Introduction
Australian standard of business combination accounting is based on International Accounting Standards. A critical review of AASB 3 has been undertaken in this essay about procedures of purchase method to be adopted for business combination accounting. The use of fair value evaluations of assets and liabilities transferred during the acquisition has been critically analyzed. Goodwill has a special role to play in business combinations, and accordingly, efforts have been made to evaluate goodwill calculation methods with particular stress on its accounting aspect. It will be seen in the write-up that Australian accounting standard AASB 3 is aptly adopting the changes that are emerging at the level of IASB.
Significance of reporting entity
AASB 3 defines reporting entity as “an entity, in respect of which it is reasonable to expect the existence of users who rely on the entity’s general purpose financial report for information that will be useful to them for making and evaluating decisions about the allocation of resources. A reporting entity can be a single entity or a group comprising a parent and all of its subsidiaries.” (AASB 3, Appendix A)
The important criteria in the determination of reporting entity in a business combination are ‘existence of users’. The existence of users does not only mean present users of the financial statements, they may be the future users of such statements. They may be investors or creditors, or even a general information seeker of that company. The idea is that company financial statements may be used by them to take important financial decisions.
In most business combinations acquirer is the reporting entity.
As the criterion is the existence of users of financial statements, these are the financial statements and financial reports prepared as per the Corporation act that bears the brunt of being a reporting entity. Therefore directors of the reporting company have to be careful in determining their company as reporting company because once identified as a reporting entity; it has to comply with certain requirements detailed as under:
- Reporting entity has to prepare financial reports following Chapter 2M of Corporation Act following all applicable accounting standards.
- Section 295(4)(d) requires directors to make a declaration that the financial statements of the company comply with all applicable accounting standards.
- A reporting company has to prepare both consolidated and separate financial statements.
The implication of the Purchase method of accounting
AASB 3 allows only the purchase for accounting the business combination. Accounting business combinations on purchases method involves the determination of the following three elements of the combination, namely
- Identification of an acquirer
- The purchase price or cost of combination, and
- Allocation of the purchase price over acquired assets and liabilities.
Identification of acquirer
Normally an acquirer is also the reporting entity in a business combination, but sometimes both may be different. An acquirer is identified from the circumstances that surround the combination process. For example, an acquirer may be the entity,
- the fair value of whose net assets are greater than the other; or
- the entity paying cash or other consideration cost say shares to purchase the other entity, or
- the company whose management is in a position to select the management team of the other company.
Identification of acquirement is important as according to AASB 3 ‘the acquirer is the combining entity that obtains control of other combining entities or businesses (AASB3, para 17)
Generally speaking, an acquirer obtains control of another entity when the acquirer has the majority of its shareholding, i.e., more than 50%. It is not necessary that a company may hold majority shareholding to have controlling powers in the other company. Under the following circumstances, a company can obtain the acquiring control even when holding less than 50% of the shareholding of the acquired company:
- when the acquirer holds the majority of the voting rights, or
- when as per an agreement, the acquirer governs the financial and operating policies of the acquired company, or
- when the acquirer is in a position to appoint a majority of board members or governing body of the other company.
Purchase price
In a business combination, purchase prices are the basis and the nexus of the entire transaction, as AASB3 allows only the purchase price method of accounting. The pooling of interest method is not allowed.
The total purchase price is equal to the fair value of the consideration given by the acquiring company. As per AASB 3, for determining the purchase price or cost of business combination a date of exchange needs to be determined. The date of exchange has been defined by AASB 3 as the date on which the acquirer effectively takes control of the acquiree. The purchase price of the combination shall be the aggregate of the following on this date of combination, namely
- fair value of the assets given by the acquirer
- fair value of liabilities incurred and assumed by the acquirer, and
- the cost incurred by the acquirer that can be directly attributed to such a combination deal.
Allocation of purchase price
Once the purchase price or cost of combination is exchanged, the next process is the allocation of such price over acquired assets and liabilities. The purchase price is allocated to identifiable tangible and intangible assets and liabilities of the subsidiary based on the fair market value of such assets and liabilities on such date of acquisition. However, while making such allocation the purchase price may increase or decrease from the fair value of net assets acquired, and these conditions are dealt with as under:
- If the purchase price exceeds the fair value of underlying net assets, the excess will be recorded as goodwill and that will be tested for impairment annually.
- If the purchase price is less than the fair value of underlying net assets, the acquirer is required to reassess the identifies assets and liabilities; and excess remaining after such reassessment is recognized in the profit or loss account.
The determination of fair values of assets
The business combination scheme prescribed under AASB 3 envisages the determination of the fair value of assets and liabilities at two stages, namely
- Firstly to compute the purchase price, the fair value of assets, stocks, and other assets transferred by the acquirer to discharge the considerations or purchase price.
- Secondly, fair value is considered when the purchase price is allocated among identified assets and liabilities acquired from the subsidiary.
It is interesting to note that though AASB 3 has prescribed methods to calculate the purchase price of business combinations and to allocate the purchase price on identifiable assets and liabilities using the fair valuation of assets and liabilities on exchange date, AASB 3 has not prescribed any method or provided any guidance on valuation of assets and liabilities.
This leads us to believe that fair valuation of assets is an exercise to find out the market value or replacement value of the assets and comparing those values with the carrying value of assets. Finding out market values of fixed assets like land and building is an expert’s job and thus that needs to be referred to say registered valuers. For other fixed assets replacement values may be computed by taking quotations from intending buyers of those fixed assets. The services of actuaries may be used to evaluate certain long-term liabilities.
About intangible assets, it would be seen whether those intangible are separable and valuation would be considered following the provisions of AASB 138. In other words, different assets and liabilities would be valued using the different and varying degrees of information available in other standards, as AASB 3 is insufficient in guiding fair valuation of tangible as well intangible assets.
Treatment of directly attributable cost in a business combination
The directly attributable costs of combinations are an integral part of the scheme of business combination accounting as envisaged by AASB 3. The direct costs attributable to the business combination may include the expenditure of the following nature:
- Professional fee of consultants like accountants, valuers, legal advisors, and others,
- The cost of maintaining a separate acquisition section to carry out all activities related to combination, and
- Other directly related administrative costs if any.
Under the scheme of evaluating the purchase price or cost of combinations as per AASB 3, the direct costs as stated above are added to the fair value of assets( including stocks, if any) given and liabilities assumed by the acquirer.
Treatment of such direct costs attributable to business combination would depend upon the nature of cost involved:
- Direct costs of acquisition are added to the amount of cash paid or the fair value of the stock issued in determining the acquisition price.
- Suppose a stock is issued, then the costs of registering and issuing securities reduce the fair value of the securities issued.
But indirect costs such as share of administrative costs running the establishment of the acquirer are not considered while evaluating the purchase price of the acquisition.
Accounting treatment of bargain purchase
The purchase method of accounting is based on a principle that purchase is the result of a bargaining process in which the combined entities have evaluated the fair value of the subsidiary’s assets and liabilities in determining the amount of cash or property or stock that will be exchanged for the stock of the subsidiary. For business combinations accounted for as a purchase, the entity acquiring the stock will be considered the parent, while the company that is being acquired will be considered the subsidiary. The accounting is done generally following either of two ways:
- If books and records are combined, the parent will record the assets and liabilities of the subsidiary
- If separate books and records are maintained, the parent will record investment in a subsidiary equal to the net amount of assets and liabilities that would have been recorded if the records were combined.
When purchase price exceeds the fair value of net assets recorded, the excess is treated as Goodwill paid for such acquisitions, and thus capitalized to Goodwill account. By AASB 3 goodwill is not amortized, but every it is tested for impairment.
A situation may also arise when the purchase price of business combination is less than the fair value of net assets acquired, then traditional treatment is that the value of non-current assets other than long term investments is proportionately reduced by the amount of such excess, and if still there is balance excess then that is treated as a deferred credit or negative goodwill. But AASB 3 requires the acquirer to reassess the identified assets and liabilities and the excess is recognized in profit or loss account.
Treatment of Goodwill in a business combination
Under the purchase method of accounting for business combinations, assets acquired and liabilities assumed are recorded based on their fair value. Accordingly, there may be some residual value of purchase price paid that is more than the fair value of net assets acquired. This residual value represents goodwill paid for the acquisition under a business combination.
So goodwill emerges in such transactions when the purchase price is greater than the fair value of net assets. However, when the purchase price is less than the fair value of net identified assets, the AASB 3 require the acquirer to reassess the identifiable assets and liabilities; and fair value of net assets acquired in excess over purchase price remaining after such reassessment is recognized in the profit or loss account.
Initially, the goodwill is recognized at a cost but tested for impairment every year on the balance sheet date or earlier as per requirements.
Goodwill may also form part of assets acquired. Like any other asset fair value of the goodwill is evaluated as intangible, only when it is identified and separable from the entity. If this is not possible Goodwill will be automatically recognized as residual value over net assets acquired.
But when such goodwill is internally generated by the acquiree, its treatment is not similar to goodwill that is externally acquired. It will not be separately recognized as identifiable assets as it would not possible to separate them from the entity. Internally generated goodwill will be reflected in the residual purchase price over the fair value of identifiable net assets acquired.
Current proposals
In keeping pace with IFRS 3 of IASB, Australian accounting standard AASB is also set to get amended with effect July 2009. According to Accounting Alert 2008/03, “ The revised AASB 3 applies prospectively to business combinations for which the acquisition date is on after the beginning of first annual reporting period beginning on or after 1 July 2009.”
Further changes in business combination accounting include greater emphasis on fair value as the measurement principle. Under the proposed accounting process fair value of the acquiree would be determined before calculating the goodwill. The purchase price will not be compared with a fair value of net assets acquired to calculate the value of the goodwill paid; instead the fair value of acquiree as the whole will be the basic parameter for determining goodwill.
The proposed draft states ‘that the fair value of the acquiree as a whole should be used as the basis for determining goodwill arising in an acquisition, summarized as follows:
The fair value of the acquiree as a whole
Less
The fair value of identifiable assets and liabilities acquired
Equals
Goodwill arising from business combinations.”
The concept of calculations of goodwill on basis of valuation of the subsidiary as a whole is a refreshing idea. The business combination involves the acquisition of the entire entity by the acquirer. Therefore goodwill should be calculated regarding the valuation of the subsidiary as a whole, and not regarding the valuation of identifiable assets and liabilities acquired in the combination process.
Conclusion
Australian accounting introduced AASB 3 in 2005 has objectives of accounting business combinations through purchase methods using fair values for identification of assets and liabilities that are transferred from subsidiary to the parent company. Business combination accounting as envisaged by AASB 3 is an effort to simplify the use of purchase method accounting of business combinations. The purchase price is the amount given plus directly attributable cost on a combination of entities. Goodwill is normally the residual of the excess purchase price paid. The emphasis in determining the purchase price and goodwill is on fair valuation. But the only lacuna is that the standard does not suggest any direct method of fair valuation of assets and liabilities. The plus point is that the Australian accounting standards concerning business combination are keeping pace with IASB. The proposed changes in IFRS 3 are also being introduced in AASB3 effective from July 2009.
References
AASB 3, Appendix A, Reporting Entity, page 38, Web.
Ibid, para 17, page 17
Accounting Alert, 2008, AASB Meeting highlights, Web.
Determining Goodwill, Accounting Alert 2008, Web.