1 Unit
CPD technical article
Graham Holt takes a look at the main issues raised in the feedback received by the IASB on IFRS 3
This article was first published in the November/December 2015 international edition of Accounting and Business magazine.
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The International Accounting Standards Board (IASB) recently completed its post-implementation review (PIR) of IFRS 3, Business Combinations. It concluded that there is general support for IFRS 3 and its related standards but that there are several areas where further research is required. This article examines the main issues raised in the feedback received by the IASB.
By definition, IFRS 3 only applies to ‘business’ combinations. The standard defines a business as an ‘integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants’.
It further states that a business consists of inputs and processes applied to those inputs that have the ability to create outputs. The PIR found that most participants believed there were benefits in having separate accounting treatments for business combinations and asset acquisitions. Many users believed that it was sometimes difficult to assess whether an asset acquisition was related to a business because the definition of a business was too broad and more guidance is needed on when an asset acquisition is not a business. For example, the wording ‘capable of being conducted as a business’ was unhelpful in deciding whether a transaction includes a business. Some sets of assets may be considered as a business in one industry but not in another.
It can be argued that a separate accounting treatment for business combinations and asset acquisitions is conceptually justified only with respect to whether or not goodwill is recognised. The main differences in the accounting treatment of an asset acquisition and a business combination relate to deferred tax, contingent payments and acquisition values. Given the difficulties in determining whether the transaction is a business combination, it was felt that the IASB should revisit whether the differences in accounting treatment are really justified. Applying the definition of a business is problematical in certain industries – such as real estate, extractive activities, and pharmaceuticals.
IFRS 3 requires all assets acquired and liabilities assumed in a business combination to be measured at acquisition-date fair value. Fair values do allow users to understand the transaction better. However, fair value makes any comparison between companies that grow organically and those that grow through acquisitions very difficult. Where inventory is increased in value due to the fair value exercise, an entity’s profitability is reduced in the next accounting period following the acquisition. It appears that entities have had several problems when fair valuing net assets on a business combination.
IFRS 3 requires the separate identification and measurement of intangible assets and goodwill, irrespective of whether the entity had recognised the asset prior to the business combination occurring. However, due to the lack of sufficiently reliable data and the unique nature of many intangibles, intangible assets are particularly difficult to measure, especially customer relationships, intangible assets with no active market, and development intangible assets.
There are varying views on the separate recognition of intangible assets from goodwill because of the subjectivity involved. One view is that these intangible assets should be recognised only if there is a market for them whereas an alternate view is that the identification of the intangibles provides insights into the purchase and an understanding of the components of the acquired business.
Many intangible assets are unique, not easy to value and valuation methods are often complex.
In addition, the measurement of contingent consideration is highly subjective. Contingent consideration must be measured at fair value at the time of the business combination and is taken into account in the determination of goodwill.
Contingent consideration classified as an asset or liability is measured at fair value at each reporting date, and changes in fair value are recognised in profit or loss.
An example given by the IASB was the pharmaceutical industry. Here, the research and development stage of a drug can constitute a significant period before it comes to market. Therefore, contingent consideration payments linked to the success of the drug can be difficult to fair value at the acquisition date or within 12 months of that date. Furthermore, many participants felt that the IASB should reconsider the subsequent accounting for contingent consideration.
Where contingent consideration is directly linked to an acquired intangible asset such as the research and development of a drug, the values of the liability and the intangible asset change in relation to the development of the project. The argument is therefore that in order to avoid an accounting mismatch, changes in the fair value of the liability should be adjusted against the value of the related intangible asset, instead of in profit or loss.
Contingent liabilities that are a present obligation and can be measured reliably are recognised in a business combination. However, the fair value of contingent liabilities is difficult to measure as fair value relies on a number of assumptions and the fair valuation exercise is not helped by the current lack of guidance in IFRS 3.
There was interesting feedback on the treatment of goodwill and bargain purchases on acquisition. IFRS 3 states that where the acquirer has made a gain from a bargain purchase that gain is recognised in profit or loss. If the gain from a bargain purchase is properly disclosed, then investors have the choice of stripping out or leaving in gains from bargain purchases in their assessment of the entity’s performance.
Many investors have no strong views on accounting for bargain purchases although some think that such gains should be shown in OCI (other comprehensive income). IAS 36, Impairment of Assets, states that goodwill should be tested for impairment annually and thus is not amortised. However, investors have mixed views on the impairment‑only approach to goodwill.
Investors who support the impairment approach feel that the current practice is useful, as it relates the price paid to what was acquired and helps in the calculation of the return on the investment. The impairment approach further reflects whether an acquisition is working as expected and confirms the current ‘value’ of goodwill. However, there are alternative views.
Purchased goodwill is gradually replaced by internally generated goodwill over time (which is the principle behind not allowing any impairment reversal), hence goodwill should be amortised. The useful life of goodwill can just as easily be calculated as that of other intangibles, and amortisation would reduce the volatility in profit or loss as compared to annual impairment charges.
As mentioned above, the identification of intangibles on acquisition is difficult, therefore the amortisation of goodwill would reduce this pressure as both goodwill and intangible assets would be amortised.
The Accounting Standards Board of Japan (ASBJ) has published a research paper, which reviews public disclosures regarding goodwill amortisation under the Japanese accounting standards. The ASBJ staff found that it is difficult to conclude that the impairment-only approach is superior to the amortisation approach. The majority of Japanese financial statement users expressed support for the amortisation approach.
It is inevitable that managerial discretion will be used in recognising impairment of goodwill as it involves significant judgment. There is an opinion that the impairment test is complex, time-consuming and expensive. The value in use calculation has its limitations, due to the difficulty in determining the pre-tax discount rate, the subjective assumptions used in the calculation and the requirement to use the most recent approved budgets, which over time can be substantially different from the business plans at acquisition. In addition, the allocation of goodwill to cash-generating units is subjective, as is the re-allocation of goodwill when a restructuring occurs.
Many investors do not support a measurement choice for non-controlling interest (NCI). IFRS 3 allows an accounting policy choice, available on a transaction by transaction basis, to measure NCI either at fair value or the NCI’s proportionate share of net assets of the acquiree. However, investors were divided on which policy was preferable. The measurement of NCI at fair value creates practical difficulties where, for example, the shares of the acquiree are not traded in an active market. As part of accounting for the business combination, the acquirer remeasures any previously held interest at fair value and takes this amount into account in the determination of goodwill. Investors do not consider these gains (or losses) in their valuation models and thus they feel that it would be useful to have these gains (or losses) clearly identified in the financial statements.
Many investors feel that it is often difficult to assess the subsequent performance of the acquired business and think that better disclosure is required. In particular, they find it hard to determine how much the business has grown organically as opposed to through acquisitions. More information on the operating performance of the acquired business after the business combination is, in their opinion, required, specifically, information on its revenues and operating profit.
IFRS 3 requires the disclosure of the revenue and profit or loss 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. Entities find it very difficult to disclose this information because information prior to the acquisition is not always readily available. Because of the practical limitations and the significant effort required to determine the disclosures, they think the IASB should consider providing some relief from this disclosure requirement. The IASB has expressed its opinions on the significance of the above points.
Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan Business School
1 Unit
CPD technical article
"Most participants saw benefits in having separate accounting treatments for business combinations and asset acquisitions"