Module 3 - Special Accounting Topics PDF

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Summary

Introduction/Overview This module aims to provide guidance on the proper accounting treatment for business combination in relation to goodwill, reverse acquisitions, and combination of mutual entities. Learning Outcomes a. Apply the methods of estimating goodwill b. Account for reverse acquisitions....

Description

1. Introduction/Overview

This module aims to provide guidance on the proper accounting treatment for business combination in relation to goodwill, reverse acquisitions, and combination of mutual entities. 2. Learning Outcomes a. b.

Apply the methods of estimating goodwill Account for reverse acquisitions.

3. Estimation of goodwill

Goodwill •

PFRS 3 provides that goodwill is an asset representing the future economic benefits arising from other assets Only acquired in a business combination that are not individually identified and separately recognized.

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a goodwill that arises from a business combination is recognized as an asset.

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Goodwill is measured and recognized on acquisition date. Subsequent expenditures on maintaining goodwill are expensed already.

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After initial recognition, goodwill is not amortized but rather tested for impairment at least annually. For this purpose, goodwill is allocated to each of the acquirer’s cash-generating unit (CGU) in the year of the business combination. If the allocation is not completed by the end of that year, it must be completed before the end of the immediately following year.

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Because goodwill is unidentifiable, it cannot be tested for impairment separately but only in conjunction with groups of assets that generate independent cash inflows (CGUs). Goodwill does not generate cash flows on its own but contributes on the cash flows of CGUs.

Due Diligence •

Due diligence audit refers to the investigation of all areas if a potential acquiree’s business before an investor agrees to a business combination transaction. The term “due diligence” may refer to the exercise of care that a reasonable and prudent person should take before entering a contract with another party. Due diligence audit is a service most commonly performed by CPAs or external auditing firms.

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Due diligence audit helps investor evaluate the possible risks and rewards of the potential investment and determine whether it would be a good decision to pursue it.

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Examples of potential risks which may be determined through a diligence audit: 1. Possibility of future losses due to the acquiree’s pending litigations and other unrecorded contingencies.

2. Overstatement in the consideration for the business combination due to the acquiree’s due to the overstated assets and understated liabilities. 3. Incompatibility of internal cultures, systems, and policies. •

Examples of potential rewards which may be determined through a due diligence audit: 1. Unrecorded assets, such as trade secrets. Trade names, customer lists, and the like. 2. Understatement in the consideration for the business combination due to the acquiree’s understated assets and overstated liabilities.

Methods of Estimating Goodwill Before the actual business combination transaction takes place, the amount of goodwill may be estimated using any of the following methods: A. Indirect valuation •

this is a residual approach wherein goodwill is measured as the excess of the sum of consideration transferred, non-controlling interest in the acquiree, and previously held equity interest in the acquiree over the fair value of net identifiable assets acquired. PFRS 3 requires this method and it is the method illustrated in the preceding discussions.

B. Direct valuation • •

Under this method, goodwill is measured based on expected future earnings from the business to be acquired. The application of the direct valuation method may require the determination of the following information: 1. Normal rate of return in the industry where the acquiree belongs. The normal rate of return may be the industry average determined from examination of annual reports of similar entities or from published statistical data. a. “Normal earnings” = (normal rate of return) x (acquiree’s net assets) 2. Estimated future earnings of the acquiree. a.

For purposes of goodwill measurement, the earnings of the acquiree are “normalized,” meaning earnings are adjusted for non-recurring income and expenses (e.g., expropriation gains or losses).

b.

The excess of the acquiree's normalized earnings over the average return in the industry represents the “excess earnings” to which goodwill is attributed. Excess earnings are sometimes referred to as “superior earnings.”

3.

Discount rate to be applied to "excess earnings”

4.

Probable duration of “excess earnings”

Illustration 1: Applications of the Direct valuation method Popoy Co. plans to acquire Basha Co. The following information was gathered through a due diligence audit: a. The actual earnings of Basha Co. for the past 5 years are shown below: Year

Earnings

2015

1,150,000

2016

1,450,000

2017

1,300,000

2018

1,350,000

2019

1,750,000

Total

7,000,000

b. Earnings in 2019 include an expropriation gain of ₱550,000. c. The fair value of Basha’s net assets as of the end of 2019 is ₱9,500,000. d. The industry average rate of return is 12%. e. Probable duration of “excess earnings” is 5 years. Method #1: Multiples of average excess earnings Under this method, goodwill is measured at the average excess earnings multiplied by the probable duration of excess earnings. Total earnings for the last 5 years

7,000,000

Less: Expropriation gain

(550,000)

Normalized earnings for the last 5 years Divided by:

6,450,000 5

(a) Average annual earnings

1,290,000

Fair value of acquiree’s net assets

9,500,000

Multiply by: Normal rate of return

12%

(b) Normal earnings

Excess earnings (a) – (b)

150,000

Multiply by: Probable duration of excess earnings Goodwill

5 750,000

Method #2: Capitalization of average excess earnings Under this method, goodwill is measured at the average excess earnings divided by a pre-determined capitalization rate. (Assume a capitalization rate of 25%). Average earnings [(7M – 550K expropriation gain) ÷ 5yrs] Normal Earnings (9.5M x 12%) Excess earnings Divided by: Capitalization rate

1,290,000 (1,140,000) 150,000 25%

Goodwill Method #3: Capitalization of average earnings Under this method, the average earnings are divided by a pre-determined capitalization rate to estimate the purchase price of the business combination. The excess of the estimated purchase price over the fair value of the acquiree’s net assets represents the goodwill. (Assume a capitalization rate of 12.50%). Average earnings [(7M – 550K expropriation gain) ÷ 5yrs] Divided by: Capitalization rate

1,290,000 12.50%

Estimated purchase price

10,320,000

Fair value of XYZ’s net assets

(9,500,000)

Goodwill

820,000

Method #4: Present value of average excess earnings Under this method, goodwill is measured at the present value of average excess earnings discounted at a pre-determined discount rate over the probable duration of excess earnings. (Assume a discount rate of 10%).

Average earnings [(7M – 550K expropriation gain) ÷ 5yrs] Normal Earnings in the industry (9.5M x 12%)

1,290,000 (1,140,000)

Excess earnings

150,000

Multiply by: PV of an ordinary annuity @10%, n=5

3.79079

Goodwill

568,619

4. Reverse Acquisitions

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In a reverse acquisition, the entity that issues securities (the legal acquirer) is identified as the acquiree for accounting purposes. The entity whose equity interests are acquired (the legal acquiree) must be the acquirer for accounting purposes.

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For example, reverse acquisitions sometimes occur when a private operating entity wants to become a public entity but does not want to register its equity shares. To accomplish that, the private entity will arrange for a public entity to acquire its equity interests in exchange for the equity interests of the public entity. In this example, the public entity is the legal acquirer because it issued its equity interests, and the private entity is the legal acquiree because its equity interests were acquired. However, in applying the acquisition-method: a. the public entity is the acquiree for accounting purposes (the accounting acquiree); and b. the private entity is the acquirer for accounting purposes (the accounting acquirer).

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The accounting acquiree must meet the definition of a business for the transaction to be accounted for as a reverse acquisition, and all of the recognition and measurement principles in this PFRS, including the requirement to recognize goodwill, apply.

Measuring the consideration transferred •

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In a reverse acquisition, the accounting acquirer usually issues no consideration for the acquiree. Instead, the accounting acquiree usually issues its equity shares to the owners of the accounting acquirer. The acquisition-date fair value of the consideration transferred by the accounting acquirer for its interest in the accounting acquiree is based on the number of equity interests the legal subsidiary (accounting acquirer) would have had to issue to give the owners of the legal parent (accounting acquiree) the same percentage of equity interest in the combined entity that results from the reverse acquisition.

Illustration: Reverse acquisition On January 1, 2020, Popoy Co., a publicly listed entity, and Basha Co., an unlisted company, exchange equity interests. Popoy Co. issues 5 shares in exchange for all the outstanding shares of Basha. Popoy’s shares are quoted at ₱50 per share, while Basha’s shares have a fair value of ₱150 per share. The statements of financial position immediately before the combination are shown below: (The assets and liabilities approximate their fair values.) Popoy Co. Basha Co. Identifiable assets

1,500,000

2,500,000

Total assets

1,500,000

2,500,000

Liabilities

1,100,000

850,000

Share capital 15,000 ordinary shares, ₱20 par

300,000

9,000 ordinary shares, ₱100 par 900,000 Retained earnings Total liabilities and equity

100,000

750,000

1,500,000

2,500,000

Requirements: a. Identify the accounting acquirer b. Compute for the goodwill Solution: Requirement (a): Basha Co. is the accounting acquirer. The business combination is a reverse acquisition because Basha (having 75% interest) obtains control over Popoy even though Popoy is the issuer of shares. Based on the facts provided, Popoy issues 5 shares for each of the 9,000 outstanding shares of Basha. After the issuance, Popoy’s equity will have the following structure:

Popoy’s currently issued shares

15,000

25%

Shares issued to XYZ (5 x 9,000)

45,000

75%

Total shares after the combination

60,000

Requirement (b): As to the substance of the problem, Basha obtains control over Popoy in a reverse acquisition. Accordingly, the consideration transferred is computed based on the number of shares Basha (accounting acquirer) would have had to issue to give Popoy (accounting acquiree) the same percentage of equity interest in the combined entity. Reverse – XYZ (accounting acquirer) issues shares to ABC Shares

%

Basha’s currently issued shares

9,000

75%

Shares issued to Popoy [(9,000÷75%) x 25%]

3,000

25%

Total shares after the combination

12,000

Basha would have had to issue 2,000 shares for the ratio of ownership interest in the combined entity to be the same. Consideration transferred (3,000sh x 150)

450,000

Non-controlling interest in the acquiree

-

Previously held equity interest in the acquiree

-

Total Fair value of Popoy’s net assets Goodwill

450,000 (400,000) 50,000

5. References Philippine Financial Reporting Standards (PFRSs) adapted by the Financial Reporting Standards Council based o the International Financial Reporting Standards (IFRSs), issued by the International Accounting Standards Board, 2020 2. Zeus Vernon B. Millan – Accounting for Business Combination (Advanced Accounting 2), Bandolin Enterprise (Publishing and Printing), Baguio City, Philippines, 2020 edition 3. https://www.ifrsbox.com/ifrs-3-business-combinations/ 1....