1 ACCT4104 Advanced Financial Accounting Dr. Winnie S.C.

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CHAPTER 14 – BUSINESS COMBINATIONS

LEARNING OBJECTIVES
 Understand the nature of a business combination
 Explain the basic steps in the acquisition method of accounting for a business combination, including the
accounting for goodwill and gain from bargain purchase
 Prepare the accounting records for business combinations
 Outline the disclosures required by IFRS 3

The Nature of Busin ess Co mbin ation

IFRS 3 Business Combinations defines a business combination as a ‘transaction or other event in which an
acquirer obtains control of one or more businesses.’

1. A ‘business’ is an integrated set of activities and assets that is capable of being conducted and
managed for the purpose of providing a return in the form of dividends, lower costs or other
economic benefits directly to investors or other owners, members or participants (IFRS 3 Business
Combinations, Appendix A).

2. Control exists when an 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
(IFRS 10 Consolidated Financial Statements).

Discussion Question #1:

How can we obtain control over a business?

Accounting f or Business Combin ations – Basic Prin cip les

IFRS 3 prescribes the acquisition method in accounting for a business combination. The key steps in this
method are:
1. Identify the acquirer
2. Determine the acquisition date
3. Recognize and measure the identifiable assets acquired and the liabilities assumed
4. Recognize and measure goodwill or a gain from bargain purchase

1. Identify the acquirer

The business combination is viewed from the perspective of the acquirer. The acquirer is the entity that
obtains control of the acquiree. In most cases this step is straightforward. In other cases, judgement may be
required. Example:
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- IFRS 3 Appendix B states that one of the entities that existed before the combination must be identified
as the acquirer.
- In substance, entity C is not the decision maker, it is just a vehicle to facilitate the business combination.
- The need to identify the acquirer stems from the need to measure the acquiree’s net assets at fair value, but
not those of the acquirer.

Indicative factors contained within Appendix B of IFRS 3 assist in identifying the acquirer
 What are the relative voting right in the combined entity after the business combination?
 In case the ownership of the combined entity is widely dispersed, does a large minority voting interest
exist?
 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 initiates the exchange?

2. Determine the acquisition date

Acquisition date is the date that the acquirer obtains control of the acquiree. Essentially, it is the point in
time when the acquirer takes over the acquiree’s net assets and records them in its own records. Determining
the correct acquisition date is important as the following are affected by the choice of acquisition date:
 Fair values of net assets acquired
 Consideration given, where the consideration takes a non-cash form e.g. shares

3. Recognize and measure the identifiable assets acquired and the liabilities assumed
Fair value allocation occurs at acquisition date and requires the recognition of:
 Identifiable tangible and intangible assets
- Including those not previously recognized by the acquiree. For example, internally generated
intangibles (e.g. customer lists, in-house R&D) that were not recognized by the acquiree because of
the requirements of IAS 38 Intangible Assets may have to be recognized by the acquirer at fair
value.
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 Liabilities
- Including those contingent liabilities. If the contingent liability has not been recognized by the
acquiree because the future outflows are not regarded as ‘probable’ or because the amounts cannot
be measured with sufficient reliability, then it is necessary to attach a fair value, even though it
would have been a breach of IAS 37 Provisions, Contingent Liabilities and Contingent Assets on
combination.

4. Recognize and measure goodwill or a gain from bargain purchase

Goodwill = FV of consideration paid – FV of net assets acquired

The consideration paid by the acquirer may consist of one or a number of the following forms of
consideration:

 Cash or other monetary assets

- 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.

 Non-monetary assets
- They are assets such as property, plant and equipment, investments, licences and patents.
- Paragraph 38 of IFRS 3 states that the acquirer shall remeasure the transferred assets or liabilities
to their fair values as of the acquisition date and recognize the resulting gains or losses, if any, in
profit or loss.

 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.

 Liabilities undertaken
- Best measured by the present values of expected future cash outflows.

 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 if the value of the shares falls below a certain amount within a
specified period of time.
- The acquirer shall recognize the acquisition-date fair values of contingent consideration as part of
the consideration transferred.
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In addition to the consideration transferred by the acquirer to the acquiree, we also need to pay attention to
the following items:

 Cost of issuing debt/equity instruments

- These costs are accounted for in accordance with IAS 32 Financial Instruments: Presentation
and IFRS 9 Financial Instruments.
- Transaction costs such as stamp duties, professional advisers’ fees, 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.
- Similarly, the costs associated with the issue of debt instruments are included in the initial
measurement of the financial liabilities.

 Acquisition-related costs
- These are costs directly attributable to the business combination.
- Examples: finder's fees; advisory, legal, accounting, valuation and other professional or
consulting fees; general administrative costs, including the costs of maintaining an internal
acquisitions department (IFRS 3 paragraph 53)
- These costs are accounted for as expenses in the periods in which they are incurred and the
services are received.

Illustrative Example 14.1 Consideration transferred in a business combination

The trial balance below represents the financial position of Whiting Ltd at 1 January 2023.

WHITING LTD
Trial Balance
as at 1 January 2023
Debit Credit
Share capital
Preference — 6000 fully paid shares $ 6 000
Ordinary — 30 000 fully paid shares 30 000
Retained earnings 21 500
Equipment $42 000
Accumulated depreciation — equipment 10 000
Inventory 18 000
Accounts receivable 16 000
Patents 3 500
Debentures 4 000
Accounts payable 8 000
$79 500 $79 500
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At this date, the business of Whiting Ltd is acquired by Salmon Ltd, with Whiting Ltd going into
liquidation. The terms of acquisition are as follows:

1. Salmon Ltd is to take over all the assets of Whiting Ltd as well as the accounts payable of
Whiting Ltd.

2. Costs of liquidation of $350 are to be paid by Whiting Ltd with funds supplied by Salmon Ltd.

3. Preference shareholders of Whiting Ltd are to receive two fully paid preference shares in
Salmon Ltd for every three shares held or, alternatively, $1 per share in cash payable at
acquisition date.

4. Ordinary shareholders of Whiting Ltd are to receive two fully paid ordinary shares in Salmon
Ltd for every share held or, alternatively, $2.50 in cash, payable half at the acquisition date and
half on 31 December 2023.

5. Debenture holders of Whiting Ltd are to be paid in cash out of funds provided by Salmon Ltd.
These debentures have a fair value of $102 per $100 debenture.

6. All shares being issued by Salmon Ltd have a fair value of $1.10 per share. Holders of 3000
preference shares and 5000 ordinary shares elect to receive the cash.

7. Costs of issuing and registering the shares issued by Salmon Ltd amount to $40 for the
preference shares and $100 for the ordinary shares.

8. Costs associated with the business combination and incurred by Salmon Ltd were $1000.

The calculation of the consideration transferred in the business combination to Salmon Ltd is shown below. The
incremental borrowing rate for Salmon Ltd is 10% p.a.
Consideration transferred: Fair value

Cash: Costs of liquidation

Preference shareholders
Ordinary shareholders
– payable immediately
– payable later
Debentures, including premium
Shares: Preference shareholders
Ordinary shareholders
Consideration transferred
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Goodwill:
 is considered to be a residual interest, after the acquirer’s interest in the identifiable tangible assets,
intangible assets, and liabilities of the acquiree is recognized.
 is an unidentifiable asset which is incapable of being individually identified and separately recognized.
 provides future economic benefits which may result from synergy between the identifiable assets
acquired or from assets, that individually, do not qualify for recognition in the financial statements.

Illustrative Example 14.2 Acquisition analysis

Using the same information in illustrative example 14.1, assume that Salmon Ltd assesses the fair
values of the identifiable assets and liabilities of Whiting Ltd to be as follows:
Equipment $36 000
Inventory 20 000
Accounts receivable 9 000
Patents 10 000
Accounts payable (8 000)
Net fair value $67 000

Acquisition analysis
Goodwill =

The journal entries for Salmon Ltd (acquirer) at acquisition date (1 January 2023) are shown below:
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Discussion Question #2:

In relation to this acquisition, are there any other journal entries required in the books of Salmon for the
year ended 31 December 2023?

Discussion Question #3:

If Salmon is paying $76,562 cash to acquire 100% shares of Whiting, how is this acquisition recorded in
Salmon’s books at the acquisition date?

Discussion Question #4:

What are the key differences in doing consolidation when the acquirer obtains control by acquiring net
assets and by acquiring share capital of the acquiree?
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Accounting f or a Gain on Bargain Purchase

 Where the acquirer’s interest in the FVINA exceeds the consideration transferred, negative goodwill
arises – this is referred to as a gain on bargain purchase.
 A gain on bargain purchase arises from:
- acquirer’s superior negotiating skills
- acquiree has made a sale for other economic reasons
- acquiree is forced to sell owing to specific circumstances such as cash flow problems
 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 or loss account.

Disclosu re
IFRS 3 paras 59‒63 contain extensive disclosure requirements in relation to business combinations

Key disclosures relate to:

 Reporting the nature and financial effects prior to the release of financial statements
 The primary reasons for the business combination
 How the acquirer obtained control of the acquiree
 A qualitative description of the factors that make up goodwill

Example:
Note 34 in KPMG illustrative disclosures–Guide to annual financial statements IFRS®– September 2022
https://assets.kpmg.com/content/dam/kpmg/xx/pdf/2022/09/2022-ifs-isg.pdf

~~ End of Chapter 14 ~~