1. Chapter 1-1

2. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

3. Chapter 1-3 1. 1.Describe historical trends in types of business combinations. 2. 2.Identify the major reasons firms combine. 3. 3.Identify the factors that managers should consider in exercising due diligence in business combinations. 4. 4.Identify defensive tactics used to attempt to block business combinations. 5. 5.Distinguish between an asset and a stock acquisition. 6. 6.Indicate the factors used to determine the price and the method of payment for a business combination. Learning Objectives

4. Chapter 1-4 7. 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. 8.Describe the two alternative views of consolidated financial statements: the economic entity and the parent company concepts. 9. 9.List and discuss each of the seven Statements of Financial Accounting Concepts (SFAC). Learning Objectives

5. Chapter 1-5 Business Combination - operations of two or more companies are brought under common control. Nature 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) - results when the board of directors of a company targeted for acquisition resists the combination.

6. Chapter 1-6 Defense Tactics Nature of the Combination 1.Poison pill: Issuing stock rights to existing shareholders. 2.Greenmail: Purchase of 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.

7. Chapter 1-7 Defense Tactics Nature of the Combination 4.Pac-man defense: Attempting an unfriendly takeover of the would-be acquiring company. 5.Selling the crown jewels: Sale of valuable assets to make the firm less attractive to the would-be acquirer. 6.Leveraged buyouts: Purchase of a controlling interest in the target firm by its managers and third- party investors, who usually incur substantial debt.

8. Chapter 1-8 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 Question Nature of the Combination

9. Chapter 1-9 Internal Expansion vs. External Expansion Business Combinations: Why? Why Not? Business combinations (external have several advantages) LO 2 Reasons firms combine. 1.Operating synergies 2.International marketplace 3.Financial synergy 4.Diversification 5.Divestitures

10. Chapter 1-10 Three distinct periods Business Combinations: Historical Perspective 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). 1945 to the present, many of the mergers that occurred from the 1950s through the 1970s were conglomerate mergers. LO 1 Describe historical trends in types of business combinations.

11. Chapter 1-11 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 Combinations LO 5 Distinguish between an asset and a stock acquisition. What Is Acquired?What Is Given Up? Net assets of S Company (Assets and Liabilities) Common Stock of S Company 1.Cash 2. Debt 3. Stock 4.Combination of above Figure 1-1

12. Chapter 1-12 Possible Advantages of Stock Acquisition Lower 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. Terminology and Types of Combinations LO 5 Distinguish between an asset and a stock acquisition.

13. Chapter 1-13 Classification by Method of Acquisition Terminology and Types of Combinations LO 5 Distinguish between an asset and a stock acquisition. A CompanyB CompanyA 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.

14. Chapter 1-14 Classification by Method of Acquisition Terminology and Types of Combinations LO 5 Distinguish between an asset and a stock acquisition. A CompanyB CompanyC 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.

15. Chapter 1-15 Classification by Method of Acquisition Terminology and Types of Combinations LO 5 Distinguish between an asset and a stock acquisition. 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.

16. Chapter 1-16 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 Review Question Terminology and Types of Combinations LO 5 Distinguish between an asset and a stock acquisition.

17. Chapter 1-17 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 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 Premiums LO 5 Distinguish between an asset and a stock acquisition.

18. Chapter 1-18 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 Deal LO 3 Factors to be considered in due diligence.

19. Chapter 1-19 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 Review Question Avoiding the Pitfalls Before the Deal LO 3 Factors to be considered in due diligence.

20. Chapter 1-20 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.  Each constituent makes two kinds of contributions to the new entity—net assets and future earnings. Determining Price and Method of Payment in Business Combinations LO 6 Factors affecting price and method of payment.

21. Chapter 1-21 Net Asset and Future Earnings Contributions Determining Price and Method of Payment in Business Combinations LO 6 Factors affecting price and method of payment. Determination of an equitable price for each constituent company requires: The valuation of each company’s net assets. Each company’s expected contribution to the future earnings of the new entity.

22. Chapter 1-22 Excess Earnings Approach to Estimate Goodwill LO 6 Factors affecting price and method of payment. 1. Identify a normal rate of return on assets for firms similar to the company being targeted. 2. Apply the rate of return (step 1) to the net assets of the target to approximate “normal earnings.” 3. Estimate the expected future earnings of the target. Exclude any nonrecurring gains or losses. 4. Subtract the normal earnings (step 2) from the expected target earnings (step 3). The difference is “excess earnings.” Determining Price and Method of Payment

23. Chapter 1-23 Excess Earnings Approach to Estimate Goodwill LO 6 Factors affecting price and method of payment. 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. Determining Price and Method of Payment 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.

24. Chapter 1-24 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. Review Question LO 6 Factors affecting price and method of payment. Determining Price and Method of Payment

25. Chapter 1-25 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. Determining Price and Method of Payment

26. Chapter 1-26 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) 960,000 Depreciation on equipment (each year) 50,000 Extraordinary loss (year 2007) 300,000 Sales commissions (each year) 250,000 LO 7 Estimating goodwill. Determining Price and Method of Payment C. The normal rate of return on net assets is 15%.

27. Chapter 1-27 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. LO 7 Estimating goodwill. Determining Price and Method of Payment

28. Chapter 1-28 Exercise 1-1 (Part A) LO 7 Estimating goodwill. Determining Price and Method of Payment 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 $15,000,000 Fair value of liabilities8,800,000 Fair value of net assets6,200,000 Normal rate of return15% Normal earnings$ 930,000

29. Chapter 1-29 Determining Price and Method of Payment Step 3 Estimate the expected future earnings of the target. Exclude any nonrecurring gains or losses. LO 7 Estimating goodwill.

30. Chapter 1-30 Determining Price and Method of Payment Step 4 Subtract the normal earnings (step 2) from the expected target earnings (step 3). The difference is “excess earnings.” LO 7 Estimating goodwill. Expected target earnings $1,028,667 Less: Normal earnings930,000 Excess earnings, per year$ 98,667

31. Chapter 1-31 Determining Price and Method of Payment Step 5 Compute estimated goodwill from “excess earnings.” LO 7 Estimating goodwill. Excess earnings $ 98,667 Present value of excess earnings (perpetuity) at 25%: 25% = $394,668 Estimated 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 $6,200,000 Estimated goodwill394,668 Implied offering price $6,594,668

32. Chapter 1-32 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. LO 7 Estimating goodwill. Determining Price and Method of Payment

33. Chapter 1-33 Determining Price and Method of Payment Part B LO 7 Estimating goodwill. Excess earnings of target (same a Part A)$ 98,667 PV factor (ordinary annuity, 3 years, 15%) x 2.28323 Estimated goodwill$ 225,279 Fair value of net assets6,200,000 Implied 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.

34. Chapter 1-34 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 Consolidated Financial Statements Economic Entity Concept - affiliated companies are a separate, identifiable economic entity. The noncontrolling interest presented as a component of stockholders’ equity.

35. Chapter 1-35 Consolidated Net Income Parent Company Concept, consolidated net income consists of the combined income of the parent company and its subsidiaries after deducting the noncontrolling interest in income as an expense in determining consolidated net income. 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 Concepts LO 8 Economic entity and parent company concepts.

36. Chapter 1-36 Consolidated Balance Sheet Values Parent 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. Alternative Concepts LO 8 Economic entity and parent company concepts.

37. Chapter 1-37 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. Review Question Alternative Concepts LO 8 Economic entity and parent company concepts.

38. Chapter 1-38 Intercompany Profit Two alternative points of view: 1.Total (100%) elimination 2.Partial elimination Alternative Concepts LO 8 Economic entity and parent company concepts. 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.

39. Chapter 1-39 Conceptual Framework Conceptual Framework LO 8 Economic entity and parent company concepts. PRINCIPLES 1.Historical cost 2.Revenue recognition 3.Matching 4.Full disclosure SFAC Nos. 1 & 2 Objectives: Provide Information: 1. Usefulness in investment and credit decisions 2. Usefulness in future cash flows 3. About enterprise resources, claims to resources, and changes SFAC No. 2 Qualitative Characteristics 1. Relevance 2. Reliability 3. Comparability 4. Consistency Also:Usefulness,Understandability SFAC No. 6 (replaced SFAC No. 3) Provides definitions of key components of financial statements ASSUMPTIONS 1.Economic entity 2.Going concern 3.Monetary unit 4.Periodicity CONSTRAINTS 1.Cost-benefit 2.Materiality 3.Industry practice 4.Conservatism PRINCIPLES 1.Historical cost 2.Revenue recognition 3.Matching 4.Full disclosure SFAC No. 5 & 7 Recognition and Measurement SFAC No. 7: Using future cash flows & present values in accounting measures Figure 1-2 Figure 1-2 Conceptual Framework for Financial Accounting and Reporting Objectives Fundamental Operational

40. Chapter 1-40 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. 2). LO 8 Economic entity and parent company concepts. FASB’s Conceptual Framework

41. Chapter 1-41 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. A shift to the economic entity concept seems to be consistent with the assumptions laid out by the FASB for GAAP (SFAC No. 5). LO 8 Economic entity and parent company concepts. FASB’s Conceptual Framework

42. Chapter 1-42 Overview of FASB’s Conceptual Framework LO 9 Statements of Financial Accounting Concepts. FASB’s Conceptual Framework SFAC No.1 -Objectives of Financial Reporting SFAC No.2 - Qualitative Characteristics of Accounting Information SFAC No.3 - Elements of Financial Statements (superceded by SFAC No. 6) SFAC No.4 - 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 The Statements of Financial Accounting Concepts issued by the FASB include:

43. Chapter 1-43 Distinguishing between Earnings and Comprehensive Income LO 9 Statements of Financial Accounting Concepts. FASB’s Conceptual Framework 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.”

44. Chapter 1-44 Asset Impairment and the Conceptual Framework LO 9 Statements of Financial Accounting Concepts. FASB’s 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 (Example: amortization of limited-life intangibles); or Loss 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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