on the lee side, and, when the
flame begins to catch, on the weather side also. Soon the whole is in a
blaze, but the dry fuel is quickly consumed and the fire dies down, so
that we see the red-hot vessel rising from the ashes. The woman
turns it continually with a long stick, sometimes one way and
sometimes another, so that it may be evenly heated all over. In
twenty minutes she rolls it out of the ash-heap, takes up the bundle
of spinach, which has been lying for two days in a jar of water, and
sprinkles the red-hot clay with it. The places where the drops fall are
marked by black spots on the uniform reddish-brown surface. With a
sigh of relief, and with visible satisfaction, the woman rises to an
erect position; she is standing just in a line between me and the fire,
from which a cloud of smoke is just rising: I press the ball of my
camera, the shutter clicks—the apotheosis is achieved! Like a
priestess, representative of her inventive sex, the graceful woman
stands: at her feet the hearth-fire she has given us beside her the
invention she has devised for us, in the background the home she has
built for us.
At Newala, also, I have had the manufacture of pottery carried on
in my presence. Technically the process is better than that already
described, for here we find the beginnings of the potter’s wheel,
which does not seem to exist in the plains; at least I have seen
nothing of the sort. The artist, a frightfully stupid Makua woman, did
not make a depression in the ground to receive the pot she was about
to shape, but used instead a large potsherd. Otherwise, she went to
work in much the same way as Salim’s mother, except that she saved
herself the trouble of walking round and round her work by squatting
at her ease and letting the pot and potsherd rotate round her; this is
surely the first step towards a machine. But it does not follow that
the pot was improved by the process. It is true that it was beautifully
rounded and presented a very creditable appearance when finished,
but the numerous large and small vessels which I have seen, and, in
part, collected, in the “less advanced” districts, are no less so. We
moderns imagine that instruments of precision are necessary to
produce excellent results. Go to the prehistoric collections of our
museums and look at the pots, urns and bowls of our ancestors in the
dim ages of the past, and you will at once perceive your error.
MAKING LONGITUDINAL CUT IN
BARK

DRAWING THE BARK OFF THE LOG

REMOVING THE OUTER BARK

 BEATING THE BARK

WORKING THE BARK-CLOTH AFTER BEATING, TO MAKE IT

SOFT

MANUFACTURE OF BARK-CLOTH AT NEWALA

To-day, nearly the whole population of German East Africa is
clothed in imported calico. This was not always the case; even now in
some parts of the north dressed skins are still the prevailing wear,
and in the north-western districts—east and north of Lake
Tanganyika—lies a zone where bark-cloth has not yet been
superseded. Probably not many generations have passed since such
bark fabrics and kilts of skins were the only clothing even in the
south. Even to-day, large quantities of this bright-red or drab
material are still to be found; but if we wish to see it, we must look in
the granaries and on the drying stages inside the native huts, where
it serves less ambitious uses as wrappings for those seeds and fruits
which require to be packed with special care. The salt produced at
Masasi, too, is packed for transport to a distance in large sheets of
bark-cloth. Wherever I found it in any degree possible, I studied the
process of making this cloth. The native requisitioned for the
purpose arrived, carrying a log between two and three yards long and
as thick as his thigh, and nothing else except a curiously-shaped
mallet and the usual long, sharp and pointed knife which all men and
boys wear in a belt at their backs without a sheath—horribile dictu!
[51]
Silently he squats down before me, and with two rapid cuts has
drawn a couple of circles round the log some two yards apart, and
slits the bark lengthwise between them with the point of his knife.
With evident care, he then scrapes off the outer rind all round the
log, so that in a quarter of an hour the inner red layer of the bark
shows up brightly-coloured between the two untouched ends. With
some trouble and much caution, he now loosens the bark at one end,
and opens the cylinder. He then stands up, takes hold of the free
edge with both hands, and turning it inside out, slowly but steadily
pulls it off in one piece. Now comes the troublesome work of
scraping all superfluous particles of outer bark from the outside of
the long, narrow piece of material, while the inner side is carefully
scrutinised for defective spots. At last it is ready for beating. Having
signalled to a friend, who immediately places a bowl of water beside
him, the artificer damps his sheet of bark all over, seizes his mallet,
lays one end of the stuff on the smoothest spot of the log, and
hammers away slowly but continuously. “Very simple!” I think to
myself. “Why, I could do that, too!”—but I am forced to change my
opinions a little later on; for the beating is quite an art, if the fabric is
not to be beaten to pieces. To prevent the breaking of the fibres, the
stuff is several times folded across, so as to interpose several
thicknesses between the mallet and the block. At last the required
state is reached, and the fundi seizes the sheet, still folded, by both
ends, and wrings it out, or calls an assistant to take one end while he
holds the other. The cloth produced in this way is not nearly so fine
and uniform in texture as the famous Uganda bark-cloth, but it is
quite soft, and, above all, cheap.
Now, too, I examine the mallet. My craftsman has been using the
simpler but better form of this implement, a conical block of some
hard wood, its base—the striking surface—being scored across and
across with more or less deeply-cut grooves, and the handle stuck
into a hole in the middle. The other and earlier form of mallet is
shaped in the same way, but the head is fastened by an ingenious
network of bark strips into the split bamboo serving as a handle. The
observation so often made, that ancient customs persist longest in
connection with religious ceremonies and in the life of children, here
finds confirmation. As we shall soon see, bark-cloth is still worn
during the unyago,[52] having been prepared with special solemn
ceremonies; and many a mother, if she has no other garment handy,
will still put her little one into a kilt of bark-cloth, which, after all,
looks better, besides being more in keeping with its African
surroundings, than the ridiculous bit of print from Ulaya.
MAKUA WOMEN