IFRS 3 - Business Combination (detailed review)
This standard prescribes the guidelines to enhance the relevance, reliability and comparability of the financial information reflected by the acquirer in its consolidated financial statements in respect of a business combination. To achieve the objective, this standard provides the accounting requirements for:
- The recognition and measurement of identifiable assets and liabilities of the acquiree along with valuation of non-controlling interest
- The determination of goodwill or bargain purchase gain relating to the business acquired
- The related disclosures required to enable the users of financial statements to analyze the effects of business combination
The requirements of this standard are applicable to the transactions which meet the definition of business combination as defined in this standard. However, this standard is not applicable to the following:
- The arrangements which are classified as joint arrangements as per IFRS 1: Joint Arrangements
- The purchase of an acquiree by the investment entity as defined in IFRS 10: Consolidated Financial Statements and which is measured at fair value through profit or loss
- The combination of entities which are under common control before and after the business combination
- The transaction in which acquiree is not a business
Identifying a Business Combination
The entity will identify the transaction as a business combination, if it entails all of the following:
- Acquiree meets the definition of ‘Business’ as defined in this standard
- There must be an absolute ‘Acquirer’ in the business combination
- The transaction results in ‘Control’ of one entity over another entity
In order to qualify as a business combination transaction, the acquiree should meet the definition of business as defined in this standard:
- Business is an interrelated set of activities which must have three essential elements:
- Inputs (which are used to produce output such as plant and machinery, infrastructure, human resource, intellectual property or materials)
- Process (it encompasses the techniques, procedures or methods to be applicable to the input to produce output)
- Output (the ultimate produce of the input and process which generates economic benefits)
- The acquiree may be a business activity under development or it may be a ceased activity but it contains the three essential elements of business as mentioned above.
- If in a transaction, acquiree does not meet the definition of ‘Business' such transaction is referred as ‘Asset Acquisition’ and in such circumstances whatever the cost is paid will become the cost of asset acquired and no goodwill is calculated
The Acquisition Method
The entity is required to apply the ‘Acquisition Method’ to account for each business combination, which includes the following:
- Determination of Acquirer
- Determination of Date of Acquisition
- Determination and recognition of goodwill or bargain purchase gain relating to acquiree business
- Determination and recognition of assets and liabilities acquired in the business combination transaction and the related non-controlling interest in acquiree
Determination of Acquirer
The acquirer is a party which has control over the investee, therefore; this standard requires that an entity will first apply the requirements in IFRS 10: Consolidated Financial Statement to identify which party controls the acquiree. However, if the guidance in IFRS 10 does not help in determining that which party controls the investee, then the entity will apply the guidelines in IFRS 3 to identify the acquirer, which are as follows:
- The acquirer is normally the party that transfers cash, other assets or assumes a liability in a business combination transaction, which is mainly affected by transfer of cash, other assets or assumption of a liability
- The acquirer is normally the party that issues its equity instruments in a business combination transaction, which is mainly affected by exchange of equity instruments. However, in a business combination transaction, which is normally referred as ‘Reverse Acquisition’ the entity which issues equity instruments becomes an acquiree.
The entity should also consider the following facts and circumstances to identify the acquirer in a business combination transaction, which is mainly effected by exchange of equity instruments:
- The acquirer is the entity which owns majority of the voting rights in the investee
- The acquirer is the entity which dominates the management of the other entity
- The acquirer is the entity which has the ability to appoint, remove or reassign the key management personnel of the investee
- The acquirer is the entity which owns largest minority holding in the investee
- The acquirer is the entity which pays premium over the fair value of net assets of the investee
- The acquirer is the entity which is larger in size than that of the investee
Date of Acquisition
It is the date when investor takes over the control of the investee, normally it is ‘Closing Date’ i.e. when assets and liabilities are taken over and consideration is transferred. However, sometimes date of acquisition may be before or after the closing date e.g. when acquirer obtains the control of investee before the closing date as per written contract.
Recognition of Assets and Liabilities at the Date of Acquisition in Acquiree
The acquirer will recognize the identifiable assets and liabilities of acquiree at the date of acquisition, separately from the goodwill acquired in a business combination. However, only those identifiable assets and liabilities will be recognized which will meet the following conditions:
a) The asset and liability which meet the definition of asset or liability given in the IASB’s framework
b) The asset and liability must be arising as a result of the business combination i.e. it must be the part of what the acquirer and acquiree has exchanged in a business combination transaction, not from a separate transaction other than the business combination
The assets and liabilities which arise from a separate transaction other than the business combination will be accounted for in the post acquisition period financial statements
For example, if the acquirer makes a plan for restructuring relating to the acquiree business such as to relocate or close an activity of acquiree in future, the resultant cost of restructuring is not the liability at the date of acquisition and it will be recognized in the post acquisition period financial statements
Similarly, some assets and liabilities relating to acquiree may need to be recognized which may not be reflected in acquiree financial statements, if those satisfy the recognition conditions as mentioned above such as intangible assets related to acquiree business in the form of brand name, customer relationships, or market share which may not have been recognized in acquiree financial statements as these may be internally generated from acquiree perspective
Designation or classifying the Assets and Liabilities of Acquiree
The acquirer can designate or classify any assets or liability at the acquisition date relating to acquiree. However, the classification should be made as per the facts, circumstances and conditions at the date of acquisition such as:
a) Classification of a certain financial asset or liability of acquiree as at amortized cost or fair value
b) Designation of a derivative financial instrument as hedging instrument
However, classification of the following is not permitted:
- Classification of lease contracts held by acquiree as finance or operation lease
- Classification of insurance contracts held by acquiree
Exception to Recognition
If there is contingent liability related to acquiree at the date of acquisition, the acquirer will not to apply IAS 37 to account for that contingent liability of acquiree, instead the acquirer is required to recognize such contingent liability of acquiree at fair value, in contrary to IAS 37, if acquiree has present obligation for it and amount of obligation is reliably measurable, even it does not requires probable outflow of economic resources.
Measurement of Assets and Liabilities of Acquiree at Acquisition date
The assets and liabilities of acquiree will be measured at their fair value at the date of acquisition. The acquirer should not recognize any separate allowance for receivables related to the trade receivable of acquiree as it is reflected in the fair value of receivables.
Exception to Measurement
a) Re-acquired Right
The acquirer is required to recognize the re-acquired right which was previously granted to acquiree (such as franchise right or brand name under a licensing agreement), along with other assets and liabilities of acquiree as part of business combination and such re-acquired right will be recognize at fair value at the date of acquisition and the fair value will be determined ignoring any renewal potential of that right. It will be amortized subsequently at its remaining contractual life at the acquisition date.
b) Asset held for Sale
The acquirer will measure the non-current asset classified as held for sale at fair value less cost to sell as per the requirements of IFRS 5.
c) Share Based Payment
If the acquirer grants or replaces any share based payment award of acquiree, then such payment will be treated as per the requirements of IFRS 2 Share Based Payment.
Exception to Recognition and Measurement both
a) Income Taxes
The acquirer is required to recognize any deferred tax asset or liability relating to the assets and liabilities of the acquiree at the date of acquisition as per the requirements of IAS 12 income taxes.
b) Employee Benefits
The acquirer will recognize any employee benefit liability or asset relating to acquiree business at the date of acquisition as per the requirements of IAS 19 Employee Benefits.
If shareholders of acquiree (seller) guarantee the acquirer, any liability, loss or a provision relating to acquiree above a specified limit, then the acquirer will recognize such indemnification as an asset at the date of acquisition on the same basis as the indemnified item, in the acquiree’s financial statements i.e. if the indemnified amount is measured at fair value, the related indemnification asset will also be measure at fair value.
Valuation of Non-controlling Interest
The interest in acquiree which is held by the party other than the acquirer is termed as non-controlling interest; this standard allows two options to measure the non-controlling interest at the date of acquisition as:
- Measure the non-controlling interest at its fair value at the date of acquisition, which is normally the quoted price of interest held by non-controlling interest or
- Measure the non-controlling interest at its proportionate share in net assets of acquiree
Valuation of Goodwill or Bargain Purchase Gain
The acquirer will measure the goodwill acquired in a business combination as the excess (a) over (b):
a) The sum of:
- The fair value of consideration transferred by acquirer
- The value of non-controlling interest, determined as per the requirements of this standard
- In case of Step Acquisition, the fair value of previously held equity interest in acquiree
b) The fair value of net assets of acquiree at acquisition date
If the (a) is less than (b) then the difference will be treated as bargain purchase gain or negative goodwill, which will be treated as income of acquirer. However, in such a case the acquirer should reassess the assets and liabilities of the acquiree which are recognized and should incorporate the additional assets or liabilities which become apparent in the reassessment and then the acquirer is required to reconsider the measurement values which are allocated to the assets or liabilities of the acquiree.
The acquirer will measure the consideration transferred to acquire the control in a business combination at its fair value on the acquisition date. The consideration transferred may be in the form of cash, other assets, equity instruments or debt instruments issued by acquirer, or contingent consideration.
- If other assets transferred as part of consideration are recognized at amounts other than the fair value, then such assets will be measured at fair value at the acquisition date and any resulting difference will be charged to profit or loss
- However, if other assets are being transferred to the acquiree instead of owners of acquiree by acquirer as consideration in a business combination, in such circumstances the assets transferred will be measured at carrying value and no gain or loss will be recognized for such assets which will be controlled by acquirer both before or after the business combination
- If the acquirer is obliged to transfer a contingent consideration in exchange for the acquiree’s business at the date of acquisition, the acquirer will recognize such contingent consideration at its fair value at the date of acquisition and it will be recorded as part of cost of investment in acquiree.
Business Combination Expenses
The business combination charges such as valuation fee, consultation fee, legal charges and professional charges incurred by acquirer for the purpose of business combination will be treated as expense of the acquirer and will be charged to statement of profit or loss. However, any issuance cost of equity or debt instruments will be accounted for as per IFRS 9 Financial Instruments.
Business Combination achieved in Stages
When an acquirer obtains the control of acquiree in stages i.e. in more than one transaction, it is termed as piecemeal or step acquisition such as when an entity first acquirers 25% interest in acquiree in 20X7 and later the acquirer purchases further 45% interest in the same acquiree in 20X9 which ultimately gives acquirer the control over acquiree.
- In case of business combination which is achieved in stages, the acquirer is required to re-measure its equity interest previously held in the acquiree at its fair value on the date of acquisition, the resulting gain or loss will be recognized in statement of profit or loss.
- If there are any fair value gains or losses relating to previously held equity interest, recognized in other comprehensive income in prior accounting years, the amount that has been recognized in other comprehensive income may be transferred to retained earnings.
This standard allows the acquirer one year from the date of acquisition onward to complete business combination accounting. It is termed as measurement period. This period is provided to allow the reasonable time to acquirer to identify, recognize and measure:
a) The assets and liabilities of acquiree
b) The fair value of previously held equity interest in acquiree if any
c) The valuation of non-controlling interest
d) The determination of goodwill or bargain purchase gain acquired in business combination
e) Determination of cost of investment
If the reporting date of acquirer comes within the measurement period and business combination accounting has not been completed to date, then the acquirer will use the provisional values for consolidation purpose and this fact will be disclosed in the accounting notes.
Later if any information becomes available within the measurement period which indicates the facts and circumstances existed at the date of acquisition; it (increase or decrease) is adjusted retrospectively to the date of acquisition and will be treated as measurement period adjustment to reflect the affect of new information obtained as per the facts and circumstances exited at the acquisition date. Such adjustment will also affect the value of the goodwill. The acquirer is required to restate the relevant amounts in the comparative information of the prior year reflected in the current year’s consolidated financial statements such as adjustment to the depreciation or amortization charges.
Any adjustment to the date of acquisition in respect of the information that becomes available after the measurement period will be treated as an adjustment of error as per IAS 8: Accounting Policies, Changes in Accounting Estimates and Errors
This standard requires the acquirer to disclose the following:
- Business combination that has taken place during the accounting period
- Business combination that has taken place after the reporting date but before the date of authorization financial statements for issue
- The details of the adjustments which have been recognized in the current accounting period in respect of business combination