Accounting news. IFRS 3 revised! Special Edition. A national Audit & Assurance publication March 2008

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1 Accounting news Special Edition A national Audit & Assurance publication March 2008 IFRS 3 revised! Just as people are starting to become comfortable with IFRS (or at least less uncomfortable) and have resigned themselves to having seen it all in respect of the complexity in accounting standards, the International Accounting Standards Board (IASB) has issued IFRS 3 Business Combinations (Revised) and an amended version of IAS 27 Consolidated and Separate Financial Statements. These standards were released on 10 January Both of these changes are the result of the joint convergence project undertaken by the IASB and the US Financial Accounting Standards Board (FASB). The Australian equivalents to IFRS 3 (Revised) and IAS 27, AASB 3 Business Combinations (2008) and AASB 127 Consolidated and Separate Financial Statements (2008) were approved by the AASB at their March 2008 meeting. For many, the standards will further shake their confidence in financial reporting, however it should be recognised that these standards are the first of potentially many that are to be issued in the next few years that will challenge long established accounting practices. Although the standards are not applicable prospectively until years commencing on or after 1 July 2009, acquiring entities need to be aware of their impacts. The major elements of the new IFRS 3 (Revised) are: All costs of acquisitions are to be expensed. The term minority interest becomes non controlling interest. Possible to generate a profit by obtaining control of an entity previously held as an investment or an associate. Option to gross up goodwill for non controlling interests. Any adjustments to the estimate of contingent consideration more than 12 months after the acquisition date are recognised in profit or loss. Share-based payments issued to owners to continue on in a managerial role to be treated as a period expense (not part of goodwill). All intangible assets to be recognised, even if not reliably measurable. Broader definition of what constitutes a business. The main amendments in IAS 27 (2008) are: Profits realised when losing control of a subsidiary to be calculated differently from current practice. Acquisitions of additional holdings in a controlled entity will not result in profits or additional goodwill. Entities are permitted to early adopt the standards for financial reporting periods beginning on or after 30 June If the entity chooses to early adopt it must apply both IFRS 3 (Revised) and IAS 27 (2008) together. 1

2 Expensing transaction costs Perhaps the most controversial aspect of the new standard is the requirement to expense costs of acquisition. This changes the long established treatment of adding transaction costs to the cost of a business combination, effectively increasing the carrying value of goodwill. It also puts the revised standard at odds with the treatment of costs associated with acquiring fixed assets. Minority interest no more Under old AGAAP, this was called outside equity interest and it was renamed minority interest (MI) on introduction of IFRS, but now under IFRS 3 (Revised), it has been renamed non controlling interest (NCI). Generation of profit when obtaining control of a company in which a non-controlling interest was held It may seem difficult to comprehend, but the new standard requires a profit to be recognised in circumstances where a company increases its holdings (taking control) of a subsidiary rather than making a sale. Co X acquires a 10% holding in Co A in 1999 for a cost of $1,000. In 2009 Co X acquires the remaining 90% of Co A for $18,000. The fair value of the net tangible assets of Co A at date of acquisition in 2009 was $10,000. Consideration consists of: FV at 2009 of the 10% holding 2,000 Cost of 90% holding 18,000 20,000 Goodwill is: Consideration 20,000 Less FV of net assets acquired (10,000) Goodwill 10,000 DR Goodwill $10,000 DR Net Assets $10,000 CR Consideration $18,000 CR Investments $1,000 CR Profit $1,000 Note that in the above example, the $1,000 taken on acquisition date to profit represents the difference between fair values of the initial 10% investment i.e. $2,000, and the carrying value, being $1,000 at the point control is achieved. Grossing up goodwill for NCI element Under current IFRS, goodwill is recognised when an entity acquires less than 100% of a subsidiary. The recognised goodwill only represents the goodwill attributable to the group not the MI. Co Z acquires 80% of Co Y for, carrying value of Co Z net assets at time of acquisition being $80,000 and FV of these net assets being $80,000. The following workings illustrate the calculation of goodwill under IFRS 3 (Current Version) and also under a new option in IFRS 3 (Revised). Goodwill recognised:- IFRS 3 (Current version) Consideration FV of assets acquired (80% of $80,000) $(64,000) Goodwill $36,000 Entries being: DR Goodwill $36,000 DR Net Assets $80,000 CR Consideration CR MI (20% of $80,000) $ 16,000 Goodwill recognised:- IFRS 3 (Revised) - Option Under an option available under IFRS 3 (Revised) goodwill will be calculated as follows: Goodwill = FV of consideration+fv of NCI-FV of net identifable assets Goodwill would be: Consideration FV of NCI x 20/80= $25,000 $125,000 Less FV net assets ($80,000) Goodwill $ 45,000 DR Goodwill $45,000 DR Net Assets $80,000 CR Consideration CR NCI $ 25,000 It should be noted that the above treatment is the only option available under FAS141 (Revised), the US equivalent to this standard. However IFRS 3 does allow the NCI to be measured at its historic carrying value not fair value (refer Current version example above). Acquisitions of additional holdings in a controlled entity will not result in profits or additional goodwill When an entity acquires additional interests in a subsidiary, the carrying amounts of the parent and non-controlling interests are adjusted to reflect the changes in ownership interest. The difference between the fair value paid and the carrying amount of the 2

3 additional interest acquired is recognised directly in equity and attributed to the parent. Current IFRS does not provide guidance on these transactions. Big Ltd has 51% holding in Little Ltd with a carrying amount of $51,000. Big Ltd further acquires 29% of Little Ltd for $58,000. DR NCI $29,000 (29%*51,000/51%) DR Equity - parent $29,000 (58,000-29,000) CR Consideration $58,000 As the additional 29% acquisition is not treated as a business combination (because Big Ltd already has control), there is no additional fair value assessment when the additional 29% is acquired. Therefore, the debit to equity of the parent of $29,000 represents the additional fair value of assets transferred to NCI which have not been recognised in the consolidated financial statements. Losing control of a subsidiary Under IAS 27 (2008), the gain on disposal of a subsidiary is measured as the difference between the proceeds and the carrying amount of the subsidiary, plus the fair value of the remaining investment. Currently the gain is calculated as the difference between the proceeds and the carrying amount of the subsidiary. Big Ltd has a 60% investment in Little Ltd with carrying amount of $60,000. Big Ltd sells 30% of Little Ltd for, therefore reducing its holding in Little Ltd to 30%. Journal Entries IAS 27 (as amended 2008) CR Net Assets in Sub $60,000 CR P&L $140,000 IAS 27 Current DR Investment in associate $30,000 CR Net assets in Sub $60,000 CR P& L $70,000 This new treatment is somewhat difficult to conceptualise. However, the Basis of Conclusions to IAS 27 (2008) states that the loss of control over a subsidiary is a significant economic event and therefore the following 2 events are recognised in the $140,000 profit: gain on book value as per current IAS 27 of $70,000; and additional $70,000 being the re-measurement of investment in associate at fair value. Sale of a subsidiary Under IAS 27 (2008), changes in ownership interest in a subsidiary that do not result in the loss of control are accounted for as transfers within equity. However, where a change in ownership involves a loss of control, the entity recognises the investment retained at fair value and recognises a profit or loss. Big Ltd has an 80% investment in Little Ltd with a carrying amount of $80,000. The fair value of Little Ltd is $200,000. Change in ownership level Journal P&L Impact Subisdiary to Subsidiary Subsidiary to Associate Subsidiary to Associate 80% to 51% 80% to 49% 51% to 49% $58,000 ($200,000*29%) CR NCI $29,000 (29%*80,000/80%) CR Equity $29,000 ($58,000-$29,000) $62,000 ($200,000*31%) $98,000 ($200,000*49%) CR Net Assets in Sub 80,000* CR P&L $80,000 NIL $80,000 $51,000 $4,000 ($200,000*2%) $98,000 ($200,000*49%) CR Net Assets in Sub $51,000** CR P&L $51,000 *net of NCI i.e. carrying value of *80% ** net of NCI i.e. carrying value of *51% The above examples illustrate how even a small change in ownership interest resulting in loss of control, results in a significant profit or loss impact. P&L Impact $140,000 $70,000 3

4 Sale of an associate The amended IAS 28 requires that on the loss of significant influence, the investor shall measure any investment retained in the former associate at fair value. Fair value of the retained investment Profit or loss = Proceeds from disposal + - Carrying amount of the investment The example below shows the implications of the new changes. Big Ltd has a 40% investment in Little Ltd with carrying amount of. The fair value of Little Ltd is $800,000 (100%). Change in ownership level Associate to Associate Associate to AFS 40% - 20% 40% - 19% Journal entries $160,000 ($800,000*20%) CR Associate $50,000 (20%/40%*) CR P&L $110,000 P&L Impact $110,000 $220,000 $168,000 ($800,000*21%) DR AFS $152,000 ($800,000*19%) CR Associate CR P&L $220,000 So whilst the 20% remaining interest in the associate is still reflected at carrying value, the 19% investment is classified as an available for sale financial asset and reflected at fair value, hence the significant impact on profit or loss. Adjustments to estimate of contingent consideration more than 12 months after acquisition date Entities must recognise the fair value of contingent consideration as part of the consideration transferred at acquisition date. Changes in the fair value of the contingent consideration after the 12 month measurement period post acquisition are recognised directly in profit or loss. There will be no subsequent adjustments against the costs of the combination (goodwill). Share-based payments issued to owners to continue on in a managerial role Share-based payments issued to owners to continue on in a managerial role are treated as a separate transaction from the business combination and therefore do not form part of the cost of the combination. Intangible assets to be recognised An intangible asset is identifiable if it: can be separated; or meets the contractual legal criterion e.g. a licence to operate a nuclear power plant is an intangible asset, even though the acquirer cannot sell or transfer the licence separately from the acquired power plant. The current version of IFRS 3 requires that intangible assets only be recognised if fair value can be measured reliably. This criterion is no longer required under IFRS 3 (Revised). Broader definition of what constitutes a business IFRS 3 (Revised) defines a business as consisting of inputs, processes and outputs. However, if an entity can continue to produce outputs, for example by integrating the business with its own inputs and processes, the integrated set of inputs, processes and outputs can constitute a business and therefore falls under the scope of IFRS 3 (Revised). 4

5 For example, where a mining entity buys a new mining tenement that is in its early development stage, the mining tenement can constitute a business even if production has not commenced. If the transaction falls under the definition of business in IFRS 3 (Revised), acquisition costs related to the transaction are expensed, whereas if the transaction is regarded as an acquisition of a group of fixed assets, acquisition costs are capitalised. Conclusion The release of IFRS 3 (Revised) highlights that the next few years will see accountants challenged by new complex concepts, which will in a number of instances contradict wellestablished practices. For those entities likely to be part of a business combination under the standard (1 July 2009 onwards) it is extremely important that the impacts of this standard are evaluated particularly in respect of EPS post acquisition. For more information Phone or visit NSW/ACT* Wayne Basford Telephone wayne.basford@bdo.com.au Northern Territory Casmel Taziwa Telephone casmel.taziwa@bdo.com.au North Queensland Greg Mitchell Telephone greg.mitchell@bdo.com.au South Australia Greg Wiese Telephone gregory.wiese@bdo.com.au Tasmania Craig Stephens Telephone craig.stephens@bdo.com.au Western Australia Glyn O Brien Telephone glyn.obrien@bdo.com.au Queensland Tim Kendall Telephone timothy.kendall@bdo.com.au Victoria Nick Burne Telephone nick.burne@bdo.com.au BDO Kendalls is a national association of separate partnerships and entities. Disclaimer: This publication is issued exclusively for the general information of clients and staff of BDO Kendalls. The contents are not a substitute for specific advice and should not be relied upon as such Accordingly, whilst every care has been taken in the presentation of the publication, no responsibility is accepted for persons acting on this information. *Liability limited by a scheme approved under Professional Standards Legislation. 5

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