Ch25 sm loftus 2e - solution manual PDF

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Solutions manual to accompany

Financial reporting 2nd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Noel Boys

© John Wiley & Sons Australia, Ltd 2018

Chapter 25: Business combinations

Chapter 25: Business combinations Comprehension questions 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.” Para B7 of AASB 3/IFRS 3 identifies three elements of a business being inputs, processes and outputs.

2. Discuss the importance of identifying the acquisition date. Acquisition date is the date on which the acquirer obtains control of the acquiree. Important because on this date:  The fair values of the identifiable assets acquired and liabilities assumed are measured.  The fair value of the consideration transferred is measured  The goodwill or gain on bargain purchase is calculated.

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3. What is meant by ‘contingent consideration’ and how is it accounted for? Appendix A: Contingent consideration:  Usually, an obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are met. However, contingent consideration also may give the acquirer the right to the return of previously transferred consideration if specified conditions are met. See AASB 3/IFRS 3 paras. 39-40 Para 39: The consideration transferred includes any asset or liability resulting from a contingent consideration arrangement. This is measured at fair value at acquisition date. Para 40: The acquirer shall classify the obligation to pay contingent consideration as a liability or equity (depending on the characteristics of the instrument being transferred). Para 58: Changes in the measurement of the obligation subsequent to acquisition date resulting from events after the acquisition date are accounted for differently depending on whether the obligation was classified as equity or debt. If classified as equity, the equity shall not be remeasured. If classified as liability, it is accounted under AASB 9/IFRS 9 as appropriate.

4. Explain the key components of ‘core’ goodwill. Core goodwill has two main components: (i) Going concern goodwill: relates to the net assets of the acquiree, in that the acquiree’s net assets together are worth more than the net assets separately, caused by the synergy created by the acquiree’s net assets within the acquiree as a going concern. (ii) Combination goodwill: relates to the extra benefits accruing because of the synergy created by the acquirer and the acquiree combining together e.g. if the raw materials available to the acquiree are of particular use to the acquirer. These benefits could affect the recorded earnings of the acquirer or the acquiree [or both] depending on the nature of the benefits.

© John Wiley and Sons Australia Ltd, 2018

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Chapter 25: Business combinations

5. What recognition criteria are applied to assets and liabilities acquired in a business combination? Para 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. [Para 11]. The assets and liabilities recognised must also be part of the exchange transaction rather than resulting from separate transactions [para 12].

6. How is an acquirer identified? Para 6: For each business combination, one of the combining entities shall be identified as the acquirer. Appendix A: The acquirer is the entity that obtains control of the acquiree. Appendix A: Control is the power to govern the financial and operating policies of the acquiree so as to obtain benefits from its activities. Determination of the acquirer requires judgement. Paragraphs B13-B18 of AASB 3/IFRS 3 provides indicators/guidelines to assist in this judgement:  Form of consideration: did one entity transfer cash or other assets for the shares of the other? [para B14]; did one entity issue its own equity interests in exchange for another entity’s equity interests? [para B15] Was there a premium paid by one of the entities? [para B16(e)]  Subsequent management: which entity’s management subsequently controls the business combination? What are the relative voting rights after the business combination? [para B15(a)] What is the composition of the senior management of the combined entity? [para B15(d)]  Large minority voting interest: The acquirer normally holds the largest minority voting interest in the combined entity. [para B15(b)]  Predator or target: which entity initiated the combination? [B17]  Relative size of the businesses: is the fair value of one entity significantly greater than another? [para B16] Large entities normally takeover small entities.

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7. Explain the key steps in the acquisition method. AASB 3/IFRS 3 para 5: 1. Identify the acquirer (refer to answer to Question 6 above) 2. Determine the acquisition date i.e. the date on which the acquirer obtains control 3. Recognise and measure the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquire i.e. at their acquisition-date fair values 4. Recognise and measure goodwill or a gain from a bargain purchase i.e. the difference between the fair value of consideration transferred and the fair value of net assets acquired.

8. How is the consideration transferred calculated? AASB 3/IFRS 3 para 37 states that the consideration transferred shall be  Measured at fair value, determined at acquisition date, and  Calculated as the sum of the fair values of the assets transferred by the acquirer, the liabilities incurred by the acquirer, and the equity interests issued by the acquirer.

9. How is a gain on bargain purchase accounted for? AASB 3/IFRS 3 para 34 specifies the measurement of the gain, identified as the amount by which the fair value of net assets acquired exceeds the fair value of consideration transferred. Para 36 requires an acquirer to:  reassess the identification and measurement of the identifiable assets acquired and liabilities assumed, and measurement of the consideration transferred. This review is to ensure that the measurements are appropriate. Para 34 requires an acquirer, subsequent to para 36 procedures, recognise any remaining gain on bargain purchase immediately in profit or loss.

10. Why is it important to identify an acquirer in a business combination? Consider the example in para B18 in Appendix B to AASB 3/IFRS 3. Assume A Ltd and B Ltd combine together by creating C Ltd which acquires all the shares in A Ltd and B Ltd and issues its own shares in exchange. As noted in para B18, C Ltd is not necessarily the acquirer. What differences occur if either A Ltd or B Ltd is identified as the acquirer? 2 effects: (i) the consideration transferred is based on what the acquirer gives up; and (ii) the acquiree’s net assets are measured at fair value. In relation to point (ii), if A Ltd is the acquirer then in the consolidated financial statements B Ltd’s net assets are adjusted to fair value while A Ltd’s net assets are at the carrying amounts in A Ltd. If B Ltd is the acquirer, A Ltd’s net assets are adjusted to fair value while B Ltd’s net assets are at the carrying amounts in B Ltd.

© John Wiley and Sons Australia Ltd, 2018

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Chapter 25: Business combinations

Case studies Case study 25.1 Applying AASB 3/IFRS 3 Bass Ltd has recently undertaken a business combination with Bream Ltd. At the start of negotiations, Bass Ltd owned 30% of the shares of Bream Ltd. The current discussions between the two entities concerned Bass Ltd’s acquisition of the remaining 70% of shares of Bream Ltd. The negotiations began on 1 January 2016 and enough shareholders in Bream Ltd agreed to the deal by 30 September 2016. The purchase agreement was for shareholders in Bream Ltd to receive in exchange shares in Bass Ltd. Over the negotiation period, the share price of Bass Ltd shares reached a low of $5.40 and a high of $6.20. The accountant for Bass Ltd, Mr Spencer, knows that AASB 3/IFRS 3 has to be applied in accounting for business combinations. However, he is confused as to how to account for the original 30% investment in Bream Ltd, what share price to use to account for the issue of Bass 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 Spencer with advice on the issues that are confusing him.

© John Wiley and Sons Australia Ltd, 2018

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

Initially recorded at fair value plus transactions cost, based on para 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, para. 42 of AASB 3/IFRS 3 requires that the acquirer remeasure its previously held equity interest in the acquiree at its acquisitiondate 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. Para 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.

© John Wiley and Sons Australia Ltd, 2018

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Chapter 25: Business combinations

Case study 25.2 Accounting for goodwill Silver Ltd has acquired a major manufacturing division from Fern Ltd. The accountant, Ms Ball, has shown the board of directors of Silver Ltd the financial information regarding the acquisition. Ms Ball calculated a residual amount of $45 000 to be reported as goodwill in the accounts. The directors are not sure whether they want to record goodwill on Silver Ltd’s statement of financial position. Some directors are not sure what goodwill is or why the company has bought it. Other directors even query whether goodwill is an asset, with some being concerned with future effects on the statement of profit or loss and other comprehensive income. Required Prepare a report for Ms Ball to present to the directors to help them understand the nature of goodwill and how to account for it.

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Nature of goodwill: Goodwill is an intangible asset and is only recognised when it is acquired as a result of a business combination. Paragraph 11 of AASB 138/IAS 38 states:  “the future economic benefits [of goodwill] may result from synergy between the identifiable assets acquired or from assets that, individually, do not qualify for recognition”. Goodwill represents the premium paid by the acquirer over and above the fair value of the net assets presumably in the belief that the business will generate additional benefits from such synergy. It may arise because the acquirer has identified undervalued or unrecorded assets that the acquiree did not or could not (under accounting standards) recognise. Importantly, only acquired goodwill may be recognised. Paragraph 48 of AASB 138/IAS 38 explicitly states internally generated goodwill shall not be recognised as an asset. How to account for it: 

Acquired goodwill - Recognised, as an asset, only in a business combination. - Measured as a residual under para 32. - Subject to annual impairment test. - If allocated to CGU, any impairment loss is first allocated to goodwill until it is exhausted. - Goodwill impairment losses cannot be reversed (on the basis that to do so would be recognising internally generated goodwill).



Future effects on Statement of Profit or Loss and Other Comprehensive Income - Will only be an expense if an impairment loss is recognised. - Impairment loss cushioned by various accounting treatments such as use of cost method for PPE, non-recognition of internally generated goodwill & internally generated intangibles.

© John Wiley and Sons Australia Ltd, 2018

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Chapter 25: Business combinations

Case study 25.3 Identifying the acquirer White Ltd has been negotiating with Cloud Ltd for several months, and agreements have finally been reached for the two companies to combine. In considering the accounting for the combined entities, management realises that, in applying AASB 3/IFRS 3, an acquirer must be identified. However, there is debate among the accounting staff as to which entity is the acquirer. Required 1. What factors/indicators should management consider in determining which entity is the acquirer? 2. Why is it necessary to identify an acquirer? In particular, what differences in accounting would arise if White Ltd or Cloud Ltd were identified as the acquirer?

© John Wiley and Sons Australia Ltd, 2018

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The acquirer is the combining entity that obtains control of the other combining entities. [Appendix A, AASB 3/IFRS 3] 1. Factors: Determination of the acquirer requires judgement. Paragraphs B13-B18 of AASB 3/IFRS 3 provide indicators/guidelines to assist in this judgement in that the acquirer is usually the entity:  Form of consideration: that transfers cash or other assets for the shares of the other [para B14]; that issues its own equity interests in exchange for another entity’s equity interests [para B15] that pays a premium to one of the entities [para B16(e)].  Subsequent management: whose management subsequently controls the business combination and retains or receives the largest relative voting rights after the business combination [para B15(a)] whose management dominates the senior management of the combined entity [para B15(d)].  Large minority voting interest: that holds the largest minority voting interest in the combined entity [para B15(b)].  Predator or target: that initiated the combination [B17].  Relative size of the businesses: whose fair value is significantly greater than that of the other combining entities [para B16]]. (Large entities normally takeover small entities) 2. Why identify an acquirer? The consideration transferred is measured on the basis of the consideration given by the acquirer, while the identifiable assets and liabilities of the acquiree are measured at fair value. Differences: In relation to White Ltd – Cloud Ltd, the main effect then would be:  If White Ltd is the acquirer, the identifiable assets, liabilities and contingent liabilities of Cloud Ltd would be measured at their acquisition-date fair value while White Ltd assets and liabilities remain at their original carrying amounts.  If Cloud Ltd were the acquirer, it would be White Ltd’s assets and liabilities that would be measured at their acquisition-date fair value.

© John Wiley and Sons Australia Ltd, 2018

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Chapter 25: Business combinations

Case study 25.4 Accounting for research Tall Ltd has acquired all the net assets of Shorts Ltd with the latter going into liquidation. Both companies operate in the area of testing and manufacturing pharmaceutical products. One of the main reasons that Tall Ltd sought to acquire Shorts Ltd was that the latter company had an impressive record in the development of drugs for the cure of some mosquito-related diseases. Shorts Ltd employed a number of scientists who were considered to be international experts in their area and at the leading edge of research in their field. Much of the recent work undertaken by these scientists was classified for accounting purposes as research, and as per AASB 138/IAS 38 Intangible Assets was expensed by Shorts Ltd. However, in deciding what it would pay to take over Shorts Ltd, Tall Ltd had paid a sizeable amount of money for the ongoing research being undertaken by Shorts Ltd as it was expected that it would be successful eventually. The accountant for Tall Ltd, Mr Basket, has suggested that the amount paid by Tall Ltd for this research should be shown as goodwill in the company’s statement of financial position. However, the directors of the company do not believe that this faithfully represents the true nature of the assets acquired in the business combination, and want to recognise this as an asset separately from goodwill. Mr Basket believes that this will not be in accordance with AASB 138/IAS 38. Required Provide the directors with advice on the accounting for the aforementioned transaction.

© John Wiley and Sons Australia Ltd, 2018

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One of the problems in accounting for a business combination is that it is only after the acquirer obtains control of the acquiree that it can accurately determine what are the assets and liabilities of the acquiree and measure their fair values. This takes time. Hence the initial accounting for the business combination is done using best estimates – the provisional numbers - and will need to be adjusted after fair values have been reliably determined. The reason given for the provisional numbers is that there is to be a review of the fair values that have been used in the accounting for the business combination. Note para 45 of AASB 3/IFRS 3:  If the initial accounting for a business combination is incomplete by the end of the reporting period in which the combination occurs, the acquirer shall report in its financial statements provisional amounts for the items for which the accounting is incomplete. During the measurement period, the acquirer shall retrospectively adjust the provisional amounts recognised at the acquisition date to reflect new information obtained about facts and circumstances that existed as of the acquisition date and, if known, would have affected the measurement of the amounts recognised as of that date. During the measurement period, the acquirer shall also recognise additional assets or liabilities if new information is obtained about facts and circumstances that existed as of th...