Business Combinations: Balance Sheet
Business Combinations
Under IFRS, business combinations are not differentiated based on the structure of the surviving entity. Under U.S. GAAP, business combinations are categorized as:
Merger. The acquiring firm absorbs all the assets and liabilities of the acquired firm, which ceases to exist. The acquiring firm is the surviving entity. Acquisition. Both entities continue to exist in a parent subsidiary relationship.
Recall that when less than 100% of the subsidiary is owned by the parent, the parent prepares consolidated financial statements but reports the unowned (minority or noncontrolling) interest on its financial statements. Consolidation. A new entity is formed that absorbs both of the combining companies.
Historically, two accounting methods have been used for business combinations: (1) the purchase method and (2) the pooling of interests method. However, the pooling method has been eliminated from U.S. GAAP and IFRS. Now, the acquisition method (which replaces the purchase method) is required.
Let’s look at an example of the acquisition method.
Suppose that on January 1, 2023, Company P acquires 80% of the common stock of Company S by paying $8,000 in cash to the shareholders of Company S. The preacquisition balance sheets of Company P and Company S are shown in Figure 7.3.
Figure 7.3: Preacquisition Balance Sheets
Under the equity method of accounting, Company P will report its 80% interest in Company S in a one line investment account on the balance sheet.
In an acquisition, the assets and liabilities of Company P and Company S are combined, and the stockholders’ equity of Company S is ignored. It is also necessary to create a minority interest account for the portion of Company S’s equity that is not owned by Company P. Figure 7.4 compares the acquisition method and the equity method on Company P’s post acquisition balance sheet.
Figure 7.4: Balance Sheet Comparison of the Acquisition and Equity Methods
Post acquisition, Company P’s current assets are lower by the $8,000 cash used to acquire 80% of Company S. Under the acquisition method, the current assets are $56,000 ($48,000 P current assets + $16,000 S current assets − $8,000 cash). With the equity method, current assets are $40,000 ($48,000 P current assets − $8,000 cash).
Professor’s note
Where does the $8,000 go? It goes to the departing shareholders from whom the shares were purchased.
When using the acquisition method, Company P reports 100% of Company S’s assets and liabilities even though Company P only owns 80%. The remaining 20% of Company S is owned by minority investors and the difference is accounted for using a noncontrolling (minority) interest account. The minority interest is created by multiplying the subsidiary’s equity by the percentage of the subsidiary not owned by the parent.
In our example, the minority interest is $2,000 ($10,000 S equity × 20%). Noncontrolling interest is reported in stockholders’ equity.