Standards
Business Combinations
The AcSB is proposing significant changes when accounting for business combinations.
FROM: NOV-DEC 2005 ISSUE | BY STEPHEN SPECTOR
The Accounting Standards Board (AcSB) in August 2005 released an exposure draft proposing changes to the way we account for business combinations. The goal of the project is to harmonize Canadian standards with those in the United States and those of the International Accounting Standards Board. Once approved, the new requirements will form Handbook Section 1582, which will replace Section 1581. A company following Section 1582 will comply with GAAP under Canadian, U.S., and international standards.
The key change has to do with the way business combinations are accounted for. Right now, if you (the acquirer) purchase a business (the acquiree), the combination is handled as a purchase. That won't change. If you acquire 100 per cent of the acquiree, the acquiree is deemed a subsidiary (Section 1590) and reported using consolidation.
Putting aside the reporting for a moment, the transaction is accounted for in a manner that recognizes that the price paid for the acquisition represents the cost of the transaction. If you paid $440 million to acquire a subsidiary, the assumption is that the amount of consideration given up represents the cost of the purchase. Now, as part of that exercise, you would determine the fair value of the identifiable assets and liabilities of the acquiree — even those that weren't previously recognized. The difference between the fair value of the net identifiable assets and the purchase price would be recognized as goodwill.
Now, suppose that you bought 90 per cent of the acquiree. When doing the calculations under Section 1581, you base everything on that percentage — 90 per cent of the fair value. Suppose the fair value of the net identifiable assets in the previous example was $420 million. If you acquired 100 per cent of the company, goodwill would be $440 million minus $420 million, or $20 million. If $440 million bought you 90 per cent of the company, goodwill would be $440 million minus 90 per cent of $420 million, or $378 million — which makes goodwill equal to $62 million.
The big change has to do with the control. It doesn't matter whether you acquire 100 per cent or 50 per cent plus one vote. Once you control a subsidiary, you make the decisions. Therefore, for a business combination accounted for under Section 1582, the acquirer will now account for 100 per cent of the fair value of the entity as whole, irrespective of the percentage acquired. That will mean that the acquirer will have to be able to ascertain the fair value of the acquired entity as a whole as well as the fair values of the individual identifiable assets and liabilities.
This requirement will also affect the way in which goodwill will be determined. There is a presumption that in a business combination between willing parties in which the acquirer purchases 100 per cent of the equity interests or net assets that constitute the acquiree, the fair value of the consideration paid is effectively the fair value of the acquiree on that date. So if you paid $440 million for 100 per cent of an entity, it is assumed that the fair value of the entity as a whole is also $440 million. Goodwill will be the difference between the fair value of the entity as a whole and the fair value of the identifiable net assets, or $440 million minus $420 million, or $20 million — just as before.
The impact will really be seen when less than 100 per cent of an entity is acquired. Suppose you pay $400 million for 90 per cent of the entity. As before, the fair value of the net identifiable assets is calculated as $420 million. However, Section 1582 demands the use of valuation techniques to determine that the fair value of the entity, as a whole, be determined; assume that works out to $450 million. This shows that in the absence of a transaction to acquire 100 per cent of an entity, there is no guarantee that the amount used for the fair value of an entity as a whole would be the same. So right away, goodwill will be different — it will be $30 million, not $20 million.
Furthermore, because this is not a 100 per cent acquisition, there will be a non-controlling interest (NCI) to deal with. Goodwill must be split between the parent and the NCI. And you simply can't take 90 per cent of the goodwill derived initially — that would be too easy. The amount paid is deemed the fair value of the interest in the acquired entity. So $400 million is deemed the fair value of the 90 per cent acquired; 90 per cent of the fair value of the net identifiable assets is $378 million. Therefore, goodwill allocated to the controlling interests would be $22 million($400 million minus $378 million). That means goodwill allocated to the NCI is $8 million. The allocation proportions are not related to the acquisition percentages; rather, it is tied to the fair values. Put another way, whereas NCI is recognized at book value under Section 1581, it will be recognized at fair value under Section 1582.
Another change has to do with what used to be considered negative goodwill. Under Section 1581, negative goodwill is not recognized. Instead, in combinations where the cost of the acquisition was less than the fair value of the identifiable net assets, the non-monetary assets were written down to eliminate this "negative" goodwill. Now in a business combination in which the acquisition-date fair value of the acquirer's interest in the acquiree exceeds the fair value of the consideration transferred for that interest (referred to as a bargain purchase), the acquirer will account for that excess by reducing goodwill until the goodwill related to that business combination is reduced to zero; any remaining excess is recognized in income.
Two other changes have to do with acquisition-related costs incurred in connection with the business combination and the exclusion of any changes in the amount of the acquirer's future income tax benefits that would be recognizable as a result of that business combination. In the first instance, rather than being added to the cost of the acquisition, these expenditures will be accounted for separately from the business combination, generally as expenses. In the second situation, Section 3465 will be amended to require such changes in future income tax benefits to be recognized either in income from continuing operations in the period of the combination or directly to contributed surplus, depending on the circumstances.
The AcSB intends that the section apply prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual period beginning on or after January 1, 2007. Earlier application will be encouraged, but the section can only be applied at the beginning of an annual period that begins on or after the section is issued.
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Stephen Spector, MA, FCGA, owns Spector and Associates and teaches Financial and Managerial Accounting at Simon Fraser University. He also serves on CGA-BC’s board of governors. E-mail shspector@shaw.ca.