Preliminary Exposure Draft of International Actuarial Standard of Practice A Practice Guideline* under International Financial Reporting Standards IFRS [2005] A Preliminary Exposure Draft of the Subcommittee on Actuarial Standards of the Committee on Insurance Accounting International Actuarial Association / Association Actuarielle Internationale Distributed on [November 306, 20056] Comments to be sent to katy.martin@actuaries.org by [March 30, 20057] *Practice Guidelines are educational and non-binding in nature. They represent a statement of appropriate practices, although not necessarily defining uniquely practices that would be adopted by all actuaries. They are intended to familiarise the actuary with approaches that might appropriately be taken in the area in question. They also serve to demonstrate to clients and other stakeholders and to non-actuaries who carry out similar work how the actuarial profession expects to approach the subject matter.
Preliminary Exposure Draft November 16, 20056 This Practice Guideline applies to an actuary only under one or more of the following circumstances: If the Practice Guideline has been endorsed by one or more IAA Full Member associations of which the actuary is a member for use in connection with relevant International Financial Reporting Standards (IFRSs); If the Practice Guideline has been formally adopted by one or more IAA Full Member associations of which the actuary is a member for use in connection with local accounting standards or other financial reporting requirements; If the actuary is required by statute, regulation, or other binding legal authority to consider the Practice Guideline for use in connection with IFRS or other relevant financial reporting requirements; If the actuary represents to a principal or other interested party that the actuary will consider the Practice Guideline for use in connection with IFRS or other relevant financial reporting requirements; or If the actuary s principal or other relevant party requires the actuary to consider the Practice Guideline for use in connection with IFRS or other relevant financial reporting requirements.
Table of Contents 1. Scope... 1 2. Publication Date... 1 3. Background... 1 4. Practice Guideline... 2 4.1 Accounting for business combinations general process... 2 4.2 Step 1 Determine the nature of the business combination... 2 4.3 Step 2 Apply accounting guidance for business combinations outside the scope of IFRS 3... 3 4.3 1 Joint ventures... 3 4.3.2 Combinations of businesses under common control... 4 4.3.3 Combinations involving two or more mutual entities... 4 4.3.4 Combinations by contract only... 4 4.4 Step 3 Apply IFRS 3 to business combinations within scope... 4 4.5 Step 4 Measure the cost of the business combination... 5 4.6 Step 5 Allocate the cost of the business combination... 5 4.6.1 Intangible assets... 6 4.6.2 Goodwill... 9 4.6.3 Deferred taxes... 10 4.6.4 Shadow accounting... 10 4.6.5 Contingent liabilities... 10 4.6.5 Contingent liabilities... 10 Appendix A Relevant IFRSs... 14 Appendix B List of terms defined in the Glossary... 15 1. Scope... 1 2. Publication Date... 1 3. Background... 1 4. Practice Guideline... 2 4.1 Accounting for business combinations general process... 2 4.2 Step 1 Determine the nature of the business combination... 2 4.3 Step 2 Apply accounting guidance for business combinations outside the scope of IFRS 3... 3 4.3 1 Joint ventures... 3 4.3.2 Combinations of businesses under common control... 4 4.3.3 Combinations involving two or more mutual entities... 4 4.3.4 Combinations by contract only... 4 4.4 Step 3 Apply IFRS 3 to business combinations within scope... 4 4.5 Step 4 Measure the cost of the business combination... 5 4.6 Step 5 Allocate the cost of the business combination... 5 4.6.1 Intangible assets... 6 4.6.2 Goodwill... 7 4.6.3 Deferred taxes... 7
4.6.4 Shadow accounting... 7 4.6.5 Contingent liabilities... 7 Appendix A Relevant IFRSs... 10 Appendix B List of terms defined in the Glossary... 11 Page 1
1. Scope The purpose of this PRACTICE GUIDELINE (PG) is to give advisory, non-binding guidance that ACTUARIES may wish to take into account when providing PROFESSIONAL SERVICES in accordance with INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRSs) concerning accounting values relating to INSURANCE CONTRACTS, INVESTMENT CONTRACTS, or SERVICE CONTRACTS issued by REPORTING ENTITIES in-force at the time of a business combination. This PG addresses professional services related to the accounting for business combinations involving insurance contracts, investment contracts, service contracts, and other FINANCIAL INSTRUMENTS for purposes of preparation or review of FINANCIAL STATEMENTS prepared in accordance with the IFRSs. This PG applies where the reporting entity is an INSURER, a CEDANT, an ISSUER, or a provider of services. It is limited to the practices that relate to the accounting for rights and obligations acquired in business combinations. Reliance on information in this PG is not a substitute for meeting the requirements of the relevant IFRSs. Practitioners are therefore directed to the relevant IFRSs (see Appendix A) for authoritative requirements. The PG refers to IFRSs that are effective as of XX XXXXX, 2006, as well as to amended IFRSs not yet effective as of XX XXXXX 2006 but for which earlier application is made. If IFRSs are amended after that date, actuaries should refer to the most recent version of the IFRS. 2. Publication Date This PG was published on [date approved by the Council of the INTERNATIONAL ASSOCIATION OF ACTUARIES (IAA)]. 3. Background Mergers and acquisitions are a regular occurrence in all business sectors, including insurance and financial services. The accounting requirements for such business combinations differ from the requirements for ongoing business activity. A separate accounting standard (INTERNATIONAL FINANCIAL REPORTING STANDARD (IFRS) 3, ) has been developed to address the specific situations of a business combination. Further guidance useful in accounting for insurance contracts involved in a business combination can be found in other IFRSs. The PG sets forth the considerations a PRACTITIONER may wish to consider when asked to provide services related to the accounting for business combinations. In performing these services, the practitioner would usually consult several IFRSs including, but not limited to, the following: 1. IFRS 3, provides guidance for determining a business combination Page 1
and how to apply the purchase accounting method including the treatment of goodwill. It also provides guidance regarding disclosure requirements. 2. IFRS 4, Insurance Contracts provides guidance for accounting for insurance contracts in a business combination. 3. INTERNATIONAL ACCOUNTING STANDARD (IAS) 38, Intangible Assets provides guidance for determining whether to recognise, how to measure, and what to disclose for intangible assets that are not specifically dealt with in other accounting standards. 4. IAS 18, Revenue - provides FINANCIAL REPORTING requirements for revenue from rendering services. 4. Practice Guideline 4.1 Accounting for business combinations general process This section outlines the general process for accounting for business combinations under INTERNATIONAL ACCOUNTING STANDARDS BOARD (IASB) accounting guidance. Later sections will present considerations regarding each step of the process. While there are some exceptions, the general process normally includes the following steps: 1. Determine the nature of the business combination; 2. Apply accounting guidance for business combinations outside the scope of IFRS 3; 3. Apply IFRS 3 to business combinations within scope; 4. If IFRS 3 applies, measure the COST of the business combination; and 5. If IFRS 3 applies, allocate the cost of the business combination. 4.2 Step 1 Determine the nature of the business combination IFRS 3 provides accounting guidance for business combinations. IFRS 3 defines a business combination as the bringing together of separate entities or businesses into one reporting entity. The result of nearly all business combinations is that one entity, the acquirer, obtains control of one or more other businesses of the acquiree (IFRS 3.4). Certain types of business combinations are excluded from the scope of IFRS 3 (see IFRS 3.3). In order to determine if IFRS 3 or some other accounting guidance applies in a particular case, the nature of the business combination is analysed. IFRS 4, Insurance Contracts, provides additional guidance regarding acquisitions involving insurance liabilities and insurance assets. Specifically, it allows expanded presentation of the value of acquired CONTRACTS and exempts certain intangible assets from the scope of IAS 36 and IAS 38. Page 2
In addition, IFRS 4 identifies acquisitions of portfolios of insurance contracts as qualifying for the expanded presentation (see IFRS 4.32). IFRS 3 states that if an entity acquires a group of assets or net assets that does not constitute a business, it shall allocate the cost of the group between the individual identifiable assets and liabilities in the group based on their relative FAIR VALUES at the acquisition date (IFRS 3.4). Thus, the accounting treatment for an acquisition of a portfolio of contracts is essentially the same as for a business combination. As a portfolio of insurance contracts is not defined, the practitioner must consider what constitutes an acquisition of a portfolio of contracts. The following are necessary conditions for defining a transaction as falling within the scope of IFRS 3: 1. The transaction must involve a group or portfolio of contracts; and 2. Control over the portfolio must be obtained as a result of the transaction. The addition of multiple contracts to an entity s book of business in a single transaction may not be sufficient to qualify as a business combination. Many believe the act of issuing contracts would not be considered an acquisition or a business combination. They believe, for example, the issuance of several individual contracts to a single owner, such as in the case of corporate-owned life insurance, would not be considered a business combination. They believe a business combination involves the transfer of contracts that have already been issued, although it may also include the right to issue future contracts using the same distribution system of the purchased block; any values directly associated with such contracts are not reflected in the liabilities or other values other than identifiable intangibles associated with the business combination. Many believe purchases of individual contracts in a secondary market (e.g., viatical settlements) would not be considered acquisitions. Portfolios consist of multiple contracts. Transfer of a block of business from one entity to another entity may be considered an acquisition of a portfolio of contracts if the acquirer obtains control of those contracts. Many believe an acquisition is distinct from reinsurance in that in the former case an entity has control over all aspects of contracts that are acquired, whereas in the latter case an entity has at best limited control over contracts that have been reinsured. In the case of reinsurance, the ceding entity does not derecognise the obligations. 4.3 Step 2 Apply accounting guidance for business combinations outside the scope of IFRS 3 This section describes the types of transactions that fall outside the scope of IFRS 3. 4.3.1 Joint ventures Page 3
IAS 31 defines a JOINT VENTURE as a contractual arrangement whereby two or more parties undertake an economic activity that is subject to joint control. IAS 31 also states, A group of individuals shall be regarded as controlling an entity when, as a result of contractual arrangements, they collectively have the power to govern its financial and operating policies so as to obtain benefits from its activities (IFRS 3.11). Thus, if control is gained by two or more entities, the transaction falls outside the scope of IFRS 3 and IAS 31 applies. 4.3.2 Combinations of businesses under common control This section presents considerations for accounting for combinations of businesses under common control. A business combination involving entities or businesses under common control is a business combination in which all of the combining entities or businesses are ultimately controlled by the same party or parties both before and after the business combination, and that control is not transitory (IFRS 3.10). A business combination where each combining entity is controlled by the same individual or group of individuals is not considered to be a business combination for the consolidated group and therefore would not be within the scope of affected by IFRS 3. 4.3.3 Combinations involving two or more mutual entities This section presents considerations for accounting for combinations involving two or more mutual entities. [These combinations are currently outside the scope of IFRS 3. This section will be updated as appropriate if the IASB makes changes to an IFRS as a result of its current exposure draft on this subject.] 4.3.4 Combinations by contract only This section presents considerations for the determination and classification of DISCRETIONARY PARTICIPATION FEATURES in insurance and investment contracts. [These combinations are currently outside the scope of IFRS 3. This section will be updated as appropriate after the IASB takes action on its current exposure draft on this subject.] 4.4 Step 3 Apply IFRS 3 to business combinations within scope This section presents considerations for applying IFRS 3 to business combinations within Page 4
its scope. IFRS 3 requires the purchase method of accounting to be applied to business combinations within its scope. The purchase method has three primary steps: 1. Identify the acquirer; 2. Measure the cost of the business combination; and 3. Allocate the cost to the assets acquired and liabilities and contingent liabilities assumed. Identifying the acquirer is typically not an actuarial function. No further guidance is provided here. The sections that follow provide guidance on measuring and allocating the cost of a business combination. 4.5 Step 4 Measure the cost of the business combination The cost of a business combination is measured as the aggregate of the fair values, at the date of exchange, of assets given, liabilities incurred or assumed, and equity instruments issued by the acquirer, in exchange for control of the acquiree; plus any costs directly attributable to the business combination (IFRS 3.24). IFRS 3 gives examples of costs that may be directly attributable to a business combination. These include professional fees paid to accountants, legal advisors, valuation specialists, and other consultants (see IFRS 3.29). IFRS 3 also gives examples of costs that are normally not considered directly attributable to a business combination (see IFRS 3.29 31). These include the following: 1. General administrative costs such as the cost of maintaining an acquisition department; and 2. Costs of issuing financial instruments to effect a business combination. Some business combinations include an adjustment to the purchase price for future events. These adjustments can be included in the cost of the business combination if the adjustment is probable and can be measured reliably. 4.6 Step 5 Allocate the cost of the business combination IFRS 3 requires the liabilities assumed and the assets acquired in a business combination to be measured at fair value. IFRS 4 allows an entity to report the fair value of the acquired contractual assets and liabilities in two COMPONENTS: Page 5
1. A liability measured according to its current ACCOUNTING POLICY; and 2. An intangible asset representing the difference between the fair value and the liability measured on the current accounting policy (see IFRS 4.31). At acquisition, consideration is given as to whether any deferred ACQUISITION COST (DAC) asset and any unearned revenue liability derived from front-end loads should be released. Consideration is also given to whether liabilities should be established for accrued bonuses. 4.6.1 Intangible assets IFRS 3.36 requires the acquirer to allocate the cost of a business combination by recognizing the acquired identifiable assets, liabilities and contingent liabilities at their fair value as of the acquisition date if they satisfy certain recognition criteria. IFRS 3.37 states that for intangible assets the criteria is that its fair value can be measured reliably. IFRS 3.45 clarifies that in order for an intangible asset to be separately recognized it must both (A) meet the definition of an intangible asset in IAS 38 Intangible Assets and (B) its fair value can be measured reliably. If the asset does not meet both of the criteria it cannot be separately recognized and any associated value would be included in any residual value (positive or negative) of the total cost less the net fair value of the identifiable assets, liabilities and contingent liabilities recognized at acquisition. IFRS 3.46 repeats the identifiability criterion from IAS 38: An intangible asset: (A) is separable, i.e., capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, asset or liability; or (B) arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations. Several intangible assets could arise from a business combination involving contracts issued by insurers. These include, but are not limited to: Value of in-force policies Renewal periods for short-duration contracts Distribution systems or relationships Service agreements Brand names, trademarks, and copyrights Proprietary software or technology Customer relationships Licenses to transact insurance business Page 6
Product approvals and registrations Value of In-force Often the most significant intangible asset recorded as a result of a business combination is the right to the future net cash flows arising from the acquriedacquired in-force book of policies. It is common to report this asset separately. IFRS 4.31 states that to comply with IFRS 3 an insurer shall, at the acquisition date, measure at fair value the insurance liabilities assumed and insurance assets acquired in a business combination. The fair value of the insurance liabilities and insurance assets would include the value of the contractual rights and obligations acquired including the right to any future net cash flows arising from those rights and obligations. IFRS 4.31 allows an expanded presentation of the fair value into two components: the value of the contractual rights and obligations acquired according to the entity s current accounting policy and an intangible asset equal to the difference between the fair value and the value of the first component. The second component is sometimes referred to as the present value of in-force (PVIF), present value of future profits (PVFP) or value of business acquired (VOBA). IFRS 4.33 excludes the intangible asset allowed under the expanded presentation from the scope of IAS 36, Impairment of Assets, and IAS 38 Intangible Assets. The exclusion from IAS 38 was prompted by the amortization methods currently being used for this asset. Some insurers use an interest method of amortization which would not be allowable under IAS 38. The IASB decided to allow continuation of methods currently in use and remove this intangible from the scope of IAS 38. Other intangibles, however, are within the scope of IAS 38. IFRS 4.17 states that the minimum liability adequacy test shall be based on the carrying amount of the relevant insurance liabilities less, any deferred acquisition costs and any related intangible assets acquired in a business combination or portfolio transfer, and to the extent the carrying amount is less than the minimum required liability, reduce the deferred acquisition cost asset or intangible asset accordingly. Thus, the IASB has made the intangible asset related to the value of future net cash flows subject to the loss recognition test of the insurance liability, and consequently exempted the intangible from the requirements of IAS 36. Amortization of the value of future profits is generally in proportion to projected distributable profits from the underlying business. Value of Renewal Periods for Short-Duration Contracts A common situation in non-life insurance is the establishment of in intangible asset related to the value of potential renewals of short-duration contracts. Page 7
Generally, the fair value would be based on the distributable earnings discounted at a market discount rate commensurate with the risk of the cash flows. Two methods for amortization that have been used are 1) in relation to expected distributable earnings used to derive the fair value estimate and 2) based on expected premiums from future renewals. Value of Distribution Systems/Relationships The value associated with a distribution system can be significant especially for distribution arrangements involving contingent commissions and business processing. Fair values of such systems can be derived from cash flow models and from valuation specialists. Amortization methods used include 1) in relation to expected distributable earnings, and 2) proportional to new business premiums. Service Agreements When an acquiree has entered into third-party contracts for various services like claims administration or to provide such services the acquirer needs to consider whether an intangible asset might exist. Due consideration of whether the terms of such agreements are at, below or above current market rates, need to be given. Amortization methods used for such intangibles include 1) in relation to the net revenue (fees charged less costs to provide the service) earned for providing the service and 2) on a straight line basis over the contract period. Brand Names, Trademarks, Copyrights The entity being acquired may have a legal right to certain identifying names, slogans, logos, etc. which would qualify for separate recognition as intangible assets. Identifying the additional cash flows associated with such items may prove difficult. Amortization would likely be based on the projected cash flows used to estimate the fair value. However, some legal rights may be renewable indefinitely leading to the conclusion that the intangible should not be amortized. Proprietary Software or Technology Some insurers have developed expert systems that could be separately recognized as having value. Such systems may be in the area of underwriting, distribution/cross selling, investment management and others. Valuation of such systems is likely to be straight line over an assumed lifetime of the system. Licenses to Transact Insurance Business Licenses typically do not expire and thus have an unlimited lifetime. Their value is typically derived from market transactions for shell companies or from brokers in that market. Product Approvals or Registrations Product forms that have been approved for issue in certain jurisdictions can be determined to be intangible assets. The value could be viewed as the alternative cost to develop the same product and go through the approval process. Page 8
Alternatively the value could be viewed as something more if the product is in a niche market with limited access. Amortization of the value could be based on the anticipated revenues expected from the sales of the new product. IFRS 3.37 requires intangible assets to be recognized if it is probable that any associated future economic benefits will flow to the acquirer, and its fair value can be measured reliably. IFRS 3.46 further notes, a non-monetary asset without physical substance must be identifiable to meet the definition of an intangible asset. In accordance with IAS 38, an asset meets the identifiability criterion in the definition of an intangible asset only if it: (a) is separable, ie capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, asset or liability; or (b) arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations. Several intangible assets could arise from the purchase of contracts issued by insurers. Among these are value of in-force, brand name, proprietary data, and distributor relationships. IFRS 4 requires the fair value of insurance liabilities and insurance assets be determined at acquisition. It allows an expanded presentation of the fair value into two components: the value of the business acquired according to the entity s current accounting policy and an intangible asset equal to the difference between the fair value and value of the first component. Subsequent measurement of the intangible asset is to be consistent with the measurement of the related insurance liability (IFRS 4.31(b)). In practice, the intangible asset is often amortised over the estimated life of the related contract cash flows. Various methods have been used to amortise the intangible asset, not all of which would comply with the requirements of IAS 38, Intangible Assets. Therefore, IFRS 4 exempts the intangible asset from the scope of IAS 38. IFRS 4 requires the intangible asset be subject to the LIABILITY ADEQUACY TEST (see IFRS 4.15). As it is included in this test, the intangible asset does not need to be tested separately and, therefore, has been excluded from the scope of IAS 36 (see IFRS 4.33). Further guidance on the liability adequacy test is provided in the practice guideline on that subject. 4.6.2 Goodwill IFRS 3 requires the acquirer to recognise goodwill acquired in a business combination as an asset; and initially measure that goodwill at its cost, being the excess of the cost of the business combination over the acquirer s interest in the net fair value of the identifiable assets, liabilities and contingent liabilities ( IFRS Page 9
3.51). Identifiable assets here include those intangible assets which have been recognised in connection with the acquisition. The value of goodwill does not need to be justified but is subject to tests of impairment. The goodwill carrying amount must be tested annually for impairment in accordance with the requirements of IAS 36, Impairment of Assets (IFRS 3.55). If the excess is negative, goodwill is set to zero by recognising difference directly in income (IFRS 3.56). Goodwill represents a payment made by the acquirer in anticipation of future economic benefits from assets that are not capable of being individually identified or reliably measured and separately recognised. Goodwill is not amortised. Goodwill is to be measured subsequently at cost less any accumulated impairment losses. The goodwill carrying amount must be tested annually for impairment in accordance with the requirements of IAS 36, Impairment of Assets (IFRS 3.55). 4.6.3 Deferred taxes Any prior deferred tax liability/asset is eliminated and replaced by a similar liability/asset for the tax effect of the deferred tax consequences of temporary differences between the tax basis of the insurance entity s assets and liabilities and the IFRS reporting basis. The primary temporary differences relate to asset valuation, in-contract and claims liabilities, and the difference between the intangible asset and the tax basis of the value of business acquired. 4.6.4 Shadow accounting If the value of the intangible asset depends in part on the value of other assets or liabilities, shadow accounting may be applicable. 4.6.5 Contingent liabilities Contingent liabilities can must be recognised in a business combination if they can be measured reliably (see IFRS 3.37). 4.6.6 Fair Value of Liabilities and the Value of Intangible Assets IFRS 4 does not prescribe a technique of the determination of the fair value of insurance-contract liabilities. Absent specific guidance, entities follow general guidance and common practices. The definition of fair value, the amount for which liabilities could be settled, is generally construed to the price that would be paid to transfer the obligations relating to a portfolio of contracts to a third party insurer. Guidance found in IAS 39, although insurance contracts are not in the scope of Page 10
IAS 39, is useful. It states that the fair value of financial instruments, when they are not traded in observable markets, is based on pricing techniques commonly used by market participants. It also calls for the greatest use of market inputs possible. Having just completed a transaction, the acquiring company is likely to have analyzed the cash flows and capital requirements of the in force contracts and to have made a determination of the value. Hence there may be information available from the analyses preformed while the transaction was negotiated which may form the basis for a fair value. Such analyses are often actuarial appraisals or embedded value calculations in which a value of in force is determined. The value of in force can be used for the intangible asset if The analysis is based on the liabilities using the methodology fund in the existing accounting policies, and The net liability, the gross liabilities less the value of in force, can be seen to be a fair value. To deem the calculated liability or the net liability fair value. While it makes no difference if the intangible asset is calculated directly or as the difference between the liability measured under exiting accounting policies and the fair value, the value should be calibrated to the extent possible with market information relating to transactions. For example, one technique for calculating the intangible asset is to discount the projected future margins expected to be released as the insurance contracts run out. future margins in the insurance liabilities. This calculation differs from common appraisal techniques that reduce value for the cost of capital. As transactions are generally trade at multiples of embedded values, the value of discounted margins may be greater lower that the amount that would be realized under current market conditions. Calculations of appraisal values and of embedded value involve practices that may not be permitted in the measurement of insurance liabilities after the IASB concludes Phase II of its Insurance Project and adopts a single prescribed methodology. Examples include anticipation of spreads to risk-free rates, consideration of future dividends or other indeterminate benefits that are not unavoidable obligations of the insurer, and consideration of future premiums when they are not required to maintain guaranteed insurability. Until the IASB adopts a new standard, there is no prohibition against using practices commonly found in the analysis of value related to transactions involving insurance contracts. The question sometimes arises whether the intangible asset should be grossed up for taxes. The asset may have been based on an analysis of after-tax cash flows and the entity may record a deferred tax liability related to the asset if it represents a difference in the timing of income between the IFRS-basis financial statements and the tax filings. The answer in the end depends again on whether Page 11
the net liability is in fact a fair value. If so, it represents the amount the entity would expect to pay to transfer its obligations and there is no need for a tax-adjustment. In this case allocating the liability between a liability that is not fair value and an intangible asset for the difference does not call for an adjustment to the asset for tax reasons. 4.7 Accounting for business combinations that occurred before the adoption of IFRS 3 Entities that have reported under IFRS before the adoption of IFRS 3 will have applied IAS 22,, to acquisitions with agreement dates before 31 March 2004 (previous combinations), the date set in IFRS 3 after which it must be applied. With the advent of IFRS 3, these entities have two possibilities. The first possibility is to apply IFRS 3 to previous combinations. This alternative can be elected if the valuation and other information needed to apply IFRS 3 were obtained at the time that the business combination was initially accounted for and if the entity applies IAS 36 and IAS 38 prospectively frorm that date. This guidance is found in IFRS 3.85 under limited retrospective application. If an entity does not make limited retrospective application of IFRS 3, it must nonetheless make some specific changes to accounting for previous combinations. These relate to goodwill and to intangible assets. Goodwill that relates to previous combinations is no longer amortised. Instead, the value on the adoption of IFRS 3 is retained and tested for impairment under the same guidance as goodwill from business combinations occurring after the adoption of IFRS 3. Previously recognised negative goodwill is eliminated by adjusting the opening balance of retained earnings (IFRS 3.79 and 3.81). Previously recognised intangible assets that do not qualify for recognition under IFRS 3 are reclassified as goodwill at the beginning of the first annual period beginning on or after 31 March 2004 (IFRS 3.82). Limited application of IFRS 3 to previous combinations does not exempt the contracts acquired from application of IAS 39 to financial instruments or application of IFRS 4 to insurance contracts and to financial liabilities with discretionary participation features. 4.8 Accounting for business combinations that occurred before the adoption of IFRS Entities adopting IFRSs for the first time must address the accounting for previous business combinations. Guidance is found in Appendix B of IFRS 1, First-time Adoption of International Financial Reporting Standards. IFRS 1 allows an entity to apply IFRS 3 to previous combinations. If IFRS 3 is not applied, presumably IAS 22 applies, as this is the standard that would have been in effect before the adoption of IFRS 3. However, Page 12
IFRS 1 does not require an entity to apply IAS 22. If an entity applies IFRS 3 to a previous combination, it must apply IFRS 3 to all later combinations. Earlier combinations can be on a different basis. When the entity does not apply IFRS 3, it can retain its existing approaches (pooling of interest, for example). The entity must nonetheless measure assets and liabilities according to applicable IFRSs, which may require an adjustment from existing practices. Any such adjustment in the measure of the asset or liability is a difference in retained earnings in the opening balance sheet on first-time adoption. For example, financial instruments must follow measurement principles of IAS 39 and insurance contracts must follow IFRS 4. Assets or liabilities that are recognised under existing practices, but would not be recognised under IFRSs, are excluded from the opening balance sheet on first-time adoption. The elimination of assets and liabilities from the opening balance sheet is made by an adjustment to goodwill. IFRS 1 allows entities to use the measurement of assets and liabilities at the acquisition date as the deemed cost of the asset or liability. The deemed cost need not conform to fair value measurement techniques under IAS 39 or to measurement approaches permitted under IAS 22. So, for example, the amortised cost of a financial liability acquired in a previous combination as of the conversion to IFRS is the present value of future cash flows, discounted at the effective rate of interest that would have been determined at the acquisition dates based on the estimated future cash flows at that date and the deemed cost as the initial value. An unresolved issue is whether the deemed cost of the liability is the gross liability or the liability net of the any intangible asset related to the financial liability. 4.9 Purchase intangible for the value of service rights A previous combination may have included financial instruments for which the service component has been separated for compliance with IFRSs, and there may have been an intangible purchase asset for the value of the contracts. In complying with IFRSs, as the service component is separate, the intangible purchase asset will likely be considered the deemed cost of the service contract. In this case, the value of the service component at the conversion date is the remaining unamortised amount of the asset, where cumulative amortisation is determined by the entity s accounting policy for amortisation of intangible assets associated with service components of financial liabilities, whether related to acquired contracts or not. Page 13
Appendix A Relevant IFRSs The most relevant International Financial Reporting Standards and International Accounting Standards for this practice guideline are listed below. IAS 1 (2001 April) Presentation of Financial Statements IAS 18 (2004 March) Revenue IAS 31 (2003 December) Financial Reporting of Interests in Joint Ventures IAS 32 (2003 December) Financial Instruments: Disclosure and Presentation IAS 36 (2004 March) Impairment of Assets IAS 38 (2004 March) Intangible Assets IAS 39 (2005 August) Financial Instruments: Recognition and Measurement IFRS 3 (2004 March) IFRS 4 (2005 August) Insurance Contracts In addition, the IASB Framework is relevant. Page 14
Appendix B List of terms defined in the Glossary The defined terms used in this practice guideline include the following, definitions for which are included in the Glossary. Accounting policy Acquisition cost Actuary Cedant Component Contract Cost Discretionary participation feature (DPF) Fair value Financial instrument Financial reporting Financial statements Insurance contract Insurer International Actuarial Association (IAA) International Accounting Standard (IAS) International Accounting Standards Board (IASB) International Financial Reporting Standard (IFRS) International Financial Reporting Standards (IFRSs) Investment contract Issuer Liability adequacy test Practice guideline (PG) Practitioner Professional services Reporting entity Service contract Page 15