Intercorporate Acquisitions and Investments in Other Entities

Intercorporate Acquisitions and Investments in Other Entities • This chapter provides an overview of complex organizational arrangements (or structures). • Complex organization structures often result from complex business strategies such as: • Extending operations into foreign countries. • Initiating new product lines. • Separating activities that fall under regulatory controls. • Reducing taxes by separating certain types of operations. Intercorporate Acquisitions and Investments in Other Entities 1-2 Intercorporate Acquisitions and Investments in Other Entities Intercorporate Acquisitions and Investments in Other Entities Generally speaking, the accounting procedures in this chapter are driven by such questions as: • Several accounting transactions may be required to initiate a complex organization structure. • Did the company acquire the common stock of another company or the assets of another company ? • Additionally, unlike most of your previous accounting courses, you will need to analyze multiple transactions for multiple companies simultaneously—not just one transaction for one company. • Was the company dissolved (i.e., liquidated) or did the company continue to exist (i.e., survive) ? • Was a new company formed ? • Thus you will need to “deal with” more than one set of books in analyzing questions, cases, exercises, and problems. • Was there a change in ownership control ? • Is the acquired company wholly-owned ? 1-3 1-4 Creating Business Entities --Basic Transactions Bad News--Good News • Complex business structures are routinely grounded in the following basic transactions: Bad News: Numerous complex organization arrangements are discussed in this chapter. (Hint: Look for similarities in the various complex organization arrangements.) • Transfer (Sale) of Assets/Entity Dissolved • Receipt of Assets from Dissolved Entity • Transfer (Sale) of Assets/Entity Survives • Receipt of Assets from Surviving entity NOTE: Assume that Book Values (BV) equal Fair Values (FV) for these transactions (i.e., the next four slides). Also, assume that cash was paid for the assets. The significance of both of these assumptions will be discussed later. Good News: The next nine chapters focus on one complex organization arrangement-stock acquisitions. 1-5 1-6 1 Transfer of Assets/Entity Dissolved Transfer of Assets/Entity Dissolved • Entries Recorded By Seller Company: • Entries Recorded By Seller Company: – To transfer net assets to Purchaser Company. Cash (from Purchaser) Current Liabilities Accumulated Depreciation Cash and Receivables Inventory Fixed Assets [Continued on next slide.] – To distribute remaining assets to shareholders of Seller Company. ??? BV BV Common Stock Additional Paid-In Capital Retain Earnings Cash BV BV BV BV BV BV ??? 1-7 1-8 Transfer of Assets/Entity Survives Receipt of Assets from Dissolved Entity • Entry Recorded By Purchaser Company: • Entries Recorded By Seller Company: – To record net assets purchased from Seller Company. – To transfer net assets to Purchaser Company. Cash and Receivables Inventory Fixed Assets (net) * Cash (to Seller) Current Liabilities Cash (from Purchaser) Current Liabilities Accumulated Depreciation Cash and Receivables Inventory Fixed Assets BV BV BV ??? BV * Fixed Assets are recorded net of Accumulated Depreciation. ??? BV BV BV BV BV [Continued on next slide.] 1-9 Transfer of Assets/Entity Survives 1-10 Receipt of Assets from Surviving Entity • Entries Recorded By Seller Company: • Entry Recorded By Purchaser Company: – To distribute remaining assets to shareholders of Seller Company. – To record net assets purchased from Seller Company. [Continued on next slide.] Cash and Receivables Inventory Fixed Assets (net) * Cash (to Seller) Current Liabilities ?????????????????????????? NO ENTRY REQUIRED—Seller Company was not dissolved. Thus the shareholders of Seller Company may reinvest the Cash (from Purchaser) as they wish. BV BV BV ??? BV • Fixed Assets are recorded net of Accumulated Depreciation. 1-11 1-12 2 Additional Thoughts Receipt of Assets from Surviving Entity • Seller Company would have recorded a “GAIN ON SALE” if their net assets would have been sold for an amount greater than book value. In turn, Seller Company would have recorded a “LOSS ON SALE” if their net assets would have been sold for an amount less than book value. NOTE: Since this was a purchase of the net assets of Seller Company (and not the common stock of Seller Company), dissolution or non-dissolution of Seller Company does not involve Purchaser Company. Thus Purchaser Company records the same entry as was previously done when Seller Company was dissolved. • In either case, Purchaser Company would have recorded the various assets and liabilities at their individual fair value (not book value). 1-13 Forms of Business Combinations 1-14 Statutory Merger • There are three primary forms of business combinations: • A statutory merger occurs when one company acquires another company and the assets and liabilities of the acquired company are transferred to the acquiring company. • Statutory Merger • Statutory Consolidation • In a statutory merger, the acquired company is liquidated and the acquiring company continues to exist. • Stock Acquisition 1-15 Statutory Consolidation 1-16 Stock Acquisition • A stock acquisition occurs when one company acquires a majority of the common stock of another company and the acquired company is not liquidated. • A statutory consolidation occurs when a new company is formed to acquire the assets and liabilities of two combining company. • In a statutory consolidation, the combining companies are dissolved and the new company is the only surviving entity. • In a stock acquisition, both companies continue to operate as separate but related corporations (i.e., affiliated corporations). 1-17 1-18 3 Stock Acquisition: Parent-Subsidiary Relationship Valuation of Business Entities • A subsidiary is a corporation that is controlled (through common stock ownership) by another corporation, that is, the parent corporation. • Controlling Interest: The parent owns a majority of the common stock of the subsidiary. • Wholly-Owned Subsidiary: The parent owns all of the common stock of the subsidiary. • Given that a subsidiary is a separate legal entity, the parent’s risk associated with the subsidiary’s activities is limited. • Assessing the overall value of a company often includes: • Valuation of Individual Assets and Liabilities • Valuation of Potential Earnings • Valuation of Consideration Exchanged 1-19 Valuation of Individual Assets and Liabilities 1-20 Valuation of Potential Earnings • Synergy occurs when assets operated together have a value that exceeds the sum of their individual values. • The value of a company’s individual assets is usually determined by appraisal. • This “going concern value” makes it desirable to operate the assets as an ongoing entity rather than sell them individually. • Current liabilities are often viewed as having fair values equal to their book values because they will be paid at face amount within a short time. • Possible approaches to measuring the value of a company’s future earnings include: • Multiples of current earnings. • Present value of anticipated future new cash flows generated by the company. • Sophisticated financial models. • Long-term liabilities must be valued based on current interest rates if different from the effective rates at the issue dates of the liabilities. 1-21 1-22 Accounting and Reporting Methods: SFAS No. 141, “Business Combinations” Valuation of Consideration Exchanged • When one company acquires another, a value must be placed on the consideration given in the exchange. • Prior to SFAS No. 141, there were two acceptable methods for reporting business combinations--the Purchase Method and the Pooling Method. • Little difficulty is encountered when cash is used in an acquisition, but valuation may be more difficult when securities are exchange, particularly illiquid or privately held securities or securities with unusual features (e.g., convertible or callable securities). • SFAS No. 141 disallowed the use of the Pooling Method. • Thus, the Purchase Method for reporting business combinations is currently the only allowable method under Generally Accepted Accounting Principles (GAAP). 1-23 1-24 4 Purchase Method (Current GAAP) Pooling Method (Not Current GAAP) • The central idea underlying the pooling method was opposite that of the purchase method—a continuity of interest. • The central idea underlying the purchase method is the same idea underlying the purchase of any asset or group of assets —there is a change in ownership control. • That is, the owners of the combining companies became the owners of the combined company. • Thus, the book values of both companies were carried forward since there was not a change in ownership control (i.e., there was no arm’s length transaction to determine a “fair” fair value). • That is, since there is a change in ownership control, the purchaser’s accounting is based on the fair value of the assets and liabilities —not the seller’s book values. 1-25 Purchase Method— Critical Concepts and Terms 1-26 Cost of Investment (a.k.a. Cost or Investment Cost or Purchase Price) • Cost of Investment (a.k.a. Cost or Investment Cost or Purchase Price) • The value of the consideration given to the owners of the acquired company normally constitutes the largest part of the total cost. • Goodwill • Fair Value of Net Identifiable Assets • There are three types of other costs that may be incurred in effecting a business combination: • Book Value of Net Identifiable Assets • Excess of Cost over Fair Value of Net Identifiable Assets • Direct costs • Costs of issuing securities • Indirect and general costs • Excess of Fair Value over Book Value of Net Identifiable Assets • Total Differential 1-27 Purchase Price --Direct Costs 1-28 Purchase Price --Costs of Issuing Securities • Costs incurred in issuing equity securities in connection with the purchase of a company should be treated as a reduction in the issue price of the equity securities issued. Examples include: Listing fees; Audit and legal fees related to the registration; and, Brokers’ commissions. • All direct costs associated with purchasing another company are capitalized as part of the total cost of the acquired company. • Examples: • Finders’ fees • Accounting fees • Legal fees • Appraisal fees • Costs incurred in issuing bonds payable in connection with the purchase of a company should be accounted for as bond issue costs and amortized over the term of the bonds. 1-29 1-30 5 Purchase Price --Indirect and General Costs Goodwill • Any amount of the purchase price in excess of the fair value of the identifiable assets and liabilities acquired is viewed as the price paid for goodwill. • All indirect and general costs related to a business combination or to the issuance of securities in a combination should be expensed as incurred. • For example, the salary costs of accountants on the staff of the acquiring company in a business combination would be expensed, even though some of their time was spent on matters related to the combination. • In theory, goodwill is the excess earnings power of the of the acquired company. • In practice, goodwill represents the premium paid to acquire control. 1-31 Subsequent Accounting for Goodwill 1-32 Bargain Purchase Price (a.k.a. Negative Goodwill) • Negative goodwill is said to exist when a purchaser pays less than the fair value of the identifiable net assets of another company in acquiring its ownership. • Goodwill is carried forward to subsequent accounting periods at the original amount, without amortization, unless it becomes impaired. • Negative goodwill is allocated as a pro rata reduction of the amounts that otherwise would have been assigned to all of the acquired assets with certain exceptions (e.g., current assets or deferred tax assets to name a few). Any amount remaining after reducing these acquired assets to zero would be recognized as an extraordinary gain. • Goodwill must be evaluated for impairment at least annually, at the same time each year, and more frequently if events occur that are likely to impair the value of goodwill. 1-33 Fair Value of Net Identifiable Assets and Book Value of Net Identifiable Assets 1-34 Fair Value of Net Identifiable Assets and Book Value of Net Identifiable Assets-Cont’d • Generally speaking, fair value is the amount that would be required to buy an asset (or refinance a liability) at the date of the business combination. • Identifiable Asset: Generally speaking, assets other than Goodwill are considered identifiable. • Generally speaking, book value is the “GAAP historical cost” of the asset (or the monetary amount owed for liabilities—adjusted for premiums and discounts, if applicable). • Identifiable Liability: Generally speaking, liabilities that are known (or, if probable, can be reasonably estimated) are considered identifiable. 1-35 1-36 6 “Excess Cost over Fair Value” and “Excess Fair Value over Book Value” Total Differential • Excess of Cost over Fair Value of Net Identifiable Assets EQUALS Cost of Investment LESS Fair Value of Net Identifiable Assets • Two Possible Views: • Total Differential EQUALS Cost of Investment LESS Book Value of Net Identifiable Assets • Excess of Fair Value over Book Value of Net Identifiable Assets EQUALS Fair Value of Net Identifiable Assets LESS Book Value of Net Identifiable Assets • Total Differential EQUALS Cost (of Investment) over Fair Value Net Identifiable Assets PLUS Fair Value over Book Value of Net Identifiable Assets 1-37 Example: Combination Effected through Purchase of Net Assets 1-38 Example: Combination Effected through Purchase of Net Assets (Cont’d.) • Point acquires the net assets of Sharp in a statutory merger by issuing Sharp 10,000 shares of $10 par common stock. The shares have a total market value of $600,000. • Entries Recorded By Acquiring Company (Point) • NOTE: All amounts on this slide (and the next slide) are actual amounts incurred by Point. • Point incurs $40,000 in legal and appraisal fees and $25,000 in stock issuance costs. – To record costs related to purchase of Acquired Company (Sharp). • The net assets of Sharp have a total fair value of $510,000. (Do not worry about the individual fair values for now.) Deferred Merger Costs Cash $40,000 $40,000 1-39 Example: Combination Effected through Purchase of Net Assets (Cont’d.) 1-40 Example: Combination Effected through Purchase of Net Assets (Cont’d.) • Entries Recorded By Acquiring Company (Point). – To record the combination of Sharp by Point. • Entries Recorded By Acquiring Company (Point) – To record costs related to issuance of Point common stock to Sharp. Deferred Stock Issue Costs Cash $25,000 $25,000 Cash and Receivables Inventory Land, Buildings and Equipment Patent Goodwill Current Liabilities Common Stock Additional Paid-In Capital Deferred Merger Costs Deferred Stock Issue Costs * See next slide. # Fair Market Value 1-41 $45,000 # 75,000 # 420,000 # 80,000 # 130,000 * $110,000 # 100,000 475,000 40,000 ** 25,000 ** **See previous two slides. 1-42 7 Example: Combination Effected through Purchase of Net Assets (Cont’d.) • Calculation of Goodwill • Investment Cost: Fair value of stock issued PLUS: Other acquisition costs Entries Recorded By Acquired Company (Sharp). • To record the transfer of net assets to Point. $600,000 40,000 Investment in Point Stock $600,000 Current Liabilities 100,000 Accumulated Depreciation 150,000 $45,000 Cash and Receivables Inventory 65,000 Land 40,000 Buildings and Equipment 400,000 Gain on sale of Net Assets 300,000 _________________________ Total purchase price • LESS: Fair value of net assets $640,000 510,000 • __________________________ • Goodwill Example: Combination Effected through Purchase of Net Assets (Cont’d.) $130,000 1-43 Example: Combination Effected through Purchase of Net Assets (Cont’d.) 1-44 Example: Combination Effected through Purchase of Stock • Point acquires the all of the common stock of Sharp issuing the shareholders of Sharp 10,000 shares of $10 par common stock. The shares have a total market value of $600,000. Entries recorded by acquired company (Sharp). • To record the liquidation of Sharp. Common Stock $100,000 Additional Paid-In Capital 50,000 Retained Earnings 150,000 Gain on Sale of Net Assets 300,000 Investment in Point Stock $600,000 • Sharp continues to operate as a separate entity after the business combination transaction. • Point incurs $40,000 in legal and appraisal fees and $25,000 in stock issuance costs. • Do not worry about fair values for now. 1-45 Example: Combination Effected through Purchase of Stock 1-46 Example: Combination Effected through Purchase of Stock • Entries Recorded By Acquiring Company (Point) • NOTE: All amounts on this slide (and the next slide) are actual amounts incurred by Point. • Entries Recorded By Acquiring Company (Point) – To record costs related to issuance of Point common stock to Sharp. – To record costs related to purchase of Acquired Company (Sharp). Deferred Merger Costs Cash Deferred Stock Issue Costs Cash $40,000 $40,000 1-47 $25,000 $25,000 1-48 8 Example: Combination Effected through Purchase of Stock (Cont’d.) Example: Combination Effected through Purchase of Stock (Cont’d.) • Entries Recorded By Acquiring Company (Point) – To record the combination of Sharp by Point. Investment in Sharp Stock $640,000 * Common Stock $100,000 475,000 Additional Paid-In Capital Deferred Merger Costs 40,000 ** Deferred Stock Issue Costs 25,000 ** • NOTE: With respect to the previous slide, identifiable assets and liabilities are not recorded at the date of the business combination since Sharp is not dissolved. * $640,000 = $600,000 Fair Value of Point Common Stock PLUS $40,000 Merger Costs ** See previous two slides. 1-49 1-50 Financial Reporting Subsequent to a Purchase Additional Thoughts • When a combination occurs during a fiscal year, income earned by the acquired company prior to the combination is not reported in the income statement of the combined entity. • As previously stated, Sharp is not dissolved and continues to operate as a separate entity after the business combination transaction. • The accounting and reporting procedures for intercorporate investments in common stock where the acquired company continues in existence are discussed in the next nine chapters. • If the combined entity reports comparative financial statements that include statements for periods before the combination, those statements include only the activities and financial statements of the acquiring company and not those of the acquired company. 1-51 Disclosure Requirements (a.k.a. Notes to the Financial Statements) • A number of disclosures are required to provide financial statement readers with information about the combination. Examples include: 1-52 Disclosure Requirements (a.k.a. Notes to the Financial Statements) • A description of the factors that contributed to the recognition of goodwill. • Contingent payments, options, or commitments. • A description of the acquired entity. • The percentage voting interests acquired. • Purchased research and development assets acquired and written off. • The primary reason for the acquisition. [Continued on next slide.] 1-53 1-54 9 You Will Survive This Chapter !!! ALWAYS ASK THESE QUESTIONS: – Did the company acquire the common stock of another company or the assets of another company ? – Was the company dissolved (i.e., liquidated) or did the company continue to exist (i.e., survive) ? – Was a new company formed ? – Was there a change in ownership control ? – Is the acquired company wholly-owned ? 1-55 10