Australian Accounting Standards Board

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1 Australian Accounting Standards Board URGENT ISSUES GROUP Issue Summary 01/3 (Final, 28/9/01) Fair Value of Equity Instruments Issued as Purchase Consideration 2001 Australian Accounting Standards Board

2 Urgent Issues Group Issue Summary Issue: Fair Value of Equity Instruments Issued as Purchase Consideration Reference UIG 01/3 (Final, 28/9/01) Abstract 41 issued September 2001 Description of Transaction/Event 1. An entity may issue its own equity instruments (e.g. shares) as purchase consideration when acquiring an asset. Paragraph 6.1 of Accounting Standards AASB 1015 and AAS 21 Acquisitions of Assets requires an acquisition to be measured at the cost to the acquiring entity. In determining the cost of acquisition, the Standards require equity instruments issued by the acquirer to be measured at their fair value as at the date of acquisition. 2. Both AASB 1015 and AAS 21 require that, where an entity or operation is acquired, any difference between the cost of acquisition and the aggregate fair value of the identifiable assets acquired (less, where applicable, the aggregate fair value of the identifiable liabilities assumed) must be accounted for in accordance with Accounting Standards AASB 1013 and AAS 18 Accounting for Goodwill. 3. The determination of the fair value of equity instruments issued in an acquisition and, therefore, the purchase consideration, has a direct effect on the calculation of any goodwill or discount on acquisition, where an entity or business operation is acquired. 4. Current Accounting Standards and other authoritative pronouncements provide limited guidance on the factors that should be taken into account in determining the fair value of equity instruments which are issued as purchase consideration, particularly those that are not traded in an active and liquid market. 5. Concern has been expressed that, in the absence of authoritative guidance, diverse or unacceptable accounting practices may be applied in determining the fair value of equity instruments issued as purchase consideration (and thus the amount of goodwill or discount on acquisition), and that this will undermine the relevance and reliability of general purpose financial reports. Issues and Status 6. Issues The issues concern the determination, for the purpose of AASB 1015 and AAS 21, of the fair value, as at the date of acquisition, of equity instruments issued as purchase consideration. The following specific issues arise: How should the fair value of purchase consideration be determined? When should the purchase consideration be measured? UIG Issue Summary 01/3 Fair Value of Equity Instruments Issued as Purchase Consideration (Final, 28/9/01) 1

3 (c) (d) (e) (f) Should the stand-alone value of the equity instruments issued by the acquirer be distinguished from the value of the equity instruments to the receiver of the equity instruments (the vendor)? Should factors known at the time of measurement of the purchase consideration which may affect the value of the equity instruments issued be taken into account? Should related transactions affect the measurement of the purchase consideration? Should the purchase consideration be adjusted when the outcome of assumptions made is known? 7. Status The UIG considered Issue Proposal Determination of Purchase Consideration in the context of AASB 1015 and AAS 21 Acquisitions of Assets at its meeting on 2 November 2000 and agreed to include the issue on its work program. Issue Summary 01/3 Fair Value of Equity Instruments Issued as Purchase Consideration Initial (1/3/01), Update #2 (31/5/01), Update #3 (12/7/01) and Update #4 (23/8/01) were discussed at the UIG meetings on 15 March, 14 June, 26 July and 6 September 2001 respectively. Issue Summary 01/3 (Update #1, 9/4/01) was prepared for discussion at the UIG meeting on 27 April 2001 but was not discussed. The UIG reached a Consensus at its meeting on 6 September A summary of the UIG s discussion of the issue is included below. UIG Meeting 15 March 2001 Members discussed the following: whether the fair value of the purchase consideration should be based on the fair value of the equity instruments issued or the fair value of the assets acquired, and agreed that Accounting Standards AASB 1015 and AAS 21 Acquisitions of Assets were clear in defining the purchase consideration in terms of the fair value of the equity instruments issued by the acquirer. Members also noted that commentary in those Standards stated that the fair value of the assets acquired may, in some instances, provide a reasonable indication of the fair value of the equity instruments issued, but agreed not to address those circumstances; the date for measurement of the purchase consideration, and agreed that AASB 1015 and AAS 21 required measurement as at the date of acquisition (i.e. the date when the acquirer obtains control of the assets acquired). Some members were of the view that measurement as at the date of announcement would be more appropriate, and some members considered that the date of announcement was effectively the date of acquisition anyway. However, members agreed that the requirements of the Standards were clear, and that this aspect would not be considered further; UIG Issue Summary 01/3 Fair Value of Equity Instruments Issued as Purchase Consideration (Final, 28/9/01) 2

4 (c) (d) (e) the valuation of equity instruments which were quoted in an active market, and took the view that prices in an active market should not be adjusted for any premiums or discounts; the valuation of equity instruments that were not quoted in an active market, and were of the view that the valuation of the instruments should take into account the information available to the issuer at the time, without subsequent adjustment for the outcome of any valuation assumptions made; and whether determination of the fair value of the equity instruments issued should take into account the particular value of the instruments to the receiver of the instruments (the vendor), with members of the view that this was not appropriate. Members were advised that the Standing Interpretations Committee (SIC) of the International Accounting Standards Board (IASB) was also considering the topic of the measurement of shares issued as purchase consideration, and that the SIC was expected to issue a Draft Interpretation on the topic prior to the next meeting of the UIG. Members decided that they would consider the SIC Draft Interpretation at their next meeting, and therefore that it was not necessary for staff to prepare a draft Abstract for the next meeting. UIG Meeting 14 June 2001 Members discussed the following: (c) whether to proceed with the project now that it was likely to be some time before it was dealt with by the IASB/SIC, and agreed to recommence active consideration of the project; the tentative views reached at the UIG meeting on 15 March, in particular the view that the fair value of listed securities at the date of acquisition was the price quoted on the market. Members noted that Accounting Standards AASB 1015 and AAS 21 Acquisitions of Assets, paragraph , state that the fair value is normally their market price but that, in some circumstances, the price at which a placement can be made is a better indicator. Members agreed that the draft Abstract should provide guidance on the interpretation of that paragraph in the context of placements, trading restrictions, escrow arrangements and controlling blocks; and whether the issues being addressed should be clarified, and agreed that the issue is the factors which may bear upon the determination of the fair value of equity instruments as at the date of acquisition. UIG Meeting 26 July 2001 Members discussed the following: the basis for determining fair value, as at the date of acquisition, of equity instruments issued as purchase consideration, with some members of the view that the best measure of the fair value normally was the price at which the instruments could be placed in the market. Some members disagreed with the UIG Issue Summary 01/3 Fair Value of Equity Instruments Issued as Purchase Consideration (Final, 28/9/01) 3

5 current emphasis in standard setting, both domestically and internationally, that the market price of listed financial instruments should be taken as the fair value of the instruments, taking the view that the size of the parcel of equity instruments and other factors relating to the particular acquisition transaction should be taken into account in determining the fair value of the instruments. Members noted that commentary in Accounting Standards AASB 1015 and AAS 21 Acquisitions of Assets and AASB 1013 and AAS 18 Accounting for Goodwill supported the placement price in some instances and agreed that the draft Abstract to be considered at the next meeting should emphasise that commentary; (c) the requirement in AASB 1015 and AAS 21 that the fair value of the purchase consideration is determined as at the date of acquisition and not the date of announcement. Members noted that the fair value as at the date of acquisition of the equity instruments issued therefore would reflect market adjustments for the effect of anticipated synergistic benefits and other factors relating to the acquisition transaction. Members agreed that draft commentary stating that making adjustments for such market effects would have the effect of measuring the instruments as at the date of announcement was incorrect and should be deleted; and whether a Consensus should apply to transactions from the date of the Consensus rather than to reporting periods ending on or after the date of the Consensus, and agreed to further consider the operative date requirements at the next meeting. UIG Meeting 6 September 2001 Members discussed the following: the proposed disclosure requirements, and noted that they were based on proposed requirements in SIC D28. Members considered that disclosure of the magnitude of any difference from a quoted market price and the reasons for not using the quoted market price would be useful information in analysing an acquisition transaction; the determination of the fair value of equity instruments issued as a means of determining the cost of acquisition to the entity. Members agreed that the Consensus should emphasise that the fair value of equity instruments that are traded in an active and liquid market is normally their market price. Members also confirmed that the quoted market price of an equity instrument may, for a number of reasons, not be indicative of the fair value at the acquisition date. They also noted that the quoted market price at the acquisition date may reflect synergistic and other benefits and other factors. Some members took the view that a placement price adopted as the fair value instead of the market price should exclude the price effects of the acquisition transaction, such as the anticipated effect of any synergistic benefits. Other members considered that no adjustment could or should be made for the price effects of the acquisition; and UIG Issue Summary 01/3 Fair Value of Equity Instruments Issued as Purchase Consideration (Final, 28/9/01) 4

6 (c) whether a Consensus should apply to transactions from the date of the Consensus or to reporting periods ending on or after the date of the Consensus, and agreed that the Consensus should apply to acquisitions announced on or after the date of the Consensus. Members then approved the Consensus and appointed a drafting subcommittee to finalise the proposed Abstract for sending it to the AASB to commence the 21-day period in which the AASB could consider whether to exercise its reserve power of veto. The Board did not veto the Consensus. (c) Authoritative Accounting Literature and Other Guidance 8. Australia Accounting Standards AASB 1015 and AAS 21 Acquisitions of Assets (November 1999) (ii) (iii) (iv) (v) (vi) (vii) (viii) where there is an acquisition, the acquired assets must be measured at the acquisition date at the cost of acquisition. (paragraph 6.1) acquisition means obtaining control of an asset, group of assets, or net assets in exchange for a cost of acquisition (paragraph 12.1) acquisition date means the date on which an acquirer obtains control of an asset, group of assets, or net assets (paragraph 12.1) cost of acquisition means the purchase consideration plus any incidental costs directly attributable to the acquisition (paragraph 12.1) purchase consideration means the fair value as at the acquisition date of assets given, equity instruments issued, or liabilities undertaken by the acquiring entity (paragraph 12.1) fair value means the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm s-length transaction (paragraph 12.1) Where it is probable that the cost of acquisition will vary because it is contingent on one or more future events and the amount of the variation can be reliably measured at the acquisition date, the amount of the variation must be included in the cost of acquisition. Where the amount of the variation cannot be reliably measured at the acquisition date, the cost of acquisition must be adjusted when the amount of the variation can be reliably measured. (paragraph 8.1) Where equity instruments or non-monetary assets are provided as all or part of the purchase consideration, the fair value of the asset, group of assets or net assets acquired may, in some instances, provide a reasonable indication of the fair value of the equity instruments issued or non-monetary assets given by the acquirer. (paragraph ) UIG Issue Summary 01/3 Fair Value of Equity Instruments Issued as Purchase Consideration (Final, 28/9/01) 5

7 (ix) (x) Where marketable securities are provided as all or part of the purchase consideration, the fair value of those securities is normally their market price as at the acquisition date. However, in some instances the notional price at which they could be placed in the market is a better indicator of fair value. (paragraph ) Where there is infrequent activity in a market or where the market is not well established, quoted market prices may not be indicative of the fair value of the assets or equity instruments given as purchase consideration. In these circumstances, estimation techniques such as reference to the current market value of another asset or equity instrument that is substantially the same, or discounted cash flow analysis are used to determine fair value. In applying discounted cash flow techniques, a current market-determined risk-adjusted discount rate is used which reflects such factors as the expected rate of return prevailing in the market for an investment having a similar exposure to risk. (paragraph ) Accounting Standards AASB 1013 and AAS 18 Accounting for Goodwill (June 1996) (ii) (iii) (iv) Goodwill which is purchased by the entity must be measured as the excess of the cost of acquisition incurred by the entity over the fair value of the identifiable net assets acquired. (AASB 1013 paragraph 5.7; paragraph 5.5 of AAS 13 is similar) Where the purchase consideration comprises shares or other securities of the purchaser and these securities are listed publicly on an Australian Stock Exchange, the price at which they could be placed in the market will usually be an indication of their fair value. Where the securities issued are those of an unlisted entity, it may be necessary to make a valuation of those securities. (paragraph 5.7.3; paragraph respectively) Where it is probable that the cost of acquisition will vary, because it is contingent upon one or more future events, and the amount of the variation can be estimated reliably at the date of acquisition, such an amount must be included in the calculation of the cost of acquisition. Where the amount of the variation cannot be reliably estimated at the date of acquisition, an accrual for the amount must be recognised as soon as it can be estimated reliably. (AASB 1013 paragraph 6.1; AAS 18 paragraph is similar) Where a variation in the cost of acquisition depends upon a contingency which affects the determination of the fair value of net assets of the acquired entity, an adjustment to the individual assets or liabilities and to the purchase consideration must be made. Where the contingency does not affect the value of the net assets of the acquired entity, the acquiring entity must treat the variation as an adjustment to the purchase consideration, thereby increasing or decreasing the amount of goodwill or discount on acquisition. (AASB 1013 paragraph 6.2; AAS 18 paragraph is similar) UIG Issue Summary 01/3 Fair Value of Equity Instruments Issued as Purchase Consideration (Final, 28/9/01) 6

8 (c) Accounting Standard AASB 1041 Revaluation of Non-Current Assets (July 2001) (ii) (iii) (iv) Fair value is defined in paragraph 11.1 as the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm s length transaction. Underlying the definition of fair value is a presumption that the entity is a going concern without any intention or need to liquidate or otherwise wind up its operations or undertake a transaction on adverse terms. Similarly, to determine the fair value of an asset, it is assumed that the asset is exchanged after an adequate period of marketing to obtain its best price. An asset s fair value is measured having regard to the highest and best use of the asset for which market participants would be prepared to pay. (paragraph 5.1.6) Where a quoted market price in an active and liquid market is available for an asset, that price represents the best evidence of the asset s fair value. When a quoted market price for the asset in an active and liquid market is not available, its fair value is estimated by reference to the best available market evidence of the price at which the asset could be exchanged between knowledgeable, willing parties in an arm s length transaction. This evidence includes current market prices for assets that are similar in use, type and condition ( similar assets ) and the price of the most recent transaction for the same or similar asset (provided that there has not been a significant change in economic circumstances between the transaction date and the reporting date). Current market prices for the same or similar assets usually can be observed for land, non-specialised buildings, used motor vehicles, and some forms of plant and equipment. For land and buildings, these prices can also be derived from observable market evidence (for example, observable current market rentals) using discounted cash flow analysis. (paragraph 5.1.7) In some circumstances, the market buying price and market selling price of an asset differ materially because the asset usually is bought separately in the new asset market but if sold separately, could only be sold for its residual value. This is often the case for specialised assets. In some other circumstances, an asset is so specialised that there is no market evidence of its market selling price. In either circumstance, an asset may be acquired separately and included in a cash-generating operation, and would only be sold in its current condition as a part of a sale of that cash-generating operation. (paragraph 5.1.8) In the circumstances described in paragraph 5.1.8, the asset s fair value is measured at its market buying price. (The best indicator of an asset s market buying price is the replacement cost of the asset s remaining future economic benefits, which is not necessarily the cost of replicating the asset, that is, its reproduction cost). (paragraph 5.1.9) UIG Issue Summary 01/3 Fair Value of Equity Instruments Issued as Purchase Consideration (Final, 28/9/01) 7

9 9. United States of America Statement of Financial Accounting Standards SFAS 141 Business Combinations (June 2001) (ii) (iii) The distinctive characteristics of preferred shares make some preferred share issues similar to debt securities, while others are similar to common shares, with many gradations in between. Those characteristics may affect the determination of the cost of an acquired entity. For example, the fair value of nonvoting, noncovertible preferred shares that lack characteristics of common shares may be determined by comparing the specified dividend and redemption terms with those of comparable securities and by assessing market factors. Thus, although the principle of recording the fair value of consideration received for shares issued applies to all equity securities, senior as well as common shares, the cost of an entity acquired by issuing senior equity securities may be determined in practice on the same basis as for debt securities (Opinion 16, paragraph 73). (paragraph 21) The fair value of securities traded in the market is generally more clearly evident than the fair value of an acquired entity (paragraph 6). Thus, the quoted market price of an equity security issued to effect a business combination generally should be used to estimate the fair value of an acquired entity after recognizing possible effects of price fluctuations, quantities traded, issue costs, and the like. The market price for a reasonable period before and after the date that the terms of the acquisition are agreed to and announced shall be considered in determining the fair value of securities issued (Opinion 16, paragraph 74). (paragraph 22) If the quoted market price is not the fair value of the equity securities, either preferred or common, the consideration received shall be estimated even though measuring directly the fair values of net assets received is difficult. Both the net assets received, including goodwill, and the extent of the adjustment of the quoted market price of the shares issued shall be weighed to determine the amount to be recorded. All aspects of the acquisition, including the negotiations, shall be studied, and independent appraisals may be used as an aid in determining the fair value of securities issued. Consideration other than equity shares distributed to effect an acquisition may provide evidence of the total fair value received (Opinion 16, paragraph 75). (paragraph 23) Statement of Financial Accounting Standards SFAS 142 Goodwill and Other Intangible Assets (June 2001) The fair value of an asset (or liability) is the amount at which that asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale. Thus, the fair value of a reporting unit refers to the amount at which the unit as a whole could be bought or sold in a UIG Issue Summary 01/3 Fair Value of Equity Instruments Issued as Purchase Consideration (Final, 28/9/01) 8

10 current transaction between willing parties. Quoted market prices in active markets are the best evidence of fair value and shall be used as the basis for the measurement, if available. However, the market price of an individual equity security (and thus the market capitalization of a reporting unit with publicly traded equity securities) may not be representative of the fair value of the reporting unit as a whole. The quoted market price of an individual equity security, therefore, need not be the sole measurement basis of the fair value of a reporting unit. (paragraph 23) (ii) If quoted market prices are not available, the estimate of fair value shall be based on the best information available, including prices for similar assets and liabilities and the results of using other valuation techniques. A present value technique is often the best available technique with which to estimate the fair value of a group of net assets (such as a reporting unit). If a present value technique is used to measure fair value, estimates of future cash flows used in that technique shall be consistent with the objective of measuring fair value. Those cash flow estimates shall incorporate assumptions that marketplace participants would use in their estimates of fair value. If that information is not available without undue cost and effort, an entity may use its own assumptions. Those cash flow estimates shall be based on reasonable and supportable assumptions and shall consider all available evidence. The weight given to the evidence shall be commensurate with the extent to which the evidence can be verified objectively. If a range is estimated for the amounts or timing of possible cash flows, the likelihood of possible outcomes shall be considered. (paragraph 24) (c) Accounting Principles Board APB Opinion 16 Business Combinations (August 1970) [Superseded by SFAS 141 Business Combinations (June 2001)] (ii) (iii) The Board believes that the date of acquisition of a company should ordinarily be the date assets are received or other assets are given or securities are issued. (paragraph 93) The cost of an acquired company and the values assigned to the assets acquired and liabilities assumed should be determined as of the date of acquisition. (paragraph 94) An asset acquired by issuing shares of stock of the acquiring corporation is recorded at the fair value of the asset, that is, shares of stock are recorded at the fair value of the consideration received for the stock the fair value of an asset received for stock issued may not be readily determinable, or the fair value of an asset acquired in an exchange may be more reliably determinable than the fair value of a noncash asset given up. Restraints on measurement have led to the practical rule that assets acquired and cost may be determined either by the fair value of the consideration given or by the fair value of the UIG Issue Summary 01/3 Fair Value of Equity Instruments Issued as Purchase Consideration (Final, 28/9/01) 9

11 property acquired which ever is the more clearly evident. (paragraph 67) (iv) (v) (vi) (vii) The fair value of securities traded in the market is normally more clearly evident than the fair value of an acquired company. Thus, the quoted market price of an equity security issued to effect a business combination may usually be used to approximate the fair value of an acquired company after recognizing possible effects of price fluctuations, quantities traded, issue costs, and the like. The market price for a reasonable period before and after the date of the terms of acquisition are agreed to and announced should be considered in determining the fair value of securities issued. (paragraph 74) If the quoted market price of securities is not the fair value of stock, either preferred or common, the consideration received should be estimated even though measuring directly the fair values of assets received is difficult. Both the consideration received, including goodwill, and the extent of the adjustment of the quoted market price of the stock issued should be weighted to determine the amount to be recorded. All aspects of the acquisition, including negotiations, should be studied, and independent appraisals may be used as an aid in determining the fair values of securities issued. Consideration other than stock distributed to effect an acquisition may provide evidence of the total fair value received. (paragraph 75) The Board concludes that cash and other assets distributed and securities issued unconditionally and amounts of contingent consideration which are determinable at the date of acquisition should be included in determining the cost of an acquired company and recorded at that date. Consideration which is issued or issuable at the expiration of a contingency period of which is held in escrow pending the outcome of the contingency should be disclosed but not recorded as a liability or shown as outstanding securities unless the outcome of the contingency is determinable beyond a reasonable doubt. (paragraph 78) Contingent consideration should usually be recorded when the contingency is resolved and consideration is issued or becomes issuable. In general, the issue of additional securities or distribution of other consideration at resolution of contingencies based on earnings should result in an additional element of cost of an acquired company. In contrast, the issue of additional securities or distribution of other consideration at resolution of contingencies based on security prices should not change the recorded cost of an acquired company. (paragraph 79) (d) Emerging Issues Task Force Abstract EITF Determination of the Measurement Date for the Market Price of Acquirer Securities Issued in a Purchase Business Combination (January 2000) Paragraph 74 of Opinion 16 states that the market price for a reasonable period before and after the date the terms of the acquisition UIG Issue Summary 01/3 Fair Value of Equity Instruments Issued as Purchase Consideration (Final, 28/9/01) 10

12 are agreed to and announced should be considered in determining the fair value of securities issued. However, paragraph 94 of Opinion 16 refers to determining the cost of an acquired company as of the date of acquisition, which is defined in paragraph 93 as, ordinarily the date assets are received and other assets are given or securities are issued. This Issue addresses that apparent contradiction. (paragraph 1) (ii) (iii) (iv) the Task Force reached a consensus that the value of the acquirer s marketable equity securities issued to effect a purchase business combination should be determined, pursuant to the guidance in paragraph 74 of Opinion 16, based on the market price of the securities over a reasonable period of time before and after the terms of the acquisition are agreed to and announced. In other words, the date of measurement of the value of the acquirer s marketable equity securities should not be influenced by the need to obtain shareholder or regulatory approvals. Task Force members observed that the reasonable period of time referred to in paragraph 74 of Opinion 16 is intended to be very short, such as a few days before and after the acquisition is agreed to and announced. Task Force members also observed that in transactions involving a hostile tender offer, the measurement date for the value of the acquirer s marketable equity securities occurs when the proposed transaction is announced and sufficient shares have been tendered to make the offer binding or when the proposed acquisition becomes nonhostile, as evidenced by the target company s agreement to the purchase price. (paragraph 4) The Task Force also reached a consensus that if the purchase price (the number of shares or the amount of other consideration) is subsequently changed as a result of further negotiations or a revised acquisition agreement, a new measurement date for valuing the acquirer s marketable equity securities that will be issued to effect the combination is established as of the date of the change. The Task Force clarified that if the change in the number of shares or other consideration is not substantive, a new measurement date does not result from the change. (paragraph 5) the Task Force reached a consensus that if the application of the formula results in a change to the number of shares or the amount of other consideration to be issued in the purchase business combination, then the first date on which the number of acquirer shares and the amount of other consideration become fixed without subsequent revision is the measurement date. That is, the measurement date is the earliest date, from the date the terms of the acquisition are agreed to and announced to the date of final application of the formula pursuant to the acquisition agreement, on which subsequent applications of the formula do not result in a change in the number of shares issued or the amount of other consideration. (paragraph 7) UIG Issue Summary 01/3 Fair Value of Equity Instruments Issued as Purchase Consideration (Final, 28/9/01) 11

13 10. Canada CICA Handbook Section 1580 Business Combinations (January 1990) (ii) (iii) (iv) (v) (vi) (vii) (viii) Under the purchase method, the acquiring company s interest in assets acquired and liabilities assumed is accounted for in the acquiring company s financial statements at the cost to the acquiring company. (paragraph.07) Where the purchase method is used to account for the combination, the cost of the purchase to the acquiring company would be determined by the fair value of the consideration given. Fair value is the amount of the consideration that would be agreed upon in an arm s length transaction between knowledgeable willing parties who are under no compulsion to act. (paragraph.25) Where shares are issued, the cost of the purchase will be the fair value of such shares. (paragraph.26) In accounting for a purchase effected by issuing shares, it may be appropriate to use the quoted market price of shares traded in the market, after recognizing the possible effects of price fluctuations, quantities traded, issue costs and similar items, in order to establish the fair value of such shares. The market price for a reasonable period before and after the date of acquisition should be considered in determining the fair value of the shares issued. (paragraph.27) If the quoted market price (as adjusted, where appropriate) is not indicative of the fair value of the shares issued, or the fair value of the shares issued is not otherwise clearly evident, the fair value of the net assets acquired should be determined for the business as a whole, including tangible and intangible assets and liabilities, and the cost of purchase would then be calculated by applying the percentage of the equity acquired to that fair value. The valuation would necessitate reference to all aspects of the acquisition, including factors entering into the negotiations, and independent appraisals may be used as an aid in determining such fair value. (paragraph.28) Where the purchase method is used to account for the combination, the cost of the purchase to the acquiring entity should be determined by the fair value of the consideration given, except as specified in Non- Monetary Transactions, paragraph (paragraph.29) A business combination agreement may provide for the issuance or payment of additional consideration contingent on specified events or transactions in the future. (paragraph.30) Where the amount of contingent consideration can be reasonably estimated at the date of acquisition and the outcome of the contingency can be determined beyond reasonable doubt, it should be recorded at that date as part of the cost of the purchase. Where the amount of contingent consideration or the outcome of the contingency cannot be UIG Issue Summary 01/3 Fair Value of Equity Instruments Issued as Purchase Consideration (Final, 28/9/01) 12

14 determined beyond reasonable doubt, details of the contingency should be disclosed in a note to the financial statements; when the contingency is resolved, the consideration should be recorded as an additional cost of the purchase. (paragraph.33) (ix) The cost of the purchase and amounts assigned to assets acquired and liabilities assumed would be determined as of the date of acquisition, which is either: a. the date on which the assets are received and the consideration is given; or b. the date of a written agreement, or a later date designated therein, which provides that control of the acquired company is effectively transferred to the acquiring company on that date, subject only to those conditions required to protect the interests of the parties involved. Where an effective date is designated for accounting purposes, it will be necessary to reduce both the cost of the purchase and net income of the acquirer from the effective date of acquisition by interest imputed at an appropriate current rate for the period from the effective date of acquisition to the date on which the consideration is given. (paragraph.39) (x) The cost of the purchase and the amounts assigned to assets acquired and liabilities assumed should be determined as of the date of the acquisition. (paragraph.40) Emerging Issues Committee Abstract EIC-62 Measurement of Cost of a Business Acquisition Effected by Issuing Shares (March 1995) The Committee reached a consensus that an entity which issues its own shares as consideration in a business acquisition should measure the cost of the acquisition at fair value. An issue of shares in exchange for a business is not a non-monetary exchange as contemplated by CICA The fact that entities may operate in the same line of business, using similar productive assets, is not relevant in determining the cost of the acquisition. (c) Emerging Issues Committee Abstract EIC-76 Fair Value of Shares Issued as Consideration in a Purchase Business Combination (November 1996) The Committee reached a consensus that the acquirer should use quoted market prices for the class of shares issued in the business combination as the basis for determining the fair value of the shares issued unless: the market for the class of shares issued is inactive or illiquid; or UIG Issue Summary 01/3 Fair Value of Equity Instruments Issued as Purchase Consideration (Final, 28/9/01) 13

15 the shares issued to effect the business combination are subject to significant restrictions preventing them from being traded for some time following their issuance. Quoted market prices are indicative of the fair value of shares actively traded in a liquid market and would be used on the basis described in the second issue in this Abstract. When the class of shares issued by the acquirer is not actively traded in a liquid market, refer to the guidance in CICA In each transaction, it is a matter of judgement whether the acquirer s shares are actively traded in a liquid market. Active, liquid markets for shares are normally found only in stock exchanges and in some organized over-the-counter markets. Quoted market prices for a class of shares may not be representative of the fair value of shares issued subject to a significant restriction, such as an escrow arrangement, that prevents them from being traded for some time following their issuance. (ii) The Committee reached a consensus that, when the market for the class of shares issued to effect a purchase business combination is active and liquid and the shares issued are not subject to significant restrictions preventing them from being traded for some time following their issuance, the acquirer should determine the fair value of the shares by: establishing an average of quoted market prices for shares of the same class over a reasonable period before and after the date of acquisition; and reducing the average quoted market price of the shares for the transaction costs incurred to issue them. The acquirer would not make other types of adjustment to quoted market prices in determining the fair value of its shares. Transaction costs that may be incurred to issue shares commonly include fees and commissions paid to underwriters, dealers and agents, levies by regulatory agencies and stock exchanges, and taxes and duties. The acquirer would reduce the average quoted market price of its shares by the costs incurred to issue them. The acquirer may further reduce the average quoted market price by other transaction costs normally incurred when issuing shares for cash but avoided in the business combination. The Committee noted that, when an acquirer in a business combination offers all sellers a substantially equivalent choice of shares or cash consideration, the cash price per share would establish the fair value of the acquirer s shares issued. UIG Issue Summary 01/3 Fair Value of Equity Instruments Issued as Purchase Consideration (Final, 28/9/01) 14

16 11. United Kingdom Financial Reporting Standard FRS 7 Fair Values in Acquisition Accounting (September 1994) (ii) The recognised assets and liabilities should be recognised at fair values that reflected the conditions at the date of acquisition. (paragraph 6) the following do not affect the fair values at the date of acquisition and therefore fall to be treated as post acquisition items a. changes resulting from the acquirer s intentions or future actions (paragraph 7) (iii) (iv) (v) The cost of acquisition is the amount of cash paid and the fair value of other purchase consideration given by the acquirer, together with the expenses of the acquisition as described in paragraph 28. Where a subsidiary undertaking is acquired in stages, the cost of acquisition is the total of the costs of the interests acquired, determined as at the date of each transaction. (paragraph 26) Where the amount of purchase consideration is contingent on one or more future events, the cost of acquisition should include a reasonable estimate of the fair value of amounts expected to be payable in the future. The cost of acquisition should be adjusted when revised estimates are made, with consequential corresponding adjustments continuing to be made to goodwill until the ultimate amount is known. (paragraph 27) In order to apply the requirements of the FRS, it is necessary to determine the fair values of the constituent parts of the purchase consideration. The purchase consideration may comprise: a. cash or other monetary items, including the assumption of liabilities by the acquirer; b. capital instruments issued by the acquirer, including shares, debentures, loans and debt instruments, share warrants and other options relating to the securities of the acquirer; or c. non-monetary assets, including securities of another entity. (paragraph 76) (vi) Where shares (and other capital instruments) issued by the acquirer are quoted on a ready market, the market price on the date of acquisition would normally provide the most reliable measure of fair value. Where control is transferred by a public offer, the relevant date is the date on which the offer or, where there is a series of revised offers, the successful offer becomes unconditional, usually as a result of a sufficient number of acceptances being received. Where, owing to unusual fluctuations, the market price on one particular date is an UIG Issue Summary 01/3 Fair Value of Equity Instruments Issued as Purchase Consideration (Final, 28/9/01) 15

17 unreliable measure of fair value, market prices for a reasonable period before the date of acquisition, during which acceptances could be made, would need to be considered. (paragraph 78) (vii) Where securities issued by the acquirer are not quoted or, if they are quoted, the market price is unreliable owing, for example, to the lack of an active market in the quantities involved, it would be necessary to make a valuation of those securities. The fair value would be estimated by taking into account items such as: a. the value of similar securities that are quoted; b. the present value of the future cash flows of the instrument issued; c. any cash alternative to the issue of securities; and d. the value of any underlying security into which there is an option to convert. (viii) (ix) (x) Where it is not possible to value the consideration given by any of the above methods, the best estimate of its value may be given by valuing the entity acquired. (paragraph 79) The terms of an acquisition may provide that the value of the purchase consideration, which may be payable in cash, shares or other securities at a future date, depends on uncertain future events, such as the future performance of the acquired company. An example is an earn-out, where consideration payable to the vendor takes the form of an initial payment, together with further payments based on a multiple of future profits of the acquired company. By its nature, the fair value of such contingent consideration cannot be determined precisely at the date of acquisition. The FRS requires that the cost of acquisition should include a reasonable estimate of its fair value. Where it is not possible to estimate the total amounts payable with any degree of certainty, at least those amounts that are reasonably expected to be payable would be recognised. Initial estimates would be revised as further and more certain information becomes available. (paragraph 81) Where contingent consideration is to be satisfied by the issue of shares, there is no obligation to transfer economic benefits and, accordingly, amounts recognised would be reported as part of shareholders funds, for example as a separate caption representing shares to be issued. In the analysis of shareholders funds, amounts would be attributed to equity and non-equity interests depending on the nature of the shares to be issued, in accordance with FRS 4 Capital Instruments. When the shares are issued, appropriate transfers would be necessary between any amounts then held in shareholders funds in respect of their issue and called up share capital and share premium. (paragraph 82) UIG Issue Summary 01/3 Fair Value of Equity Instruments Issued as Purchase Consideration (Final, 28/9/01) 16

18 12. International Accounting Standards Board International Accounting Standard IAS 22 Business Combinations (July 1998) (ii) (iii) (iv) An acquisition should be accounted for at its cost, being the amount of cash or cash equivalents paid or the fair value, at the date of exchange, of other purchase consideration given by the acquirer in exchange for control over the net assets of the other enterprise, plus any costs directly attributable to the acquisition. (paragraph 21) In determining the cost of the acquisition, marketable securities issued by the acquirer are measured at their fair value which is their market value as at the date of the exchange transaction, provided that undue fluctuations or the narrowness of the market do not make the market price an unreliable indicator. When the market price on one particular date is not a reliable indicator, price movements for a reasonable period before and after the announcement of the terms of the acquisition need to be considered. When the market is unreliable or no quotation exists, the fair value of the securities issued by the acquirer is estimated by reference to their proportional interest in the fair value of the acquirer s enterprise or by reference to the proportional interest in the fair value of the enterprise acquired, whichever is the more clearly evident. Purchase consideration which is paid in cash to shareholders of the acquiree as an alternative to securities may also provide evidence of the total fair value given. All aspects of the acquisition, including significant factors influencing the negotiations, need to be considered, and independent valuations may be used as an aid in determining the fair value of securities issued. (paragraph 24) When the acquisition agreement provides for an adjustment to the purchase consideration contingent on one or more future events, the amount if the adjustment should be included in the cost of the acquisition as at the date of acquisition if the adjustment is probable and the amount can be reliably measured. (paragraph 65) The cost of acquisition should be adjusted when a contingency affecting the amount of the purchase consideration is resolved subsequent to the date of the acquisition, so that the payment of the amount is probable and a reliable estimate of the amount can be made. (paragraph 68) Standing Interpretations Committee Draft Interpretation SIC D28 Business Combinations Measurement of Shares Issued as Purchase Consideration (July 2001) When an acquisition is achieved in one exchange transaction, the date of exchange should be the date of acquisition; that is, the date when the acquirer obtains control over the net assets and operations of the acquiree. When an acquisition is achieved in stages (e.g., successive share purchases), the fair value of the shares issued as UIG Issue Summary 01/3 Fair Value of Equity Instruments Issued as Purchase Consideration (Final, 28/9/01) 17

19 purchase consideration should be determined at the date that each exchange is recognised. (paragraph 4) (ii) The published price of a share in an active market at the date of exchange should be considered the best evidence of the share s fair value. Another price should be used only if it can be demonstrated that a price fluctuation is undue, and the other price provides a more reliable measure of the share s fair value. (paragraph 5) (d) Analysis of Issues How should the fair value of purchase consideration be determined? 13. Alternative views have developed as to how the fair value of purchase consideration should be determined in the context of an acquisition where the purchase consideration is satisfied through the issue of equity instruments: (c) View 1: The fair value of purchase consideration should be determined based on the fair value of the assets acquired. View 2: The fair value of purchase consideration should be determined based on the fair value of the equity instruments issued. View 3: Either approach is acceptable, depending on whether, in practice, the fair value of the assets acquired or the equity instruments issued is more readily determinable. View Supporters of this view argue that the valuation of purchase consideration based on the fair value of assets acquired reflects the economic substance of the transaction. Supporters state that in an acquisition not involving cash, the fair value of the equity instruments issued may not be readily determinable and may change over time, as a result of many factors not associated with the acquisition, for example, changes in economic outlook, changes in demand for the entity s product or changes in the performance of the entity itself. Supporters of this view suggest that, for these reasons, the fair value of the assets acquired is the most reliable measure of purchase consideration. 15. For example, supporters of this approach believe that if the shares of the acquirer (Company X) are listed and trading at $15 at the time the terms of the acquisition are agreed to and announced to the market and the vendor is willing to accept 3,000,000 Company X shares for the sale of 100% of Company Y (or $45 million), the fact that Company X s shares increase to $20 between the date of agreement and announcement and completion of the transaction following, for example, receipt of regulatory approval, does not mean that the fair value of Company Y is now $60 million. View Supporters of this view would measure the fair value of the purchase consideration based on the fair value of the acquirer s shares issued. They contend that the value of UIG Issue Summary 01/3 Fair Value of Equity Instruments Issued as Purchase Consideration (Final, 28/9/01) 18