SALES AND PURCHASE OF BUSINESSES (BUSINESS COMBINATION)

 1.0 INTRODUCTION

The term “business combination” is used to describe an arrangement where two or more businesses owned are operated as separate entities join together to become a single entity under a single ownership. The implication of this is that the separate businesses will discontinue their ownership and come under a single ownership. Business combination can be found in sole- proprietorship, partnership and in companies’ business arrangements. The scope of this unit covers companies’ amalgamation and absorption. Business combination can, therefore, take two forms: i) Amalgamation and ii) Absorption.

Sometimes companies are dissolved due to financial problems and after several adjustments re-register to carry on normal business. This process is called reconstruction or reorganization. This exercise is undertaken by those companies which incur heavy losses for long time and where unable to write off such losses, or companies having substantial fictitious assets such as goodwill, preliminary expenses, profit and loss account debit balances, etc.

This Unit discusses the accounting treatments of the issues raised here with a view to demonstrating the accounting presence in all types of transactions.

2.0 OBJECTIVES

At the end of this unit, you should be able to:

1. appreciate the meaning of business combination 
2. understand reason(s) why businesses combine to produce a stronger entity 
3. explain the major types of business combination 
4. appreciate the accounting entries for business combination. 

3.0 MAIN CONTENT

3.1 Accounting for Business Combination

3.1.1 Amalgamation

This refers to a situation where companies that exist separately under different ownership combine to form a new one. The major feature of this arrangement is that the two businesses that amalgamate will no longer exist, that is, they are liquidated. For example, Company A may combine with company B to form Company AB which is expected to be larger and more viable. Ideally suited to this method are similar sized businesses operating on a relatively small scale.

Reasons/benefits of amalgamation include:

1. The desire to gain larger share of the market. 
2. The desire to attain synergy. 
3. The desire to establish a solid capital base. 
4.  The desire to provide efficient customer service. 
5. The desire to acquire a base adequately for raw materials sourcing in the case of a manufacturing firm. 
6. The desire to be able to challenge a major competition. 
7.  In order to meet legal and statutory requirements. 
8. To enjoy political policies during a period. 

When businesses amalgamate, two major accounting problems arise, namely: i) those concerned with closing the books of the discontinuing businesses which are being wound up; and ii) those concerned with the establishment of new business.

3.1.1.1 Closing the Books of the Discontinuing Companies To close the books of the discontinuing companies, the following ledger accounts are necessary:

1. Realization account 
2. New company account 
3.  Sundry members account 
4. Each liability account, e.g creditors, liquidation expenses payable/creditors for dissolution expenses, loan or debenture account 
5.  Bank account 
6. Component of purchase consideration, e.g ordinary shares issued, preference share issued, debenture stock issued and cash paid. 

3.1.1.2 Realization Account

This is the account in which profit or loss on the dissolution of a discontinuing company is determined. It is usually prepared in a columnar form. The number of columns will depend on the number of companies amalgamating.

The following transactions or events are usually accounted for in the realization account:

1. Debit all assets at book value to realization account 
2.  Determine the purchase consideration and credit it to the realization account 
3. Amalgamation, dissolution or liquidation expenses should be debited to realization account. This will in effect reduce the profit on realization or increase the loss on realization 
4.  Pr ofit or loss on realization is determined, that is, the balance on realization account is transferred to the sundry members account (ordinary). 

3.1.1.3 New Company Account

This is the account where the purchase consideration and related transactions are treated. The purchase consideration, when agreed, is debited to this account (remember that the credit entry goes to realization account) while transaction relating to the purchase consideration are credited to the account when settlement of the agreed purchase consideration is made. The account can, therefore, be regarded as a “self balancing” account.

3.2Specific Accounts Needed

3.2.1 Sundry Members Account (Ordinary and Preference) The following accounting transactions are affected in the sundry members account:

1. Transfer the components of the shareholders fund (e.g. ordinary shares, preference shares, and reserves) to the account by debiting each of the components of the shareholders fund and credit sundry members account 
2. The profit/loss on realization is also transferred to this account.
3.  Each of the components of purchase consideration, when settlement is effected as agreed, including cash, are transferred to this account and the account will automatically balance. 

This account is similar to the partners’ account in the amalgamation of partnership. It should be noted, however, that if there is more than one class of preference shares, the classes must be separated and different ledger accounts opened for each class. For example, if in the balance sheet there are 10% preference shares, 8% cumulative preference shares and 5% redeemable preference shares, these are three different classes of preference shares, therefore, three different sundry members preference accounts must be opened to present each of them separately.

3.2.2 Liability Accounts

Balances on each liability account such as trade creditors and long term loans/debentures should be brought down in their respective ledger accounts. It should be noted that each liability is either settled by the discontinuing business or taken over by the new business.
Where the liability is settled by the discontinuing business, the liability account is debited and cash/bank account credited. However, where the liability is taken over by the new business, it becomes part of the purchase consideration and is treated as follows:

Dr. Liability account
Cr. New Company account
Cr. Discount Received from Creditors, where the liability has been settled at less than the book value and this is regarded as full and
final settlement. It means the discount has been received from creditors. The accounting entries are:
Dr. Liability account
Cr. Realization Account

Liabilities settled above the book value
Where a liability has been settled above its book value, the difference between the book value and the takeover value is debited to realization account. This implies that a loss was incurred in settlement of liability. The accounting entries will be:
Dr – Realization account with the difference
Cr- liability account and amount paid

3.3 Purchase Consideration 

This is the aggregate amount, which the new company is to pay the owners (that is the stakeholders) of the discontinuing business and creditors.

The components of purchase consideration in amalgamation of companies may be some or all of the following:

1. Ordinary shares issued by new company 
2.  Preference shares issued by new company 
3.  Debenture stock issued by new company 
4. Cash given by the new company 
5.  Liabilities of the old companies taken over by the new company 

Where liabilities are taken over, they form part of the purchase consideration. Such liabilities are debited to the liabilities account and credited to the new company account.

Ledger accounts are opened for each of the components of purchase consideration.

On settlement of the purchase consideration as agreed, each of the components of the purchase consideration is debited while the new company account is credited.

On distribution to the owners of discontinuing businesses, the sundry members account is debited and each of the components of purchase consideration credited.

The accounting entries necessary to close the book of discontinuing businesses being liquidated are summarized below:

Dr- Realization Account

Cr-individual assets Account

Event: the book value of the asset taken over by the company at the date of cessation

Dr- Individual Liability Account

Cr- New Company Account

Event: liabilities taken over by the new company at the date of cessation. (If part of purchase consideration)

Dr-New company’s Account

Cr- Realization Account

Event: Agreed purchase consideration (including liabilities taken over) Dr- Realization Account

Cr-Realization expenses payable account/creditors’ account for realization expenses

Event: Realization expenses.

Dr - Liquidation expenses payable account

Cr-Bank account

Event: portion of the realization expenses paid by the company being discontinued

Dr- Creditors account
Cr- Realization account 

Event: Discount received from creditors

Dr-Realization account

Cr-Sundry shareholders and debenture holders account.

 Amalgamation Journal

This is a composite journal which is prepared to reflect the assets and liabilities taken over as well as goodwill or capital reserve on amalgamation.

On the debit side of the journal are all tangible assets taken over at revaluation value or taken over value. However, if the takeover values are not given, it is assumed that the assets are taken over at book values. The takeover value will only be used when such assets are not revalued. If revalued, the revaluation value will be used instead of the takeover value. On the credit side of the journal, are all the components of purchase consideration (including liabilities taken over) as contained on the credit side of the new company account in the book of discontinuing businesses.

The difference between the debit and the credit entries made in the journal represents goodwill or capital reserve. If the balancing figure on the journal is an asset (i.e debit balance), it is referred to as goodwill. If it is a claim over the assets (i.e. credit balance), it is referred to as capital reserve.

 The Balance Sheet of the New Company

The balance sheet of the new company, after amalgamation is prepared using the figures from the opening journal subject to adjustments for transactions after amalgamation as enumerated above.

 Absorption, Takeover or Purchase of Business

Absorption involves a situation whereby a company takes over another company. The company that is taken over (i.e. absorbed company) will lose its identity (i.e. wound up) while the assets and liabilities of the absorbing company will increase after the absorption. For example, A ltd can purchase or take over B ltd to form a bigger A ltd.

This means that unlike amalgamation in which all the amalgamating businesses lose their identities, only one (i.e the absorbed company) loses its identity in the case of absorption.

The amalgamation method is employed where relatively small scaled businesses are concerned. Where this is not the case and large, complex businesses are involved, a holding company is usually established to acquire all, or majority holding, of voting shares of those companies which then continue in existence. But as subsidiaries of the holding company .the acquisition of controlling interest can also arise without the establishment of a holding company for the purpose, when an existing dominant company acquires a controlling interest in one or more other companies.

When a business takes over another business, two major problems arise. These are:

1. Those concern with the closing the books of the discontinuing business which is being wound up. 
2.  Those concern with the updating the records of the continuing business. 

Closing the Books of the Discontinuing Company
To close the books of the discontinuing company, the following ledger accounts are necessary:

1. Realization account 
2. Absorbing company’s account 
3.  Sundry members account 
4. Each liability account 
5. Bank account 
6. Account for each component of purchase consideration 

The operation of each of the ledger accounts mentioned above are similar to those of amalgamation except that all entries that are passed into new company’s account in amalgamation go to absorbing company account. On essence, profit or loss on realization is determined on realization account and transferred to sundry members’ ordinary account.

All liabilities are either paid off by the absorbed company or taken over by the absorbing company.

Each component of purchase consideration is transferred to sundry members ordinary or preference account.

All adjustments are made to bank account before the balance is transferred to realization account (i.e. bank/cash taken over by absorbing company).

It should be noted that where bank is not taken over, the balance should be debited to sundry members or ordinary account.

Accounting Entries in the Books of Absorbing or Continuing Business

The continuing business has been in existence before it took over the absorbed business. Therefore, its assets and liabilities will increase in proportion to the assets and liabilities taken over.

The account of its assets, liabilities and shareholders’ fund must be brought down in their respective ledger accounts. The records to incorporate the activities of the business taken over will be divided into two, as follows:

1. The absorbing journal 
2. Recording from the absorbing journal to the existing relevant ledger account. 

 The Absorption Journal

The journal is a composite journal which is prepared to reflect the assets and liabilities taken over and determine the goodwill or capital reserve. On the debit side of the journals are all tangible assets taken over at revaluation value or takeover value when such assets are not revalued. On the credit side of the journal are all the purchase considerations (including liabilities taken over) as stated on the credit side of the absorbing company account in the book of the discontinuing business. The difference between the debit and credit sides of the journal represent goodwill or capital reserve.

In essence, the journal is not different from the amalgamation journal except that in amalgamation, the amounts on the journals are combined amounts of the companies involved I the amalgamation, while in absorption it is only the amounts of the dissolved (absorbed) company. The formats of the two journals are similar.

Recording Items from the Absorption Journal to the Ledger Account

The ledger accounts opened for assets and claims over assets are scrutinized. Items in the absorbing journal and other journals are then transferred to the relevant ledger accounts with each of them having the narration ‘vendor’. Assets from the journal will be posted to the debit side of the relevant asset account while liabilities and claims over the assets from the journal will be posted to the credit side of each relevant ledger account.

After this, the ledger accounts are balanced and the balance sheet for the continuing business can be prepared.

 CONCLUSION

Business combination is the bringing together of separate entities or business into one reporting entity. The result of nearly all business combinations is that one entity, the acquirer, obtains control of one or more other businesses, the acquirees. All business combinations are accounted for by applying the acquisition method; the acquirer shall, therefore, disclose information that enables users of its financial statements to evaluate the nature and financial effect of business combination that were made during the period.

SUMMARY

In this Unit, readers are informed on what business combination is; and reasons that may lead to business combination which can be in form of either amalgamation or absorption. The readers were also taken through the various accounting entries with respect to amalgamation and absorption. The Unit is a demonstration of the fact that accounting treatments are very clear on the issues of purchase consideration determination, amalgamation processes, absorptions and takeovers.