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Page 1: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-1

Page 2: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-2

Introduction to BusinessIntroduction to BusinessCombinations and theCombinations and theConceptual FrameworkConceptual Framework

Advanced Accounting, Third Edition

1111

Page 3: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-3

1. Describe historical trends in types of business combinations.

2. Identify the major reasons firms combine.

3. Identify the factors that managers should consider in exercising due diligence in business combinations.

4. Identify defensive tactics used to attempt to block business combinations.

5. Distinguish between an asset and a stock acquisition.

6. Indicate the factors used to determine the price and the method of payment for a business combination.

Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives

Page 4: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-4

7. Calculate an estimate of the value of goodwill to be included in an offering price by discounting expected future excess earnings over some period of years.

8. Describe the two alternative views of consolidated financial statements: the economic entity and the parent company concepts.

9. List and discuss each of the seven Statements of Financial Accounting Concepts (SFAC).

Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives

Page 5: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-5

Business Combination - operations of two or more companies are brought under common control.

Nature of the CombinationNature of the CombinationNature of the CombinationNature of the Combination

A business combination may be:

Friendly - the boards of directors of the potential combining companies negotiate mutually agreeable terms of a proposed combination.

Unfriendly (hostile) - results when the board of directors of a company targeted for acquisition resists the combination.

Page 6: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-6

Defense Tactics

Nature of the CombinationNature of the CombinationNature of the CombinationNature of the Combination

1. Poison pill: Issuing stock rights to existing shareholders.

2. Greenmail: Purchase of shares held by acquiring company at a price substantially in excess of fair value.

3. White knight: Encouraging a third firm to acquire or merge with the target company.

Page 7: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-7

Defense Tactics

Nature of the CombinationNature of the CombinationNature of the CombinationNature of the Combination

4. Pac-man defense: Attempting an unfriendly takeover of the would-be acquiring company.

5. Selling the crown jewels: Sale of valuable assets to make the firm less attractive to the would-be acquirer.

6. Leveraged buyouts: Purchase of a controlling interest in the target firm by its managers and third-party investors, who usually incur substantial debt.

Page 8: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-8

The defense tactic that involves purchasing shares held by the would-be acquiring company at a price substantially in excess of their fair value is called

a. poison pill.

b. pac-man defense.

c. greenmail.

d. white knight.

Review QuestionReview Question

Nature of the CombinationNature of the CombinationNature of the CombinationNature of the Combination

Page 9: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-9

Internal Expansion vs. External Expansion

Business Combinations: Why? Why Business Combinations: Why? Why Not?Not?Business Combinations: Why? Why Business Combinations: Why? Why Not?Not?

Business combinations (external have several advantages)

LO 2 Reasons firms combine.LO 2 Reasons firms combine.

1. Operating synergies

2. International marketplace

3. Financial synergy

4. Diversification

5. Divestitures

Page 10: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-10

Three distinct periods

Business Combinations: Historical Business Combinations: Historical PerspectivePerspectiveBusiness Combinations: Historical Business Combinations: Historical PerspectivePerspective

1880 through 1904, huge holding companies, or trusts, were created to establish monopoly control over certain industries (horizontal integration).

1905 through 1930, to bolster the war effort, the government encouraged business combinations to obtain greater standardization of materials and parts and to discourage price competition (vertical integration).

1945 to the present, many of the mergers that occurred from the 1950s through the 1970s were conglomerate mergers.LO 1 Describe historical trends in types of business LO 1 Describe historical trends in types of business

combinations.combinations.

Page 11: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-11

Asset acquisition, a firm must acquire 100% of the assets of the other firm.

Stock acquisition, control may be obtained by purchasing 50% or more of the voting common stock (or possibly less).

Terminology and Types of Terminology and Types of CombinationsCombinationsTerminology and Types of Terminology and Types of CombinationsCombinations

LO 5 Distinguish between an asset and a stock LO 5 Distinguish between an asset and a stock acquisition.acquisition.

What Is Acquired? What Is Given Up?

Net assets of S Company(Assets and Liabilities)

Common Stock of S Company

1. Cash

2. Debt

3. Stock

4. Combination of above

Figure 1-1Figure 1-1

Page 12: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-12

Possible Advantages of Stock Acquisition

Lower total cost.

Direct formal negotiations may be avoided.

Maintaining the acquired firm as a separate legal entity.

Liability limited to the assets of the individual corporation.

Greater flexibility in filing individual or consolidated tax returns.

Terminology and Types of Terminology and Types of CombinationsCombinationsTerminology and Types of Terminology and Types of CombinationsCombinations

LO 5 Distinguish between an asset and a stock LO 5 Distinguish between an asset and a stock acquisition.acquisition.

Page 13: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-13

Classification by Method of Acquisition

Terminology and Types of Terminology and Types of CombinationsCombinationsTerminology and Types of Terminology and Types of CombinationsCombinations

LO 5 Distinguish between an asset and a stock LO 5 Distinguish between an asset and a stock acquisition.acquisition.

A Company B Company A Company+ =

Statutory Merger

One company acquires all the net assets of another company.

The acquiring company survives, whereas the acquired company ceases to exist as a separate legal entity.

Page 14: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-14

Classification by Method of Acquisition

Terminology and Types of Terminology and Types of CombinationsCombinationsTerminology and Types of Terminology and Types of CombinationsCombinations

LO 5 Distinguish between an asset and a stock LO 5 Distinguish between an asset and a stock acquisition.acquisition.

A Company B Company C Company+ =

Statutory Consolidation

A new corporation is formed to acquire two or more other corporations through an exchange of voting stock; the acquired corporations then cease to exist as separate legal entities.

Stockholders of A and B become stockholders in C.

Page 15: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-15

Classification by Method of Acquisition

Terminology and Types of Terminology and Types of CombinationsCombinationsTerminology and Types of Terminology and Types of CombinationsCombinations

LO 5 Distinguish between an asset and a stock LO 5 Distinguish between an asset and a stock acquisition.acquisition.

Financial Statements of

A Company

Financial Statements of

B Company

Consolidated Financial

Statements of A Company

and B Company

+ =

Consolidated Financial Statements

When a company acquires a controlling interest in the voting stock of another company, a parent–subsidiary relationship results.

Page 16: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-16

When a new corporation is formed to acquire two or more other corporations and the acquired corporations cease to exist as separate legal entities, the result is a statutory

a. acquisition.

b. combination.

c. consolidation.

d. merger

Review QuestionReview Question

Terminology and Types of Terminology and Types of CombinationsCombinationsTerminology and Types of Terminology and Types of CombinationsCombinations

LO 5 Distinguish between an asset and a stock LO 5 Distinguish between an asset and a stock acquisition.acquisition.

Page 17: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-17

Takeover Premium – the excess amount agreed upon in an acquisition over the prior stock price of the acquired firm.

Possible reasons for the premiums:

Acquirers’ stock prices may be at a level which makes it attractive to issue stock in the acquisition.

Credit may be generous for mergers and acquisitions.

Bidders may believe target firm is worth more than its current market value.

Acquirer may believe growth by acquisitions is essential and competition necessitates a premium.

Takeover PremiumsTakeover PremiumsTakeover PremiumsTakeover Premiums

LO 5 Distinguish between an asset and a stock LO 5 Distinguish between an asset and a stock acquisition.acquisition.

Page 18: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-18

The factors to beware of include the following:

Be cautious in interpreting any percentages.

Do not neglect to include assumed liabilities in the assessment of the cost of the merger.

Watch out for the impact on earnings of the allocation of expenses and the effects of production increases, standard cost variances, LIFO liquidations, and byproduct sales.

Note any nonrecurring items that may boost earnings.

Be careful of CEO egos.

Avoiding the Pitfalls Before the DealAvoiding the Pitfalls Before the DealAvoiding the Pitfalls Before the DealAvoiding the Pitfalls Before the Deal

LO 3 Factors to be considered in due diligence.LO 3 Factors to be considered in due diligence.

Page 19: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-19

When an acquiring company exercises due diligence in attempting a business combination, it should:

a. be skeptical about accepting the target company’s stated percentages

b. analyze the target company for assumed liabilities as well as assets

c. look for nonrecurring items such as changes in estimates

d. all the above

Review QuestionReview Question

Avoiding the Pitfalls Before the DealAvoiding the Pitfalls Before the DealAvoiding the Pitfalls Before the DealAvoiding the Pitfalls Before the Deal

LO 3 Factors to be considered in due diligence.LO 3 Factors to be considered in due diligence.

Page 20: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-20

When a business combination is effected by a stock swap, or exchange of securities, both price and method of payment problems arise.

The price is expressed as a stock exchange ratio.

Each constituent makes two kinds of contributions to the new entity—net assets and future earnings.

Determining Price and Method of Determining Price and Method of PaymentPaymentin Business Combinationsin Business Combinations

Determining Price and Method of Determining Price and Method of PaymentPaymentin Business Combinationsin Business Combinations

LO 6 Factors affecting price and method of payment.LO 6 Factors affecting price and method of payment.

Page 21: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-21

Net Asset and Future Earnings Contributions

Determining Price and Method of Determining Price and Method of PaymentPaymentin Business Combinationsin Business Combinations

Determining Price and Method of Determining Price and Method of PaymentPaymentin Business Combinationsin Business Combinations

LO 6 Factors affecting price and method of payment.LO 6 Factors affecting price and method of payment.

Determination of an equitable price for each constituent company requires:

The valuation of each company’s net assets.

Each company’s expected contribution to the future earnings of the new entity.

Page 22: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-22

Excess Earnings Approach to Estimate Goodwill

LO 6 Factors affecting price and method of payment.LO 6 Factors affecting price and method of payment.

1. Identify a normal rate of return on assets for firms similar to the company being targeted.

2. Apply the rate of return (step 1) to the net assets of the target to approximate “normal earnings.”

3. Estimate the expected future earnings of the target. Exclude any nonrecurring gains or losses.

4. Subtract the normal earnings (step 2) from the expected target earnings (step 3). The difference is “excess earnings.”

Determining Price and Method of Determining Price and Method of PaymentPaymentDetermining Price and Method of Determining Price and Method of PaymentPayment

Page 23: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-23

Excess Earnings Approach to Estimate Goodwill

LO 6 Factors affecting price and method of payment.LO 6 Factors affecting price and method of payment.

5. Compute estimated goodwill from “excess earnings.”

If the excess earnings are expected to last indefinitely, the present value may be calculated by dividing the excess earnings by the discount rate.

For finite time periods, compute the present value of an annuity.

Determining Price and Method of Determining Price and Method of PaymentPaymentDetermining Price and Method of Determining Price and Method of PaymentPayment

6. Add the estimated goodwill (step 5) to the fair value of the firm’s net identifiable assets to arrive at a possible offering price.

Page 24: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-24

A potential offering price for a company is computed by adding the estimated goodwill to the

a. book value of the company’s net assets.

b. book value of the company’s identifiable assets.

c. fair value of the company’s net assets.

d. fair value of the company’s identifiable net assets.

Review QuestionReview Question

LO 6 Factors affecting price and method of payment.LO 6 Factors affecting price and method of payment.

Determining Price and Method of Determining Price and Method of PaymentPaymentDetermining Price and Method of Determining Price and Method of PaymentPayment

Page 25: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-25

Exercise 1-1 Plantation Homes Company is considering the acquisition of Condominiums, Inc. early in 2008. To assess the amount it might be willing to pay, Plantation Homes makes the following computations and assumptions.

A. Condominiums, Inc. has identifiable assets with a total fair value of $15,000,000 and liabilities of $8,800,000. The assets include office equipment with a fair value approximating book value, buildings with a fair value 30% higher than book value, and land with a fair value 75% higher than book value. The remaining lives of the assets are deemed to be approximately equal to those used by Condominiums, Inc.

LO 7 Estimating goodwill.LO 7 Estimating goodwill.

Determining Price and Method of Determining Price and Method of PaymentPaymentDetermining Price and Method of Determining Price and Method of PaymentPayment

Page 26: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-26

Exercise 1-1 (continued)

B. Condominiums, Inc.’s pretax incomes for the years 2005 through 2007 were $1,200,000, $1,500,000, and $950,000, respectively. Plantation Homes believes that an average of these earnings represents a fair estimate of annual earnings for the indefinite future. The following are included in pretax earnings:

Depreciation on buildings (each year) 960,000Depreciation on equipment (each year) 50,000Extraordinary loss (year 2007) 300,000Sales commissions (each year) 250,000

LO 7 Estimating goodwill.LO 7 Estimating goodwill.

Determining Price and Method of Determining Price and Method of PaymentPaymentDetermining Price and Method of Determining Price and Method of PaymentPayment

C. The normal rate of return on net assets is 15%.

Page 27: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-27

Exercise 1-1 (continued)

Required:

A. Assume further that Plantation Homes feels that it must earn a 25% return on its investment and that goodwill is determined by capitalizing excess earnings. Based on these assumptions, calculate a reasonable offering price for Condominiums, Inc. Indicate how much of the price consists of goodwill. Ignore tax effects.

LO 7 Estimating goodwill.LO 7 Estimating goodwill.

Determining Price and Method of Determining Price and Method of PaymentPaymentDetermining Price and Method of Determining Price and Method of PaymentPayment

Page 28: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-28

Exercise 1-1 (Part A)

LO 7 Estimating goodwill.LO 7 Estimating goodwill.

Determining Price and Method of Determining Price and Method of PaymentPaymentDetermining Price and Method of Determining Price and Method of PaymentPayment

Step 1 Identify a normal rate of return on assets for firms similar to the company being targeted.

Excess Earnings Approach

15%

Step 2 Apply the rate of return (step 1) to the net assets of the target to approximate “normal earnings.”

Fair value of assets

$15,000,000Fair value of liabilities

8,800,000Fair value of net assets

6,200,000Normal rate of return

15%Normal earnings

$ 930,000

Page 29: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-29

Determining Price and Method of Determining Price and Method of PaymentPaymentDetermining Price and Method of Determining Price and Method of PaymentPayment

Step 3 Estimate the expected future earnings of the target. Exclude any nonrecurring gains or losses.

Pretax income of Condominiums, I nc., 2005 1,200,000$

Subtract: Additional depreciation on building ($960,000 x 30%) (288,000)

Target’s adjusted earnings, 2005 912,000$

Pretax income of Condominiums, I nc., 2006 1,500,000

Subtract: Additional depreciation on building (288,000)

Target’s adjusted earnings, 2006 1,212,000

Pretax income of Condominiums, I nc., 2007 950,000

Add: Extraordinary loss 300,000

Subtract: Additional depreciation on building (288,000)

Target’s adjusted earnings, 2007 962,000

Target’s three year total adjusted earnings 3,086,000

Target’s three year average adjusted earnings ($3,086,000 / 3) 1,028,667$

LO 7 Estimating goodwill.LO 7 Estimating goodwill.

Page 30: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-30

Determining Price and Method of Determining Price and Method of PaymentPaymentDetermining Price and Method of Determining Price and Method of PaymentPayment

Step 4 Subtract the normal earnings (step 2) from the expected target earnings (step 3). The difference is “excess earnings.”

LO 7 Estimating goodwill.LO 7 Estimating goodwill.

Expected target earnings

$1,028,667

Less: Normal earnings

930,000

Excess earnings, per year

$ 98,667

Page 31: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-31

Determining Price and Method of Determining Price and Method of PaymentPaymentDetermining Price and Method of Determining Price and Method of PaymentPayment

Step 5 Compute estimated goodwill from “excess earnings.”

LO 7 Estimating goodwill.LO 7 Estimating goodwill.

Excess earnings $ 98,667

Present value of excess earnings (perpetuity) at 25%:

25%= $394,668 Estimate

d Goodwill

Step 6 Add the estimated goodwill (step 5) to the fair value of the firm’s net identifiable assets to arrive at a possible offering price.

Net assets

$6,200,000

Estimated goodwill

394,668

Implied offering price

$6,594,668

Page 32: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-32

Exercise 1-1 (continued)

Required:

B. Assume that Plantation Homes feels that it must earn a 15% return on its investment, but that average excess earnings are to be capitalized for three years only. Based on these assumptions, calculate a reasonable offering price for Condominiums, Inc. Indicate how much of the price consists of goodwill. Ignore tax effects.

LO 7 Estimating goodwill.LO 7 Estimating goodwill.

Determining Price and Method of Determining Price and Method of PaymentPaymentDetermining Price and Method of Determining Price and Method of PaymentPayment

Page 33: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-33

Determining Price and Method of Determining Price and Method of PaymentPaymentDetermining Price and Method of Determining Price and Method of PaymentPayment

Part B

LO 7 Estimating goodwill.LO 7 Estimating goodwill.

Excess earnings of target (same a Part A) $ 98,667

PV factor (ordinary annuity, 3 years, 15%) x 2.28323

Estimated goodwill $ 225,279

Fair value of net assets 6,200,000

Implied offering price $ 6,425,279

The types of securities to be issued by the new entity in exchange for those of the combining companies must be determined. Ultimately, the exchange ratio is determined by the bargaining ability of the individual parties to the combination.

Page 34: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-34 LO 8 Economic entity and parent company concepts.LO 8 Economic entity and parent company concepts.

Parent Company Concept - primary purpose of consolidated financial statements is to provide information relevant to the controlling stockholders.

The noncontrolling interest presented as a liability or as a separate component before stockholders’ equity.

Alternative Concepts of ConsolidatedAlternative Concepts of ConsolidatedFinancial StatementsFinancial StatementsAlternative Concepts of ConsolidatedAlternative Concepts of ConsolidatedFinancial StatementsFinancial Statements

Economic Entity Concept - affiliated companies are a separate, identifiable economic entity.

The noncontrolling interest presented as a component of stockholders’ equity.

Page 35: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-35

Consolidated Net Income

Parent Company Concept, consolidated net income consists of the combined income of the parent company and its subsidiaries after deducting the noncontrolling interest in income as an expense in determining consolidated net income.

Economic Entity Concept, consolidated net income consists of the total combined income of the parent company and its subsidiaries. Total combined income is then allocated proportionately to the noncontrolling interest and the controlling interest.

Alternative ConceptsAlternative ConceptsAlternative ConceptsAlternative Concepts

LO 8 Economic entity and parent company concepts.LO 8 Economic entity and parent company concepts.

Page 36: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-36

Consolidated Balance Sheet Values

Parent Company Concept, the net assets of the subsidiary are included in the consolidated financial statements at their book value plus the parent company’s share of the difference between fair value and book value on the date of acquisition.

Economic Entity Concept, on the date of acquisition, the net assets of the subsidiary are included in the consolidated financial statements at their book value plus the entire difference between their fair value and their book value.

Alternative ConceptsAlternative ConceptsAlternative ConceptsAlternative Concepts

LO 8 Economic entity and parent company concepts.LO 8 Economic entity and parent company concepts.

Page 37: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-37

According to the economic unit concept, the primary purpose of consolidated financial statements is to provide information that is relevant to

a. majority stockholders.

b. minority stockholders.

c. creditors.

d. both majority and minority stockholders.

Review QuestionReview Question

Alternative ConceptsAlternative ConceptsAlternative ConceptsAlternative Concepts

LO 8 Economic entity and parent company concepts.LO 8 Economic entity and parent company concepts.

Page 38: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-38

Intercompany Profit

Two alternative points of view:

1. Total (100%) elimination

2. Partial elimination

Alternative ConceptsAlternative ConceptsAlternative ConceptsAlternative Concepts

LO 8 Economic entity and parent company concepts.LO 8 Economic entity and parent company concepts.

Under total elimination, the entire amount of unconfirmed intercompany profit is eliminated from combined income and the related asset balance. Under partial elimination, only the parent company’s share of the unconfirmed intercompany profit is eliminated.

Page 39: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-39

Conceptual FrameworkConceptual Framework Conceptual FrameworkConceptual Framework

LO 8 Economic entity and parent company concepts.LO 8 Economic entity and parent company concepts.

PRINCIPLESPRINCIPLES

1.1. Historical costHistorical cost

2.2. Revenue recognitionRevenue recognition

3.3. MatchingMatching

4.4. Full disclosureFull disclosure

SFACNos. 1 & 2

Objectives:Provide Information:

1. Usefulness ininvestment and credit decisions

2. Usefulness in future cash flows3. About enterprise resources, claims

to resources, and changes

SFAC No. 2Qualitative

Characteristics1. Relevance2. Reliability3. Comparability4. Consistency

Also:Usefulness,Understandability

SFAC No. 6(replaced SFAC No. 3)

Provides definitionsof key components

of financial statements

ASSUMPTIONSASSUMPTIONS1.1. Economic entityEconomic entity2.2. Going concernGoing concern3.3. Monetary unitMonetary unit4.4. PeriodicityPeriodicity

CONSTRAINTSCONSTRAINTS1.1. Cost-benefitCost-benefit2.2. MaterialityMateriality3.3. Industry practiceIndustry practice4.4. ConservatismConservatism

PRINCIPLESPRINCIPLES1.1. Historical costHistorical cost2.2. Revenue recognitionRevenue recognition3.3. MatchingMatching4.4. Full disclosureFull disclosure

SFAC No. 5 & 7Recognition and Measurement

SFAC No. 7: Using future cash flows & present values in accounting measures

Figure 1-2Figure 1-2 Conceptual Framework for Financial Accounting and Reporting

ObjectivesObjectives

FundamentalFundamental

OperationalOperational

Page 40: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-40

Economic Entity vs. Parent Concept and the Conceptual Framework

The parent concept is tied to the historical cost principle, which would suggest that the net assets related to the noncontrolling interest remain at their previous book values.

This approach might be argued to produce more “reliable” values (SFAC No. 2).

LO 8 Economic entity and parent company concepts.LO 8 Economic entity and parent company concepts.

FASB’s Conceptual FrameworkFASB’s Conceptual FrameworkFASB’s Conceptual FrameworkFASB’s Conceptual Framework

Page 41: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-41

Economic Entity vs. Parent Concept and the Conceptual Framework

The economic entity assumption views a parent and its subsidiaries as one economic entity even though they are separate legal entities.

A shift to the economic entity concept seems to be consistent with the assumptions laid out by the FASB for GAAP (SFAC No. 5).

LO 8 Economic entity and parent company concepts.LO 8 Economic entity and parent company concepts.

FASB’s Conceptual FrameworkFASB’s Conceptual FrameworkFASB’s Conceptual FrameworkFASB’s Conceptual Framework

Page 42: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-42

Overview of FASB’s Conceptual Framework

LO 9 Statements of Financial Accounting Concepts.LO 9 Statements of Financial Accounting Concepts.

FASB’s Conceptual FrameworkFASB’s Conceptual FrameworkFASB’s Conceptual FrameworkFASB’s Conceptual Framework

SFAC No.1 -Objectives of Financial Reporting

SFAC No.2 - Qualitative Characteristics of Accounting Information

SFAC No.3 - Elements of Financial Statements (superceded by SFAC No. 6)

SFAC No.4 - Nonbusiness Organizations

SFAC No.5 -Recognition and Measurement in Financial Statements

SFAC No.6 - Elements of Financial Statements (replaces SFAC No. 3)

SFAC No.7 -Using Cash Flow Information and Present Value in Accounting Measurements

The Statements of Financial Accounting Concepts issued by the FASB include:

Page 43: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-43

Distinguishing between Earnings and Comprehensive Income

LO 9 Statements of Financial Accounting Concepts.LO 9 Statements of Financial Accounting Concepts.

FASB’s Conceptual FrameworkFASB’s Conceptual FrameworkFASB’s Conceptual FrameworkFASB’s Conceptual Framework

Earnings is essentially revenues and gains minus expenses and losses, with the exception of any losses or gains that bypass earnings and, instead, are reported as a component of other comprehensive income.

SFAC No. 5 describes them as “principally certain holding gains or losses that are recognized in the period but are excluded from earnings such as some changes in market values of investments... and foreign currency translation adjustments.”

Page 44: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-44

Asset Impairment and the Conceptual Framework

LO 9 Statements of Financial Accounting Concepts.LO 9 Statements of Financial Accounting Concepts.

FASB’s Conceptual FrameworkFASB’s Conceptual FrameworkFASB’s Conceptual FrameworkFASB’s Conceptual Framework

SFAC No. 5 provides guidance with respect to expenses and losses:

Consumption of benefit. Earnings are generally recognized when an entity’s economic benefits are consumed in revenue earnings activities (Example: amortization of limited-life intangibles); or

Loss or lack of benefit. Expenses or losses are recognized if it becomes evident that previously recognized future economic benefits of assets have been reduced or eliminated, or that liabilities have increased, without associated benefits (Example: review for impairment for indefinite-life intangibles).

Page 45: Chapter 1-1. Chapter 1-2 Introduction to Business Combinations and the Conceptual Framework Advanced Accounting, Third Edition 11

Chapter 1-45

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