2. © Clarence Byrd Inc. 20081 Chapter 3 Business Combinations

3. 2 © Clarence Byrd Inc. 2008 Business Combinations Defined  Paragraph 1581.06(a) A business combination occurs when an enterprise acquires net assets that constitute a business, or acquires equity interests of one or more other enterprises and obtains control over that enterprise or enterprises.

4. 3 © Clarence Byrd Inc. 2008 Business Combinations  Legal Form A variety of legal forms can be used Accounting attempts to reflect economic substance This may require “looking through” the legal form (e.g., reverse takeovers)

5. 4 © Clarence Byrd Inc. 2008 Basic Legal Alternatives Company ACompany B B’s Assets And Liabilities Cash Or A Shares

6. 5 © Clarence Byrd Inc. 2008 Basic Legal Alternatives Company A Company B New Company New Company Shares New Company Shares Assets And Liabilities

7. 6 © Clarence Byrd Inc. 2008 Basic Legal Alternatives Company ACompany B B Company Shareholders Majority Of B Shares Cash Or A Shares

8. 7 © Clarence Byrd Inc. 2008 Basic Legal Alternatives A CompanyB Company Shareholders Of A Company Shareholders Of B Company New Company Shares Of New Company Majority Of A Company Shares Majority Of B Company Shares

9. 8 © Clarence Byrd Inc. 2008 Tax Considerations  Acquisition Of Assets Preferred by acquirer Larger CCA deductions No inherited tax assessment issues

10. 9 © Clarence Byrd Inc. 2008 Tax Considerations  Acquisition Of Shares Preferred by acquiree Capital gains taxed at low rates Gains may be eligible for the lifetime capital gains deduction

11. 10 © Clarence Byrd Inc. 2008 Alternative Accounting Methods  The Purchase Method Treats combination as a purchase of assets Must identify an acquirer Acquirer’s assets remain at book value Acquiree’s assets recorded at fair values.

12. 11 © Clarence Byrd Inc. 2008 Alternative Accounting Methods  Pooling-of-Interests Treats combination as an inconsequential combining of interests Both company’s assets remain at carrying values Retroactive presentation of income No longer GAAP in the industrialized world

13. 12 © Clarence Byrd Inc. 2008 Establishing the Acquisition Date  Paragraph 1581.19 either: the date on which the net assets or equity interests are received and the consideration is given; or the date of a written agreement, or a later date designated therein, that provides that control of the acquired enterprise is effectively transferred to the acquirer on that date, subject only to those conditions required to protect the interests of the parties involved.

14. 13 © Clarence Byrd Inc. 2008 Identification Of An Acquirer  Cash Consideration Company providing the cash is the acquirer, without regard to whether assets or shares are acquired

15. 14 © Clarence Byrd Inc. 2008 Identification Of An Acquirer  Share consideration – no new company Acquirer is the predecessor company whose shareholders wind up with the majority of the voting shares of the combined company

16. 15 © Clarence Byrd Inc. 2008 Identification Of An Acquirer  Share consideration – new company Acquirer is the predecessor company whose shareholders wind up with the majority of the voting shares of the new company

17. 16 © Clarence Byrd Inc. 2008 Identification Of An Acquirer  Other Factors (If no clear cut solution) Relative voting rights If no control: largest non-controlling interest Composition of the board of directors Composition of senior management Payment of a premium over market value

18. 17 © Clarence Byrd Inc. 2008 Identification Of An Acquirer RReverse Takeovers The legal acquirer becomes the acquiree Surprisingly common Covered in an Appendix to Chapter 4

19. 18 © Clarence Byrd Inc. 2008 Recognition  Acquirer recognizes all of the acquiree’s assets and liabilities, even if they are not recognized on the acquiree’s books  Acquiree’s income recognized only from the date of the business combination transaction

20. 19 © Clarence Byrd Inc. 2008 Cost Of The Purchase  Cost determined by: the fair value of the consideration given; or the fair value of the equity interest acquired, whichever is more determinable  Includes the direct costs of the combination transaction

21. 20 © Clarence Byrd Inc. 2008 Cost Of The Purchase On January 1, 2008, Mor issues 3 million no par shares in return for all of the outstanding voting shares of Mee. The shares are trading at $25 and have a total value of $75 million. Mor agrees that if Mee’s earnings per share exceed $3.50 per share, they will pay an additional $10 million to the Mee shareholders.

22. 21 © Clarence Byrd Inc. 2008 Cost Of The Purchase Contingent Amount Is PaidDebitCredit Investment In Mee$10,000,000 Cash$10,000,000

23. 22 © Clarence Byrd Inc. 2008 Cost Of The Purchase On January 1, 2008, Mor issues 3 million no par shares in return for all of the outstanding voting shares of Mee. The shares are trading at $25 and have a total value of $75 million. Mor agrees to pay an additional $15 million if the Mor shares are not trading at or above $30 per share at the end of the year.

24. 23 © Clarence Byrd Inc. 2008 Cost Of Purchase Contingent Amount Is PaidDebitCredit No Par Common Stock$15,000,000 Cash$15,000,000

25. 24 © Clarence Byrd Inc. 2008 Allocation Of The Purchase Price  Step A: Determine the fair values of the acquiree’s identifiable assets and liabilities  Step B: Compare this value to the purchase price If purchase price is greater, you have goodwill If identifiable assets are greater you have a balance that is referred to informally as negative goodwill

26. 25 © Clarence Byrd Inc. 2008 Determination Of Fair Values  Inventories Finished goods and work in process at net realizable value Raw materials at replacement cost

27. 26 © Clarence Byrd Inc. 2008 Determination Of Fair Values  Property, Plant, and Equipment To be used: At replacement cost To be sold: At fair value

28. 27 © Clarence Byrd Inc. 2008 Determination Of Fair Values  Intangible Assets At estimated or appraised values

29. 28 © Clarence Byrd Inc. 2008 Determination Of Fair Values  Liabilities Present value of amounts to be paid determined using appropriate current interest rates

30. 29 © Clarence Byrd Inc. 2008 Determination Of Fair Values  Temporary Differences Fair values determined without reference to their tax values Tax values may or may not be changed by the combination  Legal form  Use of rollovers Future income tax asset or liability based on the difference between fair value recorded and tax value

31. 30 © Clarence Byrd Inc. 2008 Determination Of Fair Values Loss Carry Forwards  Must determine if it is legally available  Must determine if it is more likely than not to be realized by the combined company  Fair value is the amount of the carry forward multiplied by the appropriate tax rate  May be recognized by the combined company even if not recognized by the acquiree

32. 31 © Clarence Byrd Inc. 2008 Determination Of Fair Values Identifiable Intangibles  In the Past Identifiable Intangibles (e.g., Development costs eligible for capitalization) were often lumped with goodwill, particularly if they were not recognized on the books of the acquiree  This became a problem once we stopped amortizing goodwill.

33. 32 © Clarence Byrd Inc. 2008 Determination Of Fair Values Identifiable Intangibles  Paragraph 1581.48 an intangible asset should be recognized apart from goodwill when: (a) the asset results from contractual or other legal rights (regardless of whether those rights are transferable or separable from the acquired enterprise or from other rights and obligations); or (b) the asset is capable of being separated or divided from the acquired enterprise and sold, transferred, licensed, rented, or exchanged (regardless of whether there is an intent to do so).

34. 33 © Clarence Byrd Inc. 2008 Goodwill  The Concept: The capitalized expected value of enterprise earning power in excess of a normal rate of return in the industry in which it operates  Rarely recognized when internally generated

35. 34 © Clarence Byrd Inc. 2008 Goodwill  Recognition In Practice The excess of the cost of an acquired company over the fair values assigned to individual assets acquired and liabilities assumed May include identifiable intangibles if they do not meet the Paragraph 1581.48 criteria for separate recognition

36. 35 © Clarence Byrd Inc. 2008 Goodwill Procedures  Not subject to regular amortization  Each reporting unit must be tested annually for impairment  Exceptions if: Assets and liabilities have not changed significantly Recent determination shows large excess of fair value over carrying amount Based on an analysis of events since last evaluation, the likelihood of impairment seems remote

37. 36 © Clarence Byrd Inc. 2008 Goodwill Procedures  Circumstances that may require more frequent evaluation for impairment Change in legal factors Adverse decisions by a regulator Loss of key personnel Need to write down a significant asset group within the reporting unit A goodwill impairment loss recognized by a subsidiary

38. 37 © Clarence Byrd Inc. 2008 Goodwill Presentation  Aggregate amount as a separate line item in the Balance Sheet  Aggregate amount of impairment losses as a separate line item in the Income Statement

39. 38 © Clarence Byrd Inc. 2008 Goodwill Disclosure  Paragraph 3062.51 The financial statements should disclose the following information: (a) The changes in the carrying amount of goodwill during the period including:  (i) the aggregate amount of goodwill acquired;  (ii) the aggregate amount of impairment losses recognized; and  (iii) the amount of goodwill included in the gain or loss on disposal of all or a portion of a reporting unit. Enterprises that report segment information in accordance with Segment Disclosures, Section 1701, should provide the above information about goodwill in total and for each reportable segment and should disclose any significant changes in the allocation of goodwill by reportable segment. When any portion of goodwill has not yet been allocated to a reporting unit at the date the financial statements are issued, the unallocated amount and the reasons for not allocating that amount should be disclosed.

40. 39 © Clarence Byrd Inc. 2008 Goodwill Disclosure  Paragraph 3062.53 For each goodwill impairment loss recognized, the following information should be disclosed in the financial statements that include the period in which the impairment loss is recognized: (a) a description of the facts and circumstances leading to the impairment; (b) the amount of the impairment loss; and (c) when a recognized impairment loss is an estimate that has not yet been finalized, that fact and the reasons therefore and, in subsequent periods, the nature and amount of any significant adjustments made to the initial estimate of the impairment loss.  When the carrying amount of a reporting unit exceeds its fair value, but the second step of the impairment test is not complete and a reasonable estimate of the goodwill impairment loss cannot be determined (see paragraph 3062.28), that fact and the reasons therefore should be disclosed. [JAN. 2002]

41. 40 © Clarence Byrd Inc. 2008 Negative Goodwill  Sources Overstated fair values Bargain purchase approach Inadequate rate of return on invested assets (consistent with treatment of goodwill)

42. 41 © Clarence Byrd Inc. 2008 Negative Goodwill  Allocated as a pro rata reduction in amounts assigned to acquired assets other than Financial assets (other than equity investments) Assets to be sold Future income tax assets Future benefit plan prepayments Other current assets  Any remaining amount as extraordinary gain

43. 42 © Clarence Byrd Inc. 2008 Combined Company’s Shareholders’ Equity  Under the purchase method, it is equal to the Shareholders’ Equity of the acquiring company  Conflicts with corporate enabling legislation New companies Amalgamations  If conflict – Corporate legislation prevails

44. 43 © Clarence Byrd Inc. 2008 Disclosure – 1581.55 For each material business combination completed during the period, the combined enterprise should disclose the following: (a) the name and a brief description of the acquired enterprise and, when shares are acquired, the percentage of voting shares acquired; (b) the period for which the earnings of the acquired enterprise are included in the income statement of the combined enterprise; (c) the cost of the purchase and, when applicable, the number of equity instruments issued or issuable, the value assigned to those equity instruments, and the basis for determining that value; (d) a condensed balance sheet disclosing the amount assigned to each major class of asset and liability of the acquired enterprise at the date of acquisition; (e) contingent payments, options, or commitments specified in the acquisition agreement and the accounting treatment that will be followed should any such contingency occur (see also Accounting Guideline No. 14, Disclosure of Guarantees); and (f) for any purchase price allocation that has not been finalized, that fact and the reasons therefore and, in subsequent periods, the nature and amount of any material adjustments made to the initial allocation of the purchase price.

45. 44 © Clarence Byrd Inc. 2008 Disclosure – 1581.56 When the amounts assigned to goodwill or other intangible assets acquired are significant in relation to the total cost of the purchase, the combined enterprise should disclose the following: (a) for intangible assets subject to amortization, the total amount assigned and the amount assigned to each major intangible asset class; (b) for intangible assets not subject to amortization, the total amount assigned and the amount assigned to each major intangible asset class; and (c) for goodwill:  (i) the total amount of goodwill and the amount that is expected to be deductible for tax purposes; and  (ii) for enterprises that are required to disclose segment information in accordance with Segment Disclosure, Section 1701, the amount of goodwill by reportable segment.

46. 45 © Clarence Byrd Inc. 2008 Disclosure – 1581.57 When a series of individually immaterial business combinations are completed during the period that are material in the aggregate, the combined enterprise should disclose the following: (a) the number of enterprises acquired and a brief description of those enterprises; (b) the aggregate cost of the acquired enterprises, the number of equity instruments issued or issuable, and the value assigned to those equity instruments; (c) the aggregate amount of any contingent payments, options or commitments and the accounting treatment that will be followed should any such contingency occur (when potentially significant in relation to the aggregate cost of the purchases); and (d) the information described in paragraph 1581.56, when the aggregate amount assigned to goodwill or to other intangible assets acquired is significant in relation to the aggregate cost of the purchases.

47. 46 © Clarence Byrd Inc. 2008 International Convergence  Business Combinations covered in IFRS No. 3 Will be revised in 1 st quarter 2008 CICA will adopt by mid-2008 Revised version will be in effect in Canada in 2009

48. 47 © Clarence Byrd Inc. 2008 International Convergence  Goodwill: Covered in IFRS No. 3 – Initial recognition  Also in IAS Nos. 36 and 38 – Subsequent treatment

49. 48 © Clarence Byrd Inc. 2008 IAS Nos. 36 and 38 Differences  IAS No. 38 provides more detailed guidance on intangible assets  IAS No. 38 permits revaluation to fair value in the case of intangible assets that have no active market  IAS Nos. 36 and 38 test impairment based on difference between an assets carrying value and its recoverable amount

50. 49 © Clarence Byrd Inc. 2008 FASB/IASB Convergence  FASB SFAS No.141, Business Combinations, has been issued  IFRS No. 3 revision expected in January, 2008

51. 50 © Clarence Byrd Inc. 2008