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5.1. Economic Entity Concept and Control

The acquired company may continue to operate, and maintain its own legal existence. In other words, assume Premier Tools Company bought 100% of the stock of Sledge Hammer Company. Sledge (now a "subsidiary" of Premier the "parent") will continue to operate and maintain its own legal existence. It will merely be under new ownership. But, even though it is a separate legal entity, it is viewed by accountants as part of a larger "economic entity." The intertwining of ownership means that Parent and Sub are "one" as it relates to economic performance and outcomes. Therefore, accounting rules require that parent companies "consolidate" their financial reports, and include all the assets, liabilities, and operating results of all controlled subsidiaries. When you look at the financial statements of a conglomerate like General Electric, what you are actually seeing is the consolidated picture of many separate companies owned by GE.

5.2. Accounting Issues

Although the processes of consolidation can become quite complex (at many universities, an entire course may be devoted to this subject alone), the basic principles are straightforward. Assume that Premier's "separate" (before consolidating) balance sheet, immediately after purchasing 100% of Sledge's stock, appeared as follows:

PREMIER TOOLS COMPANY Balance Sheet March 31, 20X3

ASSETS

LIABILITIES

Current Assets

Current Liabilities

Cash

$ 100,000

Accounts payable

$ 80,000

Trading securities

70,000

Salaries payable

10,000

Accounts receivable

80,000

Interest payable

10,000

$ 100,000

Inventories

200,000

$ 450,000

Long-term Liabilities

Long-term Investments

Notes payable

$ 190,000

Investment in Sledge

400,000

Mortgage liability

110,000

300,000

Property, Plant & Equipment

$ 400,000

Land

$ 25,000

STOCKHOLDERS' EQUITY

Buildings and equipment (net)

100,000

125,000

Intangible Assets

Capital stock

$ 300,000

Patent

225,000

Retained earnings

500,000

800,000

Total Assets

$1 200 000

Total Liabilities and Equity

$1 200 000

Notice the highlighted Investment in Sledge account above, indicating that Premier paid $400,000 for the stock of Sledge. Do take note that the $400,000 was not paid to Sledge; it was paid to the former owners of Sledge. Sledge merely has a new owner, but it is otherwise "unchanged" by the acquisition. Assume Sledge's separate balance sheet looks like this:

SLEDGE HAMMER COMPANY Balance Sheet March 31, 20X3

ASSETS

LIABILITIES

-1

Current Assets

Current Liabilities

Cash

$ 50,000

Accounts payable

$ 80,000

Accounts receivable

30,000

Salaries payable

20,000

$ 100,000

Inventories

20,000

$ 100,000

Long-term Liabilities

Notes payable

50,000

Property, Plant & Equipment

$ 150,000

Land

$ 75,000

STOCKHOLDERS' EQUITY

Buildings and equipment (net)

275,000

350,000

Capital stock

$ 100,000

Retained earnings

200,000

300,000

Total Assets

$ 450 000

Total Liabilities and Equity

$ 450 000

Let's examine carefully what Premier got for its $400,000 investment. Premier became the sole owner of Sledge, which has assets that are reported on Sledge's books at $450,000, and liabilities that are reported at $150,000. The resulting net book value ($450,000 - $150,000 = $300,000) is reflected as Sledge's total stockholders' equity. Now, you notice that Premier paid $100,000 in excess of book value for Sledge ($400,000 - $300,000). This excess is quite common, and is often called "purchase differential" (the difference between the price paid for another company, and the net book value of its assets and liabilities). Why would Premier pay such a premium? Remember that assets and liabilities are not necessarily reported at fair value. For example, the land held by Sledge is reported at its cost, and its current value may differ (let's assume Sledge's land is really worth $110,000, or $35,000 more than its carrying value of $75,000). That would explain part of the purchase differential. Let us assume that all other identifiable assets and liabilities are carried at their fair values. But what about the other $65,000 of purchase differential ($100,000 total differential minus the $35,000 attributable to specifically identified assets or liabilities)?

 
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