In the previous chapter, we pointed out that a corporation can obtain a subsidiary either by establishing a new corporation (a parent-founded subsidiary) or by buying an existing corporation (through a business combination). We also demonstrated the preparation of consolidated financial statements for a parent-founded subsidiary.
When a subsidiary is purchased in a business combination, the consolidation process becomes significantly more complicated. The purpose of this chapter is to explore the meaning and the broad accounting implications of business combinations. First, we will examine the general meaning of business combination, which can mean a purchase of assets as well as a purchase of a subsidiary. Next, we will look more closely at the issues surrounding purchase of a subsidiary and at consolidation at the date of acquisition. The procedures for consolidating a purchased subsidiary subsequent to acquisition are the primary focus of Chapters 4 to 7.
Definition of a Business Combination
A business combination occurs when one corporation obtains control of a group of net assets that constitutes a going concern. A key word is control—control can be obtained either by:
1. buying the assets themselves (which automatically gives control to the buyer), or
2. buying control over the corporation that owns the assets (which makes the purchased corporation a subsidiary).
A second key aspect of the definition of a business combination is that the purchaser acquires control over “net assets that constitute a business” [ED 1980.03]1—i.e., a going concern. Purchasing a group of idle assets is not a business combination. A third aspect is the phrase net assets—net assets means assets minus liabilities. Business combinations often (but not always) require the buyer to assume some or all of the seller’s liabilities. When the purchase is accomplished by buying control over another corporation, liabilities are automatically part of the package. But when the purchaser buys a group of assets separately, there may or may not be liabilities attached, such as when one corporation sells an operating division to another company. In any discussion of business combinations, remember that net assets includes any related liabilities.
1. “ED” refers to the September 1999 CICA Exposure Draft on business combinations.
Finally, observe that business combination is not synonymous with consolidation. As we discussed in the previous chapter, consolidated financial statements are prepared for a parent and its subsidiaries. The subsidiaries may be either parent-founded or purchased. A purchased subsidiary usually is the result of a business combination. But sometimes one corporation will buy control over a shell corporation or a defunct corporation. Since the acquired company is not an operating business, no business combination has occurred. As well, not all business combinations result in a parent-subsidiary relationship. When a business combination is a direct purchase of net assets, the acquired assets and liabilities are recorded directly on the books of the acquirer, as we shall discuss shortly.
Accounting for Business Combinations—General
The general approach to accounting for business combinations, whether (1) a direct purchase of net assets or (2) a purchase of control, is a three-step process: 1. Measure the cost of the purchase
2. Determine the fair values of the assets and liabilities acquired 3. Allocate the cost on the basis of the fair values
The mechanics of accounting for the acquisition will depend on the nature of the purchase, particularly on whether the purchase was of the net assets directly or of control over the net assets through acquisition of shares of the company that owns the assets. Let’s look at the general features that apply to all business combinations before we worry about the acquisition method used.