Business Combinations

(Text, Chapter 3)

Presenter Persis Ahrestani

Preparer Chuck Campbell
 Chapter 3 Learning Objectives

1. Define a business combination and evaluate relevant

factors to determine whether control exists in a business
acquisition.
2. Describe the basic forms for achieving a business
acquisition.
3. Prepare a balance sheet for an acquisition accomplished
by a purchase-of-net-assets.
4. Prepare a consolidated balance sheet for an acquisition
accomplished purchasing 100% of the acquiree’s
outstanding voting shares.

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INTRODUCTION TO BUSINESS
COMBINATIONS

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 Business combinations defined

• A business combination is a transaction or

other event in which an acquirer obtains
control of one or more businesses.

• Transactions sometimes referred to as “true

mergers” or “mergers of equals” are also
business combinations.

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 Business combinations defined

Conceptually, a business combination occurs when

businesses combine their operations. In theory,
this can happen either by one acquiring the other
or by the two businesses joining together to
become a single economic entity.

Current accounting practices require that all

business combinations be accounted for as
acquisitions.

A business combination is the acquisition of control

of all (or substantially all) of the assets of another
business.
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 Business combinations defined

A business is defined as an integrated set of activities and

assets that is capable of being conducted and managed
for the purpose of providing goods or services to
customers, providing investment income (such as
dividends or interest) or generating other income from
ordinary activities.

The purchase of all the assets of a business is not

necessarily a business combination but if it is purchased
as a going concern, it is a business combination.

The businesses must not have previously been under

common control.

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 Forms of business combinations

Business combinations may take the form of:

– acquisition of net assets (i.e., acquisition of assets and assumption
of liabilities);
– acquisition of assets but not the liabilities;
– acquisition of shares;
– control through contractual arrangements.

They may be conglomerate, horizontal or vertical

combinations.

Consideration may take the form of cash, debt, shares or

some combination of these.

The consideration may be fixed at the time of acquisition or

may contain contingent components.
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 Income tax considerations

• Acquisition of assets will usually be preferred

by the acquirer because it provides larger CCA
deductions and no inherited tax assessment
issues.
• Acquisition of shares will usually be preferred
by the acquiree because the resulting capital
gains are subject to favourable tax treatment.
• An advantage to the acquirer of acquiring
shares is that not all of the shares must be
purchased to obtain control.
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 The purchase method

The purchase method:

– used in Canada up to 2011;
– an acquirer must be identified;
– the business combination is reported as if it were
a purchase of assets;
– the acquirer’s assets remain at their book values;
– the acquiree’s assets are recorded at their cost
to the acquirer.

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 The acquisition method

The acquisition method:

– Canadian GAAP from 2011; previously (and still)
US and international GAAP
– an acquirer must be identified;
– the business combination is reported as if it were
a purchase of assets;
– the acquirer’s assets remain at their book values;
– the acquiree’s assets are recorded at their fair
values.

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 The new entity method

The new entity method:

– this method is based on the concept that when
two businesses combine, the result is a new
business entity being created;
– both company’s assets would be recorded at their
fair values on the acquisition date;
– this method has never been considered
acceptable in practice but has some theoretical
support.

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 Pooling of interests method

The pooling-of-interests method:

– the business combination is treated as an
inconsequential combining of interests;
– both companies’ assets remain at their book
values;
– income is combined retroactively;
– this method is no longer accepted as GAAP (due
to abuses in its application in the United States).

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 Pooling of interests method

If an acquirer could not be identified, earlier standards permitted

accounting for the business combination as a pooling of
interests.
In this method, the assets and liabilities of the companies were
added together at their book values and incomes were
combined retroactively as if the companies had always been
one.
The lower book values and lower amortization charges resulted in
higher net income and a higher return on capital. As a result,
companies sought to use this method and its use was abused in
the United States.
Consequently, the pooling of interests method is no longer
permitted in either Canada or the United States, nor is it
permitted under the International Financial Reporting Standards.

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THE ACQUISITION METHOD OF
ACCOUNTING FOR BUSINESS
COMBINATIONS

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 Establishing the acquisition date

The acquisition date is the date on which the

acquirer obtains control of the acquiree:
– the date on which the net assets or equity interests are
received and the consideration is given; or
– the date of a written agreement, or a later date
designated therein, that provides that the control of the
acquired enterprise is effectively transferred to the
acquirer on that date, subject only to those conditions
required to protect the interests of the parties involved.

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 Identifying the acquirer

• If the transaction is for cash, the company

providing the cash is the acquirer.

• If the transaction is for shares, the acquirer is

the predecessor company whose
shareholders have the majority of the voting
shares following the combination.

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 Identifying the acquirer

Other factors:
– largest block of shares;
– composition of the board of directors;
– composition of senior management;
– payment of a premium over market
value.

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 Determining the acquisition cost

• The acquisition cost is the total of any cash

paid, the fair value of any other assets
transferred, the present value of any promises
to pay in the future, the fair value of any shares
issued and the fair value of any contingent
consideration.
• Any direct costs of the acquisition (except the
cost of issuing shares or debt) are expensed in
the period in which they were incurred (this is a
relatively recent change in Canadian GAAP).
Costs of issuing shares or debt are deducted
from the related liability/equity account.
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 Recognition of acquired assets

• At the acquisition date, the acquirer must

recognize, separately from goodwill, the
identifiable assets acquired, the liabilities
assumed and any non-controlling interest.
• Intangible assets must be recognized if they can
be separately identified.
• Such recognition must be made, even if the
acquiree has not previously recorded the
asset/liability (e.g., internally developed patents or
technology; some contingent liabilities).
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 Deferred income taxes at
acquisition

• The fair values at the acquisition date are

determined without reference to their tax values.
• Deferred (future) income tax balances must then be
recalculated based on the difference between the
carrying value of the assets or liabilities in the
consolidated financial statements and their tax
values.
• The tax values may or may not be changed by the
combination; this depends upon the legal form of
the combination, tax rollover provisions, etc.
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 Non-controlling interest

• Non-controlling interests (NCI) arise where the legal

form of the business combination involves the
acquisition of shares and the acquirer obtains
control while owning less than 100% of the shares.
• The new standards allow two different bases for
measuring NCI on the acquisition date:
– valued at the fair value of the enterprise (including
goodwill);
– valued at the fair value of the identifiable
assets/liabilities.

We will consider this in more depth later in the course.

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 Goodwill

• Conceptually, goodwill is the capitalized expected

value of the enterprise’s earning power in excess of
a normal rate of return in the industry in which it
operates.
• It is rarely recognized when internally generated but
is recognized when purchased.
• It is calculated as a residual – the difference
between the fair value of the business (determined
from the amount paid for the controlling interest)
and the fair values of its identifiable net assets.

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 Goodwill

• In Canada, goodwill is no longer subject to

systematic amortization.
• Each reporting unit must be tested at least
annually for impairment of goodwill.
• Goodwill (net of any impairment) must be
separately disclosed in the financial
statements.
• Goodwill impairment losses must be disclosed
as a separate line item in the income
statement.
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 Negative goodwill

• Negative goodwill can arise from overvalued

net assets or from a bargain purchase.
• Before determining that there is negative
goodwill, a reassessment of all fair values must
be performed.
• If there is still a negative balance, first any
goodwill on the books of the subsidiary is
eliminated, and then any remaining balance is
taken to the acquirer’s income as a gain on the
acquisition date.
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ACQUISITION OF NET ASSETS

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 Acquisition of net assets

Holding Company Inc. acquired all of the net assets of Cheetah

Inc. by a cash payment on January 1, 2013. The balance sheet of
Holding Company Inc. immediately before the acquisition was as
follows:
Holding Company Inc.
Balance Sheet at January 1, 2013
Assets NBV
Cash $ 220,000
Receivables 60,000
Inventory 70,000
Capital Assets (net) 150,000
Total Assets $ 500,000

Liabilities and Equities

Current liabilities $ 60,000
Long-term debt 180,000
Share capital (1,000 shares) 160,000
Retained earnings 100,000
Total $ 500,000

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 Acquisition of net assets

At that date the balance sheet of Cheetah Inc. and the fair market
values of the assets and liabilities were as follows:
Cheetah Inc.
Balance Sheet at January 1, 2013
Assets NBV FMV
Cash $ 20,000 $ 20,000
Receivables 30,000 30,000
Inventory 50,000 40,000
Capital Assets (net) 70,000 130,000
Total Assets $170,000

Liabilities and Equities

Current liabilities $ 40,000 $ 40,000
Long-term debt 40,000 50,000
Share capital 60,000
Retained earnings 30,000
Total $170,000

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 Acquisition of net assets

What amount should Holdings be prepared to pay for the net

assets?
The maximum amount that they would pay equals the fair value of
the net assets plus whatever Holdings considers the goodwill of
Cheetah to be worth.
Assume that the amount paid is $150,000. What entries should
Holdings make to record the transaction?

Cash $ 20,000
Receivables 30,000
Inventory 40,000
Capital Assets 130,000
Current liabilities $
40,000 Long-term debt
50,000 Cash
150,000
Goodwill 20,000
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 Acquisition of net assets

What entries should Cheetah make to record the

transaction?
Cash $150,000
Current liabilities 40,000
Long-term debt 40,000
Cash $ 20,000
Receivables
30,000 Inventory
50,000 Capital Assets (net)
70,000 Gain on sale of
assets 60,000
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 Acquisition of net assets

The balance sheet of Holding Company Inc., immediately after the

acquisition will be as follows:
Holding Company Inc..
Balance Sheet at January 1, 2013
Assets
Cash $ 220,000 - $150,000 + $20,000 $
90,000
Receivables 60,000 + $ 30,000 90,000
Inventory 70,000 + $ 40,000 110,000
Capital Assets (net) 150,000 + $130,000 280,000
Goodwill + $ 20,000
20,000
Total Assets $ 500,000 $ 590,000
Liabilities and Equities
Current liabilities $ 60,000 + $ 40,000 $
100,000
Long-term debt 180,000 + $ 50.000
230,000
Share capital (1,000 shares) 160,000
160,000
Retained earnings 100,000
100,000 30
Total $ 500,000
 Acquisition of net assets

• It is possible that the acquisition could take place by

Holding Company Inc. issuing 500 new shares (worth
$150,000) to acquire the net assets of Cheetah Inc.
• If so, the only differences to the balance sheet after the
transaction are that cash would be higher by $150,000 and
share capital would also be higher by the same amount.
• You should note that in this case, Cheetah would own one-
third of the outstanding shares of Holdings and would
presumably account for it as a significant influence
investment.

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ACQUISITION OF SHARES

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 Acquisition of shares

• Now consider what would happen if, instead of

paying $150,000 to obtain the net assets of
Cheetah, Holdings paid $150,000 to acquire all the
shares of that company.

• What journal entries would each company record to

reflect this transaction?

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 Acquisition of shares

• In Holdings, the entry would be:

Dr. Investment in Cheetah $150,000
Cr. Cash $150,000

• Cheetah would make no entry as Cheetah is not a

party to the transaction. The transaction is
between Holdings and the former shareholders of
Cheetah. Cheetah would only change the names
of its shareholders in the share register.

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 Acquisition of shares

The balance sheet of Holding Company Inc., immediately after the

acquisition will be as follows:
Holding Company Inc..
Balance Sheet at January 1, 2013
Assets
Cash $ 220,000 - $150,000 $ 70,000
Receivables 60,000 60,000
Inventory 70,000 70,000
Investment in Cheetah Inc. + $150,000 150,000
Capital Assets (net) 150,000 150,000
Total Assets $ 500,000 $ 500,000

Liabilities and Equities

Current liabilities $ 60,000 $ 60,000
Long-term debt 180,000 180,000
Share capital (1,000 shares) 160,000 160,000
Retained earnings 100,000 100,000
Total $ 500,000 $ 500,000

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 Acquisition of shares

• Since the substance of the business combination is

the same whether the purchase is of net assets or
of shares, and since we want the financial
statements to represent the substance of
transactions, the financial statements of Holdings
should be the same whichever form of acquisition is
used.
• If the acquisition is of net assets, the combining is
done in the accounting records of Holdings. If the
acquisition is of shares, the combining is done
through the preparation of consolidated financial
statements. 36
 Acquisition of shares

• To achieve this, we must combine the financial

statements of the two companies, making the
eliminations necessary to avoid duplication.
• On the acquisition date, the only relevant statement
is the balance sheet (statement of financial position)
because we do not start to include the revenues and
expenses of the acquiree until after the acquisition
date.
• We begin the consolidation process by analyzing
the investment account in the acquirer’s books.

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Acquisition of shares

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Acquisition of shares

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Acquisition of shares

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 Acquisition of shares

• You should note that the consolidated balance

sheet on the previous slide is identical in every
respect to the balance sheet of Holdings
immediately after the transaction when the
business combination was achieved through a
purchase of net assets (slide 30).
• This will always be the case when the acquirer
acquires 100% of the outstanding shares of the
acquiree.

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 Reporting Depreciable Assets

• When we prepared the consolidated balance sheet,

we considered only the net book value of the capital
assets (i.e., cost less accumulated amortization).
• When preparing such statements in practice, we
must decide what to do about the accumulated
amortization of the subsidiary on the acquisition
date.
• The text gives two alternatives:
– proportionate restatement and
– net the amortization against cost at acquisition

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 Reporting Depreciable Assets

• We will use the net method (as the text does).

• In this method, the capital assets of the subsidiary
are brought into the consolidated balance sheet with
a cost equal to their fair value (and no accumulated
amortization).
• This gives the same results as when the acquisition
is done through a purchase of net assets.
Holdings Cheetah Adj Adj Cons B/S
Cost 200,000 100,000 60,000 (30,000) 330,000
Acc amortization 50,000 30,000 (30,000) 50,000
Net book value 150,000 70,000 280,000

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 ASPE Differences

• Parent companies may use either consolidation or

report investments in subsidiaries using the cost or
equity method. All subsidiaries must be reported
using the same method.
• The cost method may not be used if the subsidiary’s
shares are traded on an active market; fair value
should be used with changes through net income.
• Private companies that choose to use push-down
accounting must disclose the valuation changes in
the year in which push-down accounting is first
applied.
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 US GAAP Differences

• US GAAP generally requires majority voting rights

as the requirement for control.
• US GAAP does not require potential voting rights to
be considered in establishing control.
• IFRS provides an exemption to preparing
consolidated financial statements if the company’s
parent company prepares consolidated statements;
this exemption is not available under US GAAP.
• IFRS requires that the accounting policies be
uniform within the group; US GAAP only requires
that each company comply with US GAAP.
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 Reverse Takeovers

• Consider what happens when A Company which has 10,000

shares outstanding, issues 20,000 shares to acquire all of the
outstanding capital of B Company. Control of the combined
entity is in the hands of the original shareholders of B Company
who own 2/3 of the shares of A Company. This is called a
reverse takeover.
• This might be done to acquire tax losses or to acquire a listing
on a stock exchange, amongst other reasons.
• GAAP requires that the business combination be accounted for
according to its substance, not its form. The consideration is
equal to the market value of the number of shares that B
Company would have had to issue in order to effect a regular
acquisition. B Company’s shareholders’ equity values (after
giving effect to the deemed issue) are those which will appear in
the consolidated financial statements.
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 Reverse takeovers

If B Company had 15,000 shares outstanding immediately prior to

the acquisition of A, how many shares would it have issued to
have the same relative shareholdings between the two groups
of shareholders?

For B’s former shareholders to hold 2/3 of the shares, and A’s
former shareholders to hold 1/3 of the shares, B would have had
to issue 7,500 additional shares.

The accounting must reflect the substance of the transaction and

be recorded at the values implicit in the issue of 7,500 additional
shares of B to acquire control of A.

This is covered in Appendix 3A in the text and will not be

examined.

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