Fair value is a market participant notion. As such, it reflects the asset’s economic life, which might differ from the contractual life. Market participants might anticipate the ability to renew the contractual or legal right embodied in the asset. Fair value reflects market participant views of the likelihood of renewing the rights inherent in an asset and the value of any such renewal. The renewals themselves do not need to meet the identifiability criterion

An asset’s useful life should not normally exceed the period of the contractual or legal rights. If the contractual or legal rights include renewal periods, the useful life would include the renewal period(s) if there is evidence to support renewal by the entity without significant cost. A significant renewal cost represents, in substance, the cost of acquiring a new intangible asset at the renewal date.

The carrying amount of the intangible asset should be fully amortised by the renewal date, and the renewal cost is then capitalised as a new intangible asset.

Re-acquired rights

An acquirer might have granted to an acquiree a right to use one or more of the acquirer’s recognised or unrecognised assets. Examples include a right to use the acquirer’s trade name under a franchise agreement or a right to use the acquirer’s technology under a licensing agreement. The acquirer might re-acquire this right on acquisition of the acquiree. Re-acquired rights generally are identifiable intangible assets that the acquirer recognises separately from goodwill.

Re-acquired rights that include a royalty or other type of payment provision should be assessed for contract terms that are favourable or unfavourable if compared to pricing for current market transactions. A settlement gain or loss should be separately recognised and measured at the acquisition date for any favourable or unfavourable contract terms identified. A settlement gain or loss related to a re-acquired right should be measured under the guidance for the settlement of pre-existing relationships.

The amount of any settlement gain or loss should not impact the measurement of the fair value of any intangible asset related to the reacquired right.

Determining useful life of re-acquired rights

The useful life over which the re-acquired right is amortised in the post-combination period should be based on the remaining contractual term, without consideration of any contractual renewals. In the event of a reissuance of the re-acquired right to a third party in the post-combination period, any remaining unamortised amount related to the re-acquired right should be included in determining any gain or loss on re-issuance.

The acquirer’s in-process research and development

The acquiree’s in-process research and development is recognised by the acquirer separately from goodwill if it is identifiable. Example Entity G, a pharmaceutical group, acquires entity H, a rival pharmaceutical business. Entity H has incurred significant research costs in connection with two new drugs that have been undergoing clinical trials. One drug has not been given regulatory approval, although entity G expects that approval will be given within two years. The other drug has recently received regulatory approval.

The drugs’ revenue-earning potential was one of the principal reasons why entity G decided to acquire entity H.

Are either of the drugs recognised as intangible assets?

Yes. Both drugs are separable: there is evidence of exchange transactions of early-stage compounds and of late-stage products, and both are protected by patents. The fair value of rights to both drugs is recognised. The fair value of the first drug reflects the probability and the timing of the regulatory approval being obtained. Probable future economic benefits are presumed in respect of the asset acquired, and an asset is recognised. Subsequent research expenditure is expensed in accordance with IAS 38. It will be expensed until the criteria for capitalisation as development expenditure are met. The rights to the second drug also meet the recognition criteria in IAS 38 and are recognised. The approval means that it is probable that future economic benefits will flow to entity G. This will be reflected in the fair value assigned to the intangible asset.

Re-acquired rights: Useful life of a re-acquired right

A re-acquired right is not the same as a contractual right acquired from a third party. A re-acquired right recognised as an intangible asset is to be measured on the basis of the remaining contractual term of the contract that gave rise to the right, without taking into account potential renewals of that contract. Otherwise, an acquirer who controls a re-acquired right could assume indefinite renewals of its contractual term, effectively making the re-acquired right an intangible asset with an indefinite life. A right re-acquired from an acquiree in substance has a finite life (that is, the contract term); a renewal of the contractual term after the business combination is not part of what was acquired in the business combination. A re-acquired right with a finite life should be amortised over its economic useful life. In some cases, the re-acquired right might not have any contractual renewals, and the remaining contractual life might not be clear (such as with a perpetual franchise right). In such cases, an assessment should be made as to whether the re-acquired right is an indefinite-life intangible asset that would not be amortised but is subject to periodic impairment testing. A conclusion that the useful life of a re-acquired right is indefinite requires careful consideration and is expected to be infrequent.

Property, plant, and equipment

Property, plant, and equipment acquired in a business combination is recognised and measured at fair value Accumulated depreciation of the acquiree is not carried forward in a business combination.

Valuation of property, plant and equipment

The fair value of property, plant and equipment is estimated using conventional measurement principles. Market values will often be available. For land and buildings, the acquirer uses market values, normally determined by appraisal. For plant and equipment, an acquirer might need to estimate fair value, using a method such as the replacement cost approach for specialised plant and equipment that is rarely sold.

Valuation of assets acquired with funding from government grant

If the acquiree received a government grant to fund the acquisition of an asset, the asset should be recognised at its fair value, without regard to the government grant. The terms of the government grant should be separately evaluated, to determine whether there are ongoing conditions or requirements that would indicate that a separate liability exists.

Decommissioning and site restoration costs

An acquirer might obtain a long-lived asset (such as property, plant, and equipment) with a dismantlement, restoration or decommissioning liability. The decommissioning obligation is recorded at fair value (using market participant assumptions), which might be different from the amount recognised by the acquiree. If the asset’s fair value is determined on a basis that includes the cash outflows associated with decommissioning the asset, the fair value of the decommissioning liability and the asset will need to be bifurcated and recorded gross on the acquisition date balance sheet.

Example

A nuclear power plant is acquired in a business combination. The acquirer determines that a retirement obligation of C100 million associated with the power plant exists. The appraiser has included the expected cash outflows of the retirement obligation in the cash flow model, establishing the value of the plant at C500 million. The appraised value of the power plant would be C100 million higher if the retirement obligation is disregarded.

Is it correct to record the value of the power plant as C500 million?

No. The acquirer would record the power plant at its fair value of C600 million, and a separate liability of C100 million for the retirement obligation.

Inventory

Inventory acquired in a business combination is recognised and measured at fair value. Fair value of inventory is usually higher than the amount recognised by the acquiree before the business combination.

Treatment of Work-in-progress and finished goods

Work-in-progress and finished goods are measured at fair value. When considering the fair value of inventories, the measurement bases listed below are often applied: Raw materials – current replacement cost. Work-in-progress – selling price of finished goods, less the sum of (a) costs to complete, (b) costs of disposal, and (c) a reasonable profit allowance for the completing and selling effort, based on the profit for similar finished goods. Finished goods – selling price, less the sum of (a) the costs of disposal, and (b) a reasonable profit allowance for the acquirer’s selling effort, based on the profit for similar finished goods. IFRS 13 contains guidance on how fair values should be determined.

Example 1 – Fair value of finished goods of a retail outlet

IFRS 13 includes a discussion of how an acquirer might fair value finished goods inventory when acquiring a retail outlet in a business combination. A valuation input would be either a price to customers in a retail market or a price to retailers in a wholesale market, adjusted for differences between the condition and location of the inventory item and similar inventory items. Fair value measurement then reflects the price that would be received in a transaction to sell the inventory to another retailer that would complete the requisite selling efforts. Conceptually, the fair value measurement will be the same, whether adjustments are made to a retail price (downward) or to a wholesale price (upward). Generally, the price that requires the least number of subjective adjustments should be used for the fair value measurement.

Example 2 – Fair value of finished goods of a trading company

Applying IFRS 3 to merchandise stock of a trading company requires the valuation to be uplifted to fair value. The profit allocated to the completion and selling effort should be reasonable, based on the profit for similar finished goods. Another example is the valuation of merchandise stock of a trading company. It could be argued that the value added results mainly from the selling efforts of the distribution organisation. Furthermore, part of the profit could be allocated to the procurement department, because it could be argued that it contributes to the value added by negotiating advantageous prices. The impact of the valuation requirement for work-in-progress and finished goods can lead to significant adjustments in a business combination from the cost-based measured in the acquiree’s own financial statements. The remeasurement of inventory usually depresses post-combination profit margins of the acquired business, if the inventory’s fair value is higher than the cost-based measurement.

Long-term construction contracts: adjusting work-in-progress to fair value

Entity A designs and builds housing estates. Buyers of houses can specify particular design details, but the overall street and house design is determined by the house builder. The house builder accounts for the houses as separate performance obligations satisfied at a point in time under IFRS 15. Entity A has been acquired in a business combination. At the acquisition date, it has houses under construction that are, on average, 40% complete.

When completed, the total cost of construction for each house will be C90,000; each house will be sold at expected proceeds of C160,000, less selling costs of C10,000. In entity A’s books, each house currently being carried at C36,000. Applying IFRS 3 to work-in-progress requires the valuation to be uplifted to fair value. One method for determining fair value would be to consider the selling price less costs to complete, costs of disposal and expected margin. For example, management could take the selling price (C160,000) less costs to complete (assume C54,000), costs of disposal (assume C10,000) and a reasonable profit allowance for the completing and selling effort, based on the profit for similar finished goods.

The profit is made up of a construction profit and a selling profit. The profit allocated to the completion and selling effort should be reasonable, based on the profit for similar finished goods. One method for splitting the profit between the selling and construction effort is to allocate the profit in line with the relative cost of the construction and selling effort.

The construction costs are C90,000, out of total costs of C100,000, and so 90% of the profit of C60,000 is allocated to construction (C54,000) and 10% is allocated to selling (C6,000). If this allocation method is adopted, the work-in-progress valuation is calculated as follows:

This value is C21,600 higher than the book value at acquisition. It includes 40% of the C54,000 profit expected to be derived from the construction process, reflecting the fact that, at the acquisition date, the houses were already partially constructed. Whether other allocation methods are acceptable depends on the facts and circumstances. For example, there might be comparable items that are directly observable in a market. All components of acquired long-term performance obligations that are satisfied over time under IFRS 15 and that are in process on the acquisition date should be recognised at fair value.

The price that would be paid (received) to transfer the obligations (rights) to a market participant should be used to measure the contracts at fair value. The fair value of acquired performance obligations that are satisfied over time under IFRS 15 is not impacted by the acquiree’s method of accounting for the contracts before the acquisition or the acquirer’s planned accounting methodology in the post combination period.

Fair value is determined using market participant assumptions in line with IFRS 13. After the acquisition, the acquirer should account for the acquired performance obligations in accordance with IFRS 15.

Income taxes

Deferred income taxes are recognised and measured in accordance with IAS 12. Deferred taxes are provided on all the temporary differences arising between the values assigned to identifiable assets and liabilities and their tax bases.

The acquirer accounts for the potential tax effects of the temporary differences and carry-forwards of the acquiree that exist at the acquisition date or arise as a result of the business combination.

Fair value adjustments made to the acquired entity’s identifiable assets, liabilities and contingent liabilities might give rise to temporary differences, and these are tax-effected and recognised as deferred taxes.

Deferred tax assets relating to losses carried forward

The acquired entity might not have recognised a deferred tax asset in respect of its past tax losses or deductible temporary differences, because it was unable to satisfy the deferred tax asset recognition criteria. The acquirer might determine that other entities within the group will have sufficient future taxable profits to realise the tax benefits through transfer of those losses, as permitted by the tax laws. Alternatively, the expected future taxable profits of the acquiree might increase from cost savings or other synergies after acquisition. The tax benefits satisfy the criteria in paragraph 24 of IAS 12 for separate recognition of an identifiable asset of the acquiree at the acquisition date.

A deferred tax asset attributable to the unused tax losses is recognised as an acquired asset in the business combination accounting.

 Goodwill

Any difference between the carrying amount of goodwill and its tax base of nil gives rise to a taxable temporary difference that would usually result in a deferred tax liability. No deferred tax liability is recognised in relation to goodwill. Goodwill is measured as a residual, and so recognising the deferred tax liability would increase the carrying amount of the goodwill. Where purchased goodwill is non-deductible for tax purposes, it has a tax base of nil. This is the case where goodwill impairments are not allowed as a deductible expense in determining taxable profits and the cost of the goodwill is not deductible when the subsidiary is sold.

No deferred tax benefit can be recognised on any subsequent reduction in the temporary difference where the deferred tax liability itself is not recognised.

A taxable temporary difference arises where the cost of purchased goodwill is deductible for tax purposes through tax amortisation over a number of years. Any taxable temporary difference that arises at the date of the business combination does not result in a deferred tax liability

A taxable temporary difference arising after the business combination does result in a deferred tax liability.

A business combination might result in a deductible temporary difference if the carrying amount of goodwill is less than its tax base. A deferred tax asset is recognised as part of the business combination accounting (thereby reducing goodwill) if it is probable that there will be taxable profits against which the deductible temporary difference can be used.

Effect of reduction in the temporary difference where the deferred tax liability was not recognised

Goodwill of C500 is recognised in a business combination that is not deductible for tax purposes. No deferred tax is provided. After the business combination, the goodwill is impaired by C100. The temporary difference is reduced from C500 to C400. The decrease in the unrecognised deferred tax liability relates to the initial non-recognition of the liability, so the reduction cannot be recognised.

Temporary difference arising after the date of the business combination

Entity C acquires subsidiary D in a business combination. Goodwill of C500 is recognised, and C400 is deductible for tax purposes. How is the goodwill tax effected? No deferred tax liability is recognised on the taxable temporary difference of C100 arising on goodwill in the business combination, following the rule in paragraph 21 of IAS 12. In the year following the business combination, C50 of the goodwill is amortised for tax purposes. A taxable temporary difference of C50 arises and a deferred tax liability is recognised. The liability recognised in the year following the business combination is on the taxable temporary difference of C50 that did not arise on the initial recognition of goodwill.

The total temporary difference is C150 (C500 – C350); but C100 of that temporary difference arose on initial recognition of goodwill, and no deferred tax is recognised in respect of that temporary difference.

Assets held for sale

IFRS 5 allows assets (or disposal groups) to be classified as held for sale if they meet that standard’s criteria within a short period (usually three months) after a business combination. This assessment is made from the combined entity’s perspective: the IFRS 5 criteria do not need to be met by the acquiree at the date of acquisition.

A subsidiary acquired with a view to resale should be classified as a discontinued operation.

Regulatory deferral account balances

A regulatory deferral account balance is an amount that would not be recognised as an asset or a liability in accordance with other standards. However, it qualifies for recognition and deferral under IFRS 14 because it is included or expected to be included by the rate regulator in establishing the rate that can be charged to customers.

IFRS 14 applies only if the standard was applied by an entity on first-time adoption of IFRS.

IFRS 14 requires an entity to continue to apply its previous GAAP accounting policies for the recognition, measurement, and impairment and derecognition of such regulatory deferral account balances.

Where an entity acquires a business that includes regulatory deferral account balances, these balances are an exception to the recognition and measurement principles. In its consolidated financial statements, the acquirer applies its accounting policies established under IFRS 14 for the recognition and measurement of the acquiree’s regulatory deferral account balances at the date of acquisition. The acquiree’s regulatory deferral account balances are recognised in the acquirer’s consolidated financial statements in accordance with the acquirer’s policies, irrespective of whether the acquiree recognises those balances in its own financial statements.

Employee benefit plans

Employee benefit plans are an exception to the recognition principle. Employee benefit plan assets and obligations are recognised in accordance with the guidance in IAS 19.

A net employee benefit asset is recognised only to the extent that it will be available to the acquirer in the form of refunds from the plan or a reduction in future contributions.

Expected settlements by the acquirer of the acquiree’s plans would not be recognised until the relevant requirements in IAS 19 are met. Settlements are recognised in the measurement of the plan’s benefit obligations only if the settlement event has occurred by the acquisition date. A settlement occurs where an entity enters into a transaction that eliminates all further legal or constructive obligations for all or part of the benefits provided under a defined benefit plan. It would not be appropriate to recognise a settlement on the basis that it was probable.

Past service costs are recognised in the measurement of the plan’s benefit obligations only if IAS 19’s recognition requirements are met at the acquisition date. Past service costs are recognised at the earlier of the date when the plan amendment or curtailment occurs and the date when the entity recognises related restructuring costs or termination benefits.

Past service costs or curtailments that are probable at the acquisition date should not be recognised.

Employee benefit plans: Recognising post-retirement benefits

Reference to standard: IAS 19 para 103

Entity A made three acquisitions in 20X9 – entities B, C and D: a. Entity B has a defined benefit pension plan for all of its employees. It prepares financial statements in accordance with IFRS. Its most recent financial statements show that the defined benefit obligation was calculated using assumptions about projected salary increases and a discount rate that differ significantly from those that entity A uses. b. Entity C has an unfunded defined benefit pension plan. It does not prepare financial statements in accordance with IFRS, and it recognises pension costs when cash payments are made to the plan. c. Entity D has a defined benefit pension plan for all of its employees. The fair value of plan assets exceeded the present value of plan obligations. Further investigation reveals that the rules of entity D’s pension plan prohibit refunds or contribution holidays (or reductions). Entity A measures its employee benefit liabilities at the date of acquisition as follows:

19. The net pension liability is measured as the difference between the net present value of the defined benefit obligation and the fair value of plan assets, in accordance with IAS 19. Entity A reviews the assumptions used to calculate entity B’s defined benefit obligation, and it remeasures the obligation using more appropriate assumptions if the assumptions used by entity B are inconsistent with entity A’s expectations.
20. The net present value of the defined benefit pension obligation incurred by entity C is calculated in accordance with IAS 19, using appropriate assumptions. The pension obligation is recognised as an identifiable liability. c. An asset is not recognised at the acquisition date. The rules of entity D’s pension plan prevent entity A from obtaining any benefits from the plan, so the asset ceiling test in IAS 19 restricts the surplus recognised to nil.

Entity A values the pension plan assets and liabilities in accordance with IAS 19, and it discloses the irrecoverable surplus.

Modification of pension plans

An acquirer that is obliged to replace an acquiree’s share-based payment awards is required to include all or a portion of the market-based measure of the replacement awards in the measurement of consideration transferred. This obligation could arise if the terms of the acquisition agreement require replacement of the award, or if the plan itself has an automatic change of control clause requiring replacement.

A question arises as to whether liabilities that occur from modifying a pension plan can also be included in acquisition accounting if the terms of the modification are written into the acquisition agreement. The modification of pension plans should generally be treated separately from a business combination. The standard requires separate accounting for transactions that are not part of a business combination, even if entered into simultaneously. A transaction that primarily benefits the acquirer is likely to be a separate transaction.

A transaction that remunerates employees of the acquiree for future services is a separate transaction. An acquirer generally initiates a modification of a pension plan for its own benefit. The modification will also typically relate to future services of the employees. Treating a pension modification separately from a business combination is also consistent with the approach that IFRS 3 takes for replacement share based payment awards. To the extent that replacement awards are vested, the corresponding portion of the fair value of the awards is included in consideration transferred; this is because it relates to employees acting in their capacity as shareholders.

The portion of the fair value of the replacement awards for the unvested element, however, represents future compensation expense, because it relates to future service by the employees. Similarly, a modified pension plan relates to future service of employees.

Financial instruments

Financial instruments that form part of the acquiree’s net identifiable assets are measured at fair value at the date of the business combination. For those instruments already held at fair value by the acquiree, no measurement change will be required. However, a fair value adjustment might be required for other instruments held at amortised cost.

The classification or designation of certain financial instruments must be re-assessed on a business combination.

New evidence of fair value at acquisition date

The fair value of most short-term receivables and payables is usually not significantly different from their book values, because it reflects amounts expected to be received or paid in the short term. Fair value adjustments are usually limited to those arising from the acquirer’s different estimates of amounts recoverable or payable.

Example

A significant customer of an acquired entity has gone into liquidation during the measurement period. No provision was made against the receivables due from the customer in the acquired entity’s books. Is the provision now required to be included in the fair value of the receivables at the acquisition date? Any new evidence that comes to light before the fair value exercise is completed and that concerns the condition, as at the date of acquisition, of the acquired entity’s assets is taken into account in arriving at fair value. The fair value of receivables is one area where a certain amount of further investigation might be necessary. The customer was not in liquidation at the acquisition date, but it might have been in financial difficulties at that date. Unless a specific post-combination event caused the financial difficulties, the fair value of the receivables at the acquisition date should consider the effect of the bankruptcy.