It is common for companies to acquire another company or business but the question is how to know whether such an acquisition constitutes a business combination rather than an asset acquisition? What does it mean by business combination? In this article, we will explore the financial reporting requirements for business combinations in IFRS 3 Business Combinations.
IFRS 3 was first issued in March 2004 to replace IAS 22 and three related interpretations. However, in January 2008, the International Accounting Standards Board (“IASB”) issued a revised IFRS 3 and is currently being used by preparers to account for their business combinations. Take note that this standard is however, does not apply for business combinations under common control – where all the combining entities are ultimately controlled by the same party both before and after the business combination and that control is not transitory. The financial reporting consideration for business combination is in the pipeline of the IASB’s work plan – Business Combinations under Common Control. IFRS 3 is also not applied to the acquisition by an investment entity. We have covered the financial reporting requirements for investment entities in Key Principles in the Preparation of Consolidated Financial Statements in IFRS 10.
IFRS 3 is rather a complex standard but we wish to share with you on a high-level perspective the key principles in the standard. As such, we divide this topic into 2 parts. In Part I, we will share with you the definition of business combination and how entities determine whether the acquired set of activities and assets is a business combination. Part II will then discuss the high-level financial reporting requirements when an acquisition is determined to be a business combination.
Let us now go into the details of understanding a business combination in IFRS 3.
What is a business combination?
For an acquisition to be considered as a business combination, IFRS 3 requires the assets acquired and liabilities assumed to constitute a business. If such an acquisition does not constitute a business, it is accounted as an asset acquisition. What is a business? Appendix A of IFRS 3 defines a business as an integrated set of activities and assets that is 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.
IFRS 3 further states that a business consists of inputs and processes applied to those inputs that have the ability to contribute to the creation of outputs. These three elements constitute a business and entities need to determine and assess them to conclude whether the acquired set of activities and assets is a business – i.e., the full assessment approach. IFRS 3 however, introduces an optional test to identify concentration of fair value (“the concentration test”) in determining whether there is a business combination. Entities can make this election separately for each transaction or other event.
Let us now explore the full assessment approach and the concentration test in determining a business combination.
The optional test to identify concentration of fair value (“the concentration test”)
The concentration test is introduced to help to simplify an entity’s assessment of whether an acquired set of activities and assets is not a business. If the concentration test is met, the acquired set of activities and assets is not a business. However, if the concentration test is not met, or if an entity elects not to apply the test, the entity has to perform the full assessment to determine whether such an acquisition is a business.
What is the concentration test is all about? The concentration test is performed by assessing how and where the fair value of the acquired set of activities and assets are concentrated. The concentration test is met if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or group of similar identifiable assets.
Under the concentration test, the following should be observed:
- Gross assets acquired — Exclude cash and cash equivalents, deferred tax assets and goodwill resulting from the effects of deferred tax liabilities.
- Fair value of the gross assets acquired – Include any consideration transferred, including the fair value of any non-controlling interest and the fair value of any previously held interest in excess of the fair value of net identifiable assets acquired.
- Single identifiable asset – Include any asset or group of assets that would be recognised and measured as a single identifiable asset in a business combination.
- Tangible asset – A tangible asset that is attached to and cannot be physically removed and used separately from another tangible asset without incurring significant costs or diminution is utility or fair value to either asset, those assets are considered as a single identifiable asset.
- Similar assets — Entities should consider the nature of each single identifiable asset and the risk associated with managing and creating outputs from the assets.
The full assessment
We mentioned earlier that a business consists of three elements – input, processes and output. Under the full assessment approach, entities need to assess these three elements. They are explained as follows:
|Any economic resource that creates outputs or has the ability to contribute to the creation of outputs, when one or more processes are applied to it.||Any system, standard, protocol, convention or rule that when applied to input(s), create outputs or has the ability to contribute to the creation of outputs. A process includes strategic management processes, operational processes and resource management processes. Although these processes are documented, the intellectual capacity of an organised workforce having the necessary skills and experience following rules and conventions may provide the necessary processes that are capable of being applied to inputs to create outputs.||Output is the result of inputs and processes applied to those inputs that provide goods or services to customers, generate investment income or generate other income from ordinary activities.|
However, IFRS 3 further clarifies that outputs are not required for an integrated set of activities and assets to qualify as a business. It is common for an acquired set of activities and assets not to have outputs such as an early-stage entity that has not started generating revenue.
The two essential elements of a business are inputs and processes and it is not necessary to include all of the inputs or processes that the seller used in operating that business. Importantly, the process must be a substantive process so that both an input and the substantive process, together, significantly contribute to the ability to create output. In fact, if an acquired set of activities and assets has outputs, continuation of revenue does not on its own indicate that both an input and a substantive process have been acquired.
Depending on whether a set of activities and assets have outputs or not at the acquisition date, an acquired process is considered substantive when:
|A set of activities and assets does not have outputs at the acquisition date||A set of activities and assets has outputs at the acquisition date|
|– It is critical to the ability to develop or convert and acquired input(s) into outputs; and |
– The inputs acquired include both an organised workforce that has the necessary skills, knowledge or experience to perform the process and other inputs that the organised workforce could develop or convert into outputs.
|– Is critical to the ability to continue producing outputs, and the inputs acquired include an organised workforce with the necessary skills, knowledge or experience to perform that process; or |
– Significantly contributes to the ability to continue producing outputs and is considered unique or scarce or cannot be replaced without significant cost, effort or delay in the ability to continue producing outputs.
The above summarises the key principles in determining a business combination. In our next article, we will share with you on how entities account for business combinations.
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