Managers partake in economic activities to benefit shareholders and create value to their respective corporation. Integrating businesses is one example of a strategy management might employ for the purpose of expansion and increasing value. Business entities are often under the control of other business entities, this is known as a business combination. There are different types of combinations, which are defined by the FASB Accounting Standards Codification (ASC). This aspect of business ownership impacts the presentation of financial statements. This paper will define and explore reasons for business combinations, discuss recent combinations, and provide a proposal to preparers.
The FASB ASC states that a business combination is the result of an acquirer gaining control of at least one other business (ASC Glossary). The acquirer can also be referred to as the parent, and the acquiree can be called the target or subsidiary. Control is defined by the FASB ASC as direct or indirect possession of power to influence management through ownership or contract (ASC Glossary). All combinations create a single economic entity, but there are different legal forms of mergers and acquisitions (Beams). It is critical to identify the format of the business combination because it impacts the continuation of the corporations involved.
There are some instances where at least one corporation discontinues operations after a combination occurs. Statutory mergers occur when one of the original companies remains in existence while the others dissolve. There are two ways a statutory merger materializes: the acquiring company purchases assets and liabilities of another company, or the acquiring company purchases 100 percent of the target company’s stock and transfers the assets and liabilities to its books. In both cases, the assets and liabilities of the acquired company are recorded on the books of the acquiring company. In addition to statutory mergers, there is statutory consolidation, which is the result of two or more entities ceasing existence after transferring their assets or capital stock to a new, independent entity (Beams). The original companies may remain as a division of the new corporation but are no longer legally separate.
Furthermore, there are combinations in which both the acquirer and target remain as legally separate entities. A company that obtains greater than 50 percent of voting power of another company takes control of the target and is able to make decisions (Beams). The target maintains independence and becomes a subsidiary of the parent company. Finally, an entity can gain control of another entity through contractual settlements. This is an option that does not necessarily require equity ownership and is known as a variable interest entity (VIE) (Beams). According to the Accounting Research Bulletin No. 51, a VIE requires at least one of the following characteristics: 1. The equity investment is not high enough to finance the VIE and other interests will absorb some losses, and 2. Investors are incapable of decision making, are not obligated to absorb losses, and/or do not have the right to receive residual returns as compensation for the risk of any losses (FASB Reference Library). The VIE remains separate but may become a trust or partnership with the acquiring company (Beams).
Even though every combination ultimately leads to one company acquiring control over another company, it is significant to differentiate each type of combination. Stakeholders need to be aware of the benefits and risks attributed to the different types of combinations. An acquirer may be more inclined to combine through asset acquisition to avoid acquiring unnecessary assets or assuming unwanted liabilities. Additionally, there are tax benefits for the buyer, such as basis treatment and reducing taxable gain (Putz). Risks for the acquirer include high transaction costs, and time-consuming transfers (Mariner). Asset sales pose a risk to the seller because they will be taxed at capital gain rates for intangible assets and could be adhered to unsold liabilities and not enough assets to appease those liabilities (Putz). On the contrary, a stock purchase will receive less preferential tax treatment and may be faced with unknown liabilities (Mariner). The seller will most likely favor a stock sale because they could bypass being taxed at the corporate level. Regardless of the type of combination, there are benefits and risks to the parties involved.
Every corporation’s main goal is profitability. There are various reasons a combination may take place, but ultimately, entities combine to enhance business performance. Firms will combine to increase save money, whether it is through consolidation of facilities, eliminating duplicate staff, or vertical integration (Beams). For example, a company may choose to combine with their supplier in order to reduce their cost of raw materials. A company also may combine to quickly expand into new markets or become a more powerful force in their current market (Beams). Two companies that sell related products might combine to expand the scope of their brand names, for instance. Additionally, firms could expand to improve negotiating power with financial institutions or suppliers and sellers (Beams). Business combinations occur as part of a managerial strategy, although there are some scholars who warn against considering combinations as a first resort. INSEAD Professor Laurence Capron warns that combinations are complicated and expensive. There are other options aside from combining, including in house research and development and alliances (Clark). Additionally, Kellogg Insight has found an increased risk when businesses merge, contrary to the belief that mergers create diversification and mitigate risk (Rosen). It is management’s responsibility to analyze the benefits and risks of combining and decide if it is the best strategy for their circumstances.
When considering business combinations, the topic of consolidations is also important to note. Consolidating financial statements occurs when the statements represent two or more corporations. Its purpose is to present the parent and subsidiaries as if they were a single economic entity. By consolidating, the statements are presented fair and meaningful to benefit the owners and creditors of the parent (ASC 810-10-10-1). Not all consolidation procedures are the same, they are dependent on the legal format of the business combination. Two primary models for determining the appropriateness of consolidating are the voting interest entity and the VIE model. FASB provides flowcharts evaluating the suitability for consolidation for each model. See Figure 1 and Figure 2 for the respective flowcharts (ASC 810-10-05-6). Due to its contractual nature, the VIE model is more complex than the voting interest model.
When the acquired company is dissolved, a single consolidation occurs on the date of combination. This action marks the end of the acquired company and its books are permanently closed. The surviving company will incorporate the balances of the dissolved company (Beams). If the acquired company remains in existence, independent accounting records are maintained and routine consolidations occur. Consolidations in this instance are developed outside of the parent company’s financial record as to not disrupt the individual accounting systems. Worksheets are used to progress the expedite the consolidation (Beams). Regardless of the continuation of the acquired company, FASB currently requires use of the acquisition method for recognizing and measuring the following: consideration and noncontrolling interest, separately identifiable assets and liabilities, and goodwill or gain from a bargain purchase (Beams). Consideration transferred from the acquirer to the acquiree during the acquisition is the fair value of assets, liabilities and equity interests (ASC 805-30-30-7). This can also be referred to as the purchase price. The assets acquired and liabilities assumed are also measured at fair value. There are three valuation techniques for determining fair value. The three methods accepted by U.S. GAAP are the market approach, cost approach, and income approach (ASC 820-10-35-24A). The difference in consideration transferred and assets acquired and liabilities assumed results in goodwill or a gain on bargain purchase. If consideration is greater than the fair value of the assets and liabilities, goodwill is recognized. Goodwill is an asset on the books that is tested for impairment over time. Conversely, if consideration is less than the fair value of the assets and liabilities, a gain is recognized. If this is the case, the fair value of the assets acquired replaces the consideration transferred (Beams).
In 2017, there were a handful of large combinations that hit the media. Amazon purchased Whole Foods for $13.7 billion, with goodwill valued at approximately 70% of the purchase price (Kim). This is a unique acquisition because the value of the actual assets makes up a minor portion of the purchase price, and it appears Amazon is confident that Whole Foods will provide them great future value. Another combination that occurred was Michael Kors purchasing Jimmy Choo for $1.2 billion. Michael Kors is planning to combine with more luxury brands in the future to create a “luxury group”. Additionally, Coach bought out its competitor, Kate Spade, for $2.4 billion (Johnson). This is credited to a managerial strategy to change their image. Overall, it appears that many of the business combinations that occurred were for expansion purposes.
I would suggest to readers considering a business combination to plan accordingly before acquiring a company and pay special attention to the legal aspects that impact the consolidation of the financial statements. It is important to consider the long-term impact and acknowledge in house options. As for preparers, I would propose adding a statistical section to the reports, so investors can reflect on the benefits of the combination. The acquisition method forces the fair presentation of the financial reports, but investors want to know how they are benefitting. Using a statistical section showing the fair value adjustments, the percentage of profit credited to the subsidiary, and ratios of direct costs associated with maintaining the subsidiary are important information investors might be interested in. Utilizing statistics and analyses creates endless possibilities for what could be presented to shareholders.