SCHOOL OF ACCOUNTANCY

ACCT 4011 FINANCIAL ACCOUNTING STUDIES

LECTURE 2 BUSINESS COMBINATIONS II: ADVANCED APPLICATION
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 assets from acquirer to acquiree / owners of acquiree
Incurrence of (or undertake) liabilities of acquiree
Issue of equity instruments to acquiree / owners of acquiree
Contingent consideration (details see below)
Consideration transferred by the acquirer is the sum of the acquisition-date FAIR VALUE of:
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.

SCHOOL OF ACCOUNTANCY
ACCT 4011 FINANCIAL ACCOUNTING STUDIES
LECTURE 2 BUSINESS COMBINATIONS II: ADVANCED APPLICATION
Non-monetary assets transferred from acquirer
Based on fair value hierarchy
Effectively selling the 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 different from the fair
value
Remeasure the transferred assets in a business combination to fair values from carrying amounts
Recognise the transfer of assets with a gain / loss on disposal at 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.
specialised machine was $200,000 with a carrying amount of $140,000.

The cost of that

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 value of shares issued by 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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SCHOOL OF ACCOUNTANCY
ACCT 4011 FINANCIAL ACCOUNTING STUDIES
LECTURE 2 BUSINESS COMBINATIONS II: ADVANCED APPLICATION
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 price is 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 values of liabilities undertaken, with reference to the present values of 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 obligation of 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 right of the acquirer to the return of previously transferred consideration if specified conditions
are met
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SCHOOL OF ACCOUNTANCY
ACCT 4011 FINANCIAL ACCOUNTING STUDIES
LECTURE 2 BUSINESS COMBINATIONS II: ADVANCED APPLICATION
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 sums due 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.

the fair value per share of Entity A was $10 per share.

On 1 January 2014,

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%.

SCHOOL OF ACCOUNTANCY
ACCT 4011 FINANCIAL ACCOUNTING STUDIES
LECTURE 2 BUSINESS COMBINATIONS II: ADVANCED APPLICATION
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 exchange between the buyer and seller for the acquired business
Separate transactions for 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 instruments

Including transaction costs, e.g. stamp duties, professional advisers fees, underwriting costs and
brokerage fees
For issuing equity instruments, treat as reduction in the share capital of 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 amortise over
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.

SCHOOL OF ACCOUNTANCY
ACCT 4011 FINANCIAL ACCOUNTING STUDIES
LECTURE 2 BUSINESS COMBINATIONS II: ADVANCED APPLICATION
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) synergy between 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 benefits from assets that
are not capable of being individually identified and separately recognised (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 recognised
Calculated as (the simplest form):

Goodwill

Consideration transferred
(Discussed in Topic IID)

Acquirers interest in the net fair

value of the acquirees
identifiable assets and liabilities
(Discussed in Topic IIC)

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

The

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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SCHOOL OF ACCOUNTANCY
ACCT 4011 FINANCIAL ACCOUNTING STUDIES
LECTURE 2 BUSINESS COMBINATIONS II: ADVANCED APPLICATION
The trial balance of Entity B as at 1 July 2009 were as follow:

Entity A incurred incidental costs of $30,000 in relation to the acquisition.

A were $8,000.

Costs of issuing shares in Entity

Assume Entity As shares worth $1.60 each on acquisition date.

SCHOOL OF ACCOUNTANCY
ACCT 4011 FINANCIAL ACCOUNTING STUDIES
LECTURE 2 BUSINESS COMBINATIONS II: ADVANCED APPLICATION
Gain on bargain purchase (previously known as negative goodwill)
Occurred when acquirers interest in the net fair value of the acquirees identifiable assets and
liabilities > consideration transferred
Considered as anomalous or rare except limited circumstances like a forced sale by the acquiree
Steps in recognising a gain from the acquirers perspective:
Reassess whether 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 gain immediately
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 incomplete by the end of the reporting period

Acquirer has to report provisional amounts for the business combination at acquisition date
Any adjustments within the measurement period (restricted to one year from the acquisition
date) made to the provisional amounts recognised at acquisition date should be retrospectively
adjusted to reflect new information obtained regarding facts and circumstances existing as of the
acquisition date (instead of information results from events occurring after the acquisition date).
Adjustments include a revision to the goodwill already recognised as well as changes in
depreciation and amortisation
Acquirer needs to determine during the measurement period whether there is any omission of
recognition of additional assets or liabilities that existed at the acquisition date
Adjusted retrospectively if 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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SCHOOL OF ACCOUNTANCY
ACCT 4011 FINANCIAL ACCOUNTING STUDIES
LECTURE 2 BUSINESS COMBINATIONS II: ADVANCED APPLICATION
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 consideration
Indemnification 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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SCHOOL OF ACCOUNTANCY
ACCT 4011 FINANCIAL ACCOUNTING STUDIES
LECTURE 2 BUSINESS COMBINATIONS II: ADVANCED APPLICATION
Case 1: Classified as equity (e.g. by issuing a fixed amount of shares as contingent consideration)
No remeasurement is 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
number of shares as contingent consideration)
Measured at fair value at each reporting date
Any resulting gain or loss recognised in profit or loss
Illustration: 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).
end.

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

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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SCHOOL OF ACCOUNTANCY
ACCT 4011 FINANCIAL ACCOUNTING STUDIES
LECTURE 2 BUSINESS COMBINATIONS II: ADVANCED APPLICATION
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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SCHOOL OF ACCOUNTANCY
ACCT 4011 FINANCIAL ACCOUNTING STUDIES
LECTURE 2 BUSINESS COMBINATIONS II: ADVANCED APPLICATION

Recap:

Acquisition (Business
Combination)

Net assets

At acquisition, acquirer
recognises all identi2iable
assets and liabilities

Goodwill (or gain on bargain

purchase) recognised at
acquisition on ACQUIRER'S
STATEMENT OF FINANCIAL
POSITION

No parent-subsidiary
relationship; no preparation of
consolidated 2inancial statements

Shares (equity interests)

At acquisition (HKFRS 9),

Dr. Investment in acquiree (at fair value of
consideration)
Cr. Cash
Cr. Share Capital (share consideration, if any)
Cr. Contingent consideration (liability or equity)

Goodwill (or gain on bargain purchase) recognised

when preparing CONSOLIDATED FINANCIAL
STATEMENTS (as consolidated adjustment entries)

Parent-subsidiary relationship may exist; preparation of

consolidated 2inancial statements in accordance with
HKFRS 10

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