What is a Business Combination?

1. What is a Business Combination? • Occurs when one company obtains control over another company • Referred to as • Merger • Acquisition • Takeover • Sought out when the acquiring firm’s management believes it can accomplish its objectives more efficiently and at lower cost

2. Motivations for Acquisitions Growth Growth • To facilitate relationships with other companies as suppliers, subcontractors, customers • To add new facilities and capabilities • To control a source of supply • To add production or distribution facilities • To achieve customer relationships • To expand into new geographic markets • To diversify into new lines of business Growth Growth

3. Advantages of Acquiring a Company • Going concern is less costly • Eliminates the need to start from scratch • Avoids duplication of efforts that exist from growth from within • Competition is often reduced • Complementary products or services can lead to increased overall sales

4. Top M&A Deals Worldwide, 2000-2007 Exhibit 2.1

5. Types of Combinations Stock transactions governed by State laws All assets acquired and liabilities assumed are recorded directly on the books of the acquiring company

6. Statutory Merger Example IBM pays $10 million in cash to acquire DataFile, Inc. on January 1, 2010. The fair values of DataFile’s assets and liabilities are: To record the acquisition of DataFile, Inc:

7. Statutory Merger Results • 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 • Acquired assets and liabilities • Recorded at fair value at the date of acquisition • Acquiring company’s net assets are not revalued

8. Statutory Consolidation • New corporation absorbs both companies • Identify one of the companies as the acquirer • Only the acquired company’s assets and liabilities are reported by the new corporation at fair value on date of acquisition

9. Stock Acquisition • Occurs when a company acquires most or all of the voting stock of another company • Each firm continues as a separate legal entity • Investment in the acquired firm treated as an intercorporate investment • Consolidation working paper used to combine the two companies’ results To record the investment in stock:

10. Goodwill Goodwill exists if price paid by acquirer exceeds the total fair value of the specific net assets acquired. • Excess price paid occurs due to value attributable • To a company’s reputation, and • To a company’s competitive strengths • Amount is capitalized as goodwill, an intangible asset

11. Calculating Goodwill IBM pays $10 million in cash to acquire DataFile, Inc. on January 1, 2010. The fair value of DataFile’s assets and liabilities are: Goodwill is the excess of amount paid over the fair value of net assets acquired:

12. Recording an Acquisition with Goodwill To record the acquisition with goodwill at $8,000,000.

13. Evolution of Reporting Business Combinations From 1970 to 2001, two accounting methods existed: Purchase Method Pooling Method Viewed as an acquisition of one business by another Viewed as a union of two previously separate companies

14. Current U.S. GAAP for Business Combinations Exhibit 2.3

15. Business Combinations Defined • Occurs when control is obtained over one or more businesses • When is control obtained? • Direct acquisition of the assets and liabilities of the acquired company • Statutory merger • Consolidation • Asset acquisition • Obtaining a controlling interest in the voting shares of the acquired company • Stock acquisition Control is obvious Control must be evaluated

16. Transactions Excluded as Business Combinations Not covered under SFAS 141(R) • Formation of a joint venture by existing companies • Establishing a new business as a separate subsidiary • Combining companies already under common control

17. 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

18. Identifying the Acquiring Company • Acquiring company distributes cash or other assets and/or incurs liabilities • 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

19. Measuring Assets and Liabilities Acquisition cost Fair value of the net assets acquired Greater Than Report goodwill A bargain purchase exists. Report a gain. Fair value of the net assets acquired Acquisition cost Less Than

20. Estimation of Fair Values Exhibit 2.4

21. Identification of Previously Unreported Intangibles • Two criteria leading to separate recognition as an 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 Separability Criterion

22. Examples of Identifiable Intangible Assets

23. Examples of Identifiable Intangible Assets

24. Goodwill • Excess of acquisition cost over fair value of identifiable net assets acquired • Included as goodwill under SFAS 141(R) • Assembled workforce • Employees in place and able to run the business • Potential contracts • Being negotiated with prospective customers • Long-standing customer relationships • Favorable locations • Business reputation

25. Valuation of Intangibles • General measurement rules of SFAS 157 apply • 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 Always valued in the context of highest and best use

26. Three Approaches to Valuation(SFAS 157) • 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

27. Illustration of Reporting Assets Acquired and Liabilities Assumed IBM pays $25 million in cash to acquire DataFile Inc. on July 1, 2010. Fair value of DataFile’s reported assets and liabilities are: Identified and valued unreported intangible assets are: Identifiable intangibles Unreported intangible assets

28. Illustration of Reporting Assets Acquired and Liabilities Assumed continued Determining goodwill for the acquisition of DataFile Inc. for $25 million cash:

29. Illustration of Reporting Assets Acquired and Liabilities Assumed continued Recording the acquisition of DataFile Inc for $25 million cash:

30. 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 • Must be reported at date of acquisition • Requires good faith estimates of • Probability, and • Timing • Based on present value of the expected payment

31. Earnings Contingency • Derives from the beliefs of the former shareholders that they are entitled to more consideration given their company will bolster postcombination earnings • Also known as earnouts • Expected payments increase the acquisition cost • Often based on performance goals for • Revenue • Cash from operations

32. Out-of-Pocket Acquisition-Related Costs • Not included with acquisition costs • Why? Do not increase the value of the acquired business • Examples of out-of-pocket costs • Outside consulting fees and advisory services • Lawyers • Accountants • Security registration costs • Reduce the net value of the equity accounts affected • Do not increase total acquisition costs

33. Acquisition-Related Restructuring Costs • Must be expensed as incurred under SFAS 141(R) • Do not affect acquisition costs • Costs included • Shutting down departments • Reassigning or eliminating jobs • Changing supplier or production practices in connection with the combination

34. Reporting Consideration Given in an Acquisition Example IBM pays acquires DataFile Inc. on July 1, 2010. The deal is structured as: Fair value of DataFile’s reported assets and liabilities are:

35. Reporting Consideration Given in an Acquisition Example continued IBM calculates goodwill for the acquisition of DataFile Inc. as:

36. Reporting Consideration Given in an Acquisition Example continued IBM records the acquisition of DataFile Inc. as:

37. 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

38. Measurement Period • Defined as the period during which value changes may be reported as corrections to the initial acquisition entry (SFAS 141(R)) • Ends when no more information can be obtained concerning estimated values as of the acquisition date • Limited to one year after the acquisition date

39. Reporting Subsequent Changes in Asset and Liability Values IBM pays acquires DataFile Inc. on July 1, 2010. Three months after acquisition, new information reveals that equipment not belonging to DataFile was mistakenly included in the original valuation and the actual equipment fair value was $40 million instead of $60 million. IBM’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 as a loss on equipment with no change to the original equipment cost.

40. Bargain Purchases • Occurs when the acquisition cost is less than the fair value of the acquired net assets at acquisition date • May be the results of a forced sale • Seller is attempting to avoid bankruptcy or other financial losses • Report a gain on the bargain purchase • Ensures accurate reporting of asset and liability balances

41. Bargain Purchase Example IBM acquires DataFile Inc. for $20 million cash with the following fair values of assets acquired and liabilities assumed: To calculate the gain:

42. Bargain Purchase Example continued IBM acquires DataFile Inc. for $20 million cash with the following fair values of assets acquired and liabilities assumed: To record the bargain purchase: