IFRS 3: Business combinations

IFRS 3 pertains to business combinations, that is, mergers and amalgamations or similar acquisitions of control over a business. IFRS 3 overrides IAS 22. The traditional approach in accounting for business combinations was to allow entities two options, referred to as the “purchase method” and the “pooling of interest” method. The former method was said to be appropriate in cases where one entity acquired the other; the latter method where two entities, almost like equals, merged to form a third entity. The key difference between the “pooling of interest” approach and the purchase approach was that in the former, the assets/liabilities of the transferor entity came in the books of the transferee entity at cost,  the purchase method was treated as a purchase of the assets/liabilities of the transferor by the transferee, and hence, assets and liabilities would come into the books of the transferee at their fair values on the date of the acquisition. 

While this was the traditional IAS approach, the US approach was to treat all business combinations as purchase or acquisition. 

IFRS 3 falls in line with the US method, and therefore, treats all business combinations as acquisitions. Hence, it has one method for all business combinations – purchase or acquisition method. Hence, the core feature is that all identifiable assets/liabilities of the transferor entity are recognized in the books of the transferee at their fair values on the date of the acquisition. 

The scope of IFRS 3 extends to:

  • All amalgamations and mergers where control is being acquired. As a corollary, merger of entities already under common control is not a business combination.
  • All takeovers, where control over a business is being acquired.  Acquisition of assets or group of assets of a business is not a business combination.

As to whether the assets being acquired constitute a business or not, para B5 to B12 provide guidance. A business is an integrated set of processes applied on inputs, which give rise to an output. Commercial considerations are to be applied whether what is acquired is simply piecemeal assets or a business. In real life circumstances, disclosures made by the acquirer in shareholder communications or press releases will also be relevant. There is a presumption that where goodwill is present in an acquisition, a business is being acquired.

All business combinations are treated using the acquisition method. There are 4 key elements of applying the acquisition method:

  • Identifying the acquirer
  • Identifying the acquisition date
  • Identifying the assets being acquired and the liabilities being taken over, and putting the same at fair values
  • Finding out the goodwill or gain pertinent to the acquisition

Identification of the acquirer:

Identification of the acquirer is important because assets of the acquired entity are stated at fair values in the books of the acquirer – that is, there is no change in the assets/liabilities of the acquirer. Though it is not usually difficult to find who is the acquirer in a business combination, difficulties may arise in case of merger of equals, or reverse mergers. Paras B14 to B18 provide guidance. Primarily, the entity that either pays, or the one that issues equity shares for acquiring net assets is the acquirer. Other than these, there are several indicators mentioned in Para B15.

Identification of the acquisition date:

Identification of the acquisition date as that is the date on which the assets/liabilities of the acquired entity are fair-valued. Prima facie, the date of payment of the consideration and the legal transfer of the assets/liabilities is the date of acquisition. However, many acquisitions state the date from which the acquisition will be operative. For instance, in India, it is common practice for courts to order a merger to take effect from a retrospective date.

Identification of assets/liabilities and their initial recognition:

On the question of what assets/liabilities will be recognized on a business combination, the answer is, whatever assets have been acquired and liabilities taken over as a result of the business combination, and not arising out of separate transactions. There might be assets that the acquirer may recognize, but which the acquiree had not recognized – for example, patents or intangible assets that were self-developed by the acquiree. The IFRS permits acquisition of such assets.  

The valuation of the assets/liabilities is to be done on their acquisition-date fair values. The determination of fair values is done based on established fair valuation techniques relevant to the asset/liability in question. Likewise, fair value of the non-controlling interest, also known as minority interest, is computed by applying the proportion of non-controlling interests to the net assets of the acquiree entity. 

While most assets/liabilities are fair valued on acquisition, certain items like contingent liabilities, income-tax assets/liabilities, employee benefits, indemnification assets, share based payment awards, etc., are not subject to the usual fair valuation rules and are measured/valued as per specific rules applicable to each such item.

Valuation of gain/goodwill:

If the aggregate of the consideration transferred, plus fair value of non-controlling interests, exceeds the net asset value of the assets/liabilities are fair-valued in accordance with the Standard, there is a goodwill on acquisition. Other way round, there is a gain on acquisition. It is notable that the consideration provided on acquisition also requires valuation. Acquisitions may involve, for example, shares for assets, shares for shares, assets for assets, etc. In every case where the consideration is other than cash, the question of fair valuation of the consideration shall arise.  

In case where the fair value of net assets is more than the fair value of the consideration, the Standard treats the transaction as a bargain purchase, and the gain on such bargain purchase is taken to profit and loss account. Paras 34-36 pertain to recognition of such gain. 

An acquisition may also happen in stages. Paras 41-42 deal with acquisition in stages. Likewise, an acquisition may not involve payment of consideration – this special situation is covered by paras 43-44.

Subsequent measurement of assets/liabilities

The subsequent-to-acquisition-date valuation of assets/liabilities will be done as per applicable IFRSs pertaining to the relevant asset/liability. However, the Standard contains provisions about the following: 

  • reacquired rights: that is, intangible asset re-acquired on acquisition will be amortised over the remaining period of the contract.

  • contingent liabilities recognised as of the acquisition date: will be re-assessed, and recognized at higher of the amount recognized as per IAS 37, and initial recognition less cumulative amortization.

  • indemnification assets: to be de-recognised when the indemnification asset is realized, or ceases to be realizable.

contingent consideration: certain changes as mentioned in para 58 may be made on the valuation of contingent consideration paid.