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19.1.1 Extracts from FRS102-Sections 19.2
19.2 Business combinations defined
19.2.1 Extracts from FRS 102 – Section 19.3
19.2.2.1 Definition of a business combination
19.2.2.1.1 Definition of a business
19.3 Structure of a business combination
19.3.1 Extracts from FRS 102 – Section 19.4–19.5A
19.4.1 Extracts from FRS102 – Section 19.6-19.7
19.5 Purchase method – Identifying the acquirer
19.5.1 Extracts from FRS102 – Section 19.8 – 19.10 and 19.17
19.5.2.3 New entity formed to effect a business combination where equity issued.
19.5.2.3.1 Control obtained but little or no substance to it
19.5.2.3.2 Identifying the acquirer – where substance to it.
19.5.2.4 Determining the acquistition date for the purpose of Section 19
19.6 Purchase method – Cost of a business combination
19.6.1 Extracts from FRS102 – Section 19.11-19.11A
19.6.2.2.1 Purchase on deferred payment terms
19.6.2.3 Liabilities incurred or assumed
19.6.2.4 Costs directly attributable to the acquisition/ business combination
19.6.2.4.1 Examples of directly attributable cost
19.6.2.4.2 Example of costs not directly attributable
19.6.2.5 Equity issued as consideration for the acquisition
19.6.2.6 Cost where control achieved in stages
19.7 Adjustments to the cost of a business combination contingent on future events
19.7.1 Extracts from FRS102 – Section 19.12-19.13
19.7.2.1 Contingent consideration and change in estimate
19.7.2.1.1 Contingent consideration – probable at the date of acquisition.
19.7.2.1.3 Changes in contingent consideration – change in estimate
19.7.2.1.4 Contingent consideration – No provision booked in year 1
19.7.2.2 Contingency payments relating to further services
19.8 Allocating of the cost of a business combination to the asset acquire and liabilities assured.
19.8.1.1 Extracts from FRS102 – Section 19.14-19.15, 19.18 and 19.20-19.21
19.8.1.2.2 Definition of assets and liabilities
19.8.1.2.2 Determining fair value
19.8.1.2.2.1 Fair value – intentions of acquirer ignored
19.8.1.2.2.1.1 Restructuring provisions
19.8.1.2.2.2 Measurement of contingent liabilities
19.8.1.2.2.2.1 Contingent liability – right of reimbursement
19.8.1.2.2.2.2 Fair valuing contingent consideration
19.8.1.2.2.3 Future losses – non-recognition of liabilities in determining allocation of cost
19.8.1.2.2.5 Determining fair value of intangible assets
19.8.1.2.2.6 Determining fair value of inventory
19.8.1.2.2.8 Determining fair value of investment in associate and joint ventures
19.8.1.2.2.9 Determining fair value of deferred revenue
19.9 Measurement of deferred tax, employee benefit and share based payments
19.9.1 Extracts from FRS102 – Section 19.15A-19.15C
19.10 Purchases method – Subsequent adjustment to fair value and accounting for Goodwill
19.10.1 Extracts from FRS102 – Section 19.16-19.17 and 19.22-19.23
19.10.2.1 Adjustments to fair value of identified assets and liabilities
19.10.2.2 Accounting for calculating goodwill including a journal to reflect business combination.
19.10.2.2.1 Initial recognition of goodwill
19.10.2.2.2 Subsequent recognitions of goodwill
19.10.2.2.3 Journals to reflect the business combination
19.10.2.2.4 Useful life of goodwill
19.10.2.2.4.1 Change in useful economic life
19.11 Business combination achieved in stages
19.11.1 Extracts from FRS102 – Section 19.11A
19.11.2.1.1 Acquiring a further controlling interest
19.11.2.1.2 Disposing of controlling interest but controlling interest retained
19.12.1 Extracts from FRS102 – Section 19.24
19.13.1 Extracts from FRS 102 section 19.27-19.32
19.13.2.1 Group reconstruction defined
19.13.2.4 Group reorganisations and merger accounting
19.14.1 Extracts from FRS 102 section 19.25 – 19.26A
19.14.2.1 Accounting policies positive goodwill – Consolidated financial statements.
19.14.2.2 Example from the notes to the accounts
19.14.2.2.1 Contingent consideration note
19.14.2.3 Parent entity accounting policies
19.14.2.3.1 Extract from notes to the financial statements
19.14.2.5 Profit and Loss Account for parent entity
19.14.2.6 – Negative Goodwill for the financial year
19.15 Disclosures – Group reconstructions
19.15.1 Extracts from FRS 102-Section 19.33
19.15.2.2 Extract from notes to the financial statements
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The below extracts and guidance is applicable for periods beginning before 1 January 2019 and are based on the September 2015 version of FRS 102. For periods beginning on or after 1 January 2019, the March 2018 version of FRS 102 applies which incorporates the changes made by the Triennial review of FRS 102. Note the March 2018 version of FRS 102 can be voluntarily applies for periods beginning before 1 January 2019. For the extracts from the March 2018 version of FRS 102 and the related guidance please click on the following link. For details of a summary of the main changes as a result of the triennial review please see the following link.
19.8 Allocating of the Cost of a Business Combination to the Asset Acquire and Liabilities Assured.
19.8.1 Cost of a Business Combination – Allocation – Fair Valuing Assets, Liabilities and Contingent Liabilities.
19.8.1.1 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.
19.8.1.2 OmniPro comment
19.8.1.2.1 Overview
Section 19.14 and 19.15 of FRS 102 requires the cost of the business combination be allocated to the identifiable assets acquired and liabilities assumed (including contingent liabilities) of the acquire. The difference between the cost and the fair value of the net assets / liabilities represents goodwill. See further details for the calculation of goodwill at 19.10.2.2. The assets, liabilities and contingent liabilities (subject to the exception at 19.9.2 ( for deferred tax, share taxed payments and employee benefit arrangement) should only be recognised at the acquisition date if :
– For an asset (other than intangible assets)where it is possible that the future economic benefits will flow and they can be reliably measured
– For a liability ( other than a contingent liability) where it is probable future outflows of economic benefits will flow and they can be fair valued reliably.
– For intangible assets and contingent liabilities if the fair value can be reliably measured.
19.8.1.2.2 Definition of assets and liabilities
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 (FRS102 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 102 Appendix I).
19.8.1.2.2 Determining fair value
Section 19 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.
19.8.1.2.2.1 Fair value – intentions of acquirer ignored
It is very important that the acquirers intentions are not recognised as part of the fair value of assets and liabilities. For example 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. See further details at 19.8.12.2.1.1
19.8.1.2.2.1.1 Restructuring provisions
The acquirer can only recognise restructuring provisions if they have been recognised by the acquiree i.e. if they have been publically announced (they meet the definition of a provision in Section 21 of FRS 102). This is stated in Section 19.18 of FRS 102.
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.
19.8.1.2.2.2 Measurement of contingent liabilities
Section 19.15 of FRS 102 provides 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 21-Provisions does not allow recognition of contingent liabilities in general Section 19.15(c) of FRS 102 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 as stated in Section 19.20 of FRS 102. Where this is included in the fair values this results in goodwill being increased (if positive goodwill is recognised) or decreased (where negative goodwill is recognised) as stated in Section 19.20 of FRS 102 increases goodwill, Disclosure is required under Section 19.20 of FRS 102 detailing the fact that a 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.
19.8.1.2.2.2.1 Contingent liability – right of reimbursement
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.
19.8.1.2.2.2.2 Fair valuing contingent consideration
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 as stated in Section 19.21 of FRS 102.
19.8.1.2.2.3 Future losses – non-recognition of liabilities in determining allocation of cost
As per Section 19.18 (b) of FRS 102. Future losses expected to be incurred are not considered to be liabilities incurred which is in line with Section 21 of FRS 102 and are therefore ignored when identifying liabilities of the acquired entity.
19.8.1.2.2.4 Determining fair value of property, plant and equipment (including consideration of grants)
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.
In the consolidated financial statements any fair value adjustments to PPE will result in additional / reduction in the depreciation to these accounts. This is made clear in Section 19.16 of FRS 102.
For specialised PPE, the fair value can be determined from a future cash flow approach or a depreciated replacement cost approach.
19.8.1.2.2.5 Determining fair value of intangible assets
Where no active market exists the fair value would be the amount the acquirer would have paid for the asset in an arm’s length transaction between knowledgeable willing parties based on best information available. Section 18 (see 18.4.2) provides further details on this. There must be either a legal or contractual night but in addition there must be a history or evidence of exchange transactions for the same or similar assets.
This would be done by looking at the multiples used for similar assets.
IAS 38 of IFRS noted that it may not always be easy to place values on the intangibles and stated in that case where the below procedures reflected current transactions and practices in the industry the entity could value it by:
- discounting estimated future net cash flows from the asset; or
- estimating the costs that the entity avoids by owning the intangible asset and not needing to:
- license it from another party in an arm’s length transaction;
- recreate or replace it.
Examples of intangibles which would usually be recognised in a business combination if they can be reliably measured are:
- trademarks, trade names, certification marks
- internet domain names
- newspaper mastheads
- non-competition agreements
- customer lists (separable)
- non-contractual customer relationships
- advertising, construction, service or supply contracts
- user rights
- patented technology
- computer software and mask works
- franchise agreements
19.8.1.2.2.6 Determining fair value of inventory
FRS 102 provides no guidance on fair valuing inventory 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.
Example 8: Valuing work in progress
Company A acquired Company B. As part of the assets acquired it included work in progress for bicycles with a cost in the acquire 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 Company B would 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).
19.8.1.2.2.7 Determining fair value of financial instruments
The rules in Section 11-Basic Financial Instruments and Section 12-Other 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 11 basic financial instruments excluding investments which are less than 20% (i.e. which do not give significant influence), these instruments should be held at amortised costs. Where these are not carried at amortised cost, a fair value adjustment will be required.
For complex instruments, such as forward contracts these should be fair valued at the date of acquisition.
In the majority of cases, debtors, creditors, are 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 these 12 months facts will emerge which will provide evidence that there is an over/under provision. See example 12 at 19.10.2.1 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. See Section 11 of FRS 102 for how this measurement is carried out.
19.8.1.2.2.8 Determining fair value of investment in associate and joint ventures
These should be valued based on the guidance in Section 11 .27 to 11.30 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.
19.8.1.2.2.9 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 9: Deferred revenue
Company A acquired 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.
19.8.1.2.2.10 Determining fair value of contracts which are above or below market rates at date of acquisition
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 consolidated 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 10: Favorable/unfavorable contract
Company A acquired Company B. It has an operating lease on a property 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 ((CU10,000-CU6,000)*10yrs). This CU40,000 increases the goodwill.
Each year CU4,000 will be released to the consolidated profit and loss.
The opposite would occur if an asset was to be recognised.
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Examples
Example 1: Determining a Business.
Example 2: Determining a Business.
Example 3: Identifying the Acquiring Company.
Example 4: Identifying the acquirer
Example 5: Determining cost where control achieved in stages.
Example 6: Changes in contingent consideration – change in estimate.
Example 7: Contingent consideration – No provision booked in year 1.
Example 8: Valuing work in progress.
Example 10: Favorable/unfavorable contract
Example 11: Deferred tax on business combinations
Example 13: Journals to reflect the business combination.
Example 14: Revising the useful life of goodwill
Example 15: Business combination achieved in stages.
Example 16: Acquiring a further controlling interest
Example 17: Acquiring a further controlling interest
Example 18: Disposing of controlling interest but controlling interest retained.
Example 20: Group reorganisations.
Example 23: Extract from notes to the financial statements – contingent consideration note.
Example 29: Extract from the consolidated Balance Sheet for negative goodwill
Example 30: Extract from the accounting policy notes – Group reconstruction and merger accounting.
Example 31: Extract from notes to the financial statements – Merger Method.
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