Under IFRS 3, a business combination must be accounted for using a technique called the “acquisition method”. This views the transaction from the perspective of the acquirer and involves the following stages:
- Identify acquirer
- Determine acquisition date
- Recognise and measure
Assets, liabilities and NCI in acquiree
at FV at the acquisition date - Goodwill/Bargain purchase
Difference between consideration paid and net assets acquired
Let’s look at the steps involved.
1. Identify the Acquirer
The first step in the acquisition method is to identify the acquirer. So how do we do this?
The acquirer is the entity that obtains control of the other entity or business. The concept of control is dealt with under IFRS 10 Consolidated Financial Statements. In essence, control is where an investor is exposed, or has rights, to variable returns from its involvement in the investee and has the ability to effect those returns through its power over the investee.
An investor controls an investee, when all of the following are in place:
- Power over an investee
- Exposure or rights, to variable returns from its involvement with the investee, and
- The ability to use its power over the investee to affect the amount of the investors returns
Deciding who is the acquirer depends on judgement, and it can be useful to look out for these indicators when deciding the acquirer:
- The entity transferring cash or assets
- The entity that issues equity interests
- The entity that is usually larger (though not always), and the relative size of the combining units
- Voting rights in the combined entity after the combination (acquirer usually receives more voting rights)
- The board of directors and senior management of the new combined entity (acquirer usually controls the board)
New entities
If a new entity issues shares to effect a business combination, the new entity itself may not be the purchaser, instead the purchaser is identified using the control indicators we’ve just looked at.
However, if the new entity issues cash or other assets and incurs liabilities as consideration, then it may be the purchaser of the new entity.
So look to the substance of the transaction, if the new entity was formed by another entity to be a vehicle for a business combination, the other entity itself may be the purchaser.
Reverse acquisitions
A reverse acquisition is unusual in the sense that the entity being acquired is actually the acquiree. Why would this take place? Well, say if a company is listed on a stock exchange with no assets, another company might save itself listing fees by reverse acquiring the listed company. The result of this is that the listed company issues shares to the shareholders of the unlisted company, so the shareholders of the acquiree end up controlling the acquirer. In this case, the purchaser is actually the company that has been acquired.
Although legally the listed company is the parent and the private company is the subsidiary, the subsidiary is the acquirer if it has the power to govern the financial and operating policies of the parent to obtain benefits from its activities.
2. Determine the acquisition date
The next step in the acquisition method is to determine the acquisition date. This is the date the acquirer, the purchaser, obtains control of the acquiree.
If the acquisition was written down, say in contract form, the acquisition date would normally be the closing date, when the purchaser takes legal possession of the assets and assumes the liabilities of the acquiree. Watch out though, as the acquisition date could be earlier than this, say if the acquirer is allowed to take possession of the acquiree early, by some agreement between the parties.
The reason we have to ascertain the acquisition date is because it’s used when determining the fair value of things like consideration paid, assets acquired, liabilities assumed and any non-controlling interest. The acquisition date is also very important when considering pre and post-acquisition dividends, as their treatment differs.
3. Recognise and measure assets, liabilities and NCI in acquiree
Now we must recognise and measure the assets, liabilities and any non-controlling interest in the acquiree.
At the date of acquisition, the acquirer must recognise the identifiable assets acquired, the liabilities assumed and any non-controlling interests in the acquiree.
Keep in mind the other accounting standards when assessing these. For instance:
Intangible assets:
Only recognise an acquiree’s intangible assets if they are separately identifiable and can be measured reliably. Once recognised they should be accounted for as intangible assets under IAS 38 and subject to the same conditions for the recognition and measurement of other intangible assets, for instance, impairment testing and amortisation.
Intangible assets acquired do not include purchased goodwill, which is the difference between the acquisition price and the fair value of all the identifiable net assets of the acquiree, including any intangible assets.
Expected future costs:
Expected future costs cannot be included in the calculation of assets acquired or liabilities assumed. Although the acquirer expects to incur these costs, it is not obliged to incur them in the future, so it should be excluded from the calculation of assets and liabilities assumed under the acquisition method. They’re not liabilities at the acquisition date, and future expected costs relating to any restructuring of an acquiree are not typically included.
Contingent liabilities:
Contingent liabilities that meet the definition of a contingent liability under IAS 37 are recognised by the acquirer in a business combination. If the fair value of the contingent liability can be determined and there is a present obligation, it should be recognised regardless of the probability of the contingent liability becoming and actual liability. This might occur if the acquiree is engaged in a legal dispute.
Measurement
The assets acquired and liabilities assumed must be measured separately at their fair value at the acquisition date. The fair value is the amount that a third party would pay to acquire an asset or charge to assume a liability (or contingent liability).
Keep in mind any fair value adjustment to the assets or liabilities may give rise to a deferred tax asset or liability, which should be accounted for in accordance with IAS 12 Income Taxes.
Purchase price = FV of… assets given (eg.cash) + liabilities assumed/incurred + equity issued
Acquisition costs
When one entity acquires another, it may incur legal fees, accountants’ and professional advisor fees and other costs of acquisition. These directly related acquisition costs must be expensed to the profit or loss in the period of the acquisition.
Contingent consideration
Sometimes when a business combination takes place, there will be contingent consideration in place. For example, the shareholders of the acquiree may receive extra money if the acquiree reaches certain targets. Contingent consideration is additional purchase price payable depending on a future outcome or events.
The contingent consideration should be recognised as part of the cost of the acquisition. If, for some reason, it is not payable at a later date, then the change in fair value of the acquired entity should be recognised in the profit or loss.
Deferred payments
It’s not mentioned in IFRS 3 whether any deferred payments relating to the acquisition should be discounted back to present values. However, this would be consistent with other accounting standards such as IAS 39. If you decide to discount the deferred payments, take into account the following factors:
- Interest rates on loans applicable to the entity
- Sources of finance available
- Other relevant factors that could influence the rate payable
You could use the company’s weighted average cost of capital when working this out in the ACCA P2 exam (or F7). But don’t over complicate the question in the exam, unless you’re expressly told to discount the figure.
4. Goodwill / Bargain Purchase
The final step in the Acquisition Method is to calculate Goodwill or Bargain Purchase. We’ll look at this in a later blog article.