Reporting Requirements for Business Combinations - Essay Example

A CRITICAL EVALUATION OF IFRS 3 IN RELATION TO CLEAR REPORTING REQUIREMENTS FOR BUSINESS COMBINATIONS INTRODUCTION IFRS 3 defines a business combination as the bringing together of separate entities or businesses into one reporting entity, and requires the purchase method of accounting to be applied to all such transactions. Business combination is also a term applied to external expansion in which separate enterprises are brought together into one economic entity as a result of one enterprise uniting with or obtaining control over the net assets and operations of another enterprise. There is an increasing trend to expand operations through business combinations rather than through international expansions. This development is largely due to the effects of recessions, inflation and continued uncertainty over the ability of the government to control economic ills. With business combination, the surviving company is provided with the immediate availability of the resources of an established enterprise. Furthermore, the union of businesses often results in better utilization of management, in addition to acquisition of new management strength and improved capital bargaining position. In addition, a business combination may be undertaken for the income tax advantages available to one or more parties to the combination. However, business combinations involve certain limitations and risks. Corporate objectives must be taken into consideration. Only those companies which have the same or compatible sets of objectives should combine. On the other hand, successful firms are usually not willing to combine. The acquiring enterprise may also inherit the acquired firm's inefficiencies and problems together with its inadequate resources. OBJECTIVE The objective of IFRS 3 is to specify the financial reporting by an entity when it undertakes a business combination. In particular, it specifies that all business combinations should be accounted for by applying the purchase method. Therefore, the acquirer recognizes the acquiree's identifiable assets. Liabilities and contingent liabilities at their fair values at the acquisition date, and also recognize goodwill, which is subsequently tested for impairment rather than mortised. (ASC, 2005) Notable words that one must take into consideration when understanding issues of business combinations are; purchase method, fair values, acquisition date and goodwill. Under purchase method of accounting the acquiree's identifiable assets and liabilities must be measured at their fair values at acquisition date. Fair value then is defined as the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing partied in an arm's length transaction. Acquisition date is the date on which the acquirer effectively obtains control of the acquiree. Control is the power to govern the financial and operating policies of an entity or business so as to obtain benefits from its activities. Goodwill is a future economic benefits arising from assets that are not capable of being individually identified and separately recognized. SCOPE This IFRS does not apply to business combinations in which separate entities or businesses are brought together to form a joint venture. Joint venture is defined in IAS 31 Interest in Joint Ventures, as a contractual agreement whereby two or more parties undertake an economic activity that is subject to joint control. This IFRS does not also apply to combinations involving entities under common control, or businesses involving two or more mutual entities and a combination in which separate entities are brought together by contract alone to form a dual listed corporation. METHOD OF ACCOUNTING There are two methods for carrying out a business combination, the acquisition and the uniting of interest. Business combination is achieved by acquisition when one of the enterprises, the acquirer, obtains control over the net assets and operations of another enterprise which is the acquiree, in exchange for the transfer of assets, incurrence of liability or issue of equity, thereby, enabling an acquirer to be identified. Business combinations by acquisition may involve the purchase by the acquirer of the net assets of the acquiree, including any goodwill of another enterprise or by the purchase of equity of another enterprise, resulting in a parent-subsidiary relationship in which the acquirer is the parent and the acquiree is the subsidiary. The acquirer may pay cash or issue its shares of stock for the acquisition of the net assets or the equity of the acquiree. On the other hand, uniting of interest or pooling of interest is used when the stockholders of the combining enterprise combine into one entity the whole or effectively the whole, of the net assets and operations to achieve a continuing mutual sharing of the risks and benefits of the combined enterprise such that neither party can be identified as the acquirer. A business combination which is achieved by acquisition should be accounted for by the use of the purchase method of accounting. This method uses cost as the basis for recording the acquisition which is the total of the amount of consideration paid by the acquirer; the acquirer's direct cost of the combination and any contingent consideration that is determinable on the date of the business combination, where the payment is probable. ACCOUNTING FOR GOODWILL Goodwill represents the difference between the cost of the acquisition and the fair value of identifiable assets and liabilities acquired. It may be positive or negative. Purchased goodwill is capitalized as an intangible asset. Positive goodwill is the excess of the cost of acquisition over the fair value of net identifiable assets acquired as of the date of acquisition and should be recognized as an asset. Goodwill should be tested for impairment at least once a financial year. On the other hand, a negative goodwill arises when the fair value of the identifiable assets, liabilities and contingent liabilities exceeds the acquisition cost. When this exists, the fair value of the identifiable assets, liabilities and contingent liabilities must be reconsidered and adjusted. Any remaining negative goodwill is recognized as income from acquisitions and is presented in the income statement. IMPAIRMENT TESTING Goodwill should be tested for impairment each financial year. Impairment should be tested through a two-stage process using the principles for impairment. First, the carrying amount of cash generating unit, including goodwill, should be compared to its recoverable amount. Whenever this initial review shows that recoverable amount is lower than the carrying amount, a second-stage calculation should be performed. The impairment will be the amount by which the carrying value of goodwill exceeds its implied value. DISCLOSURES As stated, an acquirer shall disclose information that enables users of its financial statements to evaluate the nature and financial effect of business combinations that were effected: during the period and after the balance sheet date but before the financial statements are authorized for issue. An acquirer shall also disclose information that enables users of its financial statements to evaluate the financial effects of gains, losses. Error corrections and other adjustments recognized in the current period. An entity shall also disclose information that enables users of its financial statements to evaluate changes in the carrying amount of goodwill during the period. THE EXTENT OF FINANCIAL REPORTING STANDARDS' INFLUENCE TO THE COMPANIES' OPERATING AND FINANCIAL POLICIES INTRODUCTION: National Financial Reporting Standards or National GAAP has been created or revised in many ways to be in line with international standards. This is to eliminate complexities in reporting which is brought by different standards of different countries. International Financial Reporting Standards has been created for this purpose. Many companies are then compelled to restate their financial statements to comply with the international standards, which has then brought great effects on their operating and financial policies. To investigate the influence of these financial reporting standards, let's examine the article published by PR Newswire LLC about Vodafone's adoption of international financial reporting standards. ARTICLE DOWNLOADED FROM THE INTERNET Vodafone: Update on Adoption of International Financial Reporting Standards LONDON, Jan. 20 /PRNewswire-FirstCall/ -- Vodafone Group Plc ("Vodafone") is preparing for the adoption of International Financial Reporting Standards ("IFRS") as its primary accounting basis for the year ending 31 March 2006. As part of this transition, Vodafone is presenting today financial information prepared in accordance with IFRS for the six months to 30 September 2004 and, for illustrative purposes only, pro forma financial information for the year ended 31 March 2004. Vodafone will report under UK Generally Accepted Accounting Practice ("UK GAAP") for the year ending 31 March 2005, and will subsequently present this financial information in accordance with IFRS. The primary changes to Vodafone's reported financial information from the adoption of IFRS are as a result of the: -- Requirement not to amortize goodwill; -- Proportionate consolidation for certain Group interests, most notably Vodafone Italy, resulting from their reclassification as joint ventures; -- Requirement to amortize mobile licenses on a straight line basis; -- Recognition of deferred tax liabilities on a different basis; -- Inclusion of a fair value charge in relation to employee share options; -- Recognition of all employee benefit related assets and obligations, principally pensions; and -- Recognition of certain financial instruments at fair value and the reclassification of preference shares as debt. Ken Hydon, Financial Director, commented: "The financial information provided today shows how IFRS impacts on Vodafone's recent results in advance of its adoption in the next financial year. The most significant change is that Vodafone will no longer amortize goodwill, resulting in a clearer presentation of underlying business performance. For the six months ended 30 September 2004 the impact of the adoption of IFRS is to increase profit attributable to equity shareholders by 6.8 billion pounds Sterling comprising a credit of 7.3 billion pounds Sterling in relation to the cessation of goodwill amortization, a 0.3 billion pounds Sterling reduction in non-recurring tax income and a net charge of 0.2 billion pounds Sterling in relation to other adjustments." EVALUATION We can see from the article above that the financial reporting standards adopted internationally have created a great impact on companies all over the world. Noticeable changes include a Requirement not to amortize goodwill but rather subjected to impairment; consolidation of certain group interest; amortization of licenses using a straight line basis; recognition of deferred tax liabilities; inclusion of a fair value charge in relation to employee share options; recognition of all employee benefit related assets and obligations, principally pensions; and recognition of certain financial instruments at fair value and the reclassification of preference shares as debt. A requirement not to amortize goodwill had created substantial effect on presentation of financial statements. The analysis conducted to 100 public companies with the largest reported goodwill balances evidenced this effect. Elimination of the previous goodwill amortization requirements will likely increase these 100 companies' reported annual profits by approximately 20-25%. (Huefner & Largay III, the CPA Journal). Changes of this magnitude cause discontinuities in data time series, creating difficulties for users of financial statements in estimating trends and forecasting future performance. And the nominal tax-related cash flow effects associated with these changes demand that more attention be paid to operating cash flow when assessing a company's financial performance. Accounting for goodwill is not only controversial in the United States, it is a worldwide debate. In the U.K., goodwill is usually written off against reserves in the stockholders' equity section. It can also be capitalized and amortized, but very few companies do so. When capitalized, tax deductions for "know-how"--a certain form of goodwill--are allowed. The U.K.'s Accounting Standards Committee is considering changing its position on goodwill. The new treatment would require capitalization and amortization over a period not exceeding twenty years. This is more in line with the position taken with the International Accounting Standards Committee's Exposure Draft on Comparability. Regardless, it would appear that there are currently no cash flow differences in accounting for goodwill in the U.K. and the U.S. Amortization of goodwill in the U.S. does not impact cash flow and should not place U.S. companies at a disadvantage to U.K. companies. (The CPA Journal, April 1993) References: 1.) Deloitte, Touche & Tohmatsu, 2004, IAS Plus, IASB Publishes IFRS 3 Business Combinations, the Creative Studio, London 2.) Accounting Standards Council, 2005, Philippine Financial Reporting Standards, Manila, Philippines 3.) Vodafone Group Plc, 2006, Vodafone: Update on Adoption of International Financial Reporting Standards, PR Newswire LLC, retrieved from http://www.prnewswire.com/cgibin/stories.plACCT=104&STORY=/www/story/01-20-2005/0002865898&EDATE= Read More