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!