Electronic
Presentations in Microsoft ®
PowerPoint ®
Prepared by
Peter Secord
Saint Mary’s
University
© 2003 McGraw-Hill
Ryerson Limited

Chapter 3
Chapter 3
© 2003 McGraw-Hill Ryerson Limited
2

• Outline
– What is a business combination?
– Methods of accounting for business combinations
– Canadian GAAP and alternatives
– Illustrations of business combination accounting
– International views
– Examples
Chapter 3
© 2003 McGraw-Hill Ryerson Limited
3

• Conceptually, 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 acquired
– As a uniting of interest , where two existing businesses join together to carry out business as one economic entity
• Current Canadian rules do not differentiate: all business combinations by corporations are accounted for as purchases
Chapter 3
4
© 2003 McGraw-Hill Ryerson Limited

• A business combination is the acquisition of control of all (or substantially all) of the net assets of another business
• The purchase of assets which do not constitute a business (going concern) is not a business combination
• Neither the acquirer nor the business acquired has to be a corporation
• The businesses must not have been previously under common control.
Chapter 3
5
© 2003 McGraw-Hill Ryerson Limited

• Business combinations may occur through
– acquisition of shares (to attain control)
– acquisition of the net assets of a company
– acquisition of the assets but not the liabilities
• The first of these is the most common model, but all three situations occur in practice
• The accounting approach is the same, regardless of the legal form or other details of the business combination
Chapter 3
6
© 2003 McGraw-Hill Ryerson Limited

– On July 6, 2000, following court approval on June 27,
2000 and implementation of Canadian Airlines
Corporation’s 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 Corporation’s 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 3
7
© 2003 McGraw-Hill Ryerson Limited

• Business combinations are executed for many reasons
• The shares or assets acquired in a business combination may be paid for by
– Cash
– Debt
– Shares or other equity securities
– Any combination of the above
• Many business combinations are financed through innovative means, including contingent compensation arrangements
Chapter 3
© 2003 McGraw-Hill Ryerson Limited
8

• On 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 Corel’s share price at that time.
Chapter 3
9
© 2003 McGraw-Hill Ryerson Limited

• This 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 3
10
© 2003 McGraw-Hill Ryerson Limited

• 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 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 shareholding
• This concept may be referred to as de facto control
Chapter 3
11
© 2003 McGraw-Hill Ryerson Limited

0%
Cost
Method
Investor Ownership of Investee Shares Outstanding
Equity method
Consolidation accounting
~20% ~50%
Business combination range
100%
Chapter 3
12
© 2003 McGraw-Hill Ryerson Limited

Cost
Method
Investor Ownership of Investee Shares Outstanding
Equity method
Consolidation accounting
0% ~20% ~50% 100%
Control 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 3
13
© 2003 McGraw-Hill Ryerson Limited

Consolidation Accounting:
Creation of Subsidiary
• Although 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 Rules
 Initial investment is recorded at cost.
 The parent’s investment account and the sub’s 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 3
14
© 2003 McGraw-Hill Ryerson Limited

Consolidation Accounting:
Control and Subsidiaries
• A 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.
Chapter 3
Control of an enterprise is the continuing power to determine its strategic operating, investing and financing policies without the cooperation of others.
15
© 2003 McGraw-Hill Ryerson Limited

Consolidation Accounting:
Control and Subsidiaries
• An enterprise should consolidate all of its subsidiaries.
Chapter 3
The economic substance of the relationship indicates that the separate legal entities are one economic entity.
© 2003 McGraw-Hill Ryerson Limited
16

Consolidation Accounting:
Control and Subsidiaries
• The 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 parentsubsidiary relationship exists, (ii) the name of the subsidiary, and (iii) the percentage ownership (if any).
Chapter 3
17
© 2003 McGraw-Hill Ryerson Limited

Consolidation Accounting:
Control and Subsidiaries
• Conversely, 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 3
18
© 2003 McGraw-Hill Ryerson Limited

• When 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.
External
Shareholders
Subsidiary
Chapter 3
19
© 2003 McGraw-Hill Ryerson Limited

• Legal 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 factors
Chapter 3
20
© 2003 McGraw-Hill Ryerson Limited

• Business 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 3
© 2003 McGraw-Hill Ryerson Limited
21

• Under the purchase method, the acquiring company's interest in assets acquired and liabilities assumed is accounted for in the acquiring company's 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 3
22
© 2003 McGraw-Hill Ryerson Limited

• Business 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 combinations
Chapter 3
23
© 2003 McGraw-Hill Ryerson Limited

• Under the pooling of interest approach, assets and liabilities are combined and accounted for in the combined company's 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 3
© 2003 McGraw-Hill Ryerson Limited
24

• The “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 3
25
© 2003 McGraw-Hill Ryerson Limited

Chapter 3
© 2003 McGraw-Hill Ryerson Limited
26

• A 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 3
27
© 2003 McGraw-Hill Ryerson Limited

• The cost is determined by the fair value of the consideration given or the acquirer's 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 subsidiary
– the excess over the net of the amounts assigned is recognized as an asset, goodwill .
Chapter 3
28
© 2003 McGraw-Hill Ryerson Limited

Chapter 3
© 2003 McGraw-Hill Ryerson Limited
29

• The 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 3
30
© 2003 McGraw-Hill Ryerson Limited

• Expenses 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 3
31
© 2003 McGraw-Hill Ryerson Limited

• An 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 3
32
© 2003 McGraw-Hill Ryerson Limited

• An 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 3
33
© 2003 McGraw-Hill Ryerson Limited

• 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 3
34
© 2003 McGraw-Hill Ryerson Limited

• Extensive 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 3
35
© 2003 McGraw-Hill Ryerson Limited

• For 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 3
36
© 2003 McGraw-Hill Ryerson Limited

• The concept of control varies internationally
– Although 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 rules
– Under EU directives on company law, countries may choose between de jure and de facto control
Chapter 3
37
© 2003 McGraw-Hill Ryerson Limited

• Although 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 3
© 2003 McGraw-Hill Ryerson Limited
38

• Is 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 3
39
© 2003 McGraw-Hill Ryerson Limited

• The calculation and treatment of goodwill varies internationally
– In Japan, goodwill may be larger, as assets are not generally revalued to fair value at the time of acquisition
– In the Netherlands, it is common to write off goodwill directly at the time of acquisition
– Amortization of goodwill is the norm in some jurisdictions, and not followed in others
– This area is presently evolving, so caution must be exercised when using financial statements differences in reported income are very large
Chapter 3
40
© 2003 McGraw-Hill Ryerson Limited

Chapter 3
© 2003 McGraw-Hill Ryerson Limited
41