Paid-in capital in excess of

par62,500
Common stock )P10 par x 6.250 shares).
62,500

Deficiency: (P25 P20) x 25,000 shares issued to acquire. P125,000

Divide by fair value per share on January 1, 20x7 P
20
Added number of shares to issue..
6,250

Illustration 14-11: Stock Contingency with Present Value based on Future Stock Prices
Assuming the same information in Illustration 14-1, in addition to the stock issue, Peter
Corporation agreed to issue sufficient shares of Peter Corporation common stock to ensure a total
value of P625,000 if the fair value per share is less than P25 on December 31, 20x5.
Peter estimates that there is a 40-percent probability that the 25,000 shares issued will have a
market value of P425,000 on December 31, 20x5 and a60-percent probability that the market
value of the 25,000 shares will exceed P625,000. Peter uses an interest rate of 4 percent to
incorporate the time value of money. The amount of goodwill on acquisition will be recomputed
as follows:
Consideration transferred:
Common shares: 25,000 shares xP25 P 625,000
Notes payable
150,000
Contingent consideration (stock contingency):
((P625.000-P425,000) x40% probability (1/[1+.04]*)
Total .
Less: Fair value of identifiable assets acquired and
Liabilities assumed (refer to illustrative Problem 14-1)
Positive Excess Goodwill .

The journal entries by Peter Corporation to record the acquisition are as follows:
Cash
20,000
Receivable-net
40,000
Inventories ..
60,000
Land
200,000
Buildings-net
300,000
Equipment-net .
250,000
In-process research and development .
50,000
Goodwill .
131,923
Accounts payable .
Other liabilities .

76,923
P 851,923
720,000
P 131,923

60,000
140,000

Notes payable
Paid-in capital for Contingent Consideration
Common stock (P10 par x 25,000 shares) .
Paid-in capital in excess of par
[(P25 P10) x 25,000 shares]
Acquisition of Saul Company.

150,000
76,923
250,000
375,000

On December 31, 20x5, the contingent event occurs, wherein Peters stock price had fallen to
P20, thus requiring Peter to issue additional shares of stock to the former owners of Saul
Corporation. The entry for Peter Corporation on December 31, 20x5 to record such occurrence to
reassign the P625,000 original consideration to 31,250 shares (25,000 original shares issued +
6,250* additional shares due to contingency) would be:
Paid-in capital for Contingent Consideration 76,923
Common stock, P10 par .
Paid-in capital in excess of par ...
Settlement of contingent consideration.
*Deficiency: (P25 P20) x 25,000 shares issued to acquire ... P125,000
Divide by fair value per share on December 31, 20x5 P
20
Added number of shares to issue .
6,250

62,500
14,423

In illustration 14-7 to illustration 14-12, it should be observed that if the contingent consideration
is in the form of equity, the acquirer does not remeasure the fair value of the contingency at each
reporting date until the contingency is resolved.
Illustration 14-12: Contingency Based on Outcome of a Lawsuit
Assume that Poor Corporation acquires Standard Corporation on December 31, 2014 for cash
plus contingent consideration depending on the assessment of a lawsuit against Standard
Corporation assumed by Poor Corporation.
The initial provisional assessment includes on estimated liability for the lawsuit of P50,000 an
estimated liability for contingent consideration to the shareholders of P5,000, and goodwill of
P66,000. The acquisition contract specifies the following conditions:
So long as the lawsuit is settled for less than P100,000, Standard Corporation
shareholders will receive some additional consideration. If the lawsuit results in a
settlement of P100,000 or more, then Standard Corporation shareholders will receive no
additional consideration; and

If the settlement is resolved with a smaller (larger) outlay than anticipated (P50,000), the
shareholders of Standard Corporation will receive additional (reduced) consideration
accordingly, thus adjusting the contingent liability above or below P5,000.

On September 1, 20x5, new information reveals:

The estimated liability for the lawsuit to be P55,000, and
The estimated liability for contingent consideration to the shareholder amounted to
P4,500.
The entry by Poor Corporation on September 1, 20x5 that completed the initial recording of the
business combination would be:
Goodwill .
4,500
Estimated Liability for Contingent Consideration .
500
Estimated Liability for Lawsuit ...
5,000
Adjustment to goodwill due to measurement date
The adjustments affect goodwill because the new information was:
a. Obtained during the measurement period (seven months later), and
b. Related to circumstances that existed on the acquisition date.
Illustration 14-13: Bargain Purchase Gain
The trial balance below presents the financial position of Sierra Company on January 20x4:
Debit
Credit
Merchandise inventory ..
P1,130,000
Accounts receivable ..
800,000
Copyrights .
150,000
Equipment .
1,200,000
Accumulated depreciation .
P 150,000
Accounts payable ..
250,000
Loan payable .
100,000
Preferred stock 48,000 fully paid shares, P10 par .
480,000
Common stock 100,000 fully paid shares, P15 par
1,500,000
Retained earnings ..
800,000
Totals .
P3,280,000 P3,280,000
Sierra Company included in the notes to its accounts a contingent liability to a guarantee for a
loan. Although a present obligation existed, a liability was not recognized by Sierra Company
because of the difficulty of measuring the ultimate amount to be paid.

On this date, the business of Sierra Company is acquired by Parrot Company with Sierra
Company going into liquidation. The terms of the acquisition are as follows:
a. Parrot Company is to take over the assets and assumed the liabilities of Sierra Company.
b. Parrot pays P1,500,000 in cash to the previous shareholders of Sierra Corporation.
c. Parrot Company issued 100,000 common shares at P10 par with a fair value of P12.
d. Cost of liquidation of P10,000 are to be paid by Sierra Company with funds supplied by
Parrot Company.
e. Supply of a patent relating to the manufacturing business of Parrot Company. This has a
fair value of P200,000 but has not been recognized in the records of Parrot Company
because it resulted from an internally generated research project.
f. The contingent liability relating to the guarantee was considered to have a fair value of
P10,000.
g. Parrot Company was obligated to pa an additional P12,000 to the vendors of Sierra
Company is Sierra Company maintained existing profitability over the subsequent two
years from January 1, 20x4 (i.e., January 1, 20x4 to December 31, 20x5), it was highly
likely that Sierra Company would achieve this expectation and the fair value of the
contingent consideration was assessed at its expected value of P12,000.
Parrot Company assesses the fair values of the identifiable assets and liabilities of Sierra
Company to be as follows:
Merchandise inventory ..
P1,200,000
Accounts receivable ...
750,000
Copyrights .
200,000
Equipment .
1,150,000
Accounts payable ..
250,000
The computation of bargain purchase gain is as follows:
Consideration transferred:
Cash .
Common shares: 100,000 shares x P12
Costs of liquidation ..
Patent
Contingent consideration (P10,000 guarantee
+ P12,000 to vendors)
Total ..
Less: Fair value of identifiable assets acquired and
Liabilities assured:
Merchandise inventory
Accounts receivable
Copyrights ..
Equipment ...

P 1,500,000
1,200,000
10,000
200,000
22,000
P 2,932,000

P1,200,000
750,000
200,000
1,150,000

Accounts payable
Loan payable ...
Negative Excess Bargain Purchase Gain

(
(

250,000 )
100,000 )

2,950,000
P(
18,000 )

Merchandise inventory
1,200,000
The
journal
Entries
by
Parrot
Corporation
to record the acquisition are as follows:
Accounts Receivable
750,000
Copyrights
200,000
Equipment
1,150,000
Accounts Payable
250,000
Loan Payable
100,000
Cash
1,510,000
Common Stock (P10 par x 100,000 shares)
1,000,000
Paid in capital in excess of par
[(P12 P10) x 100, 000 shares]
200,000
Gain on Sale of Patients
200,000
Estimated liability for contingent consideration
22,000
Bargain Purchase Gain
18 000
Acquisition of Sierra Company

On November 1, 20x4, the additional payment to vendors of Sierra Company was reassessed at
P18,000 based on the improved information, the estimated liability should be adjusted and since
it is still within the measurement period, bargain purchase gain (otherwise it should be charged to
another nominal account which is, in this case it should be loss on estimated contingent
consideration) should also be adjusted accordingly, the entry would be:
Bargain purchase gain ..
6,000
Estimated liability for contingent consideration ..
Adjustment to gain measurement date.

6,000

Therefore, the bargain purchase gain to be recognized retroactively as of the date of acquisition
which is January 1, 20x4 amounted to P12,000 (P18,000 P6,000).
Illustration 14-14: Comprehensive Problem Consideration transferred versus Assets
acquired and Liabilities assumed.
Paretto Company is seeking to expand its share of the market and has negotiated to take over the
operations of Santa Company on January 1, 20x4. The balance sheets of the tow companies on
December 31, 20x3 were as follows:

Paretto
Co.
Cash
Accounts receivable (net)
inventory
Land
Buildings (net)
Plant and Equipment (net)
Patent
Goodwill
Totals

P 523000
25,0
00
35,5
00
140,0
00
60,0
00
65,0
00
10,0
00
25,0
00
883,5
00

Santa Co.
12,0
00
34,7
00
27,6
00
100,0
00
30,0
00
46,0
00
2,0
00
252,3
00
43,5

Accounts Payable
Mortgage Loan
Bonds Payable
Common Stock, 60, 000 shares at P10 par

P 56000
50,0
00
100,0
00
600,0
00

00
40,0
00
50,0
00
60,0

Common Stock, 8000 shares at 7.50 par

00
28,5

Paid-in capital in excess of par

Retained Earnings
Totals

26,8

00

00

49,0
00
883,5
00

32,0
00
252,3
00

Paretto Company is to acquire all the assets, except cash, of Santa Company. The assets of Santa
Company are all recorded at fair value except:
Fair Value
Inventory .
P 39,000
Land
130,000
Buildings .
70,000
Plan and equipment .
65,000
In exchange, Paretto Companys terms of acquisition are as follows:
Cash of P40,000, half to be paid on the date of acquisition and half on December 31, 20x4.
Paretto Company has an acquisition department, which incurred running costs over te period
of completing the business combination amounted to P12,000.
Paretto Company is to provide Santa Company with sufficient cash, additional to that already
held, to enable Santa Company to repay all of its outstanding debts. The outstanding bond
are to be redeemed at a fair value of P102 per P100 bond (or at a 2% premium). Annual leave
entitlement of P14,000 outstanding as of January 1, 20x4 and expected liquidation costs of
P16,000 have not been recognized by San Company, Costs to transport and install Santa
Companys assets at Paretto Companys premises will be P10,000. An investigation by the
liquidator of Santa Company reveals that on January 1, 20x4 the following debts were
outstanding but had not been recorded:
Accounts payable .. P 1,500
Mortgage interest ..
4,000

Holders of 3,000 common stocks of Santa Company are to receive two fully paid shares of
Paretto Company for every three shares held. Shares issued by Paretto Company have a fair
value of P32 per share. Because of doubts as to whether or not it could sustain a share price
of at least P32, Paretto Company agreed to supply cash to the value of any decrease in the
share price below P32 for the share issued, this guarantee of the share price lasting until
August 31, 20x4. Paretto Company believed that there was a 90% chance that the share price
would remain at P32 or higher and a 10% chance that it would fall to P30 (not adjusted for
any interests component).
Holders of 4,000 common stocks of Santa Company elect to receive cash at P35 per share,
payable half on the acquisition date and half on December 31, 20x4.
Parreto Company surrenders his patent to Santa Company with a carrying amount of P4,000
and has a fair value of P5,000.
Paretto Company is also to give a piece of its own prime land to Santa Company. The place
of land in question has a carrying amount of P35,000 and a fair value of P50,000.
A cash payment of P50,000 to former owners representing reimbursement of acquisition
related costs paid by the former owners and a settlement of P10,000 for an unresolved claim
by Santa Company against Paretto Company.

A severance payment of P50,000 to the CEO of Santa, whose employment is terminated

following the suggestion by Paretto Company during the negotiations for the business
combination.
A deferred payment of P20,000 (to be paid a year after) to two former owners who become
employees of Paretto company, the payment of which is not dependent on their continuing
employment or affected by their termination, and the amount payable is adjusted for yearly
interests.
Paretto Company supplied the cash on acquisition date as well as surrendering the land. The
shares were issued on January 5, and the costs of issuing the shares amounted to P18,000. The
incremental borrowing rate for Paretto Company is 10% per annual. Other acquisition-related
costs paid by Paretto Company in relation to the acquisition amounted to P15,000.

On December 31, 20x4 the fair value of Paretto Companys shares was P33. The computation of
goodwill is as follows:
TABLE
Consideration transferred;
Cash: Payable now (40,000 x 1/2)
Accounts Payable (P43, 500 + 1, 500)
Mortgage Loan (P 40, 000 + P 4, 000)
Bonds and Premium (P50, 000 x 102%)
Cost of Liquidation
Annual Leave
Common Stock:
-payable now (4000 x P35 x 1/2)
Total Cash Required

Total Cash Required

Less: Cash Already held
**Consideration Payable:
Cash: Deferred (40, 000 x 1/2 x .909091)
Cash: Deferred to former owners
(20, 000 x .909091)*
Cash Payable - later common Stock
[(4000 shares x P35 x 1/2) x .909091*
Shares: Common stock (2,000 shares x P32 per
share)

P20,000
45,000
44,000
51,000
16,000
14,000
70,000
P260,000

P260,000
(12,000)

248,000

18,182
18,182
63,636

100,000
64,000

Patent

5,000

Land
Guarantee : Contingent consideration

50,000

([10% x (32 - P30) x 2,000 shares]

400

Total

467,400

Total
Less: Fair value of identifiable assets acquired and
liabilities assumed:

467,400

Accounts Receivable

34,700

Inventory
Land

39,000

130,000
Buildings

70,000

Plant and Equipment

65,000

Positive Excess : Goodwill

128,700

The journal entries by Paretto Company to record the acquisition are as follows:
TABLE
January 1, 20x4:
Accounts Receivable
34,700
Inventory
39,000
Land
130,000
Building
70,000
Plant and Equipment
65,000
Goodwill
128,700
Cash
248,000
Consideration Payable (P18,182 + 18, 182
+ 63,636)
Common Stock (P10 par x 2000 shares)

100,000
20,000

Paid-in Capital in excess par

[(P32 -P10) x 2,000 shares]
44,000
Land
50,000
Patent
5,000
Estimated Liability for Contingent
Considertation
Acquisition of Santa company

338,700

400

Patent
Gain on Measeurement of patent

1,000
1,000

Remeasurement to fair value as part of consideration transferred on business

combination

Land

15,00
0

Gain on Sale of Land

15,000

Remeasurement to fair value as part of consideration transferred on business

combination

Acquisition-related expenses (P12,000 + P10,000 + P15,000 + P50,000

+ P10,000)

97,00
0
Cash
97,000

Acquisition related expenses

Paid-in capital in excess of par

18,00
0
Cash

18,000

Acquisition-related cost-cost of issuing shares

General Expenses

50,00
0

Cash
50,000
Severance Payment

December 31, 20x4

Consideration payable
Interest Expense (10% x P100,000)
Cash (P20,000 + P20,000 + P70,000)

100,000
10,000
110,000

Balance of consideration paid.

Estimated Liability for Contingent Consideration

Gain on Contingent Consideration

400
400

Contingency not having to be paid

The following should be observed in relation to the above solution:

1. The following three components are arrangements that are entered into primarily for the
benefit of the acquirer or the combined entity:

a.

The reimbursement of P50,000 to the former owners for the acquisition-related costs,
and
b. P10,000 paid as settlement for the unresolved claim are not part of the business
combination and shall be recognized as expenses by the acquirer.
c. The P50,000 severance payment to the CEO is not part of the exchange in the business
combination, and shall be recognized as an expense in the post-combination financial
statements. These three components are arrangements that are entered into primarily for
the benefit of the acquirer or the combined entity.
2. The deferred payment of P20,000 to two former owners is a contingent consideration rather
than compensation for future services because the payment is not dependent on their
continuing employment affected by their termination. It shall be included in the measurement
of the consideration transferred.
3. It should be noted that acquisition-related cost is not the same with liquidation related costs
even though the consequence of acquisition is liquidation of the acquire. Any costs of
liquidation or of similar item paid or supplied by the acquirer should be part of the
consideration transferred for reason that it was intended to complete the process of
liquidation. The reason for such inclusion is that the consideration received from the acquirer
may be used to pay for liabilities not assumed by the acquirer and for liquidation expenses
which is practically the same as to unrecorded liabilities from liquidation point of view.
These items should not be confused with acquisition-related costs which are considered
outright expenses. Further, any liquidation costs or similar item which was not of the same
situation as mentioned above should be treated as expense
Accounting in the Records of the Acquiree
Where the acquirer purchases the acquirees net assets and liabilities, the acquire may continue in
existence or may liquidate. The acquire accounts affected by the business combination will differ
according to actions of the acquire.
Acquiree does not liquidate
In the situation where the acquire disposes of a business, the journal entries required in the
records of the acquire are shown in Figure 14-1. Under PAS 16 Property, Plant and Equipment,
when an item of property, plant and equipment is sold, gains or losses are recognized in the
statement of comprehensive income. Similarly, on the sale of the acquire recognizes a gain or
loss.
Figure 14-1
(Journal entries of acquire on sale of business)
TABLE

Journal of Acquiree

Receivable from acquirer

Liability X
Liability Y
Liability Z
Asset X
Asset Y
Asset Z
Gain on Sale of operation
(Sale of Operation)

xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx

*separate proceeds on sale and carrying amounts

of assets sold could be recognized

Investment in Acquirer
Cash
Receivavle from Acquirer

xxx
xxx
xxx

(Receipt of consideration fron acquirer)

Acquiree Liquidates
The entries required in the records of the acquire when it sells all its net assets to the acquirer are
shown in Figure 14-2. The accounts of the acquire are transferred to two accounts, the
Liquidation account and the Shareholders Distribution account.
Figure 14-2
(Journal entries of acquire after sale of net assets)
TABLE
Journal of Acquiree
Liquidation
Asset X
Asset Y
Assett Z

xxx

Liability A
Liability A
Liability A
Liquidation

xxx
xxx
xxx

xxx
xxx
xxx

Transfer of all Assets acquired by acquirer, at their carrying

amounts

xxx

Transfer of all liabilities assumed by the acquirer

Liquidation
Cash

xxx
xxx

Liquidation and other expenses not recognized previously,

if paid by the acquiree.

Receivable from acquirer

Liquidation
consideration for net assets sold.

xxx
xxx

Cash
Investment in Acquirer
Receivable from acquirer

xxx
xxx
xxx

Receipt of consideration

Additional paid-in capital

Retained earnings
Liquidation

xxx
xxx
xxx

Transfer of reserves.

Liquidation
Shareholder's Distribution

xxx
xxx

Transfer of balance of Liquidation

Common Stock
Shareholder's distribution

xxx
xxx

Transfer of common stock

Shareholder's distribution
Cash
Investment in Acquirer

xxx
xxx
xxx

Distribution of consideration to shareholders

To the Liquidation account are transferred:

All assets taken over by the acquirer, including cash if relevant, as well as any assets not
taken over and which have a zero value including goodwill.
All liabilities taken over
The expenses of liquidation if paid by the acquire
Additional expenses to be paid by the acquire but not previously recognized by the acquire
Consideration from the acquirer as proceeds on sale of net assets
All reserves including retained earnings.
To the Shareholders Distribution account are transferred:
The balance of share capital
The balance of the Liquidation account
The portion of the consideration received from the acquirer that is distributed to the
shareholders. Some of the consideration received by the acquire may be used to pay for
liabilities not assumed by the acquirer and for liquidation expenses.
Illustration 14-15: Entries in the Acquirees Records
Using the information form Illustration 14-13, the entries in the records of Sierra Company are
shown as follows:
TABLE
Journal of Acquiree

Liquidation
Accumulated Depreciation
Merchandise Inventory

3,130,000
150,000
1,130,000

Accounts Receivable

800,000

Copyrights
Equipment

150,000
1,200,000

Assets taken over

Accounts Payable

250,000

Loan Payable

100,000

Liquidation

350,000

Liabilities Taken over

Liquidation

10,000

Liquidation cost payable

10,000

Liquidation costs payable by acquiree

Receivable from Parrot Company

2,932,000

Liquidation

2,932,000

Consideration Receivable

Cash

1,510,000

Patents

200,000

Investment in Acquirer

1,200,000

Receivable from Parrot Company

2,910,000

Receipt of Consideration

Retained earnings

800,000

Liquidation

800,000

Transfer of retained earnings

Liquidation

942,000

Shareholders' distribution

942,000

Transfer of balance of liquidation

Preferred Stock

480,000

Common Stock

1,500,000

Shareholders' Distribution

1,980,000

Transfer of Common Stock

Liquidation costs payable by acquiree

10,000

Cash

10,000

Payment of liabilities

Shareholders' Distribution
Cash

2,922,000
1,500,000

Investment in acquirer

1,200,000

Patent

200,000

Receivables from Parrot Company

22,000

Distribution of consideration to shareholders

The liquidation account effectively records the sale of the assets and the receipts of the purchase
consideration.
All items being sold by the acquire whether assets or package of the purchase are taken at
their carrying amount to the Liquidation account.
All amounts arising during the liquidation process and not previously recorded by the acquire
are also taken to the Liquidation account. In the illustration 14-14, only the liquidation costs.
The relevant amounts are debited to the Liquidation account and liabilities are raised in
relation to this item.
Any reserves recognized by the acquire in this example it is retained earnings are taken to
the Liquidation account.

The purchase consideration is credited to the Liquidation account, with the recognition of
assets received, namely cash, patent and investment in acquirer.

The balance of the Liquidation account is transferred to the Shareholders distribution account.

Merchandise inventory
Accounts receivable
Copyrights
Equipment
Liquidation costs payable
Shareholders Distribution

1,130,000
800,000
150,000
1,200,000
10,000
942,000
4,232,000

Liquidation
Accumulated depreciation 150,000
Accounts payable
250,000
Loan payable
100,000
Retained earnings
800,000
Receivable from Parrot
Company
2,932,000
4,232,000

The cash received via the purchase consideration and the balance originally held by the acquire
is used as the liabilities of the acquire, including liabilities such as liquidation costs payable
raised during the liquidation process.

Liquidators Cost
Opening balance
Receivable from Parrot
Company

Liquidation costs payable

Shareholders distribution

480,000
1,500,000

1,510,000
1,510,000

1,510,000

The capital balances of the acquiree, in this example the capital relating to preferred stock and
common stock shares issued by the acquire are taken to the credit side of the Shareholders
Distribution account. The assets to be distributed to the former shareholders of the acquire are
transferred to the debit side of the account. In this case they consist of the cash. Investment in
Parrot Company, patent and receivable from the acquirer (Parrot Company) due to estimated
liability on contingent consideration, all these having been received as part of the purchase
consideration from the acquirer. The account balances when the balance transferred from the
Liquidation account is included. At this stage, all accounts of the acquire are closed:

Cash
Investment in Acquirer
Patent
Receivable from Parrot

Shareholders Distribution
1,500,000
Preferred stock
1,200,000
Common stock
200,000
Liquidation
22,000
2,922,000
2,922,000

480,000
1,500,000
942,000

2,922,000

Business Combination with No Transfer of Consideration

PFRS 3 paragraph 33 also deals a business combination without the transfer of any consideration
by the acquirer. In such cases, PFRS 3 requires an acquirer to be identified and the acquisition
method to be applied. Example include such circumstances as:
When the acquire repurchase a sufficient quantity of its shares from others shareholders such
that the acquirer, who previously was a majority shareholder of the acquire and controls it;
When the acquirer owns the majority of the acquirees voting shares but had previously been
prevented from exercising control by regulation or by contract it that restriction lapses or is
removed, the acquirer now gains control over the acquire; and
By contract alone
Ina business combination achieved without the transfer of consideration, goodwill is determined
by using the acquisition date fair value of the acquirers interest in the acquire (measured using a
valuation technique) rather than the acquisition date fair value of the consideration transferred. \
The acquirer measures the fair value of its interest in the acquire using one or ore valuation
techniques that are appropriate in the circumstances and for which sufficient data are available. If
more than one valuation technique is used, the acquirer should evaluate the results of the
techniques, considering the relevance and reliability of the inputs used and the extend of the
available data.
Combination by Contract Alone
In a business combination achieved by contract alone, two entitles enter into a contractual
arrangement which covers, for example, operation under a single management and equalization
of voting power and earnings attributable to both entities equity investors. Such structures may
involve a stapling or formation of a dual listed corporation.
Accounting for a Combination by Contract
PFRS 3 requires one of the combining entities to be identified as the acquirer, and one to be
identified as the acquire. In reaching the conclusion that combinations achieved by contract alone
should no be excluded from the scope of PFRS, the Board noted that:

a.

Such business combinations do not involve the payment of readily measurable

consideration and in rare circumstances. It might be difficult to identify the acquirer:
b. Difficulties in identifying the acquirer are not a sufficient reason to justify a different
accounting treatment, and no further guidance is necessary for identifying the acquirer;
and
c. The acquisition method is already being applied for such combinations in the United
States and insurmountable issues have not been encountered.
Appendix
Deferred Tax Assets and Deffered Tax Liabilities Relating to the Fair Value Differentials of
Identifiable Assets and Liabilities
When fair values of identifiable assets and liabilities are recognized, tax implications follow
from recognizing the difference between the fair values and book values of the identifiable net
assets.
PAS 12 Income Taxes requires the tax effects of the differences between fair values and book
values to be accounted for as deferred tax liabilities or deferred tax assets if the basis for taxation
does not change with the business combination. In other words, if tax authorities allow
deductions based on the original cost of the asset (rather than its fair value), the difference
between the carrying amount determined at fair value and the tax base, which is the original cost,
gives rise to a taxable temporary difference or deductible temporary difference.
A taxable temporary difference is the future taxable income that arises from the recovery of the
excess of fair value over book value of identifiable net assets. Conversely, a deductible
temporary difference is the reducing in future taxable income that arises from the outflow of
undervalued liabilities or recovery of overvalued assets. These temporary differences give rise to
deferred tax liabilities or deferred tax assets.
PAS 12 requires the recognition of deferred tax liabilities or deferred tax assets on taxable or
deductible temporary differences arising from the initial recognition of fair value adjustments of
assets or liabilities in a business combination.
For example, if the fair value of inventory P50,000 and the original cost is P30,000, the excess of
P20,000 gives rise to future taxable income (referred to as a taxable temporary difference in
PAS 12). Since fair value is recognized under the acquisition method, the future tax payable
(referred to as deferred tax liability) should also be recognized.
However, no deferred tax liability should be recognized on the goodwill asset. Goodwill is a
residual and should not in itself give rise to other effects.

Deferred tax is discussed in greater depth in a later chapter.

An excess of fair value over book value of an identifiable asset gives rise to a deferred tax
liability.
An excess of book value over fair value of an identifiable liability gives rise to a deferred and
tax asset.
Conversely, an excess of fair value over book value of an identifiable liability gives rise to a
deferred and tax asset, and an excess of book value over for value of an identifiable liability
gives rise to the deferred tax liability.
For simplicity, we can assume a right of set-off between deferred tax assets and deferred tax
liabilities and show a net position (i.e. either a deferred tax liability or a deferred tax asset on
the net difference between fair values and book values of identifiable net assets) when we
allocate the consideration transferred.
Note that the deferred tax liabilities or deferred tax assets recognized on the fair value
adjustments are adjustments to the deferred tax liabilities or deferred tax assets that are
already in existence in the financial statements.
Illustration 14-16 shows the effect of income tax on business combination.
Illustration 14-16: Deferred Tax on Business Combinations Statutory Consolidation
On January 1, 20x4, the stockholders of Peter Company and Simon Company agreed to a
consolidation. Because IASB requires that one party be recognized as the acquirer and the other
as the acquire, it was agreed that Peter Company was acquiring Simon Company. Peter Company
agreed to issue 56,000 shares of its P20 par stock to acquire at the net assets of Simon at a time
when the fair value of Peters common stock was P25 per share. The tax effects on fair value
differences are recognized in this illustration on the basis that the tax bases of the identifiable
assets acquired and liabilities assumed are not affected by the business combination. Assume a
tax rate of 30%
TABLE
Simon Co.
Book
Value

Simon Co.

Simon Co.

Fair value

FV - BV

Cash

5,000

5,000

Account Receivable

40,000

35,000

5,000

Merchandise Inventory

50,000

65,000

15,000

Other intangible assets

120,000

250,000

130,000

In-process research and development

1,000,000

1,000,000

Plant and equipment

300,000

280,000

(20,000)

Total Assets

515,000

1,635,000

1,120,000

Simon Co.
Book
Value

Simon Co.

Simon Co.

Fair value

FV - BV

Current and long-term liabilities

150,000

150,000

Contingent Liabilities

50,000

50,000

Total Liabilities

150,000

200,000

50,000

Net Assets

365,000

1,435,000

1,070,000

Common Stock

200,000

Retained Earnings

165,000

Stockholders' Equity

365,000

The computation
In the event that the fair value of net assets is less than the book value of the net assets of the
acquire, then a deferred tax asset will be recognized.
Estimating the Value of Goodwill
An acquirer may attempt to forecast the future income of a target company in order to arrive at a
logical purchase price. Goodwill is often, at least in part, a payment for above-normal expected
future earnings. A forecast of future income may start by projecting recent years incomes into
the future. When this is done, it is important to factor out one-time occurrences that will not
likely recur in the near future. Examples would include extraordinary items, discontinued
operations, or any other unusual event. Expected future income is compared to normal income
Normal income is the product of the appropriate normal rate of return on assets times the fair
value of the gross assets (no deduction for liabilities) of the acquired company. Gross assets
include specifically identifiable intangible assets such as patents and copyrights but do not
include existing goodwill.
Several methods use the expected annual earnings in excess of normal to estimate goodwill. The
following are alternatives in estimating the value of goodwill (assumed figures):

1.

A common approach is to pay for a given number of years excess earnings. Assuming the
acquirer paid for four year of excess earnings:
TABLE
2. The most optimistic purchaser might expect the excess earnings to continue forever. If so, the
buyer might capitalize the excess earnings as perpetuity at the normal (industry) rate of
return. Assume the excess earnings will continue indefinitely and are to be capitalized at
normal (or industry) rate of return:
TABLE
3. Another estimation method views the factors that produce excess earnings to be of limited
duration. Assume the excess earnings will continue for only for five years and should be
capitalized at a higher rate of 16%, which reflects the risks applicable to goodwill:
TABLE
Other analysts view the normal industry earning rate to be appropriate only for identifiable assets
and not goodwill. Thus, they might capitalize excess earnings at a higher rate of return to reflect
the higher risk inherent in goodwill. All calculations of goodwill are only estimates used to assist
in the determination of the price to be paid for a company.
Stock Exchange Ratio
The price for a business combination consummated for cash or debt generally is expressed in
terms of the peso amount of the consideration issued. When common stock is issued by the
acquirer in a business combination, the price is expressed as a number of shares of the acquirers
common stock to be exchanged for each share of the acquirees common stock; this is known as
stock exchange ration.
Issuance of a Single Class of Stock in a Business Combination
When the earnings rates on assets of the constituent parties are approximately the sae and a
single class of stock is to be issued, the parties may agree that such shares shall be issued in
relation to the net asset contributions. However, when earnings rates vary and a single class of
stock is to be issued, the parties may provide that earnings regarded as above normal shall be
used as a basic for calculating goodwill and that such goodwill shall be added to the other net
assets in measuring a companys full contribution.
To illustrate the foregoing, assume that stockholders of Companies A, B, and C agree to
consolidate and form Company D. Net assets at appraised values and average adjusted earnings
of the past five years, which the parties believe offer the most reliable estimate of future
earnings, follow:
TABLE
If Company D issues a single class of stock in the net asset ration, stockholders of Companies A,
B and C will received stock in the ratio of 20:30:50 respectively. Although an equitable division
of the interest in the assets of P1,000,000 is achieved, earnings of P100,000 in the future will

accrue to stockholders in the asset ratio, resulting in a loss to original stockholders of Company
A and a gain to original stockholders of Company C.
On the other hand, if a single class of stock is issued I the earning ratio, stockholders of
Companies A, B, and C will received stock in the ratio f 30:30:40 respectively. Although an
equitable division of future earnings is achieved, stockholders will fail to maintain their original
interests in assets. Stockholders of Company A will acquire an interest that exceeds their
investment, while stockholders of Company C will acquire an interest that is less than their
investment.
To avoid the in inequities resulting from the distribution of a single class of stock either in the net
asset ration or in the earnings ratio, the parties decide that respective contributions shall be
measured by the values assigned to net assets as increased by goodwill. It is agreed that
contributions are to be determined as follows;
1. A 6% return is to be regarded as a fair return on identifiable net assets;
2. Excess earnings are to be capitalized at 20% in arriving at a value for goodwill.
When net asset and earnings factors are considered, contributions re calculated as follows.