Special Accounting Topics For Business Combination

SPECIAL ACCOUNTING TOPICS FOR BUSINESS COMBINATION
Introduction
In this chapter, the student will learn about goodwill in a business combination, reverse acquisition
and push down accounting.
Specific objectives:
At the end of the lesson, the students should be able to:
Apply the methods of estimating goodwill.
Account for reverse acquisition.
Apply push down accounting in the consolidation process.
Duration: 6 hours (Lecture/Discussion/Problem Solving)
LESSON PROPER
1) Goodwill arising from a business combination is not amortized but tested for impairment
at least annually.
2) Methods of estimating goodwill:

a) Indirect valuation- this is the residual approach wherein goodwill is measured as the
excess of the sum of consideration transferred, non controlling interest in the
acquiree, and previously held equity interest in the acquiree over the fair value of net
identifiable assets acquired. PFRS 3 requires the use of this method.
b) Direct valuation- goodwill is measured based on expected future earnings from the
business to be acquired.
Example of direct valuation method:

ABC Co. is contemplating on acquiring XYZ, Inc. The following information were
gathered through a due diligence audit.
a) The actual earnings of XYZ Inc. for the past 5 years are as follows:
Year Earnings
2016 1,200,000
2017 1,300,000
2018 1,350,000
2019 1,250,000
2020 1,800,000
Total 6,900,000
=======
b) Earnings in 2020 include an expropriation gain of P400,000.
c) The fair value of XYZ’s net assets as of the end of 2020 is P10,000,000.
d) The industry average rate of return is 12%.
e) Probable duration of excess earnings is 5 years.
Computation of goodwill:
Method 1: Multiples of average excess earnings- goodwill is measured at the average
excess earnings multiplied by the probable duration of excess earnings.
Total earnings for the last 5 years 6,900,000

Less expropriation gain ( 400,000)
Normalized earnings for the last 5 years 6,500,000
Divide by (no. of years) 5
Average annual earnings 1,300,000
Fair value of acquiree’s net assets 10,000,000

Multiply by normal rate of return x 12%
Normal earnings 1,200,000
Excess earnings 100,000
Multiply by Probable duration of excess earnings x5
Goodwill 500,000
=======
Method 2: Capitalization of average excess earnings -goodwill is measured at the average

excess earnings divided by a predetermined capitalization rate. (Assume a capitalization
rate of 25%)
Goodwill (P100,000 / 25%) = P400,000
Method 3: Capitalization of average earnings – the average earnings are divided by a

predetermined capitalization rate to estimate the purchase price of the business
combination. The excess of the estimated purchase price over the fair value of the
acquiree’s net assets represents the goodwill (Assume a capitalization rate of 12.5%)
Estimated purchase price:
Average earnings/capitalization rate (P1.3M/12.5%) 10,400,000
Fair value of XYZ’s assets 10,000,000
Goodwill 400,000
========
Method 4: Present value of average excess earnings- goodwill is measured at the present
value of average excess earnings at a pre-determined discount rate over the probable
duration of excess earnings (Assume a discount rate of 10%).
Excess earnings 100,000
Multiply by Present value of ordinary annuity @10%, n=5 3.79079
Goodwill 379,079
======
3) Impairment Test for Goodwill -After initial recognition, the acquirer shall measure
goodwill acquired in a business combination at cost less any accumulated impairment
losses in accordance with PAS 36, Impairment of Assets.
PUSH DOWN ACCOUNTING
It is a method of accounting for the purchase of another company at the purchase price rather
than its historical cost. Any gains or losses associated with the new book vales are “pushed
down” from the acquirer’s to the acquired company’s income statement and balance sheet.
Under push down accounting, allocation is recorded in the books of the subsidiary by means of
adjusting entries, thereby affecting its separate financial statements. The adjustment of
identifiable assets and liabilities of the acquired subsidiary and the recognition of goodwill are
accompanied by a write off of the subsidiary’s retained earnings. The balance is added to
Additional paid in capital. Push down accounting does not affect consolidated financial
statements; in fact, it simplifies the consolidation process.
Illustration: P Company issued 16,000 shares of its P10 par value common stock for 80% of the
20,000 outstanding shares of S Company. The fair value of P Company’s stock is P50 and the
fair value of the 20% NCI is assessed to be P170,000. P Company would make the following
entry in its books:
Investment in S Company 800,000

Common stock 160,000
Additional paid in capital 640,000
The book values and fair values of S Company’s assets on acquisition date are as follows:
Book Value Fair Value
Accounts Receivable 40,000 40,000
Inventory 100,000 110,000
Land 80,000 130,000
Buildings (net) 300,000 500,000
Equipment (net) 80,000 120,000
Liabilities at fair value equaled book value of P280,000.

S Company’s stockholders’ equity section shows the following accounts:
Common stock, P1 par P20,000
Additional paid In capital 180,000
Retained earnings 120,000
Goodwill is computed as follows:
Consideration transferred 800,000

NCI at fair value 170,000
Total consideration 970,000
Less FV of net assets acquired (P900k-280k) 620,000
Goodwill 350,000
======
The following entry would be made by S Company in its books:

Inventory 10,000
Land 50,000
Buildings, net 200,000
Equipment, net 40,000
Goodwill 350,000
Retained Earnings 120,000
Additional Paid in Capital 770,000
In preparing the consolidated statements, the following elimination entry would be entered in the
worksheet:
Common Stock 20,000

Additional paid in capital (180k + 770k) 950,000
Investment in S Company 800,000
NCI 170,000
Reverse Acquisition
In a reverse acquisition, the issuer of shares (the legal acquirer) is the accounting acquiree.
The consideration transferred in a reverse acquisition is measured based on the number of equity
interests the legal subsidiary (accounting acquirer) would have had to issue to give the owners of
the legal parent (accounting acquiree) the same percentage of equity interest in the combined
entity that results from the reverse acquisition.
For example, ABC Co. a private entity, wants to become a public entity but does not want to
register its shares. To accomplish this, ABC will arrange for a public entity to acquire its equity
interests in exchange for the public entity’s equity interests.
In this example, the public entity is the legal acquirer because it issued its equity interests, while
ABC Co. is the legal acquiree because its equity interests were acquired. However, when
applying the acquisition method:
1) The public entity is identified as the acquiree for accounting purposes (accounting
acquiree), and
2) ABC Company is identified as the accounting acquirer.
Activity:
Discussion of exercises/problems be uploaded in the LMS.

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SPECIAL ACCOUNTING TOPICS FOR BUSINESS COMBINATION

Duration: 6 hours (Lecture/Discussion/Problem Solving)

2) Methods of estimating goodwill:

Example of direct valuation method:

Total earnings for the last 5 years 6,900,000

Fair value of acquiree’s net assets 10,000,000

Method 2: Capitalization of average excess earnings -goodwill is measured at the average

Goodwill (P100,000 / 25%) = P400,000

Method 3: Capitalization of average earnings – the average earnings are divided by a

Investment in S Company 800,000

Liabilities at fair value equaled book value of P280,000.

Goodwill is computed as follows:

Consideration transferred 800,000

The following entry would be made by S Company in its books:

Common Stock 20,000

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