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Lecture 7, the Accounting and Tax Treatments(收购与兼并-外管局,黄国波)

发布时间:2014-01-23 13:03:54  

Lecture 7, the Accounting and Tax Treatments

of interests ?Purchase accounting ?Taxable, non-taxable, and tax-deferred acquisitions

chs 3+4 & “Analysis of

Business Combinations”

M&A-Guobo Huang


Accounting Standards for Recording M&As

Two accounting method for M&As:
– Purchase method: the purchase price allocated to the acquired firm’s tangible and intangible assets and liabilities, restated to fair market value. – Pooling of interests method: assets and liabilities of the two firms combined without value adjustment.


FASB adopted SFAS141 in 2001, banning the use of pooling. Pooling still permitted under IASB.
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Differences between pooling and purchase

Under pooling:
– No identification of acquirer and acquired – No adjustment of value in financial statements consolidation – Prior period results restated


Under purchase:
– – – – Differentiating acquirer and acquired A&L restated to fair market value Operating results not restated Goodwill tested annually for impairment

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Differences between IASB and US purchase methods

Amortization of goodwill
– Not permitted under US – Required with 20-yr limit under IASB


Restructuring cost provisions
– Permitted under US – Permitted only for the acquired under IASB

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In process purchased R&D
– Expensed immediately under US – Capitalized and amortized under IASB


Negative goodwill
– Created when the fair value of acquired net assets exceeds the purchase price – Allocated through pro rata reduction in the assets acquired under US (except cash, receivables, inventories, financial assets at fair value, and assets for sale). Excess as extra gain – Recognized when losses expected under IASB, otherwise recognized over life of depreciable assets. Excess as income

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Conditions for requiring pooling under IASB

? ?


The substantial majority of voting common shares of the two companies must be exchanged or pooled The fair market values of the two firms do not significantly differ The shareholders of the two firms maintain similar ownership and voting rights in the new firm as in the old firms Reality: terms can be arranged in the M&A to meet requirements of a method.
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The purchase method

Key attributes:
– The deal is treated as a purchase of assets and liabilities – The operating results of the acquired are included in the income statement of the acquirer. Prior results not restated – Target firm is much smaller: operations of target firm are absorbed into acquiring firm

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Accounting procedures
– Excess of price paid over acquired book net worth assigned to tangible depreciable assets up to fair market value; any excess to goodwill – Net worth accounts of target are eliminated – Combined common stock account is total shares times par value

– Total debit less any credit to the common stock account is a "plug" credit to the paid-in capital account – “Combined”retained earnings is just the amount of retained earnings of the acquiring firm – Reported net income lower than under pooling because of goodwill amortization – 1993 tax law change: goodwill amortization over 15 years is tax deductible
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Figure 1
Inventory Accounts receivable Property Total Accounts payable Accruals Long term debt Common stock Retained earnings Total Notes to Figure 1: 1. Inventories of Company T are reported below fair value deu to use of LIFO; property of Company T is undervalued due to inflation. 2. The book value of debt is greater than the market value of debt because the yield on the bonds is greater than the coupon rate. 3. Common stock of Company T has a fair value of $98 based on the acquisition transaction. Historical Cost $ 30 20 50 100 10 10 30 45 5 100 Company T Fair Value $ 40 20 70 130 10 10 26 98 144

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Figure 2
Company P Pre-acquisition $ Contribution of T $ Company P Consolidated $ Inventory 50 40 90 Accounts receivable 50 20 70 PP&E 100 70 170 Goodwill 14 14 Total 200 144 344 Accounts payable Accruals Long term debt Common stock Retained earnings Total 30 20 50 80 20 200 10 10 26 98 144 40 30 76 178 20 344

Notes to Figure 2 1. The purchase method results in a consolidation of common stock that reflects the original common stock plus the newly issued equity. 2. The only adjustments made are to the assets and liabilities of Company T. 3. The common equity (common stock and retained earnings accounts) of Company T is eliminated in a purchase transaction. The post-acquisition value of the common equity of Company P is the pre-acquisition value plus the value of the equity issued to finance the transaction.

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The pooling method

Major attributes:
– The two companies combined using historical cost accounting. The price paid and share price have no effect on the balance sheet and income statements – Operating results for prior periods added together – Ownership interests continue, and former accounting bases maintained.

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Accounting treatment
– Add individual asset and liability amounts of the two companies – Additional shares of common stock issued by acquiring firm offset in the paid-in capital account Retained earnings are simply added – Any remaining offset to paid-in capital account made to retained earnings – Consolidated income statement is a summation of each account

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Figure 3
Inventory Accounts receivable Property Total Accounts payable Accruals Long term debt Common stock Retained earnings Total Company P 50 50 100 200 30 20 50 80 20 200 Company T 30 20 50 100 10 10 30 45 5 100 Consolidated 80 70 150 300 40 30 80 125 25 300

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Effects of accounting methods


Balance sheet: revalued vs historical cost Income statement:
– Purchas

e method: adjustments needed
Amortization of goodwill under IASB GAAP ? Amortization of discount in bond value ? Additional depreciation from PP&E write-up ? Effect of inventory write-up on COGS

– For LIFO, minor effect – For FIFO, COGS revalued up

– Pooling method: statements added together. No goodwill and other effects, but bootstrapping – Both methods can distort the new statement, like current and historical results
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Figure 4
Sales Cost of goods sold Gross margin Selling expenses Depreciation Interest expense Earnings before tax Tax Net income Company P 2000-2002 200 120 80 26 10 4 40 14 26 2000 120 60 60 23 5 2 30 10 20 Company T 2001 136 68 68 26 6 2 34 11 23 2002 145 72 73 27 6 2 38 13 25

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Figure 5
Sales Cost of goods sold Gross margin Selling expenses Amortization of goodwill Depreciation expense Interest expense Earnings before tax Tax Net income Note: Assuming IASB GAAP Consolidated Company P: Purchase 2000 2001 2002 200 268 345 120 154 192 80 114 153 26 39 53 0.5 1 10 14 18 4 6 8 40 54.5 73 14 19.1 25.5 26 35.4 47.5

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Figure 6
Sales Cost of goods sold Gross margin Selling expenses Depreciation expense Interest expense Earnings before tax Tax Net income Consolidated Company P: Pooling 2000 2001 2002 320 336 345 180 188 192 140 148 153 49 52 53 15 16 16 6 6 6 70 74 78 24 25 27 46 49 51

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Effects on cash flow statements

Pooling: adding up individual statements, and restate previous ones Purchase:
– CFO does not change, but investment cash flows need to be recognized, like the purchase price – Distortion of CFO:
Cost of inventory acquired included in CFI instead of CFO ? Income from selling the inventory included in CFO, thus overstating CFO

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Effects on Leverage
? ? ?


Pooling : leverage is unchanged Purchase: when payment is by stock, leverage is decreased Purchase: when payment is from excess cash or increased debt, leverage is increased See the text for Tables 3.1 through 3.7 for analysis of above relationships
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Effects on ratios
– Compared to pooling, purchase methods
report higher asset values and equity (inflation), as price>stated net worth. Ratios using asset and equity values decrease ? report lower reported earnings due to greater depreciation. IASB profitability is even lower due to goodwill amortization ? result in mix of historical and market values, as acquirer not revalued, affecting balance sheet values. ? Current ratios increase due to inventory revaluation ? Debt-equity ratio may decrease or increase, depending on debt or equity financing ? Gross margin increases ? IASB coverage ratios lower than US, as R&D and goodwill are amortized ? Restatements starting only from acquisition affect comparability overtime and cross firms

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Analysis of goodwill

Economic goodwill
– Arise from economic

performance rather than accounting treatment due to repution, brand names, patents, expertise, etc – Accounting goodwill (and its amortization) under IASB needs to be eliminated to reflect economic goodwill. Not under US

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Choosing the acquisition method

The pooling method is preferred when
– The purchase price greatly exceeds the book value of the target firm – The target does not have significant depreciable assets for tax benefit – The target has other assets that depreciated above cost, which could be sold to boost income after acquisition – The target has securities etc with market value above cost

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The purchase method is preferred when
– The purchase price is below book value, so assets being written down, depreciation reduced, earnings increased (under US) – The target has many assets to write up, increasing depreciation and reducing subsequent tax – Shareholders want to avoid dilution caused by share issue

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A spinoff is the case when a division of subsidiary is distributed to a company’s shareholders Accounting treatment
– Using reverse pooling, substracting from the company the assets and liabilities of the spun-off business – Income statement of the division is little changed from before spinoff internal reporting – Balance sheet and ratios of the parent improved if the division has heavy debt

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Call for analysis of a spinoff
– Transactions that change the financial structure and profitability of the subsidiary, like special dividend to the parent – Responsibility for the subsidiary’s retirement benefits – Income tax sharing and deferred tax liabilities – Effects of other transactions on the subsidiary’s future profitability and cash flow, like administrative overhead, rents to parent, intercompany supply agreements

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Taxable vs. Nontaxable or Taxdeferred Acquisitions

Basic rules
– Nontaxable transaction: merger or tender offer involves stock-for-stock transaction – Taxable transaction: transaction involves cash or debt

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"Acquisition tax-free reorganizations" Section 368 of Internal Revenue Code
– Type A
? Statutory

merger: target firm shareholders exchange their target stock for shares in the acquiring company ? Consolidation: shareholders of both firms receive stock of new company ? Usually use pooling of interests

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– Type B
? Stock-for-stock

exchanges, target maybe liquidated into acquiring firm or maintained as an independent entity ? Usually use pooling of interests

– Type C
? Stock-for-asset

transaction; at least 80% of the fair market value of target's property must be acquired ? Typical transaction
– Target firm sells assets in exchange for acquiring firm voting stock – Target firm dissolves – Target distributes acquiring firm stock in excha

nge for old canceled target stock
? Usually

use purchase method of accounting
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Main implications
– Nontaxable reorganization
? Acquiring


– Net Operating Loss (NOL) carryover – Tax-credit carryover
? Target


– Deferred gains for shareholders

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– Taxable acquisitions
? Acquiring


– Stepped-up asset basis – Loss of NOLs and tax credits
? Target


– Immediate gain recognition by target shareholders – Depreciation recapture of income

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Tax Reform Act of 1986: less favorable to merger and acquisition activity
? ? ?

Limits on Net Operating Loss (NOL) carryovers Corporate capital gains tax at 34% Minimum 20% tax on corporate profits

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General Utilities doctrine
– General Utilities provision on tax-free asset liquidation repealed – Exemption only for small and closely held corporations


Greenmail: limit extent to which greenmail payments could be tax deductible

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Do Tax Gains Cause Acquisitions?
? ?


Increased leverage: firm can leverage itself without acquisition Net operating loss carryforwards (NOLs): could use by issuing equity and buying taxable debt Basis increase on acquired assets: could achieve by selling assets and then buying them back
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Early Empirical Tests of Tax Effects


NOLs and tax credits: in about one-fifth of mergers studied most below 10% of the acquired firm's market value Basis step-up: only about 5% of target value Leverage: debt to equity ratio increases from 30-32% on average
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Later Empirical Studies of Tax Effects


For target firms, taxable acquisitions cause abnormal returns of about 10% points higher than nontaxable Within a tax status group, returns for tender offers are 5-8% points higher than for mergers

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NOLs in tax-free transactions are 3-5% of target equity values and about 1-2% of acquiring firm equity value Step-up and capital gains in taxable transactions are 24% for targets and 4-6% for acquiring firms Tax variables alone do not fully explain the size of the takeover premium
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Taxes and LBOs

Increased taxes from LBOs
– Capital gains taxes on realized capital gains to shareholders – Taxable capital gains from asset sell off – Taxable interest income from debt payments – Increase taxable operating income – Efficient capital use generates additional taxable revenues in the economy
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Lost taxes from LBOs
– Increased tax deductions from the additional debt – Lower personal tax revenue because LBOs pay little or no dividends


On average, LBOs generated tax increases almost 200% of lost taxes; RJR-Nabisco tax payments were more th

an eight times pre-LBO taxes
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