CHAPTER 7

1. CHAPTER 7 NEW BASIS OF ACCOUNTING

2. FOCUS OF CHAPTER 7 • Recognizing a New Basis of Accounting • The Push-Down Basis of Accounting • Leveraged Buyouts

3. Push-Down Accounting: What’s Important—Form or Substance? • Rationale for Push-Down Accounting: • Relevant factor is the acquisition itself. • Form of the acquisition is NOT relevant. • Parent controls the “form of the ownership.” • Parent can ALWAYSliquidate the subsidiary into a branch/division.

4. Push-Down Accounting: The 3 Step Implementation Process • STEP 1: • Adjust all assets and liabilities to current values (“cleanses” the target’s G/L of OLD BASIS). • Record GOODWILL as well. • Offsetting credit is to Revaluation Capital. (As always, capital is shown by source.)

5. Push-Down Accounting: The 3 Step Implementation Process • STEP 2: • Eliminate balance in the Accumulated Depreciation account. • Thus depreciation cycle begins anew.

6. Push-Down Accounting:The 3 Step Implementation Process • STEP 3: • Close out the balance in the Retained Earnings account to APIC. • Thus retained earnings starts afresh.

7. Push-Down Accounting: When Is It Critical That It Be Used? • Theoretically: Whenever a subsidiary issues its OWN financial statements to externalusers. • GAAP Requirements: • Only the SEC mandates its use. (Only subsidiaries of publicly-owned companies fall under the SEC’s jurisdiction.) • The FASB has yet to require it.

8. Push-Down Accounting:Tastes Great And Less Filling • Push-down accounting: • Easy to implement. • Record-keeping is on one set of books instead of two. • Consolidation effort is easy as pie.

9. Push-Down Accounting: Why Not Used Exclusively? • One of the great unsolved mysteries of accounting. • Inertia, stubbornness??? • Clinging to “the way we have always done it”!

10. Push-Down Accounting: Is There Hope on the Horizon? • YES! Practitioners tell us they are seeing it more and more.

11. Leveraged Buyouts: A Combination Purchase & Refinancing • Basic Elements of a Leveraged Buyout: • Acquisition of a target’s assets or common stock. • Refinancing of the target’s debt structure—usually increased substantially. • Minimalequityinvestment by buyers.

12. Leveraged Buyouts: “Let’s Get Management In On The Act” • An Additional Common Features of LBOs: • Existing management becomes part of the new ownership. • Existing management’s ownership is often as high as 50%. • Such LBOs are often called “MBOs.” • Advantage of Management Being Owners: • Alignment of interests occurs between management and remaining stockholders.

13. Leveraged Buyouts: They Are NOT Business Combinations • Business Combinations: • One active business combines with anotheractive business.

14. Leveraged Buyouts: They Are NOT Business Combinations • Business Combinations: • A single corporation becomes the new owner of the target’s business. • This one legal entity now controls the target’s business.

15. Leveraged Buyouts: They Are NOT Business Combinations • Leveraged Buyouts: • A group of investors (and often the target’s management) acquire either • The target’s assetsor • Some or allof the target’s common stock.

16. Leveraged Buyouts: They Are NOT Business Combinations • Leveraged Buyouts: • After the buyout, the ownership of the target’s business may include any of the following groups: • New investors. • Management (at the same or a higherorlower level of ownership). • Former nonmanagement owners.

17. Leveraged Buyouts: The Change in Control Concept • A new basis of accounting is allowed ONLY IF: • A change in control occurs. • To assess whether a change in control has occurred, the control group concept is used.

18. Leveraged Buyouts:The “Control Group” Concept • The control group can consist of: • New investors and • Prior owners who did NOT previously have control. Could include: • Management. • Nonmangement owners who owned less than 50% of the outstanding stock.

19. Leveraged Buyouts: The Control Group Concept • BEFORE: • AFTER: • CONTROL GROUP: 30% + 45% = 70% Management Nonmanagement Owners Owners (one individual) 10% + 90% = 100% Management Nonmanagement New Owners Owners Investors 30% + 25% + 45% = 100%

20. Leveraged Buyouts: Manner of Consummating The Buyout • Creating a New Legal Entity (NLE): • Investors create an NLE. • Investors invest cash in NLE. • NLE acquires target’s common stock or assets. • If common stock is acquired, NLE is merely a nonoperating company.

21. Leveraged Buyouts:Manner of Consummating The Buyout • Reasons for Creating the New Legal Entity: • Facilitates the change in ownership control: • Attaining the agreed upon ownership percentage of the various new ownersis much easier to accomplish. • Enables NEW BASIS of accounting to be used for target’s assets (GAAP compliance). • An important objective for most LBOs.

22. Leveraged Buyouts: The KEY Issue—Has A Change In Control Occurred? • Significance of a Change in Control: • Enables use of a NEW BASIS of accounting for target’s assets. • New basis of accounting is highly important for most LBOs. • Avoids reporting negativestockholders’ equity (NSE). • Reporting NSE to lenders is highly undesirable.

23. Leveraged Buyouts: What Constitutes a Change in Control? • The change in control must be: • Genuine • Substantive • Nontemporary • If not—no change in basis of accounting (record transaction as a recapitalization).

24. Leveraged Buyouts: Accounting for a Change in Control • Types of Changes in Control: • No continuing ownership situations: • Enables 100% use of NEW BASIS of accounting (use Purchase procedures). • Continuing ownership situations: • Results in partial use of NEW BASIS. • Retains partial use of OLD BASIS. • Applying can be somewhat involved.

25. Leveraged Buyouts: Continuing Ownership Situations • In continuing ownership situations, the accounting depends on whether the continuing ownership percentage(hereafter C-O-P) • Increases or • Decreases.

26. Leveraged Buyouts: Continuing Ownership Situations • C-O-P Increases: • Continuing owners are called bulls. • C-O-P Decreases: • Continuing owners are called bears.

27. Leveraged Buyouts: C-O-P INCREASES • Accounting Procedures: • Use OLD BASIS of accounting to the extent of the former ownership percentage that continues as owners. • Called “carryover of predecessor basis.” • Ignore their personal cost basis. • Use NEW BASIS of accounting for the remaining ownership interest.

28. Leveraged Buyouts: C-O-P DECREASES • Accounting Procedures: • C-O-P Is BELOW 20%: • Use NEW BASIS of accounting for entire transaction (with some exceptions). • C-O-P Is 20% or HIGHER: • Use OLD BASIS of accounting to the extent of the former ownership percentage that continues as owners. • Use NEW BASIS for remainder.

29. Review Question #1 In push-down accounting, which accounts are adjusted to a zero balance? A. Accumulated Depreciation. B. Additional Paid-in Capital. C. Retained earnings. D. Revaluation capital. E. Goodwill. F. None of the above.

30. Review Question #1With Answer In push-down accounting, which accounts are adjusted to a zero balance? A. Accumulated Depreciation. B. Additional Paid-in Capital. C. Retained earnings. D. Revaluation capital. E. Goodwill. F. None of the above.

31. Review Question #2 In recording a leverage buyout, which accounts are adjusted to a zero balance? A. Accumulated Depreciation. B. Additional Paid-in Capital. C. Retained earnings. D. Revaluation capital. E. Goodwill. F. None of the above.

32. Review Question #2With Answer In recording a leverage buyout, which accounts are adjusted to a zero balance? A. Accumulated Depreciation. B. Additional Paid-in Capital. C. Retained earnings. D. Revaluation capital. E. Goodwill. F. None of the above.

33. End of Chapter 7 • Time to Clear Things Up—Any Questions?