EXPOSURE DRAFT FINANCIAL REPORTING BUSINESS COMBINATIONS (IFRS 3) & AMENDMENTS TO FRS 2 ACCOUNTING FOR SUBSIDIARY UNDERTAKINGS

Transcription

1 ACCOUNTING STANDARDS BOARD JULY 2005 FRED BUSINESS COMBINATIONS (IFRS 3) & AMENDMENTS TO FRS 2 ACCOUNTING FOR SUBSIDIARY UNDERTAKINGS (PARTS OF IAS 27 CONSOLIDATED AND SEPARATE FINANCIAL STATEMENTS) FINANCIAL REPORTING EXPOSURE DRAFT ACCOUNTING STANDARDS BOARD

2 For the convenience of respondents in compiling their responses, the text of the questions in the Invitation to Comment on which particular comments are invited (see pages 20 to 34) can be downloaded (in Word format) from the Insurance page in the Current Projects section of the ASB Website ( For ease of handling, we prefer comments to be sent by (in Word format) to Comments may also be sent in hard copy form to: Michelle Crisp ACCOUNTING STANDARDS BOARD 5th Floor, Aldwych House Aldwych London WC2B 4HN Comments should be despatched to be received no later than 28th October 2005.All replies will be regarded as on the public record, unless confidentiality is requested by the commentator.

3 36 BUSINESS COMBINATIONS (IFRS 3) & AMENDMENTS TO FRS 2 ACCOUNTING FOR SUBSIDIARY UNDERTAKINGS (PARTS OF IAS 27 CONSOLIDATED AND SEPARATE FINANCIAL STATEMENTS) FINANCIAL REPORTING EXPOSURE DRAFT ACCOUNTING STANDARDS BOARD

4 This Exposure Draft contains material in which the International Accounting Standard Committee Foundation (IASCF) holds the copyright and which has been reproduced with permission of the IASCF. International Financial Reporting Standards (including International Accounting Standards and SIC and IFRIC interpretations), Exposure Drafts, and other IASB publications are copyright of the IASCF. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means without the prior permission in writing of the IASCF or the Accounting Standards Board or as expressly permitted by law or under terms agreed with the appropriate reprographics rights organisation. # The Accounting Standards Board Limited 2005 ISBN

5 CONTENTS Pages PREFACE 3-19 INVITATION TO COMMENT [DRAFT] FINANCIAL REPORTING STANDARD. BUSINESS COMBINATIONS AMENDMENTS TO FRS 2 ACCOUNTING FOR SUBSIDIARY UNDERTAKINGS (PARTS OF IAS 27 CONSOLIDATED AND SEPARATE FINANCIAL STATEMENTS)

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7 PREFACE BUSINESS COMBINATIONS OVERVIEW PREFACE BY THE ACCOUNTING STANDARDS BOARD A These Financial Reporting Exposure Drafts (FREDs) are part of a package of draft UK accounting standards reflecting the outputs from Phase I and Phase II of the International Accounting Standards Board (IASB) project on business combinations. The package comprises:. FRED 36 Business Combinations (IFRS 3) and Amendments to FRS 2 Accounting for Subsidiary Undertakings (parts of IAS 27 Consolidated and Separate Financial Statements).. FRED 37 Intangible Assets (IAS 38) and FRED 38 Impairment of Assets (IAS 36).. FRED 39 Amendments to FRS 12 Provisions, Contingent Liabilities and Contingent Assets and Amendments to FRS 17 Retirement benefits. B C The first phase of the Business Combinations project resulted in the IASB issuing IFRS 3 Business Combinations, and amendments to IAS 36 Impairment of Assets and IAS 38 Intangible Assets. These were published in March The primary objective of the IASB in Phase I of the project was to require one method of accounting for business combinations the purchase method (renamed the acquisition method in Phase II). Prior to this International Accounting Standards (IAS) permitted two methods, the acquisition method and pooling of interests method (merger accounting). The second phase is being conducted by the IASB as a joint project with the US Financial Accounting Standards Board (FASB). This phase of the project has reconsidered the guidance for applying the acquisition method of accounting for a business combination and particularly the method by which acquirers recognise and measure the business over which they obtain control. This phase also aims to improve the transparency of information provided to users of financial statements. An important aspect of Phase II is to achieve 3

8 ACCOUNTING STANDARDS BOARD JULY 2005 FRED 36 convergence between International Financial Reporting Standards (IFRS) and US GAAP. D E F The outputs from the second Phase of the project comprise three exposure drafts that propose amendments to IFRS 3 Business Combinations, IAS 27 Consolidated and Separate Financial Statements and IAS 37 Provisions, Contingent Liabilities and Contingent Assets. The publication by the IASB of the exposure drafts from Phase II concludes the substantive part of the IASB s Business Combinations project. However, it does not fully complete the project. The aspects that remain outstanding include consideration of fresh start accounting. The outstanding aspects are not currently part of the IASB s active agenda. Some of the proposals set out in this FRED may conflict with existing legal requirements. These matters are being investigated and it is hoped that they will be resolved with the assistance of the Department of Trade and Industry. 4

9 PREFACE FRED 36 Business Combinations (IFRS 3) and amendments to FRS 2 Accounting for Subsidiary Undertakings (parts of IAS 27 Consolidated and Separate Financial Statements) Paragraphs 3 to 48 of this Preface set out the main differences between International Accounting Standards and existing UK accounting requirements for Business Combinations. These paragraphs have been prepared to assist readers in preparing their response on the proposals from Phase II of the IASB Business Combination project. Paragraphs 49 to 56 outline the ASB s proposals for how the IASB s proposals could be implemented into UK accounting standards. Introduction 1. This Financial Reporting Exposure Draft (FRED) sets out proposals for how the IASB s IFRS 3 Business Combinations (as amended by the IASB s exposure draft of June 2005) could be implemented into UK accounting standards. This FRED also sets out the consequential amendments to several UK accounting standards. Should the proposals be implemented into UK accounting standards, they would introduce the revised IFRS 3 Business Combinations $ as a new UK IFRS-based standard and amend FRS 2 Accounting for Subsidiary Undertakings. The new IFRSbased standard would replace FRS 6 Acquisition and Mergers and FRS 7 Fair Values in Acquisition Accounting. 2. In line with the ASB s convergence strategy, the Board proposes UK accounting standards which are based on IFRS with no changes other than those that are essential or are justifiable. $ IFRS 3 will replace those parts of FRS 10 Goodwill and intangible assets that address the accounting for goodwill arising in a business combination. 5

10 ACCOUNTING STANDARDS BOARD JULY 2005 FRED 36 Main differences between existing and proposed International Accounting Standards for Business Combinations and existing UK requirements Overview 3. The main changes to UK accounting practices that would arise from adopting the proposed standards are set out below. The ASB is concerned that certain aspects of the proposals may not improve the quality of information in financial statements. The main points are:. Under current UK accounting practice the objective of acquisition accounting is to reflect the cost of the acquisition. To the extent to which it is not represented by identifiable assets and liabilities (measured at their fair value), goodwill arises and is reported in the financial statements. This exposure draft adopts a different perspective and requires the financial statements to reflect the fair value of the acquired business. The proposals treat the group as a single economic entity (entity concept) rather than the parent entity concept that underlies existing UK accounting standards (paragraphs 5 to 7).. Any outside equity interests in a subsidiary is treated as part of the overall ownership interest in the group. As a consequence of this changes in a parent s ownership interest, that do not result in a change of control, are to be recognised as changes in equity and no gain or loss will be recognised in the profit and loss account (paragraphs 8 to10).. It is proposed that goodwill is to be recognised in full; that is, 100 per cent of goodwill is recognised even if less than 100 per cent is acquired (paragraphs 11 to 20).. Goodwill, after initial recognition, is to be measured at cost less impairment losses, and amortisation is not to be permitted (paragraphs 21 to 25). The proposals for negative goodwill are discussed in paragraphs 26 to 29.. Costs incurred in connection with an acquisition are not to be accounted for as part of the cost of the investment (paragraphs 30 to 33). 6

11 PREFACE 4. The remainder of the Preface discusses other changes in UK accounting practice:. Contingent consideration (paragraphs 34 and 35).. Method of accounting (paragraphs 36 to 39).. Group reconstructions (paragraphs 40 to 41).. Fair value hierarchy (paragraphs 42 to 48). Concepts of accounting for business combinations 5. Under current UK accounting practice the objective of acquisition accounting is to reflect the cost of the acquisition. To the extent to which it is not represented by identifiable assets and liabilities (measured at their fair value), goodwill arises and is reported in the financial statements. This exposure draft adopts a different perspective and requires the financial statements to reflect the fair value of the acquired business. It will also require that, where an acquisition is achieved in stages, any non-controlling equity investment in the acquiree immediately before acquisition shall be remeasured to fair value at the date of acquisition and a corresponding gain or loss recognised in the profit or loss. 6. In the UK, to date, accounting has been based on the parent entity concept. The parent entity concept consolidates in full the assets and liabilities of an entity even if the entity is not wholly-owned. The parent entity concept recognises the different needs of users of financial statements and that these needs can usually be met by focusing on reporting to shareholders. Under the parent entity concept the extent of minority interests (renamed non-controlling interests $ ) and transactions with non-controlling interests are separately identified in the primary financial statements. 7. In contrast, the proposals set out in this exposure draft, adopt the entity concept. As with the parent entity concept the entity concept consolidates in full the assets and liabilities of an entity even if the entity is not wholly-owned. The difference between the two concepts arises in relation to the treatment of outside interests. In $ As part of the second phase of the Business Combinations project, the IASB decided to rename minority interest to non-controlling interest. 7

12 ACCOUNTING STANDARDS BOARD JULY 2005 FRED 36 contrast to the parent entity concept the entity concept considers the group a single entity and any outside equity interest in a subsidiary us treated merely as part of an overall ownership interest. As a consequence, transactions with non-controlling interests do not give rise to gains or losses. Transactions with non-controlling interests 8. Consistent with the entity concept the IASB s proposals state that changes in a parent s ownership interest in a subsidiary after control is obtained that do not result in a loss of control shall be accounted for as transactions with equity holders with no consequential gain or loss or change to goodwill. This is explained in paragraph 4 of the Basis for Conclusions to the exposure draft of proposed amendments to IAS 27 Consolidated and Separate Financial Statements (and set out in the FRED). The IASB explains that the proposed treatment is consistent with its view that non-controlling interests are a separate component of equity. In the IASB s view non-controlling interests are part of the ownership interests in the consolidated group because they do not meet the definition of a liability within the meaning of its Framework. 9. The proposed amendments differ from the current requirement of FRS 2 which adopts the parent entity concept. FRS 2 requires that where a group reduces its interest in a subsidiary undertaking, a profit or loss should be recognised. In adopting the parent entity concept FRS 2 reports performance from the perspective of investors in the parent undertaking and provides the relevant information about the gains and losses arising on partial disposals. 10. To report transactions between the parent entity and non-controlling interests merely as transfers within equity fails to recognise that the objective of consolidated financial statements is to provide information about the financial performance of an entity to investors in the parent entity, who are the ultimate providers of capital and risk takers. The failure to recognise gains or losses on partial disposals in profit or loss may inhibit effective communication between the parent entity and its shareholders. 8

13 PREFACE Goodwill Full goodwill recognition and measurement 11. The IASB defines goodwill as future economic benefits arising from assets that are not individually identified and separately recognised. It considers goodwill to be an asset, similar to other assets and so proposes to require recognition of 100 per cent of goodwill (full goodwill), even if less than 100 per cent of an entity is acquired. This amount will represent not only goodwill attributable to the parent entity, as a result of the transaction, but also goodwill attributable to the non-controlling interest. 12. FRS 2 requires goodwill arising on an acquisition to be recognised only with respect to that part of the subsidiary undertaking that is attributable to the interest held by the parent. FRS 2 notes $ that although it might be possible to estimate by extrapolation or valuation an amount of goodwill attributable to non-controlling interests this would in effect recognise an amount for goodwill that is hypothetical because the non-controlling interest is not a party to the transaction by which the subsidiary undertaking is acquired. 13. FRS 10 Goodwill and intangible assets sets out the principles applied in the UK to the accounting for goodwill. It recognises that goodwill is not a separate asset but part of a larger asset, the investment. The cost of the investment is determined by the transaction price for which management are accountable. By recognising only goodwill attributable to the parent entity, only that part of goodwill for which management are accountable is recognised. In contrast full goodwill recognises a hypothetical amount which is apportioned to the non-controlling interests. 14. Recognition of goodwill attributable only to the parent s interest is consistent with the view that non-controlling interests (who do not hold shares in the parent entity) have no direct interests in the parent or group, but are primarily interested in the subsidiary of which they are a shareholder and in which they do have an interest in its assets and liabilities. As such they have no interest in the consolidated financial statements of the parent entity and therefore need not recognise a hypothetical amount of goodwill allocated for their interest in the group. $ Paragraph 82 of FRS 2. 9

14 ACCOUNTING STANDARDS BOARD JULY 2005 FRED The IASB s proposals measure full goodwill as the difference between the fair value of the acquiree as a whole over the fair value of its net assets at the date of acquisition. This will require that, in an acquisition of less than 100 per cent, the fair value of the acquiree as a whole is determined. 16. The exposure draft of proposed amendments to IFRS 3 notes that business combinations are usually arm s length exchange transactions and therefore, in the absence of evidence to the contrary, the consideration transferred is presumed to be the best evidence of the fair value of the acquirer s interest in the acquiree. Where a controlling interest is acquired but less than 100 per cent of a business is acquired, estimating the fair value of the acquiree had 100 per cent been acquired is extremely subjective. Using the consideration transferred to estimate the fair value of the acquiree may not be appropriate because: i. it may fail to recognise any control premium included in the consideration transferred. The control premium may be difficult to measure with sufficient reliability; and ii. the consideration transferred is based on the acquirer s assessment of future returns it anticipates the investment will generate. These returns may include an assessment of future synergy benefits the acquirer anticipates it will achieve. Some of the synergy benefits may benefit the parent entity rather than the acquired entity and thereby have little or no relevance to the non-controlling interests in the acquired entity. 17. Under the parent entity concept goodwill relates to the cost of the investment and provides useful information for users of the financial statements on the decisions and actions management has made. It is unclear to the Board how the recognition and measurement of full goodwill can improve the quality of the information provided by financial statements. Indeed it may distract from the existing clarity because arguably it introduces a notional item into the Balance Sheet that proportion of goodwill attributable to the noncontrolling interests that is not determined by a transaction. 18. The IASB explains in the Basis for Conclusions (paragraph BC16) that the amount of goodwill recognised in a business combination achieved in stages and in a business combination achieved in a single transaction will not be the same. The IASB considers this inconsistency results in information that is not complete or useful. The IASB therefore decided that the measurement objective should 10

15 PREFACE be the fair value of the acquiree on the acquisition date rather than the cost incurred in a business combination. In a business combination achieved in stages the acquirer shall remeasure its non-controlling equity investments in the acquiree at fair value as of the acquisition date and recognise any gain or loss in the profit or loss. It may, however, be questioned whether a valuation, sometimes based on subjective estimates of the fair value of an acquiree, can resolve this inconsistency and provide useful information to users of financial statements. 19. Those members of the IASB who have provided alternative views from the proposals set out in the exposure draft of proposed amendments to IFRS 3 raise some of these matters. Their views can be found on pages 226 to 230 of this FRED. 20. The Board will participate in the international debate and strongly encourages UK constituents to respond to the IASB s invitation to comment. In addition, the Board would like to assess whether there is support for adopting all of the IASB proposals into UK accounting standards. This matter is discussed in paragraphs 49 to 53 below. Subsequent measurement of goodwill 21. IFRS 3 requires that, after initial recognition, goodwill should be measured at cost less any accumulated impairment losses. The IASB concluded that more useful information would be provided if goodwill was not amortised but subjected to a rigorous and operational impairment test. The IASB s deliberations are set out in paragraphs BC136 to BC142 of the Basis for Conclusions that accompanies the current IFRS 3 (not reproduced in this FRED). 22. FRS 10 sought to charge goodwill to the profit and loss account only to the extent that the carrying value of goodwill is not supported by the current value of goodwill within the acquired business. Systematic amortisation is a practical means of recognising the reduction in value of goodwill that has a limited useful economic life. In FRS 10 there is a rebuttable presumption that, as with intangible assets, goodwill has a useful economic life of 20 years or less. 23. Those that favour amortisation of goodwill argue that goodwill is similar, at the margins, to intangible assets and therefore conceptually there is no reason to treat goodwill differently from other intangible assets. They also argue that amortisation leads to more robust financial reporting. One reason for this view is that 11

16 ACCOUNTING STANDARDS BOARD JULY 2005 FRED 36 impairment tests may fail to adequately distinguish between acquired and internally generated goodwill; another reason is that impairment tests rely on forecasts that are often subjective. 24. Subsequent measurement of goodwill is a complex issue; neither annual impairment nor amortisation is likely to result in a conclusive value for the carrying amount of goodwill. Cost and benefit considerations should therefore be taken into account in judging whether amortisation should be permitted. The simplicity and ease of setting up an amortisation schedule is a practical means of ensuring goodwill is not carried in excess of its current value. 25. The Board would like to seek its constituents views on whether the UK IFRS-based standard should be amended and an option be introduced allowing amortisation of goodwill, see paragraph 54 to 56. Business combinations in which the consideration transferred for the acquirer s interest in the acquiree is less than the fair value of that interest (negative goodwill) 26. Consistent with IFRS 3, the proposals in the second phase of the Business Combination project require that where the consideration transferred for the acquirer s interest in the acquiree is less than the fair value of that interest (after reassessment of the initial accounting) any gain shall first reduce any goodwill to zero. Any remaining excess shall be recognised as a gain on acquisition. 27. FRS 10 requires negative goodwill to be recognised in the profit and loss account in the periods in which the non-monetary assets acquired are depreciated or sold. Any negative goodwill in excess of the values of the non-monetary assets should be written back in the profit and loss account over the period expected to benefit from that negative goodwill. 28. The IASB (paragraph BC168) observes that any excess remaining after the reassessment could comprise one or more of the following components:. errors that remain, notwithstanding the reassessment, in recognising or measuring fair value of either the cost of the combination of the acquiree s identifiable assets, liabilities or contingent liabilities. 12

17 PREFACE. a requirement in an accounting standard to measure identifiable net assets acquired at an amount that is not fair value, but is treated as though it is fair value for the purpose of allocating the cost of the combination.. a bargain purchase. 29. It is clear that there are a number of reasons why the consideration transferred for the acquirer s interest in the acquiree may be less than the fair value of that interest. Where there is evidence of a bargain purchase then immediate recognition of a gain may be appropriate. However, as an excess can arise for a number of reasons, it is questionable whether immediate recognition of a gain is appropriate in all circumstances. Measurement of consideration Acquisition costs 30. It is proposed to amend IFRS 3 such that expenses of acquiring an acquisition are recognised as an expense in the profit and loss account in the period of acquisition. The IASB has concluded that such costs are not part of the consideration transferred in exchange for the acquiree. This is discussed in the Basis for Conclusions at paragraphs BC84 to BC FRS 7 specifies that the cost of acquisition is the amount of cash paid and the fair value of other purchase consideration given by the acquirer, together with the expenses of the acquisition. The expenses of the acquisition are described as fees and similar incremental costs incurred directly in making an acquisition. 32. Where the cost of acquisition includes acquisition expenses, the return on investment takes these expenses into consideration and management are accountable for the full cost of the acquisition. Some might suggest that under the IASB s proposals managers may not be accountable, in the long term, for the cost of a business combination because various unavoidable costs will have been written off when incurred. 33. It is also noted in paragraph AV18 of the alternative views that this treatment creates an inconsistency between the accounting for purchases of assets, including investments in associated companies, where the direct costs form part of the carrying 13

18 ACCOUNTING STANDARDS BOARD JULY 2005 FRED 36 amount of the asset acquired, on initial recognition. The Board considers that the proposed treatment creates an inconsistency in financial reporting. Adjustments to consideration that is contingent on future events 34. The IASB s proposals arising from the second phase amend the treatment of contingent consideration. The proposals, consistent with FRS 7, measure contingent consideration at its fair value at the date of acquisition. Where contingent consideration takes the form of a liability any subsequent remeasurement, that does not qualify as a measurement period adjustment, is treated as a gain or loss and recognised in the profit or loss account. 35. FRS 7 considers the remeasurement of contingent consideration as an adjustment to the cost of acquisition with the consequential adjustment being made to goodwill until the ultimate amount is known. This reflects the view that a revision to the estimate for contingent consideration provides more information about conditions that existed at the date of acquisition should be reported as a change in the fair value of consideration, and a corresponding change to goodwill. However, it might be argued that where the change reflects events that have occurred since the date of acquisition the revision to the estimate should be reported as post-acquisition gains or losses. Method of accounting Acquisition and merger accounting 36. IFRS 3 requires all business combinations within its scope to be accounted for using the acquisition method. The acquisition method views a business combination from the perspective of the combining entity, which is the acquirer. The acquirer purchases the acquiree and recognises in its financial statements the net assets acquired at their fair value. 37. The acquisition method requires one party to the business combination to be identified as the acquirer. The IASB concluded that most business combinations result in one entity obtaining control of another entity and therefore an acquirer could be identified for most business combinations. The IASB acknowledges that it could be difficult to identify an acquirer in some rare instances, such as entities of similar size or capitalisation 14

19 PREFACE coming together in industry restructurings, but did not agree that exceptions to applying the acquisition method should be permitted. In contrast FRS 6 permits both acquisition and merger accounting. It contains a set of criteria designed to identify true mergers and states that merger accounting should be used when those criteria are met. 38. One of the criticisms of merger accounting is that it perpetuates outof-date historical values that are of limited relevance. An alternative to merger accounting for business combinations, where there is no acquirer, could be fresh start accounting. Under this approach the net assets of all the combining entities would be measured at fair value at the date of the combination. 39. It was anticipated that the IASB would, as part of the second phase, research the application of fresh start accounting as a possible alternative to the acquisition method. The Basis for Conclusions to the exposure draft of proposed amendments to IFRS 3 notes that the IASB will undertake research into fresh start accounting. The ASB looks forward to working with the IASB on this matter. Group reconstructions 40. In Appendix C of the draft IFRS it is noted that consistent with the provisions of IFRS 3, the draft IFRS does not apply to combinations involving entities under common control, including group reconstructions. This is in contrast to FRS 6 which permitted merger accounting to be applied to group reconstructions. The Basis for Conclusions notes that the IASB intend to consider accounting for group reconstructions at a later date. 41. The Board is considering whether it should retain some of the provisions of FRS 6 and prescribe how UK group reconstructions should be accounted for. The Board would welcome views on this matter (see ASB Invitation to Comment). Fair value hierarchy 42. As part of the second phase additional guidance on the application of measuring fair value is provided in Appendix E of the draft IFRS. The additional guidance is based on the FASB s Fair Value Measurements Exposure Draft that was issued in June

20 ACCOUNTING STANDARDS BOARD JULY 2005 FRED The fair value hierarchy groups into three broad categories (levels) the inputs that should be used to estimate fair value. The hierarchy gives the highest priority to inputs that reflect quoted prices in active markets and the lowest priority to an entity s own internal estimates and assumptions. 44. FRS 7 requires the identifiable assets and liabilities of the acquiree that existed at the date of acquisition to be recognised and measured at fair values reflecting their conditions at that date. FRS 7 specifies the method for determining fair values of individual categories of assets and liabilities. 45. The guidance in Appendix E may lead to some assets being attributed different values to those currently attributed by the guidance in FRS 7, for example:. specialised tangible fixed assets, for which applying FRS 7 fair value is represented by gross replacement cost reduced by depreciation (entry perspective), whereas by applying the hierarchy these may be recognised at a lower value reflecting an exit value perspective (disposal value); and. stocks and work-in-progress, which FRS 7 requires to be valued at the lower of replacement cost and net realisable value whereas applying the hierarchy may lead to a valuation reflecting selling price less cost to complete and selling expenses. 46. The fair value attributed to acquired assets and liabilities has an impact on the post acquisition earnings. Where stocks are valued based on selling prices, at most the margin attributed to selling the stocks will be recognised in post acquisition earnings. 47. The guidance focuses on exit values that are observable market prices. The ASB continues to strongly support the deprival value model which in certain circumstances values assets at an entry value and does not regard exit value as the only basis on which to reach a fair value. 48. The IASB notes it intends to redeliberate any issues that emerge from the FASB s final statement on fair value measurement and where appropriate amend the fair value guidance in Appendix E. This approach is of concern to the Board and suggests the IASB 16

21 PREFACE could amend the guidance without further consultation prior to issuing the final IFRS. Propose UK Amendments to IASB Exposure Drafts Implementation of proposals 49. The ASB is issuing this FRED following the IASB issuing its exposure drafts of proposed amendments to IFRS 3, IAS 27 and IAS 37. These represent the decisions reached by the IASB during the second phase of the Business Combinations project. In addition, the Board has issued FRED 37 Intangible Assets and FRED 38 Impairment of Assets, which were amended as part of the first phase of the Business Combinations project. 50. The Board considers that the proposed amendments to IAS 27 (reflected in UK accounting standards as amendments to FRS 2) fail to recognise adequately that the focus of financial reporting is to report to the shareholders of the parent entity. The treatment of transactions with non-controlling interests as mere equity transactions fail to report adequately gains and losses the directors of the entity may make. In addition, the recognition of full goodwill requires a hypothetical transaction that results in a highly subjective measurement of full goodwill. The Board also noted that neither the IASB nor FASB currently adopt the entity concept to the extent proposed in the exposure drafts. 51. The Board had previously stated it would consult on implementation of the proposals arising from the Business Combinations project when both Phases of the project were complete. However, given the extent of its reservations in relation to the IASB proposals the Board has considered whether it should issue this FRED or, alternatively, adopt a wait and see strategy, until the impact of the IASB proposals have been more widely evaluated through practical implementation. 52. After deliberation, the Board decided to issue this FRED but to consult on the effective date for transition. The IASB is proposing an effective date of 1 January Although the Board states in its draft Policy Statement that it will aim to converge with a new IFRS as soon as possible it does not consider this should be undertaken without due consideration of the proposals set out in any exposure draft. 17

22 ACCOUNTING STANDARDS BOARD JULY 2005 FRED The Board therefore considers the following options are available (assuming the IASB proposals proceed to an IFRS): i. implement the Business Combinations package in full simultaneously with the IASB (ie 1 January 2007); ii. not to implement immediately but reconsider implementation of the Business Combinations package after a period of time has lapsed and the IFRSs have been in effect. This would allow consideration of the practical implications to be more fully researched; iii. issue Phase I (FRED 37 Intangible Assets and FRED 38 Impairment of Assets) to be effective 1 January 2007 but defer Phase II (FRED 36 Business Combinations and FRED 39 Amendments to FRS 12 and FRS 17) until after the IFRSs are effective and consideration of the practical implications are more fully researched; and iv. issue Phase I (as in (iii) above) plus FRED 39. It might be noted that the Preface to FRED 39 sets out some concerns the Board has in relation to the proposed amendments to FRS 12. This FRED invites comments on which of these proposals is preferred. The Board considers that it would prefer to maintain its strategy of converging with International Accounting Standards in a phased approach. However, given its reservations in relation to the second Phase findings the Board would prefer to defer implementation of the Business Combinations package until a period of time has elapsed such that IASB proposals are more fully researched through practical implementation. Subsequent measurement of goodwill 54. As explained in paragraph 25, the Board would welcome comments on whether to introduce into the UK IFRS-based standard an option for entities to elect either: (a) (b) scheduled amortisation and impairment reviews whenever there is indication that goodwill might be impaired; or non-amortisation but with an impairment test annually or more frequently if events or changes in circumstances indicate that goodwill might be impaired. 18

23 PREFACE 55. It is noted in the Preface that accompanies FRED 37 Intangible Assets and FRED 38 Impairment of Assets that where intangible assets with finite useful lives are not recognised separately from goodwill then there is a risk that the goodwill impairment test may not recognise the impairment of intangible assets. In view of this the exposure draft proposes only the wider definition of intangible assets. Were an option introduced into the UK IFRS-based standard to allow amortisation of goodwill this risk would diminish and as such the Board may reconsider whether the definition based on IFRS remains appropriate. 56. Allowing entities the option of amortisation of goodwill rather than impairment testing would provide a practical alternative to annual impairment reviews. The Board s draft Policy Statement notes that the ASB seeks to issue accounting standards that are appropriate for the entities that have to apply them; and in particular that the burden of their requirements is proportionate to the benefits they provide. 19

24 ACCOUNTING STANDARDS BOARD JULY 2005 FRED 36 INVITATION TO COMMENT ITC1 The ASB invites comment on any aspect of this Financial Reporting Exposure Drafts by 28 October 2005 the same day as the IASB has set for comments. ITC2 The ASB would particularly welcome comments on the following issues: ASB 1 Should the IASB proposals succeed to a Standard the ASB would prefer to defer implementation until the full impact of the proposal can be evaluated through practical implementation. The following options for implementation into UK accounting standards have been identified, which would you prefer? Please explain your preference. i. implement the Business Combinations package in full simultaneously with the IASB (ie 1 January 2007); ii. not to implement immediately but reconsider implementation of the Business Combinations package after a period of time has lapsed and the IFRS have been in effect. This would allow consideration of the practical implications to be more fully researched; iii. issue Phase I (FRED 37 Intangible Assets and FRED 38 Impairment of Assets) to be effective 1 January 2007 but defer Phase II (FRED 36 Business Combinations and FRED 39 Amendments to FRS 12 and FRS 17) until after the IFRS are effective and consideration of the practical implications are more fully researched; and iv. issue Phase I (as in (iii) above) plus FRED 39. It might be noted that the Preface to FRED 39 sets out some concerns the Board has in relation to the proposed amendments to FRS 12. ASB 2 Do you support the proposal, as set out in paragraphs 54 and 55, that the UK IFRS based-standard should include an option, to allow goodwill having a limited useful life to be amortised over its useful life? ASB 3 The draft FRS excludes from its scope the accounting for business combinations under common control. The Board is 20

25 INVITATION TO COMMENT considering whether to include additional guidance in the UK IFRS-based standard that would retained some of the provisions of FRS 6. FRS 6 permitted group reconstructions to be accounted for by applying merger accounting. Do you consider the Board should retain those provisions of FRS 6 that permit the use of merger accounting for group reconstructions? Do you consider that any guidance is needed? If so please provide details for the type of the guidance you consider necessary. ASB 4 The draft IFRS sets out in paragraph 43 that an acquirer shall measure and recognise, separately from goodwill, an acquired non-current asset (or disposal group) that is classified as held for sale as of the acquisition date in accordance with paragraphs 7 11 of IFRS 5 Non-current Assets Held for Sale and Discontinued Operations. IFRS 5 is not an adopted UK IFRS-based standard. Previously FRS 7 required business operations to be sold within one year of the acquisition date to be treated as a single asset and the fair value to be based on the net proceeds of sale. The draft UK IFRS-based standard proposes to retain those paragraphs of FRS 7 that were previously applicable. Do you agree with this proposal? ITC3 The ASB would also welcome comments on the questions that the IASB have asked in its exposure drafts which are reproduced below. ITC4 IASB Invitation to comment on amendments to IFRS 3 Business Combinations Objective, definition and scope The proposed objective of the Exposure Draft is:...that all business combinations be accounted for by applying the acquisition method. A business combination is a transaction or other event in which an acquirer obtains control of one or more businesses (the acquiree). In accordance with the acquisition method, the acquirer measures and recognises the acquiree, as a whole, and the assets acquired and liabilities assumed at their fair values as of the acquisition date. [paragraph 1] The objective provides the basic elements of the acquisition method of accounting for a business combination (formerly called the purchase method) by describing: 21

26 ACCOUNTING STANDARDS BOARD JULY 2005 FRED 36 (a) (b) (c) what is to be measured and recognised. An acquiring entity would measure and recognise the acquired business at its fair value, regardless of the percentage of the equity interests of the acquiree it holds at the acquisition date. That objective also provides the foundation for determining whether specific assets acquired or liabilities assumed are part of an acquiree and would be accounted for as part of the business combination. when to measure and recognise the acquiree. Recognition and measurement of a business combination would be as of the acquisition date, which is the date the acquirer obtains control of the acquiree. the measurement attribute as fair value, rather than as cost accumulation and allocation. The acquiree and the assets acquired and liabilities assumed would be measured at fair value as of the acquisition date, with limited exceptions. Consequently, the consideration transferred in exchange for the acquiree, including contingent consideration, would also be measured at fair value as of the acquisition date. The objective and definition of a business combination would apply to all business combinations in the scope of the proposed IFRS, including business combinations: (a) (b) (c) (d) involving only mutual entities achieved by contract alone achieved in stages (commonly called step acquisitions) in which the acquirer holds less than 100 per cent of the equity interests in the acquiree at the acquisition date. (See paragraphs and paragraphs BC42-BC46 of the Basis for Conclusions.) IASB 1 Are the objective and the definition of a business combination appropriate for accounting for all business combinations? If not, for which business combinations are they not appropriate, why would you make an exception, and what alternative do you suggest? 22

27 INVITATION TO COMMENT Definition of a business The Exposure Draft proposes to define a business as follows: A business is an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing either: (1) a return to investors, or (2) dividends, lower costs, or other economic benefits directly and proportionately to owners, members, or participants. [paragraph 3(d)] Paragraphs A2-A7 of Appendix A provide additional guidance for applying this definition. The proposed IFRS would amend the definition of a business in IFRS 3. (See paragraphs BC34- BC41.) IASB 2 Are the definition of a business and the additional guidance appropriate and sufficient for determining whether the assets acquired and the liabilities assumed constitute a business? If not, how would you propose to modify or clarify the definition or additional guidance? Measuring the fair value of the acquiree The Exposure Draft proposes that in a business combination that is an exchange of equal values, the acquirer should measure and recognise 100 per cent of the fair value of the acquiree as of the acquisition date. This applies even in business combinations in which the acquirer holds less than 100 per cent of the equity interests in the acquiree at that date. In those business combinations, the acquirer would measure and recognise the non-controlling interest as the sum of the non-controlling interest s proportional interest in the acquisition-date values of the identifiable assets acquired and liabilities assumed plus the goodwill attributable to the noncontrolling interest. (See paragraphs 19, 58 and BC52-BC54.) IASB 3 In a business combination in which the acquirer holds less than 100 per cent of the equity interests of the acquiree at the acquisition date, is it appropriate to recognise 100 per cent of the acquisition-date fair value of the acquiree, including 100 per 23

28 ACCOUNTING STANDARDS BOARD JULY 2005 FRED 36 cent of the values of identifiable assets acquired, liabilities assumed and goodwill, which would include the goodwill attributable to the non-controlling interest? If not, what alternative do you propose and why? The Exposure Draft proposes that a business combination is usually an arm s length transaction in which knowledgeable, unrelated willing parties are presumed to exchange equal values. In such transactions, the fair value of the consideration transferred by the acquirer on the acquisition date is the best evidence of the fair value of the acquirer s interest in the acquiree, in the absence of evidence to the contrary. Accordingly, in most business combinations, the fair value of the consideration transferred by the acquirer would be used as the basis for measuring the acquisition-date fair value of the acquirer s interest in the acquiree. However, in some business combinations, either no consideration is transferred on the acquisition date or the evidence indicates that the consideration transferred is not the best basis for measuring the acquisition-date fair value of the acquirer s interest in the acquiree. In those business combinations, the acquirer would measure the acquisition-date fair value of its interest in the acquiree and the acquisition-date fair value of the acquiree using other valuation techniques. (See paragraphs 19, 20 and A8-A26, Appendix E and paragraphs BC52-BC89.) IASB 4 Do paragraphs A8-A26 in conjunction with Appendix E provide sufficient guidance for measuring the fair value of an acquiree? If not, what additional guidance is needed? The Exposure Draft proposes a presumption that the best evidence of the fair value of the acquirer s interest in the acquiree would be the fair values of all items of consideration transferred by the acquirer in exchange for that interest measured as of the acquisition date, including: (a) (b) (c) contingent consideration; equity interests issued by the acquirer; and any non-controlling equity investment in the acquiree that the acquirer owned immediately before the acquisition date. (See paragraphs and BC55-BC58.) 24

29 INVITATION TO COMMENT IASB 5 Is the acquisition-date fair value of the consideration transferred in exchange for the acquirer s interest in the acquiree the best evidence of the fair value of that interest? If not, which forms of consideration should be measured on a date other than the acquisition date, when should they be measured, and why? The Exposure Draft proposes that after initial recognition, contingent consideration classified as: (a) (b) equity would not be remeasured. liabilities would be remeasured with changes in fair value recognised in profit or loss unless those liabilities are in the scope of IAS 39 Financial Instruments: Recognition and Measurement or [draft] IAS 37 Non-financial Liabilities. Those liabilities would be accounted for after the acquisition date in accordance with those IFRSs. (See paragraphs 26 and BC64-BC89.) IASB 6 Is the accounting for contingent consideration after the acquisition date appropriate? If not, what alternative do you propose and why? The Exposure Draft proposes that the costs that the acquirer incurs in connection with a business combination (also called acquisition-related costs) should be excluded from the measurement of the consideration transferred for the acquiree because those costs are not part of the fair value of the acquiree and are not assets. Such costs include finder s fees; advisory, legal, accounting, valuation and other professional or consulting fees; the cost of issuing debt and equity instruments; and general administrative costs, including the costs of maintaining an internal acquisitions department. The acquirer would account for those costs separately from the business combination accounting. (See paragraphs 27 and BC84-BC89.) IASB 7 Do you agree that the costs that the acquirer incurs in connection with a business combination are not assets and should be excluded from the measurement of the consideration transferred for the acquiree? If not, why? 25

30 ACCOUNTING STANDARDS BOARD JULY 2005 FRED 36 Measuring and recognising the assets acquired and the liabilities assumed The Exposure Draft proposes that an acquirer measure and recognise as of the acquisition date the fair value of the assets acquired and liabilities assumed as part of the business combination, with limited exceptions. (See paragraphs and BC111-BC116.) That requirement would result in the following significant changes to accounting for business combinations: (a) (b) Receivables (including loans) acquired in a business combination would be measured at fair value. Therefore, the acquirer would not recognise a separate valuation allowance for uncollectible amounts as of the acquisition date. An identifiable asset or liability (contingency) would be measured and recognised at fair value at the acquisition date even if the amount of the future economic benefits embodied in the asset or required to settle the liability are contingent (or conditional) on the occurrence or nonoccurrence of one or more uncertain future events. After initial recognition, such an asset would be accounted for in accordance with IAS 38 Intangible Assets or IAS 39 Financial Instruments: Recognition and Measurement, as appropriate, and such a liability would be accounted for in accordance with [draft] IAS 37 or other IFRSs as appropriate. IASB 8 Do you believe that these proposed changes to the accounting for business combinations are appropriate? If not, which changes do you believe are inappropriate, why, and what alternatives do you propose? The Exposure Draft proposes limited exceptions to the fair value measurement principle. Therefore, some assets acquired and liabilities assumed (for example, those related to deferred taxes, assets held for sale, or employee benefits) would continue to be measured and recognised in accordance with other IFRSs rather than at fair value. (See paragraphs and BC117-BC150.) 26