Hilton Adv 6e PPT Ch03

Electronic Presentations in Microsoft® PowerPoint®

Prepared by

James Myers, C.A.

University of Toronto© 2010 McGraw-Hill Ryerson Limited

Chapter 3, Slide 1© 2010 McGraw-Hill Ryerson

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Chapter 3

Business Combinations


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Learning Objectives1. Define a business combination, and describe the two

basic forms for achieving a business combination2. Compare and contrast the acquisition and new entity

methods3. Evaluate relevant factors to determine whether

control exists in a business acquisition4. Compare the balance sheet of the acquirer after a

purchase-of-net-assets business combination and the consolidated balance sheet after a purchase-of-shares business combination

5. Explain a reverse takeover and its reporting implications


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Introduction

A business combination occurs when one company unites with or obtains control of another company

The “Parent” is the controlling company and the “Subsidiary” is the controlled company

Consolidated financial statements are required to report the combined financial position and results of operations of the Parent and the Subsidiary

Control over another company can be obtained by (i) purchasing substantially all of its net assets, or (ii) acquiring enough of the company’s voting shares to control the use of its net assets

LO 1 Chapter 3, Slide 4© 2010 McGraw-Hill Ryerson

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Introduction

A conglomerate business combination involves regular businesses operating in widely different industries

A horizontal business combination involves businesses whose products are similar

A vertical business combination involves businesses where the output from one can be used as input for the other


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Business Combinations

Business combinations (“takeovers”, “amalgamations”, “acquisitions”, or “mergers”) can be friendly or hostile

In a friendly combination, management and the board of directors of both companies recommend that their shareholders approve the combination proposal

In a hostile combination the management and board of the target company recommends that its shareholders reject the combination proposal, and may employ various defences


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Business Combinations Payment for net assets or shares acquired can

be in cash, promises to pay cash in the future, or the issuance of shares, or a combination of these

The method of payment has a direct bearing on the determination of which company is the acquirer and which is being acquired


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Forms Of Business Combinations Purchase of assets – Control over another company’s

assets can be obtained by purchasing the assets outright, leaving the selling company only with the consideration received for the asset sale and any liabilities present before the sale

Purchase of shares – an alternative to the purchase of assets is for the acquirer to purchase enough voting shares from the shareholders of the acquiree that it can determine the acquiree’s strategic operating, investing, and financing policies Share purchase can be less costly since control can be achieved

by purchasing less than 100% of the voting shares. Share purchases can also have important income tax advantages.


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Forms Of Business Combinations Both forms of business combination result in the

assets and liabilities of the acquiree being combined with those of the acquirer

If control is achieved with the purchase of net assets, the combining takes place in the accounting records of the acquiree

If control is achieved by purchasing shares, the combining takes place when the consolidated financial statements are prepared


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Methods of Accounting for Business Combinations

There are four methods that have been used in practice or discussed in theory over the years: The purchase method The acquisition method The pooling-of-interests method The new entity method


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Methods of Accounting for Business Combinations

The purchase method is required GAAP prior to adoption of the acquisition method which must be adopted on or before January 1, 2011

The pooling-of-interest method was acceptable in limited situations prior to July 1, 2001 and can no longer be used

The new entity method has never been acceptable for GAAP but is worthy of future consideration


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The Purchase Method

Under the purchase method prior to 2011 or earlier adoption of IFRS 3, the acquiring company recorded the net assets of the acquired company in its investment account at the price it paid

Price includes cash payments, FMV of shares issued, and PV of any future cash payments promised

Excess of price paid over the fair value of the acquired company’s net assets are recorded as goodwill


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The Purchase Method

The fair values of identifiable net assets acquired were charged against earnings (amortized) to achieve expense matching

Goodwill was regularly reviewed for impairment and impairment losses were recorded as a charge against earnings

The purchase method is consistent with historical cost principle of accounting – record the price paid for the net assets and amortize the cost over their useful lives


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The Acquisition Method After January 1, 2011 or upon earlier adoption of IFRS

3, the acquiring company will use the acquisition method

The acquiring company records the identifiable net assets at fair values regardless of price paid.

If purchase price is > FV of identifiable net assets the excess is reported as goodwill similar to purchase method

If price paid is < FV of identifiable net assets the difference is reported as gain on purchase

Not consistent with historical cost principle but consistent with general trend toward use of fair values


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The Pooling-of-interests Method

Prior to July 1, 2001, the pooling-of-interests method was used to account for those business combinations where an acquirer could not be identified as a result of a share exchange between the combining companies that made it appear that the combination was a “merger of equals”

The former shareholders of each company in theory were agreeing to combine and continue both businesses as one new business, without disruption to operations or key personnel


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The Pooling-of-interests Method Assets and liabilities are reflected in the combined

company's financial statements at their carrying value in the combining companies' records, resulting in no goodwill and no additional amortization, which made this method attractive

Major problem of pooling-of-interests method was to determine if the companies were truly “equals”

Cannot be used for combinations after July 1, 2001 but combinations that took place prior to that date can still be reported under the pooling-of-interests method


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The New Entity Method

The new entity method has been proposed in the past as an alternative to the pooling-of-interests method requiring the revaluation of assets and liabilities contributed by both shareholder groups

This method has received virtually no support because of the additional revaluation difficulty and costs that would result


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Acquisition Method Acquisition method applies to all business combinations Acquirer should be identified for all business combinations Acquisition date is the date the acquirer obtains control of the

acquiree Acquirer should measure FV of 100% of acquiree regardless of

percentage acquired based on: fair value of consideration given by the controlling shareholder, plus the fair value of either (i) non-controlling shares or (ii) the non-controlling

shareholders’ proportionate share of the acquiree’s identifiable net assets. Business valuation techniques may be required to establish these values

Acquirer should reflect the identifiable assets and liabilities acquired at fair value separately from goodwill


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Identifying the Acquirer Identifying the acquirer using IFRS 3

If cash payments are required for acquisition, acquirer is usually the company making the payments

If shares are exchanged for acquisition, acquirer is the company whose shareholders hold more than 50% of the votes in the combined company, or if more than 2 companies are involved whose shareholders hold largest number of votes

If voting percentages are identical then examine makeup of board and management to see which company is dominant

In a share exchange acquirer is often but not always the company that issues shares

Acquirer is often but not always the larger company


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Allocation of Acquisition Cost

Acquisition cost includes: Any cash paid The fair value of assets transferred The PV of any promises to pay cash in the future The FV of any shares issued, based on the market price of

shares on the acquisition date The FV of contingent consideration (see Chapter 4)

Acquisition costs do not include fees of consultants, accountants, and lawyers which do not increase the FV of acquired company. These should be expensed in the period of acquisition

The cost of issuing debt or shares are not included in acquisition cost but are charged to the related debt or share capital


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Allocation of Acquisition Cost Allocation of acquisition cost:

Allocate to acquirer’s percentage interest in the FV of identifiable assets and liabilities of acquiree

Identifiable assets include those with value not presently recorded by the acquiree, such as internally developed patents. Also include identifiable intangible assets arising from contractual or other legal rights, or being capable of being separated and sold Failure to allocate to identifiable intangible net assets would

inflate goodwill Can allocate only to items that meet the definition of assets

and liabilities under IASB’s Framework. For example, cannot allocate expected cost of terminating the subsidiary’s employees to a liability if the terminations have not yet occurred. In this case the termination cost would be recorded in post-acquisition expense


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Allocation of Acquisition Cost Allocation of acquisition cost (cont’d):

Fair values are determined and allocated for contingent liabilities arising from past events if probable and reliably measurable

Deferred income tax assets and liabilities recorded on the subsidiary’s balance sheet are not revalued and carried forward but are instead replaced by new calculations of deferred taxes.

Any excess of cost over the foregoing represents goodwill (premium paid to achieve control)

If acquisition cost < FV of identifiable net assets, “negative goodwill” arises.

Reduce existing goodwill to zero, recognizing any remaining excess as a gain on the acquisition date.


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Disclosure Financial reporting after combination:

Net income of the acquired company is reported in the consolidated financial statements of the acquirer commencing with the date of acquisition.

Expenses of acquired company must be adjusted to reflect amortization of fair values and any goodwill losses due to impairment.

The combination does not affect prior year comparative balances.


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Illustrations of Business Combination Accounting

To illustrate the accounting method using the acquisition method, we will use the summarized balance sheets of two companies – See Exhibit 3-1

A Company Ltd will initiate the takeover of B Corporation


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Exhibit 3.1


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Illustration of Business Combination Accounting

Assume that on January 1, Year 2, A Company pays $95,000 in cash to B Corporation for all the the net assets of that company, and that no direct expenses are involved. Because cash is the means of payment, A Company is the acquirer

The acquisition is allocated as per the next slide:


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Illustration of Business Combination AccountingIllustration 1

Purchase price 95,000$ Fair market value of net assets acquired 80,000 Difference - goodwill 15,000

A Company would make the following journal entry to record the acquisition of B Corporation

Assets (in detail) 109,000 Goodwill 15,000 Liabilities (in detail) 29,000 Cash 95,000

A COMPANY LTD.BALANCE SHEETJanuary 1, Year 2

Assets (300,000 - 95,000 + 109,000) 314,000$ Goodwill 15,000

329,000$

Liabilities (120,000 + 29,000) 149,000$ Shareholder's equityCommon shares 100,000 Retained earnings 80,000

329,000$


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Illustration of Business Combination Accounting Illustration 2 Assume that on January 1, Year 2, A Company issues 4,000 common shares with a market value of $23.75 per share, to B Corporation as payment for the company’s net assets. B Corporation will be wound up after the sale of its net assets Because the method of payment is shares, the following analysis is made to determine which company is the acquirer:

Shares of A CompanyGroup X now holds 5,000Group Y will hold (on wind-up) 4,000

9,000X holds 56% of A Company’s 9,000 shares therefore X is the acquirer


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Illustration of Business Combination AccountingIllustration 2

Purchase price (4,000 shares @ $23.75) 95,000$ Fair market value of net assets acquired 80,000 Difference - goodwill 15,000

A Company would make the following journal entry to record the acquisition of B Corporation's net assets and the issuanceof 4,000 common shares at fair value on January 1, Year 2:Assets (in detail) 109,000 Goodwill 15,000 Liabilities (in detail) 29,000 Common shares 95,000

A COMPANY LTD.BALANCE SHEETJanuary 1, Year 2

Assets (300,000 + 109,000) 409,000$ Goodwill 15,000

424,000$

Liabilities (120,000 + 29,000) 149,000$ Shareholder's equityCommon shares (100,000 + 95,000) 195,000 Retained earnings 80,000

424,000$


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Control and Consolidated Financial Statements Although parent and subsidiary companies may continue as

separate legal entities after a business combination, GAAP views the substance of the relationship as a single economic entity that should be reported as such since it has a group of economic resources that are under the common control of the parent

An enterprise should consolidate all of its subsidiaries (IAS 27) to inform primarily shareholders and creditors of the parent company about the resources and results of operations of the parent and its subsidiaries as a group, by eliminating all intercompany transactions and presenting only transactions with outside entities

Consolidated financial statements are supplemented with footnote disclosures showing operating segments

Parent and subsidiaries will still be required to prepare their own separate-entity financial statements for income tax filing or internal purposes


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Control and Consolidated Financial Statements IAS 27 does not require consolidated financial

statements for external reporting under the following conditions: Parent is itself a wholly owned subsidiary, or is a partially owned

subsidiary and its owners do not object to the parent not presenting consolidated financial statements;

Parent’s debt or equity instruments are not publicly traded; Parent has not or is not filing financial statements with a regulator

for the purpose of issuing debt or equity instruments on a publicly traded market; and

The ultimate or intermediate parent of the parent produces IFRS-compliant consolidated financial statements available to the public


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Control and Consolidated Financial Statements

How is control determined? Ability to elect majority of board of directors (e.g. by holding

>50% of voting shares) is generally evidence of control If Parent controls C Company which in turn controls D Company;

Parent has indirect control of D Company If A Company holds 60% of the votes in B Company and C

Company holds the other 40%, A would normally have control of B. However if C owns convertible bonds of B or options or warrants to purchase B’s shares which if converted or exercised would give C 62% of the voting shares of B, then C Company, not A Company, would control B Company


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Control and Consolidated Financial Statements How is control determined? (cont’d)

Control can be present with less than 50% of voting shares if other factors indicate control, e.g.: Irrevocable agreement with other shareholders to convey

voting rights to parent If parent holds rights, warrants, convertible debt, or

convertible preferred shares that would, if exercised or converted, give it >50% of votes

Written agreements allow parent to dictate subsidiary’s operating policies and to receive income & intercompany profits from subsidiary (e.g. special purpose entities examined in Chapter 9 in which parent holds the risks and rewards of ownership while owning few, if any, of the shares of the controlled company).


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One company may own the largest single block of shares of another company, e.g. X Company owns 40% of Y Company while the other 60% is widely held and rarely voted with the result that X has no trouble electing the majority of Y’s directors. IASB Exposure Draft on Consolidated Financial Statements indicates that X would have control of Y provided Y’s shareholders are not organized in such a way that they actively cooperate against X when they vote their shares. Under previous Canadian GAAP this would not have given X

control since it would require the cooperation of the other 60% of shareholders not to vote.

Control and consolidation cease if for example the majority of a subsidiary’s assets are seized in a bankruptcy or if a foreign subsidiary is restricted by law from paying dividends to the parent.


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The existence of certain protective rights held by other parties does not necessarily provide those parties with control. Examples: Approve or veto rights that do not affect strategic operating

and financing policies The right to approval capital expenditures greater than a

particular threshold, or the right to approve the issue of equity or debt

The ability to remove the controlling party in the event of bankruptcy or breach of contract

Certain limitations on the operating activities of an entity, such as pricing or advertising limitations typically placed by franchisors on franchisees


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Illustration of Business Combination Accounting Illustration 3: Assume that on January 1, Year 2,

A Company pays $95,000 cash to the shareholders of B Corporation for all of their shares, and that no expenses are involved. Because cash was the means of payment, A Company is the acquirer.

The financial statements of B Corporation have not been affected by his transaction because the shareholders of B, not the company itself, sold their shares.

See Exhibit 3.2 & 3.3 on the next slides.


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Exhibit 3.2


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Exhibit 3.3


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Illustration of Business Combination Accounting Note the following for Exhibit 3.3:

A Company’s “Investment in B Corporation” balance and B Corporation’s common shares and retained earnings have been eliminated in entry (1) because they are reciprocal

The acquisition differential does not appear on the consolidated balance sheet but is reallocated to the net assets of B Corporation in entry (2)

The book values of B’s net assets + difference between B’s FV and BV = FV of B’s assets and liabilities

The elimination entries are made on the working paper only and not in the books of either company

On the date of acquisition, consolidated shareholders’ equity is always equal to the parent’s equity


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Disclosure IFRS 3 Appendix B lists the following significant

items to be disclosed for each business combination: The acquisition-date fair values of total consideration

given and each class of consideration given The acquisition-date values recognized for each major

class of assets acquired and liabilities assumed Legal and other restrictions and the carrying amount

of the assets and liabilities to which those restrictions apply


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GAAP for Private Enterprises Section 1590: Subsidiaries of Part II of the CICA

Handbook requires: All subsidiaries should either be consolidated or

accounted for using either the cost or the equity method except when a subsidiary’s equity securities are publicly traded in which case they should be recorded at market value with changes recorded in net income

Investments in and income from non-consolidated subsidiaries should be presented separately from other investments


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Reverse Takeovers Occur when one company obtains ownership of the

shares of another by issuing enough voting shares as consideration that control of the combined enterprise passes to the shareholders of the acquired enterprise

Example: A Company has 5,000 shares outstanding and issues an additional 7,000 shares to the shareholders of B Company in order to acquire 100% of the shares of B Company. The shareholders of B Company now own 7,000 out of 12,000 (58%) shares of A and are therefore in control of the combined enterprise.


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Reverse Takeovers Legally, A is the parent of B but for accounting purposes

B is the parent of A For acquisition accounting it is necessary to calculate the

acquisition price for B’s acquisition of A Determine the number of shares of B that were outstanding

before the combination Determine the number of additional shares that B would have

had to issue to reduce B’s shareholders to 58% ownership of B Number of additional shares x FV = Acquisition cost

Disclose the nature of the reverse takeover in the notes to B’s consolidated financial statements


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Hilton Adv 6e PPT Ch03