Accounting for Business combinations cash flows
1. Presentation and disclosure of cash paid/acquired in a business combination
When an entity acquires a business and part or all of the consideration is in cash or cash equivalents, part of the net assets acquired may include the acquiree’s existing cash balance. This results in different amounts being presented in the statement of cash flows and the notes to the financial statements.
IAS 7.39 and 42 require the net cash flows arising from gaining or losing control of a business, to be classified as arising from investing activities. Consequently, the statement of cash flows will not include the gross cash flows arising from the acquisition, and will instead show a single net amount. IAS 7.40 then requires the gross amounts to be disclosed in the notes.
The disclosures required by IFRS 3 Business Combinations include:
- The acquisition date fair value of total consideration transferred, analysed into each major class of consideration including the cash element (IFRS 3.B64(f)(i))
- Major classes of assets and liabilities acquired, of which cash and cash equivalents would be a class (IFRS 3.B64(i)).
2. Transaction costs
IFRS 3 requires transaction costs incurred in connection with a business combination to be expensed, because they relate to the purchase of services and not to the acquisition of the business.
Only cash outflows that result in the recognition of an asset in the statement of financial position are classified as arising from investing activities in the statement of cash flows. Consequently, cash flows arising from transaction costs related to a business combination are classified as arising from operating activities in consolidated financial statements.
However, if an entity prepares separate financial statements in accordance with IFRS, transaction costs are included as part of the cost of the investment in a subsidiary. Consequently, in the separate (parent) entity’s statement of cash flows, cash flows arising from transaction costs will be classified as arising from investing activities.
3. Deferred and contingent consideration
IAS 7.39 requires the aggregate cash flows arising from obtaining (or losing) control of a subsidiary or other business to be classified as being derived from investing activities.
This is consistent with the requirement of IAS 7.16 that only expenditure that results in an asset that is recognised in the statement of financial position can be classified as arising from investing activities.
While this appears straightforward, issues arise when determining how cash outflows associated with deferred or contingent consideration should be presented in the statement of cash flows.
(i) Deferred consideration
Some business combinations may involve deferral of (a portion of) the purchase consideration to a future date. A key question is whether cash flows associated with deferred consideration should be classified as arising from investing activities (on the basis that they are in connection with the acquisition of net assets), or from financing activities (on the basis that the vendor is providing a form of finance).
In general, these cash flows should normally be classified as arising from investing activities on the basis that this is consistent with the nature of the original transaction which gave rise to the initial recognition of assets and liabilities in the statement of financial position. This would include any adjustments resulting from additional information about facts and circumstances that existed at the acquisition date.
However, in limited cases deferred consideration may be similar in nature to a loan granted by the vendor, with the associated cash flows being classified as arising from financing activities. In our view, this may be the case when the period between the acquisition date and settlement of the deferred consideration is sufficiently long that the vendor would recognise imputed interest (see Classification of interest and dividends for the classification of cash flows relating to interest). Classification as financing would be appropriate if the vendor accepted payment in the form of a long term loan note.
(ii) Contingent consideration
When a business combination involves an adjustment to consideration payable to the vendor that is contingent on future events, IFRS 3 requires the acquirer to recognise the acquisition date fair value of the contingent consideration with an associated adjustment to goodwill.
The related obligation (which meets the definition of a financial instrument) is classified as a financial liability or within equity in accordance with the requirements of IAS 32 Financial Instruments: Presentation.
For obligations that are to be settled in cash or cash equivalents, subsequent changes in the carrying amount of the liability are recorded in profit or loss. The classification of the related cash flows is affected by this requirement, because IAS 7.16 only permits cash outflows that result in the recognition of an asset to be classified as arising from investing activities.
This requirement of IAS 7 indicates that cash payments arising from any post acquisition date increase in the carrying amount of contingent consideration cannot be classified as arising from investing activities, because the incremental amount would be charged to profit or loss and would not result in the recognition of an asset (or an increase in carrying amount of an asset).
This means that those excess cash flows would typically be classified as arising from operating activities (particularly if the increase arose from a formula linked to the operating performance of the acquired business). In limited cases, it may be appropriate to classify at least some of the cash flows as arising from financing activities (see deferred consideration above).
However, it is necessary to look at the extent to which the amount of contingent consideration payable is affected by factors other than time value of money and, the more linkage there is to future business performance, the more difficult it will be to identify any financing component.
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