FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland deals with business combinations in Section 19 Business Combinations and Goodwill.
This article explores some of the main considerations that AAT Licensed Accountants and members should consider where business combinations under the new reporting regimes are concerned.
A business may enter into a ‘business combination’ by acquiring a subsidiary. The Glossary to FRS 102 defines a ‘business combination’ as:
‘The bringing together of separate entities or businesses into one reporting entity.’
When an acquirer (a parent) acquires a target (a subsidiary), the parent may acquire it in whole or in part. In other words the parent might acquire 100% of the net assets of the subsidiary, or it could acquire a controlling stake (i.e. more than 50% but less than 100%). Section 19 in FRS 102 outlines the accounting for a business combination and any associated goodwill which might arise following an acquisition of a subsidiary.
An important point to emphasise where the definition of a business combination is concerned is that it is the bringing together of separate entities or ‘businesses’ into one reporting entity. Sometimes it may not be clear as to whether an investee is a business and is often a situation which may need further analysis because of the inherent differences in accounting for an asset purchase and a business combination.
The Glossary to FRS 102 defines a ‘business’ as:
‘An integrated set of activities and assets conducted and managed for the purpose of providing:
(a) a return to investors; or
(b) lower costs or other economic benefits directly and proportionately to policyholders or participants.
A business generally consists of inputs, processes applied to those inputs, and resulting outputs that are, or will be, used to generate revenues. If goodwill is present in a transferred set of activities and assets, the transferred set shall be presumed to be a business.’
When a business combination takes place, one party obtains control of another party (or parties). Control is usually evidenced by the parent acquiring more than 50% of the net assets of the subsidiary. However, this is not always the case and control may be obtained with a holding of less than 51% if the parent can, for example:
- cast the majority of the votes at the meeting of the board of directors;
- appoint or remove the majority of the members of the board of directors;
- govern the financial and operating policies of the entity under statute or agreement; or
- hold power over more than 50% of the voting rights by virtue of agreement with other investors.
It is important, therefore, to consider the wider picture (i.e. the substance of the arrangement) to establish whether control has, or has not, been obtained where the ownership interest is less than 51%.
Section 19 uses the ‘purchase method’ to account for business combinations. This method used to be called the ‘acquisition method’ in previous UK GAAP and is applied to all business combinations except:
- group reconstructions which are accounted for using the merger accounting method; and
- public benefit entity combinations which are in substance a gift or which are a merger and hence are accounted for in accordance with Section 34 Specialised Activities.
There are three steps in applying the purchase method:
- identify an acquirer;
- measure the cost of the business combination; and
- allocate, at the acquisition date, the cost of the business combination to the assets acquired and liabilities and provisions for contingent liabilities assumed.
Identify an acquirer
The acquirer in a business combination is the party which obtains control of the other entity (or entities). For the purpose of Section 19 the term ‘control’ is the power to govern the financial and operating policies of an entity or business so as to obtain benefits from its activities.
Quite often it is clear which party is the acquirer in a business combination. However, if a complex group structure exists it may not be as apparent. In light of this, paragraph 19.10 of FRS 102 offers examples of three indicators that an acquirer exists (note – emboldened words are defined in the Glossary to FRS 102):
- If the fair value of one of the combining entities is significantly greater than that of the other combining entity, the entity with the greater fair value is likely to be the acquirer.
- If the business combination is effected through an exchange of voting ordinary equity instruments for cash or other assets, the entity giving up cash or other assets is likely to be the acquirer.
- If the business combination results in management of one of the combining entities being able to dominate the selection of the management team of the resulting combined entity, the entity whose management is able so to dominate is likely to be the acquirer.
Cost of a business combination
The cost of the business combination is measured as the total of:
(a) the fair values at the date of acquisition of:
- assets given;
- liabilities incurred or assumed; and
- equity instruments granted; plus
(b) any costs which are directly attributable to the business combination.
If control is achieved in stages (also referred to as a ‘piecemeal acquisition’ or a ‘step acquisition’) then the cost of the business combination is the total of the fair value of assets given, liabilities assumed and equity instruments issued by the acquirer at the date of each transaction in the series.
In a business combination it is not necessarily just cash that changes hands in exchange for ownership interest, consideration can also include:
- property, plant and equipment;
- another business;
- shares (including preference shares); and
- contingent consideration.
Where any adjustments to the cost of the business combination are not recognised at the date of acquisition, but then become probable and can be measured reliably, the additional consideration is treated as an adjustment to the cost of the combination.
Allocating the cost of the business combination to the assets acquired and the liabilities and contingent liabilities assumed
The cost of the business combination is then allocated to the acquiree’s identifiable assets and liabilities and contingent liabilities (those contingent liabilities which satisfy the recognition criteria) at their fair values at the date of acquisition. However, care must be taken here because Section 19 refers to other areas of FRS 102 where different provisions apply to certain assets and liabilities, notably:
- A deferred tax asset or liability arising from the assets acquired and liabilities assumed is recognised and measured in accordance with Section 29 Income Tax.
- A liability (or, where applicable, an asset) in respect of an acquiree’s employee benefit arrangements is recognised and measured in accordance with Section 28 Employee Benefits.
- Share-based payment transactions are recognised and measured in accordance with Section 26 Share-based Payment.
Paragraph 19.15 requires the acquirer to separately recognise the acquiree’s identifiable assets, liabilities and contingent liabilities at the date of acquisition but only where they satisfy the following criteria at that date:
- In the case of an asset other than an intangible asset, it is probable that any associated future economic benefits will flow to the acquirer, and its fair value can be measured reliably.
- In the case of a liability other than a contingent liability, it is probable that an outflow of resources will be required to settle the obligation, and its fair value can be measured reliably.
- In the case of an intangible asset or a contingent liability, its fair value can be measured reliably.
Section 19 requires the purchase method to be applied to a business combination from the date of acquisition. The date of acquisition is the date on which control passes to the acquirer and is often ascertainable in the sale and purchase agreement. However, this is not always the case, particularly in a complicated business combination. Where difficulties are encountered there is no ‘one-size-fits-all’ approach and the definition of ‘control’ must be applied to the specific facts and circumstances, which will invariably require a degree of judgement.
Complications in ascertaining the date of acquisition can arise where:
- the sale and purchase agreement states that control is transferred on a date that is not the date on which the sale completes;
- control is passed subject to regulatory approval and/or shareholder approval;
- other conditions have to be satisfied after the date of completion prior to control passing; or
- where the transaction is not subject to a sale and purchase agreement and hence there is no closing date for the transaction.
Incomplete accounting at the year-/period-end
Business combinations can take a long time to complete and it may be the case that a combination is incomplete by the year-/period-end. When this is the case, the acquirer must recognise a best estimate for the amounts for which the accounting is not complete.
Within 12 months after the date of acquisition, a retrospective adjustment must be made to the provisional amounts recognised to take account of the new information obtained (i.e. actual values). Beyond this 12-month time limit, any adjustments to the initial accounting for a business combination should only be recognised in order to correct a material error and the provisions in Section 10 Accounting Policies, Estimates and Errors should be applied where this is the case.
Paragraph 19.15(c) says that the acquirer must recognise a separate provision for contingent liabilities of the acquiree, but only if the fair value of contingent liabilities can be measured reliably. Where fair value cannot be reliably measured:
(a) there is a resulting effect on the amount recognised as goodwill (or, where applicable, negative goodwill); and
(b) the acquirer should instead disclose the information concerning that contingent liability as required by Section 21 Provisions and Contingencies.
Where contingent liabilities meet the recognition criteria, the acquirer measures them separately at the higher of:
(a) the amount that would be recognised in accordance with Section 21; and
(b) the amount initially recognised less any amounts previously recognised as revenue in accordance with Section 23 Revenue.
Goodwill is basically the difference between the net assets acquired and the consideration paid for those net assets.
Positive goodwill is amortised on a systematic basis over its useful economic life. (Note: goodwill always has a finite useful life under FRS 102). Where management of an entity are unable to make a reliable estimate of the useful life of goodwill, the life must not exceed five years.
In addition, management must also review the value of goodwill to assess if there are any indicators of impairment. If this is the case, the provisions in Section 27 Impairment of Assets are triggered.
Negative goodwill arises in a bargain purchase (i.e. where the consideration is less than the net assets acquired). This can usually arise in a distressed sale where the shareholders want a quick way out of the business.
There are three steps to follow where negative goodwill arises:
- Reassess the identification and measurement of the acquiree’s assets, liabilities and provisions for contingent liabilities and the measurement of the cost of the combination. This is to ensure that everything has been captured for the purpose of the goodwill calculation (i.e. assets, liabilities and contingent liabilities are complete and the cost is complete).
- Following this reassessment, if negative goodwill is still arising, recognise and separately disclose the resulting excess on the face of the balance sheet as at the date of acquisition, immediately below goodwill, and followed by a subtotal of the net amount of goodwill and the excess.
- Recognise subsequently the excess up to the fair value of non-monetary assets acquired in profit or loss in the periods in which the non-monetary assets are recovered. Any excess exceeding the fair value of non-monetary assets acquired is recognised in profit or loss in the periods expected to be benefited.
Section 19 of FRS 102 is very comprehensive and this article has considered some of the main features of the section. Where a business combination (including a group reconstruction) arises, then the provisions in that particular section should be complied with. It should also be noted that goodwill can never have an indefinite life under FRS 102 and therefore where companies have not amortised goodwill due to indefinite useful lives under outgoing GAAP, then accounting practices will have to change on transition to comply with the standard’s requirements.
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Steve Collings is the audit and technical partner at Leavitt Walmsley Associates Ltd.