Business Combinations

Objectives of the Chapter

1. To discuss the general view of business combinations.

2. To learn accounting for business combinations (purchase versus pooling methods) on date of combination for statutory merger type of business combinations.

Business Combinations


3. To discuss the development of two alternatives for business combinations from a historical perspective.

4. Preparing financial statements following a business combination for statutory merger type of business combination.



5. To learn accounting for statutory consolidation (using purchase method).

6. To discuss the current development on business combination standards.


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 (contd.)
FASBs terms for the business entities involved in the business combination:
a.Constituent companies : all business entities enter into a business combination.

b.Combined enterprise: the business entity that results from a business combination.


Business Combinations (contd.)

c.Combinor : a constituent company whose owners end up to have control of the ownership interest of the combined enterprise.

d.Combinee : all other constituent companies other than the combinor in a business combination.


Types of Business Combinations
Friendly takeoversHostile takeovers

Reasons for 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.


Reasons for Business Combinations (contd.)

b.Obtaining new management strength or better use of existing management.

c.For the income tax advantages
For hostile takeovers: Substantial gains may result from the sale of business segments of a combinee following the business combination.

Four Methods for Carrying Out Business Combinations

1.Statutory Merger Procedures of statutory merger:

a. The board of directors of the constituent companies work out the terms of merger.

b. Stockholders of the constituent companies approve the terms of the merger.


Four Methods for Carrying Out Business Combinations (contd.)

c. the survivor issues its common stock or other consideration to stockholders of the other constituent companies to exchange for all their outstanding voting common shares.

d. The survivor dissolves and liquidates the other constituent companies.



2.Statutory Consolidation: a new corporation is formed to issue its common stock for the outstanding common stock of all constituent corporations.

Procedures of statutory consolidation:

a. similar to the statutory merger.

b. similar to the statutory merger.



c. a new corporation is formed to issue its common stock to the stockholders of all the constituent companies in exchanger for all their outstanding voting common stock.

d.the new corporation dissolves and liquidates the constituent companies.



3.Acquisition of Common Stock (a method for most of hostile takeovers)

Procedures:

a. the combinor received the approval from its board of directors to acquire common stock of the prospective target firm.



b. acquiring target firms common stock in an open market, orthrough a tender offer to stockholders of a publicly owner corporation.



c. When acquiring enough shares to have the controlling interest in the combinees voting commonshares,the target firm becomes affiliated with the combinor (the parent company) as a subsidiary.

The target firm remains as a separate legal entity.



4. Acquisitions of Assets:

Business entity acquires all or most of net assets of the other entity (using cash, debt, stock ..)


Establishing the Price for a Business Combination

1. Capitalization of expected average annual earnings of the combinee at a desired rate of return.

2. Determination of current fair value of the combinees net assets (including goodwill).


Methods of Accounting for Business Combinations
Pooling of Interest Accounting versus Purchase AccountingDefinitions:Accounting Acquisition Premium (AAP) = purchase price book value of the combinee.

Methods of Accounting for Business Combinations
Purchased Goodwill
= AAP combinees assets step-up.
Assets step up
= the fair market value of net assets of the combinee the book value of these net assets.


Methods of Accounting for Business Combinations (contd.)
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.


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).


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).


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 ).


Purchase Accounting
Cost of a Combinee including:
1.the amount of consideration paid by the combinor to a combinee.

2.the combinors direct out-of-pocket costs of the combination, and

3.contingent consideration which is determinable on the business combination date.


Cost of A Combinee (contd.)
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.

Cost of A Combinee (contd.)
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.

Accounting Treatment for Contingent Consideration

a.Contingent consideration which is determinable on the combination date:

recorded as part of the cost of the combination.


Accounting Treatment for Contingent Consideration(contd.)

b.Contingent consideration that is not determinable on the combination date:

the contingent amount is recorded as goodwill when the contingency is resolved.


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;


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.


Goodwill Computation under Purchase Accounting
Purchased Goodwill
=purchase price (total cost of the combinee)

the current fair values of identifiable net assets of the combinee.


Goodwill Computation under Purchase Accounting (contd.)
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.

Example I: Purchase Accounting For Statutory Merger, with Goodwill
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.

Example I: Purchase Accounting For Statutory Merger, with Goodwill (contd.)
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:

Example I (contd.): Out of Pocket Costs
Accounting fees: For investigation of Mason Company as prospective combinee$ 5,000 For SEC registration statement for Saxon common stock60,000Legal fees: For the business combination10,000 For SEC registration statement for Saxon common stock50,000

Example I (contd.): Out of Pocket Costs (contd.)
There was no contingent consideration in the merger contract.Finders fee51,250Printers charges for printing securities and SEC registration statement23,000SEC registration statement fee750 Total out-of-pocket costs of business combination$200,000

Example I (contd.): Mason Companys Condensed B/S Prior to The Merger

MASON COMPANY (combinee)

Balance Sheet (prior to business combination)

December 31,1999

(Continued)
AssetsCurrent assets$1,000,000Plant assets (net)3,000,000Other assets600,000Total assets4,600,000

Example I (contd.): Mason Companys Condensed B/S Prior to The Merger (contd.)

MASON COMPANY

Balance Sheet (contd.) , 12/31/1999
Liabilities & Stockholders EquityCurrent Liabilities$ 500,000Long-term debt1,000,000Common stock, no-par,$10 stated value 1,000,000Additional paid-in capital700,000Retained earnings1,400,000Total liabilities & stockholders equity$4,600,000

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:

Example I (contd.): Fair Value of Identifiable Net Assets of Combinee
Current assets$ 1,150,000Plant assets3,400,000Other assets600,000Current liabilities(500,000)Long-term debt (present value)(950,000)Identifiable net assets of combinee$3,700,000

Example I (contd.): Combinors Journal Entries for Business Combination
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.

Example I (contd.): Combinors Journal Entries for Business Combination (contd.)
Journal Entries for Saxon Corp. 12/31/1999
(Continued)
Investment in Mason Company Common Stock (150,000 x $25)3,750,000Common stock (150,000 x $10)1,500,000Paid-in Capital in Excess of Par2,250,000To record merger with Mason Company as a purchase.

12/31/1999 (contd.)
(Continued)
Investment in Mason Company Common Stock ($5,000+$10,000+$51,250)66,250Paid-in Capital in Excess of Par ($60,000+$50,000 + $23,000+750)133,750Cash200,000To record payment of out-of-pocket costs incurred in merger with Mason Company.

12/31/1999 (contd.)Current Assets11,500,000Plant Assets3,400,000Other Assets600,000Discount on Long-Term Debt50,000Goodwill116,250Current Liabilities500,000Long-Term Debt1,000,000Investment in Mason Company Common Stock ($3,750,000+$66,250) 3,816,250To allocate total cost of liquidated Mason Company to identifiable assets and liabilities, with the reminder to goodwill. (Income tax effects are disregarded.)

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.

Example I (contd.): Combinees J.E. for The Dissolution of The Company after Statutory Merger (contd.)
Journal Entries for Mason Corp.12/31/1999Current Liabilities500,000Long-Term Debt1,000,000Common Stock , $10 stated value1,000,000Paid-in Capital in Excess of Stated Value700,000Retained Earnings1,400,000Current Assets1,000,000Plant Assets (net)3,000,000Other Assets600,000

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.

Example II: Purchase Accounting with Negative Goodwill
The condensed balance sheet statement of Fairmont Corp. prior to the business combination, with related current fair value data, is presented below:

Example II (contd.):Combinees B/S Prior to Statutory Merger

FAIRMONT CORPORATION (combinee)

Balance Sheet (prior to business combination)

December 31, 1999

(Continued)
AssetsCarrying AmountsCurrent Fair ValuesCurrent assets$ 190,000$ 200,000Investment in marketable debt securities (held to maturity)50,00060,000Plant assets (net)870,000900,000Intangible assets (net)90,000100,000Total assets$1,200,000$1,260,000

Example II (contd.):Combinees B/S Prior to Statutory Merger (contd.)

FAIRMONT CORPORATION B/S (contd.)
Liabilities and Stockholders EquityCarrying AmountsCurrent Fair ValuesCurrent liabilities$ 240,000$ 240,000Long-term debt 500,000520,000Total Liabilities$ 740,000$ 760,000Common stock, $1 par$ 600,000Deficit(140,000)Total stockholders equity$ 460,000Total liabilities & stockholders equity$1,200,000

Example II (contd.) : Computing the Negative Goodwill
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

Example II (contd.) : Computing the Negative Goodwill (contd.)
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:

Example II (contd.) : Allocation of Negative Goodwill
To plant assets: $60,000 x $900,000 ($900,000 +$100,000)=$54,000To intangible assets: $60,000 x $900,000 ($900,000 +$100,000)=$6,000Total excess of current fair value of identifiable net assets over combinors cost$60,000

Example II (contd.)
Notes: No part of the $60,000 bargain-purchase 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:

Example II (contd.) : Combinors J.E. for The Acquisition of Net Assets
Journal Entries of Davis Corp. 12/31/1999
(Continued)
Investment in Net Assets of Fairmont Corporation400,000Cash400,000To record acquisition of net assets of Fairmont CorporationInvestment in Net Assets of Fairmont Corporation40,000Cash40,000To record payment of legal fees incurred in acquisition of net assets of Fairmont Corporation

Example II (contd.) : Combinors J.E. for the Acquisition of Net Assets (contd.)
12/31/1999 (contd.)Current Assets200,000Investments in Marketable Debt Securities60,000Plant Assets ($900,000 - $54,000)846,000Intangible Assets ($100,000 - $6,000)94,000Current Liabilities240,000Long-Term Debt500,000Premium on Long-Term Debt ($520,000 - $500,000)20,000Investment in Net Assets of Fairmont Corporation ($400,000 + $40,000)440,000

Example II (contd.): Note to the Journal Entries
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.


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.

Pooling-of-Interests Accounting (contd.)
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.

Pooling-of-Interests Accounting (contd.)
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.

Example III: Pooling-of-Interests Accounting for Statutory Merger
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:

Example III : Pooling-of-Interests Accounting for Statutory Merger (contd.)
Journal Entries for Saxon Corp. 12/31/1999Current Assets1,000,000Plant Assets (net)3,000,000Other Assets600,000Current Liabilities500,000Long-term Debt1,000,000Common Stock, $10 par1,500,000Paid-in Capital in Excess of Par200,000Retained Earnings1,400,000To record merger with Mason Company as a pooling of interests.

Example III : Pooling-of-Interests Accounting for Statutory Merger (contd.)
12/31/1999 (J. E. contd.)Expenses of Business Combination200,000Cash200,000To record payment of out-of-pocket costs incurred in merger with Mason Company

Example III (contd.): Notes to the example
Notes:
1. An Investment in Masons Company Common Stock account is not used in the pooling-of-interests method.

2. Masons assets, liabilities and retained earnings are recorded at their carrying amounts in Masons premerger balance sheet.

3. The common stock issued by Saxon for the business combination is recorded at par value.


Example III (contd.): Notes to the example (contd.)
Notes (contd.)
4. The Paid-in-Capital in Excess of Par equals the total premerger paid-in-capital of Mason minus the par value of Saxon's stock issued for the business combination.

5. If the par value of Saxons common stock issued for the combination exceeds the premerger paid-in capital of Mason, Saxons Paid-in Capital in Excess of Par account should be debited for the excess amount. (contd.)

.


Example III (contd.): Notes to the example (contd.)
Notes (contd.)
5. (contd.)If this account is not sufficient to absorb the excess amount, Saxons Retained Earnings account should be debited.

6. The entire out-of-pocket costs were expensed and are not tax deductible.


Advantage of Using Pooling Accounting on Financial Numbers

1.Advantage on the Post-Merger Earnings:

The following exhibit shows the balance sheet statement accounts of pooling accounting versus purchase accounting using the example of Saxon and Mason:


Advantage of Using Pooling Accounting on Financial Numbers (contd.)

(Continued)
Purchase AccountingPooling AccountingCurrent Assets1,150,0001,000,000Plant Assets3,400,0003,000,000Other Assets600,000600,000Discount on Long-Term Debt50,000Good will116,250Expense of Business Combination200,000

Purchase AccountingPooling AccountingCurrent Liabilities500,000500,000Long-Term Debt1,000,0001,000,000Common Stock, $ 10 par 1,500,0001,500,000Paid-in Capital in Excess of Par2,116,250200,000Retained Earnings1,400,000Cash200,000200,000To record merger with Mason Company.

The difference on the net assets of these two methods is:Purchase accounting
net assets$3,616,250
Pooling accounting
net assets 2,900,000
Difference $ 716,250

The composition of the $716,250 is summarized as follows:Excess of purchase asset values over pooling asset values: Current assets ($1,150,000-$1,000,000)$150,000 Plant assets ($3,400,000- $3,000,000)400,000 Goodwill116,250Excess of pooling liability values over purchase liability values: Long-term debt [$1,000,000-($1,000,000- $50,000) ]50,000Excess of purchase net assets values over pooling net assets values$716,250

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.



b.The $400,000 difference in plant assets is attributable to depreciable assets, and assuming an average economic life for these plant assets is 10 years.

c.Goodwill will be amortized in 40 years.

d.The long-term debt has a remaining 5 years to maturity.


Based on the above information, Saxons pre-tax income for the year ended 12/31/2000 would be $202,906 less under purchase accounting than under pooling accounting. Calculation is as follows:Cost of goods sold$150,000Depreciation expense ($400,000 x 1/10)40,000Amortization expense ($116,250 x 1/40)2,960Interest expense ($50,000 x 1/5)10,000Excess of year 2000 pre-tax income under pooling accounting rather than under purchase accounting$202,906

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 post-merger earnings.


2.Advantage on the Retained Earnings

The retained earnings under the pooling method is $1,400,000 greater than that of the purchase method.

This outcome also provides the managers with a greater flexibility in dividend distribution when using the pooling accounting.



3.Advantage on the Price-Earnings Ratios on the Merger Year

Assume Saxon and Mason had the following financial information prior to the business combination:



* Net of $200,000 expenses of business combination.

+ Outstanding during entire year.
Saxon CorporationMason CompanyYear ended Dec. 31, 1999: Net income $500,000*$375,000 Basic earnings per share of common stock$0.50$3.75On Dec. 31, 1999: Number of shares of common stock outstanding1,000,000+100,000+ Market price per share$25$30 Price-earnings ratio508

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).

Historical Perspective of Accounting for Business Combinations
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),

Historical Perspective of Accounting for Business Combinations (contd.)
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 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.

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.

Past Abuses of Pooling Accounting
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.

(contd.)
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.

(contd.)
Among these abuses are:
a. Retroactive Pooling

b. Retrospective Pooling

c. Part-Pooling, Part-Purchase Accounting

d. Treasure Stock Issuance


(contd.)
Contd.:
e.Issuance of Unusual Securities

f. Creation of instant Earnings

g.Contingent Payouts

h.Burying the Costs of Pooling-TypeBusiness Combinations


Past Abuses of Purchase Accounting (in the period of 1950-1960)
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.

Action by the AICPA to Curtail The Abuses
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.

Conditions Requiring Pooling Accounting in APB Opinion No. 16

1.Attributes of the combining companies (2 conditions).

These conditions were to assure that the pooling combination was truly a combining of two or more entities whose common stockholder interests were previously independently of each other.


Conditions Requiring Pooling Accounting in APB Opinion No. 16) (contd.)

2.Manner of combining ownership interests (7 conditions).

These conditions were to assure that the exchange of voting common stock actually took place in substance and in form.


Conditions Requiring Pooling Accounting in APB Opinion No. 16) (contd.)

3.Absence of planned transactions (3 conditions).

These conditions were to assure that no planned transactions, which are inconsistent with the combining of entire existing interests of common stockholders, could be arranged prior to the combination.


APB Opinion No. 16
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:

APB Opinion No. 16 (contd.)

1.Attributes of the constituent companies (2 conditions)

a. Each of the constituent companies is autonomous and has not been a subsidiary or division of another corporation within two years before the plan of combination is initiated.

b. Each of the constituent companies is independent of the other.



2.Manner of combining ownership interests (7 conditions)

b. A corporation offers and issues only common stock with rights identical to those of the majority of its outstanding voting common stock in exchange for substantially all the voting common stock interest of another company on the datethe plan of combination is consummated.



3.Absence of planned transactions (3 conditions)

a. The combined entity does not agree to retire or acquire all or part of the common stock issued to effect the combination.

b. The combined entity does not enter agreement for the benefit of the former stockholder of a constituent company.



c. The combined entity does not plan to sell a significant part of the assets of the constituent companies within two years after the combination.


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.

Discussion of Four Conditions

1.Independence of Constituent Companies

On the dates of initiation and consummation of a business combination, no constituent company may have more than 10% ownership of the outstanding voting common stock of another constituent company.


Discussion of Four Conditions (contd.)

2.Substantially All Voting Common Stock of Combinees Company Are Exchanged

The condition requires that at least 90% of the combinees outstanding voting common stock be exchanged for the issuers voting common stock.

The following are excluded from the computation of the number of shares exchanged:



1) Shares acquired before the initiation date of combination and held by either the issuer or its subsidiaries.

2) Share acquired by either the issuer or its subsidiaries after the combination is initiated, other than in exchange for the issuers voting common stock.



3) shares of the combinee still outstanding on the date the combination is consummated.

4) any voting common stock of the issuer owner by the combinee before the business combination must be converted to equivalent shares of the combinee for the 90% test.


discussion of Four Conditions (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).

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.

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.

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.

Computation of the 90% requirement follows:
(Continued)
Total Sherman Company shares issued, June 30, 1999100,000Less: Shares in Shermans treasury500Total Sherman shares outstanding, June 30, 199999,500Less:Sherman shares owned by Patton Corporation, Mar. 13, 19997500Sherman shares acquired by Patton for cash, Mar. 26, 19991000

Equivalent number of Sherman shares represented by Pattons common stock owned by Sherman, Mar. 13, 1999 (6,000 1 )4,00012,500Effective number of Sherman shares acquired June 30, 1999 in exchange for Pattons common stock87,000Application of 90% requirement (99,500 x 90%)89,550

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.


3.Restrictions on Treasury Stock

Only the treasury stock purchased under a systematic purchase plan (referred to as untainted treasury stock) can be accounted for as issuance of common stock in a pooling combination.



4.No Pending Provisions

No additional common stock can be contingently issuable to former stockholders of a combinee after a combination has been initiated.

And, no common stock can be issued to an escrow agent pending the resolution of a contingency.


Financial Statements Following a Business Combination
The assets, liabilities, and retained earnings in a balance sheet statement following a business combination are reported as follow:Assets & Lia.Retained earningsPurchase-combinorCarrying amountReportedPurchase-combineeFair valueNot reportedPooling-combinorCarrying amountReportedPooling- combineeCarrying amountReported

Financial Statements Following a Business Combination (contd.)
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.


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.


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.

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 pooling-type 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.

Example IV (contd.)

SAXON CORPORATION AND MASON COMPANY

Separate Income Statements

For Year Ended December 31, 1999

*Includes $200,000 expenses of business combination.
Saxon CorporationMason CompanySales and other revenue$10,000,000$5,000,000Costs and expenses: Costs of goods sold$ 7,000,000$3,000,000Operating expenses1,883,333*1,274,500Interest expense150,000100,500Income taxes expense466,667250,000Total costs and expenses$ 9,500,000$4,625,000Net income$ 500,000$ 375,000

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.

Example IV (contd.)

SAXON CORPORATION

Working Paper for Combined Income Statement (Pooling of Interests)

For Year Ended December 31, 1999
To eliminate intercompany interest received by Saxon Corporation from Mason
Company.
Saxon CorporationMason CompanyEliminationsCombinedSales and other revenue10,000,0005,000,000(a) 25,00014,975,000Cost and expenses: Cost of goods sold7,000,0003,000,00010,000,000 Operating expenses1,883,3331,274,5003,157,833 Interest expense150,000100,500(a) (25,000)225,500 Income taxes expense466,667250,000716,667Total costs and expenses9,500,0004,625,000(25,000)14,100,000Net income500,000375,000-0-875,000

Notes to Financial Statements Following a Business Combination
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;

Notes to Financial Statements Following a Business Combination (contd.)

2.period for which combinees operating results are included in the income statement of the combined enterprise;

3.cost of the combinee, including number of shares and value per share of common stock issued and nature of and accounting treatment for contingent consideration;

4. amortization policy for goodwill;



5.pro forma operating results for the combined enterprise for the current and preceding accounting periods as if the combination had occurred at the beginning of the preceding period.

Note: The FASB waived the proforma disclosures for nonpublic enterprises.


Required Disclosure for Pooling Accounting
1. Name and brief description of the combinee; the accounting method used for the business combination;



2. number of shares of common stock issued in the combination;

3. separate operating results of the constituent companies for the period prior to the combination that were included in the operating results of the combined entity for the combination year.


Comparison of Purchase and Pooling Accounting
The following table summarizes the principal aspects of purchase accounting and pooling-of-interests accounting for business combinations:

Comparison of Purchase and Pooling Accounting (contd.)

(Continued)
AspectPurchase AccountingPooling-of-Interests AccountingUnderlying premiseAcquisition of assetsCombining of stockholder interestsApplicabilityCombinations not meeting all 12 criteria for pooling accountingCombinations meeting all 12 criteria for pooling accounting


(Continued)
AspectPurchase AccountingPooling-of-Interests AccountingAccounting recognition of investment in combineeAt cost, including amount of consideration, direct out-of-pocket costs, and determinable contingent consideration At carrying amount of combinees net assets (all out-of-pocket costs are recognized as expenses of the issuer)Valuation of combinees net assets in combined enterpriseAt current fair values on date of combinationAt carrying amounts on date of combination


(Continued)
AspectPurchase AccountingPooling-of-Interests AccountingGoodwill recognitionYes, if combinors cost exceeds current fair value of combinees identifiable net assetsNoRetained earnings of constituent companies combined on date of business combinationNOYES


(Continued)
AspectPurchase AccountingPooling-of-Interests AccountingFinancial statements and notes for period of business combination: Balance sheetCombinors net assets at carrying amount; combinees net assets at current fair valueBoth issuers and combinees net assets at carrying amount

AspectPurchase AccountingPooling-of-Interests Accounting Income statementCombinors operations for entire period; combinees operations from date of combination to end of periodBoth issuers and combinees operations for entire period as though combination took place at beginning of period; prior periods restated comparably Disclosure of operations in notesPro forma for combined enterprise for current and preceding period as though combination took place at beginning of preceding periodSeparately for constituent companies for period prior to combination

Purchase-Type Statutory Consolidation
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.

Purchase-Type Statutory Consolidation (contd.)
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):

Example V (contd.):

LAMSON CORPORATION AND DONALD COMPANY

Separate Balance Sheets (prior to business combination)

December 31,1999

(Continued)
AssetsLamson CorporationDonald CompanyCurrent assets$ 600,000$ 400,000Plant assets (net)1,800,0001,200,000Other assets (net)400,000300,000Total assets$ 2,800,000$1,9,00,000

Example V (contd.):

LAMSON CORPORATION AND DONALD COMPANY

Separate Balance Sheets (contd.), 12/31/1999
Liabilities & Stockholders Equity Lamson CorporationDonald CompanyCurrent liabilities$ 400,000$ 300,000Long-term debt500,000200,000Common stock,$10 par430,000620,000Additional paid-in capital300,000400,000Retained earnings1,170,000380,000Total liabilities & stockholders equity$ 2,800,000$1,9,00,000

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.

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:

Example V(contd.):
Lamson CorporationDonald CompanyCurrent fair value of identifiable net assets: Lamson: $800,000+$2,000,000 +$500,000- $400,000-$500,000$2,400,000 Donald: $500,000+ $1,400,000 + $400,000 -$300,000-$200,000 $1,800,000Goodwill180,00060,000 Net assets current fair value$2,580,000$1,860,000Number of shares of LamDon common stock to be issued to constituent companies stockholders, at $60 a share agreed value 43,00031,000

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.

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:

Example V (contd.):
Journal Entries of Lamdon Corp., 12/31/1999
(Continued)
Investment in Lamson Corporation and Donald Company Common Stock (74,000 x $60)4,440,000Common Stock, no par4,440,000To record consolidation of Lamson Corporation and Donald Company as a purchase

Example V (contd.):
12/31/1999 (contd.)
(Continued)
Investment in Lamson Corporation and Donald Company Common Stock110,000Common Stock, no par90,000Cash200,000To 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.

Example V (contd.):
12/31/1999 (contd.)
(Continued)

800,000

850,000

Goodwill
Current Assets ($600,000+$500,000)1,100,000Plant Assets ($1,800,000+$1,400,000)3,200,000Other Assets ($400,000+$400,000) Current Liabilities700,000Long-Term Debt700,000Investment in Lamson Corporation and Donald Company Common Stock4,550,000

Example V (contd.):
12/31/1999 (contd.)Amount of goodwill is computed as follows: Total cost of investment ($4,400,000+$110,00)4,550,000Less: Carrying amount of Lamsons identifiable net assets ($430,000+ $300,000+1,170,000)(1,900,000)Current fair fair value of Donalds identifiable net assets(1,800,000)Amount of goodwill$ 850,000

Subsequent Issuance of Contingent Consideration
Example of Contingent Consideration (p176 and p198 of text book)
Norton Company agrees to pay $800,000 cash for Robinsons net assets (not including Robinsons slow-moving products which have been written down to scrap value by Robinson prior to the business combination).


Subsequent Issuance of Contingent Consideration
Example (contd.)These purchased net 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.


Subsequent Issuance of Contingent Consideration (contd.)

(contd.)

2.Norton will pay Robinson 25% of any pre-tax financial income in excess of $500,000 (excluding income from sale of the slow-moving product) of Robb Division for each of the four years subsequent to the business combination.


Assuming that by 12/31/x2, the end of the first year following Nortons acquisition of the net assets, another 300 units of the slow-moving product had been sold, and Nortons Rob Division had pre-tax income of $580,000 (excluding the sale of the slow-moving product). On 12/31/x2, Norton prepares the following journal entry to record the resolution of contingent consideration:

Goodwill 50,000*Cash (or payable to Robinson Company)50,000* $100 x 300=$30,000 + (580,000-500,000) x 25%= 20,000$50,000

IAS 22, Accounting for Business Combinations
International Accounting Standards Committee requires purchase accounting to be used for all business combinations except for united-of-interests type combinations.

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.

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.


Statement 142:
Requires that goodwill no longer to be amortized as expense but subject to annual review for impairment.


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.

Therefore, different financial statements were produced for similar business combinations.The following are some of the reasons stated by the FASB:


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.


Summary of Statement No. 142: (source: FASB Publication of Summary of Statement No. 142)
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

Summary of Statement No. 142: (source: FASB Publication of Summary of Statement No. 142) (contd.)
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.

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.

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.


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);



b. The carrying amount of intangible assets by major intangible asset class for those assets subject to amortization and for those not subject to amortization;

c. The estimated intangible assets amortization expense for the next five years.


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.

Business Combinations

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