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.
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:
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PREMIER TOOLS COMPANY Balance Sheet March 31, 20X3
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ASSETS
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LIABILITIES
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Current Assets
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Current Liabilities
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Cash
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$ 100,000
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Accounts payable
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$ 80,000
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Trading securities
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70,000
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Salaries payable
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10,000
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Accounts receivable
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80,000
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Interest payable
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10,000
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$ 100,000
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Inventories
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200,000
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$ 450,000
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Long-term Liabilities
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Long-term Investments
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Notes payable
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$ 190,000
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Investment in Sledge
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400,000
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Mortgage liability
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110,000
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300,000
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Property, Plant & Equipment
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$ 400,000
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Land
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$ 25,000
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STOCKHOLDERS' EQUITY
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Buildings and equipment (net)
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100,000
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125,000
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Intangible Assets
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Capital stock
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$ 300,000
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Patent
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225,000
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Retained earnings
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500,000
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800,000
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Total Assets
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$1 200 000
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Total Liabilities and Equity
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$1 200 000
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Notice the highlighted Investment in Sledge account above, indicating that Premier paid $400,000 for the stock of Sledge. Do take note that the $400,000 was not paid to Sledge; it was paid to the former owners of Sledge. Sledge merely has a new owner, but it is otherwise "unchanged" by the acquisition. Assume Sledge's separate balance sheet looks like this:
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SLEDGE HAMMER COMPANY Balance Sheet March 31, 20X3
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ASSETS
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LIABILITIES
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-1
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Current Assets
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Current Liabilities
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Cash
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$ 50,000
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Accounts payable
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$ 80,000
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Accounts receivable
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30,000
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Salaries payable
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20,000
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$ 100,000
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Inventories
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20,000
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$ 100,000
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Long-term Liabilities
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Notes payable
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50,000
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Property, Plant & Equipment
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$ 150,000
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Land
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$ 75,000
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STOCKHOLDERS' EQUITY
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Buildings and equipment (net)
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275,000
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350,000
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Capital stock
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$ 100,000
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Retained earnings
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200,000
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300,000
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Total Assets
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$ 450 000
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Total Liabilities and Equity
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$ 450 000
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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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Accounting 
