Chapter 12: Business combinations achieved in stages

A business combination is accounted for from the acquisition date. This is the date on which the acquirer obtains control of the acquiree. Many investments that end up as subsidiaries begin as smaller interests in the entities concerned.

They might be treated in the group’s financial statements in a variety of ways before they actually become subsidiaries and are accounted for under the acquisition method. For example, they could be small stakes in an entity, which are accounted for under IFRS 9.

Alternatively, they could be larger stakes, giving rise to significant influence or joint control, which are accounted for under IAS 28 and IFRS 11 respectively. If the acquirer gains control of an interest that was previously accounted for under one of these standards, it has carried out a business combination achieved in stages (also known as a ‘step acquisition’).

A business combination achieved in stages is accounted for using the acquisition method at the acquisition date. Goodwill is calculated once, at the date when control is acquired.

The components of a business combination under IFRS 3 include previously held interests. The previously held interest is remeasured to fair value at the acquisition date, and a gain or loss is recognised in profit or loss, or other comprehensive income, as appropriate.

In accounting terms, the previously held interest is treated as if it has been disposed of in return, along with consideration transferred, for the controlling interest in the subsidiary. The fair value of the previously held interest then forms one of the components that is used to calculate goodwill, along with consideration and NCI, less the fair value of identifiable net assets.

Accounting for step acquisitions on one chart

Step acquisitions – general

This applies when an equity investment in one of the following categories is increased to become a controlling interest:

• a financial asset under IFRS 9 (or, for entities that have not yet adopted IFRS 9, );
• an associate or a joint venture accounted for using equity accounting under IAS 28; or

a joint operation that constitutes a business.

These requirements apply to transactions that result in the acquirer obtaining control of an entity; they do not apply to subsequent increases and decreases in ownership interests that do not involve the loss of control.

Transactions in which control is achieved through two transactions

The principles to be applied are:

• a business combination occurs only in respect of the transaction that gives one entity control of another;
• identifiable net assets of the acquiree are remeasured to their fair value on the date of acquisition (i.e. the date that control is obtained);
• non-controlling interests are measured on the date of acquisition;
• an equity interest previously held in the acquiree which qualified as a financial asset under IFRS 9 (or, for entities that have not yet adopted IFRS 9, ) is treated as if it were disposed of and reacquired at fair value on the acquisition date. Accordingly, it is remeasured to its acquisition-date fair value and any resulting gain or loss is recognised in profit or loss or other comprehensive income, as appropriate. Any amount that has previously been recognised in other comprehensive income, and that would be reclassified to profit or loss following a disposal, is similarly reclassified from equity to profit or loss;
• an equity interest previously held in the acquiree which qualified as an associate or a joint venture, or as a joint operation that constitutes a business, is similarly treated as if it were disposed of and reacquired at fair value on the acquisition date. Accordingly, it is remeasured to its acquisition-date fair value, and any resulting gain or loss compared to its carrying amount under IAS 28 or IFRS 11 is recognised in profit or loss. Any amount that has previously been recognised in other comprehensive income, and that would be reclassified to profit or loss following a disposal, is similarly reclassified from equity to profit or loss; and
• goodwill (or a gain from a bargain purchase) is measured as follows.

Control obtained in step acquisition

Entity A has a 40% equity interest in entity B. The carrying value of the equity interest, which has been accounted for as an associate in accordance with IAS 28, is C20 million. Entity A purchases the remaining 60% interest in entity B for C300 million in cash. The fair value of the 40% previously held equity interest is determined to be C200 million. The net value of the identifiable assets and liabilities is determined to be C440 million. The tax consequences, on the gain or loss on remeasurement of the associate interest, have been ignored in this example.

How does entity A account for the business combination?

Entity A recognises at the acquisition date: 100% of the identifiable net assets. goodwill as the excess of 1 over 2 below:

1. The aggregate of: the consideration transferred; the amount of any non-controlling interest (not applicable in this example); and the acquisition date fair value of the acquirer’s previously held equity interest in the acquiree.
2. The assets and liabilities recognised in accordance with IFRS 3. The journal entry recorded on the acquisition date of the 60% controlling interest is as follows:

Dr Identifiable net assets 440

Dr Goodwill 60

Cr Cash 300

Cr Associate 20

Cr Gain on equity interest 180

Goodwill is calculated as follows:

Fair value of consideration transferred 300

Fair value of previously held equity interest 200

500

Recognised value of 100% of the identifiable net assets, measured in accordance with IFRS 3 (440)

Goodwill recognised 60

The gain on the 40% previously held equity interest is recognised in the income statement. The fair value of the previously held equity interest, less the carrying value of the previously held equity interest, is C180 million (C200m − C20m). Assume that the previously held interest is accounted for under IFRS 9 and measured at fair value with gains and losses recorded in OCI. At the date of the business combination, it is recorded at C200 million, with a revaluation reserve of C180 million recorded in equity. The entries, when control is obtained, would be:

Dr Identifiable net assets 440

Dr Goodwill 60

Cr Cash 300

Cr Financial assets at FV through OCI 200

Dr Revaluation reserve 180

Cr Equity 180

When control is obtained, financial assets accounted for under IFRS 9 at FVOCI are not recycled but can be reclassified within equity. Similarly, revaluation reserves related to the revaluation of property, plant and equipment or intangible assets are not recycled but transferred directly to retained earnings.

Other reserves held in equity that relates to the previously held interest, such as cumulative translation differences, would be recycled through profit and loss.

Recognising and measuring goodwill or a gain from a bargain purchase

Goodwill

Goodwill is defined as “an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognised”

Goodwill might arise in the acquiring group’s consolidated financial statements where a new subsidiary is acquired. Goodwill can also arise in the separate financial statements of an acquiring entity where it purchases the business and assets of another entity.

Goodwill is measured, at the acquisition date, as the amount by which the figure at 1 exceeds the figure at 2 below:

1. The aggregate of:
   1. The fair value of consideration transferred.
   2. The amount of any non-controlling interest recognised.
   3. In a business combination achieved in stages, the acquisition date fair value of the acquirer’s previously held equity interest in the acquiree.
2. The assets and liabilities recognised in accordance with IFRS 3.

Groups will need to keep detailed records of the composition of the aggregate amount of acquired goodwill − that is, to which parts of the group it relates. Goodwill must be allocated to cash-generating units (CGUs), or groups of CGUs, in order to carry out impairment reviews and to account for subsequent disposals.

A description of the factors that make up goodwill must be disclosed. Understanding the components of goodwill might assist entities in allocating the goodwill to CGUs for the purposes of impairment testing.

Goodwill arising on the acquisition of a foreign operation is treated as the foreign operation’s asset, and it is expressed in the foreign operation’s functional currency. For the purposes of initial recognition, it is calculated using the exchange rates on the acquisition date. Thereafter, the foreign currency goodwill is translated into the group’s presentation currency, for consolidation purposes, at the closing rate each period end, in accordance with IAS 21.

The choice of measurement basis for non-controlling interest might affect the amount of goodwill or a gain recognised on a bargain purchase.

Components making up goodwill

An entity that has one existing business acquires a business from another entity. The total amount of goodwill recognised in the transaction is C100. The acquirer’s management expects to benefit from synergies of the business combination, specifically from cost savings and an increase in market share. The acquired business also included assembled workforce and non-contractual customer relationships that are not separable. These items are not identifiable assets, and they are subsumed into goodwill. These components of goodwill should be disclosed in the business combination note. There is no requirement to quantify the separate components of goodwill.

Goodwill recognised depends on how noncontrolling interest is measured

Goodwill is measured as a residual. Where an entity acquires less than 100% of a business, goodwill could be one of two different amounts, depending on the choice that an entity makes when it decides how to measure noncontrolling interest (NCI).

NCI could be measured using the fair value method or the proportionate share method. Entities can choose between these two treatments on a business-combination-by-business-combination basis: Goodwill will only include amounts relating to the acquiring entity’s interest in the business acquired where NCI is measured at the NCI’s proportionate share of the acquiree’s identifiable net assets.

Goodwill will include amounts relating to both the acquiring entity’s interest and the NCI in the business acquired where NCI is measured at fair value. Example Entity A acquires entity B by purchasing 60% of its equity for C150 million in cash. The net aggregate value of the identifiable assets and liabilities, as measured in accordance with IFRS 3, is determined to be C50 million.

How much goodwill is recognised based on the two measurement bases of NCI?

Measurement at proportionate share of the acquiree’s identifiable net assets

Entity A decides to measure NCI at its proportionate share (40%) of entity B’s identifiable net assets. The goodwill recognised under IFRS 3 represents entity A’s 60% share of the total goodwill attributable to entity B. It does not include any amount of goodwill attributable to the 40% NCI. The journal entry recorded on the acquisition date for the 60% interest acquired is as follows:

Dr Identifiable net assets 50

Dr Goodwill 120

Cr Cash 150

Cr NCI 20 NCI is (C50m × 40%) = C20m.

Hence, goodwill of C120 million is calculated as consideration of C150 million plus NCI of C20 million, less identifiable assets and liabilities of C50 million. Measurement at fair value Entity A decides to measure NCI at fair value rather than at its proportionate share of the identifiable net assets. The fair value of NCI is determined to be C100 million, which is the same as the fair value on a per-share basis of the purchased interest. Goodwill recognised under IFRS 3 represents the group’s share of the total goodwill attributable to entity B, and the NCI’s share of the total goodwill attributable to entity B. The acquirer recognises at the acquisition date (i) 100% of the identifiable net assets, (ii) NCI at fair value, and (iii) goodwill. The journal entry recorded on the acquisition date for the 60% interest acquired is as follows:

Dr Identifiable net assets 50

Dr Goodwill 200

Cr Cash 150

Cr NCI 100

Gain on a bargain purchase depends on how noncontrolling interest is measured

Where identifiable net assets are greater than the fair value of the consideration transferred plus the recognised amount of non-controlling interest (NCI), a bargain purchase gain is recognised in the income statement. The bargain purchase gain recognised under the proportionate share method might be higher than the gain recognised under the fair value method where the fair value of NCI includes positive goodwill. This is because the NCI measured at the proportionate share of net assets will be lower, leading to a greater difference between identifiable net assets and consideration plus NCI.

Example

Entity A acquires entity B by purchasing 70% of its equity for C150 million in cash. The fair value of NCI is determined to be C69 million. The net aggregate value of the identifiable assets and liabilities is determined to be C220 million. For the purposes of this example, the tax consequences have been ignored. Measurement at proportionate share of the acquiree’s identifiable net assets Management has elected to measure NCI using the proportionate share method for this business combination. The bargain purchase gain is calculated as follows:

Fair value of consideration transferred 150

NCI based on proportionate share of net assets 66

Fair value of previously held equity interest n/a 216

Recognised value of 100% of the identifiable net assets, measured in accordance with the IFRS 3 220

Gain on bargain purchase 4

A bargain purchase gain of C4 million is recognised in the income statement. The journal entry recorded on the acquisition date of the 70% interest is as follows:

Dr Identifiable net assets 220

Cr Cash 150

Cr Gain on bargain purchase 4

Cr NCI 66

Measurement at fair value

Management has elected to measure NCI at fair value. This fair value includes embedded goodwill of C3 million (FV of NCI − NCI’s share of identifiable assets = C69 million (C220m × 30%)). Although the NCI value includes C3 million of embedded goodwill, the consolidated financial statements do not contain a separate goodwill line item. The bargain purchase gain is calculated as follows:

Fair value of consideration transferred 150

Fair value of NCI 69

Fair value of previously held equity interest n/a 219

Recognised value of 100% of the identifiable net assets, measured in accordance with the standards 220

Gain on bargain purchase 1

A bargain purchase gain of C1 million is recognised in the income statement. The journal entry recorded on the acquisition date of the 70% interest is as follows:

Dr Identifiable net assets 220

Cr Cash 150

Cr Gain on bargain purchase 4

Cr NCI 69

Bargain purchase

A gain on a bargain purchase occurs where the consideration, non-controlling interest and the previously held interest are less than the value of the identifiable net assets. A gain on a bargain purchase is immediately recognised by the acquirer in profit or loss.

A bargain purchase might occur where there is a forced sale, where difficult market conditions exist, or because some items in a business combination are not measured at fair value.

The acquirer should ensure that it does have a gain on a bargain purchase, and that it has used all the available evidence at the date of acquisition and re-assessed the business combination accounting. The acquirer re-assesses the identification and measurement of the acquiree’s identifiable assets and liabilities.

The acquirer reviews the measurement of:

• Identifiable assets and liabilities.
• Non-controlling interest, if any.
• The acquirer’s previously held equity interest, if any.
• Consideration transferred.

Gain on a bargain purchase

Bargain purchase gains are expected to occur infrequently. The fair value of a business might be less than the recognised net assets because of the expectation that market participants will need to carry out significant restructuring activities.

However, the assets’ recoverable amount should be considered carefully in this situation. A business that is loss-making, underperforming or in need of reorganisation is unlikely to have net assets worth more than the price paid for the business as a whole.

An acquirer should reassess whether it has correctly identified and measured the assets acquired and liabilities assumed. The fair values of the identifiable assets, liabilities and contingent liabilities are re-assessed. This could include checking the fair values of identifiable assets for impairment and checking the fair values of the identifiable liabilities to ensure that none has been omitted or understated.

The acquirer ensures that it has recognised all contingent liabilities and measured them at fair value. Any reductions to the acquired net assets, as a result of this reassessment exercise, will reduce or eliminate the bargain purchase gain.

Measurement period adjustments

The acquirer has a period of time, referred to as the ‘measurement period’, to finalise the accounting for a business combination. The measurement period provides entities with a reasonable period of time to identify, and to determine the value of:

• The identifiable assets acquired, liabilities assumed and any non-controlling interest in the acquiree.
• The consideration transferred for the acquiree or other amount used in measuring goodwill (for example, in a business combination achieved without consideration transferred).
• The equity interest in the acquiree previously held by the acquirer.
• The goodwill recognised, or a bargain purchase gain.

The measurement period ends on the earlier of the date when the acquirer receives the information that it needs (or determines that it cannot obtain the information) and one year after the acquisition date. Where the accounting for a business combination is not complete by the end of the reporting period in which the business combination occurred, provisional amounts should be reported and disclosure.

New information that gives rise to a measurement period adjustment should relate to events or circumstances existing at the acquisition date.

Factors to consider, in determining whether new information obtained gives rise to a measurement period adjustment, include the timing of the receipt of new information and whether the acquirer can identify a reason for the measurement period adjustment. Information obtained shortly after the acquisition date is more likely to reflect facts and circumstances existing at the acquisition date, as opposed to information received several months later.

The acquirer is required to recognise the adjustment as part of its acquisition accounting if a measurement period adjustment is identified. An acquirer increases or decreases the provisional amounts of identifiable assets or liabilities and, as a result, goodwill by means of increases or decreases in goodwill for measurement period adjustments.

New information obtained during the measurement period might result in an adjustment to the provisional amounts of more than one asset or liability.

An adjustment to goodwill resulting from a change to a provisional amount might be offset, in whole or part, by another adjustment to goodwill from a corresponding adjustment to a provisional amount of the other asset or liability.

Offsetting adjustments to goodwill

The acquirer might have assumed a liability to pay damages related to an accident in one of the acquiree’s facilities, part or all of which are covered by the acquiree’s insurance policy. If the acquirer obtains new information during the measurement period about the acquisition date fair value of that liability, the adjustment to goodwill resulting from a change in the provisional amount recognised for the liability might be offset (in whole or in part) by a corresponding adjustment to goodwill resulting from a change in the provisional amount recognised for the claim receivable from the insurer.

Comparative prior period information included in subsequent financial statements is revised to include the effect of the measurement period adjustment as if the accounting for the business combination had been completed on the acquisition date. The effects of a measurement period adjustment might cause changes in depreciation, amortisation or other income or expense recognised in prior periods.

All changes that do not qualify as measurement period adjustments are included in current period profit or loss. After the measurement period ends, an acquirer should revise its accounting for the business combination only to correct an error in accordance with IAS 8.

Measurement period adjustment

Entity A acquired entity B on 1 October 20X4. Entity A commissioned an independent appraisal for a piece of equipment acquired in the combination. However, the appraisal was not finalised by the time that entity A completed its 20X4 financial statements. Entity A recognised, in its 20X4 financial statements, a provisional fair value for the asset of C30,000 and a provisional value for goodwill of C100,000.

The equipment had a remaining useful life, at the acquisition date, of five years. Six months after the acquisition date, entity A received the independent appraisal, which estimated the equipment’s fair value at the acquisition date at C40,000.

How should this information be reflected in the financial statements?

The acquirer is required to recognise any adjustments to provisional values as a result of completing the initial accounting from the acquisition date. The tax consequences of the fair value adjustments have been ignored in this example. In the 20X5 financial statements, the carrying amount of goodwill is also adjusted for the increase in value of the equipment at the acquisition date of C10,000. The 20X4 comparative information is restated to reflect this adjustment and to include additional depreciation of C500 ((40,000 – 30,000)/5 × ¼) in the income statement for the year ended 31 December 20X4. An adjustment is made to the equipment’s opening carrying amount at 1 January 20X5.

That adjustment is measured as the fair value adjustment, at the acquisition date, of C10,000 (being C40,000 – C30,000) less the additional depreciation that would have been recognised if the equipment’s fair value at the acquisition date had been recognised from that date (C500 for three months’ depreciation to 31 December 20X4); that is, an overall increase of C9,500. Entity A discloses, in its 20X4 financial statements, that the initial accounting for the business combination has been determined only provisionally.

Entity A discloses, in its 20X5 financial statements, the amounts and explanations of the adjustments to the provisional values recognised during the current period. Therefore, entity A discloses that: The fair value of the equipment at the acquisition date has been increased by C10,000, with a corresponding decrease in goodwill. The 20X4 comparative information is restated to reflect this adjustment and to include additional depreciation of C500 in the income statement for the year ended 31 December 20X4.