what is a business combination?

Chapter 2:Chapter 2:Mergers and Acquisitions

Susan S. Ronald J. James A. Hamlen Huefner Largay

©Cambridge Business Publishing, 2013©Cambridge Business Publishing, 2013

What is a Business Combination?

Occurs when one company obtains control over another company

Terms used: Merger Acquisition Takeover

2


Business Strategies Achieved Through Acquisitions

3


Advantages of Acquisitions

Acquiring a going concern is less costly Eliminates the need to start from scratch Avoids duplication of efforts

Competition is often reduced Complimentary products or services can

lead to increased overall sales

4


Top M&A Deals Worldwide, 2000-20105

Exhibit 2.1


Types of Combinations6

Acquiring company remains

All assets and liabilities acquired are recorded directly on

the books of the acquiring company

New company remains

Acquiring and acquired companies remain

separate legal entities


Combination Example

An acquirer pays $25 million in cash to acquire another company. The fair value of the other company’s assets and liabilities are:

7

Current assets 2,000,000 Plant and equipment 93,000,000 Patents and copyrights 5,000,000

Current liabilities 15,000,00

0

Long-term debt 60,000,00

0

Cash 25,000,00

0

Account Fair ValueCurrent assets $ 2,000,000Plant and equipment 93,000,000Patents and copyrights 5,000,000Current liabilities 15,000,000Long-term debt 60,000,000

To record the acquisition on the acquirer’s books:

Fair values,

NOT book

values


Statutory Merger

Acquired company ceases to exist as a separate company

Subsequent transactions of acquired firm are reported on books of acquirer

Assets and liabilities acquired are recorded directly on acquiring company’s books At fair value at the date of acquisition ASC Topic 820 provides measurement

guidance

8


Statutory Consolidation New corporation absorbs both companies One of the existing companies is the

acquirer, the other is the acquiree Acquiree’s assets and liabilities reported at

fair value at date of acquisition Acquirer’s assets and liabilities remain at book

value

Same result as statutory merger

9


Stock Acquisition Occurs when a company acquires the voting

stock of another company Each firm continues as a separate legal entity Acquirer treats investment in the acquired

firm as an intercorporate investment Consolidated working paper used to combine

the two companies’ results, with same result as statutory merger or consolidation.

10

Investment in acquiree 25,000,000 Cash 25,000,000

To record the investment in stock on acquirer’s books:


Reporting Standards for Business Combinations

ASC Topic 805 Valuation of assets acquired and liabilities

assumed Valuation of consideration paid

ASC Topic 350 Valuation and subsequent reporting for

intangible assets acquired, including goodwill

ASC Topic 810 Consolidation criteria, procedures, and

consolidated financial statement format

11


Definition of Business Combination

Control is obtained over one or more businesses

Definition of a business

ASC Topics 805 and 810 apply only to business combinations

12

An integrated set of activities and assets that is capable of being conducted and managed for the

purpose of providing a return in the form of dividends, lower costs, or other economic

benefits directly to investors or other owners, members, or participants.


Learning Objective 1

Measure and account for the various assets and liabilities acquired in

mergers and acquisitions.

13


Acquisition Method

Used to report all business combinations Requires careful identification and valuation

of the Fair value of the assets acquired, and Fair value of the liabilities assumed At acquisition date

The date the acquiring company obtains control of the acquired company

Normally date consideration is paid

14


Identify Acquiring Company When no equity interests are exchanged, acquiring

company distributes cash or other assets and/or incurs liabilities

More difficult to identify the acquiring company when the business combination involves an equity exchange

Possible characteristics of acquiring company Entity that issues the equity interests Entity that is larger Owners have larger voting interest Prior owners constitute a large minority (<50%) Entity selects a majority of the governing body Dominates senior management Entity’s stockholders did not receive a premium over market

value in the exchange

15


Identify Acquiring Company

Why is it necessary to identify the acquiring company?

Acquired company’s assets and liabilities are revalued to fair value at the date of acquisition

Acquiring company’s assets and liabilities remain at book value

16


Measuring Assets and Liabilities Acquired

Acquisition cost

17

>Fair value of net assets acquired

Goodwill

Acquisition cost <

Fair value of net assets acquired

Gain on bargain

purchase


Estimation of Fair Values18

Exhibit 2.3


Identification of Previously Unreported Intangibles

Two criteria for separate recognition as an identifiable intangible by acquiring entity Intangible arises from contractual or other legal

rights, or Intangible is separable

Can be separated or divided from the acquired entity and sold, rented, licensed, or otherwise transferred

19


Examples of Identifiable Intangible Assets

20


Examples of Identifiable Intangible Assets

21


Valuation of Identifiable Intangibles

Measurement guidelines of ASC Topic 820 Fair value hierarchy

Level 1: Quoted prices in an active market Level 2: Quoted prices for similar assets,

adjusted for attributes of acquired assets Level 3: Valuation based on unobservable

estimated attributes Discounted present value Earnings and book value multiples

22


Intangibles Not Meeting Criteria as Identifiable Intangibles

Examples: Assembled workforce Potential contracts Long-standing customer relationships Favorable locations Business reputation

Consideration paid reflects these intangibles Consideration paid > fair value of identifiable

net assets

23


Goodwill

Goodwill exists if the consideration paid exceeds the total fair value of the net identifiable assets acquired.

24

Excess consideration paid occurs due to value attributed to intangible assets not meeting criteria for capitalization as identifiable intangible assets

Amount is capitalized as goodwill, an intangible asset


Calculating Goodwill25

An acquirer pays $100 million in cash to acquire another company. The fair value of the other company’s assets and liabilities are:

Acquisition cost $100,000,000Fair value of identifiable net assets acquired:

Current assets $ 3,000,000. Plant and equipment 42,000,000. Patents and copyrights 5,000,000. Current liabilities (4,000,000) Long-term debt (40,000,000) 6,000,000

Goodwill $ 94,000,000

Account Fair ValueCurrent assets $ 3,000,000Plant and equipment 42,000,000Patents and copyrights 5,000,000Current liabilities 4,000,000Long-term debt 40,000,000


Recording an Acquisition with Goodwill

26

Current assets 3,000,000

Plant and equipment 42,000,000

Patents and copyrights 5,000,000

Goodwill 94,000,000

Current liabilities 4,000,000

Long-term debt 40,000,000

Cash 100,000,000


Illustration of Previously Unreported Assets

An acquirer pays $100 million in cash to acquire another company. Fair value of the acquiree’s reported assets and liabilities are:

27

Unreported intangible assets:

Current assets $ 3,000,000 Current liabilities $ 4,000,000Plant and equipment 42,000,000 Long-term debt 40,000,000Patents and copyrights 5,000,000

Brand names $2,000,000 Favorable lease agreements 500,000 Assembled workforce 60,000,000 Potential future contracts 12,000,000 Developed technology 8,000,000

IdentifiableIntangibles

Not identifiable intangibles


Illustration of Reporting Assets Acquired and Liabilities Assumed

continued

Goodwill calculation:

28


Current assets $ 3,000,000. Plant and equipment 42,000,000. Patents and copyrights 5,000,000. Brand names 2,000,000.

Favorable lease agreements 500,000

Developed technology 8,000,000. Current liabilities (4,000,000) Long-term debt (40,000,000) 16,500,000

Goodwill $ 83,500,000


Illustration of Reporting Assets Acquired and Liabilities Assumed

continued

Recording the acquisition:

29

Current assets 3,000,000 Plant and equipment 42,000,000 Patents and copyrights 5,000,000 Brand names 2,000,000 Favorable lease agreements 500,000 Developed technology 8,000,000 Goodwill 83,500,000

Current liabilities 4,000,000Long-term debt 40,000,000Cash 100,000,000



Measure and report the various types of consideration paid.

30


Measurement of Acquisition Cost

Must be measured at fair value at the acquisition date

Acquisition cost includes Cash or other assets transferred to the former

owners by the acquirer Liabilities incurred by the acquirer and owed to

the former owners of the acquiree Stock issued by the acquirer to the former

owners of the acquiree

31


Contingent Consideration

Exists when the acquirer agrees to make additional payments to the former owners of the acquiree if certain events occur or conditions are met

Adds to acquisition cost Must be reported at date of acquisition

Requires good faith estimates of Probability, and Timing

Based on present value of the expected payment

32


Earnings Contingency The former shareholders believe they are

entitled to more consideration given their company will bolster postcombination earnings

Acquirer makes an additional payment, in cash or stock, if certain performance goals are met

Performance goals often based on Revenue Cash from operations EBITDA

Also known as an earnout

33


Earnings Contingency Example

X agrees to pay Y’s former shareholders $0.50 cash for every dollar in cash from operations above $20 million reported in the first year after acquisition. X expects 3 possible outcomes:

34

Expected payment:

Using a 5% discount rate, the present value of expected payment is approximately:

Cash from Operations Probability$15,000,000 0.30 25,000,000 0.50 35,000,000 0.20

($25,000,000 - $20,000,000) x 50% = $ 2,500,000 ($35,000,000 - $20,000,000) x 20% = 3,000,000 $ 5,500,000

($5,500,000/(1 + 0.05) = $5,238,000


Security Price Contingency

Guarantee to the former shareholders of the acquired company Guarantees that the market value of securities

issued to them in exchange for their stock does not fall below a specified amount

Acquiring company issues additional shares or cash to the former shareholders to bring the total consideration value to the minimum level

35


Security Price Contingency ExampleX issues 1 million shares with a market price of $50 per share to the former shareholders of Y. A agrees to issue additional shares to maintain the value of the shares at $50 million at the end of the first year after acquisition. X estimates the stock price at the end of the year to be three possible outcomes:

36

Expected obligation:

Using a 5% discount rate, the present value of expected payment is approximately:

Stock Price Per Share Probability$35 0.10 45 0.25 55 0.65

($50,000,000 - $35,000,000) x 10% = $1,500,000 ($50,000,000 - $45,000,000) x 25% = 1,250,000 $2,750,000

($2,750,000/(1 + 0.05) = $2,619,000


Reporting Contingent Consideration

Earnings contingencies are liabilities Security price contingencies are additional

paid-in capital Both increase the total acquisition price

37


Recording Contingent Consideration continued

Use the previous acquisition information and add the two contingent considerations:

38

Current assets 3,000,000 Plant and equipment 42,000,000 Patents and copyrights 5,000,000 Brand names 2,000,000 Favorable lease agreements 500,000 Developed technology 8,000,000 Goodwill 91,357,000

Current liabilities 4,000,000Long-term debt 40,000,000Cash 100,000,000Earnings contingency liability 5,238,000

Additional paid-in capital: security price contingency 2,619,000


Acquisition-Related Costs

Out-of-pocket costs Outside consulting fees and advisory services Lawyers Accountants

Out-of-pocket costs are expenses Do not increase the value of the acquired business

Security registration costs Reduce the net value of the equity accounts affected

(additional paid-in capital) Do not increase acquisition cost

39


Acquisition-Related Restructuring Costs

Must be expensed as incurred Do not affect acquisition cost

Examples Shutting down departments Reassigning or eliminating jobs Changing supplier or production practices in

connection with the combination

40


Reporting Consideration Paid:An Example

41

An acquirer pays the following consideration to acquire another company:

Fair value of acquirer’s assets and liabilities are:

Cash paid to former owners of the acquired company $50,000,000 Fair value of stock issued to former owners of the acquired company: 1,000,000 shares, par value $1 60,000,000 Cash paid for registration fees on stock issued 1,000,000 Cash paid for outside merger advisory services 2,000,000 Expected present value of earnout agreement 600,000 Expected present value of stock price contingency agreement 400,000

Previously reported Previously unreportedCurrent assets $ 3,000,000 Brand names $2,000,000 Plant and equipment 42,000,000 Favorable lease agreements 500,000 Patents and copyrights 5,000,000 Assembled workforce 60,000,000 Current liabilities 4,000,000 Future potential contracts 12,000,000 Long-term debt 40,000,000 Developed technology 8,000,000


Reporting Consideration Paid: An Example continued

42

Goodwill calculation:Acquisition cost

Cash paid to former owners $50,000,000 Fair value of stock issued 60,000,000 Fair value of earnout 600,000 Fair value of stock contingency 400,000 $111,000,000

Fair value of identifiable net assets acquired: Current assets $ 3,000,000 Plant and equipment 42,000,000 Patents and copyrights 5,000,000 Brand names 2,000,000 Favorable lease agreements 500,000 Developed technology 8,000,000 Current liabilities (4,000,000) Long-term debt (40,000,000) 16,500,000

Goodwill $ 94,500,000


Reporting Consideration Paid: An Example continued

43

Record the acquisition:

Current assets 3,000,000 Plant and equipment 42,000,000 Patents and copyrights 5,000,000 Brand names 2,000,000 Favorable lease agreements 500,000 Developed technology 8,000,000 Goodwill 94,500,000 Merger expenses 2,000,000

Current liabilities 4,000,000Long-term debt 40,000,000Earnout liability 600,000Common stock, $1 par 1,000,000Additional paid-in-capital--stock issue 58,000,000Additional paid-in-capital--stock contingency 400,000Cash 53,000,000



Account for changes in the values of acquired assets and liabilities, and

contingent consideration.


Subsequent Changes in Values

Value changes resulting from clarification of

facts existing as of the date of acquisition

45

Value changes caused by events occurring

after the date of acquisition

Treated as corrections to the initial acquisition

entryReported in income


Measurement Period

Defined as the period during which value changes may be reported as corrections to the initial acquisition entry

Ends when no more information can be obtained concerning estimated values as of the acquisition date Limited to one year after the acquisition date

46


Reporting Subsequent Changes in Asset and Liability Values

47

Refer to the previous acquisition illustration. Three months after the acquisition, new information reveals that $15 million of plant and equipment not belonging to the acquired company was mistakenly included in the original valuation.

The acquirer’s journal entry to correct the original acquisition:

Goodwill 15,000,000 Plant and equipment 15,000,000

If the equipment dropped in value after the date of acquisition, the decline in value would be recognized in income as a loss on equipment.


Reporting Subsequent Changes in Contingent Consideration

For value changes caused by events occurring after the date of acquisition

48

If contingent consideration is

reported as equity

If contingent consideration is

reported as a liability

• No value changes are reported

• Final settlement reported in equity

• Changes in value reported in income at each reporting date until the contingency is resolved


Contingent Consideration Value Example

49

The acquirer records an earnout agreement at $600,000 and a stock price contingency at $400,000. Four months later, new information is uncovered, causing the earnout agreement to increase in value by $500,000.

To report the change in earnout value as a correction to the original acquisition value:

To report the change in earnout value due to an improvement in business conditions since the acquisition:

Goodwill 500,000 Earnout liability 500,000

Loss on earnout 500,000 Earnout liability 500,000



Account for bargain purchases.


Bargain Purchases Occurs when the acquisition cost is less than the

fair value of the identifiable net assets at acquisition date

May be the results of a forced sale Seller is attempting to avoid bankruptcy or other

financial losses

To ensure accurate reporting of asset and liability balances Report a gain on the bargain purchase

BUT double check acquired asset and liability estimates first. Assets may be overvalued, liabilities undervalued

51


Bargain Purchase Example52

An acquirer pays $15 million cash for another company. Fair values of assets acquired and liabilities assumed are:

To calculate the gain:

Current assets $ 3,000,000 Brand names $2,000,000 Plant and equipment 42,000,000 Favorable lease agreements 500,000 Patents and copyrights 5,000,000 Assembled workforce 60,000,000 Current liabilities 4,000,000 Future potential contracts 12,000,000 Long-term debt 40,000,000 Developed technology 8,000,000


Current assets $ 3,000,000 Plant and equipment 42,000,000 Patents and copyrights 5,000,000 Brand names 2,000,000 Favorable lease agreements 500,000 Developed technology 8,000,000 Current liabilities (4,000,000) Long-term debt (40,000,000) 16,500,000

Gain on bargain purchase $ 1,500,000


Bargain Purchase Example continued

53

To record the bargain purchase:

Current assets 3,000,000 Plant and equipment 42,000,000 Patents and copyrights 5,000,000 Brand names 2,000,000 Favorable lease agreements 500,000 Developed technology 8,000,000

Current liabilities 4,000,000Long-term debt 40,000,000Cash 15,000,000Gain on bargain purchase 1,500,000



Explain the reporting requirements and issues related to in-process research and

development and preacquisition contingencies.

54


In-process Research and Development

If acquired in a business combination, must be reported as an asset At fair value Regardless of whether there is an alternative

future use

Reinforces focus on accurate measurement of assets and liabilities acquired

55

Differs from internally generated R&D costs that are expensed immediately.


Preacquisition Contingencies

An acquired entity has business situations that will result in gains or losses if and when a future event occurs

Such as Lawsuits and warranty liabilities

Result in contingent assets and liabilities If the entity is the plaintiff in a lawsuit, a

contingent asset may exist. If the entity is the defendant in a lawsuit, a

contingent liability may exist.

56


Preacquisition Contingency Categories Known assets and liabilities with ‘determined’

or ‘determinable’ fair values Recognized at date of acquisition fair value when

that value can be determined during the measurement period.

Example: warranties Other contingencies

Recognized at date of acquisition fair value when these criteria are satisfied during the measurement period: It is probable that a contingent asset or liability

exists on the acquisition date The value of the asset or liability can be

reasonably estimated Example: Unsettled lawsuit

57


IFRS for Business Combinations

IFRS 3(R) Business Combinations IAS 38 Intangible Assets IFRS and U.S. GAAP requirements for

business combinations are mostly converged ASC Topic 805 requirements converged to

IFRS

58


End of Chapter 2

59

what is a business combination?

Documents