Absorption Accounting and the Post-Merger Balance Sheet

Understand Absorption and Preparing the Post-Merger Balance Sheet

Key rules to remember

Purchase consideration

Purchase consideration = Fair value of shares issued + cash paid + other consideration given to the transferor's shareholders

Under the acquisition method, shares issued are valued at fair value, not face value. Use the issue price given in the question.

Goodwill or capital reserve (acquisition method)

Goodwill = Consideration − (Fair value of identifiable assets − Fair value of liabilities taken over)

A positive result is goodwill. A negative result is a bargain purchase gain, recognised after reassessment. It is recognised in other comprehensive income and accumulated in equity as capital reserve. If there is no clear evidence of a bargain purchase, it goes directly to capital reserve in equity.

Share capital issued

Shares to be issued = Consideration payable in shares ÷ Issue price per share

Share capital = number of shares × face value. Securities premium = number of shares × (issue price − face value).

Difference under pooling of interests

Difference = Share capital issued by transferee (plus any other consideration) − Share capital of transferor

Under common control, the transferor's reserves are carried over in the same form. The difference is adjusted in equity, usually in capital reserve. If shares issued exceed the transferor's share capital, the difference is a debit.

Post-merger balance sheet

Post-merger item = Transferee's own balance + Absorbed balance (at fair value or carrying amount) ± adjustments

Total assets must equal total equity and liabilities. Use this as your final check.

Transaction costs

Acquisition-related costs are expensed in the period incurred

Costs of issuing shares are dealt with under the equity standards, not added to goodwill.

How to solve Absorption and Preparing the Post-Merger Balance Sheet questions

1. 1Read the question for common control. If the companies are under the same promoter or group control, use pooling at carrying amounts. If not, use the acquisition method at fair values.
2. 2List the transferor's assets and liabilities. Under the acquisition method, replace book values with fair values given. Exclude items the transferee does not take over, such as cash if it is excluded.
3. 3Compute the purchase consideration. Include shares at fair value (or at face value under pooling, if the question gives no other value), cash, and any other payment.
4. 4Find the number of shares to be issued and split the amount into share capital and securities premium.
5. 5Pass the takeover entry in the transferee's books. Debit each asset taken over. Credit each liability and the consideration. The balancing figure is goodwill, or capital reserve (acquisition), or the adjustment in reserves (pooling).
6. 6Handle adjustments. Cancel inter-company debtors and creditors, remove unrealised profit in stock, and treat transaction costs as an expense. Settle any statutory reserve or liquidation expenses as the question directs.
7. 7Prepare the post-merger balance sheet. Add the transferee's old balance to the absorbed items line by line under the correct heads: equity, non-current and current liabilities, non-current and current assets.
8. 8Check that total assets equal total equity and liabilities. Fix any gap before you write the final answer.

Quickest way: Net asset and balancing figure shortcut

Common mistakes in Absorption and Preparing the Post-Merger Balance Sheet

• Using book values under the acquisition method

  Students copy the transferor's balance sheet and forget the fair value table in the question.

  Fix: Under the acquisition method, always use fair values for assets and liabilities. Use book values only for items where fair value equals book value.

• Valuing shares issued at face value when the question gives a market or fair value

  Students think consideration always equals face value of shares.

  Fix: Under the acquisition method, value shares at fair value. Credit share capital at face value and the excess to securities premium.

• Showing goodwill under pooling of interests

  Students apply one method to every question.

  Fix: Check for common control first. Under pooling, no goodwill arises. The difference goes to capital reserve or reserves.

• Dropping the transferor's reserves under pooling, or carrying them under the acquisition method

  Students mix up the two treatments.

  Fix: Under pooling, preserve the transferor's reserves in the same form. Under the acquisition method, the transferor's reserves are not carried over.

• Forgetting inter-company balances

  The transferee's debtors and the transferor's creditors seem unrelated.

  Fix: Check the notes for dealings between the two companies. Cancel the matching debtor and creditor, and remove any unrealised profit in stock.

• Balance sheet does not tally

  Students miss the premium, forget the new shares, or add a liability on the wrong side.

  Fix: Tick off each item of the takeover entry as you move it. Total both sides and trace any gap back to the entry.

Worked examples