concepts of bus. combin. - 1 business combinations “a business combination occurs when an...

Concepts of Bus. Combin. - 1

Business Combinations

“A business combination occurs when an enterprise

acquires net assets that constitute a business or equity interests of one

or more other enterprises and obtains

control over that enterprise or enterprises.”

- - SFAS No. 141

“A business combination occurs when an enterprise

acquires net assets that constitute a business or equity interests of one

or more other enterprises and obtains

control over that enterprise or enterprises.”

- - SFAS No. 141

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“A business combination occurs when two or more

companies join under common control,

meaning the ability to direct policies and

management.”

- - BAKER, et.al.

“A business combination occurs when two or more

companies join under common control,

meaning the ability to direct policies and

management.”

- - BAKER, et.al.


MOTIVATION FOR BUSINESS COMBINATIONS

Growth– New markets– Increase in market share

Reduction in operating costs Diversification Tax reasons Management incentives


BUSINESS COMBINATIONSEconomic Substance

Horizontal combinations

Vertical combinations (integration)

Conglomerates


BUSINESS COMBINATIONSLegal Form

Merger

Consolidation (Statutory)

Acquisition

Variable interests


Types of Business Combinations

P Company

S Company

P Company

Merger



P Company

S Company

Statutory Consolidation

X Company



P Company

S Company

Stock Acquisition

P Company

S Company

&


Business Combinations

Exh.2-2

ContinuedContinued

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Business Combinations – Continued

Exh.2-2

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A Control Issue – SPE’s

Special Purpose Entities (a popular type of “variable interest entity”) were misused to hide debt and manipulate earnings

As a result, the FASB (in FIN 46R) expanded the definition of “control” beyond just the holding of a majority share position.

The following indicate a controlling financial interest in a variable interest entity:– Direct or indirect ability to make decisions about the

entity’s activities– Obligation to absorb any expected losses of the entity– The right to receive any expected residuals of the

entity

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What is to be consolidated?

If dissolution occurs:All account balances are actually

consolidated in the financial records of the survivor.

If separate incorporation maintained:

Financial statement information is consolidated on work papers and not in the actual records

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When does consolidation occur?

If dissolution occurs:– Permanent consolidation occurs at the

combination date

If separate incorporation maintained:– Consolidation (on work papers, not in the actual

records!!) occurs regularly, whenever financial statements are prepared

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How does consolidation affect the accounting records?

If dissolution occurs:– Dissolved company’s records are closed out.– Surviving company’s accounts are adjusted to

include all balances of the dissolved company

If separate incorporation maintained:– Each company continues to maintain its own records

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BUSINESS COMBINATIONSMethod of Accounting

Acquisition

Purchase

Pooling of interests


Accounting for CombinationsJune 30, 2001 Calendar 2009

Purchase

ORPooling

Purchaseonly

(Not retroactive)

Acquisitiononly

(Not retroactive)

Selection based onspecific criteria

for Pooling

All new combinationsmust use Purchase(no adjustment of

older results)

All new combinationsmust use Acquisition

(no adjustment ofolder results)


Purchase

Acquisition

Horizontal

Vertical

Conglomerate

Merger StatutoryConsolidation

StockAcquisition

Pooling


The Acquisition Method

A replacement for the Purchase Method

Requires measurement of fair value of the acquired business as a whole

Requires measurement and recognition of the fair values of the separately identified assets acquired and liabilities assumed

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Acquisition Methods – Key Changes

Adopts a “business fair value” measurement approach as opposed to the traditional “cost-based” measure

Direct combination costs will be expensed as incurred

Contingent consideration obligations are recognized as part of the purchase price

With bargain purchases, no assets will be recorded at less than fair value, which will produce recognized gains on purchase

Allows for capitalization of Purchased In-Process Research and Development (IPR&D)

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Capitalization of In-Process Research and Development Costs (IPR&D)

To be recognized and measured at fair value on the acquisition date

Reported as intangible assets with indefinite lives

Subject to periodic “impairment reviews”

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Related Costs of Business Combinations (Acquisition Method)

Costs incurred for outside services (attorneys, appraisers, accountants, investment bankers, etc.) related to the combination are NOT considered part of the fair value received, and so are immediately expensed

Internal costs of acquisition (secretarial and management time) are expensed as incurred.

Costs to register and issue securities related to the acquisition reduce their fair value

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Acquisition Method - SummaryConsideration transferred equals fair values of net assets acquired

Assets acquired and liabilities assumed are recorded at their fair values

Consideration transferred is greater than the fair values of net assets acquired

Assets acquired and liabilities assumed are recorded at their fair values. Excess consideration recorded as goodwill

Consideration transferred is less than the fair values of net assets acquired

Assets acquired and liabilities assumed are recorded at their fair values. Excess of fair value over consideration is recorded as gain on bargain purchase

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When the acquisition is made

by issuing stock, the cost of the

acquisition equals the MARKET

VALUE of the stock issued.

When the acquisition is made

by issuing stock, the cost of the

acquisition equals the MARKET

VALUE of the stock issued.

Purchase Method – SFAS 141

Employed when there is a change in ownership resulting in control of one enterprise by another.

The appropriate valuation basis for any purchase transaction is “cost”.

(Total value assigned to the net assets received equals the total cost of the acquisition.)

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Accounting Challenge!!!

Allocation of “cost of acquisition” among the various assets and liabilities obtained.

Allocation depends on the relation between total cost and “fair value” of the acquired firm’s assets and liabilities.

FASB defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction of market participants at the measurement date.” (FASB, Statement of Financial Accounting Standards No. 157, Fair Value Measurements)

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“Direct Costs” of Combination

Typically includes fees to the following for advising services in arranging and structuring the combination:– Investment bankers– Accountants– Attorneys

These must be included in determining the purchase “cost.”

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Purchase Method Situations

Dissolution of the acquired company:Purchase Price = Fair ValuePurchase Price > FVPurchase Price < FV

Separate incorporation maintained.

Dissolution of the acquired company:Purchase Price = Fair ValuePurchase Price > FVPurchase Price < FV

Separate incorporation maintained.

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Purchase Method - DissolutionPurchase Price = Fair Value

Ignore the Equity and Nominal accounts of the acquired company.

Determine fair value of the acquired company’s assets and liabilities.

Prepare a journal entry to – recognize the cost of acquisition– incorporate the FV of the acquired

company’s assets and liabilities into the acquiring company’s books.

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Purchase Method - DissolutionPurchase Price > Fair Value

FV of acquired company’s assets and liabilities is added to acquiring company’s books.

Difference between Acquisition Cost and FV of acquired assets and liabilities is allocated to identifiable intangible assets and to goodwill.

Note: Goodwill should be viewed

as a residual amount

remaining after all other

identifiable and separable

intangible assets have been

recognized.

Note: Goodwill should be viewed

as a residual amount

remaining after all other

identifiable and separable

intangible assets have been

recognized.

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Purchase Method - DissolutionPurchase Price < Fair Value

When fair value exceeds cost, full allocation of fair value is not possible.

Current assets and liabilities should be consolidated at their fair value.

Non-current assets should be proportionately reduced in value (with some exceptions)

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According to SFAS 141, the following non-current assets are exceptions to the proportionate reduction, and should be recorded at assessed fair values:

– Financial assets other than equity method investments

– Assets to be disposed of by sale– Deferred tax assets– Prepaid assets related to pension or other post-

retirement benefit plans

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In the event that the difference is substantial enough to eliminate all the non-current asset balances of

the acquired company . . .

. . . The remainder is to be reported as an extraordinary gain

(SFAS 141)

In the event that the difference is substantial enough to eliminate all the non-current asset balances of

the acquired company . . .

. . . The remainder is to be reported as an extraordinary gain

(SFAS 141)

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Accounting for Additional Costs Associated with Business Combinations (SFAS 141)

Direct combination costs (Accounting, legal, investment banking and appraisal fees, etc.)

Include in the purchase price of the acquired firm

Indirect combination costs (additional internal costs such as secretarial or managerial time)

Expense as incurred

Costs to register and issue securities

Reduce the value assigned to the fair value of the securities issued (typically as a debit to APIC)

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Let’s see what happens Let’s see what happens when the acquired company when the acquired company

is not dissolved.is not dissolved.

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Purchase Method - No Dissolution

The acquired company continues as a separate entity.

– Reported on Parent’s books as the Investment in Subsidiary account.

Separate records for each company are still maintained.

The adjusted balances for the Parent and the Subsidiary are consolidated using a worksheet (no formal journal entries!)

The acquired company continues as a separate entity.

– Reported on Parent’s books as the Investment in Subsidiary account.

Separate records for each company are still maintained.

The adjusted balances for the Parent and the Subsidiary are consolidated using a worksheet (no formal journal entries!)

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Steps for Consolidation

1. Record the financial information for both Parent and Sub on the worksheet.

1. Record the financial information for both Parent and Sub on the worksheet.

2. Remove the Investment in Sub balance.2. Remove the Investment in Sub balance.

3. Remove the Sub’s equity account balances.

3. Remove the Sub’s equity account balances.

4. Adjust the Sub’s net assets to FV.4. Adjust the Sub’s net assets to FV.

5. Allocate any excess of cost over BV to identifiable, separable intangible assets

or goodwill.

5. Allocate any excess of cost over BV to identifiable, separable intangible assets

or goodwill.

6. Combine all account balances.6. Combine all account balances.

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Purchase Price Allocations - Additional Issues, SFAS No. 141

Intangibles– Current and noncurrent

assets that lack physical substance.

– Do not include financial instruments.

When should an Intangible be recognized?– Does it arise from

contractual or other legal rights?

– Can it be sold or otherwise separated from the acquired enterprise?

Intangibles– Current and noncurrent

assets that lack physical substance.

– Do not include financial instruments.

When should an Intangible be recognized?– Does it arise from

contractual or other legal rights?

– Can it be sold or otherwise separated from the acquired enterprise?

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Intangible Asset Examples

Customer Base Trademarked Brand

Names Customer Routes Effective Advertising

Programs Covenants Rights (broadcasting,

development, use, etc.)

Customer Base Trademarked Brand

Names Customer Routes Effective Advertising

Programs Covenants Rights (broadcasting,

development, use, etc.)

Databases Technological know-

how Patents & Copyrights Strong labor relations Assembled, trained

workforce Favorable

government relations

Databases Technological know-

how Patents & Copyrights Strong labor relations Assembled, trained

workforce Favorable

government relations

Exh.2-7

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In-Process R&D– Should be expensed

immediately upon acquisition (unless there are alternative future uses.)

IPR&D that has reached technological feasibility, may be “capitalized”.– Determination of fair value is

critical.

In-Process R&D– Should be expensed

immediately upon acquisition (unless there are alternative future uses.)

IPR&D that has reached technological feasibility, may be “capitalized”.– Determination of fair value is

critical.

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Unconsolidated Subsidiaries

SF AS No . 94

W hen control does notactually rest w ith the 50%

ow ners.

W hen can a Parent exclude a 50%ow ned subsidiary from consolidation?

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Pooling of Interests

Historically, many business combinations were accounted for as “Pooling of Interests.”

In SFAS 141, “Business Combinations”, the FASB stated that all business combinations should be accounted for using the

“Purchase MethodPurchase Method”.

Historically, many business combinations were accounted for as “Pooling of Interests.”

In SFAS 141, “Business Combinations”, the FASB stated that all business combinations should be accounted for using the

“Purchase MethodPurchase Method”.

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Concepts of Bus. Combin. - 40Pooling of Interest

What is essentialfor a combination to

be viewed as apooling of interest?

What is essentialfor a combination to

be viewed as apooling of interest?An exchange of

common stock.

An exchange ofcommon stock.

POOLING OF INTERESTS


Pooling of Interests

According to SFAS No. 141, the purchase method is not to be applied to past “Poolings of

Interest.”

Past poolings of interests are left intact by SFAS No. 141.

Therefore, it is important to understand how to account for

PAST poolings.

According to SFAS No. 141, the purchase method is not to be applied to past “Poolings of

Interest.”

Past poolings of interests are left intact by SFAS No. 141.

Therefore, it is important to understand how to account for

PAST poolings.

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In a pooling, one company obtained

essentially “all” of the other company’s

stock.

In a pooling, one company obtained

essentially “all” of the other company’s

stock.

The transaction involved the

exchange of common stock. No exchange of cash was allowed.

The transaction involved the

exchange of common stock. No exchange of cash was allowed.

The ownership interests of two, or more, companies were combined into one new company.

No single company was dominant.

Precise cost figures were difficult to obtain.

To use pooling of interests, 12 strict criteria had to be met.

Historical Review of Pooling of Interests

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CRITERIA FOR POOLINGAPB No. 16

Attributes of combining companies - Autonomous - Independent of one another Manner of achieving combination - Single transaction - Common stock for Common stock - For “substantially all” common stock (90%) Absence of planned transactions - Planned spin-off of assets - Contingent agreements


Historical Review of Pooling of Interests

The Book Values of the two combining companies were

joined. No Goodwill was recorded.

The Book Values of the two combining companies were

joined. No Goodwill was recorded.

Revenues and expenses were combined retroactively for the

two companies.

Revenues and expenses were combined retroactively for the

two companies.

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POOLING OF INTERESTS Accounting Considerations

Combination of ownership interests- NOT AN ACQUISITION

NO TRANSACTION by the corporate entities - No new basis of accountability

- Total combined net assets unchanged

NO CHANGE in total combined stockholders’ equity Reallocation of individual accounts may be required

Retained earnings accounts combined

Earnings - combined for entire year of pooling

Direct combination expenses = period expenses

POOLING OF INTERESTS

=+Assets Assets Assets

+ = Liabilities Liab. Liab.

Par Par

OCC OCC

RE RE+ = Stockholders’

Equity

OCC

Par

OCC

Par

RE

RE

RE

Par

Total par issued vs. Total par exchanged


Summary

Consolidation of financial information is required when one organization gains control of another.

If dissolution occurs, this consolidation is carried out at the date of acquisition and a single set of accounting records is maintained.

If separate identities are maintained, consolidation is a periodic “worksheet” process not involving journal entries. Separate accounting records are maintained.

The purchase method is currently GAAP, although the FASB has proposed changing to the Acquisition Method

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Possible Criticisms

The proposed “business fair value” measurement approach involves a departure from traditional “cost-based” measurement. This violates the Historic Cost Principle.

The proposed capitalization of IPR&D departs from the traditional SFAS 2 approach of expensing R&D as incurred.

WHAT DO YOU THINK?

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concepts of bus. combin. - 1 business combinations “a business combination occurs when an...

Documents

business combinationsexh

voting stock

acquiring companyaction

assets liabilities

definition of control

common control

separate legal entity

companystatutory merger