IFRS 3 (2008) - major changes and implications

Table of contents

1. Introduction

2. Major changes and implications
1. Treatment of minority interest and goodwill
2. Recognition of incidental acquisition costs
3. Accounting for pre-existing relationships
4. Business combinations accomplished in stages
5. Contingent considerations
6. Reacquired rights

3. Information sources used

4. Conclusion and outlook

5. References

Glossary

exposure draft (ED)

Financial Accounting Standard Board (FASB) International Accounting Standard Board (IASB) International Financial Reporting Standard (IFRS) minority interest (MI)

return on capital employed (ROCE)

1. Introduction

In June 2005 the International Accounting Standard Board (IASB) published an exposure draft (ED) of proposed amendments dealing with the International Financial Reporting Standard (IFRS) 3 Business Combinations. Until 28 October 2005 the board accepted com- ments on the amendments, which are the result of the second phase of the development of the standard. The first phase was concluded in March 2004 with the initial publication of IFRS 3. The development in phases is taking into account the efforts of the IASB and the Financial Accounting Standard Board (FASB) to come to a convergence between the United States Generally Accepted Accounting Principles (US GAAP) and the IFRS. The boards evaluated the proposals and published the revised IFRS 3 in January 2008. It will take effect on 1 July 2009.

One of the major changes associated with the revised IFRS 3 is the introduction of an accounting alternative for the treatment of minority interest (MI). It may either be accounted for by using fair values or the proportionate share of the net assets of the acquiree. Another important adjustment is the handling of direct costs occurring with acquisitions (e.g. legal and consulting services). Having been capitalized as a part of goodwill in the old version of the standard, they have to be expensed in the revised IFRS 3.

But what impact will the modifications have? And what other changes will the companies reporting in accordance with the new version of IFRS 3 have to face when the amendments come into operation? What is the reasoning of the IASB to make those changes? How do they affect the capital structure and ratios?

The remainder of this paper is organised as follows. The second section describes the changes to the previous regulations and their effects. Hereby the focus is on the full goodwill option which has been introduced. It furthermore discusses the intentions of the IASB to make those changes and on the impacts on the profit and loss account as well as on the balance sheet. It then examines how those impacts might influence the capital structure and the company’s ratios. Afterwards the third part describes the information sources this paper is based on. The report finishes with a conclusion summarizing the main points.

2. Major changes and implications

There are a number of changes in the revised IFRS 3. Some of them deviate from the proposals made in the ED of IFRS 3 published in June 2005. This is due to the fact that the two boards could not agree on converging in all respects of the proposed regulations. However, it remains to be seen how the conversion of the standards is going on and whether the last outstanding differences can be eliminated.

This report will concentrate on discussing those modified regulations, which have major effects in terms of reporting requirements and outcomes on the applying businesses (IASB, 2008a; KPMG, 2008a):

1. Treatment of minority interest and goodwill
2. Recognition of incidental acquisition costs
3. Accounting for pre-existing relationships
4. Business combinations accomplished in stages
5. Reacquired rights
6. Contingent considerations

1. Treatment of minority interest and goodwill

One of the major issues that was expected to come with the revised standard was the full- goodwill method described in ED IFRS 3.49 (IASB, 2005a). According to the ED goodwill is supposed to be calculated “as the excess of the fair value of the acquiree, as a whole, over the net amount of the recognised identifiable assets acquired and liabilities assumed” (IASB, 2005a, p. 19). Paragraphs 19 and 20 of the ED state that in most cases the consideration transferred should be the best indicator for the fair value of the acquiree. Thus is even if less than 100 per cent of the acquiree are purchased, the value of the company as a whole is derived from the consideration transferred. However, if “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” (IASB, 2005a, p. 30) other valuation techniques, such as the use of comparable market data or the calculation of the present value of expected future income, may be used (IASB, 2005a, p. 59-61).

Comparing the full goodwill method with the goodwill treatment in the IFRS 3 version of 2005, which calculates goodwill as the excess of the consideration transferred over the acquirer’s proportionate share in the net assets of the acquiree, it becomes clear that differences in the recognizable amount of goodwill will first and foremost occur when the acquirer obtains control without buying all of the shares in the acquiree. This is because both the acquirer’s portion of goodwill and the part attributable to MI are recognised under the full goodwill method.

Goodwill then, as stated in ED IFRS 3.A62 was supposed to be distributed between the acquirer and the non-controlling interest as follows: The amount recognized for the acquirer was ought to be the excess of the acquirer’s share in the acquiree’s equity at the acquisition date over the fair value of the revalued assets and liabilities of the acquiree. The residual then belongs to the MI.

However, the standard setters decided against a clear introduction of the full goodwill method and instead compromised: The acquirer may chose between recognizing the MI with its proportionate share of the net assets (2005 version of IFRS 3) or with its fair value derived by taking its market value in case the acquiree is listed at a stock exchange or, if not, by applying other valuation techniques (cf. above). The fair value recognition of MI effectively leads to the same results as the determination of goodwill described in the ED. However, the revised standard prescribes a different calculation. Paragraph 32 of the revised IFRS 3 states that goodwill has to be measured as the excess of the sum of the consideration transferred and any MI over the fair values of the identifiable acquired assets and liabilities assumed (cf. Ill. 1)^[1]. (IASB, 2008b)

illustration not visible in this excerpt

Illustration 1: system of goodwill calculation according to the revised IFRS 3

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^[1] It is assumed that no previously investments held by the acquirer.