business combinations

Chapter 5Business Combinations

ACCT 501

Objectives of the Chapter1. To discuss the general view of business combinations. 2. To learn accounting for business combinations (purchase versus pooling methods) on date of combination for statutory merger type of business combinations.

Business Combinations

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Objectives of the Chapter3. To discuss the development oftwo alternatives for business combinations from a historical perspective. Preparing financial statements following a business combination for statutory merger type of business combination.Business Combinations 3

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Objectives of the Chapter5. To learn accounting for statutory6. consolidation (using purchase method). To discuss the current development on business combination standards.


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Business combinations: events and transactions in which two or more business enterprises, or their net assets, are combined to be under the control of a single business entity.


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Business Combinations (contd.)FASBs terms for the business entities involved in the business combination: a.Constituent companies : all business entities enter into a business combination. b.Combined enterprise: the business entity that results from a business combination.

Business Combinations 6

Business Combinations (contd.)c.Combinor : a constituent company whose owners end up to have control of the ownership interest of the combined enterprise. d.Combinee : all other constituent companies other than the combinor in a business combination.Business Combinations 7

Types of Business Combinations

Friendly takeovers Hostile takeovers


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Reasons for Business Combinations

For the combination in a friendly takeover: a.Growth. Through the business combinations, the product lines can be expanded and diversified. Also, the market shares can be enlarged.


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Reasons for Business Combinations (contd.)b.Obtaining new management strength or better use of existing management. c.For the income tax advantages

For hostile takeovers: Substantial gains may result from the sale of business segments of a combinee following the business combination.Business Combinations 10

Four Methods for Carrying Out Business Combinations1.Statutory Merger Procedures of statutory merger: a. The board of directors of the constituent companies work out the terms of merger. b. Stockholders of the constituent companies approve the terms of the merger.Business Combinations 11

Four Methods for Carrying Out Business Combinations (contd.)c. the survivor issues its common stock or other consideration to stockholders of the other constituent companies to exchange for all their outstanding voting common shares. d. The survivor dissolves and liquidates the other constituent companies.


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Four Methods for Carrying Out Business Combinations (contd.)2. Statutory Consolidation: a new corporation is formed to issue its common stock for the outstanding common stock of all constituent corporations. Procedures of statutory consolidation: a. similar to the statutory merger. b. similar to the statutory merger.Business Combinations 13

Four Methods for Carrying Out Business Combinations (contd.)c. a new corporation is formed to issue its common stock to the stockholders of all the constituent companies in exchanger for all their outstanding voting common stock. d. the new corporation dissolves and liquidates the constituent companies.


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Four Methods for Carrying Out Business Combinations (contd.)3.Acquisition of Common Stock (a method for most of hostile takeovers) Procedures: a. the combinor received the approval from its board of directors to acquire common stock of the prospective target firm.Business Combinations 15

Four Methods for Carrying Out Business Combinations (contd.)b. acquiring target firms common stock in an open market, or through a tender offer to stockholders of a publicly owner corporation.


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Four Methods for Carrying Out Business Combinations (contd.)c. When acquiring enough shares to have the controlling interest in the combinees voting common shares,the target firm becomes affiliated with the combinor (the parent company) as a subsidiary. The target firm remains as a separate legal entity.Business Combinations 17

Four Methods for Carrying Out Business Combinations (contd.)4. Acquisitions of Assets: Business entity acquires all or most of net assets of the other entity (using cash, debt, stock ..)


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Establishing the Price for a Business Combination1. Capitalization of expected average annual earnings of the combinee at a desired rate of return. 2. Determination of current fair value of the combinees net assets (including goodwill).


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Methods of Accounting for Business Combinations

Pooling of Interest Accounting versus Purchase Accounting Definitions: Accounting Acquisition Premium (AAP) = purchase price book value of the combinee.Business Combinations 20

Methods of Accounting for Business CombinationsPurchased

Goodwill = AAP combinees assets step-up. step up = the fair market value of net assets of the combinee the book value of these net assets.

Assets


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Methods of Accounting for Business Combinations (contd.)

Two accounting methods for business combinations are allowed under APB Opinion No. 16: Pooling-of-interests method (pooling accounting) : The acquired firms net assets are consolidated at their existing book value and any accounting acquisition premium (AAP) is ignored.Business Combinations 22


Purchase method (purchase accounting): The acquired net assets are recorded at their fair market value and the excess of AAP over the assets step-up is recognized as goodwill. In order to adopt the pooling of interests method to account for the business combination, 12 conditions must be met (detailed later).Business Combinations 23


Impact of these two accounting methods on the financial numbers: Earnings: the depreciation associated with any assets step-up and the amortization of any purchased goodwill will result in purchase earnings, in general, to be less than pooling earnings (i.e., E purchase < E pooling).Business Combinations 24


Book Value: the book value of the accounting consolidated net assets under pooling accounting will typically be less than those reported under purchase accounting (i.e., B pooling < Bpurchase ).


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Purchase Accounting

Cost of a Combinee including: 1.the amount of consideration paid by the combinor to a combinee. 2.the combinors direct out-ofpocket costs of the combination, and 3.contingent consideration which is determinable on the business combination date.Business Combinations 26

Cost of A Combinee (contd.)

Direct out-of-pocket costs include legal fees, accounting fees, and finders fees. Costs of registering with the SEC and issuing debt securities in a business combinations are debited to Bond Issue Costs.


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Cost of A Combinee (contd.)

Cost of registering with the SEC and issuing equity securities are offset against the proceeds from the issuance of the securities. Contingent consideration: cash,other assets,or securities that may be issuable in the future.


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Accounting Treatment for Contingent Considerationa.Contingent consideration which is determinable on the combination date: recorded as part of the cost of the combination.


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Accounting Treatment for Contingent Consideration(contd.)b.Contingent consideration that is not determinable on the combination date: the contingent amount is recorded as goodwill when the contingency is resolved.


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Assigning Values to a Purchased Combinees Identifiable Assets and Liabilities (Based on APB Opinion No. 16) 1. Present value: receivables and liabilities; 2. Net realizable values : marketable securities, finished goods, goods in process inventories, plant assets held for sale or temporary use;


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Assigning Values to a Purchased Combinees Identifiable Assets and Liabilities (Based on APB Opinion No. 16) (contd.) 3. Appraised value: intangible assets, land, natural resources and nonmarketable securities; 4. Replacement cost: material and plant assets held for long-term use.


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Goodwill Computation under Purchase Accounting

Purchased Goodwill =purchase price (total cost of the combinee) the current fair values of identifiable net assets of the combinee.


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Goodwill Computation under Purchase Accounting (contd.)

Negative Goodwill: The excess amount is applied to reduce proportionally the amounts initially assigned to noncurrent assets (other than long-term investments.) If this procedure does not extinguish the excess, a Negative Goodwill account would be credited for the remaining excess.Business Combinations 34

Example I: Purchase Accounting For Statutory Merger, with Goodwill

On December 31,1999, Mason Company (the combinee) was merged into Saxon Corporation (the combinor or survivor). Both companies used the same accounting principles for assets, liabilities, revenue, and expenses and both had a December 31 fiscal year.Business Combinations 35

Example I: Purchase Accounting For Statutory Merger, with Goodwill (contd.)

Saxon issued 150,000 shares of its $10 par common stock (current fair value $25 a share) to Masons stockholders for all 100,000 issued and outstanding shares of Masons no-par, $10 stated value common stock. In addition, Saxon paid the following out-of-pocket costs associated with business combination:Business Combinations 36

Example I (contd.): Out of Pocket CostsAccounting fees: For investigation of Mason Company as prospective combinee $ 5,000 For SEC registration statement for Saxon common stock 60,000 Legal fees: For the business combination 10,000 For SEC registration statement for Saxon common stock 50,000Business Combinations 37

Example I (contd.): Out of Pocket Costs (contd.)Finders fee Printers charges for printing securities and SEC registration statement SEC registration statement fee Total out-of-pocket costs of business combination

51,250

23,000 750 $200,000

There was no contingent consideration in the merger contract.Business Combinations 38

Example I (contd.): Mason Companys Condensed B/S Prior to The MergerMASON COMPANY (combinee) Balance Sheet (prior to business combination) December 31,1999 Assets Current assets Plant assets (net) Other assets Total assets $1,000,000 3,000,000 600,000 4,600,000(Continued)Business Combinations 39

Example I (contd.): Mason Companys Condensed B/S Prior to The Merger (contd.)MASON COMPANY Balance Sheet (contd.) , 12/31/1999 Liabilities & Stockholders Equity Current Liabilities $ 500,000 Long-term debt 1,000,000 Common stock, no-par,$10 stated value 1,000,000 Additional paid-in capital 700,000 Retained earnings 1,400,000 Total liabilities & stockholders equity $4,600,000Business Combinations 40

Example I (contd.):

Using the guidelines in APB Opinion No. 16, Business Combinations, the board of directors of Saxon Corporation determined the current fair values of Mason Companys identifiable assets and liabilities (identifiable net assets) as follows:


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Example I (contd.): Fair Value of Identifiable Net Assets of CombineeCurrent assets Plant assets Other assets Current liabilities Long-term debt (present value) Identifiable net assets of combinee $ 1,150,000 3,400,000 600,000 (500,000) (950,000) $3,700,000


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Example I (contd.): Combinors Journal Entries for Business Combination

Saxon uses an investment ledger account to accumulate the total cost of Mason Company prior to assigning the cost to identifiable net assets and goodwill.


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Example I (contd.): Combinors Journal Entries for Business Combination (contd.)

Journal Entries for Saxon Corp. 12/31/1999

Investment in Mason Company Common Stock (150,000 x $25) Common stock (150,000 x $10) Paid-in Capital in Excess of ParTo record merger with Mason Company as a purchase.

3,750,000 1,500,000 2,250,000


(Continued)

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Example I (contd.): Combinors Journal Entries for Business Combination (contd.)

12/31/1999 (contd.)

Investment in Mason Company Common Stock ($5,000+$10,000+$51,250) Paid-in Capital in Excess of Par ($60,000+$50,000 + $23,000+750) CashTo record payment of out-of-pocket costs incurred in merger with Mason Company.

66,250 133,750 200,000


(Continued)

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Example I (contd.): Combinors Journal Entries for Business Combination (contd.)12/31/1999 (contd.) Current Assets Plant Assets Other Assets Discount on Long-Term Debt Goodwill Current Liabilities Long-Term Debt Investment in Mason Company Common Stock ($3,750,000+$66,250)

11,500,000 3,400,000 600,000 50,000 116,250 500,000 1,000,000 3,816,250

To allocate total cost of liquidated Mason Company to identifiable assets and liabilities, with the reminder to goodwill. (Income tax effects are disregarded.)Business Combinations 46

Example I (contd.): Combinees J.E. for The Dissolution of the Company after Statutory Merger

Mason Company (the combinee) prepares the condensed journal entry below to record the dissolution and liquidation of the company on December 31, 1999.


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Example I (contd.): Combinees J.E. for The Dissolution of The Company after Statutory Merger (contd.)

Journal Entries for Mason Corp.12/31/1999 500,000 1,000,000 1,000,000 700,000 1,400,000 1,000,000 3,000,000 600,000Business Combinations 48

Current Liabilities Long-Term Debt Common Stock , $10 stated value Paid-in Capital in Excess of Stated Value Retained Earnings Current Assets Plant Assets (net) Other Assets

Example II: Purchase Accounting for Acquisition of Net Assets, with Negative Goodwill (Bargain-Purchase Excess)

On December 31, 1999, Davis Corporation acquired the net assets of Fairmont Corporation directly from Fairmont Corp. for $400,000 cash, in a purchase-type business combination. Davis paid legal fees of $40,000 in connection with the combination.Business Combinations 49

Example II: Purchase Accounting with Negative Goodwill

The condensed balance sheet statement of Fairmont Corp. prior to the business combination, with related current fair value data, is presented below:


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Example II (contd.):Combinees B/S Prior to Statutory MergerFAIRMONT CORPORATION (combinee) Balance Sheet (prior to business combination) December 31, 1999

Assets Current assets Investment in marketable debt securities (held to maturity) Plant assets (net) Intangible assets (net) Total assets

Carrying Current Fair Amounts Values $ 190,000 $ 200,000 50,000 870,000 90,000 $1,200,000Business Combinations

60,000 900,000 100,000 $1,260,000(Continued)51

Example II (contd.):Combinees B/S Prior to Statutory Merger (contd.)FAIRMONT CORPORATION B/S (contd.)

Liabilities and Stockholders Equity Current liabilities Long-term debt Total Liabilities Common stock, $1 par Deficit Total stockholders equity Total liabilities & stockholders equity

Carrying Current Fair Amounts Values $ 240,000 $ 240,000 500,000 520,000 $ 740,000 $ 760,000 $ 600,000 (140,000) $ 460,000 $1,200,000Business Combinations 52

Example II (contd.) : Computing the Negative Goodwill

Thus, Davis acquired identifiable net assets with a current fair value of $ 500,000a for a total cost of $440,000b. a. $ 1,260,000 - $760,000= $500,000 b. $ 400,000 +$40,000= $440,000


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Example II (contd.) : Computing the Negative Goodwill (contd.)

The $60,000 excess of current fair value of the net assets over their cost to Davis ($500,000 - $440,000 = $60,000) is prorated to the plant assets and intangible assets in the ratio of their respective current fair values, as follows:


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Example II (contd.) : Allocation of Negative GoodwillTo plant assets: $60,000 x $900,000 ($900,000 +$100,000) =$54,000 To intangible assets: $60,000 x $900,000 ($900,000 +$100,000) =$6,000 Total excess of current fair value of identifiable net assets over combinors cost $60,000Business Combinations 55

Example II (contd.)

Notes: No part of the $60,000 bargainpurchase excess is allocated to current assets or to the investment in marketable securities. The journal entries on pages 54 and 55 record Davis Corporations acquisition of the net assets of Fairmont Corporation and payment of $40,000 legal fees:Business Combinations 56

Example II (contd.) : Combinors J.E. for The Acquisition of Net Assets

Journal Entries of Davis Corp. 12/31/1999 Investment in Net Assets of Fairmont Corporation CashTo record acquisition of net assets of Fairmont Corporation

400,000 400,000

Investment in Net Assets of Fairmont Corporation CashTo record payment of legal fees incurred in acquisition of net assets of Fairmont Corporation

40,000 40,000


(Continued)57

Example II (contd.) : Combinors J.E. for the Acquisition of Net Assets (contd.)

12/31/1999 (contd.)

Current Assets 200,000 Investments in Marketable Debt Securities 60,000 Plant Assets ($900,000 - $54,000) 846,000 Intangible Assets ($100,000 - $6,000) 94,000 Current Liabilities 240,000 Long-Term Debt 500,000 Premium on Long-Term Debt ($520,000 - $500,000) 20,000 Investment in Net Assets of Fairmont Corporation ($400,000 + $40,000) Business Combinations 440,00058

Example II (contd.): Note to the Journal Entries

Note to the above journal entries: To allocate total cost of net assets acquired to identifiable net assets, with excess of current fair value of the net assets over their cost prorated to noncurrent assets other than investments in marketable debt securities.Business Combinations 59

Pooling-of-Interests Accounting

The idea behind this accounting method is that the business combination is simply an exchange of common stock between an issuer and the stockholders of a combinee. Thus, this method is appropriated to be used in the case of business combinations involving only common stock exchanges between companies of approximately equal size.Business Combinations 60

Pooling-of-Interests Accounting (contd.)

Because neither party can be considered as the combinor (as previously defined), the combined assets, liabilities and retained earnings of the constituent companies are recorded at their carrying amounts.


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Pooling-of-Interests Accounting (contd.)

Both the market value of the common stock issued for the combination and the fair value of the combinees net assets are disregarded in this method. The term issuer identifies the corporation that issues its common stock to accomplish the combination.


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Example III: Pooling-of-Interests Accounting for Statutory Merger

Applying the pooling-of interests accounting method on the Example I (the business combination of Saxon and Manson) illustrated on page 32-45, the following journal entries would be prepared in Saxon Corporations accounting records:


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Example III : Pooling-of-Interests Accounting for Statutory Merger (contd.)Journal Entries for Saxon Corp. 12/31/1999 Current Assets 1,000,000 Plant Assets (net) 3,000,000 Other Assets 600,000 Current Liabilities 500,000 Long-term Debt 1,000,000 Common Stock, $10 par 1,500,000 Paid-in Capital in Excess of Par 200,000 Retained Earnings 1,400,000

To record merger with Mason Company as a pooling of interests.Business Combinations 64

Example III : Pooling-of-Interests Accounting for Statutory Merger (contd.)

12/31/1999 (J. E. contd.)

Expenses of Business Combination CashTo record payment of out-ofpocket costs incurred in merger with Mason Company

200,000 200,000


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Example III (contd.): Notes to the exampleNotes: 1. An Investment in Masons Company Common Stock account is not used in the pooling-of-interests method. 2. Masons assets, liabilities and retained earnings are recorded at their carrying amounts in Masons premerger balance sheet. 3. The common stock issued by Saxon for the business combination is recorded at par value.


Example III (contd.): Notes to the example (contd.)Notes (contd.) 4. The Paid-in-Capital in Excess of Par equals the total premerger paid-in-capital of Mason minus the par value of Saxon's stock issued for the business combination. 5. If the par value of Saxons common stock issued for the combination exceeds the premerger paid-in capital of Mason, Saxons Paid-in Capital in Excess of Par account should be debited for the excess amount. (contd.)


Example III (contd.): Notes to the example (contd.)Notes (contd.) 5. (contd.)If this account is not sufficient to absorb the excess amount, Saxons Retained Earnings account should be debited. 6. The entire out-of-pocket costs were expensed and are not tax deductible.


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Advantage of Using Pooling Accounting on Financial Numbers1.Advantage on the Post-Merger Earnings: The following exhibit shows the balance sheet statement accounts of pooling accounting versus purchase accounting using the example of Saxon and Mason:


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Advantage of Using Pooling Accounting on Financial Numbers (contd.)Current Assets Plant Assets Other Assets Discount on Long-Term Debt Good will Expense of Business Combination Purchase Accounting 1,150,000 3,400,000 600,000 50,000 116,250 200,000 Pooling Accounting 1,000,000 3,000,000 600,000

(Continued)Business Combinations 70

Advantage of Using Pooling Accounting on Financial Numbers (contd.)Current Liabilities Long-Term Debt Common Stock, $ 10 par Paid-in Capital in Excess of Par Retained Earnings Cash To record merger with Mason Company. Purchase Accounting Pooling Accounting 500,000 500,000 1,000,000 1,000,000 1,500,000 2,116,250 200,000 1,500,000 200,000 1,400,000 200,000


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Advantage of Using Pooling Accounting on Financial Numbers (contd.)

The difference on the net assets of these two methods is:Purchase

accounting net assets Pooling accounting net assets Difference

$3,616,250 2,900,000 $ 716,25072



Excess of purchase asset values over pooling asset values: Current assets ($1,150,000-$1,000,000) Plant assets ($3,400,000- $3,000,000) Goodwill Excess of pooling liability values over purchase liability values: Long-term debt [$1,000,000-($1,000,000- $50,000) ] Excess of purchase net assets values over pooling net assets valuesBusiness Combinations

The composition of the $716,250 is summarized as follows:$150,000 400,000 116,250

50,000 $716,25073


Assuming:

a.The $150,000 difference in current assets is attributable to inventories which will be allocated to CGS on FIFO basis in the following year.


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Advantage of Using Pooling Accounting on Financial Numbers (contd.)b.The $400,000 difference in plant assets is attributable to depreciable assets, and assuming an average economic life for these plant assets is 10 years. c.Goodwill will be amortized in 40 years. d.The long-term debt has a remaining 5 years to maturity.Business Combinations 75

Advantage of Using Pooling Accounting on Financial Numbers (contd.)Based on the above information, Saxons pre-tax income for the year ended 12/31/2000 would be $202,906 less under purchase accounting than under pooling accounting. Calculation is as follows: Cost of goods sold $150,000 Depreciation expense ($400,000 x 1/10) 40,000 Amortization expense ($116,250 x 1/40) 2,960 Interest expense ($50,000 x 1/5) 10,000 Excess of year 2000 pre-tax income under pooling accounting rather than under purchase accounting $202,906 Business Combinations 76


Thus, pooling accounting, in general, results in a more favorable post-merger earnings than the purchase accounting. As a result, it is preferred by mangers who would like to present a higher postmerger earnings.


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Advantage of Using Pooling Accounting on Financial Numbers (contd.)2.Advantage on the Retained Earnings The retained earnings under the pooling method is $1,400,000 greater than that of the purchase method. This outcome also provides the managers with a greater flexibility in dividend distribution when using the pooling accounting.Business Combinations 78

Advantage of Using Pooling Accounting on Financial Numbers (contd.)3.Advantage on the Price-Earnings Ratios on the Merger Year Assume Saxon and Mason had the following financial information prior to the business combination:


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Advantage of Using Pooling Accounting on Financial Numbers (contd.)Saxon Corporation Year ended Dec. 31, 1999: Net income Basic earnings per share of common stock On Dec. 31, 1999: Number of shares of common stock outstanding Market price per share Price-earnings ratio $500,000* $0.50 1,000,000+ $25 50 Mason Company $375,000 $3.75 100,000+ $30 880

* Net of $200,000 expenses of business combination. + Outstanding during entire year.Business Combinations


Using the pooling method, Saxon would report the combined enterprises net income as $875,000 for the year ended 12/31/1999 (as if these two companies were pooled as of 1/1/1999) and the EPS for Saxon would be increased from $0.50 to $0.76. Calculated as : $875,000/(1,000,000+150,000).Business Combinations 81

Historical Perspective of Accounting for Business Combinations

Due to lack of accounting pronouncement in providing clear guidance in determining the appropriate method for business combination prior to the issuance of Accounting Principle Board Opinion No. 16 Business Combinations in August 1970 (effective for business combinations initiated after October 31, 1970),Business Combinations 82

Historical Perspective of Accounting for Business Combinations (contd.)

a substantial number of business combinations arranged in the 1950s and 1960s were accounted for using pooling accounting despite the absence of the assumption for using pooling accounting .


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The pooling accounting was first sanctioned by the AICPA in its Accounting Research Bulletin No. 40, Business Combinations. This pronouncement provides very little guidance for identifying the business combinations that qualified for pooling method.Business Combinations 84


ARB No. 40 was subsequently replaced by ARB No. 48, Business Combinations which continued to allow pooling method to be used for most business combinations involving an exchange of common stock.


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Past Abuses of Pooling Accounting

The advantages of pooling accounting in post-merger earnings, retained earnings, and in the P/E ratio of the merger year with the lack of clear guidelines for pooling in ARB No. 48 led to serious abuses of pooling method.


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Past Abuses of Pooling Accounting (contd.)

Consequently, a substantial number of business combinations arranged in the 1950s and 1960s were accounted for using pooling accounting despite the absence of the assumption for using pooling accounting the combination of existing stockholders interests.


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Among these abuses are: a. Retroactive Pooling b. Retrospective Pooling c. Part-Pooling, Part-Purchase Accounting d. Treasure Stock Issuance


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Contd.: e.Issuance of Unusual Securities f. Creation of instant Earnings g.Contingent Payouts h.Burying the Costs of Pooling-Type Business Combinations


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Past Abuses of Purchase Accounting (in the period of 1950-1960)

The most common abuses of purchase accounting is the failure to allocate the cost of a combinee to the identifiable net assets acquired and to goodwill.


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Action by the AICPA to Curtail The Abuses

The Accounting Principles Board reacted to the abuses by issuing APB opinion No. 16 in which pooling accounting standards are tightened and the range of situations allowed for pooling accounting is substantially limited.Business Combinations 91

Conditions Requiring Pooling Accounting in APB Opinion No. 161.Attributes of the combining companies (2 conditions). These conditions were to assure that the pooling combination was truly a combining of two or more entities whose common stockholder interests were previously independently of each other.


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Conditions Requiring Pooling Accounting in APB Opinion No. 16) (contd.)2.Manner of combining ownership interests (7 conditions). These conditions were to assure that the exchange of voting common stock actually took place in substance and in form.


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Conditions Requiring Pooling Accounting in APB Opinion No. 16) (contd.)3.Absence of planned transactions (3 conditions). These conditions were to assure that no planned transactions, which are inconsistent with the combining of entire existing interests of common stockholders, could be arranged prior to the combination.Business Combinations 94

APB Opinion No. 16

A business combination that meets 12 conditions of APB of Opinion No.16 accounting for as a pooling regardless of the legal form of the combination. These conditions specified in APB Opinion No. 16 are:


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APB Opinion No. 16 (contd.)1.Attributes of the constituent companies (2 conditions)a. Each of the constituent companies is autonomous and has not been a subsidiary or division of another corporation within two years before the plan of combination is initiated. b. Each of the constituent companies is independent of the other.Business Combinations 96

APB Opinion No. 16 (contd.)2.Manner of combining ownership interests (7 conditions)b. A corporation offers and issues only common stock with rights identical to those of the majority of its outstanding voting common stock in exchange for substantially all the voting common stock interest of another company on the date the plan of combination is consummated.Business Combinations 97

APB Opinion No. 16 (contd.)3.Absence of planned transactions (3 conditions)a. The combined entity does not agree to retire or acquire all or part of the common stock issued to effect the combination. b. The combined entity does not enter agreement for the benefit of the former stockholder of a constituent company.


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APB Opinion No. 16 (contd.)c. The combined entity does not plan to sell a significant part of the assets of the constituent companies within two years after the combination.


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APB Opinion No. 16 (contd.)

APB stated that both purchase and pooling methods are acceptable in accounting for business combination, but not as alternatives in accounting for the same business combination. By tightening the conditions for adopting pooling accounting, many previous abuse of pooling were eliminated or reduced.Business Combinations 100

Discussion of Four Conditions1.Independence of Constituent Companies On the dates of initiation and consummation of a business combination, no constituent company may have more than 10% ownership of the outstanding voting common stock of another constituent company.Business Combinations 101

Discussion of Four Conditions (contd.)2.Substantially All Voting Common Stock of Combinees Company Are Exchanged The condition requires that at least 90% of the combinees outstanding voting common stock be exchanged for the issuers voting common stock. The following are excluded from the computation of the number of shares exchanged:Business Combinations 102

Discussion of Four Conditions (contd.)1) Shares acquired before the initiation date of combination and held by either the issuer or its subsidiaries. 2) Share acquired by either the issuer or its subsidiaries after the combination is initiated, other than in exchange for the issuers voting common stock.Business Combinations 103

Discussion of Four Conditions (contd.)3) shares of the combinee still outstanding on the date the combination is consummated. 4) any voting common stock of the issuer owner by the combinee before the business combination must be converted to equivalent shares of the combinee for the 90% test.Business Combinations 104

discussion of Four Conditions (contd.)

Example to illustrate the independence and 90% of voting common stock tests

On March 13, 1999, Patton Corporation and Sherman Company initiated a plan of business combination. Under the Plan, 1.5 shares of Pattons voting common stock (1,000,000 shares issued and outstanding prior to March 13, 1999) were to be exchanged for each outstanding share of Shermans common stock (100,000 shares issued and 99,500 shares outstanding prior to March 13,1999).Business Combinations 105

Discussion of Four Conditions (contd.)

Example to illustrate the independence and 90% of voting common stock tests (contd.) At this time, Patton owned 7,500 shares of Shermans common stock, and Sherman owned 6,000 shares of Pattons voting common stock; in addition, 500 shares of Shermans common stock were in Shermans treasury.


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Example to illustrate the independence and 90% of voting common stock tests (contd.) Neither Pattons ownership of 7.54% of Shermans outstanding common stock (7,500/ 99,500 = 7.54%) nor Shermans ownership of 0.6% of Pattons outstanding common stock (6,000/ 1,000,000 = 0.6%) exceeds the 10% limitation of the independence of constituent companies requirement.Business Combinations 107


Example to illustrate the independence and 90% of voting common stock tests (contd.) On March 26, 1999, Patton acquired in the open market for cash 1,000 shares (1.005%) of Shermans outstanding common stock. On June 30, 1999, Patton issued 136,500 shares of its voting common stock in exchange for 91,000 outstanding shares of Shermans common stock to complete the business combination.Business Combinations

108


Example to illustrate the independence and 90% of voting common stock tests (contd.)

Computation of the 90% requirement follows:100,000 500 99,500 7500 1000(Continued)109

Total Sherman Company shares issued, June 30, 1999 Less: Shares in Shermans treasury Total Sherman shares outstanding, June 30, 1999 Less: Sherman shares owned by Patton Corporation, Mar. 13, 1999 Sherman shares acquired by Patton for cash, Mar. 26, 1999Business Combinations


Example to illustrate the independence and 90% of voting common stock tests (contd.)Equivalent number of Sherman shares represented by Pattons common stock owned by Sherman, Mar. 13, 1999 (6,000 1 ) Effective number of Sherman shares acquired June 30, 1999 in exchange for Pattons common stock Application of 90% requirement (99,500 x 90%)Business Combinations

4,000

12,500 87,000 89,550110


Example to illustrate the independence and 90% of voting common stock tests (contd.)

Thus, the 91,000 shares of Sherman Company common stock actually exchanged on June 30, 1999, are in effect restated to 87,000 shares. Because the restated amount is less than 90% of Shermans 99,500 shares outstanding, the business combination does not qualify for pooling accounting.Business Combinations 111

Discussion of Four Conditions (contd.)3.Restrictions on Treasury Stock Only the treasury stock purchased under a systematic purchase plan (referred to as untainted treasury stock) can be accounted for as issuance of common stock in a pooling combination.


112

Discussion of Four Conditions (contd.)4.No Pending Provisions No additional common stock can be contingently issuable to former stockholders of a combinee after a combination has been initiated. And, no common stock can be issued to an escrow agent pending the resolution of a contingency.Business Combinations 113

Financial Statements Following a Business Combination

The assets, liabilities, and retained earnings in a balance sheet statement following a business combination are reported as follow:Purchasecombinor Purchasecombinee Poolingcombinor Poolingcombinee Assets & Lia. Retained earnings Carrying amount Reported Fair value Carrying amount Carrying amountBusiness Combinations

Not reported Reported Reported114

Financial Statements Following a Business Combination (contd.)

The combined income statement following a business combination depends on the accounting method: Purchase Accounting: The income statement of the combined entity for the period in which the business combination occurred include the operating results of the combinee after the date of the combination only.Business Combinations 115


Pooling Accounting The income statement of the combined entity for the period in which the business combination occurred includes the results of operations of the constituent companies as though the combination had been completed at the beginning of the period regardless when the combination consummated.Business Combinations 116


Comparative financial statements for preceding periods are restated for comparative purposes. Intercompany transactions prior to the combination must be eliminated from the combined income statements in a manner comparable with that described in Chapter 4 for branches.Business Combinations 117

Example IV:


To illustrate, assume that the income statements of Saxon Corporation and Mason Company for the year ended December 31, 1999 (prior to completion of their poolingtype merger described on page 60-65 example III), were as shown below. Assume also that Masons interest expense includes $25,000 paid to Saxon on a loan that was repaid prior to December 31, 1999, and that Saxons revenue includes $25,000 interest received from Mason.Business Combinations 118


Example IV (contd.)SAXON CORPORATION AND MASON COMPANY Separate Income Statements For Year Ended December 31, 1999Sales and other revenue Costs and expenses: Costs of goods sold Operating expenses Interest expense Income taxes expense Total costs and expenses Net income Saxon Corporation $10,000,000 Mason Company $5,000,000 $3,000,000 1,274,500 100,500 250,000 $4,625,000 $ 375,000119

$ 7,000,000 1,883,333* 150,000 466,667 $ 9,500,000 $ 500,000Business Combinations

*Includes $200,000 expenses of business combination.


Example IV (contd.)

The working paper for the postmerger income statement of Saxon Corporation under pooling accounting is illustrated below. The amounts in the Combined column are reported in Saxons published postmerger income statement for the year ended December 31,1999.Business Combinations 120


Example IV (contd.)SAXON CORPORATION Working Paper for Combined Income Statement (Pooling of Interests) For Year Ended December 31, 1999 Saxon Mason Eliminations Combined Corporation Company Sales and other revenue 10,000,000 5,000,000 (a) 25,000 14,975,000 Cost and expenses: Cost of goods sold 7,000,000 3,000,000 10,000,000 Operating expenses 1,883,333 1,274,500 3,157,833 Interest expense 150,000 100,500 (a) (25,000) 225,500 Income taxes expense 466,667 250,000 716,667 Total costs and expenses 9,500,000 4,625,000 (25,000) 14,100,000 Net income 500,000 375,000 -0875,000(a) To eliminate intercompany interest received by Saxon Corporation from Mason Company. Business Combinations121

Notes to Financial Statements Following a Business Combination

Extensive disclosure is required for business combinations in the period they occur. Required Disclosure for Purchase Accounting: (textbook p194) 1. Name and brief description of the combinee; also the accounting method used for the business combination;Business Combinations 122

Notes to Financial Statements Following a Business Combination (contd.)2.period for which combinees operating results are included in the income statement of the combined enterprise; 3.cost of the combinee, including number of shares and value per share of common stock issued and nature of and accounting treatment for contingent consideration; 4. amortization policy for goodwill;Business Combinations 123

Notes to Financial Statements Following a Business Combination (contd.)5.pro forma operating results for the combined enterprise for the current and preceding accounting periods as if the combination had occurred at the beginning of the preceding period. Note: The FASB waived the proformadisclosures for nonpublic enterprises.Business Combinations 124

Notes to Financial Statements Following a Business Combination (contd.)Required Disclosure for Pooling Accounting 1. Name and brief description of the combinee; the accounting method used for the business combination;


125

Notes to Financial Statements Following a Business Combination (contd.)2. number of shares of common stock issued in the combination; 3. separate operating results of the constituent companies for the period prior to the combination that were included in the operating results of the combined entity for the combination year.Business Combinations 126

Comparison of Purchase and Pooling Accounting

The following table summarizes the principal aspects of purchase accounting and pooling-of-interests accounting for business combinations:


127

Comparison of Purchase and Pooling Accounting (contd.)Aspect Purchase Accounting Acquisition of assets Combinations not meeting all 12 criteria for pooling accounting Pooling-ofInterests Accounting Combining of stockholder interests Combinations meeting all 12 criteria for pooling accounting(Continued)128

Underlying premise Applicability


Comparison of Purchase and Pooling Accounting (contd.)Aspect Accounting recognition of investment in combinee Purchase Accounting At cost, including amount of consideration, direct out-of-pocket costs, and determinable contingent consideration At current fair values on date of combination Pooling-of-Interests Accounting At carrying amount of combinees net assets (all out-ofpocket costs are recognized as expenses of the issuer) At carrying amounts on date of combination(Continued)129

Valuation of combinees net assets in combined enterprise


Comparison of Purchase and Pooling Accounting (contd.)Purchase Pooling-of-Interests Accounting Accounting No Goodwill recognition Yes, if combinors cost exceeds current fair value of combinees identifiable net assets YES Retained earnings NO of constituent companies combined on date of business combinationBusiness Combinations

Aspect

(Continued)

130

Comparison of Purchase and Pooling Accounting (contd.)Aspect Financial statements and notes for period of business combination: Balance sheet Purchase Accounting Pooling-of-Interests Accounting

Combinors net assets at carrying amount; combinees net assets at current fair value

Both issuers and combinees net assets at carrying amount(Continued)


131

Comparison of Purchase and Pooling Accounting (contd.)Pooling-of-Interests Accounting Income Combinors operations Both issuers and combinees operations for entire period; statement combinees operations for entire period as though combination from date of combination to end of took place at beginning of period; prior periods period restated comparably Disclosure of Pro forma for combined Separately for constituent companies operations in enterprise for current for period prior to and preceding period notes as though combination combination took place at beginning of preceding periodBusiness Combinations 132

Aspect

Purchase Accounting

Purchase-Type Statutory Consolidation

Due to a new corporation is formed to issue common stock to all constituent companies in this type of business combination, a combinor needs to be identified for the accounting treatment. The assets and liabilities of the identified combinor will be accounted for by the new corporation at the carrying amount while those of the combinee will be accounted for at the fair value.Business Combinations 133

Example V :

Purchase-Type Statutory Consolidation (contd.)

To illustrate, assume the following balance sheet statements of the constituent companies involved in a purchase-type statutory consolidation on December 31, 1999 (p196-199 of textbook):


134


Example V (contd.):LAMSON CORPORATION AND DONALD COMPANY Separate Balance Sheets (prior to business combination) December 31,1999

Assets Current assets Plant assets (net) Other assets (net) Total assets

Lamson Donald Corporation Company $ 600,000 $ 400,000 1,800,000 1,200,000 400,000 300,000 $ 2,800,000 $1,9,00,000Business Combinations

(Continued)

135


Example V (contd.):LAMSON CORPORATION AND DONALD COMPANY Separate Balance Sheets (contd.), 12/31/1999

Liabilities & Stockholders Equity Current liabilities Long-term debt Common stock,$10 par Additional paid-in capital Retained earnings Total liabilities & stockholders equity

Lamson Donald Corporation Company $ 400,000 $ 300,000 500,000 200,000 430,000 620,000 300,000 1,170,000 400,000 380,000

$ 2,800,000 $1,9,00,000Business Combinations 136


Example V (contd.):

The current fair values of both companies liabilities were equal to carrying amounts. Current fair values of identifiable assets, were as follows for Lamson and Donald, respectively: current assets, $800,000 and $500,000; plant assets, $2,000,000 and $1,400,000; other assets, $500,000 and $400,000.Business Combinations 137


Example V (contd.):

On December 31, 1999, in a statutory consolidation approved by shareholders of both constituent companies, a new corporation, LamDon Corporation, issued 74,000 shares of no-par, no-stated-value common stock with an agreed value of $60 a share, based on the following valuations assigned by the negotiating directors to the two constituent companies identifiable net assets and goodwill:Business Combinations 138


Example V(contd.):Lamson Corporation Current fair value of identifiable net assets: Lamson: $800,000+$2,000,000 +$500,000- $400,000-$500,000 Donald: $500,000+ $1,400,000 + $400,000 -$300,000-$200,000 Goodwill Net assets current fair value Number of shares of LamDon common stock to be issued to constituent companies stockholders, at $60 a share agreed value Donald Company

$2,400,000 $1,800,000 180,000 60,000 $2,580,000 $1,860,000

43,000

31,000139



Example V (contd.):

Because the former stockholders of Lamson Corporation receive the larger interest in the common stock of LamDon Corporation (43/74, or 58%), Lamson is the combinor in the purchase-type statutory consolidation business combination.


140


Example V (contd.):

Assuming that LamDon paid $200,000 out-of-pocket costs of the consolidation after it was consummated on December 31, 1999, LamDons journal entries would be as follows:


141


Example V (contd.):

Journal Entries of Lamdon Corp., 12/31/1999

Investment in Lamson Corporation and Donald Company Common Stock (74,000 x $60) Common Stock, no parTo record consolidation of Lamson Corporation and Donald Company as a purchase

4,440,000 4,440,000


(Continued)

142


Example V (contd.):

12/31/1999 (contd.)

Investment in Lamson Corporation and Donald Company Common Stock Common Stock, no par CashTo record payment of costs incurred in consolidation of Lamson Corporation and Donald Company. Accounting, legal, and finders fees in connection with the consolidation are recorded as investment cost; other out-of-pocket costs are recorded as a reduction in the proceeds received from the issuance of common stock.

110,000 90,000 200,000


(Continued)

143


Example V (contd.):12/31/1999 (contd.) Current Assets ($600,000+$500,000) 1,100,000 Plant Assets ($1,800,000+$1,400,000) 3,200,000 Other Assets ($400,000+$400,000) 800,000

GoodwillCurrent Liabilities Long-Term Debt Investment in Lamson Corporation and Donald Company Common Stock

850,000

700,000 700,000

4,550,000(Continued) 144



Example V (contd.):12/31/1999 (contd.) Amount of goodwill is computed as follows: Total cost of investment

($4,400,000+$110,00)

4,550,000

Less: Carrying amount of Lamsons identifiable net assets ($430,000+$300,000+1,170,000)

(1,900,000)

Current fair fair value of Donalds identifiable net assets (1,800,000) Amount of goodwill $ 850,000Business Combinations 145

Subsequent Issuance of Contingent Consideration

Example of Contingent Consideration (p176 and p198 of text book)

Norton Company agrees to pay $800,000 cash for Robinsons net assets (not including Robinsons slowmoving products which have been written down to scrap value by Robinson prior to the business combination).Business Combinations 146

Subsequent Issuance of Contingent Consideration

Example (contd.) These purchased net

assets of Robinson will be included in the Rob Division of Norton Company. In addition, the following contingent consideration was included in the contract: 1. Norton will pay Robinson $100 a unit for all sales by Robb Division of the slow-moving product.Business Combinations 147

Subsequent Issuance of Contingent Consideration (contd.)(contd.) 2.Norton will pay Robinson 25% of any pre-tax financial income in excess of $500,000 (excluding income from sale of the slow-moving product) of Robb Division for each of the four years subsequent to the business combination.Business Combinations 148

Subsequent Issuance of Contingent Consideration (contd.)

Assuming that by 12/31/x2, the end of the first year following Nortons acquisition of the net assets, another 300 units of the slowmoving product had been sold, and Nortons Rob Division had pre-tax income of $580,000 (excluding the sale of the slowmoving product). On 12/31/x2, Norton prepares the following journal entry to record the resolution of contingent consideration:Business Combinations 149

Subsequent Issuance of Contingent Consideration (contd.)Goodwill Cash (or payable to Robinson Company) * $100 x 300 + (580,000-500,000) x 25% =$30,000 = 20,000 $50,000Business Combinations 150

50,000* 50,000

IAS 22, Accounting for Business Combinations

International Accounting Standards Committee requires purchase accounting to be used for all business combinations except for united-ofinterests type combinations.


151

The Current Development on the Business Combination Standards (Excerpts from News Release of the FASB dated 7/20/01)

On July 20, 2001, FASB issued Statement No. 141, Business Combinations and Statement No. 142, Goodwill and Other Intangible Assets.


152

The Current Development on the Business Combination Standards (Excerpts from News Release of the FASB dated 7/20/01) (contd.)

Statement 141: Use of the pooling-of-interests method is not permitted. All business combinations should be accounted for using the purchase method. This statement is effective for business combinations initiated after June 30, 2001.Business Combinations 153


Statement 142: Requires that goodwill no longer to be amortized as expense but subject to annual review for impairment.


154


Reasons of issuing SFAS No. 141: (Source: summary of SAFS No. 141 published by the FASB): Due to the 12 criteria for pooling accounting failed to distinguish economically dissimilar transactions, similar business combinations were accounted for using different accounting methods.Business Combinations 155

The Current Development on the Business Combination Standards (Excerpts from News Release of the FASB dated 7/20/01) (contd.) Therefore, different financial statements were produced for similar business combinations. The following are some of the reasons stated by the FASB:


156

The Current Development on the Business Combination Standards (Excerpts from News Release of the FASB dated 7/20/01) (contd.) 1.Lack of Comparability on the financial statements when different method is adopted. 2.Criticism on the amortization of goodwill when purchase method is used. 3.Criticism from mangers on the impact of these two methods on the competition in markets for mergers and acquisitions.Business Combinations 157

Summary of Statement No. 142:(source: FASB Publication of Summary of Statement No. 142)

Intangible assets have become an important economic resource for many entities. Thus, better information for the intangible assets is needed. Some empirical studies indicate that the goodwill amortization expense is not reflected in firm valueBusiness Combinations 158

Summary of Statement No. 142:(source: FASB Publication of Summary of Statement No. 142) (contd.)

APB Opinion No. 17 assumed that goodwill and all other intangible assets were assets with finite lives and thus should be amortized, not to exceed 40 years.


159

Summary of Statement No. 142:

(source: FASB Publication of Summary of Statement No. 142) (contd.) Statement No. 142 assumed that goodwill and other intangible assets have indefinite lives and will not be amortized but rather will be tested on annual basis for impairment. Intangible assets that have finite useful lives will continue to be amortized over their useful lives, but without the arbitrary ceiling of 40 years.Business Combinations 160


Statement 142 provides guidance for the two-step process of review of the potential impairment: Consequence of SFAS No. 142: Earnings may be more volatile due to the impairment losses are likely to occur irregularly and in varying amounts.Business Combinations 161


Disclosure requirements of Statement 142: a. Information about the changes in the carrying amount of goodwill from period to period (in the aggregate and by reportable segment);


162

Summary of Statement No. 142:(source: FASB Publication of Summary of Statement No. 142) (contd.) b. The carrying amount of intangible assets by major intangible asset class for those assets subject to amortization and for those not subject to amortization; c. The estimated intangible assets amortization expense for the next five years.Business Combinations 163


FASB indicates that this statement can improve the financial reporting on these assets (goodwill and other intangible assets) because this treatment will result values of these assets better reflect the underlying economic values of these assets.


164

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