Ultimate guide to IFRS 3 Business combinations

Ultimate guide to IFRS 3 Business combinations outlines the accounting when an acquirer obtains control of a business (e.g. an acquisition or merger). Such business combinations are accounted for using the ‘acquisition method’, which generally requires assets acquired and liabilities assumed to be measured at their fair values at the acquisition date. Ultimate guide to IFRS 3 Business combinations

Definitions:

IFRS 3 Definition Acquiree: The business or businesses that the acquirer obtains control of in a business combination. Ultimate guide to IFRS 3 Business combinations

IFRS 3 Definition Acquirer: The entity that obtains control of the acquiree.

Business combination

When a buyer (acquirer) takes control of another business (the acquiree) with a transaction, it is called a business combination. There are three important considerations in this definition:

  • Business: The target entity (again the acquiree) should be a business, which has inputs and processes to convert them into recognizable outputs. Ultimate guide to IFRS 3 Business combinations

    • Input: an economic resource that creates, or has the ability to create, an output when one or more processes are applied to it. Examples include long-lived assets (including intangible assets and rights to use long-lived assets), intellectual property, the ability to obtain access to necessary materials or rights, and employees.

    • Process: a system, standard, protocol, convention or rule that creates, or has the ability to create, outputs when applied to an input or inputs. Examples include strategic management processes, operational processes and resource management processes. These processes are typically documented; however, an organised workforce with the necessary skills and experience and that follows rules and conventions may provide the processes that are capable of being applied to inputs to create outputs. Accounting, billing, payroll and other administrative systems are not typically processes used to create outputs.

    • Output: the result of inputs and processes applied to those inputs that provide or have the ability to provide a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants.

  • The transaction takes place when the acquirer transfers an amount (called consideration transferred) in the form of cash, liabilities or equities to purchase the target entity. Ultimate guide to IFRS 3 Business combinations

  • For obtaining control of the business, the acquirer, in general, must take an ownership stake of more than 50% in the business.

Business combinations can happen in the form of an acquisition or merger of two businesses. Such combinations usually take place to expand the business of the acquirer. Ultimate guide to IFRS 3 Business combinations

The practice

What does this mean in practical terms? Most transactions will be obvious business combinations (for example, the acquisition of a major multinational business) or asset transactions (for example, the purchase of a single piece of earth moving equipment). However, the assessment can become complex and judgmental. An acquired group of assets is considered to be a business if it includes inputs and processes applied to those inputs that have the ability to create the outputs of a business. Ultimate guide to IFRS 3 Business combinations

Example: Acquisition of a business

Facts: Phone Company A acquires 100% of the shares of a Phone Company B.

Analysis: the elements in the acquisition contain inputs, processes and outputs.

The inputs are: land, buildings, infrastructure (for example, call centres, cell tower leases, switches, software, licences and retail stores), furniture, computer software, customer and supplier relationships, reputation, customer contracts, brand, market share, market knowledge, experienced work staff and management expertise.

The processes are: management processes, corporate governance, organisational structures, strategic goal-setting, operational processes and human and financial resource management.

The outputs are: revenue from customers, access to new markets, increased efficiency, synergies, customer satisfaction and reputation.

A business has been acquired because all the assets and activities to provide a return are included.

Business acquired?

Not all processes need to be acquired, but the standard is silent as to whether this means at least one process or whether it is possible to acquire no processes yet still meet the definition of a business. Significant judgement is required if no processes are acquired; compelling evidence should be presented (for example, a market participant either would already have those processes or could easily replicate the current processes over a relatively short time period). Ultimate guide to IFRS 3 Business combinations

Example: Acquired assets and operations without outputs

Facts: Computer Company A acquires Software Development Company B.

Company B has been formed to make hand-held device applications. The current activities of the company include researching and developing its first product and creating a market for the product. The company has not generated any revenues and has no existing customers. Company B’s workforce is composed primarily of programmers. Company B has the intellectual property,

software and fixed assets required to develop applications.

Analysis: the elements in the acquisition contain both inputs and processes.

The inputs are: intellectual property used to design the applications, fixed assets and employees.

The processes are: strategic and operational processes for developing the applications.

It’s likely that a business has been acquired because Company B has access to the inputs and processes necessary to manage and produce outputs. The lack of outputs, such as revenue and a product, does not prevent the company from being considered a business.

Setting a framework

In situations where uncertainty exists as to whether a transaction is the acquisition of a business or assets, the following framework may be helpful in making this decision:

  • Identify the elements in the acquired group; Ultimate guide to IFRS 3 Business combinations

  • Assess the capability of the acquired group to produce outputs; and Ultimate guide to IFRS 3 Business combinations

  • Assess the capability of a market participant to produce outputs if missing elements exist. Ultimate guide to IFRS 3 Business combinations

The flow chart below attempts to combine the components defined under IFRS 3 (2008) with the decision-making framework.

Step 1: Identify the elements of the acquired group

The starting point for the analysis is to understand the inputs, processes and potential outputs. It can be useful to consider existing processes, physical assets, inputs used in the past and processes of similar businesses. Another approach is to consider the inputs and outputs together in order to identify associated processes that would be necessary to create the outputs. For example, what processes does an automotive entity perform to sheet metal and acquired parts in order to produce a car? Outputs are not required for a business to exist. For example, a start-up company with no products, revenue or customers can be a business. The results of research and development could provide return to investors. Ultimate guide to IFRS 3 Business combinations

Step 2: Assess the capability of the group to produce outputs

The acquirer needs to consider if the inputs acquired and processes transferred can produce outputs. There may be inherent processes attached to inputs. If a workforce is transferred, for example, it is reasonable to assume that the workforce has processes to produce the output. These types of inherent processes need to be considered. Ultimate guide to IFRS 3 Business combinations

Step 3: Assess the capability of a market participant to produce outputs if missing elements exist

Missing elements do not automatically mean that a group of assets and liabilities is not a business. A market participant may be capable of supplying the missing elements and producing outputs. The missing elements could be replaced through integrating the acquired group into an entity’s own operations. Market participants are theoretical third parties that could either be trade buyers or financial investors and are knowledgeable willing parties. The acquirer does not need to be a market participant in the same industry. The analysis of supplying the missing elements to produce outputs should have the same result whether the acquirer is a financial investor or a trade buyer.

Replication or replication/additional acquisitions

The question of whether missing elements can be replicated or obtained by market participants is not buyer-specific. For example, if a financial investor acquires a hotel, it may not have processes in place to run it. The financial investor could acquire relevant processes from a market participant such as another hotel management group. The easier it is to obtain the missing elements in a relatively short time-period, the more likely the set of assets and activities are a business. This determination requires judgement; entities need to consider the relevant facts and circumstances, including the nature and stage of the business and the transaction structure.

Situations such as purchase of assets, formation of joint ventures are not considered business combinations.

The accounting standards and financial reporting implications for business combinations are covered under the International Financial Reporting Standard 3 (IFRS3). It covers principles for recognizing and measuring identifiable assets acquired, liabilities assumed, and any non-controlling interest in the acquiree. Recognizing and measuring the identifiable assets acquired includes recognizing and measuring identifiable intangible assets and goodwill/badwill. Ultimate guide to IFRS 3 Business combinations

Identifiable intangible assets acquired in a business combination should be recorded separately from goodwill [IAS 38 11].

But what is meant by the term “identifiable”? In this regard, an intangible asset is identifiable if it meets either the separability criterion or the contractual-legal criterion [IAS 38 12]. With respect to separability, an acquired intangible asset meets this criterion if there is evidence of exchange transactions for that type of asset or an asset of a similar type, even if those exchanges are infrequent and regardless of whether the acquiring company has been involved in them. Ultimate guide to IFRS 3 Business combinations

Capable of separation

Furthermore, if the acquired intangible asset is capable of being separated from the acquired business, the intangible asset still meets the separability criterion for separate recognition regardless of whether management has the intent to separate it. Even if the acquiring company believes that separating the intangible asset would be uneconomical, it is the capability of being separated, rather than the probability of being separated, that is determinative. Ultimate guide to IFRS 3 Business combinations

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