A European example of complexities in applying IFRS 3
Here’s another of the issues arising from extracts of enforcement decisions issued in the past by the European Securities and Markets Authority (ESMA) (for more background see here); this is from their 19th edition:
- The issuer owned Business E whose net assets amounted to CU 1.3M and had a fair value of CU 30.0M. On 1 July 2014, the issuer contributed Business E to Entity P and in return received 80% of Entity P’s shares. Entity P, which met the definition of a business, held net assets with a carrying amount and fair value of CU 7.2M. Since the issuer controlled Entity P after the transaction and Entity P met the definition of a business, the transaction was accounted for as a business combination and the issuer was identified as the acquirer. The issuer elected to measure the non-controlling interest in Entity P after the transaction at its fair value, as permitted by paragraph 19 of IFRS 3.
- The issuer argued that it acquired the 80% of Entity P for a consideration of zero, since it retained control over Business E after the transaction. It considered that the former shareholders of Entity P are still the owners of the former net assets of Entity P, which have a fair value of CU 7.2M. Therefore, the issuer recognized the transaction as an increase of the net assets for an amount of CU 7.2M and of non-controlling interests in the same amount. No goodwill or negative goodwill was recognized.
The enforcer (as ESMA likes to term it) disagreed with this, on the following basis:
- In accordance with paragraph 37 of IFRS 3, the consideration transferred shall be calculated as the sum of the acquisition-date fair values of the assets transferred by the acquirer. As the fair value of Business E at acquisition date was CU 30M, the fair value of the 20% effectively transferred for the acquisition of Entity P is CU 6M, which represents the consideration transferred. The fair value of the identifiable net assets of Entity P is CU 7.2M and the non-controlling interest in the acquiree is CU 1.44M (20% of CU 7.2M). The issuer should have recognized goodwill of CU 0.24M as, in accordance with paragraph 32 of IFRS 3, goodwill is measured as the excess of the consideration transferred (CU 6.0M) and the amount of non-controlling interests in the acquiree (CU 1.44M) over the fair value of the identifiable net assets acquired (CU 7.2M).
- The change in the issuer’s ownership interest in Business E shall not be recognized in profit or loss as, according to paragraph 38 of IFRS 3, if an acquirer retains control of the assets and liabilities transferred as part of the consideration then it shall measure those assets and liabilities at their carrying amounts immediately before the acquisition date. As such, the non-controlling interest due to the change in ownership interest of 20% in Business E amounts to 20% of Business E’s preacquisition carrying amount of CU 1.3M or CU 0.26M.
Atypically, ESMA goes as far as providing journal entries to summarize how it sees this situation. I won’t reproduce those here, but they include a large entry into retained earnings, which of course isn’t typical of accounting for business combinations. I must admit it took a bit of time for this to completely click in my head – even though, like many of us, I’ve spent my share of time wrestling with proposed transaction structures and their potential accounting implications (there will no doubt be an eager audience for whatever the IASB might issue in the future on common control transactions).
Many will detect the instant problems with the issuer’s treatment – not least the simple clunkiness of apparently treating non-controlling interest merely as some kind of balancing figure. But the interaction of paragraphs 37 and 38 of IFRS 3, as both cited above, can be very difficult to figure out (and unfortunately, the IASB didn’t provide an implementation example on this aspect of the standard). In this case, ESMA applies them essentially as separate things. First, it applies para. 37 in isolation, comparing fair values transferred and received to identify goodwill. Then, it applies para. 38 to the assets it continues to control (ESMA takes the view that because those assets are being measured at their carrying amounts before the acquisition, it follows that the newly-created non-controlling interest in them must also be based on those amounts, which wouldn’t necessarily have been obvious to me anyway). And then, the balancing entry ends up in retained earnings, I suppose, simply because there’s no basis for recognizing it in profit or loss, given the exclusion in paragraph 38 (and that the transaction doesn’t appear to be a bargain purchase).
The ESMA example is definitely a useful reference point for similar structures, but I doubt it’s sufficiently definitive and well-explained to address all the questions and difficulties that will likely arise…
The opinions expressed are solely those of the author