ACCT 1113 (Accounting for Business Combination)

Lesson 1: Business Combination Part 1

Topic: a. Reasons why companies enter into Business Combination

b. Definition of Business Combination
c. Stages of Acquisition Method

Learning Outcomes: At the end of this module, you are expected to:
a. Explain why companies enter into business combination.
b. Explain briefly the stages of acquisition method in a business combination.
c. Compute for Goodwill/Gain on Acquisition.

LEARNING CONTENT:

Introduction:
Again, Good Day future CPAs/CMAs! Before we start, I need you take a deep breath now (while you
can, charr!) because you are about to take one of the most difficult yet interesting accounting subject.
Pero syempre alam ko naman at the end of every topic, with your best effort and time, there is no
longer difficult for you. So, introducing to you our first topic for this course - PFRS 3 Business
Combination. Under the advanced financial accounting and reporting topics, I think PFRS 3 together
with PFRS 10 (Consolidated Financial Statements) are the most favorite topics that are included in the
actual board examination, so I suggest to master this topics, put it in your heart (whoa!), I mean you
study it not just for passing this subject but for a long term purposes which you will need in your final
battle, “The CPALE”.

In this chapter, we will discuss accounting for business combination for businesses who are trying to
outdo one another either through acquisitions, mergers or consolidation. In fact, business combination
has been a trend in the corporate business across the countries in order to strengthen the firm’s
competitive advantage in the global market. The following are main reasons why companies merge with
or acquire other companies:

1. Synergies: By combining business activities, overall performance efficiency tends to

increase, and across-the-board costs tend to drop, due to the fact that each company
leverages off of the other company's strengths.
2. Growth: Mergers can give the acquiring company an opportunity to grow market share
without doing significant heavy lifting. Instead, acquirers simply buy a competitor's
business for a certain price, in what is usually referred to as a horizontal merger. For
example, a beer company may choose to buy out a smaller competing brewery, enabling
the smaller outfit to produce more beer and increase its sales to brand-loyal customers.
3. Increase Supply-Chain Pricing Power: By buying out one of its suppliers or
distributors, a business can eliminate an entire tier of costs. Specifically, buying out a
supplier, which is known as a vertical merger, lets a company save on the margins the
supplier was previously adding to its costs. Any by buying out a distributor, a company
often gains the ability to ship out products at a lower cost.
4. Eliminate Competition: Many M&A deals allow the acquirer to eliminate future
competition and gain a larger market share. On the downside, a large premium is usually
required to convince the target company's shareholders to accept the offer. It is not
uncommon for the acquiring company's shareholders to sell their shares and push the
price lower, in response to the company paying too much for the target company.

ACCT 1113: Business Combination Part 1 1

 In the Philippines, for instance, Jollibee Food Corporation which is a multinational company based in
Pasig acquired some of its competitors in the fast food business. The company acquired 80%
of Greenwich Pizza in 1994. From a 50-branch operation, Greenwich gradually established a strong
presence in the food service industry. In early 2006, Jollibee Foods Corp. bought out the remaining
shares of its partners in Greenwich Pizza Corp., equivalent to a 20% stake, for P384 million in cash. In
2000, the company acquired Chowking, a Chinese fast food restaurant, thus making Jollibee a part of
the Asian quick service restaurant segment. In 2005, Jollibee acquired Red Ribbon, a bakeshop business
in the Philippines. On October 19, 2010, Jollibee acquired 70% share of Mang Inasal, a Filipino food
chain specializing in barbecued chicken, for P3 billion ($68.8 million). JFC subsidiary Fresh N' Famous
Foods, Inc. manages the Greenwhich and Chowking brands. The Red Ribbon brand is under Red Ribbon
Bakeshop Inc. which in turn is managed by a holding company of the JFC, RRB Holdings, Inc. The firm
has also stakes on Burger King's outlets in the Philippines through Perf Restaurants, Inc. which is 54
percent owned by JFC as of 2012.

Lesson Proper:

A business combination (PFRS 3) occurs when one company acquires another or when two or more
companies are merge as one. After the combination, one company gains control over the other. The
entity that obtain control over the other is called parent or acquirer while the company that is controlled
is the subsidiary or acquiree.

TYPES OF BUSINESS COMBINATION

1. ASSET ACQUISITION (100% Ownership)
 the acquirer purchases the assets and liabilities of the acquiree and records the assets
and liabilities acquired in its accounting books. After the acquisition, the acquired entity
normally ceases to exist as a separate legal entity.
 it can be either:
a. Merger [A + B = A /B]
b. Consolidation [A + B = C]

2. STOCK ACQUISITION
 the acquirer(parent) obtains control by acquiring a majority ownership interest (e.g., more
than 50%) voting rights of the acquiree(subsidiary). After the business combination, the
parent and subsidiary retain their separate legal existence meaning they will continue to
maintain separate accounting books but for financial reporting purposes, both parent and
subsidiary are viewed as single reporting entity.
 the parent records the interest acquired as “investment in subsidiary” in its separate
book but it is eliminated when the group prepares consolidated financial statements.

Scope
PFRS 3 must be applied when accounting for business combinations, but does not apply to:
 The formation of a joint venture.
 The acquisition of an asset or group of assets that is not constitute a business.
 Combinations of entities or businesses under common control.

Technically, PFRS 3 defines business combination as a transaction or other event in which an acquirer
obtains control of one or more businesses. Transactions sometimes referred to as 'true mergers' or
'mergers of equals' are also business combinations as that term is used in PFRS 3.

ACCT 1113: Business Combination Part 1 2

Control

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

Control presumed to exist when the acquirer holds more than 50% interest the acquiree’s voting rights.
However, 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 acquiree
b. The acquirer has the power to cast the majority of votes at board meetings or equivalent
bodies within the acquiree
c. The acquirer has the power over more than half of the voting rights of the acquiree
because of an agreement with other investors.
d. The acquirer controls the acquiree’s operating and financial policies because of a law or
an agreement.

An acquirer may obtain control in variety of ways, for example:

a. by transferring cash or other assets
b. incurring liabilities
c. issuing equity instruments
d. or any combination above
e. by not issuing consideration at all (i.e. by contract alone)

Accounting for Business Combinations

The acquisition method (formerly known as 'purchase method') is used for all business combinations.
Steps in applying the acquisition method are:
1. Identification of the acquirer
2. Determination of the acquisition date
3. Recognition and measurement of the identifiable assets acquired, the liabilities assumed and
any non-controlling interest (NCI, formerly called minority interest) in the acquiree.
4. Recognition and measurement of goodwill or a gain from a bargain purchase

Identifying an acquirer
The acquirer is the entity that obtains control of the acquiree. The acquiree is the business that the
acquirer obtains control.
PFRS 3 provides additional guidance which is then considered:
 The acquirer is usually the entity that transfers cash or other assets where the business
combination is effected in this manner
 The acquirer is usually, but not always, the entity issuing equity interests where the transaction
is effected in this manner, however the entity also considers other pertinent facts and
circumstances including:
i. relative voting rights in the combined entity after the business combination.
ii. the existence of any large minority interest if no other owner or group of owners has a
significant voting interest.
iii. the composition of the governing body and senior management of the combined entity.
iv. the terms on which equity interests are exchanged.
 The acquirer is usually the entity with the largest relative size (assets, revenues or profit)
 For business combinations involving multiple entities, consideration is given to the entity
initiating the combination, and the relative sizes of the combining entities.

ACCT 1113: Business Combination Part 1 3

Determining the Acquisition date
It is the date on which the acquirer obtains control of the acquiree. This is normally the closing date
(i.e., the date on which the acquirer legally transfers the consideration, acquires the assets and
assumes liabilities of the acquiree).
However, acquisition date may be a date that is earlier or later than the closing date. For example, the
acquisition date precedes the closing date if a written agreement provides that the acquirer obtain
control on a date before the closing date. The acquirer considers all pertinent facts and circumstances
in identifying the acquisition date.

Recognition and measurement on the acquired assets and liabilities

PFRS 3 establishes the following principles in relation to the recognition and measurement of items
arising in a business combination:
 Recognition principle. Identifiable assets acquired, liabilities assumed, and non-controlling
interests in the acquiree, are recognized separately from goodwill.
Specific Recognition Principles
1. Operating leases (whereby the acquiree is the lessee) - If the terms of an operating lease
relative to market terms is:
Favorable – the acquirer shall recognize an intangible asset.
Unfavorable – the acquirer shall recognize a liability.

2. Intangible assets – The acquirer recognizes the identifiable intangible assets acquired in a
business combination if they meet either the (a) separability criterion or the (b) contractual-
legal criterion.

Exception to the Recognition Principle

 A contingent liability assumed in a business combination is recognized if:

a. it is a present obligation that arises from past events and
b. its fair value can be measured reliably.

 A contingent liability assumed in a business combination is recognized if the criteria above

are met even if the contingent liability has an improbable outflow.

 Measurement principle. All assets acquired and liabilities assumed in a business combination
are measured at acquisition-date fair value.

Recognition and measurement of goodwill or a gain from a bargain purchase

Consideration transferred xxx
Non-controlling interest xxx
Previously held interest in the acquiree xxx
Total aggregate amount xxx
Less: Fair value of identifiable net assets (xx)
Goodwill / (Gain on bargain purchase) xx(xx)

If the difference above is negative, the resulting gain is a bargain purchase in profit or loss, which may
arise in circumstances such as a forced seller acting under compulsion. However, before any bargain
purchase gain is recognized in profit or loss, the acquirer is required to undertake a review to ensure
the identification of assets and liabilities is complete, and that measurements appropriately reflect
consideration of all available information.

ACCT 1113: Business Combination Part 1 4

Illustration:

On January 1, 2020, IKUNG Co. acquired the assets and liabilities of KAPITANJAY Co. The following
are the book values of the assets and liabilities of KAPITANJAY Co. on January 1, 2020:

Cash 100,000
Inventory 50,000
PPE, net 200,000
Goodwill 20,000
Liabilities 100,000
On January 1, 2020, it was determined that the fair value of KAPITANJAY’s inventory is P 40,000 and
the PPE’s fair value is 260,000.

Step 1: Identification of the acquirer

The acquirer in the business combination above is IKUNG Co. The one who acquired
assets and liabilities of another company.
Step 2: Determination of the acquisition date
It is the date on which the acquirer obtains control of the acquiree. This is normally the
closing date (i.e., the date on which the acquirer legally transfers the consideration,
acquires the assets and assumes liabilities of the acquiree). Therefore, acquisition date
is January 1, 2020.

Step 3: Recognition and measurement of the identifiable assets acquired, the liabilities assumed
and any non-controlling interest in the acquiree.

Cash 100,000
Inventory@Fair value 40,000
PPE@Fair value 260,000
Total Assets 400,000
Liabilities (100,000)
Fair value of acquired identifiable net assets 300,000
Note: Goodwill is ignored because goodwill is an unidentifiable asset.

Step 4: Recognition and measurement of goodwill or a gain from a bargain purchase

Case 1: Assume that IKUNG Co. paid 350,000 for the assets and liabilities of KAPITANJAY
Co. Compute the goodwill/gain on acquisition?
Consideration transferred 350,000
Non-controlling interest -
Previously held interest in the acquiree -
Total aggregate amount 350,000
Less: Fair value of identifiable net assets *(300,000)
Goodwill 50,000

Relevant Journal Entries:

Cash on Hand 100,000
Inventory 40,000
PPE 260,000
Goodwill 50,000
Liabilities 100,000
Cash in Bank 350,000

ACCT 1113: Business Combination Part 1 5

 Case 2: Assume that IKUNG Co. paid 200,000 for the assets and liabilities of KAPITANJAY
Co. Compute the goodwill/gain on acquisition?
Consideration transferred 200,000
Non-controlling interest -
Previously held interest in the acquiree -
Total aggregate amount 200,000
Less: Fair value of identifiable net assets (300,000)
Gain on bargain purchase 100,000

Relevant Journal Entries:

Cash on Hand 100,000
Inventory 40,000
PPE 260,000
Liabilities 100,000
Cash in Bank 200,000
Gain on acquisition 100,000

*** END of LESSON 1***

Note: Assessment is given in the Prelim Assessment folder in this course, kindly answer and solve it
honestly.

REFERENCES

Textbooks

 Millan, Z. V. (2020). Accounting for Business Combination. Baguio City: Bandolin Enterprise.

Electronic References:

 http://www.iasplus.com/
 https://www.investopedia.com/ask/answers/why-do-companies-merge-or-acquire-other-companies/
 https://en.wikipedia.org/wiki/Jollibee_Foods_Corporation

ACCT 1113: Business Combination Part 1 6