Introduction
Mergers and acquisitions are becoming more and more common as entities aim to achieve their growth objectives other than in an organic way. IFRS 3 / Ind AS 103 – Business combinations transform the way companies plan and execute their acquisition strategies. This standard applies to most of business combinations, including amalgamations/ mergers and acquisitions. This standard lays down the principles of accounting for business combinations by way of acquisitions or mergers. Ind AS also provides guidance on a combination of entities or businesses under common control. However, IFRS does not provide guidance on combinations under common control.
The companies that engage in business combination transactions face various challenges in accounting and financial reporting of such transactions, including:
1. Accounting for purchase consideration transferred by acquirer and other transaction costs incurred in the transaction.
2. Recognition and measurement of the net assets acquired in business acquisition, commonly referred to as Purchase Price Allocation (PPA) of identified net assets acquired
3. Computation of goodwill or gain on bargain purchase/capital reserve (under Ind AS) in case of acquisition of stressed businesses.
In this blog, we would like to discuss practical challenges in the recognition and measurement of net assets acquired based on PPA and practical issues faced in accounting for acquisitions of stressed businesses.
The acquisition accounting
Business combinations can be broadly categorized as follows:
a. Acquisition of control by acquiring majority equity in the acquiree company, where legal existence of the ‘acquiree company’ continues; and
b. Amalgamation of two or more companies forming a third entity or merger of a second company into the first company, where the legal existence of the acquiree company is discontinued.
IFRS 3 / Ind AS 103 – Business Combinations, requires that a business combination transaction to be accounted for by applying the ‘acquisition method’. Acquisition method accounting is applied in the books of an ‘acquirer’ either in consolidated financial statements (CFS) or in the separate financial statements (SFS) as mentioned in the below para.
Acquisition accounting in the first scenario above i.e. in ‘a’, is applied in the CFS of an acquirer; and in the SFS of the acquirer remains unaffected by IFRS 3 / Ind AS 103 accounting. Whereas, in the second scenario ‘b’, the acquisition accounting is applied in the SFS of the acquirer and the acquirer is not required to prepare CFS.
Brief overview of the acquisition method of accounting:
Acquisition accounting is executed in the books of an acquirer as on the date of acquisition.
Accounting entry for acquisition accounting:
Debit: Fair value of net assets acquired
Debit: Goodwill (Balancing amount)
Credit: Purchase consideration payable
Credit: Non-controlling interest (NCI)
(NCI is measured either at fair value or proportionate interest in the net assets method)
Practical challenges faced in recognition and measurement of identifiable net assets
Acquirer, in practice, while recognizing the acquisition transaction is required to rely upon the valuation exercise undertaken by the registered valuer. The purchase price paid (in a business combination) needs to be allocated to the assets acquired and liabilities assumed, a process that is also referred to as a ‘purchase price allocation’. This can sometimes be challenging. For a few businesses, the purchase price may not be paid exclusively in cash, but partly in equity or could be deferred or conditional as well. This means that the definitive value of the purchase price might not be entirely clear at the moment the PPA is performed. Further, the directly attributable costs incurred to execute the business combination transaction have different accounting treatments in the SFS and CFS of the acquirer.
Recognition principle
On acquisition date, IFRS 3 / Ind AS 103 requires acquirer to recognise the identifiable assets acquired and the liabilities assumed in the acquiree if an item:
As a consequence, the acquirer may recognise some assets and liabilities that the acquiree had not previously recognised in its financial statements.
The examples of assets or liabilities considered in PPA report for recognition as a part business combination transaction which were unrecognised by an acquiree in his financial statements are:
A] Intangible asset not recognised in the books of the acquiree
The acquirer recognizes the acquired identifiable intangible assets (e.g., brand name, patents, customer relationships, non-compete agreements, etc.) that the acquiree could not recognize as assets in its financial statements because it does not satisfy the recognition criteria mentioned under IAS 38 / Ind AS 38 and charged the related costs as expenditure in the statement profit and loss in the year those are incurred.
Another example could be, ‘In-process research and development, which is recognized and measured at fair value if it is identifiable and otherwise meets the definition of an intangible asset. This is irrespective of whether the acquiree had recognized the asset in its financial statements before the business combination.
These intangible assets are required to be identified and recognized separately from goodwill. Any consideration paid for the resources which cannot be recognized as intangible assets viz. market share, skilled employee workforce, etc. need to be subsumed as a part of goodwill.
B] Post-acquisition reorganisation and consideration for pre-existing relationships:
Assets and liabilities that arise after the acquisition are not recognized as a part of acquisition accounting. For instance, costs that the acquirer expects but is not obliged to incur in the future to effect its plan to exit the activity of an acquiree; or to terminate the employment of; or relocate an acquiree’s employees are not liabilities at the acquisition date.
Similarly, any payment made for any pre-existing relationship which is not part of the acquisition is not recognized as an asset of liability as a part of acquisition accounting.
C] Transaction costs:
Directly attributable expenses which are incurred in relation to acquisition transaction by an acquirer are charged to the statement of profit and loss account as an expense in the CFS and not accounted as a part of the acquired assets and liabilities even if paid by acquiree on behalf of acquirer. Transaction costs paid shall never form part of purchase consideration as it is not paid for particular asset or a liability.
However, in SFS, as these costs are directly attributable to acquire equity shares of a subsidiary, will form of cost of investment as per the principles of IAS 27 / Ind AS 27 – Separate Financial Statements, if entity selects a choice to measure such investments at “Cost” as per IAS 27 / Ind AS 27.
D] Contingent liabilities
Few contingent liabilities which are acquired in acquisition transaction, and which are contingent because there is no probability of outflow, is recognised as a liability in the books of acquirer as an exception to the principles of IAS 37 or Ind AS 37 while executing acquisition accounting. Such contingent liabilities are considered to be recognised in the CFS of an acquirer even if it is just disclosed in the books of the acquiree.
E] Goodwill
As mentioned in point A above, an amount paid for a few resources viz. ‘market share’, ‘skilled employee work force’ etc. which are not identifiable based on the principles of ‘IAS 38 / Ind AS 38’, are included and recognized as a part of ‘Goodwill’.
Above are the few issues entities needs to consider with respect to the recognition of net assets acquired in the business combination.
After recognising the above net assets, acquirer may face practical challenges in measuring these net assets in CFS and arrive at the goodwill / gain on bargain purchase or capital reserve (in case of Ind AS). We will look at these challenges in the subsequent issue of the blog.
FinPro Consulting has helped many of their clients in accounting for business combination transactions. Apart from business combination, we at FinPro specialises in resolving complex accounting issues under IFRS / Ind AS / Indian GAAP / US GAAP etc. For more information on the subject, you can get in touch with us at info@finproconsulting.in