susiness Combinations (Part 1) Chapter 1 Business Combinations (Part 1) Related standards: pFRS 3 Business Combinations ection 19 of the PFRS for SMEs overview on the topic Our discussion on business combination is subdivided into the following chapters: Thapler Title Coverage 1 Business Combinations (Part 1) Recognition & measurement 2, Business Combinations (Part 2) Specific cases 3. Business Combinations (Part 3) Special accounting topics Learning Objectives 1. Define a business combination. 2. Explain briefly the accounting requirements for a business combination. 3. Compute for goodwill. Introduction ‘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. The company that obtains control over the other is referred to as the parent or acquirer. The other company that is ‘controlled is the subsidiary or acquiree. Business combinations are carried out either through: 1. Asset acquisition; or 2. Stock acquisition2 Chapter 1 > 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 books of accounts. 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 BCo. 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 are 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.Bus siness Combinations (Part 1) 3 A business combination may also be described as: L Horizontal combination — a business combination of two or more entities with similar businesses, e.g., a bank acquires another bank. 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. Conglomerate — a business combination of two or more entities with dissimilar businesses, eg, a real estate developer acquires a bank. Advantages of a business combination a. Competition is eliminated or lessened — competition between the combining constituents with similar businesses is eliminated while the threat of competition from other market participants is lessened. . 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.” 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; i, 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;Chapter 1 iv. increased investment opportunities due to increaseg capital; or vy. 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 combineq 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 systems, registration and licenses, some employee benefits and costs of outsourced services). : ii. Under a vertical combination, operating costs may be reduced by the ‘elimination of costs of negotiation and coordination between the companies and mark-ups on purchases. Combinations 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 decreases its average cost per unit as ” production is increased because fixed costs are allocated over “ an increased number of units produced. Cost savings on business expansion — by acquiring another company rather that creating a new one, an entity can save on start-up costs, research and development costs, cost of regulation and licenses, and other similar costs. Moreover, a business combination may be effected through exchange of equity instruments rather than the transfer of cash or other resources, 8. 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.Business Combinations (Part 1) 5) Disadvantages of a business combination ce 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 to 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, systems, and policies. d, Business combination may result in overcapitalization, which, in turn, may result to diffusion in 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 Combinations. Business Combination A business combination is “a transaction or other event in which an acquirer obtains control of one or more businesses.” Transactions referred to as ‘true mergers’ or ‘mergers of equals’ are also business combinations under PFRS 3. (PrRs3.appendix A) Essential elements in the definition of a business combination 1. Control 2. Business Control An investor controls an investee when the investor has the power to direct the investee’s relevant activities (ie. operating and financing policies), thereby affecting the variability of the investor's investment returns from the investee.Chapter 1 Control is normally presumed to exist when the acquirer holds more than 50% (or 51% or more) interest in the acquiree’s voting rights. However, this is only a presumption because control can be obtained in some other ways, such as when: 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 ower over more than half of the voting ee because of an agreement with other a. c. the acquirer has p rights of the acquir investors; or d. the acquirer controls th policies because of a law or an agreement. e acquiree’s operating and financial An acquirer may obtain control of an acquiree in a variety of ways, for example: a. by transferring cash or other assets; by incurring liabilities; by issuing equity interests; by providing more than one type of consideration; or without transferring consideration, including by contract | ep ooo alone. Illustration: Determining the existence of‘control * Example #1 ABC Co. acquires 51% ownership interest in XYZ, Inc.'s ordinary shares. Analysis: ABC is presumed to have obtained control over XYZ because of the ownership interest acquired in the voting rights of XYZ is more than 50%. Example #2 ABC Co. acquires 100% of XYZ, Inc.’s preference shares. |Business Combinations (Part 1) 7 Analysis: ABC does not obtain control over XYZ because. ference shares do not give the holder voting rights over the financial and operating policies of the investee. Example #3 ABC Co. acquires 40% ownership interest in XYZ, Inc. There is an agreement with the shareholders of XYZ that ABC will control the appointment of the majority of the board of directors of XYZ. Analysis: ABC has control over XYZ because, even though the ownership interest is only 40%, ABC has the power to appoint the majority of the board of directors of XYZ. Example #4 ABC Co. acquires 45% ownership interest in XYZ, Inc. ABC has an agreement with EFG Co., which owns 10% of XYZ, whereby EFG will always vote in the same way as ABC. Analysis: ABC has control over XYZ because it controls more than 50% of the voting rights over XYZ (ie, 45% plus 10%, per agreement with EFG). Example #5 ABC Co. acquires 50% of XYZ, Inc.'s voting shares. The board of directors of XYZ consists of 8 members. ABC. appoints 4 of them and XYZ appoints the other 4, When there are deadlocks in casting votes at meetings, the decision always lies with the directors appointed by ABC. Analysis: ABC has control over XYZ because it controls more than 50% of the voting rights over XYZ in the event there is no majority decision,Chapter 1 ee Business integrated set of activities and assets yn is capable Business is 5S cted and managed for the purpose ol Providin, of being conau + to customers, generating investment income . rvices . a ee ai is or interest) or generating other income from +s dend such as dividen ne activities.” (PFRS3.Appendix A) i lements: iness has the following three el paren any economic resource that results to an output when ‘one or more processes are applied to it, eg. ‘Ton-current assets, intellectual property, the ability to obtain access to necessary materials or rights and employees. 2. Process - any system, standard, protocol, convention or rule that when applied to an input, creates an output, e.g., strategic management processes, operational processes and resource management processes. : a Administrative systems, e.g. accounting, billing, payroll, and the like, are not processes used to create outputs. 3. Output - the result of 1 and 2 above that provides goods or services to customers, investment income or other income from ordinary activities. Identifying a business combination An entity determines whether a transaction is a business combination in relation to the definition provided under PFRS 3. If the assets acquired (and related liabilities assumed) do not constitute a business, the entity accounts for the transaction as a regular asset acquisition and not a business combination: er the entity applies other applicable Standards (e.g., entories acquired, PAS 16 for PPE acquired, etc.) Recounting for business combination ‘usiness combinations are acc r ‘ounted fi i isiti method. This method Tequires the followin i ms ita a Identifying the Acquirer, iaBusiness Combinations (Part 1) 9 b. G i. ii. iii. iv. Determining the acquisition date; and Recognizing and measuring goodwill, This requires recognizing and measuring the following: , Consideration transferred Non-controlling interest in the acquiree Previously held equity interest in the acquiree Identifiable assets acquired and liabilities assumed on the business combination. Identifying the acquirer For each business combination, one of the combining entities is identified as the acquirer. The acquirer is the entity that obtains control of the acquiree. The acquiree is the business that the acquirer obtains control of in a business combination. PERS 3 provides the following guidance in identifying the acquirer: * Who is the transferor of cash or other resources or assumes liabilities? In a business combination effected primarily by transferring cash or other assets or by incurring liabilities, the acquirer is usually ‘the entity that transfers the cash or other assets or incurs the liabilities. Who is the issuer of shares? Ina business combination. effected primarily by exchanging equity interests, the acquirer is usually the entity that issues its equity interests. However, in some business combinations, called “reverse acquisitions,” the issuing entity is the acquiree. Other pertinent facts and circumstances shall also be considered in identifying the acquirer. The acquirer is usually the entity: > whose owners, as a group, have the largest portion of the voting rights of the combined entity.Chapter 1 yo Sr 2 > ility to appoint or remoye whose owners have the abil i ‘ majority of the members of the governing body of the combined entity. ; whose (former) management dominates the managemens of the combined entity. an ; that pays a premium over the pre-combination fair value of the equity interests of the other combining entity o, entities. Who is larger? 7 The acquirer is usually the larger between the combining enti ities, measured in, for example, assets, revenues or profit. Who is the initiator of the combination? ; The acquirer is usually the one who initiated the combination. Substance over form If an new entity is formed to effect the business combination, the > Exa > acquirer is identified as follows: if the new entity is formed to issue equity interests to effect the business combination, one of the combining entities that existed before the business combination is the acquirer. if the new entity is formed to transfer cash or other assets or incur liabilities as consideration for the business combination, the new entity is the acquirer, imple: A Co.+B Co. =C Co. (new entity) If C Co. is formed to issue equity interests to A Co. and B Co., the acquirer is either A Co. or B Co., whichever company whose former owners, as a rou; i pcos : group, gain control If C Co. is formed to transfer cash to A acquirer is C Co, gebusiness Combinations (Part 1) i [Jlustration: Identifying the acquirer ABC Co. and XYZ, Inc., both listed entities, agreed to combine their businesses. The terms of the business combination is that ABC will offer 5 shares for every share of XYZ. There is no cash consideration. ABC’s market capitalization is P900 million and XYZ’s is P100 million. After the combination, the board of directors of XYZ shall comprise only directors from ABC. Three months after the acquisition, 20% of XYZ is sold. Analysis: ABC is the acquirer based on the following indicators: v ABC is the issuer of shares and the initiator of the business combination. ¥ ABCis the larger entity of the two combining constituents. ¥ ABC's (former) management dominates the management of the combined entity. ¥ Part of XYZ is sold after the acquisition. This provides additional indicator that ABC is the acquirer. Determining the acquisition date The acquisition date is the date on which the acquirer obtains control of the acquiree. This is normally the closing date (i.e., the date on which the acquirer legally transfers the consideration, acquires the assets and assumes the liabilities of the acquiree). However, the acquirer might obtain control on a date that is either earlier or later than the closing date, for example, when there is a written agreement to that effect. Recognizing and measuring goodwill . On acquisition date, the acquirer computes and_ recognizes goodwill (or gain on a bargain purchase) using the following formula:aii 12 Chapter 1 Consideration transferred xx Non-controlling interest (NCI) in the acquiree xx Previously held equity interest in the acquiree ae Total xx | Less: Fair value of net identifiable assets acquired — bx) i i bargain purchase) Goodwill / (Gain on a bargain purchase) xx A negative amount resulting from the ‘formula is called “gain on a bargain purchase” (also referred to as “negative goodwill), A bargain purchase may occur, for example, in a business combination that is a forced sale in which the acquiree is acting under compulsion. However, a bargain purchase may also occur in other instances such as when the application of the recognition and measurement exceptions for particular items provided under PERS 3 results in a gain on bargain purchase. On acquisition date, the acquirer recognizes a resulting: a. Goodwill as an asset: b. Gain on a bargain purchase as gain in profit or loss. However, before Tecognizing a gain on a bargain purchase, the acquirer shall reassess whether it has correctly identified all of the assets acquired and all of the liabilities assumed and shall tecognize any additional assets or. liabilities that are identified in that review. This is an application of the concept of conservatism. Consideration transferred The consideration transferred in a busi at fair value, which is the sum of the acquisition-date fair values of the assets transferred by the acquirer, the liabilities incurred by the acquirer to former owners of the acquiree and the i interests issued by the acquirer. pases iness combination is measuredBusiness Combinations (Part 1) 13 Examples of potential forms of consideration include: a. Cash p. Non-cash assets c. Equity instruments, e.g, shares, options and warrants d. A business or a subsidiary of the acquirer e. Contingent consideration Acquisition-related costs Acquisition-related costs are costs that the acquirer incurs to effect a business combination. Examples: a. Finder’s fees : b. Professional fees, such as advisory, valuation and consulting fees c. General administrative costs, including the costs of maintaining an internal acquisitions department d. Costs of registering and issuing debt and equity securities legal, accounting, Acquisition-related costs are expensed when incurred, except for the following: a. Costs to issue debt securities measured at amortized cost are included in the initial measurement of the secutities, eg. bond issue costs are included (as deduction) in the carrying amount of bonds payable. b. Costs to issue equity securities are deducted from share premium. If share premium is insufficient, the issue costs are deducted from retained earnings. Non-controlling interest Non-controlling interest (NCI) is the “equity in a subsidiary not attributable, directly or indirectly, to a parent.” (PFRS 3.Appendix A) Non-controlling interest is also called “minority interest.” For example, ABC Co. acquires 80% interest in XYZ, Inc. The controlling interest is 80%, while the non-controlling interest is 20% (100% - 80%). If ABC Co. acquires 100% interest in XYZ, ~, the non-controlling interest is zero.a Chapter 1 14 For each business combination, the acquirer measures any non-controlling interest in the acquiree either at: a. fair value; or ae f : p. the NCI’s proportionate share in the acquiree’s net identifiable assets. Previously held equity interest in the acquiree Previously held equity interest in the acquiree pertains to any interest held by the acquirer before the business combination. This affects the computation of goodwill only in business combinations achieved in stages. Net identifiable assets acquired Recognition principle On acquisition date, the acquirer recognizes the identifiable assets acquired, the liabilities assumed and any NCI in the acquiree separately from goodwill. Unidentifiable assets are not recognized. Examples of unidentifiable assets: a. Goodwill recorded by the acquiree prior to the business combination. . Assembled workforce c. Potential contracts that the acquiree is negotiating with prospective new customers at the acquisition date Recognition conditions a. To qualify for recognition, identifiable assets acquired and liabilities assumed must meet the definitions of assets and * liabilities provided under the Conceptual Framework at the acquisition date. For example, costs that the acquirer expects but is not obliged ia incur in the future to effect its plan to exit the acquiree’s activity or to terminate or relocate the acquiree’s employees are not liabilities at the acquisition date. Hence, these are not recognized when applying the acquisitionBusiness Combinations (Part 1) it method but rather treated’ as post-combination costs in accordance with other applicable Standards, p. The identifiable assets acquired and liabilities. assumed must be part of what the acquirer and the acquiree (or its former owners) exchanged in the business combination transaction rather than the result of separate transactions. c. Applying the recognition principle May result to the acquirer recognizing assets and liabilities that the acquiree had not previously recognized in its financial statements, For example, the acquirer May recognize an acquired intangible asset, such as a brand name, a patent or a customer relationship, that the acquiree did not Tecognize as an asset in its financial statements because it has developed the intangible asset internally and charged the related costs as. expense. Classifying identifiable assets acquired and liabilities assumed Identifiable assets acquired and liabilities assumed are classified at the acquisition date in accordance with other PFRSs that are to be applied subsequently. For example, PPE acquired in a business combination are classified at the acquisition date in accordance with PAS 16 if the assets are to be used as PPE subsequent to the acquisition date. Mensurement principle Identifiable assets acquired and liabilities assumed are measured at their acquisition-date fair values. Separate valuation allowances are not recognized at the acquisition date because the effects of uncertainty about future cash flows are included in the fair value measurement. For example, the acquirer does not recognize an “allowance for doubtful accounts” on accounts receivable acquired on a business Combination, Instead, the acquired accounts receivable are Tecognized at their acquisition-date fair values.