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Business combinations under common control. Current Regulatory Situation under IFRS 3

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Joaquín Ureña analyzes the activity developed by the IASB on business combinations under common control until now

The constant growth in the internationalization of business, the boom in corporate operations, especially mergers and acquisitions (known as Mergers and Acquisitions, or M&A), the global access to financial markets and the increasing demand for regulatory compliance of companies (Corporate Compliance), make it necessary to have common standards in corporate accounting, which allow for full comparison and interpretation.

In the case of investment operations in listed companies and for M&A operations, the existing public information on the companies that are the object of the transaction is essential and conditions, for the most part, the investor's decision making. A rational investor makes the allocation of resources - investment - with the aim of maximising the expected profit from the final wealth. In situations of risk or partial uncertainty, in which the investing agent does not know what the future behavior of the acquired asset will be, he may. 1. Worldwide M&A activity in 2018 exceeded US$ 4 trillion, with an increase of 19% in relation to 2017 according to a Thomson Reuters report, associating probabilities of what will happen depending on the level of information available. It is therefore essential that the information provided by companies is a true reflection of the economic reality of the situation, is accessible to any potential user and, above all, is comparable in terms of its assessment and registration criteria. Financial reporting allows investors to assess the potential return on investment opportunities and to monitor important management decisions in mergers and acquisitions (Astolfi et al., 2015). This is why accounting for business combinations is of particular interest. The use of different accounting methods can affect the entire process of selecting, valuing, negotiating and executing transactions (Baker et al., 2010). As Sherman (2010) points out, no transaction is more complicated than a merger or acquisition. Moreover, they are almost one of the few transactions that allow companies to record new intangible assets on their balance sheets (Bonacchi et al., 2015).

As stated by the International Accounting Standards Board (IASB) in paragraph 1.2 of the Revised Framework for Financial Reporting, 'the objective of general purpose financial reporting is to provide financial information about the enterprise that is useful to existing and potential investors, lenders and other creditors in making decisions about the provision of resources to the entity' (IASB, 2018). This statement leads us to believe that the primary purpose of financial reporting is fundamental to decision-making by all stakeholders.

Likewise, accounting information plays a potentially crucial role in corporate governance. For investors, who know nothing about the companies in which they invest, basic accounting standards are necessary to interpret the information provided by companies (La Porta et al., 1998)

All this leads to the necessary homogenisation of local accounting practices for international use, and in this spirit, the two major international issuers of accounting standards, the Financial Accounting Standards Board (FASB) in the United States and the IASB at an international level, signed a Memorandum of Understanding (MOU) in Norwalk, USA, in September 2002, in which they committed to initiate an active process of convergence and formal linking of their respective standards, with the aim of improving the uniformity, comparability and efficiency of the financial statements prepared by the companies.

This document established a guide for convergence, based on the gradual issuance of new common standards rather than the elimination of differences in already obsolete standards that require significant changes.

As a result of this joint collaboration, International Financial Reporting Standard 3 Business Combinations (IFRS 3) was published in 2008 by the IASB as a revised version of the initial standard approved in March 2004. This revised standard arises as part of a joint effort by the IASB and the FASB to improve financial reporting while promoting international convergence of accounting standards. Previously, the FABS had issued FASB Document No. 141 (revised 2007) Business Combinations and FASB Document No. 160 Non-Controlling Interests in Consolidated Financial Statements.

But as in its previous version, its scope expressly states that "This IFRS shall not apply to: (c) a combination of entities or businesses under common control" (IASB, 2008), with the corresponding application guidance provided in paragraphs B1-B4 of Appendix B of the standard, which provides details of such combinations. In particular, a combination of entities or businesses under common control is defined as follows: "A business combination between entities or businesses under common control is a business combination in which all of the combining entities or businesses are ultimately controlled by the same party or parties both before and after the business combination, and that control is not transitory' (paragraph B1, IFRS 3).

In other words, irrespective of the reasons for the combination, these are mostly restructuring operations of business groups that do not result in changes in their ultimate composition, since control remains the same.

It should be recalled that the concept of control is set out in paragraph 6 of International Financial Reporting Standard 10 Consolidated Financial Statements (IFRS 10), which states that: "An investor controls an investee when it is exposed to, or is entitled to, variable returns arising from its involvement in the investee and has the power to influence those returns through its control over the investee. Consequently, an investor controls an investee if all of the following conditions are met (a) power over the investee; (b) exposure to, or entitlement to, variable returns arising from his involvement in the investee; and (c) ability to use his power over the investee to influence the amount of the investor's returns.

These transactions, which are often carried out under common control and relate to intra-group reorganisations and restructuring, are economically neutral. The valuation of the combined group is the same as before the combination. However, in the current situation of lack of a specific standard governing them, situations may arise where, depending on the accounting method chosen by group management for the transaction, there is, for example, a change in the degree of leverage in the companies after the combination is recorded (Bonacchi et al., 2015).

Currently, these transactions under common control are accounted for using the approach in International Accounting Standard 8 Accounting Policies, Changes in Accounting Estimates and Errors (IAS 8), in application of paragraph 10:

"In the absence of an International Standard or an Interpretation that specifically applies to a transaction, other event or condition, management shall use its judgement in developing and applying an accounting policy to provide information that is:

(a) Relevant to the economic decision-making needs of users; and

(b) Reliable, in the sense that the financial statements

  • I. Present fairly the entity's financial position, financial performance and cash flows;
  • II. Reflect the economic substance of transactions, other events and conditions, and not merely their legal form;
  • III. Are neutral, ie free from bias and prejudice;
  • IV. Are prudent; and
  • V. Are complete in all material respects.”

In other words, depending on the criteria of the group's management, the transaction may be recorded by the method of acquisition (as explained in IFRS 3) or by the amount corresponding to the historical cost at which it was initially recorded. Given this situation of interpretative subjectivity, it seems reasonable that there should be a separate standard (IFRS) for business combinations under common control (Janowicz, 2017).

This paper shows the evolution of the project on business combinations under common control initially included by the IASB in its agenda in December 2007 with the creation of a working group to act as an advisor to the Board on this matter, but without obtaining results, reactivated as its own project in 2012 based on the work carried out by EFRAG2 with its request for comment letters on the subject, until the meeting held in July 2019 to discuss the information needs of potential equity investors in the combined entities.

You can see the complete article in the Accounting Viewpoint of the General Council of Economists of Spain. 

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