Module 1.

1
Computing goodwill arising from a business combination

Business Combination (Part 1)

Related Standards:
PFRS 3 Business Combination
Section 19 of the PFRS for SMEs

Learning Objectives:
1. Define a business combination
2. Explain briefly the accounting requirements for a business combination
Introduction
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.

Business combinations are carried out either through:

1. Asset acquisition; or
2. Stock acquisition

Asset Acquisition
- The acquirer purchases the assets and assumes the liabilities of the acquire in exchange for cash or other non-cash consideration
(which may be the acquirer’s own shares). After the acquisition, the acquired entity normally ceases to exist as a separate legal or
accounting entity. The acquirer records the assets acquired and liabilities assumed in the business combination in its books of
accounts.
Under the Corporation Code of the Philippines, a business combination effected through asset acquisition may be either:
a. Merger – occurs when two or more companies merge into a single entity which shall be one of the combining companies.
For example: A Co. + B Co. = A Co. or B Co.
b. Consolidation – occurs when two or more companies consolidate into a single entity which shall be the consolidated
company. For example: A Co. + B Co. = C Co.

Stock Acquisition
- Instead of acquiring the assets and assuming the liabilities of the acquiree, the acquirer obtains control over the acquire by
acquiring a majority ownership interest (e.g., more than 50%) in the voting rights of the acquire.

In a stock acquisition, the acquirer is known as the parent while the acquire is known as the subsidiary. After the business
combination, the parent and the subsidiary retain their separate legal existence. However, for financial reporting purposes, both
the parent and the subsidiary are viewed as a single reporting entity.

After the business combination, the parent and subsidiary continue to maintain their own separate accounting books, recording
separately their assets, liabilities and the transactions they enter into.

The parent records the ownership interest acquired as “investment in subsidiary” in its separate accounting books. However, the
investment is eliminated when the group prepared consolidated financial statements.

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 different levels 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 – competition between the combining constituents with similar businesses 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 that the sum of the
productivity of each constituent working independently. Synergy is most commonly described as “the whole is greater than the
sum of its parts.” It can be simplified by the expression “1 plus 1 = 3”
c. Increased business opportunities and earnings potential – business opportunity and earnings potential may be increased
through:
i. An increased variety of products or services available and a decreased dependency on limited number of products
and services;
ii. Widened dispersion of products or services and better access to new markets;
 iii.
Access to either of the acquirer’s or acquiree’s technological know-hows, research and development, secret
processes, and other information;
iv. Increased investment opportunities due to increased capital; or
v. Appreciation in worth due to an established trade name by either one of the combining constituents.
d. Reduction of operating costs of the combined entity may be reduced.
i. Under a horizontal combination, operating costs may be reduced by the elimination of unnecessary duplication of
costs (e.g., cost of information systems, registration and licenses, some employee benefits and costs of outsourced
services.
ii. 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. Combination utilized 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 – by acquiring another company rather that creating a new one, an entity can save on
start-up costs, research and developments costs, cost of regulation and licenses, and other similar costs. Moreover, a
business combination may be effected through exchange of equity instruments rather than the transfer of cash or other
resources.
g. Favorable tax implications – deferred tax assets may be transferred in a business combination. Also, business combination
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 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 in turn, 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.

Business Combination
A “business combination” is a transaction or other event in which an acquirer obtains control of one or more businesses. Transactions
referred to as “true mergers” or “mergers of equals” are also business combination under PFRS 3.

Essential elements in the definition of a business combination

1. Control
2. Business

Control
An investor controls an investee when the investor has the power to direct the investee’s relevant activities (i.e., operating and
financing policies), thereby affecting the variability of the investor’s investment returns from the investee.

Control is normally presumed to exist when the acquirer holds more than 50% (or 51% or more) interest in the acquiree’s voting rights.
However, this is only a presumption because control can be obtained in some other ways, such as when:
a. The acquirer has the power to appoint or remove the majority of the board of directors of the acquire; or
b. The acquirer has the power to cast the majority of votes at board of meetings or equivalent bodies within the acquire; or
c. The acquirer has power over more than half of the voting rights of the acquire because of an agreement with other investors;
or
d. 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:

a. By transferring cash or other assets;
b. By incurring liabilities;
c. By issuing equity interests;
d. By providing more than one type of consideration; or
e. Without transferring consideration, including by contract alone

Illustration: Determining the existence of control

Example 1: ABC Co. acquires 51% ownership interest in XYZ, Inc.’s ordinary shares.
Analysis: ABC is presumed to have obtained control over XYZ because of the ownership interest acquired in the voting rights
of XYZ is more than 50%.

Example 2 ABC Co. acquires 100% of XYZ, Inc.’s preference shares.

Analysis: ABC does not obtain control over XYZ because preference shares do not give the holder voting rights over the
financial and operating policies of the investee.