FINANCIAL REPORTING AND IR

The International Accounting Standards Board (IASB) recently issued amendments that provide a new framework for determining whether transactions should be accounted for as an acquisition of assets, or as an acquisition of a business. These amendments can have a very significant impact on how an acquisition is accounted for and how the purchase price is allocated.

The amendments did not change how a business combination is accounted for; rather, it clarifies which transactions are accounted for as a business combination. Under the amendments, it is expected that fewer transactions will be accounted for as business combinations.

The new rules must be applied (prospectively) to business combinations in fiscal years beginning on or after January 1, 2020, but we know some companies are planning to early adopt due to the perceived benefits. 

The IASB issued the amendments to address feedback that the previous definition was applied inconsistently between IFRS and US GAAP (notwithstanding identical accounting standards!) and that it was difficult to apply in practice. While these changes are largely aligned with those introduced in the U.S. in 2018, they are unfortunately no longer identical. 

There are two key aspects of the amendments. The first is an optional concentration test and the second is revisions to the definition of a business.

Optional Concentration Test – what to consider in electing this test?

Companies can now elect to treat the acquisition of a group of similar assets as an asset acquisition rather than a business combination, provided that substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or group of similar identifiable assets. The election of the concentration test can be made on a transaction by transaction basis – it is not an accounting policy election that needs to be consistently applied. 

This first aspect of the amendments has tremendous appeal to companies in certain industries, as it will simplify the accounting for a number of their acquisitions. In real estate, mining, and oil and gas, often all of the value acquired is associated with a single group of similar assets – the particular real estate or mineral property. However, as companies familiarize themselves with the exemption, some are starting to realize that there are real consequences to electing this option. Here are three observations based on our experience to date:

1. While the concentration test is very much a quantitative exercise, do not be fooled. Judgment will be required in assessing whether the ‘substantially all’ test is met and whether the assets acquired are really similar in nature and exposed to similar economic and business risks.
2. Assuming the test is met, electing to treat the transaction as an asset acquisition rather than a business combination will impact reported assets and profits, given the different accounting models for the acquisition of a group of assets versus a business. An IRO needs to understand these differences in order to respond to possible questions from analysts about the impact of making the election. For example, in a business combination transaction costs are expensed, whereas they are capitalized in an asset acquisition. Goodwill or bargain purchase gains cannot be recognized in asset acquisitions.

Also, if the transaction is structured as the purchase of shares of the acquiree, rather than a direct purchase of its assets, there is generally no step-up in the tax basis associated with the assets acquired. If treated as a business combination, the tax impact of these foregone tax deductions is initially recognized as a liability and over time as an income tax recovery. If the transaction is treated as an asset acquisition, such deferred tax liabilities cannot be recognized and income tax expense will be higher in future years.

3. Although the concentration test was initially considered to be a ‘time saver’, entities are often surprised that there is no reduction in the work or information required. In order to apply the concentration test and account for the transaction, it remains necessary to identify and determine the fair value of the various assets acquired, including intangible assets. This is a critical to determining whether or not substantially all of the fair value of the assets acquired is concentrated in a group of similar assets and for the initial measurement of the assets.

Determining the fair value of various assets acquired can take time and often involves the use of specialists. If the concentration test is met and elected, the exercise must be completed in a short time frame, particularly for transactions closing near a quarter end. In a business combination, the acquirer typically records provisional amounts for the assets acquired and liabilities assumed and subsequently adjusts them during the permitted one-year measurement period.  However, this measurement period does not exist for asset acquisitions. The allocation of the purchase price needs to be finalized in time for the release of the next quarter’s results. Revisions in future periods are not permitted and, where required, they are likely to be considered correction of errors.

The revised definition of a business – has a substantive process been acquired?

Some will suggest, correctly, that the amendments to the definition of a business are subtle. However, they will have a significant impact for some companies and industries, particularly those in the start-up phase. To represent the acquisition of a business, the ‘acquired set’^[1] (of assets and liabilities) must include, at a minimum, ‘an input and a substantive process that together significantly contribute to the ability to create output’^[2]. The guidance provides a framework to assist entities in evaluating whether a ‘substantive process’ is present – an area that was a challenge previously for some entities. 

Acquired processes are typically expected to include strategic management, operational and resource management systems, but not necessarily administrative systems. Although a process is typically documented, acquiring an organized workforce may be sufficient to meet this test. The guidance on whether a substantive process has been acquired includes a set of criteria to be considered and the criteria differ depending on whether the set has outputs (i.e. revenue producing activities).  

The amendments also provide clarity to make the assessment of whether a business is acquired, when a workforce is not acquired but there is an acquired contract for outsourced management. This aspect of the amendments may have a significant impact on asset management companies and certain real estate income trusts.

Notwithstanding the additional guidance, significant judgment will often still be required in determining if a business has been acquired. IROs need to understand how this judgment was made in the event that questions from analysts arise. 

Charmaine Mak, CPA, CA is a Senior Manager, and Rob Brouwer, FCPA, CPA is Canadian Managing Partner, Clients and Markets, for KPMG LLP in Canada.