ACCT4011_Lecture 2_Business Combinations II (Revised) (Class)

7/24/2019 ACCT4011_Lecture 2_Business Combinations II (Revised) (Class)

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SCHOOL OF ACCOUNTANCYACCT4011FINANCIAL ACCOUNTING STUDIESLECTURE 2BUSINESS COMBINATIONS II:ADVANCED APPLICATION

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Readings: Wiley Chapter 14, pages 515 527; 532 - 549

TOPIC IID DETERMINE THE AMOUNT OF CONSIDERATION

Examples of consideration in a business combination:

Transfer of assetsfrom acquirer to acquiree / owners of acquiree

Incurrence of (or undertake) liabilitiesof acquiree

Issue of equityinstruments to acquiree / owners of acquiree

Contingentconsideration (details see below)

Consideration transferred by the acquirer is the sumof the acquisition-date FAIR VALUEof:

Assets transferred by the acquirer;

Liabilities incurred by the acquirer to former owners of the acquiree; and

The equity interest issued by the acquirer.

Cash or monetary assets paid by acquirer

Normally readily determinable unless it involves deferred payment

Deferred payment:

Settlement to acquiree / owners of acquiree postponed to a time after the acquisition date

Involve present value techniques(i.e. discount rate / incremental borrowing rate)

Illustration: Entity A acquired all the net assets of Entity B at a consideration of $100,000 on 1 January 2010.Half of it was paid at acquisition date while the remaining half will be paid two years after the acquisition

date. The incremental borrowing rate of Entity A is 6% p.a. The fair value of net assets acquired on 1

January 2010 was determined to be $94,500.


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Non-monetary assets transferred from acquirer

Based on fair valuehierarchy

Effectively sellingthe non-monetary assets to the owners of the acquiree

Upon transfer / sale of the non-monetary asset to owners of the acquiree (as part of the consideration),

the carrying amount of the transferred asset in the records of the acquirer may be differentfrom the fair

value

Remeasurethe transferred assets in a business combination to fair valuesfrom carrying amounts

Recognise the transfer of assets with a gain / loss on disposalat acquisition date

(Note: This remeasurement is restricted to situation where the non-monetary assets are transferred to

the owners of the acquiree. If the non-monetary assets are transferred to the post-combination entity

which the acquirer retains control, this remeasurement does NOT apply.)

Illustration: As part of the consideration in acquiring all the net assets of Entity B, Entity A agreed to

transfer a specialised machine to Mr. Chan who has been the sole owner of Entity B. The cost of that

specialised machine was $200,000 with a carrying amount of $140,000. Due to its specialised nature,

Entity A adopted valuation techniques and calculated its fair value to be $160,000.

Equity instruments issued by acquirer

For acquisition of net assets of acquiree by issuing shares of acquirer,

Based on fair valueof shares issuedby the acquirer at acquisition date

For acquisition of shares of acquiree (i.e. share exchange transaction) by issuing shares of acquirer,

Fair value of shares issued by the acquirer at acquisition date; OR

Fair value of shares acquired from the acquiree at acquisition date, whichever is more reliably

measureable.


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Illustration:

Entity A acquires 100% of Entity B through an issue of 5,000,000 shares to the vendors of Entity B. The

following information relates to Entities A and B at the date of acquisition:

Market price per share and fair value of equity have incorporated the effects of acquisition and dilution.

Possibility 1: Entity As market priceis a reliable indicator of the fair value of Entity As quoted entity:

Possibility 2: Fair value of Entity B is a better estimate of the fair value of the shares acquired

Liabilities undertaken

Based on fair valuesof liabilities undertaken, with reference to the present valuesof expected future

cash outflows

Future losses or other costs expected to be incurred as a result of the business combination are not

liabilities undertaken

Contingent consideration

Acquisition price is not completely fixed at the time of exchange, but is instead dependent on the

outcome of future events

Either:

(1) Performance of the acquired entity (acquiree)

An obligationof the acquirer to transfer additional assets / equity interests to the former owners

of the acquiree as part of the exchange for control of the acquiree if specified future events occur

or conditions are met

OR

A rightof the acquirer to the return of previously transferred consideration if specified conditions

are met


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Illustration: Contractual agreement calls for additional payments to be made to the former

owners of the acquiree if defined revenue or earnings thresholds are met or exceeded. There

might be additional sumsdue if the acquired operations produced $4.5 million or greater revenues

in year 1 after the acquisition.

(2) Market value of the consideration initially given for the acquisition

Illustration: Acquirer issues shares to the acquiree and the acquiree is concerned that the issue of

these shares may make the market price of the acquirers shares decline over time. Acquirer

may offer additional cash or shares if the market price falls below a specified amount over a

specified period of time.

Include contingent assets and liabilities as part of the consideration transferred, measured at

acquisition-date fair value

Illustration: On 1 January 2014, Entity A acquired all the net assets of Entity B in exchange for shares in

Entity A. Entity A agreed to issue 1,000,000 ordinary shares of Entity A to Entity B. On 1 January 2014,

the fair value per share of Entity A was $10 per share. Additional payment by Entity A to Entity B if the

business achieves the following profit benchmarks during the financial year ended 31 December 2015:

Payment Probability

Profit greater than $30,000,000 $6,000,000 0.6

Profit between $15,000,000 and $30,000,000 $3,000,000 0.3

Profit below $15,000,000 Nil 0.1

The appropriate discount rate is 5%.


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Acquisition-related costs

Costs directly attributable to the combination, e.g. finders fee, advisory, legal, accounting, valuation,

general administrative costs including the costs of maintaining an internal acquisition department and

costs of issuing debt and equity instruments

Should NOT be considered as part of the consideration:

Not part of fair value exchangebetween the buyer and seller for the acquired business

Separatetransactionsfor which the buyer pays the fair value for the services received but not for

the business combination

Do not represent assets of the acquirer at acquisition date (consider whether these items can

provide future economic benefits to the entities or the benefits obtained have already been

consumed as received)

Accounted for as operating costs(expensed) in the period in which services are received

Exception: Cost of issuing debt and equity instruments should be accounted for in accordance

with HKFRS 9 Financial Instruments (see next section)

Illustration: The legal fees executing sales agreement incurred by Entity A (the acquirer) were $30,000.

Cost of issuing debt and equity instrumentsIncluding transaction costs, e.g. stamp duties, professional advisers fees, underwriting costs and

brokerage fees

For issuing equity instruments, treat as reduction in the share capitalof the entity

Illustration: The cost of issuing ordinary shares in acquiring Entity B is $10,000.

For issuing debt securities, include in the initial measurement of the liability and amortiseover

the life of the loan (which will be included in income statement as part of borrowing costs)

Illustration: The cost of issuing debt securities in acquiring Entity B is $20,000.


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TOPIC IIE RECOGNISE GOODWILL/GAIN FROM BARGAIN PURCHASE

[Note: The calculation of goodwill in this section applies to simple situations of which the business combination

involves: (1) acquisition of net assets from acquiree; or (2) acquisition of 100% equity interests of acquiree.

Calculation of goodwill involving acquisition of non-wholly-owned subsidiary (i.e. equity interests) and the

calculation of non-controlling interests (NCI) will be dealt with in Lecture 6.]

Goodwill

Results from:

(1) synergybetween the identifiable assets acquired (combination goodwill); or

(2) economies of scale expected from combining the operations of the acquirer and acquiree; or

(3) from assets that, individually, do not qualify for recognition in the financial statements but for

which the acquirer is willing to make a payment (premium) in the business combination

exceeding the aggregate recognised values of the net assets acquired (core goodwill)

Represents payment made by the acquirer in anticipation of future economic benefitsfrom assets that

are not capableof being individually identifiedand separatelyrecognised(think about the concept

of identifiability discussed under the section of Intangible Assets)

Defined in HKFRS 3 (Revised) as:

an asset representing future economic benefits arising from other assets acquired in a business

combination that are not individually identified and separately recognisedCalculated as (the simplest form):

Considered as a residual, after the acquirers interest in the identifiable tangible assets, intangible

assets and liabilities of the acquiree is recognised

Presented as an intangible asset

Illustration: On 1 July 2009, Entity A acquired all the assets (except cash) and liabilities of Entity B. The

acquisition was satisfied by the issue of 1,000,000 $1 ordinary shares of Entity A. The fair value of Entity

Bs assets and liabilities at this date was as follows:

There is no material difference between the carrying amounts and the fair values for other items.

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Considered as anomalousor rare except limited circumstances like a forced sale by the acquiree

Steps in recognising a gain from the acquirers perspective:

Reassesswhether the acquirer has

(1) correctly identified all assets acquired and liabilities assumed (recognition criteria);

(2) correctly measured at fair value all the assets acquired and liabilities assumed

(measurement criteria); and

(3) correctly measured the considered transferred

If reassessment confirms no measurement and recognition errors, recognise the gainimmediately

in profit or loss

Illustration: Entity A, a venture capitalist, paid $600,000 to acquire all the assets and liabilities of Entity B

which had been plagued by many troubles, including a lawsuit from a competitor for patent infringement

which gives rise to a contingent liability (measured at $600,000) which has not been recorded in the

individual financial statement of Entity B. The fair values of recorded net assets of Entity B were

measured at $2,000,000 as at acquisition date.

TOPIC IIF ADJUSTMENTS DURING MEASUREMENT PERIOD

Business combination may be incompleteby the end of the reporting period

Acquirer has to report provisional amountsfor the business combination at acquisition date

Any adjustments within the measurement period (restricted to one year from the acquisitiondate) made to the provisional amounts recognised at acquisition date should be retrospectively

adjustedto reflect new information obtained regarding facts and circumstances existingas of the

acquisition date (instead of information results from events occurring after the acquisition date).

Adjustments include a revision to the goodwillalready recognised as well as changes in

depreciation and amortisation

Acquirer needs to determine during the measurement period whether there is any omission of

recognitionof additional assets or liabilities that existed at the acquisition date

Adjusted retrospectivelyif there is any omission of recognition

After the measurement period, any revision in the accounting of business combination will be treated

as a correction of error in accordance with HKAS 8 Accounting Policies, Changes in Accounting

Estimates and Errors


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Any change in estimate arising from new information (e.g. settlement amount of a contingent liability)

should be recognised in the current period.

Illustration: Entity A acquired all the net assets of Entity B including a piece of specialised equipment on 1

July 2009 on which Entity A has not received the valuation report of this specialised equipment and

therefore assigned a provisional amount of $1,300,000 as the fair value, giving rise to a goodwill of

$125,000. A set of financial statement has been prepared on 31 December 2009. On 1 March 2010, Entity

A received the final value from the independent valuer indicating that the fair value of the specialised

equipment at the acquisition date should be $1,350,000. The equipment had a further 10-year life from

acquisition date.

TOPIC IIG SUBSEQUENT MEASUREMENT

After measurement period, some items on initial acquisition may need to be measured subsequently:

Contingent considerationIndemnification assets

Contingent liabilities

Goodwill

Contingent consideration

Changes resulting from events after the acquisition date, such as meeting an earnings target, reaching

a specified share price or reaching a milestone on a research and development project are NOT

measurement period adjustments(refer to Topic IIF)

Upon initial measurement, contingent consideration is either classified as

Equity (e.g. requirement for the acquirer to issue more shares subject to subsequent events); or

Liability (e.g. the requirement to provide more cash subject to subsequent events)


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Case 1: Classified as equity (e.g. by issuing a fixed amountof shares as contingent consideration)

No remeasurementis required

Subsequent settlement is accounted for within equity

Effectively issued for no consideration

No change to equity balance

Illustration: Entity A acquired all the shares of Entity B in exchange for shares in Entity A on 1 January

2015. Entity A agreed to pay Entity B an additional 10,000 shares if the market price of its shares drops

below $50 in the following year. Entity A estimates that fair value of such contingent consideration to be

$50,000.

Case 2: Classified as liability (e.g. payment of cash as contingent consideration or issuing variable

numberof shares as contingent consideration)

Measured at fair valueat each reporting date

Any resulting gain or loss recognised in profit or lossIllustration: Entity A acquired all the shares of Entity B in exchange for shares in Entity A on 1 January

2015. Part of the consideration was settled by an issue of 1,000 shares of Entity A (share price $10 at 1

January 2015). Entity A agreed to pay Entity B any deficit should the share price drops below $8 by year

end. Entity A assessed the fair value of such contingent consideration to be $150 at acquisition date.

1 January 2015,

30 June 2015, fair value of contingent consideration is assessed to be $200

31 December 2015, share price of Entity A = $8.2

31 December 2015, share price of Entity A = $7.9


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Indemnification assets

At each reporting date subsequent to the acquisition date, measure an indemnification asset

recognised as part of the business combination using the same basis as the indemnified item

Any changes in measurement of the asset are recognised in profit or loss

Derecognise the indemnification asset only when it collects the asset, sells the asset or loses the rights

to the asset

Contingent liabilities

Subsequent to acquisition date, measured as the higher of:

Amount that would be recognised in accordance with HKAS 37 (i.e. at the best estimate of the

expenditure required to settle the present obligation at the end of the reporting period); or

The amount initially recognised

Goodwill

Not amortised but subject to an annual impairment test as detailed in HKAS 36 Impairment of Assets


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ACCT4011_Lecture 2_Business Combinations II (Revised) (Class)

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