What Is a Business Combination?

IFRS 3 Business Combinations

WORKBOOK

What is a business combination?

A business combination is a transaction (or other event) in which an acquirer obtains control of one or more businesses?

a) True

b) False

Below is a list of the investments of an entity

$m
Noncurrent assets
Property, Plant and Equipment / 140
Investment
- 70% Ordinary shares of A / 85
- 70% Preferred shares of B / 100
- 70% Bonds of C / 50

Which of the above give(s) the entity legal control?

a) All the investments

b) Investment in the ordinary shares only

c) Investment in the ordinary and preferred shares only

d) Investment in bonds and ordinary shares only

Which of the following is true?

a) A transaction involves the transfer of consideration to the vendor

b) An “other event” involves transfer of cash to the vendor

c) A transaction is settled in cash

d) An “other event” involves transfer of consideration to the vendor

Below is a series of case studies involving exchange of assets. Determine if the exchange in each case constitutes a business combination and discuss how the transactions should be accounted for, citing all relevant standards and their constituent principles in support of your reasoning.

Entity A transfers a software production licence to Entity B in exchange for a hand-held application design outfit to be relinquished by Entity B.
Required
Discuss how the transactions should be accounted for.
Entity A transfers a software licence in part exchange for a popular local radio broadcast station.
Required
Discuss how the exchange should be accounted for.

Which of the following is not a business combination?

a) Entity A acquires 50% of Entity B for a fresh issue of shares at par and Entity B acquires 50% of A for a fresh issue of shares at par.

b) Entity A acquires 50% of Entity B and the directors of A secure an agreement with the directors of B to vote with them

c) Entity A acquires 50% of Entity B for a consideration in shares at a premium at a rate of $2.5 per share of entity B.

d) Entity A acquires 50% of Entity B for a consideration in cash but is precluded from exercising control over B as a result of contractual rights held by other investors in Entity B

What is the consideration for the acquisition?

All recognised and measured at fair value (PWc 25073)

Components of consideration / Forms of Consideration / Issues to consider
Assets given in exchange / - Cash
- Other assets
- Subsidiaries of the acquirer
- Contingent consideration (financial liabilities)
- Non-monetary assets / - How is the non-monetary asset measured? No guidance from IFRS 3 but using the guidance in the Framework fair values are used based on market prices, NRV, valuation and others (in that order). (Pwc 25.236)
- Measurement period (PWc 25.304)
- Subsequent measurement
Liabilities incurred / - Contingent consideration
- Equity instruments (if variable see table below)
- Deferred consideration / - are amounts contingent consideration or employee compensation? (Pwc 25.287)
- Classification of contingent consideration: Equity or financial liability (Pwc 25.249)
- Costs related to the issuance of financial liabilities are capitalised and amortised in accordance with the “effective interest method”.
Equity shares issued by acquirer / Equity instruments (fixed), options, warrants, / - Not re-measured
- Issue costs reduce proceeds
- Accounted for under IAS 32
Direct costs of the exchange / Indemnities given to acquiree against pending legislation
No consideration / None / - how is acquirer’s interest measured for the purpose of determining goodwill?
What is not consideration for the acquisition?
Payments not eligible (IFRS 3 principle is that consideration is limited to what the vendor is entitled to receive, not all the transfers and payments the acquirer is obliged to make) / Incidental expenses / - Separate from and separately account for aspects of the transaction that are not part of the business combination
Contingent consideration payable
Under IFRS 3 an obligation to transfer additional consideration to the seller if specified future events and conditions are met. / Qualifying events or conditions / Recognition criteria
Arrangement is an indemnity, not contingent consideration / A acquires B pending the outcome of a significant court case and sellers of B indemnify A up to $2m against legal costs and damages in the event of B losing the case after acquisition. / At acquisition A can recognise a contingent liability (no probability criterion) and at the same time recognise an asset (recovery of the loss up to $2m).
Escrow arrangements / Protection against misrepresentation risk refundable deposits by acquiree subject to post acquisition validation of pre-acquisition claims by the acquiree. / Measurement period adjustments
Working capital adjustments / Conditional consideration paid based on conditions existing at the balance sheet date / Measurement period adjustments
Adjustment to the purchase consideration based on the outcome of a general contingency / The sellers of B agree to reduce the purchase consideration received from A to offset legal costs in excess of $1 million should the case against B be lost. / B has indemnified A for the existing court case. A should recognise an assumed contingent liability and an asset for the amount to be recovered from B.
Assumed liability: the contingent consideration of the acquiree from a previous acquisition. / B acquired C on 1 January 2009 agreeing to pay C’s sellers $5 million extra each year for three years if profits exceed $25m in each of those years. This was accounted for as a contingent consideration as it was probable that the targets would be exceeded. In the year to 31 December the target was exceed. On 1 January 2010 A acquired B. / Under IFRS 3 A assumes the remaining contingent consideration as an identifiable liability . It does not meet the definition of a contingent consideration.

ASSESSING WHAT IS PART OF A BUSINESS COMBINATION TRANSACTION

Pre-existing relationships

Contractual / The gain or loss is the lower of
i) the amount by which the current contract value is favourable or unfavourable relative to current prices of similar transactions and
ii) the cost of compensating the counterparty for termination of the contract
Non-contractual / Contingent liabilities: pre-existing non-contractual relationships e.g. defendant and plaintiff. Outstanding obligations are settled on acquisition. The acquirer recognises a settlement gain or loss on acquisition.

Below is a case study about a settlement loss on a contractual relationship.

Settlement loss on a contractual relationship
Server provides catering services to Consumer under a fixed price contract. Server acquires Consumer for $105 million. Since the inception of the contract the market price for these services has increased by up to $10m. The terms in the contract mean that this price movement is unfavourable for Server but favourable for Consumer who has contracted to pay a fixed price despite the increase in prices for similar transactions. There is a settlement provision of $6 million in the contract which either party would be obliged to pay the counterparty to terminate the contract at acquisition. The fair value of Consumer’s identifiable net assets is $85 million excluding the favourable contingent asset.
Required
Discuss how the above transactions should be accounted for citing and explaining the principles in IFRS 3.

Below is a case study about a pre-existing obligation which is settled on acquisition. This is a non-contractual relationship.

Settlement loss arising from a previously recognised contingent liability (non-contractual pre-exiting relationship)
Acquire is a defendant in litigation for patent infringement against Absorb. On 1 January 2010 Acquire pays $75 million to acquire Absorb and effectively settles the case against it at an estimated fair value of $10 million. Acquire had recorded a provision of $7 million in its financial statements before the acquisition. The fair value of Absorb’s identifiable net assets excluding the litigation liability is $70 million.
Required
Discuss how the above transaction should be accounted for under IFRS 3

Below is a case study about a pre-existing obligation which is settled on acquisition.

Settlement charge arising from a recognised contingent liability (non-contractual pre-exiting relationship)
Aspire is a defendant in litigation for copyright infringement against Established. On 1 January 2011 Aspire obtains 100% of the voting equity shares of Established for $150 million and effectively settles the case against it at the estimated fair value of $25 million. The fair value of Established’s net assets at acquisition was $100 million. Aspire had not recorded a liability prior to acquisition.
Required
Discuss the treatment of the above transaction under IFRS 3.

Below is a case study about a pre-existing obligation which is settled on acquisition.

Settlement gain arising from a previously recognised contingent liability (non-contractual pre-exiting relationship)
Pirate is a defendant in litigation for licence infringement against Inventor. On 1 June 2010 Pirate pays $175 million to acquire Inventor and effectively settles the case against it at an estimated fair value of $20 million. Pirate had recorded a provision of $25 million in its financial statements before the acquisition. The fair value of Inventor’s identifiable net assets excluding the litigation liability is $140 million.
Required
Discuss how the above transaction should be accounted for under IFRS 3
Settlement loss scenarios
- acquirer records a liability prior to acquisition = 0 loss is entire FV at acquisition
- acquirer records a liability prior to acquisition < FV at acquisition
Settlement gain scenarios
- acquirer records a liability prior to acquisition > FV at acquisition

Re-acquired Rights

Background
Relationships often exist between the acquirer and the acquiree prior to the acquisition which involve use of certain “rights” such as trade names and licences. At acquisition the contracts are effectively settled and the acquirer may recognise a gain or loss upon settlement. At the same time the acquirer may re-acquire a right that it had granted to the acquiree to use one or more of its recognised or unrecognised assets. Such re-acquired rights are identifiable intangible assets that the acquirer separately recognises from goodwill. IFRS 3 requires that such settlement should be accounted for separately outside the business combination. IFRS 3 also requires that re-acquired rights should be valued at the acquisition-date values and included in the business combination as part of the net assets of the acquired business.
Acquisition date values
The acquisition date values are based only on the remaining contractual life of the asset. Contractual renewal not in existence at the acquisition date should not be included (even if it is contemplated). This means that cash flows relating to post-combination renewals should not be included in the valuation and that re-acquired rights are not valued at fair value, an exception to the fair value measurement principle.
Settlement gain or loss
The settlement gain or loss is the lower of i) the amount by which the current contract is favourable or unfavourable relative to current market prices for similar transactions and ii) the settlement cost incurred inn compensating the counterparty for terminating the contract.
Amortisation
A right re-acquired from an acquiree has a finite life (the remaining contractual term). Contractual renewal periods after combination are not part of the business combination and as such should be excluded from the estimation of economic useful life. Consistent with the measurement of the value the right is amortised over the remaining contractual term only.
Indefinite life asset e.g. perpetual franchise right
In some cases the re-acquired right may not have any contractual renewals. The remaining contractual life may not be clear. In this case the re-acquired right should be recognised but not amortised.
Example of re-acquired right
Galwat produces high quality applications that it sells through a network of a large number of authorised distributors and computer retail stores. Each distributor purchases a right to distribute Galwat’s applications for five years and in return receives technical support. The fee for the five year distributorship is $5m determined as fair value for the service level agreed and is paid in one instalment when the contract commences. The fee has remained unchanged for several years. The agreement can be terminated by either party for a fee of $1m. If Galwat terminates the contract an additional refund of a proportionate fee corresponding to the unexpired term of the contract must be paid.
Galwat acquires one of the distributors Dalgit with three years left on its distribution contract. The fair value of the distribution agreement at the acquisition date is $3m. Relative to current market prices for similar transactions there is no favourable or unfavourable amount.
Required
Explain how Galwat should account for the above transaction.
Solution
On acquisition Dalgit’s distributorship is effectively settled for a fee of $1m by Galwat. This transaction is separately accounted for by Galwat outside the business combination as a re-acquisition of the right to distribute from Dalgit. There is no gain or loss on settlement as the contract value is the same as current market value for similar transactions.
Galwat recognises the remaining contract value of the distribution right as an intangible asset at $3m acquired separate from goodwill. The asset will be amortised over the remaining contract term in the post combination period.
Plan of questions on reacquired rights.
- settlement loss
- settlement gain
- Indefinite life
- Renewals post acquisition
- 3rd party contracts in the mix

A re-acquired right is

a) Pre-existing relationship that is settled at acquisition

b) Post combination non-compete contract

c) Post acquisition employment services contract

d) A right previously granted by the acquirer re-acquired from the acquiree to be exercised in the post combination period.

When the re-acquired right has an indefinite life it is amortised over its economic useful life.

a) True

b) False

A re-acquired right is valued at the acquisition-date value in accordance with the measurement principles of IFRS 3. Which of the following gives the correct value if the re-acquired right has a finite life?

a) Fair value at acquisition

b) Value in use at acquisition

c) Market value at acquisition

d) Amortised replacement cost

Which of the following is true? A re-acquired right is

a) Written off by the acquiree on acquisition

b) Recognised as an intangible asset at acquisition

c) Capitalised into goodwill on consolidation

d) Charged to the combined income statement of the group

The main difference between goodwill and intangible assets is that

a) Goodwill is purchased whereas intangibles are not

b) Goodwill is amortised whereas intangibles are not

c) Goodwill is subject to annual impairment testing whereas intangibles are not

d) Goodwill is not amortised whereas intangibles are

The information below relates to the acquisition of Vindhu plc by Vandhi plc. At the date of acquisition the fair value of the intangible assets and the contingent liabilities of Vindhu plc were $250 million and $50 million respectively. At the date of the preparation of the financial statements the value of Vindhu’s net assets had increased significantly and are expected to continue to increase on account of its excellent profit performance. The intangible assets have a remaining life of ten years.

Vindhu plc
$m
Cost of acquisition / 750
Less fair value of net assets / (350)
Less restructuring provision / (100)
Goodwill / 300
Statement of comprehensive Income
Profit before amortisation / 250
Amortisation of goodwill / (50)
Interest / (15)
Profit before tax / 185
Required
Revise the above statements and explain the principles on which you base your revision.
Plan:
- Prepare interactive business combination spreadsheet to allow practice in identifying various adjusting items in the acquiree and acquirer books
-

Contingent consideration - Employee compensation arrangements

Components of consideration / Forms of Consideration / Issues to consider
Employee compensation cost (not contingent consideration)
Primary criteria for initially assessing whether employee compensation arrangements are contingent consideration or remuneration for post combination services:
- Reasons for the transaction
- Who initiated it
- Timing / Continuing employment
- does the employee forfeit the payment on termination or is the payment unaffected by whether the person is employed or not
Duration of continuing employment
- if coterminous with the period of the payment
Level of remuneration
- if contingent payment excluded reasonable relative to others
Incremental payments to employees
- if selling shareholders who become employees get the same as selling shareholders who don’t become employees
Number of shares owned
- profit share among selling shareholders who remain as employees after previously owning substantially all the shares
- previous shareholders who remain as employees owning only a small part of the business receive the same contingent payment (without being able to influence the amount) are probably being distributed consideration
Linkage of payment to valuation
- Formula: i) earnings multiple (indicates consideration as aimed at determining fair value) whereas formula based on ii) proportion of profits earned is more likely profit sharing.
Other agreements and issues. Payments may be for other contracts. / Pre combination remuneration
Golden parachute
Key issues:
i) is there a pre-combination assumed obligation to be included as part of the combination? or
ii) Is the payment a post combination expense?
Post combination remuneration
Stay bonus
Key issues:
i) Is payment consideration transferred to acquiree? or
ii) Post combination expense that is accounted for outside the combination

Employee compensation arrangements

Focus issues:

- Employee/shareholder remains after the acquisition; arrangement allows for payments to be received both as employee and shareholder. To be accounted for IFRS 3 (consideration for the business); IFRS 2 (share based payment- separate transaction outside of the combination); IAS 19 (post acquisitions employee services).

- E.g. payment linked to profit: i) valuation; ii) performance (indicates remuneration for services: share options and for cash)

Below are details of a case study involving contingent consideration and employee compensation arrangements.

Employee compensation arrangement and contingent consideration
M plc acquired a controlling interest in N a private limited company on 1 January 2010 for a consideration of $500 million in cash. M agreed to pay a cash bonus of $25,000 per annum to N’s Chief Executive if he would stay for the next two years following acquisition. The Chief Executive who has not sold his interest in N agreed to stay. As the chief executive is an employee shareholder M agreed he would be entitled to his share of the bonus pool under existing arrangements for employees of N which is payable in shares. The acquisition price had been agreed based on a formula which took into account N’s commercial potential for rapid profit generation in the future. Based on that formula N will receive 10% of the value of the business over $500 million for each of the three years following acquisition. It has been agreed that this additional sum would be distributed equally to all shareholders of N in proportion to their shareholdings. Both M and N agree that with the existing staff intact after acquisition N is expected to grow rapidly and to make a return on capital in the region of 15% to 25 % per annum and to achieve a market capitalisation of $750 million in each of the first three years following acquisition.
Required
Discuss how the above transactions should be treated by M plc in its Consolidated and Separate financial statements.

Below is a case study of contingent consideration

Dramatic change in ownership structure: employee owners sell and stay on en masse
Q’s employees who previously owned a substantial interest in Q stay on as employees together with some of their family members who were also previously employed by Q. Under the agreement for the acquisition of Q P plc agreed to issue share options to the key employees of Q if they exceed a minimum profit level consistently for two years after acquisition. The options will be issued at the end of two years. If the employees leave before that time they will forfeit all the accumulated benefits.
Required
Discuss how the above transactions should be treated in the books of P plc.

Arrangements that include contingent consideration need to be assessed to determine whether the consideration is for the business combination or for post combination expenses. Where seller employees (employee share holders in the acquiree business who stay on as employees and may retain ownership interest) are involved the emphasis is particularly on post combination remuneration for employee services.

a) True