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On 22 October 2018, the IASB issued narrow-scope amendments to IFRS 3,' Business combinations', to improve the definition of a business. The amendments will help companies determine whether an acquisition made is of a business or a group of assets. The amended definition emphasises that the output of a business is to provide goods and services to customers, whereas the previous definition focused on returns in the form of dividends, lower costs or other economic benefits to investors and others. In addition to amending the wording of the definition, the Board has provided supplementary guidance. Entities shall apply these amendments to business combinations for which the acquisition date is on or after the beginning of the first annual reporting periods beginning on or after 1 January 2020 and to asset acquisitions that occur on or after the beginning of that period. Early application is permitted. The IASB issued ‘Annual Improvements to IFRS Standards 2015 – 2017 Cycle’ in December 2017, where they clarified the measurement of previously held interest in obtaining control over a joint operation under IFRS 3.The amendment clarified that obtaining control of a business that is a joint operation is a business combination achieved in stages. The acquirer should remeasure its previously held interest in the joint operation at fair value at of the acquisition date. The amendment is effective for business combinations with acquisition date on or after the beginning of annual periods beginning on or after 1 January 2019. Earlier application is permitted.
Amendments to IFRS 3 – definition of a business
The amendments in definition of a Business clarifies that to be considered a business, an acquisition would have to include an input and a substantive process that together significantly contribute to the ability to create outputs. The new guidance provides a framework to evaluate when an input and a substantive process are present (including for early stage companies that have not generated outputs). To be a business without outputs, there will now need to be an organised workforce.
The definition of the term ‘outputs’ is narrowed to focus on goods and services provided to customers, generating investment income and other income, and it excludes returns in the form of lower costs and other economic benefits.
It is also no longer necessary to assess whether market participants are capable of replacing missing elements or integrating the acquired activities and assets.
An entity can apply a ‘concentration test’ that, if met, eliminates the need for further assessment. Under this optional test, where substantially all of the fair value of gross assets acquired is concentrated in a single asset (or a group of similar assets), the assets acquired would not represent a business.
The changes to the definition of a business will likely result in more acquisitions being accounted for as asset acquisitions across all industries, particularly real estate, pharmaceutical, and oil and gas. Application of the changes would also affect the accounting for disposal transactions.
IFRS 3 consideration contingent on providing employee services
Contingent consideration in a business combination needs to be assessed to determine if the amounts payable are consideration for the business or are payable for post-combination employee services.
Where consideration payable is automatically forfeited if the vendor ceases to provide employment services, the amount payable is treated as remuneration for post-combination employee services.
Payments that are for employee services are charged in the group’s post-combination income statement in accordance with IFRS 2 or IAS 19. Guidance on such arrangements is given in chapter 29 (para 29.194 onwards) of the IFRS Manual of Accounting.
A business combination is a transaction or event in which an entity – ('acquirer') obtains control of one or more businesses ('acquiree(s)'). Under IFRS 10, an investor controls an investee when the investor is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee. A number of factors may influence which entity has control, including: equity shareholding, control of the board and control agreements. There is a presumption of control if an entity owns more than 50% of the equity shareholding in another entity.
Business combinations occur in a variety of structures. IFRS 3, ‘Business combinations’, focuses on the substance of the transaction, rather than the legal form. The overall result of a series of transactions is considered if there are a number of transactions among the parties involved. For example, any transaction contingent on the completion of another transaction may be considered linked. Judgement is required to determine when transactions should be linked.
All business combinations, within IFRS 3’s scope, are accounted for using the acquisition method. The acquisition method views a business combination from the perspective of the acquirer and can be summarised in the following steps:
- Identify the acquirer.
- Determine the acquisition date.
- Recognise and measure the identifiable assets acquired, liabilities assumed and any non-controlling interest in the acquiree.
- Recognise and measure the consideration transferred for the acquiree.
- Recognise and measure goodwill or a gain from a bargain purchase.
The acquiree's identifiable assets (including intangible assets not previously recognised), liabilities and contingent liabilities are generally recognised at their fair value. Fair value is measured in accordance with IFRS 13. If the acquisition is for less than 100% of the acquiree, there is a non-controlling interest. The non-controlling interest represents the equity in a subsidiary that is not attributable, directly or indirectly to the parent. The acquirer can elect to measure the non-controlling interest at its fair value or at its proportionate share of the identifiable net assets on an acquisition by acquisition basis.
The consideration for the combination includes cash and cash equivalents, the fair value of any non-cash consideration given and liabilities assumed. Any equity instruments issued as part of the consideration are fair valued at the acquisition date. If any of the consideration is deferred, it is discounted to reflect its present value at the acquisition date, if the effect of discounting is material. Consideration includes only those amounts paid to the seller in exchange for control of the entity. Consideration excludes amounts paid to settle pre-existing relationships, payments that are contingent on future employee services and acquisition-related costs.
A portion of the consideration may be contingent on the outcome of future events or the acquired entity's performance ('contingent consideration'). Contingent consideration is also recognised at its fair value at the date of acquisition. The accounting for contingent consideration after the date of acquisition depends on whether it is classified as a liability (re-measured to fair value each reporting period through profit and loss) or as equity (no subsequent remeasurement). The classification as either a liability or equity is determined with reference to the guidance in IAS 32, 'Financial instruments: Presentation'.
Goodwill is recognised for the future economic benefits arising from assets acquired that are not individually identified and separately recognised. Goodwill is the difference between the consideration transferred, the amount of any non-controlling interest in the acquiree and the acquisition-date fair value of any previous equity interest in the acquiree over the fair value of the identifiable net assets acquired. If the non-controlling interest is measured at its fair value, goodwill includes amounts attributable to the non-controlling interest. If the non-controlling interest is measured at its proportionate share of identifiable net assets, goodwill includes only amounts attributable to the controlling interest – that is the parent.
Goodwill is recognised as an asset and tested annually for impairment, or more frequently if there is an indication of impairment.
In rare situations – for example, a bargain purchase as a result of a distressed sale – it is possible that no goodwill will result from the transaction. Rather, a gain will be recognised.
Business combinations excluded from IFRS 3’s scope, for example those involving businesses under common control, have a policy choice of either using the acquisition accounting method outlined in IFRS 3 or using predecessor accounting.