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Business Combinations

Purchase and Pooling methods of


accounting for business combinations
Review

of present accounting and new


standard
Consolidation exercise
ExxonMobil mini-case

Limitations of consolidated statements


Consolidation of VIEs

2005 by Robert F. Halsey, all rights reserved

Business Combinations Standard FAS 141/142

Use Purchase method only (no pooling)


Record FMV of acquired tangible and intangible assets
and depreciate/amortize these assets over UL unless
the intangible asset has an indefinite life (e.g.,
goodwill )
I/S reflects costs relating to FMV of acquired tangible
assets and amortization of identifiable intangible
assets (no amortization of goodwill)
Record goodwill for the excess (Negative Goodwill is
recognized immediately as an extraordinary gain).
Goodwill is not amortized, but is tested annually for
impairment. Also applies to goodwill in equity method
investments.
Effective date: acquisitions after 6/30/01, and for fiscal
years beginning after 12/15/01.
Affects preexisting goodwill.

Consolidation Mechanics
stock purchase at book value
Pre-acquisition
balance sheets
Investor
Company
Current assets

Post-acquisition
balance sheets

Investee
Company

Investor Company
(Equity method)

Consolidated

$ 5,000

$ 1,000

$ 5,000

$ 6,000

3,000

Other assets

10,000

4,000

10,000

14,000

Total assets

$15,000

$5,000

$18,000

$20,000

Liabilities

$ 5,000

$2,000

$ 5,000

$ 7,000

Common stock

7,000

2,000

10,000

10,000

Retained earnings

3,000

1,000

3,000

3,000

$15,000

$5,000

$18,000

$20,000

Investment

Total liabilities and equity

Consolidation exercise

Purchase Price Allocation:

2005 by Robert F. Halsey, all rights reserved

Investment balance equity


method

+
-

Investment

2005 by Robert F. Halsey, all rights reserved

Pooling of interest method


(no longer used in US)

Record assets/liabilities of target at


book values (not FMV)
No goodwill recorded
Depreciation / amortization
expense is less.

2005 by Robert F. Halsey, all rights reserved

Exxon Mobil mini-case

Exxon
Mobil
mini-case

Acquired Identifiable Intangibles

Intangibles
Intangibles

Current
Current and
and noncurrent
noncurrent assets
assets
that
that lack
lack physical
physical substance.
substance.
Do
Do not
not include
include financial
financial
instruments.
instruments.

When
When should
should an
an Intangible
Intangible

be
be recognized?
recognized?

Does
Does itit arise
arise from
from contractual
contractual
or
or other
other legal
legal rights?
rights?
Can
Can itit be
be sold
sold or
or otherwise
otherwise
separated
separated from
from the
the acquired
acquired
enterprise?
enterprise?

Types of intangible assets that


must be recorded

Marketing-related intangible assets


Trademarks, tradenames

Service marks, collective marks,


certification marks

Trade dress (unique color, shape, or


package design)

Newspaper mastheads

Internet domain names

Noncompetition agreements
Customer-related intangible assets

Customer lists

Order or production backlog

Customer contracts and related customer


relationships

Noncontractual customer relationships


Artistic-related intangible assets

Plays, operas, ballets

Books, magazines, newspapers, other


literary works

Musical works such as compositions, song


lyrics, advertising jingles

(4)Pictures, photographs

Video and audiovisual material, including


motion pictures, music videos, television
programs

Contract-based intangible assets

Licensing, royalty, standstill agreements

Advertising, construction, management,


service or supply contracts

Lease agreements

Construction permits

Franchise agreements

Operating and broadcast rights

Use rights such as drilling, water, air,


mineral, timber cutting, and route
authorities

Servicing contracts such as mortgage


servicing contracts

Employment contracts
Technology-based intangible assets

Patented technology

Computer software and mask works

Unpatented technologies

Databases, including title plants

Trade secrets, such as secret formulas,


processes, recipes.

(SFAS 141, Appendix

Hewlett-Packard provides the following allocation of its $24.2 billion purchase price
for Compaq Computer in the footnotes to its 2002 10-K.
In millions

Cash and cash equivalents

Tangible assets

3,615

Accounts receivable

4,305

Financing receivables

1,241

Inventory

1,661

Current deferred tax assets

1,475

Other current assets

1,146

Property, plant and equipment

2,998

Long-term financing receivables and other assets

1,914

Amortizable intangible assets


Acquired
intangible assets

Customer contracts and lists, distribution agreements

1,942

Developed and core technology, patents

1,501

Product trademarks

74

Intangible asset with an indefinite life

Liabilities
assumed

1,422

Goodwill

14,450

Accounts payable

(2,804)

Short- and long-term debt

(2,704)

Accrued restructuring

IPR&D

(960)

Other current liabilities

(5,933)

Other long-term liabilities

(1,908)

In-process research and development


Total purchase price

735
$

24,170

Goodwill impairment test


Investment
FMV < CV?

yes

FMV=fair market value


CV = carrying value

Mkt. Price reporting unit


-FMV net equity
Implied Goodwill
- CV Goodwill
Impairment loss

Note: not an issue for poolings

2005 by Robert F. Halsey, all rights reserved

The following footnote disclosure from Intels 2003 10-K


explains its goodwill impairment process:
During the fourth quarter of 2003, the company completed its annual impairment review
for goodwill and found indicators of impairment for the Wireless Communications and
Computing Group (WCCG) reporting unit In the fourth quarter of 2003, it became
apparent that WCCG was now expected to grow more slowly than previously projected
and triggered the goodwill impairment [review]. The impairment review requires a twostep process. The first step of the review compares the fair value of the reporting units with
substantial goodwill against their aggregate carrying values, including goodwillBased on
the comparison, the carrying value of the WCCG reporting unit exceeded the fair value.
Accordingly, the company performed the second step of the test, comparing the implied fair
value of the WCCG reporting units goodwill with the carrying amount of that goodwill.
Based on this assessment, the company recorded a non-cash impairment charge of $611
million, which is included as a component of operating income in the all other category
for segment reporting purposes.

Have shareholders suffered a loss?

Effects SFAS 140/141


(Business Combinations)

We see both purchased intangibles and


goodwill on balance sheet
Profits have increased due to
elimination of goodwill amortization
We will see significant future write-off
amounts if goodwill becomes impaired

2005 by Robert F. Halsey, all rights reserved

Gains on Sub IPOs


TYCOM LTD
During Fiscal 2000, TyCom Ltd., a
majority-owned subsidiary of the Company, completed
an initial public offering (the "TyCom IPO") of
70,300,000 of its common shares at a price of $32.00
per share. Net proceeds to TyCom from the TyCom IPO,
after
deducting
the
underwriting
discount,
commissions
and
other
direct
costs,
were
approximately $2.1 billion. Of that amount, TyCom paid
$200 million as a dividend to the Company. Prior to the
TyCom IPO, the Company's ownership in TyCom's
outstanding common shares was 100%, and at
September 30, 2001 the Company's ownership in
TyCom's
outstanding
common
shares
was
approximately 89%. As a result of the TyCom IPO, the
Company recognized a pre-tax gain on its investment
in TyCom of approximately $1.76 billion ($1.01 billion,
after-tax), which has been included in net gain on sale
of common shares of subsidiary in the Fiscal 2000
Consolidated Statement of Operations.

Gains on Sub IPOs

Assume that an investor company owns 100% of


its investee with a book value for its
stockholders equity of $1,000,000.
Also assume that the investee company issues
previously unissued shares for $500,000 and,
thereby, reduces the investors ownership to
80%.
The investor company then owns 80% of a
subsidiary with a book value of $1,500,000 for an
investment equivalent of $1,200,000 (80%
$1,500,000).
The value of its investment account has, thus,
risen by $200,000.
This increase in the investment account can be
recorded as income or a credit to APIC.

IPO accounting examples


Treatment as a gain - Citigroup:

Treatment as an increase in APIC Barnes &


Noble:

Purchased In-Process R&D

Under former standard, earnings drag was a


problem.
Solution: allocate significant portion of purchase
price to purchased R&D and write off immediately
under R&D accounting standard (FAS 2)
Effect: large loss in period of acquisition; less
earnings drag in future statements because goodwill
is reduced
Note: in the proposed amendment to FAS 142,
IPR&D will be capitalized and tested annually for
impairment, not expensed

2005 by Robert F. Halsey, all rights reserved

Hewlett-Packard, in its $24.1 billion acquisition of Compaq


Computer, allocated $735 million to IPR&D:
In-process research & development
Of the total purchase price, $735 million was allocated to IPR&D and was expensed in the
third quarter of fiscal 2002. Projects that qualify as IPR&D represent those that have not
yet reached technological feasibility and for which no future alternative uses exist.
Technological feasibility is defined as being equivalent to a beta-phase working prototype
in which there is no remaining risk relating to the development.
The value assigned to IPR&D was determined by considering the importance of each
project to the overall development plan, estimating costs to develop the purchased IPR&D
into commercially viable products, estimating the resulting net cash flows from the projects
when completed and discounting the net cash flows to their present value. The revenue
estimates used to value the purchased IPR&D were based on estimates of the relevant
market sizes and growth factors, expected trends in technology and the nature and expected
timing of new product introductions by Compaq and its competitors.
The rates utilized to discount the net cash flows to their present values were based on
Compaq's weighted average cost of capital. The weighted average cost of capital was
adjusted to reflect the difficulties and uncertainties in completing each project and thereby
achieving technological feasibility, the percentage-of-completion of each project,
anticipated market acceptance and penetration, market growth rates and risks related to the
impact of potential changes in future target markets. Based on these factors, discount rates
that range from 25%-42% were deemed appropriate for valuing the IPR&D.

Effects of current exposure draft

Transactions valued at closing date, vs. agreement date (future


acquisition price is uncertain)
IPR&D will be capitalized as an indefinite lived asset until
completion or abandonment of the project, then depreciated or
written off
Restructuring costs will be expensed (vs. accruing a liability)
Acquisition-related costs will be expensed
Bargain purchases will be recorded as an extraordinary gain (vs.
current practice of reducing carrying amount of L-T assets w/ gain
for excess)
Contingent consideration will be recognized and re-valued
annually (I/S effects: better results of sub expense, not
income)
Noncontrolling interests will be reported as equity (vs. mezzanine)
Any incidence of control will be treated as a business combination
(valued at market), even if via contract with no consideration.
No longer a presumption that development stage entities are not a
business (treat acquisitions as business combinations vs. asset
purchases)

2005 by Robert F. Halsey, all rights reserved

Business Combinations vs.


Asset Purchases

Identifiable assets valued at market under both


No liabilities recorded under asset purchase unless
assumed
No goodwill recorded under asset purchase (total
price must be allocated to assets purchased)
Purchased IPR&D is capitalized for a business
combination and expensed for an asset purchase
Contingent consideration is not valued in an asset
purchase (vs. initial valuation and changes in future
values run through income)

2005 by Robert F. Halsey, all rights reserved

Limitations of Consolidated Statements

Income versus Cash Flow


The consolidated income statement reports the combined earnings of all
consolidated entities, but the possibility of dividend restrictions as
previously discussed can limit the ability of those earnings to be paid to
the investor company.
Debt in Consolidated Financial Statements
In the absence of a specific guarantee of the debts of the subsidiary by the
parent company, creditors have recourse in the event of default only to
assets owned by the corporation that incurred the liability.
Financial statements individual companies that comprise the larger entity are
not always prepared on a comparable basis. Differences in accounting
principles, valuation bases, amortization rates, and other factors can inhibit
homogeneity and impair the validity of ratios, trends, and other analyses.
Consolidated financial statements do not reveal cash flows of subsidiaries.
Companies in poor financial condition sometimes combine with financially
strong companies, which can obscure analysis since assets of one member of
the consolidated entity cannot necessarily be used to settle liabilities of
another.
Intercompany transactions are generally unknown unless the procedures
underlying the consolidation process are reported, but consolidated
statements usually reveal only end results.
Aggregation of dissimilar subsidiaries with the total entity (e.g., manufacturing
and finance) can distort ratios and other relations.

2005 by Robert F. Halsey, all rights reserved

Consolidation of
VIEs
Value both
sides of balance sheet independently:

Assets (any assets transferred from primary beneficiary


are reported at cost - no write-up)
Implied Value (liabilities + noncontrolling interest +
capital & retained earnings
Consolidation
FMV assets>implied value assets proportionately
reduced
FMV assets<implied value extraordinary loss (no
goodwill)
Eliminate intercompany transactions
Income allocated via contract, not stock ownership
Other disclosure requirements:
Description of VIE
Description of assets serving as collateral
Limitations of recourse against primary beneficiary
Consolidation is avoided for QSPEs

Avoiding Consolidation
(Fitch Structured Finance paper)