Definition of business combination

PFRS 3 defines business combination as a “a transaction or other event in which an acquire obtains
control of one or more businesses.” Transaction sometimes referred to as ‘mergers of equals’ are also
business combination as that term is used in PFRS 3.

Essential elements in the definition of a business combination

1. Control
2. Business

Control- an investor controls an investee when the investor is exposed, or has rights, to variable
returns from its involvement with the investee and has the ability to affect those returns through its
power over the investee.

An acquirer might obtain control of an acquiree in a variety of ways, for example:

a. By transferring cash, cash equivalents or other assets (including net assets that constitute a
business);
b. By incurring liabilities:
c. By issuing equity interest;
d. By providing more than one type of consideration; or
e. Without transferring consideration, including by contract alone.

Control is normally presumed to exist when the ownership interest acquired in the voting rights of
the acquiree is more than 50% ( or 51% or more). However, this is only a presumption because
control may still be obtained without necessarily acquiring more than half of the acquiree’s voting
rights, such as in the following instances:
a. The acquirer has the power to appoint or remove the majority of the board of directors of the
acquiree; or
b. The acquirer has the power to cast the majority of votes at board meetings or equivalent bodies
within the acquiree; or
c. The acquirer has power over more than half of the voting rights of the acquiree because of an
agreement with other investors; or
d. The acquirer has power to control the financial and operating policies of the acquiree because of a
law or an agreement.

Business is an integrated set of activities and assets that is capable of being conducted and managed
for the purpose of providing a return in the form of dividends; lower costs or other economic benefits
directly to investors or other owners, member or participants.

The three elements of a business are defined as follows:

a. Input: Any economic resource that result to an output when one or more processes are
applied to it, e.g., non-current assets, intellectual property, the ability to obtain access to
necessary materials or rights and employees.

b. Process: Any system, standard, protocol, convention or rule that when applied to an input or
inputs, creates or has the ability to create outputs, e.g., strategic management processes,
operational processes and resource management processes. Accounting, billing, payroll and
other administrative systems typically are not processes used to create outputs.

c. Output: The result of inputs and processes applied to those inputs that provide or have the
ability to provide a return in the form of dividends, lower costs or other economic benefits
directly to investors or the owners, members or participants.
Accounting Requirements

A business combination occurs when one company acquires another or when two or more companies
merge into one. After the combination, one company gains control over the other.

Business combinations are carried out either through:

1. Asset acquisition; or
2. Stock acquisition

Asset acquisition - the acquirer purchases the assets and assumes the liabilities of the acquiree in
exchange for cash or other non-cash consideration (which may be the acquirer’s own shares). After
the acquisition, the acquired entity normally ceases to exist as a separate legal or accounting entity.
The acquirer records the assets acquired and liabilities assumed in the business combination in its
accounting books.

Under the Corporation Code of the Philippines, a business combination effected through asset
acquisition may be either:

a. Merger - occurs when two or more companies merge into a single entity which shall be one
of the combining companies. For example: A Co. + B Co. = A Co. or B Co.
b. Consolidation - occurs when two or more companies consolidate into a single entity which
shall be the consolidated company. For example: A Co. + B Co. = C Co.

Stock acquisition - instead of acquiring the assets and assuming the liabilities of the acquiree, the
acquirer obtains control over the acquiree by acquiring a majority ownership interest (e.g., more than
50%) in the voting rights of the acquiree.

In a stock acquisition, the acquirer is known as the parent while the acquiree is known as the
subsidiary. After the business combination the parent and the subsidiary retain their separate legal
existence. However, for financial reporting purposes, both the parent and the subsidiary shall be
viewed as a single reporting entity.

After the business combination, the parent and subsidiary continue to maintain their own separate
accounting books, recording separately their assets, liabilities and the transactions they enter into.

The parent records the ownership interest acquired as “investment in subsidiary” in its separate
accounting books. However, the investment is eliminated when the group prepares consolidated
financial statements.

A business combination may also be described as:

1. Horizontal combination - a business combination of two or more entities with similar businesses,
e.g., bank acquires another bank.
2. Vertical combination - a business combination of two or more entities operating at different levels
in a marketing chain, e.g., a manufacturer acquires its supplier of raw materials.
3. Conglomerate - a business combination of two or more entities with dissimilar businesses, e.g., a
real estate developer acquires a bank.

The advantages of a business combination may include any of a combination of the following:

a. Competition is eliminated or lessened - competition between the combining constituents

with similar businesses is eliminated while the treat of competition from other market
participants is lessened.

b. Synergy - synergy occurs when the collaboration of two or more entities results to greater
productivity than the sum of the productivity of each constituent working independently.
Synergy is most commonly described as “the whole is greater than the sum of its parts.” It can
be simplified by the expression “1 plus 1 = 3.”
 c. Increased business opportunities and earnings potential - business opportunity and earnings
potential may be increased through:
i. An increased variety of products or services available and a decreased dependency on limited
number of products and services;
ii. Widened dispersion of products or services and better access to new markets;
iii. Access to either of the acquirer’s or acquiree’s technological know-hows, research and
development, secret processes, and other information;
iv. Increased investment opportunities due to increased capital; or
v. Appreciation in worth due to an established trade name by either one of the combining
constituents.

d. Reduction of operating costs - operating costs of the combined entity may be reduced.
i. Under a horizontal combination, operating costs may be reduced by the elimination of
unnecessary duplication of costs (e.g., cost of information system, registration and licenses,
some employee benefits and costs of outsourced services).
ii. Under a vertical combination, operation costs may be reduced by the elimination of costs of
negotiation and coordination between the companies and mark-ups on purchases.

e. Combination utilize economies of scale - economies of scale refer to the increase in

productive efficiency resulting from the increase in the scale of production. An entity that
achieves economies of scale decrease its average cost per unit as production is increased
because fixed costs are allocated over an increased number of units produced.

f. Cost savings on business expansion - the cost of business expansion may be lessened when a
company acquires another company instead of putting up a branch. There may be various
regulation (e.g., in the case of banks) which may restrict the company from branching out, such
as required minimum capitalization, level of liquidity and other requirements.

Some business combinations are affected through exchange of equity instruments rather than
transfer of cash or other resources. Such business combinations also protect the interests of
shareholders because they become either the shareholders of the acquirer or the new combined
entity.

g. Favorable tax implications - deferred tax assets may be transferred in a business combination.
Also, business combinations effected without transfers of considerations may not be subjected
to taxation.

The disadvantages of a business combination may include any or combination of the following:

a. Business combination brings monopoly in the market which may have a negative impact to the
society. This could result to impediment to healthy competition between market participants.

b. The identity of one or both of the combining constituents may cease leading loss of sense of
identity for existing employees and loss of goodwill.

c. Management of the combined entity may become difficult due to incompatible internal cultures,
system , and policies.

d. Business combination may result in over-capitalization which may result to diffusion in the market
price per share and attractiveness of the combined entity’s equity instruments to potential investors.

e. The combined entity may be subjected to stricter regulation and scrutiny by the government, most
especially if the business combination poses threat to consumers’ interests.

Business combinations are accounted for under PFRS 3 Business Combination.

Objective
The objective of PFRS 3 is to improve the relevance, reliability and comparability of financial reporting
of an entity in relation to a business combination by establishing the recognition and measurement
principles and disclosures requirements for the acquirer.

Scope
PFRS 3 applies to transactions that meet the definition of a business combination. It does not apply to
the following:

a. The formation of a joint venture.

b. The acquisition of an asset or a group of assets that does not constitute a business. In such cases
the acquirer shall identify and recognize the individual identifiable assets acquired and liabilities
assumed. The cost of the group shall be allocated to the individual identifiable assets and liabilities on
the basis of their relative fair values at the date of purchase. Such transaction does not give rise to
goodwill.

c. A combination of entities or businesses under common control.

ACQUISITION METHOD OF ACCOUNTING FOR BUSINESS COMBINATIONS

IFRS 3 requires that all business combinations be accounted for by applying the acquisition method
(called the “purchase method” in the 2004 version of IFRS 3). To determine whether a transaction or
other event is a business combination, four steps in the application of the acquisition method are to
be used as follows:

(1) Identify the acquirer.

(2) Determine the acquisition date.
(3) Determine the consideration given (price paid) by the acquirer.
(4) Recognize and measure the identifiable assets acquired, the liabilities assumed and any
non-controlling interest (formerly called minority interest) in the acquiree. Any resulting goodwill or
gain from a bargain purchase should be recognized.

Illustration 1

P Company acquires S Company on January 1, 2017. Included in the purchase consideration is an

amount of P5 million payable on January 1, 2019. P Company’s borrowing cost on acquisition date is
8% per annum.

The fair value of the deferred consideration that should be included in the cost of combination is
computed below.

Present value = P5,000,000/(1+0.08)= P4,286,694

The journal entry to be recorded on the date of acquisition is given below:

Cost of combination 4,286,694
Deferred liability 4,286,694

For the next two years, this liability amount should be increased to P5,000,000 and the accretion
should be recognized as a finance cost in profit and loss. The journal entries are as follows:

At the end of the 1st year:

Finance cost (8% x 4,286,694) 342,936

Deferred liability 342,936
At end of the 2nd year:

Finance cost [8% x (4,286,692 + 342,936) 370,370

Deferred liability 370,370

Upon payment

Deferred liability 5,000,000

Cash 5,000,000

Illustration 2

P Ltd acquires 1 100% interest in the equity shares of S Ltd from two controlling shareholders on
January 1, 2017. The terms of the business combination include:

(i) P Ltd shall pay an amount of P10 million to the two controlling shareholders of S Ltd;
(ii) P Ltd shall inject property into S Ltd. The carrying amount of the property in the accounts of P Ltd
at acquisition date is P20 million. The fair market value of the property at acquisition date is P30
million;
(iii) P Ltd shall assume the bank loans of P5million taken by the two controlling shareholders when
they invested in S Ltd; and
(iv) P Ltd shall bear the future losses and future restructuring costs of S Ltd, estimated at P6million.

The cost of combination is computed as follows:

Cash consideration P10 million

Liabilities assumed 5 million
Property transferred at carrying amount 20 million
Cost of combination 35 million

APPLYING THE ACQUISITION METHOD

As mentioned earlier, control of another company may be achieved either by the acquisition of net
assets or by acquisition of stocks.

ACQUISITION OF NET ASSETS

Let us assume that the company to be acquired by Acquirer, Inc., has the following Statement of
Financial Position of June 30,2017:

J&J Company
Statement of Financial Position
June 30,2017

Cash P 200,000 Current liabilities P 125,000

Marketable securities 300,000 Bonds payable 500,000
Inventory 500,000
Land 150,000 Common stock(P1 par) 50,000
Building(net) 750,000 Additional paid in capital 700,000
Equipment(net) 400,000 Retained earnings 925,000
Total assets P 2,300,000 Total liabilities and equity P 2,300,000
Fair values for all accounts have been measured as of June 30,2017 as follows:

Cash P 200,000
Marketable securities 330,000
Inventory 550,000
Land 360,000
Building 900,000
Equipment 700,000
Unrecognized receivables 225,000 P 3,265,000

Current liabilities P 125,000

Bonds payable 500,000
Premium on bonds payable 20,000 P 645,000
Fair value of net identifiable assets P 2,620,000

BOOKS OF THE ACQUIRER

Accounting Procedures in Recording the Acquisitions

The basic accounting procedures to record the acquisition of net asset are as follows:

 All accounts identified are measured at estimated fair value. This is always the case even if the
consideration given for a company is less than the sum of the fair values of the net assets
acquired (assets less liabilities assumed, P2,620,000 in the illustration).
 If the total consideration given for a company exceeds the fair value of its net identifiable assets
(P2,620,000), the excess price paid is recorded as goodwill.
 If the total consideration given for a company is less than the fair value of its net identifiable
assets (P2,620,000), the excess of net asset over the price paid is recorded as gain on acquisition
(bargain purchase) in the period of the purchase.
 All acquisition- related cost are expense in the period in which the costs are incurred, with one
exception. The costs to issue equity securities are recognized as a reduction from the value
assigned to additional paid in capital account.

Before recording the acquisition, the acquirer should calculated the difference between the price paid
and the fair value of the net assets acquired.

Case 1: Price paid exceeds the fair value of net identifiable assets acquired.

Acquired, Inc., issues 80,000 shares of its P10 par value common stock with a market value of P40
each for J&J Company’s net assets. Acquirer, Inc. pays professional fees of P50,000 to accomplish the
acquisition and stock issuance costs of P30,000.

Analysis:

Price paid (consideration given), 80,000 shares x P40 market value P3,200,000
Fair value of net identifiable assets acquired from J&J ( 2,620,000 )
Goodwill P 580,000
Professional fees (expense) P 50,000
Stock issue costs ( reduction from additional paid-in capital) 30,000

Entries recorded by the Acquirer, Inc. are as follows:

(1) To record the net assets acquired including the new goodwill:
Cash 200,000
Marketable securities 330,000
Inventory 550,000
Land 360,000
 Building 900,000
Equipment 700,000
Receivables -trade 225,000
Goodwill 580,000
Current liabilities 125,000
Bonds payable 500,000
Premium on bonds payable 20,000
Common stocks (P10 par, 80,000 shares issued) 800,000
Additional paid in capital (P30 x 800,000 shares) 2,400,000

(2) To record acquisition- related costs:

Acquisition expense 50,000

Additional paid in capital 30,000
Cash 80,000

Case 2: Price paid is less than fair value of net identifiable assets acquired:

Acquired, Inc. issues 20,000 shares of its P115 par value common stock with a market value of P120
each for J&J Company’s net assets. Acquirer, Inc. pays professional fees of P50,000 to accomplish the
acquisition and stock issuance costs of P130,000.

Analysis:

Price paid (consideration given), 20,000 shares x P120 market value P2,400,000
Fair value of net identifiable assets acquired from J&J Company ( 2,620,000 )
Gain on acquisition (bargain purchase) P(220,000)
Professional fees (expense) P 50,000
Stock issuance costs (reduction from additional paid in capital) 130,000

Entries recorded by Acquirer, Inc. to record the acquisition and related costs are as follows:

(1) To record the acquisition of net assets:

Cash 200,000
Marketable securities 330,000
Inventory 550,000
Land 360,000
Building 900,000
Equipment 700,000
Receivables- trade 225,000
Current liabilities 125,000
Bonds payable 500,000
Premium on bonds payable 20,000
Common stock (20,000 shares x P115 par) 2,300,000
Additional paid in capital (20,000 shares x P5) 100,000
Gain on acquisition 220,000

(2) To record acquisition-related costs:

Acquisition expense 50,000

Additional paid in capital 100,000
Stock issuance costs 30,000
Cash 180,000
ACQUISITION OF STOCK

In a stock acquisition, the acquiring company deals only with existing shareholders of the acquired
company not the company itself. To illustrate, assume that on December 31, 2017, P Company
acquired all 10,000 issued and outstanding shares of S Company’s P100 par value common stocks for
P2,000,000 cash. In addition, P Company paid professional fees to accomplish the combination of
P100,000. The journal entries to record the acquisition of stocks and the acquisition-related cost in
the books of P Company on December 31, 2017 are as follows:

(1) To record the acquisition of stock from S Company:

Investment in subsidiary S Company 2,000,000
Cash 2,000,000

(2) To record the acquisition-related costs:

Acquisition expense 100,000
Cash 100,000

Recognizing and Measuring Goodwill or a Gain from a Bargain Purchase

IFRS 3 prescribes that “the acquirer shall recognize goodwill as of the acquisition date measured as
the excess of (a) over (b) below:

(a) the aggregate of:

(i) the consideration transferred measured in accordance with this IFRS, which generally requires
acquisition- date fair value;
(ii) the amount of any non-controlling interest in the acquiree measured in accordance with this
IFRS (which in either based on fair value or proportionate share of net assets); and
(iii) in a business combination achieved in stages (step acquisition), the acquisition date fair value
of the acquirer’s previously held equity interest in the acquire.

(b) the net of the acquisition- date amounts of the identifiable assets acquired and liabilities assumed
measured in accordance with this IFRS.

Illustration 1

On January 1, 2017, PP Inc acquires a 75% equity interest in SS Inc, paying cash consideration of
P50million new ordinary shares of PP Inc valued at P2 each to the former owners of SS Inc. On this
date, the net fair of the identifiable assets and liabilities of SS Inc is P100million.

The issued share capital of SS Inc consists of 50 million ordinary shares of P1 each. On acquisition date,
the shares are quoted on the stock exchange at P4 per share. Both PP Inc and SS Inc agree that the
market value is representative of the fair value of SS Inc as a whole.

Required:
Compute the goodwill on combination and the non-controlling interest in accordance with:
(1) The original IFRS 3, and
(2) The revised IFRS 3 with (a) non-controlling interest measured at fair value and (b) non-controlling
interest measured at its proportionate share of net assets.

Solution 1

(1) Original IFRS 3

Cost of combination:
Cash consideration 50m
Ordinary shares issued 50m x P2 100m
Fair value of consideration transferred 150m
 Share of net assets acquired 75% x 100m 75m
Goodwill on combination 75m
Non-controlling interest at acquisition date: 25% xP100m 25m

(2) Revised IFRS 3

NCI Measured at
Shares of net asset Fair value
Fair value of consideration transferred 150m 150m
Non- controlling interests; share of net assets:
25% x 100m 25m -
Fair value of non-controlling interest
25% x 200m - 50m
Carrying/Fair value of SS Inc as a whole 175m 200m
Fair value of net assets 100m 100m
Goodwill on combination 75m 100m

Non-controlling interest:
25% x 100m
25% x (100m + 100m) 25m -
50m

Note that if non-controlling interest is measured based on its proportionate share of the net assets,
rather that at fair value, effect would be the same as the original IFRS 3.

Impairment Test for Goodwill

After initial recognition, the acquirer shall measure goodwill acquired in a business combination at
cost less any accumulated impairment losses in accordance with PAS 36, Impairment of Assets. This
standard prohibits amortization of goodwill but it requires that goodwill must be tested for
impairment annually, or more frequently if events or changes in circumstances indicate a possible
impairment.