Accounting for Acquisitions - Assignment Example

Accounting for Acquisitions Introduction On January 4, 2010, the Financial Reporting Council (FRC) published the results of its study regarding ‘Accounting for Acquisitions’. The end – purpose of the study was for FRC to perform a review of International Financial Reporting Standards (IFRS) 3 (revised) on Business Combinations after its application and to submit feedback to the International Accounting Standards Board (IASB). In summary, the said study found that the over-all “results were disappointing” (FRC, 2010). The study highlighted several deficiencies in the various companies’ accounting for acquisitions in comparison with the relevant provisions of the 2004 version of IFRS 3. These findings may have several implications or effects on the implementation of IFRS 3 itself. This paper aims to discuss about this study, IFRS 3 and how the former may affect the implementation of the latter. A Brief History of IFRS 3 Prior to 2001, an IFRS on business combinations was just part of a project carried out by the then International Accounting Standards Council or IASC. In July 2001, the IASB took up the project in its agenda (Deloitte, 2010). The first exposure draft for this IFRS was issued in December of 2002. On March 31, 2004, IFRS 3 formally superseded International Accounting Standards (IAS) 22 (also titled Business Combinations). The then - new IFRS 3 took effect in April of 2004. By June 2005, an exposure draft to the proposed amendments on this standard was issued. Finally, in January 2008, a revised IFRS 3 was issued. The revised IFRS 3 took effect on July 1, 2009. The IASB made the revisions in line with its ongoing efforts to converge IFRS with the U. S. Generally Accepted Accounting Principles or US GAAP. What is IFRS 3? The objective of IFRS 3 is “to enhance the relevance, reliability and comparability of the information that a reporting entity provides in its financial statements about a business combination and its effects” (IFRS 3 Business Combinations, 2009). Based on the summary of IFRS 3 provided by Deloitte (2010) in its IAS Plus website, this standard requires a business combination to be accounted for using the acquisition method. It sets down the guidelines on how the entity can calculate the acquisition cost, even if the actual acquisition will require a couple of steps up to the final settlement of the transactions. It also explains the principles and guidelines behind the recognition and measurement of assets and liabilities acquired during the combination. IFRS 3 pays particular attention to how the acquirer can account for any intangible assets acquired during the business combination and how it can ultimately calculate the goodwill from the acquisition. Limited exceptions to these principles are also provided by IFRS 3. As with any other IFRS, IFRS 3 sets down specific disclosure requirements for a business combination transaction. Background of the Study The study was conducted by the FRC from 2008 to early 2009. Twenty (20) cases of business combinations or acquisitions that were considered material for the acquirer were studied in terms of the quality and consistency of the information disclosed in both the notes to the financial statements and in the companies’ business review. All these acquisitions occurred before the actual implementation of the revised IFRS 3 in 2009, thus the study was conducted according to the applicable provisions of the 2004 IFRS 3. Through the study, FRC hoped to assist companies “identify areas for improvement in their accounting for acquisitions at a time when the volume of acquisitions is expected to increase significantly (FRC, 2010). Even after the results of the study would be published, the FRC plans to continue conducting further studies and interviews to ascertain if there are any improvements in the quality of the companies’ accounting for acquisition and to see whether the information are useful to these companies. Prior to discussing the results of FRC’s study, it should be mentioned that FRC also published a discussion paper entitled Louder than Words (2009). In this discussion paper, FRC described its findings in its interviews with investors, the companies’ accounting department and other users. One such finding is that “most users…do not consider valuation of intangible assets acquired in a business combination useful” (p. 23, FRC, 2009). Those who prepare the financial statements view this valuation step as “complex, theoretical and time consuming” and, to top it all, the information disclosed are not actually the ones used in making the decision to acquire or not to acquire in the first place (p. 23, FRC, 2009). The FRC used this discussion paper to make several recommendations and calls to action on how to improve the quality of financial reporting, including the accounting for business combination. Results of the Study As stated in the Introduction, the said study found that the over-all “results were disappointing (FRC, 2010). It was noted in the results that the rationale behind these acquisitions during the period under review (by FRC) were explained well by the companies, as well as the expected future business benefits. However, the study pointed out several specific deficiencies in the companies’ reporting of major business acquisitions. One finding was that intangibles arising from several transactions during the year were aggregated, which is basically non-compliant with the related provisions of IFRS 3 (2004). Another finding was that the companies experienced difficulties in establishing “meaningful groups of intangible assets to aggregate as classes in the audited accounts” (FRC, 2010). It pointed out that there is a need to practice care to ensure compliance with the required disclosures. Another major finding is that several of the companies failed to provide adequate disclosure or information about the factors that gave rise to the goodwill recognized through the business acquisition. Lastly, for several companies reviewed, the amounts recognized as intangible assets and the disclosures provided in the notes to financial statements were not consistent with the explanation provided in the business review for the specific acquisitions. Impact of the Study on IFRS 3 and its Implementation It is worthwhile to note that the findings outlined in the FRC’s report were based on business combinations that happened in 2008, when the 2004 version of IFRS 3 was still in place. In 2008, the IASB issued the revised IFRS 3. The new version took effect in July 2009. The IASB issued this revised version in its ongoing efforts to converge the IFRS with U. S. Generally Accepted Accounting Principles or US GAAP. Through this new version, the IASB hoped that business combinations will be accounted for in the same way, whether the company is reporting under IFRS or under US GAAP (IASB, 2008). With the issuance of the new version and the results of the study, the findings of FRC will have implications and possible effects on the implementation of this new IFRS 3. One very important implication the study brought to light is how difficult it is to implement this particular IFRS. In particular, there seems to be a “lack of appreciation of the true value of intangible assets” resulting to recognition of higher goodwill (instead of more intangible assets) (Intellectual Asset Management or IAM, 2007). Also the costs associated with the analysis and calculation of balances needed for proper recognition and disclosure of the business combination were considered high or substantial, still according to IAM. These factors may mean a basic lack of understanding on the provisions of IFRS 3 (the 2004 version) and a mere ‘compliance – mode’ (instead of a need to be more transparent in the financial reports) among the companies and the accountants. Another implication is that regulators, investors, various experts and the public, in general, are realizing the need to properly disclose the business combination transactions of the companies, as these are usually so material in nature and have major impact on the financials of the companies. These are the entities that are keeping close watch on such activities. As Kevin Li (2007) puts it, part of the work of regulators (among others) is to ensure that “executives are held accountable for the (sometimes vast) sums they expend” when acquiring businesses, particularly if these sums are much higher than the fair value of the acquired assets. The study conducted by Mr. Li showed that there is “progressive tightening of rules to limit executives’ discretion”. Evidence of the above realization can be found in various studies analyzing the compliance of the companies’ disclosures with the relevant provisions of IFRS 3. The FRC is not the only one that has conducted such study. The IAM is another entity that conducted a similar study. The results of the study were featured in a 2007 article by Thayne Forbes entitled “The Failure of IFRS 3”. It will be safe to say that such studies will continue in the future, particularly in light of the fact that business combinations or acquisitions are expected to grow in 2010 and future years as the world economy and the businesses recover from the credit crunch. One such effect of FRC’s (and other entity’s) study is that there is a growing awareness that the proper application of IFRS 3 will result to an “increase in transparency of acquisitions in the financial statements” (Duff & Phelps, 2010). This means that companies, as well as investors and analysts, are beginning to realize that intangible assets, wherein most of the findings of FRC were centered on, should be recognized properly and separately from goodwill because by doing so, the financial statements will be much easier to understand and the balances are correctly stated. With the above, it is highly expected that, in the future, investors and other users or readers of financial reports will demand more and better disclosures from the entities so that they will be in a better position to review and to assess how well the company’s board of directors and management are utilizing the resources of the company. Another possible effect is the realization that there is a need to provide more guidance on how to measure and recognize the acquired assets and liabilities (particularly the intangible assets). The revised version of IFRS 3 did establish principles on recognizing and measuring these assets and liabilities as well as their classification and designation (Modack, 2008/2009). Various experts (including the Big 4 accounting firms) are issuing guidelines, question-and-answer type articles and various articles regarding IFRS 3 and the accounting for business combinations. These guidelines pay tribute to the fact that accounting for business combination is not an easy matter to deal with and there is a need for the preparers of the financial reports to assess how they can calculate and disclose best the business combination transactions. Another effect is the undertaking of continuous improvement on IFRS 3 and the relevant provisions in other standards to ensure uniformity and consistency in accounting for business combination and to somewhat ease the burden of applying this standard. The new version of IFRS 3 (which took effect in July 2009) allowed prospective application of the provisions of these standards and the recognition of reacquired rights as part of intangible assets, rather than goodwill (p. 505, Epstein and Jermakowicz, 2010). It also provided options on how to measure non-controlling interests on partial acquisitions and also excluded costs related to the acquisition from goodwill (IASB, 2010). Still another implication of FRC’s study is that there may be a need to make the standards (and the disclosures) more relevant to both the entity and the users. As mentioned in the previous section, prior to this study, the FRC had also interviewed both the users and the preparers of the financial reports. From these interviews, the FRC gleaned that there is a basic mismatch between internal and external reporting. In fact, what are actually disclosed in the business combination disclosure are not the ones being utilized by the companies internally or in terms of analyzing the business acquisition (FRC, 2009). This awareness of the basic mismatch may lead to an improved IFRS 3 that may take into consideration both internal and external financial reporting. It may also lead the preparers of the financial reports to disclose information (usually in the business review) that the company would normally use in its internal reporting. This may save the time and the effort of the preparers as they will no longer need to come up with new disclosures and new calculations to conform with the IFRS. Lastly, it may be quite possible that such results will bring about the increase in the interests of the companies to the relevant provisions of IFRS 3 and incorporate these provisions in their acquisition decision – making. In its 2008 Pocket Guide, PriceWaterhouseCoopers or PWC advised the companies (both the acquirer and the acquired) to “anticipate the accounting consequences on deals” by either “adapting their acquisition strategies, amending contractual clauses and increasing their valuation capabilities”. Through this pocket guide, the PWC (and other accounting firms as well) is calling out to the business entities to take into consideration the provisions of IFRS 3 in their decision – making process for future acquisitions. Conclusion In summary, IFRS 3 may be one of the more complex standards ever written and may also be one of the most important. Mergers and acquisitions (M&As), which are the topics of this standard, are of so importance to the entity, both due to their costs and their relevance to the business. Proper application of IFRS 3 and full disclosure of the transactions are thus needed for the investors and other users to have a grasp of the rationale behind such M&As and their impact to the company’s future and business. The FRC study has highlighted the basic problems with the provisions and the actual application of IFRS 3. The study has also pointed out that there is a serious lack of information in the reviewed companies’ financial reports regarding these transactions and a basic disconnection between what is required by the standard and what is actually found in these reports. The FRC’s study, although applicable to acquisitions and disclosures that are pre-2008 version of IFRS 3, may have major implications and effects to the application of the new IFRS 3. The growing awareness of the importance of and the criticisms on the disclosures for M&As are some of these implications. The continuous improvements of the related standard may also be an effect. The ongoing efforts to improve on the disclosures and to provide a connection between what is really analyzed within the company and what is actually disclosed in the outside world may also be another effect of this study. Whether or not the new IFRS 3 will bring about improvements in the reporting of M&As is another matter that we can all look forward to. But to be sure, the FRC and other accounting experts will surely be on the watch to ensure proper application of this new standard. References Deloitte (2010). IAS Plus: IFRS 3 Business Combinations. [Online] Available at: http://www.iasplus.com/standard/ifrs03.htm (Accessed: April 7, 2010). Duff & Phelps (2010). IFRS 3: Business Combinations. [Online] Available at: http://www.duffandphelps.com/SiteCollectionDocuments/IFRS3.pdf (Accessed April 9, 2010). Epstein, B. and Jermakowicz, E. (2010). 2010 Interpretation and Application of International Financial Reporting Standards. New Jersey: John Wiley & Sons, Inc. Available at: http://books.google.com.ph/books?id=n9QZeigBCu0C&printsec=frontcover#v=onepage&q&f=false (Accessed: April 10, 2010). FRC (2009). Louder than Words. [Online] Available at: http://www.frc.org.uk/images/ uploaded/documents/FRC%20DiscussionPaper%20louder%20than%20words.pdf (Accessed: April 10, 2010). FRC (2010). FRC Study: Accounting for Acquisitions. [Online] Available at: http://www.frc.org.uk/images/uploaded/documents/FRC%20Study%20-%20Accounting %20for%20acquisitions1.pdf (Accessed: April 6, 2010). Forbes, T. (2007). The Failure of IFRS. [Online] Available at: http://www.intangiblebusiness.com/store/data/files/76-The_failure_of_IFRS_3_Intellectual_Asset_Management_January_2007.pdf (Accessed: April 9, 2010). IASB (2010). The Revised IFRS 3 and Amended IAS 27. [Online] Available at: http://www.iasb.org/Current+Projects/IASB+Projects/Business+Combinations/The+revised+IFRS+3+and+amended+IAS+27.htm (Accessed: April 10, 2010). IFRS 3 Business Combinations (2009). [Online] Available at: http://www.iasb.org/ NR/rdonlyres/50580D48-A443-4347-BFDA-558B520C20E0/0/IFRS3.pdf (Accessed: April 5, 2010). IASB (2008). Press Release – January 10, 2008. [Online] Available at: http://www.iasplus.com/ pressrel/0801buscomb2pr.pdf (Accessed: April 8, 2010). Intellectual Asset Management (2007). The Failure of IFRS. [Online] Available at: http://www.intangiblebusiness.com/store/data/files/76-The_failure_of_IFRS_3_Intellectual_Asset_Management_January_2007.pdf (Accessed: April 8, 2010). Li, K. (2007). Trends in Accounting for Business Combinations: A Sixty – Year Review of Three Jurisdictions. Available at: http://papers.ssrn.com/sol3/papers.cfm? abstract_id=990482 (Accessed: April 10, 2010). Moodack, G. "IFRS 3 Business Combinations: Old vs New”. Accountancy SA. FindArticles.com. Available at: http://findarticles.com/p/articles/mi_qa5377/is_200812/ ai_n31171688/ (Accessed: April 10, 2010). PWC (2008). New IFRS for Acquisitions (M&A). [Online] Available at: http://www.pwc.fr/assets/files/pdf/2008/06/pwc_pg_news_ifrs.pdf (Accessed: April 11, 2010). Read More