The Hindu Business Line : Business combinations under IFRS

With mergers and acquisitions (M&A) becoming frequent, accounting implications on these have come into the spotlight. There has been considerable focus and debate on how business combinations are accounted for. Theoretically there are two methods — the pooling method and the purchase method.

The pooling method is applied when two business equals combine into a new entity with no acquirer being clearly identified. Purchase method is applied when an acquirer is clearly identified in a business combination. It may be noted that pooling is allowed only if certain conditions indicating merger of equals is fulfilled.

Under the pooling method, the excess of consideration for acquisition over the book value of the assets acquired is adjusted against reserves, since the underlying transaction is a get together of two enterprises and consequently there is no goodwill to be recorded as an asset.

Whereas under the purchase method the consideration paid over and above the fair value of the net assets acquired is captured as goodwill, which going forward is tested for impairment. Under the purchase method, all identifiable assets and liabilities are fair valued irrespective of whether those assets/liabilities were recorded or not in the books of the acquiree.

Pooling method prohibited

IFRS (International Financial Reporting Standards) 3 — Business combinations — now prohibits the pooling method. The reason being that permitting two methods vitiated comparability and created incentives for structuring business combinations to qualify for pooling and achieve a desired accounting objective given that the two methods produced quite different results.

Besides, in the real world it is improbable that there would be combination of business equals with the acquirer not being identifiable. Therefore, IFRS 3 now allows only the purchase method. With the abolition of pooling method there is no more incentive under IFRS to structure deals so as to qualify for the pooling method.

Fair value accounting under IFRS 3 reflects the true value of an acquisition and the premium paid, that is, goodwill. Going ahead it would also result in an appropriate depreciation/amortisation of assets acquired, since the fair value rather than book value of the assets would be depreciated.

It would result in greater transparency and management responsibility for the acquisition and the price paid to acquire the business. Any future impairment of acquisition goodwill will put to question the appropriateness of the management’s decision to acquire the business.

Limited guidance

Considerable judgment will be called for in applying IFRS 3, including the identification and valuation of intangible assets and contingent liabilities. Unfortunately IFRS 3 provides limited guidance on determining fair value of assets and liabilities acquired. How to determine fair values is an area that IASB clearly needs to provide guidance in the immediate future.

An interesting point to note is that IFRS 3 prohibits amortisation of goodwill and requires goodwill to be tested only for impairment. Amortisation of goodwill results in an even spread of charge to the income statement over several years; contrarily, a huge one-off impairment charge on impairment of goodwill, as required by IFRS 3, will bring in substantial volatility to the income statement.

Under Indian GAAP, there is no comprehensive standard dealing with business combinations. In fact there are as many as six standards that deal with various types of business combinations and accounting for goodwill. Many of these requirements are disparate and inconsistent, for example, goodwill resulting from an amalgamation has to be compulsorily amortised over not more than five years, whereas there is no compulsion to amortise goodwill on acquisition of a subsidiary.

Another example, is that acquisition accounting in the case of acquisition of a subsidiary or an associate is based on book values, whereas, amalgamation other than which fulfil pooling conditions, can be accounted either using book values or fair values of net assets acquired.

As stated above, acquisition accounting of subsidiaries, associates and joint ventures under Indian GAAP is based on book values rather than fair values. Unlike Indian GAAP, IFRS 3 requires assets and liabilities acquired, including contingent liabilities, to be recorded at fair value.

Contingent liabilities

These are not recorded as liabilities under Indian GAAP. Contingent liabilities are fair valued and recorded under IFRS in an acquisition, since the consideration paid for a business by an acquirer is also influenced by the nature and quantum of contingent liabilities of the acquiree.

For reasons mentioned above, goodwill determined under Indian GAAP is a plug in number, unrealistic and of little use in analysing the business combination.

IFRS 3 requires all business combinations (excludes common control transactions) within its scope to be accounted as per purchase method and prohibits pooling method. Indian GAAP permits both purchase and pooling of interest methods, in the case of amalgamations. Pooling of interest method is allowed only if the amalgamation satisfies certain specified conditions. In IFRS 3, acquisition accounting is based on substance. Reverse acquisition under IFRS is accounted assuming the legal acquirer is the acquiree. For example, a big private limited company to seek quick listing may be legally acquired by a small listed company. Under IFRS the private company would be treated as an acquirer though legally it was acquired by the listed company. In Indian GAAP, acquisition accounting is based on legal form and, in the above example, the listed company would be treated as an acquirer.

Business combination accounting under Indian GAAP is outdated and does not reflect the underlying substance and the true premium paid for an acquisition. Because of the inconsistent and disparate requirements across various standards, it provides incentives for deal structuring. It is time that an IFRS 3-like standard was introduced in India.

(The author is Partner, Ernst & Young Pvt. Ltd. The views are personal.)

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