IFRS 3 Business Combinations

IFRS 3 Business Combinations

Whether this is a business combination?

Accounting differences between asset acquisition and business combination:

	Business combination	Asset acquisition
Measurement	Fair value	At cost
Transaction cost	Expensed	Capitalised
Goodwill	Yes	No

Tests to identify whether this is a business combination or asset acquisition transaction

Step 1: Concentration test (optional test)

If substantially all of the fair value of the total assets acquired is concentrated (approximated) in a single (one) identifiable asset or group of similar identifiable assets.

If both conditions are met, the transaction is an asset acquisition, ie to:

Dr Asset at cost

Cr Bank

Step 2: If the step 1 is not performed (permitted by the standard) or conditions not met, detailed analysis must be provided based on:

Inputs – various assets
Process – management procedures
Outputs – goods, services and income

Example 1:

Company A acquires company B and a mine existed in company B.

Fair value of company B’s mine is $1.5m.

Price paid by company A for company’s B’s 100% shares is $1.4m. In addition, company A promises to assume $0.1m of company B’s bank loan liability.

Required:

In applying the concentration test, the classification of transaction?

Answer:

In concentration test, the transaction is an asset acquisition if two conditions are met:

Fair value of the acquired asset approximates to the fair value of the single asset (one acquired asset in this case, ie one mine) - $1.4m+$0.1m = $1.5m.

There is a single asset – one mine.

Therefore, the transaction is merely an asset acquisition, the accounting treatment would be to:

Dr PP&E at cost $1.5m (historical cost method)

Cr Bank $1.4m

Cr Liability $0.1m

Example 2:

Company A acquires 100% of company B and in company B, there are 5 houses leased to residential lessees and 3 office buildings leased to commercial leases.

The price paid to acquire 100% shares in company B approximates the fair value of those assets (5 houses and 3 office buildings).

There are no employees in company B, therefore, the security and cleaning works must be done by staff in company A to service those lessees.

Required:

In applying the concentration test, the classification of transaction?

Answer:

In concentration test, the transaction is an asset acquisition if two conditions are met:

Fair value of the acquired asset approximates to the fair value of the similar assets – fair value criteria is met
Assets are not similar as risks are different regarding residential and commercial lessees.

Therefore, the concentration test is not met.

Since the test is not met, detailed analysis is required on inputs, processes and outputs:

There are existing outputs (rental income) in company B, however, no staff is acquired, therefore, the transaction is an asset acquisition.

Further evidence also suggests that the transaction is an asset acquisition as the acquired process (providing cleaning and security work to other lessees) can be easily replaced without significant costs, ie these services can be provided by other third parties.

Acquisition accounting

Step 1: Identify an acquirer

The acquirer is the entity which obtains control over the acquiree.

General rule: The acquirer which transferred cash or other assets.
Other factors to consider if no cash or other assets are transferred (share for share exchange):
- Who dominates acquiree’s management
- Who has the largest portion of voting rights in the combined entity
- The acquirer is usually the larger entity (assets or profits)

Example:

Company A and B acquires company C for 70% and 30%, however, there is no cash or other asset transfer to acquire company C’s shares. The acquisition is in the form of share for share exchange.

After the combination, six of the company’s directors come from company A and three directors come from company B.

Required:

Identify the acquirer.

Answer:

Company A is the acquirer.

As the general rule does not apply, ie no cash or other assets transfers, the following factors are considered:

Who dominates acquiree’s management – company A
Who has the largest portion of voting rights in the combined entity – company A
The acquirer is usually the larger entity (assets or profits) – no information.

Step 2: Acquisition date

At acquisition date – Goodwill is calculated.
From the acquisition date – assets, liabilities, equity, income and expenses will be consolidated.

Step 3: Assets and liabilities at acquisition

Assets and liabilities at acquisition should be measured at fair value, ie fair value adjustments (FVA).

Common assets include:

Intangible assets such as internally generated brand
Existed goodwill in the acquiree’s account should not be consolidated, ie Dr Net asset Cr Goodwill is required
PP&E measured at fair value
Deferred tax asset – Dr Deferred tax asset Cr Net assets

Common liabilities include:

Contingent liabilities and provisions
Deferred tax liabilities

Example:

Company A acquires 80% of company B. The individual financial statements of company B are as follows:

Elements ($000)	Carrying value at acquisition date	Fair value at acquisition date
Share capital	5,000
Retained earnings	3,000
PP&E	500	800
Intangible assets – brand	Nil	200
Intangible assets – purchased goodwill	100	Nil
Contingent liability – lawsuit	Nil	250

Required:

Calculate the total value of company B’s net assets at the date of acquisition for the purpose of calculating goodwill.

Answer:

Elements ($000)	Carrying value at acquisition date	Fair value at acquisition date
Share capital	5,000	5,000
Retained earnings	3,000	3,000
PP&E	500	800	Dr PP&E at cost 300 Cr Net asset 300
Intangible assets – brand	Nil	200	Dr Intangible asset at cost 200 Cr Net asset 200
Intangible assets – purchased goodwill	100	Nil
Contingent liability – lawsuit	Nil	(250)	Dr Net asset 250 Cr Provision liability 250
		8,750

Goodwill calculation

Full goodwill method		The proportionate share of net assets method (Partial goodwill method)
FV of consideration	X	FV of consideration	X
FV of NCI (full goodwill)*	X	Proportionate share of net asset (partial goodwill) *	X
FV of net assets	(X)	FV of net assets	(X)
Goodwill	X	Goodwill	X
Goodwill is attributable to both controlling and non-controlling interest.		Goodwill is only attributable to controlling interest.

Bargain purchase (negative goodwill)

This arises when the combination of fair value of consideration and NCI is less than the fair value of subsidiary’s net assets being acquired.
Negative goodwill is rare and errors may have been made in estimating the fair value of consideration – detailed checks are required to confirm its accuracy.
If there are no errors made regarding the calculation, the bargain purchase should go to consolidated P/L and accumulate into group retained earnings.

Measurement period

The measurement period to update new information regarding the net assets of the acquired entity should be within 12 months after the acquisition date.

Uniform accounting policy

If a group entity uses accounting policies other than those in the consolidated financial statements, appropriate adjustments should be made on consolidation.

Illustrative question – Goodwill:

Good plc bought Bad Ltd last year for $260m for 80% of shares. The fair value of the NCI at that date was $60m. The net assets of Bad Ltd at that point was $250m.

Required:

Calculate the goodwill using full goodwill method and partial goodwill method.

Answer:

Full goodwill method:

	$m
FV of consideration	260
FV of NCI	60
FV of net assets of Bad Ltd	(250)
Goodwill	70

Partial goodwill method:

	$m
FV of consideration	260
Proportionate share of NA(20% x 250)	50
FV of net assets of Bad Ltd	(250)
Goodwill	60

Comment:

Goodwill calculated under the full goodwill method is higher than that using partial goodwill method.
The reason is that under the full goodwill method, goodwill is attributable to both controlling and non-controlling interest whereas under partial goodwill method, goodwill is only attributable to controlling interest.
Another way to calculate goodwill under partial goodwill method is as follows: $260m - $80% x $250m = $60m

Example – measurement period in goodwill calculation:

Company A acquires 100% shares in company B for $50m and on the acquisition date, the fair value of net assets in company B was $10m.

However, 2 months after the acquisition date, company A receives updated information about company B’s net assets, the company B’s net assets should be updated by $6m.

Required:

Whether company A should retrospectively adjust the goodwill calculation?

Answer:

Yes. This is because company A receives the updated information within 12 months after the acquisition date. Therefore, the initial measurement of goodwill should be adjusted.

Initial goodwill calculation:

$50m - $10m = $40m

New goodwill calculation:

$50m – ($10m+$6m) = $34m

Example – uniform accounting policy impacts on goodwill calculation:

Company A acquired 100% shares in company B for $6,000 whereas the fair value of net assets of company B was $1,000 at acquisition date.

Company A uses revaluation model for its land and buildings whereas the accounting policy in company was to use cost model.

If company B changes its accounting policy from cost model to revaluation model to measure the land and buildings value:

PP&E using cost model	$350
PP&E using revaluation model	$450
Difference (increase in value)	$100

Required:

Consolidation adjustment to bring the accounting policy of B in line with A.

Answer:

Fair value of consideration

$6,000

-Fair value of net assets

$1,000

Accounting policy adjustment:

Dr PP&E $100

Cr Net asset $100

$(1,100)

Goodwill at acquisition

$4,900

When consolidating the accounts, the subsidiary’s PP&E value will be reduced by $100 (reflected in the debit side of the journal entry).

Purchase consideration

Legal fees should be expensed to P/L rather than be capitalised as goodwill.

Cash consideration = Cash price/share x Number of shares acquired

Share for share exchange = Parent’s share price x number of Parent’s shares in issue to exchange subsidiary’s shares

Deferred considerations - This can either be cash or share for share deferred considerations.

Deferred cash consideration:

Step 1: Discount Cash price/share x Number of shares acquired:

Dr Investment in subsidiary (Goodwill)

Cr Liability (Current or Non-current liability)

Step 2: Unwind the liability to when it is finally paid:

Dr Finance cost

Cr Liability

Step 3: Settle the liability:

Dr Liability

Cr Cash

Deferred share consideration:

Step 1: Measure at fair value at acquisition date

Dr Investment in subsidiary (Goodwill)

Cr Share capital (at par value)

Cr Share premium (excess amount)

Step 2: Ignore subsequent fair value changes.

Contingent cash consideration:

Step 1: Discount Cash price/share x Number of shares acquired, times by probability of target being met:

Dr Investment in subsidiary (Goodwill)

Cr Liability (Current or Non-current liability)

Step 2: Unwind the liability to when it is finally paid:

Dr Finance cost

Cr Liability

Step 3: Settle the liability:

Dr Liability

Cr Cash

Step 4: Difference between recognised and actual liability:

Dr/Cr Liability

Cr/Dr P/L

Loan notes – Parent issues loan notes (could be convertible bonds) to acquires shares in subsidiary. For instance, parent issues $100 10% loan notes for every 200 shares acquired in subsidiary, and if there are 10,000 shares acquired. The fair value of consideration = 10,000 shares acquired/200 shares x $100 = $5,000:

Dr Investment in subsidiary (Goodwill) $5,000

Cr Loan note liability $5,000

Subsequent measurement for loan note liability is needed, ie to recognise finance cost and the interest paid per IFRS 9 Financial instruments.Dive deeper, conquer those exams, and truly make your mark by grabbing your spot in our ACCA online course today at https://www.globalapc.com/cour... – let’s crush this together!

Example:

BG plc acquired 80% shares in DC ltd. The net assets of DC ltd were $11,400m. The NCI at the date of acquisition was $2,500m.

The arrangement of the consideration is as follows：

Now:

BG plc agrees to pay $500m cash
BG plc agrees to issue 1,000m shares with $3.5/share

In 2 years’ time:

BG plc agrees to pay $2,000m
BG plc agrees to issue an additional 2,000m shares
BG plc agrees to pay another $3,000m if DC Ltd’s profits increase by 30% after acquisition. There is 80% probability that the target can be met.

The effective interest rate is 12%.

Required:

Calculate the goodwill at the date of acquisition.

Answer:

FV of consideration:

Cash consideration	500
Shares (1m x $3.5/share)	3,500
Deferred cash consideration ($2,000/1.12^2)	1,594
Deferred Shares (2m x $3.5/share)	7,000
Contingent cash (80% x $3,000/1.12^2)	1,913

14,507

+NCI

2,500

-Net Assets

(11,400)

Goodwill at acquisition:

5,607

Workings ($m):

Deferred cash consideration:

At acquisition:

Dr Investment in subsidiary (Goodwill) 1,594

Cr Liability 1,594

1^st Year:

Dr Finance Cost 191 (1,594 x 12%)

Cr Liability 191

2^nd Year:

Dr Finance Cost 215 (1,785 x 12%)

Cr Liability 215

Shares issued now:

Dr Investment in subsidiary (Goodwill)3,500

Cr Share Capital (1m x $1/share) 1,000

Cr Share Premium 2,500

Shares to be issued in 2 years’ time:

Dr Investment in subsidiary (Goodwill) (2m x $3.5/share) 7,000

Cr Share Capital (2m x $1/share) 2,000

Cr Share Premium 5,000

Contingent cash payment:

Dr Investment in subsidiary (Goodwill)1,913

Cr Liability 1,913

1^st Year:

Dr Finance Cost 230 (1,913 x 12%)

Cr Liability 230

2^nd Year:

Dr Finance Cost 257 (2,143 x 12%)

Cr Liability 257

If the actual cash payment is $2,450 where the accumulated contingent consideration liability is $2,400 at the end of the second year, the additional journal entry is needed:

Dr Finance cost $50

Cr Liability $50

When the liability is then settled:

Dr Liability $2,450

Cr Bank $2,450

Dive deeper, conquer those exams, and truly make your mark by grabbing your spot in our ACCA online course today at https://www.globalapc.com/cour... – let’s crush this together!

Categories: : Strategic Business Reporting (SBR)