Request for Information Post-implementation Review: IFRS 3 Business Combinations

Transcription

1 Ernst & Young Global Limited Becket House 1 Lambeth Palace Road London SE1 7EU Tel: +44 [0] Fax: +44 [0] ey.com International Accounting Standards Board 30 Cannon Street London EC4M 6XH 30 May 2014 Dear IASB members, Request for Information Post-implementation Review: IFRS 3 Business Combinations Ernst & Young Global Limited, the central coordinating entity of the global EY organisation, welcomes the opportunity to provide comments on the Request for Information Postimplementation Review: IFRS 3 Business Combinations (RfI). We believe the Business Combinations project, which resulted in the publication of IFRS 3 (2004) and IFRS 3 (2008), has generally improved financial reporting by establishing a consistent principle of accounting for business combination transactions at the acquisition date fair value, with limited exceptions. However, there are some areas where practical issues have arisen where further clarification would be helpful. We have highlighted these areas in Appendix A to this letter, in our responses to the specific questions asked in the RfI. Yours faithfully Ernst & Young Global Limited is a company limited by guarantee registered in England and Wales No

2 2 Appendix A responses to the specific questions 1. Your background and experience Question 1 Please tell us: a) About your role in relation to business combinations (ie preparer of financial statements, auditor, valuation specialist, user of financial statements and type of user, regulator, standard-setter, academic, accounting professional body etc). b) Your principal jurisdiction. If you are a user of financial statements, which geographical regions do you follow or invest in? c) Whether your involvement with business combinations accounting has been mainly with IFRS 3 (2004) or IFRS 3 (2008). d) If you are a preparer of financial statements: (i) Whether your jurisdiction or company is a recent adopter of IFRS and, if so, the year of adoption, and (ii) With how many business combinations accounted for under IFRS has your organisation been involved since 2004 and what were the industries of the acquirees in those combinations. e) If you are a user of financial statements, please briefly describe the main business combinations accounted for under IFRS that you have analysed since 2004 (for example, geographical regions in which those transactions took place, what were the industries of the acquirees in those business combinations etc). We are responding to the RfI in our role as auditors, advisors and valuation specialists to preparers of financial statements.

3 3 2. Definition of a business Question 2 a) Are there benefits of having separate accounting treatments for business combinations and asset acquisitions? If so, what are these benefits? b) What are the main practical implementation, auditing or enforcement challenges you face when assessing a transaction to determine whether it is a business? For the practical implementation challenges you have indicated, what are the main considerations that you take into account in your assessment? a) We believe that different accounting treatments are needed for business combinations and asset acquisitions because the acquisition of an asset is conceptually different from the acquisition of a business. The conceptual difference arises because the acquisition of a business includes recognition of goodwill. However, as shown in the table below, there are a number of areas where the treatment of an asset acquisition is different from the treatment of a business acquisition. Business combination Asset acquisition 1. Goodwill/gain on bargain purchase Recognition No recognition 2. Measurement of assets acquired and liabilities assumed 3. Directly attributable acquisitionrelated costs Generally fair value Expensed Assigned amount based on relative fair values Capitalised as part of the cost of the asset 4. Deferred tax assets and liabilities Recognition No recognition 5. Consideration in form of shares IFRS 2 does not apply IFRS 2 is applied 6. Contingent consideration Guidance in IFRS 3 No clear guidance 7. Step acquisitions Guidance in IFRS 3 No clear guidance Although we believe that an asset acquisition and a business combination are different, it is not always clear why some of the accounting treatments should be different. We do not believe there is a clear justification for the different accounting treatments numbered 3 to 7 in the table above. For example, we do not understand the conceptual basis for expensing acquisition-related costs in a business combination, but including acquisition costs in the cost of an asset in an asset acquisition. We would encourage the International Accounting Standards Board (the IASB) to consider whether the cost accumulation model continues to be appropriate for asset acquisitions and, if so, to provide clearer justification and additional guidance for the different accounting treatments above. We believe that if there are fewer differences between the accounting for

4 4 a business combination and the accounting for an asset acquisition, applying the definition of a business will be less critical. b) The main practical implementation and auditing challenges we see relate to determining whether an acquisition is a business combination. We believe that applying the definition of a business is a significant practice issue and we are aware of different interpretations of what constitutes a business under IFRS across a variety of industries. We previously highlighted our concerns in our comment letter to the IFRS Interpretations Committee (the Interpretations Committee) in August 2011 (attached in Appendix B). The key concerns in that letter were: If the acquired integrated set of activities and assets includes only observable inputs and outputs, are processes presumed to be embedded in the outputs such that the acquired set would constitute a business? When assessing whether a market participant is capable of acquiring a business and continuing to produce outputs, how (from what perspective) is output determined? Do studies/research/know-how represent an input, a process or an output? The term market participant is not defined in IFRS 3. Certain sets of activities and assets may be considered a business for a specific group of market participants if they could integrate the set of activities and assets in their processes. However, the same set of activities and assets might not be considered as a business from the perspective of other market participants. Further guidance on what constitutes a market participant would help in this determination. We have seen examples of situations where a buyer and seller enter into an arrangement at the same time as an acquisition of assets and activities. Determining whether the arrangement is part of the overall acquisition may affect the conclusion regarding whether the acquisition constitutes a business. We also note that the IASB s recently issued amendment IFRS 11 Acquisitions of Interests in Joint Operations (amendments to IFRS 11) and the exposure draft ED/2012/6 Sale or Contribution of Assets between an Investor and its Associate or Joint Venture rely on the definition of a business in their application. Therefore, having a clear definition is imperative. We are aware that although the definition of a business is the same under IFRS and US GAAP, different practices may have arisen in applying the definition. In addition, we believe there may be differences in application across jurisdictions that apply IFRS. Therefore, we recommend that the IASB considers the definition of a business and whether further clarification and guidance would be helpful to address the interpretation issues.

5 5 3. Fair value Question 3 a) To what extent is the information derived from the fair value measurements relevant and the information disclosed about fair value measurements sufficient? If there are deficiencies, what are they? b) What have been the most significant valuation challenges in measuring fair value within the context of business combination accounting? What have been the most significant challenges when auditing or enforcing those fair value measurements? c) Has fair value measurement been more challenging for particular elements: for example, specific assets, liabilities, consideration, etc.? a) We believe that information derived from the fair value measurements is relevant and we support having no further exceptions to fair value measurement. Nevertheless, in some cases, the subsequent accounting for assets and liabilities measured at fair value is not clear. For example, the fair value of a non-financial liability includes non-performance risk (i.e., the risk that the obligation is not fulfilled). However, subsequent to the acquisition, IAS 37 Provisions, Contingent Assets and Contingent Liabilities is applied, which requires measurement at the best estimate of the expenditure required to settle the obligation. This can lead to day two adjustments. Similarly, a property company with property that is classified as inventory must fair value it at acquisition, but may incur a loss on day two if the inventory is measured at net realisable value. We recommend that the IASB considers adding further guidance on the subsequent measurement of these assets and liabilities, similar to that provided for contingent liabilities, in order to address day two measurement adjustments. b) The most significant valuation and auditing challenges in fair value measurement are: Contingent consideration - due to the complexities and uncertainties in the arrangements, it can be difficult to determine the fair value. Contingent liabilities a number of different valuation approaches are used and, due to the uncertainties regarding outcomes, it is often difficult to determine the fair value as it is reliant on a number of assumptions. Valuation of separate intangible assets - due to the number of valuation approaches and the level of judgement required. In most cases, these assets do not derive separate cash flows and determining their fair value requires a number of difficult assumptions to be made. Step acquisitions it can be difficult to fair value the existing equity investment, where the shares are not quoted. For example, if the entity previously held an investment of 20%, should the investment be valued on the basis of a 20% investment, or should it be 20% of the total value (which may include a control premium)?

6 6 Non-controlling interests if there is no quoted price available, it may be difficult to determine a per-share value due to any control premium that may be included in the fair value of the controlling interest. Financial liabilities the announcement of a business combination may affect the quoted price of listed financial liabilities as a result of perceived credit enhancements provided by the acquirer or a perceived decrease in non-performance risk. The quoted price may be used as a level one fair value measurement to determine the fair value of the financial liability at the date of obtaining control. Should similar adjustments relating to perceived credit enhancements be recognised in determining the fair value of non-listed financial liabilities, and, if so, how? Equity consideration in many instances, there is a delay between the announcement of a business combination transaction and the date control is obtained. When the consideration is in the form of equity shares in a listed entity, the share price will often reflect the market s expectation of the transaction occurring, and the value of expected synergies, prior to the date control is acquired. This means measuring the equity at the fair value on the date of the acquisition may not accurately reflect the transaction that was agreed between the parties. Equity consideration publicly traded shares are commonly delivered by the acquirer as consideration in the acquisition of a business. In many instances, the shares given as consideration may be restricted from being traded for a specified period of time subsequent to the acquisition. Such restriction may involve a restriction by legend on the share certificates (i.e., a statutory restriction on transfer) or, alternatively, the shares may be restricted by virtue of a separate agreement whereby the shares are placed in escrow and are restricted from trading (i.e., a contractual restriction of transfer). In some situations, the acquirer s determination of the fair value of the shares given under the provisions of IFRS 13 may lead to a fair value based on the trading price of the shares (i.e., price X quantity) without consideration of the trading restriction. This can lead to a situation where the value ascribed to the consideration by the acquirer for acquisition accounting purposes exceeds the value that was agreed between the parties to the business combination. As such, the question arises as to whether the excess of the value ascribed to the consideration for acquisition accounting purposes should: (i) give rise to additional goodwill, which may then introduce a greater risk of impairment subsequent to the completion of the acquisition; or (ii) be recognised as a debit within shareholders equity. Clarification of the accounting in these circumstances would be helpful, recognising that when shares are given as consideration they are frequently subject to trading restrictions. c) Fair value measurement has been more challenging for particular elements, as highlighted above in our response to (b).

7 7 4. Separate recognition of intangible assets from goodwill and the accounting for negative goodwill Question 4 a) Do you find the separate recognition of intangibles useful? If so, why? How does it contribute to your understanding and analysis of the acquired business? Do you think changes are needed and, if so, what are they and why? b) What are the main implementation, auditing or enforcement challenges in the separate recognition of intangible assets from goodwill? What do you think are the main causes of those challenges? c) How useful to you find the recognition of negative goodwill in profit or loss and the disclosures about the underlying reasons why the transaction resulted in a gain? a) We believe the separate recognition of intangibles can be useful in maintaining the faithful representation of what has been acquired. We believe that intangibles that meet the recognition criteria should be recognised and amortised separately. However, in some circumstances, it is difficult to separate assets, such as customer relationship intangibles, from goodwill. Whilst, in some businesses, separate recognition of customer relationships may be appropriate, we believe, in other cases, the separation from goodwill may be somewhat arbitrary and therefore the information is less relevant. In our response to (b) below, we highlight some of the challenges in recognising customer relationship intangible assets. b) The main challenges in the separate recognition of intangibles are as follows: Recognition of customer relationship intangible assets it is difficult to determine whether the relationship is contractual or non-contractual, which is critical in recognising and measuring intangible assets. The Interpretations Committee discussed the distinction between contractual and non-contractual relationships in 2008, but did not come to any conclusions. Therefore, there is diversity in practice regarding whether entities deem customer relationships to be contractual. We recommend that the IASB considers addressing this as part of the PiR. Determining the unit of account for intangible assets can be difficult. For example, if an entity purchases 1,000 patents, should they be valued separately or is there a basis for aggregating and valuing as one unit of account? Similar issues arise where in-process research and development or customer relationship intangibles are acquired. For example, is it appropriate to recognise a single in-process research and development asset or should there be multiple assets; for example, by geographical area? Similarly, should a separate intangible asset be recognised for the relationship with each customer, or should they be aggregated according to certain factors? The determination of the unit of account can have a significant impact on subsequent impairment tests and expense recognition. Therefore, we recommend the IASB considers providing further guidance on the unit of account.

8 c) Acquisition requires significant restructuring, which cannot be recognised as part of the acquisition, but may be part of the negotiated price and may be applied by all prospective purchasers. In these circumstances, recognition of a gain may not provide the most useful information. The amount of any gain may also be increased when non-controlling interests are measured at a proportionate share of net assets. We recommend that the IASB considers the requirements for the gain on bargain purchases in light of how frequently it arises. 8

9 9 5. Non-amortisation of goodwill and indefinite-life intangible assets Question 5 a) How useful have you found the information obtained from annually assessing goodwill and intangible assets with indefinite useful lives for impairment, and why? b) Do you think that improvements are needed regarding the information provided by the impairment test? If so, what are they? c) What are the main implementation, auditing or enforcement challenges in testing goodwill or intangible assets with indefinite useful lives for impairment, and why? a) We believe there are advantages and disadvantages to both the amortisation of goodwill and the non-amortisation approach. One could argue that goodwill is replaced over time by internally generated goodwill and, therefore, goodwill should be amortised over its useful economic life. However, it may also be considered that the useful economic life of goodwill cannot be determined, and so a non-amortisation approach is preferable. We believe that it is important that IFRS and US GAAP remain converged on this point. To the extent that goodwill and indefinite life intangible assets are not amortised, we support the annual impairment test, but we have encountered a number of implementation and auditing challenges outlined in (c) below. b) We believe the information provided by the impairment test is appropriate. c) The main implementation and auditing challenges in impairment testing goodwill and intangible assets with indefinite useful lives are, as follows: The most significant practical issues relate to the allocation of goodwill to cash generating units (CGUs) for impairment testing. Goodwill is allocated to the CGUs that are expected to benefit from the synergies of the combination, which can be judgemental and difficult to apply in practice. For example, allocating goodwill to a CGU that does not have any other assets or liabilities assigned to it will be based on a number of judgemental assumptions as IAS 36 does not provide any further guidance on allocation methodologies. It is not clear what represents the lowest level within the entity at which the goodwill is monitored for internal management purposes [emphasis added], as set out in IAS This is considered by some to be the lowest level within the entity that is expected to benefit from the synergies of the combination and of which the performance is monitored. However, it could only be the lowest level within the entity for which separate internal reporting exists which includes an amount for goodwill. This difference in interpretation can lead to diversity in practice.

10 There are a number of practical difficulties related to the testing of a CGU for impairment when part of the recoverable amount is attributable to NCI. If an entity is measuring NCI at its proportionate share of net assets, this needs to be reflected in the impairment calculation. This becomes more complicated when there have been transactions with NCI holders after the business acquisition date, or if there is a group of CGUs to which goodwill is attributed that is partly measured at fair value and partly on a proportionate basis. 10

11 11 6. Non-controlling interests Question 6 a) How useful is the information resulting from the presentation and measurement requirements for NCIs? Does the information resulting from those requirements reflect the claims on consolidated equity that are not attributable to the parent? If not, what improvements do you think are needed? b) What are the main challenges in accounting for NCIs, or auditing or enforcing such accounting? Please specify the measurement option under which those challenges arise. To help us assess your answer better, we would be grateful if you could please specify the measurement option under which you account for NCIs that are present ownership interests and whether this measurement choice is made on an acquisition-by-acquisition basis. a) The information resulting from the presentation and measurement of NCI is impacted by the choice of accounting treatment for components of NCI that are present ownership interests and that entitle holders to a proportionate share of the entity s net assets. The choice of measurement basis may also impact the impairment testing of goodwill, depending on whether goodwill is recognised in the NCI (full goodwill). Whilst we accept the rationale for two accounting treatments, we believe financial reporting would be enhanced by requiring entities to select the treatment as a consistent accounting policy choice, rather than a choice that is made each time an entity accounts for an acquisition. We believe that it would be beneficial if further guidance were provided on the treatment of put and call options. In some transactions the acquirer grants options over the outstanding shares held by non-controlling shareholders, allowing or requiring the acquirer to purchase the shares at a future date. IFRS does not give specific guidance on how these options should impact the accounting for the business combination, which leads to diverse treatments being applied in practice. b) One of the most difficult practical challenges is measurement of NCI if the fair value approach is used, particularly if the shares are not quoted. The fair value of the consideration paid for the controlling interest may include a control premium and so a pro rata share price paid for the controlling interest may not be an appropriate basis for determining the fair value of the NCI.

12 12 7. Step acquisitions and loss of control Question 7 a) How useful do you find the information resulting from the step acquisition guidance in IFRS 3? If any of the information is unhelpful, please explain why. b) How useful do you find the information resulting from the accounting for a parent s retained investment upon the loss of control in a former subsidiary? If any of the information is unhelpful, please explain why. a) If an entity holds a non-controlling interest immediately prior to the acquisition of a controlling interest, the previously held interest is remeasured to fair value at the acquisition date and the gain or loss is recognised in profit or loss. Concerns have been expressed that it is counter-intuitive to recognise a gain on the existing investment in these circumstances. Moreover, it is difficult to explain this treatment to users of the financial statements. We believe the IASB should consider, as part of the review of the Conceptual Framework, whether the gain or loss is realised and therefore whether it should be recognised in the income statement or in other comprehensive income. If the IASB believes it should be recognised in other comprehensive income, then the issue of whether the gain should be recycled at a future date would also need to be addressed. As mentioned in our response to question 6(b), it can be difficult to determine the fair value of existing unquoted investments as it may be influenced by the premium paid to gain control of the investment. b) We believe the information resulting from the accounting for a parent s retained investment upon loss of control is appropriate. However, as stated in our response to (a), determination of the fair value of the retained investment can be difficult, particularly where control is lost due to changes in ownership other than sales to a third party.

13 13 8. Disclosures Question 8 a) Is other information needed to properly understand the effect of the acquisition on a group? If so, what information is needed and why would it be useful? b) Is there information required to be disclosed that is not useful and that should not be required? Please explain why. c) What are the main challenges to preparing, or auditing or enforcing the disclosures required by IFRS 3 or by the related amendments, and why? a) We do not believe that specific additional disclosure of information is typically necessary to understand the effect of acquisitions on the group. However, we note that, in some cases, preparers present the disclosures in a number of different notes to the financial statements, which may make it difficult to fully understand the impact of the acquisition. Requiring all of the relevant disclosures to be presented in one place may be useful. b) The requirement to provide disclosure about the impact of acquisitions made after the reporting date, but before the financial statements are authorised, can be difficult as the information is often not known and so the disclosures are not always meaningful. The disclosures made regarding the qualitative description of goodwill are often generic and tend not to provide useful information. Paragraph B64(q)(ii) of IFRS 3 requires disclosure of the revenue and profit or loss of the combined entity for the current period as though the acquisition had occurred at the beginning of the reporting period. In our experience, preparers find it very difficult to provide this disclosure (and it is therefore difficult to audit) as information prior to the acquisition is not always readily available. Due to the practical limitations and the significant effort required to determine the disclosures, we believe the IASB should consider providing some relief from this disclosure requirement. c) The main challenges to preparing and auditing the disclosures relate to impairment. We have observed that impairment disclosures are very mixed in practice. Although this may partly be due to the application of the standard, we believe the standard could be improved by adding further guidance on the granularity of disclosures relating to CGUs as there are differing views on the level of detailed disclosures required.

14 14 9. Other matters Question 9 Are there any other matters that you think the IASB should be aware of as it considers the PiR of IFRS 3? The IASB is interested in: a) Understanding how useful the information that is provided by the Standard and the related amendments is, and whether improvements are needed, and why; b) Learning about practical implementation matters, whether from the perspective of applying, auditing or enforcing the Standard and the related amendments; and c) Any learning points for its standard-setting process. a) In addition to the points we have raised in response to the other questions, we believe the following practical difficulties should also be addressed to improve the financial reporting of business combinations: Paragraph B18 of IFRS 3 states that a new entity that transfers cash or other assets or incurs liabilities as consideration may be the acquirer [emphasis added]. However, IFRS 3 does not specify under what circumstances this would be the case. As arrangements involving the creation of newly formed entities apply broadly and arise with some frequency, we recommend the IASB consider providing further guidance on when a new entity should be considered the acquirer in a business combination. Measuring pre-existing relationships can be difficult in practice. For example, where the pre-existing relationship is non-contractual, such as a litigation claim made by one party against the other, measuring the fair value of the claim is very judgemental and may depend on a number of assumptions being made. Where there is a contractual pre-existing relationship, which includes an at market component, identifying and measuring that can also be challenging. The accounting treatment of earn-out arrangements and determining whether they are contingent consideration or remuneration for future services is an area that often causes practical difficulties. Part of the difficulty arises due to the wording in paragraph B55 of IFRS 3. The first part of B55 states the acquirer should consider the following indicators. However, B55(a) goes on to state A contingent consideration arrangement in which the payments are automatically forfeited if employment terminates is remuneration for post-combination services [emphasis added]. This wording implies that B55(a) is a requirement rather than an indicator. We note that the Interpretations Committee did clarify, in an agenda decision in January 2013, that B55(a) is a requirement. However, clarification of this wording in the standard itself would help to avoid ambiguity.

15 15 Paragraph B55 highlights a number of indicators that need to be considered. Further guidance on how to assess these indicators would help ensure consistent treatment: Whether the duration of the required employment coincides with the payment period Level of other elements of remuneration compared with other key employees Incremental payments to other non-employee selling shareholders Number of shares owned when all selling shareholders receive the same level of additional consideration per share Link between payments and the valuation of the business Whether the formula for additional payments is based on performance or a valuation formula. IFRS 3 excludes from its scope common control transactions and the formation of joint arrangements. Whilst we agree that they are not within the scope of IFRS 3, this creates a number of issues regarding what is deemed the appropriate treatment. We believe the IASB should consider addressing these projects as soon as possible to reduce the diversity that arises in practice. b) See responses above. c) Many of the issues we have highlighted have arisen when the standard is applied in practice. As we have highlighted in our comment letters in the past, increased field testing of proposed new standards may help to address implementation issues during the consultation process.

16 Effects Question 10 From your point of view, which areas of IFRS 3 and related amendments: a) Represent benefits to users of financial statements, preparers, auditors and/or enforcers of financial information, and why; b) Have resulted in considerable unexpected costs to users of financial statements, preparers, auditors and/or enforcers of financial information, and why; or c) Have had any effect on how acquisitions are carried out (for example an effect on contractual terms)? We have addressed the effects of IFRS 3 in our responses to the earlier questions.

17 Ernst & Young Global Limited Becket House 1 Lambeth Palace Road London SE1 7EU Tel: +44 [0] Fax: +44 [0] International Financial Reporting Standards Interpretations Committee 30 Cannon Street London EC4M 6XH 19 August 2011 Dear IFRS Interpretations Committee members, Tentative Agenda Decision IFRS 3 Business Combinations definition of a business The global organisation of Ernst & Young is pleased to submit its comments on the discussion by the IFRS Interpretations Committee (the Interpretations Committee) on the definition of a business that occurred during the July 2011 meeting. We believe that the definition of a business determination is a significant practice issue and are aware of emerging differences of interpretation of what constitutes a business under IFRS across a wide array of industries. In addition to the issues raised at the last Interpretations Committee meeting, we have included below a series of questions that highlights other specific practice areas where differences of interpretation have emerged. We strongly support the Interpretations Committee taking this issue onto its agenda and recommend that the Interpretations Committee consider these additional questions in any future deliberations. We believe that many of these issues could be addressed by adding examples to IFRS 3, or further clarifying Appendix B to IFRS 3. Further, given that IFRS 3 and ASC 805 Business Combinations are converged standards, we recommend that the IASB work with the FASB staff (or EITF) to reach a converged solution. 1. If the acquired integrated set of activities and assets includes only observable inputs and outputs, are processes presumed to be embedded in the acquisition such that the acquired set would constitute a business? When an acquired integrated set of activities and assets includes inputs and outputs but no observable process, we are aware of potential diversity in practice in the determination of whether the acquired set of activities and assets constitutes a business. Some believe that because the revenue producing activities associated with the acquired set remain substantially the same before and after the acquisition, processes are embedded in the acquisition and, therefore, the acquired set constitutes a business. However, others believe that regardless of the fact there is a continuing revenue stream, if the acquired set does not include an observable process, the acquired set does not constitute a business. Ernst & Young Global Limited is a company limited by guarantee registered in England and Wales. No

18 2 The following example in the real estate industry illustrates these two views 1. Example 1: Acquisition of land and fully leased large commercial building subject to a long term lease Entity A acquires (1) land and (2) a fully-leased large commercial building with long-term leases with multiple tenants. Entity A does not acquire the processes that have been established to manage the leases (e.g., lease management, selection of tenants, marketing decisions, investment decisions) or the processes to provide services (e.g., security, cleaning, maintenance) to the building. Entity A will provide lease management and other building services through its own employees or through new outsourcing contracts with suppliers. View A: Entity A acquired a business pursuant to IFRS 3. Entity A acquired inputs (the land and fully leased building) and outputs (rental income). Because the revenue producing activities associated with the acquired set of activities and assets remain substantially the same before and after the acquisition, processes are embedded in the acquisition and, therefore, the acquired set constitutes a business. View B: Entity A did not acquire a business pursuant to IFRS 3. While Entity A acquired inputs (land and fully leased building) and outputs (rental income), because it did not acquire any observable process, the acquired set of activities and assets is not a business even though the building is currently generating rental income. While IFRS 3 states that not all of the processes used in operating the business need to be acquired, proponents of this view believe that an observable process must be included in the acquired set for the acquisition to meet the definition of a business. 2. When assessing whether a market participant is capable of acquiring a business and continuing to produce outputs, how (from what perspective) is output determined? When assessing whether a market participant is capable of acquiring a business and continuing to produce outputs, we are aware of potential diversity in practice (particularly in the extractive industry) on how (from what perspective) output is considered. Some consider output from the perspective of a market participant whereas others consider output from the perspective of the acquirer. Those that believe output should be considered from the perspective of a market participant point to the guidance in paragraph B11 of Appendix B to IFRS 3. This paragraph states Thus, in evaluating whether a particular set [of activities and assets] is 1 This issue is also prevalent in other industries. For example, in the shipping industry, a buyer may acquire only a ship and the charter (but not a crew or any other processes). In the banking industry, a buyer may acquire only a portfolio of financial assets (but not employees to manage or collect cash flows from the portfolio, or any other processes).

19 3 a business, it is not relevant whether a seller operated the set as a business, or whether the acquirer intends to operate the set as a business. This paragraph clarifies that the perspective of the acquirer is irrelevant in the definition of a business determination and that output should be considered from the perspective of a market participant. Those that believe output should be considered from the perspective of the acquirer point to the reference to continuing to produce outputs in paragraph B8 of Appendix B to IFRS 3. That is, in evaluating whether a market participant is capable of continuing to produce outputs, only outputs that the acquirer intends to create are considered (i.e., only market participants in the same market as the acquirer are considered). In this case, if the seller were producing an output different from the one intended by the acquirer or the acquired set of activities and assets is not capable of currently producing the output intended by the acquirer, then the acquired set would not constitute a business. The following example in the extractive industry illustrates these two views. Example 2: Acquisition of a mineral interest in which the seller has performed geological studies and surveys and has commenced exploration activities ABC Co. and Target Co. are mining companies. ABC Co. is a large exploration and production entity and Target Co. is a junior exploration stage entity. Target Co. owns land and a mineral interest and its principal activity is the exploration of this property (not necessarily the extraction of the mineral resources). Target Co. has some exploration processes (it has conducted drilling, sampling, geological studies, etc.) and determined through the resulting data that there are inferred, measured and/or indicated mineral resources, but has not yet commenced extraction of the minerals. ABC Co. s intended output is the mineral itself. ABC Co. acquires Target Co. and thus acquires the interest in the mineral property and the exploration processes and resulting data. View A: ABC Co. acquired a business under IFRS 3. ABC Co. acquired inputs (land and mineral interest) and processes (exploration processes). Because the acquired set of activities and assets is capable of providing a return to investors and a market participant would be capable of continuing the exploration activities to create outputs, ABC Co. acquired a business. The acquired set of integrated activities and assets is considered a business even though Target Co. is not currently producing the mineral (the intended output of ABC Co.). View B: ABC Co. did not acquire a business under IFRS 3. ABC Co. acquired inputs (land and mineral interest) and processes (exploration processes). Because the property is not currently producing the output intended by ABC Co., the acquired set is not a business.

20 4 3. Do studies/research/know-how represent an input, a process or an output? When an acquired set of integrated activities and assets includes studies/research/knowhow, we are aware of potential diversity in practice (particularly in the life sciences and extractive industries 2 ) on whether such information represents an input, a process or an output. Often, this issue arises when an integrated set of activities and assets is in the development stage. The following example in the life sciences industry illustrates the different views. Example 3: License to a product candidate Pharma A licenses a product candidate from Biotech B. The terms of the license agreement entitle Pharma A to the know how associated with the product candidate. The license agreement defines the know how as all biological materials and other tangible materials, inventions, practices, methods, protocols, formulas, knowledge, know-how, trade secrets, processes, procedures, specifications, assays, skills, experience, techniques, data and results of experimentation and testing, including pharmacological, toxicological, safety, stability and pre-clinical and clinical test data and analytical and quality control data, patentable or otherwise. Pharma A does not acquire any employees or other processes from Biotech B. View A: Pharma A did not acquire a business under IFRS 3. Pharma A has acquired only inputs (license and know how ). The know how represents an input that enhances the value of the product candidate. Know how is not viewed as a system, standard, protocol, convention or rule that when applied to the license, creates or has the ability to create outputs, and therefore is not a process. While Pharma A acquired inputs (license and know how ), it did not acquire any processes to apply to the license to create outputs. View B: Pharma A acquired a business under IFRS 3. Pharma A has acquired inputs (license) and processes ( know how ). The know how represents a process that can be applied to the license to create outputs. That is, a market participant would be capable of using the know how to continue the development of the product candidate to create outputs (e.g., the commercialisation of the product candidate or achieving certain stages of furthered development of clinical trials, which may increase the value of the product candidate). 2 In addition, we believe that this issue may have relevance to other industries where intellectual property is commonly acquired, such as in the technology industry.

21 5 View C: Pharma A acquired a business under IFRS 3. Pharma A has acquired inputs (license) and outputs ( know how ). The know how represents an output because a market participant could license/sell the product candidate and know how to generate a return. In some cases, market participants are not in the business of developing and commercialising a product candidate 3. Instead, after the product candidate achieves a certain stage of clinical development, such market participants will license/sell the product candidate and know how to another party for final development and commercialisation. Because the acquired set of activities and assets is capable of providing a return to investors, processes are embedded 4 in the acquisition and, therefore, the acquired set constitutes a business. Should you wish to discuss the contents of this letter with us, please contact Leo van der Tas at the above address or on +44 (0) Yours faithfully cc: Financial Accounting Standards Board Emerging Issues Task Force 3 This can also be seen in Example 2. 4 See Issue 1.