UM Digos College

Department of Accounting Education

Roxas Extension, Digos City

ACP 312: Accounting for Business Combination

Big Picture

Week 4-5: Unit Learning Outcomes (ULO): At the end of the unit, you are expected to:
a. Understand the nature of business combination and its accounting procedures;
b. Account for business combination by applying acquisition method in net asset
acquisitions;
c. Account for consolidated financial statements at the date of acquisition for stock
acquisitions; and
d. Understand other business combination methods such as step-acquisition, push-
down accounting and reverse acquisition.

Big Picture in Focus: ULOa. Understand the nature of business combination

and its accounting procedures

Metalanguage

The most essential terms below are operationally defined for you to have a better
understanding of this section in the course.

1. Business Combination. This is a transaction or other event in which an acquirer obtains

control of one or more businesses (the acquiree). For each business combination, one of the
combining entities shall be identified as the acquirer. (IFRS 3)
2. Control. An entity gains control over another when it has the power to govern the policies
and operations of such entity.
2.1 Control of another company may be achieved by either acquiring the assets of the
target company or acquiring a controlling interest (usually over 50%) in the target
company's voting common stock.
3. Acquisition of assets. This is a form of business combination where all of the company's
assets are acquired directly from the company. In most cases, existing liabilities of the
acquired company also are assumed. When assets are acquired and liabilities are assumed,
the transaction is referred to as an acquisition of "net assets acquisition”.
3.1 Payment may be made in cash, exchanged property, or issuance of either debt or
equity securities. Business combinations may be achieved legally either by statutory
consolidation or statutory merger.
4. Statutory consolidation. This refers to the combining of two or more existing legal entities
into one new legal entity. The previous companies are dissolved and are then replaced by the
new continuing company.
[A + B = C]

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5. Statutory merger. This refers to the absorption of one or more existing legal entities by
another existing company that continues as the sole surviving legal entity. The absorbed
company ceases to exist but may continue as a division of the surviving company.
[A + B = A or B]
6. Acquisition of stocks. In a stock acquisition, a controlling interest (typically, more than 50%)
of another company's voting common stock is acquired. The acquiring company is termed as
the parent (also the acquirer), and the acquired company is termed as a subsidiary (also the
acquiree).
6.1 Both the parent and the subsidiary remain separate legal entities and maintain
their own financial records and statements. However, for external financial reporting
purposes, the companies will usually combine their individual financial statements
into a single set of consolidated statements.
7. Purchase method. IFRS 3 requires that all business combinations be accounted for by
applying the acquisition method or purchase method. Under the purchase method, all assets
and liabilities of the acquired company are usually recorded at fair value.
8. Contingent consideration. A contingent consideration is defined in the Standard as
"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
future events occur or considerations are met".
8.1 However, contingent consideration may also give the acquirer the right to the
return of previously transferred consideration if specified conditions are met. The
specified future events may be in the form of meeting a specified level of earnings,
reaching a specified share price or reaching a certain milestone in development
projects.
9. Fair value of net assets. The total of all identifiable assets less liabilities recorded at fair
value.
10. Goodwill. This is determined to be the excess of the consideration transferred over the
net fair value of the identifiable assets and liabilities assumed. Meaning, the price paid
exceeds the fair valued assigned to net assets.
10.1 The goodwill recorded is not amortized, but is impairment tested in future
accounting periods.
11. Gain from bargain purchase or gain on acquisition. This is determined to be the excess
of the net fair value of the identifiable assets and liabilities assumed over the consideration
transferred. This is also referred to as “negative goodwill.” Meaning, the price paid is less than
the fair values assigned to net assets.
12. PFRS 3. The standard applicable to business combination.

Essential Knowledge

A. Reasons for Business Combinations

There are several ways of business expansion; it may either be through acquisition or
instruction of new amenities or through business combination. Following are the why
business combination may be preferred as compared to other means.
1. Cost Advantage. It is commonly less expensive for a firm to obtain needed amenities
through combination rather than through development.
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2. Lower Risk. The acquisition of reputable product lines and markets is usually less
risky than developing new products and markets. The threat is especially low when
the purpose is diversification.
3. Avoidance of Takeovers. Many companies combine to evade being acquired
themselves. Smaller companies tend to be more susceptible to corporate takeovers;
therefore, many of them adopt forceful buyer strategies to defend against takeover
attempts by other companies.
4. Acquisition of Intangible Assets. Business combinations bring together both
intangible and tangible resources.
5. Other Reasons. Entities may choose a business combination over other forms of
expansion for business tax advantages (for example, tax-loss carry forwards), for
personal income and estate-tax advantages, or for personal reasons.

B. Structure of Business Combination

1. Horizontal Integration — this type of combination is one that involves companies
within the same industry that have previously been competitors.
2. Vertical Integration — this type of combination takes place between two companies
involved in the same industry but at different levels. It normally involves a
combination of a company and its suppliers or customers.
3. Conglomerate Combination — is one involving companies in unrelated industries
having little, if any, production or market similarities for the purpose of entering into
new markets or industries.
4. Circular Combination - entails some diversification, but does not have a drastic
change in operation as a conglomerate.

C. Acquisition method of accounting for business combination

To determine whether a transaction or other event is a business combination, four steps in

the application of the acquisition method are to be used as follows:

1. Identify the acquirer.

- In an asset acquisition, the company transferring cash or other assets and/or assuming
liabilities is the acquiring company. In a stock acquisition, the acquirer is, in most cases,
the company transferring cash or other assets for a controlling interest in the voting
common stock of the acquiree (company being acquired).
- Some stock acquisitions may be accomplished by exchanging voting common stock.
Usually, the company issuing the voting common stock is the acquirer.
- In some cases, the acquiree may issue the stock in the acquisition. This "reverse
acquisition" may occur when a publicly traded company is acquired by a privately traded
company. (To be discussed in later units)

2. Determine the acquisition date.

- This is the date on which the acquirer obtains control of the acquiree. IFRS 3 explains
that the date on which the acquirer obtains control of the acquiree is generally the date

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on which the acquirer legally transfers the consideration, acquires the assets and
assumes the liabilities of the acquiree — the closing date.
- The acquisition date is critical because it is the date used to establish the fair value of
the company acquired, and it is usually the date that fair values are established for the
accounts of the acquired company.

3. Determine the consideration given (price paid) by the acquirer.

- Generally, the consideration given (price paid) by the acquirer is assumed to be the fair
value of the acquiree as an entity. IFRS 3 requires the consideration given in a business
combination to be measured at fair value.
- This is calculated as the sum of the acquisition-date fair values of:
a. the assets transferred by the acquirer.
b. the liabilities incurred by the acquirer to former owners of the acquiree; and
c. the equity interests issued by the acquirer.

Contingent Consideration
The acquirer shall recognize at acquisition date the fair value of contingent
consideration as part of the consideration transferred in exchange for the acquire (without
regards to the probability of contingency crystallizing in the future periods.
If the contingent consideration takes the form of additional cash consideration
payable, it shall be classified as a financial liability. If the contingent consideration is in the
form of issuing additional equity instrument, it shall be classified as an equity instrument.

Acquisition-related Costs
The costs the acquirer incurs to effect a business combination such as broker's
accounting, legal, and other professional fees; general administrative costs including the
costs of maintaining an internal acquisition department, are not included in the price of the
company acquired and are expensed.

Stock Issuance Costs

When the acquirer issues shares of stock for the net assets acquired, the stock
issuance costs such as SEC registration fees, documentary stamp tax and newspaper
publication fees are treated as a deduction from additional paid in capital (APIC) from
previous share issuance. In case APIC is reduced to zero, the remaining stock issuance costs
is treated as a contra account (stock issuance costs) from retained earnings presented as a
separate line item. (Philippine Interpretation Committee).

4. Recognize and measure the identifiable assets acquired, the liabilities assumed and
any non-controlling interest (formerly called minority interest) in the acquiree. Any
resulting goodwill or gain from a bargain purchase should be recognized.
- The identifiable assets should never include goodwill that may exist on the acquiree's
books. The only goodwill recorded in an acquisition is "new" goodwill based on the price
paid by the acquirer. The fair value of the net assets recorded is not likely to be equal to
the price paid by the acquirer.

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D. Valuation of identifiable assets and liabilities

As a general rule, assets and liabilities acquired are recorded at their individually
determined values. The acquiring company is not required to establish values immediately
on the acquisition date. A measurement period of up to one year is allowed for
measurement. Temporary values would be used in financial statements prepared prior to
the end of the measurement period. A note to the financial statements would explain the
use of temporary values. Any change in the recorded values is adjusted retroactively to the
date of acquisition. Prior-period statements are revised to reflect the final values and any
related amortizations.

Cash and Cash Equivalents, Short-term Monetary Assets and Deferred Consideration
Cash and cash equivalents and short-term monetary assets given and short-term
liabilities incurred are measured at their fair value, which is normally equal to their face
value or nominal value. Deferred consideration is measured and recorded at the present
value of the consideration and not at the nominal value of the payable. The rate of
discounting is the acquirer's current borrowing cost.

Equity Instruments Transferred

Equity instruments issued are measured at their fair value. For quoted equity
instruments issued, the published price at the date or exchange (which is the acquisition
date) of a quoted equity instrument provides the best evidence of the instrument's fair
value and shall be used.

Non-Financial Assets Transferred

Non-financial assets given shall be measured by reference to their market prices,
estimated realizable values, independent valuations or other available information relevant
to the valuation.

When a property is transferred to the acquiree rather than to its former

shareholders, the acquirer shall measure the non-monetary assets transferred at their
carrying amounts rather than at their fair value, so that it does not recognize a gain or loss
in profit or loss, both before and after the business combination (IFRS 3.38).

Self-Help: You can also refer to the sources below to help you further
understand the lesson:

Guerrero, P. and Peralta, J. (2017). Advance Accounting: Principles and Procedural

Applications, Volume 2. GIC Enterprices & Co., Inc.: Manila, Philippines

Dayag, A. (2015). Advance financial accounting Volume 2 (2016 ed.). Lajara Publishing House

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Department of Accounting Education
Roxas Extension, Digos City

Let’s Check
Activity 1. Choose the best answer.

1. Horizontal business combinations occur when one entity purchases which of the
following?
a. A supplier
b. A customer
c. A competitor
d. None of the above

2. Which of the following types of business combinations typically occurs when

management is attempting to improve the efficiency of operations?
a. Horizontal combination
b. Vertical combination
c. Conglomerate combination
d. Improved efficiency can be the goal of any type of combination

3. Control over an acquiree can be attained through which of the following?

a. Acquisition of the acquiree assets
b. Acquisition of the acquiree stocks
c. Either acquisition of the acquire assets or stock
d. Neither acquisition of the acquire assets nor stock

4. In an acquisition where there is an exchange of assets for assets, how does the value of
the acquire net assets change?
a. The net assets increase
b. The net assets decrease
c. There is no change in net assets
d. The net assets may increase, decrease or remain the same

5. In an acquisition where there is an exchange of assets for assets, how does the ownership
structure of the acquire change?
a. There is no change in the acquire ownership structure
b. The acquirer stockholders become the acquire stockholders
c. The acquirer and acquire stockholders share ownership of the acquire
d. It is not possible to determine if there is a change in the acquire ownership structure

6. A statutory merger is a(n)

a. Business combination in which only one of the two companies continues to exist as a
legal corporation
b. Business combination in which both companies continues to exist
c. Acquisition of a supplier or a customer
d. Acquisition of a competitor
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e. Legal proposal to acquire outstanding shares of the target’s stock

7. Liabilities assumed in an acquisition will be valued at the

a. Estimated fair value
b. Historical book value
c. Current replacement cost
d. Present value using market interest rate

8. Goodwill arising from business combination is

a. Charged to Retained earnings after the acquisition is completed
b. Amortized over 40 years or its useful life, whichever is longer
c. Amortized over 40 years or its useful life, whichever is shorter
d. Never amortized

9. Under PFRS 3:
a. Both direct and indirect costs are to be capitalized
b. Both direct and indirect costs are to be expensed
c. Direct costs are to be capitalized and indirect costs are to be expensed
d. Indirect costs are to be capitalized and direct costs are to be expensed

10. The cost of registering equity securities in a business combination should be recorded as
a. An income of the period
b. An expense of the period
c. Deduction from additional paid in capital
d. Part of the cost of stock acquired

Let’s Analyze
Activity 1. Evaluate the following statements below. Write True if the statement is True and
write False if otherwise.

________ 1. When two entities competing in the same industry combine, it is called a
horizontal combination.
________ 2. A vertical combination is one where the entities have a potential buyer-seller
relationship.
________ 3. A business combination in which a supplier of raw materials is acquired is a
conglomerate combination.
________ 4. In an acquisition of net assets, the ownership structure of the acquiree does
not change.
________ 5. There is an increase in the total capitalization of an acquirer when the acquirer
issues stock for the acquiree’s assets.
________ 6. The acquire entity is liquidated in a statutory merger.
________ 7. Control over the acquire assets is directly achieved in an asset exchange but
indirectly achieved in an asset (acquirer) for stock (acquire) exchange.

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________ 8. In a business combination accomplished as a stock acquisition normally two

companies exist after the combination.
________ 9. The only way to attain control over the net assets of another company is to
purchase the net assets.
________ 10. In an acquisition of net assets, the ownership structure of the acquiree
changes.

In a Nutshell

Activity 1. Understanding the concepts of accounting for business combination can help you
be analytic and procedural in your future role as an accountant. In this part, you will be
required to draw conclusions, perspectives, arguments and ideas from the unit lesson. I will
supply the first item and you will continue the rest.

1. Organizations have different reasons to acquire another business. Although some lead to
beneficial profits to both sides, the acquirer must keep in mind that acquiring a business can
also lead to loss due to acquisition of a business lacking with essential resources.

2.

3.

4.

5.

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6.

7.

8.

9.

10.

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