PHILIPPINE INTERPRETATIONS COMMITTEE (PIC) QUESTIONS AND ANSWERS (Q&As)

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1 PHILIPPINE INTERPRETATIONS COMMITTEE (PIC) QUESTIONS AND ANSWERS (Q&As) Q&A No PFRS 3, Business Combinations (2008), and PAS 40, Investment Property Acquisition of investment properties asset acquisition or business combination? Issue If one entity acquires (a) directly an investment property or properties or (b) another entity that holds one or more investment properties, should the transaction be accounted for as an asset acquisition or as a business combination? What are the relevant factors that should be considered in determining whether a transaction is an asset acquisition or a business combination? Background and Guidance Introduction If one entity acquires (a) directly an investment property or properties or (b) another entity that holds one or more investment properties, a careful evaluation or analysis on a case-by-case basis is needed to determine whether such acquisition constitutes a business as defined by PFRS 3. In practice, it may be difficult to decide whether the acquisition meets the definition of a business and, accordingly, the exercise of considerable judgment may be required. This Q&A focuses solely on the question of how to assess whether the said transaction is an asset acquisition or a business combination. It does not address the accounting for the acquisition of a subsidiary that is not a business, or the acquisition of a controlling interest of less than 100% in another entity that is not a business. Rationale of the issue Applying the definition of a business based on PFRS 3 to an investment property is not, however, always straightforward because: unlike most non-financial assets, investment properties usually generate revenues on a stand-alone basis (earning rentals being one of their defining characteristics [PAS 40.5]), while most other non-financial assets generate returns only in combination with other assets and liabilities; 1

2 in simple asset acquisitions, no obligations or activities are acquired. However, investment properties are often acquired with tenants. Tenants leases usually include related service obligations. Servicing activities along with others, such as rent collection, can be regarded as integral to an investment property asset. It is common for a single investment property to be held in a separate legal entity and for a purchaser to acquire that entity rather than the property. By contrast, most asset acquisitions are effected by acquiring the asset itself. Although acquiring a legal entity does not necessarily determine that a business combination has occurred, buying a legal entity brings with it all of the entity s assets, liabilities, contractual agreements and obligations. In most cases, an asset or group of assets and liabilities that are capable of generating revenues, combined with all or many of the activities necessary to earn those revenues, would constitute a business. However, investment property is a specific case in which generating earnings from the asset is one of the defining characteristics. Such characteristic provides complexity in assessing an investment property to constitute as a business following the definition of PFRS 3. Implications: Business combination versus asset acquisition The conclusion as to whether an acquired set of activities and assets is a business can lead to significantly different accounting results. If an acquired set of activities and assets does not meet the definition of a business, the transaction is accounted for as an asset acquisition based on the principles described in other PFRS. There are many differences in the accounting for a business combination versus an asset acquisition, such as the following: Goodwill or a gain on a bargain purchase arises only in a business combination. The initial measurement of assets acquired and liabilities assumed is generally at fair value in a business combination versus allocated cost (on a relative fair value basis) in an asset acquisition. Costs which are directly attributable to the acquisition are expensed in a business combination, but may be capitalized in an asset acquisition, to the extent that such capitalization does not result in an immediate impairment. Deferred tax assets and liabilities arising on initial recognition are recognized in a business combination, but not in an asset acquisition. Disclosures are much more onerous for business combinations than for asset acquisitions. Where the consideration is in the form of shares, PFRS 2 Share-based payment will apply for an asset acquisition, but not for a business combination. These differences not only will affect the accounting as of the acquisition date, but will also affect future amortization, depreciation and possible impairment. Accordingly, the conclusion as to whether a business has been acquired can have a significant effect on a company s reported financial position and financial performance. 2

3 Review of related accounting literature: PAS 40 and PFRS 3 What is investment property? The following definition of investment property is based on PAS Investment property is property (land or a building or part of a building or both) held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both, rather than for: (a) (b) use in the production or supply of goods or services or for administrative purposes; or sale in the ordinary course of business. Although the above definition of investment property seems relatively direct, in some practical situations, PAS provides that judgment is needed to determine whether a property qualifies as investment property. What constitutes a business? The terms business combination and business are defined in PFRS 3 Appendix A, Defined terms, as follows: A business combination is a transaction or other event in which an acquirer obtains control of one or more businesses. Transactions sometimes referred to as true mergers or mergers of equals are also business combinations as that term is used under PFRS 3. A business is an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants. On the other hand, paragraphs B5 to B12 of PFRS 3 Appendix B, Application guidance, provide guidance on identifying a business combination and the definition of a business as follows: B7 A business consists of inputs and processes applied to those inputs that have the ability to create outputs. Although businesses usually have outputs, outputs are not required for an integrated set to qualify as a business. The three elements of a business are defined as follows: (a) Input: Any economic resource that creates, or has the ability to create, outputs when one or more processes are applied to it. Examples include non-current assets (including intangible assets or rights to use non-current assets), intellectual property, the ability to obtain access to necessary materials or rights and employees. 3

4 (b) (c) Process: Any system, standard, protocol, convention or rule when applied to input or inputs, creates or has the ability to create outputs. Examples include strategic management processes, operational processes and resource management processes. These processes typically are documented, but an organized 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. (Accounting, billing, payroll and other administrative systems typically are not processes used to create outputs.) Output: The result of inputs and 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. B8 (in part) However, a business need not include all of the inputs or processes that the seller used in operating that business if market participants are capable of acquiring the business and continuing to produce outputs, for example, by integrating the business with their own inputs and processes. B12 In the absence of evidence to the contrary, a particular set of assets and activities in which goodwill is present shall be presumed to be a business. However, a business need not have goodwill. Paragraph B10 of PFRS 3 Appendix B provides some factors, which are shown below, to be considered when determining whether an integrated set of activities and assets in the development stage is a business, although not all of these factors need to be present for a particular set of activities and assets to be considered a business. Planned principal activities have begun. There are employees, intellectual property and other inputs and there are processes that could be applied to those inputs. A plan to produce outputs is being pursued. There will be an ability to obtain access to customers who will purchase the outputs. What constitutes an asset acquisition? PFRS 3.2(b) provides that if an entity acquires an asset or a group of assets, including any liabilities assumed, that does not constitute a business, then the transaction is outside the scope of PFRS 3 because it does not meet the definition of a business combination. Such transactions are accounted for as asset acquisitions, in which case, the cost of acquisition is allocated between the individual identifiable assets and liabilities in the group based on their relative fair values at the acquisition date. Consensus If one entity acquires (a) directly an investment property or properties or (b) another entity that holds one or more investment properties, then such transaction should be 4

5 accounted for in accordance with its substance. Depending on the facts and circumstances of each transaction, the acquisition will be accounted for as either a business combination or an asset acquisition. The consensus of this Q&A sets out the indicators that should be considered in making this decision. Application of the definitions of a business combination and a business In applying the PFRS 3 definitions of a business combination and a business to the acquisition of an entity that holds one or more investment properties or to a direct acquisition of an investment property, the acquirer should first identify the elements acquired; i.e., the inputs, processes and outputs. In the context of investment property businesses (excluding developers and traders): inputs are the property itself; processes are discussed in more detail below and could be ancillary type processes or more strategic type processes; and outputs are the leases from which rental income is generated. The existence of inputs and outputs alone (for example, the acquisition of a single tenant property) would not lead to a business combination. Furthermore, if the processes in an investment property business were insignificant to the arrangement as a whole, then this should not in isolation cause the transaction to be a business combination. This is consistent with PAS which provides that if an entity provides ancillary services to the occupants of a property that it holds and such services are insignificant to the overall arrangement, then such property should be treated as investment property. Therefore, where only some processes are transferred to the acquirer, PAS 40 would lead to an assessment as to how significant the processes or services are relative to the acquired investment property needed for the set of assets and activities to be a business. However, if the acquired set of assets and activities has no processes (e.g., only investment properties, and no activities, were acquired), the acquired set of assets and activities, in most cases would not constitute a business. Accordingly, such fact should be appropriately disclosed in the acquirer s financial statements. In addition, the acquirer should disclose the reason for treating the transaction as an asset acquisition. All of the specific facts and circumstances must be considered in applying this highly subjective judgment. Indicators In general, in making the determination of whether an entity s acquisition of another entity that holds one or more investment properties or a direct acquisition of an investment property constitutes a business or not, there should be consideration as to whether or not property management services and/or ancillary services were acquired and the nature of these services. It is important to note that investment property transactions vary significantly in terms of the nature of the underlying assets and the service provision contracts that are acquired and it is not possible to define a trigger point at which the transaction becomes a business combination as opposed to an asset acquisition. 5

6 However, there is a scale within which investment property transactions fall. At one end is a simple single-tenant property for which no services are included. At the other end of the scale is an investment property company. The table below sets out the processes that can be viewed as purely administrative and would not indicate the acquisition of a business and those that are more strategic and may indicate that a business has been acquired. The table, however, is not an exhaustive list of the items or factors that should be considered. The facts and circumstances of each transaction must be considered. Indicators of business combination Substantive processes and/or services acquired/provided: Lease management (rent reviews, negotiation of terms) Selection of tenants Investment decisions Management of common areas to promote increased footfall (for example, themed evenings, marketing) Marketing decisions Not necessarily indicators of business combination on their own Administrative processes and/or ancillary services acquired/provided: Security Cleaning Rent collection/invoicing Caretaker In making the above analysis, the legal form of the acquisition should not change its substance. The acquisition of an investment property or properties for which no services are acquired or provided does not become a business combination simply because it is effected using a corporate shell. Similarly, a business combination should not be accounted for as an asset acquisition simply because the acquiring entity purchases a series of assets rather than a company. See Appendix for the illustrative applications of the above indicators. Effective Date The consensus in this Q&A is effective from the date of approval by the FRSC. * * * * * 6

7 Q&A approved by PIC: December 14, 2011 (Original signed) PIC Members Dalisay B. Duque, Chairman Willie A. Baltazar Judith V. Lopez Rosario S. Bernaldo Ma. Concepcion Y. Lupisan Ma. Gracia F. Casals-Diaz Rufo R. Mendoza Sharon G. Dayoan Ruby R. Seballe Edmund Go Wilson P. Tan Lyn I. Javier/ Reynold E. Afable Normita L. Villaruz Q&A approved by FRSC: April 25,

8 Appendix The application of the factors (indicators) discussed in the Q&A to certain transactions is illustrated in the following examples. In the following examples, property investment company A acquires company B, an entity whose only activity is to hold and administer investment property assets. Is the acquisition a business combination or the acquisition of an asset (or assets)? Example 1 - single property, no tenants or services. B holds a single investment property. The property has no tenants. B has no staff and does not undertake any services. This is an asset acquisition. Company B is not revenue-generating, and no activities have been transferred to company A. Example 2 - single property with tenants B holds only a single investment property. The property has tenants subject to rental agreements but no support services or contracts are transferred when B is acquired. This is also an asset acquisition. The acquired entity is revenue-generating, but no activities have been transferred to company A. Although the rental agreements are likely to contain servicing obligations, company A has not acquired any actual activities. Example 3 - single property with tenants and services B holds a single investment property. The investment property has tenants subject to rental agreements. Certain outsourced service contracts associated with obligations contained in the rental agreements are also transferred. This is also an asset acquisition. In this case, support services have been transferred, even though they will be performed by external providers. However, these services are purely ancillary to the property and its lease agreements. Activities ancillary to earning rentals are not considered as processes that are used to create output and are given a lower weighting in deciding on classification. However, business combination accounting is also acceptable in this scenario, if such a policy is applied consistently by A in all similar transactions. This is because it would not be inconsistent with PFRS 3 definitions to conclude that this scenario amounts to acquisition of a business. 8

9 Example 4 - multiple properties, tenants, services and staff B holds 8 investment properties. The investment properties have tenants subject to rental agreements. B also employs several staff dedicated to the property management, the provision of services included in the rental agreements and administration such as invoicing, cash collection and management reporting. This is a business combination. B appears to have many of the capabilities associated with a standalone business (even if it was in fact a subsidiary). It is also questionable that certain transferred activities, such as management reporting, are purely ancillary to the properties. Further, although B holding a portfolio of properties is not necessarily decisive in indicating a business combination this factor (i) makes it less likely that all of the services/activities transferred are specifically ancillary to individual properties; and (ii) meets the "group of assets" part of the PFRS 3 Appendix A definition. Also, the fact that staff have transferred to A suggests that A might have acquired employee-related obligations. However, asset acquisition accounting may also be acceptable if activities/services/staff transferred are ancillary to the portfolio as a whole, and such a policy is applied consistently by A in all similar transactions. Example 5 - multiple properties, tenants, services and management Facts as in scenario 4 but the transferred staff also include managers responsible for portfolio management, raising finance and marketing. This is a business combination. Company A has acquired a group of revenuegenerating assets along with various staff and activities that clearly go beyond activities ancillary to the properties and their tenancy agreements. 9