Acquisitions. Measure and account for the various assets and liabilities acquired in mergers and acquisitions. (p. 40)

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1 chapter2 Mergers and Acquisitions Learning Objectives LO1 Measure and account for the various assets and liabilities acquired in mergers and acquisitions. (p. 40) LO2 Measure and report the various types of consideration paid. (p. 48) LO3 Account for changes in the values of acquired assets and liabilities, and contingent consideration. (p. 51) LO4 Account for bargain purchases. (p. 53) LO5 Explain the reporting requirements and issues related to in-process research and development and preacquisition contingencies. (p. 55) IBM Corporation International Business Machines Corporation (IBM) is a world leader in systems, software, and technology services. Its business is organized in five segments: Global Technology Services, Global Business Services, Systems and Technology, Software, and Global Financing. Per its 2010 annual report, IBM uses acquisitions to increase revenues in its high margin services and software businesses. Despite the volatility of the information technology (IT) industry over the past decade, IBM has consistently delivered superior performance, with a steady track record of sustained earnings per share growth. The company has shifted its business mix, exiting commoditized segments while increasing its presence in higher-value areas such as services, software and integrated solutions. As part of this shift, the company has acquired over 100 companies this past decade, complementing and scaling its portfolio of products and offerings. IBM made 17 acquisitions costing $6,538 million in 2010: thirteen acquisitions by the Software segment, one each by the Global Technology Services and Global Business Services segments, and two by the Systems and Technology segment. The majority of these investments were cash acquisitions of privately held companies. The table below summarizes IBM s acquisition activity for the last few years. Clearly IBM uses acquisitions to achieve its strategic goals. 32

2 Number of acquisitions Aggregate purchase price (in millions)... $6,538 $1,471 $6,796 $1,144 $4,817 $2,022 How does IBM report its acquisitions? Does it include all the assets and liabilities of these acquired companies on its balance sheet? If so, how are they valued? How are costs incurred in connection with acquisitions reported? Most large companies use acquisitions to expand or refocus their business activities. This chapter explains that the reporting for acquisitions is controversial and has evolved significantly over the years. Because acquisitions often have a major impact on company financial performance, this subject deserves careful scrutiny. Source: IBM Corporation annual reports, 2010 and Chapter Organization Introduction Motivations for combinations Types of combinations Overview of reporting for combinations Evolution of reporting for business combinations Current status of reporting for business combinations U.S. GAAP for statutory mergers and consolidations Valuation of net assets acquired Valuation of consideration paid Post-acquisition changes in estimated values of net assets acquired or consideration paid Bargain purchases Special issues: research and development and preacquisition contingencies IFRS for statutory mergers and consolidations Requirements of IFRS 3(R) INTRODUCTION A business combination also referred to as a merger, acquisition, or takeover occurs when one company obtains control over another company. Chapter 1 introduced the general reporting requirements for controlling interests in other companies. This chapter provides a detailed analysis of these requirements for acquisition of the assets and liabilities of another company. Motivations for Mergers and Acquisitions To survive and prosper, business firms need reliable and cost-effective sources of supply, efficient and high quality production, distribution, and administrative capabilities, and sufficient customers. Firms also seek to grow larger and diversify into new products or markets. How are these goals to be accomplished? One strategy is to deal with other companies as suppliers, subcontractors, customers and to grow internally by adding new facilities and capabilities. Another is the acquisition of other established firms. Combining with another company enables a firm to instantly control a source of supply, acquire additional production or distribution facilities, achieve customer relationships, expand into new geographic markets, or diversify into new lines of business. The acquiring firm seeks a business combination when 33

3 34 Chapter 2 Mergers and Acquisitions the firm s management believes that it can accomplish its objectives more efficiently and at lower cost than it could via internal growth or market transactions with other firms. Growth is a major objective of most corporate enterprises and takes many forms. Growth in sales is needed to increase the firm s share of the market and to solidify the firm s position. Growth in earnings and earnings per share is essential for the firm s securities to become more attractive in the capital markets. Growth in diversification is pursued to reduce or spread business risk, insulate earnings from downturns in business, and decrease the cost of capital. Although firms can achieve growth in these areas internally as well as externally, they may prefer combination with existing firms to expansion from within, for some of the following reasons: A going concern has its own historical records, experienced personnel, and network of suppliers, customers, and creditors. Combination with such a firm eliminates the need to start from scratch. Although managerial and other changes may be necessary, the inescapable fact is that growth from within, whether for reasons of market share or diversification, usually requires duplication of many of the efforts already made by an existing firm. The cost of duplicating these efforts could exceed the cost of acquiring the firm outright. Combination with an existing firm often leads to lower levels of actual or potential competition. When two competing firms combine, competition is reduced. Similarly, if a new firm enters an industry by acquiring an existing firm, the number of competing firms remains unchanged. But entry into an industry by forming a new firm increases the number of competitors, thereby making it more difficult for the entering firm to succeed. The combination can lead to increased sales overall, if the combined firms have complementary products or services. For example, an organization providing tax services may acquire a large CPA firm specializing in business valuation or enterprise risk services. The combined organization offers a variety of financial services to clients. To the extent that the enterprise risk clients are persuaded to switch from outside tax services to those of the combined firm, sales increase. Mergers and acquisitions (M&A) are pervasive, and are also a global phenomenon. The table below summarizes the largest acquisitions in recent years, measured in U.S. dollars. Exhibit 2.1 Top M&A Deals Worldwide, Year Acquirer Target Price (USD billions) America Online Time Warner $ RFS Holdings ABN-AMRO Holding Glaxo Wellcome Plc SauersKline Beecham Plc Royal Dutch Petroleum Co. Shell Transport & Trading Co AT&T Inc. BellSouth Corporation Comcast Corp. AT&T Broadband & Internet Svcs Pfizer Inc. Wyeth Sanofi-Synthelabo SA Aventis SA Pfizer Inc. Pharmacia Corp InBev NV Anheuser-Busch Cos. Inc JP Morgan Chase Bank One 59 Source: Thomson Reuters Pfizer Inc. s 2009 acquisition of Wyeth illustrates some of the common motivations for acquisitions. Despite being the largest pharmaceutical company worldwide, Pfizer faced a significant decline in revenues in 2011 due to loss of patent rights for the cholesterol drug Lipitor, comprising 25 percent of its sales. Analysts expected Pfizer to fall to fifth place in the industry, behind Roche, Novartis, Sanofi, and GSK. Pfizer s acquisition of Wyeth allowed it to retain top status in the industry. In addition to size, other acquisition benefits were mentioned in the financial press:

4 Chapter 2 Mergers and Acquisitions 35 The acquisition brings Pfizer into the vaccines, consumer healthcare, and veterinary drug markets. In particular, Wyeth s line includes the Prevnar vaccine for childhood infections and the rheumatoid arthritis drug Enbrel. Wyeth has several promising Alzheimer s drugs in development. The acquisition was expected to eliminate duplication and streamline operations, resulting in a 15 percent reduction in the combined workforce and a $4 billion reduction in costs. Types of Combinations Four types of business combinations can be identified from legal and organizational perspectives: 1. A statutory merger results when one company is absorbed into another company in exchange for cash, debt or stock. The acquiring company may purchase the assets and liabilities of the acquired company directly, or it may acquire and then retire the stock of the acquired company. In either case, the acquired company ceases to exist as a legal entity. Only the surviving firm remains as a legal entity. 2. A statutory consolidation takes place when a new corporation is organized to absorb the activities of two or more existing corporations. The shares of the existing companies are retired, and only the new corporation continues to exist as a legal entity. 3. An asset acquisition reflects the acquisition by one firm of assets (and possibly liabilities) of another firm, but not its shares. The selling firm may continue to survive as a legal entity, or it may liquidate entirely. The acquirer typically targets key assets for acquisition, or buys the acquiree s assets but does not assume its liabilities. Often the assets acquired are in the form of a division or product line. 4. A stock acquisition occurs when the acquiring firm obtains all or most of the voting shares of another firm. Each firm continues as a separate legal entity, and the investment in the acquired firm is treated as an intercorporate investment. The first two types of combinations are statutory in the sense that the reorganization, issue and retirement of shares are governed by the laws of a state. Even though the absorbed firms cease to exist as legal entities, their operations may continue undisturbed as divisions of the combined firm. In an asset acquisition, no stock is acquired, and the acquirer may not buy the entire company. All assets acquired and all liabilities assumed in a business combination are recorded directly on the books of the acquiring company in the statutory merger, statutory consolidation, and asset acquisition cases. In a business combination that is a stock acquisition, a parent/subsidiary relationship is created between the acquiring and acquired companies. The acquired company remains as a separate legal entity and is treated as an intercorporate investment by the acquiring firm. Consequently, the acquiring firm does not record the assets and liabilities of the acquired firm on its books. Rather, the acquiring firm records the shares of stock acquired in an Investment in Subsidiary account. This account gives a one-line summation of the acquiring company s interest in the underlying assets and liabilities of the acquired company. A stock acquisition does not affect the books of the acquired company; there is merely a change in ownership of its already-issued stock. We shall see in subsequent chapters that the parent/subsidiary relationship resulting from a controlling stock investment normally requires the preparation of consolidated financial statements. In a consolidated balance sheet, the underlying asset and liability accounts of the subsidiary replace the Investment in Subsidiary account on the acquiring company s books. Overview of Reporting for Combinations From a reporting perspective, all acquisitions involve combining the assets and liabilities of the acquired company with those of the acquiring company. The assets and liabilities acquired are reported at their fair value at the date of acquisition. Consider the following example.

5 36 Chapter 2 Mergers and Acquisitions Exhibit 2.2 Combination Illustration Suppose IBM pays $10,000,000 in cash to acquire DataFile Inc. on July 1, Fair values of DataFile s assets and liabilities are as follows: Account Fair value Current assets $ 5,000,000 Equipment ,000,000 Patents and copyrights ,000,000 Current liabilities ,000,000 Long-term debt ,000,000 If IBM absorbs the assets and liabilities of DataFile through a statutory merger, IBM makes the following entry on its books: Current assets ,000,000 Equipment ,000,000 Patents and copyrights ,000,000 Current liabilities ,000,000 Long-term debt ,000,000 Cash ,000,000 To record the acquisition of DataFile for $10,000,000 in cash. IBM records DataFile s assets and liabilities directly on its books. DataFile ceases to exist as a separate entity, and IBM reports DataFile s subsequent activities directly in its own financial records. The acquiring company does not revalue its own assets and liabilities to fair value. Only the acquired assets and liabilities are reported at fair value at the date of acquisition. IBM reports acquisition of DataFile s assets and liabilities the same way it reports any other acquisition of property. When a company buys equipment, it reports the equipment at the price paid, which presumably is its fair value. The company probably owns other equipment, and reports it at historical cost less accumulated depreciation. The company does not revalue this equipment to current fair value when it purchases additional equipment. Even if a new corporation absorbs both companies, as in a statutory consolidation, one of the companies is identified as the acquirer. The new corporation s balance sheet reports the acquirer s assets and liabilities at their book values shown in the acquirer s financial records. However, the new corporation s balance sheet reports the acquired company s assets and liabilities at fair value at the date of acquisition. Now assume IBM acquires all of the voting stock of DataFile Inc., paying the former stockholders of DataFile $10,000,000 in cash. This is a stock acquisition, and IBM makes the following entry: Investment in DataFile Inc ,000,000 Cash ,000,000 To record acquisition of all of DataFile s stock for $10,000,000 in cash. In this case, DataFile continues to exist as a separate entity, and reports its financial activities on its own books. Because IBM will likely include the activities of DataFile in its financial statements, a consolidation working paper is used to combine the financial results of IBM and DataFile, just as if IBM had reported DataFile s acquired assets and liabilities, and subsequent activities, directly on its books. Note, however, that whether the acquisition is initially reported as a statutory merger or statutory consolidation, or as a stock acquisition, the combined results are exactly the same. The only difference is that in a stock acquisition, a working paper combines the accounts of the two companies. In a statutory merger, consolidation, or asset acquisition, the acquirer reports the acquired assets and liabilities directly on its books, automatically combining the assets and liabilities of two companies. Typically the price paid by the acquiring company exceeds the total fair value of the specific net assets acquired. A company s value includes its reputation and competitive strengths, which GAAP does not recognize as specific assets. The excess amount paid is attributed to goodwill, an intangi-

6 Chapter 2 Mergers and Acquisitions 37 ble asset. For example, in Exhibit 2.2 above, suppose the fair value of the patents and copyrights is only $2,000,000. Then the acquisition cost is $8,000,000 greater than the fair values of the net assets acquired, as calculated below. Acquisition cost $10,000,000 Fair value of identifiable net assets acquired: Current assets $ 5,000,000 Equipment ,000,000 Patents and copyrights ,000,000 Current liabilities (15,000,000) Long-term debt (35,000,000) 2,000,000 Goodwill $ 8,000,000 If this acquisition is a statutory merger, IBM makes the following entry to record the acquisition: Current assets ,000,000 Equipment ,000,000 Patents and copyrights ,000,000 Goodwill ,000,000 Current liabilities ,000,000 Long-term debt ,000,000 Cash ,000,000 To record the acquisition of DataFile Inc. for $10,000,000 in cash. Many reporting issues arise during the acquisition of a business. How are fair values of acquired assets and liabilities measured? Should we include assets and liabilities not currently reported on the acquired company s balance sheet, such as research and development (R&D) or other specific intangibles? What does the purchase price include? Should we include consulting fees or fees for registering any stock issued by the acquiring company? What happens when the purchase price is less than the sum of the fair values of the net assets acquired? If the acquirer does not purchase all of the acquired company s stock, how do the financial reports reflect this outside or noncontrolling interest? Before addressing the current reporting requirements for acquisitions, it is useful to look at the evolution of reporting for business combinations over the years. Analysis of past practice is necessary when dealing with the results of acquisitions that took place under previous reporting requirements. It also highlights the reporting issues accountants have dealt with and continue to address today. Evolution of Reporting for Business Combinations Reporting for business combinations has changed dramatically in the twenty-first century. Major issues focus on identifying and valuing what was acquired, valuing and reporting the consideration paid, and valuation of and subsequent reporting of differences between the price paid and the net assets acquired. From 1970 through 2001, two accounting methods existed for recording business combinations, the purchase method and the pooling-of-interests method. Purchase Method The purchase method views a business combination as an investment in either the assets or the equity shares of another business. Like any purchase transaction in accounting, the cost, or value given up, needs to be determined. Cost is easy to determine for cash acquisitions. When the acquirer issues debt or equity securities to buy a business, the fair market value of those securities generally measures cost. Because many assets and liabilities are acquired in a business combination, the next step under the purchase method is to allocate the acquisition cost to the individual assets and liabilities. This allocation needs to be done immediately if the acquired company is to be absorbed into the acquiring company, as with a statutory merger. If the acquired company is to be maintained as a subsidiary, as in a stock acquisition, the entire acquisition cost is recorded as Investment in Subsidiary on the acquiring company s

7 38 Chapter 2 Mergers and Acquisitions books. However, the allocation as of the acquisition date must be done eventually, as part of the process of preparing consolidated financial statements. The cost of an acquisition usually exceeds the acquired company s book value assets less liabilities reported on the acquired company s balance sheet. Remaining acquisition cost was typically assigned to the rather vague intangible asset known as goodwill, and it was not unusual to have acquisitions where goodwill absorbed a large majority of the purchase price. Accounting standards in effect from 1970 to 2001 required that goodwill be straight-line amortized over not more than 40 years. Many companies chose the maximum life of 40 years, a decision that minimized the effect of goodwill amortization expense on future earnings. Others chose to write goodwill off quickly, to avoid subsequent income effects entirely. Acquisitions recorded under the purchase method reported combined net income in the acquisition year that included the acquirer s income for the entire year and the acquiree s income after the acquisition date. Pooling-of-Interests Method Whereas the purchase method views a business combination as an acquisition of one business by another, the pooling-of-interests method views it as a union of two previously separate companies, achieved through the exchange of equity shares. Treating this transaction as a joining together rather than a purchase avoids the question of acquisition cost. The pooling-ofinterests method combines the balance sheets of the two companies, with appropriate adjustments in the equity section to account for the exchange of shares. Existing carrying amounts book values of assets and liabilities are simply added together. Since no cost figure is computed, no asset revaluations occur and no goodwill is recorded. The pooling-of-interests method was used only when the combination involved an exchange of stock. By combining the book values of the two companies, the market value of the exchanged stock was ignored. Ownership and control of the combined company did not change, since the shareholders of the acquired company received shares in the acquiring company. Leaving the acquired company at book value was therefore justified by reasoning that no acquisition had occurred. Management often preferred pooling: the absence of goodwill and its amortization led to higher future reported earnings than under the purchase method. In addition, because the fair value of consideration paid was typically in excess of the reported book values of net assets acquired, assets were lower under the pooling-ofinterests method. Consequently the return on assets ratio often used by investors to evaluate companies was higher under the pooling-of-interests method. Acquisitions recorded under the pooling-of-interests method reported net income in the acquisition year that included the acquirer s and acquiree s income for the entire year, no matter when during the year the acquisition occurred. Even when the pooling took place at the end of the accounting year, the combined company s income statement included the profits of both companies for all twelve months. This practice further increased the value of the pooling-of-interests method in the eyes of management. Reporting Differences The following example illustrates the significant differences between the purchase and pooling-of-interests methods. Company A issues stock with a fair market value of $2,000,000 to acquire full ownership of Company B. Company B s assets and liabilities have book values and fair values as follows: Company B Balance Sheet Book Value Fair Value Assets $1,000,000 $1,500,000 Liabilities (700,000) (700,000) Net assets $ 300,000 $ 800,000 Under the purchase method, the transaction is valued at $2,000,000, the fair value of the issued stock. The amount in excess of the fair value of net assets acquired, $1,200,000 (5 $2,000,000 2 $800,000), is goodwill. Under the pooling-of-interests method the transaction is valued at $300,000, the book value of the net assets acquired, and there is no revaluation of Company B s assets and liabilities. For a statutory merger, Company A records the acquisition as:

8 Chapter 2 Mergers and Acquisitions 39 Purchase Method Pooling-of-interests Method Various assets ,500,000 1,000,000 Goodwill ,200,000 Various liabilities , ,000 Stockholders equity ,000, ,000 The purchase method revalues Company B s assets to fair value, an amount significantly greater than book value, and reports $1,700,000 more in assets than the pooling-of-interests method. Subsequent writeoff of these additional assets recognized under purchase accounting, whether in the form of depreciation, amortization, or impairment losses, has a dampening effect on the future income of the combined company. Valuation Controversy The purchase and pooling-of-interests methods gave two very different accounting outcomes for a business combination. Not surprisingly, this led to ongoing controversy over the preferred method of accounting for business combinations. The controversy first flared up in the late 1960s when a large number of business combinations occurred, leading to widespread use and abuse of the pooling-of-interests method. Companies applied pooling retrospectively so that combined income could be reported for a given year, even though the combination did not actually occur until early the following year. When a combination involved both cash and equity shares, some companies used a hybrid part-purchase, part-pooling method to minimize goodwill. Even when companies used the purchase method, they sometimes chose not to amortize goodwill on the grounds that it had an indefinite life. Accounting standard-setters then the Accounting Principles Board responded by issuing two standards in APB Opinion No. 16 (APBO 16) established twelve criteria that had to be met to qualify for the pooling-of-interests method, and outlawed retrospective pooling and partial pooling methods. The companion APB Opinion No. 17 required that goodwill be amortized, and that its estimated life could not exceed 40 years. Though many felt that pooling of interests was an inherently defective accounting method, APBO 16 stopped short of banning it. This approach seemed to solve the problem for a time. The number of poolings dropped steadily after 1970, to 10% or less of all business combinations by the mid-1980s. By the mid-1990s, the issue erupted again, as mega-mergers of some of the country s biggest companies began to occur. The size of the companies involved and the high level of stock prices meant that these transactions often had values in the billions of dollars, far in excess of existing book values. Many of these large transactions were structured as poolings. Concern grew that huge amounts of transaction value were being suppressed by the pooling method, and there were renewed calls for its abolition. At the same time, the purchase method had its own problems. Huge amounts were recorded as goodwill, as companies made little effort to identify and assign value to specific intangibles acquired. Goodwill life estimates were not made very seriously, and were often chosen to manage reported earnings. Companies sometimes allocated as much cost as possible to in-process research and development, which could be expensed immediately, rather than to goodwill. Others announced large-scale restructurings following the acquisition, again resulting in large immediate write-offs. Although write-offs from these approaches adversely affected current earnings, future earnings benefited as the written-off assets no longer had to be depreciated or amortized. Given the increasing concern over accounting for business combinations and the continuing number of large transactions, the FASB proposed in 1999 to significantly change the accounting for business combinations by requiring the purchase method for all business combinations, effectively eliminating the pooling-of-interests method. To reduce the residual assigned to goodwill, the FASB proposed that companies carefully analyze specific intangibles acquired, assign cost to them, and amortize them over appropriate lives. Goodwill would be amortized over not more than 20 years. The corporate community was not very happy with these proposals. They argued that the rules would discourage merger activity and harm the economy. Members of Congress supported their corporate constituents and hinted at legislation to prevent the new rules from being implemented. In the face of considerable opposition to its original proposal, the FASB crafted a compromise. They retained elimination of the pooling method and identification of specific intangibles, but the proposal that goodwill be amortized over a period not exceeding 20 years was dropped, and replaced by a provision that goodwill not be amortized at all! In place of amortization, goodwill must be assessed regularly to

9 40 Chapter 2 Mergers and Acquisitions determine whether its value has been impaired. The FASB adopted these modified provisions in 2001 when it issued SFAS 141, Business Combinations and SFAS 142, Goodwill and Other Intangible Assets. In 2008, the FASB issued SFAS 141R, making significant changes in the business combination standards. Current Status of Reporting for Business Combinations ASC Topic 805 contains current standards for reporting business combinations. Standards for valuing acquired intangible assets, including goodwill, are in ASC Topic 350. ASC Topic 810 describes consolidation procedures for stock acquisitions. The major valuation requirements found in ASC Topic 805 were significantly changed in 2008, and reflect convergence with IFRS. Definition of Business Combination The requirements of ASC Topics 805 and 810 apply only to business combinations. A business combination occurs when control is obtained over one or more businesses. Control may be obtained by direct acquisition of the assets and liabilities of the acquired company statutory merger, consolidation, or asset acquisition or by obtaining a controlling interest in the voting shares of the acquired company stock acquisition. To determine whether a business combination has occurred, we need a definition of control, and we need to identify the attributes that constitute a business. This chapter focuses on statutory mergers, consolidations, and asset acquisitions: the acquired company or division ceases to exist and the acquiring company absorbs its financial records. It is therefore obvious that the acquiring company obtains control of the acquired company. When the acquisition is structured as a stock acquisition, the question of control becomes more relevant. Discussion of the concept of control and related reporting issues appears in Chapter 3. The ASC glossary provides this definition of a business: 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. Certain transactions do not constitute a business combination. Formation of a joint venture by two or more existing companies is not a business combination. Establishing a new business as a separate subsidiary is not a business combination. In both of these cases, a new business is formed without an acquisition transaction. Combining two or more companies already under common control such as two or more existing subsidiaries, or merging an existing subsidiary into the parent company similarly does not constitute a business combination because there is no change in control. ASC Topic 805 does not prescribe the accounting for these transactions. However, acquiring a division or product line of another company is a business combination, even though the division or product line is not a separate legal entity. The remainder of this chapter discusses and illustrates the requirements of ASC Topic 805, focusing on the initial recording of acquisitions reported as statutory mergers, consolidations, or asset acquisitions, where the acquired assets and liabilities are recorded directly on the acquirer s books. VALUATION OF ASSETS ACQUIRED AND LIABILITIES ASSUMED LO1 Measure and account for the various assets and liabilities acquired in mergers and acquisitions. The acquisition method is used to report all business combinations. This method calls for careful identification and valuation of the fair value of the assets acquired and liabilities assumed at the acquisition date. Acquisition Date FASB ASC para defines the acquisition date as the date the acquiring company obtains control of the acquired company, usually the date when the consideration is paid to the former owners of the acquired company. When control was attained at an earlier date, based on agreement with the former owners of the acquired company, the earlier date is used.

10 When the parties agree on an official acquisition date prior to completing all aspects of the transaction, the acquisition date typically is the beginning of an accounting period for the acquiring entity. This accounting convenience avoids including the acquired entity at some interim date during the reporting year. Subject to provisions needed to protect the interests of the equity holders of the two entities, effective control over the acquired entity must occur on or before this chosen date. Identifying the Acquiring Company Chapter 2 Mergers and Acquisitions 41 As discussed earlier in the chapter, only the assets and liabilities of the acquired company are revalued to fair value at the acquisition date. It is therefore imperative that the acquiring and acquired companies be identified. When no equity interests are exchanged, determining the acquiring company is easy. The acquiring entity is the one distributing cash or other assets, and/or incurring liabilities. Business combinations that involve an equity exchange can be more difficult to resolve. The following characteristics typically describe the acquiring company: It is the entity that issues the equity interests. It is the larger entity, as measured by assets, revenues, or earnings. Its owners have the larger voting interest in the combined company. An individual or organized group of its prior owners constitute a large minority ( 50%) interest in the combined entity, and there are no other significant concentrations of voting interests. It constitutes or selects a majority of the governing body the Board of Directors of the combined entity. Its senior management dominates the senior management of the combined entity. Its stockholders did not receive a premium over market value in the exchange, whereas stockholders of the acquired entity did receive a premium. When these indicators do not all point in the same direction, the accountant must assess all the facts and circumstances to identify the acquiring company. Should a new entity be formed to serve as the combined entity as in a statutory consolidation one of the prior entities must still be designated as the acquiring company, following the guidelines above. Combinations involving more than two entities make identification of the acquiring company even more difficult. In such cases, additional characteristics used to identify the acquiring company include: It is the entity which initiated the combination. It is the largest entity. Once we identify the acquiring company and the acquisition date, we measure the assets acquired and liabilities assumed at fair value. If the acquisition cost is greater than the fair value of the identifiable net assets acquired, goodwill is reported. If the acquisition cost is less than the fair value of identifiable net assets acquired, the acquisition is a bargain purchase and a gain is reported. Business Application Reverse Acquisitions Usually the company issuing the equity interests is the acquirer. But in a reverse acquisition, the equity issuer does not control the combined entity. Now the former shareholders receiving the issued stock own the majority of the shares in the combined company, or the management of the other company dominates the senior management of the combined company. Reverse acquisitions are particularly popular as a technique for taking a private company public without the cost and regulatory requirements involved with an initial public offering (IPO). Here a private company acquires a publicly traded company, but the public company controls the combined entity. The publicly traded company is usually a shell, with very few products or transactions, which then absorbs the private company s products, operations, and management. Private Chinese companies have used reverse acquisitions to trade on U.S. markets without being subject to the SEC s usual rigorous regulatory and auditing standards. In 2010, the PCAOB issued an alert to investors, warning that financial information provided by these companies may not be reliable.

11 42 Chapter 2 Mergers and Acquisitions Measurement of Previously Reported Assets and Liabilities The acquired company s balance sheet reports its assets and liabilities according to GAAP. Most of the reported values will likely not reflect fair value at the date of acquisition. Cash is obviously reported at fair value, and current liabilities probably reflect the amount needed to satisfy creditors. Most short-term investments are also reported at current fair values. However, even current assets such as receivables and inventories may not be reported at fair value. For example, LIFO inventories typically reflect very old historical costs, unless the entire inventory has been recently replaced. Long-term assets, such as buildings, equipment, and reported intangibles, are reported at historical cost less accumulated depreciation or amortization. The fair value of acquired assets is based on the acquirer s planned use of those assets. Tangible operating property held by the acquired company changes in value if the acquirer intends to dispose of it or change its planned usage. The meaning of fair value, and the methods of estimating it, vary from item to item. FASB ASC Topic 820, Fair Value Measurements and Disclosures, provides a detailed definition and framework for determining fair value for a variety of asset types. Fair value may be estimated by use of quoted market prices, appraisals, estimated selling prices, estimated replacement costs, and the present value of future cash flows discounted at an appropriate interest rate. Exhibit 2.3 presents common means of determining fair values of assets and liabilities. Exhibit 2.3 Estimation of Fair Values Asset or Liability Accounts receivable Marketable securities Inventories: Raw materials Inventories: Work in process Inventories: Finished goods Property, plant and equipment to be used Property, plant and equipment to be sold Other assets Most liabilities Fair Value Estimated by Discounted expected cash inflows Quoted market prices Current replacement cost Estimated selling price, less costs to complete and sell, less reasonable profit Estimated selling price, less costs to sell, less reasonable profit Current replacement cost Estimated selling price less costs to sell Appraised value Discounted expected cash outflows Identification and Measurement of Previously Unreported Intangibles Tangible assets acquired and most liabilities assumed should be fairly easy to identify. Virtually all of these appear on the books of the acquired company. Intangible assets, however, present special problems. The existence of significant unrecorded intangible assets may be both a major reason why the business combination occurred and a major factor in the total acquisition cost. Such intangibles include brand names, market share, customer base, good locations, technology, skilled workforce, and the like. Although most of these intangibles developed internally during the life of the acquired company, very few are recorded as assets on the acquired company s books under GAAP. ASC Topic 805 specifies the requirements for reporting previously unrecognized acquired intangibles. Two criteria are employed to identify intangibles requiring separate recognition: The intangible asset arises from contractual or other legal rights, or The intangible is separable, that is, it can be separated or divided from the acquired entity and sold, rented, licensed, or otherwise transferred. Meeting either criterion is sufficient to require separate recognition of an intangible. A firm must report an intangible asset arising from contractual or other legal rights even if it is not separable. ASC para provides three examples: An operating lease with terms that are favorable to terms that could be obtained in the current market, even though the lease terms prohibit transfer of the lease to an outside party

12 Chapter 2 Mergers and Acquisitions 43 A license to operate a nuclear power plant, even though it cannot be sold or transferred to an outside party A patent licensed to others for a percentage of future revenues; even though the patent and the license cannot be separately sold, each is separately reported. The separability criterion applies when the intangible could be separated from the acquired company and transferred through sale, licensing, leasing, or other means. Evidence of separability comes from similar observable market transactions; it does not matter whether the acquired company actually intends to sell the intangible asset or such market transactions occur regularly. However, when contractual terms prevent the company from selling the intangible asset, it does not meet the separability criterion. Examples of Identifiable Intangible Assets The Codification offers many examples of reportable intangibles, grouped into broad categories as follows: Contract-based intangible assets, such as lease agreements, franchise agreements, licensing agreements, construction permits, employment contracts, broadcast rights, and mineral rights. Marketing-related intangible assets, such as brand names, trademarks, internet domain names, newspaper mastheads and non-competition agreements. Customer-related intangible assets, such as customer lists, order backlogs, and customer contracts. Technology-based intangible assets, such as patent rights, computer software, databases, and trade secrets. Artistic-based intangible assets, such as television programs, motion pictures, videos, recordings, books, photographs, and advertising jingles. Most of these intangibles meet the criteria for separate reporting based on the existence of contractual or legal rights. This category of intangibles is wide-ranging, as many business features and activities involve contractual agreements. Far fewer examples of intangibles meeting the separability criterion exist; they include customer lists, noncontractual customer relationships, databases, and unpatented technology. Unreported Intangibles Many intangibles do not meet the contractual or separability criteria and are not reported as assets acquired. Whether or not they meet the accounting definition of acquired intangible assets, the acquiring company views these intangibles as valuable, because they contribute to future cash flows. The consideration paid will reflect the value of these intangibles, and will likely exceed the fair value of the reported net assets acquired. The difference is reported as goodwill. ASC paras and 7 provide examples of intangibles that are included in goodwill. An assembled workforce, the group of employees already in place and able to run the business, including management, sales, technical and other personnel Potential contracts being negotiated with prospective customers Other examples include long-standing customer relationships, favorable locations, and business reputation. Valuation of Intangibles Although the Codification does not provide specific guidance for valuing acquired intangible assets, the general measurement guidelines of ASC Topic 820 apply. ASC paras through 57 define the fair value hierarchy, in order of priority: 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 In all cases, the asset is valued in the context of its highest and best use. If the company obtains the most value from the asset by selling it, market values are used. If the asset s value is maximized through its use within the company, market values of products it produces or the estimated present value of expected future cash inflows may be used.

13 44 Chapter 2 Mergers and Acquisitions The Codification identifies three approaches to valuation: 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 Acquired intangibles are less likely than tangible assets to be bought and sold in active markets. These assets tend to be specific in nature, deriving value from their use within the company. Quoted prices for similar assets may be appropriate, but in many cases companies employ valuation models using estimated future cash flows. For example, in its 2009 annual report, Sun Microsystems, Inc. (now merged with Oracle Corporation) describes its valuation of acquired in-process R&D (IPRD), an intangible asset: The value assigned to IPRD was determined by considering the importance of each project to the overall development plan, estimating costs to develop the purchased IPRD into commercially viable products, estimating the resulting net cash flows from the projects when completed and discounting the net cash flows to their present value. The revenue estimates used to value the purchased IPRD were based on estimates of the relevant market sizes and growth factors, expected trends in technology and the nature and expected timing of new product introductions. The rates utilized to discount the net cash flows to their present values were based on weightedaverage cost of capital. The weighted-average cost of capital was adjusted to reflect the difficulties and uncertainties in completing each project and thereby achieving technological feasibility, the percentage of completion of each project, anticipated market acceptance and penetration, market growth rates and risks related to the impact of potential changes in future target markets. Based on these factors, discount rates that generally range from 12% to 22% were deemed appropriate for valuing the purchased IPRD. Illustration of Reporting Assets Acquired and Liabilities Assumed To illustrate the reporting for assets acquired and liabilities assumed, we use the statutory merger information in Exhibit 2.4. Exhibit 2.4 Combination Illustration with Identifiable Intangibles IBM pays $25,000,000 in cash to acquire DataFile Inc. on July 1, Fair values of DataFile s reported assets and liabilities follow: Account Fair value Current assets $ 2,000,000 Plant and equipment ,000,000 Patents and copyrights ,000,000 Current liabilities ,000,000 Long-term debt ,000,000 In addition, IBM identified and valued DataFile s previously unreported intangible assets as follows: Brand names $ 1,000,000 Favorable lease agreements ,000 Assembled workforce ,000,000 In-process contracts with potential customers ,000,000 Contractual customer relationships ,000,000 Other than the assembled workforce and in-process contracts, all of the previously unreported intangibles meet the contractual or separability criteria for reporting as identifiable intangibles. IBM records the acquisition as follows:

14 Chapter 2 Mergers and Acquisitions 45 Current assets ,000,000 Plant and equipment ,000,000 Patents and copyrights ,000,000 Brand names ,000,000 Favorable lease agreements ,000 Contractual customer relationships ,000,000 Goodwill ,400,000 Current liabilities ,000,000 Long-term debt ,000,000 Cash ,000,000 To record the acquisition of DataFile for $25,000,000 in cash. Goodwill in this acquisition is the difference between the acquisition price and the fair value of the reportable net assets acquired, and is calculated as follows: Acquisition cost $25,000,000 Fair value of identifiable net assets acquired: Current assets $ 2,000,000 Plant and equipment ,000,000 Patents and copyrights ,000,000 Brand names ,000,000 Favorable lease agreements ,000 Contractual customer relationships ,000,000 Current liabilities (10,000,000) Long-term debt (40,000,000) 21,600,000 Goodwill $ 3,400,000 Although unreportable intangible assets are one reason for the existence of goodwill, another explanation is that the acquiring company paid too much for the acquired company. Subsequent goodwill impairment testing should reveal this fact, as discussed in Chapter 4. Business Application Unreported Intangibles The composition of goodwill is often discussed in financial statement footnotes. Below are some recent examples: IBM (2010 annual report, describing $4,754 million in goodwill recognized on 2010 acquisitions): The primary items that generated the goodwill are the value of the synergies between the acquired companies and IBM and the acquired assembled workforce, neither of which qualify as an amortizable intangible asset. Walt Disney (2010 annual report, describing $2.3 billion in goodwill recognized on its 2009 acquisition of Marvel): The goodwill reflects the value to Disney from leveraging Marvel intellectual property across our distribution channels, taking advantage of Disney s established global reach. continued