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May 2008

Business Combinations under IFRS

By Dolphy D’Souza, Chartered Accountant
Reading Time 5 mins
New Page 1As mergers and
acquisitions are fairly common nowadays and accounting implications significant,
there has been considerable focus and debate on how business combinations are
accounted for. Theoretically there are two methods, the pooling method and the
purchase method. The pooling method is applied when two business equals combine
into a new entity, with no acquirer being clearly identified. The purchase
method is applied when an acquirer is clearly identified in a business
combination. It may be noted that pooling is allowed only if certain conditions
indicating the merger of equals is fulfilled.

Under the pooling method the excess of consideration for
acquisition over the book value of the assets acquired is adjusted against
reserves, since the underlying transaction is a get-together of two enterprises
and consequently there is no goodwill to be recorded as an asset. Whereas under
the purchase method the consideration paid over and above the fair value of the
net assets acquired is captured as goodwill, which going forward is
tested for impairment. Under the purchase method, all identifiable assets
and liabilities are fair valued, irrespective of whether those
assets/liabilities were recorded or not in the books of the acquiree.

IFRS 3 — Business Combinations now prohibits pooling
method, since permitting two methods vitiated comparability and created
incentives for structuring business combinations to qualify for pooling, and
achieve the desired accounting objective, given that the two methods produced
quite different results. Besides in the real world it is improbable that there
would be combination of business equals with the acquirer not being
identifiable. Therefore, IFRS 3 now allows only the purchase method. With the
abolition of pooling method, there is no more incentive under IFRS to structure
deals, so as to qualify for the pooling method.

Fair value accounting under IFRS 3 reflects the true
value of an acquisition and the premium paid, i.e., goodwill. Going ahead
it would also result in an appropriate depreciation/amortisation of assets
acquired, since the fair value rather than book value of the assets would be
depreciated. It results in greater transparency and management responsibility
for the acquisition and the price paid to acquire the business. Any future
impairment of acquisition goodwill will put to question the appropriateness of
management’s decision to acquire the business.

Considerable judgment will be called for in applying IFRS 3,
including the identification and valuation of intangible assets and contingent
liabilities. Unfortunately, IFRS 3 provides limited guidance on determining fair
value of assets and liabilities acquired. There exists some guidance that
valuation report should be taken.

An interesting point to note is that IFRS 3
amortisation of goodwill and requires goodwill to be
only for impairment. Amortisation of goodwill results in an
even spread of charge to the income statement over several years; contrarily, a
huge one-off impairment charge on impairment of goodwill, as required by IFRS 3,
will bring in substantial volatility to the income statement.

Under Indian GAAP, there is no comprehensive standard dealing
with business combinations. In fact there are as many as six standards that deal
with various types of business combinations and accounting for goodwill. Many of
these requirements are disparate and inconsistent, for example, goodwill
resulting from an amalgamation has to be compulsorily amortised over not more
than 5 years, whereas there is no compulsion to amortise goodwill on acquisition
of a subsidiary. Another example is that acquisition accounting in the case of
acquisition of a subsidiary or an associate is based on book values, whereas
amalgamation other than which fulfil pooling conditions, can be accounted either
using book values or fair values of net assets acquired.

As stated above, acquisition accounting of sub-sidiaries,
associates and joint ventures under Indian GAAP is based on book values rather
than fair values. Unlike Indian GAAP, IFRS 3 requires assets and liabilities
acquired, including contingent liabilities, to be recorded at fair value.
Contingent liabilities are not recorded as liabilities under Indian GAAP.
liabilities are fair valued and recorded under IFRS in an
acquisition, since the consideration paid for a business by an acquirer is also
influenced by the nature and quantum of contingent liabilities of the acquiree.
For reasons mentioned above, goodwill determined under Indian GAAP is a plug-in
number, unrealistic and of little use in analysing the business combination.

IFRS 3 requires all Business Combinations (excludes common
control transactions) within its scope to be accounted as per purchase method
and prohibits pooling method. Indian GAAP permits both purchase method and
pooling of interest method, in the case of amalgamations. Pooling of interest
method is allowed only if the amalgamation satisfies certain specified

In IFRS 3, acquisition accounting is based on substance.
Reverse acquisition under IFRS is accounted assuming the legal acquirer is the
acquiree. For example, a big private limited company to seek quick listing may
be legally acquired by a small listed company. Under IFRS, the private company
would be treated as an acquirer though legally it was acquired by the listed
company. In Indian GAAP, acquisition accounting is based on legal
form and in the above example the listed company would be treated as an

Business combination accounting under Indian GAAP is outdated
and does not reflect the underlying substance and the true premium paid for an
acquisition. Because of the inconsistent and disparate requirements across
various standards, it provides incentives for deal structuring. It is high time
that IFRS 3 is adopted in India without waiting for 2011.

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