23 Frequently asked questions on business combinations This article aims to: Highlight some of the key examples discussed in the education material on Ind AS 103. Background Ind AS 103, Business Combinations provides guidance on accounting for business combinations by applying the acquisition method. Though, internationally, there is limited authoritative guidance on accounting for legal mergers or common control business combinations, Ind AS 103 provides guidance on common control transactions also. In addition, Ind AS 103 has one more notable difference with its global counterpart, International Financial Reporting Standard (IFRS) 3, Business Combinations. IFRS 3 requires bargain purchase gain arising on business combination to be recognised in the statement of profit and loss. Ind AS 103 requires that the bargain purchase gain should be recognised in equity as capital reserve. The Institute of Chartered Accountants of India (ICAI) has published an Education Material on Ind AS 103, which contains summary of the standard in form of key requirements and Frequently Asked Questions (FAQs) covering certain issues expected to be encountered frequently while implementing this standard in the Indian scenario.
24 Identification of business A business is an integrated set of activities and assets that are capable of being conducted and managed to provide a return to investors by way of dividends, lower costs or other economic benefits. Thus, it 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 to qualify as a business as long as there is the ability to create outputs. What constitutes a business, is a matter of professional judgement which may require careful assessment of facts and circumstances. Some of the examples discussed in the education material that help to distinguish between the group of assets and business are as follows: Development stage entity: In case an entity has a licence to develop a new drug (input), but lacks processes to apply to licence to create an output. It does not have any employees, nor pursuing a plan to produce outputs since no research and development is being performed. If such an entity is acquired by another entity then such an acquisition would not be construed as a business but instead be accounted as an asset acquisition. On the other hand, where an entity is performing final clinical trials and is pursuing a plan to produce outputs (i.e. a commercially developed drug to be sold or licensed), acquisition of shares in such an entity results in the acquirer acquiring inputs (licence for drug and employees) and processes (operational and management processes associated with the performance and supervision of the clinical trials), therefore, represents an acquisition of business. Investment property: An entity may purchase few investment properties, rented to tenants. It also takes over a contract with the property management entity (which has unique knowledge related to investment properties in the area and makes all decisions, both of strategic nature and related to the daily operations of the property). Additionally, ancillary activities necessary to fulfil the obligations arising from these lease contracts are also in place, specifically activities related to maintaining the building and administering the tenants. In this case, the acquired set of investment properties would be construed to be a business because it contains all of the inputs and processes necessary for it to be capable of creating outputs to provide an acquirer. In contrast, if the property management contract was not taken over, then the group of assets might not meet the definition of a business because the key element of the infrastructure of the business, i.e. property management, was not taken over. In such a case, the acquirer entity would be required to account for the transaction as the purchase of individual investment properties, and not as the purchase of a business. Acquisition date For each business combination, one of the combining entities would be identified as the acquirer. The acquisition date is the date on which the acquirer obtains control of the acquiree. In addition, Ind AS 103 clarifies that the date on which the acquirer obtains control of the acquiree is generally the date on which the acquirer legally transfers the consideration, acquires the assets and assumes the liabilities of the acquiree - the closing date. In practical cases, it may happen that the acquirer might obtain control on a date that is either earlier or later than the closing date. For example, the acquisition date precedes the closing date if a written agreement provides that the acquirer obtains control of the acquiree on a date before the closing date. An acquirer is required to consider all pertinent facts and circumstances in identifying the acquisition date. Few examples discussed in the education material (for business combinations that do not involve a court approved scheme) help understand the issues involved while identifying the acquisition date. Regulatory approval: A regulatory approval (e.g. Competition Commission of India) is considered substantive for an entity to acquire control of another s operations, in such a case, the acquisition is considered to be completed only on receipt of such regulatory approval. Therefore, the date of acquisition cannot be earlier than the date on which regulatory approval is obtained. Acquirer consulted on major decisions: In a case where an entity makes an offer for all the shares of an entity and the parties concerned agree that the acquirer would be consulted on any major decisions pending transfer of shares, the date of acquisition will be the date on which the acquirer obtains control of the acquiree. The activity of mere consultation would not ensure that acquirer can impose its decisions on the acquiree and has power to direct the relevant activities of the acquiree. Thus, in this case, the offer date should not be construed as the date of acquisition.
25 Contingent consideration The standard defines contingent consideration as, an obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are met. However, contingent consideration may also give the acquirer the right for return of previously transferred consideration, if specified conditions are met. Few examples discussed in the education material that help apply the guidance on contingent consideration are as follows: Consideration relating to protective clause: An entity on acquisition of another entity paid a consideration of INR5 crore of which INR4 crore is paid at the acquisition date while balance INR1 crore is placed in an escrow account. INR1 crore relates to a protective clause to protect the acquirer from any false representations and warranties, if any, made by the acquiree. In case there is no violation of the representations and warranties (reported or noticed) within one year of the acquisition date, the amount in the escrow account would be released to the sellers. In the given case, the nature of escrow amount is protective, funds would be released to the sellers based on the validity of conditions that existed at the acquisition date and are not dependent on the future performance of the entity acquired. Thus, INR1 crore is not treated as contingent consideration and instead be treated as part of purchase consideration and taken into account for computation of goodwill/bargain purchase, if any. Forfeiture on termination of employment: An acquirer may enter into an arrangement for payments to employees or selling shareholders of the acquiree that are contingent on a post-acquisition event. The accounting for such arrangements depends on whether the payments represent contingent consideration issued in the business combination (which are included in the acquisition accounting), or are separate transactions (which are accounted for in accordance with other relevant Ind AS). Certain indicators are provided in the standard that would help to evaluate whether an arrangement for payments to employees or selling shareholders is part of the exchange for the acquiree or is a transaction separate from the business combination. Generally, arrangements in which the contingent payments are not affected by employment termination may indicate that the contingent payments are additional consideration rather than remuneration. However, judgement would be required to be applied while evaluating such arrangements. Further, the standard clarifies that when in certain arrangements contingent consideration payments are automatically forfeited if employment terminates, then such payments would be considered as remuneration for post-combination services. Thus, such consideration should be treated as remuneration for the post-combination services and would not form part of purchase consideration. Subsequent measurement and accounting of contingent consideration: Ind AS 103 provides that the acquirer is required to account for changes in the fair value of contingent consideration that are not measurement period adjustments as follows: a. Contingent consideration classified as equity would not be remeasured and its subsequent settlement would be accounted for within equity. b. Other contingent consideration that: is within the scope of Ind AS 109, Financial Instruments, is required to be measured at fair value at each reporting date and changes in fair value would be recognised in profit or loss in accordance with Ind AS 109 is not within the scope of Ind AS 109 is required to be measured at fair value at each reporting date and changes in fair value would be recognised in the statement of profit and loss. In a situation, where an entity (the acquirer) acquires another entity (the acquiree) in the month of September 2017 for cash and the acquirer agrees to pay the selling shareholder an amount equivalent to 10 per cent of profits in excess of INR10 crore generated over the next two years in cash in lump sum at the end of the three years. The acquirer determines the fair value of the contingent consideration liability to be INR1 crore at the date of acquisition and this is taken into account for computation of purchase consideration. Going forward, a year after the acquisition, if the acquiree has performed better than initially projected and a higher payment is expected to be made at the end of year two and the fair value of this financial liability is INR2.5 crore at the end of the first year. In accordance with the requirement of the standard stated above, the contingent consideration should be re-measured at the end of the year i.e. 31 March 2018 by debiting the statement of profit and loss by the amount of difference in fair values of contingent liability (which in this case is INR1.5 crore) while recognising a corresponding liability for contingent consideration at the same amount (i.e. INR1.5 crore).
26 Acquisition related costs Acquisition related costs are costs which an acquirer incurs to effect a business combination and are excluded from the consideration transferred and expensed when incurred except costs to issue debt or equity securities which are to be recognised in accordance with Ind AS 32 and Ind AS 109. The acquisition-related costs include finder s fees; advisory, legal, accounting, valuation and other professional or consulting fees; general administrative costs, including the costs of maintaining an internal acquisitions department; and costs of registering and issuing debt and equity securities. The examples of such costs given in the standard are indicative and do not preclude any other cost to be considered as acquisitionrelated cost. The acquirer should account for acquisitionrelated costs as expenses in the periods in which the costs are incurred and the services are received. However, the costs to issue debt or equity securities, as already mentioned above, is required to be recognised in accordance with Ind AS 32 and Ind AS 109. The education material has examples on stamp duty and regulatory fees payable on acquisition which are as follows: Stamp duty: Any stamp duty payable for transfer of assets in connection with a business combination is an acquisition-related cost and would not be considered as a part of the fair value exchange between the buyer and seller for the business i.e. the stamp duty is incurred to acquire the ownership rights in land in order to complete the process of transfer of assets. While this cost has been incurred in connection with a business combination, it does not increase the future economic benefits from the net assets comprising the business (which would be recognised at fair value) and hence, cannot be capitalised. It is important to note that the accounting treatment of stamp duty incurred for separate acquisition of an item of property, plant and equipment (i.e. not as part of business combination) differs under Ind AS 16, Property, Plant and Equipment. Regulatory fees: Where assets acquired in a business combination include an intangible asset that comprise a wireless spectrum licence. If an entity has to pay an additional one-time payment to the regulator in the acquiree s jurisdiction in order for the rights to be transferred for the use of acquirer, then the payment to the regulator represents a transaction cost and hence, will be regarded as acquisition-related cost incurred to effect the business combination. Such costs cannot be construed to be separate from the business combination because the transfer of the rights to the acquirer is an integral part of the business combination itself. Hence, such costs would be expensed as incurred. However, had the right been acquired separately (i.e. not as part of business combination), the transaction costs would be capitalised as part of the intangible asset in accordance with requirements of Ind AS 38, Intangible Assets.
27 Accounting for common control transactions Appendix C to Ind AS 103 provides that common control business combination means a business combination involving entities or businesses in which all the combining entities or businesses are ultimately controlled by the same party or parties both before and after the business combination, and that control is not transitory. In addition, common control business combinations are required to be accounted for using the pooling of interests method. In practice, issues may arise regarding recognition of differences, arising in case of a common control business combination, if the consideration paid is in excess of the share capital of the transferor and the transferee company does not have any reserves. Appendix C to Ind AS 103 provides that the identity of the reserves is required to be preserved and to appear in the financial statements of the transferee in the same form in which they appeared in the financial statements of the transferor. The education material deals with following issues: Transferee company as no or inadequate reserves: In cases where the transferee company does not have any reserves (including capital reserve), a literal reading of the above guidance in Appendix C might suggest that the adjustment should be made to capital reserve. However, where the consideration is in excess of the carrying value of the net assets (including the reserves), the difference could be adjusted to either revenue reserve(s) or capital reserve (subject to the approvals required, if any, e.g. for capital reduction). If the transferee company has no reserves or has inadequate reserves, the debit should be to an account appropriately titled (e.g., amalgamation adjustment deficit account). The nature of such a reserve is akin to debit balance in the statement of profit and loss. The balance in the account should be presented as part of reserves. Additionally, a disclosure note explaining the nature of this account should be given in the financial statements. Asset acquisition under common control: In another practical situation, where an entity A Ltd.(the transferee) acquired 80 per cent of the share capital of another entity B Ltd. (the transferor) which held a single asset, or a group of assets not constituting a business. Further, the balance 20 per cent of the share capital was held by another unrelated third entity. The fair value of the asset is INR20,000. A Ltd controls B Ltd. as defined in Ind AS 110, Consolidated Financial Statements. Cash paid for the acquisition is INR16,000 and fair value of NCI is INR4,000. In this case, an issue arises regarding accounting of an acquisition of a controlling interest in another entity that is not a business. In accordance with Ind AS 110, an entity is required to consolidate all investees that it controls, not just those that are businesses and recognise any NCI in non-wholly owned subsidiaries. In addition, when the acquisition of an entity is not a business combination, the requirements of acquisition accounting of Ind AS 103 relating to the allocation of the consideration transferred to the identifiable assets and liabilities and the recognition of goodwill are not applicable. Requirements of Ind AS 103 stated that upon the acquisition of an asset or a group of assets that do not constitute a business, the acquirer is required to identify and recognise the individual identifiable assets acquired (including those assets that meet the definition of, and recognition criteria for, intangible assets in Ind AS 38) and liabilities assumed. The cost of the group would be allocated to the individual identifiable assets and liabilities on the basis of their relative fair values at the date of purchase. Such a transaction or event does not give rise to goodwill. Thus, it may be inferred that Ind AS 103 acknowledges that the cost paid for the assets may differ from the sum of their fair values and hence, may need to be allocated to the assets and liabilities acquired. Ind AS 16 and Ind AS 38, both provide that cost is the amount of cash or cash equivalents paid or the fair value of the other consideration given to acquire an asset at the time of its acquisition or construction or, where applicable, the amount attributed to that asset when initially recognised in accordance with the specific requirements of other Ind AS, e.g. Ind AS 102, Sharebased Payments. Therefore, when an asset is acquired, its cost is the amount of consideration paid, plus the amount of NCI recorded related to that asset- as this represents a claim relating to that asset. Additionally, Ind AS 103 provides that for each business combination, the acquirer is required to measure at the acquisition date components of NCI in the acquiree that are present ownership interests and entitle their holders to a proportionate share of the entity s net assets in the event of liquidation at either: a. fair value; or b. the present ownership instruments proportionate share in the recognised amounts of the acquiree s identifiable net assets.
28 All other components of NCI are required to be measured at their acquisition-date fair values, unless another measurement basis is required by Ind AS. Thus, in the given situation A Ltd. is required to recognise assets at cost, which is the sum of consideration given and any NCI recognised. If the NCI has a present ownership interest and is entitled to a proportionate share of net assets upon liquidation, then the acquirer has a choice to recognise the NCI at its proportionate share of net assets or its fair value (measured in accordance with Ind AS 113 Fair Value Measurement); in all other cases, NCI is recognised at fair value (measured in accordance with Ind AS 113), unless another measurement basis is required in accordance with Ind AS. Additionally, A Ltd. may also evaluate the implications of Ind AS 36, Impairment of Assets, for the asset recognised in its books.