Concepts, Rules, and Examples
Introduction to Business Combinations
Business combinations occur under two different scenarios. By far, the most common type of combination is referred to as an acquisition, which is sometimes also known as a purchase or as a purchase business combination. The other business combinations, which represent a very small minority of cases, are effected in a manner known as a uniting of interests, which is also referred to as a pooling of interests or as a merger.
The aforenoted typology is independent of the legal form of the business combination. Thus, two entities may consolidate to create a new, third enterprise. Alternatively, one entity may purchase, for cash or for stock, the stock of another enterprise, which may or may not be followed by a formal merging of the acquired entity into the acquirer. In yet other cases, one entity may simply purchase the assets of another, with or without assuming the debts of that enterprise. The form of the combination does not define whether it will be viewed as an acquisition or a uniting of interests, however. Rather, it is the substance of the transaction, which will be explored in great detail in the following paragraphs, which will serve to define it. The accounting for acquisitions differs markedly from that prescribed for unitings of interests.
Uniting of Interests
The use of pooling-of-interests (or unitings of interests) accounting had been widespread for about fifty years, particularly in the US. It evolved to address certain combinations, typically of entities of approximately the same size and of similar operations, in which identification of an acquirer was made difficult by the fact that all or most of the ownership interests of the combining entities remained as owners of the combined entity. Over time, the strict criteria were eroded, so that even mergers between entities of disparate size, where presumably the identity of the acquiring party was discernible, were often treated as unitings of interests. The primary motivation to this accounting treatment was to avoid disclosing the true acquisition cost, which would necessitate step-ups in the carrying value of many assets and quite frequently the recognition of goodwill, which would burden future operations with higher depreciation and amortization charges.
The trend is now firmly established to reduce or eliminate the use of unitings of interests accounting. The US standard setter revoked pooling accounting outright (effective mid-2001) and all future business combinations must be accounted for as purchases. The Canadian standard setter, as it often does, followed the US with a similar requirement. Australia and New Zealand had already imposed universal purchase accounting.
A theoretical case can be made for the use of unitings of interest accounting for "marriages of equals" in which neither combinant, nor any group of shareholders, emerges as the acquirer of the other. However, in adopting the new US requirement the FASB held that while such situations may exist, they are in such a small minority that it would have been dysfunctional to have provided for a second, alternative method of accounting simply to accommodate these few transactions, leaving the door open to further abuse and endless debates over "gray" transactions.
Under the former US standard, all of twelve criteria had to be satisfied in order to apply pooling (unitings) accounting, but a large fraction of public-company transactions were structured so as to take advantage of this opportunity. Under current IAS, the criteria to be satisfied are fewer, but these are nonetheless stricter, so that pooling treatment under IAS has been far less widespread than under the former US rules. Of course, beginning in mid-2001, this situation is (temporarily, perhaps) reversed, and unitings have continued to be acceptable under IAS although totally banned under US rules.
Recent evolution of uniting (pooling) of interests rules.
A declining number of standard-setting bodies now explicitly permit certain consolidations to be accounted for as poolings or unitings of interests. These include the independent national accounting standards bodies in France, the UK, Germany, and Japan, as well as IAS. The criteria to be satisfied vary substantially: a growing minority of national accounting standard-setting bodies prohibit pooling accounting altogether, and with the US now in this camp, further prohibitions are inevitable.
International accounting standard for pooling.
The international accounting standard, IAS 22, provides a rather more direct set of criteria for determining the appropriateness of pooling accounting treatment. Three tests must all be met, as follows:
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The shareholders of the combining enterprises must achieve a continuing mutual sharing of the risks and benefits attaching to the combined enterprise.
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The basis of the transaction must be principally an exchange of voting common shares of the enterprises involved.
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The whole, or effectively the whole, of the net assets and operations of the combining enterprises are combined into one entity.
The first of these criteria relates to the continual sharing of risks and benefits by the combining shareholder groups. To achieve this, according to IAS 22, the following must occur:
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The substantial majority, if not all, of the voting common shares of the combining enterprises are exchanged or pooled.
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The fair value of one enterprise is not significantly different from that of the other enterprise.
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The shareholders of each enterprise maintain substantially the same voting rights and interest in the combined entity, relative to each other, after the combination as before.
Thus, the international standards have effectively defined the essential characteristics of a true uniting of interests and have established tests that address these. In describing a uniting of interests, IAS 22 states that "...the shareholders of the combining enterprises join in a substantially equal arrangement to share control over the whole, or effectively the whole, of their net assets and operations." Furthermore, it states that to achieve such a mutual sharing of risks and benefits, "the fair value of one enterprise [cannot be] significantly different from that of the other." Although these words are perhaps suggestive of the notion that unitings cannot be said to occur unless the combining entities are virtually identical in size, the precise meaning is not made clear. Thus, it would appear that under these criteria the mergers of entities of at least somewhat differing sizes can continue to be accounted for as poolings if the other terms stated are met.
In addressing the "substantially equal arrangement" the IAS 22 approach is clearly not as ambiguous as was the former US standard, APB 16, which made no reference to the relative sizes of the combining entities or their relative net worths. However, neither is it as restrictive as the current UK standard (FRS 6), which demands approximately equal size under what is virtually a "marriage of equals" doctrine.
While IAS 22 goes on to state that a "mutual sharing...is usually not possible without a substantially equal exchange of voting common shares..." this can be read to mean that the relative interests of the combining parties cannot be altered by the transaction. For example, if one combining entity has a fair value of two-thirds of that of the other entity, this would imply that after the combination the former shareholders of the smaller enterprise should control about 40% [2/3 (2/3 + 3/3)] of the new combined entity. If this condition were not met, these shareholders would have either gained or lost relative voting power in the transaction, which would be strongly suggestive of an acquisition of one enterprise by the other. In practice, there will be many borderline circumstances in which judgment must be applied to ascertain if the terms of IAS 22 have indeed been met.
Indicators that a uniting has not occurred.
The presence of certain attributes are presumptive evidence that a uniting of interests characterization would be inappropriate. These include
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The relative equality in fair values of the combining enterprises is reduced and the percentage of voting common shares exchanged decreases.
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The financial arrangements provide a relative advantage to one group of shareholders over the other shareholders; such arrangements may take effect either prior to or after the business combination occurs.
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One party's share of the equity in the combined entity depends on how the business that it previously controlled performs subsequent to the business combination.
The Standing Interpretations Committee has offered a further set of observations that supports the notion that true unitings of interests rarely occur in practice. In SIC 9, it is noted that business combinations must be accounted for as either acquisitions or unitings of interests (no hybrid treatments are allowed), and that most such transactions are expected to be acquisitions, with only those for which an acquirer cannot be identified qualifying for unitings of interests accounting. The determination of whether there is, in fact, an acquirer and whether control exists should be based on an overall evaluation of all the relevant facts and circumstances. While the criteria in IAS 22 cannot be seen as an absolute checklist, the failure to meet any one of the following would require acquisition accounting treatment to be followed:
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There is an exchange or pooling of the substantial majority of the voting common shares of the combining entities
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There is a relative equality in the fair values of the combining enterprises
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There is a continuation of substantially the same relative percentage in voting rights and interest of the former shareholders of each combining entity in the new combined entity
While the failure to meet these criteria will absolutely necessitate acquisition accounting, the converse is not true. Even if all the foregoing are met, if an acquirer can be identified, the combination will have to be accounted for as an acquisition.
Accounting procedures in respect to unitings of interests.
The pooling-of-interests method of accounting should be used to account for unitings of interests. Financial statements of the combining enterprises for the period of the combination and for any comparative (i.e., earlier) periods shown should include the assets, liabilities, revenues, and expenses of the combining enterprises as if they had always been combined in fact. No new basis of accounting is established; the bases of all assets and liabilities remains as before the uniting. These rules are essential to the concept of a uniting of interests, which represents that formerly separate entities have merely come together to do in the future as one enterprise what they did separately in the past, without either having acquired or been acquired by the other.
No goodwill or negative goodwill can be created in a uniting of interests. Goodwill is the excess of purchase price over the fair value of net identifiable assets acquired; absent an acquisition, there can be no new basis of accounting established and thus no goodwill. The same applies to negative goodwill, which is merely the excess of the fair value of the net identifiable assets acquired over the purchase price. Once again, no acquisition means no negative goodwill.
Although it is easiest to explain the accounting for a uniting of interests as resulting simply in the combining of all recorded assets, liabilities, and equities, in fact the equity sections of the combining enterprises' balance sheets may require certain adjustments. The reason is that depending on the legal form of the uniting (e.g., one entity issuing shares for the shares of the other, or a new third entity acquiring the shares of the combining parties) and the par or stated values of the shares of the combining entities, it may be necessary to capitalize some or all of the retained earnings of one or both of the combining companies. In no event, however, can a uniting of interests result in the creation of retained earnings: The immediate postuniting combined balance of retained earnings will be equal to or less than the sum of the constituents' retained earnings. Put another way, any difference between the recorded capital accounts plus any additional consideration, and the recorded share capital acquired, should be adjusted against equity.
Any expenses incurred in consummating a uniting of interests should be recognized as expenses when incurred; they cannot be capitalized or adjusted against equity.
Basic example of uniting of interests
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To illustrate the essential elements of the pooling-of-interests method of accounting, consider the following balance sheets of the combining entities:
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| Company A | Company B | Company C | |
|---|---|---|---|
| Assets | $30,000,000 | $4,500,000 | $6,000,000 |
| Liabilities | $18,000,000 | $1,000,000 | $1,500,000 |
| Common stock: | |||
| 6,000,000 | -- | -- |
| -- | 3,000,000 | -- |
| -- | - | 1,000,000 |
| Additional paid-in capital | 2,000,000 | -- | 500,000 |
| Retained earnings | 4,000,000 | 500,000 | 3,000,000 |
| Liabilities and stockholders' equity | $30,000,000 | $4,500,000 | $6,000,000 |
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Company A will issue its shares for those of Companies B and C, and both B and C will tender 100% of their common shares. A will give one of its shares for each fifteen shares of B stock and one of its shares for each twenty-five shares of C stock. Thus, A will issue 20,000 shares to acquire B and 40,000 shares to acquire C.
In a uniting of interests, the historical basis of the assets and liabilities of the combining entities is continued. No new basis of accountability is established. The assets of the combined (postcombination) Company A will total $40,500,000; total liabilities will be $20,500,000. Total equity (net assets) will therefore equal $20,000,000.
While the total stockholders' equity of the postcombination entity will equal the sum of the combining entities' individual equity accounts, the allocation between paid-in capital and retained earnings can vary. Total (postcombination) retained earnings can be equal to or less than the sum of the constituent entities' retained earnings but cannot be more than that amount. Consider the cases of Companies B and C.
In the present example, Company A issues 20,000 shares of its stock, or an aggregate par value of $2,000,000, to substitute for Company B's $3,000,000 aggregate paid-in capital in effecting the merger with Company B. Therefore, the combined (postacquisition) balance sheet will include $2,000,000 of par value capital stock, plus $1,000,000 of additional paid-in capital. Even though only $2,000,000 of stock was issued to replace Company B's $3,000,000 of aggregate par, there can be no increase in retained earnings and no decrease in contributed capital as a consequence of the uniting.
The Company C merger presents the opposite situation: An aggregate of $4,000,000 of Company A stock is to be issued to supersede $1,000,000 of aggregate par and $500,000 of additional paid-in capital. To accomplish this, $2,500,000 of Company C retained earnings is capitalized, leaving only $500,000 of Company C retained earnings to be carried as retained earnings into the postacquisition balance sheet. In reality, such a situation would not exist. If the pooling of interests took place simultaneously, APB 16 requires only that the combined contributed capital of all entities not be reduced. Therefore, the issuance of 60,000 shares would create an entry on A's books as follows:
| Net assets | 8,000,000 | |
| Additional paid-in capital | 1,500,000 | |
| 6,000,000 | |
| 3,500,000 |
Note that the additional paid-in capital on the books of Company A is reduced by an amount sufficient to make the total increase in contributed capital of A ($4,500,000), which equals the total contributed capital of both B ($3,000,000) and C ($1,500,000). In this way, all the retained earnings of B and C are transferred to A. This accounting would hold even if A, B, and C simultaneously transferred their net assets to a new entity, D (a consolidation). The opening entry on the books of D would look the same as the consolidated balance sheet of A after the merger, as presented below.
The balance sheet of Company A after the mergers are completed is as follows:
| Assets | $40,500,000 |
| Liabilities | $20,500,000 |
| Common stock, $100 par | 12,000,000 |
| Additional paid-in capital | 500,000 |
| Retained earnings | 7,500,000 |
| Liabilities and stockholders' equity | $40,500,000 |
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If any combining entity has a deficit in its retained earnings, that deficit is continued in the combined entity (and may even be increased as a consequence of the par value changeover, as illustrated above for a nondeficit situation). It cannot be reduced or eliminated as a consequence of the combination.
Any expenses relating to a business combination accounted for as a pooling of interests (e.g., stock registration costs, finders' fees, and costs of preparing stockholders' prospectuses) must be charged against income in the period in which the combination is effected. No new assets can arise from a pooling.
Conforming accounting principles employed by the combining entities.
The historical basis of assets and liabilities is normally continued, but this rule has an exception: Where different accounting principles were employed by the combining entities, these principles should be conformed where possible by retroactive adjustment. Prior period financial statements, when reissued on a pooled basis should be restated for these changes.
Reporting on the combined entity.
When the pooling-of-interests method is used, it is necessary to report all periods presented on a combined basis. Thus, if only a single year is presented, the effect will be as if the combination occurred at the beginning of that year. If comparative statements are presented, the effect will be as if the combination occurred at the beginning of the earliest year being reported on. This is consistent with the concept of a pooling not being a discrete economic event, but rather as a combining of common interests, such that the most meaningful reporting, after the date of the combination, is to present the financial position and results of operations of those entities as if they had always been combined.
The combining entities may have had transactions with each other prior to the combination and may have had amounts due to or from each other at the end of earlier fiscal periods. To present combined statements of financial position and results of operations, all intercompany balances and transactions should be eliminated, to the extent that this is practical to accomplish.
Detailed example of uniting of interests using pooling method
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To explain further the applicability of the criteria for applying uniting of interests accounting set forth earlier, a comprehensive example will be developed here and continued in the subsequent discussion of acquisition accounting.
Ahmadi Corporation (whose balance sheet is presented as Exhibit I) is about to merge with or acquire four other entities: Belfast (Exhibit II), Cairo (Exhibit III), Delhi (Exhibit IV), and Eyre (Exhibit V). Some of these business combinations may qualify for uniting of interests accounting; others will have to be treated as acquisitions.
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The acquisitions will take place as follows, all effective as of January 31, 2004:
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Belfast is acquired by exchanging one Ahmadi common share for each fifteen of Belfast common shares.
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Cairo is acquired by exchanging one Ahmadi common share for each seventy-five of Cairo common shares.
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Delhi is acquired by paying $12,750,000 in ninety-day demand notes to retire the $13.5 million bank loan, and by exchanging one Ahmadi share for each twenty of Delhi common shares (except as noted in 8. below).
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Eyre is acquired by exchanging a new issue of $100 par, 7% preferred stock subject to a mandatory retirement plan (ending in 2005), plus common shares, for all Eyre common stock. Shareholders of Eyre will receive .35 share of Ahmadi preferred for each Eyre common share (total of 175,000 preferred shares), and one share of Ahmadi common for each four Eyre common shares (total of 125,000 common shares). Based on the dividend yield, the preferred stock has been appraised as having a fair market value of about $105.70 per share, or a total of $18,500,000.
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The appraised value of each acquired firm is given as follows (amounts in thousands):
Assets acquired
Liabilities assumed
Net asset value (FMV)
Belfast Corporation
$ 78,500
$ 2,500
$ 76,000
Cairo Company, Inc.
42,500
6,500
36,000
Delhi Corporation
111,000
7,500
103,500
Eyre, Inc.
168,000
78,000
90,000
In each case, current assets are appraised to be worth book values according to the acquired firms' balance sheets. Thus, any excess fair value vs. the respective book values is due to values of the entities' plant assets.
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Eyre originally issued 8% debentures on 1/1/01 at par value. Ahmadi purchased $20.0 million (face value) of these debentures on 1/1/02 at the market price of $97.60. The discount has been regularly amortized to earnings on a straight-line basis.
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Investments by Belfast and Cairo in the common shares of Ahmadi Corporation were recorded at cost.
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Each of the five corporations in question has been in business for at least 5 years, and none has ever been a subsidiary of each other or of any other entity.
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The acquisition agreement with Cairo provides that if earnings of the acquired subsidiary exceed certain amounts in each or any of the following 5 years, additional shares of Ahmadi will be distributed to former Cairo shareholders. Specifically, for each 50% earnings advance over 2003 levels ($2,800,000 net), an additional 10% of shares are to be issued.
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The agreement with Eyre provides that the purchase price of $80,000,000 (based on the market value of Ahmadi common shares received, plus the fair value of preferred stock received) is protected against market declines for 2 years subsequent to the merger (i.e., if the value of securities distributed to Eyre shareholders is below $80 million as of 12/31/05, additional Ahmadi Corporation common shares will be issued at that time, in an amount sufficient to bring the total value to the sum stipulated).
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Holders of 5,000 shares of Delhi stock angrily dissented to the merger plan, and Ahmadi agreed to pay them $75 for each share tendered instead of issuing common stock.
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Common stocks of the various firms were traded on stock exchanges or were quoted in the over-the-counter market in 2003 at these prices:
High
Low
Average
Ending
Ahmadi Corporation
$512
$388
$495
$492
Belfast Corporation
51 7/8
28 1/2
35 1/4
35 3/4
Cairo Company, Inc.
8 3/4
7 1/2
8
8 1/8
Delhi Corporation
12 1/2
83 1/8
90 3/8
94 1/2
Eyre, Inc.
80 1/2
61
70 1/2
76
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Key management personnel of each of the merging entities, except for the directors and officers of Cairo Company, Inc., will continue in important management roles in the new, combined enterprise. The Cairo owners and managers have indicated their plans to retire and, henceforth, to be no more than passive investors in Ahmadi Corporation.
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Exhibit I: Ahmadi Corporation Condensed Balance Sheet December 31, 2003
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| Sundry current assets | $ 75,000,000 | |
| Plant and equipment, net | $80,000,000 | |
| Investment in Eyre 8% debentures | 4,900,000 | 84,900,000 |
| $159,900,000 | |
| Sundry liabilities | $ 87,000,000 | |
| Common stock, $100 par | $22,500,000 | |
| Additional paid-in capital | 12,200,000 | |
| Retained earnings | 38,200,000 | 72,900,000 |
| Total liabilities and stockholders' equity | $159,900,000 |
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Exhibit II: Belfast Corporation Condensed Balance Sheet December 31, 2003
|
| Sundry current assets | $ 3,900,000 | |
| Plant and equipment, net | $38,500,000 | |
| Investment in Ahmadi common stock (11,250 shares) | 9,800,000 | 48,300,000 |
| $52,200,000 | |
| Sundry liabilities | $ 2,500,000 | |
| Common stock, $10 par | $20,000,000 | |
| Paid-in surplus | 14,700,000 | |
| Retained earnings | 15,000,000 | 49,700,000 |
| $52,200,000 |
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Exhibit III: Cairo Company, Inc. Condensed Balance Sheet December 31, 2003
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| Sundry current assets | $ 4,000,000 | |
| Plant and equipment, net | $17,400,000 | |
| Investment in Acquisitive common stock (4,500 shares) | 3,100,000 | 20,500,000 |
| $24,500,000 | |
| Sundry liabilities | $ 6,500,000 | |
| Common stock (no par), 3 million shares outstanding | $14,500,000 | |
| Retained earnings | 3,500,000 | 18,000,000 |
| $24,500,000 |
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Exhibit IV: Delhi Corporation Condensed Balance Sheet December 31, 2003
|
| Sundry current assets | $ 12,000,000 | |
| Plant and equipment, net | 72,000,000 | |
| $84,000,000 | |
| Sundry liabilities | $ 7,500,000 | |
| Bank term loan due 2006 (6%) | 13,500,000 | |
| Common stock, $1 par | $ 1,000,000 | |
| Premium on common stock | 3,500,000 | |
| Retained earnings | 58,500,000 | 63,000,000 |
| $84,000,000 |
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Exhibit V: Eyre, Inc. Condensed Balance Sheet December 31, 2003
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| Sundry current assets | $ 50,000,000 | |
| Plant and equipment, net | 88,000,000 | |
| $138,000,000 | |
| Sundry liabilities | $ 28,000,000 | |
| 8% debentures due 1/1/2014 | 50,000,000 | |
| Common stock, $10 par | $ 5,000,000 | |
| Paid-in capital | 6,200,000 | |
| Retained earnings | 48,800,000 | 60,000,000 |
| $138,000,000 |
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All the foregoing balance sheets are before recording the business combinations.
The first task is to determine which, if any, of the four business combinations qualify for unitingp-of-interests treatment. The first company to be acquired, Belfast Corporation, is to be obtained in exchange for only the issuing corporation's shares (which suggests a uniting). Prior to the merger, Belfast does own some of Ahmadi Corporation's shares, but there is no requirement in IAS 22 that prevents some cross-ownership prior to an acquisition or a uniting of interests. In the present instance, Belfast owned 5% of Ahmadi's common stock prior to the transaction, which is not deemed to be a deterrent to pooling accounting.
Of more importance under IAS 22 are such matters as continuity of interests, sharing of risks and rewards, and relative size of the combining parties. In the case of the Ahmadi-Belfast merger, book values are discrepant but not dramatically so ($72.9 million vs. $49.7 million); market values based on recent stock prices are also similar, but a bit less so than book values would suggest ($111 million vs. $72 million). On the other hand, the book value of Ahmadi is very similar to Belfast's fair value ($72.9 million vs. $76 million), which provides some support for the notion that these entities do not have significantly different values. Although this area remains one to which a good deal of judgment must be applied, it would appear that in this instance the relative values are close enough to warrant consideration of the pooling method of accounting. Since Belfast management will remain in place and the transaction is essentially a common stock exchange (with Belfast owners having about 35% of the total shares after the swap, before considering the effects of the other mergers), the conclusion in this case will be to permit designation of this transaction as a uniting of interests.
The Cairo Company, Inc. case is somewhat easier to resolve. In terms of relative market values, there is great disparity between the participants to this transaction ($111 million vs. $24 million), and even if the assessed fair value of Cairo's assets ($36 million) is considered, the gulf is probably too wide to bridge, in terms of satisfying IAS 22 criteria. More obviously, the fact that none of the Cairo owners and managers will continue in active roles belies the notion that there will be true coming together of the constituent parties' interests. Thus, notwithstanding that the former Cairo shareholders will continue as passive investors in Ahmadi, their perspective on the investment will almost certainly differ from that of active participants in the daily affairs of the company.
The Cairo transaction also includes an element of contingent consideration, with former Cairo stockholders eligible to receive additional Ahmadi shares if future earnings are greater than forecast. This does suggest a disparity of risks and rewards as between the two groups of owners, which would make it questionable to use pooling accounting even if the other problems noted did not exist. For all of the foregoing reasons, the conclusion will be that this transaction must be accounted for as an acquisition, not a uniting of interests.
The Delhi Corporation merger involves both cash and stock, raising a possible red flag since unitings of interest are, generally, purely stock swaps among the parties to the combination. However, the "only-stock" rule relates only to that which is issued by the acquirer for the acquired entity's voting stock; cash or other means of payment may be given in exchange for other securities (nonvoting equity or debt) of the entity acquired. In this case, Ahmadi gives an interest-bearing note for preexisting debt of Delhi, which does not affect the uniting of interests criteria. Also, the fact that a small minority of Delhi shareholders (owning 0.5% of its shares) are bought out for cash does not have any negative consequences, since this normally occurs in many business combinations of this type. The relative sizes of the combining entities (in terms of market value of stock, $111 million vs. $95 million) are extremely favorable to uniting treatment. Finally, continuity of management makes this combination clearly eligible for uniting-of-interests treatment.
Finally, consider the Eyre, Inc. merger. Common shares of Eyre are being obtained in exchange for a package of preferred and common Ahmadi shares, and additional common shares may be issued in the future if the market value of the shares originally given falls below a specified threshold.
The issuance of preferred stock that is nonvoting is a clear violation of the concept of an exchange of voting interests among the parties to the transaction. Effectively, about one-fourth of the purchase is being made for preferred stock, with the remaining three-fourths being paid for with common stock (based on relative market values of the preferred and common shares). Whether this tainting is sufficient to preclude the use of uniting of interests accounting is a matter of professional judgment, however.
More significantly, the Eyre shareholders are to be given a form of price protection in this transaction. The arrangement is for a remeasurement of the value of the consideration paid (Ahmadi's preferred and common stock) to be made in two years, with additional payments owed if there has been a market decline. This effectively means that the Eyre shareholders are not facing the same set of risks and rewards as are the Ahmadi shareholders, and this discrepancy means that this transaction is probably an acquisition, not a uniting of interests.
Furthermore, the market value of Eyre ($38 million) is vastly lower than that of Ahmadi, meaning that these transacting parties are not equals in terms of economic power and will not be equals in future operations of the combined operations. All told, therefore, it is clear that this transaction must be accounted for as an acquisition.
The necessary entries to record the Belfast and Delhi mergers as poolings in 2004 on Ahmadi's books are as follows:
| 3,900,000 | |
| 38,500.000 | |
| 9,800,000 | |
| 2,500,000 | |
| 13,333,300 | |
| 21,366,700 | |
| 15,000,000 | |
| To record Belfast acquisition by pooling | ||
| 475,000 | |
| 12,000,000 | |
| 72,000,000 | |
| 375,000 | |
| 7,500,000 | |
| 12,750,000 | |
| 750,000 | |
| 4,975,000 | |
| 58,125,000 | |
| To record Delhi acquisition by pooling |
If, instead of a merger, the combination (acquisition) form is utilized, whereby Ahmadi shares are exchanged directly for Belfast and Delhi shares held by the respective stockholders of those companies, Belfast and Delhi will continue their separate existence (albeit as wholly owned subsidiaries of Ahmadi Corporation). The entries in 2004 to record the transactions assuming a pooling are as follows:
| 49,700,000 | |
| 13,333,300 | |
| 21,366,700 | |
| 15,000,000 | |
| To record acquisition of Belfast shares | ||
| 63,000,000 | |
| 13,500,000 | |
| 475,000 | |
| 12,750,000 | |
| 375,000 | |
| 750,000 | |
| 4,975,000 | |
| 58,125,000 | |
| To record acquisition of Delhi stock, payment of bank loan and retirement of minority shares for cash | ||
The purchase accounting entries will be presented in the following section, after the basic elements of this method of accounting for business combinations are discussed. Disclosure requirements for both acquisitions and unitings are set forth later in this chapter.
Acquisition Accounting
In most business combinations, one enterprise gains control over another, and the identity of the acquirer can readily be determined. Generally, the combining enterprise that obtains more than one-half of the voting rights of the other combining enterprises is the acquirer. In exceptional cases, the party that is the acquirer does not obtain over one-half of the voting rights; but the identity of the acquirer will be the party that obtains power
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Over more than one half of the voting rights of the other enterprise by virtue of agreement with the other investors (e.g., voting trust arrangements or other contractual provisions)
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To govern the financial and operating policies of the other enterprise, under a statute or agreement
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To appoint and remove the majority of the board of directors or equivalent governing body of the other enterprise
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To cast the majority of votes at meetings of the board of directors or equivalent body
Other indicators of which party was the acquirer in any given business combination are as follows (these are suggestive only, not conclusive):
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The fair value of one entity is significantly greater than that of the other combining enterprises; in such a case, the larger entity would be deemed the acquirer.
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The combination is effected by an exchange of voting stock for cash; the entity paying the cash would be deemed to be the acquirer.
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Management of one enterprise is able to dominate selection of management of the combined entity; the dominant entity would be deemed to be the acquirer.
The major accounting issue in business acquisitons pertains to the allocation of the purchase price to the individual assets obtained and liabilities assumed. In this regard, IAS 22, as revised in 1998, made certain modifications to the requirements set forth in the original standard. While previously fair value of acquired assets was to be determined with reference to the intended use by the acquirer, as assets can obviously have alternative values based on intended use, the current standard makes no such reference. As has traditionally been the case, if the fair value of net assets (i.e., assets acquired less liabilities assumed) is less than the aggregate purchase cost, the excess will be deemed to represent goodwill. If the fair value of net assets acquired is greater than the cost, this difference will be negative goodwill, to be accounted for as specified by IAS 22. In the case of positive goodwill, the revised IAS 22 deleted the former twenty-year limit on amortizable life; in its place (to conform with the rules for all other intangible assets, as set forth in IAS 38) is the rebuttable presumption of a life of no longer than twenty years, but the possibility that a longer life (but not an indefinitely long one) can be justified. As for negative goodwill, the former benchmark and alternative treatments have been scrapped, replaced by an entirely new prescription. These matters are dealt with in detail later in this chapter.
Another major change in accounting for business acquisitions mandated by the revised IAS 22 relates to recognition of certain liabilities that arise as a consequence of the acquisition transaction. Under these rules, liabilities which relate to the acquiree's business and which arise directly as a consequence of the acquisition transaction are recorded and will affect the allocation of the purchase price to assets acquired and liabilities assumed, when the acquirer has done all the following:
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It has, at or before the date of acquisition, essentially developed a plan which involves certain specified resource outflows, such as compensation to terminated employees of the acquiree entity
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It has raised an expectation among those affected by the plan as a consequence of public announcements or similar overt actions
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It has developed the plan into a formal detailed plan that meets the criteria of IAS 37 pertaining to restructurings by the earlier of three months after the date of acquisition, or the date when financial statements are approved
When the foregoing criteria are met, accrual of certain obligations of the acquiree is required by the acquirer as an integral part of the purchase price allocation process.
If the acquisition form of combination is used, the acquired entity maintains a separate legal and accounting existence and all assets and liabilities remain at their premerger book values. However, when an accounting consolidation is performed (i.e., when consolidated financial statements are prepared), exactly the same results are obtained as those outlined above (i.e., assets and liabilities are adjusted to fair values, and goodwill is recorded). When less than 100% of the stock of the acquired entity is owned by the acquirer, a complication arises in the preparation of consolidated statements, and a minority interest (discussed below) must be computed.
The other major distinguishing characteristic of the purchase accounting method is that none of the equity accounts of the acquired entity (including its retained earnings) will appear on the acquirer's books or on consolidated financial statements. In other words, ownership interests of the acquired entity's shareholders are not continued after the merger, consolidation, or combination (acquisition) takes place.
Reverse acquisitions.
IAS 22 establishes the notion of reverse acquisitions. These are characterized by an entity issuing shares in exchange for shares in its target acquiree, such that control passes to the acquiree due to the number of additional shares issued by the acquirer. In such cases, notwithstanding the nominal or legal identification of the acquirer and acquiree, for accounting purposes, the enterprise whose shareholders now control the combined entity is the acquirer.
Accounting for acquisitions.
The purchase method is to be used to report acquisitions; the transaction is to be recorded in a manner similar to that applied to other purchases of assets. That is, the purchase price must be allocated among the various assets that are obtained, net of any liabilities assumed in the transaction, commensurate with the fair values of those assets. If the price equals the fair value of the net assets, the allocation process will be straightforward, with each asset being recorded at fair value. If the price exceeds the fair value of the net identifiable assets, a goodwill issue must be addressed, as discussed below, since the individual identifiable assets cannot be recorded at amounts greater than their respective fair values. Similarly, if the fair values of the net identifiable assets acquired exceeds the price paid, negative goodwill exists; this is also discussed later in this chapter.
The acquisition should be recognized as of the date it is effected, since this form of business combination is a discrete transaction occurring at a point in time, caused by a change in ownership and resulting in changes in the bases of accountability. The standard suggests that the critical date is that when control of the net assets and operations of the acquired entity is effectively transferred to the acquirer. One important consequence of this rule is that results of operations of the acquiree are included only from the date of the transaction. Financial statements for earlier periods are not restated to reflect the combination (although pro forma results for earlier periods can, of course, be presented for purposes of supplementary analysis).
Acquisitions should be accounted for at the cost paid or incurred. Cost is the amount of cash paid or the fair value of other consideration given to the shareholders of the acquired entity. It includes transaction costs such as legal and accounting fees, investment banking charges, and so on. Depending on the terms of the acquisition agreement, it may include certain contingent consideration as well (discussed below).
Individual assets and liabilities should be recognized separately at the date acquired, if it is both probable that any associated economic benefits will flow to the enterprise, and a reliable measure of cost or fair value to the acquirer is available. In the case of most acquisitions, these conditions will readily be met, since in an arm's-length transaction the parties normally will have knowledge of the price paid and the acquirer would not have consummated the purchase unless all the attendant benefits would flow to it in subsequent periods.
If the fair value of the identifiable net assets acquired is lower than the price paid, the excess cost should be allocated to goodwill (excess of cost over fair value of net assets acquired). If the fair value of the identifiable net assets acquired is greater than the price paid, the excess value should be allocated to negative goodwill (excess of fair value of net assets acquired over cost).
Determining purchase price.
In some acquisitions, a package consisting of different forms of consideration may be given. As is often stipulated in accounting rules, the primary measure should be the fair value of any assets given up in the transaction; these may include, in addition to cash, promissory notes, shares of stock, and even operating assets of the acquirer. Except when actual cash is exchanged, fair values may differ from book values. Thus, promissory notes may carry a rate of interest other than a market rate, in which case a premium or discount will be ascribed to the obligation. (For example, if a $10 million, 5% interest-bearing two-year note is proffered in a business acquisition, in an environment where the buyer would normally pay 8% on borrowed funds, the actual purchase price will be computed as being somewhat lower than the nominal $10 million.)
Similarly, the acquirer's common stock will virtually always have a market value different from par or stated amounts. If there is an active market for the shares, reference should be made to the price quoted, although a small discount might be imputed to reflect the fact that a large offering of new shares would, in a perfect market, have a depressing effect on price. If the market price on any given day is not deemed to be a reliable indicator, the prices over a period of days before and after the announcement of the terms of the acquisition transaction should be considered. If the stock is thinly traded, or not traded at all, or if shares in a listed company are offered with restrictions (not salable for a fixed period of time, etc.), it would be necessary to ascertain a reasonable value, possibly in consultation with investment bankers or other experts. In extreme cases, the fair value of the proportionate interest in the acquired entity's net assets, or the fair value of the fraction of the acquirer's net assets represented by the shares issued would be used as a measure, whichever is more objectively determinable. If dissenting minority shareholders of the acquiree are paid in cash, the price paid may also serve as a reliable indicator of the value of the transaction. Of course, the parties to the transaction, being at arm's length, should also be able to place an objective value on the stock being exchanged, inasmuch as they had negotiated for this price.
If the acquirer exchanges certain of its assets, either operating assets that had been subject to depreciation, or investment securities or other investments assets, such as idle land, for the stock of the acquired entity, again an assessment of fair value must be made. Book value, even if the assets had been adjusted to fair value under the alternative treatment permitted by IAS 16, could not be taken as being fair value for purposes of accounting for the business combination, unless corroborated by other evidence.
If the acquisition is to be paid for on a deferred basis, the cost to be reflected will be the present value of the future payments, discounted at the acquiring entity's normal borrowing cost, given the terms of the arrangement.
Step acquisitions.
In many instances, control over another entity is not achieved in a single transaction, but rather, after a series of such transactions. For example, one enterprise may acquire a 25% interest in another entity, followed by another 20% some time later, and then followed by another 10% at yet a later date. The last step gives the acquirer a 55% interest and, thus, control. The accounting concern is at what point in time the business combination took place and how to measure the cost of the acquisition.
IAS 22 stipulates that the cost of the acquisition is measured with reference to the cost and fair value data as of each exchange transaction. In the foregoing example, therefore, it would be necessary to look to the consideration paid for each of the three separate purchases of stock; if noncash, these would have to be valued as described earlier in this section. To the extent that the value of the consideration given differed from the fair value of the underlying net assets, measured at the date of the respective exchange, goodwill or negative goodwill would have to be recognized. Conceivably, successive purchases could be at premiums over and discounts from fair values.
In the example above, the first acquisition results in a 25% holding in the investee, which is over the threshold where significant influence is assumed to be exerted by the investor. Thus, the equity method should be employed beginning at the time of the first exchange and continuing through the second exchange (when a 45% ownership interest is achieved). Application of the equity method is explained in Chapter 10; one important aspect, however, is that the difference between cost and the fair value of the underlying interest in the net assets of the investee is to be treated as goodwill or negative goodwill and accounted for consistent with the provisions of IAS 22. Accordingly, this needs to be computed and then amortized as discussed in this chapter. The amount of unamortized goodwill (or negative goodwill) at the date of the next exchange transaction should not be merged into the next computation of goodwill, lest the amortization period for the first component be inadvertently extended beyond the limitations of the standard. In other words, each step in the transaction sequence should be accounted for as a separate acquisition.
The only exception to the foregoing requirements would occur if, as permitted under IAS 25, the entire investment is revalued to fair value at the dates of subsequent share purchases. Under this scenario, each revaluation must be accounted for as such, with the appropriate disclosures being made in the financial statements.
When control (majority ownership) is finally achieved (the third step acquisition in the example above) if an accounting consolidation is performed to produce consolidated financial statements, the fair values to be presented for the acquired entity's assets would be an appropriate blending of the fair values as of the various steps in the acquisition. In the present case, for example, using the benchmark treatment specified in IAS 22 (discussed in detail below), 25% of each asset would be reported at the fair value as of the date of the first exchange, another 20% at the fair value as of the date of the second exchange, and the final 10% at the fair value as of the date of the third exchange, with the remaining 45% of the asset stated at cost, that is, at the predecessor entity's carrying value.
Recording the Assets Acquired and Liabilities Assumed
The assets acquired and liabilities assumed in the business combination should be recorded at fair values. If the acquirer obtained a 100% interest in the acquired entity, or if a legal merger were effected, this process is straightforward. As suggested above, if the cost exceeds the fair value of the net assets acquired, the excess is deemed to be goodwill, and capitalized as an intangible asset, subject to amortization. If the fair value of net assets exceeds total cost, the difference is referred to as negative goodwill and is subjected to one of two treatments: either offset against nonmonetary assets, or credited to a liability account and later amortized (these are discussed in detail below).
Determining fair market values.
Accounting for acquisitions requires a determination of the fair market value for each of the acquired company's identifiable tangible and intangible assets and for each of its liabilities at the date of combination. The determination of these fair market values is crucial for proper application of the purchase method. The list below indicates how this is done for various assets and liabilities.
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Marketable securities—Current market values.
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Nonmarketable securities—Estimated fair values, determined on a basis consistent with relevant price-earnings ratios, dividend yields, and expected growth rates of comparable securities of entities having similar characteristics.
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Receivables—Present values of amounts to be received determined by using current interest rates, less allowances for uncollectible accounts.
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Inventories
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Finished goods and merchandise inventories—Estimated selling prices less the sum of the costs of disposal and a reasonable profit.
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Work in process inventories—Estimated selling prices of finished goods less the sum of the costs of completion, costs of disposal, and a reasonable profit.
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Raw material inventories—Current replacement costs.
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Plant and equipment—At market value as determined by appraisal; in the absence of market values, use depreciated replacement cost. Land and building are to be valued at market value.
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Identifiable intangible assets (such as patents and licenses)—Fair values determined primarily with reference to active markets as per IAS 38; in the absence of market data, use the best available information, with discounted cash flows being useful only when information about cash flows which are directly attributable to the asset, and which are largely independent of cash flows from other assets, can be developed.
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Net employee benefit assets or obligations for defined benefit plans—The actuarial present value of promised benefits, net of the fair value of related assets. (Note that an asset can be recognized only to the extent that it would be available to the enterprise as refunds or reductions in future contributions.)
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Tax assets and liabilities—The amount of tax benefit arising from tax losses or the taxes payable in respect to net earnings or loss, assessed from the perspective of the combined entity or group resulting from the acquisition. The amount to be recorded is net of the tax effect of restating other identifiable assets and liabilities at fair values.
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Liabilities (such as notes and accounts payable, long-term debt, warranties, claims payable)—Present value of amounts to be paid determined at appropriate current interest rates.
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Onerous contract obligations—At the present value of the amounts to be disbursed, including any amounts (e.g., plant closures) arising incidental to the acquisition.
IAS 22 explicitly requires that in certain cases, such as for monetary liabilities, fair value be determined by the use of discounting. In other instances, such as for intangible assets, discounting is not explicitly prescribed. However, the standard permits the use of discounting in determining fair values of any identifiable assets and liabilities.
Since aggregate purchase cost is allocated to the identifiable assets (and liabilities) according to their respective fair values to the acquirer, assets having no value are assigned no cost. For example, facilities of the acquired entity that duplicate those of the acquirer and are to be disposed of should be assigned a cost equal to estimated net salvage value, or zero if no salvage is anticipated. In rare instances, however, a negative cost equal to the estimated costs of disposal is assigned. It could also be reasonably argued that holding costs should be allocated to assets to be disposed of when debt from the business acquisition is to be paid down from the proceeds of such asset sales. In effect, the value assigned to such assets to be sold would be the present value of the estimated selling price; interest incurred on debt used to finance these assets would then be charged to the asset rather than to interest expense until the disposition actually occurs. On the other hand, if facilities of the acquired entity duplicate and are superior to facilities of the purchaser, with the intention that the latter will be disposed of, fair value must be allocated to the former. Eventual disposition of the redundant facilities of the acquirer may later result in a recognized gain or loss. This would fall into the general category of indirect costs of acquisition, which are not capitalizable or allocable to assets acquired in the purchase business combination.
Subsequent adjustment to assets acquired and liabilities assumed.
IAS 22 provides that in certain circumstances the amounts allocated to identifiable assets and liabilities in a business combination accounted for as an acquisition may be subsequently adjusted. This is to deal with those situations where certain assets or liabilities did not meet the threshold criteria for recognition at the time the acquisition transaction is consummated. To the extent that this information becomes known by the end of the first annual accounting period after the date of the business combination, the amounts allocated to various assets and liabilities may be adjusted. For example, if the existence of an intangible asset was not known with sufficient certainty to warrant asset recognition (e.g., a patent application as of that date appeared likely to be rejected, but was later granted), the adjustment will be such that the intangible asset is recognized (or increased) and the amount of goodwill (usually) will be decreased by a corresponding quantity.
After this date, however, any such adjustments must be made to income or expenses in the period the adjustment becomes known. For example, if the patent is approved two years after the acquisition transaction, the intangible asset would be increased but the offset would be to credit (i.e., increase) a revenue account or decrease an expense account.
SIC 22 has provided clarification regarding how the adjustment to the pertinent asset or liability account(s) should be computed. SIC 22 states that such adjustments should be calculated as if the newly assigned values had been used from the date of the acquisition. Thus, in the case of a depreciating asset such as a patent, the adjustment should take into account the amount of depreciation or amortization that would have been recognized subsequent to the date of acquisition, had the asset been fully recognized as of that date. This is necessary to avoid having later periods charged with more annual depreciation than would have been the case had the lack of ability to properly allocate costs at the date of the acquisition not occurred as it did.
SIC 22 also states that adjustments to amounts included in the income statement, such as depreciation or amortization of goodwill, are included in the corresponding category of income or expense presented on the face of the income statement. That is, these adjustments cannot be segregated from the normal categorization that would have been appropriate, and, for example, shown as some type of nonoperating or nonrecurring transaction.
Finally, SIC 22 requires disclosure of the amount of an adjustment recognized in the income statement of the current period that relates to comparative and prior periods. For example, if the adjustment increases depreciation expense in the current period by $15,000, and $10,000 of the increase results from the recalculation of the effects of the adjustment to identifiable assets over the comparative year, that fact would be disclosed. This is necessary to avoid misleading implications from being drawn from the comparative amounts being presented.
Allocation of Cost of Acquisition When the Acquirer Obtains Less Than 100% of the Acquiree's Voting Interest
When an acquirer obtains a majority interest, but not 100% ownership, in another entity, the process of recording the transaction will be more complicated. The portion of the acquired operation not owned by the acquirer, but claimed (in an economic sense) by outside interests, is referred to as minority interest. The accounting issue is whether, in a situation in which goodwill or negative goodwill will be reported, to value it with reference only to the price paid by the new (majority) owner, or whether to gross up the balance sheet for the minority's share as well. In general, an actual arm's-length transaction must take place before a new value can be placed on existing assets and operations (although under IAS 16 revaluations of plant assets can be made). Since the minority did not partake of the acquisition transaction, it can be argued that there is no basis on which to posit any recognition of goodwill for its share of the acquired entity.
The counterargument usually posed is that the majority change in ownership in such a situation is the most objective recent evidence of the value of the acquired enterprise. Furthermore, not to reflect the minority's interest at current market value would be to create a balance sheet having an amalgamation of dissimilar costs, some new, some old. In fact, in some countries the concept of push-down accounting (also known as new basis accounting) had gained currency, and some regulatory authorities, including the US Securities and Exchange Commission (SEC), demand the application of this form of accounting within very narrowly defined circumstances. Due to the strength of arguments on both sides of this debate, the international accounting standards setters have decided to permit both approaches, as described further in the following paragraphs.
Benchmark treatment.
Assets and liabilities recognized are measured at the aggregate of the fair value of the identifiable assets and liabilities acquired as of the date of the exchange transaction, to the extent of the acquirer's interest obtained in the transaction; plus the minority's proportion of the preacquisition carrying amounts of the assets and liabilities of the subsidiary (acquiree). This means that there will be no step-up of the minority interest to reflect the valuation indirectly being placed on the enterprise being acquired by the new majority owner.
Under this benchmark approach, the minority interest shown in a consolidated balance sheet will be the minority percentage times the net assets of the subsidiary as reported in the subsidiary's stand-alone balance sheet. Goodwill will be reported to reflect only the excess paid by the majority owner in excess of the fair value of the net identifiable assets acquired. This is illustrated in an example later in the chapter.
The logic of this approach is its adherence to the cost principle. Since the new parent/majority owner has effectively acquired only a fraction of the acquired entity's assets and liabilities, only that fraction should logically be revalued to reflect the purchase price. The remaining fraction, representing the minority shareholders' interests, has not been acquired and therefore should not, under a cost concept approach, be revalued. This method of accounting treats business acquisitions like any other type of asset acquisition.
Allowed alternative treatment.
All identifiable (i.e., excluding goodwill) assets and liabilities are recognized at their respective fair values, including those corresponding to the minority's ownership interest. This means that there is a step-up in value to equal the valuation being placed on the enterprise indirectly by the new majority owner.
Under this approach, the minority interest shown in a consolidated balance sheet will be the minority percentage times the net assets of the subsidiary as reported in the parent's consolidated balance sheet. Goodwill will be reported, as under the benchmark treatment, to reflect only the excess paid by the majority owner in excess of the fair value of the net identifiable assets acquired. This, too, is illustrated in a later example.
This approach uses the purchase price for the majority interest as an indicator of the value of the entire acquired entity. The strength of this approach is that the acquired entity's assets and liabilities are valued on a consistent basis, presumably using the most recent, objectively determined valuation data. Since international accounting standards recognize the validity of revaluations of certain assets (see the discussion of IAS 16 in Chapter 8 and of IAS 40 in Chapter 10), this approach is not really a conceptual departure from accepted practice.
Example of accounting for a purchase
|
Continuing the Ahmadi Corporation example begun in the uniting of interests discussion earlier in this chapter, the journal entries to record the purchase of the Cairo Company, Inc. and Eyre, Inc. shares will be presented. Tax effects are ignored in these examples.
Using the fair market value information given earlier and assuming that a legal merger (or consolidation) form is used, Ahmadi makes these entries in 2004, at the time of the mergers.
| 4,000,000 | |
| 19,080,000 | |
| 3,100,000 | |
| 6,500,000 | |
| 4,000,000 | |
| 15,680,000 | |
| To record purchase of net assets of Cairo |
| |
| 50,000,000 | |
| 108,000,000 | |
| 28,000,000 | |
| 50,000,000 | |
| 17,500,000 | |
| 1,000,000 | |
| 12,500,000 | |
| 49,000,000 | |
| To record purchase of net assets of Eyre |
The value of the Cairo purchase was determined by reference to the latest market value of the Ahmadi shares given ($492 per share). Notice that although the price paid (based on the market value of Ahmadi shares given up) was slightly greater than Cairo's net book value ($19.68 million vs. $18 million), it was considerably less than estimated fair value ($36 million, net). In other words, there was an excess of fair value over cost that, in accordance with the procedures specified by [AS 22, was allocated against plant and equipment (the only nonmonetary asset). Had this deficiency been large enough to reduce plant and equipment to zero, any remaining amount would have been recorded as a deferred credit (excess of fair value of net assets acquired over cost) and amortized systematically, like goodwill, over not more than twenty years, unless a longer life could be justified. Implicitly, of course, by offsetting the negative goodwill against nonmonetary assets, it will be amortized over the depreciable lives of these assets.
The total value of the Eyre purchase was $80 million ($61.5 million of common shares, measured at the market value of $492 each multiplied by the 125,000 shares given, plus 175,000 shares of preferred having an approximate value of $105.70 each). The total price exceeded the net book value of Eyre's identifiable assets, although it was still lower than the fair value thereof, so here again there is an excess of fair value over cost (i.e., negative goodwill), and the noncurrent assets are recorded at less than their fair values.
If the shares are to be held by the parent as an investment instead (i.e., the companies are not to be legally combined), the entries by the parent company would be as follows:
| 19,680,000 | |
| 4,000,000 | |
| 15,680,000 | |
| 80,000,000 | |
| 17,500,000 | |
| 1,000,000 | |
| 12,500,000 | |
| 49,000,000 |
|
Goodwill and Negative Goodwill
Goodwill.
Goodwill represents the excess purchase price paid in a business acquisition over the fair value of the identifiable net assets obtained. Presumably, when an acquiring enterprise pays this premium price, it sees value that transcends the worth of the tangible assets and the identifiable intangibles, or else the deal would not have been consummated on such terms. Goodwill arising from acquisitions must be recognized as an asset and then amortized over a useful life not exceeding twenty years, unless a longer life can be demonstrated. A longer life can sometimes be justified by reference to factors such as the foreseeable life of the business or industry; the effects of physical obsolescence, changes in demand, and other economic factors; the service life expectations of key individuals or groups of workers; any expected actions by competitors or potential competitors; and legal, regulatory, or contractual provisions affecting the useful life. In general, goodwill would have to be related closely to such identifiable assets as a patent or specific productive plant assets such as buildings, if a life longer than twenty years is to be supported.
Under previous IAS, goodwill was absolutely limited to a life of no longer than twenty years, but to conform the treatment of all intangible assets with that prescribed by recently promulgated IAS 38, the new standard imposed by IAS 22 (revised) sets twenty years as the rebuttable presumption of the useful life limit rather than the absolute maximum. The range of factors to be considered in determining the useful life of goodwill has also been expanded to include public information on estimates of useful life of goodwill in similar businesses or industries, as well as the level of maintenance expenditure or funding required to glean the benefits from the business to which the goodwill relates, and the acquirer's ability and intent to achieve that level. While cautioning against placing undue emphasis on these undeniably more subjective factors, IAS 22 (revised) also suggests that when goodwill is closely related to an asset or group of assets having longer lives (e.g., a broadcast license), a longer life may indeed be justified. If a life of greater than twenty years is elected, however, annual evaluations for impairment, consistent with provisions of IAS 37, must be undertaken, and the reasons why the twenty-year limitation presumption was overcome must be disclosed.
The amortization of recorded goodwill should be accomplished using the straight-line method in most cases, since it would be unusual, although not inconceivable, to be able to demonstrate a different pattern of expiration of value. Furthermore, the balance in the goodwill account should be reviewed at each balance sheet date to determine whether the asset had suffered any impairment. If goodwill is no longer deemed probable of being fully recovered through the profitable operations of the acquired business, it should be partially written down or fully written off. Any write-off of goodwill must be charged to expense just as normal amortization is. Once written down, goodwill cannot later be restored as an asset, again reflecting the concern that the measurement of goodwill is difficult and proof of its existence almost impossible to develop.
It should be noted that goodwill is recorded, in the case of acquisitions of less than 100%, only for the price paid by the new parent company in excess of the fair values of the net identifiable assets of the subsidiary. That is, no goodwill is imputed to the minority interests based on the price paid by the majority. While under the allowed alternative (see below) the net identifiable assets attributable to the minority may be written up to the values implied by the majority's purchase decision, goodwill will not be imputed for the minority share.
Impairment of goodwill.
Assume that an entity acquires another enterprise in a transaction accounted for as a purchase, and that after allocation of the purchase price to all identifiable assets and liabilities an unallocated excess cost of $500,000 remains. Also assume that, when it later becomes necessary to consider impairment of assets, it is determined that the acquired business comprises seven discrete cash generating units. The goodwill recorded on the acquisition (originally $500,000), net of any accumulated amortization, must be evaluated for possible impairment which will require that it be allocated to those of the seven cash generating units which can be identified with the goodwill. For example, it may be that the goodwill is associated with only one or a few of the seven cash generating units, in which case, the goodwill recognized in the balance sheet should be allocated to those assets or groups of assets. IAS 36 describes what are referred to as "bottom up" and "top down" tests, to be applied in such circumstances.
The "bottom up" test compares the recoverable amount of a cash generating unit, including allocated goodwill, to the aggregate carrying amount of those assets. If all goodwill is allocated to operating assets and cash generating units, this "bottom up" test will be adequate to accomplish the goal of testing for impairment.
In some instances, it may not be possible to allocate all goodwill to assets or groups of assets with which cash inflows and outflows can be identified. In such instances, the standard prescribes a "top down" test to be administered. In this testing mode, it is necessary to identify the smallest cash generating unit which contains the unit being evaluated, to which the goodwill can be reasonably and consistently allocated. Having done this, the recoverable amount of the larger unit (containing the unit being evaluated) is evaluated by comparing the recoverable amount to the corresponding carrying amount. If an impairment is detected in this evaluation process, the goodwill will be written down as described in the following paragraphs.
The purpose of prescribing the "top down" test is to ensure that all goodwill presented on the balance sheet gets tested for impairment (if conditions warrant), and that an inability to assign goodwill to a group of operating assets not be a terminal impediment to achieving impairment testing. At some level of aggregation (the extreme case would be to aggregate the enterprise as a whole) it will be possible to compare recoverable amounts with carrying values. A failure to follow this procedure would create the risk that goodwill could be retained on the balance sheet even if it had no further value to the enterprise, thus departing from generally accepted accounting principles in the larger sense, and from IAS 36 in particular. By applying first the "bottom up" and then the "top down" test, if there is no impairment identified during the first phase, it becomes clear that an impairment found during the subsequent testing must be associated with goodwill.
When an impairment is computed for a cash generating asset that includes goodwill, whether as a result of "bottom up" or "top down" analyses, an adjustment will be required. Under the rules established by IAS 36, an impairment loss is first absorbed by goodwill, and only when this has been eliminated entirely are further impairment losses credited to other assets in the group. This is perhaps somewhat arbitrary, but it is also logical, since the excess earnings power represented by goodwill must be deemed to have been lost if the recoverable amount of the cash generating unit is less than its carrying amount. It is also a conservative approach, and will diminish or eliminate the display of that often misunderstood and always suspiciously viewed asset, goodwill, before the carrying values of identifiable intangible and tangible assets are adjusted.
Reversal of previously recognized impairment of goodwill.
Regarding the reversal of an impairment pertaining to a cash generating unit that included goodwill, which was recognized in an earlier period, due to the special character of goodwill, IAS has imposed a requirement that, in general, reversals not be recognized for previous write-downs in goodwill. Thus, with limited exceptions, a later recovery in value of the cash generating unit will be allocated only to the identifiable assets. (The adjustments to those assets cannot be for amounts greater than would be needed to restore them to the carrying amounts at which they would be currently stated had the earlier impairment not been recognized.)
The only exception provided by IAS 36 regarding the restoration of goodwill previously written down or written off due to impairment occurs when the impairment had been the result of a discrete, externally derived event of exceptional nature, which is not anticipated to recur, coupled with the occurrence of a subsequent externally sourced event which reverses the earlier impairment. The standard notes that IAS 38 prohibits the recognition of internally generated goodwill, and further observes that most later recoveries in impaired goodwill will be the result of internally generated goodwill, in effect, replacing the externally acquired goodwill which had previously been written off. Thus, it is very unlikely that goodwill, once impaired, can be restored, since what would otherwise be characterized as a recovery of previously lost goodwill is instead more likely to be newly created, internal goodwill which cannot be recognized under the standards.
Notwithstanding the foregoing, IAS 36 does allow that externally sourced events beyond the control of the reporting entity can occur. Examples of such truly exceptional events would be the imposition of new regulations that significantly curtail the entity's operations, or decrease its profitability. If such regulations were first imposed, then later lifted, it is conceivable that an impairment that resulted in a downward adjustment to goodwill, or its elimination, could later be reversed.
Negative goodwill.
In the context of certain purchase business combinations, there will be an indicated shortfall of purchase price versus the fair value of net assets acquired. This difference has traditionally been referred to as "negative goodwill," although the term is inherently nonsensical (and will probably be banished under the expected replacement for IAS 22). Since arm's-length transactions usually favor neither party, the likelihood of the acquirer obtaining a bargain is considered remote, and apparent instances of negative goodwill are more often the result of measurement error (i.e., fair values assigned to assets and liabilities were incorrect to some extent) or of a failure to recognize a contingent or actual liability (such as for employee severance payments).
If, however, an actual bargain purchase if effected by an acquirer, the accounting question is how to handle this credit balance item, which is a residual after identifiable assets and liabilities are assigned appropriate fair (or other prescribed) values. The required accounting treatment has evolved substantially from the original standard IAS 22, through the 1993 revision, and then to the current version (1998 revision) of it—and this will change again when IAS 22 is replaced (expected to be in 2003).
Under the provisions of the original IAS 22 standard (which dates from the era when IAS were essentially compendia of all approaches then permitted by major national standard setters), three disparate ways to account for negative goodwill were permitted. These included the immediate write-off to equity (thereby increasing stockholders' equity), offsetting against the recorded amounts of the nonmonetary assets acquired in the transaction, and amortizing to income in a manner analogous to the accounting for positive goodwill.
With the goal of narrowing acceptable alternatives, IAS 22 was revised for the first time in 1993, and the immediate crediting of negative goodwill to shareholders' interests (equity) was eliminated as an acceptable approach. The other two methods—recording negative goodwill as a liability to be amortized over a period of no more than five years (or twenty years, under certain circumstances), and offsetting against nonmonetary assets obtained in the acquisition (with any excess recorded as a liability and amortized)—remained allowable.
The benchmark treatment (which despite the appellation was not deemed preferable to the allowed alternative method) under the 1993 revision to IAS 22 was to reduce the carrying value of all nonmonetary assets acquired on a pro rata basis. This was essentially the method prescribed at the time under US GAAP. It was not acceptable to select particular assets to absorb the negative goodwill. Assets having a short life, such as inventories, had to be credited with proportionally the same amount of negative goodwill as long-lived assets such as building and land. If the nonmonetary assets fully absorbed the negative goodwill, any remaining balances in the assets were to be accounted for normally. If, on the other hand, the aggregate amount of nonmonetary assets, before absorbing negative goodwill, was less than the computed amount of negative goodwill from the business acquisition, these assets were to be reduced to zero, and the remaining, unabsorbed negative goodwill was to be accounted for as deferred income and amortized in the same manner as positive goodwill (see above).
The allowed alternative treatment was to not offset negative goodwill against non-monetary assets, but rather to report it gross as deferred income, and subsequently to amortize it, generally on a straight-line basis over no more than five years. As the amortization increased reported earnings, reporting entities were inclined to keep the amortization period brief, contrary to the motive affecting amortization of positive goodwill.
Continuing its efforts to narrow the alternative accounting treatments available for given economic phenomena, the IASC in 1998 again revised IAS 22, adopting a new, single method to be applied in all cases. This is the requirement in effect currently. It concluded that negative goodwill often relates to expectations of future losses or expenses, as with the acquirer's plans to eliminate redundancies in the combined operations, which are not appropriately accruable as of the date of the acquisition. Accordingly it prescribed that, when those conditions are met, the negative goodwill should be deferred and later recognized in income as the associated losses or expenses occur and are also recognized.
To the extent that such losses or expenses are not anticipated as of the acquisition date, negative goodwill is to be recorded as a contra asset and amortized to income over the useful life of acquired identifiable nonmonetary assets, subject to the limitation that the amount of negative goodwill recorded cannot exceed the allocated cost (fair value) of those assets. Any excess negative goodwill is not to be deferred, but rather, should be taken into income immediately.
Note that if negative goodwill is deferred and amortized to income, such amortization must be based on the weighted-average useful life of the acquired depreciable and amortizable assets. It is generally not possible to associate the negative goodwill with particular assets, with the exception of those situations where expected losses or costs, such as expected losses on obsolete inventory to be liquidated, can be specifically identified. In all other cases, the amortization of negative goodwill may be on any rational and systematic basis, according to IAS 22.
Perhaps most surprising was the requirement, in IAS 22 (1998), that negative goodwill be presented as a negative asset on the balance sheet. Apparently this was deemed appropriate to the concept of negative goodwill as a contra account which serves to reduce the assets to actual historical cost.
IAS 22 also specifies that the amount of intangible assets recognized in a purchase business combination may be limited if negative goodwill is also being recognized. The standard states that no amount of identifiable intangible can be recorded if the effect would be to increase the amount credited to negative goodwill, unless the value of the identifiable intangible is supported by an active market. The purpose of this limitation is to avoid creating negative goodwill unless clearly warranted by the fair value amounts being recorded for assets acquired. Since intangibles are generally regarded as being more difficult to accurately value than tangible or financial assets, this rule serves to prevent exaggerated assignments of value to assets and to the (contra asset) negative goodwill. The practical effect of this limit will be to have the recognized amounts of certain intangible assets either reduced or eliminated in bargain purchase situations (e.g., when the acquiree has certain trade names, customer lists, and other real but not actively traded identifiable intangible assets, and it is acquired as a going concern for a price below aggregate fair value.
If the currently contemplated changes to IAS 22 are enacted, the accounting for negative goodwill will again be substantially modified. (See discussion later in this chapter.)
Contingent Consideration
In some business combinations, the purchase price is not fixed at the time of the exchange, but is instead dependent on future events. There are two major types of future events that can be used to affect the purchase price: the performance of the acquired entity, and the market value of the consideration given for the acquisition.
If the amount of the contingent consideration is likely to be incurred and can be measured reliably at the date of the acquisition, it should be included in the cost of the acquisition. If the contingent consideration is not paid later, adjustments to certain amounts recorded need to be made: The usual effects are to adjust goodwill or negative goodwill, but other assets may need adjustment if negative goodwill was offset against nonmonetary assets according to the benchmark treatment. In other cases, resolution of an uncertainty after the date of the acquisition will necessitate recording contingent consideration, which should be recognized when probable and subject to reliable estimation.
The accounting for subsequent payment of the added consideration, if the effects had not been accrued at the date of the business combination as described above, depends on whether the contingency was related to the earnings of the acquired entity or to the market value of the original consideration package given by the acquirer.
In the former instance (exemplified by the purchase of Cairo Corp. in the example presented earlier), a later payment of added cash, stock, or any other valuable consideration will require revaluation of the purchase price. This revaluation could alter the amounts allocable to noncurrent assets (where cost in the original purchase transaction was less than fair value acquired and the difference was offset against those assets), or could result in an increased amount of goodwill being recognized. The effects of a revaluation are handled prospectively: The additional amortization of goodwill and/or fixed assets is allocated to the remaining economic lives of those items, without adjustment of any postacquisition periods' results already reported.
In the latter case (exemplified by the Eyre Co. merger in the earlier illustration), the event triggering the issuance of additional shares is a decline in market value of the original purchase package. The total value of the purchase ($80,000,000 in the Eyre case) would not be changed and thus no alteration of allocated amounts would be needed. However, the issuance of extra shares of common stock will require that the allocation between the common stock and the additional paid-in capital accounts be adjusted. Had part of the original price been bonds or other debt, the reallocation could have affected the premium or discount on the debt, which would have an impact on future earnings as these accounts are subsequently amortized.
Impending Changes to Accounting for Business Combinations
As suggested earlier in this chapter, accounting for business combinations has been receiving a great deal of critical attention in recent years, from standard setters worldwide, and most of the major national accounting standard-setting bodies have already banned or severely restricted the use of pooling accounting. The most recent and most important of such actions was that taken by the US standard setter (the FASB), which ended pooling-of-interests accounting as of mid-2001. Given the IASB's goal of convergence, coupled with the excellent arguments against pooling accounting, it was to be expected that IAS 22 would be superseded by a standard which prescribes purchase accounting for all arm's-length business combinations.
The IASB undertook a two-part project in late 2001 to examine a broad range of issues pertaining to business combinations, including accounting for intangibles and goodwill, new basis accounting, the treatment of liabilities for terminating or reducing the activities of an acquiree and consolidated financial reporting. Several new standards are expected to result, including a freestanding replacement for IAS 22 and amendments to IAS 36 and 38. The major features of these changes are set forth in the following paragraphs.
IASB intends to address these matters within the framework of two major phases. The first is to deal with the definition of a business combination; the appropriate method(s) of accounting for business combinations; the accounting for goodwill (and negative goodwill) and intangible assets acquired in a business combination; the treatment of liabilities for terminating or reducing the activities of an acquiree; the initial measurement of the identifiable net assets acquired in a business combination; and the date on which equity instruments issued as consideration should be measured. IASB will also consider matters of disclosures, transitional provisions, and certain other issues identified in the Improvements Project as part of this first phase.
The second phase of the business combinations project will address the accounting for business combinations in which separate entities or operations of entities are brought together to form a joint venture, including possible applications for "fresh start" (also known as "new basis") accounting, which derives from the view that a new entity emerges as a result of a business combination and, therefore, the assets and liabilities of each of the combining entities (not just the acquiree) should be recorded at fair values. It will also consider the accounting for business combinations involving entities under common control, which are presently handled as poolings of interests. In addition, issues arising in respect of the application of the purchase method to business combinations involving two or more mutual entities, and business combinations involving the formation of a reporting entity by contract only, without the obtaining of an ownership interest, are to be examined. Finally, the second phase of the business combinations project will consider other issues arising in respect of the application of the purchase method.
Certain of the aforementioned issues are to be considered in cooperation with one or more national standard setters, including the FASB. This will hopefully serve the goal of convergence and also husband scarce resources.
Regarding the definition of business combinations, it has been agreed these are the bringing together of separate entities or operations of entities into one reporting entity. "Reporting entity" will be defined in the revised standard, which will also clarify that it can be a single entity or an economic entity comprising a parent and all of its subsidiaries. Business combinations in which separate entities or operations of entities are brought together to form a joint venture, and those involving entities (or operations of entities) under common control, will be excluded from the replacement for IAS 22 (but probably will be addressed separately, perhaps not immediately).
The reason for unifying behind the purchase method, according to IASB, is that although
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...some transaction or event [may] exist (other than a business combination involving the formation of a joint venture) in which the bringing together of separate entities or operations into one reporting entity is not an acquisition...suitable nonarbitrary criteria to distinguish those transactions from acquisition do not exist; and developing such nonarbitrary criteria would be difficult and the cost of developing and applying those criteria would outweigh the benefits obtained.
Additionally, even if such criteria could be developed, having two or more methods for accounting for essentially identical transactions would incentivize transaction structuring to gain favorable accounting treatment, which is seen as being dysfunctional.
The IASB has rejected the suggestion that new basis accounting (referred to as "fresh start" accounting by IASB)—where both parties' assets and liabilities are adjusted to fair value, not just the acquiree's—be employed when the identity of the acquirer is not apparent. For example, a brand-new entity may be created to nominally acquire both of the actual combining entities, but the mere form of this type of arrangement should not disguise the fact that one of the two preexisting businesses is acquiring the other. Accordingly, the IASB is insisting that one party to a business combination is the acquirer, and that substance must be accounted for in all cases.
The Board's business combinations projects are also devoting very substantial attention to questions about accounting for intangibles acquired in business combinations, including goodwill. It is a virtual certainty that a US GAAP-like solution will be produced, with goodwill no longer to be amortized, but rather to be subject to annual impairment testing. There will be the concomitant emphasis on the full and careful identification of all intangible assets obtained in business acquisitions, to ensure that only the true residual is allocated to the goodwill account. This effort is not to be limited in any way, even to minimize the amount that might consequently have to be recognized as negative goodwill. All identifiable intangibles will have to be given initial recognition apart from goodwill, if they arise as a result of contractual or legal rights or are separate from the business.
Intangibles with finite useful lives will continue to be accounted for in accordance with IAS 38. However, while current IAS 38 sets a rebuttable presumption of a twenty-year maximum life, the new standard will likely remove the current requirement for the recoverable amount of an identifiable intangible asset with a finite useful life and being amortized over a period in excess of twenty years (whether or not acquired in a business combination) to be measured at least at each financial year-end. Instead, the general impairment testing requirements of IAS 36 would be applied. Thus, longer lives will be less difficult to justify and implement.
More significantly, the new standard will apparently permit acknowledgment that intangibles may have indefinite lives, and thus, not be subjected to periodic amortization until it becomes clear that the life of a given intangible is indeed finite. It will be necessary to apply an annual impairment to such assets, however, using the existing procedures set forth in IAS 36 (in contrast the US GAAP solution, which created a different impairment test for goodwill than already existed for other long-lived assets).
The IASB will also address the accounting for acquired "in-process research and development" as part of the new business combinations projects. Under IAS, research costs are expensed as incurred, while development costs are capitalized, when future economic benefits can be reasonably demonstrated. (Under US GAAP, both research and development costs are expensed at once.) Thus, under the replacement for IAS 22, purchase price allocation will include assignment of cost to the fair value of acquired in-process research and development, and to the extent that this would be recognizable as an asset if internally generated, it will qualify for capitalization when part of a business acquisition, also. This would have to be recognized separately from goodwill, as with any other acquired intangible.
IASB has acknowledged that applying the same criteria to all intangible assets acquired in a business combination to assess whether they should be recognized separately from goodwill will result in the treatment of some in-process research and development projects acquired in a business combination differing from the treatment of similar projects started internally. That is because, under IAS 38, an intangible asset can never exist in respect of an in-process research project, but only in respect of an in-process development project only once all of the criteria for deferral in IAS 38 have been satisfied. In other words, there is a risk that under the new business combinations standard intangible assets may be recognized before deferral criteria are fully met. However, this consistency is seen as being unavoidable. Such assets, once recognized, will be subject to IAS 38 provisions for subsequent re-measurement, which includes the possibility for revaluation (the allowed alternative treatment).
Goodwill, which is to be nonamortizing under the new standard, will be subject to annual impairment testing, closely modeled on the US GAAP approach (adopted in SFAS 142, effective 2002). It will therefore be necessary to assign all goodwill to cash-generating units (CGU), for which cash flow projections will have to be developed. These projections will have to be based on reasonable and supportable assumptions that reflect management's best estimate of the economic conditions that will exist over the life of the CGU. Greater weight will be given to external evidence, in contrast to internal evidence assumptions. The projections will need to be based on the most recent financial budgets/forecasts that have been approved by management, which should cover a maximum period of five years, unless a longer period can be justified. Extrapolation of the cash flows beyond the five-year horizon should be based on the budgets/forecasts using a steady or declining growth rate for subsequent years, unless an increasing rate can be justified. This growth rate should not exceed the long-term average growth rate for the products, industries, or country or countries in which the entity or CGU operates, unless a higher rate can be justified.
For impairment testing purposes, the measurement objective will be the higher of value in use and net selling price, although IASB may give further consideration to measurement in general in another project. Whether there is an impairment will be determined by comparing the recoverable amount of the CGU with the carrying value of the recognized net assets. A detailed calculation of recoverable amount would not need to be made if other existing information indicates that impairment is unlikely; but if an impairment is identified, it will be measurable by comparing the carrying amount of goodwill with its implied value. Implied value is defined as the difference between the recoverable amount of the CGU and the fair value of the net assets that would be identified and recognized if the CGU were acquired at the date of the impairment test. (In other words, an allocation process such as is made at the date of the business combination is to be performed.)
The level at which management will be required, under the expected revised standards, to test goodwill for impairment (i.e., the level at which goodwill can be "allocated on a reasonable and consistent basis:) should be consistent with the level at which management monitors the return on the investment made. However, the smallest group of CGU to which goodwill can be allocated on a reasonable and consistent basis should not be larger than a primary reportable segment determined in accordance with IAS 14.
Under the new standards, when a business within a group of CGU to which goodwill has been allocated for the purpose of impairment testing is disposed of, goodwill associated with that business will be included in the carrying amount of the business in determining the gain or loss on disposal. The amount of goodwill included in that carrying amount should be based on the relative values of the business to be disposed of and the portion of the group of CGU retained. Similarly, when an entity reorganizes its reporting structure in a manner that changes the composition of one or more groups of CGU to which goodwill has been allocated for the purpose of impairment testing, goodwill will be reallocated to the groups of CGU affected using a relative value approach similar to that used when a business within a group of CGU is disposed of.
It is expected that goodwill acquired in a business combination will have to be tested for impairment before the end of the annual reporting period in which it occurred. This will be accomplished by first calculating the recoverable amount of the smallest group of CGU to which the goodwill can be allocated on a reasonable and consistent basis, and second, comparing that recoverable amount with the carrying amount of the CGU.
A detailed calculation of recoverable amount for the purpose of impairment testing goodwill in subsequent reporting periods will need be made only when one or more of the following criteria have not been satisfied:
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The assets and liabilities making up the smallest group of CGU to which goodwill can be allocated on a reasonable and consistent basis have not changed significantly since the most recent recoverable amount calculation
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The most recent recoverable amount calculation resulted in an amount that exceeded the carrying amount of the CGU by a substantial margin, or
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Based on an analysis of events that have occurred and circumstances that have changed since the most recent recoverable amount determination, the likelihood that a current recoverable amount determination would be less than the carrying amount of the CGU is remote.
The "value in use" of a CGU will be defined as the future cash flows expected to be derived by the entity from the CGU, discounted using a rate that reflects current market assessments of the time value of money and the risks specific to the asset. The IASB has decided that selected guidance from the FASB's Concepts Statement 7, Using Cash Flow Information and Present Value in Accounting Measurements, will be included with the expected revised standard, amended to reflect the measurement objective of value in use (rather than fair value).
An impairment loss will not be recognized for goodwill to the extent that it arises because an intangible asset that did not meet the criteria for recognition separately from goodwill at the date of acquisition subsequently meets those criteria and would be allocated a separate fair value when calculating the implied value of goodwill. Therefore, an intangible asset not meeting the criteria for recognition separately from goodwill as at the date of acquisition but subsequently meeting those criteria should not be allocated a separate fair value when calculating the implied value of goodwill.
Since the amount of goodwill attributable to minority interests at the date of acquisitions will not be recognized, the impairment test for goodwill should be such that the minority interest in goodwill is prevented from acting as a buffer against the identification and measurement of goodwill impairment. The rules in IAS 36 for allocating an impairment loss across the assets in a CGU will be amended so that the impairment loss attributed to goodwill is consistent with the impairment loss calculated under the new goodwill impairment test. However, no amendment will be made to those rules to reflect the effect of unrecognized increases in the values of liabilities. Reversals of impairment losses recognized in respect of goodwill will be prohibited.
The new standard will also tackle the subject of negative goodwill. Each prior iteration of IAS 22 has significantly altered the accounting accorded the excess of fair value of net assets acquired over the cost of the acquisition, and the likely replacement for IAS 22 will do no less. Any contingent liabilities of the acquiree will need to be identified and recognized at fair values by the acquirer as part of the apportionment of the cost of acquisition, provided those fair values can be reliably measured. These obligations would include contingencies due to employees of the acquiree that existed before the transaction was negotiated but which only became accruable (because not previously probable of occurrence) when the transaction was finalized. If, after reconsidering fair value allocations, contingent liabilities, and so forth, there still remains an amount that could be referred to as negative goodwill, the standard will require that this should be recognized immediately in the income statement as a gain. The term "negative goodwill" will no longer be used, however.
Under the existing standard IAS 22, in a business acquisition where less than 100% of the acquiree is obtained, there are two ways to handle the "step-up" in carrying value of assets, other than goodwill. The benchmark method is to reflect net assets acquired by the parent at fair value, with the remaining net assets—the minority's share—continuing to be carried at previous book value. Thus, under the current benchmark approach, there is no adjustment for fair value of the minority share of net assets, and the postacquisition balance sheet contains a mix of historical costs and fair values as of the transaction date. The allowed alternative is to step up the minority's share of net assets (but not recognize goodwill, however) so that the postacquisition balance sheet reflects all items at fair value (other than goodwill). The replacement standard will require the former allowed alternative method to be applied in all instances.
The new standard will additionally offer greater guidance on the accounting for "reverse acquisitions"; will stipulate that costs of registering and issuing equity instruments, even when the proceeds are used to effect a business combination, are an integral part of the equity issue transaction and should therefore be recognized as a deduction from equity; and will furthermore clarify that costs of issuing or arranging financial liabilities are, in accordance with IAS 39, required to be included in the initial measurement of the liability and do not form part of the costs directly attributable to the acquisition. A further matter to be resolved relates to the measurement date—whether the agreement date or the change in control date should be used as the date for measurement of the value of securities given in the acquisition. This remains to be further debated, since the IASB's initial decision (to use the agreement date) conflicts with the decision made by the FASB.
A second phase of the business combinations projects, yet to be actively debated, will deal with a number of other issues. Included will be the matter of combinations of entities under common control (the accounting for which does not presently permit fair value recognition); combinations of mutually owned entities; new basis accounting; and combinations in which separate entities are brought together to form a reporting entity by contract only, without the obtaining of an ownership interest.
The second phase of the business combinations project will also address whether a minority interest's imputed share of goodwill should be recognized. (This is not done under the current allowed alternative method of IAS 22.) It will furthermore define whether the purchase of a minority interest should be treated as the purchase of equity, and stipulate the appropriate treatment of business combinations achieved through successive share purchases. A range of other concerns, such as whether blockage discounts should be applied to share values in determining the amounts to be assigned to business combinations, will likely also be dealt with.
Finally, certain issues relating to the presentation of consolidated financial statements will be addressed by IASB. One of these, already decided, is that minority interest is to be displayed in the equity section of the balance sheet, rather than as a "mezzanine" item between debt and equity, or as debt, as occurs at present. However, the minority share of equity would still require differentiation from the majority (control) interests.
Consolidated Financial Statements
Requirements for consolidated financial statements.
IAS 27 prescribes the requirements for the presentation of consolidated financial statements. Essentially, if one entity controls another enterprise, consolidated financial statements are required, unless certain, rarely met conditions are satisfied. Control is deemed to exist when the parent owns, directly or indirectly through subsidiaries, more than one-half of the voting power over an enterprise. It may also exist even absent this level of ownership if the parent has more than one-half of the voting power as a result of a voting trust or similar arrangement; the power to govern the financial and operating policies of the enterprise by operation of law or by means of an agreement, the power to appoint or remove the majority of the directors or equivalent governing persons, or the power to cast a majority of votes at the meetings of the directors or its equivalent.
In limited circumstances, a majority owner may not have operating control over an enterprise, and consolidated financial reporting would not be deemed appropriate in such cases. This would be true when control is intended to be temporary because the subsidiary was acquired with the definite intention to dispose of it in the near future. It would also be valid if the subsidiary operates under severe long-term restrictions that limit its ability to remit funds to its parent entity. In either of these types of situations, the parent should account for its interest in the subsidiary as set forth in IAS 39 (discussed in Chapter 10).
It had previously been common to exclude subsidiaries from consolidated financial statements on the basis of nonhomogeneity of operations. For example, an integrated manufacturer might have excluded a financing subsidiary from its consolidated financial statements, since the operations were so dissimilar any resulting consolidated statements would have been impossible to interpret. IAS 27 makes it clear that such reasons are no longer acceptable; if the consolidated statements need further explanation for them to be meaningful, supplementary consolidating statements, showing details for each constituent entity, or detailed footnote schedules can be used to satisfy this need.
Impact of Potential Voting Interests on Consolidation
Historically, actual voting interests in subsidiaries has been the criterion used to determine
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If consolidated financial statements are to be presented; and
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What percentage to apply in determining the allocation of a subsidiary's income, included in consolidated earnings, between the parent and the minority interests.
However, the SIC has now addressed the situation in which the parent entity has, in addition to its actual voting shareholder interest, a further potential voting interest in the subsidiary.
The potential interest may exist in the form of options, warrants, convertible shares, or a contractual arrangement to acquire additional shares, including shares that it may have sold to another shareholder in the subsidiary or other party, with a right or contractual arrangement to reacquire the shares transferred.
As to whether the potential shares should be considered in reaching a decision as to whether control is present, and thus whether reporting entity is to be regarded as the parent company and should therefore prepare consolidated financial statements, SIC 33 holds that this is indeed a factor to weigh. It has concluded that the existence and effect of potential voting rights that are presently exercisable or presently convertible should be considered, in addition to the other factors set forth in IAS 27, when assessing whether an enterprise controls another enterprise. All potential voting rights should be considered, including potential voting rights held by other enterprises (which would counter the impact of the reporting entity's potential voting interest).
For example, an entity holding 40% voting rights in another entity, but having options, not offset by options held by another party, to acquire another 15% voting interest, would thus effectively have a 55% current and potential voting interest, making consolidation necessary, under the provisions of SIC 33.
Regarding whether the potential share interest should be considered when determining what fraction of the subsidiary's income should be allocated to the parent, the general answer is no. SIC 33 states that the proportion allocated to the parent and minority interests in preparing consolidated financial statements under IAS 27 should be determined based solely on present ownership interests.
However, the enterprise may, in substance, have a present ownership interest when it sells and simultaneously agrees to repurchase some of the voting shares it had held in the subsidiary, but does not lose control of access to economic benefits associated with an ownership interest. In this circumstance, the proportion allocated should be determined taking into account the eventual exercise of potential voting rights and other derivatives that, in substance, presently give access to economic benefits associated with an ownership interest. Note that the right to reacquire shares alone is not enough to have those shares included for purposes of determining the percentage of the subsidiary's income to be reported by the parent. Rather, the parent must have ongoing access to the economic benefits of ownership of those shares.
Intercompany transactions and balances.
In preparing consolidated financial statements, any transactions among members of the group must be eliminated. For example, a parent may sell merchandise to its subsidiary, at cost or with a profit margin added, before the subsidiary ultimately sells the merchandise to unrelated parties in arm's-length transactions. Furthermore, any balances due to or from members of the consolidated group at the date of the balance sheet must also be eliminated. The reason for this requirement: to avoid grossing up the financial statements for transactions or balances that do not represent economic events with outside parties. Were this rule not in effect, a consolidated group could deliberately give the appearance of being a much larger enterprise than it is in truth, merely by engaging in multiple transactions with itself.
If assets have been transferred among the entities in the controlled group at amounts in excess of the transferor's cost, and they have not yet been further transferred to outside parties (e.g., inventories) or not yet consumed (e.g., plant assets subject to depreciation) by the date of the balance sheet, the amount of profit not yet realized through an arm's-length transaction must be eliminated. This is illustrated in the following examples.
Different fiscal periods of parent and subsidiary.
A practical consideration in preparing consolidated financial statements is to have information on all constituent entities current as of the parent's year-end. If the subsidiaries have different fiscal years, they may prepare updated information as of the parent's year-end, to be used for preparing consolidated statements. Failing this, IAS 27 permits combining information as of different dates, as long as this discrepancy does not exceed three months. Of course, if this option is elected, the process of eliminating intercompany transactions and balances may become a bit more complicated, since reciprocal accounts (e.g., sales and cost of sales) will be out of balance for any events occurring after the earlier fiscal year-end but before the later one.
Consistency of accounting policies.
There is a presumption that all the members of the consolidated group should use the same accounting principles to account for similar events and transactions. However, in many cases this will not occur, as, for example, when a subsidiary is acquired that uses FIFO costing for its inventories while the parent has long employed the LIFO method. IAS 27 does not demand that one or the other entity change its method of accounting; rather, it merely requires that there be adequate disclosure of the accounting principles employed.
If a subsidiary was acquired during the period or was disposed of during the period, under the acquisition method of accounting, the results of the operations of the subsidiary should be included in consolidated financial statements only for the period it was owned. Since this may cause comparability with earlier periods presented to be impaired, there must be adequate disclosure in the accompanying footnotes to make it possible to interpret the information properly.
Example of consolidation workpaper (date of acquisition, 100% ownership)
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The worksheet for the preparation of a consolidated balance sheet for Ahmadi Corp. and its four wholly owned subsidiaries at the date of the acquisitions is shown below. Remember that it is presumed that Ahmadi (the parent) acquired the common stock of each subsidiary; had it acquired the net assets directly (through a legal merger or a consolidation), this accounting consolidation would not be necessary.
Except for Eyre, the entries are straightforward and need no further explanation, as they are necessary to eliminate the investment accounts of the parent and the equity accounts of the subsidiaries. Note that there are upward adjustments to the plant and equipment relative to the acquisitions of Cairo and Eyre. The unitings of Belfast and Delhi result in their book values being carried forward.
The elimination of the investment in Eyre debentures needs explanation. The parent paid $4,880,000 for debentures having a $5 million par on January 1, 2002. The discount has been properly amortized in 2002 and 2003, so that the carrying value at the date of acquisition of Eyre is $4,900,000. Therefore, on a consolidated basis, debt of $5 million has been extinguished at a cost of $4.9 million, for a gain on retirement of $100,000. Since the workpapers shown are only for the preparation of a consolidated balance sheet, the gain has been credited to retained earnings. This gain could also be recorded on the books of the parent, Ahmadi Corp., that would make its retained earnings equal to consolidated retained earnings.
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| Ahmadi Corp. | Belfast Corp. | Cairo Co.,Inc. | Delhi Corp. | Eyre, Inc. | Elimination entries | Consolidated balance sheet | |
|---|---|---|---|---|---|---|---|
| Current assets | $ 74,625,000 | $ 3,900,000 | $ 4,000,000 | $ 12,000,000 | $ 50,000,000 | $ -- | $144,525,000 |
| Plant and equipment | 80,000,000 | 38,500,000 | 17,400,000 | 72,000,000 | 88,000,000 | 1,680,000c | 317,580,000 |
| 5,000,000f | |||||||
| Investments | |||||||
| 4,900,000 | (4,900,000)g | |||||
| 9,8000,000 | 3,100,000 | (9,800,000)b | ||||
| (3,100,000)d | |||||||
| 49,700,000 | (49,700,00)a | |||||
| 19,680,000 | (19,680,000)c | |||||
| 76,500,000 | (25,500,000)e | |||||
| 80,000,000 | (20,000,000)f | |||||
| $385,405,000 | $ 52,200,000 | $24,500,000 | $84,000,000 | $ 138,000,000 | $462,105,000 | ||
| Current liabililies | $ 99,750,000 | $ 2,500,000 | $ 6,500,000 | $21,000,000 | $ 28,000,000 | $(13,500,000)e | $144,250,000 |
| 8% debentures | 50,000,000 | (5,000,000)g | 45,000,000 | ||||
| Preferred stock, | |||||||
| 17,500,000 | 17,500,000 | |||||
| Premium on pfd stock | 1,000,000 | 1,000,000 | |||||
| Common stock. | |||||||
| 57,308,300 | 57,308,300 | |||||
| 20,000,000 | (20,000,000)a | |||||
| 14,500,000 | (14,500,000)c | |||||
| 1,000,000 | (1,000,000)e | |||||
| 5,000,000 | (5,000,000)f | |||||
| Additional paid-in capital, etc. | 97,771,700 | 14,700,000 | 3,500,000 | 6,200,000 | (14,700,000)a | 97,771,700 | |
| (3,500,000)e | |||||||
| (6,200,000)f | |||||||
| Retained earnings | 112,075,000 | 15,000,000 | 3,500,000 | 58,500,000 | 48,800,000 | (15,000,000)a | |
| (3,500,000)c | |||||||
| (58,500,000)e | 112,175,000 | ||||||
| (48,800,000)f | |||||||
| 100,000g | |||||||
| $385,405,000 | $52,200.000 | $24,500,000 | $84,000,000 | $34,500,000 | |||
| Treasury stock (at cost) | (9,800,000)b | (12,900,000) | |||||
| (3,100,000)d | |||||||
| $462,105,000 |
|
|
Consolidated Statements in Subsequent Periods with Minority Interests
When a company acquires some, but not all, of the voting stock of another entity, the shares held by third parties represent a minority interest in the acquired company. This occurs when the acquisition form is employed. A legal merger or consolidation would give the acquirer a 100% interest in whatever assets it obtained from the selling entity. Under international accounting standards, if a parent company owns more than half of another entity, the two should be consolidated for financial statement purposes (unless to do so would mislead the statement users because control is temporary or the businesses are heterogeneous, etc.). The minority interest in the assets and earnings of the consolidated entity must also be accounted for.
When consolidated statements are prepared, the full amount of assets and liabilities (in the balance sheet) and income and expenses (in the income statement) of the subsidiary are generally presented. Accordingly, a contra must be shown for the portion of these items that does not belong to the parent company. In the balance sheet this contra is normally a credit item shown between total liabilities and stockholders' equity, representing the minority interest in consolidated net assets equal to the minority's percentage ownership in the net assets of the subsidiary entity. Although less likely, a debit balance in minority interest could result when the subsidiary has a deficit in its stockholders' equity and when there is reason to believe that the minority owners will make additional capital contributions to erase that deficit. This situation sometimes occurs where the entities are closely held and the minority owners are related parties having other business relationships with the parent company and/or its stockholders. In other circumstances, a debit in minority interest would be charged against parent company retained earnings under the concept that the loss will be borne by that company.
IAS 27 stipulates that minority interest be presented in the consolidated balance sheet separately from both liabilities and stockholders' equity. Accordingly, it will be shown in a separate caption after liabilities, but ahead of equity.
In the income statement, the minority interest in the income (or loss) of a consolidated subsidiary is shown as a deduction from (or addition to) the consolidated net income account. As above, if the minority interest in the net assets of the subsidiary has already been reduced to zero, and if a net debit minority interest will not be recorded (the usual case), the minority's interest in any further losses should not be recorded. (However, this must be explained in the footnotes.) Furthermore, if past minority losses have not been recorded, the minority's interest in current profits will not be recognized until the aggregate of such profits equals the aggregate unrecognized losses. This closely parallels the rule for equity method accounting recognition of profits and losses.
IAS 27 states that income attributable to minority interest be separately presented in the statement of earnings or operations. Generally, this is accomplished by presenting net income before minority interest, followed by the allocation to the minority, and then followed by net income.
Example of consolidation process involving a minority interest Assume the following:
|
Assume the following:
|
| Alto Company | Bass Company | |
|---|---|---|
| Assets | ||
| Cash | $ 30,900 | $ 37,400 |
| Accounts receivable (net) | 34,200 | 9,100 |
| Inventories | 22,900 | 16,100 |
| Equipment | 200,000 | 50,000 |
| Less accumulated depreciation | (21,000) | (10,000) |
| Patents | -- | 10,000 |
| $267,000 | $112,600 |
| Liabilities and stockholders' equity | ||
| Accounts payable | $ 4,000 | $ 6,600 |
| Bonds payable, 10% | 100,000 | -- |
| Common stock, $10 par | 100,000 | 50,000 |
| Additional paid-in capital | 15,000 | 15,000 |
| Retained earnings | 48,000 | 41,000 |
| $267,000 | $112,600 |
|
Note that in the foregoing, the net assets of Bass Company may be computed by one of two methods.
Method 1: Subtract the book value of the liability from the book values of the assets.
$112,600 - $6,600 = $106,000
Method 2: Add the book value of the components of Bass Company's stockholders' equity.
$50,000 + $15,000 + $41,000 = $106,000
At the date of the combination, the fair value of all the assets and liabilities were determined by appraisal, as follows:
| Bass Company Item | Book value(BV) | Fair market value(FMV) | Difference betweenBV and FMV |
|---|---|---|---|
| Cash | $ 37,400 | $ 37,400 | $ -- |
| Accounts receivable (net) | 9,100 | 9,100 | -- |
| Inventories | 16,100 | 17,100 | 1,000 |
| Equipment (net) | 40,000 | 48,000 | 8,000 |
| Patents | 10,000 | 13,000 | 3,000 |
| Accounts payable | (6,600) | (6,600) | -- |
| $106,000 | $118,000 | $12,000 |
When a minority interest exists, as in this example, the concept employed will determine whether the consolidated balance sheet reflects the full excess of fair market values over book values of the subsidiary's identifiable net assets, or only the parent company's percentage share thereof. Under the provisions of IAS 22, both approaches are acceptable. The benchmark treatment is to recognize a "step-up" for only the share of the subsidiary's assets that have effectively been purchased by the parent; thus the subsidiary's assets as included in the parent's consolidated balance sheet will be comprised of a mixture of cost bases: the parent's cost for its share of identifiable assets, and the minority interest's predecessor cost basis for its share of the assets.
The allowed alternative treatment is to record all the assets and liabilities at their fair values as of the date of the acquisition, including the portion represented by the minority interest's ownership share. There will be no mixture of costs for the net identifiable assets acquired in the business combination on the consolidated balance sheet; all items will be presented at fair values as of the acquisition date. Goodwill, however, will be presented only to the extent that the acquirer paid more than the fair values of the net identifiable assets; there will not be any goodwill attributable to the minority interest.
In the present example, Bass's identifiable (i.e., before goodwill) net assets will be reported in the Alto consolidated balance sheet at either $116,800 or at $118,000, depending on whether the benchmark treatment or the allowed alternative treatment is used under IAS 22. These amounts are computed as follows:
| Benchmark treatment | ||
|---|---|---|
| Bass Company net assets, at FMV | $118,000 | |
| 90% thereof (majority interest) | $106,200 | |
| Bass Company net assets, at cost | 106,000 | |
| 10% thereof (minority interest) | 10,600 | |
| $116,800 |
| Allowed alternative treatment | ||
|---|---|---|
| Bass Company net assets, at FMV | $118,000 | |
| 90% thereof (majority interest) | $106,200 | |
| Bass Company net assets, at FMV | 118,000 | |
| 10% thereof (minority interest) | 11,800 | |
| $118,000 |
The benchmark treatment will be utilized in the following discussion.
Assume that on January 1, 2003, Alto acquired 90% of Bass in exchange for 5,400 shares of $10 par common stock having a market value of $120,600. The purchase method is used to account for this transaction; any goodwill will be written off over ten years.
Workpapers for the consolidated balance sheet as of the date of the transaction will be as shown below.
|
| Purchase accounting 90% interest | ||||||
|---|---|---|---|---|---|---|
| Alto Company | Bass Company | Adjustments and eliminations | Minority interest | Consolidated balances | ||
| Debit | Credit | |||||
| Balance sheet, 1/1/03 | ||||||
| Cash | $ 30,900 | $ 37,400 | $ 68,300 | |||
| Accounts receivable | 34,200 | 9,100 | 43,300 | |||
| Inventories | 22,900 | 16,100 | $ 900b | 39,900 | ||
| Equipment | 200,000 | 50,000 | 9,000b | 259,000 | ||
| Accumulated depreciation | (21,000) | (10,000) | $ 1,800b | (32,800) | ||
| Investment in stock of Bass Company | 120,600 | 120,600a | ||||
| Difference between cost and book value | 25,200a | 25,200b | ||||
| Excess of cost over fair value (goodwill) | 14,400b | 14,400 | ||||
| Patents | 10,000 | 2,700b | 12,700 | |||
| Total assets | $387.600 | $112,600 | $404,800 | |||
| Accounts payable | $ 4,000 | $ 6,600 | $ 10,600 | |||
| Bonds payable | 100,000 | 100,000 | ||||
| Capital stock | 154,000 | 50,000 | 45,000a | $ 5,000 | 154,000 | |
| Additional paid-in capital | 81,600 | 15,000 | 13,500a | 1,500 | 81,600 | |
| Retained earnings | 48,000 | 41,000 | 36,900a | 4,100 | 48,000 | |
| Minority interest | $10,600 | 10,600 MI | ||||
| Total liabilities and equity | $387,600 | $112,600 | $147,600 | $147,600 | $404,800 | |
|
Based on the foregoing, the consolidated balance sheet as of the date of acquisition will be as follows:
Alto Company and Bass Company Consolidated Balance Sheet at January 1, 2003 (immediately after combination)
| Assets | |
|---|---|
| Cash | $ 68,300 |
| Accounts receivable, net | 43,300 |
| Inventories | 39,900 |
| Equipment | 259,000 |
| Less accumulated depreciation | (32,800) |
| Goodwill | 14,400 |
| Patents | 12,700 |
| $404,800 |
| Liabilities and stockholders' equity | |
|---|---|
| Accounts payable | $ 10,600 |
| Bonds payable, 10% | 100,000 |
| Minority interest in Bass | 10,600 |
| Common stock, $10 par | 154,000 |
| Additional paid-in capital | 81,600 |
| Retained earnings | 48,000 |
| $404,800 |
-
Investment on Alto Company's books
The entry to record the 90% purchase-acquisition on Alto Company's books was
Investment in stock of Bass Company
120,600
-
Capital stock
54,000
-
Additional paid-in capital
66,600
To record the issuance of 5,400 shares of $10 par stock to acquire a 90% interest in Bass Company
Although common stock is used for the consideration in our example, Alto Company could have used debentures, cash, or any other form of consideration acceptable to Bass Company's stockholders to make the purchase combination.
-
-
Difference between investment cost and book value
The difference between the investment cost and the parent company's equity in the net assets of the subsidiary is computed as follows:
Investment cost
$ 120,600
Less book value % at date of combination
Bass Company's
-
-
Capital stock
-
$ 50,000
-
-
Additional paid-in capital
-
15,000
-
-
Retained earnings
-
41,000
-
-
Total
-
$106,000
-
Parent's share of ownership
x 90%
-
Parent's share of book value
95,400
Excess of cost over book value
$ 25,200
This difference is due to several undervalued assets and to unrecorded goodwill. The allocation procedure is similar to that for a 100% purchase; however, in this case, the parent company obtained a 90% interest and thus will recognize 90% of the difference between the fair market values and book values of the subsidiary's assets, not 100%. The allocation of the cost differential was determined as follows:
Difference between BV and FMV
x 90%
Cash
$ --
$ --
Accounts receivable
--
--
Inventories
1,000
900
Equipment, net
8,000
7.200
Patents
3,000
2.700
Accounts payable
--
--
-
Totals
$12,000
$10,800
Less differential between investment cost ($120,600) and 90% of Bass' book value ($106,000)
25,200
Net purchase cost allocated to goodwill
$14,400
The equipment has a book value of $40,000 ($50,000 less 20% depreciation of $10,000). An appraisal concluded that the equipment's replacement cost was $60,000 less 20% accumulated depreciation of $12,000, resulting in a net fair value of $48,000.
-
-
Elimination entries on workpaper
The basic reciprocal accounts are the investment in subsidiary account on the parent's books and the subsidiary's stockholder equity accounts. Only the parent's share of the subsidiary's accounts may be eliminated as reciprocal accounts. The remaining 10% portion is allocated to the minority interest. The entries below include documentation showing the company source for the information. The workpaper entry to eliminate the basic reciprocal accounts is as follows:
Capital stock — Bass Co.
45,000
Additional paid-in capital — Bass Co.
13,500
Retained earnings — Bass Co.
36,900 [a]
Differential
25,200
-
Investment in stock of Bass Co.—Alto Co
120,600
[a]$41,000. x 90% = $36,900
Note that only 90% of Bass Company's stockholders' equity accounts are eliminated. Also, an account called differential is debited in the workpaper entry. The differential account is a temporary account to record the difference between the cost of the investment in Bass Company from the parent's books and the book value of the parent's interest (90% in our case) from the subsidiary's books.
The next step is to allocate the differential to the specific accounts by making the following workpaper entry:
Inventory
900
Equipment
9,000
Patents
2,700
Goodwill
14,400
-
Accumulated depreciation
1,800
-
Differential
25,200
This entry reflects the allocations prepared in step 2. above and recognizes the parent's share of the asset revaluations.
The minority interest column is the 10% interest of Bass Company's net assets owned by outside third parties. Minority interest must be disclosed because 100% of the book values of Bass Company are included in the consolidated statements, although Alto Company controls only 90% of the net assets. An alternative method to prove minority interest is to multiply the net assets of the subsidiary by the minority interest share, as follows:
Stockholders' equity of Bass Company
x
Minority interest %
=
Minority interest
$106,000
x
10%
=
$10,600
The $10,600 would be reported on the credit side of the consolidated balance sheet between liabilities and stockholders' equity.
The benchmark treatment prescribed by IAS 22 was used above to prepare the consolidated balance sheet. If the allowed alternative treatment had been employed, minority interest would have been as follows:
Total fair market value of identifiable net assets
x
Minority percentage
=
Minority interest
of Bass Company $118,000
x
10%
=
$11,800
The example does not include any other intercompany accounts as of the date of combination. If any existed, they would be eliminated to present the consolidated entity fairly. Several examples of other reciprocal accounts will be shown later for the preparation of consolidated financial statements subsequent to the date of acquisition.
If the preceding example were accounted for on a push-down basis, Bass would record the following entry on its books:
Inventories
1,000
Equipment
10,000
Patents
3,000
-
Accumulated depreciation
2,000
-
Paid-in capital
12,000
As a result, Alto would have an investment of $120,600 in a company whose net equity was $118,000. Then 90% x $118,000 or $106,200 contrasted with the cost of $120,600 would mean that the only number unaccounted for by Alto would be goodwill of $14,400. The elimination entry on the worksheet would change only with respect to the paid-in capital of Bass as follows:
Capital stock
45,000
Paid-in capital
24,300
Retained earnings
36,900
Goodwill
14,400
-
Investment
120,600
This would leave $5,000 of capital stock, $2,700 of paid-in capital, and $4,100 of retained earnings as minority interest or the same $11,800 as under the entity concept.
-
|
Example of consolidation for uniting involving minority interest
|
The foregoing entries are based on the combination being accounted for as an acquisition, using the purchase method of accounting. The same example will now be used to demonstrate the uniting of interests method, using the pooling method, applied to a minority interest situation. Assume the following:
-
On January 1, 2003, Alto Company acquired a 90% interest in Bass Company in exchange for 5,400 shares of $10 par value stock of Alto Company.
-
All criteria for a pooling have been met, and the combination is treated as a pooling of interests.
The workpaper for a consolidated balance sheet at the date of combination is presented below. Note that the first two columns are trial balances of Alto Company and Bass Company immediately after the combination was recorded by Alto Company.
-
Investment entry recorded on Alto Company's books
The following entry was made by Alto Company to record its 90% acquisition-pooling of Bass Company:
Investment in stock of Bass Co.
95,400
-
Capital stock, $10 par
54,000
-
Additional paid-in capital
4,500
-
Retained earnings
36,900
Alto Company and Bass Company Consolidated Working Papers For Date of Combination—1/1/03 Purchase accounting 90% interest
Adjustments and eliminations
Alto Company
Bass Company
Debit
Credit
Minority interest
Consolidated balances
Balance sheet, 1/1/03
-
Cash
$ 30,900
$ 37,400
$ 68,300
-
Accounts receivable
34,200
9,100
43,300
-
Inventories
22,900
16,100
39,000
-
Equipment
200,000
50,000
250,000
-
Accumulated depreciation
(21,000)
(10,000)
(32,800)
-
Investment in stock of Bass Company
95,400
95,400a
-
Patents
10,000
10,000
-
-
Total assets
-
$362,400
$112,600
$379,600
-
Accounts payable
$ 4,000
$ 6,600
$ 10,600
-
Bonds payable
100,000
100,000
-
Capital stock
154,000
50,000
45,000a
$ 5,000
154,000
-
Additional paid-in capital
19,500
15,000
13,500a
1,500
19,500
-
Retained earnings
84,000a
41,000
36,900a
4,100
84,900
-
Minority interest
$10,600
10,600 MI
-
-
Total liabilities and equity
-
$362,400
$112,600
$95,400
$95,400
$362,400
The investment entry reflects the capital mix for a pooling of less than a 100% investment. The following schedule shows the mix for our 90% combination accomplished by the issuance of 5,400 shares of Alto Company's $10 par stock:
Bass Company
Alto Company's percentage share
Alto's share of Bass's equity
Capital stock
$ 50,000
90%
$45,000
Additional paid-in capital
15,000
90%
13,500
Retained earnings
41,000
90%
36,900
$ 106,000
$95,400
The $54,000 (5,400 shares x $10 par) in new capital issued by Alto Company represents $45,000 from Bass Company's capital stock and $9,000 of the $13,500 Bass Company's additional paid-in capital. Note that the remaining $4,500 of capital and $36,900 of Bass Company's retained earnings are carried over to Alto Company's books in the combination date entry. The $10,600 of Bass's capital that is not carried over to Alto will eventually be shown as minority interest on the consolidated balance sheet.
-
-
Elimination entry on workpaper
Pooling accounting uses book values as a basis of valuation; therefore, no differential will ever occur in a pooling. The reciprocal accounts in a pooling consolidated balance sheet are in the investment in stock of Bass Company account from the parent's books and the stockholders' equity accounts from the subsidiary's books. Again, note that only 90% of the equity of Bass Company is being eliminated; the 10% remainder will be recognized as minority interest. The workpaper elimination entry is
Capital stock—Bass Co.
45,000
Additional paid-in capital—Bass Co.
13,500
Retained earnings—Bass Co.
36,900 [a]
-
Investment in stock of Bass Co.—Alto Co.
95,400
[a]$41,000 x 90% = $36,900
-
|
Consolidation process in periods subsequent to acquisition.
Given the foregoing, the following additional information is available in the first year after the acquisition (2003):
-
Alto Company uses the partial equity method to record changes in the value of the investment account. The partial equity method means that the parent reports its share of earnings, and so on, of the subsidiary on its books using the equity method, but any differential between acquisition cost and underlying fair value of net assets, and so on, is not addressed on an ongoing basis; rather, these matters await the typical year-end accounting adjustment process.
-
During 2003, Alto Company sold merchandise to Bass Company that originally cost Alto Company $15,000, and the sale was made for $20,000. On December 31, 2003, Bass Company's inventory included merchandise purchased from Alto Company at a cost to Bass Company of $12,000.
-
Also during 2003, Alto Company acquired $18,000 of merchandise from Bass Company. Bass Company uses a normal markup of 25% above its cost. Alto Company's ending inventory includes $10,000 of the merchandise acquired from Bass Company.
-
Bass Company reduced its intercompany account payable to Alto Company to a balance of $4,000 as of December 31, 2003, by making a payment of $1,000 on December 30. This $ 1,000 payment was still in transit on December 31, 2003.
-
On January 2, 2003, Bass Company acquired equipment from Alto Company for $7,000. The equipment was originally purchased by Alto Company for $5,000 and had a book value of $4,000 at the date of sale to Bass Company. The equipment had an estimated remaining life of four years as of January 2, 2003.
-
On December 31, 2003, Bass Company purchased for $44,000, 50% of the outstanding bonds issued by Alto Company. The bonds mature on December 31, 2006, and were originally issued at par. The bonds pay interest annually on December 31 of each year, and the interest was paid to the prior investor immediately before Bass Company's purchase of the bonds.
The worksheet for the preparation of consolidated financial statements as of December 31, 2003, is presented on the following pages, on the assumption that purchase accounting is used for the business combination.
The investment account balance at the statement date should be reconciled to ensure that the parent company made the proper entries under the method of accounting used to account for the investment. Since the partial equity method is used by Alto, the amortization of the excess of cost over book value will be recognized only on the worksheets.
An analysis of the investment account at December 31, 2003, is as presented below.
| Investment in Stock of Bass Company | |||
|---|---|---|---|
| Original cost | 120,600 | ||
| % of Bass Co.'s income ($9,400 x 90%) | 8,460 | 3,600 | % of Bass Co.'s dividends declared ($4,000 x 90%) |
| Balance, 12/31/03 | 125,460 | ||
Any errors will require correcting entries before the consolidation process is continued. Correcting entries will be posted to the books of the appropriate company; eliminating entries are not posted to either company's books.
The difference between the investment cost and the book value of the net assets acquired was determined and allocated in the preparation of the date of combination consolidated statements presented earlier. The same computations are used in preparing financial statements for as long as the investment is owned.
The following adjusting and eliminating entries will be required to prepare consolidated financials as of December 31, 2003. Note that a consolidated income statement is required, and therefore, the nominal (i.e., income and expense) accounts are still open. The number or letter in parentheses to the left of the entry corresponds to the key used on the worksheets presented after the following discussion.
Step 1—Complete the transaction for any intercompany items in transit at the end of the year.
| 1,000 | |
| 1,000 |
-
This adjusting entry will now properly present the financial positions of both companies, and the consolidation process may be continued.
Step 2—Prepare the eliminating entries.
| 38,000 | |
| 38,000 |
-
Total intercompany sales of $38,000 include $20,000 in a downstream transaction from Alto Company to Bass Company and $18,000 in an upstream transaction from Bass Company to Alto Company.
| 5,000 | |
| 5,000 |
-
The ending inventories are overstated because of the unrealized profit from the intercompany sales. The debit to cost of goods sold is required because a decrease in ending inventory will increase cost of goods sold to be deducted on the income statement. Supporting computations for the entry are as follows:
| In ending inventory of | ||
|---|---|---|
| Alto Company | Bass Company | |
| Intercompany sales not resold, at selling price | $10,000 | $12,000 |
| Cost basis of remaining intercompany merchandise | ||
| (8,000) | |
| (9,000) | |
| Unrealized profit | $ 2,000 | $ 3,000 |
| Note | When preparing consolidated workpapers for 2004 (the next fiscal period), an additional eliminating entry will be required if the goods in 2003's ending inventory are sold to outsiders during 2004. The additional entry will recognize the profit for 2004 that was eliminated as unrealized in 2003. This entry is necessary since the entry at the end of 2003 was made only on the worksheet. The 2004 entry will be as follows: |
| Retained earnings—Bass Co., 1/1/04 | 2,000 | |
| Retained earnings—Alto Co., 1/1/04 | 3,000 | |
| 5,000 |
| 4,000 | |
| 4,000 |
-
This entry eliminates the remaining intercompany receivable/ payable owed by Bass Company to Alto Company. This eliminating entry is necessary to avoid overstating the consolidated entity's balance sheet. The receivable/payable is not extinguished, and Bass Company must still transfer $4,000 to Alto Company in the future.
| 3,000 | |
| 2,000 | |
| 250 | |
| 750 |
-
This entry eliminates the gain on the intercompany sale of the equipment, eliminates the overstatement of equipment, and removes the excess depreciation taken on the gain. Supporting computations for the entry are as follows:
| Cost | At date of intercompany sale accum. depr. | 2003 depr. ex. | End of period accum. depr. | |
|---|---|---|---|---|
| Original basis | ||||
| (to seller, Alto Co.) | $5,000 | ($1,000) | $ 1,000 | ($2,000) |
| New basis | ||||
| (to buyer, Bass Co.) | 7,000 | -- | 1,750 | (1,750) |
| Difference | ($2,000) | ($ 750) | $ 250 |
-
If the intercompany sale had not occurred, Alto Company would have depreciated the remaining book value of $4,000 over the estimated remaining life of four years. However, since Bass Company's acquisition price ($7,000) was more than Alto Company's basis in the asset ($4,000), the depreciation recorded on the books of Bass Company will include part of the intercompany unrealized profit. The equipment must be reflected on the consolidated statements at the original cost to the consolidated entity. Therefore, the write-up of $2,000 in the equipment, the excess depreciation of $750, and the gain of $3,000 must be eliminated. The ending balance of accumulated depreciation must be shown at what it would have been if the intercompany equipment transaction had not occurred. In future periods, a retained earnings account will be used instead of the gain account; however, the other concepts will be extended to include the additional periods.
| 50,000 | |
| 44,000 | |
| 6,000 |
-
This entry eliminates the book value of Alto Company's debt against the bond investment account of Bass Company. On a consolidated entity basis, this transaction must be shown as a retirement of debt, even though Alto Company has the outstanding intercompany debt to Bass Company. Any gains or losses on debt extinguishment will be reported in the income statement. In future periods Bass Company will amortize the discount, thereby bringing the investment account up to par value. In future periods the retained earnings account will be used in the eliminating entry instead of the gain account, as the gain is closed out with other nominal accounts.
| 8,460 | |
| 3,600 | |
| 4,860 |
-
This elimination entry adjusts the investment account back to its balance at the beginning of the period and also eliminates the subsidiary income account.
| 45,000 | |
| 13,500 | |
| 36,900 | |
| 25,200 | |
| 120,600 |
-
This entry eliminates 90% of Bass Company's stockholders' equity at the beginning of the year, 1/1/03. Note that the changes during the year were eliminated in entry (f). The differential account reflects the excess of investment cost over the book value of the assets acquired.
| 900 | |
| 9,000 | |
| 2,700 | |
| 14,400 | |
| 1,800 | |
| 25,200 |
-
This entry allocates the differential (excess of investment cost over the book values of the assets acquired). Note that this entry is the same as the allocation entry made to prepare consolidated financial statements for January 1, 2003, the date of acquisition.
| 900 | |
| 1,800 | |
| 270 | |
| 1,440 | |
| 900 | |
| 1,800 | |
| 270 | |
| 1,440 |
-
The elimination entry amortizes the revaluations to fair market value made in entry (h). The inventory has been sold and therefore becomes part of cost of goods sold. The remaining revaluations will be amortized as follows:
Revaluation
Amortization period
Annual amortization
Equipment (net)
$7,200
4 years
$1,800
Patents
2,700
10 years
270
Goodwill
14,400
10 years
1,440
-
The amortizations will continue to be made on future worksheets. For example, at the end of the next year (2004), the amortization entry (i) would be as follows:
Differential
4,410
Depreciation expense
1,800
Other operating expenses—patent amortization
270
Other operating expenses—goodwill amortization
1,440
-
Inventory
900
-
Accumulated depreciation
3,600
-
Patents
540
-
Goodwill
2,880
-
-
The initial debit of $4,410 to differential is an aggregation of the prior period's charges to income statement accounts ($900 + $1,800 + $270 + $1,440). During subsequent years, some accountants prefer reducing the allocated amounts in entry (h) for prior period's charges. In this case the amortization entry in future periods would reflect just that period's amortizations.
All the foregoing entries were based on the assumption that the acquisition was accounted for as a purchase. Had the pooling-of-interests method been used, however, book value rather than fair value would have been the basis for recording the accounting consolidation entries. Thus, entry (g) would he different, while entries (h) and (i) would not be made for a pooling. All other eliminating entries would be the same. The basic elimination entry (g) for a pooling, using the equity method of accounting for the investment, would be as follows:
| Capital stock—Bass Co. | 45,000 | |
| Additional paid-in capital—Bass Co. | 13,500 | |
| Retained earnings—Bass Co. | 36,900 | |
| 95,400 |
In adjusting for the minority interest in the consolidated entity's equity and earnings, the following guidelines should be observed:
-
Only the parent's share of the subsidiary's shareholders' equity is eliminated in the basic eliminating entry. The minority interest's share is presented separately.
-
The entire amount of intercompany reciprocal items is eliminated. For example, all receivables/payables and sales/cost of sales with a 90% subsidiary are eliminated.
-
For intercompany transactions in inventory and fixed assets, the possible effect on minority interest depends on whether the original transaction affected the subsidiary's income statement. Minority interest is adjusted only if the subsidiary is the selling entity. In this case, the minority interest is adjusted for its percentage ownership of the common stock of the subsidiary. The minority interest is not adjusted for unrealized profits on downstream sales. The effects of downstream transactions are confined solely to the parent's (i.e., controlling) ownership interests.
The minority interest's share of the subsidiary's income is shown as a deduction on the consolidated income statement since 100% of the sub's revenues and expenses are combined, even though the parent company owns less than a 100% interest. For our example, the minority interest deduction on the income statement is computed as follows:
| Bass Company's reported income | $9,400 |
| Less unrealized profit on an upstream inventory sale | (2,000) |
| Bass Company's income for consolidated financial purposes | $7,400 |
| Minority interest share | x 10% |
| Minority interest on income statement | $ 740 |
The minority interest's share of the net assets of Bass Company is shown on the consolidated balance sheet between liabilities and controlling interest's equity. The computation for the minority interest shown in the balance sheet for our example is as follows:
| Bass Company's capital stock, 12/31/03 | $50,000 | |
| Minority interest share | x 10% | $ 5,000 |
| Bass Company's additional paid-in capital, 12/31/03 | $15,000 | |
| Minority interest share | x 10% | 1,500 |
| Bass Company's retained earnings. 1/1/03 | $41,000 | |
| Minority interest share | x 10% | 4,100 |
| Bass Company's 2003 income for consolidated purposes | $ 7,400 | |
| Minority interest share | x 10% | 740 |
| Bass Company's dividends during 2003 | $ 4,000 | |
| Minority interest share | x 10% | (400) |
| Total minority interest, 12/31/03 | $10,940 |
|
| Purchase accounting 90% owned subsidiary Subsequent year, partial equity method | ||||||
|---|---|---|---|---|---|---|
| Alto Company | Bass Company | Adjustments and eliminations | Minority interest | Consolidated balances | ||
| Debit | Credit | |||||
| Income statements for year ended 12/31/03 | ||||||
| $750,000 | $420,000 | $ 38,000a | $1,132,000 | ||
| 581,000 | 266,000 | 5,000b | $ 38,000a | 814,900 | |
| 900i | ||||||
| 169,000 | 154,000 | 317,100 | |||
| 28,400 | 16,200 | 1,800i | 750d | 45,650 | |
| 117,000 | 128,400 | 1,710i | 247,110 | ||
| 23,600 | 9,400 | 24,340 | |||
| 3,000 | 3,000d | ||||
| 6,000e | 6,000 | ||||
| 8,460 | 8,460f | ||||
| $ 740 | (740) | ||||
| $ 35,060 | $ 9,400 | $ 58,870 | $ 44,750 | $ 740 | $ 29,600 |
| Statement of retained earnings for year ended 12/31/03 1/1/03 retained earnings | ||||||
| $ 48,000 | $ 48,000 | ||||
| $ 41,000 | $ 36,900g | $ 4,100 | |||
| 35,060 | 9,400 | 58,870 | $ 44,750 | 740 | 29,600 |
| 83,060 | 50,400 | 4,840 | 77.600 | ||
| 15,000 | 4,000 | 3,600f | 400 | 15,000 | |
| $ 68,060 | $ 46,400 | $ 95,770 | $ 48,350 | $ 4,440 | $ 62,600 |
| $ 45,300 | $ 6,400 | $ 1,0001 | $ 52,700 | ||
| 43,700 | 12,100 | $ 1,0001 | 50,800 | ||
| 4,000c | ||||||
| 38,300 | 20,750 | 900h | 5,000b | 54,050 | |
| 9001 | ||||||
| 195,000 | 57,000 | 9,000h | 2,000d | 259,000 | |
| (35,200) | (18,900) | 250d | (57,950) | ||
| l,800h | ||||||
| 1,800i | ||||||
| 125,460 | 4,860f | ||||
| 120,600g | ||||||
| 25,200g | 25,200h | ||||
| 14,400h | 1,440i | 12,960 | |||
| 44,000 | 44,000e | ||||
| 9,000 | 2,700h | 270i | 11,430 | ||
| $412,560 | $130,350 | $ 382,990 | ||||
| Accounts payable | $ 8,900 | $ 18,950 | 4,000c | $ 23,850 | ||
| Bonds payable | 100,000 | 50,000e | 50,000 | |||
| Capital stock | 154,000 | 50,000 | 45,000g | $ 5,000 | 154,000 | |
| Additional paid-in capital | 81,600 | 15,000 | 13,500g | 1,500 | 81.600 | |
| Retained earnings (from above) | 68,060 | 46,400 | 95,770 | 48,350 | 4,440 | 62,600 |
| Minority interest | $10,940 | 10,940 | ||||
| $412,560 | $130,350 | $261,470 | $261,470 | $382,990 | ||
|
The remainder of the consolidation process consists of the following worksheet techniques:
-
Take all income items across horizontally, and foot the adjustments, minority interest, and consolidated columns down to the net income line.
-
Take the amounts on the net income line (on income statement) in the adjustments, minority interest, and consolidated balances columns down to retained earnings items across the consolidated balances column. Foot and crossfoot the retained earnings statement.
-
Take the amounts of ending retained earnings in each of the four columns down to the ending retained earnings line in the balance sheet. Foot the minority interest column and place its total in the consolidated balances column. Take all the balance sheet items across to consolidated balances column.
Other Accounting Issues Arising in Business Combinations
Depending on the tax jurisdiction, an acquirer may or may not succeed to the available tax loss carryforward benefits of an acquired entity. IAS requires that a liability approach be used in accounting for the tax effects of temporary differences, which includes the tax effects of tax loss carryforwards. If an acquirer is permitted to use the predecessor's tax benefits, the amount to be reflected in its balance sheet will be measured in accordance with IAS 12, which is the amount of the benefits expected to be realized. As expectations change over time, this amount will be amended, with any such adjustments being taken into tax expense of the period in which expectations change. If the acquirer can only utilize the benefits to offset taxes on earnings of the operations acquired (i.e., it cannot shelter other sources of earnings), it will be necessary to project profitable operations to support recording this benefit as an asset.
Subsequent identification of, or changes in value of, assets and liabilities acquired.
IAS 22 stipulates that individual assets and liabilities should be recorded in an acquisition to the extent that it is probable that any associated future economic benefits will flow to the acquirer and a reliable measure is available of the cost or fair values. In some cases, due to one or both of these criteria not being met at the date of the transaction, some assets or liabilities may not be recognized (which would normally have the ramification that goodwill or negative goodwill would be adjusted accordingly).
If new information becomes available after the date of the acquisition regarding the existence or the fair value of acquired assets or the amount of liabilities, it will be necessary to make an adjustment to some of the recorded amounts. IAS 22 sets as a time limit, however, the end of the first annual accounting period after the acquisition for any reallocation from goodwill or negative goodwill to other assets or liabilities. If such information becomes available after that date, the adjustment must be made to current period income or expense. The reason for this requirement is to avoid having changes made to goodwill or negative goodwill over an unlimited time horizon.
Changes in majority interest.
The parent's ownership interest can change as a result of purchases or sales of the subsidiary's common shares by the parent or as a consequence of capital transactions of the subsidiary. The latter circumstance is generally handled precisely as demonstrated in the equity method discussion in Chapter 10. If the parent's relative book value interest in the subsidiary has changed, gains or losses are treated as incurred in an entity's own treasury stock transactions. Gains are credited to paid-in capital; losses are charged to any paid-in capital or to retained earnings created previously.
When the parent's share of ownership increases through a purchase of additional stock, simply debit investment and credit cash for the cost. A problem occurs with consolidated income statements when the change in ownership takes place in midperiod. Consolidated statements should be prepared based on the ending ownership level.
Example of a consolidation with a change in the majority interest
|
Assume that Alto Company increased its ownership of Bass Company from 90% to 95% on October 1, 2003. The investment was acquired at book value of $5,452.50 and is determined as follows:
| Retained earnings at 10/1/03 | $50,000 | |
| Additional paid-in capital, 10/1/03 | 15,000 | |
| Retained earnings at 10/1/03 | ||
| $41,000 | |
| 7,050[a] | |
| (4,000) | 44,050 |
| $ 109,050 | ||
| x 5% | ||
| Book value acquired | $5,452,50 | |
|
[a]Assumes income vas earned evenly over the year. | ||
The consolidated net income should reflect a net of
| 90% | x | $9,400 | x | 12/12 | = | $8,460,00 |
| 5% | x | $9,400 | x | 3/12 | = | 117.50 |
| 95%c | $8,577,50 |
The interim stock purchase will result in a new account being shown on the consolidated income statement. The account is purchased preacquisition earnings, which represents the percentage of the subsidiary's income earned, in this case, on the 5% stock interest from January 1, 2003, to October 1, 2003. The basic eliminating entries would be based on the 95% ownership as follows:
| Equity in subsidiary's income—Alto Co. | 8,577.50 | |
| Dividends declared—Bass Co. | 3,600.00 | |
| Investment in stock of Bass Co. | 4,977.50 | |
| Capital stock—Bass Co. | 47,500.00 | |
| Additional paid-in capital—Bass Co. | 14,250.00 | |
| Retained earnings—Bass Co. | 38,750.00[a] | |
| Purchased preacquisition earnings | 352.50[b] | |
| Differential | 25,200,00 | |
| 126,052.50 | |
|
[a]95% x $41,000 beginning 2003 balance $38,950 Less preacquisition dividend of 5% x $4,000 (200) Retained earnings available, as adjusted $38,750
[b]5%, x $9,400 x 9/12 = $352.50 | ||
Purchased preacquisition earnings is shown as a deduction, along with minority interest, to arrive at consolidated net income. Purchased preacquisition earnings are used only with interim acquisition under the purchase accounting method; all poolings are assumed to take place at the beginning of the period regardless of when, during the period, the acquisition was actually made.
|
Combined Financial Statements
When a group of entities is under common ownership, control, or management, it is often useful to present combined (or combining, showing the separate as well as the combined entities) financial statements. In this situation, the economic substance of the nominally independent entities' operations may be more important to statement users than is the legal form of those enterprises. When consolidated statements are not presented, combined statements may be used to show the financial position, or operating results, of a group of companies that are each subsidiaries of a common parent.
The process of preparing combined statements is virtually the same as consolidations employing the pooling-of-interests method. The major exception is that the equity section of the combined balance sheet will incorporate the paid-in capital accounts of each of the combining entities. However, only a single combined retained earnings account need be presented.
Example of a combined financial statement
|
|
| Stockholders' equity | |
|---|---|
| |
| $ 500,000 |
| 3,000.000 |
| 1,000,000 |
| Additional paid-in capital | 650.000 |
| Retained earnings | 3,825,000 |
| $8,975,000 |
|
|
Combinations of Entities under Common Control
IAS 22 explicitly does not apply to entities under common control (e.g., brother-sister corporations). However, logic suggests that mergers among such affiliated entities must be accounted for "as if" poolings. This treatment is consistent with the concept of poolings as combinations of common shareholder interests. A question arises, however, when a parent (Company P) transfers ownership in one of its subsidiaries (Company B) to another of its subsidiaries (Company A) in exchange for additional shares of Company A. In such an instance, A's carrying value for the investment in B should be P's basis, not B's book value. Furthermore, if A subsequently retires the interests of minority owners of B, the transaction should be accounted for as a purchase, whether it is effected through a stock issuance by A or by a cash payment to the selling shareholders.
Furthermore, when a purchase transaction is closely followed by a sale of the parent's subsidiary to the newly acquired (target) entity, these two transactions should be viewed as a single transaction. Accordingly, the parent should recognize gain or loss on the sale of its subsidiary to the target company, to the extent of minority interest in the target entity. As a result, there will be a new basis (step-up) not only for the target company's assets and liabilities, but also for the subsidiary company's net assets. Basis is stepped up to the extent of minority participation in the target entity to which the subsidiary company was transferred.
Accounting for Special-Purpose Entities
An issue related to the accounting for entities under common control arises when one enterprise has been created solely or largely for the purpose of accommodating the other's need for financing or for engaging in certain strictly limited transactions with or on behalf of the sponsoring entity. Common objectives are to effect a lease, conduct research and development activities, or to securitize financial assets. These "special-purpose entities," (SPE) or special-purpose vehicles (SPV) have received a good deal of attention of late, largely as a consequence of several large and notorious financial frauds which utilized SPE to conceal reporting entity debt and/or to create the appearance of revenues and/or earnings when such did not actually exist.
SPE have often been used to escape the requirements of lease capitalization or other financial reporting requirements that the sponsoring enterprise wishes to evade. While there are often legitimate (i.e., those not driven by financial reporting) reasons for the use of special-purpose entities (SPE), at least a side effect, if not the main one, is that the sponsoring entity's apparent financial strength (e.g., leverage) will be distorted.
In many instances an adroitly structured SPE will not be owned, or majority owned, by the true sponsor. Were ownership the only criterion for determining whether entities need to be consolidated for financial reporting purposes, this factor could result in a "form over substance" decision to not consolidate the SPE with its sponsor. However, under the provisions of SIC 12, ownership is not the critical element in determining the need for consolidation; rather, a "beneficial interest" test is used to determine whether the SPE should be consolidated. Beneficial interest can take various forms, including ownership of debt instruments, or even a lessee relationship.
SIC 12 states that consolidation of an SPE should be effected if the substance of its relationship with another entity indicates that it is effectively controlled by the other entity. Control can derive from the nature of the predetermined activities of the SPE (what the interpretation refers to as being on "autopilot"), and emphatically can exist even when the sponsor has less than a majority interest in the SPE. SIC 12 specifically notes that the following conditions would suggest that the sponsor controls the SPE:
-
The activities of the SPE are conducted so as to provide the sponsor with the benefits thereof;
-
The sponsor in substance has decision-making powers to obtain most of the benefits of the SPE, or else an autopilot mechanism has been established such that the decision-making powers have been delegated;
-
The sponsor has the right to obtain the majority of the benefits of the SPE and consequently is exposed to risks inherent in the SPE's activities; or
-
The sponsor retains the majority of the residual or ownership risks of the SPE or its assets, in order to obtain the benefits of the SPE's activities.
SIC 12 is particularly concerned that autopilot arrangements may have been put into place specifically to obfuscate the determination of control. It cautions that although difficult to assess in some situations, control is to be attributed to the enterprise having the principal beneficial interest. The entity which arranged the autopilot mechanism would generally have had, and continue to have, control, and thus the need for consolidation with the sponsor for financial reporting purposes would accordingly be indicated. SIC 12 offers a number of examples of conditions which would be strongly indicative of control and thus of a need to consolidate the SPE's financial statements with those of its sponsor.
IASB will be revisiting accounting for SPE in the near future. The objectives of any project on this topic would be to reconfirm this basis upon which an entity should consolidate its investments, and to provide more rigorous guidance on the concept of "control." It is anticipated that an amendment to, or supplement of, IAS 27 will be the outcome of this undertaking.
It is interesting to note that in the US, the FASB has also undertaken a project to address accounting for SPE, and preliminary thinking suggests that new requirements will conform more closely to SIC 12 than existing standards have done. This suggests that the IASC's approach to this difficult area may have been more well-advised than were FASB's efforts in the past. It also highlights the likely need to base future requirements for consolidated financial reporting more definitively on the concept of "control," versus majority ownership, which heretofore has been favored due to its being objectively assessable. Given the complex structures that have been engineered (some of which, as in the case of Enron, have been done so deliberately to perpetrate frauds), it is clear that simple majority ownership may, in some circumstances, be clearly insufficient to accomplish "substance over form" financial reporting. The expected adoption of a "primary beneficiary" criterion under US GAAP would largely mirror the "beneficial interest" test under SIC 12.
Having stated a need for more universal consolidation of SPE is not, however, to deny that SPE may have many important and legitimate uses, especially to achieve isolation of assets (as in securitization trusts) that is necessary to facilitate certain very useful capital raising and other transactions. However, the legal isolation of assets can be accomplished even if for financial reporting purposes (with, of course, adequate informative disclosures) full consolidation is also prescribed.
Accounting for Leveraged Buyouts
Possibly one of the most complex accounting issues to have arisen over the past decade has been the appropriate accounting for leveraged buyouts (LBO). At the center of this issue is the question of whether a new basis of accountability has been created by the LBO transaction. If so, a step-up in the reported value of assets and/or liabilities is warranted. If not, the carryforward bases of the predecessor entity should continue to be reported in the company's financial statements.
International accounting standards do not address this issue directly. However, guidance can be obtained from the decisions made by the standard setters in the United States, which have dealt with this question. Although this guidance is not definitive, it is instructive.
The conclusion was that partial or complete new basis accounting is appropriate only when the transaction is characterized by a change in control of voting interest. A series of mechanical tests were developed by which this change in interest is to be measured. The FASB's Emerging Issues Task Force (EITF) identified three groups of interests: shareholders in the newly created company, management, and shareholders in the old company (who may or may not also have an interest in the new company). Depending on the relative interests of these groups in the old entity (OLDCO) and in the new enterprise (NEWCO), there will be either (1) a finding that the transaction was a purchase (new basis accounting applies) or (2) that it was a recapitalization or a restructuring (carryforward basis accounting applies).
Among the tests decreed to determine proper accounting for any given LBO transaction is the monetary test. This test requires that at least 80% of the net consideration paid to acquire OLDCO interests must be monetary. In this context, monetary means cash, debt, and the fair value of any equity securities given by NEWCO to selling shareholders of OLDCO. Loan proceeds provided by OLDCO to assist in the acquisition of NEWCO shares by NEWCO shareholders are excluded from this definition. If the portion of the purchase that is effected through monetary consideration is less than 80%, but other criteria are satisfied, there will be a step-up. This step-up will be limited to the percentage of the transaction represented by monetary consideration.
US GAAP guidance also presents an extensive series of examples illustrating the circumstances that would and would not meet the purchase accounting criteria to be employed in LBO. These examples should be consulted as needed when addressing an actual LBO transaction accounting issue.
Spin-Offs
Occasionally, an entity disposes of a wholly or partially owned subsidiary or of an investee by transferring it unilaterally to the entity's shareholders. The proper accounting for such a transaction, generally known as a spin-off, depends on the percentage of the company that is owned.
If the ownership percentage is relatively minor, 25% for example, the transfer to stockholders would be viewed as a dividend in kind and would be accounted for at the fair value of the property (i.e., shares in the investee) transferred.
However, when the entity whose shares are distributed is majority or wholly owned, the effect is not merely to transfer a passive investment, but to remove the operations from the former parent and to vest them with the parent's shareholders. This transaction is a true spin-off transaction, not merely a property dividend. Although international accounting standards have not addressed this matter, as a point of reference, US GAAP requires that spin-offs and similar nonreciprocal transfers to owners be accounted for at the recorded book values of the assets and liabilities transferred.
If the operations (or subsidiary) being spun off are distributed during a fiscal period, it may be necessary to estimate the results of operations for the elapsed period prior to spin-off to ascertain the net book value as of the date of the transfer. Stated another way, the operating results of the subsidiary to be disposed of should be included in the reported results of the parent through the actual date of the spin-off.
In most instances, the subsidiary being spun off will have a positive net book value. This net worth represents the cost of the nonreciprocal transfer to the owners, and like a dividend, will be reflected as a charge against the parent's retained earnings at the date of spin-off. In other situations, the operations (or subsidiary) will have a net deficit (negative net book value). Since it is unacceptable to recognize a credit to the parent's retained earnings for other than a culmination of an earnings process, the spin-off should be recorded as a credit to the parent's paid-in capital. In effect, the stockholders (the recipients of the spun-off subsidiary) have made a capital contribution to the parent company by accepting the operations having a negative book value. As with other capital transactions, this would not be presented in the income statement, only in the statement of changes in stockholders' equity (and in the statement of cash flows).
Push-Down Accounting
Push-down accounting is an unresolved issue in accounting for an entity that has had a substantial change in the ownership of its outstanding voting shares. This technique reflects the revaluation of the assets and/or liabilities of the acquired company (on its books) based on the price paid for some or all of its shares by the acquirer. Push-down accounting has no impact on the presentation of consolidated financial statements or on the separate financial statements of the parent (investor) company. These financial statements are based on the price paid for the acquisition, not on the acquired entity's book value. However, the use of this accounting technique represents a departure in the way separate financial statements of the acquired entity are presented.
Advocates of push-down accounting point out that in a purchase business combination, a new basis of accounting is established. They believe that the new basis should be pushed down to the acquired entity and should be used when presenting its own separate financial statements.
While the push-down treatment has been used by a number of entities whose shares have been purchased by others, the entire area of push-down accounting remains controversial and without clear authoritative guidance. Although push-down makes some sense in the case where a major block of the investee's shares is acquired in a single free-market transaction, a series of step transactions would require continual adjustment of the investee's carrying values for assets and liabilities. Furthermore, the price paid for a fractional share of ownership of an investee may not always be meaningfully extrapolated to a value for the investee company as a whole.
Non-Sub Subsidiaries
An issue that has recently concerned accountants is the sudden popularity of what have been called non-sub subsidiaries. This situation arises when an entity plays a major role in the creation and financing of what is often a start-up or experimental operation but does not take an equity position at the outset. For example, the parent might finance the entity by means of convertible debt or debt with warrants for the later purchase of common shares. The original equity partner in such arrangements most often will be the creative or managerial talent that generally exchanges its talents for a stock interest. If the operation prospers, the parent will exercise its rights to a majority voting stock position; if it fails, the parent presumably avoids reflecting the losses in its statements.
Although this strategy may seem to avoid the requirements of equity accounting or consolidation, the economic substance clearly suggests that the operating results of the subsidiary should be reflected in the financial statements of the real parent, even absent stock ownership. Until formal requirements are established in this area, an approach akin to the preparation of combined statements would seem reasonable.
Disclosure Requirements
Business combinations.
For all business combinations, the following disclosures are required in the financial statements for the year in which the transaction occurs:
-
The name and descriptions of combining enterprises
-
The methods of accounting for the combinations
-
The effective date of the combinations, for accounting purposes
-
The identity of any operations resulting from the combination that are intended for disposition
For business combinations accounted for as acquisitions, the following disclosures are required:
-
The percentage of voting interests acquired
-
The cost of the acquisitions, and a description of consideration paid or contingently payable
-
The nature and amount of provisions for any restructuring or plant closure expenses arising as a result of any acquisitions, and recognized as of the date of the acquisitions
Furthermore, the financial statements should disclose the following:
-
The accounting treatment for goodwill and negative goodwill, including amortization periods
-
Justification for amortization periods greater than twenty years, if applicable
-
Description of and justification for amortization of goodwill or negative goodwill by other than the straight-line method
-
A reconciliation, with respect to both goodwill and negative goodwill, at the beginning and the end of the period, showing:
-
The gross amount and accumulated amortization at the beginning of the period
-
Any additional goodwill or negative goodwill recorded during the period
-
Amortization recorded during the period
-
Any adjustments resulting from the subsequent identification or changes in value of assets and liabilities
-
Any other write-offs during the period
-
The gross amount and accumulated amortization at year-end
-
If the allocation of the purchase price to assets and liabilities is only made on a provisional basis, this fact must be disclosed, with the reasons therefor noted. When these matters are later resolved, this should also be disclosed.
For business combinations that are unitings of interests, the following disclosures are required in the period in which the event occurs:
-
A description of the shares issued, together with the percentages of each combining entity's voting shares exchanged to effect the uniting of interests
-
The amounts of assets and liabilities contributed by each constituent enterprise
-
Sales revenue, other operating revenues, extraordinary items, and net profit or loss of each enterprise prior to the date of the combination, which are included in the combined financial statements
If a business combination is effected after the balance sheet date, the foregoing disclosures should be made if practical, but the transaction should not be accounted for as if it had occurred prior to year-end.
Consolidated financial statements.
IAS 27 requires that for consolidated financial reporting, the names, countries of incorporation or residence, proportion of ownership interests, and if different, voting interests held be disclosed for all significant subsidiaries.
If any subsidiary is not included in the consolidated financial statements, the reasons must be set forth. If an entity over which the parent does not have majority voting control is included in the consolidated financial statements, the reasons for this must also be explained.
If a subsidiary was acquired or disposed of during the period, the effect of the event on the consolidated financial statements should be discussed. If parent-only financial statements are being presented (which is permitted, but not as a substitute for consolidated financial reporting), the method of accounting for interests in subsidiaries should be stated.
EAN: 2147483647
Pages: 147