IFRS 3 Business Combinations IFRS 3 replaces IAS 22. IAS 22 had been criticised because it allowed 2 methods of accounting for a business combination: the pooling of interest (merger method) and purchase method (acquisition method). Having two methods meant that comparability was lost and transactions were being deliberately structured to facilitate a particular accounting method. Pooling of interest has been banned in Australia, Canada and the US and the IASB felt that it would be advantageous to converge their standards with these standard setters. IAS 22 also included a benchmark and allowable option and allowing two different methods was not seen as appropriate. IFRS 3 deals with:

• the method of accounting for business combinations • the initial measurement of the assets and liabilities acquired • post acquisition restructuring • the treatment of negative goodwill • the treatment of goodwill on acquisition and intangible assets acquired.

Main features:

• purchase method only to be applied (merger method banned); • an acquirer is to be identified; • apply fair value to the acquired company including costs of acquisition; • recognise separately the assets and liabilities of the acquired company,

even whey the assets or liabilities were not previously recognised in the acquired company accounts:

o tangible assets at fair value; o liabilities at their fair value; and o intangible assets and contingent liabilities when their fair value can

be measured reliably; • Goodwill on acquisition is the excess of the amount paid over the fair

value of the assets acquired; • Goodwill should not be amortised, but tested for impairment in

accordance with IAS 36; • Negative goodwill is to be recognised in the profit and loss account

immediately but requires that the assets and liabilities be reassessed prior to recognising negative goodwill; and

• Requires substantial disclosures including disclosure on the changes to the carrying value of goodwill.

The standard does not apply to joint ventures, or group restructurings, mutual entities, and business combinations formed by contract alone without obtaining ownership. Companies in these categories should continue to apply IAS 22 until further guidance is issued. A limited amendment to IFRS 3 proposes that mutual entities, and business combinations formed by contract alone, should apply IFRS 3 with slight modification to avoid difficulties with calculating the cost of the combination and goodwill. IFRS 3 requires that you apply the IFRS to situations where there is a parent subsidiary relationship and it recognises that this can happen in a number of

ways including share buy backs. The IFRS requires that only the purchase method be applied in the accounting for business combinations covered by the IFRS. There are three steps identified in the IFRS do doing a consolidation:

• Identify the acquirer; • Measure the consideration paid; and • Allocate the cost over the assets and liabilities, and contingent liabilities

acquired. Identifying the acquirer The acquirer is the entity that obtains control of the other entity. Control is the power to govern the financial and operating policies. Usually this results from the acquisition of greater then 50% of the voting rights. It can also be achieved by getting:

• Power over greater then 50% of the voting control (which can be by contract)

• Power to govern the financial and operating policies • Power to appoint or remove the majority of the directors • Power to cast the majority of votes at a meeting

It can be difficult to identify an acquirer, but other indications are:

• One entity is significantly larger and therefore more likely to be the acquirer;

• The entity giving up cash in the combination is more likely to be the acquirer;

• The entity which selects the management team is usually the acquirer; • The entity which issues the equity in an equity for equity exchange is

usually the acquirer It is accepted that in a reverse takeover (say a private company being “acquired” by a small quoted company) the acquirer is usually the large company. The IFRS requires that each situation be assessed carefully. When a new entity is formed to hold the shares in the two existing companies then one of the existing companies will still be identified as the acquirer. The cost of the combination The cost of an acquisition is the fair value of assets given, liabilities incurred and equity instruments issued plus the costs directly attributed to the combination at the date of acquisition. The date of the acquisition is when the acquirer obtains control. In a piecemeal acquisition the cost is the aggregate cost of each purchase and the date of acquisition is the date that control passes. Amounts to be paid in the future should be discounted. The fair value of equity instruments issued as part of the acquisition may be valued by reference to a quoted market price and where this is unreliable or not available you may use the fair value of the proportion of the entity acquired. Future losses and other costs to be incurred in, for example, restructuring (where

the restructuring was not already accrued by the acquired entity prior to the acquisition) should not be included in costs. Costs of professional fees for accountants, lawyers, valuers and other consultants are included in costs where they are directly attributable. General administration costs should not be included. Costs incurred in arranging loans or other debt instruments used to finance an acquisition should not be included in the costs of the acquisition, they are included in the finance cost of the loan or debt instruments itself. Where there is a contingent payment included in the acquisition (for example an enhanced price where a specific profit level is achieved), the adjustment to the cost that will be caused by the contingency should be included in the cost if it is probable that the adjustment will be made and it can be reliably measured. If you are unable to measure the adjustment or you measure it incorrectly (because of say estimates made being incorrect) then you correct the calculation of cost. Where an additional payment is made to the seller because assets given (such as shares) have fallen in value and you have guaranteed the value of the assets then the cost is not adjusted. Allocation of the cost of the acquisition All of the identifiable assets and liabilities and contingent liabilities are to be identified and valued at fair value, even when these were not previously on the purchased company’s balance sheet. Non current assets meeting the requirements of IFRS 5, (assets held for resale) are recognised at fair value less selling costs. Recognise:

• Assets other then intangible assets – recognise when future economic benefit will accrue to the acquirer and its fair value can be measured reliable;

• Liabilities other then contingent liabilities – when it is probable that there

will be an outflow of recourses to settle the obligation and its fair value can be measured reliable; and

• Contingent liabilities and intangible assets – when their fair value cn be

measured. The profit and loss account should include profits and expenses based on the fair value of the assets acquired (i.e. charge depreciation on the fair value not the value per the pre acquisition balance sheet). Minority share is stated at the minorities share of the net fair value of the assets acquired. Post acquisition restructuring can not be included in the cost of the acquisition. If there is a restructuring reserve in the subsidiary at the time of the acquisition, then this can be included in the cost of the acquisition. Future losses can also not be included in the cost. A liability that only becomes probable when a

acquisition is made (i.e. a bonus payment to an employee) should be included in the cost of the acquisition. Intangible assets Intangible assets are recognised only when it meets the requirements of IAS 38 Intangible Assets, and its fair value can be reliable measured. To meet the requirements the intangible asset must:

• Be separate (it can be sold or transferred separately) • Arises from contractual or legal rights

Contingent liabilities Contingent liabilities are measured at fair value if this can be reliable measured. If you can not measure it reliable then disclose information per IAS 37. After their initial recognition, contingencies should be measured at the higher of:

• The amount that should be recognised under IAS 37 • The initial amount less amortisation per IAS 18

This section excludes financial instruments per IAS 39 but includes loans. Goodwill At the acquisition date recognise goodwill as an asset Goodwill should be recognised at cost being the amount paid less the fair value of assets and liabilities acquired. Goodwill should be carried as an asset less any impairment. Goodwill should not be amortised. Negative goodwill When it arises, reassess the identification and measurement of assets and liabilities and the measurement of cost. You then recognise negative goodwill immediately in the profit and loss account. IFRS 3 recognises that negative goodwill can arise in three circumstances:

• Errors in calculation • The requirement of an accounting standard to measure an asset at other

then fair value (for example undiscounted tax assets); or • A bargain purchase.

Piecemeal acquisition You wait until you obtain control and then do the goodwill calculation based on the accumulated cost and the fair value at the date that control passes. If you make any subsequent additional % purchases after control is obtained, then re do the goodwill calculation at each subsequent purchase. This effectively means that the subsidiary will be re-valuing, however, the IFRS states that this is not a revaluation per IAS 16. Initial accounting determined provisionally When only provisional figure are available, do the calculations using the provisional values and then the acquirer should make a correction to the initial calculations if the provisional accounts are completed within 12 months. The

goodwill calculation is based on the fair values at the date of the acquisition corrected. Any subsequent amendments to correct errors should only be made in accordance with IAS 8. Where a deferred tax assets was not recognised initially, but was subsequently realised, then reduce the goodwill by the amount of the realised gain. The reduction in goodwill is an expense and the deferred tax asset increase is income. Disclosure Disclose information I your financial statements to allow users to understand the financial effect of business combinations. Some of the disclosures include:

• Names and descriptions of the businesses acquired • Acquisition date • % acquired • cost of the acquisition • the fair value and the basis for calculating fair value • the amount of each class of asset and liability acquired • amount of negative goodwill recognised in the profit and loss account • Information require to allow users evaluate the changes in value of

goodwill. Previously recognised goodwill Apply the IFRS prospectively for accounting periods beginning on or after 31 March 2004. For accounting periods beginning on or after 31 March 2004 and acquisitions prior to this date:

• Discontinue amortising goodwill; • Eliminate accumulated amortisation with a similar reduction in goodwill; • Test for impairment annually thereafter.

Negative goodwill previously recognised should be derecognised and a prior year adjustment made. Previously recognised intangible assets that fail to meet the new requirements for recognition, are to be reclassified as goodwill. For investments previously accounted for under the equity method, apply the IFRS to the goodwill included in the carrying value of that investment. Limited retrospective application You may retrospectively apply the standard if the information is available and you also apply IAS 36 and 38 retrospectively.