1. Chapter 2 Business Combinations
© 2013 Advanced Accounting, Canadian Edition by G. Fayerman

2. Definition of a Business Combination
IFRS 3 defines a business combination as:
“a transaction or other event in which an acquirer obtains control of one or more businesses”
Control exists when the investor is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee.
A “business” is not just a group of assets, rather, it is an integrated set of activities and assets (i.e., an entity) able to produce output.
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3. Definition of a Business Combination
Note the use of the phrase “integrated set of activities” in the definition of a business.
Goodwill arises where there is synergy between assets.
Goodwill is defined in IFRS 3 as an asset representing the future economic benefits arising from assets acquired in a business combination that are not individually and separately recognized.
A very important principle is that goodwill can only be recognized when assets are acquired as part of a business.
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4. Forms of Business Combinations
Four general forms of business combinations are as follows (assuming the existence of two companies – A and B):
1. A acquires all assets and liabilities of B.
B continues as a company, holding shares in A.
2. A acquires all assets and liabilities of B.
B liquidates.
3. C is formed to acquire all assets and liabilities of A and B.
A and B liquidate.
4. A acquires a group of net assets of B, the group of net assets constituting a business, such as a division, branch, or segment, of B.
B continues to operate as a company.
Refer to Illustration 2.3 “General Forms of Business Combinations” of text for key steps involved under each of the above scenarios.
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5. Accounting for Business Combinations: Basic Principles
IFRS 3 prescribes the acquisition method in accounting for a business combination. The key steps in this method are:
1. Identify an acquirer;
2. Determine the acquisition date;
3. Recognize and measure the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree; and
4. Recognize and measure goodwill or a gain from bargain purchase.
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6. Identifying the Acquirer
The business combination is viewed from the perspective of the acquirer.
The acquirer is the entity that obtains control of the acquiree.
An acquirer must be identified in every business combination.
In most cases this step is straight forward. In other cases judgement may be required. For example, consider where two existing entities (A&B) combine and a new entity (C) is formed to acquire all the shares of the existing entities.
Who is the acquirer? It cannot be C.
Indicative factors contained within Appendix B of IFRS 3 assist in identifying the acquirer.
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7. Identifying the Acquirer
The acquisition method requires the assets and liabilities of the acquiree to be measured at fair value whereas the assets and liabilities of the acquirer continue to be measured at their carrying values.
IFRS 3 provides some indicators to assist in assessing which entity is the acquirer:
Is there a large minority voting interest in the combined entity?
What is the composition of the governing body of the combined entity?
What is the composition of the senior management that governs the combined entity subsequent to the combination?
What are the terms of the exchange of equity interests?
Which entity is the larger?
Which entity initiated the exchange?
What are the relative voting rights in the combined entity after the business combination?
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8. Determining the Acquisition Date
Acquisition date is the date that the acquirer obtains control of the acquiree.
Determining the correct acquisition date is important as the following are affected by the choice of acquisition date:
The fair values of net assets acquired
Consideration given, where the consideration takes a non-cash form
Measurement of the non-controlling interest (discussed in chapter 5).
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9. Accounting in the Records of the Acquirer: Assets Acquired and Liabilities Assumed
Fair value allocation occurs at acquisition date and requires the recognition of:
Identifiable tangible and intangible assets
Liabilities
Contingent liabilities
Any non-controlling interest in the acquiree
Goodwill
FVINA = fair value of identifiable net assets (including contingent liabilities)
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10. Accounting in the Records of the Acquirer: Contingent Liabilities
IFRS 3 requires that contingent liabilities which can be measured reliably are recognized by the acquirer.
The above requirement does not consider issues of probability.
Therefore contingent liabilities where a present obligation exists but that do not qualify for recognition in the acquiree's books under IAS 37 may be recognized by the acquirer as part of a business combination.
The fair value of a contingent liability is the amount that a third party would charge to assume those contingent liabilities. Such an amount reflects the expectations about possible cash flows. This is not simply the expected maximum/minimum cash flow.
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11. Accounting in the Records of the Acquirer: Measurement
IFRS 3 requires that assets acquired and liabilities and contingent liabilities assumed are measured at fair value.
Fair value is basically market value and is determined by judgement, estimation and a three-level ‘fair value hierarchy’ as described in IFRS 13.
Acquirer has 12 months from acquisition date to determine fair values.
At first balance date after acquisition the fair values may only be provisionally determined – a best estimate.
Finalization of fair values will result in adjustments to goodwill.
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12. Accounting in the Records of the Acquirer: Consideration Transferred
The acquirer measures the consideration transferred as the fair values at the date of acquisition of:
Assets given
Liabilities (including contingent liabilities) assumed
Equity instruments
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13. Accounting in the Records of the Acquirer: Consideration Transferred
The consideration paid by the acquirer may consist of one or a number of the following forms of consideration:
Cash
Non-monetary assets
Equity instruments
Liabilities undertaken
Cost of issuing debt/equity instruments
Contingent consideration
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14. Accounting in the Records of the Acquirer: Consideration Transferred
Cash
Where the settlement is deferred, the cash must be discounted to present value as at the date of acquisition.
The discount rate used is the entity’s incremental borrowing rate.
Equity instruments
Where an acquirer issues their own shares as consideration they need to determine the fair value of the shares as at the date of exchange.
If listed, the fair value is the quoted market price of the shares (with a few limited exceptions).
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15. Accounting in the Records of the Acquirer: Consideration Transferred
Costs of issuing debt and equity instruments
Transaction costs such as underwriting costs and brokers fees may be incurred in issuing equity instruments.
Such costs are considered to be an integral part of the equity transaction and should be recognized directly in equity.
Journal entry required would be:
Dr Share Capital xxx
Cr Cash xxx
Costs associated with the issue of debt instruments are included in the measurement of the liability.
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16. Accounting in the Records of the Acquirer: Consideration Transferred
Contingent consideration
In some cases the agreement will provide for an adjustment to the cost of the combination contingent on a future event.
Example - where an acquirer issues shares as part of their consideration, the agreement may require an additional payment of the value of the shares falls below a certain amount within a specified period of time.
If the adjustment is probable and can be measured reliably, then the amount should be included in the calculation of the cost of acquisition.
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17. Accounting in the Records of the Acquirer: Consideration Transferred
Acquisition related costs
Acquisition related costs that are directly attributable to a business combination do not form part of the consideration transferred, rather they are expensed as incurred.
Examples include finder’s fees; advisory, legal accounting, valuation and other professional or consulting fees; and general administrative costs, including the costs of maintaining an internal acquisitions department.
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18. Accounting in the Records of the Acquirer: Income Taxes
IFRS 3 specifically identifies the following tax effects:
deferred tax assets due to loss carryforwards
temporary differences due to the difference between the fair value and the undepreciated capital cost.
Under IFRS 3.25, an acquirer is required to recognize and measure the effect of any temporary differences and carryforwards of an acquiree that exist at the acquisition date or that arise as a result of the acquisitions.
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19. Accounting in the Records of the Acquirer: Goodwill
When a business combination results in goodwill, IFRS 3 requires that the goodwill is:
recognized as an asset
measured at its cost at the date of acquisition
Goodwill = consideration transferred – acquirer’s interest in the FVINA.
Goodwill is considered to be a residual interest.
Goodwill is an unidentifiable asset which is incapable of being individually identified and separately recognized.
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20. Accounting in the Records of the Acquirer: Gain on Bargain Purchase
Where the acquirer’s interest in the net fair value of the acquiree’s identifiable assets and liabilities is greater than the consideration transferred, the difference is called a gain on a bargain purchase.
Goodwill = acquirer’s interest in the FVINA – consideration transferred.
Before a gain is recognized, the acquirer must reassess whether it has correctly:
identified all the assets acquired and liabilities assumed
measured at fair value all the assets acquired and liabilities assumed
measured the consideration transferred (IFRS 3.36).
A gain on bargain purchase and goodwill cannot be recognized in the same business combination.
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21. Accounting in the Records of the Acquirer: Gain on Bargain Purchase
A gain on bargain purchase for the acquirer arises from:
Errors in measuring fair value
Another standard’s requirements
Superior negotiating skills
The existence of a gain on bargain purchase is a rare event.
In the event of a gain on bargain purchase the acquirer is required to recognize any gain immediately in the profit & loss.
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22. Accounting by the Acquirer: Shares Acquired in an Acquiree
When shares are acquired rather than the net assets the investment is accounted for in accordance with IFRS 9 Financial Instruments.
IFRS 9 requires the investment to be accounted for at fair value plus transaction costs.
The accounting treatment in the acquirers books at acquisition is:
Dr Investment in Acquiree xxx
Cr Share capital xxx
Cr Cash xxx
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23. Accounting in the Records of the Acquiree
If acquiree does not liquidate, it recognizes a gain or loss on the sale of the assets and liabilities that formed the part of the business being sold.
If the acquiree decides to liquidate, it transfers the cash remaining to the shareholders as a liquidating dividend.
No entries needed if acquiree only parts with shares.
Refer to Illustrative Example 2.5 in the text.
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24. Subsequent Adjustments to the Initial Accounting for Business Combinations
Adjustments may be made subsequent to acquisition date in relation to:
Goodwill
Contingent liabilities
Contingent consideration
On an ongoing basis goodwill is subject to impairment testing.
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25. Subsequent Adjustments to the Initial Accounting for Business Combinations
Contingent liabilities
Contingent liabilities are initially recognized at fair value.
Subsequent to acquisition date the liability is measured as the higher of:
(a) the best estimate of the expenditure required to settle the present obligation; and
(b) the amount initially recognized less cumulative amortization recognized in accordance with IAS 18 Revenue.
Subsequent adjustments do not affect the goodwill calculated at acquisition date.
e.g., where a liability was recognized in relation to a court case
e.g., where a liability was recognized in relation to a guarantee
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26. Subsequent Adjustments to the Initial Accounting for Business Combinations
Contingent consideration
At acquisition date, the contingent consideration is measured at fair value, and is classified either:
as equity (for example, the requirement for the acquirer to issue more shares subject to subsequent events); or
as a liability (for example, the requirement to provide more cash subject to subsequent events).
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27. Subsequent Adjustments to the Initial Accounting for Business Combinations
Contingent consideration
Subsequent accounting treatment is a follows:
where classified as equity, no remeasurement is required, and the subsequent settlement is accounted for within equity. This means that extra equity instruments issued are effectively issued for no consideration and there is no change to share capital.
where classified as a liability, it will be accounted for under IAS 39 and measured at fair value with movements being accounted for in accordance with that standard.
Subsequent adjustments do not affect the goodwill calculated at acquisition date.
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28. Copyright Notice
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