The IASB is now well advanced in its deliberations on Phase II of the Business Combinations project: ‘Application of the Purchase Method’. The aim of this project is to introduce requirements to supplement those of ED 3 Business Combinations. This is a joint project with the United States standard-setter, the Financial Accounting Standards Board (FASB).
An exposure draft is expected to be published before the end of 2003. Some of its proposals may be controversial. This article focuses on two specific areas: the recognition of goodwill and accounting for transactions that involve minority interests.
Full goodwill method
Under current UK standards, only purchased goodwill (as opposed to internally generated goodwill) may be recognised in the consolidated balance sheet. FRS 10 Goodwill and Intangible Assets discusses the nature of goodwill; it reflects the view that it is a bridge between the value of an investment in the entity’s own financial statements and the net assets acquired as shown in the group/consolidated financial statements. Therefore, purchased goodwill is initially measured as the difference between the cost of the investment and the group’s share of the net assets acquired.
The IASB is considering proposing that the ‘full goodwill method’ be adopted. This would measure goodwill as the difference between the fair value of the whole of the acquiree and the fair value of the net assets acquired. So where 100% of an entity has been acquired there will be no difference from current practice, if it is assumed that the consideration paid does represent the fair value of the entity (which is a reasonable assumption in most cases).
However, there would be a significant change in those cases where an interest of less than 100% in the acquiree is purchased. In these circumstances, under the ‘full goodwill method’, both goodwill and the minority interest will be increased by the goodwill that would have arisen had the whole of the acquiree been acquired.
There may be practical problems with this approach. For example, if an 80% interest in an entity has been acquired for 800, it cannot be assumed that a 100% interest would have cost, or have a fair value, of 1,000: it is likely that the consideration paid for the 80% interest included an element of ‘control premium’ that would not be relevant to an acquisition of the remaining 20% interest, because control has already been acquired. However, it may not be easy to identify the size of the control premium, in order to eliminate it in arriving at a value for the remaining interest. Continuing this example, if the control premium was 100, the 20% interest should be valued on the basis that, without the premium, 80% had a value of 700. This would give a fair value for the 100% interest of 975 (=100 + (700 x 100/80)).
There are also conceptual concerns with the approach. The UK method of accounting for goodwill requires 100% consolidation of controlled subsidiaries—which is consistent with the entity approach espoused by IASB—but then focuses down on the interest of the shareholders in the parent company. These parent shareholders are interested in the assets that they control and, in the context of goodwill, are interested in holding management accountable for any investment it has made. That objective is met by accounting for the goodwill arising in the acquisition transaction, even though no recognition is given to internally generated goodwill. Where there is a minority interest the parent shareholder is not interested in the goodwill that might have arisen on a hypothetical acquisition of the minority because this is irrelevant to the investment made by management.
Under the full goodwill method, by contrast, goodwill is treated as any other asset (‘a resource controlled by the enterprise arising from past events and from which future economic benefits are expected to flow to the enterprise’). It is therefore recognised in full with a proportion attributed to the minority interest. The question is whether goodwill truly is a resource or rather merely a difference between the value of the subsidiary acquired and the sum of the fair values of its individual assets and liabilities.
Minority interests
Another feature of the approach being proposed by IASB which would differ from existing UK practice relates to minority interests. The status of this item is at present ambiguous, with some claiming that it is equity (albeit restricted in scope) while others see it as a liability because it is deducted in arriving at shareholders’ funds and profit for the year.
The approach being considered for Business Combinations II is founded on the view that the minority represents an equity interest, rather than a liability. However, no consideration appears to have been given to the restricted scope of this equity interest; instead, all shareholders are treated equally whether they own shares in the parent entity or merely in a subsidiary. Under current UK accounting requirements transactions with the minority can give rise to a gain or a loss, for example, if there is a sale of shares in a subsidiary to new investors, whose interest becomes part of the minority interest.
The new approach means that transactions between the group and minority shareholders are characterised as equity transactions and no gain or loss is recognised. Instead, any difference between the change in the carrying value of the minority and the cash transaction is an increase or decrease in equity. Therefore where a parent entity sells part of its stake in a subsidiary, any difference between the carrying amount of the minority interest sold and the consideration received would be recognised in equity.
In a concession to the needs of users, IASB is expected to require that a deduction should continue to be made for minority interests in arriving at net income. The deduction, however, would relate only to the minority’s proportion of reported profit. It would not incorporate any gain or loss arising for the parent company on transactions with minorities.
Usefulness of information
These are potentially fundamental changes in financial reporting raising questions such as whether financial statements are primarily addressed to the parent shareholders.
If the interests of the parent company shareholders cease to be the focus of the consolidated financial statements, it will be necessary to develop a new statement showing the total profit attributable to the parent company shareholders from transactions and events of the period.
