LESSON 1 NOTES

INTRODUCTION
Due to market-related reasons, a business entity may find it worthwhile to either acquire another
entity or merge with another business entity. Such business entities are said to have combined for
accounting purposes and the mode of financial reporting adopted in such circumstances would be
substantially different from when a business entity is operating as a single unit.
For financial reporting purposes, the entity that is formed out of a business combination
transaction is called a group. The entity that acquires one or more entity is referred to as the
Parent or Holding entity while the entity or entities that are acquired are called subsidiary
(ies).
Acquisition occurs by the parent company purchasing the ordinary (voting) shares of the
subsidiary at a specified amount called consideration. This consideration could either be cash,
settlement of a subsidiary’s outstanding liability or issuance of the Parent’s equity shares to the
subsidiary’s shareholders for free.
Where the Parent acquires all the subsidiary’s shares, the subsidiary is said to be wholly owned.
Where the parent acquires more than half but less than 100% of the subsidiary’s shares, the
subsidiary is said to be partially owned. In that case, the un-acquired portion is called Minority
Interest
In identifying the Parent and subsidiaries, control is of critical importance because it also
imputes the percentage of Minority Interest.
An entity is said to control another, if it has power to govern the other entity and can use that
power to affect the profitability of the other entity.
Control therefore exist in either of the following circumstances:
a) Wholly controlled subsidiary: This is where A owns 100% of B’s voting share capital
directly
b) Partly controlled subsidiary: This is where the parent owns and controls less than 100%
but more than 50% of the voting shares of another entity. E.g. where A owns 80% of B’s
voting share capital directly. In this case, other parties own the remaining 20% of the
shares. This is described as a non-controlling interest or Minority interest since
although they own B, they cannot control B
c) Indirectly controlled subsidiary: This is where A owns a controlling interest in B. B
owns a controlling interest in C. Therefore, A controls C indirectly through its ownership
of B. C is described as a sub-subsidiary of A.
d) De facto control: Whereas De-jure means legal or factual, De-facto means realistic. De-
facto control is where A owns 45% of B’s voting share capital but the remaining 55% is
held by a large number of unrelated investors none of whom individually own more than
1% of B. This 45% holding probably gives A complete control of B. It would be unlikely
that a sufficient number of the other shareholders would vote together to stop A from
directing the company as it wishes.
 e) Contractual control: In this case, A owns 45% of B’s voting share capital. A further
10% is held by A’s bank who have agreed to use their vote as directed by A. This 45%
holding together with its power to use the votes attached to the banks shares gives A
complete control of B.
Note: Where two or more entities collectively control an investee in such a manner that they
must act together to direct the relevant activities i.e. no investor can direct the activities without
the co-operation of the others, Each investor must account for its interest in accordance with the
relevant IFRSs, such as IFRS 11 Joint Arrangements, IAS 28 Investments in Associates and Joint
Ventures or IFRS 9 Financial Instruments.
Power: An investor is said to have power over another when it has existing rights that give it the
current ability to direct the relevant activities. This power does not necessarily have to be
exercised. As long as the rights exist, all other things being equal, the investee is a subsidiary.
Financial Reporting in the context of business combination is governed by the following pieces
of Accounting standards:
a) IFRS 3 (Business Combinations)
b) IFRS 10 (Consolidated Financial statements)
c) IAS 28 (Investments in associates and joint ventures)
A REVIEW OF IFRS 3
According to IFRS 3 (Business Combinations), a business combination refers to a transaction
or other event in which an acquirer obtains control of one or more businesses.
IFRS 3 further establishes the principles and requirements for:
i. Recognition and measurement of identifiable assets acquired, liabilities assumed and
non-controlling interest in the acquiree;
ii. Recognition and measurement of goodwill (or a gain from a bargain purchase); and
iii. Disclosures that enable users to evaluate the nature and financial effects of a business
combination.
ACQUISITION METHOD
IFRS 3 prescribes that all business combinations are to be accounted for by the acquisition
method. This method involves the following 4 procedures:
1. IDENTIFYING THE ACQUIRER
This is the business entity that can be identified using the following criteria:
i. Size: The acquiring entity is relatively greater in size as described by asset base than the
others
ii. Consideration: The acquiring entity is the one that makes a transfer of either cash or
assets or incurs the liabilities on behalf of the acquiree in the combination process.
 iii. Equity issue: Is usually the entity that issues equity interests (except in a “reverse
acquisition” where the issuing entity is the acquiree).
Post-combination, the acquirer is identified as the entity:
i. whose owners have the largest portion of the voting rights in the combined entity
ii. whose owners have the ability to determine the composition of the governing body of the
combined entity;
iii. whose (former) management dominates the management of the combined entity;
2. DETERMINING THE ACQUISITION DATE
Acquisition date is the date on which the acquirer effectively obtains control of the acquiree. This
is usually the date of transfer of consideration and when net assets are fully acquired
3. RECOGNIZING AND MEASURING GOODWILL OR BARGAIN PURCHASE
Goodwill:
Refers to an asset representing the future economic benefits arising from other assets acquired in
a business combination that are not individually identified and separately recognized.
In business combination, goodwill arises when the consideration paid exceeds the value of
acquired net assets i.e. if Consideration > Value of Net assets acquired = Goodwill
On the other hand, bargain purchase results from a business combination transaction where the
consideration paid is less than the value of net assets acquired. i.e. if Consideration < Value of
Net assets acquired = Bargain purchase or Negative Goodwill
ALTERNATIVELY, Goodwill or bargain purchase could be determined by obtaining the
difference between the sum of Consideration paid and NCI against the total value of Net assets
of the subsidiary where total net assets is represented by share capital +retained earnings on
acquisition date i.e.
If (Consideration +NCI) > Total Value of net assets = Goodwill
If (Consideration +NCI) < Total Value of net assets = Bargain purchase
Illustrations
Illustration #1 - Net assets at book value (cost)
P acquired 70% of S on 1 January 2021 for Rs. 450,000 The retained earnings of S were Rs.
50,000 at that date. P recognizes non-controlling interest at the date of acquisition as a
proportionate share of net assets. The statements of financial position P and S as at 31
December 2021 were as follows:
DETAILS P LTD S LTD
Assets
Investment in S Ltd 450,000
Other assets 500,000 350,000
Total Assets 950,000 350,000
Current liabilities (200,000) (150,000)
Net Assets 750,000 200,000
Equity & Non-Current Liabilities
Share Capital 100,000 100,000
Retained Earnings 650,000 100,000
Totals 750,000 200,000

Required
Compute the goodwill or bargain purchase to be consolidated as at 31 December 2021.
SOLUTION
Parents control = 70% hence NCI = 30%
Workings:
W1 (NET ASSETS = Non-current liabilities + equities)
S LTD Net Assets Analysis
Details At Acq date Post-Acq At Consol date
Share Capital 100,000 100,000
Retained Earnings 50,000 50,000 100,000
Total 150,000 50,000 200,000

W2
Calculating the goodwill
Consideration transferred 450,000
Less: share of Net assets
acquired (70%*150000) (105,000)
Goodwill 345,000

OR
Purchase consideration 450,000
Add: NCI (on acquisition date) – 30%*150,000 45,000
Total 495,000
Less: Total net asset of subsidiary (on acq. date) (150,000)
Goodwill 345,000
Illustration #2 – Net assets at Fair value
P bought 80% of S 2 years ago. At the date of acquisition S’s retained earnings stood at Rs.
600,000 and the fair value of its net assets were Rs. 1,000,000. This was Rs. 300,000 above the
book value of the net assets at this date. The revaluation was due to an asset that had a remaining
useful economic life of 10 years as at the date of acquisition. The statements of financial position
P and S as at 31 December 2021 were as follows:
DETAILS P LTD S LTD
Assets
PPE 1,800,000 1,000,000
Investment in S Ltd 1,000,000
Other assets 400,000 300,000
Total Assets 3,200,000 1,300,000
Current liabilities (200,000) (200,000)
Net Assets 3,000,000 1,100,000
Equity & Non-Current Liabilities
Share Capital 100,000 100,000
Retained Earnings 2,900,000 1,000,000
Totals 3,000,000 1,100,000

Required: Calculate the amount of goodwill/bargain purchase

SOLUTION
Parents control = 80% hence NCI = 20%
Workings:
W1: Net assets analysis
S LTD Net Assets Analysis
Details At Acq date Post-Acq At Consol date
Share Capital 100,000 100,000
Retained Earnings(net of charged
depreciation - 300000/10*2) 600,000 340,000 940,000
fair value reserve 300,000 300,000
Total 1,000,000 340,000 1,340,000

W2: Goodwill
Calculating the goodwill
Consideration transferred 1,000,000
Less: share of Net assets acquired at
fair value (80%*1000000) (800,000)
Goodwill 200,000

OR
Purchase consideration 1,000,000
Add: NCI (on acquisition date) – 20%*1,000,000 200,000
Total 1,200,000
Less: Total net asset of subsidiary (on acq. date) (1,000,000)
Goodwill 200,000
Illustration #3 – NCI at Fair value
Here, the value of net assets acquired is rightly assumed to be the difference between the book
value of total net assets on acquisition date and the fair value of the minority interest. Therefore,
no percentage acquisition is imputed in the calculation.
Goodwill is then calculated in the usual manner as illustrated below:
P acquired 70% of S on 1 January 2021 for Rs. 450,000 The retained earnings of S were Rs.
50,000 at that date. It is P’s policy to recognize non-controlling interest at the date of acquisition
at fair value. The fair value of the non-controlling interest at the date of acquisition was Rs.
75,000. The statements of financial position P and S as at 31 December 2021 were as follows:
DETAILS P LTD S LTD
Assets
Investment in S Ltd 450,000
Other assets 500,000 350,000
Total Assets 950,000 350,000
Current liabilities (200,000) (150,000)
Net Assets 750,000 200,000
Equity & Non-Current Liabilities
Share Capital 100,000 100,000
Retained Earnings 650,000 100,000
Totals 750,000 200,000

Required
Compute the amount of goodwill to be consolidated as at 31 December 20X1.
SOLUTION
Parents control = 70% hence NCI = 30%
Workings:
W1: Net assets analysis
S LTD Net Assets Analysis
Details At Acq date Post-Acq At Consol date
Share Capital 100,000 100,000
Retained Earnings 50,000 50,000 100,000
Total 150,000 50,000 200,000

W2: Goodwill
Calculating the goodwill
Consideration transferred 450,000
Less:Fair value of Net assets acquired
(150000-75000) - NCI (75,000)
Goodwill 375,000

a) Determination of purchase consideration

According to IFRS 3, the purchase consideration for an acquisition (business combination) is the
sum of:
i. The fair values, at the acquisition date, of the assets transferred by the acquirer, such as
cash
ii. The liabilities incurred by the acquirer to the former owners of the acquiree (e.g. payment
of debt on behalf of acquiree)
iii. Market value of Equity instruments (shares) issued by the acquirer in exchange for
control of the acquiree
iv. Present value of any deferred (future) consideration payable by the acquirer at
appropriate cost of capital.
v. Present value of contingent asset or liability at an appropriate cost of capital.
Note: Transaction costs incurred in making an acquisition, e.g. legal, accountancy, advisory fees
must not be included in the cost of the acquisition but should be treated as an expense as incurred
and written off to profit or loss. Such expenses written off must be disclosed in a note to the
financial statements. However, if an entity borrows money to finance an acquisition, the costs
associated with arranging the borrowing (borrowing costs) are treated in accordance with IAS 39
i.e. they are deducted from the value of the debt and amortized over the term of the debt using
the effective rate of interest (i.e. the amortized cost method).
EXAMPLE#1 Cost of acquisition
Company P acquired 80% of the shares of Company S when the fair value of the net assets of S
was Rs. 800,000. The purchase price was Rs. 300,000 in cash plus 10,000 new shares in
Company P. The new shares were to be issued 1 month after the date of acquisition. The market
value of P’s shares at the date of acquisition was Rs.40 each. One month later the market value
had increased to Rs.45. The costs of making the acquisition were Rs. 80,000.
SOLUTION
The cost of the investment in the shares of S = Rs. 300,000 + (10,000 × Rs.40 = Rs. 700,000.
The share price at the date of acquisition is used not that at the date of issue. The costs of making
the acquisition should be written off to profit or loss. The parent company’s share of the net
assets of S at the acquisition date was Rs. 640,000 (80% × Rs. 800,000). Purchased goodwill
attributable to owners of the parent company is therefore Rs. 60,000 (Rs. 700,000 - Rs. 640,000).
EXAMPLE#2 Contingent consideration
Company X purchased 100% of the issued capital of Company S on 1 January Year 1. The
purchase agreement required Company X to pay Rs. 300,000 in cash immediately and an
additional sum of Rs. 100,000 on 31 December Year 3 if the earnings of Company S increase at
an annual rate of 25% per year in each of the three years following the acquisition. Show how
this contingent payment should be treated in calculating the goodwill arising at the date of
acquisition
Answer
The contingent consideration should be included in the cost of investment (the purchase
consideration) whether or not it is probable that it will have to be paid. The contingent
consideration of Rs. 100,000 should be measured at fair value. If it is fairly certain that the
contingent consideration will have to be paid, an appropriate measure of fair value might be the
present value of the future payment, discounted at an appropriate cost of capital. The purchase
consideration is therefore Rs. 300,000 plus the present value of the contingent (deferred)
consideration.
If there is still contingent consideration at the end of an accounting period, it might be necessary
to re-measure it depending on the performance of the subsidiary.
If the contingent consideration will be payable in cash or through debt, it should be re-measured
to fair value at the end of the reporting period and any gain or loss on re-measurement taken to
profit or loss. However, if the contingent consideration will take the form of equity, it is not re-
measured at the end of the reporting period. The eventual settlement of the payment will be
accounted for as an equity transaction (i.e. a transaction between the entity and owners of the
group in their capacity as owners)