1 Chapter 8 - Appendix A Business Combinations 1. Types of business combinations 2. Purchase accounting 3. Consolidation of purchased subsidiaries a. Consolidation process b. Recognition of minority interest c. Consolidated versus unconsolidated 4. Consolidation of foreign subsidiaries

2 1. Types of Business Combinations Mergers - occur when one company acquires all of the assets and liabilities of another company, and the acquired company is dissolved. – Journal entry on acquiring company’s books: Assetsxx Liabilitiesxx Cash, etc.xx – Note that this is a “shortcut” explanation. Actually, a statutory merger requires that the acquiring company purchases all of the outstanding common stock of the acquired company, then dissolve the acquired company (no longer a separate legal entity). The assets and liabilities of the acquired company are absorbed into the acquiring company’s books, including any goodwill that is recognized in the merger.

3 1. Types of Business Combinations Acquisitions – Acquisitions occur when one company acquires at least 50% of the common stock of another company; both companies continue to operate as separate legal entities, and maintain separate sets of books. This is called a parent/subsidiary relationship. – Journal entry on acquiring company’s books: Investment in Subsidiaryxx Cash, etc.xx – Note that, at the end of each reporting period, the books of the parent and subsidiary must be combined when reporting to the parent’s investors. This is called a “consolidation.”

4 1. Types of Business Combinations Once a merger is completed, there is now one legal entity, and no additional accounting issues exist. For an acquisition, the acquiring company must perform consolidating journal entries each year to combine the parent and subsidiary. The balance of this chapter is devoted to acquisitions.

5 2. Purchase Accounting Purchase accounting is based on the fair market value of an exchange transaction. An acquisition treated as a purchase first values the fair market value of the things given up in the exchange. This can include cash, debt, preferred stock, or common stock. The value of the cash, debt, equity, etc. becomes the value of the investment acquired. Goodwill is implied in the investment account, as is any asset revaluation.

6 2. Purchase Accounting The journal entry to record the acquisition as a purchase might take the following forms: – for cash: Investment in Subxx fair mkt. value Cashxx fair mkt. value – with the issue of common stock: Investment in Subxx fair mkt. value Common Stockxx par value APIC xx excess – (The credit to CS and APIC is the same as if the CS had been issued for cash.)

7 2. Purchase Accounting Note that the investment account contains the following information: – fair value of the net assets of the sub. – goodwill recognized on acquisition of the sub. Alternatively, the investment account contains the following information: – book value of the net assets of the sub. – revaluation of the net assets of the sub. – goodwill recognized on acquisition of the sub. This will become important in the consolidation process.

8 3. Consolidation of Purchased Subsidiaries General Information – Required for parent/sub relationships (over 50% of the common stock of the sub is owned by the parent). – Performed to give a better picture of the overall structure and performance of the combined entity.

9 3. Consolidation of Purchased Subsidiaries a. Procedure – The parent uses the equity method of accounting to record income from the investment during the year. – At the end of the year, the separate financials of parent and sub are posted to a worksheet. – The sub’s column represents the “book value” of the net assets acquired. – Any assets and liabilities of the sub that need to be revalued (to match the assumptions at acquisition), are revalued in a consolidating journal entry posted only to the worksheet. – Any goodwill (that was assumed at acquisition) is recognized in a consolidating journal entry, and subsequently written down if the related assets are impaired.

10 3. Consolidation of Purchased Subsidiaries a. Comments on Procedure - see Figure 8A-4 – Note that the subsidiary does not revalue its books at acquisition; it is the parent that assumes revaluation. – Note that the subsidiary does not recognize goodwill on its books at acquisition; it is the parent that implies this recognition in the Investment account. – The investment account is replaced by the assets and liabilities of the subsidiary, and goodwill is recognized explicitly in the consolidation process. – We will focus only on the recognition of goodwill in this chapter, since it is usually the largest single asset recognized in acquisitions.

11 3. Consolidation of Purchased Subsidiaries b. Recognition of Minority Interest - see Figure 8A-6 – If the subsidiary is less than 100% owned (but still greater than 50%), the parent still adds all of the subs assets and liabilities, and all of the subs revenues and expenses in the consolidation. – The parent must then recognize that part of the subsidiary belongs to a “Minority Interest” when reporting the results to the parent’s shareholders.

12 3. Consolidation of Purchased Subsidiaries b. Recognition of Minority Interest – On the consolidated balance sheet, this amount is often presented between liabilities and equity. It represents the minority interest claim to the assets and liabilities of the subsidiary. – On the consolidated income statement, there is a line that indicates “Minority Interest in Net Income.” This amount is subtracted from total net income, to get to the portion of income that belongs to the parent.

13 3. Consolidation of Purchased Subsidiaries c. Consolidated versus Unconsolidated F/S – Consolidated F/S show more detail as to the structure of the combined entity, but the performance of the subsidiary (or subsidiaries) can be lost in the tradeoff. – Sometimes the detail of the structure and performance of the separate subsidiary can be found in the F/S notes regarding “segment” activity, but only if the subsidiary qualifies as a reportable segment. – Some parent companies will also present “Parent Company” financials in addition to consolidated financials. The parent company statements show the same equity, but the subs activity is unconsolidated and shown in “Investment in Sub.” and “Income from Sub.”

14 3. Consolidation of Purchased Subsidiaries c. Consolidated versus Unconsolidated F/S – Note that the consolidation will not change total equity, but it will change total assets and liabilities. – This can change any ratios that deal with assets and liabilities (return on assets, debt to equity). – The FASB believes that consolidated financials reveal more about the asset and liability structure of a company. Unconsolidated financials would not show separate liabilities of the subs. – Sometimes consolidations may cloud certain patterns such as sales growth. A newly acquired subsidiary might significantly boost consolidated revenue (and the reverse is true when a subsidiary is sold). Disclosure can help clarify some of the issues.

15 4. Consolidation of Foreign Subsidiaries Foreign subsidiaries often operate with accounting standards that are different from US GAAP, and the financials must be converted to US GAAP before they can be consolidated. Foreign subsidiaries often operate in a “functional” currency that is not the US dollar. These subsidiaries must first be converted to the US dollar before they can be consolidated with the US parent. Once the financials are converted to US GAAP and US dollars, the rest of the consolidation is the same as in part 3.

16 4. Consolidation of Foreign Subsidiaries The process to convert the foreign sub’s financial statements to the US dollar uses the following rules (SFAS 52) to translate the financials: Assets and liabilities are converted at the current rate (at the balance sheet date). Equity is translated at the historical rate in effect at the date of the transaction.

17 4. Consolidation of Foreign Subsidiaries Different equity accounts are translated at specific historical rates in effect at the date of the transaction: – common stock and APIC at the date of issue. – retained earnings components at various historical rates: dividends converted at the date of declaration. revenues and expenses are converted at the average rate for the year (this is a substitute for using the individual historical rates for each revenue and expense transaction).

18 4. Consolidation of Foreign Subsidiaries After everything is converted to dollars, the sub’s balance sheet will not balance. The “plug” or residual amount to bring the balance sheet into balance is the Translation Adjustment (or Cumulative Translation Adjustment). The TA is a debit or credit plug to Stockholders’ Equity. A credit plug adds to the other equity accounts. A debit plug is treated as a contra. The interpretation of the TA is that it will not become part of income until the sub is sold.

19 4. Consolidation of Foreign Subsidiaries Example of calculation of translation adjustment. Given the following information of Beattie Company, a British subsidiary, at December 31, 2005: All amounts below are in British pounds: Balance Sheet Assets Liabilities and SE Cash 15,000A/P 55,000 A/R 114,000Long-term debt 132,000 Inventories 55,000Common stock 134,000 Plant assets 162,000Retained earn. 25,000 Total Assets 346,000 Total Liab. & SE 346,000 Statement of Retained Earnings Retained Earnings, 1/1/05 0 Add: Net income for ,000 Less: Dividends for 2005 (10,000) Retained Earnings, 12/31/05 25,000

20 4. Consolidation of Foreign Subsidiaries Given the following additional information for Beattie Company: 1. Exchange rates during 2005: 1/1/05$1.50 per pound 9/1/ per pound 12/31/ per pound Average 1.54 per pound 2. The common stock was issued on 1/1/ The cash dividend was declared on 9/1/ Income is earned evenly throughout 2005.

21 4. Consolidation of Foreign Subsidiaries Solution: Assets346,000 x $1.60 = $553,600 Liab. and SE Liab. (55+132)187,000 x $1.60 = $299,200 Common Stock134,000 x $1.50 = 201,000 Retained Earnings: Beginning Net income 35,000 x $1.54 = 53,900 - Dividends(10,000)x $1.57 = (15,700) Total Liab. and SE (excluding TA) $538,400 Translation adjustment (credit)15,200 Total Liab. and SE (same as total assets) $553,600 Note that the TA, whether debit or credit, is presented as part of total stockholders’ equity (as part of “other comprehensive income”).

22 4. Consolidation of Foreign Subsidiaries The effect of the TA on equity is equivalent to the effect of an “unrealized gain or loss on AFS investments.” No gain or loss is realized on translation is realized until the subsidiary is sold. If the subsidiary continues to operate indefinitely in the foreign country, any translation gain or loss is deferred. Rationale: if the foreign subsidiary is operating in the foreign currency of the foreign country, and is not “exchanging” the foreign currency for US dollars, then no gain or loss should be recognized in the income statement.