A business combination is when separate entities or businesses are combined into one reporting entity. Under U.S. GAAP business combinations can be structured as mergers, acquisitions or consolidations.

• In a merger, the acquirer takes 100% of the target company. Only one entity remains in existence.
• An acquisition occurs when one entity acquires "control" over the net assets of another entity. Both entities continue as separate entities through a parent-subsidiary relationship.
• A consolidation happens when two entities combine their resources and share the risk and rewards of co-ownership. Shareholders of two entities become shareholders of the combined entity.

IFRS makes no such distinction amongst business combinations.

The combined entity is required to publish consolidated financial statements. The two methods of accounting for a business combination are the acquisition method (which replaces the purchase method) and the pooling of interests method.

The fundamental difference between the two methods is the assumption made regarding whether there is a change in ownership as a result of the business combination.

• The pooling of interests method is used when some business combination are assumed to merge the ownership interests of two entities, rather than transfer control from the stockholders of one entity to those of the surviving entity. The financial statements of the separate entities are added together at their historical book values.

• The acquisition method accounts for a business combination as the acquisition of one company by another. As a result of the purchase, there is a change in the owners of the subsidiary. The change in ownership and the existence of a purchase price usually result in the revaluation of assets and liabilities at the acquisition date. That is, the assets and liabilities of the acquired company are received into the financial statements of the acquirer at their fair market values at the acquisition date.

Shareholders of the acquired company would recognize gain on the sale of the shares, so their preferences would be for the transaction to be treated as a pooling of interests, which was non-taxable to them.

In 2001 the FASB discontinued the acceptability of the pooling of interests method. A primary reason was the lack of comparability between the two methods. Keep in mind the combinations that were initiated before July 1, 2001 could still be accounted for using the pooling method.

The IFRS require that the acquisition (purchase) method should be used after March 2004.

Acquisition Method

Current IFRS and U.S. GAAP accounting standards require the use of the acquisition method to account for business combinations. The acquisition method treats the combinations as the purchase of one or more companies by another.

Balance Sheet:

• Assets and liabilities acquired are recorded at their fair values.
• Any excess of cost over fair value of net assets acquired is recorded as goodwill.

Income Statement:

• The excess of cost over book value is depreciated or amortized to reduce future earnings.
• Goodwill is not amortized but is tested annually for impairment.
• The acquired company's earnings are included with the acquiring firm's only from the date of combination forward.

Other Issues

Goodwill

Goodwill is the excess purchase price after recognizing the fair market value of all identifiable net tangible and intangible assets acquired. Goodwill has an indefinite life and is not amortized but is evaluated at least annually for impairment. Impairment losses are reported on the income statement.

• Initial recognition. If the acquisition is less than 100%, U.S. GAAP requires the noncontrolling interest to be measured at fair value (full goodwill), whereas IFRS provide the option for full or partial goodwill (measure the noncontrolling interest at the proportionate share of the acquiree's identifiable net assets).
• Level of impairment testing for goodwill.
  • IFRS: Cash generating unit (CGU) - the lowest level to which goodwill can be allocated.
  • GAAP: Reporting unit - either a business segment or one organizational level below.

• Calculating impairment of goodwill.
  • IFRS: One-step: compare recoverable amount of a CGU (higher of a) fair value less costs to sell and (b) value in use) to carrying amount.
  • GAAP: Two steps: 1. Compare FV of the reporting unit with its carrying amount including goodwill. If FV is greater than carrying amount, no impairment (skip step 2). 2. Compare implied FV of goodwill with carrying amount.

In-Process R & D

U.S. GAAP requires that in-process R&D (IPRD) of the target company should be expensed at the date of acquisition, which results in a large one-time charge. IFRS requires to identify IFRD as a separate asset with a finite life, or to include it as part of goodwill.

Minority Interests

If the acquiring company acquires less than 100%, minority (noncontrolling) shareholders' interests are reported on the consolidated financial statements (a separate line item in the equity section). However, IFRS and U.S. GAPP still differ on the measurement of noncontrolling interests.

Contingent Consideration

IFRS and U.S. GAAP classify contingent consideration as either a financial liability or equity.