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Practical application of IFRS3 - Business Combinations. By Allan Caldwell

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20th Sep 2006
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IFRS reporting is well into its first season for UK quoted companies and those with December or March year ends have already reported. While the transition has forced companies to address a whole raft of new standards, not all will have had to look in detail at IFRS 3 - Business Combinations, if they have not made an acquisition in the period.

IFRS3 was designed to improve the transparency of acquisition accounting, an area where a lot of accounting manipulation has occurred in the past. IFRS 3 requires in essence, that all assets on an acquisition, both tangible and intangible, be restated at their market values when accounting for the acquisition.

The key implications on financial statements from IFRS3
Profit and loss account ' goodwill and intangibles

  • There will no longer be a charge for the amortisation of goodwill. This is useful as such charges were often previously disregarded
  • There will be charges for the amortisation of intangible assets which have finite estimated lives. As the values of such assets could be based on the present value of future profits their amortisation will be effectively eliminating those profits as they occur after acquisition. In extreme cases it could mean that little or no profits are reported for many years after the acquisition, a highly contentious area.
  • There could be charges for impairment where the carrying value of intangible assets is higher than its value. These might occur through a change in strategy, or they might reflect badly on management. Impairment charges will be a highly sensitive area.
  • Balance sheet ' goodwill and intangibles

  • Goodwill brought forward\at the date of adoption of IFRS (which will often be significant) will be frozen at its brought value. So this figure will be stated at historic goodwill at the dates of pre IFRS3 acquisitions (including IFRS3 intangible values not required pre IFRS3), less pre IFRS3 amortisation, plus post IFRS3 goodwill at the dates of acquisitions and less impairment charges.This is such a complicated combination of concepts that the figures given will most likely be impossible to understand.
  • Some intangible assets will be stated at their historic valuations, and some intangible asset values will be after charges for amortisation and impairment.
  • Values of goodwill and intangible assets are stated at historic amounts and not revalued.
  • Goodwill and intangible assets which have not been acquired will not be shown.
  • Other issues

  • In revaluing assets there is the question where such values overlap, as they may be double counted when valued separately (such as brand and customer relationship values).
  • Stock values need to be on the basis of market value, which will need to be written down to cost post acquisition. If inventories are significant this could mean a significant hit to profits immediately post acquisition.
  • Therefore we would suggest that although IFRS3 provides some benefit, it only gives part of the story and contains some difficult concepts. Great care will need to be taken in explaining these concepts so that they are properly understood by readers of the accounts.

    Intangible assets
    UKGAAP requires recognition of an intangible asset of an acquired entity only if its fair value can be reliably measured. In practice, this meant that few intangibles are valued and reported on the balance sheet.

    IFRS3 requires recognition if the asset is identifiable; that is if it is separable or arises from contractual or other legal rights. In this context, separable means that the asset can be separated from the rest of the entity and sold, licensed, rented or transferred. While the requirement for reliable measurement is still present, IAS 38, Intangible Assets, assumes that this will be possible, stating that:

    The fair value of intangible assets acquired in business combinations can normally be measured with sufficient reliability to be recognised separately from goodwill.

    As a consequence of the strengthened requirement to recognise intangible assets, more intangibles are being recognised within business combinations and this trend is likely to continue as companies and auditors become more familiar with the process. Published accounts in the United States in the years following the introduction of SFAS 141 (the US accounting standard equivalent to IFRS3), have shown increases in the percentage of purchase price allocated to intangibles within market sectors, but the progress has been fairly glacial and goodwill remains the dominant component.

    Methods of valuation of intangibles are a subject on their own, but suffice it to say that there are a number of well understood techniques with most reliance being placed on the relief from royalty method.

    One practical area of difficulty is where intangible assets overlap, for instance brands and customer relationships. Care is needed to ensure that fair values are separated and not double counted, and the commercial realities of the market in which the entity trades must be considered. For instance, in a consumer products business such as wines and spirits, broad distribution and good customer relationships are key to success, but these will ultimately be worth little when there is a strong portfolio of brands. Most of the intangible asset value rests with the brands.

    On the other hand in a sector like retail banking, customer inertia might be worth more than a brand name. After Banco Santander bought Abbey, customer relationships were reported at a value at almost three times that of the brand, although the annual report and accounts made no mention of any overlap in value.

    Useful Life
    Company management and auditors may not be comfortable with the concept of indefinite lives for intangible assets such as brands and mastheads. However, indefinite is not the same as infinite and it is sufficient to demonstrate that:

    There is no foreseeable limit to the period over which the asset is expected to generate net cash inflows for the entity.

    There are no time limits to the legal protection of trademarks and, if the acquirer is committed to future support of a brand or masthead and the durability of the market in which the asset competes can be confirmed, there are many examples of very long lived assets, from Johnnie Walker to The Economist and Marks & Spencer.

    A template quantifying brand strength will allow assets to be grouped together in a way that makes determination of useful life readily supportable. Assets can be assigned a score using a simple 1 to 5 scale across a set of up to 20 objective criteria, and finally calculating an average of all the scores. The criteria might include, for instance ' name recognition among consumers, market share, industry stability, etc.. Those brands with an average in excess of 4 might have indefinite lives, those between 3 and 4, a twenty year life, and the rest a ten year life.

    In addition to any amortisation, it is necessary to review annually the value of intangibles for any impairment. If the present value of future anticipated cash flows is lower than the book value, that value must be written down to the impaired value. If, in future years, the value of future cash flows increases again, the write down can be reversed.

    Fair value of stocks
    Whereas UK GAAP requires stocks acquired as part of a business combination to be valued at the lower of replacement cost and realisable value, IFRS 3 defines fair value as selling price less the costs of disposal and a reasonable margin for selling effort. For high margin consumer goods this raises questions about how the margin is divided between the activities of production and selling, and ownership of the brand. Again great care is needed to ensure that fair value already attributed to the brand is not double counted by overstating the fair value of stock. Even finished goods in their branded packaging do not command the full selling price without the brand owner's approval. Sales of genuine product through unofficial channels achieve substantially lower prices than the same product sold through legitimate sales channels. Much of the value still attaches to the brand and should not be included in the revaluation of stock. For example, if the book value of stocks in an acquired entity is £1m and the royalty rate used for the corresponding brand valuation is 10%, then the operating profit margin can be allocated between brand, selling effort at, say, 5%, and the balance of 3% to be included in the fair value adjustment as shown below:

    Finished stock at cost £'m 1,000
     
    Cost of sales % 45%
    Operating profit % 18%
    Brand royalty rate 10%
    Profit attributable to selling effort 5%
    Balance of operating profit 3%
     
    Profit attributable as % cost of sales 6.5%
     
    Step up to stock value £'m 65
     
    Stock at fair value £'m 1,065

    Goodwill
    Under UK GAAP, goodwill is presumed to have a useful life not exceeding twenty years and is amortised over that period. Under IFRS 3, amortisation is not permitted and existing partially amortised goodwill is frozen at its net amount at the date of transition.

    Impairment testing of goodwill is already a requirement under UK GAAP, if circumstances indicate that the carrying value may not be recoverable. In practice, this happens rarely because amortisation steadily reduces the carrying value. Under IFRS, however, goodwill impairment becomes a much bigger issue and tests have to be carried out annually. Any impairment of goodwill is deemed to be permanent and cannot be reversed in the future.

    As goodwill does not generate cash flows directly, it must be assigned to a cash generating unit and it is the total value of all the assets, including goodwill, of the cash generating unit (CGU) that is compared to the value of future cash flows. In the event of a shortfall, the goodwill is reduced in value by a charge to profit.

    Defining cash generating units as broadly as possible, will minimise the risk of embarrassing goodwill impairment. The broadest level allowable under the standard is that of reporting segment and the acid test is whether the proposed CGU generates largely independent cash flows. If it can be argued that the cash flows within a segment are inter-related, for instance if the segment comprises vertically production and sales and distribution units, it should be possible to assign goodwill at the segment level.

    Other changes
    Merger accounting is not permitted under IFRS 3, and one of the entities agreeing to the transaction must be identified as the acquirer, and must apply the purchase method to the transaction.

    Contingent liabilities of the acquired entity must be recognised if its fair value can be measured reliably. In practice, this means calculating a probability weighted average of the possible cash flows relating to the contingent liability.

    Deferred tax must be provided in full on the fair value adjustments to the book values of acquired assets, but not on the initial recognition of goodwill.

    Negative goodwill must be credited immediately to profit, rather than over an extended period as under UK GAAP.

    Conclusion
    Mastery of the mechanics of application of the new IFRS standards should not be unduly difficult for most, although the extension of the use of fair values appears unwelcome to many.

    Inevitably, companies will end up reporting 'apples and oranges' with new acquisitions accounted for under the IFRS rules while older ones went through on UK GAAP rules. It is disappointing just how few companies have even taken advantage of the opportunity to apply IFRS 3 retrospectively to acquisitions made before the transition date, especially those groups that also report results on a US GAAP basis because of their US listings, for whom the necessary information should be readily available. Of the FTSE100, only one company (Rentokil) has so far applied IFRS 3 retrospectively.

    Allan Caldwell is a director at Intangible Business, the brand valuation, strategy and development consultancy. Allan qualified as a chartered accountant with Coopers & Lybrand (now PWC) in 1975, speaks fluent French and Spanish and has considerable international experience. Following a career in a variety of senior commercial and finance roles, latterly with Allied Domecq as Finance and Commercial Services Director for its Duty Free Division, he took up interim finance director roles for companies including Burger King and LVMH. Allan joined Intangible Business in 2004 and has since carried out forensic accounting and brand valuation projects for clients in the telecoms, drinks, lifestyle and retail sectors. He is a recognised expert and regular lecturer in accounting under IFRS and USGAAP, specifically for intangible assets and business combinations.

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