Chapter 1: Business Combinations

Related Standards:
PFRS2 Business Combination
Section 19 of the PFRS for SMEs

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 another.
- ”

 Parent or acquirer – company that obtains controlled

 Subsidiary or acquiree – other company that is controlled.
Pt of View – Parent or acquirer

It is carried out either:

a. Asset Acquisition or
b. Stock acquisition

Asset Acquisition
- The acquirer purchases the assets and assumes that the liabilities of the acquiree in exchange for cash or
other non-cash consideration.
- 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 book of
accounts.
Under Corporation code of the Philippines, Asset acquisition may be either:
1. Merger
- When two or more companies merge into single entity which shall be one of the combining sompanies.
Ex: A co + B Co. = A Co. or B Co.

2. Consolidation
- When two or more companies consolidate into single entity which shall be the consolidated company.
Example: A Co. + B. Co. = C Co.

Stock Acquisition
- The acquirer obtains control over the acquiree by acquiring a majority ownership interest (more than
50%) in the voting rights of the acquiree.
Two Partiess
 Parent – acquirer
 Subsidiary- acquiree

 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.
 The “parent” records the ownership interest acquires as “Investment in subsidiary” in its separate
accounting books. However, the investment is eliminated when the group prepares consolidated
financial statements
A business combination may also be described as:

1. Horizontal combination
- Business combination of two or more entities with similar businesses (bank acquires another bank)
- Manufacturer acquirers its suppliers
- Acquire competitor
2. Vertical combination
- Business combination of two or more entities operating at different levels in a marketing chain (a
manufacturer acquires its supplier of raw materials)

3. Conglomerate
- A business combination of two or more entities with dissimilar business (real estate developer acquires
a bank)

4. Concentric
- Companies in the same industry, but different stages of the supply chain

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
- occurs when the collaboration of two or more entities results to greater productivity than the sum of the
productivity of each constituent working independently.
- Most commonly described as “ the whole is greater than the sum of its parts”
- Efficient management

C. Increased business opportunities and earning potential

- Business opportunity and earning potential may be increased through:
a. increased variety of products or services available and decreased dependency on limited number of
products and services.
b. widened dispersion of products or services and better access to new markets
c. access to either of the acquirer’s or acquiree’s technological know-hows, R & D, secret processes and
other information
d. increased investment opportunities due to increased capital
e. appreciation in worth due to an established trade name by either one of the combining constituents.

D. Reduction of operating costs

 - Operating cost of the combined entity may be reduced:
a. Under horizontal combination, operating costs by the elimination of unnecessary duplication of costs
b. Under 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 utilize economies of scale

- Refers 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, R & D,
costs of regulation and licenses, and other similar costs.
- May be affected 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
- Effected without transfers of considerations may not be subjected to taxation

DISADVANTAGES OF BUSINESS COMBINATION

a. BC brings monopoly in the market which 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. BC may result in overcapitalization, 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
BC poses threat to consumers interests.

Objectives of PFRS 3:
 To enhance the relevance, reliability and comparability of an acquirer’s financial reporting by establishing
the recognition and measurement principles and disclosure requirements for a business combination.

It does not apply to:

 Formation of joint venture
 Acquisition of an asset or a group of assets and related liabilities that does not constitute a
business. In such a case, the acquirer allocates the lump sum purchase price to the acquired items
based on their relative fair values on the purchase date. This transaction does not give rise to
goodwill.
 A combination of entities under common control

Business combination (definition in PFRS 3)

- Transaction or other event in which an acquirer obtains control of one or more businesses.
- Transactions referred to as to “ true mergers” or ”mergers of equals
Essential elements
1. Control
2. Business
Control
- An investor controls an investee when the investor has the power to direct the investee’s relevant activities,
thereby affecting the variability of the investor’s investments returns from the investee.
- Presumed Exist when the acquirer hold more than 505 (or 51% or more) interest in the acquirer’s voter’s
right.
However, this is only a presumtption 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 BOD 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 power over more than half of the voting rights of the acquiree because of the agreement of
the 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 of an acquiree in a variety of ways, example:

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

BUSINESS
- An integrated set of activities and assets that is capable of being conducted and managed for the purpose
of providing goods or services to customers, generating investments income or generating other income
from ordinary activities.
Three (3) elements:
a) Input – any economic resource that results to an output when one or more processes are applied.
b) Process – any system, standard, protocol, convention or rule that when applied to an input, creates an
output
c) Output – the result of 1 and 2 provides goods or services to customers, investment income or other income
from ordinary activities. (finished product)

IDENTIFYING A BUSINESS COMBINATION

 If the entity acquired (related liabilities assumed) do not constitute a business, the entity accounts for
the transaction as a regular asset acquisition and NOT a business combination.

ACCOUNTING FOR BUSINESS COMBINATION

BC are accounted for using the acquisition method. The method required the following:
a) Identifying the acquirer
b) Determining the acquisition date
c) Recognizing and measuring goodwill.:
1. consideration transferred
2. Non controlling interest in the acquiree
3. Previously held equity interest in the acquiree
4. Identifiable assets acquired and liabilities assumed on the BC.

a. Identifying the acquirer

Who is the transferor of cash or other resources or assumes liabilities?
Ans: The acquirer is usually the entity that transfers the cash or other assets or incurs the liabilities.
Who us the issuer of shares?
Ans. The acquirer is usually the entity that issues of the equity interest.
- In some business combinations, called “ reverse acquisition” the issuing entity is the acquiree.
The acquirer is usually the entity:
a) Whose owners, as a group, have the largest portion of the voting rights of the combined entity
b) Whose owner have the ability to appoint or remove a majority of the members of the governing
body of the combined entity.
c) Whose management dominates the management of the combined entity.
d) That pays a premium over the pre-combination fairvalue of the equity interest of ther other
combining entity.

Who is larger?
Ans. The acquirer is usually between the combining entities

Who is the initiator if the combination?

Ans. The Acquirer is usually the one who initiated the combination.

Substance over form

 If the new entity is formed to effect the BC, the acquirer is identified as follows:
 If the new entity is formed to issue equity interest to effect the business combination, one of
the combining entities that existed before the business combination is the acquirer.
 If the new entity is formed to transfer cash or other assets or incur liabilities as consideration
of the business combination, the new entity is the acquirer.

B. Determining the acquisition date

 The acquisition date is the date on which the acquirer obtains control to the acquiree. This is normally the
closing date.
 However, the acquirer might obtain control on a date that earlier or later than closing date. (ex. When there
is written agreement to the effect)

C. Recognizing and measuring Goodwill

 On acquisition date, the acquirer computes and recognizes goodwill using the following formula:
Consideration transferred xx
Non-controlling interest (NCI) in the acquiree xx
Previously held equity interest in the acquiree xx
Total xx
Less: FV of net identifiable assets acquired (xx)
Goodwill/ (gain on bargain purchase) xx

 A negative amount resulting from the formula is called gain on bargain purchase (also called negative
goodwill)

On acquisition date, the acquiree recognizes a resulting:

a. Goodwill as an asset (if the answer is positive) SFP as assets
b. gain on bargain purchase as gain in profit or loss

CONSIDERATION TRANSFERRED
 Measured at fair value
  It is the sum of the acquisition-date fair values of the assets transferred by the acquirer, the
liabilities incurred by the acquirer to former owners of the acquiree and the equity interests issued
by the acquirer.
 Examples
 Cash
 Non-cash assets
 Equity instruments
 A business or a subsidiary of the acquirer
 Contingent consideration

Acquisition related costs

- Costs that the acquirer incures to effect a business combination.
- Examples:
 Finder’s fees
 Professional fees
 General administrative costs
 Costs of registering and issuing debt and equity securities
- Acquisition related cost are expensed when incurred, except:
 Costs to issue debt securities measured at amortized cost are included in the initial
measurement of the resulting financial liability.
 Cost to issue equity securities are deducted from share premium. If the share premium is
insufficient, the issue costs are deducted from retained earnings.

NON-CONTROLLING INTEREST
 Is the equity in a subsidiary not attributable, directly or indirectly, to a parent.
 Also called MINORITY INTEREST
 The acquirer measures its NCI in the acquiree either at
 Fair value; or
 The NCI’s proportionate share of the acquiree’s identifiable net assets

PREVIOUSLY HELD EQUITY INTEREST IN THE ACQUIREE

 It pertains to any interest held by the acquirer before the business combination.
 This affects the computation of goodwill only in business combination achieved in stages.

NET IDENTIFIABLE ASSETS ACQUIRED

 Recognition Principle
 On acquisition date, the acquirer recognizes the identifiable assets acquired, the liabilities
assumed and any NCI in the acquiree separately from goodwill.
 Unidentifiable assets are not recognized
 Recognition Conditions
a) To qualify for recognition, identifiable assets acquired and liabilities assumed must meet the
definitions of assets and liabilities provided under the Conceptual Framework at the acquisition
date.
b) The identifiable assets acquired and liabilities assumed must be part of what the acquirer and the
acquiree (or its former owners) exchanged in the business combination transaction rather than the
result of separate transactions.
c) Applying the recognition principle may result to the acquirer recognizing assets and liabilities that
the acquiree had not previously recognized in its financial statements.

 Classifying identifiable assets acquired and liabilities assumed

  Identifiable assets acquired and liabilities assumed are classified at the acquisition date in
accordance with other PFRS that are to be applied subsequently.
 Measurement principle
 Identifiable assets acquired and liabilities assumed are measured at their acquisition-date
fair values.
 Separate valuation allowances are not recognized at the acquisition date because the
effects of uncertainty about future cash flows are included in the fair value measurement.
 All acquired assets are recognized regardless of whether the acquirer intends to use
them.

RESTRUCTURING PROVISIONS
Restructuring is a program that is planned and controlled by management, and materially changes either:
 the scope of a business undertaken by an entity; or
 the manner in which that business is conducted.

Restructuring provisions may include the costs of an entity's plan

 To exit an activity of the acquiree,
 To involuntarily terminate employees of the acquiree, or
 To relocate non-continuing employees of the acquiree,

 Restructuring provisions are generally not recognized as part of business combination unless the acquiree
has at the acquisition date an existing liability for restructuring that has been recognized in accordance with
PAS 37 Provisions, Contingent Liabilities and Contingent Assets.
 A restructuring provision meets the definition of a liability at the acquisition date if the acquirer incurs a
present obligation to settle the restructuring costs assumed, such as when the acquiree developed a
detailed formal plan for the restructuring and raised a valid expectation in those affected that the
restructuring will be carried out by publicly announcing the details of the plan or has begun implementing the
plan on or before the acquisition date.

 If the acquiree's restructuring plan is conditional on it being acquired, the provision does not represent a
present obligation, nor is it a contingent liability, at acquisition date.
 Restructuring provisions that do not meet the definition of a liability at the acquisition date are recognized as
post-combination expenses of the combined entity when the costs are incurred.

SPECIFIC RECOGNITION PRINCIPLES

PFRS 3 provides the following specific recognition principle:

1. OPERATING LEASES
Acquiree is the lessee
*lessee – tenant
*lesson- landlord
General rule:
 The acquirer shall not recognize any assets or liabilities related to an operating lease in which the acquiree
is the lessee.
Exception:
 The acquirer shall determine whether the terms of each operating lease in which the acquiree is the lessee
are favorable or unfavorable.
 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.
Acquiree is the lessor
 If the acquiree is the lessor, the acquirer shall not recognize any separate intangible asset or liability
regardless of whether the terms of the operating lease are favorable or unfavorable when compared with
market terms.
2. INTANGIBLE ASSETS
The acquirer recognizes, separately from goodwill, the identifiable intangible assets acquired in a business
combination. An intangible asset is identifiable if it meets either the
(a) separability criterion or the
(b) contractual-legal criterion.

SEPARABILITY CRITERION
 An intangible asset is separable if it is capable of being separated from the acquiree and sold, transferred,
licensed, rented or exchanged, either individually or together with a related contract, identifiable asset or
liability.
 Furthermore, the separability criterion is met if there is evidence of exchange transactions for that type of
asset or an asset of a similar type, even if those transactions are infrequent and regardless of whether the
acquirer is involved in them.
 The acquirer recognizes identifiable intangible assets acquired that meet the separability criterion even if the
acquirer does not intend to sell, license or otherwise exchange the identifiable intangible asset.

 The following are examples of identifiable intangible assets acquired in a business combination that
normally meet either the separability or contractual-legal criterion and, depending on their substance, are
recognized separately from goodwill whether they were previously recognized by the acquirer as assets or
had charged them to expense because they were internally developed:
 Marketing related intangible assets
 Customer-related intangible assets
 Artistic-related intangible assets
 Contract-based intangible assets

EXCEPTION TO THE RECOGNITION PRINCIPLE – CONTINGENT LIABILITIES

 The acquirer shall apply PFRS 3, rather than PAS 37 when accounting for contingent liabilities related to
business combinations.
 Under PAS 37, a contingent liability is not recognized because it does not meet all of the recognition criteria
for a liability (i.e., meets the definition, probable, and measured reliably).
 Under PFRS 3, a contingent liability assumed in a business combination is recognized if:
 It is a present obligation that arises from past events and
 Its fair value can be measured reliably.
 So, contrary to PAS 37, a contingent liability with improbable outflow of resources embodying economic
benefits may nevertheless be recognized if both the conditions above are satisfied.

EXCEPTION TO BOTH THE RECOGNITION AND MEASUREMENT PRINCIPLES

 Income taxes – are accounted for using PAS 12 .

 Employee benefits- accounted for using PAS 19
 Indemnification of assets - arises when the former owners of the acquiree agree to reimburse the acquirer
for any payments the acquirer eventually makes upon settlement of a particular liability.| Measured at FV| if
the indemnified item is measured at other than fair value, the indemnification asset is measured using
assumptions consistent with this used to measure the indemnified items
ADDITIONAL CONCEPTS ON CONSIDERATION TRANSFERRED
 The consideration transferred in a business combination is measured at fair value. The consideration
transferred includes only those that are transferred to the former owners of the acquiree. It excludes those
that remain within the combined entity.
 Assets and liabilities transferred to the former owners of the acquiree are remeasured to acquisition-date fair
values. Any difference between their carrying amounts and fair values recognized as gain or loss in profit or
loss.
 Assets and liabilities that remain within the combined entity (for example, because the assets or liabilities
were transferred to the acquiree rather than to its former owners) are not remeasured but rather ignored
when applying the acquisition method.

EXCEPTION TO THE MEASUREMENT PRINCIPLE

 Reacquired rights
 The acquirer shall measure the value of a reacquired right recognized as an intangible asset on the
basis of the remaining contractual term of the related contract regardless of whether market
participants would consider potential contractual renewals in determining its fair value.
 Share-based payment transactions
 The acquirer shall measure a liability or an equity instrument related to share-based payment
transactions of the acquiree or the replacement of an acquiree's share-based payment transactions
with share-based payment transactions of the acquirer in accordance with the method in PFRS 2
Share-based Payment at the acquisition date.
 Among other things, PFRS 2 requires the identification of the counter-party as either non-employee
or employee and others providing similar services and the consideration of certain vesting
conditions when measuring share-based payment transactions.
 Assets held for sale
 The acquirer shall measure an acquired non-current asset (or disposal group) that is classified as
held for sale at the acquisition date at fair value less costs to sell in accordance with PFRS 5 Non-
current Assets Held for Sale and Discontinued Operations (rather than at fair value under PFRS 3).