The nature of a business combination

• AASB 3 defines a business combination as:

– ‘a transaction or other event in which an acquirer obtains control of one or more

businesses’

• Control has the same meaning as defined in AASB 10 Consolidated Financial Statements (refer to
CH 9)

• Control exists when

– An investor is exposed, or has rights, to variable returns from its involvement with the
investee and has the ability to affect those returns through its power over the investee

• A ‘business’ is not just a group of assets

– An integrated set of activities and assets

– Capable of being conducted / managed to provide a return

– in the form of dividends, lower costs or other economic benefits

The nature of a business combination

Assuming the existence of two companies – A Ltd and B Ltd

Four general forms of business combination are as follows :

1. A Ltd acquires all assets and liabilities of B Ltd

B Ltd continues as a company, holding shares in A Ltd

2. A Ltd acquires all assets and liabilities of B Ltd

B Ltd liquidates

1. C Ltd is formed to acquire all assets and liabilities of A Ltd and B Ltd

A Ltd and B Ltd liquidate

1. A Ltd acquires a group of net assets of B Ltd

(that constitutes a business)

B Ltd continues to operate

Identifying the acquirer

• The business combination is viewed from the perspective of the acquirer

• The acquirer is the entity that obtains control of the acquiree

• In most cases this step is straight forward. In other cases judgement may be required.

– E.g. where two existing entities (A&B) combine and a new entity (C) is formed to acquire
all the shares of the existing entities

– Who is the acquirer?

– A or B – it cannot be C

• Indicative factors contained within Appendix B of AASB 3 assist in identifying the acquirer

Determining the acquisition date

• Acquisition date is ‘…the date on which the acquirer obtains control of the acquiree’
(AASB 3 Appendix A)

• Determining the correct acquisition date is important as the following are affected by the choice
of acquisition date:

– The fair values of net assets acquired

– Consideration given, where the consideration takes a non-cash form

– Measurement of the non-controlling interest

• Discussed in chapter 21

– Measurement of the FV of any equity holding acquired prior to gaining control (e.g. an
initial 20% holding)

Determination of the acquirer and acquisition date – Example 1

Step 1: Identify the acquirer

In this situation, A Ltd. is clearly the acquirer

Step 2: Determine the acquisition date

As the contract indicates that the transfer of the business, and payment of cash consideration, is to
occur on 1 January 2016, then this will be the acquisition date

LO 3.3 Recognition/measurement of
assets acquired and liabilities assumed

• In a business combination the acquirer has to consider:

– The recognition and measurement of the identifiable assets acquired and the liabilities
assumed

• Recognition: at acquisition date the recognition is done for:

– Identifiable assets acquired

– Liabilities assumed

– Contingent liabilities

– Any non-controlling interest in the acquiree

– Goodwill arising in step 4

Recognition/measurement of
assets acquired and liabilities assumed (cont

Measurement

• AASB 3 requires that assets acquired and liabilities and contingent liabilities assumed are
measured at Fair Value (FV)

– Fair value is basically a market based measure (exit value)

– Determined using judgement and estimation (three techniques – market approach, cost
approach and income approach)

• The determination of FV for all assets and liabilities takes time

– Acquirer has 12 months from acquisition date to determine fair values

– At first balance date after acquisition the fair values may only be provisionally
determined – a best estimate

– Finalisation of fair values will result in adjustments to goodwill

 • FVINA = Fair Value of Identifiable Net Assets (incl. contingent liabilities)

– Recognise all identifiable assets acquired and liabilities assumed regardless of the
probability of inflows and outflows

– Therefore, certain contingent liabilities are included in FVINA

– Probability is dealt with in the measurement of FV

Recognition/measurement of
assets acquired and liabilities assumed (cont.)

Recognition and measurement of contingent Liabilities

• AASB 3 requires that contingent liabilities which can be measured reliably are recognised by the
acquirer

– Therefore contingent liabilities where a present obligation exists

– But that do not qualify for recognition in the acquiree's books under AASB 137

– May be recognised by the acquirer as part of a business combination

– What is the fair value of a contingent liability?

– It is the amount that a third party would charge to assume those contingent liabilities.

– Such an amount reflects the expectations about possible cash flows.

– It is not simply the expected maximum/minimum cash flow

– E.g. if the expected damages are $2,000 and the probability of losing the case in court is
40%, the fair value will be $800

Recognition/measurement of
assets acquired and liabilities assumed (cont.)

Recognition and measurement of intangible assets

• The AASB 3 recognition requirements, based on Framework definitions, can result in the
recognition of intangible assets excluded by AASB 138

– Where the asset can be measured reliably

 • FV of an intangible reflects market expectations about the probability of future economic
benefits flowing to the entity

– E.g. if the expected benefits are $1,000 and the probability of receiving the benefits is
90%, the fair value will be $900

LO 3.4 Recognition of goodwill

The recognition and measurement of goodwill or a gain from a bargain purchase

Goodwill calculation

• Provides future economic benefits from assets that could not be individually identified or
separately recognised in the combination

• AASB 3 requires that the goodwill is:

– Recognised as an asset to the acquirer

– Measured at its cost at the date of acquisition

• Goodwill = Consideration transferred

Less
FVINA (Acquirer’s interest)

Recognition of goodwill (cont.)

• Consideration transferred (also known as cost of acquisition:

is measured at fair value at the date of acquisition, calculated as the sum of:

• Cash consideration

• Assets transferred by the acquirer

• Liabilities incurred by the acquirer to the former owners (e.g. settlement via a
series of cash payments)

• Equity instruments issued by the acquirer

• Contingent consideration

• Etc.
Recognition of goodwill (cont.)

Consideration – Cash

• Where the settlement is deferred, the cash must be discounted to present value as at the date
of acquisition

• The discount rate used is the entity’s incremental borrowing rate; interest expense is recognised
on payment

Consideration – Equity instruments

• Where an acquirer issues their own shares as consideration they need to determine the fair
value of the shares as at the date of exchange

• If listed, the fair value is the quoted market price of the shares (with a few limited exceptions)

Recognition of goodwill (cont.)

Contingent consideration

• In some cases the agreement will provide for additional (or repayment of) consideration ,
contingent on a future event

• Example

– Where an acquirer issues shares as part of their consideration, the agreement may
require an additional payment IF the value of the shares falls below a certain amount
within a specified period of time

• If the adjustment is probable and can be measured reliably, then the amount should be included
in the calculation of the cost of acquisition

Recognition of goodwill (cont.)

Costs of issuing debt and equity instruments

• Transaction costs such as stamp duties, underwriting fees and brokers fees may be incurred in
issuing equity instruments

• Such costs are considered to be an integral part of the equity transaction and should be
recognised directly in equity

• Do not form part of the consideration transferred (expense as incurred)

 • Journal entry required would be:

Dr Share Capital xx

Cr Cash xx

• Costs associated with the issue of debt instruments are included in the measurement of the
liability

Acquisition related costs

• Acquisition related costs that are directly attributable to a business combination

– Do not form part of the consideration transferred (expense as incurred)

• Examples 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.

Indirect Acquisition of a Business

 Rather than acquiring another business by purchasing its assets and liabilities directly, it is
possible to obtain control by purchasing all or a controlling interest in its share capital.

 This is achieved by purchasing shares held by the individual shareholders in the acquiree
company.

 The investment in the acquiree company’s shares is recorded at fair value, usually represented
by the consideration paid.

 There is no recognition of goodwill in the case of an indirect acquisition of shares. This because
only one asset is being acquired (shares) and the valuation of the shares will include any implied
goodwill.

Note: The recording of goodwill on consolidation for an indirect acquisition of shares is addressed in
later chapters on consolidation.

• Often the acquirer invests in shares of the acquiree (rather than acquiring the net assets)

• Accounting depends on the acquirer – acquiree relationship

 – AASB 9 Financial Instruments applies, unless the acquiree is a Subsidiary, Associate, Joint
Venture or Joint Arrangement

• AASB 9 requires the investment to be accounted for at FV of the consideration

• The accounting treatment in the acquirer’s books at acquisition is:

• Dr Investment in A XX

• Cr Cash XX

A complete set of financial statements

• Per AASB 101, a complete set of financial statements comprises:

– Statement of Financial Position (also known as Balance Sheet)

– Statement of Profit or Loss and Other Comprehensive Income (also known as Statement
of Comprehensive Income

– Statement of Changes in Equity

– Statement of Cash flows

– Notes to the financial statements

General features of financial statements

• Per AASB 101, the following considerations must be followed in the presentation of a financial
report:

1. Fair presentation and compliance with Australian Accounting Standards: applying

Australian Accounting Standards (with additional disclosures where necessary) is
presumed to result in a fair presentation

2. Going concern: There is an assumption that all entities adopt the going concern basis of
accounting

3. Accrual basis of accounting: Except for cash flow information, the financial statements
are required to be presented using the accruals basis of accounting

4. Materiality and aggregation

 • 5. Offsetting: Assets/liabilities and income/expenses are not to be offset, unless required or
permitted by another accounting standard

• 6. Frequency of reporting: annual /half-year financial report

• 7. Comparative information: Comparative information for the immediately preceding reporting

period must be disclosed

• 8. Consistency of presentation: Financial information must be consistently presented from one

period to the next

Identification of the financial statements

• AASB 101 requires:

– The financial statements and notes to be ‘…clearly identified and distinguished’ from
other information published in the same document

• The following information must also be prominently displayed:

– Name of the entity

– Whether the financial report relates to a single entity or a group of entities

– Reporting period

– Presentation currency

– Rounding used

Information to be presented in the SOFP

• AASB 101 para. 55 requires:

– Inclusion of additional line items , headings and sub-totals in the SOPF, if relevant to the
assessment of financial position

• This judgement (para. 58) is based on an assessment of:

– The nature and liquidity of assets

– The function of assets

– The amounts, nature and timing of liabilities

• Current/non-current distinction
 • Para. 60 requires presentation of assets and liabilities

– Classified as current or non-current

– Unless order of liquidity is reliable and more relevant (e.g. banks)

• Current assets are those realised or consumed within an entity’s operating cycle

• Current liabilities are those expected to be settled within an entity’s operating cycle

• An operating cycle is the time taken from acquisition of goods to the receipt of cash or cash
equivalents and can be greater than 12 months

• Whichever presentation method is used, some line items in the SOFP will report a total figure
consisting of :

– Amounts to be recovered / settled in less than 12 months, and

– Amounts to be recovered / settled after 12 months

• For such line items:

– Additional disclosures are required to provide these sub-totals

• Conditions at balance date determine if liabilities are classified current or non-current

Information to be presented in the SOFP or the notes

• Further sub-classifications needed for some items (para. 77)

• The details will depend on

– The requirements of other standards

– The size, nature and function of the amount (AASB 101 para. 78)

– The nature and liquidity of assets, the function of assets and the amounts, nature and
timing of liabilities (AASB 101 para. 58)

• Examples

– Inventories (merchandise, raw materials, WIP, finished goods etc.)

– PP&E must be disaggregated into classes (chapter 5)

• AASB 101 prescribes specific share capital disclosures

– Figure 15.5 – Note for Disclosure of Share Capital

 – Figure 15.6 – Note for Nature and purpose of reserves

Statement of Profit or Loss and Other Comprehensive Income

• Provides information about an entity’s performance and includes:

– Income

– Expenses

– Other comprehensive income

• E.g. movements in the asset revaluation surplus

• Total comprehensive income has two components:

• Profit or loss (P&L)

• Other comprehensive income (OCI)

Profit or loss

• AASB 101 – Profit or loss

– Is the total of income less expenses, excluding the components of other comprehensive
income

• Determined using “all-inclusive” approach

– All items of income and expense shall be recognised unless an Australian accounting
Standard requires or permits otherwise

• The only exclusions relate to:

– Provisions in AASBs that require or permit items of other comprehensive income (that
meet the income / expense definition) to be excluded from profit or loss

– AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors (e.g.
correction of errors)

Other Comprehensive Income (OCI)

• OCI comprises items of income and expense that are not recognised in profit or loss.

• Components of OCI comprise

– Changes in a revaluation surplus

 – Measurements of defined benefit plans

– Gains and losses arising from the translation of financial statements of foreign
operations

– Gains and losses from investments in equity instruments measured at fair value through
other comprehensive income

– The effective portion of gains and losses on hedging instruments in a cash flow hedge

– Certain liabilities, at FV through P&L, the change due to credit risk

• Reclassification adjustments relating to components of OCI are also required to be disclosed

– Reclassification adjustments are amounts that were recognised in OCI in previous years

– But are reclassified (or “recycled”) to the current period profit or loss when the relevant
item is derecognised

– To avoid double counting, unrealised gains recognised previously in OCI must be

deducted from OCI in the period they a recycled to P&L

– Reclassification adjustments do not arise

– On changes in a revaluation surplus

– Actuarial gains or losses on defined benefit plans

Total Comprehensive Income

• Profit or Loss (Income – Expenses)

• + OCI

• = Total Comprehensive Income

• Total Comprehensive Income

– Represents the changes in equity during a period

– Resulting from transactions and events

– Other than those relating owners in their capacity as owners or shareholders

Information to be presented in the statement…

• AASB 101 (para. 10A) prescribes format of the statement

– A single statement, with two sections

• Profit / Loss section presented first

• Other Comprehensive Income section next

– Two separate statements

• Statement of Profit or Loss (or Income Statement)

• Followed immediately by the Statement of Comprehensive Income, which starts

with the Profit or Loss for the period

• AASB 101 (para. 81A & 81B) requires disclosure of:

– Profit or loss

– Total other comprehensive income

– Comprehensive income for the period

– Profit or loss attributable to non-controlling interests and owners of the parent

Comprehensive income attributable to non-controlling interests.

• Profit / Loss section - AASB 101 prescribes minimum line items:

– Revenue

– Gains/losses from derecognition of financial assets, measured at amortised cost

– Finance costs

– Share of profits/(losses) of associates and JV’s accounted for under the equity method

– Gain/loss from financial assets reclassified and now measured at fair value

– Tax expenses

– Profit/(loss) after tax from sale of discontinuing operations

– Additional lines / sub-headings / sub-totals can be provided

– E.g. Profit or loss before tax

– Income, revenue and gains

 – Revenue arises from the ordinary activities of the entity

– Sales of goods

– Fees

– Interest, dividends and royalties

– Gains

– Sale proceeds from an asset disposal is not revenue

– Gains (losses) on asset disposals are included in profit or loss section

– Gains are reported on a ‘net basis’

– A line item can be displayed as ‘Other income’

• Other comprehensive income section

• AASB 101 requires:

– Classify items of OCI by their nature

– OR group them separately according to whether:

• The items will not be reclassified subsequently to P/L

• The items will be reclassified (recycled) to P/L at some future time

– Items likely to be reclassified to P/L include:

– Gains/losses from translating foreign operations

– Effective portion of gains /losses on hedging instruments in a cash flow hedge

– Gains/losses on investments in equity instruments measure at FV via OCI

Information to be presented in the statement or the notes…

• To enhance understandability of the statement

AASB 101 requires separate disclosure of the nature and amount of certain material income and
expense items including:

– Inventory write-downs

– PPE impairments

– Cost of restructuring
 – Disposals of PPE & other investments

– Profit/(losses) re discontinuing operations

– Litigation settlements

– Reversals of provisions

• Such disclosures can be made either in the statement or in the notes

Statement of Changes in Equity (SOCE)

The following is disclosed on the SOCE:

• Total comprehensive income for the period attributable to:

– Equity holders of parent; and

– Non controlling interests

• For each component of equity

– Effects of retrospective application or retrospective restatement recognised in

accordance with AASB 108

• Changes in accounting policies / Corrections of errors required by AASB 108

• For each component of equity a reconciliation between opening and closing balances showing
changes resulting from

– Profit/(Loss)

– OCI

– Transactions with owners in their capacity as owners

– Dividends

– An entity must disclose, in the statement of changes in equity or the notes, both:

• The amount of dividends recognised during the period and

• The related amount per share

Sources Of Estimation Uncertainty

 • Para.125 AASB 101, an entity shall disclose in notes key assumptions about the future of
estimation uncertainty that is material

• Notes shall include details of

– Their nature

– Their carrying amount as at the reporting date

• Examples include:

– Future interest rates

– Future changes in salaries or prices that affect other costs

– Useful lives of non-current assets

Capital and other disclosures

• Information must be disclosed to enable users to evaluate the entity’s objectives, policies and
processes for managing capital

– Qualitative information

– Summary quantitative data about what it manages as capital

– Whether the entity complied with any externally imposed capital requirements or, if
not, the consequences of such non-compliance

• AASB 1054 Australian Additional Disclosures requires:

– Dividends

– Company details

– Audit fees

Future Developments

Extensible business reporting language (XBRL)

• A language used for the electronic communication of business and financial data

• Increased use of XBRL is expected to:

– provide major benefits in the preparation, analysis and communication of business

information
 – offer cost savings, greater efficiency, improved accuracy and reliability for those
involved in supplying or using financial data

Corporate social responsibility reporting (CSR)

• Social responsibility is the responsibility of an organisation for the impacts of its decisions and
activities on society and the environment, through transparent and ethical behaviour that:

– contributes to sustainable development, including the health and the welfare of society

– takes into account the expectations of stakeholders

– is in compliance with applicable law and consistent with international norms of

behaviour; and

– is integrated throughout the organization and practised in its relationships

Consolidated financial statements

• Consolidated financial statements

– Involves the preparation of a single set of financial statements

– Involves combining the financial statements of the individual entities in a group

– So that they show the financial position and financial performance of the group of
entities

– Presented as if they were a single economic entity

Consolidated financial statements are ‘…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

• Consolidated financial statements are prepared by

(i) Aggregating (combining), line by line, like items of assets, liabilities, equity, income and expenses

(ii) Adjusting these combined figures for inter-group transactions between entities within the group

• Purpose/Reasons for consolidation:

– Supply of relevant information

 – Comparable information

– Accountability

– Reporting of risks and benefits

Control as the criterion for consolidation

• A parent is an entity that controls one or more entities

• Control is the criterion for identifying when a parent-subsidiary relationship exists

• Significant judgement is often required in determining whether control exists

• An investor controls an investee when

– Power over the investee exists

– 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

• The following three elements are required in order for an investor to have control:

• 1. Power over the investee

• 2. Exposure, or rights, to variable returns from its involvement with the investee

• 3. The ability to use its power over the investee to affect the amount of the
investor’s returns.

• All three elements must be present for control to exist

Control as the criterion for consolidation – Power

• Power is defined as ‘…existing rights that give the current ability to direct the relevant activities’

• Power arises from rights. Most rights arise from a legal contract. Examples in AASB 10 include:
 – Voting rights

– Rights to appoint, reassign or remove members of the investee’s key management

personnel

– Rights to appoint or remove another entity that participates in management decisions

– Rights to direct the investee to enter into, or veto any changes to, transactions that
affect the investee’s returns

• Level of share ownership

• Share ownership normally provides voting rights

• Power is presumed to exist where an investor owns more than 50% of the
voting rights of an entity unless there is evidence to the contrary

• Voting rights of less than 50% can result in an investor having power over an investee –
consider the following factors:

• Dispersion of other shareholders – probability of shareholders attending

meeting lessened by location and by size of share parcels

• Attendance at AGMs – e.g. if only 60% of eligible votes attend meeting, 31% can
control meeting

• Existence of contracts – power by agreement with other investors

• Level of disorganisation or apathy of other shareholders

Control as the criterion for consolidation – Exposure or rights to variable returns

• The second element of the control definition requires that the investor has the rights to variable
returns from the investee.

• Examples of returns that can exist in parent-subsidiary relationship include:

– Dividends

– Obtaining scarce raw materials on priority basis

– Gaining access to subsidiary’s distribution network, patents

 – Economies of scale

– Denying or regulating access to subsidiary’s assets to competitors

Control as the criterion for consolidation – Ability to use the power to affect returns

• The third element requires that the parent has the ability to increase its benefits and limit its
losses from the subsidiary’s activities.

• Remember, all three elements must be present for control to exist.

Preparation of consolidated financial statements

AASB 10(paragraph 4) requires all parents to prepare consolidated financial statements

Unless they (the parent entity) meet all of the following conditions:

i. it is a wholly-owned subsidiary or is a partially-owned subsidiary of another entity and all its

other owners do not object to the parent not presenting consolidated financial statements;

ii. its debt or equity instruments are not traded in a public market;

iii. it is not required to file financial statements with a securities commission or other organisation
for the purpose of issuing instruments in a public market; and

iv. its ultimate or any intermediate parent produces consolidated financial statements available for
public use and comply with IFRSs.