2016 McGraw-Hill Education

CHAPTER
3:
Business
Combination
s
Prepared by
Shannon Butler, CPA,
Carleton University

Learning Objectives
LO1 Define a business combination, and evaluate
relevant factors to determine whether control
exists in a business acquisition.

LO2 Describe the basic forms for achieving a

business combination.

LO3 Apply the acquisition method to a purchase-ofnet-assets business combination.

LO4 Prepare consolidated financial statements for

a purchase-of-shares business combination.
2

Learning Objectives
LO5 Analyze and interpret financial statements
involving business combinations.

LO6 Identify some of the differences between

IFRS and ASPE for business combinations.

LO7 Explain a reverse takeover and its reporting

implications.

Introduction

LO1

A business combination occurs when one company, the

acquirer, obtains control of one or more businesses (IFRS
3).

Reasons for business combinations include:

Defend a competitive position
Diversify into a new market and/or geographic region
Access to new customers, products or services, expertise
or capabilities (eg. Technology)

When a business combination occurs, consolidated

financial
statements are required to report the combined financial
position and results of operations of the Parent and the
Subsidiary

Control IFRS 10

LO1

How is control determined?

Control is the power to direct the relevant

activities
of the investee.

Control requires that the investor has exposure,

or
rights to variable returns from its involvement
with
the investee and has the ability to use its power
over the investee to affect the amount of the
investors returns
5

Control IFRS 10

LO1

Owning more than 50% of the voting shares

usually, but not always, indicated control.

Control can be present with less than 50% of

voting shares if other factors indicate control,
e.g.:
Irrevocable agreement with other shareholders
to convey
voting rights to parent
If parent holds rights, warrants, convertible
debt, or convertible preferred shares that
would, if exercised or converted, give it >50%
of votes
If there are contractual agreements which give

Control IFRS 10

LO1

Deemed control if other shareholders do not

actively
cooperate when they exercise their votes.
Example: One company may own the largest
single block of shares of another company, e.g.
X Company owns 40% of Y Company while the
other 60% is widely held and rarely voted with
the result that X has no trouble electing the
majority of Ys directors X Company could be
deemed to have control in this situation as long
as the other shareholders do not actively
cooperate against X when they vote their
shares.
7

Control IFRS 10

LO1

Control and consolidation would cease if for

example the majority of a subsidiarys assets are
seized in a receivership or bankruptcy situation.

Normal business restrictions do not preclude

control by the parent.

Control IFRS 10

LO1

The existence of certain protective rights held by other

parties does not necessarily provide those parties with
control.
Examples:
Approval of veto rights that do not affect strategic
operating and financing policies.

The ability to remove the party that directs the

activities of the entity in circumstances such as
bankruptcy or on breach of contract by that party.

Certain limitations on the operating activities of an

entity, such as pricing or advertising limitations
typically placed by franchisors or franchisees.
9

Control IFRS 10

LO1

A parent can control a subsidiary, even though

other parties have protective rights relating to the
subsidiary.

A key aspect of control is the ability to direct the

activities that most significantly affect the
investors returns.

10

Forms of Business
Combinations

LO2

The are three main forms of business

combinations.

One company con obtain control over the net

assets of another company by:

1) purchasing its net assets

2) Acquiring enough of its voting shares to control the
use of its net assets, or
3) Gaining control through a contractual arrangement

11

Forms of Business
Combinations

LO2

Purchase of assets or net assets When purchasing assets

or net assets, the transaction is carried out with the selling
company.

Purchase of Shares an alternative to the purchase of assets

is for the acquirer to purchase enough voting share from the
shareholders of acquiree that it can determine the acquirees
strategic operating and financing policies.
When purchasing shares, the transaction is usually
consummated with the shareholders of the selling company.
The acquired company make no journal entries when the
acquiring company purchases shares.

Control through contractual arrangement control can be

obtained through a contractual arrangement that does not
involve buying assets or shares.

12

Forms of Business
Combinations

LO2

All three forms of business combination result

in the assets and liabilities of the companies
being combined.

If control is achieved with the purchase of net

assets, the combining takes place in the
accounting records of the acquirer.

If control is achieved by purchasing shares or

through contractual agreement, the combining
takes place when the consolidated financial
statements are prepared.
13

Forms of Business
Combinations

LO2

There are many different legal forms in which a

business combination can be consummated.

A statutory amalgamation occurs when two or

more companies combine to form a single legal
entity.

14

Accounting for Business

Combinations Under the
Acquisition Method

LO2

IFRS 3 outlines the accounting requirements for business

combinations. The main principles are:
All business combination should be accounted for by
applying the acquisition method.
An acquirer should be identified for all business
combinations.
The acquisition date is the date the acquirer obtains
control of the acquiree.
The acquirer should attempt to measure the fair value
of the acquiree, as a whole, as of the acquisition date.
The acquirer should recognize and measure the
identifiable assets acquired and the liabilities assumed
at fair value and report them separately from goodwill.
The acquirer should recognize goodwill, if any.
15

Accounting for Business

Combinations Under the
Acquisition Method

LO2

Acquisition cost measured as the fair value of

consideration given to acquire the business and is made
up of the following:
Any cash paid
Fair Value of assets transferred by the acquirer
Present value of any promises by the acquirer to pay
cash in the future
Fair value of any shares issued the value of shares is
based on the market price of the shares on the
acquisition date
Fair value of contingent consideration
Acquisition cost does not include costs such as
professional fees or costs of issuing shares.
16

LO2

Recognition and Measurement

of Net Assets Acquired
The acquirer should recognize and measure the
identifiable assets and liabilities assumed at fair value
and report them separately from goodwill.

Identifiable assets include those with value not presently

recorded by the acquiree, such as internally developed
patents.

Can allocate only to items that meet the definition of

assets and liabilities under IASBs Framework. For
example, cannot allocate expected cost of terminating
the subsidiarys employees to a liability of the
terminations have not yet occurred. In this case the
termination cost would be recorded in post-acquisition
expense.

17

LO2

Recognition of Goodwill
Goodwill is the excess of total consideration given
over the fair value of identifiable assets and
liabilities.

Negative goodwill could result in the reporting of a

gain on purchase by the acquiring company.

18

Control through Purchase

of Net Assets: Example 1

LO3

Example 1
A Company offers to buy all assets and assume all
liabilities of B Corporation. The management of B
Corporation accepts the offer.

Assume that on January 1, Year 2, A Company pays

$95,000 in cash to B Corporation for all the net
assets of that company, and that no direct costs are
involved. Because cash is the means of payment, A
Company is the acquirer.

The acquisition is allocated as per the next slide.

19

Control through Purchase

of Net Assets: Example 1

LO3

Acquisition cost (cash paid) $ 95,000

Fair value of net assets acquired
80,000
Difference goodwill
15,000
A Company would make the following journal entry to record the
acquisition of B Corporation:
Assets (in detail) 109,000
Goodwill
15,000
Liabilities (in detail) 29,000
Cash
95,000
A COMPANY LTD.
Balance Sheet
January 1, Year 2
Assets (300,000 - 95,000 + 109,000) $314,000
Goodwill
15,000
$329,000
Liabilities (120,000 + 29,000) $149,000
Shareholders equity:
Common Shares
100,000
Retained earnings
80,000
$329,000

20

Control through Purchase

of Net Assets: Example 1

LO3

Assume that on January 1, Year 2, A Company issues 4,000

common shares with a market value of $23.75 per share, to B
Corporation as payment for the companys net assets. B
Corporation will be wound up after the sale of its net assets.

Because the method of payment is shares, the following

analysis is made to determine which company is the acquirer:
Shares of A Company
Group X now holds 5,000
Group Y will hold (on wind-up)
4,000
9,000
X holds 56% of A Companys 9,000 shares therefore Group X
is the Acquirer.
21

Control through Purchase

of Net Assets: Example 2

LO3

Calculation of Goodwill:
Acquisition cost ( 4,000 shares @ $23.75) $ 95,000
Fair value of net assets acquired
80,000
Difference goodwill
15,000
A Company would make the following journal entry to record the acquisition
of B Corporations net assets and the issuance of 4,000 common shares at
fair value on January 1, Year 2
Assets (in detail)
109,000
Goodwill 15,000
Liabilities (in detail) 29,000
Cash95,000
A COMPANY LTD.
Balance Sheet
January 1, Year 2
Assets (300,000 + 109,000) $409,000
Goodwill 15,000
$424,000
Liabilities (120,000 + 29,000)
$149,000
Shareholders equity:
Common Shares (100,00 + 95,000) 195,000
Retained earnings
80,000
$424,000

22

Consolidated Financial
Statements

LO4

When an investor acquires sufficient voting shares to

obtain control over the investee, a parent-subsidiary
relationship is established.

The investor is the parent, and the investee is the

subsidiary.

Usually, the companies involved continue as separate

legal entities, with each maintaining separate
accounting records and financial statements. However,
these entities now operate as a family of companies.

23

Consolidated Financial
Statements

LO4

Consolidated statements consist of a balance sheet, a

statement of comprehensive income, a statement of

changes in equity, a cash flow statement, and the
accompanying notes.
Consolidated financial statements are the financial
statements of a group in which the assets, liabilities,
equity, income, expenses, and cash flows of the parent
and its subsidiaries are presented as those of a single
economic entity.
A Group is a parent and its subsidiaries.
A Parent is an entity that controls one or more entities
A Subsidiary is an entity that is controlled by another
entity.
Non-controlling interest is equity in a subsidiary not
attributable, directly or indirectly, to a parent.

24

Consolidated Financial
Statements

LO4

IFRS 10, paragraph 4(a), states that a parent is not

required to present consolidated financial statements for
external reporting purposes if it meets all of the following
conditions:

Parent is itself a wholly owned subsidiary, or is a partially

owned subsidiary and its owners do not object to the
parent not presenting consolidated financial statements;
Parents debt or equity instruments are not publicly
traded;
Parent has not or is not filing financial statements with a
regulator for the purpose of issuing debt or equity
instruments on a publicly traded market; and
The ultimate or intermediate parent of the parent
produces IFRS-complaint consolidated financial
25
statements for public use.

Consolidated Financial
Statements

LO4

If the parent meets the conditions of IFRS 10,

paragraph 4(a), it can (but does not have to) present
separate financial statements in accordance with IFRS
as its only financial statements to external users.

It then must follow IAS 27 Separate Financial

Statements, which accounts for investments in
subsidiaries:
a. at cost;
b. in accordance with IFRS 9; or
c. using the equity method as described in IAS 28.

26

Control through Purchase

of Net Assets: Example 3

LO4

Example 3

Assume that on January 1, Year 2, A Company pays

$95,000 cash to the shareholders of B Corporation for
all
of their shares, and that no other direct costs are
involved. Because cash was the means of payment, A
Company is the acquirer.

The financial statements of B Corporation have not

been
affected by this transaction because the shareholders
of B, not the company itself, sold their shares.

See Exhibit 3.3 & 3.4 on the next slides

27

LO4

Exhibit 3.3
CALCULATION AND ALLOCATION OF THE AQUISITION DIFFERENTIAL

Total consideration given

= cash paid by A Company
Carrying amount of B Corporations net assets
Assets
$88,000
Liabilities
30,000
58,000
Acquisition differential
37,000
Allocated as follows:
Fair Value - Carrying amount
Fair Value Excess
Assets
109,000 - 88,000 =
$21,000
Liabilities
29,000
- 30,000 =
1,000
Balance - Goodwill
$15,000

$95,000

22,000

28

LO4

Exhibit 3.4
A COMPANY LTD
CONSOLIDATED BALANCE SHEET WORKING PAPER
January 1, Year 2
A
Company

Adjustments and
B
Eliminations
Corp
Dr.
Cr.

Consolidated
balance sheet

Assets
$205,000
$88,000
(2) $ 21,000
Investment in
95,000
(1) 95,000
B Corporation
Acquisition
(1)
37,000
(2) 37,000
Differential
Goodwill
(2)
15,000
$300,000
$88,000
$329,000

$314,000

Liabilities
$120,000
$30,000
Common shares
100,000
Retained earnings
80,000
Common shares
25,000
(1)
Retained earnings
33,000
$300,000
$88,000

$149,000

(2)

1,000

15,000

100,000
80,000
25,000
(1)
33,000
$132,000
$132,000

$329,000

29

Control through Purchase

of Net Assets: Example 3

LO4

Note the following for Exhibit 3.4:

A Companys Investment in B Corporation balance and B
Corporations common shares and retained earnings have been
eliminated in entry (1) because they are reciprocal.

The acquisition differential does not appear on the consolidated

balance sheet but is reallocated to the net assets of B Corporation
in entry (2)

When we add the acquisition differential to the carrying amount of the net
assets of B Corporation, the resulting amount used for the consolidation is
the FV of each individual asset and liability of B Corporation.

The elimination entries are made on the working paper only and
not in the books or either company.

The consolidated balance sheet is prepared from the amounts shown in the
last column of the working paper.

Under the acquisition method of accounting, consolidated shareholders

equity on acquisition date is that of the parent.
30

Control through Purchase

of Net Assets: Example 4

LO4

Example 4

Assume that on January 1, Year 2, A Company issues 4,000

common shares, with a fair value of $23.75 per share, to
the shareholders of B Corporation (Group Y) for all of their
shares and that there are no direct costs involved.
Example 2 indicated that A Company is the acquirer.

The calculation and allocation of the acquisition differential

is identical to the one used in Example 3.

The working paper for the preparation of the consolidated

balance sheet as at January 1, Year 2 is shown next in
Exhibit 3.5

31

LO4

Exhibit 3.5
A COMPANY LTD
CONSOLIDATED BALANCE SHEET WORKING PAPER
January 1, Year 2
A
Company

Adjustments and
B
Eliminations
Corp
Dr.
Cr.

Consolidated
balance sheet

Assets
$300,000
$88,000
(2) $ 21,000
Investment in
95,000
(1) 95,000
B Corporation
Acquisition
(1)
37,000
(2) 37,000
Differential
Goodwill
(2)
15,000
$395,000
$88,000
$424,000

$409,000

Liabilities
$120,000
$30,000
Common shares
195,000
Retained earnings
80,000
Common shares
25,000
(1)
Retained earnings
33,000
$395,000
$88,000

$149,000

(2)

1,000

15,000

195,000
80,000
25,000
(1)
33,000
$132,000
$132,000

$424,000

32

The Direct Approach

LO4

An alternative to the worksheet Method of preparing

consolidated financial statements in Exhibit 3.4 is the
Direct Approach, preparing the financial Statements
directly without the use of a working paper.

The basic approach in the direct approach on the

acquisition date is as follows:
Carrying Carrying
amount + amount
(parent) (Subsidiary)

Acquisition
Consolidated
+/(-) differential
=
amounts

On the date of acquisition consolidated shareholders

equity = parents shareholders equity

33

LO4

Exhibit 3.6
A COMPANY LTD.
CONSOLIDATED BALANCE SHEET
January 1, Year 2
Assets (300,000 + 88,000 + 21,000)
Goodwill ( 0 + 0 + 15,000)
$424,000
Liabilities (120,000 + 30,000 1,000)
Common shares
195,000
Retained earning
80,000
$424,000

$409,000
15,000
$149,000

34

Reverse Takeover

LO4, LO7

Occurs when one company obtains ownership of the

shares of another by issuing enough voting shares as
consideration that control of the combined enterprise
passes to the shareholders of the acquired
enterprise.

In a reverse takeover, the consolidated balance sheet

incorporates the carrying amount of the net assets of
the deemed parent (the legal subsidiary) and the fair
value of the deemed subsidiary (the legal parent).

35

LO4

Reporting Depreciable Assets

There are two methods; the proportionate methods,
and the net method.

In this textbook, we will use the net method unless

otherwise indicated.

Both methods report the subsidiarys depreciable asset

at fair value but report different amounts for cost and
accumulated depreciation.

36

Other Consolidated
Financial Statements
in year of Acquisition

LO4

Consolidated net income, retained earnings, and cash

flows include the subsidiarys income and cash flows only
subsequent to the date of acquisition.

37

LO4

Disclosure Requirements
The acquirer must disclose information that enables
users of its financial statements to do the following:
a) Evaluate the nature of, and risks associated with, its
b)
c)
d)
e)

interests in subsidiaries
Evaluate the effects of those interests on its financial
position, financial performance, and cash flows
Understand the significant judgement and
assumptions it has made in determining that it has
control of another entity
Understand the composition of the group
Evaluate the nature and extent of significant
restrictions on its ability to access or use assets, and
settle liabilities, of the group.
38

LO4

Push-Down Accounting
Not permitted under IFRS but may be in the future.
Permitted by GAAP for private enterprises (ASPE),
with disclosures required in the first year of
application.

In Section 1625 in Part II of the Handbook pushdown accounting is permitted when the parent owns
90%
or more of a subsidiary. In these cases the parent
could revalue the subsidiarys assets and liabilities
based on the parents acquisition cost.

39

Subsidiary Formed by
Parent

LO4

When a parent company sets up a subsidiary company,

the preparation of the consolidated balance sheet on the
date of formation of the subsidiary requires only the
elimination of the parents investment against the
subsidiarys share capital since the subsidiary would
have no retained earnings on formation.

Carrying amounts = FV of the subsidiarys net assets

(no goodwill).

40

LO4

New-Entity Method
An alternative to the acquisition method, called
the new-entity method, as been discussed in
academic circles from time to time over the
past 40 years.

Under this method, the net assets of both the

acquiring company and the acquired company are
reported at their fair value.

41

Analysis and
Interpretation
of Financial Statements

LO5

The separate entity financial statements of the

parent present the investment in subsidiary as one
line on the balance sheet.
When the consolidated balance sheet is prepared,
the investment account is replace by the underlying
assets and liabilities of the subsidiary.
This gives the same results as is the investor had
bought the subsidiarys assets and liabilities directly.
In Exhibit 3.8, the debt-to-equity ratio is
substantially higher for the consolidated balance
sheet as compared to the separate-entity balance
sheet.
42

ASPE Differences

LO6

Part II of the CPA Canada Handbook (Section 1590)

outlines the main differences under ASPE:
An enterprise shall make an accounting policy choice to either
consolidate its subsidiaries or report its subsidiaries using
either the equity method or the cost method. All subsidiaries
should be reported using the same method.
When a subsidiary's equity securities are quoted in an active
market and the parent would normally choose to use the cost
method, the investment should not be reported at cost. Under
such circumstances, the investment should be reported at fair
value, with changes in fair value reported in net income.
Private companies con apply push-down accounting but must
disclose the amount of the change in each major class of
assets, liabilities, and shareholders equity in the year that
push-down accounting is first applied.
43