Chapter Two Consolidation of Financial Information McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Business Combinations Separate organizations tied together through common control Financial statements which represent more than one corporation are known as “consolidated” financial statements. The company which exerts control is known as the “parent.” The separate controlled companies whose information is consolidated are known as “subsidiaries.” 2-2

Why do Firms Combine? Vertical integration Cost savings Quick access to new markets Economies of scale More attractive financing opportunities Diversification of business risk Vertical integration Cost savings Quick access to new markets Economies of scale More attractive financing opportunities Diversification of business risk 2-3

Scale of Recent Combinations ACQUIRER TARGET COST (in billions of $) AT&TBellSouth$67.0 J.P. Morgan Chase Bank One 58.8 SprintNextel 35.2 Wachovia BankGolden West Financial 25.5 Walt DisneyPixar 7.4 AdidasReebok

The Consolidation Process Why Consolidated Statements?  They are presumed to be more meaningful than separate statements.  They are considered necessary for fair presentation. “The consolidation of financial information into a single set of statements becomes necessary whenever a single economic entity is created by the business combination of two or more companies.” - - ARB No. 51 (August 1959) 2-5

Business Combinations SFAS 94 (October 1987) “Consolidated financial statements became common once it was recognized that boundaries between separate corporate entities must be ignored to report the business carried on by a group of affiliated corporations as the economic and financial whole that it actually is.” 2-6

Business Combinations “A business combination occurs when an enterprise acquires net assets that constitute a business or equity interests of one or more other enterprises and obtains control over that enterprise or enterprises.” - - SFAS No. 141 “A business combination occurs when an enterprise acquires net assets that constitute a business or equity interests of one or more other enterprises and obtains control over that enterprise or enterprises.” - - SFAS No

Business Combinations Exh. 2-2Continued 2-8

Business Combinations – Continued Exh

Parent Subsidiary The Sub still prepares separate financial statements Consolidated financial statements are prepared. The parent does not prepare separate financial statements Consolidation of Financial Information 2-10

Reminder: GAAP Accounting Methods 2-11

A Control Issue – SPE’s Special Purpose Entities (a popular type of “variable interest entity”) were misused to hide debt and manipulate earnings As a result, the FASB (in FIN 46R) expanded the definition of “control” beyond just the holding of a majority share position. The following indicate a controlling financial interest in a variable interest entity:  Direct or indirect ability to make decisions about the entity’s activities  Obligation to absorb any expected losses of the entity  The right to receive any expected residuals of the entity 2-12

What is to be consolidated? If dissolution occurs: All account balances are actually consolidated in the financial records of the survivor. If separate incorporation maintained: Financial statement information is consolidated on work papers and not in the actual records 2-13

When does consolidation occur? If dissolution occurs: Permanent consolidation occurs at the combination date If separate incorporation maintained: Consolidation (on work papers, not in the actual records!!) occurs regularly, whenever financial statements are prepared 2-14

How does consolidation affect the accounting records? If dissolution occurs: Dissolved company’s records are closed out. Surviving company’s accounts are adjusted to include all balances of the dissolved company If separate incorporation maintained: Each company continues to maintain its own records 2-15

When the acquisition is made by issuing stock, the cost of the acquisition equals the MARKET VALUE of the stock issued. Purchase Method – SFAS 141 Employed when there is a change in ownership resulting in control of one enterprise by another. The appropriate valuation basis for any purchase transaction is “cost”. (Total value assigned to the net assets received equals the total cost of the acquisition.) 2-16

Accounting Challenge!!! Allocation of “cost of acquisition” among the various assets and liabilities obtained. Allocation depends on the relation between total cost and “fair value” of the acquired firm’s assets and liabilities. FASB defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction of market participants at the measurement date.” (FASB, Statement of Financial Accounting Standards No. 157, Fair Value Measurements) 2-17

“Direct Costs” of Combination Typically includes fees to the following for advising services in arranging and structuring the combination:  Investment bankers  Accountants  Attorneys These must be included in determining the purchase “cost.” 2-18

Purchase Method Situations Dissolution of the acquired company: Purchase Price = Fair Value Purchase Price > FV Purchase Price < FV Separate incorporation maintained. Dissolution of the acquired company: Purchase Price = Fair Value Purchase Price > FV Purchase Price < FV Separate incorporation maintained. 2-19

Purchase Method - Dissolution Purchase Price = Fair Value Ignore the Equity and Nominal accounts of the acquired company. Determine fair value of the acquired company’s assets and liabilities. Prepare a journal entry to  recognize the cost of acquisition  incorporate the FV of the acquired company’s assets and liabilities into the acquiring company’s books. 2-20

Purchase Method - Dissolution Purchase Price = Fair Value BigNet agrees to pay $2,550,000 (cash of $550,000 and 20,000 unissued shares of its $10 par value common stock that is currently selling for $100 per share) for all of Smallport’s assets and liabilities. Smallport then dissolves itself as a legal entity. As is typical, the $2,550,000 fair value of the consideration transferred by BigNet represents the fair value of the acquired Smallport business. 2-21

Purchase Method - Dissolution Purchase Price = Fair Value 2-22

Purchase Method - Dissolution Purchase Price > Fair Value FV of acquired company’s assets and liabilities is added to acquiring company’s books. Difference between Acquisition Cost and FV of acquired assets and liabilities is allocated to identifiable intangible assets and to goodwill. Note: Goodwill should be viewed as a residual amount remaining after all other identifiable and separable intangible assets have been recognized. 2-23

Purchase Method - Dissolution Purchase Price > Fair Value 2-24

Purchase Method - Dissolution Purchase Price < Fair Value When fair value exceeds cost, full allocation of fair value is not possible. Current assets and liabilities should be consolidated at their fair value. Non-current assets should be proportionately reduced in value (with some exceptions) 2-25

Purchase Method - Dissolution Purchase Price < Fair Value According to SFAS 141, the following non- current assets are exceptions to the proportionate reduction, and should be recorded at assessed fair values:  Financial assets other than equity method investments  Assets to be disposed of by sale  Deferred tax assets  Prepaid assets related to pension or other post- retirement benefit plans 2-26

Purchase Method - Dissolution Purchase Price < Fair Value In the event that the difference is substantial enough to eliminate all the non-current asset balances of the acquired company The remainder is to be reported as an extraordinary gain (SFAS 141) In the event that the difference is substantial enough to eliminate all the non-current asset balances of the acquired company The remainder is to be reported as an extraordinary gain (SFAS 141) 2-27

Accounting for Additional Costs Associated with Business Combinations (SFAS 141) Direct combination costs (Accounting, legal, investment banking and appraisal fees, etc.) Include in the purchase price of the acquired firm Indirect combination costs (additional internal costs such as secretarial or managerial time) Expense as incurred Costs to register and issue securities Reduce the value assigned to the fair value of the securities issued (typically as a debit to APIC) 2-28

Let’s see what happens when the acquired company is not dissolved. 2-29

Purchase Method - No Dissolution The acquired company continues as a separate entity.  Reported on Parent’s books as the Investment in Subsidiary account. Separate records for each company are still maintained. The adjusted balances for the Parent and the Subsidiary are consolidated using a worksheet (no formal journal entries!) The acquired company continues as a separate entity.  Reported on Parent’s books as the Investment in Subsidiary account. Separate records for each company are still maintained. The adjusted balances for the Parent and the Subsidiary are consolidated using a worksheet (no formal journal entries!) 2-30

Steps for Consolidation 1.Record the financial information for both Parent and Sub on the worksheet. 2.Remove the Investment in Sub balance. 3.Remove the Sub’s equity account balances. 4.Adjust the Sub’s net assets to FV. 5.Allocate any excess of cost over BV to identifiable, separable intangible assets or goodwill. 6. Combine all account balances. 2-31

No Dissolution Example 2-32

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Purchase Price Allocations - Additional Issues, SFAS No. 141 Intangibles  Current and noncurrent assets that lack physical substance.  Do not include financial instruments. When should an Intangible be recognized?  Does it arise from contractual or other legal rights?  Can it be sold or otherwise separated from the acquired enterprise? Intangibles  Current and noncurrent assets that lack physical substance.  Do not include financial instruments. When should an Intangible be recognized?  Does it arise from contractual or other legal rights?  Can it be sold or otherwise separated from the acquired enterprise? 2-37

Purchase Price Allocations - Additional Issues, SFAS No. 141 Intangible Asset Examples Customer Base Trademarked Brand Names Customer Routes Effective Advertising Programs Covenants Rights (broadcasting, development, use, etc.) Customer Base Trademarked Brand Names Customer Routes Effective Advertising Programs Covenants Rights (broadcasting, development, use, etc.) Databases Technological know- how Patents & Copyrights Strong labor relations Assembled, trained workforce Favorable government relations Databases Technological know- how Patents & Copyrights Strong labor relations Assembled, trained workforce Favorable government relations Exh

Purchase Price Allocations - Additional Issues, SFAS No. 141 In-Process R&D  Should be expensed immediately upon acquisition (unless there are alternative future uses.) IPR&D that has reached technological feasibility, may be “capitalized”.  Determination of fair value is critical. In-Process R&D  Should be expensed immediately upon acquisition (unless there are alternative future uses.) IPR&D that has reached technological feasibility, may be “capitalized”.  Determination of fair value is critical. 2-39

Unconsolidated Subsidiaries 2-40

Proposed Changes In June 2005, FASB issued two Exposure Drafts:  Business Combinations (to replace SFAS 141)  Consolidated Financial Statements, Including Accounting and Reporting of Noncontrolling Interests in Subsidiaries (to replace ARB 51) (If approved, these will take effect for fiscal years beginning after December 15, They will be applied prospectively.) 2-41

The Acquisition Method Proposed as a replacement for the Purchase Method Requires measurement of fair value of the acquired business as a whole Requires measurement and recognition of the fair values of the separately identified assets acquired and liabilities assumed 2-42

Acquisition Methods – Key Changes Adopts a “business fair value” measurement approach as opposed to the traditional “cost-based” measure Direct combination costs will be expensed as incurred Contingent consideration obligations are recognized as part of the purchase price With bargain purchases, no assets will be recorded at less than fair value, which will produce recognized gains on purchase Allows for capitalization of Purchased In- Process Research and Development (IPR&D) 2-43

Capitalization of In-Process Research and Development Costs (IPR&D) To be recognized and measured at fair value on the acquisition date Reported as intangible assets with indefinite lives Subject to periodic “impairment reviews” 2-44

Related Costs of Business Combinations (Acquisition Method) Costs incurred for outside services (attorneys, appraisers, accountants, investment bankers, etc.) related to the combination are NOT considered part of the fair value received, and so are immediately expensed Internal costs of acquisition (secretarial and management time) are expensed as incurred. Costs to register and issue securities related to the acquisition reduce their fair value 2-45

Acquisition Method - Summary Consideration transferred equals fair values of net assets acquired Assets acquired and liabilities assumed are recorded at their fair values Consideration transferred is greater than the fair values of net assets acquired Assets acquired and liabilities assumed are recorded at their fair values. Excess consideration recorded as goodwill Consideration transferred is less than the fair values of net assets acquired Assets acquired and liabilities assumed are recorded at their fair values. Excess of fair value over consideration is recorded as gain on bargain purchase 2-46

Pooling of Interests Historically, many business combinations were accounted for as “Pooling of Interests.” Purchase Method In SFAS 141, “Business Combinations”, the FASB stated that all business combinations should be accounted for using the “Purchase Method”. Historically, many business combinations were accounted for as “Pooling of Interests.” Purchase Method In SFAS 141, “Business Combinations”, the FASB stated that all business combinations should be accounted for using the “Purchase Method”. 2-47

Pooling of Interests According to SFAS No. 141, the purchase method is not to be applied to past “Poolings of Interest.” Past poolings of interests are left intact by SFAS No Therefore, it is important to understand how to account for PAST poolings. According to SFAS No. 141, the purchase method is not to be applied to past “Poolings of Interest.” Past poolings of interests are left intact by SFAS No Therefore, it is important to understand how to account for PAST poolings. 2-48

In a pooling, one company obtained essentially “all” of the other company’s stock. The transaction involved the exchange of common stock. No exchange of cash was allowed. The ownership interests of two, or more, companies were combined into one new company. No single company was dominant. Precise cost figures were difficult to obtain. To use pooling of interests, 12 strict criteria had to be met. Historical Review of Pooling of Interests 2-49

Historical Review of Pooling of Interests The Book Values of the two combining companies were joined. No Goodwill was recorded. Revenues and expenses were combined retroactively for the two companies. 2-50

Historical Review of Pooling of Interests Both companies continued to exist. An Investment in Sub account was recorded on one company’s books (usually the larger). No Goodwill was recorded. Both companies were combined at BV. Both companies continued to exist. An Investment in Sub account was recorded on one company’s books (usually the larger). No Goodwill was recorded. Both companies were combined at BV. 2-51

Historical Review of Pooling of Interests Prior Period Adjustments were made to account for differences in the ways the two companies accounted for income. A journal entry was recorded to recognize the Investment in Subsidiary. The BV’s for both companies were entered on a consolidation worksheet. Prior Period Adjustments were made to account for differences in the ways the two companies accounted for income. A journal entry was recorded to recognize the Investment in Subsidiary. The BV’s for both companies were entered on a consolidation worksheet. 2-52

Accounting for Pooling of Interests in Subsequent Periods The Investment in Sub account must be eliminated.  Also eliminate the Sub’s Equity accounts to prevent double recording. (They have already been included in the original Investment in Sub entry.) Add together the BV’s of the remaining accounts. 2-53

Summary Consolidation of financial information is required when one organization gains control of another. If dissolution occurs, this consolidation is carried out at the date of acquisition and a single set of accounting records is maintained. If separate identities are maintained, consolidation is a periodic “worksheet” process not involving journal entries. Separate accounting records are maintained. The purchase method is currently GAAP, although the FASB has proposed changing to the Acquisition Method 2-54

Possible Criticisms The proposed “business fair value” measurement approach involves a departure from traditional “cost- based” measurement. This violates the Historic Cost Principle. The proposed capitalization of IPR&D departs from the traditional SFAS 2 approach of expensing R&D as incurred. WHAT DO YOU THINK? 2-55