CHAPTER 7 NEW BASIS OF ACCOUNTING

FOCUS OF CHAPTER 7 Recognizing a New Basis of Accounting The Push-Down Basis of Accounting Leveraged Buyouts

Push-Down Accounting: What’s Important—Form or Substance? Rationale for Push-Down Accounting: – Relevant factor is the acquisition itself. – Form of the acquisition is NOT relevant. – Parent controls the “form of the ownership.” Parent can ALWAYS liquidate the subsidiary into a branch/division.

Push-Down Accounting: The 3 Step Implementation Process STEP 1: – Adjust all assets and liabilities to current values (“cleanses” the target’s G/L of OLD BASIS). Record GOODWILL as well. Offsetting credit is to Revaluation Capital. (As always, capital is shown by source.)

Push-Down Accounting: The 3 Step Implementation Process STEP 2: – Eliminate balance in the Accumulated Depreciation account. Thus depreciation cycle begins anew.

Push-Down Accounting: The 3 Step Implementation Process STEP 3: – Close out the balance in the Retained Earnings account to APIC. Thus retained earnings starts afresh.

Push-Down Accounting: When Is It Critical That It Be Used? Theoretically: Whenever a subsidiary issues its OWN financial statements to external users. GAAP Requirements: – Only the SEC mandates its use. (Only subsidiaries of publicly-owned companies fall under the SEC’s jurisdiction.) – The FASB has yet to require it.

Push-Down Accounting: Tastes Great And Less Filling Push-down accounting: – Easy to implement. – Record-keeping is on one set of books instead of two. – Consolidation effort is easy as pie.

Push-Down Accounting: Why Not Used Exclusively? – One of the great unsolved mysteries of accounting. – Inertia, stubbornness??? – Clinging to “the way we have always done it”!

Push-Down Accounting: Is There Hope on the Horizon? – YES! Practitioners tell us they are seeing it more and more.

Leveraged Buyouts: A Combination Purchase & Refinancing Basic Elements of a Leveraged Buyout: – Acquisition of a target’s assets or common stock. – Refinancing of the target’s debt structure—usually increased substantially. – Minimal equity investment by buyers.

Leveraged Buyouts: “Let’s Get Management In On The Act” An Additional Common Features of LBOs: – Existing management becomes part of the new ownership. – Existing management’s ownership is often as high as 50%. Such LBOs are often called “MBOs.” Advantage of Management Being Owners: – Alignment of interests occurs between management and remaining stockholders.

Leveraged Buyouts: They Are NOT Business Combinations Business Combinations: – One active business combines with another active business.

Leveraged Buyouts: They Are NOT Business Combinations Business Combinations: – A single corporation becomes the new owner of the target’s business. This one legal entity now controls the target’s business.

Leveraged Buyouts: They Are NOT Business Combinations Leveraged Buyouts: – A group of investors (and often the target’s management) acquire either The target’s assets or Some or all of the target’s common stock.

Leveraged Buyouts: They Are NOT Business Combinations Leveraged Buyouts: – After the buyout, the ownership of the target’s business may include any of the following groups: New investors. Management (at the same or a higher or lower level of ownership). Former nonmanagement owners.

Leveraged Buyouts: The Change in Control Concept A new basis of accounting is allowed ONLY IF: – A change in control occurs. To assess whether a change in control has occurred, the control group concept is used.

Leveraged Buyouts: The “Control Group” Concept The control group can consist of: – New investors and – Prior owners who did NOT previously have control. Could include: Management. Nonmangement owners who owned less than 50% of the outstanding stock.

Leveraged Buyouts: The Control Group Concept BEFORE: AFTER: CONTROL GROUP: 30% + 45% = 70% Management Nonmanagement Owners Owners (one individual) 10% + 90% = 100% Management Nonmanagement New Owners Owners Investors 30% + 25% + 45% = 100%

Leveraged Buyouts: Manner of Consummating The Buyout Creating a New Legal Entity (NLE): – Investors create an NLE. – Investors invest cash in NLE. – NLE acquires target’s common stock or assets. If common stock is acquired, NLE is merely a nonoperating company.

Leveraged Buyouts: Manner of Consummating The Buyout Reasons for Creating the New Legal Entity: – Facilitates the change in ownership control: Attaining the agreed upon ownership percentage of the various new owners is much easier to accomplish. – Enables NEW BASIS of accounting to be used for target’s assets (GAAP compliance). An important objective for most LBOs.

Leveraged Buyouts: The KEY Issue— Has A Change In Control Occurred? Significance of a Change in Control: – Enables use of a NEW BASIS of accounting for target’s assets. – New basis of accounting is highly important for most LBOs. Avoids reporting negative stockholders’ equity (NSE). Reporting NSE to lenders is highly undesirable.

Leveraged Buyouts: What Constitutes a Change in Control? The change in control must be: – Genuine – Substantive – Nontemporary If not—no change in basis of accounting (record transaction as a recapitalization).

Leveraged Buyouts: Accounting for a Change in Control Types of Changes in Control: – No continuing ownership situations: Enables 100% use of NEW BASIS of accounting (use Purchase procedures). – Continuing ownership situations: Results in partial use of NEW BASIS. Retains partial use of OLD BASIS. Applying can be somewhat involved.

Leveraged Buyouts: Continuing Ownership Situations In continuing ownership situations, the accounting depends on whether the continuing ownership percentage (hereafter C-O-P) – Increases or – Decreases.

Leveraged Buyouts: Continuing Ownership Situations C-O-P Increases: – Continuing owners are called bulls. C-O-P Decreases: – Continuing owners are called bears.

Leveraged Buyouts: C-O-P INCREASES Accounting Procedures: – Use OLD BASIS of accounting to the extent of the former ownership percentage that continues as owners. Called “carryover of predecessor basis.” Ignore their personal cost basis. – Use NEW BASIS of accounting for the remaining ownership interest.

Leveraged Buyouts: C-O-P DECREASES Accounting Procedures: – C-O-P Is BELOW 20%: Use NEW BASIS of accounting for entire transaction (with some exceptions). – C-O-P Is 20% or HIGHER: Use OLD BASIS of accounting to the extent of the former ownership percentage that continues as owners. Use NEW BASIS for remainder.

Review Question #1 In push-down accounting, which accounts are adjusted to a zero balance? A. Accumulated Depreciation. B. Additional Paid-in Capital. C. Retained earnings. D. Revaluation capital. E. Goodwill. F. None of the above.

Review Question #1 With Answer In push-down accounting, which accounts are adjusted to a zero balance? A. Accumulated Depreciation. B. Additional Paid-in Capital. C. Retained earnings. D. Revaluation capital. E. Goodwill. F. None of the above.

Review Question #2 In recording a leverage buyout, which accounts are adjusted to a zero balance? A. Accumulated Depreciation. B. Additional Paid-in Capital. C. Retained earnings. D. Revaluation capital. E. Goodwill. F. None of the above.

Review Question #2 With Answer In recording a leverage buyout, which accounts are adjusted to a zero balance? A. Accumulated Depreciation. B. Additional Paid-in Capital. C. Retained earnings. D. Revaluation capital. E. Goodwill. F. None of the above.

End of Chapter 7 Time to Clear Things Up—Any Questions?