Business combinations – 9 errors to watch out for
Business combinations – 9 errors to watch out for
Business combinations tend to be a significant transaction with widespread impacts on a company’s operations and financial performance. For most companies, these transactions are infrequent, each is unique and often needs a careful assessment for financial reporting. Accounting for business combination can be complex and often involves the use of judgements and estimates incorporating forward looking information.
Considering the widespread impact of business combination on the annual report, we have summarised common errors and pitfalls in accounting and disclosure of business combinations.
1. Merger Relief (UK Entities)
Under the Companies Act 2006 (the Act), Merger relief applies where an acquirer issues shares as part or full consideration to acquire an equity holding of at least 90% of another company in a transaction that is not a group reconstruction (s612). In such cases, if any excess over the par value of ordinary shares is recognised, this excess should be included in a separate non-distributable reserve (often called a merger relief or merger reserve, but other names are permitted) and not in the share premium reserve. Note that the application of merger relief is mandatory and not optional.
A common error is to recognise the excess over par value of ordinary shares issued in share premium reserve even when the acquirer is within the scope of merger relief.
2. In-Process Research and Development
In-process research and development (IPR&D) projects (whether recognised by the acquiree or not) are generally protected by legal rights and would often be separable as the knowledge gained in the research can be acquired and sold by entities (IFRS 3.B31). Hence when applying IFRS, an intangible asset should be recognised separately from goodwill even if there is uncertainty about the timing or amount of future cash inflow. Under FRS 102, the separate recognition is permissible but not required.
A common error is where the acquirer does not recognise acquired in-process research and development separately from goodwill due to uncertainty about the timing or amount of future cash inflows. Any uncertainty about the timing or amount of future cash inflow should be reflected in its fair value measurement.
3. Deferred Tax
Acquired intangible assets will often result in the recognition of a deferred tax liability, as the carrying value exceeds the future tax deductions available. The amount of goodwill that is expected to be deductible for tax purposes should also be disclosed.
A common error is where the acquirer does not recognise deferred tax liability on the acquired intangible assets without explaining the reason in the financial statements.
4. Statement Of Cash Flows
Only cash flows that result in a recognised asset in the statement of financial position are eligible for classification as cash flows from investing activities (IAS 7.16).
Under IFRS, acquisition-related costs are recognised in profit or loss in the consolidated financial statements as an expense when incurred; hence, these should be classified as cash flows from operating activities in the acquirer’s consolidated financial statements. In the separate financial statements, these costs should be classified as cash flows from investing activities if, as is generally the case, they have been capitalised as part of the cost of investment in the subsidiaries.
A common error is to classify acquisition related cost as cash flows from investing activities (rather than operating activities) in the consolidated statement of cash flows.
5. Replacement of Share Based Payment Awards
If the acquirer replaces the acquiree’s pre-existing share-based payment award, the consideration transferred may include amounts which are, in effect, compensation for services provided before the acquisition. Share-based payment awards attributable to pre-combination services are included as part of the consideration irrespective of whether the replacement was mandatory or voluntary. The only exception to the above is where the acquirer voluntarily replaces acquiree awards that would otherwise have expired because of the business combination. In such cases, the replacement award would be excluded from the consideration transferred and treated as post combination remuneration.
A common error is to exclude the replacement share based payment award from the consideration transferred in all cases and treat it as part of post combination remuneration.
6. Disclosures
IFRS 3 requires extensive disclosures in relation to business combinations that occur either during the year or after the year-end but before the financial statements are authorised for issue. Separate disclosures are required for each material acquisition (aggregate disclosures are permitted only for immaterial acquisitions).
Some of the common disclosure omissions are as follows:
- The primary reasons for the business combination and a description of how the acquirer obtained control of the acquiree
- A qualitative description of the factors that make up the goodwill recognised
- Transactions that are recognised separately from the acquired net assets
- The amounts of revenue and profit or loss of the acquiree since the acquisition date
- The revenue and profit or loss of the combined entity for the current reporting period as though the acquisition date was the beginning of the annual reporting period.
7. Alternative Performance Measures (APM)
Business combination may result in entities changing their definition of APMs. ESMA (The European Securities and Markets Authority) guidelines require such changes to be explained alongside the rationale why the changes result in more reliable and relevant information. The comparative figures should also be restated.
A common error is to disclose in the financial statements that the entity has changed its definitions of APMs with no explanation of why the change results in more reliable and relevant information to the users of the financial statements.
8. Measurement Of Contract Liability (Deferred Revenue)
A contract liability is measured at the fair value of the remaining obligation at the acquisition date, which might differ from the amount previously recognised by the acquiree. The fair value is the exit price which a market participant would be prepared to receive to assume the obligation. To determine the exit price, one may determine the price at which the remaining obligation could be assigned to subcontractors for them to agree to fulfil the remaining obligations towards the customer.
A common error is to recognise the contract liabilities at the amount previously recognised by the acquiree. Where the acquiree has material contract liability balances, the difference between the acquiree’s carrying values and fair values can be material.
9. Measurement Period Adjustments
When the initial accounting for business combination is incomplete by the end of reporting period in which the business combination occurs, the acquirer accounts for the business combination at provisional figures and later adjusts such provisional amounts when all relevant information becomes available (but within a period 12 months from the date of acquisition). When acquisition accounting is provisional, the acquirer is required to disclose that fact.
A common error where acquisition accounting was provisional and a failure to disclose that fact. Another common error is that the acquirer uses a fixed period of 12 months as the measurement period and makes retrospective amendment to the acquisition accounting even when the acquisition was not originally considered and disclosed as provisional.