Reference no: EM13330876

On July 31, 2013, Danerys Co., a private company, purchased all the net assets of King's Landing Co., another private company.  The compensation consisted of $150M in cash plus contingent consideration.  The contingent consideration was payable in cash and terms were as follows:

• Based on pre-tax income of Landings Co. from August 1, 2013 to July 31, 2014
• If pre-tax income is less than $30M, no amounts are paid
• Beginning at $30M and for each $1M in additional earning: $1M in cash on a cliff basis (so, between $30.00M and $31.99M only $1M in cash), up to $10M in payments, i.e. this maxes out at $40Mpre-tax income

On July 31, 2013, Landings Co. balance sheet consisted of the following:

Cash                                                                      $10M

Receivables                                                             $30M, net of a valuation allowance of $2M

Deferred commissions                                                $5M

Total current assets                                                 $45M

Internally-developed technology                                 $10M, net of accumulated depreciation of $15M

Total assets                                                           $55M

Accounts payable                                                    $10M

Deferred revenue                                                     $20M

Total current liabilities                                              $30M

Total equity                                                            $25M

Total liabilities and equity                                          $55M

Additional information related to the balance sheet consisted of the following:

• Receivables - Danerys Co. concurred with Landings Co. about the amount of the valuation allowance, i.e. that the fair value of the receivables equaled the net book value
• Deferred commissions - Represented payments to sales personnel for obtaining revenue contracts
• Technology consists of various systems - Danerys Co. estimates that it would take 200,000 man-hours at $100 per man-hour to rebuild the systems still in-use. Landings Co.'s technology is cutting edge, so Danerys does not consider any of the equipment to be obsolete.
• Deferred revenue - Consists primarily of delivered Technology. On-going costs to perform required maintenance for the customers are only $1M with a 25% profit margin considered appropriate.

Danerys believes that the probabilities earn-outs are: 5% for each for $1M, $2M, $9M and $10M; 10% each for $3M, $4M and $8M, and 25% each for $5M and $6M.  Danerys believes that a discount rate of 15% is appropriate.

Danerys identified two intangible assets - customer relationships for Large Customer and Small Customers.  The values for each year following the acquisition are presented below, and Danerys concluded that a discount rate of 13% is appropriate:

ASSUME: For any items that require a discount factor, please discount in one-year increments.  No need to estimate / perform pro rata adjustments over quarterly / semi-annual periods.

Danerys Co.'s marginal tax rate is 40%.

HELPFUL HINTS:

Remember from our discussion of fair value:

• For the fair value of deferred revenue and expenses, you generally will not use book value. For deferred expenses, you need to question whether there is any future value, i.e. future cash in-flows from the asset. For deferred revenue, remember that the appropriate valuation is cost-to-perform with a normal profit margin.
• For income-based approaches, you will want to discount the (probability-weighted) expected cash flow given the appropriate discount rate and time period.

Part 1: Determine the appropriate acquisition-date journal entry for the acquisition.  Please include the excel workbook showing your calculation as part of your answer.

Part 2: Write the footnote for Danerys' year-end financial statements (assume 12/31/13 year-end) related to the acquisition.  After each sentence / table, identify, in parentheses, the ASC paragraph that drives the disclosure.  DO NOT state anything like "Based on the guidance in ASC XXX-XX-XX-XX), simply put the reference in parentheses after the end of the sentence like this (ASC 805-10-50-1).  You will also want to consider the disclosure guidance in Fair Value Measurements, but remember that these are non-recurring measurements, so most of the disclosures are Not Applicable. As a starting point, look at a few companies' 10-k to model the disclosure. Salesforce.com, Verifone, and my company Blackhawk Network Holdings, Inc. provide good examples.

Part 3: Research the guidance on intangible assets and write a short memo (background, issue, and conclusion) on the appropriate methodology to amortize the customer relationship asset - straight-line or something else(?).  As part of the conclusion, include an amortization schedule.

Part 4: Write the footnote for Danerys' year-end financial statements (assume 12/31/13 year-end) related to goodwill and other intangible assets. Assume Danerys had no intangible assets prior to the acquisition.  Just like the footnote for the acquisition, reference the ASC guidance in parentheses after each sentence.  Do not include the Technology asset in this footnote.  Technically, internal-use software is an intangible asset but assume that Danerys includes this as part of their "fixed assets" along with property and equipment, as many companies do. Remember both Goodwill and amortizable intangible assets (i.e. customer relationships) are considered intangible assets, so you will need to research the guidance for both.