negotiationseries step acquisition accounting sept09 gl ifrs

8/2/2019 NegotiationSeries Step Acquisition Accounting Sept09 GL IFRS

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Negotiation series

Acquiring a subsidiary in stages

The hidden consequences of the revisedaccounting model

September 2009

ey.com/IFRS


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Acquiring a subsidiary in stages the hidden consequences of the revised accounting model

Acquiring subsidiaries has a bearing on

the fortunes of the companies involved for

years to come. While this is to be expected

from combining the operations, accountingfor the acquisition of a subsidiary that

has been acquired in stages has different

impacts on reported results and equity.

An investment in a subsidiary is often

acquired in stages both in the lead-up

to gaining control and after control has

been obtained. Sometimes this is because

an initial strategic investment has been

made as part of a long-term strategy

leading to control. In some cases, it makes

commercial sense to acquire part of a

business, and leave part owned by the

vendor executives for a period of time

to ensure they have some skin in the

game and are committed to the continued

success of the business they are selling.

Accounting for step purchases has

always been complex. The revised

standards on accounting for business

combinations (IFRS 3 BusinessCombinations) and consolidated financial

statements (IAS 27 Consolidated and

Separate Financial Statements) have

introduced significant changes to the way

these transactions are accounted for.

Whilst in many ways the changes simplify

the accounting, the new approach also

creates new risks if the accounting impacts

are not fully understood and planned for in

advance.

In this publication, we take a closer look

at the changes to accounting for stepacquisitions and the effects on reported

profits and financial position, to help avoid

surprises in the future.

2

When negotiating a business

acquisition, one of the furthest things

from the negotiators mind may be the

accounting consequences. However,

it is the negotiation of the deal that

establishes the method of accounting

for the acquisition that will affect

companies far into the future. This is a

first in a series of publications looking

at the issues to be considered when

negotiating a business acquisition.

Insights: considerations before entering into step acquisitions

The revised accounting model is effective for annual periods beginning on or

after 1 July 2009. What does management need to do before entering into such

transactions to avoid unwelcome surprises?

Understand the income statement impact fair value step-ups when obtaining

control in stages (and on loss of control) create gains/losses and recycling from

equity and the consequential impact on subsequent reported results. All affect

financial covenants, and management remuneration structures.

Understand the impact on equity effects on performance measures (return on

equity), financial covenants (gearing ratios) and sometimes tax (when tax is

based on financial measures).

Consider involving accountants, lawyers and valuers to understand and plan for

the impact of the transaction.


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Step acquisition accounting

the new methodology

The old approach to accounting for the

acquisition of a subsidiary in stages was

a cost accumulation methodology. In

contrast, the revised standard aims to fair

value all of the elements of the business

combination transaction at the date

of acquisition including any existing

ownership interests held by the acquirer.

In effect, this results in accounting for any

existing investment as if it had been sold

in order for the business to be acquired.

The accounting also reflects this the

acquiree derecognises (i.e., disposes of)

any existing investment together withthe transaction proceeds paid (at their

fair value) and recognises the acquired

businesss net assets in return.

Immediate impact

The effect of this sale accounting is that

the acquirer recognises a gain or loss

on any remeasurement of the existing

investment. If the existing investment

had already been carried at fair value with

changes recognised in equity (because

it was an available for sale (AFS)

investment in accordance with

IAS 39 Financial Instruments: Recognition

and Measurement), the AFS reserve is

recycled (or reclassified under the new

terminology) to income. The same applies

to other recyclable reserves, such as cash

flow hedge reserves and foreign currency

translation reserves, which would arise

from an investment in an associate or

joint venture. The impact of this fair value

reassessment and the sales accounting is

summarised in Table 1.

Where there is a change in the

measurement of the existing interest

(as in cases 3 and 4 in Table 1 above),

we would normally expect this to give

rise to a gain. However, there may be

some instances where a loss occurs, as

illustrated in Box 1.

Care will be needed in determining the fair

value of the existing interest, particularly if

it is unlisted its value will not necessarily

be proportionate to the price paid for the

controlling interest since that price may

include a control premium.

Table 1: Accounting for an existing investment on a step acquisition

Accounting for existing equity interests Impact

1. Fair value through income statement None

2. Available for sale Recycle AFS reserve to income statement

3. Equity accounted Recycle share of associates / JVs reserves

to income statement1

4. Proportionately consolidated Recycle share of JVs reserves to income

statement1

1Applies to all recyclable reserves, i.e., available-for-sale reserve, cash ow hedge reserve and foreign

currency translation reserve.

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Box 1: Example of a loss arising on acquisition of a subsidiary

An investor has an equity-accounted interest in a listed associate comprising

1,000 shares with a carrying value of 1,000. The quoted price of the associates

shares is 0.90 per share, i.e., 900 in total. As there is an impairment indicator,

the investment is tested for impairment in accordance with IAS 36 Impairment

of Assets. However, the investor determines that the investments value in use

exceeds 1,000. Therefore, there is no impairment loss recognised.

In the following period, the investor acquires all of the other outstanding shares in

the associate following a takeover offer. The fair value of the shares is unchanged

at 0.90 each. At the control date, the existing shares are remeasured to fair value

and the loss of 100 is recognised in the income statement.


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The tax consequences also need to

be carefully considered. The gain or

loss recognised may create additional

deferred taxes, as it is unlikely that fortax purposes this will be considered an

effective disposal. When the investment

was carried as an AFS investment, giving

rise to an AFS reserve, the deferred tax

would already have been recognised. When

the reserve is recycled to income, the tax

is also recycled to income in the same

period, therefore holding the effective tax

rate static, and retaining the deferred tax

liability. The deferred tax associated with

this gain has no bearing on the calculation

of goodwill associated with the subsidiary.

In some jurisdictions where the tax

treatment is based on the accounting

treatment, the acquisition could give rise

to an additional current tax payable on the

gains generated, thereby potentially giving

rise to real additional cash outflows, if tax

planning is not also undertaken before the

acquisition is completed.

The gain or loss is easy to understand once

you get used to reporting a profit as a

result of a purchase transaction. Similarly,

communication of the financial reportingimpact should not be difficult to manage as

it will usually be presented as a significant

one-off gain or loss. Box 2 illustrates the

impact of the new accounting and the

effect on the profit.

As always, care needs to be taken

to understand the impact on other

accounting-based measures such as loan

covenants. Many loan agreements arenot clear on which significant items, if

any, are excluded for covenant purposes.

Therefore, questions will arise as to

whether the gains/losses created from

the fair value step-ups or recycling of

equity items are taken into account or

not. For some entities, it may be the

difference between meeting a covenant

or being in breach of the covenant. For

example, an acquirer with earnings-based

covenants may be at the points of meeting

a covenant. Where it gains control of an

investment and there are recyclable debit

reserves, if these are to be included in the

assessment, this may result in a breach of

the covenant. It will therefore be critical to

determine in advance whether the gain or

loss is included for covenant purposes or,

if it is unclear, obtain prior agreement from

the financiers.

Similarly, bonus and profit share

arrangements are often based on

accounting profit. However, it is not always

clear from the terms whether the gain

or loss arising at the date of acquisition

should be included. If it is not clear, then

it may be advisable to amend the terms of

agreements before entering the transaction

rather than risk the commercial disruption

of a dispute later on. As the concept of a

gain or loss arising on the acquisition of a

subsidiary (because of the deemed disposal

of the existing investment) is new, it is

unlikely that this will be contemplated in

borrowing and remuneration arrangements.

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Acquiring a subsidiary in stages the hidden consequences of the revised accounting model 5

Entity A acquires 25% of Entity B on 1 January 2007 for 225. Entity A acquires a further 75% of Entity B on 1 January 2010

for 910. Details about Entity B for these dates are as follows (ignoring tax effects):

1 January 2007 1 January 2010

Fair value of the business 900 1,200

Value of % acquired 225 900

Fair value of the net assets 800 1,000

Value of % acquired 200 750

Equity accounted balance 258

Fair value of interest held 300

Change in fair value of assets (versus change from other activities) 70

Profit since date of acquisition of first interest 80

Share in profit since acquisition 20OCI since date of acquisition of first interest 50

Share in OCI since acquisition 13

Entity A accounts for the acquisition as if it had disposed of its equity accounted investment and acquired 100% of Entity B.

The following table summarises the accounting result under both the current and new requirements.

Old treatment New treatment

Identifiable net assets of Entity B recognised 1,000 1,000

Goodwill 185* 210**

Asset revaluation reserve (25% of 70) 17

Profit or loss (re-measurement of 25% interest from 258 to 300) 42

OCI reclassified from equity to profit or loss for the period 13

* Goodwill is currently calculated for each tranche acquired:

First 25% - Consideration (225) less 25% of net assets (200) = 25

Second 75% - Consideration (910) less 75% of net assets (750) = 160

** Goodwill is calculated as consideration given (910) plus the fair value of the previous 25% interest (300)

less 100% of net assets (1,000) = 210.

Box 2: Example of a step acquisition and the impact of the new requirements


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Acquiring a subsidiary in stages the hidden consequences of the revised accounting model6

Future impact

The accounting consequences of step

acquisitions will also affect subsequent

reported profits compared with the current

requirements. Firstly, there will be an

increased risk of impairment losses in the

future for:

Goodwill . The fair value step-up means

that goodwill on an existing interest

is effectively revalued to current

fair value. Not only will the amount

generally be larger, but any headroom

over historical cost may also disappear.

So there will be an increased risk of a

future impairment loss.

Other identifiable net assets . Although

these were also revalued under the

former IFRS 3, those revaluations

were taken to equity and the resultantreserves could have been used to

absorb future impairments before

affecting the income statement. Under

IFRS 3R, there is no reserve to absorb

any future impairments and so any such

future charges will be recognised in the

income statement.

Secondly, because AFS and other reserves

are recycled at the acquisition date, they

are no longer available for recycling in

the future. These effects are summarised

in Table 2. This effect is illustrated in theexample in Box 3.


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Acquiring a subsidiary in stages the hidden consequences of the revised accounting model 7

Table 2: Impact of step acquisition accounting methodology on future reported profits

Components of gain or loss Old treatment New treatment

1. Change in fair value of identiable net

assets:

PP&E / intangibles Create revaluation reserve Prot / loss on acquisition

future impact May be used to absorb future impairment loss No reserve to absorb future impairment

AFS instrument Create revaluation reserve Prot / loss on acquisition

future impact Recycle upon future disposal No reserve to recycle on future disposal

Foreign currency translation reserve Retained at the date of gaining control Prot / loss on acquisition

future impact Recycle upon future disposal No reserve to recycle on future disposal

2. Change in value of goodwill Not recognised Recognise revalued goodwill

future impact Headroom mitigates risk of futureimpairment

Increased risk of future impairment

Box 3: Example illustrating the subsequent impact on the income statement

Using the example in Box 2, assume that the OCI within Entity B arose from the holding of an AFS instrument. Three years

later (i.e., 1 January 2013) Entity B sells its investment in the AFS instrument for 200. At that date, Entity B had a value

in OCI attributable to the AFS instrument of 80. Entity B therefore reclassifies 80 from OCI to the income statement. The

table below illustrates the profit recognised on consolidation under the current and new requirements.

Old treatment New treatment

OCI existing at the date of salereclassified to profit

43 30

Made up of: Change since acquisition plus

ownership interest as an associate

80-50+13

Change since acquisition

80-50


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It is important to understand the reserve

impact to avoid unwelcome surprises.

An investor in an associate may have

budgeted for profits from the associatethat include recycled AFS reserves and

the recycling of cash flow hedge reserves.

When an investor takes control, these

reserves will now flow into the calculation

of the one-off gain or loss on obtaining

control, and will not be available post-

acquisition. As a result, there could be

significant changes to budgeted results

from the acquired business.

Again, where reported results are used for

other purposes such as loan covenants

and profit sharing arrangements it isimportant to consider in advance the

potential effects of a step purchase and

ensure that these are included in the due

diligence process. For example, there may

be potential anomalies whereby a gain on a

step acquisition is excluded for profit-share

purposes, but a subsequent impairment

loss on the resulting goodwill is not.

Effect on equity

The fair value step-up also affects

reported equity. This can be particularly

significant where the acquiree was a long-

standing associate (and not, therefore,

already recorded at fair value). The step

acquisition will typically result in a gain and

an increase in reported equity.

Reported equity is another measure often

included in loan covenants and ratios and

potentially profit sharing arrangements.

Performance measures, such as return

on equity, could be adversely affected by

a significant increase in reported equity

which may require careful management of

the reporting of such measures or where

they are used as performance hurdles

adjustment or normalisation to avoid

inequitable outcomes.

8 Acquiring a subsidiary in stages the hidden consequences of the revised accounting model


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Some step purchases can have a negative

impact on equity. Where an additional

interest in an existing subsidiary is acquired,

i.e., an acquisition of a non- controllinginterest (NCI), the revised standards treat

this as an equity transaction. Any difference

between the consideration paid and the

reduction in the NCI is charged directly

against the parents equity. Previously,

an entity that adopted the parent entity

extension method would record this

difference as additional goodwill.

The partial goodwill approach results in

a larger reduction in equity because the

goodwill attributable to the original NCI is

never recorded it is effectively debitedagainst equity. An example illustrating the

effect of this new requirement is included

in Box 4. This has implications for the

subsequent goodwill impairment which

we intend to explore further in a future

publication.

These reductions will have a flow-on impact

for gearing ratios, returns on equity and

other measures based on equity. Therefore,

it is vital to have an understanding of the

likely future strategy regarding ownership

of the acquiree when making the original

choice of full or partial goodwill recognition.For combinations that occurred under the

previous IFRS 3, only the partial goodwill

method applies and any planned acquisition

of the NCI for these will result in an erosion

of equity, which could have consequences

on equity based covenants. As noted above,

this may require discussion with financiers

to avoid a breach that may trigger

repayment of any loans.

Box 4: Example of an increase in ownership interest of a subsidiary

Entity A has an 80% interest in a subsidiary which has net assets of 4,000. The carrying amount of the NCI share is 800.

Entity A acquires an additional 10% interest from the NCI for 500. The following table summarises the impact of the

accounting compared to current practice.

Account New treatment Current treatments

Parent extension method* Entity concept method

Equity NCI Dr 400 Dr 400 Dr 400

Equity controlling interest Dr 100 Dr 100

Goodwill Dr 100

Cash Cr 500 Cr 500 Cr 500

* This method was commonly applied by entities in the absence of specific guidance in the existing standards.

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Conclusion

The revised IFRS 3 and IAS 27 introduce

significant changes to the way step

acquisitions are accounted for that can

significantly affect reported resultsand equity. Managing the impact of

these changes requires a considerable

planning effort and potentially involves

a variety of experts such as accountants

(to understand the impact on reported

results), lawyers (to evaluate the impact

on loan covenants and bonus and share-

based payment agreements), andvaluation professionals (to determine the

value of the existing ownership interest).

Renegotiations with financiers may also

be required.

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