IFRS 3 – Business Combination

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Introduction

The purpose of this standard is to provide guidelines with regards to the accounting for circumstances in which an entity provides information in its financial statements that reflects the result and outcomes of a business combination that took place during the reporting period of that entity. The standard also provides guidance on how to recognize and measure the assets acquired and liabilities assumed, the determination of goodwill and disclosures relating to the business combination.

Scope

The standard is applicable to all those transactions that fulfill the criteria laid out in the definition of business combination mentioned in IFRS 3. However, the standard cannot be applied with regards to the following:

• The arrangement in which two or more parties have joint control and therefore are classified and categorized as a joint arrangement in accordance with the guidelines provided by IFRS1.
• The acquisitions by investment entity that will be classified and accounted for as per the requirements of IFRS 10 and will be measured at fair value through the statement of profit or loss.
• The combination of businesses and entities that are being operated under the umbrella of common control even after the occurrence of the business combination.
• The transaction which involves an entity acquiring an asset or a combination of assets that does not constitute a business.

Identifying a Business Combination

A transaction will be classified as a business combination if it meets the following criteria:
• The asset or entity being acquired must meet the criteria laid out in the definition of ‘business’ mentioned in IFRS 3
• The outcome of the transaction causes one entity to the transaction to have control over the other entity involved in the transaction.

Business

In order for a transaction to be classified as a business combination, the acquiree to the transaction must constitute a business. If an acquiree to a transaction fails to meet the criteria mentioned in the definition of business then in that scenario the transaction will be classified as an asset acquisition and in such a situation amount paid as consideration for the asset will be considered as the cost of the asset and therefore no goodwill will be calculated with regards to the asset acquired. The definition of the term business as per IFRS 3 is as follows:

– A Business is a practice that is based upon a set of interrelated activities and generally has three elements at the core of it:

Inputs can be defined as resources (e.g. labor, material) on which the entity applies process or set of processes so that all the activity results in output being produced
Process can be defined as a procedure, standard, method or technique that when applied to an input results in output being produced
Output can be defined as the final outcome of the processor processes that are applied to an input or inputs.

Acquisition Method

As per IFRS 3, an entity is required to account for a transaction involving the acquisition of one entity by another entity through the use of the acquisition method. The following steps should be applied when using this method:

• Identifying the Acquirer
• Determining the Date of Acquisition
• Recognizing and measuring the assets, liabilities and non-controlling interest (NCI) of the acquiree
• Recognizing and measuring goodwill or gain associated with a bargain purchase
• Recognizing and measuring the consideration transferred with regards to the acquiree.

Determining the Acquirer

The guidance provided by IFRS 10 should first be used to identify the acquiring entity, in other words, the entity that controls the acquiree. If a situation occurs in which the guideline provided by IFRS10 does not helps in giving a clear indication as to which party to the transaction is the acquiring entity then in that scenario the guidelines mentioned in IFRS 3 can be used in determining the acquiring entity. The guidelines with regards to the identifying the acquiring entity are as follows:

• In a transaction involving acquisition of an entity or merger between two or more than two entities, the acquiring entity is usually the one that transfers cash or other assets given that the transaction mainly gets effected in this manner.
• In most cases, but not in all, acquiring entity is the one that issues its equity instruments in a transaction which is effected by the issuance of an entity’s equity interests.

A business combination transaction which mainly gets effected as a result of an exchange of equity interests then in that scenario the following factors should be taken in to consideration when determining the acquiring entity:

• The acquiring entity is the one which has comparatively more voting rights in the combined business entity
• The acquiring entity is the one that has control and also dominates decisions with regards to the composition of the board, committees and appointment of top level management of the combined business entity.
• The acquiring entity is the entity which owns and controls the largest minority holding in the investee given that no other party has significant voting rights
• The terms of transaction also plays a role in determining the acquiring entity as it will be the one that pays over and above the fair value of the net assets of the acquired entity
• The acquiring entity is usually the one that is comparatively larger in size than the other entity involved in a business combination.

Date of Acquisition

The acquisition date in a business combination is normally the closing date at which the acquiring entity transfers consideration, as a result, the acquiring entity obtains control of the assets and assumes liabilities of the acquiree. In some circumstances the acquiring entity may obtain control over another before or after the closing date.

Recognition of Assets acquired and Liabilities assumed at the date of acquisition in the Acquiree

As per IFRS 3, the acquiring entity is required to recognize the assets acquired and liabilities assumed of an acquiree and also the NCI in an acquiree separately from the goodwill acquired as part of the business combination transaction. The assets and liabilities of the entity that are being acquired will be recognized only if following conditions are fulfilled:

a) The assets and liabilities of the entity being acquired must fulfill the criteria laid out by the definition of an asset and liability mentioned in the IFRS framework for the preparation and presentation of financial statements.

b) The assets acquired and liabilities assumed must be a direct result of the business combination. In other words they must be a part of the arrangement between the acquiring entity and the acquiree in relation to the execution of the business combination transaction and must not result due to a separate transaction between the acquiring entity and the acquired entity.

Any Asset or Liability that arises due to a result of a separate transaction between the acquiring entity and the acquired entity will be treated in the books of accounts of the acquiring entity in the period after the acquisition of the acquired entity.

In some situations the acquiring entity is allowed to recognize an asset or a liability related with the acquired entity, which that entity itself does not recognizes in its financial statements. All this is still subject to the recognition conditions mentioned above. The example of this can be the recognition of the intangible assets of the acquiree by the acquiring entity in its financial statements only if the above mentioned conditions are fulfilled.

Classifying or Designating the Assets and Liabilities that are transferred in a business combination

As per IFRS 3 the acquiring entity, at the date of acquisition, is required to classify or designate any asset or liability of the entity being acquired by it. The acquiring entity should make such classifications on the basis of the conditions, facts and circumstances that exist at the date of acquisition. Some of the conditions that may exist at the time of the acquisition are as follows:

a) Classification of a particular financial asset or liability of the acquiree as measured at fair value or at amortized cost

b) Designation of a derivative instrument as a hedging instrument as per the guidelines given by IFRS 9

As per IFRS 3, the classification of the following is not allowed:
• Classifications of lease contracts in which the entity being acquired is the lessor in either the finance lease or in the operating lease as per IFRS 16
• Classification of a contract as an insurance contract in as per the requirements provided in IFRS 4

Contingent Liability

If the entity being acquired has a contingent liability at the date of its acquisition then as per IFRS 3 the acquiring entity will be required to recognize that contingent liability at fair value. The provision and rules of IAS 37 are not applicable on a contingent liability arising as part of the business combination.

Measurement of Assets and Liabilities of Acquiree at the date of Acquisition

As per IFRS 3, the acquiring entity is required to measure the assets and liabilities of the acquiree at their fair value at the date at which acquisition took place.

Exception to Measurement Principle

a) Re-acquired Right

The acquiring entity is required to recognize any re-acquired right which the acquiree has ownership and control off as part of the business combination transaction. IFRS 3 also requires the acquiring entity to recognize the re-acquired right at fair value at the date at which acquisition took place. The fair value for the re-acquired right is determined with reference to the remaining contractual life of the right ignoring any potential renewal of the re-acquired right.

b) Asset held for Sale

The acquiring entity is required to measure a non-current asset or disposal group that has been classified as held for sale by the acquiree at fair value less costs to sell in accordance with the guidance provided by IFRS 5.

c) Share Based Payment

The acquiring entity is required to measure an equity instrument or liability associated with the share-based payment transactions of the acquiree as per the requirements of IFRS 2. The replacement of the share based payment transactions of the acquiree with the share based payment transactions of the acquiring entity will also be dealt in accordance with the guidance provided by IFRS 2.

Exception to Recognition and Measurement Both

a) Income Taxes

The acquiring entity is required to recognize and measure a deferred tax asset or liability resulting due to the assets and liabilities of the acquiree, which are now controlled by the acquiring entity, in accordance with the guidance provided by IAS 12.

b) Employee Benefits

The acquiring entity should recognize and also measure an employee benefit asset or liability associated with the acquired entity, at the date of acquisition, in accordance with the requirements of IAS 19.

c) Indemnification Assets

If the seller to a business combination transaction guarantees the acquiring entity with regards to any of its loss, provision for a liability or a liability not going above a certain specified limit, then in such a scenario the acquiring entity will recognize and measure such a guarantee or indemnification as an asset at the date of acquisition on the same basis on which the related indemnified item was recognized and measured in the financial statements of the acquired entity.

c) Leases in which the acquire is the lessee

The acquiring entity should recognize the right-of-use assets and lease liabilities with regards to leases that are identified in accordance with the guidance provided by IFRS 16, subject to a condition that the acquired is the lessee. The acquiring entity is not required to recognize right-of-use assets and lease liabilities for the following:

• Leases for which the lease term ends within 12 months of the acquisition date; or
• Leases for which the underlying asset is of low value.

The acquiring entity should measure the lease liability at the present value with reference to the remaining lease payments (as defined by IFRS 16) as if the acquired lease was a new lease at the time of acquisition. The acquiring entity should measure the right-of-use assets at the same amount at which the lease liability is measured.

Measurement of Non-controlling Interest

The Non-controlling interest (NCI) can be defined as the interest in acquiree which has been held by the party other than the acquiring entity. IFRS 3 allows the NCI to be measured in the following two ways:

• Measure the NCI at fair value at the date at which the acquisition took place; or
• Measure the NCI at its proportionate share in identifiable net assets of the entity acquired by the acquiring entity.

Valuation of Goodwill or Bargain Purchase Gain

Goodwill can be defined as the difference between the consideration transferred by the acquiring entity to the acquired entity, the amount of any NCI in the acquired entity and the fair value, at the date of acquisition, of any previous equity interest in that same entity over the fair value of the identifiable net assets of the acquired entity. If the NCI is measured at fair value then in that case the goodwill arising as a result of acquisition includes amounts that are attributable to the NCI of the acquired entity If the NCI is measured at its proportionate share of identifiable net assets then in that scenario the goodwill only includes amounts that are attributable to the controlling interest of the entity that is acquired by the acquiring entity.

Goodwill is recognized as an asset and tested annually for impairment, or more frequently if there is an indication of impairment.

In some rare situations, for example, in case of a bargain purchase no goodwill will arise as a result of the transaction instead a gain will be recognized in profit or loss by the acquiring entity at the date of acquisition. A bargain purchase takes place when the aggregate of the consideration transferred by the acquiring entity, the amount of NCI and the fair value of any previous equity interest in the acquiree held by the acquiring entity is less than the fair value of the identifiable net assets of the acquiree that are acquired by the acquiring entity.

Subsequent Accounting or Measurement

Generally the acquiring entity should subsequently measure and account for the assets, liabilities and equity instruments of the acquired entityin accordance with the requirements of the relevant applicable standards in relation to such items. Although, the standard gives guidance with regards to the subsequent measurement of the following:

• Re-acquired rights should subsequently be amortized on the basis of the remaining contractual term of the contract in which such rights were granted at the first place
• The contingent liability should subsequently be measured at the higher off; (a) the amount that will be recognized in accordance with IAS 37 and (b) the cumulative amount of income that will be recognized in accordance with IFRS 15
• The indemnification asset should subsequently be measured on the same basis as the indemnified liability or asset, subject to any contractual restraint and collectability assessment of such an asset. The indemnification asset will be if the asset gets collected, sold or right to the asset gets lost.

Consideration Transferred

The acquiring entity will be required to measure the consideration transferred to the owners of the acquired entity in a business combination at its fair value at the date of acquisition. The consideration transferred by the acquirer to the acquiree could be in the form of cash and cash equivalents, equity instruments, debt instruments or other assets.

• If the consideration transferred by the acquiring entity as part of the combination transaction is being carried out at an amount other than its fair value then in that scenario the consideration should be recognized at its fair value at the date of acquisition and any gain or loss arising as a result will be recognized in the profit or loss.
• In some situations the transferred consideration becomes part of the combined entity and in such a scenario the assets or liabilities transferred as part of the consideration will be measured by the acquiring entity at its carrying value and therefore the no gain or loss will be recognized by the acquiring entity in the profit or loss statement.

Contingent Consideration

A part of the transferred consideration may be contingent depending on the outcome of some of the future events or the performance of the entity acquired as part of the business combination transaction. Contingent Consideration is also recognized at the fair value at the date of acquisition. The subsequent measurement with regards to the contingent consideration depends on whether it is classified as equity (no subsequent measurement required) or as a liability (consideration will subsequently be measured at fair value at each reporting period through profit or loss statement). The contingent consideration will be classified either as equity or liability, in accordance with the guidance provided by IAS 32.

Business Combination Charges or Expenses

The charges or expenses associated with the execution of a business combination transaction such as consultation fee, valuation fee, legal and professional charges should be recognized in the acquiring entity’s profit or loss statement. Although, the cost associated with the issuance of any equity or debt instrument will be recognized and treated in accordance with the requirements of IFRS9.

Execution of a Business Combination transaction in Stages

In some situations the acquiring entity obtains control of the acquiree in which it already held equity interest. In such circumstances the acquisition takes place in stages, for example, an entity holds 22% interest in another entity and a year later the acquiring entity purchases further 50% interest in the same entity which results in the acquirer finally gaining control over the other entity.

• In case of a combination transaction achieved in stages, the acquiring entity is required by IFRS 3 to re-measure its previously held equity interest in the acquired entity at fair value at the date of acquisition and also to recognize the gain or loss arising as a result of it in profit or loss.
• If any gain or loss with regards to the fair value of the equity interest, which the acquiring entity previously held in the acquired entity, has been recognized in other comprehensive income in prior accounting periods, the amount recognized in other comprehensive income can be transferred to retained earnings.

Measurement Period

As per the requirements of IFRS 3, the acquiring entity gets provided with the time period of one year after the acquisition date so that to complete all the aspects of accounting with regards to the business combination transaction. This time period provided to the acquiring entity is referred to as the measurement period. The purpose of the time period provided to the acquiring entity is to allow the entity to have enough time for identifying, recognizing and measuring the following:

a) Any asset or liability of the acquired entity
b) The fair value of the equity interest that was held by the acquiring entity in the acquired entity before the acquisition took place
c) Valuation of the NCI
d) Goodwill or gain on a bargain purchase arising as part of a business combination transaction

If a situation occurs in which the reporting date of the acquiring entity falls within the measurement period and the accounting with regards to the business combination has not yet been completed then in that scenario the acquiring entity is required to use provisional amounts for the purpose of consolidation but this should be disclosed in the notes to the accounts.

The adjustments to the provisional values can be made if the acquiring entity gets hold off information within the measurement period which clearly indicates towards the existence of certain circumstances and facts at the date at which the acquisition took place. In such a situation, the values can retrospectively be adjusted by the acquiring entity to the acquisition date and the entity can also treat these changes as measurement period adjustments that reflects the impact of the new information that was obtained as per certain circumstances and facts that existed at the date of acquisition. Adjustments like these will also impact the value of the goodwill.

In a situation where information that becomes available after the measurement period, then in such a scenario the adjustments with reference to the acquisition date will be classified and treated as adjustments to correct errors as per IAS 8.

Disclosures

IFRS 3 requires the acquiring entity to give disclosures regarding the following:

• The details regarding the acquired entity
• The date at which the acquisition took place
• All the details relating to any contingent liability that has been recognized by the acquiring entity
• Details with regards to the measurement of NCI
• Details about the assets acquired and liabilities assumed as part of the acquisition of the acquired entity
• Details with regards to the contingent consideration
• Any Business combination transaction that took place during the course of the acquiring entity’s accounting period
• A combination transaction that took place after the reporting date but before the date at which the financial statements were authorized to be issued by the acquiring entity
• The information relating to the adjustments that have been recognized in the current period with regards to the business combination transaction.

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