BUSINESS COMBINATIONS

Important Terms to Remember:

OUTLINE TOPIC:
1. Accounting for Goodwill Goodwill
2. Methods of Estimating Goodwill - Initially measured at cost, being the excess of the cost of the business
3. Reverse acquisitions and measuring the consideration transferred combination over the acquirer’s inerest in the net fair value of the
identifiable assets, liabilities and contingent liabilities recognized.
- After initial recognition, Goodwill is measured at cost less
OBJECTIVE: accumulated amortization and accumulated impairment losses.
1. Apply the methods of estimating goodwill. - Is amortized in accordance with the principles of amortization of
2. Account for reverse acquisitions. intangible assets.
- If a realiable estimate of the useful life of goodwill cannot be made,
the life is presumed to be 10 years.
LEARNING OUTCOME: - Goodwill does not generate cash inflows. It only contributes on the
1. Understand how goodwill are estimated. cash flows.
2. Able to apply reverse acquisitions in business combinations.
3. Identify the methods of determining goodwill.  For every merger and consolidation of a business combination,
the comparison should be between the following:
Guide Question: i. Consideration transferred.
1. How are goodwill treated in business combinations ? ii. Acquirer’s interest in the net fair value of the acquiree’s
2. What is the distinction of acquirer and acquiree in a reverse identifiable assets acquired and liabilities assumed.
acquisition in business combination?  Goodwill arises when I exceeds II. Goodwill is
3. How are considerations transferred in business combinations recognized as an ASSET.
measured?  Bargain Purchase arises when II exceeds I. A gain on
acquisition is recognized in the PROFIT OR LOSS.

Lesson to Research: Impairment

1. Indirect valuation as distinguished from Direct valuation of estmating
goodwill.
2. Estimating Goodwill during a purchase.
3. Application Direct valuation methods in various cases.
4. Conventional versus Reverse Acquisitions.
- Goodwill is not amortized but rather tested for impairment at least
annually.
- Impairment occur when the recoverable amount of an item is less
that its carrying amount.
- A Cash Generating Unit is impared if its recoverable amount is less
than its carrying amount including goodwill.
- Impairment loss is charged first to the CGU’s goodwill.
- Any excess is charged to the other assets in the CGU.
- Impairment of goodwill is not reversed in the subsequent period.

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- If the CGU is disposed, the goodwill allocated to it is also
derecognized and included in the determination of gain or loss from
disposal.
CGU (Cash-Generating-Units)
- Test of impairment is by allocating goodwill to each CGU in the year
of business combination or at the end of the following year when not
completed.
- CGU is the smallest identifible group of assets that generates cash
inflows that are largely independent of the cash flows from other
assets or groups of assets (PAS 36.6)
Due diligence Audit
- Investigation of acquiree’s business before an investor agrees to a
business combination.
- Refer to exercise of care that a reasonable and prudent person
should take most commonly performed by CPAs or external audit
firms.
- Helps an investor evaluate the possible risks and rewards of the
potential investment and determine whether it would be a good
decision to pursue it.
RISKS
 Future losses due to acquiree’s pending litigation
and unrecorded contingencies
 Overstatement of assets and understated liabilities
 Incomparability of internal cultures, systems and
policies
REWARDS
 Unrecorded assets, such as trade secrets, trade
name, customer lists, and the like
 Understatement in the consideration for the
business combination due to the acquiree’s
undertated assets and overstated liabilities
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Normal Earnings
- Normal Rate of Return x Aquiree’s Net Assets
Methods of Estimating Goodwill
Indirect valuation
- Goodwill is measured as the excess of the sum of:
o consideration transferred, non-controlling interest in the
acquiree, and previously held equity interest in the acquiree
over the fair value of net identifiable assets acquired.
(FPRS 3)
Direct valuation
- Goodwill is measured based on expected future earnings from the
business to be acquired
Informations required when applying Direct Valuation Method:
- Normal Rate of Return where the acquiree belongs. It refers to the
industry averaged from annual reports and other statistical data.
- Estimated future earnings of the acquiree
• which are adjusted for non-recurring income and
expenses (e.g. expropriation gains or losses).
• excess of the acquiree’s normalized earnings over
average return is called “excess earnings” or superior
earnings.
- Discount rate to be applied to “excess earning”.
- Probable duration of “excess earnings”.
Various Methods in Applying Direct Valuation:
- Multiples of average excess earnings
- Capitalization of average excess earnings
- Capitalization of average earnings
- Present value of average excess earnings
BUSINESS COMBINATIONS
owners of the legal parent (accounting acquiree) the same
percentage of equity interest in the combined entity that results from
Problem Solving: the reverse acquisition.
APPLICATION OF DIRECT VALUATION METHOD

ABC Company is contemplating on acquiring XYZ Inc. The following

information was gathered through a due diligence audit.

 The actual earnings of XYZ, Inc. for the past 5 years are shown below:
20x1 P1,200,000 Conventional acquisition versus Reverse acquisition:
20x2 1,300,000
20x3 1,350,000 Conventional acquisition Reverse acquisition
20x4 1,250,000 Issuer of shares - Accounting acquirer - Accounting
20x5 1,800,000 as consideration acquiree
Total P6,900,000 transferred
Reference to - Accounting - Accounting
 Earnings in 20x5 include expropriation gain or non-recurring combining acquirer/Legal acquirer/Legal
income/expenses of P400,000 constituents parent subsidiary
 The fair value of XYZ’s net assets as of the end of 20x5 is P10M. - Accounting - Accounting
 The industry average rate of return is 12% acquiree/Legal acquiree/legal
 Probable duration of “excess earnings” is 5 years subsidiary parent
Measurement of Fair value of consideration Fair value of the
REQUIRED: Compute for the Goodwill using Method 1 (Multiples of Consideration transferred by the notional number of
Average Excess earnings) transferred accounting acquirer. equity instruments

that the accounting

acquirer (legal
subsidiary) would have
Reverse acquisitions had to issue to the
- The opposite in a business combination where the entity that issues accounting acquiree
securities (the legal acquirer) is identified as the acquiree for (legal parent) to give
accounting purposes, while the entity whose equity interest are the owners of the
acquired (the legal acquiree) is the acquirer for accounting purposes. accounting acquiree
(egal parent the same
Measurement of Consideration Transferred percentage ownership
- An amount based on the number of equity interests the legal in the combined entity.
subsidiary (accounting acquirer) would have had to issue to give the

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Problem Solving: Reverse acquisition Sources/ References:

BOOK READING/S
Companies A and B decide to consolidate. Asset and estimated annual  Accounting for Business Combinations (Advanced Accounting 2) – Zeus
earnings contributions are as follows: V. B. Millan
A B TOTAL  Advanced Financial Accounting and Reporting (Theories and Problem) –
Net assets contribution P300,000 P400,000 P700,000 Antonio J. Dayag
Estimated annual earnings
contribution 50,000 80,000 130,000

Stockholders of the two companies agree that a single class of stock be

issued, that their contributions be measured by net assets plus allowances
for goodwill, and that 10% be considered as a nomal rate of return . Earnings
in excess of the normal rate of return shall be capitalized at 20% in calculating
goodwill. It was also agreed that the authorized capital stock of the new
corporation shall be 20,000 shares with a par value of P100 a share.

REQUIRED: a) the amount of goodwill credited to Co. A

b) total contribution of Co. B (including goodwill)

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