From
CHAPTER 1
INTERCORPORATE ACQUISITIONS AND INVESTMENTS IN OTHER ENTITIES
ANSWERS TO QUESTIONS
Q1-1Complex organization structures often result when companies do business in a complex business environment. New subsidiaries or other entities may be formed for purposes such as extending operations into foreign countries, seeking to protect existing assets from risks associated with entry into new product lines, separating activities that fall under regulatory controls, and reducing taxes by separating certain types of operations.
Q1-2The split-off and spin-off result in the same reduction of reported assets and liabilities. Only the stockholders’ equity accounts of the company are different. The number of shares outstanding remains unchanged in the case of a spin-off and retained earnings or paid-in capital is reduced. Shares of the parent are exchanged for shares of the subsidiary in a split-off, thereby reducing the outstanding shares of the parent company.
Q1-3The management of Enron appears to have used special purpose entities to avoid reporting debt on its balance sheet and to create fictional transactions that resulted in reported income. It also transferred bad loans and investments to special purpose entities to avoid recognizing losses in its income statement.
Q1-4(a)A statutory merger occurs when one company acquires another company and the assets and liabilities of the acquired company are transferred to the acquiring company; the acquired company is liquidated, and only the acquiring company remains.
(b)A statutory consolidation occurs when a new company is formed to acquire the assets and liabilities of two combining companies; the combining companies dissolve, and the new company is the only surviving entity.
(c)A stock acquisition occurs when one company acquires a majority of the common stock of another company and the acquired company is not liquidated; both companies remain as separate but related corporations.
Q1-5Assets and liabilities transferred to a new wholly-owned subsidiary normally are transferred at book value. In the event the value of an asset transferred to a newly created entity has been impaired prior to the transfer and its fair value is less than the carrying value on the transferring company’s books, the transferring company should recognize an impairment loss and the asset should then be transferred to the entity at the lower value.
Q1-6The introduction of the concept of beneficial interest expands those situations in which consolidation is required. Existing accounting standards have focused on the presence or absence of equity ownership. Consolidation and equity method reporting have been required when a company holds the required level of common stock of another entity. The beneficial interest approach says that even when a company does not hold stock of another company, consolidation should occur whenever it has a direct or indirect ability to make decisions significantly affecting the results of activities of an entity or will absorb a majority of an entity=s expected losses or receive a majority of the entity=s expected residual returns.
Q1-7Under pooling of interests accounting, the book values of the acquired company were carried forward rather than being revalued to fair values that often were higher than book values, thereby avoiding increased depreciation charges on revalued fixed assets. During most of the time pooling accounting was acceptable, goodwill was required to be amortized, and, because no goodwill was recognized under pooling, those amortization charges were avoided. The carrying forward of retained earnings of all combining companies may, in some cases, have given management increased flexibility with respect to dividends. Operating results of the combining companies were combined for the full year in which the combination occurred, not just from the point of combination, resulting in more favorable reported results in the year of the business combination. The pooling method hides the value of the consideration given, shielding management from stockholder criticism in those cases where management paid an excessive amount for the company acquired.
Q1-8Purchase accounting normally results in increased dollar amounts reported in the balance sheet. Recognition of the fair values of identifiable assets and liabilities acquired typically results in larger dollar amounts being reported. In addition, goodwill is recorded as an asset under purchase accounting, but not recognized in a pooling. Because retained earnings are not carried forward in a purchase, retained earnings typically is lower; however, recognition of the fair value of shares issued typically results in larger paid-in capital account balances. Increased depreciation charges and the amortization or impairment of goodwill generally result in lower reported net income when purchase treatment is used.
Q1-9Goodwill arises when purchase accounting is used and the fair value of the compensation given to acquire another company is greater than the fair value of its identifiable net assets. Goodwill is recorded on the books of the acquiring company when the net assets of the acquired company are transferred to the acquiring company and recorded on the acquiring company's books. When the acquired company is operated as a separate entity, the amount paid by the purchaser is included in the investment account and goodwill, as such, is not recorded on the books of either company. In this case, goodwill is only reported when the investment account of the parent is eliminated in the consolidation process.
Q1-10The purchase of a company is viewed in the same way as any other purchase of assets. The acquired company is owned by the acquiring company only for the portion of the year subsequent to the combination. Therefore, earnings are accrued only from the date of purchase forward.
Q1-11None of the retained earnings of the subsidiary should be carried forward under purchase treatment. Thus, consolidated retained earnings is limited to the balance reported by the acquiring company.
Q1-12Some companies have attempted to establish the corporate name as a symbol of quality or product availability. An acquiring company may be fearful that customers will be lost if the company is liquidated. Debt covenants are likely to require repayment of virtually all existing debt if the acquired company is liquidated. The cost of issuing new debt may be prohibitive. A parent-subsidiary relationship may be the only feasible means of proceeding if it is impossible to acquire 100 percent ownership of an acquired company. When the acquiring company does not plan to retain all operations of the acquired company, it may be easier to dispose of the portions not wanted by leaving them in the existing corporate shell and later disposing of the ownership of the company.
Q1-13Negative goodwill is said to exist when a purchaser pays less than the fair value of the identifiable net assets of another company in acquiring its ownership. This difference normally is treated as a pro rata reduction of all of the acquired assets other than cash and cash equivalents, trade receivables, inventory, financial instruments that are required by U.S. generally accepted accounting principles (GAAP) to be carried on the balance sheet at fair value, assets to be disposed of by sale, and deferred tax assets.
Q1-14If the fair value of a reporting unit acquired in a business combination exceeds its carrying amount, the goodwill of that reporting unit is considered unimpaired. On the other hand, if the carrying amount of the reporting unit exceeds its fair value, impairment of goodwill must be recognized if the carrying amount of the goodwill assigned to the reporting unit is greater than the implied value of the carrying unit=s goodwill. The implied value of the reporting unit=s goodwill is determined as the excess of the fair value of the reporting unit over the fair value of its net assets excluding goodwill.
Q1-15Additional paid-in capital reported following a business combination recorded as a purchase is the amount previously reported on the acquiring company's books plus the excess of the fair value over the par or stated value of any shares issued by the acquiring company in completing the acquisition.
Q1-16A purchase is treated prospectively. None of the financial statement data of the acquired company is included along with the financial statement data of the acquiring company for periods prior to the business combination.
Q1-17When purchase treatment is used, all costs incurred in purchasing the ownership of another company are capitalized. These normally include items such as finder's fees, the costs of title transfer, and legal fees associated with the purchase.
Q1-18When the acquiring company issues shares of stock to complete a business combination recorded as a purchase, the excess of the fair value of the stock issued over its par value is recorded as additional paid-in capital. All costs incurred by the acquiring company in issuing the securities should be treated as a reduction in the additional paid-in capital. Items such as audit fees associated with the registration of securities, listing fees, and brokers' commissions should be treated as reductions of additional paid-in capital when stock is issued. An adjustment to bond premium or bond discount is needed when bonds are used to complete the purchase.
SOLUTIONS TO CASES
C1-1 Reporting Alternatives and International Harmonization
a.In the past, when goodwill was capitalized, U.S. companies were required to systematically amortize the amount recorded, thereby reducing earnings, while companies in other countries were not required to do so. Recent changes in accounting for goodwill have substantially eliminated this objection.
b.U. S. companies must be concerned about accounting standards in other countries and about international standards (i.e., those issued by the International Accounting Standards Committee). Companies operate in a global economy today; not only do they buy and sell products and services in other countries, but they may raise capital and have operations located in other countries. Such companies may have to meet foreign reporting requirements, and these requirements may differ from U. S. reporting standards. Thus, many U. S. companies, and not just the largest, may find foreign and international reporting standards relevant if they are going to operate globally.
C1-2 Assignment of Acquisition Costs
MEMO
To:Vice-President of Finance
Troy Company
From: , CPA
Re:Recording Acquisition Costs of Business Combination
Troy Company incurred a variety of costs in acquiring the ownership of Kline Company and transferring the assets and liabilities of Kline to Troy Company. I was asked to review the relevant accounting literature and provide my recommendations on the appropriate treatment of the costs incurred in the acquisition of Kline Company.
The accounting standards applicable to the 2003 acquisition state:
The cost of an entity acquired in a business combination includes the direct costs of the business combination. Costs of registering and issuing equity securities shall be recognized as a reduction of the otherwise determinable fair value of the securities. [FASB 141, Par. 24]
A total of $720,000 was paid by Troy in completing its acquisition of Kline. The $200,000 finders= fee and $90,000 of legal fees for transferring Kline=s assets and liabilities to Troy should be included in the purchase price of Kline. The $60,000 payment for stock registration and audit fees should be recorded as a reduction of paid-in capital recorded when the Troy Company shares were issued to acquire the shares of Kline. The only cost potentially at issue is the $370,000 of legal fees resulting from the litigation by the shareholders of Kline. If this cost is considered to be a direct cost, it should be included in the costs of acquiring Kine. If, on the other hand, it is considered an indirect or general expense, it should be charged to
C1-2 (continued)
expense in 2002. The accounting standards state:
Indirect or general expenses related to business combinations shall be expensed as incurred. [FASB 141, Par. 24]
While one might argue that the $370,000 was an indirect cost, it resulted directly from the exchange of shares used to complete the business combination and should be included in the amount assigned to the cost of acquiring ownership of Kline. Of the total costs incurred, $660,000 should be assigned to the purchase price of Kline and $60,000 recorded as a reduction of paid-in-capital.
You also requested a summary of proposed changes to the requirements established in FASB 141. A report on the current status of the FASB=s proposals can be found under ABusiness Combinations: Purchase Method Procedures@ at the FASB website ( The current proposal states:
Acquisition-related costs paid to third parties (for example: finder=s, advisory, legal, accounting, and other professional fees that are attributable to negotiating or completing the business combination) are not part of the exchange transaction and should be expensed as incurred. [FASB Project Update]
Under the proposed standard, if Troy were to incur a total of $720,000 in costs when it acquires Lad Company, the full amount would be recorded as an expense.
Primary citation
FASB 141, Par. 24
FASB Project Update
C1-3 Goodwill and the Effects of Purchase Treatment
a.The nature of goodwill is not completely clear and is the subject of some disagreement. In general, goodwill is viewed as the collection of all those factors that allow a company to earn an excess return; that is, all those hard-to-identify intangible qualities that permit a firm to earn a return in excess of a normal return. Goodwill is identified with the firm as a whole and generally is considered as being not separable from the firm. Goodwill presumably arises from bringing together a particular set of resources that produces higher earnings than could the individual resources or other similar collections of resources. Factors contributing to excess earnings often are considered to include superior management, outstanding reputation, prime location, special economies, and many other factors. Some would argue that, if these factors can be identified, they each should be treated separately rather than being lumped together in a single "catch-all" account called goodwill.
The primary characteristics of an asset are that it represents (1) probable future benefits (2) controlled by a particular entity (3) resulting from past transactions or events. If one company purchases another company and is willing to pay more for that company than the fair value of its net identifiable assets, this implies the existence of some set of factors, generally called goodwill, that is expected to contribute future benefits to the combined company in the form of higher earnings. Thus, the first characteristic of an asset would seem to be present in goodwill. If these factors arose as a result of past transactions or events, the third characteristic is present. Whether a particular entity can control the factors leading to excess earnings is a matter of some debate, especially when it may be difficult to identify the factors. Nevertheless, at least some portion of those factors generally is viewed as being under at least partial control of the particular entity. Current accounting practice assumes all three elements are present and treats goodwill as an asset. Because of a lack of objectivity leading to measurement problems, goodwill may not be recognized in all situations where it is thought to exist. In particular, "self-developed" goodwill is not recognized.
Goodwill is recorded only when one or more identifiable assets are acquired in a purchase-type transaction, usually in a business combination. As with other assets, goodwill is recorded at its historical cost to the acquiring company at the time it is purchased. Its historical cost to the acquiring company in a business combination is computed as the excess of the total purchase price paid (for the stock or net assets of the acquired company) over the fair value of the net identifiable assets acquired.
b.The FASB recently changed accounting for goodwill. Under the new standard, goodwill will not be amortized in any circumstance. The carrying amount of goodwill is reduced only if it is found to be impaired or was associated with assets to be sold or otherwise disposed of.
C1-4 Business Combinations
It is very difficult to develop a single explanation for any series of events. Merger activity in the United States is impacted by events both within our economy and those around the world. As a result, there are many potential answers to the questions posed in this case.
a.The most commonly discussed factors associated with the merger activity of the nineties relate to the increased profitability of businesses. In the past, increases in profitability typically have been associated with increases in sales. The increased profitability of companies in the past decade, however, more commonly has been associated with decreased costs. Even though sales remained relatively flat, profits increased. Nearly all business entities appear to have gone through one or more downsizing events during the past decade. Fewer employees now are delivering the same amount of product to customers. Lower inventory levels and reduced investment in production facilities now are needed due to changes in production processes and delivery schedules. Thus, less investment in facilities and fewer employees have resulted in greater profits.
Companies generally have been reluctant to distribute the increased profits to shareholders through dividends. The result has been a number of companies with substantially increased cash reserves. This, in turn, has led management to look about for other investment alternatives, and cash buyouts have become more frequent in this environment.
In addition to high levels of cash on hand providing an incentive for business combinations, easy financing through debt and equity also provided encouragement for acquisitions. Throughout the nineties, interest rates were very low and borrowing was generally easy. With the enormous stock-price gains of the mid-nineties, companies found that they had a very valuable resource in shares of their stock. Thus, stock acquisitions again came into favor.
b.Establishing incentives for corporate mergers is a controversial issue. Many people in our society view mergers as not being in the best interests of society because they are seen as lessening competition and often result in many people losing their jobs. On the other hand, many mergers result in companies that are more efficient and can compete better in a global economy; this in turn may result in more jobs and lower prices. Even if corporate mergers are viewed favorably, however, the question arises as to whether the government, and ultimately the taxpayers, should be subsidizing those mergers through tax incentives. Many would argue that the desirability of individual corporate mergers, along with other types of investment opportunities, should be determined on the basis of the merits of the individual situations rather than through tax incentives.