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fm.qxd 9/16/14 6:51 PM Page vi

PREFACE

Convergence with international accounting standards has In teaching consolidation concepts, a decision must be
played an important role in virtually every project entered made about the recording method that should be empha-
into by the Financial Accounting Standards Board (FASB) sized in presenting consolidated workpaper procedures. The
in recent years. Accounting for business combinations is no three major alternatives for recording investments in sub-
exception. In the Sixth Edition of Advanced Accounting, we sidiaries are the (1) cost method, (2) partial equity (or
compare and contrast U.S. standards and international prin- simple equity) method, and (3) complete equity (or sophis-
ciples throughout the book, drawing the readers’ attention to ticated equity) method. A brief description of each method
remaining differences with an IFRS icon. The reader is made follows.
aware of important changes, both present and forecasted. We
also incorporate the FASB’s codification system for refer- 1. Cost method. The investment in subsidiary is carried at
encing standards. its cost, with no adjustments made to the investment
This book is designed for advanced courses dealing account for subsidiary income or dividends. Divi-
with financial accounting and reporting in the following top- dends received by the parent company are recorded as
ical areas: business combinations, consolidated financial an increase in cash and as dividend income.
statements, international accounting, foreign currency trans- 2. Partial equity method. The investment account is ad-
actions, accounting for derivative instruments, translation of justed for the parent company’s share of the subsidiary’s
financial statements of foreign affiliates, segment reporting reported earnings or losses, and dividends received from
and interim reporting, partnerships, fund accounting and the subsidiary are deducted from the investment account.
accounting for governmental units, and accounting for non- Generally, no other adjustments are made to the invest-
government—nonbusiness organizations. The primary ment in subsidiary account.
objective of this book is to provide a comprehensive treat- 3. Complete equity method. This method is the same as the
ment of selected topics in a clear and understandable man- partial equity method except that additional adjustments
ner. The changes related to FASB ASC Topics 805 and 810 are made to the investment in subsidiary account to reflect
(SFAS No. 141R and 160) are integrated throughout the edi- the effects of (a) the elimination of unrealized intercom-
tion. As in previous editions, we strive to maintain maxi- pany profits, (b) the amortization (depreciation) of the
mum flexibility to the instructor in the selection and breadth difference between cost and book value, and (c) the addi-
of coverage for topics dealing with consolidated financial tional stockholders’ equity transactions undertaken by the
statements and other advanced topics. subsidiary that change the parent company’s share of the
We have further expanded the number and variety of subsidiary’s stockholders’ equity.
exercises and problem materials at the end of each chapter.
We include codification exercises that require the student to We continue to present all three methods, using generic
research the FASB’s Codification to determine the appropri- icons to distinguish among the three methods. The instructor
ate GAAP for a variety of issues. In addition, we include has the flexibility to teach all three methods, or to instruct
financial statement analysis exercises that relate to real com- the students to ignore one or two. If the student is interested
panies and practical applications in virtually every chapter. in learning all three methods, he can, even if the instructor
All chapters have been updated to reflect the most recent only focuses on one or two. Also, we believe this feature
pronouncements of the Financial Accounting Standards makes the book an excellent reference for the student to keep
Board and the Governmental Accounting Standards Board after graduation, so that he or she can adapt to any method
as of this writing. needed.

vi
fm.qxd 9/16/14 6:51 PM Page vii

Preface vii

WHAT’S NEW IN THE TEXT? 4. FASB’s conceptual framework is discussed as it relates

to Advanced Accounting in Chapter 1. We also include
• Author-created online videos explain some of the marginal references to Related Concepts throughout
critical concepts of advanced accounting and walk the book. The GASB’s conceptual framework is
students through how to solve selected problems discussed in Chapters 17 and 18.
throughout the book.
5. Questions or problems related to Business Ethics are
• A continuous consolidation problem is introduced in
included in the end-of chapter materials for every
Chapters 4 and 5. This allows students to build on con-
chapter.
cepts learned in prior chapters.
• The coverage of certain topics has been expanded (such 6. We include real-company annual reports or excerpts
as contingent consideration and bargain purchases) to from reports with related questions (Analyzing Finan-
incorporate information gleaned from the FASB’s Post- cial Statements) in the end-of-chapter materials and/or
Implementation Review of FASB Statement No. 141R online for most chapters excluding Chapters 15 and 16.
and to include more realistic real-world issues. 7. In Chapter 9 of the 6th edition, the homework material
• Chapter 11 on International Accounting has been updated includes the effective interest, in addition to the straight-
to reflect the current status of international financial line method for amortization of bond premiums and dis-
reporting standards (IFRS) around the world and the counts. The Sixth Edition also includes online appen-
SEC’s position with respect to U.S. adoption. In addition, dices on deferred taxes which are related to the topics in
we pay particular attention to the remaining major joint Chapter 6 & 7. (Go to www.wiley.com/college/jeter.)
projects of the two boards (FASB and IASB), which 8. The in-the-news boxes that appear throughout the book
include revenue recognition, accounting for leases, insur- reflect recent business and economic events relevant to
ance contracts, and financial instruments. the subject matter.
• The chapters on fund accounting and governmental 9. We have integrated goodwill impairment into some
accounting (Chapters 17 and 18) were updated to reflect illustrations in the body of Chapter 5, as well as in sev-
the latest GASB pronouncements, including changes in eral homework problems. We illustrate the goodwill
the classification of the fund balance. impairment test described in FASB ASC topic 350
• An appendix to Chapter 1 has been posted online at (SFAS No. 142), discussing its frequency, the steps laid
www.wiley.com/college/jeter. This appendix illustrates out in the standard, and some of the likely implementa-
a strategy or technique for analyzing a given company, tion problems. The simplification of these tests for
such as a potential acquisition target. This strategy may smaller companies is also discussed along with the role
be applied in some of the end-of-the-chapter Analyzing of qualitative factors for determining whether the steps
Financial Statements (AFS) problems. Several addi- are necessary. There are exercises on this topic in
tional online appendices (including coverage of Chapters 2 and 5.
deferred taxes, as they pertain to individual topics 10. At the beginning of Chapter 4 we discuss three methods
throughout the text) may also be found at www.wiley of accounting for investments, depending on the level of
.com/college/jeter. ownership and the presumption of influence or control.
We emphasize the importance of the complete equity
method for certain investments that are not consolidated,
OTHER HIGHLIGHTED FEATURES or in the parent-only statements. In addition, online
OF THE TEXT materials include an expanded discussion of the account-
ing for investments. (See www.wiley.com/college/jeter.)
1. We include a feature that requires students to research
the FASB Codification in order to locate the current 11. Learning objectives are included in the margins of the
standard that applies to various issues. These exercises chapters, and relevant learning objective numbers are
appear before the problems at the end of each chapter provided with end-of-chapter materials.
and often, but not always, relate to topics addressed 12. We continue the use of graphical illustrations, which
in that chapter. (Similar questions appear on the was introduced in prior editions.
CPA exam.) 13. A few short-answer questions (and solutions) are peri-
2. We include a discussion of international accounting odically provided throughout each chapter to enable
standards on each topic where such standards exist, and students to test their knowledge of the content before
compare and contrast U.S. GAAP and IFRS. An IFRS moving on.
icon appears in the margins where this discussion 14. The organization of the worksheets applies a format
occurs. that separates accounts to the income statement, the
3. A discussion of the joint projects of the FASB and the statement of retained earnings, and the balance sheet in
IASB is incorporated throughout the textbook where distinct sections. The worksheets are placed near the
appropriate, with an expanded discussion in Chapter 11. relevant text.
fm.qxd 9/16/14 6:51 PM Page viii

viii Preface

15. All illustrations are printed upright on the page and la- WileyPLUS
beled clearly for convenient study and reference.
WileyPLUS is an online learning and assessment environ-
16. Entries made on consolidated statements workpapers ment, where students test their understanding of concepts,
are presented in general journal form. These entries are get feedback on their answers, and access learning materi-
shaded in blue to distinguish them from book entries, to als like the eText and multimedia resources. Instructors can
facilitate exposition and study. To distinguish among automate assignments, create practice quizzes, assess stu-
parent company entries and workpaper entries in the dents’ progress, and intervene with those falling behind.
body of the text, we present parent entries in gray and
workpaper entries in blue.
17. Summaries appear at the end of each chapter, and a ACKNOWLEDGMENTS
glossary of key terms is provided at the end of the
book. We wish to thank the following individuals for their sug-
gestions and assistance in the preparation of this edition.
18. Chapters 17 through 19 reflect the latest GASB and
Thank you goes to Anthony Abongwa (Monroe Col-
FASB pronouncements related to fund accounting.
lege), Jonghyuk Bae Darius Fatemi (Northern Kentucky
University), Edward Julius (California Lutheran Univer-
Clearly there are more topics in this text than can be cov- sity), Ron Mano (Westminster College), Kevin Packard
ered adequately in a one semester or one-quarter course. (Brigham Young University – Idaho), Ashley Stark (Dick-
We believe that it is generally better for both students and inson State University), Denise Stefano (Mercy College),
instructors to cover a selected number of topics in depth Deborah Strawser (Grand Canyon University Online),
rather than to undertake a superficial coverage of a larger Joseph Wall (Carthage College), and Sheila Reed (State of
number of topics. Modules of material that an instructor Tennessee).
may consider for exclusion in any one semester or quarter Thank you also goes to Sheila Ammons (Austin Com-
include the following: munity College) for preparing the Power- Point slides, to
TBD for preparing the Study Guide, to TBD for preparing
• Chapters 7–9. An expanded analysis of problems in the the Test Bank, and to TBD for their helpful textbook, solu-
preparation of consolidated financial statements. tions manual, and test bank accuracy review comments.
• Chapter 10. Insolvency—liquidation and reorganiza- Finally we would like to acknowledge a few individu-
tion. als at Wiley who helped all this come together: Ellen Keo-
• Chapters 11–14. International accounting, foreign cur- hane, Mary O’Sullivan, Christina Volpe, Beth Pearson,
rency transactions and translation, and segment and in- Joel Hollenbeck, Tai Harris, Karolina Zarychta, Maddy
terim reporting. Lesure.
• Chapters 15 and 16. Partnership accounting.
• Chapters 17 through 19. Fund accounting, accounting
for governmental units, and accounting for nongovern-
ment–nonbusiness organizations (NNOs).

SUPPLEMENTS
The following supplements are available on the book com-
panion web site: Study Guide, Excel Templates, Power-
Point Slides, Instructors’ Manual, Solutions Manual, Test
Bank, and videos. These materials are accessible form
www.wiley.com/college/jeter.
fm.qxd 9/16/14 6:51 PM Page ix

CONTENTS

1 INTRODUCTION TO BUSINESS COMBINATIONS Questions 58

AND THE CONCEPTUAL FRAMEWORK 1 Analyzing Financial Statements 58
Exercises 64
Learning Objectives 1
ASC Exercises 70
1.1 Growth Through Mergers 1
Problems 71
1.2 Nature of the Combination 3
1.3 Business Combinations: Why? Why not? 4
1.4 Business Combinations: Historical Perspective 7 3 CONSOLIDATED FINANCIAL STATEMENTS—
1.5 Terminology and Types of Combinations 10 DATE OF ACQUISITION 75
1.6 Takeover Premiums 12 Learning Objectives 75
1.7 Avoiding the Pitfalls before the Deal 13 3.1 Definitions of Subsidiary and Control 77
1.8 Determining Price and Method of Payment 3.2 Requirements for the Inclusion of Subsidiaries in
in Business Combinations 14 the Consolidated Financial Statements 80
1.9 Alternative Concepts of Consolidated 3.3 Reasons for Subsidiary Companies 81
Financial Statements 18 3.4 Consolidated Financial Statements 81
1.10 FASB’s Conceptual Framework 22 3.5 Investments at the Date of Acquisition 82
1.11 FASB Codification (Source of GAAP) 27 3.6 Consolidated Balance Sheets: The Use of
Summary 31 Workpapers 83
Appendix 1A: Evaluating Firm Performance (Online only) 3.7 A Comprehensive Illustration—More than One
Questions 32 Subsidiary Company 97
Analyzing Financial Statements 33 3.8 Limitations of Consolidated Statements 100
Exercises 35 Summary 102
ASC Exercises 36 Appendix 3A: Deferred Taxes on the Date of Acquisition
(Online only)
Appendix 3B: Consolidation of Variable Interest Entities
2 ACCOUNTING FOR BUSINESS (Online only)
COMBINATIONS 37 Questions 103
Learning Objectives 37 Analyzing Financial Statements 104
2.1 Accounting Standards on Business Combinations: Exercises 105
Background 37 ASC Exercises 109
2.2 Pro Forma Statements and Disclosure Problems 109
Requirement 45
2.3 Explanation and Illustration of Acquisition
Accounting 47 4 CONSOLIDATED FINANCIAL STATEMENTS
2.4 The Measurement Period (and Measurement AFTER ACQUISITION 116
Period Adjustments) 50 Learning Objectives 116
2.5 Contingent Consideration in an Acquisition 51 4.1 Accounting for Investments by the Cost, Partial
2.6 Leveraged Buyouts 55 Equity, and Complete Equity Methods 117
2.7 IFRS versus U.S. GAAP 55 4.2 Consolidated Statements after Acquisition—Cost
Summary 57 Method 124
Appendix 2A: Deferred Taxes in Business Combinations 4.3 Recording Investments in Subsidiaries—Equity
(Online only) Method (Partial or Complete) 134

ix
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x Contents

4.4 Elimination of Intercompany Revenue and Expense Analyzing Financial Statements 238
Items 144 Exercises 240
4.5 Interim Acquisitions of Subsidiary Stock 144 ASC Exercises 245
4.6 Consolidated Statement of Cash Flows 149 Problems 245
4.7 Illustration of Preparation of a Consolidated
Statement of Cash Flows—Year of
Acquisition 153 6 ELIMINATION OF UNREALIZED PROFIT
4.8 Compare U.S. GAAP and IFRS Regarding Equity ON INTERCOMPANY SALES
Method 156 OF INVENTORY 263
Summary 157 Learning Objectives 263
Appendix 4A: Alternative Workpaper Format 6.1 Effects of Intercompany Sales of Merchandise
(Online only) on the Determination of Consolidated
Appendix 4B: Deferred Tax Consequences When Balances 264
Affiliates File Separate Income Tax Returns— 6.2 Cost Method: Consolidated Statements
Undistributed Income (Online only) Workpaper—Upstream Sales 272
Questions 159 6.3 Cost Method—Analysis of Consolidated Net
Analyzing Financial Statements 159 Income and Consolidated Retained
Exercises 161 Earnings 277
ASC Exercises 167 6.4 Consolidated Statements Workpaper—Partial
Equity Method 279
Problems 167
6.5 Partial Equity Method—Analysis of Consolidated
Net Income and Consolidated Retained
5 ALLOCATION AND DEPRECIATION Earnings 284
OF DIFFERENCES BETWEEN 6.6 Consolidated Statements Workpaper—Complete
IMPLIED AND BOOK VALUES 186 Equity Method 285
6.7 Complete Equity Method—Analysis of
Learning Objectives 186
Consolidated Net Income and Consolidated
5.1 Computation and Allocation of the Difference Retained Earnings 290
Between Implied and Book Values to Assets and
6.8 Summary of Workpaper Entries Relating to Inter-
Liabilities of Subsidiary—Acquisition Date 188
company Sales of Inventory 290
5.2 Effect of Differences Between Implied and Book
6.9 Intercompany Profit Prior To Parent–Subsidiary
Values on Consolidated Net Income—Year
Affiliation 290
Subsequent to Acquisition 194
Summary 291
5.3 Consolidated Statements Workpaper—Using the
Cost Method 196 Appendix 6A: Deferred Taxes and Intercompany Sales
of Inventory (Online only)
5.4 Controlling and Noncontrolling Interests in
Consolidated Net Income and Retained Questions 292
Earnings—Using the Cost Method 205 Analyzing Financial Statements 292
5.5 Consolidated Statements Workpaper—Using Exercises 294
Partial Equity Method 207 ASC Exercises 296
5.6 Controlling and Noncontrolling Interests in Problems 296
consolidated Net Income and Retained Earnings—
Using Partial Equity Method 214
5.7 Consolidated Statements Workpaper—Using
7 ELIMINATION OF UNREALIZED GAINS
Complete Equity Method 216 OR LOSSES ON INTERCOMPANY SALES
5.8 Controlling Interest in Consolidated Net Income
OF PROPERTY AND EQUIPMENT 309
and Retained Earnings—Using Complete Equity Learning Objectives 309
Method 223 7.1 Intercompany Sales of Land (Nondepreciable
5.9 Additional Considerations Relating to Treatment Property) 310
of Difference Between Implied and Book 7.2 Intercompany Sales of Depreciable
Values 223 Property (Machinery, Equipment, And
5.10 Push Down Accounting 231 Buildings) 312
5.11 IFRS vs U.S. GAAP on Research & Development 7.3 Consolidated Statements Workpaper—Cost and
Costs 236 Partial Equity Methods 319
Summary 236 7.4 Calculation of Consolidated Net Income and
Questions 237 Consolidated Retained Earnings 327
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Contents xi

7.5 Consolidated Statements Workpaper—Complete 9.9 Dividends from Preacquisition Earnings 413
Equity Method 330 9.10 Subsidiary with both Preferred and Common
7.6 Calculation and Allocation of Consolidated Net Stock Outstanding 414
Income; Consolidated Retained Earnings: Complete 9.11 Consolidating a Subsidiary with Preferred Stock
Equity Method 336 Outstanding 417
7.7 Summary of Workpaper Entries Relating to Summary 427
Intercompany Sales of Equipment 336 Questions 428
7.8 Intercompany Interest, Rents, and Service Analyzing Financial Statements 428
Fees 336
Exercises 430
Summary 339
ASC Exercises 433
Appendix 7A: Deferred Taxes Consequences Related to
Problems 433
Intercompany Sales of Equipment (Online only)
Questions 340
Analyzing Financial Statements 341 10 INSOLVENCY—LIQUIDATION
Exercises 341 AND REORGANIZATION 433
ASC Exercises 344 Learning Objectives 433
Problems 344 10.1 Contractual Agreements 444
10.2 Bankruptcy 446
8 CHANGES IN OWNERSHIP INTEREST 355 10.3 Liquidation (Chapter 7) 449
10.4 Reorganization Under the Reform Act
Learning Objectives 355
(Chapter 11) 450
8.1 Changes in Ownership 355
10.5 Trustee Accounting and Reporting 460
8.2 Parent Acquires Subsidiary Stock Through Several
10.6 Realization and Liquidation Account 462
Open-Market Purchases—Cost Method 357
Summary 467
8.3 Parent Sells Subsidiary Stock Investment on the
Open Market—Cost Method 360 Questions 468
8.4 Equity Method—Purchases and Sales of Subsidiary Analyzing Financial Statements 469
Stock by the Parent 363 Exercises 469
8.5 Parent Sells Subsidiary Stock Investment on the ASC Exercises 475
Open Market—Cost Method 367 Problems 475
8.6 Subsidiary Issues Stock 368
Summary 376
Questions 376
11 INTERNATIONAL FINANCIAL REPORTING
STANDARDS 481
Analyzing Financial Statements 377
Exercises 377 Learning Objectives 481
ASC Exercises 380 11.1 The Increasing Importance of International
Accounting Standards 481
Problems 380
11.2 Historical Perspective: The Road to
Convergence 482
9 INTERCOMPANY BOND HOLDINGS AND 11.3 Similarities and Differences Between U.S. GAAP
MISCELLANEOUS TOPICS—CONSOLIDATED and IFRS 486
FINANCIAL STATEMENTS 388 11.4 GAAP Hierarchy—U.S. versus IFRS 486
11.5 Convergence Projects—FASB and IASB 495
Learning Objectives 388
11.6 International Convergene Issues 500
9.1 Intercompany Bond Holdings 389
11.7 American Depository Receipts: An Overview 503
9.2 Accounting for Bonds—A Review 390
Summary 506
9.3 Constructive Gain or Loss on Intercompany Bond
Holdings 391 Appendix 11A: List of Current International Financial
Reporting Standards Issued by IASC and IASB(Online
9.4 Accounting for Intercompany Bonds I
only)
llustrated 393
Questions 506
9.5 Book Entry Related to Bond Investment 394
Analyzing Financial Statements 507
9.6 Interim Purchase of Intercompany Bonds 409
Exercises 509
9.7 Notes Receivable Discounted 410
ASC Exercises 510
9.8 Stock Dividends Issued by a Subsidiary
Company 410 Problems 511
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xii Contents

12 ACCOUNTING FOR FOREIGN CURRENCY Summary 612

TRANSACTIONS AND HEDGING FOREIGN Appendix 14A: GE Segmental Disclosures 2013 Annual
EXCHANGE RISK 514 Report (Online only)
Questions 613
Learning Objectives 514
Analyzing Financial Statement 613
12.1 Exchange Rates—Means of Translation 515
Exercises 615
12.2 Measured versus Denominated 518
ASC Exercises 618
12.3 Foreign Currency Transactions 518
Problems 619
12.4 Using Forward Contracts as a Hedge 526
Summary 541
Questions 542 15 PARTNERSHIPS: FORMATION, OPERATION,
Analyzing Financial Statements 543
AND OWNERSHIP CHANGES 623
Exercises 543 Learning Objectives 623
ASC Exercises 550 15.1 Partnership Defined 624
Problems 550 15.2 Reasons for Forming a Partnership 625
15.3 Characteristics of a Partnership 625
15.4 Partnership Agreement 627
13 TRANSLATION OF FINANCIAL STATEMENTS 15.5 Accounting for a Partnership 629
OF FOREIGN AFFILIATES 556
15.6 Special Problems in Allocation of
Learning Objectives 556 Income and Loss 636
13.1 Accounting for Operations in Foreign 15.7 Financial Statement Presentation 637
Countries 557 15.8 Changes in the Ownership of the
13.2 Translating Financial Statements of Foreign Partnership 638
Affiliates 557 15.9 Section A: Admission of a New Partner 640
13.3 Objectives of Translation 559 15.10 Section B: Withdrawal of a Partner 646
13.4 Translation Methods 559 Summary 649
13.5 Identifying the Functional Currency 561 Questions 650
13.6 Translation of Foreign Currency Financial Exercises 650
Statements 561 ASC Exercises 656
13.7 Translation of Foreign Financial Statements Problems 656
Illustrated 565
13.8 Financial Statement Disclosure 574
13.9 Historical Developments of Accounting 16 PARTNERSHIP LIQUIDATION 663
Standards 575 Learning Objectives 663
Summary 576 16.1 Steps in the Liquidation Process 664
Appendix 13A: Accounting for a Foreign Affiliate and 16.2 Priorities of Partnership and Personal
Preparation of Consolidated Statements Workpaper Creditors 665
Illustrated (Online only) 16.3 Simple Liquidation Illustrated 668
Questions 577 16.4 Installment Liquidation 669
Analyzing Financial Statements 578 16.5 Incorporation of a Partnership 676
Exercises 579 Summary 678
ASC Exercises 585 Questions 679
Problems 585 Exercises 679
ASC Exercises 684
14 REPORTING FOR SEGMENTS AND FOR Problems 684
INTERIM FINANCIAL PERIODS 593
Learning Objectives 593 17 INTRODUCTION TO FUND
14.1 Need for Disaggregatd Financial Data 594 ACCOUNTING 690
14.2 Standards of Financial Accounting and Learning Objectives 690
Reporting 594 17.1 Classifications of Nonbusiness
14.3 International Accounting Standards Board (IASB) Organizations 691
Position on Segment Reporting 604 17.2 Distinctions Between Nonbusiness Organizations
14.4 Interim Financial Reporting 605 and Profit-Oriented Enterprises 691
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Contents xiii

17.3 Financial Accounting and Reporting Standards for Exercises 775

Nonbusiness Organizations 692 ASC Exercises 781
17.4 Fund Accounting 695 Problems 782
17.5 Comprehensive Illustration—General Fund 709
17.6 Reporting Inventory and Prepayments in the
Financial Statements 718 19 ACCOUNTING FOR NONGOVERNMENT
Summary 719 NONBUSINESS ORGANIZATIONS: COLLEGES
Appendix 17A: City of Atlanta Partial Financial
AND UNIVERSITIES, HOSPITALS AND OTHER
Statements (Online only) HEALTH CARE ORGANIZATIONS 792
Questions 720 Learning Objectives 792
Analyzing Financial Statements 720 19.1 Sources of Generally Accepted Accounting
Exercises 721 Standards for Nongovernment Nonbusiness
ASC Exercises 725 Organizations 793
Problems 725 19.2 Fund Accounting 796
19.3 Accrual Basis of Accounting 797
19.4 Accounting for Current Funds 798
18 INTRODUCTION TO ACCOUNTING 19.5 Contributions 801
FOR STATE AND LOCAL GOVERNMENTAL 19.6 Accounting for Plant Funds 804
UNITS 732 19.7 Accounting for Endowment Funds 808
Learning Objectives 732 19.8 Accounting for Investments 810
18.1 The History of Generally Accepted Governmental 19.9 Accounting for Loan Funds 811
Accounting Standards 734 19.10 Accounting for Agency (Custodial) Funds 811
18.2 The Structure of Governmental Accounting 736 19.11 Accounting for Annuity and Life Income
18.3 Governmental Fund Entities 737 Funds 812
18.4 Proprietary Funds 754 19.12 Issues Relating to Colleges and
18.5 Fiduciary Funds 757 Universities 813
18.6 Capital Assets and Long-Term Debt 757 Appendix 19A: Sample Financial Statements for Private
18.7 External Reporting Requirements (GASB Educational Institutions (Online only)
Statement No. 34) 762 Summary 813
18.8 Government Fund-Based Reporting 762 Questions 815
18.9 Government-wide Reporting 765 Analyzing Financial Statement 815
18.10 Management’s Discussion and Analysis Exercises 816
(MD&A) 769 ASC Exercises 822
18.11 Interfund Activity 770 Problems 823
Appendix 18A: Government-wide Financial Statements
City of Atlanta (Online only) Glossary 831
Summary 772
Appendix PV: Tables of Present Value 837
Questions 774
Analyzing Financial Statements 774 Index 839
fm.qxd 9/16/14 6:51 PM Page xiv
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c01.qxd 9/16/14 3:30 PM Page 1

1
INTRODUCTION TO BUSINESS
COMBINATIONS AND THE
CONCEPTUAL FRAMEWORK
CHAPTER CONTENTS LEARNING OBJECTIVES
1.1 GROWTH THROUGH MERGERS 1 Describe historical trends in types of business
1.2 NATURE OF THE COMBINATION combinations.
2 Identify the major reasons firms combine.
1.3 BUSINESS COMBINATIONS: WHY? WHY NOT?
3 Identify the factors that managers should consider in
1.4 BUSINESS COMBINATIONS: HISTORICAL PERSPECTIVE exercising due diligence in business combinations.
1.5 TERMINOLOGY AND TYPES OF COMBINATIONS 4 Identify defensive tactics used to attempt to block
business combinations.
1.6 TAKEOVER PREMIUMS
5 Distinguish between an asset and a stock
1.7 AVOIDING THE PITFALLS BEFORE THE DEAL acquisition.
1.8 DETERMINING PRICE AND METHOD OF PAYMENT IN 6 Indicate the factors used to determine the price and
BUSINESS COMBINATIONS the method of payment for a business combination.
1.9 ALTERNATIVE CONCEPTS OF CONSOLIDATED FINAN- 7 Calculate an estimate of the value of goodwill to be
CIAL STATEMENTS included in an offering price by discounting expected
future excess earnings over some period of years.
1.10 FASB’S CONCEPTUAL FRAMEWORK
8 Describe the two alternative views of consolidated
1.11 FASB CODIFICATION (SOURCE OF GAAP) financial statements: the economic entity and the
parent company concepts.
9 Discuss the Statements of Financial Accounting
Concepts (SFAC).
10 Describe some of the current joint projects of the
FASB and the International Accounting Standards
Board (IASB), and their primary objectives.

1.1 GROWTH THROUGH MERGERS

The merger between American Airlines and US Airways in 2013 has been the latest in a string
of acquisitions in an industry described by Warren Buffett a few years earlier as typifying the
“worst” sort of business. He went on to describe such a business as one that grows fast, earns
next to nothing, and takes large amounts of capital to engender growth. Twenty-nine
bankruptcies in 30 years support Buffett’s allegations. Still, the belief is growing that maybe
now, at last, airlines have finally cut capacity sufficiently to earn profits in the long run.1
Growth through mergers and acquisitions (M&A) has become a standard in business
not only in America but throughout the world. In the new millennium, the most recent in a
series of booms in merger activity was sparked by cheaper credit and by global competition,

1
WSJ, “Airlines Haven’t Reached Escape Velocity,” by Justin Lahart, 4/1/2013.

1
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2 Chapter 1 Introduction to Business Combinations and the Conceptual Framework

in addition to the usual growth-related incentives predominant during the boom of the
1990s. By the end of 2008, however, uncertainty in the commercial credit markets had led
to anxiety about whether merger transactions could continue to be achieved successfully in
the current environment, and by the middle of 2009 M&A activity had nearly come to a halt.
With plunging market values and tightened credit, the mix and nature of the financing com-
ponents were clearly in flux, and major adaptations needed to consummate any new deals.
As the markets began to recover in the second half of 2009, however, merger transac-
tions picked up once more. Banks made capital available for bigger companies, such as
Kraft, who looked to acquire Cadbury, and corporate debt offerings soared. By 2010, sev-
eral huge deals were in the works.
Merger activity has historically been highly correlated with the movement of the
stock market. Increased stock valuation increases a firm’s ability to use its shares to
acquire other companies and is often more appealing than issuing debt. During the
merger cycle of the 1990s, equity values fueled the merger wave. The slowing of merger
activity in the early years of the 21st century provided a dramatic contrast to this preced-
ing period. Beginning with the merger of Morgan Stanley and Dean Witter Discover and
ending with the biggest acquisition to that date—WorldCom’s bid for MCI—the year
1997 marked the third consecutive year of record mergers and acquisitions activity. The
pace accelerated still further in 1998 with unprecedented merger activity in the banking
industry, the auto industry, financial services, and telecommunications, among others.
This activity left experts wondering why and whether bigger was truly better. It also left
consumers asking what the impact would be on service. A wave of stock swaps was
undoubtedly sparked by record highs in the stock market, and stockholders reaped bene-
fits from the mergers in many cases, at least in the short run. Regulators voiced concern
about the dampening of competition, and consumers were quick to wonder where the real
benefits lay. Following the accounting scandals of 2001 (WorldCom, Enron, Tyco, etc.),
merger activity lulled for a few years.
Also in 2001, the Financial Accounting Standards Board (FASB) voted in two major
accounting changes related to business combinations. The first met with vehement protests
that economic activity would be further slowed as a result and the second with excitement
that it might instead be spurred. Both changes are detailed in Chapter 2.
By the middle of 2002, however, these hopes had been temporarily quelled. Instead of
increased earnings, many firms active in mergers during the 1990s were forced to report
large charges related to the diminished value of long-lived assets (mainly goodwill).
Merger activity slumped, suggesting that the frenzy had run its course. Market reaction to
the mergers that did occur during this period typified the market’s doubts. When Northrop
Grumman Corp. announced the acquisition of TRW Inc. for $7.8 billion, the deal was
praised but no market reaction was noted. In contrast, when Vivendi Universal admitted
merger-gone-wrong woes, investors scurried.
By the middle of the first decade of the 21st century, however, the frenzy was return-
ing with steady growth in merger activity from 2003 to 2006. In 2005, almost 18% of all
M&A (mergers & acquisitions) deals were in the services sector. In a one-week period in
June of 2006, $100 billion of acquisitions occurred, including Phelps Dodge’s $35.4 bil-
lion acquisition of Inco Ltd. and Falconbridge Ltd. In addition, because of the economic
rise in China and India, companies there were looking to increase their global foothold
and began acquiring European companies. Thus cross-border deals within Europe
accounted for a third of the global M&A deals.
However, by the end of 2008, a decline in overall merger activity was apparent as the
U.S. economy slid into a recession, and some forecasters were predicting the next chapter
in mergers and acquisitions to center around bankruptcy-related activity. Data from
Thomson Reuters revealed that in 2008, bankruptcy-related merger activity increased for
the first time in the last six years. For example, the number of Chapter 11 M&A purchases
rose from 136 for the entire year of 2007 to 167 for the first ten months of 2008, with more
to come. Overall mergers, on the other hand, decreased from $87 billion in the United
States ($277 billion globally) during October 2007 to $78 billion in the United States
($259 billion globally) during October 2008, based on the Reuters data.
c01.qxd 9/16/14 3:30 PM Page 3

Nature of the Combination 3

On December 4, 2007, FASB released two new standards, FASB Statement No. 141
“If we are
going to ride R, Business Combinations, and FASB Statement No. 160, Noncontrolling Interests in
IN
the IASB and Consolidated Financial Statements [ASC 805, “Business Combinations” and ASC 810,
THE
NEWS the IFRS “Consolidations,” based on FASB’s new codification system]. These standards have
[International altered the accounting for business combinations dramatically.
Financial Both statements became effective for years beginning after December 15, 2008, and
Reporting Standards] horse, we are intended to improve the relevance, comparability and transparency of financial infor-
want to make sure that it’s as mation related to business combinations, and to facilitate the convergence with interna
good as it can be. We want to tional standards. They represent the completion of the first major joint project of the
make sure that the IASB is FASB and the IASB (International Accounting Standards Board), according to one
strong, is independent, is well
FASB member, G. Michael Crooch. The FASB also believes the new standards will
resourced, and is properly
funded in a broad-based and
reduce the complexity of accounting for business combinations. These standards are inte-
secure way.”2 grated throughout this text.

Planning M&A in a Changing Environment and Under

CHANGING Accounting Requirements

“By 2006, the

1. The timing of deals is critical. The number of days between agreement or announce-
percentage ment and deal consummation can make a huge difference.
IN
THE of the 2. The effects on reporting may cause surprises. More purchases qualify as business
NEWS mergers and combinations than previously. Income tax provisions can trigger disclosures.
acquisitions 3. Assembling the needed skill and establishing the needed controls takes time. The
market
use of fair values is expanded, and more items will need remeasurement or monitor-
accounted for by private-equity
ing after the deal.
firms had increased to
approximately 15 percent from 4. The impact on earnings in the year of acquisition and subsequent years will differ
around 4 percent in 1990.”4 from that in past mergers, as will the effects on earnings of step purchases or sales.
5. Unforeseen effects on debt covenants or other legal arrangements may be lurking in
the background, as a result of the changes in key financial ratios.3
After several Growth is a major objective of many business organizations. Top management often
IN lean years, lists growth or expansion as one of its primary goals. A company may grow slowly, gradu-
THE U.S. M&A ally expanding its product lines, facilities, or services, or it may skyrocket almost overnight.
NEWS volume
Some managers consider growth so important that they say their companies must “grow or
reached $1
die.” In the past hundred years, many U.S. businesses have achieved their goal of expansion
trillion in
2013. Scott Barshay of Cravath,
through business combinations. A business combination occurs when the operations of two
Swaine, & Moore, a major law or more companies are brought under common control.
firm, claims that this growth
was caused by “a stronger
economy, . . . Congress 1.2 NATURE OF THE COMBINATION
behaving more responsibly,
and . . . all appearances of A business combination may be friendly or unfriendly. In a friendly combination, the
stability at the Fed.”5 boards of directors of the potential combining companies negotiate mutually agreeable
terms of a proposed combination. The proposal is then submitted to the stockholders of
the involved companies for approval. Normally, a two-thirds or three-fourths positive
vote is required by corporate bylaws to bind all stockholders to the combination.
An unfriendly (hostile) combination results when the board of directors of a com-
pany targeted for acquisition resists the combination. A formal tender offer enables the
acquiring firm to deal directly with individual shareholders. The tender offer, usually
published in a newspaper, typically provides a price higher than the current market price
for shares made available by a certain date. If a sufficient number of shares are not made

2
“Change Agent: Robert Hertz discusses FASB’s priorities, the road to convergence and changes ahead for
CPAs,” Journal of Accountancy, February 2008, p. 31.
3
BDO Seidman, LLP, “Client Advisory,” No. 2008-1, January 31, 2008.
4
The New York Post, “Money to Burn,” by Suzanne Kapner, March 28, 2006, p. 33.
5
“Markets Buoyant, Merger Activity Picks Up,” by David Gelles, The New York Times, DealBook, January 1, 2014.
c01.qxd 9/16/14 3:30 PM Page 4

4 Chapter 1 Introduction to Business Combinations and the Conceptual Framework

available, the acquiring firm may reserve the right to withdraw the offer. Because they are
Men’s
Wearhouse relatively quick and easily executed (often in about a month), tender offers are the pre-
IN
acquired all ferred means of acquiring public companies.
THE
NEWS the Although tender offers are the preferred method for presenting hostile bids, most ten-
outstanding der offers are friendly ones, done with the support of the target company’s management.
shares of Jos. Nonetheless, hostile takeovers have become sufficiently common that a number of mech-
A Bank with a per share offer anisms have emerged to resist takeover.
that represented a 56%
premium over Jos. A. Bank’s
closing share price. During a six Defense Tactics
month period, Jos. A. Bank
Resistance often involves various moves by the target company, generally with colorful
made several offers to acquire
Men’s Wearhouse. At the end
terms. Whether such defenses are ultimately beneficial to shareholders remains a contro-
of this six month period, Men’s versial issue. Academic research examining the price reaction to defensive actions has
Wearhouse, using a Pac Man produced mixed results, suggesting that the defenses are good for stockholders in some
strategy, made an offer to cases and bad in others. For example, when the defensive moves result in the bidder (or
acquire Jos. A Bank. No another bidder) offering an amount higher than initially offered, the stockholders benefit.
rebranding of the companies But when an offer of $40 a share is avoided and the target firm remains independent with
is expected and Men’s a price of $30, there is less evidence that the shareholders have benefited.
Wearhouse shareholders hope A certain amount of controversy surrounds the effectiveness, as well as the ultimate
to benefit from $100 to benefits, of the following defensive moves:
$150 million in synergies.6
1. Poison pill: Issuing stock rights to existing shareholders enabling them to purchase
additional shares at a price below market value, but exercisable only in the event of a
LO 4 Defensive tactics are used. potential takeover. This tactic has been effective in some instances, but bidders may
take managers to court and eliminate the defense. In other instances the original share-
holders benefit from the tactic. Chrysler Corp. announced that it was extending a
poison pill plan until February 23, 2008, under which the rights become exercisable if
anyone announces a tender offer for 15% or more, or acquires 15%, of Chrysler’s
outstanding common shares. Poison pills are rarely triggered, but their existence
serves as a preventative measure.
2. Greenmail: The purchase of any shares held by the would-be acquiring company at a
price substantially in excess of their fair value. The purchased shares are then held as
treasury stock or retired. This tactic is largely ineffective because it may result in an
expensive excise tax; further, from an accounting perspective, the excess of the price
paid over the market price is expensed.
3. White knight or white squire: Encouraging a third firm more acceptable to the target
company management to acquire or merge with the target company.
4. Pac-man defense: Attempting an unfriendly takeover of the would-be acquiring company.
5. Selling the crown jewels: The sale of valuable assets to others to make the firm less
attractive to the would-be acquirer. The negative aspect is that the firm, if it survives,
is left without some important assets.
6. Leveraged buyouts: The purchase of a controlling interest in the target firm by its
managers and third-party investors, who usually incur substantial debt in the process
and subsequently take the firm private. The bonds issued often take the form of high-
interest, high-risk “junk” bonds. Leveraged buyouts will be discussed in more detail
in Chapter 2.

1.3 BUSINESS COMBINATIONS: WHY? WHY NOT?

LO 2 Reasons firms combine. A company may expand in several ways. Some firms concentrate on internal expansion. A
firm may expand internally by engaging in product research and development. Hewlett-
Packard is an example of a company that relied for many years on new product

6
“Men’s Wearhouse Reaches $1.8 Billion Deal to Acquire Jos. A. Bank,” by Maggie McGrath, Forbes.com,
March 11, 2014.
c01.qxd 9/16/14 3:30 PM Page 5

Business Combinations: Why? Why Not? 5

development to maintain and expand its market share. A firm may choose instead to
emphasize marketing and promotional activities to obtain a greater share of a given market.
Although such efforts usually do not expand the total market, they may redistribute that
market by increasing the company’s share of it.
For other firms, external expansion is the goal; that is, they try to expand by acquiring
one or more other firms. This form of expansion, aimed at producing relatively rapid
growth, has exploded in frequency and magnitude in recent years. A company may achieve
significant cost savings as a result of external expansion, perhaps by acquiring one of its
major suppliers.
In addition to rapid expansion, the business combination method, or external expan-
sion, has several other potential advantages over internal expansion:
1. Operating synergies may take a variety of forms. Whether the merger is vertical
(a merger between a supplier and a customer) or horizontal (a merger between
competitors), combination with an existing company provides management of the
acquiring company with an established operating unit with its own experienced per-
sonnel, regular suppliers, productive facilities, and distribution channels. In the case of
Views on vertical mergers, synergies may result from the elimination of certain costs related to
IN whether negotiation, bargaining, and coordination between the parties. In the case of a horizon-
THE synergies are tal merger, potential synergies include the combination of sales forces, facilities, out-
NEWS real or simply
lets, and so on, and the elimination of unnecessary duplication in costs. When a private
a plug figure
to justify a
company is acquired, a plus may be the potential to eliminate not only duplication in
merger that shouldn’t happen costs but also unnecessary costs.
are diverse. Time Warner, for Management of the acquiring company can draw upon the operating history and
example, has fluctuated back the related historical database of the acquired company for planning purposes. A his-
and forth on this issue in recent tory of profitable operations by the acquired company may, of course, greatly reduce
years. President Jeffrey Bewkes the risk involved in the new undertaking. A careful examination of the acquired com-
recently was quoted as saying, pany’s expenses may reveal both expected and unexpected costs that can be eliminated.
“No division should subsidize On the more negative (or cautious) side, be aware that the term “synergies” is some-
another.” When queried about times used loosely. If there are truly expenses that can be eliminated, services that can
the message his predecessors
be combined, and excess capacity that can be reduced, the merger is more likely to
sent to shareholders, he said,
prove successful than if it is based on growth and “so-called synergies,” suggests
“It’s bull—”7
Michael Jensen, a professor of finance at the Harvard Business School.

GAINS FROM BULKING UP8

Industry Key Benefit of Consolidation

Antenna towers Frees up capital and management time for wireless
communications operators
Funeral homes Yields greater discounts on coffins, supplies, and
equipment
Health clubs Spreads regional marketing and advertising costs over
more facilities
Landfill sites Lets operators cope with the new environmental and
regulatory demands
Physician group practices Reduces overhead and costs of medical procedures

2. Combination may enable a company to compete more effectively in the international

marketplace. For example, an acquiring firm may diversify its operations rather
rapidly by entering new markets; alternatively, it may need to ensure its sources of sup-
ply or market outlets. Entry into new markets may also be undertaken to obtain cost sav-
ings realized by smoothing cyclical operations. Diminishing savings from cost-cutting

7
WSJ, “After Years of Pushing Synergy, Time Warner Inc. Says Enough,” by Matthew Karnitschnig,
6/2/06, p.A1.
8
Business Week, “Buy ’Em Out, Then Build ’Em Up,” by Eric Schine, 5/18/95, p. 84.
c01.qxd 9/16/14 3:30 PM Page 6

6 Chapter 1 Introduction to Business Combinations and the Conceptual Framework

within individual companies makes combination more appealing. The financial crisis in
More than a
IN third of Asia accelerated the pace for a time as American and European multinationals com-
THE bankruptcy peted for a shrinking Asian market. However, a combination of growing competition,
NEWS merger globalization, deregulation, and financial engineering has led to increasingly complex
activity in companies and elusive profits.
2008 took 3. Business combinations are sometimes entered into to take advantage of income tax
place in financial services, with laws. The opportunity to file a consolidated tax return may allow profitable corpora-
the sale of assets by Lehman tions’ tax liabilities to be reduced by the losses of unprofitable affiliates. When an ac-
Brothers (New York investment
quisition is financed using debt, the interest payments are tax deductible, creating a fi-
bank) and the $2.8 billion
acquisition by a consortium of
nancial synergy or “tax gain.” Many combinations in the past were planned to obtain
Ashikaga Bank (Japan). Others the advantage of significant operating loss carryforwards that could be utilized by the
included Thornwood acquiring company. However, the Tax Reform Act of 1986 limited the use of operat-
Associates’ $900 million ing loss carryforwards in merged companies. Because tax laws vary from year to year
purchase of Federal-Mogul, and from country to country, it is difficult to do justice to the importance of tax effects
Mendecino Redwood’s $600 within the scope of this chapter. Nonetheless, it is important to note that tax implica-
million acquisition of Pacific tions are often a driving force in merger decisions.
Lumber, and NBTY’s $371 4. Diversification resulting from a merger offers a number of advantages, including
million purchase of Leiner
increased flexibility, an internal capital market, an increase in the firm’s debt capacity,
Health Products.9
more protection from competitors over proprietary information, and sometimes a more
effective utilization of the organization’s resources. In debating the tradeoffs between
diversification and focusing on one (or a few) specialties, there are no obvious
answers.
5. Divestitures accounted for 30% or more of the merger and acquisitions activity in each
quarter from 1995 into mid-1998 and from 2001 to 2010. Shedding divisions that are
not part of a company’s core business became common during this period. In some
cases the divestitures may be viewed as “undoing” or “redoing” past acquisitions. A
popular alternative to selling off a division is to “spin off” a unit. Examples include
AT&T’s spin-off of its equipment business to form Lucent Technologies Inc., Sears
Roebuck’s spin-off of Allstate Corp. and Dean Witter Discover & Co., and Cincinnati
Bell’s proposed spin-off of its billing and customer-management businesses to form
Convergys Corp.

Notwithstanding its apparent advantages, business combination may not always be the
best means of expansion. An overriding emphasis on rapid growth may result in the pyra-
miding of one company on another without sufficient management control over the result-
ing conglomerate. Too often in such cases, management fails to maintain a sound enough
financial equity base to sustain the company during periods of recession. Unsuccessful or
incompatible combinations may lead to future divestitures.
In order to avoid large dilutions of equity, some companies have relied on the use of
various debt and preferred stock instruments to finance expansion, only to find themselves
unable to provide the required debt service during a period of decreasing economic activ-
ity. The junk bond market used to finance many of the mergers in the 1980s had essentially
collapsed by the end of that decade.
Business combinations may destroy, rather than create, value in some instances. For
example, if the merged firm’s managers transfer resources to subsidize money-losing seg-
ments instead of shutting them down, the result will be a suboptimal allocation of capital. This
situation may arise because of reluctance to eliminate jobs or to acknowledge a past mistake.
Some critics of the accounting methods used in the United States prior to 2002 to
account for business combinations argued that one of the methods did not hold executives
accountable for their actions if the price they paid was too high, thus encouraging firms to
“pay too much.” Although opinions are divided over the relative merits of the accounting
alternatives, most will agree that the resulting financial statements should reflect the
economics of the business combination. Furthermore, if and when the accounting standards

9
“Water Cooler: What Players in the Mid Market Are Talking About,” Mergers & Acquisitions, December 2008.
c01.qxd 9/16/14 3:30 PM Page 7

Business Combinations: Historical Perspective 7

and the resulting statements fail even partially at this objective, it is crucial that the users of
financial data be able to identify the deficiencies. Thus we urge the reader to keep in mind
that an important reason for learning and understanding the details of accounting for busi-
ness combinations is to understand the economics of the business combination, which in
turn requires understanding any possible deficiencies in the accounting presentation.

1.4 BUSINESS COMBINATIONS: HISTORICAL PERSPECTIVE

LO 1 Historical trends in types of In the United States there have been three fairly distinct periods characterized by many busi-
M&A. ness mergers, consolidations, and other forms of combinations: 1880–1904, 1905–1930, and
1945–present. During the first period, huge holding companies, or trusts, were created by
investment bankers seeking to establish monopoly control over certain industries. This type of
combination is generally called horizontal integration because it involves the combination of
companies within the same industry. Examples of the trusts formed during this period are J. P.
Morgan’s U.S. Steel Corporation and other giant firms such as Standard Oil, the American
Sugar Refining Company, and the American Tobacco Company. By 1904, more than 300 such
trusts had been formed, and they controlled more than 40% of the nation’s industrial capital.
The second period of business combination activity, fostered by the federal govern-
ment during World War I, continued through the 1920s. In an effort to bolster the war
effort, the government encouraged business combinations to obtain greater standardization
of materials and parts and to discourage price competition. After the war, it was difficult to
reverse this trend, and business combinations continued. These combinations were efforts
to obtain better integration of operations, reduce costs, and improve competitive positions
rather than attempts to establish monopoly control over an industry. This type of combina-
tion is called vertical integration because it involves the combination of a company with
its suppliers or customers. For example, Ford Motor Company expanded by acquiring a
glass company, rubber plantations, a cement plant, a steel mill, and other businesses that
supplied its automobile manufacturing business. From 1925 to 1930, more than 1,200 com-
binations took place, and about 7,000 companies disappeared in the process.
The third period started after World War II and has exhibited rapid growth in merger
activity since the mid-1960s, and even more rapid growth since the 1980s. The total dollar
value of mergers and acquisitions grew from under $20 billion in 1967 to over $300 billion by
1995 and over $1 trillion in 1998, and $3.5 trillion by 2006. Even allowing for changes in the
value of the dollar over time, the acceleration is obvious. By 1996, the number of yearly merg-
ers completed was nearly 7,000. Some observers have called this activity merger mania, and
most agreed that the mania had ended by mid-2002. However, by 2006, merger activity was
soaring once more. Illustration 1-1 presents two rough graphs of the level of merger activity for
acquisitions over $10 million from 1972 to 2012 in number of deals, and from 1979 to 2012 in
dollar volume. Illustration 1-2 presents summary statistics on the level of activity for the year
2012 by industry sector for acquisitions with purchase prices valued in excess of $10 million.
This most recent period can be further subdivided to focus on trends of particular
decades or subperiods. For example, many of the mergers that occurred in the United States
from the 1950s through the 1970s were conglomerate mergers. Here the primary motivation
for combination was often to diversify business risk by combining companies in different
industries having little, if any, production or market similarities, or possibly to create value
by lowering the firm’s cost of capital. One conjecture for the popularity of this type of merger
during this time period was the strictness of regulators in limiting combinations of firms in
the same industry. One conglomerate may acquire another, as Esmark did when it acquired
Norton-Simon, and conglomerates may spin off, or divest themselves of, individual busi-
nesses. Management of the conglomerate hopes to smooth earnings over time by counter-
balancing the effects of economic forces that affect different industries at different times.
In contrast, the 1980s were characterized by a relaxation in antitrust enforcement dur-
ing the Reagan administration and by the emergence of high-yield junk bonds to finance
acquisitions. The dominant type of acquisition during this period and into the 1990s was the
strategic acquisition, claiming to benefit from operating synergies. These synergies may
arise when the talents or strengths of one of the firms complement the products or needs of
c01.qxd 9/16/14 3:30 PM Page 8

8 Chapter 1 Introduction to Business Combinations and the Conceptual Framework

the other, or they may arise simply because the firms were former competitors. An argument
can be made that the dominant form of acquisition shifted in the 1980s because many of the
conglomerate mergers of the 1960s and 1970s proved unsuccessful; in fact, some of the
takeovers of the 1980s were of a disciplinary nature, intended to break up conglomerates.
Deregulation undoubtedly played a role in the popularity of combinations in the
1990s. In industries that were once fragmented because concentration was forbidden, the

ILLUSTRATION 1-1 PART A

Number of Mergers and Acquisitions over $10 Million 1972 to 2012

12,000

10,000

8,000
Number

6,000

4,000

2,000

0
1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Year
Data source: Mergers and Acquisitions, February 2002, 2004, 2006, 2009, 2010, 2013 March/April 1999, May/June.

ILLUSTRATION 1-1 PART B

Value of Mergers and Acquisitions over $10 Million 1979 to 2012

$2,000

$1,800

$1,600

$1,400
Dollars Billions

$1,200

$1,000

$800

$600

$400

$200

$0
19 1

19 3

20 9

20 1

20 9
82

19 3

19 1

00

20 3
19 9
19 0

19 9

92

19 8

02

04

20 8

10
11
84

19 8

90

94
19 5

19 5
19 7

96

20 7
86

19 7

20 5
20 6
8

0
8

0
7
8

0
8
8

9
8

0
9

0
0
19

20
19

19

20
19

20
19

19
19

19

20

Year
Data source: Mergers and Acquisitions, February 2013, 2010, 2009, 2006, 2004, 2002, March/April 1999, May/June 1989, 1982 Almanac & Index.
c01.qxd 9/16/14 3:30 PM Page 9

Business Combinations: Historical Perspective 9

ILLUSTRATION 1-2

10 Most Active Industries (Domestic Deals) by Number and Value of Transactions in 2012
Number of Deals Value of Deals
Number % of All Value % of Total
Industry Rank of Deals M&A Deals Rank ($ billions) M&A Value
Business Services 1 957 18.8% 8 24.9 4.0%
Software 2 428 8.4% 7 28.8 4.6%
Real Estate 3 307 6.0% 4 35.7 5.7%
Health Services 4 300 5.9% 3 45.0 7.2%
Oil & Gas 5 210 4.1% 2 67.0 10.7%
Insurance 6 171 3.4% 10 41.6 6.6%
Commercial Banks 7 169 3.3% – 31.0 4.9%
Investment and Commodity Firms 8 146 2.9% 9 22.2 3.5%
Measuring, Medical & Photographic Equipment 9 140 2.7% 6 30.8 4.9%
Wholesale Trade—durable goods 10 139 2.7% – 25.8 4.1%
Drugs – 83 1.6% 5 32.6 5.2%
Electric, Gas, and Water Distributions – 83 1.6% 1 116.6 18.6%
Data source: Mergers & Acquisitions, February 2013, p. 37.

pace of mergers picked up significantly in the presence of deregulation. These industries

include banking, telecommunications, and broadcasting. Although recent years have
witnessed few deals blocked due to antitrust enforcement, an example of a major transac-
tion dropped in 1996 because of a planned FTC (Federal Trade Commission) challenge
was in the drugstore industry. The FTC challenged the impact of a proposed merger
between Rite Aid Corp. and Revco D.S. Inc. on market power in several sectors of the
East and Midwest. Nonetheless, subsequent deals in the industry saw both companies
involved: Rite Aid acquired Thrifty PayLess Holdings Inc., and CVS Inc. purchased
Revco in February 1997.
Later, the Justice Department sued to block Primestar’s acquisition of a satellite slot
owned by MCI and News Corp. Other deals were dropped in the face of possible interven-
tion, including a planned merger between CPA firms KPMG Peat Marwick and Ernst &
Young in 1998. Nonetheless, over time the group of large CPA firms once referred to as the
Big 8 has blended into the Big 4, raising concerns about a possible lack of competition in
the audit market for large companies. The Justice Department reached a settlement in 2013
with American Airlines and US Airways requiring them to sell facilities at seven airports
before being allowed to consummate the planned merger.10

Before the announcement of the merger between AT&T and T-Mobile, phone handset makers such
IN as˛HTC and Motorola had two major carriers (ATT and T-Mobile) who could buy their GSM-based
THE phones. They just lost any ability to control price and profits on handsets because now a single buyer
NEWS that can dictate what GSM phones come to market. Even with LTE becoming the standard for the 4G
world, it would essentially be a market dominated by three buyers, which would place handset
makers at the mercy of the giants.11

Virtually every deal in the 2010 Wall Street lineup of potential mega-mergers faced regulatory
IN challanges both in the United States and in Europe. Examples include Oracle and Sun; Exxon and XTO
THE Energy; Yahoo and Microsoft, Kraft and Cadbury.
NEWS

10
CNN Money, “US Air and American Airlines Reach Deal with Justice to Allow Merger,” by C. Isadore and
E.˛Perez, 11/12/2013.
11
Gigaom.com “In AT&T & T-Mobile Merger, Everybody Loses,” by Om Malik, 3/20/2011.
c01.qxd 9/16/14 3:30 PM Page 10

10 Chapter 1 Introduction to Business Combinations and the Conceptual Framework

1.5 TERMINOLOGY AND TYPES OF COMBINATIONS

LO 5 Stock versus asset acquisitions. From an accounting perspective, the distinction that is most important at this stage is
between an asset acquisition and a stock acquisition. In Chapter 2, we focus on the acqui-
sition of the assets of the acquired company, where only the acquiring or new company sur-
vives. Thus the books of the acquired company are closed out, and its assets and liabilities
are transferred to the books of the acquirer. In subsequent chapters, we will discuss the
stock acquisition case where the acquired company and its books remain intact and consol-
idated financial statements are prepared periodically. In such cases, the acquiring company
debits an account “Investment in Subsidiary” rather than transferring the underlying assets
and liabilities onto its own books.
Note that the distinction between an asset acquisition and a stock acquisition does not
imply anything about the medium of exchange or consideration used to consummate the
acquisition. Thus a firm may gain control of another firm in a stock acquisition using cash,
debt, stock, or some combination of the three as consideration. Alternatively, a firm may
acquire the total assets of another firm using cash, debt, stock, or some combination of the
three. There are two independent issues related to the consummation of a combination:
what is acquired (assets or stock) and what is given up (the consideration for the combina-
tion). These are shown in Illustration 1-3.
In an asset acquisition, a firm must acquire 100% of the assets of the other firm. In a
stock acquisition, a firm may obtain control by purchasing 50% or more of the voting com-
mon stock (or possibly even less). This introduces one of the most obvious advantages of
the stock acquisition over the asset acquisition: a lower total cost in many cases. Also, in a
stock acquisition, direct formal negotiations with the acquired firm’s management may be
avoided. Further, there may be advantages to maintaining the acquired firm as a separate
legal entity. The possible advantages include liability limited to the assets of the individual
corporation and greater flexibility in filing individual or consolidated tax returns. Finally,
regulations pertaining to one of the firms do not automatically extend to the entire merged
entity in a stock acquisition. A stock acquisition has its own complications, however, and
the economics and specifics of a given situation will dictate the type of acquisition
preferred.
Other terms related to mergers and acquisitions merit mention. For example, business
combinations are sometimes classified by method of combination into three types—
statutory mergers, statutory consolidations, and stock acquisitions. However, the distinction
between these categories is largely a technicality, and the terms mergers, consolidations,
and acquisitions are popularly used interchangeably.
A statutory merger results when one company acquires all the net assets of one or
more other companies through an exchange of stock, payment of cash or other property, or
issue of debt instruments (or a combination of these methods). The acquiring company
survives, whereas the acquired company (or companies) ceases to exist as a separate
legal entity, although it may be continued as a separate division of the acquiring company.

ILLUSTRATION 1-3

What Is Acquired: What Is Given Up:

1. Cash
Net Assets of S Company
(Assets and Liabilities) 2. Debt

3. Stock
Common Stock of S Company 4. Combination of Above
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Documents with Different Content
 d ates e, ea g day s ace, ca ed o eus
"This mortal steals upon my sovereignty,
Stands brazen champion for the world of flesh,
Determines souls that waver towards the Styx—
Worse! hales the souls back from beyond the Styx,
Bringing the dead to life. This is more craft,
Brother, than we may suffer in a man.
Shall he with careless finger sway at will
The Balance of Destiny? Avenge me, Zeus!"
A Cyclops forged a thunder-bolt for Zeus,
And, black-browed, Zeus did launch it ... Thus I lost
My son Asklepios, killed thro' too much knowledge.

Asklepios! my dead Asklepios!

Let the dark King of Stygia howl for aid

To Olympos! I am King of Heaven and ask
No aid! I wreak my vengeance for myself.
I rose up in the wrath of my bereavement
And set an arrow to the silver bow
That none save I can bend, and let it fly.
I might not slay the wielder of the bolt,
But I did slay the forger of the bolt.
And when I saw the Cyclops pierced and dead
I came to Zeus and told him of my deed:
"Father, 'gainst whom my bow was never turned,
Father, that hast destroyed thine own son's son,
I defy thy doing and have destroyed thy tool."

Then while the Gods stood all aghast, Zeus spake:

"Go from among this immortal company
Which thou hast sinned against in daring so
To sin against me that am the head of all,
And learn to quell thy too fierce spirit, learn
To teach thy riotous blood obedience,
Serving the sons of men one year of days.
Go hence! thou art not of us for twelve moons."
I thi id d t F h G d
I nothing said, and went. For when we Gods
Revolt among ourselves the end is near,
And Zeus must levy justice as he will.

Asklepios! my dead Asklepios!

Had an hundred bolts been forged instead of one
I had slain an hundred Cyclops for thy sake
And suffered an hundred years of degradation!

Earth that receivest my body for a space,

I first saw light upon thee. Comfort me,
And tame a little the untamed blood in me.
Better will I endure to learn of thee
Than of the envious Gods, whom this disgrace
Serves for a secret feast to glut their hearts on.
For we have loved each other, thou and I,
And I have belted thee with golden arms,
And I have claspt thee daily with hot kisses,
And felt thee leap and pulse and answer to me
Like a shy maid grown bold and glad with love.
There's that in the core of thee that is so kin
To the core of me, it holds us twain inseverable,
Tho' from a billion blue-gold caverns of air
Translucent waves of space roll up an ocean
'Twixt earth and sun: our hearts beat time together.
My sister of the spheres has no such power
To quicken thee, be lov'd of thee and love thee.
She rains down light like argent snows; and thou,
Part shadow'd, part-illumin'd, wholly chill'd,
Submitt'st thyself to call her queen, who asks
No ardent service of thee, earth, as I do.
Yet, chaste twin-sister, we were of one birth;
Thy veins run all the silver, mine the gold.
What marvel Leto had nine days labour of us,
Strenuously thus disparting snow from flame,
To give the Gods one daughter all pure ice,
One son all perfect fire?
One son all perfect fire?...
O Thunderer!
That spark of immortal fire which, pregnant in her,
Evolved into my Godhead, issuèd
Out of thy Godhead; my humiliation
Is thy humiliation, Zeus! I stand
Supremest in thy shining progeny:
I am thy glittering symbol fix'd in heaven
To draw the dazed, adoring eyes of men:
I am thy arm of vengeance, I the hand
Bestowing thy good gifts: I am thy Voice
Of mystic prophecy and divination
Thro' which thou keep'st thy fingers on men's souls.
Daughters and sons thou hast whose attributes,
This one by twisty cunning, this by love
Too often base, this by remorseless carnage
Not bearing the high name of vengeance, these
By the insidious lusts of gold and wine,
Serve to express thee to the bodies of men;
But I express thee to the ghost in them,
For there is none whose vesture is like mine
Weft only of the spirit's highest tissues,
So that the world beholding thee thro' me
Beholds thee at thy zenith, and exalted
Out of the flesh struggles to sense an instant
The music, fire and essence of Olympos.
This Thunderer, wilt thou smirch? More dim, more dim
Than the imperial spark thou quenchest in me
Thou mak'st thy imperial fires whence I did spring,
The fount of us so indissoluble
That what shames thee shames me.
Earth, is this vengeance?

Nay, I see clearer. Rest unstained of me,

Thou God that art the father of my being.
The spirit of me, which is Thou, makes cause with thee
Against me. We must be inviolable
 ga st e e ust be o ab e
Or men will point their fingers—when We fall.

Asklepios! farewell, Asklepios!

Earth, I will serve on thee my year of days

Nor chafe beneath them like a petulant boy.
Ay, tho' Zeus force my Godhead into bonds
I will yet bear my bondage like a God.
 Transcriber's Note
Obvious punctuation and spelling errors have been
repaired.
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