Group assignment on Business Combinations
You have been engaged to audit the financial statements of Solamente Corporation for thefiscal year ended May 31, 2010. You discover that on June 1, 2009, Mika Company hadbeen merged into Solamente in a business combination. You also find that both Solamenteand Mika (prior to its liquidation) incurred legal fees, accounting fees, and printing costsfor the business combination; both companies debited those costs to an intangible assetledger account entitled “Cost of Business Combination.” In its journal entry to record thebusiness combination with Mika, Solamente increased its Cost of Business Combinationaccount by an amount equal to the balance of Mika’s comparable ledger account.
- Evaluate Solamente’s accounting for the out-of-pocket costs of the business combination with Mika in light of IFRS and GAAP guidelines.
You are the controller of Software Company, a distributor of computer software, which isplanning to acquire a portion of the net assets of a product line of Midge Company, a competitorenterprise. The projected acquisition cost is expected to exceed substantially the currentfair value of the identifiable net assets to be acquired, which the competitor has agreedto sell because of its substantial net losses of recent years. The board of directors of Softwareasks if the excess acquisition cost may appropriately be recognized as goodwill.
- Prepare a memorandum to the board of directors an answer to the question, after consulting the guidelines issued by either FASB or IASB
On February 15, 2005, officers of Sun Corporation agreed with George Merlo, sole stockholderof Merlo Company and Merlo Industries, Inc., to acquire all his common stock ownershipin the two companies as follows:
- 10,000 shares of Shane’s $1 par common stock (current fair value $30 a share) would be issued to George Merlo on February 28, 2005, for his 1,000 shares of $10 par common stock of Merlo Company. In addition, 20,000 shares of Sun common stock would be issued to George Merlo on February 28, 2010, if aggregate net income of Merlo Company for the five-year period then ended exceeded $300,000.
- $250,000 cash would be paid to George Merlo on February 28, 2005, for his 10,000 shares of $1 par common stock of Merlo Industries, Inc. In addition $250,000 in cash would be paid to George Merlo on February 28, 2010, if aggregate net income of Merlo Industries, Inc., for the five-year period then ended exceeded $300,000.
Both Merlo Company and Merlo Industries, Inc., were to be merged into Sun on February28, 2005, and were to continue operations after that date as divisions of Sun.George Merlo also agreed not to compete with Sun for the period March 1, 2005,through February 28, 2010. Because the merger was negotiated privately and George Merlosigned a “letter agreement” not to dispose of the Sun common stock he received, thebusiness combination was not subject to the jurisdiction of the SEC. Out-of-pocket costs ofthe business combination may be disregarded.
Selected financial statement data of the three constituent companies as of February 28,
2005 (prior to the merger), were as follows:
|Sun Corporation||Merlo Company||Merlo Industries, Inc.|
|Total assets||$25,000,000||$ 500,000||$ 600,000|
|Basic earnings per share||5||30||3|
The controller of Sun prepared the following condensed journal entries to record themerger on February 28, 2005:
Assets other than goodwill 600,000
Common Stock 10,000
Common Stock to Be Issued 20,000
Paid-in Capital in Excess of Par 280,000
To record merger with Merlo Company, with identifiable assets andliabilities recorded at current fair values and goodwill recognized.
Payable to George Merlo 250,000
To record merger with Merlo Industries, Inc., with assets andliabilities of Merlo Industries, Inc., recorded at current fairvalues and goodwill recognized.
- Do you concur with the controller’s journal entries? Explain.
In the absence of definitive guidelines from the FASB, companies that have applied pushdownaccounting in the separate financial statements of substantially wholly owned subsidiarieshave used accounting techniques analogous to quasi-reorganizations or toreorganizations under the U.S. Bankruptcy Code. That is, the restatement of the subsidiary’sidentifiable assets and liabilities to current fair values and the recognition of goodwill areaccompanied by a write-off of the subsidiary’s retained earnings; the balancing amount isan increase in additional paid-in capital of the subsidiary.
- What is your opinion of the foregoing accounting practice? Explain.
In paragraph 44 of Statement of Financial Accounting Standards No. 141, “Business Combinations,”the Financial Accounting Standards Board directed that if the sum of the fair valuesof assets acquired and liabilities assumed in a business combination exceeds the cost ofthe acquired enterprise, such excess should be allocated as a pro rata reduction of amountsthat otherwise would have been assigned to noncurrent assets other than specified exceptions.
- What support, if any, do you find for the action of the FASB? Explain.
On January 2, 2005, the board of directors of Photo Corporation assigned to a voting trust15,000 shares of the 60,000 shares of Soto Company common stock owned by Photo. Thetrustee of the voting trust presently has custody of 40,000 of Soto’s 105,000 shares of issuedcommon stock, of which 5,000 shares are in Soto’s treasury. The term of the votingtrust is three years.
- Are consolidated financial statements appropriate for Photo Corporation and Soto Companyfor the three years ending December 31, 2007? Explain.
On July 31, 2005, Paley Corporation transferred all right, title, and interest in several of itscurrent research and development projects to Carla Saye, sole stockholder of Saye Company,in exchange for 55 of the 100 shares of Saye Company common stock owned by
Carla Saye. On the same date, Martin Morgan, who is not related to Paley Corporation,Saye Company, or Carla Saye, acquired for $45,000 cash the remaining 45 shares of Saye
Company common stock owned by Carla Saye. Carla Saye notified the directors of PaleyCorporation of the sale of common stock to Morgan.
Because Paley had recognized as expense the costs related to the research and developmentwhen the costs were incurred, Paley’s controller prepared the following journal entryto record the business combination with Saye Company:
Investment in Saye Company Common Stock (55 x $1,000)………55,000
Gain on Disposal of Intangible Assets …………………………………….55,000
To record transfer of research and development projects to Carla
Saye in exchange for 55 shares of Saye Company common stock.
Valuation of the investment is based on an unrelated cash issuance ofSaye Companycommon stock on this date.
- Do you concur with the foregoing journal entry? Explain.
- Should the $55,000 gain be displayed in a consolidated income statement of Paley Corporation and subsidiary for the year ended July 31, 2005? Explain.
On May 31, 2005, Patrick Corporation acquired at 100, $500,000 face amount of StearCompany’s 10-year, 12%, convertible bonds due May 31, 2010. The bonds were convertibleto 50,000 shares of Stear’s voting common stock ($1 par), of which 40,000 shareswere issued and outstanding on May 31, 2005. The controller of Patrick, who also is oneof three Patrick officers who serve on the five-member board of directors of Stear, proposesto issue consolidated financial statements for Patrick Corporation and Stear Companyon May 31, 2005.
- Do you agree with the Patrick controller’s proposal? Explain.
In January 2005, Pinch Corporation, a chain of discount stores, began a program of businesscombinations with its principal suppliers. On May 31, 2005, the close of its fiscalyear, Pinch paid $8,500,000 cash and issued 100,000 shares of its common stock (currentfair value $20 a share) for all 10,000 outstanding shares of common stock of Silver Company.
Silver was a furniture manufacturer whose products were sold in Pinch’s stores. Total n stockholders’ equity of Silver on May 31, 2005, was $9,000,000. Out-of-pocket costsattributable to the business combination itself (as opposed to the SEC registration statementfor the 100,000 shares of Pinch’s common stock) paid by Pinch on May 31, 2005, totaled $100,000.
In the consolidated balance sheet of Pinch Corporation and subsidiary on May 31,
2005, the $1,600,000 [$8,500,000 + (100,000 x $20) + $100,000 – $9,000,000] differencebetween the parent company’s cost and the carrying amounts of the subsidiary’sidentifiable net assets was allocated in accordance with purchase accountingas follows:
Inventories $ 250,000
Plant assets 850,000
Total excess of cost over carrying amounts of subsidiary’s net assets$1,600,000
Under terms of the indenture for a $1,000,000 bond liability of Silver, Pinch was obligatedto maintain Silver as a separate corporation and to issue a separate balance sheet forSilver each May 31. Pinch’s controller contends that Silver’s balance sheet on May 31,2005, should value net assets at $10,600,000 – their cost to Pinch. Silver’s controllerdisputes this valuation, claiming that generally accepted accounting principles require issuanceof a historical cost balance sheet for Silver on May 31, 2005.
- Present arguments supporting the Pinch controller’s position.
- Present arguments supporting the Silver controller’s position.
- Which position do you prefer? Explain.
The board of directors of Purdido Corporation have just directed Purdido’s officers to abandonfurther efforts to complete an acquisition of all the outstanding common stock of SonteeCompany in a business combination that would have resulted in a parent company–subsidiaryrelationship between Purdido and Sontee. After learning of the board’s decision, Purdido’schief financial officer instructed the controller, a CPA who is a member of the AICPA, theFEI, and the IMA (see Chapter 1), to analyze the out-of-pocket costs of the abandonedproposed combination. After some analysis of Purdido’s accounting records, the controllerprovided the following summary to the CFO:
Out-of-Pocket Costs of Abandoned Business Combination
April 17, 2005
Legal fees relating to proposed business combination ………………………………$120,000
Finder’s fee relating to proposed business combination …………………………………….0*
Costs associated with proposed SEC registration statement for
Purdidocommon stock to have been issued in the business combination…………… 180,000
Total out-of-pocket costs of abandoned business combination……………………… $300,000
*Finder’s fee was contingent on successful completion of the business combination.
Noting that recognition of the entire $300,000 as expense on April 17, 2005, would havea depressing effect on earnings of Purdido for the quarter ending June 30, 2005, the CFOinstructed the controller to expense only $120,000 and to debit the $180,000 amount to thePaid-in Capital in Excess of Par ledger account. In response to the controller’s request forjustification of such a debit, the CFO confided that Purdido’s board was presently engagedin exploring other business combination opportunities, and that the costs incurred on theproposed SEC registration statement thus had future benefits to Purdido.
- May the controller of Purdido Corporation ethically comply with the CFO’s instructions?Explain.
Assume you are a CPA and a member of the AICPA, the FEI, and the IMA. You are CFO of a publicly owned corporation whose CEO is planning to becomethe sole stockholder of a newly established corporation in a situation with characteristicssimilar to those described in Securities and Exchange Commission AAER 34,“Securities and Exchange Commission v. Digilog, Inc. and Ronald Moyer” (describedon pages 234–235). When you inform the CEO of the SEC’s findings in AAER 34, theCEO informs you that the corporation’s independent auditors have provided a copy ofa reply by the AICPA’s Technical Information Service to a question involving a situationsimilar to that in AAER 34 and that the Technical Information Service answer wasthat consolidated financial statements were not required. The CEO gives you Section
1400.07, “Reporting on Company Where Option to Acquire Control Exists,” of the
AICPA Technical Practice Aids and orders you not to insist on consolidation of “his”corporation’s financial statements.
- What are your ethical obligations in this matter? Explain.
In a classroom discussion of the appropriate balance sheet display of the minority interestin net assets of a consolidated subsidiary, student Michael expressed a dislike for both theeconomic unit concept favored by the FASB and the alternative parent company concept.
According to Michael, the minority interest in net assets of a subsidiary is neither a part ofconsolidated stockholders’ equity, as suggested by the economic unit concept, nor a liability,as indicated by the parent company concept. Michael favored displaying minorityinterest in the “mezzanine” section of the consolidated balance sheet, between liabilitiesand stockholders’ equity. Michael suggested a precedent for such display in the Securitiesand Exchange Commission’s comparable mandated display for redeemable preferred stock,per Section 211 of the SEC’s Codification of Financial Reporting Policies. Student Rogerdisagreed with student Michael, pointing out that the FASB’s Statement of Financial AccountingConcepts No. 6, “Elements of Financial Statements,” does not identify an elemententitled mezzanine.
- Do you support the view of student Michael or of student Roger? Explain.
You have recently become the controller of Precision Corporation, a manufacturing enterprisethat has begun a program of expansion through business combinations. On February 1,2005, two weeks prior to your controllership appointment, Precision had completed theacquisition of 85% of the outstanding common stock of Sloan Company for $255,000 cash,including out-of-pocket costs. You are engaged in a discussion with Precision’s chief accountantconcerning the appropriate accounting method for Precision’s interest in SloanCompany’s operating results. The chief accountant strongly supports the cost method of accounting,offering the following arguments:
- The cost method recognizes that Precision and Sloan are separate legal entities.
- The existence of a 15% minority interest in Sloan requires emphasis on the legal separateness of the two companies.
- A parent company recognizes revenue under the cost method only when the subsidiary declares dividends. Such dividend revenue is consistent with the revenue realization principle of financial accounting. The Intercompany Investment Income account recorded in the equity method of accounting does not fit the definition of realized revenue.
- Use of the equity method of accounting might result in Precision’s declaring dividends to its shareholders out of “paper” retained earnings that belong to Sloan.
- The cost method is consistent with other aspects of historical-cost accounting, because working paper eliminations, rather than journal entries in ledger accounts, are used to recognize amortization of differences between current fair values and carrying amounts of Sloan’s identifiable net assets.
- Prepare a rebuttal to each of the chief accountant’s arguments.
In a classroom discussion of accounting standards for consolidated financial statements,student Tigist questioned the propriety of displaying dividends payable to minority stockholdersof a partially owned subsidiary as a liability in the consolidated balance sheet.
She pointed out that, under the economic unit concept of consolidated financial statements,the minority interest in net assets of subsidiary is displayed with stockholders’ equity in theconsolidated balance sheet, and that dividends payable to minority stockholders clearly area part of the interest of those stockholders in the net assets of the subsidiary. In response,student Carl contended that dividends payable to minority stockholders unquestionablymeet the definition of liabilities in paragraph 35 of Statement of Financial AccountingConcepts No. 6, “Elements of Financial Statements.”
- Do you support the view of student Tigist or of student Carl? Explain.
Consolidated Financial Statements: Special Problems
Wilma Reynolds, CPA, a member of the American Institute of Certified Public Accountants
(AICPA), is controller of Premium Corporation, a publicly owned enterprise with a now-60%-owned subsidiary, Service Company. Reynolds has informed Premium’s chief financialofficer, Wayne Cartwright, that the $150,000 increase in Premium’s investment inService, which resulted from Service’s just-completed issuance of additional commonstock to the public, should be recognized as an increase in Premium’s additional paid-incapital, in accordance with a proposed standard of the FASB. Cartwright countered that
Topic 5-H of the SEC Staff Accounting Bulletins (SAB), which is based on SAB 51 and
SAB 84, sanctions recognition of the $150,000 increase as non-operating income of Premium.
Cartwright expressed the belief that because the SEC has statutory authority to establishaccounting standards, its pronouncements should prevail over those proposed orissued by the FASB.
Do you agree with Wayne Cartwright? In formulating your answer, consider the following:
- Any Guideline issued by the
- International Financial Accounting Standard Board
- Financial Accounting Standard Board
- The practice in the Ethiopian context
The board of directors of Banking Enterprises, Inc., a holding company with 25 subsidiaryfederally chartered banks, has offered $2,500,000 to Mary Phillips, the 40% minoritystockholder of Bank of Provence, for the entire 40% interest, which has a carrying amountof $1,800,000 in the consolidated balance sheet of Banking Enterprises, Inc. and subsidiaries.In a discussion of the appropriate accounting for the $700,000 differencebetween the amount offered and the carrying amount,Banking`schief financial officer, Wendell Casey, supports recognition of goodwill. However,controller John Winston of Banking Enterprises, Inc., believes that some of the $700,000represents a greenmail-type loss, and should be recognized as such. In an appearance beforeBanking”s board, both Casey and Winston argue their positions forcefully. The boardinstructs the two men to consult with the engagement partner of Banking”sindependentauditingfirm, Crandall & Lowe, CPAs, to resolve the matter.
- Assume you are the above-described partner of Crandall & Lowe, CPAs. How would youresolve the dispute between Wendell Casey and John Winston? Explain, including mentionof the additional information you would need.
In a classroom discussion of the display, in a consolidated balance sheet, of the minorityinterest of preferred stockholders in the net assets of a subsidiary, student Ross suggestedthat such a minority interest differs from the minority interest of commonstockholders, and thus possibly warrants display in the “mezzanine” section between liabilitiesand stockholders’ equity. Student Kerry disagrees; she maintains that the termminority applies to preferred stockholders as well as common stockholders other thanthe parent company; both minority interests are part of consolidated stockholders’equity.
- Do you support the position of student Ross or of student Kerry? Explain.