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Advanced Financial Accounting: Chapter 3 Group Reporting II: Application of the Acquisition Method under IFRS 3 Tan & Lee Chapter 31© 2009.

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Presentation on theme: "Advanced Financial Accounting: Chapter 3 Group Reporting II: Application of the Acquisition Method under IFRS 3 Tan & Lee Chapter 31© 2009."— Presentation transcript:

1 Advanced Financial Accounting: Chapter 3 Group Reporting II: Application of the Acquisition Method under IFRS 3 Tan & Lee Chapter 31© 2009

2 Learning Objectives 1.Understand the difference between investor’s separate financial statements and the consolidated statements; 2.Understand the consolidation process; 3.Appreciate the acquisition method and its implications; 4.Know how to determine the cost of consideration transferred; 5.Understand the identification of the acquirer; 6.Know how to recognize and measure identifiable net assets under IFRS 3; 7.Understand the nature of goodwill; 8.Review the concept of non-controlling interests (NCI) with respect to parent and entity theories; and 9.Know how to prepare consolidation journal entries relating to fair value adjustment at acquisition date and subsequent years Tan & Lee Chapter 32© 2009

3 Content Tan & Lee Chapter 3© Introduction 2.Overview of the consolidation process 3.The acquisition method 4.Determining the amount of consideration transferred 5.Recognition and measurement of identifiable assets, liabilities and goodwill 6.Accounting for non-controlling interests under IFRS 3 7.Effects of amortization, depreciation and disposal of undervalued or overvalued assets and liabilities subsequent to acquisition 8.Goodwill impairment tests 1. Introduction

4 Separate Vs Consolidated Financial Statements Tan & Lee Chapter 3© Separate financial statements (Legal entity) Consolidated financial statements (Economic entity) Income recognitionDividendsShare of profits Asset recognition Investment in a Subsidiary carried at: Cost (IAS 27) or As a financial instrument (IAS 39) Investment in Subsidiary: Investment is eliminated and subsidiary’s net assets are added to the parent (IAS 27) Investment in an associate carried at: Cost (IAS 28) or As a financial instrument (IAS 39) Investment in an associate: Equity method (IAS 28)

5 Content Tan & Lee Chapter 3© Introduction 2.Overview of the consolidation process 3.The acquisition method 4.Determining the amount of consideration transferred 5.Recognition and measurement of identifiable assets, liabilities and goodwill 6.Accounting for non-controlling interests under IFRS 3 7.Effects of amortization, depreciation and disposal of undervalued or overvalued assets and liabilities subsequent to acquisition 8.Goodwill impairment tests 2. Overview of the consolidation process

6 Consolidation Process Consolidation is the process of preparing and presenting the financial statements of a group as an economic entity No ledgers for group entity Consolidation worksheets are prepared to: –Combine parent and subsidiaries financial statements –Adjust or eliminate intra-group transactions and balances –Allocate profit to non-controlling interests Tan & Lee Chapter 3© Parent’s Financial Statements + Subsidiaries' Financial Statements +/- Consolidation adjustments and eliminations = Consolidated financial statements Legal entities Economic entity

7 Intragroup Transactions Intragroup transactions are eliminated to: –Show the financial position, performance and cashflow of the economic (not legal) entity –Avoid double counting of transactions Example: Parent sold inventory to subsidiary for $2M The original cost of inventory is $1M Subsidiary eventually sold the inventory to external parties for $3M Q: What is the journal entry to eliminate intragroup sales transaction? Tan & Lee Chapter 3© Consolidation adjustment DrSale2,000,000 CrCost of sale2,000,000

8 Intragroup Transactions Tan & Lee Chapter 3© Extract of consolidation worksheet Parent's Income Statement Subsidiary’s Income Statement Consolidation elimination entries and adjustments Consol. Income Statement Without elimination DrCr Sales $2,000,000 $3,000,000 2,000,000 $3,000,000$5,000,000 Cost of sales (1,000,000) (2,000,000) 2,000,000 (1,000,000)($3,000,000) Gross profit $1,000,000 $2,000,000 Note: Without elimination the consolidated sales and cost of sales figures will be overstated by $2 M.

9 Content Tan & Lee Chapter 3© Introduction 2.Overview of the consolidation process 3.The acquisition method 4.Determining the amount of consideration transferred 5.Recognition and measurement of identifiable assets, liabilities and goodwill 6.Accounting for non-controlling interests under IFRS 3 7.Effects of amortization, depreciation and disposal of undervalued or overvalued assets and liabilities subsequent to acquisition 8.Goodwill impairment tests 3. The acquisition method

10 Business Combinations 結合 Tan & Lee Chapter 3© Business combinations Legal merger of net assets of acquired businesses into acquirer’s books Businesses become subsidiaries of acquirer Net assets of combining entities transferred to a newly-formed entity Former owners of a combining entity obtains control of combined entity Where an acquirer obtains control of one or more businesses (IFRS 3 App A) Examples: IFRS 3 App B:B6

11 The Acquisition Method IFRS 3 requires all business combinations to be accounted for using the acquisition method The procedures: Tan & Lee Chapter 3© Identify the acquirer Determine the acquisition date Recognize and measure the identifiable assets acquired the liabilities assumed and any non-controlling interest in the acquiree; and Recognize and measure goodwill or a gain from a bargain purchase Group financial statements if acquire subsidiaries 4-step approach: IFRS 3:5

12 Identify the Acquirer IFRS 3 requires the identification of the acquirer in all circumstances –Acquirer is the entity that obtains control of another combining entities –Control is the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities Tan & Lee Chapter 3©

13 Identify the Acquirer Tan & Lee Chapter 3© Additional control criteria under IFRS 3 Appendix B Acquirer is the entity that: Transfers cash or other assets or incurs liabilities to acquire another entity  Issues shares as purchase consideration  Pays a premium over the fair value of the equity interest Acquirer is the entity that: Has the largest relative voting rights in a combined entity Holds the largest minority voting interest in the combined entity (if no other entity has significant voting interest) Is relatively larger in size Acquirer is the entity: Whose owners have the ability to elect, appoint or remove a majority of directors Whose management is dominant in the combined entity Who initiates the business combination Based on consideration transferred Based on entity sizeBased on dominance

14 Identify the Acquirer Reverse acquisition –Legal parent is the acquiree and legal subsidiary is the acquirer –Often initiated by the legal subsidiary –Has other motive of entering into such an arrangement (eg. Backdoor listing) Exchange of shares in a reverse acquisition Tan & Lee Chapter 3© Owners of Company B (Legal subsidiary) Company A (Legal parent) Company B (Legal subsidiary) 1. Company A (Legal parent) takes over shares of Company B from owners 2. Company A issues own shares to owners of Company B as purchase consideration 3. Company B has the power to govern the financial and operating policies of the legal parent

15 Content Tan & Lee Chapter 3© Introduction 2.Overview of the consolidation process 3.The acquisition method 4.Determining the amount of consideration transferred 5.Recognition and measurement of identifiable assets, liabilities and goodwill 6.Accounting for non-controlling interests under IFRS 3 7.Effects of amortization, depreciation and disposal of undervalued or overvalued assets and liabilities subsequent to acquisition 8.Goodwill impairment tests 4. Determining the amount of consideration transferred

16 Determine the Amount of Consideration Transferred Fair value of the consideration transferred: –Determined on the acquisition date –Acquisition date is the date when the acquirer obtains control and not the date when consideration is transferred Tan & Lee Chapter 3© Fair value of assets transferred + Fair value of liabilities incurred + Fair value of equity interests issued by acquirer Consideration transferred = + Fair value of contingent consideration

17 Fair Value of Assets Transferred or Liabilities Assumed If assets transferred or liabilities assumed are not carried at fair value in the acquirer’s separate financial statements: –Remeasured gain or loss is recognized in the acquirer’s separate financial statements –Remeasured gain or loss is not recognized if the assets or liabilities remain in the combined entity’s financial statements If transfer of monetary assets or liabilities are deferred: –The fair value will be the present value of the future cashflows –Eg. Future cash settlement of $1,000,000 is due 3 years later and 3% interest is levied Fair value = $1,000,000/ (1+0.03)^3 = $915,142 Tan & Lee Chapter 3©

18 Fair value of Equity Interests Issued by the Acquirer Fair value of equity interests issued is measured by: –Market price –If market price is not available or not reliable: A proportion of acquirer’s fair value or proxied by the fair value of equity interest acquired, whichever is more reliably measurable Tan & Lee Chapter 3©

19 Illustration 1: Fair Value of Equity Issued P Ltd acquires 100% of S Co through an issue of 5,000,000 shares to the vendors of S Co. Tan & Lee Chapter 3© P Ltd S Co Number of existing shares 10,000,000 2,000,000 Number of new shares issued 5,000,000 - Market price per share $ Fair value of equity $24,000,000 $9,000,000

20 Illustration 1: Fair Value of Equity Issued Tan & Lee Chapter 3© Q1: P Ltd’s market price is a reliable indicator Consideration transferred = 5,000,000 shares x $ 2.00 = $10,000,000 Q2: P Ltd’s market price is not a reliable indicator; a proportional interest in the fair value of P Ltd is a better estimate Consideration transferred = (5,000,000/15,000,000) x $24,000,000 = $8,000,000 Q3: Fair value of S Co is a better estimate Consideration transferred = $9,000,000

21 Fair Value of Contingent Consideration Contingent consideration –Obligation (right) of the acquirer to transfer (receive) additional assets or equity interests to (from) acquiree’s former owner if specific event occurs Eg. Acquirer gets a refund of a part of the consideration transferred if the acquiree does not achieve the target profit –Fair value of the contingent consideration (refund) is added to (deducted from) consideration transferred Tan & Lee Chapter 3©

22 Acquisition-Related Costs All acquisition-related costs are expensed off Costs of issuing debt are recognized in accordance with IAS 39 –As yield adjustment to the cost of borrowing and are amortized over the life of the loan –Journal entry for the payment of debt issuance cost Costs of issuing equity are recognized in accordance with IAS 32 –A reduction against equity –Journal entry to record the payment of cost of issuing equity Tan & Lee Chapter 3© DrUnamortized debt issuance costs Cr Cash DrEquity Cr Cash

23 Content Tan & Lee Chapter 3© Introduction 2.Overview of the consolidation process 3.The acquisition method 4.Determining the amount of consideration transferred 5.Recognition and measurement of identifiable assets, liabilities and goodwill 6.Accounting for non-controlling interests under IFRS 3 7.Effects of amortization, depreciation and disposal of undervalued or overvalued assets and liabilities subsequent to acquisition 8.Goodwill impairment tests 5. Recognition and measurement of identifiable assets, liabilities and goodwill

24 Elimination of Investment Account Investment account is eliminated –Substituted with subsidiary’s 1. identifiable net assets and 2.goodwill (residual) –Avoid recognizing assets in two forms (investment in parent’s balance sheet and individual assets and liabilities of the subsidiary) Tan & Lee Chapter 3© Share of book value of subsidiary’s net assets at acquisition date + Share of excess of fair value over book value of identifiable net assets + Goodwill Consideration transferred = Eliminated against subsidiary’s share capital and pre- acquisition retained earnings What the parent is paying for

25 Recognition Principle Tan & Lee Chapter 3© Business Combination accounted under the acquisition method At acquisition date, the acquirer will recognize subsidiary’s net assets at fair value Rationale: There has been an exchange transaction at arm-length pricing There is an effective ”purchase”* of the subsidiary’s identifiable assets and liabilities at fair value To qualify for recognition: Identifiable net assets must meet the definition of an asset or a liability Identifiable net assets must be priced into the “consideration transferred” *Look at next slice

26 Recognition Principle Tan & Lee Chapter 3© Effective purchases Meaning: Under acquisition method, an acquirer obtains control through purchases of equity interests in an acquiree, there is deemed to be an effective purchases of the assets and assumption of the liabilities of the acquiree by an acquirer.

27 Recognition Principle Tan & Lee Chapter 3© Fair value differential (FV-BV) of identifiable net assets Book value of subsidiary’s identifiable net assets In separate financial statements Book value of subsidiary’s identifiable net assets recognized in consolidated financial statements At acquisition date: Fair value differential will be recognized in the consolidation worksheet In subsequent years: Depreciation/amortization/ cost of sale of asset will be based on the fair value recognized at the acquisition date These entries have to be re- enacted every year until disposal of investment

28 Intangible Assets IFRS 3 requires the acquirer to recognize the fair value of an acquiree’s unrecognized identifiable asset (e.g. intangible asset) in the combined financial statements –Justified by the acquisition of the subsidiary by the parent To qualify for recognition, the intangible asset must be: Or must arise from contractual or legal rights Example: Assembled workforce with specialized knowledge Fails to meet the separability criterion Opportunity gains from an operating lease in favorable market conditions Meets the contractual-legal criterion Tan & Lee Chapter 328© 2009

29 Contingent Liabilities & Provisions Contingent liabilities are recognized if they are: –Present obligations arising from past events and –Reliably measurable in their fair value, even if outcome is not probable (IFRS 3:23) Provisions for restructuring & termination cost are recognized if they are: Present constructive or legal obligations arising from past events Reliably measurable Tan & Lee Chapter 329© 2009 Probable outflow of economic resources

30 Indemnification Assets 賠償 Contractual indemnity –Provided by the sellers of the acquiree to the acquirer to make good any loss arising from contingency or an asset or a liability Treatment for indemnity –The acquirer has to recognize an “indemnification asset” at the same time the indemnified asset or liability is recognized –The indemnification asset is measured on the same basis as the indemnified asset or liability Eg. An acquiree is exposed to a contingent liability. Based on probabilistic estimation, the FV of the contingent liability is $100,000. The seller provides a contractual guarantee to indemnify the acquirer of the loss. –In the consolidated balance sheet, contingent liabilities and an indemnification asset of $100,000 will be recognized at fair value Tan & Lee Chapter 3©

31 Deferred Tax Relating to FV Differentials of Identifiable Assets and Liabilities The recognition of fair value differential may give rise to future tax payable or future tax deduction –tax effects need to be accounted for if the basis of taxation does not change in a business combination –i.e. If original asset is deductible based on book value, the FV differential will give rise to a temporary taxable/deductible different No deferred tax liability is recognized on goodwill Tan & Lee Chapter 3© FV > Book value of identifiable assetsDeferred tax liabilities FV < Book value of identifiable assetsDeferred tax assets FV < Book value of identifiable liabilitiesDeferred tax liabilities FV > Book value of identifiable liabilitiesDeferred tax assets

32 Measurement Period IFRS 3 allows adjustments to be made retrospectively 回顧地 to goodwill, fair value of identifiable net assets and consideration transferred: –If new information about facts and circumstances existing at acquisition date arises, –Within 1 year of acquisition date After 1 year, any correction of errors will be deemed as a prior - period adjustment Any change in estimate arising from new information on facts and circumstances after the acquisition date will be recognized in the current period and not retrospectively Tan & Lee Chapter 3©

33 Goodwill A premium that a parent pays to acquire the subsidiary –Must be recognized separately as an asset –Determined as a residual IFRS 3 allows 2 ways of determining goodwill: Tan & Lee Chapter 3© Fair value of consideration transferred + Amount of non-controlling interests + Fair value of the acquirer’s previously held interest (before control was achieved) in the acquiree - Acquiree’s recognized net identifiable assets measured in accordance with IFRS 3 Goodwill = Amount of non- controlling interests Measured at fair value at acquisition date (include goodwill) Measured as a proportion of identifiable assets as at acquisition date

34 Goodwill Tan & Lee Chapter 3© Integral to the entity as a whole, not individually identifiable or severable as a standalone asset

35 Goodwill The “top-down approach” (Johnson and Petrone, 1998) results in measurement errors in goodwill Tan & Lee Chapter 335 Goodwill residual Consideration transferred + Amount of non-controlling interests Identifiable net assets Overpayment for an acquisition or overvaluation of consideration transferred Measurement and recognition errors Above errors impact goodwill © 2009

36 Goodwill In a “bottom-up” approach (Johnson and Petrone, 1998), goodwill is substantiated as follows: Tan & Lee Chapter 3© “Going concern element” and represent the ability of an entity to generate higher rate of return over its individual assets or “core goodwill” Generated from the unique combination of the acquirer and acquiree or “combination goodwill”

37 Gain From a Bargain Purchase A gain from bargain purchase arises when: The acquirer must re-assess the fair value of identifiable net assets, consideration transferred and non-controlling interests. If there is no measurement error: –The gain will be recognized immediately in the income statement Tan & Lee Chapter 3© Fair value of consideration transferred + Amount of non-controlling interests + Fair value of the acquirer’s previously held interest in the acquiree Acquiree’s net identifiable assets measured in accordance with IFRS 3 <

38 Content Tan & Lee Chapter 3© Introduction 2.Overview of the consolidation process 3.The acquisition method 4.Determining the amount of consideration transferred 5.Recognition and measurement of identifiable assets, liabilities and goodwill 6.Accounting for non-controlling interests under IFRS 3 7.Effects of amortization, depreciation and disposal of undervalued or overvalued assets and liabilities subsequent to acquisition 8.Goodwill impairment tests 6. Accounting for non-controlling interest under IFRS 3

39 Non-Controlling Interests’ Share of Goodwill IFRS 3 Para 19 allows NCI to be measured in either of two ways Tan & Lee Chapter 3© Non-controlling interests Measured at Fair value at acquisition date (include goodwill) (Fair value option) Measured as a proportion of identifiable assets as at acquisition date

40 Non-Controlling Interests’ Share of Goodwill Under the fair value option: –FV is determined by either the active market prices of subsidiary’s equity share at acquisition date or other valuation techniques –FV per share of NCI may differ from parent due to control premium paid by parent –NCI comprises of 3 items: Tan & Lee Chapter 3© Non – controlling interests Share of book value of net assets Share of unamortized FV adjustment (FV - BV) Share of unimpaired goodwill

41 Non-Controlling Interests’ Share of Goodwill Under the fair value option: –Journal entry to record NCI at fair value (re-enacted each year): Tan & Lee Chapter 3© DrShare capital of subsidiary DrRetained earnings at acquisition date DrOther equity at acquisition date (eg. RS, SP, GR) Dr/CrFV differentials (FV- BV)/ (BV-FV) DrGoodwill (Parent & NCI) Dr/Cr Deferred tax asset/ (liability) (JUST)on fair value adjustment CrInvestment in subsidiary CrNon-controlling interests (At fair value) -FP

42 Non-Controlling Interests’ Share of Goodwill Under the 2 nd option: –NCI is a proportion of the acquiree’s identifiable net assets –NCI comprises of 2 items: Tan & Lee Chapter 3© Non – controlling interests Share of book value of net assets Share of unamortized of FV adjustments (FV- BV)

43 Non-Controlling Interests’ Share of Goodwill Under the 2 nd option: –Journal entry to record NCI (re-enacted each year): Tan & Lee Chapter 3© DrShare capital of subsidiary DrRetained earnings at acquisition date DrOther equity at acquisition date DrFV differentials DrGoodwill (Parent only) Dr/CrDeferred tax asset/ (liability) on FV adjustment CrInvestment in S subsidiary Cr Non-controlling interests (NCI % x FV of identifiable net assets of that company)

44 Non-Controlling Interests’ Share of Goodwill Tan & Lee Chapter 3© NCI measured at FV NCI measured as a proportion of the acquiree’s identifiable net assets Book value of net assets Fair value – Book value of net assets Goodwill

45 Accounting for Non-Controlling Interests under IFRS 3 In consolidation, non-controlling interests have a share of: Profit after tax Dividends declared Share capital Retained earnings and other comprehensive income (eg. Revaluation reserve) at acquisition date Change in retained earnings and other comprehensive income from the date of acquisition to the current period Fair value differential of a subsidiary’s net assets at acquisition date Goodwill (if the fair value alternative is adopted) Tan & Lee Chapter 3©

46 Reconstructing NCI on Balance Sheet Tan & Lee Chapter 3© Date of acquisition Beginning of current year End of current year NCI have a share of 1.Share capital 2.Retained earnings 3.Other equity 4.Fair value differentials 5.Goodwill NCI have a share of 1.Change in share capital* 2.Change in retained earnings 3.Change in other equity 4.Past amortization of fair value differential 5.Past impairment of goodwill NCI have a share of 1.Profit after tax 2.Current amortization of fair value differential 3.Current impairment of goodwill 4.Dividends as a repayment of profits 5.Change in other equity

47 Allocation to Non-controlling Interests Tan & Lee Chapter 3© Allocation of the change in equity from date of acquisition to the current year To transfer the NCI’s share of subsidiary’s retained earnings to NCI 2.Allocation of current profit after tax to NCI Dr Retained earnings (NCI % x in RE from acquisition date to beginning of current period) Cr NCI Dr Income to NCI Cr NCI

48 Allocation to Non-controlling Interests Tan & Lee Chapter 3© Allocation of dividends to NCI A realization of residual in a subsidiary Reduces the NCI’s stake in the net assets of the subsidiary Elimination of dividends as follows: 4.Can NCI be a debit balance? If NCI’s share of losses in a subsidiary > NCI’s existing share of subsidiary’s net assets: NCI will have a debit balance under IAS 27 DrDividend income (Parent) DrNCI (BS) CrDividends declared (Subsidiary)

49 Analytical check on Non-controlling Interests’ balance Tan & Lee Chapter 3© NCI’s balance at year-end NCI’s share of: a)Book value of net assets of subsidiary at year-end -/+ unrealized profit/loss from upstream sale b)Unamortized balance of FV adjustments at year-end c)Unimpaired balance of goodwill at year- end =

50 Content Tan & Lee Chapter 3© Introduction 2.Overview of the consolidation process 3.The acquisition method 4.Determining the amount of consideration transferred 5.Recognition and measurement of identifiable assets, liabilities and goodwill 6.Accounting for non-controlling interests under IFRS 3 7.Effects of amortization, depreciation and disposal of undervalued or overvalued assets and liabilities subsequent to acquisition 8.Goodwill impairment tests 7. Effects of amortization, depreciation and disposal of undervalued or overvalued assets and liabilities subsequent to acquisition

51 In Subsequent PERIOD Tan & Lee Chapter 3© At acquisition date, we recognize: –Fair value of identifiable net assets, –Intangibles, contingent liabilities, and –Deferred tax assets or liabilities on the above In subsequent years: –Amortization, depreciation and cost of sales of the acquired assets must be based on the fair value as at acquisition date –Since net assets are carried at book value in the separate financial statements, the subsequent amortization/depreciation/disposal are adjusted in the consolidation worksheet –Eg. When an identified asset is sold or depreciated: (FV- BV) adjustment to expense = FV of expense in consolidated financial statements BV of expense in separate financial statements + Adjusted in consolidation worksheet

52 Illustration 2: Amortization of Fair Value Differentials Tan & Lee Chapter 3© P Co paid $6,200,000 and issued 1,000,000 of its own shares to acquire 80% of S Co on 1 Jan 20X5 Fair value of P Co’s share is $3 per share Fair value of net identifiable assets is as follows: Book valueFair valueRemaining useful life Leased property4,000,0005,000, years In-process R&D 2,000,00010 years Other assets1,900,000 Liabilities(1,200,000) Contingent liability (100,000) Net assets4,700,0007,600,000 Share capital1,000,000 Retained earnings3,700,000 Shareholders’ equity4,700,000

53 Illustration 2: Amortization of Fair Value Differentials Additional information: Contingent liability of $100,000 was recognized as a provision by the acquiree in Dec 20X5 FV of NCI at acquisition date was $2,300,000 Net profit after tax of S Co for 31 Dec 20X5 was $1,000,000 No dividends were declared during 20X5 Shareholders’ equity as at 31 Dec 20X5 was $5,700,000 Q1 : Prepare the consolidation adjustments for P Co for 20X5 Q2 : Perform analytical check on balance of NCI as at 31 Dec 20X5 Tan & Lee Chapter 3©

54 Illustration 2: Amortization of Fair Value Differentials Consideration transferred = Cash consideration + Fair value of share issued = $6,200,000 + (1,000,000 x $3) = $9,200,000 Deferred tax liability = 20% x ($7,600,000 - $4,700,000) = $580,000 Goodwill = Consideration transferred + NCI – Fair value of net identifiable assets, after-tax = $9,200,000 + $2,300,000 – ($7,600,000 - $580,000) = $4,480,000 Tan & Lee Chapter 3©

55 Illustration 2: Amortization of Fair Value Differentials Tan & Lee Chapter 3© P’s share of goodwill = Consideration transferred – 80% x Fair value of net identifiable assets, after tax = $9,200,000 – 80% x $7,020,000 = $9,200,000 – $5,616,000 = $3,584,000 NCI’s share of goodwill = Consideration transferred – 20% x Fair value of net identifiable assets, after tax = $2,300,000 – 20% x $7,020,000 = $2,300,000 – $1,404,000 = $896,000

56 Illustration 2: Amortization of Fair Value Differentials Tan & Lee Chapter 3© Consolidation adjustments for 20X5 CJE 1: Elimination of investment in S DrShare capital1,000,000 DrRetained earnings3,700,000 DrLeased property1,000,000 DrIn-process R&D2,000,000 DrGoodwill4,480,000 CrContingent liability100,000 CrDeferred tax liability580,000 CrInvestment in S9,200,000 CrNon-controlling interests2,300,000

57 Illustration 2: Amortization of Fair Value Differentials Tan & Lee Chapter 3© $200,000 Dep exp: $50,000 Dep. of leased property Based on book value Based on FV $200,000 Under dep. by $50k $ 0 Amort exp: $200,000 Amort. of R&D Based on book value Based on FV Under amort. by $200k CJE 2: Depreciation and amortization of excess of FV over book value DrDepreciation of leased property50,000 DrAmortization of in-process R&D200,000 CrAccumulated depreciation50,000 CrAccumulated amortization200,000

58 Illustration 2: Amortization of Fair Value Differentials Tan & Lee Chapter 3© CJE 3: Reversal of entry relating to provision for lawsuit DrProvision for lawsuit -FP100,000 CrLoss from lawsuit -I/S100,000 Note: Contingent liability was already recognized in CJE 1. The recognition by the acquiree results in double counting; hence this reversal entry is necessary CJE 4: Tax effects on CJE 2 & CJE 3 DrDeferred tax liability30,000 CrTax expense30,000 20% * (200k +50k -100k)

59 Illustration 2: Amortization of Fair Value Differentials Tan & Lee Chapter 3© CJE 5: Allocation of current year profit to non-controlling interests (NCI) DrIncome to NCI176,000 CrNCI176,000 Net profit after tax1,000,000 Excess depreciation(50,000) Excess amortization(200,000) Reversal of loss from lawsuit100,000 Tax effects on FV adjustments30,000 Adjusted net profit880,000 NCI’s share (20%)176,000

60 Illustration 2: Amortization of Fair Value Differentials Tan & Lee Chapter 3© NCI balance: NCI at acquisition date (CJE 1)$2,300,000 Income allocated to NCI for 20x5 (CJE 5)176,000 NCI as at 31 Dec 20x5$2,476,000

61 Illustration 2: Amortization of Fair Value Differentials Tan & Lee Chapter 3© Q2 : Perform an analytical check on the balance of NCI as at 31 Dec 20X5 Non – controlling interests Share of book value of net assets Share of unamortized FV adjustment Share of unimpaired goodwill $5,700,000 x 20% = $1,140,000 + ($1,000,000 x 19/20 x 80% x 20%) + ($2,000,000 x 9/10 x 80% x 20%) = $440,000 + $896,000 = $2,476,000

62 Content Tan & Lee Chapter 3© Introduction 2.Overview of the consolidation process 3.The acquisition method 4.Determining the amount of consideration transferred 5.Recognition and measurement of identifiable assets, liabilities and goodwill 6.Accounting for non-controlling interests under IFRS 3 7.Effects of amortization, depreciation and disposal of undervalued or overvalued assets and liabilities subsequent to acquisition 8.Goodwill impairment tests

63 Goodwill Impairment Test IAS 36: Goodwill has to be reviewed annually for impairment loss –Reviewed as part of a cash-generating unit (CGU) CGU is the lowest level at which the goodwill is monitored for internal management purposes and Not larger than a segment determined under segment reporting –Goodwill will be allocated to each of the acquirer’s CGU, or group of CGUs Tan & Lee Chapter 3©

64 Goodwill Impairment Test Tan & Lee Chapter 3© Carrying amount: –Net assets of the cash-generating unit –It includes entity goodwill attributable to parent and NCI 2.Recoverable amount: –Higher of 1.FV less cost to sell (an arms-length measure), or Uses market based inputs in the pricing mechanism –2.Value in use Uses internal or entity-specific input to determine the future cash flows 3.If carrying amount > recoverable amount –Impairment loss is allocated to goodwill –Then to other assets in proportion to their individual carrying amounts –Impairment once made is not reversible, as it may result in the recognition of internally-generated goodwill which is prohibited under IAS 38

65 Goodwill Impairment Test Tan & Lee Chapter 3© Determine the carrying amount of the CGU Determine the recoverable amount of the CGU If carrying amount ≤ recoverable amount If carrying amount ≥ recoverable amount No impairment loss Allocate impairment loss to goodwill first and balance to other net assets Recoverable amount: Higher of fair value or value in use Steps for impairment test

66 Goodwill Impairment Test Tan & Lee Chapter 3© NCI at FV at acquisition date NCI as a proportion of identifiable net asset at acquisition date Goodwill on consolidation Includes NCI’s share of goodwill Excludes NCI’s share of goodwill Carrying amount of cash- generating unit Goodwill is allocated to cash-generating unit without further adjustment Goodwill has to be grossed up to include NCI’s share Notionally adjusted goodwill = Recognized goodwill/ parent’s interest Impairment loss Impairment loss is shared between parent and NCI on the same basis on which profit or loss is allocated Impairment loss is borne only by parent as goodwill for NCI is not recognized

67 Conclusion Tan & Lee Chapter 3© All business combinations are accounted for using the acquisition method: –Consideration transferred = Fair value of (assets transferred + liabilities incurred + equity interests issued by acquirer + contingent consideration) –Investment account is eliminated and substituted with: Subsidiary’s identifiable net assets; and Goodwill –Goodwill = Fair value of (consideration transferred + non-controlling interests + acquirer’s previously held interest in the acquiree) – Acquiree’s recognized net identifiable assets

68 Conclusion In consolidation: –All intragroup balances and transactions are eliminated –Non-controlling interests have a share of: Profit after tax Dividends declared Share capital Retained earnings and other comprehensive income (eg. Revaluation reserve) from acquisition date to current period Fair value differential of a subsidiary’s net assets at acquisition date Goodwill (if the fair value alternative is adopted) –In the subsequent years, amortization, depreciation and cost of sales of the acquired assets are based on fair value as at acquisition date Tan & Lee Chapter 3©

69 Conclusion Dr/ Cr Goodwill/ Gain from a bargain purchases Dr/Cr FV (whole) Dr/Cr FV (diff) Dr Net Asset Cr/ Dr Contingent Liability / Contingent Asset Cr Investment in a subsidiary Cr NCI Cr/ Dr Deferred Tax Liability/ Deferred Tax asset Tan & Lee Chapter 3©


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