Dragon Holdings: Step Acquisition, Contingent Consideration and Deferred Tax
Dragon Holdings Ltd (DHL) prepares consolidated financial statements to 31 December. On 1 October 20X5 it acquired an additional 55% of Panda Tech Ltd (PTL) for cash HK$110 million, giving it 75% and control. DHL had held 20% of PTL for several years as an equity investment designated at fair value through other comprehensive income; its carrying amount was HK$30 million and its fair value on 1 October 20X5 was HK$40 million. The acquisition agreement includes contingent consideration of up to HK$30 million payable in 20X7 if PTL's 20X6 revenue exceeds HK$200 million; its fair value at acquisition was HK$18 million. PTL's net assets at acquisition had a carrying amount of HK$120 million. Fair value adjustments were: brand HK$25 million, customer list HK$15 million, and an unrecorded lawsuit obligation of HK$8 million. The tax base of the brand and customer list is nil; the tax rate is 16.5%. DHL measures non-controlling interests at fair value, HK$45 million. Acquisition-related costs were HK$4 million. PTL's 20X6 revenue was HK$210 million and the contingent consideration was settled at HK$30 million in 20X7.
1. Calculate the goodwill arising on the acquisition and explain the treatment of the previously held interest, the NCI, the deferred tax and the lawsuit obligation.
Read the worked answer
Identifiable net assets at acquisition:
| Item | HK$ million |
|---|---|
| Carrying amount of net assets | 120.0 |
| Brand at fair value | 25.0 |
| Customer list at fair value | 15.0 |
| Lawsuit obligation at fair value | (8.0) |
| Deferred tax liability on fair value adjustments: (25 + 15) × 16.5% | (6.6) |
| Net identifiable assets | 145.4 |
Consideration and goodwill:
- Cash consideration: 110.0
- Contingent consideration at fair value: 18.0
- Fair value of previously held 20% interest: 40.0
- NCI at fair value: 45.0
- Less net identifiable assets: (145.4)
- Goodwill = HK$67.6 million
Key judgements:
- The previously held 20% is remeasured to fair value at the acquisition date; it forms part of the consideration transferred for the 75% interest (HKFRS 3.42).
- NCI is measured at fair value, so goodwill includes a share attributable to NCI. This is an election made at each business combination.
- A deferred tax liability arises on the brand and customer list because their carrying amounts in the consolidated financial statements exceed their tax bases (HKAS 12.66). The lawsuit obligation is assumed as part of the business combination and recognised at fair value under HKFRS 3.23, even though it would not qualify for separate recognition as a provision under HKAS 37; it is not tax-deductible, so no deferred tax asset arises.
2. Explain how the FVOCI investment and the acquisition-related costs are accounted for.
Read the worked answer
Previously held FVOCI investment. The 20% interest was designated as an equity instrument at fair value through other comprehensive income under HKFRS 9. At the acquisition date it is remeasured to fair value of HK$40 million. The increase of HK$10 million (40 − 30) is recognised in other comprehensive income.
On loss of significant influence and the step acquisition, the cumulative gain in OCI is not recycled to profit or loss. For equity instruments designated at FVOCI, gains and losses accumulated in OCI are transferred within equity to retained earnings on derecognition; they are never reclassified to profit or loss (HKFRS 9.5.7.1(d) and B5.7.9). This is a common exam trap: the HK$10 million does not increase the profit on the step acquisition, although the full fair value of HK$40 million is used in the goodwill calculation.
Acquisition-related costs. The HK$4 million of advisory, legal and other transaction costs are expensed as incurred in the period, not included in the consideration transferred and not capitalised as part of goodwill (HKFRS 3.53). Only costs to issue debt or equity instruments are accounted for under HKFRS 9 or HKAS 32. In the consolidated statement of profit or loss for 20X5, the HK$4 million is an expense.
3. Explain the subsequent accounting for the contingent consideration, including the effect of PTL's 20X6 revenue exceeding the target.
Read the worked answer
Classification. The contingent consideration is an obligation to pay cash if a revenue target is met, so it is a financial liability within the scope of HKFRS 9. It is measured initially at fair value (HK$18 million) as part of the consideration for the business combination and subsequently at fair value through profit or loss (HKFRS 3.58 and HKFRS 9).
Subsequent measurement. At each reporting date DHL remeasures the liability to fair value. Changes in fair value are recognised in profit or loss; they are not adjustments to goodwill and do not affect the acquisition accounting. This is true even if the change results from new information about facts that existed at the acquisition date, because the liability is measured at fair value through profit or loss under the standard's subsequent measurement requirements (unless it is a financial instrument within the scope of HKFRS 9 and measured at amortised cost, which is not the case here).
20X6 and 20X7. PTL's 20X6 revenue of HK$210 million exceeds the HK$200 million target, so the obligation becomes payable. At 31 December 20X6 the fair value is HK$30 million, and DHL recognises a loss of HK$12 million (30 − 18) in 20X6 profit or loss. In 20X7 the liability of HK$30 million is settled in cash, with no further gain or loss if the fair value remains HK$30 million. The operating cash outflow in 20X7 is classified as financing or operating depending on the entity's accounting policy for contingent consideration payments, which must be applied consistently and disclosed.