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					Financial Statement Alchemy:
Value Creation Through
Accounting




        Corporate Acquisitions - Class 10-
                      05                     1
An Information Centered View
of the Acquisition Process
  Assume a mechanistic relation between
  earnings per share as reported on the
  financial statement and stock price:
  Price/earnings multiple.
  Theory: If you increase financial statement
  earnings, you increase share price.
  Entirely information based: a change in
  accounting earnings with no change in cash
  flow.
              Corporate Acquisitions - Class 10-
                            05                     2
Motivational Example: Tyco

 Tyco earns $2000/yr. with 1000 shares
 ($2.00/sh.) , a P/E of 20, a price of $40 and a
 market cap of $40,000.
 Alarm Co. earns $1,000/yr. with 1000 shares
 ($1.00), a P/E of 10 (lower growth?), a price
 of $10 and a market cap of $10,000.
 Tyco acquires Alarm Co. for $15,000 in Tyco
 stock, a 50% premium.
     Each Alarm share exchanged for 0.375 Tyco
      shares [$15/$40)], a total of 375 shares.
                Corporate Acquisitions - Class 10-
                              05                     3
Tyco Example (2)
  What happens to Tyco’s post-acquisition
  stock price?
     Tyco reports earnings of $3000/yr. with with 1375
      shares outstanding ($2.18/sh.): acquisition is
      accretive.
     What happens to Tyco stock price: if Tyco P/E
      applies to all earnings, stock rises to $43.60.
     But its earning have increased by 9% in a short
      time. Maybe its P/E ratio should go up. And then
      its easier to finance more acquisitions.
     How easy is it to tell what’s going on if you make
      300 acquisitions a year?
                 Corporate Acquisitions - Class 10-
                               05                     4
Today’s Class
  The accounting treatment of
  acquisitions: how does it work?
  History and the new rules.
  Why does anyone care?
  Impact on practice of the FASB
  eliminating pooling.


            Corporate Acquisitions - Class 10-
                          05                     5
Pooling versus Purchase:
Historical Background
  Principles of historical cost accounting
  requires that a purchaser carry an asset on
  its balance sheet at its acquisition cost.
  Historical cost changes only when an asset is
  sold.
  An asset is a repository of costs waiting to be
  charged (through depreciation or
  amortization) against income from the asset.
  The relevant cost is that of entity whose
  income you want to measure.
  Nothing controversial so far.
               Corporate Acquisitions - Class 10-
                             05                     6
What If the Asset Is Acquired Through
Acquisition of an Entire Company?

   Are there transactions that are not a purchase and a
   sale, but a combination: the selling entity continues
   in existence as part of a larger entity?
   If so, then the entity whose income you are
   measuring hasn’t changed, and historical cost of the
   asset shouldn’t be changed.
   How can you tell which transaction is which?
   Lawyers will understand the “Sesame Street” process
   by which standards collapsed into an election.


                 Corporate Acquisitions - Class 10-
                               05                     7
What Are the Stakes?
 Critical issue is the impact on earnings.
    Acquisitions are typically (but not always)
     associated with a rising stock market
       Remember our discussion of acquisition waves at the
        first class.
    This suggests that acquisition price > the fair
     market value of assets > book value of assets.
    In purchase accounting, allocate purchase price
     among tangible assets based on fair market value.
     Any excess is amortizable good will. The good will
     created may be very large – e.g., ATT-NCR, AOL-
     Time Warner.

                       Corporate Acquisitions - Class 10-
                                     05                       8
What Are the Stakes? (2)
  Balance sheet and income statement impact
  of purchase accounting:
     Balance sheet impact: increase depreciable and
      amortizable assets.
     Income statement impact: increase depreciation
      and amortization; decrease net income and EPS.
  In pooling accounting, simply combine the
  balance sheets. No change in asset values;
  no impact on income statement.
  Can be large difference.
     In ATT/NCR, pooling accounting resulted in a 17%
      increase in ATT’s EPS; purchase accounting (pre-
      FASB 141) resulted in a 5% drop (largely from
      good will). Corporate Acquisitions - Class 10-
                         05                            9
Planning for Accounting
Treatment
  APB 16: Standards for Pooling
     46a: combining companies are autonomous and
      have not been a subsidiary or division of another
      corp. within two years.
     46b: Each of the combining companies is
      independent – no pre-transaction investments
      greater than 10%.
     47a: The combination is completed within 1 year
      (not including regulatory delay).
     47b: Only voting common stock as consideration –
      cash acquisitions cannot be a pooling.
                 Corporate Acquisitions - Class 10-
                               05                     10
Planning for Accounting
Treatment (2)
 47c: no dividends, share issuances, or other
 alteration of voting stockholders’ interests in
 anticipation of the transaction (lock-up
 options).
 47d: No share repurchases for two years
 prior to the transaction other than pursuant
 to past practice.
 47e: no special deals: all stockholders must
 be treated alike.
 47f: Voting rights immediately exercisable -
 no voting trusts.
 47g: No earn-outs.
               Corporate Acquisitions - Class 10-
                             05                     11
Planning for Accounting
Treatment (3)
  48a: no agreements to repurchase any
  of the stock issued.
  48b: No funny deals that provide
  liquidity – e.g., guarantee of non-
  recourse note.
  48c: No plan to dispose of the target’s
  assets other than in the ordinary
  course.

             Corporate Acquisitions - Class 10-
                           05                     12
Real World Use of Pooling as a
Defensive Tactic
  NCR efforts to prevent pooling in ATT bid:
     If no purchase, ATT’s EPS reduced by 5% in year
      of acquisition; if pooling EPS increased by 17%.
     Leveraged ESOP involving immediate issuance of
      8% new NCR shares: 47c (no share issuances).
     NCR repurchased 19.5 million shares: 47d.
     NCR paid $1 share special dividend: 47c.
  ATT paid an extra $685 million (10%) for
  cooperation in securing pooling treatment
  plus an estimated $50 million in accounting
  and legal fees.
                 Corporate Acquisitions - Class 10-
                               05                     13
Real World Use of Pooling as a
Defensive Tactic (2)
  Warner-Lambert/American Home use of
  stock options.
     Each gave the other the right to buy
      19.9% of common stock, exercisable if
      another company gets control.
     Grant does not block pooling.
     Exercise following third party acquisition
      (Pfizer) would prevent pooling.
     Rescission eliminates barrier.
                Corporate Acquisitions - Class 10-
                              05                     14
Why Does Anyone Care?
 Theory: Mechanistic relation between
 accounting earnings and stock price
 inconsistent with market efficiency.
 Empirical evidence: makes no difference.
 So why do people care so much?
     High tech community thinks pooling is critical to
      acquisitions: e.g., AOL-TimeWarner.
        CEO of Cisco said in 1999 that if pooling eliminated their
         acquisition strategy would change.
     Banking industry.
     A high premium creates an earnings problem with
      purchase accounting.
                   Corporate Acquisitions - Class 10-
                                 05                             15
New Rule: FASB 141
  After 30 years, the dissenters to APB 16 were
  vindicated: Pooling is eliminated.
  Efforts to pacify opponents:
     How does it deal with good will?
        Separates into intangible assets – like software, etc. –
         and goodwill.
              The value of intangible assets have to be amortized over
               their useful life.
              Goodwill is not amortized at all!
              Each year, a determination must be made whether the
               carrying value of balance sheet goodwill has been
               impaired.
              If so, write the value down to FMV and run through
               income statement – i.e. one time charge.
                      Corporate Acquisitions - Class 10-
                                    05                                16
Example (based on FASB 141
Ex. C)
Pre-acquisition Balance Sheet of Target (in millions)
Assets
Current assets        $2.4
Property & Plant         .5 (net of .5 depreciation)
Intangibles               0
Goodwill                  0
 Total                $2.9
                                        Assume Target is
Liabilities and Equity                  acquired for $9.4 million
Current liabilities      .5
Long term debt          1.1
  Total                $1.6

Equity (net assets)     $1.3
                          Corporate Acquisitions - Class 10-
                                        05                          17
What is Impact of pre-FASB
141 Pooling?
  No impact on values of pre-acquisition
  target balance sheet.
  No change in target income statement.




            Corporate Acquisitions - Class 10-
                          05                     18
  What is Impact of pre-FASB
  141 Purchase?
  Allocate purchase price among assets based on FMV; excess is
  good will amortizable over no more than 40 years.
  Post-acquisition Balance Sheet of Target (in millions)
Assets                                       Liabilities and Equity
Current assets     $2.4                      Current liabilities     .5
Property & Plant     1.5                     Long term debt         1.1
Goodwill             7.1                        Total              $1.6
 Total             $11.0                     Equity (net assets)   $9.4
Impact on balance sheet: P&P 
$1.0M; $7.1M in good will.
 Impact on income stmnt: If P&P 10 year straight line: $100K per year
If goodwill amortized over 40 years, $177, 500 per year.
                           Corporate Acquisitions - Class 10-
                                         05                               19
What is Impact of Post-141
Purchase?
 Balance Sheet
 Assets
 Current assets                                                         $2.4
 Property & Plant                                                        1.5
 Allocation of $4.9M to intangibles, composed of:
        Registered trademarks not subject to amor.              $1.4
        R& D assets written off on date of acq.                 1.0
        Remaining (patents, software, etc.) with four
        year useful life                                         2.5
                                                                        4.9
 Goodwill                                                               2.2
                           Corporate Acquisitions - Class 10-
                                         05                            $11.0   20
What is Impact of Post-141
Purchase? (2)
  Post-141 Purchase Income Statement:
     Year 1
        Write off of R&D= ($1M); increase in depreciation=
         ($100K); amortization of intangibles ($2.5M over 4
         years)= ($625K)
        Total reduction in income= $1.725M
     Years 2 to 4
        Increase in depreciation= ($100K); amortization of
         intangibles ($2.5M over 4 years)= ($625K)
        Total reduction in income= $725M per year.
     Years 5 to 10
        Increase in depreciation= ($100K)
                   Corporate Acquisitions - Class 10-
                                 05                           21
   Difference Between Pre and
   Post-141 Purchase
    Post-141 Income Effect

    ($1.725M)       ($725K)               ($100)                    0

Years    1            2-4                   5-10                  10-40


        ($277.5K)   ($277.5K)             ($277.5K)               ($177.5K)


    Pre-141 Income Effect
                                                              Goodwill
                         Corporate Acquisitions - Class 10-
                                       05                                 22
Assessment
 Difference between pre- and post-141
 is the treatment of goodwill.
     Large goodwill transactions – like
      technology acquisitions – are better off
      under FASB 141 than APB 16 because of
      non-amortization of goodwill, as long as
      things go well.


               Corporate Acquisitions - Class 10-
                             05                     23
Assessment(2)
  What happens if things go badly?
     Under FASB 142, annual test to see if goodwill is impaired –
      FMV<book value.
     If so, then recognize impairment loss and reduce book
      value.
  AOL-Time Warner announced a goodwill impairment
  loss of $40-60 billion in 2002.
     Tradeoff: risk of such a loss under post-141 compared to
      certainty of annual earnings charge of $1B to $1.5B over
      next 40 years.
     Note analyst comment: “The charge is a mechanical change
      that has no real bearing on cash or on earnings.”
     Then why did pooling matter in the first place?
        Time-Warner change in stock options
                    Corporate Acquisitions - Class 10-
                                  05                            24
Assessment (3)
  Good news for transaction planners
     Reduces artificial restraints on transaction
      structure.
        Go over again APB 16’s requirements:
             Only stock – now can use mixed consideration
             No earn outs – now you can use them
             No toeholds more than 10% -- now you can do multi-step
              transactions
             Treat all shareholders the same – now you can take care
              of Wasserman
             No special dividends, etc.
             No plan to dispose of assets: now can do immediate post-
              acquisition restructuring
             Accounting is no longer a defensive tactic

                    Corporate Acquisitions - Class 10-
                                  05                               25

				
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