ACC 424 Financial Reporting II

ACC 424Financial Reporting II

Lecture 2Accounting for mergers &

acquisitions (M & A)

2

Agenda - M &A accounting

• Introduction– nature of M & A accounting

– types of M &A

– relation to consolidation

• M & A motivations• Purchase & pooling methods

• Application of – purchase method

– pooling method

• Abuses of – pooling

– purchase

• Future

3

Nature of M & A accounting

• Business combination – Bringing two or more companies under

common control

• M & A accounting– Accounting for the business

combination transaction

• Consolidation– Consolidation of the financial

statements of a group of companies under common control into one set of financial statements

4

Types of combinations

1 Statutory merger– company B absorbed into company A

– B ceases to exist & shares retired

– A survives

2 Statutory consolidation– new co. C formed to absorb co.s A & B

– A & B cease to exist & shares retired

– only C survives

3 Stock acquisition– one co. acquires all or most of voting stock of another

co.

– both co.s survive

– acquiring firm is the parent of the acquired firm (the subsidiary) because it owns a controlling interest

4 Asset acquisition– one co. acquires all or part of the assets, liabilities &

business operations of another co.

– selling firm may continue to survive or may liquidate

5

Relation to consolidation

• Types 1 & 2 are statutory since state laws govern reorganization

– only one co. survives so no consolidation– absorbed assets & liabilities included in surviving co.

books

• In stock acquisition– two co.s continue to survive & have their own books – parent co. has an asset (investment in subsidiary) to

represent the net investment in the subsidiary– assets & liabilities of subsidiary are not shown

separately in the parent’s books– parent has controlling interest so consolidated

financial statements are prepared showing both co.s assets & liabilities

• In asset acquisition

– selling co. may continue to survive but doesn’t control the other (may be unrelated) so no consolidation

– acquired assets & liabilities appear in acquiring co.s books

6

Combination motives

• Shareholders benefit if – combined co.’s market value > sum of separate

combining co.’s market values

• Are the following likely to increase value in a combination?

– economies of scale• vertical

• horizontal

• managerial?

– unused tax shields

– elimination of inefficiencies• financial (excess cash)

• operating & investment

– diversification

– lower financing costs

– increasing earnings & earning per share (EPS)

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Increasing EPS Motivation

• Underlying logic– Relies on inefficient capital

markets– Assumes no cash flow effects

(sources of increased value)

• Example– Assume pooling (no earnings

effects)– Two situations

• Assuming efficient markets

• Assuming inefficient markets

8

EPS example

• Two firms considering merger World Muck &

Enterprises Slurry

EPS $2.00 $2.00

Stock price $40 $20

P/E ratio 20 10

# of shares 100,000 100,000

Total earnings $200,000 $200,000

Total market value $4,000,000 $2,000,000

Earnings per dollar

invested in stock $.05 $.10

• Alternative structuresWorld takes over Muck & Slurry

Muck & Slurry takes over World

9

Efficient marketsWorld Enterprises takes over Muck & Slurry

World Muck &World

Enterprises Slurry after merger

Total earnings $200,000 $200,000 $400,000

Total market value $4,000,000 $2,000,000$6,000,000

# of shares 100,000 100,000 150,000

EPS $2.00 $2.00 $2.67

Stock price $40 $20 $40

P/E ratio 20 10 15

Earnings per dollar

invested (E/P) $.05 $.10 $.067

World Enterprises pays the market value for Muck & Slurry $20 per share or $2,000,000 in total since there are no cash flow effects. That requires issuance of $2,000,000/$40 = 50,000 shares

10

Efficient marketsWorld Enterprises takes over Muck & Slurry

• World Enterprises P/E ratio falls it will have lower growth. Its future earnings per dollar invested will grow more slowly

11

Efficient markets Muck & Slurry takes over World Enterprises

World Muck &M & S


Total earnings $200,000 $200,000 $400,000


# of shares 100,000 100,000 300,000

EPS $2.00 $2.00 $1.33

Stock price $40 $20 $20

P/E ratio 20 10 15

Earnings per dollar

invested (E/P) $.05 $.10 $.067

Muck & Slurry pays the market value for World Enterprises $40 per share or $4,000,000 in total since there are no cash flow effects. That requires issuance of $4,000,000/$20 = 200,000 shares. Notice the P/E ratio is unchanged from when World took over

12

Inefficient marketsWorld Enterprises takes over Muck & Slurry

World Muck & World


Total earnings $200,000 $200,000 $400,000


# of shares 100,000 100,000 150,000

EPS $2.00 $2.00 $2.67

Stock price $40 $20 $53.33

P/E ratio 20 10 20

Value added by takeover = $8,000,000-$6,000,000 = $2,000,000

(even though no cash flow effects)Stock market assumes the growth of earnings per dollar invested for World

Enterprises is unchanged with the addition of Muck & Slurry so P/E ratio remains at 20

13

Inefficient markets Muck & Slurry takes over World Enterprises

World Muck &M & S


Total earnings $200,000 $200,000 $400,000


# of shares 100,000 100,000 300,000

EPS $2.00 $2.00 $1.33

Stock price $40 $20 $13.33

P/E ratio 20 10 10

Value lost by takeover = $6,000,000-$4,000,000 = $2,000,000

(even though no cash flow effects) Stock market assumes the growth of earnings per dollar invested for Muck

& Slurry is unchanged with the addition of World Enterprises so P/E ratio remains at 10

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Example with inefficient markets

• The economics of the surviving firm are unchanged whichever firm takes over

• Whether you add $2 million in value or lose $2 million depends on the name you give the surviving company

• The assumption that the P/E ratio is unchanged is unlikely to be descriptive

15

Purchase & pooling methods

• Currently two methods of accounting for business combination (APBO 16):– purchase method

– pooling method

• Purchase method – treats the combination as an acquisition of

assets or equity shares, the outcome of a market transaction

– consideration given by acquiring firm serves as basis for valuing assets or equities acquired

• Pooling method– treats combination as a union of previously

separate ownership interests achieved via exchange of equity securities

– no purchase or sale, no new basis of valuation

16

Purchase methodUnder existing standards

• allocates market consideration to identifiable assets & liabilities on basis of fair market value

• any excess of market consideration over net fair market value of assets & liabilities is recorded as goodwill

• any deficiency is allocated proportionately (on market value) among noncurrent assets except long-term investments in marketable securities

• goodwill is amortized on a straight-line basis over 10-40 years

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Methods’ accounting implications

18

Methods’ accounting effects

• Current and future earnings usually higher under pooling– Earnings of combination year increased by

acquired co.’s earnings

– Future earnings decreased under purchase because of increased depreciation on revalued assets & amortization of goodwill

• Balance sheet is usually stronger under purchase– Asset values written up

• Earnings and balance sheet effects combine to produce higher accounting returns on equity (& assets) under pooling

19

Example of accounting effects

• Two firms have the following owners’ equity at combination & income and rate of return on equity for next year: Owners’ Income Return

on

Equity Equity

Corporation A $100 $20 20%

Corporation B 50 10 20%

• Assume corporation A – takes over corporation B

– issues shares with a market value of $100

– if the combination is a purchase the differential of $50 is amortized over five years

• Then the combined firm’s profitability is Owners’ Income Return on

Equity Equity

Purchase $200 $20 10%

Pooling of interests 150 30 20%

20

Standard-setters’ reaction to accounting effects

• Effect on accounting rate of return might not affect stock market (on average), just as the EPS effects might not influence stock market

• Accounting standard setters, however, are concerned that it will influence investors– APB 16 made pooling more difficult to achieve

– Current proposal to eliminate pooling

21

APBO 16 conditions for pooling

22

Time series of methods’ use

23

Time series of methods’ use1994-1998

Purchase Pooling

Year Number Percent Number Percent Total

1998 317 92 27 8 344

1997 278 88 38 12 316

1996 256 89 32 11 288

1995 244 88 32 12 276

1994 215 92 19 8 234

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Alternative explanation for relative decline in poolings

• Williams Act passed in 1968• Combination of the act & the

Securities Act of 1933 meant if the consideration is– Cash, there is no delay in making the

offer

– Stocks, there is an average delay of 49 days (in 1969)

• By late 1970’s intense competition for acquisitions made cash much more attractive (Gilson 1986)

• Cannot use pooling if the consideration is cash

25

APB 16’s stock price effects

• A negative stock price effect was observed for firms active in the take-over market when APB 16 was issued in 1970 (Leftwich, Journal of Accounting & Economics, 1981)

• That stock price drop varied with the firm’s leverage

26

Application of purchase method

Modification of P1.4

AMAX Corporation merged with (acquired) BETAX Corporation on December 31, 19X8. Consultants’ and attorneys’ fees relating to the merger (acquisition) amounted to $50,000, and the costs of registering and issuing securities exchanged in the merger (acquisition) totaled $30,000. Condensed balance sheet data for AMAX and BETAX just prior to the combination and estimated fair values of BETAX properties and liabilities are given below:

Required: Prepare journal entries to record the combination of AMAX and BETAX given AMAX issues 10,000 shares with a market value of $800,000 for all the shares in BETAX in a purchase transaction and assuming:

a) BETAX is merged into AMAX; b) AMAX acquires BETAX

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• Merger First determine differential between price & book value (premium or discount):

Market value of shares issued $800,000

Consultants’ & attorneys’ fees 50,000

Total acquisition cost $850,000

Common stock $100,000

Additional Paid-In Capital 100,000

Retained earnings 300,000

Total book value of net assets $500,000

Differential (premium) $350,000

Then allocate it to changes in fair market values of assets & liabilities and goodwill:

Increase in value of inventory $120,000

Increase in value of net plant assets 200,000

Decrease in value of long-term debt 20,000

$340,000

Less: Decrease in cash & receivables 50,000

Increase in market value of identifiable net assets $290,000

Goodwill 60,000

Differential (premium) $350,000

(entries in AMAX books)

Cash and receivables

28


• Merger

Journal entries in AMAX’s books

Cash and receivables $850,000

Inventory 920,000

Plant assets 700,000

Goodwill 60,000

Current liabilities$700,000

Long-term debt 980,000

Common stock ($10 par) 100,000

Additional paid-in capital ($700K-30K) 670,000

Cash 80,000

To record the merger of BETAX Corporation

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• Stock acquisition

Journal entries in AMAX’s books

Investment in BETAX $850,000

Common stock$100,000

Additional paid-in capital 670,000

Cash 80,000

To record the acquisition of the outstanding common of BETAX corporation

30

Application of pooling method

• Assuming the same facts as the previous problem, prepare journal entries to record the merger of AMAX and BETAX given:

a) AMAX exchanges 12,000 shares for all the shares of BETAX in a pooling of interests;

b) AMAX exchanges 20,800 shares for all the shares of BETAX in a pooling of interests;

c) AMAX exchanges 52,000 shares for all the shares of BETAX in a pooling of interests;

• Assuming the same facts as the previous problem, prepare journal entries to record AMAX’s acquisition of BETAX given AMAX exchanges 12,000 shares for all the shares of BETAX in a pooling of interests;

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• Merger a) 12,000 shares exchangedSince the assets & liabilities of the pooled firms are carried forward at their

book values, the stockholder’s equity of the combined firms is the sum of the two firms’ stockholders’ equity. This summation is complicated by three requirements:

i) the common stock issued by AMAX has to be recorded at its par value;

ii) the contributed capital of the combined firm cannot be less than the sum of the contributed capitals of the combining

firms; and

iii) retained earnings of the combined firm should be equal to the sum of the retained earnings of the combining firms.

If the par value of the common stock issued by AMAX differs from the par value of the BETAX common stock the Additional paid-in capital absorbs that difference.

In this problem the shareholders’ equity of AMAX has to be increased by the $500,000 shareholders’ equity of BETAX. Since in part a) AMAX issues 12,000 shares with par value of $120,000 and BETAX’s par value of its shares that were exchanged is $100,000, Additional paid-in capital is credited with $80,000 not the $100,000 showing in BETAX’s books.

The credit to AMAX’s shareholders’ equity then must be the net asset value of BETAX, $500,000 and it is split as follows:

Common stock $120,000



$500,000

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• Merger a) 12,000 shares exchanged (continued)

The entry in AMAX’s journal is then:

Cash and receivables $ 900,000

Inventory 800,000

Plant assets 1,100,000

Expenses of business combination 80,000

Accumulated depreciation $ 600,000

Current liabilities 700,000

Long-term debt 1,000,000

Common stock 120,000



Cash 80,000

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• Merger b) 20,800 shares exchanged

The difference between BETAX’s common stock and that issued by AMAX is now $108,000. Deducting that from BETAX’s Additional paid-in capital of $100,000 leaves produces an $8,000 debit to Additional paid-in capital.

The entry in AMAX’s journal is unchanged except for the composition of the credit to shareholders’ equity:


Additional paid-in capital (debit) (8,000)


$500,000

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• Merger c) 52,000 shares exchanged

In this case, the difference in common stock $420,000 exceeds BETAX’s Additional paid-in capital by $320,000. Given the second requirement that the contributed capital cannot be less than the sum of the contributed capitals, Additional paid-in capital cannot be reduced by more than AMAX’s $300,000 balance. The remainder, $20,000 is reduces the credit to Retained earnings from $300,000 to $280,000 violating the admonition that Retained earnings be the sum of the merging firms’ Retained earnings.

Again the entry in AMAX’s journal is unchanged except for the composition of the credit to shareholders’ equity:


Additional paid-in capital (debit) (300,000)


$500,000

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• Stock acquisition 12,000 shares exchanged

Assume the pooling conditions are satisfied

The entry in AMAX’s journal is then:

Investment in BETAX $ 500,000

Expenses of business combination 80,000

Common stock 120,000



Cash 80,000

Notice that the credits to owners’ equity are the same. All that happens is that the individual assets and liabilities book values are replaced by the investment account which is equal to the net asset value of BETAX

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Abuse of pooling

• The text (pp. 1-33 to 1-35) reports that Western Equities (Westec) used retrospective poolings to increase 1964 and 1965 earnings and suggests these poolings influenced the stock price

• How can you reconcile this case with an efficient stock market?

37

Abuse of purchase

• In the 1980s thrifts (S&Ls) with regulator (FSLIC) and government backing used purchase accounting to overstate earnings and equity

• The regulators and the government wanted healthy thrifts to take over failing thrifts and encouraged the healthy thrifts to use purchase accounting for the combination to meet required capital restrictions

38

Abuse of purchase

• Andrew (1981) provides an example

• Thrift A acquires insolvent thrift B

• B’s balance sheetAssets Equities & liab.s

Loan portfolio $100m Deposits $100m

_____ Equity __ 0

$100m $100m

The loan portfolio is really only worth $60m at current interest rates, so equity is really a negative $40m

A’s purchase entry records $60m for the loan portfolio and goodwill of $40m so its capital is not reduced

In future years A records income for the increase in value of the loan portfolio at $4m a year (assuming the loans’ average life is 10 years) and amortizes the goodwill over 40 years producing a net $3m of income per year for the next 10 years

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Abuse of purchase

• The administration eventually limited the use of intangible assets to satisfy capital requirements

• Financial institutions that acquired failing thrifts under government pressure and with the promised use of purchase accounting to meet the requirements sued the government

• The institutions won

• In the capital market, management uses accounting to try to fool the market. In the political market, regulators and politicians use accounting to try to fool the voters

• The thrift example is far from unique

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Future

• The FASB’s Business Combinations ED would eliminate pooling

• The ED would – limit goodwill’s useful life to 20 years– Require acquired identifiable intangible

assets that can be reliably measured separate from the goodwill to be recorded

– If the fair value of net assets exceeds the market consideration, the excess is first allocated pro rata to intangible assets that have no observable market. If any excess remains it is allocated to nonfinancial depreciable assets & other acquired intangible assets.

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ACC 424 Financial Reporting II

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