IFRS 3IFRS 3Business CombinationsBusiness Combinations

Mumbai, December 20, 2005P.R. RAMESH - Deloitte

AgendaAgenda

ScopeScope Application of the Purchase MethodApplication of the Purchase Method Revised IAS 38Revised IAS 38 Revised IAS 36Revised IAS 36 Valuation ConsiderationsValuation Considerations TransitionTransition Questions and AnswersQuestions and Answers

ScopeScope

Business CombinationBusiness Combination– Transaction where two or more entities or Transaction where two or more entities or

businesses are brought together to form a single businesses are brought together to form a single reporting entityreporting entity

BusinessBusiness Integrated set of activities and assets Integrated set of activities and assets

conducted and managed for the purposes of conducted and managed for the purposes of providingproviding

– A return to investors; orA return to investors; or– Lower costs or other economic benefits Lower costs or other economic benefits

directly and proportionately to shareholders.directly and proportionately to shareholders.

ScopeScope

Scope ExemptionsScope Exemptions– Business combinations in which separate Business combinations in which separate

entities or businesses form a joint ventureentities or businesses form a joint venture– Business Combinations involving entities or Business Combinations involving entities or

businesses under common controlbusinesses under common control– Business Combinations involving two or more Business Combinations involving two or more

mutual entitiesmutual entities– Business Combinations in which separate Business Combinations in which separate

entities or businesses are brought together by entities or businesses are brought together by contract alone without the obtaining of an contract alone without the obtaining of an ownership interestownership interest

Purchase MethodPurchase Method

Identify an Acquirer

Determine the cost of the business combination

Allocate the cost of the business combination

Identify an Identify an AcquirerAcquirer

ConsiderConsider– Respective sizes of entities prior to the Respective sizes of entities prior to the

combinationcombination– Power to govern financial and operating Power to govern financial and operating

policies of combined entitypolicies of combined entity– Voting rights in combined entityVoting rights in combined entity

Acquirer for accounting may be different than Acquirer for accounting may be different than legal acquirer (a ‘reverse acquisition’)legal acquirer (a ‘reverse acquisition’)

Where a new entity is formed one of the pre-Where a new entity is formed one of the pre-existing entities must be identified as the existing entities must be identified as the acquireracquirer

Cost of Business Cost of Business CombinationCombination

Equity instruments issued as purchase Equity instruments issued as purchase consideration measured at market priceconsideration measured at market price

Include Include – Cash considerationCash consideration– Equity instruments issues to effect the Equity instruments issues to effect the

transactiontransaction– Expenses incurred by the acquirer solely for Expenses incurred by the acquirer solely for

purpose of business combination (e.g. legal purpose of business combination (e.g. legal fees)fees)

– Contingent payments to the extent they are Contingent payments to the extent they are probable and can be reliably measuredprobable and can be reliably measured

Costs of arranging finance for the acquisition and Costs of arranging finance for the acquisition and costs of issuing equity instruments are not costs of issuing equity instruments are not recognised as an asset – they are accounted for in recognised as an asset – they are accounted for in accordance with IAS 39 (i.e. initial cost to treated accordance with IAS 39 (i.e. initial cost to treated as either liability or offering costs)as either liability or offering costs)

Allocate Cost of Allocate Cost of Business Business CombinationCombination

Assets are recognized at fair value if it can be Assets are recognized at fair value if it can be measured reliably and it is probable that the measured reliably and it is probable that the economic benefit will flow to the acquirereconomic benefit will flow to the acquirer

Liabilities, other than contingent liabilities are Liabilities, other than contingent liabilities are recognized at fair value only if it can be measures recognized at fair value only if it can be measures reliably and it is probable that there would be an reliably and it is probable that there would be an outflow of economic benefit to settle obligationoutflow of economic benefit to settle obligation

Only allocate to those assets, liabilities and Only allocate to those assets, liabilities and contingent liabilities of the acquiree that exist at the contingent liabilities of the acquiree that exist at the date of acquisition (i.e. restructuring)date of acquisition (i.e. restructuring)

Measure contingent liabilities if reliably measurable Measure contingent liabilities if reliably measurable – base on the amount a third party would charge to – base on the amount a third party would charge to assume the liabilityassume the liability

Fair Values of Net Fair Values of Net Assets and Assets and Contingent LiabilitiesContingent Liabilities

Traded financial instruments (eg. investments) at market valuesTraded financial instruments (eg. investments) at market values Unquoted financial instruments based on estimated values such as price-Unquoted financial instruments based on estimated values such as price-

earning ratio, dividend yield, growth rates of similar traded instrumentsearning ratio, dividend yield, growth rates of similar traded instruments Long-term receivables and other long-term assets at present values Long-term receivables and other long-term assets at present values

determined at appropriate current interest rates less allowances for determined at appropriate current interest rates less allowances for doubtful receivables and collection costsdoubtful receivables and collection costs

Inventories- Finished goods at selling price less sum of cost of disposal Inventories- Finished goods at selling price less sum of cost of disposal and profit and profit allowance for acquirer’s effort allowance for acquirer’s effort

Work-in-progress at selling price of finished goods less sum Work-in-progress at selling price of finished goods less sum

of cost to of cost to complete, cost of disposal and profit allowance for complete, cost of disposal and profit allowance for acquirer’s effort acquirer’s effort

Raw materials at replacement costRaw materials at replacement cost

Land and building at market valuesLand and building at market values Plant and equipment at market values determined by an appraiser. In Plant and equipment at market values determined by an appraiser. In

absence of market value depreciated replacement costabsence of market value depreciated replacement cost Net employee defined benefit asset or liability at present value less fair Net employee defined benefit asset or liability at present value less fair

value of plan assetsvalue of plan assets Long-term liability at present values at appropriate interest ratesLong-term liability at present values at appropriate interest rates

GoodwillGoodwill

Cost of Business Combination

-

Fair Value of assets, liabilities and contingent liabilities assumed

> 0 Goodwill

Recognise as an asset at date of transactionRecognise as an asset at date of transactionDo not amortiseDo not amortiseTest for impairment at least annuallyTest for impairment at least annually

Negative Goodwill’Negative Goodwill’

Cost of Business Combination

-

Fair Value of assets, liabilities and contingent liabilities assumed

< 0 Negative Goodwill

Reassess the fair values originally determinedReassess the fair values originally determined Any remaining excess is recognised in profit and Any remaining excess is recognised in profit and loss immediatelyloss immediately

IAS 38IAS 38

Identification and recognition of certain Identification and recognition of certain intangible assetsintangible assets

Finite useful life – amortiseFinite useful life – amortise Indefinite useful life – Assess annually for Indefinite useful life – Assess annually for

impairmentimpairment Reassess the useful life of intangible Reassess the useful life of intangible

assets at least annuallyassets at least annually

IAS 36 – Cash-IAS 36 – Cash-generating unitsgenerating units

Cash-generating units (CGUs)Cash-generating units (CGUs)– The smallest identifiable group of assets that The smallest identifiable group of assets that

generate cash inflows that are largely generate cash inflows that are largely independent of the cash inflows from other independent of the cash inflows from other groups of assetsgroups of assets

Allocate acquired goodwill amongst CGUs expected Allocate acquired goodwill amongst CGUs expected to benefit from the synergies of the combinationto benefit from the synergies of the combination

CGUs (or groups of CGUs) to which goodwill is CGUs (or groups of CGUs) to which goodwill is allocated for impairment testing must beallocated for impairment testing must be– Lowest level at which management monitor Lowest level at which management monitor

goodwillgoodwill– No larger than a segment (in accordance with No larger than a segment (in accordance with

IAS 14)IAS 14)

IAS 36 – IAS 36 – CalculationCalculation

Determine carrying amount of the CGU Determine carrying amount of the CGU (including allocated goodwill)(including allocated goodwill)

Determine fair value less costs to sell Determine fair value less costs to sell and/or value in useand/or value in use

Compare higher of the two with carrying Compare higher of the two with carrying amountamount

Any shortfall must be recognised as a Any shortfall must be recognised as a recoverable amount write-downrecoverable amount write-down

IAS 36 – Write-IAS 36 – Write-downsdowns

All write-downs are recognised All write-downs are recognised immediatelyimmediately

Where a write-down is required in relation Where a write-down is required in relation to a CGU with allocated goodwill, the to a CGU with allocated goodwill, the goodwill is first written downgoodwill is first written down

Any remaining write down is taken Any remaining write down is taken proportionately against the non-monetary proportionately against the non-monetary assets assets

Write-downs of goodwill may not be Write-downs of goodwill may not be reversed in future reporting periodsreversed in future reporting periods

IAS 36 – Practical IAS 36 – Practical ConsiderationsConsiderations

A CGU must be assessed at the same A CGU must be assessed at the same time each yeartime each year

Where an indicator of impairment exists, Where an indicator of impairment exists, the asset concerned must be tested for the asset concerned must be tested for impairment before testing the CGUimpairment before testing the CGU

Detailed calculations may be carried Detailed calculations may be carried forward from prior reporting periods forward from prior reporting periods providing certain conditions are metproviding certain conditions are met

Valuation Valuation ConsiderationsConsiderations

Overview Overview – Cash Generating Unit ValuationsCash Generating Unit Valuations– Identifiable Intangible Asset ValuationsIdentifiable Intangible Asset Valuations– Documentation GuidelinesDocumentation Guidelines

Cash Generating Cash Generating Unit Valuations (1)Unit Valuations (1)

Assessing the Recoverable Amount of a CGUAssessing the Recoverable Amount of a CGU– IAS 36 (18) defines recoverable amount as the HIGHER of:IAS 36 (18) defines recoverable amount as the HIGHER of:

Fair value less costs to sell; andFair value less costs to sell; and Value in UseValue in Use

– Best evidence of an asset’s FAIR VALUE (less costs to sell) is Best evidence of an asset’s FAIR VALUE (less costs to sell) is a price in a binding sale in an arm’s length transaction, a price in a binding sale in an arm’s length transaction, adjusted incremental costs that would be directly adjusted incremental costs that would be directly attributable to the disposal of the asset. Consider:attributable to the disposal of the asset. Consider:

Binding sales agreement; orBinding sales agreement; or Comparable companies and Transactions involving Comparable companies and Transactions involving

similar companies (MARKET APPROACH)similar companies (MARKET APPROACH)– The expected present value of the future cash flows derived The expected present value of the future cash flows derived

from the asset (DCF APPROACH) should be used in assessing from the asset (DCF APPROACH) should be used in assessing the VALUE IN USEthe VALUE IN USE

Cash Generating Cash Generating Unit Valuations (2)Unit Valuations (2)

MARKET APPROACH – Key Elements and MARKET APPROACH – Key Elements and ConsiderationsConsiderations– Typical methodologiesTypical methodologies

Comparable public companiesComparable public companies Comparable transactionsComparable transactions

– Valuation multiplesValuation multiples Market value of “Invested Capital” to Market value of “Invested Capital” to

revenue, EBITDA, or EBITrevenue, EBITDA, or EBIT Market value of “Equity” to net income, or Market value of “Equity” to net income, or

BV of tangible net equityBV of tangible net equity

Intangible Asset Intangible Asset Valuations (1)Valuations (1)

Recognition as part of a business combinationRecognition as part of a business combination– Recognised separately if it meets the following criteria:Recognised separately if it meets the following criteria:

Separately identifiable Separately identifiable (i.e. capable of being separated (i.e. capable of being separated or divided from the entity and sold, transferred, or divided from the entity and sold, transferred, licensed, rented, or exchanged – either individually or licensed, rented, or exchanged – either individually or together together with a related contract, asset or liability)with a related contract, asset or liability)

Controlled by the entity Controlled by the entity (arises from contractual or (arises from contractual or other legal rights, regardless of whether those rights other legal rights, regardless of whether those rights are transferable or separable from the entity or from are transferable or separable from the entity or from other rights and obligations)other rights and obligations)

A source of future economic benefitsA source of future economic benefits Fair value can be measured reliablyFair value can be measured reliably

– Useful list of “Illustrative Examples” of types intangibles Useful list of “Illustrative Examples” of types intangibles is provided with IFRS 3 – similar to SFAS 141is provided with IFRS 3 – similar to SFAS 141

– Determination will ultimately be based on the facts and Determination will ultimately be based on the facts and circumstances of each individual business combinationcircumstances of each individual business combination

Intangible Asset Intangible Asset Valuations (2)Valuations (2)

Intangible Asset ValuationsIntangible Asset Valuations– Market ApproachMarket Approach

Comparable transactionComparable transaction– Income ApproachIncome Approach

Relief-from-royaltyRelief-from-royalty Discounted cash flowDiscounted cash flow Cost-savingsCost-savings

– Cost ApproachCost Approach Replacement costReplacement cost

Documentation Documentation GuidelinesGuidelines

Key Elements of Valuation DocumentationKey Elements of Valuation Documentation– Description of the CGUDescription of the CGU

Nature of operationsNature of operations Consider value driversConsider value drivers

– Financial analysis with respect to the CGUFinancial analysis with respect to the CGU Financial conditionFinancial condition Profitability and earnings capacityProfitability and earnings capacity Available documentation regarding Available documentation regarding

forecastsforecasts

Documentation Documentation GuidelinesGuidelines

Key Elements of Valuation Key Elements of Valuation Documentation (cont.)Documentation (cont.)– Supporting calculations consistent with Supporting calculations consistent with

generally accepted valuation procedures for generally accepted valuation procedures for each valuation method adoptedeach valuation method adopted

– Sufficient documentation of key assumptions Sufficient documentation of key assumptions and sources of dataand sources of data

– Rationale for conclusion and rationalisation of Rationale for conclusion and rationalisation of various indications of value – global sense various indications of value – global sense checkcheck

Closing Closing ObservationsObservations

Appropriate valuation methodologies should Appropriate valuation methodologies should be carefully selected and consistently be carefully selected and consistently applied over timeapplied over time

Whether a particular fair value measurement Whether a particular fair value measurement is prepared internally or with the assistance is prepared internally or with the assistance of a third-party specialist, the level of of a third-party specialist, the level of documentation to support the conclusions of documentation to support the conclusions of the entity is expected to be similarthe entity is expected to be similar

It’s a subjective and difficult area – so please It’s a subjective and difficult area – so please consult with the appropriate specialistsconsult with the appropriate specialists

Tax Effect of Tax Effect of Business Business CombinationCombination

Fair value of assets and liabilities may Fair value of assets and liabilities may result in deferred tax asset or liabilityresult in deferred tax asset or liability

If asset or liability is not recognized If asset or liability is not recognized which subsequently is incurred or which subsequently is incurred or realized then:realized then:

recognize benefit \ expense in P&Lrecognize benefit \ expense in P&L

adjust carrying value of goodwill through adjust carrying value of goodwill through P&L P&L

Transition – Transition – Current IFRS UserCurrent IFRS User

Applies to transactions for which agreement date is on or Applies to transactions for which agreement date is on or after 31 March 2004after 31 March 2004

In the first reporting period beginning on or after 31 March In the first reporting period beginning on or after 31 March 20042004– Discontinue amortisation of goodwill in first reporting Discontinue amortisation of goodwill in first reporting

period after period after – Eliminate carrying amount of goodwill amortisation Eliminate carrying amount of goodwill amortisation

against goodwillagainst goodwill– Test carrying amount of goodwill for impairmentTest carrying amount of goodwill for impairment– Reclassify intangibles recognised in previous business Reclassify intangibles recognised in previous business

combinations that do not meet the recognition criteria to combinations that do not meet the recognition criteria to goodwillgoodwill

Early adoption can only be achieved in conjunction with Early adoption can only be achieved in conjunction with early adoption of revised IAS 36 and IAS 38early adoption of revised IAS 36 and IAS 38

Transitional requirements should be applied in respect of Transitional requirements should be applied in respect of goodwill arising from joint ventures and associatesgoodwill arising from joint ventures and associates

Transition – First-Transition – First-Time AdopterTime Adopter

Not required to restate prior business combinations Not required to restate prior business combinations accounted for under a standard different from the accounted for under a standard different from the IFRS applicable at the date of reporting.IFRS applicable at the date of reporting.

Still need to eliminate assets and liabilities that do Still need to eliminate assets and liabilities that do not meet the recognition criteria under IFRS not meet the recognition criteria under IFRS outside of a business combination (adjustment to outside of a business combination (adjustment to goodwill). goodwill).

If subsidiary has not been consolidated under If subsidiary has not been consolidated under previous GAAP, restate assets and liabilities in previous GAAP, restate assets and liabilities in accordance with IFRSaccordance with IFRS

Test goodwill in opening IFRS balance sheet for Test goodwill in opening IFRS balance sheet for impairment.impairment.

Must account for all business combinations after Must account for all business combinations after date of transition in accordance with IFRS 3date of transition in accordance with IFRS 3

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