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2 - 0 Advanced Accounting by Debra Jeter and Paul Chaney Chapter 2: Methods of Accounting for Business Combinations Slides Authored by Hannah Wong, Ph.D.

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Presentation on theme: "2 - 0 Advanced Accounting by Debra Jeter and Paul Chaney Chapter 2: Methods of Accounting for Business Combinations Slides Authored by Hannah Wong, Ph.D."— Presentation transcript:

1 2 - 0 Advanced Accounting by Debra Jeter and Paul Chaney Chapter 2: Methods of Accounting for Business Combinations Slides Authored by Hannah Wong, Ph.D. Rutgers University

2 2 - 1 Accounting Methods for Business Combinations Purchase Method l treats the combination as the purchase of one or more companies by another. Pooling of Interests Method l treats the combination as two or more groups of stockholders uniting their ownership interests by an exchange of common stock.

3 2 - 2 Comparison of Purchase and Pooling of Interests Purchase lAssets and liabilities acquired are recorded at their fair values. lAny excess of cost over fair value of net assets acquired is recorded as goodwill. Pooling of Interests lAssets and liabilities are recorded at their precombination book values. lNo excess of cost over book value exists, and no new goodwill is recorded

4 2 - 3 Comparison of Purchase and Pooling of Interests Purchase lThe acquired company’s retained earnings are not added into the acquiring company’s retained earnings. lEquity securities issued are recorded at their fair market value. Pooling of Interests lThe acquired company’s retained earnings are added into the acquiring company’s retained earnings. lEquity shares issued are recorded at the book value of the acquired shares.

5 2 - 4 Comparison of Purchase and Pooling of Interests Purchase lThe excess of cost over book value is depreciated or amortized to reduce future earnings. lThe acquired company’s earnings are included with the acquiring firm’s only from the date of combination forward. Pooling of Interests lThere is no additional depreciation or amortization expense. lThe issuer and combiner companies’ earnings are combined for the full fiscal year in which the combination occurs.

6 2 - 5 Comparison of Purchase and Pooling of Interests Purchase lDirect costs are capitalized as part of the acquisition cost. lIndirect costs are expensed. lSecurity issuance costs are deducted from additional paid-in capital. Pooling of Interests lDirect costs are expensed in the year in which incurred. lIndirect costs are expensed. lSecurity issuance costs are expensed.

7 2 - 6 Acquisition Costs - An Illustration lFacts: n SMC Company acquires 100% of the net assets of Bee Company by issuing shares of common stock with a fair value of $120,000. n SMC incurred:  $1,500 of accounting and consulting costs  $3,000 of stock issue costs  $2,000 monthly overhead cost for its mergers department

8 2 - 7 Acquisition Costs - An Illustration lPooling Accounting: Accounting and Consulting Expense (Direct) 1,500 Merger Department Expense (Indirect) 2,000 Securities Issue Expense (Security Issue Costs) 3,000 Cash 6,500 lPurchase Accounting: Goodwill (Direct)1,500 Merger Department Expense (Indirect)2,000 Other Contributed Capital (Security Issue Costs)3,000 Cash 6,500

9 2 - 8 Disadvantages of Pooling Method lValues given and received are ignored in a negotiated transaction. l“Instant earnings” can result n from sale of newly pooled assets that are carried at their precombination low book values, and n from including precombination earnings of other companies in the year of combination.

10 2 - 9 Disadvantages of Purchase Method lSubjective - appraisal of assets or stock values are necessary. lInconsistent - accounting for one part of the combined company on a fair value and the other part of a historical basis.

11 Pro Forma Statements lFinancial statements “as if” the combination had been consummated. lFunctions n provide information in the planning stages of the combination n disclose relevant information subsequent to the combination

12 Disclosure Requirements lPurchase Method n notes to financial statements should include pro forma information  in the year of combination  in the immediately preceding period if comparative financial statements are presented

13 Disclosure Requirements lPooling Method n financial statements should be restated on a pro forma basis for all years presented n notes to financial statements should include  disclosure that the statements of previously separately firms have been combined  operating results of separate firms prior to the combination

14 Purchase Example - Facts lOn January 1, 2000, P Company acquired the assets and assumed the liabilities of S Company. lP Company gave one of its $15 par value common shares for each share of S company common stock. lP Company common stock has a fair value per share of $48. l Refer to Illustration 2-4 for the companies balance sheet information.

15 Purchase Example - Journal Entry Cash and Receivables 170,000 Inventories 140,000 Land 400,000 Buildings & Equipment (Net)1,000,000 Discount on Bonds Payable 50,000 Goodwill 230,000 Current Liabilities150,000 Bonds Payable400,000 Common Stock450,000 Other Contributed Capital990,000 Identifiable net assets acquired are recorded at their market value on the acquisition date Goodwill = excess cost over fair value of identifiable assets acquired Common stock issued is recorded at market value on the acquisition date

16 Equity Allocation in Pooling of Interests - Case A P issued shares with par value of $450,000 Common stock -S $300,000 Other Contributed Capital - S $50,000 Retained Earnings - S $140,000 Common Stock - P $750,000 Other Contributed Capital - P $400,000 Retained Earnings - P $350,000 $300,000 $50,000 $100,000 $140,000

17 Journal Entry - Case A Cash and Receivables 180,000 Inventories 100,000 Land 120,000 Buildings & Equipment 900,000 Other Contributed Capital 100,000 Accumulated Depreciation300,000 Current Liabilities110,000 Bonds Payable400,000 Common Stock 450,000 Retained Earnings140,000 net assets acquired are carried forward at their book value Total shareholders’ equity of S Company ($490,000) is carried forward to P Company Par value of common stock issued is recorded

18 Equity Allocation in Pooling of Interests - Case B P issued shares with par value of $800,000 Common stock -S $300,000 Other Contributed Capital - S $50,000 Retained Earnings - S $140,000 Common Stock - P $750,000 Other Contributed Capital - P $400,000 Retained Earnings - P $350,000 $300,000 $50,000 $400,000 $90,000 $50,000

19 Journal Entry - Case B Cash and Receivables 180,000 Inventories 100,000 Land 120,000 Buildings & Equipment 900,000 Other Contributed Capital 400,000 Accumulated Depreciation300,000 Current Liabilities110,000 Bonds Payable400,000 Common Stock 800,000 Retained Earnings 90,000 net assets acquired are carried forward at their book value Total shareholders’ equity of S Company ($490,000) is carried forward to P Company Par value of common stock issued is recorded

20 Equity Allocation in Pooling of Interests - Case C P issued shares with par value of $330,000 Common stock -S $300,000 Other Contributed Capital - S $50,000 Retained Earnings - S $140,000 Common Stock - P $750,000 Other Contributed Capital - P $400,000 Retained Earnings - P $350,000 $300,000 $30,000 $140,000 $20,000

21 Journal Entry - Case C Cash and Receivables 180,000 Inventories 100,000 Land 120,000 Buildings & Equipment 900,000 Accumulated Depreciation300,000 Current Liabilities110,000 Bonds Payable400,000 Common Stock 330,000 Other Contributed Capital 20,000 Retained Earnings140,000 net assets acquired are carried forward at their book value Total shareholders’ equity of S Company ($490,000) is carried forward to P Company Par value of common stock issued is recorded

22 Equity Allocation in Pooling of Interests - Case D P issued shares with par value of $275,000 Common stock -S $300,000 Other Contributed Capital - S $50,000 Retained Earnings - S $140,000 Common Stock - P $750,000 Other Contributed Capital - P $400,000 Retained Earnings - P $350,000 $275,000 $25,000 $140,000 $50,000

23 Pooling Example - Case D Cash and Receivables 180,000 Inventories 100,000 Land 120,000 Buildings & Equipment 900,000 Accumulated Depreciation300,000 Current Liabilities110,000 Bonds Payable400,000 Common Stock 275,000 Other Contributed Capital 75,000 Retained Earnings140,000 net assets acquired are carried forward at their book value Total shareholders’ equity of S Company ($490,000) is carried forward to P Company Par value of common stock issued is recorded

24 Bargain Purchase Bargain = Fair value of identifiable net assets acquired Less: Purchase price Valuation of Net Assets Acquired: l Current assets, long-term investments in marketable securities, liabilities = fair value l Previously recorded goodwill = 0 l Long-term assets = fair value - bargain allocation (The bargain is allocated to long-term assets in proportion to their fair value.) l Any remaining bargain is recorded as negative goodwill and amortized over a maximum of 40 years.

25 Bargain Purchase - Example Bargain = Fair value of identifiable net assets ($23,000) - Purchase price ($17,000) = $6,000Building $4,500 Land $1,500 Current Assets 5,000 Buildings ($15,000-$4,500) 10,500 Land ($5,000-$1,500) 3,500 Liabilities 2,000 Cash 17,000 Building and Land is recorded at fair value minus allocated bargain Current assets and liabilities are recorded at fair value

26 Contingent Considerations lContingencies based on earnings lContingencies based on security prices

27 Earnings Contingency lDefinition n additional consideration to be made if the combined company’s future earnings equal or exceed a threshold. lAccounting Treatment n as additional cost of acquisition

28 Stock Price Contingency lDefinition n additional consideration to be made if the future market value of shares issued is less than the guaranteed value lAccounting Treatment n no effect on acquisition cost n as an adjustment to Other Contributed Capital

29 Leveraged Buyout (LBO) A management group contributes stock they hold and borrows funds to a create new company, which acquires all the outstanding common shares of their employer company.

30 Leveraged Buyout (LBO) Stock of employer company held by managers Borrowed Fund New Company Employer Company acquires

31 Leveraged Buyout (LBO) lValuation of New Company n net assets acquired by borrowed fund  market value n net assets contributed by managers  book value

32 Leveraged Buyout (LBO) Example Book Value Market Value Net assets contributed by managers Net assets acquired by borrowed fund of $31,500 Valuation of Net Assets in New Company $1,000 $9,000 10%90% Goodwill $9,000 Excess cost applied to plant assets = $13,500 Excess of cost over book value

33 Criteria for Pooling of Interests lCompany Attributes n autonomous of any other companies n independent of other combining companies

34 Criteria for Pooling of Interests lExchange of Stock n single transaction n common stock for 90% common stock n no change in equity interest n no abnormal treasury stock transactions n same ratio of interest of individual stockholders n voting rights immediately exercisable n no provision for future issuance of stock

35 Criteria for Pooling of Interests lAbsence of Planned Transactions n no agreement to reacquire stock n no financial arrangements for shareholders n no unusual disposal of assets

36 Advanced Accounting by Debra Jeter and Paul Chaney Copyright © 2001 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.


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