Goodwill arising in consolidation
In the group accounts that we have analyzed up to now, the cost of the shares acquired by the parent company has always been equal to the nominal value of said shares. This is rarely the case in practice and we must now consider some more complicated examples. First, we will examine the entries made by the parent company on its own balance sheet when it acquired shares.
Suppose that when the directors of company X agree to pay $120,000 for a 100% investment in A limited, they must believe that in addition to its $80,000 tangible assets, ABC limited must also have $40,000 worth of intangible assets. . This amount of $40,000 paid in excess of the value of the tangible assets acquired is called goodwill arising on consolidation (sometimes called acquisition premium).
When company X limited wants to buy shares in company Y limited it must pay the previous owners of those shares. The most obvious form of payment would be cash. Suppose X buys all of the $40,000 1 shares in Y and pays $60,000 in cash to the previous shareholders under consideration. The entries in the X books would be:
Debit – Investment in Y at cost $60,000
However, previous shareholders might be willing to invest in some other worthwhile company. For example, they might accept an agreed number of shares in limited X. X limited would then issue new shares in the agreed number and allocate them to the former shareholders of s Y limited. This type of deal may be attractive to X as it avoids the need for a large cash outlay. The first of shareholder Y would return an indirect interest in the profitability of that company through his new interest in its parent company.
Goodwill and acquisition gains
Assuming instead that Company S made a profit of $8,000 in the period before the acquisition, its balance sheet just before the purchase would be as follows.
Net tangible assets $40,000
Share capital $40,000
If H now buys all the shares of company S, he will acquire $48,000 worth of net tangible assets (capital stock + reserves) at a cost of $60,000. Clearly, in this case, intangible assets S (goodwill) are valued at $12,000 by the parent company and must be incorporated in the write-off process to arrive at a goodwill figure that arises on consolidation. In other words, not only the share capital of S, but also its acquisition reserves, must be written off against the asset “investment in S limited” in the accounts of the parent company. The unhidden balance of $12,000 appears on the consolidated balance sheet.
The consequence of this is that the acquisition reserves of a subsidiary company are not aggregated with the reserves of the parent companies in the consolidated balance sheet. The consolidated reserves figure includes parent reserves plus post-acquisition reserves from subsidiaries only. Post-acquisition reserves are simply reserves, not less reserves at the time of acquisition.