Professional Documents
Culture Documents
CHAP TER 3
Business Combinations
Examples
Covered By Section 1582
3-4. Examples of business combination transactions that are within the scope of Section
1582 include the following:
• A corporation acquires all of the net assets of a second corporation for cash and the
activities of the corporation meet the definition of a business.
• A corporation issues shares to the owners of an unincorporated business in return for
all of their net assets and these net assets meet the definition of a business.
• A corporation issues new shares as consideration for all of the outstanding shares of a
second corporation and the activities of the corporation meet the definition of a
business.
• A new corporation is formed and issues shares to the owners of two separate unincor-
porated businesses in return for all of the net assets of the two enterprises.
desire to retain the name of one of the enterprises, the ability to access the capital markets in a
particular manner, or simply various contractual arrangements that one or both of the enter-
prises have with suppliers, employees, or customers.
3-7. This is an important issue for accountants as the legal form used can, in some circum-
stances, obscure the actual economic substance of a transaction. An outstanding example of
this type of situation would be transactions that are referred to as reverse acquisitions.
Example Of Reverse Acquisition Company X, with 100,000 shares outstanding ,
issues 400,000 of its shares to the shareholders of Company Y in return for all of the
shares of that Company. From a legal perspective, Company X is the parent company,
because it is holding 100 percent of the shares of Company Y. Correspondingly, from a
legal perspective, Company Y is the subsidiary. However, from an economic point of
view, the former shareholders of Company Y now own a controlling interest in
Company X. This means that, in actual fact, the subsidiary, Company Y has acquired
the parent, Company X.
3-8. As an accountant’s mandate is to focus on economic substance, the accountant must
be able to look through the complex legal structures that are sometimes used to effect busi-
ness combinations. This is necessary in order to base accounting procedures on the real
events that have occurred. To accomplish this goal, accountants must have some knowledge
of the various legal forms that are used. As a result, we will illustrate the basic legal forms that
can be used to effect a business combination.
3-9. Note, however, this is an extremely complex area, particularly when consideration is
given to tax factors. A full discussion of legal forms for business combinations goes beyond the
scope of this text.
Example
3-10. Our discussion of legal form will use a simple example to illustrate the various
possible alternatives.
Example The Alpha Company and the Beta Company have, for a variety of reasons,
decided to come together in a business combination transaction and continue their
operations as a single economic entity. The date of the combination transaction is
December 31, 2009 and, on that date the Balance Sheets of the two companies are as
follows:
Alpha And Beta Companies
Balance Sheets
As At December 31, 2009
Alpha Beta
Current Assets $153,000 $ 35,000
Non-Current Assets 82,000 85,000
Total Assets $235,000 $120,000
3-11. In order to simplify the use of this Balance Sheet information in the examples which
follow, we will assume that all of the identifiable assets and liabilities of the two Companies
have fair values that are equal to their carrying values. In addition, we will assume that the
shares of the two Companies are trading at their book values. This would be $34.00 per share
62 Chapter 3
Legal Avenues To Combination
Figure 3 - 1
Acquisition Of Assets From Beta Company
$78,000 In Cash
Alpha Beta
Company Company
Beta’s Assets And Liabilities
for Alpha [($95,000 + $75,000) ÷ 5,000] and $7.80 per share for Beta [($53,000 + $25,000)
÷ 10,000]. This indicates total market values for Alpha Company and Beta Company of
$170,000 and $78,000, respectively.
Basic Alternatives
3-12. We will consider four basic alternatives in our discussion of the legal forms for imple-
menting business combination transactions. These alternatives can be outlined as follows:
Forms Based On An Acquisition Of Assets
1. Alpha Company could acquire the net assets of Beta Company through a direct
purchase from Beta. The consideration paid to Beta could be cash, other assets,
or Alpha Company debt or equity securities.
2. A new organization, Sigma Company, could be formed to directly acquire the net
assets of Alpha Company and Beta Company. As the Sigma Company is newly
formed, it would generally not have any assets to use as consideration in this
transaction. Given this, Alpha and Beta would receive debt or equity securities of
Sigma Company.
Forms Based On An Acquisition Of Shares
1. Alpha could acquire the shares of Beta Company directly from the shareholders of
Beta. The consideration paid to the Beta shareholders could be cash, other assets,
or Alpha Company debt or equity securities.
2. A new organization, Sigma Company, could be formed. Sigma Company could
then issue its debt or equity securities directly to the shareholders of Alpha
Company and Beta Company in return for the shares of the two Companies.
3-13. There are other possibilities here. For example, if Alpha had a subsidiary, Alpha could
gain control over Beta by having the subsidiary acquire the Beta Company shares from the
Beta shareholders. In addition, most corporate legislation provides for what is referred to as a
statutory amalgamation. This involves a process whereby two corporations become a single
corporation that is, in effect, a continuation of the predecessor corporations. However, an
understanding of the four basic approaches we have described is adequate for the purposes of
this material. These basic alternatives will be discussed and illustrated in the material which
follows.
3-15. At this point, it is likely that the Beta Company would go through a windup operation.
This would involve distributing the cash received from Alpha Company to its shareholders in
return for their shares. If this were to happen, the Beta Company shares would be canceled
and the Beta Company would cease to exist as a separate legal entity.
3-16. Without regard to the course of action taken by Beta Company after the sale of its net
assets, all of the assets and liabilities of the combined Companies will be recorded on Alpha
Company ’s books and the accounting for the combined Companies will take place as a
continuation of Alpha Company ’s records. This means that the business combination transac-
tion has been carried out in such a fashion that both Companies’ operations have been
transferred to a single continuing legal entity.
3-17. Alpha Company ’s Balance Sheet subsequent to the business combination transaction
would be as follows:
Alpha Company
Balance Sheet As At December 31, 2009
Acquisition Of Beta Assets For Cash
Current Assets ($153,000 - $78,000 + $35,000) $110,000
Non-Current Assets ($82,000 + $85,000) 167,000
Total Assets $277,000
3-18. It would not be necessary for Alpha to acquire 100 percent of the net assets of Beta in
order to have the transaction qualify as a business combination transaction. If Alpha were to
acquire, for example, the manufacturing division of Beta, this transaction would be subject to
the accounting rules for business combinations. The key point is that Alpha must acquire a
group of assets sufficient to meet the definition of a business entity.
3-19. You should also note that this business combination transaction could have been
carried out using Alpha Company shares rather than cash. While the economic outcome
would be the same unification of the two Companies, the resulting Alpha Company Balance
Sheet would be somewhat different.
3-20. More specifically, the Current Assets would not have been reduced by the $78,000
outflow of cash and there would be an additional $78,000 in Common Stock outstanding . If
the new shares were issued at their December 31, 2009 market value of $34.00 per share, this
transaction would have required 2,294 new Alpha shares to be issued ($78,000 ÷ $34.00).
This alternative Balance Sheet would be as follows:
Alpha Company
Balance Sheet As At December 31, 2009
Acquisition Of Beta Assets For Shares
Current Assets ($153,000 + $35,000) $188,000
Non-Current Assets ($82,000 + $85,000) 167,000
Total Assets $355,000
Figure 3 - 2
New Company Acquisition Of Assets From Beta Company
Alpha
Company
Beta
Company
7,800 Sigma Shares
3-24. As was the case when Alpha acquired the net assets of Beta on a direct basis, the result
of the business combination is that both Companies’ operations have been transferred to a
single continuing legal entity. The only difference here is that the continuing legal entity is a
new company rather than one of the combining Companies.
Business Combinations 65
Legal Avenues To Combination
Figure 3 - 3
Acquisition Of Shares From Beta Shareholders
$78,000
In Cash Shareholders
Alpha Of Beta
Company Beta Company
100% Of Beta
Shares
3-25. The resulting Sigma Company Balance Sheet is fundamentally the same as the one
that resulted from Alpha Company acquiring the net assets of Beta using Alpha shares as
consideration (see Paragraph 3-20). The only difference is that, because Sigma is a new
Company, all of the Shareholders’ Equity must be allocated to Common Stock, rather than
being split between Common Stock and Retained Earnings.
Figure 3 - 4
New Company Acquisition Of Shares From Beta Shareholders
Sigma Company
Shareholders Shareholders
Of Alpha Alpha Beta Of Beta
Company Company
3-35. In this case, there will be three ongoing legal entities. These would be the parent
Sigma Company, as well as Alpha Company and Beta Company, which have now become
subsidiaries. Once again we are faced with a situation in which, despite the presence of more
than one separate legal entity, the underlying economic fact is that we have a single unified
economic entity. This requires the information for these three Companies to be presented in a
single consolidated Balance Sheet as follows:
Sigma Company And Subsidiaries
Consolidated Balance Sheet
As At December 31, 2009
3-36. You will note that the only differences between this consolidated Balance Sheet and
the one that was prepared when Alpha acquired the shares of Beta (see Paragraph 3-30) are:
• Current Assets are $78,000 higher because Alpha used cash as consideration where
Sigma issued Common Stock.
• Shareholders’ Equity consists only of Common Stock with no Retained Earnings
balance because Sigma is a new Company.
Exercise Three - 1
All of the identifiable assets and liabilities of the two Companies have fair values that
are equal to their carrying values. The shares of the two Companies are trading at their
book values. This would be $17 per share for Blocker [($1,800,000 + $1,260,000) ÷
180,000] and $45 per share for Blockee [($1,145,000 + $1,150,000) ÷ 51,000]. This
indicates total market values for Blocker Company and Blockee Company of
$3,060,000 and $2,295,000, respectively.
Prepare the December 31, 2009 Balance Sheet for the economic entity that results
from the following business combinations:
A. Blocker acquires 100 percent of the net assets of Blockee in return for consider-
ation of $2,295,000. The consideration is made up of $795,000 in cash and debt
securities with a maturity value of $1,500,000.
B. Blocker acquires 100 percent of the outstanding shares of Blockee by issuing
135,000 new Blocker shares to the Blockee shareholders. The total market value
of these shares is $2,295,000 [(135,000)($17)].
C. A new company, Blockbuster Inc., is formed. The new company decides to issue
shares with a fair market value of $15 per share. The shareholders of Blocker
receive 204,000 of the new shares in return for their Blocker shares (total fair
market value of $3,060,000), while the shareholders of Blockee receive 153,000
of the new shares in return for their Blockee shares (total fair market value
$2,295,000).
business through the payment of cash or other assets, the acquired assets will have a
completely new tax base, established by the amount of non-share consideration given. There
would be no carry over of any of the tax values (i.e., adjusted cost base or undepreciated
capital cost) that are associated with the business which gave up the assets.
Share Consideration
3-39. The same analysis could apply to situations in which shares are issued to acquire the
assets of another business. However, while the transfer might take place at new tax values,
there is also the possibility that different values might be used. As long as the transferor of the
assets is a Canadian corporation, the parties to the combination can use the Income Tax Act
Section 85 rollover provisions. In simplified terms, ITA Section 85 allows assets to be trans-
ferred at an elected value that could be anywhere between the fair market value of the assets
and their tax values in the hands of the transferor.
Tax Planning
3-40. In general, investors will prefer to acquire assets rather than shares. In most situa-
tions, the value of the acquired assets will exceed their carrying values and, if the investor
acquires assets, these higher values can be recorded and become the basis for future capital
cost allowance (CCA) deductions. In contrast, if the investor acquires shares, the investee
company will continue to use the lower carrying values as the basis for CCA, resulting in higher
taxable income and taxes payable.
3-41. In addition, if the investor acquires shares, any problems involving the investee’s tax
returns for earlier years are acquired along with the shares. When the investor company
acquires assets, it simply has a group of assets with a new adjusted cost base and any investee
tax problems are left with the selling entity.
3-42. From the point of view of a person selling an existing business, they will generally have
a preference for selling shares. If shares are sold, any resulting income will be taxed as a
capital gain, only one-half of which will be taxable. In the alternative sale of assets, income
will include capital gains, but may also include fully taxable recapture of CCA. Further, for the
seller to have access to the funds resulting from the sale, it may be necessary to go through a
complex windup procedure.
3-43. If the corporation being sold is a qualified small business corporation, there is an
additional advantage to selling shares rather than assets. Gains on the sale of shares of this
type of corporation may be eligible for the special $750,000 lifetime capital gains deduction.
Acquisition Of Shares
3-44. In looking at situations in which the combination is carried out through an acquisition
of shares, the type of consideration used also has some influence. If shares are acquired
through the payment of cash or other assets, the shares will have a new tax base equal to their
fair market value as evidenced by the amount of consideration given. In addition, any excess
of consideration over the adjusted cost base of the shares given up will create an immediate
capital gain in the hands of the transferor.
3-45. However, if new shares are issued to acquire the target shares, Section 85.1 of the
Income Tax Act can be used. This Section provides that in a share for share exchange, any gain
on the shares being transferred can effectively be deferred. Under the provisions of this
Section, the old shares are deemed to have been transferred at their adjusted cost base and, in
turn, the adjusted cost base of the old shares becomes the adjusted cost base of the new shares
that have been received.
3-46. While the type of consideration used to effect the business combination can make a
significant difference to the transferor of the shares, it does not influence the tax status of the
assets that have been indirectly acquired through share ownership. As this legal form of
combination results in both parties continuing to operate as separate legal and taxable enti-
ties, the assets remain on the books of the separate companies and their tax bases are not
affected in any way by the transaction.
70 Chapter 3
Alternative Accounting Methods
3-47. As noted previously, in most cases these tax bases will be lower than the fair market
values of the assets and, as a result, lower than the tax bases that would normally arise if the
assets were acquired directly. For this reason, the acquiring company will generally prefer to
acquire net assets directly, rather than acquiring its right to use the assets through acquisition
of a controlling interest in shares.
ComCo One and ComCo Two are both corporations. They have decided to imple-
ment a business combination transaction and continue operations on a combined
basis. The legal form of the combination is yet to be determined.
New Entity View An alternative to the acquisition view is that, when two businesses
are combined, it is an event that results in a new business entity being created. In
circumstances where this view might be appropriate, it would follow that there should
be a new basis of accounting for the assets of both companies. Again using the infor-
mation from Paragraph 3-49, the combined Balance Sheet would be as follows:
ComCo One’s Fair Values $ 900,000
ComCo Two’s Fair Values 1,000,000
Combined Net Assets $1,900,000
Pooling Of Interests View The third alternative takes the position that when two
businesses combine, the result is a simple continuation of the operations of the two
combining enterprises. This would suggest that there should be no new basis of
accounting for either of the combining companies, a view that is reflected in the
following Balance Sheet:
ComCo One’s Carrying Values $ 650,000
ComCo Two’s Carrying Values 800,000
Combined Net Assets $1,450,000
3-51. You will note that the application of these alternative views produces significantly
different values for the combined net assets. These results range from a low of $1,450,000
under the pooling of interests view, to a high of $1,900,000 under the new entity view. Given
these differences, it is not surprising that controversy has existed as to which of these views
should be incorporated into our accounting requirements.
A Potential Problem
3-56. As we have noted, the Acquisition Method of accounting for business combination
transactions is based on the view that such transactions are simply an acquisition of assets.
This interpretation requires that one of the combining companies be identified as the
acquiring company.
3-57. In the great majority of business combination transactions, the determination of an
acquirer may be a fairly simple matter. However, because the Acquisition Method is being
used for such transactions, including some where that method might not be the most appro-
priate choice, there will be situations where the identification of an acquirer is difficult. This
will be discussed more fully in the next section which deals with the application of the Acquisi-
tion Method.
Identification Of An Acquirer
Basic Recommendation
3-61. The concepts underlying the acquisition method require that an acquirer be identi-
fied in each business combination transaction. This is reflected in the following
recommendation:
Paragraph 1582.06 For each business combination, one of the combining entities
shall be identified as the acquirer. (January, 2011)
3-62. As defined in Section 1582, the acquirer is the business that obtains control over the
other business or businesses in a business combination transaction. For purposes of deter-
mining control, Section 1582 refers users to the guidance on control that is found in Section
1590, “Subsidiaries”. However, the situation is complicated by the fact that business combi-
nations can take forms other than the acquisition of a subsidiary. Given this, more detailed
consideration is required in dealing with this recommendation.
Business Combinations 73
Application Of The Acquisition Method
Figure 3 - 5
Identifying An Acquirer
Cash Consideration
3-63. As we have noted, Section 1582 requires the use of the acquisition method, even in
those situations where the economic substance of the transaction suggests that neither
company can be identified as the acquirer. Given this, it is not surprising that Section 1582
provides additional guidance in this area.
3-64. However, before we examine this more detailed guidance, we will look at some situa-
tions where the identification process presents no problems. The least complex situations are
those in which one company uses cash to acquire either the net assets of the other combining
company or, alternatively pays cash to the shareholders of the other combining company in
order to acquire a controlling interest in the net assets of that company.
Example 1 Company A pays $2,000,000 to Company B in order to acquire the net
assets of that company. Since Company B has not received any of the shares of
Company A as part of the combination transaction, they have no continuing participa-
tion in the combined company. Clearly Alpha Company A is the acquirer.
Example 2 Company A pays $2,000,000 to the shareholders of Company B in
return for 100 percent of their outstanding shares in that company. While in this case
Company B would continue as a legal entity after the combination transaction, its
former shareholders would not participate in its ownership. As was the case when the
cash was paid to Company B, we would conclude that Company A is the acquirer.
Share Consideration
3-65. The situation becomes more complex when voting shares are used as consideration.
This reflects the fact that voting shares allow the pre-combination equity interests in both of
the combining companies to have a continuing equity interest in the combined company.
This would be the case without regard to whether the acquirer’s shares were issued to acquire
assets or, alternatively, to acquire shares from the acquiree’s shareholders.
3-66. Conceptually, the solution to the problem is fairly simple. Assuming that the
combining enterprises are both corporations, the acquirer is the company whose share-
holders, as a group, wind up with more than 50 percent of the voting shares in the combined
company. While the preceding guideline sounds fairly simple, its implementation can be
somewhat confusing . Consider, for example, the case depicted in Figure 3-5.
3-67. In this legal form, the combined entity will be the consolidated enterprise consisting
of Alpha Company and its subsidiary Beta Company. The Alpha Company shareholder group
will consist of both the original Alpha Company shareholders and the new Alpha Company
shareholders who were formerly Beta Company shareholders. In the usual case, fewer than 1
million shares would have been issued to the Beta Company shareholders and, as a conse-
quence, the original Alpha Company shareholders will be in a majority position. This means
that Alpha Company will be identified as the acquirer.
74 Chapter 3
Application Of The Acquisition Method
3-68. There are, however, other possibilities. If Alpha issued more than 1 million shares to
the shareholders of Beta, the former Beta shareholders would then own the majority of the
voting shares of Alpha and this means that Beta Company would have to be considered the
acquirer. This type of situation is referred to as a reverse acquisition and will be given more
attention later in this section.
Example Continuing the example from Paragraph 3-66, if Alpha, a company with
1,000,000 shares outstanding , issues 2,000,000 new shares to the Beta shareholders
as consideration for their shares, the former Beta shareholders now hold two-thirds
(2,000,000/3,000,000) of the outstanding shares of Alpha.
Analysis From a legal point of view, Alpha has acquired control of Beta through
ownership of 100 percent of Beta’s outstanding voting shares. Stated alternatively,
Alpha is the parent company and Beta is its subsidiary. If you were to discuss this situa-
tion with a lawyer, there would be no question that Alpha Company is the acquiring
company from a legal perspective.
However, this is in conflict with the economic picture. As a group, the former Beta
shareholders own a majority of shares in the combined economic entity and, under
the requirements of the CICA Handbook, Beta is deemed to be the acquirer. In other
words, the economic outcome is the “reverse” of the legal result.
3-75. Reverse acquisitions are surprisingly common in practice and are used to accomplish
a variety of objectives. One of the more common, however, is to obtain a listing on a public
stock exchange. Referring to the example just presented, assume that Alpha is an inactive
public company that is listed on a Canadian stock exchange. It is being used purely as a
holding company for a group of relatively liquid investments. In contrast, Beta is a very active
private company that would like to be listed on a public stock exchange.
3-76. Through the reverse acquisition procedure that we have just described, the share-
holders of Beta have retained control over Beta. However, the shares that they hold to
exercise that control are those of Alpha and these shares can be traded on a public stock
exchange. The transaction could be further extended by having Alpha divest itself of its
investment holdings and change its name to Beta Company. If this happens, Beta has, in
effect, acquired a listing on a public stock exchange through a procedure that may be less
costly and time consuming than going through the usual listing procedures. More detailed
attention will be given to this subject in Appendix B to Chapter 4.
Exercise Three - 2
Example Company A, as part of the consideration paid to acquire the net assets of
Company B, transfers non-monetary assets to Company B. These assets have a
carrying value of $150,000 and a fair value of $200,000. The combined company will
continue to use these assets.
Analysis As the assets remain within the combined business, they will be recorded
at $150,000 and no gain or loss will be recognized.
Exercise Three - 3
Contingent Consideration
3-85. In negotiating the terms of a business combination transaction, there will be differ-
ences of opinion with respect to the values involved. It is likely that the stakeholders in the
acquiree will be inclined to believe that their business is worth more than the acquirer is
willing to pay. On the other side of the transaction, the acquirer may believe that any acquirer
shares that are being issued to carry out the transaction have a higher value than the stake-
holders in the acquiree are willing to believe.
3-86. Contingent consideration can be used to resolve such disputes. For example, the
acquirer might agree to pay additional consideration if the earnings of the acquired business
achieve some specified target level within a specified period of time. Similarly, the acquiree
stakeholders might agree to accept future shares, provided the acquirer is willing to issue
additional shares in the event that the shares do not reach a specified market price within a
specified period of time.
78 Chapter 3
Application Of The Acquisition Method
3-87. When contingent consideration is used, Section 1582 makes the following
recommendation:
Paragraph 1582.39 The consideration the acquirer transfers in exchange for the
acquiree includes any asset or liability resulting from a contingent consideration
arrangement. The acquirer shall recognize the acquisition-date fair value of contin-
gent consideration as part of the consideration transferred in exchange for the
acquiree.
3-88. This recommendation requires recognition, at the time of and as part of the cost of an
acquisition, the fair value of any contingent consideration. This fair value amount may be:
An Asset Of The Acquirer For example, the agreement may require the acquiree to
pay an amount to the acquirer if the contingency occurs.
A Liability Of The Acquirer For example, the agreement may require the acquirer
to pay additional amounts to the acquiree if the contingency occurs.
An Equity Instrument Of The Acquirer For example, the agreement may require
the acquirer to issue additional securities to the acquiree if the contingency occurs.
3-89. In somewhat simplified terms, the accounting subsequent to the date of the combina-
tion will require ongoing measurement of the fair value of the asset, liability, or equity
instrument. In general, if the amount recorded is an asset or liability, changes in its fair value
will be recorded in income. Alternatively, if the amount recorded is an equity instrument,
changes in its fair value will be recorded as an adjustment of shareholders’ equity.
3-90. A simple example will illustrate the accounting procedures that are required when
contingent consideration results in a liability:
Example - Contingent Liability On January 1, 2009, the Mor Company issues 3 million
of its no par value voting shares in return for all of the outstanding voting shares of the Mee
Company. On this date the Mor Company shares have a fair value of $25 per share or $75
million in total. In addition to the current payment, the Mor Company agrees that, if the
2009 earnings per share of the Mee Company is in excess of $3.50, the Mor Company will
pay an additional $10 million in cash to the former shareholders of the Mee Company.
Analysis To begin, Mor will have to assign a fair value to the possibility that it will have to
pay the additional $10 million (Section 1582 does not provide guidance on this process).
After considering all relevant factors, the Company assigns a fair value of $2,500,000 to
this potential liability (this amount cannot be calculated using the information in the
example). Based on this, the investment is recorded as follows:
Investment In Mee [(3,000,000)($25) + $2,500,000] $77,500,000
No Par Common Stock $75,000,000
Contingent Liability 2,500,000
If at the end of 2009, the Mee Company ’s earnings per share has exceeded the contin-
gency level of $3.50, the following entry to record the contingency payment would be
required:
Loss On Contingency $7,500,000
Contingent Liability 2,500,000
Cash $10,000,000
Alternatively, if the earnings per share do not exceed $3.50 per share, no additional
payment would be made and the following journal entry would be required:
Contingent Liability $2,500,000
Gain On Contingency $2,500,000
Business Combinations 79
Application Of The Acquisition Method
Exercise Three - 4
Exercise Three - 5
Exercise Three - 6
Provide the journal entry that would be required to record the acquisition of the Gee
Ltd. shares on June 30, 2009. In addition, provide the entry that would be required
on December 31, 2009:
A. if Goger has to issue the additional shares (shares are trading at $30); and
B. if Goger does not have to issue the additional shares (shares are trading at $33).
(b) an acquiree owns and operates a nuclear power plant. The license to operate that
power plant is an intangible asset that meets the contractual-legal criterion for
recognition separately from goodwill, even if the acquirer cannot sell or transfer it
separately from the acquired power plant. An acquirer may recognize the fair
value of the operating license and the fair value of the power plant as a single asset
for financial reporting purposes if the useful lives of those assets are similar.
(c) an acquiree owns a technology patent. It has licensed that patent to others for
their exclusive use outside the domestic market, receiving a specified percentage
of future foreign revenue in exchange. Both the technology patent and the related
license agreement meet the contractual-legal criterion for recognition separately
from goodwill even if selling or exchanging the patent and the related license
agreement separately from one another would not be practical.
Paragraph 1582.15 At the acquisition date, the acquirer shall classify or designate
the identifiable assets acquired and liabilities assumed as necessary to apply other
Sections subsequently. The acquirer shall make those classifications or designations on
the basis of the contractual terms, economic conditions, its operating or accounting
policies and other pertinent conditions as they exist at the acquisition date. (January,
2011)
3-95. This classification process will serve to determine which Sections of the CICA Hand-
book are applicable to the various assets and liabilities that have been recognized.
Additional Guidance
3-98. The use of fair values in accounting has become fairly widespread. In addition, the
application of the acquisition method to business combination transactions is based on the
same principles that apply to the acquisition of single assets. The major complicating factor is
the fact that a single purchase price must be allocated over a large group of identifiable assets,
identifiable liabilities, and goodwill.
3-99. Given this situation, Section 1582 does not provide extensive guidance on the appli-
cation of this measurement principle. The guidance that it does include is found in Appendix
B of Section 1582 as follows:
Paragraph 1582.B41 Assets With Uncertain Cash Flows (Valuation Allowances)
The acquirer shall not recognize a separate valuation allowance as of the acquisition
date for assets acquired in a business combination that are measured at their acquisi-
tion-date fair values because the effects of uncertainty about future cash flows are
included in the fair value measure. For example, because this Section requires the
82 Chapter 3
Application Of The Acquisition Method
Exercise Three - 7
3-115. We have previously noted that, when the legal form of the business combination
involves an acquisition of shares, the assets and operations of the combined company will be
reflected in consolidated financial statements. As will be discussed in more detail in subse-
quent chapters, consolidated statements include 100 percent of both companies’ assets and
liabilities in the Balance Sheet. This means that, in situations where the acquirer obtains less
than 100 percent of the acquiree’s shares, a non-controlling interest will be disclosed on the
equity side of the consolidated Balance Sheet.
3-116. Note that, while the CICA Handbook and IFRSs refer to this amount as a non-control-
ling interest, it is also commonly referred to as a minority interest. The more generally
applicable term is non-controlling interest because there are situations in which control can
be obtained through holding a large minority interest.
3-117. The measurement of this non-controlling interest has proved to be one of the more
controversial issues in developing standards for business combinations. The alternatives will
be illustrated in the example which follows.
On this date, Fader Inc. issues $540,000 of its shares to the shareholders of Fadee Ltd. in
order to acquire a controlling 60 percent interest in Fadee Ltd.
3-119. There will be a 40 percent, non-controlling interest in Fadee Ltd. that will be
disclosed in the consolidated Balance Sheet. In somewhat simplified terms, there are three
alternative bases for the valuation of the non-controlling interest:
3-120. Consolidated Balance Sheets illustrating the three alternatives are as follows:
86 Chapter 3
Application Of The Acquisition Method
Fair Value
Carrying Identifiable Fair Value
Consolidated Balance Sheets Values Assets Enterprise
Carrying Value Of Net Identifiable Assets
($2,200,000 + $600,000) $2,800,000 $2,800,000 $2,800,000
Fair Value Change - Increase 105,000 175,000 175,000
Goodwill 75,000 75,000 125,000
Total Net Assets $2,980,000 $3,050,000 $3,100,000
3-121. Note that the manner in which the non-controlling interest is measured determines
what portion of fair value changes and goodwill will be recognized on the asset side of the
Balance Sheet.
• When the non-controlling interest is based on carrying values, only the acquirer’s
share of the fair value change and goodwill are recognized in the consolidated assets.
• When the non-controlling interest is based on the fair value of the identifiable assets,
100 percent of the fair value change is recognized, but only the acquirer’s share of
goodwill.
• When the non-controlling interest is based on the fair value of the enterprise, 100
percent of the fair value change and 100 percent of the goodwill are recognized in the
consolidated assets.
Further Discussion
3-126. The alternative approaches to the measurement of the non-controlling interest are
based on differing views of the nature of this interest. This issue will be given a more detailed
discussion when we begin our presentation of consolidation procedures in Chapter 4. Also in
Business Combinations 87
Goodwill
that material, we will provide a more complete discussion of measuring the non-controlling
interest on a basis other than as a percent of the fair value of the enterprise.
Goodwill
The Concept
3-132. In order to record the business combination transaction, the fair values of the identi-
fiable assets and liabilities of the acquiree are determined on an individual basis. When these
assets are put together as a business enterprise, it is unlikely that the sum of these fair values
will be equal to the value of the business as an operating economic entity.
3-133. If the assets were used in an effective and efficient manner, it is possible for the busi-
ness to be worth considerably more than the sum of its individual asset values. Alternatively,
ineffectual management or other factors can depress the value of a business well below the
88 Chapter 3
Goodwill
3-136. While it is clear that, in this simplified example, Ryerson has goodwill, it is unlikely
that it will be recorded in the Company ’s Balance Sheet. Even in situations where an enter-
prise has incurred significant costs for the creation of goodwill (e.g ., management training or
advertising directed at enhancing the image of the enterprise), GAAP does not permit the
recognition of internally generated goodwill. This reflects the belief that there is no reliable
procedure for the measurement of such amounts.
3-137. In a more general context, this belief prevents the recognition of most internally
generated intangible assets. The only exception to this is the recognition of certain develop-
ment costs as assets under the provisions of Section 3064 of the CICA Handbook, “Goodwill
And Intangible Assets”.
3-139. At first glance, it appears that this recommendation is calling for a single approach to
the measurement of goodwill. However, Section 1582 provides two different ways of
measuring the non-controlling interest. (See our Paragraph 3-122.) As the non-controlling
interest is included in the calculation of goodwill, the result is two different ways of measuring
goodwill.
Example Victer Inc. acquires 80 percent of the outstanding voting shares of Viclee Ltd.
at a cost of $4 million, a figure which implies a total fair value for the enterprise of
$5,000,000. The fair value of the non-controlling interest is $1 million. This is deter-
mined on the basis of 20 percent of the fair value of the enterprise. On the acquisition
date the fair value of the identifiable assets of Viclee is $4,500,000.
Analysis The two alternative values that can be used for the non-controlling interest are
$900,000 [(20%)($4,500,000)] and $1,000,000 [(20%)($5,000,000)]. As shown in the
following table, each will produce a different goodwill figure:
Percent Of Fair Value
Identifiable Assets Enterprise
Investment Cost (Consideration Transferred) $4,000,000 $4,000,000
Non-Controlling Interest 900,000 1,000,000
1582.32(a) Total $4,900,000 $5,000,000
1582.32(b) Net Assets ( 4,500,000) ( 4,500,000)
Goodwill $ 400,000 $ 500,000
Additional Guidance
3-140. When a business combination involves only an exchange of equity interests, the
general rule is that the consideration transferred will be measured on the basis of the fair value
of the acquirer’s shares. There may, however, be situations in which the acquiree’s shares can
be measured more reliably. If so, Section 1582 recommends that the acquirer determine the
amount of goodwill by using the acquisition-date fair value of the acquiree’s equity interests.
3-141. We have previously noted that there may be business combinations in which no
consideration is transferred. In such situations, Section 1582 recommends that the acquirer
use the acquisition-date fair value of their interest in the acquiree determined using a valua-
tion technique in place of the acquisition-date fair value of the consideration transferred.
Exercise Three - 8
3-143. While not explicitly stated, it is clear from the wording of this recommendation that
the amount recorded as goodwill will not be subject to amortization. Rather, it will be the
subject of a periodic impairment test which may or may not result in a write-down of any
amount that is recorded.
3-144. Any goodwill balance that is recognized will generally be tested on an annual basis
for impairment. As specified in the following recommendation, the annual test can some-
times be omitted:
Paragraph 3064.84 Goodwill of a reporting unit should be tested for impairment on
an annual basis, unless all of the following criteria have been met:
(a) The assets and liabilities that make up the reporting unit have not changed signifi-
cantly since the most recent fair value determination.
(b) The most recent fair value determination resulted in an amount that exceeded the
carrying amount of the reporting unit by a substantial margin.
(c) Based on an analysis of events that have occurred and circumstances that have
changed since the most recent fair value determination, the likelihood that a
current fair value determination would be less than the current carrying amount of
the reporting unit is remote. (January, 2002)
3-145. Alternatively, more frequent testing may be required under some circumstances:
Paragraph 3064.87 Goodwill of a reporting unit should be tested for impairment
between annual tests when an event or circumstance occurs that more likely than not
reduces the fair value of a reporting unit below its carrying amount. (January, 2002)
3-146. Examples of such events or circumstances are as follows:
• a significant adverse change in legal factors or in the business climate;
• an adverse action or assessment by a regulator;
• unanticipated competition;
• a loss of key personnel;
• a more-likely-than-not expectation that a significant portion or all of a reporting unit
will be sold or otherwise disposed of;
• the testing for write-down or impairment of a significant asset group within a
reporting unit; or
• the recognition of a goodwill impairment loss in its separate financial statements by a
subsidiary that is a component of the reporting unit.
3-147. Consistent with other Handbook Sections which require asset write-downs (e.g .,
Section 3051, “Investments”), once a goodwill impairment loss is recognized, it cannot be
reversed in a subsequent period.
A reporting unit is the level of reporting at which goodwill is tested for impairment
and is either an operating segment (see “Segment Disclosure”, Section 1701), or one
level below (referred to as a component).
3-151. In practice, this requirement presents significant difficulties. When there is a busi-
ness combination transaction, any amount recognized as goodwill must be allocated to
individual reporting units. In order to accomplish this, all of the other net assets acquired
must also be assigned to segments. Further complicating the situation is that, when these new
requirements are first adopted, they must be applied retroactively to all previous business
combination transactions.
When the carrying amount of a reporting unit exceeds its fair value, but the second step
of the impairment test is not complete and a reasonable estimate of the goodwill
impairment loss cannot be determined (see paragraph 3062.28), that fact and the
reasons therefor should be disclosed. (January, 2002)
Inadequate Rate of Return A third interpretation is that the discount reflects the
fact that the acquired enterprise is not earning a normal rate of return on its assets,
resulting in a going concern value that is less than the sum of the fair values of the iden-
tifiable net assets. This interpretation would suggest the use of a general valuation
account that would be shown as a contra to the total assets balance.
3-159. Section 1582 recognizes the possibility that the first view, overstated fair values, is
applicable by requiring a review of the recognition and measurement procedures applied to
the identifiable assets and liabilities acquired in the business combination transaction.
Paragraph 1582.36 Before recognizing a gain on a bargain purchase, the acquirer
shall reassess whether it has correctly identified all of the assets acquired and all of the
liabilities assumed and shall recognize any additional assets or liabilities that are iden-
tified in that review. The acquirer shall then review the procedures used to measure
the amounts this Section requires to be recognized at the acquisition date for all of the
following:
(a) the identifiable assets acquired and liabilities assumed;
(b) the non-controlling interest in the acquiree, if any;
(c) for a business combination achieved in stages, the acquirer’s previously held
equity interest in the acquiree; and
(d) the consideration transferred.
3-160. However, if this review fails to identify the cause of the negative goodwill, the basic
recommendation adopts the bargain purchase perspective:
Paragraph 1582.34 Occasionally, an acquirer will make a bargain purchase, which
is a business combination in which the amount in paragraph 1582.32(b) exceeds the
aggregate of the amounts specified in paragraph 1582.32(a). If that excess remains
after applying the requirements in paragraph 1582.36, the acquirer shall recognize
the resulting gain in net income on the acquisition date. The gain shall be attributed to
the acquirer.
Exercise Three - 9
Step Acquisitions
3-161. In business combinations involving share acquisitions, it is not uncommon for the
ultimate acquirer to acquire their controlling interest through more than one share purchase.
Example On December 31, 2007, Batter Inc. acquires 35 percent of the
outstanding voting shares of Battee Ltd. On December 31, 2009, Batter acquires an
additional 40 percent of the Battee voting shares.
Analysis Until December 31, 2009, it is likely that Batter’s Investment In Battee will
be classified as a significantly influenced investment and accounted for using the
equity method. However, when Batter acquires the additional 40 percent interest on
December 31, 2009, there is a business combination transaction and consolidated
statements will have to be prepared for presentation on that date.
94 Chapter 3
Acquisition Method Example
3-162. As you may recall (see our Paragraph 3-138), in the determination of goodwill, the
required calculation includes “the acquisition-date fair value of the acquirer’s previously
held equity interest in the acquiree”.
3-163. The application of this provision is fairly complex and requires a fairly complete
understanding of consolidation procedures. Given this, we will defer our coverage of step
acquisitions until Chapter 5.
International Convergence
3-164. As noted as the beginning of this Chapter, the content of Section 1582 of the CICA
Handbook is identical to the content of IFRS No. 3, Business Combinations. In contrast, a few
differences remain between CICA Handbook Section 3064 and IAS No. 38, Intangible Assets.
In brief, these differences can be described as follows:
• Section 3064 and IAS No. 38 use somewhat different procedures for impairment
testing of intangible assets.
• IAS No. 38 has a requirement for periodic review of residual values. There is no corre-
sponding requirement under Section 3064.
• IAS No. 38 allows the revaluation of intangible assets to fair value, provided data is
available from an active market. Section 3064 does not permit such revaluation.
• Under IAS No. 38, relocation and reorganization costs must be expensed. Section
3064 allows some of these costs to be capitalized.
Example On December 31, 2009, the Balance Sheets of the Dor and Dee
Companies, prior to any business combination transaction, are as follows:
Balance Sheets
As At December 31, 2009
Dor Company Dee Company
Cash $ 1,200,000 $ 600,000
Accounts Receivable 2,400,000 800,000
Inventories 3,800,000 1,200,000
Plant And Equipment (Net) 4,600,000 2,400,000
Total Assets $12,000,000 $5,000,000
*On this date, prior to the transactions described in the following paragraphs, each
Company has 450,000 common shares outstanding .
On December 31, 2009, the Dor Company issues 204,000 shares of its No Par
Common Stock to the Dee Company in return for 100 percent of its net assets. On this
Business Combinations 95
Acquisition Method Example
date the shares of the Dor Company are trading at $25 per share. All of the identifi-
able assets and liabilities of the Dee Company have fair values that are equal to their
carrying values except for the Plant And Equipment which has a fair value of
$2,700,000 and a remaining useful life of ten years. Both Companies have a
December 31 year end and, for the year ending December 31, 2009, Dor reported
Net Income of $800,000 and Dee reported Net Income of $250,000.
Identification Of An Acquirer
3-166. Since the Dor Company issued fewer shares (204,000) to the Dee Company than it
had outstanding prior to the business combination (450,000), the shareholders of the Dor
Company would be the majority shareholders in the combined company and the Dor
Company would be identified as the acquirer.
Investment Analysis
3-168. In order to determine goodwill and the other values that will be used in the prepara-
tion of consolidated financial statements, some type of investment analysis schedule is
required. In cases such as this, where a non-controlling interest is not present, a fairly simple
schedule can be used. A more comprehensive analysis schedule will be presented in Chapter
4 where we give detailed consideration to the non-controlling interest.
3-169. The required investment analysis schedule for this example would be as follows:
Carrying Value Of Dee’s Net Identifiable Assets
($5,000,000 - $700,000) $4,300,000
Fair Value Increase On Plant ($2,700,000 - $2,400,000) 300,000
Fair Value Of Dee’s Net Identifiable Assets $4,600,000
3-170. Given the purchase price and the fair values, the Goodwill that will be recognized
from this business combination can be calculated in the following manner:
Investment Cost (Consideration Transferred)[(204,000)($25)] $5,100,000
Fair Value Of Dee’s Net Identifiable Assets ( 4,600,000)
Goodwill To Be Recognized $ 500,000
Journal Entry
3-171. Using the preceding investment analysis, we are now in a position to record the busi-
ness combination. It would be recorded on the books of the Dor Company as a simple
acquisition of assets and liabilities. Except for Dee’s Plant And Equipment and the Goodwill
to be recorded as a result of the business combination, the carrying values from the books of
the Dee Company would be used. The entry is as follows:
Cash $ 600,000
Accounts Receivable 800,000
Inventories 1,200,000
Plant And Equipment (Fair Value) 2,700,000
Goodwill (Arising From The Acquisition) 500,000
Liabilities $ 700,000
Common Stock - No Par (Dor) 5,100,000
Dor Company
Balance Sheet
As At December 31, 2009
Cash ($1,200,000 + $600,000) $ 1,800,000
Accounts Receivable ($2,400,000 + $800,000) 3,200,000
Inventories ($3,800,000 + $1,200,000) 5,000,000
Plant And Equipment ($4,600,000 + $2,700,000) 7,300,000
Goodwill 500,000
Total Assets $17,800,000
Exercise Three - 10
Balance Sheets
As At December 31, 2009
On December 31, 2009, the Saller Company issues 135,000 common shares to the
Sallee Company in return for 100 percent of its net assets. On this date, the shares of
the Saller Company are trading at $52 per share. Sallee’s Cash and Accounts Receiv-
able have fair values that are equal to their carrying values. With respect to Sallee’s
other assets and liabilities, the Inventories have a fair value of $2,732,000, the Prop-
erty, Plant And Equipment has a fair value of $4,512,000, and the liabilities have a fair
value of $2,115,000. Both Companies have a December 31 year end and, for the year
ending December 31, 2009, Saller reported Net Income of $1,465,000 and Sallee
reported Net Income of $372,000.
Prepare the combined Balance Sheet that would be presented by Saller Company on
December 31, 2009. In addition, determine the Net Income and Earnings Per Share
of the Saller Company that would be reported for the year ending December 31,
2009.