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2020 | Book

Financial Analysis of Mergers and Acquisitions

Understanding Financial Statements and Accounting Rules with Case Studies

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About this book

Mergers and acquisitions (M&As) reshape the corporate landscape helping companies expand market share and gain a strategic advantage. The ability to understand and analyze these transactions is a crucial skill. The first step in acquiring that skill is being able to gather and analyse information on M&As from public sources, such as financial statements. This textbook helps its readers better analyze M&A transactions using information provided in financial statements. Covering accounting and reporting of consolidations, goodwill, non-controlling interests, step acquisitions, spin-offs, equity carve-outs, joint ventures, leveraged buyouts, disposal of subsidiaries, special purpose entities, and taxes, it focuses on the link between underlying economic events and the information in financial statements and how this link affects the assessment of corporate performance. The first part of the book provides description of the accounting rules governing M&A transactions, while the second part includes cases of M&A transactions. Each case focuses on a different element of an M&A transaction, and it is followed by a detailed solution with a complete analysis. Unlike other books in this field, this textbook focuses exclusively on accounting and financial analysis for graduate and upper undergraduate level courses in financial analysis, corporate finance, and financial accounting.

Table of Contents

Frontmatter

Accounting and Financial Reporting

Frontmatter
Chapter 1. Introduction to Accounting for Inter-corporate Investments
Abstract
The purpose of this chapter is to introduce the accounting methods used in transactions where one company invests in the debt and equity securities of another company. We focus our attention on investments in the voting shares of another company. In particular, we present the accounting method used to account for passive investments without significant influence over the investee (Cost or Fair Value), investments where the investor has significant influence over the investee (Equity method), and investments where the investor controls the investee (Purchase method). We also discuss the measurement of goodwill and non-controlling interests. Finally, we introduce two additional methods for inter-corporate investments: the Pooling of Interests method and Proportionate Consolidation; which are less frequently applied in practice.
Eli Amir, Marco Ghitti
Chapter 2. Main Issues in Purchase Accounting
Abstract
In this chapter, we focus on the purchase (acquisition) method, which is applied by an investor to account for controlling interests in the investee. In particular, we discuss the following issues: identifying the acquirer and the acquiree, determining the acquisition date, measuring the acquisition consideration goodwill and non-controlling interests. We also demonstrate the accounting treatment in cases of negative goodwill and for reverse acquisitions.
Eli Amir, Marco Ghitti
Chapter 3. More Issues in Purchase Accounting
Abstract
This chapter discusses additional issues related to the application of the purchase (acquisition) method of accounting. To determine the fair value of net assets acquired, the acquirer must identify, measure, and recognize provisions that exist at the time of acquisition. We discuss the effect of these provisions on the consolidation process and on subsequent income. We also discuss acquisitions in which the acquirer achieves control in multiple steps. For example, an acquirer may first acquire 25% of the voting shares of a target company in the first step, and only later achieve control by acquiring an additional 40% of the voting shares. In addition, we present the accounting process in cases of complete and partial disposal of subsidiaries. In particular, we focus on when disposal of subsidiaries results in the recognition of gains/losses in the income statement and when disposals are recorded as transactions among equity holders. Finally, we explain and demonstrate the preparation of the consolidated cash flow statement in the presence of acquisitions.
Eli Amir, Marco Ghitti
Chapter 4. Spin-Offs and Equity Carve-Outs
Abstract
Spin-offs, carve-outs, and split-offs are popular ways for parent companies to divest assets, divisions or subsidiaries. All three transactions often result in separate public equity of the divested assets. The main reason for creating publicly traded equity is to increase the value of the parent’s shares by focusing on core businesses. Another motivation is to make the divested assets more visible to market participants, inducing information gathering, and by that increase its value. In this chapter, we discuss the motivation for these transactions and explain their accounting aspects.
Eli Amir, Marco Ghitti
Chapter 5. Special Purpose Entities
Abstract
A special purpose entity (SPE) or a special purpose vehicle (SPV) is an entity created by a sponsoring/originating entity to accomplish a narrow and well-defined, often temporary, objective. SPEs are widely used in practice, mostly in securitizations and debt financing, but also in leases and project development. An interesting feature of SPEs is that, typically, voting rights do not represent the primary factor in deciding who controls them. Therefore, a new accounting model is needed to establish who controls and who should consolidate SPEs. In this chapter, we cover the main accounting and financial reporting aspects of SPEs under IFRS and US GAAP, and provide examples of typical SPEs used in practice.
Eli Amir, Marco Ghitti
Chapter 6. Tax Issues in Business Combinations
Abstract
Accounting rules under IFRS and US GAAP require the use of one specific accounting method, the purchase (acquisition) method—for almost all types of business combination transactions. These accounting rules require the buyer to consolidate the newly acquired subsidiary, while the seller records the disposal of  the subsidiary, as described in previous chapters. However, tax rules may be different. Depending on the tax structure of the transaction, the seller may or may not be required to pay taxes following the transaction, while the buyer may or may not receive a step-up in the tax basis of the acquired assets. Furthermore, the tax structure of the transaction has a significant effect on the recognition of deferred tax assets and liabilities on the acquirer’s balance sheet. In this chapter, we discuss some tax aspects of business combinations. We distinguish between taxable and tax-free transactions, between the book basis and the tax basis of an asset, and between a step-up and a carryover in the tax basis of an asset in a business combination. We also discuss the recognition of deferred tax assets and liabilities and the status of acquired goodwill in business combinations.
Eli Amir, Marco Ghitti
Chapter 7. Leveraged Buyouts and Recapitalizations
Abstract
In a corporate reorganization, a company changes its internal or external structure to improve efficiency or to increase revenues and income. Corporate reorganizations often result in a change of control. In this chapter, we review two types of corporate reorganizations: Leveraged Buyouts (LBOs) and Recapitalizations (RECAPs). Many times, these transactions are characterized by high levels of debt, secured by the assets and cash flows of the acquired company. These situations raise questions about whether the assets and liabilities of the acquired company should retain their historical bases, or should they change the accounting basis to fair value. In the first part of this chapter, we discuss LBOs and RECAPs. In the second part, we introduce a new accounting procedure called pushdown accounting. According to this procedure, following a change-in-control event, an acquired company that issues separate financial statements, may elect to present its assets and liabilities, including goodwill, at fair valued at the time of acquisition.
Eli Amir, Marco Ghitti
Chapter 8. Financial Analysis of Business Combinations (Ratios)
Abstract
Financial statement analysis (FSA) uses information in financial statements to form expectations about a company’s current and future financial performance so that users will be able to make informed investment, credit, and other economic decisions. One common way of analyzing financial statements is by using financial ratios. However, while accounting and financial reporting are subject to strict rules, the use of financial ratios is not governed by rules and regulations, and thus may differ substantially across users of financial information. We begin this chapter by introducing basic financial statement reformulations and ratio analysis techniques. Then, we assess the effect of accounting methods for intercorporate investments on financial ratios. In particular, we discuss and demonstrate how the equity method, full consolidation and proportionate consolidation affect profitability, efficiency, liquidity, and capital structure ratios.
Eli Amir, Marco Ghitti
Chapter 9. Financial Analysis of Business Combinations (Advanced Issues)
Abstract
This chapter focuses on the financial reporting implications of accounting methods for merger and acquisition transactions (equity method, full consolidation, and proportionate consolidation). We begin by comparing each method to each other in terms of off-balance sheet financing. The equity method is a single-line consolidation method, which means that the investee’s liabilities are netted against its assets, and hence, the investee’s debt is not shown explicitly on the investor’s balance sheet. In contrast, proportionate consolidation and full consolidation show the investee’s debt on their balance sheets. We continue by analysing changes in purchase price allocations. Acquirers may, in fact, revise the initial purchase price allocation of an acquisition and these revisions may provide useful information to the users of financial statements. An additional choice for acquirers reporting under IFRS is between the partial and full fair value method for non-controlling interests and goodwill. We analyse the motivation and the reporting implications of this choice. Then, we analyse the growth of a company, as reflected in the financial statements, separating organic (internal) growth from acquired growth. The chapter ends by analysing the impact of acquisitions on the acquirer’s cash flow statement.
Eli Amir, Marco Ghitti

Case Studies

Frontmatter
Chapter 10. Kraft Group (Part I): Cadbury Acquisition—Purchase Accounting
Abstract
In February 2010, Kraft Foods, a US publicly listed company, announced it had acquired control of Cadbury, a leading confectionery company listed on the London Stock Exchange. The merger between the two companies created the second largest confectionery, food, and beverage company in the world. The purpose of this case is to introduce the reader to the basic elements of consolidation using the purchase method. Using financial information from both companies, we measure the deal consideration, the fair value of net assets acquired and goodwill; then, we produce a pro-forma consolidated balance sheet. We also discuss the differences between the full fair value and partial methods for goodwill and non-controlling interests and the effects of fair value adjustments on subsequent consolidated income.
Eli Amir, Marco Ghitti
Chapter 11. The Bank of Hope: The Merger of Wilshire Bank and BBCN Bancorp
Abstract
The purpose of this case is to introduce the application of the purchase method in the banking industry. While the elements of consolidation in the banking industry are similar to those in other industries, the terminology and the structure of financial statements are quite different. In this case, we analyze the stock-for-stock merger of Wilshire Bank and BBCN Bancorp in 2015. Both Wilshire and BBCN are commercial banks specializing in providing services to the Korean-American communities. In analyzing the case, we focus primarily on identifying the acquirer and the date of acquisition in a stock transaction, measuring consideration in a stock-for-stock deal, identifying fair value adjustments, and computing goodwill under both the partial and the full fair value methods.
Eli Amir, Marco Ghitti
Chapter 12. AT&T: Equity Method Investments
Abstract
Unlike the purchase method, the equity method deals with investments in which the investor has significant influence over the investee but not control. The investments under the equity method are recorded as assets on the investor’s balance sheet and the share in the net income of affiliates is presented on the investor’s income statement. AT&T is a holding company whose subsidiaries and affiliates operate worldwide in the telecommunications, media, and technology industries. During June 2018, AT&T completed the acquisition of Time Warner, a giant media, and entertainment conglomerate. As part of the acquisition of Time Warner, AT&T had investments in affiliates under the equity method. Using the information in AT&T’s financial statements we explain the differences between three methods for intercorporate investments: full consolidation under the purchase method, single-line consolidation under the equity method, and the proportionate consolidation method.
Eli Amir, Marco Ghitti
Chapter 13. Nokia Siemens Networks: Purchase Accounting, Equity Method, and Proportionate Consolidation
Abstract
During June, 2006, Nokia and Siemens announced the merger of their network business operations. The newly created entity was called Nokia Siemens Networks (“NSN”) and was ranked among the top three industry leaders in the telecom vendor sector. Prior to the transaction, Nokia and Siemens each owned 100% of their respective subsidiaries and, as part of the transaction, each entity relinquished control of its respective subsidiary for a 50% stake in NSN. In this case, we analyze the accounting implications of this transaction for both Nokia and Siemens. In particular, we analyze the transaction using three different methods for inter-corporate investments: equity method, proportionate consolidation, and full consolidation under the purchase method. Using common ratios, we examine which method would be preferred by the transacting companies.
Eli Amir, Marco Ghitti
Chapter 14. Ensign Group: The Spin-Off of CareTrust REIT
Abstract
A spin-off is basically a dividend-in-kind whereby a company distributes shares in a subsidiary to its shareholders on a pro-rata basis. The purpose of this case is to explain the reasons why companies spin-off parts of their operations. We also explain and demonstrate the accounting treatment of a spin-off transaction highlighting the differences between US GAAP and IFRS. We use the interesting case of Ensign where the spun-off entity is a Real Estate Investment Trust (REIT). The transactions unlocked value for the existing shareholders and created an attractive investment in a REIT for new and existing investors.
Eli Amir, Marco Ghitti
Chapter 15. Altria Group: The Carve-Out and Spin-Off of Kraft
Abstract
Following a spin-off and an equity carve-out new shares are traded in the public equity market. What is an equity carve-out? What is a spin-off? What common objectives do they have, and what differences? We provide insights to these questions by analyzing the case of Altria and Kraft. In addition, the case raises and provides feedback on the following questions: how did Altria and Kraft account for the carve-out and spin-off of Kraft in 2001 and 2007, respectively? Why did Altria carve-out just less than 20% of its ownership of Kraft in 2001? Why did it then spin-off its remaining interest in 2007? Finally, we address the issues of gain/loss recognition in spin-offs and carve-outs.
Eli Amir, Marco Ghitti
Chapter 16. The Sale of Coca Tea: The Impact of Taxes
Abstract
Taxes often have significant impacts on deal structures and deal considerations. A transaction could be structured as a stock or asset deal and as taxable or tax-free. Each structure could result in different negotiated consideration, due to tax payments or tax refunds to/from the government. Different tax structures could also have significant impact on the acquirer’s as well as on the seller’s financial statements, in particular, on deferred tax assets/liabilities, goodwill and recognized gains/losses. In this case, we demonstrate the impact of five different tax structures on the financial statements of the acquirer and the seller.
Eli Amir, Marco Ghitti
Chapter 17. Surgery Partners: Pushdown Accounting
Abstract
Normally, following a change-in-control event, the acquirer recognizes the acquired assets and liabilities of the target at fair value at the time of acquisition, while accounting for goodwill and non-controlling interests when appropriate. However, since 2014, US GAAP allows subsidiaries that issue separate financial statements, following a change-in-control event, to elect pushdown accounting. This accounting procedure allows the subsidiary to present its own assets and liabilities, including goodwill, at fair value (similar to the basis used in the parent company). In this case, we analyze the financial statements of Surgery Partners, a company in the healthcare services industry, who was acquired by a major private equity investor and elected pushdown accounting. Using the information in the case, we construct the balance sheet of Surgery Partners immediately before the election of pushdown accounting. This allows us to analyze the impact of pushdown accounting on the company’s financial statements, and the reason for electing this procedure.
Eli Amir, Marco Ghitti
Chapter 18. Kraft Group (Part II): Cadbury Acquisition—Post-acquisition Performance
Abstract
In February 2010, Kraft Foods, a US publicly listed company, acquired Cadbury, a leading confectionery company listed on the London Stock Exchange. In this case, we focus on measuring post-merger performance. In particular, we examine whether the growth in Kraft’s sales and income was organic (internal) or merely a result of multiple acquisitions. The analysis focuses on measuring comparable sales and income while excluding the effects of acquisitions. We also measure whether the acquisition of Cadbury was successful by looking at the behavior of certain ratios over time and by measuring the effect of cost savings.
Eli Amir, Marco Ghitti
Backmatter
Metadata
Title
Financial Analysis of Mergers and Acquisitions
Authors
Prof. Dr. Eli Amir
Dr. Marco Ghitti
Copyright Year
2020
Electronic ISBN
978-3-030-61769-1
Print ISBN
978-3-030-61768-4
DOI
https://doi.org/10.1007/978-3-030-61769-1

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