Objectives
The overriding objective of IFRS 3 is to improve the relevance, representational faithfulness, transparency and comparability of information provided in financial statements about business combinations and their effects on the reporting entity by establishing principles and requirements with respect to how an acquirer, in its consolidated financial statements:
1. Recognises and measures identifiable assets acquired, liabilities assumed and the non‐controlling interest in the acquiree, if any;
2. Recognises and measures acquired goodwill or a gain from a bargain purchase;
3. Determines the nature and extent of disclosures sufficient to enable the reader to evaluate the nature of the business combination and its financial effects on the consolidated reporting entity;
4. Accounts for and reports non‐controlling interests in subsidiaries; and 5. Deconsolidates a subsidiary when it ceases to hold a controlling interest in it.
Scope
Transactions or other events that meet the definition of a business combination are subject to IFRS 3. Excluded from the scope of these standards, however, are:
1. Formation of a joint venture/arrangement;
2. Acquisition of an asset or group of assets that does not represent a business; and 3. Combinations between entities or businesses under common control.
The requirements of this Standard do not apply to the acquisition by an investment entity, as defined in IFRS 10 Consolidated Financial Statements, of an investment in a subsidiary that is required to be measured at fair value through profit or loss.
BUSINESS COMBINATIONS
IFRS 3 establishes the fair value principle for accounting for business combinations. The fair value principle means that, upon obtaining control of the subsidiary, the exchange transaction is measured at fair value. All assets, liabilities and equity (except equity acquired by the controlling interest) of the acquired entity are measured at fair value. IFRS 3 includes several exceptions to this principle.
Determining Fair Value
Accounting for acquisitions requires the determination of the fair value for each of the acquired entity's identifiable tangible and intangible assets and for each of its liabilities at the date of combination (except for assets which are to be resold and which are to be accounted for at fair value less costs to sell under IFRS 5; and for those items to which limited exceptions to recognition and measurement principles apply). IFRS 3 provides illustrative examples OF how to treat certain assets, particularly intangibles, but provides no general guidance on determining fair value.
IFRS 13, Fair Value Measurement, which defines the term fair value and sets out in a single standard a framework for measuring fair value and the related disclosures. IFRS 13 is discussed in further detail within Chapter 25.
Transactions and Events Accounted for as Business Combinations
A business combination results from the occurrence of a transaction or other event that results in an acquirer obtaining control of one or more businesses. This can occur in many different ways that include the following examples individually or in some cases in combination:
1. Transfer of cash, cash equivalents or other assets, including the transfer of assets of another business of the acquirer;
2. Incurring liabilities;
3. Issuance of equity instruments;
4. Providing more than one type of consideration; or
5. By contract alone without the transfer of consideration, such as when:
1. An acquiree business repurchases enough of its own shares to cause one of its existing investors (the acquirer) to obtain control over it;
2. There is a lapse of minority veto rights that had previously prevented the acquirer from controlling an acquiree in which it held a majority voting interest; or
3. An acquirer and acquiree contractually agree to combine their businesses without a transfer of consideration between them.
Qualifying as a Business
Under IFRS 3, to be considered a business, an integrated group of activities and assets must be capable of being conducted and managed for the purpose of providing goods or services to customers, generating investment income (such as dividends or interest) or generating other income from ordinary activities. The word capable was added to emphasise the fact that the definition does not preclude a development stage enterprise from qualifying as a business. The business definition was amended for accounting periods commencing on or after January 1, 2020, through a post‐implementation review of the standard, aiming to address the practical difficulties experienced in identifying businesses. The definition and related guidance elaborate further that a business consists of inputs and processes applied to those inputs that have the ability to create outputs. While outputs are usually present in a business, they are not required to qualify as a business as long as there is the ability to create them.
An input is an economic resource that creates or has the ability to create outputs when one or more processes are applied to it. Examples OF inputs include property, plant and equipment, intangible rights to use property, plant and equipment, intellectual property or other intangible assets and access to markets in which to hire employees or purchase materials.
A process is a system, protocol, convention or rule with the ability to create outputs when applied to one or more inputs. Processes are usually documented; however, an organised workforce with the requisite skills and experience may apply processes necessary to create outputs by following established rules and conventions. In evaluating whether an activity is a process, functions such as accounting, billing, payroll and other administrative systems do not meet the definition. Thus, processes are the types of activities that an entity engages in to produce the products and/or services that it provides to the marketplace rather than the internal activities it follows in operating its business.
An output is simply the by‐product resulting from applying processes to inputs. An output provides, or has the ability to provide, a return to the investors, members, participants or other owners.
To assist preparers, a concentration test has been added to IFRS 3. An entity can elect to adopt the test on each transaction or event. The concentration test, when met, will result in the set of activities or assets not meeting the definition of a business. No further assessment is required. The concentration test is met if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable or asset or group of similar identifiable assets. Further guidance on the application of the concentration test is included within Appendix B, including examples of what does not constitute a group of similar identifiable assets. IFRS 3 does not include any additional commentary on the meaning of
“substantially all” as this phrase is used in several standards already.
If the concentration test has not been adopted, when analysing a transaction or event to determine whether it is a business combination, it is not necessary that the acquirer retain, post‐combination, all of the inputs or processes used by the seller in operating the business. If market participants could, for example, acquire the business in an arm's‐length transaction and continue to produce outputs by integrating the business
with their own inputs and processes, then that subset of remaining inputs and processes still meets the definition of a business from the standpoint of the acquirer.
The guidance in IFRS 3 provides additional flexibility by providing that it is not necessary that a business have liabilities, although that situation is expected to be rare. The broad scope of the term “capable of” requires judgement in determining whether an acquired set of activities and assets constitutes a business, to be accounted for by applying the acquisition method.
As discussed previously, development stage enterprises are not precluded from the criteria for being deemed a business. This is true even if they do not yet produce outputs. If there are no outputs being produced, the acquirer is to determine whether the enterprise constitutes a business by considering whether it:
1. Has started its planned principal activities;
2. Has hired employees;
3. Has obtained intellectual property;
4. Has obtained other inputs;
5. Has implemented processes that could be applied to its inputs;
6. Is pursuing a plan to produce outputs;
7. Will have the ability to obtain access to customers that will purchase the outputs.
It is important to note, however, that not all of these factors need to be present for a given set of development stage activities and assets to qualify as a business. The relevant question to ask is whether a market participant would be capable of conducting or managing the set of activities and assets as a business irrespective of whether the seller did so, or the acquirer intends to do so.
Finally, IFRS 3 acknowledged the circular logic of asserting that, in the absence of evidence to the contrary, if goodwill is included in a set of assets and activities, it can be presumed to be a business. The circularity arises from the fact that, to apply IFRS to determine whether to initially recognise goodwill, the accountant would be required to first determine whether there had, in fact, been an acquisition of a business. Otherwise, it would not be permitted to recognise goodwill. It is not necessary, however, that goodwill be present to consider a set of assets and activities to be a business.
Techniques for Structuring Business Combinations
A business combination can be structured in a number of different ways that satisfy the acquirer's strategic, operational, legal, tax and risk management objectives. Some of the more frequently used structures are:
1. One or more businesses become subsidiaries of the acquirer. As subsidiaries, they continue to operate as separate legal entities.
2. The net assets of one or more businesses are legally merged into the acquirer. In this case, the acquiree entity ceases to exist (in legal vernacular, this is referred to as a statutory merger and normally the transaction is subject to approval by a majority of the outstanding voting shares of the acquiree).
3. The owners of the acquiree transfer their equity interests to the acquirer entity or to the owners of the acquirer entity in exchange for equity interests in the acquirer.
4. All of the combining entities transfer their net assets, or their owners transfer their equity interests into a new entity formed for the purpose of the transaction. This is sometimes referred to as a roll‐up or put‐together transaction.
5. A former owner or group of former owners of one of the combining entities obtains control of the combined entities collectively.
6. An acquirer might hold a non‐controlling equity interest in an entity and subsequently purchase additional equity interests sufficient to give it control over the investee. These transactions are referred to as step acquisitions or business combinations achieved in stages.
Accounting for Business Combinations under the Acquisition Method
The acquirer is to account for a business combination using the acquisition method. This term represents an expansion of the now‐outdated term
“purchase method.” The change in terminology was made to emphasise that a business combination can occur even when a purchase transaction is not involved.
The following steps are required to apply the acquisition method:
1. Identify the acquirer;
2. Determine the acquisition date;
3. Identify assets and liabilities requiring separate accounting;
4. Identifying assets and liabilities that require acquisition date classification or designation;
5. Recognise and measure the identifiable tangible and intangible assets acquired and liabilities assumed;
6. Recognise and measure any non‐controlling interest in the acquiree;
7. Measure the consideration transferred; and
8. Recognise and measure goodwill or, if the business combination results in a bargain purchase, recognise a gain from the bargain purchase.
Step 1—Identify the acquirer
IFRS 3 strongly emphasises the concept that every business combination has an acquirer. In the “basis for conclusions” that accompanies IFRS 3, the IASB asserts that:
“true mergers” or “mergers of equals” in which none of the combining entities obtain control of the others are so rare as to be virtually non‐existent.1
The provisions of IFRS 10, Consolidated Financial Statements, should be used to identify the acquirer—the entity that obtains control of the acquiree. The acquirer is the combining entity that obtains control of the other combining entities.
While IFRS 10 provides that, in general, control is presumed to exist when the parent owns, directly or indirectly, a majority of the voting power of another entity, this is not an absolute rule to be applied in all cases. In fact, IFRS 10 explicitly provides that in exceptional circumstances, it can be
clearly demonstrated that majority ownership does not constitute control, but rather that the minority ownership may constitute control (refer to Chapter 14). Exceptions to the general majority ownership rule include, but are not limited to, the following situations:
1. An entity that is in legal re‐organisation or bankruptcy;
2. An entity subject to uncertainties due to government‐imposed restrictions, such as foreign exchange restrictions or controls, whose severity casts doubt on the majority owner's ability to control the entity; or
3. If the acquiree is an SPE (Special Purpose Entity), the creator or sponsor of the SPE is always considered to be the acquirer. Accounting for SPEs is discussed later in this chapter.
If applying the guidance in IFRS 10 does not clearly indicate the party that is the acquirer, IFRS 3 provides factors to consider in making that determination under different facts and circumstances.
1. Relative size—Generally, the acquirer is the entity whose relative size is significantly larger than that of the other entity or entities. Size can be compared by using measures such as assets, revenues or net profit.
2. Initiator of the transaction—When more than two entities are involved, another factor to consider (besides relative size) is which of the entities initiated the transaction.
3. Roll‐ups or put‐together transactions—When a new entity is formed to issue equity interests to effect a business combination, one of the pre‐existing entities is to be identified as the acquirer. If, instead, a newly formed entity transfers cash or other assets, or incurs liabilities as consideration to effect a business combination, that new entity may be considered to be the acquirer.
4. Non‐equity consideration—In business combinations accomplished primarily by the transfer of cash or other assets, or by incurring liabilities, the entity that transfers the cash or other assets, or incurs the liabilities, is usually the acquirer.
5. Exchange of equity interests—In business combinations that are accomplished primarily by the exchange of equity interests, the entity that issues its equity interests is generally considered to be the acquirer. One notable exception that occurs frequently in practice is often referred to as a reverse acquisition, discussed in detail later in this chapter. In a reverse acquisition, the entity issuing equity interests is legally the acquirer, but for accounting purposes is considered the acquiree. There are, however, other factors that should be considered in identifying the acquirer when equity interests are exchanged. These include:
1. Relative voting rights in the combined entity after the business combination—Generally, the acquirer is the entity whose owners, as a group, retain or obtain the largest portion of the voting rights in the consolidated entity. This determination must take into
consideration the existence of any unusual or special voting arrangements as well as any options, warrants or convertible securities.
2. The existence of a large minority voting interest in the combined entity in the event no other owner or organised group of owners possesses a significant voting interest—Generally, the acquirer is the entity whose owner or organised group of owners holds the largest minority voting interest in the combined entity.
3. The composition of the governing body of the combined entity—Generally, the acquirer is the entity whose owners have the ability to elect, appoint or remove a majority of members of the governing body of the combined entity.
4. The composition of the senior management of the combined entity—Generally, the acquirer is the entity whose former management dominates the management of the combined entity.
5. Terms of the equity exchange—Generally, the acquirer is the entity that pays a premium over the pre‐combination fair value of the equity interests of the other entity or entities.
Step 2—Determine the acquisition date
The acquisition date is that date on which the acquirer obtains control of the acquiree. As discussed previously, this concept of control is not always evidenced by ownership of voting rights.
The general rule is that the acquisition date is the date on which the acquirer legally transfers consideration, acquires the assets and assumes the liabilities of the acquiree. This date, in a relatively straightforward transaction, is referred to as the closing date. Not all transactions are that straightforward, however. All pertinent facts and circumstances are to be considered in determining the acquisition date and this includes the meeting of any significant condition's precedent. The parties to a business combination might, for example, execute a contract that entitles the acquirer to the rights and obligates the acquirer with respect to the obligations of the acquiree prior to the actual closing date. Thus, in evaluating economic substance over legal form, the acquirer will have contractually acquired the target on the date it executed the contract.
Example of acquisition date preceding closing date
In 20XX, Henan Corporation (HC), a China‐based holding company, purchased more than 20 wine brands and specified distribution assets from a French company. In its annual report, HC disclosed that the acquired assets were transferred to a subsidiary of the seller, in which HC received, in connection with the transaction, economic rights (these were structured as “tracker shares” in the holding subsidiary of the seller) with respect to the acquired assets prior to their actual legal transfer to the company. In addition, HC obtained the contractual right to manage the acquired assets prior to their legal transfer to HC, resulting in the acquirer obtaining control of the acquiree on the date before the closing date. Among the reasons HC cited for entering into these arrangements was their commercial desire to obtain the economic benefits associated with owning and operating the acquired assets as soon as possible after funding the purchase price for them.
Until the assets were legally transferred to HC, the transaction was accounted for under IFRS 10 and consequently HC's interests in the tracker shares of the seller's subsidiary were consolidated since HC was considered the sponsor of that subsidiary. The seller's residual interest in the holding subsidiary was reported in the consolidated financial statements of HC as a non‐controlling interest.
Step 3—Identify assets and liabilities requiring separate accounting
IFRS 3 provides a basic recognition principle that, as of the acquisition date, the acquirer is to recognise, separately from goodwill, the fair values of all identifiable assets acquired (whether tangible or intangible), the liabilities assumed, and, if applicable, any non‐controlling interest
(previously referred to as “minority interest”) in the acquiree.
In applying the recognition principle to a business combination, the acquirer may recognise assets and liabilities that had not been recognised by