Effects of IFRS 9, 15 and 16 on business combinations occurring after the effective dates of these new standards
In April 2019 Accounting News, we considered how, in light of the usual transition assessments preparers need to make with regard to the ‘triple threat’ new standards, thought is also required to determine the impact of these new standards on past business combinations accounted for under IFRS 3 Business Combinations, where ‘acquisition date’ for the combination was prior to the effective date of these standards (i.e. periods beginning on or after 1 January 2018 for the new revenue and financial instruments standards, and 1 January 2019 for the new leases standard).
This month we focus on the impact these three new standards could have on business combinations entered into after their effective dates.
Impact of IFRS 9 Financial Instruments - Classification of Financial Assets
The classification of financial assets under IFRS 9 occurs at their initial recognition.
For financial assets acquired in a business combination, initial recognition occurs at the time of the business combination.
This could result in different assumptions being made by the acquiree on initial recognition, and the acquirer at the date of the business combination, and means that:
- The contractual cash flow test (i.e. assessing whether a debt instrument gives rise to solely payments of principal and interest)
- Assessing the business model in which a financial asset is used, and
- The fair value option, are all available at the time financial assets are initially recognised by the acquirer in a business combination.
This may result in different classifications in the group financial statements as compared to the books of the acquiree, and will affect measurement of financial assets from the perspective of the acquirer and the acquiree.
Impact of IFRS 9 Financial Instruments - Staging Provisions of Expected Credit Loss Requirements
For financial assets acquired in a business combination that are subject to the expected credit loss (ECL) requirements of IFRS 9 (e.g. debt instruments measured at amortised cost or fair value through other comprehensive income - FVTOCI), entities may have to segregate those financial assets acquired in a business combination from those originated by the entity and its subsidiaries. This is due to the staging provisions of IFRS 9’s ECL requirements, where financial assets subject to ECL are categorised into ‘buckets’:
- Stage 1: Financial assets that have not had a significant increase in credit risk since initial recognition
- Stage 2: Financial assets that have had a significant increase in credit risk since initial recognition, or
- Stage 3: Credit-impaired financial assets.
Since the relative change in credit risk since initial recognition is the mechanism for migration between these stages, ‘initial recognition’ must be considered carefully. For an acquirer, ‘initial recognition’ is the date of the business combination.
Entity A is a lending entity, who acquired Entity B on 1 January 2020.
Entity B has several portfolios of loans measured at amortised cost, which are categorised into Stages 1 – 3 based on the relative movement in credit risk since they were originated by Entity B.
From the perspective of Entity A, all such financial assets must be categorised into Stage 1 at the time of the business combination occurring (assuming no such assets are purchased or originated credit impaired financial assets).
This will result in several significant implications, which may be complex to address in financial reporting systems:
- Entity A’s assessment of the staging of these loans will differ from Entity B’s.
- In order to address the staging provisions, Entity A will need to develop policies and procedures to measure the relative movement in credit risk since the date of the business combination, and
- The ongoing ECL required on the instruments may therefore differ as staging may differ (e.g. a 12-month ECL may be required for Entity A, but a lifetime ECL may be required for Entity B).
There are also significant implications on the presentation of financial assets subject to ECL.
Impact of IFRS 9 Financial Instruments - Presentation of Expected Credit Losses
Like most assets acquired in a business combination, financial assets acquired in a business combination that are subject to the ECL requirements of IFRS 9 are initially recorded at their fair value as at the date of the business combination. While ECL is a forward-looking measure with some similarities to fair value measurement, the concepts are not identical. Therefore, the net carrying value of financial assets may differ from their fair value.
Continuing on from Example 1, assume a particular financial asset subject to ECL that is owned by Entity B prior to the business combination had a gross carrying value of $100.
It also has a corresponding $20 ECL recorded against it, representing the lifetime ECL of the financial asset, as it is classified as a Stage 2 financial asset.
At the time of the business combination, Entity A determines its fair value to be $78 (note that the fair value of a financial asset may be more or less than the gross carrying value less ECL depending on a number of factors).
No separate valuation allowance is recorded in the purchase price allocation by Entity A (IFRS 3.B41) because the fair value of the financial asset incorporates uncertainty regarding credit risk. The difference in classification and measurement of the financial asset from the perspective of Entity B and Entity A’s consolidated records as at the time of the business combination can be demonstrated as follows:
Gross carrying value
Net carrying value
Stage in ECL methodology
Stage 1 – 12-month ECL
Stage 2 – lifetime ECL
This results in not only the carrying value differing upon the completion of the business combination, but also the measurement of the ECL balance and the staging of the financial asset in the ECL guidance. Addressing these differences from a systems and process standpoint may be complex, especially if Entity A and B are required to maintain distinct financial records for reasons such as local jurisdictional regulation.
Impact of IFRS 15 Revenue from Contracts with Customers - Accounting for Contracts with Satisfied Performance Obligations and Interaction with IFRS 9 and IFRS 15
Entities that acquire entities with completed contracts for which revenue recognition remains outstanding will have to carefully examine the contractual terms of contracts.
Entity Y acquires Entity Z.
Entity Z has a contract to develop a website for a customer in the scope of IFRS 15, where revenue is based on the number of website visits over the next 5 years.
At the time Entity Z is acquired, Entity Z has satisfied its performance obligation as the website is developed and no deliverables remain, however, revenue has not been entirely recognised for the contract, due to the variable amount of the transaction price being constrained (IFRS 15, paragraph 56).
Therefore, despite the fact that Entity Z has satisfied all the performance obligations identified in the contract, revenue will continue to be recognised as the variable consideration constraint is ‘released’ over the 5-year period.
When Entity Y acquires Entity Z, it accounts for the contract acquired using IFRS 3. As discussed above, this would include measuring the outstanding performance obligations at their fair value, however, no such performance obligations exist, because Entity Z satisfied them all prior to the date of the business combination. In substance, Entity Y has acquired a stream of future cash flows that will vary depending on website traffic, with no obligation to perform any activities associated with the contract.
At the time of the acquisition, Entity Y must measure an asset relating to the stream of future cash flows that are expected to be received. This may be achieved by determining a best estimate of the cash flows to be received and applying an appropriate discount rate. To subsequently measure the asset acquired by Entity Y in the business combination, Y must consider the nature of the asset it received in the business combination.
As the cash flows do not require Entity Y to provide any goods or services, from the perspective of the acquirer, the contract is a financial asset in the scope of IFRS 9, not a contract with a customer in the scope of IFRS 15.
The financial asset must therefore be classified based on the requirements of IFRS 9. Because the financial asset’s cash flows vary depending on the next 5 years of website traffic, the financial asset would not satisfy the contractual cash flow test under IFRS 9, and would therefore be mandatorily classified as at fair value through profit or loss (FVTPL). As such, the contract is therefore initially recorded at fair value by Entity Y and subsequently measured at FVTPL.
Since the financial asset is not on the scope of IFRS 15, movements in the financial asset’s carrying value will be recorded in profit or loss, but they would not be classified as revenue under IFRS 15. They would be presented with other fair value movements in financial assets classified as fair value through profit or loss.
This results in significantly different financial reporting outcomes in the consolidated accounts of Entity Y compared to Entity Z. As the uncertainty surrounding the amount of cash is resolved, Entity Z will record revenue under IFRS 15, subject to the variable consideration constraint. Entity Y will record income (being fair value movements on the financial asset at FVTPL) arising from financial instruments, which is not ‘top line’ revenue, and is also subject to different measurement guidance (fair value measurement under IFRS 9 and IFRS 13 vs. variable consideration subject to the variable consideration constraint under IFRS 15).
Impact of IFRS 15 Revenue from Contracts with Customers - Resetting Discount Rates in Contracts with Significant Financing Components
IFRS 15 requires that the transaction price of contracts be adjusted when a contract contains the benefit of a significant financing component to either the customer or the entity itself. This would result in the adjustment of the transaction price and the presentation of finance income when the benefit of financing is to the customer or the presentation of finance expense when the benefit of financing is to the entity itself.
The discount rate used to adjust the transaction price and subsequently used to calculate finance income or expense is determined at the inception of the contract, but it must be re-assessed by an acquirer in a business combination.
Contract assets and contract liabilities will be recognised at their fair value in a business combination. Inherent in this will be the determination of a discount rate based on the guidance in IFRS 13 Fair Value Measurement, which is a market participant-based rate.
In subsequently accounting for the contract, from the perspective of the acquirer, a discount rate as determined using the principles of IFRS 15 will be used to subsequently measure the contract. The effect of this difference in accounting between the acquirer and the acquiree would be especially apparent in long-term contracts with ‘over time’ revenue recognition, such as certain long-term construction contracts.
Impact of IFRS 16 Leases - Measurement of Lease Contracts for Lessees
Since almost all lease contracts will be recorded ‘on balance sheet’ under IFRS 16, leases acquired in business combinations will require specific measurement considerations. Leases liabilities will be recorded based on the present value of the remaining lease payments, with a corresponding right-of-use asset (adjusted for favourable or unfavourable terms compared to market). This measurement requirement has several key points to consider:
- While IFRS 3 will no longer result in separate intangibles being recognised for favourable lease terms, entities must still identify when lease contracts have favourable terms, as it will adjust the value of right-of-use assets.
- The lease liability and corresponding right-of-use asset being ‘reset’ to equal one another (assuming no adjustment to the right-of-use asset for favourable or unfavourable terms) at the time of the business combination may create significant differences between acquirer and acquiree records. This is because the acquiree’s amortisation tables may differ substantially as a result of the acquired leases being treated as if they were brand new leases from the perspective of the acquirer, including the option to expense low value or short-term leases (based on the remaining term as at the date of the business combination).
Contingent Consideration Payable
For business combinations occurring both prior to and after the effective dates of IFRS 9, 15 and 16, the business impact on contingent consideration payable must be considered.
It is common for acquirers to pay a fee to the seller of a business, which is contingent on the future operations and profitability of the acquired entity. This fee may be a multiple of net income, earnings before interest, tax, depreciation and amortisation (‘EBITDA’), or some other metric.
IFRS 9, 15 and 16 may have significant impacts on the calculation of items such as net income and EBITDA, which may impact the amount of contingent consideration payable. For business combinations that occurred prior to the effective dates of IFRS 9, 15 and 16, the terms of the agreements must be analysed to determine whether the basis of accounting to determine the contingent amount is based on a ‘frozen’ set of accounting policies, or whether they are updated to reflect changes arising from IFRS 9, 15 and 16.
For business combinations occurring subsequent to the effective dates of the new standards, entities must be aware of the impact the new standards will have on these metrics. For example, if entities have historically used a multiplier of EBITDA in contingent consideration agreements, the effects of IFRS 16 on EBITDA must be considered.