1 59 CHAP TER 3 Business Combinations A Note On Relevant Accounting Standards 3-0. During the period until 2011 when IFRSs are incorporated into Canadian GAAP, the CICA Handbook contains two different Sections which deal with business combination transactions. Further, in those cases where the business combination involves the acquisition of a subsidiary, there are three Sections which deal with the preparation of consolidated financial statements. Section 1581, which was introduced into the Handbook in 2001, can still be used until convergence occurs in If an enterprise chooses to apply this standard, it must continue to use Section 1600, the section on consolidated financial statements that was introduced into the Handbook in As noted in Chapter 1, in January, 2009, three new CICA Handbook Sections were added. These were: Section 1582, Business Combinations ; Section 1601, Consolidated Financial Statements ; and Section 1602, Non-Controlling Interests. These new sections serve to largely converge the CICA Handbook material on business combinations and consolidations with the relevant IFRSs. In particular, the content of Section 1582 is identical to IFRS No. 3, Business Combinations. The focus of the material in this Chapter and in the subsequent Chapters dealing with the preparation of consolidated financial statements, will be new Sections 1582, 1601, and Over the next few years, the use of the older Handbook Sections will decline and, in 2011, they will no longer be part of Canadian GAAP. Given this, we do not believe that it is appropriate to continue detailed coverage of these standards. If such coverage is relevant to your needs, it can be found in the previous edition of this text. Business Combinations Defined Basic Definition 3-1. The CICA Handbook defines a business combination transaction in the following manner: Paragraph A(e) A business combination is a transaction or other event in which an acquirer obtains control of one or more businesses. Transactions sometimes
2 60 Chapter 3 Legal Avenues To Combination referred to as true mergers or mergers of equals are also business combinations as that term is used in this Section The economic concept that underlies the term business combination is that you have two or more independent and viable economic entities that are joined together for future operations as a single economic or business entity. The original economic entities can be corporations, unincorporated entities, or even a separable portion of a larger economic entity. The key factor is that each could be operated as a single, viable, business entity The question of whether a group of assets constitutes a business is relevant in that the accounting procedures for a business combination can be significantly different than those used for a simple acquisition of assets. Specifically, no goodwill can be recognized when there is an acquisition of assets that do not constitute a business. Because of the importance of this difference, Section 1582 provides a definition of a business: Paragraph A(d) A business is 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 owners, members or participants. Examples Covered By Section 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 unincorporated businesses in return for all of the net assets of the two enterprises. Excluded From The Scope Of Section Section 1582 specifically excludes certain transactions from its scope. These are listed in Paragraph as follows: The formation of a joint venture. The acquisition of a group of assets that do not constitute a business. In this situation, the assets acquired will be accounted for separately. If their cost does not equal the sum of their fair values, the consideration paid will be allocated to the individual assets in proportion to their fair value (a so-called basket purchase). A combination of businesses that are under common control. For example, if one subsidiary of Company A were to acquire the assets of a different subsidiary of Company A, the transaction would not be considered to be a business combination. A combination between not-for-profit organizations. In addition, Section 1582 does not apply to the acquisition of a profit oriented organization by a not-for-profit organization. These transactions are dealt with under CICA Handbook Section Reporting Controlled And Related Entities By Not-For-Profit Organizations. Legal Avenues To Combination The Problem 3-6. In reading the preceding section, it is likely that you recognized that a variety of legal forms can be used to combine the operations of two independent business entities. The choice among these forms involves a great many issues, including tax considerations, the
3 Business Combinations 61 Legal Avenues To Combination 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 enterprises have with suppliers, employees, or customers This is an important issue for accountants as the legal form used can, in some circumstances, 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 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 business 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 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 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 Liabilities $ 65,000 $ 42,000 Common Stock: (5,000 Shares Issued And Outstanding) 95,000 N/A (10,000 Shares Issued And Outstanding) N/A 53,000 Retained Earnings 75,000 25,000 Total Equities $235,000 $120, 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
4 62 Chapter 3 Legal Avenues To Combination Figure 3-1 Acquisition Of Assets From Beta Company Alpha Company $78,000 In Cash Beta s Assets And Liabilities Beta Company 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 We will consider four basic alternatives in our discussion of the legal forms for implementing 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 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. Acquisition Of Assets By Alpha Company Perhaps the most straightforward way in which the Alpha and Beta Companies could be combined would be to have one of the Companies simply acquire the net identifiable assets directly from the other Company. Using our basic example, assume Beta s fair market value is $78,000 (equal to the Company s net book value of $53,000 + $25,000). Based on this, Alpha Company gives Beta Company cash of $78,000 to acquire the assets and liabilities of Beta Company. This approach is depicted in Figure 3-1.
5 Business Combinations 63 Legal Avenues To Combination 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 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 transaction has been carried out in such a fashion that both Companies operations have been transferred to a single continuing legal entity 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 Liabilities ($65,000 + $42,000) $107,000 Common Stock (Alpha s 5,000 Shares) 95,000 Retained Earnings (Alpha s Balance) 75,000 Total Equities $277, 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 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 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 Liabilities ($65,000 + $42,000) $107,000 Common Stock ($95,000 + $78,000) 173,000 Retained Earnings (Alpha s Balance) 75,000 Total Equities $355,000
6 64 Chapter 3 Legal Avenues To Combination Figure 3-2 New Company Acquisition Of Assets From Beta Company 17,000 Sigma Shares Alpha Company Sigma Company Assets And Liabilities Of Alpha And Beta 7,800 Sigma Shares Beta Company Acquisition Of Assets By Sigma Company (A New Company) The acquisition of assets approach could also be implemented through the use of a new corporation. Continuing to use our basic example, assume that a new Company, the Sigma Company, is formed and the new Company decides to issue shares with a fair market value of $10 per share. Based on this value and the respective market values of the two companies, Sigma will issue 17,000 shares to Alpha Company ($170,000 $10) and 7,800 shares to Beta Company ($78,000 $10) in return for the assets and liabilities of the two Companies You should note that any value could have been used for the Sigma Company shares as long as the number of shares issued to Alpha and Beta was proportionate to the market values of the two companies. For example, a value of $5 could have been used for the Sigma shares, provided 34,000 shares were issued to Alpha and 15,600 shares to Beta (34,000 shares at $5 equals the $170,000 fair market value for Alpha, while 15,600 shares at $5 equals the $78,000 fair market value for Beta). This approach to bringing the two companies together is depicted in Figure Under this approach, Sigma Company acquires the net assets of both Alpha and Beta Companies. As Sigma is a new company, it would not have significant assets. Unless this new company issues debt to finance the acquisition of Alpha and Beta, the only consideration that can be used in this transaction would be newly issued Sigma shares. Sigma Company s Balance Sheet subsequent to the business combination transaction would be as follows: Sigma Company Balance Sheet As At December 31, 2009 Current Assets ($153,000 + $35,000) $188,000 Non-Current Assets ($82,000 + $85,000) 167,000 Total Assets $355,000 Liabilities ($65,000 + $42,000) $107,000 Common Stock (24,800 Shares Issued And Outstanding) 248,000 Total Equities $355, 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.
7 Business Combinations 65 Legal Avenues To Combination Figure 3-3 Acquisition Of Shares From Beta Shareholders Alpha Company $78,000 In Cash Shareholders Of Beta Beta Company 100% Of Beta Shares 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. Acquisition Of Shares By Alpha Company Procedures Another legal route to the combination of Alpha and Beta would be to have one of the two Companies acquire a majority of the outstanding voting shares of the other Company. Continuing to use our basic example, the Alpha Company will give $78,000 in cash to the Beta shareholders in return for 100 percent of the outstanding shares of the Beta Company. This approach is depicted in Figure While in this example we have assumed that Alpha acquired 100 percent of the shares of Beta, a business combination would have occurred as long as Alpha acquired sufficient shares to achieve control over Beta. In general, this would require acquisition of a majority of Beta s voting shares The acquisition of shares could be carried out in a variety of ways. Alpha could simply acquire the shares in the open market. Alternatively, they could be acquired from a majority shareholder, through a public tender offer to all shareholders, or through some combination of these methods Regardless of the method used, acquisition of a majority of the outstanding voting shares of Beta Company would mean that Alpha Company is in a position to exercise complete control over the affairs of the Beta Company. As a result of this fact, the two Companies could be viewed as a single economic entity and a business combination could be said to have occurred This would be the case despite the fact that the two Companies have retained their separate legal identities. In this situation, in order to reflect the economic unification of the two Companies, consolidated financial statements would have to be prepared. While we have not yet covered the detailed procedures for preparing consolidated financial statements, the basic idea is that the investee s (subsidiary s) assets and liabilities will be added to those of the investor (parent). The resulting consolidated Balance Sheet would be as follows:
8 66 Chapter 3 Legal Avenues To Combination Alpha Company And Subsidiary Consolidated Balance Sheet As At December 31, 2009 Current Assets ($153,000 - $78,000 + $35,000) $110,000 Non-Current Assets ($82,000 + $85,000) 167,000 Total Assets $277,000 Liabilities ($65,000 + $42,000) $107,000 Common Stock (Alpha s 5,000 Shares) 95,000 Retained Earnings (Alpha s Balance) 75,000 Total Equities $277,000 Advantages Of Using Shares At first glance, it would appear that gaining control of a business by acquiring its shares would be a less desirable alternative than acquiring the assets of the desired business. When shares are acquired, the result is that the combined company is operating as two separate and distinct legal entities. This requires the application of the complex procedures associated with preparing consolidated financial statements. Alternatively, if assets are acquired, the combined assets wind up on the books of a single legal entity and consolidation procedures are not required Despite the complexities associated with preparing consolidated financial statements, there are a number of advantages that can be associated with acquiring shares rather than assets to effect the business combination transaction: The acquisition of shares can be a method of going around a company s management if they are hostile to the idea of being acquired. Less financing is needed as only a majority share ownership is required for control over 100 percent of the net assets. It may be possible to acquire shares when the stock market is depressed, thereby paying less than the fair values of the identifiable assets of the business. Shares, particularly if they are publicly traded, are a much more liquid asset than would be the individual assets of an operating company. The acquisition of shares provides for the continuation of the acquired company in unaltered legal form. This means it retains its identity for marketing purposes, the tax basis of all of its assets remain unchanged, and there is no interruption of the business relationships that have been built up by the acquired company As a result of all of these advantages, the majority of business combinations involving large, publicly traded companies will be implemented using a legal form which involves an acquisition of shares. Acquisition Of Shares By Sigma Company (A New Company) As was the case with business combinations based on an acquisition of assets, an alternative to having one entity acquire the shares of the other is to establish a new company to acquire the shares of both predecessor companies. As in our earlier example, we will call the new company Sigma Company. We will assume that it issues 17,000 of its shares to the shareholders of Alpha Company in return for all of their outstanding shares. Correspondingly, 7,800 shares will be issued to the shareholders of Beta Company in return for all of their outstanding shares. This business combination transaction is depicted in Figure 3-4 (following page).
9 Business Combinations 67 Legal Avenues To Combination Figure 3-4 New Company Acquisition Of Shares From Beta Shareholders Sigma Company 100% of Alpha Shares 17,000 Sigma Shares 7,800 Sigma Shares 100% of Beta Shares Shareholders Of Alpha Alpha Company Beta Company Shareholders Of Beta 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 Current Assets ($153,000 + $35,000) $188,000 Non-Current Assets ($82,000 + $85,000) 167,000 Total Assets $355,000 Liabilities ($65,000 + $42,000) $107,000 Common Stock (24,800 Shares Issued And Outstanding) 248,000 Total Equities $355, 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 Subject Legal Avenues To Combination Two corporations, Blocker Company and Blockee Company, have decided to combine and continue their operations as a single economic entity. The date of the business combination transaction is December 31, 2009 and, on that date, the Balance Sheets of the two Companies are as follows:
10 68 Chapter 3 Legal Avenues And Tax Considerations Blocker and Blockee Companies Balance Sheets As At December 31, 2009 Blocker Blockee Company Company Current Assets $1,406,000 $ 987,000 Non-Current Assets 2,476,000 1,762,000 Total Assets $3,882,000 $2,749,000 Liabilities $ 822,000 $ 454,000 Common Stock: (180,000 Shares Outstanding) 1,800,000 N/A (51,000 Shares) N/A 1,145,000 Retained Earnings 1,260,000 1,150,000 Total Equities $3,882,000 $2,749,000 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 consideration 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). End of Exercise. Solution available in Study Guide. Legal Avenues And Tax Considerations Acquisition Of Assets Cash Consideration While it would not be appropriate in financial reporting material to provide a comprehensive discussion of the tax provisions that are associated with the various legal avenues to combination, these matters are of sufficient importance that a brief description of major tax aspects is required Looking first at combinations involving the acquisition of assets, there is a need to distinguish between situations in which cash and/or other assets are the consideration and those situations in which new shares are issued. If a company acquires the assets of another
11 Business Combinations 69 Legal Avenues And Tax Considerations 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 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 transferred 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 In general, investors will prefer to acquire assets rather than shares. In most situations, 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 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 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 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 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 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 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 entities, the assets remain on the books of the separate companies and their tax bases are not affected in any way by the transaction.
12 70 Chapter 3 Alternative Accounting Methods 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. Alternative Accounting Methods Alternative Views Of Economic Substance Influence On Accounting Method A fundamental concept that underlies the establishment of accounting standards is that, without regard to legal form, standards should be designed to reflect the real economic substance of the transactions and events that are reported in financial statements. This is a particular problem in dealing with business combinations as the legal form of these transactions can be heavily influenced by considerations other than the information needs of investors. Given this situation, it is very important to understand the economic substance of the transactions that are being reported In somewhat simplified terms, there are three views of what really happens when two businesses are combined. These different views impact on accounting procedures in that they determine whether there should be a new basis of accountability for either or both of the combining companies. If there is a new basis, assets and liabilities will have to be measured in a way that reflects their fair values at the combination date. If not, the existing carrying values of the assets and liabilities of the combining companies will be carried forward to the accounting records of the combined company. We will use the following simple example to illustrate the impact of alterative views of a combination transaction on required accounting procedures: ComCo One ComCo Two Net Assets At Carrying Values $650,000 $ 800,000 Excess Of Fair Value Over Carrying Value 100,000 75,000 Unrecognized Goodwill 150, ,000 Net Assets At Fair Values $900,000 $1,000,000 ComCo One and ComCo Two are both corporations. They have decided to implement a business combination transaction and continue operations on a combined basis. The legal form of the combination is yet to be determined. Alternative Views Described The three alternative views of the economic substance of a business combination transaction are described in this section. In each case, the basic accounting implications of that view are illustrated using the example from Paragraph Acquisition View In many business combinations one of the combining companies can be easily identified as the dominant or controlling interest in the combined company. In such situations, one of the combining companies can be identified as the acquirer and the economic substance of the business combination transaction is that one business has purchased the assets of another. In this type of situation, there is no justification for altering the carrying values of the acquirer s assets. However, as would be the case in any other purchase of assets, the assets of the acquired company would be recorded at their fair value on the acquisition date. Using the information in our Paragraph 3-49 example, the combined Balance Sheet would be as follows: ComCo One s Carrying Values (The Acquirer) $ 650,000 ComCo Two s Fair Values (The Acquiree) 1,000,000 Combined Net Assets $1,650,000
13 Business Combinations 71 Alternative Accounting Methods 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 information 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, 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. The AcSB s Choice It is likely that, for each of the alternative views described, a real world example could be found of a business combination where that view would be appropriate. There are undoubtedly combination transactions that are simple poolings of the two business entities. Correspondingly, there are combinations that result in a completely new business organization that could best be represented through a new accounting basis for the assets of both entities Despite the possibility of different scenarios, it is clear that the great majority of business combinations involve one of the participating business entities acquiring control over the operations of the other business entity. Given this, it is equally clear that such combinations should be accounted for in a manner that is consistent with the accounting procedures that are used for other acquisitions of assets. The method of accounting that accomplishes this goal is referred to, not surprisingly, as the Acquisition Method of accounting for business combination transactions. Note Until 2009, Canadian standards referred to this method as the Purchase Method of accounting for business combinations. In fact, Section 1581 of the CICA Handbook still refers to this method. However, as the Acquisition Method is used in IFRSs, we will make no further reference to the Purchase Method As it is likely that there are business combinations that reflect both the new entity view and the pooling of interests view, standard setters could have allowed methods other than the Acquisition Method when the circumstances were appropriate. In fact, at one point in time, pooling of interests accounting was widely used in the United States However, it has proved very difficult to specify the circumstances under which alternative methods would be appropriate. In addition, the use of pooling of interests accounting has been used to reduce recorded asset values and the expenses that result from the use of these assets. As a consequence, the FASB, and IASB, and the AcSB have concluded that the Acquisition Method should be used for all business combination transactions. Reflecting this position, Section 1582 contains the following recommendation:
14 72 Chapter 3 Application Of The Acquisition Method Paragraph An entity shall account for each business combination by applying the acquisition method. (January, 2011) Byrd & Chen Note The recommendations in Section 1582 are dated January, 2011 as this is their effective date. However, Section 1582 was added to the Handbook in January, 2009 and earlier application is permitted. Earlier application is conditional on simultaneously adopting Sections 1601 and 1602 which were also added in January, A Potential Problem 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 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 appropriate 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 Acquisition Method. Application Of The Acquisition Method Acquisition Date Business combinations are usually very complex transactions supported by detailed legal agreements involving the transfer of assets or equity interest to an acquiring business entity. While in some cases a single date may be involved, it is not uncommon for more than one date to be specified for the various components of the transaction Establishing the appropriate acquisition date is an important issue in that this is the date on which the assets of the acquiree will be measured. The choice of date can have a significant influence on these amounts. Because of this, the Handbook provides the following Recommendation: Paragraph The acquirer shall identify the acquisition date, which is the date on which it obtains control of the acquiree. (January, 2011) In general, this will be the date on which the assets and liabilities of the acquiree are legally transferred to the acquirer. It could be earlier if a written agreement transfers control prior to that date. It would appear unlikely that the transfer of control would occur subsequent to the closing date for the transfer of the assets. Identification Of An Acquirer Basic Recommendation The concepts underlying the acquisition method require that an acquirer be identified in each business combination transaction. This is reflected in the following recommendation: Paragraph For each business combination, one of the combining entities shall be identified as the acquirer. (January, 2011) 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 determining 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 combinations can take forms other than the acquisition of a subsidiary. Given this, more detailed consideration is required in dealing with this recommendation.
15 Business Combinations 73 Application Of The Acquisition Method Figure 3-5 Identifying An Acquirer Alpha Company (1 Million Outstanding Shares) New Alpha Shares 100% Of Beta Shares Beta Shareholders Cash Consideration 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 However, before we examine this more detailed guidance, we will look at some situations 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 participation 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 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 Conceptually, the solution to the problem is fairly simple. Assuming that the combining enterprises are both corporations, the acquirer is the company whose shareholders, 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 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 consequence, the original Alpha Company shareholders will be in a majority position. This means that Alpha Company will be identified as the acquirer.
16 74 Chapter 3 Application Of The Acquisition Method 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. Formation Of New Company In those combinations where a new company is formed to acquire either the assets or the shares of the two combining companies, the analysis is usually straightforward. The new company will be issuing shares as consideration for the assets or shares of the combining companies. Without regard to whether the new company acquires assets or shares, the acquirer is the predecessor company that receives the majority of shares in the new company. Additional Handbook Guidance Continuing with the example from Figure 3-5, a further possibility would be that Alpha would issue exactly 1 million shares to the Beta shareholders. In this case, neither shareholder group has a majority of voting shares. This is an example of a type of situation where simply looking at the post-combination holdings of voting shares will not serve to clearly identify an acquirer In such situations, Section 1582 provides additional guidance as follows: Relative Voting Rights In The Combined Entity The acquirer is usually the combining entity whose owners as a group retain or receive the largest portion of the voting rights in the combined entity. In determining which group of owners retains or receives the largest portion of the voting rights, an entity should consider the existence of any unusual or special voting arrangements and options, warrants or convertible securities. Existence Of A Large Minority Voting Interest If no other owner or organized group of owners has a significant voting interest the acquirer is usually the combining entity whose single owner or organized group of owners holds the largest minority voting interest in the combined entity. Composition Of Governing Body 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. Composition Of Senior Management The acquirer is usually the combining entity whose (former) management dominates the management of the combined entity. Terms Of Exchange The acquirer is usually the combining entity that pays a premium over the pre-combination fair value of the equity interests of the other combining entity or entities Other considerations include the relative size of the combining companies. The acquirer is normally the largest of the combining companies in terms of either assets or revenues. Also determining which company initiated the transaction can be helpful in establishing the control interest in a business combination Section 1582 also notes that, in cases where a new company is formed to carry out the combination, it will usually be one of the combining companies that will be identified as the acquirer. While from a legal perspective, the new company has acquired either the assets or shares of the combining company, it would be unusual for this company to be identified as the acquirer. Reverse Acquisitions As we have noted, in some business combination transactions a reverse acquisition may occur. This involves an acquisition where a company issues so many of its own shares that the acquired company or its shareholders wind up holding a majority of shares in the legal acquirer.
17 Business Combinations 75 Application Of The Acquisition Method 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 situation 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 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 Through the reverse acquisition procedure that we have just described, the shareholders 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. Subject: Identification Of An Acquirer Exercise Three - 2 For each of the following independent Cases, indicate which of the combining companies should be designated as the acquirer. Explain your conclusion. A. Delta has 100,000 shares of common stock outstanding. In order to acquire 100 percent of the voting shares of Epsilon, it issues 150,000 new shares of common stock to the shareholders of Epsilon. B. Delta has 100,000 shares of common stock outstanding. It pays cash of $1,500,000 in order to acquire 48 percent of the voting shares of Epsilon. No other Epsilon shareholder owns more than 5 percent of the voting shares. C. Delta, Epsilon, Zeta, and Gamma transfer all of their net assets to a new corporation, Alphamega. In return, Gamma receives 40 percent of the shares in Alphamega, while the other three Companies each receive 20 percent of the Alphamega shares. D. Delta has 100,000 shares of common stock outstanding. Delta issues 105,000 shares to the sole shareholder of Epsilon in return for all of his outstanding shares. As it is the intention of this shareholder to retire from business activities, the management of Delta will be in charge of the operations of the combined company. End of Exercise. Solution available in Study Guide.
18 76 Chapter 3 Application Of The Acquisition Method Determining The Cost Of The Acquisition Basic Approach The cost of the acquisition in a business combination transaction is based on the amount of consideration transferred by the acquirer. With respect to the measurement of this consideration, Section 1582 contains the following recommendation: Paragraph The consideration transferred in a business combination shall be measured at fair value, which shall be calculated as the sum of the acquisition-date fair values of the assets transferred by the acquirer, the liabilities incurred by the acquirer to former owners of the acquiree, and the equity interests issued by the acquirer. (However, any portion of the acquirer s share-based payment awards exchanged for awards held by the acquiree s employees that is included in consideration transferred in the business combination shall be measured in accordance with paragraph rather than at fair value.) Examples of potential forms of consideration include cash, other assets, a business or a subsidiary of the acquirer, contingent consideration, common or preference equity instruments, options, warrants and member interests of mutual entities. Byrd & Chen Note Paragraph requires that measurement of share-based payment awards be based on Section 3870, Stock-Based Compensation And Other Stock-Based Payments The problems involved in implementing this recommendation would vary with the nature of the consideration given. The following guidelines would cover most situations: If the acquirer pays cash there is no significant problem. If shares with a quoted market price are issued by the acquirer, this market price will normally be used as the primary measure of the purchase price. If the acquirer issues shares that do not have a market price or if it is agreed that the market price of the shares issued is not indicative of their fair value, the fair value of the net assets acquired would serve as the purchase price in the application of this method of accounting for business combinations. Acquisitions Where No Consideration Is Involved While this basic approach will apply in most business combination transactions, it is possible that control of a business can be acquired without the transfer of consideration. Examples of this type of situation are as follows: The acquiree repurchases a sufficient number of its own shares for an existing investor (the acquirer) to obtain control. Minority veto rights lapse that previously kept the acquirer from controlling an acquiree in which the acquirer held the majority voting rights. The acquirer and acquiree agree to combine their businesses by contract alone. The acquirer transfers no consideration in exchange for control of an acquiree and holds no equity interests in the acquiree, either on the acquisition date or previously. Consideration With Accrued Gains Or Loss When non-monetary assets are transferred as consideration in a business combination transaction, it is likely that their fair value will be different than their carrying value on the books of the acquiree. If the assets are transferred outside of the combined entity, the assets will be recorded on the combined books at their fair value, with the resulting gain or loss included immediately in Net Income However, if the transferred assets remain within the combined entity, they should be recorded at their pre-transfer carrying value, with no gain or loss being recognized.
19 Business Combinations 77 Application Of The Acquisition Method 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 Subject: Non-Monetary Assets As Consideration Markor Inc. transfers a group of investments to the shareholders of Sarkee Ltd. in return for a controlling interest in the shares of that company. These investments have a carrying value of $2 million on the books of Markor. Their fair value is $3.5 million. How would this transaction be recorded on the books of Markor Inc.? End Of Exercise. Solution available in Study Guide. Direct Costs Of Combination - General Rules It is a fairly well established accounting principle that the direct costs associated with the acquisition of an asset should be included in the cost of the acquired assets. For example, Section 3061 of the CICA Handbook indicates that the cost of property, plant, and equipment includes the purchase price and other acquisition costs such as option costs when an option is exercised, brokers' commissions, installation costs including architectural, design and engineering fees, legal fees, survey costs, site preparation costs, freight charges, transportation insurance costs, duties, testing and preparation charges Somewhat surprisingly, Section 1582 takes a very different position with respect to the direct costs incurred by an acquirer in a business combination transaction: Paragraph Acquisition-related costs are costs the acquirer incurs to effect a business combination. Those costs include finder s fees; advisory, legal, accounting, valuation and other professional or consulting fees; general administrative costs, including the costs of maintaining an internal acquisitions department; and costs of registering and issuing debt and equity securities. The acquirer shall account for acquisition-related costs as expenses in the periods in which the costs are incurred and the services are received, with one exception. The costs to issue debt or equity securities shall be recognized in accordance with Section 3610, Capital Costs, and Section 3855, Financial Instruments Recognition And Measurement This represents a change from the position taken previously in Canadian GAAP. Under Section 1581, the direct costs of combination were added to the acquisition cost. Contingent Consideration In negotiating the terms of a business combination transaction, there will be differences 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 stakeholders in the acquiree are willing to believe 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.
20 78 Chapter 3 Application Of The Acquisition Method When contingent consideration is used, Section 1582 makes the following recommendation: Paragraph 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 contingent consideration as part of the consideration transferred in exchange for the acquiree 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 In somewhat simplified terms, the accounting subsequent to the date of the combination 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 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 contingency 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
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