Business Combination ( Part 3)

Special accounting topics for business combination

1. Goodwill
2. Reverse acquisition
3. Combination of mutual entities

Goodwill
Only goodwill that arises from a business combination is recognized as an asset. Goodwill arising from
other sources (e.g., internally generated) is not recognized. The amount recognized as goodwill is
determined on the acquisition date of a business combination. Subsequent expenditures on maintaining
goodwill are expensed immediately.

Subsequent to initial recognition, goodwill is not amortized but rather tested for impairment at least
annually.

For this purpose, goodwill shall be allocated to each of the acquirer’s cash-generating units (CGU) in the
year of business combination. If the allocation is not completed by the end of the year of business
combination, it must be completed before the end of the immediately following year.

Cash-generating unit (CGU) is the smallest identifiable group of assets that generates cash inflows that are largely
independent of the cash inflows from other assets or groups of assets.

Goodwill shall be allocated to the CGUs expected to benefit from the synergies of the business
combination. The methodology used to assign goodwill must be reasonable, supportable, and applied in
a consistent manner. For example, goodwill may be allocated based on the relative fair values of the
CGUs.

Illustration 1: Applications of the Direct valuation method

ABC Co. is contemplating on acquiring XYZ, Inc. The following information was gathered through a
diligence audit:

 The actual earnings of XYZ, Inc. The following information was gathered through a diligence audit:
Year Earnings
20x1 1,200,000
20x2 1,300,000
20x3 1,350,000
20x4 1,250,000
20x5 1,800,000
Total 6, 900,000

 Earnings in 20x5 include an expropriation gain of P400,000.

 The fair value of XYZ’s net assets as of the end of 20x5 is P10,000,000.
 The industry average rate of return is 12%.
 Probable duration of “excess earnings” is 5 years.

Method #1: Multiples of average excess earnings

Under this, method, goodwill is measured at the average excess earnings multiplied by the probable
duration of excess earnings.

Total earnings for the last 5 years 6,900,000

Less: Expropriation gain ( 400,000 )
Normalized earnings for the last 5 years 6,500,000
Divide by: 5
(a) Average annual earnings 1,300,000

Fair value of acquiree’s net assets 10,000,000

Multiply by: Normal rate of return 12%
(b) Normal earnings 1,200,000
Excess earnings (a) - (b) 100,000
Multiply by: Probable duration of excess earnings 5
Goodwill 500,000
Method #2: Capitalization of average excess earnings
Under this method, goodwill is measured at the average excess earnings divided by a pre-determined
capitalization rate. ( Assume a capitalization rate 25%).
Average earnings (6.9M - .4M expropriation gain) ÷ 5years 1,300,000
Normal earnings in the industry (10M x 12%) ( 1,200,000 )
Excess earnings 100,000
Divide by: Capitalization rate 25%
Goodwill 400,000

Method #3: Capitalization of average earnings

Under this method, the average earnings are divided by a pre-determined capitalization rate to estimate
the purchase price of the business combination. The excess of the estimated purchase price over the fair
value of the acquiree’s nt assets represents the goodwill. (Assume a capitalization rate of 12.5%).

Average earnings (6.9M - .4M expropriation gain) ÷ 5 years 1,300,000

Divide by: Capitalization rate 12.5%
Estimate purchase price 10,400,000
Fair value of XYZ’s net assets ( 10,000,000 )
Goodwill 400,000

Notice that if the “excess earnings” is used in the computations, the amount directly computed is
goodwill. On the other hand, if the “average earnings” is used, the amount directly computed is the
estimated purchase price.

Method #4: Presented value of average excess earnings

Under this method, goodwill is measured at the present value of average excess earnings discounted at a
pre-determined discount rate over the probable duration of excess earnings. (Assume a discount rate of
10%).

Average earnings (6.9M - .4M expropriation gain) ÷5 years 1,300,000

Normal earnings in the industry (10M x 12%) ( 1,200,000 )
Excess earnings 100,000
Multiply by: PV of an ordinary annuity @10%, n=5 3.79079
Goodwill 379,079

Reverse acquisition
In a business combination accomplished through exchange of equity interests, the acquirer is usually the
entity that issues its equity interests. However, the opposite is true for reverse acquisitions.

In a reverse acquisition, the entity that issues securities ( the legal acquirer ) is identified as the acquiree
for accounting purposes while the entity whose equity interests are acquired ( the legal acquiree ) is the
acquirer for accounting purposes

For example , ABC Co., a private entity, wants to become a public entity but does not want to register
its shares. To accomplish this, ABC will arrange for a public entity to acquire its equity interests in
exchange for public entity’s equity interests.

In the example above , the public entity is the legal acquirer because it issued its equity interests, and the
private entity is the legal acquiree because its equity interests were acquired.
However,when applying the guidance provided under PFRS 3:
a. The public entity is identified as the acquiree for accounting purposes (the accounting acquiree); and
b. The private entity (ABC Co.) is identified as the acquirer for accounting purposes (the accounting
acquirer).

Measuring the consideration transferred

In substance, the accounting acquirer usually issues no consideration to the acquiree. Instead, the
accounting acquiree issues its equity shares to the owners of the accounting acquirer to enable the
accounting acquirer to obtain control over the accounting acquiree.

As such, the acquisition-date fair value of the consideration transferred by the accounting acquirer shall
be measured as an amount based on the number of equity interest the legal subsidiary (accounting
acquirer) would have had to issue to give the owners of the legal parent (accounting acquirer) would
have had to issue to give the owners of the legal parent (accounting acquiree) the same percentage of
equity interest in the combined entity that results from the reverse acquisition.
Conventional acquisition vs. Reverse acquisition
Conventional Reverse
acquisition acquisition
Issuer of shares as The issuer of shares is the The issuer of shares is the
consideration transferred accounting acquirer. accounting acquiree.
Reference to combining - Accounting acquirer/ - Accounting acquirer/ Legal
constituents Legal parent subsidiary
- Accounting acquiree/ Legal - Accounting acquiree/ Legal
subsidiary parent

Measurement of consideration Fair value of consideration Fair value of the notional

transferred transferred by the accounting number of equity instruments
acquirer. that the accounting acquirer
(legal subsidiary) would have
had to issue to the accounting
acquiree (legal parent) to give
the owners of the accounting
acquiree (legal parent) the
same percentage ownership in
the combined entity.

Illustration: Reverse acquisition

On January 1, 20x1, XYZ, Inc ., an unlisted company, acquires ABC Co., a publicly listed entity, through an
exchange of equity instruments. ABC Co. issues 5 shares in exchange for each ordinary share of XYZ, Inc,
All of XYZ’s shareholders exchange their shares in ABC Co. Therefore, ABC Co. issues 40,000 ordinary
shares in exchange for all 8,000 ordinary shares of XYZ, Inc.

The fair value of each ordinary share of XYZ on January 1, 20x1 is P200. The quoted market price of ABC’s
ordinary shares at that date is P40.

The statements of financial position of the combining entities immediately before combination are
shown below:

ABC Co. XYZ, Inc

(legal parent,accounting acquiree ) (legal subsidiary, accounting acquirer )
Identifiable assets 1,600,000 2,400,000
Total assets 1,600,000 2,400,000
Liabilities 1, 300,000 700,000
Share capital:
10,000 ordinary
shares, P10 par 100,000
8,000 ordinary
shares, P100 par 800,000
Retained earnings 200,000 900,000
Total liabilities and equity 1,600,000 2,400,000

The fair values of ABC’s identifiable assets and liabilities on January 1,20x1 are the same as their carrying
amounts.

Requirements: Compute for goodwill (gain on bargain purchase).

Solution:
Analyses:
 XYZ, Inc lets itself acquired (legal form) for it to gain control over the legal acquirer (substance).

Combination of mutual entities

PFRS 3 defines a mutual entity 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.”
Examples: a mutual insurance company, a credit union, and a cooperative entity.

Mutual entities may be differentiated from other types of businesses on the basis that members of
mutual entities are both customers and owners. Members generally expect to receive benefits from their
membership, normally in the form of reduced fees charged for goods and services or patronage dividends.
The portion of patronage dividends allocated to each members is often based on the amount of business
the members did with the mutual entity during the year.

When two mutual entities combine, the acquirer gives member or equity interests in itself in exchange
for the member interest in the acquiree. Consideration is transferred but its fair value is not readily
determinable by reference to a market.

In such case, the acquirer determines 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 acquirer’s equity interest
transferred as consideration.

Illustration: Combination of mutual entities

ABC Coop. and XYZ Coop. are cooperative institutions. On January 1, 20x1, the two entities combined,
with ABC identified as the acquirer. ABC shall issue member interests to XYZ. As a result, members of XYZ
become members of ABC. An estimated cash flow models indicates an acquisition-date fair valuation of
XYZ, as an entity, at P1,000,000. The fair value of XYZ’s identifiable net assets is P800,000.

Requirements: Compute for goodwill and provide the acquisition-date journal entry.
Solution:
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 (800,000)
Goodwill 200,000

ABC records its acquisition of XYZ in its consolidated financial statements as follows:
Jan. 1, Identifiable assets acquired 800,000
20x1 Goodwill 200,000
Member interests issued 1,000,000