IFRS 3 – Business Combinations
What is a business combination and why do reporting entities undertake business combinations?
Reporting entities undertake business combinations to expand or deepen their business activities. A business combination represents the joining of entities or businesses that previously operated separately into a single economic entity, such that one entity (the acquirer) obtains control over another entity or another business (the acquiree). The consideration the acquirer pays to obtain control can take different forms, ranging from cash or other assets, through a liability incurred by the acquirer (a purchase on credit), to issuing the acquirer’s shares to the seller.
Business combinations are carried out for a wide variety of business purposes: entry into new areas of activity and risk reduction through diversification, synergy considerations between the merging businesses (economies of scale in production and/or marketing, reduction of duplications and increased market power when facing customers, suppliers and competitors), streamlining the acquiree’s operations, leveraging tax advantages and sometimes even due to managerial considerations (managers wishing to increase their power even if the merger does not necessarily add value to shareholders). Note that antitrust laws and regulations typically prevent situations where mergers between competing companies operating in the same market (horizontal mergers) or mergers between companies that are not in the same market but are supplier and distributor (vertical mergers) harm competition.
How are business combinations defined for accounting purposes and how do they differ from legal definitions?
In practice, different terms are used to describe business combinations: acquisition, share swap, merger of businesses and business integration. The accounting definition of a business combination is based on an economic definition, as noted—obtaining control of another business. It is important to emphasise that this accounting definition is not necessarily identical to legal and tax definitions.
Legally, business combinations can be effected in various forms, sometimes chosen for tax reasons. The two most common forms are acquiring shares that confer control and acquiring net assets.
Which accounting methods were historically used for business combinations and why was one eliminated?
In the past, two accounting methods were used to account for a business combination: the purchase method and the pooling-of-interests method, with the latter used for combinations of entities of similar size (“merger of equals”). The rationale behind the purchase method is that one business has taken over another, and therefore it should be accounted for as a purchase in every respect — recognising the acquiree’s assets and liabilities at their fair value at the acquisition date, similar to accounting for the purchase of a single asset. By contrast, the concept underlying the pooling-of-interests method was that, in a merger of equals, it is not possible to clearly identify one party as having acquired the other (an act of purchase), and therefore the guiding concept is that two groups of shareholders have combined their holdings to operate together. Consequently, under the pooling-of-interests method, following the combination both businesses continued to be measured at their pre-combination carrying amounts, and neither was remeasured to fair value.
Although the use of the pooling-of-interests method was limited to certain cases only, many objections were raised against it. First, analysts and other financial statement users argued that permitting two accounting methods for substantially similar transactions impairs comparability of financial statements. Moreover, the prevailing view was that merely having a choice between two methods leading to different accounting outcomes created an incentive to structure business combinations to achieve the desired accounting result. For example, companies preferred the pooling-of-interests method to avoid recording heavy future amortisation of goodwill (which used to be amortised on a systematic basis) or impairment, as well as other purchase accounting premiums, which would weigh on future consolidated profit or loss post-combination.
What accounting method does IFRS 3 require for business combinations?
IFRS 3 requires that all business combinations within its scope be accounted for using the acquisition method, under which one of the combining businesses is identified as the acquiree and the other as the acquirer. Under this method, the acquirer generally recognises in its financial statements all the acquiree’s identifiable assets and liabilities (tangible and intangible) at fair value at the acquisition date. To this end, the fair value of all identifiable assets and liabilities of the acquiree must be measured and, in certain cases, the fair value of non-controlling interests as well. In addition, the acquirer’s statement of profit or loss will include the acquiree’s post-acquisition profit or loss by combining the acquiree’s revenue and expenses with the acquirer’s results based on the acquirer’s cost. For example, the depreciation expense for the acquiree’s assets included in the acquirer’s profit or loss after the acquisition date will be based on the fair value of those assets at the acquisition date, i.e., their cost to the acquirer.
What are the main steps in applying the acquisition method?
Applying the acquisition method includes the following steps: determining the acquisition date, identifying the acquirer, measuring the cost of the business combination and allocating the cost of the business combination at the acquisition date to the assets acquired and liabilities (including contingent liabilities) assumed.
How does IFRS 3 treat goodwill and identifiable intangible assets?
The Standard reflects the modern approach to accounting for goodwill and intangible assets acquired in a business combination. Goodwill represents the economic benefits arising from a business that cannot be identified separately and is measured at the acquisition date as a residual amount. Under current accepted approach, goodwill is not amortised on a systematic basis. Instead, it is subject to an annual impairment test. In the past, goodwill was amortised on a straight-line basis over various periods (from 20 years under former IFRS Accounting Standards up to 40 years under former US GAAP). This approach is no longer applied, among other reasons, due to concerns about arbitrary determination of useful lives or amortisation that did not necessarily reflect the pattern of consumption of goodwill, if any, given that it is not an identifiable asset. At the same time, under the current approach, clear and strict principles were established for identifying and separating intangible assets from goodwill, partly out of concern that reporting entities would have an incentive to inflate goodwill because it is not amortised on a systematic basis. Furthermore, since IFRS Accounting Standards require goodwill and intangible assets with indefinite useful lives not be amortised, IAS 36 Impairment of Assets sets out principles for performing an annual impairment test for those assets.
How does IFRS 3 interact with IAS 38 and IAS 36?
As noted, the Standard applies to the accounting for goodwill at initial recognition and in subsequent periods. The accounting for identifiable intangible assets is set out in IAS 38 Intangible Assets. However, the Standard deals extensively with the identification of intangible assets at the acquisition date and includes common examples of identifiable intangible assets.
Does IFRS 3 permit push-down accounting?
The Standard prohibits applying “push-down accounting,” which is required under U.S. SEC rules in certain circumstances, usually where all or substantially all shares of the acquiree are purchased. Under push-down accounting, the acquiree’s assets and liabilities are measured at fair value at the acquisition date in the acquiree’s own financial statements. In contrast, under IFRS 3 measuring the acquiree’s assets and liabilities at fair value at the acquisition date is performed only in the consolidated financial statements and not in the acquiree’s own financial statements.
Which transactions are excluded from the scope of IFRS 3?
Note that the Standard does not apply to business combinations under common control, which usually arise from a reorganisation of holdings within a group. For example, a parent owns two subsidiaries, Company A and Company B. As part of group reorganisation, Company A acquires the shares of Company B in exchange for issuing shares to the parent, so that after the reorganisation the parent still controls both Company A (directly) and Company B (indirectly). In practice, such transactions may be accounted for using more than one approach: the acquisition method or similarly to the pooling-of-interests method (“as pooling”).
What is the entity concept adopted by IFRS 3 and what are its implications?
IFRS 3 includes two Conceptual principles as follows:
A. The entity concept
IFRS 3 is currently based on the entity concept, as opposed to the proprietary concept that was previously used. The difference between the two concepts relates to the treatment of non-controlling interests: the proprietary concept views them as external owners (even if presented in equity), while the entity concept views them as an integral part of the group’s shareholders.
Applying the entity concept has significant implications for the financial statements, starting with the accounting for changes in ownership interests, through the measurement of goodwill and non-controlling interests, and including other implications for the relationship between majority and minority shareholders.
As a result, a decrease in ownership interest in a subsidiary due to a direct sale of shares or due to an issuance of shares by the subsidiary to a third party, that does not result in a loss of control, represents a transaction with non-controlling interests who, under the entity concept, are shareholders in every respect. Therefore, the transaction is accounted for within equity.
Similarly, an increase in ownership interest in an existing subsidiary (that does not result in obtaining control) due to a direct purchase of shares or due to a buyback of shares by the subsidiary from a third party, represents a transaction with non-controlling interests who, under the entity concept, are shareholders in every respect. Therefore, the transaction is accounted for within equity.
In addition, under the entity concept, goodwill in the consolidated financial statements may be measured on a full fair value basis, such that non-controlling interests “participate” in goodwill and, are thus measured at the acquisition-date fair value. However, unlike US GAAP, IFRS 3 permits the application of the proprietary concept in this regard, i.e., measuring non-controlling interests at their proportionate share of the identifiable net assets, so that goodwill is recognised only to the extent of the parent’s share.
How does IFRS 3 address transitions between different accounting models for investments?
B. A conceptual approach to transitions between accounting models
Another conceptual principle in IFRS 3 relates to transitions between different accounting models for investments in shares, which are treated as triggers for full notional transactions (derecognition and re-recognition), and not only for the transaction actually carried out (for example, only a relative increase/decrease in ownership).
Consequently, under IFRS 3, an increase in ownership interest that results in obtaining control is treated as a notional sale at the acquisition-date fair value of the previously held interest that had been accounted for as a financial asset or under the equity method, as applicable. Simultaneously, the acquisition is also accounted for as the initial inclusion of a “new” subsidiary in the consolidated group. This concept directly leads to recognition of a gain or loss on the previously held shares.
Similarly, under IFRS 10, a decrease in ownership interest in a subsidiary that results in a loss of control is treated as a notional exit of the entire subsidiary from the consolidated group. Therefore, a gain or loss should be recognised not only on the shares sold, but also on the shares retained, which will be measured at fair value at the date when control is lost, and subsequently accounted for as a financial asset or under the equity method, as applicable. Note that this notional concept is also relevant to a loss of significant influence.