IAS 1 Common control transactions v Newco formation

Common control transactions v Newco formation

are two different events, that sometimes interactCommon control transactions v Newco formation

  • Common control transactions represent the transfer of assets or an exchange of equity interests among entities under the same parent’s control. “Control” can be established through a majority voting interest, as well as variable interests and contractual arrangements. Entities that are consolidated by the same parent—or that would be consolidated, if consolidated financial statements were required to be prepared by the parent or controlling party—are considered to be under common control.Determining whether common control exists requires judgment and could have broad implications for financial reporting, deals and tax. Just a few examples are:
    • A reporting entity charters a newly formed entity to effect a transaction.
    • A ‘Never-Neverland‘-domiciled company transfers assets to a subsidiary domiciled in a different jurisdiction.
    • Two companies under common control combine to form one legal entity.
    • Prior to spin-off of a subsidiary by a parent entity, another wholly owned subsidiary transfers net assets to the “SpinCo.”
    • As part of a reorganization, a parent entity merges with and into a wholly owned subsidiary.
  • Newco formations may be used in Business Combinations or businesses controlled by the same party (or parties). Just a few examples are: Common control transactions v Newco formation
    • A Newco can be formed by the controlling party (for example, to facilitate subsequent disposal of the newly created group through an initial public offering (IPO) or a spin-off or by a third-party acquirer (for example to raise funds to effect the acquisition); Common control transactions v Newco formation
    • A Newco can pay cash or shares to effect an acquisition; and
    • A Newco can be formed to acquire just one business or more than one business.

OverviewAcquisition accounting

In general, the acquirer in a common control transaction has a choice of applying either book value accounting or acquisition accounting in its consolidated financial statements.

The transferor losing control in a common control transaction that is not a demerger applies the general guidance on loss of control in its consolidated financial statements.

In general, the transferor in a common control transaction that is a demerger has a choice of applying either book value accounting or fair value accounting in its consolidated financial statements.

Newco formations generally fall into one of two categories: to effect a business combination involving a third party, or to effect a restructuring among entities under common control.

In a Newco formation to effect a business combination involving a third party, acquisition accounting generally applies.

In a Newco formation to effect a restructuring among entities under common control, in our view it is first necessary to determine whether there has been a business combination. If there has been, then the same accounting choices are available as for common control transactions in consolidated financial statements.

This narrative deals with business combinations among entities under common control. It does not deal with the wider issue of common control transactions in general – e.g. the transfer of a single item of property, plant and equipment between fellow subsidiaries. Common control transactions v Newco formation

The accounting issues dealt with in this narratives are not explicitly covered in any of the IFRS standards.

Common control transactions

A business combination involving entities or businesses under common control is exempt from the scope of the business combinations standard (see Business Combinations). [IFRS 3.2]

A business combination involving entities or businesses under common control is a business combination in which all of the combining entities or businesses are ultimately controlled by the same party or parties both before and after the combination and that control is not transitory. The concept of control is discussed in ‘Control of an investee‘. [IFRS 3.B1]

A simple example of a business combination under common control is as follows:

Common control transactions v Newco formation

A group of individuals is regarded as controlling an entity if, as a result of contractual arrangements, they exercise control. In general, the requirement for there to be a contractual arrangement should be applied strictly and is not overcome by an established pattern of voting together. [IFRS 3.B2]

It is not necessary that an individual, or a group of individuals acting together under a contractual arrangement to control an entity, be subject to the financial reporting requirements of IFRS Standards. Also, the entities are not required to be part of the same consolidated financial statements. [IFRS 3.B3]

The extent of NCI in each of the combining entities before and after the business combination is not relevant in determining whether the combination involves entities under common control. [IFRS 3.B4]

In general, the common control exemption in accounting for business combinations also applies to the transfer of investments in equity-accounted investees between investors under common control.

Consolidated financial statements of the acquirer

In general, the acquirer in a common control transaction can choose an accounting policy in respect of its consolidated financial statements, to be applied consistently to all similar common control transactions, to use:

  • ‘book value (carry-over basis) accounting’ on the basis that the investment has simply been moved from one part of the group to another; or
  • acquisition accounting’ on the basis that the acquirer is a separate entity in its own right and should not be confused with the economic group as a whole.

Book value (carry-over basis) accounting

In general, the acquirer in its consolidated financial statements has a choice, to be applied consistently, in respect of whose book values are used: the ultimate parent, any intermediate parent, the transferor or the entity transferred.

In general, the acquirer is permitted, but not required, to re-present its comparatives and adjust its current year before the date of the transaction as if the combination had occurred before the start of the earliest period presented. However, this restatement should not, in our view, extend to periods during which the entities were not under common control.

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In general, to the extent that the common control transaction involves transactions with NCI, the changes in NCI should be accounted for as acquisitions and/or disposals of NCI on the date when the changes occur (see chapter 2.5).

Acquisition accounting

In general, in applying acquisition accounting to a common control transaction, the acquisition accounting methodology in the business combinations standard should be applied in its entirety by analogy (see chapter 2.6).

Consolidated financial statements of the transferor

The standard on consolidated financial statements scopes out the loss of control through a demerger (see below), but it does not contain a scope exception when an intermediate parent loses control of a business in another form of common control transaction. Therefore, the transferor in a common control transaction that is not a demerger applies the general guidance on loss of control, and calculates the gain or loss on disposal with reference to the fair value of the consideration received (see chapter 2.5). [IFRS 10.B98]

The requirements of the held-for-sale standard apply to the transferor in a common control transaction, regardless of whether the disposal occurs through non-reciprocal distribution of the shares in a subsidiary (a demerger or spin-off) or a sale (see chapter 5.4).

In general, a demerger that is a common control transaction may be accounted for on either a fair value basis, in which case a gain or loss is recognised in profit or loss, or a book value basis, in which case no gain or loss is recognised.

Discussion paper IASB (2021)

The International Accounting Standards Board (the Board) has published a discussion paper, which includes proposed reporting requirements for such transactions. The Board’s objective is to reduce diversity in practice and improve comparability and transparency. This is part of a longer project for business combinations under common control (business combinations under common control), see below, and is expected that in September 2021 a decision will be made.

The Board is exploring two possible measurement methods:Acquisition accounting

  • the acquisition method (i.e. applying IFRS 3); and
  • a specific book-value method (similar to ‘book value (carry-over basis) accounting’ mentioned above).

Under the proposals, the method the company uses would depend on the type of transaction.

The acquisition method would be used for transactions that affect non-controlling shareholders because those transactions are similar to business combinations in the scope of IFRS 3. However, the Board is proposing certain exceptions to this rule – e.g. if the company’s shares are not publicly traded, and the non-controlling shareholders are related parties of the company.

The book-value method proposed would be used for all other transactions because such transactions only move economic resources within the group and are not like those covered by IFRS 3.

The Board’s proposal is summarised in the following flowchart.

Common control transactions v Newco formation

Current accounting

Should pre-combination information be restated?

No. The Board is proposing to prohibit the restatement of pre-combination information. This means that the financial information of the transferred company would be included in the financial statements of the receiving company prospectively – i.e. from the date of the transaction.

This would represent a change from current practice for some companies.

Set the framework – Historical Interpretations Committee

‘Transistory’ common control (IFRS 3.2(c))

The Interpretations Committee considered an issue regarding whether a reorganisation involving the formation of a new entity to facilitate the sale of part of an organisation is a business combination within the scope of IFRS 3 (Decision from March 2006).

IFRS 3 does not apply to business combinations in which all the combining entities or businesses are under common control both before and after the combination, unless that control is transitory. It was suggested to the Interpretations Committee that, because control of the new entity is transitory, a combination involving that newly formed entity would be within the scope of IFRS 3.

Paragraph 22 of IFRS 3 [now paragraph B18] states that when an entity is formed to issue equity instruments to effect a business combination, one of the combining entities that existed before the combination must be identified as the acquirer on the basis of the evidence available [now must be identified as the acquirer by applying the guidance in paragraphs B13-B17].

The Interpretations Committee noted that, to be consistent, the question of whether the entities or businesses are under common control applies to the combining entities that existed before the combination, excluding the newly formed entity. Accordingly, the Interpretations Committee decided not to add this topic to its agenda.

The Interpretations Committee also considered a request for guidance on how to apply IFRS 3 to reorganisations in which control remains within the original group. The Interpretations Committee decided not to add this topic to the agenda, since it was unlikely that it would reach agreement in a reasonable period, in the light of existing diversity in practice and the explicit exclusion of common control transactions from the scope of IFRS 3.

Associates and common control (IFRS 3.2(c))

In October 2012, the Interpretations Committee received a request seeking clarification of the accounting for an acquisition of an interest in an associate or joint venture from an entity under common control. The submitter’s question is whether it is appropriate to apply the scope exemption for business combinations under common control, which is set out in IFRS 3 Business Combinations, by analogy to the acquisition of an interest in an associate or joint venture under common control (Decision from May 2013).

The Interpretations Committee observed that paragraph 32 of IAS 28 Investments in Associates and Joint Ventures has guidance on the acquisition of an interest in an associate or joint venture and does not distinguish between acquisition of an investment under common control and acquisition of an investment from an entity that is not under common control.

The Interpretations Committee also observed that paragraph 10 of IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors requires management to use its judgement in developing and applying an accounting policy only in the absence of a Standard that specifically applies to a transaction.

Something else -   Components of Financial Statements

The Interpretations Committee also observed that paragraph 26 of IAS 28 states that many of the procedures that are appropriate for the application of the equity method are similar to the consolidation procedures described in IFRS 10 Consolidated Financial Statements. That paragraph further states that the concepts underlying the procedures used in accounting for the acquisition of a subsidiary are also adopted in accounting for the acquisition of an investment in an associate or a joint venture.

The Interpretations Committee also observed that paragraph 2(c) of IFRS 3 states that IFRS 3 does not apply to a combination of entities or businesses under common control. The Interpretations Committee observed that some might read these paragraphs as contradicting the guidance in paragraph 32 of IAS 28 (see above), potentially leading to a lack of clarity.

The Interpretations Committee was specifically concerned that this lack of clarity has led to diversity in practice for the accounting of the acquisition of an interest in an associate or joint venture under common control.

The Interpretations Committee noted that accounting for the acquisition of an interest in an associate or joint venture under common control would be better considered within the context of broader projects on accounting for business combinations under common control and the equity method of accounting.

The Interpretations Committee also noted that the IASB, in its May 2012 meeting, added a project on accounting for business combinations under common control as one of the priority research projects as well as a project on the equity method of accounting as one of the research activities to its future agenda. Consequently, the Interpretations Committee decided not to take this issue onto its agenda.

Subsequent developments

The IASB has subsequently discussed the question of accounting for business combinations under common control, and feedback from the Post-implementation Review (PIR) of IFRS 3. As a result of the PIR feedback, a number of issues were added to the IASB’s research agenda, including how to clarify the definition of a business, which was to be addressed first before giving further consideration to business combinations under common control.

During the period from the end of 2015 to mid-2017, the IASB developed guidance to clarify the definition of a business, which was at the same time as the FASB was developing similar guidance for the purposes of the equivalent converged guidance in US GAAP for business combinations.

In the final quarter of 2017, the IASB recommenced its business combinations under common control project, but see above for more recent developments.

Business combinations involving entities under common control – Presentation of comparatives when applying the Pooling of Interests method (IFRS 3.2(c) and IAS 27)

The Interpretations Committee received a request for guidance on the presentation of comparatives when applying the pooling of interests method for business combinations between entities under common control when preparing financial statements in accordance with IFRS (decision January 2010).

The request asked whether IAS 27 Consolidated Financial Statements (in the mean time superseded by IFRS 10 Consolidated financial statements) restricts the application of the pooling of interests method of accounting such that periods prior to the date of the common control transaction cannot be restated on a combined basis.

The Interpretations Committee noted that IFRS 3 (revised 2008) excludes from its scope ‘a combination of entities or businesses under common control’. The Interpretations Committee noted that resolving the issue would require interpreting the interaction of multiple IFRSs.

The Interpretations Committee also noted that in December 2007 the Board added a project to its research agenda to examine the definition of common control and the methods of accounting for business combinations under common control in the acquirer’s consolidated and separate financial statements. Consequently, the Interpretations Committee decided not to add this issue to its agenda.

Business Combinations involving Entities Under Common Control

Q1 – Is the application of IFRS 3 by analogy, through application of the hierarchy in IAS 8.10-12 appropriate in respect of transactions involving business combinations under common control?

As mentioned before, business combinations under common control are scoped out of IFRS 3 (IFRS 3.2(c)).

In the absence of specific guidance, IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors (IAS 8.10-12) require that management uses judgement to develop an accounting policy, drawing from sources based on the following hierarchy:

  • The requirements within other IFRSs which deal with similar and related issues
  • The definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework
  • Pronouncements from other similar standard-setting bodies as well as other accounting literature and industry practice (to the extent they do not conflict with the above). Common control transactions v Newco formation

Note: Local regulatory requirements may also be relevant when determining the appropriate accounting approach, and may be more restrictive than IFRS (see Q5 below). Common control transactions v Newco formation

Because IFRS does not specify the accounting approach to be followed, an entity should select one of the following two approaches as an accounting policy choice to be applied consistently to all similar transactions for business combinations involving entities under common control: Common control transactions v Newco formation

  • The acquisition method (as set out in IFRS 3), or Common control transactions v Newco formation
  • Book value accounting (often referred to as the pooling of interests method).

However, the use of the acquisition method results in a reassessment of the carrying amounts of assets and liabilities, and the recognition of goodwill and certain intangible assets, which otherwise would not be permitted. Consequently, in our view, when selecting an appropriate accounting policy it is necessary to consider whether the business combination involving entities under common control represents a substantive transaction. Factors to consider include:

  • The purpose of the transaction Common control transactions v Newco formation
  • Whether the transaction price is at fair value (when the transaction is not effected through the issue of equity shares)
  • The activities of the entities involved in the transaction. Common control transactions v Newco formation

This links to the criteria in IAS 8.10, meaning that the financial statements need to be both relevant to the economic decision making needs of users, and reliable. IAS 8.10 notes that reliable means that the financial statements:

  • Represent faithfully the financial position, financial performance and cash flows of the entity
  • Reflect the economic substance of transactions, other events and conditions, and not merely the legal form
  • Are neutral (ie free from bias) Common control transactions v Newco formation
  • Are prudent, and Common control transactions v Newco formation
  • Are complete in all material respects. Common control transactions v Newco formation

The rationale for applying IFRS 3 is that, although it is part of a group of entities under common control, the acquirer is still a separate entity in its own right. Consequently, from that entity’s perspective there has been a substantive transaction.

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The rationale for book value accounting is that the business has simply been moved from one part of a group of entities under common control to another. This view might be taken in circumstances in which businesses have been moved around a group as part of a restructuring or for tax planning purposes, or in preparation for the sale or listing of part of an existing group.

Q2 – If IFRS 3 is applied by analogy, is it necessary to apply all of its requirements?

Yes. Consequently, this would include consideration of whether acquisition, or reverse acquisition, accounting is appropriate. In both cases, the assets and liabilities of the accounting acquiree (whether this is the legal subsidiary or subgroup in the case of acquisition accounting, or the legal parent in the case of reverse acquisition accounting) will be remeasured to fair value.

Q3 – If book value accounting is applied, what is the level at which the book values are obtained?

An entity should select one of the following approaches as an accounting policy choice (to be applied consistently to all business combinations involving entities under common control), to obtain book values from the financial statements of:

  • the entity transferred Common control transactions v Newco formation
  • the immediate parent of the entity transferred Common control transactions v Newco formation
  • any intermediate parent entity, or Common control transactions v Newco formation
  • the ultimate parent entity. Common control transactions v Newco formation

When book values are taken from the financial statements of a parent entity, these will be the amounts included in the consolidated financial statements of that immediate, intermediate or ultimate parent entity (including goodwill).

In order to enhance the consistency of the existence and measurement of assets and liabilities attributable to each of the entities involved in a business combination under common control, an approach of looking to amounts recorded at ultimate parent entity level may be an appropriate approach. Common control transactions v Newco formation

Q4 – If book value accounting is applied, should comparatives be restated?

If book value accounting is applied, the acquirer is permitted (but not required) to restate its comparatives as if the combination had taken place at the start of the earliest period presented in its financial statements. However, this restatement needs to exclude any periods during which the combining entities were not under common control. Consequently, it will be necessary to review the dates from which each of the combining entities was controlled. Common control transactions v Newco formation

Q5 – What approaches are different regulators accepting?

In some jurisdictions, regulators may take a more restrictive approach for business combinations involving entities under common control than set out above (for example, only permitting book value accounting, or either requiring or prohibiting the inclusion of comparative amounts). Consequently, certain approaches that might otherwise be permitted by IFRS may not be available.

Transactions involving a Newco formation

Although it is not a term that is defined in any of the standards, in practice a ‘Newco’ is a new entity. However, a Newco can also be an existing entity that is itself not a business under the business combination standard.

A ‘Newco formation’ is a transaction that involves the formation of a new entity for the purpose of effecting a business combination or a transaction that purports to be a business combination. Common control transactions v Newco formation

Newco formations generally fall into two categories. They are either used to effect a business combination involving a third party, or in a restructuring among entities under common control. Common control transactions v Newco formation

If a Newco is used to effect a business combination involving a third party, then acquisition accounting generally applies.

In a Newco formation used in a restructuring among entities under common control, in general it is necessary to determine whether there has been a business combination – i.e. whether it is possible to identity an acquirer and an acquiree. If there has been a business combination, then the guidance on accounting for common control transactions in the consolidated financial statements of the acquirer applies (see above). However, if only one business is put under Newco, then there is no business combination and book value accounting applies to the business transferred. Common control transactions v Newco formation

For the purposes of the discussion that follows, a ‘merger’ is a transaction that involves the combination of two or more entities in which one of the legal entities survives and the other ceases to exist, or in which both existing entities cease to exist and a new legal entity comes into existence (often referred to as an ‘amalgamation’). Common control transactions v Newco formation

In general, when a legal merger or amalgamation follows a Newco formation to effect a business combination involving a third party, the surviving/emerging entity has a choice over which predecessor financial statements continue after the transaction:

  • the consolidated financial statements of Newco, on the basis that Newco was the acquirer in the business combination and therefore the newly merged entity should be a continuation of Newco consolidated; or
  • the consolidated financial statements of the acquiree in the business combination, on the basis that the acquiree continues to reflect the operations of the merged entity; from the acquiree’s point of view, there has simply been a change in shareholding.

Also read: Common control business combinations

Common control transactions v Newco formation

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