Business combinations (IFRS 3)

LOs
 Explain Business combinations and
 Methods of its arrangement,
 Accounting for BC
 Business Combination—Intro...
 Why for business expansion?
 Survival & profitability.
 Risk management.
 Through developing new earning potential and those in
cyclical industries can add greater stability to earnings
through diversification.
 To get advantage of economies of scale in
production & distribution.
 How do business expand? Does a business
expansion leads to change in organizational structure?
 Internal expansion: through new product development and
expansion of existing product lines into new markets. or
 External expansion: Acquiring other companies already in
those markets So called business combination.
Business Combination—Intro...
 Business expansion may result in creation of
parent-subsidiary relationships.
 A subsidiary may be created or acquired.
 What is a parent & subsidiary company?
 A subsidiary is a corporation under the control
of another company,
 A parent company: a company having controls over the
other, usually through majority ownership of its common
stock.
 Control: relates to the ability to direct policies
and management.
 Which method of expansion is better, internal
or external? Why?
Organizational Structure and
Financial Reporting
 Business expansion changes organizational
structure  determine the appropriate
financial reporting procedures. How?
 Do you think the financial reporting will vary
for a newly established company (internal
expansion) and a company acquired by
parent? Why?
ACCOUNTING FOR INTERNAL EXPANSION:
CREATING BUSINESS ENTITIES

 A company may decide to conduct a portion of their

operation through a separate entity like corporate
subsidiaries, corporate joint ventures, or partnerships.
 However the accounting and reporting for
investments in corporate joint ventures and
subsidiaries do have different IFRS standards.
 Do you think a company which transfers assets &
liabilities in return for shares of newly created
company recognizes any gain or loss from transfer?
Why? Hint: think of the existence of arms length transaction.
ACCOUNTING FOR INTERNAL EXPANSION:
CREATING BUSINESS ENTITIES
 Recognizing assets from related company under the absence of
an arm’s-length transaction is not appropriate.
 Thus, assets & liabilities transferred to the created entity
valued at book value.
 i.e. the parent
 recognizes ownership interest at the book value of the net
assets transferred.
 Recognizes no gains or losses are recognized on the transfer.
 Subsequently, prepares a consolidated statement with the
subsidiary.
 Overall, the consolidated financial statements appear the
same as if the transfer had not taken place.
 The subsidiary
 begins accounting for the transferred assets and liabilities
based on book values at the time of transfer.
 ACCOUNTING FOR INTERNAL EXPANSION: CREATING BUSINESS ENTITIES
Example: As an illustration of a created entity

 Assume that ‘A’ Company creates a subsidiary, ‘B’ Company,

and transfers the following assets to ‘B’ in exchange for all 1,000
shares of ‘B’s’ Br 200 par common stock:
Cash Inventory Land Building Equipment Total
Cost - 50,000 75,000 100,000 250,000 475,000
Book Value 70,000 50,000 75,000 80,000 160,000 435,000

 Required: present journal entries on the books of

company ‘A’ and company ‘B’.

Record the creation of ‘B’ Co. *Br110,000 = (Br100,000 - Br80,000) + (Br250,000 - Br160,000)
ACCOUNTING FOR INTERNAL EXPANSION: CREATING BUSINESS
ENTITIES
Example: As an illustration of a created entity
‘A’ records the transfer with the following entry

‘B’ Company records the transfer of assets and the issuance of stock (at the book
value of the assets) as follows:
Cash 70,000
Inventory 50,000
Land 75,000
Building 100,000
Equipment 250,000
Accumulated Depreciation 110,000
Common Stock, Br200 par 200,000
Additional Paid-In Capital 235,000
ACCOUNTING FOR EXTERNAL
EXPANSION: BUSINESS COMBINATIONS
 Forms of Business Combinations
 Forms of Business Combinations

• Merger: A + B = A
One company acquires a second company and
the second company ceases to exist.
• Consolidation: A + B = C
Two companies form a third company and the
original two companies cease to exist.
• Asset acquisition:Parent & Subsidiaries:
A+B=A+B
One company acquires the common stock of a second
company, and after the transaction both companies
continue to exist.
Methods of Effecting Business
Combinations
 Methods: combinations through
 Acquisition of assets or
 An acquisition of stock

 Acquisition by Other Means (through

contractual agreement)
 Do you think accounting for a business
combination varies for acquisition of assets
and acquisition of stock?
 Yes! How?
Methods of Effecting Business Combinations:
Acquisition of Assets
 Usually it is a friendly takeover.
 One company acquires another company’s
assets and assumes other company’s
liabilities through direct negotiations
with its management.
 The acquired company liquidates through
distributing assets or securities received from
the combinations.
 Usually it forms a merger or statutory
combinations.
Methods of Effecting Business Combinations:
Acquisition of Stock
 Do you think a company has to acquire all
outstanding voting shares for combination to exist?
 Not necessarily!
 Because possible to get control over another co.
through acquiring majority (>50%) of outstanding
shares or controlling interest.
 Controlling interest vs. non-controlling interest
 Shares of acquired company held by
 acquirer: controlling interest
 Other owners (other than acquirer): non-controlling/minority
interest.
 Do you think combination through stock acquisition
leads to liquidation of acquired company?
 How do you think will it be accounted?
Methods of Effecting Business Combinations:
Acquisition of Stock
 Acquired and both companies remain in
existence as separate legal entities.
 The stock of the acquired company is
recorded on the books of the acquiring
company as an investment.
Accounting for Business
Combinations
IFRS 3
What is Business combination?

 A business combination is:

√ a transaction or other event in which a
reporting entity (the acquirer) obtains control
of one or more businesses (the acquiree).
 When a control exists or an investor controls an
investee ?
 When the investor has a right to returns from the investee and
 Has the ability to affect those returns through its power over
the investee.
 What is Business combination?
 What is business?
 Business:
 is an integrated set of activities and assets
 capable of being conducted and managed for the
purpose of:
 providing goods or services to customers,
 generating investment income such as dividend or interest,
or
 generating other income.
What is Business combination?
 How does an acquirer obtain control?
 Using various alternative ways
 Such as
 By issuing equity securities and/or
 By transferring cash or other assets and/or
 By assuming liabilities.
 Combination by contract alone without transferring
considerations.
 Question:
Identify a business combination
1) Company A purchases the manufacturing facility
(plant and manufacturing equipment only) that
Company B uses in producing its products.
2) Company A purchases the brand name of Company B.
3) Company A purchases the net assets of Company B
which includes manufacturing facility, employees,
brand name, and all managements and operational
processes etc.
4) Company A enters into a joint arrangement with
Company B to combine their business, where they
have joint control.
Accounting for business combinations
 IFRS 3 requires the use of acquisition method
Theacquirer purchases net-assets.
Thus the acquirer recognises
 acquiree’s identifiable assets, liabilities and
contingent liabilities at their fair values at the
acquisition date, and
 goodwill, which is subsequently tested for
impairment (rather than amortised)
NB. Assets and liabilities to be recognized shall fulfil the definition
in Framework For Preparation And Presentation Of Financial
Statement(the 2001 Framework).
 THE ACQUISITION METHOD
The following steps should be undertaken in applying the
acquisition method:
1. Identify the acquirer;
2. Determine the acquisition date; date on which the
acquirer obtains control
3. Recognize and measure the identifiable net assets
acquired at fair value;
4. Recognize and measure any non-controlling interest;
and
5. Recognize and measure goodwill or gain from a
bargain purchase.
How we calculate cost of a business combination
(CONSIDERATION TRANSFERRED)
 CONSIDERATION TRANSFERRED
● The consideration transferred is measured at the fair

value of the sum of assets transferred and liabilities

assumed

● Acquisition-related costs are costs the acquirer incurs to effect a

business combination.
e.g. external legal and advisory costs and the costs of
maintaining an internal acquisitions department.

● These costs are accounted for as expenses in the periods in which

the costs are incurred and the services are received. However, the
costs to issue debt or equity instruments are recognized according
to IAS 32 and IFRS 9
 CT-Contingent Consideration
Contingent consideration is usually an obligation
of the acquirer to transfer additional assets or equity
interests to the former owners of the acquiree if specified
future events occur or conditions are met.
 However, contingent consideration may also entitle the
acquirer to the return of previously transferred
consideration if specified conditions are met
Contingent consideration
 is included at its fair value at acquisition date
 subsequent changes in fair value are not included
in the consideration transferred at acquisition-
date
EXAMPLE: How much is CT?
26
● Entity A acquires 75% of entity B in exchange for ETB 85,000
cash and 1,000 entity A shares (fair value = ETB 10,000)
issued for the transfer.
● Entity A incurred ETB 5,000 advisory and legal costs directly
attributable to the business combination and ETB 1,000 share
issue expenses.
Question: Compute cost of acquisition if Co. A offers the
following considerations to acquire Co. B.

1. Shares issued which have a fair value of

Br202,000 and market value of Br200,000.
2. Cash of Br294,000 which includes Br14,000
finance cost.
3. Contingent consideration based on future
profits of Company B in the following two
years is included at its fair value of Br 60,000.
 4.Recognise and measure any non-controlling interest
IFRS 3 has an explicit option on a transaction-by-transaction basis to
measure NCI at the date of acquisition at either:
 fair value (new method) e.g. if available, share price of NCI
equity shares; or using other valuation techniques if not publicly
traded;
or
 NCI’s proportionate share of the net identifiable assets of the
entity acquired (old method).

 New method argued that old method of calculating goodwill only

recognises the goodwill acquired by the parent i.e. any goodwill
attributable to NCI is not recognised.
Illustration of Proportionate and Fair Value
Method
 Example 2: NCI (Old and new methods)

P pays Br800m to purchase 80% of the shares of S. The

fair value of 100% of S’s identifiable net assets is Br600m.
Measure non-controlling interests at their proportionate interest
(Old)
If P elects to measure non-controlling interests at their
proportionate interest in net assets of S of Br120m (20% x
Br600m)

Measure non-controlling interests at fair value(New)

If P elects to measure non-controlling interests at fair
value and determines that fair value to be Br185m,

The fair value of the 20% non-controlling interest in S will

not necessarily be proportionate to the price paid by P for
its 80%, primarily due to control premium or discount.
 5. Recognize and measure goodwill or gain from a bargain
purchase
Goodwill is measured as the difference between:
I. the aggregate of(a+b+c)
a. the acquisition-date fair value of the consideration transferred;
b. the amount of any non-controlling interest in the entity acquired
(two measurement options); and
c. The fair value of any interest in the acquiree already held by the
acquirer if any

II. the net of the acquisition-date amounts of the identifiable assets

acquired and the liabilities assumed, both measured in accordance
with IFRS 3

Goodwill= I-II
 Example : Goodwill Calculation
P pays Br800m to purchase 80% of the shares of S. The
fair value of 100% of S’s identifiable net assets is Br600m.

In simple terms, Goodwill = Consideration paid by parent +

Non-controlling Interest – Fair Value of subsidiary’s net
assets

If P elects to measure non-controlling interests at fair

value and determines that fair value to be Br185m, then
goodwill of Br385m is recognized (Br800m + Br185m –
Br600m).
Explanation
Explanation and
and Illustration
Illustration of
ofAcquisition
AcquisitionAccounting
Accounting

Example 1: Galaxy Company acquired the assets (except for cash) and assumed
the liabilities of Axis Company. Immediately prior to the acquisition, Axis
Company’s balance sheet was as follows:(assume value of consideration
transferred is $990,000 in cash)

Any
Goodwill?
Explanation
Explanation and
and Illustration
Illustration of
ofAcquisition
AcquisitionAccounting
Accounting

Example 1: Galaxy Company acquired the assets (except for cash) and
assumed the liabilities of Axis Company. Immediately prior to the acquisition,
Axis Company’s balance sheet was as follows(assume value of consideration
transferred is Br

Fair value of
assets,
without cash
$1,824,000
Explanation
Explanation and
and Illustration
Illustration of
ofAcquisition
AcquisitionAccounting
Accounting

Example 1: A. Prepare the journal entry on the books of Galaxy Co. to

record the purchase of the assets and assumption of the liabilities of Axis
Co. if the amount paid was $1,560,000 in cash.

Calculation of Goodwill

Fair value of assets, without cash $1,824,000

Fair value of liabilities 594,000
Fair value of net assets 1,230,000
Price paid 1,560,000
Goodwill $ 330,000
Explanation
Explanation and
and Illustration
Illustration of
ofAcquisition
AcquisitionAccounting
Accounting

Example 1: A. Prepare the journal entry on the books of Galaxy Co.

to record the purchase of the assets and assumption of the liabilities of
Axis Co. if the amount paid was $1,560,000 in cash.

Receivables 228,000
Inventory 396,000
Plant and equipment 540,000
Land 660,000
Goodwill 330,000
Liabilities 594,000
Cash 1,560,000
 Gain on a bargain purchase(i.e. negative goodwill)
 If the value of acquired identifiable assets and
liabilities exceeds the consideration transferred,
the acquirer immediately recognizes a gain
(bargain purchase)

 When the price paid to acquire another firm is

lower than the fair value of identifiable net assets
(assets minus liabilities), the acquisition is
referred to as a bargain.

 Treated as immediate income i.e. ‘credit ’ in

Explanation
Explanation and
and Illustration
Illustration of
ofAcquisition
AcquisitionAccounting
Accounting

Example 1: B. Repeat the requirement in (A) assuming that the amount

paid was $990,000.

Calculation of Goodwill or Bargain Purchase

Fair value of assets, without cash $1,824,000

Fair value of liabilities 594,000
Fair value of net assets 1,230,000
Price paid 990,000
Bargain purchase $ 240,000
Explanation
Explanation and
and Illustration
Illustration of
ofAcquisition
AcquisitionAccounting
Accounting

Example 1: B. Repeat the requirement in (A) assuming that the amount

paid was $990,000.

Receivables 228,000
Inventory 396,000
Plant and equipment 540,000
Land 660,000
Liabilities 594,000
Cash 990,000
Gain on acquisition (ordinary) 240,000