Business Combinations under Common Control Accounting based on Current values vs Predecessor Values

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Gwendoline Barton
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1 Agenda Paper 5 Business Combinations under Common Control Accounting based on Current values vs Predecessor Values Staff of the Standard Setting Department, Hong Kong Institute of CPAs

2 Recap of previous discussions 2 We discussed Business Combinations under Common Control (BCUCC) at previous meetings AOSSG 2017 IFASS Understanding the conceptual rationale for the accounting for BCUCC 2017 AOSSG What's the premise for separate accounting methods for 3 rd party vs related party mergers & acquisitions 2018 H1 IFASS/ASAF The predecessor method how did it begin and how has it evolved HKICPA-OIC investor survey on economic substance of mergers & acquisitions 2018 H2 IFASS HKICPA-OIC experience in applying the predecessor method in Hong Kong and Italy

3 Involving transfer of a business Not involving transfer of a business Why we are looking at this 3 IASB tentatively set the scope of its BCUCC project as: Transactions under common control - BCUCC that are scoped-out of IFRS 3; and - other group restructurings, e.g. a new company issues shares to acquire one business under common control. IASB has so far considered and tentatively decided to apply the current value approach as the starting point of accounting for BCUCC when the receiving entity has non-controlling shareholders. Covered by other IFRS Standard Other transactions, e.g. group restructurings BCUCC scoped-out of IFRS3

4 Why we are looking at this (continued) 4 We would like to explore what factors should be considered when determining which measurement method is more appropriate for a BCUCC. BCUCC + other group restructurings Current value approach Factors When is a current value method or another method appropriate? Other measurement methods, e.g. predecessor method

5 Observed factors that could be considered 5 Conceptual Framework NCI % Feedback from outreach and discussions Published guidance on BCUCC 2. Nature of NCI 3. Listed vs Private 4. Economic substance 5. Measurement uncertainty

6 1. Consider NCI as a factor 6 NCI A P B IASB tentative decision Current value approach as a starting point C C P A C B C Other measurement alternatives?

7 1. Consider NCI as a factor (continued) 7 What we heard so far if the receiving entity has NCI: Primary users Noncontrolling shareholders What is useful information Current value approach would provide most useful information to non-controlling shareholders because: From the new reporting entity's perspective, there is a new business and a change in control. Current values provide information comparable with business combinations with third parties. Current values give the most recent information about the transferred entity. However, some think that the controlling party is a primary user and therefore their information needs should also be considered.

8 1. Consider NCI as a factor (continued) 8 What we heard so far if the receiving entity has no NCI: Primary users Controlling party Potential investors Lenders/ creditors What is useful information Prefer predecessor method because no change in control before and after the BCUCC and therefore current value is not relevant for decision making. not cost-beneficial to recognise fair value of the net assets acquired. Some are indifferent about the accounting method because investors have no existing interest in any of the combining entities at the time of combination. Some prefer alternative method (e.g. fresh-start) when reorganisations involve IPO and fresh investment. Indifferent about the accounting method because: finite credit interest in the receiving entity; focus more on the liquidity, cash flow and overall solvency of the receiving entity; and have other resources to assess the value of the business.

9 1. Consider NCI as a factor (continued) 9 49% Absolute NCI % 0% BCUCC + other group restructurings Significant NCI% Insignificant NCI% Current value approach better reflects the values exchanged. NCI tend to find current value more useful for decision-making. Is it worth applying a more costly method to meet the information needs of an insignificant NCI%? What is insignificant?

10 1. Consider NCI as a factor (continued) 10 What other jurisdictions say if the receiving entity has NCI: Apply predecessor values when Canada guidance for private entities Transferred business has <20% change in unrelated interest. The mere existence of NCI is not sufficient to warrant acquisition accounting given the costs to apply it. UK guidance for private entities 0% change in the NCI of the net assets of the group. Transfer is within a wholly-owned group. What we think when setting a quantitative factor: Clear requirement Ensure consistent application Difficult to determine the 'substantive' threshold Creates opportunities for structured transactions to meet the 'bright line'

11 2. Consider the nature of NCI as a factor 11 Information needs of NCI may depend on the nature of NCI: Unrelated third parties Institutional investors Private investors Related parties Close family members Key management personnel (as defined under IAS 24) General purpose financial statements are their key information source. They do not solely rely on general purpose financial statements. What we heard: If a BCUCC only affects NCI that are all related parties, it may not be cost-beneficial to apply the current value approach.

3. Consider listed vs private as a factor 12 Private company Private ownership In a traditional private group structure, power is usually concentrated in a few individual controlling related

12 3. Consider listed vs private as a factor 12 Private company Private ownership In a traditional private group structure, power is usually concentrated in a few individual controlling related shareholders, NCI are usually management or friends. Close-knit management and owner relationship may affect value exchanged in a restructured transaction. Public-listed company Equity interests are publicly traded. Relatively diversified ownership. Have incentives to maximise corporate value. Subject to listing rules and requirements.

13 3. Consider listed vs private as a factor (continued) 13 Should both private and listed entities apply the same measurement method for BCUCC? What we heard: View 1: Yes View 2 : No Information needs of primary users is the same and therefore a consistent accounting method for BCUCC regardless whether the entity is private or listed. Listed entities are more exposed to unrelated public investors, while private entities are not. Entities with a lot of unrelated investors may not have equal access to useful information.

14 4. Consider economic substance as a factor 14 A joint investor survey* findings indicated respondents considered that the substance of a BCUCC may not always be the same as a BC. For example, BCUCCs undertaken for the purpose of tax benefits are considered to have no commercial substance. Some preparers also expressed the same view during our outreach. Some investors considered that when a BCUCC has a different substance from a BC, a different accounting method should be used. *Note: Hong Kong and Italy standard-setting staff conducted a joint investor survey: how investor view the substance of BCUCC vs business combinations with third parties.

4. Consider economic substance as a factor (continued) Qualitative factors to assess whether a BCUCC has the same substance as a BC 15 Joint investors survey Canada guidance for

for the transferred entity is at fair market value Future cash flow of the receiving entity change significantly as a result of the transaction Consideration amount is supported by

15 4. Consider economic substance as a factor (continued) Qualitative factors to assess whether a BCUCC has the same substance as a BC 15 Joint investors survey Canada guidance for private entities Material change to the future cash flow of the receiving entity Material change expected on the profitability performance of the receiving entity Consideration paid for the transferred entity is at fair market value Future cash flow of the receiving entity change significantly as a result of the transaction Consideration amount is supported by independent evidence such as comparable quoted market values What we heard when setting a qualitative assessment: Principle based Judgment involved leading to potential diversity in practice

16 5. Consider measurement uncertainty as a factor Conceptual Framework of Financial Reporting Faithful Representation " When monetary amounts in financial reports cannot be observed directly and must instead be estimated, measurement uncertainty arises." A high level of measurement uncertainty does not necessarily prevent the use of a measurement basis that provides relevant information. However, in some cases the level of measurement uncertainty is so high that information provided by a measurement basis might not provide a sufficiently faithful representation. In such cases, it is appropriate to consider selecting a different measurement basis that would also result in relevant information.

17 5. Consider measurement uncertainty as a factor (continued) Should a different measurement basis be used to account for BCUCC when there is a high level of measurement uncertainty? Examples in other standards: IAS 38 IAS 40 If an intangible asset in a class cannot be revalued because there is no active market for this asset, the asset shall be carried at its last revalued amount less any accumulated amortisation and impairment losses. (IAS 38.82) An entity can reliably measure the fair value of an investment property on a continuing basis, except when the market is inactive and alternative reliable measurements of fair value are not available. (IAS 40.53) 17 IFRS 9 Removal of cost as measurement basis for equity instruments in IAS 39.46(c). Measurement at cost is not applicable to equity investments because cost provides little information with predictive value about the future cash flows arising from the financial instruments. (IFRS 9.BC )

18 5. Consider measurement uncertainty as a factor (continued) 18 However, there is another view that high measurement uncertainty also exists in business combinations with third parties why should this be a factor that leads to a different accounting method for BCUCC?

19 Staff observations and analysis 19 Information needs and cost-benefit incentives are different for NCI and the controlling party. Current value approach may not be relevant or cost beneficial for all BCUCC, e.g. When the receiving entity has little or no unrelated NCI When a BCUCC has a different substance from a BC When there is a high measurement uncertainty using the current value approach Need to consider all factors holistically to determine the appropriate measurement approach. Following a principle-based approach, determining the method of accounting should be based on a set of factors, not a defined scope (e.g. private group vs listed group)

20 Discussion points Would the factors identified help you determine the appropriate measurement approach for BCUCC? 2. Are there other factors you would consider when determining the measurement for BCUCC? 3. How would you apply the factors to determine the measurement approach for scenario 1 and 2 (slides 21 22)?

21 Scenario 1 21 NCI P 100% 100% A B 10% 20% 70% C D 100% D 100% Background C has a well-developed manufacturing base and sales channel. D has developed a prototype that is expected to be a 'game-changer' in the industry. C decides to buy 100% interest in D to expand its business (assume this is a business combination). Huge cash flow is expected when D's prototype is put to market in the next 3-5 years. C agrees to pay a consideration based on D's net assets. C believes it may be difficult to estimate the fair market value of D's prototype.

22 Scenario 2 22 P 100% 100% A B 30% 70% 100% C D 100% Background Same background as scenario 1, except that : C is owned by A and B with 30% and 70% interest respectively. No NCI in C. P plans to list C and D as a group after C acquires D. D IPO

Business Combinations under Common Control

IFRS Foundation IASB Business Combinations under Common Control Methods of accounting IASB Meeting - December 2017 Copyright IFRS Foundation. All rights reserved Disclaimer 2 This paper has been prepared