Re.: IASB Request for Information Post-implementation Review: IFRS 3 Business Combinations

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1 Mr Hans Hoogervorst Chairman of the International Accounting Standards Board 30 Cannon Street London EC4M 6XH United Kingdom 28 May /636 Dear Mr Hoogervorst Re.: IASB Request for Information Post-implementation Review: IFRS 3 Business Combinations The IDW appreciates the opportunity to comment on the IASB Request for Information Post-implementation Review: IFRS 3 Business Combinations. We welcome the introduction of Post-implementation Reviews of each new standard or major amendment as an integral part of the standard-setting process. Such reviews are an appropriate and useful means of giving the Board the opportunity to assess whether new accounting requirements are working well in practice. We would like to comment on certain aspects of the business combination accounting introduced by IFRS 3 as follows: Question 1 Our background and experience Please tell us: about your role in relation to business combinations (i.e. preparer of financial statements, auditor, valuation specialist, user of financial statements and type of user, regulator, standard-setter, academic, accounting professional body etc.).* ) your principal jurisdiction. If you are a user of financial statements, which geographical regions do you follow or invest in?

2 page 2/10 IDW CL to Mr Hans Hoogervorst on Request for Information Post-implementation Review: IFRS 3 Business Combinations (d) (e) whether your involvement with business combinations accounting has been mainly with IFRS 3 (2004) or IFRS 3 (2008). if you are a preparer of financial statements: (i) whether your jurisdiction or company is a recent adopter of IFRS and, if so, the year of adoption; and (ii) with how many business combinations accounted for under IFRS has your organisation been involved since 2004 and what were the industries of the acquirees in those combinations. if you are a user of financial statements, please briefly describe the main business combinations accounted for under IFRS that you have analysed since 2004 (for example, geographical regions in which those transactions took place, what were the industries of the acquirees in those business combinations etc.). *) Type of user includes: buy-side analyst, sell-side analyst, credit rating analyst, creditor/lender, other (please specify). The Institut der Wirtschaftsprüfer in Deutschland e.v. (IDW) is a professional organisation established to serve the interests of its members who comprise both individual Wirtschaftsprüfer [German Public Auditors] and Wirtschaftsprüfungsgesellschaften [German Public Audit firms]. We represent over 12,000 Wirtschaftsprüfer, or about 86 % of all Wirtschaftsprüfer in Germany. Question 2 Definition of a business Are there benefits of having separate accounting treatments for business combinations and asset acquisitions? If so, what are these benefits? What are the main practical implementation, auditing or enforcement challenges you face when assessing a transaction to determine whether it is a business? For the practical implementation challenges that you have indicated, what are the main considerations that you take into account in your assessment? In general, the IDW believes that separate accounting treatments for business combinations and asset acquisitions are reasonable. However, we recommend the IASB re-deliberate certain conceptual differences between a business combination and an asset acquisition. Separate accounting treatments should only be required if they are conceptually justified. While we believe that different accounting treatments for business combinations and asset acquisitions regarding goodwill are conceptually justified, we question whether this is true in respect of acquisitionrelated costs, deferred taxes or contingent consideration.

3 page 3/10 IDW CL to Mr Hans Hoogervorst on Request for Information Post-implementation Review: IFRS 3 Business Combinations As generally known, differentiating between business combinations and asset acquisitions can be difficult in practice. In particular, determining whether a group of assets constitutes a business or not is often not straightforward. In this context, we refer to the ESMAs 13th Extract from the EECS s Database of Enforcement describing a specific case preparers, auditors and enforcers regularly have to deal with. We recommend the IASB re-deliberate whether the guidance in IFRS 3 could be clarified. Moreover, additional guidance on accounting for asset acquisitions would be useful. Question 3 Fair Value To what extent is the information derived from the fair value measurements relevant and the information disclosed about fair value measurements sufficient? *) If there are deficiencies, what are they? What have been the most significant valuation challenges in measuring fair value within the context of business combination accounting? What have been the most significant challenges when auditing or enforcing those fair value measurements? Has fair value measurement been more challenging for particular elements: for example, specific assets, liabilities, consideration etc.? *) According to the Conceptual Framework information is relevant if it has predictive value, confirmatory value or both. We believe that, in case of business combinations, information derived from fair value measurements is generally of most relevance. However, measuring specific assets and liabilities at their acquisition-date fair values can cause significant problems for their subsequent measurement: For example, a non-financial liability acquired within a business combination is recognised and measured at fair value. According to paragraph 42 of IFRS 13, the fair value of the non-financial liability has to reflect the effect of non-performance risk (including the entity s own credit risk). The subsequent measurement is dealt with in IAS 37. This standard does not explicitly state whether or not own credit risk should be included. Consequently, there is a de-facto option that could result in a significantly different accounting outcome. The IFRS Interpretations Committee has already ascertained that the predominant practice today is to exclude own credit risk, which is generally viewed as a risk of the entity rather than a risk specific to the liability (IFRIC Update, March 2011). As a consequence, the effect of including the own credit risk at initial measurement and excluding it subsequently would have to be recognised in profit or loss immediately after the business combination.

4 page 4/10 IDW CL to Mr Hans Hoogervorst on Request for Information Post-implementation Review: IFRS 3 Business Combinations Furthermore, the requirement to recognise deferred tax on temporary differences arising on net assets acquired in a business combination may lead to an increase in goodwill resulting from deferred tax liabilities. This could cause inappropriate impairments on goodwill since the value in use has to be determined on a pre-tax basis. Hence, we also suggest the Board consider this application issue concerning the interaction between IFRS 3 and IAS 36. In practice, measuring assets and liabilities at fair value is always challenging when there are inactive markets and quoted prices are unavailable. Our experience indicates problems in determining the fair value of: intangible assets non-financial assets where the valuation premise has to be applied (highest and best use) and contingent consideration. The whole process of determining the fair values of those assets (i.e. obtaining and providing relevant inputs, determining the appropriate valuation technique etc.) is highly subjective and thus largely at the discretion of the preparer. Question 4 Separate recognition of intangible assets from goodwill and the accounting for negative goodwill Do you find the separate recognition of intangible assets useful? If so, why? How does it contribute to your understanding and analysis of the acquired business? Do you think changes are needed and, if so, what are they and why? What are the main implementation, auditing or enforcement challenges in the separate recognition of intangible assets from goodwill? What do you think are the main causes of those challenges? How useful do you find the recognition of negative goodwill in profit or loss and the disclosures about the underlying reasons why the transaction resulted in a gain? Separate recognition of intangible assets from goodwill Separate recognition of intangible assets, as opposed to their inclusion in goodwill, only provides better information to users of financial statements if the acquisitiondate fair values of those assets can be reliably measured. Although, in practice, some standardised valuation techniques have been developed for estimating the fair value of certain kind of intangible assets (e.g. multi-period excess earnings method, relief-from-royalty method), a significant degree of judgement is still

5 page 5/10 IDW CL to Mr Hans Hoogervorst on Request for Information Post-implementation Review: IFRS 3 Business Combinations required in many cases (e.g. determination of inputs like the useful life of a brand or a customer list). Recognising various intangible assets for customer relationships, such as customer lists, order production backlog, customer contracts and non-contractual customer relationships is too burdensome. The corresponding costs are not justified by the benefits. In respect of intangible assets with an indefinite useful life, we doubt the usefulness of separating them from goodwill. Although some users might be interested in the value of a particular brand, the informative value is very limited. In addition, since most entities do not use the individual values of intangible assets with an indefinite useful life for internal management purposes, requiring the separation of intangible assets with an indefinite useful life from goodwill is also not justified on costbenefit-considerations. Accounting for negative goodwill We agree with the current accounting for negative goodwill, provided it results from a real bargain purchase. However, negative goodwill often arises when an acquirer anticipates future restructuring expenses which cannot be recognised as a liability on acquisition. Expected future losses cannot always be allocated to the acquiree s assets, since by definition the fair values do not encompass the expected future losses of the entity as a whole. From our point of view, it is not reasonable to recognise such negative goodwill as an immediate gain. In these cases, we believe that the re-introduction of the treatment of negative goodwill pursuant to IAS 22 would be preferable. Question 5 Non-amortisation of goodwill and indefinite-life intangible assets How useful have you found the information obtained from annually assessing goodwill and intangible assets with indefinite useful lives for impairment, and why? Do you think that improvements are needed regarding the information provided by the impairment test? If so, what are they? What are the main implementation, auditing or enforcement challenges in testing goodwill or intangible assets with indefinite useful lives for impairment, and why?

6 page 6/10 IDW CL to Mr Hans Hoogervorst on Request for Information Post-implementation Review: IFRS 3 Business Combinations During earlier deliberations concerning the introduction of the impairment-only approach in IFRS, the IDW has expressed serious concerns over non-amortisation of goodwill: From a conceptual point of view, acquired goodwill is an asset with a limited useful life and therefore, it should be amortised on a systematic basis over its expected useful life like any other non-current wasting asset. If an entity is able to maintain the original overall value of goodwill acquired in a business combination over time, the acquired goodwill itself is consumed but continuously replaced with internally generated goodwill. There should be no exceptions to the general principle that internally generated goodwill cannot be recognised. Amortisation of acquired goodwill over its limited useful life with regular impairment testing ensures that the carrying amount of acquired goodwill is reduced to zero at the end of its estimated useful life. In our view, this leads to a more faithful representation of the acquired goodwill than the impairment-only approach. Moreover, we do not agree with the Boards argument in paragraph BC131E of IAS 36 that the useful life of acquired goodwill ( ) is not possible to predict and therefore, the amount amortised ( ) can be described as at best an arbitrary estimate of the consumption of acquired goodwill during a period. The problem of determining the useful life not only applies to acquired goodwill, but also to other tangible and intangible assets. In general, many accounting issues in IFRS necessitate estimation to a certain degree. So this is not a compelling argument against the amortisation of goodwill. Besides, pursuant to IAS 1, all sources of estimation uncertainty have to be disclosed. Furthermore, discussions between preparers, auditors and enforcers have revealed problems due to how the impairment-only approach is being applied in practice. From an auditor s point of view, whilst estimations and judgements are unavoidable, impairment testing is highly subjective and open to abuse. For example, identifying cash-generating units or determining whether an indication for impairment exists is nearly completely at the discretion of an entity s management. Auditors can often only evaluate whether the underlying assumptions are plausible as opposed to being completely unrealistic. The auditability of impairment testing is therefore problematical. Consequently, from our point of view, amortisation of acquired goodwill would be the best solution, since the importance of the impairment test as well as the corresponding audit risk would decline over time. Further issues challenging the impairment test of goodwill in accordance with IAS 36 are: Estimating future cash flows (including the distinction between day-to-day servicing and improving or enhancing the asset s performance)

7 page 7/10 IDW CL to Mr Hans Hoogervorst on Request for Information Post-implementation Review: IFRS 3 Business Combinations Applying a pre-tax approach to calculate value in use of a cash-generating unit. In practice, it is more common to use post-tax cash flows and a post-tax discount rate. Allocating and re-allocating goodwill to cash-generating units. Goodwill impairment in non-wholly-owned subsidiaries: gross-up and allocation of impairment losses between a parent and the non-controlling interests (including the consideration of control premiums and changing quotes between the parent and the non-controlling interests). Question 6 Non-controlling interests How useful is the information resulting from the presentation and measurement requirements for NCIs? Does the information resulting from those requirements reflect the claims on consolidated equity that are not attributable to the parent? If not, what improvements do you think are needed? What are the main challenges in the accounting for NCIs, or auditing or enforcing such accounting? Please specify the measurement option under which those challenges arise. To help us assess your answer better, we would be grateful if you could please specify the measurement option under which you account for NCIs that are present ownership interests and whether this measurement choice is made on an acquisition-by-acquisition basis. In our view, the IASB should retain the choice of measurement basis for noncontrolling interests. Although we believe that the full fair value method is conceptually more sound, in practice, most entities measure non-controlling interests at their proportionate share of the acquiree s identifiable net assets. Additional guidance on the application of both methods would be helpful especially regarding the goodwill impairment test. We refer to our answer to question 5. Further, we emphasise the necessity to clarify how to account for put options that oblige the parent to purchase shares of its subsidiary held by a non-controllinginterest shareholder for cash or another financial asset (NCI puts). In this context, we refer to our comment letter on the Draft IFRIC Interpretation 2012/2 Put Options Written on Non-controlling Interests, dated 6 September 2012.

8 page 8/10 IDW CL to Mr Hans Hoogervorst on Request for Information Post-implementation Review: IFRS 3 Business Combinations Question 7 Step acquisitions and loss of control How useful do you find the information resulting from the step acquisition guidance in IFRS 3? If any of the information is unhelpful, please explain why. How useful do you find the information resulting from the accounting for a parent s retained investment upon the loss of control in a former subsidiary? If any of the information is unhelpful, please explain why. In general, the IDW agrees with the current accounting requirements for step acquisitions and loss of control. We believe that measuring both, assets and liabilities of the acquiree as well as the acquirer s previously held equity interest at the acquisition-date fair value, provides useful information. Compared to the prior accounting of step acquisition (i.e. measuring the assets and liabilities of the acquiree at fair value at each step for the purpose of calculating a portion of goodwill) the current accounting is also a simplification. Nevertheless, we still have some concerns regarding the following requirements in paragraph 42 of IFRS 3: In prior reporting periods, the acquirer may have recognised changes in the value of its equity interest in the acquiree in other comprehensive income (for example, because the investment was classified as available for sale). If so, the amount that was recognised in other comprehensive income shall be recognised on the same basis as would be required if the acquirer had disposed directly of the previously held equity interest. Recognising such gains or losses in profit or loss does not necessarily reflect the entity s performance in the reporting period. However, the IASB might only be able to consider this issue when it has developed new principles for measuring and presenting performance. Question 8 Disclosures Is other information needed to properly understand the effect of the acquisition on a group? If so, what information is needed and why would it be useful? Is there information required to be disclosed that is not useful and that should not be required? Please explain why. What are the main challenges to preparing, auditing or enforcing the disclosures required by IFRS 3 or by the related amendments, and why? N/a.

9 page 9/10 IDW CL to Mr Hans Hoogervorst on Request for Information Post-implementation Review: IFRS 3 Business Combinations Question 9 Other matters Are there other matters that you think the IASB should be aware of as it considers the PiR of IFRS 3? The IASB is interested in: understanding how useful the information that is provided by the Standard and the related amendments is, and whether improvements are needed, and why; learning about practical implementation matters, whether from the perspective of applying, auditing or enforcing the Standard and the related amendments; and any learning points for its standard-setting process. We recommend the IASB restart a project on accounting for business combinations under common control. Originally, this issue was part of the convergence project on business combinations between the IASB and the FASB. However, in 2008, business combinations under common control were explicitly scoped out of IFRS 3 in order to avoid deferring the release of that standard. Since then, due to the absence of specific guidance, entities have had to select an appropriate accounting policy using the hierarchy described in IAS 8. The IFRS IC has also affirmed that there is considerable diversity in practice. It has previously encouraged the Board to reactivate it (we refer to the IASB Staff paper 6B, dated July 2011). The IDW continues to support this view. Question 10 Effects From your point of view, which areas of IFRS 3 and related amendments: represent benefits to users of financial statements, preparers, auditors and/or enforcers of financial information, and why; have resulted in considerable unexpected costs to users of financial statements, preparers, auditors and/or enforcers of financial information, and why; or have had an effect on how acquisitions are carried out (for example, an effect on contractual terms)? We are aware of preparer s considerable burden of judging whether arrangements are contingent payments in the business combination or remuneration to employees or selling shareholders for post-combination services. From our point of

10 page 10/10 IDW CL to Mr Hans Hoogervorst on Request for Information Post-implementation Review: IFRS 3 Business Combinations view, the Board should re-consider the respective requirements in IFRS 3 and redeliberate whether such complex guidance is really necessary. We would be pleased to answer any questions that you may have or discuss any aspect of this letter. Yours sincerely Ulrich Schneiß Deputy Technical Director Accounting and Auditing Uwe Fieseler Director International Accounting