ACTG08-18 ACCOUNTING FOR BUSINESS COMBINATION

1st Semester / AY 2020-2021

COURSE DESCRIPTION:

This course provides students a comprehensive understanding and application of

the accounting principles relating to mergers and acquisition, preparation of
consolidated financial statements, including financial reporting in hyperinflationary
economies, effects of changes in foreign exchange rates and accounting for derivatives
and hedging transactions.

COURSE LEARNING OUTCOMES:

1. Students are expected to be able to prepare journal entries to record business

acquisition.
2. Students are expected to be able prepare consolidated financial statements,
including the separate financial statements of the parent company and its
subsidiaries.
3. Students are expected to apply the applicable financial reporting requirements in
hyperinflationary economies.
4. Students are expected to properly recognize the effects of changes in foreign
exchange rates and the apply the applicable financial reporting requirements.
5. Students are expected to apply the proper accounting principles for derivatives
and hedging transactions.
Week 1

MODULE 1 – BUSINESS COMBINATION

(RECOGNITION AND MEASUREMENT)

Introduction
This module aims to provide students a comprehensive understanding and
application of the proper accounting principles for the recognition and measurement
relating to business combination. It also provides the students the comparison between
the full Philippine Financial Reporting Standard (PFRS) and the Philippine Financial
Reporting Standard for Small and Medium-sized Entities (PFRS for SMEs).

Learning Outcomes:
a. Define a business combination.
b. Identify a business combination transaction.
c. Explain briefly the accounting requirements for a business combination.
d. Apply the proper accounting principle for business combination transaction.
e. Compute for goodwill.
f. Compare the difference between the full PFRS and PFRS for SMEs.

Lesson 1 – Business Combination (Recognition & Measurement)

A business combination occurs when one company acquires another or when
two or more companies merge into one. After the combination, one company gains
control over the other. The company that obtains control over the other is referred to as
the parent or acquirer. The other company that is controlled is the subsidiary or
acquiree.
PFRS 3 Business Combinations is the standard to be applied for business
combination transactions to improve the relevance, reliability and comparability of the
information that a reporting entity provides in its financial statements about a business
combination and its effects.

PFRS 3 defines the following:

A. Business combination
 transaction or other event in which an acquirer obtains control of one or
more businesses
B. Business
 An integrated set of activities and assets that is capable of being
conducted and managed for the purpose of providing goods or services to

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customers, generating investment income (such as dividends or interest)

or generating other income from ordinary activities
C. Acquisition Date
 The date on which the acquirer obtains control of the acquire
D. Acquirer
 The entity that obtains control of the acquiree
E. Acquiree
 The business or businesses that the acquirer obtains control of in a
business combination

Business Combination are carried out either through:

A. Asset acquisition
 Acquirer purchases assets and assumes liabilities in exchange of cash or
non-cash consideration
 Under the Revised Corporation Code of the Philippines, a business
combination effected through asset acquisition may be either:
1. Merger
 Occurs when two or more companies merge into a single
entity which shall be one of the combining companies.
 A Co. + B Co. = A Co. or B Co.
2. Consolidation
 occurs when two or more companies consolidate into a
single entity which shall be the consolidated company
 A Co. + B Co. = C Co.

B. Stock acquisition
 Acquirer obtains control over the acquire by acquiring a majority
ownership interest in the voting rights of the acquire (generally more than
50%).
 Acquirer is known as the parent while the acquiree is known as the
subsidiary.
 After the business combination, both companies retain their separate legal
existence and continue to maintain their own separate accounting books.

 For financial reporting purposes, both the parent and subsidiary are
viewed as a single reporting entity.

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C. A business combination may also be described as:

1. Horizontal combination
 A business combination of two or more entities with similar businesses
(e.g., a bank acquires another bank).
2. Vertical combination
 A business combination of two or more entities operating at a different
level in a marketing chain (e.g., a manufacturer acquires its supplier of
raw materials)
3. Conglomerate
 A business combination of two or more entities with dissimilar
businesses (e.g., a real estate developer acquires a bank)

Advantages of a business combination

A. Competition is eliminated or lessened
 A competition between the combining constituents with similar business is
eliminated while the threat of competition from other market participants is
lessened
B. Synergy
 Synergy occurs when the collaboration of two or more entities results to
greater productivity than the sum of the productivity of each constituent
working independently. It can be simplified by the expression 1 + 1 = 3
C. Increased business opportunities and earnings potential
 Business opportunity and earnings potential may be increased through:
1. An increased variety of products or services available and a
decreased dependency on limited number of products and services;
2. Widened dispersion of products or devices and better access to
new markets;
3. Access to either of the acquirer’s or acquiree’s technological know-
hows, research and development, secret processes, and other
information.
4. Increased investment opportunities due to increased capital; or
5. Appreciation in worth due to an established trade name by either
one of the combining constituents
D. Reduction of operating costs
 Operating costs of the combined entity may be reduced.
1. Under a horizonal combination, operating costs may be reduced by
the elimination of unnecessary duplication of costs

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2. Under a vertical combination, operating costs may be reduced by

the elimination of costs of negotiation and coordination between the
companies and mark-ups on purchases.

E. Combinations utilize economies of scale

 Economies of scale refer to the increase in productive efficiency resulting
from the increase in the scale of production.
 An entity that achieves economies of scale decreases its average cost per
unit as production is increased because fixed costs are allocated over an
increased number of units produced.
F. Cost savings on business expansion
 The cost of business expansion may be lessened when a company
acquires another company instead of putting up a branch.
G. Favorable tax implications
 Deferred tax assets may be transferred in a business combination.
 Business combinations effected without transfers of considerations may
not be subjected to taxation.

Disadvantages of a business combination

A. Business combination brings monopoly in the market which may have a negative
impact to the society. This could result to impediment to a healthy competition
between market participants.
B. The identity of one or both of the combining constituents may cease, leading to
loss of sense of identity for existing employees and loss of goodwill.
C. Management of the combined entity may become difficult due to incompatible
internal cultures, systems, and policies.
D. Business combination may result in over-capitalization which may result to
diffusion in market price per share and attractiveness of the combined entity’s
equity instruments to potential investors.
E. The combined entity may be subjected to stricter regulation and scrutiny by the
government, most especially if the business combination poses threat to
consumers’ interests.

PFRS 3 Business Combinations

PFRS 3 outlines the accounting when an acquirer obtains control of a business
(e.g. an acquisition or merger). Such business combinations are accounted for using the

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‘acquisition method’, which generally requires assets acquired and liabilities assumed
to be measured at their fair values at the acquisition date.
As defined in PFRS 3, business combination is a transaction or other event in
which the acquirer obtains control of one or more businesses.

Essential Elements in the definition of Business Combination:

A. Control
 As provided in PFRS 10, “an investor controls an investee when it 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.”
 Control is normally presumed to exist when the acquirer holds more than
50% interest in the acquiree’s voting interest.
 Control can also be obtained when:
1. The acquirer has the power to appoint or remove the majority of the
board of directors of the acquiree; or
2. The acquirer has the power to cast the majority of votes at board
meetings or equivalent bodies within the acquiree; or
3. The acquirer has power over more than half of the voting rights of
the acquiree because of an agreement with other investors; or
4. The acquirer controls the acquiree’s operating and financial policies
because of a law or an agreement.
 An acquirer may obtain control of an acquiree in a variety of ways, for
example:
1. By transferring cash or other assets;
2. By incurring liabilities;
3. By issuing equity interests;
4. By providing more than one type of consideration; or
5. Without transferring consideration, including by contract alone.

B. Business
 As defined by PFRS 3, 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.
 A business has the following three elements:
1. Input

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 any economic resource that results to an output when one or

more processes are applied to it
2. Process
 any system, standard, protocol, convention or rule that when
applied to an input, creates an output
3. Output
 the result of input and process that provides investment returns
to the stakeholders of the business

Determining whether a transaction is a business combination

(Is it a business combination or not?)
Any investor who acquires some investment needs to determine whether this
transaction or event is a business combination or not.
PFRS 3 requires that assets and liabilities acquired need to constitute a
business, otherwise it’s not a business combination and an investor needs to account
for the transaction as a regular asset acquisition in line with other PFRS.
The three elements of a business should be considered to determine if the
transaction is a business combination.

Lesson 2 – Accounting for Business Combination

Business combinations are accounted for using the acquisition method. PFRS
3 provides that, applying this method requires the following steps:
1. Identifying the acquirer;
2. Determining the acquisition date;
3. Recognizing and measuring the identifiable assets acquired, the
liabilities assumed and any non-controlling interest in the acquiree; and

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4. Recognizing and measuring goodwill or a gain from a bargain

purchase.

I. Step 1: Identifying the acquirer

 The acquirer is the entity that obtains control of the acquiree.
 PFRS 3 provides the following guidance in identifying the acquirer:
1. In a business combination effected primarily by transferring cash or
other assets or by incurring liabilities
 the acquirer usually the entity that transfers the cash or other
assets or incurs liabilities.
2. In a business combination effected primarily by exchanging equity
interests
 the acquirer is usually the entity that issues its equity
interests.
 if it is a reverse acquisition, the issuing entity is the acquiree.
 Other pertinent facts and circumstances shall also be
considered in identifying the acquirer in a business combination
effected by exchanging equity interests including the following:
a. Whose owner, as a group, have the largest portion of
the voting rights of the combined entity.
b. Whose single owner or organized group of owners holds
the largest minority voting interest in the combined entity.
c. Whose owners have the ability to appoint or remove a
majority of the members of the governing body of the
combined entity
d. Whose (former) management dominates the
management of the combined entity

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e. That pays a premium over the pre-combination fair value

of the equity interests of the other combining entity or
entities.

3. As to size
 The acquirer is usually the combining entity whose relative size
is significantly greater than that of the other combining entity
or entities
4. In a business combination involving more than two entities
 The acquirer is usually the one who initiated the combination.
5. In a business combination wherein a new entity is formed
 The acquirer is identified as follows:
a. If a new entity is formed to issue equity interests to
effect a business combination, one of the combining
entities that existed before the business combination shall
be identified as the acquirer by applying the guidance
provided above.
b. In contrast, a new entity that transfers cash or other
assets or incurs liabilities as consideration may be the
acquirer

Illustration: Identifying the acquirer

Example #1
Popoy Co. and Basha Co. agreed to combine their companies. They
agreed that Popoy will offer 10 shares for every share of Basha. They also
agreed that there is no cash consideration. Popoy’s market capitalization is
₱500 million and Basha’s is ₱50 million. After the combination, the board of
directors of Basha shall comprise only directors from Popoy’s. 25% of
Basha is sold few months after the acquisition,

Analysis:
Popoy is the acquirer based on the following indicators:
 Popoy is the issuer of shares and the initiator of the business
combination
 Popoy is the larger entity of the two combining constituents
 The board of directors of Basha after the combination comprises
only directors from Popoy. This gives Popoy the ability to dominate
the management of Basha.

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 Part of Basha is sold after the acquisition. This provides additional

indicator that Popoy is the acquirer

II. Step 2: Determining the Acquisition Date

 The acquirer shall identify the acquisition date, which is the date on
which it obtains control of the acquiree.
 The date on which the acquirer obtains control of the acquiree is
generally the date on which the acquirer legally transfers the
consideration, acquires the assets and assumes the liabilities of the
acquiree—the closing date.
 However, the acquirer might obtain control on a date that is either earlier
or later than the closing date. For example, the acquisition date precedes
the closing date if a written agreement provides that the acquirer obtains
control of the acquiree on a date before the closing date. An acquirer
shall consider all pertinent facts and circumstances in identifying the
acquisition date.

III. Step 3: Recognizing and measuring the identifiable assets acquired, the
liabilities assumed and any non-controlling interest in the acquiree
A. Acquired assets and liabilities
Recognition Principle
 On acquisition date, the acquirer recognizes, separately from
goodwill the identifiable assets acquired, the liabilities assumed
and any non-controlling interest (NCI) in the acquiree.

Recognition Conditions
a. Identifiable assets acquired and liabilities assumed must meet
the definitions of assets and liabilities provided under the
Conceptual Framework at the acquisition date.
b. It must be part of what the acquirer and acquiree exchanged in
the business combination transaction rather than the result of
separate transactions.
c. Applying the recognition principle may result to the acquirer
recognizing assets and liabilities that the acquiree had not
previously recognized in its financial statements

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Classifying identifiable assets acquired and liabilities assumed

 Identifiable assets acquired and liabilities assumed are classified at
the acquisition date in accordance with other PFRSs that are to be
applied subsequently

Measurement Principle
 The acquirer shall measure the identifiable assets acquired and the
liabilities assumed at their acquisition- date fair values.
 Separate valuation allowances are not recognized at the
acquisition date because the effects of uncertainty about future
cash flows are included in the fair value measurement.
 All acquired assets are recognized regardless of whether the
acquirer intends to use them.

B. Non-controlling Interest
 As provided in PFRS 3, non-controlling interest (NCI) or “minority
interest” is the equity in a subsidiary not attributable, directly or
indirectly, to a parent.
 For example, there is no NCI when an investor acquires 100% share
in a company because the investor owns subsidiary’s equity in full.
But, when an investor acquires 75% (less than 100%), then the 25% is
the NCI.
 For each business combination, the acquirer measures any non-
controlling interest in the acquiree either at:
1. Fair value; or
2. The NCI’s proportionate share of the acquiree’s identifiable
net assets.

IV. Step 4: Recognizing and measuring the goodwill

 Goodwill is an asset representing the future economic benefits arising
from other assets acquired in a business combination that are not
individually identified and separately recognized.
 On acquisition date, the acquirer computes and recognizes goodwill or
gain on a bargain purchase using the following formula:

Consideration transferred xx
Non-controlling interest (NCI) in the acquiree xx
Previously held equity interest in the acquiree xx

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Total xx
Less: Fair value of net identifiable assets acquired (xx)
Goodwill / (Gain on a bargain purchase) xx

 A negative amount resulting from the formula is called “gain on a

bargain purchase” (also referred as “negative goodwill”)
 On the acquisition date, the acquirer recognizes a resulting:
a. Goodwill as an asset
b. Gain on a bargain purchase as gain in profit or loss
 Before recognizing, the acquirer shall reassess to ensure that
the measurements appropriately reflect consideration of all
available information as of the acquisition date. (Application of
the concept of conservatism)
 If the gain on a bargain purchase remains after reassessment,
the acquirer shall recognize the resulting gain in profit or
loss on the acquisition date. The gain shall be attributed to
the acquirer.

A. Consideration Transferred
 The consideration transferred is measured at fair value, which is the
sum of the acquisition-date fair values of the assets transferred by the
acquirer, the liabilities incurred by the acquirer to former owners of the
acquiree and the equity interests issued by the acquirer.

Examples of potential forms of consideration include:

1. Cash
2. other assets
3. a business or a subsidiary of the acquirer
4. contingent consideration
5. ordinary or preference equity instruments, options, warrants
6. member interests of mutual entities.

Additional concepts on consideration transferred

 The consideration transferred in a business combination includes
only those that are transferred to the former owners of the
acquiree. It excludes those that remain within the combined entity.
 Assets and liabilities transferred to the former owners of the
acquiree are remeasured to acquisition-date fair values. Any
remeasurement gain or loss is recognized in profit or loss.

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 Assets and liabilities remain within the combined entity are not
remeasured but rather ignored when applying the acquisition
method.

B. Acquisition-related costs
 These are costs the acquirer incurs to effect a business combination.
Examples:
1. Finder’s fees
2. Professional fees, such as advisory, legal, accounting,
valuation and consulting fees
3. General administrative costs, including the costs of
maintaining an internal acquisitions department
4. Costs of registering and issuing debt and equity securities

 Acquisition-related costs are expenses when they are incurred,

except cost to issue debts or equity securities which shall be
recognized in accordance with PAS 32 and PFRS 9:
1. Costs to issue debt securities measured at amortized costs
are included in the initial measurement of the resulting
financial liability.
2. Costs to issue equity securities are deducted from share
premium. If share premium is insufficient, the issue costs
are deducted from retained earnings.
C. Previously held equity interest in the acquiree
This pertains to any interest held by the acquirer before the business
combination. This affects the computation of goodwill only in
business combination achieved in stages (discussed in the next
module).

Illustration 1: Asset Acquisition

On January 1, 2020, Popoy Co. acquired all assets and assumed all
liabilities of the Basha Co. Due to the business combination Popoy Co.
incurred transaction costs for accounting and legal fees amounting to
₱100,000. The carrying amounts and fair values of the assets and liabilities
of Basha acquired by Popoy are shown below:

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As of January 1, 2020
Assets Carrying amounts Fair values
Cash in bank
20,000 20,000
Receivables
220,000 150,000
Allowance for doubtful
accounts (50,000) -
Inventory
510,000 430,000
Building – net
1,500,000 1,200,000
Goodwill
100,000 50,000
Total Assets 2,300,000 1,850,000

Liabilities
Accounts Payable
500,000 300,000
Total Liabilities
500,000 300,000

Assumption #1:
Popoy Co. paid ₱2,000,000 cash as consideration for acquiring the net
assets of Basha, how much is the goodwill (gain on bargain purchase) on
the business combination?

Solution:
Consideration transferred
2,000,000
Non-controlling interest in the acquiree
-
Previously held equity interest in the acquiree
-
Total
2,000,000
Fair value of net identifiable assets acquired
(1,500,000)
Goodwill
500,000

The fair value of the net identifiable assets of the acquiree is computed as
follows:

Fair value of identifiable assets acquired excluding

goodwill
1,800,000
Fair value of liabilities assumed
(300,000)
Fair value of net identifiable assets acquired
1,500,000

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The goodwill recorded by the acquiree is unidentifiable, thus, it should be

excluded from the identifiable assets acquired. Only identifiable assets are
recognized.

Entries in the books of the Popoy (acquirer):

Jan. 1, Cash in bank 20,000
2020 Receivables 150,000
Inventory 430,000
Building 1,200,000
Goodwill 500,000
Accounts Payable 300,000
Cash in bank 2,000,000
To record the assets
acquired and liabilities
assumed on a business
combination
Jan. 1, Professional fees expense 100,000
2020 Cash in bank 100,000
To record the
acquisition-related costs

Basha Co. should account the business combination as a liquidation of a

business. Such that, all the assets, liabilities, and equity are derecognized
and the difference between the carrying amount of the items derecognized
and the proceeds of the disposal is treated as a gain or loss on disposal
of business.

The entries in Basha’s books are as follows:

Jan. 1, Cash on hand 2,000,000
2020 Allowance for doubtful account 50,000
Accounts payable 500,000
Cash in bank 20,000
Receivables 220,000
Inventory 510,000
Building 1,500,000
Goodwill 100,000
Gain on disposal of 200,000
business

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To record the liquidation

of the business
Jan. 1, Share capital (& other accounts in 1,800,000
2020 equity) 200,000
Gain on disposal of business 2,000,000
Cash on hand
To record the
settlement of owner’s
equity

Assumption #2:
If Popoy Co. paid ₱1,300,000 cash as consideration for the net assets of
Basha Co., how much is the goodwill (gain on bargain purchase) on the
business combination?

Solution:
Consideration transferred
1,300,000
Non-controlling interest in the acquiree
-
Previously held equity interest in the acquiree
-
Total
1,300,000
Fair value of net identifiable assets acquired
(1,500,000)
Gain on a bargain purchase
(200,000)

Entries in the books of the Popoy (acquirer):

Jan. 1, Cash in bank 20,000
2020 Receivables 150,000
Inventory 430,000
Building 1,200,000
Accounts Payable 300,000
Cash in bank 1,300,000
Gain on bargain purchase 200,000
To record the assets
acquired and liabilities
assumed on a business
combination
Jan. 1, Professional fees expense 100,000

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2020 Cash in bank 100,000

To record the
acquisition-related costs

Illustration 2: Stock acquisition with NCI

Popoy Co. acquired 75% of the voting shares of Basha Co. on January 1,
2020. On this date, Basha’s identifiable assets and liabilities have fair values
of ₱1,400,000 and ₱400,000, respectively.

Assumption #1:
Popoy Co. paid ₱1,300,000 for the 75% interest in Basha Co. and elects the
option to measure non-controlling interest at fair value. The independent
consultant engaged by Popoy Co. determined that the fair value of the 25%
non-controlling interest in Basha Co. is ₱200,000. How much is the goodwill
or gain in bargain purchase on the business combination?

Solution:
Consideration transferred
1,300,000
Non-controlling interest in the acquiree
200,000
Previously held equity interest in the acquiree
-
Total
1,500,000
Fair value of net identifiable assets acquired
(1,000,000)
Goodwill 500,000

Entries are as follows:

To record the acquisition in Popoy’s separate books of accounts:
Jan. 1, Investment in subsidiary 1,300,000
2020 Cash 1,300,000

To include Basha in Popoy’s consolidated financial statements:

Jan. 1, Identifiable assets acquired 1,400,000
20x1 Goodwill 500,000
Liabilities assumed 400,000
Investment in subsidiary 1,300,000
Non-controlling interest in 200,000
Basha Co.

Note:

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The non-controlling interest is presented in the consolidated statement of

financial position within equity but separately from the equity of the owners
of Popoy Co. (parent).

Assumption #2:
Popoy Co. paid ₱1,300,000 for the 75% interest in Basha Co. and elects the
option to measure non-controlling interest at the non-controlling interest’s
proportionate share of Basha’s net identifiable assets.

How much is the goodwill or gain on bargain purchase on the business

combination?

Solution:
Consideration transferred
1,300,000
Non-controlling interest in the acquiree
250,000
Previously held equity interest in the acquiree
-
Total
1,550,000
Fair value of net identifiable assets acquired
(1,000,000)
Goodwill
550,000

The NCI’s proportionate share of Basha’s identifiable assets is computed as

follows:
Fair value of net identifiable assets acquired 1,000,000
Multiply by: Non-controlling interest 25%
NCI’s proportionate share in net identifiable
assets 250,000

Illustration 3: Transaction costs

On January 1, 2020, Popoy Co. acquired all the identifiable assets and
assumed all the liabilities of Basha Co. On this date, the identifiable assets
acquired and liabilities assumed have fair values of ₱1,600,000 and
₱600,000, respectively. Popoy incurred the following acquisition-related
costs: legal fees ₱20,000, due diligence costs ₱100,000, and general
administrative costs of maintaining an internal acquisition department
₱30,000.

Assumption #1
As consideration for the business combination, Popoy transferred 10,000 of

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its own equity instruments with par value per share of ₱100 and fair value
per share of ₱120 to Basha’s former owners. Costs of registering the
shares amounted to ₱50,000. How much is the goodwill or gain on bargain
purchase on the business combination?

Solution:
Consideration transferred (10,000 sh. X 120)
1,200,000
Non-controlling interest in the acquiree
-
Previously held equity interest in the acquiree
-
Total
1,200,000
Fair value of net identifiable assets acquired
(1,000,000)
Goodwill
200,000

Entries in the books of the acquirer:

Jan. 1, Identifiable assets acquired 1,600,000
2020 Goodwill 200,000
Liabilities assumed 600,000
Share capital 1,000,000
Share Premium 200,000
To record the issuance of
shares as consideration
for the business
combination
Jan. 1, Share Premium 50,000
2020 Cash in bank 50,000

To record the costs of

equity transaction
Jan. 1, Professional fees expense 120,000
2020 General and administrative costs 30,000
Cash in bank 150,000
To record the acquisition-
related costs

Note:
The acquisition-related costs are expensed, except for the costs to issue
equity securities which are deducted from share premium.

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Assumption #2
As consideration for the business combination, Popoy Co. issued bonds
with face amount and fair value of ₱1,200,000. Transaction costs incurred in
issuing the bonds amounted to ₱50,000. How much is the goodwill or gain
on bargain purchase on the business combination?

Solution:
Consideration transferred
1,000,000
Non-controlling interest in the acquiree
-
Previously held equity interest in the acquiree
-
Total
1,200,000
Fair value of net identifiable assets acquired
(1,000,000)
Goodwill 200,000
Entries in the books of the acquirer:
Jan. 1, Identifiable assets acquired 1,600,00
2020 Goodwill 0
Liabilities assumed 200,000 600,000
Bonds payable 1,200,000
To record the issuance of
bonds as consideration for
the business combination
Jan. 1, Bond issue costs 50,000
2020 Cash 50,000
To record the bond issue
costs
Jan. 1, Professional fees expense 120,000
2020 General and administrative costs 30,000
Cash in bank 150,000
To record the acquisition-
related costs

Notes:
 The bond issue costs are deducted when determining the carrying
amount of the bonds. The carrying amount of the bonds payable is
P1,150,000.

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 For goodwill computation:

a. the consideration transferred is measured at the fair value of
the debt securities issued without deduction for the
transaction costs.
b. the acquisition-related costs, including costs of issuing debt
and equity securities, do not affect the computation of
goodwill.
Illustration 4: Consideration transferred
On January 1, 2020, Popoy acquired all the identifiable assets and assumed
all the liabilities of Basha Co.. The assets and liabilities have fair values of
₱1,500,000 and ₱600,000, respectively. As consideration:
 Popoy agrees to pay ₱1,000,000 cash, of which half is payable on
January 1, 2020 and the other half on December 1, 2024. The
prevailing market rate as of January 1, 2020 is 10%.
 In additions, Popoy agrees to transfer a building with a carrying
amount of ₱500,000 and fair value of ₱400,000 shall be transferred to
the former owners of Basha.
 After the combination, Popoy will continue the activities of Basha.
Popoy agrees to provide a patented technology with a carrying
amount of ₱60,000 in the books of Popoy and a fair value of ₱80,000
for use in Basha’s activities.

How much is the goodwill or gain on bargain purchase?

Solution:
Consideration transferred
1,210,461
Non-controlling interest in the acquiree
-
Previously held equity interest in the acquiree
-
Total 1,210,461
Fair value of net identifiable assets acquired
(900,000)
Goodwill 310,461

The fair value of the consideration transferred is determined as follows:

Cash payment
500,000
Present value of future cash payment
(1M x 50% X PV of ₱1 @ 10%, n=5) 310,461
Land transferred to former owners of XYZ (at fair
400,000

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value)
Fair value of consideration transferred 1,210,461

Notes:
 The building is remeasured to acquisition date fair-value before it
is transferred. The ₱100,000 adjustment is recognized as
impairment loss.
 The patented technology is not included in the consideration
transferred because it remains within the combined entity. The
patented technology continues to be measured at carrying
amount.

Illustration 2: Consideration transferred – Dividends on

On January 1, 2020, Popoy Co. acquired all the assets and assumes all the
liabilities of Basha Co. for ₱1,500,000. The assets and liabilities have fair
values of ₱1,500,000 and ₱600,000, respectively.

Basha’s liabilities include ₱100,000 cash dividends declared on December

28, 2019, to shareholders of record on January 15, 2020, and payable on
January 31, 2020.

How much is the goodwill or gain on bargain purchase?

Solution:
Consideration transferred
1,400,000
Non-controlling interest in the acquiree
-
Previously held equity interest in the acquiree
-
Total
1,400,000
Fair value of net identifiable assets acquired
(900,000)
Goodwill
500,000

For purposes of computing the goodwill, the ₱100,000 payment is excluded

from the consideration transferred because this is not a payment for the
business combination, but rather for the purchased dividends.

Journal entries:
Jan. 1, Identifiable assets acquired 1,500,000
2020 Goodwill 500,000
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Liabilities assumed (including 600,000

dividends)
Cash 1,400,000
Jan. 1, Dividends payable 100,000
2020 Cash 100,000

Lesson 3 – Restructuring provisions

 PAS 37 provides that restructuring is a program that is planned and controlled by
management and materially changes either:
1. The scope of a business undertaken by an entity; or
2. The manner in which that business is conducted

Restructuring provisions may include the costs of an entity’s plan

1. To exit an activity of the acquiree.
2. To involuntarily terminate employees of the acquiree, or
3. To relocate non-continuing employees of the acquiree.

The costs above are sometimes referred to as “liquidation costs”. However, a

restructuring provision do not include such costs as:
1. Retraining or relocating continuing staff,
2. Marketing, or
3. Investment in new systems and distribution networks.

 Restructuring provisions are generally not recognized as part of business

combination unless the acquiree has at the acquisition date an existing liability
for restructuring that has been recognized in accordance with PAS 37 Provisions,
Contingent Liabilities and Contingent Assets.

A restructuring provision will be recognized as:

2. Liability if it meets the definition of liability as the acquisition date:
 Acquirer incurs a present obligation to settle the restructuring costs
assumed, such as when the acquiree developed a detailed formal
plan for the restructuring and raised a valid expectation in those
affected that the restructuring will be carried out by publicly
announcing the details of the plan or has begun implementing the plan
on or before the acquisition date.

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3. Post-combination expenses of the combined entity when incurred:

 Acquiree’s restructuring plan is conditional on it being acquired (not
present obligation nor contingent liability)
 Restructuring provisions that do not meet the definition of a liability at
the acquisition date

Illustration: Restructuring provisions

On January 1, 2020, Popoy Co. acquired Basha Co. by paying cash of ₱1,500,000.
On this date, the identifiable assets acquired and liabilities assumed have fair values
of ₱1,600,000 and ₱600,000, respectively. Popoy Co. has estimated restructuring
provisions of ₱200,000 representing costs of exiting the activity of Basha, including
costs of terminating and relocating employees of XYZ.

How much is the goodwill or gain on bargain purchase on the business combination?

Solution:
Consideration transferred
1,500,000
Non-controlling interest in the acquiree
-
Previously held equity interest in the acquiree
-
Total
1,500,000
Fair value of net identifiable assets acquired
(1,000,000)
Goodwill
500,000

Note:
 Restructuring provisions are simply ignored in the computation of goodwill. It
may form part of business combination only if they meet the definition of
liability as of the acquisition date

Lesson 4 – Specific Recognition Principles

PFRS 3 provides the following specific recognition principles:
I. Operating Leases
A. Acquiree is the lessee
General rule:

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The acquirer shall not recognize any assets or liabilities related to an

operating lease in which the acquiree is the lessee.

Exception:
The acquirer shall determine whether the terms of each operating lease in
which the acquiree is the lessee are favorable or unfavorable.

If the terms of an operating lease relative to market terms is:

1. Favorable – the acquirer shall recognize an intangible asset
2. Unfavorable – the acquirer shall recognize a liability

B. Acquiree is the lessor

If the acquiree is the lessor, the acquirer shall not recognize any separate
intangible asset or liability regardless of whether the terms of the operating
lease are favorable or unfavorable when compared with market terms.

Illustration: Specific recognition principles – Operating leases

On January 1, 2020, Popoy Co. acquired all the identifiable assets and assumed
all the liabilities of Basha Co. for ₱1,500,000. On this date, the identifiable
assets acquired and liabilities assumed have fair values of ₱1,600,000 and
₱600,000, respectively.

Assumption #1:
Popoy is renting out a building to Basha under an operating lease. The terms of
the lease compared with market terms are favorable. The fair value of the
differential is estimated at ₱50,000.

How much is the goodwill or gain on bargain purchase?

Solution:
Consideration transferred
1,500,000
Non-controlling interest in the acquiree
-
Previously held equity interest in the acquiree
-
Total
1,500,000
Fair value of net identifiable assets acquired
(1,050,000)
Goodwill 450,000

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The fair value of the net identifiable assets acquired is computed as follows:
FV of identifiable assets acquired, including intangible
asset on the operating lease with favorable terms 1,650,000
FV of liabilities assumed (600,000)
Fair value of net identifiable assets acquired 1,050,000

Assumption #2:
Popoy is renting out a patent to Basha under operating lease. The terms of the
lease compared with market terms are unfavorable. The fair value of the
differential is estimated at ₱50,000.

How much is the goodwill or gain on bargain purchase?

Solution:
Consideration transferred
1,500,000
Non-controlling interest in the acquiree
-
Previously held equity interest in the acquiree
-
Total
1,500,000
Fair value of net identifiable assets acquired
(950,000)
Goodwill 550,000

The fair value of net identifiable assets acquired is computed as follows:

FV of identifiable assets acquired
1,600,000
FV of liabilities assumed, including liability on the
operating lease with favorable terms
(650,000)
Fair value of net identifiable assets acquired
950,000

Assumption #3:
Popoy is renting a building from Basha under operating leases. The terms of the
operating lease compared with market terms are favorable. The fair value of the
differential is estimated at ₱50,000.

How much is the goodwill or gain on bargain purchase?

Solution:
Consideration transferred 1,500,000
Non-controlling interest in the acquiree -
Previously held equity interest in the acquiree -

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Total 1,500,000
Fair value of net identifiable assets acquired (1,000,000)
Goodwill 500,000

No intangible asset or liability is recognized, regardless of the terms, because

the acquiree is the lessor.

II. INTANGIBLE ASSETS

The acquirer recognizes, separately from goodwill, the identifiable
intangible assets acquired in a business combination. An intangible asset is
identifiable if it is either (a) separable or (b) arises from contractual or other
legal rights

A. Separability criterion
An intangible asset is separable if it is capable of being separated
from the acquiree and sold, transferred, licensed, rented or exchanged,
either individually or together with a related contract, identifiable asset
or liability.

The separability criterion is met even if:

1. The exchange transactions are infrequent and regardless of
whether the acquirer is involved in them, as long as there is an
evidence of exchange transaction for that type of asset or
similar type; or
2. The acquirer does not intend to sell, license or otherwise
exchange the identifiable intangible asset

B. Contractual-legal criterion
An intangible asset that is not separable is nonetheless identifiable
if it arises from contractual or other legal rights

Example:
Entity A acquires Entity B, an owner of a nuclear power plant. Entity
A obtains Entity B’s license to operate the nuclear power plant.
However, the terms of the license prohibit Entity A from selling or
transferring the license to another party.
Analysis: The license is an identifiable intangible asset because,
although it is not separable, it meets the contractual-legal criterion.

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Illustration: Intangible assets – separability and contractual legal criteria

On January 1, 2020, Popoy Co. acquired all the assets and liabilities of Basha
Co. for ₱1,000,000. Relevant financial information of Basha are as follows:
Carrying amounts Fair values
Other assets 1,300,000 1,180,000
Computer software 100,000 -
Patent - 50,000
Goodwill 100,000 20,000
Total Assets 1,500,000 1,250,000

Liabilities
Bonds Payables 400,000 450,000
Total Liabilities 400,000 450,000

Additional information:
 The computer software is considered obsolete
 The patent has a remaining useful life of 10 years and a remaining
legal life of 12 years.
 Basha Co. has research and development (R&D) projects with fair
value of ₱50,000. However, Basha recognized the R&D costs as
expenses when they were incurred.

How much is the goodwill or gain on bargain purchase?

Solution:
Consideration transferred
1,000,000
Non-controlling interest in the acquiree
-
Previously held equity interest in the acquiree
-
Total
1,000,000
Fair value of net identifiable assets acquired
(830,000)
Goodwill
170,000

The fair value of net identifiable assets acquired is computed as follows:

Fair value of identifiable assets acquired, excluding
computer software and recorded goodwill but
including patent and R&D
1,280,000
Fair value of liabilities assumed
(450,000)
Fair value of net identifiable assets acquired
830,000

An acquirer recognizes an acquiree’s R&D as intangible asset even if the

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acquiree has already expensed the related costs.

Illustration 2: Intangible assets

On January 1, 2020, Popoy Co. acquired all the assets and liabilities of XYZ,
Inc. for ₱1,500,000. XYZ’s assets and liabilities have fair values of
₱1,600,000 and ₱600,000, respectively. Not included in the fair of assets are
the following unrecorded intangible assets:
Type of intangible asset Fair value
Customer list 50,000
Customer contract #1 20,000
Customer contract #2 10,000
Order (production) backlog 20,000
Internet domain name 25,000
Trademark 35,000
Trade secret processes 25,000
Mask words 15,000
Total 200,000

Additional information:
 Customer contract #1 refers to an agreement between Basha and a
customer, wherein Basha is to supply goods to customer for a period
of 5 years. The remaining period of the contract is 3 years. The
agreement is expected to be renewed at the contract-end but is not
separable.
 Customer contract #2 refers to Basha’s insurance segment’s portfolio
of one-year motor insurance contracts that are cancellable by policy
holders.
 Basha transacts with its customers solely through purchase and sales
orders. As of acquisition date, has a backlog of customer purchase
orders from 60% of its customers, all of whom are recurring customers.
The other 40% are also recurring customers but Basha has no open
purchase orders or other contracts with those customers.
 The internet domain name is registered.

How much is the goodwill or gain on bargain purchase?

Solution:
Consideration transferred
1,500,000
Non-controlling interest in the acquiree
-
Previously held equity interest in the acquiree
-
Total
1,500,000

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Fair value of net identifiable assets acquired

(1,200,000)
Goodwill 300,000

Lesson 5 – Exceptions to the recognition or measurement principles

PFRS 3 provides limited exceptions to its recognition and measurement principles.

Exception to the recognition principle – Contingent liabilities

 The requirements of PAS 37 do not apply when accounting for contingent
liabilities related to business combination as of the acquisition date.
 Under PFRS 3, a contingent liability assumed in a business combination is
recognized if:
a. It is a present obligation that arises from past events and
b. Its fair value can be measured reliably.

 Therefore, contrary to PAS 37, the acquirer recognizes a contingent liability

assumed in business combination at the acquisition date even if it is NOT
probable that an outflow of resources embodying economic benefits will be
required to settle the obligation. As long as both the conditions above are
satisfied, a contingent liability will be recognized.

Illustration: Contingent liabilities

On January 1, 2020, Popoy Co. acquires 90% interest in Basha Co. for ₱1,000,000.
Basha’s recognized assets and liabilities have fair values of ₱1,600,000 and
₱600,000, respectively. ABC opts to measure the non-controlling interest at fair value.
The NCI’s fair value is ₱100,000.

Basha has a pending litigation, for which no provision was recognized because
Basha strongly believes that it will win the case. The fair value of settling the litigation
is ₱50,000.

How much is the goodwill or gain on bargain purchase?

Solution:
Consideration transferred 1,000,000
Non-controlling interest in the acquiree 100,000
Previously held equity interest in the acquiree -
Total 1,100,000

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Fair value of net identifiable assets acquired (950,000)

Goodwill 150,000

The adjusted fair value of net identifiable assets acquired is computed as follows:
Fair value of identifiable assets acquired 1,600,000
Total fair value of liabilities assumed:
Fair value of liabilities assumed 600,000
Contingent liability (pending litigation) 50,000 (650,000)
Fair value of net identifiable assets acquired
950,000

The contingent liability is recognized even if it is NOT probable because it (a)

represents a present obligation and (b) has fair value.

Exceptions to both the recognition and measurement principles

The following items shall be recognized and measured as at acquisition date under
other applicable standards:
1. Income taxes
 are accounted for using PAS 12 Income Taxes. For example, deferred
taxes are measured based on temporary differences arising from the
measurement of identifiable assets and liabilities assumed by the acquirer
at acquisition date.
 Deferred taxes affects the amount of goodwill or gain on bargain purchase
recognized at acquisition date. However, PAS 12 prohibits the recognition
of deferred tax liabilities arising from the initial recognition of goodwill.
Illustration: Deferred taxes
On January 1, 2020, Popoy Co. acquired all the assets and liabilities of
Basha Co. for ₱2,000,000. Basha’s financial information on such date are
as follows:
Assets Carrying amounts Fair values
Cash in bank 20,000 20,000
Receivables 300,000 150,000
Allowance for doubtful
accounts (50,000) -
Inventory 530,000 350,000
Building – net 1,300,000 1,500,000
Goodwill 100,000 30,000
Total Assets 2,200,000 2,050,000

Liabilities
Payables 400,000 450,000

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Basha has an unrecorded patent with a fair value of ₱30,000 and a

contingent liability with fair value of ₱20,000. The contingent liability is a
present obligation, but its outflow is improbable.

Fair value adjustments to the carrying amounts of assets and liabilities do

not affect their tax bases. All adjustments result to temporary differences.
Popoy’s tax rate is 30%

How much is the goodwill or gain on bargain purchase?

Solution:

RECALL: (PAS 12 INCOME TAXES):

 If the carrying amount of an asset exceeds its tax base, the
difference is a taxable temporary difference, which, if
multiplied by the tax rate represents a deferred tax liability.
 For asset: CA>TB = TTD or FI>TI; TTD x tax rate = DTL

The deferred taxes are computed as follows:

Fair values Previous Taxable /

(CA for carrying (deductible)
financial amounts (TB for temporary
reporting) taxation) difference
Cash in bank 20,000 20,000 -
Receivables – net 150,000 250,000 (100,000)
Inventory
350,000 530,000 (180,000)
Building – net
1,500,00 1,300,000 200,000
Patent
30,000 - 30,000
Payables
450,000 400,000 (50,000)
Contingent liability 20,000 - (20,000)

Taxable temporary difference (TTD) 230,000

Multiply by: Tax rate 30%
Deferred tax liability 69,000

Deductible temporary difference (DTD) 350,000

Multiply by: Tax rate 30%
Deferred tax asset 105,000

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Goodwill is computed as follows:

Consideration transferred 2,000,000
Non-controlling interest in the acquiree -
Previously held equity interest in the acquiree -
Total 2,000,000
Fair value of net identifiable assets acquired (1,754,000)
Goodwill 246,000

The fair value of the net identifiable assets of the acquiree is computed as
follows:
Fair value of identifiable assets acquired excluding
recorded goodwill (2.05M – 30K goodwill + 30K patent + 105K
DTA) 2,155,000
Fair value of liabilities assumed
(450K + 20K contingent + 69K DTL) (401,000)
Fair value of net identifiable assets acquired
1,754,000

2. Employee benefits
 are accounted for using PAS 19 Employee benefits. For example, defined
benefit obligations are measured through actuarial valuations.

3. Indemnification assets
 arises when the former owners of the acquiree agree to reimburse the
acquirer for any payments the acquirer eventually makes upon settlement
of a liability.
 The acquirer shall recognize an indemnification asset at the same time
and on the same basis as the indemnified item.
 Accordingly, if the indemnified item is measured at fair value, the
indemnification asset is also measured at fair value. If the indemnified item
is measured at other than fair value, the indemnification asset is measured
using assumptions consistent with those used to measure the indemnified
item.
 Example:
Entity A acquires Entity B. At the acquisition date, the taxing authority is
disputing Entity B’s tax returns in prior years. The former owners of Entity
B agree to reimburse Entity A in case Entity A will be held liable to pay
Entity B’s tax deficiencies in the prior years.

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At the acquisition date, Entity A recognizes a tax liability to the taxing

authority and an indemnification asset for the reimbursement due from the
former owners of Entity B

Exceptions to the measurement principle

A. Reacquired rights
Reacquired rights are measured based on the remaining term of the
related contract. (Discussed in the next chapter)

B. Share-based payment transactions

Liabilities and equity instruments related to the acquiree’s share-based
payment transactions are accounted for using the PFRS 2 Share-based
payment.

C. Assets held for sale

A non-current asset (or disposal group) that is classified as held for sale at
the acquisition date at fair value less costs to sell in accordance with PFRS 5
Non-current Assets Held for sale and Discontinued Operations, rather than at fair
value under PFRS 3.

Illustration: Held for sale assets

On January 1, 2020, Popoy Co. acquired all the assets and liabilities of Basha
Co. for ₱1,500,000. The assets and liabilities assumed have fair values of
₱1,600,000 and ₱600,000, respectively.

Additional information:
 Included in Basha’s assets is a building that Popoy intends to sell
immediately. The criteria for “held for sale” classification criteria under
PFRS 5 are met. Costs to sell the building are ₱50,000.
 Not included in Basha’s asset is a research and development project that
Popoy does not intend to use. The fair value of this asset is ₱100,000
 Not included in the assets of Basha is a customer list with an estimated
value of ₱10,000. However, confidentiality prohibits Popoy from selling,
leasing or otherwise exchanging information about the customers in the
list.

How much is the goodwill or gain on bargain purchase?

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Solution:
Consideration transferred
1,500,000
Non-controlling interest in the acquiree
-
Previously held equity interest in the acquiree
-
Total 1,500,000
Fair value of net identifiable assets acquired
(1,050,000)
Goodwill 450,000

The fair value of the net identifiable assets is computed as follows:

Fair value of identifiable assets 1,600,000
Costs to sell of the “held for sale” asset
(50,000)
Fair value of unrecognized research and development
100,000
Adjusted value of identifiable assets 1,650,000
Fair value of liabilities assumed
(600,000)
Fair value of net identifiable assets acquired 1,050,000

Notes:
 The “held for sale” factory plant is measured at fair value less cost to sell.
 An identifiable asset acquired (R&D) is recognized regardless of whether
the acquirer intends to use it.
 The customer list is not recognized because it is not identifiable.

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DIFFERENCES BETWEEN THE PROVISIONS OF THE FULL PFRS AND THE

PFRS FOR SMEs

Full PFRS PFRS for SMEs

1. Accounting method and computation of goodwill
PFRS 3 Business Combinations The PFRS for SMEs requires a
requires a business combination to be business combination to be accounted
accounted for using the acquisition for under the purchase method
method.
Goodwill is computed as follows:
Goodwill is computed as follows:
Fair vales of assets given,
Consideration transferred xx liabilities incurred, and
Non-controlling interest xx
equity instruments xx
Previously held equity interest xx
Acquisition-related costs xx
Total xx
Cost of business combination xx
Less: Fair value of net
Less: Acquirer’s interest in the
identifiable assets
fair value of the acquiree’s
acquired (xx)
net identifiable assets (xx)
Goodwill (Negative
Goodwill (Negative goodwill) xx
goodwill) xx
 Acquisition-related costs are
 Acquisition-related costs are
included in the cost of the
expensed, except for costs of
business combination, except
issuing equity and debt
for costs of issuing equity and
securities.
debt securities.

2. Non-controlling interests
NCI is included in the measurement of NCI is not included in the measurement
goodwill and is measured either: of goodwill. NCI in the consolidated
a. At fair value; or financial statements is measured at the
b. At the NCI’s proportionate share NCI’s proportionate share in the
in the acquiree’s net assets. acquiree’s net assets.

3. Operating lease – Reacquired right

If the terms of an operating lease No equivalent provision under PFRS for
relative to market terms is: SMEs.
a. Favorable – the acquirer shall
recognize an intangible asset
b. Unfavorable – the acquirer shall
recognize a liability

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4. Intangible assets acquired in a business combination

Recognized if the intangible asset Recognized if the fair value can be
meets either (a) separability criterion or measured reliably.
the (b) contractual-legal criterion.

5. Contingent liabilities
Recognized if it is a present obligation Recognized if fair value can be
and fair value can be measured reliably. measured reliably.

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