The Guts of Acquisition Accounting Complex Deals: Class 4 The Guts of Acquisition Accounting Comprehensive acquisition accounting example Non-controlling interests Full fair value method vs. IFRS’s optional proportionate share method Contrasting consolidated financial statements with the equity method

PPA: The Overall Fair Value of the Acquired Entity May be Comprised of a Number of Distinct Pieces Fair value of consideration issued by acquirer to outside shareholders of target Direct consideration paid by acquirer to the Target’s shareholder’s or its Employees + Contingent Consideration (contingent options given to target shareholders as insurance) + Equity-based compensation / golden parachutes given to target’s employees for past services If acquirer buys < 100% of target, must add value of non-controlling stake to get fair value of target + Fair Value of non-controlling interests (if any) If acquirer has pre-existing non-controlling stake in target, this stake must be re-valued to fair value + Fair Value of pre-existing equity interests (if any)

Non-Controlling Interests Target Reflected at its Total Fair Value = Fair Value of Controlling + Fair Value Non-Controlling Interests Parent Parent controls the subsidiary (X > 50%) and must consolidate. Parent adds 100% of Subsidiary’s assets and liabilities to the balance sheet line-by-line even though Parent owns < 100% of Subsidiary. Non-Controlling Interests X % > 50% Outside Shareholders of Subsidiary Subsidiary (100 – X) % Requires a separate owners’ equity account to reflect consolidated net assets not owned by parent’s shareholders Consolidated Assets = Aparent + Asub Consolidated Liabilities = Lparent + Lsub Consolidated Owners’ Equity = OEparent + NCI in Sub’s Net Assets

Acquisition Accounting with NCI: Example Deal Structure: A acquires 90% (45M / 50M shares) of T ’s outstanding voting common stock for a cash offer price of $17 /shr on 12/31/20 Pre-deal Balance Sheets (in millions (M)): A T Cash $ 700 $ 200 Intangibles 500 – Goodwill – 30 PP&E, net 200 150 Total Assets $ 1,400 $ 380 Long-term debt 300 80 Equity 1,100 300 Total Liabilities & Equity $ 1,400 $ 380

Additional Deal Information and Assumptions A issues debt in the amount of $765M to finance the stock acquisition. The financing fee for issuing the acquisition debt is 2% ($765*.02 = $15.3M) $17/share used to value the non-controlling interests ($17 * 5M shares = $85M) Fair value of T ’s separable intangibles is $300M. These intangibles are carried at zero on T’s per-deal balance sheet. Fair value of T ’s PP&E is $300M, but carried at $150M on T’s pre-deal balance sheet. T ’s long term debt is fairly valued at $80M. Transaction fees (including advisory fees, accountant and lawyer fees) of $25M are paid in cash on the deal closing date. Ignore all tax implications for this deal.

Sources and Uses of Funds Statement Cash Paid for 90% of T’s Equity $ 765.0 = $17/shr × 45M shares Transaction Fees 25.0 (given) Financing Fees on new debt 15.3 = 2% × $765 Total Uses of Funds $ 805.3 Sources of Funds: Balance Sheet Cash $ 40.3 = $25 + $15.3 Stock Issuance 0.0 (given) Acquisition Debt 765.0 (given) Total Sources of Funds $ 805.3

Purchase Price Allocation: NCI at Full Fair Value (required under U. S Purchase Price Allocation: NCI at Full Fair Value (required under U.S. GAAP; optional under IFRS) Fair Value of 100% of T: – 100% of BVNAT: = Unamortized Differential: (1) Write-up PP&E to fair value: (2) Write-up Intangibles to Fair Value: (3) Write-off of T ’s “Old” Goodwill: – Net Asset Write-ups: = Total Goodwill: $ 765+$85 = $850 = Controlling + NCI (300) $ 550 $ 150 =Revalue PP&E to $300 300 =Value intangibles @ $300 (30) (420) $ 130 FVINAT = BVNAT + Net Asset Write-up = $300 + $420 = $720 Fair Value of 100% of T = FVINAT + Goodwill = $720 + 130 = $850

Digression: Proportionate Share Method (U. S Digression: Proportionate Share Method (U.S. GAAP not allowed; IFRS optional) Under IFRS, firms have the option of Measuring NCI and Goodwill at full fair value (as in U.S. GAAP), or Measuring NCI at its proportionate share of FVINA => Deal measured at: 100 % FVINA + the Controlling Interest’s share of goodwill Difference between 1 & 2 is that Goodwill is not recognized for the NCI under 2! From the previous slide under full fair value: NCI = $85 and GW = $130 Under proportionate share method: NCIproportionate =FVINAT * NCI% or $720*.10 = $72. GWproportionate = (1- NCI% ) * GWfull fair value = .90 * $130 = $117 $ 765 = $17/shr × 45M shares (648) = 90% × $720 117 = $765 – $648 Fair value of 90% of T: 90% of FVINA of T ’s : = Goodwill (Controlling Interest)

Purchase Price Allocation: Proportionate Share Method (U. S Purchase Price Allocation: Proportionate Share Method (U.S. GAAP not allowed; IFRS optional) Fair Value of 100% of T: – 100% of BVNAT: = Unamortized Differential: (1) Write-up PP&E to fair value: (2) Write-up Intangibles to Fair Value: (3) Write-off of T ’s “Old” Goodwill: – Net Asset Write-ups: = Total Goodwill: $ 765+$72 = $837 = Controlling + NCI (300) $ 537 $ 150 =Revalue PP&E to $300 300 =Value intangibles @ $300 (30) (420) $ 117 FVINAT = BVNAT + Net Asset Write-up = $300 + $420 = $720 Fair Value of 100% of T = FVINAT + Goodwill = $720 + 117 = $837

Deal Closing Journal Entries (using Full Fair Value Method) Record the fair value of 100% of T, the issuance of acquisition debt plus financing fees and non-controlling interest (NCI) at fair value: Investment in T (temporary account) $ 850.0 Transaction Fees (Expense) 25.0 Capitalized Financing Fees 15.3 Acquisition Debt $ 765.0 Cash 40.3 Non-controlling Interest (NCI) (Equity) 85.0 Note: Debt issuance fees are capitalized under and amortized to interest expense over the duration of the debt. Any costs associated with equity issuance are treated as a reduction of APIC

Deal Closing Journal Entries (using Full Fair Value Method) Remove ‘Investment in T’ and replace it with T’s revalued balance sheet from PPA: T ’s book value of assets and liabilities The write-ups to bring T’s assets and liabilities to fair value Goodwill of $130 Cash – T (1) $ 200 PP&E – T (1) 150 PP&E – T (2) $ 150 Intangible – T (2) 300 Goodwill (3) 130 LT-Debt – T(1) $80 Investment in T (temporary account) $ 850 Note: all we have done is replaced the value of T, $850, with the detailed fair values of the underlying assets and liabilities that comprise T.

Acquisition Method: A’s Post-Deal Balance Sheet A T Adj. Consolidated Cash $ 700 $ 200 (40.3) $ 859.7 PP&E, net 200 150 150.0 500.0 Intangibles 500 0 300.0 800.0 Capitalized Financing – – 15.3 15.3 Old Goodwill 30 (30.0) 0 Goodwill (CI + NCI) – - 130.0 130.0 Total Assets $ 1,400 $380 525.0 $2,305.0 Long-term Debt $ 300 $ 80 $ 380.0 Senior Acquisition Debt – – 765.0 765.0 Equity (CI) 1,100 300 (325.0)* 1,075.0 Equity (NCI) – – 85.0 85.0 Total Liabilities & Equity $ 1,400 $ 380 525.0 $2,305.0 * Eliminate T’s equity ($300) and reflect $25 transactions cost expense as reduction of A’s Retained Earnings

Recall Structure of the Equity Method Parent Subsidiary x % Parent’s Balance Sheet Subsidiary’s Balance Sheet Although the accounting for A’s acquisition of T requires consolidation due to control, we next consider what this deal looks like under the equity method for comparison purposes.

Equity Method PPA: Focuses only on A’s slice of T Consideration for 90% of T’s Equity: – 90% of BVNAT: = Unamortized Differential: (1) PP&E Step-up: (2) Unrecognized Intangibles: (3) Write-off of T ’s Goodwill: – Net Asset Step-ups: = Total (Implied) Goodwill: $ 765 = $17/shr × 45M shares (270) = 90% × $300 $ 495 $ 135 = 90% × ($300 – $150) 270 = 90% × ($300 – $0) (27) = 90% × ($0 – $30) (378) = 90% × (FV – BV) $ 117

Equity Method: Deal Journal Entries Record the acquisition of 90% of T, the issuance of acquisition debt along with the associated financing fees, transaction fees: Investment in T $ 765.0 Transaction Fees (Expense) 25.0 Capitalized Financing Fees 15.3 Acquisition Debt $ 765.0 Cash 40.3

(2) Equity Method: A’s Balance Sheet on 12/31/20 Cash $ 659.7 = $700 – $40.3 Identifiable Intangibles 500.0 PP&E, net 200.0 Investment in T 765.0 = $765 (buried GW = $117) Capitalized Financing Costs 15.3 = $765 × 2% Total Assets $ 2,140.0 Long-term Debt 300.0 Senior Acquisition Debt 765.0 (Acquisition Debt) Equity 1,075.0 = $1,100 – $25 transaction fees Total Liabilities & Equity $ 2,140.0

Balance Sheet Comparison on 12/31/20 (1) (2) Consolidation Equity A T Method Cash $ 700 $ 200 $ 859.7 $ 659.7 PP&E, net 200 150 500 200 Intangibles 500 0 800 500 Capitalized Financing – – 15.3 15.3 Investment in T – – – 765 Goodwill (CI + NCI) – 30 130 – Total Assets $ 1,400 $ 380 $ 2,305 $ 2,140 Long-term Debt $ 300 $ 80 $ 380 $ 300 Senior Acquisition Debt – – 765 765 Total Liabilities 300 80 1,145 1,035 Equity (NCI) – – 85 – Equity (CI) 1,100 300 1,075 1,075 Total Equity 1,100 300 1,150 1,075 Total Liabilities & Equity $ 1,400 $ 380 $ 2,305 $ 2,140 A’s Post-Deal Balance Sheet Pre-Deal Standalone Balance Sheets

Acquisition Accounting Post-acquisition Stand-alone income statements for 2021 before acquisition accounting considerations A T Sales $ 200 $ 150 Cost of Goods Sold (100) (50) Gross Profit $ 100 $100 SG&A Expense (25) (30) Amortization Expense (10) – Depreciation Expense (5) (10) Net Income $ 60 $ 60 Objective of example: Construct A’s “pro-forma” post-acquisition Income Statement for 2021 assuming A prepares: (1) Consolidated financial statements. (2) “Parent-only” financial statements using the equity method. Reconcile differences between the two accounting treatments.

Additional Information and Assumptions A issues 5-year senior notes in the amount of $765 to finance the stock acquisition. The interest rate on this debt is 5% and Financing fee for issuing this debt is 2% and amortized straight-line over 5 years. $300 fair value write-up established for T’s identifiable definite-lived intangible assets. The average useful life for these finite-lived intangibles is 20 years. The fair value of T ’s PP&E is $300 with an average useful life of 15 years. T declares and pays dividends of $10 during 2011. $17 per share used for valuing the stake of the non-controlling interests ($17 * 5M shares = $85) T ’s long term debt is fairly valued at $80. Transaction fees (including advisory fees, etc.) of $25 are paid in cash on the deal closing date. Ignore all tax implications for this deal.

Acquisition Accounting Entries in 2021: Note: T’s Standalone financial statements do not reflect Acquisition Accounting adjustments Depreciation Expense $ 10 PP&E, net $ 10 (100% of Step-up in T ’s PP&E / Useful Life = $150 / 15 years = $10) Amortization Expense 15 Identifiable Intangibles 15 (100% of T ’s Unrecognized Intangibles /Useful Life = $300 / 20 years = $15) Interest Expense $ 3.1 Capitalized Financing Costs $ 3.1 (Capitalized Financing Costs/ Amortized Life = $15.3 / 5 years = $3.1) Interest Expense 38.3 Cash 38.3 (5% Interest on A’s Acquisition Debt = $765 × 0.05 = $38.3) Record deprecation and amortization of asset write-ups Amortize capitalized financing costs on A’s books Record A’s interest expense on acquisition debt

Acquisition Method: Pro Forma Combined Statement of Income for 2021 2021 Stand-Alone A T Adj. Consolidated Sales $ 200 $ 150 – $ 350.0 COGS (100) (50) – (150.0) Gross Profit 100 100 – 200.0 SG&A & Interest Expense (25) (30) (41.4) (96.4) Amortization Expense (10) – (15.0) (25.0) Depreciation Expense (5) (10) (10.0) (25.0) Total Net Income $ 60 $ 60 (66.4) 53.6 Income Attributable to NCI – – (3.5) (3.5) Net Income Attributable to A $ 60 $ 60 $ (69.9) $ 50.1

Computation of Net Income Attributable to NCI in 2021 T ’s Stand-alone Net Income $ 60.0 Incremental Expenses from Fair Value Adjustments: Incremental Depreciation (10.0) Incremental Amortization (15.0) T ’s Net Income (After Merger Adjustments) 35.0 Non-controlling Interest Ownership 10.0 % Net Income Attributable to NCI $ 3.5

Acquisition Method: Consolidated Balance Sheet on 12/31/21 Cash $ 965.4 (from Statement of Cash Flows) Intangibles 775.0 = $800 – ($15 + $10) PP&E, net 475.0 = $500 – ($5 + $10 + $10) Capitalized Financing Costs 12.2 = $15.3 – $3.1 Goodwill 130.0 (not amortized) Total Assets $ 2,357.6 Long-term Debt $ 380.0 Senior Acquisition Debt 765.0 Total Liabilities $ 1,145.0 Equity (CI) $ 1,125.1 = $1,075 + $50.1 Equity (NCI) 87.5 = $85 + $3.5 – $1 Total Equity $ 1,212.6 Total Liabilities & Equity $ 2,357.6

Acquisition Method: Controlling Interest’s (CI) Equity on 12/31/21 Post-Deal Equity (CI) Balance (12/31/20) $ 1,075 + A’s Consolidated Net Income 50.1 – Dividends Paid to A’s Shareholders (0) Equity (CI) End Balance (12/31/21) $ 1,125.1

Acquisition Method: Non-controlling Interest (NCI) on 12/31/21 Equity (NCI) Beg. Balance (12/31/20) $ 85.0 + T ’s Net Income Attributable to NCI 3.5 – Dividends Paid to NCI (10% of T’s $10 dividend) (1.0) Equity (NCI) End Balance (12/31/21) $ 87.5

Acquisition Method: Pro Forma Combined SCF for Year Ended 2021 Total Net Income $ 53.6 + Amortization Expense: 25.0 + Depreciation Expense: 25.0 + Amortization of Capitalized Financing Costs 3.1 Cash Flows from Operating Activities $ 106.7 Cash Flows from Investing Activities 0.0 – 10% of T’s $10 Dividend paid to NCI (1.0) Cash Flows from Financing Activities (1.0) Net Increase (Decrease) in Cash $ 105.7 Beginning Cash (01/01/21) 859.7 Ending Cash (12/31/21) $ 965.4

“Parent Only” financial statements using the equity method: Deal related journal entries in 2021 i. Record A’s share of T ’s income for 2021 Investment in T $ 54 Equity income in T $ 54 (NOTE: 90% of T ’s Net Income = $60 × 0.90 = $54) ii. Record receipt of dividend from T in 2021 Cash 9 Investment in T 9 (NOTE: 90% of Dividend Paid by T = $10 × 0.90 = $9) Investment in T 12/31/10 765 54 (i) 9 (ii) 12/31/11 20 21

Equity Method: Other Deal Adjustments in 2021 ((iii) Depreciation Expense $ 9 Investment in T $ 9 90% of Step-up in T ’s PP&E /Useful Life= [ $150 / 15 years] × 0.90 = $9 (IV) Amortization Expense 13.5 Investment in T 13.5 90% of T ’s Unrecognized Intangibles / Intangible Useful Life = [ $300 / 20 years] × 0.90 = $13.5 Interest Expense (SG&A) $ 3.1 Capitalized Financing Costs $ 3.1 (Capitalized Financing Costs/ Amortized Life = $15.3 / 5 years = $3.1) Interest Expense (SG&A) 38.3 Cash 38.3 (5% Interest on A’s Acquisition Debt = $765 × 0.05 = $38.3) Record 90% of deprecation and amortization of asset write-ups (and reflect in Investment in T 20 21 Amortize capitalized financing costs on A’s books Record A’s interest expense on acquisition debt

Equity Method: A’s Income Statement for 2021 Income Statement (2021) A Sales $ 200.0 (A’s standalone revenue) COGS (100.0) (A’s standalone COGS) Gross Profit $ 100.0 (A’s standalone gross profit) Equity Income in T 31.5 = $54 – $9 – $13.5 SG&A & Interest Expense (66.4) = $25 + $3.1 + $38.3 Amortization Expense (10.0) (A’s standalone amortization) Depreciation Expense (5.0) (A’s standalone depreciation) Net Income $ 50.1

Equity Method: A’s Balance Sheet on 12/31/21 Cash Intangibles PP&E, net Investment in T Capitalized Financing Costs Total Assets Long-term Debt Senior Acquisition Debt Equity Total Liabilities & Equity $ 705.4 (from Statement of Cash Flows) 490.0 = $500 – $10 195.0 = $200 – $5 787.5 = $765 + ($31.5 – $9) 12.2 = $15.3 - $3.1 $ 2,190.1 300.0 765.0 (Acquisition Debt) 1,125.1 = $1,075 + $50.1 $ 2,190.1

Equity Method: A’s Cash Flow Statement (2021) A’s Net Income $ 50.1 – Equity Income in T (31.5) + Dividends from T (90%*$10) 9.0 + Amortization Expense: 10.0 + Depreciation Expense: 5.0 + Amortization of Capitalized Financing Costs 3.1 Cash Flows from Operating Activities $ 45.7 Cash Flows from Investing Activities 0.0 Cash Flows from Financing Activities 0.0 Net Increase (Decrease) in Cash $ 45.7 Beginning Cash (01/01/21) 659.7 Ending Cash (12/31/21) $ 705.4

2021 Income Statements: Consolidation versus Parent Only (equity method) (1) (2) Consolidation Equity A T Method Sales $ 200 $ 150 $ 350.0 $ 200.0 Cost of Goods Sold (COGS) (100) (50) (150.0) (100.0) Gross Profit $ 100 $ 100 $ 200.0 $ 100.0 Equity Income in T – – – 31.5 SG&A Expense (25) (35) (96.4) (66.4) Amortization Expense (10) – (25.0) (10.0) Depreciation Expense (5) (10) (25.0) (5.0) Net Income Attributable to NCI – – (3.5) – Net Income $ 60 $ 60 $ 50.1 $ 50.1 A’s Post-Deal 2021 Statement of Income 2021 Stand-Alone Income Statements

12/31/21 Balance Sheets: Consolidation versus Parent Only (equity method) (1) (2) Consolidation Equity Method Cash $ 965.4 $ 705.4 PP&E, net 475.0 195.0 Intangibles 775.0 490.0 Capitalized Financing 12.2 12.2 Investment in T – 787.5 Goodwill (CI + NCI) 130.0 – Total Assets $ 2,357.6 $ 2,190.1 Long-term Debt $ 380.0 $ 300.0 Senior Acquisition Debt 765.0 765.0 Total Liabilities $1,145.0 $ 1,065.0 Equity (NCI) 87.5 – Equity (CI) 1,125.1 1,125.1 Total Equity $ 1,212.6 $ 1,123.9 Total Liabilities & Equity $ 2,357.6 $ 2,190.1 A’s 12/31/21 Balance Sheets