Solutions IFRS 3 Business combinations Solutions Véronique Weets Instituut van de Bedrijfsrevisoren 1
Solutions TABLE OF CONTENT Table of content... 2 IFRS 3 Business combinations... 3 Identifying the acquirer... 3 Goodwill... 8 Measurement period... 12 Comprehensive case... 14 Contingent consideration... 16 Bargain purchases... 18 Business combinations achieved in stages... 19 Determining what is part of the business combination transaction... 22 Restructurings and liabilities... 22 Employee benefits... 24 Pre existing relationships... 25 Contingent payments to employees or selling shareholders... 26 Share based payments... 28 Intangible assets... 30 Reverse acquisitions... 35 Income taxes... 39 Impairment of goodwill... 41 Instituut van de Bedrijfsrevisoren 2
Identifying the acquirer IFRS 3 BUSINESS COMBINATIONS IDENTIFYING THE ACQUIRER 1. Mocas owns three subsidiaries that are all independent entities; Hara, Neb and Luc. Mocas owns the following percentage of each subsidiary: Hara 80%, Neb 60%, Luc 55%. Neb purchases Luc. What IFRS governs the accounting treatment of Neb s acquisition of Luc? This transaction does not affect Mocas s requirements concerning the preparation of consolidated financial statements and related IFRS requirements since Mocas has remained the owner of all subsidiary entities. The purchase transaction occurred within the group of entities under common control and is outside the scope of IFRS 3. 2. Entity A owns 40 shares of the 100 shares of D. The remaining shares of D are owned by B (55 shares) and C (5shares). D offers its shareholders the right to sell in their shares at fair value. Only B accepts the offer and sells 30 shares. Does the transaction represents a business combination? Yes, due to the transaction A acquires control. It now has 57% of the outstanding shares of D. 3. An entity may decide to outsource its information technology or call centre operations to a third party. Before the outsourcing, these functions generally will have been operated as a cost centre for the business as a whole, rather than as a business per se. Generally, the staff, plant and equipment and other working capital of the outsourced department are transferred to the third party, and a contractual arrangement entered into with the third party for the provision of the service to the outsourcing entity on an ongoing basis. Does the transaction represents a business combination? While they were part of the outsourcing entity, the operations generally would not have been considered a business and would not have been operated as such. However, the third party that acquires the assets and liabilities and takes on the staff could be seen to have acquired a business, as the transferred set of assets and activities is capable of being operated as a business. The conclusion is even clearer where the transferred assets and employees are used as the seed capital to offer similar services to other parties (Deloitte, Business combinations and changes in ownership interests, 2008). 4. A public limited Entity, owns 50% of B and 49% of C. There is an agreement with the shareholders of C that the group will control the board of directors (Wiley workbook and guide, 2006, pg 338). Should C be considered to be a subsidiary in the group accounts? C will be consolidated on the basis of actual dominant influence and control exercised by the group because of the control contract. 5. Entity A wholly owns the share capital of Entity B, Entity C and Entity D. In turn Entities B,C and D each own 17% of Entity E s share capital (PWC, chapter 24). Does A control E? Entity E is a subsidiary of Entity A because Entity A controls via its shareholdings in Entities B, C and D, 51% of Entity E s share capital, which confers to Entity A control of over 50% of the voting power in E. Instituut van de Bedrijfsrevisoren 3
Identifying the acquirer 6. Entity A owns 45% of the voting shares of Entity B. Entity A also has an agreement with other shareholders that they will always vote a further 20% holding in the same way as Entity A (PWC, chapter 24). Does A control B? The agreement between Entity A and the other shareholders provides Entity A with control over 65% of the voting rights of Entity B. This is because the other shareholders will vote in accordance with the instructions of Entity A. Entity A, therefore, controls Entity B and Entity B is its subsidiary and should be consolidated in Entity A s consolidated financial statements. 7. Three Entities A, B and C invest in Entity D to manufacture footballs. Entity A has considerable experience in manufacturing footballs and has developed new technology to improve their production. Entity B and Entity C are both banks that have previously financed Entity A s operations. Entity A will contribute technology and know how to Entity D, whilst Entity B and Entity C will contribute finance. The share ownership will be Entity A: 40%, Entity B: 30% and Entity C/ 30%. Each Entity will appoint directors in proportion to their ownership percentage. An agreement between the shareholders states that all directors will be non executive except for the managing director and the finance director, both of whom will be appointed by Entity A in recognition of its expertise in the area of football manufacture. The shareholder agreement delegates to Entity A s managing director and its finance director the power to set Entity D s operating policies and operating budget. However, requests for additional financing must be considered by the board (PWC, chapter 24). Which entity controls D? The delegation of powers over the entity s operating policies and budget to the directors appointed by Entity A, provides Entity A with effective control of Entity D. Although there are some powers retained by the full board, including decisions over changes to financing and share structure, these are limited and provide rights that are more protective than executive. 8. Entity A controls the composition of Entity B s board. The board of directors of Entity B has seven members, four appointed by Entity A and three appointed by Entity C. One of the directors of Entity A rarely attends board meetings and strategic decisions are often taken by the majority vote of the remaining board members. That is, three from Entity A and three from Entity C (PWC, chapter 24). Which entity has to consolidate B? Although Entity A might not have exercised its power in practice, it still has the ability to exercise control should it which to do so. Therefore, even though it has not exercised this power, Entity B is still Entity A s subsidiary. 9. Entity A owns 45% of the shares in Entity B, but controls the composition of its board of directors by having the power to appoint or remove the majority of Entity B s directors (PWC, chapter 24). Should A consolidate B? The ability of Entity A to control the composition of Entity B s board confers control of Entity B to Entity A. Although certain decisions are reserved for a shareholder vote, where A has control of only 45% of the votes, such decisions tend to be protective in nature. Provided the decisions reserved for shareholder vote do not interfere with the operations of Entity B, Entity A will be able to control Entity B s operating and financial policies so as to obtain benefits from its activities. And hence, Entity B would be regarded as Entity A s subsidiary. 10. Entity A owns 50% of the voting shares of Entity B. The board of directors consist of eight members. Entity A appoints four directors and two other investors appoint two directors each. One of Entity A s Instituut van de Bedrijfsrevisoren 4
Identifying the acquirer nominated directors always serves as chairman of Entity B s board and has the casting vote at board meetings (PWC, chapter 24). Does A control B? Entity A has the casting vote at board meetings in the event that the directors cannot reach a majority decision. This provides Entity A with control of board decisions and, therefore, control of Entity B. 11. Entity A and Entity B own 80% and 20% respectively of the ordinary shares that carry voting rights at a general meeting of shareholders of Entity C. Entity A sells one half of its interest to Entity D and buys call options from Entity D that are exercisable at any time at a premium to the market price on issue. If the options are exercised they would give Entity A its original 80% ownership interest and equivalent voting rights. The exercise price is not deliberately set so high that the possibility of exercise is remote (IAS 27 IG8). Which entity controls C? Although the options are out of the money when issued, they are exercisable immediately. Hence, Entity A has the power to govern the financial and operating polices of Entity C and, as a consequence, Entity C is determined to be a subsidiary A. The substance of the arrangement may be a financing transaction if the premium represents a lender s return to Entity D. 12. Entity A,B and C own 40%, 30% and 30% respectively of the ordinary shares that carry voting rights at a general meeting of shareholders of Entity D. Entity A also owns call options that are exercisable at any time at the fair value of the underlying shares and if exercised would give it an additional 20% of the voting rights in Entity D and reduce Entity B s and Entity C s interest to 20% each. If the options are exercised Entity A would have control over more than 50% of the voting power of Entity D (IAS 27, IG 8). Which entity has to consolidate D? The existence of the potential voting rights that can be exercised at any time gives Entity A the power to govern the financial and operating policies of Entity D and, hence, Entity D is its subsidiary. 13. Entities A, B and C own 25%, 35% and 40% respectively of the ordinary shares that carry voting rights at a general meeting of shareholders of Entity D. Entities B and C also have share warrants that are exercisable at any time at a fixed price and provide potential voting rights. Entity A has a call option to purchase these share warrants at any time for a nominal amount, and, if the call option is exercised, would give Entity A the potential to increase its ownership interest, and thereby its voting rights, in Entity D to 51% (and dilute Entity B s interest to 23% and Entity C s interest to 26%) (IAS 27, IG 8). Which entity has to consolidate D? Although these warrants are not owned by Entity A, they are considered in the assessment, because they are presently exercisable by Entity B and C. Normally, if an action (for example, the purchase or exercise of another right) is required before an entity has ownership of the potential voting rights, the potential voting rights are not considered to be held by the entity. However, in this case, the share warrants are, in substance, held by Entity A, because the terms of the call option indicate that it is almost certain the option will be exercised. The combination of the call option and share warrants give Entity A the power to set the operating and financial policies of Entity D, because Entity A could currently exercise the option and share warrants. Hence Entity D is a subsidiary of A. 14. Entities A, B and C each own 33% of the ordinary shares that carry voting rights at a general meeting of shareholders of Entity D. Entities A,B and C each have the right to appoint two directors to the board of directors of Entity D. Entity A also owns call options that are exercisable at a fixed price (that is not excessive) Instituut van de Bedrijfsrevisoren 5
Identifying the acquirer at any time and if exercised would give it all the voting rights in Entity D. Entity A s management does not intend to exercise the call options even if Entities B and C do not vote in the same manner as Entity A (IAS 27, IG 8). Does entity A control entity D? The intention of Entity A s management should not be taken into account in assessing whether Entity A has control of Entity D. The existence of the potential voting shares and Entity A s ability to exercise the options and thereby gain control of Entity D indicate that Entity D is a subsidiary of Entity A. 15. Entities A and B own 55% and 45% respectively of the ordinary shares that carry voting rights at a general meeting of shareholders of Entity C. Entity B also holds debt instruments that are convertible into ordinary shares of Entity C. The debt can be converted by paying a substantial premium, in comparison to Entity B s net assets, at any time and if converted would require Entity B to borrow additional funds to make the payment. If converted, Entity B would receive 70% of the voting rights and Entity A s interest would reduce to 30%. Although the debt instruments are convertible at a substantial price, the price is not so high that the possibility of conversion is remote (IAS 27, IG 8). Which entity has to consolidate entity C? The debt is presently convertible and the conversion feature gives Entity B the power to set the operating and financial policies of Entity C. The existence of the potential voting rights indicates that Entity B, not Entity A controls Entity C. The financial capability of Entity B to pay the conversion price does not influence the assessment 16. Additional guidance in marginal cases Factor Acquirer is Consideration primarily cash, other assets or incurring liabilities Usually the entity that transfers the cash or other assets, or incurs the liabilities Consideration primarily in equity interests Usually the entity that issues its equity interests. However, in a reverse acquisition, the acquire may issue equity interests Relative size Usually the entity whose relative size (measured in, for example, assets, revenues or profit) is significantly greater than that of the other combining entities More than two combining entities Consider which entity initiated the combination (as well as relative sizes) New entity formed which issues equity interests One of the combining entities that existed before the combination, identified by applying the guidance in other paragraphs Instituut van de Bedrijfsrevisoren 6
Identifying the acquirer New entity formed which transfers cash, other assets or incurs liabilities New entity may be the acquirer Relative voting rights in the combined entity after the combination Usually the entity whose owners as a group retain or receive the largest portion of the combined voting rights, after considering the existence of any unusual or special voting arrangements and options, warrants or convertible notes No majority interest in the combined entity, but single large minority interest Usually the entity whose single owner or group or organized voters holds the largest minority voting interest in the entity Composition of the governing body of the combined entity Usually the entity whose (former) management dominates the combined management Terms of the exchange of equity interests Usually the entity that pays a premium over precombination fair value of the other entity or entities. Instituut van de Bedrijfsrevisoren 7
Goodwill GOODWILL 1. Consider the following information (ACCA, pg 2308) At 31 December 20X5 Parent Subsidiary Cu CU Non current assets Tangibles 1 000 800 Cost of investment in Subsidiary 1 200 Net current assets 400 200 2 600 1 000 Issued capital 100 900 Retained earnings 2 500 100 2 600 1 000 Parent bought 100% of Subsidiary on 31 December 20X5 Subsidiary's reserves are CU 100 at the date of acquisition Calculate the goodwill and prepare the consolidated balance sheet at 31 December 20X5 Subsidiary net assets at acquisition date: 900 + 100 = 1000 Goodwill: 1 200 1 000 = 200 At 31 December 20X5 Consolidated Balance Sheet Non current assets Goodwill 200 Tangibles 1 800 Net current assets 600 2 600 Issued capital 100 Retained earnings 2 500 2 600 Instituut van de Bedrijfsrevisoren 8
Goodwill 2. Mocas purchased 75% of the capital of Haraf for CU 250 000 on 1 July 20X0. at this date the equity of Haraf was: CU Share capital 100 000 General reserve 60 000 Retained earnings 40 000 At this date Haraf had not recorded any goodwill, and all identifiable assets and liabilities were recorded at fair value except for the following cases: Carrying amount Fair value CU CU Inventory 70 000 100 000 Plant (cost CU 170 000) 150 000 190 000 Land 50 000 100 000 The tax rate is 30%. Calculate the goodwill and determine the journal entries related to the business combination a. If the non controlling interest is measured at its fair value of 80 000 Subsidiary net assets at acquisition date: CU Total equity 200 000 Revaluation reserve inventory 30 000 *0.7=21 000 Revaluation reserve plant 40 000*0.7=28 000 Revaluation reserve land 50 000*0.7 =35 000 Net assets 284 000 Minority interest 80 000 Net assets acquired 204 000 Alternative calculation method CU Total equity 200 000 Revaluation inventory 30 000 Revaluation plant 40 000 Revaluation land 50 000 Deferred tax liability (120 000 * 0.3) = (36 000) Net assets 284 000 Minority interest 80 000 Net assets acquired 204 000 Goodwill: 250 000 204 000 = 46 000 Instituut van de Bedrijfsrevisoren 9
Goodwill Dr Plant 40 000 Cr Deferred tax liability 12 000 Cr Revaluation reserve 28 000 Dr Land 50 000 Cr Deferred tax liability 15 000 Cr Revaluation reserve 25 000 Dr Inventory 30 000 Cr Deferred tax liability 9 000 Cr Revaluation reserve 21 000 Dr Retained earnings 60 000 Dr Share capital 100 000 Dr General reserve 40 000 Dr Goodwill 46 000 Dr Revaluation reserve 84 000 Cr Shares in Haraf 250 000 Cr Minority interest 80 000 b. If the non controlling interest is measured at its proportionate share in the net assets of Haraf Subsidiary net assets at acquisition date: CU Total equity 200 000 Revaluation reserve inventory 30 000 *0.7=21 000 Revaluation reserve plant 40 000*0.7=28 000 Revaluation reserve land 50 000*0.7 =35 000 Net assets 284 000 Minority interest 284 000 * 0.25=71 000 Net assets acquired 213 000 Alternative calculation method CU Total equity 200 000 Revaluation inventory 30 000 Revaluation plant 40 000 Revaluation land 50 000 Deferred tax liability (120 000 * 0.3) = (36 000) Net assets 284 000 Minority interest (284 000 * 0.25) = 71 000 Net assets acquired 213 000 Goodwill: 250 000 213 000 = 37 000 Instituut van de Bedrijfsrevisoren 10
Goodwill Dr Plant 40 000 Cr Deferred tax liability 12 000 Cr Revaluation reserve 28 000 Dr Land 50 000 Cr Deferred tax liability 15 000 Cr Revaluation reserve 25 000 Dr Inventory 30 000 Cr Deferred tax liability 9 000 Cr Revaluation reserve 21 000 Dr Retained earnings 60 000 Dr Share capital 100 000 Dr General reserve 40 000 Dr Goodwill 37 000 Dr Revaluation reserve 84 000 Cr Shares in Haraf 250 000 Cr Minority interest 71 000 Instituut van de Bedrijfsrevisoren 11
Measurement period MEASUREMENT PERIOD 1. Maltis acquired the net assets of BodySculpt on 31 December 20X5. The cost of acquisition was CU4.2 million and goodwill on acquisition was CU0.6 million. While preparing the financial statements for the combined Maltis at the end of 20X6 the following items were identified: During 20X6 Maltis discovered that BodySculpt owned land that had been acquired many years ago but which had not been separately identified and recorded at acquisition. Maltis estimated that the fair value of the property as at the date of acquisition was CU120 000. BodySculpt holds a significant investment in Pool Side. Due to a change in economic conditions affecting Pool Side s industry in the latter half of 20X6, the recoverable amount of the investment was estimated to have fallen below its carrying amount by CU80 000. How should Maltis treat these two items in its consolidated financial statements at 31 December 20X6? The discovery of land increases the amount of identifiable net assets acquired and so decreases the amount recognized as goodwill on acquisition. It has no affect on the cost of acquisition. Assuming that the recoverable value of goodwill remains greater than its carrying value following the adjusting transaction, the journal entry is: Dr Land 120 000 Cr Goodwill 120 000 The impairment in the value of BodySculpt s investment in Pool Side resulted from an event occurring subsequent to the date of acquisition. Accordingly, the write down does not affect the fair value of the net assets of BodySculpt at the date of acquisition and does not therefore affect the amount of goodwill on acquisition. 2. AC acquires TC on 30 September 30 20X7. AC seeks an independent appraisal for an item of property, plant, and equipment acquired in the combination, and the appraisal was not completed by the time AC issued its financial statements for the year ending 31 December 20X7. In its 20X7 annual financial statements, AC recognized a provisional fair value for the asset of CU30 000. At the acquisition date, the item of property, plant, and equipment had a remaining useful life of five years. Five months after the acquisition date, AC received the independent appraisal, which estimated the asset s acquisition date fair value as CU40 000. How should AC report this transaction? AC is required to recognize any adjustments to provisional values as if the accounting for the business combination had been complete at the acquisition date. In its financial statements for the year ending 31 December 20X8, AC retrospectively adjusts the 20X7 prior year information as follows: The carrying amount of property, plant, and equipment as of 31 December 31 20X7, is increased by CU9 500. That adjustment is measured as the fair value adjustment at the acquisition date of CU10 000 less the additional depreciation that would have been recognized had the asset s fair value at the acquisition date been recognized from that date (CU500 for 3 months depreciation). The carrying amount of goodwill as of 31 December 20X7, is decreased by the CU10 000. Depreciation expense is increased by CU500. Instituut van de Bedrijfsrevisoren 12
Measurement period AC discloses: In its 20X7 financial statements, that the initial accounting for the business combination has not been completed because the appraisal of property, plant, and equipment has not yet been received. In its 20X8 financial statements, the amounts and explanations of the adjustments to the provisional values recognized during the current reporting period are disclosed. Therefore, AC discloses that the 20X7 comparative information is retrospectively adjusted to increase the fair value of the item of property, plant, and equipment at the acquisition date has been increased by CU9 500, offset by a decrease to goodwill of CU10 000 and an increase in depreciation expense of CU500 Instituut van de Bedrijfsrevisoren 13
Comprehensive case COMPREHENSIVE CASE Rotorua Ltd and Waikato Ltd are two family owned flax producing companies in New Zealand. Rotorua Ltd is owned by the Wood family, while the Bradbury family owns Waikato Ltd. The Wood family has one daughter, and she is engaged to be married to the son of the Bradbury family. Because the daughter is currently managing Waikato Ltd, it is proposed that she be allowed to manage both companies after the wedding. As a result, it is agreed by the two families that Rotorua Ltd should take over the net assets of Waikato Ltd. The balance sheet of Waikato Ltd immediately prior to the takeover is as follows: Carrying amount CU Fair value CU Cash 20 000 20 000 Accounts Receivable 140 000 125 000 Land 620 000 840 000 Buildings (net) 530 000 550 000 Farm equipment (net) 360 000 364 000 Irrigation equipment (net) 220 000 225 000 Vehicles (net) 160 000 172 000 2 050 000 Accounts payable 80 000 80 000 Loan Maori Bank 480 000 480 000 Share capital 670 000 Retained earnings 820 000 2 050 000 The takeover agreement specified the following details: 1. Rotorua Lts is to acquire all assets of Waikato Ltd except for cash, and one of the vehicles (having a carrying amount of CU45 000 and a fair value of 48 000), and assume all the liabilities except for the loan from the Maori Bank. Waikato Ltd is then to go into liquidation. 2. Rotorua Ltd is to supply sufficient cash to enable the debt to the Maori Bank to be paid off and to cover the liquidation costs of CU5 500. It will also give CU 150 000 to be distributed to Mr and Mrs Bradbury to assist in paying the wedding costs. 3. Rotorya Ltd is also to give a piece of its own prime land to Waikato Ltd to be distributed to Mr and Mrs Bradbury, this eventually being available to be given to any off spring of the forthcoming marriage. The piece of land in question has a carrying amount of CU80 000 and a fair value of CU220 000 4. Rotorua Ltd is to issue 100 000 shares, these having a fair value of s14 per share, to be distributed via Waikato Ltd to the soon to be married son of Mr and Mrs Bradbury, who is currently a shareholder in Waikato Ltd. 5. The takeover proceeded as per the agreement with Rotorua Ltd incurring incidental acquisition costs of CU25 000, while there were Cu18 000 share issue costs. Prepare the acquisition analysis and the journal entries to record the acquisition of Waikato Ltd in the records of Rotorua Ltd in accordance with the present version of IFRS 3 Fair value of identifiable assets and liabilities acquired: Instituut van de Bedrijfsrevisoren 14
Comprehensive case Fair value CU Accounts Receivable 125 000 Land 840 000 Buildings (net) 550 000 Farm equipment (net) 364 000 Irrigation equipment (net) 225 000 Vehicles (net) 172 000 48 000 124 000 Accounts payable 80 000 Share capital Retained earnings 2 148 000 Consideration transferred: CU Shares 100 000 * CU14 1 400 000 Cash 480 000 + 150 000 20 000 615 500 Land 220 000 2 235 500 Goodwill = CU 2 235 500 2 148 000 = CU87 500 Dr Accounts receivable 125 000 Dr Land 840 000 Dr Buildings 550 000 Dr Farm equipment 364 000 Dr Irrigation equipment 225 000 Dr Vehicles 124 000 Dr Goodwill 87 500 Cr Accounts payable 80 000 Cr Share capital 1 400 000 Cr Cash 615 500 Cr Income sale of land 220 000 Dr Costs payable 25 000 Cr Cash 25 000 Dr Share capital 18 000 Cr Cash 18 000 Dr Carrying amount of land sold 80 000 Cr Land 80 000 Instituut van de Bedrijfsrevisoren 15
Contingent consideration CONTINGENT CONSIDERATION Entity A acquires 85% of XYZ on 1 July 20X5 on the following terms Issuance of 5 000 shares of Entity A equity shares to XYZ shareholders. At the date of exchange, which is also the acquisition date, the market value of Entity A s shares is 250 per share. Entity A s share price did not fluctuate unduly before or after the issuance. Par value of the stock is 80 per share. Issuance costs related to the stock total 66 000. Entity A also issues notes payable to the XYZ shareholders on 1 July 20X5. XYZ shareholders will receive a total of CU 400 000 one year from the date of acquisition. Entity A s incremental borrowing rate is 12 %. The present value factor for 12% is 0.8929. The terms also require that at the end of six months after the acquisition, Entity A will pay in cash to each XYZ shareholder an additional amount in relation to the number of shares of Entity A stock that they received if the following conditions are met: o o If XYZ s net profit is between 20% and 30% higher than the net profit earned during the six months prior to acquisition, the shareholder is entitled to a cash payment of 50 for each share received in Entity A. If XYZ s net profit is more than 30% higher than the net profit earned during the six months prior to acquisition, the shareholder is entitled to a cash payment of 70 for each share received in Entity A. At the date of acquisition, Entity A estimated that the probability of having an increase in net profit of more than 20% is 80%, and the probability for an increase of more than 30% is 20%. Entity A also incurred the following costs: CU Legal services for review and preparation of purchase documents 85 000 Accounting services to assist in evaluating and recording the acquisition 110 000 Registration and business transfer fees to government offices 20 000 Appraisal services for determination of fair value on certain assets 45 000 Costs to remove XYZ s old signs and install new signs. 52 000 Instituut van de Bedrijfsrevisoren 16
Contingent consideration a. Based on the information shown above, calculate the initial cost of the acquisition that will be recorded on Entity A s accounting records. Cost of the acquisition includes the following: CU 5 000 equity shares, fair value of 250 per share (issue costs are not a component of the cost of the acquisition, they are accounted for as a reduction of equity) 1 250 000 Present value of notes payable 400 000 * 0.8929 357 160 Provision for additional cash payment (5 000 shares of stock * 50)*0.80 + (5000 shares of stock * 70)*0.25 270 000 Fair value of the consideration transferred to the acquire 1 877 160 b. At 31 December 20X5 Entity A established that XYZ s net profit for the six months following acquisition was 32% higher than the net profit earned during the six months previous to the acquisition. Give the appropriate accounting entry. An adjusting entry is needed for the difference between the amount that originally estimated for the contingent payment and the total that is due. An estimate of 270 000 was included in the initially recorded cost of the acquisition. Total cash payments to the former XYZ shareholders under the terms of the agreement will be 350 000. The adjusting transaction is: Dr Income statement 70 000 Cr Liabilities payable to XYZ shareholders 70 000 Instituut van de Bedrijfsrevisoren 17
Bargain purchases BARGAIN PURCHASES On 1 January 20X5, AC acquires 80 % of the equity interests of TC, a private entity, in exchange for cash of CU150. Because they needed to dispose of their investments in TC by a specified date, the former owners of TC did not have sufficient time to market TC to multiple potential buyers. The management of AC initially measures the separately recognizable identifiable assets acquired and the liabilities assumed as of the acquisition date in accordance with the requirements of IFRS 3. The identifiable assets are measured at CU250, and the liabilities assumed are measured at CU50. AC engages an independent consultant who determines that the fair value of the 20 % non controlling interest in TC is CU42. The fair value of TC s identifiable net assets (CU200, calculated as CU250 CU50) exceeds the fair value of the consideration transferred plus the fair value of the non controlling interest in TC. Therefore, AC reviews the procedures it used to identify and measure the assets acquired and liabilities assumed and to measure the fair value of both the non controlling interest in TC and the consideration transferred. After that review, AC decides that the procedures and resulting measures were appropriate. a. How should AC measure the gain on its purchase of the 80 % interest? Fair value of the identifiable net assets acquired (CU250 50) 200 Fair value of the consideration transferred for AC s 80 % in TC; plus (150) Fair value of non controlling interest in TC (42 (192) Gain on bargain purchase of 80 percent interest 8 b. How should AC record its acquisition of TC in its consolidated financial statements? Dr Identifiable assets acquired 250 Cr Cash 150 Cr Liabilities assumed 50 Cr Gain on bargain purchase 8 Cr Equity NC interest 42 c. If the acquirer chose to measure the non controlling interest in TC on the basis of its proportionate interest in the identifiable net assets of the acquiree, how much would the gain on the bargain purchase be? The recognized amount of the non controlling interest would be: CU40 (CU200 *0,20). The gain on the bargain purchase then would be CU10 (CU200 (CU150 + CU40)). Instituut van de Bedrijfsrevisoren 18
Business combinations achieved in stages BUSINESS COMBINATIONS ACHIEVED IN STAGES 1. A acquired 75% controlling interest in B in two stages In 20X1, A acquired a 15% equity interest for cash consideration of 10 000. A classified the interest as available for sale under IAS 39. From 20X1 to the end of 20X5, A reported fair value increases of 2 000 in other comprehensive income. In 20X6, A acquired a further 60% equity interest for cash consideration of 60 000. A identified net assets of B with a fair value of 80 000. A elected to measure non controlling interests at their share of net assets. On the date of acquisition, the previously held 15% interest had a fair value of 12 500. Give the appropriate journal entries Dr Gain previously reported in OCI (12 000 10 000) 2 000 Dr Investment in B (12 500 12 000) 500 Cr Profit or loss 2 500 Dr Fair value of net assets in acquire 80 000 Dr Goodwill 12 500 Cr Fair value of consideration given for controlling interest 60 000 Cr Non controlling interest (25%*80 000) 20 000 Cr Fair value of previously held interest 12 500 2. C acquired a 75% controlling interest in D in two stages In 20X1, C acquired a 40% equity interest for cash consideration of 40 000. C classified the interest as an associate under IAS 28. At the date that C acquired its interest, the fair value of D s identifiable net assets was 80 000. From 20X1 to 20X, C equity accounted for its share of undistributed profits totaling 5000 and included its share of an IAS 16 revaluation gain of 3 000 in other comprehensive income. Therefore, in 20X6, the carrying amount of C s interest in D was 48 000. In 20X6, C acquired a further 35% equity interest for cash consideration of 55 000. C identified net assets of D with a fair value of 110 000. C elected to measure non controlling interests at fair value of 30 000. On the date of acquisition, the previously held 40% interest had a fair value of 50 000. Give the appropriate journal entries (ignore any profits earned prior to the acquisition) Dr Investment in D (50 000 48 000) 2 000 Cr Profit or loss 2 000 The revaluation gain of 3000 previously recognized in OCI is not reclassified to profit or loss because it would not be reclassified if the interest in D were disposed of. Dr Fair value of net assets in acquire 110 000 Dr Goodwill 25 000 Cr Fair value of consideration given for controlling interest 55 000 Cr Non controlling interest (25%*80 000) 30 000 Cr Fair value of previously held interest 50 000 Instituut van de Bedrijfsrevisoren 19
Business combinations achieved in stages 3. a) In 20X1, A acquired a 75% equity interest in B for cash consideration of 90 000. B s identifiable net assets at fair value were 100 000. The fair value of the 25% non controlling equity interest (NCI) was 28 000. Calculate the goodwill for the two options of measuring the NCI NCI @% of net assets NCI @ fair value Fair value of consideration NCI Fair value of net assets Goodwill 90 000 90 000 25 000 28 000 115 000 118 000 100 000 100 000 15 000 18 000 b) In the subsequent years, B increased net assets by 20 000 to 120 000. This is reflected in an increase of the carrying amount within equity attributed to non controlling interests with 5000. In 20X6, A then acquired the 25% equity interest held by non controlling interests for cash consideration of 35 000. Give the appropriate accounting entries for both alternatives NCI @% of net assets Dr Non controlling interest 30 000 Dr Negative movement in parent equity 5 000 Cr Cash 35 000 NCI @ fair value Dr Non controlling interest 33 000 Dr Negative movement in parent equity 2 000 Cr Cash 35 000 4. In 20X1, A acquired a 100% equity interest in B for cash consideration of 125 000. B s identifiable net assets at fair value were 100 000. Goodwill of 25 000 was identified and recognized. In subsequent years, B increased net assets by 20 000 to 120 000. This is reflected in equity attributable to the parent. A then disposed 30% of its equity interest to non controlling interests for 40 000. NCI is measured at % of net assets. Give the appropriate accounting entry Dr Cash 40 000 Dr Positive movement in parent equity 4 000 Cr NCI (30%*120 000) 36 000 There is no adjustment to the carrying amount of goodwill because control has been retained. 5. In 20X1, A acquired a 100% interest in B for cash consideration of 125 000. B s identifiable net assets at fair value were 100 000. Goodwill of 25 000 was identified and recognized. In the subsequent years, B increased net assets by 20 000 to 120 000. Of this, 15 000 was reported in profit or loss and 5000, relating to Instituut van de Bedrijfsrevisoren 20
Business combinations achieved in stages fair value movements on an available for sale financial asset, was reported within other comprehensive income. A then disposed of 75% of its equity interest for cash consideration of 115 000. The resulting 25% equity interest is classified as an associate under IAS 28 and has a fair value of 38 000. Give the appropriate accounting entry Dr Cash 115 000 Dr Interest in associate 38 000 Dr Gain previously reported in OCI 5 000 Cr Goodwill 25 000 Cr Fair value of B 120 000 Cr Gain on disposal of subsidiary 13 000 Instituut van de Bedrijfsrevisoren 21
Determining what is part of the business combination DETERMINING WHAT IS PART OF THE BUSINESS COMBINATION TRANSACTION RESTRUCTURINGS AND LIABILITIES 1. Company A acquires company B, effective 1 March 20X5. At the date of acquisition, company A intends to close a division of company B. As at the date of acquisition, management has developed and the board has approved the main features of the restructuring plan and, based on available information, best estimates of the costs have been made. As at the date of acquisition, a public announcement of company A s intentions has been made and relevant parties have been informed of the planned closure. Within in a week of the acquisition being effected, management commences the process of informing unions, lessors, institutional investors and other key shareholders of the broad characteristics of its restructuring program. A detailed plan for the restructuring is developed within three months and implemented soon thereafter. Should company A create a provision for restructuring as part of its acquisition accounting entries? No under IFRS 3 the acquirer cannot recognize the provision if it is not already recognized as a liability of the acquiree. How would your answer change if all the circumstances are the same as those above except that company A decided that, instead of closing a division of company B, it would close down one of its own facilities? In this situation, although the closing of the facility only arises because of the proposed acquisition, whether or not a present obligation exists would need to be considered in accordance with the requirements for an internal restructuring as opposed to a restructuring recognized as part of an acquisition. This is because [IFRS 3 s] requirements relating to restructuring provisions recognized as part of an acquisition relate only to assets and liabilities of the acquiree. Since the intended closure relates to an operation of the acquirer, a restructuring provision cannot be raised in the books of the acquiree and cannot be considered as part of a restructuring recognized as part of an acquisition 2. On 9 June 2008, Diageo completed the acquisition of Ketel One Worldwide BV (KOW), a 50:50 company based in the Netherlands, which owns the exclusive and perpetual global rights to market, sell and distribute Ketel One vodka products. Diageo paid 471 million for a 50% equity stake in KOW. Additional costs relating to the acquisition of 2 million are expected to be incurred in the year ending 30 June 2009. Diageo controls the operating and financial policies of the company and consolidates 100% of KOW with a 50% minority interest. The Nolet Group has an option to sell their 50% equity stake in the company to Diageo for $900 million ( 452 million) plus interest from 9 June 2011 to 9 June 2013. If the Nolet Group exercises this option but Diageo chooses not to buy their stake, Diageo will pay $100 million ( 50 million) and the Nolet Group may then pursue a sale of their stake to a third party, subject to rights of first offer and last refusal on Diageo s part. Fair value adjustments include the recognition of worldwide distribution rights into perpetuity of Ketel One vodka products of 911 million, the establishment of a deferred tax liability of 116 million and the creation of a financial liability at fair value of 32 million for the potential amount payable to the Nolet Group. Goodwill of 166 million arose on the acquisition (Diageo, annual report 2008). Instituut van de Bedrijfsrevisoren 22
Determining what is part of the business combination Book value million Fair value adjustments million Fair value million Brands 33 33 Intangible assets 911 911 Property, plant and equipment 2 2 Working capital 8 2 10 Deferred taxation (115) (115) Financial liability (32)* (32) Bank overdrafts Net identifiable assets and 10 799 809 liabilities Goodwill arising on acquisition 174 Minority interests (456) Consideration payable 527 Satisfied by: Cash consideration paid 524 Contingent/deferred consideration payable/(receivable) 3 527 Cash consideration paid for 524 investments in subsidiaries Cash consideration payable for 62 investments in associates Deferred consideration payable for (11) investments in associates Bank overdrafts acquired Prior year purchase consideration adjustment Net cash outflow 575 *A third party has established a fair value for the potential liability that represents the present value of the potential penalty. Comment on the accounting for the fair value of the assets acquired and liabilities and contingent liabilities assumed in the KOW Deal (remark: the table also contains information on other business combinations). The 32 million is not a liability of the acquired company and we believe therefore that it is inappropriate to include it as an adjustment to net assets acquired. Instituut van de Bedrijfsrevisoren 23
Determining what is part of the business combination EMPLOYEE BENEFITS TC appointed a candidate as its new CEO under a ten year contract. The contract required TC to pay the candidate 5 million if TC is acquired before the contract expires. AC acquires TC eight years later. The CEO was still employed at the acquisition date and will receive the additional payment under the existing contract. Should company A create a provision for this payment as part of its acquisition accounting entries? In this example, TC entered into the employment agreement before the negotiations of the combination began, and the purpose of the agreement was to obtain the services of the CEO. Thus, there is no evidence that the agreement was arranged primarily to provide benefits to AC or the combined entity. Therefore, the liability to pay 5 million is included in the application of the acquisition method. Would your answer change if TC entered into the agreement with the CEO at the suggestion of AC during the negotiations for the business combination, and the payment is contingent on the CEO remaining in employment for 3 years following a successful acquisition? The primary purpose of the agreement appears to be to retain the services of the CEO. Since the CEO is not a shareholder, and the payment is contingent on continuing employment, the payment is accounted for as postacquisition remuneration separately from the application of the acquisition method. Instituut van de Bedrijfsrevisoren 24
Determining what is part of the business combination PRE EXISTING RELATIONSHIPS AC purchases electronic components from TC under a five year supply contract at fixed rates. Currently, the fixed rates are higher than the rates at which AC could purchase similar electronic components from another supplier. The supply contract allows AC to terminate the contract before the end of the initial five year term but only by paying a 6 million penalty. With three years remaining under the supply contract, AC pays 50 million to acquire TC, which is the fair value of TC based on what other market participants would be willing to pay. Included in the total fair value of TC is 8 million related to the fair value of the supply contract with AC. The 8 million represents a 3 million component that is at market because the pricing is comparable to pricing for current market transactions for the same or similar items (selling effort, customer relationships and so on) and a 5 million component for pricing that is unfavorable to AC because it exceeds the price of current market transactions for similar items.tc has no other identifiable assets or liabilities related to the supply contract before the business combination. What amount will be included in the consideration transferred to TC for the acquisition? AC calculates a loss of 5 million (the lesser of 6 million stated settlement amount and the amount by which the contract is unfavorable to the acquirer) separately from the business combination. The 3 million at market component of the contract is part of goodwill. Whether AC had recognized previously an amount in its financial statements related to a pre existing relationship will affect the amount recognized as a gain or loss for the effective settlement of the relationship. Suppose that IFRSs had required to recognize a 6 million liability for the supply contract before the business combination. In that situation, AC recognizes a 1 million settlement gain on the contract in profit or loss at the acquisition date (the 5 million measured loss on the contract less the 6 million loss previously recognized). In other words, AC has in effect settled a recognized liability of 6 million for 5 million, resulting in a gain of 1 million. Instituut van de Bedrijfsrevisoren 25
Determining what is part of the business combination CONTINGENT PAYMENTS TO EMPLOYEES OR SELLING SHAREHOLDERS Determine for the following features in contingent payment transactions entered into by the acquirer to remunerate employees or former owners of the acquiree for future services whether they give an indication that the cost of the contingent payment is part of the business combination transaction or whether they give an indication that the cost of the contingent payment should be treated as post combination remuneration cost. Part of the business combination transaction Post combination remuneration Contingent payment is automatically forfeited if employment terminates X Period of required employment is longer than period for contingent payment X Other remuneration is at reasonable level as compared with other key personnel of the combined entity X Selling shareholders who do not become employees receive lower contingent payments per share than the other selling shareholders X (for incremental amount paid to shareholders who become employees) Selling shareholders who continue as key employees owned only a small number of shares in the acquiree and all selling shareholders receive the same amount of contingent consideration on a per share basis X Selling shareholders who owned substantially all of the shares in the acquiree continue as key employees X Initial consideration transferred at the acquisition date is based on the low end of a range established in the valuation of the acquiree and the contingent formula relates to that valuation approach X Contingent payment formula is consistent with prior profit sharing arrangements X Instituut van de Bedrijfsrevisoren 26
Determining what is part of the business combination Contingent payment is a specified percentage of earnings X (profit sharing) Contingent payment is determined on the basis of a multiple of earnings X (intended to establish or verify the fair value of the acquire) In connection with the acquisition and the contingent payment arrangement, the acquirer entered into a property lease arrangement with a significant selling shareholder. The lease payments are significantly below market. Part of the contingent payment should be treated as payments for the use of the leased property in the post combination financial statements Instituut van de Bedrijfsrevisoren 27
Determining what is part of the business combination SHARE BASED PAYMENTS 1. AC acquires TC. AC issues replacement awards of CU110 (market based measure) at the acquisition date for TC awards of CU100 (market based measure) at the acquisition date. No post combination services are required for the replacement awards and TC's employees had rendered all of the required service for the acquiree awards as of the acquisition date. What amount will be included in the consideration transferred to TC for the acquisition? The amount attributable to pre combination service is the market based measure of TC's awards (CU100) at the acquisition date; that amount is included in the consideration transferred in the business combination. The amount attributable to post combination service is CU10, which is the difference between the total value of the replacement awards (CU110) and the portion attributable to pre combination service (CU100). Because no post combination service is required for the replacement awards, AC immediately recognises CU10 as remuneration cost in its post combination financial statements. 2. AC acquires TC. AC exchanges replacement awards that require one year of post combination service for share based payment awards of TC, for which employees had completed the vesting period before the business combination. The market based measure of both awards is CU100 at the acquisition date. When originally granted, TC's awards had a vesting period of four years. As of the acquisition date, the TC employees holding unexercised awards had rendered a total of seven years of service since the grant date. What amount will be included in the consideration transferred to TC for the acquisition? Even though TC employees had already rendered all of the service, AC attributes a portion of the replacement award to post combination remuneration cost, because the replacement awards require one year of postcombination service. The total vesting period is five years the vesting period for the original acquiree award completed before the acquisition date (four years) plus the vesting period for the replacement award (one year). The portion attributable to pre combination services equals the market based measure of the acquiree award (CU100) multiplied by the ratio of the pre combination vesting period (four years) to the total vesting period (five years). Thus, CU80 (CU100 * 4/5 years) is attributed to the pre combination vesting period and therefore included in the consideration transferred in the business combination. The remaining CU20 is attributed to the post combination vesting period and is therefore recognised as remuneration cost in AC's post combination financial statements in accordance with IFRS 2. 3. AC exchanges replacement awards that require one year of post combination service for share based payment awards of TC, for which employees had not yet rendered all of the service as of the acquisition date. The market based measure of both awards is CU100 at the acquisition date. When originally granted, the awards of TC had a vesting period of four years. As of the acquisition date, the TC employees had rendered two years' service, and they would have been required to render two additional years of service after the acquisition date for their awards to vest. Accordingly, only a portion of the TC awards is attributable to precombination service. What amount will be included in the consideration transferred to TC for the acquisition? The replacement awards require only one year of post combination service. Because employees have already rendered two years of service, the total vesting period is three years. The portion attributable to pre Instituut van de Bedrijfsrevisoren 28