Week 8 | Business Combination

Question 1

What is meant by a business combination?

Answer 1

A transaction or other event in which an acquirer obtains control over one or more businesses
“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

Question 2

2. Discuss the importance of identifying the acquisition date?

Answer 2

The acquisition date is important because it affects the net measurement of the:
- identifiable net assets acquired
- purchase consideration
- Non-controlling interest in an acquiree
- Any previously held equity interest in an acquiree

Question 3

3. What is meant by ‘contingent consideration’ and how is it accounted for? (para 39, 40 and 58)

Answer 3

Contingent consideration: Usually, an obligation of the acquirer to transfer additional assets or equity interests to the
former owners of an acquiree as part of the exchange for control of the acquiree if specified
future events occur or conditions are met. However, contingent consideration also may give
the acquirer the right to the return of previously transferred consideration if specified
conditions are met.
See AASB 3/IFRS 3 paras. 39-40

Para 39: The consideration transferred includes any asset or liability resulting from a contingent
consideration arrangement. This is measured at fair value at acquisition date.

Para 40: The acquirer shall classify the obligation to pay contingent consideration as a liability
or equity (depending on the characteristics of the instrument being transferred).

Para 58: Changes in the measurement of the obligation subsequent to acquisition date resulting
from events after the acquisition date are accounted for differently depending on
whether the obligation was classified as equity or debt.
If classified as equity, the equity shall not be remeasured.
If classified as liability, it is accounted under AASB 9/IFRS 9 as appropriate.

Question 4

5. What recognition criteria are applied to assets and liabilities acquired in a business combination?

Answer 4

Para 10 of AASB 3/IFRS 3 states that the identifiable assets acquired and liabilities assumed shall
be recognised separately from goodwill.

Because the assets and liabilities are measured at fair value, the assets and liabilities are
recognised regardless of the degree of probability of inflow/outflow of economic benefits. The
fair value reflects such expectations in its measurement.

The assets and liabilities recognised must meet the definitions of assets and liabilities in the
Framework. [Para 11].

The assets and liabilities recognised must also be part of the exchange transaction rather than
resulting from separate transactions [para 12].

Question 5

8. How is the consideration transferred calculated?

Answer 5

The consideration transferred stated by AASB 3/ IFRS 3 para 37, shall be:
- Measured at fair value, determined at acquisition date
- Calculated as sum of the fair values of the assets transferred by the acquirer, the liabilities incurred by the acquirer and the equity interests issued by the acquirer

Question 6

9. How is a gain on bargain purchase accounted for?

Answer 6

AASB 3/IFRS 3 para 34 specifies the measurement of the gain, identified as the amount by which
the fair value of net assets acquired exceeds the fair value of consideration transferred.

Para 36 requires an acquirer to:
* reassess the identification and measurement of the identifiable assets acquired and liabilities
assumed, and measurement of the consideration transferred. This review is to ensure that the
measurements are appropriate.

Para 34 requires an acquirer, subsequent to para 36 procedures, recognise any remaining gain on
bargain purchase immediately in profit or loss.

Question 7

What are the consolidated financial statements?

Answer 7

According to Appendix A of AASB 10/IFRS 10 Consolidated Financial Statements, the
consolidated financial statements are:

“The financial statements of a group in which the assets, liabilities, equity, income, expenses and
cash flows of the parent and its subsidiaries are presented as those of a single economic entity.”

As stated in paragraph B86 of AASB 10/IFRS 10, consolidated financial statements “combine
like items of assets, liabilities, equity, income, expenses and cash flows” of the entities in the
group.

Question 8

What is the purpose of preparing consolidated financial statement?

Answer 8

The purpose of preparing consolidated financial statements is to show the combined financial
position, financial performance and cash flows of the group of entities as if they were a single
economic entity. As such, they consist of a consolidated statement of financial position, a
consolidated statement of profit or loss and other comprehensive income, a consolidated
statement of changes in equity and a consolidated statement of cash flows. These consolidated
statements reflect only the effects of transactions with external parties to the group.

Question 9

What is a group, a parent and a subsidiary?

Answer 9

According to Appendix A of AASB 10/IFRS 10 Consolidated Financial Statements:
* A group is formed by a parent and all its subsidiaries.
* A parent is an entity that controls one or more entities.
* A subsidiary is an entity that is controlled by another entity, a parent.

Question 10

Why do the regulators require the parent entity to prepare consolidated financial
statements?

Answer 10

Some of the reasons for which the regulators require the parent entity to prepare consolidated
financial statements are as follows:

i. To supply relevant information to investors in the parent entity.

The information obtained from the consolidated financial statements is relevant to investors in
the parent entity. A shareholder’s wealth in the parent is dependent not only on how that entity
performs, but also on the performance of the other entities controlled by the parent. To require
these investors in analysing their investment to source their information from the financial
statements of each of the entities comprising the group would place a large cost burden on those
investors.

ii. To allow comparison of the group with similar entities.

Some entities are organised into a group structure such that different activities are undertaken by
separate entities within the group. Other entities are organised differently, with some having all
activities conducted within the one entity. Access to consolidated financial statements makes
comparisons across the group an easier task for the users of financial statements.

iii. To assist in the discharge of accountability by management of the group.

A key purpose of financial reporting is the discharge of accountability by management. Entities
that are responsible or accountable for managing a pool of resources — being the recipients of
economic benefits and responsible for payment of obligations — are generally required to report
on their activities and are held accountable for the management of those activities. The
consolidated financial statements report the assets under the control of the group management
together with the claims on those assets, as well as the performance obtained in the management
of those assets. Based on the information contained within these statements, the management of
the group can be held accountable for their actions.

iv. To report the risks and benefits of the group as a single economic entity.

There are risks associated with managing an entity, and an entity rarely obtains control of another
without also obtaining significant opportunities to benefit from that control. The consolidated
financial statements allow an assessment of these risks and benefits. Note, however, that the
benefits from intragroup transactions are eliminated when preparing consolidated financial
statements, as those statements should only reflect the effects of transactions with external parties.

v. To ensure consistency of information provided to users.

The consolidated financial statements are prepared after adjusting the separate financial
statements of the entities within the group for the different accounting policies applied, making
sure that all the items reported are combined after being recognised and measured consistently.

Question 11

7. What is meant by the term ‘control’?

Answer 11

Control of an investee is defined in Appendix A of AASB 10/IFRS 10 Consolidated Financial
Statements as follows:
An investor controls an investee when the investor is exposed, or has rights, to variable returns
from its involvement with the investee and has the ability to affect those returns through its power
over the investee.

Question 12

8. What are the key elements of control?

Answer 12

Based on the definition of control from Appendix A of AASB 10/IFRS 10 Consolidated Financial
Statements, paragraph 7 of AASB 10/IFRS 10 identifies three elements that must be held by an
investor in order for it to have control:
* Power over the investee.
* Exposure or rights to variable returns from the parent’s involvement with the subsidiary
* The ability to use the power over the subsidiary to affect the amount of the parent’s returns.

Question 13

9. When does an investor have power over an investee?

Answer 13

Power is defined in Appendix A of AASB 10/IFRS 10 Consolidated Financial Statements as
“existing rights that give the current ability to direct the relevant activities”.

An investor has power over an investor when it has the current right to direct the relevant activities
of the investee.

Based on this definition, four characteristics of power can be identified:
* power is related to relevant activities
* power arises from existing rights
* power is the ability to direct
* the ability to direct must be current to have power.

Question 14

13. What benefits could be sought by an entity that obtains control over another entity?

Answer 14

Consider:
* Dividends
* Returns from structuring activities with the investee e.g. obtaining a supply of raw material,
access to a port facility
* Returns from denying or regulating access to a subsidiary’s assets e.g. a patent for a
competing product
* Returns from economies of scale
* Remuneration from provision of services such as servicing of assets, and management

Question 15

14. What is the link between ownership interest and control?

Answer 15

As paragraph B35 of AASB 10/IFRS 10 Consolidated Financial Statements states, where an
investor holds more than half of the voting rights of the investee, the investor has power over the
investee in the absence of other evidence.

Different classes of shares may have different voting rights. However, unless otherwise specified
in the company’s constitution, each shareholder has one vote for each share held. Therefore, it is
normally assumed that the percentage of ownership interest of an investor is equivalent to the
percentage of voting rights that this investor holds in the investee. As such, it is normally assumed
that an investor that has more than 50% ownership interest in an investee has the power over the
investee. Given that the shares give to the shareholders the right to receive dividends, it is further
assumed that an investor holding more 50% ownership interest has control. Of course, a
shareholder with less than 50% ownership interest may still have control if there is any other
evidence that the shareholder is exposed, or has rights, to variable returns from its involvement
with the investee and has the ability to affect those returns through its power over the investee.
Also, a shareholder with more than 50% ownership interest may not have control, especially if
most of the shares held are non-voting shares.

Question 16

Voting rights

Alvin Ltd has 37% of the voting interest in Theodore Ltd. An investment bank with which
Alvin Ltd has business relationships holds a 15% voting interest in Theodore Ltd. Because
of the closeness of the business relationship with the bank, Alvin Ltd believes it can rely
on the bank’s support to ensure it cannot be outvoted at general meetings of Theodore Ltd.
However, there is no guarantee that the bank will always support Alvin Ltd.

Answer 16

Discuss:
* the concept of control
* the need to apply judgement
* these situations are often referred to “strawmen” – other parties that act as agents or in
conjunction with others. In the example in this question, Alvin Ltd has the expectation that
the voting of the investment bank will most likely be aligned with its own, ensuring that it
cannot be outvoted.

If control is the basis for consolidation, a factor to consider is the influence available through a
friendly party. Note that there is no guarantee that the investment bank will always vote with
Alvin Ltd – the relationship may change over time. However, many of the other factors considered
in relation to an investor and control, such as the attendance at the AGM and the size of blocks
of shareholdings may also change over time. What it matters is whether currently the voting of
the investment bank is aligned with Alvin Ltd and that seems to be the case, meaning that Alvin
Ltd is the parent of Theodore Ltd.

Question 17

Options

Thomas Ltd and Jackson Ltd own 80% and 20% respectively of the ordinary shares that
carry voting rights at a general meeting of shareholders of Stanmar Ltd. Thomas Ltd sells
half of its interest to Benson Ltd and buys call options from Benson Ltd that are
exercisable at any time at a premium to the market price when issued and, if exercised,
would give Thomas Ltd its original 80% ownership interest and voting rights. At the end of
the current financial period, the options are out of the money.

Answer 17

Exercise 26.6

Facts:

Thomas Ltd - 40% of ordinary shares of Stanmar Ltd
Jackson Ltd - 20% of ordinary shares of Stanmar Ltd
Benson Ltd - 40% of ordinary shares of Stanmar Ltd

Thomas Ltd owns call options that would give it 80% of the voting rights of Stanmar Ltd.

When considering potential voting rights, an investor shall consider the purpose and design of the
instrument, as well as the purpose and design of any other involvement the investor has with the
investee. This includes an assessment of the various terms and conditions of the instrument as well
as the investor’s apparent expectations, motives and reasons for agreeing to those terms and
conditions.

If the investor also has voting or other decision-making rights relating to the investee’s activities,
the investor assesses whether those rights, in combination with potential voting rights, give the
investor power.

An investor, in assessing whether it has power, considers only substantive rights relating to an
investee (held by the investor and others). For a right to be substantive, the holder must have the
practical ability to exercise that right. It is necessary to consider any barriers that might prevent the
holder from exercising the rights. Examples of such barriers include:
(i) Financial penalties and incentives that would prevent (or deter) the holder from exercising its
rights.
(ii) An exercise or conversion price that creates a financial barrier that would prevent (or deter)
the holder from exercising its rights.
(iii) Terms and conditions that make it unlikely that the rights would be exercised, for example,
conditions that narrowly limit the timing of their exercise.
(iv) The absence of an explicit, reasonable mechanism in the founding documents of an investee or
in applicable laws or regulations that would allow the holder to exercise its rights.
(v) The inability of the holder of the rights to obtain the information necessary to exercise its
rights.
(vi) Operational barriers or incentives that would prevent (or deter) the holder from exercising its
rights (e.g. the absence of other managers willing or able to provide specialised services or
provide the services and take on other interests held by the incumbent manager).
(vii) Legal or regulatory requirements that prevent the holder from exercising its rights (e.g. where
a foreign investor is prohibited from exercising its rights).

As the call options are out of money, Thomas Ltd’s management will certainly not exercise the
options. As such, the options are not substantive and therefore they should not be considered in
determining control.

In conclusion, Thomas Ltd is not the parent of Stanmar Ltd.