IFRS 3 - Business Combinations Archives

In summary

IASB issued a discussion paper on potential changes to the accounting for goodwill
Preliminary view of the Board is to NOT re-introduce the amortization model
Instead it proposes to end mandatory annual impairment testing and simplify the impairment model
Further disclosure requirements are proposed to track performance of an acquired company after acquisition date
The comment period for the discussion paper ended on 31 December 2020. The discussion paper feedback is expected in March 2021

Following feedback received in a post-implementation review on IFRS 3 ‘Business Combinations’, IASB is exploring whether companies can, at a reasonable cost, provide investors with more useful information about the acquisitions those companies make.

To that extend, the Board has issued a discussion paper on which stakeholders can provide their input. The main focus in that paper is on improving disclosures around acquisitions in financial reporting and on the current methodology of goodwill accounting.

In this article we will look at the most important feedback from that post-implementation review and proposals from the IASB in response to this feedback, in its discussion paper.

Feedback from the post-implementation review

Based on feedback received from investors, preparers, auditors and regulators, the IASB concluded that there were broadly two high-priority focus areas in the implemented standard on business combinations that needed further investigation:

1. The effectiveness and complexity of testing goodwill for impairment

As could be expected, many preparers of financial statements think that the goodwill impairment test is complex, time-consuming and expensive. They also believe that there is too much judgement involved, especially in determining value in use (VIU) and allocating goodwill to the cash-generating units (CGU’s).

The clarity that is provided to investors by applying the impairment methodology does not justify its complexity and cost, in the view of these respondents.

2. Subsequent accounting for goodwill

Does the current practice of testing goodwill for impairment suffice, or should we move to amortizing goodwill in combination with indication-based impairment testing?

Some investors think that keeping the original goodwill amount intact is useful for relating the price paid to what was acquired and for calculating the return on invested capital. The absence of impairment charges is considered to be a good indication of the success of an acquisition.

Others believe that goodwill that arises with an acquisition is replaced by internally generated goodwill over time. These respondents support a change to amortization of (externally generated) goodwill, as further discussed below.

On a closely related topic, some feedback indicated that current disclosure requirements in IFRS 3 do not suffice to properly track the performance of an acquired company in the post-acquisition period.

Proposals from the Board

To address the points made regarding effectiveness and complexity of goodwill impairment testing, the Board’s preliminary conclusions are the following:

It cannot design a different impairment test for cash-generating units containing goodwill that is significantly more effective than the impairment test in IAS 36 at recognizing impairment losses on goodwill on a timely basis and at a reasonable cost.
Instead, it should develop proposals intended to reduce the cost and complexity of performing the impairment test by providing relief from the obligatory annual quantitative impairment test if there is no indication that an impairment may have occurred.
The Board will make proposals that should simplify the calculation of Value in Use, in case an impairment test is to be performed.

On the topic of goodwill accounting subsequent to an acquisition, the main conclusion of the Board is that it should not re-introduce the amortization of goodwill. We will take a closer look at the Board’s considerations in the next paragraph.

In order to improve the tracking of post-acquisition performance, the Board is proposing to enhance the disclosure objectives and requirements in IFRS 3 to improve the information provided to investors about an acquisition and its subsequent performance. The main proposals includes adding disclosures around:

*Disclosing the performance of acquisitions in the Annual Report*

The strategic rationale for undertaking an acquisition and the objectives that management had for the acquisition at the acquisition date.
The subsequent performance of an acquisition that is based on the internal information and metrics the company’s management uses to monitor and measure the acquisition’s progress against the objectives of the acquisition.

Goodwill accounting: impairment or amortization

One of the more persistent discussions in the accounting world is that of amortization – or not – of goodwill that arises on acquisitions. Under Dutch GAAP for example, such goodwill is still being amortized whereas companies reporting under IFRS or US GAAP are testing goodwill for impairment annually, without amortization.

As said above, supporters of amortization claim that goodwill generated in a business combination is gradually being replaced by internally generated goodwill. Some claim that by not amortizing goodwill, it gets overstated which makes it difficult to assess management’s performance.

Besides these conceptual arguments, there are other, more practical considerations. The most important one is that impairment testing does not meet the objectives from the Board, as impairment charges are recognized too late, impairment testing does not provide enough meaningful information to investors and is costly and complex to execute.

Those who favor the impairment model over amortizing often argue that amortization periods often are arbitrary and that an amortization charge in the income statement therefore is meaningless. Some claim that goodwill is not even a wasting asset with a finite useful life so should not be amortized. The information that is provided in the impairment testing method can be meaningful, at least more so than an arbitrary amortization charge, according this group of stakeholders.

The IASB is of the view that it can’t change a methodology every few years and only if the foreseen benefits would outweigh the related cost and disruption. Having said that, Board members can be found in both the amortization- and in the impairment camp. Only a narrow majority led to the Board’s preliminary view to maintain the impairment model as the subsequent accounting method for goodwill.

Next steps

After a lengthy post-implementation process that started in early 2015, the IASB issued a Discussion Paper in March 2020. The response period to this DP, stretched further due to COVID-19, ended by 31 December 2020.

The Board will share respondent’s feedback by end of March 2021. Based on this feedback, the Board will decide whether and how to develop detailed proposals in the next stage of the project.

It will be hard to find common ground between supporters of amortization and those that favor impairment testing. The IASB will try to avoid divergence from USGAAP on such an important topic and it is the Board’s objective not change its methodologies every other year in the first place.

Therefore, I would be surprised if the Board changes its preliminary view stated in the Discussion Paper with regards to the goodwill accounting methodology. However, there may be some changes to the additional disclosure requirements as a result of respondents’ push-back.

When companies acquire other companies in third-party transactions, the accounting is usually defined by IFRS 3 “Business Combinations”. However, when a company is acquired by another company within the same group, IFRS 3 does not apply. This situation may arise in a group restructuring or in anticipation of selling an entity or business, and is referred to as a “Business Combination under Common Control” (“BCUCC”).

Currently there is no guidance for BCUCC accounting in IFRS, and an acquiring entity needs to make its own policy choice for the accounting methodology to apply for the acquisition. In practice, that choice is between acquisition accounting according to IFRS 3, or some form of predecessor accounting. That situation does not do very well for the comparison of financial information by investors.

The IASB prioritized the topic on its agenda some time ago and started a research project. We will take a closer look at how the current situation is impacting financial reporting of companies, and at the status of IASB’s research project.

Business Combinations Under Common Control

Business combination accounting under IFRS 3 is applied for transactions or other events in which an acquirer obtains control of one or more businesses. Transactions sometimes referred to as ‘true mergers’ or ‘mergers of equals’ are also business combinations. As said, IFRS exempts business combinations between companies or businesses that are held by the same party. IFRS 3 defines a Business Combination Under Common Control (“BCUCC”) as

“A business combination in which all of the combining businesses are ultimately controlled by the same party or parties both before and after the business combination, and that control is not transitory”
IFRS 3 – Application Guidance Appendix B – paragraph B1

This definition gave rise to a number of questions from securities markets regulators and reporting entities around the concept of “transitory” control and the application of the BCUCC exemption for group restructuring projects.

Important questions, as the answer is driving the accounting for the transaction!

The BCUCC exemption

What happens when a business combination falls outside the scope of IFRS 3 due to the BCUCC exemption? As said, there is no direct guidance in IFRS Standards for that today. Basically, acquiring entities need to define their own (consistently applied) accounting policy and have a choice to either:

1) Apply the acquisition accounting rules of IFRS 3: recognize the assets and liabilities of the acquired company at fair value, and record the difference between purchase price and net assets acquired as goodwill.

2) Use a form of predecessor accounting: recognize assets and liabilities acquired at the carrying values reported by the acquired company. Any difference between purchase price and net assets acquired goes directly to equity, in a dedicated reserve.

The IASB is looking to provide further guidance on the accounting- and disclosure requirements to be applied when companies face a BCUCC exemption in the future. As part of that project, a Discussion Paper will be issued in H2-2020 to get the feedback from stakeholders. Ultimately, that should lead to a new Standard, or an update of IFRS 3.

Group restructuring

Group restructuring usually involves the transfer of entities or businesses between existing or newly created entities under common control. In current IFRS 3 a restructuring can be either a regular business combination under IFRS 3, or a BCUCC. The following examples were used in an IFRS webinar in February 2018, to demonstrate the dilemma:

In the first example, entity A is acquiring entity C from entity B. Both A and C are operational businesses and the transaction would qualify as a business combination in the scope of IFRS 3. However, because A and B are controlled by the same parent company P, the BCUCC exemption applies and the transaction is out of the IFRS 3 scope.

In the second example, a Newco is incorporated by parent company P, to purchase the shares in entity C from entity B.

As Newco has no business activities, this transaction does not qualify as a business combination in the scope of current IFRS 3 and hence it is not a BCUCC.

As in substance these two situations are comparable, the IASB tentatively decided that “the scope of its project includes transactions under common control in which a reporting entity obtains control of one or more businesses, regardless of whether IFRS 3 would identify the reporting entity as the acquirer, if IFRS 3 were applied to the transaction (eg when a Newco issues shares to acquire one business under common control).”

Transitory control

Companies could structure a third-party acquisition in a way that leads to common control immediately prior to the acquisition to benefit from the BCUCC exemption. To avoid that situation, the BCUCC exemption includes the notion of “transitory” common control (we will discuss “control” in more detail some other time). This concept relates to the period of common control before (and after) the transaction.

Common control is not transitory when the combining entities have been under common control for a longer period prior to the combination.

The concept of transitory control led to application questions from stakeholders, which have been clarified by the IASB. The following examples were discussed in the Feburary 2018 IASB webinar.

The first situation concerns parent company P that is preparing to sell its fully controlled subsidiaries A and B through an Initial Public Offering (IPO). To do so, P incorporates a Newco and transfers the shares in entity A and B to it.

Is P’s control over Newco transitory? Some would say it is, since this control is lost following the IPO. Others would argue that the substance of the transaction is the IPO, which should not lead to applying IFRS 3 on the earlier combination.

And what if the transfer of A and B to Newco was conditional of a successful IPO? Here one could argue that the IPO effectively precedes the business combination of A and B in Newco, hence the business combination is not under common control and IFRS 3 applies.

IASB clarified that parent company P’s control over the combined entities is NOT transitory. From Newco’s perspective the BCUCC exemption applies and the transaction is not in the scope of IFRS 3.

In another scenario, entity B is acquired by parent company P in a third-party transaction, followed by a transfer of entity B to entity A. Entities A and B are subsequently sold in an IPO.

In IASB’s view, P’s control over the combined entities is not transitory, regardless of the fact that B had been purchased in an external acquisition before the combination, and that A and B are subsequently sold in an external sale.

IASB clarified that parent company P’s control over the combined entities is NOT transitory. From entity A’s perspective the BCUCC exemption applies and the transaction is not in the scope of IFRS 3.

Where it all leads to

At this point in IASB’s BCUCC project, the Board has clarified the scope of when a business combination should be considered ‘under common control’. That is important, because it is driving the way an acquiring company should account for the combination in its consolidated accounts.

In the final phase of the project, IASB will be gathering the input from stakeholders and prepare further guidance on when to apply what accounting methodology in a BCUCC situation. The Board already tentatively decided that there will be not one single remaining methodology. The Board will likely prescribe acquisition accounting (according to IFRS 3) on business combinations where the acquiring entity has non-controlling interests. In all other BCUCC, predecessor accounting will likely be mandatory. IASB will come up with a more precise predecessor methodology description in the final guidance.

For a deeper insight in the Board’s considerations, check out this “In Brief” article.

The Discussion Paper was issued in November 2020 and solicits feedback from regulators, investors, reporting entities and other stakeholders. Due to covid-19, the Board has extended the comment period from 180 to 270 days. That takes implementation well into 2021 but should lead to a balanced and agreed-upon piece of accounting guidance to fix the existing hole in IFRS 3!

Goodwill accounting reconsidered