Business Combinations
(Text, Chapter 3)
Presenter
Erin Rao
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Chapter 3 Learning Objectives
1. Define a business combination and evaluate relevant
factors to determine whether control exists in a business
acquisition.
2. Describe the basic forms for achieving a business
acquisition.
3. Prepare a balance sheet for an acquisition accomplished
by a purchase-of-net-assets.
4. Prepare a consolidated balance sheet for an acquisition
accomplished purchasing 100% of the acquiree’s
outstanding voting shares.
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INTRODUCTION TO BUSINESS
COMBINATIONS
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Business combinations defined
• IFRS 3: A business combination is a
transaction or other event in which an acquirer
obtains control of one or more businesses.
• Transactions sometimes referred to as “true
mergers” or “mergers of equals” are also
business combinations.
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Business combinations defined
Conceptually, a business combination occurs when
businesses combine their operations. In theory, this
can happen either by one acquiring the other or by the
two businesses joining together to become a single
economic entity.
Current accounting practices require that all business
combinations be accounted for as acquisitions –
acquisition accounting.
A business combination is essentially the acquisition of
control of all (or substantially all) of the assets of
another business that are capable of being conducted
as a business.
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Business combinations defined
A business is defined as an integrated set of
activities and assets that is capable of being
conducted and managed for the purpose of
providing a return in the form of dividends, lower
costs or other economic benefits to its owners.
The purchase of all the assets of a business is not
necessarily a business combination, but if it is
purchased as a going concern, it is a business
combination.
Will a potential buyer will be able to manage the
integrated set of assets as a business?
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Forms of business combinations
Business combinations may take the form of:
– acquisition of net assets (i.e., acquisition of assets and assumption
of liabilities);
– acquisition of assets but not the liabilities;
– acquisition of shares.
They may also be contractual arrangement or creation of a
new company.
Consideration may take the form of cash, debt, shares or
some combination of these.
The consideration may be fixed at the time of acquisition or
may contain contingent components.
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Income tax considerations
• Acquisition of assets will usually be preferred
by the acquirer because it provides larger CCA
deductions and no inherited tax assessment
issues.
• Acquisition of shares will usually be preferred
by the acquiree because the resulting capital
gains are subject to favourable tax treatment.
• An advantage to the acquirer of acquiring
shares is that not all of the shares must be
purchased to obtain control.
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The purchase method
The purchase method:
– used in Canada up to 2011;
– an acquirer must be identified;
– the business combination is reported as if it were
a purchase of assets;
– the acquirer’s assets remain at their book values;
– the acquiree’s assets are recorded at their cost
to the acquirer.
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The acquisition method
The acquisition method: IFRS 3
– Canadian GAAP from 2011; previously (and still)
US GAAP and IFRS
– an acquirer must be identified;
– the business combination is reported as if it were
a purchase of assets;
– the acquirer’s assets remain at their book values;
– the acquiree’s assets are recorded at their fair
values.
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The new entity method
The new entity method:
– this method is based on the concept that when
two businesses combine, the result is a new
business entity being created;
– both company’s assets would be recorded at their
fair values on the acquisition date;
– this method has never been considered
acceptable in practice but has some theoretical
support.
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Pooling of interests method
The pooling-of-interests method:
– the business combination is treated as an
inconsequential combining of interests;
– both companies’ assets remain at their book
values;
– income is combined retroactively;
– this method is no longer accepted as GAAP.
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Pooling of interests method
If an acquirer could not be identified, earlier standards permitted
accounting for the business combination as a pooling of
interests.
In this method, the assets and liabilities of the companies were
added together at their book values and incomes were
combined retroactively as if the companies had always been
one.
The lower book values and lower amortization charges resulted in
higher net income and a higher return on capital. As a result,
companies sought to use this method and its use was abused in
the United States.
Consequently, the pooling of interests method is no longer
permitted in either Canada or the United States, nor is it
permitted under the International Financial Reporting Standards.
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THE ACQUISITION METHOD OF
ACCOUNTING FOR BUSINESS
COMBINATIONS
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Establishing the acquisition date
The acquisition date is the date on which the
acquirer obtains control of the acquiree:
– the date on which the net assets or equity interests are
received and the consideration is given; or
– the date of a written agreement, or a later/earlier date
designated therein, that provides that the control of the
acquired enterprise is effectively transferred to the
acquirer on that date, subject only to those conditions
required to protect the interests of the parties involved.
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Identifying the acquirer
•
If the transaction is for cash, the company
providing the cash is the acquirer.
•
If the transaction is for shares, the acquirer is
the predecessor company whose
shareholders have the majority of the voting
shares following the combination.
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Identifying the acquirer
Other factors:
–
–
–
–
largest block of shares;
composition of the board of directors;
composition of senior management;
payment of a premium over market
value.
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Determining the acquisition cost
• The acquisition cost (or purchase price) is the total of:
– any cash paid
– the fair value of any other assets transferred
– the present value of any promises to pay in the future
– the fair value of any shares issued and
– the fair value of any contingent consideration.
• Any direct costs of the acquisition (except the cost of
issuing shares or debt) are expensed in the period in which
they were incurred.
• Costs of issuing shares or debt are deducted from the
related liability/equity account. (Intermediate Accounting)
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Recognition of acquired assets
• At the acquisition date, the acquirer must
recognize, separately from goodwill, the
identifiable assets acquired, the liabilities assumed
and any non-controlling interest.
• Intangible assets must be recognized if they can
be separately identified.
– Such recognition must be made, even if the
acquiree has not previously recorded the asset/
liability (e.g. internally developed patents or
technology; customer list; some contingent
liabilities).
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Deferred income taxes at
acquisition
• The fair values at the acquisition date are
determined without reference to their tax values.
• Deferred income tax balances must then be
recalculated based on the difference between the
carrying value of the assets or liabilities in the
consolidated financial statements and their tax
values.
• The tax values may or may not be changed by the
combination; this depends upon the legal form of the
combination, tax rollover provisions, etc.
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Non-controlling interest
• Non-controlling interests (NCI) arise where the legal
form of the business combination involves the
acquisition of shares and the acquirer obtains
control while owning less than 100% of the shares.
• IFRS 3 allows two different bases for measuring NCI
on the acquisition date:
– valued at the fair value of the identifiable assets/
liabilities;
– valued at the fair value of the enterprise (including
goodwill).
• We will consider this in more depth later in the
course.
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Goodwill
• Conceptually, goodwill is the capitalized expected
value of the enterprise’s earning power in excess of
a normal rate of return in the industry in which it
operates.
• It is never recognized when internally generated but
is recognized in a business combination.
• It is calculated as a residual – the difference
between the fair value of the business (determined
from the amount paid for the controlling interest) and
the fair values of its identifiable net assets.
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Goodwill
• Goodwill is not amortized.
• Each cash generating unit must be tested at
least annually for impairment of goodwill.
• Goodwill (net of any impairment) must be
separately disclosed in the financial statements
(where material).
• Goodwill impairment losses must be disclosed
(where material).
• Impairment losses related to goodwill may never
be reversed.
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Negative goodwill
• Bargain Purchase
• Negative goodwill can arise from overvalued
net assets or from a bargain purchase.
• Before determining that there is negative
goodwill, a reassessment of all fair values must
be performed.
• If there is still a negative balance, taken to the
acquirer’s income as a gain on the acquisition
date.
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CONTROL THROUGH…
1. ACQUISITION OF NET ASSETS
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Acquisition of net assets
Holding Company Inc. acquired all of the net assets of Cheetah
Inc. by a cash payment on January 1, 2013. The balance sheet of
Holding Company Inc. immediately before the acquisition was as
follows:
Assets
Cash
Receivables
Inventory
Capital Assets (net)
Total Assets
Holding Company Inc.
Balance Sheet at January 1, 2013
NBV
$ 220,000
60,000
70,000
150,000
$ 500,000
Liabilities and Equities
Current liabilities
Long-term debt
Share capital (1,000 shares)
Retained earnings
Total
$ 60,000
180,000
160,000
100,000
$ 500,000
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Acquisition of net assets
At that date the balance sheet of Cheetah Inc. and the fair market
values of the assets and liabilities were as follows:
Assets
Cash
Receivables
Inventory
Capital Assets (net)
Total Assets
Liabilities and Equities
Current liabilities
Long-term debt
Share capital
Retained earnings
Total
Cheetah Inc.
Balance Sheet at January 1, 2013
NBV
FMV
$ 20,000
$ 20,000
30,000
30,000
50,000
40,000
70,000
130,000
$170,000
$ 40,000
40,000
60,000
30,000
$170,000
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$ 40,000
50,000
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Acquisition of net assets
What amount should Holdings be prepared to pay for the net
assets?
The maximum amount that they would pay equals the fair value of
the net assets plus whatever Holdings considers the goodwill of
Cheetah to be worth.
Assume that the amount paid is $150,000.
Holdings make to record the transaction?
Cash
Receivables
Inventory
Capital Assets
Current liabilities
Long-term debt
Cash
Goodwill
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What entries should
$ 20,000
30,000
40,000
130,000
$ 40,000
50,000
150,000
20,000
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Acquisition of net assets
What entries should Cheetah make to record the
transaction?
Cash
$150,000
Current liabilities
40,000
Long-term debt
40,000
Cash
Receivables
Inventory
Capital Assets (net)
Gain on sale of assets
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$ 20,000
30,000
50,000
70,000
60,000
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Acquisition of net assets
The balance sheet of Holding Company Inc., immediately after the
acquisition will be as follows:
Holding Company Inc..
Balance Sheet at January 1, 2013
Assets
Cash
$ 220,000
Receivables
60,000
Inventory
70,000
Capital Assets (net)
150,000
Goodwill
Total Assets
$ 500,000
Liabilities and Equities
Current liabilities
$ 60,000
Long-term debt
180,000
Share capital (1,000 shares) 160,000
Retained earnings
100,000
Total
$ 500,000
- $150,000 + $20,000
+ $ 30,000
+ $ 40,000
+ $130,000
+ $ 20,000
+ $ 40,000
+ $ 50.000
$ 90,000
90,000
110,000
280,000
20,000
$ 590,000
$ 100,000
230,000
160,000
100,000
$590,000
Note that this is not a consolidated balance sheet.
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Acquisition of net assets
• It is possible that the acquisition could take place by
Holding Company Inc. issuing 500 new shares (worth
$150,000) to acquire the net assets of Cheetah Inc.
• If so, the only differences to the balance sheet after the
transaction are that cash would be higher by $150,000 and
share capital would also be higher by the same amount.
• You should note that in this case, Cheetah would own onethird of the outstanding shares of Holdings and would
presumably account for it as a significant influence
investment.
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Acquisition of net assets
Important to note when control is achieved through
purchase of net assets:
• The journal entry made by Holding Company is in
Holding Company’s books or general ledger system
• This is not a consolidation!
• The selling company (Cheetah) records a journal
entry in its books or general ledger system for the
sale of the net assets
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CONTROL THROUGH…
2. ACQUISITION OF SHARES
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Acquisition of shares
• Now consider what would happen if, instead of
paying $150,000 to obtain the net assets of
Cheetah, Holdings paid $150,000 to acquire all the
shares of that company.
• What journal entries would each company record to
reflect this transaction?
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Acquisition of shares
• In Holdings, the entry would be:
Dr. Investment in Cheetah
Cr. Cash
$150,000
$150,000
• Cheetah would make no entry as Cheetah is not a
party to the transaction. The transaction is
between Holdings and the former shareholders of
Cheetah. Cheetah would only change the names
of its shareholders in the share register.
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Acquisition of shares
The balance sheet of Holding Company Inc., immediately after the
acquisition will be as follows:
Holding Company Inc..
Balance Sheet at January 1, 2013
Assets
Cash
Receivables
Inventory
Investment in Cheetah Inc.
Capital Assets (net)
Total Assets
Liabilities and Equities
Current liabilities
Long-term debt
Share capital (1,000 shares)
Retained earnings
Total
$ 220,000
60,000
70,000
- $150,000
150,000
$ 500,000
$ 70,000
60,000
70,000
150,000
150,000
$ 500,000
$ 60,000
180,000
160,000
100,000
$ 60,000
180,000
160,000
100,000
$ 500,000
$ 500,000
+ $150,000
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Acquisition of shares
• Since the substance of the business combination is
the same whether the purchase is of net assets or of
shares, and since we want the financial statements
to represent the substance of transactions, the
financial statements of Holdings should be the same
whichever form of acquisition is used.
• If the acquisition is of net assets, the combining is
done in the accounting records of Holdings. If the
acquisition is of shares, the combining is done
through the preparation of consolidated financial
statements.
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Acquisition of shares
• To achieve this, we must combine the financial
statements of the two companies, making the
eliminations necessary to avoid duplication =
consolidation entries or eliminating entries.
• On the acquisition date, the only relevant statement
is the balance sheet (statement of financial position)
because we do not start to include the revenues and
expenses of the acquiree until after the acquisition
date.
• We begin the consolidation process by analyzing
the investment account in the acquirer’s books.
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Acquisition of shares
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Acquisition of shares
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Acquisition of shares
Consolidation entry required to eliminate the
investment account and record the assets/liabilities
at fair value and the goodwill on the acquisition date:
DR Share capital (Cheetah)
DR Retained earnings (Cheetah)
CR Investment in Cheetah
CR Inventory
DR Capital assets
CR Long-term debt
DR Goodwill
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60,000
30,000
150,000
10,000
60,000
10,000
20,000
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Acquisition of shares
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Acquisition of shares
• You should note that the consolidated balance
sheet on the previous slide is identical in every
respect to the balance sheet of Holdings
immediately after the transaction when the
business combination was achieved through a
purchase of net assets (slide 30).
• This will always be the case when the acquirer
acquires 100% of the outstanding shares of the
acquiree.
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Reporting Depreciable Assets
• When we prepared the consolidated balance sheet,
we considered only the net book value of the capital
assets (i.e., cost less accumulated depreciation).
• When preparing such statements in practice, we
must decide what to do about the accumulated
depreciation of the subsidiary on the acquisition
date.
• Your text gives two alternatives:
– proportionate restatement and
– net the amortization against cost at acquisition
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Reporting Depreciable Assets
• We will use the net method (as your text does).
• In this method, the capital assets of the subsidiary
are brought into the consolidated balance sheet with
a cost equal to their fair value (and no accumulated
depreciation).
• This gives the same results as when the acquisition
is done through a purchase of net assets.
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ASPE Differences
• Parent companies may use either consolidation or
report investments in subsidiaries using the cost or
equity method. All subsidiaries must be reported
using the same method.
• The cost method may not be used if the subsidiary’s
shares are traded on an active market; fair value
should be used with changes through net income.
• Private companies that choose to use push-down
accounting must disclose the valuation changes in
the year in which push-down accounting is first
applied.
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Reverse Takeovers
• Consider what happens when A Company which has 10,000
shares outstanding, issues 20,000 shares to acquire all of the
outstanding capital of B Company. Control of the combined
entity is in the hands of the original shareholders of B Company
who own 2/3 of the shares of A Company. This is called a
reverse takeover.
• This might be done to acquire tax losses or to acquire a listing
on a stock exchange, amongst other reasons.
• IFRS requires that the business combination be accounted for
according to its substance, not its form. The consideration is
equal to the market value of the number of shares that B
Company would have had to issue in order to effect a regular
acquisition. B Company’s shareholders’ equity values (after
giving effect to the deemed issue) are those which will appear in
the consolidated financial statements.
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Reverse takeovers
This is covered in Appendix 3A in the textbook and
will not be examined.
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COMPREHENSIVE PROBLEM
COURSE COMPANION
PROBLEM 2-2
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