Chapter 11: Business Combinations and Consolidated Financial Statements

Perspective and Issues

Business combinations may be structured in a wide variety of ways, but under current IAS they will be accounted for in one of two manners—either as acquisitions (purchases), or as unitings (poolings) of interests. While the use of pooling of interests accounting is likely to be banned by IASB, probably in 2003 (as is has recently been by the FASB in the US), as of late 2002 the criteria under IAS 22 remain intact. Thus, if certain restrictive conditions are met, business combinations by entities reporting under IAS may still be accounted for in this manner.

A uniting of interests presumes that the ownership interests of the predecessor combining entities continue essentially unchanged in the new combined enterprise. Because unitings (poolings) do not give rise to revaluations of assets and liabilities of either of the combining entities, no step-up in carrying values will be recognized and no goodwill will be created—and thus future periods will generally not suffer the burden of higher depreciation and amortization charges. For this reason, many combining entities (particularly those whose shares are publicly traded) have greatly preferred such accounting and often will be highly motivated to structure such transactions so as to meet the IAS 22 criteria for pooling accounting.

Increasingly it has become difficult to rationalize that such transactions are indeed marriages of equals, because in almost all instances it will be reasonably clear that one entity in fact acquired the other, even if the acquiree's shareholders continue as shareholders in the successor entity. Although IAS 22's criteria for pooling treatment were rather restrictive (compared, for example, to the former US standard), and thus relatively few business combinations were qualified to use that accounting, the trend among major national standard-setting bodies has been to entirely eliminate such accounting, and the IASB is poised to follow suit. Under a revised or successor standard, as currently being debated, purchase accounting would be universally applied, and the methodology would be quite similar (but not identical) to that currently prescribed by IAS 22 and described in this chapter.

When a combination is accounted for as an acquisition, the assets acquired and liabilities assumed are recorded at their fair values using purchase accounting. If the fair value of the net assets acquired equal an amount other than the total acquisition price, the excess (or deficiency) is generally referred to as goodwill (negative goodwill). Goodwill can arise only in the context of a business combination that is an acquisition. While fair values of many assets and liabilities are generally readily determined (and in an arm's-length transaction should be known to the parties) certain recognition and measurement problems do arise. Included here are the value of contingent consideration promises made to former owners of the acquired entity, and the need to recognize certain expenses that arise by virtue of the transaction, such as those pertaining to elimination of duplicate facilities.

Some of the more challenging issues affecting accounting for business combinations accounted for as purchases arise in connection with acquired intangible assets, including goodwill. IAS 38 addressed the accounting for intangibles, in general (discussed in Chapter 9), and the IASB's current projects on business combinations will likely make changes to the existing standard. The recent changes to US GAAP—under which amortization of goodwill has been eliminated, being superseded by a new impairment testing regime—are expected to be closely emulated in the forthcoming changes to IAS. The expected course of these developments will be discussed in the current chapter.

At a practical level, acquired entities are either held as subsidiaries or are fully merged into the acquirer. The consolidated financial reporting of the surviving entity or parent company will be identical in either case, but in the former there will be a need to maintain "memo" records so that asset and liability step-ups or step-downs (to reflect fair values as of the acquisition date, further adjusted for amortization and other occurrences thereafter until the financial statement date) can be made in preparing consolidated financial statements. Where an actual merger has occurred, however, these will have been formally recorded at the date of acquisition. The applicability of pooling or purchase accounting is not dependent upon the legal structure of the posttransaction entity.

Major accounting issues affecting business combinations and the preparation of consolidated or combined financial statements are as follows:

1. The proper accounting basis for the assets and liabilities of the combining entities

2. The decision to treat a combination as a uniting of interests or as an acquisition

3. The elimination of intercompany balances and transactions in the preparation of consolidated or combined statements.

Also examined in this chapter are special problems arising from specific acquisition transactions, such as reverse acquisitions, and emerging practices having complex accounting implications, such as special-purpose entities.

Sources of IAS

IAS 22, 27, 36, 37, 38

SIC 9, 12, 22, 28, 33