Accounting for Business Combination PDF

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AFAR04 – BUSINESS COMBINATIONS: STATUTORY MERGERS &FULL STOCK ACQUISITIONRELATED STANDARDS: PFRS 3 – BUSINESS COMBINATIONSTOPIC OUTLINELECTURE NOTESBASIC CONCEPTS AND INTRODUCTIONDEFINITIONA business combination is a transaction or other event in which an acquirer obtains control of one or more ...

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PSBA: AFAR 04_BUSINESS COMBINATIONS: STATUTORY MERGERS & FULL STOCK ACQUISITION

AFAR04

BATCH 2020

BUSINESS COMBINATIONS: STATUTORY MERGERS & FULL STOCK ACQUISITION RELATED STANDARDS: PFRS 3 – BUSINESS COMBINATIONS –

TOPIC OUTLINE Basic Concepts and Introduction

BUSINESS COMBINATIONS (PFRS 3)

Accounting for Business Combination Accounting for Cost of Business Combination PFRS for SMEs

LECTURE NOTES BASIC CONCEPTS AND INTRODUCTION DEFINITION A business combination is 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" are also business combinations as that term is used in PFRS 3. Essential elements in the definition of a business combination are: (1) Control Control is the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. Control is normally presumed to exist when the acquirer holds more than 50% interest (QUANTITATIVE THRESHOLD) in the acquiree voting rights. However, this is only a presumption because control can be obtained in some other ways, such as when (QUALITATIVE THRESHOLD): (a) The acquirer has the power to appoint or remove the majority of board of directors of the acquiree. (b) The acquirer has the power to cast the majority of votes at board meetings or equivalent bodies within the acquiree. (c) The acquirer has power over more than half of the voting rights of the acquiree because of an agreement with other investors (d) The acquirer controls the acquiree’s operating and financial policies because of law or an agreement. An acquirer may obtain control of an acquiree in variety of ways, for example: (a) by transferring cash or other assets (b) by incurring liabilities (c) by issuing equity securities (d) by providing more than one type of consideration (e) without transferring consideration, including by contract alone (2)

Business A business is 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".

CLASSIFICATION OF BUSINESS COMBINATION ACCORDING TO STRUCTURE (BUSINESS POINT OF VIEW) (a) Horizontal Integration – this type of business combination is one that involves companies within the same industry that have been previously competitors.

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PSBA: AFAR 04_BUSINESS COMBINATIONS: STATUTORY MERGERS & FULL STOCK ACQUISITION (b)

(c) (d)

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Vertical Integration - this type of business combination take place between two companies involved in the same industry but at different levels. It normally involves a combination of a company and its supplier 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 a new market or industry. Circular Combination – entails some diversification, but does not have a drastic change in operation as a comglomerate.

ACCORDING TO METHOD (LEGAL POINT OF VIEW) (a) ASSET ACQUISTION – The acquirer purchases the assets and assumes liabilities of the acquiree in exchange of cash or other non-cash consideration. Under the Corporation Code of the Philippines, a business combination effected through asset acquisition may be either:  Merger – occurs when two or more companies merge into a single entity which shall be one of the combining entities. For example: A Corp. + B Corp. = A Corp. or B. Corp.  Consolidation – occurs when two or more companies consolidate into a single entity which shall be the consolidated entity. For example: A Corp. + B Corp. = C Corp. (b) STOCK ACQUISITION – instead of acquiring the assets and assuming the liability of the acquiree, the acquirer obtains control over the acquiree by acquiring majority ownership interest in the voting rights of the acquiree. In stock acquisition, the acquirer is known as the parent while the acquiree is known as subsidiary. After the acquisition, the entities retain their separate legal existence but for financial reporting purposes, both entities are viewed as a single reporting entity. ACCOUNTING FOR BUSINESS COMBINATIONS Business combinations are accounted for using the ACQUISITION METHOD. This method requires the following steps or procedures: (1) IDENTIFY THE ACQUIRER (a) In a business combination effected primarily by transferring cash or other assets, or by incurring liabilities, the acquirer is usually the entity that transfers the cash or other assets , or incurs the liabilities. (b) In a business combination effected primarily by exchanging equity interests, the acquirer is usually the entity that issues its equity interests. (c) The acquirer is usually the combining entity whose relative size measured in terms of assets , revenue or profit is significantly greater than that of the other combining entities. (d) In a business combination involving more than two entities, determining the acquirer shall include a consideration of which of the combining entities initiated the combination as well as the relative size of the entities. (e) If a new entity is formed to issue equity interests to effect a business combination, one of the combining entities that existed before the combination shall be identified as the acquirer. (f) The combining entity whose owners as a group receive the largest proportion of the voting rights in the combined entity is likely the acquirer. (g) Where there is a large minority interest in the combined entity and no other owner has a significant voting interest, the holder of the large minority interest is likely the acquirer. (h) Where one entity has the ability to select the management team or the majority of the members of the governing body of the combined entity, such entity is likely the acquirer. (2)

DETERMINE THE ACQUISITION DATE The acquisition date is the date on which an ACQUIRER OBTAINS CONTROL over the acquiree. The acquisition date is normally the date on which the acquirer legally transfers the consideration, acquires the assets and assumes the liabilities of the acquiree. The acquisition date is also known as, the "CLOSING DATE”. However, it is possible for control to pass to the acquirer before or several dates are key to a business combination, it is the date determines the acquisition date. For example, the acquisition date written agreement provides that the acquirer obtains control of the closing date.

(3)

after the closing date. Where on which control passes that precedes the closing date if a acquiree on a date before the

RECOGNIZING AND MEASURING GOODWILL On acquisition date, the acquirer computes and recognizes goodwill (or gain or bargain purchase) using the following formula: Consideration transferred xxx NCI in the acquiree xxx Previously held equity interest in the acquiree xxx Total xxx Less: Fair value of net identifiable assets acquired xxx Goodwill / (Gain on Bargain Purchase) xxx Goodwill is recognized as an asset while gain on bargain purchase is presented as gain in profit or loss.

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NOTE: NCI and Previously held equity interest in the acquiree are to be discussed on the next topic. Consideration transferred The consideration transferred may include assets or liabilities of the acquirer that have carrying amounts that differ from their fair values at the acquisition date. The following are the considerations that the acquirer may transfer or incur and their proper measurement: (1) Cash or other monetary assets – The fair value is the amount of cash or cash equivalent dispersed. (2) Deferred payment – the fair value to the acquirer is the amount the entity would have to borrow to settle their debt immediately. Basically, the amount should be at present value. (3) Non-monetary assets - Their fair values on acquisition date. (4) Equity instruments – If an acquirer issues its own shares as consideration, it will need to determine the fair value of those shares at the date of exchange. (5) Debt instruments or liabilities undertaken – The fair values of liabilities undertaken are best measured by the present value of future cash flows. (6) Contingent consideration – The acquirer shall recognize the acquisition-date fair value of contingent consideration. Changes that are result of the acquirer obtaining additional information about facts and circumstances that existed at the acquisition date, and that occur within the measurement period (which may be a maximum of one year from the acquisition date) are recognized as adjustments against the original accounting for the acquisition (in other words are adjusted in goodwill). Changes resulting from events after the acquisition date are not measurement period adjustments. Such changes are therefore accounted for separately from the business combination. Recognition and Measurement of Acquired Assets and Liabilities Recognition Principle On acquisition date, the acquirer recognizes the identifiable assets acquired and liabilities assumed. To qualify for recognition, the identifiable assets and liabilities must meet the definition of assets and liabilities in the Conceptual Framework for Financial Reporting. Unidentifiable assets are NOT RECOGNIZED. Examples of which are as follows:  Goodwill recorded by acquiree prior to the business combination  Assembled workforce  Potential contracts that the acquiree is negotiating with prospective mew customers at the acquisition date. Measurement Principle 1. The acquirer shall measure the identifiable assets acquired and the liabilities assumed at their acquisition-date fair value. 2. For each business combination, the acquirer shall measure any non-controlling interest in the acquiree either at: a. Fair value b. The non-controlling interest's proportionate share of the acquiree's identifiable net assets. Specific Recognition Principle (1) Operating Leases Acquiree is the lessee General Rule: The acquirer does not recognize any assets or liabilities related to an operating lease in which the acquiree is the lessee. Exception: The acquirer determines whether the terms of each operating lease in which the acquiree is the lessee are favorable or unfavorable If the terms of the lease relative to market terms is:  Favorable – the acquirer recognizes an intangible asset.  Unfavorable – the acquirer recognizes a liability. Acquiree is the lessor If the acquiree is the lessor, the acquirer does not recognize any separate intangible asset or liability regardless whether the terms of the operating lease are favorable or unfavorable when compared with market terms. (2)

Intangible assets PFRS 3 requires the acquirer to recognize IDENTIFIABLE ASSETS acquired regardless of the degree of probability of an inflow of economic benefits. An intangible asset is identifiable if it:  can be separated or  meets the contractual-legal criterion. (If it arises from legal or contractual right regardless of separability.

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Exception to the Recognition Principle

(1) Contingent Liabilities recognized when they represent a present obligation and their fair value is determinable even if the outflow is improbable

Exceptions to both the Recognition and Measurement Principle (1) Deferred Taxes - PAS 12 is applied (2) Employee Benefits - PAS 19 is applied (3) Indemnification assets recognized and measured on the same basis as the indemnified item.

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Exception to the Measurement Principle (1) Reacquired rights measured based on the remaining terms of the related contract (2) Share-based payment - PFRS 2 is applied (3) NCA Held for Sale measured at fair value less costs to sell

Measurement Period If the initial accounting for business combination is incomplete by the end of the reporting period in which the combination occurred, the acquirer can use provisional amounts to measure any of the following for which the accounting is incomplete:  Consideration transferred  NCI in the acquiree  Previously held equity interest in the acquiree  Identifiable assets acquired and liabilities assumed Within 12 MONTHS FROM THE ACQUISITION DATE (the measurement period), the acquirer retrospectively adjusts the provisional amounts for any new information obtained that provides evidence of facts and circumstances that existed as of the acquisition date, which if known would have affected the measurement of the amounts recognized on that date. Any adjustment to a provisional amount is recognized as an adjustment to goodwill or gain on bargain purchase. ACCOUNTING FOR COSTS OF BUSINESS COMBINATION Acquisition-related Costs Examples Professional fees paid to accountants, legal advisors, valuers Direct Costs and other consultants (finders and brokerage fees) to affect the combination General and administrative costs, Indirect Costs including the costs of maintaining an internal acquisitions department transaction costs such as stamp duties, professional adviser's fees, Cost of Issuing Equity Securities underwriting costs and brokerage fees Cost of Issuing Debt Securities

Bond issue costs

Treatment

Expensed as incurred

Expensed as incurred

Debit to APIC or Share Premium Account Deducted from Carrying Amount of Financial Liability

PFRS FOR SMEs FULL PFRS

PFRS for SMEs Accounting Method PFRS 3 requires the use of ACQUISITION PFRS for SMEs requires the use of PURCHASE METHOD METHOD Acquisition Related Costs Included in the cost of business combination Expensed except for costs of issuing debt or except for costs of issuing debt or equity securities equity securities Operating Lease PFRS 3 has a specific provision for operating PFRS for SMEs has no specific provision for leases. operating leases. Intangible Assets Acquired Recognized if the intangible asset is either (a) separable or (b) arises from legal or Recognized if its fair value can be measured contractual right reliably Contingent Liabilities Recognized if it is a present obligation and its

Recognized if its fair value can be measured

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PSBA: AFAR 04_BUSINESS COMBINATIONS: STATUTORY MERGERS & FULL STOCK ACQUISITION fair value can be measured reliably

reliably

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DISCUSSION EXERCISES STRAIGHT PROBLEMS: 1. On January 1, 2019, ALABAMA CORP. acquired all the assets and assumed all of the liabilities of ALABANG INC. As of this date, the carrying amounts and fair values of the assets and liabilities of ALABANG acquired by ALABAMA are shown below: Carrying amounts Fair value Petty cash fund 10,000 10,000 Receivables 200,000 120,000 Allowance for doubtful accounts (30,000) Inventory 520,000 350,000 Building – net 1,000,000 1,100,000 Goodwill 100,000 20,000 Payables 400,000 400,000 On the negotiation for the business combination, ALABAMA incurred transaction costs amounting to P100,000 for legal, accounting and consultancy fees. REQUIREMENTS: (a) If ALABAMA paid P1,500,000 cash as consideration for the assets and liabilities of ALABANG, how much is the goodwill or gain or bargain purchase on the business combination? Consideration transferred Fair value of net identifiable assets (P1,580,000 – P400,000) Goodwill

(b)

If ALABAMA paid P1,000,000 cash as consideration for the assets and liabilities of ALABANG, how much is the goodwill or gain or bargain purchase on the business combination? Consideration transferred Fair value of net identifiable assets (P1,580,000 – P400,000) Goodwill

(c)

P1,000,000 (1,180,000) P180,000

If ALABAMA is an SME and paid P1,500,000 cash as consideration for the assets and liabilities of ALABANG, how much is the goodwill or gain or bargain purchase on the business combination? Consideration transferred (P1,500,000 + 100,000) Fair value of net identifiable assets (P1,580,000 – P400,000) Goodwill

2.

P1,500,000 (1,180,000) P320,000

P1,600,000 (1,180,000) P420,000

On January 1, 2020, ALASKA CORP. acquired all the assets and assumed all the liabilities of CONDENSADA CORP for the following considerations: Cash of P200,000 plus an installment payment of P1,000,000 on December 31, 2020. The  incremental borrowing rate of ALASKA is 5% per annum. (Round-off present value factors in 2 decimal places) Bonds payable with a face value of P500,000. At the acquisition date, the bonds are trading at  110. The bonds are classified as financial liability at amortized cost. ALASKA agreed to pay additional P200,000 on January 1, 2022 if the average income of  CONDENSADA during the 2-year period of 2020 – 2022 exceeds P10 million per year. The expected value is P200,000 calculated based on the 40% probability of achieving the target average income. As of this date, the carrying amounts and fair values of the assets and liabilities of CONDENSADA are shown below: Carrying amounts Fair value Current assets 500,000 800,000 Building – net 400,000 200,000 Equipment – net 200,000 150,000 Patent 200,000 Computer software 150,000 Current liabilities 300,000 350,000 Additional information:  CONDENSADA is a defendant in a pending litigation for which no provision was recognized because CONDENSADA believes that it will win the case. The fair value of settling the litigation is P100,000.  ALASKA is renting out a building to CONDENSADA under an operating lease. The terms of the lease compared with market terms are favorable. The fair value of differential is P50,000.  CONDENSADA has research and development projects with a fair value of P150,000. However, CONDENSADA recognized the costs expenses.  The assets include an equipment which was assigned a provisional amount of P150,000. This equipment was assigned a tentative useful life of 10 years and to be depreciated using straightline method. The equipment’s fair value on October 1, 2020 is P300,000.  In addition, ALASKA had an out-of-pocket costs of P10,000 for direct cost, P5,000 for indirect costs and P20,000 for bond issuance costs. REQUIREMENTS: (a) Compute the amount of goodwill arising from the business combination.

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PSBA: AFAR 04_BUSINESS COMBINATIONS: STATUTORY MERGERS & FULL STOCK ACQUISITION Consideration transferred: Cash Notes payable (1,000,000 x 0.95) Bonds payable (500,000 x 1.10) Contingent consideration Fair value of net identifiable assets: Current assets Building – net Equipment – net Patent Research and development costs Operating lease – intangible assets Current liabilities Contingent liabilities Goodwill Adjustment for provisional amounts Adjusted amount of goodwill

(b)

800,000 200,000 150,000 200,000 150,000 50,000 (350,000) (100,000)

P200,000 950,000 550,000 200,000 800,000 200,000 150,000 200,000 150,000 (50,000) (350,000) (100,000)

P1,900,000

1,000,000 P900,000 150,000 P1,050,000

P1,900,000

1,100,0...