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ACCOUNTING FOR BUSINESS COMBINATION
Lesson 1: Introduction to Business Combination
Objective of this chapter - In this chapter you will:
1.Understand why businesses combine
2.Know what are the economic motivations for doing business combination
3.Learn the different types/forms of business combination from business point of view
4.Learn the different types/forms of business combination from legal point of view and accounting
point of view
5.Flashback: concepts of accounting for business combinations
6.Note the difference between Equity Method, Acquisition Method and Joint Venture Method of
Accounting

Introduction

Businesses may decide to combine because of various reasons. It could be due to corporations want to
increase their value that they normally cannot do alone or they want to diversify their businesses or
acquire assets or many other motivations. However, corporations before entering into business
combinations, they must need to carefully look at the provisions of the governing law, the Revised
Corporation Code of the Philippines (RCCP).

Types of Business Combination (from business point of view)

Business combinations can be categorized into the following four types:

1.Vertical combination (vertical integration) - This is a business combination wherein various

departments of large industrial units come together under single management. Vertical
integration is a strategy whereby a company owns or controls its suppliers, distributors, or retail
locations to control its value or supply chain. Vertical integration benefits companies by allowing
them to control the process, reduce costs, and improve efficiencies.
(ie; Netflix, Andoks) 3 types: forward, backward & balanced integration

2.Horizontal combination (horizontal integration) - Also referred as voluntary combination, it is

an association of two or more business units of same nature under a single management. Both the
business units involved in combination are engaged in same activity and their combination is,
therefore, referred as horizontal combination. Horizontal integration is the acquisition of a business operating at the same
level of the value chain in a similar or different industry. (ie; Facebook + Instagram; Jolibee + Mang Inasal)

3.Circular combination - A circular merger is a transaction to combine companies that operate

within the same general market, but offer a different product mix. A company engages in a circular
merger to offer a greater range of products or services within their market. Companies also
pursue circular mergers to share common distribution and research facilities and promoting
market enlargement. The acquiring company benefits by economies of resource sharing and
diversification. (ie, SM Holdings)

4.Diagonal combination- A diagonal business combination involves two or more business entities
performing subsidiary services combining themselves under a single management. The key
objective of this amalgamation is making the business unit large and self sufficient.
*
A Conglomerate Merger is a union between companies that operate in different industries and are
involved in distinct, unrelated business activities. They are divided into two:
1. Pure conglomerate mergers is comprised of two companies that operate in separate and distinct
markets.
2. Mixed conglomerate mergers is one where the merging firms intend to expand their product lines
or target markets, so they may eventually no longer only be involved in totally unrelated core
businesses.
2 Legal Forms of Business Combination

1. Merger often times called Acquisition If two or more corporations merge into a single corporation which shall
be one of the constituent corporations then there is a Merger (Article 76 RCCP). The Supreme Court explained
what a Merger is, saying that:

“Merger is a re-organization of two or more corporations that results in their consolidating into a
single corporation, which is one of the constituent corporations, one disappearing or dissolving and
the other surviving. To put it another way, merger is the absorption of one or more corporations by
another existing corporation, which retains its identity and takes over the rights, privileges,
franchises, properties, claims, liabilities and obligations of the absorbed corporation(s). The
absorbing corporation continues its existence while the life or lives of the other corporation(s) is or
are terminated.”

As part of the merger process, the shareholders of the merged corporation receive
payment for their shares and/or
shares in the surviving corporation.

Conceptually, it looks like this: A +B = A (where A is the surviving corporation and B was the merged
corporation.)

Example: Grab Phils. + Uber Phils. = Grab Phils (where “Grab” is the surviving corporation and “Uber”
was the merged corporation. Uber ceased its operation in the Philippines and only Grab continued.)

2.Consolidation If two or more corporations consolidate into a new single corporation which shall be the consolidated
corporation (Article 76 RCCP).

“Consolidation is the union of two or more corporations into a single new corporation, called the
consolidated corporation, all the constituent corporations thereby ceasing to exist as separate
entities. The consolidated corporation shall thereupon and thereafter possess all the rights,
privileges, immunities, franchises and properties, and assume all the liabilities and obligations of each
of the constituent corporations in the same manner as if it had itself incurred such liabilities or
obligations.” (Bangko Sentral ng Pilipinas)

Consolidation: A contractual and statutory process by which

two or more corporations jointly become a completely new corporation (the successor
corporation),
the original corporations cease to exist and to do business as separate entities, and
the successor corporation acquires all of the assets and liabilities of the original (now defunct)
corporations.

Conceptually, it looks like A + B = C (here, distinct companies A and B consolidate into a new
company, C)

Example: Lucio Tan Co. + Asia Brewery Inc. + Fortune Tobacco Corp. = LT Group (here, distinct
companies like Lucio Tan Co., Asia Brewery Inc. and Fortune Tobacco Corp. consolidate into a new
company, LT Group rest of the companies will cease their operations.)

Example: Lucio Tan + PNB + ABC = LT Group (here, distinct companies Lucio Tan Co., PNB and ABC
consolidate into a new company, LT Group rest of the companies will cease their operations.)
Lucio Tan – Parent
Rest of the companies - Subsidiariies
LT Group – Consolidated company

Question: Why is it that there are still operations of Asia Brewery Inc. + Fortune Tobacco Corp. PNB +
ABC up to this moment when the theory say they should cease to do business or stop operations?

*WHEN DOES MERGERS AND CONSOLIDATIONS TAKE EFFECT?

If two or more corporations decide to merge or consolidate, they must seek the approval of the
Securities and Exchange Commission (SEC) before they can complete the same. The time that the SEC
issues a certificate of merger or consolidation is the time of its effectivity.
It is to be noted however, that if the corporations that are parties to a merger or consolidation
includes banks or banking institutions, building and loan associations, trust companies, insurance
companies, public utilities, educational institutions and other special corporations governed by
special laws, the favorable recommendation of the appropriate government agency shall first be
obtained.
*WHAT ARE THE EFFECTS OF A MERGERS OR CONSOLIDATIONS?
According to (Section 80, RCCP) these are the effects of a merger or consolidation

1. The constituent corporations shall become a single corporation which, in case of merger, shall be
the surviving corporation designated in the plan of merger; and, in case of consolidation, shall be the
consolidated corporation designated in the plan of consolidation;
2. The separate existence of the constituent corporations shall cease, except that of the surviving or
the consolidated corporation;
3. The surviving or the consolidated corporation shall possess all the rights, privileges, immunities
and powers and shall be subject to all the duties and liabilities of a corporation organized under this
Code;
4. The surviving or the consolidated corporation shall thereupon and thereafter possess all the rights,
privileges, immunities and franchises of each of the constituent corporations; and all property, real or
personal, and all receivables due on whatever account, including subscriptions to shares and other
choses in action, and all and every other interest of, or belonging to, or due to each constituent
corporation, shall be deemed transferred to and vested in such surviving or consolidated corporation
without further act or deed; and
5. The surviving or consolidated corporation shall be responsible and liable for all the liabilities and
obligations of each of the constituent corporations in the same manner as if such surviving or
consolidated corporation had itself incurred such liabilities or obligations; and any pending claim,
action or proceeding brought by or against any of such constituent corporations may be prosecuted
by or against the surviving or consolidated corporation. The rights of creditors or liens upon the
property of any of such constituent corporations shall not be impaired by such merger or
consolidation.

*APPRAISAL RIGHT OF A DISSENTING STOCKHOLDER TO A MERGER OR CONSOLIDATION

A stockholder of a corporation who dissents to its merger or consolidation has an appraisal right
under (Section 81 of the RCCP). Meaning, a stockholder who does not agree to a merger or
consolidation can demand the corporation to pay him or her the fair value of his or her shares.

What are the Major Reasons Why Companies Merge?

Companies can come together in a merger due to several reasons. Some of the inducing factors are:
Economic necessity
Economics of sale
Operating economies
Synergy
Diversification
Growth
Better financial planning
Utilization of tax shields
Elimination of competition
Increase in value

Major Benefits of A Merger

Companies enter into mergers with expectations of better days in business ahead. Among the major
benefits of mergers are:
Increased goodwill
Tax benefits
Entry into more markets.
Combined forces to face competition.
Increased financial resources.
More growth and expansion.
Increased market share.

What are the Major Reasons Behind Consolidations?

The top five reasons why companies decide to venture into consolidation are:
Streamlining the management and improving decision making.
Saving resources, money, and to reinvest funds.
Launching new services in faster and easier ways.
Improving security
Streamlining provision of customer services.
Notable Benefits of Consolidation
When companies enter into a consolidation, they enjoy benefits such as:
Established and uniformed operation procedures.
Reduced costs through economies of scale.
Elimination of redundancy.
Lowered overhead expenditures.

SUMMARY:
Characteristics Merger Consolidation
Meaning is a statutory and contractual is the contractual and statutory process
combination of two or more entities or where two or more entities, usually
companies into one. companies join hands to form a
completely new, more solid, and stronger entity.

Form For a merger to happen, two or more Consolidation, takes place when different
companies come together and combine ventures come together, combine forces, and
forces where the company taking over is join into one completely new venture.
left as the existing entity.

Resultant the company absorbed will cease to exist all the companies involved stop existing, and
Entity and only the acquiring company a new large company is formed.
continues to exist.

Flashback: concepts of accounting for business combinations

GAAP for Business Combinations

Since 1950 up to year 2000, both the pooling of interest and the purchase method of accounting
for business combinations were acceptable.
In June 30, 2001 all combinations initiated after that date use the purchase method as per (FASB
ASC 805)
Periods beginning after December 15, 2008 all business combinations in that fiscal period started
to use the acquisition method (FASB ASC 810-10-5-2)

International Accounting
Most major economies prohibit the use of pooling of interest method.
The International Accounting Standards Board (IASB) specifically prohibits the use of pooling of
interest method and requires the use of acquisition method.

What is Pooling of Interests?

Pooling of interests refers to a technique of recording a merger or acquisition, whereby the assets and
liabilities of the two companies are summed together and then netted. The pooling-of-interests method
allowed assets and liabilities to be transferred from the acquired company to the acquirer at book values.
Intangible assets, such as goodwill, were not included in the calculation.
Before being phased out by the Financial Accounting Standards Board (FASB) in 2001, pooling of
interests was the most preferred technique because it usually resulted in high earnings for the surviving
firm.

What isPurchase Method of Accounting?

Purchase acquisition accounting is a method of reporting the purchase of a company on the balance sheet
of the company that acquires it. It treats the target firm as an investment. There is no pooling of assets.
Rather, the assets of the target firm are added to the balance sheet of the acquirer at a price that reflects
their fair market value. This, in turn, increases the acquirer's fair market value. Liabilities of the target are
subtracted from the fair value of the assets.
The amount paid by the acquirer over the net value of the target's assets and liabilities is considered
goodwill, which is kept on the balance sheet and amortized yearly.

What is Equity Method and Joint Venture?

Summary of IAS 28 (as amended in 2011)

Objective of IAS 28
The objective of IAS 28 (as amended in 2011) is to prescribe the accounting for investments in associates
and to set out the requirements for the application of the equity method when accounting for
investments in associates and joint ventures. [IAS 28(2011).1]

Scope of IAS 28
IAS 28 applies to all entities that are investors with joint control of, or significant influence over, an
investee (associate or joint venture). [IAS 28(2011).2]
Key definitions [IAS 28.3]
Associate
- An entity over which the investor has significant influence
Significant influence
- The power to participate in the financial and operating policy decisions of the
investee but is not control or joint control of those policies
Joint arrangement
- An arrangement of which two or more parties have joint control
Joint control
- The contractually agreed sharing of control of an arrangement, which exists only when
decisions about the relevant activities require the unanimous consent of the parties sharing control
Joint venture
- A joint arrangement whereby the parties that have joint control of the arrangement
have rights to the net assets of the arrangement
Joint venturer
- A party to a joint venture that has joint control of that joint venture
Equity method
- A method of accounting whereby the investment is initially recognised at cost and
adjusted thereafter for the post-acquisition change in the investor's share of the investee's net assets.
The investor's profit or loss includes its share of the investee's profit or loss and the investor's other
comprehensive income includes its share of the investee's other comprehensive income

Difference between Equity Method, Acquisition Method and Joint Venture Method of Accounting
Example: Assume Company P has 80% interest in Company S

Under Equity Method:

Balance Sheet- Company P reports reports 80% interest in Company S as a single line item under
assets on the balance sheet. Liabilities and equity stay the same.

Income Statement- 80% interest (x) Company S’s Net income gets included in Company P’s net
income. Revenues and expenses stay the same.

Under Acquisition Method:

Balance Sheet: 100% of Company P’s assets and liabilities get reported on Company S’s balance
sheet. Next calculate the portion not owned, minority interest. 100-80%=20% minority interest.
20% x Company S’s Equity= minority interest added to Company P’s Equity. Ex. if Company S has
100K Equity then 20K (100 x 20%) will be added to Company P’s Equity under minority interest.
This is why equity increases under the acquisition and not the equity method.

Income Statement: 100% of revenues and expense of Company S are combined with the the
revenues and expenses of Company P. Again, like with the balance sheet, you have to calculate
minority interest and base it off Company S’s Net income. If Company S has Net Income of 1000
then minority interest reported on Company P’s income statement is 2000.

Under Joint Ventures Method:

require equity method under IFRS and GAAP except in rare
circumstances. The other method besides the equity method for joint ventures is proportionate
consolidation.
Balance Sheet: Under proportionate consolidation Company P will report 80% of Company S’s
Assets and liabilities. No minority interest is necessary. Equity is ignored.

Income Statement: Company P will report 80% of Company S’s revenues and expenses. No
minority interest is necessary.

References:
Abo Law Firm – Written by: Atty. Jon Dominic Penaranda
Advanced Accounting – McGraw-Hill/Irwin
Advanced Accounting – Dayag
Advanced Financial Accounting and Reporting (AFAR) – Millan
Advanced Financial Accounting and Reporting (AFAR) – Guererro
AFAR Lectures – B. Dela Cruz
CFI; Investopedia; International Financial Reporting Tool; Delloite: iasplus.com; IFRS: iasplus.com
Advanced Accounting 12
th
Edition – Beams, Anthony, Bettinghaus, Smith (Disucused by T. Camden)