A transaction is either accounted for as a business acquisition under IFRS 3, Business Combinations, or, if it is not a business combination, in accordance with the appropriate standard for an asset purchase (for example: IAS 16 Property, Plant and Equipment; IAS 38 Intangible Assets; or IAS 40 Investment Property).
The question is important (and there are significant consequences to getting the answer wrong or not considering the question at all!), because in a business combination:
- Goodwill or a gain on bargain purchase is accounted for;
- Assets acquired and liabilities assumed are accounted for at their fair values rather than being recognized at their relative fair values in an asset purchase;
- Directly attributable acquisition costs are expensed versus capitalized as part of the asset purchased;
- Deferred tax assets and liabilities are recognized in a business combination;
- IFRS provides guidance on recognizing contingent consideration but there is no guidance in the standards applicable to asset purchases;
- The disclosure requirements are considerable in the financial statements for a period in which a business combination is completed, and the same disclosure applies in any year where an acquisition is made subsequent to the report date but before the financial statements are issued; and
- Also note that some of these differences continue in future periods, such as impairment and depreciation/amortization.
An entity first needs to determine whether the assets acquired and liabilities assumed constitute a business (IFRS 3.3). If they do not meet the definition of a business, then the default is to account for the transaction an asset purchase.
Appendix A to IFRS 3 defines a business as, ‘an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return…to investors or other owners, members or participants.’ A business therefore consists of inputs and processes applied to those inputs that have the ability to generate outputs. Therefore, outputs themselves are not required.
Input: are economic resources, such as intellectual property, access to necessary materials, employees and non-current assets such as intangible assets or the rights to use non-current assets.
Process: is any system, standard, protocol, convention or rule, such as strategic management processes, operational or resource management processes. Administrative processes are specifically excluded.
Output: is a return in the form of dividends, lower costs or other economic benefits
You should note the following in applying the definition:
- If the transaction does not include both inputs and processes then it is not a business combination.
- Some processes must be included in the transaction, but all processes used by the vendor need not be included. Some necessary processes may be provided by the acquirer on integrating the business with their own operations.
- A business need not have liabilities.
- The set of assets and activities must be capable of being conducted and managed as a business by a market participant. Whether the seller operated the set as a business and whether the acquirer intends to operate it as a business is not relevant.
- There is a rebuttable presumption that an asset that includes goodwill is a business.
- The elements of a business vary by both industry and structure of an entity.
- New businesses often have few inputs and processes and only one (or no) outputs. In this situation, other factors must be considered, including whether the set:
- Has begun planned principal activities;
- Is pursuing a plan to produce outputs; and
- Is expected to obtain access to customers to purchase those outputs.
The determination of whether a transaction is a business acquisition or an asset purchase is a judgement call that must be disclosed.
The Application Guidance provides more detail that is useful in applying IFRS 3, including the following.
The definition of a business includes inputs and processes and may also result in outputs, although outputs are not necessary for a business to exist. A process is defined as, ‘any system, standard, protocol, convention or rule’ (IFRS 3.B7) that when applied to inputs creates, or has the ability to create, outputs. Examples of processes include strategic management, operational and resource management. Inputs are economic resources that create, or have the ability to create, outputs when one or more processes are applied, and include intangible assets or the rights to use non-current assets.
‘To be capable of being conducted and managed for the purposes defined, an integrated set of activities and assets requires two essential elements – inputs and processes’. Therefore both assets and processes must be included in the acquisition, even though all necessary processes need not be acquired (some processes may be contributed by the acquirer) (IFRS 3.B8). If no processes are included, then the transaction is an asset purchase; if this was not the case, then any asset purchased for use in an existing business would meet the definition of a business, which would be non-sense.
Furthermore, processes are described as ‘activities’ in IFRS 3.B8, which is consistent with the English language definitions of the word: (i) as a noun, ‘a series of actions or steps taken’ and (ii) as a verb, ‘perform a series of mechanical or chemical operations on something in order to change or preserve it.’ The purchase of in-place leases, for example, represents economic inputs and not a process; the leases represent a right to benefit from non-current assets. There are no activities inherent in a rent-roll, instead leasing and other management processes are applied to it.
Where the acquisition includes both inputs and some level of process (over and above administrative functions, which are specifically excluded by the definition) the determination can involve significant judgement. The IFRS Interpretations Committee White Paper of May 2013 addressed the application of this principle in practice by different sectors, including the real estate sector, and in different jurisdictions.
One view in practice is that the processes acquired must have a level of sophistication that involves a degree of knowledge unique to the assets being acquired for a business to exist. Common themes in the responses received include:
- Examples of significant management processes that management views as being integral for a business to exist, include marketing, tenancy management, financing, development operations and other functions that are typically undertaken by the parent company or external management.
- The acquisition of an investment property together with the employment of key management personnel of the vendor is a strong indicator of a business.
- Other processes such as cleaning, security and maintenance are generally not considered to be significant processes. Therefore, a transaction that only includes those or similar processes is generally treated as an asset purchase.
Note that these necessary processes meet both the definition in IFRS 3 and the English language definition, while in-place leases acquired do not.
The view that a level of sophistication is required is predominant in Europe and Australia and is consistent with the requirement that processes be at a more supervisory or management level (as per the definition: strategic management, operational and resource management). The view from respondents using US GAAP (which is nearly identical to IFRS guidance) is that ‘any process that, when applied to an input or inputs, create or have the ability to create outputs, gives rise to a business.’ Therefore, transactions are more likely to result in business acquisitions than asset purchases in the US GAAP world.
Under Canadian Accounting Standards for Private Enterprises (ASPE) the relevant standard is 1582 Business Combinations, which is a copy of IFRS 3 Business Combinations. Therefore, the guidance surrounding IFRS can also be applied to the same asset or business combination question under ASPE. In applying the GAAP hierarchy in ASPE (standard 1100 Generally Accepted Accounting Principles), the first consideration would be IFRS and not US GAAP. This is logical given the fact that 1582 and IFRS 3 are identical.
The International Accounting Standards Board (IASB) carried out a Post Implementation Review (PIR) of IFRS 3 in 2014/2015. The review found that stakeholders find it difficult to apply the definition of a business in practice. The IASB issued an exposure draft in June 2016 which proposes: amending the language used in the standard, adding illustrative examples and simplifying the application of the standard in some situations. The comment period closed on October 31, 2016. Watch this space for an IFRS Condensed piece on the final amendments to the standard.
Specific professional advice should be obtained prior to the implementation of any suggestion contained in this article.