Forms of business combination
A business combination is when companies join. Main forms:
- Merger (absorption): one company takes over another's assets and debts and the other disappears. Or two form a new one.
- Acquisition of control: the buyer (parent) buys more than half of the voting shares of another company (the subsidiary). Both stay legally separate.
- Share exchange / holding company: shares are swapped, or a new holding company owns several companies.
Why combine: grow bigger, enter a market, save costs, get skills or technology.
Financial statements after a merger
After a merger the new company makes one set of statements. The buyer values what it gets (assets and debts) at fair value.
Goodwill = price paid − fair value of net assets acquired (assets − liabilities).
Example: price 130, net assets 100, goodwill 30. Goodwill is an asset that shows the extra value of brand, customers and skills. It is written off over time (or tested for loss in value). If the price is lower than net assets, the difference is a gain (a bargain purchase).
Preparing consolidated statements
The parent and subsidiary keep separate books, but readers want one picture of the group. Steps:
- Add the matching lines of both companies.
- Eliminate the investment: the parent's "shares in subsidiary" against the parent's share of the subsidiary's equity. Any gap is goodwill.
- Non-controlling interest (outside owners' share): if the parent owns 80%, show 20% of the subsidiary's equity (and 20% of its profit) as outside interest.
- Eliminate internal dealings: sales between group companies, and what they owe each other (receivable and payable).
- Remove unrealised profit on goods still unsold inside the group.
Only dealings with people outside the group stay.
Consolidated tax-effect accounting
Tax is paid by each company on its own profit. When the group removes an unrealised profit, the seller has already paid tax on it. The group profit falls, but the tax does not. This timing gap is fixed by deferred tax.
Example: unrealised profit 20, tax rate 30%. Group removes 20 of profit and recognises a deferred tax asset of 6 (20 × 30%). Net reduction in group profit = 20 − 6 = 14.
When the goods are finally sold outside, the profit becomes real and the deferred tax asset is used up. Tax effects also arise when subsidiary assets are revalued to fair value on acquisition (usually a deferred tax liability).
Key formulas and definitions
- Key terms: Parent = controls; Subsidiary = controlled
- Goodwill = price − share of net assets
- NCI = outside % × subsidiary equity
- Consolidated = add − eliminate internal items
- Unrealised profit = selling price − cost on unsold goods
- Deferred tax asset = unrealised profit × tax rate
Worked examples
1. Company A takes over B by merger and pays 130 in shares. B's assets (fair) are 150 and debts 50. Find the goodwill.
Net assets = 150 − 50 = 100. Goodwill = 130 − 100 = 30.
2. Parent P owns 100% of S. P's total assets are 300 including investment in S of 80. S's assets are 120 and S's equity is 80. What are the consolidated assets?
Add: 300 + 120 = 420. Eliminate the investment 80 against S's equity 80: 420 − 80 = 340. No goodwill, since price equals equity.
3. P pays 90 for 80% of S whose net assets are 100. Find goodwill and non-controlling interest.
Share of net assets = 80% × 100 = 80. Goodwill = 90 − 80 = 10. NCI = 20% × 100 = 20.
4. P sells goods costing 60 to S for 80. S still holds all of them. Tax rate 30%. What are the consolidation adjustments?
Eliminate sales 80 and cost 80 inside the group. Unrealised profit = 80 − 60 = 20, removed from S's stock (stock shown at 60). Deferred tax asset = 20 × 30% = 6. Group profit falls by 20 − 6 = 14.
Common mistakes
- Adding the investment in the subsidiary and the subsidiary's capital too. They must be eliminated.
- Forgetting non-controlling interest when the parent owns less than 100%.
- Leaving internal sales and receivables in the group statements.
- Removing unrealised profit but forgetting the deferred tax effect.