IFRS 3 governs the accounting for business combinations, defined as transactions or events where an acquirer obtains control of one or more businesses. However, IFRS 3 does not cover (IFRS 3.2-2A):
- Business combinations 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 (note that from an investor’s viewpoint, forming a joint arrangement is not a business combination since no party controls a joint arrangement).
- Acquisition by an investment entity of an investment in a subsidiary measured at fair value through profit or loss.
Identifying a business combination
Business combinations can be structured in various forms due to legal, tax, or other considerations. These may include (IFRS 3.B5-B6):
- One or more businesses becoming subsidiaries of the acquirer.
- Merging of net assets into the acquirer.
- Transferring net assets or equity interests to another entity.
- All combining entities transferring assets or equity interests to a newly formed entity.
- A situation where a group of former owners controls the newly combined entity.
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Defining a business
A business is a set of inputs and processes capable of producing outputs. Inputs are resources such as non-current assets, intellectual property, access to materials, rights, and employees. Processes are systems, conventions or rules, including strategic management or resource management processes, applied to inputs to generate outputs. These processes can be documented or inherent in the workforce’s expertise and experience. Outputs are goods, services, or income like dividends or interest.
However, outputs are not a prerequisite for an activity set to be considered a business. To qualify as a business, there must be both inputs and substantial processes that contribute to producing outputs. Not all inputs or processes used by the seller are necessary; at minimum, an input and a substantive process should be present. The mere continuation of revenue or presence of outputs does not suffice to classify an acquired set as a business. The composition of a business varies across industries and operations, with established businesses typically having a variety of inputs, processes, and outputs, while new businesses might have fewer inputs and processes, and perhaps only a single output.
While liabilities are common in businesses, they are not a defining characteristic. The assessment of whether a set of activities and assets constitutes a business depends on its ability to be operated and managed as a business by a market participant, regardless of its previous management by the seller or the acquirer’s intentions (IFRS 3.B7-B11).
Assessing whether an acquired process is substantive
Determining whether an acquired process is substantive involves closely examining the involved activities and assets, especially their capacity to produce outputs. For early-stage entities not yet generating revenue at the time of acquisition, they are considered to have no outputs. In contrast, if the set of activities and assets was producing revenue at that point, it is recognised as having outputs, regardless of its potential to generate future revenue post-acquisition due to integration by the purchaser.
A process is deemed substantive if it is essential for transforming inputs into outputs. These inputs should include an organised workforce equipped with necessary skills, knowledge, or experience, as well as additional resources like intellectual property or economic resources that can be developed into outputs.
When the set of activities and assets produces outputs at the acquisition date, the substantive nature of the acquired process depends on its role in sustaining output production. The inputs should either consist of a workforce capable of executing these processes or must significantly aid in continuing output production, while being unique, scarce, or costly and time-consuming to replace.
A standalone acquired contract, though an input, does not constitute a substantive process by itself. However, contracts granting access to an organised workforce might indicate a substantive process. The contract’s duration, renewal terms, and the challenges in replacing the workforce are key in evaluating the importance of processes for creating outputs. Processes that are merely supportive or minor do not qualify as substantive in this respect (IFRS 3.B12-B12D).
Optional concentration test
The optional ‘concentration test’ in IFRS 3.B7B offers a simplified method to determine if an acquired set of activities and assets is a business. Entities can apply this test on a transaction-by-transaction basis. The test is passed, indicating the set is not a business, if the majority of the fair value of gross assets acquired is concentrated in a single identifiable asset or a group of similar assets.
This test excludes certain assets like cash, cash equivalents, or deferred tax assets. The fair value calculation should include the transferred consideration, any non-controlling interest, and previously held interest, minus the fair value of net identifiable assets acquired. If the fair value of gross assets surpasses this sum, further calculation is needed.
A single identifiable asset is either an asset or asset group considered as one in a business combination, like inseparable physical assets or assets costly to separate (e.g., land and buildings). When assessing similarity, the nature of each asset and the risks in managing and producing outputs from them should be considered, focusing on risk characteristics. Dissimilar assets include different tangible or intangible asset classes (like inventory and manufacturing equipment or brand names and licences), financial and non-financial assets, financial assets of different classes, or assets within the same class but with significantly varying risk characteristics.
The optional concentration test is further explained in Grant Thornton’s publication.
Business combinations under common control
In late 2023, the IASB has decided to abandon its project on business combinations under common control (BCUCC). As a result, entities are left without a standardised accounting policy for BCUCCs, potentially indefinitely. The Discussion Paper on BCUCC by the IASB will provide valuable guidance in this area. Other useful resources include:
- Technical publication by GrantThornton.
- IFRS staff paper on parent-subsidiary mergers.
More about IFRS 3
See other pages relating to IFRS 3:
Accounting for Business Combinations
Disclosure Requirements for Business Combinations