COMBINATIONS AND CONSOLIDATIONS
Reasons for Combination
The primary purpose of the formation of a combination or a
consolidation of two or more corporations, or of the taking over
of a partnership business by a corporation, is to secure greater
profits through unity of control. To this end the various parties to
the consolidation agree to subordinate their own interests if the
effectiveness of the larger unit is thereby increased. The main object
in view is the control of any external or internal factors that affect
earnings. Profit may be increased by economy of operation resulting
from large-scale production, by economies in use of by-products, by
the standardization of product and improvement of quality, and by the
elimination of duplicate effort; or the control of sources of supplies
or of a marketing organization, or greater ease in obtaining capital,
or greater facility in dealing with labor, may be among the advantages
obtained. In the past the most important of all factors has been the
elimination of competition by the control of selling prices, thus
securing a greater hold on the market and reducing selling expense. A
consolidated enterprise enjoys the advantage of adding to its plant
facilities and rounding out the scope of its activities without the
expenditure of new construction or capital purchases entailing the
raising of large sums of money.
Types of Consolidation
In the popular mind the terms, combination, trust, holding company,
consolidation, and merger stand very much for one and the same thing.
The end sought is generally the same, namely, the power to control in
some degree the conditions surrounding a particular industry. The means
used are dictated by the actual conditions governing the situation,
such as the possibility of coming to an agreement, legal aspects,
financial factors, etc.
Where the elimination of competition was the main consideration, the
end sought was most easily achieved by arrangements variously termed a
“gentleman’s agreement,” an “interlocking directorate,” a “community
of interest,” a “pool,” or a “voting trust”—the results of which were
generally referred to as “combinations.” Like the earlier form of the
holding company, the “trust,” they are known in the federal courts as
“combinations in restraint of trade,” are illegal, and are no longer
entered into.
The trust derived its name from the fact that it was controlled by a
board of trustees who issued trust certificates in lieu of the stock of
the participating companies. Popular aversion to this form of control
has led to the formation of another and better type of organization
known as the “holding company.” While the holding company is generally
classed among the combinations in restraint of trade and in a number
of instances, like its predecessor, has come to grief through the
enforcement of the anti-trust laws, its legality is recognized in those
states where ownership of the stock of other corporations is allowed by
law and where no restraint of trade or interference with competition
is effected. A holding company organized in one state may control
corporations organized under the laws of other states. The holding
corporation can itself be controlled by the ownership of 50 or 51 per
cent of its stock, and the control of its subsidiaries is obtained with
stock ownership in the same ratio. Thus a relatively small capital
investment may exercise a far-reaching control.
A holding company as a rule buys up the controlling stock interest
of the companies in which it is interested, and elects its own men
on the board of directors of the subsidiaries. Frequently the larger
stockholders of competing corporations get together and form the
holding company. In this case very little difficulty is experienced so
far as financing is concerned, which is usually a matter of exchanging
the stock of the various companies for the stock of the holding company.
One of the advantages accruing to the holding company, aside from
the favorable financial and legal aspects of the enterprise, is that
the subsidiaries remain as operating and business units. This is
often desirable because of the value of the good-will accruing to
the constituent companies from years of business dealing with their
customers. The advantages of the close consolidation may be often
obtained by stimulating rivalry between the various plants of the same
industry and by exchanging information as to successful methods of
operation.
A holding company does not generally own all the stock of the
subsidiary. Often, however, this is necessary because of the trouble
that a small minority of the stockholders can create if the interests
of the subsidiary and the holding company clash; such as might be the
case if, for reasons of efficiency, the plant of the subsidiary were
closed down. It would naturally be a gain to the holding company but a
loss to the minority stockholders of the subsidiary if the productive
capacity of another plant could be utilized to better advantage.
Accounting for the Holding Company
In Chapter XV where the principles of valuation of permanent
investments were discussed, reference was made to the method of
valuing the holdings of the stock of subsidiaries as carried on the
books of the holding company. A distinction was there made between the
accounting procedure in showing the holdings of the subsidiary stocks
when the parent company has complete ownership, and when its ownership
is only partial—though usually a controlling—ownership. If the
ownership is complete, as there pointed out, to show the consolidated
balance sheet and profit and loss summaries is the best and only
intelligible presentation of condition. Where ownership is not complete
the balance sheet of the holding company must carry the stock of the
subsidiary at a valuation which varies in accordance with the earnings
and dividend policy of the subsidiary. In addition to the method of
showing the valuation of the holdings in the subsidiary, it may for
certain purposes and particularly for internal use, be desirable to
append to the statements of the holding company financial statements
of each of the subsidiaries so as to give an intelligent view of the
condition of the properties of all the companies. These appended
statements are, of course, not an integral part of the financial
statements of the holding company but are necessary as furnishing
information which the officers of the holding company may need in their
direction of the policy of the subsidiary. For a detailed discussion
of the consolidated balance sheet and profit and loss summaries the
student is referred to Chapter XXXIV.
Aside from the financial statements, no special accounting problems or
peculiarities arise in accounting for the holding company. Where, as
is usual, accounts with the subsidiaries appear on the books of the
holding company other than stock accounts showing the investment, the
chief problem lies in the valuation of these accounts. That feature was
also discussed in Chapter XV to which the student is referred.
Distinction between Consolidation and Merger
Consolidation, in the legal sense, refers to the complete union of
two or more enterprises. It is a fusion whereby each company loses
its identity in the larger unit of the new corporation. The prior
corporations are dissolved and cease to exist. The stock of the old
corporation is exchanged for that of the new corporation upon an agreed
ratio. The usual procedure for statutory consolidation is as follows:
1. Agreement by the directors of the various companies
as to terms, etc.
2. Assent of the stockholders of each company to the
directors’ agreement.
3. Filing of certified copies of the agreement, with the
vote in its favor, in the same offices in which the
certificates of incorporation of each corporation
were originally filed.
4. The exchange and issuance of new stock for the
old stock of the constituent companies.
The merger of a number of corporations is generally held to be a method
of consolidating. The difference is that a consolidation is a fusion
while a merger is rather an absorption. The constituent companies are
merged into an existing one and no new corporation is formed. The
rights, franchises, and interest are deemed to be transferred to, and
vested in, the corporation into which the various companies have been
merged without any deed or transfer, and the liabilities follow the
rights.
Formation of Consolidation and Merger
In the formation of a consolidation or a merger the services of a
promoter may be necessary. This is especially true if the various
companies are direct competitors and deep-rooted jealousies exist.
Under the circumstances an outsider has the best chance of effecting
an agreement between the parties. The difficulty encountered in all
consolidations and mergers is the exaggerated idea of officials
regarding the importance and value of their own plant and organization
as related to the rest. This difficulty is accentuated in effecting a
merger because of the irrevocable nature of the compact and the almost
complete disappearance of lines of demarcation as to the tangible and
intangible assets of the various units. These difficulties are overcome
in many instances by the promoter’s keeping the terms arrived at with
each company a secret. Direct dealing is possible in the case of a
merger when the various companies are supplementary to each other, such
as would be the case where a selling organization is merged into a
manufacturing corporation the product of which it distributes.
Principles of Valuation of the Constituent Companies
In all the foregoing cases the question at once arises as to the
principles which should govern in arriving at a valuation. Should
the value of the net assets comprising plant, equipment, etc., or
the earnings for a number of years serve as a basis in arriving at
the ratio of exchange in cash or stock? What relative weight should
be given to the various items? A concern with large assets when not
running its plant to full capacity would be averse to having the
apportionments based on earnings. The corporation with relatively small
assets but with large earnings on the capital invested would not want
the value computed on net assets.
If the net assets are an important factor of valuation, an appraisal
should be made either through a committee or by independent appraisers.
If such an appraisal cannot be made, the books should be examined to
see that the valuation of each plant and equipment is correct. Great
care should be exercised to see that capital additions represent actual
additions to the plant or serve to increase its capacity or lower its
cost of production. The method of handling improvement expenditures
should be uniform. It is necessary to determine that proper entries
have been made in respect of property abandoned or equipment removed
from service. Another point requiring careful investigation is the
provision of ample reserves for depreciation, and the same method of
calculation and consideration of the different elements of depreciation
and the conditions under which they are operative must be taken into
account in all the companies.
The main problem in using earnings as the basis for valuation is the
determination of the number of years’ profits to be averaged. Care
must be exercised to handle uniformly the earnings and expenses of the
various companies.
Fundamental Principle of Equalization of Conditions
Before an intelligent estimate or computation can be made of the
relative value of each unit in the proposed consolidation or merger,
the various items that make up the assets and earnings of each company
should be examined from the same point of view. Accounting systems
and methods are so varied that a common basis of computation must be
constructed or agreed upon before a comparison can be made. In general,
the following points should be considered:
1. A uniform accounting system for all the companies
to be merged, in order to have the same basis in
arriving at the results.
2. The reserves for depreciation should be based on
an analogous system of calculation.
3. Costs should be determined in the same way if the
companies carry on the same industry; if the
industries are not similar the cost should be reduced
to the same basis.
4. The apportionment of labor, factory expense, and
factory overhead should be uniform.
5. Only real items of cost should be included under the
head of cost of plant and all income charges
should be eliminated so as to give a basis for
comparing manufacturing items.
6. The same methods of inventory-taking, both of
working assets and fixed capital, should be used.
Proper valuation of accounts receivable should
be made. The accounts payable should be properly shown.
7. The amount of orders on hand should be considered.
The past year may have been poor and the books
may not reflect the true state of affairs.
Valuation of Partnership
Where, as frequently happens, a partnership is a party to the
merger, it is necessary to consider the method of handling certain
items in the partnership accounting which differs from their handling
under the corporate form, so that the valuation of the assets and
earnings of all the properties can be placed on an equitable basis.
Such items are partners’ salaries and drawings, and the interest
on capital and drawings for the purpose of adjusting the various
partners’ interests. In partnership accounting the proper treatment
of partners’ salaries, drawings, and interest on capital and drawings
requires that these appropriations of profits be shown in the profit
and loss summary; i.e., the figure of net profits for a partnership
is determined before taking into consideration the items mentioned.
However, one occasionally finds partners’ salaries and adjustments
on account of interest handled as expenses of the business. To place
the earning capacity of the partnership on an equitable basis for
comparison with the earnings of a corporation, a reasonable figure
for the salaries of the partners as managers of the business must be
agreed upon and treated as an expense chargeable to operations before
the determination of net profits. Partners’ drawings and interest
adjustments on account of capital and drawings should not be taken
into account in the determination of earning capacity. In determining
the amounts of partners’ salaries, that which would be appropriate for
similar capacities in a corporation should be allowed as deductions
from earnings. All the items mentioned above in connection with placing
the properties of the several corporations on an equitable basis for
valuation apply with equal force to the properties of any partnerships
which may become parties to the merger.
Earning Capacity
Any extraordinary profits or losses not due to the ordinary operations
of the business should be eliminated when computing profits. Interest
on borrowed money should not be included. The charges to operating
expense on account of repairs should be adequate, and care must be
taken to see that charges to the repair accounts do not show a sudden
falling off toward the close of the period under review. The reserve
for depreciation should be credited with the proper amounts. Sales,
effected for a subsequent period, are not to be considered in the
accounts of the current period as this would tend to inflate the
profits. Shipments made to branch offices or on consignment account
should not be regarded as sales. Ample provisions should be made for
all liabilities for expenditures incurred during the period under
review and outstanding at the close thereof. The inventories should
be checked over carefully and certified by the parties taking them.
Allowance for old or obsolete material should be made.
Good-Will
The determination of the value of good-will is generally a delicate
proposition unless the parties to the consolidation or merger first
agree as to the basis on which it is to be computed. This is generally
anything that the interested parties choose to make it.
The two methods commonly used for estimating the value of good-will
have already been discussed in Chapter XVIII.
Capitalization of a Consolidation or a Merger
The capitalization of a corporation, in a legal sense, is the sum total
of the par value of the authorized capital stock. From an investment or
economic point of view it is the sum total of all the stock and bonds
issued or outstanding.
There are three different bases of capitalization: (1) cost of property
plus accumulated surplus value; (2) cost of reproducing the property;
and (3) earning power. According to legal theory the investment or the
cost plus surplus is the proper basis. This idea has been fostered by
the fact that shares have been assigned a definite face value. While at
the beginning of a new enterprise investment value and capitalization
may closely correspond generally, they soon diverge widely—due to
smaller or greater earnings than were estimated or to depreciation or
accretion in the value of the assets. When the _potential_ earning
power of the business begins to be realized, conditions begin to
change and the value of the tangible and intangible assets fluctuates.
The basis of capitalization changes with these fluctuations and the
laws regulating it are in practice only complied with nominally.
The custom is to adjust the value of the assets to harmonize with
the capitalization rather than vice versa. Such a policy is to be
deprecated.
The cost of reproducing the property as a basis of capitalization is
as yet only seriously considered in theory. It is very doubtful if the
method will ever be used in actual practice.
Earnings, past or potential, perhaps form the basis for capitalization
most frequently used. Investment value closely corresponds to the
rate earned and the degree of permanency of the earning power. To
secure an income is the motive of all investment. In practically all
consolidations and mergers the estimated increase in earnings due to
the application of better methods of operation plays an important part
not only in the promotion and formation of the new company, but also in
deciding upon the capitalization. While the plant value and the past
earnings of each of the companies may be considered in allotting them
their respective interests, these are not a safe guide as to future
earnings. In the case of partnerships especially and often in the case
of corporations, there is a loss of valuable good-will. It is generally
held that the benefits of consolidation greatly overbalance these
disadvantages. The savings due to the elimination of duplicate work in
factory and office, the cutting down of the item of rent, the saving in
the cost of selling, the greater effectiveness of advertising, etc.—all
are reasons held out as warranting this or that capitalization.
Payment of Amalgamated Interests
In a consolidation or a merger the usual practice is to pay the
various interests in the companies which are amalgamated with bonds,
preferred and common stock, and in some instances with cash. The
proportion and kind of payment will depend upon the conditions
surrounding each case. The prevalent custom is to pay for the net
assets in preferred stock and to issue common stock for good-will.
Often, however, bonds are used to pay for the tangible assets;
preferred stock is issued for the intangible assets; and common stock
represents the additional profits that are expected to accrue to
the corporation through the consolidation or merger. The issue of
bonds to cover _all_ the tangible assets is generally a dangerous
procedure because of the high fixed charges resulting therefrom—though
advantageous when the difference between the fixed charges and the net
earnings is large. Bonds generally carry relatively small interest
because of their safety, whereas the use of preferred stock entails a
smaller equity for the common. The bondholder is not concerned with the
capitalization or nature of the issues over which he takes precedence.
For the same reason it is not usual for the preferred stockholder to
complain about overcapitalization through the use of common stock. The
business risk involved depends upon the nature of the business and the
ability of the management. No financial arrangements should be made
that do not take into consideration the fluctuations that are inherent
in the business and their effect upon net income.
Another apportionment sometimes made is to issue bonds for the fixed
assets; preferred stock for the working capital; and common stock
in proportion to the prospective earnings of the consolidation or
merger. New bonds are exchanged for the old bonds or preferred stock
of the constituent companies, while the common is exchanged for the
corresponding issues in the merged corporations. The balance is used
for the purpose of paying organization expenses and the fees of the
promoters, and to provide working capital for the consolidation. The
ratio and the medium will depend to a great extent upon the nature of
the business, the attitude of those who are interested in the merger
corporations, and the optimism or hopes of the promoters.
Closing the Books of the Merged Concerns
Closing the books of the merged concerns presents the problems of
accounting for the sale of the subsidiary companies. This may be
effected in two ways. Where the sale is made at the book values as
carried on the records of the subsidiary, no adjustments whatever
become necessary. Where, however, the price received is less or greater
than the book value of the concern, it becomes necessary to show the
difference between book and sale valuation. In taking account of these
differences two methods are employed. Under the one an adjustment is
made of all the detailed valuations of the items of property as taken
over. It becomes necessary, therefore, to adjust each property account
through its depreciation reserve or through surplus, in order to bring
it to the value at which it is taken over. This may, and frequently
does, necessitate setting up a good-will account on the books of the
vendor company. After the books are thus brought into accord with the
sale agreement, the closing of the accounts follows the procedure laid
down in Chapter XXVIII for the liquidation of a company.
Under the second and more common method, no attempt is made to adjust
the individual items of properties sold in accordance with the
appraisal committee’s report, but all differences are cleared in a lump
sum through the surplus or deficit accounts. If the sale is made for
cash, the amount received is then disbursed as a liquidating dividend
to the shareholders. If the property is sold for stock and bonds in the
merged company, either this stock is handed over en bloc, in which case
it is likewise distributed as a liquidating dividend, or the merger
company may issue the stock and bonds as a liquidating dividend for
the vendor company on the basis of the report of the shares belonging
to each stockholder. Upon notice that such stock and bonds have been
issued to its shareholders, the vendor company closes up its records
completely by cancelling its proprietorship accounts against the charge
account set up against the merger company until the stock is issued.
Opening the Books of the Merger
As a merger is a corporation, the opening of its records follows
the same lines as that of any other corporation, excepting that
when payment of subscriptions for capital stock is to be recorded,
cognizance must be taken of the manner of payment. The subscription
contract, in so far as it relates to the various subsidiaries, is
usually canceled by turning over the properties of the subsidiaries.
The assets are taken over at an appraised price which becomes the
basis for the amount of subscription to the stock of the merger by
each subsidiary. In Chapter I, where mention was made of the payment
of stock subscriptions in property, it was pointed out that it may
be desirable to bring onto the books the lump sum representing the
appraised purchase price paid for the subsidiary some time before the
appraisal committee has submitted its report on the detailed valuation
of the various items of property taken over from the subsidiary. The
customary method of handling the situation on the books of the merger
was there shown. The bookkeeper is not concerned with the valuation of
any of the items taken over, but must make his entries in accordance
with the valuation report turned in by the appraisal committee. The
main problem in the merger, then, is one of valuation and not of
accounting. As stated above, payment to the subsidiaries may be made
by the merger in either of two ways. An entire block of stock may be
turned over to the subsidiary company and be distributed by it as
liquidating dividends to its stockholders, or the merger may issue
shares to the individual stockholders of the subsidiaries in accordance
with information furnished by the subsidiary.