A Question Not to be Underestimated: Asset or Business Acquisition?

A transaction is either accounted for as a business acquisition under IFRS 3, Business Combinations, or, if it is not a business combination, in accordance with the appropriate standard for an asset purchase (for example: IAS 16 Property, Plant and Equipment; IAS 38 Intangible Assets; or IAS 40 Investment Property).

The question is important (and there are significant consequences to getting the answer wrong or not considering the question at all!), because in a business combination:

  • Goodwill or a gain on bargain purchase is accounted for;
  • Assets acquired and liabilities assumed are accounted for at their fair values rather than being recognized at their relative fair values in an asset purchase;
  • Directly attributable acquisition costs are expensed versus capitalized as part of the asset purchased;
  • Deferred tax assets and liabilities are recognized in a business combination;
  • IFRS provides guidance on recognizing contingent consideration but there is no guidance in the standards applicable to asset purchases;
  • The disclosure requirements are considerable in the financial statements for a period in which a business combination is completed, and the same disclosure applies in any year where an acquisition is made subsequent to the report date but before the financial statements are issued; and
  • Also note that some of these differences continue in future periods, such as impairment and depreciation/amortization.

An entity first needs to determine whether the assets acquired and liabilities assumed constitute a business (IFRS 3.3). If they do not meet the definition of a business, then the default is to account for the transaction an asset purchase.

Appendix A to IFRS 3 defines a business as, ‘an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return…to investors or other owners, members or participants.’  A business therefore consists of inputs and processes applied to those inputs that have the ability to generate outputs. Therefore, outputs themselves are not required.

Input: are economic resources, such as intellectual property, access to necessary materials, employees and non-current assets such as intangible assets or the rights to use non-current assets.

Process: is any system, standard, protocol, convention or rule, such as strategic management processes, operational or resource management processes. Administrative processes are specifically excluded.

Output: is a return in the form of dividends, lower costs or other economic benefits

You should note the following in applying the definition:

  • If the transaction does not include both inputs and processes then it is not a business combination.
  • Some processes must be included in the transaction, but all processes used by the vendor need not be included. Some necessary processes may be provided by the acquirer on integrating the business with their own operations.
  • A business need not have liabilities.
  • The set of assets and activities must be capable of being conducted and managed as a business by a market participant. Whether the seller operated the set as a business and whether the acquirer intends to operate it as a business is not relevant.
  • There is a rebuttable presumption that an asset that includes goodwill is a business.
  • The elements of a business vary by both industry and structure of an entity.
  • New businesses often have few inputs and processes and only one (or no) outputs. In this situation, other factors must be considered, including whether the set:
    • Has begun planned principal activities;
    • Is pursuing a plan to produce outputs; and
    • Is expected to obtain access to customers to purchase those outputs.

The determination of whether a transaction is a business acquisition or an asset purchase is a judgement call that must be disclosed.

The Application Guidance provides more detail that is useful in applying IFRS 3, including the following.

The definition of a business includes inputs and processes and may also result in outputs, although outputs are not necessary for a business to exist. A process is defined as, ‘any system, standard, protocol, convention or rule’ (IFRS 3.B7) that when applied to inputs creates, or has the ability to create, outputs. Examples of processes include strategic management, operational and resource management. Inputs are economic resources that create, or have the ability to create, outputs when one or more processes are applied, and include intangible assets or the rights to use non-current assets.

‘To be capable of being conducted and managed for the purposes defined, an integrated set of activities and assets requires two essential elements – inputs and processes’. Therefore both assets and processes must be included in the acquisition, even though all necessary processes need not be acquired (some processes may be contributed by the acquirer) (IFRS 3.B8). If no processes are included, then the transaction is an asset purchase; if this was not the case, then any asset purchased for use in an existing business would meet the definition of a business, which would be non-sense.

Furthermore, processes are described as ‘activities’ in IFRS 3.B8, which is consistent with the English language definitions of the word: (i) as a noun, ‘a series of actions or steps taken’ and (ii) as a verb, ‘perform a series of mechanical or chemical operations on something in order to change or preserve it.’ The purchase of in-place leases, for example, represents economic inputs and not a process; the leases represent a right to benefit from non-current assets. There are no activities inherent in a rent-roll, instead leasing and other management processes are applied to it.

Where the acquisition includes both inputs and some level of process (over and above administrative functions, which are specifically excluded by the definition) the determination can involve significant judgement. The IFRS Interpretations Committee White Paper of May 2013 addressed the application of this principle in practice by different sectors, including the real estate sector, and in different jurisdictions.

One view in practice is that the processes acquired must have a level of sophistication that involves a degree of knowledge unique to the assets being acquired for a business to exist. Common themes in the responses received include:

(a)    Examples of significant management processes that management views as being integral for a business to exist, include marketing, tenancy management, financing, development operations and other functions that are typically undertaken by the parent company or external management.

(b)    The acquisition of an investment property together with the employment of key management personnel of the vendor is a strong indicator of a business.

(c)     Other processes such as cleaning, security and maintenance are generally not considered to be significant processes. Therefore, a transaction that only includes those or similar processes is generally treated as an asset purchase.

Note that these necessary processes meet both the definition in IFRS 3 and the English language definition, while in-place leases acquired do not.

The view that a level of sophistication is required is predominant in Europe and Australia and is consistent with the requirement that processes be at a more supervisory or management level (as per the definition: strategic management, operational and resource management).

The view from respondents using US GAAP (which is nearly identical to IFRS guidance) is that ‘any process that, when applied to an input or inputs, create or have the ability to create outputs, gives rise to a business.’  Therefore, transactions are more likely to result in business acquisitions than asset purchases in the US GAAP world.

Under Canadian Accounting Standards for Private Enterprises (ASPE) the relevant standard is 1582 Business Combinations, which is a copy of IFRS 3 Business Combinations. Therefore, the guidance surrounding IFRS can also be applied to the same asset or business combination question under ASPE. In applying the GAAP hierarchy in ASPE (standard 1100 Generally Accepted Accounting Principles), the first consideration would be IFRS and not US GAAP. This is logical given the fact that 1582 and IFRS 3 are identical.

The International Accounting Standards Board (IASB) carried out a Post Implementation Review (PIR) of IFRS 3 in 2014/2015. The review found that stakeholders find it difficult to apply the definition of a business in practice. The IASB issued an exposure draft in June 2016 which proposes: amending the language used in the standard, adding illustrative examples and simplifying the application of the standard in some situations. The comment period closed on October 31, 2016. Watch this space for an IFRS Condensed piece on the final amendments to the standard.

Identification and composition of cash generating units Plausibility and consistency of cash flow projections

The following article was originally published by Wiley Insight IFRS.

  1. Are you aware of potential misapplications of IAS 36 [with respect to CGU’s] by reporting entities in your jurisdiction? If yes, are the areas of concern those flagged by the regulators or are there other areas of concern? If you are aware of potential misapplications of IAS 36 are they due to inadvertent or opportunistic application of the standard, an inability to comprehend fully the requirements of the standard, or for some other reason?
  2. Are you aware of any concerns about the effectiveness of the CGU concept in achieving the objectives of the standard?
  3. Are you aware of potential misapplications of IAS 36 [with respect to cash flow projections] by reporting entities in your jurisdiction in the manner identified by the regulators? If yes, is this due to inadvertent or opportunistic application of the standard, an inability to comprehend fully the requirements of the standard, or for some other reason?
  4. In your view, is the information relating to cash flow projections required to be disclosed by IAS 36 providing investors and other stakeholders with a suitable set of information? If not, in what respects to you believe the disclosures are deficient?

 

Recent misapplications of IAS 36, based on the writer’s experience and the published results of reviews performed by the Canadian regulators, include:

  • The use of overly aggressive cash flow projections when compared to the historical trend for the Cash Generating Unit (CGU). This is a theme in the Canadian jurisdiction which is continuing from the pre-changeover environment.
  • Boilerplate disclosures, for example, where an entity discloses the definition of a CGU instead of specifically describing how the definition has been applied by management.
  • The failure to identify the CGU for which impairment losses were recognized; and
  • Not providing a description and the reason for changing the aggregation of assets into CGU’s, despite being required to do so by IAS 36.130(d)(iii).

The reasons for the misapplication of the standard are difficult to decipher. It does not appear to be through opportunistic application: the reviews performed by the market regulators and audit regulator (the Canadian Public Accountability Board) do not usually result in reissuance of financial statements.

There were some significant differences between IAS 36 and the Canadian standard prior to adoption of IFRS. Furthermore, the adoption of IFRS in Canada coincided with the financial crisis and resulting economic doldrums. The risk of error due to misapplication is also increased for smaller entities that often lack the breadth of experience in applying the standard and the budget to hire outside financial reporting or valuation expertise.

The CGU concept has wide acceptance in the Canadian jurisdiction: ‘CGU’ is a concept applied by the valuation community. In terms of economic reality, entity value is driven by cash generated by groups of assets. The writer is not aware of any concerns about the effectiveness of the CGU model, outside of the details of its application.

Cash flow projection disclosures are required to be made when a CGU includes goodwill or indefinite life intangible assets. The specific detail required where recoverable amount is based on VIU (Value In Use) relates to: the key assumptions, the approach taken by management (that is, past experience or external information), the period projected based on budget or forecast, the growth rate used for extrapolation and the discount rate. In the same scenario, but using FVLCS (Fair Value Less Cost to Sell), the required disclosure includes the period covered, the growth rate and the discount rate.

The cash flow projection information does provide financial statement users with a basis with which to understand the key assumptions behind the forecasts, management’s approach and the mechanics of the exercise. There are still improvements that could be made, however, such as:

  • Details related to cash flows used for measuring recoverable amount are not required (but encouraged) where intangible assets with finite lives are being tested. For many entities that carry long-term non-financial assets the estimation process and the related uncertainties around those estimates are likely to be one of the more significant for users of financial statements.
  • Given the economic uncertainty and the level of risk premiums currently demanded by markets, it seems that this level of disclosure would be useful whenever indications of impairment exist. This would avoid relying on entities applying the general standard in IAS 1.125 for estimation uncertainty.
  • It is possible to reflect the risks inherent in the cash flows through either a risk adjusted discount rate or by adjustments to the cash flows by using an expected value approach. Being informed of the discount rate is of limited use for purposes of comparison between entities. Instead, commentary of which risks are reflected and where would be useful.

The problem in applying the standard could be addressed by management and the audit committee considering the entity’s financial reporting from the perspective of the user.

Technical parameters of value determinations

Growth rates

 5.  Do some entities in your jurisdiction use seemingly high long-term growth rates? If so, do they provide sufficient justification (as required by IAS 36.134(d)(iv))?

6.  Do you observe substantial differences across industries or time due to the issue of growth rates?

7.  How do entities in your jurisdiction incorporate the impact of economic and financial crises into their cost of capital parameters with respect to long-term growth expectations and historically low risk-free rates?

8.  In your view, do entities in your jurisdiction pay enough attention when linking inflation assumptions and the time horizon against which the cash flow is forecasted?

 

Growth rates observed by the writer in recent years have been in the range of 0% to 3% and are based on a variety of factors, including: long-term real GDP growth, inflation rates or expectations, and estimated long-term growth of the CGU considering also historical performance. None of these entities have reflected growth in real dollar terms in their valuation models, and disclosure of the entity’s justification for high growth rates, as required by IAS 36.134(d)(iv), was therefore not necessary.

There is no correlation observed between industries or time, which is a function of the narrowness of the range of growth rates observed.

A public entity that has both traded equity and debt instruments is able to calculate a weighted average cost of capital (WACC) based on those observable markets. For such an entity, any selling of the stock and debt instruments in the secondary market during a financial crisis would increase the cost of capital.

Any entity that has thinly traded equity or debt instruments is forced to estimate the WACC. An estimate would be built-up starting with the risk free rate (such as the long-term bond yield) plus estimates of the other components. In times of crisis when the risk free rate falls market participants would require a higher risk premium, being one of those components.

Such growth rates applied to terminal cash flow values are consistent with current inflation estimates: the Bank of Canada is projecting Consumer Price Index inflation of 1.7% and 2.0% for 2014 and 2015 respectively. If growth is expected to be the same as the inflation rate (so there is no built-in growth over and above inflation to have a positive effect on VIU) then the point is moot. However, if the growth rate used in the model is lower than the expected inflation rate during the time period, there would be a built-in contraction of cash flows for the period beyond the projection. Often this is not explicitly disclosed.

Discount rates

9.  Based on your experience, are the discount rates used by entities consistent with the requirements in IAS 36.55? In particular, do the discount rates reflect the risks specific to the asset and do they reflect the market assessments of those risks and the current market assessment of the time value of money?

10.  Do you experience cases in your jurisdiction of entities not disclosing the respective discount rate that is applied in the context of a value derivation for each CGU that carries a significant portion of goodwill?

11.  How do you assess the severity of a lack of details on the specific discount rates in terms of the reconciliation of valuation results?

 

Entities often provide boilerplate disclosures about taking into account risks specific to the CGU and the current time value of money, without providing any indication as to what asset specific risks have been incorporated into the discount rate. In many cases, it is possible to relate the discount rates used to different business lines only in general terms, but the driver in each case and the exact risks built into the discount rate (as opposed to being reflected in expected cash flows) cannot be seen.

Disparate valuation results can be reconciled, or the differences justified or rationalized, in many ways depending on the circumstances. Take as a simple example, an entity where indicators of impairment are apparent, such as a market capitalization below the book value of assets or operating losses. It seems the disclosures related to impairment testing (and impairment losses recognized) are not driven by any perceived need of the reader to be able to understand that reconciliation process. Indeed, a very detailed disclosure of the build-up of the discount rate in that case, together with the other disclosures required, will not get the reader any closer to understanding why no impairment loss exists.

Similarly, an entity is not required to disclose the assumptions used to determine the recoverable amount when there are indications that an asset may be impaired – disclosure is encouraged but not required.

Comparison of parameters applied by different entities is not possible due to the lack of transparency around which risks are built into the cash flows and which are built into the discount rate. A comparison of discount rates would be meaningless, and potentially misleading, in terms of the relative riskiness of different cash flows.