Advanced Financial Accounting I
Advanced Financial Accounting I ADMS 4520 – Winter 2012 – Patrice Gelinas Lecture 2 – Business Combinations – Jan 13 Introduction A business combination occurs when one company unites with or obtains control of another company. The ‘parent’ is the controlling company and the ‘subsidiary’ is the controlled company. Consolidated financial statements are required to report the combined financial position and results of operations of the parent and the subsidiary. Control over another company can be obtained by (i) purchasing substantially all of its net assets, or (ii) acquiring enough of the company’s voting shares to control the use of its net assets. A conglomerate business combination involves regular businesses operating in widely different industries. A horizontal business combination involves businesses whose products are similar. A vertical business combination involves businesses where the output from one can be used as input from the other. Business Combinations Business combinations (‘takeovers’, ‘amalgamations’, ‘acquisitions’ or ‘mergers’) can be friendly or hostile. In a friendly combination, management and the board of directors of both companies recommend that their shareholders approve the combination proposal. In a hostile combination the management and board of the target company recommends that its shareholders reject the combination proposal, and may employ various defences. Payment for net assets or shares acquired can be in cash, promises to pay cash in the future, or the issuance of shares, or a combination of these. The method of payment has a direct bearing on the determination of which company is the acquirer and which is being acquired. Forms of Business Combinations Purchase of Assets – Control over another company’s assets can be obtained by purchasing the assets outright, leaving the selling company only with the consideration received for the asset sale and any liabilities present before the sale. Purchase of Shares – An alternative to the purchase of assets is for the acquirer to purchase enough voting shares from the shareholders of the acquire that it can determine the acquiree’s strategic operating, investing, and financial policies.
o Share purchase can be less costly since control can be achieved by purchasing less than 100% of the voting shares. Share purchases can also have important income tax advantages. Both forms of business combination result in the assets and liabilities of the acquiree being combined with those of the acquirer. If control is achieved with the purchase of net assets, the combining takes place in the accounting records of the acquiree. If control is achieved by purchasing shares, the combining takes place when the consolidated financial statements are prepared.
Methods of Accounting for Business Combinations There are four methods that have been used in practice or discussed in theory over the years: o The purchase method. o The acquisition method. o The poolingofinterests method. o The new entity method. The purchase method is required GAAP prior to adoption of the acquisition method which must be adopted on or before January 1, 2011. The poolingofinterest method was acceptable in limited situations prior to July 1, 2001 and can no longer be used. The new entity method has never been acceptable for GAAP but is worthy of future consideration. The Purchase Method Under the purchase method prior to 2011 or earlier adoption of IFRS 3, the acquiring company recorded the net assets of the acquired company in its investment account at the price it paid. Price includes cash payments, FMV of shares issued, and PV of any future cash payments promised. Excess of price paid over the fair value of the acquired company’s net assets are recorded as goodwill. The fair values of identifiable net assets acquired were charged against earnings (amortized) to achieve expense matching. Goodwill was regularly reviewed for impairment and impairment losses were recorded as a charge against earnings. The purchase method is consistent with historical cost principle of accounting – record the price paid for the net assets and amortizes the cost over their useful lives. The Acquisition Method
After January 1, 2011 or upon earlier adoption of IFRS 3, the acquiring company will use the acquisition method. The acquiring company records the identifiable net assets at fair values regardless of price paid. If purchase price is > FV of identifiable net assets the excess is reported as goodwill similar to purchase method. If price paid is 50% of votes. Written agreements allow parent to dictate subsidiary’s operating policies and to receive income & intercompany profits from subsidiary (e.g. special purpose entities examined in Chapter 9 in which parent holds the risks and rewards of ownership while owning few, if any, of the shares of the controlled company). o One company may own the largest single block of share of another company, e.g. X Company owns 40% of Y Company while the other 60% is widely held and rarely voted with the result that X has no trouble electing the majority of Y’s directors. IASB Exposure Draft on Consolidated Financial Statements indicates that X would have control of Y provided Y’s shareholders are not organized in such a way that they actively cooperate against X when they vote their shares.
Under previous Canadian GAAP this would not have given X control since it would require the cooperation of the other 60% of shareholders not to vote. o Control and consolidation cease if for example, the majority of a subsidiary’s assets are seized in a bankruptcy or if a foreign subsidiary is restricted by law from paying dividends to the parent. The existence of certain protective rights held by other parties does not necessarily provide those parties with control. Examples: o Approve or veto rights that do not affect strategic operating and financing policies. o The right to approval capital expenditures greater than a particular threshold, or the right to approve the issue of equity or debt. o The ability to remove the controlling party in the event of bankruptcy or breach of contract. o Certain limitations on the operating activities of an entity, such as pricing or advertising limitations typically placed by franchisors or franchisees.
Disclosure IFRS 3 Appendix B lists the following significant items to be disclosed for each business combination: o The acquisitiondate fair values of total consideration given and each class of consideration given. o The acquisitiondate values recognized for each major class of assets acquired and liabilities assumed. o Legal and other restrictions and the carrying amount of the assets and liabilities to which those restrictions apply. GAAP for Private Enterprises Section 1590: Subsidiaries of Part II of the CICA Handbook requires: o All subsidiaries should either be consolidated or accounted for using either the cost or the equity method except when a subsidiary’s equity securities are publicly traded in which case they should be recorded at market value with changes recorded in net income. o Investments in and income from nonconsolidated subsidiaries should be presented separately from other investments. Reverse Takeovers Occur when one company obtains ownership of the shares of another by issuing enough voting shares as consideration that control of the combined enterprise passes to the shareholders of the acquired enterprise.
Legally, A is the parent of B but for accounting purposes B is the parent of A. For acquisition accounting it is necessary to calculate the acquisition price for B’s acquisition of A. o Determine the number of shares of B that were outstanding before the combination. o Determine the number of additional shares that B would have had to issue to reduce B’s shareholders to 58% ownership of B. o Number of additional shares x FV = acquisition cost. Disclose the nature of the reverse takeover in the notes to B’s consolidated financial statements.
o Share purchase can be less costly since control can be achieved by purchasing less than 100% of the voting shares. Share purchases can also have important income tax advantages. Both forms of business combination result in the assets and liabilities of the acquiree being combined with those of the acquirer. If control is achieved with the purchase of net assets, the combining takes place in the accounting records of the acquiree. If control is achieved by purchasing shares, the combining takes place when the consolidated financial statements are prepared.
Methods of Accounting for Business Combinations There are four methods that have been used in practice or discussed in theory over the years: o The purchase method. o The acquisition method. o The poolingofinterests method. o The new entity method. The purchase method is required GAAP prior to adoption of the acquisition method which must be adopted on or before January 1, 2011. The poolingofinterest method was acceptable in limited situations prior to July 1, 2001 and can no longer be used. The new entity method has never been acceptable for GAAP but is worthy of future consideration. The Purchase Method Under the purchase method prior to 2011 or earlier adoption of IFRS 3, the acquiring company recorded the net assets of the acquired company in its investment account at the price it paid. Price includes cash payments, FMV of shares issued, and PV of any future cash payments promised. Excess of price paid over the fair value of the acquired company’s net assets are recorded as goodwill. The fair values of identifiable net assets acquired were charged against earnings (amortized) to achieve expense matching. Goodwill was regularly reviewed for impairment and impairment losses were recorded as a charge against earnings. The purchase method is consistent with historical cost principle of accounting – record the price paid for the net assets and amortizes the cost over their useful lives. The Acquisition Method
After January 1, 2011 or upon earlier adoption of IFRS 3, the acquiring company will use the acquisition method. The acquiring company records the identifiable net assets at fair values regardless of price paid. If purchase price is > FV of identifiable net assets the excess is reported as goodwill similar to purchase method. If price paid is 50% of votes. Written agreements allow parent to dictate subsidiary’s operating policies and to receive income & intercompany profits from subsidiary (e.g. special purpose entities examined in Chapter 9 in which parent holds the risks and rewards of ownership while owning few, if any, of the shares of the controlled company). o One company may own the largest single block of share of another company, e.g. X Company owns 40% of Y Company while the other 60% is widely held and rarely voted with the result that X has no trouble electing the majority of Y’s directors. IASB Exposure Draft on Consolidated Financial Statements indicates that X would have control of Y provided Y’s shareholders are not organized in such a way that they actively cooperate against X when they vote their shares.
Under previous Canadian GAAP this would not have given X control since it would require the cooperation of the other 60% of shareholders not to vote. o Control and consolidation cease if for example, the majority of a subsidiary’s assets are seized in a bankruptcy or if a foreign subsidiary is restricted by law from paying dividends to the parent. The existence of certain protective rights held by other parties does not necessarily provide those parties with control. Examples: o Approve or veto rights that do not affect strategic operating and financing policies. o The right to approval capital expenditures greater than a particular threshold, or the right to approve the issue of equity or debt. o The ability to remove the controlling party in the event of bankruptcy or breach of contract. o Certain limitations on the operating activities of an entity, such as pricing or advertising limitations typically placed by franchisors or franchisees.
Disclosure IFRS 3 Appendix B lists the following significant items to be disclosed for each business combination: o The acquisitiondate fair values of total consideration given and each class of consideration given. o The acquisitiondate values recognized for each major class of assets acquired and liabilities assumed. o Legal and other restrictions and the carrying amount of the assets and liabilities to which those restrictions apply. GAAP for Private Enterprises Section 1590: Subsidiaries of Part II of the CICA Handbook requires: o All subsidiaries should either be consolidated or accounted for using either the cost or the equity method except when a subsidiary’s equity securities are publicly traded in which case they should be recorded at market value with changes recorded in net income. o Investments in and income from nonconsolidated subsidiaries should be presented separately from other investments. Reverse Takeovers Occur when one company obtains ownership of the shares of another by issuing enough voting shares as consideration that control of the combined enterprise passes to the shareholders of the acquired enterprise.
Legally, A is the parent of B but for accounting purposes B is the parent of A. For acquisition accounting it is necessary to calculate the acquisition price for B’s acquisition of A. o Determine the number of shares of B that were outstanding before the combination. o Determine the number of additional shares that B would have had to issue to reduce B’s shareholders to 58% ownership of B. o Number of additional shares x FV = acquisition cost. Disclose the nature of the reverse takeover in the notes to B’s consolidated financial statements.
