Chapter 1 - Business Combinations: Statutory Merger and Statutory Consolidation Introduction ‘Accounting for business combinations is one of the most significant and interesting topics of accounting theary and practice. Simultaneously it multifaceted and dlvsive. Business combinations involve financial fronsactions of immeasurable magnitudes, business empires, rumphant stories and individual fortunes, managerial genius, and management debacies. By their nature, they affect the destiny of entire Companies. Each is exceptional and must be evaluated in terms ofits economic substance, regardless of its legal form, Why do business entities enter into business combination? Although a number of reasons have been cited, the overriding reason is probably growth. Growth is a major objective of many business organizations. ‘A company may grow slowly, may gradually expand its product lines, facilities, or services, or may skyrocket almost ovemight. : i uness combinations may destroy value rather than create, in some instances. For example, it the monagers of merged firm transfer resources to subsidize money-losing segments instead of shutting them down, the result will be a suboptimal allocation of capital. Ths station may arise because of reluctance fo eliminate jobs or fo acknowledge a past mistake. This chopler presents reasons for the popularity of business combination, the methods and techniques in eating with them. The Nature of a Business Combination A business combination may be friendly or unfriendly (hostile takeovers): + In.aflendly combination, the board of directors of the potential combining companies negotiates mutually agreeable terms of a proposed combination. The proposal is submitted to the stockholders of the involved companies for approval. Normally, a two- thirds or three-fourths positive vote is required by corporate by-laws to bind all stockholders to the combination. + An unfriendly (hostile) combination results when the board of directors of a company targeted for acquisition resists the combination, A formal tender offer enables the ‘acquiring fim to deal directly with individual shareholders. fa sufficient number of shares are not made available, the acauiring fim may reserve the right to withdraw the offer. Because they are relatively quick and easily executed (often in about a month), tender offers are the preferred means of acquiring public companies. Although tender offers are the preferred method for presenting hostile bids, most tender offers are friendly ones, done with the support of the target company's management. Nonetheless, hostile takeovers have become sufficiently common that a number of mechanisms have emerged to resist takeover. Resistance often involves varlous moves b y the target company, generally with colorful a Whether such defenses are ultimately beneficial to shareholders fabs remains a mlroversial issue. Academic research examining the price reaction to defensive Advanced Financial, = — Accounting ~ A Comprehensive: Conceptual & Procedural Approachi 2 CHAPTER? | actions has produced mixed results, suggesting that the defenses are good for | stockholders in some cases and bad in others, fefensive tactics or m untiendly (hostile) takeover, the following are d ctics Or moves fo resist the oe ‘osed business combination with the following colorful designations: | 1. Poison Pil. An amendment of the articles of incorporation or by-laws to moke it more difficult to obtain stockholder approval for a takeover. 2. Greenmall. An acquisition of common stock presently owned by the prospective acaviring (acquirer) company at a price substantially lower in excess of the prospective acquirer's cost, with the stock thus placed in the treasury or rete. The purchased shares are then held os ireasury stock or retired, This tactic is largely ineffective because it may result Jo an expensive excise tax; further, ftom an accounting perspective, the excess of the price paid over the market price is expensed. 3. White Knight or White Squite. A search for a candidate to be the acquirer in a fienaly ‘okeover. This is simply encouraging a third company more acceptable to the target company. ane 4. Pac-man Defense. Aitempting cn unttiendly takeover of the would be acquiing company. 5. “Selling the Crown Jewels” or “Scorched Earth”. The sale of valuable assets to otheis 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. 6. Shark Repellant. An acquisition of substantial amounts of outstanding common stock for the treasury or for retirement, or the incuring of substantial long-term debt in exchange for outstanding common stock. 7. Leveraged Buyouts. When management desires to own the business, it may arrange fo buy out the stockholders using the company's asiels fo finance the deal. The bonds issued often toke the form of high-interest, high-isk “junk” bonds. . 8, The Mudslinging Defense. When the acquiring company offers stock instead of cash, he prospective acauiring (acquirer) company's management may try to convince the stockholders that the stock would be a bad investment. 9. The Defensive Acquisition Tactic. When a major reason for an attempted takeover is the | prospective acquiring (acquirer) company's favorable cash postion, the prospective acquiring (acquirer) company may try to rid itself of this excess cash by attempting fo takeover of its own. Reasons for Business Combinations There are several ways of business expansion; it may either be through acquisition ot construction. of new amenities or through business combination. Following are the, feasons 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. 2. Lower Risk. The acquisition of reputable product fines and markets is usually less risky by developing new products and markets. The threat is especially low when the pues diversfication. —— “Advanced Financial Accounting ~ A Comprehensive: Conceptual & Procedural ApproachBUSINESS COMBINATION ~ STATUTORY MERGER and STATUTORY CONSOLIDATION 3 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 take over 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. Types of Business Combinations Business combinations may be classitied under three schemes: 1. One based on the structure of the combination, 2. One based on the method used to accomplish the combination, and * 3. One based on the accounting method used. Siructure of Business Combination, In'general terms, business combinations unite previously separate business entities. The overiding objective of business combinations must be increasing profitability; however, mony firms can become more efficient by horizontally, or vertically integrating operations or by diversifying their risks through conglomerate operations, or by diversifying through change in operation. Because of this reason, combinations are classiied by structure into four types ~ horizontal, vertical, conglomerate, and circular. ‘+ Horizontal Integration - this type of combination is one that involves Companies within the same industry that have previously been competitors + Vertical Integration - this type of combination tokes 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. + 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. | + Ctreular Combination -enfais some civersiication, but does not have a caste change | in operation as a conglomerate. Possible Structures The structure of a business combination may be determined by a variety of factors, including legal and tax strategies. Other factors might include market considerations and regulatory considerations include: one business becomes a subsidiary of another; two entities are legally merged into one entity; one entity transfers its net assets to another enti an entity's owners transfer their equity interests to the owners of another entity; two or more entities transfer their net assets, or the owners transfer their equity interests, to t ‘newly-formed entity (sometimes termed a. “roll-up or: ‘put-together' transaction); and * a group of former owners of one entity obtains control of a combined entity.4 CHAPTER 1 Methods/Types of Combinations/Legal Forms of Effecting Business Combinations There are four types of combination which can be identified from legal and ‘organizational perspectives. From legal perspective, accounting and ‘organizational perspective, the specific procedures to be used in accounting for a business combination is effected through an ‘acquisition of net assets of assets or an acquisition of stock, the distinction of which is most important at this stage. |. Acquisition of Net Assets (Assets less Liabilties). The books of the acquired (acquire) company are closed out, and its assets and liabilities are transferred fo the books of the acquirer (or the acquiring /surviving company).in this aspect of combination, sometimes one enterprise acquires another enterprise's net assets through direct negotiations with its management, The acquiree (acquired) compony generally distibutes to its stockholders the asset or securities or debt instruments received in the combination from the acauirer (acaviring) 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 and liabilities acquisition: ‘© The.acquiter acquires from another enterprise all or most of the net assets of the other enterprise for cash or other property, debt instruments, and equity | instruments (common or preferred stock), ora combination thereof. «The acquirer must acquire 100% of the net assets of the acquiee (acquired) company. + Itinvolves only when the acquirer (acquiing) company survives. ‘Acquisitions of Net Assets (assets less labilies) are classified into: ‘AsStatutory merger (to be discussed in succeeding paragraphs) B.Statufory consolidation (10 be discussed in succeeding paragraphs) In this chapter, we focus on the acquisition of net assets of the acquired company. I. Acquisition of Common Stock (Stock Acquistion). The books of the acquirer (acquiring) | company and acquitee (acquired) company remain intact and consolidated financial statements are prepared periodically. In such cases, the acquirer (acquiing) company debits an account “Investment in Subsidiary”, the stock of the acquired company is recorded as an inter-corporate | investment; rather than transferring the’ underlying assets and liabilities onto its own | books. A business combination effected through a stock acquisition does not necessarily have fo involve the acquisition of all of a company’s outstanding voting (common) shares. In| those cases, contfol of afiother company is acquired. Following are the features of a stock acquisition: a. The acquirer acquires voting (common) stock from another enterprise for cash of ‘other property, debt instruments, and equity instruments (common or prefered stock), ora combination thereof. y ‘dvaneed Financial Accounting ~ A Comprehensive: Conceptual & Procedural ApproachBUSINESS COMBINATION ~ STATUTORY MERGER and STATUTORY CONSOLIDATION 5 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 fo the acquirer gaining control. The total of the shares of an acquired company not held by the controling shareholder is caled the non-controling interest. ©. The acquired company need not be dissolved; that is, the acquired company does not have to go out of existence. Both the acquirer (acquiing) company and the ‘acquiree (acquired) company remain as separate legal entity. Further discussions and istration for the topic “stock acquisition” will be discussed in the succeeding chapters (Chapters 2-5). . il, Asset Acquisition. It reflects the acquisition by one firm of assets (and possibly liabilities) of nother firm, but not its shares. The sling fim may continue to survive as a legal entity, orit may liquidate entirely. The acquirer typically targets key assets for acquisition, or buys the acquiree’s assets but does not assume its labilties. Often the assets acquired are in the form of a division or product line. The acquires may not buy the entire ently. It should be noted that asset acquisition is not within the scope of business combination ‘under PERS 3 (refer to discussion below). There are two independent issues related to the consummation of a combination: + what is acquired (net assets, stock or assets) and +. what is given up (the consideration for the combination). Acquisition of Net Assets (Assets less Liabilities) The terms merger and consolidation are often used synonymously for acquisitions. 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 A statutory merger entails that acquiring (acquirer) company survives, whereas the acquired (acquire) company (or companies) ceases to exist as a separate legal entity, although it may be continued as a separate division of the acquiring company. Thus, if ‘A Company acquires B Company in a statutory merger, the combination is often expressed as: X Company + Y Company = X Company or Y Company The board of directors of the companies involved normally negotiates the terms of a plan of 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. : Statutory Consolidation 4 Statutory consolidation results when a new corporation is formed to acquire’ two or More other corporations; the acquiréd: corporations then cease to exist (dissolve) as enn legal entities. For example; if C Company is formed to consolidate A ‘Ompany and B Company, the combination is generally expressed as: X Company + Y Company = Z Company _ Maced Financial Accounting =A Comprehensive: Cncaptaal }& Procedural Approach =‘ CHAPTER} Stockholders of the acquired companies (X and ¥} become stockholders in the new tatty (2). The acguited companies in a statutory consolation may be operated os ssparcte divons of the new corporation, jst as hey may be Under d stalvlory merger, Statutory consolidations require the same type of stockholder approval as statutory mergers do. Future references in this chopter: T° The tern merges in the technicol sense of a business combination in which all but one of the combining companies go out of existence. «Similety, the term consolidation will be used in is technical sense to refer to o Business combination in which all he combining companies are dissolved and a new corporation is formed to take over their net assets. «Consolidation is also used in accounting which refers to the accounting process or procedures of combining paren} and subsidiary financial statements, such as in the Expressions “principles of consolidation’. “consoldation procedures,” and “consolidated financial statements.” In succeeding chapters, the meaning of the term “consolidation” refers to stock acquistion. As a matter of procedure fo prepare consolidated financial statements, the business combination defined os stock acquisition is exoressed as: Financial Statements + Financial Stalements’= Consolidated Financial Statements of ofX Company of Y Company X Company and Y Company ‘Accounting Concept of Business Combination The accounting standard relevant for accounting for business combinations is PFRS 3. 'Susiness Combinations) issued by the Intemational Accounting Standards Board (IASB). In reading PFRS 3, iis important fo note that Appendix A contains different terms wrile ‘Appendix B contains application guidance - both Appendices are an integral part of PFRS 3. The IASB has also published a Basis for Conclusions on PFRS 3, but this is not an integral part of the standard. | Definition PFRS 3 defines “business combination” as‘a transaction or other event in which an | acquirer obtains control of one or more businesses. Transactions sometimes referred to as “true mergers” or “mergers of equals” also are business combinations. 1 ‘first key aspect in this definition is “control”. This means that there must be a triggering | economic event or transaction and not, for example, merely a decision to start preparing combined or consolidated financial statements for an existing group. Control can usually be obtained either by: 1._ Buying the assets themselves (which automatically gives control to the buyer), OF 2. Buying enough shares in the corporation that owns the assets to enable the investor (acquirer) to control the investee (acquire) corporation (which makes; the purchased comoration a subsidiary) Economic events that might result in an entity obtaining control include: «transferring cash or other assets (including net assets that constitute a business); « incuring liabilities; | _ Issuing eauity instruments; “vanced Franca Acounting ~ A Compretensive Concaphoal & Procedural ApproachBUSINESS COMBINATION ~ STATUTORY MERGER and STATUTORY CONSOLIDATION. rt + "a. combination of the above; and + @ transaction not involving consideration, such as combination by contract alone (e.g. a dual listed structure) The meaning of "contro!" will be discussed later in Chapter 2 and the accounting procedures are thoroughly discussed in succeeding chapters. The second key aspect of the definition is that the acquirer obtains control of a “business”. Identtying a Business PERS 3 defines the term “business” as “an integrated set of activites and assets that is capable of being conducted and managed for the purpose of providing goods or services fo customers, generating investment income (such as dividends or interes!) or «generating other income from ordinary activites.” The definition of business was narrowed by: * focusing on providing goods and services to customers + removing the emphasis from providing a retum to shareholders, * removing the reference to ‘lower costs or other economics benefits The business combination must involve the acquisition of a business, which generally has three elements: + Inputs - an economic resource (e.g. non-current assets, intellectual property), that merely need to have the ability to contribute to the creation of outputs. + Process ~ a system, standard, protocol, convention’or rule that when applied to an input or inputs, creates outputs (e.g. strategic’ management, operational processes, resource management) © Output - the result of inputs and processes applied to those inputs The result of inputs and processes applied to those inputs that provide goods or services | to customers, generate investment income (such as dividends or interest) or generate other income from ordinary activities. + The intellectual capacity of an ‘organized workforce having the necessary skils and experience in following rules and conventions may provide the necessary 1: processes applied to inputs to create outputs. «The focus on outputs is on returns from goods and services provided investment income, and other income from ordinary activities. | The purpose of defining a business is fo distinguish between the acquisitions of a group of assefs such as a number of chairs, bookshelves and fiing cabinets ~ ‘and the | Acquisition of an entity that is capable of producing some fotm of output. Accounting | fora group of assets is based on standards such as PAS 16 Property, Plant and | Equioment rather than PFRS 3. j ae 7 —____\ 8 CHAPTER 1 Scope of Business Combination The following transactions are within the scope 1. Combinations involving mutual entities. of PFRS 3: ‘A mutual entity is defined as an entity, ther than an investor-owned entity. that provides dividends, lower costs or other economic benefits directly to its owners, members or participants, €.g., a mutugy insurance company, a credit union and a cooperative entity. 2. Combinations achieved by contract alone (dual listing stapling). Inq combination achieved by contract alone, Wo entities enter into a contractual ‘arrangement which covers, for ‘example, operation under a single management ‘and equalization of voting power ‘and eamings attributable to both entities’ equity investors. Such structures may involve a ‘stapling’ or formation of a dua listed corporation. ‘Accounting for busines ss combination by contract under PFRS 3 requires one of the combining entities to be identified as the acquirer, and one to be identified Ge the ocquiree. In reaching the conclusion that combinations achieved 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. Where the business combination results in the formation of all types of joint ‘arangements (oint ventures and joint operations) and the scope exception only applies fo the financial statements ofthe joint venture or the joint operation tse nd not the accounting for the interest in a joint arangement in the financial statements of a party to the joint arrangement. Where the business combination involves 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 bo! before and after the combination, and that control is not transitory. Where the acquisition of an asset or a group of assefs does not constitute ai business, The term used to indicate this transaction is “asset acquisition”. In such) circumstances, the acquirer: ©, Identifies and recognizes-the individual identifiable assets acquired (includin those assets that meet the definition of, and recognition criteria for intangibl ‘ssets in PAS 38 Intangible Assets) and'liabilities assumed; and b. Allocates the cost of the group of assets and liabilities to the individual assets ‘and liabilities on the basis of their relative fair value at the date of purchase. n » Such transaction or event does not give rise to goodwill. The Acquisition Method : The acquisition method is applied on the acquistion date which is the date the acquire! obtains control of the acquiree.. The acquisition method approaches a business combination from the perspective of the acquirer (not the acquitee), the entity that obtains control of the other entities) in the business combination. * “Advanced Financial Accounting ~ A ‘Comprehensive: Conceptual & Procedural Approach[BUSINESS COMBINATION ~ STATUTORY MERGER and STATUTORY CONSOLIDATION ¢ Under the acquisition method, all assets and liabilities are Id peritabes ; re Identified and reported at ‘Accounting Procedures for a Business Combination The required method of accounting for a business combination under paragraph 4 of HES 3s the acquition method. Under the acaustion method, he general approach fo accounting business combinations Is a five step process: . Identify the acquirer, 2. Determine the acquisition date; 3, Calculate the fair value of the purchase consideration transfered {le., the cost of purchase) 4. Recognize and measure the identifiable assets and labilties of the business, and .. Recognize and measure either goodwill or a gain from a bargain purchase, if either exists in the transaction, Ifan acquirer gains control by purchasing less than 100% of the acquired entity, then the fourth step includes measuring and recognizing the non-controlling interests (NCI). Discussion of NCI will be in Chapter 2. Identifying the Acquirer PFRS 3 paragraph 7 states that “the acquirer is the entity that obtains control of the acquire". Paragraph 6 requires that in each business combination, one of the : combining entities should be identified as the acquirer. The concept of control under PFRS 3 will be discussed methodically in Chapter 2. PRS 3, however, recognizes that it may be difficult fo identity which entity has control over other combining entities. In the event that the’overiding 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 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 a specific entity. Therefore, the business combination occurs at the date of the assets or nef 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: * Adate nominated in the contract; ‘ =” The date on which assets acquired are delivered to the acquirer; and = The date on which an offer becomes unconditional. * These. dates may be important but determination of acquisition date does'n hysical possession of the asse depend on the date the acquirer receives pl e acquired, or actually pays out the consideration to the acquiree. ‘Advanced Financial Accounting ~ A Comprehensive: Conceptual & Procedural ApproachCHAPTER | determine acquisition date ensures tha . trol as the key criterion to the susdanee of the transaction determines the accounting rather than the form of the transaction. a Ata i Is Made for th wired may be delivered in stages or payment hese spe tsmadé one « period of fime with a number of payments being require, fs noted in porograph 9 of PFRS 3, on the closing date of the combination. the acquire, legaly transfer the consideration ~ cosh or shares - and acquires the assets cnd labitis ‘of he acquire. However, in some cases this may not be the acquisition date, int in time when the ne} *. The definition of acquisition date then relates to the point e asses of the acquiree become the net assets of the acquirer ~ in essence the date on which the acquirer can recognize the net assets acquired in its own records, There are four main areas where the selection of the date affects the accounting for q business combination: 1. The identifiable assets acquired and liabilities assumed by the acquirer cre measured at the fair value on the acquisition date, The choice of fair value is affected by the choice of the acquisition date. ‘The consideration paid by the acquirer is determined as the sum of the fair values of assets given, equity issued and/or liabilities undertaken in an exchange. for the net assets or shares of another entity. The choice of date affects the measure of fair value. e 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 interes! ~ defined in the Appendix A as the equity in a subsidiary not attributable, directly) or indirectly, to a parent, This ndn-controlling interest is also measured ot fait Value on acquisition date. (This concept will be discussed and illustrated in Chapter 2) . The acquirer may have previously held an equity interest in the acquitee prior to obtaining contol of the acquitee. For example, entity X may have previousiy acquired 20% of the shores of 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 os an asset i the records of entity X. On acquisition date, the fair value of this investment ‘measured. (This concept will be discussed and illustrated in Chapter 2) The effect of determining the acquisition date is that the financial position of # combined entity on acquisition date should report the assets and liabilities of th acquire on that date and any profits reports as a resulf of the acquiee’s operat within the business combination should reflect profs earned afer the acquistion date. Calculating the Fair Value of the Consideration Transferred: Accounting Records of Acquirer According to PFRS 3 paragraph 37, the consideration transferred: « ismeasured at fair value.at acquisition date «is calculated as the sum of the acquisition date fair values of: "Advanced Financial Accounting ~ A Comprehensive: Conceptual & Procedural Approach 7 iBUSINESS COMBINATION ~ STATUTORY MERGER and STATUTORY CONSOLIDATION, n 1. the assets transferred by the acquirer; 2. the liabilities incured by the acquirer to former owners of the acquire; anc 3. the equity interest issued by the acquirer. Ina specific exchange, the consideration transferred fo 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 interests of mutual entities. The consideration transferred includes the following items: 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 fo the acquirer is the amount the entity would have fo borrow to settle the debt immediately (L.e., the present value of the obligation). Hence, the discount rate used is the. entity's incremental borrowing rate. Non-monetary Assets. Non-monetary assets are assets such as property, plant nd equipment, investments, licenses and patents. As noted earlier, if active second-hand market exists, fair values can be obtained by reference to those markets. In this case, the acquirer is in effect selling the non-monetary asset fo the acquire. Thus, itis eaming an income equal to the fair value on the sale of the asset. If the carying amount of the asset 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. es Equity Instruments. If an acquirer issues its own shares as consideration, it needs to determine the fair value of those shares at acquisition date. For listed entities, reference is made to the quoted prices of the shares, Acquisition date model (equity instruments would be measured on the date the acquirer obtains control over the business acquired). '. Liabilities Undertaken. The fair values of liabilities are best: measured by the Present values of expected future cash outfiows. 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 valve 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. PFRS 3 provides the following definition of contingent consideration, “Usually, an Obligation of the acquirer to transfer additional assets or equity interests fo the ‘Advanced Finance Accounting ~ A Comprehensive: Conceptual & Procediral Approach2 CHAPTER 1 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 also may give the acquirer the right to the return of previously transfered consideration if specified conditions are met". Contingent consideration is on add-on to the base acquisition price that is baseg ‘on events occurring or conditions being met some time after the purchase takes place, This topic will be discussed further later.in this chapter with illustrations. . Share-based payment awards (Acquirer share-based payment awards exchanged for awards held by the acquiree's employees). The share-baseq payment transactions of the acquiree or the replacement of an acquiree’s share-based payment transactions with share-based transactions of the acq are ‘measured in accordance with PFRS 2 referred to as the “market based measure". The acquirer is obliged to replace the acquiree's awards, either all or a portion of: the market-based measure of the acquirer's replacement awards is included in measuring consideration transferred in the business combination. The acquirer's considered to be obliged to replace the awards if the, acquire or its employ have the ability to enforce replacement. Acquisition-Related Costs In addition fo the consideration transferred by the acquirer t6 the acquiree, a further item to be considered in determining the cost of the business combination is the acquisttion-related costs. ‘Acquisition-related costs are excluded from the measurement of the consideratio paid, because such costs are not part of the fair value of the acquire and are assets. They are as follows: 1. Costs directly attributable fo the combination which includes costs such as let fees, finder's and brokerage fee, advisory, accounting, valuation and oth professional or consulting fees. Indirect, ongoing costs, general costs including the cost to maintain an inter acquisiion department (mergers and acquisitions department], os well general and administrative costs such as managerial [including the costs maintaining an internal acquisitions department (management salar depreciation, rent, and costs incurred to duplicate facilities), overhead that allocated to the merger but would have existed in its absence and other costs which cannot be directly atiributed to the particular acquisition. ss The PFRS 3 accounting for these outlays is a result of the decision to record th identifiable assets acquired and liabilities assumed at fair valve. The acquisition-related costs associated with a business combination are accounted as expenses in the periods in which they are incurred and the services are received.BUSINESS COMBINATION ~ STATUTORY MERGER and ‘STATUTORY CONSOLIDATION 13 The key reasons given for this approach cre: + Acquisiion-elated costs ore not part of the fair value exchange between the buyer and seller. * They are separate transactions for which the buyer pays the fair value for the services received. ; + These amounts do not generally represent assets of the acquirer at acquisition date because the benefits obtained are consumed as the services are received, In contrast fo PAS 16 Property, Plant and Equipment and PAS 38 Intangible Assets, assets acquired are initially recorded at cost, so directly attributable costs are considered as art of the cost of acquisition and capitalized into the cost of the asset acquired. Costs of Issuing Equity Instruments / Share Issuance Costs The costs of issuing equity instruments is also excluded from the consideration and accounted for separately. Inissuing equity instruments such as shares as part of the consideration paid, transaction costs such as documentary stamp duties on new shares, professional adviser's fees, underwriting costs and brokerage fees may be incurred. ‘As noted in paragraph 53 of PFRS 3, these costs are accounted for in accordance ‘with PAS 32 Financial Instruments: Disclosure and Presentation, Paragraph 35 of PAS 32 states that these outlays should be treated as a reduction in the share capital of the entity as such costs reduce the proceeds from the equity issue (meaning reducing the additional paid-in capital), net of any related income tax benefit. Further, if the share premium or additional paid-in capital from the related issuance is not enough to absorb such costs, the Philippine Interpretations Committee (PIC) concluded that the excess shall be debited to “Share Issuance Costs” which will be treated as a contra shareholders’ equity account as a deduction in the following order "of priority: 1. Share Premium from previous share issuance; or* "2. Retained Earnings with appropriate disclosure. *on a personal note, the word “or” indicated on the Philippine Interpretations Committee (PIC) Q&A 1s published should be removed since itis quite misleading because the statement “order of priority” was aready in used. Companies often incur additional acquisition-related restructuring costs, including shutting-down departments, reassigning or eliminating jobs, and changing suppliers or Production practices in connection with business combinations. Unless represented by Acquisition-date liabilities, these costs ore expensed as incurred and do not affect acquisition cost. In the past, firms have sought to capitalize these “acquisition-related” restructuring Costs, effectively reporting them as goodwill and not as expenses. The PIC Committee also considered listing fee for initial public offering of shares as an outright expense, ‘Advanced Financial Accounting = A Comprehensive: Conceptual & Procedural ApproachCosts of Issuing Debt Instruments i ind Issuing debt Instruments it ity instruments, the costs of arranging ai 4 feces a ‘accordance with PFRS $), ore ere pat re ee ie deemed as yield adjustments fo 1. peared ‘he initial measurement of the lability as bond Issue costs ang amortized the life of the debt. The summary of acquisitionelated cost is shown as follows on Table 1-1: Table 1-1: Summary of Acquistion-related Costs net vtelated costs i "bulable costs | Legal fees, finders and brokerage | Expenses eee fee, . advisory, accounting, valuation (values) ond other professional or consuting fees to effect the combination. 2. Indirect acquisition costs General ond administrative costs | Expenses such as monagerial (including the costs of maintaining an intemal acauistions deporkment (management salaries, depreciation, rent, and. costs incured to dupicate facilfes), overhead that ore allocated to the merger but would have existed in its absence and other Costs of which cannot be directly ottibvied fo the pariculor ‘ocavistion 3. Costs of issuing securities (ssue | Trarsaction costs such as stamp | Debit to “Shore Premium’ ‘ond register stocks)" refer fo | duties on new shares, professional | or “Additional ~ paidiin discussion above. ‘advisers fees, underwriting costs | capital” account. and brokerage fees may be incured ' 4. Cost of arranging (registering) | Professional —adviser’s__ fees, | Bond issue costs “and issuing debt securities or | underwriting costs and brokerage financial obilties fees moy be incured, Frinciples in Assessing What is Pat of the Business Combination PERS 3 requires that an acquiter shall assess whether ai iny portion of the transaction pric {payments oF other arrangements) and any assets acquired or liabiliies assumed cured are not a part or a component ofthe exchange for the acquitee. Only the consideration transferred and the assets ac ji quired or liabilities assumed incuned that ore part of the exchange for the acquir i ir brea ce pat uiree sholl be included in the busin “Advanced Financial Accounting ~ A Comprehensive: Conceptual & Procedural Ap,BUSINESS COMBINATION ~ STATUTORY MERGER and STATUTORY CONSOLIDATION 5S Any portion of the transaction price or any assets acquired or liabilities assumed or Incumed that are not parts or components of the exchange for the acquire shall be accounted for separately from the business combination. The following are guidelines fo assess what part of the business combination for certain items requires the acquirer to evaluate the substance of transactions entered into by the parties: A 1, Transactions entered into or any amounts paid that are designed primarily for the economic benefit of the acquiree (or its former owners) before the combination. Although, the amounts are not paid directly to thé acquiree (vendor), they will sill form part of the purchase consideration for the business combination as the acquirer is acting on behalf of the acquirer (vendor) in making the payments. However, this principle would not apply to any costs incurred by the acquirer (vendor) on its own behalf in making the acquisiion, as these must be accounted for outside the business combination. y . Transactions entered into or any amounts paid into by or on behalf of the acquirer or the combined entity are not part of the business combination transaction, and are likely to be accounted for as separate transaction. The following are examples of separate transactions that are not to be included in applying the acquisition method: A transaction that settles pre-existing relationships between the acquirer ‘and the acquire; b. A transaction that compensates employees or former employees of the acquire for future services; and ¢. A transaction that reimburses the acquire or its former owners for paying the acquirer's acquisition related costs. Pre-existing Relationships. A pre-existing relationship is a relationship between the acquirer and the acquiree that existed before the business combination and this may include a contractual relationship, such as a vendor and customer telationship, a franchisor and franchisee relationship, and a licensor and “ licensee relationship. It may also include a non-contractual relationship, such as a plaintiff and defendant relationship. Compensation to Employees or Former Owners of Acquiree. Whether amrangements for contingent payments to employees or former owners of an acquiree should be considered as contingent consideration that is included in the measurement of the consideration transferred or are separate transactions depends on the nature of the arrangement. Recognition and Measurement of Assets Acquired and Liabilities Assumed: Accounting Records of the Acquirer PRS 3 sets out basic Principles for the recognition and measurement of identifiable Ss8els acquired, liabilities assumed and non-controlling interests. .Having established thos Principles, the PFRS 3 provides detailed application for specific assets and labities and a number of limited exceptions to the general pinciples, ‘tveced Finance Acounting ~A Comprehensive: Conceptual & Procedural ApproachCHAPTER 4 16 Under the acquisition method, the acquirer Is required to: 1. Recognize Identifiable assets and liabilities separately from goodwill; and 2, Measure such assets and llabllifies at thelr fair values on the date of acquisition, Recognition Principle for Assets and Liabilities A key word is identifiable. The acquirer may be able to identify many more assets ang liabilities than those shown in the acquiree's balance sheet. PERS 3 paragraph 10 requires that, as of the acquisition date, the acquirer should recognize, separately from goodwill, the identifiable assets acquired, the liabilities ‘assumed and any non-controlling interests in the acquirer (Chapter 2). Paragraph 83 of the Framework for the preperation and presentation of Financial Statements specifies fwo recognition criteria for assets and liabilities stating that the tecognition occurs if: * tis 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 deciding whether or not to recognize an asset or liability in a busit combination, it is assumed that the probability fest for the assets acquired and liabilities assumed in a business combination is unnecessary. These assets and liabilities will always be able to be measured reliably. Use of estimates simply means the measure may involve uncertainty but it does not mean the measure is unreliable. In relation to the probability criterion, PERS 3 states explicitly that the acquirer is required to recognize identifiable assets acquired and liabilities assumed regardless of the DEGREE of PROBABILITY of an inflow or outflow of economic benefits. The assets ‘acquired and liabilities assumed are measured at fair value (refer to further discussion in "the topic of “contingent labilfies" in the succeeding paragraphs). Conditions for Recognition Principle In paragraphs 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: : |. Atthe acquisition date, the assets and liabilties recognized by the acquirer must| ‘meet the. definitions of assets and liabilities in the Framework. Any expected future costs cannot be included in the calculation of assets and liabilities: Acquired and liabilities assumed, The following ore outcomes as a result of applying this recognition condition: * Post-acquisiion reorganization. Costs the Acquirer expects but it is not obliged to incur in the future to affect ‘ts plan to ext an activity of an acquiree. To terminate the employment of or relocate an acquiree's employees is not liabilities at the ‘Acquisition date, Unrecognized assets and llabilities. The ai Icquirer may recognize some assets and liabilities that the acquiree had not Previously recognized in its financid! statements.BUSINESS COMBINATION ~ STATUTORY MERGER and STATUTORY CONSOLIDATION. ‘ 7 For example, the acquirer recognizes the acquired identifiable assets (such as brand names. patents or customer relationships). in-process research and development (to be discussed later) that the acquiree did not recognize as assets in its financial statements, Exception to the Recognition Principle , One area affected by this condition is the accounting for contingent liabi ties. pis a Provisions, Contingent Liabilities and Contingent Assets (refer to discussion elo). ). 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 the application 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. ‘As noted in Paragraph 13 of PFRS 3, a possible result of applying the principles of PERS 3 is that there may be assets and liabilities recognized as a result of the business combination that were not recognized by the acquire. One example of this is internally generated intangibles that were not recognized by the acquiree on the opplication of PAS 38 Intangible Assets: for example, infemally. generated brands would not be recognized by an acquire but would be recognized by the acquiter. The acquirer would measure these at fair valve. Measurement Principle for Assets and Uabilities Identifiable assets acquired and the liabilities assumed are measured at their fair values ‘on acquisition date fair values. PFRS 13 defines “faiir value” as the price that would be received to sell an asset or paid fo transfer a liability in an orderly transaction between market pariicipants at the measurement date (i.e., an exit price). That definition of fair value emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Fair value is basically a market-based measure in a transaction between unrelated Parties. However, the process of determining fair value necessarily involves judgment nd estimation. The acquiring entity is not actually trading the items in the marketplace for cash, but is tying to estimate what the exchange price would be ifit did so. Hence, {the determination of fair value involves estimation. 10 aati the determination offi value, ine standard setters have developed a at Value hierarchy. The hi , ts used in valuation techniques info three levels. ierarchy categorizes the Inpt ae chy gives the highest priority to (ynadjusted) quoted prices in ‘active markets Cal assets or liabiities and the lowest priority to unobservable inputs.a CHAPTER If the inputs used fo measure fair value are categorized into different levels of the foir value hierarchy, the fair valve measurement is categorized inits ently in the level of the lowest level input that is significant fo the entire measurement (based on the application of judgment). The purpose of which is to provide a list of ways in which market value can be measured in a business combination, in order of preference. : * Measurement under the fair value hierarchy is as folows {it should be noted that inputs care being prioritized): " «Level 1 Inputs - are fully observable and are unadjusted quoted prices in an active market for identical assets and liabilities. * Level 2 Inputs - are directly or indirectly observable inputs other than Level | inputs. «Level 3 Inputs - unobservable inputs for the asset or liability (not based on observable market data). Valuation Techniques The objective of using a 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 market Participants and the measurement date under current market conditions. Three widely used valuation 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 (e.g. a business) this is known s analogy or benchmark approach. ; + Income approach or income-based- based on future economic benefit derived from owning the asset or converts future amounts (cash flows or income and expenses) to a single current (discounted) amount, reflecting curent market expectations about those future amounts. * Cost approach or cost-based- refiects, the amount that would be requied currently to replace the service capacity. of an asset (current replacement cost), although the result may not reflect fair value. In some cases, a single valuation technique will be appropriate, whereas in others multiple valuation techniques will be appropriate. The market-based approach is the best approach; howéver, such data frequently are not available. Therefore, the most often methods are income-based. All of these methods. provide a great deal of opportunity for management judgment in determining such fair valves, especially in,the case of intangible assets. Valuation of Identifiable Assets and Liabilities The above discussion on recognition and measurement principles serves as guidelines «as fo the proper recording and vaivation of identifiable assets and liabilities: “Advanced Financial Accounting = A Comprehensive: Conceptual & Procedural Approach | | | |BUSINESS COMBINATION ~ STATUTORY MERGER and STATUTORY CONSOLIDATION «The first step in recording an acquisition is to record the existing assets and liabilities accounts (except goodwill). As a general rule, assets and liabilities are to be recorded at their individually determined fair values. + The prefered method Is quoted market value, where an active market for the + item exists.’ Where there is not an active market, independent appraisals, discounted cash flow analysis, and other types of analysis are used fo estimate fair values. There are some exceptions to the use of fair value that apply to accounts such as assets for resale and deferred taxes (see below for discussion). © The acquirer is not required to establish values immediately on the acquisitior date. > In summary, the procedures for recording the assets and liabiliies of the acquiree are «5 follows: 1. Identifiable Tangible Assets. An asset other than an intangible asset is recognized if itis probable (probability fest) that any associated future economic. benefits will flow to the acquirer, and its foir value can be medsured reliably (reliability tesi). : A. Current Assets - these are recorded at estimated fair values. An acquirer is not permitted to recognize a separate valuation allowance as of the acquisition date for assets acquired in a business combination that are measured at their acquisition date fair values. This would include recording accounts ond notes receivable at the estimated ‘amounts to be collected. Accounts and notes receivable are to be recorded in a net account that represents the probable cash flows;.a separate valuation account for uncollectible accounts is not allowed because the effects of uncertainty about future cash flows are included in the fair value measure. All accounts share the rule that only the net fair value is recorded, and valuation accounts are not used. . Assets held for sale (assets that are going to be sold rather than to be used in operations). The acquirer should measure an acquired non-curent asset (or disposal group) that is classified as held for sale at the acquisition date in accordance with PERS 5 Non-current Assets Held for Sale and Discontinued Operations at fair value less costs fo sell. The exception as stated above is to avoid ttie need to recognize a loss for the seling costs immediately after a business combination (a so-called Day 2 loss). If the assets had inifially been measured at their fair value at the acquisition date. They are listed os current assets. Property, plant and equipment - operating assets will require an estimate of fair value and will: be’ recorded at that net amount with no’ separate accumulated depreciation account. The principle of “no valvation allowance" also extends to property, plant and equipment such that, following a business combination, such assets are 2 ‘Advanced Financial Accounting ~ A Comprehensive: Conceptual & Procedural ApproachCH i APTER 1 siated at o single far value amount, and not at a gross “deemed cost ang accumulated depreciation. Investments In equty-accounted entities ~ for purposes of recognizing ong measuring this identifiable asset, there is no diference between aninvestmeny that is an associate or an investment that is trade investment acquirer has acquired the investment not the underlying asse of the associate. Accordingly, the fair value of the associate should be determined on the basis of the value of the shares of the associate rather than by calculating a fair value based on the appropriate share of the fair values of the Various identifiable assets and liabilities of the associate. P t because the 8 and liabitties , 2. Identifiable Intangible Assets. PFRS 3 fequires the acquirer, to recognize identifiable-assets acquired regardless of the degree of probability of an inflow of economic -benefits. This change emphasizes the expectation that al intangible assets that satisfy the definition criteria in PAS 38, if acquired as part of ‘a business combination, must be Tecognized, An intangible asset is identifiable it, it: * can be separated; or 2 * meets the contractual-legal criterion e.g. license to operate a nuclear Power plant is an intangible asset, even though the acquirer cannot sell or transfer the license separately from the acquired power plant. Separabilty criterion. An intangible is separable if itis capable of being separated or divided from the entity sold, transferred, licensed, rented, or exchanged, either individually or together with a related contract. it is identifiable asset or liability regardless of whether the entity intends to do so. Examples are customer and subscriber lists, depositor relationships, regisiered trademarks, unpatented technical expertise, favorable operating leases (see below for further discussion), licenses and technology patents. Contractual-legal criterion. An intangible asset that arises from contractual or legal rights is identifiable regardless of whether those rights are transferable or separable from the acquiree or from other rights and obligations. Examples are license to operate a nuclear power plant is an intangible asset, even though the acquirer cannot sell or transfer the license separately from the acquired power plant, an acquiree leases a manufacturing facity under an operating lease that has terms favorable to market terms, an acquirer owns and operates an electric power plant, an acquirer owns a technology patent. PFRS 3 presumes that where an intangible asset satisfies either of the criteria above, sufficient information should exist to measure reliably its fair valve. A non-monetary asset without physical substance acquired ina business combination might meet the identifiability criterion for identification as an intangible asset but notbe included in the guidance. Advanced Financial Accounting = A Comprehensive: Conceptual & Procedural Approach 1BUSINESS COMBINATION ~ STATUTORY MERGER and STATUTORY CONSOLIDATION. 4 The guidance designated the assets as being “contractual”, ie., arising from: contractual or other legal rights or “non-contractual”, Le., not arising from Contractual or other legal rights but are separable, while nothing designated as “contractual” might also be separable. However, it emphasizes that separabllity is not a necessary condition for an asset to meet the contractual-legal criterion. The table below summarizes the items mentioned above in their Classification as An intangible asset and are therefore fo be recognized separately from goodwill. + Marketing-related intangible Assets > Trademarks, rade “names, service marts, collective marks and certification marks + Trade dress (unique color, shape or package design) - Newspaper mastheads - _ Intemet domain names ~ Non-compefition agreements © Customer-related Intangible Assets - Order or production backlog - Customer contracts and the related customer relationships - Non-contractual customer relationships = Customer lists © Affistic-related Intangible Assets = Plays, operas and ballets ~ Books, magazines, newspapers and other literary works - Musical works such as compositions, song lyrics and advertising jingles - Pictures and photographs ~ Video and audiovisual material, including motion pictures or films, music videos and television programs + Contract-based Intangible Assets - Licensing royalty and standstil agreenents ~ Adverising construction, management, service or supply contracts ~ Ledse agreements (whether the acquiree is the lessee or lessor) - Construction permits - Franchise Agreements - Operating and broadcasting rights ~ Use rights such as dfiling, water, air, mineral, timber-getting and route authorities + Servicing contracts such as mortgage servicing contracts - Employment contracts + Technological-based Intangible Assets - Patented technology - Computer software and masks works ~ Unpatented technology ~ Databases includingjftie plants 4 ~ Trade secrets such as secret formulas, processes or recipes ‘Advanced Financial Accounting =A ‘Comprehensive: Conceptual & Procedural ApproachCHAPTER] | Other intangible assets being acquired as part of business combinations with their proper valuation are: 1. Emission rights. Emission rights acquired in a business combination meet the definition of an intangible asset and should therefore be recognizes on the acquisition date at their fair value, x Reacquired rights. As part of business combination, an acquirer may reacquite a right that it had previousy granted to the acquiree fo use con, or more of the acquirer's recognized or unrecognized assets such as Fight to use the acquirer's trade name under franchise agreement. Areacquited rights an intangible that the acquirer recognizes separately from goodwill. Relative fo the above discussions and examples, care should be considered fo {s recognition of intangible assets: : A. Existing intangible assets - these will be recorded at estimated fair value. The valuation of these items such as Patent and copyrights will typically require the use of discounted cash flow ‘analysis. 5. Intangible assets not curently recorded by the acquire - identifiable intangible assets must be separately recorded; their value cannot be swept into the “goodwill classification: An intangible asset is identifiable if it arises from contractual or other legal fights (even iti is not separable). For example, the acquirer may have a Customer Ist that could be sold separately and has ‘a determinable value, PFRS. 3 made it clear that in-process research and development, the ‘acquirer recognizes all fangible and intangible research and development assets ‘acquired in a business combination and recorded at fair value as an asset on the date of acquisition. : This requirement does not extend to IPRD (in-process research and development) in contexts other than business combinations. in any event, the importance of maintaining supporting documentation for any amounts ‘assigned to IPRD is clear: They are considered Separable on occasion that they are bought and sold by entities. C. When the acquiree is a lessee with respect to assets in Use. As a tule, the Acquirer should not recognize any asset or liabiity related to an operating lease in which the acquire is the lessee. The acquiree has no recorded ‘assets for assets under operating leases. If however, the terms of the lease are favorable os compored to curent market rates, an infangible asset would be recorded equal to the discounted present valve of the SAVINGS. If the lease terms are unfavorable, an estimated liability would be recorded equal to the discounted present value of the rent in EXCESS of fair rental rates. ‘Advanced Financial Accounting ~ A Comprehensive: Conceptual & Procedural Approach‘BUSINESS COMBINATION ~ STATUTORY MERGER arid a STATUTORY CONSOLIDATION On the other hand, when the acquire may have acted as a lessor or the acquire is simply, the lessor, where an asset such as a building ora patent is “leased out by the acquiree under on operating lease, the acquirer takes the terms of the lease into account in measuring the acquisition date fair value of the asset. In other words, the acquirer does not recognize separately an intangible asset or ability ifthe terms of the lease are favorable or unfavorable relative fo market terms and prices. : It should be observed that in the United States, such is not the case when the ‘acquiree is the lessor in on operating lease. in US FASB, the classification of the lease is not changed unless the terms are changed. For operating leases, the acquiree has the asset recorded at fgir value, and it is not affected by the terms of any lease applicable to that asset. Note that the lessor ferms are favorable when the contract rental rate exceeds fair rental value, and terms are unfavorable when the fair rental Value exceeds the contract rate. 2. Existing Liabilities - these are also recorded at fair values (or present value). For current contractual liabilities, they may likely be the existing recorded value. For estimated liabilities, a new fair value may be used in Place of recorded values. Long-term liabilities will be adjusted to a value different from recorded value if there has been a material change in interest rates, In cases of deferred revenue, an acquirer should recognize a liability for deferred revenue of the acquiee only if it relates to an oulstanding performance + obligation qssumed by the acquirer. Such performance obligations would include obligations to provide goods or services, or the right fo use an asset, The measurement of the deferred revenue should be based on the fair value of the obligation at the date of acquisition, which will not be necessarily the same 0s the amount of deferred revenue recognized by the acquires, Contingent liabilities - PFRS 3 require the contingent liabilities of the ‘ocauiree to be recognized and measured in a business Combination at acquisition date fair value. This may result fo the recognition of contingent liablliies that would not qualify for recognition under PAS 37 Provisions, Contingent Liablties ond Contingent Assets. ‘ In @ business combination, the fequirements of PAS 37 are not applied in “determining which Contingent liabilities should be recognized as of the. acquisition date. Instead, PFRS 3 requires that the acquirer should recognize a contingent liability ‘assumed in a business combination 5 of the acquisition date if: ° tis ¢ present obligation that arises from past events; and *- Its fair value can be measured reliably. ‘Advanced Financial Accounting =A Comprehensive: Conceptual & Procedural Approach7 - CHAPTER 7 uirer recognizes the liability even itt Is not probable that an outflow of Terources embodying economic benef: wil be requted to sete tne obiigation, Therefore, conirary to PAS 37, PFRS 3 requires ‘the acquirer fo recognize g contingent liability assumed in a business combination at the acquisition date even I it Is NOT probable that an outflow of resources embodying economic benefits wil be requied to settle the obligation (refer fo further guidelines mentioned above in "Recognition Principle for Assets and Liabilities"). However, possible obligations aring from past events that willbe confimed only by the occurence or non-occurence of one or more uncertain future events not wholly within the contol of the acquirer are not recognized also under PERS 3. The underlying assumption in PFRS 3 is that if a reliable fair value measure of a contingent liability is available (already PRESENT), the implied probabilities of outcomes are incorporated in the fair value measure. In this respect, the emphasis in PERS 3 inclines towards the use of expected values to determine fair values. This is in contrast to PAS 37 that requires categorical classification of a liability. If the future outflow is less than “probable,” it is not recognized under PAS 37. However, under PFRS 3, a liability which may not have a probable outflow may have a fair value that is greater than zero. Using statistical terminology, the Qpproach in PAS 37 is best described as “categorical” or “binary” (ie. the decision criterion is to recognize the liability only itt is probable or nothing iit is not probable) while the approach in PFRS 8 may be described as “continuous” (Le. recognize the liability if the expected Value of the item is not zero and is reliably measurable) For example, if a contingent liability has a Probability of 0.1 for a loss outcome of 50,000 and a probability of 0.9 for an outcome of zero loss, an expected liability ‘of P5,000 should be recognized if the probabilities and the loss outcomes are reliably measurable. However, in the separate financial statements, the contingent liability would not be recognized os it is not probable: The measurement approach in PRS 3 is more progressive than the undérlying ‘approach in PAS 37. : The unique treatment of contingent liabilities and intangible assets in a business _ combination is probably due to the concem of standard-setters that too many “identifiable” elements are subsumed or included in goodwill, which is a non- identifiable residual, : When a contingent liability is recognized by the acquirer in consolidation, subsequent adjustment needs to be made when the contingent liability materializes. 3 "Financial Accounting ~ A Comprehensive: Conceptual & Procedural Approach[BUSINESS COMBINATION ~ STATUTORY MERGER and | STATUTORY CONSOLIDATION. : ‘An ACQUIREE recognizes a liability only when the outflow ‘of resources is probable, but the ACQUIRER recognizes a reliably measured fair value of a "contingent liability ct a much earller stage (i.e., present obiigation) in the consolidated financial statements. = |. abilities associated with testrudturing or exit activities - the foir value of on existing restructuring or exit activity for which the acquire is obligated is recorded as a separate liability To record a liability, there must be an existing obligation to other entities. The possible future costs connected with restructuring or exit activities that may be planned by the acquirer are not part of the acquisition ard are expensed in future periods. : 5. Other Assets/Liabilities a. Employee benefit plans - the asset or liability under employee benefit plans is not recorded at fair valve. Instead, a liability is recorded if the projected benefit obligation exceeds the plan assets. An asset-is recorded when the plan assets exceed the projected benefit obligation. b. Indemnification assets - the seller in a business corhbination may contractually indemnify the acquirer for the outcome of a contingency or uncertainty related to all or part of a specttic asset or liability. For example, the seller may indemnity the acquirer against losses above a certain amount on a liability arising from a parlicular contingency, such os legal action or income tax uncertainty. PFRS 3 requires the following: * The acquirer has to recognize an “indemnification asset” at the same time that the acquirer recognizes the indemnified asset or liability. * The indemnification asset has to be measured on the same basis as that of the indemnified asset or lability at acquisition date fair value. For an indemnification asset measured at fair value, the effects of uncertainty about future cash flows because of collectibility considerations are included in the fair value measure and a separate valuation allowance is not necessary. cc. Income Taxes - PFRS 3 requires the acquirer to recognize and measure a deferred tax asset or liability arising from assets acquired ‘and liabilities ‘assumed in a business combination in accordance with PAS 12. The acquirer is also required to account for the potential tax effects of temporary differences and cary forwards of an acquiree that exists at the acquisition date or arise as a result of the acquisition in aecordance with PAS 12. Deferred tax assets or liabilities generally are measured at undiscounted amounts in accordance with PAS 12, and it was decided not to require deferred tax assets or liabilities acquired in a business combination to be Measured at fair value. ‘Advanced Financial Accounting ~ A Comprehensive: Conceptuel & Procedural Approach