M3 - Business Combination, Statutory Merger and Statutory Consolidation

Module 3
Business Combination – Statutory Merger and Statutory Consolidation
Introduction
IFRS 3 Business Combinations outlines the accounting when an acquirer obtains control of a business
(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.
Reasons for Business Combination

1. Value creation – two companies may undertake a merger to increase the wealth of their
shareholders. Generally, the consolidation of two businesses results in synergies that increase the
value of a newly created business entity. Essentially, synergy means that the value of a merged
company exceeds the sum of the values of the two individual companies. Two types of synergies are:
 revenue synergies – improve the company’s revenue-generating ability (expansion,
diversification, R&D activities)
 cost synergies – reduce the company’s cost structure (economies of scale, access to new
technologies, limitation of certain costs)
2. Diversification – entering into a new market of offering new products or services
3. Acquisition of assets – a merger can be motivated by a desire to acquire assets that cannot be
obtained using other methods, assets that are unique or that are usually developed internally for a
long term (new technology, software).
4. Increase in financial capacity – every company faces a maximum financial capacity to finance its
operations through debt or equity markets. Lacking adequate financial capacity, a company may
merge with another – secure higher financial capacity that can be employed in further business
development processes.
5. Tax purposes – if a company generates significant taxable income, it can merge with a company with
a substantial carry forward tax loss. After the merger, total tax liability of the consolidated company
will be much lower than the tax liability of the independent company.
6. Incentives for managers -managers may prefer mergers because empirical evidences suggests that
the size of the company and compensation of managers are correlated.
A business combination can be friendly or unfriendly/hostile takeover. In a friendly combination, the BOD
of the potential combining companies negotiates mutually agreeable terms of a proposed combination. A
proposal is submitted to the stockholders of the involved companies for approval – 2/3 or ¾ positive vote is
required by corporate by-laws to bind all stockholders to the combination. An unfriendly/hostile
combination results when the BOD of a company targeted for acquisition resists the combination. A formal
tender offer enables the acquiring firm to deal with individual shareholders, if there are no sufficient share
available the acquiring firm may reserve the right to withdraw the offer. Hostile takeovers have become
sufficiently common that a number of mechanisms have emerged to resist takeover.
In an unfriendly/hostile combination, resistance often involves various moves by the target company. The
following are the tactics or moves to resist the proposed business combination:
 Poison pill – amendment of the articles of incorporations or by-laws to make it difficult to obtain
stockholder approval for a takeover.
 Greenmail – acquisition of common stock presently owned by the prospective acquiring (acquirer)
company at a price substantially lower in excess of the prospective acquirer’s cost, with the stock
thus placed in the treasury as retired.
 White Knight or White Square – a search for a candidate to be the acquirer in a friendly takeover.
This is simply encouraging a third company more acceptable to the target company.
 Pac-man defense – attempting an unfriendly takeover of the would-be acquiring company.
 “Selling the Crown Jewels” or “Scorched Earth” – the sale of valuable assets to others to make the firm
less attractive to the would-be acquirer. The negative aspect is that the firm, if it survives, is left
without some important assets.
 Shark Repellant – an acquisition of substantial amounts of outstanding common stock for the
treasury or for retirement, or the incurring of substantial long-term debt in exchange for outstanding
common stock.
 Leveraged Buyouts – when the management desires to own the business, it may arrange to buy out
the stockholders using the company’s assets to finance the deal. The bond issued often take the form
of high-interest, high-risk “junk” bonds.
 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.
 The Defensive Acquisition Tactic – when a major reason for an attempted takeover is the prospective
acquiring (acquirer) company’s favorable cash position, the prospective acquiring (acquirer)
company may try to rid itself if this excess cash by attempting to takeover of its own.
Types of Business Combination

Business combination may be classified under three schemes:
1. Based on the structure of the combination;
2. Based on the method used to accomplish the combination; and
3. Based on accounting method used
Structure of Business Combination

In general term, business combination unites previously separate business entities. The overriding objective
of business combinations must be increasing profitability; however, many firms can become more efficient by
horizontally, vertically integrating operations or 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:
1. Horizontal Integration – same industry, previously competitors
2. Vertical Integration – same industry but at different levels
3. Conglomerate Combination – unrelated industries for the purpose of entering into new market or
industries
4. Circular Combination – entails some diversification, but does not have a drastic change in operation
as a conglomerate
Methods/Legal Forms of Effecting Business Combinations

From an accounting perspective, the specific procedures to be used in accounting for a business combination
is affected through an acquisition of assets or acquisition of stock, the distinction of which is most important
at this stage.
1. Acquisition of Assets
The books of the acquired (acquiree) company are closed out, and its assets and liabilities are
transferred to the books of the acquirer (acquiring/surviving company). In this aspect of
combination, sometimes, one enterprise acquires another enterprise’s net assets through
negotiations with its management.
The acquiree (acquired) company generally distributes to its stockholders the assets or securities or
debt 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 acquisition:

a. The acquirer acquires from another enterprise all or most of the gross assets or net assets of the
other enterprise for cash or other property, debt instruments and equity instruments (common
or preferred stocks) or a combination thereof.
b. The acquirer must acquire 100% of the net assets of the acquired (acquiree) company.
c. It involves only when the acquirer (acquiring) company survives.
In this module, we focus on the acquisition of net assets of the acquired company.
2. Acquisition of Common Stock (Stock Acquisition)

The books of the acquirer (acquiring) company and acquiree (acquired) company remain intact and
consolidated financial statements are prepared periodically.
In such case, the acquirer (acquiring) company debits an account Investment in Subsidiary, the
stock of the acquired company is recorded as an intercorporate investment; rather than
transferring the underlying assets and liabilities onto its own books.
A business combination effected through stock acquisition does not necessarily have to involve
the acquisition of all of a company’s outstanding voting (common) shares. In those cases,
CONTROL of another company is acquired.
Following are the features of stock acquisition:

a. The acquirer acquires voting (common) stock from another enterprise for cash or other
property, debt instruments and equity instruments (common or preferred stock), or a
combination thereof.
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 to go
out of existence. Both the acquirer (acquiring) company and the acquiree (acquired) company
remain as separate legal entity.
There are two independent issues related to the consummation of a combination: what is acquired (asset or
stock) and what is given up (the consideration for the combination).
Acquisition of Assets
The terms merger and consolidation are often used synonymously for acquisition. 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 – acquiring company survives, whereas the acquired company (or companies) ceases
to exist as a separate legal entity, although it may be continued as a separate division of the acquiring
company. The BOD of the companies involved normally negotiates the terms of a plan to 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.
A Company + B Company = A Company or B Company
Statutory Consolidation – a new corporation is formed to acquire two or more other corporations; the
acquired corporations then cease to exist (dissolve) as separate legal entities.
A Company + B Company = C Company
Stockholders of the acquired companies (companies A and B) become stockholders in the new entity
(company C). The acquired companies in a statutory consolidation may be operated as separate division
of the new corporation, just as they may be under a statutory merger. Statutory consolidation requires
the same type of stockholders’ approval as statutory mergers do.
Consolidation is also used in accounting which refers to the accounting process or procedures of
combining parent and subsidiary financial statements, such as in the expressions principles of
consolidation, consolidation procedures and consolidated financial statements. In succeeding
modules, the meaning of the term consolidation refers to stock acquisition. As a matter of procedure to
prepare consolidated financial statements, the business combination defined as stock acquisition is
expressed as:
Financial Statements of A Company + Financial Statements of B Company = Consolidated
Financial Statements of A and B Company
Accounting Concept of Business Combination

The accounting standard relevant for accounting for business combinations is PFRS 3, Business
Combinations, issued by the International Accounting Standards Board (IASB).
Appendix A of PFRS 3 defines business combination as a transaction or other event in which an acquirer
obtains control of one or more businesses.
Power over the investee

Exposure or rights, to variable returns
Ability to use power over the investee
Integrated set of activities and assets that is capable of being

conducted and managed for the purpose providing return in
the form of dividends, lower costs or other economic
benefits directly to investors or other owners, members and
participant.
Scope of Business Combinations

Transactions within the PFRS 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.
2. Combinations achieved by contract alone (dual listing stapling) – in a combination achieved by
contract alone two entities enter into a contractual agreement which covers, for example, operation
under a single management and equalization of voting power and earnings attributable to both
entities’ equity investors. Such structures may involve a stapling or formation of dual listed
corporation.
Accounting for business combination by contract under PFRS 3 requires one of the combining entities to be
identified as the acquirer, and one to be identified as the acquiree. In reaching the conclusion that
combinations achieve by contract alone should not be excluded from the scope of PFRS 3.
On the other hand, the following transactions are not within the scope of PFRS 3:
1. Formation of all types of joint arrangements (joint ventures and joint operations)
2. Business combination involving 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 transitory.
3. Where acquisition of an asset or a group of assets does not constitute a business
Such transactions or events do not result to goodwill.
The Acquisition Method

The acquisition method is applied on the acquisition date which is date the acquirer obtains control of the
acquiree. The acquisition method approaches a business combination from the perspective of the
acquirer (not the acquiree), the entity that obtains control of the other entity/ies in the business
combination. Under the acquisition method, all assets and liabilities are identified and reported at their
FAIR VALUES.
The required method for a business combination under paragraph 4 of PFRS 3 is the acquisition method.
Under the acquisition method, the general approach to accounting business combination is a five (5)
step process:
1. Identify the acquirer;
2. Determine the acquisition date;
3. Calculate the fair value of the purchase consideration transferred (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.
Note: If an acquirer gains control by purchasing less than 100% of the acquirer entity, then the 4 th
step includes measuring and recognizing the non-controlling interest (NCI) – discussed in the
succeeding modules.
Identifying the acquirer

PFRS 3 paragraph 7 states that the acquirer is the entity that obtains control or the acquiree. For
every business combination, one of the combining entities should be identified as he acquirer.
The concept of control will be discussed in the succeeding chapter (stock acquisition). PFRS 3, however,
recognized that it may be difficult to identify which entity has control over the 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 Appendix A 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 specific
entity. Therefore, the business combination occurs as the date of the assets or ne 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 contract is signed
 The date the consideration is paid
 A date nominated in the contract
 The date on which assets acquired are delivered to the acquirer
 The date on which an offer becomes unconditional
These dates 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.
The use of control as the key criterion to determine acquisition date ensures that the substance of
the transaction determines the accounting rather than the form of the transaction. The definition of
acquisition date then relates to the point in time when the net assets of the acquiree becomes the net
assets of the acquirer – in essence the date which the acquirer can recognize the net assets acquired in its
own records. This approach is consistent with the Framework in which an asset is defined in terms of
future economic benefits that are controlled by an entity.
There are four areas where the selection of the date affects the accounting for business combination:
1. The identifiable assets acquired and liabilities assumed by the acquirer are measure at the
fair value on the acquisition date. The choice of fair value is affected by the choice of
acquisition date.
2. The consideration paid by the acquirer is determined as the sum of fair values of assets given,
equity issued and/or liabilities undertaken in an exchange of the net assets or shares of another
entity. The choice of sate affects the measure of fair value.
3. The acquirer may acquire only some of the shares of the acquiree. The owners of the balance
of the shares of the acquiree are called the non-controlling interest – defined in Appendix A as
the equity in a subsidiary not attributable, directly or indirectly, to a parent. This non-controlling
interest is also measured at fair value on acquisition date.
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 on
entity Y and now acquires the remaining 80% giving it control of entity Y. The acquisition date
is the date when entity X 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 is
measured.
The effect of determining the acquisition date is that the financial position of the combined entity
on acquisition date should report the assets and liabilities of the acquiree on that date and any
profits reports as a result of the acquiree’s operation within the business combination should reflect
profits earned after the acquisition date.
Calculating the Fair Value of the Consideration: Accounting Records of the Acquirer
According to PFRS 3 paragraph 37, the consideration transferred:
 is measured at fair value at acquisition date
 is calculated as 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 interest issued by the acquirer
In a specific exchange, the consideration transferred to the acquirer could include just one form of
consideration, such as cash, but could equally well consist of a number 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 interest of mutual entities.
The consideration transferred includes the following:

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 after the acquisition date. For deferred payment, the fair value to the acquirer
is the amount the entity would have to borrow to settle the debt immediately (i.e., present value of
the obligation). Hence, the discount rate used is the entity’s incremental borrowing rate.
2. Non-monetary assets. Non-monetary assets such as property, plant and equipment, investments,
licenses and patents. If active second-hand market exists, fair values can be obtained by
reference to those markets. The items sold in the market may not be exactly the same as the item
being exchanged in business combination and an estimate of fair value for the specific item may have
to be made. Where active markets do not exist, other means of valuation, including the use of
experts, may be used. In this case, the acquirer is in effect selling the non-monetary assets to the
acquiree. Thus, it is earning an income equal to the fair value on the sale of the assets. If the carrying
amount if the assets 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 instrument. If the acquirer issues its own shares as consideration, it needs to determine the
fair value of those shares at the acquisition date. For listed entities, reference is made to the quoted
price of the shares.
4. Liabilities undertaken. The fair value of the liabilities is best measured by the present values of
expected future cash outflows. Future losses or other costs expected to be incurred 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. Appendix A of PFRS 3 provides the following
definition of contingent consideration, “usually, an obligation of the acquirer to transfer additional
assets or equity interests to the former owners of an acquiree as part of the exchange for control of
the acquiree if specified under future events occur or conditions are met. However, contingent
consideration may also give the acquirer the right to the return of previously transferred
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 will be discussed further in
the succeeding modules).
6. Share-based payment awards (acquirer share-based payment awards exchange 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 measured in accordance with PFRS 2 (referred to as the “market-
based measure), rather than at fair value.
Acquisition Related Costs

In addition to the consideration transferred, 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 measurement of the consideration paid, because such costs are not part of the fair value
of the acquiree and are not assets. These costs are the following:
Acquisition-related costs Examples Treatment
Directly attributable costs Professional fees paid to accountants, legal Expense
advisers, valuers and other consultants (finders
and brokerage fees) to affect the combination.
Indirect acquisition costs General and administrative costs, including the Expense
costs of maintaining an internal acquisitions
department (management salaries, depreciation,
rent and costs incurred to duplicate facilities) and
other costs of which cannot be directly attributable
to the particular acquisition
Costs of issuing securities Transaction costs such as stamp duties, Debit to Additional
(issue and registers stocks) professional adviser’s fees, underwriting costs and Paid-in Capital
brokerage fees may be incurred. account
Costs of arranging Professional adviser’s fees, underwriting costs and Bond issue costs
(registering) and issuing debt brokerage fees may be incurred.
securities or financial
liabilities
Principles in assessing what is Part of 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 or incurred that are part for the exchange for the acquiree
shall be included in the business combination accounting. Any portion of the transaction price or
any assets acquired or liabilities assumed or incurred that are not parts or components of the
exchange for the acquiree shall be accounted for separately from business combination.
Recognition Principles for Assets and Liabilities

The key word is identifiable. The acquirer may be able to identify many more assets and liabilities than
those shown in the acquiree’s balance sheet. PFRS 3paragraph 10 requires that, as of the date of
acquisition, the acquirer should recognize, separately from goodwill, the identifiable assets
acquired, the liabilities assumes and any non-controlling interests in the acquirer.
Paragraph 83 of the Conceptual Framework for the preparation and presentation of Financial Statements
specifies two recognition criteria for assets and liabilities stating that recognition occurs if:
 It is probable that any future economic benefit will flow to or from the entity; and
 The item has a cost or value that can be reliably measured.
In paragraph 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:
 At the acquisition date, the assets and liabilities recognized by the acquirer must meet the
definition of assets and liabilities in the Framework. Any expected future costs cannot be
included in the calculation of assets and liabilities acquired and assumed.
 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 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.
Measurement Principle for Assets and Liabilities

Identifiable assets acquired and liabilities assumed are measured as fair values on the acquisition date.
PFRS 3 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. That
definition of fair value emphasizes that fair value is a market-based measurement, not an entity-
specific measurement. The process of determining the fair value necessarily involves judgement and
estimation. To assist in the determination of fair value, the standard setters have developed a fair value
hierarchy which categorized the inputs used in valuation techniques into three levels.
Level 1 Inputs Fully observable and are unadjusted quoted price in an active market for
identical assets and liabilities.
Level 2 Inputs Directly and indirectly observable inputs other than Level 1 inputs.
Level 3 Inputs Unobservable inputs for assets and liabilities.
Valuation Techniques
An entity uses valuation techniques appropriate to the circumstances and for which sufficient data are
available to measure fair value, maximizing the use of relevant observable inputs and minimizing the use
of observable inputs.
The objective of valuation technique is to estimate the price at which an orderly transaction to sell the
asset or to transfer the liability would take place between the market participants and the measurement
date under current market conditions. These widely used 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.
 Cost approach or cost-based – reflects the amount that would be required currently to replace
the service capacity of an asset, although the result may not reflect the fair value.
 Income approach or income-based – based on future economic benefit derived from owning
the assets or converts future amounts to a single current amount, reflecting current market
expectations about those future amounts.
Valuation of Identifiable Assets and Liabilities

Valuation
Current Assets Recorded at estimated fair value; accounts and notes receivable are recorded at
net amount (no valuation allowance)
Assets held for sale Valuation on shall be measure in accordance to PFRS 5, Non-current Assets Held
for Sale and Discontinued Operations (at fair value less cost to sell)
Property, plant and equipment Recorded at net amount with no separate accumulated depreciation account
Investments in equity-accounted Based on the fair value of shares of the associate
entities
Identifiable intangible assets Estimated fair value
Existing liabilities Recorded at fair values or present value
Contingent liabilities Reliable fair value measurement
Liabilities associated with the Fair value
restructuring or exit activities
Employee benefit plans Liabilities are recorded if the projected benefit obligation exceeds the assets
while an asset is recorded when plan assets exceed the projected benefit
obligation.
Indemnification assets Measured at fair value
Income taxes Deferred tax assets and liabilities are measured at undiscounted amounts
Employee benefits Measurement of liability (or asset) shall be in accordance to PAS 19
Measuring and Recognizing of Goodwill or a Gain from Bargain Purchase: Accounting Records of the
Acquirer
Goodwill
PFRS 3 paragraph 32 states that “the acquirer shall recognize goodwill as of the acquisition date, measured in
excess of (i) over (ii) below:
(i) The aggregate of:
a. The consideration transferred measured in accordance with this Standard which
generally requires acquisition date fair value;
b. The amount of any non-controlling interest in the acquiree measured in accordance with
this Standard; and
c. In a business combination achieved in stages, the acquisition date fair value of the
acquirer’s previously held equity interest in the acquiree.
(ii) The net of the acquisition date amounts of the identifiable assets acquired and the liabilities
assumed measured in accordance with this Standard.
In this module, the business combinations defined as statutory merger and statutory consolidation, goodwill
is determined to be as the excess of the consideration transferred over the net fair value of the identifiable
assets and liabilities assumed. Thus:
Consideration transferred XX
Less: Identifiable assets acquired and liabilities assumed XX
Difference / Goodwill XX
Goodwill is accounted for as an asset and is defined in PFRS 3 as an “asset representing the future economic
benefits arising from other assets as acquired in a business combination that are not individually identified
and separately recognized.”
The criterion of being individually identifiable relates to the characteristics of identifiability as used in PAS
38, Intangible Assets to distinguish intangible assets from goodwill. Goodwill acquired in a purchase of net
assets is recorded on the acquirer’s books, along with the fair values of the other assets and liabilities
acquired.
Having recognized goodwill arising in the business combination, the subsequent accounting is directed from
other accounting standards:
 Goodwill is not subject to amortization but is subject to annual impairment test as detailed in PAS 36.
 Goodwill cannot be revalued because PAS 38 does not allow the recognition of internally generated
goodwill.
Bargain Purchase Gain

When the acquirer’s interest in the net fair value of the acquiree’s identifiable assets and liabilities is greater
than the consideration transferred, the difference is called a bargain purchase gain, thus:
Identifiable assets acquired and liabilities assumed XX
Less: Consideration transferred XX
Difference / Bargain Purchase Gain XX
The result of bargain purchase is considered by the members of the board (paragraph BC371) as an irregular
transaction as parties to the business combination do not deliberately assets at amounts lower than their fair
value. Paragraph 36 of PFRS 3 requires that before a bargain purchase gain is recognized:
1. An entity should first reassess whether:
 It has correctly identified all the assets acquired and liabilities assumed;
 It has correctly measured at fair value all the assets acquired and liabilities assumed; and
 It has correctly measured the consideration transferred.
2. Any remaining excess should be recognized immediately in profit or loss.
The purpose here is to make sure that the measurement at acquisition date reflects all information available
on that date. Note that one effect of recognizing a bargain purchase is that there is no recognition of
goodwill. It should be noted that under PFS 3 paragraph 34, it requires that gain be attributable to the
acquirer only and shall be recognized by the acquirer in its statement of comprehensive income or income
statement.
Use of Provisional Values

If the initial accounting for a business combination is incomplete by the end of the reporting period in which
the combination occurs, the financial statements should be prepared using provisional amounts for the items
for which the accounting is incomplete.
PFRS 3 permits adjustments to items recognized in the original accounting for a business combination as long
as it is within the measurement period (i.e., for a maximum of one year after the acquisition date, where
new information about facts and circumstances existing on the acquisition date obtained) . Measurement
period is the period after the initial acquisition date during which the acquirer may adjust the
provisional amounts recognized at the acquisition date. This period allows a reasonable time to obtain
the information necessary to identify and measure the fair value of the acquiree’s assets and liabilities as well
as the fair value of the consideration transferred. Any adjustments are made retrospectively as if those
adjustments had been made on the acquisition date.
In general, assets and liabilities assumed or incurred, and equity instruments issued in a business
combination are subsequently measured and accounted for in accordance with other applicable PFRSs,
according to their nature.
Examples of PFRSs that provide guidance on the subsequent measurement and accounting for assets acquired
and liabilities assumed or incurred in a business combination include:
 PAS 38 Intangible Assets
 PAS 36 Impairment of Assets
 PFRS 4 Insurance Contracts
 PAS 12 Income Taxes
 PFRS 2 Share-based Payment
 PFRS 10 Consolidated Financial Statements
In summary, there are normally two areas where adjustments need to be made subsequent to the initial
accounting after acquisition date, they are:
1. Goodwill. Having recognized goodwill arising in the business combination, the subsequent
accounting is directed from other accounting standards:
 Goodwill is not subject to amortization but is subject to annual impairment test as detailed in
PAS 36.
 Goodwill cannot be revalued because PAS 38 does not allow the recognition of internally
generated goodwill.
2. Contingent liabilities. Having recognized any contingent liabilities of the acquiree as liabilities, the
acquirer must then determine a subsequent measurement of the liability. The liability is initially
recognized at fair value. Subsequent to the acquisition date, according to paragraph 56 of PFRS 3, the
liability is measured as the higher of:
 The amount that would be recognized in accordance with PAS 37
 The amount initially recognized less, if appropriate, cumulative amortization recognized in
accordance with PAS 18 Revenue.
Retrospective Adjustments
The adjustments to provisional amounts should be recognized as if the accounting for the business
combination had been completed on the acquisition date. Therefore, comparative information for prior
periods presented in the financial statements is revised, including making any change in depreciation,
amortization or other income effects recognized in completing the initial accounting.
 Adjustments to recognized items – during the measurement period, the acquirer retrospectively
adjust the provisional amounts recognized at the acquisition date to reflect new information
obtained about facts and circumstances that existed as of the acquisition date, if known, would have
affected the measurement of the amounts recognized as of that date.
 Adjustments to unrecognized items – during the measurement period, the acquirer also recognizes
additional assets or liabilities if new information is obtained about facts and circumstances that
existed as of the acquisition date that, if known, would have resulted in the recognition of those
assets and liabilities as of that date.
 Information to be considered – the acquirer is required to consider all pertinent factors in
determining whether information obtained after the acquisition date should result in an adjustment
to the provisional amounts recognized or whether that information results from events that occurred
after the acquisition date.
Pertinent factors include the date when additional information is obtained and whether the acquirer
can identify a reason for a change to provisional amounts. Information that is obtained shortly after
the acquisition date is more likely to reflect circumstances that existed on the acquisition date than is
information obtained several months later.
 Revising goodwill – the acquirer recognizes an increase (decrease) in the provisional amount
recognized for an identifiable asset (liability) by means of a decrease (increase) in goodwill.
However, new information obtained during the measurement period may sometimes result in an
adjustment to the provisional amount of more than one asset or liability.
Adjustments after the Measurement Period

After the measurement period, any correction of errors will be deemed as a prior-period adjustment in
accordance to PAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. However, any change in
estimate arising from new information (settlement of a cash contingent liability) should be recognized in the
current period.
Contingent Consideration
PFRS 3 requires that all contractual contingencies, as well as non-contractual liabilities for which it is more
likely than not that an asset or liability exists, be measured and recognized at fair value on the acquisition
date. This includes contingencies based on earnings, guarantees of future security prices and contingent
payout based on the outcome of a lawsuit.
The contingency’s fair value on acquisition date is recognized as part of the acquisition regardless of whether
based on future performance of the target firm or the future stock prices of the acquirer. These two examples
of contingencies will result to two contingent considerations either as equity or cash/liability.
 Future performance – where the future income or cash flows of the acquiree (target firm) is
regarded as uncertain, the agreement contains a clause that requires the acquirer to provide
additional consideration to the acquiree if the income/cash flows of the acquiree is not equal or
exceeds a specific amount over some specified period.
 Future stock prices – where the acquirer issue shares to the acquiree and the acquiree is concerned
that the issue of these shares may make the market price of the acquirer’s shares decline over time.
Contingent consideration will be classified as either a liability or equity depending on the nature:
 As a liability if the contingent consideration will be paid in the form of cash or another asset or
 As equity if issuing additional shares will satisfy the contingent consideration. After the initial
recognition, the contingent consideration will not be remeasured.
Subsequent to the business combination, PFRS 3 provides guidance on the measures to be used:
 Where the contingent consideration is classified as an asset or liability (cash contingency), the
acquirer measures the fair value of the contingency at each reporting date until the contingency is
resolved. This, it:
o Is a financial instrument and is within the scope of PAS 39/PFRS 9 is measured at fair value,
with resulting gain or loss recognized either on profit or loss or in other comprehensive
income in accordance with PAS 39; and
The value of the contingent consideration normally will change as the future unfolds.
Recognition of these changes depends on whether those changes relate to:
a. Additional information obtained during the measurement period, which means that
changes in fair value of the contingent consideration due to gathering of information
about facts and circumstances that existed at the acquisition date and within a
maximum of one year subsequent to the acquisition date. The changes are
considered part of the original purchase consideration transferred and the original
accounting of the acquisition is adjusted accordingly which affects goodwill or gain
on purchase.
b. Events occurring after the acquisition date. The changes are recognized separately
form the business combination and usually are adjusted as gains or losses on the
acquirer’s statement of comprehensive income (net income section).
o Is not within the scope of PAS 39/PFRS 9 is accounted for in accordance with PAS 37 or
other PFRSs as appropriate.
 Where the contingent consideration is classified as equity (stock contingency), no measurement is

required until the contingency is resolved. When the contingency is settled, the subsequent
settlements change in fair value is reflected and accounted for within the equity accounts. This
means that if extra equity instruments are issued, they are effectively issued for no consideration
and there is no change to capital (or common) stock.
It should be noted that the subsequent accounting for contingent consideration is to treat it as a
post-acquisition event that is not affecting the measurements made on acquisition date. Hence, any
subsequent adjustments do not affect the goodwill calculated on acquisition date.
Deferred Tax arising from a Business Combination

The requirements of PFRS 3 have resulted in amendments to PAS 12 Income Taxes. In addition to
consequential changes in terminology, a more significant change is made in respect of the port-combination
recognition of deferred tax assets acquired in a business combination as follows:
PAS 12.68 (as amended by PFRS 3)

 Acquired deferred tax benefits recognized within the measurement period that result from new
information about facts and circumstances that existed at the acquisition date reduce the carrying
amount o any goodwill related to that acquisition. If the carrying amount of that goodwill is zero, any
remaining deferred tac benefits are recognized in profit or loss; and
 All other acquired deferred tax benefits realized are recognized in profit or loss (or outside profit or
loss) if otherwise required by PAS 12.
Problem Illustration 1. Goodwill Computation with Contingent Consideration based on Future

Performance – Earnings
On December 31, 2019, Peter Corporation enters into a business combination by acquiring the assets and
assumed the liabilities of Saul Corporation in which Saul Corporation will be dissolved. Peter’s consideration
transferred consists of the following:
a. 25,000 unissued shares if its ₱10 par common stock, with a market value of ₱25 per share;
b. ₱150,000 long-term, 8% notes payable; and
c. A contingent payment of ₱100,000 cash on January 1, 2022, if the average income of during the 2-
year period exceeds ₱250,0000 per year. Peter estimates that there is a 30% chance of probability
that the ₱100,000 payment is required.
In addition, Peter pays the following at the time of the merger:

 Finder’s fee - ₱10,000
 Accounting fee - ₱20,000
 Legal fees to arrange the business combination - ₱35,000
 Cost of SEC registration, including accounting and legal fees - ₱15,000
 Cost of printing and issuing stock certificates - ₱12,000
 Indirect costs of combining, including allocated overhead and executive salaries - ₱23,000.
Balance sheet and fair value information for the two companies on December 31, 2019, immediately before
the merger, are as follows:
Peter Corporation Saul Corporation
Book value Fair value Book value Fair value
Cash 230,000 230,000 20,000 20,000
Accounts Receivable – net 80,000 80,000 40,000 40,000
Inventories 240,000 300,000 100,000 60,000
Land 90,000 200,000 60,000 200,000
Buildings – net (10-year life) 400,000 600,000 200,000 300,000
Equipment – net (5-year life) 360,000 490,000 180,000 250,000
In-process Research and Development – – – 50,000
Total Assets 1,400,000 1,900,000 600,000 920,000
Accounts Payable 180,000 180,000 60,000 60,000

Other Liabilities 200,000 180,000 120,000 140,000
Common stock, ₱10 par 600,000 200,000
Additional paid-in capital 200,000 160,000
Retained Earnings 220,000 60,000
Total Liabilities and 1,400,000 600,000
Equity
The computation of goodwill is as follows;

Consideration transferred:
Common shares 25,000 at ₱25 per share 625,000
Notes Payable 150,000
Contingent consideration (cash contingency)
₱100,000 * 30% probability 30,000
Total 805,000
Less: Fair Value identifiable assets acquired and liabilities assumed:
Cash 20,000
Accounts Receivable – net 40,000
Inventories 60,000
Land 200,000
Buildings – net 300,000
Equipment – net 250,000
In-process Research and Development 50,000
Accounts Payable (60,000)
Other Payables (140,000) 720,000
Difference / Goodwill 85,000
The journal entries by Peter Corporation to record the acquisition are as follows:
Cash 20,000
Inventories 60,000
Land 200,000
Goodwill 85,000
Accounts Payable 60,000
Other Payables 140,000
Estimated Liability for Contingent Consideration 30,000
Common stock 250,000
Paid-in capital in excess of par [25,000 shares * (₱25 - ₱10)] 375,000
Acquisition of Saul Corporation
Acquisition-related expenses 65,000

Cash 65,000
Acquisition-related costs – direct costs
Paid-in capital in excess of par 27,000

Cash 27,000
Acquisition-related costs – costs to issue and register stocks
Acquisition-related expenses – indirect costs 23,000

Cash 23,000
Acquisition-related costs – indirect costs
The balance sheet of Peter Corporation immediately after the acquisition is presented below:
Peter Corporation
Balance Sheet
December 31, 2019
Cash 135,000
Inventories 300,00
Land 290,000
Goodwill 85,000
Total Assets 2,290,000

Total Liabilities 760,000
Common stock, ₱10 par 850,000

Paid-in capital in excess of par [(200,000+372,000)-27,000] 548,000
Retained Earnings (220,000-65000-23000) 132,000
Total Stockholders’ Equity 1,530,000
Total Liabilities and Stockholders’ Equity 2,290,000
Problem Illustration 2. Provisional Amount on Asset Acquired

Assume that the value of the buildings in Problem Illustration 1 was provisionally determined on December
31, 2019. On August 1, 2020, Peter Corporation received the final value from the independent appraisal, the
fair value at acquisition date being ₱320,000.
The entry on August 1, 2020 to reflect the adjustment since it is still within the measurement period of one
(1) year would be:
Buildings 20,000
Goodwill 20,000
Adjustment to goodwill due to measurement date
Assets that have been provisionally recorded as of the acquisition date are retrospectively adjusted in value
during the measurement period for new information that clarifies the acquisition date value. The adjustment
affects the goodwill since the measurement period is still within one (1) year (i.e., eight months from
acquisition date) Therefore, the goodwill to be reported then on the acquisition should be ₱65,000.
The succeeding problem illustrations are the different situations regarding contingent considerations.
Problem Illustration 3. Cash/Liability Contingency applying Measurement Date Rule
Assume the information in Problem Illustration 1 and that on August 31, 2020 because of improved
information about facts and circumstances that existed on the acquisition date, the contingent consideration
was revised to an expected value of ₱50,000.
Since the adjustment is still within the measurement period, the entry to adjust the liability would be:
Goodwill 20,000
Adjustment to goodwill due to measurement date
The goodwill to be reported then on the acquisition should be ₱105,000.
On November 1, 2020, the probability value of the contingent consideration amounted to ₱40,000, the entry
to adjust the liability would be:
Gain on estimated contingent consideration 10,000
Adjustment after measurement date
In this case, the measurement period ends at the earlier of:

a. One year from date of acquisition, or
b. The date when the acquirer receives needed information about facts and circumstances (or learns
that the information is unobtainable) to consummate the acquisition.
The information received by Peter Corporation on August 31, 2020 indicates that measurement period
already ends. Thus, the transaction on November 1, 2020 will be treated in accordance with PAS 8 Accounting
Policies, Changes in Estimates and Errors. The acquirer then measures the fair value of the contingency at each
reporting date until the contingency is resolved. Changes in the fair value of the contingent consideration are
reported as a gain or loss in earnings, and the liability is also adjusted.
Further, on December 15, 2020, the expected value of the contingent consideration amounted to ₱65,000, the
entry would be:
Loss on estimated liability contingent consideration 25,000
After the measurement date, any correction of errors will be deemed as a prior-period adjustment in
accordance with PAS 8. However, a change in estimate arising from new information (for example, the
settlement amount of a contingent liability) should be recognized in the current period.
On January, 1 2022, Saul’s average income in 2020 is ₱270,000 and 2021 ₱260,000, which means that the
target is met. Peter Corporation will make the following entry:
Loss on estimated contingent consideration 35,000
Cash 100,000
Settlement of contingent consideration
Problem Illustration 4. Cash/Liability Contingency with Present Value based on Future Performance –
Cash Flows
Assume the same information in Problem Illustration 1, except that a contingent payment of ₱100,000 cash if
Saul Corporation will generate cash flows from operations of ₱300,000 or more in 2020. Saul estimates that
there is a 35% chance that the ₱100,000 will be required. Saul uses an interest rate of 4% to incorporate the
time value of money.
The amount of goodwill on acquisition will be computed as follows:

₱100,000 * 35% probability * [1/ (1+.04*)] 33,654
Total 808,654
Less: Fair Value identifiable assets acquired and liabilities assumed: 720,000
*Present value of ₱1 @ 4% for one period
Cash 20,000
Inventories 60,000
Land 200,000
Goodwill 88,654
On December 31, 2020, Saul Corporation’s cash flow from operations amounted to ₱280,000, which means
that it did not exceed the cash flows from operations threshold of ₱300,000. Therefore, there is no cash
payment to be made to Saul Corporation. The entry of Peter Corporation on December 31, 2020 to record
such occurrence would be:
Gain on estimated contingent consideration 33,654
Since the contingent event does not happen, the position taken by PFRS 3 is that the conditions that prevent
the target from being met occurred in a subsequent period and that Peter had the information to measure the
liability on the acquisition date based on circumstances that existed at that time. Thus, the adjustment will
flow through income statement in the subsequent period.
Problem Illustration 5. Cash/Liability Contingency based on Future Performance – Earnings

Assuming the same information in Problem Illustration 1, except that instead of contingent payment of
₱100,000 cash, an additional cash payment would be made on January 1, 2022, equal to twice the amount by
which average annual earnings of Saul Corporation exceed ₱25,000 per year, prior to January 1, 2022. Net
income was ₱65,000 in 2020 and ₱70,000 on 2021.
The entry by Peter Corporation in January 1, 2022 for the payment of the contingent consideration would be:
Loss on estimated contingent consideration 55,000
Cash [(65,000+70,000)/2-25,000] 85,000
Problem Illustration 6. Stock Contingency based on Future Performance – Earnings with Market Value
of Stock Given
Assuming the same information in Problem Illustration 1, in addition to the stock issue, Peter Corporation
also agreed to issue additional shares of common stock to the former stockholders of Saul Corporation if the
average post-combination earnings over the next two years (2020 and 2021) equaled or exceeded ₱390,000.
The additional 1,000 shares expected to be issued are valued at ₱15,000.
The amount of goodwill on acquisition will be computed as follows:

₱100,000 * 30% probability 30,000
Contingent consideration (stock contingency) 15,000
Total 820,000
Cash 20,000
Inventories 60,000
Land 200,000
Goodwill 100,000
Paid-in capital for Contingent Consideration 15,000
On January 1, 2022, the target is met or contingent event happens - average post-combination earnings over
the years amounted to ₱410,000. Thus, Peter Corporation will make the following entry for the issuance of
1,000 additional shares.
Common stock (1,000 shares * ₱10 par) 10,000
In the event that the contingent does not meet, then, the account “Paid-in capital for Contingent
Consideration” will be closed to account “Paid in capital from not meeting the target.
Problem Illustration 7. Stock Contingency based on Future Performance – Earnings
also agreed to issue 5,000 additional shares if the average income during the 2-year period exceeded ₱80,000
per year.
Thus, the above transaction requires the same entry with Problem Illustration 1 on December 31, 2019. Prior
to the termination of the contingency, it would be described in footnote.
On January 1, 2022, the average income amounted to ₱110,000 (the contingent event occurs). Thus, the entry
to record the occurrence of such event to reassign the ₱625,000 original consideration to 30,000 shares
(25,000 original shares issued + 5,000 additional shares due to contingency) would be:
Problem Illustration 8. Stock Contingency based on Future Stock Prices

also agreed to issue 5,000 additional shares if two years later, the fair value of acquirer fell below ₱25 per
share.
Thus, the above transaction requires the same entry with Problem Illustration 1 on December 31, 2019. Prior
On January 1, 2022, the contingent event happens and the stock had a fair value below ₱25. Thus, the entry to
record the occurrence of such event to reassign the ₱625,000 original consideration to 30,000 shares (25,000
original shares issued + 5,000 additional shares due to contingency) would be:
Problem Illustration 9. Stock Contingency based on Future Performance – Earnings

also agreed to issue additional shares on January 1, 2022, equal in value to twice the amount by which
average annual earnings of Saul Corporation exceed ₱25,000 per year, prior to January 1, 2022. Net income
was ₱65,000 in 2020 and ₱70,000 in 2021.
Thus, the above transaction required the same entry with Problem Illustration 1 on December 31, 2019. Prior
On January 1, 2022, the contingent event happens since the average annual earnings for 2020 and 2021
exceeded the ₱25,000 and stock had a fair value of ₱20 per share. Thus, the entry to record the occurrence of
such event to reassign the ₱625,000 original consideration to 29,450 shares (25,000 original shares issued +
4,250* additional shares due to contingency) would be:
*{[(65,000+70,000)/2 – 25,000] * 2} / ₱20 per share
Problem Illustration 10. Stock Contingency based on Future Stock Prices

also agreed to issue additional shares on January 1, 2022, to compensate for any fall in the value of Peter
Common stock below ₱25 per share. The settlement would be to cure the deficiency by issuing added shares
based on the fair value on January 1, 2022. The market price of the shares on January 1, 2022 was ₱20.
Thus, the above transaction required the same entry with Problem Illustration 1 on December 31, 2019. Prior
On January 1, 2022, the contingent event happens since the fair value per share fell below ₱25. Thus, the
entry to record the occurrence of such event to reassign the ₱625,000 original consideration to 31,250 shares
(25,000 original shares issued + 6,250* additional shares due to contingency) would be:
*Deficiency: (₱25 - ₱20) * 25,000 shares issued to acquire 125,000
Divided by value per share on January 1, 2022 20
Additional shares to issue 6,250
Problem Illustration 11. Stock Contingency with Present Value based on Future Stock Prices
agreed to issue sufficient shares of Peter Corporation common stock to ensure a total value of ₱625,000 if the
fair value per share is less than ₱25 per share on December 31, 2020. Peter estimates that there is a 40%
probability that the 25,000 shares issued will have a market value of ₱425,000 on December 31, 2020 and a
60% probability that the market value of the 25,000 shares issued will exceed ₱625,000. Peter uses an
interest rate of 4% to incorporate the time value of money. The amount of goodwill on acquisition will be
recomputed as follows:
Contingent consideration (stock contingency)
{[₱625,000 - ₱425,000] * 40% (1/1 + .04*)} 76,923
Total 851,923
Cash 20,000
Inventories 60,000
Land 200,000
Goodwill 131,923
On December 31, 2020, the contingent event occurs, wherein Peter’s stock price had fallen to ₱20, thus
requiring peter to issue additional shares of stock to the former owners of Saul Corporation. The entry for
Peter Corporation on December 31, 2020 to record such occurrence to reassign the ₱625,000 original
consideration to 31,250 shares (25,000 original shares issued + 6,250* additional shares due to contingency)
would be:
Common stock, ₱10 par 62,500
*Deficiency: (₱25 - ₱20) * 25,000 shares issued to acquire 125,000
Divided by value per share on December 31, 2020 20
Additional shares to issue 6,250
Problem Illustration No. 7 to 11 should be observed that if the contingent consideration is in the form of equity, the
acquirer does not remeasure the fair value of the contingency at each reporting date until the contingency is resolved.
Problem Illustration 12. Contingency based on Outcome of a Lawsuit

Assume that Poor Corporation acquired Standard Corporation on December 31, 2019 for cash plus contingent
consideration depending on the assessment of a lawsuit against Standard Corporation assumed by Poor
Corporation.
The initial provisional assessment includes an estimated liability for the lawsuit of ₱50,000, an estimated
liability for contingent consideration to the shareholders of ₱5,000, and goodwill of ₱66,000. The acquisition
contract specified the following conditions:
 So long as the lawsuit is settled for less than ₱100,000, Standard Corporation shareholders will
receive some additional consideration. If the lawsuit results in a settlement of ₱100,000 or more,
then Standard Corporation shareholders will receive no additional consideration; and
 If the settlement is resolved with a smaller (larger) outlay than anticipated (₱50,000), the
shareholders of Standard Corporation will receive additional (reduced) consideration accordingly,
thus adjusting the contingent liability above or below ₱5,000.
On September 1, 2020, new information reveals:

 The estimated liability for the lawsuit to be ₱55,000 and
 The estimated liability for contingent consideration to the shareholders amounted to ₱4,500
The entry by Poor Corporation on September 1, 2020 that completed the initial recording of the business
combination would be:
Goodwill 4.500
Estimated Liability for Contingent Consideration 500
Estimated Liability for Lawsuit 5,000
Adjustments to goodwill due to measurement date
The adjustments affect goodwill because the new information was:

a. Obtained during the measurement period (seven months later) and
b. Related to circumstances that existed on the acquisition date.
Problem Illustration 13. Bargain Purchase Gain

The trial balance below presents the financial position of Sierra Company on January 1, 2019.
Debit Credit
Merchandise inventory 130,000
Accounts Receivable 800,000
Copyrights 150,000
Equipment 1,200,000
Accumulated Depreciation 150,000
Loan Payable 100,000
Preferred stock – 48,000 fully paid shares, ₱10 par 480,000
Common stock – 100,000 fully paid shares, ₱15 par 1,500,000
Retained Earnings 800,000
Total 3,280,000 3,280,000
Sierra Company included in the notes to its accounts a contingent liability to a guarantee by a loan. Although a
present obligation existed, a liability was not recognized by Sierra Company because of the difficulty of
measuring the ultimate amount to be paid.
On this date, the business of Sierra Company is acquired by Parrot Company with Sierra Company going into
liquidation. The terms of the acquisition are as follows:
a. Parrot Company takes over the assets and assumed the liabilities of Sierra Company;
b. Parrot pays ₱1,500,000 in cash to the previous shareholders of Sierra Company;
c. Parrot Company issued 100,000 common shares to ₱10 par with a fair value of ₱12;
d. Costs of liquidation of ₱10,000 are to be paid by Sierra Company with funds supplied by Parrot
Company;
e. Supply of a patent relating to the manufacturing business of Parrot Company. This has a fair value of
₱200,000 but has not been recognized in the records of Parrot Company because it resulted from an
internally generated research project;
f. The contingent liability relating to the guarantee was considered to have fair value of ₱10,000; and
g. Parrot Company was obligated to pay an additional ₱12,000 to the vendors of Sierra Company if
Sierra Company maintained existing profitability over the subsequent two years from January 1,
2019. It was highly likely that Sierra Company would achieve this expectation and the fair value of
the contingent consideration was assessed at its expected value of ₱12,000.
Parrot Company assessed the fair values of the identifiable assets and liabilities of Sierra Company to be as
follows:
Merchandise inventory 1,200,000
Copyrights 200,000
Equipment 1,150,000
The computation of bargain purchase gain is as follows:

Cash 1,500,000
Common shares 100,000 at ₱12 per share 1,200,000
Costs of liquidation 10,000
Contingent consideration (₱10,000 guarantee + ₱12,000 to vendors) 22,000
Patent 200,000
Total 2,932,000
Less: Fair Value identifiable assets acquired and liabilities assumed:
Merchandise Inventory 1,200,000
Copyrights 200,000
Equipment 1,150,000
Accounts Payable (250,000)
Loan Payable (100,000) 2,950,000
Difference / Bargain Purchase Gain (18,000)
The journal entries by Parrot Company to record the acquisition are as follows:
Merchandise Inventories 1,200,000
Patent 200,000
Equipment 1,150,000
Loan Payable 100,000
Cash 1,510,000
Common stock (100,000 shares * ₱10 par) 1,000,000
Gain on Sale of Patent 200,000
Bargain Purchase Gain 18,000
Acquisition of Sierra Company
On November 1, 2019, the additional payment to vendors of Sierra Company was reassessed at ₱18,000
based on the improved information, the estimated liability should be adjusted and since it is still within the
measurement period, bargain purchase gain (otherwise, it should be charged to another nominal account
which is, in this case it should be “loss on estimated contingent consideration”) should also be adjusted
accordingly, the entry would be:
Bargain Purchase Gain 6,000
Adjustment to gain due to measurement date
Therefore, the bargain purchase gain to be recognized retroactively as of the date of which is January 1, 2019 amounted to
₱12,000.
Problem Illustration 14. Comprehensive Problem – Consideration transferred versus assets acquired
and liabilities assumed
Paretto Company is seeking to expand its share of the market and has negotiated to take over the operations
of Santa Company on January 1, 2019. The balance sheets of the two companies on December 31, 2018 were
as follows:
Paretto Co. Santa Co.
Cash 523,000 12,000
Accounts Receivable – net 25,000 34,700
Inventories 35,500 27,600
Land 140,000 100,000
Buildings – net 60,000 30,000
Plant and Equipment – net 65,000 46,000
Patent 10,000 -
Goodwill 25,000 2,000
Total Assets 883,500 252,300
Accounts Payable 56,000 43,500

Mortgage Loan 50,000 40,000
Bonds Payables 100,000 50,000
Total Liabilities 206,000 133,500
Common stock, 60,000 shares at ₱10 par 600,000

Common stock, 8,000 shares at ₱7.50 par 60,000
Paid-in capital in excess of par 28,500 26,800
Retained Earnings 49,000 32,000
Total Stockholders’ Equity 677,500 118,800
Total Liabilities and Stockholders’ Equity 883,500 252,300
Paretto Company is to acquire all the assets, except cash, of Santa Company. The assets of Santa Company are
all record at fair value except:
Fair Value
Inventories 39,000
Land 130,000
Buildings 70,000
Plant and Equipment 65,000
In exchange, Paretto Company’s terms of acquisition are as follows:

 Cash of ₱40,000, half to be paid on the date of acquisition and half on December 31, 2019. Paretto
Company has an acquisition department which incurred running costs over the period of completing
the business combination amounted to ₱12,000.
 Paretto Company is to provide Santa Company with sufficient cash, additional to that already held, to
enable Santa Company to repay all of its outstanding debts. The outstanding bonds are to be
redeemed at fair value of ₱102 per ₱100 bond (or at 2% premium). Annual leave entitlement of
₱14,000 outstanding as of January 1, 2019 and expected liquidation costs of ₱16,000 have not been
recognized by Santa Company. Costs to transport and install Santa Company’s assets at Paretto
Company’s premises will be ₱10,000. An investigation by the liquidator of Santa Company reveals
that on January 1, 2019, the following debts were outstanding but had not been recorded:
Mortgage interest 4,000
 Holders of 3,000 common stocks of Santa Company are to receive two fully paid shares of Paretto
Company for every three shares held. Shares issued by Paretto Company have a fair value of ₱32 per
share. Because of doubts as to whether or not it could sustain a share price of at least ₱32, Paretto
Company agreed to supply cash to the value of any decrease in the share price below ₱32 for the
shares issued, this guarantee of the share price lasting until August 31, 2019. Paretto Company
believed that there was a 90% chance that the share price would remain at ₱32 or higher.
 Holders of 4,000 common stocks of Santa Company elect to receive cash at ₱35 per share payable half
on the acquisition date and half on December 31, 2019.
 Paretto Company surrenders his patents to Santa Company with a carrying amount of ₱4,000 and has
a fair value of ₱5,000.
 Paretto Company is also to give a piece of its own prime land to Santa Company. The piece of land in
question has a carrying amount of ₱35,000 and a fair value of ₱50,000.
 Cash payment of ₱50,000 to former owners representing reimbursement of acquisition-related costs
paid by the former owners and a settlement of ₱10,000 for an unresolved claim by Santa Company
against Paretto Company.
 A severance payment of ₱50,000 to the CEO of Santa, whose employment is terminated following the
suggestion by Paretto Company during the negotiations for the business combination.
 A deferred payment of ₱20,000 (to be paid a year after) to two former owners who become
employees of Paretto Company, the payment of which is not dependent on their continuing
employment or affected by their termination and the amount payable is adjusted for yearly interest.
Paretto Company supplied the cash on acquisition date as well as surrendering the land. The shares were
issued on January 5, and the costs of issuing the shares amounted to ₱18,000. The incremental borrowing
rate for Paretto Company is 10% per annum. Other acquisition-related costs paid by Paretto Company in
relation to the acquisition amounted to ₱15,000. On December 31, 2019, the fair value of Paretto Company’s
share was ₱33.
The computation of goodwill is as follows:

Cash – half payable now (₱40,000 * ½) 20,000
Accounts Payable (₱43,500+₱1,500) 45,000
Mortgage Loan (₱40,000+₱4,000) 44,000
Bonds and premium (₱50,000*102%) 51,000
Costs of liquidation 16,000
Annual leave 14,000
Common stock – payable now (4,000 shares * ₱35 * ½) 70,000
Total cash required 260,000
Cash already held (12,000) 248,000
Cash - deferred (₱40,000 * ½ * 0.909091) 18,182

Deferred payment to former owners (₱20,000*0.909091) 18,182
Cash payment – common stock (4,000 shares * ₱35* ½ * 0.909091) 63,636 100,000
Shares – common stock (2,000 shares * ₱32) 64,000
Patent 5,000
Land 50,000
Contingent liability – guarantee [(₱32-₱30) * 2,000 shares] * 10% 400
Total consideration 467,400
Fair value of identifiable assets acquired and liabilities assumed:
Inventory 39,000
Land 130,000
Buildings 70,000
Plant and equipment 65,000 338,700
Goodwill 128,700
*present value of ₱1 at 10% for one year.
**cash payable in one year’s time discounted at 10% per annum.
The journal entries by Paretto Company to record the acquisition are as follows
January 1, 2019
Inventory 39,000
Land 130,000
Buildings 70,000
Plant and equipment 65,000
Goodwill 128,700
Cash 248,000
Consideration payable (₱18,182 + ₱18,182 + ₱63,636) 100,000
Common stock (2,000 shares * ₱10) 20,000
Paid-in capital in excess of par [(₱32-₱10) * 2,000 shares] 44,000
Land 50,000
Patent 5,000
Estimated liability for Contingent Consideration 400
Acquisition of Santa Company.
Patent 1,000
Gain on remeasurement of patent 1,000
Remeasurement to fair value as part of consideration transferred on business combination.
Land 15,000
Gain on sale of land 15,000
Remeasurement to fair value as part of consideration transferred on business combination.
Acquisition-related expenses (₱12,000 + ₱10,000 + ₱15,000 + ₱50,000 +

₱10,000 97,000
Cash 97,000
Acquisition-related expenses

Cash 18,000
Acquisition-related cost – issuing of shares
General expenses 50,000

Cash 50,000
Severance payment.
December 31, 2019

Consideration payable 100,000
Interest expense (₱100,000 * 10%) 10,000
Cash (₱20,000 + ₱20,000 + ₱70,000) 110,000
Balance of consideration paid.
Estimated liability for Contingent Consideration 400

Gain on contingent consideration 400
Contingency not having to be paid.
The following should be observed in relation to the above situation:

1. The following three components are arrangements that are entered into primarily for the benefit of the
acquirer or the combined entity:
a. The reimbursement of ₱50,000 to the former owners for the acquisition related costs; and
b. ₱10,000 paid in excess for the unresolved claim are not part of the business combination and shall be
recognized as an expense by the acquirer.
c. The ₱50,000 severance payment to the CEO is not part of the exchange in the business combination and
shall be recognized as an expense in the post-combination financial statements. These three components
are arrangements that are entered into primarily for the benefit of the acquirer or the combined entity.
2. The deferred payment of ₱20,000 to two former owners is a contingent consideration rather than a compensation
for future services because the payment is not dependent on their continuing employment affected by their
termination. It shall be included in the measurement of the consideration transferred.
3. It should be noted that acquisition-related cost is not the same with liquidation-related costs even though the
consequence of acquisition is liquidation of the acquiree. Any costs of liquidation or of similar item paid or supplied
by the acquirer should be part of the consideration transferred for reason that it was intended to complete the
process of liquidation. The reason for such inclusion is that the consideration received from the acquirer may be used
to pay for liabilities not assumed by the acquirer and for liquidation expenses which is practically the same as to
unrecorded liabilities from liquidation point of view. These items should no be confused with acquisition-related
costs which are considered outright expenses. Further, any liquidation costs or similar item which was not of the
same situation as mentioned above should be treated as expenses.
Accounting in the records of the Acquiree

Where the acquirer purchases that acquiree’s net assets and liabilities, the acquiree may continue in existence
or may liquidate. The acquiree accounts affected by the business combination will differ according to actions
of the acquiree.
Acquiree does not liquidate

In the situation where the acquiree disposes of a business, the journal entries required in the records of the
acquiree are shown below. Under PAS 16, Property Plant and Equipment, when an item of property, plant and
equipment is sold, gains or losses are recognized in the statement of comprehensive income. Similarly, on the
sale of the acquiree recognizes a gain or loss.
Journal entries of acquiree on sale of business
Receivable form acquirer XX
Liability X XX
Liability Y XX
Liability Z XX
Asset X XX
Asset Y XX
Asset Z XX
Gain on sale of operation* XX
Sale of operation
*Separate proceeds on sale and carrying amounts of assets sold could be recognized.
Investment in acquirer XX
Cash XX
Receivable from acquirer XX
Receipt of consideration from acquirer.
Acquiree liquidates
The entries required in the records of the acquiree when it sells all its net assets to the acquirer are shown
below. The accounts of the acquiree are transferred to two accounts, the liquidation account and the
shareholders’ distribution account.
Journal entries of acquiree on after sale of net assets
Liquidation XX
Asset X XX
Asset Y XX
Asset Z XX
Transfer of all assets acquired by acquirer at their carrying amount.
Liability X XX
Liability Y XX
Liability Z XX
Liquidation XX
Transfer of all liabilities assumed by the acquirer.
Liquidation XX
Cash XX
Liquidation and other expenses not recognized previously, if paid by the acquiree
Liquidation XX
Consideration for net assets sold.
Cash XX
Receipt of consideration.
Additional paid-in capital XX

Retained Earnings XX
Liquidation XX
Transfer of reserves.
Liquidation XX
Shareholders’ Distribution XX
Transfer of balance of liquidation.
Common stock XX
Shareholders’ Distribution XX
Transfer of common stock.
Shareholders’ distribution XX
Cash XX
Distribution of consideration to shareholders.
To the Liquidation account are transferred:
 All assets taken over by the acquirer, including cash if relevant, as well as any assets not taken over
and which have a zero-value including goodwill
 All liabilities taken over
 The expenses of liquidation if paid by the acquiree
 Additional expenses to be paid by the acquiree but not previously recognized by the acquiree
 Consideration from the acquirer as proceeds on sale of net assets
 All reserves including retained earnings
To the Shareholders’ Distribution account are transferred:
 The balance of share capital
 The balance of the liquidation account
 The portion of the consideration received from the acquirer that is distributed to the shareholders.
Some of the consideration received by the acquiree may be used to pay for liabilities not assumed by
the acquirer and for liquidation expenses
Problem Illustration 15. Entries in the Acquiree’s Records

Using the information from Problem Illustration 13, prepare the journal entries in the books of Sierra
Company.
Liquidation 3,130,000
Accumulated Depreciation 150,000
Merchandise Inventory 1,130,000
Accounts receivable 800,000
Copyrights 150,000
Equipment 1,200,000
Assets taken over.
Accounts payable 250,000

Loan payable 100,000
Liquidation 350,000
Liabilities taken over.
Liquidation 10,000
Liquidation costs payable 10,000
Liquidation and other expenses not recognized previously, if paid by the acquiree
Receivable from Parrot Company 2,932,000

Liquidation 2,932,000
Consideration receivable.
Cash 1,510,000
Patents 200,000
Investment in acquirer 1,200,000
Receivable from Parrot Company 2,910,000
Receipt of consideration.

Liquidation 800,000
Transfer of retained earnings.
Liquidation 942,000
Shareholders’ Distribution 942,00
Transfer of balance of liquidation.
Preferred stock 480,000
Common stock 1,500,000
Shareholders’ Distribution 1,980,000
Transfer of common stock.
Liquidation of costs payable 10,000

Cash 10,000
Payment of liabilities.
Shareholders’ distribution 2,922,000

Cash 1,500,000
Investment in acquirer 1,200,000
Patent 200,000
Receivable from Parrot Company 22,000
Distribution of consideration to shareholders.
The liquidation account effectively records the sale of the assets and the receipts of the purchase
consideration.
 All items being sold by the acquiree – whether assets or package of the purchase are taken at their
carrying amount to the Liquidation account.
 All amounts arising during the liquidation to process and not previously recorded by the acquiree are
also taken to the Liquidation account. In the problem illustration 15, only the liquidation costs. There
relevant amounts are debited to liquidation account and liabilities are raised in relation to this item.
 Any reserves recognized by the acquiree – in this example it is retained earnings – are taken into the
Liquidation account.
 The purchase consideration is credited to the Liquidation account, with the recognition of assets
received.
The balance of the Liquidation account is transferred to the Shareholders’ Distribution account.
Liquidation
Merchandise Inventory 1,130,000 Accumulated depreciation 150,000
Accounts receivable 800,000 Accounts payable 250,000
Copyrights 150,000 Loan payable 100,000
Equipment 1,200,000 Retained earnings 800,000
Liquidation sots payable 10,000 Receivable from Parrot Company 2,932,000
Shareholders’ distribution 942,000
4,232,000 4,232,000
The cash received via the purchase consideration and the balance originally held by the acquiree is used as
the liabilities of the acquiree, including liabilities such as liquidation costs payable raised during the
liquidation process.
Liquidator’s Cash
Opening balance - Liquidation costs payable 10,000
Receivable from Parrot Company 1,510,000 Shareholders’ distribution 1,500,000
1,510,000 1,510,000
The capital balance of the acquiree, in this example the capital relating to preferred stock and common stock
issued by the acquiree are taken to the credit side of the Shareholders’ Distribution account. The assets are to
be distributed to the former shareholders of the acquiree are transferred to the debit side of the account.
Shareholders’ Distribution
Cash 1,500,000 Preferred stock 480,000
Investment in acquirer 1,200,000 Common stock 1,500,000
Patent 200,000 Liquidation 942,000
Receivable from Parrot Company 22,000
2,922,000 2,922,000
Business combination with no transfer of consideration

PFRS 3 paragraph 33 also deals a business combination without the transfer of any consideration by the
acquirer. In such cases, PFRS 3 requires an acquirer to be identified and the acquisition method to be applied.
Examples include such circumstances as:
 When the acquirer repurchases a sufficient quantity of its shares from other shareholders such that
the acquirer, who previously was a minority owner of the acquiree, now is the majority shareholder
of the acquiree and controls it;
 When the acquirer owns the majority of the acquiree’s voting shares but had previously been
prevented from exercising control by regulation or by contract – if that restriction lapses or is
removed, the acquirer not gains control over the acquiree; and
 By contract alone
In a business combination achieved without the transfer of consideration, goodwill is determined by

using the acquisition date fair value of the acquirer’s interest in the acquiree (measured using a
valuation technique) rather than the acquisition date fair value of the consideration transferred.
The acquirer measures the fair value of its interest in the acquiree using one or more valuation techniques
that are appropriate in the circumstances and for which sufficient data are available. Is more than one
valuation technique is used, the acquirer should evaluate the results of the techniques, considering the
relevance and reliability of the inputs used and the extent of the available data.
Combination by Contract Alone

In a business combination achieved by contract alone, two entities enter into a contractual arrangement
which covers, for example, operation under a single management and equalization of voting power and
earnings attributable to both entities’ equity investors. Such structure may involve a “stapling” or formation
of a dual listed corporation.
Accounting for a Combination by Contract

PFRS 3 requires one of the combining entities to be identified as the acquirer and one to be identified as the
acquiree. In reaching the conclusion that combinations achieved by contract alone should not be excluded
from the scope of PFRS 3, the Board noted that:
a. Such business combinations do not involve the payment of readily measurable consideration and, in
rare circumstances, it might be difficult to identify the acquirer;
b. Difficulties in identifying the acquirer are not a sufficient reason to justify a different accounting
treatment and no further guidance is necessary for identifying the acquirer; and
c. The acquisition method is already being applied for such combinations in the United States and
insurmountable have not been encountered.
Appendix
Deferred tax Assets and Deferred Tax Liabilities relating to the Fair Value Differentials of Identifiable
Assets and Liabilities
When the fair values of identifiable assets and liabilities are recognized, tax implications follow from
recognizing the difference between the fair values and book values of the identifiable net assets. PAS 12
Income Taxes requires the tax effects of the differences between fair values and book values to be accounted
for as deferred tax liabilities or deferred tax assets if the basis for taxation does not change with the business
combination. In other words, if tax authorities allow deductions based on the original cost of the asset (rather
than its fair value), the difference between the carrying amount determined at fair value and the tax base,
which is the original cost, gives rise to a taxable temporary difference or deductible temporary difference.
A taxable temporary difference is the future taxable income that arise from the recovery of the excess of fair
value over book value if identifiable net assets. Conversely, a deductible temporary difference is the reduction
in future taxable income that arises from the outflow of undervalued liabilities or recovery of overvalued
assets. These temporary differences give rise to deferred tax liabilities or deferred tax assets.
PAS 12 requires the recognition of deferred tax liabilities or deferred tax assets on taxable or deductible
temporary differences arising from the initial recognition of fair value adjustments of assets or liabilities in a
business combination.
For example, if the fair value of inventory is ₱50,000 and the original cost is ₱30,000, the excess of ₱20,000
gives rise to future taxable income (referred to as a “taxable temporary difference” in PAS 12). Since fair value
is recognized under the acquisition method, future tax payable (referred to as “deferred tax liability”) should
also be recognized.
However, no deferred tax liability should be recognized on the goodwill asset. Goodwill is a residual and
should not in itself give rise to other effects. Deferred tax is discussed in greater depth in a later module.
 An excess of fair value over book value of an identifiable asset gives rise to a deferred tax liability.
This is because the excess gives rise to an increase in future economic benefits that will be taxed
when realized. The increase in future tax payable is recognized as a deferred tax liability at the date
of acquisition in the consolidated balance sheet.
 An excess of book value over fair value of an identifiable asset gives rise to a deferred tax asset. If fair
value of an identifiable asset gives rise to a deferred tax asset. If fair value is less than book value, the
realization of a lower level of future economic benefits will give rise to lower future taxable income
and a lower tax payable in the future. The reduction in future tax payable constitutes a deferred tax
asset at the date of acquisition, which is recognized as asset when allocating the consideration
transferred.
 Conversely, an excess of fair value over book value of an identifiable liability gives rise to a deferred
tax asset, and an excess of book value over fair value of an identifiable liability gives rise to the
deferred tax liability.
 For simplicity, we can assume a right of set-off between deferred tax assets and liabilities and show a
net position (i.e., either a deferred tax liability or deferred tax asset on the net difference between fair
values and book values of identifiable net assets) when we allocate the consideration transferred.
 Note that the deferred tax liabilities or deferred tax assets recognized on the fair value adjustments
are adjustments to the deferred tax liabilities or deferred tax assets that are already in existence in
the financial statements.
Problem Illustration 16. Deferred Tax on Business Combinations – Statutory Consolidation

On January 1, 2019, the stockholders of Peter Company and Simon Company agreed to a consolidation.
Because IASB requires that one party be recognized as the acquirer and the other as the acquiree, it was
agreed that Peter company was the acquiring company. Peter agreed to issue 56,000 shares of its ₱20 par
stock to acquire all the net assets of Simon at a time when the fair value of Peter’s common stock was ₱25 per
share. The tax effects on fair value differences are recognized in this illustration not the basis that the tax
bases of the identifiable asset acquired and liabilities assumed are not affected by the business combination.
Assume tax rate of 30%.
Simon Company Book Value Fair Value Difference
Cash 5,000 5,000 -
Accounts Receivable 40,000 35,000 (5,000)
Merchandise Inventory 50,000 65,000 15,000
Other intangible assets 120,000 250,000 130,000
In-process research and development - 1,000,000 1,000,000
Plant and equipment 300,000 280,000 (20,000)
Total Assets 515,000 1,635,000 1,120,000
Current and long-term liabilities 150,000 150,000 -

Contingent liabilities - 50,000 50,000
Total Liabilities 150,000 200,000 50,000
Net Assets 365,000 1,435,000 1,070,000

Stockholders’ Equity 365,000
The computation of goodwill with tax effect is as follows:

Common stock (50,000 shares * ₱25) 1,400,000
Fair value of identifiable assets and liabilities assumed
Cash 5,000
Other tangible assets 250,000
In-process research and development 1,000,000
Current and long-term liabilities (150,000)
Contingent liabilities (50,000)
Deferred tax liability (₱1,070,000 * 30%) (321,000) (1,114,000)
Goodwill 286,000
The journal entries of Peter Company to record the acquisition are as follows:
Cash 5,000
Other tangible assets 250,000
In-process research and development 1,000,000
Goodwill 286,000
Current and long-term liabilities 150,000
Contingent liabilities 50,000
Deferred tax liability 321,000
Common stock (56,000 shares * ₱20) 1,120,000
Paid-in capital in excess of par [(₱25 - ₱20) * 56,000] 280,000
Acquisition of net assets of Simon Company.
In the event that the fair value of the net assets is less than the book value of the net assets of the acquiree,
then a deferred tax asset will be recognized.
Estimating the Value of Goodwill

An acquirer may attempt to forecast the future income of target company in order to arrive at a logical
purchase price. Goodwill is often, at least in part, a payment of above-normal expected future earnings. A
forecast of future income may start by projecting recent years’ incomes into the future. When this is done, it is
important to factor out “one-time” occurrences that will not likely recur in the near future. Examples would
income extraordinary items, discontinued operations, or any other unusual event. Expected future income is
compared to “normal” income. Normal income is the product of the appropriate normal rate of return on
assets times the fair value of the gross assets (no deduction for liabilities) of the acquired company. Gross
assets include specifically identifiable intangible assets such as patents and copyrights but do not include
existing goodwill.
Several methods use the expected annual earnings in excess of normal to estimated goodwill. The following
are alternatives in estimating the value of goodwill (assumed figures):
1. A common approach is to pay for a given number of years’ excess earnings. Assuming the acquirer paid
for four years of excess earnings:
Expected average future income 200,000
Normal return on assets:
Fair value of total identifiable assets 1,692,000
Multiplied by normal rate of return 10% 169,200
Expected annual earnings in excess of normal 30,800
Multiplied by number of years of excess earnings 5
Goodwill 154,000
2. The most optimistic purchaser might expect the excess earnings to continue forever. If so, the buyer
might capitalize the excess earnings as perpetuity at the normal (industry) rate of return. Assume the
excess earnings will continue indefinitely and are to be capitalized at normal (or industry) rate of return:
Divided by normal rate of return 10%
Goodwill 308,000
3. Another estimated method views the factors that produce excess earnings to be of limited duration.
Assume the excess earnings will continue for only for 5 years and should be capitalized at a higher rate
16% which reflects the risks applicable to goodwill.
Multiplied by present value of an annuity of ₱1 at 16% for 5 years 3,2743
Goodwill 100,848
Other analysts view the normal industry earning rate to be appropriate only for identifiable assets and
not goodwill. Thus, they might capitalize excess earnings at a higher rate or return to reflect the higher
risk inherent in goodwill. All calculations of goodwill are only estimates used to assist in the
determination of the price to be paid for a company.
Stock Exchange Ratio

The price of the business consummated for cash or debt generally is expressed in terms of the peso amount of
the consideration issued. When common stock is issued by the acquirer in a business combination, the price
is expressed as a number of shares of the acquirer’s common stock to be exchanged for each share of the
acquiree’s common stock; this is known as stock exchange ratio.
Issuance of a Single Class of Stock in a Business Combination

When the earnings rates on assets of the constituent parties are approximately the same and a single class of
stock is to be issued, the parties may agree that such shares shall be issued in relation to the net asset
contributions. However, when earnings rates vary and a single class of stock is to be issued, the parties may
provide those earnings regarded as above normal shall be used as a basic for calculating goodwill and that
such goodwill shall be added to the other net assets in measuring a company’s full contribution.
To illustrate, assume that stockholders of Companies A, B and C agreed to consolidate and form Company D.
Net assets at appraised values and average adjusted earnings of the past five years, which the parties believe
offer the most reliable estimate of future earnings, follow:
Co. A Co. B Co. C Total

Net asset contribution 200,000 300,000 500,000 1,000,000
Percentage of asset contribution to total assets 20% 30% 50%
Earnings contribution 30,000 30,000 40,000 100,000
Percentage of earnings contribution to total earnings 30% 30% 40%
If Company D issues a single class of stock in the net asset ratio, stockholders of Companies A, B and C will
receive stock in the ratio of 20:30:50, respectively. Although an equitable division of the interest in the assets
of ₱1,000,000 is achieved, earnings of ₱100,000 in the future will accrue to stockholders in the asset ratio,
resulting in a loss to original stockholders of Company A and a gain to original stockholders of Company C.
On the other hand, if a single class of stock is issued in the earnings ratio, stockholders of Companies A, B and
C will receive stock in the ratio of 30:30:40, respectively. Although an equitable division of future earnings is
achieved, stockholders will fail to maintain their original interests in assets. Stockholders of Company A will
acquire an interest that exceeds their investment, while stockholders of Company C will acquire an interest
that is less than their investment.
To avoid the inequalities resulting form the distribution of a single class of stock either in the net asset ratio
or in the earnings ratio, the parties decide that respective contributions shall be measured by the values
assigned to net assets as increased by goodwill. It is agreed that contributions are to be determined as
follows:
a. A 6% return is to be recognized as a fair return on identifiable net assets;
b. Excess earnings are to be capitalized at 20% in arriving at a value for goodwill. When net assets and
earnings factors are considered, contributions are calculated as follows:
Goodwill:
Average annual earnings 30,000 30,000 40,000
Normal annual return on assets, 6% 12,000 18,000 30,000
Excess annual earnings 18,000 12,000 10,000
Excess annual earnings capitalized at 20% 90,000 60,000 50,000 200,000
Total contribution 290,000 360,000 550,000 1,200,000
Based on the above calculations, the distribution of shares to stockholders of the constituent companied
would be made in proportion to their relative contributions. Assume, for example, that a total of 25,000
shares of Company D were to be issued. These shares would be distributed as follows:
Co. A 290,000 ÷ 1,200,000 x 25,000 shares 6,042 shares

Co. B 360,000 ÷ 1,200,000 x 25,000 shares 7,500 shares
Co. C 550,000 ÷ 1,200,000 x 25,000 shares 11,458 shares
Total 25,000 shares
A comparison of the relative net asset and earnings contributions by Companies A, B and C and the relative
claims upon net assets and earnings of the new company in each case is as follows:
Co. A Co. B Co. C
Net asset contribution 20% 30% 50%
Earnings contribution 30% 30% 40%
Claim upon net assets and earnings of a new 24% 30% 46%
company
When relative contributions differ from relative net asset contributions, original relationships in both
earnings and net asset contributions of the individual companies cannot be preserved by the issuance of a
single class of increased share in net assets; however, it fails to retain its original shares in earnings. Company
C fails to maintain its interest in net assets but gains an increased share in earnings. Company B, whose assets
and earnings shares were the same, retains its original relative status in both assets and earnings.
Issuance of Several Classes of Stock in Business Combination

If original relationships in both net assets and earnings are to be preserved, it will be necessary to issue more
than a single class of stock. The following procedures must be applied in the allocation of several classes of
stock of the new company to the constituent groups.
1. Earnings contributions of the constituent companied should be capitalized at a certain rate, but this
rate must not exceed the earnings rate of any of the constituent companies. This procedure
determined the total stock to be issued to each company.
2. Preferred stock should be distributed to constituent companies in proportion to the net assets that
they contribute. Such stock should be preferred as to assets upon dissolution, with the preferences
equal to the value of properties contributed. The dividend rate should not exceed the rate used in
capitalizing profits. Shares should be fully participating with common.
3. Common stock should be issued to each company for the difference between the company’s total
stock as calculated in (1), and the amount it received in preferred stock as calculated in (2).
The issuance of stock that is preferred as to assets results in the preservation of claims in the new
organization that are equal to the net asset contributions. Participating preferred stock supplemented by
common stock so that the total stock issued is in the earnings ratio makes possible a distribution of earnings
in the earnings ratio.
To illustrate, assume contributions to Company D by Companied A, B and C as previously indicated:

Earnings contribution 30,000 30,000 40,000 100,000
Claim upon net assets and earnings of a new 15% 10% 8% 10%
company
It is agreed that earnings are to be capitalized at 8% in determining the total stock to be issued. Fully
participating 6% preferred stock, ₱100 par, and preferred as to assets of this par value, is to be issued
exchange for net assets transferred. Common stock, ₱100 par, is to be issued to each company for the
difference between the total stock to which it is entitled and the preferred stock that it is to receive. The
common stock is regarded as payment of goodwill. The stock allotment is made as follows:
Total stock to be issued (earnings ÷ 0.08) 375,000 375,000 500,000 1,250,000
Amount of preferred stock to be issued (equal to
asset contribution) 200,000 300,000 500,000 1,000,000
Amount of common stock to be issued (balance
representing payment for goodwill) 175,000 175,000 - 250,000
The preferred stock issued of stockholders of Companies A, B and C preserves their claims to assets in the
new organization in amounts equal to assets contributed. The preferred and common issues provide for a
distribution of earnings in the earnings contribution ratio.
--end--

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M3 - Business Combination, Statutory Merger and Statutory Consolidation

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Module 3

Business Combination – Statutory Merger and Statutory Consolidation

Reasons for Business Combination

Types of Business Combination

Structure of Business Combination

Methods/Legal Forms of Effecting Business Combinations

Following are the features of an asset acquisition:

2. Acquisition of Common Stock (Stock Acquisition)

Following are the features of stock acquisition:

A Company + B Company = A Company or B Company

Accounting Concept of Business Combination

Power over the investee

Integrated set of activities and assets that is capable of being

Scope of Business Combinations

Such transactions or events do not result to goodwill.

The Acquisition Method

Identifying the acquirer

Determining the Acquisition Date

The consideration transferred includes the following:

Acquisition Related Costs

Principles in assessing what is Part of Business Combination

Recognition Principles for Assets and Liabilities

Measurement Principle for Assets and Liabilities

Valuation of Identifiable Assets and Liabilities

Bargain Purchase Gain

Use of Provisional Values

Adjustments after the Measurement Period

 Where the contingent consideration is classified as equity (stock contingency), no measurement is

Deferred Tax arising from a Business Combination

PAS 12.68 (as amended by PFRS 3)

Problem Illustration 1. Goodwill Computation with Contingent Consideration based on Future

In addition, Peter pays the following at the time of the merger:

Accounts Payable 180,000 180,000 60,000 60,000

The computation of goodwill is as follows;

Acquisition-related expenses 65,000

Paid-in capital in excess of par 27,000

Acquisition-related expenses – indirect costs 23,000

Accounts Payable 240,000

Common stock, ₱10 par 850,000

Problem Illustration 2. Provisional Amount on Asset Acquired

The goodwill to be reported then on the acquisition should be ₱105,000.

In this case, the measurement period ends at the earlier of:

The amount of goodwill on acquisition will be computed as follows:

Problem Illustration 5. Cash/Liability Contingency based on Future Performance – Earnings

The amount of goodwill on acquisition will be computed as follows:

Problem Illustration 8. Stock Contingency based on Future Stock Prices

Problem Illustration 9. Stock Contingency based on Future Performance – Earnings

Problem Illustration 10. Stock Contingency based on Future Stock Prices

Problem Illustration 12. Contingency based on Outcome of a Lawsuit

On September 1, 2020, new information reveals:

The adjustments affect goodwill because the new information was:

Problem Illustration 13. Bargain Purchase Gain

The computation of bargain purchase gain is as follows:

Accounts Payable 56,000 43,500

Common stock, 60,000 shares at ₱10 par 600,000

In exchange, Paretto Company’s terms of acquisition are as follows:

The computation of goodwill is as follows:

Cash - deferred (₱40,000 * ½ * 0.909091) 18,182