THE CPA BOARD EXAMS OUTLINES SERIES

by John Mahatma Agripa, CPA

ADVANCED FINANCIAL ACCOUNTING

AND REPORTING

BUSINESS
COMBINATIONS:
DATE OF ACQUISITION +
SUBSEQUENT TO ACQUISITION
Based on lectures by Rodiel C. Ferrer, CPA, Ph.D.
(CPAR)
GENERAL CONCEPTS:
BUSINESS COMBINATION AT DATE OF ACQUISITION

 Business combinations are transactions where the acquirer

obtains control over another entity called the acquiree, through
either asset acquisition or purchase of at least 51% of the
acquiree’s voting stocks

 In an asset acquisition, the entire net assets of the acquiree are

obtained, resulting to either the dissolution of the acquiree
(statutory merger) or the formation of a new entity with the
dissolution of both the acquirer and acquiree (statutory
consolidation). Since one or both entities are dissolved, there is no
parent-subsidiary relationship in asset acquisitions

In stock acquisition, on the other hand, both entities continue to

operate after the transaction. If the acquirer obtains less than the
entire voting stocks of the acquiree, there emerges a parent-
subsidiary relationship, in which case the non-controlling interest
(NCI) is recognized

 Accounting business combinations uses the purchase/acquisition

method, where acquiree assets are measured at fair value. The
outlawed pooling-of-interest method records acquiree assets at
book value

 All business combinations require disclosure of who is the

acquirer, when is the acquisition date (when the fair value of
acquiree assets shall be based, which is still adjustable one year
after this date), the identifiable assets (excluding acquiree
goodwill), the non-controlling interest, and the goodwill or gain
from acquisition

TOTAL ASSETS, LIABILITIES AND EQUITY

ON DATE OF ACQUISITION

 As an alternative to the ‘CARLAS’ formula, the total assets,

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liabilities and equity of the acquirer right after the acquisition can
be computed as follows. The items shall be discussed on
subsequent sections

Total acquirer assets, at book value xx

ADD: Total acquiree assets, at fair value xx
ADD: Goodwill xx
DEDUCT: Cash, non-cash assets paid xx
DEDUCT: Expenses paid xx
Total assets xx

Total acquirer liabilities, at book value xx

ADD: Total acquiree liabilities, at fair value xx
ADD: Bonds, notes and other debt issued xx
ADD: Contingent consideration xx
ADD: Expenses not yet paid xx
Total liabilities xx

Total acquirer equity xx

ADD: Non-controlling interest xx
ADD: Shares issued as part of payment, at fair value xx
ADD/DEDUCT: Gains/losses from bargain purchase,
previously-held investments, contingent consideration xx
DEDUCT: All expenses, regardless of payment xx
Total equity xx

GOODWILL / GAIN ON
BARGAIN PURCHASE OPTION

 Goodwill results if the acquirer pays more than the fair value of
the net assets of the acquiree. Otherwise, a gain on bargain
purchase option emerges. Goodwill is not an identifiable asset,
and therefore not recorded by the acquirer if the acquiree has
preexisting ones (and thus not included in the formula above)

In cases that the business combination involves acquisition of

two or more acquirees, goodwill from the acquirees is not
combined. If there’s a gain on one acquiree, it is not netted
against the goodwill of the other acquiree

 Goodwill/gain from the combination can be computed with

either of the following formulas:

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 Fair value of previously-held interest xx
ADD: Fair value of additional consideration xx
ADD: Fair value of contingent consideration payable xx
ADD: Present value of deferred consideration xx
Purchase price xx
ADD: Fair value of non-controlling interest xx
Fair value of acquiree xx
DEDUCT: Book value of acquiree’s net asset xx
Excess xx
ADD: Overvalued assets xx
DEDUCT: Undervalued assets xx
Goodwill / (Gain) xx

Purchase price (includes control premium, if any) xx

DEDUCT: Fair value of acquiree net assets xx
Goodwill / (Gain) xx

Control premium refers to additional payments made by the

acquirer to make sure the acquiree sells its assets to them

 The fair value of acquiree net assets are provisional, which

means they can still be changed within one year from the date of
acquisition, subsequently affecting goodwill. The changes are
applied retrospectively, which means if there is a change on fair
values a few months from the date of acquisition, the resulting
goodwill shall be the goodwill as of the date of acquisition

 Goodwill is allocated between the parent and subsidiary using

their interest percentages, while any gain is all allocated to the
parent

NON-CONTROLLING INTEREST
AND THE D&A SCHEDULE

 As mentioned, non-controlling interest (NCI) is only recognized

in stock acquisitions of less than the entire voting shares of the
acquiree. This is measured at fair value or implied value, if fair
value is not available. This forms part of goodwill computation
and of total equity

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 The implied value of NCI can be computed as follows:

Purchase price xx
DEDUCT: Control premium, only if included in purchase price xx
xx
DIVIDE: Controlling interest % xx%
xx
MULTIPLY: Non-controlling interest % xx%
NCI implied value xx

 The amount of NCI to be recorded follows the floor test – it must

be the higher between the given fair or implied value of NCI, and
the proportionate/relevant share. In no instance should the NCI
be lower than the proportionate/relevant share. The floor test
may be overridden in some jurisdictions, but for examination
purposes it shall always be followed

 NCI and goodwill can actually both be computed with the D&A
schedule, as follows:

Total Purchase price NCI

Fair value of subsidiary (f) (a) (e)
Relevant share (b) (c) (d)
Goodwill / (gain) (g) xx xx

First enter the purchase price (includes the control premium) in

(a) and the fair value of the acquiree’s net assets in (b).
Remember that existing goodwill of acquiree is not included.
Multiply (b) with the controlling interest % for (c) and with the
NCI % for (d)

(d) is the proportionate/relevant share, which is the basis for the

floor test. If the NCI’s fair value or implied value is lower than
this amount, (d) is copied to (e). (a) and (e) are then added, and
deducted with (b) for the goodwill/gain (g)

PREVIOUSLY-HELD INTEREST

 This refer to the interest on the acquiree by the acquirer below

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 51% such as investments in associate and equity securities that
didn’t grant it control over the former. Its fair value shall form
part of the purchase price for the computation of goodwill, which
can be computed as follows:

Additional consideration for the additional interest to obtain

control xx
DIVIDE: Additional interest % xx%
xx
MULTIPLY: % of previously-held interest xx%
Fair value of previously-held interest xx

For instance, if the acquirer previously had an investment in

associate (25%) over the acquiree, and pays Php 100,000 for
another 30% interest, thereby granting it control, Php 100,000
is the additional consideration and the 30% is the additional
interest percentage. 25% is the previously-held interest
percentage

 Gains/losses from previously-held interest forms part of total

equity. To compute, the carrying value of the investment in
associate (or any other investment) has to be adjusted (for
income, dividends, impairment) and compared with the
computed fair value

 A business combination in which this arises is called step-up

acquisition

CONTINGENT LIABILITY PAYABLE

 Also called upfront fee, these are additional payments promised

by the acquirer to be paid if certain conditions are met. These
amounts are presented in their present values. The present
value forms part of purchase price, and gains/losses form part
of total equity

 Since provisional, this present value may change within one year
of the acquisition, which retrospectively affects goodwill.

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 However, if the change is the result of meeting earnings targets,
milestones in research and development, or reaching specific
markets, goodwill is not adjusted. In such cases, a separate
account is made

 The gains/losses are the changes in the consideration payable.

Since a liability, increases in the amount is a loss, and vice versa

EXPENSES AND OTHER ITEMS

 There are generally three expense accounts in business

combinations – direct costs, indirect costs, and costs to issue
and register (or stock issuance costs). They form part of the
computation for total assets, liabilities and equity

These expenses, including direct cost, are not capitalized in the

investment in subsidiary account

 Also included in the purchase price in the computation of

goodwill are fully amortized and internally-generated intangible
assets, both of which are considered identifiable

GENERAL CONCEPTS:
BUSINESS COMBINATION SUBSEQUENT TO ACQUISITION

 Problems on business combination subsequent to acquisition

revolve around the preparation of consolidated financial
statements and computation of consolidated net income in the
presence of a parent-subsidiary relationship

 In its separate financial statements, the parent/holding company

accounts for its control over its subsidiary with an investment in
subsidiary account, measured with the cost model. The account is
composed of cash, share or contingent considerations given

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COMPUTATION OF CONSOLIDATED
NET INCOME (CNI)

 There are in total 27 items considered in the computation of

consolidated net income, divided into the parent’s and that of the
non-controlling interest. Components are discussed in the
subsequent sections

CNI - Parent CNI - NCI

Parent net income xx
DEDUCT: Dividend from subsidiary xx
Income from own operation of parent xx
ADD/DEDUCT: Share in net income/loss
of subsidiary xx xx
DEDUCT: Amortization of undervaluations xx xx
ADD: Amortization of overvaluations xx xx
ADD: Gains from bargain purchase,
previously-held interest and
contingent considerations xx
DEDUCT: Impairment losses xx xx
ADD: Realized profit from beginning
inventory (RPBI), downstream sales xx
DEDUCT: Unrealized profit from ending
inventory (UPEI), downstream sales xx
ADD: RPBI, upstream sales xx xx
DEDUCT: UPEI, upstream sales xx xx
ADD: Realized gains from upstream sales xx xx
ADD: Realized gains from downstream sales xx
DEDUCT: Realized losses from upstream xx xx
DEDUCT: Realized losses from downstream xx
DEDUCT: Unrealized gains from upstream xx xx
DEDUCT: Unrealized gains from downstream xx
ADD: Unrealized losses from upstream xx xx
ADD: Unrealized losses from downstream xx xx
Consolidated net income (parent + NCI) xx xx

Items shared by both parent and the non-controlling interest –

particularly share in net income/loss of subsidiary, amortization of
undervaluations and overvaluations, and profits/gains/losses
from upstream sales – are divided according to ownership
percentage

If the business combination occurred sometime during the year,

say in May, the said items shall be prorated according to the
remaining months of the year (multiplied by 8/12)

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The exception would be impairment losses, which is divided
according to the proportion of goodwill belonging to the parent
and NCI as computed with the D&A schedule (see page 5). This is
not prorated

Gains from bargain purchase, previous interest and contingent

consideration are only included in the computation if the net
income related to the year of the business combination

OVER/UNDERVALUATION OF
ASSETS

 There is overvaluation if the book value of the asset exceeds its

market value. On the opposite case, there’s undervaluation

Amortization of the over/undervaluation depends on the related

asset. If the asset is depreciable, the amount is amortized as it
is depreciated, according to remaining useful life. If the asset is
part of inventory or is non-depreciable like land, the amount is
amortized if the asset is sold

If silent, the amount of inventory given is assumed to be all sold

during the year, thus all amortized

INTERCOMPANY SALES:
UPSTREAM AND DOWNSTREAM SALES

 Intercompany sales are transactions between the parent and

subsidiary, classified as either upstream (sale of subsidiary to
parent) or downstream (sale of parent to subsidiary). The sale
may be that of inventory, depreciable assets or land

As seen in the formula, all gains and losses, realized or

unrealized, from upstream sales go both to the parent and
subsidiary – divided according to the percentage of interest.

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 Gains and losses from downstream sales only go to the parent

The gains and losses may be realized or unrealized. There is an

unrealized gain if the seller (parent or subsidiary) transfers the
asset to the buyer (subsidiary or parent) at a price higher than
book value. The gain is only between the two entities, so its
effect is removed from consolidated income – unrealized gains
are deducted, while unrealized losses are added back. Realized
gains occur when the transferred asset is sold to a third party at
a price higher than the book value

The treatment of these gains and losses differ according to the

related asset – inventory, depreciable asset or land

 Unrealized profit from ending inventory (UPEI) is actually the

markup on inventory transferred from the parent/subsidiary still
remaining on the stocks. Ending inventory purchased from
outside sources does not constitute UPEI. On the following year,
this very amount becomes realized profit from beginning
inventory (RPBI), assuming of course that the entire inventory is
sold next year to third parties. If the same inventory is not sold,
UPEI for that inventory will remain the following year

 Unrealized gains or losses from transfer of depreciable assets

and land is recorded only in the year they are transferred to the
parent/subsidiary. For depreciable assets, this amount is
amortized on a straight-line basis according to the asset’s
remaining useful life, and recorded as realized gains or losses. If
the asset is sold to third parties, the unamortized amount is fully
recorded as realized

For land, the unrealized amount becomes realized only if the

land is sold to third parties. This unrealized amount is strictly the
only amount that shall be realized, even if the land was sold at a
way higher price

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CONSOLIDATED FINANCIAL
STATEMENTS

 The preparation of consolidated financial statements is only

required for public entities. The computation of total assets and
liabilities follow the formulas on page 3. Formulas for other
consolidated components of the financial statements are as
follows:

Parent sales xx
ADD: Subsidiary sales xx
DEDUCT: Intercompany sales, at selling price xx
Consolidated sales xx

Parent COGS xx
ADD: Subsidiary COGS xx
DEDUCT: Intercompany purchases, at selling price xx
ADD: UPEI, upstream and downstream xx
DEDUCT: RPBI, upstream and downstream xx
Consolidated cost of goods sold xx

Parent gross profit xx

ADD: Subsidiary gross profit xx
DEDUCT: UPEI, upstream and downstream xx
ADD: RPBI, upstream and downstream xx
ADD: Amortization of inventory overvaluation xx
DEDUCT: Amortization of inventory undervaluation xx
Consolidated gross profit xx

Parent expenses xx
ADD: Subsidiary expenses xx
ADD: Amortization of depreciable asset undervaluation xx
DEDUCT: Amortization of depreciable asset overvaluation xx
ADD: Realized losses from depreciable assets xx
DEDUCT: Realized gains from depreciable assets xx
Consolidated expenses xx

Parent shareholders equity xx

ADD: Non-controlling interest, at date of acquisition xx
ADD: Parent net income xx
ADD: Subsidiary net income xx
DEDUCT: Parent dividend declarations xx
DEDUCT: Share of dividend from subsidiary xx
Consolidated shareholders equity xx

Parent retained earnings, beginning xx

ADD: Parent net income xx
DEDUCT: Parent dividend declarations xx
Consolidated retained earnings xx

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