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4 CHAPTER 4

INTRODUCTION TO BUSINESS COMBINATIONS

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4FOCUS OF CHAPTER 4

Business Combinations (EXTERNAL expansion):

Legal Considerations The Arena in Which Takeover Battles

Are Waged Purchase Accounting Accounting for Goodwill Appendix: Income Tax Considerations

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4 The Purchase Method: A Whole New Basis of Accounting is Established

The new basis of accounting is based on the acquirer’s purchase price.

The depreciation cycle for fixed assets begins

a new at a higher or lower level.

If cost > CV, goodwill exists. Recognize as an asset--do not amortize. Evaluate periodically for possible impairment.

If cost < CV, a bargain purchase element (or “negative goodwill”) exists.

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4 The Pooling of Interests Method: No Longer Allowed

The target company’s basis ofaccounting in its assets is usedby the consolidated group.

The depreciation cycle merely continues along as if no business combination had occurred.

Goodwill is NEVER recognized--thus

future income statements will NOT have goodwill expense. Managements loved it.

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4 Acquiring ASSETS Versus Acquiring COMMON STOCK: Often a Major Issue

Major Decision Factors: Legal considerations--Buyer must

be extremely careful NOT to assume responsibility for (and thus “inherit”)the target company’s: Unrecorded liabilities. Contingent liabilities

(lawsuits).

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4 Acquiring ASSETS Versus Acquiring COMMON STOCK: Often a Major Issue

Major Decision Factors (continued): Tax considerations--Often requires

major negotiations involving resolution of: Seller’s tax desires. Buyer’s tax desires.

Ease of consummation--Acquiring common stock is simple compared with acquiring assets.

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4 Acquiring ASSETS: Advantages and Disadvantages

Major Advantages of Acquiring Assets: Will NOT inherit a target’s contingent

liabilities (excluding environmental). Will NOT inherit a target’s unwanted

labor union. Major Disadvantages of Acquiring Assets:

Transfers of titles on real estate and other assets can be time-consuming.

Transfer of contracts may NOT be possible.

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4 Acquiring COMMON STOCK: Advantages and Disadvantages

Advantages of Acquiring Common Stock: Will make transfer quite easy. Will inherit nontransferable contracts.

Disadvantages of Acquiring Common Stock: Will inherit contingent liabilities and an

unwanted labor union. Will acquire unwanted facilities/units. Will be hard to access target’s cash.

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4 Business Combinations: Organizational Forms that Can Result

The focus is on what property is received--NOT on what property is given.

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4 Organizational Forms:Types of Property that Can Be Received

Common Stock--Results in a parent-subsidiary relationship.

Target’s Assets--Results in a home office-branch/division relationship.

P

S

Home Office

Branch/Division

P controls S

1 legal entity

2 legal entities

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4 Organizational Forms: Specialized Options

Option #1: STATUTORY MERGER : A temporary parent-subsidiary

relationship is created. The parent then liquidates the

subsidiary into the parent pursuant to state laws.

The result: ONE legal entity survives.

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4 Organizational Forms:Specialized Options

Option #2: STATUTORY CONSOLIDATION: New corporation (TOPCO) is created. TOPCO issues stock to BOTH combining

companies in exchange for their o/s stock. Each combining company becomes

a temporary subsidiary of TOPCO Both subs are liquidated into TOPCO

and become divisions. Result: ONE legal entity survives.

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4 Organizational Forms:Specialized Options

Option #3: HOLDING COMPANY: Similar to a statutory consolidation

except that the two subsidiaries are NOT liquidated into TOPCO.

TOPCO

P S

3 legal entities

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4Review Question #1

To qualify for for purchase accounting treatment:A. One company must acquire common stock of the other combining company.B. A statutory consolidation must occur.C. Each company must be approximately the same size.D. A stock-for-stock exchange must occur.E. None of the above.

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4Review Question #1--With Answer

To qualify for for purchase accounting treatment:A. One company must acquire common stock of the other combining company.B. A statutory consolidation must occur.C. Each company must be approximately the same size.D. A stock-for-stock exchange must occur.E. None of the above.

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4Review Question #2

In purchase accounting:A. Common stock must be the consideration given.B. Goodwill is not reported.C. A statutory merger occurs.D. A change of basis in accounting occurs.E. None of the above.

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4Review Question #2--With Answer

In purchase accounting:A. Common stock must be the consideration given.B. Goodwill is not reported.C. A statutory merger occurs.D. A change of basis in accounting occurs.E. None of the above.

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4Review Question #3

In purchase accounting:A. Preferred stock must be the consideration given.B. Goodwill is always reported.C. A holding company must be created to effect the merger.D. Financial reporting symmetry occurs between the two combining companies.E. None of the above.

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4Review Question #3--With Answer

In purchase accounting:A. Preferred stock must be the consideration given.B. Goodwill is always reported.C. A holding company must be created to effect the merger.D. Financial reporting symmetry occurs between the two combining companies.E. None of the above.

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4Review Question #4

Which of the following COULD occur or result? Purchase Pooling A. Goodwill..........................B. Change in basis..............C. Statutory merger............D. Stock-for-stock exchangeE. Symmetrical reporting....

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4Review Question #4--With Answer

Which of the following COULD occur or result? Purchase Pooling A. Goodwill.......................... YES NOB. Change in basis.............. YES NOC. Statutory merger............ YES YESD. Stock-for-stock exchange YES YESE. Symmetrical reporting.... YES YES

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4Review Question #5

Which of the following COULD occur or result? Purchase Pooling A. Preferred stock issuance. B. Parent-subsidiary............ C. Home office-division...... D. Acquisition of assets....... E. Acquisition of stock........

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4Review Question #5--With Answer

Which of the following COULD occur or result? Purchase Pooling A. Preferred stock issuance. YES NO B. Parent-subsidiary............ YES YES C. Home office-division...... YES YES D. Acquisition of assets....... YES YES E. Acquisition of stock........ YES YES

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4Review Question #6

A way to force out a target company’s dissenting shareholders is to use:A. Purchase accounting. B. Pooling of interests accounting. C. A statutory merger. D. A statutory consolidation. E. None of the above.

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4Review Question #6--With Answer

A way to force out a target company’s dissenting shareholders is to use:A. Purchase accounting. B. Pooling of interests accounting. C. A statutory merger. D. A statutory consolidation. E. None of the above.

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4 End of Chapter 4 (Appendix material follows)

Time to Clear Things Up--Any Questions?

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4Tax Rules: SYMMETRY Always Occurs Between Seller and Buyer

SELLER’S TAX TREATMENT

ALWAYS DETERMINES BUYER’STAX TREATMENT : If seller has a taxable transaction, buyer

uses new basis of accounting. If seller has a nontaxable transaction,

buyer uses old basis of accounting.

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4 Taxable Business Combinations: SYMMETRY Between Seller and Buyer

Seller has taxable gain or loss. Buyer is required to use a new

tax basis, which can be either: A step up in tax basis (CV>BV). A step down in tax basis (CV<BV).

GOODWILL is reported if Cost > CV. A Section 197 intangible asset.

Mandatory amortization--15 year life.

Form 1120 orForm 1040

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4 Nontaxable Business Combinations: SYMMETRY Between Buyer and Seller

Seller does NOT report taxable gain/loss. Buyer must use OLD tax basis of property

acquired--regardless of FV of the consideration given for that property.

Commonly Used Descriptions for Buyer: Buyer “inherits” the old tax basis.

Buyer is “stuck with” the old tax basis.