It has been a long time coming, but the IASB has at last concluded its business combinations project. IFRS 3 on business combinations and IAS 27 on consolidated accounts were issued this month. It is more than two years since the original exposure drafts were released and it is easy to forget how much disquiet they caused at the time. The IASB has made some changes in the final standards, but many of the original proposals remain. Although the standards are not in force until 2009 they are likely to have significant effects on earnings, extending for a number of years after an acquisition.
Let me explain some of the more challenging implications.
•The cost of a business combination includes cash paid, shares issued and any payments that are contingent on future events. Items traditionally considered as part of the cost of the business combination may no longer be so. It was an unpopular proposal in the exposure draft, but expensing of transaction costs is there in the final standard. There may be a quite significant debit in the period of an acquisition, which was previously included in goodwill.
•The consideration also, in effect, includes any previously held interest in the acquired business. When control is obtained, the previously held interest will in future have to be remeasured to fair value and a gain or loss is recognised in the income statement. The converse is also true, in that when control is lost, for example, when a former subsidiary becomes an associate, the remaining interest is also fair valued through the income statement.
•Many acquisitions are made with an element of the payments being contingent (cash payable if profit targets are met, for example). This shares the risks regarding the value of the business being purchased. Previously, contingent payments were accrued only when probable, and they were added to and adjusted against goodwill. Under the new standard, all contingent payments are fair valued as part of goodwill at the time of the acquisition. They are subsequently remeasured to fair value through the income statement.
So, if your acquired business does better than you assumed in working out the fair value of the contingent payment arrangements at the outset, it may, paradoxically, result in a debit in the income statement; on the other hand, if the opposite occurs it would be a credit. Assessing fair value is often a challenge – particularly in this type of situation where the contingent arrangements are agreed to accommodate an uncertainty about the future performance of the business being acquired. Although, of course, it will always be important to distinguish between payments that are truly contingent as distinct from those that, in reality, are just deferred consideration.
•Most companies follow a ‘parent-company’ approach to consolidation, which means that a purchase of a minority interest leads to goodwill while a sale of shares to a minority results in a gain or loss. The new standards cement an 'economic entity' view whereby minorities are viewed in the same way as the parent shareholders, as just another class of equity. This means that transactions with them under the new standards will not result in goodwill or gains: all effects will be recorded in equity. It will also mean some additional disclosures to get back to the financials attributable to the shareholders of the Group.
These are just some of the ways in which earnings may be impacted by the new standards. PwC has produced a guide IFRS 3R: Impact on earnings, the crucial Q&A for decision-makers. It deals with the earnings issues discussed above and some of the other implications of the new standards.
So acquisitive companies can expect increased earnings volatility, both in the year of the acquisition and in the years following. The IASB believes that this makes the financial statements more transparent - it is clearer what is part of the acquisition and what is not.
Do you agree? What effects do you think the standards will have? I would be interested in your views.
There is no denying that the business combinations project has been controversial. For the first time, the IASB has published a feedback statement summarising the comments made in response to the exposure drafts and explaining how those comments influenced the final standards. The statement can be downloaded from the IASB’s website and makes interesting reading. Do you think it adequately explains and justifies the Board's rationale for rejecting so much adverse comment? As such do you feel it strengthens the Board’s accountability to all its stakeholders? Again, I would be interested in your views, either by email or by commenting here.
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