Advanced Accounting-100 Introduction to Business Combinations Page 1

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1 Advanced Accounting-100 Introduction to Business Combinations Page 1 INTRODUCTION TO BUSINESS COMBINATIONS I. Key Concepts and Terms: A. Business Combinations 1. OBJECTIVES: a. Growth--increase economic strength; new markets; b. Diversification--decrease dependency on existing suppliers/markets c. Competitive Advantage--economies of scale; access to new data 4. Tax advantages-- tax free reorganization (as defined in the Internal Revenue Code (IRC) #368); Net operating loss (NOL) carry forward / carry back (IRC #172) 2. TYPES OF BUSINESS COMBINATIONS: (Defined by the courts through the Sherman and Clayton anti-trust acts) a. Horizontal--Firms in same market with similar products b. Vertical--Supplier/customer relationship c. Conglomerate--firms with various diversified products and markets Note: The IRC #368 recognizes three methods of combination; the 80% provision is an IRS requirement only; 50% is the requirement for GAAP 1. TYPE A: a. Statutory Merger-- (A + B = A); one survivor from combining firms; b. Statutory Consolidation-- (A + B = C); a new company is formed to acquire the net assets of the combining companies; -- the "statutory" reference refers to the statutes of the state where the Corporation is chartered -- a continuity of interest required -- debt and cash exchanged is limited by statute 2. TYPE B: a. Acquisition of Stock--(Independent A and Independent B combine to form parent A and subsidiary B) --generally no cash to change hands except to acquire a minority interest; --acquiring company must "control" at least 80% of the acquired company voting stock; 3. TYPE C: a. Acquisition of Assets--acquired directly from the company through direct negotiation; --to be tax free, at least 80% must be acquired for stock; 3. CONSOLIDATED FINANCIAL STATEMENTS: When one company obtains a controlling interest (generally an amount over 50 percent) of another parties stock in a purchase combination or at least 90% of another parties stock in a pooling combination, the acquiring company is able to exert "significant influence" over the acquired company. This influence means that transactions between the consolidated companies can no longer be considered independent (at arms-length), because one company could require the other to engage in transactions that would never be made between independent parties. The effects of these "intercompany transactions" must be eliminated prior to the presentation of the consolidated financial statements in order to avoid distortion of the economic reality underlying the transaction. This is accomplished by having the parent (in a purchase combination or "issuer" company in a pooling combination) prepare consolidated financial statements. The consolidated financial statements are the financial statements of the parent (issuer in a pooling) and the consolidated subsidiaries. The unique aspect of consolidated financial statements is that they eliminate the effects of all intercompany transactions between members of the consolidated group prior to the presentation of the financial statements. These elimination entries are working paper entries made by the parent (issuer company in a pooling) and are never recorded on the separate books of any member of the consolidated group. It is important to note that each entity continues to exist as a separate legal entity but is considered a single consolidated accounting entity for purposes of financial reporting. a. Example: To illustrate, consider that "P" company owns 100% of "S" company common stock. "S" purchases a machine tool for $100 in the open market from an independent party and then sells it to "P" for $500. Note that "P" could go into the open market and buy the exact same machine tool for $100. If "P" buys the machine tool from "S", the effect is to artificially overstate both the income of "S" and the assets on the books of "P". The following journal entries would have been made by "S" and "P" respectively:

2 Advanced Accounting-100 Introduction to Business Combinations Page 2 "S" Books "P" Books Record purchase of machine tool: Machine tool No entry Cash Record sale of machine tool to "P": Record purchase of machine tool: Cash Machine tool Machine tool Cash Gain on sale of machine tool Notice that "S" has recorded $400 gain, and "P" carries the machine tool at $500; both of these amounts are distortions resulting from an intercompany transaction. GAAP requires that "P" carry the asset at the lower cost to the consolidated group or market value. This means that the consolidated financial statements must carry the asset at $100 and "S" should not recognize any profit on the sale. This would be the same result that would have been obtained if "P" had made an "arm-length" purchase in the open market with an independent party. The following adjusting entries would be made by "P" on the consolidated working papers to eliminate the effects of the intercompany transaction and insure that the consolidated financial statements report only the fair market value of the asset (as established in the market) and eliminate the fictitious gain: Eliminate the effects of the intercompany sale: * Gain on sale of machine tool machine tool *This entry is made on the consolidated working papers prepared by the parent (issuer in a pooling) and are not recorded on the books of any member of the consolidated group. Note: We re getting a bit ahead of ourselves here, but notice that the machine tool is now carried at FMV ($100) and the gain on the sale is eliminated in the consolidation process we ll learn about this elimination process in detail in future examples. 4. MINORITY INTEREST: When the controlling interest in a business combination is less than 100% a minority interest exists; i.e. those subsidiary stockholders holding the shares that are not owned by the controlling interest are referred to as the minority interest; the minority interest may or may not be related to the consolidated group in other investments but are always treated as non- related in preparing consolidated financial statements. a. Example: "P" purchases 85% of the common stock of "S" in a purchase combination. The 15% not held by "P" (the controlling interest) are referred to as the minority interest. 5. METHODS OF BUSINESS COMBINATIONS: The GAAP underlying the procedures of recording business combinations is found in APB- 16 (Business Combinations), APB-18 (Equity Method) and SFAS-12 (Cost Method). APB-16 establishes 12 requirements that must be met by the combining firms in order for the combination to qualify as a pooling of interest; if any of those requirements are not met, the firms must record the combination as a purchase. Under purchase accounting, there are two alternative approaches, which may be elected: the equity method (as promulgated in APB-18) and the cost method (as promulgated in SFAS-12). This relationship is outlined below: APB-16 Business Combinations Establishes 12 requirements that must be met in order for the combining companies to qualify for a Pooling of Interest Requirements not met Requirements Met Follow Purchase Accounting Procedures i.e. SFAS 115 or APB 18 FMV ACCT Equity Method Follow Pooling Procedures* (Use of Pooling is allowed only if the consolidation was properly recorded as a Pooling prior to SFAS 141 in 2001(revised 2007)

3 Advanced Accounting-100 Introduction to Business Combinations Page 3 6. PURCHASE COMBINATIONS: In a purchase consolidation one company (the parent) gains control of another by purchasing a controlling interest (greater than 50%) of the assets or voting stock of another (subsidiary) company. Because a "purchase" has taken place, any excess of cost over the fair market value of the identifiable assets is allocated to goodwill. Remember that goodwill can only be created in a purchase combination. a. Summary of Procedures: 1. Record the investment at full cost: Full cost is defined as all costs normal and necessary to complete the purchase with the exception of SEC registration costs and stock issuance costs (which are expensed). 2. Analyzing the Investment in a Purchase Combination: Allocate the excess of cost over book value (or book value over cost) to the assets and liabilities of the subsidiary as follows: a. Subsidiary current assets, liabilities and investments in marketable equity securities will always be valued at their full market value. (These accounts can be referred to as the fair market value (FMV) accounts in that they must always be adjusted to full fair market value). b. Subsidiary non current assets will be allocated any excess of cost over book value remaining. c. Any excess of cost over book value remaining after bringing all other accounts to full fair market value is allocated to goodwill. Recall that goodwill can only be created in a purchase combination in which all identifiable assets and liabilities have been brought to full fair market value. 3. The application of these procedures is accomplished by through a procedure known as Analyzing the Investment. This procedure is illustrated below. 4. The effects of intercompany transactions must be eliminated. 5. Intercompany bonds must be treated as though retired. Purchase Combinations Summary Table Type of Account "P" Books "S" Books Consolidated Books FMV Accounts (CA, Liabilities, MES) All FMV accounts must be valued at full FMV BV + FMV Non-Current Assets (NCA) BV + Purchase Differential Available to NCA after writing FMV account to full FMV Note: the allocation of available excess to NCA is made so as to insure than NCA are carried in accordance with their relative FMV. BV + adjusted value CS PIC Retained Earnings SHE of "P" only 7. POOLING COMBINATIONS: The conceptual foundation underlying a pooling of interest is that two existing companies combine their existing interest and continue in a new form; a pooling is simply a change of accounting entity in which A + B = C or A + B = either A or B. No purchase takes place the ownership interest of the new entity consists of the pooled interest of the pre-existing companies. The company issuing the securities of the new entity is called the "issuer" company and the company or companies giving up their existing securities are called the "combiner" company. An important difference between pooling combinations and purchase combinations is that pooling combinations allow the "issuer" company to absorb the "combiners" retained earnings. This means that the issuer accrues the combiner s net income for the entire year even if the combination takes place on the last day of the accounting year. This is sometimes referred to as "instant earnings". a. Summary of procedures: 1. Record the investment at the book value of the assets less the book value of the liabilities, and expense all costs of the combination in the current period (recall that in a purchase all cost were capitalized except for SEC and stock registration costs). 2. The value of par issued to consummate the pooling is compared to the percentage of Combiner PIC obtained. No goodwill can ever be created in a pooling, but pre-existing goodwill is treated like any other asset. 3. If par issued is less than total combiner PIC obtained, the difference is credited to Issuer PIC. If par issued is greater than PIC obtained the difference is debited against I PIC to the extent available and then debited against C retained earnings.

4 Advanced Accounting-100 Introduction to Business Combinations Page 4 4. The application of these procedures is accomplished through a procedure known as analyzing the investment. Note that the analysis process in a pooling combination differs from the analysis procedure in a purchase combination. Analyzing the investment in a pooling combination: --Step 1: Analyze the pooling to determine the makeup of PIC received. Par issued (Par x number of shares issued)... Total PIC received: Common stock (Par x number of shares received)... If par issued < PIC received then allocated to issuer PIC (where x-y is negative number). gain**) $ xxx,xxx yyy,yyy Zzz, zzz (This is a Good Deal, equivalent to a If par issued > PIC received; excess of par issued over PIC received (w=x-y; w is positive) $ www,www (This is a Bad Deal, equivalent to a loss**) Therefore: 1. Reduce Issuer PIC (to extent available)... $ AA, AAA; if that is not sufficient to account for the deficit then 2. reduce Combiner RE as required to balance (w=a+b) bb,bbb ** Note: Remember there can never be a real gain or loss on transactions involving a companies own stock. When a credit is needed to balance, credit Paid in Capital in excess of Par (PIC); When a debit is called for, Debit the Combiner s (The surviving company) PIC to the extent it is available (you must check the account balances given in the problem) then reduce (debit) Combiner RE as required to balance. This is the same procedure followed in every transaction involving a companies own stock (including treasury stock transactions). --Step 2: Record the pooling Current assets... xx,xxx* Property, plant, and equipment... xxx,xxx* Other assets... xx,xxx* ** PIC-Issuer (if par issued > PIC received)... xx,xxx ** PIC-Issuer (par issued < PIC received)... xx,xxx Accumulated depreciation... xx,xxx* Accounts payable... xx,xxx* Common stock... xxx,xxx*** Retained earnings... xxx,xxx*** * Recorded at book value without adjustment ** Will not appear simultaneously *** Recorded at the adjusted value derived by the analysis of the pooling (see step #1 Above) -- Combinations by pooling of interest will NEVER result in goodwill because the combination is at book value. -- All expenses incurred in pooling are deducted from income of the combined corporation for the period in which the expenses are incurred. Recall that in a purchase combination only SEC registration costs and stock issuance cost were expense. -- Treasury stock issued by the acquiring company should be treated as though retired. -- The effects of intercompany transactions are eliminated. -- Intercompany bonds are treated as though retired

5 Advanced Accounting-100 Introduction to Business Combinations Page 5 Acquistion Terminology: A. Stock Acquisitions 1. Friendly: Stockholders of target company agree to sell shares based on the tender offer 2. Unfriendly: Management and/or a significant number of shareholders oppose the sale 3. Greenmail: The target company is willing to pay a premium price to purchase treasury shares in order to thwart to acquisition. 4. White Knight: Target company identifies another company to acquire it; often used when the initial acquisition is being made by a competitor in the same industry and the target companies management thinks it will be sacked after acquisition. 5. Poison Pill: If the acquiring company attempts to gain control by purchasing a minimal number of shares, the target company may offer to sell shares to its existing stockholders at an extremely discounted price. This has the effect of increasing the number of shares that that must be acquired to gain control which increases the cost of the acquisition. 6. Selling the Crown Jewels: Management of the target company may sell of those assets that the acquiring company is most interested in, thereby eliminating the purpose of the acquisition. 7. Leveraged Buyout: A technique often used by management of the target company to purchase controlling interest in their company through debt (bond) financing. The bonds issued to purchase the stock are often Junk Bonds (high interest with relatively little collateral value). i. An interesting and important tax consideration is that if the new management can raise the value of the company, that increase in value is taxed at capital gains rates as opposed to income tax rates This is how venture capitalist can convert what would normally be income into capital gains and reap the corresponding tax benefits (under current tax law) note: