UvA IFRS 1 course Business combinations and consolidation

Arjan Brouwer

Agenda
Consolidation (IAS 27R and SIC12, as of 2013 IFRS 10)
Investments in Associates (IAS 28) Interests in Joint Ventures (IAS 31, as of 2013 IFRS 11) Entity accounts Business Combinations (IFRS 3R)

Consolidation
Arjan Brouwer

Introduction - Classification of investments

Purchase of an equity investment

Significant influence (usually 20-50%) Could be either: associated company joint venture
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Control (usually >50%) Would be a subsidiary and requires consolidation

None of the two (usually < 20%) Apply relevant policies for investments using IAS 39

When does an entity have control ?

Situation Parent owns > 50% voting power
Standard presumes that control exists in this situation

Parent is able to have more than 50% of the voting power through an agreement Parent has the power to govern the financial and operating policies through statute or agreement Parent has the power to appoint the majority of the members of the board of directors Parent has the power to cast the majority of votes at board of directors meetings
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When else does an entity have control ?

Potential voting rights:

An entity owns instruments that, if exercised or converted, give the entity power over the financial and operating policies of another entity (e.g. share warrants, share call options, debt or equity instruments, etc.)

IAS 27 requires all potential voting rights that are currently exercisable or convertible are considered.

ALL FACTS AND CIRCUMSTANCES SHOULD BE EXAMINED

When else does an entity have control ?

Example: Entity A, B and C own 25%, 35% and 40% respectively of the ordinary shares that carry voting rights at a general meeting of shareholders of entity D.
Entities B and C have share warrants exercisable at any time at a fixed price and provide potential voting rights. Entity A has a call option to purchase these share warrants at any time for a nominal amount. If exercised, it would give entity A the potential to increase its ownership interest in entity D to 51%. Which entity, if any, has control?

When else does an entity have control ?

Answer:

When else does an entity have control ?

De facto control: When an entity owns less than 50% of voting shares in another entity but is deemed to have control. Example: Entity A owns 48% of entity B. Entity B is listed. No other shareholder owns more than 5% of its equity shares The other shareholders have not formed any group that might vote collectively for their combined 52% shareholding Entity A nominates a majority of directors and, due to its presence at general meetings, these nominations are approved. Does Entity A have de facto control?
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When else does an entity have control ?

Answer:

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Special Purpose Entity (SPE)

It is one thing to have a bank report losses because some of the loans on its balance sheet went bad. That is part of the business of banking. It is something else, however, for a bank to report a multibillion-dollar loss from taking some risk that had never been mentioned in its financial statements
NYT article February 29th 2008

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Special Purpose Entity (SPE)

Special Purpose Entity: An entity created to accomplish a narrow and well-defined objective, for example, to effect a lease, research and development activities or a securitisation of financial assets. SPEs may take the form of a corporation, trust, partnership or unincorporated entity.

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Special Purpose Entity (SPE)

SPEs activities
SIC 12 Decision making power over the SPE

Benefits

Risk exposure

The control concept requires in each case assessment of all relevant factors in order to determine if control exists.
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Special Purpose Entity (SPE) - example

Should Ahold consolidate SAC?

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Investments in Associates

Arjan Brouwer

Introduction scope and definitions

IAS 28 Scope and definitions
Significant influence is the power to participate in the financial and operating policy decisions of the investee but is not control over those policies (control defined as in IAS 27) -The IAS 28's requirements shall be applied in accounting for investments in associates except for such investments held by - Venture capital organisations - Mutual funds, unit trusts and similar entities including investment-linked insurance funds
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Definition
Hold 20%+ voting power of the investee

Significant Influence demonstrated by:

Representation on the board of directors or equivalent governing body of the investee Participation in policy making processes Material transactions between the investor and the investee Provision of essential technical information. Interchange of managerial personnel

(directly or indirectly through Subsidiaries)

Hold < 20%+ voting power of the investee

Substantial or majority ownership by another party, does not preclude an investor from having significant influence in an entity
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Significant influence
In which of the following examples does an Investor/Associate relationship exist?
A. B. Company P holds 20% of the voting shares in Company A Company P holds 10% of the voting shares in company A but has representation on the board of directors (2 of the 8 Directors are from Company P).

C.

Company P holds 15% of the voting shares in Company A and has 2 members on the Board of Directors (total Directors = 6). The company A Directors never vote in the meetings although they have the right to do so.

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Significant Influence
In which of the following examples is there an Investor/Associate relationship?
A. Company P holds 20% of the voting shares in Company A

B.

Company P holds 10% of the voting shares in company A but has representation on the board of directors (2 of the 8 Directors are from Company P).

C.

Company P holds 15% of the voting shares in Company A and has 2 members on the Board of Directors (total Directors = 6). The company A Directors never vote in the meetings although they have the right to do so.

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Measurement
An associate is initially recorded at cost Subsequently the carrying value of an associate increases (decreases) by the investors share of the associates profit (loss) The investor's share of the associate's profit or loss is adjusted for the effect of any fair value differences recognised on acquisition of the associate Distributions received reduce carrying amount of the investment

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M Measurement
Cost (fair value of consideration) Book NAV of investment Subsequent accounting Carrying value of an investment in consolidated a/c NAV in consolidated accounts

Share of profit/ (loss)

Dividends

Fair value adjustments

Share of FV adjustments

NBV of fair value adjustment NBV of goodwill

Goodwill
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Goodwill Impairment

Measurement
Question Poltergeist Ltd, a company with subsidiaries, acquired 25,000 of the 100,000 ordinary shares of Alchemists Co on 1 January 2002 for a total cost of 100,000. In the year to 31 December 2002, Alchemists earns profits after tax of 40,000, from which it declares a dividend of 8,000.
What is the amount shown in Poltergeists consolidated income statement and balance sheet for the year ended 31 December 2002 with respect to its investment in Alchemists?

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Measurement
Answer

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Measurement
Investor Elimination of unrealised profits/losses Unrealised profits / losses are eliminated to the extent of investors interest in associate

Downstream

Associate (accounted for using equity method)

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Upstream

but NOT to the extent that the transaction provides evidence of an impairment of the asset transferred

Measurement
Question Assume that Poltergeist Ltd owns 40% of Apple Book Co (ABC).
ABC sold books (inventory) to Poltergeist in 2002 for 10,000 above its cost to ABC. 20% of this inventory remains unsold by Poltergeist at the end of 2002. ABCs net income for the year, including the profit on the inventory sold to Poltergeist, is 100,000. Assume that ABCs tax rate is 35%. How much of ABCs profit should be recognised in Poltergeists income statement for the year? (a) 40,000
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(b) 39,200

(c) 39,480

Measurement
Answer

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Measurement

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Measurement
Impairment of an investment in an associate
Apply IAS 36 Impairment of Assets The recoverable amount of an investment in an associate is assessed for each associate The entire carrying amount of the investment in the associate is compared to recoverable amount, which is the higher of value in use or fair value less costs to sell.

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Interests in Joint Ventures

Arjan Brouwer

Introduction scope and definitions

IAS 31 - Scope and definitions
This standard shall be applied in accounting for interests in joint ventures, and the reporting of joint venture assets, liabilities, income and expenses in the financial statements of venturers and investors Definitions Joint Control the contractually agreed sharing of control over an economic activity Joint Venture a contractual agreement whereby two or more parties undertake an economic activity that is subject to joint control
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Introduction scope and definitions

Contractual agreement
Within IAS 31, activities with no contractual arrangement to establish joint control are not joint ventures The contractual agreement Distinguishes interests with joint control from those where the investor has a significant influence Ensures no single venturer is in a position to exert universal control

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Accounting for the different forms of Joint Ventures

Different forms of Joint Ventures
Jointly Controlled Entities Jointly Controlled Operations Jointly Controlled Assets

An entity is created and jointly controlled

Each venturer bears own costs and takes a share of the proceeds

An asset that is shared and jointly controlled

Separate legal entity formed

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No legal entity formed

Accounting for jointly controlled entities

Combine assets, liabilities, income and expenses on a line by line basis. Benchmark treatment Proportionate Consolidation Two methods Include separate lines for each of assets, liabilities, income and expenses

Alternative treatment Equity Method

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Transactions between a venturer and a jointly controlled entity

Transactions in normal course of operations
Sale for amount in excess of carrying value No Sale for amount less than carrying value Was the asset impaired prior to sale? Yes
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Gain* recognised to the extent of other venturers equity interest Loss recognised to the extent of other venturers equity interest

Entire loss recognised immediately

* Gain recognised provided that significant risks and rewards of ownership are transferred

Transactions between a venturer and a jointly controlled entity

Non-monetary contributions in exchange for an equity interest
Gains and losses to be treated as with normal transactions. If Risks/rewards are not transferred to JV, or Reliable measure of gain/loss is not possible, or Contributed assets are similar (nature,use, fair value) then

Exception is under SIC 13.

Gain/loss considered unrealised not recognised in the Income Statement

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Transactions between venturer and Joint Venture

Question - Snape is a business venture that is jointly controlled by Potter and Dursley - Potter and Dursley both have a 50% interest in Snape - Both investors apply proportionate consolidation to account for their investment in Snape - On 1 January 2009 Potter sells a warehouse for 150,000 in cash to Snape - The warehouse transferred by Potter to Snape had a book value of 80,000 and a remaining useful life of 10 years
What is the gain to be reported by Potter in its consolidated accounts as of 31 December 2009?
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Transactions between venturer and Joint Venture

Answer

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Transactions between venturer and Joint Venture

Question When can the remainder of the gain be recognised?

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Transactions between venturer and Joint Venture

Answer

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IFRS 10 and 11
Arjan Brouwer

Consolidation and Joint Arrangements The main elements of the new standards
Revised Control definition: Power and exposure to variable returns
De-facto control: Control present when < 50% shareholding? Potential voting rights: Substance must be assessed Two types of joint arrangements: Joint operations and Joint ventures. Distinction based on substance Proportionate consolidation eliminated for JVs: All joint ventures will be equity accounted

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Key changes to joint arrangement accounting Types of joint arrangements

Type under IAS 31 Type under IFRS 11 Contractual rights and obligations under IFRS 11

Jointly controlled assets Jointly controlled operations

Joint operations

Rights to assets and obligations for the liabilities of the arrangement

Rights to the net assets of the arrangement

Joint ventures Jointly controlled entities

Joint arrangements dont require ALL parties to have joint control

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Key changes to joint arrangement accounting Common terms in contractual arrangements

Joint Operation Terms of the contractual arrangement Rights to assets The parties have rights to the assets and obligations for the liabilities. The parties share all interests in the assets in a specified proportion. The parties share all obligations for the liabilities in a specified proportion. The parties are liable for claims raised by third parties or by customers of the arrangement. Joint Venture The parties have rights to the net assets relating to the arrangement. The assets belong to the arrangement. No parties to the arrangement have rights, title or ownership in the assets. The joint arrangement is liable for debts and obligations of the arrangement. The parties are liable only to the extent of their investment in the arrangement. Creditors to the arrangement do not have any right of recourse against any party in respect of debts or obligations of the arrangement. The arrangement establishes each partys share in profit or loss of the arrangement.

Obligations for liabilities

Revenues, expenses, profits or losses Guarantees

The arrangement establishes allocation based on relative performance of each party (e.g. basis of capacity used by each party) - this could differ from their share in the arrangement.

The provision of guarantees, or the commitment to provide them, does not by itself determine the classification of a joint arrangement.
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Entity accounts
Arjan Brouwer

Entity accounts Valuation of participations

Consolidated My equity in the entity accounts financial statements will be the same as IFRS that of the equity in my consolidated Entity accounts accounts

IFRS

Accounting policies consolidated financial statements

Dutch GAAP

Entity accounts - Valuation of participations

Valuation of participations in separate accounts:

a) b) c)

At cost or based on IAS 39, when IFRS* separate; Net asset value based on IFRS*- valuation principles, when IFRS* consolidated; Net asset value based on Dutch GAAP, when Title 9, Book 2 Civil Code.

Business Combinations
Arjan Brouwer

Accounting: Overall concept

Purchase Accounting and Purchase Price Allocation:
1. 2. 3. 4. 5. 6. How much did you pay? Which identifiable assets did you acquire? Which identifiable (contingent) liabilities did you assume? What is the fair value of the acquired assets and liabilities? How much is the deferred tax? What is the difference between the price paid and the fair value of net assets?

Slide 48

Within IFRS 3R - double column approach

Excluded elements
Goodwill Consideration Assets, liabilities and contingent liabilities

Previous interest Non-controlling interest

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Within IFRS 3R - double column approach

Transaction costs
Goodwill Consideration Assets, liabilities and contingent liabilities

Previous interest Non-controlling interest

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Within IFRS 3R - double column approach

Remuneration for future employee services Goodwill Consideration Assets, liabilities and contingent liabilities

Previous interest Non-controlling interest

Slide 51

Within IFRS 3R - double column approach

Settlement of pre-existing relationships Goodwill Consideration Assets, liabilities and contingent liabilities

Previous interest Non-controlling interest

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Case study Travel Finance Solutions

Part 1 Cost of the acquisition Part 2 Pre-existing relationships and reacquired rights Part 3 Goodwill calculation: Partial and Full Goodwill Method Part 4 Step up and step down: the economic entity concept

Slide 53

Introduction to case study

Proposed acquisition by Softpro of Travel Finance Solutions from Pear Plus and management

Pear Plus

Management 10%

Mr. Dos
20%

70%

Travel Finance Solutions

Slide 54

Travel Finance Solutions part 1

Cost of the acquisition

Slide 55

What forms part of the consideration?

Principles: Paid to vendor : Assets transferred, liabilities incurred and equity issued. Measured at fair value (FV) at date control passes. Exclude items not part of consideration. Contingent consideration: recognised at FV. Subsequent fair value changes are recognized in the income statement

Slide 56

Indemnification or Contingent Consideration ?

Arrangement related to future events or conditions? NO Neither contingent consideration nor indemnification YES Contingent consideration or Indemnification

Arrangement related to a specific asset or liability arising from a past event? NO YES

Contingent consideration
Slide 57

Indemnification
Obligation of seller

Obligation or right of acquirer

Contingent consideration Acquisition date accounting

Recognition
Measurement

At acquisition date!
Fair Value!
Debt/Asset or Equity!

Classification

Slide 58

Contingent consideration - Post acquisition accounting

Contingent consideration classified as: Re-measure at FV Asset / Liability
IAS 39 Financial liability Financial asset (IAS 37)

Equity
Slide 59

No re-measurement

Indemnification
Recognition and Measurement

Based on indemnified item

Exception to recognition and FV measurement principle! Points to consider: Limitation on indemnified amount
Slide 60

Credit worthiness of the seller

Shareholder or employee ?
Allocate, to consider: Duration (of employment vs contingency) Level of remuneration Incremental payments Linkage to valuation/ formula used

Contingent consideration? Continuing NO employment required? YES NO Payments forfeited when employment terminates? YES Post-acquisition employment expense

Contingent consideration
Slide 61

Travel Finance Solutions part 1

Cost of the acquisition

Slide 62

Travel Finance Solutions Part 2

Pre-existing relationships and reacquired rights

Slide 63

What are pre-existing relationships and reacquired rights?

Pre-existing relationship A relationship that existed between the acquirer and acquiree before the business combination was contemplated Can be contractual or non-contractual
Reacquired right A right that the acquirer had previously granted to the acquiree to use one or more of the acquirer's recognised or unrecognised assets, and which the acquiree still held at acquisition date Separately identifiable intangible asset of acquiree
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Examples of pre-existing relationships and reacquired rights

Right to use a patent Lease for office accommodation Distributorship Fixed price supply contract
Slide 65

Legal case

Fixed volume, market price purchase contract

Possible interdependency
Pre-Business Combination

A
At date of Business Combination

B
Recognition of reacquired right (if any)

Settlement of pre-existing relationship

Slide 66

How are pre-existing relationships and reacquired rights accounted for?

Pre-existing relationship A separate value must be allocated to the relationship that existed between the acquirer and acquiree before the business combination was contemplated Does not form part of the consideration for the business, but settlement is separately accounted for
Reacquired right A reacquired tight is a separately identifiable intangible asset of the acquiree and is therefore separately recognized in the PPA.
Slide 67

Settlement of the relationship

Settlement of relationship

Contractual relationship NO At FV Lower of: YES

Slide 68

Favourable/ unfavourable element

Settlement provision in contract

Travel Finance Solutions Part 2

Pre-existing relationships and reacquired rights

Slide 69

Travel Finance Solutions Part 3

Goodwill calculation: Partial and Full Goodwill Method

Slide 70

Case study Goodwill determination

Travel Finance Solutions Acquisition facts

Purchase price of the 80% interest: EUR 750 million Total transaction costs: EUR 20 million Fair value of identifiable assets and liabilities: EUR 670 million Question: calculate the goodwill based on the full goodwill method and the partial goodwill method.

Slide 71

Case study Goodwill Determination based on partial method

Goodwill calculation Total purchase consideration Net identifiable assets Non-controlling interest Goodwill IFRS 3R partial 750.000 670.000134.000 214.000

Partial method is in line with past practice

Slide 72

Case study Goodwill Determination based on full method

Goodwill calculation Total purchase consideration Net identifiable assets Non-controlling interest Goodwill IFRS 3R partial IFRS 3R full 750.000 750.000 670.000670.000134.000 187.500 214.000 267.500

IFRS 3R The goodwill associated with both the acquirers interest and noncontrolling interest (i.e. 100% of the goodwill of the acquiree) may be recognized in a business combination

Accounting Impact Companies that make the choice to recognize the noncontrolling interest at fair value (full goodwill method) will recognize more goodwill. Recording goodwill for the non-controlling interest may present new complexities surrounding valuation, allocation, and impairment testing
Slide 73

Travel Finance Solutions case study

Part 4 Step up and step down: the economic entity concept

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Non controlling interests: the economic entity model

Key features of the economic entity model 100% of subsidiary assets/liabilities recognised - including goodwill with a portion allocated to non-controlling interest Non-controlling interest presented within equity/appropriation of profit Transactions with minorities are considered transactions with equity holders and treated as contributions and distributions Disclosures required to explain impact of transactions with noncontrolling interest

Slide 75

Stepping up and down

Impact of economic entity model:
No gains or losses in income statement from transactions with noncontrolling (minority) interest holders. No (new) PPA or goodwill when non-controlling interest is acquired. Impact recognized in equity.

But:
Gains or losses are recognized when control is lost (also on the interest retained) or when control is acquired (on the previously held interest) See double column approach: all elements at fair value.

Slide 76

Example 1: Stepping up
Step-acquisition - pre-existing interest In 20X1 Softpro acquires 40% stake in Click Limited for EUR 4m 20X2: 40% stake carrying value EUR 5.5m. 20X2: FV of 40% was EUR 8m In 20X2 Softpro acquires remaining 60% stake for EUR 12m GAIN on remeasurement of associate EUR 2.5m in income statement
Slide 77

Example 2: Stepping down

Principles of losing control
De-recognise assets (inc. goodwill) and liabilities De-recognise NCI Recognise consideration received Recognise at Fair Value any investment retained Reclassify to income statement any gain or loss previously recognised in other comprehensive income
Slide 78

Difference to income statement

Travel Finance Solutions case study

Part 4 Step up and step down: the economic entity concept

Slide 79

UvA IFRS 1 course Business combinations and consolidation

Arjan Brouwer