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Business Combination-lesson 1

Accountancy (Saint Ferdinand College)

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SUBJECT: Accounting 15
DESCIPTIVE TITLE: Accounting for Business Combination
Instructor: Alfredo R. Cabiso

This course covers essential issues on financial accounting and reporting in Business
Combinations. It covers accounting on Mergers and Consolidation.
Page | 1
The materials in this learning module are taken from the following:
1. Main reference Textbook: Advanced Financial Accounting Volume 2 by Antonio
Dayag.
2. Other references:
 Advanced Financial Accounting Volume 2 by Peralta, et.al.
 CPA Reviewer in Practical Accounting by Antonio Dayag
 CPA Reviewer in Practical Accounting by Peralta, et.al.

LESSON NO.1
BUSINESS COMBINATIONS -1
STATUTORY MERGER AND STATUTORY CONSOLIDATION

Learning Objective:
The students should be able:
 To know the reasons or purposes of business combinations
 To know the types of business combinations
 To know scope of business combinations
 To know the accounting procedures for business combinations

Introduction:
Accounting for business combinations is one of the most significant and interesting topics of
accounting theory and practice. Business combinations involve financial transactions of
immeasurable magnitudes, business empires, triumphant stories and individual fortunes,
managerial genius and managerial debacles. By their nature, they affect the destiny of entire
companies. Each is exceptional and must be evaluated in terms of its economic substance,
regardless of its legal form.

Reasons for business combinations

1. Cost advantage. It is commonly less expensive for a firm to obtain needed amenities
through combination rather than through development
2. Lower risk. The acquisition of reputable product lines and markets is usually less risky
than developing new products and markets. The threat is especially low when the
purpose is diversification.
3. Avoidance of takeovers. Many companies combine to evade being acquired
themselves. Smaller companies tend to be more susceptible to corporate takeovers,
therefore many of them adopt forceful buyer strategies to defend against takeover
attempts by other companies.
4. Acquisition of intangible assets. Business combinations bring together both
intangible and intangible resources.
5. Other reasons. Entities may choose business combination over other forms of
expansion for business tax advantages (for example, tax-loss carry forward), for
personal income and estate tax advantages or for personal reasons.

Types of business combinations

1. Based on structure of business combinations
2. Based on the methods used to accomplish the combination
3. Based on accounting method used

1.Business combinations based on structure of business combinations

a. Horizontal integration – this type of combination is one that involves companies within
the same industry that have been previously been competitors.

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b. Vertical integration. – this type of business combination takes place between two
companies involved in the same industry, but at different levels. It normally involves a
combination of a company and its suppliers or customers.

c. Conglomerate combination – is one involving companies in unrelated industries having

little, if any, production or market similarities for purpose of entering into new markets or
industries
Page | 2 d. Circular combination – entails same diversification, but not have a drastic change in
operation as a conglomerate

2. Business combinations based on the methods/legal form used to accomplish the combination
a. Acquisition of assets. The books of the acquired (acquire) company are closed out and
its assets and liabilities are transferred to the books of the acquirer (or the
acquiring/surviving company)
b. Acquisition of common stock (stock acquisition). The books of the acquirer
(acquiring) company and acquire (acquired) company remain intact and consolidated
financial statements are prepared periodically

Acquisition of Assets
The terms merger and consolidation are often used synonymously for acquisitions. However,
legally and in accounting there is a difference. The distinction between these categories is
largely a technicality, and the terms mergers, consolidation, and acquisitions are popularly used
interchangeably.

Statutory Merger. A statutory merger entails that acquiring company survives, whereas the
acquired company (or companies) ceases to exist as a separate legal entity, although it may be
continued as a separate division of the acquiring company. Thus, if A Company acquires B
Company in a statutory merger, the combination is often expressed as:
A Company + B Company = A Company

Statutory Consolidation. A statutory consolidation results when a new corporation is

formed to acquire two or more other corporations, the acquired corporations then cease to
exist (dissolve) as separate legal entities. For example, if C Company is formed to consolidate
a company, the combination is generally expressed as:
A Company + B Company = C Company
Stockholders of the acquired companies A and B become stockholders in the new company
(C). The acquired companies in a statutory consolidation maybe operated as separate divisions
of the new corporation, just as they maybe be under a statutory merger.

Accounting Concept of Business Combination

The accounting standard relevant for accounting for business combinations is PFRS 3
(Business Combinations issued by the international Accounting Standards Board (IASB)

Definition
PFRS3 Appendix A defines “business combination” as a transaction or other event in which an
acquirer obtains control of one or more businesses. Transactions sometimes referred to as
“true merger” or” mergers of equals: also, are business combinations.

A first key aspect in this definition is “control”. This means that there must be a triggering
event or transaction and not, for example, merely a decision to start preparing combined or
consolidated financial statements for an existing group. Control can usually be obtained either
by:

1. Buying the assets themselves (which automatically gives control to the buyer.
2. Buying enough shares in the corporation that owns the assets to enable the investor
(acquirer) to control the investee (acquire) corporation (which makes the purchased
corporation a subsidiary.

Economic events that might result in an entity obtaining control include:

a. Transferring cash or other assets (including net assets) that constitute a business)
b. Incurring liabilities
c. Issuing equity instrument
d. A combination of the above, and

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e. A transaction not involving consideration, such as combination by accounting alone

(.e.g. a dual listed companies)

The second key aspect of the definition is that the acquirer obtains control of a business

Scope of Business Combination

The following transactions are within the scope of PFRS 3:
Page | 3 1. Combinations involving mutual entities. A mutual entity is defined as an entity that
provides dividends, lower costs or other economic benefits directly to its owners,
members or participants, e.g., a mutual insurance company, a credit union and a
cooperative entity.
2. Combinations achieved by contract alone (dual listing stapling). Two entities enter
into a contractual arrangement which covers, for example, operations under a single
management and equalization of voting power and earnings attributable to both entities’
equity investors. Such structure s may involve a ‘ stapling’ or formation of a dual listed
corporation.

Accounting for business combination by contract under PFRS 3 requires one of the
combining entities to be identified as the acquire.

Transactions or events that are not within the the scope of PFRS 3 (business combinations)
are those that does not give rise to goodwill (or bargain purchase gain)

The acquisition Method

The acquisition method is applied on the acquisition date which is the date the acquirer obtains
control of the acquire. The acquisition method approaches a business combination from the
perspective of the acquirer (not the acquire), the entity that obtains control of the other
entity(ies) in the business combination.

Under the acquisition method all assets and liabilities are identified and reported at their fair
values.

Accounting procedures for a business combination under the acquisition method

1. Identify the acquirer
2. Determine the acquisition date
3. Calculate the fair value of the purchase consideration transferred (i.e., the cost of
purchase)
4. Recognize and measure the identifiable assets and liabilities of the business, and
5. Recognize and measure either goodwill or a gain from a bargain purchase, if either
exists in the transaction

Calculating the fair value of the consideration transferred: Accounting records of the
acquirer
According to PFRS 3, paragraph 37, the consideration transferred:
 Is measured at fair value at acquisition date
 Is calculated as the sum of the acquisition date fair values of:
1. The assets transferred by the acquirer;
2. The liabilities incurred by the acquirer to former owners of the acquire; and
3. The equity interest issued by the acquirer.

The consideration transferred includes the following items:

1. Cash or other monetary assets. The fair value is the amount of cash or cash
equivalent dispersed. The amount is readily determinable. One problem that may occur
arises when the settlement is deferred to a time after the acquisition date. For deferred
payment, the fair value is the amount the entity would have to borrow to settle the debt
(i.e. the present value of the obligation. Hence the discount rate used is the entity’s
incremental borrowing rate.
2. Non-monetary assets. These are assets such as property, plant and equipment,
investments, licenses ad patents. In this case, the acquirer is in effect selling the non-
monetary assets to the acquire.
3. Equity instruments. The acquirer issues its own shares as consideration.

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4. Contingent consideration. The contingent consideration may include the distribution

of cash or other assets or the issuance of debt or equity securities. Contingent
considerations is an add-on to the base acquisition price that is based on events
occurring or conditions being met some time after the purchase takes place

Page |Share-based
4 payment awards. The acquirer is obliged to replaced the acquiree’s awards,
either all or a portion of the market-based measure of the acquirer’s replacement awards is
included in measuring consideration transferred in the business combination

Acquisition-Related costs
These are excluded in from the measurement of the consideration paid because such
costs are not part of the fair value of the acquire and are not assets.
1. Cost directly attributable to the combination which includes costs such as finder’s
fee, advisory, legal accounting, valuation and other professional or consulting
fees.
2. Indirect ongoing costs, general costs including the cost to maintain an internal
acquisition department (mergers and acquisitions department), as well as other
general administrative costs.

Acquisition-Related costs associated with a business combination are accounted for as

expenses

Measuring and recognizing Goodwill or a gain from bargain purchase. Accounting

records of the acquirer.

Goodwill is accounted for as an asset and is defined in PFRS 3 as 1’ an asset representing the
future economic benefits arising from other assets as acquired in a business combination that
are not individually identified and separately recognized.

The criterion of being individually identified relates to the characteristics of

“identifiability” as used in PAS 38 Intangible Assets to distinguish intangible assets from
goodwill. Note paragraph 11 of PAS 38 in this regard requires an intangible asset to be
identifiable to distinguish it from goodwill

Under statutory merger and statutory consolidation. Goodwill is determined as the excess of
the consideration transferred over the net fair value of the identifiable assets and liabilities
assumed, thus:

GOODWILL = consideration transferred less acquirer’s interest net fair value of the
acquiree’s identifiable assets and liabilities

Items included in Goodwill

The acquirer includes into goodwill the following:
 Acquired intangible asset that is not identifiable as of the acquisition date
1. Assembled workforce of the acquire – is a collection of employees rather than an
individual employee. It did not arise from contractual or legal right.
 Items that do not qualify as assets at the acquisition date
2. Potential contracts with new customers or contracts under negotiations but are yet
uncommitted
3. Contingent assets - another example would be the place the acquire has a
contingent asset.
4. Future contract renewal

Bargain Purchase Gain. When the acquirer’s interest in the net fair value of the acquiree’s
identifiable assets and liabilities is greater than the consideration transferred, the difference is
called bargain purchase gain, thus

Bargain purchase gain =Acquiree’s interest net fair value assets and liabilities less
consideration transferred

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IDENTIFIABLE INTANGIBLE ASSETS

An intangible asset is regarded as identifiable if it meets the separability criterion or the
contractual-legal criterion
 Separability criterion. An intangible is separable if it is capable of being separated or
divided from the entity sold, transferred, licensed, rented or exchanged, either
individually or together with a related contract. Examples: Customer and subscriber
Page | 5 lists, depositor relationships, registered trademarks, unpatented technical expertise,
favorable operating leases, licenses and technology patents.
 Contractual-legal criterion. An intangible asset that arises from contractual or legal
rights is identifiable regardless of whether those rights are transferable or separable from
the acquire, or from other rights and obligations. Examples: acquired leases a
manufacturing facility under an operating lease that has terms favorable to market terms,
an acquirer owns and operates an electric plant, an acquirer owns a technology patent.

The following items are included in the illustrative examples that the IASB regards as meeting
the definition of an intangible asset and are therefore to be recognized separately from goodwill.
 Marketing-related intangible assets
a) Trademarks, trade names, service marks, collective design
b) Trade dress(unique color, shape or package design
c) Newspaper mastheads
d) Internet domain names
e) Non-competitive agreements
 Customer-related intangible assets
a) Order or production backlog
b) Customer contracts and the related customer relationships
c) Non-contractual customer relationships
d) Customer lists
 Artistic-related intangibles
a) Plays, operas and ballets
b) Books, magazines, newspapers and other literary works
c) Musical works such as compositions, song lyrics and advertising jingles
d) Pictures and photographs
e) Video and audiovisual material, including motion pictures or films, music videos and
television programs
 Contract-based intangible assets
a) Licensing royalty and standstill agreements
b) Advertising construction, management, service or supply contracts
c) Lease agreements whether the acquirer is the lessee or the lessor)
d) Construction permits
e) Franchise agreements
f) Operating and broadcasting rights
g) Use rights such as drilling, water, air, mineral, timber-getting and route authorities
h) Servicing contracts such as mortgage servicing contracts
i) Employment contracts
 Technological-based intangible assets
a) Patented technology
b) Computer software and masks works
c) Unpatented technology
d) Databases including plants
e) Trade secrets such as secret formulas, processes or recipes
 Other intangible assets being acquired as part of business combinations with
their proper valuations
a) Emission rights
b) Reacquired rights

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ILLUSTRATIVE PROBLEMS

Problem #1. Valuation of assets and liabilities, consideration transferred, goodwill and
bargain purchase

Tony Inc. acquires all of Jaramillo Co.s assets and liabilities on January 1, 2020. Tony incurs
Page |the
6 following costs for the acquisition:
50,000 shares of new Tony common stock, par value P2/
share, market value P80/share to the former owner of Fair value of
Jaramillo P4,000,000 stock issued
Registration fees connected with issuing the new shares,
paid in cash 500,000 Cash payment
Cash paid to former stockholders of Jaramillo, there were
200,000 shares of Jaramillo outstanding, and Tony
agreed to pay P90 in cash for each share of 18,000,000 Cash payment
outstanding Jaramillo stock
Consulting fees paid to Philippine brokers, in cash 1,100,000 Cash payment

The balance sheets of both companies immediately prior to the acquisition are as follows:
Tony Inc Jaramillo Co.
Assets Book Value Book value Fair Value
Cash P25,000,000 P90,000 P90,000
Receivables 2,000,000 200,000 190,000
Inventories 20,000,000 8,110,000 7,000,000
Plant & equipment, net 99,500,000 50,000,000 40,000,000
Trademarks 5,000,000 1,000,000 4,000,000
Total assets P151,500,000 P59,400,000
Liabilities & Equity
Current liabilities P500,000 P400,000 400,000
Long-term liabilities 70,000,000 45,000,000 47,000,000
Common stock, par 2,000,000 1,000,000
APIC 55,000,000 10,000,000
Retained earnings 25,000,000 6,000,000
Treasury stock (1,000,000) (3,000,000)
Total liabilities & equity P251,500,000 P59,400,000,

In addition to the assets and liabilities already reported, Jaramillo has the following previous
unrecorded intangible assets that meet the requirements for capitalization:
Intangible asset Fair value
Brand names P5,000,000
Secret formula 7,000,000

Required:
1. Prepare the journal entry or entries to record the acquisition on Tony’s books
2. Assume the same information as above, but Jaramillo has an additional previously
unrecorded intangible that meets the requirements for capitalization: a noncompetitive
agreement with a fair value of P10,000,000. All fair value calculations have been double
checked for accuracy and found to be correct. Prepare the journal entry or entries to record
the acquisition on Tony’s books.
3. Prepare Tony’s balance sheet for (1) and (2) above immediately following the merger.
4. Determine the following amounts immediately following the merger: (a) total assets; (b) total
liabilities; (c) additional paid-in capital (share premium), (d) retained earnings (accumulated
profit or loss); and (e) stockholders’ equity

Problem #2. Valuation of Assets acquired and liabilities assumed, Measurement of

Consideration transferred, change in value of assets acquired, pre-acquisition
contingency, In-process R& D.

Sandy Corporation’s balance sheet at January 2, 2020 is as follows:

Dr(Cr)
Cash and receivable P200,000,000
Inventories 600,000,000
Property, plant and equipment(net) 7,500,000,000

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Current liabilities (400,000,000)

Long-term debt (7,200,000,000)
Capital stock (7,200,000)
Retained earnings (25,000,000)
Accumulated other comprehensive income (5,000,000)

An analysis of Sandy’s assets and liabilities reveals that book values of some reported items do
Page |not
7 reflect their market values at the date of acquisition.
 Inventories are overvalued by P200,000,000
 Property, plant and equipment is overvalued by P2,000,000,000
 Long-term debt is undervalued by P100,000,000

In addition, the following items are not currently reported on Sandy’s balance sheet
 Customer contracts, valued at P25,000,000
 Skilled workforce valued at P45,000,000
 In-process research and development, valued at P300,000,000
 Potential contracts with prospective customers, valued at P15,000,000
 Sandy has not recorded expected future warranty liabilities with a present value of
P10,000,000

On January 2, 2020, Velasco Corp. issues new stock with a market value of P700,000,000 to
acquire the assets and liabilities of Sandy. Stock registration fees are P100,000,000, paid in
cash. Consulting accounting and legal fees connected with the merger are P150,000,000, paid
in cash. In addition, Velasco enters into an earnings contingency agreement, whereby Velasco
will pay the former shareholders of Sandy an additional amount if Sandys’ performance meets
certain minimum levels. The present value of the contingency is estimated at P50,000,000.

Required:
1. Prepare the journal entry or entries Velasco make to record the acquisition
2. Now assume that during March 2020, new information comes in regarding the value of
Sandy’s property, plant and equipment at the date of acquisition. It is determined that
the property was actually worth P1,500,000 less than previously estimated. Make the
entry to record the new information.

Problem # 3. Assets and liabilities acquired, goodwill and bargain purchase gain,
contingent consideration, changes in contingent consideration.

Here are the pre-acquisition balance sheets of Pop Company and Sicle Company on
December 31, 2019:
Pop Co. Sicle Co.
Book Value Book value Market Value
Current Assets P5,000,000 P2,000,000 P1,500,000
Investments 1,000,000 500,000 500,000
Land 10,000,000 5,000,000 6,000,000
Buildings (net) 40,000,000 25,000,000 16,000,000
Equipment(net) 25,000,000 10,000,000 2,000,000
P81,000,000 P42,500,000
Current liabilities P4,000,000 P1,500,000 1,500,000
Long-term liabilities 20,000,000 10,000,000 12,000,000
Common stock, P10 par 5,000,000 1,000,000
Additional paid-in capital 40,000,000 20,000,000
Retained earnings 12,000,000 10,000,000
P81,000,000 P42,500,000

In addition to the above, Sicle Co has identifiable intangibles with a fair value of P5,000,000, not
recognized on its books but appropriately capitalized by Pop.

On January 1, 2016, Pop issues 400,000 shares of its stock with a par value of P10/share and
a market value of P100/share. To acquire Sicle Company’s assets and liabilities. Stock
registration fees are P1,100,000, paid in cash.

Required:
1. Present the journal entry that Pop makes to record the acquisition.

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2. In relation to no. 1 requirement, determine the following: (a) total assets; (b) total
liabilities; (c)additional paid-in capital (share premium); (d) retained earnings
(accumulated profit or loss; and (e)stockholder’s equity.
3. With the same requirements of (1) and (2) above, but now assume Pop instead issued
100,000 shares of stock for Sicle’s assets and liabilities, and registration costs are
P800,000, paid in cash.
4. Now assume that Pop issues 100,000 shares for all of Sicle’s shares, as in requirement
Page | 8 (2) above and Pop agrees to pay cash to Sicle’s previous owners if the combined
earnings of Sicle exceed a certain threshold over the next two years. The expected
present value of the earnings contingency is P8,000,000. Prepare Pop’s acquisition
entry.
5. Assume the same facts as in requirement (3). Before the contingency period is over, the
estimated value of the earnings contingency declines to P5,000,000. Prepare Pop’s
entry to reflect the change in value of the earnings contingency, if
(a) The value decline occurs within the measurement period, i.e. June 30, 2020, then
the amount further declines by P200,000 on August 1, 2020.
(b) The value decline is due to events occurring subsequent to acquisition.

Problem # 4. Consideration transferred: Cash plus Contingent consideration

Pham Company acquired the assets (except for cash) and assumed the liabilities of Senn
Company on January 1, 2019 paying P720,000 cash. Senn Company’s December 31, 2018
balance sheet reflecting both book values and fair values showed:
Book Value Fair Value
Accounts receivable(net) P72,000 P65,000
Inventory 86,000 99,000
Land 110,000 162,000
Buildings(net) 369,000 450,000
Equipment(net) 237,000 288,000
Total P874,000 P1,064,000
Accounts payable P83,000 P83,000
Note payable 180,000 180,000
Common stock, P2 par value 153,000
Other contingent capital 229,000
Retained earnings 229,000
Total P874,000

As part of the negotiations, Pham Company agreed to pay the former stockholder of Senn
Company P135,000 cash if the post combination earnings of the combined company (Pham)
reached certain levels during 2018 and 2019.

Required.
1. Record the journal entry on the books of Pham Company to record the acquisition on
January 1, 2018. It is expected that the earnings target is likely to be met.
2. Assuming the earnings contingent is met, prepare the journal entry on Pham
Company’s books to settle the contingency on January 2, 2020.
3. Assuming the earnings continency is not met, prepare the necessary journal entry on
Pham Company’s books on January 2, 2020.

Problem # 5. Acquiree: Two Corporations

Effective December 31, 2019, Zintel Corporation proposes to issue additional shares of its
common stock in exchange for all the assets and liabilities of Smit Corporation and Platz
Corporation, after which Smith and Platz will distribute the Zintel stock to their stockholders in
complete liquidation and dissolution. Balance sheets of each of the corporations immediately
prior to merger on December 31, 2019 follow. The commo stock exchange ratio was negotiated
to 1:1 for both Smith and Platz.
Zintel Smith Platz
Current Assets P1,600,000 P350,000 P12,000
Long-term assets (net) 5,700,000 1,890,000 98,000
Total P7,300,000 P2,240,000 P110,000

Current liabilities P700,000 P110,000 P9,000

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Long-term debt 1,100,000 430,000 61,000

Common stock, P5 par value 2,500,000 700,000 20,000
Retained Earnings 3,000,000 1,000,000 20,000
Total P7,300,000 P2,240,000 P110,000

Required: Prepare journal entries on Zintel’s book to record the combination. Assume the
following:
Page | 9 1. The identifiable assets and liabilities of Smith and Platz are all reflected in the balance
sheets (above), and their recorded amount are equal to their current fair values except
the long-term assets.
2. The fair value of Smith’s long-term assets exceeds their book value by P20,000 and the
fair value of Platz long-term assets exceed their book values by P5,000. Zintel’s
common stock is traded actively and has a current market price of P15 per share.

Problem #. 6. Liquidation of Acquiree. Accounting by Acquirer.

Homer Ltd. is seeking to expand its share of the widgets market and has negotiated to take
over the operations of Tan Ltd. on January 1, 2020. The balance sheets of the two companies
as of December 31, 2019 were as follows:
Homer Tan
Cash P23,000 P12,000
Receivables 25,000 34,700
Inventory 35,500 27,600
Freehold land 150,000 100,000
Buildings (net) 60,000 30,000
Plant and equipment (net) 65,000 46,000
Goodwill 25,000 2,000
P383,500 P257,300

Accounts payable P56,000 P43,500

Mortgage loan 50,000 40,000
Debentures 100,000 50,000
Common stock, 100,000 shares 100,000
Common stock, 60,000 shares 60,000
Additional paid-in capital 28,500 26,800
Retained Earnings 49,000 32,000
P383.500 P252,300

Homer Ltd. is to acquire all the assets, except cash of Tan Ltd. The assets of Tan are all
recorded at fair values except:
Fair Value
Inventory 39,000
Freehold land 130,000
Building 40,000

In exchange, Homer Ltd. is to provide sufficient extra cash to allow Tan Ltd. to repay all of its
outstanding debits and its liquidation costs of P2,400, plus two fully paid shares in Homer Ltd.
for every three shares held in Tan Ltd. The fair value of a share in Homer Ltd is P3.20. An
investigation by the liquidator of Tan Ltd. reveals that on December 31, 2019, the following
outstanding debts were outstanding but had not been recorded:
Accounts payable P1,600
Mortgage interest 40,000
The debentures issued by Tan Ltd. are to be redeemed at a 5% premium. Costs of issuing the
shares were P1,200.

Required:
1. Prepare the acquisition analysis and journal entries to record the business combination
in the records of Homer Ltd.
2. Prepare the liquidation, liquidator’s cash, and shareholders’ distribution accounts for Tan
Ltd.

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Problem # 7. Acquisition Entry, Deferred taxes

Patel Company issued 100,000 shares of P1 par value common stock (market Value of
P6/share) for the net assets of Seely Company on January 1, 2020, in a statutory merger.
Seely Company had the following assets, liabilities, and owners’ equity at that time:
Book Value
Page | 10 Tax Basis Fair Value Difference
Cash P20,000 P20,000
Accounts receivable 112,000 112,000
Inventory 82,000 134,000 52,000
Land 30,000 55,000 25,000
Plant assets (net) 392,000 463,000 71,000
Total assets P636,000 P784,000

Allowance for uncollectible accounts P10,000 P10,000

Accounts payable 54,000 54,000
Bonds payable 200,000 180,000 20,000
Common stock, P1 par value 80,000
Other contributed capital 132,000
Retained Earnings 160,000
Total equities P636,000

Required: Prepare the journal entry to record the assets acquired and liabilities assumed.
Assume an income tax rate of 40%.

EXERCISES/ASSIGNMENT

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