UK: Financial Reporting - IFRS - Business Combinations – A New Model

Last Updated: 20 March 2008
Article by Yvonne Lang

Recent revisions to IFRS 3 and IAS 27 mean that changes will be required to long-established accounting treatments and could affect the structure of future acquisitions.

The revised versions of IFRS 3 ‘Business combinations’ and IAS 27 ‘Consolidated and separate financial statements’ were issued at the beginning of the year. They are set not only to change long-established accounting practice, but also the shape of future acquisitions. The revisions mark the culmination of a joint project between the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) and, while there is considerable convergence, some differences remain. As a consequence there could still be significantly different financial reporting between companies applying IFRS and US GAAP.

Both standards come into effect for periods that begin on or after 1 July 2009. While it is possible to adopt for earlier periods, both standards must be adopted together and the revised standards cannot be implemented for periods beginning before 30 June 2007.

Measuring the cost of the business combination

As with the existing version of IFRS 3, consideration in a business combination is measured at fair value at the acquisition date. However, the revised version concentrates on what the vendor receives rather than what the acquisition costs the acquirer. Acquisition costs, such as legal and advisory fees, which have historically been included as part of the purchase consideration and, therefore, within the calculation of goodwill, will, in future, be recognised in the income statement in the period they are incurred.

Contingent consideration arrangements, such as earn-outs, are common to many acquisition agreements. While the fair value of such arrangements will continue to be included as part of the cost of the business combination, subsequent adjustments will be accounted for very differently. Adjustments are currently applied by amending the goodwill figure but, in future, they will need to be dealt with in the income statement.

Provisional fair values

At the date of acquisition, companies need to assess the fair value of the assets and liabilities acquired. Where it is not possible to make a definite assessment, companies can attribute provisional values and agree final figures within 12 months from the date of acquisition. None of this is new. However, whereas previously any adjustments to fair values were accounted for as adjustments in the period in which they were identified, under the revised IFRS 3, they will have to be treated as prior period adjustments and comparatives restated.

Non-contractual customer relationships

What might seem to be a small change in wording within the illustrative examples could have significant implications with respect to the recognition of intangible assets. Intangible assets are recognised if they arise either from a contract or are separable for non-contracted customer relations. The current wording in IFRS 3 implies that evidence of separability exists where there has been an exchange transaction for the same or similar assets. In the revised version, extension of this criteria to evidence that "other entities" have sold or transferred such assets significantly widens the scope and hence the likelihood that such relations will need separate recognition.

The demise of minority interests

Once the new standard comes into effect, the term ‘minority interest’ will be banished to the history books in so far as IFRS is concerned and will be replaced by ‘non-controlling interests’.

It is not only the name that is changing, but potentially the accounting treatment as well. Currently, at acquisition, the non-controlling interest is calculated by reference to the proportionate share of the identified net assets of the acquired entity. In what may seem an unusual move, the IASB is now offering companies a choice of how they account for their noncontrolling interests at the point control is obtained. As part of the convergence with US GAAP, the revised IFRS 3 introduces the option, on a transaction by transaction basis, to measure the non-controlling interest at fair value (US GAAP permits only fair value). In circumstances where the shares are actively traded, this fair value would be measured by reference to market value. Otherwise, a valuation technique would need to be applied.

Step acquisitions

The majority of business combinations arise in circumstances where the interest goes from 0% to 100% in one go. However, this is not always the case and accounting for so-called ‘step acquisitions’ has always left preparers reaching for their textbooks. However, the position is set to become easier as the IASB has sought to simplify the requirements. Where an entity goes from having an interest in a company (whether investment, associate or joint venture) to a position of obtaining control of that company, it will be required to re-measure to fair value its original investment. This fair value will form part of determining the total consideration given for the acquisition. To the extent that there is a gain or loss on the re-measurement, it will need to be included within the income statement.

However, once control has been obtained, further increases or decreases in ownership interest are treated as transactions with shareholders and recorded in equity. It will not be necessary to re-measure to fair value each time.

Consequential amendments to IAS 27

Certain amendments have also been made to IAS 27, primarily to reflect the new approach to changes in controlling and non-controlling interests.

Changes in a parent entity’s interest that do not result in a change of control are dealt with within equity and no adjustment is made to goodwill. When control is lost, all assets, liabilities and non-controlling interests are derecognised. Any interest that remains is recognised at its fair value on the date that control was lost.

There are also consequential amendments to both IAS 28 ‘Investments in associates’ and IAS 31 ‘Interests in joint ventures’. Where an entity ceases to have significant influence over an associate, it derecognises the associate. It also includes in the income statement the difference between the proceeds received and any retained interest and the carrying amount of the associate at the date significant influence was lost.

Smith & Williamson commentary

With the revised IFRS 3, we see a number of areas that will make understanding the cost and effect of acquisitions more difficult. In addition, greater volatility of reported earnings is highly likely, particularly in very acquisitive companies. For example, take the position of a company that makes acquisitions on a regular basis. If it also usually attributes provisional fair values, then there is the very real prospect of year upon year of prior period adjustments.

As well as introducing volatility in earnings, the change in treatment of contingent consideration is likely to lead to some interesting discussions between entities and their auditors. Companies will want to avoid unpredictable ‘costs’ in the income statement and this could lead to conflict with the requirement that deferred consideration be reflected at fair value.

Equally, the writing off of often substantial acquisition costs before the company has the benefit of the associated business activity, could result in not only volatility of results, but also impact on distributable profits.

All of these issues are likely to lead companies to look long and hard at the way in which deals are structured and their professional advisers are remunerated.



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