Business combinations, share-based payments, and the accounting implications of a global pandemic or natural disaster
This article identifies the issues that candidates should take into account when deciding whether or not an investor has control over an investee. It also reflects upon how share-based payments should be accounted for when they are part of the purchase consideration for a subsidiary in a business combination. Finally, using a global pandemic as context, it provides guidance on the application of IFRS Accounting Standards to contemporary situations.
Revision of the basic principles of consolidation
When answering SBR exam questions that test control, candidates’ answers often lack focus.
Control is not simply a matter of owning more than 50% of the voting share capital of an entity. IFRS 10 Consolidated Financial Statements states that an investor controls an investee when the investor has all of the following:
i. Power over the investee
ii. Exposure, or rights, to variable returns from its involvement with the investee, and
iii. The ability to use its power over the investee to affect the amount of the investors returns.
The following table identifies factors that candidates should apply to SBR exam questions when assessing whether (or not) control exists.
Power over the investee
|Exposure or rights to variable returns
|The ability to use its power to affect returns
If, after applying the above to the SBR exam question scenario, the outcome of the assessment of control is still unclear, other evidence must be used, including:
- the ability to direct investee to act on investor’s behalf;
- whether key management personnel or the majority of governing body are related parties of investor; and
- whether any special relationships exist between investee and investor.
Joo Co and Cat Co hold 40% each of the voting rights of Door Co. The remaining 20% are held by Hag Co. A shareholders’ agreement states that the purpose of Door Co is to generate capital gains from buying and selling properties. All decisions concerning buying and selling properties, and their financing require the unanimous agreement of both Joo Co and Cat Co.
Joo Co is responsible for all management activities for which it receives payment and additionally has the final decision on appointments to the board of directors.
Required: discuss the factors that should be taken into account when assessing whether Joo Co or Cat Co has control over Door Co.
The major finance and management activities will both affect Door Co’s returns. Therefore, Joo Co and Cat Co should evaluate which set of activities has the greatest effect on returns.
Given the purpose of Door Co is to achieve capital gains, this may indicate capital investment activities have the most significant impact. If so, the conclusion would be that Joo Co and Cat Co have joint control because these activities are directed by joint decision-making. The deemed significant influence of Hag Co would not change this assessment of which entity has power over Door Co. If, however, management activities and key management personnel appointments are considered more significant, the conclusion would be that Joo Co has control of Door Co because it solely directs these relevant activities.
Different exam question scenarios will provide different amounts of information and sometimes it won’t be possible to discuss every issue identified in the table above. However, SBR candidates should discuss and apply more than just the 50% ownership criteria. This will increase the breadth and depth of their answers.
Share-based payment – replacement awards on acquisition
Another issue that SBR candidates appear to struggle with is the accounting treatment required when an entity includes a share-based payment as part of the consideration paid for a subsidiary in a business combination; for example, when the acquirer agrees to take over any existing share-based payment awards that have already been granted to the employees of the acquiree. Alternatively, the acquirer may change the terms of the share-based payment awards to provide an incentive for key employees to remain an employee of the acquired entity. Such transactions are included within the scope of IFRS 2 Share-based Payment.
These arrangements must be analysed to determine whether they represent compensation for services in the pre-acquisition period, the post-acquisition period, or both. Amounts attributable to the pre-acquisition period should be accounted for as part of the purchase consideration. Amounts attributable to the post-acquisition period should be recognised as an expense for that period. Amounts attributable to both the pre- and post-acquisition periods should be allocated to the purchase consideration and post-acquisition costs accordingly.
On 1 April 20X3, Natural Co granted equity share-based payment awards to its employees. These shares awards had a fair value of $20 million and were subject to the employees remaining in employment for the next 3 years.
On 1 April 20X5, Digital Co purchased all of the share capital of Natural Co for cash of $80 million. A condition of the acquisition is that Digital Co is required to issue replacement equity share awards to the employees of Natural Co that will vest on 31 March 20X6.
On 1 April 20X5, the fair value of Natural Co’s net assets was $90 million, the fair value of the original share award was $24 million and that of the replacement share awards was $28 million.
The financial year end is 31 March each year.
Required: calculate the impact of the share-based payment awards when accounting for the acquisition, including goodwill.
The amount of the replacement share award that is attributable to pre-acquisition services is determined by multiplying the fair value of the original award by the ratio of the vesting period completed at the date of the business combination to the greater of:
- The total vesting period, as determined at the date of the business combination, and
- The original vesting period.
The period before the date of acquisition is (a) 2 years [1 April 20X3 to 31 March 20X5].
The vesting period of the replacement awards is (b) 1 year (b) [1 April 20X5 to 31 March 20X6].
The original vesting period is © 3 years [1 April 20X3 to 31 March 20X6].
Therefore, the total vesting period at 1 April 20X5 is 3 years (a + b) which is the same as the original vesting period.
The pre-acquisition service amount is $24 million x 2 years/3 years = $16 million. This is accounted for as part of the purchase consideration (see below).
The post-acquisition service amount therefore is $12 million ($28m - $16m). This is accounted for as a cost for the year ended 31 March 20X6.
|Goodwill at 1 April 20X5
|Equity-share based awards
|Net assets of Natural Co (fair value)
|At 31 March 20X6 (vesting date)
|Remuneration cost (SOPL)
|Equity-share based awards (SOP - Equity)
The above approach is a sensible one which is also logical and clear to mark. Therefore, it is an approach that the SBR examining team recommends that you follow when answering similar such questions.
The accounting implications of a global pandemic or other natural disaster
A global pandemic undoubtedly has an impact on the financial reporting practices of many entities in different business contexts. Indeed, many entities, during a global pandemic, experience conditions that are often associated with a significant economic downturn. However, there is no particular IFRS Accounting Standard that is more relevant than any other.
The SBR examining team has often commented that candidates incorrectly think that only one IFRS Accounting Standard can be used to provide an answer to an exam question scenario. Such an approach is likely to produce a narrow response. The following table demonstrates the range of accounting implications arising from a global pandemic, as well as other situations, such as economic downturns.
|IFRS Accounting Standards
|Issues for discussion
|IAS 1 Presentation of Financial Statements
|Assessment of an entity’s ability to continue as a going concern at the dates the financial statements are approved.
Disclose uncertainties – significant judgements and sources of estimation/uncertainty need to be appropriately disclosed. This will also have impacts on the going concern assessments if judged material.
If going concern is an issue, financial statements may need to be prepared on net realisable basis/net settlement value.
|IAS 2 Inventories
|Inventory must be stated at the lower of cost or net realisable value (NRV); however, NRV calculation may be challenging (no market prices or no demand for products).
Entities may need to reassess their practices for fixed overhead cost allocation as production levels fall materially.
Inventory may be obsolete, especially if perishable.
|IAS 10 Events after the Reporting Period
The evaluation of pandemic information that becomes available after the end of the reporting period but before the date of authorisation of the financial statements.
|IAS 12 Income Taxes
|Recovery of deferred tax (DT) assets arising from accumulated tax losses and therefore assess probable future taxable profits or tax planning opportunities or whether sufficient DT liabilities which are expected to reverse.
Will entities have to restrict the DT Asset recognised?
Consequences of adjustments to the carrying amounts of assets and liabilities will have DT impact. Some examples will include the impact of impairment losses or decreases in the value of a pension surplus.
|IAS 19 Employee Benefits
|Adjustments/provisions for severance.
Falls in interest rates and plan asset portfolios may require significant adjustments requiring the services of actuaries to reflect changes in any defined benefit schemes.
|IAS 20 Accounting for Government Grants and Disclosure of Government Assistance
|Government assistance to help entities that are experiencing financial difficulty.
Reimbursement of employment costs is recognised in profit or loss. Disclosure of aid such as short-term debt facilities.
|IAS 23 Borrowing Costs
|Suspension of capitalisation of borrowing costs if a global pandemic has interrupted the acquisition, construction or production of a qualifying asset. Any borrowing costs incurred during such periods should be expensed through profit or loss.
|IAS 36 Impairment of Assets
|Assess whether the impact of a pandemic has potentially led to an asset impairment (tangible, intangibles and financial assets) – effectively the pandemic is a trigger event that indicates an impairment review is required.
Management may face significant challenges in preparing the budgets and forecasts necessary to estimate the recoverable amount of an asset (or CGU) because of decreased demand, business interruptions, cancelled orders and similar issues.
Difficulty assessing fair values when no active market or market participants
|IAS 37 Provisions, Contingent Liabilities and Contingent Assets
|Potential restructuring provisions and onerous contract provisions may need measured and recognised and insurance recoveries disclosed (need to assess certainty of these recoveries).
If material expenses or income for example restructuring and onerous contract provisions and impairment losses) should they be disclosed separately?
|IFRS 2 Share-based Payment
|Vesting conditions for share-based payments with performance conditions may not be met.
|IFRS 5 Non-current Assets Held for Sale and Discontinued Operations
|An asset (or a disposal group) no longer meets the conditions for ‘held for sale’ for example an entity may now face difficulties in identifying a buyer or in completing the sale within the 12-month period from classification.
Ceased operations that meet the definition of discontinued operations will require separate presentation and disclosure.
|IFRS 9 Financial Instruments
|Allowance for expected credit losses (ECL) - reductions in forecasts in economic growth increase the probability of default and entities will need to revisit the provision matrix approach for trade receivables.
Classification of financial assets – there may have been a change in the entity’s business model. An entity may decide or need to sell receivables classified as ‘held to collect’ which will therefore change classification.
Hedge accounting – a future transaction may no longer be highly probable and so hedge accounting might need to be discontinued.
Entities also need to consider other issues, such as interest rate changes, debt covenants, and modifications to payment terms.
|IFRS 13 Fair Value Measurement
|Companies need to look at the decisions, assumptions and inputs to fair value measurement as market-based measures are likely to change significantly and perhaps in unpredictable ways. If using level 2 or 3, inputs will require more extensive disclosure.
|IFRS 15 Revenue from Contracts with Customers
|Contract enforceability - may not be able to approve a contract under an entity’s normal business practices
Collectability – may be a significant deterioration of a customer’s ability to pay.
Contract modifications – entity may grant a price concession to a customer.
Variable considerations – an entity may need to reassess its estimated transaction price
Significant financing component – an entity may provide extended payment terms.
Revenue recognition - an entity may need to reconsider the timing of revenue recognition if it is unable to satisfy its performance obligations on a timely basis.
|IFRS 16 Leases
|Impairments to right-of use assets.
Economic stimulus measures have led to lower interest rates and changes to lease terms – lease liabilities may need remeasured.
Impairments of lease receivables for lessors.
|Other non‑IFRS issues
|Many central banks have cut their base rates – this will affect the measurement of many assets and liabilities
|Alternative performance measures
|Entities may need to provide new alternative performance measures (APMs) or adjust existing APMs – adequate/extensive disclosures will be required to ensure they do not mislead
The SBR examining team is not stating that discussion of all of these IFRS Accounting Standards would be required, or could be expected, to answer an SBR exam question. However, the table does demonstrate that the accounting implications of a global pandemic cover a wide range of IFRS Accounting Standards. SBR candidates should use the signposts and clues contained in the question scenario to identify which IFRS Accounting Standards are relevant.
This article should be used to stimulate thoughts about how these issues might impact on responses when practicing SBR exam questions. However, this article should not be interpreted as a signpost to the content of future SBR exam questions.
ACCA candidates should focus on wider reading including making use of the learning resources that ACCA have available such as technical articles and the examiner reports. By using these resources now, exam technique can be refined and improved.