Accounting For Business Combinations - Financial Reporting and Analysis

The combination of business entities by merger or acquisition is very frequent. There are many possible reasons for this external business expansion, including achieving economies of scale and savings of time in entering a new market.

There are two methods of accounting for a business combination—the pooling of interestsmethod and the purchasemethod. The accounting for a merger or acquisition is guided by 12 specific criteria to judge a combination. If the 12 criteria are met, then the acquisition must be accounted for as a pooling of interests. The criteria leave some room for judgment in determining if the pooling method should be used.

A pooling of interests involves an exchange of voting common stock. With the pooling method, the recorded assets and liabilities of the firms involved are carried forward to the combined entity at their previous recorded amounts. Income of the combined firm includes income of the constituents for the entire period. The prior years are restated to show the combined firms as merged (pooled).

Since the pooling method results in the acquired assets and liabilities being carried forward at the amount that they were previously recorded, this results in a net under statement of assets, liabilities, and equity in relation to the acquisition values. This will lead to a subsequent over statement of income because of the reduced expenses subsequently recognized. With the pooling method, the resulting retained earnings in stockholders’ equity represents the prior retained earnings of both companies.

The purchase method views the business combination as the acquisition of one entity by another. The firm doing the acquiring records the identifiable assets and liabilities at fair value at the date of acquisition. The difference between the fair value of the identifiable assets and liabilities and the amount paid is recorded as goodwill (an asset). Since good will must be amortized to expense, this can result in substantial subsequent expense.

With a purchase, the acquiring firm picks up the income of the acquired firm from the date of acquisition. Retained earnings of the acquired firm do not continue.

The Daimler - Benz / Chrysler Corp. merger depicts the advantage of pooling over the purchase method. Chrysler had a book value of approximately $12 billion, while the transaction valued Chrysler at approximately $39 billion. The purchase method would have resulted in approximately $27 billion of goodwill. This would have been a subsequent $27 billion drag on earnings.

An introduction to the basic financial statements. Later chapters will cover these statements in detail. An understanding of the sequence of accounting procedures completed during each accounting period, called the accounting cycle, will help in understanding the end result - financial statements.

Management is responsible for financial statements. These statements are examined by auditors who express an opinion regarding the statements’ conformity to GAAP in the auditor’s report. The auditor’s report often points out key factors that can affect financial statement analysis. The SEC has begun a program to integrate the Form 10-K requirements with those of the annual report.

A reporting option available to public companies, a summary annual report (a condensed annual report), omits much of the financial information included in a typical annual report.

The EMH relates to the ability of capital markets to generate prices for securities that reflect worth. The market will not be efficient if the market does not have access to relevant information or if fraudulent information is provided.

Individuals in financial positions must be able to recognize ethical issues and resolve them appropriately.

With the expansion of international business and global capital markets, the business community and governments have shown an increased interest in the harmonization of international accounting standards.

The combination of business entities by merger or acquisition is very frequent. An understanding of how a business combination can impact the basic statements is important to the analyst.

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