IFRS 3 Business Combinations

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IFRS 3Business Combinations
Mumbai, December 20, 2005 P.R. RAMESH - Deloitte
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Agenda

• Scope
• Application of the Purchase Method
• Revised IAS 38
• Revised IAS 36
• Valuation Considerations
• Transition
• Questions and Answers

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Scope

• Business Combination
• Transaction where two or more entities or
  businesses are brought together to form a single
  reporting entity
• Business
• Integrated set of activities and assets conducted
  and managed for the purposes of providing
• A return to investors or
• Lower costs or other economic benefits directly
  and proportionately to shareholders.

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Scope

• Scope Exemptions
• Business combinations in which separate entities
  or businesses form a joint venture
• Business Combinations involving entities or
  businesses under common control
• Business Combinations involving two or more
  mutual entities
• Business Combinations in which separate entities
  or businesses are brought together by contract
  alone without the obtaining of an ownership
  interest

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Purchase Method
Identify an Acquirer

Determine the cost of the business combination
Allocate the cost of the business combination
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Identify an Acquirer

• Consider
• Respective sizes of entities prior to the
  combination
• Power to govern financial and operating policies
  of combined entity
• Voting rights in combined entity
• Acquirer for accounting may be different than
  legal acquirer (a reverse acquisition)
• Where a new entity is formed one of the
  pre-existing entities must be identified as the
  acquirer

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Cost of Business Combination

• Equity instruments issued as purchase
  consideration measured at market price
• Include
• Cash consideration
• Equity instruments issues to effect the
  transaction
• Expenses incurred by the acquirer solely for
  purpose of business combination (e.g. legal fees)
• Contingent payments to the extent they are
  probable and can be reliably measured
• Costs of arranging finance for the acquisition
  and costs of issuing equity instruments are not
  recognised as an asset they are accounted for
  in accordance with IAS 39 (i.e. initial cost to
  treated as either liability or offering costs)

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Allocate Cost of Business Combination

• Assets are recognized at fair value if it can be
  measured reliably and it is probable that the
  economic benefit will flow to the acquirer
• Liabilities, other than contingent liabilities
  are recognized at fair value only if it can be
  measures reliably and it is probable that there
  would be an outflow of economic benefit to settle
  obligation
• Only allocate to those assets, liabilities and
  contingent liabilities of the acquiree that exist
  at the date of acquisition (i.e. restructuring)
• Measure contingent liabilities if reliably
  measurable base on the amount a third party
  would charge to assume the liability

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Fair Values of Net Assets and Contingent
Liabilities

• Traded financial instruments (eg. investments) at
  market values
• Unquoted financial instruments based on estimated
  values such as price-earning ratio, dividend
  yield, growth rates of similar traded instruments
• Long-term receivables and other long-term assets
  at present values determined at appropriate
  current interest rates less allowances for
  doubtful receivables and collection costs
• Inventories- Finished goods at selling price less
  sum of cost of disposal and profit
  allowance for acquirers effort
• Work-in-progress at selling price of
  finished goods less sum of cost to
  complete, cost of disposal and profit allowance
  for acquirers effort
• Raw materials at replacement cost
• Land and building at market values
• Plant and equipment at market values determined
  by an appraiser. In absence of market value
  depreciated replacement cost
• Net employee defined benefit asset or liability
  at present value less fair value of plan assets
• Long-term liability at present values at
  appropriate interest rates

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Goodwill
Fair Value of assets, liabilities and contingent
liabilities assumed
Cost of Business Combination

-
gt 0
Goodwill

• Recognise as an asset at date of transaction
• Do not amortise
• Test for impairment at least annually

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Negative Goodwill
Fair Value of assets, liabilities and contingent
liabilities assumed
Cost of Business Combination

-
lt 0
Negative Goodwill

• Reassess the fair values originally determined
• Any remaining excess is recognised in profit
  and
• loss immediately

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IAS 38

• Identification and recognition of certain
  intangible assets
• Finite useful life amortise
• Indefinite useful life Assess annually for
  impairment
• Reassess the useful life of intangible assets at
  least annually

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IAS 36 Cash-generating units

• Cash-generating units (CGUs)
• The smallest identifiable group of assets that
  generate cash inflows that are largely
  independent of the cash inflows from other groups
  of assets
• Allocate acquired goodwill amongst CGUs expected
  to benefit from the synergies of the combination
• CGUs (or groups of CGUs) to which goodwill is
  allocated for impairment testing must be
• Lowest level at which management monitor goodwill
• No larger than a segment (in accordance with IAS
  14)

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IAS 36 Calculation

• Determine carrying amount of the CGU (including
  allocated goodwill)
• Determine fair value less costs to sell and/or
  value in use
• Compare higher of the two with carrying amount
• Any shortfall must be recognised as a recoverable
  amount write-down

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IAS 36 Write-downs

• All write-downs are recognised immediately
• Where a write-down is required in relation to a
  CGU with allocated goodwill, the goodwill is
  first written down
• Any remaining write down is taken proportionately
  against the non-monetary assets
• Write-downs of goodwill may not be reversed in
  future reporting periods

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IAS 36 Practical Considerations

• A CGU must be assessed at the same time each year
• Where an indicator of impairment exists, the
  asset concerned must be tested for impairment
  before testing the CGU
• Detailed calculations may be carried forward from
  prior reporting periods providing certain
  conditions are met

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Valuation Considerations

• Overview
• Cash Generating Unit Valuations
• Identifiable Intangible Asset Valuations
• Documentation Guidelines

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Cash Generating Unit Valuations (1)

• Assessing the Recoverable Amount of a CGU
• IAS 36 (18) defines recoverable amount as the
  HIGHER of
• Fair value less costs to sell and
• Value in Use
• Best evidence of an assets FAIR VALUE (less
  costs to sell) is a price in a binding sale in an
  arms length transaction, adjusted incremental
  costs that would be directly attributable to the
  disposal of the asset. Consider
• Binding sales agreement or
• Comparable companies and Transactions involving
  similar companies (MARKET APPROACH)
• The expected present value of the future cash
  flows derived from the asset (DCF APPROACH)
  should be used in assessing the VALUE IN USE

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Cash Generating Unit Valuations (2)

• MARKET APPROACH Key Elements and Considerations
• Typical methodologies
• Comparable public companies
• Comparable transactions
• Valuation multiples
• Market value of Invested Capital to revenue,
  EBITDA, or EBIT
• Market value of Equity to net income, or BV of
  tangible net equity

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Intangible Asset Valuations (1)

• Recognition as part of a business combination
• Recognised separately if it meets the following
  criteria
• Separately identifiable (i.e. capable of being
  separated or divided from the entity and sold,
  transferred, licensed, rented, or exchanged
  either individually or together with a related
  contract, asset or liability)
• Controlled by the entity (arises from contractual
  or other legal rights, regardless of whether
  those rights are transferable or separable from
  the entity or from other rights and obligations)
• A source of future economic benefits
• Fair value can be measured reliably
• Useful list of Illustrative Examples of types
  intangibles is provided with IFRS 3 similar to
  SFAS 141
• Determination will ultimately be based on the
  facts and circumstances of each individual
  business combination

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Intangible Asset Valuations (2)

• Intangible Asset Valuations
• Market Approach
• Comparable transaction
• Income Approach
• Relief-from-royalty
• Discounted cash flow
• Cost-savings
• Cost Approach
• Replacement cost

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Documentation Guidelines

• Key Elements of Valuation Documentation
• Description of the CGU
• Nature of operations
• Consider value drivers
• Financial analysis with respect to the CGU
• Financial condition
• Profitability and earnings capacity
• Available documentation regarding forecasts

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Documentation Guidelines

• Key Elements of Valuation Documentation (cont.)
• Supporting calculations consistent with generally
  accepted valuation procedures for each valuation
  method adopted
• Sufficient documentation of key assumptions and
  sources of data
• Rationale for conclusion and rationalisation of
  various indications of value global sense check

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Closing Observations

• Appropriate valuation methodologies should be
  carefully selected and consistently applied over
  time
• Whether a particular fair value measurement is
  prepared internally or with the assistance of a
  third-party specialist, the level of
  documentation to support the conclusions of the
  entity is expected to be similar
• Its a subjective and difficult area so please
  consult with the appropriate specialists

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Tax Effect of Business Combination

• Fair value of assets and liabilities may result
  in deferred tax asset or liability
• If asset or liability is not recognized which
  subsequently is incurred or realized then
• recognize benefit \ expense in PL
• adjust carrying value of goodwill through PL

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Transition Current IFRS User

• Applies to transactions for which agreement date
  is on or after 31 March 2004
• In the first reporting period beginning on or
  after 31 March 2004
• Discontinue amortisation of goodwill in first
  reporting period after
• Eliminate carrying amount of goodwill
  amortisation against goodwill
• Test carrying amount of goodwill for impairment
• Reclassify intangibles recognised in previous
  business combinations that do not meet the
  recognition criteria to goodwill
• Early adoption can only be achieved in
  conjunction with early adoption of revised IAS 36
  and IAS 38
• Transitional requirements should be applied in
  respect of goodwill arising from joint ventures
  and associates

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Transition First-Time Adopter

• Not required to restate prior business
  combinations accounted for under a standard
  different from the IFRS applicable at the date of
  reporting.
• Still need to eliminate assets and liabilities
  that do not meet the recognition criteria under
  IFRS outside of a business combination
  (adjustment to goodwill).
• If subsidiary has not been consolidated under
  previous GAAP, restate assets and liabilities in
  accordance with IFRS
• Test goodwill in opening IFRS balance sheet for
  impairment.
• Must account for all business combinations after
  date of transition in accordance with IFRS 3

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• THANK YOU