This article provides an introduction to IFRS® 3, Business Combinations and IFRS, 10 Consolidated Financial Statements, including piecemeal acquisitions and disposals.
The purchase consideration includes the fair value of all interests that the acquirer may have held previously in the acquired business. This includes any interest in an associate or joint venture, or other equity interests of the acquired business. Any previous stake is seen as being ‘given up’ to acquire the entity, and a gain or loss is recorded on its disposal.
If the acquirer already held an interest in the acquired entity before acquisition, the standard requires the existing stake to be re-measured to fair value at the date of acquisition, taking into account any movement to the statement of profit or loss together with any gains previously recorded in equity that relate to the existing holding. If the value of the stake has increased, there will be a gain recognised in the statement of comprehensive income of the acquirer at the date of the business combination. A loss would only occur if the existing interest has a carrying amount in excess of the proportion of the fair value of the business obtained and no impairment had been recorded previously. This loss situation is not expected to occur frequently.
Contingent consideration is also recognised at fair value even if payment is not deemed to be probable at the date of the acquisition.
Josey acquires 100% of the equity of Burton on 31 December 2008. There are three elements to the purchase consideration: an immediate payment of $5m, and two further payments of $1m if the return on capital employed (ROCE) exceeds 10% in each of the subsequent financial years ending 31 December. All indicators have suggested that this target will be met. Josey uses a discount rate of 7% in any present value calculations.
Determine the value of the investment.
The two payments that are conditional upon reaching the target ROCE are contingent consideration and the fair value of $(1m/1.07 + 1m/1.072) ie $1.81m will be added to the immediate cash payment of $5m to give a total consideration of $6.81m.
All subsequent changes in debt-contingent consideration are recognised in the statement of profit or loss, rather than against goodwill, as they are deemed to be a liability recognised in accordance with IFRS 9, Financial Instruments. An increase in the liability for good performance by the subsidiary results in an expense in the statement of profit or loss, and under-performance against targets will result in a reduction in the expected payment and will be recorded as a gain in the statement of profit or loss. These changes were previously recorded against goodwill.
The nature of the contingent consideration is important as it may meet the definition of a liability or equity. If it meets the definition of equity, then there will be no re-measurement. The new requirement is that contingent consideration is fair valued at acquisition and, unless it is equity, is subsequently re-measured through earnings rather than the historic practice of re-measuring through goodwill. This change is likely to increase the focus and attention on the opening fair value calculation and subsequent re-measurements.
The standard also requires any gain on a ‘bargain purchase’ (negative goodwill) to be recorded in the statement of profit or loss, as in the previous standard.
Transaction costs no longer form a part of the acquisition price; they are expensed as incurred. Transaction costs are not deemed to be part of what is paid to the seller of a business. They are also not deemed to be assets of the purchased business that should be recognised on acquisition. The standard requires entities to disclose the amount of transaction costs that have been incurred.
The standard clarifies accounting for employee share-based payments by providing additional guidance on valuation, as well as on how to decide whether share awards are part of the consideration for the business combination or are compensation for future services.
Goodwill and non-controlling interests (NCI)
Goodwill is ‘an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognised’ (IFRS 3 Appendix A). In simple terms, goodwill is measured as the difference between:
- the consideration paid plus any NCI, and
- the acquisition–date fair value of identifiable net assets acquired
Thus, the measurement of NCI impacts on the calculation of goodwill. IFRS 3 gives entities the option, on an individual transaction basis, to measure NCIs at the fair value of their proportion of identifiable assets and liabilities (partial method), or at full fair value (full method).
Missile acquires a subsidiary on 1 January 2008. The fair value of the identifiable net assets of the subsidiary was $2,170m. Missile acquired 70% of the shares of the subsidiary for $2.145m. The NCI was fair valued at $683m.
Compare the value of goodwill under the partial and full methods.
Goodwill based on the partial and full goodwill methods under IFRS 3 (Revised) would be:
|Fair value of identifiable net assets||(2,170)|
|NCI (30% x 2,170)||651|
|Fair value of identifiable net assets||(2,170)|
It can be seen that goodwill is effectively adjusted for the change in the value of the NCI, which represents the goodwill attributable to the NCI of $32m ($658m – $626m). Choosing this method of accounting for NCI only makes a difference in an acquisition where less than 100% of the acquired business is purchased. The full goodwill method will increase reported net assets on the statement of financial position, which means that any future impairment of goodwill will be greater. Although measuring NCI at fair value may prove difficult, goodwill impairment testing is likely to be easier under full goodwill, as there is no need to gross-up goodwill for partially owned subsidiaries.
Fair valuing assets and liabilities
IFRS 3 (Revised) requires all of the identifiable assets and liabilities of the acquiree to be included in the consolidated statement of financial position. Most assets are recognised at fair value, with exceptions for certain items such as deferred tax and pension obligations. The International Accounting Standards Board provided additional clarity that has resulted in more intangible assets being recognised than previously. Acquirers are required to recognise brands, licences and customer relationships, and other intangible assets.
Contingent assets are not recognised, and contingent liabilities are measured at fair value. After the date of the business combination, contingent liabilities are re-measured at the higher of the original amount and the amount in accordance with the relevant standard.
The ability of an acquirer to recognise a liability for terminating or reducing the activities of the acquiree is severely restricted. A restructuring provision can be recognised in a business combination only when the acquiree has, at the acquisition date, an existing liability for which there are detailed conditions in IAS 37, but these conditions are unlikely to exist at the acquisition date in most business combinations.
An acquirer has a maximum period of 12 months from the date of acquisition to finalise the acquisition accounting. The adjustment period ends when the acquirer has gathered all the necessary information, subject to the 12-month maximum. There is no exemption from the 12-month rule for deferred tax assets or changes in the amount of contingent consideration. The revised standard will only allow adjustments against goodwill within this one-year period.
Where NCI is measured at fair value, the valuation methods used for determining that value require to be disclosed; and, in a step acquisition, disclosure is required of the fair value of any previously held equity interest in the acquiree, and the amount of gain or loss recognised in the statement of profit or loss resulting from re-measurement.
IFRS 10, Consolidated financial statements
The objective of IFRS 10 is to establish principles for the presentation and preparation of consolidated financial statements. These are the financial statements of a group where the parent and its subsidiaries are presented as those of a single economic entity. The economic entity approach treats all providers of equity capital as shareholders of the entity, even when they are not shareholders in the parent company.
For example, disposal of a partial interest in a subsidiary in which the parent company retains control, does not result in a gain or loss but in an increase or decrease in equity under the economic entity approach. Purchase of some or all of the NCI is treated as a treasury transaction and accounted for in equity. A partial disposal of an interest in a subsidiary in which the parent company loses control but retains an interest as an associate, creates the recognition of gain or loss on the entire interest. A gain or loss is recognised on the part that has been disposed of, and a further holding gain is recognised on the interest retained, being the difference between the fair value of the interest and the carrying amount of the interest. The gains are recognised in the statement of comprehensive income. Amendments to IAS 28, Investments in Associates, extend this treatment to associates and joint ventures.
On 1 January 2008, A acquired a 50% interest in B for $60m. A already held a 20% interest which had been acquired for $20m but which was valued at $24m at 1 January 2008. The fair value of the NCI at 1 January 2008 was $40m, and the fair value of the identifiable net assets of B was $110m. The goodwill calculation would be as follows, using the full goodwill method:
|1 January 2008 consideration||60|
|Fair value of interest held||24|
|Fair value of identifiable net assets||(110)|
A gain of $4m would be recorded on the increase in the value of the previous holding in B.
Acquisition of part of an NCI
On 1 January 2008, Rage acquired 70% of the equity interests of Pin, a public limited company. The purchase consideration comprised cash of $360m. The fair value of the identifiable net assets was $480m. The fair value of the NCI in Pin was $210m on 1 January 2008. Rage wishes to use the full goodwill method for all acquisitions. Rage acquired a further 10% interest from the NCIs in Pin on 31 December 2008 for a cash consideration of $85m. The carrying amount of the net assets of Pin was $535m at 31 December 2008.
|Fair value of consideration for 70% interest||360|
|Fair value of NCI||210|
|Fair value of identifiable net assets||(480)|
Acquisition of further interest
The net assets of Pin have increased by $(535 – 480)m – ie $55m and therefore the NCI has increased by 30% of $55m – ie $16.5m. However, Rage has purchased an additional 10% of the shares and this is treated as a treasury transaction. There is no adjustment to goodwill on the further acquisition.
|Pin NCI, 1 January 2008||210|
|Share of increase in net assets in post-acquisition period||16.5|
|Net assets, 31 December 2008||226.5|
|Transfer to equity of Rage (10/30 x 226.5)||(75.5)|
|Balance at 31 December 2008 – NCI||151|
|Fair value of consideration||85|
|Charge to NCI||(75.5)|
|Negative movement in equity||9.5|
Rage has effectively purchased a further share of the NCI, with the premium paid for that share naturally being charged to equity. The situation is comparable when a parent company sells part of its holding but retains control.
Disposal of part of holding to NCI
Using Example 4, instead of acquiring a further 10%, Rage disposes of a 10% interest to the NCIs in Pin on 31 December 2008 for a cash consideration of $65m. The carrying amount of the net assets of Pin is $535m at 31 December 2008.
|Pin net assets at 1 January 2008||480|
|Increase in net assets||55|
|Net assets at 31 December 2008||535|
|Fair value of consideration||65|
|Transfer to NCI (10% x (535 net assets + 90 goodwill))||(62.5)|
|Positive movement in equity||2.5|
The parent has effectively sold 10% of the carrying amount of the net assets (including goodwill) of the subsidiary ($62.5m) at 31 December 2008 for a consideration of $65m, giving a profit of $2.5m, which is taken to equity.
Disposal of controlling interest while retaining associate holding
IFRS 10 sets out the adjustments to be made when a parent loses control of a subsidiary:
- Derecognise the carrying amount of assets (including goodwill), liabilities and NCIs
- Recognise the fair value of consideration received
- Recognise any distribution of shares to owners
- Recognise the fair value of any residual interest
- Reclassify to profit or loss any amounts (the entire amount, not a proportion) relating to the subsidiary’s assets and liabilities previously recognised in other comprehensive income, as if the assets and liabilities had been disposed of directly
- Recognise the fair value of any residual interest.
Disposal of controlling interest
On 1 January 2008, Rage acquired a 90% interest in Machine, a public limited company, for a cash consideration of $80m. Machine’s identifiable net assets had a fair value of £74m and the NCI had a fair value of $6m. Rage uses the full goodwill method. On 31 December 2008, Grange disposed of 65% of the equity of Machine (no other investor obtained control as a result of the disposal) when its identifiable net assets were $83m. Of the increase in net assets, $6m had been reported in profit or loss, and $3m had been reported in comprehensive income. The sale proceeds were $65m, and the remaining equity interest was fair valued at $25m. After the disposal, Machine is classified as an associate in accordance with IAS 28, Investments in Associates. The gain recognised in profit or loss would be as follows:
|Fair value of consideration||65|
|Fair value of residual interest to be recognised as an associate||25|
|Gain reported in comprehensive income||3|
|Less net assets and goodwill derecognised:|
|goodwill (80 + 6 – 74)||(12)|
|Gain on disposal to profit or loss||4.9|
After the sale of the interest, the holding in the associate will be fair valued at $25m.
Issues associated with both IFRS 3 and IFRS 10 will be tested regularly in SBR and candidates should be comfortable with the numerical examples provided above. Candidates should also be able to provide an explanation of the principles that support these calculations.