Business Combinations

Business Combinations

The business combination is the transaction by virtue of which one company acquires control over the other company.

Every holding company is required to prepare consolidated financial statements (covering group affairs) in addition to separate financial statements of its own. Accounting treatment of business combinations varies depending upon the extent of control or significance over the target company.

Influence level Indications Accounting Treatment
In separate financial statements In consolidated financial statements
Control (Subsidiary company)
  • Acquirer controls more than 50% shares of the investee; and/or
  • Acquirer has the power to control financial and operational policies of the investee
Initial recognition at cost. Subsequently to be checked for impairment. Acquisition method
Significant influence (Associated company)
  • Acquirer controls more than 20% but less than 50% shares of the investee; and/or
  • Acquirer participates or has the influence on financial and operational policies of the investee but does not control those
Initial recognition at cost. Subsequently to be checked for impairment. Equity method
Less than significant influence
  • Acquirer controls less than 20% shares of the investee; and/or
  • Does not have influence on financial and operational policies of the investee
Initial recognition at cost. Subsequently to be treated as available for sale investments and carried at fair value. Not applicable

Rules for consolidated financial statements (acquisition method):

Following rules are followed while preparing consolidated financial statements:

  • All assets and liabilities of subsidiary company are taken in the consolidated balance sheet (except for inter-company receivables and payables)
  • All revenues and expenses of the subsidiary company are taken in the consolidated profit and loss account (except for inter-company transactions)
  • Goodwill adjustment (the difference between the fair value of net assets at acquisition date and consideration for acquisition) is recognized in consolidated financial statement
  • Investment in the subsidiary company as appearing in separate financial statements of the holding company is not included in the consolidated financial statements
  • Share capital and pre-acquisition profits of the subsidiary company are not included in the consolidated financial statements, rather only holding company’s share in post-acquisition profit is taken
  • Non-controlling interest (representing the interest of minority shareholders in a subsidiary company) is included in the consolidated financial statements

Example – Consolidation:

Review the following data for two companies. An acquirer company named ABC and the target company named SBC.

Now assume that Company ABC acquires 80% shares of Company SBC for $ 800,000. In order to prepare consolidated financial statements, we need to follow the rules defined above.

Consolidated Balance sheet after above adjustments would be as follows:

Non-controlling interest = (Net assets of subsidiary) x (minority shareholding)
= 1,000,000 x 20%
= 200,000

Rules for consolidating investment in associated companies (Equity method):

The equity method is used for consolidating investment in associated companies. This method simply requires recognition of proportionate share in profits earned by the associated company during the year. The closing balance of investment in the associated company will be determined as follows:

Opening balance of investment in associated company xxxx
Add: Share in profit of associated company xxx
Less: Dividend received from associated company xxx
Closing value of investment in associated company xxxx

Example:

Company ABC invested in 50,000 shares of $ 10 each of Company XYZ which represented 25% shareholding at the time of acquisition of shares. During the year, the Company earned a profit of $ 400,000 and announced a dividend of $ 1 per share.

The value of an investment to be included in the consolidated balance sheet would be as follows:

Opening value ( 50,000 x10) 500,000
Add: Share in profit of associated company (400,000 x 25%) 100,000
Less: Dividend received from associated company (50,000 x 1 ) 50,000
Closing value of investment in associated company 550,000

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