Chapter 3

Chapter 3
Group Reporting II:
Application of the
Acquisition Method
under IFRS 3

1
Copyright © 2016 by McGraw-Hill Education (Asia). All rights reserved.

Learning Objectives

1. Understand the difference between investor’s separate financial

statements and the consolidated statements;
2. Understand the differences in various modes of business
combinations and the similarities in their economic substance;
3. Appreciate the significance of the acquisition method and its
implications for consolidation;
4. Know how to determine the amount of consideration transferred;
5. Understand special issues concerning control and identification of
the acquirer;
6. Know how to recognize and measure identifiable assets,
liabilities, and goodwill in accordance with IFRS 3 requirements;
7. Understand the nature of goodwill;

Content

1. Introduction
Introduction
2. Overview of the Consolidation Process
3. Business Combinations
4. Determining the Amount of Consideration Transferred
5. Recognition and Measurement of Identifiable Assets, Liabilities
and Goodwill
6. Conclusion

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Chapter 3

Introduction
Separate financial Consolidated financial
statements statements
(Legal entity) (Economic entity)
Governing rules and In accordance with
In accordance with IFRS 10
regulations corporate regulations
IFRS 10 allowed for exemptions
by a parent if it’s:
 A wholly owned or partially
owned subsidiary;
 Debt or equity instruments not
traded in public;
Possible exemptions
No exemption  Did not file financial
for presentation
statements for purpose of
issuing instruments to public;
and
 Ultimate parent produces
consolidated financial
statements.
4

Separate vs Consolidated Financial

Statement
Consolidated financial
Separate financial statements
statements
(Legal entity)
(Economic entity)

Income recognition Dividends Share of profits

Investment in a subsidiary carried
at: Investment in a subsidiary:
• Cost (IAS 27) or • Investment is eliminated
and subsidiary’s net assets
• As a financial instrument (IFRS
areadded to the parent
9)
(IFRS 10)
• Equity method
Asset recognition
Investment in an associate or joint
venture carried at: Investment in an associate:
• Cost or equity method (IAS 28) • Equity method (IAS 28)
or
• As a financial instrument (IFRS
9)
5

Content

1. Introduction
2. Overview of
Overview of the
the Consolidation
Consolidation Process
Process
3. Business Combinations
4. Determining the Amount of Consideration Transferred
5. Recognition and Measurement of Identifiable Assets, Liabilities
and Goodwill
6. Conclusion

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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
7

Intra-group Transactions
• Intra-group transactions are eliminated to:
– Show the financial position, performance and cash flows of the economic (not
legal) entity.
– Avoid double counting of transactions within the economic entity.

Example:
• Parent sold inventory to subsidiary for $2M
• The original cost of inventory is $1M
• Subsidiary eventually sold the inventory to external parties for $3M

Q: What is the journal entry to eliminate intra-group sales transaction?

Consolidation adjustment
Dr Sales 2,000,000
Cr Cost of sales 2,000,000

Intra-group Transactions

Extract of consolidated worksheet

Consolidation
elimination entries
Parent's Subsidiary's Consolidate
and adjustment
Income Income d income Without
Statement Statement Dr Cr statement elimination
Sales $2,000,000 $3,000,000 2,000,000 $3,000,000 $5,000,000
Cost of
sales (1,000,000) (2,000,000) 2,000,000 (1,000,000) ($3,000,000)
Gross
profit $1,000,000 $1,000,000 $2,000,000 $2,000,000

Note: Without elimination the consolidated sales and cost of sales figures
will be overstated by $2 M.

*The consolidation process will be discussed in greater detail in Chap 4.

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Chapter 3

Content

1. Introduction
2. Overview of the Consolidation Process
3. The acquisition
Business method
Combinations
4. Determining the Amount of Consideration Transferred
5. Recognition and Measurement of Identifiable Assets, Liabilities
and Goodwill
6. Conclusion

10

Business Combinations

• Business Combinations may take different forms; however two

characteristics are present:

Acquirer has • 3 main attributes of control (IFRS 10)

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

• 2 vital characteristics of a business

Target of (IFRS 3)
acquisition is a • Integrated set of activities and assets
• Capable of being conducted and managed to
business provide returns (i.e. dividends) to investors and
other stakeholders.

Business Combinations involving entities under common control is outside of scope

of IFRS 3
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Business Combinations

Where an acquirer
obtains control of
Business
one or more
combinations
businesses (IFRS 3
App A)

Examples: IFRS 3 App B:B6

Direct Net assets Former

Businesses
acquisition of net of combining owners of a
become
assets of entities transferred combining entity
subsidiaries of
acquired to a newly-formed obtains control
acquirer
business entity of combined entity

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Chapter 3

Direct Acquisition of Net Assets of Acquired

Business

Transfer net
assets Acquirer’s separate
financial
Former owners of
statements will now
the net assets of
include goodwill
acquired
and other net
businesses
assets of the
Transfer acquired business
consideration

• Business combination does not give rise to a parent-subsidiary relationship.

• Goodwill is recognized in the separate financial statements of the acquirer.
• No distinction between legal entity and enlarged economic entity
• No consolidation required and no NCI arisen
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Businesses Become Subsidiaries of

Acquirer
Acquirer’s Group

Former owners
transfers equity of
subsidiary

Former
owners of a Acquirer Subsidiary
subsidiary
Acquirer transfers
consideration

• Business combination gives rise to parent-subsidiary relationship

• Goodwill is recognized in the consolidated financial statements
• Consolidated financial statements are required
• NCI is recognized in the consolidated financial statements
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Direct Acquisition of Net Assets vs

Becoming a Subsidiary
Direct acquisition Businesses becoming
a subsidiary
Parent-subsidiary
Does not exist Exists
relationship
Required to represent
Consolidated financial
Not required financial performance of
statements
economic entity
Recognized in separate Recognized in
Goodwill financial statements of consolidated financial
acquirer statements
NCI in consolidated
NCI No NCI
financial statements

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Chapter 3

Net Assets of Combining Entities

Transferred to a Newly Formed Entity

Acquirer Acquiree

New legal
entity is
the
Net assets of acquirer are Net assets of acquiree, including
recognized at pre-
economic goodwill and identifiable net
combination carrying entity assets, are recognized at their
amounts acquisition date fair values

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Net Assets of Combining Entities

Transferred to a Newly Formed Entity
• Acquirer and acquiree transfer their assets and liabilities to a newly
formed entity
– Controlling entity is the acquirer, and the other entity is the acquiree
• Legal entity incorporates the assets and liabilities of the enlarged
economic entity
• This business combination would give rise to goodwill to be
recognized in the newly formed entity’s financial statements
• Consolidation is not required as separate legal entities of acquirer
and acquiree cease to exist

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Former Owners of a Combining Entity

obtains Control of the Combined Entity
• Business combination involves a Reverse Takeover (RTO)
• Former owners of legal subsidiary obtains control over the enlarged
economic entity
• Reason for RTO:
– Raising public funds without having to undergo a more costly process of
raising funds through an Initial Public Offering (IPO)

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Chapter 3

The Acquisition Method

• IFRS 3 requires all business combinations to be accounted for using

the acquisition method from the perspective of an acquirer.

• An acquirer can obtain control in an acquiree through:

1. Acquisition of assets and assumption of liabilities of acquiree
 Include assets and liabilities not previously recognised by
acquiree: contingent liabilities, brand name, in-process R&D etc.
2. Acquisition of controlling interest in the equity of acquiree
 Deemed to be effective acquisition of assets and assumption of
liabilities of acquiree
 Control over an acquiree in substance means that acquirer has
control over net assets of acquiree
 Effects: (2) accounted for as if they are effects of (1)
3. Combination of (1) and (2)
 Effects: Accounted for as if they are effects of (1)

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The Acquisition Method

4-step
• The procedures: approach:
IFRS 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

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Identify the Acquirer

• IFRS 3 requires the identification of the acquirer in all circumstances

– Acquirer is the entity that obtains control of another combining entities
– Concept of control is based on IFRS 10 but the standard may not
always conclusively determine the identity of the acquirer.
– IFRS 3 Appendix B provides additional criteria to identify controlling
acquirer.

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Chapter 3

Identify the Acquirer

Additional control criteria under IFRS 3 Appendix B

Based on consideration
Based on entity size Based on dominance
transferred

Acquirer is the entity that: Acquirer is the entity: Acquirer is the entity:

• Transfers cash or other
assets or incurs liabilities to
acquire another entity
• Issues shares as
consideration to acquire
shares of another entity
• Pays a premium over the fair
value of the equity interest
• Whose owners hold the
largest relative voting rights
in a combined entity
• Whose owners hold the
largest minority voting
interest in the combined
entity (if no other entity has
significant voting interest)
• Which is larger in size
• Whose owners have the
ability to elect, appoint or
remove a majority of
directors
• Whose management is
dominant in the combined
entity
• Who initiates the business
combination

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Identify the Acquirer – Reverse Acquisition

• Reverse acquisition
– Legal parent is the acquiree and legal subsidiary is the acquirer
– Often initiated by the legal subsidiary
– Motive for entering into such an arrangement often to seek a backdoor
listing

• Exchange of shares in a reverse acquisition

1. Company A (Legal parent) takes Owners of Company B
over shares of Company B from (Legal subsidiary)
owners

2. Company A issues own shares to

Company A owners of Company B as
(Legal parent) purchase consideration

Company B
3. Company B has the power and ability (Legal subsidiary)
to affect the returns of the legal parent
after the share exchange
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Identify the Acquirer – Reverse Acquisition

Example
On 1 July 20x5, P (private), arranged to have all its shares acquired by L
(public listed). The arrangement required L to issue 20 million shares to P’s
shareholders in exchange for the existing 6 million shares of P. Existing shareholders
of L owned 5 million of L.
After the issue of 20 million L shares, P’s shareholders now owned 80% (20
million shares out of a total of 25 million shares) of the issued shares of L. L’s
shareholders owned 20% of the shares in the combined entity after the share issue. P’s
shareholder act in concert to exercise control over L.

L’s shareholders P’s shareholders

(5 million shares) (20 million shares)
20% 80%
L
100%

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Chapter 3

Content

1. Introduction
2. Overview of the Consolidation Process
3. Business Combinations
4. Determining the
Determining theAmount
Amount of
of Consideration
Consideration Transferred
Transferred
5. Recognition and Measurement of Identifiable Assets, Liabilities
and Goodwill
6. Conclusion

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Determine the Amount of Consideration

Transferred
Consideration Fair value of Fair value of
transferred* =
Fair value + Fair value + equity
+ contingent
of assets of liabilities
transferred incurred interests consideration
by the issued by
acquirer acquirer

• *Fair value (FV) of the consideration transferred:

– Determined on the acquisition date
– Acquisition date is the date when the acquirer obtains control and not the
date when consideration is transferred
– Acquisition-related costs are not included

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Fair Value of Assets Transferred

or Liabilities Assumed
• If assets transferred or liabilities assumed are not carried at fair
value in the acquirer’s separate financial statements:
– Remeasure in fair value and recognize gain or loss in the acquirer’s
separate financial statements
– Remeasured gain or loss is not recognized if the asset or liabilities
remain in the combined entity’s financial statements

• If transfer of monetary assets or liabilities are deferred, the time

value of money should be recognized:
– The fair value will be the present value of the future cash outflows
– E.g. Future cash settlement of $1,000,000 is due 3 years later and 3%
interest is levied
Present value to be recognised = $1,000,000 / (1+0.03)^3
= $915,142

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Chapter 3

Fair Value of Equity Interests Issued

by the Acquirer
• Fair value of equity interests issued is measured:
– (1) By market price (e.g. published quoted prices of shares)
– (2) With reference to either the acquisition date fair value of the acquirer OR
acquiree, whichever is more reliable. (For example, if market price is not
available or not reliable for the acquiree, use the fair value of the acquirer)

• Illustration of (2) Issues X number of shares

Acquirer Owners of Acquiree

Conveys A number of shares to acquirer
Total number of
shares after
issue: Y Gains control over acquiree

FV of acquirer’s
equity: $Z Acquiree
FV of equity issued is either:
• X/Y multiplied by $Z; or
• A/B multiplied by $C

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Illustration 1:
Fair Value of Equity Issued
P Ltd acquires 100% of S Co. through an issue of 5,000,000 shares
to the owners of S Co.

P Ltd S Co
Number of existing shares 10,000,000 2,000,000
Number of new shares issued 5,000,000 –
Market price per share $2.00 –
Fair value of equity 30,000,000 9,000,000

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Illustration 1:
Fair Value of Equity Issued
Situation 1: P Ltd’s market price is a reliable indicator

Consideration transferred = 5,000,000 shares x $2.00

= $10,000,000

Situation 2: Fair value of S Co. is a better estimate

Consideration transferred = $9,000,000

Explanation: Since P Ltd is acquiring 100% of S Co, the fair value of

the equity (FV of S Co. as a whole including the implicit goodwill)
acquired by P is $9 million.

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Chapter 3

Fair Value of Contingent Consideration

• Contingent consideration
– Obligation (right) of the acquirer to transfer (receive) additional assets or equity
interests to (from) acquiree’s former owner if specific event occurs
• E.g. Event A: acquirer gets a refund of part of the consideration transferred if the
acquiree does not achieve the target profit
• Fair value of contingent consideration or refund will change as new information arises

– Fair value of the contingent consideration has to be estimated through determining the
present value of the probability-weighted outcome; if the contingent event leads to a
refund (For example, event A) the fair value of the refund (probability-weighted
outcome) is deducted from consideration transferred

– Fair value of contingent consideration is adjusted retrospectively as a correction of

error if events after acquisition reveal information that was missed or misapplied as at
the acquisition date

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Contingent Consideration

• Assuming 2 outcomes
o Expected value = (Probability of contingent event

occurring * consideration) + (Probability of contingent

event not occurring * 0)
o Fair value = Present value of expected value

= PVFi,n x Expected value

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Example: Contingent Consideration

• An acquirer undertakes to pay an additional $2 million to

the vendor at the end of 3 years from acquisition date if
the annual profit of the subsidiary does not fall below $5
million over a 3-year period. Probability that annual profit
will be at least $5 million over the 3-year period = 0.60.
Present value factor at 5% at the end of 3 years =
0.8638.

 Fair value of contingent consideration

= 0.8638 x [($2,000,000 x 0.60) + (0 x 0.40)]
= $1,036,560

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Chapter 3

Acquisition-Related Costs
• All acquisition-related costs are expensed off
• Costs of issuing debt are recognized in accordance with IAS 39 or
IFRS 9
– As yield adjustment to the cost of borrowing and are amortized over the
tenure of the loan
– Journal entry for the payment of debt issuance cost
Dr Unamortized debt issuance costs
Cr Cash

• Costs of issuing equity are recognized in accordance with IAS 32

– A reduction against equity
– Journal entry to record the payment of cost of issuing equity
Dr Equity
Cr Cash

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Content

1. Introduction
2. Overview of the Consolidation Process
3. Business Combinations
4. Determining the Amount of Consideration Transferred
5.
5. Recognition and
Recognition and measurement
Measurement of
of identifiable
Identifiableassets,
Assets,liabilities
Liabilitiesand
goodwill
and Goodwill
6. Conclusion

35

Recognition Principle

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
subsidiary’s identifiable assets and liabilities
arm-length pricing
at fair value

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Chapter 3

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
– (2) INA must be priced into the consideration transferred and must not be
separate unrelated transactions
• Concept of separate transactions:
– As of the acquisition date, pre-existing relationships between acquirer and
acquiree comes to an end
• Rationale: Impossible to have contracts with oneself
– Effective termination of pre-existing relationship through a business
combination may give rise to a settlement gain or loss for the acquirer
– The settlement gain or loss is presumed to have been priced into the fair
value of consideration transferred by the acquirer
– Acquirer also recognizes “reacquired rights” as an intangible asset
• Rationale: It is deemed that the rights flowing from the pre-existing
contracts revert to the acquirer on the acquisition date
37

Example – Settlement Loss and Reacquired

Rights
Example:
• Market rate for franchise is $120,000 per annum at acquisition date,
and remaining contractual term is 3 years
• Discount factor is 5% per annum over 3 years
• Terms of contract are unfavourable to the acquirer as contracted fee
is $100,000 but market rate is $120,000
• Included in contract is a penalty provision of $60,000 for early
termination of the franchise

38

Example – Settlement Loss and Reacquired

Rights
• Present value of settlement loss
= ($100,000 – $120,000) / (1.05) + ($100,000 – $120,000) / (1.05)2 +
($100,000 – $120,000) / (1.05)3
= $54,465

• Acquirer recognizes settlement loss of $54,465

Dr Settlement loss (I/S) $54,465

Cr Investment in acquiree $54,465

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Chapter 3

Example – Settlement Loss and Reacquired

Rights
• Present value of reacquired rights of the remaining term recognized
by the acquirer as an intangible asset:
= 120,000 / (1.05) + 120,000 / (1.05)2 + 120,000 / (1.05)3
= $326,790

• On consolidation the investment in acquiree is eliminated and the

intangible asset is recognized.
• A partial elimination entry:
Dr Intangible asset – Reacquired rights $326,790
Cr Investment in acquiree $326,790

• Intangible asset would subsequently be amortized over the

remaining contractual period of 3 years.
40

Recognition Principle

At acquisition date:
Fair value • Fair value differential will
differential be recognized in the
consolidation worksheet

In subsequent years:
• Depreciation/amortizatio
n/cost of sale of asset
Book value of Fair value of will be based on the fair
subsidiary’s subsidiary’s 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

41

Classification of Identifiable Assets or

Liabilities
• IFRS 3 requires a “fresh start” approach and hence classification of
identifiable assets or liabilities is made with respect to:
1. Information;
2. Conditions; and
3. Corporate policies existing as at acquisition date
Example: Bond investment

Reclassified as held-to-
Classified as Available-
maturity according to
for-sale securities
acquirer’s group policy

Under acquiree’s financial statements Under consolidated financial statements

• On acquisition, the acquirer is required or permitted to re-designate an

asset or liability in accordance with its accounting policies
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Chapter 3

Intangible Assets
• IFRS 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”)
Example of intangible assets: Brand names and customer
relationships – When Heineken acquired APB; it acquired the iconic
Tiger Beer Brand.

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Intangible Assets

Are these considered intangible assets?

Assembled workforce with × No: Firm-specific and integrated
specialized knowledge with acquiree
× (Fails separability criterion)
Potential contracts or contracts under × No: Fails separability or
negotiation contractual-legal criterion

Opportunity gains from an operating  Yes: Meets the contractual-legal

lease in favorable market conditions
Customer and subscriber lists of
acquiree
criterion
 Yes: Meets the separability criterion
(show evidence of exchange
transactions for similar types of
lists)

44

Contingent Liabilities & Provisions

• Contingent liabilities are recognized by acquirer if they are:
– Present obligations arising from past events and
– Reliably measurable, even if outcome is not probable (IFRS 3:23)

• Example: Provisions for restructuring & termination costs are

recognized if they are:

Probable
outflow of
Reliably
economic
measurable
resources

Present
constructive or
legal obligations
arising from past
events
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Chapter 3

Indemnification Assets
• Contractual indemnity
– Provided by the former owners of the acquiree to the acquirer to make
good any subsequent loss arising from contingency or an asset or a
liability

• Treatment for indemnity

– The acquirer has to recognize an “indemnification asset” at the same
time the indemnified asset or liability is recognized
– The indemnification asset is measured on the same basis as the
indemnified asset or liability

• 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 and an indemnification asset of $100,000 at FV
46

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

47

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 Carrying
amount of amount of
acquirer’s acquirer’s Acquirer’s
assets + liabilities + equity + NCI
Acq date FV Acq date of share of
of acquiree’s FV of equity of
identifiable acquiree’s acquiree
assets + identifiable
Goodwill liabilities
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Chapter 3

Non-controlling Interests
• IFRS 3 allows NCI at acquisition date to be measured at either:
– Fair value; or
– The present ownership instruments’ proportionate share in the
recognized amount of identifiable assets

Fair value method Proportionate share of identifiable

• Obtain a reliable measure of
fair value of NCI (e.g. quoted
price in active market)
• In absence of quoted price, use
valuation techniques to value
NCI (e.g. peer companies’
valuation or appropriate
assumptions)
assets method
• Applies present ownership interests
held by NCI to the recognized
amounts of identifiable net assets to
determine initial amount of NCI
• If NCI have potential ordinary shares,
they should be measured at fair value
49

Fair Value Method of Non-controlling

Interests
• Typically the fair value of NCI as at acquisition date is as follows:

Fair value of Fair value of

Percentage
NCI at acquiree as at
acquisition = shareholding x acquisition
of NCI
date date

• Fair value of NCI as at acquisition date would not be proportional to

the fair value of consideration transferred by the acquirer to obtain
control
– Rationale: The consideration transferred would include a control
premium

50

Goodwill
• A premium that an acquirer pays to achieve synergies from business
combination
– Must be recognized separately as an asset
– Determined as a residual
• IFRS 3 allows 2 ways of determining goodwill:
Goodwill = Fair value of consideration transferred – Acquiree’s
+ recognized net
Fair value of non-controlling interests identifiable assets
+ measured in
Fair value of the acquirer’s previously accordance with
held interest in the acquiree IFRS 3

Fair value of non- Measured at fair value at acquisition date

controlling interests (include goodwill)

Measured as a proportion of identifiable

assets as at acquisition date

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Chapter 3

Goodwill

Goodwill

Depends on reliable Integral to the entity as

measurement of An expectation of Integral to the entity as a
consideration transferred, a whole, not individually
future economic benefits
whole, not individually
NCI, previously held identifiable or identifiable or severable
severable
equity interests and arising from acquisition as a standalone asset
identifiable net assets as a standalone asset

52

Goodwill
• The “top-down approach” (Johnson and Petrone, 1998) results in
measurement errors in goodwill

Consideration transferred +
Overpayment for an
Fair value of non-controlling interests
acquisition or
overvaluation of
consideration
transferred

Identifiable net assets

Measurement and
recognition errors
The above errors should not be
included as part of “goodwill”
IFRS 3 suggests that
the “one-year”
“measurement period” is
important to rectify
measurement and
recognition errors to
Goodwill ensure the accuracy and
“purity” of goodwill
53

Goodwill

• In a “bottom-up” approach (Johnson and Petrone, 1998):

Goodwill

Internally-generated
Goodwill Fair value of synergies
(Combination goodwill)
(Core Goodwill)

• “Going concern element” • Generated from the unique

and represent the ability of
acquiree to generate higher
rate of return than from its
individual assets
combination of the acquirer
and acquiree
• FV of the group > than sum
of FV of individual entities
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Chapter 3

Illustration 1: Goodwill
Illustration 1
On 1 July 20x1, P purchased 1.5 million shares from S Co’s existing owners.
Total number of shares issued by S Co. was 2 million. A reliable FV of S Co’s
share was $10/share. P Co. was obligated to pay an additional $1 million to
vendors of S Co. if S Co. maintained existing profitability over the subsequent
two years from 1 July 20x1. It was highly likely that S Co. would achieve this
expectation and the fair value of the contingent consideration was assessed at
$1 million. FV of NCI as at 1 July 20x1 was $5 million. Assume a tax rate of
20%
Additional information of S Co.
• Book value of net assets: $3,650,000
• FV of net assets: $14,350,000
• FV less book value (net assets): $10,700,000
• Share capital: $2,000,000
• Retained earnings: $1,650,000

55

Illustration 1: Goodwill
Determine the acquirer's interest in the acquiree:
, ,
Percentage ownership (75%)
, ,

Consideration transferred: = ($1,500,000 x $10) + $1,000,000 [FV of

contingent consideration]
= $16,000,000

Determine goodwill: Consideration transferred + FV of NCI – FV of identifiable net

assets at acquisition date

Determine deferred tax liability of (20% x $10,700,000) = $2,140,000

Determine FV of identifiable net assets = $14,350,000 – $2,140,000 = $12,210,000
Goodwill = $16,000,000 + $5,000,000 – $12,210,000 = $8,790,000

56

Gain from a Bargain Purchase

• A gain from bargain purchase arises when:

Fair value of consideration transferred

<
+ Fair value of
Fair value of non-controlling interests identifiable net
+
assets
Fair value of the acquirer’s previously
held interest in the acquiree

• In essence, a windfall gain to acquirer

• The acquirer must re-assess the fair value of identifiable net assets,
consideration transferred and non-controlling interests. If there is no
measurement error:
– The gain will be recognized immediately in the income statement

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Measurement Period
• IFRS 3 allows adjustments to be made retrospectively to “provisional
amounts” relating to goodwill, fair value of identifiable net assets and
consideration transferred if:
– New information about facts and circumstances existing at acquisition date
arises,
– Within 1 year of acquisition date (“Measurement period”)

• Events and circumstances arising after acquisition date does not lead to
measurement period adjustments
‒ Adjustments only allowed because of incorrect or incomplete information
available as at acquisition date but was missed or misapplied

• After measurement period (1 year), any correction of errors will be

deemed as a prior - period adjustment (IAS 8)
‒ Exception: Any change in estimate arising from information on new events
and circumstances arising after acquisition date will be recognized in the
current period
‒ Example: acquirer may fail to obtain information on all contracts of acquiree
as at acquisition date
58

Measurement Period – Summary

Retrospective
Error: Discovery of Any correction of
change: Adjust
info on facts and error after end of
goodwill, fair
circumstances measurement period
value of
existing as of requires prior period
identifiable net
acquisition date item disclosures
assets, fair value
of NCI as if the
accounting was
completed on
Acquisition 12 months
acquisition date End of
date
measurement
Prospective period
Change in change: no
estimate: correction of
Circumstances goodwill, fair
arising after value of
acquisition date identifiable net
assets or fair
value of NCI
59

Purchase of Assets that Do Not Constitute a

Business
• A target which does not constitute a business when acquired would
not be accounted for as an acquisition of an asset or a group of
assets.
• Purchaser will have to identify and recognize the individual
identifiable assets acquired as well as liabilities assumed in the
transaction
– All assets purchased and liabilities incurred would be measured at fair
value
– Goodwill will not be recognized from the transaction

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Illustration 2: Acquisition of Assets that do

not Constitute a Business
• X Co. paid $600,000 in cash to acquire a group of net assets from Y
Co.
• Group of assets did not meet the definition of a business under IFRS
3

Carrying values Fair value at date Allocated cost

($) of acquisition ($) ($)
Intangible asset – 200,000 300,000 324,000
club membership
Plant 150,000 200,000 216,000
Inventories 50,000 55,000 60,000
400,000 555,000 600,000

61

Illustration 2: Acquisition of Assets that do

not Constitute a Business

Being accounting for acquisition of assets

Dr Intangible asset 324,000
Dr Plant 216,000
Dr Inventory 60,000
Cr Cash 600,000

62

Appendix 1: Investment Entities

• Definition of investment entity
– Obtains funds from one or more investor for the purpose of providing
those investor(s) with investment management services
– Commits to its investor(s) that its business purpose is to invest funds
solely for returns from capital appreciation, investment income or both
– Measures and evaluates performance of substantially all of its
investments on a fair value basis
• An exception to the consolidation principle for a particular class of
investors is described as “investment entities”
– Rationale: To address the special information needs of users on the
performance of asset management and private equity industries, and
the consolidated information may not be as relevant to this class of
business given the purpose of the business and nature of returns and
relative importance of fair value information over consolidated
information

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Appendix 1: Investment Entities –

Exception to Consolidation
• Business purpose
– Must be that of providing investment management services
– IASB is of the view that the provision of these investment related
services is an extension of the investment entity’s business purpose and
this does not detract it from its primary business model of investing for
capital appreciation, investment income, or both
– Investment entity may also participate in the following activities,
provided they undertake to maximize the investment return and do not
represent a substantial business activity or source of income
 Providing management services and strategic advice to an investee
 Providing financial support
– An investment entity must also have exit strategies documenting how
the entity plans to realize capital appreciation from substantially all of
the investments that have the potential to be held indefinitely

64

Appendix 1: Investment Entities –

Exception to Consolidation
• Fair value measurement
– Investment entities are required to provide investors with fair value
information and measure substantially all of its investments at fair value
in its financial statements whenever fair value is required or permitted in
accordance with IFRSs
– Investment entities are required to report fair value information internally
to the entity’s key management personnel, who uses fair value as the
primary measurement attribute to evaluate the performance of
substantially all of its investments and to make investment decisions

65

Appendix 1: Investment Entities –

Accounting by an Investment entity
• Investment entities should not consolidate its investments in subsidiaries
• Investment entities are required to present their investments at fair value
through profit or loss (FVTPL) in accordance with IFRS 9
• Should investment entities have subsidiaries that provide services that are
related to the investment entity’s investment activities, they are to be
consolidated

Investment Entity

Subsidiary Joint
Subsidiary Subsidiary Associate
(Service Co) Ventures

Consolidate FVTPL FVTPL FVTPL FVTPL

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Appendix 1: Investment Entities –

Accounting by Parent that holds an Investment Entity

• If parent company is a non-investment entity, that parent will have to

unwind the fair value accounting applied by its investment entity
subsidiaries and consolidate on a line by line basis the investment
entity subsidiaries as well as the subsidiaries held by the investment
entity subsidiaries
Fair value accounting
Parent (Non- unwound, consolidation
and equity accounting
Investment Entity)

All investments accounted

Investment Entity for at FVTPL

Joint
Subsidiary Subsidiary Associate
Ventures

67

Appendix 1: Investment Entities –

Accounting by Parent that holds an Investment Entity

• If parent company is an investment entity, that parent will measure

all its investments in subsidiaries at fair value

All investments accounted

Parent for at FVTPL
(Investment Entity)

All investments accounted

Investment Entity for at FVTPL

Joint
Subsidiary Subsidiary Associate
Ventures

68

Appendix 2:
Settlement of Pre-Existing Relationships
• IASB recognizes that the acquirer and acquiree may have a pre-
existing relationship or other arrangement before negotiations for the
business combinations began
– Hence total consideration may comprise of two parts:

• Accounted for as
Amount paid in business combination
exchange for acquiree using acquisition method
of accounting
Total
consideration
Amount paid in • Accounted for separately
settlement for other from business
transactions combination transactions

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Appendix 2:
Settlement of Pre-Existing Relationships
• The following indicators enables one to determine if transaction is part of the
exchange for the acquiree or separate from the business combination
1. Reason for transaction
 Understanding the intent and purpose of the transaction
2. Who initiated the transaction
 The identity of the party who initiated the transaction may provide some
insights as to whether the transaction was carried out as part of the
exchange for the acquiree
3. Timing of the transaction
 Transactions that occur before the negotiation are likely to provide little
or no benefit to the acquirer:
– Transaction that in effect settles pre-existing relationships between
acquirer and acquiree
– Transaction that remunerates employees or former owners of the
acquiree for future services
– Transaction that reimburses the acquiree or its former owners for
paying the acquirer’s acquisition costs
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Appendix 2:
Settlement of Pre-Existing Relationships
• Accounting treatment for settlement of pre-existing relationship
Settlement of
pre-existing
relationship

Contractual Non-contractual
relationship relationship

Lower of (1) or (2)

(1) (Un)Favourable element
Fair value

(2) Settlement provision in contract

• Recognize a gain/loss on settlement as of the acquisition date

71

Appendix 2:
Settlement of Pre-Existing Relationships
• Remunerating employees for future services
– It is important to analyze carefully the nature of these employee
compensation arrangements in order to apply the proper accounting
treatment
– Payment can be made to either
o Pre-combination employment services; or
 Accounted for as part of the consideration transferred in the
business combination transaction
o Post-combination employment services; or
 Payment is accounted for separately from business
combination transactions
o A combination of pre- and post-combination services
 Amount paid will be allocated to payment for post combination
services and consideration transferred in exchange for the
acquiree
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Appendix 2:
Settlement of Pre-Existing Relationships
Employee
Compensation
Arrangements

Both pre- and post-

Pre-combination Pre-combination
combination
services services
services

Allocate to
Consideration remuneration Remuneration
transferred services first and services
rest to
consideration
transferred

Contingent Not contingent Contingent Not contingent

consideration consideration consideration consideration

IFRS 3: FV at acquisition date IFRS 2 or IAS 19

73

Appendix 2:
Settlement of Pre-Existing Relationships
• Share based payment transactions
In situations where the acquirer
replaces the acquiree’s share-based
payment transactions with that of the
acquirer
What should be done
Acquirer should measure the liability
or equity instrument relating to the
replacement awards in accordance
with IFRS 2 Share-Based Payment

In situations where the awards held IFRS 3 requires an attribution of

by employee do not expire on
business combination
either all or a portion of the fair value
of the acquirer’s replacement grant
at the acquisition date as
consideration transferred for the
business combination, and the
remainder will be recognized as
remuneration cost

74

Appendix 2:
Settlement of Pre-Existing Relationships
• Transaction for payment of acquisition costs
– IFRS 3 requires the acquirer to account for acquisition-related costs as
expenses in the periods in which the costs are incurred and the
services, received
– With the exception of cost incurred to issue debt or equity securities
 Rationale: Acquisition costs are neither part of the consideration
transferred in exchange for acquiree nor part of fair value of
identifiable net assets transferred by acquiree
– Acquirer is required to reimburse the acquiree or its former owners for
the payment of acquisition related expenses on behalf of the acquirer
has to be accounted for separately

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Conclusion

• All business combinations are characterized by three conditions:

1. Existence of acquirer
2. Acquirer has control over an acquiree
3. Acquiree is a business
• Many modes of business combinations:
– Acquirers acquires net assets of the business
(Consequence: Assets and liabilities acquired recognized in the acquirer’s
legal entity financial statements)
– Acquirer acquires control over the equity of the acquiree
(Consequence: acquirer and acquiree retain separate legal identities but
economically, these entities belong to same group)
– Regardless of form, economic substance of combination is the same
and acquisition method should be applied

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Conclusion

• Acquisition method
– Identify acquirer with reference to the control criteria of IFRS 10
– Recognize and measure identifiable net assets at fair value at acquisition
date
– Goodwill is a residual figure and is determined on a “top-down” approach
 May include recognition and measurement errors and identifiable
elements
• Measurement period
– Acquirers are allowed a 12 month measurement period to correct and revise
the following on a retrospectively basis:
1. Provisional amounts of goodwill
2. Fair value of identifiable net assets
3. Fair value of Non-controlling interests
4. Fair value of previously held interests

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