Business Combinations: New Rules for a LongStanding Business Practice

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FISCHER | TAYLOR | CHENG

Chapter 1 Learning Objectives

1. 2. Describe the major economic advantages of business combinations. Differentiate between accounting for an acquisition of assets and accounting for an acquisition of a controlling interest in the common stock of a company. Explain the basics of the acquisition model. Allocate the acquisition price to the assets and liabilities of the acquired company. Demonstrate an understanding of the tax issues that arise in an acquisition. Explain the disclosure that is required in the period in which an acquisition occurs. Apply the impairment test to goodwill and adjust goodwill when needed Understand that some non-publicly traded companies may use special rules that differ from the methods in this chapter. Estimate the value of goodwill. (Appendix)
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3. 4. 5. 6. 7. 8. 9.

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Economic Advantages of Combinations

Types of mergers
Backward vertical integration Forward vertical integration Horizontal merger Product extension merger Market extension merger Conglomerate merger

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Economic Advantages of Combinations

Possible tax advantages
Accept stock to create a tax free reorganization Transferable carry-forward feature of net operating losses Net taxable income reported for the consolidated company

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Acquisition of Control
Acquire net assets
Acquire directly from target company Assume liabilities Payment in cash, debt, or equity

Acquire controlling interest

Typically more than 50% of targets voting common stock Creates parent/subsidiary relationship Separate legal entities remain

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Acquisition of Control
Defenses against unfriendly offers
Greenmail White knight Poison pill Selling the crown jewels Leveraged buyouts

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Acquisition of Control
Accounting ramifications asset acquisition
Acquiring company records assets and liabilities Subsequent accounting procedures are same as for any single accounting entity

Accounting ramifications stock acquisition

Parent records an investment Parent and sub remain separate legal entities with their own separate sets of accounts and separate financial statements Consolidated financial statements reflect presence of one economic entity
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Evolution of Accounting Methods

Pre-2001
Purchase accounting: record net assets at fair value Pooling of interests
Record net assets at their book value A merger of equals Specific qualifying criteria

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Evolution of Accounting Methods

FASB Statement #141, 2001
Pooling eliminated for new combinations
Pre-2001 combinations accounted for under pooling may continue

Purchase method recorded fair values for the portion of the net assets acquired in the purchase

FASB Statement #141R, 2007 (ASC 805)

Acquisition method
All assets and liabilities recorded at fair value regardless of the percentage interest Discontinued the discounting of fixed and intangible assets to values less than fair value

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Applying the Acquisition Method

1. Identify the acquirer 2. Determine the acquisition date
Date used to establish fair value of the company acquired

3. Measure the fair value of the acquiree 4. Record the acquirees assets and liabilities that are assumed
Net assets = excess of assets over liabilities Fair values are determined per ASC 820 Identifiable assets never include pre-existing goodwill Only new goodwill is recorded in an acquisition

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Valuation of Identifiable Assets and Liabilities

Current assets recorded at fair value
Valuation accounts are not used

Existing liabilities recorded at fair value Property, plant, and equipment recorded at fair value
Accumulated depreciation is not recorded

Assets scheduled for sale are recorded at net realizable value

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Valuation of Identifiable Assets and Liabilities

Acquiree was the lessor of assets in use
Leases retain their definition if terms are not modified Operating leases
Recognize an intangible asset if terms are favorable Record an estimated liability if the terms are unfavorable

Example: Excess of current payment over contractual amount Remaining term of lease (months) Annual discount rate Asset (present value beginning mode)
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$300 60 8% $14,894
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Valuation of Identifiable Assets and Liabilities

Acquiree acted as lessor
Leases retain their definition if terms are not modified Operating lease
Asset under lease is on books of acquiree Record at fair value Evaluate terms; record asset (liability) if favorable (unfavorable) to the acquiree/lessor

Intangible assets not separately recorded

Arises from contractual or other legal rights or is separable Identify and record separately Allows for recognition that acquiree was barred from recognizing

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Valuation of Identifiable Assets and Liabilities

Research and development
Fair values of tangible and intangible assets are recorded

Contingent assets and liabilities

Possessed by acquiree on the acquisition date

Liabilities associated with restructuring or exit activities

Existing liabilities to other entities

Employee benefit plans

Asset if projected benefit obligation > plan assets Liability if projected benefit obligation < plan assets

Deferred tax assets and liabilities

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Applying the Acquisition Model

Bal Sheet 10/1/2011 Cash Marketable securities Inventory Land Buildings (net) Equipment (net) Customer list Current liabilities 8% 5-yr bonds Premium on bond pay Warranty liability $1 par common stock Addn'l pd-in capital Retained earnings 40,000 60,000 100,000 30,000 150,000 80,000 FASB ASC 820-10-35 10/1/2011 40,000 66,000 110,000 72,000 288,000 145,000 125,000 (25,000) (100,000) (4,000) (12,000)

book value L1 - market L1 - market L2 - adj mkt L2 - adj mkt L1 - market L3 - other est (25,000) book value (100,000) face L2 - adj mkt L3 - other est (10,000) (140,000) (185,000) fair value of net identifiable assets

705,000

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Recording the Acquisition

All accounts are recorded at fair value Price paid > fair value of net identifiable assets
Recognize goodwill

Price paid < fair value of net identifiable assets

Recognize gain on acquisition of business

All acquisitions costs are expensed

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Recording the Acquisition: Goodwill

Price paid (40,000 shares $20 mkt value) Fair value of net assets acquired Goodwill $ 800,000 (705,000) $ 95,000

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Recording the Acquisition: Gain

Price paid (25,000 shares $20 mkt value) Fair value of net assets acquired Gain $ 500,000 (705,000) $ 205,000

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Changes in Value During Measurement Period

Values recorded on the acquisition date are considered provisional During the measurement period values assigned to accounts recorded during purchase may be adjusted to better reflect the value as of the acquisition date
Changes in value caused by events that occur after the acquisition date are not a part of this adjustment

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Changes in Value During Measurement Period

Adjust assets and liabilities to revised value as of acquisition date Net effect of adjustment will be recorded to
Goodwill Gain Retained Earnings if gain was recorded in prior period

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Changes in Value During Measurement Period

Depreciation and amortization are adjusted retroactively

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Recording Contingent Consideration

Acquirer agrees to additional consideration if identified triggers are met Contingent consideration that is payable in any form other than additional stock
Measure based on probability of achieving target Include as part of consideration for determining goodwill or gain Record as a contingent liability in acquisition entry

Revalue consideration in measurement period

Adjust Goodwill and Liability
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Recording Contingent Consideration

Contingent consideration is additional stock
Treat as a change in estimate

No liability is recorded on acquisition date When triggers are met reassign the original consideration assigned to the stock to a greater number of shares
Reduce additional paid-in capital Record additional shares issued at par

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Accounting by the Acquiree

Record receipt of consideration Remove assets and liabilities at their book values Recognize gain or loss on sale of business Typical final step
Distribute consideration received to shareholders Cease operations

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Tax Issues: Tax Loss Carryovers

On date of acquisition
Value of expected future tax loss carryovers is recorded as a deferred tax asset (DTA) Allowance for Unrealizable Tax Assets recorded to reduce the DTA to the estimated realizable amount

DTA fully offset by valuation account increases goodwill Within the measurement period
Valuation account adjustment Goodwill adjustment
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Tax Issues: Tax Values in an Acquisition

Limitations on value in a taxable exchange: Fair value of plant asset $90,000 Tax value (accelerated depreciation) (50,000) Excess not deductible 40,000 Tax rate 40% Deferred tax liability (DTL) $16,000 DTL is amortized to current tax liability over the depreciable life of the asset.
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Tax Issues: Nontaxable Exchange

Acquirers deductions for amortization and depreciation are limited to book value of acquiree All accounts are recorded at full fair value Difference Fair value of identifiable asset exceeds book value Book value of identifiable asset exceeds fair value Fair value of liability exceeds book value Book value of liability exceeds fair value
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Results in DTL DTA DTA DTL

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Goodwill Impairment
Test: Goodwill is impaired if estimated value of business unit is less than remaining book value of net assets (including goodwill). New goodwill estimate:
Estimated value of business unit New estimate of identifiable net assets at fair value = New goodwill estimate

Impairment Loss:
Book value of goodwill New goodwill estimate = Impairment loss

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Impairment: Example
Recorded $100,000 goodwill in purchase three years ago. Now: Net assets at book value Fair value of the business unit Fair value net identifiable assets (not including goodwill)

$650,000 $625,000 $580,000

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Impairment Calculations
Test Estimated value of business unit $625,000 Book value of assets (including goodwill) 650,000 Excess book $25,000 Goodwill is impaired Adjustment Estimated value of business unit $625,000 Fair value of identifiable assets, not including GW 580,000 New GW estimate 45,000 GW book value 100,000 Impairment loss $55,000

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Special Methods for Smaller Companies

IABSs standards for small and medium-sized entities (SMEs)
Available to companies that issue financial statements to external users but do not have publically traded debt or equity.

Acquisition-related costs: include in purchase cost Goodwill: amortized over 10 years or another reliable estimate period

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Appendix: Estimating Goodwill

Goodwill is based on expectation of excess earnings
Forecast future continuing income Estimate normal income of the entity

Models using excess earnings to estimate goodwill

Excess earnings in perpetuity Excess earnings for a given number of years
Non-discounted Discounted
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