y Oe, 110 Chapter 3 Business Combinations (Part 3) Related standard: PERS 3 Business Combinations Learning Objectives ' ' \ Apply the methods of estimating goodwill. 2. Account for reverse acquisitions. Special accounting topics for business combination This chapter discusses accounting for business combination in relation to the following: 1. Goodwill 2. Reverse acquisitions 3. Combination of mutual entities Goodwill recognized on acquisition date. Subsequent expenditures on maintaining goodwill are expensed immediately. — After initial recognition, goodwill ig.» i af y tot amortized but rather tested for impairment at least ann I i . Fe goodwill is allocated to each of the acy ct this purpose, i —— the acquirer’ : : units (CCU in the Year of business combinatine eo eee he aie is not completed by the end of that year, it m the end of the immediately following year. “TELE completed bye > Cash-generating unit (CGU) is “the smallest identi of assets that generates cash inflows hentia care i lat independent of the cash inflows from other assets or op EY, assets.” (PAS36.6) © groups of Goodwill is allocated to the CGUs ex from the synergies of the business combination genet Ing a 2a Scanned with CamScannerBusiness Combinations (Part 3) 111 methodology that is reasonable, supportable, and applied in a consistent manner. For example, goodwi ‘ g ‘ll on the relative fair values of the ce ie may be allocated based Because ill is unidentifiable, it cannot be tested for impairment fepaaily bt only in conjunction with groups of assets that generate independenteash inflows Tee" CEUD. Goodwill does yoDgenerate cash flows on its own but contributes on the cash flows of CGUs. = A CGU to which goodwill has been allocated is tested for impairment_annually. A_CGU is impaired if its recoverable amount is (less than) its carrying amount including the allocated goodwill. Impairment loss is charged first to the CGU's goodwill and any excess is charged tothe other assets in the CGU. Impairment of goodwill is not reversed in a subsequent period. If the CGU is disposed, the goodwill allocated to it is also derecognized and included in the determination of gain or loss from the disposal. The subsequent accounting for goodwill is discussed extensively in Intermediate Accounting Part 1B. The accounting for impairment loss on goodwill in the consolidated financial statements is discussed in Chapter 6. Due diligence Before negotiations take place for a business combination, the acquirer normally initiates a due diligence audit for the purpose of determining the appropriate amount of consideration to be transferred to.the acquiree. Due diligence audit refers to the investigation of all areas of a potential acq business before an investor agrees to a business combination transaction. The term “due diligence” may refer to the exercise of care that a reasonable and prudent person should take before entering a contract with another party. Due diligence audit is a service most commonly performed by CPAs or external auditing firms. Scanned with CamScannerCh wey) a i investor evaluate the iigence audit helps an in sg) eet of the potential investment and doi. Me risks and rev isi e it. ing whether it would be a good decision to pursut Examples of potential risks which may ,be determing * —— ili it: a due diligence audit a Yrs of future losses due to the acquitee’s peng , litigations and other unrecorded ann : ' 2. Overstatement in the consideration for the busin : “combination due to the acquiree’s overstated assets ang understated liabilities. ta . Incompatibility of internal cultures, systems, and policies, ing 2 Examples of potential rewards which may be determineg through a due diligence audié 1, Unrecorded assets, such as trade secrets, trade name, customer lists, and the like, 2. Understatement in the consideration for the business combination due to the acquiree’s understated assets and Overstated liabilities, Methods of estimating goodwill Before the actual business combination transaction takes place, the timated using any of i wont i any of the following 1 Indirect valuation ~ this is residual a i es roach wherein Soodwill is measured as the excess af the sare op consideration transferred, non- “Normal earnings” is equal to normal rate of return multiplied by the acquiree’s net assets, b. Estimated future earings of the acquiree. i, For purposes of goodwill measurement, the earnings of the acquiree are “normalized,” meaning earnings are adjusted for non-recurring income and expenses (e.g., exproptiation gains or losses; —— + The excess of the acquiree’s normalized earnings over the average return in the industry represents the “excess earnings” to which goodwill is attributed, Excess earnings are sometimes referred to as “superior earnings.” ~— ¢. Discount rate to be applied to “excess earnings” d. Probable duration of “excess earnings” Illustration 1: Applications of the Direct valuation method ABC Co, 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: Year Earnings 20x1 1,200,000 20x2 1,300,000 20x3 1,350,000 20x4 1,250,000 20%5 1,800,000 Total 6,900,000 * Earnings in 20x5 include an expropriation gain of P400,000. * The fair value of XYZ’s net assets as of the end of 20x5 is 10,000,000. Scanned with CamScannerChapters ol Ld lhe return is 12%. average rate : mings” is 5 years. + Theindustry xcess ea + of “El + Probable duration of earnings erage excess Method #1: Multiples del is measured at the ae EXeg, Under this beat probable duration of excess earnings, tiplies earings mul 6,900,000 Total earnings for the last 5 years (400,000, Less: Expropriation gait i yeare 6,500,000 Normalized earnings for the last 5 y 5 Divide by; : oe 1,300,000 (a) Average annual earnings ),000 Fair value of acquiree's net assets oe Multiply by: Normal rate of return | () Normal earnings 1,200,000. Excess earnings (a) - (b) 100,000 Multiply by: Probable duration of excess eamings Goodwill italization of average excess earnings Under this method, goodwill is Measured at the average excess earings divided by a pre-determined capitalization rate, (Assume 8 capitalization rate of 25%), Average earings (69M 4M expropriation Bain) +5 yrs) 1,300,000 Normal earnings (tom 12%) (1,200,000) Excess earnings 100,000 Divide by: Capitalization rate 25% Goodwill __ 400,000 —_—_—e Method #3; Capitalization of average earnings Under this method, the average e: determined amings are divided by pre- capitalization rate to estimate the Purchase price of combination. The excess of the estimated Purchase the business Scanned with CamScannerBusiness Combinations (Part. 3) 115 price over the fair value Of the acquiree’s net assets represents the goodwill. (Assume a capitalization rate of 12.5%). ° Average earnings [(6.9M— Me propria Divide by: Capitalization rate ae oie Estimated purchase price ~~ 10,400,000 Fair value of XYZ’s net assets 000, ) Goodtwitt Le y Notice that if the “excess computations, the amount directly computed is goodwill. On the other hand, if the “average earnings” is used, the amount directly computed is the estimated purchase price. earnings” is used in the Method #4: Present value of average excess earnings Under this method, goodwill is measured at the present value of average excess earnings discounted at a pre-determined discount rate over the probable duration of excess earnings. (Assume a discount rate of 10%). : Average earnings (6.9M - 4M expropriation gain) +5 years 1,300,000 Normal earnings in the iridustry (10M x 12%) (1,200,000) Excess earnings 100,000 Multiply by: PV of an ordinary annuity @10%, n=5 3.79079 Goodwill — 379,079 __ Illustration 2: Applications of the Direct valuation method ABC Co. is estimating the goodwill in the expected purchase of XYZ, Inc, in January 20x6. The following information was determined. Earnings ‘Year-end net assets ia 120,000 $90,000 20x2 130,000 580090 2043 135,000 anno i ne 360,000 20x83... 2140,000" So Total 650,000) _ 2,750,000 Scanned with CamScanneriS 116 Case #1: Excess earnings Goodwill shall be measured by spas 930%, with normal returm on averag | end net assets in 20%5 a] pproximate fair value. capitalizing excess earings , t assets at 10%. The yea, Requirement; Compute for the estimated purchase price in the contemplated business combination. Solution: ‘Average earnings (650,000+ 5 years) 130,000 Normal earnings on average net assets [10% x (275M +5)] (55,000) Excess earnings 75,000 Divide by: Capitalization rate 30% Goodwill 250,000 Add: Fair value of net identifiable assets acquired 590,000 Estimated purchase price 840,000 Case #2: Average earnings Goodwill shall be measured by capitalizing average earnings at 16%, The year-end net assets in 20x5 approximate fair value. Requirement: Compute for the estimated purchase price and goodwill in the contemplated business combination. Solution: Average earnings (650,000 +5 years) Divide by: Capitalization rate SP Estimated purchase price ee Fair value of net identifiable assets acquired eanee Goodwill —— Sno) 2,500 22500 Illustration 3: Applications of the Direct valuation method ABC Co. plans to acquire the.net assets of XYZ, Inc. with carryi, amount of 9,000,000, This amount approximates tah a except for one asset whose fair value exceeds its carrying atbunt Scanned with CamScannerBusiness Combinations (Part 3) 117 by P1,000,000. XYZ's average earnings are P 1,300,000. The industry average rate of return is 12% of the fair value of net assets. XYZ’ excess earnings are expected to last for 5 years. The expected return on the investment is 10%, Requirement: Compute for the estimated purchase price using the ‘present value of average excess earnings" approach. Solution: Average earnings 1,300,000 Normal earnings in the industry (12% x 10M") (1,200,000) Excess earnings 100,000 Multiply by: PV of an ordinary annuity @10%, n=5 3.79079 Goodwill 379,079 * Carrying amount of equity 9,000,000 Excess of fair value of one asset over its carrying amount _ 1,000,000 Fair value of XYZ’s net assets 10,000,000 Estimated purchase price (squeeze) 10,379,079 Less: Fair value of XYZ’s net assets (10,000,000) Goodwill a Illustration 4: Applications of the Direct valuation method ABC Co. acquired the net assets of XYZ, Inc. for P10.4M. The acquisition resulted to goodwill of 400,000 measured by capitalizing the annual superior earnings of XYZ at 25%. The normal rate of return is 12% on net assets before recognition of goodwill. “Requirement: Compute for the average earnings of XYZ. Solution: Scanned with CamScannerChapter 3 me 1,300,000 a 3 Average earnings oy (1,200,000) ey ings (12% x 10 CPO aaa a vi or Superior earnings (given) 7 Excess eal vide by: Capitalization rate Divide by; Capitalizat mt wy Goodwill (given) ees 10,400,000 * Purchase price (given) + (10,000,000) Less: Fair value of net assets acquired (que onan Goodwill (given) | lustration 5: Applications of the Direct valuation method ABC Co. and XYZ, Inc, decided to combine and set up a new entity ~ Alphabets Corporation. The individual records of the combining constituents show the following: ABC Co, . XYZ, Inc, Net assets (at fair values) 400,000 600,000 Average annual earings 80,000 120,000 tituents and ordinary shares ith share of P50 for the excess. of t will) over net & Par value per ‘otal contributi contribution plus BOod! assets contibutin gt it The normal rate of return is 10% Of net asset, f; be capitalized at 20%, ® Bess earnings will Requirements; Compute for the following: a. Goodwill, b. Total contributions of ABC Co. and XYZ, Inc, © The ratio of total shares (preference and ordi is ABC Co, and XYZ, Inc, a oo Scanned with CamScannerBusiness Combinations (Part 3) 119 ice ecclesia eae Solutions: Requirement (a): ABC Co. Inc. _ Total Average annual earnings 80,000 120,000 Normal earnings.on net assets (40,000) (60,000) Excess earnings 40,000 60,000 Divide by: Capitalization rate 20% 20% Goodwill 200,000 300,000 500,000 Requirement (b): ABCCo. XYZ, Inc. Total Total contribution (squeeze) 600,000 900,000 1,500,000 Fair value of net assets (400,000) _ (600,000) Goodwill 200,000 300,000 Requirement (c): ABC Co. XYZ,Inc. Totals Net asset contributions 400,000 600,000 1,000,000 Divide by: Par value per share of PS 100 100 100 Number of preference shares issued 4,000 6,000 10,000 Total contribution 600,000 900,000 1,500,000 Net asset contribution (400,000) (600,000) (1,000,000) Excess of total contribution 200,000 300,000 500,000 50. 50 50 Divide by: Par value per share of OS aber 4,000 6,000 10,000 Number of ordinary shares issued Total PS and OS issued 8,000 __12,000 20,000 40% 60% 100% Ratio of shares issued Scanned with CamScannerChapter 3 itions , h exchai Reverse acquisitions lished throug Ne Of en, ‘ ination accomp! 7 i ‘qui Inabusinesscombinat® usually the entity that issues Ts e i iver is 7 Ui interests, the_acquirer aut Verse ACqUISHHiong, itr ever, the opposite i j i Ee revese acquisition, the eon ert (the legal acquirer) is identified as the ae ate oa me purposes, while the entity whose equity fe Mired ty legal acquiree) is the acquirer for accounting purposes For example, ABC Co,, a private entity, wants to become 4 public entity but does not want to register its shares, To accomplish this, ABC will arrange for a public entity to acquire its equity interests in exchange for the public entity's equity interests, In here, the public entity is the legal acquirer because it issued its equity interests, and ABC Co. is the legal acquiree because its equity interests were acquired. However, when applying the acquisition method: a. the public entity is identified as Purposes (accounting acquiree); and b. ABCCo. is identified as the as the accounting acquirer. ein the Consideration transferred hide stance, the accounting acquirer issues no Considerati Ue acquiree. Instead, the accounting acquiree i, ae interests to the owners of the accounting a ai obtain control over the accounting acquire eS ben ® AS such, the acquisition-date fair Scanned with CamScannerBusiness Combinations (Part 3) 121 GD Conventional acquisition vs, Reverse acquisition: Conventional ; acquisition Reverse acquisition Tesuer of shares as + Accounting acquirer. | - A eee 8 acquirer. iccounting acquiree. transferred Reference to + Accounting acquirer/ | - Accounting combining Legal parent acquirer/ Legal constituents > Accounting acquiree/ | subsidiary Legal subsidiary = Accounting acquiree/ Legal parent Measurement of Fair value of Fair value of the consideration consideration notional number of transferred transferred by the equity instruments that accounting acquirer. 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. Illustration: Reverse acquisition : ABC Co., a publicly listed entity, and XYZ, Inc, an unlisted company, exchange equity interests. : © ABC Co, issues 5 shares in exchange for all the outstanding shares of XYZ, Inc. , , * ABC's shares are quoted at P40 per share, while XYZ’s shares have a fair value of P200 per share. : © The statements of financial position immediately before the combination are shown below: ABC Co. XYZ, Inc. te 1,600,000 2,400,000 —Hentifable assets __———"o79 oq 2,400,000 wlotal assets Scanned with CamScannerLee | 12 | 1,300,000 700,009 Liabilities ital 100,000 samen} shares, 710 par 800,000 4,000 ordinary shares, #200 Pat 200,000 900,000 Retained earnings 7,600,000 2,400,000 Total liabilities and equi + The assets and liabilities approximate their fair values. Requirements: a. Identify the accounting acquirer. b. Compute for the goodwill. Solution: Requirement (a): Legal form of the contract: ABC issues 5 shares for each of the 8,000 outstanding shares of XYZ. After the issuance, ABC’s equity will have the following structure: ABC's currently issued shares Shares issued to XYZ (5 x8,000) oe ae Total shares after the combination co ste Analysis: The busi i ieee ness combination is a reve; is the issuer of dure rae, ores ABC despite ry eae (egal form) in order to In other words, XYZ, Jot jp cl poate gain control over ABC (outils Pe acquired > XYZ, Inc, the legal acquiree, is oo > ABC, Co., the legal ees ithe acai eter ONS Aquiree, Scanned with CamScannerBusiness Combinations (Part 3) 123 Requirement (b): Substance of the contract: XYZ obtains control over ABC in a reverse acquisition. Accordingly, the consideration transferred is computed based on the number of shares XYZ, (accounting acquirer) would have had to issue to give ABC (accounting acquiree) the same percentage of equity interest in the combined entity. Reverse — XYZ (accounting acquirer) issues shares to ABC Shares % XYZ’s currently issued shares 8,000 80% Shares issued to ABC [(8,000 + 80%) x 20%) 2,000 20% Total shares after the combination 10,000 —_— If the business combination had taken the form of XYZ issuing additional ordinary shares to ABC’s shareholders, XYZ would have had to issue 2,000 shares for the ratio of ownership interest in the combined entity to be the same. XYZ’s shareholders would then own 8,000 of the 10,000 issued shares of XYZ (80% of the combined entity), while ABC’s shareholders own 2,000 (20% of the combined entity). Consideration transferred (2,000 sh. x P200) 400,000 Non-controlling interest in the acquiree - Previously held equity interest in the acquiree a a Total ae fee Fair value of ABC’s net assets (1.6M-1.3M) ame Goodwill Scanned with CamScannerChapter from a business combination is He impairment at least annually, the issuer of shares (the lega} Api Goodwill arising amortized but teste ; «Ina reverse acquisition, i iree. i counting acquire’ . Pi ae ae transfetred in a Teverse acquisition The consi ber of equity interests the lega d based on the num : ; subiiay (accounting acquirer) would have had to issue to give th, owners of the legal parent (accounting acquiree) the same percentage of equity interest in the combined entity that results from the reverse acquisition. un PROBLEMS: PROBLEM 1: FOR CLASSROOM DISCUSSION Methods of estimating goodwill Use the following information for the next ‘four items: Entity A is contemplating on acquiring Entity B. Relevant information follows: ¢ Entity B’s average annual earnings in th 71,000,000. iB e past 5 years were * Entity B’s net assets as at the current ~ it value of P8,000,000, ‘earend have a fait ° The industry average rate of return ON equity ;. * The probable duration of Entity Bre re 812%, “ jeans Sess earnings” is 5 Goodwill is equal to the average excess earn; mi i 25%. How much is the goodwill? "8S capitalized at 2. Goodwill is measured by capitalizing the avera, 12%, How much is the goodwill? Be earnings at Scanned with CamScanneriness Combinations (Part 3, Busi ‘art 3) 125 3, Goodwill is measured at the undiscounted amount of total excess earnings expected to be ear i srowravach inthe grodvat ‘ned from the combination. 4, Goodwill is measured by discountin i the earnings at 9%, How much is the goodtll? ee Pee Reverse acquisition 5, Entity A and Entity B exchanged equity interests in a business combination. Relevant information follows: e Entity A has 2,000 issued shares. To effect the business combination, Entity A will issue 2 new shares for each of the 3,000 total outstanding shares of Entity B. ¢ Entity A’s shares have fair value of P100 per share, while Entity B’s shares have fair value of P300 per share. e Entity A’s net identifiable assets have a fair value of 260,000 as at the acquisition date. How much is the goodwill? PROBLEM 2: MULTIPLE CHOICE - THEORY 1. After initial recognition, goodwill arising from a business combination is (use ‘full PFRSs‘) a. amortized over its useful life, not exceeding 10 years. b. not amortized but tested for impairment at least annually. c. amortized over its useful life, not exceeding 40 years. d, |. amortized and tested for impairment. 2. How is goodwill tested for impairment? a. Goodwill is allocated to CGUs. The CGUs are the ones tested for impairment. Any impairment is charged first to the allocated goodwill, and any excess is charged to the other assets in the CGU. Scanned with CamScannerChapter 3 mS ie, cannot be seen, iy t, the accountant mug tu a : unidentifiable, b. Goodwill i il for impairment to test good! cae be tested for impairment on its own _ c, Goodwil it if itis bad, the goodwill is impaireg) tant smells it, if itis , : , 4, Anyot these as a matter of accounting policy choice, 3. The costs of internally developed goodwill and the costs of maintaining a recognized goodwill are a. capitalized as costs of goodwill. rs not capitalized but rather expensed when incurred, sometimes capitalized and sometimes expensed. ignored for accounting purposes. aos a reverse acquisition, the issuer of shares is the accou: the legal acquirer is also the the consideration transfe the legally acquired is th inting acquirer, accounting acquirer. rred is liability rather than asset, € accounting acquirer, Boop 5 a atnil. d. as an amount based on the Number of equity interests the rests legal subsidiary (accounting acquire) issue to give the Owners of the i. pete had to : are} : acquiree) the same Percentage of equi fi | {Sccounting combined entity that results Test in the from the Teverse acquisition, Scanned with CamScanneress Combinations (Part 3) 127 usit oBLEM 3: MULTIPLE CHOICE. compyr, Lise the, following information for the next three iieteae Gamer Co. and Player Co, are Planning to combine their pusinesses and put Up a new entity called App Corporation. App will issue 100,000 ordinary shares, which ste to be subdivided between Gamer and Player based on their total contributions, including goodwill. Goodwill is computed by capitalizing excess earnings at 20%. The industry normal earnings are 5% of net assets, . Gamer Co. Player Co. Fair value of net identifiable assets 500,000 ae Average annual earnings 40,000 39,000 1, How much is the total goodwill expected to arise from the ' business combination? a. 175,000 c. 75,000 b. 100,000 d.0 2. How many shares’ will be issued to Gamer and ‘Player, respectively? Gamer Co. Player Co. a, 45,500 54,500 b. 64,500 35,500 c 25,500 74,500 d. 54,500 45,500 3. Which of the combining entities is most likely the acquirer? a. Gamer Co, c, App Corporation b. Player Co, d, Google Play all the assets and liabilities of Day 1 need to pay a premium equal to excess average annual The appropriate * Cloudy Co. plans to acquire Co. Cloudy expects that it will need the discounted amount of Day's exc camings in order to effect the transaction: discount rate is 10%. Scanned with CamScannersgeanings in tne past 760 Day's ; i Barings “ol 120,000 : 130,000 mano 20x4 125,000 2035 140,000 Tol 650000 «© The 20x4 earnings include an expropriation loss. of 740,000. H «Day's net assets have a current fair value of 590,000. «The industry average rate of return on net assets is 12%, «The probable duration of “excess earnings” is 5 years. How much is the estimated purchase price? a, 932,432 b. 844,741 ¢. 817,447 d. 798,324 5. Sunday Co, a publidy listed entity, and Monday Co, a Private company, exchange equity interests in a business combination. * Sunday Co. issues 12 shares for all the outstanding shares of Monday. * Sunday's shares are quoted at P60 i per share, while Monday's shares have a fair value of P200 per share. * The net assets of the entities immediate] befor the combination are shown below: (The iowa the acquisition-date fair values) bata EQUITY Sunday Cx Share capital: z Monday Co, 12,000 ordinary shares, P10 par 9,000 ordinary shares, P100 par Retained earnin, 900,000 10,000 pone Total equit 195,000 800,000 1,700,000" 120,000 How much is the goodwill? a, 50,000 b.60,000 ——_«. 70,000 4. 90,000 Scanned with CamScanner