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«Business combinations and changes in ownership interests A guide to the revised IFRS 3 and IAS 27 Audit.Tax.Consulting.Financial Advisory. Contacts ...»

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Goodwill may be likely to occur where the particular set of assets or activities includes a trade or operating activity that generates revenue. In addition, the requirements in relation to accounting for transactions that are not business combinations (see section 5.4) require an entity to determine the fair values of the acquired assets and liabilities so as to proportionally allocate the cost of the group of assets and liabilities. This analysis may quickly identify that the total consideration paid exceeds the aggregate fair value of the assets acquired and liabilities assumed, potentially indicating the existence of goodwill.

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5.3.2 Inputs, processes and outputs The guidance describes a business as consisting of inputs and processes applied to those inputs that have the ability to create outputs. Although outputs are usually present, they are not required for an integrated set of activities and assets to qualify as a business. [IFRS 3(2008).B7]

The following points are summarised from IFRS 3(2008).B7 – B11:

(a) inputs are economic resources including employees, materials and non-current assets (including rights of use);

(b) processes are systems, standards, protocols, conventions or rules that when applied to inputs, create outputs. Examples would include strategic management, operations and resource management. Accounting, billing, payroll and similar administrative systems typically are not used to create outputs.;

(c) outputs provide a return in the form of dividends, lower costs or other economic benefits to stakeholders;

(d) as a result of an acquisition, an acquirer may combine the acquiree’s inputs and processes with its own with the result that it is not necessary that all pre-acquisition inputs and processes remain unchanged;

(e) a business may not have outputs (e.g. where it is in a development stage);

(f) a business may or may not have liabilities; and (g) the assessment as to whether a particular set of assets and activities is a business is made by reference to whether the integrated set is capable of being conducted and managed as a business by a market participant – it is not relevant whether the seller operated the set as a business or whether the acquirer intends to operate the set as a business.

Example 5.3.

2A Outsourcing arrangements The application of the revised guidance around the identification of a business can, in some circumstances, lead to different conclusions under IFRS 3(2008) and IFRS 3(2004) as to whether a business exists. One of these areas, depending on the nature of the arrangement, can be the treatment of an outsourcing arrangement.

For example, an entity may decide to outsource its information technology or call centre operations to a third party. Before the outsourcing, these functions generally will have been operated as a cost centre for the business as a whole, rather than as a business per se.

Generally, the staff, plant and equipment and other working capital of the outsourced department are transferred to the third party, and a contractual arrangement entered into with the third party for the provision of the service to the outsourcing entity on an ongoing basis.

Identifying a business combination

While they were part of the outsourcing entity, the operations generally would not have been considered a business and would not have been operated as such. However, the third party that acquires the assets and liabilities and takes on the staff could be seen to have acquired a business, as the transferred set of assets and activities is capable of being operated as a business. The conclusion is even clearer where the transferred assets and employees are used as the ‘seed capital’ to offer similar services to other parties.

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Industries where the required inputs are minimal When assessing whether a particular set of assets and activities is a business, it is important to consider the normal nature of the assets and activities in the relevant business sector or industry. In some industries, there may be a relatively low number of assets required as inputs, working capital requirements may be low, or the number of employees used in the process of creating outputs may be low. The acquisition of assets and activities in these types of industries must be assessed by reference to these normal levels.

For example, an entity may acquire a set of assets and activities that represents the ownership and management of a group of pipelines used for the transport of oil, gas and other hydrocarbons on behalf of a number of customers. The operation has a limited number of employees (mainly used in maintenance of the pipelines and billing of customers), a system used for tracking transported hydrocarbons and a minor amount of working capital. The transaction involves the transfer of employees and systems, but not the working capital.

Notwithstanding that the inputs into the process are minimal, the group of pipelines will meet the definition of a business and so the transaction will be accounted for as a business combination.

5.4 Accounting for a transaction that is not a business combination Where a transaction or other event does not meet the definition of a business combination due to the acquiree not meeting the definition of a business, it is termed an ‘asset acquisition’. In such

circumstances, the acquirer:

[IFRS 3(2008).2(b)] • identifies and recognises the individual identifiable assets acquired (including those assets that meet the definition of, and recognition criteria for, intangible assets in IAS 38 Intangible Assets) and liabilities assumed; and • allocates the cost of the group of assets and liabilities to the individual identifiable assets and liabilities on the basis of their relative fair values at the date of purchase.

Such a transaction or event does not give rise to goodwill.

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Example 5.4A Incorporation of a new subsidiary In corporate groups, it is common for subsidiaries to be incorporated for specific purposes (e.


to house particular operations, to act as service companies, or for other structuring purposes).

In such circumstances, the acquisition of a ‘shell’ or ‘shelf’ company is not a business combination as defined in IFRS 3(2008) because no business is being acquired.

Accordingly, the acquisition or incorporation of such an entity should be accounted for in the separate financial statements of the legal parent in accordance with IAS 27, which would require initial measurement at cost (i.e. the costs of incorporating or acquiring the ‘shelf’ entity).

In the consolidated financial statements, the costs would be recognised as start-up, restructuring or similar costs in accordance with IAS 38 Intangible Assets.

Example 5.4B Exploration and evaluation assets held in corporate shells In some jurisdictions, it is common for rights to tenure over exploration and evaluation interests to be held in separate companies for each tenement, area of interest, field, etc.

Management of the entity’s exploration and evaluation activities is centralised, including any plant and equipment used, employees, service and other contracts, and similar items.

In many cases, transactions involving the transfer of a particular exploration and evaluation interest involves the legal transfer of the company, rather than the underlying right or title over the interest.

Where an entity acquires a company in these circumstances, it is likely that the acquisition will not meet the definition of a business combination, because the acquisition is in substance the acquisition of the exploration and evaluation interest, rather than the acquisition of a business.

Accordingly, in the consolidated financial statements, such a transaction would be accounted for in accordance with the entity’s accounting policy for exploration and evaluation under IFRS 6 Exploration for and Evaluation of Mineral Resources, rather than as a business combination.

Identifying the acquirer

6. Identifying the acquirer IFRS 3(2008) continues the requirement of IFRS 3(2004) that, for each business combination, one of the combining entities should be identified as the acquirer. [IFRS 3(2008).6 & (Appendix A)] The acquirer and the acquiree are identified by applying the guidance in IAS 27(2008) regarding the concept of control. Where identification is not achieved by this analysis, application guidance in IFRS 3(2008).B14 – B18 provides additional guidance. [IFRS 3(2008).7]

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Control is the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. [IAS 27(2008).4] Financial and operating policies are not defined in IAS 27. Operating policies generally would include those policies that guide activities such as sales, marketing, manufacturing, human resources, and acquisitions and disposals of investments. Financial policies generally would be those policies that guide dividend policies, budget approvals, credit terms, issue of debt, cash management, capital expenditures and accounting policies.

6.1.1 Policies and benefits

The definition of control encompasses both the notion of governance and the economic consequences of that governance (i.e. benefits and risks). Governance relates to the power to make decisions. In the definition of control, the phrase ‘power to control’ implies having the capacity or ability to accomplish something – in this case, to govern the decision-making process through the selection of financial and operating policies. This does not require active participation or ownership of shares.

In situations where one entity has the power to govern another entity’s policies, but derives no benefits from its activities, there is a presumption that control does not exist.

Example 6.1.

1A General partners A limited partnership is formed with 3 partners: A is the general partner with responsibility for management for which it receives a fee that is comparable with similar arrangements between third parties; B and C are limited partners with no responsibility for management and 50% share of profits each. A cannot be removed by B and C.

As general partner, A will govern the financial and operating policies of the partnership.

However, because A does not participate in the benefits of the partnership’s activities, it would be concluded that A does not control the partnership within the meaning of IAS 27.

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Laws around the establishment and operation of a trust usually involve the appointment of a trustee (sometimes called a ‘responsible entity’). The trust arrangement usually creates an equitable obligation on the trustee to deal with the property of the trust for the benefit of beneficiaries. The trustee has legal ownership of the property of the trust, whereas the beneficiaries have ‘beneficial’ or ‘equitable’ ownership in the trust property.

Although a trustee can control the financial and operating policies of a trust, it does not control the trust because it is generally unable to obtain benefits from its activities. This generally holds true even if the trustee is compensated for the services provided to the trust, unless those compensation arrangements are structured in a way that results in a transfer of benefits to the trustee that exceeds a normal compensation arrangement.

Overall, a trustee’s relationship with the trust can be viewed as a fiduciary relationship rather than one of control.

6.1.2 Presumption of control Control is generally presumed to exist when the parent owns, directly or indirectly through subsidiaries, more than half of the voting power of an entity. In exceptional circumstances, however, it may be possible to clearly demonstrate that such ownership does not constitute control. Control

also exists when the parent owns half or less of the voting power of an entity when there is:

[IAS 27(2008).13] (a) power over more than half of the voting rights by virtue of an agreement with other investors;

(b) power to govern the financial and operating policies of the entity under a statute or an agreement;

(c) power to appoint or remove the majority of the members of the board of directors or equivalent governing body and control of the entity is by that board or body; or (d) power to cast the majority of votes at meetings of the board of directors or equivalent governing body and control of the entity is by that board or body.

The definition and guidance on control is intended to identify whether an entity has sole control over one or more other entities. Where two entities have joint control under a contractual agreement (i.e. they are able to exercise control by cooperating, but neither can unilaterally exercise control without the agreement of the other), then the arrangement will not fall within the scope of either IAS 27 or IFRS 3, but will fall within the scope of IAS 31.

Identifying the acquirer 6.1.3 Potential voting rights An entity may own instruments (e.g. share warrants, share call options, debt or equity instruments that are convertible into ordinary shares) that have the potential (if exercised or converted) to give the entity voting power or reduce another party’s voting power over the financial and operating policies of another entity (potential voting rights).

• Where potential voting rights are currently exercisable or convertible, they are considered when assessing whether an entity has the power to govern another entity’s financial and operating policies. [IAS 27(2008).14] • Where potential voting rights are not exercisable or convertible until a future date or until the occurrence of a future event, they are not considered in making that assessment.

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