Chapter 3 Business Combinations - McGraw-Hill

Electronic Presentations in Microsoft PowerPointPrepared byPeter Secord Saint Marys University 2003 McGraw-Hill Ryerson LimitedChapter 31 2003 McGraw-Hill Ryerson Limited Chapter 3 Business CombinationsChapter 32 2003 McGraw-Hill Ryerson Limited Business CombinationsOutlineWhat is a business combination?Methods of accounting for business combinationsCanadian GAAP and alternativesIllustrations of business combination accountingInternational viewsExamplesChapter 33 2003 McGraw-Hill Ryerson Limited Business CombinationsConceptually,a business combination occurs when businesses combine their operations;this can happen in two basic ways:As an acquisition or purchase of one business by another,where control is acquiredAs a uniting of interest,where two existing businesses join together to carry out business as one economic entityCurrent Canadian rules do not differentiate:all business combinations by corporations are accounted for as purchasesChapter 34 2003 McGraw-Hill Ryerson Limited Business CombinationsA business combination is the acquisition of control of all(or substantially all)of the net assets of another businessThe purchase of assets which do not constitute a business(going concern)is not a business combinationNeither the acquirer nor the business acquired has to be a corporationThe businesses must not have been previously under common control.Chapter 35 2003 McGraw-Hill Ryerson Limited Business CombinationsBusiness combinations may occur throughacquisition of shares(to attain control)acquisition of the net assets of a companyacquisition of the assets but not the liabilitiesThe first of these is the most common model,but all three situations occur in practiceThe accounting approach is the same,regardless of the legal form or other details of the business combinationChapter 36 2003 McGraw-Hill Ryerson Limited Business Combinations-ExamplesOn July 6,2000,following court approval on June 27,2000 and implementation of Canadian Airlines Corporations financial restructuring plan,Canadian Airlines International Ltd.(Canadian Airlines)became a wholly-owned subsidiary of the Corporation.As a result of the court approval of the plan of arrangement in late June 2000,the financial position of Canadian Airlines was included in the Corporations consolidated statement of financial position as at June 30,2000.The acquisition was accounted for by the purchase method of accounting and assets and liabilities were recorded at their fair values at the time of acquisition.Chapter 37 2003 McGraw-Hill Ryerson Limited Business CombinationsBusiness combinations are executed for many reasonsThe shares or assets acquired in a business combination may be paid for byCashDebtShares or other equity securitiesAny combination of the aboveMany business combinations are financed through innovative means,including contingent compensation arrangementsChapter 38 2003 McGraw-Hill Ryerson Limited Business Combinations-ExamplesOn October 29,2001,Corel acquired Micrografx,Inc.Micrografx developed enterprise process and graphics software,solutions and services.The technology acquired will aid in the development of new products that enable customers to create graphic-rich content that can be output easily and simultaneously to multiple channels,including the Web.Upon close,approximately 6.9 million common shares were issued to former Micrografx shareholders for a value of$16.0 million representing approximately 50%of the total consideration.The remaining consideration was in the form of 16,038,875 participation rights,which will convert one year after closing into$1.02 USD per participation right in cash or Corel common shares,contingent upon Corels share price at that time.Chapter 39 2003 McGraw-Hill Ryerson Limited Business combinations,Section 1581This new Section,which replaces Business Combinations,Handbook s.1580,establishes standards for the recognition,measurement and disclosure of business combinations.A business combination occurs when an enterprise acquires net assets that constitute a business,or acquires equity interests of one or more other enterprises and obtains control over that enterprise or enterprises.Enterprises are required to use the purchase method of accounting for all business combinations.Use of the pooling of interests method is prohibited.Chapter 310 2003 McGraw-Hill Ryerson Limited After the business combination occurs?We know that the investor can own any amount of shares in the investee,and that influence varies directly with the amount of shares owned.When control is acquiredcontrol is acquired,the investor and investee are referred to as parent and subsidiary.Rather than report using the cost or equity method,the parent will prepare consolidated financial statements and combine the accounts of the subsidiary with those of the parent in the published financial statements.Control is determined by the facts of the relationship,not by the exact percentage shareholdingThis concept may be referred to as de facto controlChapter 311 2003 McGraw-Hill Ryerson Limited Significance of Size of InvestmentInvestor Ownershipof Investee Shares Outstanding0%20%50%100%Cost MethodEquity methodConsolidation accountingBusiness combination rangeChapter 312 2003 McGraw-Hill Ryerson Limited Significance of Size of InvestmentInvestor Ownershipof Investee Shares Outstanding0%20%50%100%Cost MethodEquity methodConsolidation accountingControl is presumed when the ownership percentage is 50%or more;exact determination is based on the facts of the relationship between shareholders and the company.Chapter 313 2003 McGraw-Hill Ryerson Limited Consolidation Accounting:Creation of SubsidiaryAlthough the parent and the subsidiary(sub)may be separate legal entities,they are effectively linked by the ownership structure.The financial statements must be combined for reporting purposes when the parent controls the subsidiary.General RulesInitial investment is recorded at cost.The parents investment account and the subs equity accounts are both eliminated on the consolidated balance sheet.All transactions and balances between the parent and the sub are eliminated(only external transactions reported).Chapter 314 2003 McGraw-Hill Ryerson Limited Consolidation Accounting:Control and SubsidiariesA subsidiary is an enterprise controlled by another enterprise(the parent)that has the right and ability to obtain future economic benefits from the resources of the enterprise and is exposed to the related risks.Control of an enterprise is the continuing power to determine its strategic operating,investing and financing policies without the co-operation of others.Chapter 315 2003 McGraw-Hill Ryerson Limited Consolidation Accounting:Control and SubsidiariesAn enterprise should consolidate all of its subsidiaries.The economic substance of the relationship indicates that the separate legal entities are one economic entity.Chapter 316 2003 McGraw-Hill Ryerson Limited Consolidation Accounting:Control and SubsidiariesThe concept of de facto control does not require majority ownership to have control and to prepare consolidated financial statements-control leads to consolidation in all cases:When a reporting enterprise does not own,directly or indirectly through subsidiaries,an equity interest carrying the right to elect the majority of the members of the board of directors of a subsidiary,the reporting enterprise should disclose(i)the basis for the determination that a parent-subsidiary relationship exists,(ii)the name of the subsidiary,and(iii)the percentage ownership(if any).Chapter 317 2003 McGraw-Hill Ryerson Limited Consolidation Accounting:Control and SubsidiariesConversely,not all majority owned investments will be consolidated(as they are not all controlled):When a reporting enterprise owns,directly or indirectly through subsidiaries,an equity interest carrying the right to elect the majority of the members of the board of directors of an investee that is not a subsidiary,the reporting enterprise should disclose(i)the basis for the determination that a parent-subsidiary relationship does not exist,(ii)the name of the investee,(iii)the percentage ownership,and(iv)either separate financial statements of the investee,combined financial statements of similar investees or,provided all information significant to the consolidated financial statements is disclosed,condensed financial statements(including notes)of the investee.Chapter 318 2003 McGraw-Hill Ryerson Limited Non-controlling(Minority)InterestWhen a parent owns more than 50%,but less than 100%.The remaining,external shareholders equity interest must be accounted for.The non-controlling(minority)shareholders interest is recorded on the consolidated balance sheet and income statement.SubsidiaryParentExternalShareholdersChapter 319 2003 McGraw-Hill Ryerson Limited Essence of Consolidation AccountingLegal structure of the entities is ignored;accounting follows the substance of the relationship between the companies.All intercompany transactions are eliminated.Non-controlling(Minority)interest is shown separately in the consolidated statements,between liabilities and shareholders equity.When the parent acquires its interest from an earlier owner,the accounting approach will be determined by the form of the consideration given and other relevant factorsChapter 320 2003 McGraw-Hill Ryerson Limited Business Combinations:PurchaseBusiness combinations in which a company acquires control of another company can be considered acquisitions in the sense that they involve a buyer and a seller with the buyer paying cash or other consideration either for shares representing voting control or for net assets.Chapter 321 2003 McGraw-Hill Ryerson Limited Business Combinations:PurchaseUnder the purchase method,the acquiring companys interest in assets acquired and liabilities assumed is accounted for in the acquiring companys financial statements at the cost to the acquiring company.The reported income of the acquiring company includes the results of operations of the acquired company from the date of acquisition only.Chapter 322 2003 McGraw-Hill Ryerson Limited Business Combinations:PoolingBusiness combinations in which the ownership interests of two or more companies are joined together through an exchange of voting shares and in which none of the parties involved can be identified as an acquirer can be considered pooling of interests in the sense that the shareholders combine their resources to carry on in combination the previous businesses.Present accounting rules in Canada and the US do not permit pooling of interest accounting for business combinationsChapter 323 2003 McGraw-Hill Ryerson Limited Business Combinations:PoolingUnder the pooling of interest approach,assets and liabilities are combined and accounted for in the combined companys financial statements at their carrying value in the combining companies records.The reported income of the combined company includes income of the combining companies for the entire fiscal period in which the combination took place.Financial statements of the combined company presented for prior periods are restated to reflect the financial position and results of operations as if the companies had been combined since their inception.Pooling of Interest rewrites history,and the potential for abuse of this method is highly controversial.Chapter 324 2003 McGraw-Hill Ryerson Limited Purchase vs Pooling of InterestThe“old”Canadian rules contained these provisions:The purchase method should be used to account for all business combinations,except for those rare transactions where an acquirer cannot be identified.The pooling of interests method should be used to account for those rare business combinations in which it is not possible to identify one of the parties as the acquirer.The“new”rules allow only the purchase method-an acquirer is always assumed!Chapter 325 2003 McGraw-Hill Ryerson Limited Pooling differs from PurchaseChapter 326 2003 McGraw-Hill Ryerson Limited Timing of a Business CombinationA business combination is initiated on the earlier of:(a)the date that the major terms of a plan,including when applicable the ratio of exchange of shares,are announced publicly or otherwise formally made known to the owners of any one of the combining enterprises;and(b)the date that owners of a combining enterprise are notified in writing of an exchange offer.Chapter 327 2003 McGraw-Hill Ryerson Limited Cost of the acquisition and allocationThe cost is determined by the fair value of the consideration given or the acquirers share of the fair value of the net assets or equity interests acquired,whichever is more reliably measurable.It is allocated as follows:all assets acquired and liabilities assumed are assigned a portion of the total cost of the purchase based on their fair values at acquisition;allocations may be made to items previously unrecorded by the subsidiarythe excess over the net of the amounts assigned is recognized as an asset,goodwill.Chapter 328 2003 McGraw-Hill Ryerson Limited Cost allocation:typical disclosureChapter 329 2003 McGraw-Hill Ryerson Limited Allocation of Purchase PriceThe interest of any non-controlling shareholders in the identifiable assets acquired and liabilities assumed should be based on their carrying values in the accounting records of the company acquired.This interest should be included in the amount disclosed as non-controlling interest on the balance sheet(Minority interest is reported at book value)Chapter 330 2003 McGraw-Hill Ryerson Limited Expenses related to the acquisitionExpenses directly incurred in effecting a business combination accounted for as a purchase should be included as part of the cost of the purchase.Such expenses will therefore be included in the amounts to be assigned to the individual assets acquired and liabilities assumed.Where shares are issued to effect the acquisition,the costs of registering and issuing such shares would be treated as a capital transaction.Chapter 331 2003 McGraw-Hill Ryerson Limited Intangible assets and negative goodwillAn intangible asset acquired in a business combination is recognized apart from goodwill when it satisfies certain conditions,otherwise it should be included in the amount recognized as goodwill.When the net of assets acquired and liabilities assumed exceeds the cost of the purchase,the excess(negative goodwill)is allocated to reduce certain assets and any remaining excess is treated as an extraordinary gain.Chapter 332 2003 McGraw-Hill Ryerson Limited Intangible assets apart from goodwillAn intangible asset should be recognized apart from goodwill when:(a)the asset results from contractual or other legal rights(regardless of whether those rights are transferable or separable from the acquired enterprise or from other rights and obligations);or(b)the asset is capable of being separated or divided from the acquired enterprise and sold,transferred,licensed,rented,or exchanged(regardless of whether there is an intent to do so).Otherwise it should be included in the amount recognized as goodwill.Chapter 333 2003 McGraw-Hill Ryerson Limited“Negative Goodwill”When the net of the amounts assigned to assets acquired and liabilities assumed exceeds the cost of the purchase(“excess”or“negative goodwill”):(a)that excess should be allocated as a pro rata reduction of the amounts that otherwise would be assigned to all of the acquired assets except:(i)financial assets other than investments accounted for by the equity method;(ii)assets to be disposed of by sale;(iii)future income tax assets;(iv)prepaid assets relating to employee future benefit plans;&(v)any other current assets,to the extent the excess is eliminated;and(b)remaining excess presented as an extraordinary gain.Chapter 334 2003 McGraw-Hill Ryerson Limited Business combinations,Section 1581Extensive disclosure requirements are required for each business combination and aggregate data for individually immaterial combinations.The Section is effective for business combinations initiated on or after July 1,2001.The Section also applies to business combinations accounted for by the purchase method with a date of acquisition on or after July 1,2001.Chapter 335 2003 McGraw-Hill Ryerson Limited Business combinations,Section 1581For business combinations with a date of acquisition before July 1,2001,that were accounted for by the purchase method:(a)The carrying amount of acquired intangible assets that do not meet the criteria in paragraph 1581.48 for recognition apart from goodwill(and any related future income tax liabilities)should be reclassified as goodwill upon initial application of Section 3062 to the entire financial statements.(b)The carrying amount of any recognized intangible assets that meet the recognition criteria in paragraph 1581.48 and that have been included in an amount reported as goodwill(or as goodwill and intangible assets)should be reclassified and accounted for as an asset apart from goodwill upon initial application of Section 3062 to the entire financial statements.Chapter 336 2003 McGraw-Hill Ryerson Limited International ViewThe concept of control varies internationallyAlthough the Canadian position,as well as the position under international accounting standards,are clearly based on the concept of de facto control,the determination of control for consolidation purposes may also be based strictly on the percentage of voting shares owned.Ownership of 50%of voting shares is the basis for legal control,and this de jure control can form the basis for consolidation of a subsidiary.For example,this is the position in US rulesUnder EU directives on company law,countries may choose between de jure and de facto controlChapter 337 2003 McGraw-Hill Ryerson Limited International ViewAlthough Canada and the United States have“abolished”pooling of interest accounting,this method is still in use(although rarely)in other jurisdictions.Pooling of interest is permitted under international accounting standards,in those exceptional circumstances where an acquirer cannot be identified.Chapter 338 2003 McGraw-Hill Ryerson Limited International ViewIs pooling of interest the only alternative to the purchase method?The international accounting standards committee has been examining the“fresh start”approach(similar to the new entity approach,occasionally mentioned in Canada)as a possible treatment when an acquirer cannot be identified.The IASC currently allows pooling of interest,yet notes that the pooling of interest method is not necessarily the best approach when the acquirer cannot be identified.Chapter 339 2003 McGraw-Hill Ryerson Limited International ViewThe calculation and treatment of goodwill varies internationallyIn Japan,goodwill may be larger,as assets are not generally revalued to fair value at the time of acquisitionIn the Netherlands,it is common to write off goodwill directly at the time of acquisitionAmortization of goodwill is the norm in some jurisdictions,and not followed in othersThis area is presently evolving,so caution must be exercised when using financial statements-differences in reported income are very largeChapter 340 2003 McGraw-Hill Ryerson Limited International ViewChapter 341 2003 McGraw-Hill Ryerson Limited