ACCOUNTING BUSINESS

COMBINATION
MILLAN 2018 EDITION

Jane G.
Villanue
va
 BSA3_B

1. Introduction/Overview
This module aims to provide students a comprehensive understanding and application of the
proper accounting principles for the recognition and measurement relating to a business combination. It
also provides the students with a comparison between the full Philippine Financial Reporting Standard
(PFRS) and the Philippine Financial Reporting Standard for Small and Medium-sized. Entities (PFRS for
SMEs).

2. Learning Outcomes
1. Define a business combination.

2. Identify a business combination transaction.

3. Explain briefly the accounting requirements for a business combination.

4. Apply the proper accounting principle for business combination transaction.

5. Compute for goodwill.

6. Compare the difference between the full PFRS and PFRS for SMEs.

3. Business Combination (Recognition & Measurement)

A business combination occurs when one company acquires another or when two or more

companies merge into one. After the combination, one company gains control over the other. The

company that obtains control over the other is referred to as the parent or acquirer. The other

company that is controlled is the subsidiary or acquiree.

PFRS 3 Business Combinations is the standard to be applied for business combination transactions

to improve the relevance, reliability, and comparability of the information that a reporting entity

provides in its financial statements about a business combination and its effects.

3.1. PFRS 3 defines the following:

A. Business combination

• the transaction or other events in which an acquirer obtains control of one or more

businesses

B. Business

• 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

C. Acquisition Date

• The date on which the acquirer obtains control of the acquire

D. Acquirer

• The entity that obtains control of the acquiree

E. Acquiree

• The business or businesses that the acquirer obtains control of in a business combination

3.2. Business Combination is carried out either through:

A. Asset acquisition

o Acquirer purchases assets and assumes liabilities in exchange for cash or non-cash consideration

o Under the Revised Corporation Code of the Philippines, a business combination effected through
asset acquisition may be either:

1. Merger

▪ Occurs when two or more companies merge into a single entity which shall be one of the
combining companies.

▪ A Co. + B Co. = A Co. or B Co.

2. Consolidation

▪ occurs when two or more companies consolidate into a single entity which shall be the
consolidated company

▪ A Co. + B Co. = C Co.

B. Stock Acquisition

o Acquirer obtains control over the acquire by acquiring a majority ownership interest in the voting
rights of the acquire (generally more than 50%).

o Acquirer is known as the parent while the acquiree is known as the subsidiary.

o After the business combination, both companies retain their separate legal existence and
continue to maintain their own separate accounting books.

o For financial reporting purposes, both the parent and subsidiary are viewed as a single
reporting entity.

C. A business combination may also be described as:

1. Horizontal combination

▪ A business combination of two or more entities with similar businesses (e.g., a bank acquires
another bank).
2. Vertical combination

▪ A business combination of two or more entities operating at a different level in a marketing chain
(e.g., a manufacturer acquires its supplier of raw materials)

3. Conglomerate

▪ A business combination of two or more entities with dissimilar businesses (e.g., a real estate
developer acquires a bank)

3.3. Advantages and Disadvantages of a Business Combination

Advantages of a business combination

A. Competition is eliminated or lessened

o A competition between the combining constituents with similar businesses is eliminated while
the threat of competition from other market participants is lessened

B. Synergy

o Synergy occurs when the collaboration of two or more entities results in greater productivity
than the sum of the productivity of each constituent working independently. It can be simplified by the
expression 1 + 1 = 3

C. Increased business opportunities and earnings potential

o Business opportunity and earnings potential may be increased through:

1. An increased variety of products or services available and a decreased dependency on a

limited number of products and services;

2. Widened dispersion of products or devices and better access to new markets;

3. Access to either of the acquirer’s or acquiree’s technological know-how, research and

development, secret processes, and other information.

4. Increased investment opportunities due to increased capital; or

5. Appreciation in worth due to an established trade name by either one of the

combining constituents

D. Reduction of operating costs

o Operating costs of the combined entity may be reduced.

1. Under a horizontal combination, operating costs may be reduced by the elimination of

unnecessary duplication of costs

2. Under a vertical combination, operating costs may be reduced by the elimination of costs of
negotiation and coordination between the companies and mark-ups on purchases.

E. Combinations utilize economies of scale

 o Economies of scale refer to the increase in productive efficiency resulting from the increase in the
scale of production.

o An entity that achieves economies of scale decreases its average cost per unit as production is
increased because fixed costs are allocated over an increased number of units produced.

F. Cost savings on business expansion

o The cost of business expansion may be lessened when a company acquires another company
instead of putting up a branch.

G. Favorable tax implications

o Deferred tax assets may be transferred in a business combination.

o Business combinations effected without transfers of considerations may not be subjected to

taxation.

Disadvantages of a business combination

1.The business combination brings a monopoly in the market which may have a negative impact on
society. This could result in an impediment to healthy competition between market participants.

2. The identity of one or both of the combining constituents may cease, leading to a loss of sense of
identity for existing employees and loss of goodwill.

3. Management of the combined entity may become difficult due to incompatible internal cultures,
systems, and policies.

4. The business combination may result in over-capitalization which may result in diffusion in market
price per share and attractiveness of the combined entity’s equity instruments to potential investors.

5. The combined entity maybe subjected to stricter regulation and scrutiny by the government, most
especially if the business combination poses threat to consumers’ interests

3.4. PFRS 3 Business Combinations

PFRS 3 outlines the accounting when an acquirer obtains control of a business (e.g. an acquisition or
merger). Such business combinations are accounted for using the ‘acquisition method’, which generally
requires assets acquired and liabilities assumed to be measured at their fair values at the acquisition
date.

As defined in PFRS 3, the business combination is a transaction or other event in which the
acquirer obtains control of one or more businesses.

Essential Elements in the definition of Business Combination:

A. Control

o As provided in PFRS 10, “an investor controls an investee when it 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.”
 o Control is normally presumed to exist when the acquirer holds more than 50% interest in the
acquiree’s voting interest.

o Control can also be obtained when:

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 controls the acquiree’s operating and financial policies because of a law or an
agreement.

o An acquirer may obtain control of an acquiree in a variety of ways, for example:

1. By transferring cash or other assets;

2. By incurring liabilities;

3. By issuing equity interests;

4. By providing more than one type of consideration; or

5. Without transferring consideration, including by contract alone.

B. Business

o As defined by PFRS 3, business is an integrated set of activities and assets that is capable of being
conducted and managed for the purpose of providing a return in the form of dividends, lower costs or
other economic benefits directly to investors or other owners, members, or participants.

o A business has the following three elements:

1. Input

▪ any economic resource that results to an output when one or more processes are applied to it

2. Process

▪ any system, standard, protocol, convention or rule that when applied to an input, creates an
output

3. Output

▪ the result of input and process that provides investment returns to the stakeholders of
the business

3.5. Determining whether a transaction is a business combination

(Is it a business combination or not?)

Any investor who acquires some investment needs to determine whether this transaction or event is a
business combination or not.

PFRS 3 requires that assets and liabilities acquired need to constitute a business, otherwise it’s not a
business combination and an investor needs to account for the transaction as a regular asset acquisition
in line with other PFRS.

The three elements of a business should be considered to determine if the transaction is a business

combination.

4. Accounting for Business Combination

Business combinations are accounted for using the acquisition method. PFRS 3 provides that, applying
this method requires the following steps:

1. Identifying the acquirer;

2. Determining the acquisition date;

3. Recognizing and measuring the identifiable assets acquired, the liabilities assumed and any non-
controlling interest in the acquiree; and

4. Recognizing and measuring goodwill or a gain from a bargain purchase.

4.1. Step 1: Identifying the acquirer

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

• PFRS 3 provides the following guidance in identifying the acquirer:

1. In a business combination effected primarily by transferring cash or other assets or by incurring

liabilities

▪ the acquirer usually the entity that transfers the cash or other assets or incurs liabilities.

2. In a business combination effected primarily by exchanging equity interests

▪ the acquirer is usually the entity that issues its equity interests.
 ▪ if it is a reverse acquisition, the issuing the entity is the acquiree.

▪ Other pertinent facts and circumstances shall also be considered in identifying the acquirer in
a business combination effected by exchanging equity interests including the following:

a. Whose owner, as a group, have the largest portion of the voting rights of the combined entity.

b. Whose a single owner or organized group of owners holds the largest minority voting interest in the
combined entity.

c. Whose owners have the ability to appoint or remove a majority of the members of the
governing body of the combined entity

d. Whose (former) management dominates the management of the combined entity

e. That pays a premium over the pre-combination fair value of the equity interests of the other
combining entity or entities.

3. As to size

▪ The acquirer is usually the combining entity whose relative size is significantly greater than that
of the other combining entity or entities

4. In a business combination involving more than two entities

▪ The acquirer is usually the one who initiated the combination.

5. In a business combination wherein a new entity is formed

▪ The acquirer is identified as follows:

a. If a new entity is formed to issue equity interests to effect a business combination, one of the

combining entities that existed before the business combination shall be identified as the acquirer by
applying the guidance provided above.

b. In contrast, a new entity that transfers cash or other assets or incurs liabilities as consideration
may be the acquirer

4.2. Step 2: Determining the Acquisition Date

• The acquirer shall identify the acquisition date, which is the date on which it obtains control of the
acquiree.

• The date on which the acquirer obtains control of the acquiree is generally the date on which the
acquirer legally transfers the consideration, acquires the assets and assumes the liabilities of the
acquiree—the closing date.

• However, the acquirer might obtain control on a date that is either earlier or later than the closing
date. For example, the acquisition date precedes the closing date if a written agreement provides that
the acquirer obtains control of the acquiree on a date before the
closing date. An acquirer shall consider all pertinent facts and circumstances in identifying the
acquisition date.

4.3. Step 3: Recognizing and measuring the identifiable assets acquired, the liabilities assumed

and any non-controlling interest in the acquiree

A. Acquired assets and liabilities

Recognition Principle

▪ On acquisition date, the acquirer recognizes, separately from goodwill the identifiable
assets acquired, the liabilities assumed and any non-controlling interest (NCI) in the acquiree.

Recognition Conditions

a. Identifiable assets acquired and liabilities assumed must meet the definitions of assets and
liabilities provided under the Conceptual Framework at the acquisition date.

b. It must be part of what the acquirer and acquiree exchanged in the business combination
transaction rather than the result of separate transactions.

c.Applying the recognition principle may result to the acquirer recognizing assets and liabilities that
the acquiree had not previously recognized in its financial statements

Classifying identifiable assets acquired and liabilities assumed

▪ Identifiable assets acquired and liabilities assumed are classified at the acquisition date in
accordance with other PFRSs that are to be applied subsequently
Measurement Principle

▪ The acquirer shall measure the identifiable assets acquired and the liabilities assumed at their
acquisition-date fair values.

▪ Separate valuation allowances are not recognized at the acquisition date because the effects
of uncertainty about future cash flows are included in the fair value measurement.

▪ All acquired assets are recognized regardless of whether the acquirer intends to use them.

B. Non-controlling Interest

o As provided in PFRS 3, non-controlling interest (NCI) or “minority interest” is the equity in a

subsidiary not attributable, directly or indirectly, to a parent.

o For example, there is no NCI when an investor acquires 100% share in a company because the
investor owns the subsidiary’s equity in full. But, when an investor acquires 75% (less than 100%), then
25% is NCI.

o For each business combination, the acquirer measures any non-controlling interest in the acquiree
either at:

1. Fair value; or

2. The NCI’s proportionate share of the acquiree’s identifiable net assets.

4.4. Step 4: Recognizing and measuring the goodwill

• Goodwill is an asset representing the future economic benefits arising from other assets acquired
in a business combination that is not individually identified and separately recognized.

• On acquisition date, the acquirer computes and recognizes goodwill or gain on a bargain purchase
using the following formula:

• A negative amount resulting from the formula is called “gain on a bargain purchase” (also referred
to as “negative goodwill”)

• On the acquisition date, the acquirer recognizes a resulting:

a. Goodwill as an asset

b. Gain on bargain purchase as gain in profit or loss

 ▪ Before recognizing, the acquirer shall reassess to ensure that the measurements appropriately
reflect consideration of all available information as of the acquisition date. (Application of the concept
of conservatism)

▪ If the gain on a bargain purchase remains after reassessment, the acquirer shall recognize the
resulting gain in profit or loss on the acquisition date. The gain shall be attributed to the acquirer.

A. Consideration Transferred

o The consideration transferred is measured at fair value, which is the sum of the acquisition-date
fair values of the assets transferred by the acquirer, the liabilities incurred by the acquirer to former
owners of the acquiree and the equity interests issued by the acquirer.

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

6. member interests of mutual entities.

Additional concepts on consideration transferred

▪ The consideration transferred in a business combination includes only those that are transferred
to the former owners of the acquiree. It excludes those that remain within the combined entity.

▪ Assets and liabilities transferred to the former owners of the acquiree are remeasured to
acquisition-date fair values. Any remeasurement gain or loss is recognized in profit or loss.

▪ Assets and liabilities remain within the combined entity are not remeasured but rather ignored
when applying the acquisition method.

B. Acquisition-related costs

o These are costs the acquirer incurs to effect a business combination.

Examples:

1. Finder’s fees

2. Professional fees, such as advisory, legal, accounting, valuation and consulting fees

3. General administrative costs, including the costs of maintaining an internal acquisitions

department

4. Costs of registering and issuing debt and equity securities

 o Acquisition-related costs are expenses when they are incurred, except the cost to issue debts or
equity securities which shall be recognized in accordance with PAS 32 and PFRS 9:

1. Costs to issue debt securities measured at amortized costs are included in the initial measurement
of the resulting financial liability.

2. Costs to issue equity securities are deducted from share premium. If the share premium is
insufficient, the issue costs are deducted from retained earnings.

C. Previously held equity interest in the acquiree

o This pertains to any interest held by the acquirer before the business combination. This affects the
computation of goodwill only in a business combination achieved in stages (discussed in the next
module)

4.5. Illustrations
Illustration 1: Asset Acquisition
On January 1, 2020, Popoy Co.
acquired all assets and assumed
all liabilities of the
Basha Co. Due to the business
combination Popoy Co.
incurred transaction costs for
accounting and legal fees
amounting to ₱100,000. The
carrying amounts and fair
values of the assets and
liabilities of Basha acquired by
Popoy are shown below:
As of January 1, 2020
 Assets Carrying amounts
Fair values
Cash in bank 20,000 20,000
Receivables 220,000
150,000
Allowance for doubtful
accounts (50,000) -
Inventory 510,000 430,000
Building – net 1,500,000
1,200,000
Goodwill 100,000 50,000
Total Assets
Liabilities
Accounts Payable
Total Liabilities
Assumption #1:
Popoy Co. paid ₱2,000,000
cash as consideration for
acquiring the net assets of
Basha,
how much is the goodwill (gain
on bargain purchase) on the
business combination?
Solution:
Consideration transferred
2,000,000
Non-controlling interest in the
acquiree -
Previously held equity interest
in the acquiree -
 Total 2,000,000
Fair value of net identifiable
assets acquired (1,500,000)
Goodwill 500,000
5. Restructuring provisions
• PAS 37 provides that restructuring is a program that is planned and controlled by
management and materially changes either:

1. The scope of a business undertaken by an entity; or

2. The manner in which that business is conducted

Restructuring provisions may include the costs of an entity’s plan

1. To exit the activity of the acquiree.

2. To involuntarily terminate employees of the acquiree, or

3.To relocate non-continuing employees of the acquiree.

The costs above are sometimes referred to as “liquidation costs”. However, a restructuring
provision does not include such costs as:

1.Retraining or relocating continuing staff,

2. Marketing, or

3. Investment in new systems and distribution networks.

• Restructuring provisions are generally not recognized as part of business combination unless
the acquiree has at the acquisition date an existing liability for restructuring that has been
recognized in accordance with PAS 37 Provisions, Contingent

Liabilities and Contingent Assets.

A restructuring provision will be recognized as:

1. Liability if it meets the definition of liability as to the acquisition date:

▪ Acquirer incurs a present obligation to settle the restructuring costs assumed, such as when
the acquiree developed a detailed formal plan for the restructuring and raised a valid expectation in
those affected that the restructuring will be carried out by publicly announcing the details of the plan or
has begun implementing the plan on or before the acquisition date.

2. Post-combination expenses of the combined entity when incurred:

▪ Acquiree’s restructuring plan is conditional on it being acquired (not the present obligation nor
contingent liability)

▪ Restructuring provisions that do not meet the definition of a liability at the acquisition date
6. Specific Recognition Principles
PFRS 3 provides the following specific recognition principles:

I. Operating Leases

A. Acquiree is the lessee

General rule:

The acquirer shall not recognize any assets or liabilities related to an operating lease in which

the acquiree is the lessee.

Exception:

The acquirer shall determine whether the terms of each operating lease in which the acquiree is the
lessee are favorable or unfavorable.

If the terms of an operating lease relative to market terms is:

1. Favorable – the acquirer shall recognize an intangible asset

2. Unfavorable – the acquirer shall recognize a liability

B. Acquiree is the lessor

If the acquiree is the lessor, the acquirer shall not recognize any separate intangible asset or

liability regardless of whether the terms of the operating lease are favorable or unfavorable when

compared with market terms.

II. INTANGIBLE ASSETS

The acquirer recognizes, separately from goodwill, the identifiable intangible assets acquired in a

business combination. An intangible asset is identifiable if it is either (a) separable or (b) arises

from contractual or other legal rights

A. Separability criterion

An intangible asset is separable if it is capable of being separated from the acquiree and sold,

transferred, licensed, rented or exchanged, either individually or together with a related contract,

identifiable asset or liability.

The separability criterion is met even if:

1. The exchange transactions are infrequent and regardless of whether the acquirer is

involved in them, as long as there is evidence of exchange transaction for that type of asset or similar
type; or

2. The acquirer does not intend to sell, license or otherwise exchange the identifiable
intangible asset

B. Contractual-legal criterion

An intangible asset that is not separable is nonetheless identifiable if it arises from contractual or

other legal rights

Example:

Entity A acquires Entity B, an owner of a nuclear power plant. Entity A obtains Entity B’s license to
operate the nuclear power plant. However, the terms of the license prohibit Entity A from selling or
transferring the license to another party.

Analysis: The license is an identifiable intangible asset because, although it is not separable, it

meets the contractual-legal criterion.

7. Exceptions to the recognition or measurement principles
PFRS 3 provides limited exceptions to its recognition and measurement principles.

Exception to the recognition principle – Contingent liabilities

• The requirements of PAS 37 do not apply when accounting for contingent liabilities related to the
business combination as of the acquisition date.

• Under PFRS 3, a contingent liability assumed in a business combination is recognized if:

a. It is a present obligation that arises from past events and

b. Its fair value can be measured reliably.

• Therefore, contrary to PAS 37, the acquirer recognizes a contingent liability assumed in business
combination at the acquisition date even if it is NOT probable that an outflow of resources embodying
economic benefits will be required to settle the obligation. As long as both the conditions above are
satisfied, a contingent liability will be recognized.
Exceptions to both the recognition and measurement principles

The following items shall be recognized and measured as at acquisition date under other applicable

standards:

1. Income taxes

• are accounted for using PAS 12 Income Taxes. For example, deferred taxes are measured based on
temporary differences arising from the measurement of identifiable assets and liabilities assumed by the
acquirer at the acquisition date.

• Deferred taxes affect the amount of goodwill or gain on bargain purchase recognized at the
acquisition date. However, PAS 12 prohibits the recognition of deferred tax liabilities arising from
the initial recognition of goodwill.
2. Employee benefits

• are accounted for using PAS 19 Employee benefits. For example, defined benefit

obligations are measured through actuarial valuations.

3. Indemnification assets

• arises when the former owners of the acquiree agree to reimburse the acquirer for any
payments the acquirer eventually makes upon settlement of liability.

• The acquirer shall recognize an indemnification asset at the same time and on the same basis as
the indemnified item.

• Accordingly, if the indemnified item is measured at fair value, the indemnification asset is also
measured at fair value. If the indemnified item is measured at other than fair value, the indemnification
asset is measured using assumptions consistent with those used to measure the indemnified item.

Example:

Entity A acquires Entity B. At the acquisition date, the taxing authority is disputing Entity B’s tax returns
in prior years. The former owners of Entity B agree to reimburse Entity A in case Entity A will be held
liable to pay Entity B’s tax deficiencies in the prior years.

At the acquisition date, Entity A recognizes a tax liability to the taxing authority and an
indemnification asset for the reimbursement due from the former owners of Entity B

Exceptions to the measurement principle

A. Reacquired rights

Reacquired rights are measured based on the remaining term of the related contract. (Discussed in the
next chapter)

B. Share-based payment transactions

Liabilities and equity instruments related to the acquiree’s share-based payment transactions are
accounted for using the PFRS 2 Share-based payment.

C. Assets held for sale

A non-current asset (or disposal group) that is classified as held for sale at the acquisition date at fair
value less costs to sell in accordance with PFRS 5 Non-current Assets Held for sale and Discontinued
Operations, rather than at fair value under PFRS 3.
8. Differences between the provisions of the full PFRS and the PFRS for SMEs