CHAPTER 1: ACCOUNTING FOR BUSINESS COMBINATION Advanced Accounting 2

LEARNING OBJECTIVES:

By the end of this chapter, the students will able to know:

 Why do firms engage in business combinations?
 Did the company acquire the ordinary share of another company or the assets of another company?
 Was the company dissolved (i.e., liquidated) or did the company continue to exist (i.e., survive)?
 Was a new company formed?
 Was there a change in ownership control?
 Is there acquired company wholly-owned?
 When one company gains control over another company, how should the relationship between the two parties be
presented for external reporting purposes?
 Why have standard setters designated fair value as the fundamental basis for recording a business combination?
 Business combinations historically were accounted for as either a purchase or pooling of interests. Why did the IASB
allows only the purchase method of accounting for business combination?

A business is defined as an integrated set of activities and assets that is capable of being conducted and managed for
the purpose of providing a return directly to investors or other owners, members or participants.

Business firms constantly strive to produce economic value added for their shareholders. Each day, new companies and
new products enter the market-place, and others are forced to leave or change substantially in order to survive. Related to
this strategy, expansion has been long regarded as a proper goal of business entities. A business may choose to expand
either internally or externally. In the former case it expands by undertaking investment projects, such as the purchase of new
premises and plant, while in the latter case it expands by purchasing a collection of assets in the form of an established
business. In this setting, existing companies often find it necessary to combine their operations with those of other
companies or to establish new operating units in emerging areas of business activity.

In recent years, the business world has witnessed many corporate acquisitions and combinations, often involving some
of the nation’s largest and best-known companies. Some of these combinations have captured the attention of the public
because of the personalities involved, the daring strategies employed and the huge sum of money at stake.

Companies often acquire ownership or other interests in other companies through a variety of arrangements and for a
variety of reasons. Some companies invest in other companies simply to earn a favorable return by taking advantage of
potentially profitable situations. Business combinations are typically viewed as a way to jump-start economies of scale.
Savings may result from the elimination of duplicative assets. Perhaps both companies will utilize common facilities and
share fixed costs. There may be further economies as one management team replaces two separate sets of managers. It may
be possible to better coordinate production, marketing, and administrative costs.

However, companies can have many other reasons for acquiring interests in other entities, including to (1) gain control
over other companies, (2) enter new market or product areas through companies established in those areas, (3) ensure a
supply of raw materials or other production inputs, (4) ensure a customer for production output, (5) gain economies
associated with greater size, (6) diversify, (7) gain new technology, (8) lessen competition, and (9) limit risk.

Business combinations are undertaken for business advantages derived from the integration of business activities
(Beams, et al. 2004). The integration may be:

 Horizontal integration – is the combination of firms in the same business lines and markets. It involves
companies within the same industry that were previously competitors, such as the combination of Banco de
Oro (BDO) and Equitable PCI Bank Inc. (EPCI) in 2007.

 Vertical Integration – is the combination of firms with operations in different, but successive stages of
production and/or distribution. It involves a company and its suppliers or customers. An example would be the
acquisition of a food distribution company by a restaurant chain. The intended benefit of the vertical
combination is the closer coordination of different levels of activity in a given industry. Recently, manufacturers
have purchased retail dealers to control the distribution of their products. For example, the major automakers
have been actively acquiring auto dealerships.

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 Conglomeration – is the combination of firms with unrelated and diverse products and/or service function. It
involves companies in unrelated industries having little, if any, production or market similarities. A company
may want to diversify by entering a new industry. The purchase of Nabisco Holding Corporation, a food product
company, by Philip Morris, a tobacco company was just such a diversification.

On the other hand, a number of accounting and reporting issues arise when two or more companies join under common
ownership. One set of issues involves how to account for the business combination. The procedures used can have a
substantial effect on financial statements prepared subsequent to the combination. Other issues involve how to account for
intercorporate ownership interests in periods following an acquisition and how to report the results of operations and the
financial positions of related companies.

IDENTIFYING A BUSINESS COMBINATION

IFRS 3 (effective 2009) defines Business Combination as “a transaction or event in which an acquirer obtains control
of one or more business”.

Business combination can also be defined as the bringing together of separate entities or businesses into one reporting
entity. The single (accounting/economic) entity carries on the activities of the previously separate, independent
enterprises. The accounting concept of a business combination emphasizes the single entity and the independence of the
combining companies prior to the combination

In a business combination one or more of the combining companies may lose their separate legal identities; however,
dissolution of the legal entities is not necessary within the accounting concept of business combination. Although financial
accounting is concerned with both the legal and economic effects of transactions and events, and many of its conventions
are based upon legal rules, the economic substance of transactions and events is usually emphasized when the legal form
differs from the economic substance and suggests different treatment. Therefore, financial accounting emphasizes the single
entity in business combinations even if more than one legal entity continues to exist (substance over form).

A business combination may involve the following:

a) purchase by an entity of the equity of another entity,

b) purchase of all the net assets of another entity, assumption of the liabilities of another entity, or
c) purchase of some of the net assets of another entity that together form one or more businesses.

A business combination may be affected by the issue of equity instruments, the transfer of cash, cash equivalents
or other assets, or a combination thereof. The transaction may be between the shareholders of the combining entities or
between the entity and the shareholders of another entity.

Business combination may involve the establishment of a new entity to control the combining entities or net assets
transferred, or the restructuring of one or more of the combining entities. It may result also in a parent-subsidiary
relationship in which the acquirer is the parent and the acquire a subsidiary of the acquirer. It may involve the purchase of
the net assets, including any goodwill, of another entity rather than the purchase of the equity of another entity.

FORMS OF BUSINESS COMBINATION

From the legal point of view, business combinations are classified as follows: (Beams, et al, 2004)

1) Acquisition of Net Assets – the acquiring corporation must negotiate with management to obtain the assets and
assume the liabilities of the company being acquired in exchange for cash, securities, or other consideration.

a. Statutory Merger – occurs when one corporation acquires the other corporations and retains their original identity,
while the acquired corporations are automatically dissolved or liquidated. All assets and liabilities are recorded on
the books of the acquiring corporation.

 Company “A” acquires Company “B” then dissolves “B” and liquidates “B”
 Company “B” cease to exist as separate legal entities
 Company “B” (dissolved) often continues as a division of the survivor (“A”)

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 Company “A”, which now owns the net assets, rather than the outstanding ordinary shares, of the liquidated
corporations

b. Statutory Consolidation – occurs when a new corporation is formed to take over the assets and operations of two
or more separate business entities and all the combining companies are dissolved. All assets and liabilities are
recorded on the books of the new corporation. In many situations, however, the resulting corporation is new in form
only, while in substance it actually is one of the combining companies reincorporated with a new name.

2) Acquisition of Ordinary Shares – occurs when one corporation (the investor/parent) acquires controlling interest
(greater than 50% of the outstanding ordinary shares) in another corporation (the investee/subsidiary). Both
corporations continue to operate as separate, but related, legal corporations. Because neither of the combining
companies is liquidated, the acquiring company must report its ownership interest in the other company as an
investment. The assets and liabilities, although under control of a single business entity (the parent), are recorded on
two separate sets of books.

METHODS OF ACCOUNTING FOR BUSINESS COMBINATION

Historically, there were two generally accepted methods of accounting for business combinations – the Pooling of
Interest Method and the Purchase Method. With the release of IFRS 3 (effective 2009) paragraph 4, the acquisition
method (formerly known as purchase method) is now required for all business combinations, thus effectively
prohibiting future use of the pooling of interest method.

In an acquisition, there is usually either the payment of assets or liability incurrence for the other business. In an
acquisition, one party acquires a controlling interest in another party in a bargained transaction between independent
parties.

A purchase combination may occur in one of the two ways. The acquirer may buy the assets of the target company,
which is then usually liquidated and only one entity remains. Alternatively, the acquirer purchases more than 50% of the
acquired (target) company’s outstanding voting ordinary share. In this case, the two entities are consolidated.

The acquisition method is an application of the cost principle in that assets acquired are recorded at the price paid
(which is their fair market value), fair values of other assets distributed, or fair values of the liabilities incurred. This gives rise
to a new basis for the net assets acquired.

Purchase accounting requires the recording of assets acquired and liabilities assumed at their fair values at the
date of combination.

Under the acquisition method, none of the equity accounts of the acquired business appears on the acquirer’s
records or on the consolidated financial statements. In effect, ownership interests of the acquired company’s
shareholders are not continued after the combination.

An advantage of the acquisition method is that fair value is used to recognize the acquired company’s assets just as in
the case of acquiring a separate asset. The disadvantages of the purchase method are difficulty in determining fair value
and the mixing of fair value of the acquired company’s assets and historical cost of the acquiring company’s assets.

Applying the acquisition method requires: [IFRS 3 (effective 2009) paragraph 5]

a) identifying the acquirer

b) determining the acquisition date
c) recognizing and measuring the identifiable net assets acquired, the liabilities assumed and any non-controlling
interest in the acquire; and
d) recognizing and measuring goodwill or a gain from a bargain purchase.

Identifying the acquirer

 The acquirer is the combining entity that obtains control of the other combining entities or businesses.
 Although sometimes it may be difficult to identify an acquirer, there are usually indications that one exists. For
example:

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a) If the fair value of one of the combining entities is significantly greater than that of the other combining
entity, the entity with the greater fair value is likely to be the acquirer.
b) If the business combination is effected through an exchange of voting ordinary equity instruments for cash
or other assets, the entity giving up cash or other assets is likely to be the acquirer.
c) If the business combination results in the management of one of the combining entities being able to
dominate the selection of the management of the team of the resulting combined entity, the entity whose
management is able to dominate is likely to be the acquirer.

 In a business combination effected through an exchange of equity interests, the entity that issues the equity
instruments is normally the acquirer.

Determining the acquisition date

 Acquisition date is the date on which the acquirer obtains control of the acquire.
 Generally, this is the date on which the acquirer legally transfers the consideration, acquires the assets and assumes
the liabilities of the acquire – the closing date.

Recognition and Measurement of the identifiable net assets acquired, the liabilities assumed and any non-
controlling interest (NCI) in the acquire

 As of the acquisition date, the acquirer shall recognize, separately from goodwill, the identifiable net assets acquired,
the liabilities assumed and any non-controlling interest in the acquiree.
 To qualify for recognition, the identifiable net assets acquired and the liabilities assumed must, meet the definition
of assets and liabilities in the Framework for the Preparation and Presentation of Financial Statements.
 The acquirer shall measure the identifiable assets acquired and liabilities assumed at their acquisition date fair
values.
 PFRS 3 allows an accounting policy choice, available on a transaction by transaction basis, to measure NCI either
at:
- fair value (sometimes called the full goodwill method), or
- the NCI’s proportionate share of net assets of the acquiree (option is available on a transaction by
transaction basis).

Recognizing and measuring goodwill or a gain from a bargain purchase

 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 IFRS 3 (effective 2009), which generally requires
acquisition-date fair values.
ii. the amount of any non-controlling interest in the acquiree measured in accordance with IFRS 3 (effective
2009); and
iii. in a business combination achieved in stages, the acquisition-date fair values of the acquirer’s previously
held equity interest in the acquiree;
(b) the net of the acquisition-date amounts of the identifiable net assets acquired and the liabilities assumed
measured in accordance with IFRS 3 (effective 2009).

 An acquirer will make a bargain purchase, which is a business combination in which the amount in (b) above exceeds
the aggregate amounts specified in (a) above.
 Before recognizing a gain on 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 the review.

ACCOUNTING PROCEDURES – ACQUISITION METHOD

1. Determine the cost of acquisition

 Cost is the amount of cash or cash equivalents paid or the fair value, at the date of exchange, of the other assets
given, liabilities incurred or assumed and equity instruments issued by the acquirer in exchange for control over the
net assets of the other enterprise.

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 Often times when the buyer and seller cannot agree on the total purchase price in an acquisition, the two parties
agree to an additional payment, or contingent consideration, based on the outcome of future events. These
payments are commonly referred to as earn outs and are typically based on revenue or earnings targets that the
acquired company must meet after the acquisition date.

 Contingent consideration that is determinable at the date of acquisition is recorded as part of the cost of
combination. An example of a contingent (uncertain) liability is a pending lawsuit.
 PFRS 3 (par. 39-40) states that if the cost is subject to adjustment contingent on future events, the acquirer
includes the amounts of that adjustment in the cost of the combination at the acquisition date if the
adjustment is a present obligation that arises from the past events and its fair value can be measured
reliably, regardless of the probability of the cash flow arising.
 Changes that are result of the acquirer to obtain additional information about facts and circumstances that
existed at the acquisition date, and that occur within the measurement period are recognized as
adjustments against the original accounting for the acquisition.
 Changes resulting from the events after the acquisition date are not measurement period adjustments.
Accounting for such change depends on whether the additional consideration is an equity instrument or
cash or other assets paid or owed. If it is equity, the original amount is not remeasured. If the additional
consideration is cash or other assets paid or owed, the changed amount is recognized in profit or loss.

 Direct cost of acquisition includes professional fees paid to accountants, legal advisers, valuers, and other
consultants to effect the combination
 Direct acquisition costs other than cost of issuing of equity securities are recognized as expenses. This
cost does not form part of the fair value of the exchange transaction with the former owners of the acquired
business.

 General administrative costs, including the costs of maintaining an acquisitions department, and other costs that
cannot be directly attributed to the particular combination being accounted for are not included in the cost of
combination; they are recognized as an expense when incurred.

 The costs of arranging and issuing financial liabilities are an integral part of the liability issue transaction, even when
the liabilities are issued to effect a business combination, rather than costs directly attributable to the business
combination. Such costs shall be included in the initial measurement of the liability.

 The costs of issuing equity instruments are an integral part of the equity transaction, even when the equity
instruments are issued to effect a business combination, rather than costs directly attributable to the combination.
Such costs reduce the proceeds from the equity issue.

2. Determine the difference between the acquisition costs and the fair value of identifiable assets and liabilities
acquired.

 Assets acquired and liabilities assumed as part of the business combination should be recognized at their fair value.
They should be recognized to the extent that the benefits derived from the transactions or events are to be received
by the acquiree. To the extent that a transaction or event relates to the benefits of the acquirer or the combined
entity, it is post-combination in nature and should not be recognized as part of the business combination
accounting. The following factors should be considered
 Whether the acquiree or the acquirer is the most significant beneficiary,
 The timing of the event or transaction,
 The reason for the transaction, and
 Who initiated the transaction.

 The acquirer shall, at the acquisition date:

a) Recognize goodwill acquired in a business combination as an asset; and
b) Initially measure that goodwill at its cost, being the excess of the cost of the business combination over the
acquirer’s interest in the net fair value of the identifiable assets, liabilities, and contingent liabilities
recognized.
 Goodwill acquired in a business combination represents a payment made by the acquirer in
anticipation of future economic benefits from assets that are not capable of being individually
identified and separately recognized.

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 After initial recognition, the acquirer shall measure goodwill acquired in a business combination at
cost less any accumulated impairment losses.
 Goodwill acquired in a business combination shall not be amortized.

 If the acquirer’s interest in the net fair value of the identifiable assets, liabilities and contingent liabilities recognized
exceeds the cost of the business combination (sometimes referred to as negative goodwill or gain on bargain
purchase), the acquirer shall:
a) Reassess the measurement both the net assets acquired and the consideration paid (to reaffirm that the
business combination is not an exchange of equal values)
b) Where unequal values are confirmed overpayments should be recognized in profit or loss at the date of
acquisition.

3. Prepare the entries to record the cost of acquisition and other costs of business combinations.

PROVISIONAL ACCOUNTING

If the initial accounting for a business combination can be determined only provisionally by the end of the first reporting
period, account for the combination using provisional values. Adjustments to provisional values within one year relating to
facts and circumstances that existed at the acquisition date. [PFRS 3.45] No adjustments after one year except to correct an
error in accordance with IAS 8. [PFRS 3.50]

BUSINESS COMBINATION ACHIEVED IN STAGES (Step Acquisitions)

Prior to control being obtained, the investment is accounted for under IAS 28, IAS 31, or IAS 39, as appropriate. On the
date that control is obtained, the fair values of the acquired entity’s assets and liabilities, including goodwill, are measured
(with the option to measure full goodwill or only the acquirer’s percentage of goodwill). Any resulting adjustments to
previously recognized assets and liabilities are recognized in profit or loss. Thus, attaining control triggers remeasurement.
[PFRS 3.41-42]

END OF CHAPTER 1

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