IFRS 3

Overview

Business combinations are becoming increasingly complex. The nature of the purchase consideration and legal form are often driven by financial and tax features. Structures have to be carefully modelled to ensure that transactions optimise post-acquisition earnings, and enable the company’s strategic business objectives to be met.

Reverse takeovers allow private entities to obtain public listings. Business combinations can be consummated using successive share purchases, and the use of earn-out models to tie vendors to the future success of acquired entities, further add to the complexities of financial reporting.

Modern accounting requirements emphasise the importance of disaggregating goodwill into identifiable intangible assets, reflecting the move towards a more knowledge based economy where intangible assets, such as brands, are key assets.

Intangible assets represent an increasingly important economic resource. They may have a short life, though, and their ammortisation may dilute earnings in the short term.

Users should carefully review the financial statement disclosures on business combinations. Extensive disclosures should allow the users of financial statements to understand the effect of business combinations in a period, and should improve the predictive value of financial information.

Treatment of investments by a Parent Company

The flowchart below summarises the interaction between the different IFRS standards for different levels of involvement of an investee company:

IFRS 3: Business Combinations

A business combination is an event in which an acquirer obtains control of one or more businesses. Transactions sometimes referred to as ‘true mergers’ or ‘mergers of equals’ are also business combinations.

Business combination achieved in stages are known as ‘step acquisitions’.

Business combinations are accounted for using the acquisition method

Goodwill, in a business combination, is measured as the excess of the aggregate of:

• the fair value of consideration transferred,
• the non-controlling (minority) interest, and
• the acquisition date fair value of any previously held equity interest in the acquiree,

Over the:

• net of the acquisition date amounts of the identifiable net assets of the acquiree.

The non-controlling (minority) interest is measured at acquisition either at: fair value, of the NCI’s proportionate share of the fair value of the net assets of the acquiree.

Single-Entity Concept

In a straightforward business combination one entity acquires another, resulting in a parent (P) - subsidiary (S) relationship.

The underlying concept behind consolidation is the single-entity concept where P and S are treated as one single entity.

Because of the single-entity concept, any intra-group balances and transactions should be cancelled out on consolidation, including:

• Current accounts
• Intra-group loans
• Intra-group trading and unrealised profits
• NCA transfer PURPs

Out of Scope

The IFRS 3 standard does not apply to:

• The formation of a joint venture
• The acquisition of an asset or group of assets that is not a business
• Acquisitions by an investment entity of a subsidiary that is required to be measured at fair value through profit or loss under IFRS 10 Consolidated Financial Statements (e.g. investment entities)
• Combinations of entities or businesses under common control

Is a transaction a business combination?

The standard provides additional guidance on determining whether a transaction meets the definition of a business combination. This includes:

• Business combinations can occur in various ways, such as by transferring cash, incurring liabilities, issuing equity instruments (or any combination thereof), or by not issuing consideration at all (i.e. by contract alone)
• Business combinations can be structured in various ways to satisfy legal, taxation or other objectives, including one entity becoming a subsidiary of another, the transfer of net assets from one entity to another or to a new entity
• The business combination must involve the acquisition of a business, which generally has three elements:
  • Inputs – an economic resource (e.g. non-current assets, intellectual property) that creates outputs when one or more processes are applied to it
  • Process – a system, standard, protocol, convention or rule that when applied to an input or inputs, creates outputs (e.g. strategic management, operational processes, resource management)
  • Output – the result of inputs and processes applied to those inputs.

Acquisition Method

Steps in applying the acquisition method, under IFRS 3, should be as follows:

1. Identification of the ‘acquirer’
2. Determination of the ‘acquisition date’
3. Recognition and measurement, at their fair value, the identifiable assets acquired (including internally generated intangibles such as brand names), liabilities assumed (including contingent liabilities if they can be reliably measured), and any non-controlling interest in the acquiree
4. Recognition and measurement of goodwill or a gain from a bargain purchase

Identifying an acquirer

The guidance in IFRS 10 Consolidated Financial Statements is used to identify an acquirer in a business combination, i.e. the entity that obtains ‘control’ of the acquiree.

If the guidance in IFRS 10 does not clearly indicate which of the combining entities is an acquirer, IFRS 3 provides additional guidance which is then considered:

• The acquirer is usually the entity that transfers cash or other assets where the business combination is effected in this manner
• The acquirer is usually, but not always, the entity issuing equity interests where the transaction is effected in this manner, however the entity also considers other pertinent facts and circumstances including:
  • Relative voting rights in the combined entity after the business combination
  • The existence of any large minority interest if no other owner or group of owners has a significant voting interest
  • The composition of the governing body and senior management of the combined entity
  • The terms on which equity interests are exchanged
• The acquirer is usually the entity with the largest relative size (assets, revenues or profit)
• Business combinations involving multiple entities, consideration is given to the entity initiating the combination, and the relative sizes of the combining entities.

Reverse Acquisitions

IFRS 3 also addresses certain types of acquisitions, known as reverse takeovers

This is where Company A acquires ownership of Company B through a share exchange (For example, a private entity may arrange to have itself acquired by a smaller public entity as a means of obtaining a stock exchange listing)

The number of shares issued by Company A to Company B is so great, that control of the combined entity after the transaction is with the shareholders of Company B.

Legally, though Company A maybe regarded as the parent company, IFRS states that it is Company B shareholders who control the combined entity, and Company B should be treated as the acquirer.

Company B should apply the acquisition method to the assets and liabilities of Company A

Step acquisitions

Prior to control being obtained, an acquirer accounts for its investment in the equity interests of an acquiree in accordance with the nature of the investment by applying the relevant standard, e.g. IAS 28 Investments in Associates and Joint Ventures (2011), IFRS 11 Joint Arrangements, or IFRS 9 Financial Instruments.

As part of accounting for the business combination, the acquirer remeasures any previously held interest at fair value and takes this amount into account in the determination of goodwill. Any resultant gain or loss is recognised in profit or loss or other comprehensive income as appropriate.

Contingent consideration

Contingent consideration must be measured at fair value at the time of the business combination and is taken into account in the determination of goodwill.

If the amount of contingent consideration changes as a result of a post-acquisition event (such as meeting an earnings target), accounting for the change in consideration depends on whether the additional consideration is classified as an equity instrument or an asset or liability:

• If the contingent consideration is classified as an equity instrument, the original amount is not remeasured
• If the additional consideration is classified as an asset or liability that is a financial instrument, the contingent consideration is measured at fair value and gains and losses are recognised in either profit or loss or other comprehensive income in accordance with IFRS 9 Financial Instruments
• If the additional consideration is not within the scope of IFRS 9, it is accounted for in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets or other IFRSs as appropriate.

Where a change in the fair value of contingent consideration is the result of additional information about facts and circumstances that existed at the acquisition date, these changes are accounted for as measurement period adjustments if they arise during the measurement period.

Acquisitions Costs

These costs should not form part of the consideration or the calculation of goodwill.

Instead, all finders’ fees, legal, accounting, valuation and other professional fees must be expensed through the profit or loss.

Costs incurred to issue securities should be dealt with in accordance with IFRS 9.

Pre-existing relationships and re-acquired rights

If the acquirer and acquiree were parties to a pre-existing relationship (for instance, the acquirer had granted the acquiree a right to use its intellectual property), this must 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 measured as follows:

• for pre-existing non-contractual relationships (for example, a lawsuit): by reference to fair value
• for pre-existing contractual relationships: at the lesser of (a) the favourable/unfavourable contract position and (b) 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.

Further Information