acct 501 chapter 5 business combinations 2 objectives of the chapter 1. to discuss the general view...

ACCT 501

Chapter 5

Business Combinations

Business Combinations 2

Objectives of the Chapter

1. 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.



3. To discuss the development of two alternatives for business

combinations from a historical perspective.

4. Preparing financial statements following a business combination for statutory

merger type of business combination.



5. To learn accounting for statutory consolidation (using purchase method).

6. To discuss the current development on business combination standards.


Business Combinations

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.


Business Combinations (contd.)

FASB’s 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 (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.


Types of Business Combinations

Friendly takeovers

Hostile takeovers


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.


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.


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.


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.


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.


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.


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.



b. acquiring target firm’s common stock in an open market, or through a tender offer to stockholders of a publicly owner corporation.



c. When acquiring enough shares to have the controlling interest in

the combinee’s voting commonshares,the target firm

becomes affiliated with the combinor (the parent company) as a subsidiary.

The target firm remains as a separate legal entity.


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 ……..)


Establishing the Price for a Business Combination

1. Capitalization of expected average annual earnings of the combinee at a desired rate of return.

2. Determination of current fair value of the combinee’s net assets (including goodwill).


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.


Methods of Accounting for Business Combinations

Purchased Goodwill = AAP – combinee’s assets step-up.

Assets step up = the fair market value of net assets

of the combinee – the book value of these net assets.


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 firm’s net assets are consolidated at their existing book value and any accounting acquisition premium (AAP) is ignored.


Methods of Accounting for Business Combinations (contd.) 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).


Methods of Accounting for Business Combinations (contd.) 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).


Methods of Accounting for Business Combinations (contd.) 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 ).


Purchase Accounting

Cost of a Combinee including: 1.the amount of consideration paid by

the combinor to a combinee. 2.the combinor’s direct “out-of-

pocket” costs of the combination, and

3.contingent consideration which is determinable on the business combination date.


Cost of A Combinee (contd.)

Direct out-of-pocket costs include legal fees, accounting fees, and finder’s fees.

Costs of registering with the SEC and issuing debt securities in a business combinations are debited to Bond Issue Costs.


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.


Accounting Treatment for Contingent Consideration

a.Contingent consideration which is determinable on the

combination date:

recorded as part of the cost of the combination.


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.


Assigning Values to a Purchased Combinee’s 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;


Assigning Values to a Purchased Combinee’s 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.


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.


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.


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.


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 Mason’s stockholders for all 100,000 issued and outstanding shares of Mason’s no-par, $10 stated value common stock.

In addition, Saxon paid the following out-of-pocket costs associated with business combination:


Example I (contd.): Out of Pocket Costs

Accounting fees: For investigation of Mason Company as prospective combinee $ 5,000 For SEC registration statement for Saxon common stock 60,000Legal fees: For the business combination 10,000 For SEC registration statement for Saxon common stock 50,000


Example I (contd.): Out of Pocket Costs (contd.)

Finder’s fee 51,250Printer’s charges for printing securities and SEC registration statement 23,000SEC registration statement fee 750

Total out-of-pocket costs of business combination $200,000 There was no contingent consideration in the

merger contract.


Example I (contd.): Mason Company’s Condensed B/S Prior to The Merger

MASON COMPANY (combinee)Balance Sheet (prior to business combination)

December 31,1999

AssetsCurrent assets $1,000,000Plant assets (net) 3,000,000Other assets 600,000

Total assets 4,600,000

(Continued)


Example I (contd.): Mason Company’s Condensed B/S Prior to The Merger (contd.)

MASON COMPANY Balance Sheet (contd.) , 12/31/1999

Liabilities & Stockholders’ EquityCurrent Liabilities $ 500,000Long-term debt 1,000,000Common stock, no-par,$10 stated value 1,000,000Additional paid-in capital 700,000Retained earnings 1,400,000

Total liabilities & stockholders’ equity $4,600,000


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 Company’s identifiable assets and liabilities (identifiable net assets) as follows:


Example I (contd.): Fair Value of Identifiable Net Assets of Combinee

Current assets $ 1,150,000Plant assets 3,400,000Other assets 600,000Current liabilities (500,000)Long-term debt (present value) (950,000)

Identifiable net assets of combinee $3,700,000


Example I (contd.): Combinor’s 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.


Example I (contd.): Combinor’s Journal Entries for Business Combination (contd.) Journal Entries for Saxon Corp. 12/31/1999

Investment in Mason Company Common Stock (150,000 x $25) 3,750,000

Common stock (150,000 x $10) 1,500,000Paid-in Capital in Excess of Par 2,250,000

To record merger with Mason Company as a purchase.

(Continued)


Example I (contd.): Combinor’s Journal Entries for Business Combination (contd.) 12/31/1999 (contd.)

Investment in Mason Company Common Stock ($5,000+$10,000+$51,250) 66,250Paid-in Capital in Excess of Par ($60,000+$50,000 + $23,000+750) 133,750

Cash 200,000To record payment of out-of-pocket costs incurred in merger with Mason Company.

(Continued)


Example I (contd.): Combinor’s Journal Entries for Business Combination (contd.) 12/31/1999 (contd.)

Current Assets 11,500,000

Plant Assets 3,400,000

Other Assets 600,000

Discount on Long-Term Debt 50,000

Goodwill 116,250

Current Liabilities 500,000

Long-Term Debt 1,000,000

Investment in Mason Company Common Stock ($3,750,000+$66,250) 3,816,250To allocate total cost of liquidated Mason Company to identifiable assets and liabilities, with the reminder to goodwill. (Income tax effects are disregarded.)


Example I (contd.): Combinee’s 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.


Example I (contd.): Combinee’s J.E. for The Dissolution of The Company after Statutory Merger (contd.) Journal Entries for Mason Corp.12/31/1999


Long-Term Debt 1,000,000

Common Stock , $10 stated value 1,000,000Paid-in Capital in Excess of Stated Value 700,000Retained Earnings 1,400,000

Current Assets 1,000,000

Plant Assets (net) 3,000,000



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.


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:


Example II (contd.):Combinee’s B/S Prior to Statutory Merger

FAIRMONT CORPORATION (combinee)Balance Sheet (prior to business combination)

December 31, 1999Assets Carrying

AmountsCurrent Fair

ValuesCurrent assets $ 190,000 $ 200,000Investment in marketable debt securities (held to maturity) 50,000 60,000Plant assets (net) 870,000 900,000Intangible assets (net) 90,000 100,000

Total assets $1,200,000 $1,260,000(Continued)


Example II (contd.):Combinee’s B/S Prior to Statutory Merger (contd.)

FAIRMONT CORPORATION B/S (contd.)

Liabilities and Stockholders’ Equity

Carrying Amounts

Current Fair Values

Current liabilities $ 240,000 $ 240,000Long-term debt 500,000 520,000

Total Liabilities $ 740,000 $ 760,000Common stock, $1 par $ 600,000Deficit (140,000)

Total stockholders’ equity $ 460,000Total liabilities & stockholders’ equity $1,200,000


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


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:


Example II (contd.) : Allocation of Negative Goodwill

To 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) =$6,000Total excess of current fair value of identifiable net assets over combinor’s cost $60,000


Example II (contd.)

Notes: No part of the $60,000 bargain-purchase excess is allocated to current assets or to the investment in marketable securities.

The journal entries on pages 54 and 55 record Davis Corporation’s acquisition of the net assets of Fairmont Corporation and payment of $40,000 legal fees:


Example II (contd.) : Combinor’s J.E. for The Acquisition of Net Assets Journal Entries of Davis Corp. 12/31/1999

Investment in Net Assets of Fairmont Corporation 400,000

Cash 400,000To record acquisition of net assets of Fairmont Corporation

(Continued)

Investment in Net Assets of Fairmont Corporation 40,000

Cash 40,000To record payment of legal fees incurred in acquisition of net assets of Fairmont Corporation


Example II (contd.) : Combinor’s J.E. for the Acquisition of Net Assets (contd.) 12/31/1999 (contd.)Current Assets 200,000Investments in Marketable Debt Securities 60,000Plant Assets ($900,000 - $54,000) 846,000Intangible Assets ($100,000 - $6,000) 94,000

Current Liabilities 240,000Long-Term Debt 500,000Premium on Long-Term Debt ($520,000 - $500,000) 20,000Investment in Net Assets of Fairmont Corporation ($400,000 + $40,000) 440,000


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.


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.


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.


Pooling-of-Interests Accounting (contd.) Both the market value of the common

stock issued for the combination and the fair value of the combinee’s net assets are disregarded in this method.

The term “issuer” identifies the corporation that issues its common stock to accomplish the combination.


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 Corporation’s accounting records:


Example III : Pooling-of-Interests Accounting for Statutory Merger (contd.) Journal Entries for Saxon Corp. 12/31/1999Current Assets 1,000,000

Plant Assets (net) 3,000,000



Long-term Debt 1,000,000

Common Stock, $10 par 1,500,000

Paid-in Capital in Excess of Par 200,000Retained Earnings 1,400,000

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


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

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

Expenses of Business Combination 200,000

Cash 200,000To record payment of out-of-pocket costs incurred in merger with Mason Company


Example III (contd.): Notes to the example

Notes:1. An Investment in Mason’s Company

Common Stock account is not used in the pooling-of-interests method.

2. Mason’s assets, liabilities and retained earnings are recorded at their carrying amounts in Mason’s 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 Saxon’s common stock issued for the combination exceeds the premerger paid-in capital of Mason, Saxon’s 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, Saxon’s Retained Earnings account should be debited.

6. The entire out-of-pocket costs were expensed and are not tax deductible.


Advantage of Using Pooling Accounting on Financial Numbers

1.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:


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

Purchase Accounting Pooling Accounting

Current Assets 1,150,000 1,000,000

Plant Assets 3,400,000 3,000,000

Other Assets 600,000 600,000

Discount on Long-Term Debt 50,000Good will 116,250

Expense of Business Combination

200,000

(Continued)



Purchase Accounting Pooling Accounting

Current Liabilities 500,000 500,000

Long-Term Debt 1,000,000 1,000,000

Common Stock, $ 10 par 1,500,000 1,500,000Paid-in Capital in Excess of Par 2,116,250 200,000Retained Earnings 1,400,000

Cash 200,000 200,000

To record merger with Mason Company.



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

Purchase accounting

net assets $3,616,250 Pooling accounting

net assets 2,900,000 Difference $ 716,250


Advantage of Using Pooling Accounting on Financial Numbers (contd.) The composition of the $716,250 is

summarized as follows:Excess of purchase asset values over pooling asset values: Current assets ($1,150,000-$1,000,000) $150,000 Plant assets ($3,400,000- $3,000,000) 400,000 Goodwill 116,250Excess of pooling liability values over purchase liability values: Long-term debt [$1,000,000-($1,000,000- $50,000) ] 50,000Excess of purchase net assets values over pooling net assets values $716,250



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.



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.


Advantage of Using Pooling Accounting on Financial Numbers (contd.) Based on the above information, Saxon’s 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 $150,000Depreciation expense ($400,000 x 1/10) 40,000Amortization expense ($116,250 x 1/40) 2,960Interest expense ($50,000 x 1/5) 10,000Excess of year 2000 pre-tax income under pooling accounting rather than under purchase accounting $202,906



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 post-merger earnings.



2.Advantage on the Retained EarningsThe 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.



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:



Saxon Corporation

Mason Company

Year ended Dec. 31, 1999:

Net income $500,000* $375,000 Basic earnings per share of common stock $0.50 $3.75On Dec. 31, 1999:

Number of shares of common stock outstanding 1,000,000+ 100,000+ Market price per share $25 $30 Price-earnings ratio 50 8* Net of $200,000 expenses of business combination.

+ Outstanding during entire year.



Using the pooling method, Saxon would report the combined enterprise’s 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).


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),


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 .


Historical Perspective of Accounting for Business Combinations (contd.) 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.


Historical Perspective of Accounting for Business Combinations (contd.) 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.


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.


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.


Past Abuses of Pooling Accounting(contd.) Among these abuses are:

a. Retroactive Pooling

b. Retrospective Pooling

c. Part-Pooling, Part-Purchase Accounting

d. Treasure Stock Issuance


Past Abuses of Pooling Accounting(contd.) Contd.:

e.Issuance of Unusual Securities

f. Creation of “instant Earnings”

g.Contingent Payouts

h.“Burying” the Costs of Pooling-TypeBusiness Combinations


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.


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.


Conditions Requiring Pooling Accounting in APB Opinion No. 16

1.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.


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.


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.


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:


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.



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.



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.



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.



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.


Discussion of Four Conditions

1.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.


Discussion of Four Conditions (contd.)2.Substantially All Voting Common

Stock of Combinee’s Company Are ExchangedThe condition requires that at least 90% of the combinee’s outstanding voting common stock be exchanged for the issuer’s voting common stock.

The following are excluded from the computation of the number of shares exchanged:


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 issuer’s voting common stock.


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.


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 Patton’s voting common stock (1,000,000 shares issued and outstanding prior to March 13, 1999) were to be exchanged for each outstanding share of Sherman’s common stock (100,000 shares issued and 99,500 shares outstanding prior to March 13,1999).


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 Sherman’s common stock, and Sherman owned 6,000 shares of Patton’s voting common stock; in addition, 500 shares of Sherman’s common stock were in Sherman’s treasury.


Discussion of Four Conditions (contd.)Example to illustrate the independence and 90% of voting common stock tests (contd.) Neither Patton’s ownership of 7.54% of

Sherman’s outstanding common stock (7,500/ 99,500 = 7.54%) nor Sherman’s ownership of 0.6% of Patton’s outstanding common stock (6,000/ 1,000,000 = 0.6%) exceeds the 10% limitation of the independence of constituent companies requirement.


Discussion of Four Conditions (contd.)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 Sherman’s 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 Sherman’s common stock to complete the business combination.


Discussion of Four Conditions (contd.)Example to illustrate the independence and 90% of voting common stock tests (contd.) Computation of the 90% requirement follows:Total Sherman Company shares issued, June 30, 1999 100,000Less: Shares in Sherman’s treasury 500Total Sherman shares outstanding, June 30, 1999 99,500Less:

Sherman shares owned by Patton Corporation, Mar. 13, 1999 7500Sherman shares acquired by Patton for cash, Mar. 26, 1999 1000

(Continued)


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

Equivalent number of Sherman shares represented by Patton’s common stock owned by Sherman, Mar. 13, 1999 (6,000÷ 1 ½) 4,000 12,500

Effective number of Sherman shares acquired June 30, 1999 in exchange for Patton’s common stock 87,000Application of 90% requirement (99,500 x 90%) 89,550


Discussion of Four Conditions (contd.)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 Sherman’s 99,500 shares outstanding, the business combination does not qualify for pooling accounting.


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.


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.


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:

Assets & Lia. Retained earnings

Purchase-combinor

Carrying amount Reported

Purchase-combinee

Fair value Not reported

Pooling-combinor


Pooling- combinee



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.


Financial Statements Following a Business Combination (contd.) 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.


Financial Statements Following a Business Combination (contd.) 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.


Financial Statements Following a Business Combination (contd.)

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 pooling-type merger described on page 60-65 example III), were as shown below.

Assume also that Mason’s interest expense includes $25,000 paid to Saxon on a loan that was repaid prior to December 31, 1999, and that Saxon’s revenue includes $25,000 interest received from Mason.



Example IV (contd.)SAXON CORPORATION AND MASON COMPANY

Separate Income StatementsFor Year Ended December 31, 1999

Saxon Corporation

Mason Company

Sales and other revenue $10,000,000 $5,000,000Costs and expenses:

Costs of goods sold $ 7,000,000 $3,000,000Operating expenses 1,883,333* 1,274,500Interest expense 150,000 100,500Income taxes expense 466,667 250,000

Total costs and expenses $ 9,500,000 $4,625,000

Net income $ 500,000 $ 375,000*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 Saxon’s published postmerger income statement for the year ended December 31,1999.



Example IV (contd.)

Saxon Corporation

Mason Company

Eliminations Combined

Sales and other revenue 10,000,000 5,000,000 (a) 25,000 14,975,000Cost 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

expenses9,500,000 4,625,000 (25,000) 14,100,000

Net income 500,000 375,000 -0- 875,000

SAXON CORPORATIONWorking Paper for Combined Income Statement (Pooling of Interests)

For Year Ended December 31, 1999

(a) To eliminate intercompany interest received by Saxon Corporation from MasonCompany.


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;


Notes to Financial Statements Following a Business Combination (contd.) 2.period for which combinee’s 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;


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 proforma disclosures for nonpublic enterprises.



Required Disclosure for Pooling Accounting

1. Name and brief description of the combinee; the accounting method used for the business combination;



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.


Comparison of Purchase and Pooling Accounting The following table summarizes the

principal aspects of purchase accounting and pooling-of-interests accounting for business combinations:


Comparison of Purchase and Pooling Accounting (contd.)

Aspect Purchase Accounting

Pooling-of-Interests

AccountingUnderlying premise

Acquisition of assets

Combining of stockholder interests

Applicability Combinations not meeting all 12 criteria for pooling accounting

Combinations meeting all 12 criteria for pooling accounting

(Continued)





Accounting recognition of investment in combinee

At cost, including amount of consideration, direct out-of-pocket costs, and determinable contingent consideration

At carrying amount of combinee’s net assets (all out-of-pocket costs are recognized as expenses of the issuer)

Valuation of combinee’s net assets in combined enterprise

At current fair values on date of combination

At carrying amounts on date of combination

(Continued)





Goodwill recognition Yes, if combinor’s cost exceeds current fair value of combinee’s identifiable net assets

No

Retained earnings of constituent companies combined on date of business combination

NO YES

(Continued)





Financial statements and notes for period of business combination: Balance sheet Combinor’s net assets

at carrying amount; combinee’s net assets at current fair value

Both issuer’s and combinee’s net assets at carrying amount

(Continued)



Aspect Purchase Accounting Pooling-of-Interests Accounting

Income statement

Combinor’s operations for entire period; combinee’s operations from date of combination to end of period

Both issuer’s and combinee’s operations for entire period as though combination took place at beginning of period; prior periods restated comparably

Disclosure of operations in notes

Pro forma for combined enterprise for current and preceding period as though combination took place at beginning of preceding period

Separately for constituent companies for period prior to combination


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.


Purchase-Type Statutory Consolidation (contd.)Example V : 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):


Purchase-Type Statutory Consolidation (contd.)

Example V (contd.):LAMSON CORPORATION AND DONALD COMPANY

Separate Balance Sheets (prior to business combination)December 31,1999

Assets Lamson Corporation

Donald Company

Current assets $ 600,000 $ 400,000Plant assets (net) 1,800,000 1,200,000Other assets (net) 400,000 300,000

Total assets $ 2,800,000 $1,9,00,000

(Continued)



Example V (contd.):LAMSON CORPORATION AND DONALD COMPANY

Separate Balance Sheets (contd.), 12/31/1999

Liabilities & Stockholders’ Equity

Lamson Corporation

Donald Company

Current liabilities $ 400,000 $ 300,000Long-term debt 500,000 200,000Common stock,$10 par 430,000 620,000Additional paid-in capital 300,000 400,000Retained earnings 1,170,000 380,000

Total liabilities & stockholders’ equity $ 2,800,000 $1,9,00,000



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.



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:



Example V(contd.):Lamson

CorporationDonald

CompanyCurrent fair value of identifiable net assets: Lamson: $800,000+$2,000,000 +$500,000- $400,000-$500,000 $2,400,000 Donald: $500,000+ $1,400,000 + $400,000 -$300,000-$200,000 $1,800,000Goodwill 180,000 60,000 Net assets’ current fair value $2,580,000 $1,860,000Number of shares of LamDon common stock to be issued to constituent companies’ stockholders, at $60 a share agreed value 43,000 31,000



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.



Example V (contd.): Assuming that LamDon paid $200,000

out-of-pocket costs of the consolidation after it was consummated on December 31, 1999, LamDon’s journal entries would be as follows:



Example V (contd.): Journal Entries of Lamdon Corp., 12/31/1999

Investment in Lamson

Corporation and Donald

Company Common Stock

(74,000 x $60) 4,440,000Common Stock, no par 4,440,000

To record consolidation of Lamson Corporation and Donald Company as a purchase

(Continued)



Example V (contd.): 12/31/1999 (contd.)

Investment in Lamson Corporation and Donald Company Common Stock 110,000

Common Stock, no par 90,000

Cash 200,000To record payment of costs incurred in consolidation of Lamson Corporation and Donald Company. Accounting, legal, and finder’s 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. (Continued)



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)


Long-Term Debt 700,000

Investment in Lamson Corporation and Donald Company Common Stock 4,550,000

(Continued)

800,000 850,000Goodwil

l



Example V (contd.): 12/31/1999 (contd.)Amount of goodwill is computed as follows: Total cost of investment ($4,400,000+$110,00) 4,550,000Less: Carrying amount of

Lamson’s identifiable net assets ($430,000+ $300,000+1,170,000) (1,900,000)Current fair fair value of Donald’s identifiable net assets (1,800,000)

Amount of goodwill $ 850,000


Subsequent Issuance of Contingent Consideration Example of Contingent Consideration

(p176 and p198 of text book)

Norton Company agrees to pay $800,000 cash for Robinson’s net assets (not including Robinson’s slow-moving products which have been written down to scrap value by Robinson prior to the business combination).


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.


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.


Subsequent Issuance of Contingent Consideration (contd.) Assuming that by 12/31/x2, the end of the

first year following Norton’s acquisition of the net assets, another 300 units of the slow-moving product had been sold, and Norton’s Rob Division had pre-tax income of $580,000 (excluding the sale of the slow-moving product).

On 12/31/x2, Norton prepares the following journal entry to record the resolution of contingent consideration:


Subsequent Issuance of Contingent Consideration (contd.)

Goodwill 50,000*

Cash (or payable to

Robinson Company)

50,000

* $100 x 300 =$30,000

+ (580,000-500,000) x 25% = 20,000

$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-of-interests –type combinations.


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.


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.


The Current Development on the Business Combination Standards (Excerpts from News Release of the FASB dated 7/20/01) (contd.) Statement 142:

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


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


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:


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.


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 value


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.


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.


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


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


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.


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

acct 501 chapter 5 business combinations 2 objectives of the chapter 1. to discuss the general view...

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