CHAPTER 3:

Business
Combinations

Prepared by
Shannon Butler, CPA, CA
© 2022 McGraw Hill Limited Carleton University
 Learning Objectives, Part 1

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-of-

net-assets business combination.

LO4 Prepare consolidated financial statements for a

purchase-of-shares business combination.
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 Learning Objectives, Part 2

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. (Appendix 3A)

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 Introduction

 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.

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 Business Combinations, Part 1

 A business combination is defined in IFRS 3 as a transaction or

other events in which an acquirer obtains control of one or
more businesses.
 There are two key aspects to this: control and businesses.
 A business is defined in IFRS 3 as an integrated set of activities
and assets that can be 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,
members, or participants.

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 Business Combinations, Part 2

 A business consists of inputs and processes applied to those

inputs that have the ability to create outputs.

 Buying a group of assets that do not constitute a business is

a basket purchase, not a business combination.

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 Control – IFRS 10, Part 1

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 investor’s returns.

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 Control – IFRS 10, Part 2

 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.

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 Control – IFRS 10, Part 3

 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 Y’s
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.

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 Control – IFRS 10, Part 4

 Control and consolidation would cease if for example the

majority of a subsidiary’s assets are seized in a receivership or
bankruptcy situation.

 Normal business restrictions do not preclude control by the

parent.

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 Control – IFRS 10, Part 5
 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.

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 Control – IFRS 10, Part 6

 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 investor’s returns.

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 Forms of Business Combinations,
Part 1
 The are three main forms of business combinations.
 One company can 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

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 Forms of Business Combinations,
Part 2
 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 acquiree’s
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.

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 Forms of Business Combinations,
Part 3

 Control through contractual arrangement – control can be

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

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 Forms of Business Combinations,
Part 4
 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.

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 Forms of Business Combinations,
Part 5

 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.

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Accounting for Business Combinations under
the Acquisition Method, Part 1
 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.

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Accounting for Business Combinations under
the Acquisition Method, Part 2
 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.

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 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 IASB’s Framework. For example, cannot allocate
expected cost of terminating the subsidiary’s employees to a liability of
the terminations have not yet occurred. In this case the termination
cost would be recorded in post-acquisition expense.

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 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.

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 Control through Purchase of Net
Assets: Example 1, Part 1
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.

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 Control through Purchase of Net
Assets: Example 1, Part 2
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
© 2022 McGraw Hill Limited $329,000 23
 Control through Purchase of Net
Assets: Example 2, Part 1
 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 Group X
is the Acquirer.

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 Control through Purchase of Net
Assets: Example 2, Part 2
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
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
Cash 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
Shareholders’ equity:
Common Shares (100,00 + 95,000) 195,000
Retained earnings 80,000
© 2022 McGraw Hill Limited $424,000 25
Consolidated Financial Statements,
Part 1
 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.

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 Consolidated Financial Statements,
Part 2
 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.
 The following definitions are provided in Appendix A of IFRS 10:
a. 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.
b. A Group is a parent and its subsidiaries.
c. A Parent is an entity that controls one or more entities
d. A Subsidiary is an entity that is controlled by another entity.
e. Non-controlling interest is equity in a subsidiary not attributable, directly or
indirectly, to a parent.

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 Consolidated Financial Statements,
Part 3
 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:
a. 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;
b. Parents debt or equity instruments are not publicly traded;
c. 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
d. The ultimate or intermediate parent of the parent produces IFRS-
complaint consolidated financial statements for public use.

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Consolidated Financial Statements,
Part 4
 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.

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Control through Purchase of Shares:
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

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 Exhibit 3.3
CALCULATION AND ALLOCATION OF THE ACQUISITION DIFFERENTIAL

Total consideration given = cash paid by A Company $ 95,000

Less: Carrying amount of B Corporation’s net
assets:
Assets $88,000

Liabilities 30,000

58,000

Acquisition differential 37,000

Allocated as follows:

Fair value excess Fair Value − Carrying Amount

Assets 109,000 − 88,000 = $21,000

Liabilities 29,000 − 30,000 = 1,000 22,000

Balance—goodwill $ 15,000

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 Exhibit 3.4
A COMPANY LTD.
CONSOLIDATED BALANCE SHEET WORKING PAPER
At January 1, Year 2
Consolidat
Adjustments
ed Balance
and
Eliminations
Sheet
A B
Dr. Cr.
Company Corp.
Assets $205,000 $88,000 (2) $ 21,000 $314,000
Investment in B $ 95,000
95,000 (1)
Corporation
Acquisition differential (1) 37,000 (2) 37,000

Goodwill _________ ________ (2) 15,000 15,000

$300,000 $88,000 $329,000

Liabilities $120,000 $30,000 (2) 1,000 $149,000

Common shares 100,000 100,000

Retained earnings 80,000 80,000

Common shares 25,000 (1) 25,000

Retained earnings 33,000 (1) 33,000 ________

_________ ________
_
$300,000 $88,000 $132,000 $132,000 $329,000

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 Control through Purchase of Net
Assets: Example 3, Part 1
Note the following for Exhibit 3.4:
1. A Company’s “Investment in B Corporation” balance and B
Corporation’s common shares and retained earnings have been
eliminated in entry (1) because they are reciprocal.
2. The acquisition differential does not appear on the consolidated
balance sheet but is reallocated to the net assets of B Corporation
in entry (2)
3. 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.

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 Control through Purchase of Net
Assets: Example 3, Part 2
Note the following for Exhibit 3.4 continued:

4. The elimination entries are made on the working paper only

and not in the books or either company.

5. The consolidated balance sheet is prepared from the amounts

shown in the last column of the working paper.

6. Under the acquisition method of accounting, consolidated

shareholders’ equity on acquisition date is that of the parent.

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 Control through Purchase of Net
Assets: 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

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 Exhibit 3.5
A COMPANY LTD.
CONSOLIDATED BALANCE SHEET WORKING PAPER
At January 1, Year 2
Consolidated
Adjustments and Balance Sheet
Eliminations

A B
Dr. Cr.
Company Corp.
Assets $300,000 $88,000 (2) $ 21,000 $409,000

Investment in B Corporation 95,000 (1) $ 95,000

Acquisition differential (1) 37,000 (2) 37,000

Goodwill (2) 15,000 15,000

$395,000 $88,000 $424,000
Liabilities $120,000 $30,000 (2) 1,000 $149,000
Common shares 195,000 195,000
Retained earnings 80,000 80,000
Common shares 25,000 (1) 25,000

Retained earnings 33,000 (1) 33,000

$395,000 $88,000 $132,000 $132,000 $424,000

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 The Direct Approach

 An alternative to the worksheet method of preparing consolidated

financial statements is the Direct Approach, preparing the financial
Statements directly without the use of a working paper.
 The basic process involved in the direct approach is as follows:

Carrying amount Carrying amount Acquisition Consolidated

+ + (−) =
(parent) (subsidiary) differential amounts
 On the date of acquisition consolidated shareholders’
equity = parent’s shareholders equity

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 Exhibit 3.6 – Illustration of the
Direct Approach
A COMPANY LTD.
CONSOLIDATED BALANCE SHEET
At January 1, Year 2
Assets (300,000 + 88,000 + 21,000) $409,000
Goodwill (0 + 0 + 15,000) 15,000
$424,000
Liabilities (120,000 + 30,000 − 1,000) $149,000
Common shares 195,000
Retained earnings 80,000
$424,000

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 Reverse Takeover

 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).

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 Reporting Depreciable Assets

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

 In this textbook, we will use the net method unless otherwise

indicated.

 Both methods report the subsidiary’s depreciable asset at fair

value but report different amounts for cost and accumulated
depreciation.

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Other Consolidated Financial Statements
in Year of Acquisition

 Consolidated net income, retained earnings, and cash flows

include the subsidiary’s income and cash flows only
subsequent to the date of acquisition.

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 Disclosure Requirements, Part 1

 The acquirer must disclose information that enables users of

its financial statements to evaluate the nature and financial
effect of a business combination that occurs either (a) during
the current reporting period or (b) after the end of the
reporting period but before the financial statements are
authorized for issue.

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 Disclosure Requirements, Part 2
 IFRS 3 indicates that the acquirer shall disclose the
following:
a. The name and a description of the acquire.
b. The acquisition date.
c. The percentage of voting equity interests acquired.
d. The primary reasons for the business combination and a
description of how the acquirer obtained control of the
acquiree.
e. A qualitative description of the factors that make up the
goodwill recognized.
f. The acquisition-date fair value of the total consideration
transferred and the acquisition-date fair value of each major
class of consideration.
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 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 push-down

accounting is permitted when the parent owns 90% or more of
a subsidiary. In these cases the parent could revalue the
subsidiary’s assets and liabilities based on the parent’s
acquisition cost.

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 Subsidiary Formed by Parent

 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
parent’s investment against the subsidiary’s share capital since
the subsidiary would have no retained earnings on formation.

 Carrying amounts = FV of the subsidiary’s net assets

(no goodwill).

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 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 50 years.

 Under this method, the net assets of both the acquiring

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

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 Analysis and Interpretation
of Financial Statements
 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
subsidiary’s assets and liabilities directly.

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 ASPE Differences, Part 1

 Part II of the CPA Canada Handbook 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. (Section 1591)
 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. (Section
1591)
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 ASPE Differences, Part 2

 Part II of the CPA Canada Handbook outlines the main

differences under ASPE continued:
 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. (Section 1625)

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