ACCOUNTING FOR BUSINESS FOR BUSINESS COMBINATION

Definition of a Business Combination

A business combination is “a transaction or other event in which an acquirer obtains control of one or more
businesses.” (PFRS 3)

Control
• An investor controls an investee when the investor is exposed, or has rights, to variable returns from its
involvement with the investee and has the ability to affect those returns through its power over the investee.
• Control is normally presumed to exist when the ownership interest acquired in the voting rights of the
acquiree is more than 50% (or 51% or more).

Control may exist even if the acquirer holds less than 50% interest in the voting rights of acquiree, such as in the
following cases:
1. The acquirer has the power to appoint or remove the majority of the board of directors of the acquiree;
or
2. The acquirer has the power to cast the majority of votes at board meetings or equivalent bodies within
the acquiree; or
3. The acquirer has power over more than half of the voting rights of the acquiree because of an agreement
with other investors; or
4. The acquirer has power to control the financial and operating policies of the acquiree because of a law or
an agreement.

Accounting for business combinations

Business combinations are accounted for using the acquisition method. This method requires the following:
1. Identifying the acquirer;
2. Determining the acquisition date; and
3. Recognizing and measuring goodwill. This requires recognizing and measuring the following:
a. Consideration transferred
b. Non-controlling interest in the acquiree
c. Previously held equity interest in the acquiree
d. Identifiable assets acquired and liabilities assumed on the business combination.

Identifying the acquirer

• The acquirer is the entity that obtains control of the acquiree. The acquiree is the business that the acquirer
obtains control of in a business combination.
• The acquirer is normally the entity that:
a. Transfers cash or other assets and incurs liabilities;
b. Issues its equity interests (except in reverse acquisitions);
c. Receives the largest portion of the voting rights;
d. Has the ability to elect or appoint or to remove a majority ;
e. Dominates the management of the combined entity;
f. Significantly larger of the combining entities;
g. Initiated the combination

Determining the acquisition date

• The acquisition date is the date on which the acquirer obtains control of the acquiree.

Recognizing and measuring goodwill

Consideration transferred xx
Non-controlling interest in the acquiree (NCI) xx
Previously held equity interest in the acquiree xx
Total xx
Less: Fair value of net identifiable assets acquired (xx)
Goodwill / (Gain on a bargain purchase) xx

On acquisition date, the acquirer recognizes a resulting:

 a. Goodwill as an asset.
b. Gain on a bargain purchase as gain in profit or loss.

The consideration transferred in a business combination is measured at fair value.

Examples of potential forms of consideration include:
1. Cash,
2. Other assets,
3. A business or a subsidiary of the acquirer,
4. Contingent consideration,
5. Ordinary or preference equity instruments, options, warrants and member interests of mutual
entities.

Acquisition-related costs
• Acquisition-related costs are costs the acquirer incurs to effect a business combination.
• Acquisition-related costs are recognized as expenses in the periods in which they are incurred, except for the
following:
a. Costs to issue debt securities measured at amortized cost – included in the initial measurement of the
resulting financial liability.
b. Costs to issue equity securities – are accounted for as deduction from share premium. If share
premium is insufficient, the issue costs are deducted from retained earnings.

Non-controlling interest (NCI)

• Non-controlling interest (NCI) is the equity in a subsidiary not attributable, directly or indirectly, to a parent.
• NCI is measured either at:
a. Fair value, or
b. The NCI’s proportionate share of the acquiree’s identifiable net assets.

Previously held equity interest in the acquire

Previously held equity interest in the acquiree pertains to any interest held by the acquirer before the business
combination.

Net identifiable assets acquired

• On acquisition date, the acquirer shall recognize, separately from goodwill, the identifiable assets acquired,
the liabilities assumed and any non-controlling interest in the acquiree.
• Any unidentifiable asset of the acquiree (e.g., any recorded goodwill by the acquiree) shall not be recognized.
• The identifiable assets acquired and the liabilities assumed are measured at their acquisition-date fair values.

Reverse acquisitions
• In a business combination accomplished through exchange of equity interests, the acquirer is usually the
entity that issues its equity interests. However, the opposite is true for reverse acquisitions.
• In a reverse acquisition, the entity that issues securities (the legal acquirer) is identified as the acquiree for
accounting purposes while the entity whose equity interests are acquired (the legal acquiree) is the acquirer
for accounting purposes

PFRS 10 Consolidated Financial Statements

Definition of terms
• Parent – an entity that controls one or more entities.
• Subsidiary – an entity that is controlled by another entity.
• Group – a parent and its subsidiaries.
• Consolidated financial statements – the financial statements of a group in which the assets, liabilities, equity,
income, expenses and cash flows of the parent and its subsidiaries are presented as those of a single
economic entity.

Preparation of Consolidated FS
• A parent entity is required to present consolidated financial statements, except when all of the following
conditions are met:
a. The parent is a subsidiary of another entity and all its other owners do not object to the
parent not presenting consolidated financial statements;
 b. The parent’s debt or equity instruments are not traded in a public market (or being processed
for such purpose); and
c. The parent’s ultimate or any intermediate parent produces consolidated financial statements

Accounting requirements
• Consolidated financial statements shall be prepared using uniform accounting policies.
• The financial statements of the parent and its subsidiaries used in preparing consolidated financial statements
shall have the same reporting dates. (The maximum difference in reporting dates is 3 months.)
• Consolidation begins from the date the investor obtains control of the investee and ceases when the investor
loses control of the investee.

Measurement
• Income and expenses of the subsidiary are based on the amounts of the assets and liabilities recognized in
the consolidated financial statements at the acquisition date.
• Investments in subsidiaries are accounted for in the parent’s separate financial statements either:
a. at cost;
b. in accordance with PFRS 9 Financial Instruments; or
c. using the equity method.

NCI in net assets of the subsidiary

• Non-controlling interests shall be presented in the consolidated statement of financial position within equity,
separately from the equity of the owners of the parent.
• Non-controlling interest in the net assets consists of:
1. The amount determined at the acquisition date using PFRS 3; and
The NCI’s share of changes in equity since the acquisition date.

NCI in profit or loss and comprehensive income

• The profit or loss and each component of other comprehensive income in the consolidated statement of
profit or loss and other comprehensive income shall be attributed to the following:
1. Owners of the parent
2. Non-controlling interests

Preparing the Consolidated financial statements

• Consolidated financial statements are prepared by combining the financial statements of the parent and its
subsidiaries line by line by adding together similar items of assets, liabilities, equity, income and expenses.

Consolidation at date of acquisition

1. Eliminate the “Investment in subsidiary” account. This requires:
a. Measuring the identifiable assets acquired and liabilities assumed in the business combination at
their acquisition-date fair values.
b. Recognizing the goodwill from the business combination.
c. Eliminating the subsidiary’s pre-combination equity accounts and replacing them with the non-
controlling interest.
2. Add, line by line, similar items of assets and liabilities of the combining constituents.
Quiz
1. In a business combination, how should long-term debt of the acquired company generally be recognized on
acquisition date?
a. Fair value
b. Amortized cost
c. Carrying amount
d. Fair value less costs to sell

2. In a business combination accounted for under the acquisition method, the fair value of the net identifiable assets
acquired exceeded the consideration transferred. How should the excess fair value be reported?
a. As negative goodwill, recognized in profit or loss in the period the business combination occurred.
b. As an extraordinary gain.
c. As a reduction of the values assigned to noncurrent assets and an extraordinary gain for any unallocated
portion.
d. As positive goodwill.

3. The costs of issuing equity securities in a business combination are

a. expensed
b. treated as direct reduction in equity
c. included in the initial measurement of the credit to share capital account
d. b and c

4. The costs of issuing debt securities in a business combination are

a. expensed
b. included in the initial measurement of the debt securities issued
c. accounted for like a “discount” on liability
d. b and c

5. A business combination is accounted for properly as an acquisition. Direct costs of combination, other than
registration and issuance costs of equity securities, should be:
a. Capitalized as a deferred charge and amortized.
b. Deducted directly from the retained earnings of the combined corporation.
c. Deducted in determining the net income of the combined corporation for the period in which the costs were
incurred.
d. Included in the acquisition cost to be allocated to identifiable assets according to their fair values.

Problem Solving
On January 1, 20x1, DIMINUTIVE Co. acquired all of the assets and assumed all of the liabilities of SMALL, Inc. As of
this date, the carrying amounts and fair values of the assets and liabilities of SMALL acquired by DIMINUTIVE are
shown below:
Assets Carrying amounts Fair values
Cash in bank 20,000 20,000
Receivables 400,000 240,000
Allowance for probable losses on
(60,000)
Receivables
Inventory 1,040,000 700,000
Building – net 2,000,000 2,200,000
Goodwill 200,000 40,000
Total assets 3,600,000 3,200,000

Liabilities
Payables 800,000 800,000

On the negotiation for the business combination, DIMINUTIVE Co. incurred transaction costs amounting to ₱200,000
for legal, accounting, and consultancy fees.

Case #1: If DIMINUTIVE Co. paid ₱3,000,000 cash as consideration for the assets and liabilities of SMALL, Inc., how
much is the goodwill (gain on bargain purchase) on the business combination?

Case #2: If DIMINUTIVE Co. paid ₱2,000,000 cash as consideration for the assets and liabilities of SMALL, Inc., how
much is the goodwill (gain on bargain purchase) on the business combination?
Use the following information for the next two questions:
Parent Co. acquires Subsidiary Co. on January 1, 20x1. The financial statements of Parent and Subsidiary on the
acquisition date are shown below:

Parent Subsidiary
 
Co. Co.
Cash in bank 12,000 6,000
Accounts receivable 36,000 14,400
Inventory 48,000 27,600
Investment in subsidiary 90,000 -
Building, net 216,000 48,000
Total assets 402,000 96,000

Accounts payable 60,000 7,200

Share capital 204,000 60,000
Share premium 78,000 -
Retained earnings 60,000 28,800
Total liabilities and
402,000 96,000
equity

Additional information:
 The carrying amounts of subsidiary’s net identifiable assets approximate their acquisition-date fair values, except
for the following:
- Inventory, ₱37,200
- Building, net, ₱57,600

 The computations required under PFRS 3 resulted to the following:

- Goodwill, ₱3,600
- NCI in net assets, ₱21,600.

1. How much is the consolidated total assets on January 1, 20x1?

a. 428,600 c. 430,800
b. 440,800 d. 465,800

2. How much is the consolidated total equity on January 1, 20x1?

a. 336,600 c. 328,600
b. 363,600 d. 336,800