IFRS 3 Recognising what you acquired in a business combination

IFRS 3 Recognising what you acquired in a business combination or recognizing and measuring the identifiable assets acquired, liabilities assumed, and any non-controlling interest in the acquiree.

IFRS 3 provides the following recognition principle for assets acquired, liabilities assumed, and any non controlling interest in the acquiree:

Excerpt from IFRS 3 10

As of the acquisition date, the acquirer shall recognize, separately from goodwill, the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree. Recognition of identifiable assets acquired and liabilities assumed is subject to the conditions specified in IFRS 3 11 and IFRS 3 12.

An acquirer should recognize the identifiable assets acquired and the liabilities assumed on the acquisition date if they meet the definitions of assets and liabilities in the Framework for the Preparation and Presentation of Financial Statements for IFRS. For example, costs that an acquirer expects to incur but is not obligated to incur at the acquisition date (e.g., restructuring costs) are not liabilities assumed under IFRS 3 11.

An acquirer may also recognize assets and liabilities that are not recognized by the acquiree in its financial statements prior to the acquisition date, due to differences between the recognition principles in a business combination and other IFRS.

This can result in the recognition of intangible assets in a business combination, such as a brand name or customer relationship, which the acquiree would not recognize in its financial statements because these intangible assets were internally generated. This is because such assets may be identifiable and measured reliably, were not internally generated by the acquirer and have been paid in a regular business transaction (of in IFRS language: orderly transaction between market participants). IFRS 3 Recognising what you acquired in a business combination

Certain assets acquired and liabilities assumed in connection with a business combination may not be considered part of the assets and liabilities exchanged in the business combination and will be recognized as separate transactions in accordance with other IFRS. IFRS 3 Recognising what you acquired in a business combination

IFRS 3 provides the following principle with regard to the measurement of assets acquired and liabilities assumed and any non-controlling interest in the acquiree:

The acquirer shall measure the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree at their acquisition-date fair values.

IFRS 3 18

The acquirer shall measure the identifiable assets acquired and the liabilities assumed at their acquisition-date fair values.

IFRS 3 19

For each business combination, the acquirer shall measure at the acquisition date components of non-controlling interests in the acquiree that are present ownership interests and entitle their holders to a proportionate share of the entity’s net assets in the event of liquidation at either: (a) fair value; or (b) the present ownership instruments’ proportionate share in the recognised amounts of the acquiree’s identifiable net assets.

The measurement of the identifiable assets acquired and liabilities assumed is at fair value, with limited exceptions as provided for in IFRS 3. The definition of fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

See valuation techniques for a discussion of the valuation techniques and issues related to the fair value measurement of the identifiable assets acquired and liabilities assumed.

The following table provides a summary of the exceptions to the recognition and fair value measurement principles in IFRS 3, along with references to where these exceptions are discussed in this chapter. IFRS 3 Recognising what you acquired in a business combination

Summary of exceptions to the recognition and fair value measurement principles

Measurement principle

Reacquired rights

Assets held for sale

Share-based payment awards

Recognition and measurement principles

Income taxes

Employee benefits

Contingencies

Indemnification assets

Recognition and measurement of particular assets acquired and liabilities assumed

The recognition and measurement of particular assets acquired and liabilities assumed are discussed in the following part of this session.

Assets that the acquirer does not intend to use

An acquirer, for competitive or other reasons, may not use an acquired asset or may intend to use the asset in a way that is not its highest and best use (i.e., different from the way other market-participants would use the asset). IFRS 3 specifies that the intended use of an asset by the acquirer does not affect its fair value. See Assets that the acquirer does not intend to use for further information on the subsequent measurement of assets that the acquirer does not intend to use. IFRS 3 Recognising what you acquired in a business combination

– Defensive intangible assets

A company may acquire intangible assets in a business combination that it has no intention to actively use but intends to hold (lock up) to prevent others from obtaining access to them (defensive intangible assets). Defensive intangible assets may include assets that the entity will never actively use, as well as assets that will be actively used by the entity only during a transition period. In either case, the company will lock up the defensive intangible assets to prevent others from obtaining access to them for a period longer than the period of active use.

Examples of defensive intangible assets include brand names and trademarks. A company should utilize market-participant assumptions, not acquirer specific assumptions, in determining the fair value of defensive intangible assets. IFRS 3 Recognising what you acquired in a business combination

Determining the useful life of defensive intangible assets can be challenging. The value of defensive intangible assets will likely diminish over a period of time as a result of the lack of market exposure or competitive environment or other factors.

Therefore, the immediate write-off of defensive intangible assets would not be appropriate. It would also be rare for such assets to have an indefinite life. See Types of identifiable intangible assets and Intangible assets that the acquirer does not intend to use for further information on the initial and subsequent measurement of defensive intangible assets. IFRS 3 Recognising what you acquired in a business combination

– Asset valuation allowances

Separate valuation allowances are not recognized for acquired assets that are measured at fair value, as any uncertainties about future cash flows are included in their fair value measurement, as described in IFRS 3 B41. This precludes the separate recognition of an allowance for doubtful accounts or an allowance for loan losses. Companies may need to separately track contractual receivables and any valuation losses to comply with certain disclosure and other regulatory requirements in industries such as financial services.

In accordance with IFRS 3 B64(h), in the reporting period in which the business combination occurs, the acquirer should disclose the fair value of the acquired receivables, their gross contractual amounts, and an estimate of cash flows not expected to be collected. IFRS 3 Recognising what you acquired in a business combination

The use of a separate valuation allowance is permitted for assets that are not measured at fair value on the acquisition date (e.g., certain indemnification assets).

Inventory

Acquired inventory can be in the form of finished goods, work in progress, and raw materials. IFRS 3 requires that inventory be measured at its fair value on the acquisition date. Ordinarily, the amount recognized for inventory at fair value by the acquirer will be higher than the amount recognized by the acquiree before the business combination. See valuation methods for further information on valuation methods. IFRS 3 Recognising what you acquired in a business combination

Contracts

Contracts (e.g., leases, sales contracts, supply contracts) assumed in a business combination may give rise to assets or liabilities. An intangible asset or liability may be recognized for contract terms that are favorable or unfavorable compared to current market transactions, or related to identifiable economic benefits for contract terms that are at market. See Intangible assets acquired in a business combination for further discussion of the accounting for contract-related intangible assets.

– Loss contracts

A loss [onerous] contract occurs if the unavoidable costs of meeting the obligations under a contract exceed the expected future economic benefits to be received. However, unprofitable operations of an acquired business do not necessarily indicate that the contracts of the acquired business are loss [onerous] contracts.

A loss [onerous] contract should be recognized as a liability at fair value if the contract is a loss [onerous] contract to the acquiree at the acquisition date. Amortization of the loss [onerous] contract is usually recognized as contra revenue. An acquirer should have support for certain key assumptions, such as market price and the unavoidable costs to fulfill the contract (e.g., manufacturing costs, service costs), if a liability for a loss [onerous] contract is recognized.

For example, Company A acquires Company B in a business combination. Company B is contractually obligated to fulfil a previous fixed price contract to produce a fixed number of components for one of its customers. However, Company B’s unavoidable costs to manufacture the component exceed the sales price in the contract. As a result, Company B has incurred losses on the sale of this product and the combined entity is expected to continue to do so in the future.

Company B’s contract is considered a loss [onerous] contract that is assumed by Company A in the acquisition. Therefore, Company A would record a liability for the loss [onerous] contract assumed in the business combination. IFRS 3 Recognising what you acquired in a business combination

When measuring a loss [onerous] contract, an acquirer should consider whether the amount to be recognized should be adjusted for any intangible assets or liabilities already recognized for contract terms that are favorable or unfavorable compared to current market terms. A contract assumed in a business combination that becomes a loss [onerous] contract as a result of the acquirer’s actions or intentions should be recognized through earnings [profit or loss] in the postcombination period based on the applicable framework in IFRS.

Intangible assets

All identifiable intangible assets that are acquired in a business combination should be recognized at fair value on the acquisition date. Identifiable intangible assets are recognized separately if they arise from contractual or other legal rights or if they are separable (i.e., capable of being sold, transferred, licensed, rented, or exchanged separately from the entity). See Intangible assets acquired in a business combination for guidance on the recognition and measurement of intangible assets. IFRS 3 Recognising what you acquired in a business combination

Reacquired rights

An acquirer may reacquire a right that it had previously granted to the acquiree to use one or more of the acquirer’s recognized or unrecognized assets. Examples of such rights include a right to use the acquirer’s trade name under a franchise agreement or a right to use the acquirer’s technology under a technology licensing agreement. Such reacquired rights generally are identifiable intangible assets that the acquirer separately recognizes from goodwill in accordance with IFRS 3 B35.

The reacquisition must be evaluated separately to determine if a gain or loss on the settlement should be recognized. See Calculating the gain or loss on settlement of preexisting relationships for further information.

Understanding the facts and circumstances, including those surrounding the original relationship between the parties prior to the business combination, is necessary to determine whether the reacquired right constitutes an identifiable intangible asset. Some considerations include: IFRS 3 Recognising what you acquired in a business combination

  • How was the original relationship structured and accounted for? What was the intent of both parties at inception?
  • Was the original relationship an outright sale with immediate revenue recognition, or was deferred revenue recorded as a result? Was an up-front, one-time payment made, or was the payment stream ongoing? Was the original relationship an arm’s-length transaction, or was the original transaction set up to benefit a majority-owned subsidiary or joint venture entity with off-market terms? IFRS 3 Recognising what you acquired in a business combination
  • Was the original relationship created through a capital transaction, or was it created through an operating (executory) arrangement? Did it result in the ability or right to resell some tangible or intangible rights? IFRS 3 Recognising what you acquired in a business combination
  • Has there been any enhanced or incremental value to the acquirer since the original transaction? IFRS 3 Recognising what you acquired in a business combination
  • Is the reacquired right exclusive or nonexclusive? IFRS 3 Recognising what you acquired in a business combination

Contracts giving rise to reacquired rights that include a royalty or other type of payment provision should be assessed for contract terms that are favorable or unfavorable when compared to pricing for current market transactions.

A settlement gain or loss should be recognized and measured at the acquisition date for any favorable or unfavorable contract terms identified. A settlement gain or loss related to a reacquired right should be measured consistently with the guidance for the settlement of preexisting relationships.

See Calculating the gain or loss on settlement of preexisting relationships for further information. The amount of any settlement gain or loss should not impact the measurement of the fair value of any intangible asset related to the reacquired right. IFRS 3 Recognising what you acquired in a business combination

The acquisition of a reacquired right may be accompanied by the acquisition of other intangibles that should be recognized separately from both the reacquired right and goodwill. For example, a company grants a franchise to a franchisee to develop a business in a particular country. The franchise agreement includes the right to use the company’s trade name and proprietary technology.

After a few years, the company decides to reacquire the franchise in a business combination for an amount greater than the fair value of a new franchise right. The excess of the value transferred over the franchise right is an indicator that other intangibles, such as customer relationships, customer contracts, and additional technology, could have been acquired along with the reacquired right. IFRS 3 Recognising what you acquired in a business combination

– Determining the value and useful life of reacquired rights

Reacquired rights are identified as an exception to the fair value measurement principle, because the value recognized for reacquired rights is not based on market-participant assumptions. In accordance with IFRS 3 29, the value of a reacquired right is determined based on the estimated cash flows over the remaining contractual life, even if market-participants would reflect expected renewals in their measurement of that right.

The basis for this measurement exception is that a contractual right acquired from a third party is not the same as a reacquired right under IFRS 3 BC309. Because a reacquired right is no longer a contract with a third party, an acquirer that controls a reacquired right could assume indefinite renewals of its contractual term, effectively making the reacquired right an indefinite-lived intangible asset. IFRS 3 Recognising what you acquired in a business combination

Assets acquired and liabilities assumed, including any reacquired rights, should be measured using a valuation technique that considers cash flows after payment of a royalty rate to the acquirer for the right that is being reacquired because the acquiring entity is already entitled to this royalty.

The amount of consideration that the acquirer would be willing to pay for the acquiree is based on the cash flows that the acquiree is able to generate above and beyond the royalty rate that the acquirer is already entitled to under the agreement.

The Boards concluded that a right reacquired from an acquiree in substance has a finite life (i.e., the contract term); a renewal of the contractual term after the business combination is not part of what was acquired in the business combination. IF RS 3 Recognising what you acquired in a business combination

Therefore, consistent with the measurement of the acquisition date value of reacquired rights, the useful life over which the reacquired right is amortized in the postcombination period should be based on the remaining contractual term without consideration of any contractual renewals.

In the event of a reissuance of the reacquired right to a third party in the postcombination period, any remaining unamortized amount related to the reacquired right should be included in the determination of any gain or loss upon reissuance in accordance with IFRS 3 55.

In some cases, the reacquired right may not have any contractual renewals and the remaining contractual life may not be clear, such as with a perpetual franchise right. An assessment should be made as to whether the reacquired right is an indefinite-lived intangible asset that would not be amortized, but subject to periodic impairment testing.

A conclusion that the useful life is indefinite requires careful consideration and is expected to be infrequent. If it is determined that the reacquired right is not an indefinite-lived intangible asset, then the reacquired right should be amortized over its economic useful life. IFRS 3 Recognising what you acquired in a business combination

The following example illustrates the recognition and measurement of a reacquired right in a business combination. IFRS 3 Recognising what you acquired in a business combination

EXAMPLE – Recognition and measurement of a reacquired right

Company A owns and operates a chain of retail coffee stores. Company A also licenses the use of its trade name to unrelated third parties through franchise agreements, typically for renewable five-year terms. In addition to on-going fees for cooperative advertising, these franchise agreements require the franchisee to pay Company A an up-front fee and an on-going percentage of revenue for continued use of the trade name. IFRS 3 Recognising what you acquired in a business combination

Company B is a franchisee with the exclusive right to use Company A’s trade name and operate coffee stores in a specific market. Pursuant to its franchise agreement, Company B pays to Company A a royalty rate equal to 6% of revenue. Company B does not have the ability to transfer or assign the franchise right without the express permission of Company A.

Company A acquires Company B for cash consideration. Company B has three years remaining on the initial five-year term of its franchise agreement with Company A as of the acquisition date. There is no unfavorable/favorable element of the contract. IFRS 3 Recognising what you acquired in a business combination

What should Company A consider when recognizing the reacquired right?

Analysis IFRS 3 Recognising what you acquired in a business combination

Company A will recognize a separate intangible asset at the acquisition date related to the reacquired franchise right, which will be amortized over the remaining three-year period. The value ascribed to the reacquired franchise right under the acquisition method should exclude the value of potential renewals.

The royalty payments under the franchise agreement should not be used to value the reacquired right, as Company A already owns the trade name and is entitled to the royalty payments under the franchise agreement.

Instead, Company A’s valuation of the reacquired right should consider Company B’s applicable net cash flows after payment of the 6% royalty. In addition to the reacquired franchise rights, other assets acquired and liabilities assumed by Company A should also be measured using a valuation technique that considers Company B’s cash flows after payment of the royalty rate to Company A.

Property, plant, and equipment

Property, plant, and equipment (PPE) acquired in a business combination should be recognized and measured at fair value. Accumulated depreciation of the acquiree is not carried forward in a business combination. The fair value will often be established by a specialised valuation expert for the type of PPE at hand. IFRS 3 Recognising what you acquired in a business combination

Government grants

Assets acquired with funding from a government grant should be recognized at fair value without regard to the government grant. Similarly, if the government grant provides an ongoing right to receive future benefits, that right should be measured at its acquisition-date fair value and separately recognized.

For a government grant to be recognized as an asset, the grant should be uniquely available to the acquirer and not dependent on future actions. The terms of the government grant should be evaluated to determine whether there are on-going conditions or requirements that would indicate that a liability exists. If a liability exists, the liability should be recognized at its fair value on the acquisition date. IFRS 3 Recognising what you acquired in a business combination

Consideration of decommissioning and site restoration costs

An acquirer may obtain long-lived assets, such as property, plant, and equipment, that upon retirement require the acquirer to dismantle or remove the assets and restore the site on which it is located (i.e., retirement obligations). If a retirement obligation exists, it must be recognized at fair value (using market-participant assumptions), which may be different than the amount recognized by the acquiree.

If the fair value of the asset is based on a quoted market price, and that market price implicitly includes the costs that will be incurred in retiring the asset, then the fair value of the asset retirement obligation will need to be added back to the net fair value of the asset. IFRS 3 Recognising what you acquired in a business combination

For example, a nuclear power plant is acquired in a business combination. The acquirer determines that a retirement obligation of CU100 million (fair value) associated with the power plant exists. The appraiser has included the expected cash outflows of the retirement obligation in the cash flow model, establishing the value of the plant at CU500 million.

That is, the appraised value of the power plant would be CU100 million higher if the retirement obligation is disregarded. The acquirer would record the power plant at its fair value of CU600 million and a liability of CU100 million for the retirement obligation. IFRS 3 Recognising what you acquired in a business combination

Income taxes

Income taxes are identified as an exception to the recognition and fair value measurement principles. The acquirer should record all deferred tax assets and liabilities of the acquiree that are related to any temporary differences, tax carry forwards, and uncertain tax positions in accordance with IAS 12, Income Taxes and IFRIC 23 Uncertainty over Income Tax Treatments).

Deferred tax liabilities are not recognized for non tax-deductible goodwill under IFRS. However, deferred tax liabilities should be recognized for differences between the book and tax basis of indefinite-lived intangible assets. IFRS 3 Recognising what you acquired in a business combination

Subsequent changes to deferred tax assets, liabilities, valuation allowances, or liabilities for any income tax uncertainties of the acquiree will impact income tax expense in the post combination period unless the change is determined to be a measurement period adjustment. See Measurement period adjustments for further information on measurement period adjustments.

Adjustments or changes to the acquirer’s deferred tax assets or liabilities as a result of a business combination should be reflected in earnings [profit or loss] or, if specifically permitted, charged to equity in the period subsequent to the acquisition. IFRS 3 Recognising what you acquired in a business combination

Recognition of assets held for sale

Assets held for sale are an exception to the fair value measurement principle, because they are measured at fair value less costs to sell. A long-lived asset [or non-current asset] or group of assets (disposal group) may be classified and measured as assets held for sale at the acquisition date if, from the acquirer’s perspective, the classification criteria in IFRS 5, Non-current Assets Held-for-sale and Discontinued Operations, are met. IFRS 3 Recognising what you acquired in a business combination

IFRS 5 11 provides specific criteria which, if met, would require the acquirer to present newly-acquired assets as assets held for sale. The criteria require a plan to dispose of the assets within a year and that it be probable [highly probable] that the acquirer will meet the other held-for sale criteria within a short period of time after the acquisition date (usually within three months).

The other criteria in IFRS 5 7-8 include (1) management having the authority to approve an action commits to sell the assets; (2) assets are available for immediate sale in their present condition, subject only to sales terms that are usual and customary; (3) an active program to locate a buyer and actions to complete the sale are initiated; (4) assets are being actively marketed; and (5) it is unlikely there will be significant changes to, or withdrawal from, the plan to sell the assets. IFRS 3 Recognising what you acquired in a business combination

If the criteria are not met, those assets should not be classified as assets held-for-sale until all applicable criteria have been met. IFRS 3 Recognising what you acquired in a business combination

Employee benefit plans

Employee benefit plans are an exception to the recognition and fair value measurement principles. In accordance with IFRS 3 26, employee benefit plan obligations are recognized and measured in accordance with the guidance in applicable IFRS, rather than at fair value, as per IAS 19, Employee Benefits. IFRS 3 Recognising what you acquired in a business combination

If a business combination involves the assumption of defined-benefit pension plans or other similar post retirement benefit plans, the acquirer should use the present value of the defined-benefit obligations less the fair value of any plan assets to determine the net employee benefit assets or liabilities to be recognized. Acquiree balances should not be carried forward on the acquisition date.

In accordance with IAS 19 64(b) and IFRIC 14, if there is a net employee-benefit asset, it is recognized only to the extent that it will be available to the acquirer in the form of refunds from the plan or a reduction in future contributions. IFRS 3 Recognising what you acquired in a business combination

Under IAS 19 110-111, settlements or curtailments are recognized in the measurement of the plan’s benefit obligations only if the settlement or curtailment event has occurred by the acquisition date. A settlement occurs when an entity enters into a transaction that eliminates all further legal or constructive obligation for all or part of the benefits provided under a defined-benefit plan.

A curtailment occurs when an entity is demonstrably committed to make a material reduction in the number of employees covered by a plan, amends a defined-benefit plan’s terms such that a material element of future service by current employees will no longer qualify for benefits or will qualify only for reduced benefits.

Consistent with the guidance in IAS 19, it would not be appropriate to recognize a settlement or curtailment on the basis that it was probable. That is, expected settlements or curtailments by the acquirer of the acquiree’s plans would not be recognized until the relevant requirements in IAS 19 are met. IFRS 3 Recognising what you acquired in a business combination

Q&A Topics

– Modifications to defined benefit pension plans

As part of the acquisition accounting in a business combination could modifications to defined benefit pension plans be written into the acquisition agreement as an obligation of the acquirer?

IFRS 3 generally requires employee compensation costs for future services, including pension costs, to be recognized in earnings [profit or loss] in the post combination period. Modifications to defined benefit pension plans are usually done for the benefit of the acquirer. A transaction that primarily benefits the acquirer is likely to be a separate transaction. Additionally, modifications to a defined benefit pension plan would typically relate to future services of the employees.

It is not appropriate to analogize this situation to the exception in IFRS 3 dealing with share-based compensation arrangements. That exception allows the acquirer to include a portion of the fair value based measure of replacement share-based payment awards as consideration in acquisition accounting through an obligation created by a provision written into the acquisition agreement. Such an exception should not be applied to modifications to defined benefit pension plans under the scenario described. IFRS 3 Recognising what you acquired in a business combination

IFRS 3 B50 provides further interpretive guidance of factors to consider when evaluating what is part of a business combination, such as the reason for the transaction, who initiated the transaction and the timing of the transaction. See BCG 3.2 Assessing what is part of the consideration transferred for the acquiree for further information on accounting for compensation arrangements. IFRS 3 Recognising what you acquired in a business combination

Payables and debt

An acquiree’s payables and debt assumed by the acquirer are recognized at fair value in a business combination. Short-term payables may be recorded based on their settlement amounts in most situations since settlement amounts would be expected to approximate fair value. However, the measurement of debt at fair value may result in an amount different from what was recognized by the acquiree before the business combination. IFRS 3 Recognising what you acquired in a business combination

So debt assumed in a business combination is initially measured at fair value and then subsequently measured at amortized cost.

When a reporting entity with listed debt is acquired, the traded price of the debt often changes to reflect the credit enhancement expected to be provided by the acquirer (i.e., the trading price will reflect the market’s assumption that the debt will become a liability of the new group). IFRS 3 Recognising what you acquired in a business combination

The credit standing of the combined entity in a business combination will often be used in determining the fair value of the acquired debt. For example, if acquired debt is expected to be credit-enhanced because the debt holders are expected to become general creditors of the combined entity, the valuation of the acquired debt would reflect the characteristics of the acquirer’s post-combination credit rating. IFRS 3 Recognising what you acquired in a business combination

If the acquirer is not expected to legally add any credit enhancement to the debt or in some other way guarantee the debt (i.e., the debt will continue to be secured only by the net assets of the acquired entity), the fair value of the debt may not change. IFRS 3 Recognising what you acquired in a business combination

The business combinations standards require the fair value of debt to be determined as of the acquisition date. If the acquiree has public debt, the quoted price should be used. If the acquiree has both public and non public debt, the price of the public debt should also be considered as one of the inputs used to value the non public debt.

However, if the credit characteristics of the debt acquired remain unchanged after the acquisition because, for example, the debt remains secured by only the net assets of the acquired entity, the value of the acquired debt should reflect the characteristics of the acquiree’s pre-combination credit rating. IFRS 3 Recognising what you acquired in a business combination

Q: How should unamortized deferred financing costs of the acquiree be accounted for in a business combination?

The accounting treatment for debt issue costs in the periods before and after a transaction depends on whether the debt is assumed by the acquirer. This is primarily a legal determination and should consider the requirements of the debt and acquisition agreements and the timing of repayment relative to the acquisition. Debt legally assumed by the acquirer should be recorded at fair value. Any existing deferred financing costs would be eliminated. IFRS 3 Recognising what you acquired in a business combination

Guarantees

All guarantees assumed in a business combination are recognized at fair value. Financial guarantees are defined in IFRS 9 as follows: A financial guarantee is a promise to take responsibility for another company’s financial obligation if that company cannot meet its obligation. The entity assuming this responsibility is called the guarantor.

Such a guarantee can be limited or unlimited, making the guarantor liable for only a portion or all of the debt. IFRS 3 Recognising what you acquired in a business combination

A contract with a customer may partially be in scope of IFRS 15 and partially within the scope of other standards, e.g. a contract for the lease of an asset and maintenance of the leased equipment. In such instances, an entity must first apply the other standards if those standards specify how to separate and/or initially measure one or more parts of the contract. The entity will then apply IFRS 15 to the remaining components of the contract (IFRS 15 7). IFRS 3 Recognising what you acquired in a business combination

For example – If a contract includes a financial instrument (e.g. financial guarantee) and a revenue component, the fair value of the financial instrument is first measured under IFRS 9 Financial Instruments and the balance contract consideration is allocated in accordance with IFRS 15. IFRS 3 Recognising what you acquired in a business combination

Transactions that fall within the scope of multiple standards should be separated into components, so that each component can be accounted for under the relevant standards.

Contingencies

Contingencies are existing conditions, situations, or sets of circumstances resulting in uncertainty about a possible gain or loss that will be resolved if one or more future events occur or fail to occur. The following is a summary of the accounting for acquired contingencies under IFRS 3. IFRS 3 Recognising what you acquired in a business combination

Initial accounting (acquisition date): Record at fair value if it meets the definition of a present obligation and is reliably measurable. Recognized regardless of whether it is probable that an outflow of resources will be required to settle the obligation.

Subsequent accounting (post combination): Recognized at the higher of (1) best estimate or (2) acquisition-date fair value less amortization at the end of each reporting period, with changes in value included in profit or loss until settled. IFRS 3 Recognising what you acquired in a business combination

– Contingent liabilities

Contingent liabilities are either possible or present obligations as defined in IAS 37. In accordance with IFRS 3 22, possible obligations are obligations that arise from past events whose existence will be confirmed only by the occurrence or non occurrence of one or more uncertain future events not wholly within the control of any entity. Present obligations are legal or constructive obligations that result from a past event.

An acquirer recognizes at fair value on the acquisition date, in accordance with IFRS 3 23, all contingent liabilities assumed that are present obligations that also are reliably measurable. Contingent assets and possible obligations assumed are not recognized by the acquirer on the acquisition date.

[IFRS 3 56] After initial recognition and until the liability is settled, cancelled or expires, the acquirer shall measure a contingent liability recognised in a business combination at the higher of:

  • the amount that would be recognised in accordance with IAS 37; and
  • the amount initially recognised less, if appropriate, the cumulative amount of income recognised in accordance with the principles of IFRS 15 Revenue from Contracts with Customers.

Indemnification assets

Indemnification assets are an exception to the recognition and fair value measurement principles because indemnification assets are recognized and measured differently than other contingent assets. Indemnification assets (sometimes referred to as seller indemnifications) may be recognized if the seller contractually indemnifies, in whole or in part, the buyer for a particular uncertainty, such as a contingent liability or an uncertain tax position.

The recognition and measurement of an indemnification asset is based on the related indemnified item. That is, the acquirer should recognize an indemnification asset at the same time that it recognizes the indemnified item, measured on the same basis as the indemnified item, subject to collectibility or contractual limitations on the indemnified amount.

Therefore, if the indemnification relates to an asset or a liability that is recognized at the acquisition date and measured at its acquisition-date fair value, the acquirer should recognize the indemnification asset at its acquisition date fair value on the acquisition date.

If an indemnification asset is measured at fair value, a separate valuation allowance is not necessary because its fair value measurement will reflect any uncertainties in future cash flows resulting from collectibility considerations.

Indemnification assets recognized on the acquisition date (or at the same time as the indemnified item) continue to be measured on the same basis as the related indemnified item subject to collectibility and contractual limitations on the indemnified amount until they are collected, sold, cancelled, or expire in the post combination period.

Q: How should a buyer account for an indemnification from the seller when the indemnified item has not met the criteria to be recognized on the acquisition date?

IFRS 3 states that an indemnification asset should be recognized at the same time as the indemnified item. Therefore, if the indemnified item has not met the recognition criteria as of the acquisition date, an indemnification asset should not be recognized.

If the indemnified item is recognized subsequent to the acquisition, the indemnification asset would then also be recognized on the same basis as the indemnified item subject to management’s assessment of the collectibility of the indemnification asset and any contractual limitations on the indemnified amount. This accounting would be applicable even if the indemnified item is recognized outside of the measurement period.

Q: Does an indemnification arrangement need to be specified in the acquisition agreement to achieve indemnification accounting?

Indemnification accounting can still apply even if the indemnification arrangement is the subject of a separate agreement. Indemnification accounting applies as long as the arrangement is entered into on the acquisition date, is an agreement reached between the acquirer and seller, and relates to a specific contingency or uncertainty of the acquired business, or is in connection with the business combination.

Q: Should acquisition consideration held in escrow for the seller’s satisfaction of general representation and warranties be accounted for as an indemnification asset?

General representations and warranties would not typically relate to any contingency or uncertainty related to a specific asset or liability of the acquired business. Therefore, in most cases, the amounts

held in escrow for the seller’s satisfaction of general representations and warranties would not be accounted for as an indemnification asset.

EXAMPLE – Recognition and measurement of an indemnification asset

As part of an acquisition, the seller provides an indemnification to the acquirer for potential losses from an environmental matter related to the acquiree. The contractual terms of the seller indemnification provide for the reimbursement of any losses greater than CU100 million.

There are no issues surrounding the collectibility of the arrangement from the seller. A contingent liability of CU110 million is recognized by the acquirer on the acquisition date using similar criteria to IFRS 3 56 because the fair value of the contingent liability could not be determined during the measurement period. At the next reporting period, the amount recognized for the environmental liability is increased to CU115 million based on new information.

How should the seller indemnification be recognized and measured?

Analysis

The seller indemnification should be considered an indemnification asset and should be recognized and measured on a similar basis as the related environmental contingency. On the acquisition date, an indemnification asset of CU10 million (CU110–CU100), is recognized. At the next reporting period after the acquisition date, the indemnification asset is increased to CU15 million (CU115 less CU100), with the CU5 million adjustment offsetting the earnings [profit or loss] impact of the CU5 million increase in the contingent liability.

Recognition of liabilities related to restructurings or exit activities

Liabilities related to restructurings or exit activities of the acquiree should only be recognized at the acquisition date if they are pre-existing liabilities of the acquiree and were not incurred for the benefit of the acquirer. Absent these conditions, including a plan for restructuring or exit activities in the purchase agreement does not create an obligation for accounting purposes to be assumed by the acquirer at the acquisition date.

Liabilities and the related expense for restructurings or exit activities that are not preexisting liabilities of the acquiree should be recognized through earnings [profit or loss] in the postcombination period when all applicable criteria of IAS 37 have been met.

Liabilities related to restructuring or exit activities that were recorded by the acquiree after negotiations to sell the company began should be assessed to determine whether such restructurings or exit activities were done in contemplation of the acquisition for the benefit of the acquirer. If the restructuring activities was done for the benefit of the acquirer, the acquirer should account for the restructuring activities as a separate transaction. Refer to IFRS 3 B50 for more guidance on separate transactions.

The following examples illustrate the recognition and measurement of liabilities related to restructuring or exit activities.

EXAMPLE – Restructuring efforts of the acquiree vs. restructuring efforts of the acquirer

On the acquisition date, an acquiree has an existing liability/obligation related to a restructuring that was initiated one year before the business combination was contemplated. In addition, in connection with the acquisition, the acquirer identified several operating locations to close and selected employees of the acquiree to terminate to realise certain anticipated synergies from combining operations in the postcombination period. Six months after the acquisition date, the obligation for this restructuring action is recognized, as the recognition criteria under IAS 37 are met.

How should the acquirer account for the two restructurings?

Analysis

The acquirer would account for the two restructurings as follows:

  • Restructuring initiated by the acquiree: The acquirer would recognize the previously recorded restructuring liability at fair value as part of the business combination, since it is an obligation of the acquiree at the acquisition date.
  • Restructuring initiated by the acquirer: The acquirer would recognize the effect of the restructuring in earnings [profit or loss] in the post combination period, rather than as part of the business combination. Since the restructuring is not an obligation at the acquisition date, the restructuring does not meet the definition of a liability and is not a liability assumed in the business combination.
EXAMPLE – Seller’s reimbursement of acquirer’s post combination restructuring costs

The sale and purchase agreement for a business combination contains a provision for the seller to reimburse the acquirer for certain qualifying costs of restructuring the acquiree during the post combination period. Although it is probable that qualifying restructuring costs will be incurred by the acquirer, there is no liability for restructuring that meets the recognition criteria at the combination date.

How should the reimbursement right be recorded?

Analysis

The reimbursement right is a separate arrangement and not part of the business combination because the restructuring action was initiated by the acquirer for the future economic benefit of the combined entity. The purchase price for the business must be allocated (on a reasonable basis such as relative fair value) to the amount paid for the acquiree and the amount paid for the reimbursement right.

The reimbursement right should be recognized as an asset on the acquisition date with cash receipts from the seller recognized as settlements. The acquirer should expense postcombination restructuring costs in its postcombination consolidated financial statements.

Deferred or unearned revenue

The acquirer recognizes a liability related to deferred revenue only to the extent that the deferred revenue represents an obligation assumed by the acquirer (i.e., obligation to provide goods, services, or the right to use an asset or some other concession or consideration given to a customer).

The liability related to deferred revenue should be based on the fair value of the obligation on the acquisition date, which may differ from the amount previously recognized by the acquiree. See FV 7.3.3.6 Deferred revenue for further information on deferred or unearned revenue.

Deferred charges arising from leases

The balance sheet of an acquiree before the acquisition date may include deferred or prepaid rent related to an operating lease, resulting from the accounting guidance in IAS17 33 to generally recognize operating lease income (lessor) or expense (lessee) on a straight-line basis if lease terms include increasing or escalating lease payments.

The acquirer should not recognize the acquiree’s deferred rent using the acquisition method because it does not meet the definition of an asset or liability. The acquirer may record deferred rent starting from the acquisition date in the postcombination period based on the terms of the assumed lease.

The following example illustrates the recognition of deferred rent in a business combination. I IFRS 9 Hedge accounting content FRS 3 Recognising what you acquired in a business combination

EXAMPLE – Recognition of deferred rent

On the acquisition date, Company A assumes an acquiree’s operating lease. The acquiree is the lessee. IFRS 3 Recognising what you acquired in a business combination

The terms of the lease are: IFRS 3 Recognising what you acquired in a business combination

  • Four-year lease term IFRS 3 Recognising what you acquired in a business combination
  • Lease payments are: IFRS 3 Recognising what you acquired in a business combination
    • Year 1: CU100 IFRS 3 Recognising what you acquired in a business combination
    • Year 2: CU200 IFRS 3 Recognising what you acquired in a business combination
    • Year 3: CU300 IFRS 3 Recognising what you acquired in a business combination
    • Year 4: CU400 IFRS 3 Recognising what you acquired in a business combination

On the acquisition date, the lease had a remaining contractual life of two years, and the acquiree had recognized a CU2001 liability for deferred rent. For the purpose of this example, other identifiable intangible assets and liabilities related to the operating lease are ignored.

How should Company A account for the deferred rent?

Analysis IFRS 3 Recognising what you acquired in a business combination

Company A does not recognize any amounts related to the acquiree’s deferred rent liability on the acquisition date. However, the terms of the acquiree’s lease will give rise to deferred rent in the post combination period. Company A will record a deferred rent liability of CU502 at the end of the first year after the acquisition. IFRS 3 Recognising what you acquired in a business combination

Although deferred rent of the acquiree is not recognized in a business combination, the acquirer may recognize an intangible asset or liability related to the lease, depending on its nature or terms.

Classifying or designating identifiable assets and liabilities

IFRS 3 provides the following principle with regard to classifying or designating the identifiable net assets acquired: IFRS 3 Recognising what you acquired in a business combination

Excerpt from IFRS 3 15

At the acquisition date, the acquirer shall classify or designate the identifiable assets acquired and liabilities assumed as necessary to subsequently apply other GAAP [IFRSs subsequently]. The acquirer shall make those classifications or designations on the basis of the contractual terms, economic conditions, its operating or accounting policies, and other pertinent conditions as they exist at the acquisition date.

The acquirer must classify or designate identifiable assets acquired, liabilities assumed, and other arrangements on the acquisition date, as necessary, to apply the appropriate accounting in the post combination period. As described in IFRS 3 15, the classification or designation should be based on all pertinent factors, such as contractual terms, economic conditions, and the acquirer’s operating or accounting policies, as of the acquisition date. IFRS 3 Recognising what you acquired in a business combination

The acquirer’s designation or classification of an asset or liability may result in accounting different from the historical accounting used by the acquiree. For example:

  • Classifying assets as held for sale: As discussed in Recognition of assets held for sale, the classification of assets held-for-sale is based on whether the acquirer has met, or will meet, all of the necessary criteria. IFRS 3 Recognising what you acquired in a business combination
  • Classifying investments in debt or equity securities: Investment securities are classified based on the acquirer’s investment strategies and intent in accordance with IAS 39/ IFRS 9.
  • Re-evaluation of the acquiree’s contracts: The identification of embedded derivatives and the determination of whether they should be recognized separately from the contract is based on the facts and circumstances existing on the acquisition date. IFRS 3 Recognising what you acquired in a business combination
  • Designation and redesignation of the acquiree’s pre-combination hedging relationships: The decision to apply hedge accounting is based on the acquirer’s intent and the terms and value of the derivative instruments to be used as hedges on the acquisition date. IFRS 3 Recognising what you acquired in a business combination

IFRS 3 provides one exception to the classification or designation principle classification for a lease contract in which the acquiree is the lessor of either an operating lease or a finance lease in accordance with IFRS 16 Leases. IFRS 3 Recognising what you acquired in a business combination

The classification of these contracts is based on either the contractual terms and other factors at contract inception or the date (which could be the acquisition date) that a modification of these contracts triggered a change in their classification in accordance with the applicable IFRS. IFRS 3 Recognising what you acquired in a business combination

Financial instruments—classification or designation of financial instruments and hedging relationships

An acquiree may have a variety of financial instruments that meet the definition of a derivative instrument. The type and purpose of these instruments will typically depend on the nature of the acquiree’s business activities and risk management practices. These financial instruments may have been (1) scoped out of IAS 39/IFRS 9, (2) used in hedging relationships, (3) used in an “economic hedging relationship,” or (4) used in trading operations. IFRS 3 Recognising what you acquired in a business combination

Generally, the pre-acquisition accounting for the acquiree’s financial instruments is not relevant to the post combination accounting by the acquirer. Several issues could arise with respect to an acquiree’s financial instruments and hedging relationships and the subsequent accounting by the acquiring entity. The key issues are summarized below: IFRS 3 Recognising what you acquired in a business combination

  • Re-evaluation of the acquiree’s contracts: All contracts and arrangements of the acquiree need to be re-evaluated at the acquisition date to determine if any contracts are derivatives or contain embedded derivatives that need to be separated and accounted for as financial instruments. This includes reviewing contracts that qualify for the normal purchases and sales exception and documenting the basis for making such an election. The determination is made based on the facts and circumstances at the date of the acquisition.
  • Designation and redesignation of the acquiree’s pre-combination hedging relationships: To obtain hedge accounting for the acquiree’s pre-combination hedging relationships, the acquirer will need to designate hedging relationships anew and prepare new contemporaneous documentation for each. The derivative instrument may not match the newly designated hedged item as closely as it does the acquiree’s item. IFRS 3 Recognising what you acquired in a business combination

Long-term construction contracts

An acquiree may have long-term construction contracts that are in process on the acquisition date. These contracts should be recognized at fair value, as defined in IFRS 13. IFRS 13, the price that would be paid (received) to transfer the obligations (rights) to a market participant should be utilized to measure the contracts at fair value. IFRS 3 Recognising what you acquired in a business combination

The fair value of acquired long-term construction contracts is not impacted by the acquiree’s method of accounting for the contracts before the acquisition or the acquirer’s planned accounting methodology in the post combination period (i.e., the fair value is determined using market-participant assumptions). IFRS 3 Recognising what you acquired in a business combination

Subsequent to the acquisition, the acquirer should account for the acquired contracts in accordance with IFRS 15 Revenue from contract with customers and to recognize the contract at fair value, which is the price that would be paid (received) to transfer the obligations (rights) to a market-participant as described in IFRS 13. Revenue should mostly be recognized post-acquisition in accordance with IFRS 15 B2 – B13. IFRS 3 Recognising what you acquired in a business combination

IFRS 3 Recognising what you acquired in a business combination

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