Business combinations pt. 1

A business combination is defined as the “transaction or other event in which an acquirer obtains control of one or more businesses”. [IFRS 3 Business Combinations Appendix A / ASC Master Glossary].

Although IFRS 10 Consolidated Financial Statements and ASC 810 Consolidation provide guidance for assessing whether control is or has been obtained and for consolidation procedures to be applied, then parents shall account for the initial acquisition of subsidiaries in accordance with IFRS 3/ASC 805 Business Combinations. These standards provide guidance for the measurement of specific items to be included in the consolidated financial statements, e.g. goodwill and non-controlling interest arising from the acquisition of a subsidiary.

Hence, from the definition above, parent entity who is acquiring a subsidiary, needs to determine whether the subsidiary constitutes a business in order to apply IFRS 3 / ASC 805.

Is the subsidiary a business?

Entities applying US GAAP are required to start their assessment with screening test (concentration test under IFRS). Entities applying IFRS may but are not required to start their assessment with concentration test. They can jump straight into analysing the existence of three elements of business.

Under the screening test, if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or group of similar identifiable assets, the subsidiary is not considered a business. The steps of screening test could be summarised as follows:

• Determine all identifiable assets
• Combine any identifiable assets as per exceptions provided in ASC 805-10-55-58
• Assess whetherthe remaining assets are similar assets
• Determine fair value of gross assets acquired
• Compare the fair value of singe identifiable asset/group of similar identifiable assets to the fair value of gross assets acquired
• Is substiantially all of the fair value of the gross assets acquired concentrated in a single identifiable asset/group of similar identifiable assets?
• YES > the entity acquired does not constitute a business
  NO > assess whether the three elements of business are

If the screening test is not met, the parent assesses whether the acquired set of assets and activities constitutes a business based on whether it has at a minimum the three elements of business. That assessment is similar under ASC 805 and IFRS 3.

A business is an integrated set of activities and assets that is capable of being conducted and managed with the aim of providing goods or services to customers, generating investment income (e.g. dividends or interest) or generating other income from ordinary activities. The three elements of a business are:

If the assets acquired and liabilities assumed do not constitute a business, the transaction is accounted for as an acquisition of a group of assets, i.e., the cost of the group is allocated to the individual identifiable assets and liabilities on the basis of their relative fair values at the date of purchase and goodwill is not recognised.

If based on the above analysis an investor determines that it has acquired a business, the business combination shall be accounted for by applying the acquisition method.

Acquisition method of accounting

Involves the following steps:

• Identifying the acquirer
• Determining the acquisition date
• Recognising and measuring the identifiable assets acquired, the liabilities assumed, and any non–controlling interest
• Recognising and measuring goodwill or a gain from a bargain purchase

Identifying the acquirer

The acquirer is the entity that obtains control of the acquiree.

In a business combination effected primarily by transferring cash or other assets or by incurring liabilities, the acquirer is usually the entity that transfers the cash or other assets or incurs the liabilities.

In a business combination effected primarily by exchanging equity interests, the acquirer is usually the entity that issues its equity interests, but in some business combinations, so–called ‘reverse acquisitions’, the issuing entity is the acquiree.

The acquirer is usually the combining entity whose relative size is significantly greater than that of the other combining entity.

Determining the acquisition date

Acquisition date is the date on which the acquirer obtains control of the acquiree.

This is generally the closing date, i.e., the date on which the acquirer legally transfers the consideration, acquires the assets and assumes the liabilities of the acquiree, however this does not necessarily mean that the transaction has to be closed or finalised at law before the acquirer obtains control over the acquiree.

The acquisition date could also be earlier or later than the closing date, if a written agreement provides that the acquirer obtains control of the acquiree on a date before or after the closing date.

Recognising and measuring the identifiable assets acquired, the liabilities assumed, and any non–controlling interest

All identifiable assets acquired, liabilities assumed and non-controlling interests in the acquiree are recognised separately from goodwill.

An asset or liability, in order to qualify for recognition must meet the respective definition provided by the standards. Further, assets and liabilities should exist at the acquisition date and any assets and liabilities arising after the acquisition are not recognised.

Identifiable intangible assets arising from contractual or legal rights, or which are separable are also recognised separately from goodwill (e.g. customer contracts and related customer relationships, royalties).

The identifiable assets acquired, and liabilities assumed are measured at their acquisition–date fair values, thus adjustments are most probably necessary to the carrying values.

Non-controlling interest is the equity in a subsidiary that is not directly or indirectly attributable to a parent. NCI arises only if the parent acquires less than 100% of the subsidiary.

Non–controlling interests that are present ownership interests and entitle their holders to a proportionate share of the entity’s net assets in the event of liquidation can be measured either:

• at fair value, or
• at the non–controlling interest’s proportionate share of the acquiree’s net identifiable assets

Recognising and measuring goodwill or a gain from a bargain purchase

Goodwill at the acquisition date is calculated as the difference between:

• The aggregate of:
  1. The consideration transferred (generally measured at acquisition–date fair value)
  2. The amount of any non–controlling interest in the acquiree, and
  3. The acquisition–date fair value of the acquirer’s previously held equity interest in the acquiree
• The net of the acquisition–date fair values (or other amounts recognised in accordance with the requirements of the standard) of the identifiable assets acquired and the liabilities assumed

Positive goodwill is recognised as an intangible asset in the statement of financial position and tested for impairment annually.

In case the negative goodwill arises, the parent should reassess all components of the computation to verify that no error has been made and recognise a gain in profit or loss.

Illustrative example

Consideration transferred and acquisition related costs

Consideration transferred, including any contingent consideration is measured at acquisition date fair value. Any subsequent changes to the consideration transferred will be accounted for depending on the initial assessment of the contingent consideration.

Costs related to the acquisition of a subsidiary shall be expensed in the period the expenses are incurred and respective services received and are not part of the consideration transferred for the acquiree. The costs of registering and issuing debt/equity are recognised in accordance with IAS 32 and IFRS 9, i.e., as a reduction of the proceeds of the debt or equity securities issued.