Chapter 5

Business Combinations

2003 The McGraw-Hill

Companies, Inc., All Rights
Reserved
 Scope of the Chapter

Definition of Business Combinations.

Reasons for the popularity of business
combinations.
Techniques for arranging a business
combination.
The accounting method for business
combinations.

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 Definitions

According to the Financial Accounting

Standards Board, a business combination is
an event or a procedure, in which, an entity
acquires net assets that constitute a business
or acquires equity interests of one or more
other entities and obtains control over that
entity or entities.
Commonly, business combinations are often
referred to as mergers and acquisitions.

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 Definitions
Combined Enterprise: The accounting entity that
results from a business combination.
Constituent Companies: The business enterprises
that enter into a business combination.
Combinor: A constituent company entering into a
purchase-type business combination whose owners as
a group end up with control of the ownership interests
in the combined enterprises.
Combinee: A constituent company other than the
combinor in a business combination.

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 Classes of Business Combinations

Business Combinations

Friendly Takeover Hostile Takeover

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 Friendly Takeovers

The Board of Directors of all

constituent companies amicably
determine the terms of the business
combination.
The proposal is submitted to share
holders of all constituent companies
for approval.

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 Hostile Takeovers

In this type of takeovers the target

combinee typically resists the
proposed business combination.
The target combinee uses one or more
of the several defensive tactics.

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 Tactics for Defense Used in
Hostile Takeovers

Pac-man Defense: A threat to undertake a

hostile takeover of the prospective
combinor.
White Knight: A search for a candidate to
be the combinor in a friendly takeover.
Scorched Earth: The disposal, by sale or
by spin-off to stockholders, of one or more
profitable business segments.

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 Tactics for Defense Used in
Hostile Takeovers

Shark Repellent: An acquisition of

substantial amounts of outstanding
common stock for the treasury or for
retirement, or the incurring of substantial
long-term debt in exchange for
outstanding common stock.

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 Tactics for Defense Used in
Hostile Takeovers

Poison Pill: An amendment of the articles of

incorporation or bylaws to make it more difficult
to obtain stockholder approval for a takeover.
Green Mail: An acquisition of common stock
presently owned by the prospective combinor
at a price substantially in excess of the
prospective combinors cost, with the stock
thus acquired placed in the treasury or retired.

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 Business Combinations:
Why And How?

In recent years Growth has been main

reason for business enterprises to
enter into a business combination.
There could be many more reasons.

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 Business Combinations:
Why And How?

The external method of achieving

growth is more rapid than growth
through internal methods.
Obtaining new management strength
or better use of existing management.

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 Business Combinations:
Why And How?

Achieving manufacturing or other operating

economies.
A business combination may be undertaken for
income tax advantages.
The hostile takeovers are mostly motivated by
the prospect of substantial gain resulting from
the sale of business segments of a combinee
following the business combination.

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 Antitrust Considerations

Antitrust litigations is a one obstacle faced by large

corporations that undertake business combinations.
The U.S. Government on occasion has opposed
concentration of economic power in large business
enterprises.
Business combinations have been challenged by the
Federal Trade Commission or the Antitrust Division of
the Department of Justice, under the provisions of
Section 7 of the Clayton Act.

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 Types of Business Combinations

Horizontal: A combination involving

enterprises in the same industry.
Vertical: A Combination involving an enterprise
and its customers or suppliers.
Conglomerate: A combination between
enterprises in unrelated industries or markets.

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 Methods for Arranging Business
Combinations

Statutory Merger
Statutory Consolidation
Acquisition of Common Stock
Acquisition of Assets

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 Statutory Merger

It is executed under provisions of applicable

state laws.
The boards of directors of the constituent
companies approve a plan for the exchange of
voting common stock (and perhaps some
preferred stock, cash or long-term debt) of one
of the corporations (the survivor) for all the
outstanding voting common stock of the other
corporations.

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 Statutory Merger

Stockholders of all constituent companies

must approve the terms of the merger.
Some states require approval by a two-
thirds majority of stockholders, thus
acquiring ownership of those
corporations.

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 Statutory Merger

The other corporations are then

dissolved and liquidated and thus cease
to exist as separate legal entities, and
their activities often are continues as
divisions of the survivor, which now
owns the net assets, rather than the
outstanding common stock, of the
liquidated corporations.

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 Statutory Consolidation

This also is consummated in accordance with

applicable state laws.
A new corporation is formed to issue its common stock
for the outstanding common stock of two or more
existing corporations, which then go out of existence.
The new corporation thus acquires the net assets of
the defunct corporations, whose activities may be
continued as divisions of the new corporation.

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 Acquisition of Common Stock

One corporation (the investor) may issue

preferred or common stock, cash, debt or
a combination thereof to acquire from
present stockholders a controlling
interest in the voting common stock of
another corporation (the investee).

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 Acquisition of Common Stock

This stock acquisition program may be

accomplished through direct acquisition
in the stock market, through negotiations
with the principal stockholders of a
closely held corporation or through a
tender offer to stockholders of a publicly
owned corporation.

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 Acquisition of Common Stock

A tender offer is a publicly announced

intention to acquire, for a stated amount
of consideration, a maximum number of
shares of the combinees common stock
tendered by holders thereof to an
agent, such as an investment banker or a
commercial bank.

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 Acquisition of Common Stock

The price per share stated in the tender offer

usually is well above the prevailing market
price of the combinees common stock.
If a controlling interest in the combinees voting
common stock is acquired, that corporation
becomes affiliated with the combinor parent
company as a subsidiary but is not dissolved
and liquidated and remains a separate legal
entity.

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 Acquisition of Common Stock

The business combination through this

method, requires authorization by the
combinors board of directors and may
require ratification by the combinees
stockholders.
Most hostile takeovers are accomplished
by this means.

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 Acquisition of Assets
A business enterprise may acquire from another
enterprise all or most of the gross assets or net assets
of the other enterprise for cash, debt, preferred or
common stock, or a combination thereof.
The transaction must be approved by the boards of
directors and stockholders or other owners of the
constituent companies.
The selling enterprise may continue its existence as a
separate entity or it may be dissolved and liquidated, it
does not become an affiliate of the combinor.

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 Establishing the Price for A
Business Combination

This is a very important early step in planning

a business combination.
The price for a business combination
consummated for cash or debt generally is
expressed in terms of the total dollar amount
of the consideration issued.

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 Establishing the Price for A
Business Combination

When common stock is issued by the

combinor in a business combination, the price
is expressed as a ratio of the number of
shares of the combinors common stock to be
exchanged for each share of the combinees
common stock.

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 Establishing the Price for A
Business Combination

The amount of cash or debt securities, or the

number of shares of common or preferred
stock, to be issued in a business combination
generally is determined by variations of two
methods:
1. Capitalization of expected average annual earnings
of the combinee at a desired rate of return.
2. Determination of current fair value of the
combinees net assets (including goodwill).

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 Purchase Method Of Accounting
For Business Combinations

Initial Recognition: Assets are commonly

acquired in exchange transactions that trigger
the initial recognition of the assets acquired
and any liabilities assumed.
Initial Measurement: Like other exchange
transactions, acquisitions are measured on the
basis of the fair values exchanged.

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 Purchase Method Of Accounting
For Business Combinations

Allocating Cost: Acquiring assets in groups

requires not only ascertaining the cost of the
asset (or net asset) group but also allocating
that cost to the individual assets (or individual
assets and liabilities) that make up the group.
Accounting after Acquisition: The nature of
an asset and not the manner of its acquisitions
determines an acquiring entitys subsequent
accounting for the asset.

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 Determination of the Combinor

Because the carrying amounts of the net

assets of the combinor are not affected by a
business combination, the combinor must be
accurately identified.
The FASB stated that in a business
combination effected solely by the distribution
of cash or other assets or by incurring
liabilities, the combinor is the distributing or
incurring constituent company.

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 Determination of the Combinor

For combinations effected by the issuance of equity

securities, consideration of all the facts and
circumstances is required to identify the combinor.
The common theme is that the combinor is the
constituent company whose stockholders as a group
retain or receive the largest portion of the voting rights
of the combined enterprise and thereby can elect a
majority of the governing board of directors or other
group of the combined enterprise.

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 Computation of Cost of a Combinee

The cost of a combinee in a business

combination accounted for by the purchase
method is the total of:
1. The amount of consideration paid by the combinor.
2. The combinors direct out-of-pocked costs of the
combination.
3. Any contingent consideration that is determinable
on the date of the business combination.

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 Amount of Consideration

This is the total amount of cash paid, the

current fair value of other assets distributed,
the present value of debt securities issued, and
the current fair (or market) value of equity
securities issued by the combinor.

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 Direct Out-Of-Pocket Costs

Included in this category are some legal fees,

some accounting fees and finders fees.
A finders fee is paid to the investment banking
firm or other organization or individuals that
investigated the combinee, assisted in
determining the price of the business
combination, and otherwise rendered services
to bring about the combination.

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 Direct Out-Of-Pocket Costs

Costs of registering with SEC and issuing debt

securities are not direct costs of the business
combination but are offset against the proceeds from
the issuance of the securities.
Indirect out-of-pocket costs of the combination, such
as salaries of officers of constituent companies
involved in negotiation and completion of the
combination, are recognized as expenses incurred by
the constituent companies.

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 Contingent Consideration

Contingent consideration is additional cash,

other assets, or securities that may be issuable
in the future, contingent on future events such
as a specified level of earnings or a designated
market price for a security that had been
issued to complete the business combination.

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 Contingent Consideration

Contingent consideration that is determinable

on the consummation date of a combination is
recorded as part of the cost of the combination.
Contingent consideration not determinable on
the date of the combination is recorded when
the contingency is resolved and the additional
consideration is paid or issued (or becomes
payable or issuable).

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 Allocation Of Cost Of A Combinee

The cost of a combinee in a business

combination must be allocated to assets
(other than goodwill) acquired and liabilities
assumed based on their estimated fair values
on the date of the combination.
Any excess of total costs over the amounts
thus allocated is assigned to goodwill.

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 Allocation Of Cost Of A Combinee

Methods for determining fair values included

present values for receivables and most
liabilities; net realizable value less a
reasonable profit for work in process and
finished goods inventories; and appraised
values for land, natural resources, and non-
marketable securities.

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 Allocation Of Cost Of A Combinee

In addition, the following combinee intangible

assets were to be recognized individually and
valued at fair value:
Assets arising from contractual or legal rights, such
as patents, copyrights, and franchises.
Other assets that are separable from the combinee
entity and can be sold, licensed, exchanged, and
the like, such as customer lists and non-patented
technology.

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 Allocation Of Cost Of A Combinee

Other matters involved in the allocation of the

cost of a combinee in a business combination
are:
A part of the cost of a combinee is allocable to
identifiable tangible and intangible assets that
resulted from research and development activities
of the combined enterprise. Subsequently, such
assts are to be expensed, as required by FASB,
unless they may be used for other than research
and development activities in the future.

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 Allocation Of Cost Of A Combinee

In a business combination, leases of the combinee-

lessee are classified by the combined enterprise as
they were by the combinee unless the provisions of
the lease are modified to the extent it must be
considered a new lease. Thus, unmodified capital
leases of the combinee are treated as capital leases
by the combined enterprise, and the leased property
and related liability are recognized in accordance
with the guidelines of FASB statement No. 141.

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 Allocation Of Cost Of A Combinee
A combinee in a business combination may have
pre-acquisition contingencies, which are contingent
assets (other than potential income tax benefits of a
loss carry forward), contingent liabilities, or
contingent impairments of assets, that existed prior
to completion of the business combination. If so, an
allocation period, generally not longer than one year
from the date the combination is completed, may be
used to determine the current fair value of a pre-
acquisition contingency.

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 Goodwill

Goodwill is recognized in business combination

because the total cost of the combinee
exceeds the current fair value of identifiable net
assets of the combinee.
The amount of goodwill recognized on the date
the business combination is consummated
may be adjusted subsequently when
contingent consideration becomes issuable.

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 Negative Goodwill

In some purchase-type business combinations

(known as bargain purchases), the current fair
value assigned to the identifiable net assets
acquired exceed the total cost of the combinee.
A bargain purchase is most likely to occur for a
combinee with a history of losses or when
common stock prices are extremely low.

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 Negative Goodwill

The excess of the current fair values over total

cost is applied pro rata to reduce (but not
below zero) the amounts initially assigned to
financial assets other than investments
accounted for by the equity method; assets to
be disposed of by sale; deferred tax assets;
prepaid assets relating to pension or other
postretirement benefits; and any other current
assets.

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 Negative Goodwill

If any excess of current fair values over cost of

the combinees net assets remains after the
foregoing reduction, it is recognized as an
extraordinary gain by the combinor.

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