IASB ISSUES: NEW REQUIREMENTS FOR CHANGES IN DEGREE OF CONTROL
The International Accounting Standards Board (IASB) completed the second phase of its business combinations project on 10 January 2008 by issuing a revised version of IFRS 3 – Business Combinations and an amended version of IAS 27 – Consolidated and Separate Financial Statements (referred to as “IFRS 3R” and “IAS 27R” respectively). The new requirements of IFRS 3R apply prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual period beginning on or after 1 July 2009. The new requirements of IAS 27R apply to financial periods beginning on or after 1 July 2009 (most of the amendments addressed in this article should be applied prospectively).
The revised Standards provide new guidance on the accounting treatment of transactions with non-controlling interests (previously known as “minority interests”) as well as a change in the holding of a non-controlling interest to one in which control is obtained (referred to as “step acquisitions”). This article provides a summary of the requirements of IFRS 3R and IAS 27R with respect to these types of transactions, together with illustrative examples.
Acquisition of an interest from the non-controlling shareholders
A parent company may increase its stake in an existing subsidiary by buying all or part of the non-controlling interests. For example, H Ltd may acquire 60% of S Ltd and subsequently purchase an additional 20% interest in S Ltd. Under both IFRS 3 and IFRS 3R, when a parent purchases additional shares from the non-controlling shareholders in a subsidiary, it does not give rise to the step-up of net assets to fair value. The reason is that it is only the obtaining of “control” in a business combination that is a significant economic event, which triggers a fair value determination. Subsequent transactions with non-controlling interests would not affect the recognition or measurement of these assets and liabilities.
The current version of IAS 27 is silent on accounting for the acquisition of non-controlling interests. One of the generally accepted accounting practices is to apply a hybrid “parent entity” model, which regards non-controlling interests as a special class of equity separate to that of the parent entity. Consequently, changes in control are accounted for only from the parent entity’s perspective, resulting in the parent acquiring more or new assets rather than acquiring more rights to the income from the assets it already controls. Thus, if a parent purchases additional shares from the non-controlling shareholders in a subsidiary, it is regarded as the acquisition of an additional economic interest by the parent. Under the parent entity model the difference between the consideration paid and the parent’s share of the carrying amount of the net assets acquired is classified as goodwill.
IAS 27R adopts the economic entity model for accounting for transactions with non-controlling interests. This approach views a group of companies as a single economic entity. Non-controlling interests represent their residual interest in the net assets of the subsidiary and are classified as pure equity, being no different in substance from the parent’s equity interest in the subsidiary. If a parent therefore purchases an additional interest in an existing subsidiary, on consolidation the non-controlling interest is reduced to reflect its revised interest in the carrying amount of the net assets of the subsidiary. The difference between the amount paid by the parent and the reduction in the non-controlling interest is a debit or credit to equity. The logic for the debit or credit to equity is that, since the transaction is between equity participants, paying a premium over the carrying amount of the net assets of the subsidiary to acquire an additional stake is akin to a distribution and is accounted for as such.
Disposal of an interest to the non-controlling shareholders
The current version of IAS 27 is also silent on the accounting for sale of a portion of a parent’s interest in a subsidiary whilst retaining control. One method that was used was to regard such transaction as a disposal by the parent of a portion of the subsidiary’s net assets to the non-controlling shareholders. The gain or loss would be recognised in the profit and loss account (not equity) as the difference between the increase in the non-controlling interest and the proceeds of the disposal adjusted for the proportion of goodwill realised.
However, IAS 27R requires the difference between the proceeds on disposal and the increase in the non-controlling interest to be recognised in equity. Unlike the parent entity model, goodwill will not be affected by a decrease in the degree of control when applying the economic entity model. Instead, the group’s statement of changes in equity will reflect a gain or loss equal to the difference between the proceeds on disposal and the increase in the non-controlling interest.
Certain business combinations are achieved in stages. For example, a company may acquire an additional interest in an available-for-sale investment resulting in control being obtained. Alternatively, an investor may purchase an additional stake in an associate resulting in it acquiring control. The current version of IFRS 3 (para. 59) requires the acquirer notionally to restate the net assets of the acquiree to fair value. Any resulting changes in equity from the previously held interests are to be recognised as a revaluation and be presented outside the income statement. However, IFRS 3R (para. 42) views the obtaining of control as a disposal of the previously held investment rather than an increase in its interest in the net assets of the acquiree. Consequently, the investor is required to remeasure the investment to its fair value under IAS 39, resulting in a gain or loss being presented in the income statement. Goodwill on consolidation will be computed as the difference between the acquisition date fair value of the acquirer’s previously held equity interest plus the consideration paid for the newly acquired interest and the fair value of the acquiree’s identifiable assets and liabilities.
Applying IFRS 3R and IAS 27R in practice
The application of the revised Standards is best illustrated by means of three scenarios contrasting the new requirements with those of the current version of the Standards (referred to as the “parent entity method”): See overleaf for Balance sheet scenarios.
The changes in IFRS 3R and IAS 27R as discussed in this article could be significant especially where there are large acquisitions. Parent entities acquiring additional stakes in existing subsidiaries will effectively incur a write-off of the premium on acquisition against equity. Furthermore, the resultant gain or loss on disposal of a stake in a subsidiary is accounted for against equity rather than being recorded in the income statement albeit at a larger amount. Furthermore, the accounting for step acquisitions is now valued based on the fair value of the shares in terms of IAS 39 (rather than as a revaluation of the underlying net assets) and any resultant gain in adjusting previously held equity interests to fair value is presented in the income statement rather than equity. Companies intending to change their shareholdings in subsidiaries and other investments should bear these requirements in mind when preparing their financial statements and explaining financial results to analysts.
Finally, it should be noted that IFRS 3R and IAS 27R need only be applied prospectively for financial periods beginning on or after 1 July 2009. Consequently, comparatives do not require restating as the revised Standards do not apply to any such changes in ownership that occurred before an entity adopts them. Earlier application of IAS 27R is permitted provided the entity also applies IFRS 3R.
- International Accounting Standards Board (IASB). 2004. IFRS 3: Business Combinations, Issued March 2004. London: IASB.
- International Accounting Standards Board (IASB). 2008. IFRS 3R: Business Combinations, Issued January 2008. London: IASB.
- International Accounting Standards Board (IASB). 2003. IAS 27: Consolidated and Separate Financial Statements, Issued December 2003. London: IASB.
- International Accounting Standards Board (IASB). 2008. IAS 27R: Consolidated and Separate Financial Statements, Issued January 2008. London: IASB.
- Nurnberg, H. 2001. Minority Interest in the Consolidated Earnings Statement, Accounting Horizons, June 2001, Vol. 15, No 2, pp. 119-146.
- PricewaterhouseCoopers. 2007. Manual of Accounting – IFRS for the UK 2007, Kingston-upon-Thames: CCH Wolters Kluwer.
Zwi Y. Sacho CA(SA), BCompt (Hons), MCompt, ACA(UK) is a corporate finance executive at Lopian Gross Barnett & Co in Manchester UK.