IFRS 3 – more reasons not to be so cheerful!

Some European observations on the quality of compliance with aspects of IFRS 3

As we discussed here, the IASB recently completed its post-implementation review of IFRS 3 Business Combinations. If that’s not enough insight into the state of things with this standard, you can also look to the ESMA Report on Enforcement and Regulatory Activities of Accounting Enforcers in 2014, recently issued by the European Securities and Markets Authority. Here’s what that document has to say:

  • “In 2014, in order to contribute to the Post-implementation Review of IFRS 3 Business Combinations, performed by the IASB, and to evaluate the application of IFRS 3 in Europe, ESMA undertook a review of the application of the requirements of this standard and published its report (ESMA/2014/643)24 in June 2014. ESMA evaluated the consistency of application of key requirements of IFRS 3 as well as the compliance with entity-specific IFRS 3 disclosures on the basis of a sample of the 2012 annual IFRS financial statements of 56 issuers.
  • In its general observations, ESMA considered that IFRS 3 disclosures have generally been provided by issuers, even though in some cases such disclosures were lacking, such as when they were not tailored to the specific circumstances of a transaction or when they were presented outside the financial statements such as in the management report. ESMA concluded that certain improvements to the standards were necessary in areas such as mandatory tender offers, the definition of a business and adjustments to fair value amounts during the measurement period.
  • In its evaluation, ESMA considered that even though issuers reviewed recognized and measured goodwill in 86% of the business combinations, descriptions of the factors making up goodwill were often boilerplate and referred only to the possible realization of synergies without providing details about the expected achievement of those synergies. A quarter of the business combinations analyzed did not recognize intangible items separately from goodwill. Furthermore, ESMA noted that bargain purchases happened more frequently than the IASB originally expected.
  • Although 92% of issuers presented a summary of fair values of major assets and liabilities acquired, the aggregation of certain items of different nature limited the usefulness of the information provided. The most common intangibles recognized by issuers included in the review were customer-related and marketing-related. The review showed that valuation techniques used to determine the fair-value of those assets were based on discounted cash flow techniques.
  • ESMA noted that some issuers referred to external valuations of intangible assets without providing details of the measurement techniques used to determine their fair value. Only a third of the issuers in the sample disclosed the valuation technique but not the key assumptions. ESMA encouraged issuers to provide information on the assumptions and measurement techniques used in the valuation of material assets, liabilities and non-controlling interests. ESMA also believed that those disclosures merely referring to the use of external valuations without providing additional details do not help users in understanding the economics behind those measurements.
  • Overall, ESMA urged issuers to consider whether disclosures are sufficiently detailed and specific to provide an understanding of the underlying transactions. As such, presenting transaction information in one note assists users in understanding the rationale for the transactions, evaluating assets and liabilities acquired, and assessing stewardship.
  • Considering the frequency with which customer-related intangibles are recognized and the enforcement issues identified, ESMA encouraged the IASB to analyze whether customer relationships stemming from both contractual and non-contractual arrangements should be subject to the same recognition principles.”

The more detailed report cited above provides more information on some of these matters, some of it quite interesting. For example, regarding bargain purchases: “Enforcement experience also shows that in some situations bargain gains result because future restructuring costs (that do not fulfil the conditions of contingent liabilities) cannot be recognized, despite the fact they were considered in the negotiations when determining the purchase price of the acquisition or they were deemed necessary.” Many readers will probably have some sympathy with the desire to have more guidance on defining a business, an issue identified by ESMA as arising “in particular, in the real estate, extractive industries and pharmaceutical sectors. Various factors, such as whether the transaction involves a portfolio, of buildings or a single one, the nature of the activity related to the building and whether personnel is transferred may have different impact on the assessment.” Practically speaking though, I’m not sure the IASB is ever going to draw a bunch of industry-specific bright lines, as this basically seems to suggest it should.

Regarding disclosure, I wonder how much of the additional information requested would really be decision-critical. For example, I suppose issuers could provide “details about the expected achievement of (the) synergies” making up their goodwill, but does anyone really believe that management usually has such a specific sense of how the economics of a transaction will play out? At a time when we’re meant to be concentrating on reducing disclosure overload, the several pages of information requirements in IFRS 3 might seem like a good place to start cutting….

The opinions expressed are solely those of the author

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