MODULE 12 Accounting For Business Combination PART 2
MODULE 12 Accounting For Business Combination PART 2
12
INTRODUCTION
This module aims to provide students additional guidance for applying the
acquisition method to types of business combinations. This module also deals with
accounting treatment for business combination in relation to goodwill, reverse
acquisitions, and combination of mutual entities.
LEARNING CONTENT
Requirements:
Compute for the following:
a. Number of shares issued by ABC Co.
b. Par value per share of the shares issued
c. Acquisition-date fair value of the net identifiable assets of XYZ
Solutions:
Requirement (a): Number of shares issued
The consideration transferred is in the form of shares. Accordingly, this is reflected on
the increase in share capital and share premium:
The fair value of the shares issued as consideration for the business combination is
₱1,000,000.
Fair value of shares transferred 1,000,000
Divided by: ABC’s fair value per share 100
Number of shares issued 10,000
Additional information:
ABC’s share capital consists of 60,000 ordinary shares with par value of ₱10 per share
XYZ’s share capital consists of 3,000 ordinary shares with par value of ₱100 per share.
Requirements:
Compute for the following:
a. Number of shares issued by ABC Co.
b. Fair value per share of the shares issued
c. Goodwill recognized on acquisition date
d. Retained earnings of the combined entity immediately after the business combination
Solutions:
Requirement (a): Number of shares issued
ABC Co. Combined entity Increase
Share capital 600,000 700,000 100,000
XYZ’s equity accounts are ignored in the computations above because an acquiree’s
(subsidiary) equity accounts are eliminated in the consolidated financial statements
and replaced by non-controlling interest.
Requirement (c): Goodwill
Consideration transferred 1,000,000
Non-controlling interest in the acquiree -
Previously held equity interest in the acquiree -
Total 1,000,000
Fair value of net identifiable assets acquired (700,000)
Goodwill 300,000
The statement of financial position of the combined entity immediately after the
business combination is shown below:
Combined entity
Identifiable asset 4,000,000
Goodwill 300,000
Total Assets 4,300,000
Liabilities 1,600,000
Share capital 700,000
Share premium 1,200,000
Retained earnings 800,000
Total Liabilities and equity 4,300,000
On January 1, 20x4, ABC acquired additional 60% ownership interest in XYZ for
₱800,000. Relevant information follows:
a. The previously held 15% interest has a carrying amount of ₱170,000 on
December 31, 20x3 and fair value of ₱180,000 on January 1, 20x4.
b. XYZ’s net identifiable assets have a fair value of ₱1,000,000.
c. ABC elected to measure NCI at proportionate share.
Requirement:
Compute for the goodwill under each of the scenarios below.
Solution:
Consideration transferred
800,000
Non-controlling interest in the acquiree 250,000
Previously held equity interest in the acquiree
180,000
Total 1,230,000
Fair value of net identifiable assets acquired
(1,000,000)
Goodwill 230,000
Solution:
Consideration transferred -
Non-controlling interest in the acquiree 400,000
Previously held equity interest in the acquiree 600,000
Total 1,000,000
Fair value of net identifiable assets acquired (1,000,000)
Goodwill -
Solution:
Consideration transferred
-
Non-controlling interest in the acquiree
1,000,000
Previously held equity interest in the acquiree
-
Total
1,000,000
Fair value of net identifiable assets acquired
(1,000,000)
Goodwill
-
Measurement Period
If the initial accounting for a business combination is incomplete by the end of
the reporting period in which the combination occurs, the acquirer can use
provisional amounts to measure any of the following for which the accounting
is incomplete:
a. Consideration transferred
b. Non-controlling interest in the acquiree
c. Previously held equity interest in the acquiree
d. The identifiable assets acquired and liabilities assumed
Fact Pattern
On October 1, 20x1, ABC Co. acquired all the identifiable assets and assumed all of
the liabilities of XYZ, Inc. for ₱1,000,000. On this date, XYZ’s the identifiable assets
and liabilities have fair values of ₱1,600,000 and ₱900,000, respectively.
On July 1, 20x2, ABC received the valuation report for the building. The buildings
fair value on October 1, 20x1 is ₱500,000 and its remaining useful life from that
date is 5 years.
Requirements:
a. What is the measurement period?
b. How should ABC account for the new information obtained on July 1, 20x2?
c. How much is the adjusted goodwill?
d. What are the adjusting entries?
Solution:
Requirement (a): Measurement period
The measurement period is from October 1, 20x1 to September 30, 20x2, or if
earlier, (i) the date ABC Co. obtains the information it was seeking about the
facts and circumstances that existed as of the acquisition date or (ii) the date
ABC Co. learns that more information is not obtainable.
If monthly depreciation expenses were recognized during January to June 30, 20x2,
those shall be adjusted accordingly.
Requirement:
Compute for the adjusted goodwill and provide the adjusting entries.
Solutions:
Provisional Adjusted
Consideration transferred 1,000,000 1,000,000
Non-controlling interest in the acquiree - -
Previously held equity interest in the
acquiree - -
Total 1,000,000 1,000,000
Fair value of net identifiable assets
acquired (700,000) (800,000)
Goodwill 300,000 200,000
Requirement:
Compute for the adjusted goodwill.
Solution:
Provisiona Adjusted
l
Consideration transferred 1,000,000 1,100,000
Non-controlling interest in the acquiree - -
Previously held equity interest in the
acquiree - -
Total 1,000,000 1,100,000
Fair value of net identifiable assets
acquired (700,000) (900,000)
Goodwill 300,000 200,000
Illustration:
ABC Co. acquired all the assets and liabilities of XYZ, Inc. for ₱1,000,000. XYZ’s
assets and liabilities have fair values of ₱1,600,000 and ₱900,000, respectively.
Additional information:
a. XYZ incurred ₱10,000 legal fees in processing the regulatory requirements
for the combination. ABC agreed to reimburse the said amount.
b. XYZ will terminate its activities after the business combination. ABC agreed
to reimburse XYZ’s estimated liquidation costs of ₱200,000.
c. ABC will retain XYZ’s former key employees. ABC agreed to pay the key
employees ₱100,000 as signing bonuses.
d. ABC agreed to pay additional ₱50,000 directly to Mr. Numerix, the previous
major shareholder of XYZ, to persuade him in selling his shareholdings to
ABC.
e. Ms. Vital Statistix, a former major shareholder of XYZ, will acquire title to the
inventories with fair value of P90,000 that were included in the asset
valuation.
Requirement:
Compute for the goodwill or gain on bargain purchase.
Solution:
Consideration transferred 1,050,000
Non-controlling interest in the acquiree -
Previously held equity interest in the acquiree -
Total 1,050,000
Fair value of net identifiable assets acquired (610,000)
Goodwill 440,000
Reacquired rights
A right that an acquirer has previously granted to the acquiree, that is
reacquired as a result of the business combination is recognized as an
intangible asset separately from goodwill.
Examples of reacquired rights:
1. Right to use the acquirer’s intangible assets such as trade name
under a franchise agreement.
2. Right to use the acquirer’s technology under a technology
licensing agreement.
The settlement gain or loss is adjusted for the derecognition of any related
asset or liability that the acquirer has previously recognized.
Additional information:
Prior to business combination, ABC granted XYZ the right to use ABC’s
patented technology over a 5-year period in exchange for ₱100,000 cash
(payable on grant date) and royalty fees based on XYZ’s sales over the 5-year
period.
ABC recognized the ₱100,000 license fee as deferred liability (unearned
income) and amortized it over 5 years. The carrying amount of the deferred
liability on January 1, 20x1 is ₱60,000.
On the other hand, XYZ recognized the license fee as prepayment (prepaid
asset) and amortized it based on the number of products sold. The carrying
amount of the prepayment on January 1, 20x1 is ₱50,000.
On acquisition date, the fair value of the license agreement is ₱120,000. This
consists of the following components:
₱40,000 “at-market” (based on market participants’ estimates); and
₱80,000 “off-market” (the excess of ₱120,000 fair value from cash
flow estimates over ₱40,000 ‘at-market’ value).
The off-market component is favorable to XYZ and unfavorable to
ABC, as royalty rates have increased considerably in comparable
markets since the initiation of the contract. The contract does not
have any cancellation clause or any minimum royalty payment
requirements.
Requirement:
Compute for goodwill or gain on bargain purchase.
Solution:
As mentioned in the previous chapter, a reacquired right is measured based on the
remaining term of the related contract. This is in contrast with other assets which
are measured based on market participation.
In the illustration above, the ₱80,000 “off-market” value is unfavorable from the
perspective of ABC Co. (because the royalty fees that XYZ is paying ABC are below-
market rate). Accordingly, ABC recognizes a settlement loss.
ABC recognizes the ₱40,000 “at-market” value component of the reacquired right as
an intangible asset, separate from goodwill, to be amortized over the remaining
term of the agreement.
The ₱50,000 prepayment recognized by XYZ is excluded from the identifiable assets
acquired and replaced by the intangible asset on the reacquired right.
Journal entries:
Jan 1, Identifiable assets acquired 1,590,000
20x1 Goodwill 230,000
Liabilities assumed 900,000
Cash 920,000
To record the business
combination
Jan 1, Settlement loss 20,000
20x1 Deferred liability 60,000
Cash 80,000
To record the effective settlement
of pre-existing relationship as a
separate transaction from business
combination transaction
Notes:
Additional information:
ABC and XYZ have a pre-existing supply contract under which ABC could
purchase raw materials from XYZ at discounted rates. The contract has a
remaining term of three years, which ABC can terminate by paying ₱100,000
penalty.
The supply contract has a fair value of ₱160,000, of which ₱70,000 is “at-
market”. The “off-market” component is unfavorable to ABC because it
exceeds the price of current market transactions for similar items.
No assets or liabilities related to the contract were recognized in either of
ABC’s or XYZ’s books as at the acquisition date.
Solution:
The ₱90,000 “off-market” value is unfavorable from the perspective of ABC Co.
Accordingly, ABC recognizes a settlement loss.
ABC is the defendant on a pending patent infringement suit filed by XYZ. ABC
recognized a provision of ₱130,000 on the lawsuit. After the business combination,
the disputed patent will be transferred to ABC. The fair value of settling the pending
lawsuit is ₱100,000.
Requirement:
Compute for the goodwill.
Solution:
The ₱100,000 fair value is excluded from the consideration transferred on the
business combination and treated as payment for the settlement of the pre-exiting
relationship (separate transaction).
Journal entries:
Jan 1, Identifiable assets acquired 1,600,000
20x1 Goodwill 200,000
Liabilities assumed 900,000
Cash 900,000
Jan 1, Estimated liability on a pending lawsuit 130,000
20x1 Cash 100,000
Settlement gain 30,000
Subsequent Measurement and Accounting
Subsequent to acquisition date, the acquirer accounts for assets acquired,
liabilities assumed and equity instruments issued in a business combination in
accordance with other PFRSs applicable to those items. However, the following
are subsequently accounted for under PFRS 3:
a. Reacquired rights
b. Indemnification assets
c. Contingent liabilities recognized as of the acquisition date
d. Contingent Consideration
I. Reacquired Rights
Reacquired rights recognized as intangible assets are amortized over
the term of the related contract
B. Subsequent measurement
A change in fair value of a contingent consideration resulting from
additional information obtained during the measurement period is
accounted for as a retrospective adjustment to provisional amount.
Changes in fair value that are not measurement period adjustments
are accounted for depending on the classification of the contingent
consideration:
a. A contingent consideration classified as equity is not
remeasured and its subsequent settlement is accounted for
within equity.
b. A contingent consideration classified as an asset or a
liability is measured at fair value at each reporting date.
Changes in fair value are recognized in profit or loss.
Illustration 1: Contingent consideration classified as equity
On January 1, 20x1, ABC Co. issued 10,000 shares with par value of ₱10 per share and fair value
of ₱100 per share in exchange for all the assets and liabilities of XYZ. XYZ’s assets and liabilities
have fair values of ₱1,600,000 and ₱900,000, respectively.
In addition, ABC agrees to issue additional 1,000 shares to the former owners of XYZ if the
market price of ABC’s shares increases to ₱120 per share by December 31, 20x1. The fair value
of the contingent consideration as of January 1, 20x1 is ₱90,000, based on consideration of the
vesting conditions.
Requirement:
Compute for the goodwill.
Solution:
Consideration transferred (1M+90K contingent
consideration) 1,090,000
Non-controlling interest in the acquiree -
Previously held equity interest in the acquiree -
Total 1,090,000
Fair value of net identifiable assets acquired (700,000)
Goodwill 390,000
Journal entries:
Jan 1, Identifiable assets acquired 1,600,000
20x1 Goodwill 390,000
Liabilities assumed 900,000
Share capital 100,000
Share premium 900,000
Share premium-contingent 90,000
consideration
Solution:
Dec 31,
No Entry
20x1
Jan 15, Share premium-contingent consideration 90,000
20x2 Share capital 10,000
Share premium 80,000
To record the issuance of 1,000
additional shares
A contingent consideration that is classified as equity is not remeasured and its subsequent
settlement is accounted for within equity.
Case #2
The market price of ABC’s share on December 31, 20x is ₱90.
Regardless of whether the vesting condition is met, the amount recognized in equity for a
contingent consideration remain in equity. This, however, does not preclude an entity from
transferring amounts within equity (reclassification between equity accounts).
ABC agrees to pay additional cash equal to 10% of the 20x1 year-end profit that exceeds
₱400,000. XYZ historically has reported profits of ₱300,000 to ₱400,000 each year. The fair
value of the contingent consideration as of January 1, 20x1 is ₱10,000, based on assessments of
the expected level of profits for the year, as well as, forecasts, plans and industry trends.
Solution:
Consideration transferred (1M+10K contingent
consideration) 1,010,000
Non-controlling interest in the acquiree -
Previously held equity interest in the acquiree -
Total 1,010,000
Fair value of net identifiable assets acquired (700,000)
Goodwill 310,000
Journal entries:
Jan 1, Identifiable assets acquired 1,600,000
20x1 Goodwill 310,000
Liabilities assumed 900,000
Liability for contingent consideration 10,000
Cash 1,000,000
Solution:
Dec 31, Unrealized loss – P/L 5,000
20x1 Liability for contingent consideration 5,0000
To recognize loss on change in fair
value of contingent consideration
classified as liability
Jan 15, Liability for contingent consideration 15,000
20x2 Cash 15,000
Case #2
The profit for the year is ₱300,000.
Solution:
Dec 31, Liability for contingent consideration 10,000
20x1 Gain on extinguishment of liability - P/L 10,000
In Case 1 & 2 above, the fair value changes relate to the meeting and non-meeting of the
earnings target, which are not measurement period adjustments. Accordingly, these are
recognized in profit or loss. The recognized goodwill is not affected regardless of the outcome
of the contingency.
Five years ago, XYZ appointed Mr. Boss as the CEO under a ten-year contract which requires
XYZ to pay Mr. Boss ₱100,000 if XYZ is acquired before the contract expires. ABC assumes the
obligation to pay Mr. Boss the contracted amount.
Requirement: Compute for the goodwill.
Solution:
Consideration transferred 1,000,000
Non-controlling interest in the acquiree 80,000
Previously held equity interest in the acquiree -
Total 1,080,000
Fair value of net identifiable assets acquired (600,000)
Goodwill 480,000
The employment contract existed long before the business combination, and for the purpose of
obtaining the services of the CEO. There is no evidence that the agreement was arranged
primarily for the benefit of ABC or the combined entity. Therefore, the ₱100,000 obligation is
treated as an additional liability assumed rather than an adjustment to the consideration
transferred.
DIFFERENCES BETWEEN THE PROVISIONS OF THE FULL PFRS AND THE PFRS
FOR SMEs
7. Contingent consideration
Initial measurement Initial measurement
Included in the consideration Included in the cost of business
transferred at acquisition-date combination if it is probable
fair value and can be measured reliably.
Goodwill
Only a goodwill that arises from a business combination is recognized as an
asset.
Goodwill is measured and recognized on acquisition date. Subsequent
expenditures on maintaining goodwill are expensed already.
After initial recognition, goodwill is not amortized but rather tested for
impairment at least annually. For this purpose, goodwill is allocated to each
of the acquirer’s cash-generating unit (CGU) in the year of the business
combination. If the allocation is not completed by the end of that year, it must
be completed before the end of the immediately following year.
Cash-Generating Unit
Is the “smallest identifiable group of assets that generates cash inflows that
are largely independent of the cash inflows from other assets or group of
assets” (PAS 36.6)
Due Diligence
Due diligence audit refers to the investigation of all areas if a potential
acquiree’s business before an investor agrees to a business combination
transaction. The term “due diligence” may refer to the exercise of care that a
reasonable and prudent person should take before entering a contract with
another party. Due diligence audit is a service most commonly performed by
CPAs or external auditing firms.
Due diligence audit helps investor evaluate the possible risks and rewards of
the potential investment and determine whether it would be a good decision to
pursue it.
Solution:
Average earnings (650,000 ÷ 5yrs) 130,000
Normal Earnings on average net assets [10% x (2.75M ÷
(55,000)
5)]
Excess earnings 75,000
Divided by: Capitalization rate 30%
Goodwill 250,000
Add: Fair value of net identifiable assets acquired 590,000
Estimated purchase price 840,000
Requirement: Compute for the estimated purchase price and goodwill in the
contemplated business combination.
Solution:
Average earnings (650,000 ÷ 5yrs) 130,000
Divided by: Capitalization rate 16%
Estimated purchase price 812,500
Fair value of net identifiable assets acquired 590,000
Goodwill 222,500
Requirement: Compute for the estimated purchase price using the "present
value of average excess earnings" approach.
Solution:
Average earnings 1,300,000
Normal earnings in the industry (12% x 10M*) (1,200,000)
Excess earnings 100,000
Multiply by: PV of an ordinary annuity @10%, n=5 3.79079
Goodwill 379,079
Solution:
Average earnings (squeeze) 1,300,000
Normal earnings in the industry (12% x 10M*) (1,200,000)
Excess earnings or Superior earnings 100,000
Divided by: Capitalization rate 25%
Goodwill 400,000
Alphabets Corporation issues 10% preference shares with par value per
share of P100 for the net assets contributions of the combining constituents
and ordinary shares with par value per share of ₱50 for the excess of total
contributions (net assets contribution plus goodwill) over net assets
contributions.
The normal rate of return is 10% of net assets. Excess earnings will be
capitalized at 20%.
Solutions:
Requirement (a):
ABC Co. XYZ, Inc. Total
Average annual earnings 80,000 120,000
Normal earnings on net
assets (40,000) (60,000)
Excess earnings 40,000 60,000
Divide by: Capitalization rate 20% 20%
Goodwill 200,000 300,000 500,000
Requirement (b):
ABC Co. XYZ, Inc. Total
Total contribution
(squeeze) 600,000 900,000 1,500,000
Fair value of net assets (400,000) (600,000)
Goodwill 200,000 300,000
Requirement (c):
ABC Co. XYZ, Inc. Total
Net assets contributions 400,000 600,000 1,000,000
Divide by: Par value per share of PS 100 100 100
Number of preference shares
issued 4,000 6,000 10,000
Reverse Acquisitions
In a reverse acquisition, the entity that issues securities (the legal acquirer) is
identified as the acquiree for accounting purposes, while the entity whose
equity interests are acquired (the legal acquiree) is the acquirer for
accounting purposes.
For example, ABC Co., a private entity, wants to become a public entity but does
not want to register its shares. To accomplish this, ABC will arrange for a public
entity to acquire its equity interests in exchange for the public entity’s equity
interests.
In here, the public entity is the legal acquirer because it issued its equity
interests, and ABC Co. is the legal acquiree because its equity interests were
acquired. However, when applying the acquisition method:
a. the public entity is identified as the acquiree for accounting purposes
(accounting acquiree); and
b. ABC Co. is identified as the as the accounting acquirer.
Requirements:
a. Identify the accounting acquirer
b. Compute for the goodwill
Solution:
Requirement (a):
Legal form of the contract: ABC issues 5 shares for each of the 8,000 outstanding
shares of XYZ. After the issuance, ABC’s equity will have the following structure:
Analysis:
The business combination is a reverse acquisition because XYZ obtains control
over ABC despite the fact that ABC is the issuer of shares. In other words, XYZ let
itself be acquired (legal form) in order to gain control over ABC (substance).
Requirement (b):
Substance of the contract: XYZ obtains control over ABC in a reverse acquisition.
Accordingly, the consideration transferred is computed based on the number of
shares XYZ (accounting acquirer) would have had to issue to give ABC (accounting
acquiree) the same percentage of equity interest in the combined entity.
If the business combination had taken the form of XYZ issuing additional ordinary
shares to ABC’s shareholders, XYZ would have had to issue 2,000 shares for the
ratio of ownership interest in the combined entity to be the same. XYZ’s
shareholders would then own 8,000 of the 10,000 issued shares of XYZ (80% of the
combined entity), while ABC’s shareholders own 2,000 (20% of the combined
entity).
The consideration transferred includes only those that are transferred to the
previous owners of the acquiree. It excludes those that are retained by the
combined entity after the combination and those that are in effect used to
settle a pre-existing relationship.
Notable differences between the provision of the full PFRSs and the PFRS for SMEs:
Full PFRSs PFRS for SMEs
6. Previously held equity interest in the acquiree
In a business combination achieved in No equivalent provision under PFRS for
stages, the acquirer's previously held SMEs.
equity interest in the acquiree is
remeasured to fair value and included in
the computation of goodwill
7. Contingent consideration
Initial measurement: initial measurement:
Included in the consideration Included in the cost of business
transferred at acquisition-date fair combination if it is probable and can be
value. measured reliably.
Subsequent measurement: Subsequent measurement:
a) a measurement period adjustment is Change in fair value is treated as an
adjusted to goodwill. adjustment to the cost of business
combination (i.e., adjustment to
b) not a measurement period
goodwill).
adjustment:
i. remains in equity, if the contingent
consideration is classified as equity
ii. is recognized in profit or loss, if the
contingent consideration is classified as
liability or asset.
MODULE SUMMARY
Goodwill arising from a business combination is not amortized but tested for
impairement at least annually.
In a reverse acquisition, the issuer of shares ( the legal acquirer) is the
accounting acquiree.
The consideration transferred in a reverse acquisition is measured based on
the number of equity interest the legal subsidiary (accounting acquirer)
would have had to issue to give the owner of the legal parent (accounting
acquiree) the same percentage of equity interest in the combined entity that
results fron the reverse acquisition.
REFERENCES:
BOOKS:
WEBSITE REFERENCES:
http://www.iasplus.com/
http://www.picpa.com.ph/
MODULE ACTIVTY/ASSESSMENT
ACTIVITY 1:
2. This type of business combination occurs when, for example, a private entity
decides to have itself “acquired” by a smaller public entity in order to obtain a
stock exchange listing.
a. Step acquisition c. Reverse acquisition
b. Rewind acquisition d. Stock acquisition
Requirements:
a. How much is the estimated goodwill under the multiples of average excess earnings
method?
b. How much is the estimated goodwill under the capitalization of average excess
earnings method? Use a capitalization rate of 25%.
c. How much is the estimated goodwill under the capitalization of average earnings
method? Use a capitalization rate of 12.5%.
d. How much is the estimated goodwill under the present value of average excess
earnings method? Use a discount rate of 10%.