Chapter 14 – Business Combinations
The relevant accounting standard in accounting for business combinations is IFRS 3 Business
Combinations. A business combination is defined as a transaction or other event in which an acquirer
obtains control of one or more businesses. The term business is defined as an integrated set of activities
and assets that is capable of being conducted and managed for the purpose of providing a return in the
form of dividends, lower costs or other economic benefits directly to investors or other owner, members
or participants. Thus, a division might also be regarded as a business, such that the acquisition thereof is
regarded as a business combination. The purpose of defining a business is to distinguish between the
acquisition of a group of assets that does not constitute a business and the acquisition of a business.
The most obvious way in which control (over the net assets of another entity) can be achieved is through
one entity acquiring sufficient shares of another entity on the open market to have a controlling interest.
Alternatively, an entity could simply buy the actual net assets of another entity. A business combination
could also occur without any exchange of assets or equity involved in the exchange. For example, a
business combination could occur where two entities merged under a contract.
IFRS 3 applies to all business combinations, with the exception of the following situations:
• Where the business combination results in the formation of a joint venture.
• Where the business combination involves entities or businesses under common control. This
occurs where all of the combining entities are controlled by the same party or parties both before
and after the combination, and where control is not transitory.
The required method of accounting for a business combination under IFRS 3 is the acquisition method,
which consists of four steps:
1. Identify the acquirer.
o The acquirer is the entity that obtains control of another entity (the acquiree).
o Sometimes, identification of an acquirer requires judgment. Consider the situation where
entity A combines with entity A. To effect the combination, a new company (entity C) is
formed, which issues shares to acquire all the shares of both entities A and B. As entity C
is created solely to formalize the organization structure, it is not the acquirer, even though
it is the legal parent of both of the other entities. IFRS 3.B18 states that, if a new entity is
formed to issues equity interests to effect a business combination, one of the entities that
existed before the combination must be identified as the acquirer.
o Some indicators to assist in assessing which entity is the acquirer are as follows:
▪ What are the relative voting rights in the combined entity after the business
combination? The acquirer is usually the entity whose owners have the largest
portion of the voting rights in the combined entity.
▪ What is the composition of the governing body of the combined entity? The
acquirer is usually the combining entity whose owners have the ability to elect or
appoint or to remove a majority of the members of the governing body of the
combined entity.
▪ What are the terms of the exchange of equity interests? Has one of the entities
paid a premium over the pre-combination fair value of one of the combining
entities, an amount paid in order to gain control?
, o IFRS 3.6 requires an acquirer to be identified in every business combination, even though
it may be argued that it is not always possible to do so (for instance, in the case of a ‘true’
merger). The need to identify the acquirer stems from the need to measure the acquiree’s
assets at fair value, but not those of the acquirer.
2. Determine the acquisition date.
o The acquisition date is defined as the date on which the acquirer obtains control of the
acquiree. Other dates, such as the date that the contract is signed or the date on which
the assets are delivered may be important issues for management, but they do not
necessarily reflect the acquisition date.
o The effect of determining the acquisition date is that the financial position of the
combined entity at acquisition date should report the assets and liabilities of the acquiree
at that date, and any profits reported as a result of the acquiree’s operations within the
business combination should reflect profits earned after the acquisition date.
3. Recognize and measure the identifiable assets acquired, the liabilities assumed, and any non-
controlling interest in the acquiree.
o IFRS 3.10 states that as of acquisition date, the acquirer shall recognize, separately from
goodwill, the identifiable assets acquired, the liabilities assumed and any non-controlling
interest in the acquiree.
o There are two conditions that have to be met prior to the recognition of assets and
liabilities acquired in the business combination: (1) at the acquisition date, the assets and
liabilities recognized by the acquirer must meet the definitions of assets and liabilities in
the Conceptual Framework and (2) the item acquired or assumed must be part of the
business acquired rather than the result of a separate transaction.
▪ The first condition can have implications for the treatment of contingent
liabilities. If the liability has been treated as contingent because the future
outflows are not regarded as ‘probable’ (and therefore it is not recognized in the
financial statements of the acquiree), then the acquirer shall recognize as of the
acquisition date a contingent liability if its fair value can be measured reliably.
Therefore, contrary to IAS 37 Provisions, Contingent Liabilities and Contingent
Assets, the acquirer recognizes a contingent liability assumed in a business
combination at the acquisition date even if it is not probable that an outflow of
resources embodying economic benefits will be required to settle the obligation.
▪ With regard to the second condition, suppose that the acquiree had a claim
outstanding against the acquirer before the acquisition date. If the acquirer
agrees to settle the claim as part of the combination and part of the consideration
includes a sum in settlement of the claim then it would be necessary to account
for the acquisition as two transactions and the sum paid in settlement would have
to be separated out from the consideration.
o A possible result of applying the principles of IFRS 3 may be the recognition of assets and
liabilities as a result of the business combination that were not previously recognized by
the acquiree. For example, internally generated intangibles that were not recognized by
the acquiree because of the requirements of IAS 38 Intangible Assets may have to be
recognized by the acquirer at fair value.
, o IFRS 3.18 states that the acquirer should measure the identifiable assets acquired and the
liabilities assumed at their fair values on acquisition date. Fair value is defined as the price
that would be received to sell an asset or to transfer a liability in an orderly transaction
between market participants at the measurement date.
4. Recognize and measure goodwill or a gain from a bargain purchase.
o According to IFRS 3.32, the acquirer shall recognize goodwill as of the acquisition date
measured as the excess of (a) over (b) below:
▪ (a) The aggregate of (1) the consideration transferred measured in accordance
with IFRS 3, (2) the amount of any non-controlling interest in the acquiree
measured in accordance with IFRS 3, and (3) the acquisition-date fair value of the
acquirer’s previously held equity interest in the acquiree (in case of a business
combination achieved in stages).
▪ (b) The net of the acquisition-date amounts of the identifiable assets acquired
and the liabilities assumed.
o The consideration transferred is measured at fair value at acquisition date and it is
calculated as the sum of the acquisition-date fair value of the assets transferred by the
acquirer, the liabilities incurred by the acquirer to former owners of the acquiree, and the
equity interest issued by the acquirer. The consideration transferred could consist of a
number of forms of consideration, such as cash, other assets, shares and contingent
consideration.
▪ For a deferred cash payment, the fair value to the acquirer is the amount the
entity would have to borrow to settle the debt immediately. The discount rate
used is the entity’s incremental borrowing rate. Use of cash, including a deferred
payment, to acquire net asset results in the acquirer recording the journal entry
shown below. The second journal entry refers to the actual payment, where the
interest component needs to be recognized.
Debit Credit
Net Assets XXX
Cash XXX
Payable to Acquiree XXX
Payable to Acquiree XXX
Interest Expense XXX
Cash XXX
▪ When the carrying amount of a non-monetary asset in the records of the acquirer
is different from its fair value, a gain or loss on the asset is recognized in profit or
loss at acquisition date. If a plant (with a cost of $180, a carrying amount of $150
and a fair value of $155) is used as part of the consideration to acquire net assets,
then the acquirer records the following journal entries:
Debit Credit
Accumulated Depreciation $30
Plant $25
Gain $5
Net Assets acquired XXX
, Plant $155
Other Consideration Payable XXX
▪ If an acquirer issues its own shares as consideration, it needs to determine the
fair value of those shares at the acquisition date. For listed entities, reference is
made to the quoted prices of the shares.
▪ The fair values of liabilities assumed are best measured by the present values of
expected future cash outflows. Future losses or other costs expected to be
incurred as a result of the combination are not liabilities of the acquirer and are
therefore not included in the calculation of the fair value of consideration paid.
▪ In issuing equity instruments, such as shares as part of the consideration paid,
transaction costs such as stamp duties, professional advisers’ fees, underwriting
costs and brokerage fees may be incurred. These outlays should be treated as a
reduction in the share capital of the entity as such costs reduce the proceeds from
the equity issues. Hence, costs incurred in issuing shares as part of the
consideration paid results in the journal entry shown below. Similarly, the costs
of arranging and issuing financial liabilities are an integral part of the liability issue
transaction and therefore included in the initial measurement of the liability.
Debit Credit
Share Capital XXX
Cash XXX
▪ Contingent consideration is defined as an obligation of the acquirer to transfer
additional assets or equity interests to the former owners of an acquiree as part
of the exchange for control of the acquiree if specified future events occur or
conditions are met. However, contingent consideration also may give the
acquirer the right to the return of previously transferred consideration if specified
conditions are met. The acquirer shall recognize the acquisition-date fair values
of contingent consideration as part of the consideration transferred.
o In addition to the consideration transferred by the acquirer to the acquiree, a further item
to be considered in determining the cost of the business combination is the costs directly
attributable to the combination, which includes costs such as finder’s fees, professional
or consulting fees and general administrative costs. In IAS 16 Property, Plant and
Equipment and IAS 38 Intangible Assets, directly attributable costs are capitalized into the
cost of the asset acquired. In contrast, the acquisition-related costs associated with a
business combination are accounted for as expenses in the periods in which they are
incurred and the services are received.
o Goodwill is an asset representing the future economic benefits arising from other assets
acquired in a business combination that are not individually identified and separately
recognized. Goodwill could, for instance, be the result of synergies that the acquirer
expects to achieve or it might include unrecognized intangible assets. Goodwill is not
subject to amortization but is subject to an annual impairment test as detailed in IAS 36
Impairment of Assets.
▪ Where the acquirer’s interest in the net fair value of the acquiree’s identifiable
assets and liabilities is greater than the consideration transferred, the difference
is called a gain on a bargain purchase. The acquirer shall recognize this gain in
