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Accounting alert 2008/01 - Latest changes in business combination accounting

IASB’s Phase II business combination proposals reach fruition, bringing significant change

The International Accounting Standards Board (IASB) has released revised versions of IFRS 3 Business Combinations and IAS 27 Separate and Consolidated Financial Statements.  These revised Standards will apply to annual periods beginning on or after 1 July 2009 and form an important part of the so-called 'IFRS Mark II' transition that will apply, starting from 2009-10. The Australian Accounting Standards Board (AASB) is expected to issue equivalent Australian Standards shortly.

Early consideration of the new requirements is important for the following reasons:

  • in some cases the revised standards contain requirements which have the effect of clarifying the requirements of the existing standards
  • mergers and acquisitions currently under contemplation may be directly or indirectly impacted by the new requirements
  • early adoption may be beneficial in some circumstances.

In this Accounting alert, we provide a high-level overview of the revised Standards and focus on some of the issues arising from them for Australian entities, covering the following topics:

You can also download a PDF version of this Accounting alert at the bottom of the page.

The revised Standards have been updated on our What's new in financial reporting for December 2007 summary. Click here to access the summary. For-profit entities claiming compliance with IFRS should consider making disclosures about these and other pronouncements that have been issued by the IASB or IFRIC but not yet issued by the AASB at the date of signing the financial report. See our analysis in our commonly asked questions around pronouncements on issue but not applied in the financial report. 

Overview and background

Summary of the major impacts

The revised Standards introduce significant change, including:

  • a greater emphasis on the use of fair value - increasing the judgement and subjectivity around business combination accounting and requiring greater involvement of valuation experts
  • introducing further volatility in the income statement - transaction costs, changes in the value of contingent consideration, settlement of pre-existing contracts, share-based payments and similar items will generally be accounted for separately from business combinations
  • focussing on changes in control as a significant economic event - introducing requirements to remeasure interests to fair value on gaining or losing control and recognising all transactions between controlling and non-controlling shareholders whilst control is retained, directly in equity.

The following table summarises at a very high level the major impacts of the revised IFRS 3 and IAS 27, each of which are discussed in more detail below:

Area Overview Comments
Measuring goodwill More emphasis on fair value, but a free choice in how to measure noncontrolling interests (NCIs), allowing NCIs to be measured either including or excluding goodwill
  • measurement options provide flexibility in some cases, particularly in post-combination changes in control
Previous ownership interests Previous ownership interests must be measured at fair value at the date that control is obtained
  • generally results in the recognition of a gain in the income statement at the time of the business combination
Contingent consideration Contingent consideration must be measured at fair value at the time of the business combination
  • subsequent changes in the value will be recognised in the income statement
Acquisition related costs Must be accounted for separately from the business combination and expensed, unless it relates to debt or equity securities
  • this may include stamp duty and non-recoverable GST
Pre-existing relationships

Must be accounted for separately from the business combination, will generally result in the recognition of a gain or loss in the income statement.

However, reacquired rights are recognised as an intangible asset

  • will introduce volatility in the income statement
  • reacquired rights must be amortised in post-acquisition profits
Replacement share-based payment awards New rules for determining the amount taken into account in the recognition of goodwill and the amount recognised in post-combination profit and loss
  • careful planning is required where these arrangements exist to minimise post-combination expense recognition
Intangible assets Must always be recognised and measured, i.e. there is no 'reliable measurement' out
  • higher valuation costs are likely
  • new valuation standards being developed by the International Valuations Standards Committee (IVSC)
Changes in ownership interests Only affects assets, liabilities and income statement where control is obtained or lost. All other transactions are equity transactions
  • may provide an opportunity to partially avoid goodwill recognition in some cases
Other changes The revised Standards also contain a number of other changes in accounting for business combinations and consolidation.
  • the impact of these changes will vary between entities and transactions
Transitional requirements The revised Standards must generally be applied on a prospective basis, with some exceptions.
  • the prospective application will impact post-transition changes in ownership interests in subsidiaries and deferred taxes, but will not impact accounting for contingent consideration related to business combinations with an acquisition date prior to the date of transition
How the revised Standards were developed

The revised Standards are a result of the joint IASB-FASB 'business combinations' project, the first phase of which resulted in the original IFRS 3 Business Combinations (the Australian equivalent is AASB 3 Business Combinations).  The revised IFRS 3 and IAS 27 are the culmination of the second phase of the project and resulted in near word-for-word exposure drafts and Standards being issued by the IASB and FASB, with any differences (with one important exception) being largely driven by differences in terminology or other requirements between IFRS and US-GAAP. In addition, although the wording used under IFRS and US-GAAP is nearly the same, the structure of the Standards are different, so that items included in the main body of the Standard under one framework is included as guidance or elsewhere in the other - fortunately a table of concordance is provided in the Illustrative Examples and US GAAP Comparison accompanying IFRS 3.

The FASB pronouncements resulting from this process address a number of issues that remain unresolved under IFRS.  For instance, the FASB pronouncements deal with such issues as the control and consolidation of variable interest entities and income tax uncertainties.  Many of these differences are expected to be addressed in current or future IASB-FASB convergence projects and so have been left out of the IASB pronouncements at the current time.

For more information about the remaining differences between IFRS and US-GAAP, see our IAS Plus Newsletter "IASB revises IFRS 3 and IAS 27" (PDF 122kb).

An interesting dilemma for the AASB

The differences between the IASB and FASB Standards also create an interesting dilemma for the AASB, as the FASB has excluded from the scope of its Standard combinations between not-for-profit organisations or acquisition of for-profit businesses by a not-for-profit organisation. The Basis for Conclusions on IFRS 3 notes that the IASB does not provide scope exceptions for not-for-profit activities in the private or public sector, as it is not a primary focus of the IASB.

Consistent with the AASB 'sector neutral' approach, the existing AASB 3 does not currently include a scope exemption for all business combinations undertaken in the not-for-profit or public sectors. However, many business combinations in these sectors occur between mutual entities or by contract alone and as are outside the scope of the existing AASB 3 under exemptions for those transaction types. However, these types of business combinations have now been brought within the scope of the revised IFRS 3.

The AASB has decided that it will conduct research into the suitability of applying the forthcoming revised AASB 3 Business Combinations to transactions by not-for-profit entities (see Accounting alert 2007/20).

Whilst the revised Standards are an important achievement in the harmonisation of IFRS and US-GAAP, their issue has not been without problems and difficulties.  The exposure drafts were issued on 30 June 2005 and immediately received widespread negative feedback from constituents across all sectors: preparers, users and auditors.  For instance, our global Deloitte submission on the proposals (PDF 103kb) called for a refinement of the current requirements and alignment of US-GAAP with IFRS, rather than a wholesale change under both regimes to a new approach that would introduce much more use of fair value based measurement, increasing costs and creating operational difficulties without commensurate benefits to the users of financial statements.

In response to the widespread concern with the proposals in the 2005 exposure drafts, the IASB and FASB began a complete redeliberation of their original proposals in late 2005, revisiting the basic 'principles' and rebuilding the requirements throughout 2006 and the first half of 2007.

Did the redeliberations result in any significant changes to the final revised Standards?  Unfortunately in the eyes of many, not really.  The Boards have stuck to their guns and issued Standards that largely conform to their original underlying principles.  There are some important differences (such as the option to account for non-controlling (minority) interests by reference to their share of the net assets of an acquiree, rather than at fair value) but many of the other changes are not substantive when considered from the perspective of the outcomes they produce.

Greater emphasis on fair value as the measurement principle

Determining goodwill

The 2005 exposure drafts proposed that the fair value of the acquiree as a whole should be used as the basis for determining goodwill arising in an acquisition, summarised as follows:

Fair value of the acquiree as a whole less Fair value of identifiable assets and liabilities acquired equals Goodwill arising from the combination


This approach would have meant determining the fair value of the acquiree, with a rebuttable presumption that the acquisition-date fair value of the consideration transferred is the best evidence of the fair value of the acquirer's interest in the acquiree at that date.  Noncontrolling interest (NCI, currently termed 'minority interest') would also then be measured at fair value.

As part of its redeliberations, the IASB decided not to continue with a focus on the fair value of the business as a whole or, as a consequence, the full goodwill method. Instead, the focus was shifted back to the components of business combination transactions, being the consideration transferred and the assets, liabilities and equity instruments of the acquiree. The revised IFRS 3 therefore takes a slightly different approach to the determination of goodwill, as follows (in simplified terms):

Fair value of consideration transferred
+
Amount of any NCI
+
Fair value of any previously held equity interest in the acquiree
less Fair value of identifiable assets and liabilities acquired equals Goodwill arising from the combination


Notwithstanding the move from a 'whole of entity' approach to 'components' approach, the outcomes under the two approaches are not substantively different, with the following exceptions:

  • the 'components' approach eliminates uncertainty where the fair value of the acquiree as a whole may not equate to the fair value of the consideration (and NCI) - this means for example that some bargain purchases will not result in the recognition of a gain, e.g. where the entity pays less than full fair value of the entity as a whole but some goodwill still arises in the transaction
  • under the revised IFRS 3 NCI can be measured on two bases - by reference to their share of the net assets of an acquiree, or the fair value of the NCI, with the primary difference being that the latter measure includes the NCI's share of goodwill whereas the former approach can result in the goodwill associated with the NCI being debited directly to equity if subsequently acquired (this is covered in more detail below).
  • any portion of the acquirer's share-based payment awards exchanged for awards held by the acquiree's employees that is included in consideration transferred in the business combination is measured using a 'market-based measure' determined in accordance with IFRS 2 Share-based Payment rather than at fair value (this is covered in more detail below).
Previous ownership interests

Because of the emphasis on fair value at the acquisition date, the revised IFRS 3 requires any previous ownership interests in the acquiree to be taken into account in the initial accounting for the business combination at fair value.

This means that those previous ownership interests are required to be recognised at their fair value at the date of the combination, usually leading to the recognition of a gain in the income statement.  This treatment applies even though changes in fair value related to the prior ownership interest may have been accounted directly in equity (e.g. as an available-for-sale financial asset).

This treatment follows from the principle in the 2005 exposure drafts that obtaining control is a significant economic event that should trigger a full remeasurement.  This is different to the approach required under the existing IFRS 3 where goodwill is determined in relation to each 'step acquisition', rather than at the acquisition date.  However, the existing and revised IFRS 3 both require the fair value of acquired identifiable assets and liabilities to be measured at the acquisition date.

The revised treatment has the following implications compared to the existing IFRS 3:

  • goodwill will generally be recognised at a higher amount than under the existing requirements as it is determined entirely at the acquisition date, rather than at each date that an ownership interest is acquired
  • gains (and potentially losses in some cases) can result from business combinations, leading to potential volatility in reported profits - whereas under the existing IFRS 3, changes in the fair values of identifiable net assets were recognised directly in equity to the extent of the pre-combination ownership interest in the acquiree
  • 'strategic investments' made in entities prior to taking control will have no impact on the goodwill eventually recognised if the entity is subsequently acquired.  In some acquisitions, it is sometimes argued from a commercial perspective that a prior investment provides additional leverage in an acquisition situation due to a lower cash entry cost to the investment - this benefit will be eroded, at least from an accounting perspective, under the revised IFRS 3.

Example

Entity A acquired a 15% interest in Entity B for $5.0 million a number of years ago and has accounted for its investment in B as an available-for-sale investment under IAS 39 Financial Instruments: Recognition and Measurement.  Entity A subsequently acquired a further 60% interest in Entity B and obtained control.  At the date of the transaction, A's 15% interest in B was measured at $6.5 million, resulting in an available-for-sale reserve of $1.5 million (ignoring tax effects).

Under the requirements of the existing IFRS 3, the effects of accounting for the 15% interest as an available-for-sale financial asset would be reversed (bringing the carrying amount back to cost) and then 'step acquisition' accounting applied such that goodwill in respect of the original 15% would be determined based on the fair values of B's assets and liabilities at the date A acquired its 15% interest.

In applying the revised IFRS 3 requirements to the transaction, the $1.5 million available-for-sale reserve would be recycled to the income statement as if the previous interest had been disposed.  Accordingly, A would recognise a gain of $1.5 million in its income statement as a result of the business combination.  Goodwill would then be determined based on the acquisition date fair values, potentially resulting in goodwill that is higher than the existing IFRS 3.

Measuring noncontrolling interests

The 2005 exposure drafts proposed that the fair value of the acquiree as a whole be used as the basis for measurement, meaning that NCIs would be measured at fair value at the date of the business combination and so incorporate the NCI's share of goodwill.  Because a so-called 'control premium' is one component of overall goodwill in a business combination, this would mean that in many cases the goodwill allocation between the controlling and noncontrolling interests would not be in proportion to their relative ownership interests.

It is fair to say that constituents were 'underwhelmed' by these proposals.  Many argued that the requirement to determine the fair value of the entity as a whole, where a NCI existed, imposed an unnecessary and potentially costly valuation process on the acquirer for little benefit.  Others argued that the conceptual reasoning behind recognising the NCI's share of goodwill was flawed.

In its redeliberations, many IASB members agreed with the concerns of constituents and favoured measuring NCI based on the NCI's proportion of the recognised assets and liabilities of the acquiree, i.e. without goodwill.  However, a number of other IASB members fully supported the use of fair value for NCI and accordingly, the IASB was unable to agree on a single approach.

In order to achieve the necessary majority required to issue the revised IFRS 3, the IASB decided to allow a choice in the measurement of NCI, as follows:

  • at fair value, i.e. including goodwill, or
  • based on the NCI's proportionate share of the acquiree's net identifiable assets, i.e. excluding goodwill.

This choice is available for each business combination, so the entity can use fair value for one business combination and the proportionate share of the acquiree's net identifiable assets for another.  This will afford a significant amount of flexibility to entities in accounting for business combinations, particularly where further acquisitions of ownership interests are expected to be acquired (read more about this issue below).

However, care needs to be taken for the following reasons:

  • although the NCI's share of goodwill may not be required to be recognised on the balance sheet, it will still need to be taken into account when conducting impairment testing under IAS 36 Impairment of Assets
  • the revised SFAS 141 requires an entity to use the fair value method for NCIs, meaning that entities that have US-GAAP reporting obligations should consider adopting the fair value method.

The IASB also noted in its Business Combinations Phase II Project Summary and Feedback Statement that it intends to conduct a post-implementation review of the revised IFRS 3, which will include an assessment of the NCI option.

Comprehensive example

This example is based on the example included in paragraphs IE45-IE49 of the Illustrative Examples accompanying IFRS 3. The example shows the impact of measuring NCIs under the two approaches permitted by the revised IFRS 3. It also illustrates how the business combination is accounted for and incorporates a 'bargain purchase', to illustrate all the concepts discussed above.

Entity AC acquires an 80% interest in Entity TC for $150 million on 1 January 20X5. Due to an urgent sale need, the vendors of TC accept a lower price than if a full market auction had occurred. The fair value of TC's identifiable assets are $250 million and its liabilities are measured at $50 million. An independent consultant values the 20% NCI at $42 million.

The business combination is accounted for as follows under each approach:

$million NCI at fair value NCI based on net identifiable assets
Total value of the business combination:
- fair value of consideration transferred
- amount of NCI recognised

150
42

150
40
  192 190
Fair value of the net assets acquired:
- assets
- liabilities

250
(50)

250
(50)
  200 200
Gain on bargain purchase of 80% interest 8 10
Amounts recognised in the consolidated balance sheet:
- fair value of net assets acquired
- NCI


200
42


200
40
Contingent consideration

The revised IFRS 3 generally requires all aspects of a business combination to be measured at fair value at the acquisition date, including contingent consideration. 

Although the revised IFRS 3 retains a maximum 12-month 'measurement period' during which certain changes in values can be recognised against the original acquisition, subsequent changes outside this period in the value of contingent consideration (and the other aspects of a business combination) are accounted for separately from the business combination.  This will generally mean that changes in contingent consideration will be recognised in the profit and loss.  Contingent consideration will be treated as a financial instrument under IAS 32 Financial Instruments: Presentation and IAS 39 Financial Instruments: Recognition and Measurement, unless another accounting standard is applicable.

This new approach will represent a significant change to the manner in which contingent consideration is currently treated - where adjustments to the initial accounting for the business combination for changes in contingent consideration can be made at any time.  Importantly, contingent consideration arising in relation to business combinations that occur prior to the initial application of the revised IFRS 3 will continue to be accounted for under the existing IFRS 3, meaning that retrospective adjustments to the initial accounting for these business combinations will still be possible.

Determining what is part of the business combination

General principle

The revised IFRS 3 only permits consideration transferred for the acquiree, along with the assets acquired and liabilities assumed or incurred in the exchange for the acquiree, to be taken into account in the initial accounting for the business combination using the acquisition method.

All other transactions are to be accounted for separately from the business combination in accordance with relevant IFRSs and not taken into account in the measurement of goodwill. Many of these other transactions will lead to the recognition of an expense.

With some important exceptions, such as the expensing of transaction costs, the revised IFRS 3 effectively provides additional guidance on accounting under the existing IFRS 3.  The level of guidance and specific requirements might be seen by some as a set of 'rules' on how to apply the basic principles already established.  However, the additional guidance may potentially make it more difficult to adopt other approaches under the current IFRS 3 in matters now 'clarified' in the revised Standard - such as in relation to the settlement of pre-existing contracts and certain replacement share-based payment awards.
Acquisition related costs

The revised IFRS 3 requires that all transaction costs be accounted for separately from the business combination.  All acquisition-related costs are required to be recognised as expenses, except where they relate to debt or equity securities, in which case they are recognised in accordance with IAS 32 Financial Instruments: Presentation and IAS 39 Financial Instruments: Recognition and Measurement.

Acquisition costs that would be expensed include:

  • finder's fees
  • advisory, legal, accounting, valuation, and other professional or consulting fees
  • general administrative costs, including the costs of maintaining an internal acquisitions department.

Stamp duties

In the Australian context, the question of the treatment of stamp duty arising in business combinations arose as part of the initial consideration of the 2005 exposure drafts. Stamp duty is an unavoidable cost that must be paid by any buyer, so is conceptually different from the examples noted above as those vary from buyer to buyer and are paid in exchange for services received (which are the basis of some of the arguments for treating these separately from the business combination noted by the IASB).

Stamp duty is also necessarily incurred as part of the 'consideration transferred' in exchange for the acquiree and economic theory may indicate that the fair value of businesses might increase in the absence of stamp duties. Furthermore, stamp duties cannot be avoided and there is no 'service received' (in a normal sense) from the payment of stamp duty.

Therefore, there were differing views at the time of the 2005 exposure drafts as to whether stamp duties should be considered 'acquisition-related costs' (and so expensed) or as part of the 'consideration transferred' (and so taken into account in determining the fair value of the acquiree). Similar issues may arise where GST paid is not refundable.

In our submission to the AASB on the 2005 exposure drafts, we sought clarification of the treatment of stamp duty and other transaction taxes or government imposts arising in business combinations. Whilst the issue has not been specifically addressed in the revised IFRS 3 and therefore may be considered somewhat uncertain, the reference to the requirement to expense acquisition-related costs "in the periods in which the costs are incurred and the services are received" might imply that these amounts should be expensed.

Pre-existing relationships

Existing relationships between the acquirer and acquiree must be accounted for separately from the business combination.  In most cases, this will lead to the recognition of a gain or loss for the amount of the consideration transferred to the vendor which effectively represents a 'settlement' of the pre-existing relationship. 

The amount of the gain or loss is determined as follows:

  • for pre-existing non-contractual relationships (e.g. a lawsuit) - by reference to fair value
  • for pre-existing contractual relationships - the lesser of:
    • the favourable/unfavourable contract position, and
    • any stated settlement provisions in the contract available to the counterparty to whom the contract is unfavourable.

However, where the transaction effectively represents a reacquired right, an intangible asset is recognised and measured on the basis of the remaining contractual term of the related contract excluding any renewals.  The asset is then subsequently amortised over the remaining contractual term, again excluding any renewals.  This applies even though a third party may consider potential contract renewals in determining the fair value of the right.  This is effectively a codification into both IFRS and US-GAAP of EITF Issue No. 04-1, Accounting for Preexisting Relationships between the Parties to a Business Combination, although that EITF did not explicitly deal with amortisation.

However, if the reacquired right contains terms that are favourable or unfavourable relative to the terms of current market transactions for the same or similar items, a settlement gain or loss is recognised in the same way as for other pre-existing contractual relationships.

Simplified example - pre-existing contract

This example is based on the example included in paragraphs IE54-IE57 of the Illustrative Examples accompanying the revised IFRS 3.

AC acquires TC in a business combination. A number of years prior to the business combination, AC and TC entered into a contract whereby AC purchased electronic components from TC at fixed rates. The fixed rates under the contract are higher than the rates at which AC could purchase similar electronic components from another supplier. The original contractual period was five years and there are three years remaining in the initial period of the contract at the time of the acquisition, although AC has the right to terminate the contract by paying a $6 million penalty.

Included in the total fair value of TC is an $8 million amount related to the supply contract with TC. $3 million of the amount relates to the contract 'at market' (selling effort, customer relationships and so forth) and the remainder represents the 'above market' value of the contract.

AC recognises a loss of $5 million, being the lesser of the 'above market' rates under the contact and the amount that could be paid to exit the contract (which is $6 million). The remaining $3 million of the contract is recognised as part of goodwill.


Simplified example - reacquired right

This example is based on an example in the discussion paper considered by the IASB and FASB when determining the approach to reacquired rights. A copy of this discussion paper can be found here.

Acquirer Co. grants a franchise right to Target Co. to operate under Acquirer Co.'s name in the northeast region of the country in which it operates. Two years later, Acquirer Co. decides to expand its business and enters into an agreement to acquire Target Co for $50,000. Target Co.'s business consists of the franchise right (fair value $20,000), a customer list (fair value $10,000), some operating assets and liabilities (net fair value $15,000), an assembled workforce (recognised as part of goodwill), and processes. At the time of the acquisition, the franchise right is at market terms (therefore, Acquirer Co. would not recognise an off-market settlement gain or loss). Assume that the franchise right has a fixed term and is not renewable.

Under the revised IFRS 3, Acquirer Co. will recognise an intangible asset for the reacquired franchise right at its fair value of $20,000. This right will be amortised over the remaining term of the franchise agreement.

Replacement share-based payment awards

The revised IFRS 3 introduces a number of examples and guidelines for when to treat particular replacement share-based payment awards as part of the cost of the combination and when to treat amounts as employee compensation.

Where the acquirer is obliged to replace the acquiree's awards, either all or a portion of the market-based measure of the acquirer's replacement awards is included in measuring the consideration transferred in the business combination.

The portion of the replacement award attributable to pre-combination service is the 'market-based measure' (determined in accordance with IFRS 2 Share-based Payment) of the acquiree award multiplied by the ratio of the portion of the vesting period completed to the greater of the total vesting period or the original vesting period of the acquiree award. This may be represented in formula form as follows:

Portion attributable to pre-combination service  Market-based measure of acquiree award 
Portion of vesting period completed
Greater
of
 
Total vesting period
and
Original vesting period of the acquiree award 

The amount attributable to post-combination service, and so recognised as remuneration cost in the post-combination financial statements, is determined as the difference between the market-based measure of the acquirer's replacement award, less the amount determined from the formula above.

In applying these requirements, the best estimate of the number of replacement awards that are expected to vest are taken into account in the measurement of the consideration transferred in the business combination. Subsequent 'true ups' of the amount are accounted for in accordance with IFRS 2 Share-based Payment and are not adjusted against the initial accounting for the acquisition.

The examples below illustrate how these requirements are applied in practice.

These guidelines effectively represent 'rules' as to how to account for share-based payments arising in the context of a business combination.  The following are some examples of these 'rules':

  • the excess of the market-based measure of an acquirer's awards over the market-based measure of the acquiree's awards (at the time of the combination) is expensed, such an expense being recognised immediately if there is no further service period
  • replacement awards are expensed over the total service period if the service period of the acquirer's awards are longer than the acquiree's original awards
  • replacement awards that do not require post-combination service can result in a compensation expense if the original awards had not vested
  • if the acquiree's awards expire as a consequence of a business combination and the acquirer replaces those awards even though it is not obliged to do so, all of the market-based measure of the replacement awards is recognised as remuneration cost in the post-combination financial statements.

Example

Entity M acquires Entity N in a business combination. As part of the business combination, M agrees to replace N's existing options on issue to its employees with its own options which vest immediately. N's employees have already served the required service to earn their rewards. At the acquisition date, the market-based measures of the replaced award and replacement awards were $100,000 and $110,000 respectively.

The amount attributable to pre-combination service and so taken into the determination of goodwill is the market-based measure of N's awards ($100,000). The amount attributable to post-combination service is $10,000, being the excess of the market-based measure of M's awards ($110,000) over N's replaced awards ($100,000). As there is no service period for M's replacement awards, the $10,000 is expensed in post-combination profits immediately. This expense is recognised even though N's replaced options had already vested at the acquisition date.


Example

Entity P acquires Entity Q in a business combination. As part of the business combination, P issues replacement awards to Q's employees that had no service period. Q's original awards had a service period of four years but only two had been served at acquisition date. The market-based measure of P's replacement awards and Q's replaced awards are both $140,000 at the acquisition date.

In this case, 50% of the value of the replaced awards (being $70,000) would be recognised as a post-combination expense, even though the replacement awards have no service period. The amount of replacement awards attributable to pre-combination services equals the market-based measure of Q's award ($140,000) multiplied by the ratio of the pre-combination service period (two years) to the greater of the total service period (two years) or the original service period of Q's award (four years).

Intangible assets

The revised IFRS 3 changes the recognition criteria for intangible assets acquired in a business combination.  All acquired intangible assets are required to be recognised separately from goodwill - accordingly, it is presumed that the fair value of every intangible asset acquired in a business combination can be measured reliably.

The recognition and measurement of intangible assets is one of the most difficult areas of the existing IFRS 3 to apply in practice.  Valuation practices have developed over time and their interpretation and implementation remains varied.  However, it is clear that the challenge of identifying and measuring intangible assets will need to be more rigorous under the revised IFRS 3.

During 2007, the International Valuation Standards Committee (IVSC) released a Discussion Paper Determination of Fair Value of Intangible Assets for IFRS Reporting Purposes. This Discussion Paper works through a consideration of technical valuation issues and available valuation methods and sets out a proposed approach to the selection of valuation methods and application guidance. A copy of the Discussion Paper can be downloaded from IAS Plus (PDF 916kb).

Changes in ownership interests

Basic principle

Consistent with the view that a change in control (either a gain or a loss) is a significant economic event, the revised IFRS 3 and IAS 27 consider that only the gaining or losing of control should trigger a remeasurement.  Therefore, in overview terms:

  • changes in ownership interests where control is retained do not trigger any remeasurements
  • the gaining or losing of control will trigger a remeasurement of any existing or retained ownership interest to fair value.
Changes in ownership interests where control is retained

The revised IAS 27 requires changes in a parent's ownership interest in a subsidiary that do not result in a loss of control to be accounted for as equity transactions, i.e. transactions with owners acting in their capacity as owners.

The revised IAS 27 will introduce for the first time IFRS requirements around these types of transactions.  Currently, there are numerous approaches suggested as to how to account for changes in ownership interests in this situation.

The effects of the new requirements are as follows:

  • changes in ownership interests will not change the carrying amounts of any assets or liabilities in the balance sheet, including goodwill
  • in the case of the additional purchase of ownership interest, the difference between the amount paid and the existing carrying amount of the NCI will give rise to an amount recognised directly in equity
  • similarly, other changes in ownership interests will always give rise to amounts recognised directly in equity
  • no amount will be recognised in the income statement as a result of a change in ownership interest in a subsidiary while control over that subsidiary is retained.

Because entities have a choice in how to initially measure the NCI's interest at the time of the business combination occurring (as discussed above), this also has impacts on the amount recognised in equity in any subsequent acquisition.  In effect, electing to measure NCI on the basis of the NCI's proportionate share of net identifiable assets will result in the NCI's share of goodwill being recognised as a debit directly in equity where the NCI is subsequently acquired.

Because of the above effect, we expect that many entities will choose to measure NCI on the basis of the NCI's proportionate share of the acquiree's net identifiable assets. Because the revised IFRS 3 focuses on changes in control as the significant event, the date that control is achieved may in some instances precede the date that an acquisition is finalised, e.g. an on-market takeover where control is obtained and the offer becomes unconditional, but the entity continues with the offer and subsequently achieves full control. Depending upon how IAS 27 and IFRS 3 are interpreted, this may also provide the opportunity for some amount of the goodwill in the transaction to be effectively treated as an equity transaction.

Similar outcomes may also result with tax-consolidation resets that arise on moving to full control after the initial acquisition of a controlling interest in a subsidiary - these might arguably result in the recognition of a gain in the income statement or alternatively, be included in the amount recognised directly in equity on application of IAS 27.

 

Example

Entity F acquires 80% of Entity G for $1,000, being the fair value of the consideration transferred. The fair value of net assets acquired was $1,000. The fair value of the NCI at the acquisition date is $250. F subsequently acquires the remaining 20% interest in G from the NCI for $450. FV of net assets at that date is $1,500 (20% equates to $300). For the purposes of this example, the impacts of post-acquisition profits and other reserve movements of G are ignored, as are any deferred tax implications.

Under the revised IAS 27, the acquisition of the remaining 20% interest is treated as an equity transaction. Accordingly, there is no effect on the net assets recognised from the original acquisition. The amount recognised directly in equity depends on the entity's choice as to how to account for NCI resulting from the acquisition, i.e. at fair value or based on the net assets of G's identifiable net assets.

If NCI is measured at fair value, goodwill arising is determined as the aggregate of the consideration transferred ($1,000) and the fair value of the NCI at the acquisition date ($250), less the fair value of the identifiable net assets acquired ($1,000), being $250. The amount attributable to the NCI is 20% of the net assets acquired ($200) plus the NCI's share of the goodwill ($50, being $250 fair value, less goodwill attributable to the controlling interest of $200) for a total amount of $250. On acquisition of the NCI, an amount of $450 is paid for the NCI of $250, leading to a debit reserve of $200 ($450 - $250).

If NCI is measured based on identifiable net assets, goodwill arising is determined as the aggregate of the consideration transferred ($1,000) and the recognised amount of the NCI at the acquisition date ($200, being 20% of $1,000), less the fair value of the identifiable net assets acquired ($1,000), being $200. On acquisition of the NCI, an amount of $450 is paid for the NCI of $200, leading to a debit reserve of $250 ($450 - $200). The table below illustrates the different outcomes that can result:

  NCI at fair value NCI at net asset value
80% 100% 80% 100%
Net identifiable assets acquired
Goodwill arising in the combination
Entity F's other assets (including cash)
1,000
250
2,000
1,000
250
1,550
1,000
200
2,000
1,000
200
1,550
Consolidated net assets 3,250 2,800 3,200 2,750
Non-controlling interest
Reserves
Other equity
250
-
3,000
-
(200)
3,000
200
-
3,000
-
(250)
3,000
Total equity 3,250 2,800 3,200 2,750

The difference between these two methods is that the NCI's share of goodwill is fully recognised as an asset where the fair value basis is adopted, but effectively subsumed into the amount debited directly to equity where the NCI is determined by reference to the identifiable net assets.

Under the current IAS 27, there is no guidance as to how to account for the transaction, and numerous methods have been suggested by accounting professionals, some of which have greater support than others. These alternative approaches result in various combinations of the following:

  • a change to the amount of goodwill recognised
  • changes in the recognised values of other assets and liabilities
  • recognition of some proportion of the amount paid to the NCI directly in reserves.

It is clear that the change in approach introduced by the revised IAS 27 will have a significant impact in accounting for these types of transactions.

Loss of control

The revised IAS 27 introduces requirements on accounting for the loss of control of a subsidiary - including:

  • requiring all relevant reserves to be recycled when a loss of control occurs, e.g. foreign exchange differences, hedging and available-for-sale reserves
  • requiring any remaining ownership interest to be initially measured at fair value at the date that control is lost
  • providing guidance when a series of transactions might be to be viewed as 'linked' such that the effects of the transactions are considered together when accounting for the loss of control.

The revised IAS 27 does not explicitly deal with how the effects of a loss of control that occurs as a result of a demerger or in-specie distribution should be accounted for as part of the deconsolidation process. The IASB decided not to deal with this issue as part of the Business Combinations Phase II project at its March 2007 meeting (Deloitte observer notes from this meeting are available on IAS Plus). However, IFRIC currently has an active project on accounting for non-cash distributions (IAS Plus project page) and the IASB decided at its December 2007 meeting to include consideration of demergers and spin-offs within its new project on common control transactions (meeting summary, IAS Plus project page).

The introduction into the revised IAS 27 of guidance as to when a series of transactions are to be viewed as 'linked transactions' when accounting for a loss of control is likely to be applied much more widely, much in the same way as the guidance on 'commercial substance' in IAS 16 Property, Plant and Equipment.

Other changes

The revised Standards also contain a number of other changes in accounting for business combinations and consolidation, the impacts of which will vary between entities and transactions.

Some of the more significant changes include:

  • business combinations involving mutual entities or by contract alone have been brought into the scope of the revised IFRS 3 - such transactions will need to be accounted for fully in accordance with the revised Standard
  • the definition and guidance around what constitutes a 'business' and a 'business combination' has been amended - this may impact the classification of some transactions in some marginal circumstances
  • the measurement of some particular categories of acquired assets and liabilities has been clarified, e.g. in relation to operating leases, valuation allowances, assets not expected to be used by the acquirer, embedded derivatives, etc
  • the post-combination recognition of deferred tax assets acquired in a business combination will no longer result in an adjustment to goodwill where it occurs outside the 'measurement period' (this change will apply to all business combinations, not just those occurring after application of the revised IFRS 3)
  • new requirements around indemnification assets related to a business combination have been introduced - measurement will be consistent with the assumptions used in the measurement of the related liability
  • losses are attributed to the non-controlling interest even if this results in the non-controlling interest having a debit balance - this is currently prohibited unless the NCI has a binding obligation and is able to make an additional investment to cover the losses
  • consequential amendments have been made to numerous Standards to be consistent with the new requirements and terminology in the revised IFRS 3 and IAS 27 - in some cases, new requirements have been introduced such as a requirement to fair value retained interests on loss of joint control or significant influence (IAS 28 and IAS 31), how to treat reserve amounts on a partial disposal of an interest in a foreign operation (IAS 21) and the impact of the measurement basis for non-controlling interests on impairment testing (IAS 36)
  • new and amended disclosure requirements have been introduced - many of which relate to other significant changes implemented by the revised Standards, with new requirements around contingent consideration, transactions related to business combinations, non-controlling interests, step acquisitions, gain/losses on loss of control of a subsidiary and deferred tax assets.

Transitional requirements

The revised IFRS 3 and IAS 27 must be applied to annual reporting periods beginning on or after 1 July 2009.

With some exceptions, IFRS 3 must be applied prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after 1 July 2009.

The requirements of the revised IAS 27 must be applied retrospectively, with the following exceptions:

  • profit and loss attributed to non-controlling interests is not restated to take into account losses that would have resulted in a deficit balance of NCI
  • the pre-transition treatment of changes in ownership interests in a subsidiary after control is obtained is not adjusted to accord with the new requirements
  • pre-transition transactions that resulted in the loss of control of a subsidiary are not restated.

The effects of the exceptions to the general retrospective requirements of the revised IAS 27 is that the new requirements around changes in ownership interests and non-controlling interests are also applied on a prospective basis.

The acquisition date determines which version of IFRS 3 to apply. If the acquisition date is on or after the beginning of the annual reporting period during which the revised IFRS 3 is first applied (1 July 2009 for entities with June year ends), then the new Standards must be applied in full to the transaction.

Where the acquisition date is before the beginning of the annual reporting period during which the revised IFRS 3 is first applied, the existing IFRS 3 is applied and the amendments to IAS 27 are ignored. Therefore, these transactions are accounted for under the existing requirements and this accounting is not adjusted on transition (e.g. including for capitalised acquisition costs, pre-transition changes in ownership interests, the determination of NCIs, gains/losses on disposal of subsidiaries, etc). Similarly, contingent consideration adjustments that arise after the date of transition would be adjusted against the initial accounting for the business combination, because the old IFRS 3 required this treatment.

However, the new requirements are applied to post-transition changes in ownership interests and changes in deferred taxes, where these occur after the mandatory application date, but they do apply to all post-transition transactions that relate to business combinations no matter when they occurred..

For example, if an additional interest was purchased in a partly owned subsidiary where control was obtained prior to 1 July 2009 (for a June reporting entity), the purchase of the additional interest would be accounted for as an equity transaction, regardless of how the original acquisition was accounted for or whether there had been earlier step acquisitions.

Specific transitional provisions override the requirements of the old IFRS 3 in relation to deferred taxes, meaning that no goodwill adjustments can be made where deferred taxes arising in a pre-transition business combination are recognised for the first time after the beginning of the annual reporting period in which the revised Standard is applied.

There are also specific transitional provisions in relation to entities (such as mutual entities) that have not yet applied IFRS 3 and had one or more business combinations that were accounted for using the purchase method.

The requirements of IFRS 3 and IAS 27 can be early adopted, but only to the beginning of an annual reporting period that begins on or after 30 June 2007.

Action points

The following action points should be considered as part of the planning for implementation of the revised IFRS 3 and IAS 27 (and their forthcoming Australian equivalents) and their further pre-implementation impacts.

Existing accounting policies
  • how do our existing accounting policies compare with those required by the revised Standards, particularly in those areas where the revised Standards provide more guidance on the requirements of the existing Standards?
  • how will the transitional provisions impact us? Although most requirements are prospective to post-transition combinations, retrospective application is required some areas, such as post-transition changes in ownership interests and adjustments to deferred tax assets relating to pre-transition date combinations that occur after the initial application of the Standard
  • should any of our existing accounting policies be changed to align with the new requirements, before the adoption of the revised Standards (where permitted under the existing Standards)?
Planning
  • how will the proposals impact mergers and acquisitions that are currently being contemplated?
  • what training is required within the organisation to ensure that all personnel involved in business combinations are aware of the impacts of the new requirements?
  • how does the new Standard affect our long-term strategy? Should possible merger and acquisition transactions be brought forward or deferred?
Impacts
  • how does the new Standard impact deal metrics - particularly those items that may lead to post-combination expenses such as share-based payment arrangements, existing contracts and so on? Taking these effects into account in early in the deal cycle can avoid unpleasant surprises later in the deal process when terms and arrangements may be difficult to change
  • what changes are necessary in our budgeting and forecasting systems, including those used for the evaluation of possible merger and acquisition activity?
  • how do the new requirements interact with the tax regimes in which the entity operates? In the Australian context, different outcomes may result under the revised Standards and the tax consolidation regime
  • are amendments to our systems required to accommodate the new requirements? Are our systems sufficiently flexible to allow for different methods of accounting in different accounting periods?
  • given the higher emphasis on fair value in the revised Standards, what valuation resources and assistance will be required?
Opportunities
  • what approach to the measurement of non-controlling (minority) interests should be adopted (transaction by transaction approach)? Does this choice allow us any flexibility in accounting going forward?
  • is early adoption attractive? Some transactions may be more favourably reported under the revised Standards.

More information

For more information on the revised IFRS 3 and IAS 27, see the following:

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