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Business Combinations
ACCT 501
Business Combinations
4.
Business Combinations
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
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Friendly takeovers
Hostile takeovers
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.
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For hostile takeovers: Substantial gains may result from the sale of business segments of a combinee following the business combination.
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Pooling of Interest Accounting versus Purchase Accounting Definitions: Accounting Acquisition Premium (AAP) = purchase price book value of the combinee.
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Goodwill = AAP combinees assets step-up. step up = the fair market value of net assets of the combinee the book value of these net assets.
Assets
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21
Two accounting methods for business combinations are allowed under APB Opinion No. 16: Pooling-of-interests method (pooling accounting) : The acquired firms net assets are consolidated at their existing book value and any accounting acquisition premium (AAP) is ignored.
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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).
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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).
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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 ).
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25
Purchase Accounting
Cost of a Combinee including: 1.the amount of consideration paid by the combinor to a combinee. 2.the combinors direct out-ofpocket costs of the combination, and 3.contingent consideration which is determinable on the business combination date.
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Direct out-of-pocket costs include legal fees, accounting fees, and finders fees. Costs of registering with the SEC and issuing debt securities in a business combinations are debited to Bond Issue Costs.
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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.
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Assigning Values to a Purchased Combinees 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;
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Assigning Values to a Purchased Combinees 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.
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Purchased Goodwill =purchase price (total cost of the combinee) the current fair values of identifiable net assets of the combinee.
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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.
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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.
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Saxon issued 150,000 shares of its $10 par common stock (current fair value $25 a share) to Masons stockholders for all 100,000 issued and outstanding shares of Masons no-par, $10 stated value common stock. In addition, Saxon paid the following out-of-pocket costs associated with business combination:
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51,250
Example I (contd.): Mason Companys Condensed B/S Prior to The Merger (contd.)
MASON COMPANY Balance Sheet (contd.) , 12/31/1999 Liabilities & Stockholders Equity Current Liabilities $ 500,000 Long-term debt 1,000,000 Common stock, no-par,$10 stated value 1,000,000 Additional paid-in capital 700,000 Retained earnings 1,400,000 Total liabilities & stockholders equity $4,600,000
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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 Companys identifiable assets and liabilities (identifiable net assets) as follows:
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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.
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Investment in Mason Company Common Stock (150,000 x $25) Common stock (150,000 x $10) Paid-in Capital in Excess of Par
To record merger with Mason Company as a purchase.
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(Continued)
44
12/31/1999 (contd.)
Investment in Mason Company Common Stock ($5,000+$10,000+$51,250) Paid-in Capital in Excess of Par ($60,000+$50,000 + $23,000+750) Cash
To record payment of out-of-pocket costs incurred in merger with Mason Company.
66,250 133,750
200,000
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(Continued)
45
To allocate total cost of liquidated Mason Company to identifiable assets and liabilities, with the reminder to goodwill. (Income tax effects are disregarded.)
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Example I (contd.): Combinees 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.
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47
Example I (contd.): Combinees J.E. for The Dissolution of The Company after Statutory Merger (contd.)
Current Liabilities Long-Term Debt Common Stock , $10 stated value Paid-in Capital in Excess of Stated Value Retained Earnings Current Assets Plant Assets (net) Other Assets
1,000,000
700,000 1,400,000 1,000,000 3,000,000 600,000
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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.
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The condensed balance sheet statement of Fairmont Corp. prior to the business combination, with related current fair value data, is presented below:
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Assets
Current assets Investment in marketable debt securities (held to maturity) Plant assets (net) Intangible assets (net) Total assets
Carrying Current Fair Amounts Values $ 190,000 $ 200,000 60,000 900,000 100,000 $1,260,000
(Continued)51
Liabilities and Stockholders Equity Current liabilities Long-term debt Total Liabilities Common stock, $1 par Deficit Total stockholders equity Total liabilities & stockholders equity
Carrying Current Fair Amounts Values $ 240,000 $ 240,000 500,000 520,000 $ 740,000 $ 760,000 $ 600,000 (140,000) $ 460,000
$1,200,000
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Thus, Davis acquired identifiable net assets with a current fair value of $ 500,000a for a total cost of $440,000b. a. $ 1,260,000 - $760,000= $500,000 b. $ 400,000 +$40,000= $440,000
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The $60,000 excess of current fair value of the net assets over their cost to Davis ($500,000 - $440,000 = $60,000) is prorated to the plant assets and intangible assets in the ratio of their respective current fair values, as follows:
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Example II (contd.)
Notes: No part of the $60,000 bargainpurchase excess is allocated to current assets or to the investment in marketable securities.
The journal entries on pages 54 and 55 record Davis Corporations acquisition of the net assets of Fairmont Corporation and payment of $40,000 legal fees:
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Journal Entries of Davis Corp. 12/31/1999 Investment in Net Assets of Fairmont Corporation Cash
To record acquisition of net assets of Fairmont Corporation
400,000 400,000
40,000 40,000
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(Continued)57
Example II (contd.) : Combinors J.E. for the Acquisition of Net Assets (contd.)
12/31/1999 (contd.)
Current Assets 200,000 Investments in Marketable Debt Securities 60,000 Plant Assets ($900,000 - $54,000) 846,000 Intangible Assets ($100,000 - $6,000) 94,000 Current Liabilities 240,000 Long-Term Debt 500,000 Premium on Long-Term Debt ($520,000 - $500,000) 20,000 Investment in Net Assets of Fairmont Corporation ($400,000 + $40,000) Business Combinations 440,00058
Note to the above journal entries: To allocate total cost of net assets acquired to identifiable net assets, with excess of current fair value of the net assets over their cost prorated to noncurrent assets other than investments in marketable debt securities.
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Pooling-of-Interests Accounting
The idea behind this accounting method is that the business combination is simply an exchange of common stock between an issuer and the stockholders of a combinee. Thus, this method is appropriated to be used in the case of business combinations involving only common stock exchanges between companies of approximately equal size.
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Because neither party can be considered as the combinor (as previously defined), the combined assets, liabilities and retained earnings of the constituent companies are recorded at their carrying amounts.
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Both the market value of the common stock issued for the combination and the fair value of the combinees net assets are disregarded in this method. The term issuer identifies the corporation that issues its common stock to accomplish the combination.
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Applying the pooling-of interests accounting method on the Example I (the business combination of Saxon and Manson) illustrated on page 32-45, the following journal entries would be prepared in Saxon Corporations accounting records:
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200,000 200,000
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(Continued)
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2,116,250
200,000
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Excess of purchase asset values over pooling asset values: Current assets ($1,150,000-$1,000,000) Plant assets ($3,400,000- $3,000,000) Goodwill Excess of pooling liability values over purchase liability values: Long-term debt [$1,000,000-($1,000,000- $50,000) ] Excess of purchase net assets values over pooling net assets values
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50,000 $716,250
73
Assuming:
a.The $150,000 difference in current assets is attributable to inventories which will be allocated to CGS on FIFO basis in the following year.
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Thus, pooling accounting, in general, results in a more favorable post-merger earnings than the purchase accounting. As a result, it is preferred by mangers who would like to present a higher postmerger earnings.
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Year ended Dec. 31, 1999: Net income Basic earnings per share of common stock On Dec. 31, 1999: Number of shares of common stock outstanding Market price per share Price-earnings ratio
Using the pooling method, Saxon would report the combined enterprises net income as $875,000 for the year ended 12/31/1999 (as if these two companies were pooled as of 1/1/1999) and the EPS for Saxon would be increased from $0.50 to $0.76. Calculated as : $875,000/(1,000,000+150,000).
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Due to lack of accounting pronouncement in providing clear guidance in determining the appropriate method for business combination prior to the issuance of Accounting Principle Board Opinion No. 16 Business Combinations in August 1970 (effective for business combinations initiated after October 31, 1970),
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a substantial number of business combinations arranged in the 1950s and 1960s were accounted for using pooling accounting despite the absence of the assumption for using pooling accounting .
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The pooling accounting was first sanctioned by the AICPA in its Accounting Research Bulletin No. 40, Business Combinations. This pronouncement provides very little guidance for identifying the business combinations that qualified for pooling method.
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ARB No. 40 was subsequently replaced by ARB No. 48, Business Combinations which continued to allow pooling method to be used for most business combinations involving an exchange of common stock.
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The advantages of pooling accounting in post-merger earnings, retained earnings, and in the P/E ratio of the merger year with the lack of clear guidelines for pooling in ARB No. 48 led to serious abuses of pooling method.
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Consequently, a substantial number of business combinations arranged in the 1950s and 1960s were accounted for using pooling accounting despite the absence of the assumption for using pooling accounting the combination of existing stockholders interests.
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Among these abuses are: a. Retroactive Pooling b. Retrospective Pooling c. Part-Pooling, Part-Purchase Accounting d. Treasure Stock Issuance
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Contd.: e.Issuance of Unusual Securities f. Creation of instant Earnings g.Contingent Payouts h.Burying the Costs of Pooling-Type Business Combinations
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The most common abuses of purchase accounting is the failure to allocate the cost of a combinee to the identifiable net assets acquired and to goodwill.
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The Accounting Principles Board reacted to the abuses by issuing APB opinion No. 16 in which pooling accounting standards are tightened and the range of situations allowed for pooling accounting is substantially limited.
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A business combination that meets 12 conditions of APB of Opinion No.16 accounting for as a pooling regardless of the legal form of the combination. These conditions specified in APB Opinion No. 16 are:
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APB stated that both purchase and pooling methods are acceptable in accounting for business combination, but not as alternatives in accounting for the same business combination. By tightening the conditions for adopting pooling accounting, many previous abuse of pooling were eliminated or reduced.
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(contd.)
Example to illustrate the independence and 90% of voting common stock tests
On March 13, 1999, Patton Corporation and Sherman Company initiated a plan of business combination. Under the Plan, 1.5 shares of Pattons voting common stock (1,000,000 shares issued and outstanding prior to March 13, 1999) were to be exchanged for each outstanding share of Shermans common stock (100,000 shares issued and 99,500 shares outstanding prior to March 13,1999).
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Example to illustrate the independence and 90% of voting common stock tests (contd.)
At this time, Patton owned 7,500 shares of Shermans common stock, and Sherman owned 6,000 shares of Pattons voting common stock; in addition, 500 shares of Shermans common stock were in Shermans treasury.
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Example to illustrate the independence and 90% of voting common stock tests (contd.)
Neither Pattons ownership of 7.54% of Shermans outstanding common stock (7,500/ 99,500 = 7.54%) nor Shermans ownership of 0.6% of Pattons outstanding common stock (6,000/ 1,000,000 = 0.6%) exceeds the 10% limitation of the independence of constituent companies requirement.
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Example to illustrate the independence and 90% of voting common stock tests (contd.)
On March 26, 1999, Patton acquired in the open market for cash 1,000 shares (1.005%) of Shermans outstanding common stock. On June 30, 1999, Patton issued 136,500 shares of its voting common stock in exchange for 91,000 outstanding shares of Shermans common stock to complete the business combination.
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Example to illustrate the independence and 90% of voting common stock tests (contd.)
Total Sherman Company shares issued, June 30, 1999 Less: Shares in Shermans treasury Total Sherman shares outstanding, June 30, 1999 Less: Sherman shares owned by Patton Corporation, Mar. 13, 1999 Sherman shares acquired by Patton for cash, Mar. 26, 1999
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Example to illustrate the independence and 90% of voting common stock tests (contd.)
Equivalent number of Sherman shares represented by Pattons common stock owned by Sherman, Mar. 13, 1999 (6,000 1 ) Effective number of Sherman shares acquired June 30, 1999 in exchange for Pattons common stock Application of 90% requirement (99,500 x 90%)
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4,000
12,500
87,000
89,550
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Example to illustrate the independence and 90% of voting common stock tests (contd.)
Thus, the 91,000 shares of Sherman Company common stock actually exchanged on June 30, 1999, are in effect restated to 87,000 shares. Because the restated amount is less than 90% of Shermans 99,500 shares outstanding, the business combination does not qualify for pooling accounting.
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The assets, liabilities, and retained earnings in a balance sheet statement following a business combination are reported as follow:
Assets & Lia. Purchasecombinor Purchasecombinee Poolingcombinor Poolingcombinee Carrying amount Fair value Carrying amount Carrying amount
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The combined income statement following a business combination depends on the accounting method: Purchase Accounting: The income statement of the combined entity for the period in which the business combination occurred include the operating results of the combinee after the date of the combination only.
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Pooling Accounting The income statement of the combined entity for the period in which the business combination occurred includes the results of operations of the constituent companies as though the combination had been completed at the beginning of the period regardless when the combination consummated.
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Comparative financial statements for preceding periods are restated for comparative purposes. Intercompany transactions prior to the combination must be eliminated from the combined income statements in a manner comparable with that described in Chapter 4 for branches.
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Example IV:
To illustrate, assume that the income statements of Saxon Corporation and Mason Company for the year ended December 31, 1999 (prior to completion of their poolingtype merger described on page 60-65 example III), were as shown below. Assume also that Masons interest expense includes $25,000 paid to Saxon on a loan that was repaid prior to December 31, 1999, and that Saxons revenue includes $25,000 interest received from Mason.
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Example IV (contd.)
SAXON CORPORATION AND MASON COMPANY Separate Income Statements For Year Ended December 31, 1999
Sales and other revenue Costs and expenses: Costs of goods sold Operating expenses Interest expense Income taxes expense Total costs and expenses Net income Saxon Corporation $10,000,000
Example IV (contd.)
The working paper for the postmerger income statement of Saxon Corporation under pooling accounting is illustrated below. The amounts in the Combined column are reported in Saxons published postmerger income statement for the year ended December 31,1999.
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Example IV (contd.)
SAXON CORPORATION Working Paper for Combined Income Statement (Pooling of Interests) For Year Ended December 31, 1999 Saxon Mason Eliminations Combined Corporation Company Sales and other revenue 10,000,000 5,000,000 (a) 25,000 14,975,000 Cost and expenses: Cost of goods sold 7,000,000 3,000,000 10,000,000 Operating expenses 1,883,333 1,274,500 3,157,833 Interest expense 150,000 100,500 (a) (25,000) 225,500 Income taxes expense 466,667 250,000 716,667 Total costs and expenses 9,500,000 4,625,000 (25,000) 14,100,000 Net income 500,000 375,000 -0875,000
(a) To eliminate intercompany interest received by Saxon Corporation from Mason Company. Business Combinations
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Extensive disclosure is required for business combinations in the period they occur. Required Disclosure for Purchase Accounting: (textbook p194) 1. Name and brief description of the combinee; also the accounting method used for the business combination;
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The following table summarizes the principal aspects of purchase accounting and pooling-of-interests accounting for business combinations:
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Pooling-ofInterests Accounting Combining of stockholder interests Combinations meeting all 12 criteria for pooling accounting
(Continued)
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Aspect
(Continued)
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Combinors net assets at carrying amount; combinees net assets at current fair value
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Aspect
Purchase Accounting
Due to a new corporation is formed to issue common stock to all constituent companies in this type of business combination, a combinor needs to be identified for the accounting treatment. The assets and liabilities of the identified combinor will be accounted for by the new corporation at the carrying amount while those of the combinee will be accounted for at the fair value.
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Example V :
To illustrate, assume the following balance sheet statements of the constituent companies involved in a purchase-type statutory consolidation on December 31, 1999 (p196-199 of textbook):
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Example V (contd.):
LAMSON CORPORATION AND DONALD COMPANY Separate Balance Sheets (prior to business combination) December 31,1999
Assets
Current assets Plant assets (net) Other assets (net) Total assets
Lamson Donald Corporation Company $ 600,000 $ 400,000 1,800,000 1,200,000 400,000 300,000 $ 2,800,000 $1,9,00,000
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(Continued)
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Example V (contd.):
Liabilities & Stockholders Equity Current liabilities Long-term debt Common stock,$10 par Additional paid-in capital Retained earnings Total liabilities & stockholders equity
LAMSON CORPORATION AND DONALD COMPANY Separate Balance Sheets (contd.), 12/31/1999
Lamson Donald Corporation Company $ 400,000 $ 300,000 500,000 200,000 430,000 620,000
300,000 1,170,000
400,000 380,000
$ 2,800,000 $1,9,00,000
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Example V (contd.):
The current fair values of both companies liabilities were equal to carrying amounts. Current fair values of identifiable assets, were as follows for Lamson and Donald, respectively: current assets, $800,000 and $500,000; plant assets, $2,000,000 and $1,400,000; other assets, $500,000 and $400,000.
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Example V (contd.):
On December 31, 1999, in a statutory consolidation approved by shareholders of both constituent companies, a new corporation, LamDon Corporation, issued 74,000 shares of no-par, no-stated-value common stock with an agreed value of $60 a share, based on the following valuations assigned by the negotiating directors to the two constituent companies identifiable net assets and goodwill:
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Example V(contd.):
Current fair value of identifiable net assets: Lamson: $800,000+$2,000,000 +$500,000- $400,000-$500,000 Donald: $500,000+ $1,400,000 + $400,000 -$300,000-$200,000 Goodwill Net assets current fair value Number of shares of LamDon common stock to be issued to constituent companies stockholders, at $60 a share agreed value
43,000
31,000
139
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Example V (contd.):
Because the former stockholders of Lamson Corporation receive the larger interest in the common stock of LamDon Corporation (43/74, or 58%), Lamson is the combinor in the purchase-type statutory consolidation business combination.
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Example V (contd.):
Assuming that LamDon paid $200,000 out-of-pocket costs of the consolidation after it was consummated on December 31, 1999, LamDons journal entries would be as follows:
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Example V (contd.):
Investment in Lamson Corporation and Donald Company Common Stock (74,000 x $60) Common Stock, no par
To record consolidation of Lamson Corporation and Donald Company as a purchase
4,440,000 4,440,000
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(Continued)
142
Example V (contd.):
12/31/1999 (contd.)
Investment in Lamson Corporation and Donald Company Common Stock Common Stock, no par Cash
To record payment of costs incurred in consolidation of Lamson Corporation and Donald Company. Accounting, legal, and finders fees in connection with the consolidation are recorded as investment cost; other out-of-pocket costs are recorded as a reduction in the proceeds received from the issuance of common stock.
110,000
90,000 200,000
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(Continued)
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Example V (contd.):
12/31/1999 (contd.) Current Assets ($600,000+$500,000) 1,100,000 Plant Assets ($1,800,000+$1,400,000) 3,200,000 Other Assets ($400,000+$400,000) 800,000
Goodwill
Current Liabilities Long-Term Debt Investment in Lamson Corporation and Donald Company Common Stock
850,000
700,000 700,000
4,550,000
(Continued) 144
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Example V (contd.):
12/31/1999 (contd.) Amount of goodwill is computed as follows: Total cost of investment
($4,400,000+$110,00)
4,550,000
(1,900,000)
Current fair fair value of Donalds identifiable net assets (1,800,000) Amount of goodwill $ 850,000
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Norton Company agrees to pay $800,000 cash for Robinsons net assets (not including Robinsons slowmoving products which have been written down to scrap value by Robinson prior to the business combination).
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assets of Robinson will be included in the Rob Division of Norton Company. In addition, the following contingent consideration was included in the contract: 1. Norton will pay Robinson $100 a unit for all sales by Robb Division of the slow-moving product.
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Assuming that by 12/31/x2, the end of the first year following Nortons acquisition of the net assets, another 300 units of the slowmoving product had been sold, and Nortons Rob Division had pre-tax income of $580,000 (excluding the sale of the slowmoving product). On 12/31/x2, Norton prepares the following journal entry to record the resolution of contingent consideration:
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50,000* 50,000
$50,000
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International Accounting Standards Committee requires purchase accounting to be used for all business combinations except for united-ofinterests type combinations.
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The Current Development on the Business Combination Standards (Excerpts from News Release of the FASB dated 7/20/01)
On July 20, 2001, FASB issued Statement No. 141, Business Combinations and Statement No. 142, Goodwill and Other Intangible Assets.
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The Current Development on the Business Combination Standards (Excerpts from News Release of the FASB dated 7/20/01) (contd.)
Statement 141: Use of the pooling-of-interests method is not permitted. All business combinations should be accounted for using the purchase method. This statement is effective for business combinations initiated after June 30, 2001.
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The Current Development on the Business Combination Standards (Excerpts from News Release of the FASB dated 7/20/01) (contd.)
Statement 142: Requires that goodwill no longer to be amortized as expense but subject to annual review for impairment.
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The Current Development on the Business Combination Standards (Excerpts from News Release of the FASB dated 7/20/01) (contd.)
Reasons of issuing SFAS No. 141: (Source: summary of SAFS No. 141 published by the FASB): Due to the 12 criteria for pooling accounting failed to distinguish economically dissimilar transactions, similar business combinations were accounted for using different accounting methods.
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The Current Development on the Business Combination Standards (Excerpts from News Release of the FASB dated 7/20/01) (contd.) Therefore, different financial statements were produced for similar business combinations. The following are some of the reasons stated by the FASB:
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The Current Development on the Business Combination Standards (Excerpts from News Release of the FASB dated 7/20/01) (contd.) 1.Lack of Comparability on the financial statements when different method is adopted. 2.Criticism on the amortization of goodwill when purchase method is used. 3.Criticism from mangers on the impact of these two methods on the competition in markets for mergers and acquisitions.
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Intangible assets have become an important economic resource for many entities. Thus, better information for the intangible assets is needed. Some empirical studies indicate that the goodwill amortization expense is not reflected in firm value
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APB Opinion No. 17 assumed that goodwill and all other intangible assets were assets with finite lives and thus should be amortized, not to exceed 40 years.
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(source: FASB Publication of Summary of Statement No. 142) (contd.) Statement No. 142 assumed that goodwill and other intangible assets have indefinite lives and will not be amortized but rather will be tested on annual basis for impairment. Intangible assets that have finite useful lives will continue to be amortized over their useful lives, but without the arbitrary ceiling of 40 years.
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Statement 142 provides guidance for the two-step process of review of the potential impairment: Consequence of SFAS No. 142: Earnings may be more volatile due to the impairment losses are likely to occur irregularly and in varying amounts.
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Disclosure requirements of Statement 142: a. Information about the changes in the carrying amount of goodwill from period to period (in the aggregate and by reportable segment);
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FASB indicates that this statement can improve the financial reporting on these assets (goodwill and other intangible assets) because this treatment will result values of these assets better reflect the underlying economic values of these assets.
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