A.Majority Investments

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Mergers-Notes – 2/03/03

A.Majority investments

1.Unconsolidated statement

a.Use Equity method

i)Actually several equity methods

ii)Text uses complete or full equity method

(1)Includes all typical equity adjustments

(2)Means everything recorded fully prior to consolidation

(3)Means unconsolidated statement follows accounting procedure by itself

(4)Easiest to convert to consolidation

iii)Advantage of the complete or full equity method

(1)Owners’ equity position does not change

(2)Owners’ equity before consolidation = owners’ equity after consolidation

iv)Companies can use incomplete equity method

(1)No specific rules

(2)Use basic equity approach

(3)Ignore some events

(4)Must adjust for the ignored events in consolidation

(5)Without adjustments OE in sub would change and get out of sync

b.Could use cost method

i)Record at acquisition price

ii)Do not adjust value

iii)Must make additional adjustments to get to consolidated statement

iv)Again, without adjustments OE in sub would change and get out of sync

2.On consolidation

a.Must end up the same irrespective of unconsolidated report

b.Ignoring events now means adjusting for them later

c.End up keeping side records to facilitate adjustments

d.Need some records irrespective of method used

B.Types of combinations

1.Statutory merger - A absorbs B; B disappears

2.Consolidation - A & B form C; C survives

3.Asset Acquisition – A acquires part of B

a.B may liquidate

b.B may own part of A (or sell its ownership)

4.Stock acquisition – A buys stock in B

a.B survives

b.May lead to investment position

c.May lead to consolidation – B is a subsidiary

C.Accounting for combinations

1.Pooling v purchase

a.Choose available until 7/2001

b.Purchase only since 7/2001

c.Old pooling accounting doesn’t have to be changed

d.Will be part of company’s books forever

2.Purchase method

a.Determine market value of the cost of the acquisition

b.Allocate cost of transaction across assets

i)Done immediately if acquired firm disappears

ii)Done immediately if assets are acquired from another firm

(1)Asset acquisition entry

Acquired assets (market)

Acquired liabilities (market)

Cost of acquisition (debt, equity, cash)

(2)No consolidation necessary

iii)Called investment in subsidiary if there is a stock acquisition and B survives

(1)Stock acquisition entry

Investment in subsidiary

Cost of acquisition (debt, equity, cash)

(2)Then there is a consolidation

c.Income in the year of acquisition

i)Acquirer’s income for the full year

ii)Acquired firm’s income for rest of the year

3.Goodwill (due to consolidation)

a.Purchase price usually exceeds value of individual assets

b.Value created as a package of assets not valued in assets alone

c.Excess is called goodwill

d.Amortized over up to 40 years before 7/2001

e.Now – no amortization

f.Value reviewed annually

4.Pooling of interests

a.Combination of equals

b.Treated as firms were always together

c.Therefore

i)No purchase so book values are used for combination

ii)Income of the two firms are combined as thought they were always together

iii)Done immediately if assets are acquired from another firm

(1)Asset acquisition entry

Acquired assets (book)

Acquired liabilities (book)

Ownership (book)

(2)No consolidation necessary

iv)Called investment in subsidiary if there is a stock acquisition

(1)Stock acquisition entry

Investment in subsidiary

Ownership (book)

(2)Then there is a consolidation

D.Applying the purchase method – asset acquisition

1.Basic steps

a.Determine the cost of the acquisition

b.Allocate the cost to assets and liabilities

c.Adjust for the interactions between the acquiring and acquired firms

2.Cost of the acquired firm

a.Cash is easy

b.If securities are included

c.Fair value of securities or fair value of assets

i)Fair value of securities easier

ii)Not necessarily value at time of transaction

iii)SFAS 141 suggests considering period around announcement date

d.Costs directly related to combination also included

3.Acquisition cost issues

a.Identify assets and liabilities

b.Allocate the costs

4.Identify tangible assets

a.Easy

b.Already on books

5.Identify intangible assets

a.Ones acquired by acquiree on books

b.Internally developed assets not on books

c.Before SFAS 141 – goodwill was used freely

6.After SFAS 141 –

a.goodwill only if intangible assets cannot be found

b.Intangible asset if

i)It arises from contractual or other legal rights

(1)Patents

(2)Trademarks

(3)Mineral rights

ii)It is can be separated from the acquired entity and sold or licensed

(1)Databases

(2)Customer lists

c.Goodwill asset should be a smaller leftover

d.Impact on amortization

i)None for goodwill

ii)Shorter period for newly recognized intangibles (less than 40 years)

7.Cost allocation methods

a.Methods clear for some assets

b.Marketable securities – use market prices

c.Accounts receivable – expected discounted cash flows (EUA)

d.Inventory – replacement cost or NRV-∏

i)Cost of acquisition

ii)Estimated market value minus normal rate of return

iii)Subtracting profit recognizes that profit is obtained only on sale

e.PPE – replacement cost (estimates can be tough)

i)No real market for used assets

ii)Could be an expected cash flow estimate

f.Liabilities – discounted cash flow

i)Most liabilities have a certain obligation

ii)Could change estimates on warranties

g.Differences from accounting values

i)Some assets recorded at premiums

ii)Some assets recorded at discounts

iii)Same with liabilities

E.Example of a statutory merger

1.A swallows B; B disappears

a.Determine cost of acquisition

i)Includes market value of cash, debt & equity issued

ii)Includes direct costs of acquisition (lawyers’ fees & consultants)

b.Subtract book value of acquisition

c.Result is premium to be allocated to tangible & intangible assets

d.Premium = cost of acquisition – book value

e.Determine allocation of premium to tangible assets

i)Determine fair value of B’s assets

ii)Subtract book value of B’s assets

iii)Result is premium assigned to assets

f.Determine allocation to tangible liabilities

i)Determine fair value of B’s liabilities

ii)Subtract book value of B’s liabilities

iii)Result is premium assigned to liabilities

iv)Reduced value of a liability is like a premium to an asset

g.Leftover premium is assigned to intangibles

i)Determine value of identifiable intangible assets

ii)Writeoff of acquired research and development

h.Leftover is goodwill

i.Goodwill = cost of acquisition – fair value (first pass)

j.Entry

Assets at fair value

Goodwill

Liabilities at fair value

Direct costs

Value of securities issued

F.Negative goodwill

1.Sometimes market value of acquisition less than fair value

2.Need to allocate negative premium across firm

3.Two stage process

a.Determine fair value of assets and liabilities as in any case

b.Excess of fair value over market value is negative goodwill

c.Excess is allocated proportionately to fair value of assets

d.Exceptions

i)Financial assets (except for equity method investments)

ii)Assets the firm intends to sell

iii)Deferred tax assets

iv)Prepaid pension and postretirement benefit assets

v)Other current assets