After studying this chapter, you should be able to do the following:

1. Define a business combination, and evaluate relevant factors to determine whether control exists in a business acquisition.
2. Describe the basic forms for achieving a business combination.
3. Prepare and compare consolidated balances sheets under the acquisition and new-entity methods.
4. Apply the acquisition method to a purchase-of-net-assets business combination.
5. Apply the acquisition method to a purchase-of-shares business combination.
6. Analyze and interpret financial statements involving business combinations.
7. Identify some of the differences between IFRS and ASPE for business combinations.
8. Explain a reverse takeover and its reporting implications.

A business combination is defined in IFRS 3 as a transaction or other event in which an acquirer obtains control of one or more businesses. This definition has two key aspects: control and businesses. When a business combination does occur, the requirements of IFRS 3 must be applied. On the other hand, if an entity acquires all of the assets of another entity but they do not meet the definition of a business, IFRS 3 would not be applicable. Instead, the assets acquired would be treated as a basket purchase, and the total cost would be allocated to the individual assets in proportion to their fair market values.

There are many types of business combinations including a conglomerate business combination, a horizontal business combination, and a vertical business combination. Other terms that are often used synonymously with the term business combination are takeover, amalgamation, acquisition, and merger.

A business combination takes place when one company gains control over the net assets of another company. Control can be achieved by the purchase of the net assets or by the purchase of enough voting shares to gain control over the use of the net assets. In the latter situation a parent–subsidiary relationship is created that requires the preparation of consolidated financial statements.

Guidance for determining control is provided in IFRS 10. IFRS 10 states that an investor controls an investee when it is exposed or has rights to variable returns from its involvement with the investee, and it has the ability to affect those returns through its power over the investee. This definition contains the following three elements: (a) power, (b) returns, and (c) links between power and returns.

There are three methods of accounting for business combinations that have either been recently used in practice or discussed in theory over the years. The following table indicates the current status and effective usage dates for these three methods:

Prior to 2011, the purchase method was used to account for the combination. Under this method, the acquiring company’s net assets are measured at their carrying value and the acquired company’s net assets are measured at the price paid for the assets by the acquiring company. Effective January 1, 2011, the acquisition method must be used to report a business combination, and an acquirer must be identified.

Under the acquisition method, the identifiable assets and liabilities acquired are recorded at fair values, with the acquisition cost excess recorded as goodwill. An acquirer must be identified for all business combinations. This is important because it is the net assets of the acquiree that are reported at fair values. The acquirer is determined based on which shareholder group controls the consolidated company. The acquisition cost is measured as the fair value of consideration given to acquire the business. The acquisition cost does not include costs such as professional fees or costs of issuing debt or shares. The acquisition cost is allocated to the acquirer’s interest in the fair value of the identifiable assets and liabilities of the acquired company. Identifiable assets and liabilities should be recorded separately from goodwill. Goodwill is the excess of the purchase price over the fair value of identifiable assets and liabilities. If the acquisition cost is less than the fair value of the identifiable net assets acquired, we have what is sometimes described as a "negative goodwill" situation. Negative goodwill (also known as a bargain purchase) could result in the reporting of a gain on purchase by the acquiring company.

Under push-down accounting, on the date of acquisition the subsidiary revalues its assets and liabilities based on the parent’s acquisition cost. The allocation of the acquisition differential is "pushed down" to the actual accounting records of the subsidiary. This practice became permissible under Canadian GAAP in 1992 with the issuance of Section 1625, "Comprehensive Revaluation of Assets and Liabilities." Section 1625 allowed push-down accounting only when a subsidiary was at least 90 percent owned by a parent. Push-down accounting is not presently allowed under IFRSs. Push-down accounting is another example where GAAP allowed a departure from historical cost accounting and allowed the use of current values in financial reporting. Even though the subsidiary was not involved in the transaction with the parent (the transaction involved the parent and the shareholders of the subsidiary), the subsidiary was allowed to revalue its assets and liabilities based on the value paid by the parent to acquire these net assets.

Financial Reporting after the Combination - The net income generated by the net assets of the acquired company is reported in the financial statements of the acquirer commencing with the date of acquisition. This net income must be adjusted to reflect the amortizations of the fair values of the assets and liabilities purchased and any goodwill losses due to impairment. Prior years’ comparative financial statements are not retrospectively changed to reflect the combination. The consolidated financial statements are additional financial statements that combine the separate-entity financial statements of the parent and subsidiary under the hypothetical situation that these two legal entities were operating as one single entity. The consolidated financial statements are prepared by the parent company and are often referred to as the third set of financial statements. Consolidated financial statements are prepared primarily for the benefit of the shareholders and creditors of the parent company. The minority shareholders and creditors of the subsidiary find the separate entity statement of the subsidiary more useful than the consolidated statements. The acquirer must disclose information that enables users of its financial statements to evaluate the basis of control and how this affects the amounts included in the consolidated financial statements and the nature and financial effect of restrictions that are a consequence of assets and liabilities being held by subsidiaries (as discussed in Appendix B of IFRS 3).

ASPE Differences – The following paragraphs from Part II of the CICA Handbook outline the main accounting and reporting requirements for investments in subsidiaries:

• An enterprise shall make an accounting policy choice to either consolidate its subsidiaries or report its subsidiaries using either the equity method or the cost method. All subsidiaries should be reported using the same method. (Section 1590)
• When a subsidiary’s equity securities are quoted in an active market and the parent would normally choose to use the cost method, the investment should not be reported at cost. Under such circumstances, the investment should be reported at fair value, with changes in fair value reported in net income. (Section 1590)
• Private companies can apply push-down accounting but must disclose the amount of the change in each major class of assets, liabilities, and shareholders’ equity in the year that push-down accounting is first applied. (Section 1625)

A reverse takeover occurs when an enterprise obtains ownership of the shares of another enterprise but, as part of the transaction, issues enough voting shares as consideration that control of the combined enterprise passes to the shareholders of the acquired enterprise. Although legally the enterprise that issues the shares is regarded as the parent or continuing enterprise, the enterprise whose former shareholders now control the combined enterprise is treated as the acquirer. For accounting purposes, the acquirer is identified based on which shareholder group has control over the combined entity. In a reverse takeover, the legal parent is deemed to be the subsidiary for accounting purposes and the legal subsidiary is deemed to be the parent. The acquisition cost for the deemed parent is determined based on a hypothetical situation that could have achieved the same percentage ownership in the combined entity. Goodwill of the deemed subsidiary is based on the hypothetical acquisition cost. Shareholders’ equity should reflect the shareholders’ equity of the deemed parent. Note disclosure is required to explain that the reporting follows the substance (rather than the legal form) of who has control. When preparing the consolidated financial statements, the legal parent/deemed subsidiary’s assets are brought in (consolidated) at fair value while the legal subsidiary/deemed parent’s assets are brought in at their carrying amount. The comparative amounts are those of the legal subsidiary/ deemed parent. The consolidated financial statements use the name and shares outstanding of the legal parent. The consolidated financial statements use values consistent with who, in substance, is the parent and who, in substance, is the subsidiary.