IFRS 3 Application of the definition of a business

IFRS 3 Application of the definition of a business – Highlights

In October 2018, the International Accounting Standards Board (IASB or Board) issued amendments to the definition of a business in IFRS 3 Business Combinations. The amendments are intended to assist entities to determine whether a transaction should be accounted for as a business combination or as an asset acquisition.

IFRS 3 continues to adopt a market participant’s perspective to determine whether an acquired set of activities and assets is a business. The amendments: clarify the minimum requirements for a business; remove the assessment of whether market participants are capable of replacing any missing elements; add guidance to help entities assess whether an acquired process is substantive; narrow the definitions of a business and of outputs; and introduce an optional fair value concentration test. The Board also added examples to illustrate the application of the guidance in IFRS 3 on the definition of a business. IFRS 3 Application of the definition of a business

The Board expects that the amendments to IFRS 3 and the equivalent amendments made to US GAAP in 2017, will lead to more consistency in applying the definition of a business across entities applying IFRS and entities applying US GAAP.

The amendments to IFRS 3 are effective for annual reporting periods beginning on or after 1 January 2020 and apply prospectively. Earlier application is permitted. The following example illustrates the application of the concentration test and the evaluation of whether a set is a business. IFRS 3 Application of the definition of a business

Example: Life sciences IFRS 3 Application of definition of a business

Pharma Co. purchases a legal entity that holds a Phase 3 compound (i.e., a compound in the clinical research phase) developed to treat diabetes, a Phase 3 compound to treat Alzheimer’s disease and the related at-market CRO and CMO contracts for each compound.

Included with each project are the historical know-how, formula protocols, designs and procedures expected to be needed to complete the related phase of testing. No employees, other assets or other activities are transferred. Assume both Phase 3 compounds have equal fair value.

Application of the concentration test IFRS 3 Application of definition of a business

Pharma Co. concludes that, while the compounds are separate Intellectual Property Research & Development assets in the same major asset class, the assets are not similar because the risks associated with creating outputs from each asset differ significantly. This is because the compounds (1) are intended to treat significantly different medical conditions, (2) have significantly different potential customer bases and (3) have significantly different expected markets and regulatory risks. IFRS 3 Application of the definition of a business

Therefore, substantially all of the fair value of the gross assets acquired (the concentration test) is not concentrated in a single identifiable asset or a group of similar identifiable assets. Pharma Co. must then evaluate whether the set includes an input and a substantive process that together significantly contribute to the ability to create outputs.

Determination of whether an input and substantive process exist IFRS 3 Application of definition of a business

Pharma Co. concludes the set does not contain a substantive process because the set is not generating outputs and does not include employees that form an organized workforce. Therefore, the set does not include a substantive process and is not a business. The acquisition is not treated as a business combination but an asset acquisition.

Background

IFRS 3 establishes different accounting requirements for a business combination as opposed to the acquisItion of an asset or a group of assets that does not constitute a business.

Business combinations are accounted for by applying the acquisition method, which, among other things, may give rise to goodwill. In contrast, when accounting for asset acquisitions, the acquirer allocates the transaction price to the individual identifiable assets acquired and liabilities assumed on the basis of their relative fair values and no goodwill is recognised.

Therefore, whether or not an acquired set of activities and assets is a business, is a key consideration in determining how the transaction should be accounted for. Prior to the amendments, IFRS 3 stated that a business consists of inputs and processes applied to those inputs that have the ability to create outputs, although outputs are not necessarily required for an integrated set to qualify as a business. IFRS 3 Application of the definition of a business

However, from the Post-implementation Review (PIR) of IFRS 3, the IASB learned that many stakeholders had concerns about how to interpret and apply the definition of a business.

To address those concerns, the Board set out to clarify the definition of a business, with the objective of helping entities to determine whether a transaction should be accounted for as a business combination or as an asset acquisition.

Market participant’s perspective

IFRS 3 adopts a market participant’s perspective in determining whether an acquired set of activities and assets is a business. This means that it is irrelevant whether the seller operated the set as a business or whether the acquirer intends to operate the set as a business. Some respondents to the PIR of IFRS 3 noted that such a fact driven assessment may not provide the most useful information, as it does not consider the business rationale, strategic considerations and objectives of the acquirer.

However, the IASB decided not to make any changes in this respect, because an assessment made from a market participant’s perspective and driven by facts (rather than the acquirer’s intentions) helps to prevent similar transactions being accounted for differently. IFRS 3 Application of the definition of a business

Also, the Board noted that bringing more subjective elements into the determination would likely have increased diversity in practice.

Overview of the main amendments

Minimum requirements to be a business

In the IASB’s view, the existence of a process (or processes) is what distinguishes a business from a non-business. Consequently, the Board decided that to be considered a business, an integrated set of activities and assets must include, at a minimum, an input and a substantive process that together significantly contribute to the ability to create output. It also clarified that a business can exist without including all of the inputs and processes needed to create outputs. That is, the inputs and processes applied to those inputs must have the ‘ability to contribute to the creation of outputs’ rather than the ‘ability to create outputs’. IFRS 3 Application of the definition of a business

Market participant’s ability to replace missing elements

Prior to the amendments, IFRS 3 stated that a business need not include all of the inputs or processes that the seller used in operating that business, “if market participants are capable of acquiring the business and continuing to produce outputs, for example, by integrating the business with their own inputs and processes”.

The IASB, however, decided to base the assessment on what has been acquired in its current state and condition, rather than on whether market participants are capable of replacing any missing elements, for example, by integrating the acquired activities and assets. Therefore, the reference to such integration was deleted from IFRS 3. Instead, the amendments focus on whether acquired inputs and acquired substantive processes together significantly contribute to the ability to create outputs.

Assessing whether an acquired process is substantive

The PIR of IFRS 3 also revealed difficulties in assessing: whether the acquired processes are sufficient to constitute one of the elements of a business; whether any missing processes are so significant that an acquired set of activities and assets is not a business; and, how to apply the definition of a business when the acquired set of activities and assets does not generate revenue. In response, the IASB added guidance to help entities assess whether an acquired process is substantive. That guidance requires more persuasive evidence when there are no outputs, because the existence of outputs already provides some evidence that the acquired set of activities and assets is a business.

The Board also reasoned that, although itself an input, the presence of an organised workforce is an indicator of a substantive process. This is because the ‘intellectual capacity’ of an organised workforce having the necessary skills and experience following rules and conventions may provide the necessary processes (even if not documented) that are capable of being applied to inputs to create outputs. IFRS 3 Application of the definition of a business

The amendments to IFRS 3 specify that if a set of activities and assets does not have outputs at the acquisition date, an acquired process shall be considered substantive only if: (a) it is critical to the ability to develop or convert acquired inputs into outputs; and (b) the inputs acquired include both an organised workforce with the necessary skills, knowledge, or experience to perform that process and other inputs that the organised workforce could develop or convert into outputs.

In contrast, if a set of activities and assets has outputs at that date, an acquired process shall be considered substantive if: (a) it is critical to the ability to continue producing outputs and the acquired inputs include an organised workforce with the necessary skills, knowledge, or experience to perform that process; or (b) it significantly contributes to the ability to continue producing outputs and either is considered unique or scarce, or cannot be replaced without significant cost, effort or delay in the ability to continue producing outputs.

The Board also added some clarifications to IFRS 3 to support these requirements, including that an acquired contract is not itself a substantive process. An acquired contract, such as a contract for outsourced property management or outsourced asset management, may however give access to an organised workforce.

Narrowed definition of outputs

Previously, outputs were defined as returns in the form of dividends, lower costs or other economic benefits provided directly to investors or other owners, members or participants. As part of the amendments to IFRS 3, the IASB narrowed the definition of outputs to focus on goods or services provided to customers, investment income (such as dividends or interest) or other income from ordinary activities. The definition of a business in Appendix A of IFRS 3 was amended accordingly.

According to the Board, the previous reference to lower costs and other economic benefits provided directly to investors did not help to distinguish between an asset and a business. For example, many asset acquisitions may be made with the motive of lowering costs but may not involve acquiring a substantive process. Therefore, this wording was excluded from the definition of outputs and the definition of a business. IFRS 3 Application of the definition of a business

Optional concentration test

Whilst applying the definition of a business might involve significant judgement, many respondents to the PIR of IFRS 3 noted that there was little or no guidance to identify situations where an acquired set of activities and assets is not a business. To address those concerns, the IASB introduced an optional fair value concentration test. The purpose of this test is to permit a simplified assessment of whether an acquired set of activities and assets is not a business. Entities may elect whether or not to apply the concentration test on a transaction-by-transaction basis.

The concentration test is met 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 test is based on gross assets, not net assets, as the Board concluded that whether a set of activities and assets includes a substantive process does not depend on how the set is financed. In addition, certain assets are excluded from the gross assets considered in the test. IFRS 3 Application of the definition of a business

If the test is met, the set of activities and assets is determined not to be a business and no further assessment is needed. If the test is not met, or if an entity elects not to apply the test, a detailed assessment must be performed applying the normal requirements in IFRS 3. As such, the concentration test never determines that a transaction is a business combination.

General model of measurement of insurance contracts

IFRS 3 Application of the definition of a business

IFRS 3 Application of the definition of a business IFRS 3 Application of the definition of a business

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