1. Slide 7-1 7 CHAPTER 7 NEW BASIS OF ACCOUNTING

2. Slide 7-2 7 FOCUS OF CHAPTER 7 l Recognizing a New Basis of Accounting l The Push-Down Basis of Accounting l Leveraged Buyouts

3. Slide 7-3 7 Push-Down Accounting: What’s Important--Form or Substance? l Rationale for Push-Down Accounting: n Relevant factor is the acquisition itself. n Form of the acquisition is NOT relevant. n Parent controls the “ form of the ownership.” s Parent can ALWAYS liquidate the subsidiary into a branch/division.

4. Slide 7-4 7 Push-Down Accounting: The 3 Step Implementation Process l STEP 1: n Adjust all assets and liabilities to current values ( “cleanses” the target’s G/L of OLD BASIS ). s Record GOODWILL as well. s Offsetting credit is to Revaluation Capital. (As always, capital is shown by source.) SOAP

5. Slide 7-5 7 Push-Down Accounting: The 3 Step Implementation Process l STEP 2: n Eliminate balance in the Accumulated Depreciation account. s Thus depreciation cycle begins anew.

6. Slide 7-6 7 Push-Down Accounting: The 3 Step Implementation Process l STEP 3: n Close out the balance in the Retained Earnings account to APIC. s Thus retained earnings starts afresh.

7. Slide 7-7 7 Push-Down Accounting: When Is It Critical That It Be Used? l Theoretically: Whenever a subsidiary issues its OWN financial statements to external users. l GAAP Requirements: n Only the SEC mandates its use. (Only subsidiaries of publicly-owned companies fall under the SEC’s jurisdiction.) n The FASB has yet to require it.

8. Slide 7-8 7 Push-Down Accounting: Tastes Great And Less Filling l Push-down accounting: n Easy to implement. n Record-keeping is on one set of books instead of two. n Consolidation effort is easy as pie.

9. Slide 7-9 7 Push-Down Accounting: Why Not Used Exclusively? n One of the great unsolved mysteries of accounting. n Inertia, stubbornness??? n Clinging to “the way we have always done it”!

10. Slide 7-10 7 Push-Down Accounting: Is There Hope on the Horizon? n YES! Practitioners tell us they are seeing it more and more.

11. Slide 7-11 7 Leveraged Buyouts: A Combination Purchase & Refinancing l Basic Elements of a Leveraged Buyout: n Acquisition of a target’s assets or common stock. n Refinancing of the target’s debt structure--usually increased substantially. n Minimal equity investment by buyers.

12. Slide 7-12 7 Leveraged Buyouts: “Let’s Get Management In On The Act” l An Additional Common Features of LBOs: n Existing management becomes part of the new ownership. n Existing management’s ownership is often as high as 50%. s Such LBOs are often called “MBOs.” l Advantage of Management Being Owners: n Alignment of interests occurs between management and remaining stockholders.

13. Slide 7-13 7 Leveraged Buyouts: They Are NOT Business Combinations l Business Combinations: n One active business combines with another active business. + Target

14. Slide 7-14 7 Leveraged Buyouts: They Are NOT Business Combinations l Business Combinations: n A single corporation becomes the new owner of the target’s business. s This one legal entity now controls the target’s business.

15. Slide 7-15 7 Leveraged Buyouts: They Are NOT Business Combinations l Leveraged Buyouts : n A group of investors (and often the target’s management) acquire either s The target’s assets or s Some or all of the target’s common stock. Target $

16. Slide 7-16 7 Leveraged Buyouts: They Are NOT Business Combinations l Leveraged Buyouts : n After the buyout, the ownership of the target’s business may include any of the following groups : s New investors. s Management (at the same or a higher or lower level of ownership). s Former nonmanagement owners.

17. Slide 7-17 7 Leveraged Buyouts: The Change in Control Concept lA new basis of accounting is allowed ONLY IF : n A change in control occurs. lTo assess whether a change in control has occurred, the control group concept is used.

18. Slide 7-18 7 Leveraged Buyouts: The “Control Group” Concept lThe control group can consist of: n New investors and n Prior owners who did NOT previously have control. Could include: s Management. s Nonmangement owners who owned less than 50% of the outstanding stock.

19. Slide 7-19 7 Leveraged Buyouts: The Control Group Concept l BEFORE: l AFTER: l CONTROL GROUP: 30% + 45% = 70% Management Nonmanagement Owners Owners (one individual) 10% + 90% = 100% Management Nonmanagement New Owners Owners Investors 30% + 25% + 45% = 100%

20. Slide 7-20 7 Leveraged Buyouts: Manner of Consummating The Buyout l Creating a New Legal Entity (NLE): n Investors create an NLE. n Investors invest cash in NLE. n NLE acquires target’s common stock or assets. s If common stock is acquired, NLE is merely a nonoperating (shell) company.

21. Slide 7-21 7 Leveraged Buyouts: Manner of Consummating The Buyout l Reasons for Creating the New Legal Entity: n Facilitates the change in ownership control: s Attaining the agreed upon ownership percentage of the various new owners is much easier to accomplish. n Enables NEW BASIS of accounting to be used for target’s assets (GAAP compliance). s An important objective for most LBOs.

22. Slide 7-22 7 Leveraged Buyouts: The KEY Issue-- Has A Change In Control Occurred? l Significance of a Change in Control: n Enables use of a NEW BASIS of accounting for target’s assets. n New basis of accounting is highly important for most LBOs. s Avoids reporting negative stockholders’ equity (NSE). s Reporting NSE to lenders is highly undesirable.

23. Slide 7-23 7 Leveraged Buyouts: What Constitutes a Change in Control? l The change in control must be: n Genuine n Substantive n Nontemporary l If not-- no change in basis of accounting (record transaction as a recapitalization ).

24. Slide 7-24 7 Leveraged Buyouts: Accounting for a Change in Control l Types of Changes in Control: n No continuing ownership situations : s Enables 100% use of NEW BASIS of accounting [use Purchase procedures]. n Continuing ownership situations: s Results in partial use of NEW BASIS. s Retains partial use of OLD BASIS. s Applying can be somewhat involved.

25. Slide 7-25 7 Leveraged Buyouts: Continuing Ownership Situations lIn continuing ownership situations, the accounting depends on whether the continuing ownership percentage (hereafter C-O-P ) n Increases or n Decreases.

26. Slide 7-26 7 Leveraged Buyouts: Continuing Ownership Situations l C-O-P Increases : n Continuing owners are called bulls. l C-O-P Decreases : n Continuing owners are called bears.

27. Slide 7-27 7 Leveraged Buyouts: C-O-P INCREASES l Accounting Procedures: n Use OLD BASIS of accounting to the extent of the former ownership percentage that continues as owners. s Called “carryover of predecessor basis.” s Ignore their personal cost basis. n Use NEW BASIS of accounting for the remaining ownership interest.

28. Slide 7-28 7 Leveraged Buyouts: C-O-P DECREASES l Accounting Procedures: n C-O-P Is BELOW 20% : s Use NEW BASIS of accounting for entire transaction (with some exceptions). n C-O-P Is 20% or HIGHER : s Use OLD BASIS of accounting to the extent of the former ownership percentage that continues as owners. s Use NEW BASIS for remainder.

29. Slide 7-29 7 Review Question #1 l In push-down accounting, which accounts are adjusted to a zero balance? n A. Accumulated Depreciation. n B. Additional Paid-in Capital. n C. Retained earnings. n D. Revaluation capital. n E. Goodwill. n F. None of the above.

30. Slide 7-30 7 Review Question #1--With Answer l In push-down accounting, which accounts are adjusted to a zero balance? n A. Accumulated Depreciation. n B. Additional Paid-in Capital. n C. Retained earnings. n D. Revaluation capital. n E. Goodwill. n F. None of the above.

31. Slide 7-31 7 Review Question #2 l In recording a leverage buyout, which accounts are adjusted to a zero balance? n A. Accumulated Depreciation. n B. Additional Paid-in Capital. n C. Retained earnings. n D. Revaluation capital. n E. Goodwill. n F. None of the above.

32. Slide 7-32 7 Review Question #2--With Answer l In recording a leverage buyout, which accounts are adjusted to a zero balance? n A. Accumulated Depreciation. n B. Additional Paid-in Capital. n C. Retained earnings. n D. Revaluation capital. n E. Goodwill. n F. None of the above.

33. Slide 7-33 7 End of Chapter 7 l Time to Clear Things Up-- Any Questions?