IFRS 3, Business Combinations was issued in January 2008 as the second phase of a joint project with the Financial Accounting Standards Board (FASB), the US standards setter, and is designed to improve financial reporting and international convergence in this area. The standard has also led to minor changes in IAS 27, Consolidated and Separate Financial Statements. The requirements of the revised IFRS 3 have been examinable since December 2008. This article relates to the relevance of IFRS 3 to Paper F7, Financial Reporting.
This article is also of interest to candidates studying UK-based papers, as under UK regulation consolidated goodwill is calculated using the non-controlling interest’s (NCI) proportionate share of the subsidiary’s identifiable net assets (referred to as method (ii) below).
The revised IFRS 3 introduces:
- Restrictions on the expenses that can form part of the acquisition costs
- New principles for the treatment of contingent consideration
- A choice in the measurement of non-controlling interests (which have a knock-on effect to consolidated goodwill), considerable guidance on recognising and measuring the identifiable assets and liabilities of the acquired subsidiary, in particular the illustrative examples discuss several intangibles, such as market-related, customer-related, artistic-related and technology-related assets.
All acquisition costs, even those directly related to the acquisition such as professional fees (legal, accounting, valuation, etc), must be expensed. The costs of issuing debt or equity are to be accounted for under the rules of IAS 39, Financial Instruments: Recognition and Measurement.
IFRS 3 defines contingent consideration as: ‘Usually, an obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are met. However, contingent consideration also may give the acquirer the right to the return of previously transferred consideration if specified conditions are met’ (this would be an asset).
IFRS 3 requires the acquirer to recognise any contingent consideration as part of the consideration for the acquiree. It must be recognised at its fair value which is ‘the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction’. This ‘fair value’ approach is consistent with the way in which other forms of consideration are valued. Applying this definition to contingent consideration may not be easy as the definition is largely hypothetical; it is highly unlikely that the acquisition date liability for contingent consideration could be or would be settled by ‘willing parties in an arm’s length transaction’. An exam question would give the fair value of any contingent consideration or would specify how it is to be calculated. The payment of contingent consideration may be in the form of equity, a liability (issuing a debt instrument) or cash.
If there is a change to the fair value of contingent consideration due to additional information obtained after the acquisition date that affects the facts or circumstances as they existed at the acquisition date, it is treated as a ‘measurement period adjustment’ and the contingent liability (and goodwill) are remeasured. This is effectively a retrospective adjustment and is rather similar to an adjusting event under IAS 10, Events After the Reporting Period. Changes in the fair value of contingent consideration due to events after the acquisition date (for example, meeting an earnings target which triggers a higher payment than was provided for at acquisition) are treated as follows:
- Contingent consideration classified as equity shall not be remeasured, and its subsequent settlement shall be accounted for within equity (eg Cr share capital/share premium Dr retained earnings).
- Contingent consideration classified as an asset or a liability that:
– is a financial instrument and is within the scope of IAS 39 shall be measured at fair value, with any resulting gain or loss recognised either in the statement of profit or loss, or in other comprehensive income in accordance with that IFRS
– is not within the scope of IAS 39 shall be accounted for in accordance with IAS 37, Provisions, Contingent Liabilities and Contingent Assets, or other IFRSs as appropriate.
Note that although contingent consideration is usually a liability, it may be an asset if the acquirer has the right to a return of some of the consideration transferred if certain conditions are met.
Goodwill and non-controlling interests
The acquirer (parent) measures any non-controlling interest either:
- at fair value as determined by the directors of the acquiring company (often called the ‘full goodwill’ method); or
- at the non-controlling interest’s proportionate share of the acquiree’s (subsidiary’s) identifiable net assets (this is the UK method).
The differential effect of the two methods is that (i) recognises the whole of the goodwill attributable to an acquired subsidiary, whereas (ii) only recognises the parent’s share of the goodwill.
Parent pays $100m for 80% of Subsidiary which has net assets with a fair value of $75m. The directors of Parent have determined the fair value of the NCI at the date of acquisition was $25m.