Chapter 8: Recognising and measuring identifiable assets acquired, liabilities assumed and non-controlling interest

IFRS 3 states that 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:

1. 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.
2. 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.

There is no explicit requirement for an asset or liability to be reliably measurable, except for contingent liabilities. An asset is identifiable if it either:

• is separable (that is, capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, identifiable asset or liability, regardless of whether the entity intends to do so);
• or arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations.

The assets and liabilities should exist at the acquisition date. Assets and liabilities that arise after the acquisition (such as future liabilities incurred to carry out restructuring of the acquiree) are not recognised.

Benefits that the acquirer expects to accrue to its own business as a result of the acquisition are not recognised as identifiable assets, but rather are subsumed into goodwill.

Items that do not meet the definition of assets: potential contracts

Items that do not meet the definition of assets include potential contracts that are under negotiation at the acquisition date. The relationships associated with those potential contracts might meet the definition of an intangible asset, but the potential contracts themselves do not. Such items form part of goodwill.

Items that do not meet the definition of assets: contingent assets

Contingent assets occur where an entity is uncertain whether an asset exists at a reporting date, but where a future event that is outside the entity’s control will confirm whether or not the asset exists. Contingent assets do not meet the definition of assets in the Conceptual Framework, so they are not recognised in a business combination. If an asset exists at the date of acquisition, being an unconditional right, it is not a contingent asset, and so it is recognised at fair value or in accordance with the relevant standards.

Assets and liabilities identified in an acquisition that were not identified before acquisition

All identifiable assets and liabilities of the acquired business are recognised. Acquisition accounting might result in the recognition of a number of assets and liabilities of the acquired business that were not recorded in its own financial statements. Not all items that meet the definitions of assets and liabilities are necessarily recorded in an entity’s financial statements as soon as they are identified (for example, intangible assets or contingent liabilities). However, in business combination accounting, intangible assets are recognised if they are identifiable, and contingent liabilities are recognised if they can be measured reliably. Probability is reflected in the fair value measurement.

Example

Assets that an acquirer might recognise include:

1. Customer lists. Entity A, a retailer, has developed extensive customer lists. Entity A frequently licenses these lists to other third parties, because there are no confidentiality agreements that prohibit selling, exchanging or leasing the information. Entity A has not recognised an intangible asset in connection with these customer lists, since IAS 38 prohibits the recognition of internally generated intangible assets. Entity B, a competitor, acquires entity A. Entity B recognises an intangible asset in connection with the customer lists, because they are identifiable: the customer lists meet the separability criterion and they are identifiable.
2. Assets that the acquiree did not recognise because it did not prepare its financial statements in accordance with IFRS. Entity E acquires entity F, which operates in country Y. Entity F uses YGAAP and has not recognised, on its balance sheet, the fair value of the interest rate swaps and forward currency contracts used to manage its interest rate and currency exposures. Entity E recognises the fair value of entity F’s derivative financial instruments as identifiable assets or liabilities. Examples of liabilities that might crystallise as a result of an acquisition are those arising from pre-existing contractual arrangements, such as compensation clauses in directors’ service contracts that are triggered in the event of a change of ownership.

Assets and liabilities of an acquiree that are not recognised by the acquirer

Some items that are recognised by the acquiree might not be recognised by the acquirer. An example is goodwill recognised in the acquiree’s balance sheet from previous business combinations. That purchased goodwill is not an identifiable asset of the acquiree.

Classifying or designating identifiable assets and liabilities

An acquirer makes classification, designation and assessment decisions for the identifiable assets and liabilities of an acquiree based on conditions at the acquisition date. The conditions to consider are the contractual terms, economic conditions and the acquirer’s operating and accounting policies, as well as any other pertinent factors. The classification might affect recognition and measurement after the acquisition date.

There are two exceptions to the principle of re-assessment at the date of acquisition. These apply to lease contracts in which the acquiree is the lessor under IFRS 16 and insurance contracts. Such contracts are classified based on the original contract terms or on any subsequent modification (as operating or finance leases and as insurance contracts respectively). They are not re-assessed at the acquisition date unless they are modified at that date. This does not apply to errors in classification made by the acquired entity.

Leases in which the acquiree is the lessor under IFRS 16 and insurance contracts should be re-assessed where errors have been made by the acquired entity. Similarly, if the acquiree did not apply IFRS, the acquirer should classify and designate all contracts at the acquisition date.

Examples of where a classification, designation or assessment decision is required

Some common examples where a classification, designation or assessment decision is required are given in the table below.

The post-combination accounting for particular items can depend on how they are classified or designated. For example:

• The IFRS 9 categories result in different measurement methods for financial assets and liabilities.
• Designation as a hedging instrument gives different accounting for a derivative or non-derivative financial instrument.
• Separation or not of an embedded derivative result in different accounting.

Designate each financial asset as: at fair value through profit or loss: Hedge accounting

An acquirer purchases entity B on 1 January 20X0. Entity B has several interest rate swaps, which it is using to fix interest rates on its long-term liabilities. Entity B has appropriately documented these interest rate swaps as cash flow hedging instruments, in accordance with IFRS 9. The interest rate swaps will expire in three years from 1 January 20X0.

The swaps are in a liability position of C1,500 at the date of acquisition. An acquirer cannot assume the continuation of hedging relationships in its consolidated financial statements. The acquirer must designate hedging relationships on the basis of the pertinent conditions as they exist at the acquisition date.

The acquirer will, therefore, need to re-designate all of entity B’s hedging relationships if it wants to recognise those relationships in its consolidated financial statements. available-for-sale; held to maturity; or Designate each financial liability as: at fair value through profit or loss; or Designating derivatives with non-zero fair values leads to ineffectiveness.

The ineffectiveness might be so great, in some cases, that the relationship would fail to qualify for hedge accounting and would need to be adjusted to its fair value each reporting period through profit and loss. Hedging relationships need to be contemporaneously documented. The acquirer will, therefore, need to have all hedging documentation in place at the date of acquisition.

The acquirer will want to understand the type of hedging that entity B has done before the acquisition date, so that it can understand what new derivatives it might need to acquire and the contemporaneous documentation that it will need to put in place at the acquisition date. Entity B might want to close out its derivative instruments immediately before the acquisition date, to avoid some of the pitfalls with non-zero fair value derivatives. This would allow the acquirer to enter new derivative instruments, with a zero-fair value on the acquisition date, for the desired hedging relationships.

The acquirer has the flexibility to reclassify financial assets and liabilities of the acquired business on the acquisition date. The acquirer might choose, as an alternative to closing out entity B’s derivatives, to use the fair value option for some hedged items. This would reduce mismatches in income because of remeasuring the derivative instrument at fair value each period.

Application of measurement requirements

Assets that the acquirer does not intend to use

Fair value is based on assumptions made by market participants; it is not an entity-specific concept. The acquirer’s specific intentions are not relevant when measuring an asset’s fair value. If the acquirer intends to put an asset to a use that would realise less value than the fair value, or if it intends not to use the asset at all, this does not affect its fair value at the acquisition date.

But the acquirer’s intention or subsequent use of the asset might affect the asset’s useful life after the acquisition date.

Measurement Practical application of measurement requirements

Post-combination change of use does not impact fair value at acquisition date

Entity A acquires entity B in a business combination. Entity B’s assets include a factory that entity A plans to phase out over the next three to five years. Entity B carries the factory at cost less accumulated depreciation. Entity A also plans to align entity B’s customer warranties with its own more favourable terms, and to settle pending litigation out of court. Entity A wishes to record the factory at a nominal amount in the business combination, to recognise a warranty provision based on its intended settlement terms, and to include the settlement contingent liability at the amount it expects to pay in court.

Can it do this? No. The fair value attributed to assets and liabilities is not affected by the acquirer’s intentions; it is based on market participant assumptions.

The factory should be recorded initially at fair value. The decision to phase out the facility is a trigger for impairment testing after the acquisition date, as well as for re-assessing useful economic life. Management carries out an impairment test in accordance with IAS 36. The carrying amount is depreciated to its estimated residual value over three to five years. Entity A’s decision to phase out the factory does not affect its fair value at the date of the business combination.

The acquirer’s intention to provide more generous warranty settlements is not recognised in the business combination. The warranty provision is valued based on contractual terms at the acquisition date. The warranty provision is increased only when a constructive obligation exists, with a corresponding charge to the income statement. The pending litigation represents a contingent liability at the date of acquisition and is recognised in the business combination at fair value.

This amount might be different from the amount that entity A is planning to offer. Fair value reflects expected cash flows, which are based on the probabilities of the different potential outcomes.

Fair values not affected by the acquirer’s intentions: intangible assets that the acquirer does not intend to use

Entity J has acquired its principal competitor, entity K. Entity J’s management has explained that its motivation for the acquisition was to acquire market share by taking its rival’s brand out of the market. Management has proposed to measure the brand at a minimal value, because it will be removed from the market shortly after the acquisition. Management’s proposal is not appropriate in these circumstances.

The fair value attributed to assets and liabilities is not affected by the acquirer’s intentions. The fair value is what a hypothetical market participant would pay for the assets. The value of the brand name is based on assumptions that would be made by market participants in determining the price at which they would transact. An entity’s intentions and subsequent use of the asset will affect its useful life after the acquisition date.

Direct benefits will be received for as long as the asset is directly used. However, an entity might continue to receive indirect benefits from an asset if it prevents the asset from being used by others. The useful life should reflect the acquiring entity’s consumption of the asset’s expected benefits. This life is the time period over which the asset is expected to contribute directly or indirectly to the acquiring entity’s future cash flows. We would not expect such an asset to be expensed immediately at the date of acquisition, nor would we expect such an asset to have an indefinite useful life.

This intangible asset will need to be reviewed and tested for impairment, when appropriate, in the post-combination period under IAS 36.

Asset valuation allowances

A separate valuation allowance, such as a provision for impairment of receivables, is not recognised when assets are measured at their acquisition date fair values. The asset’s fair value includes the probabilities and uncertainties regarding future cash flows.

Loss allowances relating to financial assets at the first reporting date under IFRS 9

A financial asset acquired in a business combination could attract a loss allowance at the first reporting date after it is recognised under IFRS 9, even if that date is the date on which the business combination has taken place. These acquired assets are treated in the same way as other financial assets for recognition of impairment. No additional loss allowance is required for credit-impaired financial assets (stage 3) if there are no changes in the cumulative lifetime expected credit loss since acquisition date. This differs from other purchased financial assets.

Contracts

Intangible assets or liabilities might be recognised for certain contracts whose terms are favourable or unfavourable to current market terms. The terms of a contract should be compared to market prices at the date of acquisition, to determine whether an intangible asset or liability should be recognised. If the terms of an acquired contract are favourable relative to market prices, an intangible asset is recognised. If the terms of the acquired contract are unfavourable relative to market prices, a liability is recognised.

Favourable and unfavourable purchase contracts

A significant area of judgement, in measuring favourable and unfavourable contracts, is whether contract renewal or extension terms at the same price should be considered. The following factors should be considered when determining whether to include renewals or extensions: Whether the renewals or extensions are at the acquiree’s discretion, without the need to renegotiate key terms. Renewals or extensions that are within the acquiree’s control are likely to be considered if the terms are favourable to the acquirer. Whether there are any other factors that would indicate that a contract might or might not be renewed. Each arrangement is recognised and measured separately. The resulting amounts for favourable and unfavourable contracts are not offset. The following examples deal with recognising and measuring favourable and unfavourable contracts.

Example 1 – Favourable purchase contract

Entity A acquires entity B in a business combination. Entity B purchases electricity through a contract, which is in year three of a five-year arrangement. At the end of the original term, entity B has the option, at its sole discretion, to extend the purchase contract for another five years. The annual cost of electricity under the original contract is C80 per year, and the annual cost for the five-year extension period is C110 per year. The current annual market price for electricity at the acquisition date is C200, and market rates are not expected to change in the future. Assume that entity B meets the own use exemption and does not account for the contract as a derivative. Entity B’s purchase contract for electricity is favourable. Both the original contract and extension terms allow entity B to purchase electricity at amounts below the annual market price of C200 in this situation. Entity A is likely to consider the favourable five-year extension term, as well as the remaining two years of the original contractual term.

Example 2 – Unfavourable purchase contract

Assume the same facts as above, except that the current annual market price for electricity at the acquisition date is C50, and market rates are not expected to change in the future. Entity B’s purchase contract is unfavourable. Both the original contract and extension terms require it to pay amounts in excess of the current annual market price of C50 in this situation. Entity A recognises a liability for the two years remaining under the original contract term, but the extension term is not considered in measuring the unfavourable contract, because entity A can choose not to extend the contract.

Onerous contracts

An onerous contract occurs if the unavoidable costs of meeting the obligations under a contract exceed the expected future economic benefits to be received.

Unprofitable operations of an acquired business do not necessarily indicate that the contracts of the acquired business are onerous.

An onerous contract should be recognised as a liability.

Measurement of onerous contracts

When measuring an onerous contract, an acquirer should consider whether the amount to be recognised should be adjusted for any intangible assets or liabilities already recognised for contract terms that are favourable or unfavourable, compared to current market terms. If a liability for an onerous contract is recognised, an acquirer should have support for certain key assumptions, such as market price and the unavoidable costs to fulfil the contract (for example, manufacturing costs and service costs).

Example

Entity A acquires entity B in a business combination. Entity B is contractually obliged to fulfil a fixed-price contract for a fixed number of components for one of its customers.

Components to be produced after the acquisition date: 5,000

Contract price is: C80 per component

Unavoidable costs are: C95 per component

Entity B’s unavoidable costs to manufacture the component exceed the sales price in the contract. Entity B has incurred losses on the sale of the components. The combined entity is expected to continue to do so in the future. What assets and liabilities related to this contract should be recognised, and how should they be measured?

Scenario 1: Market price is C90 per component

This contract is unfavourable, compared to current market terms. The carrying value of the unfavourable component is (C90 – C80) × 5,000 = C50,000. Fair value of the liability at acquisition date is C48,000. Onerous component of the contract is (C95 – C90) × 5,000 = C25,000. Fair value of the provision at the acquisition date is C24,000. Entity A would record a liability related to the unfavourable component of C48,000 and a provision related to the onerous contract of C24,000.

Scenario 2: Market price is C100 per component

This contract is unfavourable, compared to current market terms. The carrying value of the unfavourable component is (C100 – C80) × 5,000 = C100,000. Fair value of the liability at the acquisition date is C96,000. Entity A would record a liability related to the unfavourable component of C96,000. No additional provision for the onerous contract should be recognised.

Intangible assets

An intangible asset is an identifiable non-monetary asset without physical substance.

An acquirer recognises an acquiree’s intangible assets at the acquisition date if they are identifiable. An asset is identifiable if it arises from contractual or legal rights or is separable from the business.

An intangible asset that meets the contractual legal criterion is identifiable and recognised, whether it is separable or not.

Intangible assets that are not separable

The standard’s application guidance includes some examples of intangible assets that are contractual-legal and not separable.

Example 1

An acquiree owns and operates a nuclear power plant. The licence to operate that power plant is an intangible asset that meets the contractual-legal criterion for recognition separately from goodwill, even if the acquirer cannot sell or transfer it apart from the acquired power plant. An acquirer could recognise the fair value of the operating licence and the fair value of the power plant as a single asset for financial reporting purposes, if the useful lives of those assets are similar.

Example 2

An acquiree owns a technology patent. It has licensed that patent to others for their exclusive use outside the domestic market, receiving a specified percentage of future foreign revenue in exchange. Both the technology patent and the related licence agreement meet the contractual-legal criterion for recognition separately from goodwill, even if selling or exchanging the patent and the related licence agreement apart from one another would not be practical.

Intangible asset that is separable only with another asset

Example 1 – Trademark and related expertise

Entity A acquired entity B. Entity B has a trademarked product, and it has inhouse (but not legally protected) expertise that is needed to produce the trademarked product. It can only sell the trademark along with the related unprotected expertise. Is the expertise recognised as an intangible asset in the business combination? Yes. The unprotected expertise does not meet the contractual-legal criterion. However, because it can be separated from entity B and sold if the trademark is sold, it meets the separability criterion. [IFRS 3 App B para B34(b)].

Example 2 – Deposits and depositor relationship

Entity C acquired entity D. Entity D operates in a territory where deposit liabilities and the related depositor relationships are exchanged in observable transactions. Does entity C recognise the depositor relationships in the business combination? Yes. The relationships can be sold together with the related deposits, and there is evidence of this separability through exchange transactions. [IFRS 3 App B para B34(a)].

Identifying intangible assets in media and telecommunications

Entity E acquired entity F. Entity E is a media company with operations in telecommunications and entertainment. The goodwill, following allocation of the initial purchase price, was larger than management had expected. A subsequent detailed analysis of the business valuations and due diligence reports identifies that the following items have been included in goodwill: Concession to operate a telecom network. Broadcasting licence. Highly skilled assembled workforce. Employment contracts for key employees, with enforceable noncompete clauses. Talent contracts for star presenters, also with enforceable non-compete clauses. Advertising contracts. Contractual customer relationships. Programming rights for first exclusive re-run of two popular programmes. Databases containing customer information. Should these items be recognised separately from goodwill? There are a number of items currently incorrectly included in goodwill that management should recognise as separate intangible assets. The concession to operate a telecom network and the broadcasting licence are protected by legal rights and are separable from the entity. Both meet the contractual-legal criterion. They should, therefore, be recognised as intangible assets. The assembled workforce remains subsumed in goodwill.

It represents the value that allows the acquirer to operate the acquired business from the date of acquisition, and it is not the intellectual capital of the workforce. It is not identifiable, being neither separable from the business nor contractual in nature. It should not, therefore, be recognised separately from goodwill.. Non-compete clauses in employment contracts give rise to economic benefits, as a result of legal rights, and they should be recognised as intangible assets.

The entity can control the benefits arising from employment through provisions in the contracts, unlike the assembled workforce. These prevent employees from passing on valuable company information to a competitor for a period after leaving. The future benefits arising from working with a number of star presenters employed by the acquired entity are protected by legal rights through talent contracts, and they are legally enforceable. These contracts are also separable from the acquired entity, and they should be recognised separately as intangible assets. An intangible asset theoretically exists to the extent that an employment contract is beneficial, compared to market terms.

However, the recognition of favourable or unfavourable employment contract assets and liabilities is rare in practice. Normal employment contracts rarely give rise to favourable or unfavourable assets, because they are very difficult to measure against ‘market rates’ and are not enforceable. Benefits from advertising contracts and programming rights are protected by legal rights, as well as being separable from the entity. They should be recognised as separately identifiable intangible assets.

Customer information stored in databases will be used by the acquirer in future advertising campaigns. Benefits from the use of the databases are not protected by legal rights. Whether they are separable from the acquired entity depends on applicable data protection legislation. If legislation allows the acquirer to separate the information contained in the databases from the business and sell it to a third party, it should be recognised as a separately identifiable intangible asset. If not, it should be subsumed in goodwill.