Question

Briefly discuss the GAAP and IFRS positions on business combinations. Suggest which methods provide the most transparent information to investors. Provide two (2) examples to support your rationale.

Answer 1

A.

Before discussing the positions of IFRS and US GAAP on business combinations we must first understand what the term business combination actually means. In simple words, the term business combination means the combining of one or more businesses. The acquiring business exercises its control on the acquired business. Under business combination the acquirer (the business acquiring other businesses) acquires one or multiple entities and they function as one unit. Since the functioning of the business is as a single unit therefore, for financial reporting purpose consolidated financial statements are prepared. Now let us see the take of US GAAP and IFRS on business combinations:

IFRS:

IFRS 10 Consolidated Financial Statements

Scope: An entity that is a parent (Acquirer) shall present consolidated financial statements. The application of this IFRS is on all entities, except as follows:

(1) a parent need not present consolidated financial statements if it meets all the following conditions:

   (i) it is a wholly-owned subsidiary or is a partially-owned subsidiary of another entity and all its other owners, including those not otherwise entitled to vote, have been informed about, and do not object to, the parent not presenting consolidated financial statements.

   (ii) its debt or equity instruments are not traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local and regional markets).

   (iii) it did not file, nor is it in the process of filing, its financial statements with a securities commission or other regulatory organisation for the purpose of issuing any class of instruments in a public market.

   (iv) its ultimate or any intermediate parent produces consolidated financial statements that are available for public use and comply with IFRSs.

(2) post-employment benefit plans or other long-term employee benefit plans to which IAS 19 Employee Benefits applies.

(3) an investment entity need not present consolidated financial statements if it is required, to measure all of its subsidiaries at fair value through profit or loss.

Meaning of the term CONTROL

For the purposes of identifying a business combination, the word control is defined in "IFRS 10, Consolidated Financial Statements", as follows: “An investor controls an investee when the investor is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee.”

Meaning of the term POWER

In simple words the term power means to exercise control. An investor has power over an investee when the investor has existing rights that give it the current ability to direct the relevant activities or render certain directions, ie the activities and directions that significantly affect the investee’s returns in a positive manner.

Accounting Considerations

Consolidation procedures
(a) combine like items of assets, liabilities, equity, income, expenses and cash flows of the parent with those of its subsidiaries.

(b) offset (eliminate) the carrying amount of the parent’s investment in each subsidiary and the parent’s portion of equity of each subsidiary (IFRS 3 explains how to account for any related goodwill).

(c) eliminate in full intragroup assets and liabilities, equity, income, expenses and cash flows relating to transactions between entities of the group (profits or losses resulting from intragroup transactions that are recognised in assets, such as inventory and fixed assets, are eliminated in full). Intragroup losses may indicate an impairment that requires recognition in the consolidated financial statements. IFRS 12 Income Taxes applies to temporary differences that arise from the elimination of profits and losses resulting from intragroup transactions. Uniform accounting policies.

NOTE: If a member of the group uses accounting policies other than those adopted in the consolidated financial statements for like transactions and events in similar circumstances, appropriate adjustments are made to that group member’s financial statements in preparing the consolidated financial statements to ensure conformity with the group’s accounting policies.

Measurement

An entity includes the income and expenses of a subsidiary in the consolidated financial statements from the date it gains control until the date when the entity ceases to control the subsidiary. Income and expenses of the subsidiary are based on the amounts of the assets and liabilities recognised in the consolidated financial statements at the acquisition date.

Potential voting rights

When potential voting rights, or other derivatives containing potential voting rights, exist, the proportion of profit or loss and changes in equity allocated to the parent and non-controlling interests in preparing consolidated financial statements is determined solely on the basis of existing ownership interests and does not reflect the possible exercise or conversion of potential voting rights and other derivatives. In some circumstances an entity has, in substance, an existing ownership interest as a result of a transaction that currently gives the entity access to the returns associated with an ownership interest. In such circumstances, the proportion allocated to the parent and non-controlling interests in preparing consolidated financial statements is determined by taking into account the eventual exercise of those potential voting rights and other derivatives that currently give the entity access to the returns.

Reporting date

The financial statements of the parent and its subsidiaries used in the preparation of the consolidated financial statements shall have the same reporting date. When the end of the reporting period of the parent is different from that of a subsidiary, the subsidiary prepares, for consolidation purposes, additional financial information as of the same date as the financial statements of the parent to enable the parent to consolidate the financial information of the subsidiary, unless it is impracticable to do so. If it is impracticable to do so, the parent shall consolidate the financial information of the subsidiary using the most recent financial statements of the subsidiary adjusted for the effects of significant transactions or events that occur between the date of those financial statements and the date of the consolidated financial statements. In any case, the difference between the date of the subsidiary’s financial statements and that of the consolidated financial statements shall be no more than three months, and the length of the reporting periods and any difference between the dates of the financial statements shall be the same from period to period.

Non-controlling interests

An entity shall attribute the profit or loss and each component of other comprehensive income to the owners of the parent and to the non-controlling interests. The entity shall also attribute total comprehensive income to the owners of the parent and to the non-controlling interests even if this results in the non-controlling interests having a deficit balance. If a subsidiary has outstanding cumulative preference shares that are classified as equity and are held by non-controlling interests, the entity shall compute its share of profit or loss after adjusting for the dividends on such shares, whether or not such dividends have been declared. Changes in the proportion held by non-controlling interests. When the proportion of the equity held by non-controlling interests changes, an entity shall adjust the carrying amounts of the controlling and non-controlling interests to reflect the changes in their relative interests in the subsidiary. The entity shall recognise directly in equity any difference between the amount by which the non-controlling interests are adjusted and the fair value of the consideration paid or received, and attribute it to the owners of the parent.

Loss of control

A parent might lose control of a subsidiary in two or more arrangements (transactions). However, sometimes circumstances indicate that the multiple arrangements should be accounted for as a single transaction. In determining whether to account for the arrangements as a single transaction, a parent shall consider all the terms and conditions of the arrangements and their economic effects.

The Business Combinations under US GAAP

ASC805-Business Combinations

Accounting Considerations:

When a business acquisition occurs, the accounting is governed by ASC 805 – business combinations. ASC 805 requires that each asset and liability acquired in a business combination be recorded at fair value as of the acquisition date, including internally-developed intangible assets of the target company that may not have been previously reflected on the books.

For tangible assets, such as cash, accounts receivable and prepaid expenses, the process of determining their fair value is relatively straightforward. Things get more complicated when dealing with intangible assets since one cannot simply point to a bank statement or general ledger balance to determine their value as of the acquisition date. It is the process of valuing a company’s intangible assets that often requires the assistance of a valuation expert given the complexity associated with valuing intangibles and the documentation required by audit firms to support the purchase price allocation for an acquisition.

One of the first steps in valuing an acquired company's intangible assets is determining what intangibles may be present. Gone are the days when all of the purchase price in excess of a target company's net tangible assets in an acquisition could be allocated to “goodwill” — this amount must now first be allocated to specifically identifiable intangible assets with only the remaining residual balance allocated to goodwill.

While the valuation of intangible assets in an acquisition is the most notable requirement of ASC 805, it reaches into other areas of business combination accounting, as well. For instance, ASC 805 requires the valuation of earnouts which must be presented at fair value as a liability on the balance sheet. This can make the determination of the purchase price in an acquisition a much more complex process than simply identifying the amount of cash paid at closing. However, when earnouts are contingent on the continued employment of one of the sellers after the transaction, it may be required that these earnout payments be expensed as incurred rather than reflected as part of the purchase price.

Given the complexity of ASC 805, it is a best practice for companies to get out in front of the accounting for business combinations before their year-end audit begins. Companies should discuss acquisitions with their auditors as they occur and determine the level of analysis that will be required to document/support the value of any acquired intangible assets and whether the use of a third-party valuation expert will be necessary. Proactively addressing these issues can lead to a much smoother audit process and avoid potential delays that may be encountered otherwise.

Now, to answer the second part of the question we must look at the comparision of US GAAP and IFRS 10 and then decide which one is better. Considering the general view asked in the question it would be relevant to say that IFRS 10 would give a clear pitcure of consolidated financial statements to the investors as it considers the chances for bleak miss outs and is based on updated event base.