ACC2001 FINANCIAL ACCOUNTING

Trimester 1 AY2020/21

LECTURE 8: ACCOUNTING FOR BUSINESS

COMBINATIONS II

1
 Recap - Business Combinations
• Business Combinations may take different forms; however two
characteristics are present:

Acquirer has • 3 main attributes of control (SFRS(I) 10)

• Power over acquiree
control of business • Exposure or rights to variable returns of acquiree
• Ability to use power to affect acquiree’s returns.
acquired

• 2 vital characteristics of a business (SFRS(I) 3)

Target of • Integrated set of activities and assets
acquisition is a • Capable of being conducted and managed to provide
returns (i.e. dividends) to investors and other
business stakeholders.

Business Combinations involving entities under common control is outside of scope of

SFRS(I) 3
2
 The Acquisition Method

4-step
• The procedures: approach:
SFRS(I) 3:5
Identify the acquirer

Determine the acquisition date

Recognize and measure the identifiable assets acquired

Group the liabilities assumed and any non-controlling
financial interest in the acquiree; and
statements if
acquire
subsidiaries Recognize and measure goodwill or
a gain from a bargain purchase

3
Identify the Acquirer and Acquisition date

• SFRS(I) 3 requires the identification of the acquirer in all

circumstances
– For each business combination, one of the combining entities shall be
identified as the acquirer (para 6).
– Acquirer is the entity that obtains control of another combining entity.

• Concept of control is based on SFRS(I) 10 but the standard may not

always conclusively determine the identity of the acquirer (para 7).
– SFRS(I) 3 Appendix B provides additional criteria to identify controlling
acquirer.

• The acquirer shall identify the acquisition date, which is the date on
which it obtains control of the acquiree (para 8)
– The date on which the acquirer obtains control of the acquiree is generally the
date on which the acquirer legally transfers the consideration, acquires the
assets and assumes the liabilities of the acquiree (i.e., the closing date). 4
Recognition and Measurement of Identifiable Assets
and Liabilities at Fair Value

Business Combinations are accounted under the acquisition method

Requirement: At acquisition date, the acquirer will recognize

acquiree’s net assets at fair value
Underlying assumption:
There is an effective ”acquisition” of the
There has been an exchange transaction at arm-
subsidiary’s identifiable assets and liabilities at
length pricing
fair value

5
Recall the M1 takeover offer..

Question: Is the fair value of each M1 share worth $0.563 (NAV), $1.63 (last traded
price) or 2.06 (offer price)?
6
 In M1 takeover offer..

Acquirer’s Group

Issue 1: Acquirer
transfers
consideration

Former
owners of a Acquirer Subsidiary
subsidiary
Issue 2: Former
owners transfer
equity of subsidiary

• Issue 1: What is the fair value amount of consideration transferred? $2.06 cash
• Issue 2: What is the fair value amount of consideration received in exchange
for the consideration transferred? (a) 56.3 cents or (b) $1.63 or (c) $2.06? 7
Fair Value of Acquiree

• In the books of the acquiree, the identifiable assets and liabilities are
carried at their book values (56.3 cents in M1).
– The individual book values in the financial statements may be carried at cost and
may not reflect the fair values of the identifiable assets and liabilities. And in
some cases, the book values may be zero (e.g. contingent assets and liabilities
and certain intangible assets that may not qualify for recognition).
• Under the acquisition method, the acquirer is deemed to have acquired
the goodwill and identifiable assets and liabilities of the acquiree at fair
value.
– The acquirer would thus recognize the acquiree’s assets and liabilities at fair value on
acquisition date.
• Once recognized, the fair value of identifiable assets and liabilities of the
acquiree is initial cost to the acquirer as at the date of acquisition.
– Subsequent depreciation, amortization expense or cost of sales of identifiable net
assets of an acquiree would be determined on the basis of the fair values recognized
as at the acquisition date.
8
Intangible Assets

• Besides recognizing the excess of fair value over book value of existing on-
balance sheet assets, the acquirer has to recognize the fair value of an
acquiree’s unrecognized identifiable assets.
– These assets are typically internally generated intangible assets.

• While an acquiree’s unrecognized intangible assets has a zero book value of

in its balance sheet, the acquisition event justifies the recognition of
intangible assets at fair value as at the date of acquisition by the acquirer.
– Note: The acquirer recognizes an acquiree’s intangible assets separately from
goodwill.

• How is goodwill different from other intangible assets?

– The identifiability criteria (in SFRS(I) 1-38 Intangible Assets) provide a basis to
determine whether an intangible asset should be recognized separately from
goodwill or not.
9
Intangible Assets
• SFRS(I) 3 requires the acquirer to recognize the fair value of an
acquiree’s unrecognized identifiable asset (e.g. intangible asset) in the
consolidated financial statements
– Rationale: the acquisition event justifies recognition of intangible assets
– Do not provide guidance on measurement of fair value of the recognized
intangible asset

• To qualify for recognition, the intangible asset must either:

1. Be Separable (“Separability criterion”) OR
2. Arises from contractual or other legal rights (“Contractual-legal
criterion”)

• The identifiability criterion is met by either one of the above two

conditions.

• Goodwill does not meet either of these conditions.

10
Goodwill versus Intangible Assets
Are these considered intangible assets?
Assembled workforce with specialized
knowledge
Potential contracts or contracts under
negotiation
Opportunity gains from an operating
lease in favorable market conditions
Customer and subscriber lists of
acquiree
× No: Firm-specific and integrated with
acquiree
× (Fails separability criterion)
× No: Fails separability or contractual-
legal criterion
✓ Yes: Meets the contractual-legal
criterion
✓ Yes: Meets the separability criterion
(show evidence of exchange
transactions for similar types of lists)
11
The Acquisition Method

We apply the acquisition method to all business combinations

Justifying the Subsequently

recognition of • Identifiable net assets at
________________
• Acquisition of
fair value
control of the • Internally-generated • Amortization of
• Effective fair value excess
voting rights
purchase of Intangible assets • Goodwill
of an entity • ________________ and
• Net assets in
________ impairment
Goodwill reviews
the entity • _________________
Equivalent to
Leading to

Note: Net assets include both: recognized and unrecognized assets

12
Different business combinations

• While the acquisition method holds for all business

combinations, the accounting treatment differs depending on
the types of business combinations:
– Scenario 1: The assets and liabilities at acquisition date fair values are
recognized in the consolidated financial statements (if the acquirer
obtains control of another legal entity).
– Scenario 2: The assets and liabilities at acquisition date fair values are
recognized on the acquirer’s own books (if there is a direct acquisition of
net assets of acquired businesses).
– Scenario 3: The assets and liabilities at acquisition date fair values are
recognized in the books of a newly formed entity (if the acquired net
assets are transferred to a newly formed entity)

• Only scenario 1 requires consolidation.

13
Direct acquisition of net assets

• In a direct acquisition of net assets of acquired businesses (scenario 2):

– Initial and subsequent accounting for these assets will be the same as for stand-
alone assets that are purchased by the acquirer.
– At acquisition date, the acquirer will recognize identifiable assets and liabilities
acquired at fair value in its books.
– Goodwill is also recognized as an asset in the acquirer’s books.
– Subsequently, the acquirer will depreciate the initial fair value of the acquired
fixed assets over their remaining useful life.
– The same accounting applies if the net assets of an acquiree are transferred to a
newly formed entity (scenario 3).
– That is, no consolidation is required.

14
Acquisition of Assets that constitute a Business

• X Co. paid $600,000 in cash to acquire a group of net assets from Y Co.
• The group of assets meet the definition of a business under SFRS(I) 3
Carrying values ($) Fair value at date of
acquisition ($)
Intangible asset – Patent 200,000 300,000
Plant 150,000 200,000
Inventories 50,000 55,000
400,000 555,000

• What is the fair value of consideration transferred?

– $600,000 cash
• What is the fair value of consideration received?
– Net assets from Y Co that is valued at $555,000 + Goodwill amounting to $45,000
• What does the goodwill represent?
– Payment for anticipated benefits that are not capable of being individually
identified and separately recognized 15
 Acquisition of Assets that constitute a Business

Being accounting for acquisition of assets (in Co X’s books)

Dr Patent 300,000
Dr Plant 200,000
Dr Inventory 55,000
Dr Goodwill 45,000
Cr Cash 600,000

Being accounting for sale of assets (in Co Y’s books)

Dr Cash 600,000
Cr Patent 200,000
Cr Plant 150,000
Cr Inventory 50,000
Cr Gain from sale of assets 200,000

Two related questions:

(1) Who owns Co Y? (a) Co X or (b) shareholders of Y Co?
16
(2) What did the shareholders of Y Co sold to X Co? (a) Equity stake in Co Y or (b) assets of Co Y?
Direct acquisition of equity

• In acquisition of controlling interest of acquired businesses (scenario 1):

– The acquirer (Co X) and acquiree (Co Y) remain as two separate legal entities.
– The former owners of the acquiree sold their equity interests to the acquirer;
the acquirer (Co X) becomes the new owner of the acquiree (Co Y).
– The acquiree continues to carry its assets and liabilities on the basis of its
accounting policies, typically at historical cost.
– The acquirer recognizes only an “Investment in subsidiary” as an asset
– On consolidation, the investment in subsidiary has to be eliminated, and in its
place, the acquisition-date fair values of identifiable assets and liabilities and
goodwill have to be recognized.
– Consolidation adjustments have to be put in place to adjust
depreciation/amortization and cost of sales of the acquired assets.
– These consolidation adjustments with respect to the fair value differential of
identifiable assets and liabilities (and their subsequent cumulative depreciation
and amortization) must be repeated at each consolidation year end for as long
as the investment in the subsidiary remains.
17
Acquiring assets versus equity

Company X Company X

Acquires controlling interest in equity Buys over net assets of Co Y

of Co Y

Company Y’s Company Y’s

equity interest Net assets

• Co X becomes the new legal • Co X becomes the new

owner of Co Y legal owner of the net
• Co Y’s equity interest will be assets of Co Y
transferred to Co X but Co • Co Y’s assets will be
Y’s assets still reside in Co Y transferred to Co X’s books

Question: Does it make a difference to Company X whether it owns Co Y’s equity

interest or Co Y’s net assets?
18
If Co Y owns a BMW 700 series company car, who gets to use the car?
Overview of the Consolidation Process

Legal entities Economic entity

Parent’s Subsidiaries' Consolidation Consolidated

Financial + Financial +/– adjustments and = financial
Statements Statements eliminations statements

• Consolidation is the process of preparing and presenting the financial

statements of a group as an economic entity
• No ledgers for group entity
• Consolidation worksheets are prepared to:
– Combine parent’s and subsidiaries financial statements
– Adjust or eliminate effects of intra-group transactions and balances
– Allocate profit to non-controlling interests
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Elimination of Investment Account

What the parent is paying for

Consideration Share of book Share of excess

transferred by value of of fair value
Goodwill
parent = subsidiary’s net + over book value +
assets at of identifiable
acquisition date net assets
Eliminated against
subsidiary’s share
capital, pre-acquisition
retained earnings and
pre-acquisition other Recognized assets at fair value Unrecognized assets at fair value
equity items
• Investment account is eliminated
– To ensure that the investment account must be zero
– Substituted with subsidiary’s identifiable net assets and goodwill (residual)
– Rationale: Avoid recognizing assets in two forms (investment in parent’s statement of
financial position and individual assets and liabilities of subsidiary)
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Steps in Consolidation

• Step 1: Analysis of the “investment” account

(Goodwill Accounting – assess the “goodwill”)

• Step 2: Elimination of the “investment” account

1. Record the balances for each company in the worksheet
2. Remove the investment account from the worksheet
3. Remove the subsidiary’s equity account balances
4. Record revalued assets and liabilities
5. Record the Goodwill
6. Add the balances across the page

21
 Acquiring a Subsidiary

On 31 Dec 2015, P acquired 100% of S shares for $130,000 cash.

Balance Sheet at 31 Dec 2015 Balance Sheet at 31 Dec 2015

Before acquisition ($’000) After acquisition ($’000)
P S P S
Cash 70 30
Cash 200 30
Investment in S 130 -
Other Assets 300 170
Other Assets 300 170
Total Assets 500 200
Total Assets 500 200
Liabilities 140 150 Liabilities 140 150
Share Capital 100 30 Share Capital 100 30
Retained Earnings 260 20 Retained Earnings 260 20
Liabilities & Equity 500 200 Liabilities & Equity 500 200
22
Acquiring a Subsidiary

• The following journal entry is recorded on P’s books:

Being accounting for acquisition of S
Dr Investment in S 130,000
Cr Cash 130,000

• Investment in “S” = $130,000 cash

• What is the acquisition price for?

– Total assets of S? Total assets of S: $200,000
– Total liabilities of S? Total liabilities of S: $150,000

• Total shareholders' equity (Net assets) = $50,000

• “Something else” ($80,000)
– The sum of both components must add to the consideration paid ($130,000).
23
Goodwill
• P paid $130,000 for 100% of S which has net assets of $50,000 on its balance
sheet. Therefore, P paid $80,000 in excess of the net assets of S.

Price paid for S $130,000

Less: Net assets of S 50,000
Excess payment 80,000

• Why is P willing to pay more than the net assets of S?

– The fair market value of S’ individual assets is greater than their combined
book value (at historical cost) – undervalued assets.
– S has other intangible assets not recognized on its books (e.g. Brands,
customer lists, internally generated R&D and patents) – unrecognized
intangible assets.
– Other factors such as there are potential synergies if P and S are combined
(e.g. reputation, customer loyalty, management expertise, human capital) –
goodwill.
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Goodwill Accounting

• The acquisition method of accounting recognizes that P paid a price for

both undervalued assets and goodwill; hence, the excess must be
accounted for.
• Assume that the identifiable assets of S are correctly valued (no
undervalued assets).
Excess payment $ 80,000
Allocated as follows:
Goodwill 80,000

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Step 2: Elimination Entries

Balance Sheet at 31 Dec 2015 ($’000) Take out this “Investment in S” and
substitute it with the assets and
P liabilities of S plus the excess
payment:
Cash 70
Acquisition price of S $130
Investment in S 130

Other Assets 300 Represented by:

Total Assets 500 Total assets of S 200
Total liabilities of S (150)
Liabilities 140 Net assets of S 50
Share Capital 100 Excess payment allocated
to: Goodwill 80
Retained Earnings 260
$130
Liabilities & Equity 500

The two companies' accounts cannot be simply added to get the consolidated
amounts. Otherwise some items such as Investment and Stockholders’ Equity
accounts would be double counted. 26
Step 2: Elimination Entries

Balance Sheet at 31 Dec 2015 ($’000)

P S Adjustments Consolidated

Dr Cr

Cash 70 30

Investment in S 130

Other Assets 300 170

1. Record the balances
Goodwill
for each company in
Total Assets 500 200 the worksheet.

Liabilities 140 150

Share Capital 100 30

Retained Earnings 260 20

Liabilities & Equity 500 200 27

Step 2: Elimination Entries

Balance Sheet at 31 Dec 2015 ($’000)

Including 2 “components”: P S Adjustments Consolidated

$50 (S’ net assets)
+ $80 (goodwill) Dr Cr

Cash 70 30

Investment in S 130 130

Other Assets 300 170
To avoid double counting
Goodwill in net assets.

Total Assets 500 200

Liabilities 140 150

Share Capital 100 30 2. Remove the

investment account
Retained Earnings 260 20 from the worksheet.

Liabilities & Equity 500 200 28

Step 2: Elimination Entries

Balance Sheet at 31 Dec 2015 ($’000)

P S Adjustments Consolidated

Dr Cr

Cash 70 30

Investment in S 130 130

3. Remove the subsidiary’s
Other Assets 300 170 equity account
balances.
Goodwill

Total Assets 500 200

Liabilities 140 150

Share Capital 100 30 30 To avoid double counting

in equity.
Retained Earnings 260 20 20

Liabilities & Equity 500 200 29

Step 2: Elimination Entries

Balance Sheet at 31 Dec 2015 ($’000)

P S Adjustments Consolidated

Dr Cr

Cash 70 30

Investment in S 130 130

Other Assets 300 170

Goodwill 80

Total Assets 500 200

Liabilities 140 150

4. Record the
Share Capital 100 30 30 Goodwill.

Retained Earnings 260 20 20

Liabilities & Equity 500 200 130 130 30

 Step 2: Elimination Entries

Balance Sheet at 31 Dec 2015 ($’000)

P S Adjustments Consolidated

Dr Cr
Cash 70 30 100
Investment in S 130 130 -
Other Assets 300 170 470
Goodwill 80 80
Total Assets 500 200 650
Liabilities 140 150 290
Share Capital 100 30 30 100
Retained Earnings 260 20 20 260
Liabilities & Equity 500 200 130 130 650
31
Step 2: Elimination Entries
2015

CJE1: Elimination of investment in subsidiary

Dr Goodwill 80,000
Dr Share capital 30,000
Dr Retained earnings 20,000
Cr Investment in Subsidiary 130,000

Re-enacting CJE

• Building blocks of consolidation worksheet are the legal entity financial

statements of parent and subsidiary

• CJE 1 has to be re-enacted at each reporting date as long as Parent has control
over subsidiary

• Each consolidation process is a fresh-start approach

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Pre-acquisition reserves vs Post acquisition reserves

• Pre-acquisition reserves – arise before the subsidiary is acquired

• Post-acquisition reserves – arise after the subsidiary is acquired

• Why is the distinction important?

• Pre-acquisition reserves represent the net assets of the
subsidiary at acquisition date, hence has to be eliminated
against the cost of investment

• Post-acquisition reserves represent the reserves earned by the

subsidiary after it became a member of the group and
therefore form part of the group’s reserves and consequently
will have to be included in the consolidated FS.
33
Consolidation after one year

• For the year ended 31 Dec 2016, P made a profit of $20,000 (not
including income from investment in S), while S made a profit of $10,000.
• Assume:
– no tax.
– no dividends.
– no intercompany transactions.
• P now has to consolidate the accounts of S with itself.
• Goodwill ($80,000) is not amortized but carried on the consolidated
balance sheet as an asset.

34
Consolidation after one year

$’000 P S Adjustments Consol.

Dr. Cr.
Revenue 70 40 Consol. Retained Earnings 110
= 260 + 20 – 20
Expenses (50) (30) + 30 (Consol. Net Income) (80)
Net Income 20 10 =290 30
Cash 90 30 120
Investment in S (at cost) 130 - 130 -
Other Assets 320 200 520
Goodwill - - 80 80
Total Assets 540 230 720
Liabilities 160 170 330
Share capital 100 30 30 100
Retained earnings (beginning) 260 20 20 260
Net Income for the year 20 10 30
Liabilities & Equity 540 230 130 130 720
35
Consolidation after one year

$’000 P S Adjustments Consol.

Dr. Cr.
Revenue 70 40 110
Expenses (50) (30) (80)
Net Income 20 10 30
Cash 90 30 120
Investment in S (at cost) 130 - 130 -
Other Assets 320 200 520
Goodwill - - 80 80
Total Assets 540 230 720
Liabilities 160 170 330
Share capital 100 30 30 100
Retained earnings (ending) 280 30 20 290

Liabilities & Equity 540 230 130 130 720

36
Elimination Entries (one year later)
2016
CJE1: Elimination of investment in subsidiary
Dr Goodwill 80,000
Dr Share capital 30,000
Dr Retained earnings 20,000
Cr Investment in Subsidiary 130,000

Points to note

• P’s retained earnings were $260,000 at the beginning of the year. S’s retained
earnings (pre-acquisition reserves) were $20,000 at the beginning of the year.

• Intuitively, you can think of P Group has made a total profit of $30,000 for the
year ended 31 Dec 2016
• Since P Co made a profit of $20,000 and S Co made a profit of $10,000

• Hence, the Group’s retained earnings as at 31 Dec 2016 would be $290,000

• P Co retained earnings: $260,000 + $20,000 (post-acquisition)
• S Co retained earnings: $10,000 (post-acquisition)
37
 Acquiring a subsidiary – revalued assets
On 31 Dec 2015, P acquired 100% of S shares for $130,000 cash. “Other assets” of S have
fair value of $200,000 as a result of revaluing its inventory. In addition, S holds a trademark
with a fair value of $20,000 but this asset is not recorded in S’s books.

Balance Sheet at 31 Dec 2015 Balance Sheet at 31 Dec 2015

Before acquisition ($’000) After acquisition ($’000)
P S P S
Cash 70 30
Cash 200 30
Investment in S 130 -
Other assets 300 170
Other assets 300 170
Total Assets 500 200
Total Assets 500 200
Liabilities 140 150 Liabilities 140 150
Share Capital 100 30 Share Capital 100 30
Retained Earnings 260 20 Retained Earnings 260 20
Liabilities & Equity 500 200 Liabilities & Equity 500 200 38
Acquiring a subsidiary – revalued assets

• The following journal entry is recorded on P’s books:

Being accounting for acquisition of S
Dr Investment in S 130,000
Cr Cash 130,000

• Investment in “S” = $130,000 cash

• What is the acquisition price for?

– Total assets of S? Total assets of S: $250,000 (fair value) or $200,000 (book value)?
– Answer: $200,000 (other assets) + $30,000 cash + $20,000 trademark = $250,000
– Total liabilities of S? Total liabilities of S: $150,000

• Net identifiable assets of S = $100,000

• “Something else” ($30,000)
– The sum of both components must add to the consideration paid ($130,000). 39
Step 1: Goodwill Accounting

• The allocation of the excess amount:

Excess payment $ 80
Allocated as follows:
Other assets 30 [FV (200) – BV (170)]
Trade Mark 20
Goodwill 30

• The allocation of the goodwill of $30,000 is the residual amount after

accounting for the fair values of identifiable assets and liabilities.

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Step 2: Elimination Entries

Balance Sheet at 31 Dec 2015 ($’000)

P S Adjustments Consolidated

Dr Cr

Cash 70 30 100
Investment in S 130 130 -
Other assets 300 170 30 500
Trademark 20 20
Goodwill 30 30

Total Assets 500 200 650

Liabilities 140 150 290

Share Capital 100 30 30 100

Retained Earnings 260 20 20 260

Liabilities & Equity 500 200 130 130 650 41

Step 2: Elimination Entries

CJE1: Elimination of investment in subsidiary

Dr Inventory 30,000
Dr Trademark 20,000
Dr Goodwill 30,000
Dr Share capital 30,000
Dr Retained earnings 20,000
Cr Investment in Subsidiary 130,000

Re-enacting CJE

• CJE 1 has to be re-enacted at each reporting date as long as Parent has control
over subsidiary

• In subsequent years, the differential fair value adjustments of trademark have to

be amortized through a consolidation journal entry.

• The cost of inventory will be based on the fair value recognized at the acquisition
date at the group level. 42
Remeasurement of Subsidiary’s Identifiable Net Assets

At acquisition date:
Fair value • Fair value differential will
$50,000 differential be recognized in the
consolidation worksheet

In subsequent years:
• Depreciation/amortization
(and cost of sale of asset)
Book value of Book value of will be based on the fair
subsidiary’s subsidiary’s $200,000 value recognized at the
identifiable net identifiable net acquisition date
assets assets
These entries have to be re-
enacted every year until the
disposal of investment

43
In a nutshell..
• If a business combination is effected through the acquisition of voting
rights (equity) of another entity, the acquirer and the acquiree will retain
their separate legal identities.
– However, they belong to the same economic entity
• As a result of the acquisition of the subsidiary by the parent, there is an
effective “acquisition” of the identifiable assets and liabilities of the
subsidiary at fair value. However, these assets and liabilities still reside in
the books of the subsidiary.
– The acquisition method requires the economic entity to recognize the assets
and liabilities of the acquiree at fair value as at acquisition date. Once
recognized, the fair value of identifiable assets and liabilities of the acquiree is
initial cost to the acquirer as at the date of acquisition.
• In the books of the acquiree, the identifiable assets and liabilities are
carried at their book values.
– The differences between the fair values and the book values of the assets and
liabilities (of the subsidiary) acquired at the date of acquisition are recognized as
consolidation adjustments in the consolidation worksheet.
44
Does Remeasurement of Subsidiary’s Identifiable Net
Assets affect Taxation?

At acquisition date:
Fair value • Fair value differential will
$50,000 differential be recognized in the
consolidation worksheet

In subsequent years:
• Depreciation/amortization
(and cost of sale of asset)
Book value of Book value of will be based on the fair
subsidiary’s subsidiary’s $200,000 value recognized at the
identifiable net identifiable net acquisition date
assets assets
Issue: What about tax effects?

45
Deferred Tax Relating to FV Differentials of Identifiable
Assets and Liabilities

• The recognition of fair value differential may give rise to future tax
payable or future tax deduction
– tax effects need to be accounted for because the basis for taxation does not
change in a business combination
– i.e. The excess of fair value over book value of identifiable net assets will give
rise to a taxable temporary difference and vice versa.

FV > Book value of identifiable assets Deferred tax liabilities

FV < Book value of identifiable assets Deferred tax assets
FV < Book value of identifiable liabilities Deferred tax liabilities
FV > Book value of identifiable liabilities Deferred tax assets

• No deferred tax liability is recognized on goodwill as goodwill is a

residual
46
Deferred Tax Relating to FV Differentials of
Identifiable Assets and Liabilities

• When fair values of identifiable assets and liabilities are recognized,

the acquirer has to consider consequential tax effects.
– SFRS(I) 1-12 Income Taxes requires the tax effects on the differences
between fair values and book values to be accounted for as deferred tax
liabilities or deferred tax assets if the basis for taxation does not change with
the business combination.
• For example, if the fair value of inventory is $50,000 and the original
cost is $20,000 there is a fair value differential of $30,000. The
excess of $30,000 gives rise to future taxable income.
– Since fair value is recognized under the acquisition method, the future tax
payable (“deferred tax liability”) should also be recognized.
• Recovery is determined in relation to the nature of the asset.
– If the proceeds from the recovery of the asset is tax-exempt (e.g. absence of
capital gains tax), no recognition of a deferred tax liability is required. For
example, fixed assets and intangible assets are generally held for production
rather than for re-sale.
47
Case 1: Elimination Entries (tax effects)

CJE1: Elimination of investment in subsidiary

Dr Inventory 30,000
Dr Trademark 20,000
Dr Goodwill 36,000
Dr Share capital 30,000
Dr Retained earnings 20,000
Cr Deferred tax liability 6,000
Cr Investment in Subsidiary 130,000
Points to note

• Assume a tax rate of 20%, the fair value differential of inventory ($30,000) is
subject to future tax liability of $6,000.
• An excess of fair value over book value of an identifiable asset gives rise to a deferred
tax liability (i.e. the excess gives rise to an increase in future economic benefits that will
be taxed when realized). The increase in future tax payable is thus recognized as a
deferred tax liability at the date of acquisition by the acquirer.

• In this example, no deferred tax liability is recognized on the trademark and

goodwill asset. 48
Case 2: Elimination Entries (tax effects)
CJE1: Elimination of investment in subsidiary
Dr Inventory 30,000
Dr Trademark 20,000
Dr Goodwill 40,000
Dr Share capital 30,000
Dr Retained earnings 20,000
Cr Deferred tax liability 10,000
Cr Investment in Subsidiary 130,000

Points to note

• Assume a tax rate of 20%

• In this example, both the fair value differentials of the inventory and trademark
are subject to future tax payable.

• No deferred tax liability is recognized on the goodwill asset.

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