C H A P T E R

1. C H A P T E R 2 Updated Sixth Edition Consolidation of Financial Information

2. Why do Firms Combine? • Vertical integration. • Cost savings. • Quick access to new markets. • Economies of scale. • More attractive financing opportunities. • Diversification of business risk.

3. Business Combinations • In a business combination, one company (parent) gains CONTROL over another company (called a “subsidiary” or “sub”). • For reporting purposes, the combined companies are treated as if they were one.

4. Business Combinations:Creating a Single Economic Entity Statutory Merger There are 3 basic types of combinations. Acquisition of Majority Interest Statutory Consolidation

5. Parent Subsidiary The parent does not prepare separate financial statements Consolidated financial statements are prepared. The Sub still prepares separate financial statements Consolidation of Financial Information

6. GAAP Accounting Methods

7. Purchase Method • Used when one company “acquires” control of another company. • Three basic criteria: • One company is clearly in the “acquiring” role. • A bargained exchange has taken place. • An historical cost figure can be determined. If the acquisition is made by issuing stock, the cost of the acquisition is equal to the MARKET VALUE of the stock issued.

8. Purchase Method Example • Big wants control of Little. • Big’s 2,000 stockholders hold a total of 2,500,000 shares of $10 par value Big stock. • Little’s 1,000 stockholders hold a total of 600,000 shares of $5 par value Little stock. • Little’s current market price is $30 per share.

9. Purchase Method Example Assume that Big purchases 100% of Little from Little’s stockholders for $18,000,000.

10. Purchase Method Example Assume that Big purchases 100% of Little from Little’s stockholders for $18,000,000.

11. Purchase Method Example Assume that Big purchases 100% of Little from Little’s stockholders for $18,000,000.

12. Purchase Method Example Assume that Big purchases 100% of Little from Little’s stockholders for $18,000,000.

13. Let’s look at some different situations where the Purchase Method would be used.

14. Purchase Method Situations • Dissolution of the acquired company: • Cost = FMV • Cost > FMV • Cost < FMV • Separate incorporation is maintained.

15. Purchase MethodCost = FMV, Dissolution • Ignore the Equity and Nominal accounts of the acquired company. • Determine FMV of the acquired company’s assets and liabilities. • Prepare a journal entry to • recognize cost of the acquisition • incorporate the FMV of acquired company’s assets and liabilities into acquiring company’s books.

16. Cost = FMV, DissolutionExample On 1/1/02, Large acquired 100% of Tiny for $300,000 cash. Prepare the entry to record Large’s purchase.

17. Cost = FMV, DissolutionExample Tiny’s fair market value was $300,000 which is equal to the price paid by Large. Record the purchased assets at their market value.

18. Purchase MethodCost > FMV, Dissolution • At date of acquisition: • Acquired company should prepare a B/S as of the date of acquisition. • Acquired company’s income prior to acquisition is irrelevant to the acquiring company. • FMV of acquired company’s assets and liabilities is added to acquiring company’s books. • Difference between Cost and FMV is allocated to goodwill and other intangibles. Note: Goodwill should be viewed as a residual amount remaining after all other identifiable and separable intangible assets have been identified.

19. Cost > FMV, DissolutionExample On 1/1/02, Huge acquires 100% of Small for $250,000 cash. Small has no identifiable, separable intangible assets.

20. Cost > FMV, DissolutionExample Goodwill will be recorded as an intangible asset on Huge’s books, but will not be amortized.

21. Cost > FMV, DissolutionExample Large will record $33,000 of Goodwill and will record the other purchased assets at their FMV.

22. Purchase MethodCost < FMV, Dissolution • FMV can occasionally exceed cost. • Current assets and liabilities should be consolidated at their FMV. • Long-term assets should be recorded at a value between FMV and BV. • each L-T asset’s FMV should be reduced by a proportionate share of the excess of FMV over cost.

23. Cost Substantially < FMV In the event that the difference is substantial enough to eliminate all the non-current asset balances of the acquired company . . . . . . The remainder is to be reported as an extraordinary gain (SFAS 141)

24. Let’s see what happens when the acquired company is not dissolved.

25. Purchase MethodNo Dissolution • The acquired company continues as a separate entity. • The acquisition shows up on the Parent’s books in the Investment in Subsidiary account. • Separate records for each company are still maintained. • The adjusted balances for the Parent and the Subsidiary are consolidated using a worksheet.

26. Rules of Consolidation Record the financial information for both Parent and Sub on the worksheet. Remove the Investment in Sub balance. Remove the Sub’s equity account balances. Adjust the Sub’s net assets to FMV. Allocate any excess of cost over BV to identifiable, separable intangible assets or goodwill. Combine all account balances.

27. No DissolutionExample On 1/1/03, Huge acquires 100% of Small for $250,000 cash. Small holds a trademark that is valued at $25,000.

28. Record the balances for each company in the worksheet.

29. Remove the investment account from the worksheet.

30. Remove the subsidiary’s equity account balances. Let’s look at the computation of Goodwill next.

31. Goodwill Computation for Huge’s Acquisition of Small We use these numbers for steps #4 & #5.

32. Adjust the subsidiary’s balances to FMV.

33. Record the trademark and the Goodwill.

34. Add the balances across the page.

35. Purchase Price Allocations - Additional Issues • Consolidation Costs • Legal Fees, Direct Costs of Combination • Increase the Investment in Subsidiary account. • Stock Issuance Costs • Broker Fees, Registration Fees, etc. • Decrease the Parent’s Paid-In Capital account.

36. Purchase Price Allocations - Additional Issues • Intangibles • Often difficult to determine FMV • Better to assign an estimated value rather than include in Goodwill • In-Process R&D • Should be expensed immediately upon acquisition.

37. Customer Base Trademarked Brand Names Customer Routes Effective Advertising Programs Covenants Rights (broadcasting, development, use, etc.) Databases Technological know-how Patents & Copyrights Strong labor relations Assembled, trained workforce Favorable government relations SFAS 141Business Combinations Intangible Asset Examples

38. Let’s look at Pooling of Interests.

39. Pooling of Interests Historically, business combinations have been accounted for as “Purchases” or “Pooling of Interests.” In its SFAS 141, “Business Combinations”, the FASB states that all business combinations should be accounted for using the purchase method. FASB

40. Pooling of Interests The purchase method is not to be applied prospectively, leaving intact prior poolings of interests. Therefore, it is important to understand how to account for PAST poolings. FASB

41. The ownership intersts of two, or more, companies were combined into one new company. No single company was dominant. Precise cost figures were difficult to obtain. To use pooling of interests, 12 strict criteria had to be met. In a pooling, one company obtained essentially “all” of the other company’s stock. The transaction involvee the exchange of common stock. No exchange of cash was allowed. Historical Review of Pooling of Interests

42. Historical Review of Pooling of Interests The Book Values of the two combining companies were joined. No Goodwill was recorded. Revenues and expenses were combined retroactively for the two companies.

43. Historical Review of Pooling of Interests • Both companies continued to exist. • An Investment in Sub account was recorded on one company’s books (usually the larger). • No Goodwill was recorded. • Both companies were combined at BV.

44. Historical Review of Pooling of Interests • Prior Period Adjustments were made to account for differences in the ways the two companies accounted for income. • A journal entry was recorded to recognize the Investment in Subsidiary. • The BV’s for both companies were entered on a consolidation worksheet.

45. Continued Accounting for Pooling of Interests • The Investment in Sub account must be eliminated. • Also eliminate the Sub’s Equity accounts to prevent double-counting. • They have already been included in the original Investment in Sub entry. • Add together the BV’s of the remaining accounts.

46. No DissolutionExample On 12/31/99, EarthCo merged with Small, Inc. by giving 60,000 shares of $1 par value common stock (FMV = $30 per share) for substantially all of Small’s common shares. Using the information provided for EarthCo and Small, Inc., prepare the journal entry necessary to complete the combination, assuming Small was NOT dissolved.

47. No DissolutionExample The Investment account for EarthCo should be equal to the BV of Small at the beginning of the period.

48. No DissolutionExample Prepare the entry to record the combination transaction.

49. No DissolutionExample Prepare the entry to record the combination transaction.

50. No DissolutionExample Prepare the entry to record the combination transaction.