The acquisition method- IFRS 3

The acquisition method’s overall principles can be summarised in the following steps:

Step 1: Identifying the acquirer

An acquirer is identified for all business combinations. There can only be one acquirer in a business combination. The acquirer is the combining entity that obtains control of the acquiree, being the other combining business or businesses.

The guidance in IFRS 10 is used to determine which entity is the acquirer in a business combination:

“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”

The acquirer is usually the entity that issues its equity instruments, where the business combination is affected primarily by exchanging equity interests.

Other indicators of the acquirer’s identity, where equity interests have been exchanged, are:

The terms of the exchange of equity interests – the acquirer is usually the party that pays more than the pre-combination fair value for the other combining entity.

An acquirer could obtain control of a business without transferring any consideration. This might occur where:

• The acquiree buys back enough of its own shares that the acquirer manages to gain control.
• The rights of other (minority) shareholders that stopped the acquirer from controlling the acquiree lapse.
• The acquirer and acquiree combined businesses through a contract, but with no transfer of consideration. No equity interest is held in the acquiree, either at the acquisition date or earlier.

This might be achieved through a stapling transaction or through the formation of a dual-listed entity. The acquisition method applies to such business combinations, and an acquirer is identified.

Step 2

The acquisition date is “the date on which the acquirer obtains control of the acquiree” . Generally, this is the date on which the acquirer transfers consideration and acquires the assets and liabilities of the acquiree.

The acquirer might obtain control on a date that is either earlier or later than the date on which the transaction is closed or finalized at law. All pertinent facts and circumstances surrounding a business combination should be considered in assessing when the acquirer has obtained control. The date on which control passes is a matter of fact, and it cannot be backdated or artificially altered.

Step 3

Consideration transferred is generally measured at fair value. Consideration transferred includes the assets transferred, the liabilities incurred by the acquirer to the former owners of the acquiree, and the equity interests issued by the acquirer to the former owners of the acquiree.

Examples of consideration transferred include cash, other assets, contingent consideration, a subsidiary or a business of the acquirer transferred to the seller, common or preferred equity instruments, options, warrants and member interests of mutual entities.

Deferred consideration

Part of the consideration for a business combination might be unconditional, becoming payable at a date after the business combination has been completed. Such deferred consideration could take the form of cash, shares or other consideration where the amounts are known with certainty. Where the deferred consideration is conditional, this is ‘contingent consideration’. Contingent consideration is measured at fair value at the acquisition date.

Classification of consideration

Financial assets and liabilities and equity instruments are defined by IAS 32.

An equity instrument is a contract that evidences a residual interest in an entity’s assets, after deducting all of its liabilities.

A financial liability is:

• a contractual obligation to deliver cash or another financial instrument, or to exchange financial assets or liabilities under conditions that are potentially unfavorable; or
• a contract that will or might be settled in its own equity instruments and is a:
• non-derivative for which an entity is or might be obliged to deliver a variable number of its own equity shares; or
• derivative that will or might be settled other than by exchange of a fixed amount of cash or another financial asset for a fixed number of its own equity instruments.

Classification of deferred consideration

• The fair value of deferred cash consideration is accounted for by the acquirer as a financial liability.
• The difference between the amount (fair value) at the acquisition date and the total amount payable is a finance cost. It is charged as interest expense in the acquirer’s post-acquisition income statement over the period when the liability is outstanding.
• Deferred consideration is first classified by IAS 32 as a liability or equity. If the deferred consideration is an equity instrument, the fair value should be credited directly to shareholders’ funds. Deferred consideration should be disclosed under share capital, as a separate caption, with a heading such as ‘shares to be issued’.
• The deferred consideration might be classified as a liability if the amount of deferred consideration payable is fixed at the acquisition date, and the number of shares issued to satisfy that consideration varies according to the market price of the shares at the date when the consideration is issued.

Classification of contingent consideration

• An acquirer’s obligation to pay contingent consideration that meets the definition of a financial instrument is classified as a financial liability or equity, based on IAS 32.
• A contingent consideration arrangement that is required to be settled in cash or other assets should be classified as a liability.
• A contingent consideration arrangement might be settled with an entity’s own equity shares, but it is accounted for as a liability (for example, a fixed amount to be paid in a variable number of shares).
• Contingent consideration arrangements that will be settled in a fixed number of the issuer’s equity instruments are usually classified as equity. If the arrangement results in the delivery of a variable number of shares, it is classified as a liability.
• Equity classification is precluded for contingent consideration arrangements that meet the definition of a derivative if the arrangement has a settlement choice (for example, net share or net cash), even if it is the issuer’s exclusive choice.

Step 4

Recognising and measuring identifiable assets acquired, liabilities assumed and non-controlling interest

The recognition principle is: “as of the acquisition date, the acquirer shall recognise, separately from goodwill, the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquiree” .

There are certain exceptions to the general recognition principle.

• Contingent liabilities
• Income taxes
• Employee benefits
• Regulatory deferral account balances
• Indemnification assets

An asset or liability, in order to qualify for recognition, should meet the definitions contained in the IASB’s Conceptual Framework.

The definitions are as follows:

(a) An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.

(b) A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.”

Step 5

Recognising and measuring goodwill or a gain from a bargain purchase

Goodwill is defined as “an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognised” .

Goodwill might arise in the acquiring group’s consolidated financial statements where a new subsidiary is acquired. Goodwill can also arise in the separate financial statements of an acquiring entity where it purchases the business and assets of another entity.

Goodwill is measured, at the acquisition date, as the amount by which the figure at A exceeds the figure at B below:

A=The aggregate of:

• B = The assets and liabilities recognised in accordance with IFRS 3.

Groups will need to keep detailed records of the composition of the aggregate amount of acquired goodwill − that is, to which parts of the group it relates. Goodwill must be allocated to cash-generating units (CGUs), or groups of CGUs, in order to carry out impairment reviews and to account for subsequent disposals.