1. Slide 4-1 4 CHAPTER 4 INTRODUCTION TO BUSINESS COMBINATIONS

2. Slide 4-2 4 FOCUS OF CHAPTER 4 l Business Combinations (EXTERNAL expansion): l Legal Considerations l The Arena in Which Takeover Battles Are Waged l Purchase Accounting l Accounting for Goodwill l Appendix: Income Tax Considerations

3. Slide 4-3 4 The Purchase Method: A Whole New Basis of Accounting is Established lThe new basis of accounting is based on the acquirer’s purchase price. lThe depreciation cycle for fixed assets begins a new at a higher or lower level. lIf cost > CV, goodwill exists. Recognize as an asset--do not amortize. Evaluate periodically for possible impairment. lIf cost < CV, a bargain purchase element (or “negative goodwill”) exists.

4. Slide 4-4 4 The Pooling of Interests Method: No Longer Allowed lThe target company’s basis of accounting in its assets is used by the consolidated group. lThe depreciation cycle merely continues along as if no business combination had occurred. l Goodwill is NEVER recognized--thus future income statements will NOT have goodwill expense. Managements loved it.

5. Slide 4-5 4 Acquiring ASSETS Versus Acquiring COMMON STOCK: Often a Major Issue l Major Decision Factors: n Legal considerations-- Buyer must be extremely careful NOT to assume responsibility for (and thus “inherit”) the target company’s: s Unrecorded liabilities. s C ontingent liabilities (lawsuits).

6. Slide 4-6 4 Acquiring ASSETS Versus Acquiring COMMON STOCK: Often a Major Issue l Major Decision Factors (continued) : n Tax considerations-- Often requires major negotiations involving resolution of: s Seller’s tax desires. s Buyer’s tax desires. n Ease of consummation-- Acquiring common stock is simple compared with acquiring assets.

7. Slide 4-7 4 Acquiring ASSETS: Advantages and Disadvantages l Major Advantages of Acquiring Assets: n Will NOT inherit a target’s contingent liabilities ( excluding environmental). n Will NOT inherit a target’s unwanted labor union. l Major Disadvantages of Acquiring Assets: n Transfers of titles on real estate and other assets can be time-consuming. n Transfer of contracts may NOT be possible.

8. Slide 4-8 4 Acquiring COMMON STOCK: Advantages and Disadvantages l Advantages of Acquiring Common Stock: n Will make transfer quite easy. n Will inherit nontransferable contracts. l Disadvantages of Acquiring Common Stock: n Will inherit contingent liabilities and an unwanted labor union. n Will acquire unwanted facilities/units. n Will be hard to access target’s cash.

9. Slide 4-9 4 Business Combinations: Organizational Forms that Can Result lThe focus is on what property is received-- NOT on what property is given.

10. Slide 4-10 4 Organizational Forms: Types of Property that Can Be Received l Common Stock-- Results in a parent- subsidiary relationship. l Target’s Assets-- Results in a home office- branch/division relationship. P S Home Office Branch/Division P controls S 1 legal entity 2 legal entities

11. Slide 4-11 4 Organizational Forms: Specialized Options l Option #1: STATUTORY MERGER : n A temporary parent-subsidiary relationship is created. n The parent then liquidates the subsidiary into the parent pursuant to state laws. n The result: ONE legal entity survives.

12. Slide 4-12 4 Organizational Forms: Specialized Options l Option #2: STATUTORY CONSOLIDATION : n New corporation (TOPCO) is created. n TOPCO issues stock to BOTH combining companies in exchange for their o/s stock. n Each combining company becomes a temporary subsidiary of TOPCO n Both subs are liquidated into TOPCO and become divisions. n Result: ONE legal entity survives.

13. Slide 4-13 4 Organizational Forms: Specialized Options l Option #3: HOLDING COMPANY: n Similar to a statutory consolidation except that the two subsidiaries are NOT liquidated into TOPCO. TOPCO PS 3 legal entities

14. Slide 4-14 4 Review Question #1 l To qualify for for purchase accounting treatment: A. One company must acquire common stock of the other combining company. B. A statutory consolidation must occur. C. Each company must be approximately the same size. D. A stock-for-stock exchange must occur. E. None of the above.

15. Slide 4-15 4 Review Question #1--With Answer l To qualify for for purchase accounting treatment: A. One company must acquire common stock of the other combining company. B. A statutory consolidation must occur. C. Each company must be approximately the same size. D. A stock-for-stock exchange must occur. E. None of the above.

16. Slide 4-16 4 Review Question #2 l In purchase accounting: A. Common stock must be the consideration given. B. Goodwill is not reported. C. A statutory merger occurs. D. A change of basis in accounting occurs. E. None of the above.

17. Slide 4-17 4 Review Question #2--With Answer l In purchase accounting: A. Common stock must be the consideration given. B. Goodwill is not reported. C. A statutory merger occurs. D. A change of basis in accounting occurs. E. None of the above.

18. Slide 4-18 4 Review Question #3 l In purchase accounting: A. Preferred stock must be the consideration given. B. Goodwill is always reported. C. A holding company must be created to effect the merger. D. Financial reporting symmetry occurs between the two combining companies. E. None of the above.

19. Slide 4-19 4 Review Question #3--With Answer l In purchase accounting: A. Preferred stock must be the consideration given. B. Goodwill is always reported. C. A holding company must be created to effect the merger. D. Financial reporting symmetry occurs between the two combining companies. E. None of the above.

20. Slide 4-20 4 Review Question #4 l Which of the following COULD occur or result? Purchase Pooling A. Goodwill.......................... B. Change in basis.............. C. Statutory merger............ D. Stock-for-stock exchange E. Symmetrical reporting....

21. Slide 4-21 4 Review Question #4--With Answer l Which of the following COULD occur or result? Purchase Pooling A. Goodwill.......................... YES NO B. Change in basis.............. YES NO C. Statutory merger............ YES YES D. Stock-for-stock exchange YES YES E. Symmetrical reporting.... YES YES

22. Slide 4-22 4 Review Question #5 l Which of the following COULD occur or result? Purchase Pooling A. Preferred stock issuance. B. Parent-subsidiary............ C. Home office-division...... D. Acquisition of assets....... E. Acquisition of stock........

23. Slide 4-23 4 Review Question #5--With Answer l Which of the following COULD occur or result? Purchase Pooling A. Preferred stock issuance. YES NO B. Parent-subsidiary............ YES YES C. Home office-division...... YES YES D. Acquisition of assets....... YES YES E. Acquisition of stock........ YES YES

24. Slide 4-24 4 Review Question #6 l A way to force out a target company’s dissenting shareholders is to use: A. Purchase accounting. B. Pooling of interests accounting. C. A statutory merger. D. A statutory consolidation. E. None of the above.

25. Slide 4-25 4 Review Question #6--With Answer l A way to force out a target company’s dissenting shareholders is to use: A. Purchase accounting. B. Pooling of interests accounting. C. A statutory merger. D. A statutory consolidation. E. None of the above.

26. Slide 4-26 4 End of Chapter 4 (Appendix material follows) l Time to Clear Things Up-- Any Questions?

27. Slide 4-27 4 Tax Rules: SYMMETRY Always Occurs Between Seller and Buyer l SELLER’S TAX TREATMENT ALWAYS DETERMINES BUYER’S TAX TREATMENT : n If seller has a taxable transaction, buyer uses new basis of accounting. n If seller has a nontaxable transaction, buyer uses old basis of accounting.

28. Slide 4-28 4 Taxable Business Combinations: SYMMETRY Between Seller and Buyer l Seller has taxable gain or loss. l Buyer is required to use a new tax basis, which can be either: n A step up in tax basis ( CV>BV ). n A step down in tax basis ( CV<BV ). l GOODWILL is reported if Cost > CV. n A Section 197 intangible asset. n Mandatory amortization-- 15 year life. Form 1120 or Form 1040

29. Slide 4-29 4 Nontaxable Business Combinations: SYMMETRY Between Buyer and Seller l Seller does NOT report taxable gain/loss. l Buyer must use OLD tax basis of property acquired--regardless of FV of the consideration given for that property. l Commonly Used Descriptions for Buyer: n Buyer “inherits” the old tax basis. n Buyer is “ stuck with” the old tax basis.