Business Combinations (Part 1) 1 Chapter 1 Business Combinations (Part 1) Related standards: PERS 3 Business Combinations Section 19 of the PFRS for SMEs Overview on the topic Our discussion on business combination is subdivided into the following chapters: Chapter Title Coverage 1 Business Combinations (Part 1) Recognition & measurement 2 Business Combinations (Part 2) Specific cases 3 Business Combinations (Part 3) Special accounting topics Learning Objectives L._ Define a business combination. 2. Explain briefly the accounting requirements for a business combination. 3. Compute for goodwill. Introduction A business combination occurs when one company acquires another or when two or more companies merge into one. After the combination, one company gains control over the other. The company that obtains control over the other is referred to as the parent or acquirer. The other company that is controlled is the subsidiary or acquiree. Business combinations are carried out either through: 1. Asset acquisition; or 2. Stock acquisitionChapter | > Asset acquisition - the acquirer purchases the assets assumes the liabilities of the acquiree in exchange for cast other non-cash consideration (which may be the acquire own shares). After the acquisition, the acquired normally ceases to exist as a separate legal or accou entity. The acquirer records the assets acquired and liabiliti assumed in the business combination in its books of accour Under the Corporation Code of the Philippines, business combination effected through asset acquisition may be either: a. Merger - occurs when two or more companies merge into a single entity which shall be one of the combining companies. For example: A Co. + BCo. =A Co. or B Co. b. Consolidation - occurs when two or more companies consolidate into a single entity which shall be the consolidated company. For example: A Co. + B Co. = C Co. Stock acquisition - instead of acquiring the assets and assuming the liabilities of the acquiree, the acquirer obtains control over the acquiree by acquiring a majority ownership interest (e.g, more than 50%) in the voting rights of the acquiree. In a stock acquisition, the acquirer is known as the parent while the acquiree is known as the subsidiary. After the business combination, the parent and the subsidiary retain their separate legal existence. However, for financial reporting purposes, both the parent and the subsidiary are viewed as a single reporting entity. After the business combination, the parent and subsidiary continue to maintain their own separate accounting books, recording separately their assets, liabilities and the transactions they enter into. The parent records the ownership interest acquired as “investment in subsidiary” in its separate accounting books. However, the investment is eliminated when the group Prepares consolidated financial statements.Business Combinations (Part 1) 3 A business combination may also be described as: 1 Horizontal combination — a business combination of two or more entities with similar businesses, e.g., a bank acquires another bank. Vertical combination — a business combination of two or more entities operating at different levels in a marketing chain, eg., a manufacturer acquires its supplier of raw materials. Conglomerate — a business combination of two or more entities with dissimilar businesses, e.g., a real estate developer acquires a bank. Advantages of a business combination a. iti, Competition is eliminated or lessened — competition between the combining constituents with similar businesses is eliminated while the threat of competition from other market participants is lessened. Synergy — synergy occurs when the collaboration of two or more entities results to greater productivity than the sum of the productivity of each constituent working independently. Synergy is most commonly described as “the whole is greater than the sum of its parts.” It can be simplified by the expression “I plus 1=3.” Increased business opportunities and earnings potential — business opportunity and earnings potential may be increased through: an increased variety of products or services available and a decreased dependency on limited number of products and services; widened dispersion of products or services and better access to new markets; access to either of the acquirer's or acquiree’s technological know-hows, research and development, secret processes, and other information;4 Chapter 1 iv. increased investment opportunities due to increased capital; or Vv. appreciation in worth due to an established trade name by either one of the combining constituents. d. Reduction of operating costs - operating costs of the combined entity may be reduced. i, Under a horizontal combination, operating costs may be reduced by the elimination of unnecessary duplication of costs (e.g., cost of information systems, registration and licenses, some employee benefits and costs of outsourced services). ii, Under a vertical combination, operating costs may be reduced by the elimination of costs of negotiation and coordination between the companies and mark-ups on purchases. e. Combinations utilize economies of scale - economies of scale refer to the increase in productive efficiency resulting from the increase in the scale of production. An entity that achieves economies of scale decreases its average cost per unit as production is increased because fixed costs are allocated over an increased number of units produced. f. Cost savings on business expansion - by acquiring another company rather that creating a new one, an entity can save on start-up costs, research and development costs, cost of regulation and licenses, and other similar costs. Moreover, a business combination may be effected through exchange of equity instruments rather than the transfer of cash or other Fesources. g- Favorable tax implications - deferred tax assets may be transferred in a business combination. Also, business combinations effected without transfers of considerations may not be subjected to taxation.w Business Combinations (Part 1) Disadvantages of a business combination a. Business combination brings monopoly in the market which may have a negative impact to the society. This could result to impediment to healthy competition between market participants. b. The identity of one or both of the combining constituents may cease, leading to loss of sense of identity for existing employees and loss of goodwill. c. Management of the combined entity may become difficult due to incompatible internal cultures, systems, and policies. d. Business combination may result in overcapitalization, which, in turn, may result to diffusion in market price per share and attractiveness of the combined entity’s equity instruments to potential investors. e. The combined entity may be subjected to stricter regulation and scrutiny by the government, most especially if the business combination poses threat to consumers’ interests. Business combinations are accounted for under PFRS 3 Business Combinations. Business Combination A business combination is “a transaction or other event in which an acquirer obtains control of one or more businesses.” Transactions referred to as ‘true mergers’ or ‘mergers of equals’ are also business combinations under PFRS 3. ([Link] 4) Essential elements in the definition of a business combination 1. Control 2, Business Control An investor controls an investee when the investor has the power to direct the investee’s relevant activities (i.e., operating and financing policies), thereby affecting the variability of the investor's investment returns from the investee.ae __ Chapter 1 Control is normally presumed to exist when the acquire; holds more than 50% (or 51% or more) interest in the acquiree’, voting rights. However, this is only a presumption because can be obtained in some other ways, such as when: a. the acquirer has the power to appoint or remove of the board of directors of the acquiree; or contro] the majority b. the acquirer has the power to cast the Majority of votes at board meetings or equivalent bodies within the acquiree; or c. the acquirer has power over more than half of the voting Tights of the acquiree because of an agreement with other investors; or d. the acquirer controls the acquiree’s operating and financial policies because of a law or an agreement. An acquirer ma of ways, for example: by transferring cash or other assets; by incurring liabilities; by issuing equity interests; - . by providing more than one type of consideration; or without transferring consideration, including by contract alone. y obtain control of an acquiree in a variety pao Illustration: Determining the existence of control Example #1 ABC Co. acquires 51% ownership interest in XYZ, Inc's ordinary shares. Analysis: ABC is presumed to have obtained control over XYZ because of the ownership interest acquired in the voting rights of XYZis more than 50%. Example #2 | ABC Co. acquires 100% of XYZ, Inc.’s preference shares.