Companies in India, like their peers elsewhere, are resorting to mergers and acquisitions to enhance their global presence and competitiveness, expand overseas and get strategic benefits through backward or forward integration. However, they have been crimped by the lack of a comprehensive accounting treatise or standard.
Under GAAP (generally accepted accounting principles), several standards deal with business combinations but they all are old, outdated and suffer from several shortcomings. For instance, Accounting Standard 10 (AS-10), Accounting for Fixed Assets — which deals with acquisition of a business — was issued 23 years back; AS-14, Accounting for Amalgamations — only covering mergers where the acquired company ceases to exist—some 15 years back; and AS-21, Consolidated Financial Statements — dealing with the acquisition of subsidiaries — became applicable in 2001.
Except AS-10, most standards either require or allow the use of book value of the acquired assets and liabilities, not necessarily reflecting the true economic substance of the acquisition. AS-14 requires pooling of interest method to be followed if certain conditions are met. The purchase method also allows use of book value as an alternative. Under AS-21, consolidation of subsidiaries is also based on book value. Treatments prescribed for goodwill are inconsistent: AS-10 recommends but does not require amortization of goodwill, AS-14 requires amortization of goodwill over a five-year period and AS-21 is conveniently silent.
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Business combinations may happen as acquisition of a division or acquisition of the company itself, or leveraged buyouts. Generally, there is a major change in the ownership of the acquired business or entity and all shareholders need not remain common. Further, consideration for such business purchase may not be settled in the form of dilution of equity by the acquirer. AS-14 only deals with amalgamations where the acquired company ceases to exist and allows pooling of interest method. Under the International Financial Reporting System, IFRS 3 — on Business Combinations — allows the true substance of an acquisition to be reflected.
IFRS 3 specifically prohibits use of the pooling of interest method; hence, all business combinations, whatever the form and design, need to be accounted under the purchase method. In applying this method, all assets and liabilities of the acquired entity need to be taken at fair value, more reflective of their current market worth. Moreover, off-balance sheet items need to be identified and these also need to be “fair valued” and recognized in the books. Subject to the fulfilment of necessary criteria, it is possible to recognize the customer base acquired as an intangible asset, which may not be possible under Indian GAAP. Similarly, in case of a customer claim or suit filed against the company, the likely provision for such contingency would need to be evaluated and recognized as a liability. Usually provisions are made for contingent liabilities only if an outflow of resources is probable. However, for IFRS 3, the degree of uncertainty will get factored into the fair-value pricing model.
Therefore, IFRS 3 focuses on identification of all assets and liabilities of the acquired business, tangible or intangible, contingent or otherwise, requiring them to be recorded at their fair value. It also currently allows acquisition-related transaction costs to be adjusted in goodwill, which Indian GAAP does not. Legal expenses, due diligence costs and other expenses related to acquisitions may be quite significant.
IFRS 3 allows negative goodwill to be taken to the income statement. Quite a bold treatment, but it has its merits because it reflects acquisition of a business at a lesser price — a transaction gain which has been already consummated. Goodwill is not required to be amortized and needs to be checked for impairment on an annual basis. IFRS stipulates extensive disclosure requirements, which enhance the quality of reporting to the users of financial statements and provide greater insight into the finer details of an acquisition. IFRS also allows a window of 12 months from the date of the business combination, for any provisional allocation adjustments in the values of acquired assets and liabilities.
IFRS 3 is also evolving: The International Accounting Standards Board has made some key changes that will apply to all business combinations happening on or after 1 July. This will have significant impact on the results of future business combinations. For instance, the revision in IFRS 3 would mean recognizing contingent consideration obligations at their acquisition-date fair values, with subsequent changes in fair value generally reflected in profit and loss. This is a significant change from the current practice of recognizing contingent consideration obligations only when the contingency is probable and can be measured reliably, with subsequent adjustments generally reflected in goodwill. Transaction costs and general and administration cost relating to business combination will need to be expensed.
Indian companies will largely benefit from IFRS 3, since there is no comparable Indian GAAP standard. There is an urgent need for the Institute of Chartered Accountants of India to issue an IFRS 3-based standard, to be made mandatory well before 1 April 2011, the date for migration to IFRS.
India will move to IFRS starting 2011. Navin Agrawal is a director with Ernst & Young India Pvt. Ltd. This is the ninth in a series that analyses the impact of IFRS on industries and regulatory issues pertaining to its convergence with Indian GAAP.
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