Document classification: Internal ACCM4300 Financial Reporting Workshop 7: Business Combination (AASB 3) WARNING This material has been reproduced and communicated to you by or on behalf of Kaplan Business School pursuant to Section 113P of the Copyright Act 1968 (Act). This material in this communication may be subject to copyright under the Act. Any further reproduction or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. Unless otherwise specifically referenced, material in this slide deck has been adopted from Financial reporting in Australia / Janice Loftus, Ken Leo, Sorin Daniliuc, Noel Boys, Belinda Luke, Hong Ang, Karyn Byrnes. Second edition. John Wiley & Sons Australia, Ltd; Leo, K, Knapp, J, McGowan, S, Sweeting, J & Meng, L, Company Accounting, 12th edition, John Wiley & Sons Australia, Ltd, Queensland. Prepared by © Kaplan Business School Document classification: Internal Learning objectives 1. Demonstrate an understanding of the nature of a business combination and its various forms 2. Determine the basic steps in the acquisition method of accounting for business combinations 3. Recommend the accounting requirements for a business combination in the books of the acquirer 4. Determine the requirements for subsequent adjustments to the initial accounting for a business combination. Document classification: Internal Learning objectives 1. Demonstrate an understanding of the nature of a business combination and its various forms 2. Determine the basic steps in the acquisition method of accounting for business combinations 3. Recommend the accounting requirements for a business combination in the books of the acquirer 4. Determine the requirements for subsequent adjustments to the initial accounting for a business combination. Document classification: Internal The nature of a business combination • A business combination is defined in Appendix A to AASB 3/IFRS 3 as: A transaction or other event in which an acquirer obtains control of one or more businesses. • 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 directly to investors or other owners, members or participants. Document classification: Internal The nature of a business combination Assuming the existence of two companies, A Ltd and B Ltd, the following general forms of business combinations are covered in this workshop: 1. A Ltd acquires all the assets and liabilities of B Ltd. B Ltd continues as a company, holding shares in A Ltd. 2. A Ltd acquires all the assets and liabilities of B Ltd. B Ltd liquidates. 3. C Ltd is formed to acquire all the assets and liabilities of A Ltd and B Ltd. A Ltd and B Ltd liquidate. Document classification: Internal The nature of a business combination 4. A Ltd acquires a group of net assets of B Ltd, the group of net assets constituting a business, such as a division, branch or segment, of B Ltd. B Ltd continues to operate as a company. A business combination could also occur without any exchange of assets or equity between the entities involved in the exchange. Document classification: Internal Workshop Activity 1 Discuss the importance of identifying the acquisition date Document classification: Internal Learning objectives 1. Demonstrate an understanding of the nature of a business combination and its various forms 2. Determine the basic steps in the acquisition method of accounting for business combinations 3. Recommend the accounting requirements for a business combination in the books of the acquirer 4. Determine the requirements for subsequent adjustments to the initial accounting for a business combination. Document classification: Internal Accounting for business combinations-basic principles The four key steps in this method are noted in paragraph 5 of standard AASB 3. 1. Identify the acquirer. 2. Determine the acquisition date. 3. Recognise and measure the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. 4. Recognise and measure goodwill or a gain from a bargain purchase. Document classification: Internal Accounting for business combinations-basic principles Identifying the acquirer [step 1] • Appendix A of AASB 3/IFRS 3 provides the following definitions: ̶ Acquiree: The business or businesses that the acquirer obtains control of in a business combination. ̶ Acquirer: The entity that obtains control of the acquiree. Document classification: Internal Accounting for business combinations-basic principles Identifying the acquirer [step 1] • Consider the situation where entity A combines with entity B. • To effect the combination, a new company (entity C) is formed, which issues shares to acquire all the shares of both entities A and B. • As entity C is created solely to formalise the organisation structure, it is not the acquirer although it may be considered to be the legal parent of both the other entities. Document classification: Internal Accounting for business combinations-basic principles Determining the acquisition date [step 2] • Acquisition date is defined in Appendix A to AASB 3/IFRS 3 as follows: • The date on which the acquirer obtains control of the aquiree. • A business combination involves the joining together of assets under the control of a specific entity. • Therefore, the business combination occurs at the date the assets or net assets are under the control of the acquirer. Document classification: Internal Accounting for business combinations-basic principles Determining the acquisition date [step 2] • Other dates that are important during the process of the business combination may be: 1. The date the contract is signed 2. The date the consideration is paid 3. A date nominated in the contract 4. The date on which assets acquired are delivered to the acquirer 5. The date on which an offer becomes unconditional. Document classification: Internal Accounting in the records of the acquirer • Account for a business combination in the records of the acquirer. • Where the acquirer purchases assets and assumes liabilities of another entity, it has to consider: 1. The recognition and measurement of the identifiable assets acquired and the liabilities assumed (step 3 of the acquisition method) 2. The recognition and measurement of goodwill or a gain from a bargain purchase (step 4 of the acquisition method). Document classification: Internal Workshop Activity 2 White Ltd has been negotiating with Cloud Ltd for several months, and agreements have finally been reached for the two companies to combine. In considering the accounting for the combined entities, management realises that, in applying AASB 3/IFRS 3, an acquirer must be identified. However, there is debate among the accounting staff as to which entity is the acquirer. Required a) What factors/indicators should management consider in determining which entity is the acquirer? b) Why is it necessary to identify an acquirer? In particular, what differences in accounting would arise if White Ltd or Cloud Ltd were identified as the acquirer? Document classification: Internal Learning objectives 1. Demonstrate an understanding of the nature of a business combination and its various forms 2. Determine the basic steps in the acquisition method of accounting for business combinations 3. Recommend the accounting requirements for a business combination in the books of the acquirer 4. Determine the requirements for subsequent adjustments to the initial accounting for a business combination. Document classification: Internal Recognition and measurement of assets acquired and liabilities assumed [step 3] Recognition • The assets acquired and liabilities assumed are measured at fair value. • That fair value will reflect expectations about the probability of inflows or outflows of benefits. • The probability criterion is then unnecessary where fair values are used as the measurement method. • In recognising the assets and liabilities, it is necessary to classify or designate them. Document classification: Internal Recognition and measurement of assets acquired and liabilities assumed [step 3] • Fair value is defined in Appendix A of AASB 3/IFRS 3 as: the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. • Fair value is basically a market-based measure in a transaction between unrelated parties. • Fair value is measured in accordance with AASB 13/IFRS 13 Fair Value Measurement. Document classification: Internal Recognition and measurement of assets acquired and liabilities assumed [step 3] AASB 13/IFRS 13 describes three valuation techniques that an entity might use to determine fair value: ̶ The market approach ̶ The income approach ̶ The cost approach. Document classification: Internal Accounting by the acquirer: shares acquired in an acquiree • The investment is measured at fair value because the investment is not held within a business model whose objective is to hold assets in order to collect contractual cash flows. • The investment is measured at the fair value of the consideration transferred. • It is expected that in most exchanges the fair value of the shares acquired will equal the fair value of the consideration transferred. Document classification: Internal Accounting by the acquirer: shares acquired in an acquiree Existence of a previously held equity interest • As a business combination occurs when the acquirer obtains control of the acquiree, it is on the date of the second acquisition of shares that the business combination occurs. • In AASB 3/IFRS 3, this is referred to as a business combination achieved in stages — sometimes called a step acquisition. Document classification: Internal Accounting in the records of the acquiree • Where the acquirer purchases the acquiree’s assets and liabilities, the acquiree may continue in existence or may liquidate. • The acquiree accounts affected by the business combination will differ according to the actions of the acquiree. Document classification: Internal Accounting in the records of the acquiree Acquiree does not liquidate • Under AASB 116/IAS 16 Property, Plant and Equipment, when an item of property, plant and equipment is sold, gains or losses are recognised in the statement of profit or loss and other comprehensive income. • Similarly, on the sale of a business, the acquiree recognises a gain or loss. Document classification: Internal Accounting in the records of the acquiree Acquiree liquidates • The accounts of the acquiree are transferred to two accounts, the Liquidation account and the Shareholders’ Distribution account. • To the Liquidation account are transferred: ̶ All liabilities taken over ̶ The expenses of liquidation if paid by the acquiree ̶ Additional expenses to be paid by the acquiree but not previously recognised by the acquiree. Document classification: Internal Accounting in the records of the acquiree Acquirer buys only shares in the acquiree • When the acquirer buys only shares in the acquiree, there are no entries in the records of the acquiree because the transaction is between the acquirer and the shareholders of the acquiree entity. • The acquiree itself is not involved. Document classification: Internal Workshop Activity 3 The trial balance of Jackman Ltd at 1 January 2022 was as follows: Document classification: Internal Workshop Activity 3 (Contd.) • At this date, all the assets and liabilities of Jackman Ltd are sold to Hugh Ltd, with Jackman Ltd going into voluntary liquidation. The terms of acquisition are: • Hugh Ltd is to take over all the assets of Jackman Ltd, as well as the accounts payable of Jackman Ltd. • Costs of liquidation of $700 are to be paid by Jackman Ltd with funds supplied by Hugh Ltd. • Preference shares in Jackman Ltd are to receive two fully paid shares in Hugh Ltd for every three shares held, or alternatively, $0.80 per share in cash payable at the acquisition date. • Ordinary shareholders of Jackman Ltd are to receive two fully paid ordinary shares in Hugh Ltd for every share held or, alternatively, $2.50 in cash payable half at the acquisition date and half in one year’s time. • Debenture holders of Jackman Ltd are to be paid in cash out of funds provided by Hugh Ltd. The debentures have a fair value of $102 per $100 debenture. • All shares issued by Hugh Ltd have a fair value of $1.20 per share. • Costs of issuing and registering the shares issued by Hugh Ltd amount to $80 for the preference shares and $200 for the ordinary shares. • Legal and accounting costs associated with the acquisition of Jackman Ltd amount to $2000. • The two parties agree on the terms of the arrangement, and holders of 6 000 preference shares and 10 000 ordinary shares elect to receive cash. Document classification: Internal Workshop Activity 3 (Contd.) Hugh Ltd assesses the fair values of the identifiable assets and liabilities of Jackman Ltd to be as follows: Hugh Ltd has an incremental borrowing rate of 10%. Required A. Prepare the acquisition analysis in relation to the above acquisition by Hugh Ltd. B. Prepare the journal entries in the records of Hugh Ltd at the date of acquisition. C. Prepare the journal entry for the payment of the deferred consideration in one year’s time Document classification: Internal Learning objectives 1. Demonstrate an understanding of the nature of a business combination and its various forms 2. Determine the basic steps in the acquisition method of accounting for business combinations 3. Recommend the accounting requirements for a business combination in the books of the acquirer 4. Determine the requirements for subsequent adjustments to the initial accounting for a business combination. Document classification: Internal Subsequent adjustments to the initial accounting for a business combination • Account for subsequent adjustments to the initial accounting for a business combination. • Three areas where adjustments may need to be made subsequent to the initial accounting after acquisition date are: ̶ Goodwill ̶ Contingent liabilities ̶ Contingent consideration. Document classification: Internal Subsequent adjustments to the initial accounting for a business combination Goodwill • Having recognised goodwill arising in the business combination, the subsequent accounting is directed from other accounting standards. ̶ Goodwill is not subject to amortisation but is subject to an annual impairment test as detailed in AASB 136/IAS 36 Impairment of Assets. ̶ Goodwill cannot be revalued because AASB 138/IAS 38 Intangible Assets does not allow the recognition of internally generated goodwill. Document classification: Internal Subsequent adjustments to the initial accounting for a business combination Contingent liabilities • Having recognised any contingent liabilities of the acquiree as liabilities, the acquirer must then determine a subsequent measurement for the liability. • Under AASB 137/IAS 37 paragraph 36, the liability would be measured at the best estimate of the expenditure required to settle the present obligation at the end of the reporting period. Document classification: Internal Subsequent adjustments to the initial accounting for a business combination Contingent consideration • Subsequent to the business combination, paragraph 54 of AASB 3/IFRS 3 requires the accounting for contingent consideration to be in accordance with the accounting standard that would normally apply to these accounts. • Where the contingent consideration is a financial liability, it will be accounted for under AASB 9/IFRS 9 and measured at fair value with movements being accounted for in accordance with that standard. Document classification: Internal Disclosure — business combinations • Paragraphs 59–63 of AASB 3/IFRS 3 contain information on disclosures required in relation to business combinations. • Goodwill is not to be considered just a residual calculation • An understanding of where the synergies exist will assist management in managing the earnings from goodwill as well as in any later impairment tests of goodwill. Document classification: Internal Workshop Activity 4 On 1 July 2022, the financial position of Thurman Ltd was as follows: Document classification: Internal Workshop Activity 4 (Contd.) Uma Ltd acquired all the assets and assumed all the liabilities of Thurman Ltd on 1 July 2022. In exchange, Uma Ltd agreed to: • issue 5 Uma Ltd shares for every Thurman Ltd share held. Uma Ltd shares were assessed to have a fair value of $8 per share. • Costs of share issue were $600. • transfer a patent to the former shareholders of Thurman Ltd; the patent had been internally generated by Uma Ltd and was carried at $400 000. It was considered to have a fair value of $1 200 000. • pay cash of $2.00 per share to the former shareholders of Thurman Ltd for each share held in Thurman Ltd. Document classification: Internal Workshop Activity 4 (Contd.) • At 30 June 2022, Thurman Ltd had reported a contingent liability relating to a guarantee given by that company to another entity. Thurman Ltd did not record the guarantee as a liability because of the difficulty of measuring the liability. The fair value of this contingent liability was assessed as $20 000. • Uma Ltd incurred $9000 in costs in relation to accounting and legal fees in relation to its acquisition of Thurman Ltd. Required Prepare the journal entries in the records of Uma Ltd in relation to its acquisition of Thurman Ltd at 1 July 2022. Document classification: Internal Key Terms Acquirer The entity that obtains control of the acquiree. Acquisition date The date on which the acquirer obtains control of the acquiree. Business combination A transaction or other event in which an acquirer obtains control of one or more businesses. Fair value The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Goodwill An asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognised. Document classification: Internal Additional Readings and Resources Please refer to the additional resources listed below, available under Weekly Content > Week 7 on your Resource List. Australian Accounting Standards Board (AASB), 2023, AASB 3 Business Combinations, AASB. CPDbox, S 2021, IFRS 3 Business Combinations - summary 2021, [online video] YouTube. Loftus, J., Leo, K., Daniliuc, S., Luke, B., Ang, H.N., Bradbury, M., Hanlon, D., Boys, N. & Byrnes, K. (2022). Financial Reporting. 4th ed. John Wiley & Sons Australia, Ltd. Document classification: Internal