Chapter 3 Methods of accounting for business combination

Main contents  Distinguish between the purchase method and pooling of interests method  Acquisition expenses,valuation of assets and liabilities,pro forma statements under each method  Equity allocation rule  The impact on financial statements of the differences between two methods,and why some firms prefer the pooling of interests

Introduction to the methods  What’s more important ?economic substance or accounting appearance?  Exposure draft in 1999 by FASB: elimination of pooling method,the way of amortization of goodwill and other concerns.  The two methods :purchase and pooling of interests.

Comparison of purchase and pooling of interests  The essence of the pooling method is that neither of two firms is considered dominant and hence it is difficult to refer to one as acquirer  Carried forward at their previous carrying amounts

The economic consequences of two methods From an income statement perspective  The pooling is more appealing,because of no burden from goodwill amortization,additional depreciation,or other charges  Under the purchase,assets revaluation usually price higher than book value, net income adversely affected,ROA or ROE weakened,therefore it yields a lower net income divided by a larger base of assts

Form a balance sheet perspective  Purchase has advantage of reflecting more current values for assets and liabilities of acquired firm,however, no reflecting the retained earnings

Treatment of acquisition expenses  Acquisition expenses includes direct,indirect,and security issuance costs  Under Pooling,all types of acquisition expenses are expensed in the period incurred  Under purchase,each kind of expenses is treated differently :direct expenses are capitalized ; indirect expenses are charged to expense as incurred ;security issuance costs are assigned to the valuation of the security thus reducing the additional contributed capital for stock issues or adjusting the premium or discount on bond issues.

Purchase versus pooling- authoritative position  Background of APB opinion No.16  The specific conditions for pooling  Advantage and disadvantage of two methods  The trend and the terminal

Pro forma statements and disclosure requirement  Pro forma statements are prepared to show the effect of planed or contemplated transactions by showing how they might have affected the historical financial statements if they had been consummated during the period covered by those statements. They serves as : (1)to provide information in the planning stages of combination (2)to disclosed relevant information subsequent to the combination

Pro forma statements  Prepared before combination is under consideration  The tentative or hypothetical nature should be clearly indicated  A valuable method of disclosing relevant information subsequent to the combination  Under purchase method  Under pooling method

Illustration of purchase accounting The purchase method treats the combination as the purchase of one or more companies by another.the acquiring company records the purchase at its cost,including direct acquisition expense. If cash is given,the amount paid constitutes cost ; If debt securities are given,the present value of future payments represents cost.

 Assets acquired by issuing shares of stock of the acquiring corporation are recorded at the fair values of the stock given or the assets received.  Once the total cost is determined,it must be allocated to the identifiable assets,liabilities assumed and goodwill.  Goodwill must be amortized over its economic life but not in excess of 40years

Illustration of pooling  The pooling method interprets a business combination as a process in which two or more groups of stockholders unite their ownership interests by an exchange of common stock.  Both the net assets of combining companies and the stockholder groups remain intact,but combined.  Fair values of assets and liabilities are ignored,except in the determination of an equitable exchange ratio of common stock,and the assets and liabilities assumed are carried forward to the new or surviving entity at their book value.

How to combine the equity  How much is allocated to common stock,to other contributed capital,and to retained earnings ?  The answer depends on the circumstances ;In particular,the par value of two firms’ common stock and whether the total contributed capital of the combiner is sufficient to cover the par value of the new shares issued.

Equity allocation rule  When the par (or stated )value of the shares issued by the issuing firm exceeds the total par or stated value of the combining company’s stock,the excess should be deducted first from the combined other contributed capital and then fro combined retained earnings.

Equity allocation rule If par value issued exceeds par value of combining firm Then reduce : combined other contributed capital (by the remainder of the excess set off by the other contributed capital of combined firm); combined retained earnings (by the remainder of excess set off by the retained earnings of combined firm); If par value issued is less than par value of combining firm Then increase :combined other contributed capital

Case1:other contributed capital is reduced Cash and receivables 180,000 Inventories 100,000 Land 120,000 Building 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

Case2:other contributed capital is eliminated Cash and receivables 180,000 Inventories 100,000 Land 120,000 Building 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

Case3:other contributed capital is added in part Cash and receivables 180,000 Inventories 100,000 Land 120,000 Building 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

Case4:other contributed capital is added in part Cash and receivables 180,000 Inventories 100,000 Land 120,000 Building 900,000 accumulated depreciation 300,000 current liabilities 110,000 bonds payable 400,000 common stock 275,000 other contributed capital 75,000 earnings 140,000

Financial statement differences between accounting methods Purchase method tends to report higher asset values than pooling, because of the adjustment to market value and the recording of goodwill,but lower earnings because of the excess depreciation and amortization charges under purchase method.

Income effect of purchase vs pooling purchase pooling difference building &equipment depreciation 50,000 30,000 20,000 amortization of goodwill 5, ,750 bond discount amortization 5, ,000 inventory added to cost of sales 140, ,000 40,000 total charges 200, ,000 70,750 *Building &equipment depreciation Pooling 600,000/20=30,000; Purchase 1,000,000/20=50,000 If giving the net income under pooling =370,750;then net income under purchase=300,00 Roe (under purchase)=300,000/2,940,000(i2-5)=10.2% Roe (under pooling)=370,750/1,990,000(i2-6)=18.6%

Bargain purchase Refer to purchase price below fair value of identifiable (assets minus liabilities) The accounting rules : Current assets ; Previously recorded goodwill; Long-lived assets A deferred credit (negative goodwill)

Example investment in old company 1,000(10,000*10%) no par common stock 1,000 cash 31,500 notes payable 31,500 investment in old company 31,500 cash 31,500 plant assets 22,500 other net assets 1,000 goodwill 9,000 investment in old company 32,500