In the world of finance and accounting, understanding business combinations and the associated treatment of goodwill is crucial. This article aims to simplify the concept of business combinations under IFRS 3 for professional accountants in practice and provide a practical example to illustrate the accounting entries involved, especially in the context of South African entities.

What is a Business Combination?

A business combination occurs when one entity gains control over one or more other businesses. This control typically involves the ability to govern the financial and operating policies of the acquired business to obtain benefits from its activities. Such transactions can include mergers, acquisitions, and consolidations.

A key aspect of a business combination is that it involves acquiring an operational business, capable of generating economic benefits for the acquirer, not just purchasing assets. Business combinations happen when one company takes control of another. Here are some common ways this can occur:

1. Merger: Two companies join to form a new one. For example, Company A and Company B merge to become Company C.

2. Acquisition: One company buys another. For example, Company A buys 80% of Company B's shares and takes control.

3. Consolidation: Two companies combine into one, keeping one name. For example, Company A and Company B become just Company A.

4. Asset Purchase: One company buys the assets of another, like equipment or patents. For example, Company A buys all of Company B's manufacturing equipment.

5. Reverse Takeover: A private company buys a public one to become publicly traded without the hassle of an initial public offering. For example, Private Company A buys Public Company B and takes its place on the stock market.

How and When Does Goodwill Arise?

Goodwill arises in a business combination when the purchase price paid for the acquired business exceeds the fair value of its identifiable net assets at the acquisition date. Goodwill represents the future economic benefits from assets that are not individually identifiable and separately recognised. This may include elements like a strong brand reputation, customer loyalty, or an exceptional workforce.

Goodwill = Purchase Price - Fair Value of Net Assets

Treatment of Goodwill Under IFRS 3

Under IFRS 3, "Business Combinations," goodwill is recorded as an asset on the balance sheet of the acquirer. It is not amortised but is tested annually for impairment. An impairment test is conducted to determine if the carrying amount of goodwill exceeds its recoverable amount, with any excess recognized as a loss in the income statement.

Practical Example: Acquisition of Company B by Company A

Let's consider Company A, a South African retail corporation, which acquires the assets and liabilities of Company B, a smaller competitor, as a going concern for R1,200,000. It is important to note that Company A is not purchasing the shares of Company B but rather its assets and liabilities. The fair value of Company B’s identifiable net assets at the time of acquisition is R900,000.

Calculation of Goodwill:

Goodwill = Consideration Transferred − Fair Value of Identifiable Net Assets

R1,200,000−R900,000 = R300,000

Accounting Entries at Acquisition:

• Debit various asset accounts for R900,000 (total fair value of identifiable assets)

• Debit Goodwill for R300,000

• Credit Cash for R1,200,000 (consideration transferred)

Annual Impairment Testing: Each year, the goodwill is tested for impairment. If an impairment is found (i.e., the recoverable amount of the cash-generating unit is less than it carrying amount), the following entry is made:

• Debit Impairment Loss

• Credit Goodwill

Conclusion

Understanding business combinations and the proper treatment of goodwill are vital for accountants in the professional field. This knowledge ensures accurate financial reporting and compliance with IFRS standards, providing clear and reliable financial information to stakeholders. By grasping these concepts and knowing how to apply them in practical scenarios, professional accountants can effectively navigate complex transactions and maintain the integrity of financial statements.

Gain Better Understanding of the Accounting Standards, enroll to CIBA’s Accountant-In-Practice CPD Sub 2024

The CIBA Accountant-In-Practice CPD Subscription option provides you with the knowledge and skills to earn a higher income from providing accounting services to SMEs. Subscribing to the Accountant-in-Practice series provides you access to monthly webinars covering ethics, financials, reporting, audit and assurance, working papers, law, technology, management topics, and enable you to:

• Be aware of the latest legislative changes and what it means for your business, practice, and your clients;

• Prepare compliant financial statements fast;

• Issue reliable reports on financial statements;

• Understand the laws and regulations that govern your profession; and

• Develop enhanced business advisory skills.