Module 3

A. Course Code – Title : C-APrE7 Accounting for Business Combinations

B. Module No – Title : MO 3 – Business Combination Accounting Procedures
Part 1

C. Time Frame : 1 week – 3 hours

D. Materials : Syllabus, Learning Plan, Curriculum Map, Writing
Materials, Accounting Standards and Books.
1. Overview
This learning material provides a detailed discussion of the acquisition method prescribed by
PFRS 3. It introduces the learner to the subject, guides the learner through the official text, develops the
learner’s understanding of the requirements through the use of examples and indicates significant
judgements that are required in accounting for business combinations. Furthermore, the module includes
questions that are designed to test the learner’s knowledge of the concepts applied pertaining to business
combinations.

2. Desired Learning Outcomes

At the end of the learning session, you should be able to:
a. Apply the steps in acquisition method
b. Identify the acquirer and the consideration transferred.
c. Identify the treatment of acquisition costs
d. Determine the acquisition date.
e. Recognize and Measure the fair value of the net assets acquired and the non-
controlling interest (if any).

3. Content/Discussion
The Acquisition Method
The four basic steps in the acquisition method are as follows:

STEP 1 — Determine the acquirer

The acquirer is the entity that obtains control of the acquiree. Factors that may help identify the acquirer
include:
■ Who pays cash or other assets as part of the acquisition transaction
■ Who has more voting rights in the combined entity following the acquisition
■ Who holds the largest minority voting interest in the combined entity
■ Who is able to elect, appoint or remove members from the governing body of the combined entity
■ Who takes the lead in managing the combined entity
■ Who is larger (in terms of assets, revenues, earnings or some other measure)
■ Who initiated the acquisition

The acquirer often is the party that pays cash or other assets as part of the acquisition transaction. An
acquirer might obtain control, however, without transferring any consideration. The following table
provides examples:
Example Description
Repurchase of shares An acquiree repurchases a significant number of its own shares. If the
number of shares is large enough, this can result in an existing investor (the
acquirer) obtaining control of the acquiree.
Lapse of minority veto rights An investor may hold a majority of the voting interest in an investee. If
minority veto rights exist, however, these rights prevent the investor from
having control of the investee. If the minority veto rights lapse, this can
result in the investor (the acquirer) obtaining control of the investee.
Business combination by contract Two parties may agree to enter into a contract to combine their businesses
alone without transferring any consideration, such as a stapling arrangement or the
formation of a dual-listed corporation.

You have to take note that in some cases, the acquirer identified for accounting purposes is different from
the legal acquirer. This is called a reverse acquisition or reverse merger. For instance, a reverse
acquisition might take place if a private company wants to become public without having to register its
equity shares.

STEP 2 — Determine the acquisition date

The acquisition date is the date on which the acquirer obtains control of the acquiree and the
measurement date for recording the assets acquired and liabilities assumed in the transaction. An acquirer
typically obtains control over an acquiree by exchanging consideration, such as:
■ Transferring cash or other assets
■ Incurring liabilities
■ Issuing equity interests
■ Performing a combination of these
 In some cases, an acquirer can obtain control without exchanging any consideration. For example,
an acquirer might gain control through a stapling arrangement or as a result of a lapse in minority veto
rights.
If an acquirer obtains control of the acquiree over time, in stages, the business combination is
referred to as a step acquisition. For instance, an entity might have a 10% interest in an investee, but no
control, and then purchase an additional 50% interest in the investee, gaining control and resulting in a
business combination.

OBSERVATION: You should take note that acquisition date usually is the date at which the acquirer
legally transfers consideration to the acquiree. The acquisition date also might be the closing date for the
contract or another date. All pertinent facts and circumstances must be assessed to identify the acquisition
date. An acquirer is encouraged to maintain documentation supporting its conclusion. Regulators or other
users of financial statements sometimes ask how the acquisition date was identified.

Determining the acquisition date is key because it is the date at which the business combination is
measured. It is also the date that starts the measurement period. During the measurement period, an
acquirer may be allowed to adjust its initial accounting for the business combination, as described later in
this special report. The measurement period exists to give an acquirer enough time to gather the
information necessary to account for the business combination. The measurement period may extend for a
maximum of one year from the acquisition date.

STEP 3 — Recognize and measure the net assets acquired and noncontrolling interest (if any).
This step is to recognize and measure the assets acquired, liabilities assumed and any
noncontrolling interest.
All assets acquired and liabilities assumed in a business combination must be recognized by the
acquirer in its financial statements. This might result in the acquirer recognizing an asset or liability that
was not previously recognized in the acquiree’s financial statements, such as a brand name, patent,
customer relationship or other intangible asset developed internally by the acquiree. The acquirer must
recognize 100% of the acquiree’s net assets, even when other parties retain a noncontrolling interest.
Various items require judgment to determine if they are part of the business combination. For
instance, the acquirer and the acquiree may have a pre-existing arrangement or relationship in place prior
to the acquisition; pre-existing arrangements are not part of the business combination and must be
accounted for according to other relevant GAAP. An acquirer also must cautiously evaluate transactions
to compensate employees (or former owners) of the acquiree for future services. It also describes various
factors to consider to determine whether a compensation arrangement is part of the business combination
and gives related examples. The factors include the terms of the continuing employment — such as the
duration and level of compensation — how the compensation relates to amounts paid to selling
shareholders who do not become employees, the number of shares owned by the employees after the
acquisition, how the amount of other consideration transferred in the business combination compares to
the valuation of the acquiree, the formula used to determine the compensation, as well as other
arrangements and issues.
OBSERVATION: You have to take note that identifying all of the assets and liabilities exchanged in a
business combination requires careful attention. An acquirer is encouraged to consider the definitions of
assets and liabilities in FASB Concepts Statement No. 6, Elements of Financial Statements, as part of its
analysis. For areas requiring judgment, the acquirer is encouraged to document thoroughly the basis for
its conclusions.
A common pitfall is to overlook one or more of the items exchanged, such as an intangible asset
or a contingency. Failing to identify and measure one of the items exchanged results in the acquirer
recording the wrong amount of goodwill. In addition, it results in improper accounting for the item in a
future period. For example, if an acquirer overlooks an intangible asset and fails to record it separately,
the intangible asset is recognized as part of goodwill. This results in improper accounting for the
intangible asset in future periods because intangible assets must be amortized, and an overstatement of
goodwill, where an overstated goodwill balance may not be assessed properly for impairment.

Costs of Business Combination

An acquirer might incur various transaction costs related to a business combination. Examples are
finder’s fees, professional or consulting fees (such as advisory, legal, accounting or valuation costs),
general and administrative costs (such as those to run internal departments dedicated to acquisitions) and
costs to register or issue debt and equity securities. These costs are collectively referred to in the standard
as “acquisition-related costs.” Acquisition-related costs generally must be accounted for separately from
the business combination and expensed as incurred. In other words, they are not capitalized as part of
the business combination transaction. An exception applies to the costs to issue debt or equity securities;
these costs must be treated in accordance with applicable GAAP and the acquirer must disclose its
accounting for these costs in the notes to its financial statements.

General Measurement
The general measurement principle for business combinations is that all assets acquired and
liabilities assumed must be measured at fair value as of the acquisition date. Fair value is the price an
entity would receive to sell an asset — or pay to transfer a liability — in a transaction that is orderly,
takes place between market participants and occurs at the acquisition date.

OBSERVATION: An acquirer may not intend to use certain assets acquired in the business
combination. For instance, an acquirer might buy its competitor for the sole purpose of acquiring and
retiring the competitor’s brand. In this case, an acquirer may be tempted to assign a low or zero value to
the competitor’s brand. The acquirer, however, must determine the fair value of the brand using
assumptions consistent with those that a market participant would use. This may result in the acquirer
assigning a relatively high value to the brand, and then having to recognize an impairment loss in a later
period when the brand is retired.
 Determining the fair value of certain assets as of the acquisition date may be difficult. For
example, intangible assets and contingencies may be hard to measure because management must use
judgment and make assumptions about the future. An acquirer often uses valuation experts to assist in the
valuation of assets acquired and liabilities assumed in a business combination. Ultimately, however, the
acquirer is responsible for the valuation approach and assumptions used.

The valuation of a business combination is often highly scrutinized by regulators and users of the
financial statements. An acquirer that thoroughly documents the bases for its conclusions will be better
prepared to address questions from users as they arise.

An acquirer does not record valuation allowances at the acquisition date for assets deemed
uncollectible, such as loans or receivables. This is because the assets are measured at fair value as of the
acquisition date. A fair value measurement already reflects expectations about uncollectible balances.
Exceptions exist to the general measurement principle for indemnification assets, income taxes,
employee benefits, reacquired rights, share-based payment awards, assets held for sale and certain assets
and liabilities related to contingencies. These items are measured according to the specific rules provided
in the standard, which may result in some items being recorded at amounts other than fair value as of the
acquisition date. For instance, PFRS 3 requires an indemnification asset to be measured on the same basis
as the indemnified item. If the indemnified item is not measured at fair value, it might be necessary to
establish a valuation allowance for the indemnification asset.

Non-controlling Interest
Once an acquirer has identified all of the assets acquired and liabilities assumed in the business
combination, the acquirer also must determine if a noncontrolling interest exists.
The noncontrolling interest represents the portion of net assets not attributable to the acquirer. In
other words, the portion attributable to other investors. The acquirer must measure the noncontrolling
interest at fair value as of the acquisition date. The fair value of the noncontrolling interest often is
determined based on the number of shares held by the noncontrolling interest and the quoted market price
of a share. If the quoted market price of a share is not available, the acquirer must use another valuation
technique. Often, the per-share valuation of the acquirer’s interest and the noncontrolling interest differ.
This is generally because the per-share valuation of the acquirer’s interest includes a control premium.
The control premium reflects the fact that market participants typically are willing to pay more per share
for the ability to have control over an investee.
OBSERVATION: You have to take note that it is not uncommon for an acquirer to pay a control
premium between 10–20% of the fair value of the individual shares. The amount of the control premium
can be affected by a number of factors and may depend, in part, on the particular industry or market.

Provisional Amounts and Measurement Period

 The accounting for a business combination requires substantial effort and resources. The initial
accounting often is incomplete at the end of the reporting period in which the business combination
happens. This is because the acquirer has been unable to obtain all pertinent information necessary to
evaluate the conditions that existed as of the acquisition date. As a result, the acquirer may have to record
provisional amounts for certain assets or liabilities — for instance, independent valuations for intangible
assets may not yet be finalized. The acquirer can record adjustments to these provisional estimates during
the measurement period, subject to certain conditions. For example, the acquirer must provide disclosures
that clearly denote the provisional items outstanding during the measurement period.
The measurement period is intended to allow an acquirer sufficient time to obtain the information
necessary to evaluate the conditions that existed as of the acquisition date. When the acquirer receives the
necessary information, adjustments may be necessary either:
■ To revise the amounts recorded for assets and liabilities recognized at the time of the
acquisition.
■ To recognize new assets and liabilities that would have been recognized at the time of the
acquisition if all facts and circumstances had been known at that time when an acquirer makes a
measurement period adjustment, the acquirer usually records a corresponding debit or credit to goodwill.

An acquirer must not record a measurement period adjustment for either of the following:
■ The correction of an error. An acquirer must account for the correction of an error according to
Accounting Changes and Error Corrections. For example, an acquirer might record the wrong amount in
its general ledger for an asset acquired due to a typo. The adjustment made to record the proper amount is
accounted for as the correction of an error.
■ Events that happened after the acquisition date. These events must be accounted for in the periods in
which they occur following relevant guidance in the Codification. For instance, the impairment of an
available-for-sale debt security occurring after the acquisition date is accounted for under Investments —
Debt and Equity Securities.

OBSERVATION: You have to take note that improper application of the guidance on the measurement
period is a common cause of errors and misstatements in an acquirer’s financial statements. Some
frequent pitfalls in applying this guidance are:
• Presuming that the measurement period lasts for a full twelve months. Twelve months is the maximum
time that the measurement period can remain open. The measurement period ends when the acquirer
obtains the information necessary to evaluate the conditions that existed as of the acquisition date.
• Failing to provide the required disclosures indicating the provisional items outstanding. If this happens,
an acquirer cannot record an adjustment to goodwill. Instead, the adjustment is recognized through
earnings.
• Recording corrections of errors or events happening after the acquisition date as measurement period
adjustments.
ILLUSTRATION: The following illustration includes three scenarios. The scenarios show how slight
changes in facts and circumstances might lead to a different conclusion about whether an adjustment to an
environmental liability is a measurement period adjustment, the correction of an error or an event
happening after the acquisition date. In all three scenarios, assume the following:

• On December 20, 2019, an acquirer buys a small energy infrastructure company (the acquiree) in a
business combination. The acquiree owns and operates pipelines and terminals that transport and store
natural gas, petroleum products and crude oil.
• In the days leading up to the business combination, one of the acquiree’s crude oil tanks experiences a
small leak that is suspected of causing low levels of contamination to nearby soil and groundwater. The
acquirer assumes the acquiree’s environmental liability to clean up the damage.
• For the December 31, 2019 financial statements, the acquirer records an initial estimate of the
environmental liability, but is awaiting additional information to finalize the estimate — such as the
results of soil and groundwater testing and independent evaluations by professionals specializing in the
remediation of environmental contamination.

SCENARIO 1 – MEASUREMENT PERIOD ADJUSTMENT

In its December 31, 2019 financial statements, the acquirer discloses the business combination
and provides all required disclosures about the measurement period. In particular, the disclosure indicates
that the final valuation of the environmental liability is pending. In July 2020, the acquirer receives the
rest of the information necessary to finalize its estimate of the environmental liability. The acquirer
records the adjustment to the environmental liability as a measurement period adjustment.

SCENARIO 2 – CORRECTION OF AN ERROR

In its December 31, 2019 financial statements, the acquirer discloses the business combination.
The acquirer, however, fails to provide the required disclosures about the measurement period. In July
2020, the acquirer receives the rest of the information necessary to finalize its estimate of the
environmental liability. The acquirer records the adjustment to the environmental liability as the
correction of an error.

SCENARIO 3 – EVENTS HAPPENING AFTER THE ACQUISITION DATE

After the acquisition date, a different crude oil tank on the site springs a small leak. The acquirer
must increase its environmental liability for the cost to remediate the additional damage. The increase is
reflected in current period activity because it was triggered by an event happening after the acquisition
date.

4. Progress Check
 a. Apply the steps in acquisition method
b. Identify the acquirer and the consideration transferred.
c. Identify the treatment of acquisition costs
d. Determine the acquisition date.
e. Recognize and Measure the fair value of the net assets acquired and the non-
controlling interest (if any).

5. Assignment
Establish a concept map pertaining to the accounting procedures as prescribed by PFRS 3.

6. Evaluation
Theory Questions
1. An entity shall account for each business combination by applying the
a. Acquisition method b. Pooling of interest method c. Consolidation method d. Any of the
above

2. The acquisition date is normally the

a. Closing date b. Agreement date c. Date of exchange d. Settlement date

3. Assets and liabilities acquired in a business combination are measured at

a. Agreement date fair value c. Settlement date fair value
b. Acquisition date fair value d. Any of these.

4. LMN’s acquisition date of GHI for cash proceeded as follows:

January 23, 2009 Approach made to the management of GHI seeking endorsement of the acquisition
March 20, 2009 Public offer made for 100% of the equity shares of GHI, conditional on regulatory
approval, shareholder approval and receiving acceptances representing 60% of GHI
shares
June 14, 2009 Receipt of regulatory approval
July 1, 2009 Receipt of shareholder approval
July 30, 2009 Acceptances received to date represents 50% of GHI’s share
August 15, 2009 Acceptance received to date represents 95% of GHI’s share
August 25, 2009 Cash paid out to GHI’s accepting shareholder
November 13, 2009 Cash paid out to the remaining shareholder under a compulsory share acquisition
scheme

The date of acquisition is

 a. June 14, 2009 b. July 1, 2009 c. July 30, 2009 d. August 15, 2009

5. Non-controlling interest in the acquire is measured at the acquisition date at

a. Fair value c. Either A or B
b. Proportional interest in investee’s net assets d. Both A and B

6. Applying the acquisition method do not require

a. Identifying the acquirer
b. Determining the acquisition date
c. Recognizing an investment in subsidiary account
d. Recognizing and measuring goodwill or gain from a bargain purchase

7. Which is incorrect regarding the recognition conditions for identifiable assets acquired or liabilities
assumed in a business combination?
a. Assets acquired and liabilities assumed must meet the definition of assets and liabilities in the
Framework for the Presentation of Financial Statements at the acquisition date.
b. The identifiable assets acquired and liabilities assumed must be part of what the acquirer and the
acquire exchange in the business combination rather than the result of separate transaction.
c. The acquirer must not recognize assets that are not currently recognized in the books of the
acquiree.
d. Contingent liability assumed in a business combination should be recognized if it is a present
obligation that arise from past event and can be measured reliably.

8. The seller in a business combination may contractually agree to indemnify the acquirer for the
outcome of a contingency or uncertainly related to all or part of a specific asset or liability. Such
arrangement will give rise to a/an
a. Insurance asset b. Intangible asset c. Probable asset d. Indemnification asset

9. The consideration transferred in a business combination do not include

a. Fair value of assets transferred c. Non-controlling interest in the acquiree
b. Fair value of liabilities incurred d. Equity interest issued by the acquirer

10. Should the following costs be included in the consideration transferred in a business combination,
according to PFRS3 Business combinations?
1) Costs of maintaining an acquisitions department.
2) Fees paid to accountants to effect the combination.
Cost (1) Cost (2) Cost (1) Cost (2)
a. No No c. Yes No
b. No Yes d. Yes Yes

11. Are the following statements about an acquisition true or false, according to PFRS3Business
combinations?
1) The acquirer should recognize the acquiree's contingent liabilities if certain conditions are met.
2) The acquirer should recognize the acquiree's contingent assets if certain conditions are met.
Statement (1) Statement (2) Statement (1) Statement (2)
a. False False c. True False
b. False True d. True True
12. An acquirer in a business combination may acquire control of an acquiree without transferring
consideration. This may occur under the following circumstance, except:
a. The acquiree repurchases a sufficient number of its own shares for an existing investor (the
acquirer) to obtain control.
b. Minority veto rights lapse that previously kept the acquirer from controlling an acquiree in which
the acquirer held the majority voting rights.
c. The acquirer and acquiree agree to combine their businesses by contract alone.
d. None of these.

E. References

1. Millan, Z.V. (2019). Accounting for Business Combinations. Baguio City, Philippines:
Bandoline Enterprise
2. Dayag, A.J. (2019). Advanced Accounting Vol. 2. Manila, Philippines: Lajara Publishing
House