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IFRS 3 on business combinations will have a major impact on

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					                                                                      Issue 4
                                                                      October 2006

By Jeanette Hern, Partner, Johannesburg



IFRS 3 on business combinations will have a major impact on accounting for
mergers and acquisitions. How will the changes affect you?
                                                 What are the key implications of
1      Effective date
                                            2    IFRS 3 compared to existing
                                                 accounting rules?


3      Are there any exceptions?
                                            4    How do I identify the acquirer?



5      Reverse acquisitions
                                            6    How is goodwill calculated?



7      How is the cost of the acquisition
       calculated?                          8    How do I assess the fair value of
                                                 the assets and liabilities?



9      Is my target business likely to
       have intangible assets?              10   How are fair values of intangibles
                                                 calculated?



11     Do tax losses affect the goodwill
       calculation?                         12   How are pension surpluses or
                                                 deficits treated?



13     What do I do if I have negative
       goodwill?                            14   What happens if fair values need to
                                                 be estimated?



15     What do I do with past business
       combinations?                        16   Our national IFRS implementation
                                                 team
1 Effective date

For entities adopting IFRS for the first time, IFRS 3 'Business Combinations' applies to all business
combinations from their date of transition to IFRS (the beginning of the earliest period for which full
IFRS comparative information is presented in the first IFRS accounts). For instance, for a business
applying IFRS for the first time in its accounts for the year ended 31 December 2005, IFRS 3 will
apply to combinations from 1 January 2004 onwards.

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2 What are the key implications of IFRS 3 compared to existing accounting
rules?
The major changes in IFRS 3 are as follows:
•  Merger accounting is now banned for all business combinations falling within IFRS 3's scope.
   The purchase method (acquisition accounting) must be used.
•  Through the application of IAS 38 'Intangible Assets', many more intangible assets are likely to
   be recognised than under existing rules. Valuation of intangible assets may require significant
   additional work during an acquisition process.
•  Amortisation of goodwill is prohibited. Goodwill is tested for impairment annually and stated net
   of impairment losses. Impairment tests could impose a significant additional burden.
•  Intangible assets with finite lives must be amortised over those lives. Intangible assets with
   indefinite lives are tested annually for impairment, but not amortised.
•  Negative goodwill is not recognised in the balance sheet. It is taken as an immediate gain to the
   profit and loss account.

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3 Are there any exceptions?

IFRS 3 excludes the following combinations from its scope:
•  combinations involving the formation of joint ventures
•  combinations effected by contract alone
•  combinations of mutual entities
•  combinations of entities already under common control (which includes most group
   reconstructions).

Note that a business combination may be either a purchase of equity interest in an entity or the
purchase of assets which constitute a business.

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4 How do I identify the acquirer?

An acquirer must be identified in all business combinations. The acquirer is the party that has the
power to govern the financial and operating policies of the acquiree. Control may, for example, be
achieved via equity voting rights, contractual agreement, power to appoint the majority of directors or
control over the majority of votes at directors' meetings. Where the identity of the acquirer is not
obvious, the size of the combining businesses or domination of one party's management team should
be considered.

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5 Reverse acquisitions
Reverse acquisitions occur where the acquirer under IFRS 3 becomes the legal subsidiary but the
former shareholders of the subsidiary actually acquire control, e.g. where a private company is
acquired by a listed shell in a share-for-share exchange such that the former shareholders of the
private company gain control. Fair value accounting is applied to the assets of the legal parent, which
is treated as the acquiree. Reverse acquisition accounting reflects the substance of the transaction.

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6 How is goodwill calculated?
Goodwill is calculated initially as the difference between the fair value of the cost of the acquisition
less the fair value of the net assets acquired (net assets being all assets, including other intangible
assets less all liabilities).

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7 How is the cost of the acquisition calculated?
The cost of acquisition is the fair value of assets given, liabilities incurred or assumed, and equity
instruments issued by the acquirer in exchange for control of the acquiree, plus directly attributable
costs. Costs relating to the issue of debt or equity instruments should be excluded.

Where part of the consideration is based on contingent events, this should be recognised to the
extent that payment is probable and the amount can be measured reliably. Subsequent revisions
should then be reflected by updating the cost of the combination until the final outcome is known.

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8 How do I assess the fair value of the assets and liabilities?
The fair value assessment will include all of the acquiree's assets and liabilities, including those not
previously recognised by the acquiree. Intangible assets and contingent liabilities are included,
provided fair value can be measured reliably, which is usually presumed to be the case.

In the goodwill calculation liabilities do not include provision for future operating losses of the
acquired business or recognition of restructuring costs, which were conditional upon the business
combination proceeding. Onerous contracts are however included as liabilities (e.g. onerous leases).

IFRS 3 contains detailed provisions on the basis to be used to estimate fair values of various assets
and liabilities. For instance, finished goods stock is valued at selling price less costs of disposal less
a reasonable profit allowance for the selling effort. The fair value of a contingent liability is the amount
a third party would charge in order to assume the liability.

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9 Is my target business likely to have intangible assets?
Most businesses are likely to include intangible assets. Intangible assets are defined (in IAS 38) as
non- monetary assets without physical substance that either arise from contractual or legal rights or
are separable. IFRS 3 gives various examples of intangible assets, including:
•   sales orders or purchase orders
•   customer contracts and customer relationships
•   non-competition agreements
•   lease agreements (e.g. an existing lease on better than current market terms gives rise to an
    intangible asset)
•   franchise agreements (e.g. motor dealerships)
•   employment contracts at below market value terms (e.g. of a football club with players on long-
    term contracts at lower than current market terms)
•   patented technology and separable unpatented technology
•   internet domain names.

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10 How are fair values of intangibles calculated?
Intangibles can be included only where their fair value can be estimated reliably. IAS 38 takes the
view that most intangible assets can be measured reliably. This may require considerable resource
by acquiring companies, through time spent on ascertaining and performing valuation techniques.

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11 Do tax losses affect the goodwill calculation?
Where an acquiree has tax losses at acquisition and it is probable that they can be used within the
group, a deferred tax asset is recognised on acquisition (and therefore included in the goodwill
calculation). If the asset is not recognised initially (as recovery could not be assessed as probable at
acquisition) but is later assessed as recoverable, the goodwill should be updated to reflect this
deferred tax asset. However, a deferred asset cannot be recognised to the extent that it creates
negative goodwill.

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12 How are pension surpluses or deficits treated?
The fair value of a pension surplus should be recognised to the extent that it is available to the
acquirer through refunds or lower future contributions. The fair value of any pension deficit should be
recognised as a liability on acquisition.

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13 What do I do if I have negative goodwill?
You should reassess all assets and liabilities to ensure that no assets have been overstated or
liabilities understated or omitted (to double check the calculation). Negative goodwill would occur, for
example, if a bargain price were achieved. Negative goodwill is credited immediately to the profit and
loss account.

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14 What happens if fair values need to be estimated?
At the time of acquisition, fair values of acquired assets or liabilities may be based on provisional
estimates. If, within 12 months of the acquisition date, a revised estimate is available, goodwill should
be adjusted to reflect this. Comparative information should also be adjusted when provisional values
are determined finally. There is no time limit for revising the estimates in connection with deferred tax
assets created by the acquiree's tax losses. There is also no time limit for adjusting for material
errors, which are accounted for under IAS 8 by restating the accounts, including comparatives.

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15 What do I do with past business combinations?
Past business combinations, i.e. those occurring prior to the date of transition to IFRS, need not be
restated in accordance with IFRS 3. If the information necessary to restate past business
combinations in accordance with IFRS 3 is available, such statement is permitted. However, if a past
combination is restated, all subsequent combinations must be too.

Where goodwill is carried forward from business combinations prior to the transition to IFRS, this
should remain on the balance sheet at its existing (amortised) value, but amortisation ceases from
that point onwards. This goodwill is then tested annually for impairment. Any existing negative
goodwill should be transferred to reserves in the opening IFRS balance sheet.

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16 Our national IFRS implementation team

Cape Town                                           Johannesburg
Neil Adams                                          Jeanette Hern; Frank Timmins;
T +27 (0) 21 481 9000                               Jessica Saayman; Christel Pretorius
                                                    T +27 (0) 11 322 4500
Durban
Ahmed Timol                                         Port Elizabeth
T +27 (0) 31 576 5500                               Rudi Scholtz
                                                    T +27 (0) 41 373 4200
East London
Noreen Hartmann                                     Pretoria / Tshwane
T +27 (0) 43 726 9898                               Anabel Vieira
                                                    T +27 (0) 12 346 1430

				
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