INTRODUCTION TO

1
CHAPTER 4

• INTRODUCTION TO
• BUSINESS COMBINATIONS

2
FOCUS OF CHAPTER 4

• Business Combinations (EXTERNAL expansion)
• Legal Considerations
• The Arena in Which Takeover Battles Are Waged
• Purchase Accounting
• Accounting for Goodwill
• Appendix 4A Income Tax Considerations

3
The Purchase Method A Whole New Basis of
Accounting is Established

• The new basis of accounting is based on the
  acquirers purchase price.
• The depreciation cycle for fixed assets begins a
  new at a higher or lower level.
• If cost gt CV, goodwill exists. Recognize as an
  asset--do not amortize. Evaluate periodically
  for possible impairment.
• If cost lt CV, a bargain purchase element (or
  negative goodwill) exists.

4
The Pooling of Interests Method No Longer
Allowed

• The target companys 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.

5
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 companys
• Unrecorded liabilities.
• Contingent liabilities (lawsuits).

6
Acquiring ASSETS Versus Acquiring COMMON
STOCK Often a Major Issue

• Major Decision Factors (continued)
• Tax considerations--Often requires major
  negotiations involving resolution of
• Sellers tax desires.
• Buyers tax desires.
• Ease of consummation--Acquiring common stock is
  simple compared with acquiring assets.

7
Acquiring ASSETS Advantages and Disadvantages

• Major Advantages of Acquiring Assets
• Will NOT inherit a targets contingent
  liabilities (excluding environmental).
• Will NOT inherit a targets unwantedlabor 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.

8
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 targets cash.

9
Business Combinations Organizational Forms that
Can Result

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

10
Organizational FormsTypes of Property that Can
Be Received
P

• Common Stock--Results in a parent-subsidiary
  relationship.
• Targets Assets--Results in a home
  office-branch/division relationship.

P controls S
S
2 legal entities
Home Office
Branch/Division
1 legal entity
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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.

12
Organizational FormsSpecialized 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 becomesa temporary
  subsidiary of TOPCO
• Both subs are liquidated into TOPCOand become
  divisions.
• Result ONE legal entity survives.

13
Organizational FormsSpecialized 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
14
Review Question 1

• To qualify for for purchase accounting
  treatmentA. 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.

15
Review Question 1--With Answer

• To qualify for for purchase accounting
  treatmentA. 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.

16
Review Question 2

• In purchase accountingA. 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.

17
Review Question 2--With Answer

• In purchase accountingA. 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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Review Question 3

• In purchase accountingA. 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 consistency occurs between the two
  combining companies.E. None of the above.

19
Review Question 3--With Answer

• In purchase accountingA. 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 consistency occurs between the two
  combining companies.E. None of the above.

20
Review 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....

21
Review 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

22
Review 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........

23
Review 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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Review Question 6

• A way to force out a target companys dissenting
  shareholders is to useA. Purchase accounting.
  B. Pooling of interests accounting. C. A
  statutory merger. D. A statutory consolidation.
  E. None of the above.

25
Review Question 6--With Answer

• A way to force out a target companys dissenting
  shareholders is to useA. Purchase accounting.
  B. Pooling of interests accounting. C. A
  statutory merger. D. A statutory consolidation.
  E. None of the above.

26
End of Chapter 4 (Appendix 4A material follows)

• Time to Clear Things Up--Any Questions?

27
Tax Rules CONSISTENCY Always Occurs Between
Seller and Buyer

• SELLERS TAX TREATMENT ALWAYS DETERMINES
  BUYERSTAX 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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Taxable Business Combinations CONSISTENCY
Between Sellerand Buyer
Form 1120 or Form 1040

• 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 (CVgtBV).
• A step down in tax basis (CVltBV).
• GOODWILL is reported if Cost gt CV.
• A Section 197 intangible asset.
• Mandatory amortization--15 year life.

29
Nontaxable Business Combinations CONSISTENCY
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.