baker_ab.az.Chap001

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Intercorporate

Acquisitionsand

Investments inOther Entities

1

© 2009 The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin



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The Development of ComplexBusiness Structures

• Enterprise expansion as a means ofsurvival and profitability

– Size often allows economies of scale

– New earning potential

– Earnings stability through diversification

– Management rewards for bigger company

size – Prestige associated with company size



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Organizational Structure andBusiness Objectives

• A subsidiary is a corporation that iscontrolled by another corporation, referredto as a parent company, usually through

majority ownership of its common stock

• Because a subsidiary is a separate legalentity, the parent’s risk associated with the

subsidiary’s activities is limited



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Organizational Structure, Acquisitions,and Ethical Considerations

• Manipulation of financial reporting

– Usage of subsidiaries or other entities toborrow money without reporting the debt on

their balance sheets

– Using special entities to manipulate profits

– Manipulation of accounting for mergers and

acquisitions• Pooling-of-interests



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Business Expansion and Forms ofOrganizational Structure

• Expansion from within: New subsidiariesor entities such as partnerships, jointventures, or special entities

• Motivating factors: – Helps establish clear lines of control and

facilitate the evaluation of operating results

– Special tax incentives

– Regulatory reasons

– Protection from legal liability

– Disposing of a portion of existing operations



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– A spin-off

• Occurs when the ownership of a newly created orexisting subsidiary is distributed to the parent’s

stockholders without the stockholders surrenderingany of their stock in the parent company

– A split-off

• Occurs when the subsidiary’s shares are

exchanged for shares of the parent, therebyleading to a reduction in the outstanding shares ofthe parent company


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• Expansion through business combinations

– Entry into new product areas or geographicregions by acquiring or combining with other

companies – A business combination occurs when “. . .

an acquirer obtains control of one or more

businesses” – The concept of control relates to the ability to

direct policies and management




• Traditional view - Control is gained byacquiring a majority of the company’scommon stock

• However, it is possible to gain control withless than majority ownership or with noownership at all

– Informal arrangements – Formal agreements• Consummation of a written agreement requires

recognition on the books of one or more of thecompanies that are a party to the combination



Frequency of BusinessCombinations

– 1960s - Merger boom• Conglomerates

– 1980s - Increase in the number of businesscombinations

• Leveraged buyouts and the resulting debt

– 1990s - All previous records for merger activityshattered

– Downturn of the early 2000s, and decline in mergers

– Increased activity toward the middle of 2003 thataccelerated through the middle of the decade

• Role of private equity

– Effect of the credit crunch of 2007-2008



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Organizational Structure andFinancial Reporting

• Merger - A business combination in whichthe acquired company’s assets and

liabilities are combined with those of the

acquiring company results in no additionalorganizational components

– Financial reporting is based on the original

organizational structure



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• Controlling ownership - A businesscombination in which the acquiredcompany remains as a separate legal

entity with a majority of its common stockowned by the purchasing company leadsto a parent –subsidiary relationship

– Accounting standards normally requireconsolidated financial statements



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• Noncontrolling ownership - The purchase of aless-than-majority interest in another corporationdoes not usually result in a business

combination or controlling situation• Other beneficial interest - One company may

have a beneficial interest in another entity evenwithout a direct ownership interest

– The beneficial interest may be defined by theagreement establishing the entity or by an operatingor financing agreement



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Creating Business Entities

• The company transfers assets, andperhaps liabilities, to an entity that thecompany has created and controls and in

which it holds majority ownership – The company transfers assets and liabilities

to the created entity at book value, and the

transferring company recognizes anownership interest in the newly created entityequal to the book value of the net assetstransferred



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• Recognition of fair values of the assetstransferred in excess of their carryingvalues on the books of the transferring

company is not appropriate in the absenceof an arm’s-length transaction

• No gains or losses are recognized on the

transfer by the transferring company




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• If the value of an asset transferred to anewly created entity has been impairedprior to the transfer and its fair value is

less than the carrying value on thetransferring company’s books, the

transferring company should recognize an

impairment loss and transfer the asset tothe new entity at the lower fair value




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Forms of Business Combinations

• A statutory merger

– The acquired company’s assets and liabilities are

transferred to the acquiring company, and the

acquired company is dissolved, or liquidated – The operations of the previously separate companiesare carried on in a single legal entity

• A statutory consolidation

– Both combining companies are dissolved and theassets and liabilities of both companies aretransferred to a newly created corporation



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• A stock acquisition

– One company acquires the voting shares of anothercompany and the two companies continue to operate

as separate, but related, legal entities – The acquiring company accounts for its ownershipinterest in the other company as an investment

– Parent –subsidiary relationship

– For general-purpose financial reporting, a parentcompany and its subsidiaries present consolidatedfinancial statements that appear largely as if thecompanies had actually merged into one



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AA Company

BB Company

AA Company

(a ) Statutory Merger

AA Company

BB Company

CC Company

AA Company

BB Company

AA Company

BB Company

(b ) Statutory Consolidation

(c ) Stock Acquisition



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Determining the Type of BusinessCombination

AA Company invests in BB Company

Acquires netassets

Acquires stock

Record as statutorymerger or statutory

consolidation

Acquired companyliquidated?

Record as stockacquisition and

operate as subsidiary

Yes

No



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Methods of Effecting BusinessCombinations

• Acquisition of assets

– Statutory Merger

– Statutory Consolidation

• Acquisition of stock – A majority of the outstanding voting shares usually is

required unless other factors lead to the acquirergaining control

– Noncontrolling interest: The total of the shares of anacquired company not held by the controllingshareholder

• Acquisition by other means



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Valuation of Business Entities

• Value of individual assets and liabilities

– Value determined by appraisal

• Value of potential earnings

– “Going-concern value” based on:

• A multiple of current earnings.

• Present value of the anticipated future net cash

flows generated by the company.

• Valuation of consideration exchanged



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Accounting for BusinessCombinations

• Two methods acceptable earlier:

– Purchase

– Pooling of interests

• 2001 - the FASB eliminated pooling of interests• 2007 - FASB 141R replaced the purchase

method with the acquisition method

– This must be used to account for all businesscombinations for which the acquisition date is in fiscalyears beginning on or after December 15, 2008

– FASB 141R may not be applied retroactively



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Acquisition Accounting

• The acquirer recognizes all assetsacquired and liabilities assumed in abusiness combination and measures them

at their acquisition-date fair values – If less than 100 percent of the acquiree is

acquired, the noncontrolling interest also ismeasured at its acquisition-date fair value

• Fair value measurement – The FASB decided in FASB 141R to focus

directly on the value of the considerationgiven



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• Points to consider: – No separate asset valuation accounts related

to assets acquired are recognized

– Long-lived assets classified at the acquisitiondate as held for sale are valued at fair valueless cost to sell

– Deferred income taxes related to the business

combination and assets and liabilities relatedto an acquiree’s employee benefit plans arevalued in accordance with the relevant FASBstandards





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Goodwill

• Components used in determining goodwill:1. The fair value of the consideration given by the

acquirer

2. The fair value of any interest in the acquiree already

held by the acquirer3. The fair value of the noncontrolling interest in the

acquiree, if any

• The total of these three amounts, all measured

at the acquisition date, is compared with theacquisition-date fair value of the acquiree’s netidentifiable assets, and the difference isgoodwill



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Acquisition Method - Illustration

Sharp Company Assets, Liabilities, and Equities Book Value Fair Value

Balance Sheet Cash and Receivables $45,000 $45,000

Information, Inventory 65,000 75,000

December 31, 20X0 Land 40,000 70,000

Buildings and Equipment 400,000 350,000

Accumulated Depreciation (150,000)

Patent 80,000

Total Assets $400,000 $620,000

Current Liabilities 100,000 110,000Common Stock ($5 par) 100,000

Additional Paid-In Capital 50,000

Retained Earnings 150,000

Total Liabilities and Equities $400,000

Fair Value of Net Assets $510,000

Market value of shares issued $610,000Legal and appraisal fees $40,000

Stock issue costs $25,000

Point Corporation acquires all of the assets and assumes all of the

liabilities of Sharp Company in a statutory merger by issuing to Sharp

10,000 shares of $10 par common stock.



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Entries Recorded by Acquiring Company Entries Recorded by Acquired Company

Merger Expense 40,000 Investment in Point Stock 610,000

Cash 40,000 Current Liabilities 100,000

Record costs related to acquisition of Sharp Company. Accumulated Depreciation 150,000

Cash and Receivables 45,000

Deferred Stock Issue Costs 25,000 Inventory 65,000

Cash 25,000 Land 40,000

Record costs related to issuance of common stock. Buildings and Equipment 400,000Gain on Sale of Net Assets 310,000

On the date of combination, Point records the acquisition Record transfer of assets to Point Corporation.

of Sharp with the following entry:

Cash and Receivables 45,000 Common Stock 100,000

Inventory 75,000 Additional Paid-In Capital 50,000

Land 70,000 Retained Earnings 150,000

Buildings and Equipment 350,000 Gain on Sale of Net Assets 310,000

Patent 80,000 Investment in Point Stock 610,000Goodwill 100,000 Record distribution of Point Corporation stock.

Current Liabilities 110,000

Common Stock 100,000

Additional Paid-In Capital 485,000

Deferred Stock Issue Costs 25,000

Record acquisition of Sharp Company.



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• Testing for goodwill impairment:

– When goodwill arises in a business combination, itmust be assigned to individual reporting units

– To test for impairment, the fair value of the reportingunit is compared with its carrying amount

– If the fair value of the reporting unit exceeds itscarrying amount, the goodwill of that reporting unit isconsidered unimpaired

– If the carrying amount of the reporting unit exceeds itsfair value, an impairment of the reporting unit’s

goodwill is implied



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– The amount of the reporting unit’s goodwill

impairment is measured as the excess of thecarrying amount of the unit’s goodwill over the

implied value of its goodwill – The implied value of its goodwill is determined

as the excess of the fair value of the reportingunit over the fair value of its net assets

excluding goodwill – Goodwill impairment losses are recognized in

income from continuing operations or income

before extraordinary gains and losses



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• Bargain Purchase

– Results when the fair value of the considerationgiven, along with the fair value of any equity interestin the acquiree already held and the fair value of anynoncontrolling interest in the acquiree, is less than thefair value of the acquiree’s net identifiable assets

• If acquisition-date valuations are appropriate, the acquirerrecognizes a gain at the date of acquisition

• The amount of the gain must be disclosed, along with wherethe gain is reported and the factors that led to it

– Note: FASB 141R does not state a treatment for the

situation opposite to that of a bargain purchase



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• Combination effected through acquisition ofstock

– The acquired company continues to exist, and the

acquirer records an investment in the common stockof the acquiree rather than its individual assets andliabilities

– The acquirer records its investment in the acquiree’s

common stock at the total fair value of theconsideration given in exchange

– The acquiree may continue to operate as a separatecompany, or it may lose its separate identity and bemerged into the acquiring company



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• Financial reporting subsequent to abusiness combination

– Financial statements prepared subsequent to

a business combination reflect the combinedentity only from the date of combination

– When a combination occurs during a fiscal

period, income earned by the acquiree prior tothe combination is not reported in the incomeof the combined enterprise



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20X0 20X1

Point Corporation:

Separate income (excluding any income from Sharp) $300,000 $300,000

Shares outstanding, December 31 30,000 40,000

Sharp Company:Net income $60,000 $60,000

To illustrate financial reporting subsequent to a business combination,assume the following information for Point Corporation and Sharp Company:

Point acquires all of Sharp’s stock at book value on January 1, 20X1, by

issuing 10,000 shares of common stock. The net income and earningsper share that Point presents in its comparative financial statements for

the two years are as follows:20X0:

Net Income $300,000

Earnings per Share ($300,000/30,000 shares) $10.00

20X1:

Net Income ($300,000 + $60,000) $360,000

Earnings per Share ($360,000/40,000 shares) $9.00



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FASB 141R - Disclosure requirements1. Identification and description of the acquired company, the acquisition date, and the

percentage ownership acquired.

2. The main reasons for the acquisition and a description of the factors that led to the

recognition of goodwill.

3. The acquisition-date fair value of the consideration transferred, the fair value of each

component of the consideration, and a description of any contingent consideration.4. The acquisition-date amounts recognized for each major class of assets acquired and

liabilities assumed.

5. The business combination–related costs incurred, the amount expensed, and where they were

reported, along with any issue costs not expensed and how they were recognized.

6. The acquiree’s revenue and net income included in the consolidated income statement for the

period since acquisition, and the results of operations for the combined company as if thebusiness combination had occurred at the beginning of the reporting period.

7. The total amount of goodwill, the amount expected to be deductible for tax purposes, changes

in goodwill during each subsequent period, and, if the company is required to report segment

information, the amount of goodwill assigned to each segment.

8. For less-than-100-percent acquisitions, the acquisition-date fair value of the noncontrolling

interest and the valuation method used.



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Additional Considerations in Accountingfor Business Combinations

• Uncertainty in business combinations

– Measurement Period

• FASB 141R allows for this period of time to

properly ascertain fair values• The period ends once the acquirer obtains the

necessary information about the facts as of theacquisition date

• May not exceed one year



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– Contingent consideration• Sometimes the consideration exchanged is not fixed in

amount, but rather is contingent on future events

• E.g. A contingent-share agreement

• FASB 141R requires contingent consideration to be valuedat fair value as of the acquisition date and classified as eithera liability or equity

– Acquiree contingencies• Under FASB 141R, the acquirer must recognize all

contingencies that arise from contractual rights or obligationsand other contingencies if it is more likely than not that theymeet the definition of an asset/liability at the acquisition date

• Recorded by the acquirer at acquisition-date fair value



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• In-process research and development

– The FASB concluded that valuable ongoingresearch and development projects of an

acquiree are assets and should be recordedat their acquisition-date fair values, even ifthey have no alternative use

– These projects should be classified asindefinite-lived and, therefore, should not beamortized until completed or abandoned

– They should be tested for impairment




• Noncontrolling equity held prior to combination

– An acquirer that held an equity position in an acquireeimmediately prior to the acquisition date must revaluethat equity position to its fair value at the acquisitiondate and recognize a gain or loss on the revaluation

• Acquisitions by contract alone

– The amount of the acquiree’s net assets at the date of

acquisition is attributed to the noncontrolling interestand included in the noncontrolling interest reported insubsequent consolidated financial statements

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baker_ab.az.Chap001