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) |
|
Initial recognition at cost. Subsequently to be checked for impairment. | Acquisition method |
| Significant influence (Associated company) |
|
Initial recognition at cost. Subsequently to be checked for impairment. | Equity method |
| Less than significant influence |
|
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 |
