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SOLUTION MANUAL FOR ADVANCED ACCOUNTING 6TH EDITION BY JETER Chapter – Accounting For Business Combinations 2.1 ACCOUNTING STANDARDS ON BUSINESS COMBINATIONS: BACKGROUND A Accounting standards now mandate the use of the acquisition (purchase) method for accounting for mergers & acquisitions Until 2001, companies had a choice, albeit strictly regulated, between these two methods: 1) the pooling of interests method (this method was grandfathered into the Codification), and 2) Acquisition (Purchase) method 2.2 PRO FORMA STATEMENTS AND DISCLOSURE REQUIREMENT A Pro forma statements have historically served two functions in relation to business combinations: To provide information in the planning stages of the combination, and To disclose relevant information subsequent to the combination Note: This aspect was particularly important prior to the elimination of the pooling method, as a means of enabling users to compare mergers despite the dissimilarity on the face of the principal statements between those accounted for under purchase and pooling B The term “pro forma” is also frequently used, aside from mergers, to indicate any calculations which are computed “as if” alternative rules or standards had been applied For example, a firm may disclose in its press releases that earnings excluding certain one-time charges reflect a more positive trend than the GAAP-reported EPS However, the SEC has recently cracked down on the extent to which these types of pro forma calculations may be presented, and the details that should be included in such announcements C The notes to the statements contain useful information to facilitate comparison between periods 2.3 EXPLANATION AND ILLUSTRATION OF ACQUISITION ACCOUNTING A If cash is used, payment equals cost; if debt securities are used, present value of future payments represents cost B Assets acquired via issued shares are recorded at fair values of the stock given or the assets received whichever is more clearly evident C If stock is actively traded, market price is a better estimate of fair value than appraisal values D Goodwill (GW) is recorded as any excess of total cost over the sum of amounts assigned to identifiable assets and liabilities and, under SFAS No 142 [ASC 350] is no longer amortized E Goodwill must be tested for impairment at a level referred to as a reporting unit – generally a level lower than that of the entire entity If the implied fair value of the reporting unit’s goodwill is less than its carrying amount, goodwill is considered impaired See Flowchart on the next page F Goodwill impairment losses should be aggregated and presented as a separate line item in the operating section of the income statement G Bargain acquisition—when the net amount of fair values of identifiable assets less liabilities exceeds the total cost of the acquired company—a gain is recognized in the period of the acquisition under current GAAP H When S Company acquires P Company with stock, common stock is credited for the par value of the shares issued, with the remainder credited to other contributed capital Individual assets acquired and liabilities assumed are recorded at their fair values Plant assets and other long-lived assets are recorded at their fair values unless a bargain has occurred, in which case their values are reduced below fair value to the extent of the bargain When the cost exceeds the fair value of identifiable net assets, any excess of cost over the fair value is recorded as goodwill I Income Tax Consequences of Acquisition Method Business Combinations: deferred tax assets and/or liabilities must be recognized for differences between the assigned values and tax bases of the assets and liabilities acquired Such differences are likely when the combination is tax-free to the sellers 2.4 THE MEASUREMENT PERIOD (AND MEASUREMENT PERIOD ADJUSTMENTS) A The measurement period is the period after the acquisition date during which the acquirer may adjust the provisional amounts recognized for a business combination B During the measurement period, the acquirer is required to retrospectively adjust the provisional amounts at the acquisition date to reflect new information obtained about facts and circumstances that existed at the acquisition date C The Measurement period shall not exceed one year from the acquisition date 2.5 CONTINGENT CONSIDERATION IN AN ACQUISITION A Contingency—transfer of assets subsequent to acquisition from parent to subsidiary, generally dependent of some measure of performance B Contingency based on earnings is probably the most common, but it may create conflicts upon implementation because of measures which are out of the control of certain managers after the merger, as well as creating possible incentives for manipulation of earnings numbers (and may lead to decisions which are short-term rather than long-term focused) C Contingency based on security prices serves to correct some of the shortcomings of contingency calculations based on earnings (manipulation of numbers, for example), but leads to its own set of problems; for example, market prices fluctuate in response to many economy-wide factors that are almost completely outside the managers’ control Illustration 2-4 Deals Reporting the Amount of Contingent Consideration (Earnouts) Public Acquirers 2010 to 2014 $ Millions Year No of Value Earn-out/Deal 2010 2011 2012 2013 2014* Deals 121 154 110 100 47.3 37.8 57.9 72.5 19.2 Source: Thomson SDC Platinum * partial year 2014 Value 34.7% 32.9% 30.9% 34.5% 40.4% 2.6 LEVERAGED BUYOUTS A Group of employees/management creates a new company to acquire all the outstanding shares of employer/original company B Consensus position is that only portion of the net assets acquired with borrowed funds have actually been purchased and therefore recorded at cost Illustration 2-5 The Leveraged Buyout Market (LBO) 2000-2009 No of % of all Year Deals Deals 2002 187 3.1% 2003 197 3.0% 2004 366 4.7% 2005 520 6.1% 2006 754 7.8% 2007 815 7.8% 2008 576 6.8% 2009 287 4.9% 2010 438 6.4% 2011 593 7.6% 2012 666 6.4% Source: Mergers and Acquisitions February 2009, 2010, 2011 2.7 IFRS versus U.S GAAP Illustration 2-7 Comparison of Business Combinations and Consolidations under U.S GAAP and IFRS1 U.S GAAP Fair value of contingent consideration recorded at acquisition date, with subsequent adjustments recognized through earnings if contingent liability (no adjustment for equity) Contingent assets and liabilities assumed (such as warranties) are measured at fair value on the acquisition date if they can be reasonable estimated If not, they are treated according to SFAS No Noncontrolling interest is recorded at fair value and is presented in equity Special purpose entities (SPEs) are consolidated if the most significant activities of the SPE are controlled Qualified SPE (QSPEs) are no longer exempted from consolidation rules Direct acquisition costs (excluding the costs of issuing debt or equity securities) are expenses Goodwill is not amortized, but is tested for impairment using a two-step process Negative goodwill in an acquisition is recorded as an ordinary gain in income (not extraordinary) Fair value is based on exit prices, i.e the price that would be received to sell IFRS GAAP IFRS 3R uses the same approach Under IFRS 3R a contingent liability is recognized at the acquisition date if its fair value can be reliably measured Noncontrolling interest can be recorded either at fair value or at the proportionate share of the net assets acquired Also presented in equity Special purpose entities (SPEs) are consolidated if controlled QSPEs are not addressed IFRS 3R uses the same approach Goodwill is not amortized, but is tested for impairment using a one-step process IAS 36 uses the same approach Fair value is the amount for which an asset could be an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date Purchased in-process R&D is capitalized with subsequent expenditures expensed The capitalized portion is then amortized 10 Parent and subsidiary accounting policies not need to conform 11 Restructuring plans are accounted for separately from the business combination and generally expensed (unless conditions in SFAS no 146 are met) 12 Measurement period ends at the earlier of a) one year from the acquisition date, or b) the date when the acquirer receives needed information to consummate the acquisition 13 For step acquisitions, all previous ownership interests are adjusted to fair value, with any gain or loss recorded in earnings 14 Reporting dates for the parent and subsidiary can be different up to three months Significant events in that time must be disclosed 15 Potential voting rights are generally not considered in determining control 10 exchanged or a liability settled between knowledgeable, willing parties in an arm’s length transaction Purchased in-process R&D is capitalized with the potential for subsequent expenditures to be capitalized The capitalized portion is then amortized 10 Parent and subsidiary accounting policies need to conform 11 Similar accounting under IFRS and amended IAS 27 12 IFRS is similar to U.S GAAP 13 IFRS is similar to U.S GAAP 14 Permits a three-month difference if impractical to prepare the subsidiary’s statements on the same date; however, adjustments are required for significant events in that period 15 Potential voting rights are considered if currently exercisable APPENDIX 2A- Deferred Taxes in Business Combinations A B Motivation for selling firm: structure the deal so that any gain resulting is tax-free at the time of the combination Deferred tax liability (or asset) needs to be recognized by purchaser when the book value of the assets is used (inherited) for tax purposes, but the fair value is recognized in the accounting books under purchase accounting rules 11 ... with the potential for subsequent expenditures to be capitalized The capitalized portion is then amortized 10 Parent and subsidiary accounting policies need to conform 11 Similar accounting under... to be recognized by purchaser when the book value of the assets is used (inherited) for tax purposes, but the fair value is recognized in the accounting books under purchase accounting rules... capitalized portion is then amortized 10 Parent and subsidiary accounting policies not need to conform 11 Restructuring plans are accounted for separately from the business combination and generally