On December 30 Year 7 Pepper Company agreed to form
On December 30, Year 7, Pepper Company agreed to form a business combination with Salt Limited. Pepper issued 2,320 of its common shares for all (2,900) of the outstanding common shares of Salt. This transaction increased the number of the outstanding Pepper shares from 3,800 to 6,120. The market value of the shares was $50 per share for Pepper and $40 for Salt. The balance sheets for the two companies just prior to the acquisition were as follows (in 000s):
Consolidated financial statements will be prepared to combine the financial statements for the two companies. The management of Pepper is concerned about not exceeding a debt-to-equity ratio of 3:1 because of a covenant in a borrowing agreement with its bank. It wants to see how these consolidated statements would differ under two different methods of reporting: acquisition and new entity. Management also has the following questions when reporting this business combination:
• Why, under the acquisition method, is one set of assets and liabilities adjusted to fair value, whereas the other set is left at carrying amount?
• Given that under the acquisition method we can measure and report the net assets at fair values at the date of acquisition, why would we not report fair values at each subsequent reporting date?
• Which balance sheet best reflects the economic reality of the business combination?
Prepare a consolidated balance sheet at the date of acquisition under the two methods and respond to the questions asked by management.
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