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IFRS3 - Business Combinations - Part 1

Several countries have adopted the IFRS 3 and some of the effective dates are as follow:

Country   Standard   Effective date
International   IFRS 3   31st March 2004
Australia   AASB 3   1st January 2005
Hong Kong   HK FRS 3   1st January 2005
Malaysia   FRS 3   1st January 2006
New Zealand   NZ FRS 3   1st January 2007 1
Singapore   FRS 103   1st July 2004
US GAAP   FAS 141   1st July 2001 2

1 Early adoption is permitted only if entity complies with NZ FRS 1 on 1 January 2005.
2 FAS141 predates the introduction of IFRS 3, but contains many similar provisions. However, there are key differences in certain areas.

Financial reporting rules for acquisitions were radically changed by the introduction of the IFRS 3. The new standard requires that the Purchase Method to be applied for all acquisitions.

Before IFR3, previous accounting standards permitted business combinations to be accounted for using Pooling of Interests Method or the Purchase Method. The Pooling Method was intended only for combinations of companies of similar market value, when both groups of shareholders retain their ownership interests in the new company. However, in practice, the Pooling Method was frequently used, even in the case of unfriendly acquisitions.

The Pooling of Interests Method differs from the Purchase Method in the following:

  1. There is no acquirer or the acquired firm.
  2. Financial statements are consolidated without adjustment; no fair values are recognized for either company.
  3. Operating results for the combined firm are restated (combined) for all periods prior to the merger date.

Under IFRS 3, the Purchase Method requires the allocation of the purchase price to all of the acquired identifiable tangible and intangible assets and liabilities, some of which may have been previously unrecognized. The assets and liabilities of the acquired company are received by the financial statements of the acquirer at their fair market values at the acquisition date. Due to the acquisition, and the mix of historical and market values, post merger balance sheets are not comparable to the pre-acquisition balance sheet of the acquirer.

Application of the Purchase Method

Applying the purchase method involves the following steps:

  1. Identification of an acquirer
  2. Measuring the cost of a business combination
  3. Purchase price allocation

Identification of an acquirer

A business combination is the bringing together of separate entities or businesses into one reporting entity. The acquirer obtains control of the other entities or businesses.

Control is the power to govern the policies so as to benefit from it. Control is obtained in the business combination if the acquirer obtains one of the following:

  1. More than 50% of voting rights.
  2. Agreement to govern the financial and operating policies.
  3. Power to appoint or remove majority of the board of directors or equivalent governing body.
  4. Power to cast majority votes at board meetings.

Other common indicators to identify an acquirer in the business combination are:

  1. Acquirer giving up cash for exchange of equity.
  2. Value of the acquirer is significantly greater than that of the acquiree.
  3. Acquirer dominates the management team.

Measuring the cost of a business combination

The acquirer's cost of a business combination is the aggregate of:

  1. Fair values of the assets given, liabilities incurred or assumed, and equity instruments issued by the acquirer at the date of exchange; and
  2. Any costs directly attributable to the business combination.

The acquisition date is the date on which the acquirer effectively obtains control of the acquiree. If acquirer gains control of the acquiree through a single exchange transaction, the date of exchange is the acquisition date. However, if more than one exchange transaction is involved, the cost of the business combination is the sum of the individual transactions. The date of exchange is the date of each exchange transaction whereas the acquisition date is the date on which the acquirer obtains control of the acquiree.

Assets given and liabilities incurred or assumed by the acquirer in exchange for control are required to be measured at their fair values at the date of exchange. The cost of business combination also includes any costs directly attributable to the combination, such as professional fees to accountants, legal advisers, valuers, and other consultants. General administrative costs including internal staff costs and other costs that cannot be directly attributed to the combination are not included in the cost of combination.

Cost of arranging and issuing financial liabilities to effect a business combination shall be recorded in the initial measurement of the liability, while costs of issuing equity instruments shall not be included in the cost of a business combination.

In the next issue, we will discuss the Purchase Price Allocation process and the recognition of Goodwill.