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Chapter 3

Chapter 3. Business Combinations. Business Combinations Defined.

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Chapter 3

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  1. Chapter 3 Business Combinations

  2. Business Combinations Defined • Paragraph 1581.06(a) A business combination occurs when an enterprise acquires net assets that constitute a business, or acquires equity interests of one or more other enterprises and obtains control over that enterprise or enterprises.

  3. Business Combinations • Legal Form • A variety of legal forms can be used • Accounting attempts to reflect economic substance • This may require “looking through” the legal form (e.g., reverse takeovers)

  4. Basic Legal Alternatives Acquisition Of Assets By Combining Company Company A Company B Cash Or A Shares B’s Assets And Liabilities

  5. Basic Legal Alternatives Acquisition Of Assets By New Company New Company Shares Company A New Company Assets And Liabilities Company B New Company Shares

  6. Basic Legal Alternatives Acquisition Of Shares By Combining Company Cash Or A Shares Company A B Company Shareholders Company B Majority Of B Shares

  7. Basic Legal Alternatives Acquisition Of Shares By New Company New Company Majority Of A Company Shares Majority Of B Company Shares Shares Of New Company Shareholders Of A Company A Company B Company Shareholders Of B Company

  8. Tax Considerations • Acquisition Of Assets • Preferred by acquirer • Larger CCA deductions • No inherited tax assessment issues

  9. Tax Considerations • Acquisition Of Shares • Preferred by acquiree • Capital gains taxed at low rates • Gains may be eligible for the lifetime capital gains deduction

  10. Alternative Accounting Methods • The Purchase Method • Treats combination as a purchase of assets • Must identify an acquirer • Acquirer’s assets remain at book value • Acquiree’s assets recorded at fair values.

  11. Alternative Accounting Methods • Pooling-of-Interests • Treats combination as an inconsequential combining of interests • Both company’s assets remain at carrying values • Retroactive presentation of income • No longer GAAP in the industrialized world

  12. Establishing the Acquisition Date • Paragraph 1581.19 either: • the date on which the net assets or equity interests are received and the consideration is given; or • the date of a written agreement, or a later date designated therein, that provides that control of the acquired enterprise is effectively transferred to the acquirer on that date, subject only to those conditions required to protect the interests of the parties involved.

  13. Identification Of An Acquirer • Cash Consideration • Company providing the cash is the acquirer, without regard to whether assets or shares are acquired

  14. Identification Of An Acquirer • Share consideration – no new company • Acquirer is the predecessor company whose shareholders wind up with the majority of the voting shares of the combined company

  15. Identification Of An Acquirer • Share consideration – new company • Acquirer is the predecessor company whose shareholders wind up with the majority of the voting shares of the new company

  16. Identification Of An Acquirer • Other Factors (If no clear cut solution) • Relative voting rights • If no control: largest non-controlling interest • Composition of the board of directors • Composition of senior management • Payment of a premium over market value

  17. Identification Of An Acquirer • Reverse Takeovers • The legal acquirer becomes the acquiree • Surprisingly common • Covered in an Appendix to Chapter 4

  18. Recognition • Acquirer recognizes all of the acquiree’s assets and liabilities, even if they are not recognized on the acquiree’s books • Acquiree’s income recognized only from the date of the business combination transaction

  19. Cost Of The Purchase • Cost determined by: • the fair value of the consideration given; or • the fair value of the equity interest acquired, whichever is more determinable • Includes the direct costs of the combination transaction

  20. Cost Of The Purchase Contingency Based On Earnings On January 1, 2008, Mor issues 3 million no par shares in return for all of the outstanding voting shares of Mee. The shares are trading at $25 and have a total value of $75 million. Mor agrees that if Mee’s earnings per share exceed $3.50 per share, they will pay an additional $10 million to the Mee shareholders.

  21. Cost Of The Purchase Contingency Based On Earnings

  22. Cost Of The Purchase Contingency Based On Share Price On January 1, 2008, Mor issues 3 million no par shares in return for all of the outstanding voting shares of Mee. The shares are trading at $25 and have a total value of $75 million. Mor agrees to pay an additional $15 million if the Mor shares are not trading at or above $30 per share at the end of the year.

  23. Cost Of Purchase Contingency Based On Share Price

  24. Allocation Of The Purchase Price • Step A: Determine the fair values of the acquiree’s identifiable assets and liabilities • Step B: Compare this value to the purchase price • If purchase price is greater, you have goodwill • If identifiable assets are greater you have a balance that is referred to informally as negative goodwill

  25. Determination Of Fair Values • Inventories • Finished goods and work in process at net realizable value • Raw materials at replacement cost

  26. Determination Of Fair Values • Property, Plant, and Equipment • To be used: At replacement cost • To be sold: At fair value

  27. Determination Of Fair Values • Intangible Assets • At estimated or appraised values

  28. Determination Of Fair Values • Liabilities • Present value of amounts to be paid determined using appropriate current interest rates

  29. Determination Of Fair Values • Temporary Differences • Fair values determined without reference to their tax values • Tax values may or may not be changed by the combination • Legal form • Use of rollovers • Future income tax asset or liability based on the difference between fair value recorded and tax value

  30. Determination Of Fair Values • Loss Carry Forwards • Must determine if it is legally available • Must determine if it is more likely than not to be realized by the combined company • Fair value is the amount of the carry forward multiplied by the appropriate tax rate • May be recognized by the combined company even if not recognized by the acquiree

  31. Determination Of Fair Values • Identifiable Intangibles • In the Past • Identifiable Intangibles (e.g., Development costs eligible for capitalization) were often lumped with goodwill, particularly if they were not recognized on the books of the acquiree • This became a problem once we stopped amortizing goodwill.

  32. Determination Of Fair Values • Identifiable Intangibles • Paragraph 1581.48 an intangible asset should be recognized apart from goodwill when: • (a) the asset results from contractual or other legal rights (regardless of whether those rights are transferable or separable from the acquired enterprise or from other rights and obligations); or • (b) the asset is capable of being separated or divided from the acquired enterprise and sold, transferred, licensed, rented, or exchanged (regardless of whether there is an intent to do so).

  33. Goodwill • The Concept: The capitalized expected value of enterprise earning power in excess of a normal rate of return in the industry in which it operates • Rarely recognized when internally generated

  34. Goodwill • Recognition In Practice • The excess of the cost of an acquired company over the fair values assigned to individual assets acquired and liabilities assumed • May include identifiable intangibles if they do not meet the Paragraph 1581.48 criteria for separate recognition

  35. Goodwill Procedures • Not subject to regular amortization • Each reporting unit must be tested annually for impairment • Exceptions if: • Assets and liabilities have not changed significantly • Recent determination shows large excess of fair value over carrying amount • Based on an analysis of events since last evaluation, the likelihood of impairment seems remote

  36. Goodwill Procedures • Circumstances that may require more frequent evaluation for impairment • Change in legal factors • Adverse decisions by a regulator • Loss of key personnel • Need to write down a significant asset group within the reporting unit • A goodwill impairment loss recognized by a subsidiary

  37. Goodwill Presentation • Aggregate amount as a separate line item in the Balance Sheet • Aggregate amount of impairment losses as a separate line item in the Income Statement

  38. Goodwill Disclosure • Paragraph 3062.51 The financial statements should disclose the following information: • (a) The changes in the carrying amount of goodwill during the period including: • (i) the aggregate amount of goodwill acquired; • (ii) the aggregate amount of impairment losses recognized; and • (iii) the amount of goodwill included in the gain or loss on disposal of all or a portion of a reporting unit. • Enterprises that report segment information in accordance with Segment Disclosures, Section 1701, should provide the above information about goodwill in total and for each reportable segment and should disclose any significant changes in the allocation of goodwill by reportable segment. When any portion of goodwill has not yet been allocated to a reporting unit at the date the financial statements are issued, the unallocated amount and the reasons for not allocating that amount should be disclosed.

  39. Goodwill Disclosure • Paragraph 3062.53 For each goodwill impairment loss recognized, the following information should be disclosed in the financial statements that include the period in which the impairment loss is recognized: • (a) a description of the facts and circumstances leading to the impairment; • (b) the amount of the impairment loss; and • (c) when a recognized impairment loss is an estimate that has not yet been finalized, that fact and the reasons therefore and, in subsequent periods, the nature and amount of any significant adjustments made to the initial estimate of the impairment loss. • When the carrying amount of a reporting unit exceeds its fair value, but the second step of the impairment test is not complete and a reasonable estimate of the goodwill impairment loss cannot be determined (see paragraph 3062.28), that fact and the reasons therefore should be disclosed. [JAN. 2002]

  40. Negative Goodwill • Sources • Overstated fair values • Bargain purchase approach • Inadequate rate of return on invested assets (consistent with treatment of goodwill)

  41. Negative Goodwill • Allocated as a pro rata reduction in amounts assigned to acquired assets other than • Financial assets (other than equity investments) • Assets to be sold • Future income tax assets • Future benefit plan prepayments • Other current assets • Any remaining amount as extraordinary gain

  42. Under the purchase method, it is equal to the Shareholders’ Equity of the acquiring company Conflicts with corporate enabling legislation New companies Amalgamations If conflict – Corporate legislation prevails Combined Company’s Shareholders’ Equity

  43. Disclosure – 1581.55 For each material business combination completed during the period, the combined enterprise should disclose the following: • (a) the name and a brief description of the acquired enterprise and, when shares are acquired, the percentage of voting shares acquired; • (b) the period for which the earnings of the acquired enterprise are included in the income statement of the combined enterprise; • (c) the cost of the purchase and, when applicable, the number of equity instruments issued or issuable, the value assigned to those equity instruments, and the basis for determining that value; • (d) a condensed balance sheet disclosing the amount assigned to each major class of asset and liability of the acquired enterprise at the date of acquisition; • (e) contingent payments, options, or commitments specified in the acquisition agreement and the accounting treatment that will be followed should any such contingency occur (see also Accounting Guideline No. 14, Disclosure of Guarantees); and • (f) for any purchase price allocation that has not been finalized, that fact and the reasons therefore and, in subsequent periods, the nature and amount of any material adjustments made to the initial allocation of the purchase price.

  44. Disclosure – 1581.56 When the amounts assigned to goodwill or other intangible assets acquired are significant in relation to the total cost of the purchase, the combined enterprise should disclose the following: • (a) for intangible assets subject to amortization, the total amount assigned and the amount assigned to each major intangible asset class; • (b) for intangible assets not subject to amortization, the total amount assigned and the amount assigned to each major intangible asset class; and • (c) for goodwill: • (i) the total amount of goodwill and the amount that is expected to be deductible for tax purposes; and • (ii) for enterprises that are required to disclose segment information in accordance with Segment Disclosure, Section 1701, the amount of goodwill by reportable segment.

  45. Disclosure – 1581.57 When a series of individually immaterial business combinations are completed during the period that are material in the aggregate, the combined enterprise should disclose the following: • (a) the number of enterprises acquired and a brief description of those enterprises; • (b) the aggregate cost of the acquired enterprises, the number of equity instruments issued or issuable, and the value assigned to those equity instruments; • (c) the aggregate amount of any contingent payments, options or commitments and the accounting treatment that will be followed should any such contingency occur (when potentially significant in relation to the aggregate cost of the purchases); and • (d) the information described in paragraph 1581.56, when the aggregate amount assigned to goodwill or to other intangible assets acquired is significant in relation to the aggregate cost of the purchases.

  46. International Convergence • Business Combinations covered in IFRS No. 3 • Will be revised in 1st quarter 2008 • CICA will adopt by mid-2008 • Revised version will be in effect in Canada in 2009

  47. International Convergence • Goodwill: Covered in IFRS No. 3 – Initial recognition • Also in IAS Nos. 36 and 38 – Subsequent treatment

  48. IAS Nos. 36 and 38 Differences • IAS No. 38 provides more detailed guidance on intangible assets • IAS No. 38 permits revaluation to fair value in the case of intangible assets that have no active market • IAS Nos. 36 and 38 test impairment based on difference between an assets carrying value and its recoverable amount

  49. FASB SFAS No.141, Business Combinations, has been issued IFRS No. 3 revision expected in January, 2008 FASB/IASB Convergence

  50. The End

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