📈Financial Accounting II Unit 13 – Consolidated Statements: Mergers & Goodwill

Key Concepts

• Business combinations involve the joining of two or more separate entities into one reporting entity
• Mergers occur when two companies combine to form a single new company
• Acquisitions happen when one company takes over another and establishes itself as the new owner
• Consolidated financial statements present the results of a parent company and its subsidiaries as if they were a single economic entity
• Goodwill represents the excess of the purchase price over the fair value of the net identifiable assets acquired in a business combination
  • Calculated as the difference between the consideration transferred and the net identifiable assets acquired
  • Recognized as an intangible asset on the balance sheet of the acquirer
• Non-controlling interest (NCI) is the portion of equity in a subsidiary not attributable to the parent company
• Intra-group transactions are transactions between members of the same group (parent and subsidiaries)

Business Combinations and Mergers

• Business combinations can be achieved through various methods such as mergers, acquisitions, or consolidations
• In a merger, two companies agree to combine their operations and form a new entity
  • Merger of equals occurs when two companies of similar size combine (ExxonMobil)
  • Reverse merger happens when a private company merges with a public company to become publicly listed
• Acquisitions involve one company buying another company's shares or assets to gain control
  • Friendly acquisition occurs when the target company's management approves the deal (Microsoft acquiring LinkedIn)
  • Hostile takeover happens when the target company's management opposes the acquisition attempt
• Consolidation involves the combination of two or more companies to form a new company, with the original companies ceasing to exist
• Reasons for business combinations include synergies, growth, diversification, and market power

Consolidation Methods

• Consolidation methods determine how the financial statements of the parent and subsidiaries are combined
• Purchase method is used when one company acquires another and obtains control
  • Assets and liabilities of the acquired company are recorded at their fair values on the acquisition date
  • Goodwill is recognized for the excess of the purchase price over the fair value of net assets acquired
• Pooling of interests method is used when two companies merge to form a new entity
  • Assets and liabilities of both companies are combined at their book values
  • No goodwill is recognized under this method
• Equity method is used when the investor has significant influence over the investee (usually 20-50% ownership)
  • Investor records its share of the investee's profits or losses in its income statement
  • Investment account is adjusted for the investor's share of the investee's income or losses and dividends received

Goodwill and Its Treatment

• Goodwill is an intangible asset that arises in a business combination when the purchase price exceeds the fair value of the net identifiable assets acquired
• Goodwill is calculated as the difference between the consideration transferred (purchase price) and the fair value of the net identifiable assets acquired
• Goodwill is recognized on the balance sheet of the acquirer and is subject to annual impairment tests
  • Impairment occurs when the carrying value of goodwill exceeds its implied fair value
  • Impairment losses are recognized in the income statement and cannot be reversed
• Negative goodwill arises when the fair value of the net identifiable assets acquired exceeds the purchase price
  • Negative goodwill is recognized as a gain in the income statement on the acquisition date
• Goodwill is not amortized but is tested for impairment annually or more frequently if events or changes in circumstances indicate that it might be impaired

Preparing Consolidated Financial Statements

• Consolidated financial statements present the financial position, results of operations, and cash flows of a parent company and its subsidiaries as if they were a single economic entity
• Steps in preparing consolidated financial statements:
  1. Eliminate intra-group transactions and balances
  2. Adjust for differences in accounting policies between the parent and subsidiaries
  3. Allocate the purchase price to the identifiable assets and liabilities acquired
  4. Calculate and recognize goodwill or gain on bargain purchase
  5. Determine non-controlling interest (NCI) in the subsidiary's net assets
  6. Prepare the consolidated balance sheet, income statement, and cash flow statement
• Consolidated balance sheet combines the assets, liabilities, and equity of the parent and subsidiaries, eliminating intra-group balances
• Consolidated income statement combines the revenues, expenses, and profits of the parent and subsidiaries, eliminating intra-group transactions
• Consolidated cash flow statement presents the cash inflows and outflows of the parent and subsidiaries as a single entity

Intra-Group Transactions and Balances

• Intra-group transactions are transactions between members of the same group (parent and subsidiaries)
• Examples of intra-group transactions include sales of goods or services, loans, and dividends
• Intra-group balances are balances between members of the same group, such as receivables and payables
• Intra-group transactions and balances must be eliminated in the preparation of consolidated financial statements to avoid double-counting
  • Elimination entries are made to remove the effects of intra-group transactions and balances
  • Unrealized profits or losses on intra-group transactions are deferred until the assets are sold to third parties
• Failure to eliminate intra-group transactions and balances can lead to overstatement of assets, liabilities, revenues, and expenses in the consolidated financial statements

Disclosure Requirements

• Disclosure requirements for business combinations and consolidated financial statements are set by accounting standards (IFRS 3 and IFRS 10)
• Disclosures provide users with relevant information about the nature and financial effects of business combinations and the relationship between the parent and its subsidiaries
• Key disclosures for business combinations:
  • Name and description of the acquiree
  • Acquisition date
  • Percentage of voting equity interests acquired
  • Primary reasons for the business combination and how the acquirer obtained control
  • Fair value of the consideration transferred and its components
  • Amounts recognized for each major class of assets acquired and liabilities assumed
  • Amount of goodwill or gain on bargain purchase recognized and the factors that contributed to it
• Key disclosures for consolidated financial statements:
  • Composition of the group, including changes in the structure during the period
  • Basis of preparation of the consolidated financial statements
  • Significant accounting policies applied
  • Non-controlling interests in the group's activities and cash flows
  • Nature and extent of significant restrictions on the ability to access or use assets and settle liabilities of the group

Practical Applications and Case Studies

• Business combinations and consolidated financial statements are common in practice, especially among large corporations
• Real-world examples of mergers and acquisitions:
  • Merger of Dow Chemical and DuPont to form DowDuPont (2017)
  • Acquisition of Time Warner by AT&T (2018)
  • Merger of Fiat Chrysler Automobiles and Peugeot to form Stellantis (2021)
• Case studies can help understand the complexities and challenges of business combinations and consolidated financial reporting
  • Analyzing the financial statements of companies involved in mergers or acquisitions
  • Examining the impact of different consolidation methods on the reported financial results
  • Evaluating the goodwill recognized in a business combination and its subsequent impairment testing
  • Assessing the adequacy and clarity of disclosures related to business combinations and consolidated financial statements
• Practical considerations for accountants and auditors:
  • Understanding the accounting standards and their application to specific transactions and events
  • Obtaining sufficient appropriate audit evidence to support the accounting for business combinations and consolidated financial statements
  • Communicating effectively with management, those charged with governance, and other stakeholders about the financial reporting implications of business combinations and consolidations