1 Accounting for Business Combinations under IFRS 3 Goodwill and Intangible Assets under IFRS 3 and...

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Accounting for Business Combinations under IFRS 3Goodwill and Intangible Assets under IFRS 3 and IAS 38Vienna, March 14, 2006

By Thierry Bertrand, Partner, E&Y

Olivier Lemaire, Partner, E&Y

Renaud Breyer, Manager, E&Y

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Agenda

• Scope of IFRS 3• Identifying the acquirer• Cost of the acquisition• Allocation of cost• Accounting for adjustments to provisional

accounting• Accounting for goodwill• First-time adoption issues• Exposure draft – Phase 2

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Case study – IFRS 3

• Fact patterns described in appendix A

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Scope of IFRS 3

Question

• Does the transaction constitute a business combination within the scope of IFRS 3? For the purpose of answering this question, assume ADC is the acquirer.

Answer

• ?

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Scope of IFRS 3 (cont’d)

Transaction represents a business combination and is within the scope of IFRS 3.

1. Does the transaction satisfy the definition of a business

combination ?

Transaction is outside the scope of IFRS 3 ?

3. Is the business combination within the scope of IFRS 3 ?

Yes

Yes

No

No

2. Does the acquiree satisfy the definition of a business ?

No

Yes

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Explanation

• Does the transaction satisfy the definition of a business combination?

• Does the acquiree satisfy the definition of a business?

ADC’s acquisition of OLH gives rise to a parent/subsidiary relationship. Therefore, this transaction satisfies the definition of a business combination (i.e., the bringing together of separate entities into one reporting entity).

ADC (the acquirer) has obtained control of OLH (the acquiree).

OLH is an integrated set of activities and assets conducted and manages to provide return to investors.

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Explanation (cont’d)• Is the business combination within the scope of IFRS 3?

IFRS 3 does not apply to:– business combinations in which separate entities or businesses

are brought together to form a joint venture;– business combinations involving entities under common control;– business combinations involving two or more mutual entities; and– business combinations in which separate entities or businesses

are brought together to form a reporting entity by contract alone without the obtaining of an ownership interest (i.e., dual listed companies). (IFRS 3.3)

ADC’s acquisition of OLH is within the scope of IFRS 3. Therefore, ADC’s acquisition of OLH is a business combination that is included within the scope of IFRS 3.

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Question

• Instead of acquiring the issued shares of OLH, assume ADC has acquired the net assets of OLH. Does the transaction still constitute a business combination within the scope of IFRS 3?

Answer

• ?

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Explanation

• Does the transaction satisfy the definition of a business combination?

ADC’s acquisition of OLH gives rise to a parent/subsidiary relationship.

• Does the acquiree satisfy the definition of a business?

The net assets of OLH would constitute a business (i.e., satisfies the definition of a business).

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• Is the business combination within the scope of IFRS 3?

– business combinations in which separate entities or businesses are brought together to form a joint venture;

– business combinations involving entities under common control;– business combinations involving two or more mutual entities; and– business combinations in which separate entities or businesses

are brought together to form a reporting entity by contract alone without the obtaining of an ownership interest (i.e., dual listed companies). (IFRS 3.3)

Further, this particular transaction is not excluded from thescope of IFRS 3. Therefore this combination would beaccounted for by applying IFRS 3

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Question

• Assume ADC and OLH are proprietary companies that are owned by the same parent entity. Does the transaction constitute a business combination within the scope of IFRS 3?

Answer

• No. Business combinations involving entities under common control are excluded from the scope of IFRS 3.

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Question

• Assume ADC and OLH enter into a contractual arrangement under which the activities of two companies are brought together, managed and operated on a unified basis as if they were a single economic enterprise while retaining their separate legal identities and stock exchange listings. Does the transaction constitute a business combination within the scope of IFRS 3? (For the purpose of answering this question, assume ADC is adjudged the acquirer.)

Answer

• No, as it is a transaction in which separate entities are brought together to form a reporting entity by contract alone without the obtaining of an ownership interest.

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Scope of IFRS 3 – Some practical issues

Question:

• Should IFRS 3 apply to the acquisition of additional ownership interests in a joint venture resulting in a former venturer gaining control on the joint venture?

Business combinations achieved in stages when control is obtained over a former joint venture

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Scope of IFRS 3 – Some practical issues (cont’d)

Fact patterns:

• Entities M and P currently operate under a agreement a joint venture, J, with M holding a 75% interest and P a 25% interest. M accounts for J's activities according to IAS 31 using the proportionate consolidation method.

• M now buys out P's 25% interest in J and as a result, obtains control over J's activities.

• Should M account for the acquisition of the remaining 25% as for a step acquisition and record J's net assets at 100% of their fair values at the date that M obtains control of J?

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Answer:

• Yes, acquisition of the remaining 25 % of J should be accounted for as a business combination. IFRS 3 applies when control is obtained over a former joint venture. Therefore, at the date control is obtained, M shall:

– determine goodwill for the newly acquired 25 % interest using the cost of that transaction and the fair value of J's identifiable net assets at the date control is obtained;

– recognise the assets and liabilities at 100 % of their fair value at the date of obtaining control; and

– treat any adjustment to those fair values relating to previously held interests as a revaluation.

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Business combination achieved in stages

Question:

• Is it acceptable for any revaluation amount arising in a business combination achieved in stages to be recycled through profit or loss on subsequent disposal of the underlying assets (or liabilities) or businesses concerned?

When a business combination involves more than one exchange transaction, the fair value adjustments related to held interests prior to the control acquisition are accounted for in an equity revaluation reserve.

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• Revaluation surplus can arise when a business combination is achieved in stages

• However, IFRS 3 is silent as to whether any such revaluation surplus can or shall be recycled into profit or loss at a later date.

• IAS 27 also does not make any reference to such revaluation surplus being taken into account in calculating the gain or loss on disposal of a subsidiary.

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Answer:

Answer based on facts and circumstances:

• It depends whether the revaluation amounts are related to assets or liabilities whose revaluation are normally recycled through the profit or loss on disposal in accordance with the relevant accounting standard (such as available-for-sale investments under IAS 39)

• In the other cases, any revaluation amount should not be recycled into P&L either on disposal of the underlying assets or of the business concerned (PP&E, intangible assets).

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Identifying the acquirer

4. The legal acquirer will be the entity that is acquiring the issued shares of

the other entity.

1. What is legal form of the businesses that are subject to the

business combination? For example, does the business combination

involve legal entities or groups of assets/net assets that constitute a

business?

The legal acquiree (legal subsidiary) shall be adjudged the [in-substance] acquirer for the purpose of applying

IFRS 3.

3. Does the transaction constitute a reverse acquisition (i.e., is the legal

acquiree actually obtaining control of the legal acquirer)?

Entities

No

Typically, the acquirer will be the entity acquiring the group of

assets/net assets.

Yes

Assets

2. Was a new entity formed to issue equity instruments to effect a

business combination between two or more pre-existing entities?

One of the combining entities that existed before the combination shall

be adjudged the acquirer on the evidence available.

Yes

No

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Identifying the acquirer (cont’d)

Question

• Which entity would be adjudged the acquirer under IFRS 3 ?

Answer

• ADC

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• Assume that a newly formed company, NewCo, effected the business combination between ADC and OLH by issuing shares to the owners of ADC and OLH in exchange for the issued shares of those companies.

• Also assume that as a result of the transaction, the existing directors of ADC and two of the existing directors of OLH have taken up the board positions in NewCo.

NewCo

ADC OLH

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Question

• Which entity would be adjudged the acquirer under IFRS 3 ?

Answer

• ADC

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• Assume that in order to effect the business combination, OLH issued shares to the owners of ADC in exchange for the issued shares of ADC. Also assume that as a result of the transaction, the existing 4 directors of ADC taken up board positions with OLH and that one of the directors of OLH has resigned. There are now 6 directors in OLH.

• Before the transaction:

ADC Shareholder

s

ADC

OLH Shareholder

s

OLH

1

2

1: OLH issues shares to ADC shareholders.

2: Ownership of ADC issued shares transfers to OLH

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• After the transaction:

OLH Shareholders (including previous ADC shareholders)

ADC

OLHLegal parent

Legal subsidiary

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Question

• Who is the acquirer under IFRS 3?

Answer

• ADC

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Cost of acquisition

Question

• What is the cost of the business combination under IFRS 3?

Answer

• The cost of the business combination to ADC is:

EUR million

Fair value of assets given (10 million shares x EUR 10/share) 100

Plus: directly attributable costs:

Legal fees and other due diligence costs 5

Total cost 105

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Cost of acquisition (cont’d)

Question:

• What impact, if any, does this have on the cost of the combination?

Answer:

• Given the additional consideration can be reliably measured and the fact that management consider that it is probable it will be paid out, the EUR 5,000,000 should be included in the cost of the combination (this will impact the amount of goodwill/’excess over cost’ recognised).

Assume OLH is a proprietary company with 1 owner (further assume that the owner will not continue as a key employee of OLH post combination). In addition to the purchase consideration outlined in the fact patterns (i.e., 10 million shares in ADC), ADC agrees to pay a further EUR 5,000,000 cash if OLH achieves a profit of EUR 10,000,000 in the 12 months following the business combination. As at the acquisition date (1 May 20X5), ADC management believe that it is probable that the profit level will be achieved and that the additional consideration will be required.

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Cost of acquisition (cont’d)

Question:

• What impact, if any, does this have on the cost of the combination?

Answer:

• The cost of the combination is retrospectively adjusted to remove the contingent consideration that has not actually been paid. This adjustment will impact the amount of goodwill/‘excess over cost’ recognised.

Following on the previous assumption, assume that OLH does not achieve the EUR 10,000,000 profit in the 12 months following the business combination and therefore the additional consideration is not paid.

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Cost of acquisition – Practical issues

Question:

• Are acquisition costs recorded gross or net of applicable income taxes ? IFRS 3 does not provide specific guidance.

Answer:

• In accordance with the “no offsetting” principle in paragraph 32 of IAS 1, Presentation of Financial Statements, and in the absence of specific guidance in IFRS 3 to the contrary, acquisition costs are recorded gross-that is, if any costs directly attributable to the acquisition are deductible for income tax purposes, the related taxes are not netted against the acquisition costs.

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Question:

• Company A engages Company X, which has specific technical knowledge, to assist in identifying an investment target. Company X recommends that Company A purchase Company B. Company A has agreed to pay Company X a performance fee in the event that the return from its investment in Company B exceeds a specified target. Can this be accounted for as contingent consideration arising on business combination?

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Answer:

• No. The payment to Company X is not contingent consideration as it is not part of the agreement between the vendor and the purchaser. It arises from a separate agreement with the third party adviser. Accordingly, whilst the payment to Company X is part of the cost of the combination it must be measured as at the combination date. Any subsequent remeasurement cannot be adjusted against the cost of the combination except where it is an adjustment to the initial accounting under paragraph 62 of IFRS 3. However, an adjustment to the initial accounting must reflect conditions as they existed at the date of the combination and does not take into account subsequent events.

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Cost of acquisition – Contingent consideration vs deferred consideration

Question

• Should a payment that is uncertain, in both amount and timing, at acquisition date in a business combination be treated as ‘contingent consideration’?

Fact pattern

• Adjustments to the cost of a business combination that are contingent on future events can take a number of forms. Examples include:

– an additional payment of EUR 1m if a drug currently under development receives approval at a later date;

– an additional payment of EUR 1m if the acquiree's profit in the year after acquisition exceeds EUR 2m; and

– an additional payment of 50% of actual EBITDA of the acquiree in the year after acquisition.

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Cost of acquisition – Contingent consideration vs deferred consideration (cont’d)Fact pattern (cont’d)

• The issue is whether the payment of an uncertain amount should be accounted for as contingent consideration (with the amount ultimately paid adjusted to the cost of the combination) or whether it is more akin to deferred consideration (that must be estimated at acquisition date with any future changes in that estimate taken to income).

Answer

• Yes. Any consideration for a business combination where the amount or the timing is not known with certainty is contingent consideration. Therefore any adjustments to that consideration are made to goodwill (assuming there is no compensation element). The only adjustment made to the income statement is to unwind the discount recognised at the date of acquisition. Therefore in the examples in fact pattern all scenarios would result in a classification as contingent consideration.

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Allocation of cost

• Fact patterns described in appendix B.

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Allocation of cost (cont’d)Question• Identify which items would be recognised separately from goodwill

under IFRS 3, and why (i.e., due to satisfying the specified recognition criteria in IFRS 3 and IAS 38).

Item IFRS 3

(a) Customer contracts Satisfies the definition of an intangible asset (arises from contractual rights) and fair value can be reliably measured. Therefore recognised separately from goodwill. (IFRS 3.37(c))

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Allocation of cost (cont’d)

Item IFRS 3

(b) Non-contractual customer relationships

IAS 38 Intangible Assets states that in the absence of legal rights to protect, or other ways to control, these relationships, the entity usually has insufficient control to meet the definition of an intangible asset. However, exchange transactions for the same or similar non-contractual relationships (other than as part of a business combination) provides evidence that the entity is nonetheless able to control the expected future benefits flowing from the customer relationships (in which case the relationships would satisfy the “separable” criterion and therefore meet the definition of an intangible asset). In this example, there is no such evidence therefore, the relationships are not separately recognised. (IAS 38.16)

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Item IFRS 3

(c) Internet domain names

Satisfies the definition of an intangible asset (arises from contractual or other legal rights) and fair value can be reliably measured. Therefore recognised separately from goodwill. (IFRS 3.37(c))

(d) Brand name Satisfies the definition of an intangible asset (arises from contractual or other legal rights) and fair value can be reliably measured. Therefore recognised separately from goodwill. (IFRS 3.37(c))

(e) Customer database Satisfies the definition of an intangible asset (separable) and fair value can be reliably measured. Therefore recognised separately from goodwill. (IFRS 3.37(c))

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Item IFRS 3

(f) In-process R&D Satisfies the definition of an intangible asset (separable) and fair value can be reliably measured. Therefore recognised separately from goodwill. (IFRS 3.37(c))Also, IAS 38.34 states “the acquirer recognises as an asset separately from goodwill an IPR&D project of the acquiree if the project meets the definition of an intangible asset and its fair value can be reliably measured.

(g) Lease agreement IFRS 3 requires all liabilities of the acquiree that satisfy the general recognition criteria of probable and reliable measurement to be recognised at their fair values (therefore, includes agreements equally proportionately unperformed that are not at current market rates – “out-of-the-money”). (IFRS 3.37(b))

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Item IFRS 3

(h) Website contract Satisfies the definition of an intangible asset (arises from contractual or other legal rights) and fair value can be reliably measured. Therefore recognise separately from goodwill. (IFRS 3.37(c))

(i) Damages claim IFRS 3 requires all contingent liabilities of the acquiree to be recognised at their fair values (provided that fair value can be reliably measured). (IFRS 3.37(c)).

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• Marketing related

– Trademarks, trade names, service marks…

– Internet domain names– Newspaper mastheads

• Customer related

– Customer lists– Order backlog– Contractual relationships

• Artistic

– Plays, operas, ballets, books, musical works, pictures, films…

• Contract-based

– Licenses, royalties, leases, agreements, rights, contracts

• Technology-based

– Patents, sofware, databases, trade secrets

Other examples of intangible assets which are typically recognized as part of a business combination separately from goodwill:

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Question

• Would ADC be able to recognise a restructuring provision under IFRS 3?

Answer

• ADC is not able to recognise a provision for the restructuring of OLH. Only the existing liabilities for restructuring recognized in OLH in accordance with IAS 37 are recognized as allocation of the cost.

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• Allocate the cost of the business combination to the assets, liabilities and contingent liabilities of the acquiree (purchase price allocation).

On-line Homes (OLH) Book value Fair value

Cash 10 10

Debtors, net 20 20

Mortgage loan receivables# 55 47

P,P & E 30 35

IPR&D - 1

Intangible-Software 2 2

Intangible-Customer contracts - 15

Intangible-Domain name - 2

Intangible-Brand name - 20

Intangible-Database - 1

Intangible-Website contract - 2

TOTAL ASSETS 117 155

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On-line Homes (OLH) Book value Fair value

Deferred tax - (8)

Payables (30) (30)

Provisions (10) (10)

Interest bearing liabilities (10) (15)

Liability – operating lease agreement - (3)

Contingent liability - (2)

TOTAL LIABILITIES (50) (68)

NET ASSETS 67 87

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Allocation of cost – accounting for deferred tax effect (cont’d)

• As a consequence of the fair value adjustments recognised on acquisition, ADC must calculate the tax effect of these adjustments in accordance with IAS 12 Income Tax.

• Applicable income tax rate is 30%.

Table 1: Calculate temporary differences

• The fair value of the identifiable assets and liabilities (excluding deferred tax liabilities and assets) acquired by ADC and recognised in ADC’s consolidated financial report is set out in the following table, together with their tax base and the resulting temporary differences:

On-line Homes (OLH) Fair value Tax base Temporary differences

Cash 10 10 -

Debtors, net 20 20 -

Mortgage loan receivables 47 55 (8)

P,P & E 35 20 15

IPR&D 1 - 1

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On-line Homes (OLH) Fair value Tax base Temporary differences

Intangible-Software 2 2 -

Intangible-Customer contracts 15 - 15

Intangible-Domain name 2 - 2

Intangible-Brand name 20 - 20

Intangible-Database 1 - 1

Intangible-Website contract 2 - 2

Payables (30) (30) -

Provisions (10) - (10)

Interest bearing liabilities (15) (10) (5)

Liability – operating lease agreement (3) - (3)

Contingent liability (2) - (2)

Fair value of the identifiable assets and liabilities acquired, excluding deferred tax

95 67 28

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Table 2: Calculate deferred tax balance

Temporary differences Applicable tax rate Deferred tax balance

EUR 28 30% EUR 8.4

• The deferred tax asset arising from the mortgage loan receivables, the provisions, the interest bearing liability, the liability – operating lease agreement and the contingent liability is offset against the deferred tax liabilities arising from PP&E and the identifiable intangible assets. This gives rise to a net deferred tax liability of EUR 8 million.

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Accounting for adjustments to provisional accounting

• Assume that ADC had accounted for the business combination on a provisional basis (for example, ADC was awaiting a final valuation with respect to the brand name acquired).

• Assume that within 12 months of the acquisition date, ADC obtains a final valuation with regard to the brand name (i.e., EUR 25 million instead of the provisional amount of EUR 20 million).

• Assume that ADC had estimated the useful life of the brand name to be 40 years. Therefore, 2 months worth of amortisation charges was recorded for the reporting period ended 30 June 20X5 (EUR 20 million / 40 years * 2/12 = EUR 83,333).

Question• How would the adjustment be accounted for under IFRS 3? Provide

journals to illustrate the required adjustment

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Accounting for adjustments to provisional accounting (cont’d)

Answer

• ADC has to adjust the provisional accounting and adjust goodwill as appropriate.

• Given the change in the determination of fair value, the amortisation charge for the period ended 30 June 20X5 should have been EUR 104,167 (i.e., EUR 25 million / 40 years * 2/12).

• ADC would therefore adjust the comparative figures in its consolidated financial report for the year ended 30 June 20X6 as follows:

Dr Cr

Intangible-Brand name 5,000,000

Amortisation expense 20,833

Goodwill 5,000,000

Accumulated amortisation 20,833

Notes:1: EUR 104,167 - EUR 83,333 = EUR 20,833

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Accounting for adjustments to provisional accounting (cont’d)

• In accordance with IFRS 3.69, ADC discloses in its 20X5 financial report that the initial accounting for the business combination has been determined only provisionally, and explains why this is the case. In accordance with IFRS 3.73(b), the entity discloses in its 20X6 financial report the amounts and explanations of the adjustments to the provisional values recognised during the current reporting period. Therefore, the entity discloses that:

– the fair value of the brand name at the acquisition date has been increased by EUR 5 million with a corresponding decrease in goodwill; and

– the 20X5 comparative information is restated to reflect this adjustment and to include additional depreciation of EUR 20,833 relating to the year ended 30 June 20X5

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Accounting for goodwill

Question• How is any residual (i.e., difference between the cost of the combination and the fair

value of the identifiable net assets acquired) accounted for under IFRS 3?

Answer• The acquirer shall, at the acquisition date measure that goodwill at its cost, being the

excess of the cost of the business combination over the acquirer’s interest in the net fair value of the identifiable assets, liabilities and contingent liabilities. Therefore, the goodwill is calculated as follows:

EUR million

Cost of the business combination 105

Less: net fair value of identifiable assets, liabilities and contingent liabilities of the acquiree, including deferred tax liability

87

Goodwill 18

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Accounting for goodwill (cont’d)

Assume ADC issues only 7.5 million ordinary shares as purchase consideration for the acquisition of 100% of the issued shares of OLH.

Question• How is any residual amount accounted for under IFRS 3?

Answer EUR million

Cost of the business combination (EUR 75m + EUR 5m) 80

Less: net fair value of identifiable assets, liabilities and contingent liabilities of the acquiree, including deferred tax liability (see SS 5 and 6)

87

Excess over cost (7)

Assuming a reassessment of the identifiable net assets and the cost of the business combination does not result in changes to these amounts, ADC would recognise the excess over cost as an immediate gain (formerly denominated “negative goodwill” or “badwill”).

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Use ExemptionApply IFRS 3

First-time application – Exemption for Past Business Combinations

Apply IFRS 3 from a point in time, use

exemption for earlier

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First-time application – Retrospective Application of IFRS 3

• A retrospective application of IFRS 3 will involve a consideration of the following:

– Classification of a business combination

– Measuring the cost of the business combination at the time the transaction took place

– Cost allocation: separately recognise the acquiree’s assets, liabilities and contingent liabilities

• More definitive approach to identifying and recognising intangible assets

• Contingent liabilities

– Non-amortisation of goodwill

– Excess over cost

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First-time application – Use Exemption under IFRS 1

• Using the exemption gives rise to consequential amendments that deal with the following:

– Classification of the past business combination– Recognition of assets and liabilities acquired in the past business

combination– Measurement of assets and liabilities acquired in the past

business combination

• Some of the adjustments impact opening retained earnings, whilst others impact goodwill

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First-time application – Other accounting issues

• Retrospective application of IFRS 3– Appropriate documentation to support restatements performed

by management– Necessary information to retrospectively apply IAS 36 (annual

goodwill impairment test) and IAS 38 (identification and separate recognition of intangible assets)

• Use exemption under IFRS 1– Goodwill impairment test at date of transition– Reclassification of intangibles as appropriate

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Summary – First-time Adoption

• 3 Courses of Action– Apply IFRS 3 retrospectively to all past business combinations;

or– Utilise the exemption within IFRS 1 for all past business

combinations; or – Apply IFRS 3 retrospectively to some past combinations and

utilise the exemption for others.

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Phase 2 – Business Combinations

• Exposure Draft of amendments to IFRS 3, IAS 27, and IAS 37 / IAS 19 were issued in June 2005

• Culmination of a joint project with FASB dealing with “application of the purchase method of accounting”

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Phase 2 – Key Proposals

• Expensing acquisition-related transaction costs• Recognising contingent consideration at their acquisition-

date fair values• Recognising the fair value of contingencies• Recognising full goodwill

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Phase 2 – Key Proposals (2)

• Recognising holding gains and losses in step acquisitions• Accounting for changes in ownership of a subsidiary

(without loosing control) as equity transactions

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