Business Combination 2

Learning Objectives
1. Account for business combinations (a) accomplish through share-for-share exchanges, (b) achieved
in stages, and (c) achieve without transfer of consideration.
2. Explain the “measurement period” in relation to business combinations.
3. Distinguish what is part of a business combination and what is part of a “separate transaction.”
4. Account for settlement of pre-existing relationship between an acquirer and an acquiree.

Share-for-share exchanges
In a business combination accomplished through a mere exchange of equity interests between the
acquirer and the acquiree (or its former owners), the acquisition-date fair value of the acquiree’s
equity interests may be more reliably measurable than the acquisition-date fair value of the
acquirer’s equity interests.

In such case, the acquirer shall determine the amount of goodwill by using the acquisition-date fair
value of the acquiree’s equity interests instead of the acquisition-date fair value of the equity
interests transferred.

The use of the fair value of the acquiree’s equity interests in this situation, as an alternative to
measuring the fair value of consideration transferred by the acquirer, is on grounds of reliable
measurement only.

Illustration 1: Fair value pf acquiree’s share is more reliably determinable

XYZ, Inc., an unlisted company, acquires ABC Co., a publicly listed entity, through an exchange of
equity instruments.

In this case, the published price of the quoted equity instruments of ABC (acquiree) at acquisition
date is likely to provide a more reliable indicator of fair value than the valuation methods used to
measure the fair value of XYZ’s (acquirer) equity instruments.

Illustration 2: Fair value of acquirer’s shares is reliably determinable

On January 1, 20x1, ABC Co. acquired all of the identifiable assets and assumed all of the liabilities of
XYZ, Inc. by issuing its own ordinary shares. Information at acquisition date is shown below:
ABC Co. XYZ Co. Combined entity
(carrying amounts) (fair values)
Identifiable assets 2,400,000 1,600,000 4,000,000
Goodwill - - ?

Total assets 2,400,000 1,600,000 ?

Liabilities 700,000 900,000 1,600,000
Share capital 600,000 300,000 700,000
Share premium 300,000 250,000 1,200,000
Retained earnings 800,000 150,000 ?
Total liabilities and equity 2,400,00 1,600,000 ?

Additional information:

 ABC’s share capital consists of 60,000 ordinary shares with par value of P10 per share.
 XYZ’s share capital consists of 3,000 ordinary shares with par value of P100 per share.

Requirements: compute for the following

a. Fair value of consideration transferred on the business combination, including the number of
shares issued and their acquisition-date fair value per share.
b. Goodwill recognized on acquisition date.
c. Retained earnings of the combined entity immediately after the business combination.
Requirement (a): Fair value of consideration transferred
Because the consideration transferred is in the form of ABC’s own shares, the fair value of the
consideration transferred is computed by determining the increase in ABC’s share capital and share
premium accounts as shown below:

ABC Co. Combined entity Increase

Share capital 600,000 700,000 100,000

Share premium 300,000 1,200,000 900,000
Totals 900,000 1,900,000 1,000,000

The fair value of the shares transferred as consideration for the business combination is P1,000,000
(i.e., total increase in ABC’s share capital and share premium accounts).

The number of shares issued in the business combination is computed as follows:

Increase in ABC’s share capital account(see table above) 100,000
Divide by: ABC’s par value per share 10
Number of shares issued 10,000

The acquisition-date fair value per share of the shares issued is computed as follows:
Fair value of consideration transferred 1,000,000
Divide by: number of shares issued 10,000
Acquisition-date fair value per share 100

Notice that XYZ’s share capital accounts are ignored in the computations above because the business
combination was accomplished through “asset acquisition.” XYZ’s assets and liabilities shall be
recorded in ABC’s books and XYZ’s share capital accounts including retained earnings will be
eliminated. Non-controlling interest will not arise because ABC acquired 100% interest.

Journal entry
The entry in the books of ABC Co. To record the issuance of the shares is as follows:
Jan. 1, 20x2 Investment in subsidiary (fair value) 1,000,000
Ordinary share capital (10k x P10) 100,000
Share premium 900,000
to recognize the investment in subsidiary

Requirement (b): Goodwill

Goodwill (gain on bargain purchase) is computed as follows:
Consideration transferred 1,000,000
Non-controlling interest in the acquiree -
Previously held equity interest in the acquiree -
Total 1,000,000
Fair value of net identifiable assets acquired (1.6M - .9M) ( 700,000)
Goodwill 300,000

Requirement (c): Retained earnings of the combined entity

Because XYZ’s retained earnings will be eliminated after the business combination, the retained
earnings of the combined entity immediately after the business combination is equal to ABC’s
acquisition-date retained earnings (i.e., P800,000)

The statement of financial position of the combined entity immediately after the business
combination is shown below:
Combined entity
Identifiable assets 4,000,000
 Goodwill 300,000
Total assets 4,300,000

Liabilities 1,600,000
Share capital 700,000
Share premium 1,200,000
Retained earnings 800,000
Total liabilities and equity 4,300,000

Business combination achieved in stages

A business combination achieved in stages occurs when an investors acquires additional shares from
an investee which it had previously held equity interest and the additional shares purchased results to
the investor obtaining control over the investee. In other words, controlling interest is obtained
through two or more separate transactions. A business combination achieved in stages is also
referred to as “step acquisition.”

Illustration 1: Business combination achieved in stages- PAS 28

On January 1, 20x1, ABC Co. acquired 30% ownership interest in XYZ, Inc. For P100,000. Because the
investment gave ABC significant influence over XYZ, the investment was accounted for under the
equity method in accordance with PAS 28 Investments in Associates and Joint Ventures.

From 20x1 to the end of 20x3, ABC recognized P50,000 net share in the profits of the associate and
P10,000 share in dividends. Therefore, the carrying amount of the investment in associate account on
January 1 ,20x3, is P140,000.
On January 1,20x4, ABC acquired additional 60% ownership interest in XYZ, Inc. for P800,000. As of
this date, ABC has identified the following:
a. The previously held 30% interest has a fair value of P180,000.
b. XYZ’s net identifiable assets have a fair value of P1,000,000.
c. ABC elected to measure non-controlling interests at the non-controlling interest’s proportionate
share of XYZ’s identifiable net assets.

Requirement: Compute for goodwill.

Solution:
Consideration transferred 800,000
Non-controlling interest in the acquiree (1M x 10%*) 100,000
Previously held equity interest in the acquiree 180,000
Total 1,080,000
Fair value of net identifiable assets acquired (1,000,000)
Goodwill 80,000

The pertinent entries are:

Jan. 1, 20x4 Investment in associate (180K-140K) 40,000
Gain on remeasurement - P/L 40,000
Jan. 1, 20x4 Investment in subsidiary (800K +180K) 980,000
Cash in bank 800,000
Investment in associate 180,000

Business combination achieved without transfer of consideration

The acquirer shall nevertheless apply the acquisition method to business combinations in which the
acquirer obtains control over an acquiree without transferring consideration.

The reason why the “purchase method” previously used for the business combinations has been
replaced with the “acquisition method” is to emphasize that a business combination may occur even
when a purchase transaction is not involved.

Examples of circumstances where the acquirer obtains control without transferring consideration:
 a. The acquiree repurchases a sufficient number of its own shares from other investors so that
acquirer will be able to obtain control.
For example, ABC Co. holds 40,000 ordinary shares representing a 40% ownership interest in XYZ,
Inc.’s 100,000 outstanding ordinary shares. Subsequently, XYZ repurchases 25,000 shares from other
investors to be held as treasury shares. After the treasury shares transaction,ABC’s ownership interest
will be increased to 53.33% (40,000 ÷ 75,000).

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. The acquirer
transfers no consideration in exchange for control of an acquiree and holds no equity interests in
the acquiree, either on the acquisition date or previously. Examples of business combinations
achieved by contract alone include bringing two businesses together in a stapling arrangement
or forming a dual listed corporation.

In a business combination in which no consideration is transferred, the acquirer substitutes the

acquisition-date fair value of its interest in the acquiree for the acquisition-date fair value of the
consideration transferred to measure goodwill or a gain on a bargain purchase.

In a business combination achieved by contract alone the acquirer attributes to the owners of the
acquiree the amount of the acquiree’s net asset measured either at fair value or at the
non-controlling interest’s proportionate share of the acquiree’s net identifiable assets. In other words,
the equity interests in the acquiree held by parties other than the acquirer are a non-controlling
interest in the acquirer’s post-combination financial statements even if the result is that all of the
equity interests in the acquiree are attributed to the non-controlling interest.

Illustration 1: Business combination - w/o transfer of consideration

ABC Co. owns 36,000 shares representing 40% ownership interest in XYZ, Inc.’s 90,000 outstanding
ordinary shares. ABC accounts for the investment under the equity method.

On January 1, 20x1, XYZ reacquired 30,000 of its own shares from other investors so that ABC shall
obtain control over XYZ. The following were determined as of acquisition date:
a. The previously held 40% interest has a fair value of P180,000.
b. XYZ’s net identifiable assets have a fair value of P1,000,000.
c. ABC elected to measure non-controlling interest at the non-controlling interest’s proportionate
share of XYZ’s net identifiable assets.

Requirement: Compute for goodwill.

Solution:
Consideration transferred (1M x 60%*) 600,000
Non-controlling interest in the acquiree (1M x 40%*) 400,000
Previously held equity interest in the acquiree -
Total 1,000,000
Fair value of net identifiable assets acquired (1,000,000)
Goodwill -

*After the business combination , ABC’s ownership interest is increased to 60% (i.e., 36,000+60,000).
Consequently, the non-controlling interest is 40%.

Notice that the acquisition-date fair value of ABC’s interest in XYZ is substituted for the
acquisition-date fair value of the consideration transferred to measure goodwill or a gain or bargain
purchase.

Since there is no change in the actual number of shares held by ABC before and after the business
combination, no amount is attributed to the previously held equity interest in the acquiree when
computing for goodwill or gain on bargain purchase. However, a remeasurement gain or loss shall be
recognized on the reclassification of the previously held equity interest in the acquiree.
The entry for the business combination is:
Jan. 1, 20x4 Investment in subsidiary 600,000
Investment in associate 180,000
Gain on measurement- P/L 420,000

Measurement period
If the initial accounting for a business combination is incomplete by the end of the reporting period in
which the combination occurs, the acquirer shall report in its financial statements provisional
amounts for the items for which the accounting is incomplete.

If new information is obtained during the measurement period which provides evidence of facts and
circumstances that existed as of the acquisition date that, if known, would have affected the
measurement of the amounts recognized as of that date, the acquirer shall retrospectively adjust the
provisional amounts recognized at the acquisition date.

Additional assets or liabilities may also be recognized during the measurement period 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.

The measurement periods ends as soon as the acquirer receives the information it was seeking about
facts and circumstances that existed as of the acquisition date or learns that more information is not
obtained.

However, the measurement period shall not exceed one year from the acquisition date.

The measurement period is the period after the acquisition date during which the acquirer may adjust
the provisional amounts recognized for a business combination. The measurement period provides
the acquirer with a reasonable time to obtain the information necessary to identify and measure the
following as of the acquisition date in accordance with the requirements of PFRS 3:
a. The consideration transferred;
b. Any non-controlling interest in the acquiree:
c. Previously held equity interest in the acquiree, in the case of a business combination achieved in
stages;
d. The identifiable assets acquired and liabilities assumed; and
e. The resulting goodwill or gain on a bargain purchase.

The acquirer recognizes an increase (decrease) in the provisional amount recognized for an
identifiable asset (liability) by means of a decrease (increase) in goodwill.

During the measurement period, the acquirer shall recognize adjustments to the provisional amounts
as if the accounting for the business combination had been complete at the acquisition date. Thus,
the acquirer shall restate comparative information for prior periods presented in financial statements
as needed.

After the measurement period ends, any revision on the accounting for a business combination shall
be treated as correction of error that is accounted for under PAS 8 Accounting Policies, Changes in
Accounting Estimates and Errors.

Illustration1: Provisional amounts - identifiable assets acquired

Fact pattern
On September 30, 20x1, ABC Co. acquired all of the identifiable assets and assumed all of the
liabilities of XYZ, Inc. By paying cash of P1,000,000. On this date, the identifiable assets acquired and
liabilities assumed have fair values of P1,600,000 and P900,000, respectively.
Case #1: Identifiable asset recognized at provisional amount
ABC engaged an independent valuer to appraise a building acquired from XYZ. However, the valuation
report was not received by the time ABC authorized for issue its financial statements for the year
ended December 31,20x1. As such the building was assigned a provisional amount of P700,000. Also,
the building was tentatively assigned an estimate useful life of 10 years from acquisition date. ABC
uses the straight line method of depreciation and recognized three months’ depreciation on the
building in 20x1.

On July 1, 20x2, ABC finally received the valuation report from the independent valuer which shows
that the fair value of the building on September 30,20x1 is P500,000 and the remaining useful from
that date is 5 years.

Question:How should ABC account for the new information obtained?

Answer: ABC should retrospectively adjust the provisional amount assigned to the building. The
adjustment shall be charged to the goodwill recognized on acquisition date. Depreciation expense
shall also be retrospectively adjusted as necessary. ABC shall then restate its 20x1 financial
statements and provide the disclosures required under PFRS 3.

The measurement period adjustments are computed as follows:

The unadjusted goodwill is computed as follows:

Consideration transferred 1,000,000
Non-controlling interest in the acquiree -
Previously held equity interest in the acquiree -
Total 1,000,000
Fair value of net identifiable assets acquired (1.6M - .9M) (700,000)
Goodwill (recognized on Sept. 30, 20x1) 300,000

The adjusted fair value of net identifiable assets acquired is computed as follows:
Fair value of identifiable assets acquired 1,600,000
Provisional amount assigned to building ( 700,000 )
Fair value of building per appraisal 500,000
Adjusted fair value of identifiable assets acquired 1,400,000
Fair value of liabilities assumed ( 900,000 )
Adjusted fair value of net identifiable assets acquired 500,000

The adjusted goodwill is computed as follows:

Consideration transferred 1,000,000
Non-controlling interest in the acquiree -
Previously held equity interest in the acquiree -
Total 1,000,000
Fair value of net identifiable assets acquired (500,000)
Goodwill 500,000

The adjustment to goodwill is computed as follows:

Goodwill recognized on September 30,20x1 300,000
Adjusted goodwill 500,000
Increase in goodwill 200,000

The adjustment to depreciation expense recognized in 20x1 is computed as follows:

Depreciation recognized(P700,000 ÷ 10 years x 3/12) 17,500
Adjusted depreciation (P500,000 ÷ 5 years x 3/12) 25,000
Additional depreciation expense for 20x1 7,500
The measurement period adjusting entries are as follows:
July 1, 20x2 Goodwill 200,000
Building 200,000
To record the adjustment to the provisional amount assigned to
the building
July 1, 20x2 Retained earnings 7,500
Accumulated depreciation 7,500
To record the adjustment to 20x1 depreciation
If monthly depreciation expenses were recognized during January to June 30, 20x2, the recognized
depreciation expenses shall also be adjusted accordingly.

Case#3: Information obtained beyond the measurement period

On November 1,20x2, the internal auditors of ABC discovered an error on the recorded identifiable
assets acquired from the business combination. A patent with fair value of P100,000 and remaining
useful life of 4years as of September 30,20x1 was omitted from the valuation listing.

Question: How should ABC account for the new information obtained?

Answer: Because the new information is obtained after the measurement period (i.e., beyond one
year from September 30, 20x1), ABC should account for the new information in accordance with PAS
8 as correction of a prior period error. PAS 8 requires the correction of a prior period error to be
accounted for retrospectively and for the financial statements to be presented as if the error had
never occurred by correcting the prior period’s information.

The correcting entries on the 20x1 financial statements are as follows:

Nov. 1, 20x2 Patent 100,000
Goodwill 100,000
Nov. 1, 20x2 Retained earnings (100K ÷ 4x 3/12) 6,250
Accumulated amortization 6,250

The unrecorded patent in nonetheless recognized, but this time not as a measurement period
adjustment but rather as correction of error. Goodwill is charged for the correction of error because if
ABC had known the existence and value of the unrecorded patent on September 30, 20x1, the
amount of goodwill that should have been recognized on that date is P200,000.

Determining what is part of the business combination transaction

Before the business combination, the acquirer and the acquiree may have pre-existing relationship or
they may enter into transaction during the negotiation period that are separate from the business
combination.

In such cases, the acquirer shall identify amounts that are not part of the consideration transferred
on the business combination. In applying the acquisition method, the acquirer shall recognize only the
consideration transferred on the business combination. Separate transaction shall be excluded from
the consideration transferred and accounted for under other relevant PFRSs.

A transaction that is arranged primarily for the benefit of the acquirer or the combined entity rather
than primarily for the benefit of the acquiree or its former owners before the combination is likely to
be a separate transaction. Thus, the portion of the transaction price shall be excluded from the
consideration transferred when applying the acquisition method.

PFRS 3 provides the following guidance when determining whether a transaction is part of a business
combination or a separate transaction:
a. Reasons for the transaction
A transaction that is arranged primarily for the benefit of the acquirer or the combined entity rather
than primarily for the benefit of the acquirer or the combined entity rather than primarily for the
benefit of the acquiree or its former owner before the combination is more likely to be a separate
transaction. Thus, the portion of the transaction price shall be excluded from the consideration
transferred when applying the acquisition method.

On the other hand, a transaction that is arranged primarily for the benefit of the acquiree or its
former owners before the combinations more likely to be a part of the business combination
transaction.

b. Party initiating the transaction

A transaction initiated by the acquiree is more likely for the benefits of the acquirer or the combined
entity and, therefore , is more likely a separate transaction.

On the other hand, a transaction initiated by the acquiree or its former owners is more likely a part of
the business combination transaction.

c. Timing of the transaction

A transaction between the acquirer and the acquiree that takes place during the negotiations of the
terms of a business combinations is more likely to have been entered into in contemplation of the
business combination.

The following are examples of separate transactions that are not to be included in applying the
acquisition method:

a. Settlement of pre-existing relationships between the acquirer and acquiree;

b. Remuneration to employees or former owners of the acquiree for future services; and
c. Reimbursement to the acquiree or its former owners for paying the acquirer’s acquisition-related
costs.