What is a Business Combination?

2. What is a Business Combination? • Occurs when one company obtains control over another company • Terms used: • Merger • Acquisition • Takeover

3. Business Strategies Achieved Through Acquisitions • Control a source of supply • Acquire new technology, production or distribution facilities • Expand into new geographic markets, acquire new customers • Diversify into new lines of business Supply chain Grow Diversify

4. 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

5. Top M&A Deals Worldwide, 2000-2010 Exhibit 2.1

6. Types of Combinations Acquiring company remains New company remains All assets and liabilities acquired are recorded directly on the books of the acquiring company Acquiring and acquired companies remain separate legal entities

7. 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: Fair values, NOT book values To record the acquisition on the acquirer’s books:

8. 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

9. 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

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

11. 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

12. 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 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.

13. Learning Objective 1 Measure and account for the various assets and liabilities acquired in mergers and acquisitions.

14. 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

15. 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

16. 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

17. Measuring Assets and Liabilities Acquired Acquisition cost Fair value of net assets acquired > Goodwill Gain on bargain purchase Fair value of net assets acquired Acquisition cost <

18. Estimation of Fair Values Exhibit 2.3

19. 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

20. Examples of Identifiable Intangible Assets

21. Examples of Identifiable Intangible Assets

22. 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

23. 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

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

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

26. Recording an Acquisition with Goodwill

27. 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: Unreported intangible assets: Identifiable Intangibles Not identifiable intangibles

28. Illustration of Reporting Assets Acquired and Liabilities Assumedcontinued Goodwill calculation:

29. Illustration of Reporting Assets Acquired and Liabilities Assumed continued Recording the acquisition:

30. Learning Objective 2 Measure and report the various types of consideration paid.

31. 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

32. 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

33. 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

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

35. 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

36. Security Price Contingency Example X 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: Expected obligation: Using a 5% discount rate, the present value of expected payment is approximately:

37. Reporting Contingent Consideration • Earnings contingencies are liabilities • Security price contingencies are additional paid-in capital • Both increase the total acquisition price

38. Recording Contingent Consideration continued • Use the previous acquisition information and add the two contingent considerations:

39. 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

40. 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

41. Reporting Consideration Paid:An Example An acquirer pays the following consideration to acquire another company: Fair value of acquirer’s assets and liabilities are:

42. Reporting Consideration Paid: An Example continued Goodwill calculation:

43. Reporting Consideration Paid: An Example continued Record the acquisition:

44. Learning Objective 3 Account for changes in the values of acquired assets and liabilities, and contingent consideration.

45. Subsequent Changes in Values Value changes resulting from clarification of facts existing as of the date of acquisition Value changes caused by events occurring after the date of acquisition Treated as corrections to the initial acquisition entry Reported in income

46. 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

47. Reporting Subsequent Changes in Asset and Liability Values 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: 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.

48. Reporting Subsequent Changes in Contingent Consideration For value changes caused by events occurring after the date of acquisition 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

49. Contingent Consideration Value Example 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:

50. Learning Objective 4 Account for bargain purchases.