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Class Notes For Advanced Accounting, 4th Edition

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    Chapter 1 1 CHAPTER ONE – INTRODUCTION TO BUSINESS COMBINATIONS I. BUSINESS COMBINATIONS A business combination occurs when the operations of two or more companies are brought under common control. While merger activity (business combinations) experienced a slowdown in the economic decline of 2002 through mid - 2003, by July of 2003 , evidence of renewed interest was obvious . This trend continued, and global merger activity passed the one trillion dollar mark for the first quarter of 2007, the greatest activity on record according to CNN. II. NATURE OF THE COMBINATION A. Nature of the combination 1. In a friendly combination , the boards of directors of the potential combining companies negotiate mutually agreeable terms of a proposed combination. The proposal is then submitted to the stockholders of the involved companies for approval. 2. An unfriendly (hostile) combination results when the board of directors of a company targeted for acquisition resists the combination. A formal tender offer enables the acquiring firm to deal directly with individual shareholders. B. Defense tactics Resistance often involves various moves by the target company. Whether or not such defenses are ultimately beneficial to shareholders remains a controversial issue. 1. Poison pill: Issuing stock rights to existing shareholders enabling them to purchase additional shares at a price below market value, but exercisable only in the event of a potential takeover. Example: Cisco creates "poison pill" to block takeovers b y James Niccolai http://www.computerworld.com/home/news.nsf/all/9806125poison Cisco Systems, Inc. said yesterday that its board of directors has approved a shareholder rights plan designed to protect the networking company's investors in the event of a hostile takeover bid. Known in the business world as a "poison pill," the plan is a strategic maneuver to make the company's stock less attractive to potential bidders and to encourage bidders to solicit offerings through the company's board of directors, the San Jose, Calif., company said. A company spokeswoman said Cisco isn't currently

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    Chapter 1 2 the target of a takeover bid, but added that such plans aren't uncommon at large corporations. Under the plan, Cisco shareholders would have the right to acquire for half price one share in the company for each share held as of June 22. The plan would kick in if a person or company acquires or announces an offer to acquire 15% or more of the company's common stock, Cisco said. 2. Greenmail: The purchase of any shares held by the would - be acquiring company at a price substantially in excess of their fair value. The purchased shares are then held as treasury stock or retired. 3. White knight or white squire: Encouraging a third firm more acceptable to the target company management to acquire or merge with the target company. 4. Pac - man defense : Attempting an unfriendly takeover of the would - be acquiring company. 5. Selling the crown jewels : The sale of valuable assets to others to make the firm less attractive to the would - be acquirer. The negative aspect is that the firm, if it survives, is left without some important assets. 6. Leveraged buyouts : The purchase of a controlling interest in the target firm by its managers and third party investors, who usually incur substantial debt in the process and subsequently take the firm private. The bonds issued often take the form of high interest, high risk “junk” bonds. III. BUSINESS COMBINATIONS: WHY? WHY NOT? A. A company may expand in several ways. Some firms concentrate on internal expansion. For other firms external expansion is the goal; a company may achieve significant cost savings as a result of external expansion. In addition to rapid expansion, the business combination method, or external expansion, has several other potential advantages over internal expansion: 1. Operating synergies may take a variety of forms. In the case of vertical mergers (a merger between a supplier and a customer), synergies may result from the elimination of certain costs related to negotiation, bargaining, and coordination between the parties. In the case of a horizontal merger (a merger between competitors), potential synergies include the combination of sales forces, facilities, outlets, etc., and the elimination of unnecessary duplication in costs.

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    Chapter 1 3 2. Combination may enable a company to compete more effectively in the international marketplace . 3. Business combinations are sometimes entered into to take advantage of income tax laws. The opportunity to file a consolidated tax return may allow profitable corporations’ tax liability to be reduced by the losses of unprofitable affiliates. 4. Diversification resulting from a merger offers a number of advantages, including increased flexibility, an internal capital market, an increase in the firm’s debt capacity, more protection from competitors over proprietary information, and sometimes a more effective utilization of the organization’s resources. 5. Divestitures accounted for over 30% of the merger and acquisitions activity in each quarter from 1995 into mid - 1998. Shedding divisions that are not part of a company’s core business became common during this period. In some cases the divestitures may be viewed as “undoing” or “redoing” past acquisitions. B. Notwithstanding its apparent advantages, business combination may not always be the best means of expansion. 1. An overriding emphasis on rapid growth may result in the pyramiding of one company on another without sufficient management control over the resulting conglomerate. Unsuccessful or incompatible combinations may lead to future divestitures. 2. In order to avoid large dilutions of equity, some companies have relied on the use of various debt and preferred stock instruments to finance expansion, only to find themselves unable to provide the required debt service during a period of decreasing economic activity. The junk bond market used to finance many of the mergers in the 1980s had essentially collapsed by the end of that decade. 3. Business combinations may destroy, rather than create, value in some instances. IV. BUSINESS COMBINATIONS -- AN HISTORICAL PERSPECTIVE A. In the United States there have been three fairly distinct periods characterized by many business mergers, consolidations, and other forms of combinations: 1880 - 1904; 1905 - 1930; and 1945 - present.

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    Chapter 1 4 1. 1880 - 1904, huge holding companies or trusts were created by investment bankers seeking to establish monopoly control over certain industries. This type of combination is generally called horizontal integration because it involves the combination of companies within the same industry. 2. 1905 - 1930, business combination activity of this period, fostered by the federal government during World War I, was encouraged to obtain greater standardization of materials and parts and to discourage price competition. After the war, these combinations were efforts to obtain better integration of operations, reduce costs, and improve competitive positions rather than attempts to establish monopoly control over an industry. This type of combination is called vertical integration because it involves the combination of a company with its suppliers or customers. 3. 1945 - present, the third period has exhibited rapid growth in merger activity since the mid - 1960s, and even more rapid since the 1980s. Some observers have called this activity " merger mania .'' Illustration 1 - 1 presents a rough graph of the le vel of merger activity from 1972 to 2005 in number of deals, and from 1979 to 12005 in dollar volume. Illustration 1 - 2 presents summary statistics on the lev el of activity for the year 2005 by industry sector for acquisitions with purchas e prices valued in excess of $1 0 million. B. This most recent period can be further subdivided to focus on trends of particular decades or subperiods. 1. From the 1950s to the 1970s most mergers were conglomerate mergers. Here the primary motivation for combination was often to diversify business risk 2. The 1980s were characterized by a relaxation in antitrust enforcement during the Reagan administration and by the emergence of high - yield junk bonds to finance acquisitions. The dominant type of acquisition during this period and into the 1990s has been strategic acquisitions claiming to benefit from operating synergies . A temporary decline in activity near the end of the 1980s may be traced to the collapse of the junk bond market and to an economic recession. 3. By the mid - 1990s the credit markets had recovered, and the upsurge in mergers renewed to greater levels than ever before. Deregulation undoubtedly played a role in the popularity of

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    Chapter 1 5 combinations in the 1990s. Although recent years have witnessed few deals blocked due to antitrust enforcement. On May 13, 1998, the United States government announced its intent to appoint a panel of economic advisors to evaluate the impact of merger activity on the economy. V. TERMINOLOGY AND TYPES OF COMBINATIONS A. From an accounting perspective, the distinction that is most important at this stage is between an asset acquisition and a stock acquisition . An asset acquisition involves the purchase of all of the acquired company’s net assets, whereas a stock acquisition involves the attainment of control via purchase of a controlling interest in the stock of the acquired company. B. A statutory merger results when one company acquires all the net assets of one or more other companies through an exchange of stock, payment of cash or other property, or the issue of debt instruments (or a combination of these methods). Thus, if A Company acquires B Company in a statutory merger, the combination is often expressed as Statutory Merger + = C. A statutory consolidation results when a new corporation is formed to acquire two or more other corporations through an exchange of voting stock; the acquired corporations then cease to exist as separate legal entities. Thus, if C Company is formed to consolidate A Company and B Company, the combination is generally expressed as Statutory Consolidation + = D. A stock acquisition occurs when one corporation pays cash or issues stock or debt for all or part of the voting stock of another company, and the acquired company remains intact as a separate legal entity. Thus, if A Company acquires 50% of the voting stock of B Company), a parent - subsidiary relationship results. Consolidated financial statements (explained in later chapters) are prepared and the business combination is often expressed as A Company B Company A Company A Company B Company C Company

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    Chapter 1 6 Consolidated Financial Statements + = VII. TAKEOVER PREMIUMS A takeover premium is the term applied to the excess of the amount offered, or agreed upon, in an acquisition over the prior stock price of the acquired firm. VIII. AVOIDING THE PITFALLS BEFORE THE DEAL To consider the potential impact on a firm’s earnings realistically, the acquiring firm’s managers and advisors must exercise due diligence in considering the information presented to them. Some of the factors to beware include: A. Be cautious in interpreting any percentages presented by the selling company. B. Don’t neglect to include assumed liabilities in the assessment of the cost of the merger. In addition to liabilities that are on the books of the acquired firm, be aware of the possibility of less obvious liabilities. C. Watch out for the impact on earnings of the allocation of expenses and the effects of production increases, standard cost variances, LIFO liquidations, and by - product sales. D. Note any nonrecurring items which may have artificially or temporarily boosted earnings. In addition to nonrecurring gains or revenues, look for recent changes in estimates, accrual levels, and methods . E. Be careful of CEO egos . IX. DETERMINING PRICE AND METHOD OF PAYMENT IN BUSINESS COMBINATIONS Whether an acquisition is structured as an asset acquisition or a stock acquisition, the acquiring firm must choose to finance the combination with cash, stock, or debt (or some combination). Financial Statements of A Company Financial Statements of B Company Consolidated Financial Statements of A Company and B Company

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    Chapter 1 7 A. When a business combination is effected through an open - market acquisition of stock, no particular problems arise in connection with determining price or method of payment. Price is determined by the normal functioning of the stock market, and payment is generally in cash, although some or all of the cash may have to be raised by the acquiring company through debt or equity issues. B. When a business combination is effected by a stock swap, or exchange of securities, both price and method of payment problems arise. In this case, the price is expressed in terms of a stock exchange ratio , which is generally defined as the number of shares of the acquiring company to be exchanged for each share of the acquired company, and constitutes a negotiated price . It is important to understand that each constituent of the combination makes two kinds of contributions to the new entity -- net assets and future earnings. The accountant often becomes deeply involved in the determination of the values of these contributions. X. NET ASSET AND FUTURE EARNINGS CONTRIBUTIONS A. Determination of an equitable price for each constituent company, and of the resulting exchange ratio, requires the valuation of each company's net assets, as well as their expected contribution to the future earnings of the new entity. To estimate current replacement costs of real estate and other items of plant and equipment, the services of appraisal firms may be needed. B. Estimation of the value of goodwill to be included in an offering price is subjective. A number of alternative methods are available, usually involving the discounting of expected future cash flows (or free cash flows), earnings, or excess earnings over some period of years. Generally, the use of free cash flows or earnings yields an estimate of the entire firm value (including goodwill), whereas the use of excess earnings yields an estimate of the goodwill component of total firm value. C. Steps in the excess earnings approach: Excess Earnings Approach to Estimating Goodwill 1. Identify a normal rate of return on assets for firms similar to the company being targeted. 2. Apply the rate of return identified in step 1 to the level of identifiable assets (or net assets) of the target to approximate what the “normal” firm in this industry might generate with the same level of resources. We will refer to the product as “normal earnings.” 3. Estimate the expected future earnings of the target. 4. Subtract the normal earnings calculated in step 2 from the expected target earnings from step 3. The difference is “excess earnings.”

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    Chapter 1 8 If the normal earnings are greater than the target’s expected earnings, then no goodwill is implied under this approach. 5. To compute estimated goodwill from “excess earnings,” we must assume an appropriate time period and a discount rate. The shorter the time period and the higher the discount rate, the more conservative the estimate. Because of the assumptions needed in step 5, a range of goodwill estimates may be obtained simply by varying the assumed discount rate and/or the assumed discount period. 6. Add the estimated goodwill from step 5 to the fair value of the firm’s net identifiable assets to arrive at a possible offering price. XI. ALTERNATIVE CONCEPTS OF CONSOLIDATED FINANCIAL STATEMENTS A. Parent Company Concept: The pa rent company concept emphasizes the interests of the parent's shareholders. As a result, the consolidated financial statements reflected those stockholder interests in the parent itself, plus their undivided interests in the net assets of the parent's subsidiaries . B. Economic Unit Concept : The economic unit concept emphasizes control of the whole by a single management. As a result, under this concept, consolidated financial statements are intended to provide information about a group of legal entities - a parent company and its subsidiaries - operating as a single unit. In its most recent pronouncements, FASB has opted to adopt this concept, and the 4th edition chapters (2 through 9) are based on the economic unit concept . C. Noncontrolling Interest 1. Under the economic unit concept, a noncontrolling interest is a part of the ownership equity in the entire economic unit. 2. Under the parent company concept, the nature and classification of a noncontrolling interest are unclear. D. Consolidated Net Income 1. Under the parent company concept, consolidated net income consists of the realized combined income of the parent company and its subsidiaries after deducting noncontrolling interest in income; that is, the noncontrolling interest in income is deducted as an expense item in determining consolidated net income.

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    Chapter 1 9 2. Under the economic unit concept, consolidated net income consists of the total realized combined income of the parent company and its subsidiaries. The total combined income is then allocated proportionately to the noncontrolling interest and the controlling interest. Noncontrolling interest in income is considered an allocated portion of consolidated net income, rather than an element in the determination of consolidated net income. E. Consolidated Balance Sheet Values 1. Under the parent company concept, the value assigned to the net assets should not exceed cost to the parent company. 2. Under the economic unit concept, on the date of acquisition, the net assets of the subsidiary are included in the consolidated financial statements at their book value plus the entire difference between their fair value and their book value. F. Elimination of Unrealized Intercompany Profit The elimination methods associated with these two points of view are generally referred to as total (100%) elimination and partial elimination. Note: this issue is unlikely to mean much to students at this point in their study, and may be returned to after chapter 6. It is included here, nonetheless, for the sake of thoroughness and because the discussion is fairly intuitive. 1. Partial elimination is consistent with the parent company concept. 2. Total elimination is consistent with the economic unit concept. 3. Current and Past Practice a. Current (and past) practice follows neither the parent company nor the economic unit concept entirely. The differences in practice relate primarily to the classification of noncontrolling interest and the total elimination of unrealized intercompany profits in assets acquired from an affiliate. However, as previously stated, the expectation is that the economic entity concept will be followed in the future. b. Current accounting standards require the total elimination of unrealized intercompany profit in assets acquired from affiliated companies, regardless of the percentage of ownership.

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    Chapter 1 10

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    Chapter 2 1 CHAPTER TWO – ACCOUNTING FOR BUSINESS COMBINATIONS I. METHOD OF ACCOUNTING FOR NET ASSET ACQUISITIONS : PURCHASE OR ACQUISITION ACCOUNTING 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. Pooling of i nterest s – previous s tandards clearly defined the criteria necessary to qualify for this accounting treatment, and the SEC was involved in its enforcement . 2. Acquisition ( Purchase ) - all other combinations (i.e, those not qualifying for pooling treatment) were always accounted for by the purchase method , as all combinations are currently. I I. PRO FORMA STATEMENTS AND DISCLOSURE REQUIREMENT A. Pro forma statements have historically serve d two functions in relation to business combinations: 1. To provide information in the planning stages of the combination, and 2. 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 . I II. EXPLANATION AND ILLUSTRATION OF ACQUISITION ACCOUNTING

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    Chapter 2 2 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. F. Goodwill impairment losses sh ould 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 C ompany 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 e xcess of cost over the fair value is recorded as goodwill . I. Income Tax Consequences of Acquisition Method Business Combinations: deferred tax asset s 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.

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    Chapter 2 3 IV . CONTINGENT CONSIDERATION IN A PURCHASE 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. V . 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. APPENDIX A : Deferred Taxes in Business Combinations A. Motivation for selling firm: structure the deal so that any gain resulting is tax - free at the time of the combination. B. 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.

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    Chapter 2 4 APPENDIX B: Did Firms Prefer Pooling; And, If So, Why? I. A. Some facts about pooling 1. Majority of US mergers did not meet pooling criteria. Therefore the purchase method was more widely used, but firms (especially in large mergers) sometimes went to great lengths to qualify for pooling treatment. Furthermore, when the elimination of the pooling method was proposed, it meant with vehement protests from a number of fronts. 2. Why did firms care? The two methods resulted in a substantial difference in the way the combined financial statements appeared. 3. Pooling — neither of the two firms was considered dominant. The acquiring firm was termed the “issuer” and the other firm was the “non - issuer.” Assets, liabilities, and retained earnings were taken forward at their previous carrying amounts. Operating results of the two companies were combined for the entire period being presented, regardless of the date of acquisition. Previously issued statements (when presented) were restated as if the companies had always been combined. 4. Pooling -- income statements subsequent to the transaction did not include goodwill amortization, excess depreciation, or other charges due to asset revaluing. 5. Purchase accounting yields a generally lower net income divided by a larger base of assets, and therefore a substantially decreased return on assets (ROA) in most cases relative to pooling. However, this effect has been lessened by another FASB change which essentially eliminates the amortization of goodwill. 6. Pooling required review of prior year statements which facilitated trend analysis. 7. See Illustration 2 - 1 for comparison of the two methods 8. Balance sheet differences — Purchase accounting reflects more current values for the combining firm’s assets and liabilites. Pooling combined retained earnings of the two firms (in most cases), leading to generally greater retained earnings balances for the combined entity relative to purhase. Purchase, on the other hand, does not reflect any retained earnings from the acquired entity.

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    Chapter 2 5 B. Treatment of Acquisition Expenses Contrasted 1. Pooling — all types of expenses (direct, indirect, and security issue costs) were expensed in the period incurred. 2. Purchase — each category of expenses is treated differently, as shown below. Pooling Purchase Direct Expenses Expense (IS) Capitalize (GW or PPE) Indirect Expense Expense (IS) Expense Security Issue Costs Expense (IS) Adjust additional PIC C. PURCHASE VERSUS POOLING -- AUTHORITATIVE POSITION (AND HISTORICAL PERSPECTIVE) 1. The Financial Accounting Standards Board (FASB) has recently eliminated the pooling method. As a result, all acquisitions are now accounted for by the purchase method. 2. Prior to the issuance of APB Opinion No. 16 , “Business Combinations,” the pooling method was widely used and abused. This opinion delineated the specific conditions under which pooling was required; all other combinations had to be accounted for as purchases. a. Paragraphs 45 -- 48 of Opinion No. 16 spelled out the specific conditions under which pooling was required. b. Twelve conditions in Opinion No. 16 were specified to meet requirements for pooling. c. Opinion No. 16 attempted to define criteria clearly, remove any choice of method (other than that provided by judicious planning of a combination's terms), and prohibit partial pooling. 3. Advantages and disadvantages, both theoretical and practical, were noted for both methods. 4. Opinion No. 16 , issued in 1970, significantly reduced the proportion of business combinations accounted for as poolings of interests and improved business combination accounting and reporting to a large extent. However, pooling remained a popular and controversial method for very large mergers until FASB eliminated it in 2001.

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    Chapter 2 6 II . A LOOK BACK: EXPLANATION AND ILLUSTRATION OF POOLING OF INTERESTS A. Business combination process in which two or more groups of stockholders united their ownership interests by an exchange of common stock. B. Owners retained proprietary rights C. Fair value of assets and liabilities were ignored except in the determination of an equitable exchange ratio of common stock. Assets and liabilities were carried forward at book value. D. Equity allocation to common stock, to other contributed capital and to retained earnings: 1. If par value of shares issued equals par value of existing shares on books of the combining firm — show addition of all other contributed capital and retained earnings. 2. If par value of shares issued exceeds par value of existing shares — equity transfer rule — when the par (or stated) value of the shares issued by the issuing firm exceeds the total par or stated value of the combining company'’ stock, the excess should be deducted first from the combined other contributed capital and then from combined retained earnings (RE) . 3. If par value of shares issued is less than par value of existing shares on books of the combining firm — show addition of other contributed capital and retained earnings plus additional “other contributed capital” for the difference between par values. 4. Results of operations for that period were the sum of the results of: (1) Operations of the separate companies as if they had been combined from the beginning of the fiscal period to the date the combination is consummated. (2) The combined operations from that date to the end of the period. III. FINANCIAL STATEMENT DIFFERENCES BETWEEN ACCOUNTING METHODS A. Purchase and pooling of interest methods were not intended to be considered as alternatives in accounting for a specific business combination. Nonetheless business managers often regarded them as such in the planning stages of an acquisition. Furthermore, those acquisitions that were initially recorded under the pooling rules remain on the books under those rules; i.e. the elimination was not retroactive. Thus, it is

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    Chapter 2 7 important to realize that so long as those companies do not unwind or spin off such prior acquisitions, the “old” pooling rules will continue to affect the appearance of financial statements for years to come. B. Purchase accounting tends to report higher asset values but lower earnings (due to excess depreciation and amortization) versus pooling of interest. C. Bargain purchases — purchase price below fair value of identifiable net assets — will yield ordinary gain under acquisition (purchase) rules. (In the past, extraordinary gains were sometimes recorded.)

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    Chapter 3 1 CHAPTER THREE – CONSOLIDATED FINANCIAL STATEMENTS I. DEFINITIONS OF SUBSIDIARY AND CONTROL A. Subsidia r y : S ituation wherein a parent company (and/or parent’s other subsidiaries) owns a controlling interest in the voting shares of another company, usually more than 50% of the voting shares . B. Control : T he ability of an entity to direct the policies and management that guide the ongoing activities of another entity so as to increase its benefits and limit its losses from that other entity’s activities. For purposes of consolidated financial statements, control involves decision - making ability that is not shared with others. It stresses the need to prepare consolidated financial statements whenever control exists, even in the absence of a majority ownership. C. Parent: When a stock acquisition occurs, the acquiring company is generally referred to as the parent . D. N oncontrolling (minority) interest : Shareholders hol d ing the remaining stock in a subsidiary outside of that held by the parent company . E. Affiliated companies : T he related companies having a joint relationship . Each of the affiliated companies continues its separate legal existence . II. REQUIREMENTS FOR THE INCLUSION OF SUBSIDIARIES IN THE CONSOLIDATED FINANCIAL STATEMENTS A. Given t he purpose that consolidated statements is to present for a single accounting entity the net resources and operating results of a group of companies under common control , also considering the problems related to off - balance - sheet financing, the FASB has taken the position that essentially all controlled corporations should be consolidated. B. Under some circumstances, majority - owned subsidiaries should be excluded from the consolidated statements. Those circumstances include: 1. Control does not rest with the majority owner – e.g. as when the firm is in bankruptcy. 2. A foreign company is domiciled in a country with foreign exchange restrictions, controls, or governmentally imposed uncertainties that cast significant doubt on the parent’s ability to control the subsidiary. 3. Majority owned investments that are not consolidated for one of the above reasons are normally reported as investments using the cost method (with fair value adjustments, if needed) because the subsidiaries are not controlled nor significantly influenced by the parent company. III. REASONS FOR SUBSIDIARY COMPANIES

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    Chapter 3 2 A. Stock acquisition is relatively simple in some cases. Mechanisms such as open market purchases and cash tender offers help avoid the often long & difficult negotiations of stock for stock exchange in complete takeovers. B. Control of subsidiary’s operations can be accomplished with smaller investment – not all of the subsidiary’s stock must be acquired, but only a sufficient portion to achieve control. C. Limited liability - separate legal existence of individual affiliates provides an element of protection of the parent’s assets from creditors of the subsidiary. D. In some cases, one of the entities may be subject to regulation while others are not. In a stock acquisition, the other entities may maintain their unregulated status. IV. CONSOLIDATED FINANCIAL STATEMENTS A. Statements prepared for a parent company and its subsidiaries. They represent the sum of assets, liabilities, revenues, and expenses of the affiliates after eliminating the effect of any transactions among the affiliated companies. B. When a parent acquires controlling interest in a subsidiary, the parent makes an entry to debit Investment in Subsidiary and credit either cash, debt, or stock (or combination) depending on medium of exchange. Assume the acquisition has a cash purchase price of $5 million. Entry in parent’s books is: C. Investment in Subsidiary $5,000,000 Cash $5,000,00 C. The investment account represents the parent’s investment in the different asset and liability accounts of the subsidiary. The subsidiary continues to maintain detailed books based on historical book values, which are not as current as the market values assessed by the parent at the date of acquisition but are detailed as to classification. Consolidation process summarization: Investment Account on the Parent’s Books Asset and Liability Accounts on the Subsidiary’s Books Valuation in the financial statements MARKET VALUE HISTORICAL VALUE Classification in the financial statements ONE ACCOUNT MULTIPLE ACCOUNTS D. Process of preparing consolidated financial statements aims to achieve market value and multiple accounts characteristics (items in the diagonal in part C above). Consolidated statements ignore the legal aspects of the separate entities and focus on the economic entity under the control of management, and thus focus on substance rather than form. Consolidated statements are not to be used as substitutes for the statements prepared by the separate subsidiaries.

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    Chapter 3 3 V. INVESTMENTS AT THE DATE OF ACQUISITION A. Recording Investments at Cost (Parent’s Books) 1. Purchase method – stock investment is recorded at its cost as measured by the fair value of the consideration given or received, whichever is more clearly evident. 2. Both direct and i ndirect costs (costs of maintaining an M&A dept , for example ) should be expensed as incurred. B. If cash is used for the acquisition, the investment is recorded at its cash cost, including broker's fees and other direct costs of the investment. C. If the c ompany acquires only part of s hares and pays an acquisition fee, the investment is recorded at its cost of purchasing shares and other direct costs of investment. D. If the company issues stock in the acquisition, the investment is recorded at the fair value of the stock issued, giving effect to any costs of registering the stock issue. E. If the c ompany pa ys additional fees, such as a finder’s fee, the cost of that fee should be expensed under Exposure Draft No. 1204 - 001 . VI. CONSOLIDATED BALANCE SHEETS: THE USE OF WORKPAPERS A. The u se of w orkpapers 1. Consolidated balance sheet reports the sum of the assets and liabilities of a parent and its subsidiaries as if they constituted a single company. 2. Assets and liabilities are summed in their entirety (whether 100% ownership or not). 3. Noncontrolling interests are reflected as a component of owner’s equity . 4. Eliminations must be made to cancel effects of transactions among the parent and its subsidiaries, as shown in the table below . 5. A workpaper is used to summarize the effects of the various additions, eliminations, etc. Intercompany Accounts to be Eliminated Parent’s Accounts Subsidiary’s Accounts Investment in Subsidiary Against Equity Accounts Intercompany receivable (payable) Against Intercompany payable (receivable) Advances to subsidiary (from subsidiary) Against Advances to parent (to parent) Interest revenue (interest expense) Against Interest expense (interest revenue) Dividend revenue (dividends declared) Against Dividends declared (dividend revenue) Management fee received from Against Management fee paid to

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    Chapter 3 4 subsidiary subsidiary Sales to subsidiary (purchases of inventory from subsidiary) Against Purchases of inventory from parent (sales to parent) B. Investment elimination 1. An important basic elimination in the preparation of consolidated statements is the elimination of the investment account and the related subsidiary's stockholders' equity. 2. To start t he process of combining the individual assets and liabilities of a parent company and its subsidiary at the date of acquisition, the first step is to prepare a “Computation and Allocation of Difference between Implied and Book Value” schedule (CAD). Preparation of this schedule requires us to address two basic issues. a. Determine the percentage of stock acquired in the subsidiary (Is it a 100% acquisition, or a smaller percentage?) and calculate Implied Value (IV) by dividing the purchase price by the percentage acquired. b. Compare the IV to the book value of the equity of the target . If a difference between implied and book value exists, we must then allocate that difference to adjust the underlying assets and/or liabilities of the acquired company. c. Book value of the equity = Assets of S Company minus Liabilities of S Company, or recorded values of all S Company equity accounts summed. d. Note that the comparison is implied value (IV) to book value, rather than market value of the acquired entity. e. The steps above lead to the following possible cases: CASE 1. The value of the subsidiary (IV), as implied by the purchase price, is equal to the book value of the subsidiary company's equity, and (a) The parent company acquires 100% of the subsidiary company's stock; or (b) The parent company acquires less than 100% of the subsidiary company's stock. CASE 2. The IV exceeds the book value of the subsidiary company's equity, and (a) The parent company acquires 100% of the subsidiary company's stock; or (b) The parent company acquires less than 100% of the subsidiary company's stock. CASE 3. The IV is less than the book value of the subsidiary company's equity, and (a) The parent company acquires 100% of the subsidiary company's stock; or (b) The parent company acquires less than 100% of the subsidiary company's stock. D. Illustration of the alternatives 1. C ase 1(a): IV (implied value) Is Equal to Book Value of Subsidiary Stock – Total Ownership (100% of Subsidiary Stock Acquired)

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    Chapter 3 5 P acquires all outstanding stock (5,000 shares) of S Company for a cash payment of $80,000 Journal entry: Investment in S Company $80,000 Cash $80,000 P company's cash balance drops to $20,000 and an investment of $80,000 is recognized Computation and allocation of difference between implied and book value: Cost of investment (purchase price) = IV $80,000 Book value of equity $80,000 Difference between implied and book value 0 Note: Eliminating entries are made to cancel the effects of intercompany transactions and are made on workpapers only Eliminating entry in this example: Common Stock - S Company $50,000 Other Contributed Capital - S Company $10,000 Retained Earnings - S Company $20,000 Investment in S Company $80,000 A workpaper for the preparation of a consolidated balance sheet for P an d S Companies on January 1, 2007 , the date of acquisition, is presented in Illustration 3 - 2. 2. CASE 1(b): IV Is Equal to Book Value of Subsidiary Company's Stock – Partial Ownership (Less than 100% of Subsidiary Stock Acquired) P acquires 90% of outstanding stock (4,500 shares) of S Company for a cash payment of $72,000 In this case, consideration must be given to a noncontrolling interest because P owns less than 100% of S Company. Journal entry: Investment in S Company $72,000 Cash $72,000 P C ompany's cash balance drops to $28,000 and an investment of $72,000 is recognized

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    Chapter 3 6 Computation and Allocation of Difference Schedule Parent Non - Total Share Controlling Value Share Purchase price and implied value $ 72,000 8,000 80,000 Less: Book value of equity acquired: Common stock 45,000 5,000 50,000 Other contributed capital 9,000 1,000 10 ,000 Retained earnings 18,000 2,0 00 20,000 Total book value 72,000 8,000 80,000 Difference between implied and book value 0 0 0 Eliminating entry in this example: Common Stock - S Company $50 ,000 Other Contributed Capital - S Company $ 10 ,000 Re tained Earnings - S Company $20 ,000 Investment in S Company $72,000 Noncontrolling Interest in Equity (NCI) 8,000 Illustration 3 shows the balance sheets of S and P Company before the consolidation, the eliminating entries, as well as the consolidated balance sheet. Note that the investment by P in S reflects only its percentage of S Company’s equity. Thus, when eliminating the equity accounts of S, we must recognize the emergence of a noncontrolling interest (NCI). Nonetheless, all the assets and liabilities of S Company and P Company are used to make up the consolidated balance sheet because the purpose of the latter is to show the resources that are under control of a single management, not owned ! The noncontrolling interest represents the ownership of other shareholders in the net assets of S Company. And last, note that the assets are $8,000 greater than in the example before because P Company has $8,000 more left in cash (on the equity side of the balance sheet this difference is made up by the noncontrolling interest). 3. CASE 2(b): Implied Value (IV) Exceeds Book Value of Subsidiary Company's Stock Acquired – Partial Ownership (Less than 100% of the Subsidiary Company's Stock Acquired) [Note that Case 2(a) is omitted here, as it is relatively easy to understand once Case 2(b) is grasped.] P acquires 80% of outstanding stock (4,000 shares) of S Company for a cash payment of $74,000 Again, consideration must be given to a noncontrolling interest because P owns less than 100% of S Company. At the same time, the amount by which IV exceeds the book value of S Company equity must be allocated to an asset or assets in the workpaper entries .

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    Chapter 3 7 Journal entry: Investment in S Company $74,000 Cash $74,000 P Company's cash balance is to $26,000 and an investment of $74,000 is recognized. We assume in this case that the difference between the book value of the equity and the implied value is attributable to undervalued land. Computation and Allocation of Difference Schedule Parent Non - Total Share Controlling Value Share Purchase price and implied value $ 74 ,000 18,500 92,500 Less: Book value of equity acquired: Common stock 40,000 10,000 50,000 Other contributed capital 8,000 2,000 10,000 Retained earnings 16,000 4,000 20 ,000 Total book value 64,000 16,000 80 ,000 Difference between implied and book value 10,000 2,500 12,500 Adjust land upward (mark to market) ( 10,000) (2,500) ( 12,500 ) Balance - 0 - - 0 - - 0 - Eliminating entry in this example: Common Stock - S Company $50 ,000 Other Contributed Capital - S Company $ 10 ,000 Retained Earnings - S C ompany $20 ,000 Difference between implied and book value $12,5 00 Investment in S Company $74,000 Noncontrolling Interest (NCI) 18,500 Land $12,5 00 Difference between implied and book value $12,5 00 As one can see, the account “Difference between implied and book value” is only a temporary account; the debit to land could also have been made in the early journal entry when the equity accounts of S Company were eliminated. Illustration 3 - 4 shows the balance sheets of S and P Company before the consolidation, the eliminating entries, as well as the consolidated balance sheet. Note the adjustment of land. Reasons for paying for more than the book value: a. Conservative accounting principles were applied b. Unrecorded goodwill c. Overvaluation of liabilities

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    Chapter 3 8 d. Bidding war over company to be acquired drives the price up 4. CASE 3(b): Implied Value (IV) Is Less than Book Value of Subsidiary Stock – Partial Ownership (Less than 100% of Subsidiary Stock Acquired) [Note that Case 3(a) is omitted here, as it is relatively easy to understand once Case 3(b) is grasped.] P acquires 80% of outstanding stock (4,000 shares) of S Company for a cash payment of $60,000 Again, consideration must be given to a noncontrolling interest because P owns less than 100% of S Company. At the same time, the amount that exceeds the book value of S Company equity must be allocated to an asset (or a gain may be recognized, if no market value adjustments are warranted); however this time, the value of the asset is written down rather than up. Journal entry: Investment in S Company $60,000 Cash $60,000 P Company's cash balance is to $40,000 and an investment of $60,000 is recognized. We assume in this case that the difference between the book value of the equity and the implied value is attributable to overvalued land. Computation and Allocation of Difference Schedule Parent Non - Total Share Controlling Value Share Purchase price and implied value $ 60,000 15,000 $75,000 Less: Book value of equity acquired: Common stock 40,000 10,000 50,000 Other contributed capital 8,000 2,000 10 ,000 Retained earnings 16,000 4,000 20,000 Total book value 64,000 16,000 $80,000 Difference between implied and book value (4,000) (1,000) (5,000) Land, adjust downward 4,000 1,000 5,000 Balance - 0 - - 0 - - 0 - Eliminating entry in this example: Common Stock - S Company $5 0,000 Other Contributed Capital - S Company $ 10 ,000 Re tained Earnings - S Company $20 ,000 Difference between implied and book value $ 5, 000 Investment in S Company $ 60,000 Noncontrolling Interest (NCI) $15,000

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    Chapter 3 9 Difference between implied and book value $ 5 ,000 Land $ 5 ,000 Illustration 3 - 5 shows the balance sheets of S and P Company before the consolidation, the eliminating entries, as well as the consolidated balance sheet. Note the (downward) adjustment of land . E. Subsidiary Treasury Stock Holdings Treasury stock is excluded from the computation of the percentage of interest acquired because the latter is based on stock outstanding Example: P Company acquires 18,000 of S Company’s shares for $320,000 S Company’s equity section appears as follows: Common stock, $10 par, 25,000 shares issued $250,000 Other contributed capital $50,000 Retained Earnings $125,000 $425,000 Less: Treasury stock at cost, 1,000 shares $25,000 $40 0 ,000 P Company’s interest in S Company is 18,000/24,000 = 75%. Implied Value (IV) = $320,000/75%, or $426,667. The NCI is 25% x $426,667, or $106,667. Since Treasury Stock is a contra account, P Company’s share must be reduced accordingly. Eliminating entry: Common Stock - S Company $ 250,000 Other Contributed Capital - S Company $ 50,000 Retained Earnings - S Company $ 125,000 Difference between IV and Book Value $ 26,667 Treasury stock $ 2 5,000 Investment in S Company $320,000 Noncontrollling Interest in Equity (NCI) $106,667 E. Other Intercompany Balance Sheet Eliminations All receivables or payables as well as cash advances must be eliminated against the reciprocal accounts of the other company. A $5,000 cash advance by P Company to S Company: Advance from P Company $25,000 Advance to S Company $25,000 F. Adjusting Entries Prior to Eliminating Entries In case certain transactions are not completed, adjusting entries must be made. VII. A COMPREHENSIVE ILLUSTRATION - MORE THAN ONE SUBSIDIARY COMPANY (Illustration 3 - 6, 3 - 7)

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    Chapter 3 10 Parent company owns a direct controlling interest in more than one subsidiary A. Balance sheet of each affiliate is entered on the workpaper. B. Any adjustments are prepared. C. All related intercompany accounts, including those between subsidiary companies, are eliminated. D. Remaining balances are combined, constituting a consolidated balance sheet. E. Formal consolidated balance sheet is prepared from the detail in the consolidated balance sheet columns of the workpaper. F. Balance sheet data are classified according to normal balance sheet arrangements. G. Noncontrolling interest in consolidated net assets is reported as a component of stockholders’ equity. V III . LIMITATIONS OF CONSOLIDATED STATEMENTS: A. Noncontrolling stockholders and regulatory agencies – consolidated statements contain insufficient detail about individual subsidiaries. B. Creditors – have claims only against the resources of particular subsidiary, unless the parent guarantees the claims. C. Financial analysts – difficult to analyze or compare diversified companies operating across several industries.

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    Chapter 3 11 Appendix A : Deferred Taxes on the Date of Acquisition A. If a purchase acquisition is tax - free to the seller, the tax bases of the acquired assets and liabilities are carried forward at book value. B. The assets and liabilities of the acquired company are recorded on the consolidated books at adjusted fair value. C. The difference between the tax bases and the recorded values gives rise to deferred taxes. Appendix B : Consolidation of Variable Interest Entities (VIEs) A. A n entity is considered a VIE and is subject to consolidation under FASB Interpretation No. 46 if: 1. Its total equity at risk is not adequate to allow the entity to finance its own activities without additional subordinated financial support, 2. If the voting rights of the equity investors do not reflect their economic interests, or 3. If the equity investors lack one or more of the following three characteristics: a. Direct or indirect ability to make decisions that control the entity, b. The obligation to absorb the expected losses of the entity, or c. The right to receive the expected residual returns of the entity. B. The primary beneficiary of a VIE must disclose: 1. The nature, purpose, size, and activities of the VIE, 2. The carrying amount and classification of consolidated assets that are collateral for the obligations of the VIE, 3. Any lack of recourse by creditors of a consolidated VIE to the general credit of the primary beneficiary.

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    Chapter 4 1 CHAPTER FOUR – CONSOLIDATED FINANCIAL STATEMENTS AFTER ACQUISITION I. THREE METHODS OF REPORTING ON PARENT’S BOOKS A. Investments in voting stock of other companies may be consolidated, or they may be separately reported in the financial statements at cost, at fair value, or at equity. The method of reporting adopted depends on a number of factors including the size of the investment, the extent to which the investor exercises control over the activities of the investee, and the marketability of the securities. B. Generally speaking, there are three levels of influence or control by an investor over an investee, which determine the appropriate accounting treatment. There are no absolute percentages to distinguish among these levels, but there are guidelines. The three levels and the corresponding accounting treatment are summarized as follows: Level Guideline Percentages Usual Accounting Treatment No significant influence Less than 20% Investment carried at fair value at current year - end (trading or available for sale securities) – method traditionally referred to as “Cost” method with an adjustment for market changes. Significant influence (no control) 20 to 50% Investment measured under the equity method Effective control Greater than 50% Consolidated statements required (investment eliminated, combined financial statements): investment recorded under cost, partial equity, or complete equity method. C. Differences among the three methods in accounting for the investment on the books of the parent are also summarized in Figure 4 - 1. D. Cost Method on Books of Investor P Company acquired 90% of the outstanding voting stock of S Company at the beginning of Year 1 for $800,000. Income (loss) of S Company and dividends declared by S Company during the next three years were: During the third year, the firm pays a liquidating dividend (i.e. the cumulative dividends declared exceeds the cumulative income earned). Year Income (Loss) Dividends Declared Cumulative Income Over (Under) Dividends 1 $90,000 $30,000 $60,000 2 (20,000) 30,000 10,000 3 10,000 30,000 (10,000) P’s books Year 1 – P’s Books Investment in S Company 800,000 Cash 800,000

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    Chapter 4 2 To record the initial investment Cash 7,000 Dividend Income 27,000 To record dividends received .9($30,000). Year 2 – P’s Books Cash 7,000 Dividend Income 27,000 To record dividends received .9($30,000). Year 3 – P’s Books Cash 7,000 Dividend Income 18,000 Investment in S Company 9,000 To record dividends received, $9,000 of which represents a return of investment. After these entries are posted, the investment account will appear as follows: Investment in S company (Cost Method) Year 1 Cost 800,000 Year 3 Liquidating dividend 9,000 Year 3 Balance 791,000 Year 1 entries record the initial investment and the receipt of dividends from S Company. In Year 2, although S Company incurred a $20,000 loss, there was a $60,000 excess of earnings over dividends in Year 1. Consequently, the dividends received are recognized as income by P Company. In Year 3, however, a liquidating dividend occurs. From the point of view of a parent company, a purchased subsidiary is deemed to have distributed a liquidating dividend when the cumulative amount of its dividends declared exceeds its cumulative reported earnings after its acquisition. Such excess dividends are treated as a return of capital, and are recorded as a reduction of the investment account rather than as dividend income. The liquidating dividend is 90% of the excess of dividends paid over cumulative earnings since acquisition (90% of $10,000). E. Partial Equity Method on Books of Investor P Company has elected to use the partial equity method to record the investment in S Company above. The entries for the first three years would appear as follows: Year 1 – P’s Books Investment in S Company 800,000 Cash 800,000 To record the initial investment. Investment in S Company 81,000 Equity in Subsidiary Income .9($90,000) 81,000

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