59
CHAP TER 3
Business Combinations
A Note On Relevant Accounting Standards
3-0. During the period until 2011 when IFRSs are incorporated into Canadian GAAP, the
CICA Handbook contains two different Sections which deal with business combination transactions. Further, in those cases where the business combination involves the acquisition of a
subsidiary, there are three Sections which deal with the preparation of consolidated financial
statements. Section 1581, which was introduced into the Handbook in 2001, can still be used
until convergence occurs in 2011. If an enterprise chooses to apply this standard, it must
continue to use Section 1600, the section on consolidated financial statements that was introduced into the Handbook in 1975.
As noted in Chapter 1, in January, 2009, three new CICA Handbook Sections were added.
These were:
•
•
•
Section 1582, “Business Combinations”;
Section 1601, “Consolidated Financial Statements”; and
Section 1602, “Non-Controlling Interests”.
These new sections serve to largely converge the CICA Handbook material on business combinations and consolidations with the relevant IFRSs. In particular, the content of Section 1582
is identical to IFRS No. 3, Business Combinations.
The focus of the material in this Chapter and in the subsequent Chapters dealing with the
preparation of consolidated financial statements, will be new Sections 1582, 1601, and 1602.
Over the next few years, the use of the older Handbook Sections will decline and, in 2011,
they will no longer be part of Canadian GAAP. Given this, we do not believe that it is appropriate to continue detailed coverage of these standards. If such coverage is relevant to your
needs, it can be found in the previous edition of this text.
Business Combinations Defined
Basic Definition
3-1.
The CICA Handbook defines a business combination transaction in the following
manner:
Paragraph 1582.02A(e) A business combination is a transaction or other event in
which an acquirer obtains control of one or more businesses. Transactions sometimes
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Chapter 3
Legal Avenues To Combination
referred to as “true mergers” or “mergers of equals” are also business combinations as
that term is used in this Section.
3-2. The economic concept that underlies the term “business combination” is that you have
two or more independent and viable economic entities that are joined together for future
operations as a single economic or business entity. The original economic entities can be
corporations, unincorporated entities, or even a separable portion of a larger economic
entity. The key factor is that each could be operated as a single, viable, business entity.
3-3. The question of whether a group of assets constitutes a business is relevant in that the
accounting procedures for a business combination can be significantly different than those
used for a simple acquisition of assets. Specifically, no goodwill can be recognized when there
is an acquisition of assets that do not constitute a business. Because of the importance of this
difference, Section 1582 provides a definition of a business:
Paragraph 1582.02A(d) A business is an integrated set of activities and assets that is
capable of being conducted and managed for the purpose of providing a return in the
form of dividends, lower costs, or other economic benefits directly to investors or
other owners, members or participants.
Examples
Covered By Section 1582
3-4. Examples of business combination transactions that are within the scope of Section
1582 include the following:
•
•
•
•
A corporation acquires all of the net assets of a second corporation for cash and the
activities of the corporation meet the definition of a business.
A corporation issues shares to the owners of an unincorporated business in return for
all of their net assets and these net assets meet the definition of a business.
A corporation issues new shares as consideration for all of the outstanding shares of a
second corporation and the activities of the corporation meet the definition of a
business.
A new corporation is formed and issues shares to the owners of two separate unincorporated businesses in return for all of the net assets of the two enterprises.
Excluded From The Scope Of Section 1582
3-5. Section 1582 specifically excludes certain transactions from its scope. These are listed
in Paragraph 1582.02 as follows:
•
•
•
•
The formation of a joint venture.
The acquisition of a group of assets that do not constitute a business. In this situation,
the assets acquired will be accounted for separately. If their cost does not equal the
sum of their fair values, the consideration paid will be allocated to the individual
assets in proportion to their fair value (a so-called basket purchase).
A combination of businesses that are under common control. For example, if one
subsidiary of Company A were to acquire the assets of a different subsidiary of
Company A, the transaction would not be considered to be a business combination.
A combination between not-for-profit organizations. In addition, Section 1582 does
not apply to the acquisition of a profit oriented organization by a not-for-profit organization. These transactions are dealt with under CICA Handbook Section 4450.
“Reporting Controlled And Related Entities By Not-For-Profit Organizations.
Legal Avenues To Combination
The Problem
3-6. In reading the preceding section, it is likely that you recognized that a variety of legal
forms can be used to combine the operations of two independent business entities. The
choice among these forms involves a great many issues, including tax considerations, the
Business Combinations
Legal Avenues To Combination
desire to retain the name of one of the enterprises, the ability to access the capital markets in a
particular manner, or simply various contractual arrangements that one or both of the enterprises have with suppliers, employees, or customers.
3-7. This is an important issue for accountants as the legal form used can, in some circumstances, obscure the actual economic substance of a transaction. An outstanding example of
this type of situation would be transactions that are referred to as reverse acquisitions.
Example Of Reverse Acquisition Company X, with 100,000 shares outstanding ,
issues 400,000 of its shares to the shareholders of Company Y in return for all of the
shares of that Company. From a legal perspective, Company X is the parent company,
because it is holding 100 percent of the shares of Company Y. Correspondingly, from a
legal perspective, Company Y is the subsidiary. However, from an economic point of
view, the former shareholders of Company Y now own a controlling interest in
Company X. This means that, in actual fact, the subsidiary, Company Y has acquired
the parent, Company X.
3-8. As an accountant’s mandate is to focus on economic substance, the accountant must
be able to look through the complex legal structures that are sometimes used to effect business combinations. This is necessary in order to base accounting procedures on the real
events that have occurred. To accomplish this goal, accountants must have some knowledge
of the various legal forms that are used. As a result, we will illustrate the basic legal forms that
can be used to effect a business combination.
3-9. Note, however, this is an extremely complex area, particularly when consideration is
given to tax factors. A full discussion of legal forms for business combinations goes beyond the
scope of this text.
Example
3-10. Our discussion of legal form will use a simple example to illustrate the various
possible alternatives.
Example The Alpha Company and the Beta Company have, for a variety of reasons,
decided to come together in a business combination transaction and continue their
operations as a single economic entity. The date of the combination transaction is
December 31, 2009 and, on that date the Balance Sheets of the two companies are as
follows:
Alpha And Beta Companies
Balance Sheets
As At December 31, 2009
Alpha
Beta
Current Assets
Non-Current Assets
$153,000
82,000
$ 35,000
85,000
Total Assets
$235,000
$120,000
Liabilities
$ 65,000
Common Stock:
(5,000 Shares Issued And Outstanding)
95,000
(10,000 Shares Issued And Outstanding)
N/A
Retained Earnings
75,000
$ 42,000
Total Equities
$120,000
$235,000
N/A
53,000
25,000
3-11. In order to simplify the use of this Balance Sheet information in the examples which
follow, we will assume that all of the identifiable assets and liabilities of the two Companies
have fair values that are equal to their carrying values. In addition, we will assume that the
shares of the two Companies are trading at their book values. This would be $34.00 per share
61
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Chapter 3
Legal Avenues To Combination
Figure 3 - 1
Acquisition Of Assets From Beta Company
$78,000 In Cash
Alpha
Company
Beta
Company
Beta’s Assets And Liabilities
for Alpha [($95,000 + $75,000) ÷ 5,000] and $7.80 per share for Beta [($53,000 + $25,000)
÷ 10,000]. This indicates total market values for Alpha Company and Beta Company of
$170,000 and $78,000, respectively.
Basic Alternatives
3-12. We will consider four basic alternatives in our discussion of the legal forms for implementing business combination transactions. These alternatives can be outlined as follows:
Forms Based On An Acquisition Of Assets
1. Alpha Company could acquire the net assets of Beta Company through a direct
purchase from Beta. The consideration paid to Beta could be cash, other assets,
or Alpha Company debt or equity securities.
2. A new organization, Sigma Company, could be formed to directly acquire the net
assets of Alpha Company and Beta Company. As the Sigma Company is newly
formed, it would generally not have any assets to use as consideration in this
transaction. Given this, Alpha and Beta would receive debt or equity securities of
Sigma Company.
Forms Based On An Acquisition Of Shares
1. Alpha could acquire the shares of Beta Company directly from the shareholders of
Beta. The consideration paid to the Beta shareholders could be cash, other assets,
or Alpha Company debt or equity securities.
2. A new organization, Sigma Company, could be formed. Sigma Company could
then issue its debt or equity securities directly to the shareholders of Alpha
Company and Beta Company in return for the shares of the two Companies.
3-13. There are other possibilities here. For example, if Alpha had a subsidiary, Alpha could
gain control over Beta by having the subsidiary acquire the Beta Company shares from the
Beta shareholders. In addition, most corporate legislation provides for what is referred to as a
statutory amalgamation. This involves a process whereby two corporations become a single
corporation that is, in effect, a continuation of the predecessor corporations. However, an
understanding of the four basic approaches we have described is adequate for the purposes of
this material. These basic alternatives will be discussed and illustrated in the material which
follows.
Acquisition Of Assets By Alpha Company
3-14. Perhaps the most straightforward way in which the Alpha and Beta Companies could
be combined would be to have one of the Companies simply acquire the net identifiable
assets directly from the other Company. Using our basic example, assume Beta’s fair market
value is $78,000 (equal to the Company ’s net book value of $53,000 + $25,000). Based on
this, Alpha Company gives Beta Company cash of $78,000 to acquire the assets and liabilities
of Beta Company. This approach is depicted in Figure 3-1.
Business Combinations
Legal Avenues To Combination
3-15. At this point, it is likely that the Beta Company would go through a windup operation.
This would involve distributing the cash received from Alpha Company to its shareholders in
return for their shares. If this were to happen, the Beta Company shares would be canceled
and the Beta Company would cease to exist as a separate legal entity.
3-16. Without regard to the course of action taken by Beta Company after the sale of its net
assets, all of the assets and liabilities of the combined Companies will be recorded on Alpha
Company ’s books and the accounting for the combined Companies will take place as a
continuation of Alpha Company ’s records. This means that the business combination transaction has been carried out in such a fashion that both Companies’ operations have been
transferred to a single continuing legal entity.
3-17. Alpha Company ’s Balance Sheet subsequent to the business combination transaction
would be as follows:
Alpha Company
Balance Sheet As At December 31, 2009
Acquisition Of Beta Assets For Cash
Current Assets ($153,000 - $78,000 + $35,000)
Non-Current Assets ($82,000 + $85,000)
$110,000
167,000
Total Assets
$277,000
Liabilities ($65,000 + $42,000)
Common Stock (Alpha’s 5,000 Shares)
Retained Earnings (Alpha’s Balance)
$107,000
95,000
75,000
Total Equities
$277,000
3-18. It would not be necessary for Alpha to acquire 100 percent of the net assets of Beta in
order to have the transaction qualify as a business combination transaction. If Alpha were to
acquire, for example, the manufacturing division of Beta, this transaction would be subject to
the accounting rules for business combinations. The key point is that Alpha must acquire a
group of assets sufficient to meet the definition of a business entity.
3-19. You should also note that this business combination transaction could have been
carried out using Alpha Company shares rather than cash. While the economic outcome
would be the same unification of the two Companies, the resulting Alpha Company Balance
Sheet would be somewhat different.
3-20. More specifically, the Current Assets would not have been reduced by the $78,000
outflow of cash and there would be an additional $78,000 in Common Stock outstanding . If
the new shares were issued at their December 31, 2009 market value of $34.00 per share, this
transaction would have required 2,294 new Alpha shares to be issued ($78,000 ÷ $34.00).
This alternative Balance Sheet would be as follows:
Alpha Company
Balance Sheet As At December 31, 2009
Acquisition Of Beta Assets For Shares
Current Assets ($153,000 + $35,000)
Non-Current Assets ($82,000 + $85,000)
$188,000
167,000
Total Assets
$355,000
Liabilities ($65,000 + $42,000)
Common Stock ($95,000 + $78,000)
Retained Earnings (Alpha’s Balance)
$107,000
173,000
75,000
Total Equities
$355,000
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Chapter 3
Legal Avenues To Combination
Figure 3 - 2
New Company Acquisition Of Assets From Beta Company
17,000 Sigma Shares
Alpha
Company
Sigma
Company
Assets And Liabilities
Of Alpha And Beta
Beta
Company
7,800 Sigma Shares
Acquisition Of Assets By Sigma Company (A New Company)
3-21. The acquisition of assets approach could also be implemented through the use of a
new corporation. Continuing to use our basic example, assume that a new Company, the
Sigma Company, is formed and the new Company decides to issue shares with a fair market
value of $10 per share. Based on this value and the respective market values of the two
companies, Sigma will issue 17,000 shares to Alpha Company ($170,000 ÷ $10) and 7,800
shares to Beta Company ($78,000 ÷ $10) in return for the assets and liabilities of the two
Companies.
3-22. You should note that any value could have been used for the Sigma Company shares
as long as the number of shares issued to Alpha and Beta was proportionate to the market
values of the two companies. For example, a value of $5 could have been used for the Sigma
shares, provided 34,000 shares were issued to Alpha and 15,600 shares to Beta (34,000
shares at $5 equals the $170,000 fair market value for Alpha, while 15,600 shares at $5 equals
the $78,000 fair market value for Beta). This approach to bringing the two companies
together is depicted in Figure 3-2.
3-23. Under this approach, Sigma Company acquires the net assets of both Alpha and Beta
Companies. As Sigma is a new company, it would not have significant assets. Unless this new
company issues debt to finance the acquisition of Alpha and Beta, the only consideration that
can be used in this transaction would be newly issued Sigma shares. Sigma Company ’s
Balance Sheet subsequent to the business combination transaction would be as follows:
Sigma Company
Balance Sheet As At December 31, 2009
Current Assets ($153,000 + $35,000)
Non-Current Assets ($82,000 + $85,000)
$188,000
167,000
Total Assets
$355,000
Liabilities ($65,000 + $42,000)
Common Stock
(24,800 Shares Issued And Outstanding)
$107,000
Total Equities
$355,000
248,000
3-24. As was the case when Alpha acquired the net assets of Beta on a direct basis, the result
of the business combination is that both Companies’ operations have been transferred to a
single continuing legal entity. The only difference here is that the continuing legal entity is a
new company rather than one of the combining Companies.
Business Combinations
Legal Avenues To Combination
Figure 3 - 3
Acquisition Of Shares From Beta Shareholders
Alpha
Company
$78,000
In Cash
Shareholders
Of
Beta
Beta
Company
100% Of Beta
Shares
3-25. The resulting Sigma Company Balance Sheet is fundamentally the same as the one
that resulted from Alpha Company acquiring the net assets of Beta using Alpha shares as
consideration (see Paragraph 3-20). The only difference is that, because Sigma is a new
Company, all of the Shareholders’ Equity must be allocated to Common Stock, rather than
being split between Common Stock and Retained Earnings.
Acquisition Of Shares By Alpha Company
Procedures
3-26. Another legal route to the combination of Alpha and Beta would be to have one of the
two Companies acquire a majority of the outstanding voting shares of the other Company.
Continuing to use our basic example, the Alpha Company will give $78,000 in cash to the Beta
shareholders in return for 100 percent of the outstanding shares of the Beta Company. This
approach is depicted in Figure 3-3.
3-27. While in this example we have assumed that Alpha acquired 100 percent of the shares
of Beta, a business combination would have occurred as long as Alpha acquired sufficient
shares to achieve control over Beta. In general, this would require acquisition of a majority of
Beta’s voting shares.
3-28. The acquisition of shares could be carried out in a variety of ways. Alpha could simply
acquire the shares in the open market. Alternatively, they could be acquired from a majority
shareholder, through a public tender offer to all shareholders, or through some combination
of these methods.
3-29. Regardless of the method used, acquisition of a majority of the outstanding voting
shares of Beta Company would mean that Alpha Company is in a position to exercise
complete control over the affairs of the Beta Company. As a result of this fact, the two
Companies could be viewed as a single economic entity and a business combination could be
said to have occurred.
3-30. This would be the case despite the fact that the two Companies have retained their
separate legal identities. In this situation, in order to reflect the economic unification of the
two Companies, consolidated financial statements would have to be prepared. While we
have not yet covered the detailed procedures for preparing consolidated financial statements, the basic idea is that the investee’s (subsidiary ’s) assets and liabilities will be added to
those of the investor (parent). The resulting consolidated Balance Sheet would be as follows:
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Chapter 3
Legal Avenues To Combination
Alpha Company And Subsidiary
Consolidated Balance Sheet
As At December 31, 2009
Current Assets ($153,000 - $78,000 + $35,000)
Non-Current Assets ($82,000 + $85,000)
$110,000
167,000
Total Assets
$277,000
Liabilities ($65,000 + $42,000)
Common Stock (Alpha’s 5,000 Shares)
Retained Earnings (Alpha’s Balance)
$107,000
95,000
75,000
Total Equities
$277,000
Advantages Of Using Shares
3-31. At first glance, it would appear that gaining control of a business by acquiring its
shares would be a less desirable alternative than acquiring the assets of the desired business.
When shares are acquired, the result is that the combined company is operating as two separate and distinct legal entities. This requires the application of the complex procedures
associated with preparing consolidated financial statements. Alternatively, if assets are
acquired, the combined assets wind up on the books of a single legal entity and consolidation
procedures are not required.
3-32. Despite the complexities associated with preparing consolidated financial statements, there are a number of advantages that can be associated with acquiring shares rather
than assets to effect the business combination transaction:
•
The acquisition of shares can be a method of going around a company’s management
if they are hostile to the idea of being acquired.
•
Less financing is needed as only a majority share ownership is required for control
over 100 percent of the net assets.
•
It may be possible to acquire shares when the stock market is depressed, thereby
paying less than the fair values of the identifiable assets of the business.
•
Shares, particularly if they are publicly traded, are a much more liquid asset than
would be the individual assets of an operating company.
•
The acquisition of shares provides for the continuation of the acquired company in
unaltered legal form. This means it retains its identity for marketing purposes, the tax
basis of all of its assets remain unchanged, and there is no interruption of the business
relationships that have been built up by the acquired company.
3-33. As a result of all of these advantages, the majority of business combinations involving
large, publicly traded companies will be implemented using a legal form which involves an
acquisition of shares.
Acquisition Of Shares By Sigma Company (A New Company)
3-34. As was the case with business combinations based on an acquisition of assets, an alternative to having one entity acquire the shares of the other is to establish a new company to
acquire the shares of both predecessor companies. As in our earlier example, we will call the
new company Sigma Company. We will assume that it issues 17,000 of its shares to the shareholders of Alpha Company in return for all of their outstanding shares. Correspondingly,
7,800 shares will be issued to the shareholders of Beta Company in return for all of their
outstanding shares. This business combination transaction is depicted in Figure 3-4
(following page).
Business Combinations
Legal Avenues To Combination
Figure 3 - 4
New Company Acquisition Of Shares From Beta Shareholders
Sigma Company
100% of
Alpha Shares
Shareholders
Of Alpha
17,000 Sigma
Shares
Alpha
Company
7,800 Sigma
Shares
Beta
Company
100% of Beta
Shares
Shareholders
Of Beta
3-35. In this case, there will be three ongoing legal entities. These would be the parent
Sigma Company, as well as Alpha Company and Beta Company, which have now become
subsidiaries. Once again we are faced with a situation in which, despite the presence of more
than one separate legal entity, the underlying economic fact is that we have a single unified
economic entity. This requires the information for these three Companies to be presented in a
single consolidated Balance Sheet as follows:
Sigma Company And Subsidiaries
Consolidated Balance Sheet
As At December 31, 2009
Current Assets ($153,000 + $35,000)
Non-Current Assets ($82,000 + $85,000)
$188,000
167,000
Total Assets
$355,000
Liabilities ($65,000 + $42,000)
$107,000
Common Stock (24,800 Shares Issued And Outstanding) 248,000
Total Equities
$355,000
3-36. You will note that the only differences between this consolidated Balance Sheet and
the one that was prepared when Alpha acquired the shares of Beta (see Paragraph 3-30) are:
•
Current Assets are $78,000 higher because Alpha used cash as consideration where
Sigma issued Common Stock.
•
Shareholders’ Equity consists only of Common Stock with no Retained Earnings
balance because Sigma is a new Company.
Exercise Three - 1
Subject
Legal Avenues To Combination
Two corporations, Blocker Company and Blockee Company, have decided to
combine and continue their operations as a single economic entity. The date of the
business combination transaction is December 31, 2009 and, on that date, the
Balance Sheets of the two Companies are as follows:
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Chapter 3
Legal Avenues And Tax Considerations
Blocker and Blockee Companies
Balance Sheets As At December 31, 2009
Blocker
Company
Blockee
Company
Current Assets
Non-Current Assets
$1,406,000
2,476,000
$ 987,000
1,762,000
Total Assets
$3,882,000
$2,749,000
Liabilities
Common Stock:
(180,000 Shares Outstanding)
(51,000 Shares)
Retained Earnings
$ 822,000
$ 454,000
1,800,000
N/A
1,260,000
N/A
1,145,000
1,150,000
Total Equities
$3,882,000
$2,749,000
All of the identifiable assets and liabilities of the two Companies have fair values that
are equal to their carrying values. The shares of the two Companies are trading at their
book values. This would be $17 per share for Blocker [($1,800,000 + $1,260,000) ÷
180,000] and $45 per share for Blockee [($1,145,000 + $1,150,000) ÷ 51,000]. This
indicates total market values for Blocker Company and Blockee Company of
$3,060,000 and $2,295,000, respectively.
Prepare the December 31, 2009 Balance Sheet for the economic entity that results
from the following business combinations:
A. Blocker acquires 100 percent of the net assets of Blockee in return for consideration of $2,295,000. The consideration is made up of $795,000 in cash and debt
securities with a maturity value of $1,500,000.
B. Blocker acquires 100 percent of the outstanding shares of Blockee by issuing
135,000 new Blocker shares to the Blockee shareholders. The total market value
of these shares is $2,295,000 [(135,000)($17)].
C. A new company, Blockbuster Inc., is formed. The new company decides to issue
shares with a fair market value of $15 per share. The shareholders of Blocker
receive 204,000 of the new shares in return for their Blocker shares (total fair
market value of $3,060,000), while the shareholders of Blockee receive 153,000
of the new shares in return for their Blockee shares (total fair market value
$2,295,000).
End of Exercise. Solution available in Study Guide.
Legal Avenues And Tax Considerations
Acquisition Of Assets
Cash Consideration
3-37. While it would not be appropriate in financial reporting material to provide a
comprehensive discussion of the tax provisions that are associated with the various legal
avenues to combination, these matters are of sufficient importance that a brief description of
major tax aspects is required.
3-38. Looking first at combinations involving the acquisition of assets, there is a need to
distinguish between situations in which cash and/or other assets are the consideration and
those situations in which new shares are issued. If a company acquires the assets of another
Business Combinations
Legal Avenues And Tax Considerations
business through the payment of cash or other assets, the acquired assets will have a
completely new tax base, established by the amount of non-share consideration given. There
would be no carry over of any of the tax values (i.e., adjusted cost base or undepreciated
capital cost) that are associated with the business which gave up the assets.
Share Consideration
3-39. The same analysis could apply to situations in which shares are issued to acquire the
assets of another business. However, while the transfer might take place at new tax values,
there is also the possibility that different values might be used. As long as the transferor of the
assets is a Canadian corporation, the parties to the combination can use the Income Tax Act
Section 85 rollover provisions. In simplified terms, ITA Section 85 allows assets to be transferred at an elected value that could be anywhere between the fair market value of the assets
and their tax values in the hands of the transferor.
Tax Planning
3-40. In general, investors will prefer to acquire assets rather than shares. In most situations, the value of the acquired assets will exceed their carrying values and, if the investor
acquires assets, these higher values can be recorded and become the basis for future capital
cost allowance (CCA) deductions. In contrast, if the investor acquires shares, the investee
company will continue to use the lower carrying values as the basis for CCA, resulting in higher
taxable income and taxes payable.
3-41. In addition, if the investor acquires shares, any problems involving the investee’s tax
returns for earlier years are acquired along with the shares. When the investor company
acquires assets, it simply has a group of assets with a new adjusted cost base and any investee
tax problems are left with the selling entity.
3-42. From the point of view of a person selling an existing business, they will generally have
a preference for selling shares. If shares are sold, any resulting income will be taxed as a
capital gain, only one-half of which will be taxable. In the alternative sale of assets, income
will include capital gains, but may also include fully taxable recapture of CCA. Further, for the
seller to have access to the funds resulting from the sale, it may be necessary to go through a
complex windup procedure.
3-43. If the corporation being sold is a qualified small business corporation, there is an
additional advantage to selling shares rather than assets. Gains on the sale of shares of this
type of corporation may be eligible for the special $750,000 lifetime capital gains deduction.
Acquisition Of Shares
3-44. In looking at situations in which the combination is carried out through an acquisition
of shares, the type of consideration used also has some influence. If shares are acquired
through the payment of cash or other assets, the shares will have a new tax base equal to their
fair market value as evidenced by the amount of consideration given. In addition, any excess
of consideration over the adjusted cost base of the shares given up will create an immediate
capital gain in the hands of the transferor.
3-45. However, if new shares are issued to acquire the target shares, Section 85.1 of the
Income Tax Act can be used. This Section provides that in a share for share exchange, any gain
on the shares being transferred can effectively be deferred. Under the provisions of this
Section, the old shares are deemed to have been transferred at their adjusted cost base and, in
turn, the adjusted cost base of the old shares becomes the adjusted cost base of the new shares
that have been received.
3-46. While the type of consideration used to effect the business combination can make a
significant difference to the transferor of the shares, it does not influence the tax status of the
assets that have been indirectly acquired through share ownership. As this legal form of
combination results in both parties continuing to operate as separate legal and taxable entities, the assets remain on the books of the separate companies and their tax bases are not
affected in any way by the transaction.
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Chapter 3
Alternative Accounting Methods
3-47. As noted previously, in most cases these tax bases will be lower than the fair market
values of the assets and, as a result, lower than the tax bases that would normally arise if the
assets were acquired directly. For this reason, the acquiring company will generally prefer to
acquire net assets directly, rather than acquiring its right to use the assets through acquisition
of a controlling interest in shares.
Alternative Accounting Methods
Alternative Views Of Economic Substance
Influence On Accounting Method
3-48. A fundamental concept that underlies the establishment of accounting standards is
that, without regard to legal form, standards should be designed to reflect the real economic
substance of the transactions and events that are reported in financial statements. This is a
particular problem in dealing with business combinations as the legal form of these transactions can be heavily influenced by considerations other than the information needs of
investors. Given this situation, it is very important to understand the economic substance of
the transactions that are being reported.
3-49. In somewhat simplified terms, there are three views of what really happens when two
businesses are combined. These different views impact on accounting procedures in that
they determine whether there should be a new basis of accountability for either or both of the
combining companies. If there is a new basis, assets and liabilities will have to be measured in
a way that reflects their fair values at the combination date. If not, the existing carrying values
of the assets and liabilities of the combining companies will be carried forward to the
accounting records of the combined company. We will use the following simple example to
illustrate the impact of alterative views of a combination transaction on required accounting
procedures:
ComCo One
ComCo Two
Net Assets At Carrying Values
Excess Of Fair Value Over Carrying Value
Unrecognized Goodwill
$650,000
100,000
150,000
$ 800,000
75,000
125,000
Net Assets At Fair Values
$900,000
$1,000,000
ComCo One and ComCo Two are both corporations. They have decided to implement a business combination transaction and continue operations on a combined
basis. The legal form of the combination is yet to be determined.
Alternative Views Described
3-50. The three alternative views of the economic substance of a business combination
transaction are described in this section. In each case, the basic accounting implications of
that view are illustrated using the example from Paragraph 3-49.
Acquisition View In many business combinations one of the combining companies
can be easily identified as the dominant or controlling interest in the combined
company. In such situations, one of the combining companies can be identified as the
acquirer and the economic substance of the business combination transaction is that
one business has purchased the assets of another. In this type of situation, there is no
justification for altering the carrying values of the acquirer’s assets. However, as
would be the case in any other purchase of assets, the assets of the acquired company
would be recorded at their fair value on the acquisition date. Using the information in
our Paragraph 3-49 example, the combined Balance Sheet would be as follows:
ComCo One’s Carrying Values (The Acquirer)
ComCo Two’s Fair Values (The Acquiree)
$ 650,000
1,000,000
Combined Net Assets
$1,650,000
Business Combinations
Alternative Accounting Methods
New Entity View An alternative to the acquisition view is that, when two businesses
are combined, it is an event that results in a new business entity being created. In
circumstances where this view might be appropriate, it would follow that there should
be a new basis of accounting for the assets of both companies. Again using the information from Paragraph 3-49, the combined Balance Sheet would be as follows:
ComCo One’s Fair Values
ComCo Two’s Fair Values
$ 900,000
1,000,000
Combined Net Assets
$1,900,000
Pooling Of Interests View The third alternative takes the position that when two
businesses combine, the result is a simple continuation of the operations of the two
combining enterprises. This would suggest that there should be no new basis of
accounting for either of the combining companies, a view that is reflected in the
following Balance Sheet:
ComCo One’s Carrying Values
ComCo Two’s Carrying Values
$ 650,000
800,000
Combined Net Assets
$1,450,000
3-51. You will note that the application of these alternative views produces significantly
different values for the combined net assets. These results range from a low of $1,450,000
under the pooling of interests view, to a high of $1,900,000 under the new entity view. Given
these differences, it is not surprising that controversy has existed as to which of these views
should be incorporated into our accounting requirements.
The AcSB’s Choice
3-52. It is likely that, for each of the alternative views described, a real world example could
be found of a business combination where that view would be appropriate. There are
undoubtedly combination transactions that are simple poolings of the two business entities.
Correspondingly, there are combinations that result in a completely new business organization that could best be represented through a new accounting basis for the assets of both
entities.
3-53. Despite the possibility of different scenarios, it is clear that the great majority of business combinations involve one of the participating business entities acquiring control over the
operations of the other business entity. Given this, it is equally clear that such combinations
should be accounted for in a manner that is consistent with the accounting procedures that
are used for other acquisitions of assets. The method of accounting that accomplishes this
goal is referred to, not surprisingly, as the Acquisition Method of accounting for business
combination transactions.
Note Until 2009, Canadian standards referred to this method as the Purchase
Method of accounting for business combinations. In fact, Section 1581 of the CICA
Handbook still refers to this method. However, as the Acquisition Method is used in
IFRSs, we will make no further reference to the Purchase Method.
3-54. As it is likely that there are business combinations that reflect both the new entity view
and the pooling of interests view, standard setters could have allowed methods other than the
Acquisition Method when the circumstances were appropriate. In fact, at one point in time,
pooling of interests accounting was widely used in the United States.
3-55. However, it has proved very difficult to specify the circumstances under which alternative methods would be appropriate. In addition, the use of pooling of interests accounting
has been used to reduce recorded asset values and the expenses that result from the use of
these assets. As a consequence, the FASB, and IASB, and the AcSB have concluded that the
Acquisition Method should be used for all business combination transactions. Reflecting this
position, Section 1582 contains the following recommendation:
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Paragraph 1582.04 An entity shall account for each business combination by
applying the acquisition method. (January, 2011)
Byrd & Chen Note The recommendations in Section 1582 are dated January, 2011
as this is their effective date. However, Section 1582 was added to the Handbook in
January, 2009 and earlier application is permitted. Earlier application is conditional
on simultaneously adopting Sections 1601 and 1602 which were also added in
January, 2009.
A Potential Problem
3-56. As we have noted, the Acquisition Method of accounting for business combination
transactions is based on the view that such transactions are simply an acquisition of assets.
This interpretation requires that one of the combining companies be identified as the
acquiring company.
3-57. In the great majority of business combination transactions, the determination of an
acquirer may be a fairly simple matter. However, because the Acquisition Method is being
used for such transactions, including some where that method might not be the most appropriate choice, there will be situations where the identification of an acquirer is difficult. This
will be discussed more fully in the next section which deals with the application of the Acquisition Method.
Application Of The Acquisition Method
Acquisition Date
3-58. Business combinations are usually very complex transactions supported by detailed
legal agreements involving the transfer of assets or equity interest to an acquiring business
entity. While in some cases a single date may be involved, it is not uncommon for more than
one date to be specified for the various components of the transaction.
3-59. Establishing the appropriate acquisition date is an important issue in that this is the
date on which the assets of the acquiree will be measured. The choice of date can have a
significant influence on these amounts. Because of this, the Handbook provides the following
Recommendation:
Paragraph 1582.08 The acquirer shall identify the acquisition date, which is the
date on which it obtains control of the acquiree. (January, 2011)
3-60. In general, this will be the date on which the assets and liabilities of the acquiree are
legally transferred to the acquirer. It could be earlier if a written agreement transfers control
prior to that date. It would appear unlikely that the transfer of control would occur subsequent to the closing date for the transfer of the assets.
Identification Of An Acquirer
Basic Recommendation
3-61. The concepts underlying the acquisition method require that an acquirer be identified in each business combination transaction. This is reflected in the following
recommendation:
Paragraph 1582.06
For each business combination, one of the combining entities
shall be identified as the acquirer. (January, 2011)
3-62. As defined in Section 1582, the acquirer is the business that obtains control over the
other business or businesses in a business combination transaction. For purposes of determining control, Section 1582 refers users to the guidance on control that is found in Section
1590, “Subsidiaries”. However, the situation is complicated by the fact that business combinations can take forms other than the acquisition of a subsidiary. Given this, more detailed
consideration is required in dealing with this recommendation.
Business Combinations
Application Of The Acquisition Method
Figure 3 - 5
Identifying An Acquirer
Alpha
Company
(1 Million
Outstanding
Shares)
New Alpha Shares
Beta
Shareholders
100% Of Beta Shares
Cash Consideration
3-63. As we have noted, Section 1582 requires the use of the acquisition method, even in
those situations where the economic substance of the transaction suggests that neither
company can be identified as the acquirer. Given this, it is not surprising that Section 1582
provides additional guidance in this area.
3-64. However, before we examine this more detailed guidance, we will look at some situations where the identification process presents no problems. The least complex situations are
those in which one company uses cash to acquire either the net assets of the other combining
company or, alternatively pays cash to the shareholders of the other combining company in
order to acquire a controlling interest in the net assets of that company.
Example 1 Company A pays $2,000,000 to Company B in order to acquire the net
assets of that company. Since Company B has not received any of the shares of
Company A as part of the combination transaction, they have no continuing participation in the combined company. Clearly Alpha Company A is the acquirer.
Example 2 Company A pays $2,000,000 to the shareholders of Company B in
return for 100 percent of their outstanding shares in that company. While in this case
Company B would continue as a legal entity after the combination transaction, its
former shareholders would not participate in its ownership. As was the case when the
cash was paid to Company B, we would conclude that Company A is the acquirer.
Share Consideration
3-65. The situation becomes more complex when voting shares are used as consideration.
This reflects the fact that voting shares allow the pre-combination equity interests in both of
the combining companies to have a continuing equity interest in the combined company.
This would be the case without regard to whether the acquirer’s shares were issued to acquire
assets or, alternatively, to acquire shares from the acquiree’s shareholders.
3-66. Conceptually, the solution to the problem is fairly simple. Assuming that the
combining enterprises are both corporations, the acquirer is the company whose shareholders, as a group, wind up with more than 50 percent of the voting shares in the combined
company. While the preceding guideline sounds fairly simple, its implementation can be
somewhat confusing . Consider, for example, the case depicted in Figure 3-5.
3-67. In this legal form, the combined entity will be the consolidated enterprise consisting
of Alpha Company and its subsidiary Beta Company. The Alpha Company shareholder group
will consist of both the original Alpha Company shareholders and the new Alpha Company
shareholders who were formerly Beta Company shareholders. In the usual case, fewer than 1
million shares would have been issued to the Beta Company shareholders and, as a consequence, the original Alpha Company shareholders will be in a majority position. This means
that Alpha Company will be identified as the acquirer.
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3-68. There are, however, other possibilities. If Alpha issued more than 1 million shares to
the shareholders of Beta, the former Beta shareholders would then own the majority of the
voting shares of Alpha and this means that Beta Company would have to be considered the
acquirer. This type of situation is referred to as a reverse acquisition and will be given more
attention later in this section.
Formation Of New Company
3-69. In those combinations where a new company is formed to acquire either the assets or
the shares of the two combining companies, the analysis is usually straightforward. The new
company will be issuing shares as consideration for the assets or shares of the combining
companies. Without regard to whether the new company acquires assets or shares, the
acquirer is the predecessor company that receives the majority of shares in the new company.
Additional Handbook Guidance
3-70. Continuing with the example from Figure 3-5, a further possibility would be that
Alpha would issue exactly 1 million shares to the Beta shareholders. In this case, neither
shareholder group has a majority of voting shares. This is an example of a type of situation
where simply looking at the post-combination holdings of voting shares will not serve to
clearly identify an acquirer.
3-71. In such situations, Section 1582 provides additional guidance as follows:
Relative Voting Rights In The Combined Entity The acquirer is usually the
combining entity whose owners as a group retain or receive the largest portion of the
voting rights in the combined entity. In determining which group of owners retains or
receives the largest portion of the voting rights, an entity should consider the existence of any unusual or special voting arrangements and options, warrants or
convertible securities.
Existence Of A Large Minority Voting Interest If no other owner or organized
group of owners has a significant voting interest — the acquirer is usually the
combining entity whose single owner or organized group of owners holds the largest
minority voting interest in the combined entity.
Composition Of Governing Body The acquirer is usually the combining entity
whose owners have the ability to elect or appoint or to remove a majority of the
members of the governing body of the combined entity.
Composition Of Senior Management The acquirer is usually the combining entity
whose (former) management dominates the management of the combined entity.
Terms Of Exchange The acquirer is usually the combining entity that pays a
premium over the pre-combination fair value of the equity interests of the other
combining entity or entities.
3-72. Other considerations include the relative size of the combining companies. The
acquirer is normally the largest of the combining companies in terms of either assets or revenues. Also determining which company initiated the transaction can be helpful in
establishing the control interest in a business combination.
3-73. Section 1582 also notes that, in cases where a new company is formed to carry out the
combination, it will usually be one of the combining companies that will be identified as the
acquirer. While from a legal perspective, the new company has acquired either the assets or
shares of the combining company, it would be unusual for this company to be identified as the
acquirer.
Reverse Acquisitions
3-74. As we have noted, in some business combination transactions a “reverse acquisition”
may occur. This involves an acquisition where a company issues so many of its own shares that
the acquired company or its shareholders wind up holding a majority of shares in the legal
acquirer.
Business Combinations
Application Of The Acquisition Method
Example Continuing the example from Paragraph 3-66, if Alpha, a company with
1,000,000 shares outstanding , issues 2,000,000 new shares to the Beta shareholders
as consideration for their shares, the former Beta shareholders now hold two-thirds
(2,000,000/3,000,000) of the outstanding shares of Alpha.
Analysis From a legal point of view, Alpha has acquired control of Beta through
ownership of 100 percent of Beta’s outstanding voting shares. Stated alternatively,
Alpha is the parent company and Beta is its subsidiary. If you were to discuss this situation with a lawyer, there would be no question that Alpha Company is the acquiring
company from a legal perspective.
However, this is in conflict with the economic picture. As a group, the former Beta
shareholders own a majority of shares in the combined economic entity and, under
the requirements of the CICA Handbook, Beta is deemed to be the acquirer. In other
words, the economic outcome is the “reverse” of the legal result.
3-75. Reverse acquisitions are surprisingly common in practice and are used to accomplish
a variety of objectives. One of the more common, however, is to obtain a listing on a public
stock exchange. Referring to the example just presented, assume that Alpha is an inactive
public company that is listed on a Canadian stock exchange. It is being used purely as a
holding company for a group of relatively liquid investments. In contrast, Beta is a very active
private company that would like to be listed on a public stock exchange.
3-76. Through the reverse acquisition procedure that we have just described, the shareholders of Beta have retained control over Beta. However, the shares that they hold to
exercise that control are those of Alpha and these shares can be traded on a public stock
exchange. The transaction could be further extended by having Alpha divest itself of its
investment holdings and change its name to Beta Company. If this happens, Beta has, in
effect, acquired a listing on a public stock exchange through a procedure that may be less
costly and time consuming than going through the usual listing procedures. More detailed
attention will be given to this subject in Appendix B to Chapter 4.
Exercise Three - 2
Subject:
Identification Of An Acquirer
For each of the following independent Cases, indicate which of the combining
companies should be designated as the acquirer. Explain your conclusion.
A. Delta has 100,000 shares of common stock outstanding. In order to acquire 100
percent of the voting shares of Epsilon, it issues 150,000 new shares of common
stock to the shareholders of Epsilon.
B. Delta has 100,000 shares of common stock outstanding. It pays cash of
$1,500,000 in order to acquire 48 percent of the voting shares of Epsilon. No
other Epsilon shareholder owns more than 5 percent of the voting shares.
C. Delta, Epsilon, Zeta, and Gamma transfer all of their net assets to a new corporation, Alphamega. In return, Gamma receives 40 percent of the shares in
Alphamega, while the other three Companies each receive 20 percent of the
Alphamega shares.
D. Delta has 100,000 shares of common stock outstanding. Delta issues 105,000
shares to the sole shareholder of Epsilon in return for all of his outstanding shares.
As it is the intention of this shareholder to retire from business activities, the
management of Delta will be in charge of the operations of the combined
company.
End of Exercise. Solution available in Study Guide.
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Determining The Cost Of The Acquisition
Basic Approach
3-77. The cost of the acquisition in a business combination transaction is based on the
amount of consideration transferred by the acquirer. With respect to the measurement of this
consideration, Section 1582 contains the following recommendation:
Paragraph 1582.37 The consideration transferred in a business combination shall
be measured at fair value, which shall be calculated as the sum of the acquisition-date
fair values of the assets transferred by the acquirer, the liabilities incurred by the
acquirer to former owners of the acquiree, and the equity interests issued by the
acquirer. (However, any portion of the acquirer’s share-based payment awards
exchanged for awards held by the acquiree’s employees that is included in consideration transferred in the business combination shall be measured in accordance with
paragraph 1582.30 rather than at fair value.) Examples of potential forms of consideration include cash, other assets, a business or a subsidiary of the acquirer, contingent
consideration, common or preference equity instruments, options, warrants and
member interests of mutual entities.
Byrd & Chen Note Paragraph 1582.30 requires that measurement of share-based
payment awards be based on Section 3870, “Stock-Based Compensation And Other
Stock-Based Payments.
3-78. The problems involved in implementing this recommendation would vary with the
nature of the consideration given. The following guidelines would cover most situations:
•
If the acquirer pays cash there is no significant problem.
•
If shares with a quoted market price are issued by the acquirer, this market price will
normally be used as the primary measure of the purchase price.
•
If the acquirer issues shares that do not have a market price or if it is agreed that the
market price of the shares issued is not indicative of their fair value, the fair value of
the net assets acquired would serve as the purchase price in the application of this
method of accounting for business combinations.
Acquisitions Where No Consideration Is Involved
3-79. While this basic approach will apply in most business combination transactions, it is
possible that control of a business can be acquired without the transfer of consideration.
Examples of this type of situation are as follows:
•
The acquiree repurchases a sufficient number of its own shares for an existing investor
(the acquirer) to obtain control.
•
Minority veto rights lapse that previously kept the acquirer from controlling an
acquiree in which the acquirer held the majority voting rights.
•
The acquirer and acquiree agree to combine their businesses by contract alone. The
acquirer transfers no consideration in exchange for control of an acquiree and holds
no equity interests in the acquiree, either on the acquisition date or previously.
Consideration With Accrued Gains Or Loss
3-80. When non-monetary assets are transferred as consideration in a business combination transaction, it is likely that their fair value will be different than their carrying value on the
books of the acquiree. If the assets are transferred outside of the combined entity, the assets
will be recorded on the combined books at their fair value, with the resulting gain or loss
included immediately in Net Income.
3-81. However, if the transferred assets remain within the combined entity, they should be
recorded at their pre-transfer carrying value, with no gain or loss being recognized.
Business Combinations
Application Of The Acquisition Method
Example Company A, as part of the consideration paid to acquire the net assets of
Company B, transfers non-monetary assets to Company B. These assets have a
carrying value of $150,000 and a fair value of $200,000. The combined company will
continue to use these assets.
Analysis As the assets remain within the combined business, they will be recorded
at $150,000 and no gain or loss will be recognized.
Exercise Three - 3
Subject:
Non-Monetary Assets As Consideration
Markor Inc. transfers a group of investments to the shareholders of Sarkee Ltd. in
return for a controlling interest in the shares of that company. These investments have
a carrying value of $2 million on the books of Markor. Their fair value is $3.5 million.
How would this transaction be recorded on the books of Markor Inc.?
End Of Exercise. Solution available in Study Guide.
Direct Costs Of Combination - General Rules
3-82. It is a fairly well established accounting principle that the direct costs associated with
the acquisition of an asset should be included in the cost of the acquired assets. For example,
Section 3061 of the CICA Handbook indicates that the cost of property, plant, and equipment
includes the purchase price and other acquisition costs such as option costs when an option is
exercised, brokers' commissions, installation costs including architectural, design and engineering fees, legal fees, survey costs, site preparation costs, freight charges, transportation
insurance costs, duties, testing and preparation charges.
3-83. Somewhat surprisingly, Section 1582 takes a very different position with respect to
the direct costs incurred by an acquirer in a business combination transaction:
Paragraph 1582.53 Acquisition-related costs are costs the acquirer incurs to effect
a business combination. Those costs include finder ’s fees; advisory, legal,
accounting , valuation and other professional or consulting fees; general administrative costs, including the costs of maintaining an internal acquisitions department;
and costs of registering and issuing debt and equity securities. The acquirer shall
account for acquisition-related costs as expenses in the periods in which the costs are
incurred and the services are received, with one exception. The costs to issue debt or
equity securities shall be recognized in accordance with Section 3610, “Capital
Costs”, and Section 3855, “Financial Instruments — Recognition And Measurement”.
3-84. This represents a change from the position taken previously in Canadian GAAP.
Under Section 1581, the direct costs of combination were added to the acquisition cost.
Contingent Consideration
3-85. In negotiating the terms of a business combination transaction, there will be differences of opinion with respect to the values involved. It is likely that the stakeholders in the
acquiree will be inclined to believe that their business is worth more than the acquirer is
willing to pay. On the other side of the transaction, the acquirer may believe that any acquirer
shares that are being issued to carry out the transaction have a higher value than the stakeholders in the acquiree are willing to believe.
3-86. Contingent consideration can be used to resolve such disputes. For example, the
acquirer might agree to pay additional consideration if the earnings of the acquired business
achieve some specified target level within a specified period of time. Similarly, the acquiree
stakeholders might agree to accept future shares, provided the acquirer is willing to issue
additional shares in the event that the shares do not reach a specified market price within a
specified period of time.
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3-87. When contingent consideration is used, Section 1582 makes the following
recommendation:
Paragraph 1582.39 The consideration the acquirer transfers in exchange for the
acquiree includes any asset or liability resulting from a contingent consideration
arrangement. The acquirer shall recognize the acquisition-date fair value of contingent consideration as part of the consideration transferred in exchange for the
acquiree.
3-88. This recommendation requires recognition, at the time of and as part of the cost of an
acquisition, the fair value of any contingent consideration. This fair value amount may be:
An Asset Of The Acquirer For example, the agreement may require the acquiree to
pay an amount to the acquirer if the contingency occurs.
A Liability Of The Acquirer For example, the agreement may require the acquirer
to pay additional amounts to the acquiree if the contingency occurs.
An Equity Instrument Of The Acquirer For example, the agreement may require
the acquirer to issue additional securities to the acquiree if the contingency occurs.
3-89. In somewhat simplified terms, the accounting subsequent to the date of the combination will require ongoing measurement of the fair value of the asset, liability, or equity
instrument. In general, if the amount recorded is an asset or liability, changes in its fair value
will be recorded in income. Alternatively, if the amount recorded is an equity instrument,
changes in its fair value will be recorded as an adjustment of shareholders’ equity.
3-90. A simple example will illustrate the accounting procedures that are required when
contingent consideration results in a liability:
Example - Contingent Liability On January 1, 2009, the Mor Company issues 3 million
of its no par value voting shares in return for all of the outstanding voting shares of the Mee
Company. On this date the Mor Company shares have a fair value of $25 per share or $75
million in total. In addition to the current payment, the Mor Company agrees that, if the
2009 earnings per share of the Mee Company is in excess of $3.50, the Mor Company will
pay an additional $10 million in cash to the former shareholders of the Mee Company.
Analysis To begin, Mor will have to assign a fair value to the possibility that it will have to
pay the additional $10 million (Section 1582 does not provide guidance on this process).
After considering all relevant factors, the Company assigns a fair value of $2,500,000 to
this potential liability (this amount cannot be calculated using the information in the
example). Based on this, the investment is recorded as follows:
Investment In Mee [(3,000,000)($25) + $2,500,000]
No Par Common Stock
Contingent Liability
$77,500,000
$75,000,000
2,500,000
If at the end of 2009, the Mee Company ’s earnings per share has exceeded the contingency level of $3.50, the following entry to record the contingency payment would be
required:
Loss On Contingency
Contingent Liability
Cash
$7,500,000
2,500,000
$10,000,000
Alternatively, if the earnings per share do not exceed $3.50 per share, no additional
payment would be made and the following journal entry would be required:
Contingent Liability
Gain On Contingency
$2,500,000
$2,500,000
Business Combinations
Application Of The Acquisition Method
Exercise Three - 4
Subject:
Contingent Liability
On June 30, 2009, Lor Inc. issues 1,250,000 of its no par value voting shares in return
for all of the outstanding voting shares of Lee Ltd. At this time, the Lor shares are
trading at $11 per share. Negotiators for Lee have argued that this price is too low
because it does not reflect the large increase in Earnings Per Share that is expected for
their year ending December 31, 2009.
In order to resolve this dispute, Lor agrees to pay an additional $2,500,000 in cash on
March 1, 2010, provided Lee’s Earnings Per Share for the year ending December 31,
2009 reach or exceed $1.90 per share. The fair value of this obligation is estimated to
be $1,100,000.
On December 31, 2009, the Lor shares are trading at $11.50 per share. Lee’s Earnings
Per Share for the year are reported as $2.05 and, on March 1, 2010, Lor pays the
agreed-upon $2,500,000.
Provide the journal entries that would be required to record the issuance of Lor shares
on June 30, 2009, the entry required on December 31, 2009 when Lor Inc. closes its
books, and entry to record the payment of the $2,500,000 on March 1, 2010.
Exercise Three - 5
Subject:
Contingent Asset
On June 30, 2009, Solor Inc. issues 1,250,000 of its no par value voting shares in
return for all of the outstanding voting shares of Solee Ltd. At this time, the Solor
shares are trading at $11 per share. Negotiators for Solee have argued that this
number of shares is not appropriate because current market conditions have kept the
share price of Solar Inc. above its real long-term value.
In order to resolve this dispute, the shareholders of Solee have agreed to pay Solor
Inc. an additional $1.50 for each share received, provided the value of the Solor
shares is above $11 on December 31, 2009. Solor estimates the fair value of this
contingent asset to be $1,200,000.
On December 31, 2009, the Solor shares are trading at $11.75 per share and, as a
consequence, the Solee shareholders pay to Solar Inc. the additional $1,875,000
[(1,250,000)($1.50)].
Provide the journal entries that would be required to record the issuance of Solor
shares on June 30, 2009, and the additional payment on December 31, 2009.
Exercise Three - 6
Subject:
Contingent Equity Instrument
On June 30, 2009, Goger Inc. issues 2,500,000 of its no par value voting shares to the
shareholders of Gee Ltd. in return for all of their outstanding voting shares. At this
time, the Goger shares are trading at $32 per share. Negotiators for Gee have argued
that this number of shares is not sufficient because they anticipate that the price of
these shares will drop subsequent to the business combination transaction.
In order to resolve this dispute, Goger Inc. agrees that it will issue an additional
500,000 of its shares if the price of its shares is below $32 on December 31, 2009.
Goger estimates that, on June 30, 2009, the fair value of this obligation to issue shares
is $3 million.
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Provide the journal entry that would be required to record the acquisition of the Gee
Ltd. shares on June 30, 2009. In addition, provide the entry that would be required
on December 31, 2009:
A. if Goger has to issue the additional shares (shares are trading at $30); and
B. if Goger does not have to issue the additional shares (shares are trading at $33).
End of Exercises. Solutions available in Study Guide.
Recognition Of Acquired Assets
General Principle
3-91. Section 1582 provides the following recommendation with respect to the recognition
of assets acquired in a business combination transaction:
Paragraph 1582.10 As of the acquisition date, the acquirer shall recognize, separately from goodwill, the identifiable assets acquired, the liabilities assumed and any
non-controlling interest in the acquiree. Recognition of identifiable assets acquired
and liabilities assumed is subject to the conditions specified in paragraphs 1582.11 .12. (January, 2011)
3-92. Several additional points can be noted with respect to this recommendation:
Must Meet Section 1000 Definitions The assets and liabilities that are to be recognized in a business combination transaction must meet the definitions of these
elements that are found in Section 1000, “Financial Statement Concepts”.
Must Be Part Of The Exchange In situations where the acquirer and the acquiree
have a relationship that exists prior to the business combination, it must be determined if modifications that are made to this relationship during the negotiations are
part of the combination transaction. For example, if during the combination negotiations, a legal dispute between the acquirer and acquiree is settled, the cost of the
settlement would be accounted for separately from the business combination.
Unrecognized Acquiree Assets The combination transaction may result in the
recognition of acquiree assets that were not recognized on the acquiree’s books. For
example, the acquiree may have an internally developed patent that has a positive
value at the date of the combination. While this asset would not be recognized in the
acquiree’s books, it would be recognized as part of the assets acquired in the business
combination transaction.
The Problem Of Intangible Assets
3-93. The term “identifiable assets” encompasses all tangible assets, as well as many intangibles (e.g ., a patent or trade mark). However, intangibles do not have physical substance and
can only be recognized in circumstances where they can be identified. Appendix B of Section
1582 provides the following guidance with respect to the identification and recognition of
intangibles:
Paragraph 1582B.32 An intangible asset that meets the contractual-legal criterion
is identifiable even if the asset is not transferable or separable from the acquiree or
from other rights and obligations. For example:
(a) an acquiree leases a manufacturing facility under an operating lease that has
terms that are favourable relative to market terms. The lease terms explicitly
prohibit transfer of the lease (through either sale or sublease). The amount by
which the lease terms are favourable compared with the terms of current market
transactions for the same or similar items is an intangible asset that meets the
contractual-legal criterion for recognition separately from goodwill, even though
the acquirer cannot sell or otherwise transfer the lease contract.
Business Combinations
Application Of The Acquisition Method
(b) an acquiree owns and operates a nuclear power plant. The license to operate that
power plant is an intangible asset that meets the contractual-legal criterion for
recognition separately from goodwill, even if the acquirer cannot sell or transfer it
separately from the acquired power plant. An acquirer may recognize the fair
value of the operating license and the fair value of the power plant as a single asset
for financial reporting purposes if the useful lives of those assets are similar.
(c) an acquiree owns a technology patent. It has licensed that patent to others for
their exclusive use outside the domestic market, receiving a specified percentage
of future foreign revenue in exchange. Both the technology patent and the related
license agreement meet the contractual-legal criterion for recognition separately
from goodwill even if selling or exchanging the patent and the related license
agreement separately from one another would not be practical.
Classification Of Acquired Assets
3-94. Once it is determined which acquiree assets will be recognized in the business combination transaction, Section 1582 requires that they be classified:
Paragraph 1582.15 At the acquisition date, the acquirer shall classify or designate
the identifiable assets acquired and liabilities assumed as necessary to apply other
Sections subsequently. The acquirer shall make those classifications or designations on
the basis of the contractual terms, economic conditions, its operating or accounting
policies and other pertinent conditions as they exist at the acquisition date. (January,
2011)
3-95. This classification process will serve to determine which Sections of the CICA Handbook are applicable to the various assets and liabilities that have been recognized.
Measurement Of Identifiable Assets And Liabilities
Basis Principle
3-96. The basic measurement principle that is to be used in applying the acquisition
method is stated as follows:
Paragraph 1582.18 The acquirer shall measure the identifiable assets acquired and
the liabilities assumed at their acquisition-date fair values. (January, 2011)
3-97. In terms of implementing this recommendation, the following definition of fair value
is provided:
Paragraph 1582.02A(i) Fair value is the amount of the consideration that would be
agreed upon in an arm’s length transaction between knowledgeable, willing parties
who are under no compulsion to act.
Additional Guidance
3-98. The use of fair values in accounting has become fairly widespread. In addition, the
application of the acquisition method to business combination transactions is based on the
same principles that apply to the acquisition of single assets. The major complicating factor is
the fact that a single purchase price must be allocated over a large group of identifiable assets,
identifiable liabilities, and goodwill.
3-99. Given this situation, Section 1582 does not provide extensive guidance on the application of this measurement principle. The guidance that it does include is found in Appendix
B of Section 1582 as follows:
Paragraph 1582.B41 Assets With Uncertain Cash Flows (Valuation Allowances)
The acquirer shall not recognize a separate valuation allowance as of the acquisition
date for assets acquired in a business combination that are measured at their acquisition-date fair values because the effects of uncertainty about future cash flows are
included in the fair value measure. For example, because this Section requires the
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Application Of The Acquisition Method
acquirer to measure acquired receivables, including loans, at their acquisition-date
fair values, the acquirer does not recognize a separate valuation allowance for the
contractual cash flows that are deemed to be uncollectible at that date.
Paragraph 1582.B42 Assets Subject To Operating Leases In Which The Acquiree
Is The Lessor In measuring the acquisition-date fair value of an asset such as a
building or a patent that is subject to an operating lease in which the acquiree is the
lessor, the acquirer shall take into account the terms of the lease. In other words, the
acquirer does not recognize a separate asset or liability if the terms of an operating
lease are either favourable or unfavourable when compared with market terms as
paragraph 1582.B29 requires for leases in which the acquiree is the lessee.
Paragraph 1582.B43 Assets That The Acquirer Intends Not To Use Or To Use In A
Way That Is Different From The Way Other Market Participants Would Use Them
For competitive or other reasons, the acquirer may intend not to use an acquired
asset, for example, a research and development intangible asset, or it may intend to
use the asset in a way that is different from the way in which other market participants
would use it. Nevertheless, the acquirer shall measure the asset at fair value determined in accordance with its use by other market participants.
3-100. Guidance is also provided with respect to measuring the non-controlling interest.
However, this issue is of such importance that we will devote a separate section to dealing
with it at a later point in this Chapter
Exceptions To Recognition And Measurement Principles
Exceptions To Recognition Principle Only
3-101. Section 3290, “Contingencies”, defines a contingency as an existing condition or
situation involving uncertainty as to possible gain or loss to an enterprise that will ultimately
be resolved when one or more future events occur or fail to occur. Resolution of the uncertainty may confirm the acquisition of an asset or the reduction of a liability or the loss or
impairment of an asset or the incurrence of a liability.
3-102. The requirements in Section 3290 do not apply in determining which contingent
liabilities to recognize as of the acquisition date. In a business combination transaction, the
acquirer will recognize a contingent liability assumed in a business combination if it is a
present obligation that arises from past events and its fair value can be measured reliably. This
is in contrast to the treatment under Section 3290 in that the acquirer recognizes a contingent
liability assumed in a business combination at the acquisition date even if it is not likely that a
future event will confirm that an asset had been impaired or a liability incurred at the date of
the financial statements.
Exceptions To Measurement Principle Only
3-103.
There are 3 exceptions here. As described in Section 1582, they are as follows:
Paragraph 1582.29 Reacquired Rights The acquirer shall measure the value of a
reacquired right recognized as an intangible asset on the basis of the remaining
contractual term of the related contract regardless of whether market participants
would consider potential contractual renewals in determining its fair value.
Byrd & Chen Note These are rights that have been previously granted to the
acquiree. For example, the acquiree may have the right to use the acquirer’s
trademark.
Paragraph 1582.30 The acquirer shall measure a liability or an equity instrument
related to the replacement of an acquiree’s share-based payment awards with
share-based payment awards of the acquirer in accordance with the method in
Section 3870, “Stock-Based Compensation And Other Stock-Based Payments”.
Paragraph 1582.31 The acquirer shall measure an acquired non-current asset (or
disposal group) that is classified as held for sale at the acquisition date in accordance
Business Combinations
Application Of The Acquisition Method
with Section 3475, “Disposal Of Long-Lived Assets And Discontinued Operations”, at
fair value less costs to sell in accordance with paragraphs 3475.13 - .22.
Exceptions To Both Principles
3-104. Section 1582 indicates that, with respect to income taxes, both measurement and
recognition should be based on Section 3465, “Income Taxes”. There are a number of
complexities here that will be dealt with in the next section of this Chapter.
3-105. Without going into detail, there are also exceptions related to accrued benefit obligations to employees and for indemnification assets. We will not discuss these exceptions in
more detail in this text.
Tax Considerations In Allocating The Investment Cost
Determination of Fair Values - Temporary Differences
3-106. If a business combination involves an acquisition of assets, the newly acquired assets
will generally have a tax basis equal to their carrying value and no temporary differences will
be present. This means that the existing future income asset or liability values (FITAL values)
of the acquiree will not be carried forward and no additional FITAL values will be recorded as
a result of the business combination transaction.
3-107. However, in many business combination transactions, the fair values of acquired
assets will differ from their tax values on the books of the acquired company. This situation
can result from two possible causes:
•
In situations where assets have been acquired to effect the business combination, the
transfer of assets may involve a rollover provision (e.g., ITA 85) under which assets are
transferred at elected values without regard to their fair values at the time of the business combination.
•
In situations where shares have been acquired to effect the business combination, the
acquired subsidiary will continue as a separate legal entity and will retain old tax
values for its assets, without regard to their fair values at the time of the business
combination.
3-108. In economic terms, temporary differences clearly have an influence on the determination of fair value. An asset that has been fully depreciated for tax purposes has a fair value
that is less than the fair value of the same asset when its value is fully deductible. This raises
the question of how the presence of temporary differences should be dealt with in the context
of business combination transactions. While Section 1582 does not deal with this issue, it
would be our opinion that fair values should be determined without reference to tax considerations. This value would then be offset or enhanced by a future income tax asset or liability.
3-109.
A simple example will serve to clarify this point.
Example Meta Inc. acquires all of the outstanding shares of Acta Ltd. At that time,
Acta Ltd. has depreciable assets with an original cost of $540,000, a replacement cost
of $500,000, a carrying value on the books of Acta Ltd. of $380,000 and an undepreciated capital cost (UCC) of $200,000. Both companies are subject to a tax rate of
40 percent.
Analysis On the books of Acta Ltd., there would be a Future Income Tax Liability of
$72,000 [(40%)($380,000 - $200,000)]. This amount would not be carried forward
to the consolidated financial statements.
The depreciable assets would be recorded in the consolidated financial statements at
their full replacement cost of $500,000, without regard to the fact that their deductibility is limited to the UCC amount of $200,000. The temporary difference would be
reflected in a Future Income Tax Liability of $120,000 [(40%)($500,000 - $200,000)],
to be included in the consolidated financial statements.
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Application Of The Acquisition Method
Exercise Three - 7
Subject:
Temporary Differences In Business Combination Transactions
Gor Inc. completes a business combination with Gee Ltd. at the end of the current
year. At the time of this business combination, Gee Ltd. has property, plant, and
equipment with an original cost of $2,432,000, a replacement cost of $1,863,000,
and a net book value of $1,578,000. The undepreciated capital cost (UCC) of the
various classes to which this equipment has been allocated is $842,000. As Gee Ltd.
has been subject to a tax rate of 35 percent, the $736,000 ($1,578,000 - $842,000)
temporary difference is reflected in a Future Income Tax Liability of $257,600.
Calculate the Future Income Tax Liability that will be disclosed in the books of the
combined company assuming that:
A. Gor acquires the shares of Gee.
B. Gor acquires the assets of Gee.
End of Exercise. Solution available in Study Guide.
Determination of Fair Values - Loss Carry Forwards
3-110. A further tax related consideration involves loss carry forward benefits. Under the
provisions of Section 3465, “Income Taxes”, the benefit of a loss carry forward can only be
recognized as an asset when it is more likely than not that the benefit will be realized. The
implementation of this concept involves a number of difficulties in the context of accounting
for business combinations.
3-111. The first of these problems is the question of whether the loss carry forward can be
transferred to the combined company. If the combination involves an acquisition of assets, it
is likely that the loss carry forward will not be available to the combined company. If no rollover provision is used, the benefit of the carry forward will certainly be lost if assets are
acquired. However, some rollover provisions (e.g ., ITA 87) provide for a transfer of loss carry
forward benefits in the context of an acquisition of assets.
3-112. If shares are acquired, the loss carry forward will continue on the books of the
subsidiary company. However, its availability may be limited by the acquisition of control
rules [see ITA 111(4)].
3-113. A full discussion of these issues extends well beyond the scope of this text. What can
be said here is this:
•
•
•
•
If the loss carry forward benefit is legally available to the combined company; and
if it is more likely than not that the benefit will be realized by the combined company;
then
its fair value is equal to the amount of the carry forward multiplied by the appropriate
tax rate; and
this amount should be recognized in the financial statements of the combined
company, without regard to whether it has been recognized by the acquiree. Note
that the combined company may be able to claim that realization is more likely than
not, even if the acquiree could not make this claim as a separate company.
Measurement Of The Non-Controlling Interest
The Problem
3-114. To this point we have only given consideration to transactions in which 100 percent
of both businesses were included in the business combination. However, in those cases
where the legal form involves an acquisition of shares, it is not uncommon for the acquirer to
obtain control through owning less than 100 percent of the outstanding shares of the
acquiree.
Business Combinations
Application Of The Acquisition Method
3-115. We have previously noted that, when the legal form of the business combination
involves an acquisition of shares, the assets and operations of the combined company will be
reflected in consolidated financial statements. As will be discussed in more detail in subsequent chapters, consolidated statements include 100 percent of both companies’ assets and
liabilities in the Balance Sheet. This means that, in situations where the acquirer obtains less
than 100 percent of the acquiree’s shares, a non-controlling interest will be disclosed on the
equity side of the consolidated Balance Sheet.
3-116. Note that, while the CICA Handbook and IFRSs refer to this amount as a non-controlling interest, it is also commonly referred to as a minority interest. The more generally
applicable term is non-controlling interest because there are situations in which control can
be obtained through holding a large minority interest.
3-117. The measurement of this non-controlling interest has proved to be one of the more
controversial issues in developing standards for business combinations. The alternatives will
be illustrated in the example which follows.
Example Illustrating Alternative Solutions
3-118. In order to illustrate the various alternatives here, we will use the following simple
example.
Example On the date of a business combination transaction, the condensed Balance
Sheets of Fader Inc. and Fadee Ltd. are as follows:
Fader Inc.
Fadee Ltd.
Net Identifiable Assets At Carrying Values
Excess Of Fair Value Over Carrying Value
$2,200,000
300,000
$600,000
175,000
Fair Value Of Net Identifiable Assets
Unrecognized Goodwill
$2,500,000
Nil
$775,000
125,000
Fair Value Of The Enterprise
$2,500,000
$900,000
Shareholders’ Equity At Carrying Value
$2,200,000
$600,000
On this date, Fader Inc. issues $540,000 of its shares to the shareholders of Fadee Ltd. in
order to acquire a controlling 60 percent interest in Fadee Ltd.
3-119. There will be a 40 percent, non-controlling interest in Fadee Ltd. that will be
disclosed in the consolidated Balance Sheet. In somewhat simplified terms, there are three
alternative bases for the valuation of the non-controlling interest:
Carrying Values The non-controlling interest could be calculated as $240,000, 40
percent of the $600,000 in carrying values for Fadee’s net identifiable assets. In this
case, only 60 percent of Fadee’s fair value increase and goodwill will be recognized.
Fair Value Of Identifiable Assets The non-controlling interest could be calculated
as $310,000, 40 percent of the $775,000 fair value of Fadee’s net identifiable assets.
In this case, all of the $175,000 fair value change will be recognized, but only 60
percent of the goodwill.
Fair Value Of Enterprise The non-controlling interest could be calculated as
$360,000, 40 percent of the $900,000 fair value of the enterprise. In this case, 100
percent of the fair value change on Fadee’s identifiable assets would be recognized,
as well as 100 percent of the goodwill
3-120.
Consolidated Balance Sheets illustrating the three alternatives are as follows:
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Chapter 3
Application Of The Acquisition Method
Carrying
Values
Fair Value
Identifiable
Assets
Fair Value
Enterprise
Carrying Value Of Net Identifiable Assets
($2,200,000 + $600,000)
Fair Value Change - Increase
Goodwill
$2,800,000
105,000
75,000
$2,800,000
175,000
75,000
$2,800,000
175,000
125,000
Total Net Assets
$2,980,000
$3,050,000
$3,100,000
Non-Controlling Interest
Shareholders’ Equity ($2,200,000 + $540,000)
$ 240,000
2,740,000
$ 310,000
2,740,000
$ 360,000
2,740,000
Total Equities
$2,980,000
$3,050,000
$3,100,000
Consolidated Balance Sheets
3-121. Note that the manner in which the non-controlling interest is measured determines
what portion of fair value changes and goodwill will be recognized on the asset side of the
Balance Sheet.
•
•
•
When the non-controlling interest is based on carrying values, only the acquirer’s
share of the fair value change and goodwill are recognized in the consolidated assets.
When the non-controlling interest is based on the fair value of the identifiable assets,
100 percent of the fair value change is recognized, but only the acquirer’s share of
goodwill.
When the non-controlling interest is based on the fair value of the enterprise, 100
percent of the fair value change and 100 percent of the goodwill are recognized in the
consolidated assets.
Conclusion Of The Standard Setters
3-122. Prior to the introduction of Section 1582 in January, 2009, Canadian standards
recommended the use of carrying values for calculating the non-controlling interest. It was
expected that, as Canada moved towards convergence, the IASB would require the calculation of this interest based on the full fair value of the enterprise. Unfortunately, the IASB did
not have the courage to make this change. Their recommendation, as reflected in Section
1582, is as follows:
Paragraph 1582.19 For each business combination, the acquirer shall measure any
non-controlling interest in the acquiree either at fair value or at the non-controlling
interest’s proportionate share of the acquiree’s identifiable net assets.
3-123. This unfortunate and politically motivated compromise provides for two different
approaches to applying the acquisition method in situations where there is a non-controlling
interest. In effect, it provides for two different approaches to preparing consolidated financial statements.
3-124. In our example in Paragraph 3-120, we have illustrated both of these approaches.
The second column of our table shows the non-controlling interest valued as this interest’s
share of acquiree identifiable net assets, while the third column calculates the non-controlling interest on the basis of the fair value of the enterprise.
3-125. Basing the non-controlling interest on this interest’s share of the fair value of the
total enterprise is not a completely accurate representation of the requirements of paragraph
1582.19. Technically, this paragraph requires a separate determination of the fair value of the
non-controlling interest and recognizes that this value may not be proportional, on a
share-by-share, basis with the controlling interest.
Further Discussion
3-126. The alternative approaches to the measurement of the non-controlling interest are
based on differing views of the nature of this interest. This issue will be given a more detailed
discussion when we begin our presentation of consolidation procedures in Chapter 4. Also in
Business Combinations
Goodwill
that material, we will provide a more complete discussion of measuring the non-controlling
interest on a basis other than as a percent of the fair value of the enterprise.
Acquisition Method and Net Income
3-127. While this is not stated explicitly in Section 1582, the acquiree’s income will only be
included in the combined company results from the date of the acquisition. Given this, earnings per share figures will only reflect shares that are outstanding subsequent to the
combination transaction.
Example On December 31, 2009, Korner Inc. has 1,000,000 shares outstanding .
On that date, it issues 400,000 new shares to acquire 100 percent of the net assets of
Kornee Ltd. During the year ending December 31, 2009, Korner Inc. has Net Income
of $250,000, while Kornee Ltd. has Net Income of $175,000. Korner Inc. has a
December 31 year end.
Analysis The income that would be reported by the combined company would be
$250,000. This reflects the fact that Kornee Ltd. has no income during the period
subsequent to the combination. The earnings per share figure would be $0.25
[($250,000 ÷ 1,000,000)]. While there were 1,400,000 shares outstanding on
December 31, 2009, the denominator in earnings per share calculations is based on a
weighted average number of shares. As the 400,000 new shares were issued on
December 31, 2009, their weight would be nil.
Acquisition Method And Shareholders’ Equity
3-128. As the acquisition method of accounting for business combinations takes the position that the transaction is simply an acquisition of assets, the acquiring company ’s
shareholders’ equity would only be changed to the extent that new shares were issued as
consideration to the acquired company or its shareholders.
3-129. However, under some of the legal forms of combination, this may be in violation of
relevant corporate legislation. For example, if the net assets of two existing companies are
transferred to a newly established corporation, the Canada Business Corporations Act would
require that all of the shareholders’ equity of the new corporation be classified as contributed
capital.
3-130. A further problem would arise if the combination was implemented using a statutory
amalgamation provision. In this type of transaction, corporate legislation usually requires
that the contributed capital of the amalgamated company be equal to the aggregate of the
contributed capital of the amalgamating enterprises.
3-131. This is, of course, in conflict with the acquisition method of accounting requirement
that the shareholders’ equity of the combined company have the same amounts of contributed capital and retained earnings as the acquiring company. When conflicts of this sort arise,
the relevant corporate legislation must be the determining factor in the presentation of the
combined company ’s shareholders’ equity. In the case of statutory amalgamations, the Handbook suggests that the additional capital be allocated to a contributed surplus account.
Goodwill
The Concept
3-132. In order to record the business combination transaction, the fair values of the identifiable assets and liabilities of the acquiree are determined on an individual basis. When these
assets are put together as a business enterprise, it is unlikely that the sum of these fair values
will be equal to the value of the business as an operating economic entity.
3-133. If the assets were used in an effective and efficient manner, it is possible for the business to be worth considerably more than the sum of its individual asset values. Alternatively,
ineffectual management or other factors can depress the value of a business well below the
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Goodwill
sum of the fair values of its assets.
3-134. Note that this is not a clear indication that the assets should be liquidated on an individual basis. Fair values are based on the value of an asset to a going concern and, while in
some cases they may be equal to liquidation values, this is not likely to be the case for most
non-current assets.
3-135. If the business is worth more than the sum of its individual asset values, this will be
reflected in the price paid by an acquirer in a business combination. In this situation, when
the fair value of a business exceeds the fair values of its identifiable net assets, the excess is
generally referred to as goodwill. From a conceptual point of view, goodwill is the capitalized
expected value of enterprise earning power in excess of a normal rate of return for the particular industry in which it operates. As an example of this concept, consider the following:
Example Ryerson Ltd. has net identifiable assets with a current fair value of $1
million. Its annual income has been $150,000 for many years and it is anticipated that
this level of earnings will continue indefinitely. A normal rate of return in Ryerson’s
industry is 10 percent as reflected in business values that are typically 10 times
reported earnings.
Analysis Given this information, it is clear that Ryerson has goodwill. Normal earnings on Ryerson’s $1 million in net assets would be $100,000, well below the
Company ’s $150,000. Based on these earnings and a valuation benchmark of 10
times earnings, the value of Ryerson as a going concern would be $1.5 million. This
would suggest the presence of goodwill as follows:
Value Of Ryerson As A Going Concern
Fair Value Of Ryerson’s Net Identifiable Assets
Goodwill
$1,500,000
( 1,000,000)
$ 500,000
3-136. While it is clear that, in this simplified example, Ryerson has goodwill, it is unlikely
that it will be recorded in the Company ’s Balance Sheet. Even in situations where an enterprise has incurred significant costs for the creation of goodwill (e.g ., management training or
advertising directed at enhancing the image of the enterprise), GAAP does not permit the
recognition of internally generated goodwill. This reflects the belief that there is no reliable
procedure for the measurement of such amounts.
3-137. In a more general context, this belief prevents the recognition of most internally
generated intangible assets. The only exception to this is the recognition of certain development costs as assets under the provisions of Section 3064 of the CICA Handbook, “Goodwill
And Intangible Assets”.
Measurement Under Section 1582
Basic Recommendation
3-138.
Section 1582 contains the following with respect to the measurement of goodwill:
Paragraph 1582.32 The acquirer shall recognize goodwill as of the acquisition date
measured as the excess of (a) over (b) below:
(a) the aggregate of:
(i) the consideration transferred measured in accordance with this Section,
which generally requires acquisition-date fair value (see paragraph 1582.37);
(ii) the amount of any non-controlling interest in the acquiree measured in accordance with this Section; and
(iii) in a business combination achieved in stages (see paragraphs 1582.41-.42),
the acquisition-date fair value of the acquirer’s previously held equity interest
in the acquiree.
(b) the net of the acquisition-date amounts of the identifiable assets acquired and the
liabilities assumed measured in accordance with this Section. (January, 2011)
Business Combinations
Goodwill
3-139. At first glance, it appears that this recommendation is calling for a single approach to
the measurement of goodwill. However, Section 1582 provides two different ways of
measuring the non-controlling interest. (See our Paragraph 3-122.) As the non-controlling
interest is included in the calculation of goodwill, the result is two different ways of measuring
goodwill.
Example Victer Inc. acquires 80 percent of the outstanding voting shares of Viclee Ltd.
at a cost of $4 million, a figure which implies a total fair value for the enterprise of
$5,000,000. The fair value of the non-controlling interest is $1 million. This is determined on the basis of 20 percent of the fair value of the enterprise. On the acquisition
date the fair value of the identifiable assets of Viclee is $4,500,000.
Analysis The two alternative values that can be used for the non-controlling interest are
$900,000 [(20%)($4,500,000)] and $1,000,000 [(20%)($5,000,000)]. As shown in the
following table, each will produce a different goodwill figure:
Percent Of
Identifiable Assets
Investment Cost (Consideration Transferred)
Non-Controlling Interest
1582.32(a) Total
1582.32(b) Net Assets
Goodwill
Fair Value
Enterprise
$4,000,000
900,000
$4,000,000
1,000,000
$4,900,000
( 4,500,000)
$5,000,000
( 4,500,000)
$ 400,000
$ 500,000
Additional Guidance
3-140. When a business combination involves only an exchange of equity interests, the
general rule is that the consideration transferred will be measured on the basis of the fair value
of the acquirer’s shares. There may, however, be situations in which the acquiree’s shares can
be measured more reliably. If so, Section 1582 recommends that the acquirer determine the
amount of goodwill by using the acquisition-date fair value of the acquiree’s equity interests.
3-141. We have previously noted that there may be business combinations in which no
consideration is transferred. In such situations, Section 1582 recommends that the acquirer
use the acquisition-date fair value of their interest in the acquiree determined using a valuation technique in place of the acquisition-date fair value of the consideration transferred.
Exercise Three - 8
Subject:
Alternative Measures Of Goodwill
On December 31, 2009, Ulee Ltd. has net identifiable assets with a fair value of
$2,850,000. On this date, Tonser Inc. acquires 65 percent of its outstanding voting
shares for $2,275,000. It is estimated that the non-controlling interest that will be
recognized in this business combination transaction has a fair value of $1,225,000.
Determine the two alternative values for goodwill that can be recognized in the
consolidated Balance Sheet at the time of acquisition.
End of Exercise. Solution available in Study Guide.
General Accounting Procedures
3-142. The required accounting procedures for recognized goodwill are found in Section
3064, “Goodwill And Intangible Assets”. The basic recommendation is as follows:
Paragraph 3064.67 Goodwill should be recognized on an enterprise's balance sheet
at the amount initially recognized, less any write-down for impairment. (January,
2002)
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Goodwill
3-143. While not explicitly stated, it is clear from the wording of this recommendation that
the amount recorded as goodwill will not be subject to amortization. Rather, it will be the
subject of a periodic impairment test which may or may not result in a write-down of any
amount that is recorded.
3-144. Any goodwill balance that is recognized will generally be tested on an annual basis
for impairment. As specified in the following recommendation, the annual test can sometimes be omitted:
Paragraph 3064.84 Goodwill of a reporting unit should be tested for impairment on
an annual basis, unless all of the following criteria have been met:
(a) The assets and liabilities that make up the reporting unit have not changed significantly since the most recent fair value determination.
(b) The most recent fair value determination resulted in an amount that exceeded the
carrying amount of the reporting unit by a substantial margin.
(c) Based on an analysis of events that have occurred and circumstances that have
changed since the most recent fair value determination, the likelihood that a
current fair value determination would be less than the current carrying amount of
the reporting unit is remote. (January, 2002)
3-145.
Alternatively, more frequent testing may be required under some circumstances:
Paragraph 3064.87 Goodwill of a reporting unit should be tested for impairment
between annual tests when an event or circumstance occurs that more likely than not
reduces the fair value of a reporting unit below its carrying amount. (January, 2002)
3-146.
•
•
•
•
•
•
•
Examples of such events or circumstances are as follows:
a significant adverse change in legal factors or in the business climate;
an adverse action or assessment by a regulator;
unanticipated competition;
a loss of key personnel;
a more-likely-than-not expectation that a significant portion or all of a reporting unit
will be sold or otherwise disposed of;
the testing for write-down or impairment of a significant asset group within a
reporting unit; or
the recognition of a goodwill impairment loss in its separate financial statements by a
subsidiary that is a component of the reporting unit.
3-147. Consistent with other Handbook Sections which require asset write-downs (e.g .,
Section 3051, “Investments”), once a goodwill impairment loss is recognized, it cannot be
reversed in a subsequent period.
Differential Reporting Option
3-148. As we have noted, there are significant practical difficulties associated with the
required periodic testing for goodwill impairment. For non-publicly accountable enterprises,
it is unlikely that the costs of such periodic testing can be justified by the benefits received.
Because of this, the AcSB has provided a differential reporting option for qualifying
enterprises.
3-149. This option, which is found in Paragraph 3064.100, indicates that qualifying enterprises may elect to test goodwill for impairment only when an event or circumstance occurs
that indicates that the fair value of a reporting unit may be less than its carrying amount. Examples of such events are listed in Paragraph 3-146.
Goodwill Impairment Losses
3-150. Section 3064 requires that goodwill impairment losses be measured at the reporting
unit level. For this purpose, reporting units are defined as follows:
Business Combinations
Goodwill
A reporting unit is the level of reporting at which goodwill is tested for impairment
and is either an operating segment (see “Segment Disclosure”, Section 1701), or one
level below (referred to as a component).
3-151. In practice, this requirement presents significant difficulties. When there is a business combination transaction, any amount recognized as goodwill must be allocated to
individual reporting units. In order to accomplish this, all of the other net assets acquired
must also be assigned to segments. Further complicating the situation is that, when these new
requirements are first adopted, they must be applied retroactively to all previous business
combination transactions.
Goodwill Presentation and Disclosure
3-152. With respect to the presentation of goodwill in the financial statements, the
following two recommendations are relevant:
Paragraph 3064.93 The aggregate amount of goodwill should be presented as a
separate line item in an enterprise's balance sheet. (January, 2002)
Paragraph 3064.94 The aggregate amount of goodwill impairment losses should be
presented as a separate line item in the income statement before extraordinary items
and discontinued operations, unless a goodwill impairment loss is associated with a
discontinued operation. A goodwill impairment loss associated with a discontinued
operation should be included on a net-of-tax basis within the results of discontinued
operations. (January, 2002)
Paragraph 3064.95 Intangible assets should be aggregated and presented as a separate line item in an enterprise's balance sheet. (January, 2002)
3-153. With respect to the disclosure of goodwill, the following recommendations are
relevant:
Paragraph 3064.96
information:
The financial statements should disclose the following
(a) The changes in the carrying amount of goodwill during the period including:
(i) the aggregate amount of goodwill acquired;
(ii) the aggregate amount of impairment losses recognized; and
(iii) the amount of goodwill included in the gain or loss on disposal of all or a
portion of a reporting unit.
Enterprises that report segment information in accordance with “Segment Disclosures”, Section 1701, should provide the above information about goodwill in
total and for each reportable segment and should disclose any significant changes
in the allocation of goodwill by reportable segment. When any portion of goodwill
has not yet been allocated to a reporting unit at the date the financial statements
are issued, the unallocated amount and the reasons for not allocating that amount
should be disclosed.
(b) and (c) [These additional subparagraphs refer to intangibles other than goodwill.]
Paragraph 3064.98 For each goodwill impairment loss recognized, the following
information should be disclosed in the financial statements that include the period in
which the impairment loss is recognized:
(a) a description of the facts and circumstances leading to the impairment;
(b) the amount of the impairment loss; and
(c) when a recognized impairment loss is an estimate that has not yet been finalized,
that fact and the reasons therefor and, in subsequent periods, the nature and
amount of any significant adjustments made to the initial estimate of the impairment loss.
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Chapter 3
Goodwill
When the carrying amount of a reporting unit exceeds its fair value, but the second step
of the impairment test is not complete and a reasonable estimate of the goodwill
impairment loss cannot be determined (see paragraph 3062.28), that fact and the
reasons therefor should be disclosed. (January, 2002)
Evaluation of Goodwill Procedures
3-154. When there is a business combination transaction we have an objective measure of
the amount of goodwill that is present at that time. However, we do not attempt to identify the
specific reasons that this value exists. Given the lack of any specific explanation for the presence of goodwill, it is extremely difficult to arrive at a rational estimate of its useful life.
3-155. For many years we used an arbitrary solution to the problem — amortization over a
period not to exceed 40 years. At one point in time, there appeared to be a belief that this
maximum was too long and that goodwill should be written off over a shorter period. In 1993,
the IASB recommended that goodwill arising in business combination transactions should be
written off over a period not exceeding five years.
3-156. Standard setters in the U.S. and Canada considered similar changes. However, with
the possibility of having to use purchase method accounting (now known as acquisition
method accounting) for all business combinations on the horizon, the view that goodwill had
an indefinite life moved to the forefront. While it would perhaps be overly cynical to suggest
this change was necessary in order to muster the required support for the elimination of the
pooling-of-interests method, it certainly facilitated this process. If goodwill had an indefinite
life, it would not have to be amortized, thereby eliminating a major depressant of post-combination earnings when the purchase method was applied.
Bargain Purchase (a.k.a., Negative Goodwill)
Basic Rules
3-157. Fair values for the identifiable assets of the acquiree are determined on a going
concern basis. As these values are, in general, in excess of the liquidation values of the assets,
it is possible that an enterprise might be sold for less than the sum of the fair values of its net
assets.
Example Loser Inc. has net assets with a carrying value of $650,000 and fair values
totaling $900,000. These net assets are acquired in a business combination transaction for $725,000 in cash, resulting in negative goodwill of $175,000. Note that the
$900,000 figure reflects fair values and these are not equal to liquidation values. If
the sum of the liquidation values of these assets exceeded $725,000, it is likely that
Loser Inc. would have been liquidated, rather than sold as a going concern.
3-158. In recording this business combination transaction, the acquired assets will require
a debit of $900,000, while the cash payment will be recognized with a credit of $725,000.
We are left in need of an additional credit of $175,000, an amount that is sometimes referred
to as negative goodwill. There are various possibilities for this credit, depending on how we
analyze the reason for its existence. The various possibilities that are considered in the literature on this subject are as follows:
Overstated Fair Values One view would be that an adequate job of determining
the fair values of the identifiable assets was not done and, as a result, they are overstated. If this view is adopted, the appropriate credit would be to one or more of the
identifiable assets acquired in the business combination transaction. In general, we
would assume that the assets to be reduced would be non-financial items.
Bargain Purchase A second view would be that a bargain purchase was involved.
The suggestion would be that, perhaps because of poor operating results, the
acquiree enterprise is being sold under some form of duress and this has resulted in an
artificially low price. Consistent with this view would be a credit to some type of gain
on the transaction.
Business Combinations
Goodwill
Inadequate Rate of Return A third interpretation is that the discount reflects the
fact that the acquired enterprise is not earning a normal rate of return on its assets,
resulting in a going concern value that is less than the sum of the fair values of the identifiable net assets. This interpretation would suggest the use of a general valuation
account that would be shown as a contra to the total assets balance.
3-159. Section 1582 recognizes the possibility that the first view, overstated fair values, is
applicable by requiring a review of the recognition and measurement procedures applied to
the identifiable assets and liabilities acquired in the business combination transaction.
Paragraph 1582.36 Before recognizing a gain on a bargain purchase, the acquirer
shall reassess whether it has correctly identified all of the assets acquired and all of the
liabilities assumed and shall recognize any additional assets or liabilities that are identified in that review. The acquirer shall then review the procedures used to measure
the amounts this Section requires to be recognized at the acquisition date for all of the
following:
(a) the identifiable assets acquired and liabilities assumed;
(b) the non-controlling interest in the acquiree, if any;
(c) for a business combination achieved in stages, the acquirer’s previously held
equity interest in the acquiree; and
(d) the consideration transferred.
3-160. However, if this review fails to identify the cause of the negative goodwill, the basic
recommendation adopts the bargain purchase perspective:
Paragraph 1582.34 Occasionally, an acquirer will make a bargain purchase, which
is a business combination in which the amount in paragraph 1582.32(b) exceeds the
aggregate of the amounts specified in paragraph 1582.32(a). If that excess remains
after applying the requirements in paragraph 1582.36, the acquirer shall recognize
the resulting gain in net income on the acquisition date. The gain shall be attributed to
the acquirer.
Exercise Three - 9
Subject:
Negative Goodwill
On December 31, 2009, 100 percent of the shares of Manee Ltd. are acquired by
another corporation for $1,850,000 in cash. On this date, the assets and liabilities of
Manee Ltd. have a fair value of $2,375,000. Provide the journal entry that would be
required on the acquirer’s books to record this transaction.
End of Exercise. Solution available in Study Guide.
Step Acquisitions
3-161. In business combinations involving share acquisitions, it is not uncommon for the
ultimate acquirer to acquire their controlling interest through more than one share purchase.
Example On December 31, 2007, Batter Inc. acquires 35 percent of the
outstanding voting shares of Battee Ltd. On December 31, 2009, Batter acquires an
additional 40 percent of the Battee voting shares.
Analysis Until December 31, 2009, it is likely that Batter’s Investment In Battee will
be classified as a significantly influenced investment and accounted for using the
equity method. However, when Batter acquires the additional 40 percent interest on
December 31, 2009, there is a business combination transaction and consolidated
statements will have to be prepared for presentation on that date.
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Acquisition Method Example
3-162. As you may recall (see our Paragraph 3-138), in the determination of goodwill, the
required calculation includes “the acquisition-date fair value of the acquirer’s previously
held equity interest in the acquiree”.
3-163. The application of this provision is fairly complex and requires a fairly complete
understanding of consolidation procedures. Given this, we will defer our coverage of step
acquisitions until Chapter 5.
International Convergence
3-164. As noted as the beginning of this Chapter, the content of Section 1582 of the CICA
Handbook is identical to the content of IFRS No. 3, Business Combinations. In contrast, a few
differences remain between CICA Handbook Section 3064 and IAS No. 38, Intangible Assets.
In brief, these differences can be described as follows:
•
•
•
•
Section 3064 and IAS No. 38 use somewhat different procedures for impairment
testing of intangible assets.
IAS No. 38 has a requirement for periodic review of residual values. There is no corresponding requirement under Section 3064.
IAS No. 38 allows the revaluation of intangible assets to fair value, provided data is
available from an active market. Section 3064 does not permit such revaluation.
Under IAS No. 38, relocation and reorganization costs must be expensed. Section
3064 allows some of these costs to be capitalized.
Acquisition Method Example
Basic Data
3-165. The preceding material has provided a discussion and description of the various
procedures that are required in the application of the acquisition method of accounting for
business combinations. The example which follows will serve to illustrate the application of
these procedures. It involves a purchase of net assets, not shares. We will cover in detail business combinations involving share purchases and consolidated financial statements in
Chapters 4 to 7. We have ignored tax considerations in this example.
Example On December 31, 2009, the Balance Sheets of the Dor and Dee
Companies, prior to any business combination transaction, are as follows:
Balance Sheets
As At December 31, 2009
Dor Company
Dee Company
Cash
Accounts Receivable
Inventories
Plant And Equipment (Net)
$ 1,200,000
2,400,000
3,800,000
4,600,000
$ 600,000
800,000
1,200,000
2,400,000
Total Assets
$12,000,000
$5,000,000
Liabilities
Common Stock - No Par*
Retained Earnings
$ 1,500,000
6,000,000
4,500,000
$ 700,000
2,500,000
1,800,000
Total Equities
$12,000,000
$5,000,000
*On this date, prior to the transactions described in the following paragraphs, each
Company has 450,000 common shares outstanding .
On December 31, 2009, the Dor Company issues 204,000 shares of its No Par
Common Stock to the Dee Company in return for 100 percent of its net assets. On this
Business Combinations
Acquisition Method Example
date the shares of the Dor Company are trading at $25 per share. All of the identifiable assets and liabilities of the Dee Company have fair values that are equal to their
carrying values except for the Plant And Equipment which has a fair value of
$2,700,000 and a remaining useful life of ten years. Both Companies have a
December 31 year end and, for the year ending December 31, 2009, Dor reported
Net Income of $800,000 and Dee reported Net Income of $250,000.
Identification Of An Acquirer
3-166. Since the Dor Company issued fewer shares (204,000) to the Dee Company than it
had outstanding prior to the business combination (450,000), the shareholders of the Dor
Company would be the majority shareholders in the combined company and the Dor
Company would be identified as the acquirer.
Determination Of Purchase Price
3-167. With a market value of $25 per share, the 204,000 shares issued to effect the business combination would have a total market value in the amount of $5,100,000. This would
be the purchase price of the Dee Company.
Investment Analysis
3-168. In order to determine goodwill and the other values that will be used in the preparation of consolidated financial statements, some type of investment analysis schedule is
required. In cases such as this, where a non-controlling interest is not present, a fairly simple
schedule can be used. A more comprehensive analysis schedule will be presented in Chapter
4 where we give detailed consideration to the non-controlling interest.
3-169.
The required investment analysis schedule for this example would be as follows:
Carrying Value Of Dee’s Net Identifiable Assets
($5,000,000 - $700,000)
Fair Value Increase On Plant ($2,700,000 - $2,400,000)
$4,300,000
300,000
Fair Value Of Dee’s Net Identifiable Assets
$4,600,000
3-170. Given the purchase price and the fair values, the Goodwill that will be recognized
from this business combination can be calculated in the following manner:
Investment Cost (Consideration Transferred)[(204,000)($25)] $5,100,000
Fair Value Of Dee’s Net Identifiable Assets
( 4,600,000)
Goodwill To Be Recognized
$ 500,000
Journal Entry
3-171. Using the preceding investment analysis, we are now in a position to record the business combination. It would be recorded on the books of the Dor Company as a simple
acquisition of assets and liabilities. Except for Dee’s Plant And Equipment and the Goodwill
to be recorded as a result of the business combination, the carrying values from the books of
the Dee Company would be used. The entry is as follows:
Cash
Accounts Receivable
Inventories
Plant And Equipment (Fair Value)
Goodwill (Arising From The Acquisition)
Liabilities
Common Stock - No Par (Dor)
$ 600,000
800,000
1,200,000
2,700,000
500,000
$ 700,000
5,100,000
Combined Balance Sheet
3-172. The resulting December 31, 2009 Balance Sheet for the Dor Company, which now
includes all of the assets and liabilities of the Dee Company, would be as follows:
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Chapter 3
Acquisition Method Example
Dor Company
Balance Sheet
As At December 31, 2009
Cash ($1,200,000 + $600,000)
Accounts Receivable ($2,400,000 + $800,000)
Inventories ($3,800,000 + $1,200,000)
Plant And Equipment ($4,600,000 + $2,700,000)
Goodwill
$ 1,800,000
3,200,000
5,000,000
7,300,000
500,000
Total Assets
$17,800,000
Liabilities ($1,500,000 + $700,000)
Common Stock - No Par ($6,000,000 + $5,100,000)
Retained Earnings (Dor’s Only)
$ 2,200,000
11,100,000
4,500,000
Total Equities
$17,800,000
Combined Income and Earnings Per Share
3-173. We noted previously that the income of the acquired company is only included in
the combined companies’ income from the date of acquisition. As the date of acquisition was
December 31, 2009, none of Dee’s 2009 Net Income would be included in the Net Income of
the combined company. This means that Dor’s reported Net Income for the year ending
December 31, 2009 will be $800,000.
3-174. With respect to Earnings Per Share, Dor Company would have 654,000 shares
outstanding at the end of the year (450,000 original shares, plus the 204,000 shares issued to
acquire the net assets of Dee Company). However, the additional 204,000 shares were issued
on December 31, 2009 and, in the basic Earnings Per Share calculation, they would have a
weight of nil. This means that basic Earnings Per Share for the combined company would be
$1.78 ($800,000 ÷ 450,000).
Exercise Three - 10
Subject:
Application Of The Acquisition Method
On December 31, 2009, the Balance Sheets of the Saller and Sallee Companies, prior
to any business combination transaction, are as follows:
Balance Sheets
As At December 31, 2009
Saller Company
Sallee Company
Cash
Accounts Receivable
Inventories
Property, Plant, And Equipment (Net)
$ 1,876,000
3,432,000
5,262,000
6,485,000
$ 564,000
1,232,000
2,485,000
4,672,000
Total Assets
$17,055,000
$8,953,000
Liabilities
$ 4,843,000
Common Shares Issued And Outstanding:
Saller (423,000 Shares)
9,306,000
Sallee (185,000 Shares)
N/A
Retained Earnings
2,906,000
$2,237,000
Total Equities
$8,953,000
$17,055,000
N/A
3,885,000
2,831,000
Business Combinations
Acquisition Method Example
On December 31, 2009, the Saller Company issues 135,000 common shares to the
Sallee Company in return for 100 percent of its net assets. On this date, the shares of
the Saller Company are trading at $52 per share. Sallee’s Cash and Accounts Receivable have fair values that are equal to their carrying values. With respect to Sallee’s
other assets and liabilities, the Inventories have a fair value of $2,732,000, the Property, Plant And Equipment has a fair value of $4,512,000, and the liabilities have a fair
value of $2,115,000. Both Companies have a December 31 year end and, for the year
ending December 31, 2009, Saller reported Net Income of $1,465,000 and Sallee
reported Net Income of $372,000.
Prepare the combined Balance Sheet that would be presented by Saller Company on
December 31, 2009. In addition, determine the Net Income and Earnings Per Share
of the Saller Company that would be reported for the year ending December 31,
2009.
End of Exercise. Solution available in Study Guide.
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