CHAPTER 7

NEW BASIS OF ACCOUNTING

FOCUS OF CHAPTER 7

• Recognizing a New Basis of Accounting

• The Push-Down Basis of Accounting

• Leveraged Buyouts

Push-Down Accounting: What’s Important—Form or Substance?

• Rationale for Push-Down Accounting:– Relevant factor is the acquisition itself.– Form of the acquisition is NOT relevant.– Parent controls the “form of the

ownership.”• Parent can ALWAYS liquidate the

subsidiary into a branch/division.

Push-Down Accounting: The 3 Step Implementation Process

• STEP 1: – Adjust all assets and liabilities to

current values (“cleanses” the target’s G/L of OLD BASIS).• Record GOODWILL as well.• Offsetting credit is to Revaluation

Capital. (As always, capital is shown by source.)

Push-Down Accounting: The 3 Step Implementation Process

• STEP 2:– Eliminate balance in the

Accumulated Depreciation account.• Thus depreciation cycle begins

anew.

Push-Down Accounting: The 3 Step Implementation Process

• STEP 3: – Close out the balance in the

Retained Earnings account to APIC.• Thus retained earnings starts

afresh.

Push-Down Accounting: When Is It Critical That It Be Used?

• Theoretically: Whenever a subsidiary issues its OWN financial statements to external users.

• GAAP Requirements: – Only the SEC mandates its use. (Only

subsidiaries of publicly-owned companies fall under the SEC’s jurisdiction.)

– The FASB has yet to require it.

Push-Down Accounting: Tastes Great And Less Filling

• Push-down accounting:– Easy to implement.– Record-keeping is on one set of books

instead of two.– Consolidation effort is easy as pie.

Push-Down Accounting: Why Not Used Exclusively?

– One of the great unsolved mysteries of accounting.

– Inertia, stubbornness???

– Clinging to “the way we have always done it”!

Push-Down Accounting: Is There Hope on the Horizon?

– YES! Practitioners tell us they are seeing it more and more.

Leveraged Buyouts: A Combination Purchase & Refinancing

• Basic Elements of a Leveraged Buyout:– Acquisition of a target’s assets or

common stock.– Refinancing of the target’s debt

structure—usually increased substantially.

– Minimal equity investment by buyers.

Leveraged Buyouts: “Let’s Get Management In On The Act”

• An Additional Common Features of LBOs:– Existing management becomes part of the

new ownership.– Existing management’s ownership is often

as high as 50%.• Such LBOs are often called “MBOs.”

• Advantage of Management Being Owners:– Alignment of interests occurs between

management and remaining stockholders.

Leveraged Buyouts: They Are NOT Business Combinations

• Business Combinations:– One active business combines with

another active business.

Leveraged Buyouts: They Are NOT Business Combinations

• Business Combinations:– A single corporation becomes the new

owner of the target’s business. • This one legal entity now controls

the target’s business.

Leveraged Buyouts: They Are NOT Business Combinations

• Leveraged Buyouts:– A group of investors (and often the

target’s management) acquire either• The target’s assets or• Some or all of the target’s common

stock.

Leveraged Buyouts: They Are NOT Business Combinations

• Leveraged Buyouts:– After the buyout, the ownership of the

target’s business may include any of the following groups:• New investors.• Management (at the same or a

higher or lower level of ownership).• Former nonmanagement owners.

Leveraged Buyouts: The Change in Control Concept

• A new basis of accounting is allowed ONLY IF:– A change in control occurs.

• To assess whether a change in control has occurred, the control group concept is used.

Leveraged Buyouts: The “Control Group” Concept

• The control group can consist of:– New investors and– Prior owners who did NOT previously

have control. Could include:• Management.• Nonmangement owners who

owned less than 50% of the outstanding stock.

Leveraged Buyouts: The Control Group Concept

• BEFORE:

• AFTER:

• CONTROL GROUP: 30% + 45% = 70%

Management Nonmanagement Owners Owners (one individual) 10% + 90% = 100% Management Nonmanagement New Owners Owners Investors 30% + 25% + 45% = 100%

Leveraged Buyouts: Manner of Consummating The Buyout

• Creating a New Legal Entity (NLE):– Investors create an NLE.– Investors invest cash in NLE.– NLE acquires target’s common stock

or assets.• If common stock is acquired, NLE

is merely a nonoperating company.

Leveraged Buyouts:Manner of Consummating The Buyout

• Reasons for Creating the New Legal Entity:– Facilitates the change in ownership control:

• Attaining the agreed upon ownership percentage of the various new ownersis much easier to accomplish.

– Enables NEW BASIS of accounting to be used for target’s assets (GAAP compliance).• An important objective for most LBOs.

Leveraged Buyouts: The KEY Issue—Has A Change In Control Occurred?

• Significance of a Change in Control:– Enables use of a NEW BASIS of

accounting for target’s assets.– New basis of accounting is highly

important for most LBOs.• Avoids reporting negative

stockholders’ equity (NSE).• Reporting NSE to lenders is highly

undesirable.

Leveraged Buyouts: What Constitutes a Change in Control?

• The change in control must be:– Genuine– Substantive– Nontemporary

• If not—no change in basis of accounting (record transaction as a recapitalization).

Leveraged Buyouts: Accounting for a Change in Control

• Types of Changes in Control:– No continuing ownership situations:

• Enables 100% use of NEW BASIS of accounting (use Purchase procedures).

– Continuing ownership situations:• Results in partial use of NEW BASIS.• Retains partial use of OLD BASIS.• Applying can be somewhat involved.

Leveraged Buyouts: Continuing Ownership Situations

• In continuing ownership situations, the accounting depends on whether the continuing ownership percentage(hereafter C-O-P)– Increases or– Decreases.

Leveraged Buyouts: Continuing Ownership Situations

• C-O-P Increases:– Continuing owners are called bulls.

• C-O-P Decreases:– Continuing owners are called bears.

Leveraged Buyouts: C-O-P INCREASES

• Accounting Procedures:– Use OLD BASIS of accounting to the

extent of the former ownership percentage that continues as owners. • Called “carryover of predecessor

basis.”• Ignore their personal cost basis.

– Use NEW BASIS of accounting for the remaining ownership interest.

Leveraged Buyouts: C-O-P DECREASES

• Accounting Procedures:– C-O-P Is BELOW 20%:

• Use NEW BASIS of accounting for entire transaction (with some exceptions).

– C-O-P Is 20% or HIGHER:• Use OLD BASIS of accounting to the

extent of the former ownership percentage that continues as owners.

• Use NEW BASIS for remainder.

Review Question #1

In push-down accounting, which accounts are adjusted to a zero balance?

A. Accumulated Depreciation.

B. Additional Paid-in Capital.

C. Retained earnings.

D. Revaluation capital.

E. Goodwill.

F. None of the above.

Review Question #1With Answer

In push-down accounting, which accounts are adjusted to a zero balance?

A. Accumulated Depreciation.

B. Additional Paid-in Capital.

C. Retained earnings.

D. Revaluation capital.

E. Goodwill.

F. None of the above.

Review Question #2

In recording a leverage buyout, which accounts are adjusted to a zero balance?

A. Accumulated Depreciation.

B. Additional Paid-in Capital.

C. Retained earnings.

D. Revaluation capital.

E. Goodwill.

F. None of the above.

Review Question #2With Answer

In recording a leverage buyout, which accounts are adjusted to a zero balance?

A. Accumulated Depreciation.

B. Additional Paid-in Capital.

C. Retained earnings.

D. Revaluation capital.

E. Goodwill.

F. None of the above.

End of Chapter 7

• Time to Clear Things Up—Any Questions?