CHAPTER 4

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 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.

4. The Pooling of Interests Method:No Longer Allowed • The target company’s basis of accounting in its assets is used by 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 Vs. Acquiring COMMON STOCK: Often a MajorIssue • 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).

6. Acquiring ASSETS Vs. Acquiring COMMON STOCK: Often a MajorIssue • 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.

7. 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 unwantedlabor union. • Major Disadvantages of Acquiring Assets: • Transfers of titles on real estate and other assets can be time-consuming. • Transfer of contracts may NOTbe 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 target’s cash.

9. Business Combinations: Organizational Forms that Can Result • The focus is on what property isreceived—NOT on what property is given.

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

11. 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 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 temporarysubsidiary of TOPCO. • Both subs are liquidated into TOPCO and become divisions. • Result: ONE legal entity survives.

13. Organizational Forms:Specialized Options • Option #3: HOLDING COMPANY: • Similar to a statutory consolidation except that the two subsidiaries are NOTliquidated into TOPCO. TOPCO P S 3 legal entities

14. Review 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.

15. Review Question #1With 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.

16. Review 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.

17. Review Question #2With 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.

18. Review 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 toeffect the merger. D. Financial reporting consistency occursbetween the two combining companies. E. None of the above.

19. Review Question #3With Answer In purchase accounting: A. Preferred stock must be the consideration given. B. Goodwill is always reported. C. A holding company must be created toeffect the merger. D. Financial reporting consistency occursbetween the two combining companies. E. None of the above.

20. Review Question #4 Which of the following COULD occur or result?PurchasePoolingA. Goodwill...........................B. Change in basis..............C. Statutory merger.............D. Stock-for-stock exchangeE. Symmetrical reporting.....

21. Review Question #4With Answer Which of the following COULD occur or result?PurchasePoolingA. 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?PurchasePooling A. Preferred stock issuance. B. Parent-subsidiary............ C. Home office-division....... D. Acquisition of assets....... E. Acquisition of stock.........

23. Review Question #5With Answer Which of the following COULD occur or result?PurchasePooling 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

24. Review 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.

25. Review Question #6With 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. • 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 SELLER’STAX TREATMENT ALWAYS DETERMINES BUYER’S TAX TREATMENT: • If seller has a taxable transaction, buyeruses new basis of accounting. • If seller has a nontaxable transaction, buyer uses old basis of accounting. Appendix 4A

28. Taxable Business Combinations: CONSISTENCY Between Seller and Buyer • Seller has taxable gain or loss. • Buyer is required to use a newtax basis, which can be either: • A step up in tax basis (CV>BV). • A stepdown in tax basis (CV<BV). • GOODWILL is reported if Cost > CV. • A Section 197 intangible asset. • Mandatory amortization—15 year life. Form 1120 or Form 1040 Appendix 4A

29. Nontaxable Business Combinations: CONSISTENCY Between Buyer and Seller • Seller does NOTreport 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. Appendix 4A