Acquisitions and mergers as per IFRS 3

Acquisitions and mergers

Acquisitions and mergers are becoming more and more common as entities aim to achieve their growth objectives. IFRS 3 ‘Business Combinations’ contains the requirements for these transactions, which are challenging in practice.

This narrative sets out how an entity should determine if the transaction is a business combination, and whether it is within the scope of IFRS 3.

Identifying a business combination

IFRS 3 refers to a ‘business combination’ rather than more commonly used phrases such as takeover, acquisition or Acquisitions and mergersmerger 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 case below).

Case – Straightforward business combination

Entity T is a clothing manufacturer and has traded for a number of years. Entity T is deemed to be a business.

On 1 January 2020, Entity A pays CU 2,000 to acquire 100% of the ordinary voting shares of Entity T. No other type of shares has been issued by Entity T. On the same day, the three main executive directors of Entity A take on the same roles in Entity T.

Consider this…..

Entity A obtains control on 1 January 2020 by acquiring 100% of the voting rights. As Entity T is a business, this is a business combination in accordance with IFRS 3.

However, a business combination may be structured, and an entity may obtain control of that structure, in a variety of ways.

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Employee share purchase plans

Employee share purchase plans

In an ESPP, the employees are usually entitled to buy shares at a discounted price. The terms and conditions can vary significantly and some ESPPs include option features. (IFRS 2.IG17)

In my view, the predominant feature of the share-based payment arrangement determines the accounting for the entire fair value of the grant. That is, depending on the predominant features, a share purchase plan is either a true ESPP or an option plan.

All of the terms and conditions of the arrangement should be considered when determining the type of equity instruments granted and judgement is required. The determination is important because the measurement and some aspects of the accounting for each are different (see below).

Options are characterised by the right, but not the obligation, to buy a share at a fixed price. An option has a value (i.e. the option premium), because the option holder has the benefit of any future gains and has none of the risks of loss beyond any option premium paid. The value of an option is determined in part by its duration and by the expected volatility of the share price during the term of the option.

In my view, the principal characteristic of an ESPP is the right to buy shares at a discount to current market prices. ESPPs that grant short-term fixed purchase prices do not have significant option characteristics because they do not allow the grant holder to benefit from volatility. I believe that ESPPs that provide a longer-term option to buy shares at a specified price are, in substance, option plans, and should be accounted for as such. (IFRS 2.B4-B41)

Examples of other option features that may be found in ESPPs are: (IFRS 2.IG17)

  • ESPPs with look-back features, whereby the employees are able to buy shares at a discount, and choose whether the discount is applied to the entity’s share price at the date of the grant or its share price at the date of purchase;
  • ESPPs in which the employees are allowed to decide after a significant period of time whether to participate in the plan; and
  • ESPPs in which employees are permitted to cancel their participation before or at the end of a specified period and obtain a refund of any amounts paid into the plan.

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Determination of the vesting period in IFRS 2

Determination of the vesting period

Service commencement date and grant date – The ‘vesting period’ is the period during which all of the specified vesting conditions are to be satisfied in order for the employees to be entitled unconditionally to the equity instrument. Normally, this is the period between grant date and the vesting date. (IFRS 2.A)

However, services are recognised when they are received and grant date may occur after the employees have begun rendering services. Grant date is a measurement date only. If grant date occurs after the service commencement date, then the entity estimates the grant-date fair value of the equity instruments for the purpose of recognising the services from the service commencement date until grant date.

A possible method of estimating the fair value of the equity instruments is by assuming that grant date is at the reporting date. Once grant date has been established, the entity revises the earlier estimates so that the amounts recognised for services received are based on the grant-date fair value of the equity instruments. In our view, this revision should be treated as a change in estimate. (IFRS 2.IG4, IGEx1A, IGEx2)

Case – Service commencement date before grant date

Determination of the vesting period

On 1 January Year 1, Company B sets up an arrangement in which the employees receive share options, subject to a four-year service condition. The total number of equity instruments granted will be determined objectively based on B’s profit in Year 1. The total number of options will be allocated to employees who started service on or before 1 January Year 1.

Significant subjective factors are involved in determining the number of instruments allocated to each individual employee and B concludes that grant date should be postponed until the outcome of the subjective evaluations is known in April Year 2 – i.e. subsequent to the approval of the financial statements for the reporting period ending 31 December Year 1.

Because the subjective factors are determined only in April Year 2, grant date cannot be before this date. However, in this case there is a clearly defined performance period, commencing on 1 January Year 1, which indicates that the employees have begun rendering their services before grant date. Accordingly, B recognises the cost of the services received from the date on which service commences – i.e. 1 January Year 1.

The estimate used in the Year 1 financial statements is based on an estimate of the fair value, assuming that grant date is 31 December Year 1. This estimate will be revised in April Year 2 when the fair value at grant date is determined.

Assume that B estimates on 31 December Year 1 that the grant-date fair value of an equity instrument granted will be 10 and the actual fair value on grant date of April Year 2 is 9. Based on preliminary profit figures, B further estimates at 31 December Year 1 that the total number of equity instruments granted will be 100, which is confirmed by the final profit figure. If all instruments are expected to and actually do vest, then the accounting is as follows.

Determination of the vesting period

Notes

1. 100 x 10.
2. 100 x 9.
3. 1,000 x 1/4.
4. 900 x 2/4.
5. 900 x 3/4.
6. 900 x 4/4.

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Employee cash-settled share-based payments in IFRS 2

Employee cash-settled share-based payments

In short – For employee cash-settled share-based payments, an entity recognises a cost and a corresponding liability. The liability is remeasured, until settlement date, for subsequent changes in fair value.

Overview

  • Employee services received in a cash-settled share-based payment are measured indirectly at the fair value of the liability at grant date.
  • Market and non-vesting conditions are taken into account in determining the fair value of the liability.
  • Service and non-market performance conditions are taken into account in estimating the number of awards that are expected to vest, with a true-up to the number ultimately satisfied.Example Disclosure financial instruments
  • The grant-date fair value of the liability is recognised over the vesting period.
  • The grant-date fair value of the liability is capitalised if the services received qualify for asset recognition.
  • The liability is remeasured at each reporting date and at settlement date so that the ultimate liability equals the cash payment on settlement date.
  • Remeasurements during the vesting period are recognised immediately to the extent that they relate to past services, and recognised over the remaining vesting period to the extent that they relate to future services. Remeasurements after the vesting period are recognised immediately.
  • Remeasurements of the liability are recognised in profit or loss.

Basic principles of accounting for cash-settled share-based payment transactions with employees

Initial measurement

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Equity – 2 understand it all at best

Equity

There are, at least, two ways to discuss equity:

  • Equity is the residual interest in the assets of the entity after deducting all its liabilities, or
  • An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

But also:

1. Equity the residual interest in the assets of the entity after deducting all its liabilities

1. Statement of Financial Position

Assets

Equity and liabilities

1. Non-current assets

2. Current assets

Help

Help

A – TOTAL ASSETS [1 + 2] = B

3. Non-current liabilities (including Provisions)

4. Current liabilities (including Provisions)

5. Equity [1 + 2 -/- 3 -/- 4]

Help

B – TOTAL EQUITY AND LIABILITIES [3 + 4 + 5] = A

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Preference shares in EPS Calculations

Preference shares in EPS Calculations

Preference shares may in accordance with IAS 32 Financial Instruments: Presentation be classified as a whole or by their component parts into a financial liability and/or an equity instrument, depending on their terms. They may be convertible into ordinary shares.

This narrative builds on the basic principles introduced in EPS or earnings per share, and sets out the specific basic and diluted EPS implications of the following types of instrument(s).

An entity needs to consider whether equity-classified preference shares are a class of ordinary shares. If the entity has more than one class of ordinary shares, then it is required to present EPS for each class. Ordinary shares of the same ‘class’ are those shares that have the same right to receive dividends or otherwise share in the profit for the period. Additional considerations for classes of ordinary shares are set out below in classes of ordinary shares. [IAS 33.5–6]

EPS implications

Generally, how preference shares are dealt with in EPS depends on their accounting classification as liabilities or equity instruments, and whether they are convertible into ordinary shares.

Preference shares in EPS Calculations

Potential impact on basic EPS

Potential impact on diluted EPS

The numerator might or might not be affected and the denominator is not affected.

The numerator and the denominator might or might not be affected.

Preference shares that are wholly classified as liabilities under IAS 32 are not ordinary shares. The returns to the holders of these shares – e.g. post-tax amounts of preference dividends – have generally been recognised in profit or loss and therefore no further adjustment to the numerator is necessary. [IAS 33.13]

For preference shares that are wholly or partly classified as equity instruments under IAS 32, the numerator is adjusted for any returns to the holders of these shares, which include the post-tax amounts of preference dividends and any differences arising on settlement. For additional considerations and examples of adjustments for equity-classified preference shares in basic EPS. [IAS 33.12]

In addition, separate disclosure of EPS amounts is required for equity-classified preference shares that form a separate class of ordinary shares. [IAS 33.66]

Preference shares that are convertible into ordinary shares, other than those that are mandatorily convertible, are POSs (see Convertible instruments).

For equity-classified convertible preference shares, the potential adjustment:

  • to the numerator includes the returns to the holders of these shares adjusted in the calculation of basic EPS (see left); and
  • to the denominator is based on the additional ordinary shares resulting from the assumed conversion.

Conversion is assumed to have occurred at the beginning of the period (or, if later, the date of issuance of the convertible preference shares).

For liability-classified convertible preference shares, the potential adjustment:

  • to the numerator includes the post-tax amount of any dividends and other consequential changes in income or expense that would result from the assumed conversion; and
  • to the denominator is based on the additional ordinary shares resulting from the assumed conversion.

Conversion is assumed to have occurred at the beginning of the period (or, if later, the date of issuance of the convertible preference shares). For an example of adjustments for convertible instruments containing a liability component, see contracts settled in shares or cash.

Dilutive or anti-dilutive?

Generally, a convertible preference share is anti-dilutive whenever the amount of the dividend on such shares declared in or accumulated for the current period and any other required adjustment to the numerator per ordinary share obtainable on conversion exceeds basic EPS from continuing operations. [IAS 33.50]

Classes of ordinary shares

If an entity has more classes of ordinary shares, then EPS is disclosed for each class of ordinary shares that has a different right to share in the profit for the period. Therefore, for an entity that applies IAS 33, it is important to identify which of the instruments in issue are ordinary shares and to determine if there is more than one class of ordinary shares. (IAS 33.66)

IAS 33 defines an ‘ordinary share’ as ‘an equity instrument that is subordinate to all other classes of equity instruments’. It also explains that ordinary shares participate in profit for the period only after other types of shares such as preference shares have participated, and that ordinary shares of the same class are those shares that have the same right to receive dividends or otherwise share in the profit for the period. (IAS 33.5–6)

If an entity has shares with different rights, then it considers whether all of the shares are in fact ordinary shares. Consider the following contrasting examples.

Case – Two classes of ordinary shares

Company X has two classes of shares, A and B. The holders of class B shares are entitled to dividends equal to 50% of any dividends declared on the class A shares, but the shares are otherwise identical to class A shares. Both classes are subordinate to all other classes of equity instruments with respect to participation in profit.

In this case, X concludes that both class A and class B shares are ordinary shares despite the difference in entitlement to dividends. Disclosure of separate EPS amounts is therefore required for both class A and class B ordinary shares.

In general, an entity is not required to present separate EPS information for participating preference shares that are not considered to be a separate class of ordinary shares.

Case – Participating preference shares that are not ordinary shares

Company C has two classes of shares, X and Y. Shareholders of class X are entitled to a fixed dividend per share and have the right to participate in any additional dividends declared. The class Y shareholders participate equally with class X shareholders with respect to the additional dividends only.

In this example, C concludes that class X shares are not considered to be ordinary, because the fixed entitlement creates a preference over the class Y shares, and the class Y shareholders are subordinate to the class X shareholders. This is even if both classes participate equally in the residual assets of C on dissolution.

The class Y shares are the only class of ordinary shares, and therefore the only class of shares for which disclosure of EPS information is required. However, the participating rights of each class of these shares should be considered in determining earnings attributable to ordinary shareholders.

In general, puttable instruments that qualify for equity classification instead of financial liability classification under IAS 32 Financial Instruments: Presentation are not ordinary shares for the purposes of IAS 33. We believe that it is not appropriate to apply by analogy the limited scope exemption under IAS 32 for EPS calculation purposes. (IAS 32.16A–16F)

The EPS presentation is not required for, or as a result of the existence of, such instruments. However, when determining the earnings that are attributable to the ordinary shareholders, the terms of these instruments should be evaluated to determine if they are participating instruments.

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Preference shares in EPS Calculations

Contracts settled in shares or cash for IAS 33 EPS calculations

Contracts settled in shares or cash

Contracts that may be settled in shares or in cash deals with contracts that contain settlement alternatives at the issuing entity’s or the holder’s option. An example of such contracts is a share warrant that can be settled either gross in ordinary shares or net in cash.

If the contract falls under IFRS 2 Share-based Payment, then the classification depends on which party holds the settlement choice. If the issuing entity has that choice, then the contract is classified wholly as either equity-settled or cash-settled, depending on whether the entity has a present obligation to settle in cash. If the counterparty has the choice of settlement, then the contract is classified as a compound instrument. [IFRS 2.34–43]

If such a contract falls in the scope of IAS 32 Financial Instruments: Presentation, then it can contain a derivative, a liability and/or an equity component, depending on its terms. For example, a conversion option in a convertible bond that on exercise can be settled in shares or net in cash would generally mean that the whole instrument is a liability. [IAS 32.26–27, IAS 33.IE8]

This narrative covers the EPS implications of contracts that may be settled in shares or in cash in general. Additional considerations in the context of specific instruments are set out in the following chapters:

  • instruments under share-based payment arrangements: see Chapter 5.17; and
  • convertible instruments: see Chapter 5.11.

EPS implications

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Accounting Policies to First IFRS FS

Accounting Policies to First IFRS FS – An entity must use the same accounting policies in its opening IFRS statement of financial position and throughout all periods presented in its first IFRS financial statements. Those accounting policies must comply with each IFRSs effective at the end of its first IFRS reporting period, unless there is a mandatory exception to retrospective application or an optional exemption from the requirements of IFRSs.

[IFRS 1, paras 7 – 9]Accounting Policies to First IFRS FS

Note that:

  • An entity may apply a new IFRS that is not yet mandatory if that IFRSs permits early application.
  • The transitional provisions in IFRSs do not apply to a first-time adopter’s transition to IFRSs.

Mandatory Exceptions to Retrospective Application and Optional Exemptions from Read more

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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