Chapter 26: Business Combination

Chapter 26: CQ 1, CQ5, CQ 11, CQ12; Case study 26.1; Exercise 26.1; 26.2
Chapter 27: CQ 1, CQ2, CQ 3, CQ4, CQ 8; CQ13;

Exercise 27.2 and 27.3

1. What is meant by a ‘business combination’?

AASB 3/IFRS 3 Appendix A:

A business combination is defined as:

 A transaction or other event in which an acquirer obtains control of one or more
businesses.

A business is then defined as:

 An integrated set of activities and assets that is capable of being conducted and managed
for the purpose of providing a return in the form of dividends, lower costs or other
economic benefits directly to investors or other owners, members or participants.

Paragraph B7 of AASB 3/IFRS 3 identifies three elements of a business being inputs,

processes and outputs.

Q5 What key conditions must be satisfied in order for a business

combination to occur?

Answer:
The focus of this chapter is where the acquisition of net assets of other entities is deemed to
be a business combination. There are two key conditions to be satisfied in order for a
business combination to occur.

1. The assets or net assets acquired must be a business. The key feature of a business is that
it must be capable of providing goods or services, generating investment income or other
income from ordinary activities. The application guidance provided by paragraph B7 of
AASB 3/IFRS 3 indicates that a business consists of inputs (i.e. economic resources) to
which processes (e.g. strategic management, operational and resource management
processes) are applied, which then have the ability to create outputs. To be a business, an
entity does not have to produce outputs — it only has to be capable of doing that. Hence, an
entity still in the development stage, such as a mining operation that is currently exploring but
not yet producing ore, can still be classed as a business. Also, the business combination may
or may not include the acquisition of processes. A business combination can still be
recognised under AASB 3/IFRS 3 if the acquirer integrates the acquired business into its own
inputs and processes in order to create outputs.

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2. The acquirer must obtain control of that business. Control exists when an entity has the
power to direct the future benefits from the assets acquired and has the ability to get varying,
rather than fixed, returns from using those assets. The term ‘control’ is defined in AASB
10/IFRS 10 Consolidated Financial Statements and is explained in more detail in chapter 27.

CQ11 What recognition criteria are applied to assets and liabilities acquired
in a business combination?

Answer:

Paragraph 10 of AASB 3/IFRS 3 states that the identifiable assets acquired and liabilities
assumed shall be recognised separately from goodwill.

Because the assets and liabilities are measured at fair value, the assets and liabilities are
recognised regardless of the degree of probability of inflow/outflow of economic benefits.
The fair value reflects such expectations in its measurement.

The assets and liabilities recognised must meet the definitions of assets and liabilities in the
Framework. [paragraph 11 of AASB 3/IFRS 3].

The assets and liabilities recognised must also be part of the exchange transaction rather than
resulting from separate transactions [paragraph 12 of AASB 3/IFRS 3].

CQ 12: How are the identifiable assets and liabilities acquired in a business combination
measured?

Answer:

Paragraph 18 of AASB 3/IFRS 3 requires that identifiable assets acquired and liabilities
assumed are measured at their acquisition‐date fair values.

Information about fair value measurement is found in AASB 13/IFRS 13 Fair Value
Measurement (see chapter 4). Fair value is an exit price, being the price that would be
received to sell an asset or paid to transfer a liability in an orderly transaction between market
participants at the measurement date. This price is measured using one of three possible
valuation techniques:

• market approach
• income approach
• cost approach.

Inputs into the valuation techniques are classified into a fair value hierarchy with the inputs
being prioritised into three levels: Level 1, Level 2 and Level 3.

• Level 1 inputs are quoted prices in an active market for identical assets and liabilities.
• Level 2 inputs are quoted market prices for the asset or liability that are observable, either
directly (i.e. as prices) or indirectly (i.e. derived from prices).

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• Level 3 inputs are not based on observable market data.

It may be that the measurement of the acquired identifiable assets and liabilities is not
completed by the end of the accounting period. This may happen, for example, where an
acquisition occurs close to the end of an accounting period. In this situation, paragraph 45 of
AASB 3/IFRS 3 requires the acquirer to prepare provisional best estimates of fair value, and
report these provisional amounts in its financial statements. These will be adjusted to the
actual fair values when the amounts are subsequently determined. The measurement period in
which the adjustments can be made cannot exceed 1 year after the acquisition date.

CQ 16: How can goodwill arise on acquisition and how is it accounted for?
According to paragraph 32 of AASB 3/IFRS 3, goodwill is measured at acquisition date and
occurs when the fair value of the consideration transferred plus the non ‐controlling interest in
the acquiree plus the acquirer’s previously held equity interest in the acquiree is greater than
the net fair value of the identifiable assets acquired and liabilities assumed.

As a non‐controlling interest and a previously held equity interest arise in business

combinations only where the acquirer buys the shares of an acquiree (see chapters 29–31),
these calculations are not applicable to circumstances where an acquirer buys assets or net
assets of an acquiree. Hence, in the business combinations discussed in this chapter, goodwill
arises when the consideration transferred is greater than the net fair value of identifiable
assets acquired and liabilities assumed.

The rationale here is that if the amount paid for the business is greater than the fair value of
the identifiable net assets acquired, then the acquirer is willing to pay a premium to acquire
some form of unidentifiable benefit, which is referred to as goodwill.

Case studies

Case study 26.1

Applying AASB 3/IFRS 3

Hikoi Ltd has recently undertaken a negotiations to acquire 70% of shares of Hapu Ltd.
At the start of negotiations, Hikoi Ltd owned 30% of the shares of Hapu Ltd. The
negotiations began on 1 January 2023 and enough shareholders in Hapu Ltd agreed to
the deal by 30 September 2023. The agreement was for shareholders in Hapu Ltd to
receive shares in Hikoi Ltd in exchange for their shares in Hapu Ltd. Over the
negotiation period, the share price of Hikoi Ltd shares reached a low of $5.40 and a
high of $6.20.

The accountant for Hikoi Ltd, Mr Taumata, knows that AASB 3/IFRS 3 must be
applied in accounting for the business combination. However, he is confused as to how
to account for the original 30% investment in Hapu Ltd, what share price to use to
account for the issue of Hikoi Ltd’s shares, and how the varying dates such as the date
of exchange and acquisition date will affect the accounting for the business combination.

Required
Provide Mr Taumata with advice on the issues that are confusing him.

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Answer:

Issue 1: how to account for the original 30% investment in Hapu Ltd.

 Initially recorded at fair value plus transactions cost, based on paragraph 5.1.1 of AASB
9/IFRS 9.
 Subsequently accounted for under AASB9/IFRS 9 e.g. could be measured at fair value
with changes in value included in profit or loss or changes recognised directly in equity.
 On formation of the business combination, paragraph 42 of AASB 3/IFRS 3 requires that
the acquirer remeasure its previously held equity interest in the acquiree at its acquisition-
date fair value and recognise the resultant gain/loss in profit or loss. Where the
investment had been measured at fair value with increments recognised directly in equity,
these amounts are transferred at acquisition date to profit or loss as well, and disclosed as
reclassification adjustments.

Issue 2: what share price to use.

Paragraph 37 of AASB 3/IFRS 3 requires the use of the fair value at the date of acquisition.
This price will include all expectations of the takeover, including any premium for control.

Issue 3: effects of different dates.

AASB 3/IFRS 3 refers to acquisition date only. All measures of fair value are made on
acquisition date, for both the consideration transferred and the assets acquired and liabilities
assumed.

As noted under Issue 1, the initial 30% investment that was first recognised on the date it was
acquired must be remeasured to fair value at the acquisition date of the business combination
i.e. the date the remaining 70% is acquired.

Exercise 26.1

Accounting by an acquirer

On 1 July 2024, Samaria Ltd acquired the following assets and liabilities from Natia
Ltd.
Carrying
amount Fair value
Land $ 600 000 $ 750 000
Plant (cost $800 000) 560 000 600 000
Inventories 160 000 190 000
Cash 50 000 50 000
Accounts payable (40 000) (40 000)
Loans (200 000) (200 000)

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In exchange for these assets and liabilities, Samaria Ltd issued 200 000 shares for
$3.50 per share with a fair value at 1 July 2024 of $5.00 per share.

Required
1. Prepare the journal entries in the records of Samaria Ltd to account for the
acquisition of the assets and liabilities of Natia Ltd.
2. Prepare the journal entries assuming that the fair value of Samaria Ltd’s shares
was $4 per share at 1 July 2024.
(LO6)

SAMARIA LTD – NATIA LTD

Acquisition analysis:

Net fair value of identifiable assets and liabilities acquired:

Land $750 000
Plant 600 000
Inventories 190 000
Cash 50 000
1 590 000

Accounts payable 40 000

Loans 200 000
240 000
Net assets $1 350 000

Consideration transferred:
200 000 shares at $5.00 each $1 000 000

Gain on bargain purchase ($1 350 000 - $1 000 000) $350 000

1. Journal entries: Samaria Ltd, FV of shares = $5.00 per share:

Land Dr 750 000

Plant Dr 600 000
Inventories Dr 190 000
Cash Dr 50 000
Gain on bargain purchase Cr 350 000
Accounts payable Cr 40 000
Loans Cr 200 000
Share capital Cr 1 000 000

2. Journal entries: Samaria Ltd, FV of shares = $4.00 per share:

Fair value of acquiree’s net assets $1 350 000

Consideration transferred: 200 000 x $4 $800 000
Gain on bargain purchase $550 000

Land Dr 750 000

Plant Dr 600 000

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 Inventories Dr 190 000
Cash Dr 50 000
Accounts payable Cr 40 000
Loans Cr 200 000
Share capital Cr 800 000
Gain on bargain purchase Cr 550 000

Exercise 26.2

Accounting by an acquirer

Talia Ltd acquired all the assets and liabilities of Sefina Ltd on 1 July 2024. At this date,
the assets and liabilities of Sefina Ltd consisted of:

In exchange for the net assets of Sefina Ltd, at acquisition Talia Ltd agreed to:
• issue 10 Talia Ltd shares for every Sefina Ltd share — Talia Ltd shares were
considered to have a fair value of $10 per share; costs of share issue were $2 000
• transfer a patent to the former shareholders of Sefina Ltd — the patent was carried
in the records of Talia Ltd at $750 000 but was considered to have a fair value of $1
million
• pay $5.20 per share in cash to each of the former shareholders of Sefina Ltd.

Talia Ltd incurred $20 000 in costs associated with the acquisition of the net assets of
Sefina Ltd.

Required
1. Prepare an acquisition analysis in relation to this acquisition.
2. Prepare the journal entries in Talia Ltd to record the acquisition at 1 July 2024.
(LO6)

TALIA LTD – SEFINA LTD

1. Acquisition analysis:
Fair value of identifiable assets and liabilities acquired:
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 Current assets $980 000
Non-current assets 4 220 000
5 200 000
Liabilities 500 000
$4 700 000
Consideration transferred:
Shares: 100 000 x 10 x $10 $10 000 000
Patent 1 000 000
Cash: 100 000 x $5.20 520 000
$11 520 000
Goodwill ($11 520 000 - $4 700 000) $6 820 000
2. Journal entries for Talia Ltd:

Patent Dr 250 000

Gain Cr 250 000
(Re-measurement as part of consideration
transferred in a business combination)

Current assets Dr 980 000

Non-current assets Dr 4 220 000
Goodwill Dr 6 820 000
Liabilities Cr 500 000
Share capital Cr 10 000 000
Patent Cr 1 000 000
Cash Cr 520 000
(Acquisition of Sefina Ltd)

Acquisition-related expenses Dr 20 000

Cash Cr 20 000
(Payment of directly attributable costs)

Share capital Dr 2 000

Cash Cr 2 000
(Costs of issuing shares)

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 Chapter 27: Consolidation: Controlled entities

CQ1 What are the consolidated financial statements?

Answer:
According to Appendix A of AASB 10/IFRS 10 Consolidated Financial Statements, the
consolidated financial statements are:
The financial statements of a group in which the assets, liabilities, equity, income, expenses
and cash flows of the parent and its subsidiaries are presented as those of a single
economic entity.
As stated in paragraph B86 of AASB 10/IFRS 10, consolidated financial statements
“combine like items of assets, liabilities, equity, income, expenses and cash flows” of the
entities in the group.

CQ2 What is the purpose of preparing consolidated financial statements for

a group?

Answer: The purpose of preparing consolidated financial statements is to show the combined
financial position, financial performance and cash flows of the group of entities as if they
were a single economic entity. As such, they consist of a consolidated statement of financial
position, a consolidated statement of profit or loss and other comprehensive income, a
consolidated statement of changes in equity and a consolidated statement of cash flows.
These consolidated statements reflect only the effects of transactions with external parties to
the group.

.

CQ3 What is a group, a parent and a subsidiary?

Answer: According to Appendix A of AASB 10/IFRS 10 Consolidated Financial

Statements:
A group is formed by a parent and all its subsidiaries.
A parent is an entity that controls one or more entities.
A subsidiary is an entity that is controlled by another entity, a parent

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CQ4 What is a parent–subsidiary relationship?

Answer:

The parent–subsidiary relationship is a special case of an investor–investee relationship,

where the investor (the parent) has control over the investee (the subsidiary). The parent–
subsidiary relationship gives rise to a group for which normally consolidated financial
statements need to be prepared.

CQ 6: Why do the regulators require the parent entity to prepare consolidated financial
statements for a group?

Some of the reasons for which the regulators require the parent entity to prepare consolidated
financial statements are as follows:

i. To supply relevant information to investors in the parent entity.

The information obtained from the consolidated financial statements is relevant to investors
in the parent entity. A shareholder’s wealth in the parent is dependent not only on how that
entity performs, but also on the performance of the other entities controlled by the parent. To
require these investors in analysing their investment to source their information from the
financial statements of each of the entities comprising the group would place a large cost
burden on those investors.

ii. To allow comparison of the group with similar entities.

Some entities are organised into a group structure such that different activities are undertaken
by separate entities within the group. Other entities are organised differently, with some
having all activities conducted within the one entity. Access to consolidated financial
statements makes comparisons across the group an easier task for the users of financial
statements.

iii. To assist in the discharge of accountability by management of the group.

A key purpose of financial reporting is the discharge of accountability by management.

Entities that are responsible or accountable for managing a pool of resources — being the
recipients of economic benefits and responsible for payment of obligations — are generally
required to report on their activities and are held accountable for the management of those
activities. The consolidated financial statements report the assets under the control of the
group management together with the claims on those assets, as well as the performance
obtained in the management of those assets. Based on the information contained within these
statements, the management of the group can be held accountable for their actions.

iv. To report the risks and benefits of the group as a single economic entity.

There are risks associated with managing an entity, and an entity rarely obtains control of
another without also obtaining significant opportunities to benefit from that control. The
consolidated financial statements allow an assessment of these risks and benefits. Note,

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however, that the benefits from intragroup transactions are eliminated when preparing
consolidated financial statements, as those statements should only reflect the effects of
transactions with external parties.

v. To ensure consistency of information provided to users.

The consolidated financial statements are prepared after adjusting the separate financial
statements of the entities within the group for the different accounting policies applied,
making sure that all the items reported are combined after being recognised and measured
consistently.

CQ 8: What are the key elements of control over an investee?

Based on the definition of control from Appendix A of AASB 10/IFRS 10 Consolidated

Financial Statements, paragraph 7 of AASB 10/IFRS 10 identifies three elements that must
be held by an investor in order for it to have control:
 Power over the investee.
 Exposure or rights to variable returns from the parent’s involvement with the subsidiary
 The ability to use the power over the subsidiary to affect the amount of the parent’s
returns.

CQ 13: Give examples of factors to consider in determining the existence of power when
the investor holds less than 50% of the voting shares of an investee.

Where an investor owns less than 50% of the shares of an investee, the determination of
whether the investor has power over the investee is not always easy. In determining the
existence of power, together with the size of the investor’s ownership interest, it is necessary
to examine the potential actions of the holders of the other shares in the investee. Some
factors to assist in this process are as follows.

• Attendance at annual general meetings. The probability of shareholders attending the

annual general meeting and exercising their voting rights may be lessened by the level of
their voting rights and geographical location.
• Level of dilution and disorganisation or apathy of the remaining shareholders. Holders of
small parcels of shares are often not organised into voting blocks.
• The existence of contracts. As noted in paragraph B39 of AASB 10/IFRS 10, a contractual
arrangement between an investor and other holders of shares may give the investor sufficient
voting rights to have power.

A number of problems arise in assessing the existence of power based on the actions and
characteristics of the remaining shareholders where the investor holds less than the majority
of voting shares. First, there is the question of temporary control. If the identification of the
parent is based on some of the factors listed previously that may change over time, there is a
danger of a change in the identity of the parent over time. For example, the percentage of
votes cast at annual general meetings may historically be 70%, but in a particular year it may

11
be 50%. A shareholder with 30% of the voting shares has control in the latter circumstance
but not in the former. Similarly, consider the situation where there are two shareholders with
substantial holdings of voting shares, neither of them having power over the investee. One of
the holders of a substantial block of shares may sell its shares to a large number of buyers.
The other shareholder with a substantial holding of voting shares may suddenly find that it
has the power to control. Second, the ability of an entity to control another entity may rely on
the relationships with other entities. For example, a holder of 40% of the voting shares in an
investee may be ‘friendly’ with the holder of another 11% of shares. The 11% shareholder
might be a financial institution that has invested in the holder of the 40% ownership interest
and plans to vote with that entity to increase the potential for repayment of loans by the
investee. However, business relationships and loyalties are not always permanent.

Exercise 27.2

Voting rights

Ubud Ltd owns 38% of the shares of Toba Ltd; no other party owns more than 2% of
the shares. In each of the previous year’s annual general meetings, only the holders of
around 70% of the shares were present and voted.

Required
Discuss the potential for Toba Ltd to be classified as a subsidiary of Ubud Ltd. (LO2)

Ubud Ltd Toba Ltd

38%
Discuss:
 The concept of control.
 The need for judgement.
 Factors to consider when determining the existence of control:
- NCI = 62%
- no other party > 2% interest
- only 70% attendance at AGM last years.
 Apply to above situation.

It will probably be concluded that Ubud Ltd is the parent of Toba Ltd as Ubud Ltd seems to
have the current ability to control as it has the majority interest, the other shareholders are
dispersed and some are not interested in the management of the entity.

However, the students should also consider and discuss:

 The difference between actual control and capacity to control: the party actually
controlling the other entity may not have the capacity to control. For example, just
because Ubud Ltd’s nominees may be elected as board members does not automatically
mean that it becomes the parent of Toba Ltd. It simply means that it actually controls that
entity. The question is whether it has the capacity to control.
 Attendance at AGMs: If holders of 77% of the voting shares attended the AGM this year,
then holders of 39% of the shares could have outvoted Ubud Ltd. They may allow Ubud
Ltd to manage Toba Ltd because of the great managerial skills or business connections of
Ubud Ltd. In this case, Ubud Ltd is not the parent of Toba Ltd.

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 The purpose of consolidation: If Ubud Ltd is actually controlling Toba Ltd, even though
it does not have the capacity to control, would the shareholders of Ubud Ltd be interested
in a set of consolidated financial statements for the combined group? Does the issue of
accountability provide sufficient grounds for the consolidation of the two entities?

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Exercise 27.3

Voting rights

Batak Ltd has 35% of the voting interest in Kalimantan Ltd. An investment bank with
which Batak Ltd has business relationships holds a 20% voting interest in Kalimantan
Ltd. Because of the closeness of the business relationship with the bank, Batak Ltd
believes it can rely on the bank’s support to ensure it cannot be outvoted at general
meetings of Kalimantan Ltd.

Required
Discuss whether Batak Ltd is a parent of Kalimantan Ltd. (LO2)

Discuss:
 the concept of control
 the need to apply judgement
 these situations are often referred to “strawmen” – other parties that act as agents or in
conjunction with others. In the example in this question, Batak Ltd has the expectation
that the voting of the investment bank will most likely be aligned with its own, ensuring
that it cannot be outvoted.

If control is the basis for consolidation, a factor to consider is the influence available through
a friendly party. Note that there is no guarantee that the investment bank will always vote
with Batak Ltd – the relationship may change over time. However, many of the other factors
considered in relation to an investor and control, such as the attendance at the AGM and the
size of blocks of shareholdings may also change over time. What it matters is whether
currently the voting of the investment bank is aligned with Batak Ltd and that seems to be the
case, meaning that Batak Ltd is the parent of Kalimantan Ltd.

Exercise 27.6

Parent-subsidiary relationship

In the following independent situations, determine whether a parent–subsidiary

relationship exists, and which entity, if any, is a parent.

1. Raja Ltd is a company that was negatively affected by a major downturn in the
economy. It previously obtained a significant loan from Komodo Bank. When Raja Ltd
was unable to make its loan repayments, the bank made an agreement with Raja Ltd to
become involved in the management of that company. Under the agreement between the
two entities, Raja Ltd’s managers had to obtain authority from the bank for
acquisitions over $20 000 and for its budgets.

2. Ampat Ltd is a major financing company whose interest in investing is return on the
investment. Ampat Ltd does not get involved in the management of its investments. If

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an investee is not managed properly, Ampat Ltd sells its shares in that investee and
selects a more profitable investee to invest in. It previously held a 45% ownership
interest in Java Ltd as well as providing substantial convertible debt finance to that
entity. Recently, Java Ltd was having cash flow difficulties and persuaded Ampat Ltd to
convert some of the convertible debt into equity so as to ease the effects of interest
payments on cash flow. As a result, Ampat Ltd’s equity interest in Java Ltd increased to
55%. Ampat Ltd still wanted to remain as a passive investor, with no changes in the
directors on the board of Java Ltd. These directors were appointed by the holders of the
shares not held by Ampat Ltd.
(LO2)

Answer:
In each of these circumstances the following principle from the Basis of Conclusions to
AASB 10/IFRS 10 should be used:

BC41 The definition of control includes three elements, namely an investor’s:

(a) power over the investee;
(b) exposure, or rights, to variable returns from its involvement with the investee; and
(c) the ability to use its power over the investee to affect the amount of the investor’s returns.

1. This question will be looked at under two scenarios:

(i) Raja Ltd is not a subsidiary of any other entity.

The key issue is whether the fact that the bank has authority in relation to acquisitions and
approval of budgets is sufficient to give the bank the status of a parent. The bank will receive
a return from Raja Ltd in the form of interest on the loan.

Komodo Bank has:

 Power over Raja Ltd, as it has rights arising from the legal contract
 It can affect some of the relevant activities e.g. acquisitions, but not others such as
appointment of key management personnel.

Raja Ltd will not be a subsidiary of Komodo Bank because:

 The bank is not exposed to variable returns from its involvement with Raja Ltd. The
interest payments are not affected by the profitability of Raja Ltd.
 It cannot use its power over Raja Ltd to affect the amount of its returns, as the returns are
fixed interest payments.

(ii) Raja Ltd is a wholly owned subsidiary of another entity, Bali Ltd.

The key issue in this scenario is whether the authority given to the bank in relation to
acquisitions and budget approval is sufficient to state that Bali Ltd does not control Raja Ltd.
The key issue is whether Bali Ltd still has power over Raja Ltd given the arrangements with
the bank.

Relevant activities over which a parent should have power include:

(a) selling and purchasing of goods or services;
(b) managing financial assets during their life (including upon default);
(c) selecting, acquiring or disposing of assets;

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(d) researching and developing new products or processes; and
(e) determining a funding structure or obtaining funding.

Decisions about relevant activities include:

(a) establishing operating and capital decisions of the investee, including budgets; and
(b) appointing and remunerating an investee’s key management personnel or service
providers and terminating their services or employment.

The key issue then is whether Bali Ltd has the ability to direct the relevant activities i.e. those
activities that most significantly affect the investee’s returns. It is probable that Bali Ltd no
longer controls Raja Ltd as the bank can: veto any changes to significant transactions for the
benefit of Bali Ltd. It can deny the company its ability to make acquisitions, and it can reject
moves within a budget to undertake changes in inventory production.

In conclusion, a parent-subsidiary relationship does not exist in this case.

2. Ampat Ltd currently holds 55% of the shares of Java Ltd. It does not want to become
involved in the management of Java Ltd, and the directors are appointed by the non-
controlling interest (NCI).

Control is not based on actual control but on the capacity to control. Ampat Ltd:
 has power over the investee via its share ownership
 is exposed to variable returns via dividends arising from its share ownership
 has the ability to affect those returns as it can become involved in management whenever
it wishes, given its superior voting power.

Ampat Ltd is a parent of Java Ltd. Further, when Ampat Ltd held a 45% interest in Java Ltd
it also held convertible debt in that entity which could, if converted, give it an equity interest
of 55%. In this situation, Ampat Ltd was a parent of Java Ltd. It would appear under the
circumstances that the conversion was substantive i.e. economically feasible, and currently
exercisable.

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