Type:
Solution Manual
Resource:
Advanced Accounting
Edition:
12th Edition
Author(s):
Floyd A. Beams Joseph H. Anthony Bruce Bettinghaus Kenneth Smith
Chapter 1 BUSINESS COMBINATIONS Chapter Outline A BUSINESS COMBINATION IS THE UNION OF PREVIOUSLY SEPARATE BUSINESS ENTITIES. A
Horizontal integration is the combination of firms in the same business lines and markets.
B
Vertical integration is the combination of firms in the same business, but with operations in different, successive, stages of production and/or distribution.
C
Conglomeration is the combination of firms with unrelated and diverse products and/or service functions.
D
Reasons companies choose to expand through combination rather than by building new facilities include: 1 2 3 4 5 6
Cost advantage - may be less expensive to acquire rather than build facilities or develop R&D Lower risk - may be less risky to acquire product lines or markets rather than develop new products, particularly if the goal is diversification Fewer operating delays - the facilities are in place, thereby shortening the time to market Avoidance of takeovers Acquisition of intangible assets Other reasons - business tax advantages, such as tax loss carryforwards
ANTITRUST LAWS PROHIBIT BUSINESS COMBINATIONS THAT RESTRAIN TRADE OR IMPAIR COMPETITION. A
Proposed business combinations are reviewed by federal agencies such as the Justice Department, the Federal Trade Commission, the Federal Reserve Board, the Department of Transportation, the Federal Communications Commission, and the Securities and Exchange Commission.
B
State agencies review business combinations for possible violations of state statutes.
C
Combining companies can argue that cost savings or better products could offset decreased competition.
LEGAL FORM OF BUSINESS COMBINATIONS: .
1
A
Acquisition: 1 2
B
One corporation acquires the productive assets of another business entity and integrates those assets into its own operations (see B & C below), or One corporation obtains operating control over the productive facilities of another entity by acquiring a majority of its outstanding voting stock. A + B = A + B (usually requires consolidated statements)
Merger: One corporation takes over all the operations of another business entity and that entity is dissolved (see Illustration 1-1). A+B=A
C
Consolidation: A new corporation is formed to take over the assets and operations of two or more separate business entities and all the combining companies are dissolved (see Illustration 1-1). A+B=C
D
Business combination: A corporation and one or more incorporated or unincorporated businesses are brought together under the control of a single management team. That control is established when:
E
1
One or more corporations becomes a subsidiary (i.e., when another corporation acquires a majority of its outstanding voting stock),
2
One company transfers its net assets to another, or
3
Each company transfers its net assets to a newly formed corporation.
Merger, consolidation, and acquisition are often used in a generic sense as synonyms for business combinations. The term "consolidation" also refers to the accounting process of combining a parent company’s financial statements with those of its subsidiaries.
GAAP .
2
A
The pooling of interest method of accounting was eliminated for all transactions initiated after June 30, 2001. All subsequent combinations must use the acquisition method.
2
Prior combinations accounted for by the pooling of interests method were allowed to continue as acceptable financial reporting practice for past business combinations.
3
Elimination of pooling makes U. S. GAAP more consistent with international accounting standards. Most major economies prohibit the use of pooling of interests accounting.
Acquisition method (all business combinations initiated after 12/15/08 follow the same GAAP used in recording the purchase of other assets and liabilities).
3
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1
1
Cost is measured by the cash disbursed, the fair value of property given up, or the fair value of securities issued.
2
Direct costs of acquisition: a
Direct costs of registering and issuing securities are charged against additional paid-in capital.
b
Other direct costs of combining (accounting and legal fees) are expensed.
c
Costs to close duplicate facilities, and other indirect costs are expensed.
Recording fair values in an acquisition – steps to record an acquisition: a
Determine the fair values of all identifiable tangible and intangible assets acquired and liabilities assumed.
b
GAAP provides specific guidelines for valuing assets and liabilities.
c
All identifiable assets and liabilities are valued regardless of whether they are recorded on the books of the acquired company (e.g., a patent where all R&D was expensed as incurred).
d
Assets and liabilities that arise from contingencies should be recognized at fair value if fair value can be reasonably estimated.
e
Exceptions to fair value include deferred tax assets and liabilities, pensions and other benefits, and leases. These items should be accounted for pursuant to specific accounting principles governing these items. 3
f
4
No value is assigned to goodwill recorded on the books of the acquired company.
The acquiring company records the assets received and liabilities assumed at their fair values. a
First, fair values are assigned to all identifiable tangible and intangible assets acquired and liabilities assumed. (1) See text Exhibit 1-2 for a list of intangible assets that meet the criteria for recognition. Recognizable intangible assets must meet either a separability or a contractual-legal criterion.
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.
b
If cost is greater than fair value of the identifiable net assets acquired, the excess cost is assigned to goodwill.
c
If fair value is greater than cost, the excess fair value is recorded as an ordinary gain by the acquirer.
Contingent Consideration in a Purchase Business Combination a
Contingent consideration is an additional payment made to the previous stockholders of the acquired company contingent on future events or transactions. The contingent consideration may include the distribution of cash, other assets, or the issuance of debt or equity securities.
b
Contingent consideration must be measured and recorded at fair value as of the acquisition date as part of the consideration transferred in the acquisition.
c
If the contingent consideration is to be paid in additional shares to acquiree, it is in the form of equity, and the Investment and Paid in Capital accounts are increased by the value of the contingent consideration.
d
If the contingent consideration is to be paid in cash to the acquiree, the Investment and liability accounts are increased by the fair value of the contingent consideration.
e
If the contingency is based on security prices, the recorded cost of the acquired company should not change. When the contingency is resolved, the fair market value of the additional consideration is applied to proportionately reduce securities issued and recorded at the date of acquisition.
4
f
In the case of a liability, the acquirer measures the fair value of the contingency at each reporting date until the contingency is resolved, and changes in value are recorded as gains and losses, with corresponding adjustments to the liability.
THE GOODWILL CONTROVERSY A
Goodwill is defined as the excess of the investment cost over the fair value of assets received.
B
Goodwill is no longer amortized for financial reporting purposes. In certain cases, it can be amortized and deducted over 15 years.
C
Firms must periodically assess goodwill for impairment in its value. An impairment occurs when the recorded value of goodwill is greater than its fair value.
D
1
When an impairment occurs, firms must write down goodwill to a new estimated amount and record a loss in calculating net income of a period.
2
The treatment of goodwill has not retroactively changed, but firms will cease amortizing all previously recorded goodwill.
3
Goodwill and all other intangibles that have indefinite useful lives will be periodically reviewed (at least annually) and adjusted for value impairment but no longer amortized.
GAAP also redefines the reporting entity in accounting for intangible assets. Firms will treat goodwill and other intangible assets as assets of the business reporting unit. 1
These intangible assets will be reported based on their fair value at acquisition date.
E
Internally developed intangibles that are not specifically identifiable, have indeterminate lives, or are inherent in a continuing business related to the entity will not be recognized as an asset, but expensed (the same treatment will continue for acquired research and development costs).
F
Recognizing and measuring impairment losses related to goodwill, a two-step process 1 Step one compares carrying (book) values to fair values at the business reporting unit level. If fair value is less than book value, an impairment has occurred. 2
.
Step two measures the impairment. The carrying value of goodwill is compared to its implied fair value. The excess book value over implied fair value is the impairment loss. The loss cannot exceed the book value of the goodwill. Previously recognized impairment losses cannot be reversed. 5
3
G
H
The impairment test is conducted at least annually, and more frequently if certain conditions warrant.
Amortization versus non-amortization 1
Amortization is required for intangible assets with a definite useful life.
2
The method of amortization should reflect the expected pattern of consumption of the economic benefits of the intangible asset.
3
If a pattern is not determinable, straight-line amortization is acceptable.
4
Firms will not amortize intangibles with an indefinite life that cannot be estimated. Like goodwill, these assets should be periodically evaluated for possible impairments.
Financial Reporting: Financial statement disclosures for a business combination: a
The name and a brief description of the acquired company, acquisition date and portion of voting stock acquired, reason for the acquisition, and the manner in which acquirer obtained control.
b
Information about goodwill or gain from a bargain purchase.
c
Nature, terms, and fair value of consideration transferred.
d
Details about assets acquired, liabilities assumed, and any noncontrolling interests.
e
Reduction in acquirer’s pre-existing deferred tax asset valuation allowance due to the business combination.
f
Information about transactions with the acquire accounted for separately from the business combination.
g
Details about step acquisitions.
h
In the case of a public company acquirer, pro-forma information.
In addition, GAAP requires: 1
.
Material aggregate amounts of goodwill be reported as a separate balance sheet item 6
2
Goodwill impairment losses must be shown separately on the income statement as a component of income from operations
3
Increased disclosures for intangibles (See text Exhibit 1-3)
SARBANES-OXLEY ACT OF 2002 A
After the high-profile collapses of WorldCom, Enron, and other companies, Congress enacted legislation intended to prevent future financial reporting and auditing abuses, the result was the Sarbanes-Oxley Act of 2002 (SOX).
B
The new rules focus primarily on corporate governance, auditing, and internal control issues.
C
The law has far-reaching implications including:
D
1
Establishment of an independent board, Public Company Accounting Oversight Board, to regulate the accounting and auditing professions.
2
Requirements restricting certain services provided by auditors to their audit clients.
3
Requirements for greater independence of corporate board of directors.
4
Requirements that the CEO and CFO certify the financial statements and the entity’s internal control.
5
Requirements that independent auditors review and attest to management’s internal control assessments.
6
Increased disclosures relating to off-balance sheet financing, contractual obligations.
7
Increases the types of items requiring disclosure on Form 8-K and shortens the filing period.
Text Exhibit 1-5 provides an example of management’s responsibility for financial results and report on internal control.
Description of assignment material
Minutes
Questions (5) Exercises (5) El-1 4 MC general El-2 [Pat/Sag] AICPA 2 MC problem-type .
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5 10
El-3 El-4 El-5
[Pal/Sip] Prepare stockholders’ equity section [Pan/Set] Journal entries to record an acquisition [Pan/Sis] Journal entries to record an acquisition with direct costs and fair value/book value differences
Problems (5) Pl-1 [Pin/San] Prepare balance sheet after acquisition Pl-2 [Pet/Sea] Prepare balance sheet after an acquisition Pl-3 [Par/Sin] Journal entries and balance sheet an acquisition Pl-4 [Pub/Sun] Allocation schedule and balance sheet Pl-5 [Pat/Saw] Journal entries and balance sheet for an acquisition
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20 20 18 25 35
Internet assignment Using annual reports from the websites of three major publicly traded companies, answer questions regarding merger activity. For one company, review Form 10-K and determine what additional information is disclosed that is not available in the annual report.
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Illustration 1-1
DIAGRAM OF BASIC TYPES OF BUSINESS COMBINATIONS MERGER
Company A (Surviving Entity)
Net assets of B
Company B (Dissolved Entity)
Company A may acquire the net assets of Company B by issuing debt or equity securities or assets directly to Company B for B's net assets or to B's stockholders for all of B's outstanding stock. In either case, Company B is dissolved and Company A takes over the net assets of Company B. A+B=A CONSOLIDATION Company B Net Assets of B
(Dissolved Entity)
Net Assets of C
Company C (Dissolved entity)
Company A (A new entity)
Company A may acquire the net assets of Company B and Company C by issuing stock directly to Companies B and C for their net assets or to the stockholders of Companies B and C for all of their stock. In either case, Companies B and C are dissolved and Company A takes over their assets. A+B=C ACQUISITION OF NET ASSETS WITHOUT DISSOLUTION .
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Company A (Acquiring Entity)
All or a major portion of B's operating assets Company B
Same as for a merger or consolidation except that Company A issues debt or equity securities or assets directly to Company B and Company B continues to exist as a separate legal entity.
ACQUISITION OF OUTSTANDING STOCK
(Parent-Subsidiary operations and consolidated financial statements)
Over 50% of Stock of B
Company A (Parent)
Company B (Subsidiary)
Similar to a merger or consolidation except that Company A receives a majority of the outstanding voting stock of Company B by issuing debt or equity securities or assets to the stockholders of Company B. Company B continues to exist as a separate legal entity and to operate in a parentsubsidiary relationship with Company A. A+B=A+B
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Illustration 1-2 Business Combinations Mergers
Consolidations Acquisition of Net Assets
Acquisition of Controlling Interest
Purchase Accounting Needs Investment Acctg. Cost vs. Equity Needs Consolidated Statements
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Chapter 2 STOCK INVESTMENTS - INVESTOR ACCOUNTING AND REPORTING Chapter Outline ACCOUNTING FOR STOCK INVESTMENTS – ALL STOCK INVESTMENTS MUST BE RECORDED AT THE INVESTOR’S COST (FAIR VALUE AT ACQUISITION). A
TWO METHODS OF ACCOUNTING FOR STOCK INVESTMENTS GENERALLY APPLY (FAIR VALUE/COST AND EQUITY).
B
In the absence of evidence to the contrary, an investment of 20% or more is presumed to give the investor an ability to exercise significant influence. The equity method requires that the investment be recorded at cost and the investment account adjusted for earnings, losses, and dividends. 1
The equity method should not be used if the ability to exercise significant influence is temporary or if the investee is a foreign company operating under severe exchange restrictions or controls.
2
GAAP provides indicators of the inability to exercise significant influence: a
Opposition by the investee that challenges the investor’s influence
b
Surrender of significant stockholder rights by agreement between investor and investee
c
Concentration of majority ownership
d
Inadequate or untimely information to apply the equity method
e
Failure to obtain representation on the investee’s board of directors
ACCOUNTING FOR NONCURRENT COMMON STOCK INVESTMENTS UNDER THE FAIR VALUE/COST METHOD: A
The fair value/cost method is used for common stock investments of less than 20% unless it can be demonstrated that the investor company has the ability to exercise significant influence over the investee company.
B
GAAP classifies equity securities that have a readily determinable market value as either trading securities or available-for-sale securities. 1
.
Investment is initially recorded at cost. 12
2
The investment is adjusted to fair value at the end of the fiscal period.
3
Unrealized gains or losses are reported either in income or as an equity adjustment to the balance sheet (other comprehensive income), depending on the company’s intention for holding the stock.
4
Unrealized gains and losses associated with ‘trading’ securities are recorded as part of income. a
5
Unrealized gains and losses associated with ‘available for sale’ securities are considered “other comprehensive income” and are reported in the income statement, on a separate statement of comprehensive income, or in a statement of changes in equity. a
C
Trading securities are very short-term holdings – continued relationships are not expected.
Only dividend income and realized gains and losses impact income and EPS for available for sale securities.
Under the fair value/cost method: 1
Investment is initially recorded at cost.
2
Dividends received are recorded as dividend income. a
An exception: Liquidating dividends are deducted from the investment account. Liquidating dividends are those dividends received in excess of the investor’s share of earnings after the stock is acquired and are considered a return of capital.
ACCOUNTING FOR NONCURRENT COMMON STOCK INVESTMENTS UNDER THE EQUITY METHOD: A
.
Application of the equity method 1
The investment is initially recorded at cost.
2
Subsequently, the investor records its share of the investee’s income as an increase to the investment account (losses will decrease the investment account).
3
Dividends received from the investee are recorded as a decrease to the investment account.
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a
4
The investment account moves in the same direction as the investee’s net assets (for example, income increases assets for both).
Additional adjustments are required. a
Intercompany profits and losses are eliminated until realized.
b
Cost-book value differentials are accounted for as if the investee were a consolidated subsidiary. (1) The difference between the investment cost and the underlying equity is assigned to identifiable assets and liabilities based on their fair values with any remaining difference allocated to goodwill. (2) The difference between investment cost and book value acquired will disappear over the remaining lives of identifiable assets and liabilities, except for amounts assigned to land, goodwill, and intangible assets having an indeterminate life, which are not amortized. (3) If the book value acquired is greater than the investment cost, the difference should be allocated against non-current assets other than marketable securities with any remaining amount treated as an extraordinary gain (negative goodwill).
c
The investment is reported on one line of the investor’s balance sheet and income on one line of the investor’s income statement, a one-line consolidation. (1) Except extraordinary and other below-the-line items
C
D
Accounting for an interim investment 1
Absent evidence to the contrary, income of the investee is assumed to be earned proportionately throughout the year.
2
The investee’s book value at an interim date is determined by adding income earned from the last statement date to beginning stockholders’ equity and deducting dividends declared to the date of purchase.
Investments acquired step-by-step 1
.
An investor may acquire significant influence through a series of purchases.
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2
Prior to obtaining significant influence, the fair value/cost method is used. When an investment qualifies for the equity method, the investment account is adjusted to the equity method and the investor’s retained earnings are adjusted retroactively. a
E
This is a change in reporting entity and it requires retroactive restatement if material.
Sale of an equity interest 1
When an investor reduces its equity interest in an investee to below 20%, the retained investment is accounted for under the fair value/cost method. a
Gain or loss from the equity interest sold is the difference between the selling price and the book value of the equity interest immediately before the sale.
b
Immediately after the sale, the balance of the investment account becomes the new cost basis.
F
If the stock is purchased directly from the investee (rather than its shareholders), the investor’s interest is determined by dividing shares acquired by shares outstanding immediately after the issuance of the additional shares.
G
Investees with preferred stock
H
1
Special adjustments are necessary when investees have both common and preferred stock outstanding.
2
Investee’s stockholders’ equity must be allocated into its common and preferred stock components to determine the book value of the common stock investment.
3
Investee’s net income must also be allocated into common and preferred stock components.
4
Call or liquidating premiums and dividends in arrears must also be considered in determining the investor’s share of earnings.
EXTRAORDINARY ITEMS – one-line consolidation does not apply. Investment income must be separated into ordinary and extraordinary components.
DISCLOSURES FOR EQUITY INVESTMENTS
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15
A
B
Material investments accounted for by the equity method require disclosure of: 1
The investee’s name and percent of ownership in common stock, the investor’s accounting policies with respect to investments in common stock, the cost/book value differentials and accounting treatment
2
The aggregate value of each identified investment for which quoted market prices are available
3
Summarized information about the investee’s assets, liabilities, and results of operations
Related party transactions 1
Related party transactions arise when one of the transacting parties has the ability to significantly influence the operations of the other.
2
There is no presumption of arms-length bargaining between the related parties.
3
Required disclosures include the nature of the relationship, a description of the transaction, the dollar amount of the transaction (and any change in the method used to establish the terms of the transaction), and amounts due to or due from related parties at the balance sheet date for each balance sheet presented.
TESTING GOODWILL FOR IMPAIRMENT A
GAAP eliminates former requirements to amortize goodwill; rather, goodwill must be periodically tested for impairment. 1
B
Firms may find this valuable for two reasons. a
Firms may recognize significant impairment losses on initial adoption which are treated as a “cumulative effect of an accounting change” (appears after “income from operations”).
b
Firms will no longer report annual goodwill expense charges.
Recognizing and measuring impairment losses is a two-step process. 1
First, carrying values and fair values of net assets are compared at the business reporting unit level. a
.
If fair value is greater than carrying value, goodwill is deemed unimpaired and no further action is necessary.
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