1 Business Combination Two or more independent business entities combined into one larger accounting entity, with one firm acquiring control

2 Reasons Firms Combine  Vertical Integration  Cost Savings  Quick Entry into New Markets  Economies of Scale  More Attractive Financing Opportunities  Diversification of Business Risk  Business Expansion  Increasingly Competitive Environment 2-2

3 Recent Notable Business Combinations 2-3

4 Advantages of Combinations Structural –Horizontal Combination –Vertical Combination –Conglomerate Possible Tax Advantages –Accept stock to create a tax free reorganization –Transferable carry-forward feature of net operating losses –Net taxable income reported for the consolidated company

5 Consolidation Process Why Consolidated Statements? –Presumed to be more meaningful than separate statements. –Considered necessary for a 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

6 Types of Combinations Merger Consolidation Acquisition of Controlling Interest

7 Business Combinations 2-7

8 Business Combinations A business combination occurs when one enterprise acquires either the (1) net assets that constitute a business or (2) the equity interests of one or more enterprises - - SFAS No. 141

9 FASB Control Model  The FASB provides guidance and defines control when accounting for business combinations with this control model:  “A reporting entity has the power to direct the activities of another entity when it has the current ability to direct the activities of the entity that significantly affect the entity's returns.”  The power criterion defines control both operationally through “majority voting shares” and conceptually through contractual rights. 2-9

10 Acquisition of Control Acquire “Net Assets” –Acquire directly from target company –Assume liabilities –Payment in cash, debt, or equity Acquire Controlling Interest –Greater than 50% target’s voting common stock –Creates parent/subsidiary relationship –Separate legal and operating entities remain –External reporting --- single set of financial statements

11 Acquisition of Control Accounting Ramifications – Asset Acquisition –Acquiring company records assets and liabilities –Subsequent accounting procedures are same as for any single accounting entity Accounting Ramifications – Stock Acquisition –Parent records an investment –Parent and sub remain separate legal entities with their own separate sets of accounts and separate financial statements –Consolidated financial statements reflect presence of one economic entity (on workpapers only, not in the actual records!!)

12 The Acquisition Method  Used to account for business combinations.  Requires recognizing and measuring at fair value:  Consideration transferred for the acquired business  Noncontrolling interest  Separately identified assets and liabilities  Goodwill or gain from a bargain purchase  Any contingent considerations. 2-12

13 Fair Value Approaches  Market Approach – fair value can be estimated referencing similar market trades.  Income Approach – fair value can be estimated using the discounted future cash flows of the asset.  Cost Approach – estimates fair values by reference to the current cost of replacing an asset with another of comparable economic utility. 2-13

14 Acquisition Method What if the consideration transferred does NOT EQUAL the Fair Value of the Assets acquired? If the consideration is LESS than the Fair Value of the Assets acquired, we got a BARGAIN!! And we will record a GAIN on the acquisition!! If the consideration is MORE than the Fair Value of the Assets acquired, the difference is attributed to GOODWILL 2-14

15 Acquisition Method Example Purchase Price = Fair Value BigNet pays $2,550,000 ($550,000 cash 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 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. Dissolution of Subsidiary 2-15

16 Acquisition Method Example Purchase Price > Fair Value BigNet pays $3,000,000 ($1,000,000 cash 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 as a legal entity. The $3,000,000 fair value of the consideration transferred by BigNet is greater than the fair value of the acquired Smallport business. Dissolution of Subsidiary 2-16

17 Acquisition Method Example Purchase Price < Fair Value BigNet pays $2,000,000 by issuing 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 as a legal entity. The $2,000,000 fair value of the consideration transferred by BigNet is less than the fair value of the acquired Smallport business. Dissolution of Subsidiary 2-17

18 Related Costs of Business Combinations  Direct Costs of the acquisition (attorneys, appraisers, accountants, investment bankers, etc.) are NOT part of the fair value received, and are immediately expensed.  Indirect or Internal Costs of acquisition (secretarial and management time) are period costs expensed as incurred.  Costs to register and issue securities related to the acquisition reduce their fair value. 2-18

19 Acquisition Method – Consolidation Workpaper Example 2-19

20 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

21 Steps in Acquisition Process 1.Identify the acquirer (buyer) 2.Determine the acquisition date –Date used to establish fair value of the company acquired 3.Measure the fair value of the acquiree (seller) 4.Record the acquiree’s (seller) assets and liabilities that are assumed –Net assets = excess of assets over liabilities –Fair values are determined per FASB Statement 157 –Identifiable assets never include pre-existing goodwill –Only “new” goodwill is recorded in an acquisition

22 Valuation of Identifiable Assets and Liabilities Current assets recorded at fair value –Valuation accounts are not used Existing liabilities recorded at fair value Property, plant, and equipment recorded at fair value –Accumulated depreciation is not recorded Assets scheduled for sale record at net realizable value

23 Valuation of Identifiable Assets and Liabilities Acquiree was lessor of assets in use –Leases retain their definition if terms are not modified –Operating leases Recognize an intangible asset if terms are favorable Record an estimated liability if the terms are unfavorable Example: Excess of current payment over contractual amount$300 Remaining term of lease (months)60 Discount (annual rate)8% Asset (present value beginning mode)$14,894

24 Valuation of Identifiable Assets and Liabilities Acquiree acted as lessor –Leases retain their definition if terms are not modified –Operating lease Asset under lease is on books of acquiree Record at fair value Evaluate terms; record asset (liability) if favorable (unfavorable) to the acquiree/lessor Intangible assets not separately recorded –Arises from contractual or other legal rights or is separable –Identify and record separately –Allows for recognition that acquiree was barred from recognizing

25 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

26 Valuation of Identifiable Assets and Liabilities Research and Development –Fair values of tangible and intangible assets are recorded Contingent Assets and Liabilities –Possessed by acquiree on the acquisition date Liabilities Associated with Restructuring or Exit Activities –Existing liabilities to other entities Employee Benefit Plans –Asset if projected benefit obligation > plan assets –Liability if projected benefit obligation < plan assets Deferred Taxes

27 Recording the Acquisition Record all accounts at fair value If Price Paid > Fair Value --- Recognize Goodwill If Price Paid < Fair Value ---Recognize Gain on Acquisition Expense all acquisitions costs

28 Accounting by the Acquiree Record receipt of consideration Remove assets and liabilities at their book values Recognize gain or loss on sale of business Typical final step –Distribute consideration received to shareholders –Cease operations

29 Changes in Value During Measurement Period Values recorded on the acquisition date are considered provisional During the measurement period values assigned to accounts recorded during purchase may be adjusted to better reflect the value as of the acquisition date Note: Changes in value caused by events that occur after the acquisition date are not a part of this adjustment

30 Recording Contingent Consideration Acquirer agrees to additional consideration if identified triggers are met Contingent consideration that is payable in any form other than additional stock –Measure based on probability of achieving target –Include as part of consideration for determining goodwill or gain –Record as a contingent liability in acquisition entry Revalue consideration in measurement period –Adjust Goodwill and Liability

31 Recording Contingent Consideration Contingent consideration is additional stock –Treat as a change in estimate No liability is recorded on acquisition date When triggers are met reassign the original consideration assigned to the stock to a greater number of shares –Reduce additional paid-in capital –Record additional shares issued at par

32 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. 2-32

33 Pooling of Interests According to SFAS No. 141, the purchase method is not to be applied to past “Pooling of Interest.” Past Pooling of interests are left intact by SFAS No Therefore, it is important to understand how to account for PAST Pooling. According to SFAS No. 141, the purchase method is not to be applied to past “Pooling of Interest.” Past Pooling of interests are left intact by SFAS No Therefore, it is important to understand how to account for PAST Pooling. 2-33

34 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 2-34

35 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. 2-35

36 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. 2-36

37 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. 2-37

38 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. 2-38

39 I can’t take much more of this! End of Chapter 2