Accounting: The Language of Business (Part 89)

Art history and Elizabethan poetry don't employ workers; the arduous and tedious application of business sciences such as computer programming and accounting does.

Edward Conard

Income Taxes, Unusual Income Items, and Investments in Stocks (Part E)

by

Charles Lamson 

Business Combinations

Each year, many businesses combine in order to produce more efficiently or to diversify product lines. Business combinations often involve complex accounting principles and terminology. The objective of this section is to introduce some of the unique terminology and concepts related to business combinations. The use and proportion of consolidated financial statements are also briefly described.

Mergers and Consolidations

One corporation may acquire all the assets and liabilities of a second corporation, which is then dissolved. This joining of two corporations is called a merger. The acquiring company may use cash, debt, or its own stock as the payment. Whatever the form of payment, the amount received by the dissolving corporation is distributed to its stockholders in final liquidation. For example, Mattel Inc. acquired Mindscape Inc. For $152 million in cash and stock. As a result of the merger, Mindscape no longer exists as a separate company (Warren, Reeve, & Fess, 2005).

A new corporation may be created, and the assets and liabilities of two or more existing corporations transferred to it. This type of combination is called a consolidation. The new corporation usually issues its own stock in exchange for the net assets acquired. The original corporations are then dissolved. For example, Exxon Mobil Corporation became the new consolidated company that resulted from combining two individual corporations---Exxon and Mobil. 

Parent and Subsidiary Corporations

Business combinations may also occur when one corporation buys a controlling share of the outstanding voting stock of one or more other corporations. In this case, none of the corporations dissolve. The corporations continue as separate legal entities in a present subsidiary relationship. The corporation owning all or a majority of the voting stock of the other corporation is called the parent company. The corporation that is controlled is called the subsidiary company. Two or more corporations closely related through stock ownership are sometimes called affiliated companies. An example of an affiliated company is ESPN, Inc., a subsidiary of Walt Disney Company (investopedia.com).

A corporation (the acquiring company) may acquire the controlling share of the voting common stock of another corporation (the target company) by paying cash, exchanging other assets, issuing debt, or using some combination of these methods. In addition, a parent-subsidiary relationship may be created by exchanging the voting common stock of the acquiring corporation (the parent) for the common stock of the acquired corporation (the subsidiary). Regardless if there is an outright purchase of assets or common stock or an exchange of common stock, the transaction is recorded like a normal purchase of assets, and the combination is accounted for by the purchase method.

Under the purchase method, the subsidiary's net assets are reported in the consolidated balance sheet at their fair market value at the time of the purchase. In some cases, a parent may pay more than the fair market value of a subsidiary's net assets because the subsidiary has prospects for high future earnings. The difference between the amount paid by the parent and the fair market value of the subsidiary's net assets is reported on the consolidated balance sheet as an intangible asset. This asset is identified as Goodwill or Excess of cost of business acquired over related net assets.

Consolidated Financial Statements

Although a parent and subsidiary corporations may operate as a single economic unit, they continue to maintain separate accounting records and prepare their own periodic financial statements. At the end of the year, the financial statements of the parent and subsidiary are combined and reported as a single company. These combined financial statements are called consolidated financial statements. Such statements are usually identified by adding "and subsidiary(ies)" to the name of the parent corporation or by adding  "consolidated" to the statement title.

To the stockholders of the parent company, consolidated financial statements are more meaningful than separate statements for each corporation. This is because the parent company, in substance, controls the subsidiaries, even though the parent and its subsidiaries are separate entities.

When a consolidated balance sheet is prepared, the ownership interest of the parent and the subsidiary's stock, which is the balance in the parent investment in subsidiary account, must be eliminated. This is done by eliminating the parent's investment in subsidiary account against the balances of the subsidiary's stockholders' equity accounts.

If the parent owns less than 100% of the subsidiary's stock, the subsidiary owned by outsiders is not eliminated but it is normally reported immediately following the consolidated total liabilities. The amount is described as the minority interest.

When the data on the financial statements of the parent and its subsidiaries are combined to form the consolidated statements, intercompany transactions are given special attention. An example of such a transaction is the parent purchasing goods from the subsidiary or the subsidiary loaning money to the parent. These transactions affect the individual account of the parent and subsidiary and thus the financial statements of both companies. To illustrate, assume that P Inc. (the parent) sold merchandise to S Inc. (the subsidiary) for $90,000. The merchandise cost P Inc. $50,000. In turn, S Inc. sold the merchandise to a customer for $120,000.

The individual income for P Inc. and S Inc. are shown in Exhibit 6. The consolidated (combined) income statement is shown in Exhibit 7. The consolidated income statement presents the income statements for P Inc. and S Inc. as if they were one operating entity. Thus, the $90,000 sale (P Inc.) and the $90,000 cost of merchandise sold (S Inc.) are eliminated. This is because the consolidated entity cannot sell to itself or buy from itself.

EXHIBIT 6 Income Statements for P Inc. and S Inc.

EXHIBIT 7 Consolidated Income Statement for P Inc. and S Inc.

Many U.S. corporations own subsidiaries in foreign countries. Such corporations are often called multinational corporations. The financial statements of the foreign subsidiary are usually prepared in the foreign currency. Before the financial statements of foreign subsidiaries are consolidated with their domestic parent's financial statements, the amount shown on the statements for the foreign companies must be converted to U.S. dollars. For example, General Motors Corporation is a multinational company that consolidates its foreign subsidiaries, such as the European Opel division, into U.S. dollars.

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 575-578*

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