Advanced Financial Accounting: Chapter 3

Advanced Financial Accounting: Chapter 3
Group Reporting II: Application of the Acquisition Method under IFRS 3 Tan & Lee Chapter 3 © 2009

Learning Objectives Understand the difference between investor’s separate financial statements and the consolidated statements; Understand the consolidation process; Appreciate the acquisition method and its implications; Know how to determine the cost of consideration transferred; Understand the identification of the acquirer; Know how to recognize and measure identifiable net assets under IFRS 3; Understand the nature of goodwill; Review the concept of non-controlling interests (NCI) with respect to parent and entity theories; and Know how to prepare consolidation journal entries relating to fair value adjustment at acquisition date and subsequent years Tan & Lee Chapter 3 © 2009

Content Introduction 1. Introduction
Overview of the consolidation process The acquisition method Determining the amount of consideration transferred Recognition and measurement of identifiable assets, liabilities and goodwill Accounting for non-controlling interests under IFRS 3 Effects of amortization, depreciation and disposal of undervalued or overvalued assets and liabilities subsequent to acquisition Goodwill impairment tests Introduction Tan & Lee Chapter 3 © 2009

Separate Vs Consolidated Financial Statements
Separate financial statements (Legal entity) Consolidated financial statements (Economic entity) Income recognition Dividends Share of profits Asset recognition Investment in a Subsidiary carried at: Cost (IAS 27) or As a financial instrument (IAS 39) Investment in Subsidiary: Investment is eliminated and subsidiary’s net assets are added to the parent (IAS 27) Investment in an associate carried at: Cost (IAS 28) or Investment in an associate: Equity method (IAS 28) Tan & Lee Chapter 3 © 2009

Content Introduction Overview of the consolidation process
The acquisition method Determining the amount of consideration transferred Recognition and measurement of identifiable assets, liabilities and goodwill Accounting for non-controlling interests under IFRS 3 Effects of amortization, depreciation and disposal of undervalued or overvalued assets and liabilities subsequent to acquisition Goodwill impairment tests Overview of the consolidation process Tan & Lee Chapter 3 © 2009

Consolidation Process
Legal entities Economic entity Parent’s Financial Statements Subsidiaries' Financial Statements Consolidated financial statements + +/- Consolidation adjustments and eliminations = Consolidation is the process of preparing and presenting the financial statements of a group as an economic entity No ledgers for group entity Consolidation worksheets are prepared to: Combine parent and subsidiaries financial statements Adjust or eliminate intra-group transactions and balances Allocate profit to non-controlling interests Tan & Lee Chapter 3 © 2009

Intragroup Transactions
Intragroup transactions are eliminated to: Show the financial position, performance and cashflow of the economic (not legal) entity Avoid double counting of transactions Example: Parent sold inventory to subsidiary for $2M The original cost of inventory is $1M Subsidiary eventually sold the inventory to external parties for $3M Q: What is the journal entry to eliminate intragroup sales transaction? Consolidation adjustment Dr Sale 2,000,000 Cr Cost of sale Tan & Lee Chapter 3 © 2009

Intragroup Transactions
Extract of consolidation worksheet Parent's Income Statement Subsidiary’s Income Statement Consolidation elimination entries and adjustments Consol. Income Statement Without elimination Dr Cr Sales $2,000,000 $3,000,000 2,000,000 $5,000,000 Cost of sales (1,000,000) (2,000,000) ($3,000,000) Gross profit $1,000,000 Note: Without elimination the consolidated sales and cost of sales figures will be overstated by $2 M. Tan & Lee Chapter 3 © 2009

The acquisition method Determining the amount of consideration transferred Recognition and measurement of identifiable assets, liabilities and goodwill Accounting for non-controlling interests under IFRS 3 Effects of amortization, depreciation and disposal of undervalued or overvalued assets and liabilities subsequent to acquisition Goodwill impairment tests The acquisition method Tan & Lee Chapter 3 © 2009

Business Combinations 結合
Where an acquirer obtains control of one or more businesses (IFRS 3 App A) Examples: IFRS 3 App B:B6 Tan & Lee Chapter 3 © 2009

The Acquisition Method
IFRS 3 requires all business combinations to be accounted for using the acquisition method The procedures: Identify the acquirer Determine the acquisition date Recognize and measure the identifiable assets acquired the liabilities assumed and any non-controlling interest in the acquiree; and Recognize and measure goodwill or a gain from a bargain purchase Group financial statements if acquire subsidiaries 4-step approach: IFRS 3:5 Tan & Lee Chapter 3 © 2009

Identify the Acquirer IFRS 3 requires the identification of the acquirer in all circumstances Acquirer is the entity that obtains control of another combining entities Control is the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities Tan & Lee Chapter 3 © 2009

Identify the Acquirer Additional control criteria under IFRS 3 Appendix B Based on consideration transferred Based on entity size Based on dominance Acquirer is the entity that: Transfers cash or other assets or incurs liabilities to acquire another entity Issues shares as purchase consideration Pays a premium over the fair value of the equity interest Acquirer is the entity that: Has the largest relative voting rights in a combined entity Holds the largest minority voting interest in the combined entity (if no other entity has significant voting interest) Is relatively larger in size Acquirer is the entity: Whose owners have the ability to elect, appoint or remove a majority of directors Whose management is dominant in the combined entity Who initiates the business combination Tan & Lee Chapter 3 © 2009

Identify the Acquirer Reverse acquisition
Legal parent is the acquiree and legal subsidiary is the acquirer Often initiated by the legal subsidiary Has other motive of entering into such an arrangement (eg. Backdoor listing) Exchange of shares in a reverse acquisition 1. Company A (Legal parent) takes over shares of Company B from owners Owners of Company B (Legal subsidiary) 2. Company A issues own shares to owners of Company B as purchase consideration Company A (Legal parent) Company B (Legal subsidiary) 3. Company B has the power to govern the financial and operating policies of the legal parent Tan & Lee Chapter 3 © 2009

The acquisition method Determining the amount of consideration transferred Recognition and measurement of identifiable assets, liabilities and goodwill Accounting for non-controlling interests under IFRS 3 Effects of amortization, depreciation and disposal of undervalued or overvalued assets and liabilities subsequent to acquisition Goodwill impairment tests Determining the amount of consideration transferred Tan & Lee Chapter 3 © 2009

Determine the Amount of Consideration Transferred
Fair value of assets transferred + Fair value of liabilities incurred Fair value of equity interests issued by acquirer Consideration transferred = Fair value of contingent consideration Fair value of the consideration transferred: Determined on the acquisition date Acquisition date is the date when the acquirer obtains control and not the date when consideration is transferred Tan & Lee Chapter 3 © 2009

Fair Value of Assets Transferred or Liabilities Assumed
If assets transferred or liabilities assumed are not carried at fair value in the acquirer’s separate financial statements: Remeasured gain or loss is recognized in the acquirer’s separate financial statements Remeasured gain or loss is not recognized if the assets or liabilities remain in the combined entity’s financial statements If transfer of monetary assets or liabilities are deferred: The fair value will be the present value of the future cashflows Eg. Future cash settlement of $1,000,000 is due 3 years later and 3% interest is levied Fair value = $1,000,000/ (1+0.03)^3 = $915,142 Tan & Lee Chapter 3 © 2009

Fair value of Equity Interests Issued by the Acquirer
Fair value of equity interests issued is measured by: Market price If market price is not available or not reliable: A proportion of acquirer’s fair value or proxied by the fair value of equity interest acquired, whichever is more reliably measurable Tan & Lee Chapter 3 © 2009

Illustration 1: Fair Value of Equity Issued
P Ltd acquires 100% of S Co through an issue of 5,000,000 shares to the vendors of S Co. P Ltd S Co Number of existing shares 10,000,000 2,000,000 Number of new shares issued 5,000,000 - Market price per share $2.00 Fair value of equity $24,000,000 $9,000,000 Tan & Lee Chapter 3 © 2009

Illustration 1: Fair Value of Equity Issued
Q1: P Ltd’s market price is a reliable indicator Consideration transferred = 5,000,000 shares x $ 2.00 = $10,000,000 Q2: P Ltd’s market price is not a reliable indicator; a proportional interest in the fair value of P Ltd is a better estimate Consideration transferred = (5,000,000/15,000,000) x $24,000,000 = $8,000,000 Q3: Fair value of S Co is a better estimate Consideration transferred = $9,000,000 Tan & Lee Chapter 3 © 2009

Fair Value of Contingent Consideration
Obligation (right) of the acquirer to transfer (receive) additional assets or equity interests to (from) acquiree’s former owner if specific event occurs Eg. Acquirer gets a refund of a part of the consideration transferred if the acquiree does not achieve the target profit Fair value of the contingent consideration (refund) is added to (deducted from) consideration transferred Tan & Lee Chapter 3 © 2009

Acquisition-Related Costs
All acquisition-related costs are expensed off Costs of issuing debt are recognized in accordance with IAS 39 As yield adjustment to the cost of borrowing and are amortized over the life of the loan Journal entry for the payment of debt issuance cost Costs of issuing equity are recognized in accordance with IAS 32 A reduction against equity Journal entry to record the payment of cost of issuing equity Dr Unamortized debt issuance costs Cr Cash Dr Equity Cr Cash Tan & Lee Chapter 3 © 2009

The acquisition method Determining the amount of consideration transferred Recognition and measurement of identifiable assets, liabilities and goodwill Accounting for non-controlling interests under IFRS 3 Effects of amortization, depreciation and disposal of undervalued or overvalued assets and liabilities subsequent to acquisition Goodwill impairment tests Recognition and measurement of identifiable assets, liabilities and goodwill Tan & Lee Chapter 3 © 2009

Elimination of Investment Account
What the parent is paying for Share of book value of subsidiary’s net assets at acquisition date Share of excess of fair value over book value of identifiable net assets Goodwill Consideration transferred + + = Eliminated against subsidiary’s share capital and pre-acquisition retained earnings Investment account is eliminated Substituted with subsidiary’s 1. identifiable net assets and 2.goodwill (residual) Avoid recognizing assets in two forms (investment in parent’s balance sheet and individual assets and liabilities of the subsidiary) Tan & Lee Chapter 3 © 2009

Recognition Principle
Business Combination accounted under the acquisition method At acquisition date, the acquirer will recognize subsidiary’s net assets at fair value To qualify for recognition: Identifiable net assets must meet the definition of an asset or a liability Identifiable net assets must be priced into the “consideration transferred” Rationale: There has been an exchange transaction at arm-length pricing There is an effective ”purchase”* of the subsidiary’s identifiable assets and liabilities at fair value Tan & Lee Chapter 3 © 2009 *Look at next slice

Effective purchases Meaning: Under acquisition method, an acquirer obtains control through purchases of equity interests in an acquiree, there is deemed to be an effective purchases of the assets and assumption of the liabilities of the acquiree by an acquirer. Tan & Lee Chapter 3 © 2009 26

Fair value differential (FV-BV) of identifiable net assets At acquisition date: Fair value differential will be recognized in the consolidation worksheet In subsequent years: Depreciation/amortization/ cost of sale of asset will be based on the fair value recognized at the acquisition date These entries have to be re-enacted every year until disposal of investment Book value of subsidiary’s identifiable net assets In separate financial statements Book value of subsidiary’s identifiable net assets recognized in consolidated financial statements Tan & Lee Chapter 3 © 2009

Intangible Assets IFRS 3 requires the acquirer to recognize the fair value of an acquiree’s unrecognized identifiable asset (e.g. intangible asset) in the combined financial statements Justified by the acquisition of the subsidiary by the parent To qualify for recognition, the intangible asset must be: Example: Assembled workforce with specialized knowledge Fails to meet the separability criterion Opportunity gains from an operating lease in favorable market conditions Meets the contractual-legal Or must arise from contractual or legal rights Tan & Lee Chapter 3 © 2009

Contingent Liabilities & Provisions
Contingent liabilities are recognized if they are: Present obligations arising from past events and Reliably measurable in their fair value, even if outcome is not probable (IFRS 3:23) Provisions for restructuring & termination cost are recognized if they are: Probable outflow of economic resources Reliably measurable Present constructive or legal obligations arising from past events Tan & Lee Chapter 3 © 2009

Indemnification Assets 賠償
Contractual indemnity Provided by the sellers of the acquiree to the acquirer to make good any loss arising from contingency or an asset or a liability Treatment for indemnity The acquirer has to recognize an “indemnification asset” at the same time the indemnified asset or liability is recognized The indemnification asset is measured on the same basis as the indemnified asset or liability Eg. An acquiree is exposed to a contingent liability. Based on probabilistic estimation, the FV of the contingent liability is $100,000. The seller provides a contractual guarantee to indemnify the acquirer of the loss. In the consolidated balance sheet, contingent liabilities and an indemnification asset of $100,000 will be recognized at fair value Tan & Lee Chapter 3 © 2009

Deferred Tax Relating to FV Differentials of Identifiable Assets and Liabilities
The recognition of fair value differential may give rise to future tax payable or future tax deduction tax effects need to be accounted for if the basis of taxation does not change in a business combination i.e. If original asset is deductible based on book value, the FV differential will give rise to a temporary taxable/deductible different No deferred tax liability is recognized on goodwill FV > Book value of identifiable assets Deferred tax liabilities FV < Book value of identifiable assets Deferred tax assets FV < Book value of identifiable liabilities FV > Book value of identifiable liabilities Tan & Lee Chapter 3 © 2009

Measurement Period IFRS 3 allows adjustments to be made retrospectively回顧地 to goodwill, fair value of identifiable net assets and consideration transferred: If new information about facts and circumstances existing at acquisition date arises, Within 1 year of acquisition date After 1 year, any correction of errors will be deemed as a prior - period adjustment Any change in estimate arising from new information on facts and circumstances after the acquisition date will be recognized in the current period and not retrospectively Tan & Lee Chapter 3 © 2009

Goodwill - = A premium that a parent pays to acquire the subsidiary
Fair value of consideration transferred + Amount of non-controlling interests Fair value of the acquirer’s previously held interest (before control was achieved) in the acquiree - Acquiree’s recognized net identifiable assets measured in accordance with IFRS 3 Goodwill = Measured at fair value at acquisition date (include goodwill) Measured as a proportion of identifiable assets as at acquisition date Goodwill A premium that a parent pays to acquire the subsidiary Must be recognized separately as an asset Determined as a residual IFRS 3 allows 2 ways of determining goodwill: Tan & Lee Chapter 3 © 2009

Goodwill The “top-down approach” (Johnson and Petrone, 1998) results in measurement errors in goodwill Goodwill residual Consideration transferred + Amount of non-controlling interests Identifiable net assets Overpayment for an acquisition or overvaluation of consideration transferred Measurement and recognition errors Above errors impact goodwill Tan & Lee Chapter 3 © 2009

Goodwill In a “bottom-up” approach (Johnson and Petrone, 1998), goodwill is substantiated as follows: “Going concern element” and represent the ability of an entity to generate higher rate of return over its individual assets or “core goodwill” Generated from the unique combination of the acquirer and acquiree or “combination goodwill” Tan & Lee Chapter 3 © 2009

Gain From a Bargain Purchase
A gain from bargain purchase arises when: The acquirer must re-assess the fair value of identifiable net assets, consideration transferred and non-controlling interests. If there is no measurement error: The gain will be recognized immediately in the income statement Fair value of consideration transferred + Amount of non-controlling interests Fair value of the acquirer’s previously held interest in the acquiree < Acquiree’s net identifiable assets measured in accordance with IFRS 3 Tan & Lee Chapter 3 © 2009

The acquisition method Determining the amount of consideration transferred Recognition and measurement of identifiable assets, liabilities and goodwill Accounting for non-controlling interests under IFRS 3 Effects of amortization, depreciation and disposal of undervalued or overvalued assets and liabilities subsequent to acquisition Goodwill impairment tests Accounting for non-controlling interest under IFRS 3 Tan & Lee Chapter 3 © 2009

Non-Controlling Interests’ Share of Goodwill
IFRS 3 Para 19 allows NCI to be measured in either of two ways Non-controlling interests Measured at Fair value at acquisition date (include goodwill) (Fair value option) Measured as a proportion of identifiable assets as at acquisition date Tan & Lee Chapter 3 © 2009

Under the fair value option: FV is determined by either the active market prices of subsidiary’s equity share at acquisition date or other valuation techniques FV per share of NCI may differ from parent due to control premium paid by parent NCI comprises of 3 items: Non – controlling interests Share of book value of net assets Share of unamortized FV adjustment (FV - BV) Share of unimpaired goodwill Tan & Lee Chapter 3 © 2009

Under the fair value option: Journal entry to record NCI at fair value (re-enacted each year): Dr Share capital of subsidiary Retained earnings at acquisition date Other equity at acquisition date (eg. RS, SP, GR) Dr/Cr FV differentials (FV- BV)/ (BV-FV) Goodwill (Parent & NCI) Deferred tax asset/ (liability) (JUST)on fair value adjustment Cr Investment in subsidiary Non-controlling interests (At fair value) -FP Tan & Lee Chapter 3 © 2009

Under the 2nd option: Journal entry to record NCI (re-enacted each year): Dr Share capital of subsidiary Retained earnings at acquisition date Other equity at acquisition date FV differentials Goodwill (Parent only) Dr/Cr Deferred tax asset/ (liability) on FV adjustment Cr Investment in S subsidiary Non-controlling interests (NCI % x FV of identifiable net assets of that company) Tan & Lee Chapter 3 © 2009

Accounting for Non-Controlling Interests under IFRS 3
In consolidation, non-controlling interests have a share of: Profit after tax Dividends declared Share capital Retained earnings and other comprehensive income (eg. Revaluation reserve) at acquisition date Change in retained earnings and other comprehensive income from the date of acquisition to the current period Fair value differential of a subsidiary’s net assets at acquisition date Goodwill (if the fair value alternative is adopted) Tan & Lee Chapter 3 © 2009

Reconstructing NCI on Balance Sheet
Date of acquisition Beginning of current year End of current year NCI have a share of Share capital Retained earnings Other equity Fair value differentials Goodwill Change in share capital* Change in retained earnings Change in other equity Past amortization of fair value differential Past impairment of goodwill Profit after tax Current amortization of fair value differential Current impairment of goodwill Dividends as a repayment of profits Tan & Lee Chapter 3 © 2009

Allocation to Non-controlling Interests
Allocation of the change in equity from date of acquisition to the current year To transfer the NCI’s share of subsidiary’s retained earnings to NCI Allocation of current profit after tax to NCI Dr Retained earnings (NCI % x in RE from acquisition date to beginning of current period) Cr NCI Dr Income to NCI Cr NCI Tan & Lee Chapter 3 © 2009

Allocation to Non-controlling Interests
Allocation of dividends to NCI A realization of residual in a subsidiary Reduces the NCI’s stake in the net assets of the subsidiary Elimination of dividends as follows: Can NCI be a debit balance? If NCI’s share of losses in a subsidiary > NCI’s existing share of subsidiary’s net assets: NCI will have a debit balance under IAS 27 Dr Dividend income (Parent) NCI (BS) Cr Dividends declared (Subsidiary) Tan & Lee Chapter 3 © 2009

Analytical check on Non-controlling Interests’ balance
NCI’s share of: Book value of net assets of subsidiary at year-end -/+ unrealized profit/loss from upstream sale Unamortized balance of FV adjustments at year-end Unimpaired balance of goodwill at year-end NCI’s balance at year-end = Tan & Lee Chapter 3 © 2009

The acquisition method Determining the amount of consideration transferred Recognition and measurement of identifiable assets, liabilities and goodwill Accounting for non-controlling interests under IFRS 3 Effects of amortization, depreciation and disposal of undervalued or overvalued assets and liabilities subsequent to acquisition Goodwill impairment tests Effects of amortization, depreciation and disposal of undervalued or overvalued assets and liabilities subsequent to acquisition Tan & Lee Chapter 3 © 2009

In Subsequent PERIOD + = At acquisition date, we recognize:
Fair value of identifiable net assets, Intangibles, contingent liabilities, and Deferred tax assets or liabilities on the above In subsequent years: Amortization, depreciation and cost of sales of the acquired assets must be based on the fair value as at acquisition date Since net assets are carried at book value in the separate financial statements, the subsequent amortization/depreciation/disposal are adjusted in the consolidation worksheet Eg. When an identified asset is sold or depreciated: BV of expense in separate financial statements (FV- BV) adjustment to expense FV of expense in consolidated financial statements + = Adjusted in consolidation worksheet Tan & Lee Chapter 3 © 2009

Illustration 2: Amortization of Fair Value Differentials
P Co paid $6,200,000 and issued 1,000,000 of its own shares to acquire 80% of S Co on 1 Jan 20X5 Fair value of P Co’s share is $3 per share Fair value of net identifiable assets is as follows: Book value Fair value Remaining useful life Leased property 4,000,000 5,000,000 20 years In-process R&D 2,000,000 10 years Other assets 1,900,000 Liabilities (1,200,000) Contingent liability (100,000) Net assets 4,700,000 7,600,000 Share capital 1,000,000 Retained earnings 3,700,000 Shareholders’ equity Tan & Lee Chapter 3 © 2009

Additional information: Contingent liability of $100,000 was recognized as a provision by the acquiree in Dec 20X5 FV of NCI at acquisition date was $2,300,000 Net profit after tax of S Co for 31 Dec 20X5 was $1,000,000 No dividends were declared during 20X5 Shareholders’ equity as at 31 Dec 20X5 was $5,700,000 Q1 : Prepare the consolidation adjustments for P Co for 20X5 Q2 : Perform analytical check on balance of NCI as at 31 Dec 20X5 Tan & Lee Chapter 3 © 2009

Consideration transferred = Cash consideration + Fair value of share issued = $6,200,000 + (1,000,000 x $3) = $9,200,000 Deferred tax liability = 20% x ($7,600,000 - $4,700,000) = $580,000 Goodwill = Consideration transferred + NCI – Fair value of net identifiable assets, after-tax = $9,200,000 + $2,300,000 – ($7,600,000 - $580,000) = $4,480,000 Tan & Lee Chapter 3 © 2009

P’s share of goodwill = Consideration transferred – 80% x Fair value of net identifiable assets, after tax = $9,200,000 – 80% x $7,020,000 = $9,200,000 – $5,616,000 = $3,584,000 NCI’s share of goodwill = Consideration transferred – 20% x Fair = $2,300,000 – 20% x $7,020,000 = $2,300,000 – $1,404,000 = $896,000 Tan & Lee Chapter 3 © 2009

Consolidation adjustments for 20X5 CJE 1: Elimination of investment in S Dr Share capital 1,000,000 Retained earnings 3,700,000 Leased property In-process R&D 2,000,000 Goodwill 4,480,000 Cr Contingent liability 100,000 Deferred tax liability 580,000 Investment in S 9,200,000 Non-controlling interests 2,300,000 Tan & Lee Chapter 3 © 2009

CJE 2: Depreciation and amortization of excess of FV over book value Dr Depreciation of leased property 50,000 Amortization of in-process R&D 200,000 Cr Accumulated depreciation Accumulated amortization Under dep. by $50k $ 0 Amort exp: $200,000 Amort. of R&D Based on book value Based on FV Under amort. by $200k Dep exp: $50,000 Dep. of leased property $200,000 $200,000 Based on book value Based on FV Tan & Lee Chapter 3 © 2009

CJE 3: Reversal of entry relating to provision for lawsuit Dr Provision for lawsuit -FP 100,000 Cr Loss from lawsuit -I/S Note: Contingent liability was already recognized in CJE 1. The recognition by the acquiree results in double counting; hence this reversal entry is necessary CJE 4: Tax effects on CJE 2 & CJE 3 Dr Deferred tax liability 30,000 Cr Tax expense 20% * (200k +50k -100k) Tan & Lee Chapter 3 © 2009

CJE 5: Allocation of current year profit to non-controlling interests (NCI) Dr Income to NCI 176,000 Cr NCI Net profit after tax 1,000,000 Excess depreciation (50,000) Excess amortization (200,000) Reversal of loss from lawsuit 100,000 Tax effects on FV adjustments 30,000 Adjusted net profit 880,000 NCI’s share (20%) Tan & Lee Chapter 3 © 2009

Q2 : Perform an analytical check on the balance of NCI as at 31 Dec 20X5 $5,700,000 x 20% = $1,140,000 ($1,000,000 x 19/20 x 80% x 20%) + ($2,000,000 x 9/10 x 80% x 20%) = $440,000 $896,000 = $2,476,000 + + Tan & Lee Chapter 3 © 2009

The acquisition method Determining the amount of consideration transferred Recognition and measurement of identifiable assets, liabilities and goodwill Accounting for non-controlling interests under IFRS 3 Effects of amortization, depreciation and disposal of undervalued or overvalued assets and liabilities subsequent to acquisition Goodwill impairment tests Goodwill impairment tests Tan & Lee Chapter 3 © 2009

Goodwill Impairment Test
IAS 36: Goodwill has to be reviewed annually for impairment loss Reviewed as part of a cash-generating unit (CGU) CGU is the lowest level at which the goodwill is monitored for internal management purposes and Not larger than a segment determined under segment reporting Goodwill will be allocated to each of the acquirer’s CGU, or group of CGUs Tan & Lee Chapter 3 © 2009

Carrying amount: Net assets of the cash-generating unit It includes entity goodwill attributable to parent and NCI Recoverable amount: Higher of 1.FV less cost to sell (an arms-length measure), or Uses market based inputs in the pricing mechanism 2.Value in use Uses internal or entity-specific input to determine the future cash flows If carrying amount > recoverable amount Impairment loss is allocated to goodwill Then to other assets in proportion to their individual carrying amounts Impairment once made is not reversible, as it may result in the recognition of internally-generated goodwill which is prohibited under IAS 38 Tan & Lee Chapter 3 © 2009

Steps for impairment test Determine the carrying amount of the CGU Determine the recoverable amount of the CGU Recoverable amount: Higher of fair value or value in use If carrying amount ≤ recoverable amount If carrying amount ≥ recoverable amount No impairment loss Allocate impairment loss to goodwill first and balance to other net assets Tan & Lee Chapter 3 © 2009

NCI at FV at acquisition date NCI as a proportion of identifiable net asset at acquisition date Goodwill on consolidation Includes NCI’s share of goodwill Excludes NCI’s share of goodwill Carrying amount of cash-generating unit Goodwill is allocated to cash-generating unit without further adjustment Goodwill has to be grossed up to include NCI’s share Notionally adjusted goodwill = Recognized goodwill/ parent’s interest Impairment loss Impairment loss is shared between parent and NCI on the same basis on which profit or loss is allocated Impairment loss is borne only by parent as goodwill for NCI is not recognized Tan & Lee Chapter 3 © 2009

Conclusion All business combinations are accounted for using the acquisition method: Consideration transferred = Fair value of (assets transferred + liabilities incurred + equity interests issued by acquirer + contingent consideration) Investment account is eliminated and substituted with: Subsidiary’s identifiable net assets; and Goodwill Goodwill = Fair value of (consideration transferred + non-controlling interests + acquirer’s previously held interest in the acquiree) – Acquiree’s recognized net identifiable assets Tan & Lee Chapter 3 © 2009

Conclusion In consolidation:
All intragroup balances and transactions are eliminated Non-controlling interests have a share of: Profit after tax Dividends declared Share capital Retained earnings and other comprehensive income (eg. Revaluation reserve) from acquisition date to current period Fair value differential of a subsidiary’s net assets at acquisition date Goodwill (if the fair value alternative is adopted) In the subsequent years, amortization, depreciation and cost of sales of the acquired assets are based on fair value as at acquisition date Tan & Lee Chapter 3 © 2009

Conclusion Dr/ Cr Goodwill/ Gain from a bargain purchases
Dr/Cr FV (whole) Dr/Cr FV (diff) Dr Net Asset Cr/ Dr Contingent Liability / Contingent Asset Cr Investment in a subsidiary Cr NCI Cr/ Dr Deferred Tax Liability/ Deferred Tax asset Tan & Lee Chapter 3 © 2009 69

Advanced Financial Accounting: Chapter 3

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