ADVANCED FINANCIAL

ACCOUNTING STUDIES
Lecture 1
Business Combinations I: Basic Concepts

Angie Wang
School of Accountancy
Business Combinations

❑ IFRS 3 defines a business combination as a:

▪ ‘. . . transaction or other event in which an acquirer obtains control of one or
more businesses.’
 Business Combinations
❑Business combinations may take different forms; however, two characteristics are
present:

Acquirer obtains
CONTROL of
business acquired

Target is one or
more BUSINESSES
Business Combinations
❑ An investor controls an investee IF and ONLY IF the investor has all of the
following elements: [IFRS 10:7]

Power

Control
Ability

Returns
 Business Combinations
❑Business combinations may take different forms; however, two characteristics are
present:

• 3 main attributes of control

Acquirer obtains - power over acquiree
CONTROL of - exposure or rights to variable returns of the acquiree
business acquired - ability to use such power to affect the acquirer’s returns

Target is one or
more BUSINESSES
Business Combinations
❑ A ‘business’ is NOT just a group of assets, rather, it is an integrated set of activities
and assets able to produce a return
❑ Substantive processes: depends on whether an acquired set of activities and assets
has outputs at acquisition date.
 Business Combinations
❑Business combinations may take different forms; however, two characteristics are
present:

• 3 main attributes of control

Acquirer obtains - power over acquiree
CONTROL of - exposure or rights to variable returns of the acquiree
business acquired - ability to use such power to affect the acquirer’s returns

• 3 vital characteristics of a business

Target is one or - integrated set of activities and assets
- capable of being conducted and managed for providing a return
more BUSINESSES - consists of inputs and substantive processes applied to those
inputs that have the ability to contribute to the creation of outputs
 Business Combinations
Four general forms of business combination (assuming substantive processes)
Entity A Entity B Remarks
1. Acquired ALL net assets of Entity B: Continued as a company: No parent-subsidiary
relationship
-Receipt of assets and liabilities of -Sale of assets and liabilities to Entity A
Entity B -Gain or loss on sale
-Consideration transferred to Entity B -Receipt of consideration transferred
(Issued shares to Entity B / paid cash) (holding shares in Entity A / receiving
cash)
2. Acquired ALL net assets of Entity B: Liquidated: No parent-subsidiary
relationship
-Receipt of assets and liabilities of -Liquidation account, including gain/loss
Entity B on liquidation
-Consideration transferred to Entity B -Receipt of purchase consideration
(Issued shares to Entity B / paid cash) -Distribution of consideration to
appropriate parties, including
shareholders
 Business Combinations
Entity A Entity B Remarks
3. Liquidated: Liquidated: Entity C (a new company)
is formed:
-Liquidation account, including -Liquidation account, including -Acquire ALL net assets of
gain/loss on liquidation gain/loss on liquidation Entities A and B
-Receipt of purchase consideration -Receipt of purchase consideration -Issued shares / paid cash
-Distribution of consideration to -Distribution of consideration to “put-together” transaction
appropriate parties, including appropriate parties, including
shareholders shareholders
4. Acquired EQUITY INTERESTS Continued to operate as Parent-subsidiary
(shares) of Entity B: legal entity: relationship exists:

- Indirectly control / acquire a group of -Became SUBSIDIARY of -Required preparation of

net assets of Entity B Entity A (if being “controlled”) consolidated financial
statements (HKFRS/IFRS
10 Consolidated
Financial Statements)
Accounting for Business Combinations
Standards relevant to the preparation and presentation of
consolidated financial statements

HKFRS/IFRS 3 Business Combination (deals with business

combination generally)

HKFRS/IFRS 10 Consolidated Financial Statements

*The result of a business combination (IFRS 3) may or may not be a parent-subsidiary

relationship (IFRS 10).
Accounting for Business Combinations
❑ HKFRS/IFRS 3 (Revised) applies to the above business combinations EXCEPT:
- That the business combinations involves a formation of a joint arrangement / venture
- Joint arrangement: an arrangement of which two or more parties have joint control
- Governed by accounting standard HKFRS 11 Joint Arrangements and HKAS 28 (2011)
Investments in Associates and Joint Ventures

- That the business combinations involves entities or businesses under common control
- Common control: ultimately controlled by the same party or parties before and after the
combination
- Governed by accounting guidance AG5 Merger Accounting for Common Control Combination

- That the acquisition does not represent a business (i.e., acquisition of assets or groups of assets)
- Governed by accounting standard HKAS 16 Property, Plant and Equipment
Accounting for Business Combinations
❑ The required method of accounting for a business combination under paragraph 4
of HKFRS/IFRS 3 is the acquisition method.

❑ Acquisition method:
- Based on fair value principle
- Upon obtaining control of the subsidiary, the exchange transaction is measured
at fair value.
The Acquisition Method
❑ The key steps in the acquisition method are:

Identify the acquirer

Determine the acquisition date

Recognize and measure the identifiable assets acquired,

Determine consideration the liabilities assumed and any non-controlling
transferred interest in the acquiree; and

Recognize and measure goodwill or

a gain from a bargain purchase
The Acquisition Method
-Identifying the Acquirer
❑ The business combination is viewed from the perspective of the acquirer.

❑ The acquirer is the entity that obtains control of the acquiree.

The Acquisition Method
-Identifying the Acquirer
❑An acquirer can obtain control in an acquiree through:

1. Acquisition of assets and assumption of liabilities of the acquiree

- Include assets and liabilities not previously recognized by acquiree: contingent
liabilities, brand name, in-process R&D etc.
2. Acquisition of controlling interest in the equity of the acquiree
- Deemed to be effective acquisition of assets and assumption of liabilities of
the acquiree
- Control over an acquiree in substance means that acquirer has control over
net assets of the acquiree
3. Combination of (1) and (2)
The Acquisition Method
-Identifying the Acquirer
❑ In most cases this step is straightforward. In other cases, judgement may be
required.

❑ Indicative factors contained within Appendix B of IFRS 3 assist in identifying the

acquirer.
• Relative size of the two entities
• Initiator of the transaction
• Direction of transfer of non-equity consideration (if the combination accomplished by
• transfer of cash or other assets)
• Relative voting rights in the combined entity after the business combination (after
• considering special voting arrangements as well as options, warrants or convertible
• securities)
• Composition of the governing body of the combined entity
• Composition of the senior management of the combined entity
The Acquisition Method
-Identifying the Acquirer
❑ Special case: Entity A combines with Entity B to form a new company Entity C.
Entity C issued shares to acquire all the shares of both Entities A and B. Who is the
acquirer?
The Acquisition Method
-Identifying the Acquirer
❑ Special case: Entity A combines with Entity B to form a new company Entity C.
Entity C issued shares to acquire all the shares of both Entities A and B. Who is the
acquirer?

❑ As entity C is created solely to formalise the organisation structure, it is NOT the

acquirer, even though it is the legal parent of both of the other entities.
- Paragraph B18 of Appendix B to IFRS 3 states that one of the entities that
existed before the combination must be identified as the acquirer. Entity C is not
a party to the decisions associated with creating the business combination, it is
just a vehicle used to facilitate the combination.
- Seek for indicative factors contained within Appendix B of IFRS 3. Entity A or B
may be the acquirer.
The Acquisition Method-recap
❑ The key steps in the acquisition method are:

Identify the acquirer

Determine the acquisition date

Recognize and measure the identifiable assets acquired,

Determine consideration the liabilities assumed and any non-controlling
transferred interest in the acquiree; and

Recognize and measure goodwill or

a gain from a bargain purchase
The Acquisition Method
-Determine the acquisition date
❑ Acquisition date is the date that the acquirer obtains control of the acquiree.

❑ General principle = the date on which the acquirer legally transfers consideration,
acquires the assets, and assume liabilities of the acquiree

❑ Determining the correct acquisition date is important as the following are affected
by the choice of acquisition date:
- The fair values of net assets acquired
- Consideration given, where the consideration takes a non-cash form
- Measurement of the non-controlling interest
The Acquisition Method
-Determine the acquisition date
❑ Example:
- Jan. 1, 2022: Directors of Entity A approached directors of Entity B with the
proposal for the acquisition of all the issued shares of Entity B.
- Mar. 3, 2022: Both parties agreed on the terms and signed contract.
- May 5, 2022: 20% of the consideration has been paid as deposit of the acquisition.
- Jan. 1, 2023: Entity A acquired the remaining 80% of shares.
When is the acquisition date?
The acquisition date is the date when entity A acquired the 80% interest. The 20%
share holding will be recorded as an asset in the records of entity A. At acquisition
date, the fair value of this investment is measured.
The Acquisition Method-recap
❑ The key steps in the acquisition method are:

Identify the acquirer

Determine the acquisition date

Recognize and measure the identifiable assets acquired,

Determine consideration the liabilities assumed and any non-controlling
transferred interest in the acquiree; and

Recognize and measure goodwill or

a gain from a bargain purchase
The Acquisition Method
-Recognize and measure the identifiable assets acquired and
the liabilities assumed
❑ Fair value allocation occurs at acquisition date and requires the recognition of:

- Identifiable tangible and intangible assets

- Liabilities
- Contingent liabilities
- Any non-controlling interest in the acquiree
- Goodwill
The Acquisition Method
-Recognize and measure the identifiable assets acquired and
the liabilities assumed
❑ Recognition Principle:

Identifiable net assets (INA) must comply with two conditions to qualify for
recognition:

(1) INA must meet the definition of an asset or a liability in the conceptual framework
for financial reporting;

(2) INA must be priced into the consideration transferred and not a separate stand-
alone transactions.
The Acquisition Method
-Recognize and measure the identifiable assets acquired and
the liabilities assumed
❑ Principle 1: INA must meet the definition of an asset or a liability in the conceptual
framework for financial reporting.

❑ (Review) Definition of “assets” and “liabilities” in the Framework

ASSETS LIABILITIES
(A) It is probable that any future economic It is probable that there is an outflow of
Probability test benefit will flow to the entity future economic benefit from the entity
(B) The item has a cost or value that can be The item has a cost or value that can be
Measurement test reliably measured reliably measured
The Acquisition Method
-Recognize and measure the identifiable assets acquired and
the liabilities assumed
❑ For business combinations, the probability test in criteria (A) is unnecessary due to
the adoption of fair value approach:

- Recognition of assets and liabilities is required regardless of the degree of

probability of an inflow or outflow of economic benefits.

- Fair value reflects ‘market expectation’ of future economic benefits.

- Probability being reflected by the fair value (i.e., fair value measure captures both
the amount of future economic benefits AND the probable likelihood of their
realisation.)
The Acquisition Method
-Recognize and measure the identifiable assets acquired and
the liabilities assumed
❑ Application of Principle (1): Intangible Assets

❑ (Review) Recognition of internally generated intangibles (e.g., brand name) is

prohibited under HKAS 38 Intangible Assets → expensed as incurred

❑ Intangible assets acquired in a business combination are to be recognized if they

meet either of two criteria (therefore considered as “identifiable”):
(1) Separability criterion – can be sold or transferred alone with evidence of exchange transactions;
or
(2) Legal/contractual criterion – results from contractual or other legal rights
The Acquisition Method
-Recognize and measure the identifiable assets acquired and
the liabilities assumed
Are these considered intangible assets?
Assembled workforce with specialized knowledge × No: Firm-specific and integrated with acquiree
× (Fails separability criterion)

Potential contracts or contracts under negotiation × No: Fails separability or contractual-legal criterion

Opportunity gains from an operating lease in ✓ Yes: Meets the contractual-legal criterion
favorable market conditions
Customer and subscriber lists of acquiree ✓ Yes: Meets the separability criterion (show evidence
of exchange transactions for similar types of lists)
The Acquisition Method
-Recognize and measure the identifiable assets acquired and
the liabilities assumed
❑ Examples of intangible assets which can be recognised in a business combination:

- Marketing-related intangible assets (e.g., trademarks)

- Customer-related intangible assets (e.g., customer list, order and production
backlog, contractual or non-contractual customer relationship)
- Artistic intangible assets (e.g., lyrics)
- Contract-based intangible assets (e.g., royalty, broadcast rights, franchise rights,
use and operating rights)
- Technology-based intangible assets (e.g., patented software)
- In-process research and development assets
The Acquisition Method
-Recognize and measure the identifiable assets acquired and
the liabilities assumed
❑ Application of an EXCEPTION to Principle (1): Contingent Liabilities

❑ (Review) Definition of contingent liabilities in HKAS 37 Provisions, Contingent Liabilities and

Contingent Assets:
(a) a POSSIBLE obligation that arises from past events and whose existence will be confirmed
only by the occurrence or non-occurrence of one or more uncertain future events not wholly
within the control of the entity [NON-LIABILITIES]; OR
(b) a PRESENT obligation that arises from past events [REAL LIABILITIES] but is not
recognized because:
(i) it is not probable that an outflow of resources embodying economic benefits will be
required to settle the obligation; or
(ii) the amount of the obligation cannot be measured with sufficient reliability.
The Acquisition Method
-Recognize and measure the identifiable assets acquired and
the liabilities assumed
❑ (Review) Treatment of contingent liabilities under HKAS 37: Not recognized in the
financial statements but must be disclosed in the financial statements unless the
possibility of an outflow in settlement is remote.

❑ Applying the principle of disregarding the probability test with fair value approach
under HKFRS/IFRS 3 (Revised), contingent liability (b)(i) as at acquisition date can
be recognized in a business combination at its fair value.

❑ Applying Principle (1), contingent liability (a) & (b)(ii) fail to meet the definition of
liabilities and cannot be recognized in a business combination.
The Acquisition Method
-Recognize and measure the identifiable assets acquired and
the liabilities assumed
❑ Application of an EXCEPTION to Principle (1): Indemnification Assets

❑ Indemnification assets:
- Sellers of the acquiree may provide a contractual indemnity to the acquirer to
make good any loss arising from a contingency or an asset or a liability (i.e.,
protecting the acquirer from potential adverse effects of an unfavourable future
resolution and guaranteeing by the seller that the acquirer’s liability will not
exceed a specified amount).
- Acquirer then obtains an indemnification asset.
The Acquisition Method
-Recognize and measure the identifiable assets acquired and
the liabilities assumed
❑ Applying the principle of disregarding the probability test with fair value approach
under HKFRS/IFRS 3 (Revised), acquirer has to recognize an ‘indemnification
asset’ at the same time that the acquirer recognizes the indemnified asset or liability.

❑ The indemnification asset is measured on the same basis as the indemnified item.

❑ Example: An acquiree is exposed to a contingent liability. Based on probabilistic estimation, the FV

of the contingent liability is $100,000. The former owners provide a contractual guarantee to
indemnify the acquirer of the loss.
- In the consolidated balance sheet, the acquirer recognizes contingent liabilities of $100,000 and
an indemnification asset of $100,000 at FV.
The Acquisition Method
-Recognize and measure the identifiable assets acquired and
the liabilities assumed
❑ Principle 2: INA must be priced into the consideration transferred and NOT a
separate stand-alone transactions.

❑ Examples of separate transactions:

- A settlement of a pre-existing relationship between acquirer and acquiree (e.g., as a supplier)
- Compensation to employees or former owners of the acquiree for future services
- Reimbursement to the acquiree or its former owners for paying the acquirer’s acquisition-related
costs (e.g., accounting fee, legal fee, valuation fee)
 The Acquisition Method
-Recognize and measure non-controlling Interests
❑Non-controlling interests (NCI) arises when acquirer obtains control of a subsidiary but does not have
full ownership of voting rights.

❑In a business combination, NCI are recognized by the acquirer as equity based on the following equation
Rationale: To represent outside interests’ share in the net assets of the acquiree.

Assets - Liabilities = Equity

Carrying amount of
Carrying amount of
acquirer’s assets + Acquirer’s equity
acquirer’s liabilities
Acquisition date FV + NCI share of
+ Acquisition date
of acquiree’s equity of
of FV of acquiree’s
identifiable assets + acquiree
identifiable liabilities
Goodwill
The Acquisition Method-recap
❑ The key steps in the acquisition method are:

Identify the acquirer

Determine the acquisition date

Recognize and measure the identifiable assets acquired,

Determine consideration the liabilities assumed and any non-controlling
transferred interest in the acquiree; and

Recognize and measure goodwill or

a gain from a bargain purchase
Any questions?
For next time…
• Buy or obtain access to the textbooks

• Read McGraw Hill Ch3, Wiley Ch14