Chapter 4

Business Combinations
(IFRS 3)
 1. INTRODUCTION

 Business combination (IFRS-3 ): is a transaction or other

event in which a reporting entity (the acquirer) obtains
control of one or more businesses (the acquiree).

 Commonly, business combinations are often referred to

as Mergers and Acquisitions (M&A).

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 1. INTRODUCTION
 This chapter deals with the treatment by an investing
entity ('acquirer') when it acquires a substantial
shareholding in another entity ('acquiree').
– The transaction which brings these two parties together is
known as a 'business combination' and creates a 'group' of
entities.

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 Definitions
 Combined Enterprise: The accounting entity that results from a
business combination.
 Constituent Companies: The business enterprises that enter into
a business combination.
 Combinor: A constituent company entering into a purchase-type
business combination whose owners as a group end up with
control of the ownership interests in the combined enterprises.
 Combinee: A constituent company other than the combinor in a
business combination.

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Company groups
 Company group characteristics
– Vertical group: Combination of Customers/suppliers
– Horizontal group: Enterprises in same industry
– Conglomerate : Co.s in Unrelated industries
 Group expansion
– Development of new subsidiaries
– Acquisition by takeover of other companies
– Merger between companies
 Classes of Business Combinations

B u s in e s s C o m b in a t io n s

F r ie n d ly T a k e o v e r H o s t ile T a k e o v e r
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 Friendly Takeovers

 BODs of all constituent companies amicably

determine the terms of the business
combination.
 Proposal is submitted to share holders of all
constituent Cos. for approval.

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 Hostile Takeovers

 Target combinee typically resists the

proposed business combination.
 Target combinee uses one or more of the
several defensive tactics.

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 Tactics for Defense Used in Hostile
Takeovers
 Pac-man Defense: A threat to undertake a hostile
takeover of the prospective combinor.
 White Knight: A search for a candidate to be the
combinor in a friendly takeover.
 Scorched Earth: The disposal, by sale or by spin-off
to stockholders, of one or more profitable business
segments.

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 Tactics for Defense Used in Hostile
Takeovers

 Shark Repellent: An acquisition of substantial

amts of outstanding C/S for the treasury or for
retirement, or the incurring of substantial LTD in
exchange for outstanding common stock.

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 Tactics for Defense Used in Hostile
Takeovers
 Poison Pill: An amendment of the articles of
incorporation or bylaws to make it more difficult to
obtain s/holder approval for a takeover.
 Green Mail: An acquisition of common stock presently
owned by the prospective combinor at a price
substantially in excess of the prospective combinor’s
cost, with the stock thus acquired placed in the treasury
or retired.

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 Business Combinations:
Why And How?
 In recent years Growth has been main reason
for business enterprises to enter into a
business combination.
 There could be many more reasons.
 Entities may increase their mkt share, diversify their
business or improve vertical integration of their activities
in a No. of ways, including by:

–
organic growth or through acquisitions.

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 Business Combinations:
Why And How?

 The external (M&A) method of achieving

growth is more rapid than growth through
internal (Organic) methods.
 Obtaining new mgt strength or better use of
existing management.
– Goodwill associated with Subsidiaries

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 Business Combinations:
Why And How?

 Achieving manufacturing or other operating economies. =

SYNERGY
 A business combination may be undertaken for income tax
advantages.
 Hostile takeovers are mostly motivated by the prospect of
substantial gain resulting from the sale of business segments.

 To increase Market share, & profit

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 Introduction
• A business combination is a transaction or other event in which a reporting
entity (the acquirer) obtains control of one or more businesses (the
acquiree).
SCOPE:
• IFRS 3 does not apply to the following:
• The formation of a joint venture
• The acquisition of an asset or group of assets that is not a business
as defined
• A combination of entities or businesses under common control

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 The acquisition method
• Business combinations are accounted for using the
acquisition method, i.e:
• Identifying the acquirer;
• Determining the acquisition date;
• Recognise & measure the identifiable NAs and any
NCI; and
• Recognise and measure any goodwill or bargain
purchase.

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 1. Identifying the acquirer

• The acquirer is the entity that obtains control of another entity

EXAMPLE: Who is the acquirer?

• On 31/12/20X0 A has 100 shares in issue.

• On 1/1/20X1 A issued 200 new A shares to the owners of B in

exchange for all of B’s shares.

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can you identify the acquirer? 18

In the absence of evidence to the contrary:

Example 1: Companies A and B combine businesses by forming C.
C issues 30 million and 20 million shares to A’s & B’s shareholders in
exchange for A’s and B’s businesses.
Example 2: same as Example 1, except:
20 million shares are issued to each of A’s & B’s shareholders.
C had 9 board members, 5 appointed by A’s shareholders and 4 by B’s.

Example 3: on 31 December 2014 A has 100 million shares in issue. On 1

January 2015 A issued 200 million new A shares to the owners of B in
exchange for all of B’s shares.
 Determining the acquisition date
• The acquisition date is the date on which the acquirer
obtains control

• often the date the consideration is transferred, assets

are acquired & liabilities assumed—closing date

• may be other dates (earlier or later than the closing

date) at which control is assumed

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 2. Determine the acquisition date

It is the date on which the acquirer obtains

control of the acquiree.
Example: On 15 January 20X1, Entity A signed an agreement for
the purchase of 100 per cent of Entity B for cash. The purchase
agreement specifies that the acquisition date is 1 April 20X1.
However, Entity A can, with effect from 31 January 20X1, remove
any of Entity B’s directors and appoint directors of its choice. On
1 March 20X1 Entity A removed all of the existing directors
of Entity B and appointed directors of its choice. On 1 April
20X1 ownership of all of the shares in Entity B is transferred to
Entity A and the consideration is paid in cash.
3. Recognition & measurement
• Recognition principle:
• separate recognition of identifiable NAs &
contingent liabilities assumed.
• Measurement principle
• assets and liabilities that qualify for recognition are
measured at their acquisition-date FVs.
• measurement at FV provides relevant information that is
more comparable & understandable

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3. Recognise and measure the identifiable net assets acquired

• At acquisition date, allocate the cost of a

business combination by recognising the
acquiree’s identifiable net assets at their
acquisition-date fair value
 Acquirer’s net assets – account for @ CAs
 Net assets of the acquiree - remeasured to FV
3. Recognise and measure the identifiable net assets acquired
(cont’d)

• Recognition criteria for assets and liabilities that existed

at the acquisition date:
Assets other than intangibles – probable that
associated future economic benefits will flow to the
acquirer, and FV can be measured reliably
Intangible assets – FV can be measured reliably
Liabilities other than contingent liabilities – probable
outflow of economic benefits, and fair value can be
measured reliably; not future losses or restructuring
costs unless previously recognised by acquiree
Contingent liabilities – FV can be measured reliably
Consideration transferred
•The fair values at the date of exchange, of assets
given, liabilities incurred, and equity instruments issued:
 Deferred amounts discounted to present value
 Published price of shares at date of exchange
 No provision for future losses or expected costs
 For contingent consideration, provide probable amount
• Any costs directly attributable to the business combination
are excluded e.g. professional fees, allocation of admin costs,
etc.
Costs of a business combination

 All acquisition-related costs (e.g. advisory, legal,

accounting, valuation, other professional fees and
general administrative costs) are recognised as
period expenses in accordance with the
appropriate IFRS.
 Costs incurred to issue debt or equity securities
should be recognised in accordance with the
standards on financial instruments.
Provisional accounting

 Correction of provisional fair values

If done within 12 months of acquisition:
– Restate assets, depreciation, goodwill retrospectively from acquisition
date
– Adjust comparatives
 If done more than 12 months after acquisition
 Only restate retrospectively for errors
 Changes in estimates recognised in current and future periods
 Consideration transferred
• The consideration transferred is measured at the FV of
the sum of assets transferred & liabilities assumed
• Acquisition-related costs are excluded

• Contingent consideration is included at its fair value

at acquisition date
• (subsequent changes in FV are not included in the
consideration transferred at acquisition-date)

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 Example 1:
What is the cost of the Bus Com? 28

• Entity A acquires 75% of entity B in exchange for CU85,000

cash and 1,000 entity A shares (fair value = CU10,000) issued
for the transfer.

• Entity A incurred CU5,000 advisory and legal costs directly

attributable to the business combination and CU1,000 share
issue expenses.
 EXAMPLE 2: Det. the value of the inv’t.

J acquires 100% of the equity of B on 31 December

2008.
There are 3 elements to the purchase consideration:
an immediate payment of $5m cash, and two further
payments of $1m if the return on capital employed
(ROCE) exceeds 10% in each of the subsequent
financial years ending 31 Dec.
All indicators have suggested that this target will be met.
J uses a discount rate of 7% in any present value
calculations.

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  Consdn ttd = $5m+ PV (Cont payt)
= $5m + $1.81m = $6.18M
 fair value of $(1m/1.07 + 1m/1.072) ie $1.81m

NB: All subsequent changes in debt-contingent

consideration are recognised in the Profit or loss, rather
than against goodwill

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 Forms of Consideration
Share exchange
EX 3: The parent has acquired 12,000 $1 shares in the subsidiary by issuing
5 of its own $1 shares for every 4 shares in the subsidiary. The market value
of the parent company's shares is $6.
RQD: Pass the entry.

Ex 4: (Deferred consideration)
The parent acquired 75% of the subsidiary's 80m $1 shares on 1
Jan 20X6. It paid $3.50 per share and agreed to pay a further
$108m on 1 January 20X7.
The parent company's cost of capital is 8%.
RQD: a) Compute the Total consideration.
Deferred consideration …

$m
80m shares x 75% x $3.50 210
Deferred consideration:
$108m x 1 / 1.08 100
Total consideration 310

NB: At 31 December 20X6 $8m will be charged to Fin. costs, being the unwinding of
the discount on the deferred consideration.
4. Recognise and measure any non-controlling interest

IFRS 3 has an explicit option on a transaction-by-transaction basis to

measure NCI at the date of acquisition at either:
fair value (new method) e.g. if available, share price of NCI equity
shares; or using other valuation techniques if not publicly traded;
or
NCI’s proportionate share of the net identifiable assets of the entity
acquired (old method).

Argued that old method of calculating goodwill only recognises the

goodwill acquired by the parent i.e. any goodwill attributable to NCI is
not recognised.
In the new method goodwill is recognized for both parent and NCI
 Example: NCI (Old method)
Parent pays €100m for 80% of Subsidiary which has net assets with a fair value of
€75m. Goodwill of €40m (€100m – (80% x €75m)) would be recognised, and the non-
controlling interests would be €15m (20% x €75m).
    €m 
Cost of acquisition   100 
Fair value of net assets €75m   
Group share of net assets 80% (60) 
Goodwill   40 
If we assume that purchasing 100% of Subsidiary would have cost proportionately more, the
consideration would have been €125m (€100m/80%) and goodwill would then be €50m
(€125m - €75m) and there would be no non-controlling interests.

NB: This demonstrates that, where NCI exists, the traditional

consolidation method only records the parent’s share of the
goodwill.
Example: NCI (New method)

Developing the example, and assuming that the value of the

goodwill of the NCI is proportionate to that of the parent, therefore
consolidated goodwill of €50m would be recognised (this includes
both the controlling (€40m) and the NCI (€10m) in goodwill) & the
NCI would be €25m (€15m + €10m attributed goodwill).
In effect, consolidated goodwill and the NCI are ‘grossed up’ by the
NCI’s share of goodwill (€10m in this case).
 Example: NCI (Old and new methods)
P pays €800m to purchase 80% of the shares of S. The FV of 100% of
S’s identifiable NAs is €600m. (Assume published FV of minorities
=€185m)
 
(I) proportionate (Partial) Method:
NCI = €120m (20% x €600m),
the CFS show goodwill = €320 (€800m + €120m – €600m).
 
(II) fair value (FULL) Method:
Goodwill = €800m + €185m – €600m
= €385m

NB: The FV of the 20% non-controlling interest in S will not necessarily

be proportionate to the price paid by P for its 80%, primarily due to
control premium or discount.
 EXERCISE: NCI
 P acquired 70% of the 200,000 equity shares of S, its only
subsidiary, on 1 April 20X8 when the REs of S were
$450,000.
 The carrying amounts of S Co's net assets at the date of
acquisition were equal to their FVs. P measures NCI @ FV,
based on share price. The market value of S shares at the
date of acquisition was $1.75.
 At 31 March 20X9 the REs of S were $750,000. At what
amount should the NCI appear in the Consolidated-SoFP
of P at 31 March 20X9?

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 EXAMPLE 2

 M acquires a subsidiary on 1 Jan 2008. The FV of the

identifiable NAs of the subsidiary were $2,170m.
 M acquired 70% of the shares of the subsidiary for
$2.145m. The NCI was fair valued at $683m.

Requirement: Compare the value of goodwill under the

partial and full methods.

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 Solution:
Partial goodwill $m
Purchase consideration 2,145
Fair value of identifiable NA (2,170)
NCI (30% x 2,170) 651
Goodwill 626

Full goodwill $m
Purchase consideration 2,145
FV of NCI 683 2,828
FV of identifiable Nas (2,170)
Goodwill 658

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 Gain on a bargain purchase

Negative G-will could arise when the aggregate of the FVs of the separable
NAs acquired exceed what the parent Co. paid for them. a.k.a 'gain on a
bargain purchase'.

In this situation:

(a)An entity should first re-assess the Amts at which it has measured both
the cost of the combination and the acquiree's identifiable NA. This exercise
should identify any errors.

(b) Any excess remaining should be recognised immediately in profit or

loss
 Q1: P &S (Subsequent m/t of NCI)
P acquired 70% of the 200,000 equity shares of S, its only
subsidiary, on 1 April 20X8 when the Res of S were
$450,000. The CA of S Co's NAs at the date of acquisition
were equal to their FVs.
P measures NCI @ FV, based on share price. The market
value of S shares at the date of acquisition was $1.75.
At 31 March 20X9 the RE of S were $750,000.

RQD: At what amount should the NCI appear in the C-SoFP

of P at 31 March 20X9?
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 Q2: GOOD WILL
 Bal obtained a 60% holding in the 100,000 $1 shares of
Mist on 1 January 20X8, when the RE of Mist were
$850,000.
 Consideration comprised $250,000 cash, $400,000
payable on 1 January 20X9 and one share in Bal for
each two shares acquired. Bal has a cost of capital of
8% and the market value of its shares on 1 January
20X8 was $2.30.
 Bal measures NCI @ FV. The FV of the NCI at 1 Jan
20X8 was estimated to be $400,000.
– What was the goodwill arising on acquisition?
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 Q3: Acquisition cost & FV of NA of sub
 On 1 August 20X7 Patronic purchased 18m of the 24 m $1
equity shares of Sardonic.
 The acquisition was through a share exchange of 2 shares
in P for every 3 shares in S. The market price of a share in
P at 1 Aug 20X7 was $5.75. P will also pay in cash on 31
July 20X9 (two years after acquisition) $2.42 per acquired
share of Sardonic.
 Patronic's cost of capital is 10% per annum.
– What is the amt of the consideration attributable to P for the
acquisition of S?
– Assuming NCIs are valued at their proportionate share (PARTIAL
VALUE), & Good will was measured at $22.5 Million; How much
43 was the FV of net identifiable assets of Sardonic as of Aug 1/2007?
 Q4: FV of NCI
 Chuchu acquired 70% of Bang's 100,000 Br. 1 ordinary
shares for Br. 800,000 when the RE of Bang were
Br.570,000 & the bal. in its revaluation surplus was
Br.150,000. Bang also has an internally developed
BRAND NAME which has been independently valued at
Br.90,000.
 The NCI in Bang was measured @FV by the date of
acquisition. If the goodwill arising on acquisition is computed
at Birr 110,000; what would be the FV of the NCI at the date
of acquisition?

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 Q5: GOODWILL Computations
 Epsilon prepares consolidated financial statements under IFRSs. Your assistant has prepared the first draft of the financial
statements for the year ended 31 March 20X6 but there is a transaction about which she is unsure. This is listed below:
 Transaction
(i) On 1 April 20X5 Epsilon acquired a new subsidiary, Kappa, purchasing all 100 million shares of Kappa. The terms of the sale
agreement included the exchange of three shares in Epsilon for every two shares acquired in Kappa. On 1 April 20X5 the market
value of a share in Epsilon was $10 and the market value of a share in Kappa $13.50.
(ii) The terms of the share purchase included the payment of an additional $1.21 per share acquired provided the profits of Kappa for
the two years ending 31 March 20X7 exceeded a target figure.
(iii) Legal and professional fees associated with the acquisition of Kappa shares were $1,200,000, including $200,000 relating to the
cost of issuing shares.
 
(iv) The individual statement of financial position of Kappa at 1 April 20X5 comprised net assets that had a FV at that date of $1,200
million. Additionally Epsilon considered Kappa possessed certain intangible assets that were not recognised in its individual SoFP:
– Customer relationships had a reliable estimate of value of $100 million. This value has been derived from the sale of
customer databases in the past.
– Employee expertise had a reliable estimate of value of $80 million.

(v) The directors of Epsilon were unsure how long the goodwill on acquisition of Kappa would last but they thought that ten years
might be a prudent estimate of its useful economic life. However, they considered that the goodwill had not suffered any
impairment up to 31 March 20X6.
(vi) The annual discount rate to use in any relevant calculations is 10%.
 Required: Compute the goodwill on consolidation of Kappa that will appear in the C-SoFP of Epsilon at 31Mar/X6

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