1. Advanced Financial Accounting: Chapter 3
Group Reporting II
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2. Learning Objectives
Understand the difference between investor’s separate financial statements and the consolidated statements;
Understand the differences and similarities in various mode of business combinations;
Appreciate the acquisition method and its implications;
Know how to determine the amount of consideration transferred;
Understand the identification of the acquirer;
Know how to recognize and measure identifiable net assets, liabilities and goodwill in accordance to IFRS 3; and
Understand the nature of goodwill.
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3. Content Introduction 1. Introduction
Overview of the consolidation process
Business combinations
Determining the amount of consideration transferred
Recognition and measurement of identifiable assets, liabilities and goodwill
Conclusion
Introduction
Check with professor with regards to content page.
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4. Separate financial statements Consolidated financial statements
Introduction
Separate financial statements
(Legal entity)
Consolidated financial statements
(Economic entity)
Governing rules and regulations
In accordance with corporate regulations
In accordance with IFRS 10
Possible exemptions for presentation
No exemption
IFRS 10 allowed for exemptions by a parent if it’s :
A wholly owned or partially owned subsidiary;
Debt or equity instruments not traded in public;
Did not file financial statements for purpose of issuing instruments to public; and
Ultimate parent produces consolidated financial statements.
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5. Separate Vs Consolidated Financial Statement
Separate financial statements
(Legal entity)
Consolidated financial statements
(Economic entity)
Income recognition
Dividends
Share of profits
Asset recognition
Investment in a subsidiary carried at:
Cost (IAS 27) or
As a financial instrument (IFRS 9)
Investment in a subsidiary:
Investment is eliminated and subsidiary’s net assets are added to the parent (IFRS 10)
Investment in an associate carried at:
Cost (IAS 28) or
Investment in an associate:
Equity method (IAS 28)
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6. Content Introduction Overview of the consolidation process
Business combinations
Determining the amount of consideration transferred
Recognition and measurement of identifiable assets, liabilities and goodwill
Conclusion
Overview of the consolidation process
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7. Consolidation Process
Legal entities
Economic entity
Parent’s Financial Statements
Subsidiaries' Financial Statements
Consolidated financial statements +
+/-
Consolidation adjustments and eliminations =
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’s and subsidiaries financial statements
Adjust or eliminate effects of intra-group transactions and balances
Allocate profit to non-controlling interests
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8. Intragroup Transactions
Intragroup transactions are eliminated to:
Show the financial position, performance and cash flows of the economic (not legal) entity.
Avoid double counting of transactions within the economic entity.
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?
Consolidation adjustment Dr
Sales
2,000,000 Cr
Cost of sales
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9. Intragroup Transactions
Extract of consolidated worksheet
Parent's Income Statement
Subsidiary's Income Statement
Consolidation elimination entries and adjustment
Consolidated income statement
Without elimination Dr Cr
Sales
$2,000,000
$3,000,000
2,000,000
$5,000,000
Cost of sales
(1,000,000)
(2,000,000)
($3,000,000)
Gross profit
$1,000,000
Note: Without elimination the consolidated sales and cost of sales figures will be overstated by $2 M.
* The consolidation process will be discussed in greater detail in Chap 4.
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10. Content Introduction Overview of the consolidation process
The acquisition method
Determining the amount of consideration transferred
Recognition and measurement of identifiable assets, liabilities and goodwill
Conclusion
Business Combinations
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11. 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
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12. Business Combinations
Business combinations may take different forms ; however two characteristics are present:
3 main attributes of control
Power over acquiree
Exposure or rights to variable returns of acquiree
Ability to use power to affect acquiree’s returns.
Acquirer has control of business acquired
2 vital characteristics of a business (IFRS 3)
Integrated set of activities and assets
Capable of being conducted and managed to provide returns (i.e. dividends) to investors and other stakeholders.
Target of acquisition is a business
Business combinations involving entities under common control is outside of scope of IFRS 3
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13. The Acquisition Method
IFRS 3 requires all business combinations to be accounted for using the acquisition method from the perspective of an acquirer.
An acquirer can obtain control in an acquiree through:
Acquisition of assets and assumption of liabilities of acquiree
Include assets and liabilities not previously recognised by acquiree: contingent liabilities, brand name, in-process R&D etc.
Acquisition of controlling interest in the equity of acquiree
Deemed to be effective acquisition of assets and assumption of liabilities of acquiree
Control over an acquiree in substance means that acquirer has control over net assets of acquiree
Effects: (2) accounted for as if they are effects of (1)
Combination of (1) and (2)*
Effects: Accounted for as if they are effects of (1)
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14. The Acquisition Method
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
The procedures:
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15. 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
Concept of control is based on IFRS 10 but the standard may not always conclusively determine the identity of the acquirer.
IFRS 3 Appendix B provides additional criteria to identify controlling acquirer.
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16. Identify the Acquirer
Additional control criteria under IFRS 3 Appendix B
Based on consideration transferred
Based on entity size
Based on dominance
Acquirer is the entity that:
Transfers cash or other assets or incurs liabilities to acquire another entity
Issues shares as consideration to acquire shares of another entity
Pays a premium over the fair value of the equity interest
Acquirer is the entity:
Whose owners hold the largest relative voting rights in a combined entity
Whose owners hold the largest minority voting interest in the combined entity (if no other entity has significant voting interest)
Which is 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
Take note of point A
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17. Identify the Acquirer – Reverse Acquisition
Legal parent is the acquiree and legal subsidiary is the acquirer
Often initiated by the legal subsidiary
Motive for entering into such an arrangement often to seek a backdoor listing
Exchange of shares in a reverse acquisition
1. Company A (Legal parent) takes over shares of Company B from owners
Owners of Company B (Legal subsidiary)
2. Company A issues own shares to owners of Company B as purchase consideration
Company A (Legal parent)
Company B
(Legal subsidiary)
3. Company B has the power and ability to affect the returns of the legal parent after the share exchange
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18. Identify the Acquirer – Reverse Acquisition
Example On 1 July 20x5, P (private), arranged to have all its shares acquired by L (public listed). The arrangement required L to issue 20 million shares to P’s shareholders in exchange for the existing 6 million shares of P. Existing shareholders of L owned 5 million of L. After the issue of 20 million L shares, P’s shareholders now owned 80% (20 million shares out of a total of 25 million shares) of the issued shares of the combined entity. L’s shareholders owned 20% of the shares in the combined entity after the share issue. P’s shareholder act in concert to exercise control over the combined entity.
L’s shareholders
(5 million shares)
P’s shareholders
(20 million shares) L P
20%
80%
100%
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19. Content Introduction Overview of the consolidation process
Business combinations
Determining the amount of consideration transferred
Recognition and measurement of identifiable assets, liabilities and goodwill
Conclusion
Determining the amount of consideration transferred
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20. Determine the Amount of Consideration Transferred
Fair value of assets transferred +
Fair value of liabilities incurred
Fair value of equity interests issued by acquirer to former owners
Consideration transferred* =
Fair value of contingent consideration
*Fair value (FV) 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
Acquisition-related costs are not included
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21. 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:
Remeasure in fair value and recognize gain or loss in the acquirer’s separate financial statements
Remeasured gain or loss is not recognized if the asset or liabilities remain in the combined entity’s financial statements
If transfer of monetary assets or liabilities are deferred, the time value of money should be recognized:
The fair value will be the present value of the future cash outflows
Eg. Future cash settlement of $1,000,000 is due 3 years later and 3% interest is levied
Present value to be recognised = $1,000,000/ (1+0.03)^3
= $915,142
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22. Fair value of Equity Interests Issued by the Acquirer
Fair value of equity interests issued is measured:
(1) By market price (e.g. published quoted prices of shares)
(2) With reference to either the acquisition date fair value of the acquirer OR acquiree, whichever is more reliable. (For example, if market price is not available or not reliable for the acquiree, use the fair value of the acquirer)
Illustration of (2)
Issues X number of shares
Acquirer
Owners of Acquiree
Conveys A number of shares to acquirer
Total number of shares after issue: Y
FV of acquirer’s equity: $Z
Gains control over acquiree
Acquiree
FV of equity issued is either:
X/Y multiplied by $Z; or
A/B multiplied by $C
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23. Illustration 1: Fair Value of Equity Issued
P Ltd acquires 100% of S Co through an issue of 5,000,000 shares to the owners of S Co.
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
$2.00
Fair value of equity
30,000,000
9,000,000
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24. Illustration 1: Fair Value of Equity Issued
Situation 1: P Ltd’s market price is a reliable indicator
Consideration transferred = 5,000,000 shares x $ 2.00
= $10,000,000
Situation 2: Fair value of S Co is a better estimate
Consideration transferred = $9,000,000
Explanation: Since P Ltd is acquiring 100% of S Co, the fair value of the equity (FV of S Co. as a whole including the implicit goodwill) acquired by P is $9 million.
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25. Fair Value of 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. Event A: acquirer gets a refund of part of the consideration transferred if the acquiree does not achieve the target profit
Fair value of contingent consideration or refund will change as new information arises
Fair value of the contingent consideration has to be estimated (For event A) is deducted from consideration transferred
Fair value of contingent consideration is adjusted retrospectively as a correction of error if events after acquisition reveal information that was missed or misapplied during the acquisition date
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26. 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 tenure 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 Dr
Unamortized debt issuance costs Cr
Cash Dr
Equity Cr
Cash
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27. Content Introduction Overview of the consolidation process
Business combinations
Determining the amount of consideration transferred
Recognition and measurement of identifiable assets, liabilities and goodwill
Conclusion
Recognition and measurement of identifiable assets, liabilities and
goodwill
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28. Recognition Principle
Business Combinations are accounted under the acquisition method
Requirement: At acquisition date, the acquirer will recognize
acquiree’s net assets at fair value
Underlying assumption:
There has been an exchange transaction at arm-length pricing
There is an effective ”acquisition” of the subsidiary’s identifiable assets and liabilities at fair value
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29. Recognition Principle
Identifiable net assets (INA) must comply with two conditions to qualify for recognition:
(1) INA must meet the definition of an asset or a liability
(2) INA must be priced into the consideration transferred and not a separate stand-alone transactions
Concept of separate transactions:
Transaction that is entered into for the benefit of acquirer rather than acquiree
Pre-existing relationship with acquiree – for e.g. as a supplier – the payment for the goods is separate from the consideration transferred
However, certain pre-existing relationship can be classified as “reacquired rights” and should be recognized as an intangible asset on the basis of the remaining contractual term of the contract – for e.g. Reacquiring franchised rights granted to acquiree
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30. Recognition Principle
Fair value
differential
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 the disposal of investment
Book value of subsidiary’s identifiable net assets
Fair value of subsidiary’s identifiable net assets
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31. Classification of Identifiable Assets or Liabilities
Classification of identifiable assets or liabilities is made with respect to:
Information;
Conditions; and
Corporate policies existing as at acquisition date
Example: Bond investment
Classified as Available-for-sale securities
Reclassified as held-to-maturity according to acquirer’s group policy
Under acquiree’s financial statements
Under consolidated financial statements
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32. 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 consolidated financial statements
Rationale: the acquisition event justifies recognition of intangible assets
Do not provide guidance on measurement of fair value of the recognized intangible asset
To qualify for recognition, the intangible asset must either:
Be Separable (“Separability criterion”) OR
Arises from contractual or other legal rights (“Contractual-legal criterion”)
Example of intangible assets: Brand names and customer relationships – When Heineken acquired APB; it acquired the iconic Tiger Beer Brand.
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33. Intangible Assets Are these considered intangible assets?
Assembled workforce with specialized knowledge
No: Firm-specific and integrated with acquiree
(Fails separability criterion)
Potential contracts or contracts under negotiation
No: Fails separability or contractual-legal criterion
Opportunity gains from an operating lease in favorable market conditions
Yes: Meets the contractual-legal criterion
Customer and subscriber lists of acquiree
Yes: Meets the separability criterion (show evidence of exchange transactions for similar types of lists)
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34. Contingent Liabilities & Provisions
Contingent liabilities are recognized by acquirer if they are:
Present obligations arising from past events and
Reliably measurable, even if outcome is not probable (IFRS 3:23)
Example: Provisions for restructuring & termination costs are recognized if they are:
Probable outflow of economic resources
Reliably measurable
Present constructive or legal obligations arising from past events
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35. Indemnification Assets
Contractual indemnity
Provided by the former owners of the acquiree to the acquirer to make good any subsequent 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
Example: An acquiree is exposed to a contingent liability. Based on probabilistic estimation, the FV of the contingent liability is $100,000. The former owners provide a contractual guarantee to indemnify the acquirer of the loss.
In the consolidated balance sheet, the acquirer recognizes contingent liabilities and an indemnification asset of $100,000 at FV
To insert
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36. 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 because the basis for taxation does not change in a business combination
i.e. The excess of fair value over book value of identifiable net assets will give rise to a taxable temporary difference and vice versa.
No deferred tax liability is recognized on goodwill as goodwill is a residual
FV > Book value of identifiable assets
Deferred tax liabilities
FV < Book value of identifiable assets
Deferred tax assets
FV < Book value of identifiable liabilities
FV > Book value of identifiable liabilities
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37. Non-controlling interests
Non-controlling interests (NCI) arises when acquirer obtains control of a subsidiary but does not have full ownership of voting rights.
In a business combination, NCI are recognized by the acquirer as equity based on the following equation
Rationale: To represent outside interests’ share in the net assets of the acquiree
Assets -
Liabilities =
Equity
Carrying amount of acquirer’s assets +
Acq date FV of acquiree’s identifiable assets + Goodwill
Carrying amount of acquirer’s liabilities + Acq date of FV of acquiree’s identifiable liabilities
Acquirer’s equity + NCI share of equity of acquiree
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38. Non-controlling interests
IFRS 3 allows NCI at acquisition date to be measured at either:
Fair value; or
The present ownership instruments’ proportionate share in the recognized amount of identifiable assets
Fair value method
Proportionate share of identifiable assets method
Obtain a reliable measure of fair value of NCI (e.g. quoted price in active market)
In absence of quoted price, use valuation techniques to value NCI (e.g. peer companies’ valuation or appropriate assumptions)
Applies present ownership interests held by NCI to the recognized amounts of identifiable net assets to determine initial amount of NCI
If NCI have potential ordinary shares, they should be measured at fair value
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39. Goodwill - = IFRS 3 allows 2 ways of determining goodwill:
Fair value of consideration transferred +
Fair value of non-controlling interests
Fair value of the acquirer’s previously held interest in the acquiree -
Acquiree’s recognized net identifiable assets measured in accordance with IFRS 3
Goodwill =
Measured at fair value at acquisition date (include goodwill)
Measured as a proportion of identifiable assets as at acquisition date
Goodwill
A premium that an acquirer pays to achieve synergies from business combination
Must be recognized separately as an asset
Determined as a residual
IFRS 3 allows 2 ways of determining goodwill:
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40. Goodwill
Goodwill
Depends on reliable measurement of consideration transferred, NCI, previously held equity interests and identifiable net assets
An expectation of
future economic benefits
arising from acquisition
Integral to the entity as a whole, not individually identifiable or severable as a standalone asset
Integral to the entity as a whole, not individually identifiable or severable as a standalone asset
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41. Goodwill
The “top-down approach” (Johnson and Petrone, 1998) results in measurement errors in goodwill
Goodwill
Consideration transferred +
Fair value of non-controlling interests
Identifiable net assets
Overpayment for an acquisition or overvaluation of consideration transferred
Measurement and recognition errors
The above errors should not be included as part of “goodwill”
IFRS 3 suggests that the “one-year “measurement period” is important to rectify measurement and recognition errors to ensure the accuracy and “purity” of goodwill
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42. Goodwill In a “bottom-up” approach (Johnson and Petrone, 1998):
Internally-generated
(Core Goodwill)
Fair value of synergies
(Combination goodwill)
“Going concern element” and represent the ability of acquiree to generate higher rate of return than from its individual assets
Generated from the unique combination of the acquirer and acquiree
FV of the group > than sum of FV of individual entities
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43. Illustration 1: Goodwill
On 1 July 20x1, P purchased 1.5 million shares from S Co’s existing owners. Total number of shares issued by S Co was 2 million. A reliable FV of S Co’s share was $10/share. P Co was obligated to pay an additional $1 million to vendors of S Co if S Co maintained existing profitability over the subsequent two years from 1 July 20x1. It was highly likely that S Co would achieve this expectation and the fair value of the contingent consideration was assessed at $1 million. FV of NCI as at 1 July 20x1 was $5 million. Assume a tax rate of 20%
Additional information of S Co.
Book value of net assets: $3,650,000
FV of net assets : $14,350,000
FV less book value (net assets): $10,700,000
Share capital: $2,000,000
Retained earnings: $1,650,000
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44. Illustration 1: Goodwill
Determine the acquirer's interest in the acquiree: Percentage ownership = 1,500,000 2,000,000 (75%) Consideration transferred: = ($1,500,000 x $10) + $1,000,000 [FV of contingent consideration] = $16,000,000 Determine goodwill: Consideration transferred + FV of NCI – FV of identifiable net assets at acquisition date Determine deferred tax liability of (20% x $10,700,000) = $2,140,000 Determine FV of identifiable net assets = $14,350,000 - $2,140,000 = $12,210,000 Goodwill = $16,000,000 + $5,000,000 - $12,210,000 = $8,790,000
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45. Gain From a Bargain Purchase
A gain from bargain purchase arises when:
In essence, a windfall gain to acquirer
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
Fair value of consideration transferred +
Fair value 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
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46. Measurement Period
IFRS 3 allows adjustments to be made retrospectively to “provisional amounts” relating 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 (“Measurement period”)
Events and circumstances arising after acquisition date does not lead to measurement period adjustments
Adjustments only allowed because of incorrect or incomplete information available as at acquisition date but was missed or misapplied
After measurement period (1 year), any correction of errors will be deemed as a prior - period adjustment (IAS 8)
Exception: Any change in estimate arising from information on new events and circumstances arising after acquisition date will be recognized in the current period
Example: acquirer may fail to obtain information on all contracts of acquiree as at acquisition date
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47. Measurement Period – Summary
Acquisition date
12 months
End of measurement period
Error: Discovery of info on facts and circumstances existing as of acquisition date
Retrospective change: Adjust goodwill, fair value of identifiable net assets, fair value of NCI as if the accounting was completed on acquisition date
Change in estimate: Circumstances arising after acquisition date
Prospective change: no correction of goodwill, fair value of identifiable net assets or fair value of NCI
Any correction of error after end of measurement period requires prior period item disclosures
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48. Conclusion
All business combinations are characterized by three conditions:
Existence of acquirer
Acquirer has control over an acquiree
Acquiree is a business
Many modes of business combinations:
Acquirers acquires net assets of the business
(Consequence: Assets and liabilities acquired recognized in the acquirer’s legal entity financial statements)
Acquirer acquires control over the equity of the acquiree
(Consequence: acquirer and acquiree retain separate legal identities but economically, these entities belong to same group)
Regardless of form, economic substance of combination is the same and acquisition method should be applied
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49. Conclusion Acquisition method Measurement period
Identify acquirer with reference to the control criteria of IFRS 10
Recognize and measure identifiable net assets at fair value at acquisition date
Goodwill is a residual figure and is determined on a “top-down” approach
May include recognition and measurement errors and identifiable elements
Measurement period
Acquirers are allowed a 12 month measurement period to correct and revise the following on a retrospectively basis:
Provisional amounts of goodwill
Fair value of identifiable net assets
Fair value of Non-controlling interests
Fair value of previously held interests
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