Chapter 2
Business
Combinations
© 2013 Advanced Accounting, Canadian Edition by G. Fayerman
Definition of a Business Combination
• IFRS 3 defines a business combination as:
“a transaction or other event in which an acquirer
obtains control of one or more businesses”
• Control exists when the investor is exposed, or has
rights, to variable returns from its involvement with
the investee and has the ability to affect those
returns through its power over the investee.
• A “business” is not just a group of assets, rather, it is
an integrated set of activities and assets (i.e., an
entity) able to produce output.
LO 1
Definition of a Business Combination
• Note the use of the phrase “integrated set of
activities” in the definition of a business.
• Goodwill arises where there is synergy between
assets.
• Goodwill is defined in IFRS 3 as an asset representing
the future economic benefits arising from assets
acquired in a business combination that are not
individually and separately recognized.
• A very important principle is that goodwill can only be
recognized when assets are acquired as part of a
business.
LO 1
Forms of Business Combinations
Four general forms of business combinations are as follows
(assuming the existence of two companies – A and B):
1. A acquires all assets and liabilities of B.
B continues as a company, holding shares in A.
2. A acquires all assets and liabilities of B.
B liquidates.
3. C is formed to acquire all assets and liabilities of A and
B.
A and B liquidate.
4. A acquires a group of net assets of B, the group of net
assets constituting a business, such as a division, branch,
or segment, of B.
B continues to operate as a company.
Refer to Illustration 2.3 “General Forms of Business Combinations” of text for key steps
involved under each of the above scenarios.
LO 1
Accounting for Business
Combinations: Basic Principles
•
IFRS 3 prescribes the acquisition method in
accounting for a business combination. The key
steps in this method are:
1. Identify an acquirer;
2. Determine the acquisition date;
3. Recognize and measure the identifiable assets
acquired, the liabilities assumed, and any noncontrolling interest in the acquiree; and
4. Recognize and measure goodwill or a gain
from bargain purchase.
LO 2
Identifying the Acquirer
• The business combination is viewed from the
perspective of the acquirer.
• The acquirer is the entity that obtains control of the
acquiree.
• An acquirer must be identified in every business
combination.
• In most cases this step is straight forward. In other
cases judgement may be required. For example,
consider where two existing entities (A&B)
combine and a new entity (C) is formed to
acquire all the shares of the existing entities.
• Who is the acquirer? It cannot be C.
o Indicative factors contained within Appendix B of IFRS 3 assist in
identifying the acquirer.
LO 2
Identifying the Acquirer
• The acquisition method requires the assets and
liabilities of the acquiree to be measured at fair
value whereas the assets and liabilities of the
acquirer continue to be measured at their carrying
values.
• IFRS 3 provides some indicators to assist in assessing
which entity is the acquirer:
o Is there a large minority voting interest in the combined entity?
o What is the composition of the governing body of the combined entity?
o What is the composition of the senior management that governs the
combined entity subsequent to the combination?
o What are the terms of the exchange of equity interests?
o Which entity is the larger?
o Which entity initiated the exchange?
o What are the relative voting rights in the combined entity after the
business combination?
LO 2
Determining the Acquisition Date
• Acquisition date is the date that the acquirer
obtains control of the acquiree.
• Determining the correct acquisition date is
important as the following are affected by the
choice of acquisition date:
o The fair values of net assets acquired
o Consideration given, where the consideration takes a
non-cash form
o Measurement of the non-controlling interest (discussed
in chapter 5).
LO 3
Accounting in the Records of the Acquirer:
Assets Acquired and Liabilities Assumed
Fair value allocation occurs at acquisition date and
requires the recognition of:
• Identifiable tangible and intangible assets
• Liabilities
• Contingent liabilities
• Any non-controlling interest in the acquiree
• Goodwill
FVINA = fair value of identifiable net assets (including
contingent liabilities)
LO 3
Accounting in the Records of the Acquirer:
Contingent Liabilities
• IFRS 3 requires that contingent liabilities which can be
measured reliably are recognized by the acquirer.
• The above requirement does not consider issues of
probability.
• Therefore contingent liabilities where a present
obligation exists but that do not qualify for recognition
in the acquiree's books under IAS 37 may be
recognized by the acquirer as part of a business
combination.
• The fair value of a contingent liability is the amount
that a third party would charge to assume those
contingent liabilities. Such an amount reflects the
expectations about possible cash flows. This is not
simply the expected maximum/minimum cash flow.
LO 3
Accounting in the Records of the Acquirer:
Measurement
• IFRS 3 requires that assets acquired and liabilities and
contingent liabilities assumed are measured at fair value.
• Fair value is basically market value and is determined by
judgement, estimation and a three-level ‘fair value
hierarchy’ as described in IFRS 13.
• Acquirer has 12 months from acquisition date to
determine fair values.
• At first balance date after acquisition the fair values may
only be provisionally determined – a best estimate.
• Finalization of fair values will result in adjustments to
goodwill.
LO 3
Accounting in the Records of the Acquirer:
Consideration Transferred
The acquirer measures the consideration transferred
as the fair values at the date of acquisition of:
• Assets given
• Liabilities (including contingent liabilities)
assumed
• Equity instruments
LO 3
Accounting in the Records of the Acquirer:
Consideration Transferred
The consideration paid by the acquirer may consist
of one or a number of the following forms of
consideration:
•
•
•
•
•
•
Cash
Non-monetary assets
Equity instruments
Liabilities undertaken
Cost of issuing debt/equity instruments
Contingent consideration
LO 3
Accounting in the Records of the Acquirer:
Consideration Transferred
Cash
• Where the settlement is deferred, the cash must be
discounted to present value as at the date of
acquisition.
• The discount rate used is the entity’s incremental
borrowing rate.
Equity instruments
• Where an acquirer issues their own shares as
consideration they need to determine the fair
value of the shares as at the date of exchange.
• If listed, the fair value is the quoted market price of
the shares (with a few limited exceptions).
LO 3
Accounting in the Records of the Acquirer:
Consideration Transferred
Costs of issuing debt and equity instruments
• Transaction costs such as underwriting costs and
brokers fees may be incurred in issuing equity
instruments.
• Such costs are considered to be an integral part of the
equity transaction and should be recognized directly in
equity.
• Journal entry required would be:
Dr
Share Capital
Cr
Cash
xxx
xxx
• Costs associated with the issue of debt instruments are
included in the measurement of the liability.
LO 3
Accounting in the Records of the Acquirer:
Consideration Transferred
Contingent consideration
• In some cases the agreement will provide for an
adjustment to the cost of the combination contingent
on a future event.
• Example - where an acquirer issues shares as part of
their consideration, the agreement may require an
additional payment of the value of the shares falls
below a certain amount within a specified period of
time.
• If the adjustment is probable and can be measured
reliably, then the amount should be included in the
calculation of the cost of acquisition.
LO 3
Accounting in the Records of the Acquirer:
Consideration Transferred
Acquisition related costs
• Acquisition related costs that are directly
attributable to a business combination do not form
part of the consideration transferred, rather they
are expensed as incurred.
• Examples include finder’s fees; advisory, legal
accounting, valuation and other professional or
consulting fees; and general administrative costs,
including the costs of maintaining an internal
acquisitions department.
LO 3
Accounting in the Records of the Acquirer:
Income Taxes
• IFRS 3 specifically identifies the following tax
effects:
o deferred tax assets due to loss carryforwards
o temporary differences due to the difference between
the fair value and the undepreciated capital cost.
• Under IFRS 3.25, an acquirer is required to
recognize and measure the effect of any
temporary differences and carryforwards of an
acquiree that exist at the acquisition date or that
arise as a result of the acquisitions.
LO 3
Accounting in the Records of the Acquirer:
Goodwill
• When a business combination results in goodwill,
IFRS 3 requires that the goodwill is:
o recognized as an asset
o measured at its cost at the date of acquisition
• Goodwill = consideration transferred – acquirer’s
interest in the FVINA.
• Goodwill is considered to be a residual interest.
• Goodwill is an unidentifiable asset which is
incapable of being individually identified and
separately recognized.
LO 3
Accounting in the Records of the Acquirer:
Gain on Bargain Purchase
• Where the acquirer’s interest in the net fair value of the
acquiree’s identifiable assets and liabilities is greater than the
consideration transferred, the difference is called a gain on a
bargain purchase.
• Goodwill = acquirer’s interest in the FVINA – consideration
transferred.
• Before a gain is recognized, the acquirer must reassess
whether it has correctly:
o identified all the assets acquired and liabilities assumed
o measured at fair value all the assets acquired and liabilities
assumed
o measured the consideration transferred (IFRS 3.36).
• A gain on bargain purchase and goodwill cannot be
recognized in the same business combination.
LO 3
Accounting in the Records of the Acquirer:
Gain on Bargain Purchase
• A gain on bargain purchase for the acquirer arises
from:
o Errors in measuring fair value
o Another standard’s requirements
o Superior negotiating skills
• The existence of a gain on bargain purchase is a
rare event.
• In the event of a gain on bargain purchase the
acquirer is required to recognize any gain
immediately in the profit & loss.
LO 3
Accounting by the Acquirer:
Shares Acquired in an Acquiree
• When shares are acquired rather than the net
assets the investment is accounted for in
accordance with IFRS 9 Financial Instruments.
• IFRS 9 requires the investment to be accounted
for at fair value plus transaction costs.
• The accounting treatment in the acquirers books
at acquisition is:
Dr Investment in Acquiree
Cr Share capital
Cr Cash
xxx
xxx
xxx
LO 3
Accounting in the Records
of the Acquiree
• If acquiree does not liquidate, it recognizes a gain
or loss on the sale of the assets and liabilities that
formed the part of the business being sold.
Refer to Illustrative Example 2.5 in the text.
• If the acquiree decides to liquidate, it transfers the
cash remaining to the shareholders as a liquidating
dividend.
• No entries needed if acquiree only parts with
shares.
LO 4
Subsequent Adjustments to the Initial
Accounting for Business Combinations
Adjustments may be made subsequent to acquisition
date in relation to:
• Goodwill
• Contingent liabilities
• Contingent consideration
Goodwill
• On an ongoing basis goodwill is subject to
impairment testing.
LO 5
Subsequent Adjustments to the Initial
Accounting for Business Combinations
Contingent liabilities
• Contingent liabilities are initially recognized at fair value.
• Subsequent to acquisition date the liability is measured as
the higher of:
o (a) the best estimate of the expenditure required to settle
the present obligation; and
e.g., where a liability was recognized in relation to a court case
o (b) the amount initially recognized less cumulative
amortization recognized in accordance with IAS 18
Revenue.
e.g., where a liability was recognized in relation to a guarantee
• Subsequent adjustments do not affect the goodwill
calculated at acquisition date.
LO 5
Subsequent Adjustments to the Initial
Accounting for Business Combinations
Contingent consideration
• At acquisition date, the contingent consideration
is measured at fair value, and is classified either:
o as equity (for example, the requirement for the acquirer
to issue more shares subject to subsequent events); or
o as a liability (for example, the requirement to provide
more cash subject to subsequent events).
LO 5
Subsequent Adjustments to the Initial
Accounting for Business Combinations
Contingent consideration
• Subsequent accounting treatment is a follows:
o where classified as equity, no remeasurement is required,
and the subsequent settlement is accounted for within
equity. This means that extra equity instruments issued are
effectively issued for no consideration and there is no
change to share capital.
o where classified as a liability, it will be accounted for
under IAS 39 and measured at fair value with movements
being accounted for in accordance with that standard.
• Subsequent adjustments do not affect the
goodwill calculated at acquisition date.
LO 5
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