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ASC 805 - Business Combinations

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November 18, 2017

Regan Garey, DBA, CPA

Acquisition Method

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ASC 805-10 provides guidance on the acquisition method, specifically addressing the following:

• Whether a particular transaction or event is a business combination

• The identification of the acquirer and the acquisition date

• The period of time that an acquirer has to adjust provisional amounts, referred to as the measurement period.

• The determination of what is part of a business combination transaction. (FASB)

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805-20 Identifiable Assets and Liabilities and Any Noncontrolling Interest

ASC 805-20 provides further guidance on the acquisition method, specifically discussing the recognition and measurement of the following:

Key Components of ASC 805

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• Identifiable assets• Liabilities• Goodwill treatment• Tax implications.

Overview

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Tax benefits can be a critical, motivating factor for entering into an alliance rather than an alternative structure.

Tax attributes available with an alliance formation can create advantages over traditional M&A transactions. (PWC)

Mergers & acquisitions —a snapshot Changing the way you think about tomorrow’s deals

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Formation stage

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Here, the tax structure and initial decisions are made and the alliance is created.

Tax decisions made at the onset of the alliance formation will carry impacts for the entire alliance life cycle, not just in the initial stage of formation.

Each alliance structure will have its own tax advantages and consequences.

Immediate Tax Costs

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Generally, limiting immediate tax costs is the primary objective at formation.

This would include deferring immediate taxes and accelerating tax benefits.

PWC Example

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How an alliance is formed will impact the available tax benefits and associated tax costs for the alliance and its owners.

In the U.S., pass through entities and other alliance tax structures can generally defer current tax costs, prevent double taxation, and allow for a more efficient use of existing tax attributes.

Unused tax benefits

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The amounts of unused tax benefits at the participant level may impact the motivations and direction of the alliance formation.

Participants should be aware that some structures may trigger immediate tax costs in the form of transfer or stamp taxes.

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Contributions during Formation

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During formation, participants will decide what function the alliance will serve, and therefore what assets, such as:Fixed assets or intellectual property, the participants agree to contribute or provide access (such as licensing or leasing arrangements).

Depending on the type of assets and method of providing access, there are different tax effects.

An Example

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Suppose an alliance is formed as a partnership in a country with currency controls. There are regulatory limitations and exchange rate impacts to repatriating cash. Cash may be costly to repatriate to the participant in the U.S. and may be best spent on permanent reinvestment in the alliance. Determining which jurisdiction to form the alliance should include expectations for distributing income from the alliance.

Ongoing Stage

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During the ongoing stage, the alliance may distribute earnings to participants.

Ongoing Stage

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A number of decisions made at formation will impact the amounts available for distribution:i) determining which participant should receive the benefits of the alliances’ tax attributes, ii) leaving enough working capital available for the alliance to meet its operational requirements, andiii) ensuring tax compliance.

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Ongoing Stage

PWC

alliances-tax-planning-considerations.pdf

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While ideally made at formation, the execution of these decisions and the actual results of the alliance operations will dictate the distributions to each participant.

Business Combination

Understand that completeownership is not a prerequisitefor the formation of a businesscombination.

Break Out Questions

What is the prior name and the current name of a parent company owning less

than 100% of another? What is the significance of this name??

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Noncontrolling Interest

Although most parent companies do possess 100 percent ownership of their subsidiaries, a significant number establish control with a lesser amount of stock.

If the parent doesn’t own 100% of the company, WHO owns the rest of it?

Noncontrolling Shareholders

The ownership interests of the Noncontrolling Shareholders must be reflected in the consolidated financial statements.

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Noncontrolling Interest

The Parent, with controlling interest, must consolidate 100% of the Subsidiary’s financial information. The acquisition method requires that the subsidiary be valued at the acquisition-date fair value.

Total Acquired Firm Value/Partial Acquisitions

The total acquired firm fair value in a partial acquisition is the sum of

The fair value of the controlling interest. The fair value of the noncontrolling

interest at the acquisition date.

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Noncontrolling Interest Example

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Assume Parker Corporation wants to acquire 90% of Strong Company. Strong’s stock has been trading for around $60 per share.

Parker has to pay a premium for the shares needed to gain control.

If Parker pays $70 per share to induce enough stockholders to sell, how will the 10% of Strong that Parker does not own be recorded?

Noncontrolling Interest Example

Parker purchased 9,000 shares at $70 per share. The fair value of their consideration transferred is $630,000.

The remaining 1,000 shares trade at $60 per share indicating that the fair value of the noncontrolling interest is $60,000. The total acquisition-date fair value of the sub is $690,000.

Fair value of controlling interest :($70 X 9,000 shares) . . . . . . . . . . . . . . . $630,000Fair value of noncontrolling interest ($60 X 1,000 shares) . . . . . . . . . . . . . . . . . 60,000Total fair value of sub. . . . . . . . . . . . . . $690,000

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Allocating Goodwill

Allocate goodwill acquired ina business combination acrossthe controlling and noncontrollinginterests.

Noncontrolling Interest Example

The total acquisition-date fair value (amount paid) of Strong of $690,000 is greater than the fair value of the identifiable net assets acquired of $600,000 (10,000 shares x $60 per share). The difference is allocated to Goodwill.

The parent first allocates goodwill to its controlling interest for the excess of the fair value of the parent’s equity interest over its share of the fair value of the net identifiable assets. ($600,000 X 90% = 540, 000).

Goodwill allocated to the controlling and noncontrolling interests will not always be proportional to the percentages owned.

Noncontrolling Interest Example

Total acquisition-date fair value . . . . . . . . . . $690,000Fair value of net identifiable net assets . . . . . (600,000)Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 90,000

There is no excess goodwill to assign to the noncontrolling interest.

Assign Goodwill: Controlling NoncontrollingInterest Interest

Fair value at acquisition date . . . . . $630,000 $60,000Relative fair value of identifiable netassets acquired ($600,000 X 90%). . (540,000) ----------and ($600,000 X 10%) . . . . . . . . . . . . . --------- ($60,000)Goodwill . . . . . . . . . . . . . . . . . . . . . . . $90,000 $0

Noncontrolling Interest - Example

If the shares were not actively traded, the $70 per share consideration transferred by Parker would be considered the best measure of fair value of Strong, and the fair value of the noncontrolling interest would be estimated at $70,000.

Fair value of controlling interest ($70 X 9,000 shares) . $630,000Fair value of noncontrolling interest ($70 X 1,000 shares). 70,000Total fair value of Strong Company . . . . . . . . . . . . . . . . $700,000

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Noncontrolling Interest - Example

Assign Goodwill: Controlling NoncontrollingInterest Interest

Fair value at acquisition date . . . . . $630,000 $70,000Relative fair value of identifiable netassets acquired ($600,000 X 90%). . (540,000) ----------and ($600,000 X 10%) . . . . . . . . . . . . . --------- ($60,000)Goodwill . . . . . . . . . . . . . . . . . . . . . . . $90,000 $10,000

Because the price per share paid by the parent equals the noncontrolling interest per share fair value, goodwill is recognized proportionately across the two ownership groups.

Allocation of Noncontrolling Interest

Understand the computationand allocation of consolidatednet income in the presence of anoncontrolling interest.

Allocating Subsidiary’s Net Income

The subsidiary’s net income (including excess acquisition-date fair-value amortizations) must be allocated to its owners - the parent and the noncontrolling interest - to properly measure their respective equity in the consolidated entity.

Assume that the relative ownership percentages of the parent and noncontrolling interest represent an appropriate basis for attributing all elements (including excess acquisition-date fair-value amortizations for identifiable assets and liabilities) of a subsidiary’s income across the ownership groups.

Allocating Sub’s NI cont’d

Including the excess fair-value amortizations is based on the assumption that the noncontrolling interest represents equity in the subsidiary’s net assets as remeasured on the acquisition date.

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Strong earns $80,000 in the first year and there is a $30,000 annual excess fair value amortization.

Noncontrolling Interest - Example

The $5,000 noncontrolling interest in the sub’s net income is subtracted from the combined entity’s consolidated net income to derive parent’s interest in consolidated net income.

Four NCI Figures Calculated

Identify and calculate the fournoncontrolling interest figuresthat must be included withinthe consolidation process andprepare a consolidation worksheetin the presence of a noncontrollinginterest.

Noncontrolling Interests and Consolidations

The consolidation process remains substantially unchanged with a noncontrolling interest. The parent company must determine and then enter each of these figures when constructing a worksheet:

Noncontrolling interest: In subsidiary at beginning of the current year. In subsidiary’s current year net income. In subsidiary’s current year dividend payments.

In subsidiary as of the end of the year.

Noncontrolling Interest - Example

Assume that King Co. acquires 80% of Pawn Co’s 100,000 outstanding voting shares on January 1, 2014, for $9.75 per share or a total of $780,000 cash.

The shares are trading at an average of $9.75 per share before and after the acquisition.

The total fair value of Pawn to be used initially in consolidation is:

Consideration transferred by King. . . . . . $780,000Noncontrolling interest fair value . . . . . . . .195,000Pawn’s total fair value on Jan. 1, 2014 . . . $975,000

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Noncontrolling Interest -Excess Fair Value Allocations Noncontrolling Interest - Example

Pawn Company changes in retained earnings since acquisition:Net income - Current year (2015) . . . . . . . . . . . . $90,000Less: Dividends declared. . . . . . . . . . . . . . . . . . . . .(50,000)Increase in retained earnings (2015) . . . . . . . . . . $40,000Prior years (2014) Increase in retained earnings. $70,000

To complete the information needed for this combination, assume that Pawn Company reports the following changes in retained earnings since King’s acquisition:

Using a Worksheet and Journal Entries

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Breakout Questions

Why use a worksheet- what information is needed in this context?

Why complete Journal Entries in this context?

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Noncontrolling Interest -Worksheet Example

King uses the Equity Method to account for Pawn subsequent to acquisition. The consolidation process is substantially the same.

At each consolidation, worksheet JOURNAL ENTRIES S, A, I, D, and E are prepare AND…

A column will be added to the worksheet to record the noncontrolling interest in the subsidiary.

Noncontrolling Interest -Worksheet Example

Noncontrolling Interest –Worksheet Example

Noncontrolling Interest –Worksheet Example

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NCI in Consolidated F/S

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Identify appropriate placementsfor the components of the noncontrolling interest in consolidated financial statements.

Consolidated Financial Statement

1. Consolidated net income is computed at the combined entity level and allocated to the noncontrolling and controlling interests. The statement of changes in owners’ equity provides details of the ownership changes for the year for both the controlling and noncontrolling interest shareholders.

2. If appropriate, each component of other comprehensive income is allocated to the controlling and noncontrolling interest. The statement of changes in owners’ equity would also provide an allocation of accumulated other comprehensive income elements across the controlling and noncontrolling interests.

3. Note the placement of the noncontrolling interest in the subsidiary’s equity in the consolidated owners’ equity section.

Consolidated Financial StatementIncome Statement, Owners’ Equity Consolidated Financial Statement

Balance Sheet

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Control Premium

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Determine the effect on consolidated financial statements of a control premium paid by the parent.

Noncontrolling Interest –Premium Paid

If King had paid $11.00 for their shares, at a time when they were trading for $9.75, then the goodwill allocation would look like this:

Effects of using the Initial Value Method

The initial value method employs cash basis for income recognition.

The parent recognizes dividend income rather than an equity income accrual.

Parent does not accrue the percentage of the sub’s income earned in excess of dividends (the increase in subsidiary retained earnings).

The parent does not record amortization expense, therefore it must include it in the consolidation process if proper totals are to be achieved.

Effects of using the Initial Value Method

If the Parent used the Initial Value Method to account for the Sub after acquisition, Entry *C is used to convert to the Equity Method.The entry will combine the increase in the Sub’s Retained Earnings since acquisition X the parent’s percentage of ownership, and the parent’s share of amortization expense since acquisition.

Entry D is not necessary.

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Effects of using the Partial Equity Method

Entry *C converts from the Partial Equity Method to the Equity Method, but only the adjustment for the parent’s share of amortization expense is necessary.

If the Parent used the Partial Equity Method to account for the Subsidiary after acquisition, Entry *C is used to convert to the Equity Method.

Midyear Acquisitions

Understand the impact onconsolidated financial statementsof a midyear acquisition.

Mid-Year Acquisitions

When control of a Sub is acquired at a time subsequent to the beginning of the sub’s fiscal year: The income statements are consolidated as usual The Sub’s pre-acquisition revenues and expenses are

excluded from the Parent’s consolidated statements (adjusted via Entry S)

Only a partial year’s amortization on excess fair value is taken.

Step Acquisition

Understand the impact onconsolidated financial statementswhen a step acquisitionhas taken place.

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Step Acquisitions

A step acquisition occurs when control is achieved in a series of equity acquisitions, as opposed to a single transaction. As with all business combinations, the acquisition method measures the acquired firm (including the noncontrolling interest) at fair value at the date control is obtained.The parent utilizes a single uniform valuation basis for all subsidiary assets acquired and liabilities assumed—fair value at the date control is obtained.

Step Acquisitions

If the parent held a noncontrolling interest in the acquired firm, the parent remeasures that interest to fair value and recognizes a gain or loss.

Step Acquisitions cont’d

If after obtaining control, the parent increases its ownership interest in the subsidiary, no further remeasurementtakes place.

The parent simply accounts for the additional subsidiary shares acquired as an equity transaction—consistent with transactions with other owners, as opposed to outsiders.

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Sale of a Subsidiary

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Record the sale of a subsidiary(or a portion of its shares).

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Sales of Subsidiary Stock

If the parent maintains control, it recognizes no gains or losses – the sale is shown in the equity section.If the sale results in the loss of control, the parent recognizes any resulting gain or loss in consolidated net income.

What is reported on the consolidated statements when a Parent sells some of its ownership in a Subsidiary?

Breakout Questions: Comment!!

If the parent maintains control, it recognizes no gains or losses – the sale is shown in the equity section.

If the sale results in the loss of control, the parent recognizes any resulting gain or loss in consolidated net income.

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Sales of Subsidiary Stock

If the parent retains any of its former sub’s shares, the investment should be remeasured to fair value on the date control is lost.

Any resulting gain or loss from the remeasurement should be recognized in the parent’s net income.

If it sells less than the entire investment, parent must select a cost-flow assumption if it has made more than one purchase.

For securities, the use of specific identification based on serial numbers is acceptable, although averaging or FIFO assumptions often are applied.

Noncontrolling Interest –International Accounting Standards

IFRS permits fair value measurement, or the noncontrolling interest may be measured at a proportionate share of the Sub’s identifiable net asset fair value, which excludes goodwill. This option assumes that any goodwill created via acquisition applies solely to the controlling interest.

U.S. GAAP requires fair value measurement. Thus, acquisition-date fair value provides a basis for reporting the noncontrolling interest which is adjusted for its share of subsidiary income and dividends subsequent to acquisition.

US GAAP vs. IFRS

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Recap of Some Concepts

1. "Noncontrolling interest" refers to an equity interest that is held in a member of a business combination by an unrelated (outside) party.

2. A control premium is the portion of an acquisition price (above currently traded market values) paid by a parent company to induce shareholders to sell a sufficient number of shares to obtain control. The extra payment typically becomes part of the goodwill acquired in the acquisition attributable to the parent company.

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Recap cont’d

3. When a company sells a portion of an investment, it must remove the carrying value of that portion from its investment account. The carrying value is based upon application of the equity method.

Thus, if either the initial value method or the partial equity method has been used, a company must first restate the account to the equity method before recording the sales transaction. The same method is applied to the operations of the current period occurring prior to the time of sale.

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METHODS OF VALUATION FOR MERGERS AND ACQUISITIONS

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Because a corporation is assumed to have infinite life, the analysis is broken into two parts: a forecast period and a terminal value.

Forecast Period

Ideally, the forecast period should comprise the internal over which the firm is in a transitional state as when enjoying a temporary competitive advantage. (i.e., the circumstances where expected returns exceed required returns).

In most circumstances, a forecast period of five or ten years is used.

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Terminal Value

The terminal value of the company derived from free cash flows occurring after the forecast period, is estimated in the last year of the forecast period and

Capitalizes the present value of all future cash flows beyond the forecast period.

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Steady- State assumption

Once a schedule of free cash flows is developed for the enterprise, the weighted average cost of capital (WACC) is used to discount them to determine the present value.

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Free cash flow

Free cash flow equals: The sum of net operating profits after

taxes (NOPAT), plus depreciation and noncash charges, less capital investment and less investment in working capital. NOPAT captures the earnings after taxes that are available to all providers of capital.

This is, NOPAT has no deductions for financing costs.

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Forecast Period

The forecast period is normally the years during which the analyst estimates free cash flows that are consistent with creating value.

Value is created whenever earnings power increases or when asset efficiency is improved.

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From the Journal of Management

Study done on methodology designed to aid researchers in assessing market expectations of future cash flows related to discrete events, such as acquisition announcements.

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Eroding Firm Value

More specifically, acquisitions were often found to erode acquiring firm value and produce highly volatile market returns.

Given that acquirers generally pay premiums to acquire targets, results showed that target shareholders generally fared well, often experiencing significant positive returns.

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Environmental Uncertainty

Bergh and Lawless (1988) showed that highly diversified firms were most likely to pursue acquisitions in decreasing environmental uncertainty, whereas the opposite occurred in less diversified firms.

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Firm Strategy

Thornton (2001), however demonstrated that the failure to shift firms strategy with environmental changes increased acquisition likelihood.

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Comprehensive Framework

This comprehensive theoretical framework categories recent acquisitions research into three broad areas: (a) antecedents, the factors that lead firms to undertake acquisitions; (b) moderators, internal and external factors that moderate acquisition performance; and (c) other acquisition outcomes.

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External governance structure also influence acquisition likelihood

Antitrust laws did not appear to impede acquisition activity and furthermore, that countries with high accounting standards and stronger shareholder protection had a greater amount of acquisition activity than their counterparts (Rossi & Volpin, 2004).

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Ways to Finance Acquisitions

A common argument asserts that managers finance acquisitions with cash when they perceive their firms are undervalued and with stock when they perceive their firms are overvalued suggesting that the market should perceive stock-financed deals as a signal of bidder overvaluation.

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Expertise

Powerful banks with specialized expertise are quick to use this expertise and, thus direct clients to complex solutions, such as stock-financed deals.

In support, he reported that using investment banks to advise stock-financed acquisitions harmed acquirer performance.

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Target-bidder

Still other scholars have examined that effects of acquiring at different stages within acquisitions waves.

For example, Carow et al. (2004) found moving early in acquisitions waves resulted in higher combined target-bidder abnormal returns.

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Bidder

However, they further reported that early moving bidder accrued positive returns only when they:

Possessed superior information Paid with cash Expanded in related industries during

widespread expansion periods.

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Early vs. Late Acquisitons?

In a more fine-grained analysis of the performance consequences of acquiring at different wave stages. It was revealed that firms that acquired early within an industry acquisitions wave achieved positive returns, whereas the market punished later acquirers.

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Barkema and Schijven (2008b)

Argued that although acquisitions are often treated as independent events, most are actually a component of a broader acquisitions strategy,

And such broad acquisitions strategies are more likely to require significant sequential organizational restructuring to more fully realize benefits from multiple acquisitions.

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Barkema and Schijven (2008b)

Following this argument, they demonstrated that the performance implications of a single acquisition are dependent on that acquisition’s position within the acquirers’ acquisition sequence.

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Barkema and Schijven (2008b)

Thus, accounting for post acquisition integration as a long-term process rather than a “one-shot game” can reveal acquirers gain that are often overlooked when examining single acquisition events.

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Conclusion

Today, we discussed the acquisition method, specifically:

• The accounting perspective, worksheet, journal entries

• Tax implications• Strategic approach • Cycle of business combinations and acquisition

sequence.

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Questions?

Thanks for your attention today!

Regan Garey, regangarey@yahoo.com Accounting Professor, Lock Haven

University