Scope of IFRS 3
IFRS 3 covers accounting for business combinations which are defined as transactions or other events in which an acquirer obtains control of one or more businesses. Excluded from the scope are:
- combinations of entities under common control,
- acquisitions of assets that do not constitute a business,
- formation of a joint arrangement in the financial statements of the joint arrangement itself (formation of a joint arrangement from the perspective of an investor is not a business combination by definition because no party controls a joint arrangement)
- acquisition by an investment entity of an investment in a subsidiary that is required to be measured at fair value through profit or loss.
What is a business combination?
A business combination is a transaction in which one entity obtains control of one or more businesses. A business is a mixture of inputs (e.g. assets, contracts, employees) and processes capable of converting these inputs into outputs (products, costs reductions and other economic benefits). The definition of a business in IFRS 3 is rather inclusive and in case of doubts whether a company acquired a business or just a group of assets – it’s probably a business. The phrase ‘capable of’ with reference to producing outputs makes it easier for start-ups to qualify as business, as in fact input and processes will be enough to meet the IFRS 3 definition of a business.
Note that the IASB has amended the definition of a business in IFRS 3 which will be effective for periods beginning on 1 January 2020. The new model introduces an optional concentration test under which a transaction will be treated as an asset acquisition if substantially all of the fair value of the gross assets acquired is concentrated in a single asset (or a group of similar assets). Read more on IFRS.org.
Example: start-up company
Acquirer Company (AC) acquired Target Company (TC), a start-up company that developed a new social network app. TC does not generate any revenue yet. TC should be considered a business as it has inputs (employees, social network app) and processes (operational processes for developing and maintaining the social network app). TC is capable of producing output in the form of e.g. advertising revenue.
See paragraphs IFRS 3.B7-B12 for more discussion on the definition of a business.
Business combination can by effected in a variety of ways due to economic, tax or legal reasons. The most common are transferring cash, assuming liabilities and issuing equity instruments to owners of the business being acquired. For other examples given by IFRS 3, see paragraphs IFRS 3.B5-B6.
Acquisition of individual assets
In case of an acquisition of assets that do not constitute a business, the acquirer recognises individual identifiable assets (and liabilities) by allocating the cost of acquisition on the basis of their relative fair values at the date of purchase. Goodwill is not recognised (IFRS 3.2b).
Accounting for business combination
Business combinations should be accounted for using the acquisition method consisting of the following steps (IFRS 3.4-5):
- identifying the acquirer
- determining the acquisition date
- recognising and measuring the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquire
- recognising and measuring goodwill or a gain from a bargain purchase
Pooling of interest method, fresh start method, or other methods are not allowed by IFRS 3. However, they may be used in accounting for business combinations under common control.
Identifying the acquirer
General requirements for identifying the acquirer
Entities are required to identify the acquirer for each business combination (IFRS 3.6-7). The acquirer is an entity that obtains control over the target. ‘Control‘ is used here in the meaning introduced by IFRS 10.
It is usually straightforward to determine which entity is the acquirer – it is the entity that transfers cash or issues equity instruments and is clearly larger (in terms of assets, revenue etc.) than other parties involved in the transaction. Paragraphs IFRS 3.B14-B18 provide more guidance on identifying the acquirer.
Paragraphs IFRS 3.B19-B27 provide guidance on a particular kind of business combination called reverse acquisitions, or reverse takeovers, or reverse IPO (initial public offering). Reverse acquisition occurs when a (usually) publicly traded company is taken over by a private company. First, owners of the private company obtain control over the public company by buying adequate number of shares on the market. Second, the public company ‘acquires’ the private company by issuing its shares to owners of the private company. Finally, both entities are merged into one entity or operations of the private company are transferred to the public company. In the end, the benefit for the owners of a private company is that they can take their business public without going through costly and lengthy IPO process.
The public company is usually a legal acquirer as it issues shares to owners of the private company in exchange for shares in the private company. Despite the legal classification, if the guidance in IFRS 3.B14-B18 indicates that the private company is de facto the acquirer, the business combination should be accounted for with the private company as the acquirer.
Determining the acquisition date
Acquisition date is the date when the acquirer obtains control over the target. It is usually straightforward to determine the acquisition date, which is usually the so called ‘closing date’. Closing date is the date when the consideration is transferred to the seller. However, IFRS 3 takes into account instances when the control is obtained before or after the closing date (IFRS 3.8-9).
Example: Determining the acquisition date
Acquirer Company (AC) acquired Target Company (TC). The following milestones relate to the transaction:
- preliminary agreement signed: June 5th (transaction subject to consent of competition authorities)
- consent of competition authorities received: September 20th
- final agreement signed: September 24th
- payment by AC to former owners of TC: September 25th
- AC ownership of shares registered by the court registry: November 3rd
As said before, the key in determining the acquisition date is the notion of control. In the example above, the control was most likely obtained on September 25th, i.e. when the payment is made. In practice, the payment is often made at the same time as final agreement is signed. If there are any legal procedures to be fulfilled after the acquisition, they are usually virtually certain to be successfully processed and the control over TC is usually passed by TC’s former owners to AC before that date.
In practice, the acquisition date is often set at the month closing date, as it is easier to determine the value of assets and liabilities acquired. This approach is specifically allowed by IFRS 3.BC110 provided that there are no material events between the month closing date and actual acquisition date.
Recognition of assets, liabilities and non-controlling interest
As of the acquisition date, the acquirer shall recognise the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the target. Typical examples of assets that are recognised on business combination, but were not recognised before by the target, are internally generated intangible assets such as brands, patents or customer relationships. It is presumed that all assets and liabilities acquired in a business combination satisfy the criterion of probability of inflow/outflow of resources as set out in Framework (IFRS 3.BC126-BC130).
At the acquisition date, the acquirer should classify or designate acquired assets and assumed liabilities as required by other relevant IFRS (e.g. IFRS 9). This should be done based on terms and conditions existing at the date of business combination (IFRS 3.15). Exceptions to this rule relate to classification of lease contracts where the target is the lessor and insurance contracts under IFRS 17 (IFRS 3.17).
Recognition of acquired identifiable assets
Definition of identifiable assets
An asset must be identifiable in order to be recognised by the acquirer. An identifiable asset meets one of the two criteria:
- Separability criterion or
- Contractual-legal criterion.
An asset is separable if it can be separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, identifiable asset or liability. This criterion is to be assessed irrespective of what the acquirer plans to do with the asset. There needs to be evidence of exchange transactions for that type of asset or an asset of a similar type, even if those transactions are infrequent (IFRS 3.B33-B34).
Examples of assets that can be recognised under separability criterion are:
- Customer lists and non-contractual customer relationships. Customer lists may include data such as name, age, geographical location or history of orders. Customer list is recognised as an intangible asset if the terms of confidentiality or other agreements or simply the law do not prohibit the entity from selling, leasing or otherwise exchanging the list. (IFRS 3.IE24, IE31).
- Technology-based intangible assets (IFRS 3.IE39-IE44)
An asset meets the contractual-legal criterion if it arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations (IFRS 3.B32). Examples of such assets are:
- Licences to operate in a specific sector, geographical area etc. even if not separable from the related assets or legal entity.
- Legally protected trademarks (IFRS 3.IE18-IE21).
- Internet domains (IFRS 3.IE 22).
- Customer contracts and orders, together with related customer relationships (IFRS 3.IE25-IE30). Contracts and placed orders (even if cancellable) arise from contractual rights and therefore need not meet the separability criterion in order to be recognised. In other words, they are recognised even if the terms of confidentiality or other agreements or simply the law prohibit the acquirer/target from selling, leasing or otherwise exchanging these contracts.
Customer relationships meet the contractual-legal criterion if an entity has a practice of establishing contracts with its customers, regardless of whether a contract exists at the acquisition date (IFRS 3.IE30c).
- Copyright materials such as films, books etc. (IFRS 3. IE32-IE33).
- Contract-based intangible assets. Lots of examples of contract-based intangible assets are given in IFRS 3.IE34-IE38
- Technology-based intangible assets (IFRS 3.IE39-IE44)
Items that are not identifiable
Assets that do not meet separability criterion or contractual-legal criterion cannot be recognised separately. They are included in the value of goodwill (IFRS 3.B37-B40). Examples of such assets are:
- assembled workforce
- potential contracts
- synergy benefits
- contingent assets
- expected renewals of reacquired rights
In-process research and development project
IAS 38.34 specifically requires separate recognition of acquired in-process research and development project. Paragraphs IAS 38.42-43 cover subsequent expenditure on an acquired in-process research and development project. If such a project is never completed, it must be impaired.
Assets that the acquirer does not intend to use
All assets and liabilities acquired should be recognised irrespective of whether they were recognised by the target (IFRS 3.10-13) or whether the acquirer intends to use them. Assets that the acquirer does not intend to use or intends to use in a ‘suboptimal’ way should still be measured at fair value assuming their highest and best use. They also cannot be written-off immediately after the acquisition, as the impairment loss under IAS 36 can be recognised only when both value in use and fair value less costs of disposal are below the carrying value of the asset (IFRS 3.B43). Such assets will be removed from the accounts through amortisation over their useful life. It may be challenging to determine the useful life of such asset, especially if the acquirer does not intend to use it at all, but some estimate needs to be made. See examples below.
Example: acquired brand that will not be used after the business combination
Acquiring Company (AC) acquired a competitor, the Target Company (TC), which had a TC brand with a fair value of $10 million. AC intends to withdraw the brand of TC from the market within a year, which will increase the market share of its original AC brand. AC intends to keep legal rights to brand TC forever in order to prevent other companies from using it.
AC recognises TC brand at its fair value of $10 million despite intent to withdraw the brand from the market. The economic benefits for AC to be obtained from TC brand is that competitors cannot use it, which in turn increases profits of AC. The useful life should therefore be longer than 1 year during which AC intends to withdraw the TC brand from the market. The useful life can be estimated as the period over which a significant competitor will fill the void after TC was withdrawn from the market, which will depend on many variables, such as the significance of entry barriers.
Example: acquired software that will not be used after the business combination
Acquiring Company (AC) acquired a competitor, the Target Company (TC), which had a customised client relationship management software (CRM) with a fair value of $2 million (determined with the assumption of continuous use). AC has its own CRM software and therefore intends to migrate all customers of TC there within 6 months. As a result, CRM software of TC will be useless after 6 months, it was so customised that AC will not be able to sell it to third parties.
AC recognises TC’s CRM software at fair value of $2 million even though it will use it only for 6 months. This software will be amortised over those 6 months as this is the period during which AC will obtain benefits from it.
Recognition of acquired liabilities
On acquisition, entities should recognise all liabilities if there is a present obligation and possibility of reliable measurement. In particular, entities should recognise assumed contingent liabilities for which a present obligation exists, even if the probability of outflow of resources is lower than 50% (IFRS 3.22-23).
Conversely, entities cannot recognise liabilities for future expenditures for which there is no present obligation as at the acquisition date. So any restructurings that the acquirer plans to carry out are not recognised at the acquisition date.
Measurement of acquired assets and liabilities
The acquirer measures the identifiable assets acquired and the liabilities assumed at their acquisition-date fair values (IFRS 3.18-19), with certain exceptions as specified below. IFRS 3 does not say how to measure fair value, as this is covered in IFRS 13.
Assets acquired in a business combination should be accounted for in a ‘fresh start’ mode, e.g. allowance for credit losses or accumulated depreciation of fixed assets should not be continued in financial statements of the acquirer (IFRS 3.B41).
Exceptions to recognition or measurement principles
There are exceptions to the recognition and measurement principles of IFRS 3 applicable to certain specified assets and liabilities. These are set out in paragraphs IFRS 3.22-31,54-57 and include items as discussed below.
Contingent liabilities and contingent assets
The acquirer should recognise assumed contingent liabilities for which a present obligation exists at fair value, even if the probability of outflow of resources is lower than 50% (IFRS 3.22-23). This approach is different from ‘regular’ requirements of IAS 37 where a liability is recognised only when the probability of outflow of resources exceeds 50%.
After the initial recognition, the contingent liability is measured at the higher of the following amounts:
- the amount that would be recognised in accordance with IAS 37;
- the amount initially recognised less, if appropriate, the cumulative amount of revenue recognised in accordance with IFRS 15.
The method of subsequent measurement specified above forbids to derecognise a liability assumed in a business combination until it is settled or expires.
When it comes to contingent assets, the acquirer should not recognise them unless the target has an unconditional right at the acquisition date. If there is an unconditional right, an asset is no longer considered contingent and should be recognised at fair value and subsequently measured in accordance with appropriate IFRS, e.g. IFRS 9 (IFRS 3.BC276). It is often difficult to assess whether a right is unconditional, especially for non-contractual assets. In practice, if there is any doubt, a separate asset is not recognised until all uncertainties are resolved.
Deferred tax resulting from temporary differences and unused tax losses is accounted for according to IAS 12, i.e. not at fair value (IFRS 3.24-25). Deferred tax is recognised for assets and liabilities recognised at business combination as well as for fair value adjustments (IAS 12.19).
More discussion on business combinations and income tax accounting can be found in IAS 12.
Employee benefits are recognised and measured in accordance with IAS 19, i.e. not at fair value (IFRS 3.26).
It is common occurrence that the acquirer protects himself from uncertain and/or unknown outcomes of pending or potential matters relating to target. The most common examples are claims and litigation (C&L) where the seller promises to reimburse the acquirer if the amounts to be paid as a result of C&L relating to pre-acquisition events exceed a certain amount. In such cases, the acquirer has an indemnification asset. Such an asset should be measured (both on initial recognition and subsequent measurement) on the same basis as the indemnified item (C&L liability in our example) with consideration given to credit risk (IFRS 3.27-28). In practice, such assets are valued at the same amount as related liability, subject to any contractual limits for indemnification.
Leases in which the target is the lessee
Right-of-use assets and lease liabilities for leases where the target is the lessee are recognised at the present value of the remaining lease payments as if the acquired lease were a new lease at the acquisition date. The acquirer measures the right-of-use asset at the same amount as the lease liability, adjusted to reflect favourable or unfavourable terms of the lease when compared with market terms (IFRS 3.28A). More on leases in IFRS 16.
Leases in which the target is the lessor
Operating leases in which the target is the lessor are not recognised separately if the terms of an operating lease are either favourable or unfavourable when compared with market terms. Instead, terms of the lease are taken into account when measuring the fair value of the asset subject to a lease (IFRS 3.B42).
It may happen that one of the assets acquired a as part of business combination is a right previously granted by the acquirer to the target. It most often concerns a right to use an asset (recognised or unrecognised by the acquirer) by the target (such as brand). Such a right is recognised as an asset on a business combination, but the fair value measurement should be based only on the remaining contractual term, i.e. without taking into account possible contract renewals (IFRS 3.29). A reacquired right should be amortised over the remaining contractual period.
If the terms of reacquired right were favourable or unfavourable relatively to market terms, a settlement gain or loss on pre-existing relationship should be recognised.
See a separate section on share-based payment arrangements in the context of business combinations in IFRS 2.
Assets held for sale
Acquired assets held for sale should be initially measured at fair value less costs to sell in accordance with IFRS 5 (IFRS 3.31).
Recognising and measuring goodwill
Goodwill is the difference between (IFRS 3.32):
- Consideration transferred,
- Non-controlling interest remaining
- Fair value of the acquirer’s previously held equity interest in the target and
- Net identifiable assets acquired and the liabilities assumed.
Acquirer Company (AC) acquires 80% shareholding of Target Company (TC) for $100m. TC has the following assets and liabilities as at the acquisition date:
|Assets ($ m)|
|80||Property, plant and equipment|
|10||Cash and cash equivalents|
|Equity and liabilities ($ m)|
|135||Total equity and liabilities|
AC assesses that the fair value of assets and liabilities of TC equals their net book value as presented in the statement of financial position of TC. Additionally, AC considers that the brand of entity TC is an identifiable asset to be recognised on acquisition. It is an internally generated brand, so it hasn’t been recognised by TC. Fair value of ‘TC’ brand is estimated at $20m. Impact of this acquisition on consolidated financial statements of AC is as follows ($m):
|Impact on assets ($m)|
|80||Property, plant and equipment|
|10||Cash and cash equivalents (held by TC)|
|(100)||Cash and cash equivalents (paid for 80% shareholding in TC)|
|87.8||Total impact on assets|
|Impact on equity and liabilities ($ m)|
|16.8||Non-controlling interest (at the proportionate share)|
|16.8||Total impact on equity|
|6||Deffered tax liabilities (relating to brand "TC", tax rate assumed at 30%)|
|71||Total impact on liabilities|
|87.8||Total impact on equity and liabilities|
Goodwill represents future economic benefits arising from e.g. acquired workforce, expected synergies or assets acquired that are not individually identified and separately recognised. IFRS 3.B64e requires a qualitative description of the factors that make up the goodwill recognised.
Goodwill is not amortised, but is subject to impairment testing at least annually as per IAS 36 requirements.
If goodwill relates to an acquisition of a foreign subsidiary it is expressed in functional currency of this subsidiary and then subsequently translated as per IAS 21 requirements.
Consideration transferred and contingent consideration
Consideration transferred is the sum of fair values of (IFRS 3.37):
- assets transferred by the acquirer
- liabilities to former owners incurred by the acquirer
- equity interests issued by the acquirer
Usually, consideration is paid in cash. If acquirer transfers other assets, they should be remeasured at fair value at acquisition date. Any difference between fair value and net book value is recognised immediately in P/L. This rule does not apply to assets transferred to the target as acquirer controls them also after the acquisition (IFRS 3.38).
Sometimes the amount (level) of consideration depends on future events. Such consideration is referred to as contingent consideration and it should also be recognised at fair value as a part of business combination. General criteria of IFRS 13 for determination of fair value of liabilities apply also to contingent consideration. Note that the part of contingent consideration that depends on continuous employment of the selling shareholder needs to be excluded from acquisition accounting and treated as an expense in future periods (IFRS 16.B55(a) and January 2013 IFRIC update).
If all contingent consideration is paid in full, but the acquirer has a right to partial return, such a right is recognised as an asset at fair value and it decreases total consideration (IFRS 3.39-40).
Changes in fair value of contingent consideration resulting from events after the acquisition date (e.g. meeting post-acquisition performance targets) are recognised in P/L. Classification in P/L is not covered in IFRS, usually it is presented as a part of operating income and changes resulting from unwinding of discount are presented in finance costs.
Contingent consideration classified as equity as per IAS 32 is not subsequently remeasured and its settlement is accounted for within equity (IFRS 3.58). See IAS 32 for equity/liability distinction.
The acquirer sometimes has a right to withhold part of the consideration for a specific period in case of e.g. violation of the share purchase agreement by the seller (e.g. non-disclosure of a claim against the target). Any changes/adjustments to withheld consideration will result from additional information about facts and circumstances that existed at the acquisition date and are treated as measurement period adjustments.
Similarly, the level of consideration often depends on the level of working capital of the target as at the acquisition date, but this is determined sometime after the acquisition. Any changes to consideration resulting from working capital balances of the target as at the acquisition date are treated as measurement period adjustments.
It is possible that the acquirer obtains control without transferring consideration. It can happen e.g. when the target repurchases its own shares or some rights held by previous controlling interests lapse. All IFRS 3 requirements apply also to this kind of business combinations (IFRS 3.43-44).
Measurement of non-controlling interest
IFRS 3 allows two measurement basis for non-controlling interest (IFRS 3.19):
- fair value or
- the present ownership instruments’ proportionate share of target’s identifiable net assets.
Note that variant 2/ is available only for equity instruments that are present ownership instruments and entitle their holders to a proportionate share of the target’s net assets in the event of liquidation. So e.g. preference shares that entitle their holders to disproportionately higher or lower share of the target’s net assets in the event of liquidation must be measured at fair value.
Fair value of non-controlling interest need to be determined using valuation techniques under IFRS 13. If shares of the target are quoted, their fair value will be determined as ‘price x quantity’. However, it will hardly ever be the case, and it is important to keep in mind that the fair value of non-controlling interest will be usually lower than implied by simple reference to controlling interest of the acquirer. It is so because the acquirer paid so-called control premium (IFRS 3.B44-B45).
Note that non-controlling interests are all instruments classified as equity, not only shares.
Example: two methods of measurement of non-controlling interest
Acquirer Company (AC) acquires 70% shareholding in Target Company (TC) for $50m. Net identifiable assets of TC as at the acquisition date measured under IFRS amount to $40m. Impact of this acquisition on consolidated financial statements of AC is as follows ($m):
Method 1: Non-controlling interest measured at fair value:
|TC's net assets||40|
* measured at fair value under IFRS 13, not the same as a simple math: $50/70%*30%.
Method 2: Non-controlling interest measured at present ownership interest:
|TC's net assets||40|
The decision about the measurement basis can be made on a transaction-by-transaction basis. There are three major implications of such a decision:
- Non-controlling interest measured at fair value will usually be higher than when measured at proportionate share of identifiable net assets – the corresponding impact affects goodwill, making it also higher (see the illustrative example in the excel file above).
- When an impairment loss is charged against goodwill, its amount will be higher when non-controlling interest is measured at fair value (see point 1/ above). The ‘additional’ impairment loss will be allocated to non-controlling interest.
- When the non-controlling interest is subsequently reduced through purchase of additional shares by the parent company, such a transaction is accounted for as an equity transaction under IFRS 10. The higher the non-controlling interest is valued before such a transaction, the lower the reduction in consolidated equity after the transaction.
Previously held equity interest in the target
An acquirer may obtain control over target in which it held some equity interest at the time of obtaining control. For example: Acquirer Company (AC) has 30% interest in Target Company (TC), and then it acquires additional 40% which in aggregate gives AC a 70% interest and control over TC. This is often referred to as step acquisition or piecemeal acquisition. In such a case, the 30% interest should be remeasured to fair value at the acquisition date and any difference between fair value at the date of obtaining control and carrying value should be recognised as gain/loss in P/L or OCI as if it was sold (including recycling OCI to P/L if applicable) (IFRS 3.41-42).
The fair value of previously held equity interest in the target is then derecognised and included in calculation of goodwill.
Gain on bargain purchase
In theory, the equation used for calculating goodwill gives a negative number. Is such cases, a one-off gain on bargain purchase is recognised in P/L. But before that, IFRS 3 requires reassessment and re-examination of all the steps performed in business acquisition accounting (IFRS 3.34-36). IFRS 3.B64n(ii) requires also a disclosure of the reasons why the transaction resulted in a gain (e.g. the seller was under pressure due to liquidity issues).
Gains on bargain purchases are rare in real life. If initial calculations reveal such a gain, fair valuation of assets is usually decreased (alternatively – fair valuation of liabilities is increased). It happens so, because one-off gains are usually excluded from KPIs observed by management and investors. On the other hand, the lower the value of assets, the lower subsequent on-going depreciation and amortisation charges or gains on disposal.
IFRS 3 does not cover overpayments. It is so because the board believes such instances are rare are nearly impossible to detect. Anyway, an acquirer cannot recognise any loss on acquisition due to overpayment, so any overpayment will increase the value of goodwill. In theory, overpayment will trigger an impairment loss during nearest impairment test (IFRS 3.BC382).
Acquisition-related costs, such as professional fees, should be expensed in the periods in which the costs are incurred and the services are received. The costs to issue debt or equity securities shall be recognised in accordance with IAS 32 and IFRS 9 (IFRS 3.53).
The complexity of business combinations combined with often limited access to financial data of the target before the acquisition can make the acquisition accounting impossible to conclude before reporting date. IFRS 3 takes such limitations into account and introduces 12-month measurement period. It is a period during which the acquirer can make retrospective adjustments to acquisition accounting if it obtains new information about facts and circumstances that existed at the acquisition date. Such adjustments should be applied retrospectively together with changes in comparative data, e.g. depreciation charges (IFRS 3.45-50).
Determining what is part of the business combination transaction
Paragraphs IFRS 3.51-52; B50-B62 cover pre-existing relationships and transactions entered into during business combinations which are de facto separate transactions. Transactions that are entered into primarily for the benefit of the acquirer or the combined entity, rather than primarily for the benefit of the target (or its former owners) before the combination, are likely to be separate transactions and should be accounted for separately from the business combination. Examples of such transactions given in IFRS 3.52 are:
- settlements of pre-existing relationships between acquirer and target and
- remuneration of employees or former owners of the target for future services (see also IFRS 16.B55(a) and January 2013 IFRIC update).
IFRS 3.B50 lists factors to consider when assessing whether a transaction should be accounted for separately from a business combination. These include reasons for the transaction, who initiated the transaction and timing of the transaction. Additionally, paragraphs IFRS 3.B54-B55 provide detailed guidance on contingent payments to employees or former owners of the target that help to determine whether such payments are remuneration for future service or a contingent consideration for the target.
The accounting for share-based payment arrangements in the context of business combinations is covered in IFRS 2.
If the business combination settles a pre-existing relationship, the acquirer recognises a gain or loss, measured as follows (IFRS 3.B52):
- for a pre-existing non-contractual relationship (such as a lawsuit), fair value.
- for a pre-existing contractual relationship, the lesser of (i) and (ii):
- the amount by which the contract is favourable or unfavourable from the perspective of the acquirer when compared with terms for current market transactions for the same or similar items.
- the amount of any stated settlement provisions in the contract available to the counterparty to whom the contract is unfavourable
Example: settlement of pre-existing lawsuit
Acquirer Company (AC) acquired Target Company (TC) for $100 m. Before the acquisition, TC filed a lawsuit against AC for breaches of contractual terms. TC demanded a payment of $10m from AC. AC did not recognise any provision as it believed that the probability of cash outflow relating to this case is only 20%. Fair value of the liability is estimated at $2 m.
This claim becomes an intragroup claim after the business combination, so it should be considered effectively settled in the consolidated financial statements of AC and AC should account for this settlement separately from business combination. $2m should be expensed as a cost of settlement, and the remaining $98 m should be accounted for as a consideration for acquisition of TC.
Example: settlement of pre-existing contract
Acquirer Company (AC) acquired Target Company (TC) for $100 m. Before the acquisition, TC was a supplier of AC. At the acquisition date, they had a valid supply contract for product Y at fixed prices and the remaining contractual term was 3 years. As prices of the product Y dropped on the market since the conclusion of the contract, it was unfavourable for AC at the acquisition date. AC was contractually committed to order a minimum of 1,000 pieces of Y each year until the expiration of the contract. AC could terminate the contract, but then it would need to pay a penalty of $5 million to TC.
The fair value of the contract from the supplier’s (TC) perspective is determined at $7 million, of which $3 million relates to above-market fixed pricing, and the remaining $4 million relates to at-market prices. In other words, $3 million is the fair value of the contract attributable to the fact that it is unfavourable to AC.
As a part of the acquisition accounting, the $3 million of consideration paid is recognised by AC as an expense relating to settlement of pre-existing contract. The remaining $4 million corresponding to at-market prices forms a part of goodwill (IFRS 3.IE56).
Overview of disclosure requirements
Disclosure requirements relating to business combinations are set out in paragraphs IFRS 3.59-63,B64-67. Additionally, paragraph IAS 7.40 also lists disclosure requirements for obtaining and losing control of subsidiaries or other businesses, but these can be met by complying with IFRS 3 requirements.
Interestingly, disclosure requirements of IFRS 13 relating to fair value measurements generally do not apply to fair value of assets and liabilities recognised on business combination. So there is no need to provide them unless specifically required by IFRS 3 (eg. for non-controlling interest). Illustrative disclosures included in IFRS 3.IE72 confirm this view. Additionally, IFRS 13 states (IFRS 13.91) that its disclosure requirements relate to fair value measurements after initial recognition.
Disclosure of pro-forma information
Overview of disclosure of pro-forma information
Arguably the most discussed disclosure requirements concern pro-forma information. IFRS 3.B64(q) requires disclosure of revenue and net income of the target since the acquisition date as well as of the combined entity for the current reporting period as though the acquisition date for all business combinations that occurred during the year had been as of the beginning of the annual reporting period.
There is no guidance on how the pro-forma information should be prepared. A simple arithmetical sum will probably not provide meaningful information. The following adjustments should be considered:
Elimination of intragroup transactions
All intragroup transactions should be eliminated in the pro-forma information as it is done on consolidation when preparing actual results.
Adjustments for differences in accounting policies
Pro-forma information should be prepared using uniform accounting policies. If accounting policies of the target where different than those of the acquirer, relevant adjustments to historical results should be made.
Depreciation/amortisation of assets recognised on acquisition
If there are any assets recognised on acquisition by the acquirer, depreciation/amortisation charge relating to those assets should be included in net income from the beginning of the period. The same for additional charge relating to fair value adjustments for assets already recognised by the target.
Increased borrowing costs
If the acquisition was financed through debt, increased borrowing costs should be included in the pro-forma information from the beginning of the period.
Synergy benefits are often a major reason for a business combination. They however need time to be effected after the acquisition and taking them into account for pro-forma information would make this information not comparable with actual results reported immediately after the acquisition. Therefore, synergy benefits are usually excluded from pro-forma information.
However, if there are specific material synergy benefits effected immediately after the acquisition, they can be included in pro-forma information. In such a case, disclosure is crucial.
Some of the above adjustments are more judgemental than others. A description of assumptions used in preparation of pro-forma information will be very useful to users of financial statements. They would also happily see pro-forma information of combined entities for comparative period(s), but IASB decided not to add this requirement to IFRS 3. But it is not forbidden either, so for very significant acquisitions entities may want to add pro-forma information also for comparative period(s).