AFA 4e PPT Chap03
AFA 4e PPT Chap03
Chapter 3
Group Reporting II:
Application of the
Acquisition Method
under IFRS 3
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Copyright © 2019 by McGraw-Hill Education (Asia). All rights reserved.
Learning Objectives
Content
1. Introduction
Introduction
2. Overview of the consolidation process
3. Business combinations
4. Determining the amount of consideration transferred
5. Recognition and measurement of identifiable assets, liabilities and
goodwill
6. Conclusion
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Introduction
Separate financial
Consolidated financial statements
statements
(Economic entity)
(Legal entity)
In accordance with
Governing rules and
corporate regulations In accordance with IFRS 10
regulations
and IAS 27
IFRS 10 allowed for exemptions by a
parent if all conditions are met:
▪ A wholly owned or partially owned
subsidiary;
▪ Debt or equity instruments not
Possible exemptions traded in public;
No exemption
for presentation ▪ Did not file financial statements for
purpose of issuing instruments to
public; and
▪ Ultimate or any immediate parent
produces financial statements
available for public use
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Content
1. Introduction
2. Overview of
Overview of the
the consolidation
consolidation process
process
3. Business combinations
4. Determining the amount of consideration transferred
5. Recognition and measurement of identifiable assets, liabilities and
goodwill
6. Conclusion
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Consolidation Process
Intragroup Transactions
• Intragroup transactions are eliminated to:
– Show the financial position, performance and cash flows of the
economic (not legal) entity.
– Avoid double counting of transactions within the economic entity.
Example:
• Parent sold inventory to subsidiary for $2M
• The original cost of inventory is $1M
• Subsidiary eventually sold the inventory to external parties for $3M
Intragroup Transactions
Extract of consolidated worksheet
Consolidation
elimination entries
Parent's Subsidiary's Consolidated
and adjustment
Income Income income Without
Statement Statement Dr Cr statement elimination
Sales $2,000,000 $3,000,000 2,000,000 $3,000,000 $5,000,000
Cost of
sales (1,000,000) (2,000,000) 2,000,000 (1,000,000) ($3,000,000)
Gross
profit $1,000,000 $1,000,000 $2,000,000 $2,000,000
Note: Without elimination the consolidated sales and cost of sales figures
will be overstated by $2 M.
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Content
1. Introduction
2. Overview of the consolidation process
3. The acquisition
Business method
Combinations
4. Determining the amount of consideration transferred
5. Recognition and measurement of identifiable assets, liabilities and
goodwill
6. Conclusion
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Business Combinations
Business Combinations
Where an acquirer
obtains control of
Business
one or more
combinations
businesses (IFRS 3
App A)
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Transfer net
assets Acquirer’s separate
financial
Former owners of
statements will now
the net assets of
include goodwill
acquired
and other net
businesses
assets of the
Transfer acquired business
consideration
Acquirer’s Group
Former owners
transfers equity of
subsidiary
Former
owners of a Acquirer Subsidiary
subsidiary
Acquirer transfers
consideration
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Acquirer Acquiree
New legal
entity is
the
Net assets of acquirer are Net assets of acquiree, including
recognized at pre-
economic goodwill and identifiable net
combination carrying entity assets, are recognized at their
amounts acquisition date fair values
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Based on consideration
Based on entity size Based on dominance
transferred
Acquirer is usually the entity Acquirer is usually the entity: Acquirer is usually the entity:
that:
• Whose owners hold the • Whose owners have the
• Transfers cash or other largest relative voting rights ability to elect, appoint or
assets or incurs liabilities to in a combined entity remove a majority of
acquire another entity directors
• Whose owners hold the
▪ Issues shares as largest minority voting • Whose management is
consideration to acquire interest in the combined dominant in the combined
shares of another entity entity (if no other entity has entity
significant voting interest)
▪ Pays a premium over the •Who initiates the business
fair value of the equity • Which is larger in size combination
interest
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• Reverse acquisition
– Legal parent is the acquiree and legal subsidiary is the acquirer
– Often initiated by the legal subsidiary
– Motive for entering into such an arrangement often to seek a backdoor
listing
Company B
3. Company B has the power and ability (Legal subsidiary)
to affect the returns of the legal parent
after the share exchange
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Example
On 1 July 20x5, P (private), arranged to have all its shares acquired by L
(public listed). The arrangement required L to issue 20 million shares to P’s
shareholders in exchange for the existing 6 million shares of P. Existing shareholders
of L owned 5 million of L.
After the issue of 20 million L shares, P’s shareholders now owned 80% (20
million shares out of a total of 25 million shares) of the issued shares of L. L’s
shareholders owned 20% of the shares in the combined entity after the share issue. P’s
shareholder act in concert to exercise control over L.
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Content
1. Introduction
2. Overview of the consolidation process
3. Business combinations
4. Determining the
Determining the amount
amount of
of consideration
consideration transferred
transferred
5. Recognition and measurement of identifiable assets, liabilities and
goodwill
6. Conclusion
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FV of acquirer’s
equity: $Z Acquiree
FV of equity issued is either:
• X/Y multiplied by $Z; or
• A/B multiplied by $C
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Illustration 1:
Fair Value of Equity Issued
P Ltd acquires 100% of S Co through an issue of 5,000,000 shares
to the owners of S Co.
P Ltd S Co
Number of existing shares 10,000,000 2,000,000
Number of new shares issued 5,000,000 -
Market price per share $2.00 -
Fair value of equity 30,000,000 9,000,000
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Illustration 1:
Fair Value of Equity Issued
Situation 1: P Ltd’s market price is a reliable indicator
Consideration transferred = 5,000,000 shares x $ 2.00
= $10,000,000
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– Fair value of the contingent consideration has to be estimated through determining the
present value of the probability-weighted outcome; if the contingent event leads to a
refund (For example, event A) the fair value of the refund (probability-weighted
outcome) is deducted from consideration transferred
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Contingent consideration
• Assuming 2 outcomes
o Expected value = (Probability of contingent event
occurring * consideration) + (Probability of contingent
event not occurring * 0)
o Fair value = Present value of expected value
= PVF i,n x Expected value
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Acquisition-Related Costs
• All acquisition-related costs are expensed off
• Costs of issuing debt are recognized in accordance with IFRS 9
– As yield adjustment to the cost of borrowing and are amortized over the
tenure of the loan
– Journal entry for the payment of debt issuance cost
Dr Equity
Cr Cash
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Content
1. Introduction
2. Overview of the consolidation process
3. Business combinations
4. Determining the amount of consideration transferred
5.
5. Recognition and
Recognition and measurement
measurement of
of identifiable
identifiable assets,
assets,liabilities
liabilities and
and
goodwill
goodwill
6. Conclusion
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Recognition Principle
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Recognition Principle
• Identifiable net assets (INA) must comply with two conditions to qualify for
recognition:
– (1) INA must meet the definition of an asset or a liability
– (2) INA must be priced into the consideration transferred and must not be
separate stand-alone transactions
• Issue of pre-existing relationship and reacquired rights:
– As of the acquisition date, pre-existing relationships between acquirer and
acquiree comes to an end
• Rationale: Impossible to have contracts with oneself
– Effective termination of pre-existing relationship through a business
combination may give rise to a settlement gain or loss for the acquirer
– The settlement gain or loss is presumed to have been priced into the fair
value of consideration transferred by the acquirer
– Acquirer also recognizes “reacquired rights” as an intangible asset
• Rationale: It is deemed that the rights flowing from the pre-existing
contracts revert to the acquirer on the acquisition date
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Recognition Principle
Fair value of subsidiary’s
identifiable net assets
At acquisition date:
• Fair value differential
Fair value will be recognized in
differential the consolidation
worksheet
In subsequent years:
• Depreciation/amortization/
cost of sale of asset will be
Book value of Book value of based on the fair value
subsidiary’s subsidiary’s recognized at the
identifiable net identifiable net acquisition date
assets assets
These entries have to be re-
enacted every year until the
disposal of investment
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Intangible Assets
• IFRS 3 requires the acquirer to recognize the fair value of an acquiree’s
unrecognized identifiable assets (e.g. intangible asset) in the
consolidated financial statements
– Rationale: the acquisition event justifies recognition of intangible
assets
– Do not provide guidance on measurement of fair value of the
recognized intangible asset
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Intangible Assets
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Reliable
Probable
outflow of measurement
economic of amount of
resources obligation
Present
constructive or
legal obligations
arising from past
events
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Indemnification Assets
• Contractual indemnity
– Provided by the former owners of the acquiree to the acquirer to make
good any subsequent loss arising from contingency or an asset or a
liability
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Non-controlling interests
• Non-controlling interests (NCI) arises when acquirer obtains control of a
subsidiary but does not have full ownership of voting rights.
• Rationale: To represent outside equity interests’ share in the net assets of the
acquiree – the accounting equation at acquisition date is as follows:
Assets - Liabilities = Equity
Carrying Carrying
amount of amount of
acquirer’s acquirer’s Acquirer’s
assets + liabilities + equity + NCI
Acq date FV Acq date of share of
of acquiree’s FV of equity of
identifiable acquiree’s acquiree
assets + identifiable
Goodwill liabilities
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Non-controlling interests
• IFRS 3 allows NCI at acquisition date to be measured at either:
– Fair value; or
– The present ownership instruments’ proportionate share in the
recognized amount of identifiable assets
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Goodwill
• A premium that an acquirer pays to achieve synergies from business
combination
– Must be recognized separately as an asset
– Determined as a residual
• IFRS 3 allows 2 ways of determining goodwill:
Goodwill = Fair value of consideration transferred - Acquiree’s
+ recognized net
Fair value of non-controlling interests identifiable assets
+ measured in
Fair value of the acquirer’s previously accordance with
held interest in the acquiree IFRS 3
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Goodwill
Goodwill
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Goodwill
• The “top-down approach” (Johnson and Petrone, 1998) results in
measurement errors in goodwill
Consideration transferred +
Overpayment for an
acquisition or
Fair value of non-controlling interests
overvaluation of
consideration
transferred
Goodwill
Goodwill
Internally-generated
Goodwill Fair value of synergies
(Combination goodwill)
(Core Goodwill)
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Illustration 1: Goodwill
Illustration 1
On 1 July 20x1, P purchased 1.5 million shares from S Co’s existing owners.
Total number of shares issued by S Co was 2 million. A reliable FV of S Co’s
share was $10/share. P Co was obligated to pay an additional $1 million to
vendors of S Co if S Co maintained existing profitability over the subsequent
two years from 1 July 20x1. It was highly likely that S Co would achieve this
expectation and the fair value of the contingent consideration was assessed at
$1 million. FV of NCI as at 1 July 20x1 was $5 million. Assume a tax rate of
20%
Additional information of S Co.
• Book value of net assets: $3,650,000
• FV of net assets : $14,350,000
• FV less book value (net assets): $10,700,000
• Share capital: $2,000,000
• Retained earnings: $1,650,000
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Illustration 1: Goodwill
Determine the acquirer's interest in the acquiree:
1,500,000
Percentage ownership = (75%)
2,000,000
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<
+ Fair value of
Fair value of non-controlling interests identifiable net
at acquisition date
+ assets
Fair value of the acquirer’s previously
held interest in the acquiree
• In essence, a windfall gain to acquirer
• The acquirer must re-assess the fair value of identifiable net assets,
consideration transferred and non-controlling interests. If there is no
measurement error:
– The gain will be recognized immediately in the income statement
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Measurement Period
• IFRS 3 allows adjustments to be made retrospectively to “provisional
amounts” relating to goodwill, fair value of identifiable net assets and
consideration transferred if:
– New information about facts and circumstances existing at acquisition date
arises,
– Within 1 year of acquisition date (“Measurement period”)
• Events and circumstances arising after acquisition date does not lead to
measurement period adjustments
• Adjustments only allowed because of incorrect or incomplete information
available as at acquisition date but was missed or misapplied
• Any change in estimate arising from information on new events and
circumstances arising after acquisition date is not a correction of error and
will be recognized in the current period
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Investment Entity
Subsidiary Joint
Subsidiary Subsidiary Associate
(Service Co) Ventures
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Joint
Subsidiary Subsidiary Associate
Ventures
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Joint
Subsidiary Subsidiary Associate
Ventures
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Appendix 2:
Settlement of Pre-Existing Relationships
• IASB recognizes that the acquirer and acquiree may have a pre-
existing relationship or other arrangement before negotiations for the
business combinations began
– Hence total consideration may comprise of two parts:
• Accounted for as
Amount paid in business combination
exchange for acquiree using acquisition method
of accounting
Total
consideration
Amount paid in • Accounted for separately
settlement for other from business
transactions combination transactions
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Appendix 2:
Settlement of Pre-Existing Relationships
• The following indicators enables one to determine if transaction is part of the
exchange for the acquiree or separate from the business combination
1. Reason for transaction
• Understanding the intent and purpose of the transaction
2. Who initiated the transaction
• The identity of the party who initiated the transaction may provide some
insights as to whether the transaction was carried out as part of the
exchange for the acquiree
3. Timing of the transaction
• Transactions that occur before the negotiation are likely to provide little
or no benefit to the acquirer:
– Transaction that in effect settles pre-existing relationships between
acquirer and acquiree
– Transaction that remunerates employees or former owners of the
acquiree for future services
– Transaction that reimburses the acquiree or its former owners for
paying the acquirer’s acquisition costs
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Appendix 2:
Settlement of Pre-Existing Relationships
• Accounting treatment for settlement of pre-existing relationship
Settlement of
pre-existing
relationship
Contractual Non-contractual
relationship relationship
Appendix 2:
Settlement of Pre-Existing Relationships
• Remunerating employees for future services
– It is important to analyze carefully the nature of these employee
compensation arrangements in order to apply the proper accounting
treatment
– Payment can be made to either
• Pre-combination employment services; or
– Accounted for as part of the consideration transferred in the
business combination transaction
• Post-combination employment services; or
– Payment is accounted for separately from business
combination transactions
• A combination of pre- and post-combination services
– Amount paid will be allocated to payment for post combination
services and consideration transferred in exchange for the
acquiree
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Appendix 2:
Settlement of Pre-Existing Relationships
Employee
Compensation
Arrangements
Allocate to
Consideration remuneration Remuneration
transferred services first and services
rest to
consideration
transferred
Appendix 2:
Settlement of Pre-Existing Relationships
• Share based payment transactions
What should be done
In situations where the acquirer Acquirer should measure the liability
replaces the acquiree’s share-based or equity instrument relating to the
payment transactions with that of the replacement awards in accordance
acquirer with IFRS 2 Share-Based Payment
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Appendix 2:
Settlement of Pre-Existing Relationships
• Transaction for payment of acquisition costs
– IFRS 3 requires the acquirer to account for acquisition-related costs as
expenses in the periods in which the costs are incurred and the
services, received
– With the exception of cost incurred to issue debt or equity securities
• Rationale: Acquisition costs are neither part of the consideration
transferred in exchange for acquiree nor part of fair value of
identifiable net assets transferred by acquiree
– Acquirer is required to reimburse the acquiree or its former owners for
the payment of acquisition related expenses on behalf of the acquirer
has to be accounted for separately
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Conclusion
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Conclusion
• Acquisition method
– Identify acquirer with reference to the control criteria of IFRS 10
– Recognize and measure identifiable net assets at fair value at acquisition
date
– Goodwill is a residual figure and is determined on a “top-down” approach
▪ May include recognition and measurement errors and identifiable
elements
• Measurement period
– Acquirers are allowed a 12 month measurement period to correct and revise
the following on a retrospectively basis:
1. Provisional amounts of goodwill
2. Fair value of identifiable net assets
3. Fair value of Non-controlling interests
4. Fair value of previously held interests
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