Business combinations Lecture 4 Business combinations

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Objectives Understand the nature and form of business combinations. Acquisition method of accounting for business combination. Determine how to measure goodwill or a gain from a bargain purchase. Explain an excess on acquisition and how to account for it. Account for business combinations in the records of the acquiree.

Business combinations IFRS 3 Business Combinations (Appendix A) defines a ‘business combination’ as “a transaction or other event in which an acquirer obtains control of one or more businesses”. A ‘business’ is an integrated set of activities and assets for the purpose of providing a return, lower costs or other economic benefits. Accounting for a group of non-current assets is accounted for under IAS 16 Property, Plant and Equipment rather than IFRS 3. If goodwill is acquired, a group of assets acquired must constitute a business and accounted for under IFRS 3.

Business combinations - example ENTITY A ACQUIRER ENTITY B AQUIREE Sale of mining division to entity A Issue of shares to entity B Entity A acquires a mining division from entity B and selling shares in itself to entity B. Entity B is acquiring shares from entity A and selling a mining division to entity A. Entity A is undertaking a business combination. Entity B is not undertaking a business combination: it is acquiring shares in entity A only. Entity A is the acquirer as it obtains control of the mining division from Entity B.

Business combination - example Various business combinations are possible using the previous example: A Ltd acquires all net assets of B Ltd – B Ltd continues to operate as a company. A Ltd acquires net assets of B Ltd – B liquidates. C Ltd is formed to acquire net assets of A Ltd and B Ltd – A Ltd and B Ltd liquidate. A Ltd acquires a division, branch or segment (a business) of B Ltd – B Ltd continues to operate as a company.

Accounting by an acquirer IFRS 3 (Para. 4) prescribes the acquisition method in accounting for business combinations. This method involves: Identifying an acquirer. Determine the acquisition date. Recognise and measure the identifiable assets acquired, liabilities assumed and any non-controlling interest in the acquiree. Recognise and measure goodwill or a gain from a bargain purchase. Acquisition method is applied on the acquisition date, the date the acquirer obtains control of acquiree.

Identification of an acquirer The key criterion in identifying an acquirer is control. Control is the power to govern the financial and operating policies of an entity or business so as to obtain benefits from its activities. A combining entity shall be presumed to have obtained control of another entity when it acquires more than 50% of that entity’s voting rights. Other factors such as power to appoint or remove the majority of members of board of directors that indicate control.

Determining the acquisition date Acquisition date: Date on which the acquirer effectively gains control of the acquiree (i.e. acquiree’s assets or net assets are under control of the acquirer). Acquisition date may not necessarily be the date when the acquirer receives physical possession of the assets acquired or the date when acquirer pays the acquiree. Assets may be acquired in stages without control being achieved by the acquirer.

Importance of acquisition date Identifiable assets acquired and liabilities assumed by the acquirer are measured at fair value at acquisition date. The choice of fair value is affected by choice of acquisition date. Consideration paid by acquirer is determined by the sum of the fair values of assets given, equity issued and/or liabilities undertaken in exchange for the net assets or shares of the acquiree. Choice of acquisition date determines fair value of consideration paid. Acquirer may only acquire some of the shares in acquiree. The non-controlling interest (what the acquirer does not own) is also measured at fair value at acquisition date.

Consideration transferred The objective is to measure the consideration transferred to the acquiree. The acquirer shall recognise goodwill at acquisition date as the excess of (a) over (b): (Para 32): a) the aggregate of: - the consideration transferred - amount of any non-controlling interest - in a business combination achieved in stages, the fair value of previously held equity interest in acquiree. b) net fair value of identifiable assets and liabilities acquired at acquisition date. Consideration paid may include cash, non-monetary assets, equity instruments, liabilities undertaken, directly attributable costs, cost of issuing debt/equity instruments.

Consideration transferred Use of cash, non-monetary assets and share capital to acquire assets would result in the acquirer recording this entry at acquisition date: DR Net assets X CR Payable to acquiree X CR Proceeds on disposal of asset X CR Share Capital X On payment of the purchase consideration, the acquirer records: DR Payable to acquiree X CR Cash X

Consideration transferred Sale of non-cash assets (e.g. plant) as part of the consideration results in acquirer recording: DR Accumulated Depreciation – Plant X CR Plant X CR Gain X e.g. If plant costs $180, carrying amount is $150 & fair value is $155, the acquirer records: DR Accumulated Deprec. – Plant 30 CR Plant 25 CR Gain 5

Consideration transferred Payment of acquisition related costs by acquirer: DR Acquisition costs X CR Cash X Payment of share issue costs by acquirer: DR Share capital X CR Cash X

Goodwill Goodwill is defined in Appendix A to IFRS 3 as “an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognised”. Goodwill acquired in a business combination represents a payment made by the acquirer in anticipation of FEBs. Goodwill is a residual amount after the aquiree’s interest in the identifiable tangible assets, intangible assets and liabilities of the acquiree are recognised. After initial recognition, the acquirer shall measure goodwill acquired in a business combination at cost less any accumulated impairment losses.

How is goodwill measured? Acquisition Analysis: Consideration transferred = X Acquirer’s interest in the net fair value of the acquiree’s identifiable assets & liabilities + fair value of non-controlling interest + fair value of any previously held equity interest = Y Goodwill = X - Y

Acquisition analysis Net FV of identifiable assets acquired and liabilities assumed: Accounts receivable $12 000 Inventory 15 000 Plant and equipment 100 000 Accounts payable (11 000) Net Fair Value 116 000 Consideration transferred: Shares (20 000 x $2.70) 54 000 Cash Debentures (10 000 x $1.05) 10 500 Shareholders (20 000 x $1.00) 20 000 30 500 Land (FV) 45 000 Cost of the business combination 129 500 Goodwill: ($129 500 – $116 000) $13 500 Assume land had a historical cost of $32,000 and acquisition relation expenses were $1,500.

Accounting by the acquirer Journal entries of acquirer Accounts receivable Dr 12 000 Inventory Dr 15 000 Plant and equipment Dr 100 000 Goodwill Dr 13 500 Accounts payable Cr 11 000 Consideration payable Cr 30 500 Share capital Cr 54 000 Proceeds on sale of land Cr 45 000 Acquisition related expenses Dr 1 500 Payable to acquiree Dr 30 500 Cash Cr 32 000 Carrying amount of land sold Dr 32 000 Land Cr 32 000

Test Your Understanding On 1 July 2012, Flint Ltd acquired the following assets and liabilities from Jasper Ltd: Carrying Amount Fair Value Land $300,000 $350,000 Plant (cost $400,000) $280,000 $290,000 Inventory $80,000 $85,000 Cash $15,000 $15,000 Accounts Payable ($20,000) ($20,000) Loans ($80,000) ($80,000)   In exchange for these assets and liabilities, Flint Ltd issued 100,000 shares that had been issued for $1.20 per share but at 1 July 2012 had a fair value of $6.50 per share. Prepare the acquisition analysis of Jasper Ltd.

Test Your Understanding Acquisition analysis 1 July 2012: Net fair value of identifiable assets and liabilities acquired: Land $350 000 Plant 290 000 Inventory 85 000 Cash 15 000 740 000 Accounts payable 20 000 Loans 80 000 100 000 Net assets $640 000 Consideration transferred: 100 000 shares at $6.50 each $650 000 Goodwill = $650 000 - $640 000 = $10 000

Accounting for a gain on bargain purchase Gain on bargain purchase = Acquirer’s interest in the net fair value of the acquiree’s identifiable assets and liabilities less Consideration transferred If an excess is identified, the acquirer must reassess whether it has correctly (Para 36): a) identified all the assets acquired and liabilities assumed; b) measured at fair value all the assets acquired and liabilities assumed; c) measured the consideration transferred.

Accounting for a gain on bargain purchase Net FV of identifiable assets acquired & liabilities assumed: Accounts receivable $ 9 000 Inventory 25 000 Equipment 45 000 Patents 5 000 Furniture 6 000 Accounts payable (8 000) 82 000 Consideration transferred: Purchase consideration Shares - ordinary 55 000 Shares – preference 2 200 Cash Debentures 9 362 Cost of Liquidation 10 000 Cost of the business combination 76 562 Gain on Bargain Purchase: ($82 000 – $76 562) $5 438

Accounting for a gain on Journal entries of acquirer bargain purchase Journal entries of acquirer Accounts receivable Dr 9 000 Inventory Dr 25 000 Equipment Dr 45 000 Patent Dr 5 000 Furniture Dr 6 000 Accounts payable Cr 8 000 Consideration Payable Cr 19 362 Share capital – ordinary Cr 54 000 Share Capital – preference Cr 2 200 Gain (profit & loss) Cr 5 438

Acquisition of shares in an acquiree Shares acquired are recorded at fair value + transaction costs. Example: Acquirer acquired all shares in Acquiree for $60,000 in exchange for $20 000 cash and 80 000 shares valued at 50 cents each. Transaction costs were $700. Share issue costs were $2,000. They were paid in cash. Acquirer Journal entries: Shares in acquiree 60,700 Cash 20,700 Share Capital 40,000 (Acquisition of shares in acquiree) Share Capital 2,000 Cash 2,000 (Share issue costs)

Step Acquisition of shares Assume X Ltd had previously held 20% of the shares in Y Ltd. X Ltd then acquired the remaining 80% of shares in Y Ltd. In this example, it is the date of the second acquisition of shares that the business combination occurs. Each purchase of shares prior to the date the acquirer obtains control will be accounted for as shown in the previous Slide (Slide 26).

Step Acquisition of shares In a business combination achieved in stages, the acquirer shall measure its previously held equity interest in the acquiree at its acquisition-date fair value and recognise the resulting gain or loss in profit and loss. Example: Assume X Ltd had acquired 20% of Y Ltd’s shares on 1 January 2010 for $10 000 and this investment has a fair value of $15 000 on 1 January 2011. X Ltd then acquired the remaining 80% of Y Ltd on 1 January 2011. X Ltd would then record: Shares in Y Ltd 5,000 Gain (Profit and Loss) 5,000 (remeasurement of previously held equity interest in Y Ltd)

Accounting by the acquiree When acquiree does not liquidate after selling all of its net assets – gain or loss is recognised in the income statement.

Accounting by the acquiree Acquiree does not liquidate Receivable from acquirer Dr x Liability A Dr x Liability B Dr x Asset A Cr x Asset B Cr x Asset C Cr x Gain on sale Cr x (gain on sale of operation) Share in acquirer Dr x Cash Dr x Receivable from acquirer Cr x (Receipt of consideration from acquirer) .

Accounting by the acquiree Where acquiree liquidates after selling all of its net assets: Accounts of acquiree are transferred to Liquidation account & Shareholder’s distribution account. Transfer to Liquidation account: All assets taken over by acquirer including goodwill All liabilities taken over Liquidation expenses & other unrecorded liabilities Consideration from acquirer All reserves & retained earnings Balance of Liquidation account is then transferred to Shareholder’s Distribution account.

Accounting by the acquiree Liquidation Assets taken over x Contra asset accounts x Unrecognised amounts Liabilities taken over x (e.g. liquidation costs) x Reserves of acquiree x Balance to Shareholders’ Receivable from acquirer x distribution account x _ X x

Accounting by the acquiree SHAREHOLDERS’ DISTRIBUTION Receivable from acquirer: Share capital x cash x Balance from Liquidation shares x account x x x