Chapter 5

Business Combinations

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc. 2006

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.

Definitions

According to the FASB, 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.

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.

Classes of Business Combinations

Business Combinations

Friendly Takeover
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Hostile Takeover

Friendly Takeovers
Board of Directors of all constituent companies amicably determine the terms of the business combination. Proposal is submitted to share holders of all constituent companies for approval.

Hostile Takeovers
Target combinee typically resists the proposed business combination. Target combinee uses one or more of the several defensive tactics.

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.

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.

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. Hostile takeovers are mostly motivated by the prospect of substantial gain resulting from the sale of business segments.

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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 twothirds majority of stockholders, thus acquiring ownership of those corporations.

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Statutory Merger

Company A acquires Company B then dissolves B and liquidates B Company B cease to exist as separate legal entities Company B (dissolved) often continues as a division of the survivor (A) , which now owns the net assets, rather than the outstanding common stock, of the liquidated corporations.

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Statutory Consolidation

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

Stock acquisition program may be accomplished through Direct acquisition in the stock market Negotiations with the principal stockholders of a closely held corporation 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 common stock For a stated amount of consideration A maximum number of shares of the combinees common stock tendered by holders thereof to an agent

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Acquisition of Common Stock

Price per share stated in the tender offer usually is a premium to prices prior to the announcement A controlling interest in the combinees voting common stock is acquired, 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

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

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

Common stock is issued by the combinor in a business combination 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

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. 2.

Capitalization of expected average annual earnings of the combinee at a desired rate of return. 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. 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. 2.

3.

The amount of consideration paid by the combinor. The combinors direct out-of-pocked costs of the combination. 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; Appraised values for land, natural resources, and non-marketable securities.

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Allocation Of Cost Of A Combinee

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 combineelessee 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. 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. 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

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

Excess of current fair values over cost of the combinees net assets remains after the foregoing reduction Is recognized as an extraordinary gain by the combinor

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