Advanced Financial Accounting

RSM 321

Class 2
Ch. 3: Business Combinations

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 Chapter 3 – Business Combinations
• A business combination involves one company obtaining control of the net
assets of another company. The acquirer is the entity that obtains control of
one or more businesses in a business combination (IFRS 3). The concept
of control and how to determine who has it is discussed in IFRS 10. We
return to this topic on slide 21.
• A business combination occurs in one of three ways:
– 1) when one company acquires enough voting shares of another
company to control the use of the net assets of that company.
– 2) when one company acquires the assets or net assets of another
company, provided that the assets constitute a business.
– 3) when one company gains control over another company through a
contractual arrangement, without actually acquiring any shares of the
other company. We will cover this topic in Chapter 9.
• Business definition: a business is an integrated set of activities and assets
that is capable of being conducted and managed for the purpose of
providing a return.

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 Business Combinations
• Payment for assets, net assets or shares acquired can
be in cash, promises to pay cash in the future, or the
issuance of shares, or a combination of these.

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 Forms Of Business Combinations
• Purchase of assets or net assets – Control over
another company’s assets or net assets can be obtained
by purchasing the assets outright, leaving the selling
company only with the consideration received for the
asset sale and any liabilities present before the sale or
only with the consideration received for the net asset
sale.
• Purchase of shares – an alternative to the purchase of
assets is for the acquirer to purchase enough voting
shares from the shareholders of the acquiree that it can
determine the acquiree’s strategic operating and
financing policies.
– Share purchase can be less costly since control can be achieved
by purchasing less than 100% of the voting shares. Share
purchases can also have important income tax advantages.
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 Forms Of Business Combinations

• Both forms of business combination result in the assets

or net assets of the acquiree being combined with those
of the acquirer.
• If control is achieved with the purchase of assets or net
assets, the combining takes place in the accounting
records of the acquirer.
• If control is achieved by purchasing shares, the
combining takes place when the consolidated financial
statements are prepared.

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 The Acquisition Method

• Method of accounting which must be adopted on or

before January 1, 2011.
• Prior to this time, the purchase method was used.

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 The Acquisition Method
• Note: all discussion of the acquisition method in Session
2 will assume a 100% acquisition.
• The acquiring company records the identifiable net
assets at fair values regardless of the acquisition cost.
• If acquisition cost is > FV of identifiable net assets the
excess is reported as goodwill similar to purchase
method.
• If acquisition cost is < FV of identifiable net assets the
difference is reported as gain on purchase.
• Not consistent with historical cost principle but consistent
with general trend toward use of fair values.

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 Acquisition Method

• Acquisition method applies to all business combinations.

• Acquirer should be identified for all business
combinations.
• Acquisition date is the date the acquirer obtains control
of the acquiree.
• Acquirer should reflect the identifiable assets and
liabilities acquired at fair value separately from goodwill.

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 Identifying the Acquirer
• Identifying the acquirer using IFRS 3
– The acquirer usually is the party that ends up with control; that is, the ability to
make the investee’s decisions. Key is to use your judgment given the facts.
– Some potential indicators are as follows: (IFRS 3, Appendix B, B13-B17)
• If cash payments are required for acquisition, the acquirer is usually the
company making the payments (B14).
• If shares are exchanged for acquisition, acquirer is usually the company
whose shareholders hold more than 50% of the votes in the combined
company, or if more than 2 companies are involved it is usually the company
whose shareholders hold the largest number of votes (B15(a)).
• If voting percentages are identical then examine makeup of board and
management to see which company is dominant (B15(c), (d)).
• In a share exchange acquirer is often but not always the company that
issues shares (B14).
• Acquirer is often but not always the larger company (B16)
• The acquirer is usually the combining entity that pays a premium over the
pre-combination fair value of the equity interests of the other combining
entity or entities (B15(e)).
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 Allocation of Acquisition Cost
• Acquisition cost includes:
– Any cash paid
– The fair value of assets transferred
– The PV of any promises to pay cash in the future
– The FV of any shares issued, based on the market price of
shares on the acquisition date
– The FV of contingent consideration (see Chapter 4)
• Acquisition costs do not include fees of consultants,
accountants, and lawyers which do not increase the FV
of acquired company. These should be expensed in the
period of acquisition as there is no remaining future
benefit.
• The cost of issuing debt or shares are not included in
acquisition cost but are charged to the related debt or
share capital.

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 Allocation of Acquisition Cost
• Allocation of acquisition cost:
– Allocate to the identifiable assets and liabilities of acquiree.
– Identifiable assets include those with value not presently
recorded by the acquiree, such as internally developed patents.
Also include identifiable intangible assets arising from
contractual or other legal rights, or being capable of being
separated and sold.
– Failure to allocate to identifiable intangible net assets would
inflate goodwill.
– Can allocate only to items that meet the definition of assets and
liabilities under IASB’s Conceptual Framework. For example,
cannot allocate expected cost of terminating the subsidiary’s
employees to a liability if the acquirer is not obligated to incur
these costs at the date of acquisition. In this case the
termination cost would be recorded as post-acquisition expense.

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 Allocation of Acquisition Cost
• Allocation of acquisition cost (cont’d):
– Fair values are determined and allocated for
contingent liabilities arising from past events if their
fair value can be measured reliably.
– Any excess of cost over the foregoing represents
goodwill.
– If acquisition cost < FV of identifiable net assets,
“negative goodwill” arises. This is reported as gain on
purchase (more in chapter 4).

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 Illustrations of Business Combination
Accounting

• To illustrate the accounting method using the acquisition

method, we will use the summarized balance sheets of
two companies – See Exhibit 3-2.
• A Company Ltd will initiate the takeover of B
Corporation.

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Exhibit 3.2

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 Illustration of Business Combination
Accounting

• 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 expenses are involved.
Because cash is the means of payment, A Company is
the acquirer.
• The acquisition is allocated as per the next slide:

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 Illustration of Business Combination
Accounting
Illustration 1
Purchase price $ 95,000
Fair market 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

Shareholder's equity
Common shares 100,000
Retained earnings 80,000
$ 329,000

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 Illustration of Business Combination
Accounting
Illustration 2
• 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 company’s 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 Company’s 9,000 shares; therefore Company A is
the acquirer

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 Illustration of Business Combination
Accounting
Illustration 2
Purchase price (4,000 shares @ $23.75) $ 95,000
Fair market 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's 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
Common shares 95,000

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

Shareholder's equity
Common shares (100,000 + 95,000) 195,000
Retained earnings 80,000
$ 424,000
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 Control and Consolidated Financial
Statements
• Although parent and subsidiary companies may continue as
separate legal entities after a business combination, GAAP views
the substance of the relationship as a single economic entity that
should be reported as such since it has a group of economic
resources that are under the common control of the parent.
• An enterprise should consolidate all of its subsidiaries (IFRS 10) to
inform primarily shareholders and creditors of the parent company
about the resources and results of operations of the parent and its
subsidiaries as a group, by eliminating all intercompany transactions
and presenting only transactions with outside entities.
• Consolidated financial statements are supplemented with footnote
disclosures showing operating segments.
• Parent and subsidiaries will still be required to prepare their own
separate-entity financial statements for income tax filing or internal
purposes.
• ASPE 1591 &1601 IFRS 10

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 Control and Consolidated Financial
Statements

• Common control concept –It is very important that you

see main benefit of consolidation for entities under
common control. Think of the balance sheet and
earnings manipulation that will set in when entities under
common control are not consolidated by the parent ex.
Enron.

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 Control and Consolidated Financial
Statements
Definition of Control
• IFRS 10 states that an investor controls an investee when it 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 (IFRS 10.6).
• Power is the ability to direct the relevant activities (i.e., “call the
shots”) (IFRS 10.11).
• Normally, it will be voting rights that give the investor power.
• Sometimes, power results from one or more contractual
arrangements, a topic we return to in Chapter 9.
• Normally, voting control dictates power. One would only need to
assess additional considerations if shareholder voting rights do not
dictate power (IFRS 10, Appendix B16).

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 Control and Consolidated Financial
Statements

• How is control determined?

– Ability to elect majority of board of directors (e.g. by holding
>50% of voting shares) is generally evidence of control.
– If Parent controls C Company which in turn controls D Company;
Parent has indirect control of D Company.
– If A Company holds 60% of the votes in B Company and C
Company holds the other 40%, A would normally have control of
B. However if C owns convertible bonds of B or options or
warrants to purchase B’s shares which if converted or exercised
would give C greater than 50% of the voting shares of B, then C
Company, not A Company, would control B Company.

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 Control and Consolidated Financial
Statements
• How is control determined? (cont’d)
– 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.
• Written agreements allow parent to dictate subsidiary’s
operating policies and to receive income & intercompany
profits from subsidiary (e.g. special purpose entities examined
in Chapter 9 in which parent holds the risks and rewards of
ownership while owning few, if any, of the shares of the
controlled company).
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 Control and Consolidated Financial
Statements

• How is control determined? (cont’d)

– 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 Y’s directors. X
would have control of Y provided Y’s shareholders are not
organized in such a way that they actively cooperate against X
when they vote their shares.
– Control and consolidation cease if for example the majority of a
subsidiary’s assets are seized in a bankruptcy or if a foreign
subsidiary is restricted by law from paying dividends to the
parent.

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 Control and Consolidated Financial
Statements
• How is control determined? (cont’d)
– The existence of certain protective rights held by other parties
does not necessarily provide those parties with control.
Examples:
• Approval or veto rights that do not affect strategic operating
and financing policies.
• The right to approve capital expenditures greater than a
particular threshold, or the right to approve the issue of equity
or debt.
• The ability to remove the controlling party in the event of
bankruptcy or breach of contract.
• Certain limitations on the operating activities of an entity, such
as pricing or advertising limitations typically placed by
franchisors on franchisees.

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 Control and Consolidated Financial
Statements

• How is control determined? (cont’d)

– Later in this class, we will look at the Barton/Squall illustration. It
asks two questions : Who is the acquirer and how do we apply
the acquistion method ?(using concepts in IFRS 3). Who has
control of the new company and must therefore consolidate the
new company ?(using concepts in IFRS 10).

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 Illustration of Business Combination
Accounting

Illustration 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 expenses
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.
• The formula for the next slide would be:
AC = NAV at FV + GW
AC = BOOK OE + FVI’s + GW
AC - BOOK OE = FVI’s + GW

acquisition differential

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Exhibit 3.3

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Exhibit 3.4 – Worksheet Method

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 Exhibit 3.4 – Direct Method

Exhibit 3.4 - Direct Approach - Share Purchase with Cash

A Company Limited
Consolidated Balance Sheet
January 1, Year 2

Assets (205000+88000+21000) $ 314,000

Investment in B Corporation (95000-95000) $ -
Goodwill (15000) $ 15,000

Total Assets $ 329,000

Liabilities (120000+30000-1000) $ 149,000

Common stock (100000+25000-25000) $ 100,000
Retained earnings (80000+33000-33000) $ 80,000

Total Liabilities and Shareholders' Equity $ 329,000

• Notice that the outcome is the same as Illustration 1.

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 Illustration of Business Combination
Accounting

Illustration 4
• Assume that on January 1, Year 2, A Company issues 4,000
common shares, with a market value of $23.75 per share, to the
shareholders of B Corporation for all of their shares, and there are
no direct costs involved. The analysis made in Illustration 2
indicates that 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 3.5 & 3.6 on the next slides.

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Exhibit 3.5 – Worksheet Method

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 Exhibit 3.6 – Direct Method

• Notice that the outcome is the same as Illustration 2.

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 Summary: Shares versus Net
Assets/Cash versus Share Consideration

Consideration Received
Shares Net Assets

Cash Illustration 3 Illustration 1

Consideration Given

Shares of Acquirer Illustration 4 Illustration 2

Illustration 3 is same as Illustration 1 (i.e. shares = net assets since equity equals assets less liabilities)
Illustration 4 is same as Illustration 2 (i.e. shares = net assets since equity equals assets less liabilities)
Illustration 1/3 are not the same as illustration 2/4 (i.e. paying in shares results in ownership dilution whereas paying in cash does
not)

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 Variations in the Forms of Business
Combinations

• Exhibit 3.1 illustrates variations from the forms of business combinations described in
Illustration 1-4 above. You are responsible for Exhibit 3.1, including the topic of
reverse takeovers, at the conceptual level only. We will discuss each stick diagram in
Exhibit 3.1, with sticks 1-4 referring to the left column and sticks 5-9 referring to the
right column.

• For the column where consolidated f/s are not required, the first stick diagram is
easy. A Co. is the acquirer and the net assets of A Co. are reported at carrying
amount while the net assets of X Co. are reported at fair value on the balance sheet
of A Co. at the date of acquisition. This example corresponds to Illustration 1above.

• The second stick diagram in the left column is also easy, similar principles apply, and
corresponds to Illustration 2 above. A Co. is the acquirer and the net assets of A Co.
are reported at carrying amount while the net assets of X Co. are reported at fair
value on the balance sheet of A Co. at the date of acquisition. The shareholders
equity at the date of acquisition is the pre-merger of A Co. plus the 50 shares issued
at fv.

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 Variations in the Forms of Business
Combinations
• The third stick diagram in the left column is more complicated. A Co. is in effect the
acquirer and the net assets of A Co. are reported at carrying amount on the books of
New Co. while the net assets of X Co. are reported at fair value on the balance sheet of
New Co. Applying the acquisition method, the shareholders equity of New Co. at the
date of acquisition would be the sum of the pre-merger shareholders equity of A Co.
plus the New Co. shares issued at fair value to acquire the net assets (including
goodwill) of X Co. We will not hold you responsible for the various journal entries that
accomplish this outcome, since a far simpler way to achieve the same end result is
described in the next paragraph.

Concerning the third stick diagram, it would be easier if New Co. purchased the shares
of both companies by issuing New Co. shares to each of Mr. A and Mr. X and then
winding up both companies by way of a statutory amalgamation. In effect, this is the
Barton/Squall scenario to which we turn shortly. If that were the form, the shareholders
equity of New Co. at the date of acquisition would be the sum of the pre-merger
shareholders equity of A Co. plus the New Co. shares issued to Mr. X at fair value.

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 Variations in the Forms of Business
Combinations
• The fourth stick diagram in the left column has the same result as the second stick
diagram, except that X Co. is wound up, for reasons explained at the bottom of page
114 of the text.
• Turning to the right column of Exhibit 3.1, the first two stick diagrams are easy and
correspond to Illustrations 3 and 4 later in the Chapter. A Co. is the acquirer and the
net assets of A Co. are reported at carrying amount while the net assets of X Co. are
reported at fair value on the consolidated balance sheet of A Co. at the date of
acquisition. In the second stick diagram the shareholders equity is the pre-merger SE
of A Co. plus the 50 shares issued at fv.
• The third stick diagram in the right column involves a reverse takeover. Here, Exhibit
3.1 of the text is clear that X Co. is the acquirer(since Mr. X now has voting control over
A Co.), the net assets of X Co. are reported at carrying amount while the net assets of
A Co. are reported at fair value on the consolidated balance sheet at the date of
acquisition. You are not responsible for the details, just the simple concept.
• The fourth stick diagram in the right column involves A Co. and B Co. being subs of
New Co. A Co. is the acquirer and the net assets of A Co. are reported at carrying
amount while the net assets of X Co. are reported at fair value on the consolidated
balance sheet of New Co. at the date of acquisition. Thereafter, New Co. must
consolidate A Co. and X Co. each reporting period.
This is, in effect, similar to the Barton/Squall scenario, to which we will turn shortly. In
that variation, New Co. buys the shares of A Co. and X Co. and A Co. and X Co. are
wound up. This would be simpler and more effective, compared to the fourth stick
diagram. 38
 Variations in the Forms of Business
Combinations
• In the fifth stick diagram in the right column, a business combination has occurred
because A Co. obtained control of X Co. through a contractual arrangement. Mergers
involving control obtained by contract rather than voting shares are covered in Chapter
9, including what the acquisition date balance sheet would look like. Until then, you are
not responsible for the details, just the simple concept.
• Planet Publishing (C3-6) is a variation on Exhibit 3.1 whereby Consolidated Statements
are not required after the merger.
Planet purchased shares of Space with Shares of Planet issued to the former
shareholders of Space and Space was then would up. The end result is the fourth stick
diagram in the left column.
Planet is the acquirer and the net assets of Space are brought on to Planet’s balance
sheet at fair value, while the net assets of the pre-merger Planet remain at book. The
Planet shareholder’s equity at the date of acquisition is the pre-merger book SE of
Planet plus the fv of the Planet shares issued.

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 Tutorial This Week
– P 2-2
– P 2-4: equity and cost method accounting
– P 2-5: FVTPL/investment in associate/fair-
value-through-OCI

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