Accounting for mergers – Best 2 Read

Accounting for mergers

Mergers and acquisitions (business combinations) can have a fundamental impact on the acquirer’s operations, resources and strategies. For most entities such transactions are infrequent, and each is unique. IFRS 3 ‘Business Combinations’ contains the requirements for accounting for mergers, which are challenging in practice.

This narrative provides a high-level overview of IFRS 3 and explains the key steps in accounting for business combinations in accordance with this Standard. It also highlights some practical application issues dealing with:

  • how to avoid unintended accounting consequences when bringing two businesses together, and
  • deal terms and what effect they can have on accounting for business combinations.

The acquisition method in accounting for mergers

IFRS 3 establishes the accounting and reporting requirements (known as ‘the acquisition method’) for the acquirer in a business combination. The key steps in applying the acquisition method are summarised below:

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Operating cash flows under IAS 7

Operating cash flows

Cash flows must be analysed between operating, investing and financing activities.

For operating cash flows, the direct method of presentation is preferred, but the indirect method is acceptable.

Here are the differences and similarities between the direct and indirect method. Note the subtotals for operating, investing and financing activities are the same amount in both methods!

Indirect method cash flow statement

Direct method cash flow statement

Starts with:

Starts with:

  • Profit before tax
  • Adjustment for:
    • non-cash items
    • depreciation/amortization (add back to profit)
    • gain on disposal of NCA (deduct)
    • loss in disposal of NCA (add back)
    • remove impact of accruals
    • Interest expense (add back)
    • Interest income (deduct and relocate to Investing activities)
  • Movement on working capital items
    • Receivables (deduct increase, add decrease)
    • Payables (add increase, deduct decrease)
    • Inventory (deduct increase, add decrease)
    • Interest paid (deduct)
    • Taxation (including deferred tax movements) (deduct).
  • Acquisition cash flows
  • Receipts from customers
  • Less Payments to:
    • suppliers
    • employees
    • other operating expenses
    • interest charges
    • taxation

Operating cash flows

Cash Flows from Operating activities

Cash Flows from Operating activities

  • purchase of non-current assets
  • sale/disposal of non-current assets
  • acquisition cash flows
  • interest received/dividend received on investment.

Cash Flows from Investing activities

Cash Flows from Investing activities

  • purchase of (treasure) shares
  • cash from shares issued
  • dividend payments to owners
  • take loan/issue bonds
  • acquisition cash flows
  • payments under lease agreements

Cash Flows from Financing activities

Cash Flows from Financing activities

Common cash flow classification errors in practice

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Restructuring

Restructuring – What are the IFRS requirements?

A restructuring can comprise numerous activities, including termination or relocation of a business, a change in management structure and lay-offs. At a high level, the associated costs are recognized when (1) the program is of such scale that it meets the IFRS definition of a restructuring, and (2) management has an obligation to proceed with the restructuring. In addition, the nature of the costs matters – certain costs cannot be recognized before being incurred, and employment termination costs may need to be recognized earlier than other restructuring costs.

Psychological risk

Restructuring costs are in the scope of IAS 37 Provisions, Contingent Liabilities and Contingent Assets with the exception of employee termination benefits, which are accounted for under IAS 19 Employee benefits.

Restructuring vs. exit activities

IAS 37 defines a restructuring as a program that materially changes the scope of a business or the manner in which it is conducted. US GAAP uses the term ‘exit activities’, which may be broader than a ‘restructuring’ under IFRS. Understanding the scale of the restructuring is therefore important because not all programs may qualify for cost recognition under IFRS.

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Example accounting policies

Example accounting policies

Get the requirements for properly disclosing the accounting policies to provide the users of your financial statements with useful financial data, in the common language prescribed in the world’s most widely used standards for financial reporting, the IFRS Standards. First there is a section providing guidance on what the requirements are, followed by a comprehensive example, easy to tailor to the specific needs of your company.Example accounting policies

Example accounting policies guidance

Whether to disclose an accounting policy

1. In deciding whether a particular accounting policy should be disclosed, management considers whether disclosure would assist users in understanding how transactions, other events and conditions are reflected in the reported financial performance and financial position. Disclosure of particular accounting policies is especially useful to users where those policies are selected from alternatives allowed in IFRS. [IAS 1.119]

2. Some IFRSs specifically require disclosure of particular accounting policies, including choices made by management between different policies they allow. For example, IAS 16 Property, Plant and Equipment requires disclosure of the measurement bases used for classes of property, plant and equipment and IFRS 3 Business Combinations requires disclosure of the measurement basis used for non-controlling interest acquired during the period.

3. In this guidance, policies are disclosed that are specific to the entity and relevant for an understanding of individual line items in the financial statements, together with the notes for those line items. Other, more general policies are disclosed in the note 25 in the example below. Where permitted by local requirements, entities could consider moving these non-entity-specific policies into an Appendix.

Change in accounting policy – new and revised accounting standards

4. Where an entity has changed any of its accounting policies, either as a result of a new or revised accounting standard or voluntarily, it must explain the change in its notes. Additional disclosures are required where a policy is changed retrospectively, see note 26 for further information. [IAS 8.28]

5. New or revised accounting standards and interpretations only need to be disclosed if they resulted in a change in accounting policy which had an impact in the current year or could impact on future periods. There is no need to disclose pronouncements that did not have any impact on the entity’s accounting policies and amounts recognised in the financial statements. [IAS 8.28]

6. For the purpose of this edition, it is assumed that RePort Co. PLC did not have to make any changes to its accounting policies, as it is not affected by the interest rate benchmark reforms, and the other amendments summarised in Appendix D are only clarifications that did not require any changes. However, this assumption will not necessarily apply to all entities. Where there has been a change in policy, this will need to be explained, see note 26 for further information.

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Software as a service

What is cloud computing and more specific software as a service?

Cloud computing is essentially a model for delivering information technology services in which resources are retrieved from the internet through web-based tools and applications, rather than a direct connection to a server. Data and software packages are stored in servers. Cloud computing structures allow access to information as long as an electronic device has access to the internet.

This type of system allows employees to work remotely. Cloud computing is so named because the information being accessed is found in the ‘clouds’, and does not require a user to be in a specific place to gain access to it. Companies may find that cloud computing allows them to reduce the cost of information management, since they are not required to own their own servers and can use capacity leased from third parties. Additionally, the cloud-like structure allows companies to upgrade software more quickly.

There are various types of cloud computing arrangements. Cloud services usually fall into one of three service models: infrastructure, platform and software. Here the focus is on software as a service (SaaS).

What is SaaS?

SaaS is a software distribution model in which the customer does not take possession of the supplier’s hardware andSoftware as a service application software. Instead, customers accesses the supplier’s hardware and application software from devices over the internet or via a dedicated line. In these types of arrangements, the customer does not manage or control the underlying cloud infrastructure, including the network, servers, operating systems, storage, and even individual application software capabilities, with the possible exception of limited user-specific application software configuration settings, nor is the customer responsible for upgrades to the underlying systems and software.

The key issues

In practice, it is clear that there are various application issues relating to the customer’s accounting in SaaS arrangements. These arrangements may often be bundled with other products and services, such as implementation, data migration, business process mapping, training, and project management.

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Initial Coin Offering

Initial Coin Offering

An Initial Coin Offering (‘ICO’) is a form of fundraising that harnesses the power of cryptographic assets and blockchain-based trading. Similar to a crowdfunding campaign, an ICO allocates (issues or promises to issue) digital token(s) instead of shares to the parties that provided contributions for the development of the digital token. These ICO tokens typically do not represent an ownership interest in the entity, but they often provide access to a platform (if and when developed) and can often be traded on a crypto exchange. The population of ICO tokens in an ICO is generally set at a fixed amount.

It should be noted that ICOs might be subject to local securities law, and significant regulatory considerations might apply.

Each ICO is bespoke and will have unique terms and conditions. It is critical for issuers to review the whitepaper (A whitepaper is a concept paper authored by the developers of a platform, to set out an idea and overall value proposition to prospective investors. The whitepaper commonly outlines the development roadmap and key milestones that the development team expects to meet) or underlying documents accompanying the ICO token issuance, and to understand what exactly is being offered to investors/subscribers. In situations where rights and obligations arising from a whitepaper or their legal enforceability are unclear, legal advice might be needed, to determine the relevant terms.

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M and A

M and A or Mergers and Acquisitions

in IFRS language Business Combinations.

1 Identifying a business combination

IFRS 3 refers to a ‘business combination’ rather than more commonly used phrases such as takeover, acquisition or merger because the objective is to encompass all the transactions in which an acquirer obtains control over an acquiree no matter how the transaction is structured. A business combination is defined as a transaction or other event in which an acquirer (an investor entity) obtains control of one or more businesses.

An entity’s purchase of a controlling interest in another unrelated operating entity will usually be a business combination (see Simple case – Straightforward business combination below). However, a business combination (M and A) may be structured, and an entity may obtain control of that structure, in a variety of ways.

Examples of business combinations structurings

Examples of ways an entity may obtain control

A business becomes the subsidiary of an acquirer

The entity transfers cash, cash equivalents or other assets(including net assets that constitute a business)

Net assets of one or more businesses are legally merged with an acquirer

The entity incurs liabilities

One combining entity transfers its net assets, or its owners transfer their equity interests, to another combining entity or its owners

The entity issues shares

The entity transfers more than one type of consideration, or

Two or more entities transfer their net assets, or the owners of those entities transfer their equity interests to a newly created entity, which in exchange issues shares, or

The entity does not transfer consideration and obtains control for example by contract alone Some examples of this:

  • ‘dual listed companies’ or ‘stapled entity structures’
  • acquiree repurchases a sufficient number of its own shares for an existing shareholder to obtain control
  • a condition in the shareholder agreement that prevents the majority shareholder exercising control of the entity has expired, or
  • a call option over a controlling interest that becomes exercisable.

A group of former owners of one of the combining entities obtains control of the combined entity, i.e. former owners, as a group, retain control of the entity they previously owned.

Therefore, identifying a business combination transaction requires the determination of whether:

  • what is acquired constitutes a ‘business’ as defined in IFRS3, and
  • control has been obtained.

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IAS 24 Related parties by definition

IAS 24 Related parties by definition starts with two classes of related parties:Third party services

  • person(s) IAS 24 Related parties by definition
  • entity(ies) IAS 24 Related parties by definition

in relation to the central entity in this standards the REPORTING ENTITY. IAS 24 Related parties by definition

The reporting entity in IAS 24 is referred to (so it strictly is spoken not an IFRS Definition) as the entity that is preparing its financial statements (consolidated and/or unconsolidated).

PERSONS

For persons it includes close members of that person’s family – where family is sometimes broader than a domestic (legal) definition of a married couple, as follows:

Starting point is a person and its relation with the reporting entity, the (related party) person has … Read more

Disclosure financial assets and liabilities

Disclosure financial assets and liabilities

– provides a narrative providing guidance on users of financial statements’ needs to present financial disclosures in the notes to the financial statements grouped in more logical orders. But there is and never will be a one-size fits all.

Here it has been decided to separately disclose financial assets and liabilities and non-financial assets and liabilities, because of the distinct different nature of these classes of assets and liabilities and the resulting different types of disclosures, risks and tabulations.

Disclosure financial assets and liabilities guidance

Disclosing financial assets and liabilities (financial instruments) in one note

Users of financial reports have indicated that they would like to be able to quickly access all of the information about the entity’s financial assets and liabilities in one location in the financial report. The notes are therefore structured such that financial items and non-financial items are discussed separately. However, this is not a mandatory requirement in the accounting standards.

Accounting policies, estimates and judgements

For readers of Financial Statements it is helpful if information about accounting policies that are specific to the entityDisclosure financial assets and liabilitiesand about significant estimates and judgements is disclosed with the relevant line items, rather than in separate notes. However, this format is also not mandatory. For general commentary regarding the disclosures of accounting policies refer to note 25. Commentary about the disclosure of significant estimates and judgements is provided in note 11.

Scope of accounting standard for disclosure of financial instruments

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IFRS 7 does not apply to the following items as they are not financial instruments as defined in paragraph 11 of IAS 32:

  1. prepayments made (right to receive future good or service, not cash or a financial asset)
  2. tax receivables and payables and similar items (statutory rights or obligations, not contractual), or
  3. contract liabilities (obligation to deliver good or service, not cash or financial asset).

While contract assets are also not financial assets, they are explicitly included in the scope of IFRS 7 for the purpose of the credit risk disclosures. Liabilities for sales returns and volume discounts (see note 7(f)) may be considered financial liabilities on the basis that they require payments to the customer. However, they should be excluded from financial liabilities if the arrangement is executory. the Reporting entity Plc determined this to be the case. [IFRS 7.5A]

Classification of preference shares

Preference shares must be analysed carefully to determine if they contain features that cause the instrument not to meet the definition of an equity instrument. If such shares meet the definition of equity, the entity may elect to carry them at FVOCI without recycling to profit or loss if not held for trading.

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