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Chapter 5 - PowerPoint PPT Presentation


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Chapter 5. Business Combinations. Objectives of the Chapter. 1. To discuss the general view of business combinations. 2. To learn accounting for business combinations (purchase versus pooling methods) on date of combination for statutory merger type of business combinations .

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Chapter 5


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  1. Chapter 5 Business Combinations

  2. Objectives of the Chapter • 1. To discuss the general view of business combinations. • 2. To learn accounting for business combinations (purchase versus pooling methods) on date of combination for statutory merger type of business combinations. Business Combinations

  3. Objectives of the Chapter • 3. To discuss the development of two alternatives for business combinations from a historical perspective. • 4. Preparing financial statements following a business combination for statutory merger type of business combination. Business Combinations

  4. Objectives of the Chapter • 5. To learn accounting for statutory consolidation (using purchase method). • 6. To discuss the current development on business combination standards. Business Combinations

  5. Business Combinations • Business combinations: events and transactions in which two or more business enterprises, or their net assets, are combined to be under the control of a single business entity. Business Combinations

  6. Business Combinations (contd.) • FASB’s terms for the business entities involved in the business combination: • a.Constituent companies : all business entities enter into a business combination. • b.Combined enterprise: the business entity that results from a business combination. Business Combinations

  7. Business Combinations (contd.) • c.Combinor : a constituent company whose owners end up to have control of the ownership interest of the combined enterprise. • d.Combinee : all other constituent companies other than the combinor in a business combination. Business Combinations

  8. Types of Business Combinations • Friendly takeovers • Hostile takeovers Business Combinations

  9. Reasons for Business Combinations • For the combination in a friendly takeover: •  a.Growth. • Through the business combinations, the product lines can be expanded and diversified. Also, the market shares can be enlarged. Business Combinations

  10. Reasons for Business Combinations (contd.) • b.Obtaining new management strength or better use of existing management. • c.For the income tax advantages • For hostile takeovers: Substantial gains may result from the sale of business segments of a combinee following the business combination. Business Combinations

  11. Four Methods for Carrying Out Business Combinations • 1.Statutory Merger Procedures of statutory merger: • a. The board of directors of the constituent companies work out the terms of merger. • b. Stockholders of the constituent companies approve the terms of the merger. Business Combinations

  12. Four Methods for Carrying Out Business Combinations (contd.) • c. the survivor issues its common stock or other consideration to stockholders of the other constituent companies to exchange for all their outstanding voting common shares. • d. The survivor dissolves and liquidates the other constituent companies. Business Combinations

  13. Four Methods for Carrying Out Business Combinations (contd.) • 2. Statutory Consolidation: a new corporation is formed to issue its common stock for the outstanding common stock of all constituent corporations. • Procedures of statutory consolidation: • a. similar to the statutory merger. • b. similar to the statutory merger. Business Combinations

  14. Four Methods for Carrying Out Business Combinations (contd.) • c. a new corporation is formed to issue its common stock to the stockholders of all the constituent companies in exchanger for all their outstanding voting common stock. • d. the new corporation dissolves and liquidates the constituent companies. Business Combinations

  15. Four Methods for Carrying Out Business Combinations (contd.) • 3.Acquisition of Common Stock (a method for most of hostile takeovers) • Procedures: • a. the combinor received the approval from its board of directors to acquire common stock of the prospective target firm.  Business Combinations

  16. Four Methods for Carrying Out Business Combinations (contd.) • b. acquiring target firm’s common stock in an open market, or through a tender offer to stockholders of a publicly owner corporation. Business Combinations

  17. Four Methods for Carrying Out Business Combinations (contd.) • c. When acquiring enough shares to have the controlling interest in the combinee’s voting common shares,the target firm becomes affiliated with the combinor (the parent company) as a subsidiary. • The target firm remains as a separate legal entity.   Business Combinations

  18. Four Methods for Carrying Out Business Combinations (contd.) • 4. Acquisitions of Assets: • Business entity acquires all or most of net assets of the other entity (using cash, debt, stock ……..) Business Combinations

  19. Establishing the Price for a Business Combination • 1. Capitalization of expected average annual earnings of the combinee at a desired rate of return. • 2. Determination of current fair value of the combinee’s net assets (including goodwill). Business Combinations

  20. Methods of Accounting for Business Combinations • Pooling of Interest Accounting versus Purchase Accounting • Definitions: • Accounting Acquisition Premium (AAP) = purchase price – book value of the combinee. Business Combinations

  21. Methods of Accounting for Business Combinations • Purchased Goodwill • = AAP – combinee’s assets step-up. • Assets step up • = the fair market value of net assets of the combinee – the book value of these net assets. Business Combinations

  22. Methods of Accounting for Business Combinations (contd.) • Two accounting methods for business combinations are allowed under APB Opinion No. 16: • Pooling-of-interests method (pooling accounting) : • The acquired firm’s net assets are consolidated at their existing book value and any accounting acquisition premium (AAP) is ignored. Business Combinations

  23. Methods of Accounting for Business Combinations (contd.) • Purchase method (purchase accounting): • The acquired net assets are recorded at their fair market value and the excess of AAP over the assets step-up is recognized as goodwill. •   In order to adopt the pooling of interests method to account for the business combination, 12 conditions must be met (detailed later). Business Combinations

  24. Methods of Accounting for Business Combinations (contd.) • Impact of these two accounting methods on the financial numbers: • Earnings: • the depreciation associated with any assets step-up and the amortization of any purchased goodwill will result in purchase earnings, in general, to be less than pooling earnings (i.e., E purchase < E pooling). Business Combinations

  25. Methods of Accounting for Business Combinations (contd.) • Book Value: • the book value of the accounting consolidated net assets under pooling accounting will typically be less than those reported under purchase accounting (i.e., B pooling < Bpurchase ). Business Combinations

  26. Purchase Accounting • Cost of a Combinee including: •  1.the amount of consideration paid by the combinor to a combinee. • 2.the combinor’s direct “out-of- pocket” costs of the combination, and • 3.contingent consideration which is determinable on the business combination date. Business Combinations

  27. Cost of A Combinee (contd.) • Direct out-of-pocket costs include legal fees, accounting fees, and finder’s fees. • Costs of registering with the SEC and issuing debt securities in a business combinations are debited to Bond Issue Costs. Business Combinations

  28. Cost of A Combinee (contd.) • Cost of registering with the SEC and issuing equity securities are offset against the proceeds from the issuance of the securities. • Contingent consideration: cash,other assets,or securities that may be issuable in the future. Business Combinations

  29. Accounting Treatment for Contingent Consideration • a.Contingent consideration which is determinable on the combination date: • recorded as part of the cost of the combination. Business Combinations

  30. Accounting Treatment for Contingent Consideration(contd.) • b.Contingent consideration that is not determinable on the combination date: • the contingent amount is recorded as goodwill when the contingency is resolved. Business Combinations

  31. Assigning Values to a Purchased Combinee’s Identifiable Assets and Liabilities (Based on APB Opinion No. 16) • 1. Present value: receivables and liabilities; • 2. Net realizable values : marketable securities, finished goods, goods in process inventories, plant assets held for sale or temporary use; Business Combinations

  32. Assigning Values to a Purchased Combinee’s Identifiable Assets and Liabilities (Based on APB Opinion No. 16) (contd.) • 3. Appraised value: intangible assets, land, natural resources and nonmarketable securities; • 4. Replacement cost: material and plant assets held for long-term use. Business Combinations

  33. Goodwill Computation under Purchase Accounting • Purchased Goodwill • =purchase price (total cost of the combinee) – • the current fair values of identifiable net assets of the combinee. Business Combinations

  34. Goodwill Computation under Purchase Accounting (contd.) • Negative Goodwill: • The excess amount is applied to reduce proportionally the amounts initially assigned to noncurrent assets (other than long-term investments.) • If this procedure does not extinguish the excess, a Negative Goodwill account would be credited for the remaining excess. Business Combinations

  35. Example I: Purchase Accounting For Statutory Merger, with Goodwill • On December 31,1999, Mason Company (the combinee) was merged into Saxon Corporation (the combinor or survivor). • Both companies used the same accounting principles for assets, liabilities, revenue, and expenses and both had a December 31 fiscal year. Business Combinations

  36. Example I: Purchase Accounting For Statutory Merger, with Goodwill (contd.) • Saxon issued 150,000 shares of its $10 par common stock (current fair value $25 a share) to Mason’s stockholders for all 100,000 issued and outstanding shares of Mason’s no-par, $10 stated value common stock. • In addition, Saxon paid the following out-of-pocket costs associated with business combination: Business Combinations

  37. Example I (contd.): Out of Pocket Costs Business Combinations

  38. Example I (contd.): Out of Pocket Costs (contd.) • There was no contingent consideration in the merger contract. Business Combinations

  39. Example I (contd.): Mason Company’s Condensed B/S Prior to The Merger • MASON COMPANY (combinee) • Balance Sheet (prior to business combination) • December 31,1999 (Continued) Business Combinations

  40. Example I (contd.): Mason Company’s Condensed B/S Prior to The Merger (contd.) • MASON COMPANY • Balance Sheet (contd.) , 12/31/1999 Business Combinations

  41. Example I (contd.): • Using the guidelines in APB Opinion No. 16, “Business Combinations”, the board of directors of Saxon Corporation determined the current fair values of Mason Company’s identifiable assets and liabilities (identifiable net assets) as follows: Business Combinations

  42. Example I (contd.): Fair Value of Identifiable Net Assets of Combinee Business Combinations

  43. Example I (contd.): Combinor’s Journal Entries for Business Combination • Saxon uses an investment ledger account to accumulate the total cost of Mason Company prior to assigning the cost to identifiable net assets and goodwill. Business Combinations

  44. Example I (contd.): Combinor’s Journal Entries for Business Combination (contd.) • Journal Entries for Saxon Corp. 12/31/1999 (Continued) Business Combinations

  45. Example I (contd.): Combinor’s Journal Entries for Business Combination (contd.) • 12/31/1999 (contd.) (Continued) Business Combinations

  46. Example I (contd.): Combinor’s Journal Entries for Business Combination (contd.) • 12/31/1999 (contd.) Business Combinations

  47. Example I (contd.): Combinee’s J.E. for The Dissolution of the Company after Statutory Merger • Mason Company (the combinee) prepares the condensed journal entry below to record the dissolution and liquidation of the company on December 31, 1999. Business Combinations

  48. Example I (contd.): Combinee’s J.E. for The Dissolution of The Company after Statutory Merger (contd.) • Journal Entries for Mason Corp.12/31/1999 Business Combinations

  49. Example II: Purchase Accounting for Acquisition of Net Assets, with Negative Goodwill (Bargain-Purchase Excess) • On December 31, 1999, Davis Corporation acquired the net assets of Fairmont Corporation directly from Fairmont Corp. for $400,000 cash, in a purchase-type business combination. • Davis paid legal fees of $40,000 in connection with the combination. Business Combinations

  50. Example II: Purchase Accounting with Negative Goodwill • The condensed balance sheet statement of Fairmont Corp. prior to the business combination, with related current fair value data, is presented below: Business Combinations