Chapter 13: Assessing what is part of a business combination transaction

Only amounts that are part of what the acquirer and the acquiree (or the acquiree’s former owners) exchange in the business combination are included in the business combination accounting. These items need to be either consideration transferred, or assets acquired and liabilities assumed or non-controlling interest. Items that are not part of the business combination are accounted for separately, under appropriate IFRSs.

Examples of separate transactions are the settlement of pre-existing relationships, creation of non-compete agreements, and key employees’ compensation plans.

A transaction is more likely to be a separate transaction where it has been entered into by or on behalf of the acquirer, or for the benefit of the acquirer or the combined entity, before the business combination.

Indicators of whether the transaction is part of the business combination or not, which are neither mutually exclusive nor individually conclusive, are:

• The reasons for the transaction: a transaction that is arranged for the benefit of the acquirer (or the combined entity), rather than the acquiree or its owners before the business combination, is less likely to be part of the business combination.
• Who initiated the transaction: a transaction that is initiated by the acquirer might be for the benefit of the acquirer (or the combined entity), with little or no benefit for the acquiree or its owners before the business combination.
• The timing of the transaction: a transaction that occurs during the period when the terms of the business combination are negotiated is more likely to have been entered into in contemplation of the combination to benefit the acquirer (or the combined entity). The acquiree or its former owners before the combination are likely to achieve little or no benefit from the transaction, except for those benefits that they will obtain as part of the combined entity.

Settlement of pre-existing relationships between the acquirer and the acquiree

The acquirer and acquiree in a business combination might have a relationship before the business combination occurs. The business combination effectively settles that relationship. Settlement occurs when the relationship becomes an ’inter-company’ relationship and is eliminated on the acquisition. The relationship is treated as ‘settled’, from an external perspective. It might continue the same terms after the acquisition, because any ongoing relationship is internal to the group.

A pre-existing relationship can either be contractual (for example, seller and customer, licensor, and licensee) or it can be non-contractual (for example, plaintiff and defendant)

The acquirer identifies any pre-existing relationships, and it determines which pre-existing relationships have been effectively settled. The amount that the acquirer pays might include an amount (positive or negative) that settles that relationship. This is not part of the business combination, and it is accounted for separately.

If the acquirer has previously recognised an amount in the financial statements related to a pre-existing relationship, the settlement gain or loss related to the pre-existing relationship is adjusted (that is, increasing or decreasing any gain or loss) for the amount previously recognised. The asset or liability would be eliminated on consolidation, because any asset would be considered recovered, and any liability would be considered settled. The elimination entry would impact the gain or loss on settlement.

Calculating gain or loss on settlement of pre-existing relationship

The acquirer might need to recognise a gain or loss for the effective settlement of a pre-existing relationship. If there is more than one contract or agreement between the parties with a pre-existing relationship, or more than one pre-existing relationship, the settlement of each contract and each pre-existing relationship is assessed separately.

Settlement gains and losses from non-contractual relationships are measured at fair value on the acquisition date.

Settlement gains and losses from contractual relationships are measured at the lesser of the following amounts:

1. The amount by which the contract terms are either favourable or unfavourable (from the acquirer’s perspective), compared to pricing for current market transactions for the same or similar items. If the contract terms are favourable compared to current market transactions, a settlement gain is recognised. If the contract terms are unfavourable compared to current market transactions, a settlement loss is recognised.
2. The amount of any stated settlement provisions in the contract available to the counterparty to whom the contract is unfavourable. The amount of any settlement provision, for breach of contract or voluntary termination, is used to determine the settlement gain or loss. Provisions that provide a remedy for events not within the control of the counterparty (such as a change in control, bankruptcy or liquidation) are generally not considered a settlement provision in determining settlement gains or losses.

Calculating gain or loss on settlement of pre-existing relationship

Where the contract is silent on the amount of any settlement provision, it is generally not appropriate to deem the settlement provision to be nil. The commercial substance of the arrangement should be assessed to determine the amount that would be paid to exit the contract. For example, where a contract is unfavourable to the acquirer, the unfavourable element would provide a starting point in assessing the settlement amount. The process for determining the settlement of a pre-existing relationship is illustrated in the following flow chart:

Settlement of pre-existing debtor/creditor relationship between acquirer and acquiree

Entity A has accounts payable of C100 million to entity B, and entity B has accounts receivable of C100 million from entity A. Both the recorded payable and the corresponding receivable approximate to fair value. Entity A acquires entity B for C2,000 million in a business combination.

The fair value (in accordance with IFRS 3) of entity B’s identifiable net assets is C1,750 million, excluding the receivable from entity A.

How is the pre-existing relationship accounted for in the business combination accounting?

The pre-existing relationship between entities A and B is effectively settled. No gain or loss is recognised on the settlement, because the payable was effectively settled at the recorded amount. Entity A should reduce the consideration transferred for the acquisition by C100 million, to account for the effective settlement of the payable to entity B. The acquisition of entity B and the effective settlement of the payable are recorded as separate transactions:

Dr Payable to entity B 100

Dr Goodwill 150

Dr Acquired net assets of entity B 1,750

Cr Cash 2,000

Settlement loss with a liability previously recorded on a non-contractual relationship

Entity A is a defendant in litigation relating to a patent infringement claim brought by entity B. Entity A pays C50 million to acquire entity B and effectively settles the lawsuit. The fair value of the settlement of the lawsuit is estimated to be C5 million. Entity A had recorded a C3 million provision in its financial statements before the acquisition. The fair value of entity B’s identifiable net assets is C40 million, excluding the lawsuit contingent asset. The fair value of the non-contractual relationship is C5 million. Entity A records a settlement loss related to the litigation of C2 million in its income statement, giving effect to the provision already recorded and ignoring the effect of income taxes. The acquisition of entity B and the effective settlement of the litigation are recorded as separate transactions:

Dr Litigation liability 3

Dr Loss on settlement of lawsuit with entity B 2

Dr Goodwill 5

Dr Acquired net assets of entity B 40

Cr Cash 50

In this example, C5 million of the cash paid has been used to settle the litigation, and C45 million has been used to purchase entity B. If entity A had previously recorded a liability greater than C5 million, a settlement gain would be recognised for the difference between the liability previously recorded and the fair value of the settlement.

Settlement loss on a contractual relationship

Entity C provides services to entity D under a fixed-price contract. Entity C acquires entity D for C100 million. The market price for these services has increased since the inception of the contract. The terms in the contract are unfavourable, compared to current market transactions, for entity C in the amount of C10 million. The contract contains a provision that would cost either party C6 million to terminate the contract at the acquisition date. The fair value of entity D’s identifiable net assets is C82 million, excluding the favourable contract asset. How much loss does entity C recognise on settlement of the contract? Entity C recognises a settlement loss of C6 million, excluding the effect of income taxes.

The amount recognised is the lesser of: 1. The amount by which the contract terms are either favourable or unfavourable (from the acquirer’s perspective), compared to pricing for current market transactions for the same or similar items. This is C10 million. 2. The amount of any stated settlement provisions in the contract available to the counterparty to whom the contract is unfavourable. This is C6 million. The C100 million in cash, paid by entity C, is attributed as C6 million to settle the services contract and C94 million to acquire entity D.

The C4 million difference, between the fair value of the unfavourable contract terms and the contractual settlement provision, is included as part of the business combination (and will be part of goodwill). The acquisition of entity D and the effective settlement of the services contract would be recorded as follows:

Dr Loss on settlement of service contract with entity D 6

Dr Goodwill 12

Dr Acquired net assets of entity D 82

Cr Cash 100

In the absence of the settlement provision, a C10 million provision would be recorded for the unfavourable amount of the contract.

Pre-existing relationships and re-acquired rights

Settlement of pre-existing relationship involving re-acquired rights

Example 1 – Re-acquired franchise

Entity M acquires entity N. The fair value of the amount paid by entity M to the owners of entity N is C10 million. Four years earlier, entity M had granted a 10-year franchise allowing entity N to operate in China. The cost of the franchise was C250,000. The contract allows either party to terminate the franchise at a cost of the unexpired initial fee plus 20%. At the date of acquisition, the settlement amount is C180,000 ((C250,000 × 6/10) + 20%). Entity M has acquired entity N because it sees high potential in the Chinese market and wishes to exploit it. Entity M calculates that, under current economic conditions and at current prices, it could grant a six-year franchise for a price of C450,000.

How is the franchise accounted for as part of the business combination?

The franchise right is recognised at C450,000 (that is, the fair value at market rates of a franchise based on the remaining contractual life). The gain or loss on settlement of the contract is the lower of: C300,000, which is the amount by which the right is unfavourable to entity M compared to market terms. This is the difference between the amount that entity M could receive for granting a similar right (C450,000) and the price that it was granted for (C150,000, being C250,000 × 6/10). C180,000, which is the amount that entity M would have to pay to terminate the right at the date of acquisition.

The loss on settlement of the contract is C180,000. Therefore, of the C10 million paid, C9,820,000 is accounted for as consideration for the business combination and C180,000 is accounted for separately as a settlement loss on the re-acquired right.

Example 2 – Re-acquired right

Entity C produces high-specification consumer electronic goods that it sells through a network of 4,000 authorised distributors and general electric stores. Each authorised distributor purchases a right to distribute entity C’s products for five years and, in return, it receives marketing and technical support. The cost of the five-year distributorship is C5 million, which is considered to reflect the fair value of the support services received throughout the five-year period, and the amount is paid in one instalment when the contract commences. The cost of the distributorship has remained constant for several years. The distributorship agreement can be cancelled by either party on payment of a cancellation fee of C1 million. An additional refund amount, of a proportion of the C5 million fee for the remaining term, must be paid if the agreement is terminated by entity C. Entity C has decided to acquire one of the distributors, entity D. Entity D has three years left on its distribution contract. The fair value of the distribution agreement at the acquisition date is C3 million. There is no unfavourable or favourable element of the contract.

How should entity C account for the acquisition of the distributorship right?

Entity C will not recognise any gain or loss on settlement of the contract, given that there is no unfavourable or favourable element. Entity C will recognise an intangible asset of C3 million in the acquisition accounting, which will be amortised over the remaining three year period. The acquisition of a re-acquired right might be accompanied by the acquisition of other intangibles, which should be recognised separately from both the re-acquired right and goodwill.

For example, an entity grants a franchise to a franchisee to develop a business in a particular country. The franchise agreement includes the right to use the entity’s trade name and proprietary technology. After a few years, the entity decides to re-acquire the franchise, by acquiring the franchisee in a business combination for an amount greater than the fair value of a new franchise right. The excess of the value transferred over the franchise right is an indicator that other intangibles (such as customer relationships, customer contracts and additional technology) could have been acquired with the re-acquired right.