Section 14 – Business Combinations and Goodwill

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Section 14 – Business Combinations and Goodwill

Section 14 deals with the accounting for business combinations including goodwill but only applies to business combinations in the form of acquiring the business assets and liabilities of a business as opposed to acquiring shares. FRS 105 does not permit consolidated financial statements to be prepared therefore rules for business combinations that relate to the acquisition of shares is not applicable as FRS 105 requires such acquisitions to be stated at the cost less impairment in the individual entity financial statements. It provides guidance on identifying the acquirer, measuring the cost of the business combination, allocating the costs of the acquired assets and determining the fair value of all assets and liabilities and how goodwill should be determined and accounted for.

Accounting for a trade and asset acquisition

Extract from FRS 105 – Section 14.1

14.1 Where a micro-entity effects a business combination by acquiring the trade and assets of another business, it shall apply Section 19 Business Combinations and Goodwill of FRS 102, except for the following:

a micro-entity shall not separately identify and recognise intangible assets;
a micro-entity shall not recognise a deferred tax asset or liability;
a micro-entity shall not apply paragraph 19.23 of FRS 102, but instead apply paragraph 14.2 of this FRS;
a micro-entity shall not recognise and measure a share-based payment transaction in accordance with Section 28 Employee Beneﬁt of FRS 102, but instead apply Section 23 Employee Beneﬁts of this FRS; and
a micro-entity is not required to provide any of the

Goodwill arising on a trade and asset acquisition

Extract from FRS 105 – Section 14.2

14.2 Where a micro-entity has recognised goodwill acquired in a trade and asset acquisition (in accordance with paragraph 19.22 of FRS 102), the micro-entity shall measure that goodwill at cost less accumulated amortisation and accumulated impairment losses:

a) A micro-entity shall follow the principles in paragraphs 13.9 to 13.14 of this FRS for amortisation of goodwill. Goodwill shall be considered to have a ﬁnite useful life, and shall be amortised on a systematic basis over its life. If, in exceptional cases, a micro-entity is unable to make a reliable estimate of the useful life of goodwill, the life shall not exceed ten years.

b) A micro-entity shall follow Section 22 Impairment of Assets of this FRS for recognising and measuring the impairment of goodwill.

OmniPro comment

FRS 105 only provides rules on accounting for business combinations which are acquired through the acquisition of trade assets and liabilities as opposed to shares. FRS 105 does not permit consolidated financial statements to be prepared therefore the accounting for acquisition where shares is acquired is not applicable. Section 14.1 above makes it clear that an entity should refer to Section 19 of FRS 102 for guidance on accounting for business combination where trade assets and liabilities are acquired with the exception of the below:

Section 14.1(a) makes it clear that it is not permitted to separate out intangible assets from goodwill instead it is all treated as goodwill.
No requirement to recognise deferred tax on any differences between book amounts of the assets/liabilities just prior to the acquisition when compared to the fair value at the date of acquisition. This is because FRS 105 does not permit deferred tax to be recognised.
No requirement for the disclosures stated in section 19 of FRS 102
No requirement to measure equity share based payments as part of the fair value of assets acquired/liabilities assumed until the shares are issued.

References to Section 19 of FRS 102 in the remaining part of this section are made as Section 14 of FRS 105 directs the reader to Section 19 of FRS 102 for guidance on accounting for business combinations.

Definition of a business combination

FRS 102, Section 19.3 states that a business combination is the bringing together of separate entities or businesses into one reporting entity. The result of nearly all business combinations is that one entity, the acquirer, obtains control of one or more other businesses, the acquiree. The acquisition date is the date on which the acquirer obtains control of the acquiree.

Appendix I of FRS 105 defines a business as ‘an integrated set of activities and assets conducted and managed for the purpose of providing:

A return to investors; or
Lower costs or other economic benefits directly and proportionately to policyholders or participants.

A business generally consists of inputs, processes applied to those inputs and resulting outputs that are, or will be, used to generate revenues. If goodwill is present in a transferred set of activities and assets, the transferred set shall be presumed to be a business.’

FRS 102 or FRS 105 does not define inputs, processes and outputs however IFRS 3 provides further guidance as follows:

Input: examples include fixed assets, intellectual property, intangible assets, ability to gain access to certain materials or rights and employees.

Processes: any system, standard, protocol is a process if when applied to an input/inputs, that either creates or has the ability to create outputs. Examples include strategic management processes, operational processes and resource management processes. An organised workforce having the necessary skills and experience following rules and conventions may provide the necessary processes that are capable of being applied to inputs to create outputs.

Output: the results of inputs, processes applied to those inputs that provide or have the ability to provide a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants.

Appendix I of FRS 102 states where goodwill arises on acquisition there is a rebuttable presumption that a business has been acquired. However lack of goodwill does not automatically exclude a transaction from being a business.

Example 1: Determining a Business

Company A is a building contractor. Company A purchased land and buildings from a third party. In this case this is not a business it is merely assets.

Example 2: Determining a Business

Company A acquired the stock, fixed assets, creditors, customers lists, (employees were also transferred) from a third party which produced customer products and which will continue to produce these products.

In this instance as they have acquired the fixed assets, stock (i.e. the inputs), and have the processes (i.e. the employees, customers) to produce the output (i.e. being the product), this would be classed as a business.

Structure of a business combination

Extracts from FRS 102 – Section 19.4–19.5A

19.4 A business combination may be structured in a variety of ways for legal, taxation or other reasons. It may involve:

the purchase by an entity of the equity of another entity,

the purchase of all the net assets of another entity,

the assumption of the liabilities of another entity, or the purchase of some of the net assets of another entity that together form one or more businesses.

19.5 A business combination may be effected by the issue of equity instruments, the transfer of cash, cash equivalents or other assets, or a mixture of these. The transaction may be between the shareholders of the combining entities or between one entity and the shareholders of another entity. It may involve the establishment of a new entity to control the combining entities or net assets transferred, or the restructuring of one or more of the combining entities.

OmniPro comment

It is clear from the above that whatever the legal structure, if it meets the definition of a business combination it comes within the remit of Section 14.

Therefore where the goodwill and net assets of a business are purchased (i.e. not through the purchase of shares), although it does not create a subsidiary/parent relationship it should still be accounted for as a business combination.

An entity does not have to physically pay cash in order to come within the remit of section 19 of FRS 102 or Section 14 of FRS 105. Examples would include instances where the entity previously had a significant influence but as a result of a share buyback of main shareholders or a change of rights to the shares, the entity then becomes the controlling party, this is then accounted for as a business combination and accounted for under the purchase method. This is not that applicable for FRS 105 as accounting for acquisition of shares as a business combination is not required or permitted.

Purchase method – Cost of a business combination

Extracts from FRS102 – Section 19.11-19.11A

19.11 The acquirer shall measure the cost of a business combination as the aggregate of:

(a) the fair values, at the acquisition date, of assets given, liabilities incurred or assumed, and equity instruments issued by the acquirer, in exchange for control of the acquiree; plus

(b) any costs directly attributable to the business combination.

19.11A Where control is achieved following a series of transactions, the cost of the business combination is the aggregate of the fair values of the assets given, liabilities assumed and equity instruments issued by the acquirer at the date of each transaction in the series.

OmniPro comment

Where cash is paid for the business, the cost of the business combination is effectively the cash price paid being its fair value.

Where payment is deferred and it is for greater than one year the present value of the amount to be paid is the cost of the business combination.

The calculation of deferred consideration is considered further below.

Consideration paid could also include group loans or borrowings taken over in the acquired entity. Future losses expected to be incurred are not considered to be liabilities incurred.

Costs directly attributable to the acquisition

Cost that would be considered to be directly attributable to the business combination (costs that have to be incurred to effect the business) would include:

professional fees paid to accountants, legal advisors, valuers and other consultants to effect the combination
Cost of paying a third party to investigate or assist in identifying a potential target but only if the fee is payable on condition that the combination takes place.
Cost for auditing the completion accounts and undertaking due diligence work

Example of costs which would not be considered to be directly attributable to the business combination are:

Incremental costs that are attributable towards the cost of obtaining finance to purchase the combination e.g. costs directly attributable to financial liabilities or cost associated with the issue of equity instruments.

Costs charged by professional advisors in order to allow the entity to obtain finance or issue shares
General administrative costs e.g. staff costs of the acquirer’s regardless of their position and regardless of how long they have worked on it
Overhead costs

Equity issued as consideration for the acquisition

Where equity instruments issued by the acquirer are given as consideration for the business combination, then the equity instruments have to be fair valued.

The fair value exercise should follow the requirement of Section 11 of FRS 102 when determining fair value i.e. in reality a listed share price will not be available so a discounted cash flow model will have to be used. These discounted cash flows should use market information when determining the valuation and very little internal information. Where the variability of various valuation techniques is not significant, or the probabilities of the various estimates within the range can be reasonably assessed and used in estimating fair value, the valuation of the equity instrument is likely to be reliable.

Adjustments to the cost of a business combination contingent on future events

Extracts from FRS102 – Section 19.12-19.13

19.12 When a business combination agreement provides for an adjustment to the cost of the combination contingent on future events, the acquirer shall include the estimated amount of that adjustment in the cost of the combination at the acquisition date if the adjustment is probable and can be measured reliably.

19.13 However, if the potential adjustment is not recognised at the acquisition date but subsequently becomes probable and can be measured reliably, the additional consideration shall be treated as an adjustment to the cost of the combination. Allocating the cost of a business combination to the assets acquired and liabilities and contingent liabilities assumed

OmniPro comment

Contingent consideration and change in estimate

Section 19.12 and 19.13 of FRS 102 deals with contingent consideration. This is where the price payable to the acquiree is conditional on future events. A flat price is paid for the target entity and a further amount may be payable if profits exceed a certain level in the future. Where the future payment is linked to the cost of an employee’s future service then these costs do not form part of the cost of a business combination instead they should be charged to the profit and loss. This is discussed further below.

Where contingent consideration exists, the fair value of the expected future payment where it can be reliably measured should be included within the cost of the business combination but it must be probable the amount will be paid. Where the contingent consideration is payable over a period of more than one year the expected payment should be present valued.

Examples of contingent consideration which would meet the definition of being included in the cost of the acquisition are:

Additional amounts payable if the acquiree’s profit in the year after acquisition exceeds a certain value

An additional payment if EBITA is maintained or increased after acquisition.

Where a reliable estimate of the contingent consideration cannot be determined or it is not probable it will be payable but it later becomes probable/can now be reliably measured, or the expected consideration changes the adjustment to show the corrected contingent consideration should be included in the cost of the combination and therefore set against the goodwill figure.

The adjustment to goodwill for the change in contingent consideration does not require retrospective adjustment as in effect this is a change in estimate as opposed to an error. This adjustment also has an effect on the amortisation of goodwill as ultimately the goodwill figure will have either reduced or increased.

In this case an entity should charge the additional amortisation on goodwill in the year of the adjustment where the previous estimate was overstated or otherwise credit the over amortisation back to the profit and loss for an under statement of the initial contingent consideration amount. Disclosure of the change in estimate would need to be included in the disclosure notes to the financial statements in line with Section 8 for ROI entities. Alternatively an entity can choose to amortise the updated profit figure over its remaining useful life.

Example 3: Changes in contingent consideration – change in estimate

Company A acquires the trade assets and liabilities of Company B at the start of year 1. The purchase price was CU1,000,000 and a further CU300,000 will be payable in three years time if the future profits remain at CU350,000 or a further CU370,000 if profits increase to CU450,000 for each of the four years.

At the start of year 1, in calculating the business combination cost, Company A would have to assess if it is probable that the company will maintain the profit level. If we assume that it is probable that the CU300,000 will be maintained and the CU450,000 will not be obtained. Then the present value of the CU300,000 should be recognised within goodwill as a cost of the business combination. Assume goodwill before accounting for the contingent consideration in the business combination is CU100,000 and the discount rate is 5%. Assume the amortisation of goodwill is 10 years.

The present value of CU300,000 in 3 years time is CU259,151 (CU300,000/(1.05)^3). Three years is used here as the fair value is determined at the date of acquisition. The deemed interest on the unwinding of the discount would be:

End of year 1:	CU12,958 (CU259,151 X 5%)
End of year 2:	CU13,605 ((CU259,151 + CU12,958) X 5%)
End of year 3:	CU14,286 ((CU2591,51 + CU12,958 + CU13,605) X 5%)

Therefore this CU259,151 will be added to goodwill i.e. Dr goodwill, Cr provisions. The posting for the unwinding of the discount at the end of year 1 would be to: Cr provision for contingent consideration CU12,958, Dr interest expense CU12,958.

Assume at the end of year 2 the company believes CU450,000 profits will be achieved in each of these years so the probable consideration to be paid is CU370,000. In this case the entity should use the discount rate at the end of year 2 to determine the present value however here as this is repayable within one year no discounting has been performed. The adjustment posted at the end of year 2 would be:

	CU	CU
Dr Goodwill	67,429***
Dr Amortisation of Goodwill on Adjustment in P&L	16,857**
Cr Provision for Contingent Consideration		84,286*

*Total carrying amount of provision at end of year 2 = CU259,151+interest for year 1 of CU12,958 + interest for year 2 of CU13,605= CU285,714.

The carrying amount of CU285,714 less the required provision based on the new estimate of CU370,000 = CU84,286

**Amortisation of additional goodwill = CU84,286/10yrs*2yrs as two years have elapsed= CU16,857

***Goodwill adjustment = CU84,286 less the amortisation of CU16,857 that would have been charged if this were recognised initially= CU67,429.

In this case the company could also choose to amortise the updated goodwill figure over the remaining life instead if posting a catch up amortisation charge e.g. the new goodwill figure could be CU291,670.

This CU291,607 would then by depreciated over the remaining life of 8 years.

Example 4: Contingent consideration – No provision booked in year 1

If we assume in the above example that a reliable estimate cannot be measured at the date of acquisition and therefore no provision was posted but at the end of year 2 a reliable estimate of CU300,000 can be made. The adjustment required would be to:

	CU	CU
Dr Goodwill	217,687*
Dr Amortisation of Goodwill on Adjustment in P&L	54,422**
Cr Provision for Contingent Consideration		272,109***

*Goodwill adjustment = CU272,109 less the amortisation of CU27,211 that would have been charged if this were recognised initially= CU244,898.

**Amortisation of additional goodwill = CU272,109/10yrs*2yrs as two years have elapsed= CU54,422

***The present value of CU300,000 in 2 years time is CU272,109 (CU300,000/(1.05)^2). Two years is used here as the fair value is determined at the date of the change in estimate. If the discount rate was different at that time than the discount rate at the date of the initial acquisition the new discount rate would be used.

The entity can instead also choose to amortise the CU272,109 over the remaining 8 years from that date.

As can be seen no prior year adjustment is required as it is a change in accounting estimate.

Contingency payments relating to further services

Section 19 of FRS 102 does not differentiate between contingent consideration that in substance, is additional to the purchase price and contingent consideration that, in substance represents compensation for future services.

IFRS 3 on the other hand does differentiate and states that where a contingency payment is part of the agreement which is a payment for future services then this should be expensed to the profit and loss account and should not be included in the cost. Generally where the payment does not have to be paid if the employee leaves this is akin to a payment for future services. Given Section 2 of FRS 102 states that substance over form should be considered, it is not unreasonable that FRS 102 should apply the same principals as IFRS.

This means that entities should assess each element of the contingent consideration payable to determine if it is a payment made to the vendor in their capacity of a vendor or an employee. The following factors should be considered when making this assessment:

The level of remuneration paid after the acquisition (is it low to compensate for the fact that the contingent payment is paying some of this fee)

The formula for determining the consideration as to what is included

Duration of continuing employment.

Cost of a business combination – contingent liabilities

Extracts from FRS102 – Section 19.14-19.15, 19.18 and 19.20-19.21

19.14 The acquirer shall, at the acquisition date, allocate the cost of a business combination

those contingent liabilities (that satisfy the recognition criteria in paragraph 19.20) at their fair values at that date, except for the items specified in paragraphs 19.15A to 19.15C. Any difference between the cost of the business combination and the acquirer’s interest in the net amount of the identifiable assets, liabilities and provisions for contingent liabilities so recognised shall be accounted for in accordance with paragraphs 19.22 to 19.24.

19.15 Except for the items specified in paragraphs 19.15A to 19.15C, the acquirer shall recognise separately the acquiree’s identifiable assets, liabilities and contingent liabilities at the acquisition date only if they satisfy the following criteria at that date:

(a) In the case of an asset other than an intangible asset, it is probable that any associated future economic benefits will flow to the acquirer, and its fair value can be measured reliably.

(b) In the case of a liability other than a contingent liability, it is probable that an outflow of resources will be required to settle the obligation, and its fair value can be measured reliably.

(c) In the case of an intangible asset or a contingent liability, its fair value can be measured reliably.

19.20 Paragraph 19.15(c) specifies that the acquirer recognises separately a provision for a contingent liability of the acquiree only if its fair value can be measured reliably. If its fair value cannot be measured reliably:

(a) there is a resulting effect on the amount recognised as goodwill or the amount accounted for in accordance with paragraph 19.24; and

(b) the acquirer shall disclose the information about that contingent liability as required by Section 21.

19.21 After their initial recognition, the acquirer shall measure contingent liabilities that are

recognised separately in accordance with paragraph 19.15(c) at the higher of:

(a) the amount that would be recognised in accordance with Section 21; and

(b) the amount initially recognised less amounts previously recognised as revenue in accordance with Section 23 Revenue.

19.18 In accordance with paragraph 19.14, the acquirer recognises separately only the identifiable assets, liabilities and contingent liabilities of the acquiree that existed at the acquisition date and satisfy the recognition criteria in paragraph 19.15 (except for the items specified in paragraphs 19.15A to 19.15C). Therefore:

(a) the acquirer shall recognise liabilities for terminating or reducing the activities of the acquiree as part of allocating the cost of the combination only to the extent that the acquiree has, at the acquisition date, an existing liability for restructuring recognised in accordance with Section 21 Provisions and Contingencies; and

(b) the acquirer, when allocating the cost of the combination, shall not recognise liabilities for future losses or other costs expected to be incurred as a result of the business combination.

OmniPro comment

The identifiable assets acquired and liabilities assumed must meet the definition of assets and liabilities the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

An asset is a resource controlled by an entity as a result of past events and from which economic benefits can be expected to flow to the entity (FRS105 Appendix I).

A liability is a present obligation of the entity arising from past events, the settlement from which is expected to result from an outflow of economic benefits (FRS 105 Appendix I).

Section 19 of FRS 102 does not provide any guidance on the definition of fair value. Section 2 states that in the absence of specific guidance Section 11.27 to 11.32 of FRS 102 should be used. The hierarchy would state that where available a quoted price should be used but where this is not available a valuation model should be used. In the absence of this judgement should be used.

It is very important that the acquirers intentions are not recognised as part of the fair value of assets and liabilities. The acquirer can only recognise restructuring provisions if they have been recognised by the acquiree i.e. if they have been publically announced. The fact that the entity may intend ceasing factory lines for example should not be incorporated into the fair value instead the depreciation of the asset should be adjusted.

The same would be the case if the company acquired a competitor and after acquisition would close the operation, here the fair value given must reflect the value that would be placed on it by a third party.

Measurement of contingent liabilities

Detailed in 19.15 of FRS 102 are detailed conditions with regard to recognition of the assets and liabilities acquired. Accounting for intangibles and contingent liabilities is different than any other standard, in that these can be measured where they can be reliably measured. There is no need for there to be a probable outflow of economic benefits.

Although Section 16 of FRS 105 -Provisions does not allow recognition of contingent liabilities in general Section 19.15(c) makes it clear that a provision should be recognised for a contingent liability in a business combination. Where in a business combination, contingent liabilities exists, these are required to be fair valued where they can be reliably measured. Where this is included in the fair values and as a result it increases goodwill, disclosure is required detailing the fact that a contingent liability has been recognised.

Examples of contingent liabilities may be a tax exposure which was not required to be provided in the acquirees books or legal cases would be another example.

If under the purchase agreement the acquirer is indemnified, the acquirer cannot net the contingent liability with the asset. The asset must be assessed in its own rights and recognised separately at acquisition. An asset should only be recognised where it is virtually certain that it will be achieved.

The fair value is based on the amount that a third party would charge to assume the contingent liability. Regardless of probability, any acquirer would charge something for to take on a potential liability. Where the liability is more than expected, the increase is posted to the profit and loss.

Future losses expected to be incurred are not considered to be liabilities incurred which is in line with Section 16 of FRS 105.

Determining fair value of property, plant and equipment

When determining the fair value of PPE, it would be good practice to review the guidance on revaluations contained in Section 17.15C and 17.15D of FRS 102. This would suggest that non-specialised property should be valued at market prices by a qualified valuer. The valuer should ignore government grants when valuing PPE as these are fair valued separately usually at the amount to be repaid in the event of a condition in the grant being breached.

For specialised PPE, the fair value can be determined from a future cash flow approach or a depreciated replacement cost approach.

Determining fair value of intangible assets

Section 14.1(a) of FRS 105 makes it clear that intangible assets should not be separately identified from goodwill instead it should be consumed within goodwill.

Determining fair value of inventory

FRS 102 provides no guidance however IFRS 3 states that:

finished goods should be valued using selling prices less costs of disposal and a reasonable profit allowance for the selling effort of the acquirer based on profit for similar finished goods.

WIP should be valued at the selling price of the finished goods less costs to complete, cost of disposal and a reasonable profit allowance for the selling effort of the acquirer based on profit for similar finished goods.

It would be reasonable that the above guidance be used under FRS 102/105.

Example 5: Valuing work in progress

Company A acquired the trade assets and liabilities of Company B. As part of the assets acquired it included work in progress for bicycles with a cost in the acquiree books at CU100,000. The selling price of these bikes when they are finished goods is CU300,000.

In the fair value exercise, the acquirer would need to determine how much extra it will cost to complete. This can be done by looking at the total costs it would be expected that it will incur to produce these bikes in full. Assume the total cost to complete is CU250,000, therefore a profit of CU50,000 would have been made.

In order to determine the fair value, the following calculation would be required to determine the profit allowance of CU20,000:

CU50,000 being the profit that would have been made * (CU150,000 being the costs incurred to date / CU250,000 being the total cost to produce the bikes) =CU30,000

Therefore the fair value of the WIP would be CU120,000 (CU300,000-CU150,000-CU30,000 being the profit element).

Determining fair value of financial instruments

The rules in Section 9 Financial Instruments should be followed when fair valuing these instruments. Depending on the accounting framework adopted by the acquiree this may result in differences especially where fair valuing is not required.

Under Section 9 of FRS 105, these instruments should be held at cost/transaction price less repayments etc and if payment is beyond normal credit terms, then at the cash price.

For complex instruments, such as forward contracts these should be fair valued at the date of acquisition.

In the majority of cases, debtors, creditors, is not usually significantly different from the book values unless the acquiree did not account for financing transactions.

The majority of differences between fair value and book value are:

Difference in the carrying amount of debtors due to an over/under provision in the books of the acquiree. Under Section 19.19 of FRS 102, an entity has 12 months from the date of acquisition to determine the fair values of the assets and liabilities. Therefore, during this 12 months facts will emerge which will provide evidence that there is an over/under provision. See example 11 below which illustrates how this adjustment would be accounted for i.e. as prior year adjustment or not and the effect it has on goodwill.

Loans in the acquirer not charged at market rates. In this case the acquirer will have to determine the amortised cost of these loans and identify the financing element (i.e. present value at a market rate of interest and release the difference to the profit and loss over the life of the loan on a straight line basis. See Section 14(a) of FRS 105 for how the difference is released to the profit and loss account (i.e. the interest element is released on a straight line basis over the contracts life over the contract life).

Determining fair value of investment in associate, subsidiaries and joint ventures

These should be valued based on the guidance in Section 11 of FRS 102 for fair valuing i.e. based on an active market, or where not available a discounted cash flow model using as much industry inputs as possible.

Determining fair value of listed shares

Listed shares should be valued at the market value at the date of acquisition.

Determining fair value of deferred revenue

Deferred revenue should only be recognised as part of the liabilities taken over to the extent that it relates to an outstanding performance obligation assumed by the acquirer. The fair value of the obligation at the date of acquisition is recognised. This is likely to be lower than the acquirees book value as the amount of revenue that another party would expect to receive on meeting that obligation would not include any profit element relating to the selling or other efforts completed by the acquiree.

If the acquiree’s deferred revenue does not relate to an outstanding performance obligation but to goods or services that have already been delivered, no liability should be recognised by the acquirer.

Example 6: Deferred revenue

Company A acquired the trade assets and liabilities of Company B. Part of the net liabilities taken over was deferred revenue of CU40,000 for an outstanding service contract which has to be performed. In fair valuing this obligation Company A determines that another third party would take this outstanding contracts work on and would have charged CU35,000. Company A should include in the acquisition cost calculation the CU35,000 and not the CU40,000.

Determining fair value of non-beneficial/beneficial controls

If at the acquisition date, the acquiree has contracts it has entered into which are at rates above or below market rates then these will need to be fair valued. Note these are not onerous contracts as these items are still used by the entity. If they were onerous contracts they should have already been provided for in the acquiree’s books.

Where these contracts exist, the net liability or asset is recognised and released to the profit and loss over the life of the contract.

Where the contract is above market rate = difference between contract rate and lease rate (applies to operating leases also) recognised as a liability

Where the contract is below market rate = difference between contract rate and lease rate (applies to operating leases also) recognised as an asset

Example 7: Favorable/unfavorable contract

Company A acquired the trade assets and liabilities of Company B. As part of the acquisition it took on an operating lease on a property which was at an unfavorable rate. The market rent for a similar property in the area is CU6,000 per annum however the rate charged to Company B is CU10,000. This lease has 10 years to run. The provision to be recognised at acquisition date at its fair value is CU40,000 ((CU100,000-CU60,000)*10yrs). This CU40,000 increases the goodwill.

Each year CU4,000 will be released to the profit and loss.

The opposite would occur if an asset was to be recognised.

Employee benefits

Where an amount is payable as part of the acquisition and deemed to be for future services, this cost should be accounted for in accordance with Section 23-Employee benefits. Therefore they should be recognised in the profit and loss over the period to which the contingency relates i.e. the length of time the employee has to remain in service after the acquisition. The amount provided for in the profit and loss should use a best estimate of the likely volume of employees that will stay on to receive the payment.

Share based payments

It would be unusual to have to account for share based payments as part of the acquisition cost. Usually where share are issued they are based on an agreed price per share. Equity settled shares should be ignored until the shares are issued in line with requirements of Section 21 of FRS 105. Where shares are issued as part of contingent consideration which are issued based on an agreed total value this would be accounted for as normal contingent consideration as discussed above.

Deferred tax

Deferred tax recognised in the acquired entities books should be derecognised as deferred tax cannot be recognised under FRS 105. No deferred tax is to be recognized on any fair value adjustments on acquisition.

Purchases method – Subsequent adjustment to fair value and Goodwill

Extracts from FRS102 – Section 19.16-19.17 and 19.22-19.23

19.16 The acquirer’s statement of comprehensive income shall incorporate the acquiree’s profits or losses after the acquisition date by including the acquiree’s income and expenses based on the cost of the business combination to the acquirer. For example, depreciation expense included after the acquisition date in the acquirer’s statement of comprehensive income that relates to the acquiree’s depreciable assets shall be based on the fair values of those depreciable assets at the acquisition date, i.e. their cost to the acquirer.

Subsequent adjustment to fair value

19.19 If the initial accounting for a business combination is incomplete by the end of the reporting period in which the combination occurs, the acquirer shall recognise in its financial statements provisional amounts for the items for which the accounting is incomplete. Within twelve months after the acquisition date, the acquirer shall retrospectively adjust the provisional amounts recognised as assets and liabilities at the acquisition date (ie account for them as if they were made at the acquisition date) to reflect new information obtained. Beyond twelve months after the acquisition date, adjustments to the initial accounting for a business combination shall be recognized only to correct a material error in accordance with Section 10 Accounting Policies, Estimates and Errors.

Goodwill

19.22 The acquirer shall, at the acquisition date:

(a) recognise goodwill acquired in a business combination as an asset; and

(b) initially measure that goodwill at its cost, being the excess of the cost of the business combination over the acquirer’s interest in the net amount of the identifiable assets, liabilities and contingent liabilities recognised and measured in accordance with paragraphs 19.15, 19.15A to 19.15C.

19.23 After initial recognition, the acquirer shall measure goodwill acquired in a business combination at cost less accumulated amortisation and accumulated impairment losses:

(a) An entity shall follow the principles in paragraphs 18.19 to 18.24 for amortisation of goodwill. Goodwill shall be considered to have a finite useful life, and shall be amortised on a systematic basis over its life. If, in exceptional cases, an entity is unable to make a reliable estimate of the useful life of goodwill, the life shall not exceed 10 years.

(b) An entity shall follow Section 27 Impairment of Assets for recognising and measuring the impairment of goodwill.

OmniPro comment

Adjustments to fair value of identified liabilities

As per Section 19.19 of FRS 102 adjustments to the fair value of the liabilities and assets can be made for 12 months following the date of acquisition. After this date no adjustment can be made to goodwill unless there was a material error in which case a prior year adjustment would have to be made to the financial statements.

After the 12 month period has elapsed, prior year adjustments cannot be done for changes in estimates in the fair values (it can only be done for changes in estimates within the 12 month period) other than where contingent consideration exists which was discussed above and shown in examples 3 and 4 above where any adjustments are posted to goodwill prospectively. When an acquisition occurs part way through the financial year, the 12 month period for adjustment to fair values will straddle two financial years. In this case if in the second financial year, an adjustment is required to the fair values, then a prior year adjustment will be required to restate the goodwill and fair value of assets and any depreciation impact etc. stated in the prior year i.e. it must be adjusted retrospectively. See illustration in the examples below:

Example 8: Subsequent adjustment to fair values at the acquisition date and amortisation of goodwill and fair value uplifts on acquisition

Company A acquired the trade assets and liabilities of company B on 1 October 20X4. The year end for the financial statements is 31 December. When signing off the (entity as the net assets are acquired) financial statements, the company could not get a professional valuation for the property, plant and equipment within the time period. Therefore Company A estimated a fair value of CU100,000. Note the NBV of the PPE in the acquirees book was CU90,000.

In addition Company A estimated the bad debt provision on the trade debtor balance and deemed the fair value of debtors to be CU10,000 which equaled the book value. The fair value of all assets and liabilities including the aforementioned was CU200,000. Goodwill at the date of acquisition was calculated at CU49,000. The total cost of the acquisition was CU250,000.

The useful life of goodwill was determined to be 10 years and the remaining life on the property, plant and equipment was 5 years.

The profits made from 1 October to 31 December 20X4 was CU20,000.

In the 31 December 20X4 financial statements the following adjustments would be posted to the financial statements to reflect the goodwill on the acquisition date:

	CU	CU
Dr Net Assets	200,000
Dr Goodwill	50,000
Cr Bank		250,000

The below journal would be posted to recognise the depreciation on the uplift in PPE:

Dr Depreciation

(CU10,000/5 years* 3/12^th)

500

Cr Accumulated Depreciation PPE

500

The below journal would be posted to recognise the amortisation on goodwill:

	CU	CU
Dr Amortisation	1,250*
Cr Accumulated Amortisation Goodwill			1,250

*goodwill on recognition is CU50,000/10yrs*3/12^th being period 1 October to 31 December

On 1 February 20X5 (within the 12 month limit), Company A obtained the valuation for the PPE on the date of acquisition which was CU150,000. Following a review of the debtors acquired on acquisition at 31 August 20X5, evidence showed that the fair value at the date of acquisition was CU5,000 instead of the estimated CU10,000. The company is preparing the 31 December 20X5 entity financial statements.

Note a prior year adjustment is required here as the 12 month adjustment period straddles 2 accounting periods. The journals to be posted in the 20X4 accounts to show the prior year adjustment are:

	CU	CU
Dr PPE (see note 1)	47,500
Cr Debtors (see note 2)		5,000
Dr Depreciation on PPE (see note 1)	2,500
Cr Amortisation of Goodwill (See note 3)		1,125
Cr Goodwill (See note 3)		43,875

Being journal to reflect adjustment to reflect change in fair values within the 12 month period

Note 1: Fair value adjustment to PPE

Updated fair value of PPE included in calculation of goodwill CU150,000

Initial fair value of PPE included in calculation of goodwill (CU100,000)

Adjustment to be made to goodwill CU50,000

Additional depreciation that should have been charged from period 1

October to 31 December 20X4 (CU50,000/5yrs*3/12th) (CU2,500)

Total adjustment to be made to PPE CU47,500

Note 2: Fair value adjustment to debtors

Updated fair value of debtors included in calculation of goodwill CU5,000

Initial fair value of debtors included in calculation of goodwill (CU10,000)

Adjustment to be made to goodwill (CU5,000)

Note 3: Adjustment to goodwill

Adjustment to reflect updated PPE fair value CU50,000

Adjustment to reflect updated debtors fair value (CU5,000)

Adjustment to goodwill cost CU45,000

Additional amortisation that should have been charged on goodwill from

1 October to 31 December 20X4 (CU45,000/10yrs useful life*3/12^th) (CU1,125)

Total adjustment to goodwill in 31 December 20X4 accounts – credit CU43,875

In the 20X5 entity financial statements the updated goodwill figure of CU95,000 (CU50,000+CU45,000) and PPE fair value figure of CU150,000 (CU90,000+CU10,000+CU50,000) will be amortised/depreciated.

Goodwill

See example 8 above which illustrates the requirements of Section 19.22 and 19.23.

Useful life of goodwill

Section 14.2 of FRS 105 as supported by Section 13.9-13.14 of FRS 105 makes it clear that goodwill is considered to have a finite life. The standard specifies that where a useful life cannot be determined then a useful life should not exceed 10 years.

Where goodwill acquired prior to the transition to FRS 105 has been determined and presumably there was a basis for this as required by old GAAP, it is unlikely that this will have any impact as it will continue to be amortised over the period determined under old GAAP. However, for goodwill acquired since the date of transition, entities will need to assess the useful economic life and if it cannot be determined a life of 10 years or less must be chosen. This cannot be chosen as a default, instead a good effort has to be made to determine a useful life.

Where a change in useful life of goodwill is determined due to a change in estimate this should be adjusted for prospectively. See example of same in example 9 below.

Example 9: Revising the useful life of goodwill

In year 1 goodwill was recognised for CU100,000 on the acquisition of trade assets and liabilities. It had an estimated life of 6 years. Its estimated residual value was estimated to be CU10,000. Note it was deemed appropriate to assume a residual value as it met the condition in 13.13 in section 13 as there was an active market for this intangible and it was likely it would be there at the end of the useful life of the intangible (e.g. a pub licence or an off-licence). This residual value was assessed for indicators of change at each year end and there were no issues up to the end of year 4. At the start of year 5, due to a change in the market for this type of asset the residual value increased to CU20,000 (being the value of the future residual amount). At the end of year 4, the asset had a carrying amount as follows:

	CU
Cost	100,000
Residual Value	(10,000)
Depreciable Amount	90,000
Depreciation (90,000 / 6 yrs * 4 yrs)	(60,000)
Carrying Amount	30,000

In year 5, the residual amount is CU20,000, therefore the depreciable amount is CU80,000. Deducting depreciation charged to date of CU60,000 leaves CU20,000 to be depreciated over the remaining useful life of 2 years. Therefore, depreciation of CU10,000 is charged in year 5 and year 6.

If we take this example and assume the residual value increases to CU50,000, then the carrying amount in year 5 of CU30,000 is in excess of the residual amount. Therefore no depreciation is required in year 5 and 6 and any over depreciation is not reversed.

Example 10: Change in accounting estimate disclosure – ROI only

During the year ended 31 December 201X the company changed its amortisation method for goodwill to amortise same over 20 years on a straight line basis as opposed to 10 years. The effect of same was to reduce the amortisation charge by CU680,000 for the current yearThe reason for the change in depreciation method is that the new policy more correctly reflects the useful economic life of these assets.

Amortisation ceases when an asset is derecognised

The standard specifies the method of amortisation used should reflect the way in which the economic benefits are derived. Where this cannot be easily determined the straight line method should be used which writes the asset off over its useful life. An example of the straight line method was given in example 9 above.

Under old GAAP i.e. FRSSE as opposed to FRS 102 (as FRS 102 is the same as FRS 105), it was possible for intangible assets to have an indefinite useful economic life and as a result no amortisation was charged instead an annual impairment review was performed. On transition to FRS 102 these assets will now have to be assigned a useful economic life and where this cannot be determined then it will have to be assigned a life not exceeding 10 years. This will result in an additional amortisation charge and will also require an adjustment on transition to FRS 105 from FRSSE/old GAAP.

Example 11: Transition adjustments for intangibles previously having limited life

Goodwill of CU500,000 was recognised under old GAAP/FRSSE (acquired 5 years prior to the date of transition) which was determined to have a finite useful life. On transition, under FRS 105, a useful life of 15 years was determined. Therefore, a transition adjustment is required whereby, if the useful life on the date of transition is 15 years, then the original useful life should have been 20 years when acquired. Therefore, amortisation of CU125,000 (i.e. CU500,000/20 years * 5 years) will need to be posted to retained earnings on transition so as to show the carrying amount at CU375,000 (CU500,000-CU125,000) in the opening balance sheet. This assumes the exemption not to restate goodwill on business combinations entered into pre the date of transition has not been claimed. If this is claimed and it was acquired pre transition; then there would be no adjustment at transition instead it would be amortised over 15 years from transition.

A number of factors should be considered when estimating a useful life for an intangible, these include:

– Expected usage of the asset by the entity, and whether it could be managed efficiently by the management team;

– The typical product life cycles for the asset, and public information about estimates of useful lives of similar assets that are used in a similar way;

– Technical, technological, commercial or other types of obsolescence;

– The stability of the industry in which the asset operates, and changes in the market demand for the products or services from or related to the asset;

– Expected actions by competitors or potential competitors;

– The level of maintenance expenditure required to maintain the asset’s operating capability, and whether management intends to perform that level of maintenance;

– Whether the asset’s useful life is dependent on the useful life of other assets of the entity.

Impairment

Identifying and accounting for impairment of goodwill is dealt with by Section 22 of FRS 105. At each reporting period goodwill should be reviewed for indicators of impairment as per Section 22. Where indicators are identified, an impairment review should be carried out. See Section 22 for further details of how this should be accounted for and how it should be carried out. Goodwill impairment cannot be reversed.

Section 22 does not require an impairment review to be carried out for goodwill with a useful economic life of over 20 years nor does it require an impairment review to be performed the first year after acquisition (this was required under FRSSE/old GAAP). It does require an impairment review to be performed where there are indicators of impairment.

Negative goodwill

Extracts from FRS102 – Section 19.24

19.24 If the acquirer’s interest in the net amount of the identifiable assets, liabilities and provisions for contingent liabilities recognised in accordance with paragraph 19.14 exceeds the cost of the business combination (also referred to as ‘negative goodwill’), the acquirer shall:

a) Reassess the identification and measurement of the acquiree’s assets, liabilities and provisions for contingent liabilities and the measurement of the cost of the combination.

b) Recognise and separately disclose the resulting excess on the face of the statement of financial position on the acquisition date, immediately below goodwill, and followed by a subtotal of the net amount of goodwill and the excess.

c) Recognise subsequently the excess up to the fair value of non-monetary assets acquired in profit or loss in the periods in which the non- monetary assets are recovered. Any excess exceeding the fair value of non-monetary assets acquired shall be recognised in profit or loss in the periods expected to be benefited.

OmniPro comment

Section 19.24 of FRS 102 makes it clear that it is unusual for negative goodwill to occur in an acquisition so if this occurs an entity must reassess the fair values determined for assets and liabilities to make sure the valuations are accurate. If after assessing the values no issues are found, then the negative goodwill should be recognised.

The negative goodwill is then allocated to the non-monetary items of the acquired entity (e.g. PPE, inventory, investments).

The negative goodwill should be credited to the profit and loss on a basis in which the non-monetary items are realised. Therefore where an element of the goodwill is allocated to inventory, the negative goodwill is written back to the profit and loss over the period the inventory included on the balance sheet at the date of acquisition is utilised and where it is allocated to PPE it is released over the period it is depreciated.

The non-monetary asset to which the negative goodwill attaches too should be determined based on judgement and if not easily determinable allocated pro-rata.

Example 12: Negative goodwill

Company A acquired the trade assets and liabilities of Company B for CU200,000 when the fair value of the net assets were CU250,000. In this instance there is negative goodwill of CU50,000. Assume the acquisition occurred at the start of year 1. Assume the negative goodwill attached to the inventory at the date of acquisition and this inventory will be utilised over two years.

After a reassessment Company A is happy that this negative goodwill exists. Therefore the acquisition journals would be:

	CU	CU
Dr Net Assets	250,000
Cr Goodwill		50,000
Cr Bank		200,000

The journal required at the end of year 1 to recognise the amortisation of the negative goodwill is:

Dr Negative Goodwill

25,000

Cr Amortisation of Negative Goodwill

(CU50,000/2yrs*1yr of stock disposed of)

25,000

Group reconstructions

Extracts from FRS 102 section 19.27-19.32

19.27 Group reconstructions may be accounted for by using the merger accounting method provided:

(a) the use of the merger accounting method is not prohibited by company law or other relevant legislation;

(b) the ultimate equity holders remain the same, and the rights of each equity holder, relative to the others, are unchanged; and

(c) no non-controlling interest in the net assets of the group is altered by the transfer.

19.28 The provisions of paragraphs 19.29 to 19.33, which are explained by reference to an acquirer or issuing entity that issues shares as consideration for the transfer to it of shares in the other parties to the combination, should also be read so as to apply to other arrangements that achieve similar results.

Merger accounting method

19.29 With the merger accounting method the carrying values of the assets and liabilities of the parties to the combination are not required to be adjusted to fair value, although appropriate adjustments shall be made to achieve uniformity of accounting policies in the combining entities.

19.30 The results and cash flows of all the combining entities shall be brought into the financial statements of the combined entity from the beginning of the financial year in which the combination occurred, adjusted so as to achieve uniformity of accounting policies. The comparative information shall be restated by including the total comprehensive income for all the combining entities for the previous reporting period and their statement of financial position for the previous reporting date, adjusted as necessary to achieve uniformity of accounting policies.

19.31 The difference, if any, between the nominal value of the shares issued plus the fair value of any other consideration given, and the nominal value of the shares received in exchange shall be shown as a movement on other reserves in the consolidated financial statements. Any existing balances on the share premium account or capital redemption reserve of the new subsidiary shall be brought in by being shown as a movement on other reserves. These movements shall be shown in the statement of changes in equity.

19.32 Merger expenses are not to be included as part of this adjustment, but shall be charged to the statement of comprehensive income as part of profit or loss of the combined entity at the effective date of the group reconstruction.

OmniPro comment

Where the conditions for merger accounting is met it results in considerable less work for the acquiring entity. No fair value valuations are required to be performed and no goodwill needs to be calculated. The net assets as per the acquired entity is the amount that is recognised in the acquired entity financial statements. Section 19.27 of FRS 102 above describes the conditions for the relief to be claimed.

Merger accounting differs from the purchase method of accounting as follows:

Under merger accounting, the results, balance sheet and cashflows for the acquirer are shown in the current and comparative financial year of the parent accounts regardless of what period in the year this was acquired.
Under purchase method accounting, the results are only shown from the date of acquisition and the comparative figures on first acquisition does not include the acquirees results
Merger accounting does not require the net assets of the acquirer to be fair valued whereas purchase accounting does, and any fair value adjustments must be accounted for in the parent.
Merger accounting does not require goodwill to be calculated whereas purchase accounting does.

Note where inter group sales are made the normal rules with regard to intergroup balances/sales/profits are applied to eliminate these.

Example 13: Group reorganisations

Company A who is a member of a group with Parent A, acquires the trade assets and liabilities of Company B who is owned 100% by Parent A on 1 March in return for the issuance of 100 CU1 ordinary shares for CU1,801 each i.e.CU180,100. This CU180,100 is equivalent to the net assets of Company B. Company A applies merger accounting and the year end is 31 December. The profit for the 9 month period to 31 December in Company B was CU20,000 and the profit made for the full year is CU60,000.

In the entity financial statements of Company A the following would be shown assuming the below results. Note the profit made for the full year is included, the date of acquisition is irrelevant.

Applying this to the above example journals would be:

	CU	CU
Dr Net Assets	180,100
Cr Ordinary Share Capital		100
Cr Merger Reserve (note this includes the CU20,000 earned for the first 3 months)		180,000

Transition exemptions

Section 28.10(a) provides an exemption to entities whereby the can elect not to restate the business combinations and goodwill recognised on business combinations entered into prior to the date of transition. Goodwill or intangibles cannot be adjusted on transition where this exemption is taken. This will mean that any intangibles for example which were previously recognised in a business combination pre transition will remain.

In addition, if under FRS 105, assets or liabilities were not recognised under the fair value rules of old GAAP/FRSSE, an adjustment to retained earnings will be required where this adjustment is required. It is unlikely for an adjustment to be required in this area where the previous entity adopted Irish/UK GAAP as the requirements for measurement and recognition were similar. See example 23 for details of the adjustment.

Where in the unlikely event an entity elects not to avail of this exemption, the entity has a choice to apply the restatements back as far back as it likes. However from that date any combinations entered into must be accounted for under FRS 105. The entity cannot pick and choose which ones to adjust. Note even where an entity claims exemption under Section 28.10(a) not to restate business combinations prior to the date of transition, deferred tax recognised under these combinaitons under old GAAP/FRS 102 will still have to be derecognised on transition. As the exemption is claimed it cannot hit the goodwill, instead it will hit P&L reserves.

Principal transition adjustments

The main adjustments expected on transition are detailed below:

1) Adjustment required to combinations entered into after the date of transition assuming exemption for non-restatement of prior year combinations prior to the date of transition is claimed

Where companies have entered into a business combination after the date of transition i.e. in the comparative year or the current year, a transition adjustment will be required to restate the business combination to what it should have been under FRS 105. Note even where an entity claims exemption under Section 28.10(a) not to restate business combinations prior to the date of transition, deferred tax recognised under these combinaitons under old GAAP/FRS 102 will still have to be derecognised on transition. As the exemption is claimed it cannot hit the goodwill recognised, instead it will hit P&L reserves. See example 18 for details of the adjustment.

The principal differences where a business combination (by way of acquisition of trade assets and liabilities) are likely to arise are:

Differences applicable to old GAAP/FRSSE

Under old GAAP, the creation of a separate intangible asset from goodwill in a business combination had to occur where its value could be measured reliably and it was separable. If it did not meet the condition then it must be consumed within goodwill. Under FRS 105 intangible assets cannot be separated from goodwill where there is a business combination. Hence no intangibles will be recognised in a business combination resulting in more goodwill requiring recognition.

Where the acquired trade includes deferred tax balances (acquired in the comparative or current year) these will have to be derecognised on transition to FRS 105. FRSSE/old GAAP required deferred tax to be recognised equal to the deferred tax of the acquired trade at the date of the acquisition where applicable. Hence an adjustment will be required to derecognise these. In reality this adjustment will be made as part of a journal to derecognise deferred tax as a whole as detailed in section 24.

FRS 102 does not allow an indefinite useful life where old GAAP/FRSSE did, therefore a life will have to be determined at the acquisition date under FRS 105 and where this cannot be determined it should be set at a maximum of 10 years. Not included in this example but included in the examples that follow

Differences applicable to FRS 102

Under FRS 102 an intangible should be recognised in a business combination where it could be reliably measured, it did not have to be separable. Under FRS 105 intangible assets cannot be separated from goodwill where there is a business combination, instead it must be consumed within goodwill. Hence no intangibles will be recognised in a business combination resulting in more goodwill requiring recognition.

Possible additional amortisation to be recognised on goodwill and amortisation to be reversed on intangibles where new intangibles were recognised under FRS 102 for the aforementioned reasons where the useful life of the intangible differs from the goodwill

The reversal of deferred tax balances for the difference between book value and fair value (other than on goodwill) as the recognition of this deferred tax is not permitted under FRS 105. Hence a transition adjustment will be required to derecognise the deferred tax on acquisition and the carrying amount required at each year end. In effect FRS 105 does not permit deferred tax.

As a separate point where the acquired trade includes deferred tax balances (acquired in the comparative or current year) these will have to be derecognised on transition to FRS 105. FRS 102 required deferred tax to be recognised equal to the deferred tax of the acquired trade at the date of the acquisition where applicable (plus the deferred tax on fair value adjustments as detailed above). Hence an adjustment will be required to derecognise these. In reality this adjustment will be made as part of a journal to derecognise deferred tax as whole.

Example 14: Adjustments to business combinations where it occurs after the date of transition – Applicable where FRS 102 was the previous accounting framework

Parent A acquired trade assets and liabilities of Company B for CU1,000,000 on 2 January 2015. Assume the date of transition is 1 January 2015. Under FRS 102 deferred tax has been recognised on any fair value uplifts on acquisition when compared to original book amount. Assume the useful life of goodwill is 10 years.

Assume the deferred tax on the adjustments under FRS 102 to reflect the fair value of the monetary assets reverses in the first year and the useful life of PPE is 10 years.

Details of the book value and fair value at the time of acquisition for FRS 102 and FRS 105 purposes is detailed below:

		FRS 105	FRS 102
	Book value	Fair value	Fair value	Difference
Property, Plant and Equipment	CU300,000	CU550,000	CU550,000	CUNil
Intangible Assets	CUnil	CUnil	CU100,000	(CU100,000)
Inventory	CU150,000	CU170,000	CU170,000	CUNil
Cash	CU100,000	CU100,000	CU100,000	CUNil
Debtors	CU20,000	CU25,000	CU25,000	CUNil
Creditors	(CU100,000)	(CU100,000)	(CU100,000)	CUNil
Contingent Liabilities	CU-	(CU10,000)	(CU10,000)	CUNil
Deferred tax on fair value uplift	N/a	N/a	(CU26,500*)	CU26,500
Deferred Tax as per acquirees books	(CU60,000)	(	(CU60,000)	CU60,000
Total Net Assets	CU410,000	CU735,000	CU748,500	(CU13,500)
Consideration		CU1,000,000	CU1,000,000	CUNil
Goodwill		CU265,000	CU251,500	(CU13,500)

Given that FRS 105 does not permit intangibles to be separated the intangibles of CU100,000 should not have been recognised. Assume the useful life of intangibles was determined to be 5 years for this example.

The deferred tax to be recognised on acquisition under FRS 102, not to be recognised under FRS 105:

Uplift in Property, Plant and Equipment	CU150,000
Uplift in Intangible Assets	CU100,000
Uplift in Inventory	CU20,000
Uplift in Cash	CUnil
Uplift in Contingent Liabilities	(CU10,000)
Uplift in Debtors	CU5,000
Uplift in Creditors	CUnil
Total Timing Difference	CU265,000
Deferred Tax (CU265,00010%)	CU26,500

*Once the above exercise is completed under FRS 102 management should assess the rate that the asset/liabilities are expected to be reversed. Here the debtors, inventory, contingent liability property, plant and equipment are going to be reversed during trading as they are trading assets. In relation to the intangible assets, if it is assumed these will be used throughout the trade and have little residual value then the trade tax rate should be used in measuring the deferred tax and not the sales tax rate. The deferred tax liability to recognise as a result of the uplift in value is:

CU265,000 * 10%= CU26,500. Therefore total deferred tax to be shown in the financial statements is = CU26,500+CU60,000=CU86,500. As FRS 105 does not permit such recognition the below journals reverse this deferred tax.

Adjustment required to the comparative financial statements:

At 31 December 2015

	CU	CU
Dr Goodwill (CU265,000-CU251,500)	13,500
Dr Deferred Tax Liability for fair value uplift (as above)	26,500
Dr Deferred Tax Liability recognised being the book amount of the acquirer	60,000
Cr Intangible Assets (CU100,000 less nil)		100,000

Being journals required to post adjustments so as to show the correct fair values and goodwill under FRS 105 and derecognise the deferred tax recognised on fair value adjustments and other adjustments.

Journal for change in amortisation

	CU		CU
Dr Amortisation of Goodwill in P&L**		1,350**
Cr Amortisation of Intangibles in P&L***				20,000***
Cr Accumulated Amortisation of Goodwill				1,350
Dr Accumulated Amortisation of Intangibles		20,000

Being journal to reflect increase in goodwill amortisation and decrease in intangible amortisation due to FRS 102 figures posted being different to what is required under FRS 105.

**The goodwill balance has increased by CU13,500 under FRS 105 on acquistion. However under FRS 102, the goodwill of CU251,500 was depreciated over 10 years so therefore depreciation of CU25,150 (CU251,500/10yrs) was charged in the FRS 102 financial statements.

The amortisation that should have been charged under FRS 105 is = (CU265,000/10yrs) = CU26,500.

Therefore the additional charge of CU1,350 (CU26,500-CU25,150) is recognised under FRS 105.

***The intangible balance has decreased by CU100,000 under FRS 105 on acquisition as intangibles cannot be recognised separately under FRS 105 which means the amortisation previously recognised under FRS 102 of CU20,000 (CU100,000/5 yrs) has to be reversed. The amortisation that should have been charged under FRS 105 is = CUnil.

Therefore journal required to reverse the amortisation of CU20,000 (CU20,000-CUnil) posted under FRS 105 is as per above.

Journal for derecognise the deferred tax recognised on the uplift and set against goodwill:

	CU	CU
Dr Deferred Tax in P&L	6,015
Cr Deferred Tax Liability ((CU4,515 +CU1,500)		6,015****

Being journal to reverse the movement on the deferred tax posted under FRS 102 as deferred tax is not applicable under FRS 105 and therefore was never recognised.

****Reversal of the timing difference of inventory (CU20,000), contingent liability (CU10,000) and debtors (CU5,000) = (CU20,000-CU10,000+CU5,000)*10%= CU1,500

Reversal of the timing difference on fair value adjustment on PPE and intangibles for the depreciation/amortisation charge in the year = (CU25,150+CU20,000)*10%=CU4,515.

Adjustments required in the 31 December 2016 year end accounts assuming the above journals are posted into reserves where relevant:

The same type of journals would be posted for the amortisation/depreciation on intangible, goodwill and PPE in the 2016 as the 2015 year assuming financial statements have first been performed under old GAAP. Deferred tax of CU4,515 would only be posted as the monetary differences have been reduced to nil in the prior year.

	CU	CU
Dr Deferred Tax in P&L	4,515
Cr Deferred Tax Liability ((CU4,515)		4,515****

Being journal to reverse the movement on the deferred tax posted under FRS 102 as deferred tax is not applicable under FRS 105 and therefore was never recognised.

Note the movement on the deferred tax that does not relate to the deferred tax recognised on the fair value movements should also be reversed in the comparative and current year, however these would be reversed as one journal as detailed in Section 24 of this website.

Note the above example assumes the write off of intangibles differs from the write off of goodwill but that may not always be the case as they may have the same useful economic life hence no journal would be required for the amortisation element if that is the case. In addition the above example assumes there is deferred tax transferring in, this may not always be applicable in an asset purchase hence that element would not be applicable.

Example 15: Adjustments to business combinations where it occurs after the date of transition – Applicable where old GAAP/FRSSE was the previous accounting framework

If we take the previous example and this time assume the previous accounting framework was FRSSE/old GAAP, the fair values would be as follows (note the example here assumes that it was possible to separately identify intangibles from goodwill, however in the majority of cases under old GAAP this may not have been possible (could be possible for off licenses which could be separable) – if it was not possible then the difference between the fair value and the book values is reflected as goodwill).

Details of the book value and fair value at the time of acquisition for FRS 102 and FRS 105 purposes is detailed below:

		FRS 105	FRSSE/old GAAP
	Book value	Fair value	Fair value	Difference
Property, Plant and Equipment	CU300,000	CU550,000	CU550,000	CUNil
Intangible Assets	CUnil	CUnil	CU100,000	(CU100,000)
Inventory	CU150,000	CU170,000	CU170,000	CUNil
Cash	CU100,000	CU100,000	CU100,000	CUNil
Debtors	CU20,000	CU25,000	CU25,000	CUNil
Creditors	(CU100,000)	(CU100,000)	(CU100,000)	CUNil
Contingent Liabilities	CU-	(CU10,000)	(CU10,000)	CUNil
Deferred tax on fair value uplift	N/a	N/a	N/a	CUNil
Deferred Tax as per acquires books	(CU60,000)	( )	(CU60,000)	CU60,000
Total Net Assets	CU410,000	CU735,000	CU775,000	(CU40,000)
Consideration		CU1,000,000	CU1,000,000	CUNil
Goodwill		CU265,000	CU225,000	(CU40,000)

31 December 2015

	CU	CU
Dr Goodwill (CU265,000-CU225,000)	40,000
Dr Deferred Tax Liability recognised being the book amount of the acquirer	60,000
Cr Intangible Assets (CU100,000 less nil)		100,000

Being journals required to post adjustments so as to show the correct fair values and goodwill under FRS 105 and derecognise the deferred tax recognised.

Journal for change in amortisation

	CU	CU
Dr Amortisation of Goodwill in P&L	4,000
Cr Amortisation of Intangibles in P&L		20,000
Cr Accumulated Amortisation of Goodwill		4,000
Dr Accumulated Amortisation of Intangibles	20,000

Being journal to reflect increase in goodwill amortisation and decrease in intangible amortisation due to old GAAP figures posted being different to what is required under FRS 105.

Adjustments required in the 31 December 2016 year end accounts assuming the above journals are posted into reserves where relevant:

In addition the above example assumes there is deferred tax transferring in, this may not always be applicable in an asset purchase hence that element would not be applicable.

2) Adjustment required to combinations entered into pre date of transition assuming exemption is not claimed

Some entities may decide not to claim the exemption contained in Section 28.10(a). The entity has a choice to apply the restatements back as far back as it likes. However from that date any combinations entered into date must be accounted for under FRS 105. The entity cannot pick and choose which ones to adjust. In reality there is no advantage to restating combinations before the date of transition. See illustrations below where an entity transition from FRS 102 or FRSSE/old GAAP.

Example 16: Adjustments to business combinations where it occurs before date of transition but exemption Section 28.10(a) not claimed – applicable for entity’s transitioning from FRS 102

Parent A acquired trade assets and liabilities of Company B for CU1,000,000 on 2 January 2014. Assume the date of transition is 1 January 2015. Under FRS 102 deferred tax has been recognised on any fair value uplifts on acquisition when compared to original book amount. Assume the useful life of goodwill is 10 years.

Assume the deferred tax on the adjustments under FRS 102 to reflect the fair value of the monetary assets reverses in the first year and the useful life of PPE is 10 years.

Details of the book value and fair value at the time of acquisition for FRS 102 and FRS 105 purposes is detailed below:

		FRS 105	FRS 102
	Book value	Fair value	Fair value	Difference
Property, Plant and Equipment	CU300,000	CU550,000	CU550,000	CUNil
Intangible Assets	CUnil	CUnil	CU100,000	(CU100,000)
Inventory	CU150,000	CU170,000	CU170,000	CUNil
Cash	CU100,000	CU100,000	CU100,000	CUNil
Debtors	CU20,000	CU25,000	CU25,000	CUNil
Creditors	(CU100,000)	(CU100,000)	(CU100,000)	CUNil
Contingent Liabilities	CU-	(CU10,000)	(CU10,000)	CUNil
Deferred tax on fair value uplift	N/a	N/a	(CU26,500*)	CU26,500
Deferred Tax as per acquires books	(CU60,000)	(	(CU60,000)	CU60,000
Total Net Assets	CU410,000	CU735,000	CU748,500	(CU13,500)
Consideration		CU1,000,000	CU1,000,000	CUNil
Goodwill		CU265,000	CU251,500	(CU13,500)

The deferred tax to be recognised on acquisition under FRS 102, not to be recognised under FRS 105:

Uplift in Property, Plant and Equipment	CU150,000
Uplift in Intangible Assets	CU100,000
Uplift in Inventory	CU20,000
Uplift in Cash	CUnil
Uplift in Contingent Liabilities	(CU10,000)
Uplift in Debtors	CU5,000
Uplift in Creditors	CUnil
Total Timing Difference	CU265,000
Deferred Tax (CU265,00010%)	CU26,500

CU265,000 * 10%= CU26,500. Therefore total deferred tax to be shown in the consolidated financial statements is = CU26,500+CU60,000=CU86,500. As FRS 105 does not permit such recognition the below journals reverse this deferred tax.

Adjustment required at 1 January 2015

	CU	CU
Dr Goodwill (CU265,000-CU251,500)	13,500
Dr Deferred Tax Liability for fair value uplift (as above)	26,500
Dr Deferred Tax Liability recognised being the book amount of the acquirer	60,000
Cr Intangible Assets (CU100,000 less nil)		100,000

Journal for change in amortisation

	CU	CU
Dr Amortisation of Goodwill in P&L Reserves**	1,350**
Cr Amortisation of Intangibles in P&L Reserves***		20,000***
Cr Accumulated Amortisation of Goodwill		1,350
Dr Accumulated Amortisation of Intangibles	20,000

Being journal to reflect increase in goodwill amortisation and decrease in intangible amortisation due to FRS 102 figures posted being different to what is required under FRS 105 at the date of transition.

The amortisation that should have been charged under FRS 105 is = (CU265,000/10yrs) = CU26,500.

Therefore the additional charge of CU1,350 (CU26,500-CU25,150) is recognised under FRS 105.

Therefore journal required to reverse the amortisation of CU20,000 (CU20,000-CUnil) posted under FRS 105 is as per above.

Journal for derecognise the deferred tax recognised on the uplift and set against goodwill:

	CU	CU
Dr Deferred Tax in P&L Reserves	6,015
Cr Deferred Tax Liability ((CU4,515 +CU1,500)		6,015****

Being journal to reverse the movement on the deferred tax posted under FRS 102 as deferred tax is not applicable under FRS 105 and therefore was never recognised posted to reserves.

****Reversal of the timing difference of inventory (CU20,000), contingent liability (CU10,000) and debtors (CU5,000) = (CU20,000-CU10,000+CU5,000)*10%= CU1,500

Reversal of the timing difference on fair value adjustment on PPE and intangibles for the depreciation/amortisation charge in the year = (CU25,150+CU20,000)*10%=CU4,515.

Adjustments required in the 31 December 2015 year end accounts assuming the above journals are posted into reserves where relevant:

The same type of journals would be posted for the amortisation/depreciation on intangible, goodwill and PPE in the 2015 as the journals at the date of transition with the only exception being that they will hit the profit and loss account as opposite reserves assuming financial statements have first been prepared under old GAAP. Deferred tax of CU4,515 would only be posted as the monetary differences have been reduced to nil in the prior year.

Journal for change in amortisation

	CU	CU
Dr Amortisation of Goodwill in P&L Reserves**	1,350**
Cr Amortisation of Intangibles in P&L Reserves***		20,000***
Cr Accumulated Amortisation of Goodwill		1,350
Dr Accumulated Amortisation of Intangibles	20,000

Being journal to reflect increase in goodwill amortisation and decrease in intangible amortisation due to FRS 102 figures posted being different to what is required under FRS 105

Journal for change in deferred tax

	CU	CU
Dr Deferred Tax in P&L	4,515
Cr Deferred Tax Liability ((CU4,515)		4,515****

Being journal to reverse the movement on the deferred tax posted under FRS 102 as deferred tax is not applicable under FRS 105 and therefore was never recognised.

****Reversal of the timing difference on fair value adjustment on PPE and intangibles for the depreciation/amortisation charged in the year = (CU25,150+CU20,000)*10%=CU4,515.

Adjustments required in the 31 December 2016 year end accounts assuming the above journals are posted into reserves where relevant:

The same type of journals would be posted in 2016 as the 2015 year assuming entity financial statements have first been performed under old GAAP.

Example 17: Adjustments to business combinations where it occurs before date of transition but exemption Section 28.10(c) not claimed – applicable for entity’s transitioning from FRSSE/old GAAP

The journals to be posted if this arises are similar to example 16 above but adjusted for the figures within example 15 above which dealt with a business combination under old GAAP when compared to FRS 105.

Example 18: Adjustments to business combinations where it occurs pre the date of transition – when exemption in Section 28.10(a) is availed of – Applicable to old GAAP/FRSSE & FRS 102 entities that transition

Note even where an entity claims exemption under Section 28.10(a) not to restate business combinations prior to the date of transition, deferred tax recognised under these combinations under old GAAP/FRS 102 will still have to be derecognised on transition. As the exemption is claimed it cannot hit the goodwill recognised, instead it will hit P&L reserves.

If we take the details as per example 16 and assume this combination occurred pre the date of transition and Section 28.10a exemption is claimed, the following journal is required (note in reality these will be derecognised as part of one journal to derecognise deferred tax on the balance sheet and P&L, it has been shown here for education purposes). Assume the deferred tax liability on the book amounts did not move for the purposes of this example:

At 1 January 2015 (assuming the entity is transitioning from FRS 102 where deferred tax was recognised)

	CU	CU
Dr Deferred Tax Liability recognised being the book amount of the acquirer at date of transition	60,000
Dr Deferred Tax Liability recognised on fair value difference on acquisition at date of transition (CU26,500-CU6,015)	20,485
Cr P&L Reserves		80,485

Being journals derecognise the carrying amount of deferred tax as it is not permitted to be recognised under FRS 105.

At 1 January 2015 (assuming the entity is transitioning from FRSSE/old GAAP where deferred tax was recognised) – not always applicable for FRSSE/ old GAAP

	CU	CU
Dr Deferred Tax Liability recognised being the book amount of the acquirer	60,000
Cr P&L Reserves		60,000

Being journals to derecognise deferred tax at the date of transition as it is not permitted to be recognised under FRS 105.

At 31 December 2015 (assuming the entity is transitioning from FRS 102 where deferred tax was recognised)

The journals where the entity has transitioned from FRS 102 are:

	CU	CU
Dr Deferred Tax in P&L	4,515
Cr Deferred Tax Liability ((CU4,515)		4,515****

Being journal to reverse the movement on the deferred tax posted under FRS 102 as deferred tax is not applicable under FRS 105 and therefore was never recognised.

Note the movement on the deferred tax that does not relate to the deferred tax recognised on the fair value movements should also be reversed in the comparative, however these would be reversed as one journal as detailed in Section 24 of this website (not applicable for the purposes of this example.

At 31 December 2015 (assuming the entity is transitioning from FRSSE/old GAAP where deferred tax was recognised)

No journal for FRSSE as we have assumed no deferred tax movement recognised in the example.

At 31 December 2016 (assuming the entity is transitioning from FRS 102 where deferred tax was recognised)

The journal is as per the 2015 year.

At 31 December 2016 (assuming the entity is transitioning from FRSSE/old GAAP where deferred tax was recognised)

No journal for FRSSE as we have assumed no deferred tax movement recognised in the example.

3) On transition even where these exemptions are not claimed there may be a possible adjustment to inventory as under old GAAP/FRSSE the value to be placed on any inventory where the inventory is not traded in a market in which the acquirer participates as both a buyer and a seller at the date of acquisition is the lower of replacement cost or net realisable value. Under FRS 105 fair value should be used regardless of whether the acquirer participates in an active market in which they are both buyers and sellers. The FRS 105 treatment is the same as FRS 102 in this regard.

4) Adjustment required to reflect amortisation on goodwill previously determined to have an indefinite life under old GAAP/FRSSE or life could not be determined so default of 20 years used – where the exemption in Section 28.10a is claimed

Where the exemption not to restate prior year business combinations and goodwill is availed of, then no adjustment is allowed to be made to goodwill. Therefore on transition where in the past under old GAAP/FRSSE the default rate of 20 years was used as the useful life could not be determined at the time or where the goodwill was considered indefinite, no adjustment will be required to opening reserves on transition. Instead where the 20 years cannot be substantiated (which is unlikely in practice as in the past the entity was able to justify the carrying amount), the entity should assess if they can determine the remaining useful life at that time. If after all efforts are exhausted, then a useful life of 10 years should be used. This is adjusted prospectively and the amortisation will have be charged from the date of transition.

Example 19: Transition adjustment for goodwill previously determined infinite where Section 35.10(a) is claimed- applicable to entities transitioning from FRSSE/old GAAP

Company A had goodwill with a carrying amount on transition of CU10,000. This was not previously amortised under old GAAP as it was deemed to have an infinite life. The useful life is now determined to be 10 years. Assume transition exemption 28.10(a) is claimed and the date of transition is 1 January 2015 and the goodwill was not previously allowed for tax purposes.

The adjustment to be recognised in the 31 December 2015 books is:

Dr Goodwill Amortisation

1,000

Cr Goodwill Accumulated Amortization

(CU10,000/10yrs being remaining UEL)

1,000

Being journal to recognise amortisation on goodwill as under old GAAP it was considered infinite.

The same journal will be required in the 31 December 2016 TB and the above journal should be posted to the profit and loss reserve.

Example 20: Transition adjustment for goodwill where previously used the default life 20 years where Section 28.10(a) is claimed – applicable to FRSSE/old GAAP

Company A had goodwill with a carrying amount on transition of CU10,000. This was previously amortised under old GAAP at the default rate of 20 years. There are 15 years remaining at the date of transition. If in the unlikely event that the remaining useful life cannot be justified and a life cannot be determined then the default rate under FRS 105 of 10 years should be used. The useful life is now determined to be 10 years. Assume transition exemption 28.10(a) is claimed, the date of transition is 1 January 2015.

The adjustment to be recognised in the 31 December 2015 books is:

	CU	CU
Dr Goodwill Amortisation	500
Cr Goodwill Accumulated Amortisation		500*

Being journal to recognise the additional amortisation on goodwill required under FRS 105.

*under old GAAP the amortisation charge for 2015 would have been CU500 (CU10,000/20yrs).

On transition to FRS 105, the life was determined to be 10 years by default. Therefore the amortisation should have been CU1,000 (CU10,000/10yrs). Therefore an adjustment is required in 31 December 2015 to increase the charge by CU500.

The same journal will be required in the 31 December 2016 TB.

If in the above example the remaining useful life of goodwill was less than 10 years then it may be appropriate to use the lower useful life.

5) Goodwill with an indefinite useful life under old GAAP (applicable to entities transitioning from FRSSE/old GAAP only – not applicable to FRS 102 adopters)

Under FRSSE/old GAAP it was possible for intangible assets and goodwill to have an indefinite useful economic life and as a result no amortisation was charged instead an annual impairment review was performed. On transition to FRS 105 these assets will now have to be assigned a useful economic life and where this cannot be determined then it will have to be assigned a life not exceeding 10 years. This will result in an additional amortisation charge and will also require an adjustment on transition to FRS 105. In example 21 below we have assumed a useful life could be determined of 20 years however where an entity cannot determine a useful life then the default useful life of 10 years should be utilised. It we assume for instance in example 21 below, that the default life of 10 years had to be used, then the carrying amount to be shown in the opening balance sheet on transition would be CU250,000 (CU500,000/10 years*5 years of life remaining).

If the capital allowances were available on these intangibles and the allowances were given in line with the amortisation charged, then a corporation tax asset would need to be booked at transition and this would be deductible over a 5 year period assuming the tax authorities’ guidance states that it is over 5 years.

As Section 24 of FRS 105 does not permit deferred tax to be recognised there is no need to consider deferred tax instead any deferred tax on the balance sheet on the date of transition or in the comparative years P&L is stripped out on transition. See section 24 for further details.

Note if in the comparative year goodwill was acquired/recognised which was not amortised a similar adjustment would be required as per example 21 below.

Example 26: Goodwill with an indefinite useful life under old GAAP/FRSSE (not applicable for entities that applied FRS 102 prior to transition) assuming exemption In Section 28.10a is not availed of re business combinations entered into pre transition.

Goodwill of CU500,000 was recognised under old GAAP (acquired 5 years prior to the date of transition) which was determined to have a infinite useful life. Assume on transition, under FRS 102, a useful life of 15 years was determined. Therefore, a transition adjustment is required whereby, if the useful life on the date of transition is 15 years, then the original useful life should have been 20 years when acquired. Therefore, amortisation of CU125,000 (i.e. CU500,000/20 years * 5 years) will need to be posted to retained earnings on transition so as to show the carrying amount at CU375,000 in the opening balance sheet. The journals required are: Assume the date of transition is 1 January 2015

1 January 2015

	CU	CU
Dr Profit and Loss Reserves	125,000
Cr Intangible Asset/Goodwill		125,000

Being journal to recognise amortisation charge for the period from acquisition to the date of transition i.e. 1 January 2015 for a company with a December year end. Then in future years an amortisation charge of CU25,000 (CU500k/20yrs) should be posted.

The journals required for 31 December 2015 assuming the above journals are posted to reserves:

Dr Amortisation in the P&L

(CU500,000/20yrs)

25,000

Cr Accumulated Amortisation

25,000

Being journal to reflect amortisation for the 2015 year as intangible was not previously amortised.

The same journal as above will be required to be posted for the 2016 year assuming the above journals are posted to reserves.

Disclosure in the notes

Extract from FRS 105 – Section 14.3

14.3 A micro-entity shall determine the amount of any ﬁnancial commitments, guarantees and contingencies not recognised in the statement of ﬁnancial position for trade and asset acquisitions and disclose that amount within the total amount of ﬁnancial commitments, guarantees and contingencies (see paragraph 6A.2).

OmniPro comment

The above disclosures are self-explanatory and could relate to litigation or disclosure with regard to contingent consideration, etc. etc.

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