OLD VS NEW
he IASB revised IFRS3, Business Combinations and amended IAS27, Consolidated and Separate Financial Statements in January 2008 as part of the second phase of the joint effort by the IASB and the FASB to improve financial reporting while promoting the international convergence of accounting standards. The amendments provide guidance for the application of the acquisition method, allow for non-controlling interest in an acquiree to be measured at fair value and provide principles for the measurement of goodwill acquired. The revised or amended standards are applicable for years ending on or after 30 June 2010, and earlier application is permitted.
The revised IFRS3 sets out the following five-pronged approach to applying the acquisition method, namely: see diagram 1 below.
The revised IFRS3 places increased emphasis on measuring the various elements of the acquisition at fair value at the acquisition date. This is evident in:
- the requirement to measure the net assets of the acquiree at their acquisition-date fair values;
- the option to measure the non-controlling interest at fair value at the acquisition date;
- measuring the consideration transferred at fair value; and
- measuring the interest in the subsidiary already held by the parent, i.e. prior to obtaining control at fair value (rather than at cost as was the requirement in the 2004 IFRS3) on the date that control is obtained.
This article aims to highlight the changes in the accounting treatment of business combinations that have arisen as a result of the revised IFRS3, focusing on the accounting principles surrounding the recognition and measurement of the identifiable net assets of the acquiree and any non-controlling interest in the acquiree; and the implications for calculating and measuring goodwill (at acquisition and subsequent thereto).
1 Non-controlling interest
Non-controlling interest is defined as the “equity in a subsidiary which is not attributable, directly or indirectly, to a parent” (the 2004 versions of IFRS3 and IAS27 refer to this as a minority interest).
Previously, IFRS required this interest to be measured at the acquisition date, at its proportionate share of the fair value of the net assets of the acquiree. The revised IFRS3 gives the acquirer a choice in terms of measuring the non-controlling interest in the acquiree at the acquisition date, with the impact of the choice affecting the measurement of goodwill. The acquirer can either measure the non-controlling interest at fair value (being the market price of the shares not held by the acquirer where the shares are listed, or using a valuation model) or at the non-controlling interest’s proportionate share of the acquiree’s identifiable net assets.
This choice is not a policy decision; the acquirer can choose which measurement principle to apply on an investment-by-investment basis. The introduction of a choice such as this could be problematic, as it appears to contradict the IASB’s decision a few years back to eliminate options in order to improve comparability.
- Recognising and measuring the identifiable assets acquired and liabilities assumed
The 2004 version of IFRS3 requires the acquirer, at the acquisition date, to recognise separately from goodwill:
- any asset (other than an intangible asset), if it was probable that the future economic benefits would flow to the acquirer, and its fair value could be measured reliably;
- any liability (other than a contingent liability) if it was probable that an outflow of future economic benefits was probable, and its fair value could be measured reliably; and
- in the case of an intangible asset or contingent liability, if its fair value could be measured reliably.
The standard requires the identifiable assets, liabilities and contingent liabilities that met these recognition criteria to be measured at their respective fair values at the acquisition date. The one exception was non-current assets (or disposal groups) that are classified as held for sale in terms of IFRS5, Non-current assets held for sale and discontinued operations, which were measured at fair value less cost to sell (as noted below, this remains an exception in the revised IFRS3).
The revised IRFS3 reinforces these principles by establishing general recognition and measurement principles. The standard, however, also introduces exceptions to the recognition or measurement principle or both. The accounting treatment in the revised IFRS is summarised in (Diagram 2)
The revised standard also provides guidance on the classification and designation of identifiable assets acquired and liabilities assumed in a business combination. The general principle is that the classification and designation is based on conditions that exist at the acquisition date, with the exception of the classification of leasing arrangements and the classification of a contract as an insurance contract. In both these instances, the acquirer classifies the related contracts based on conditions that existed at the inception of the contract (or the modification date if the terms of the contract have been modified in a way that alters the classification of the contract subsequently).
Finalisation of acquisition date fair values – “the measurement period”
As is the case with the 2004 version of IFRS3, the revised version acknowledges that it is not always practical to finalise, at the acquisition date, the fair values of the identifiable net assets of the acquiree. The initial accounting for a business combination requires a determination of the fair values to be used in relation to the assets, liabilities and contingent liabilities acquired, as well as of the consideration transferred and the measurement of a non-controlling interest.
The period in which the initial accounting is finalised is known as the measurement period, which ends on the earlier of the date on which the outstanding information relating to the acquisition is received and 12 months after the acquisition date. The 2004 version of IFRS3 included an exception to the 12-month rule relating to recognising deferred tax assets, which existed at the acquisition date, but which could not be recognised. No such exception applies in the revised IFRS3.
As is the case with the 2004 version of IFRS3, measurement period adjustments are recognised as if the accounting for the business combination had been completed at the acquisition date. Therefore, if the previous reporting date falls between the acquisition date and the end of the measurement period, comparative information for the previous reporting period is restated as applicable.
Once the measurement period has elapsed, any changes to the accounting for a business combination, and consequently the goodwill arising at acquisition, should be made only to correct an error, and must be accounted for in accordance with IAS8, Accounting Policies, Changes in Accounting Estimates, and Errors.
- Consideration transferred
As with the 2004 version of IFRS3, the revised version requires the acquirer to determine the cost of acquisition with reference to fair values of assets transferred and liabilities assumed and equity instruments issued by the acquirer. However, there are differences in determining the cost of acquisition between the two versions, the most significant of which relate to the treatment of acquisition-related costs and contingent considerations.
- Acquisition-related costs
In terms of the 2004 version of IFRS3, those costs directly attributable to the business combination (such as advisory and legal fees) were included as part of the cost of acquisition. The revised IFRS3 requires all acquisition-related costs to be expensed. The rationale behind expensing these costs immediately rather than capitalising them is that the IASB and FASB concluded that these costs do not form part of the fair value exchange between the acquirer and the seller of the business. These costs relate to a separate transaction that occurs between the acquirer and the service provider(s). This could have significant implications as in many instances the professional fees paid to effect a business combination are significant and will now have to be recognised in the acquirer’s profit or loss.
- Contingent consideration
The consideration that the acquirer transfers to effect the business combination may be contingent on some event. This results in a contingent consideration arrangement, for example earn-out clauses, where the cost of the investment is linked to future profit or revenue levels.
The 2004 version of IFRS3 required the acquirer to include contingent consideration in the cost of the business combination if the adjustment was probable and could be measured reliably, at acquisition or subsequently.
The revised IFRS3 requires the acquirer to measure the contingent consideration at its acquisition-date fair value and include this as part of the consideration transferred in exchange for the acquiree and to classify the contingent consideration as an asset, liability or equity, depending on the nature of the payment. Subsequent to the acquisition date, the cost of the acquisition may only be adjusted for changes in the fair value of the contingent consideration that are measurement period adjustments. Non-measurement period adjustments (such as meeting the earnings target) do not result in changes to the cost of acquisition.
Having determined the fair value included in the cost of acquisition the following apply:
- Where the contingent consideration has been classified as equity, no remeasurement occurs and the settlement of the contingent consideration is accounted for within equity.
- Where the contingent consideration is an asset or liability it is accounted for subsequently in terms of IAS39, Financial instruments: recognition and measurement if it is a financial asset or liability or IAS37 or any other applicable standard where it is not within the scope of IAS39. The implication thereof is that any adjustment to the fair value of the contingent consideration is recognised in the statement of comprehensive income, either in profit or loss or other comprehensive income, rather than as an adjustment to the cost of acquisition.
Additional guidance
The revised IFRS3 also provides additional guidance on the following:
- Transfers of assets or liabilities by the acquirer to the acquiree rather than the seller of the business. As the assets and liabilities remain within the group after the business combination, the acquirer measures the assets and liabilities at their carrying amounts rather than at fair value. The implication is that no profit or loss is recognised.
- As at the acquisition date, the acquiree may have granted share-based payments to its employees. The acquirer may exchange its share-based payment awards for awards held by the employees of the acquiree, i.e. the acquiree issues replacement awards to the employees of the acquiree. The issue is whether the replacement awards are treated as part of the consideration transferred to obtain control or as a post-acquisition remuneration cost, or both. The accounting treatment is driven largely by whether the acquirer is obliged to make a replacement award or not. If the acquirer is obliged to replace the acquiree awards, either all or a portion of the market-based measure of the acquirer’s replacement awards are included in measuring the consideration transferred in the business combination. If the acquirer is not required to replace the awards but does so voluntarily, the replacement awards are recognised as a post-acquisition remuneration cost. The standard also gives guidance on how to measure these replacement awards, at acquisition and subsequent thereto.
- Transactions entered into to benefit the acquirer or the combined entity rather than primarily for the benefit of the acquiree (or its former owners) prior to the combination do not form part of the business combination. Examples include a transaction that effectively settles a relationship that may have existed between the acquirer and the acquiree before the business combination (a “pre-existing relationship”, which could be contractual such as a licensor-licensee relationship or non-contractual, for example, where the acquirer and acquiree are opposing parties in a lawsuit) or a transaction that remunerates employees of the acquiree for future services – this may arise where the employees are also the sellers of the business. In such cases, payments made to settle the pre-existing relationship or to employees for future services are not included as part of the business combination.
- Goodwill acquired (and bargain purchases)
Both the previous and revised versions of IFRS3 calculate goodwill as a residual amount. The revised IFRS3, however, requires the acquirer, after having recognised the identifiable assets and liabilities and any non-controlling interest, to identify goodwill acquired as follows: see diagram 3.
The above applies when a controlling interest is acquired immediately or in stages. This is an important change from the 2004 version of IFRS3. The revised IFRS3 clarifies that goodwill is recognised as a separate asset for the first time when there is control, and is derecognised when control is lost. Any changes in ownership interests between these dates do not change the goodwill balance recognised.
Where the non-controlling interest is measured at its share of the net asset value, the goodwill will relate to only the parent entity’s investment. If the non-controlling interest is measured at fair value, the difference between the fair value and the non-controlling interest’s proportionate share of the acquiree’s net asset value forms part of the goodwill recognised. This is referred to as the ‘full goodwill method’, as goodwill relating to 100 per cent of the shares is recognised. This implies that the full goodwill method is not as simple as taking the goodwill calculated by measuring the non-controlling interest at its proportionate share of the acquisition-date fair value of the acquiree’s net assets and grossing up that amount. The reason for this is that the acquirer is likely to pay a premium for control, grossing up the goodwill on this basis, which would result in an inappropriate goodwill amount being recognised in the group annual financial statements.
Example of calculating goodwill
P Limited acquired 60 percent of the issued share capital of S Limited at 1 January 2010 for R190 000. P Limited considered the net assets of S Limited to be fairly valued, except for the land, which has a carrying amount of R100 000 and a fair value of R125 000 at the acquisition date. The fair value of the non-controlling interest (NCI) at acquisition was R120 000 (and P Limited has elected to measure the non-controlling interest at fair value at acquisition as permitted by paragraph 19 of the revised IFRS3). Ignore any tax implications. See table 1 and 2.
Table 1: Non-controlling interest measured at its share of the acquisition date value of the net assets of the acquiree
| Analysis of the equity of S Limited | |||
| P Limited | NCI | ||
| 100% | 60% | 40% | |
| R | R | R | |
| At acquisition date: | |||
| Share capital | 120 000 | 72 000 | 48 000 |
| Retained income | 150 000 | 90 000 | 60 000 |
| Land (R125 000 – R100 000) | 25 000 | 15 000 | 10 000 |
| Fair value of net assets of S Limited | 295 000 | 177 000 | 118 000 |
| Goodwill acquired | 13 000 | 13 000 | – |
| 380 000 | 190 000 | 118 000 | |
Goodwill of R13 000 and non-controlling interest of R118 000 are recognised at acquisition.
Table 2: Non-controlling interest measured at fair value
| Analysis of the equity of S Limited | |||
| P Limited | NCI | ||
| 100% | 60% | 40% | |
| R | R | R | |
| At acquisition date: | |||
| Share capital | 120 000 | 72 000 | 48 000 |
| Retained income | 150 000 | 90 000 | 60 000 |
| Land | 25 000 | 15 000 | 10 000 |
| Fair value of net assets of S Limited | 295 000 | 177 000 | 118 000 |
| Goodwill acquired | 15 000 | 13 000 | 2 000 |
| 310 000 | 190 000 | 120 000 | |
Goodwill of R15 000 and non-controlling interest of R120 000 are recognised at acquisition. The effect is that both goodwill and the non-controlling interest is increased by R2 000.
Bargain purchases
In rare cases where the fair value of the identifiable assets and liabilities exceeds the cost of acquisition and the non-controlling interest in the acquiree, the business combination is acquired at a bargain price (that is, a discount). This discount was previously termed ‘negative goodwill’ or ‘the excess of the acquirer’s interest
in the net fair value of the acquiree’s identifiable assets, liabilities and contingent liabilities over cost’. In the group financial statements, the acquirer should recognise the resulting gain in profit or loss on the acquisition date. The gain is attributable to the acquirer. This applies irrespective of how the non-controlling interest is measured at the acquisition date, i.e. at fair value or its proportionate share of the acquisition date fair values of the acquiree’s net assets. Therefore, the acquirer could recognise a gain (or an additional gain) in the group profit or loss as a result of how the fair value of the non-controlling interest compares to its proportionate share of the net assets of the acquiree. The boards however concluded this is, in principle, appropriate, as it is the acquirer that is better off as a result of the bargain purchase.
As with the 2004 version of IFRS3, before recognising a gain on a bargain purchase price, the acquirer should reassess whether all the assets acquired and all the liabilities assumed were correctly identified and measured, and review whether the non-controlling interest in the acquiree and the consideration transferred have been correctly measured. If not, the acquirer should first recognise any additional assets or liabilities that have not yet been identified and measured accordingly. The objective of the review is to ensure that the measurements used are appropriate to reflect all available information at the acquisition date, and to distinguish between bargain purchase gains and measurement errors at the acquisition date.
Subsequent measurement of goodwill
After initial recognition, the acquirer should measure goodwill at cost less any accumulated impairment losses. Goodwill is subject to an annual impairment test as detailed in IAS36, Impairment of Assets. As a result of the amendments to IFRS3 relating to calculating goodwill, consequential amendments have been made to IAS36. These amendments build on the principles in the 2004 version of IAS36, i.e. –
- Goodwill is tested for impairment with reference to the cash generating unit to which it belongs.
- If the cash generated unit is impaired, any impairment loss is allocated first to reduce the carrying amount of goodwill, and subsequently to the other assets of the cash generating unit on a pro-rata basis, subject to not reducing the carrying amount of these assets below nil or their individual recoverable amounts, where applicable.
To take into account the option to apply the ‘full goodwill method’, these principles have now been expanded on as follows:
- In the case of a partially-held subsidiary (or part thereof), which is in itself a cash generating unit, the impairment loss is allocated between the parent and the non-controlling interest on the same basis as that on which profits or losses are allocated.
- In the case of a partially-held subsidiary that is part of a larger cash generating unit, impairment losses are allocated to the parts of the cash generating unit that have non-controlling interest and those that do not, as follows:
- To the extent that the impairment relates to goodwill in the cash generating unit, the relative carrying amounts of the goodwill of the parts before the impairment. For example, a cash generating unit comprises two subsidiaries, A (100% held) and B (80% held) and the carrying amount of the goodwill in the cash generating unit before impairment is R200, of which R120 relates to subsidiary A and R80 to subsidiary B. If the goodwill in the cash generating unit is impaired by R100, then R60 of the impairment loss is allocated to subsidiary A (R120/R200 x R100) and R40 to subsidiary B (R80/R200 x R100).
- To the extent that the impairment loss relates to identifiable assets within the cash generating unit, the relative carrying amounts of the net identifiable assets of the parts before the impairment. The allocation to each asset is done on a pro-rata basis of the carrying amount of each asset (as outlined above).
Consequently, for those parts of the cash generating unit that have a non-controlling interest, the impairment loss is allocated between the parent and the non-controlling interest on the same basis as that on which profits or losses are allocated. For those parts of the cash generating unit that do not have a non-controlling interest, the impairment loss is allocated in full to the parent.
Following on from the previous example, if S Limited is itself a cash generating unit, earns profits of R100 000 during the financial year ending 31 December 2010 and has a recoverable amount of R350 000 as at 31 December 2010, the impairment implications are as follows (ignore any tax implications and assume that any impairment loss relating to assets recognised by S Limited can be recognised in full): see table 3 below.
Table 3: Non-controlling interest measured at its share of the acquisition date value of the net assets of the acquiree
| Net asset value of S Limited as at 31 December 2010(R295 000 at acquisition + R100 000 post-acquisition profits) | R395 000 |
| Goodwill relating to the acquisition of S Limited | R13 000 |
| Unrecognised non-controlling interest i.e. adjustment to ‘gross-up’ goodwill in accordance with IAS36:(R13 000/60% = R21 667 – R13 000 = R8 667) | R8 667 |
| R416 667 |
A theoretical impairment loss of R66 667, being R416 667 (carrying amount of S Limited, including goodwill) less the recoverable amount of R350 000 arises. This impairment loss will be allocated as follows:
Goodwill R21 667
Remaining assets of S Limited
(R66 667 – R21 667) R45 000
R66 667
However, as P Limited has only recognised goodwill relating to its 60 percent shareholding, only 60 percent of the impairment loss relating to goodwill is recognised, i.e. R21 667 x 60% = R13 000 (which is the goodwill recognised in the group financial statements of P Limited, as the non-controlling interest is measured at its proportionate share of S Limited’s net assets at acquisition), of which all is allocated to the shareholders of P Limited. Therefore, even though S Limited is a partially-held subsidiary, none of the impairment loss relating to goodwill is allocated to the non-controlling interest in this example. The impairment loss relating to the remaining assets will be allocated between P Limited and the non-controlling interest on the same basis as the profits or losses of S Limited are allocated.
The group profit or loss of P Limited will include an impairment loss of R58 000 (R13 000 relating to goodwill and R45 000 relating to the remaining assets of S Limited). This loss will be attributed as follows:
Shareholders of the parent
(R13 000 + R45 000 x 60%) R40 000
Non-controlling interest
(R45 000 x 40%) R18 000
R58 000
See table 4 below.
Table 4: Non-controlling interest measured at fair value
| Net asset value of S Limited as at 31 December 2010(R295 000 at acquisition + R100 000 post-acquisition profits) | R395 000 |
| Goodwill relating to the acquisition of S Limited | R15 000 |
| R410 000 |
An impairment loss of R60 000, being R410 000 (carrying amount of S Limited, including goodwill) less the recoverable amount of R350 000 arises. This impairment loss will be allocated as follows:
Goodwill R15 000
Remaining assets of S Limited R45 000
R60 000
As S Limited is a partially held subsidiary and its non-controlling interest is measured at fair value at the acquisition date, the impairment loss of R15 000 relating to goodwill will be attributed between P Limited and the non-controlling interest on the same basis as its profits. R6000 (R15000 x 40%) of the impairment loss relating to goodwill is therefore allocated to the non-controlling interest. It is evident that in allocating impairment loss relating to goodwill to the non-controlling interest, it is irrelevant that only goodwill of R2 000 was recognised in relation to the non-controlling interest at acquisition.
The group profit or loss of P Limited will include an impairment loss of R60 000 (R15 000 relating to goodwill and R45 000 relating to the remaining assets of S Limited). This loss will be attributed as follows:
Shareholders of the parent
(R60 000 x 60%) R36 000
Non-controlling interest
(R60 000 x 40%) R24 000
R60 000
If we contrast the two examples on the left:
- As the recoverable amount was less than the carrying amount of S Limited (excluding goodwill), the goodwill recognised as a result of the acquisition of S Limited is fully impaired.
- Where the ‘full goodwill method’ is applied, an additional impairment loss of R2 000 arises. This is the additional goodwill that is recognised as a result of the non-controlling interest being measured at fair value and because the goodwill is fully impaired.
- However, the amount of the impairment loss allocated to the shareholders of P Limited relating to goodwill is less when the ‘full goodwill method’ is applied. This is because under this method the impairment loss relating to goodwill is allocated on the same basis as the profits of S Limited. Where the non-controlling interest is measured at its proportionate share of the subsidiary’s net assets at acquisition, any impairment loss relating to goodwill is allocated to the shareholders of the parent only.
The choice regarding the measurement of the non-controlling interest in a subsidiary therefore not only has implications for measuring goodwill at the acquisition date. Where the goodwill is impaired subsequently, the effect on the profits attributed to the shareholders of the parent and, consequently, the earnings per share figures will also differ.
References:
IFRS3, Business Combinations. IASB (2004)
IFRS3, Business Combinations. IASB (2008)
Basis for Conclusions to IFRS3, Business Combinations. IASB (2008)
IAS36, Impairment of Assets. IASB (2008)
Goolam Modack is a Lecturer and Ilse Lubbe, a Senior Lecturer, in the Department of Accounting at the University of Cape Town.
