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Business Combinations and Consolidated Financial StatementsHow the changes will impact your business

Executive Summary...........................................................................1

1. Introduction ...................................................................................2

2. Changes in application of the acquisition method of accounting.......................................................................3

3. Consolidated Financial Statements...........................................9

4. Effective Date and Transition....................................................11

5. Differences between IFRS and US GAAP................................12

Contents

1

Executive SummaryIn January 2008, the International Accounting Standards Board

(IASB or Board) issued revised standards, IFRS 3 Business

Combinations (IFRS 3R) and IAS 27 Consolidated and Separate

Financial Statements (IAS 27R), that significantly change the

accounting for business combinations and transactions with

non-controlling interests (minority interests).

In this publication, we discuss the key changes introduced by

IFRS 3R and IAS 27R and what these will mean for your

business — in particular, how they may change the way

acquisitions are structured and negotiated. The most significant

changes introduced and their potential impact can be seen in

Table 1 below. Sections 2 and 3 discuss IFRS 3R and IAS 27R

in more detail. Applying the new requirements will mean, in

many cases, that either goodwill will be lower or that the

reported results of the group will decrease or become more

volatile — both in the year of acquisition and subsequently.

And all of this could have an impact on debt covenants and

management remuneration structures tied to the performance

of the group, which will require management to re-examine

these. Every acquisition will be affected by the requirement

to expense transaction costs.

The changes will also require more extensive disclosures, partic-

ularly of the determination of fair value for contingent liabilities

acquired. Going forward, management will need to ensure that

disclosures meet the requirement of the standard, without being

detrimental to future negotiations or its competitive position.

IFRS 3R and IAS 27R are not applicable until annual periods

beginning on or after 1 July 2009, although early application is

permitted for annual periods beginning on or after 30 June 2007.

1 July 2009 may seem a long way off, but management should

consider the effect of changes when planning or negotiating

future transactions, particularly where a less than 100% interest

is being acquired. Generally, there is no need to restate acquisitions

that take place prior to the effective date. The exception to this

and the specific requirements for transitioning to the new

standard are discussed further in Section 4.

While the project was conducted jointly with the US Financial

Accounting Standards Board (FASB) as part of the convergence

programme with the IASB, and is based on the same underlying

principles, a number of differences between the IASB and FASB

standards exist due to different ‘exemptions’ within the revised

standards, and the interaction of the business combinations

standards with other IASB and FASB standards that differ from

each other. A summary of the key differences is contained in

Section 5.

Summary of change Goodwill Time/cost to implement

Reported resultsVolatility Earnings

Option to measure non-controlling interest at its fair value (a) � — —

Accounting for changes in ownership interests of a subsidiary (that do not result in loss of control) as an equity transaction (a) — — (a)

Contingent consideration recognised at fair value at the date of acquisition, with subsequent changes generally reflected in profit or loss � � � Future �

Expensing acquisition costs as incurred � — — Current �

Reassess the classification of all assets and liabilities of the acquiree � � � —

Separately account for re-acquired rights of the acquirer and pre-existing relationshipsbetween the acquirer and acquiree � or � � � —

Contingent liabilities only reflect those that are present obligations arising from past events � � — —

Recognise gains or losses from measuring initial equity holdings in step acquisitions at fair value � � — Current �

Separately account for indemnities related to liabilities of the acquiree � — � —

Note (a): The impact on goodwill and reported results is dependent on both the choice of accounting policy applied in the past when acquiringthe non-controlling interest and the option chosen to measure non-controlling interest when applying the revised standard. The different permutations and the effect on goodwill are discussed further in Section 3.2.

Table 1: Summary of key changes in accounting and their impact on goodwill and reported results

Impact on

2 BU S I N E S S CO M B I NAT I O N S A N D CO N S O L I DAT E D FI NA N C I A L STAT E M E N T S

1. IntroductionThe current practice of accounting for business combinations

is a cost-based approach, whereby the cost of the acquired entity

is allocated to the assets acquired and liabilities (and contingent

liabilities) assumed. In contrast, the revised standards are based

on the principle that, upon obtaining control of another entity,

the underlying exchange transaction should be measured at fair

value, and this should be the basis on which the assets, liabilities

and equity (other than that purchased by the controller) of the

acquired entity are measured. However, a number of exceptions

to this principle have been included in the standard, as explained

in the following sections.

A business combination occurs when an entity ‘obtains control

of one or more businesses’ by acquiring its net assets or its

equity interests. While the focus on ‘obtaining control’ appears

to be narrower than ‘bringing together’ a business, as currently

exists in IFRS 3, we do not believe that in practice this will

give rise to any significant changes. However, IFRS 3R has

redefined a business as:

“… an integrated set of activities and assets that is capable

of being conducted and managed for the purpose of

providing a return in the form of dividends, lower costs,

or other economic benefits directly to investors or other

owners, members, or participants.”

While a business consists of inputs, processes applied to those

inputs, and outputs, IFRS 3R states that it is not necessary for

outputs to be present for the acquired set of assets to qualify as

a business. It is only necessary that inputs and processes are,

or will be, used to create outputs. It is not necessary for the

acquired set of assets to include all of the inputs or processes

used by the seller to operate that business. If other market

participants are able to produce outputs from the set of assets,

for example, by integrating them with their own inputs and

processes, then this is ‘capable of’ being conducted in a

manner that constitutes a business according to IFRS 3. It is

not relevant whether the seller had historically operated the

transferred set of assets as a business or whether the acquirer

intends to operate the transferred set as a business. The broad

scope of the term ‘capable of’ requires judgment in assessing

whether an acquired set of activities and assets constitutes a

business, to which the acquisition method is to be applied.

As outputs are not required to exist at the acquisition date, some

development-stage enterprises may now qualify as businesses.

In these situations, various factors will need to be assessed to

determine whether the transferred set of assets and activities is

a business, including whether the set has begun its planned

principal activities, has employees and other inputs and processes

that can be applied to those inputs, is pursuing a plan to produce

outputs, and has the ability to obtain access to customers that

will purchase those outputs.

We expect that there will be an increase in the number of

acquisition transactions that will be accounted for as a business

combination under IFRS 3R compared with current practice.

It is likely that difficulties will arise — and careful judgment

will be required, particularly for acquisitions of single-asset

entities, and assets such as non-operating oil fields.

At the time IFRS 3 was issued in 2004, the IASB excluded from

its scope mutual entities (e.g., credit unions and cooperatives)

and combinations between entities brought together by contract

alone, without obtaining an ownership interest. The Boards

concluded that these events are economically similar to

combinations between other entities and, therefore, extended

the scope of IFRS 3R to include such transactions — thereby

requiring the acquisition method to be applied. Due to the way

such transactions are structured, there is additional guidance

to explain how this method is to be applied in such cases. As

the ‘pooling of interests’ method was often applied to such

transactions in the past, considerably more time and effort will

be required by such entities to apply the acquisition method in

the future. Business combinations between entities under

common control and those in which businesses are brought

together to form a joint venture remain outside of the scope

of IFRS 3R.

3

2. Changes in the application of the acquisition method of accounting2.1 Recognising and measuring goodwill or again from a bargain purchaseAs noted above, the underlying principle in IFRS 3R is for all

components of the business acquired to be recognised at their

fair value. This effectively means that the consideration paid and

the assets and liabilities of the acquiree and equity attributable

to non-controlling interests are measured at fair value. In

acknowledging the strong disagreement of many of its

constituents with recognising non-controlling interests at

fair value, the IASB introduced an option as to how non-

controlling interest (formerly minority interest) is measured.

As a result, the way in which goodwill or a gain on a bargain

purchase is calculated has changed, being the difference between:

1. The acquisition-date fair value of the consideration

transferred plus the amount of any non-controlling

interest in the acquiree plus the acquisition-date fair value

of the acquirer’s previously held equity interest in the

acquiree; and

2. The acquisition-date fair values (or other amounts recognised

in accordance with the requirements of IFRS 3R, as

discussed below) of the identifiable assets acquired and

liabilities assumed.

Goodwill arises when 1 exceeds 2. A bargain purchase arises

when 2 exceeds 1.

2.1.1 Recognising and measuring non-controlling interestsIFRS 3R provides a choice of two methods for management

to measure non-controlling interests arising in a business

combination: Option 1 – to measure the non-controlling interest

at fair value (effectively recognising the acquired business at

fair value); Option 2 – to measure the non-controlling interest

at the share of the value of net assets acquired, as calculated

in accordance with IFRS 3R. The choice is made for each

business combination (rather than being an accounting policy

choice), and will require management to carefully consider their

future intentions regarding the acquisition of the non-controlling

interest, as the two methods, combined with the revisions to

accounting for changes in ownership interest of a subsidiary

(see 3.2 below) will potentially result in significantly different

amounts of goodwill.

Option 1 – Measuring non-controlling interest at fair valueNon-controlling interest is measured at its fair value, determined

on the basis of market prices for equity shares not held by the

acquirer or, if these are not available, by using a valuation

technique. The result is that recognised goodwill represents all

of the goodwill of the acquired business, not just the acquirer’s

share as currently recognised under IFRS 3.

The amount of consideration transferred by an acquirer is not

usually indicative of the fair value of the non-controlling interest,

because consideration transferred by the acquirer will generally

include a control premium. Therefore, it is often not appropriate

to determine the fair value of the acquired business as a whole

or that of the non-controlling interest by extrapolating the fair

value of the acquirer’s interest. Hence, adopting this option

also means that additional time and expertise may be needed

to determine the fair value of the non-controlling interest (see

the example in box 1).

Option 2 – Measuring non-controlling interest at the value of theassets and liabilities of the acquiree, calculated in accordancewith IFRS 3R.Non-controlling interest is measured as the share of the value

of the assets and liabilities of the acquiree, consistent with the

current requirements of IFRS 3 (see the example in box 1).

The result is that recognised goodwill represents only the

acquirer’s share, as it does today. However, contrary to the

practice commonly applied today, the subsequent acquisition

of the outstanding non-controlling interest does not give rise

to additional goodwill being recorded, as the transaction is

regarded as one between shareholders (see 3.2 below).

Which option?Management must elect, for each acquisition, the option to

measure the non-controlling interest. This will be largely

dependent on the future intentions to acquire non-controlling

interest, due to the potential impact on equity when the out-

standing interest is acquired.

4 BU S I N E S S CO M B I NAT I O N S A N D CO N S O L I DAT E D FI NA N C I A L STAT E M E N T S

2.1.2 Bargain purchases When a bargain purchase (as defined above) occurs, a gain on

acquisition is recognised in the profit or loss. While this is

consistent with the current requirements of IFRS 3, the amount

recognised may differ, due to the other changes in the standard.

Consistent with the current requirements of IFRS 3, before the

gain can be recognised, the acquirer reassesses the procedures

used to identify and measure acquisition-date fair values of:

1) the identifiable assets acquired and liabilities assumed;

2) the non-controlling interest in the acquiree (if any);

3) for business combinations achieved in stages (as discussed

below), the acquirer’s previously held interest in the acquiree; and

4) the consideration transferred. Any excess that remains is

recognised as a gain, which is attributed only to the acquirer.

Box 1 Example:Entity B has 40% of its shares publicly traded on an exchange. Entity A purchases the 60% non-publicly traded shares in one transaction, paying€630. Based on the trading price of the shares of entity B at the date ofgaining control a value of €400 is assigned to the 40% non-controllinginterest, indicating that entity A has paid a control premium of €30. Thefair value of entity B’s identifiable net assets is €700.

Option 1: Non-controlling interest at fair valueAcquirer accounts for the acquisition as follows:

Fair value of identifiable net assets acquired €700Goodwill 330

Cash 630Non-controlling interest 400

The amount of goodwill associated with the controlling interest is €210,which is equal to the consideration transferred (€630) for the controllinginterest less the controlling interest’s share in the fair value of the identifiablenet assets acquired of €420 (€700 x 60%). The remaining €120 of goodwill(€330 total less €210 associated with the controlling interest) is associatedwith the non-controlling interest.

Option 2: Non-controlling interest at proportion of net assetsAcquirer accounts for the acquisition as follows:

Fair value of identifiable net assets acquired €700Goodwill 210

Cash 630Non-controlling interest 280

The goodwill of € 210 represents only that associated with the parent,being the difference between the consideration transferred (€630) and the share of the fair value of the identifiable net assets acquired of €420 (€700 x 60%).

2.1.3 Consideration transferredThe consideration transferred is comprised of the acquisition-

date fair values of assets transferred by the acquirer, liabilities

to former owners that are incurred by the acquirer — including

the fair value of contingent consideration — and equity interests

issued by the acquirer.

When the consideration transferred includes assets or liabilities

with carrying amounts that differ from the acquisition-date

fair values, the acquirer should remeasure the transferred

assets or liabilities at their acquisition-date fair values and

recognise the resulting gain or loss in profit or loss. However,

if the transferred assets or liabilities remain in the combined

entity after the acquisition date, the gain or loss is eliminated

in the consolidated financial statements and the respective

transferred assets or liabilities are restored to their historical

carrying amount.

When the combination is by contract alone, there is unlikely

to be any consideration, and IFRS 3R acknowledges this by

indicating that there will be a 100% non-controlling interest

in the net fair value of the acquiree’s assets and liabilities.

Depending on the option chosen to measure non-controlling

interest, this could result in recognising goodwill relating

only to the non-controlling interest or recognising no

goodwill at all.

Contingent considerationAn acquirer may commit to deliver (or receive) cash, additional

equity interests, or other assets to (or from) former owners of an

acquired business after the acquisition date, if certain specified

events occur or conditions are met in the future. Buyers and

sellers commonly use these arrangements when there are

differences in view as to the fair value of the acquired business.

Contingent consideration arrangements are recognised as of the

acquisition date (as part of the consideration transferred in

exchange for the acquired business) at fair value — giving

rise to either an asset or a liability. This approach represents a

significant change from the practice under IFRS 3 of recognising

contingent consideration only when the contingency is probable

and can be reliably measured. The initial measurement of

contingent consideration at the fair value of the obligation is

based on an assessment of the circumstances and expectations

that exist as of the acquisition date. Classification of contingent

consideration obligations as either liabilities or equity is based

on other applicable accounting standards.

5

Another significant change from current practice under IFRS 3 is

that subsequent changes in the value of contingent consideration

no longer result in changes to goodwill. Instead, subsequent

changes in value that relate to post-combination events and

changes in circumstances of the combined entity (as opposed to

changes arising from additional information about circumstances

at the acquisition date) are accounted for, as follows:

• Contingent consideration classified as equity is not

remeasured, and settlement is accounted for within equity.

• Contingent consideration that takes the form of financial

instruments within the scope of IAS 39 Financial

Instruments: Recognition and Measurement is measured at

fair value, with changes in value recognised either in profit

or loss or in equity as required by IAS 39.

• Contingent consideration that does not take the form of a

financial instrument within the scope of IAS 39 is accounted

for in accordance with IAS 37 or other applicable standards,

with changes in value recognised in the profit or loss.

In a number of cases, the terms of the arrangement will result

in a derivative being recognised, (as contingent consideration is

no longer scoped out of IAS 39) thereby leading to an increase

in the volatility of reported results. The IASB is currently

discussing proposals to revise the definition of a derivative

as it relates to payments linked to profits, and this may result

in even more contingent consideration arrangements being

classified as derivatives.

As goodwill is no longer adjusted for the actual outcome of

contingencies, it is important to have a reliable estimate of fair

value at the date of acquisition. As re-measurement will affect

subsequent results, the potential impact on debt covenants and

management remuneration structures should also be evaluated

at acquisition date.

Transaction costsAn acquirer often incurs acquisition-related costs such as costs

for the services of lawyers, investment bankers, accountants,

valuation experts, and other third parties. As such costs are not

part of the fair value exchange between the buyer and the

seller for the acquired business, they are accounted for as a

separate transaction in which payments are made in exchange

for services received, and will generally be expensed in the

period in which the services are received. This is a significant

difference from current practice in which such costs are

included in the cost of the combination, and are therefore

included in the calculation of goodwill. Results reported for the

period of any acquisition will now be affected. It must also be

remembered that this must be included as part of operating cost.

Share-based payment awards exchanged for awards held by theacquiree’s employeesAcquirers often exchange share-based payment awards (i.e.,

replacement awards) for awards held by employees of the

acquired business. These exchanges frequently occur because

the acquirer wants to avoid having non-controlling interests

in the acquiree, and/or to motivate former employees of the

acquiree to contribute to the overall results of the combined,

post-acquisition business. Such exchanges are accounted

for as a modification of a plan in accordance with IFRS 2

Share-based Payments.

If the acquirer is obligated to issue replacement awards in

exchange for acquiree share-based payment awards held by

employees of the acquiree, then all or a portion of the market-

based measure of the acquirer’s replacement awards should be

treated as part of the consideration transferred by the acquirer.

The effect will be to increase goodwill and record a corresponding

amount in equity. The acquirer is considered to have an obligation

if the employees or the acquiree can enforce replacement.

Such an obligation may arise from the terms of the acquisition

agreement, the terms of the acquiree’s award scheme or

legislation. If the acquirer is not obligated to issue replacement

awards but elects to do so, none of the replacement awards

are treated as part of the consideration transferred, therefore

having no impact on goodwill and equity. Rather, the replacement

awards are a post-combination modification, giving rise to

employee compensation expenses.

Therefore, where management is considering replacement of the

acquiree’s share-based payment schemes, careful consideration

should be given at the time of negotiating the arrangement to

ensure management’s intention is correctly reflected.

The portion of the replacement award that is treated as consid-

eration transferred is the amount attributable to past service

that the employee has provided to the acquiree, based on the

market-based measure of the awards issued by the acquiree

(not the market-based measure of the replacement awards

issued by the acquirer). When additional service conditions are

imposed by the acquirer, this affects the total vesting period

and, therefore, the portion of the awards that is considered

pre-combination service.

6 BU S I N E S S CO M B I NAT I O N S A N D CO N S O L I DAT E D FI NA N C I A L STAT E M E N T S

As a result, the portion of replacement award treated as part of

the consideration transferred (i.e., the portion related to past

services) is determined as follows:

Market-based measure at

the acquisition date of the

replaced (i.e., acquiree) award

The excess of the market-based measure at the acquisition date

of the replacement (i.e., acquirer) award over the amount

treated as consideration transferred is recognised as compensation

cost over the period from the acquisition date until the end of

the vesting period. Effectively, this means the excess of the

market-based measure of the replacement awards over the

market-based measure of the acquiree award, if any, is recognised

as compensation cost in the acquirer’s post-combination financial

statements. Therefore, management must carefully consider

the terms of replacement awards to avoid surprises.

2.1.4 A business combination achieved in stagesAn acquirer may obtain control of an acquiree in stages, by

successive purchases of shares (commonly referred to as a

‘step acquisition’). If the acquirer holds a non-controlling equity

investment in the acquiree immediately before obtaining control,

that investment is remeasured to fair value as at the date of

gaining control, with any gain or loss on remeasurement

recognised in profit or loss.1 A change from holding a non-

controlling equity investment in an entity to obtaining control

of that entity is regarded as a significant change in the nature

of, and economic circumstances surrounding, that investment,

which results in a change in the classification and measurement

of the investment.

This is a significant change from the cost accumulation model

that applies under current IFRS 3, whereby goodwill was

calculated for each separate purchase. Under IFRS 3R, the

previously held balance is remeasured to fair value at the date of

obtaining control, with the result that if fair value has increased

since each purchase date, goodwill will be higher than that

recognised today. Any increase in fair value that has arisen is

reflected in profit or loss at the date of gaining control. Conversely,

if there has been a decrease in fair value, this may have already

been recognised as an impairment loss in earlier periods. If not,

it will give rise to an additional charge at the date of gaining control.

2.2 Recognising and measuring assetsacquired and liabilities assumedIdentifiable assets acquired and liabilities assumed are recognised

and measured at fair value as of the acquisition date, (with

certain limited exceptions). Guidance is provided in IFRS 3R

on recognising and measuring particular assets and liabilities.

However, much of the general guidance relating to fair value

in the existing IFRS 3 is no longer included in anticipation of

a separate standard on fair value measurement being issued.

But IFRS 3R does clarify that, if an acquired asset is not intended

to be used by the acquirer, or is to be used in a manner different

from the way in which other market participants would use it,

then this factor is ignored. That is, the asset should be valued

in accordance with how it would be used by other market

participants. Although IFRS 3 was silent on this issue, the

practice that developed was consistent with this principle.

A number of these requirements differ from current practice,

and/or existing IFRS 3, and each will result in a different

amount of goodwill being reported.

While the objective of the second phase of the business

combinations project was not focused on how to account for

assets acquired and liabilities assumed after the date of

acquisition, IFRS 3R does provide accounting guidance for

certain acquired assets and assumed liabilities after the

business combination. We discuss these below.

2.2.1 Classifying and designating assets acquired and liabilities assumedThe classification and designation of all assets acquired and

liabilities assumed are reassessed by the acquirer at the date of

acquisition, based on the contractual terms, economic conditions,

accounting policies of the acquirer and any other relevant factors

as at that date, with the exception of:

• Classification of leases in accordance with IAS 17 Leases –

classification is determined based on the contractual terms

and factors at inception of the contract, unless the contract

terms are modified at the date of acquisition.

x

1 If the acquirer recognised changes in the value of the investment directly in equity (i.e. the investment was classified as available-for-sale in accordance withIAS 39), the amount recognised directly in equity as of the acquisition date should be reclassified at the acquisition date on the same basis as if the asset wasdisposed (i.e., recognised in profit or loss).

Complete vesting period

Greater of total vesting

period and original

vesting period

7

• Classification of a contract as an insurance contract in

accordance with IFRS 4 Insurance Contracts – classification

is determined based on the contractual terms and factors at

inception of the contract, unless the contract terms are

modified at the date of acquisition.

IFRS 3 was silent on this point and differing practices developed.

Therefore, all financial instruments of the acquiree must be

carefully reviewed to determine how they should be classified

and designated and subsequently accounted for. For example,

the classification of financial assets as ‘held-for-sale’ or ‘held

at fair value through the profit and loss’ will need to be assessed

in addition to a re-designation (if effectiveness is achievable)

of hedging relationships. This also extends to a reassessment

of whether any embedded derivatives exist in any contracts

that relate to the assets acquired and liabilities assumed. It is

not appropriate for an acquirer to simply assume the same

classifications and designations of financial instruments that

the acquirer previously adopted. Such reassessments can

be time-consuming and may result in additional assets or

liabilities having to be remeasured to fair value.

2.2.2 Operating leasesIFRS 3R contains specific guidance relating to operating leases,

which reflects practice that has developed in applying IFRS 3.

Lessees recognise operating leases as either intangible assets or

liabilities to the extent that the terms of the lease are favourable

(asset) or unfavourable (liability) relative to current market

terms and prices.

A lessor, however, will not separately recognise an intangible

asset or liability where the terms of the lease are favourable or

unfavourable relative to market terms and prices. The extent of

any off-market terms will instead be reflected in the carrying

value of the asset subject to lease.

2.2.3 Intangible assetsIdentifiable intangible assets are recognised separately from

goodwill if it is either contractual or separable. IFRS 3 currently

also requires that an asset’s fair value can be reliably measured,

but this requirement has not been carried forward in IFRS 3R.

Therefore, whenever an intangible asset can be separately

identified, it must now be recognised and measured. This

may increase the accounting complexity for some business

combinations, and therefore add time and cost, and will result in

higher post-combination amortisation charges being recognised.

2.2.4 Valuation allowancesAs assets acquired are to be measured at their fair value (which

will reflect any uncertainty about future cash flows), at the

date of acquisition, it is not appropriate to present separately a

valuation allowance relating to such assets. This may be a

change from current practice for some entities, particularly

those in the financial services industry. The need to maintain

appropriate records for the period subsequent to acquisition

may require enhancements to information systems.

2.2.5 Exceptions to the recognition and/or measurement principle

Contingent liabilitiesIFRS 3R retains the same accounting requirements for contingent

liabilities as the current IFRS 3, except that the contingency

must meet the definition of a liability. That is, there must be a

present obligation arising from a past event that can be reliably

measured. Such a liability is recognised at fair value. The

determination of whether a past event has occurred is a matter

of judgment, particularly in cases of litigation claims, and it is

likely to require greater time and effort to identify. Additionally,

fewer claims may meet this criteria and fewer contingent

liabilities are likely to be recognised.

Reacquired rightsIn some cases the assets of the acquiree include a right previously

granted to it by the acquirer to use one of the acquirer’s assets,

such as the licence of a brand, trade name or technology. No

account is taken of any renewal rights (either explicit or implicit)

in determining the asset’s fair value. The acquisition results in

the acquirer reacquiring that right. That reacquired right is

recognised as an identifiable intangible asset. After acquisition,

the asset is amortised over the remaining contractual period of

the contract, and will not include any renewal periods.

If the terms of the right are favourable or unfavourable compared

with market terms and prices at the date of acquisition, a

settlement gain or loss will be recognised in profit or loss.

As IFRS 3 was silent in this area, different practices have arisen.

Consequently for some entities, this may result in a significantly

different outcome for future acquisitions — in relation to both the

assets recognised and the reported results in the period of an

acquisition, and the amortisation recognised post-combination.

8 BU S I N E S S CO M B I NAT I O N S A N D CO N S O L I DAT E D FI NA N C I A L STAT E M E N T S

Deferred tax assets and liabilitiesConsistent with IFRS 3, deferred income tax assets and liabilities

are recognised and measured in accordance with IAS 12

Income Taxes, rather than at their acquisition-date fair values.

However, IAS 12 has also been amended to change the

accounting for deferred tax benefits that do not meet the

recognition criteria at the date of acquisition, but are

subsequently recognised, as follows:

• A change arising from new information obtained within

the measurement period (i.e., within one year after the

acquisition date) about facts and circumstances existing at

the acquisition date, results in a reduction of goodwill.

• All other changes are recognised in profit or loss.

Management must therefore carefully assess the reasons for

changes in deferred tax assets during the measurement period

to determine whether they relate to facts and circumstances at

the acquisition date, or whether they arise from changes in

facts and circumstances after the acquisition date.

IAS 12 has also been amended to require any tax benefits

arising from the excess of tax-deductible goodwill over

goodwill for financial reporting purposes to be accounted for

at the acquisition date as a deferred tax asset similar to other

temporary differences.

Indemnification assetsIn certain situations, particularly when there are uncertainties

surrounding the outcome of pre-acquisition contingencies

(e.g., uncertain tax positions, environmental liabilities, or legal

matters), the seller may indemnify the acquirer against an adverse

outcome. From the acquirer’s perspective, the indemnity is an

acquired asset. However, the recognition and measurement of

the indemnity asset is linked to the related indemnified item.

When the indemnified item is measured at fair value at the

date of acquisition, the indemnity asset is also measured at

fair value (and reflects uncertainty relating to the collectability

of the asset). When the indemnified item is one that is not

measured at fair value (as the item is an exception to the general

principle), or it is not recognised (as it cannot be reliably

measured), the indemnity asset is recognised and measured

using the same assumptions (subject to the assessment of

collectability). Consequently, if the related liability is not

recognised at the date of acquisition, an indemnification asset

is also not recognised. This effectively results in eliminating a

mismatch that arises today when applying IFRS 3.

Subsequent to the business combination, the indemnification

asset is measured using the same assumptions as are used to

calculate the liability, (subject to the assessment of collectability

and contractual limitations on its amount). Any changes in the

measurement of the asset are recognised in profit or loss,

where changes in the measurement of the related liability are

also recognised.

Employee benefitsConsistent with current practice, assets and liabilities relating to

employee benefit plans are measured in accordance with IAS 19

Employee Benefits. Therefore, any amendments to a plan that

are made in connection with, or at the same time as, the business

combination, are considered to be a post-combination event.

Other exceptionsConsistent with the current IFRS 3, non-current assets (or

disposal groups) classified as ‘held for sale’ at acquisition date

are accounted for in accordance with IFRS 5. That is, they are

valued at fair value less costs to sell. The Board intends to

amend IFRS 5 to change its measurement principle to fair

value in order that this exception is eliminated from IFRS 3R.

Non-current assets held for sale and discontinued operationsCurrently, IFRS 3 does not discuss how to account for the

acquiree’s share-based payment transactions in an acquisition,

which has led to differing practices evolving. However IFRS 3R

requires the liability arising from a share-based payment award

or an equity instrument issued to be measured in accordance

with IFRS 2, rather than at fair value. Management may

therefore need to change its approach to how such items are

considered in future acquisitions.

2.3 Assessing what is part of the exchange for the acquireeAn acquirer must assess whether any assets acquired, liabilities

assumed, or portions of the transaction price do not form part

of the exchange for the acquiree. This means the acquirer

should evaluate the substance of arrangements entered into by

the parties before, or at the time of, the combination. Factors

such as the reasons for the other aspects of the transaction, the

party initiating the transaction or event, the nature and extent

of pre-existing relationships between the acquirer and the

acquiree or its former owners, and the timing of the overall

transaction should be considered in completing the assessment.

9

Examples of payments or other arrangements that would not

be considered part of the exchange for the acquiree include

the following:

• Payments that effectively settle pre-existing relationships

between the acquirer and acquiree, for example, a lawsuit

or supply contract. An element of the consideration is

allocated to the settlement of the relationship which can

give rise to a gain or loss recognised in profit or loss.

• Payments to compensate former owners or employees of

the acquiree for future services. In a number of businesses,

success is dependent on relationships held by the former

owners or employees (e.g., advisory service businesses,

brokers, recruitment businesses). In other businesses, the

skills of the former owners or employees may be critical.

The acquirer often locks these people into the business

going forward to ensure this is not lost and that it is

transferred to others. Invariably, this is achieved through

substantial additional payments linked to continued

employment. To date, practice has varied as to the extent to

which such payments were considered part of the

consideration paid for the business. Considerable

application guidance has been included which indicates

that, when there is a payment of ‘earn-out’ or other amounts

conditional on continued employment by the acquirer, the

payments are treated as compensation for future services

rather than as consideration. Consequently, it will be

critical that the accounting is considered before terms of

acquisition agreements are finalised or there will be nasty

surprises for many businesses.

3. Consolidated financial statementsAs a result of the changes to accounting for business combinations,

the Board reconsidered related aspects of IAS 27, primarily

those relating to non-controlling interests: accounting for

increases and decreases of ownership after control has been

obtained, and accounting for the loss of control of a subsidiary.

The basic principle underlying the changes has been the use

of the economic entity concept model — whereby all residual

economic interest holders in any part of the consolidated entity

are regarded as having an equity interest in the consolidated

entity, regardless of their decision-making ability and where in

the group the interest is held. By contrast, existing IFRS has

adopted a mixed model, applying some elements of an economic

entity concept model (e.g., when a minority interest is classified

as a component of equity) and other elements of a parent entity

model (e.g., where losses attributable to a minority interest,

that result in the minority interest becoming negative, are

allocated to the parent unless there is a binding obligation).

3.1 Allocation of losses to non-controllinginterestsWhen a partially-owned subsidiary incurs losses, these are to

be allocated to both controlling and non-controlling interests,

even if those losses exceed the non-controlling interest in the

equity of the subsidiary. This is significantly different from the

practice today whereby IAS 27 only permits these losses to be

allocated to the non-controlling interest if minority interests

entered into a binding obligation to cover the funding. The

controlling interest in such situations will now be higher than

it was under IAS 27.

3.2 Changes in ownership interest – withoutloss of controlChanges in a parent’s controlling ownership interest that do

not result in a loss of control of the subsidiary are accounted

for as equity transactions — with the owners acting in their

capacity as owners — and therefore do not give rise to gains

or losses.

A parent may increase its ownership interest in a subsidiary by

purchasing additional shares, by having the subsidiary re-acquire

a portion of outstanding shares from non-controlling interests,

or by having the subsidiary issue new shares to the parent.

Similarly, a parent may reduce its ownership interest by selling

shares in the subsidiary, by having the subsidiary issue new

shares to non-controlling interests or by having the subsidiary

buy-back shares from the parent. When such events occur, the

carrying amounts of controlling and non-controlling interest

are adjusted to reflect the change in respective ownership

interests. To the extent that the consideration payable/receivable

for the increase/decrease in interest exceeds the carrying

value of the relevant non-controlling interest, it is recognised

directly in equity attributable to the controlling interest.

This method of accounting applies, regardless of the option

chosen to measure non-controlling interest when control was

initially obtained — that is at its fair value, or at the proportionate

share of the net assets as discussed in section 2.1.1.

Current PracticeNew Practice – effect on goodwill compared with

current practiceGoodwill relating

to the NCI* acquiredNCI – share of

net assetsNCI – fair value of

businessAquire Goodwill(Option 1 above)

Goodwill recognised as difference between proceeds and carrying value Lower (a)

Equity Transaction(Option 2 above)

No goodwill recognised Same Higher

Combination of above(Option 3 above)

Goodwill recognised as difference between proceeds and fair value Lower (a)

Table 2: Effect on Goodwill after the change in accounting for acquisitions of non-controlling interest

Note (a): Generally, due to the difference in measurement, we would expect that goodwill may be slightly lower. However, the new practice mayresult in significantly more or less goodwill if the acquisition of non-controlling interest takes place after a significant period of time from theacquisition of the original controlling interest.

* NCI = non-controlling interest

10 BU S I N E S S CO M B I NAT I O N S A N D CO N S O L I DAT E D FI NA N C I A L STAT E M E N T S

Example:A parent owns an 80% interest in a subsidiary which has net assets of€4,000. The carrying amount of the non-controlling interest share is €800.The parent acquires an additional 10% interest from the non-controllinginterest for €500. The parent accounts for this directly in consolidatedequity as follows:

Equity – non-controlling interest €400Equity – controlling interest 100

Cash €500

This differs significantly from practice today, whereby entities

effectively have a choice of three accounting policies, in the

absence of any guiding principle in IFRS, as follows:

1. Any difference between the carrying amount of the relevant

non-controlling interest and the consideration payable is

regarded as the purchase or disposal of goodwill. This has

been by far the most common practice applied. In the

example above, this would have resulted in an increase

in goodwill of €100.

2. Accounting for a change in the non-controlling interest

as an equity transaction between owners acting in their

capacity as owners. Any difference between the carrying

amount of the relevant non-controlling interest and the

consideration payable is regarded as an increase or

decrease in equity, consistent with IAS 27R.

3. Accounting for the acquisition of a non-controlling interest

as a partial acquisition or disposal of goodwill and partially

an equity transaction.

IAS 27R effectively removes options 1 and 3 above. This, together

with the option introduced to initially measure non-controlling

interest, means that goodwill could be impacted in a number of

ways. Table 2 indicates how these combinations affect goodwill

compared with that recognised today (ignoring the impact of

other changes in IFRS 3R) once a 100% interest is held (i.e.,

the non-controlling interest has been acquired).

As common practice has been to account for changes in

ownership interest similar to an acquisition or disposal of

goodwill, management will need to adopt the new method to

measure non-controlling interests when they anticipate acquiring

the outstanding interests, in order to avoid a future reduction

in equity (representing goodwill attributable to the non-

controlling interest being acquired).

Another area of significantly different practice has been

accounting for put options offered by parent entities to non-

controlling interests, due to conflicts between IFRS 3 and IAS 32.

The revised standards do not address this area. It remains unclear

how current practices will be impacted, and management should

monitor developments in this area.

3.3 Loss of control of a subsidiaryControl of a subsidiary may be lost as the result of a parent’s

decision to sell its controlling interest in the subsidiary to another

party or as a result of a subsidiary issuing its shares to others.

Control may also be lost, with or without a change in absolute

or relative ownership levels, as a result of a contractual

arrangement or if the subsidiary becomes subject to the control

of a government, court, administrator, or regulator (e.g.,

through legal reorganisation or bankruptcy). Consistent with

11

the approach taken for step acquisitions, when control of a

subsidiary is lost, and an interest is retained, that interest is

measured at fair value, and this is factored into the calculation

of the gain or loss on disposal.

The gain or loss on disposal is therefore calculated as follows:

Fair value of the proceeds (if any) from the transaction

that resulted in the loss of control

+ Fair value of any retained non-controlling equity investment

in the former subsidiary, at the date control is lost

+ Carrying value of the non-controlling interest in the former

subsidiary (including accumulated other comprehensive

income attributable to it) at the date control is lost

- Carrying value of the former subsidiary’s net assets at the

date control is lost

+/- Any amounts included in other components of equity

that relate to the subsidiary, that would be required to be

reclassified to profit or loss or another component of equity

if the parent had disposed of the related assets and liabilities.

This change applies also to situations in which an entity loses

joint control of, or significant influence over, another entity.

Example:Entity A has a 90% controlling interest in Entity B. On December 31, 2006,the carrying value of Entity B’s net assets in Entity A’s consolidated financialstatements is €100 and the carrying amount attributable to the non-controlling interests in Entity B (including the non-controlling interest’sshare of accumulated other comprehensive income) is €10. On January 1,2007, Entity A sells 80% of the share in Entity B to a third party for cashproceeds of €120. As a result of the sale, Entity A loses control of Entity Bbut retains a 10% non-controlling interest in Entity B. The fair value of theretained interest on that date is €12.

The gain on sale of the 80% interest in Entity B is calculated follows:

Cash proceeds €120Fair value of retained non-controlling equity investment 12

€132

Less:Carrying value of Company B’s net assets €100Less Carrying value of the non-controlling interest 10 90

Gain on sale € 42

3.3.1 Multiple arrangements that result in loss of control of a subsidiaryTo prevent different accounting for transactions that are structured

differently, but have essentially the same economic consequences,

the Board concluded that an entity that expects to sell ownership

interests or otherwise lose control of a subsidiary through

multiple arrangements should consider whether or not the

multiple arrangements should be accounted for as a single

transaction. Although not intended to be an all-inclusive list,

IFRS 3R indicates that one or more of the following factors

may indicate multiple arrangements that should be accounted

for as a single transaction:

• The arrangements are entered into at the same time.

• The arrangements are entered into in contemplation of

one another.

• The arrangements form a single transaction designed to

achieve an overall commercial effect.

• The occurrence of one arrangement is dependent on the

occurrence of at least one other arrangement.

• One arrangement considered on its own is not economically

justified, but when considered with one or more other

arrangements, it is economically justified, for example,

when one disposal is priced below market value, that is

compensated for by a subsequent disposal priced above

market value.

4. Effective date and transitionIFRS 3R and IAS 27R come into effect for the first annual

reporting period beginning on or after 1 July 2009. Earlier

adoption is permitted, although they may not be applied to periods

beginning prior to 30 June 2007. If early adoption is elected,

both IFRS 3R and IAS 27R must be applied at the same time.

IFRS 3R is to be applied prospectively to business combinations

for which the acquisition date is on or after the beginning of the

annual period in which the standard is adopted. No adjustment

is permitted for business combinations taking place before that

date, with one exception noted below. Therefore, transactions

occurring before IFRS 3R is effective continue to apply current

IFRS 3, for example post-acquisition adjustments to contingent

consideration will continue to result in changes to the cost

of the acquisition and, consequently, to goodwill on those

acquisitions. The one exception relates to changes in deferred

tax assets of the acquiree: any change in a deferred tax benefit

acquired in a business combination before the application of

IFRS 3R, that occurs after IFRS 3R is adopted, does not adjust

goodwill, but is recognised in profit or loss for the period (or

if permitted by IAS 12, directly in equity).

5. Differences between IFRS 3R and IAS 27R and US FAS 141R and FAS 160

Description IFRS US GAAP Impact

Non-controlling interest in an acquiree

The acquirer has a choice to measurethe non-controlling interest at its proportionate share of the acquiree’s net identifiable assets or at its fair value.

A non-controlling interest in an acquireeis measured at fair value.

Goodwill impacted, as discussed in 2.1.1.

Contingent assets and liabilities

The acquirer recognises a contingent liability assumed in a business combination if it is a present obligationthat arises from past events and its fairvalue can be measured reliably.

Contingent liabilities are measured subsequently at the higher of the amount that would be recognised inaccordance with IAS 37 or the amountinitially recognised less cumulative amortisation recognised in accordancewith IAS 18 Revenue.

Contingent assets are not recognised.

The acquirer recognises assets acquiredand liabilities assumed that arise fromcontractual contingencies at the acquisition date.

The acquirer recognises any other con-tingency (noncontractual contingencies)as an asset or liability at the acquisitiondate if it is more likely than not that itgives rise to an asset or a liability at the acquisition date.

When new information about the possibleoutcomes of the contingency is obtained:– Contingent liabilities are subsequently

measured at the higher of the acquisition date fair value and theamount that would be recognised byapplying Statement 5.

– Contingent assets are subsequentlymeasured at the lower of the acquisition date fair value and thebest estimate of the future settlement.

Goodwill will be greater under IFRS where contingent assets are recognisedunder US GAAP.

Goodwill may be impacted by differencesin the recognition and measurement ofcontingent liabilities.

Subsequent measurement will impactreported results subsequent to theacquisition.

Definition of control Control is defined in IAS 27R as “thepower to govern the financial and operating policies of an entity so as to obtain benefits from its activities”.

The acquirer is the entity that obtainscontrol of the acquiree, applying this definition.

Control means majority voting interest asexplained in paragraph 2 of AccountingResearch Bulletin No. 51, ConsolidatedFinancial Statements or primary beneficiary in accordance with FASBInterpretation no. 46(R), Consolidation of Variable Interest Entities.

The acquirer is the entity that obtainscontrol of the acquiree, applying this definition.

Potentially different entities would beidentified as the acquirer in a businesscombination.

12 BU S I N E S S CO M B I NAT I O N S A N D CO N S O L I DAT E D FI NA N C I A L STAT E M E N T S

By contrast, the changes in IAS 27R are applied retrospectively,

except in the following scenarios:

• Attribution of losses to non-controlling interests.

• Changes in ownership interest of a subsidiary that was

acquired prior to the standard being adopted.

• Loss of control of a subsidiary occurring prior to the

standard being adopted.

Restatement will therefore only be required in those circumstances

where multiple arrangements should, in substance, be accounted

for as a single transaction and an element of the transaction has

not yet been completed or was completed in the comparative

period. As a result, management will need to assess all disposal

transactions occurring during the period IFRS 3R is adopted

and the comparative period to assess if a change to the

accounting is required.

13

Description IFRS US GAAP Impact

Definition of fair value Fair value is the amount for which anasset could be exchanged, or a liabilitysettled, between knowledgeable, willingparties in an arm’s length transaction.

Fair value is defined in FASB StatementNo. 157, Fair Value Measurements, as theprice that would be received to sell anasset or paid to transfer a liability in an orderly transaction between marketparticipants at the measurement date.

Potentially different values assigned toassets and liabilities at the acquisitiondate, affecting the amount of goodwillrecognised and subsequent reportedresults.

References to other standardsExceptions to the recognitionand measurement principles

Deferred tax:Accounted for in accordance with IAS 12.

Employee benefits:Accounted for in accordance with IAS 19.

Share based payments:Accounted for in accordance with IFRS 2.

Deferred tax:Accounted for in accordance with FASB Statement No. 109 Accounting for Income Taxes.

Employee benefits:Accounted for in accordance with anumber of US standards including, APB 12, and FASB statements numbered:43, 87, 88, 106, 112, 146 and 158.

Share based payments:Accounted for in accordance with FAS 123(R) Share-based Payments.

Differences in recognition and measurement of the assets and liabilities affect the goodwill recognisedand subsequent reported results.

Classification of contingentconsideration

Contingent consideration classified as aliability is either within the scope of IAS 39 or is accounted for in accordancewith IAS 37.

Contingent consideration classified as a liability and is measured subsequentlyat fair value.

Subsequent measurement of the liabilitymay differ, affecting the reported results.

Lessor – assets with operating leases

Fair value of the asset subject to thelease is based on the terms of the lease.

Fair value of the asset subject to thelease is measured based on market conditions, independent of any leaseterms. A separate asset or liability isrecognised for the lease, if the termsdiffer from market terms.

Classification difference in the balancesheet and may also result in differencesin the subsequent reported results.

Effective date Business combinations for which theacquisition date is on or after financialyears beginning on or after 1 July 2009.Early application is permitted.

Business combinations for which theacquisition date is on or after the beginning of the first annual reportingperiod beginning on or after 15 December2008. Early application is prohibited.

Early IFRS 3R adopters will report significantly different results.

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