Chapter 4 Business Combinations

CHAPTER FOUR
BUSINESS COMBINATIONS
4.1. Nature of Business Combinations
Business combinations are events or transactions in which two or more business enterprises, or their net
assets, are brought under common control in a single accounting entity. Other terms frequently applied
to business combinations are mergers and acquisitions.Business combinations may be friendly takeovers
and hostile takeovers.
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.
 Pac-man Defense: a threat to undertake in 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 of one or more business segments that attracts the
combinor. The profitable segment can be disposed through sale or spin-off. This is
sometimes called selling the crown jewels: The sale of valuable assets to others to make
the firm less attractive to the would-be acquirer. The negative aspect is that the firm, if it
survives, is left without some important assets
 Shark Repellent: an acquisitions 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.
 Poison Pill: an amendment of the articles of incorporation or bylaws to make it more
difficult to obtain stockholder approval for a takeover.
 Greenmail: an acquisition of common stock presently owned by the prospective
combinor at a price substantially in excess of the prospective combinor's cost, with the
stock thus acquired placed in the treasury or retired
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Business Combinations: Why and How?
Why do business enterprises enter into combinations?
In recent years Growth has been main reason for business enterprises to enter into a business
combination.There could be many more reasons.
 Obtaining new management strength or better use of existing management.
 Vertical integration of one firm’s output and another firm’s distribution or further processing.
 Cost saving through elimination of duplicate facilities and staff.
 Quick entry for new and existing products into domestic or foreign markets.
 Economics of scale allowing greater efficiency and negotiating power.
 The ability to access financing at more attractive rates. As firms grow in size, negotiating power
with financial institutions can grow.
 Diversification of business risk.
 A business combination may be undertaken for income tax advantages.
Terminology
A business combination refers to any set of conditions in which two or more organizations are joined
together through common control. The company whose business is being wanted is after called the
target company.
The company attempting to acquire the target company’s business is referred to as the acquiring
company.The
company.The legal agreement that specifies the terms and provisions of the business combination is
known as the acquisition, purchase, or merger agreement.
agreement. The process of attempting to acquire a
target company’s business is often called a takeover attempt.
Business combinations can be categorized as vertical, horizontal, or conglomerate.
 Vertical combinations take place between companies involved in the same industry but at
different levels.
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 Horizontal combinations take place between companies that are competitors at the same level in
a given industry.
 Conglomerate combinations involve companies in totally unrelated industries.
4.2. Methods for Arranging Business Combinations
The four common methods for carrying out a business combination are statutory merger, statutory
consolidation, common stock, and acquisition of assets.
Statutory Merger
Statutory Merger is a merger in which one of the merging companies continues to exist as a legal
entity while the other or other are dissolved. A business combination in which one company (the
survivor) acquires all the outstanding common stock of one or more other companies that are then
dissolved and liquidated, with their net assets owned by the survivor.
Procedures in a statutory merger

 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
corporation’s (the survivor) for all the outstanding voting common stock of the other
corporations.
 Stockholders of all constituent companies must approve the terms of the merger.
For example:
 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.
Statutory Consolidation
Statutory Consolidation is a business combination in which a new corporation issues common stock for all
outstanding common stock of two or more other corporations that are then dissolved and liquidated, with
their net assets owned by the new corporation. It is a in which a new corporate entity is created from the
two or more merging companies, which cease to exist.
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Procedures in a statutory consolidation
 Is consummated in accordance with applicable state laws.Stockholders of the constituent
companies approve the terms of the merger, in accordance with applicable corporate bylaws and
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 non-operational corporations, whose
activities may be continued as divisions of the new corporation.
E.g. ABC Company acquires XYZ Company; but a new Company AYZ is created
to issue common stocks for the two companies which are now defunct.
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).Corporation becomes affiliated with the combinor parent company as a
subsidiary but is not dissolved and liquidated and remains a separate legal entity.
ABC Company acquires over 50% of the voting stock of XYZ Company, a parent-subsidiary
relationship results and XYZ Company is now a subsidiary of ABC Company (Parent)
A COMPANY + B COMPANY = A+B COMPANY

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.A tender offer is a publicly
announced intention to acquire common stock. The price per share state in the tender offer
usually is well above the prevailing market price
Acquisition of Assets
A business enterprise may acquire from another enterprise all or most of its gross assets or net assets for
cash debt, preferred or common stock, or a combination thereof. The transaction generally must be
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approved by the boards of the constituent companies. The selling enterprise may continue its existence
as a separate or it may be dissolved and liquidated; it does not become an affiliate of the combinor.
4.3. Methods of Accounting for Business Combinations

Purchase Accounting
Accounting for a business combination by the purchase method follows principles normally applicable
under historical cost accounting to record acquisition of assets and issuances of stock and to accounting
for assets and liabilities after acquisition.
 Assets (including goodwill) acquired for cash would be recognized at the amount of cash paid
 Assets acquired involving the issuance of debt, preferred stock, or common stock would be
recognized at the current fair value of the asset, or the debt or the stock, whichever was more
clearly evident.
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:
 The amount of consideration paid by the combinor
 The combinor’s direct out of pocket costs
 Any contingent consideration that is determinable on the date of the business combination
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/market value of equity securities issued by the combinor.
Direct Out of Pocket Costs
Included in this category are:
 legal fees
 accounting fees
 finder’s fees
A finder’s 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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Indirect out of pocket costs such as salaries of officers of the constituent companies involved in
negotiation and completion of the completion, are recognized as expenses incurred by the constituent
companies.
Contingent Considerations
Contingent consideration is additional cash, other assets, or securities that may be issued in the future,
contingent on future events such as a specified level of earnings or a designated market price for a
security that has been issued to complete the business combination. Contingent consideration that is
determinable on the consummation date of a combination is recorded as part of the cost of the
combination while that not determinable on the date of combination is recorded when the contingency is
resolved and the additional consideration is paid or issued or becomes payable or issuable.
Allocation of Cost of a Combinee

APB Opinion No. 16 provides the following principles for allocating cost of a combinee in a purchase
type business combination.
 First, all identifiable assets acquired and liabilities assumed in a business combination should be
assigned a portion of the cost of the acquired company, normally equal to their fair values at the
date of acquisition
 Second, the excess of the cost of the acquired company over the sum of the amounts assigned to
identifiable assets acquired less liabilities assumed should be recorded as goodwill.
Identifiable Assets and Liabilities

APB Opinion No. 16 provides guidelines for assigning values to a purchased combinee’s identifiable
assets and liabilities.
 Present values for receivables and liabilities
 Net realizable values for:
 marketable securities
 Finished goods and in process inventories
 Plant assets held for sale or temporary use
 appraise values for:
 Intangible assets
 Land
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 Natural resources
 Non marketable securities
 Replacement cost for:
 For inventories of material and plant assets held for long term use.
Goodwill
Goodwill is recognized frequently because the total cost of the combinee exceeds the current fair value
of identifiable net assets. The amount of goodwill recognized at the outset may be adjusted subsequently
when contingent considerations become issuable.
Negative Goodwill
Negative goodwill means an excess of current fair value of the combinee’s identifiable net assets over
their cost to the combinor.
Pooling of Interest Accounting

The original premise of pooling of interest method was that certain business combinations involving the
exchange of common stock between an issuer and the stockholders of a combinee were more in the
nature of a combining of existing stockholder interests than an acquisition of assets or raising of capital.
Combining of existing stockholder interests was evidenced by combinations involving common stock
exchanges between corporations of approximately equal size. The stockholders and managements of
these corporations continue their relative interests and activities in the combined enterprise as they
previously did in the constituent companies. Because neither of the equal sized companies could be
considered the combinor, the pooling of interest method of accounting provided for carrying forward to
the accounting records of the combined enterprise the combined assets, liabilities, and retained earnings
of the constituent companies at their carrying amounts. The current fair value of the common stock
issued to effect the business combination and the current fair value of the combinee’s net assets are
disregarded in pooling of interest accounting. Further, because there is no identifiable combinor, the
term issuer identifies the corporation that issues its common stock to accomplish the combination.
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Under Pooling-of-Interest (Uniting Interest) accounting method, the balance sheet items of the two
companies are simply added together. Pooling of interests was the preferable method to use because it
doesn't result in the creation of goodwill.
, companies could add together the book values of their net assets without indicating which entity was
the "purchaser" and which was the "purchased." When this method was used, investors often had
difficulty identifying who was buying whom or determining how to evaluate the transactions. Thus,
FASB ruled out Pooling-of-Interests through FASB Statement No. 141 in 2001 for new business
combinations. FASB unanimously voted to eliminate pooling of interests as an acceptable method of
accounting for business combinations.

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CHAPTER FOUR

 Proposal is submitted to share holders of all constituent companies for approval.

Business combinations can be categorized as vertical, horizontal, or conglomerate.

Procedures in a statutory merger

Acquisition of Common Stock

A COMPANY + B COMPANY = A+B COMPANY

4.3. Methods of Accounting for Business Combinations

Computation of Cost of a Combinee

Allocation of Cost of a Combinee

Identifiable Assets and Liabilities

Pooling of Interest Accounting

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