Chapter 1
Intercorporate
Acquisitions and
Investments in Other
Entities
McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
Development of Complex Business Structures
Reasons for Enterprise expansion
Size often allows economies of scale
New earning potential
Earnings stability through diversification
Management rewards for bigger company size
Prestige associated with company size
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Organizational Structure and Business Objectives
A subsidiary is a corporation that is
controlled by another corporation,
referred to as a parent company.
Control is usually through majority
P
ownership of its common stock.
Because a subsidiary is a separate
legal entity, the parent’s risk
associated with the subsidiary’s
activities is limited.
S
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Organizational Structure and Ethical Considerations
Manipulation of financial reporting
The use of subsidiaries or other entities to borrow
money without reporting the debt on their
balance sheets
Using special entities to manipulate profits
Manipulation of accounting for mergers and
acquisitions
Pooling-of-interests allowed for manipulation
The FASB did away with it and modified acquisition
accounting
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Business Expansion and forms of Organization
Structure
Two Types of Expansion
Internal Expansion
Investment account (Parent) = BV of net assets (Sub)
External Expansion
Acquisition price usually is not the same as BV, carrying value, or
even FMV of net assets
$
P
P
Sub
Shareholders
External Stock Internal Stock $
Expansion Expansion
S S
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Business Expansion for Within
New entities are created
subsidiaries
partnerships
joint ventures
special entities
Motivating factors:
Helps establish clear lines of control and facilitate the
evaluation of operating results
Special tax incentives
Regulatory reasons
Protection from legal liability
Disposing of a portion of existing operations
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Business Expansion
A spin-off
Occurs when the ownership of a newly created or existing
subsidiary is distributed to the parent’s stockholders
without the stockholders surrendering any of their stock
in the parent company.
A split-off
Occurs when the subsidiary’s shares are exchanged for
shares of the parent, thereby leading to a reduction in the
outstanding shares of the parent company.
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Control: How?
The Usual Way
Owning more than 50% of the subsidiary’s outstanding
voting stock (50% plus only 1 share will do it)
The Unusual Way
Having contractual agreements or financial arrangements
that effectively achieve control
Informal arrangements
Formal agreements
Consummation of a written agreement requires recognition on
the books of one or more of the companies that are a party to
the combination.
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Forms of Organizational Structure
Expansion through business combinations
Entry into new product areas or geographic
regions by acquiring or combining with other
companies.
A business combination occurs when “. . . an
acquirer obtains control of one or more
businesses.”
The concept of control relates to the ability to
direct policies and management.
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Organizational Structure and Reporting
Merger
A business combination in which the acquired
company’s assets and liabilities are combined
with those of the acquiring company, resulting in
no additional organizational components.
Financial reporting is based on the original
organizational structure.
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Organizational Structure and Reporting
Controlling ownership
A business combination in which the acquired
company remains as a separate legal entity with a
majority of its common stock owned by the
purchasing company, leading to a parent–
subsidiary relationship.
Accounting standards normally require
consolidated financial statements.
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Organizational Structure and Reporting
Noncontrolling ownership
The purchase of a less-than-majority interest in another
corporation does not usually result in a business
combination or a controlling situation.
Other beneficial interest
One company may have a beneficial interest in another
entity even without a direct ownership interest.
The beneficial interest may be defined by the agreement
establishing the entity or by an operating or financing
agreement.
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Accounting for Business Combinations
Big Picture: Valuation of the acquired company
In the past, there were two methods:
Pooling of Interests Method (Investment = BV of Sub)
Purchase Method (Investment in Sub = FV given)
SFAS 141 (ASC 805)(Effective July 2001) required the
purchase method.
SFAS 141R (ASC 805) (Effective December 2008) modified
rules—“Acquisition Method”
FASB 141R (ASC 805) may not be applied retroactively
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Acquisition Accounting
The acquirer recognizes all assets acquired and
liabilities assumed in a business combination and
measures them at their acquisition-date fair values.
If less than 100 percent of the acquiree is acquired, the
noncontrolling interest also is measured at its acquisition-
date fair value.
Fair value measurement
The FASB decided in FASB 141R (ASC 805) to focus
directly on the value of the consideration given.
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Goodwill
Components used in determining goodwill:
1. The fair value of the consideration given by the acquirer
2. The fair value of any interest in the acquiree already held
by the acquirer
3. The fair value of the noncontrolling interest in the
acquiree, if any
The total of these three amounts, all measured at
the acquisition date, is compared with the
acquisition-date fair value of the acquiree’s net
identifiable assets, and the difference is goodwill.
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The Acquisition Method
Establishes A New Basis of Accounting
The new basis of accounting depends on the
acquirer’s purchase price (FMV) + the NCI’s (FMV).
The depreciation cycle for fixed assets starts over
based on current values and estimates.
If acquisition price > FMV, goodwill exists.
Recognize as an asset.
Do not amortize.
Evaluate periodically for possible impairment.
If acquisition price < FMV, a bargain purchase
element exists.
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The Pooling of Interests Method
No longer allowed!
The target company’s basis of accounting in its
assets was used by the consolidated group.
The depreciation cycle merely continued along as
if no business combination had occurred.
Goodwill was never recognized; thus, future
income statements did not have goodwill
amortization expense.
Managers loved it!
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Methods of Effecting Business Combinations
Acquisition of assets
Statutory Merger
Statutory Consolidation
Acquisition of stock
A majority of the outstanding voting shares usually is
required unless other factors lead to the acquirer gaining
control.
Noncontrolling interest: the total of the shares of an
acquired company not held by the controlling shareholder.
Acquisition by other means
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Valuation of Business Entities
Value of individual assets and liabilities
Value determined by appraisal
Value of potential earnings
“Going-concern value” based on:
A multiple of current earnings.
Present value of the anticipated future net cash flows
generated by the company.
Valuation of consideration exchanged
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Acquiring Assets vs. Stock
Major Decision Factors
Legal considerations—Buyer must be extremely
careful NOT to assume responsibility for (and
thus “inherit”) the target company’s
Unrecorded liabilities.
Contingent liabilities (lawsuits).
vs.
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Acquiring Assets vs. Stock
Major Decision Factors (continued)
Tax considerations—Often requires major
negotiations involving resolution of
Seller’s tax desires.
Buyer’s tax desires.
Ease of consummation—acquiring common stock
is simple compared with acquiring assets.
vs.
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Acquiring Assets
Major Advantages of Acquiring Assets
Will not inherit a target’s contingent liabilities
(excluding environmental).
Will not inherit a target’s unwanted labor union.
Major Disadvantages of Acquiring Assets
Transfer of titles on real estate and other assets
can be time consuming.
Transfer of contracts may not be possible.
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Acquiring Common Stock
Advantages of Acquiring Common Stock
Easy transfer
May inherit nontransferable contracts
Disadvantages of Acquiring Common Stock
May inherit contingent liabilities or unwanted
labor union connection.
May acquire unwanted facilities/units.
Will likely be hard to access target’s cash.
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Creating Business Entities
The company transfers assets, and perhaps
liabilities, to an entity that the company has
created and controls and in which it holds
majority ownership.
The company transfers assets and liabilities to
the created entity at book value, and the
transferring company recognizes an ownership
interest in the newly created entity equal to the
book value of the net assets transferred.
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Creating Business Entities
Recognition of fair values of the assets
transferred in excess of their carrying values
on the books of the transferring company is
not appropriate in the absence of an arm’s-
length transaction.
No gains or losses are recognized on the
transfer by the transferring company.
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Creating Business Entities
If the value of an asset transferred to a newly
created entity has been impaired prior to the
transfer and its fair value is less than the
carrying value on the transferring company’s
books, the transferring company should
recognize an impairment loss and transfer the
asset to the new entity at the lower fair value.
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Internal Expansion: Creating a subsidiary
Parent sets up the new legal entity.
Based on state laws
Parent transfers assets to the new company.
Subsidiary begins to operate.
Example: Parent sets up Sub and transfers
P
$1,000 for no-par stock.
Stock $
Parent:
Sub: S
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Forms of Business Combinations
AA Company
AA Company
BB Company
(a) Statutory Merger
AA Company
CC Company
BB Company
(b) Statutory Consolidation
AA Company AA Company
BB Company BB Company
(c) Stock Acquisition
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Determining the Type of Business Combination
AA Company invests in BB Company
Acquires
Acquires net
net
assets Acquires stock
assets
Yes Acquired
Acquired company
company
liquidated?
liquidated?
No
Record
Record as
as statutory
statutory Record
Record as
as stock
stock
merger
merger or statutory
or statutory acquisition
acquisition and
and
consolidation
consolidation operate as subsidiary
operate as subsidiary
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Forms of Business Combination—Details
Option #1: Statutory Merger
Peaceful Merger:
One entity transfers assets to another in exchange for stock
and/or cash.
It liquidates pursuant to state laws.
Hostile Takeover:
One company buys the stock of another, creating a temporary
parent-subsidiary relationship.
The parent then liquidates the subsidiary into the parent pursuant
to state laws.
The result: one legal entity survives.
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