ACCOUNTING FOR BUSINESS COMBINATION

BUSINESS COMBINATION- DATE OF ACQUISITION

Introduction
As defined by PFRS 3, a business combination is a transaction or event in which an acquirer
obtains control of one or more businesses. In a business combination, one of the parties can always be
identified as the acquirer, being the entity that obtains control of the other business (the acquiree). The
core principle of PFRS 3 sets out that an acquirer of a business recognizes the asset acquired and
liabilities assumed at their acquisition-date fair values and discloses information that enable users to
evaluate the nature and financial effects of the acquisition.

THE SCOPE OF PFRS 3 (Use your textbook as a reference – CH1 and CH2)

Within the Scope Outside the Scope

a. Combinations involving mutual entities a. Combination results in the formation of all

b. Combinations achieved by contract alone types of joint arrangements.
b. Combination involves entities or businesses
under common control. Common control is a
business combination in which all of the
combining entities or businesses are
ultimately controlled by the same party before
of after the combination, and that control is
not transitory.
c. Acquisition of an asset or a group of asset
does not constitute a business.

IDENTIFYING A BUSINESS COMBINATION

As defined by PFRS 3 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 cost
or other economic benefits directly to investors or other owners, members or participants.
An entity shall assess whether the group of assets acquired constitute a business. Applying the
guidance of PFRS 3 a business consists of inputs and processes applied to those inputs that have the
ability to create outputs. It have to be noted that output is not necessary for an integrated set to qualify
as business but the mere ability to produce outputs out of the existing processes and inputs.
These elements are defined as follows:
1. Inputs- an economic resource that merely need to have the ability to contribute to the creation of
outputs (e.g. non-current assets, intellectual property).

2. Process- a system, standard, protocol convention or rule that when applied to an input or inputs,
creates an output (e.g. strategic management, operational process and resource management).

3. Output- the result of inputs and processes applied to those inputs; the result of inputs and process
that provides investment returns to the stakeholders of the business.

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Defensive Techniques. Enumerate. (9)
1. Poison Pill – an amendment of the articles of incorporation or by-laws to make it more difficult to obtain
stockholder approval for a takeover.
2. Greenmail – an acquisition of common stock presently owned by the prospective acquiring (acquirer)
company at a price substantially lower in excess of the prospective acquirer’s cost, with the stock thus
placed in the treasury or retired. The purchased shares are then held as treasury stock or retired.
3. White Knight or While Squire – a search for a candidate to be the acquirer in a friendly takeover. This is
simply encouraging a third company more acceptable to the target company.
4. Pac-man Defense – attempting an unfriendly takeover of the “would be acquiring company”.
5. “Selling the Crown Jewels” or “Scorched Earth” – the sale of valuable assets to others to make the firm
less attractive to the “would be acquirer”. The negative aspect is that the firm, if it survives, is left without
some important assets.
6. Shark Repellant – an acquisition of substantial amounts of outstanding common stock for the treasury or
for retirement, or the incurring of substantial long-term debt in exchange for outstanding common stocks.
7. Leveraged Buyouts – when management desires to own the business, it may arrange to buy out the
stockholders using the company’s asset to finance the deal. The bonds issued often take to the form of
high-interest, high-risk “junk” bonds.
8. The Mudslinging Defense – when the acquiring company offers stock instead of cash, the prospective
acquiring (acquirer) company’s management may try to convince the stockholders that the stock would
be a bad investment.
9. The Defensive Acquisition Tactic – when a major reason for an attempted takeover is the prospective
acquiring (acquirer) company’s favorable cash position, the prospective acquiring (acquirer) company
may try to rid itself of this excess cash by attempting to takeover its own.

A. Structure of Business Combination (4)

1. Horizontal Integration – is one that involves companies within the same industry that have
previously been competitors.
2. Vertical Integration – takes place between two companies involved in the same industry
but at different levels. It normally involves a combination of a company and its suppliers or
customers.
3. Conglomerate Combination – is one involving companies in unrelated industries having
little, if any, production or market similarities for the purpose of entering into new markets or
industries.
4. Circular Combination – entails some diversification, but does not have a drastic change in
operation as a conglomerate.

B. Method to Accomplish the Combination (3)

1. Acquisition of Common Stock (Stock Acquisition) – the books of the acquirer (acquiring)
company and acquire (acquired) company remain intact and consolidated financial
statements are prepared periodically.
2. Asset Acquisition – it reflects the acquisition by one firm of assets of another firm, but not
its shares. The acquirer typically targets key assets for acquisition, or buys the acquiree’s
assets but does not assume its liabilities. The acquirer may not buy the entire entity.
3. Acquisition of Net Assets (Assets less Liabilities) – the book of acquired (acquire) are
closed out, and its assets and liabilities are transferred to the books of the acquirer (or the
acquiring/surviving company).

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 a. Statutory Merger – entails that acquiring company survives, whereas acquired company
ceases to exist as legal entity. X Company + Y Company = X or Y Company
b. Statutory Consolidation – when a new corporation is formed to acquire two or more other
corporations; the acquired corporations then cease to exist as separate legal entity.
X Company + Y Company = Z Company

C. Accounting Method Used

I. The accounting method for a business combination under paragraph 4 of PFRS 3 is the
acquisition method.

D. Five Step Process in Acquisition Method

1. Identify the acquirer
2. Determine the acquisition date
3. Calculate the fair value of the purchase consideration transferred
4. Recognize and measure the identifiable assets and liabilities of the business
5. Recognize and measure either goodwill or a gain from a bargain purchase, if either exists in
the transaction

E. Control. An investor controls an investee if and only if the investor has all the following:
1. Power over the investee. Power is the ability to direct those activities which significantly
affect the investee’s returns. It arises from rights, which may be straightforward (e.g. through
voting rights) or complex (e.g. through one or more contractual arrangements).
2. Exposure, or rights, to variable returns from involvement with the investee. Returns must
have the potential to vary as a result of the investee’s performance and can be positive,
negative or both.
3. Ability to use power over the investee to affect the amount of the investor’s returns.

F. Acquisition Date the date on which the acquirer obtains control of the acquiree.

G. Identifiable when: (1) the business combination occurs at the date of the assets

(2) the net assets are under the control of the acquirer

H. Fair Value. market-based measure in a transaction between unrelated parties

I. Non-controlling Interest.
Non Controlling Interest is the “equity in a subsidiary not attributable, directly or
indirectly, to a parent”. Non Controlling Asset is also called “minority interest”

Exceptions to Recognition Principle

Contingent Liabilities
In a business combination where the acquired entity has contingent liabilities the recognition
principle of PAS 37 would not apply. Instead, the acquirer shall recognize contingent liabilities assumed
as of the acquisition date if it arises from past events and it has a fair value that can be measured
reliably, regardless of whether it is probable or not that an outflow of resources embodying economic
benefits will be required to settle the obligation.

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 J. Formula to Compute Goodwill/ Gain from Bargain Purchase

Consideration Transferred xxx

NCI in the acquiree xxx
Previously held equity interest in the acquiree xxx
Total xxx
Less: FV of net identifiable assets acquired (xx)
Goodwill/Gain on bargain purchase xxx

K. Contingent Consideration.
An add on to the base acquisition price that is based on events occuring or conditions being met
some time after the purchase takes place.

The acquirer is required to measure the assets acquired and liabilities assumed in a business
combination at its acquisition-date fair values, however, such information is not always available at that date
and the entity measures identifiable items at provisional amounts. Therefore, PFRS 3 allows a
measurement period which is a period after the acquisition date during which the acquirer may adjust the
provisional amounts recognized for a business combination.

L. How to Identify Measurement Period Adjustments?

a. Within the scope of PFRS 9
b. Not within the scope of PFRS 9

M. Business Combination Achieved in Stages. Prior to control being obtained, an acquirer

accounts for its investment in the equity interests of an acquiree in accordance with the nature
of the investment bby applying the relevant standard. As part of accounting for the business
combination, the acquirer remeasures any previously held interest at fair value and takes this
amount into account in the determination of goodwill as noted above. Any resultant gain or loss
is recognized in profit or loss or other comprehensive income as appropriate.

N. Acquisition Costs. Acquisition costs are costs that the acquirer incurs to effect a business
combination.

COSTS TREATMENT
a. Direct and Indirect Expense
Ex. DIRECT: Legal fees, finders and brokerage fee,
advisory, accounting, valuation and other
professional or consulting fees to effect the
combination. INDIRECT: General and
Administrative cost, overhead that are allocated to
the merger but would have existed in its absence
and other costs of which cannot be directly
attributed to the particular acquisition.

b. Share Issuance Cost Debit to “Share Premium” or “Additional paid-in

Ex. Transaction costs such as stamp duties on new capital” account.
shares, professional adviser’s fees, underwriting
costs and brokerage fees may be incurred

c. Bond Issue Cost Bond issue cost

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 Ex. Professional advisers fees, underwriting costs
and brokerage fees may be incurred

O. Measurement of Consideration
Consideration Measured at
1. Cash/Monetary
Face Value

2. Non-Monetary
Fair Value

3. Issuance of Stocks
Fair Value

4. Assume Liabilities
Fair Value

5. Contingent Consideration

6. Share-Based Payment
Market based

P. Levels of Ownership
a. Passive Investment
b. Strategic Investment 1. Influential
2. Controlling

Q. PAS27 is entitled SEPARATE FINANCIAL STATEMENTS

R. PFRS 10 is entitled CONSOLIDATED FINANCIAL STATEMENTS
Consolidation is the process of combining the assets, liabilities, earnings, and cash flows of a
parent and its subsidiaries as if they were one economic entity.

S. Two Methods of Consolidation. Differentiate. Write the corresponding formula.

a. Cost Method b. Equity Method
P/L P/L
Purchase Price xx Impairment Loss (-) Purchase Price xx Investment Inc +
Transaction Cost xx Dividend Inc + . Transaction Cost xx Impairment Loss (-)
Impairment Loss (xx) P/L xx Investment Income xx P/L xx
CV of Investment xx Dividend xx
Impairment Loss (xx)
CV of Investment xx
T. Theory in Consolidation
1. Entity (Economic Unit) Theory – non-controlling interests are deemed to be as important as
a stakeholder of the combined entity similar to the majority shareholders.
2. Parent Theory – focuses on the information needs of the parent company shareholder.
3. Proprietary Theory – the parent is seen as having a direct interest in a subsidiary’s assets
and liabilities. Pro-rata or proportional consolidation.

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U. RmEAR stands for? Reliable measurement, Eliminate, Amortize, Recognize

Push-down Accounting. Refers to the practice of revaluing an acquired subsidiary’s assets

and liabilities to their fair values directly on that subsidiary’s books at the date of acquisition.

Reverse Acquisition. Occurs when an enterprise obtains ownership of the shares of another
enterprise but, as part of the transaction, issues enough voting shares as consideration that
control of the combined enterprise passes to the shareholders of the acquired enterprise.

V. Define.
Investment Entities. An entity that obtains funds from one or more investors for the
purpose of providing those investor/s with investment management services. It also commits
to its investors that its business purpose is to invest fund solely for returns from capital
appreciation, investment income, or both; and measures and evaluates the performance of
substantially all of its investments on a fair value basis.

Variable Interest Entities. also known as structured entities. They set up the reporting
enterprise to perform a very specific and narrow function. Created simply by delegating
specific powers to certain individuals to act on behalf of the sponsoring corporation by
creating sort of “agency” relationship with individuals instead of corporate entities.

W. Useful Computational Formulas

NON-CONTROLLING INTEREST
At Fair Value
1) Given in the problem
2) Not given, then estimate the Fair Value

I. Consideration paid includes premium II. Consideration paid includes premium

III. Proportionate Share in Identifiable CONSOLIDATED TOTAL ASSETS

Net Assets of the Subsidiary
Total Assets of Parent @BV xx
Total Assets of Subs. @FV xx
Goodwill xx
FV of Net Assets x NCI%= INAS Direct cost (if paid) (xx)
Indirect cost (if paid) (xx)
Cost to issue or register (if paid) (xx)
TOTAL ASSETS xx

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 CONSOLIDATED TOTAL LIABILITIES CONSOLIDATED RETAINED EARNINGS

Total Liabilities of Parent @BV xx Retained Earnings -Parent, beg. xx

Total Liabilities of Subs @FV xx CI in Net Income xx
CCP xx Dividends declared (xx)
Purchase Price (Liabilities) xx TOTAL RE xx
Direct cost (if unpaid) xx
Indirect cost (if unpaid) xx
Cost to issue or register (if unpaid) xx
TOTAL LIABILITIES xx

CONSOLIDATED SHAREHOLDER’S EQUITY NOTES:

SHE of Parent @BV xx Consideration Transferred xx

NCI xx Less FV of Identifiable assets acquired
Gain on BPO xx And liabilities assumed (xx)
Gain on PHI xx GOODWILL xx
Gain on CCP xx
Purchase Price (Stocks @FV) xx
Direct cost (xx)
Indirect cost (xx)
Cost to issue or register (xx)
TOTAL SHE xx

PROBLEM-SOLVING

I – Statutory Merger versus Stock Acquisition

Valuation of assets and liabilities acquired, stock acquisition, goodwill, stock price contingency

Below is the condensed balance sheet of Sons, Inc., along with estimates of fair values. Pop, Inc. is
planning to acquire Sons by issuing 100,000 shares of its P1 par value common stock (market value P8/share) in
exchange for all the outstanding common stock of Sons. Pop also guarantees the value of its shares issued. The
expected present value of this stock price contingency is P200,000.

Pre-Combination Condensed Balance Sheet

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 Book value Fair value
Current assets P 380,000 P 350,000
Plant assets ___740,000 810,000
Total assets P1,120,000
Liabilities P 500,000 450,000
Common stock 50,000
Additional paid-in capital 170,000
Retained earnings ___400,000
Total liabilities and equity P1,120,000

Required:

1. Statutory Merger: Prepare Pops’ (acquirer/acquiring) entry(ies) to record the acquisition.

2. Stock Acquisition: Prepare Pops’ (parent/acquirer/acquiring) entry to record the acquisition.

1. Statutory Merger
Current Assets P350,000
Plant Assets 810,000
Goodwill 290,000*
Liabilities P450,000
Common Stock, 1par 100 shares 100,000
Additional Paid-in Capital 700,000
APIC Stock Contingent Consideration 200,000

Common Stock (100k shares x 8) P800,000

Expected Probability of PV stock Price Contingency 200,000
Total Consideration Transferred P1,000,000
FV on net identifiable asset and liabilities acquired
Current Asset P350,000
Plant Asset 810,000
Liabilities (450,000) (710,000)
Goodwill P290,000

2. Stock Acquisition
Investment in Subsidiary P1,000,000
Common Stock, 1par 100 shares P100,000
Additional Paid-in Capital 700,000
APIC Stock Contingent Consideration 200,000

Common Stock (100k shares x 8) P800,000

Expected Probability of PV stock Price Contingency 200,000
Total Consideration Transferred P1,000,000
Less: BV of shareholders’ Equity of Subsidiary:
Common stock P50,000
Additional Paid-in capital 170,000
Retained Earnings 400,000 (620,000)
Allocated Excess P380,000
Add(Less): Over/Undervaluation of net assets
Decrease in Current Asset (350k – 380k) (30,000)
Increase in Plant Asset (810k – 740k) 70,000
Decrease in Liabilities (500k – 450k) 50,000 (90,000)

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 Goodwill P290,000

II - Assets and Liabilities Acquired, Goodwill and Bargain Purchase Gain, Contingent Consideration,
Changes in Contingent Consideration

1Here are the pre-acquisition balance sheets of Pop Company and Sicle Company on December 31, 20x5:

Pop Co. Sicle Co.

Book value Book value Market value
Current assets P 5,000,000 P 2,000,000 P 1,500,000
Investments 1,000,000 500,000 500,000
Land 10,000,000 5,000,000 6,000,000
Buildings (net) 40,000,000 25,000,000 16,000,000
Equipment (net) 25,000,000 10,000,000 2,000,000
Total assets P81,000,000 P42,500,000
Current liabilities P 4,000,000 P 1,500,000 1,500,000
Long-term liabilities 20,000,000 10,000,000 12,000,000
Common stock, P10 par 5,000,000 1,000,000
Additional paid-in capital 40,000,000 20,000,000
Retained earnings 12,000,000 10,000,000
Total liabilities & equity P81,000,000 P42,500,000

In addition to the above, Sicle Co. has identifiable intangibles with a fair value of P5,000,000, not
recognized on its books but appropriately capitalized by Pop.
On January 1, 20x6, Pop issues 400,000 shares of its stock, with a par value of P10/share and a market
value of P100/share, to acquire Sicle Company’s assets and liabilities. SEC registration fees are P1,100,000, paid
in cash.

Required:
1. Determine the following:
(a) Total assets;
(b) Total liabilities;
(c) Additional paid-in capital (share premium);
(d) Retained earnings (accumulated profit or loss); and
(e) Stockholders’/Shareholders’ equity;

2. Assume Pop issued 90,000 shares of stock at a market value of P100 per share with contingent cash
consideration amounted to P500,000 that is present obligation and reliably measureable, expected
present value of earnout agreement of P200,000 and probability present value of stock price contingency
agreement of P300,000. The following out-of-pocket costs in relation to acquisition are as follows:

Legal fees for the contract of business combination P 80,000

Broker’s fee 40,000

Accountant’s fee for pre-acquisition audit 100,000

Other direct cost of acquisition 70,000

Internal secretarial, general and allocated expenses 60,000

Documentary stamp tax on the new shares 20,000

SEC registration fee of issued shares 90,000

Printing costs of share certificates. 50,000

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 Stock exchange listing fee 30,000

Determine the following:

(a) Total assets;
(b) Total liabilities;
(c) Additional paid-in capital (share premium);
(d) Retained earnings (accumulated profit or loss); and
(e) Stockholders’/Shareholders’ equity;
3. Now assume that Pop issues 100,000 shares for all of Sicle’s shares, as in requirement (1) above, and
Pop agrees to pay cash to Salt’s previous owners if the combined earnings of Pop and Sicle exceed a
certain threshold over the next two years. The expected present value of the earnings contingency is
P8,000,000. Determine the amount of goodwill (bargain purchase gain or gain on acquisition).
4. Assume the same facts as in requirement (3). Before the contingency period is over, the estimated value
of the earnings contingency declines to P7,800,000. Prepare Pop’s entry to reflect the change in
value of the earnings contingency, if
(a) the value decline occurs within the measurement period, or
(b) the value decline is due to events occurring subsequent to acquisition.

1. a.
Assets of Pop (81M – 1.1M) P79,900,000
Assets of Sicle:
Current Assets P1,500,000
Investment 500,000
Land 6,000,000
Building (net) 16,000,000
Equipment (net) 2,000,000
Initial Goodwill 5,000,000
Goodwill 22,500,000 53,500,000
Total Assets P133,400,000
b.
Liabilities of Pop (4M+20M) P24,000,000
Liabilities of Sicle:
Current Liabilities P1,500,000
Long Term Liabilities 12,000,000 13,500,000
Total Liabilities P37,500,000

c.
Pop: (40M+(90 x 400,000) – 1.1m) P74,900,000
Sicle: -
APIC (Share Premium) P74,900,000
d.
Pop P12,000,000
Sicle -
Retained Earnings (AP/L) P12,000,000
e.
Pop 5m+(10x400,000) P9,000,000
APIC (Share Premium) 74,900,000
Retained Earnings (AP/L) 12,000,000
Stockholder’s Equity P95,900,000

Number 2 Solution:

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a.
Assets of Pop (81M – 540,000) P80,460,000
Assets of Sicle:
Current Assets P1,500,000
Investment 500,000
Land 6,000,000
Building (net) 16,000,000
Equipment (net) 2,000,000
Initial Goodwill 5,000,000 31,000,000
Total Assets P111,460,000

b.
Liabilities of Pop (4M+20M+200K) P24,200,000
Liabilities of Sicle:
Current Liabilities P1,500,000
Long Term Liabilities 12,000,000 13,500,000
Total Liabilities P37,700,000

c.
Pop 40M+(90x90K)+300K P48,400,000
Less: Stock Issuance Cost:
Documentary Stamp P20,000
SEC Registration Fee 90,000
Printing Costs 50,000 160,000
APIC of Pop P48,240,000
Sicle -
APIC (Share Premium) P48,240,000

d.
Pop, Retained Earnings, Initial P12,000,000
Legal Fees (80,000)
Broker’s Fee (40,000)
Accountant’s fee for pre-acquisition audit (100,000)
Other direct cost of acquisition (70,000)
Internal secretarial, general and allocated expenses (60,000)
Stock exchange listing fee (30,000)
Total P11,620,00
Negative Goodwill/GAIN 8,000,000
Sicle -
Retained Earnings (AP/L) P19,620,000

f.
Pop 5m+(10x90,000) P5,900,000
APIC (Share Premium) 48,240,000
Retained Earnings (AP/L) 19,620,000
Stockholder’s Equity P73,760,000

Consideration Transferred (100x100K Shares) P10,000,000

Estimated Liability for Contingent Consideration 8,000,000

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 Total Consideration Transferred P18,000,000
Less: FV of Assets and Liabilities acquired
Current Assets P1,500,000
Investment 500,000
Land 6,000,000
Building (net) 16,000,000
Equipment (net) 2,000,000
Identifiable intangibles 5,000,000
Current Liabilities (1,500,000)
Long Term liabilities (12,000,000) 17,500,000
Goodwill P500,000

Number 3 Solution:

a. Estimated Liability for Contingent Consideration 200,000

Goodwill 200,000

b. Estimated Liability for Contingent Consideration 200,000

Gain on Acquisition 200,000
Gain on Acquisition 200,000
Retained Earnings 200,000

III –Valuation of Assets acquired and Liabilities assumed, Measurement of Consideration Transferred,
Change in value of Assets acquired, Pre-acquisition Contingency, In-process R&D

1Sandy Corporation’s balance sheet at January 2, 20x5 is as follows:

Sandy-Dr(Cr)
Cash and receivables………………………………………………………….. P200,000,000
Inventories………………………………………………………………………… 600,000,000
Property, plant and equipment, net…………………………………………. 7,500,000,000
Current liabilities………………………………………………………………….. (400,000,000)
Long-term debt…………………………………………………………………… (7,200,000,000)
Capital stock………………………………………………………………………. (7,200,000)
Retained earnings……………………………………………………………….. ( 25,000,000)
Accumulated other comprehensive income……………………………… (5,000,000)

An analysis of Sandy’s assets and liabilities reveals that book values of some reported items do not reflect their
market values at the date of acquisition:
 Inventories are overvalued by P200,000,000
 Property, plant and equipment is overvalued by P2,000,000,000
 Long-term debt is undervalued by P100,000,000
In addition, the following items are not currently reported on Sandy’s balance sheet:
 Customer contracts, valued at P25,000,000
 Skilled work force, valued at P45,000,000
 In-process research and development, valued at P300,000,000
 Potential contracts with prospective customers, valued at P15,000,000
 Sandy has not recorded expected future warranty liabilities with a present value of
P10,000,000

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 On January 2, 20x5, Velasco issues new stock with a market value of P700,000,000 to acquire the assets
and liabilities of Sandy. Stock registration fees are P100,000,000, paid in cash. Consulting, accounting, and legal
fees connected with the merger are P150,000,000, paid in cash. In addition, Velasco enters into an earnings
contingency agreement, whereby Velasco will pay the former shareholders of Sandy an additional amount if
Sandy’s performance meets certain minimum levels. The present value of the contingency is estimated at
P50,000,000.

Required:
1. Determine the amount of goodwill.
2. Assume that during March, 20x5, new information comes in regarding the value of Sandy’s property, plant
and equipment at the date of acquisition. It is determined that the property was actually worth P1,500,000
less than previously estimated. Make the entry to record this new information.

1.
Consideration Transferred
Shares 700,000,000
Estimated Liability for Contingent Consideration 50,000,000
750,000,000
Less: FV of Assets and Liabilities Acquired
Cash and Receivables 200,000,000
Inventories 400,000,000
PPE 5,500,000,000
Customer Contracts 25,000,000
In-Process R&D 300,000,000
Current Liabilities (400,000,000)
Long-term debt (7,300,000,000)
Warranty liability (10,000,000)
GOODWILL 2,035,000,000

2.
Acquisition-related expenses 150,000,000
Cash 150,000,000

Share Premium 100,000,000

Cash 100,000,000

Goodwill 1,500,000
PPE 1,500,000

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