Chapter 1 - Business Combinations: Statutory Merger and Statutory Consolidation Introduction ‘Accounting for business combinations is one of the most significant and interesting topics of accounting theory and practice. Simultaneously it is multifaceted and divisive. Business combinations involve financial transactions of immeasurable magnitudes. business empires. triumphant stories and individual fortunes, managerial genius, and management debacles. By their nature, they affect the destiny of entire companies. Each is exceptional and must be evaluated in terms of its economic substance, regardless of itslegal form. Why do business entities enter into a business combination? Although a number of redsons have been cited, the overriding reason is probably growth. Growth is a major objective of many business organizations. ‘A company, may grow slowly, may gradually expand its product lines, facilities, or services, or may skyrocket almost overnight Business combinations may destroy value rather than create, in some instances. For example, if the managers of merged firm transfer resources to subsidize money-losing segments instead of shutting them down, the result will be a suboptimal allocation of capital. This situation may arise because of reluctance to eliminate jobs or fo acknowledge a past mistake. This chapter presents reasons for the popularity of business combination, the methods and techniques in dealing with them. The Nature of a Business Combination A business combination may be friendly or unfriendly (hostile takeovers): * Ina friendly combination, the board of directors of the potential combining companies negotiates mutually agreeable terms of a proposed combination. The proposal is submitted to the stockholders of the involved companies for approval. Normally, a two- thirds or three-fourths positive vote is required by corporate by-laws to bind all stockholders to the combination. «An unfriendly (hostile) combination results when the board of directors of a company targeted for acquisition resists the combination. A formal tender offer enables the acquiring firm to deal directly with individual shareholders. If a sufficient number of shares are not made available, the acquiring firm may reserve the right to withdraw the offer. Because they are relatively quick and easily executed (often in about a month), tender offers are the preferred means of acquiring public companies. Although tender offers are the preferred method for presenting hostile bids, most tender offers are friendly ones, done with the support of the target company's management. Nonetheless, hostile takeovers have become sufficiently common that a number of mechanisms have emerged to resist takeover. Resistance often involves various moves by the target company, generally with colorful terms. Whether such defenses are ultimately beneficial to shareholders or not remains a controversial issue. Academic research examining the price reaction to defensive — cae =A Cees Ce -2 CHAPTER 1 " roduced mixed results, suggesting that the defenses are Good f, cerca in some cases and bad in others, 7 jostile) takeover, the following are defensive tactics Or moves to Tesist i ee Ae pasion with the following colorful designations: the pro} Poison Pil. An amendment ofthe articles of incorporation or bylaws to make i morg " Gcut to obtain stockholder approval for 0 takeover. 2. Greenmail. An acquisition of common stock presently owned by the Prospecs, : acquiring (acquirer) company at a price substantially lower in excess of the Prospective acquirer's cost, with the stock thus placed inthe treasury or retired. The purchaseq are then held as treasury stock or retired, This tactic is largely ineffective because it Tay result to an expensive excise tax; further, from an accounting Perspective, the €xcess of the price paid over the market price is expensed, 3. White Knight or White Squire. A search for a candidate to be th ; takeover. This is simply encouraging a third company more act company. '€ Acquirer in a fy ‘ceptable to the forget 4, Pac-man Defense. Attempting an unfriendly takeover of the we company. “Selling the Crown Jewels” or “Scorched Earth”. the sale of valuable make the firm less attractive to the “would be acquirer". firm, if it survives, is left without some important assets. Ould be Acquitng Assets to others to The negative aspect is that the Shark Repellant. An acquisition of substantial amounts of outstanding common stock the treasury or for retirement, or the incuning of substantial long-term debt in exchange for outstanding common stock. . Leveraged Buyouts. When Management desires to own the business, it May arrange to buy out the stockholders using the company's assets to finance the deal, The bonds issued offen take the form of high-interest, high-risk “junk" bonds. 8. The Mudslinging Defense. When the Acquiring company offers stock instead of cash, the Prospective acquiring (acquirer) company's management May try to convince the stockholders that the stock would be a bad investment. 9. The Defensive Acquisition Tactic. When a Major reason for an attempted takeoveris the Prospective acquiring (acquirer) company's favorable cash Position, the prospective acquiring (acquirer) company may try to id itself of this excess cash by attempting to takeover of its own, Reasons for Business Combinations There are several Construction of né Feasons why business 1. Cost Advantage. it is commonly less expensive for a firm to obtain needed amenities through Combination rather t than through development. 2. Lower Risk. Th © acquisition of reputable product lines and markets is usually less risky thon developin . ‘A i Givesitcota Products and markets, The threat is especially low when the purpose65 COMBINATION ~ STATUTORY MERGER and STATUTORY CONSOLIDATION 3 3, Avoidance of Takeovers. Many companies combine to evade being acavired themselves. Smaller companies tend to be more susceptible to corporate takeovers; therefore, many of them adopt forceful buyer strategies to defend against take over attempts by other companies. 4, Acquisition of Intangible Assets. Business combinations bring together both intangible and tangible resources. 5. Other Reasons. Entities may choose a business combination over other forms of expansion for business tax advantages (for example, tax-loss cary forwards), for personal income and estate-tax advantages, or for personal reasons. Types of Business Combinations Business combinations may be classitied under three schemes: 1. One based on the structure of the combination, 2, One based on the method used to accomplish the combination, and 3. One based on the accounting method used. Structure of Business Combination In general terms, business combinations unite previously separate business entities. The overiding objective of business combinations must be increasing profitability; however, many firms can become more efficient by horizontally, or vertically integrating operations or by diversifying their risks through conglomerate operations, or by diversifying through change in operation. Because of this reason, combinations are classified by structure into four types - horizontal, vertical, conglomerate, and circular. «Horizontal Integration - this type of combination is one that involves companies within the some industry that have previously been competitors. © Vertical Integration - this type of combination takes place between two companies involved in the same industry but at different levels. It normally involves a combination of acompany and its suppliers or customers. * Conglomerate Combination - is one involving companies in unrelated industries having little, if any, production or market similarities for the purpose of entering into new markets or industries. «Circular Combination - entails some diversification, but does not have a drastic change in operation as a conglomerate. Possible Structures The structure of a business combination may be determined by a variety of factors, including legal and tax strategies. Other factors might include market considerations and regulatory considerations include: ‘one business becomes a subsidiary of another; two entities are legally merged into one entity; ‘one entity transfers its net assets to another entity; an entity's owners transfer their equity interests to the owners of another entity; two or more entities transfer their net assets, or the owners transfer their equity interests, to ‘a newly-formed entity (sometimes termed a “roll-up or ‘put-together’ transaction); and © agroup of former owners of one entity obtains control of a combined entity. = ae ama AgaCHAPTER J et od 1 pe: 7 Combinations of Combinations/Legal Forms of Effecting Business ee combination which can be identified from legal ang f combi There are four Hier ee tional perspectives. A é 3 organiza} five, accounting and organizational Cee ae specific From legal perspec! on accounting for a business combination is ae ee an procedures 4 aaa ‘or assets or an acquisition of stock, the distinction of which is acquisition of n' i is stage. ist important at this st mos ts (Assets less Liabilities). The books of the acquired (acquiree) ACQUIS” oe issu, ond iis assets and labilfies are transferred 10 the Books ofthe af othe acquiring /surviving company).In this aspect of combination, sometimes anaehis ‘acquires another enterprise’s net assets through direct negotiations with o L its management. i istributes to its stockholders the Asset @ (acquired) company generally dis bute: Pr et of peer fee instruments received in the combination from the acquirer (acquiring) company and liquidates. The acquired (acquiring) company accounts for the combination by recording each asset acquired, each liability assumed, and the consideration given in exchange. Following are the features of an asset and liabilities acquisition: The acquirer acquires from another enterprise all or most of the net assets of the other enterprise for cash or other property, debt instruments, ang equity instruments (common or preferred stock), or a combination thereof, « The acquirer must acquire 100% of the net assets of the acquiree (acquired) company. | + Itinvolves only when the acquirer (acquiring) company survives. Acquisitions of Net Assets (assets less liabilities) are classified into: A.Statutory merger (to be discussed in succeeding paragraphs) B.Statutory consolidation (to be discussed in succeeding paragraphs} In this chapter, we focus on the acquisition of net assets of the acquired company. Acquisition of Common Stock (Stock Acquisition). The books of the acquirer (acquiring) company and acquire (acquired) company remain intact and consolidated financial statements are prepared periodically. In such cases, the acquirer (acquiring) company debits an account “Investment in Subsidiary”, the stock of the acquired company is recorded as an inter-corporate riled rather than transferring the Underlying assets and liabilities onto its own Ks, A business combination effected through a stock acquisition does not necessarily have to involve the acquisition of all of @ company’s outstanding voting (common) shares. In those cases, control of nother company is acquired. Following are the features of a stock acquisition: a. The acquirer acquires voting (common) stock from another enterprise for cash of other property, debt instruments, and equity instruments (common or preferred stock], or a combination thereof.usiNEss COMBINATION ~ STATUTORY MERGER and STATUTORY CONSOLIDATION 5 b, The acquirer must obtain control by purchasing 50% or more of the voting common stock or possibly less when other factors are present that lead to the acquirer gaining control. The total of the shares of an acquired company not held by the controlling shareholder is called the non-controlling interest. c. The acquired company need not be dissolved: that is, the acquired company does not have fo go out of existence. Both the acquirer (acquiring) company and the acquiree (acquired) company remain as separate legal entity. Further discussions and illustration for the topic “stock acquisition” will be discussed in the succeeding chapters (Chapters 2-5). ‘Asset Acquisition. Iteflects the acquisition by one firm of assets (and possibly liabilities) of ‘nother firm, but not its shares. The seling fim may continue to survive os c legal entity, orit may liquidate entirely. The acquirer typically targets key assets for acquisition, of buys the acquiree's assets but does not assume its liabilities, Often the assets acquired are in the form of a division or product line. The acquirer may not buy the entire entity. It should be noted that asset acquisition is not within the scope of business combination under PRS 3 (refer to discussion below). There are two independent issues related to the consummation of a combination: «what is acquired (net assets, stock or assets) and «what is given up (the consideration for the combination). ‘Acquisition of Net Assets (Assets less Uabilities) The terms merger and consolidation are ‘often used synonymously for acquisitions. However, legally and in accounting, there is a difference. The distinction between these categories is largely a technicality, and the terms mergers, consolidations, and acquisitions are popularly used interchangeably. Statutory Merger A statutory merger entails that acquiring (acquirer) company survives, whereas the acquired (acquire) company (or companies) ceases to exist as a separate legal entity, although it may be continued as a separate division of the acquiring company. Thus, if A Company acquires B Company in a statutory merger, the combination is often expressed as: X Company + Y Company = X Company or Y Company The board of directors of the companies involved normally negotiates the terms of a plan of merger, which must then be approved by the stockholders of each company involved. Laws or corporation by-laws dictate the percentage of positive votes required for approval of the plan. Statutory Consolidation A statutory consolidation results when a new corporation is formed to acquire two or more other corporations; the acquired corpordtions then cease to exist (dissolve) as separate legal entities. For example, if C Company is formed to consolidate A Company and B Company, the combination is generally expressed as: X Company + Y Company = Z Company \dvanced Financial Accounting ~ A Comprehensive: Conceptual & Procedural ApproachCHAPTER 6 ee it ie Y) become stockholders in th tockholders of the acquired companies (X and ome © ne aT (2). The acquired companies in a statutory consolidation may be Operated s separate divisions of the new corporation, just as they may be under a statutory Merge, Statutory consolidations require the same type of stockholder approval as Stauton, mergers do. Future references in this chapter: : aeiucass + The term merger in the technical sense of a business combination in the combining companies go out of existence. * Similarly, the term consolidation will be used in its technical sense to refer to a busing combination in which alll the combining companies are dissolved and a new Corporation is formed to take over their net assets. * Consolidation is also used in accounting which refers to the accounting Process Procedures of combining parent and subsidiary financial statements, such Qs in te expressions “principles of consolidation”. “consolidation procedures,” and “Consolidate financial statements.” in succeeding chapters, the meaning of the term “co, o refers to stock acquisition. As a matter of procedure to prepare consolidate financig statements, the business combination defined s stock acquisition is expressed Os: Financial Statements + Financial Statements = Consolidated Financial Statements of of X Company of Y Company X Company and Y Company which all but one ml Accounting Concept of Business Combination The accounting standard relevant for accounting for business combinations is PERS 3 (Business Combinations) issued by the International Accounting Standards Board (IASB), In reading PFRS 3, it is important to note that Appendix A contains different terms while Appendix B contains application guidance - both Appendices are an integral part of PERS 3. The IASB has also published a Basis for Conclusions on PFRS 3, but this is not an integral part of the standard. Definition PFRS 3 defines “business combination” as @ transaction or other event in which on acquirer obtains control of one or more businesses. Transactions sometimes referred o as “true mergers” or “mergers of equals” also are business combinations. A first key aspect in this definition is “control”. This means that there must be a triggering €conomic event or transaction and not, for example, merely a decision to stat Preparing combined or consolidated financial statements for an existing group. Control can usually be obtained either by: |. Buying the assets themselves (which automatically gives control to the buvel . Buying enough shares in the Corporation that owns the assets to enable a investor (acquirer) to control the investee (acquire) corporation (which mo! the purchased Corporation a subsidiary) Economic events that might result in an entity obtaining control include: snes * transferring cash or other assets (including net assets that constitute a busi ¢ incurring liabilities; * issuing equity instruments;BUSINESS COMBINATION ~ STATUTORY MERGER and STATUTORY CONSOLIDATION 1 « acombination of the above; and @ transaction not involving consideration, such as combination by contract alone (e.g. a dual listed structure) The meaning of “control” will be discussed later in Chapter 2 and the accounting procedures are thoroughly discussed in succeeding chapters. The second key aspect of the definition is that the acquirer obtains control of a “business”. Identifying a Business PFRS 3 defines the term “business” as “an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing goods or services to customers, generating investment income (such as dividends or interest) or generating other income from ordinary activities.” The definition of business was narrowed by: «focusing on providing goods and services to customers «removing the emphasis from providing a retum to shareholders «removing the reference to ‘lower costs or other economics benefits The business combination must involve the acquisition of a business, which generally has three elements: «Inputs - an economic resource (e.g. non-curent assets, intellectual property} that merely need to have the ability to contribute to the creation of outputs. « Process - a system, standard, protocol, convention or rule that when applied to an input or inputs, creates outputs (e.g. strategic management, operational processes, resource management} © Output - the result of inputs and processes applied to those inputs The result of inputs and processes applied to those inputs that provide goods or services to customers, generate investment income (such as dividends or interest) or generate other income from ordinary activities. «+ The intellectual capacity of an organized workforce having the necessary skills and experience in following rules and conventions may provide the necessary processes applied to inputs to create outputs. * The focus on outputs is on returns from goods and services provided investment income, and other income from ordinary activities. The purpose of defining a business is to distinguish between the acquisitions of a group of assefs such as a number of chairs, bookshelves and filing cabinets - and the acquisition of an entity that is capable of producing some form of output. Accounting for a group of assets is based on standards such as PAS 16 Property, Plant and Equipment rather than PFRS 3. ‘Advanced Financial Accounting ~ A Comprehensive: Conceptual & Procedural 1 Approach8 CHAPTER y Scope of Business Combination The following transactions are within the scope of PERS 3: 1. Combinations involving mutual entities. A mutual entity is defined as an entity, other than an investor-owned entity, that provides dividends, lower costs or other economic benefits directly to its owners, members or participants, e.g., a mutual insurance company, a credit union and a cooperative entity. 2. Combinations achieved by contract alone (dual listing stapling). In g combination achieved by contract alone, two entities enter into a contractual arrangement which covers. for example, operation under a single management ‘ond equalization of voting power and earings attributable to both entities! equity investors. Such structures May involve a ‘stapling’ or formation of a dual listed corporation. combination by contract under PFRS 3 requires one of be identified as the acquirer, and one to be identified hing the conclusion that combinations achieved by ‘excluded from the scope of PFRS 3. Accounting for business the combining entities to as the acquiree. In reac! contract alone should not be On the other hand, the following transactions are not within the scope of PFRS 3; 1. Where the business combination results in the formation of all types. of joint arrangements (joint ventures and joint operations) and the scope exception only applies to the financial statements of the joint venture or the joint operation itself and not the accounting for the interest in a joint arrangement in the financial statements of a party fo the joint arrangement. 2. Where the business combination involves entities or businesses under common control, Common control Is a business combination in which all of the combining entities or businesses are ultimately controlled by the same party or parties both before and after the combination, and that control is not transitory. 2. Where the acquisition of an asset or a group of assets does not constitute a business. The term used to indicate this transaction is “asset acquisition”. In such circumstances, the acquirer: a. Identifies and recognizes the individual identifiable assets acquired (including those assets that meet the definition of, and recognition criteria for intangible assets in PAS 38 Intangible Assets) and liabilities assumed; and b. Allocates the cost of the group of assets and liabilities to the individual assets nd liabilities on the basis of their relative fair value at the date of purchase. Such transaction or event does not give rise to goodwill. The Acquisition Method The acquisition method is applied on the ac te the acquirer ’ ‘quisition date which is the date the obtains control of the acquiree. The acquisition method approaches a business combination from the perspective of the acquirer (not the acquiree), the entity tha! obtains control of the other enti{ies) in the business combination.BUSINESS COMBINATION ~ STATUTORY MERGER and STATUTORY CONSOLIDATION ° Under the acquisition method, all assets and liabilities ide Tarawa are identified and reported at Accounting Procedures for a Business Combination The required method of accounting for a business combination under paragraph 4 of PERS 3 Is the acquisition method. Under the acquisition method, the general approach fo accounting business combinations is a five step process: 1. Identify the acquirer; 2. Determine the acquisition date; 3. Calculate the fair value of the purchase consideration transferred (ie., the cost of purchase) 4, Recognize and measure the identifiable assets and liabilities of the business, and 5. Recognize and measure either goodwill or a gain from a bargain purchase, if either exists in the transaction, If an acquirer gains control by purchasing less than 100% of the acquired entity, then the fourth step includes measuring and recognizing the non-controlling interests (NCI). Discussion of NCI will be in Chapter 2. Identitying the Acquirer PFRS 3 paragraph 7 states that “the acquirer is the entity that obtains control of the acquiree". Paragraph 6 requires that in each business combination, one of the combining entities should be identified as the acquirer. The concept of control under PFRS 3 will be discussed methodically in Chapter 2. PFRS 3, however, recognizes that it may be difficult to identify which entity has control over other combining entities. In the event that the overriding principle of "control” in PFRS 3 does not conclusively determine the identity of the acquirer, PFRS 3 provides additional guidance. Determining the Acquisition Date PFRS 3 defines “acquisition date” as the date on which the acquirer obtains control of the acquiree. ‘A business combination involves the joining together of assets under the control of a specific entity. Therefore, the business combination occurs at the date of the assefs or net assets are under the control of the acquirer. This date is the acquisition date. © Other dates that are important during the process of business combination may be: * The date the contracts signed; * The date the consideration is paid; * Adate nominated in the contract; = The date on which assets acquired are delivered to the acquiter; and * The,date on which on offer becomes unconditional. * These dafes may be important but determination of acquisition date does not depend on the date the acquirer receives physical possession of the assets acquired, or actually pays out the consideration to the acquiree. — = = ENCHAPTE, * The use of control as the key criterion t ! 10 determine acquisit the substance of the transaction determines the aecounting il ensures of the transaction. S rather than the att om For example, assets acquired may be deliv. C ered in stages or paymer reeunlis ee ube poor of time with a number of siesta Bone for thes o 3, on the closing date of th inatti "evieg legally transfers the consideration — cash Wires he oon AME aca Sf d or shares ~ and acquires th Chi of the acquire. However, in some cases this may not be the acaustion tae ee lite « The piel of acquisition date then relates to the point in time whe; sa Es de doe become the net assets of the acquirer ~ in eae . ic| \@ acquirer can recognize the net ited ine, sobre fel assets acquired in its on There are four main areas where the selection of the date , business combination: oe accounting for g 1, The identifiable assets acquired and liabilities assumed by the ac measured at the fair value on the acquisition date. The choice of affected by the choice of the acquisition date. Quirer cy, fair value t 2. The consideration paid by the acquirer is determined as the sum of the values of assets given, equity issued and/or liabilities undertaken in an excha : for the net assets or shares of another entity. The choice of date affects measure of fair value. » 3. The acquirer may acquire only some of the shares of the acquiree. The owners o the balance of the shares of the acquiree are called the non-controlling interey - defined in the Appendix A as the equity in a subsidiary not attributable, directly or indirectly, to a parent. This non-controlling interest is also measured at foi value on acquisition date. (This concept will be discussed and illustrated in Chapter 2) 4, The acquirer may have previously held an equity interest in the acquiree prior to obtaining control of the acquiree. For example, entity X may have previously acquired 20% of the shares of entity Y, and now acquires the remaining 80% giving it control of entity Y. The acquisition date is the date when enlity acquired the 80% interest. The 20% shareholding will be recorded as an asset in the records of entity X. On acquisition date, the fair value of this investment i measured. (This concept will be discussed and illustrated in Chapter 2) The effect of determining the acquisition date is that the financial position pel combined entity on acquisition date should report the assets and liabilities of ! acquiree on that date and any profits reports as a result of the acquiree’s o within the business combination should reflect profits earned after the acquisition da'®- ; : the Calculating the Fair Value of the Consideration Transferred: Accounting Records of Acquirer According to PFRS 3 paragraph 37, the consideration transferred: * ismeasured at fair value at acquisiti ' * iscalculated as the sum of the acquisition date fair values of:BUSINESS COMBINATION ~ STATUTORY MERGER and STATUTORY CONSOLIDATION * 1. the assets transferred by the acquirer; 2. the liabilities incurred by the acquirer to former owners of the acquiree; and 3. the equity interest issued by the acquirer. Ina specific exchange, the consideration transfered to the acquirer could include just ‘one form of consideration, such as cash, but could equally va aaah of Fates of forms such as cash, other assets, a business or a subsidiary of the acquirer, contingent consideration, equity instruments (common or preferred stock) and debt instruments, options, warrants and member interests of mutual entities. : The consideration transferred includes the following items: 1. Cash or Other Monetary Assets. The fair value is the amount of cash or cash equivalent dispersed. The amount is usually readily determinable. One problem that may occur arises when the settlement is deferred to a time alter the acquisition date. For deferred payment, the fair value to the acquirer is the amount the entity would have fo borrow to settle the debt immediately (Le. the present value of the obligation). Hence, the discount rate used is the entity’s incremental borrowing rate. 2. Non-monetary Assets. Non-monetary assets are assets such as property, plant and equipment, investments, licenses and patents. As noted earlier, if active second-hand market exists, fair values can be obtained by reference to those markets. In this case, the acquirer is in effect selling the non-monetary asset to the acquiree. Thus, it is eaming an income equal to the fair value on the sale of the asset. If the carying amount of the asset in the records of the acquirer is different from fair value, a gain or loss on the asset is recognized at acquisition date. This principle is in compliance with paragraph 38 of PFRS 3. 3. Equity Instruments. If an acquirer issues its own shares as consideration, it needs fo determine the fair value of those shares at acquisition date. For listed entities, reference is made to the quoted prices of the shares. ‘Acquisition date model (equity instruments would be measured on the date the acquirer obtains control over the business acquired). 4, abilities Undertaken. The fair values of liabilities are best measured by the present values of expected future cash outflows. Future losses or other costs expected to be incured as a result of the combination are not liabilities of the acquirer and are therefore not included in the calculation of the fair value of consideration paid. 5. Contingent Consideration. The contingent consideration may include the distribution of cash or other assets or the issuance of debt or equity securities. PFRS 3 provides the following definition of contingent consideration, “Usually, on obligation of the acquirer to transfer additional assets or equity interests fo the “{dvanced Financial Accounting ~ A Comprehensive: Conceptual & Procedural ApproachCHAPTER 1 former owners of an acquiree as part of the exchange for control of the acquire if specified under future events occur oF conditions are met. However, contingent consideration also may give the acquirer the right fo the return of previously transfered consideration if specified conditions are met”. Contingent consideration is an add-on to the base acquisition price that is based ‘on events occurring or conditions being met some time after the purchase takes place. This topic will be discussed further later in this chapter with illustrations. 6. Share-based payment awards (Acquirer share-based payment awards exchanged for awards held by the acquiree's employees). The share-based payment transactions of the acquiree or the replacement of an acquiree's share-based payment transactions with share-based transactions of the acquirer are measured in accordance with PFRS 2 referred to as the “market based measure”. The acauirer is obliged to replace the acquiree's awards, either all or a portion of the market-based measure of the acquirer's replacement awards is included in measuring consideration transferred in the business combination. The acquirer is considered to be obliged to replace the awards if the acquiree or its employees have the ability to enforce replacement. Acquisition-Related Costs In addition to the consideration transferred by the acquirer to the acquiree, a further item to be considered in determining the cost of the business combination is the acquisition-related costs. Acquisition-related costs are excluded from the measurement of the consideration paid, because such costs are not part of the fair value of the acquiree and are not assets. They are as follows: 1. Costs directly attributable to the combination which includes costs such as legal fees, finder's and brokerage fee, advisory, accounting, valuation and other professional or consulting fees. . Indirect, ongoing costs, general costs including the cost to maintain an intemal acquisition department (mergers and acquisitions department), as well as general and administrative costs such as managerial {including the costs of maintaining an internal acquisitions department (management salaries, depreciation, rent, and costs incured to duplicate facilities), overhead that are allocated to the merger but would have existed in its absence and other costs of which cannot be directly attributed to the particular acquisition. The PFRS 3 accounting for these outlays is a result of the decision to record the identifiable assets acquired and liabilities assumed at fair value. The acquisition-related Costs Gssociated with a business combination are accounted for @s expenses in the periods in which they are incurred and the services are received. ‘Advanced Financial Accounting ~A Comprehensh Con aAerr BUSINESS COMBINATION ~ STATUTORY MERGER and STATUTORY CONSOLIDATION 8 The key reasons given for this approach are: « Acquisiion-related costs are not part of the fair value exchange between the buyer and seller, « They are separate transactions for which the buyer pays the fair value for the services received. « These amounts do not generally represent assets of the acquirer at acquisition date because the benefits obtained are consumed as the services are received. In contrast to PAS 16 Property, Plant and Equipment and PAS 38 Intangible Assets, assets acquired are initially recorded at cost, so directly attributable costs are considered as part of the cost of acquisition and capitalized into the cost of the asset acquired. Costs of Issuing Equity Instruments / Share Issuance Costs The costs of issuing equity instruments is also excluded from the consideration and accounted for separately. In issuing equity instruments such as shares as part of the consideration paid, transaction costs such as documentary stamp duties on new shares, professional adviser's fees, underwriting costs and brokerage fees may be incurred. As noted in paragraph 53 of PFRS 3, these costs are accounted for in accordance with PAS 32 Financial Instruments: Disclosure and Presentation. Paragraph 35 of PAS 32 states thot these outlays should be treated as a reduction in the share capital of the entity as such costs reduce the proceeds from the equity issue (meaning reducing the additional paid-in capital), net of any related income tax benefit. Further, if the share premium or additional paid-in capital from the related issuance is not enough to absorb such costs, the Philippine Interpretations Committee (PIC) concluded that the excess shall be debited to “Share Issuance Costs” which will be treated as a contra shareholders’ equity account as a deduction in the following order of priority: 1. Share Premium from previous share issuance; or* 2. Retained Earnings with appropriate disclosure. ‘on a personal note, the word “or” indicated on the Philippine Interpretations Commitiee (PIC) Q&A 4 published should be removed since itis quite misleading because the statement “order of prioty” was already in used. Companies often incur additional acquisition-related restructuring costs, including shutting-down departments, reassigning or eliminating jobs, and changing suppliers or production practices in connection with business combinations. Unless represented by ‘acquisition-date liabilities, these costs are expensed as incured and do not affect acquisition cost. In the past, firms have sought to capitalize these “acquisition-related" restructuring Costs, effectively reporting them as goodwill and not as expenses. The PIC Committee also considered listing fee for initial public offering of shares as an outright expense.“ CHAPTER} Costs of Issuing Debt Instruments Similarly with equity instruments, the costs of arranging and issuing debt instruments oy financial liabilities in accordance with PFRS 9), are an integral part of the liability issue transaction. They are deemed as yield adjustments to the cost of borrowing. These costs ‘care included in the initial measurement of the liability as bond Issue costs ang amortized the life of the debt. The summary of acquisition-related cost is shown as follows on Table 1-1: Table 1-1: Summary of Acquisition-related Costs: ‘Acquisition-related costs Examples 1. Directly attributable costs Legal fees, finders and brokerage fee, advisory, accounting, valuation (values) and other professional or consulting fees to effect the combination. Treatment Expenses 2. Indirect acauisition costs General and administrative costs | Expenses | such as managerial {including | the costs of maintaining an | internal acquisitions department | | | {management salaries, | | depreciation, rent, and costs | incuned to duplicate facities) overhead that are allocated to the merger but would have existed in its absence and other attibuted acauisition to the particular 3. Costs of issuing securities (sue cond register stocks}* - refer to | | | costs of which cannot be directly | | Transaction costs such as stamp duties on new shares, professional Debit to “Share Premium" or “Additional paidin discussion above. adver’ fees, underwring cos | conta’ account, | ‘ond brokerage fees may be incured | | | 4. Cost of arranging (registering) | Professional adviser’s fees, | Bondissue costs | and issuing debt securities or financial fabiities undermiting costs and brokerage | fees may be incurred. | Principles in Assessing What Is Part of the Business Combination PFRS 3 requires that an acquirer shall assess whether any portion of the transaction price (payments or other arrangements) and any assets acquired or liabilities assumed or incurred are not a part or a component of the exchange for the acquiree. Only the consideration transferred and the assets acquired or liabilities assumed of incurred that are part of the exchange for the acquire shall be included in the business combination accounting. “Advanced Financial Accounting ~ A Comprehensive: Conceptual & Procedural ApproachBUSINESS COMBINATION ~ STATUTORY MERGER and STATUTORY CONSOLIDATION z Any portion of the transaction price or any assets acquired or liabilities assumed or incured that are not parts or components of the exchange for the acquiree shall be accounted for separately from the business combination. The following are guidelines fo assess what part of the business combination for certain items requires the acquirer to evaluate the substance of transactions entered into by the parties: 1 Transactions entered into or any amounts paid that are designed primarily for the economic benefit of the acquiree (or its former owners) before the combination. Although, the amounts are not paid directly to the acquiree (vendor), they will still form port of the purchase consideration for the business combination as the acquirer is acting on behalf of the acquirer (vendor) in making the payments. However, this principle would not apply fo any costs incurred by the acquirer (vendor) on its own behalf in making the acquisition, as these must be accounted for outside the business combination. 2. Transactions entered into or any amounts paid into by or on behalf of the acquirer or the combined entity are not part of the business combination transaction, and are likely to be accounted for as separate transaction. The following are examples of separate transactions that are not fo be included In applying the acquisition method: a. A transaction that settles pre-existing relationships between the acquirer and the acquire; * b. A transaction that compensates employees or former employees of the acquire for future services; and cc. A transaction that reimburses the acquiree or its former owners for paying the acquirer's acquisition related costs. Pre-existing Relationships. A pre-existing relationship is a relationship between the acquirer and the acquiree that existed before the business combination and this may include a contractual relationship, such as a vendor and customer relationship, a franchisor and franchisee relationship, and a licensor and licensee relationship. It may also include a non-contractual relationship, such as plaintiff and defendant relationship. Compensation to Employees or Former Owners of Acquiree. Whether arrangements for contingent payments to employees or former owners of an ‘acquire should be considered as contingent consideration that is included in the measurement of the consideration transferred or are separate transactions depends on the nature of the arrangement. Recognition and Measurement of Assets Acquired and Liabilities Assumed: Accounting Records of the Acquirer , PFRS 3 sets out:basic principles for the recognition and measurement of identifiable assets acquired, liabilities assumed and non-controlling interests. Having established those principles, the PFRS 3 provides detailed application for specific assets and liabilities and a number of limited exceptions to the general principles. ‘Advanced Financial Accounting ~ A Comprehensive: Conceptual & Procedural ApproachB CHAPTER, 16 Under the acquisition method, the acquirer is required to: tely from goodwill; and 1. Recognize Identifiable assets and liabilifies separa 2. Measure such assets and liabilities at their falr values on the date of acquisition, Recognition Principle for Assets and Liabilities A key word is identifiable. Tne acquirer may be able to identify many more assets ang liabilities than those shown in the acquiree's balance sheet. ition date, the acquirer sho, PFRS 3 paragraph 10 requires that, as of the acquis ld recognize, separately from goodwill, the identifiable assets acquired, the liablities assumed and any non-controlling interests in the acquirer (Chapter 2). Paragraph 83 of the Framework for the preparation and presentation of Financia) Statements specifies two recognition criteria for assets and liabilities stating that the recognition occurs if: * Itis probable that any future economic benefit will flow fo or from the entity; ang The item has a cost or value that can be reliably measured. In deciding whether or not to recognize an asset or liability in a business combination, is assumed that the probability test for the assets acquired and liabilities assumed in g business combination is unnecessary. These assets and liabilities will always be able to be meosured reliably. Use of estimates simply means the measure may involve uncertainty but it does not mean the measure is unreliable. |n relation to the probability criterion, PFRS 3 states explicitly that the acquirer is required to recognize identifiable assets acquired and liabilities assumed regardless of the DEGREE of PROBABILITY of an inflow or outflow of economic benefits. The assets acquired and liabilities assumed are measured at fair value (refer to further discussion in the topic of “contingent liabilities" in the succeeding Paragraphs). Conditions for Recognition Principle In paragraphs 11 and 12 of PFRS 3, there are two conditions that have to be met prior to the recognition of assets and liabilities acquired in the business combination: 1. At the acquisition date, the assets and liabilities recognized by the acquirer must meet the definitions of assets and liabilities in the Framework. Any expected future costs cannot be included in the calculation of assets and liabilities acquired and liabilities assumed. The following are outcomes as a result of applying this recognition condition: * Post-acquisition reorganization. Costs the acquirer expects. but it is not obliged to incur in the future to affect its plan to exit an activity of on acquire. To terminate the employment of or relocate an acquiree’s employees is not liabilities at the acquisition date. + Unrecognized assets and liabilities. The acquirer May recognize some assets and liabilities that the acquiree had not previously recognized in its financial statements. ‘Advanced Financial Accounting ~ A Comprehensive: Conceptual & Procedural ApproachBUSINESS COMBINATION ~ STATUTORY MERGER and STATUTORY CONSOLIDATION 7 For example, the acquirer recognizes the acquired identifiable assets (such as brand names, patents or customer telationships), in-process research and development (to be discussed later) that the acquiree did not recognize as assets in its financial statements. Exception to the Recognition Principle One area affected by this condition is the accounting for contingent liabilities. PAS 37 Provisions, Contingent Liabilities and Contingent Assets (refer to discussion below). 2. The item acquired or assumed must be part of the business acquired rather than the result of a separate transaction. This recognition principle is an example of the application of substance over form wherein the entities involved in the transactions may link another transaction with the business combination, but in substance it is a separate transaction. As noted in Paragraph 13 of PFRS 3, a possible result of applying the principles of PERS 3 is that there may be assets and liabilities recognized as a result of the business combination that were not recognized by the acquiree. One example of this is internally generated intangibles that were not recognized by the acquire on the application of PAS 38 Intangible Assets; for example, internally generated brands would not be recognized by an acquire but would be recognized by the acquirer. The acquirer would measure these at fair value. Measurement Principle for Assets and Liabilities Identifiable assets acquired and the liabilities assumed are measured at their fair values on acquisition date fair values. PERS 13 defines “fair value” as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (i.e., an exit price). That definition of fair value emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Fair value is basically a market-based measure in a transaction between unrelated Parties. However, the process of determining fair value necessarily involves judgment and estimation. The acquiring entity is not actually trading the items in the marketplace for cash, but is trying to estimate what the exchange price would be if it did so. Hence, the determination of fair value involves estimation. To assist in the determination of fair value, the standard setters have developed a fair value hierarchy. The hierarchy categorizes the inputs used in vaivation techniques into three levels. The hierarchy gives the highest priority to (unadjusted) quoted prices in active markets for identical assets or liabilities and the lowest priority fo unobservable inputs. ‘Advanced Financial Accounting ~ A Comprehensive: Conceptual & Procedural ApproachCHAPTER ff 18 value are categorized into different levels of the fair bE surement is categorized in its entirety in the level of ificant to the entire measurement (based on the if the inputs used to me value hierarchy, the foir value meos the lowest level input that is signi application of judgment). The purpose of which is to provide a list of ways in which market value can be measured in a business combination, in order of preference. Measurement under the fair value hierarchy is as follows [it should be noted that inputs are being prioritized): Level 1 Inputs - are fully observable and are unadjusted quoted prices in on active market for identical assets and liabilities. Level 2 Inputs - are directly or indirectly observable inputs other than Level 1 inputs. , Level 3 Inputs - unobservable inputs for the asset or liability (not based on observable market data). Valuation Techniques The objective of using a valuation technique is to estimate the price at which on orderly transaction to sell the asset or to transfer the liability would take place between market Participants and the measurement date under curent market conditions, Three widely used valvation techniques are: «Market approach or market-based- uses prices and other relevant information generated by market transactions involving identical or comparable (similar) assets, liabilities, or a group of assets and liabilities (e.g. a business) this is known ‘as analogy or benchmark approach. + Income approach or income-based- based on future economic benefit derived from owning the asset or converts future amounts (cash flows or income ond expenses) to a single current (discounted) amount, teflecting current market expectations about those future amounts, * Cost approach or cost-based- reflects the amount that would be required Currently fo replace the service capacity of an asset (current replacement cost), although the result may not reflect fair value. In some cases, a single valuation technique will be appropriate, whereas in others Multiple valuation techniques will be appropriate. The market-based approach is the best approach; however, such data frequently are not available. Therefore, the most offen methods are income-based. All of these methods provide a great deal of opportunity for Management judgment in determining such fair values, especially in the case of intangible assets. Valuation of Identifiable Assets and Liabilities The above discussion on recognition and measurement Principles serves as guidelines as to the proper recording and valuation of identifiable assets and liabilities, ‘Advanced Financlal Accounting = A Comprehensive: Conceptual & Procedural ApproachBUSINESS COMBINATION ~ STATUTORY MERGER and STATUTORY CONSOLIDATION 19 + The first step in recording an acquisition is to record the existing assets and liabilities accounts (except goodwill). As a general rule, assets and liabilities are to be recorded at their individually determined fair values. The preferred method is quoted market value, where an active market for the item exists. Where there is not an active market, independent appraisals, discounted cash flow analysis, and other types of analysis are used to estimate fair values. There are some exceptions to the use of fair value that apply to accounts such as assets for resale and deferred taxes (see below for discussion). . ee is not required to establish values immediately on the acquisition In summary, the procedures for recording the assets and liabilities of the acquire are as follows: 1 Identifiable Tangible Assets. An asset other than an intangible asset is recognized if it is probable (probability test) that any associated future economic benefits will flow to the acquirer, and its fair value can be measured reliably (reliability test). A. Current Assets - these are recorded at estimated fair values. An acquirer is not permitted to 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. This would include recording accounts and notes receivable at the estimated amounts to be collected. Accounts and notes receivable are to be recorded in a net account that represents the probable cash flows; a separate valuation account for uncollectible accounts is not allowed because the effects of uncertainty about future cash flows are included in the fair value measure. All accounts share the rule that only the net fair value is recorded, and valuation accounts are not used. B. Assets held for sale (assets that are going to be sold rather than fo be used in operations). The acquirer should measure an acquired non-current asset (or disposal group) that is classified as held for sale at the acquisition date in accordance with PFRS 5 Non-current Assets Held for Sale and Discontinued Operations at fair value less costs fo sell. The exception as stated above is to avoid the need to recognize a loss for the selling costs immediately after a business combination (a so-called Day 2 10ss), if the assets had initially been measured at their fair value at the acquisition date. They are listed as current assets. 1 C. Property, plant and equipment ~ operating assets will require an estimate of fair value and will be recorded at that net amount with no separate accumulated depreciation account. i rehiay The principle of “no valuation allowance” also extends to property, plant and equipment such that, following a business combination, such assets are [Advanced Financial Accounting ~ A Comprehensive: Conceptual & Procedural Approach | \\0\.)CHAPTER 1 stated at a single fair value amount, and not at a gross “deemed cost" and accumulated depreciation. 7 ; - of recognizing an ). Investments in equity-accounted entities - for purposes measuring this identifiable asset, there is no difference Lida ll ests that is an associate or an investment that is trade investment cas i acquirer has acquired the investment not the underlying assets and li 5 of the associate. Accordingly, the fair value of the associate should be determined on the basis of the value of the shares of the associate rather than by calculating a fair value based on the appropriate share of the fair values of the various identifiable assets and liabilities of the associate. 9 2. Identifiable Intangible Assets. PFRS 3 requires the acquirer to recognize dentable Hoerbaattnte tegardless of the degree of probability of an inflow of economic benefits. This change emphasizes the expectation that all intangible assets that satisfy the definition criteria in PAS 38, if acquired as part of a business combination, must be recognized. An intangible asset is identifiable if, it: * can be separated; or * meets the contractual-legal criterion e.g. license to operate a nuclear power plant is an intangible asset, even though the acquirer cannot sell or transfer the license separately from the acquired power plant. « Separability criterion. An intangible is separable if it is capable of being Separated or divided from the entity sold, transferred, licensed, rented, or exchanged, either individually or together with a related contract. It is identifiable asset or liability regardless of whether the entity intends to do so. Examples are customer and subscriber lists, depositor relationships, registered trademarks, unpatented technical expertise, favorable operating leases (see below for further discussion), licenses and technology patents. * Contractual-legal criterion, An intangible asset that arises from contractual or legal rights is identifiable Tegardless of whether those rights are transferable or separable from the acquire or from other rights and obligations, Examples are license to operate a nuclear power plant is an intangible asset, even though the acquirer cannot sell or transfer the license separately from the acquired power plant, an acquiree leases a Manufacturing facility under Qn operating lease that has terms favorable to market terms, an acquirer Owns and operates an electric Power plant, an acquirer owns a technology patent. PFRS 3 presumes that where an intangible asset satisfies either of the criteria above, sufficient information should exist to measure reli liably its fair value. A non-monetary asset without pl Combination might meet the ider intangible asset but not be include: hysical_ substance acquired in a business ntifiability criterion for identification as on din the guidance, ‘Advanced Financial Accounting ~ A Comprehensiver Conceptual & Procedural Approach :BUSINESS COMBINATION ~ STATUTORY MERGER and STATUTORY CONSOLIDATION 2 The guidance designated the assefs as being “contractual’, i... arising from contractual or other legal rights or “non-contractual’, i.e., not arising from contractual or other legal rights but are separable, while nothing designated as “contractual” might also be separable. However, it emphasizes that separability is not a necessary condition for an asset to meet the contractual-legal criterion. The table below summarizes the items mentioned above in their classification as an intangible asset and are therefore to be recognized separately from goodwill. Marketing-related Intangible Assets - Trademarks, trade names, service marks, collective marks and certification marks - Trade dress (unique color, shape or package design) - Newspaper mastheads - Intemet domain names - Non-competition agreements Customer-related Intangible Assets - Order or production backlog = Customer contracts and the related customer relationships = Non-contractual customer relationships Customer lists Artistic-related Intangible Assets - Plays, operas and ballets = Books, magazines, newspapers and other literary works = Musical works such as compositions, song lyrics and advertising jingles = Pictures and photographs Video and audiovisual material, including motion pictures or films, music videos and television programs Contract-based Intangible Assets = Licensing royalty and standstill agreements - Advertising construction, management, service or supply contracts - Lease agreements (whether the acquiree is the lessee or lessor) = Construction permits = Franchise Agreements = Operating and broadcasting rights - Use rights such as driling, water, air, mineral, timber-getting and route authorities - Servicing contracts such as mortgage servicing contracts - Employment contracts Technological-based Intangible Assets - Patented technology = Computer software and masks works - Unpatented technology =~ Databases including title plants ~ Trade secrets such as secret formulas, processes or recipes ‘Advanced Financial Accounting - A Comprehensive: Conceptual & Procedural ApproachCHAPTER 7? 2 Other intangible assets being acquired as part of business combinations with their proper valuation are: 1. Emission rights. Emission rights acquired in a business combination meet the definition of an intangible asset and should therefore be recognized on the acquisition date at their fair value. 2, Reacquired tights. As part of business combination, an acquirer may feacquire a right that it had previously granted to the acquire to use one or more of the acquirer's recognized or unrecognized assets such as right touse the acquirer's trade name under franchise agreement. Areacquired right is an intangible that the acquirer recognizes separately from goodwill. Relative to the above discussions and examples, care should be considered to as recognition of intangible assets: A. Existing intangible assets -- these will be recorded at estimated fair value. The Valuation of these items such os patent and copyrights will typically require the use of discounted cash flow analysis, B. Intangible assets not curently recorded by the acquiree - identifiable intangible assets must be separately recorded; their value cannot be swept into the “goodwill" classification. An intangible asset is identifiable if it arises from contractual or other legal rights (even if it is not separable). For example, the acquirer may have a Customer list that could be sold separately and has a determinable valve. PFRS 3 made it clear that in-process research and development, the acquirer recognizes all tangible and intangible research and development assets acquired in a business combination and recorded at fair value as an asset on the date of acquisition. This requirement does not extend to IPRD (in-process research and development) in contexts other than business combinations. In any event, the importance of maintaining supporting documentation for any amounts assigned to'IPRD is clear. They are considered separable on occasion that they are bought and sold by entities, C. When the acquiree is a lessee with tespect to assets in use. As a rule, the ‘acquirer should not recognize any asset or liability related to an operating lease in which the acquire is the lessee, The. acquiree has no recorded assets for assets under operating leases, If however, the terms of the lease are market rates, an intangible asset would be {> present value of the SAVINGS. favorable as compared to current € recorded equal to the discounted If the lease terms are unfavorable, an estimated liability would be recorded equal to the discounted present value of the rent in EXCESS of fair rental rates. Advanced Financal Accounting =A Comprehensive: oncontual }& Procedural ApproachBUSINESS COMBINATION ~ STATUTORY MERGER and STATUTORY CONSOLIDATION B On the other hand, when the acquiree may have acted as a lessor or the acquitee is simply, the lessor, where an asset such as a building or a patent is leased out by the acquiree under an operating lease, the acquirer takes the terms of the lease into account in measuring the acquisition date fair value of the asset. In other words, the acquirer does not recognize separately an intangible asset or liability if the terms of the lease are favorable or unfavorable relative to market terms and prices. It should be observed that in the United States, such is not the case when the ‘acquiree is the lessor in an operating lease. In US FASB, the classification of the lease is not changed unless the terms are changed. For operating leases, the acquiree has the asset recorded at fair value, and it is not affected by the terms of any lease applicable to that asset. Note that the lessor terms are favorable when the contract rental rate exceeds fair rental value, and terms are unfavorable when the fair rental value exceeds the contract rate. 2. Existing Liabilities - these are also recorded at fair values (or present value). For current contractual liabilities, they may likely be the existing recorded value. For estimated liabilities, a new fair value may be used in place of recorded values. Long-term liabilities will be adjusted to a value different from recorded value if there has been a material change in interest rates. In cases of deferred revenue, an acquirer should recognize a liability for deferred revenue of the acquiree only if it relates to an outstanding performance obligation assumed by the acquirer. Such performance obligations would include obligations to provide goods or services, or the right to use an asset. The measurement of the deferred revenue should be based on the fair value of the obligation at the date of acquisition, which will not be necessarily the same as the amount of deferred revenue recognized by the acquire. 3. Contingent liabilities - PFRS 3 require the contingent liabilities of the acquiree to be recognized and measured in a business combination at acquisition date fair value, This may result to the recognition of contingent liabilities that would not qualify for recognition under PAS 37 Provisions, Contingent Liabilities and Contingent Assets. In a business combination, the requirements of PAS 37 are not applied in determining which contingent liabilities should be recognized as of the acquisition date. Instead, PFRS 3 requires that the acquirer should recognize a contingent liability assumed in a business combination as of the acquisition date if: «. [tis a present obligation that arises from past events; and * Its fair value can be measured reliably. ead wa emaran