Module PROFE03 ACCOUNTING FOR BUSINESS COMBINATIONS

CHAPTER 3 BUSINESS COMBINATIONS SPECIAL ACCOUNTING TOPICS

Learning Objectives:

Apply the methods of estimating goodwill.

Account for reverse acquisitions.

Methods of estimating goodwill

1. Indirect valuation – this is the method required by PFRS 3 and it is the method
illustrated in the preceding discussions.

2. Direct valuation – under this method, goodwill is measured on the basis of

expected future earnings from the business to be acquired.

Direct valuation method

The direct valuation method may require the determination of one or more of the
following information:

a. Normal rate of return in the industry where the acquiree belongs (e.g., industry
average)

b. Normal earnings = Normal rate of return x Acquiree’s net assets

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c. Estimated future earnings of the acquiree.

• The earnings of the acquiree are “normalized,” i.e., adjusted for

non-recurring income and expenses.

• The excess of the acquiree’s normalized earnings over the average

return in the industry represents the “excess earnings” to which
goodwill is attributed.

d. Discount rate to be applied to “excess earnings”

e. Probable duration of “excess earnings”

Reverse acquisitions

• In a business combination accomplished through exchange of equity interests,

the acquirer is usually the entity that issues its equity interests. However, the
opposite is true for reverse acquisitions.

• In a reverse acquisition, the entity that issues securities (the legal acquirer) is
identified as the acquiree for accounting purposes while the entity whose
equity interests are acquired (the legal acquiree) is the acquirer for accounting
purposes

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 Conventional acquisition vs. Reverse acquisition:

Conventional acquisition Reverse acquisition

Issuer of shares as The issuer of shares is the The issuer of shares is the
consideration accounting acquirer. accounting acquiree.
transferred

Reference to combining ˗ Accounting acquirer/ ˗ Accounting

constituents Legal parent acquirer/ Legal
˗ Accounting acquiree/ subsidiary
Legal subsidiary ˗ Accounting
acquiree/ Legal
parent

Conventional acquisition Reverse acquisition

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Measurement of Fair value of consideration Fair value of the notional

consideration transferred by the number of equity
transferred accounting acquirer. instruments that the
accounting acquirer
(legal subsidiary) would
have had to issue to the
accounting acquiree
(legal parent) to give the
owners of the
accounting acquiree
(legal parent) the same
percentage ownership in
the combined entity.

Sample Problem:

UNFLEDGED Co. is contemplating on acquiring IMMATURE, Inc. The following

information was gathered through a diligence audit:

 The actual earnings of IMMATURE, Inc. for the past 5 years are shown below:
Year Earnings
20x1 2,400,000
20x2 2,600,000
20x3 2,700,000
20x4 2,500,000
20x5 3,600,000
Total 13,800,000

 Earnings in 20x5 included an expropriation gain of ₱800,000.

 The fair value of IMMATURE’s net assets as of the end of 20x5 is ₱20,000,000.
 The industry average rate of return is 12%.
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 Probable duration of “excess earnings” is 5 years.

Requirements:
a. How much is the estimated goodwill under the multiples of average excess earnings
method?
b. How much is the estimated goodwill under the capitalization of average excess
earnings method? Use a capitalization rate of 25%.
c. How much is the estimated goodwill under the capitalization of average earnings
method? Use a capitalization rate of 12.5%.
d. How much is the estimated goodwill under the present value of average excess
earnings method? Use a discount rate of 10%.

Solutions:
Method #1: Multiples of average excess earnings

Average earnings (13.8M – .8M expropriation gain) ÷ 5 years 2,600,000

Normal earnings in the industry (20M x 12%) (2,400,000)

Excess earnings 200,000

Multiply by: Probable duration of excess earnings 5

Goodwill 1,000,000

Method #2: Capitalization of average excess earnings

Average earnings (13.8M – .8M expropriation gain) ÷ 5 years 2,600,000

Normal earnings in the industry (20M x 12%) (2,400,000)

Excess earnings 200,000

Divide by: Capitalization rate 25%

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Goodwill 800,000

Method #3: Capitalization of average earnings

Average earnings (13.8M – .8M expropriation gain) ÷ 5 years 2,600,000

Divide by: Capitalization rate 12.5%

Estimated purchase price 20,800,000

Fair value of acquiree’s net assets (20,000,000)

Goodwill 800,000

Method #4: Present value of average excess earnings

Average earnings (13.8M – .8M expropriation gain) ÷ 5 years 2,600,000

Normal earnings in the industry (20M x 12%) (2,400,000)

Excess earnings 200,000

Multiply by: PV of an ordinary annuity @10%, n=5 3.79079

Goodwill 758,158

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Reference:

ACCOUNTING FOR BUSINESS COMBINATIONS (ADVANCE ACCOUNTING 2) LECTURE

AID 2018 BY ZEUS VERNON B. MILLAN

Lecture Notes Compilation of Dean Rene Boy R. Bacay, CPA, CrFA, CMC, MBA, FRIAcc

For further discussion please refer to the link provided:

Business Combinations on Special Cases Part 1- https://www.youtube.com/watch?v=SXtrGdp8PnQ&t=49s

Business Combination on Special Cases Part 2- https://www.youtube.com/watch?v=dqy7FZ4X1PE

Business Combination on Special Cases Part 3- https://www.youtube.com/watch?v=dghGN8Ym5UY