Joint Business Combinations Project
3 and the Project’s Impact on Convergence with U.S.
Christoph Watrin, Christiane Strohm, and Ralf Struffert
JANUARY 2006 - Starting
in 2005, the public corporations in all 25 European Union
nations must comply with International Financial Reporting
Standards (IFRS)/International Accounting Standards (IAS).
The motivation to converge IFRS/IAS and U.S. Generally Accepted
Accounting Principles (GAAP) as part of the ongoing internationalization
of accounting is stronger than. Every effort is being made
to keep joint projects on a “similar” time schedule
at each standards-setting body. The main goal is to achieve
greater comparability among consolidated financial statements,
which are still prepared using different accounting concepts.
of the most important subjects of the convergence project
is the accounting for business combinations, because of
the number of these transactions. FASB and the International
Accounting Standards Board (IASB) started to work on a common
business-combinations project to achieve a reconciliation
of the accounting for business combinations using IFRS and
U.S. GAAP (see www.iasb.org
and www.fasb.org). During the last few years, the accounting
for consolidated financial statements has been very controversial,
as evidenced by the reception of SFAS 141, Business
Combinations, and SFAS 142, Goodwill and Other
July 2001, the business combinations project has been one
of the IASB’s main issues. The work process was originally
separated into two phases, whereas forthcoming phases can
be expected. As a result of Phase I, Exposure Draft (ED)
3, Business Combinations, was published on December
5, 2002, and comments were accepted until April 4, 2003.
In addition, major changes to the accounting for intangible
assets and the application of the impairment test for goodwill
were planned, which led to published drafts of relevant
standards (ED-IAS 36 and ED-IAS 38). National
standards setters all over Europe criticized the proposed
changes in the EDs. Phase I ended on March 31, 2004, with
the publishing of IFRS 3, Business Combinations,
and the refined IAS 36, Impairment of Assets, and
IAS 38, Intangible Assets. The new standards, including
additional notes, comprise more than 490 pages, showing
the complexity of this project. The new IFRS 3 will replace
IAS 22, as well as the interpretations SIC-9, SIC-22, and
SIC-28 (Introduction 1, IFRS 3, and IFRS 3, Appendix C).
The IASB incorporated some of the main aspects of American
standards, but also decided deliberately against the American
approach in certain areas.
3 applies to all business combinations with an agreement
date after March 31, 2004. For goodwill remaining from previous
transactions, IFRS 3 applies prospectively for business
years beginning on or after March 31, 2004 (IFRS 3.78-81).
Following IFRS 3.85, an entity is permitted to retrospectively
apply IFRS 3, IAS 36, and IAS 38, if it meets certain requirements.
Relevant information required for a successful application
of IFRS 3 must be available when the business combination
was initially accounted for. In addition, the refined IAS
36 and IAS 38 need to be applied.
of IFRS 3
3 applies to all business combinations. The result of nearly
all business combinations is that one entity obtains control
over one or more other businesses. Obtaining control over
one or more entities that are not businesses is not considered
a business combination. While economic entities are subject
to IAS 22.8, IFRS 3 pertains to reporting entities. IFRS
3 does not apply to joint ventures, business combinations
involving entities or businesses under common control, mutual
entities, and reporting entities without the obtaining of
an ownership interest.
exclusion of mutual entities and reporting entities by contract
alone without the obtaining of an ownership interest was
motivated by problems with applying the purchase method.
Therefore, the ED of proposed amendments to IFRS 3, “Combinations
by Contract Alone or Involving Mutual Entities,” was
published on April 29, 2004, as an interim solution. Several
European standards setters criticized the proposal (see
The criticism mostly pertained to the plan for the interim
solution to be replaced shortly, the inconsistency with
IFRS 3, the proposed modified purchase method, and the amendment
being so close to the 2005 deadline for the adoption of
IFRS in Europe. The IASB noted the disagreement and decided
not to proceed with the ED. With respect to practical benefits,
no support for an interim solution exists.
now, in the wake of the ED of proposed amendments to IFRS
3’s June to October 2005 comment period, formations
of joint ventures and combinations involving only entities
and businesses under common control have been proposed to
be excluded from IFRS 3. The amendments to IFRS 3 will be
effective prospectively for business combinations with an
acquisition date on or after January 2007. Because the IASB
recently received comments on the proposed amendments, changes
are still possible. Therefore, the authors will focus on
the currently effective provisions of IFRS 3, as issued
in March 2004.
major change in IFRS 3, as compared to IAS 22, is the prohibition
of the pooling-of-interests method, which previously could
have been used when several conditions were present. From
now on, all business combinations will be accounted for
using the full-purchase method. Almost all standards setters
had a positive reaction to this change, because the sphere
of influence was deleted. The allowance of just one method
has increased the comparability of financial statements.
This is a step in the direction of convergence, given that
the pooling-of-interests method has already been prohibited
in Australia, Canada, and the United States. The information
provided in consolidated financial statements will be improved
through more comparability.
of Business Combinations
application of the purchase method is based on the assumption
that the acquiring business can be identified. Following
IFRS 3, the acquirer is the combining entity that obtains
control of the other combining entities or businesses. All
pertinent facts and circumstances should be considered,
including the possibility of “reverse acquisitions”
(IFRS 3.21). A business is assumed to obtain control when
it has the power to govern the financial and operating policies
of an entity or business in order to benefit from its activities.
This term in IFRS 3.19 was carried over from IAS 22.8 and
ensures convergence with IAS 27. A control relationship
is assumed when the acquirer owns more than one-half of
the voting rights, unless it can be demonstrated that such
ownership does not constitute control. A control relationship
might be present when more than one-half of the voting rights
are owned by virtue of an agreement with other investors.
In addition, a control relationship might be present if
the acquirer is able to govern the financial and operating
policies under a statute or an agreement, to appoint or
remove the majority of the board of directors or equivalent
governing body, or, finally, to cast the majority of votes
on the board of directors or equivalent body.
costs of a business combination at the date of exchange
are measured as an aggregate of the fair values of assets
received, liabilities incurred or assumed, and equity instruments
issued by the acquirer. There is an exception for noncurrent
assets held for sale, as mentioned in IFRS 5, where the
costs of the disposal are subtracted. In addition, any costs
directly attributable to the business combination are included.
These fees are defined as professional fees paid to accountants,
legal advisors, appraisers, and other consultants to execute
the business combination. Explicitly excluded are general
administrative costs, such as emission costs for financial
liabilities and costs for the registration or issue of equity
the costs of the business combination have been determined,
these costs must be allocated to the assets acquired and
the liabilities and contingent liabilities assumed. The
previous option between the benchmark treatment and the
alternative treatment has been dropped in favor of the full
fair value approach. This decision means that identifiable
assets, liabilities, and contingent liabilities are measured
initially by the acquirer at their fair value, irrespective
of the extent of any minority interest. Any minority interest
in the aquiree is measured as the minority proportion of
the net fair values of those items; the minority proportion
of the goodwill is not recorded.
the option to choose between treatments will lead to more
comparability between consolidated financial statements.
Allowing only the full fair value approach is a consequence
of the growing importance of fair value accounting in the
IFRS (e.g., IAS 39 and ED IAS 39), which in also reflected
in U.S. GAAP.
goodwill recognized as an asset is measured initially as
the excess of the cost of the business combination over
the acquirer’s interest in the net fair values of
the identifiable assets, liabilities, and contingent liabilities.
It can include the following components: the fair value
of the going-concern element of the acquiree; the fair value
of the expected synergies; overpayments by the acquirer;
errors in measuring and recognizing the fair value of either
the cost of the business combination or the acquiree’s
identifiable assets, liabilities, and contingent liabilities;
or a requirement in an accounting standard to measure those
identifiable items at an amount that is not fair value.
It is questionable whether the latter two components could
lead to goodwill; the IASB assumed that most goodwill would
come from the first two components. Therefore, this core
goodwill complies with the requirements of the IASB Framework.
The IASB later said that components of core goodwill have
to be specified in line with SFAS 141’s treatment.
change, compared to IAS 22, is IFRS 3’s prohibition
of amortization, which follows the treatment in SFAS 142.
From now on, goodwill is reviewed at least annually in accordance
with IAS 36. If goodwill is impaired, an impairment loss
must be recognized. This treatment eliminates previous problems
with estimating an amortization schedule, but it leads to
problems with respect to measuring fair value.
IAS 36, goodwill is allocated to each of the acquirer’s
cash-generating units or groups that are expected to benefit
from the synergies of the combination. A cash-generating
unit is the smallest group of assets that includes the asset
and generated cash inflows that are largely independent
of the cash inflows from other assets or groups of assets.
Each unit or group of units to which goodwill is allocated
will represent the lowest level within the entity at which
goodwill is monitored for internal management purposes and
shall not be larger than a segment based on either the entity’s
primary or the entity’s secondary reporting format,
in accordance with IAS 14.
annual impairment testing may be performed at any time during
an annual period, provided it is performed at the same time
every year. In addition, whenever an indication exists that
the unit may be impaired, impairment testing is necessary.
testing requires the comparison of the carrying amount of
the unit, including goodwill, with the recoverable amount
of the unit. No impairment exists when the recoverable amount
exceeds the carrying amount. In the opposite case, the impairment
will be recognized as a loss. Therefore, the carrying amount
of any goodwill allocated to the cash-generating unit will
be reduced. Then, the loss will be allocated to the other
assets of the unit pro rata on the basis of the carrying
amount of each asset in the unit under IAS 36. However,
the reduction of the carrying amount will not be lower than
the highest of its fair value less costs to sell, its value
in use, and zero. The amount of the loss that would have
been allocated without this limitation will be added back
pro rata to the other assets of the unit.
36 suggested two steps for impairment testing. The first
step was meant to identify goodwill impairment. If indicators
suggested impairment, the implied value of the goodwill
would be compared with its carrying amount. The IASB rejected
this treatment and followed the one-step impairment-only
approach because the benefits of the two-step approach did
not seem to justify the effort. The current structure was
maintained, which differs greatly from the U.S. GAAP approach
embodied by SFAS 142. The impairment-only approach, does,
however, treat goodwill the same as other intangible assets.
standards setters generally supported the U.S. GAAP approach,
but recognized the implementation problems. Some standards
setters suggested an interim solution, which would give
companies the option between annual amortization and an
impairment-only approach. Others were against an impairment-only
approach, believing that goodwill should not have an infinite
useful life and should be amortized the same way as other
noncurrent, wasting assets.
a minority interest exists in a cash-generating unit to
which goodwill has been allocated, the carrying amount of
those units comprises both the parent’s interest and
the minority interest in the identifiable net assets of
the unit and the parent’s interest in goodwill. However,
part of the recoverable amount of the cash-generating unit
is attributable to the minority interest in goodwill.
testing cash-generating units with goodwill and minority
interest can be illustrated as follows (see IAS 36, illustrative
example 7). Entity D acquires a 70% ownership in entity
B for $1,000 on January 1, 2005. At that date, B’s
identifiable net assets have a carrying amount of $1,900
and a fair value of $2,300. The carrying amount for liabilities
($900) and contingent liabilities ($100) is equal to the
fair value. Therefore, D recognizes in its consolidated
financial statements identifiable net assets at their fair
value of $1,300 ($2,300 – $900 – $100) and goodwill
of business combination $1,000
70% of $1,300
B is the cash-generating unit expecting to benefit from
the synergies of the combination, so the goodwill has been
allocated to it. This cash-generating unit is tested for
impairment at the end of 2005, and the recoverable amount
is $1,000. D uses straight-line depreciation over a 10-year
useful life for net assets. A portion of B’s recoverable
amount of $1,000 is attributable to the unrecognized minority
interest in goodwill. The carrying amount of B must be notionally
adjusted to include goodwill attributable to the minority
interest ($90 x 30%/ 70% = $39), as follows:
impairment loss of the $299 is allocated to the assets in
the unit by first reducing the carrying amount of goodwill
to zero, which requires an allocation of $129. Because the
goodwill is recognized only to the extent of D’s 70%
ownership interest in B, D recognizes only 70% of that goodwill
impairment loss ($90). The remaining impairment loss ($299
– $129 = $170) is recognized by reducing the carrying
amounts of B’s identifiable net assets, as shown below:
impairment loss recognized for goodwill cannot be reversed
in a subsequent period under IAS 36. This provision is in
accordance with the prohibition of internally generated
goodwill under IAS 38. European standards setters criticized
the prohibition of a reversal of an impairment loss. Some
supported a reversal only when the primary external reason
for the impairment no longer exists, thus avoiding a reversal
for internally generated goodwill. The prohibition of a
reversal is in line with SFAS 142.
effects of the prohibition of the annual amortization of
goodwill must be examined in practice. Companies that have
amortized large amounts of goodwill in the past, will, assuming
no impairment is necessary, have higher net profits but
without qualitative improvements. On the other hand, these
companies will have higher losses resulting from impairments
if the acquired unit does not develop as successfully as
issuance of the ED of amendments to IFRS 3 in June 2005
as a result of phase two indicates that the business combinations
project will help achieve convergence between U.S. GAAP
one major change to IFRS 3, the ED proposes that an acquirer
measure the fair value of the acquiree, as a whole, as of
the acquisition date. This full goodwill method recognizes
not only the purchased goodwill attributable to an acquirer
as a result of the purchase transaction, but also the goodwill
attributable to a noncontrolling interest in the subsidiary.
The IASB believes that this method is appropriate because
it is consistent with the control and completeness concepts
underlying the preparation of consolidated financial statements.
results of the second phase are the EDs of proposed amendments
to IAS 27, Consolidated and Separate Financial Statements,
and to IAS 37, Provisions, Contingent Liabilities and
Contingent Assets, both issued for comment over June
to October 2005.
FASB and the IASB reached the same conclusions on fundamental
issues, they reached different conclusions on a few limited
matters. Most of the differences arise because of each board’s
decision to produce guidance for accounting for business
combinations that is consistent with other existing SFAS
or IFRS (ED-IFRS 3 part N).
addition, the second phase of the business combinations
project still needs to consider the accounting for business
combinations in which separate businesses or entities are
brought together to form a joint venture (see ED to IFRS
3.2). Furthermore, the accounting for business combinations
involving entities under common control has to be considered
(see ED to IFRS 3.2). Common control can be assumed when
the same party or parties control all of the combining entities
or businesses and the control is not transitory. These business
combinations are highly relevant when consolidated businesses
advantages and disadvantages of the fresh-start accounting
method should be taken into account. If the combination
of businesses cannot be characterized as a purchase but
rather as the creation of a new business, the fresh-start
method might be the relevant accounting method. If so, the
fair values of the net property, and possibly the original
goodwill of the combined businesses, would be represented
in the consolidated financial statement.
addition to the outstanding developments of the business
combinations project, other changes are expected. The IFRS
“Consolidation Including Special Purpose Entities”
(SPE) has been on the IASB’s agenda since April 2002.
Part of this project will determine when a company has to
consolidate its interest. Particularly, the control concept
will be refined as one main element. However, the IASB will
not change the recent definition, but the term “power”
as part of the control definition needs to be clarified.
During a meeting in September 2003, the IASB announced that
control can be assumed when an investor has the power to
govern the financial and operating policies of an entity
or business so as to obtain benefits from its activities.
The expected consolidation standard, which will replace
both IAS 27 and SIC-12, will apply to the consolidation
of SPEs and non-SPEs. The illustration of asset-backed securities
transactions is fraught with difficulty. The general criteria
of IAS 27were not, however, addressed in the ED of amendments
to IAS 27, which focuses on accounting for ownership interests
after control is obtained. Furthermore, the interpretation
of SIC-12 regarding this topic is linked with application
problems. The revision of these standards and the planned
assimilation, with the illustration of ABS transactions
after IAS 39, is welcomed.
3, Accounting for Business Combinations, closely
resembles U.S. GAAP accounting. However, it is not an exact
copy, because the final IFRS 3 differs in key aspects—like
the impairment test for goodwill—from the U.S. standard.
3 and the revisions to IAS 36 and 38 have been welcomed
by most. Through this movement toward convergence, the quality
of accounting will increase. The elimination of the pooling-of-interests
method can be seen as a major advance in the comparability
of financial statements and a major restriction of the ability
of companies to select among different accounting treatments
to achieve their desired results.
if the convergence of consolidated accounting is achieved,
it must be discussed whether and how IFRS 3 and the changes
of IAS 36 and 38 will actually improve the conditions for
applying companies. It remains to be seen whether the new
regulations—particularly the prohibition of the annual
goodwill amortization—will prove successful. In the
end, IFRS 3 is only an interim solution to the persistent
challenge of accounting for business combinations as shown
by the issued ED of amendments to IFRS 3.
Watrin, PhD, is a professor of business taxation
and chair of the department of accounting and business taxation
at the University of Muenster, Germany.
Christiane Strohm is currently a visiting
scholar at the Marshall School of Business at the University
of Southern California, supported by the German Academic Exchange
Service. She is enrolled in the PhD program at the University
Ralf Struffert is enrolled in the PhD program
at the University of Muenster.