The acquisition method

An entity shall account for each business combination by applying the acquisition method. Applying the acquisition method requires:

  1. identifying the acquirer;
  2. determining the acquisition date;
  3. recognising and measuring the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquiree; and
  4. recognising and measuring goodwill or a gain from a bargain purchase.

Here is an overview of which each step will be discussed after the overview

The acquisition method

Identifying the acquirer

For each business combination, one of the combining entities shall be identified as the acquirer. (IFRS 3 6)

Application of the above principle requires one of the parties in a business combination to be identified as the acquirer for accounting purposes. The process of identifying the acquirer begins with
the determination of the party that obtains control based on the guidance in the consolidation standards. As a result, the guidance in IFRS 10 Consolidated Financial Statements shall be used to identify the acquirer—the entity that obtains control of another entity, ie the acquiree.

A party that has power over the investee; exposure, or rights, to variable returns from its involvement in the investee; and the ability to use that power over the investee to affect the amount of the investor’s returns has control.

If the accounting acquirer is not apparent when considering the guidance in IFRS 10, the following additional guidance is provided in the Standards to assist in the identification of the acquirer:

The entity that transfers cash or other assets, or incurs liabilities to effect a business combination is generally identified as the acquirer, as discussed in IFRS 3 B14.

The entity that issues equity interests is usually the acquirer in a business combination that primarily involves the exchange of equity interests. However, it is sometimes not clear which party is the acquirer if a business combination is effected through the exchange of equity interests. In these situations, the acquirer for accounting purposes may not be the legal acquirer (i.e., the entity that issues its equity interest to effect the business combination). The acquisition method

Business combinations in which the legal acquirer is not the accounting acquirer are commonly referred to as “reverse acquisitions.” All pertinent facts and circumstances should be considered in determining the acquirer in a business combination that primarily involves the exchange of equity interests. If a business combination has occurred but applying the guidance in IFRS 10 does not clearly indicate which of the combining entities is the acquirer, the factors in Guidance in identifying the acquirer shall be considered in making that determination.

The weight of relative voting rights in the combined entity after the business combination generally increases as the portion of the voting rights held by the majority becomes more significant (e.g., split of 75% and 25% may be more determinative than a split of 51% and 49%). The acquisition method

The existence of a party with a large minority voting interest may be a factor in determining the acquirer. For example, a newly combined entity’s ownership includes a single investor with a 40% ownership, while the remaining 60% ownership is held by a widely dispersed group. The single investor that owns the 40% ownership in the combined entity is considered a large minority voting interest. The acquisition method

Consideration should be given to the initial composition of the board and whether the composition of the board is subject to change within a short period of time after the acquisition date. Assessing the significance of this factor in the identification of the acquirer would include an understanding of which combining entity has the ability to impact the composition of the board. These include, among other things, the terms of the current members serving on the governing body, the process for replacing current members, and the committees or individuals that have a role in selecting new members for the governing body. The acquisition method

Consideration should be given to the number of executive positions, the roles and responsibilities associated with each position, and the existence and terms of any employment contracts. The seniority of the various management positions should be given greater weight over the actual number of senior management positions in the determination of the composition of senior management. The acquisition method

The terms of the exchange of equity interests are not limited to situations where the equity securities exchanged are traded in a public market. In situations where either or both securities are not publicly traded, the reliability of the fair value measure of the privately held equity securities should be considered prior to assessing whether an entity paid a premium over the precombination fair value of the other combining entity or entities. The acquisition method

Other factors to consider in determining the acquirer include: The acquisition method

  • The combining entity whose relative size is significantly larger than the other combining entity or entities usually is the acquirer. Assessing relative size may include an understanding of the
    combining entities’ assets, revenues, or earnings [profit]. The acquisition method
  • An acquirer should be identified in a business combination involving more than two entities. The identification of the acquirer should consider which entity initiated the business combination, the relative size of the combining entities, and any other pertinent information. The acquisition method
  • A new entity formed to effect a business combination is not necessarily the acquirer. One of the existing combining entities should be determined to be the acquirer in a business combination involving the issuance of equity interests by a newly formed entity (Newco). However, a Newco that transfers cash or other assets, or that incurs liabilities as consideration may be deemed to be the accounting acquirer in certain situations. The acquisition method

Determining the acquisition date

The acquirer shall identify the acquisition date, which is the date on which it obtains control of the acquiree.

The date on which the acquirer obtains control of the acquiree is generally the date on which the acquirer legally transfers the consideration, acquires the assets and assumes the liabilities of the acquiree—the closing date. However, the acquirer might obtain control on a date that is either earlier or later than the closing date. For example, the acquisition date precedes the closing date if a written agreement provides that the acquirer obtains control of the acquiree on a date before the closing date. An acquirer shall consider all pertinent facts and circumstances in identifying the acquisition date.

Determining the acquisition date for a business combination achieved without the transfer of consideration
An acquirer may obtain control through a transaction or event without the purchase of a controlling ownership interest (i.e., a business combination achieved without the transfer of consideration). The acquisition date for these business combinations is the date control is obtained through the other transaction or event. This situation may arise, for example, if an investee enters into a share buy-back arrangement with certain investors and, as a result, control of the investee changes. In this example, the acquisition date should be the date on which the share repurchase (and cancellation) occurs, resulting in an investor obtaining control over the investee. The acquisition method


Recognition principle

The acquisition method As of the purchase date, the acquirer shall recognise, 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 Recognition conditions – Identifiable assets acquired and liabilities assumed and Recognition conditions – Assets and liabilities part of the exchange (see below).

The acquisition method The acquisition method The acquisition method 

The acquisition method The acquisition method The acquisition method

The acquisition method The acquisition method The acquisition method The acquisition method


Recognition conditions – Identifiable assets acquired and liabilities assumed

To qualify for recognition as part of applying the purchase method, the identifiable assets acquired and liabilities assumed must meet the definitions of assets and liabilities in the Conceptual Framework at the acquisition date. For example, costs the acquirer expects but is not obliged to incur in the future to effect its plan to exit an activity of an acquiree or to terminate the employment of or relocate an acquiree’s employees are not liabilities at the acquisition date. Therefore, the acquirer does not recognise those costs as part of applying the acquisition method. Instead, the acquirer recognises those costs in its post-combination financial statements in accordance with other IFRS.

Assets and liabilities part of the exchange

In addition, to qualify for recognition as part of applying the acquisition method, the identifiable assets acquired and liabilities assumed must be part of what the acquirer and the acquiree (or its former owners) exchanged in the business combination transaction rather than the result of separate transactions. The acquirer shall apply the guidance in Determining what is part of the business combination transaction to determine which assets acquired or liabilities assumed are part of the exchange for the acquiree and which, if any, are the result of separate transactions to be accounted for in accordance with their nature and the applicable IFRSs.

Recognising previously not recognised assets and liabilities

The acquirer’s application of the recognition principle and conditions may result in recognising some assets and liabilities that the acquiree had not previously recognised as assets and liabilities in its financial statements. For example, the acquirer recognises the acquired identifiable intangible assets, such as a brand name, a patent or a customer relationship, that the acquiree did not recognise as assets in its financial statements because it developed them internally and charged the related costs to expense.

Recognising leases and intangible assets

Recognising leases and intangible assets provide guidance on recognising operating leases and intangible assets. Exception to the recognition principle and Exceptions to both the recognition and measurement principles in Exceptions to IFRS principles in the acquisition method specify the types of identifiable assets and liabilities that include items for which this IFRS provides limited exceptions to the recognition principle and conditions.


Classifying or designating identifiable assets acquired and liabilities assumed in a business combination

At the acquisition date, the acquirer shall classify or designate the identifiable assets acquired and liabilities assumed as necessary to apply other 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.

Different accounting possible

In some situations, IFRSs provide for different accounting depending on how an entity classifies or designates a particular asset or liability. Examples of classifications or designations that the acquirer shall make on the basis of the pertinent conditions as they exist at the acquisition date include but are not limited to:

  1. classification of particular financial assets and liabilities as measured at fair value through profit or loss or at amortised cost, or as a financial asset measured at fair value through other comprehensive income in accordance with IFRS Financial Instruments;
  2. designation of a derivative instrument as a hedging instrument in accordance with IFRS 9; and
  3. assessment of whether an embedded derivative should be separated from a host contract in accordance with IFRS 9 (which is a matter of ‘classification’ as this IFRS uses that term).

Exceptions

This IFRS provides two exceptions to the principle relating to Classify or designate assets and liabilities:

  1. classification of a lease contract as either an operating lease or a finance lease in accordance with IFRS 16 Leases; and
  2. classification of a contract as an insurance contract in accordance with IFRS 4 Insurance Contracts.

The acquirer shall classify those contracts on the basis of the contractual terms and other factors at the inception of the contract (or, if the terms of the contract have been modified in a manner that would change its classification, at the date of that modification, which might be the acquisition date).

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.


Measurement principle – Acquisition-date fair values

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

Defensive intangible assets The acquisition method

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. The acquisition method

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. The acquisition method

Asset valuation allowances The acquisition method

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.

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 The acquisition method

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.

Contracts The acquisition method

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.

Loss contracts The acquisition method

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. The acquisition method

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.

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 post combination 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).

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.

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:

  • How was the original relationship structured and accounted for? What was the intent of both parties at inception? The acquisition method
  • 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? The acquisition method
  • 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? The acquisition method
  • Has there been any enhanced or incremental value to the acquirer since the original transaction? The acquisition method
  • Is the reacquired right exclusive or nonexclusive? The acquisition method

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. 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. The acquisition method

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.

Non-controlling interests

The acquisition method 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:

  1. fair value; or
  2. the present ownership instruments’ proportionate share in the recognised amounts of the acquiree’s identifiable net assets.

All other components of non-controlling interests shall be measured at their acquisition-date fair values, unless another measurement basis is required by IFRSs.

Exceptions

Exceptions to both the recognition and measurement principles in Exceptions to IFRS principles in the acquisition method specify the types of identifiable assets and liabilities that include items for which this IFRS provides limited exceptions to the measurement principle.

Example of applying the acquisition method

The following example provides an example of the general application of the acquisition method in a business combination.

EXAMPLE – Applying the acquisition method
Company A acquires all of the equity of Company B in a business combination. The company applied the acquisition method based on the following information on the acquisition date:

  • Company A pays CU100 million in cash to acquire all outstanding equity of Company B.
  • Company A incurs CU15 million of expenses related to the acquisition. The expenses incurred include legal, accounting, and other professional fees.
  • Company A agreed to pay CU6 million in cash if the acquiree’s first year’s postcombination revenues are more than CU200 million. The fair value of this contingent consideration arrangement at the acquisition date is CU2 million.
  • The fair value of tangible assets and assumed liabilities on the acquisition date is CU70 million and CU35 million, respectively.
  • The fair value of identifiable intangible assets is CU25 million.
  • Company A intends to incur CU18 million of restructuring costs by severing employees and closing various facilities of Company B shortly after the acquisition.
  • There are no measurement period adjustments.
  • Company A obtains control of Company B on the closing date.

How should the acquisition be recorded?

Analysis
The following analysis excludes the accounting for any tax effects of the transaction.

– Identifying the acquirer
Company A is identified as the acquirer because it acquired all of Company B’s equity interests for
cash. The acquirer can be identified based on the guidance in ASC 810-10 and IFRS 10.

– Determining the acquisition date
The acquisition date is the closing date.

– Purchase accounting
Company A would recognize and measure all identifiable assets acquired and liabilities assumed at the acquisition date. There is no noncontrolling interest because Company A acquired all of the equity of Company B. Company A would record the acquired net assets of Company B in the amount of CU60 million (CU95 million of assets less CU35 million of liabilities), excluding goodwill, as follows (in millions):

Identified tangible assets acquired CU 70
Identified intangible assets acquired CU 25
Less: Liabilities assumed CU 35
Total acquired net assets CU 60

Company A would not record any amounts related to its expected restructuring activities as of the acquisition date because Company A did not meet the relevant US GAAP or IFRS criteria. The recognition of exit/restructuring costs would be recognized in postcombination periods.

Recognizing and measuring goodwill

Acquisition costs are not part of the business combination and will be expensed as incurred. Company A would make the following entry (in millions):

Acquisition costs in profit or loss CU 15
Cash CU 15

The consideration transferred is CU 102 million, which is calculated as follows (in millions):

Cash CU 100
Contingent consideration—liability CU 2¹
Total consideration transferred CU 102

1 The contingent consideration liability will continue to be measured at fair value in the postcombination period with changes in its value reflected in earnings [profit or loss].

The acquisition results in goodwill because the CU102 million consideration transferred is in excess of the CU60 million identifiable net assets acquired, excluding goodwill, of Company B. Goodwill resulting from the acquisition of Company B is CU42 million and is measured, as follows (in millions):

Total consideration transferred CU 102
Less: acquired net assets of Company B (60)
Goodwill to be recognized CU 42

Continue reading: Goodwill or gain from a bargain

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