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Acquisition Method
When one company controls another company the controlling company is called the parent
and the controlled company is called the subsidiary. Since the parent controls the operating
and financing decisions of the subsidiary, it is worthwhile to look at both the companies'
financial performance and financial position together. Consolidated financial statements are
prepared to achieve this objective. US GAAP and IFRS require the consolidated financial
statements to be prepared under the acquisition method.
In the acquisition method, the parent includes all the assets of the subsidiary on its
consolidated balance sheet and includes all the subsidiary's revenues and expenses in its
consolidated revenues and expenses. It creates a component called 'non-controlling
interest' or 'minority interest' in its equity section which represents the claim of others on
the subsidiary's net assets. A line item also appears on the consolidated income statement
below net income which represents net income attributable to the non-controlling interest.
Example
Company P currently holds 75% of the outstanding share capitals of Company S. Company P's
assets are $30 million, its liabilities are $20 million and its shareholders' equity is $10 million.
Company S's assets are $10 million, its liabilities are $7 million and its equity is $3 million.
Company P will include the assets of Company S on its balance sheet so its total assets will
be $40 million ($30 million + $10 million), its total liabilities will be $27 million ($20 million + $7
million). Its equity will be $13 million ($40 million minus $27 million) but it will have two
components: first component would result to the interest of the Company P in Company S's
net assets while the other component is called the non-controlling interest and it represents
the interest of other Company S shareholders who hold the remaining 25% of the
outstanding shares. Non-controlling interest on Company P's balance sheet would equal 25%
of Company S's net assets ($10 million minus $7 million) which equals $0.75 million. The
equity component that represents Company P's interest is hence $12.25 million (total equity
of $13 million minus non-controlling interest of $0.75 million).
Full Goodwill Method
In the full goodwill method, goodwill is calculated as the difference between the total fair
value of the target company and the fair value of it net identifiable assets. Full goodwill
method is mandatorily required by US GAAP and allowed as an option by IFRS (besides the
partial goodwill method).
There are a lot of acquisitions in which the acquirer obtains more than 50% but less than 100%
ownership. In such situations there are two possible methods for calculation of goodwill:
difference between total fair value of company and total fair value of net identifiable asset
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(that is the full goodwill method) or the difference between purchase consideration and the
acquirer's share of fair value of net identifiable assets (that is the partial goodwill method).
Example
Company A acquired 75% shareholding in Company B for $20 million. Book value of net
identifiable assets of Company B is $14 million. The fair value of Company B's asset is the
same as their book value except accounts receivables which are impaired by $1 million. Book
value of assets is $54 million while book value of liabilities is $40 million
The first input that we need for calculation of goodwill under full goodwill method is the fair
value of the target, i.e. Company B. If 75% of Company B is worth $20 million then 100% of
Company B should be worth $20 million/75% which equals $26.67 million. The fair value of net
identifiable assets of Company B equals book value +/- fair value adjustments. In this
example fair value of net identifiable assets is $13 million which equals $14 million minus $1
million on account of impairment of accounts receivable. Goodwill under full goodwill
method is hence $13.67 million.
Company A will pass the following journal entry to record the business combination.
Goodwill $13.67 M

Assets $53 M

Liabilities

$40 M
Cash

$20 M
Non-controlling interest

$6.67 M
Non-controlling interest is calculated as 25% of total fair value of assets ($26.67*0.25). It can
also be arrived at the balancing figure: (goodwill under full goodwill method + assets
acquired liabilities assumed cash paid)
Partial Goodwill Method
In the partial goodwill method, goodwill is calculated as the difference between the
purchase consideration paid and the acquirer's share of the fair value of the net identifiable
assets. In partial goodwill method, only the acquirer's share of the goodwill is recognized.
Goodwill under full goodwill method exceeds goodwill under partial goodwill method by the
non-controlling interest share of the goodwill.
Partial goodwill method is not allowed under US GAAP but it is allowed as an option under
IFRS (besides the full goodwill method).
Goodwill under partial goodwill method differs from goodwill under full goodwill method
only in situations in which investment by the acquirer is less than 100%.
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Example
Let's follow the same example that we discussed in full goodwill method.
Company A acquired 75% shareholding in Company B for $20 million. Book value of net
identifiable assets of Company B is $14 million. The fair value of Company B's asset is the
same as their book value except accounts receivables which are impaired by $1 million. Book
value of assets is $54 million while book value of liabilities is $40 million.
The purchase consideration is the cash paid to acquire 75% ownership and it equals $20
million.
Fair value of net identifiable assets is $13 million ($54 million book value minus $1 million on
account if impairment in accounts receivable minus liabilities of $40 million). The acquirer's
share of the net identifiable assets equals 75% of $13 million which equals $9.75 million.
Goodwill is hence $20 million minus $9.75 which equals $10.25 million.
Company A will pass the following journal entry to record the business combination.
Goodwill $10.25 M

Assets $53 M

Liabilities

$40 M
Cash

$20 M
Non-Controlling Interest

$3.25 M
Non-controlling interest is calculated as 25% of fair value of net identifiable assets. It equals
$3.25 ($13 million multiplied by 0.25). It can also be arrived at the balancing figure: (goodwill
under full goodwill method + assets acquired liabilities assumed cash paid).
Total goodwill under full goodwill method was $13.67 and non-controlling interest was $6.67
million. The difference is non-controlling interest in case of partial goodwill is only because in
partial goodwill method the non-controlling interest share of goodwill is not recorded which
equals $3.42 million (0.25 of ($26.67 minus $13 million)).
Equity Method
When Company A invests in 20% to 50% of outstanding stock of Company B, it normally
indicates that Company A has significant influence over Company B and the investment is
accounted for under equity method.
In equity method the investing company records the investment in associate initially at cost.
Suppose Company A purchased 25,000 of the 100,000 outstanding shares of Company B at
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$10 per share on 1 Jan 2011. It records the investment at $250,000 which is the cost of
investment (25,000 shares at $10 per share) as shown in the following journal entry:
Investment in Company B $250,000

Cash

$250,000
In subsequent years it adds its share of the associate's profit to the cost of investment. If
Company B's profit for the year ended 31 December 2011 is $100,000, it will add $25,000 to
the cost of investment calculated as the product of net profit of the associate (Company B)
and Company A's holding percentage in Company B (25,000/100,000).
Investment in Company B $25,000

Share in income of associate

$25,000
Any dividends received from the associate is subtracted from the cost of investment. If
Company B declared dividends of $60,000 in the financial year ended 31 December 2011,
Company A will subtract $15,000 (its share in the dividend).
Cash $15,000

Investment in Company B

$15,000
The investment in associate is reported as a non-current asset on the balance sheet at its
carrying amount which is calculate as follows:
Carrying amount of investment at the beginning of the year XXX
Add: share in profit of associate XXX
Less: dividends received from associate XXX
Carrying amount of investment at the year end XXX
Investment in Company B would appear on the balance sheet of Company A at $260,000
calculated as follows:
Investment in Company B as at 1 Jan 2011 $250,000
Add: share in profit of Company for FY 2011 $25,000
Less: dividends received from Company B in FY 2011 $15,000
Investment in Company B as at 31 Dec 2011 $260,000


Business Combinations
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A business combination is an event which leads to one company controlling the other. The
company that acquires control is called the acquirer while the company being acquired is
called the target. Since the operating and financing decisions of the target are controlled by
the acquirer after the business combination, it is useful to treat both the companies as a
single company and prepare their consolidated financial statements.
The acquirer normally controls the company by purchasing its common stock. Accounting
standards prescribe different accounting treatment for different extents of stock holding
based on the nature of influence or control.
Neither Significant Influence nor Control
Investments up to 20% of the acquirer's outstanding stock are treated as financial
instruments and are normally carried at fair value.
Significant Influence: Equity Method or Proportionate Consolidation
Investments in 20% to 50% of the outstanding common stock of the acquirer results in
significant influence and acquirer and target are called associates. Such investments are
accounted for using equity method (under US GAAP) or equity method or proportionate
consolidation method (under IFRS).
Control: Acquisition Method and Consolidation
Investments in more than 50% of the acquirer's outstanding common stock results in control
of the target by the acquirer. The acquirer and target are called parent and subsidiary
respectively. Such investments are accounted for under the acquisition method.