Chapter 3 . Ms r. Fe le, goodwill be allocated based. Business Combinations (Part 3) | tists a inher arian Mma holon relative fair values of the CGU: unidentifiable, it cannot be tested for ‘only in conjunction with groups of Related standard: PFRS 3 Business Combinations | Learning Objectives 1. Apply the methods of estimating goodwill. 2. Account for reverse acquisitions Special accounting topics for business combination This chapter discusses accounting for business combinati relation to the following: 1, Goodwill 2. Reverse acquisitions 3. Combination of mutual entities any excess is charged to the other assets in the CGU. rment of goodwill is not reversed in a subsequent period. If the CGU is disposed, the goodwill allocated to it is also ognized and included in the determination of gain or loss isposal. sequent accounting for goodwill is discussed extensively Intermediate Accounting Part 1B, The accounting for impairment on goodwill in the consolidated financial statements is issed in Chapter 6. Goodwill Only a goodwill that arises from a business combination recognized as an asset. Goodwill arising from other sources ( internally generated) is not recognized. Goodwill is measured ar recognized on acquisition date. Subsequent expenditures maintaining goodwill are expensed immediately After initial recognition, goodwill is not amortized rather tested for impainnent at least annually. For this purp goodwill is allocated to each of the acquirer's cash-genet diligence re negotiations take place for a business combination, the juirer normally initiates a due diligenice audit for the purpose of ‘ining the appropriate amount of consideration to be isfetred to the acquiree. Due diligence audit refers to the investigation of all areas of potential acquiree’s business before an investor agrees to a ness combination transaction. The term “due diligence” may t to the exercise of care that a reasonable and prudent person Id take before entering a contract with another party. Due ligence audit is a service most commonly performed by CPAs or jernal auditing firms. ed by the énd of that year, it must be completed be the end of the immediately following year. > Cash-generating unit (CGU) is “the smallest identifiable Goodwill is allocated to the CGUs expected to ben from the synergies of the business combination using12 Due diligence audit helps an investor evaluate the risks and rewards of the potential investment and dé whether it would be a good decision to pursue it, Examples of potential risks which may be through a due diligence audit: 1. Possibility of future losses due to the acquiree’s litigations and other unrecorded contingencies. Overstatement in the consideration for the bus combination due to the acquiree’s overstated assets understated liabilities. Incompatibility of internal cultures, systems, and policies. 2 3. Examples of potential rewards which may be through a due diligence audit: 1, Unrecorded assets, such as trade secrets, trade name, cu lists, and the like. Understatement in ‘the consideration for the busi combination due to the acquiree’s understated assets overstated liabilities. 2 Methods of estimating goodwill Before the actual business combination transaction takes place, amount of goodwill may be estimated using any of the follo methods: 1. Indirect valuation — this is a residual approach whe ‘goodwill is measured as the excess of the sum of considerat transferred, non-controlling interest in the acquiree, previously held equity interest in the acquiree over the value of net identifiable assets acquired. PERS 3 requires method and it is the method illustrated in the discussions. . Direct valuation — under this method, goodwill is meas based on expected future earnings from the business to acquired. Combinations (Part 3) 113 ‘The application of the direct valuation method may quire the determination of the following information: 4. Normal rate of return in the industry where the acquire belongs. The normal rate of return may be the industry average determined from examination of annual reports of similar entities or from published statistical data. > “Normal earnings” is equal to normal rate of return multiplied by the acquiree’s net assets. p, Estimated future earnings of the acquire. i. For purposes of goodwill measurement, the earnings of the acquiree are “normalized,” meaning earnings are adjusted for non-recurring income and expenses (€-8., expropriation gains or losses). ‘The excess of the acquiree’s normalized earnings over the average retum in the industry represents the “excess earnings” to which goodwill is attributed. Excess earnings are sometimes referred to as “superior earnings.” Discount rate to be applied to “excess earnings” . Probable duration of “excess earnings” tration 1: Applications of the Direct valuation method Co. is contemplating on acquiring XYZ, Inc. The following mation was gathered through a due diligence audit: "The actual earnings of XYZ, Inc. for the past 5 years are shown below: Year Earnings 20x1 1,200,000 20x2 1,300,000 20x3 1,350,000 0x4 1,250,000 205 1,800,000 Total 6,900,000 Earnings in 20x5 include an expropriation gain of P400,000. The fair value of XYZ's net assets as of the end of 20x5 is P10,000,000.5 + The industry average rate of retum is 12%. fair value of the acquiree’s net assets Sa + Probable duration of “excess earnings” is 5 years, Method #1: Multiples of average excess earnings Under this method, goodwill is measured at the average 1,300,000, 12.50% ccarnings multiplied by the probable duration of excess ea 110,400,000 (20,000,000) _ Total earnings for the last 5 years 400,000. Notice that if the “excess earnings” is used in the the amount directly computed is goodwill. On the the “average earnings” is used, the amount directly Normalized earings for the last 5 years Fair value of acquiree’s net assets thod #4: Present value of average excess earnings jer this method, goodwill is measured at the present value of \ge excess earnings discounted at a pre-determined discount the probable duration of excess earnings. (Assume a Multiply by: Normal rate of return Multiply by: Probable duration of excess earnings ings (69M ~ 4M expropriation gain) +5 years thod #2: Capitalization of average excess earings Under this method, goodwill is measured at the average A aia lune gia a capitalization rate of 25%). 1,300,000 4,200,000) 100,000, 3.79079 379,079 : Applications of the Direct valuation method . is estimating the goodwill in the expected purchase of XYZ, Inc. in January 20x6. The following information was Average earings (69M 4M expropriation gin) 5 ys] Divide by: Capitalization rate ‘Method #3: Capitalization of average earnings Under this method, the average earings are divided by a «determined capitalization rate to estimate the purchase price the business combination. The excess of the estimated purcha:Combinations (Part 3) i 000,000, XYZ's average earnings are P1,300,000. The industry rate of return is 12% of the fair value of net assets. XYZ's ‘eamings are expected to last for 5 years. The expected on the investment is 10%. Case #1; Excess earnings Goodwill shall be measured by capitalizing excess 30%, with normal return on average net assets at 10%. The end net assets in 20x5 approximate fair value. Requirement: Compute for the estimated purchase price in contemplated business combination. Solution: eee mings in the industry (12% x 20") (4,200,000) Average earnings (650,000 +5 years) a) ‘Normal earnings on average net as ae Exesearinge CAO Po PV of an ordinary annuity @10%, ne5 aoe Divide by: Capitalization rate r Goodwill ‘Add: Fair value of net identifiable assets acquired srrying amount of equity : 9,000,000 si ean ye gd ns of fair value of one asset over its carrying amount _ 1,000,000 tale of XYZ's met assets 10,000,000 Case #2: Average earnings Goodwill shall be measured by capitalizing average earnings 16%, The year-end net assets in 20x5 approximate fair value. 079 mated purchase price (squeeze) 10,379, Fair value of XYZ’s net assets (10,000,000) ait 379,079 Requirement: Compute for the estimated purchase price ‘goodwill in the contemplated business combination. grupiliccy bclanientremriatnp Co. acquired the net assets of XYZ, Inc. for P10.4M. The Solution: peace ee ee "o eof XYZ ges me Average earnings (650,000 +5 years) oe arian 2 ed Divide by: Capitalization’ rate jormal rate of retum is 12% on net assets before recognition of Estimated purchase price Fair value of net identifiable assets acquired ee cg “Requirement: Compute for the average earnings of XYZ. Illustration 3: Applications of the Direct valuation method or ABC Co. plans to acquire the net assets of XYZ, Inc. with18. Combinations (Part 3) 9 Average earnings Normal earnings 2% x10") Excess earnings or Superior earnings (sien) Divide by: Capitalization rate Goodwill igo en) ABCCo. XYZ, Ine. ‘Total contribution (aqueeze) 600,000 900,000 1,500,000 value'of net assets (400,000) (600,000) will 200,000 300,000 200,000 Illustration 5: Applications of the Direct valuation method ABC Co. and XYZ, Inc. decided to combine and set up a entity ~ Alphabets Corporation. The individual records of combining constituents show the following: ABC Co, 400,000 irement (C Po ABCCo, XYZ.Inc. Totals asset contributions 400,000 600,000 1,000,000 Alphabets Corporation issues 10% preference shares with 100 100 value per share of P100 for the net assets contributions of Ws) combining constituents and ordinary shares with par value share of P50 for the excess of total: contributions (net as contribution plus goodwill) over net assets contributions. ‘The normal rate of return is 10% of net assets. Excess earnings be capitalized at 20% Compute for the following: Total contributions of ABC Co. and XYZ, Inc. c. The ratio of total shares (preference and ordinary) issued ABC Co, and XYZ, Inc(Part 3) 121 120 i Pate S SO Reverse acquisitions utional acquisition vs. Reverse acquisition: Ina business combination accomplished through exchange of Conventional ea aa acquisition Ge |= Accounting acquirer. | - Accounting acquiree = Accounting acquirer) | - legal acquire) is the acquirer for accounting purposes i pees cot) For example, ABC Co,, a private entity, wants to Legal subsidiary public entity but does not want to register its share accomplish this, ABC will arrange for a public entity to a equity interests in exchange for the public entity's equity i atior Fair value of Fair value of the In here, the public entity is the legal acquirer be eration ‘consideration notional number of issued its equity interests, and ABC Co. is the legal erred transferred by the ecu metres tbe because its equity interests were acquired. However, SY eee applying the acquisition method: Seas gael a. the public entity is identified as the acquiree for acco issue tothe accounting purposes (accounting acquiree); and acquiree (legal parent) b. ABC Co. is identified as the as the accounting acquirer. to giveth pene be Measuring the consideration transferred In substance, the accounting acquirer issues no considerati cond ane the acquire. Instead, the accounting acquire issues interests to the owners of the accounting acquirer for th ‘obtain control over the accounting acquire. As such, the acquisition-date fair value of consideration transferred by the accounting acquirer is m tration: Reverse acquisition ypany, exchange equity interests. ‘ABC Co. issues 5 shares in exchange for all the outstanding, shares of XYZ, Ine. ABC's shares are quoted at P40 per share, while XYZ’s shares have a fair value of P200 per share + The statements of financial position immediately before the -quiree) the same percentage that results from the re acquisition. combination are shown below: ABC Co. XYZ, Inc. Mentifiable assets 1,600,000 2,400,000 1,600,000 2,400,000, Total assetsLiabilities 1,300,000 ‘Share capita: 10,000 ordinary shares, P10 par 100,000 8,000 ordinary shares, P100 par Retained earnings Total liabilities and equit se ~XYZ (accounting acquirer) issues shares to ABC Shares * The assets and liabilities approximate their fair values, 3.000 80% ¥» currently issued shares 2,000 20% Requirements: sued to ABC [(8,000 + 80%) x 20%] STON . combinati ae a. Identify the accounting acquirer, pres ber Pecos tin b. Compute for the goodwill. If the business combination had taken the form of XYZ XYZ shares to ABC's shareholders, Solution: sponse chanel sa gc anal, wild have had to issue 2,000 shares Z's shareholders Raia rest in the combined entity to be the same. XYZ’s Jd then own 8,000 of the 10,000 issued shares of XYZ (80% of Legal form of the contract: ABC issues 5 shares for each of the ‘combined entity), while ABC’s shareholders own 2,000 (20% of Outstanding shares of XYZ. After the issuance, ABC's equity. have the following structure: 4 ABC's currently issued shares 10,000 ‘Shares issued to XYZ (5x 8,000) 40,000 Total shares aftr the combination 50,000 (300,000), Jue of ABC's net assets (1.6M~13M) fi —— ee Analysis: The business combination is a reverse acqu because XYZ obtains control over ABC despite the fact that is the issuer of shares: In other words, XYZ let itsel (legal form) in order to gain control over ABC (substance) > XYZ, Inc, the legal acquiree, is the accounting acquirer. » ABC, Co., the legal acquirer, is the accounting acquire.125 PROBLEMS: PROBLEM 1: FOR CLASSROO! I: yM DISt Methods of estimating goodwill Fa fa a the following information for the next four items: ity A is contemplating on acquiring Entity B. Rel + Entity B’s net assets as at the current year-end have a + The industry averay : ie Tate of retum on The probable duration of Entity B’s Socal pant s ‘+ Ina reverse acquisition, the issuer of shares (the legal ac © The consideration transferred in a reverse acquisit |. Goodwill is equal to the average excess earnings capitalized . Goodwill is measured by capitaliz capitalizing the average earni mings amortized | ii ized but tested for impairment at least annually. yw much is the goodwill? will is measured by discounting the average excess is the accounting acquiree. snings at 9%. How much is the goodwill? measure ies ‘ps on the number of equity interests the subsidiary acownting acre) wold he had suf bas pe et parent (accounting acquiree) the juity inte ir it ans nae terest in the combined entity that result acquisition Minty A and Entity B exchanged equity interests in a business {ombination. Relevant information follows: | Entity A has 2,000 issued shares. To effect the business combination, Entity A will issue 2 new shares for each of the 3,000 total outstanding shares of Entity B. Entity A’s shares have fair value of F100 per share, while Entity B’s shares have fair value of P300 per share. + Entity A’s net identifiable assets have a fair value of £260,000 as at the acquisition date. formation follows: How much is the goodwill? Enty Bs average annual earings inthe pit 5 year {OBLEM 2: MULTIPLE CHOICE - THEORY ‘Aiter initial recognition, goodwill arising from a business ‘combination is (use ‘full PFRSS’) a. amortized over its useful life, not exceeding 10 years. b. notamortized but tested for impairment at least annually. ¢. amortized over its useful life, not exceeding 40 years. ‘d, amortized and tested for impairment, value of P8,000,000. years. (25%. How much is vege How is goodwill tested for impairment? a. Goodwill is allocated to CGUs. The (CGUs are the ones tested for impairment. Any impairment is charged first t0 the allocated goodwill, and any excess is charged to the other assets in the CGU. 12%. How much is the goodwill?tons (Part 3) (M3: MULTIPLE CHOICE - COMPUTATIONAL, up a new entity called App Corporation. xe 100,000 ordit shares, which are to be between Gamer and Player based on their total arb eieat ions, including goodwill. sonbaines Rope eee goodwill and the xdwill is computed by capitalizing excess earnings at 20%, are A eactiatend ay Sop be ceca q industry normal earnings are 5% of net assets. +b. not capitalized 2 sometimes capitalized and sometimes expensed, ice yye annual earnings pw much is the total goodwill expected to arise from the jniness combination? the accounting acquirer. bi. the legal acquirer is also the cece acta ‘ the consideration transferred is liability rather than a: the legally acquired is the accounting acquirer. 75,000 4.0 How many shares will be issued to Gamer and Player, He (the consideration transfered in a reverse acquis espectively? Gamer Co. Player Co. a. atnil ‘b. at cost rather than fair value. . aoe 2 2am ©. ina reverse fashion bj 25: en y squeezing upwards starting ; 25,500 o das an amount based on the number of equity interests iced Gabacipetecnenatecesue legal subsidiary-(accounting acquirer) would have had Which of the combining entities is most likely the acquirer? a. Gamer Co. c. App Corporation b. Player Co. 4. Google Play Cloudy Co. plans to acquire all the assets and liabilities of Day Co. Cloudy expects that it will need to pay a premium equal to the discounted amount of Day's excess average annual ‘earnings in order to effect the transaction. The appropriate discount rate is 10%.Day's earnings in the past 5 years: + The 20x4 earnings include an expropriation Day's net assets have a current fair value of P590,000.. ‘The industry average rate of return on net assets is 12 ‘+ The probable duration of “excess earnings” is 5 years. How much is the estimated purchase price? . Sunday Co, a publicly listed entity, and Monday private company, exchange equity interests in a busi ‘© Sunday:Co. issues 12 shares for all the outstanding sl ines are quoted at P60 per share, Monday's shares have a fair value of P200 per share. * The net assets of the entities immediately before combination are shown below: (The amounts app: the acquisition-date fair values) 12,000 ordinary shares, #10 par 9,000 ordinary shares, P100 par How much is the goodwill? duction IRS 3 deals with the accounting for a business combination at acquisition date, while PFRS 10 deals with the preparation of consolidated financial statements after the find presentation ‘business combination. Consolidated financial statements ~ “the financial statements » > > or Group ~“a ane Parent - “anentity that controls one or more entities.” > Subsidiary - “an entity that is controlled by another entity.” S 10Appendix A) Wd Financial Statements (Pert D) olidated Financial Statements (Part 1) idated Financial Statements the PFRS for SMEs jow on the topic discussion on business combination is subdivided into the ing chapters: jer Title Coverage ‘Consolidated FS (Part 1) Basic consolidation procedures Consolidated FS Consolidated FS (Part 3) Miscellaneous topics 7 Consolidated FS (Part 4) Measurement at other than cost wning Objectives State the elements of control. Prepare consolidated financial statements at the acquisition .pare consolidated financial statements at a subsequent