Question

what is the difference in consolidated results between a business combination whereby the acquired company is dissolved, and a business combination whereby separate incorporation is maintained?  

Answer 1

A business combination is a transaction in which the acquirer obtains control of another business (the acquiree). Business combinations are a common way for companies to grow in size, rather than growing through organic (internal) activities.

A business is an integrated set of activities and assets that can provide a return to investors in the form of dividends, reduced costs, or other economic benefits. A business typically has inputs, processes, and outputs. A development-stage entity may not yet have outputs, in which case you can substitute other factors, such as having begun operations and having plans to produce output, and having access to customers who can purchase the outputs.

A business combination is not the formation of a joint venture, nor does it involve the acquisition of a set of assets that do not constitute a business.

When there is a business consolidation, the acquirer thereafter reports consolidated results that combine its own financial statements with those of the acquiree. The acquirer does not include in this consolidation the financial statements of the acquiree for any reporting periods prior to the acquisition date.

Several years later, the Financial Accounting Standards Board (FASB), responded by issuing FIN 46, which established the concept of a Variable Interest Entity (VIE). In short, the new standard requires that these types of entities be consolidated into the financial statements of the entity that benefits the most from their operating income and who holds the risk to absorb any operating losses and liabilities (i.e. the “primary beneficiary”).

It sounds easy enough, but as practitioners can attest, the standards are extensive and a bit confusing, which continues to result in ‘diversity in practice'. For instance, with the advent of FIN 46, many in public and private accounting practice interpreted the new literature as precluding the use of combined financial statement presentation. In fact, financial statements that were once presented on a combined basis, were often switched to consolidated presentation. However, this appears to be a misinterpretation, as the new accounting rules on VIEs did not abolish or change in anyway the use of combined financial presentation.

At the end of the day, both presentation methods report the aggregate results of operations and financial position of two or more entities. In a consolidated presentation, there is a parent company that has a controlling interest in one or more subsidiary entities and/or is the primary beneficiary of one or more VIEs. Conversely, a combined presentation is appropriate when two or more entities are under common control, but no actual parent company exists.

For example, in the construction industry, it is common to form separate legal entities to hold real estate and/or construction equipment that is leased to the operating company and at times to third-parties. Often times an individual (or group of individuals) controls each entity, but there is no parent company that holds an interest in the real estate and/or equipment entity.

In these situations, accounting standards are clear that a combined financial statement presentation is likely more meaningful and therefore preferred over a consolidated presentation (ASC 810-55-1b). Nonetheless, we still see practitioners evaluating the real estate and equipment entities as VIEs and consolidating them into the operating company. Again, the results from operations and the financial position of the group remains the same; however, the consolidated presentation of controlling interest in the balance sheet and income statement is often misleading.

Specifically, the equity and income of the real estate entity and the equipment entity are reported as non-controlling interest, in that the operating company has no direct ownership in these entities. Again, these entities are controlled by an individual (or group of individuals) and not by a parent company. Under a combined presentation, there is no non-controlling interest and all equity and results from operations are combined.

To illustrate how consolidated presentation can be misleading to users of the financial information, let’s assume that the operating company, real estate, and equipment entities reported the following financial position and results of operations:

	Construction Company	Real Estate	Equipment
Assets	$1,250,000	$500,000	$175,000
Liabilities	850,000	350,000	135,000
Equity	400,000	150,000	40,000
Income (less inter-company leases)	125,000	15,000	10,000

The following table presents the differences between the two reporting methods:

	Consolidated	Combined
Assets	$1,925,000	$1,925,000
Liabilities	1,335,000	1,335,000
Controlling Equity	400,000	590,000
Non-controlling Equity	190,000	-
Total Liabilities and Equity	$1,925,000	$1,925,000
Controlling Income	$125,000	$150,000
Non-controlling Income	25,000	-
Net Income	$150,000	$150,000

Notice that under the consolidated presentation there is a separate line item for non-controlling equity as well as non-controlling income. These amounts represent the total equity of the real estate entity and the equipment entity as well as any third-party rentals (i.e. inter-company rentals are eliminated in either presentation method.

This is misleading as it suggests that there is a third-party that hold interest in the real estate entity and equipment entity (i.e. non-controlling interest) when in fact all interest is under common control. Certainly there might be situations where a VIE would exist under a common controlled group, but under this often seen real world example it is clear that the VIE literature is not applicable and instead combined presentation is appropriate.

For combinations resulting in complete ownership, the acquisition method allocates the fair value of the consideration transferred to the seperately recognized assets acquired and liabilities assumed based on their individual fair value.