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Business Combinations 1

Legal Avenues To Combination

59
Business Combinations

A Note On Relevant Accounting Standards

During the period until 2011 when IFRSs are incorporated into Canadian GAAP, the
CICA Handbook contains two different Sections which deal with business combination
trans- actions. 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 2011. If an enterprise
chooses to apply this standard, it must continue to use Section 1600, the section on
consolidated financial statements that was intro- duced into the Handbook in 1975.
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 combi- nations 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 1602. 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 appro- priate 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 3
Legal Avenues To Combination

Business Combinations Defined

Basic Definition
The CICA Handbook defines a business combination transaction in the
following manner:
Paragraph 1582.02A(e) A business combination is a transaction or
other event in which an acquirer obtains control of one or more businesses.
Transactions sometimes 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.
3-3. 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 1582.02A(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 1582
3-4. 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 unincor- porated businesses in return for all of the net
assets of the two enterprises.
Excluded From The Scope Of Section 1582
Section 1582 specifically excludes certain transactions from its scope. These are listed in
Paragraph 1582.02 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 orga- nization. These transactions
are dealt with under CICA Handbook Section 4450. “Reporting
Controlled And Related Entities By Not-For-Profit Organizations.

Legal Avenues To Combination

The Problem

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 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 enter- prises have with suppliers,
employees, or customers.
This is an important issue for accountants as the legal form used can, in some
circum- stances, 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.
accountant must be able to look through the complex legal structures that are
sometimes used to effect busi- ness 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
Business Combinations 5
Legal Avenues To Combination

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 95,000 N/A
Outstanding)
(10,000 Shares Issued And N/A 53,000
Outstanding)
Retained Earnings 75,000 25,000
Total Equities $235,000 $120,000

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
Figure 3 - 1
Acquisition Of Assets From Beta Company

$78,000 In Cash
Alpha Beta
Company Company
Beta’s Assets And Liabilities

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
imple- menting 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.
Business Combinations 7
Legal Avenues To Combination

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.
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 transac- tion 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 $277,000

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
72 Chapter 3
Application Of The Acquisition Method

Figure 3 - 2
New Company Acquisition Of Assets From Beta Company

17,000 Sigma Shares

Alpha
Company

Sigma Assets And Liabilities


Company Of Alpha And Beta

Beta
Company
7,800 Sigma Shares

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.
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)
Business Combinations 73
Application Of The Acquisition Method

248,000

Total Equities $355,000

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.

Figure 3 - 3
Acquisition Of Shares From Beta Shareholders

$78,000
In Cash Shareholders
Alpha Of Beta
Company 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.
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
74 Chapter 3
Application Of The Acquisition Method

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 state- ments, 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:

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 sepa- rate 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 state-
ments, 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.
Business Combinations 75
Application Of The Acquisition Method

• 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


alter- native 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 share- holders 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
New Company Acquisition Of Shares From Beta Shareholders

Sigma Company

100% of 100% of Beta


Alpha Shares 17,000 Sigma 7,800 Sigma Shares
Shares Shares

Shareholders Shareholders
Of Alpha Alpha Beta Of Beta
Company Company

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
76 Chapter 3
Application Of The Acquisition Method

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
Total Equities $355,000
Outstanding) 248,000

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.

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:
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


Business Combinations 77
Application Of The Acquisition Method

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 consider- ation 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
78 Chapter 3
Application Of The Acquisition Method

of another

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 trans- ferred
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
situa- tions, 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
Business Combinations 79
Application Of The Acquisition Method

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 enti- ties, the assets remain
on the books of the separate companies and their tax bases are not affected in
any way by the transaction.

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
transac- tions 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
80 Chapter 3
Application Of The Acquisition Method

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 $ 800,000
$650,00
0
Excess Of Fair Value Over Carrying Value 75,000
100,00
0
Unrecognized Goodwill 125,000
150,00
0
Net Assets At Fair Values $1,000,000
$900,00
0

ComCo One and ComCo Two are both corporations. They have decided to
imple- ment 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 3-49.
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
Business Combinations 81
Application Of The Acquisition Method

Alternative accounting method

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 infor- mation 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 $1,450,000

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 organiza- tion 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
busi- ness 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
82 Chapter 3
Application Of The Acquisition Method

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
alter- native 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:
Paragraph 1582.04 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, 2009.

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 appro- priate 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 Acquisi- tion 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:
Business Combinations 83
Application Of The Acquisition Method

Paragraph 1582.08 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 subse- quent to the closing date for the transfer of the
assets.

Identification Of An Acquirer
Basic Recommendation
3-61. The concepts underlying the acquisition method require that an
acquirer be identi- fied in each business combination transaction. This
is reflected in the following recommendation:
Paragraph 1582.06 For each business combination, one of the
combining entities shall be identified as the acquirer. (January,
2011)
3-62. 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 deter- mining 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 combi- nations
can take forms other than the acquisition of a subsidiary. Given this, more
detailed consideration is required in dealing with this recommendation.
84 Chapter 3
Application Of The Acquisition Method

Figure 3 - 5
Identifying An
Acquirer

Alpha New Alpha Shares


Company Beta
(1 Million Shareholders
Outstanding
Shares) 100% Of Beta Shares

Cash Consideration
3-63. 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.
3-64. However, before we examine this more detailed guidance, we will look
at some situa- tions 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 participa- tion 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
3-65. 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.
Business Combinations 85
Application Of The Acquisition Method

3-66. Conceptually, the solution to the problem is fairly simple. Assuming


that the combining enterprises are both corporations, the acquirer is the
company whose share- holders, 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 3-5.
3-67. 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
conse- quence, the original Alpha Company shareholders will be in a majority
position. This means that Alpha Company will be identified as the acquirer.
86 Chapter 3
Application Of The Acquisition Method

3-68. 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


3-69. 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


3-70. 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.
3-71. 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 exis- tence 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
Business Combinations 87
Application Of The Acquisition Method

interests of the other combining entity or entities.


3-72. 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 reve- nues. Also determining which company
initiated the transaction can be helpful in establishing the control interest in a
business combination.
3-73. 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
3-74. 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.
88 Chapter 3
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 situa- tion 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.
3-75. 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.
3-76. Through the reverse acquisition procedure that we have just described,
the share- holders 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.

Exercise Three - 2

Subject: Identification Of An Acquirer


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
Business Combinations 89
Application Of The Acquisition Method

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 corpora- tion, 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.
90 Chapter 3
Application Of The Acquisition Method

Determining The Cost Of The Acquisition


Basic Approach
3-77. 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 1582.37 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 consider- ation transferred
in the business combination shall be measured in accordance with
paragraph 1582.30 rather than at fair value.) Examples of potential
forms of consider- ation 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 1582.30 requires that measurement of
share-based payment awards be based on Section 3870, “Stock-
Based Compensation And Other Stock-Based Payments.
3-78. 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


3-79. 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
Business Combinations 91
Application Of The Acquisition Method

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


3-80. When non-monetary assets are transferred as consideration in a business
combina- tion 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.
3-81. 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.
92 Chapter 3
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


3-82. 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 engi-
neering fees, legal fees, survey costs, site preparation costs, freight charges,
transportation insurance costs, duties, testing and preparation charges.
3-83. 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 1582.53 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 administra- tive 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”.
3-84. This represents a change from the position taken previously in
Canadian GAAP. Under Section 1581, the direct costs of combination were
Business Combinations 93
Application Of The Acquisition Method

added to the acquisition cost.

Contingent Consideration
3-85. In negotiating the terms of a business combination transaction,
there will be differ- ences 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 stake- holders in the acquiree are willing to believe.
3-86. 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.
94 Chapter 3
Application Of The Acquisition Method

3-87. When contingent consideration is used, Section 1582 makes the


following recommendation:

Paragraph 1582.39 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 contin- gent consideration as part of
the consideration transferred in exchange for the acquiree.

3-88. 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.

3-89. In somewhat simplified terms, the accounting subsequent to the date of


the combina- tion 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.
3-90. 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
Business Combinations 95
Application Of The Acquisition Method

(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 contin- gency 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
$2,500,00
0
96 Chapter 3
Application Of The Acquisition Method

Exercise Three - 4

Subject: Contingent Liability


On June 30, 2009, Lor Inc. issues 1,250,000 of its no par value voting
shares in return for all of the outstanding voting shares of Lee Ltd. At
this time, the Lor shares are trading at $11 per share. Negotiators for
Lee have argued that this price is too low because it does not reflect the
large increase in Earnings Per Share that is expected for their year ending
December 31, 2009.
In order to resolve this dispute, Lor agrees to pay an additional
$2,500,000 in cash on March 1, 2010, provided Lee’s Earnings Per
Share for the year ending December 31, 2009 reach or exceed $1.90
per share. The fair value of this obligation is estimated to be
$1,100,000.
On December 31, 2009, the Lor shares are trading at $11.50 per share.
Lee’s Earnings Per Share for the year are reported as $2.05 and,
on March 1, 2010, Lor pays the agreed-upon $2,500,000.
Provide the journal entries that would be required to record the
issuance of Lor shares on June 30, 2009, the entry required on
December 31, 2009 when Lor Inc. closes its books, and entry to record
the payment of the $2,500,000 on March 1, 2010.

Exercise Three - 5

Subject: Contingent Asset


On June 30, 2009, Solor Inc. issues 1,250,000 of its no par value
voting shares in return for all of the outstanding voting shares of Solee
Ltd. At this time, the Solor shares are trading at $11 per share.
Negotiators for Solee have argued that this number of shares is not
appropriate because current market conditions have kept the share
price of Solar Inc. above its real long-term value.
In order to resolve this dispute, the shareholders of Solee have agreed
to pay Solor Inc. an additional $1.50 for each share received, provided
the value of the Solor shares is above $11 on December 31, 2009.
Solor estimates the fair value of this contingent asset to be $1,200,000.
On December 31, 2009, the Solor shares are trading at $11.75 per
share and, as a consequence, the Solee shareholders pay to Solar Inc.
the additional $1,875,000 [(1,250,000)($1.50)].
Provide the journal entries that would be required to record the
issuance of Solor shares on June 30, 2009, and the additional payment
on December 31, 2009.
Business Combinations 97
Application Of The Acquisition Method

Exercise Three - 6

Subject: Contingent Equity Instrument


On June 30, 2009, Goger Inc. issues 2,500,000 of its no par value
voting shares to the shareholders of Gee Ltd. in return for all of their
outstanding voting shares. At this time, the Goger shares are trading at
$32 per share. Negotiators for Gee have argued that this number of
shares is not sufficient because they anticipate that the price of these
shares will drop subsequent to the business combination transaction.
In order to resolve this dispute, Goger Inc. agrees that it will issue an
additional 500,000 of its shares if the price of its shares is below $32
on December 31, 2009. Goger estimates that, on June 30, 2009, the
fair value of this obligation to issue shares is $3 million.
98 Chapter 3
Application Of The Acquisition Method

Provide the journal entry that would be required to record the


acquisition of the Gee Ltd. shares on June 30, 2009. In addition,
provide the entry that would be required on December 31, 2009:
A. if Goger has to issue the additional shares (shares are trading at $30); and
B. if Goger does not have to issue the additional shares (shares are trading at
$33).

End of Exercises. Solutions available in Study Guide.

Recognition Of Acquired Assets


General Principle
3-91. Section 1582 provides the following recommendation with respect to
the recognition of assets acquired in a business combination transaction:
Paragraph 1582.10 As of the acquisition date, the acquirer shall
recognize, sepa- rately from goodwill, the identifiable assets
acquired, the liabilities assumed and any non-controlling interest
in the acquiree. Recognition of identifiable assets acquired and
liabilities assumed is subject to the conditions specified in
paragraphs 1582.11 -
.12. (January, 2011)
3-92. Several additional points can be noted with respect to this recommendation:
Must Meet Section 1000 Definitions The assets and liabilities that
are to be recog- nized in a business combination transaction must
meet the definitions of these elements that are found in Section
1000, “Financial Statement Concepts”.
Must Be Part Of The Exchange In situations where the acquirer and
the acquiree have a relationship that exists prior to the business
combination, it must be deter- mined if modifications that are made to
this relationship during the negotiations are part of the combination
transaction. For example, if during the combination negotia- tions, a
legal dispute between the acquirer and acquiree is settled, the cost of
the settlement would be accounted for separately from the business
combination.
Unrecognized Acquiree Assets The combination transaction may
result in the recognition of acquiree assets that were not recognized on
the acquiree’s books. For example, the acquiree may have an
internally developed patent that has a positive value at the date of the
combination. While this asset would not be recognized in the
acquiree’s books, it would be recognized as part of the assets acquired in
the business combination transaction.

The Problem Of Intangible Assets


3-93. The term “identifiable assets” encompasses all tangible assets, as
well as many intan- gibles (e.g., a patent or trade mark). However,
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Application Of The Acquisition Method

intangibles do not have physical substance and can only be recognized in


circumstances where they can be identified. Appendix B of Section 1582
provides the following guidance with respect to the identification and
recognition of intangibles:
Paragraph 1582B.32 An intangible asset that meets the contractual-
legal criterion is identifiable even if the asset is not transferable or
separable from the acquiree or from other rights and obligations. For
example:
(a) an acquiree leases a manufacturing facility under an operating
lease that has terms that are favourable relative to market
terms. The lease terms explicitly prohibit transfer of the lease
(through either sale or sublease). The amount by which the
lease terms are favourable compared with the terms of current
market transactions for the same or similar items is an
intangible asset that meets the contractual-legal criterion for
recognition separately from goodwill, even though the acquirer
cannot sell or otherwise transfer the lease contract.
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Application Of The Acquisition Method

(b) an acquiree owns and operates a nuclear power plant. The license
to operate that power plant is an intangible asset that meets the
contractual-legal criterion for recognition separately from
goodwill, even if the acquirer cannot sell or transfer it separately
from the acquired power plant. An acquirer may recognize the
fair value of the operating license and the fair value of the power
plant as a single asset for financial reporting purposes if the
useful lives of those assets are similar.
(c) an acquiree owns a technology patent. It has licensed that
patent to others for their exclusive use outside the domestic
market, receiving a specified percentage of future foreign revenue
in exchange. Both the technology patent and the related license
agreement meet the contractual-legal criterion for recognition
separately from goodwill even if selling or exchanging the
patent and the related license agreement separately from one
another would not be practical.

Classification Of Acquired Assets


3-94. Once it is determined which acquiree assets will be recognized in the
business combi- nation transaction, Section 1582 requires that they be
classified:

Paragraph 1582.15 At the acquisition date, the acquirer shall classify


or designate the identifiable assets acquired and liabilities assumed as
necessary to apply other Sections subsequently. The acquirer shall
make those classifications or designations on the basis of the
contractual terms, economic conditions, its operating or accounting
policies and other pertinent conditions as they exist at the acquisition
date. (January, 2011)
3-95. This classification process will serve to determine which Sections of the
CICA Hand- book are applicable to the various assets and liabilities that have
been recognized.

Measurement Of Identifiable Assets And Liabilities


Basis Principle
3-96. The basic measurement principle that is to be used in applying the
acquisition method is stated as follows:
Paragraph 1582.18 The acquirer shall measure the identifiable assets
acquired and the liabilities assumed at their acquisition-date fair
values. (January, 2011)
3-97. In terms of implementing this recommendation, the following definition
of fair value is provided:
Paragraph 1582.02A(i) Fair value is the amount of the consideration
that would be agreed upon in an arm’s length transaction between
knowledgeable, willing parties who are under no compulsion to act.
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Application Of The Acquisition Method

Additional Guidance
3-98. The use of fair values in accounting has become fairly widespread.
In addition, the application of the acquisition method to business
combination transactions is based on the same principles that apply to the
acquisition of single assets. The major complicating factor is the fact that a
single purchase price must be allocated over a large group of identifiable
assets, identifiable liabilities, and goodwill.
3-99. Given this situation, Section 1582 does not provide extensive guidance
on the appli- cation of this measurement principle. The guidance that it does
include is found in Appendix B of Section 1582 as follows:
Paragraph 1582.B41 Assets With Uncertain Cash Flows (Valuation
Allowances) The acquirer shall not recognize a separate valuation
allowance as of the acquisition date for assets acquired in a business
combination that are measured at their acquisi- tion-date fair values
because the effects of uncertainty about future cash flows are included
in the fair value measure. For example, because this Section requires
the
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Acquisition Method Example

acquirer to measure acquired receivables, including loans, at their


acquisition-date fair values, the acquirer does not recognize a separate
valuation allowance for the contractual cash flows that are deemed to
be uncollectible at that date.
Paragraph 1582.B42 Assets Subject To Operating Leases In Which The
Acquiree Is The Lessor In measuring the acquisition-date fair value of
an asset such as a building or a patent that is subject to an operating
lease in which the acquiree is the lessor, the acquirer shall take into
account the terms of the lease. In other words, the acquirer does not
recognize a separate asset or liability if the terms of an operating lease
are either favourable or unfavourable when compared with market
terms as paragraph 1582.B29 requires for leases in which the acquiree
is the lessee.
Paragraph 1582.B43 Assets That The Acquirer Intends Not To Use
Or To Use In A Way That Is Different From The Way Other Market
Participants Would Use Them For competitive or other reasons,
the acquirer may intend not to use an acquired asset, for example, a
research and development intangible asset, or it may intend to use
the asset in a way that is different from the way in which other market
participants would use it. Nevertheless, the acquirer shall measure
the asset at fair value deter- mined in accordance with its use by
other market participants.
Guidance is also provided with respect to measuring the non-controlling interest.
However, this issue is of such importance that we will devote a separate section to
dealing with it at a later point in this Chapter

Exceptions To Recognition And Measurement Principles

Exceptions To Recognition Principle Only

Section 3290, “Contingencies”, defines a contingency as an existing condition or


situation involving uncertainty as to possible gain or loss to an enterprise that will
ultimately be resolved when one or more future events occur or fail to occur.
Resolution of the uncer- tainty may confirm the acquisition of an asset or the
reduction of a liability or the loss or impairment of an asset or the incurrence of a
liability.

The requirements in Section 3290 do not apply in determining which contingent


liabilities to recognize as of the acquisition date. In a business combination
transaction, the acquirer will recognize a contingent liability assumed in a business
combination if it is a present obligation that arises from past events and its fair value
can be measured reliably. This is in contrast to the treatment under Section 3290 in
that the acquirer recognizes a contingent liability assumed in a business combination
at the acquisition date even if it is not likely that a future event will confirm that an
asset had been impaired or a liability incurred at the date of the financial statements.
Business Combinations 10
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Acquisition Method Example

Exceptions To Measurement Principle Only

There are 3 exceptions here. As described in Section 1582, they are as follows:
Paragraph 1582.29 Reacquired Rights The acquirer shall measure the value
of a reacquired right recognized as an intangible asset on the basis of the
remaining contractual term of the related contract regardless of whether
market participants would consider potential contractual renewals in
determining its fair value.
Byrd & Chen Note These are rights that have been previously granted to the
acquiree. For example, the acquiree may have the right to use the acquirer’s
trademark.
Paragraph 1582.30 The acquirer shall measure a liability or an equity instrument
related to the replacement of an acquiree’s share-based payment awards with
share-based payment awards of the acquirer in accordance with the method in
Section 3870, “Stock-Based Compensation And Other Stock-Based Payments”.
Paragraph 1582.31 The acquirer shall measure an acquired non-current asset (or
disposal group) that is classified as held for sale at the acquisition date in
accordance with Section 3475, “Disposal Of Long-Lived Assets And Discontinued
Operations”, at fair value less costs to sell in accordance with paragraphs 3475.13
- .22.

Exceptions To Both Principles

Section 1582 indicates that, with respect to income taxes, both measurement and recognition
should be based on Section 3465, “Income Taxes”. There are a number of complexities here
that will be dealt with in the next section of this Chapter.

Without going into detail, there are also exceptions related to accrued
benefit obli- gations to employees and for indemnification assets. We will not
discuss these exceptions in more detail in this text.