©Cambridge Business Publishing, 2010 What is a Business Combination? Occurs when one company...

©Cambridge Business Publishing, 2010©Cambridge Business Publishing, 2010

What is a Business Combination?

Occurs when one company obtains control over another company

Referred to as Merger Acquisition Takeover

Sought out when the acquiring firm’s management believes it can accomplish its objectives more efficiently and at lower cost

1


Motivations for Acquisitions

To facilitate relationships with other companies as suppliers, subcontractors, customers

To add new facilities and capabilities To control a source of supply To add production or distribution facilities To achieve customer relationships To expand into new geographic markets To diversify into new lines of business

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Advantages of Acquiring a Company

Going concern is less costly Eliminates the need to start from scratch Avoids duplication of efforts that exist from

growth from within

Competition is often reduced Complementary products or services can

lead to increased overall sales

3


Top M&A Deals Worldwide, 2000-20074

Exhibit 2.1


Types of Combinations5

Stock transactions governed by State laws

All assets acquired and

liabilities assumed are

recorded directly on the books of

the acquiring company


Statutory Merger ExampleIBM pays $10 million in cash to acquire DataFile, Inc. on January 1, 2010. The fair values of DataFile’s assets and liabilities are:

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Current assets 5,000,000 Equipment 45,000,000 Patents and copyrights 10,000,000

Current liabilities 15,000,00

0

Long-term debt 35,000,00

0

Cash 10,000,00

0

Account Fair ValueCurrent assets $ 5,000,000Equipment 45,000,000Patents and copyrights 10,000,000Current liabilities 15,000,000Long-term debt 35,000,000

To record the acquisition of DataFile, Inc:


Statutory Merger Results

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 Acquired assets and liabilities

Recorded at fair value at the date of acquisition

Acquiring company’s net assets are not revalued

7


Statutory Consolidation

New corporation absorbs both companies Identify one of the companies as the

acquirer Only the acquired company’s assets and

liabilities are reported by the new corporation at fair value on date of acquisition

8


Stock Acquisition

Occurs when a company acquires most or all of the voting stock of another company

Each firm continues as a separate legal entity Investment in the acquired firm treated as an

intercorporate investment Consolidation working paper used to combine

the two companies’ results

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Investment in DataFile, Inc. 10,000,000 Cash 10,000,000

To record the investment in stock:


Goodwill

Goodwill exists if price paid by acquirer exceeds the total fair value of the specific net assets acquired.

10

Excess price paid occurs due to value attributable To a company’s reputation, and To a company’s competitive strengths

Amount is capitalized as goodwill, an intangible asset


Calculating Goodwill11

IBM pays $10 million in cash to acquire DataFile, Inc. on January 1, 2010. The fair value of DataFile’s assets and liabilities are:

Acquisition cost $10,000,000Fair value of identifiable net assets acquired:

Current assets $ 5,000,000. Equipment 45,000,000. Patents and copyrights 2,000,000. Current liabilities (15,000,000) Long-term debt (35,000,000) 2,000,000

Goodwill $ 8,000,000

Current assets $ 5,000,000 Current liabilities $15,000,000Equipment 45,000,000 Long-term debt 35,000,000Patents and copyrights 10,000,000

Goodwill is the excess of amount paid over the fair value of net assets acquired:


Recording an Acquisition with Goodwill

To record the acquisition with goodwill at $8,000,000.

12

Current assets 5,000,000 Equipment 45,000,000 Patents and copyrights 2,000,000 Goodwill 8,000,000

Current liabilities 15,000,000Long-term debt 35,000,000Cash 10,000,000


Evolution of Reporting Business Combinations

From 1970 to 2001, two accounting methods existed:

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Purchase Method Pooling Method

Viewed as an acquisition of one

business by another

Viewed as a union of two previously

separate companies


Current U.S. GAAP for Business Combinations

14

Exhibit 2.3


Business Combinations Defined

Occurs when control is obtained over one or more businesses

When is control obtained? Direct acquisition of the assets and liabilities of

the acquired company Statutory merger Consolidation Asset acquisition

Obtaining a controlling interest in the voting shares of the acquired company Stock acquisition

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Control is obvious

Control must be evaluated


Transactions Excluded as Business Combinations

Not covered under SFAS 141(R) Formation of a joint venture by existing

companies Establishing a new business as a separate

subsidiary Combining companies already under

common control

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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

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Identifying the Acquiring Company

Acquiring company distributes cash or other assets and/or incurs liabilities

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

18


Measuring Assets and Liabilities

Acquisition cost

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Greater Than

Fair value of the net assets

acquired

Report goodwill

Acquisition cost

Less Than

Fair value of the net assets

acquired

A bargain purchase

exists. Report a

gain.


Estimation of Fair Values20

Exhibit 2.4


Identification of Previously Unreported Intangibles

Two criteria leading to separate recognition as an 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

21

Separability Criterion


Examples of Identifiable Intangible Assets22


Examples of Identifiable Intangible Assets23


Goodwill

Excess of acquisition cost over fair value of identifiable net assets acquired

Included as goodwill under SFAS 141(R) Assembled workforce

Employees in place and able to run the business Potential contracts

Being negotiated with prospective customers Long-standing customer relationships Favorable locations Business reputation

24


Valuation of Intangibles

General measurement rules of SFAS 157 apply Level 1: Quoted prices in an active market for

identical assets Level 2: Quoted market prices for similar

assets, adjusted for the attributes of the assets in question

Level 3: Valuation based on unobservable estimated attributes

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Always valued in the context of highest and best use


Three Approaches to Valuation(SFAS 157)

Market Quoted market prices of identical or similar

assets

Income Valuation models used to calculate the present

value of future cash flows or earnings

Cost Estimation of replacement cost of the services

provided by the asset

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Illustration of Reporting Assets Acquired and Liabilities Assumed

IBM pays $25 million in cash to acquire DataFile Inc. on July 1, 2010. Fair value of DataFile’s reported assets and liabilities are:

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Identified and valued unreported intangible assets are:

Current assets $ 2,000,000 Current liabilities $10,000,000Equipment 60,000,000 Long-term debt 40,000,000Patents and copyrights 5,000,000

Brand names $1,000,000 Favorable lease agreements 600,000 Assembled workforce 5,000,000 In-process contracts with potential customers 2,000,000 Contractual customer relationships 3,000,000

Identifiableintangibles

Unreported intangible assets


Illustration of Reporting Assets Acquired and Liabilities Assumed continued

Determining goodwill for the acquisition of DataFile Inc. for $25 million cash:

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Current assets $2,000,000. Plant and equipment 60,000,000. Patents and copyrights 5,000,000. Brand names 1,000,000. Favorable lease agreements 600,000. Contractual customer relationships 3,000,000. Current liabilities (10,000,000) Long-term debt (40,000,000) 21,600,000

Goodwill $3,400,000


Illustration of Reporting Assets Acquired and Liabilities Assumed continued

Recording the acquisition of DataFile Inc for $25 million cash:

29

Current assets 2,000,000 Plant and equipment 60,000,000 Patents and copyrights 5,000,000 Brand names 1,000,000 Favorable lease agreements 600,000 Contractual customer relationships 3,000,000 Goodwill 3,400,000

Current liabilities 10,000,000Long-term debt 40,000,000Cash 25,000,000


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

Must be reported at date of acquisition Requires good faith estimates of

Probability, and Timing

Based on present value of the expected payment

30


Earnings Contingency

Derives from the beliefs of the former shareholders that they are entitled to more consideration given their company will bolster postcombination earnings

Also known as earnouts Expected payments increase the acquisition

cost Often based on performance goals for

Revenue Cash from operations

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Out-of-Pocket Acquisition-Related Costs

Not included with acquisition costs Why? Do not increase the value of the

acquired business Examples of out-of-pocket costs

Outside consulting fees and advisory services Lawyers Accountants

Security registration costs Reduce the net value of the equity accounts

affected Do not increase total acquisition costs

32


Acquisition-Related Restructuring Costs

Must be expensed as incurred under SFAS 141(R) Do not affect acquisition costs

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

connection with the combination

33


Reporting Consideration Given in an Acquisition Example

34

IBM pays acquires DataFile Inc. on July 1, 2010. The deal is structured as:

Fair value of DataFile’s reported assets and liabilities are:

Cash paid to former owners of DataFile $3,000,000 Fair value of stock issued to former owners of DataFile: 1,000,000 shares, par value $.50 20,000,000 Cash paid for registration fees on stock issued 600,000 Cash paid for outside merger advisory services 1,200,000 Expected present value of earnout agreement 1,500,000 Expected present value of stock price contingency agreement 800,000

Current assets $ 2,000,000 Brand Names $1,000,000 Plant and equipment 60,000,000 Favorable lease agreements 600,000 Patents and copyrights 5,000,000 Assembled workforce 5,000,000 Current liabilities 10,000,000 In-process contracts with potential customers 2,000,000 Long-term debt 40,000,000 Contractual customer relationships 3,000,000


Reporting Consideration Given in an Acquisition Example continued

35

IBM calculates goodwill for the acquisition of DataFile Inc. as:Acquisition cost

Cash to former owners of DataFile $3,000,000 Cash paid for registration fees 600,000 Fair value of stock issued, net 19,400,000 Fair value of earnout 1,500,000 Fair value of stock contingency 800,000 $25,300,000

Fair value of identifiable net assets acquired: Current assets $2,000,000 Plant and equipment 60,000,000 Patents and copyrights 5,000,000 Brand names 1,000,000 Favorable lease agreements 600,000 Contractual customer relationships 3,000,000 Current liabilities (10,000,000) Long-term debt (40,000,000) 21,600,000

Goodwill $3,700,000


Reporting Consideration Given in an Acquisition Example continued

36

IBM records the acquisition of DataFile Inc. as:

Current assets 2,000,000 Plant and equipment 60,000,000 Patents and copyrights 5,000,000 Brand names 1,000,000 Favorable lease agreements 600,000 Contractual customer relationships 3,000,000 Goodwill 3,700,000 Merger expenses 1,200,000

Current liabilities 10,000,000Long-term debt 40,000,000Earnout liability 1,500,000Common stock, $.50 par 500,000Additional paid-in-capital--stock issue 18,900,000Additional paid-in-capital--stock contingency 800,000Cash 4,800,000


Subsequent Changes in Values

Value changes resulting from clarification of facts existing as of the date of

acquisition

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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 (SFAS 141(R))

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

38


Reporting Subsequent Changes in Asset and Liability Values

39

IBM pays acquires DataFile Inc. on July 1, 2010. Three months after acquisition, new information reveals that equipment not belonging to DataFile was mistakenly included in the original valuation and the actual equipment fair value was $40 million instead of $60 million.

IBM’s journal entry to correct the original acquisition:

Goodwill 20,000,000 Plant and equipment 20,000,000

If the equipment dropped in value after the date of acquisition, the decline in value would be recognized as a loss on equipment with no change to the original equipment cost.


Bargain Purchases

Occurs when the acquisition cost is less than the fair value of the acquired net assets at acquisition date

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

other financial losses

Report a gain on the bargain purchase Ensures accurate reporting of asset and

liability balances

40


Bargain Purchase Example41

IBM acquires DataFile Inc. for $20 million cash with the following fair values of assets acquired and liabilities assumed:

To calculate the gain:

Current assets $ 2,000,000 Brand names $1,000,000 Plant and equipment 60,000,000 Favorable lease agreements 600,000 Patents and copyrights 5,000,000 Assembled workforce 5,000,000 Current liabilities 10,000,000 In-process contracts with potential customers 2,000,000 Long-term debt 40,000,000 Contractual customer relationships 3,000,000


Current assets $2,000,000 Plant and equipment 60,000,000 Patents and copyrights 5,000,000 Brand names 1,000,000 Favorable lease agreements 600,000 Contractual customer relationships 3,000,000 Current liabilities (10,000,000) Long-term debt (40,000,000) 21,600,000

Gain on bargain purchase $1,600,000


Bargain Purchase Example continued

42

IBM acquires DataFile Inc. for $20 million cash with the following fair values of assets acquired and liabilities assumed:

To record the bargain purchase:

Current assets $ 2,000,000 Brand names $1,000,000 Plant and equipment 60,000,000 Favorable lease agreements 600,000 Patents and copyrights 5,000,000 Assembled workforce 5,000,000 Current liabilities 10,000,000 In-process contracts with potential customers 2,000,000 Long-term debt 40,000,000 Contractual customer relationships 3,000,000

Current assets 2,000,000 Plant and equipment 60,000,000 Patents and copyrights 5,000,000 Brand names 1,000,000 Favorable lease agreements 600,000 Contractual customer relationships 3,000,000

Current liabilities 10,000,000Long-term debt 40,000,000Cash 20,000,000Gain on bargain purchase 1,600,000

©Cambridge Business Publishing, 2010 What is a Business Combination? Occurs when one company...

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