IFRS 3 - Understanding the key to the Business Combination

By Luis Arturo Orellana, RSM Guatemala

Famed Victorian art critic John Ruskin once said that “it is impossible to pay just a little and expect to get a lot”. This quote relates to the “Law of Business Balance” which has been adapted into the colloquialism “you get what you pay for”

A business combination is a transaction where the acquirer obtains control of one or more businesses. Business combinations are a common method for organisations to grow quickly. Identifying the consideration transferred and the effective date of the transition of control usually presents certain challenges due to the intricate wording of the Purchase Stock Agreements (PSA) or whatever legal instrument is used to specify the business. The main challenge that consultants will face during a business combination is discovering precisely what has been obtained for the price being paid. 

However, once these two issues are dealt with, the real challenge begins; understanding whether what has been acquired constitutes an actual business. 

Definitions in IFRS 3 are quite broad and when applied to a series of common acquisitions in our markets, they regularly conclude that an acquisition constitutes a business combination. However, a recent standard update came into effect allowing businesses to demonstrate that some acquisitions are an acquisition of assets and not necessarily a business combination. The improvement to which we refer is "the concentration test", which is met if "substantially all the fair value of the gross assets acquired is concentrated in a single identifiable asset or group of similar identifiable assets."

Whilst exploring the test of concentration, we realise that the total consideration transferred plays no role in the application of the concentration test. This is an exclusively fair value exercise. Accounting under IFRS does not seem to align with the wise words of John Ruskin, as you do not necessarily get what you pay for. However, at the time of making the accounting record, we must recognise that the payment was greater than the fair value (on occasion, less than) and the acquisition record will be precisely the value that is reasonable. 

If our acquisition does not meet the concentration test, then we are facing a pure business combination and we must apply the acquisition method in its entirety. By now we already know the fair value of the gross assets and possibly of any liabilities to be recorded at the acquisition date. Now it is time to focus on the industry or sector where the new business will participate. We will have to develop the business model and identify the “value drivers”. Without this knowledge, it would be very difficult to discover the intangible assets that arise from the business combination. Some are clearly visible such as, trademarks, customer sales contracts, permits and licenses. Others are a bit more difficult to identify and measure such as non-contractual relationships with clients or business secrets such as recipes or formulas.

To measure the new intangibles identified, we use standard valuation techniques. The standard suggests that, as far as possible, we use techniques that favour the use of market variables. At this point, most of the consultants in the region frown, because the availability of market data is still a pending task in our countries. This poses a significant but not insurmountable challenge because methods focused on revenue and ultimately cost will come to the rescue. These methods, although they have some subjective elements mainly manifest in the projections, are usually quite acceptable when they are reasonably well supported. In any case, with the recent events that have occurred in the markets due to the great capacity for summons and action within Reddit, it turns out that large and sophisticated markets can also be victims of the mischief of users.

Incidentally, the market valuation for GameStop Corporation (GME) in its "glory week" revealed that we cannot use this information indiscriminately and without judgment either. Those who paid in the excess of $200 per GME share have certainly learned the lesson the hard way.

Perhaps in the future an artificial intelligence algorithm will be able to elucidate the ill intentions of those conversations and prevent a similar event from taking place. Until such a time as that can be used, all that remains now is to exercise prudence. 

Finally, adding and subtracting all our work will leave a difference between the consideration transferred and the fair value of the net assets. If the difference is positive the consideration transferred is greater than the net assets, we record a Goodwill. On the contrary, in the exceptional case that our net assets are greater than the consideration transferred, we will register an Advantageous Purchase and our result for the period will receive the benefit, which hopefully was in cash. In the end, John Ruskin is not always right, just “almost” always. We closed the process by writing the report, verifying that all the stages were met and that the disclosures are clear and complete.

Now everything is in the hands of the accountant whose task is not easy either, as now you will have to figure out how and where to make each record that arose from the business combination. The good news is that at this stage, RSM can also help.
 

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