Michelle Crisp reviews comments arising from consultation on Business Combinations Financial Reporting Exposure Drafts
In July 2005 the IASB issued Exposure Drafts setting out its proposals from the second phase of the Business Combinations package. As part of its proposed strategy for convergence with International Financial Reporting Standards the ASB issued a "bumper edition" of Financial Reporting Exposure Drafts: FREDs 36 to 39. These FREDs re-packaged the IASB existing IFRSs and its proposals from the second phase of the IASB's Business Combinations project as draft Financial Reporting Standards, and highlighted certain issues that the ASB considered its constituents might like to reflect on.
This article considers what might be in store for the IASB in the New Year when it considers the comment letters to its Exposure Drafts. This article considers what might be in store for the IASB in the New Year when it considers the comment letters to its Exposure Drafts. Of course respondents expressed a variety of views and here we can only give an overview of some of the main themes.
The IASB Exposure Drafts were founded on four fundamental principles:
- The acquirer obtains control of the acquiree at the acquisition date and thereby becomes responsible and accountable for all of the acquiree's assets, liabilities and activities, regardless of the percentage of its ownership in the acquiree;
- The total amount to be recognised for the acquiree should be the fair value of the acquiree as a whole;
- Business combinations generally are exchange transactions in which knowledgeable, unrelated willing parties are presumed to exchange equal values; and
- The identifiable assets acquired and liabilities assumed in a business combination should be recognised at their fair values on the date control is obtained.
These principles were robustly reflected in the IASB's proposals set out in its Exposure Drafts, however early implementation of the proposals does not appear to be on UK respondents' "Christmas lists". UK respondents might relax and enjoy the spirit of Christmas as the IASB has acknowledged that publication of IFRS based on the Exposure Drafts is unlikely to take place in 2006.
The first of the principles results in a gain or loss being recognised when control of a subsidiary is obtained in stages. This is because the proposals require the acquirer to remeasure its non-controlling equity investment at the acquisition date to fair value and recognise any resulting gain or loss in the profit and loss account. The IASB explains that this reflects its conclusion that gaining control of a business is an event that should trigger remeasurement. However, many UK respondents were perturbed by the recognition of a gain or loss in the profit and loss account and considered that it should be recognised in equity. Additionally, respondents considered that remeasurement of non-controlling equity investments is related to the second principle.
The second principle raised significant debate with respondents raising two particular concerns. The first was that the principle extended the use of fair value measurement without proper conceptual debate as to its appropriateness. The second was a concern about the cost and operational difficulties associated with measuring the fair value of the acquiree. Respondents questioned whether the resulting information provided by applying the principle improved the reliability of financial reporting.
In questioning the ability to reliably measure the fair value of the acquiree, respondents appear to be questioning the third principle, that business combinations generally are exchange transactions in which it is presumed equal values are exchanged. It was noted by one respondent that "when two entities enter into a transaction each will believe that he is getting a good, or at least a worthwhile, deal; it may well be that both sides believe that there is an unequal exchange of values". Most UK respondents agreed with the Alternative Views set out in the Exposure Drafts - that the total value of the acquired business is an extremely subjective measure.
Whilst UK constituents are used to working with the fourth principle they were a little shocked by what might be considered "over indulgence" by the IASB. In applying this principle the IASB reconsidered the recognition of goodwill and whether the information provided by the full goodwill method is relevant. The IASB observed that under the 'Framework' the objective of consolidated financial statements is to provide information about the economic resources controlled by the parent. The IASB concluded that an entity's financial statements provide users with more useful information about the entity's financial position when they include all of the assets under its control regardless of the extent of ownership interest held. Thus the IASB concluded that the full goodwill method is consistent with the concept that control over another entity makes the controlling entity accountable for all of that other entity's assets and liabilities. The first point to note is that this decision relies on the IASB's earlier decision that goodwill is an asset. Some UK respondents noted that even if goodwill is considered to be an asset, it is not like other assets and users of financial statements often disregard it. Giving consideration to this point it becomes questionable what benefits the recognition of full goodwill would bring to financial reporting. It seems that UK respondents consider you can have too much "goodwill".
Some respondents related the recognition of full goodwill to the introduction of the 'economic entity concept', applied in the Exposure Drafts. Until now UK and IFRS have applied the 'parent entity concept' which focuses on reporting to shareholders of the parent entity. Many UK respondents are concerned that the economic entity concept (which treats the group as a single economic unit and non-controlling interests as part of group equity) will result in a loss of focus in financial reporting and undermine the very purpose of financial statements. They consider that group financial statements are prepared from the perspective of the parent company's shareholders not non-controlling interests. Non-controlling interests were another area where many respondents had problems with the IASB's proposals. In accordance with the economic entity concept no gain or loss, or adjustment to goodwill, is recognised when changes in ownership interest arise after control is obtained. Respondents argued not only against this proposal but also considered that there had been a lack of conceptual debate on how non-controlling interests should be treated.
It is perhaps worth noting that a number of UK respondents questioned the benefits the proposals would bring to financial reporting and therefore why the Exposure Drafts were being published at this point in time. Perhaps as a consequence of being unable to identify what benefits the proposals would bring, some UK respondents questioned whether the IASB had adhered to due process by not issuing the proposals as a Discussion Paper first. Similarly there was a concern expressed about the timing of the Exposure Drafts in relation to other projects being undertaken by the IASB - such as the conceptual framework project and performance reporting.
The IASB set out the four fundamental principles it considered would improve significantly financial reporting for business combinations. They then undertook a conceptually robust approach to their implementation. UK respondents question the practicality of the proposals (despite their conceptual richness), the benefits they bring to financial reporting and whether the resulting financial information improves the reliability of financial statements. At the last count the IASB and FASB had received 257 responses to their proposals - it seems it could be a long and cruel mid-winter that is spent analysing these responses and planning the way forward.
In its response to the IASB the ASB suggested that acquisition accounting may not always be appropriate and suggested research into 'fresh start' accounting. It might be UK constituents would prefer the IASB to take a 'fresh' look at it proposals.
As part of the second phase of the Business Combinations project the IASB also issued proposed amendments to IAS 37 'Provisions, Contingent Assets and Contingent Liabilities' (these proposals were issued as FRED 39 in the UK). The amendments required a different analysis for the recognition of contingent liabilities and proposed contingent assets should be recognised in accordance with IAS 38 'Intangible Assets'. UK respondents were not supportive of these proposals and many considered the proposals lacked practical application.
The amendments to IAS 37 also propose to remove the probability criterion from the recognition of a liability. The absence of a threshold and the increased level of subjectivity means, for example, that a liability would have to be recognised if there was only a 10 per cent risk of an outflow. Many UK respondents support the alternative view of one IASB member that the new analysis fails to provide adequate guidance on when an unconditional obligation should be recognised.
The ASB set out its views on the IASB proposals in its response letter to the IASB. The ASB views are consistent with the views of many respondents. In its response letter the ASB stated "In our view the proposals introduce new concepts and we do not support the conversion of the Exposure Drafts into International Financial Reporting Standards until proper debate on these concepts has been undertaken." The ASB response letter can be found at www.frc.org.uk/asb/publications/other.cfm
