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

Accounting Methods for Business Combinations Purchase Method treats the combination as the purchase of one or more companies by another. Pooling of Interests Method (not allowed after June 30, 2001) treats the combination as two or more groups of stockholders uniting their ownership interests by an exchange of common stock. Obj 1

FASB Issues New Standards APB 16, “Business Combinations” and APB 17, “Intangible Assets” were superceded by SFAS 142, “Goodwill and Other Intangible Assets” in June 2001. SFAS 141 – prohibits the use of the pooling method in accounting for business combinations and in favor of the purchase method. SFAS 142 – mandates that goodwill resulting from a business combination should be tested for impairment – annually rather than expensed over a 20-40 year period. Obj 1

Comparison of Purchase and Pooling of Interests Assets and liabilities acquired are recorded at their fair values. Any excess of cost over fair value of net assets acquired is recorded as goodwill. Pooling of Interests Assets and liabilities are recorded at their precombination book values. No excess of cost over book value exists, and no new goodwill is recorded Obj 1

Comparison of Purchase and Pooling of Interests The acquired company’s retained earnings are added into the acquiring company’s retained earnings. Equity shares issued are recorded at the book value of the acquired shares. Purchase The acquired company’s retained earnings are not added into the acquiring company’s retained earnings. Equity securities issued are recorded at their fair market value. Obj 1

Comparison of Purchase and Pooling of Interests There is no additional depreciation or amortization expense. The issuer and combiner companies’ earnings are combined for the full fiscal year in which the combination occurs. Purchase The excess of cost over book value is depreciated or amortized to reduce future earnings. The acquired company’s earnings are included with the acquiring firm’s only from the date of combination forward. Obj 1

Comparison of Purchase and Pooling of Interests Direct costs are capitalized as part of the acquisition cost. Indirect costs are expensed. Security issuance costs are deducted from additional paid-in capital. Pooling of Interests Direct costs are expensed in the year in which incurred. Indirect costs are expensed. Security issuance costs are expensed. Obj 1

Goodwill Impairment Test 3 Step Process Assign goodwill to a reporting unit (level at which management reviews performance – product, geographic, facility…). Measure if difference between current FMV and purchase price still exists. If goodwill has diminished, book. No upward adjustment allowed. Obj 2

Disclosure Requirements SFAS 141 – “Business Combinations” Total amount of acquired goodwill and amount to be deductible for tax purposes. Amount of goodwill by reporting segment. Obj 3

Disclosure Requirements SFAS 142 – “Goodwill & Other Intangible Assets” Aggregate amount of goodwill should be reported as a separate line item on the face of the balance sheet. Aggregate impairment loss should be reported as a separate line in the operating section of the income statement (unless from discontinued operations). Obj 3

SFAS 142 - Footnotes Description of facts and circumstances leading to an impairment. Amount of impairment loss and how fair value was determined. Nature and amounts of any adjustments to impairment estimates from earlier periods. Footnote or disclose on face the income before extra- ordinaries and net income adjusted to exclude amortization of goodwill no longer amortized under SFAS 142. Reconciliation of adjusted net income to reported net income. Adjusted EPS amounts. Obj 3

Acquisition Expenses Direct Expenses – (accounting, legal & consulting) capitalize as part of assets acquired. Indirect Expenses – (mergers dept., labor & overhead diverted to the merger) expense currently. Security Issuance Costs – (legal, under-writing, banking) reduce additional paid-in capital on shares issued or adjust premium/discount on bonds. Obj 3

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

Acquisition Costs - An Illustration Pooling 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 Purchase Accounting: Goodwill (Direct) 1,500 Merger Department Expense (Indirect) 2,000 Other Contributed Capital (Security Issue Costs) 3,000 Cash 6,500 Obj 3

Pro-forma “As-If” Financial Statements SFAS 141 requires pro-forma financial statements (in notes) in year of material combination. Pro-formas must include: Revenue Income before extraordinary items Cumulative effect of changes in accounting principles Net income Earnings per share Material nonrecurring items included Obj 4

Purchase Example - Facts On January 1, 2003, P Company acquired the assets and assumed the liabilities of S Company. P Company gave one of its $15 par value common shares for each share of S company common stock. P Company common stock has a fair value per share of $48. Refer to Illustration 2-3 for the companies’ balance sheet information. Obj 5

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 Liabilities 150,000 Bonds Payable 400,000 Common Stock 450,000 Other Contributed Capital 990,000 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 Obj 5

Financial Statement Differences Purchase vs. Pooling Purchase method causes assets to be restated at FMV. Assets are higher on balance sheet. Depreciation expense is higher in later years. Cost of goods sold may be higher if inventories are increased in value and vice versa. Obj 6

Valuation of Net Assets Acquired: Bargain Purchase Bargain = Fair value of identifiable net assets acquired Less: Purchase price Valuation of Net Assets Acquired: Current assets, long-term investments in marketable securities, liabilities = fair value Previously recorded goodwill = 0 Long-term assets = fair value - bargain allocation (The bargain is allocated to long-term assets in proportion to their fair value.) Any remaining bargain is recorded as negative goodwill Obj 6

Bargain Purchase - Example Bargain = Fair value of identifiable net assets ($23,000) - Purchase price ($17,000) = $6,000 Building $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 Obj 6

Contingent Considerations Contingencies based on earnings Contingencies based on security prices Obj 7

Earnings Contingency Definition Accounting Treatment additional consideration to be made if the combined company’s future earnings equal or exceed a threshold. Accounting Treatment as additional cost of acquisition Obj 7

Stock Price Contingency Definition additional consideration to be made if the future market value of shares issued is less than the guaranteed value Accounting Treatment no effect on acquisition cost as an adjustment to Other Contributed Capital Obj 7

Leveraged Buyout (LBO) A management group contributes stock it holds and borrows funds to create a new company, which acquires all the outstanding common shares of its employer company. Obj 8

Leveraged Buyout (LBO) Borrowed Funds Stock of employer company held by managers New Company acquires Employer Company Obj 8

Leveraged Buyout (LBO) Valuation of New Company net assets acquired by borrowed funds market value net assets contributed by managers book value Obj 8

Leveraged Buyout (LBO) Example Valuation of Net Assets in New Company Excess of cost over book value Market Value Excess cost applied to plant assets = $13,500 Goodwill $9,000 Book Value $1,000 $9,000 10% 90% Net assets contributed by managers Net assets acquired by borrowed fund of $31,500 Obj 8

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Criteria for Pooling of Interests Company Attributes autonomous of any other companies independent of other combining companies Obj

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

Criteria for Pooling of Interests Absence of Planned Transactions no agreement to reacquire stock no financial arrangements for shareholders no unusual disposal of assets Obj

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

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

Financial statements “as if” the combination had been consummated. Pro Forma Statements Financial statements “as if” the combination had been consummated. Functions provide information in the planning stages of the combination disclose relevant information subsequent to the combination Obj 9

Equity Allocation in Pooling of Interests - Case A P issued shares with par value of $450,000 Other Contributed Capital - S $50,000 Retained Earnings - S $140,000 Common stock -S $300,000 $300,000 $50,000 $140,000 Common Stock - P $750,000 Other Contributed Capital - P $400,000 Retained Earnings - P $350,000 $100,000 Obj 9

Journal Entry - Case A Cash and Receivables 180,000 net assets acquired are carried forward at their book value Cash and Receivables 180,000 Inventories 100,000 Land 120,000 Buildings & Equipment 900,000 Other Contributed Capital 100,000 Accumulated Depreciation 300,000 Current Liabilities 110,000 Bonds Payable 400,000 Common Stock 450,000 Retained Earnings 140,000 Total shareholders’ equity of S Company ($490,000) is carried forward to P Company Par value of common stock issued is recorded Obj 9

Equity Allocation in Pooling of Interests - Case B P issued shares with par value of $800,000 Other Contributed Capital - S $50,000 Retained Earnings - S $140,000 Common stock -S $300,000 $50,000 $50,000 $300,000 $90,000 Common Stock - P $750,000 Other Contributed Capital - P $400,000 Retained Earnings - P $350,000 $400,000 Obj 9

Journal Entry - Case B Cash and Receivables 180,000 net assets acquired are carried forward at their book value Cash and Receivables 180,000 Inventories 100,000 Land 120,000 Buildings & Equipment 900,000 Other Contributed Capital 400,000 Accumulated Depreciation 300,000 Current Liabilities 110,000 Bonds Payable 400,000 Common Stock 800,000 Retained Earnings 90,000 Total shareholders’ equity of S Company ($490,000) is carried forward to P Company Par value of common stock issued is recorded Obj 9

Equity Allocation in Pooling of Interests - Case C P issued shares with par value of $330,000 Other Contributed Capital - S $50,000 Retained Earnings - S $140,000 Common stock -S $300,000 $30,000 $20,000 $300,000 $140,000 Common Stock - P $750,000 Other Contributed Capital - P $400,000 Retained Earnings - P $350,000 Obj 9

Journal Entry - Case C Cash and Receivables 180,000 net assets acquired are carried forward at their book value Cash and Receivables 180,000 Inventories 100,000 Land 120,000 Buildings & Equipment 900,000 Accumulated Depreciation 300,000 Current Liabilities 110,000 Bonds Payable 400,000 Common Stock 330,000 Other Contributed Capital 20,000 Retained Earnings 140,000 Total shareholders’ equity of S Company ($490,000) is carried forward to P Company Par value of common stock issued is recorded Obj 9

Equity Allocation in Pooling of Interests - Case D P issued shares with par value of $275,000 Other Contributed Capital - S $50,000 Retained Earnings - S $140,000 Common stock -S $300,000 $25,000 $50,000 $275,000 $140,000 Common Stock - P $750,000 Other Contributed Capital - P $400,000 Retained Earnings - P $350,000 Obj 9

Pooling Example - Case D net assets acquired are carried forward at their book value Cash and Receivables 180,000 Inventories 100,000 Land 120,000 Buildings & Equipment 900,000 Accumulated Depreciation 300,000 Current Liabilities 110,000 Bonds Payable 400,000 Common Stock 275,000 Other Contributed Capital 75,000 Retained Earnings 140,000 Total shareholders’ equity of S Company ($490,000) is carried forward to P Company Par value of common stock issued is recorded Obj 9