Chapter 1
Overview and History of Accounting
for Business Combinations
Learning Objectives
After completing this chapter, you should be able to explain
• The background and history of the standards on business combinations.
• The purpose and objectives of the revised statement on business combinations.
• The role of convergence in the standard-setting process.
• The influence of the Securities and Exchange Commission (SEC) and other regulators
regarding business combinations.
Introduction
There is a long history of business combinations, commonly referred to as mergers and
acquisitions (M&A) in the United Stated and throughout the world. When looking at M&A from
a historical perspective, it can be viewed as waves. Beginning in 1898 through the present, there
have been a total of five waves, each occurring at a different time and exhibiting some unique
characteristics. The current or fifth wave began in the early 1990’s and continues to the present.
In this wave, a very large percentage of the total global activity occurred outside of the U.S.
According to barternews.com, “There was incredible growth globally in the M&A arena last
year, with record-setting volume of $474.3 billion coming from Asia-Pacific regions, up 46%
from $324.5 billion in 2004. In the U.S., M&A volume rose 30% from $886.2 billion in 2004. In
Europe, the figure was 49% higher than the $729.5 billion in 2004. Activity in Eastern Europe
nearly doubled to a record $117.4 billion.”
More recently, the International Accounting Standards Board (IASB) has indicated that business
combinations are an important feature of the capital markets. In 2006, there were more than
13,000 M&A transactions worldwide. Just under half, with a combined value of $1.49 trillion,
were completed by entities that apply U.S. GAAP. Most of the rest, worth about $1.82 trillion,
were completed by entities that apply International Financial Reporting Standards (IFRSs) or are
moving to IFRSs. Over the last decade the average annual value of corporate acquisitions
worldwide has been the equivalent of 8–10% of the total market capitalization of listed
securities.
Given the economic events and crisis facing the global economy today, the impetus for
continued M&A activity seems to remain high. PWC’s 12th Annual Global CEO Survey Report
completed in early 2009 reported that CEO’s felt that “in order to meet cross-border growth
objectives over the next three years, CEOs have to deal with a lack of capital, extremely tight
credit and uncertainty about company valuations. Last year’s survey found that most companies
were using collaborative business relationships opportunistically. It suggested that a more
strategic approach would emerge. This year, many CEOs say that they are already collaborating
with most major stakeholders, including supply-chain partners, providers of capital and
industry…Twenty-five percent of CEOs still believe that M&A will play a greater role in crossborder
expansion …over the next three years but more CEOs are confronting the challenges of
unexpected costs and cultural conflicts...”
1
The Role of Control in U.S. GAAP
In accounting for investments, including business combinations, a major determining factor
dictating the appropriate accounting has been “control.” In keeping with the change in focus of
the Financial Accounting Standards Board (FASB) from a rules-based approach to a more
principles-based approach, the determination of control demonstrated by various investments
(including business entities) has changed as well.
In May 1993, the FASB issued FASB Accounting Standards Codification (ASC) 320,
Investments–Debt and Equity Securities (SFAS No. 115). This Statement provides guidance on
how to account for such investments using the following guidelines:
• The initial investments in equity securities are recorded at cost and subsequently adjusted
to fair value if fair value is readily determinable; otherwise, the investment remains at
cost.
• Equity securities held for sale in the short term are classified as trading securities and are
reported at fair value, with unrealized gains and losses included in earnings.
• Equity securities not classified as trading securities are classified as available-for-sale
securities and are reported at fair value, with unrealized gains and losses excluded from
earnings and reported in a separate component of shareholders’ equity as part of other
comprehensive income.
• Dividends received are recognized as income for both trading and available-for-sale
securities.
These procedures are required for investments when neither significant influence nor control is
present. While control or significant influence can be determined in many ways, traditionally the
accounting literature has considered less than 20% ownership to be a general guideline.
When the level of ownership enables an investor to control an investee, an economic situation is
present which is not adequately addressed by FASB ASC 320 (SFAS No. 115) and an entirely
different set of accounting procedures is applicable. According to FASB ASC 810,
Consolidation (ARB No. 51), control generally requires the consolidation of the entity. In the
FASB’s February 1999 exposure draft, Consolidated Financial Statements: Purpose and Policy,
“control” is explicitly defined as
The ability of an entity to direct the policies and management that guide the ongoing
activities of another entity so as to increase its benefits and limit its losses from that other
entity’s activities. For purposes of consolidated financial statements, control involves
decision-making ability that is not shared with others.
More recently, FASB ASC 810 [FIN No. 46(R)] expands the use of consolidated financial
statements to include entities that are financially controlled through special contractual
arrangements.
In both of the above situations, the focus is on control of one entity by another and it is that
control which dictates the appropriate accounting. When one entity has a significant ownership
interest in another entity without having actual control, FASB ASC 323, Investments–Equity
Method and Joint Ventures (APB Opinion No. 18), requires the application of the equity method.
Criteria for using the equity method largely are reflective of “significant influence” even though
the investor may own less than 50% of the voting stock. Guidance is provided by listing several
conditions that indicate the presence of significant influence. It also established a general
ownership test of between 20% and 50% of the voting stock of the investee.
Within U.S. GAAP, the accounting standards governing the accounting for business
combinations have changed a great deal over the years.
In December 2007, the FASB issued FASB ASC 805, Business Combinations [SFAS No.
141(R)], effective for fiscal years beginning after December 15, 2008, which requires that all
business combinations be accounted for using the “acquisition method.” FASB ASC 805 [SFAS
No. 141(R)] retains much of the previous guidance in accounting for business combinations
including the elimination of the “pooling of interests method” of accounting for business
combinations. The FASB eliminated the pooling of interests method primarily due to believing
that the method provided less relevant information to investors in ignoring the values exchanged
in a business combination transaction and not providing investors with the information needed to
assess the subsequent performance of an investment and compare it with the performance of
other companies. The underlying concept of the acquisition method is that one company has
acquired another company and a sale has occurred. FASB ASC 805 [SFAS No. 141(R)] does not
apply to the formation of a joint venture, the acquisition of an asset or a group of assets that does
not constitute a business, a combination between entities under common control, or a
combination between not-for-profit organizations or the acquisition of a for-profit business entity
by a not-for-profit organization.
Thus the accounting for a business combination follows the concepts normally applicable to the
initial recognition and measurement of assets acquired, liabilities assumed or incurred, and
equity shares issued, as well as to the subsequent accounting for those items. Generally, like
other exchange transactions, acquisitions are measured on the basis of the fair values exchanged.
That is, the fair values of the net assets acquired and the consideration paid are assumed to be
equal, absent evidence to the contrary. Thus, the cost of an acquisition to the acquiring entity is
equal to the fair values exchanged and no gain or loss generally is recognized. Exceptions to that
general condition include (a) the gain or loss that is recognized if the fair value of noncash assets
given as consideration differs from their carrying amounts on the acquiring entity’s books and
(b) the extraordinary gain that sometimes is recognized by the acquiring entity if the fair value of
the net assets acquired in a business combination exceeds the cost of the acquired entity.
Exchange transactions in which the consideration given is cash are measured by the amount of
cash paid. However, if the consideration given is not in the form of cash (that is, in the form of
noncash assets, liabilities incurred, or equity interests issued), measurement is based on the fair
value of the consideration given or the fair value of the asset (or net assets) acquired, whichever
is more clearly evident and, thus, more reliably measurable.
Objectives of FASB ASC 805 [SFAS No. 141(R)]
The objectives of FASB ASC 805, Business Combinations [SFAS No. 141(R)], are to improve
the relevance, representational faithfulness, and comparability of the information that a reporting
entity provides in its financial reports about a business combination and its effects. The statement
does that by
• Improving the transparency of financial reporting and providing investors with clearer
pictures of the effects of mergers and acquisitions.
• Improving the comparability of financial statements worldwide.
• Extending the use of fair value measurements.
Under FASB ASC 805 [SFAS No. 141(R)] the focus is once again on control. The FASB
replaced the term “purchase method” used in previous guidance with “acquisition method” to
distinguish that a business combination is the result of a change of control rather than simply a
purchase. Under this concept, a business combination might occur in the absence of a purchase
transaction. The scope of FASB ASC 805 [SFAS No. 141(R)] is broader than the previous
guidance, which applied only to business combinations in which control was obtained by
transferring consideration. FASB ASC 805 [SFAS No. 141(R)] defines the “acquirer” as the
entity that obtains control of one or more businesses in the business combination and establishes
the acquisition date as the date that the acquirer achieves control. It did not define the acquirer,
although guidance is included on identifying the acquirer. By applying the same accounting
method, the acquisition method, to all transactions and other events in which one entity obtains
control over one or more other businesses, FASB ASC 805 [SFAS No. 141(R)] improves the
comparability of the information about business combinations provided in financial reports.
FASB ASC 805 [SFAS No. 141(R)] retains the previous guidance for identifying and
recognizing intangible assets separately from goodwill in a business combination.
The Role of Convergence in Business Combination Guidance
The business combination projects of both the FASB and the IASB are designed to unify M&A
accounting across the world’s major capital markets. When the projects were started, rapidly
accelerating movement of global capital flows had been observed. There had been a five-fold
increase in the volume of transatlantic deals between 2003 and 2006. Investors and their advisers
need to assess how the activities of the acquirer and its acquired business will combine, which is
challenging enough when entities use the same accounting standards. It is more difficult to make
comparisons when acquirers are accounting for acquisitions in different ways, whether as a
1 PWC 12th Annual Global CEO Survey, Key Findings, http://www.pwc.com/ceosurvey/key_findings.html
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