ADVANCE ACCOUNTING Ch01

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Introduction to BusinessIntroduction to BusinessCombinations and theCombinations and theConceptual FrameworkConceptual Framework

Advanced Accounting, Fifth Edition

11

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1. Describe historical trends in types of business combinations.2. Identify the major reasons firms combine.3. Identify the factors that managers should consider in exercising due diligence in

business combinations.4. Identify defensive tactics used to attempt to block business combinations.5. Distinguish between an asset and a stock acquisition.6. Indicate the factors used to determine the price and the method of payment for

a business combination.7. Calculate an estimate of the value of goodwill to be included in an offering price

by discounting expected future excess earnings over some period of years.8. Describe the two alternative views of consolidated financial statements: the

economic entity and the parent company concepts.9. List and discuss each of the Statements of Financial Accounting Concepts

(SFAC).10. Describe some of the current joint projects of the FASB and the International

Accounting Standards Board (IASB), and their primary objectives.

Learning ObjectivesLearning Objectives

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On December 4, 2007, FASB released two new standards,

FASB Statement No. 141 R, Business Combinations, and

FASB Statement No. 160, Noncontrolling Interests in Consolidated Financial Statements. [ASC 805, “Business Combinations” and ASC 810, “Consolidations”, based on FASB’s new codification system]

These standards Became effective for years beginning after December

15, 2008, and Are intended to improve the relevance, comparability

and transparency of financial information related to business combinations, and to facilitate the convergence with international standards.

IntroductionIntroduction

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Business Combination - operations of two or more companies are brought under common control.

Nature of the CombinationNature of the Combination

A business combination may be:Friendly - the boards of directors of the potential combining companies negotiate mutually agreeable terms of a proposed combination.Unfriendly (hostile) - the board of directors of a company targeted for acquisition resists the combination.

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Defensive Tactics


1. Poison pill: Issuing stock rights to existing shareholders; exercisable only in the event of a potential takeover.

2. Greenmail: Purchasing shares held by acquiring company at a price substantially in excess of fair value.

3. White knight: Encouraging a third firm to acquire or merge with the target company.

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Defensive Tactics (continued)


4. Pac-man defense: Attempting an unfriendly takeover of the would-be acquiring company.

5. Selling the crown jewels: Selling valuable assets to make the firm less attractive to the would-be acquirer.

6. Leveraged buyouts: Purchasing a controlling interest in the target firm by its managers and third-party investors, who usually incur substantial debt.

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The defense tactic that involves purchasing shares held by the would-be acquiring company at a price substantially in excess of their fair value is called

a. poison pill.b. pac-man defense.c. greenmail.d. white knight.

Review QuestionReview Question


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Advantages of External Expansion

Business Combinations: Why? Why Business Combinations: Why? Why Not?Not?

LO 2 Reasons firms combine.LO 2 Reasons firms combine.

1. Rapid expansion2. Operating synergies3. International marketplace4. Financial synergy5. Diversification6. Divestitures

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Three distinct periods

Business Combinations: Historical Business Combinations: Historical PerspectivePerspective

1880 through 1904, huge holding companies, or trusts, were created to establish monopoly control over certain industries (horizontal integration).

1905 through 1930, to bolster the war effort, the government encouraged business combinations to obtain greater standardization of materials and parts and to discourage price competition (vertical integration).

LO 1 Describe historical trends in types of business LO 1 Describe historical trends in types of business combinations.combinations.

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Three distinct periods

Business Combinations: Historical Business Combinations: Historical PerspectivePerspective

1945 to the present, many of the mergers that occurred from the 1950s through the 1970s were conglomerate mergers.

In contrast, the 1980s were characterized by a relaxation in antitrust enforcement and by the emergence of high-yield junk bonds to finance acquisitions.

Deregulation undoubtedly played a role in the popularity of combinations in the 1990s.

LO 1 Describe historical trends in types of business LO 1 Describe historical trends in types of business combinations.combinations.

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Asset acquisition, a firm must acquire 100% of the assets of the other firm.Stock acquisition, control may be obtained by purchasing 50% or more of the voting common stock (or possibly less).

Terminology and Types of Terminology and Types of CombinationsCombinations

LO 5 Distinguish between an asset and a stock LO 5 Distinguish between an asset and a stock acquisition.acquisition.

What Is Acquired? What Is Given Up?

Net assets of S Company(Assets and Liabilities)

Common Stock of S Company

1. Cash2. Debt3. Stock4. Combination of

above

Figure 1-1Figure 1-1

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Possible Advantages of Stock AcquisitionLower total cost.Direct formal negotiations may be avoided.Maintaining the acquired firm as a separate legal entity. Liability limited to the assets of the individual corporation.Greater flexibility in filing individual or consolidated tax returns.



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Classification by Method of Acquisition



A Company B Company A Company+ =

Statutory Merger

One company acquires all the net assets of another company. The acquiring company survives, whereas the acquired company ceases to exist as a separate legal entity.

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A Company B Company C Company+ =

Statutory Consolidation

A new corporation is formed to acquire two or more other corporations through an exchange of voting stock; the acquired corporations then cease to exist as separate legal entities.Stockholders of A and B become stockholders in C.

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Financial Statements of

A Company

Financial Statements of

B Company

Consolidated Financial

Statements of A Company

and B Company

+ =

Consolidated Financial Statements

When a company acquires a controlling interest in the voting stock of another company, a parent–subsidiary relationship results.

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When a new corporation is formed to acquire two or more other corporations and the acquired corporations cease to exist as separate legal entities, the result is a statutory

a. acquisition.b. combination.c. consolidation.d. merger




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Takeover Premium – the excess amount agreed upon in an acquisition over the prior stock price of the acquired firm.

Possible reasons for the premiums:Acquirers’ stock prices may be at a level which makes it attractive to issue stock (rather than cash) in the acquisition.Credit may be generous for mergers and acquisitions.Bidders may believe target firm is worth more than its current market value.Acquirer may believe growth by acquisitions is essential and competition necessitates a premium.

Takeover PremiumsTakeover Premiums


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The factors to beware of include the following:Be cautious in interpreting any percentages.Do not neglect to include assumed liabilities in the assessment of the cost of the merger.Watch out for the impact on earnings of the allocation of expenses and the effects of production increases, standard cost variances, LIFO liquidations, and byproduct sales.Note any nonrecurring items that may boost earnings.Be careful of CEO egos.

Avoiding the Pitfalls Before the DealAvoiding the Pitfalls Before the Deal

LO 3 Factors to be considered in due diligence.LO 3 Factors to be considered in due diligence.

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When an acquiring company exercises due diligence in attempting a business combination, it should:

a. be skeptical about accepting the target company’s stated percentages

b. analyze the target company for assumed liabilities as well as assets

c. look for nonrecurring items such as changes in estimates

d. all the above


Avoiding the Pitfalls Before the DealAvoiding the Pitfalls Before the Deal

LO 3 Factors to be considered in due diligence.LO 3 Factors to be considered in due diligence.

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When a business combination is effected by a stock swap, or exchange of securities, both price and method of payment problems arise.

The price is expressed as a stock exchange ratio (generally defined as the number of shares of the acquiring company to be exchanged for each share of the acquired company).

Each constituent makes two kinds of contributions to the new entity—net assets and future earnings.

Determining Price and Method of Determining Price and Method of PaymentPaymentin Business Combinationsin Business Combinations

LO 6 Factors affecting price and method of payment.LO 6 Factors affecting price and method of payment.

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Net Asset and Future Earnings Contributions

Determining Price and Method of Determining Price and Method of PaymentPaymentin Business Combinationsin Business Combinations


Determination of an equitable price for each constituent company requires:

The valuation of each company’s net assets and

Each company’s expected contribution to the future earnings of the new entity.

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Excess Earnings Approach to Estimate Goodwill


Step 1:Identify a normal rate of return on assets for firms similar to the company being targeted.

Step 2: Apply the rate of return (step 1) to the net assets of the target to approximate “normal earnings.”

Step 3: Estimate the expected future earnings of the target. Exclude any nonrecurring gains or losses.

Step 4: Subtract the normal earnings (step 2) from the expected target earnings (step 3). The difference is “excess earnings.”

Determining Price and Method of Determining Price and Method of PaymentPayment

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Excess Earnings Approach to Estimate Goodwill


Step 5: Compute estimated goodwill from “excess earnings.”If the excess earnings are expected to last

indefinitely, the present value may be calculated by dividing the excess earnings by the discount rate.

For finite time periods, compute the present value of an annuity.


Step 6: Add the estimated goodwill (step 5) to the fair value of the firm’s net identifiable assets to arrive at a possible offering price.

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A potential offering price for a company is computed by adding the estimated goodwill to the

a. book value of the company’s net assets.b. book value of the company’s identifiable assets.c. fair value of the company’s net assets.d. fair value of the company’s identifiable net assets.




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Exercise 1-1: Plantation Homes Company is considering the acquisition of Condominiums, Inc. early in 2008. To assess the amount it might be willing to pay, Plantation Homes makes the following computations and assumptions.

A. Condominiums, Inc. has identifiable assets with a total fair value of $15,000,000 and liabilities of $8,800,000. The assets include office equipment with a fair value approximating book value, buildings with a fair value 30% higher than book value, and land with a fair value 75% higher than book value. The remaining lives of the assets are deemed to be approximately equal to those used by Condominiums, Inc. LO 7 Estimating goodwill.LO 7 Estimating goodwill.


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Exercise 1-1: (continued)B. Condominiums, Inc.’s pretax incomes for the years 2005 through 2007 were $1,200,000, $1,500,000, and $950,000, respectively. Plantation Homes believes that an average of these earnings represents a fair estimate of annual earnings for the indefinite future. The following are included in pretax earnings:

Depreciation on buildings (each year) 960,000Depreciation on equipment (each year) 50,000Extraordinary loss (year 2007) 300,000Sales commissions (each year) 250,000

LO 7 Estimating goodwill.LO 7 Estimating goodwill.


C. The normal rate of return on net assets is 15%.

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Exercise 1-1: (continued)Required:A. Assume further that Plantation Homes feels that it must

earn a 25% return on its investment and that goodwill is determined by capitalizing excess earnings. Based on these assumptions, calculate a reasonable offering price for Condominiums, Inc. Indicate how much of the price consists of goodwill. Ignore tax effects.



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Exercise 1-1: (Part A)



Step 1 Identify a normal rate of return on assets for firms similar to the company being targeted.

Excess Earnings Approach

15%

Step 2 Apply the rate of return (step 1) to the net assets of the target to approximate “normal earnings.”

Fair value of assets

$15,000,000Fair value of liabilities

8,800,000Fair value of net assets

6,200,000Normal rate of return

15%Normal earnings

$ 930,000

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Step 3 Estimate the expected future earnings of the target. Exclude any nonrecurring gains or losses.

Pretax income of Condominiums, I nc., 2005 1,200,000$ Subtract: Additional depreciation on building ($960,000 x 30%) (288,000) Target’s adjusted earnings, 2005 912,000$

Pretax income of Condominiums, I nc., 2006 1,500,000 Subtract: Additional depreciation on building (288,000) Target’s adjusted earnings, 2006 1,212,000

Pretax income of Condominiums, I nc., 2007 950,000 Add: Extraordinary loss 300,000 Subtract: Additional depreciation on building (288,000) Target’s adjusted earnings, 2007 962,000 Target’s three year total adjusted earnings 3,086,000 Target’s three year average adjusted earnings ($3,086,000 / 3) 1,028,667$


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Step 4 Subtract the normal earnings (step 2) from the expected target earnings (step 3). The difference is “excess earnings.”


Expected target earnings

$1,028,667Less: Normal earnings

930,000Excess earnings, per year

$ 98,667

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Step 5 Compute estimated goodwill from “excess earnings.”


Excess earnings $ 98,667

Present value of excess earnings (perpetuity) at 25%:

25%= $394,668 Estimate

d Goodwill

Step 6 Add the estimated goodwill (step 5) to the fair value of the firm’s net identifiable assets to arrive at a possible offering price.

Net assets

$6,200,000Estimated goodwill

394,668Implied offering price

$6,594,668

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Exercise 1-1 (continued)Required:B. Assume that Plantation Homes feels that it must earn a

15% return on its investment, but that average excess earnings are to be capitalized for three years only. Based on these assumptions, calculate a reasonable offering price for Condominiums, Inc. Indicate how much of the price consists of goodwill. Ignore tax effects.



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Part B


Excess earnings of target (same a Part A) $ 98,667PV factor (ordinary annuity, 3 years, 15%) x 2.28323 Estimated goodwill $ 225,279Fair value of net assets 6,200,000Implied offering price $ 6,425,279

The types of securities to be issued by the new entity in exchange for those of the combining companies must be determined. Ultimately, the exchange ratio is determined by the bargaining ability of the individual parties to the combination.

Slide 1-34 LO 8 Economic entity and parent company concepts.LO 8 Economic entity and parent company concepts.

Parent Company Concept - primary purpose of consolidated financial statements is to provide information relevant to the controlling stockholders.

The noncontrolling interest presented as a liability or as a separate component before stockholders’ equity.

Alternative Concepts of ConsolidatedAlternative Concepts of ConsolidatedFinancial StatementsFinancial Statements

Economic Entity Concept - affiliated companies are a separate, identifiable economic entity.

The noncontrolling interest presented as a component of stockholders’ equity.

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Consolidated Net IncomeParent Company Concept, consolidated net income consists of the realized combined income of the parent company and its subsidiaries after deducting the noncontrolling interest in income (noncontrolling interest in income is an expense item).Economic Entity Concept, consolidated net income consists of the total combined income of the parent company and its subsidiaries. Total combined income is then allocated proportionately to the noncontrolling interest and the controlling interest.

Alternative ConceptsAlternative Concepts

LO 8 Economic entity and parent company concepts.LO 8 Economic entity and parent company concepts.

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Consolidated Balance Sheet ValuesParent Company Concept, the net assets of the subsidiary are included in the consolidated financial statements at their book value plus the parent company’s share of the difference between fair value and book value on the date of acquisition.Economic Entity Concept, on the date of acquisition, the net assets of the subsidiary are included in the consolidated financial statements at their book value plus the entire difference between their fair value and their book value.



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According to the economic unit concept, the primary purpose of consolidated financial statements is to provide information that is relevant to

a. majority stockholders.b. minority stockholders.c. creditors.d. both majority and minority stockholders.




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Intercompany ProfitTwo alternative points of view:

1. Total (100%) elimination2. Partial elimination



Under total elimination, the entire amount of unconfirmed intercompany profit is eliminated from combined income and the related asset balance. Under partial elimination, only the parent company’s share of the unconfirmed intercompany profit is eliminated.

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Conceptual FrameworkConceptual Framework


Figure 1-2Figure 1-2 Conceptual Framework for Financial Accounting and Reporting

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Economic Entity vs. Parent Concept and the Conceptual Framework

The parent concept is tied to the historical cost principle, which would suggest that the net assets related to the noncontrolling interest remain at their previous book values.This approach might be argued to produce more “reliable” values (SFAC No. 8).


FASB’s Conceptual FrameworkFASB’s Conceptual Framework

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Economic Entity vs. Parent Concept and the Conceptual Framework

The economic entity assumption views a parent and its subsidiaries as one economic entity even though they are separate legal entities. The economic entity concept is an integral part of the FASB’s conceptual framework and is named specifically in SFAC No. 5 as one of the basic assumptions in accounting.



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Overview of FASB’s Conceptual Framework

LO 9 Statements of Financial Accounting Concepts.LO 9 Statements of Financial Accounting Concepts.


SFAC No.1- Objectives of Financial Reporting (replaced by SFAC No. 8)

SFAC No.2 - Qualitative Characteristics of Accounting Information (replaced by SFAC No. 8)

SFAC No.3 - Elements of Financial Statements (replaced by SFAC No. 6)

The Statements of Financial Accounting Concepts issued by the FASB include:

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Overview of FASB’s Conceptual Framework



SFAC No.4 - Objectives of Financial Reporting by Nonbusiness Organizations

SFAC No.5 -Recognition and Measurement in Financial Statements

SFAC No.6 - Elements of Financial Statements (replaces SFAC No. 3)

SFAC No.7 -Using Cash Flow Information and Present Value in Accounting Measurements

SFAC No.8 – The Objective of General Purpose Financial Reporting (replaces SFAC No. 1 and No. 2)

The Statements of Financial Accounting Concepts issued by the FASB include:

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Distinguishing Between Earnings and Comprehensive Income



Earnings is essentially revenues and gains minus expenses and losses, with the exception of any losses or gains that bypass earnings and, instead, are reported as a component of other comprehensive income.

SFAC No. 5 describes them as “principally certain holding gains or losses that are recognized in the period but are excluded from earnings such as some changes in market values of investments... and foreign currency translation adjustments.”

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Asset Impairment and the Conceptual Framework



SFAC No. 5 provides guidance with respect to expenses and losses:Consumption of benefit. Earnings are generally recognized when an entity’s economic benefits are consumed in revenue earnings activities (or matched to the period incurred or allocated systematically) (Example: amortization of limited-life intangibles); orLoss or lack of benefit. Expenses or losses are recognized if it becomes evident that previously recognized future economic benefits of assets have been reduced or eliminated, or that liabilities have increased, without associated benefits (Example: review for impairment for indefinite-life intangibles).

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LO 10 Describe some of the current joint projects of the FASB and the LO 10 Describe some of the current joint projects of the FASB and the International Accounting Standards Board (IASB), and their primary International Accounting Standards Board (IASB), and their primary objectives.objectives.

Appendix: FASB Codification ProjectAppendix: FASB Codification Project

On July 1, 2009, the FASB launched the FASB Accounting Standards Codification.

Single source of authoritative nongovernmental U.S. generally accepted accounting principles (GAAP).

Codification is effective for interim and annual periods ending after September 15, 2009.

All existing accounting standards documents are superseded as described in FASB Statement No. 168, “The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles.”

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Structure of the Codification Roughly 90 accounting topics Contains four groupings of numbers.

1) the topic, 2) the subtopic, 3) the section, and 4) the paragraph

The code 450-20-25-2 refers to topic 450 (which is ‘contingencies’); subtopic 20 (which is loss ‘contingencies’); section 25 (which is recognition); and 2 (refers to the second paragraph).

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a. Financial Accounting Standards Board (FASB)1. Statements (FAS)2. Interpretations (FIN)3. Technical Bulletins (FTB)4. Staff Positions (FSP)5. Staff Implementation Guides (Q&A)6. Statement No. 138 Examples

b. Emerging Issues Task Force (EITF)1. Abstracts2. Topic D

c. Derivative Implementation Group (DIG) Issuesd. Accounting Principles Board (APB) Opinionse. Accounting Research Bulletins (ARB)f. Accounting Interpretations (AIN)g. American Institute of Certified Public Accountants (AICPA)

1. Statements of Position (SOP)2. Audit and Accounting Guides (AAG)—only incremental accounting guidance3. Practice Bulletins (PB), including the Notices to Practitioners elevated to

PracticeBulletin status by Practice Bulletin 1

4. Technical Inquiry Service (TIS)—only for Software Revenue RecognitionLO 10 Describe some of the current joint projects of the FASB and the LO 10 Describe some of the current joint projects of the FASB and the

International Accounting Standards Board (IASB), and their primary International Accounting Standards Board (IASB), and their primary objectives.objectives.


Literature included in

the Codification

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(a) Regulation S-X (SX)(b) Financial Reporting Releases (FRR)/Accounting Series

Releases (ASR)(c) Interpretive Releases (IR)(d) SEC Staff guidance in

1. Staff Accounting Bulletins (SAB)2. EITF Topic D and SEC Staff Observer comments.



Additional SEC literature included in the Codification for reference

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Changes to GAAP: Updating the FASB StandardsUpdates to the Codification are called AccountingStandards Updates and are referenced asASU YYYY-xx, where the Ys indicate the year of Update and xx represents the number of the update For that year.

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Economy & Finance

ADVANCE ACCOUNTING Ch01