Chapter 8 - Appendix A
Business Combinations
1. Types of business combinations
2. Purchase accounting
3. Consolidation of purchased subsidiaries
a. Consolidation process
b. Recognition of minority interest
c. Consolidated versus unconsolidated
4. Consolidation of foreign subsidiaries
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1. Types of Business Combinations

Mergers - occur when one company acquires all
of the assets and liabilities of another company,
and the acquired company is dissolved.
– Journal entry on acquiring company’s books:
Assets
xx
Liabilities
xx
Cash, etc.
xx
– Note that this is a “shortcut” explanation. Actually, a
statutory merger requires that the acquiring company
purchases all of the outstanding common stock of the
acquired company, then dissolve the acquired company
(no longer a separate legal entity). The assets and
liabilities of the acquired company are absorbed into the
acquiring company’s books, including any goodwill that
is recognized in the merger.
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1. Types of Business Combinations

Acquisitions
– Acquisitions occur when one company acquires
at least 50% of the common stock of another
company; both companies continue to operate
as separate legal entities, and maintain
separate sets of books. This is called a
parent/subsidiary relationship.
– Journal entry on acquiring company’s books:
Investment in Subsidiary xx
Cash, etc.
xx
– Note that, at the end of each reporting period,
the books of the parent and subsidiary must be
combined when reporting to the parent’s
investors. This is called a “consolidation.”
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1. Types of Business Combinations



Once a merger is completed, there is now
one legal entity, and no additional accounting
issues exist.
For an acquisition, the acquiring company
must perform consolidating journal entries
each year to combine the parent and
subsidiary.
The balance of this chapter is devoted to
acquisitions.
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2. Purchase Accounting

Purchase accounting is based on the fair
market value of an exchange transaction.
 An acquisition treated as a purchase first
values the fair market value of the things
given up in the exchange. This can include
cash, debt, preferred stock, or common stock.
 The value of the cash, debt, equity, etc.
becomes the value of the investment
acquired.
 Goodwill is implied in the investment account,
as is any asset revaluation.
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2. Purchase Accounting

The journal entry to record the acquisition as a
purchase might take the following forms:
– for cash:
Investment in Sub
xx
fair mkt. value
Cash
xx fair mkt. value
– with the issue of common stock:
Investment in Sub
xx
fair mkt. value
Common Stock
xx par value
APIC
xx excess
– (The credit to CS and APIC is the same as if the
CS had been issued for cash.)
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2. Purchase Accounting

Note that the investment account contains the
following information:
– fair value of the net assets of the sub.
– goodwill recognized on acquisition of the sub.
 Alternatively, the investment account contains the
following information:
– book value of the net assets of the sub.
– revaluation of the net assets of the sub.
– goodwill recognized on acquisition of the sub.
 This will become important in the consolidation
process.
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3. Consolidation of Purchased Subsidiaries

General Information
– Required for parent/sub relationships (over
50% of the common stock of the sub is
owned by the parent).
– Performed to give a better picture of the
overall structure and performance of the
combined entity.
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3. Consolidation of Purchased Subsidiaries
a. Procedure
– The parent uses the equity method of accounting to
record income from the investment during the year.
– At the end of the year, the separate financials of
parent and sub are posted to a worksheet.
– The sub’s column represents the “book value” of
the net assets acquired.
– Any assets and liabilities of the sub that need to be
revalued (to match the assumptions at acquisition),
are revalued in a consolidating journal entry posted
only to the worksheet.
– Any goodwill (that was assumed at acquisition) is
recognized in a consolidating journal entry, and
subsequently written down if the related assets are
impaired.
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3. Consolidation of Purchased Subsidiaries
a. Comments on Procedure - see Figure 8A-4
– Note that the subsidiary does not revalue its books
at acquisition; it is the parent that assumes
revaluation.
– Note that the subsidiary does not recognize
goodwill on its books at acquisition; it is the parent
that implies this recognition in the Investment
account.
– The investment account is replaced by the assets
and liabilities of the subsidiary, and goodwill is
recognized explicitly in the consolidation process.
– We will focus only on the recognition of goodwill in
this chapter, since it is usually the largest single
asset recognized in acquisitions.
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3. Consolidation of Purchased Subsidiaries
b. Recognition of Minority Interest see Figure 8A-6
– If the subsidiary is less than 100% owned
(but still greater than 50%), the parent still
adds all of the subs assets and liabilities, and
all of the subs revenues and expenses in the
consolidation.
– The parent must then recognize that part of
the subsidiary belongs to a “Minority Interest”
when reporting the results to the parent’s
shareholders.
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3. Consolidation of Purchased Subsidiaries
b. Recognition of Minority Interest
– On the consolidated balance sheet, this
amount is often presented between
liabilities and equity. It represents the
minority interest claim to the assets and
liabilities of the subsidiary.
– On the consolidated income statement,
there is a line that indicates “Minority
Interest in Net Income.” This amount is
subtracted from total net income, to get to
the portion of income that belongs to the
parent.
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3. Consolidation of Purchased Subsidiaries
c. Consolidated versus Unconsolidated F/S
– Consolidated F/S show more detail as to the
structure of the combined entity, but the
performance of the subsidiary (or subsidiaries)
can be lost in the tradeoff.
– Sometimes the detail of the structure and
performance of the separate subsidiary can be
found in the F/S notes regarding “segment”
activity, but only if the subsidiary qualifies as a
reportable segment.
– Some parent companies will also present “Parent
Company” financials in addition to consolidated
financials. The parent company statements show
the same equity, but the subs activity is
unconsolidated and shown in “Investment in Sub.”
and “Income from Sub.”
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3. Consolidation of Purchased Subsidiaries
c. Consolidated versus Unconsolidated F/S
– Note that the consolidation will not change total
equity, but it will change total assets and liabilities.
– This can change any ratios that deal with assets
and liabilities (return on assets, debt to equity).
– The FASB believes that consolidated financials
reveal more about the asset and liability structure
of a company. Unconsolidated financials would not
show separate liabilities of the subs.
– Sometimes consolidations may cloud certain
patterns such as sales growth. A newly acquired
subsidiary might significantly boost consolidated
revenue (and the reverse is true when a subsidiary
is sold). Disclosure can help clarify some of the
issues.
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4. Consolidation of Foreign Subsidiaries

Foreign subsidiaries often operate with
accounting standards that are different from
US GAAP, and the financials must be
converted to US GAAP before they can be
consolidated.
 Foreign subsidiaries often operate in a
“functional” currency that is not the US
dollar. These subsidiaries must first be
converted to the US dollar before they can
be consolidated with the US parent.
 Once the financials are converted to US
GAAP and US dollars, the rest of the
consolidation is the same as in part 3.
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4. Consolidation of Foreign Subsidiaries
The process to convert the foreign sub’s
financial statements to the US dollar uses
the following rules (SFAS 52) to translate
the financials:
 Assets and liabilities are converted at the
current rate (at the balance sheet date).
 Equity is translated at the historical rate in
effect at the date of the transaction.

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4. Consolidation of Foreign Subsidiaries
Different
equity accounts are translated at
specific historical rates in effect at the date of
the transaction:
–common stock and APIC at the date of issue.
–retained earnings components at various
historical rates:
 dividends converted at the date of
declaration.
 revenues and expenses are converted
at the average rate for the year (this is a
substitute for using the individual
historical rates for each revenue and
expense transaction).
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4. Consolidation of Foreign Subsidiaries



After everything is converted to dollars, the
sub’s balance sheet will not balance. The
“plug” or residual amount to bring the balance
sheet into balance is the Translation
Adjustment (or Cumulative Translation
Adjustment).
The TA is a debit or credit plug to
Stockholders’ Equity. A credit plug adds to
the other equity accounts. A debit plug is
treated as a contra.
The interpretation of the TA is that it will not
become part of income until the sub is sold.
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4. Consolidation of Foreign Subsidiaries
Example of calculation of translation adjustment.
Given the following information of Beattie Company, a British
subsidiary, at December 31, 2005:
All amounts below are in British pounds:
Balance Sheet
Assets
Liabilities and SE
Cash
15,000
A/P
55,000
A/R
114,000
Long-term debt 132,000
Inventories
55,000
Common stock 134,000
Plant assets
162,000
Retained earn.
25,000
Total Assets
346,000 Total Liab. & SE
346,000
Statement of Retained Earnings
Retained Earnings, 1/1/05
0
Add: Net income for 2005
35,000
Less: Dividends for 2005
(10,000)
Retained Earnings, 12/31/05 25,000
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4. Consolidation of Foreign Subsidiaries
Given the following additional information for Beattie
Company:
1. Exchange rates during 2005:
1/1/05
$1.50 per pound
9/1/05
1.57 per pound
12/31/05
1.60 per pound
Average
1.54 per pound
2. The common stock was issued on 1/1/05.
3. The cash dividend was declared on 9/1/05.
4. Income is earned evenly throughout 2005.
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4. Consolidation of Foreign Subsidiaries
Solution:
Assets
346,000 x $1.60 = $553,600
Liab. and SE
Liab. (55+132)
187,000 x $1.60
Common Stock
134,000 x $1.50
Retained Earnings:
Beginning
-0+Net income
35,000 x $1.54
- Dividends
(10,000)x $1.57
Total Liab. and SE (excluding TA)
Translation adjustment (credit)
Total Liab. and SE (same as total assets)
= $299,200
= 201,000
-0=
53,900
= (15,700)
$538,400
15,200
$553,600
Note that the TA, whether debit or credit, is presented as part
of total stockholders’ equity (as part of “other comprehensive
income”).
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4. Consolidation of Foreign Subsidiaries

The effect of the TA on equity is equivalent to the
effect of an “unrealized gain or loss on AFS
investments.”
 No gain or loss is realized on translation is
realized until the subsidiary is sold.
 If the subsidiary continues to operate indefinitely
in the foreign country, any translation gain or loss
is deferred.
 Rationale: if the foreign subsidiary is operating in
the foreign currency of the foreign country, and is
not “exchanging” the foreign currency for US
dollars, then no gain or loss should be recognized
in the income statement.
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