This month, the ASB has issued four Financial Reporting Exposure Drafts (FREDs) of UK accounting standards reflecting the outputs from Phase I and Phase II of the International Accounting Standards Board (IASB) project on business combinations.

The package of FREDs comprises:

• FRED 36 'Business Combinations (IFRS 3) and Amendments to FRS 2 Accounting for Subsidiary Undertakings (parts of IAS 27 Consolidated and Separate Financial Statements)'.
• FRED 37 'Intangible Assets (IAS 38)'.
• FRED 38 'Impairment of Assets (IAS 36)'.
• FRED 39 'Amendments to FRS 12 Provisions, contingent liabilities and contingent assets and Amendments to FRS 17 Retirement benefits'.

Comments on the proposals are sought by 28 October.

FRED 36

The IASB issued IFRS 3 in March 2004 following completion of the first phase of its Business Combinations project. FRED 36 is based on the Exposure Draft of Proposed Amendments to IFRS 3 issued by the IASB in June 2005 and the Exposure Draft of Proposed Amendments to IAS 27.

The main changes to existing accounting practices that would arise from adopting the proposals in FRED 36 are set out below. The ASB is concerned that certain aspects of the proposals may not improve the quality of information in financial statements.

Under current UK accounting practice the objective of acquisition accounting is to reflect the cost of the acquisition. To the extent to which it is not represented by identifiable assets and liabilities (measured at their fair value), goodwill arises and is reported in the financial statements. This exposure draft adopts a different perspective and requires the financial statements to reflect the fair value of the acquired business.

The proposals treat the group as a single economic entity ('entity concept') and any outside equity interest in a subsidiary is treated as part of the overall ownership interest in the group. As a consequence of this changes in a parent's ownership interest, that do not result in a change of control, are to be recognised as changes in equity. No gain or loss will be recognised in the profit and loss account. In the UK, to date, accounting has been based on the 'parent entity concept'. Under the parent entity concept the extent of noncontrolling interests and transactions with non-controlling interests are separately identified in the primary financial statements.

It is proposed that goodwill is to be recognised in full; that is 100% of goodwill is recognised even if less than 100% is acquired. FRS 2 requires that goodwill arising on acquisition should only be recognised with respect to the part of the subsidiary undertaking that is attributable to the interest held by the parent entity.

Goodwill, after initial recognition, is to be measured at cost less impairment losses, and amortisation is not to be permitted. The IASB concluded that more useful information would be provided if goodwill was not amortised but subjected to a rigorous and operational impairment test. FRS 10 'Goodwill and Intangible Assets' seeks to charge goodwill to the profit and loss account only to the extent that the carrying value of goodwill is not supported by the current value of goodwill within the acquired business.

Subsequent measurement of goodwill is a complex issue; neither annual impairment nor amortisation is likely to result in a conclusive value for the carrying amount of goodwill. The ASB is seeking views on whether the UK IFRS-based standard should be amended and an option introduced allowing amortisation of goodwill.

Costs incurred in connection with an acquisition are not to be accounted for as part of the cost of the investment.

FRED 37 and FRED 38

As part of the first phase of the Business Combinations project the IASB amended both IAS 38 'Intangible Assets' and IAS 36 'Impairment of Assets'. FREDs 37 and 38 propose the adoption of UK standards based on the current text of these standards.

The main differences between the proposed standards and current accounting practice are:

FRED 37 - definition of an intangible asset

The IASB reconsidered the definition of an intangible asset and affirmed the view that identifiability is the characteristic that conceptually distinguishes other intangible assets from goodwill.

IAS 38 does not define 'identifiable' but states an intangible asset meets the identification criterion when it:

• is separable, i.e. is capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract asset or liability; or
• arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity of from other rights and obligations.

This is in contrast to FRS 10 which defines identifiable assets as assets that are capable of being disposed of or discharged separately, without disposing of a business of the undertaking. The proposed Standard therefore extends the definition of an intangible asset to include those that are not separable.

FRED 38 - impairment tests

To justify the carrying of goodwill without systematic amortisation it is clear that a robust test for impairment is required. The impairment test must provide confidence in its ability to identify reductions in the carrying amount of acquired goodwill. There are two key differences between the impairment test set out in FRS 11 and that of IAS 36:

• the FRS 11 test attempts to distinguish between acquired and internally generated goodwill and to recognise only impairment of the acquired part. The proposed Standard does not include such a test;
• the FRS 11 impairment test includes a test to check the accuracy of impairment by comparing actual cash flows against those projected; IAS 36 does not contain a similar test.

FRED 39

It is proposed that FRS 12 is renamed 'Non-financial Liabilities'. A non-financial liability is defined as a liability other than a financial liability as defined in FRS 25 'Financial Instruments: Disclosure and Presentation'. The IASB states that this amendment is to clarify that IAS 37 (and thereby FRS 12) should be applied to all non-financial liabilities that are not within the scope of other Standards.

The Exposure Draft no longer applies the terms 'contingent liabilities' and 'contingent assets'. Contractual rights and obligations can be divided into two types: 'conditional' and 'unconditional'. An entity recognises a liability relating to the unconditional obligation; uncertainty about the future event is reflected in the measurement of the liability. The term 'contingency' is used to refer to uncertainty about the amount required to settle the liability, rather than uncertainty as to whether a liability exists.

Under FRS 12, a provision is only recognised if it is probable that an outflow of economic resources would be required to settle the provision. When applying the amended definitions all unconditional obligations that meet the definition of a liability are considered for recognition. The draft Standard omits the probability criterion from recognition and moves it to measurement.

The amendments made to the recognition criterion, particularly the removal of the probability criterion, will give rise to a greater number of liabilities meeting the recognition criteria. These amendments place greater emphasis on satisfying the definition of a liability. The Exposure Draft notes that an essential characteristic of a liability is that the entity has a present obligation arising from a past event. The removal of the probability criterion from recognition will require all present obligations that meet the definition of a liability to be recognised.

What will change? - a simplified example

A entity is being sued for damages of £10 million. Legal proceedings have started, but the entity disputes liability. The entity estimates that it has a 20 per cent chance of losing the case. Under FRS 12, the entity would disclose a contingent liability in the notes to the accounts. Under the proposals in FRED 39, the entity has an unconditional obligation to stand ready to pay the damages if awarded. In this case, it would recognise a nonfinancial liability of £2 million.

The IASB is also proposing to amend the requirements relating to restructurings. The revised Standard states that a decision to restructure, even if accompanied with an announcement by management is not the requisite past event for the recognition of a liability. It would appear that this amendment will result in many restructurings that were previously recognised as 'single sum amounts' being recognised as a number of individual amounts when each cost meets the definition of a liability.

UK accounting standards currently include no specific requirements for accounting for termination benefits other than the general principles of FRS 12. It is proposed to introduce that section of IAS 19 ‘Employee Benefits’ that define and set out the accounting requirements for termination benefits into FRS 17 (FRS 17 will be renamed 'Retirement and Termination Benefits').

Termination benefits may be either 'involuntary' (provided as a result of an entity's decision to terminate an employee's employment) or 'voluntary' (offered for a short period of time in exchange for an employee's decision to accept voluntary termination).

A liability and expense for 'voluntary’ termination benefits shall be recognised when the employee accepts the entity's offer to those termination benefits.

A liability and expense for 'involuntary’ termination benefits, except where provided in exchange for the employees future services, shall be recognised when the entity has a plan of termination that it has communicated to the employees and the plan meets the criteria specified in the Standard. Involuntary termination benefits provided in exchange for the employees future services shall be recognised over the period of service.