Chapter 8 - Appendix A Business Combinations

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Chapter 8 - Appendix ABusiness Combinations

• 1. Types of business combinations
• 2. Purchase accounting
• 3. Consolidation of purchased subsidiaries
• a. Consolidation process
• b. Recognition of minority interest
• c. Consolidated versus unconsolidated
• 4. Consolidation of foreign subsidiaries

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1. Types of Business Combinations

• Mergers - occur when one company acquires all of
  the assets and liabilities of another company,
  and the acquired company is dissolved.
• Journal entry on acquiring companys books
• Assets xx
• Liabilities xx
• Cash, etc. xx
• Note that this is a shortcut explanation.
  Actually, a statutory merger requires that the
  acquiring company purchases all of the
  outstanding common stock of the acquired company,
  then dissolve the acquired company (no longer a
  separate legal entity). The assets and
  liabilities of the acquired company are absorbed
  into the acquiring companys books, including any
  goodwill that is recognized in the merger.

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1. Types of Business Combinations

• Acquisitions
• Acquisitions occur when one company acquires at
  least 50 of the common stock of another company
  both companies continue to operate as separate
  legal entities, and maintain separate sets of
  books. This is called a parent/subsidiary
  relationship.
• Journal entry on acquiring companys books
• Investment in Subsidiary xx
• Cash, etc. xx
• Note that, at the end of each reporting period,
  the books of the parent and subsidiary must be
  combined when reporting to the parents
  investors. This is called a consolidation.

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1. Types of Business Combinations

• Once a merger is completed, there is now one
  legal entity, and no additional accounting issues
  exist.
• For an acquisition, the acquiring company must
  perform consolidating journal entries each year
  to combine the parent and subsidiary.
• The balance of this chapter is devoted to
  acquisitions.

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2. Purchase Accounting

• Purchase accounting is based on the fair market
  value of an exchange transaction.
• An acquisition treated as a purchase first values
  the fair market value of the things given up in
  the exchange. This can include cash, debt,
  preferred stock, or common stock.
• The value of the cash, debt, equity, etc. becomes
  the value of the investment acquired.
• Goodwill is implied in the investment account, as
  is any asset revaluation.

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2. Purchase Accounting

• The journal entry to record the acquisition as a
  purchase might take the following forms
• for cash
• Investment in Sub xx fair mkt. value
• Cash xx fair mkt. value
• with the issue of common stock
• Investment in Sub xx fair mkt. value
• Common Stock xx par value
• APIC xx excess
• (The credit to CS and APIC is the same as if the
  CS had been issued for cash.)

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2. Purchase Accounting

• Note that the investment account contains the
  following information
• fair value of the net assets of the sub.
• goodwill recognized on acquisition of the sub.
• Alternatively, the investment account contains
  the following information
• book value of the net assets of the sub.
• revaluation of the net assets of the sub.
• goodwill recognized on acquisition of the sub.
• This will become important in the consolidation
  process.

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3. Consolidation of Purchased Subsidiaries

• General Information
• Required for parent/sub relationships (over 50
  of the common stock of the sub is owned by the
  parent).
• Performed to give a better picture of the overall
  structure and performance of the combined entity.

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3. Consolidation of Purchased Subsidiaries

• a. Procedure
• The parent uses the equity method of accounting
  to record income from the investment during the
  year.
• At the end of the year, the separate financials
  of parent and sub are posted to a worksheet.
• The subs column represents the book value of
  the net assets acquired.
• Any assets and liabilities of the sub that need
  to be revalued (to match the assumptions at
  acquisition), are revalued in a consolidating
  journal entry posted only to the worksheet.
• Any goodwill (that was assumed at acquisition) is
  recognized in a consolidating journal entry, and
  subsequently written down if the related assets
  are impaired.

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3. Consolidation of Purchased Subsidiaries

• a. Comments on Procedure - see Figure 8A-4
• Note that the subsidiary does not revalue its
  books at acquisition it is the parent that
  assumes revaluation.
• Note that the subsidiary does not recognize
  goodwill on its books at acquisition it is the
  parent that implies this recognition in the
  Investment account.
• The investment account is replaced by the assets
  and liabilities of the subsidiary, and goodwill
  is recognized explicitly in the consolidation
  process.
• We will focus only on the recognition of goodwill
  in this chapter, since it is usually the largest
  single asset recognized in acquisitions.

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3. Consolidation of Purchased Subsidiaries

• b. Recognition of Minority Interest -
• see Figure 8A-6
• If the subsidiary is less than 100 owned (but
  still greater than 50), the parent still adds
  all of the subs assets and liabilities, and all
  of the subs revenues and expenses in the
  consolidation.
• The parent must then recognize that part of the
  subsidiary belongs to a Minority Interest when
  reporting the results to the parents
  shareholders.

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3. Consolidation of Purchased Subsidiaries

• b. Recognition of Minority Interest
• On the consolidated balance sheet, this amount is
  often presented between liabilities and equity.
  It represents the minority interest claim to the
  assets and liabilities of the subsidiary.
• On the consolidated income statement, there is a
  line that indicates Minority Interest in Net
  Income. This amount is subtracted from total
  net income, to get to the portion of income that
  belongs to the parent.

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3. Consolidation of Purchased Subsidiaries

• c. Consolidated versus Unconsolidated F/S
• Consolidated F/S show more detail as to the
  structure of the combined entity, but the
  performance of the subsidiary (or subsidiaries)
  can be lost in the tradeoff.
• Sometimes the detail of the structure and
  performance of the separate subsidiary can be
  found in the F/S notes regarding segment
  activity, but only if the subsidiary qualifies as
  a reportable segment.
• Some parent companies will also present Parent
  Company financials in addition to consolidated
  financials. The parent company statements show
  the same equity, but the subs activity is
  unconsolidated and shown in Investment in Sub.
  and Income from Sub.

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3. Consolidation of Purchased Subsidiaries

• c. Consolidated versus Unconsolidated F/S
• Note that the consolidation will not change total
  equity, but it will change total assets and
  liabilities.
• This can change any ratios that deal with assets
  and liabilities (return on assets, debt to
  equity).
• The FASB believes that consolidated financials
  reveal more about the asset and liability
  structure of a company. Unconsolidated
  financials would not show separate liabilities of
  the subs.
• Sometimes consolidations may cloud certain
  patterns such as sales growth. A newly acquired
  subsidiary might significantly boost consolidated
  revenue (and the reverse is true when a
  subsidiary is sold). Disclosure can help clarify
  some of the issues.

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4. Consolidation of Foreign Subsidiaries

• Foreign subsidiaries often operate with
  accounting standards that are different from US
  GAAP, and the financials must be converted to US
  GAAP before they can be consolidated.
• Foreign subsidiaries often operate in a
  functional currency that is not the US dollar.
  These subsidiaries must first be converted to the
  US dollar before they can be consolidated with
  the US parent.
• Once the financials are converted to US GAAP and
  US dollars, the rest of the consolidation is the
  same as in part 3.

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4. Consolidation of Foreign Subsidiaries

• The process to convert the foreign subs
  financial statements to the US dollar uses the
  following rules (SFAS 52) to translate the
  financials
• Assets and liabilities are converted at the
  current rate (at the balance sheet date).
• Equity is translated at the historical rate in
  effect at the date of the transaction.

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4. Consolidation of Foreign Subsidiaries

• Different equity accounts are translated at
  specific historical rates in effect at the date
  of the transaction
• common stock and APIC at the date of issue.
• retained earnings components at various
  historical rates
• dividends converted at the date of declaration.
• revenues and expenses are converted at the
  average rate for the year (this is a substitute
  for using the individual historical rates for
  each revenue and expense transaction).

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4. Consolidation of Foreign Subsidiaries

• After everything is converted to dollars, the
  subs balance sheet will not balance. The plug
  or residual amount to bring the balance sheet
  into balance is the Translation Adjustment (or
  Cumulative Translation Adjustment).
• The TA is a debit or credit plug to Stockholders
  Equity. A credit plug adds to the other equity
  accounts. A debit plug is treated as a contra.
• The interpretation of the TA is that it will not
  become part of income until the sub is sold.

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4. Consolidation of Foreign Subsidiaries

• Example of calculation of translation adjustment.
• Given the following information of Beattie
  Company, a British subsidiary, at December 31,
  2005
• All amounts below are in British pounds
• Balance Sheet
• Assets Liabilities and SE
• Cash 15,000 A/P 55,000
• A/R 114,000 Long-term debt 132,000
• Inventories 55,000 Common stock 134,000
• Plant assets 162,000 Retained earn.
  25,000
• Total Assets 346,000 Total Liab. SE
  346,000
• Statement of Retained Earnings
• Retained Earnings, 1/1/05 0
• Add Net income for 2005 35,000
• Less Dividends for 2005 (10,000)
• Retained Earnings, 12/31/05 25,000

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4. Consolidation of Foreign Subsidiaries

• Given the following additional information for
  Beattie Company
• 1. Exchange rates during 2005
• 1/1/05 1.50 per pound
• 9/1/05 1.57 per pound
• 12/31/05 1.60 per pound
• Average 1.54 per pound
• 2. The common stock was issued on 1/1/05.
• 3. The cash dividend was declared on 9/1/05.
• 4. Income is earned evenly throughout 2005.

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4. Consolidation of Foreign Subsidiaries

• Solution
• Assets 346,000 x 1.60 553,600
• Liab. and SE
• Liab. (55132) 187,000 x 1.60 299,200
• Common Stock 134,000 x 1.50 201,000
• Retained Earnings
• Beginning -0- -0-
• Net income 35,000 x 1.54 53,900
• - Dividends (10,000)x 1.57 (15,700)
• Total Liab. and SE (excluding TA)
  538,400
• Translation adjustment (credit) 15,200
• Total Liab. and SE (same as total assets)
  553,600
• Note that the TA, whether debit or credit, is
  presented as part of total stockholders equity
  (as part of other comprehensive income).

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4. Consolidation of Foreign Subsidiaries

• The effect of the TA on equity is equivalent to
  the effect of an unrealized gain or loss on AFS
  investments.
• No gain or loss is realized on translation is
  realized until the subsidiary is sold.
• If the subsidiary continues to operate
  indefinitely in the foreign country, any
  translation gain or loss is deferred.
• Rationale if the foreign subsidiary is
  operating in the foreign currency of the foreign
  country, and is not exchanging the foreign
  currency for US dollars, then no gain or loss
  should be recognized in the income statement.