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Purchase Price Allocation III

Purchase Price Allocation Under the Equity Method

In an M&A context under the equity method of accounting, we record the initial investment in an unconsolidated subsidiary at cost in the Investment in Affiliate account. If the investor pays more for the investment than its proportionate share of the subsidiary's book value of net assets (BVNA), the associated premium, or excess purchase price, is allocated to the differences between the fair values and book values of the subsidiary's assets and liabilities. Any residual after the allocation is implied, or embedded, goodwill. Goodwill and purchase price allocation are discussed in greater detail in subsequent lessons and our detailed equity method example.

Recall from our lesson on subsidiary accounting that if a company acquires 20-50% of a target's stock, the acquirer accounts for its purchase using the equity method. Let's work through a lengthy, but not terribly onerous, example using the equity method.

Example A

On 1/1/08, Alpha acquires 40% of Tango's outstanding stock for $400. Tango pays dividends of $25 from net income of $150 earned in 2008. Both Alpha and Tango have tax rates of 25%. The FV of Tango's PP&E is $100, and Tango's book and tax balance sheets are the same on 1/1/08. Tango's fixed assets depreciate over 6 years. On 12/31/08, Alpha writes down the value of its impaired investment in Tango by $17. The balance sheets of Alpha and Tango before the deal on 1/1/08 are as shown in part (A).

(A) What goodwill is implied in this acquisition?

(B) What journal entry does Alpha make to record its acquisition of Tango on 1/1/08?

Record Stock Acquisition
dr. Investment in Affiliate $400   
    cr. Cash   $400 

(C) What journal entry does Alpha make to record its share of Tango's 2008 net income?

Record Equity Income
dr. Investment in Affiliate $60   
    cr. Equity Income in Affiliate   $60 

(D) What journal entry does Alpha make to record the dividend it receives from Tango?

Record Dividend
dr. Cash $10   
    cr. Investment in Affiliate   $10 

(E) What journal entry does Alpha make to record incremental depreciation in 2008 resulting from the write-up of PP&E?

Record Incremental Depreciation
dr. Equity Income in Affiliate $3   
    cr. Investment in Affiliate   $3 

(F) What journal entry does Alpha make to record the impairment of implied goodwill?

Record Implied Goodwill Impairment
dr. Equity Income in Affiliate $17   
    cr. Investment in Affiliate   $17 

Let's pause here and consider some calculations that may have tripped you up. In the purchase price allocation, BVNA is calculated as the percentage of Tango's stock purchased multiplied by Tango's shareholders' equity, or:

40% × $320 = $128

The write-up of PP&E is calculated as the same percentage multiplied by the difference between the FV and book value of Tango's PP&E, or:

40% × ($100 − $40) = $24

The DTL is calculated as Alpha's tax rate multiplied by the percentage of Tango's stock acquired by A multiplied by the difference between the FV and tax basis of Tango's PP&E, or:

25% × 40% × ($100 − $40) = $6

The incremental depreciation journal entry may seem a bit unintuitive. After all, we don't record Tango's PP&E on Alpha's balance sheet under the equity method. However, recall that we are writing up Tango's PP&E in the purchase price allocation from Alpha's perspective, but not from Tango's perspective; Tango continues to carry PP&E on its books at its historical value after the transaction closes. Tango's reported net income is misleading to Alpha because it does not reflect the incremental depreciation of $4 (= $24 ÷ 6 years) resulting from the write-up. So, Alpha must adjust its equity income from Tango downward to reflect the incremental depreciation as follows:

$4 × (1 − 25%) = $3

The other calculations and journal entries above are fairly straightforward. When thinking about the journal entries, it helps to consider the fundamental accounting equation, A = L + SE, and how each component of the equation changes with each journal entry you make. For example, when the acquirer initially records the acquisition, it credits cash (A goes down) and debits the equity investment (A goes up by the same amount). The A = L + SE equality holds!

Before we proceed, be sure you are comfortable with what we have covered so far in this example because we are about to dial up the complexity. You may also want to review our lesson on the Dividends Received Deduction (DRD) at this point.

Taxes

From our example, recognize that Alpha's share of Tango's 2008 earnings, $60, may be either paid out as dividends in the current period or retained by Tango and distributed later. The dividend received by Alpha, $10, is taxable to Alpha in the current period, while the balance of Alpha's share of Tango's 2008 retained earnings, $50 (= $60 − $10), is taxable to Alpha in the future.

Note that the DRD is only applied to the dividend Alpha receives from Tango, rather than Alpha's entire share of Tango's earnings. In other words, we are taxing the undistributed portion of Alpha's share of Tango's earnings at the full tax rate. Whether you apply the DRD to deferred taxes is a judgment call. Accountants will generally advise you not to, since companies rarely pay "catch-up" dividends (i.e. they will not likely distribute dividends in the future that were not distributed in the current period). So, these undistributed dividends would never qualify for the DRD because they are not expected to be distributed in the future. If you do expect undistributed earnings to be paid out in a future period, then you would apply the DRD to the undistributed earnings.

Example A (continued)

(H) What is Alpha's future taxable income as it relates to Tango?

Alpha's share of Tango's net income [= 40% × $150]   $60 
( – ) 80% DRD [= 80% × $10]   (8)
Total taxable income (present and future)   $52 
( – ) Current taxable income [= $10 × (1−80%)]   (2)
Future taxable income   $50 

(I) What journal entry will Alpha make to record income tax expense related to Tango in 2008?

Income tax expense [= 25% × $52] (total)   $13.0 
Taxes in 2008 [= 25% × $2] (current)   0.5 
Deferred income taxes [= 25% × $50] (future)   12.5 
Record Income Tax Expense
dr. Income Tax Expense $13.0   
    cr. Cash   $0.5 
    cr. DTL   $12.5 

What we are effectively saying here is that of the total tax expense recorded by Alpha to account for its investment in Tango in 2008, only a portion will actually be paid in cash in the current period. The balance will be paid at some point in the future, giving rise to the DTL.

Putting It All Together

The remainder of this example is fairly straightforward; we are simply going to apply the work we have already done to build Alpha's financial statements.

Example A (continued)

(J) What will Alpha's balance sheet of look like on 1/1/08 immediately after the deal closes?

Alpha's Balance Sheet, 1/1/08
Cash  $400 
PP&E  $100 
Investment in Affiliate   $400 
 
Shareholders' Equity   $900 

All we did here was apply the first journal entry recorded above to Alpha's pre-deal balance sheet.

(K) What is Alpha's equity income from Tango?

Alpha's share of Tango's net income [= 40% × $150]   $60 
( – ) Depreciation of PP&E write-up [= $4 × (1−25%)]   (3)
( – ) Impairment of investment   (17)
Equity income in affiliate   $40 

(L) Now, suppose that in 2008 Alpha has revenues of $500 and operating expenses of $340, which include depreciation expense of $9. What is Alpha's total income tax expense for 2008?

Recall from step (I) that we computed Alpha's tax expense attributable to the investment in Tango as $13. Now, we just need to determine the tax expense resulting from Tango's own operations:

Income Tax Expense from Alpha's Operations
dr. Income Tax Expense [=25%×(500−340)] $40   
    cr. Cash   $40 

So, Alpha's total tax expense is $13 + $40 = $53.

(M) What will Alpha's income statement look like for 2008?

Alpha's 2008 Income Statement
Revenues   $500 
Operating Expenses   (340)
Equity Income in Affiliate   40 
Earnings Before Tax   200 
Tax Expense   (53)
Net Income   $147 

(N) What is the value of Alpha's investment in Tango on 12/31/08?

Investment in affiliate, 1/1/08   $400 
( + ) Equity income in affiliate   40 
( – ) Dividends received   (10)
Investment in affiliate, 12/31/08   $430 

(O) What will Alpha's 2008 cash flow statement look like?

Alpha's 2008 Cash Flow Statement
Net Income   $147.0 
( + ) Depreciation   9.0 
( + ) Increase in DTL   12.5 
( – ) Undistributed Earnings from Tango   (30.0)
Cash Flow from Operations   138.5 
( + ) Cash Flow from Investing   (400.0)
( + ) Cash Flow from Financing   0.0 
Increase/(Decrease) in Cash   ($261.5)

Before we finish this example, you should be sure you understand how Alpha's undistributed earnings from Tango are calculated in step (O). Recall that of the $40 in equity income from Tango, only $10 was actually distributed to Alpha via cash dividend. However, the entire $40 is included in net income atop Alpha's cash flow statement. So, we need to subtract from net income the amount that was not distributed to Alpha, or $30 (= $40 − $10).

Example A (continued)

(P) What will Alpha's balance sheet of look like on 12/31/08?

Alpha's Balance Sheet, 12/31/08
Cash [= $800 − $261.5]   $538.5 
PP&E [= $100 − $9]   91.0 
Investment in Affiliate [step(N)]   430.0 
Total Assets   $1,059.5 
 
DTL [step(I)]   $12.5 
Shareholders' Equity [= $900 + $147]   1,047.0 
Total Liabilities & Shareholders' Equity   $1,059.5 

Alas, we are done. If we have covered anything here that isn't completely clear, you should download this example in Excel and examine the equations used to calculate each cell.

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