IAS 22 similarly did not deal with the formation of joint ventures or transactions among enterprises under common control. However, IAS 22 included within its scope combinations involving two or more mutual entities, and combinations in which separate entities or businesses are brought together to form a reporting entity by contract alone without the obtaining of an ownership interest.
Business combinations involving the formation of a joint venture
BC17 Although the treatment by venturers of interests in joint ventures is addressed in IAS 31 Interests in Joint Ventures, the Board has not yet considered the accounting by a joint venture upon its formation. The issues involved relate to broader 'new basis' issues that the Board intends to address as part of the second phase of its Business Combinations project.
BC18 However, in developing ED 3 and the IFRS, the Board considered whether it should amend the definition of joint control in IAS 31. The Board decided to consider this issue because it was concerned that its decision to eliminate the pooling of interests method (see paragraphs BC37-BC55) would create incentives for business combinations to be structured to meet the definition of a joint venture. A joint venture is defined in IAS 31 as 'a contractual arrangement whereby two or more parties undertake an economic activity that is subject to joint control.' Joint control was defined as 'the contractually agreed sharing of control over an economic activity.'
BC19 The Board considered as a starting point the following definition proposed in the 1999 G4+1 discussion paper Reporting Interests in Joint Ventures and Similar Arrangements:
Joint control over an enterprise exists when no one party alone has the power to control its strategic operating, investing, and financing decisions, but two or more parties together can do so, and each of the parties sharing control (joint venturers) must consent.
BC20 In developing ED 3, the Board decided that the definition of joint control should be more closely aligned with the definition proposed by the G4+1. ED 3 proposed amending the definition of joint control as follows:
Joint control is the contractually agreed sharing of control over an economic activity exists only when the financial and operating decisions relating to the activity require the unanimous consent of the parties sharing control (the venturers).
BC21 Many respondents to ED 3 suggested that, unlike the definition proposed by the G4+1, the above definition would result in a joint venture existing only when unanimous consent is required for all, rather than just strategic, financial and operating decisions. They recommended that the Board retain the former definition of joint control in IAS 31, pending a comprehensive review of that Standard.
BC22 The Board agreed with the respondents' concerns that requiring unanimous consent on all financial and operating decisions would narrow by too far the types of arrangements meeting the definition of a joint venture. However, the Board remained concerned that the former definition of joint control could result in the requirement to apply the purchase method being circumvented when a business combination involves the owners of multiple businesses (for example, multiple medical practices) agreeing to combine their businesses into a new entity (sometimes referred to as rollup transactions). In such circumstances, the owners of the combining businesses could avoid the requirement to apply the purchase method by contractually agreeing that all the essential strategic operating, investing, and financing decisions require the consent of a majority of the owners. The Board concluded that in the absence of a contractual agreement requiring unanimous consent to strategic operating, investing and financing decisions of the parties sharing control, such transactions should be accounted for by applying the purchase method.
BC23 As a result, the Board decided to amend the definition of joint control as follows:
Joint control is the contractually agreed sharing of control over an economic activity, and exists only when the strategic financial and operating decisions relating to the activity require the unanimous consent of the parties sharing control (the venturers).
Business combinations involving entities under common control (paragraphs 10-13)
BC24 Because the first phase of the project primarily dealt with the issues identified in paragraph BC3, the Board also decided to defer until the second phase of the project consideration of the accounting for business combinations involving entities or businesses under common control.
BC25 The former Standing Interpretations Committee (SIC) received numerous requests to clarify the types of transactions that were within the IAS 22 scope exclusion for transactions among enterprises under common control. The SIC concluded that, in the absence of authoritative guidance, the identification of transactions within the scope exclusion was likely to receive divergent or unacceptable treatment. Therefore, the SIC agreed in December 2000 to add this issue to its agenda. The SIC had not, however, completed its deliberations by the time the Board began the first phase of its Business Combinations project. In developing ED 3 and the IFRS the Board reached the same view as the SIC and agreed that the IFRS replacing IAS 22 should include authoritative guidance on this issue.
BC26 Because the IFRS addresses the accounting for business combinations and not other transactions, the Board concluded that the nature of the scope exclusion would be better expressed as 'business combinations involving entities or businesses under common control’ rather than 'transactions among enterprises under common control’.
BC27 The IFRS defines a business combination involving entities or businesses under common control as a business combination in which all of the combining entities or businesses ultimately are controlled by the same party or parties both before and after the combination, and that control is not transitory. In arriving at this definition, and the related guidance in paragraphs 10-13, the Board first considered the meaning of common control. The Board noted that control is defined in IFRSs as the power to govern the financial and operating policies of an entity or business so as to obtain benefits from its activities. This definition requires consideration of direct and indirect relationships and is not limited to control by another entity; control can, for example, rest with an individual or a group of individuals acting collectively under contractual arrangements. In addition, the definition of control means that control of an entity can exist irrespective of the extent of minority interest in that entity. The Board also noted that the ordinary meaning of 'common’ is a similarity shared by two or more things. Therefore, the Board concluded that entities or businesses are under common control when the same party or parties have the power to govern the financial and operating policies of those entities or businesses so as to obtain benefits from their activities. The Board further concluded that for a business combination to involve entities or businesses under common control, the combining entities or businesses would need to be controlled by the same party or parties both before and after the combination.
BC28 The Board noted the concern expressed by some that business combinations between parties acting at arm's length could be structured through the use of 'grooming’ transactions so that, for a brief period immediately before the combination, the combining entities or businesses are under common control. In this way, it might be possible for combinations that would otherwise be accounted for in accordance with the IFRS using the purchase method to be accounted for using some other method. Thus, the Board decided that for a business combination to be excluded from the scope of the IFRS as one involving entities or businesses under common control, the combining entities or businesses should be controlled by the same party or parties both before and after the combination, and that control should not be transitory.
Combinations involving mutual entities or the bringing together of separate entities to form a reporting entity by contract alone
BC29 The Board decided to exclude from the scope of the IFRS the following business combinations:
(a) combinations involving two or more mutual entities.
(b) combinations in which separate entities are brought together to form a reporting entity by contract alone without the obtaining of an ownership interest. This includes combinations in which separate entities are brought together by contract to form a dual listed corporation.
BC30 ED 3 did not propose to exclude such transactions from the scope of the IFRS, but instead proposed to delay the application of the IFRS to the accounting for such transactions until the Board issues guidance on the application of the purchase method to those transactions. In developing ED 3, the Board observed that differences between the ownership structures of mutual entities (such as mutual insurance companies or mutual cooperative entities) and those of investor-owned entities give rise to complications in applying the purchase method to business combinations involving two or more mutual entities. Similarly, the Board noted that complications arise in applying the purchase method to combinations involving the formation of a reporting entity by contract alone without the obtaining of an ownership interest. The Board decided to propose in ED 3 that until those issues are resolved as part of the second phase of the Business Combinations project, the accounting for such transactions should continue to be dealt with by IAS 22.
BC31 During its redeliberations, the Board observed that continuing to apply IAS 22 to such transactions would result in them being classified either as unitings of interests or as acquisitions. If such a transaction were classified as a uniting of interests, it would be required by IAS 22 to be accounted for by applying the pooling of interests method. The Board decided that this would not be consistent with its conclusion that there are no circumstances in which the pooling of interests method provides information superior to that provided by the purchase method (see paragraphs BC50-BC53). The Board also observed that if such a transaction were classified as an acquisition, it would be required by IAS 22 to be accounted for by applying the purchase method, but a different version of the purchase method from that contained in the IFRS. The Board considered it troublesome that two versions of the purchase method might coexist for a period of time, particularly given that the two versions might produce quite different results. For example, unlike the IFRS, IAS 22 would require goodwill amortisation and permit restructuring plans that do not meet the definition of a liability to be recognised as a provision as part of allocating the cost of the combination.
BC32 The Board then considered whether entities should be required to apply the IFRS to such transactions, focusing its discussion on two issues that might arise in applying the purchase method to those transactions. The first was the proposition that it might be difficult to identify the acquirer. The second was the concern that such transactions normally do not involve the payment of any readily measurable consideration. Thus, difficulties would arise in estimating the cost of the business combination and any goodwill acquired in the combination.
BC33 On the first issue, the Board reaffirmed its conclusion outlined in paragraphs BC54 and BC55.
BC34 On the second issue, the Board decided that until it develops as part of the second phase of its Business Combinations project guidance on applying the purchase method to such transactions, the IFRS should include such transactions within its scope. However, the IFRS should require the aggregate fair value of the acquiree's identifiable assets, liabilities and contingent liabilities to be treated as the deemed cost of the business combination. Therefore, until guidance is developed as part of the second phase of the Business Combinations project on estimating the fair value of an acquiree when the combination does not involve readily measurable consideration, no goodwill would arise in the accounting for such transactions. The Board decided, however, that it would not be appropriate to incorporate this interim solution into the IFRS without first exposing it for public comment. Therefore, given the Board's desire to issue the IFRS before the end of March 2004, the Board decided:
(a) to proceed with publishing the IFRS before the end of March 2004, but to exclude such transactions from its scope.
(b) to publish at about the same time as the IFRS an exposure draft proposing a limited amendment to the IFRS whereby such transactions would be included within the scope of the IFRS, but with the aggregate fair value of the acquiree's identifiable assets, liabilities and contingent liabilities being treated as the deemed cost of the combination.
Scope inclusions (paragraph 8)
BC35 The Board concluded that, because the first phase of the project dealt primarily with the issues identified in paragraph BC3, the IFRS should apply to the same transactions as IAS 22. The Board observed that the definition of a business combination in IAS 22, and therefore the scope of IAS 22, included combinations in which one entity obtains control of another, but for which the date of obtaining control (the acquisition date) does not coincide with the date of acquiring an ownership interest (the date of exchange). This might occur, for example, when an investee enters into share buy-back arrangements with some of its investors and, as a result of those arrangements, control of the investee changes.
BC36 However, the Board noted that some constituents might not have appreciated this implication of IAS 22's scope. Accordingly, the Board decided that the IFRS should explicitly state that such transactions are within its scope.
Method of accounting (paragraph 14)
BC37 ED 3 proposed, and the IFRS requires, all business combinations within its scope to be accounted for using the purchase method. IAS 22 permitted business combinations to be accounted for using one of two methods: the pooling of interests method for combinations classified as unitings of interests and the purchase method for combinations classified as acquisitions.
BC38 Although IAS 22 tightly restricted the scope of business combinations that could be accounted for using the pooling of interests method, analysts and other users of financial statements indicated that permitting two methods of accounting for business combinations impaired the comparability of financial statements. Others indicated that requiring more than one method of accounting for substantially similar transactions created incentives for structuring transactions to achieve a desired accounting result, particularly given that the two methods produce substantially different results. These factors, combined with the prohibition of the pooling of interests method in Australia, Canada and the United States, prompted the Board to examine whether, given that few combinations were understood to be accounted for in accordance with IAS 22 using the pooling of interests method, it would be advantageous for international standards to converge with those in Australia and North America by also prohibiting the method.
BC39 After considering all the information and arguments put before it, including case studies drawn from situations encountered in practice, the Board concluded that most business combinations result in one entity obtaining control of another entity (or entities) or business(es), and therefore that an acquirer could be identified for most combinations. However, the Board decided that it should not, in the first phase of its project, rule out the possibility of a business combination occurring (other than a combination involving the formation of a joint venture) in which one of the combining entities does not obtain control of the other combining entity or entities (often referred to as a 'true merger’ or 'merger of equals').
BC40 Therefore, the Board focused first on the appropriate method of accounting for business combinations in which one entity obtains control of another entity or business. Next it considered the method of accounting that should be applied to those business combinations within the scope of the IFRS for which one of the combining entities does not obtain control of the other combining entity (or entities), assuming such transactions exist.
BC41 For the reasons discussed in paragraphs BC44-BC46, the Board concluded that the purchase method is the appropriate method of accounting for business combinations in which one entity obtains control of another entity (or entities) or business(es).
BC42 As discussed in paragraphs BC47-BC49, the Board concluded that the IFRS arising from the first phase of the project should also require the purchase method to be applied to those combinations within its scope for which one of the combining entities does not obtain control of the other combining entity. The Board acknowledged, however, that a case might be made for using the 'fresh start’ method to account for such business combinations. The fresh start method derives from the view that a new entity emerges as a result of such a business combination. Therefore, a case can be made that the assets and liabilities of each of the combining entities, including assets and liabilities not previously recognised, should be recognised by the new entity at their fair values. However, the Board observed that to the best of its knowledge the fresh start method is not currently applied in any jurisdiction in accounting for business combinations, and that one of the primary aims of the first phase of the project is to seek international convergence on the method(s) of accounting for combinations. Therefore, the Board committed itself to exploring in a future phase of its Business Combinations project whether the fresh start method might be applied to some combinations. The Board noted, however, that business combinations to which the fresh start method might be applied would not necessarily be all of those that would be classified by IAS 22 as unitings of interests and accounted for by applying the pooling of interests method. Consequently, the pooling of interests method in IAS 22 could not simply be replaced with the fresh start method.
BC43 Most of the respondents to ED 3 supported the proposal to eliminate the pooling of interests method and require all business combinations to be accounted for by applying the purchase method, pending the Board's future consideration of whether the fresh start method might be applied to some combinations.
Business combinations in which one of the combining entities obtains control
BC44 The Board concluded that the purchase method is the only appropriate method of accounting for business combinations in which one entity obtains control of one or more other entities or businesses. The purchase method views a combination from the perspective of the combining entity that is the acquirer (ie the combining entity that obtains control of the other combining entities or businesses). The acquirer purchases net assets and recognises in its financial statements the assets acquired and liabilities and contingent liabilities assumed, including those not previously recognised by the acquiree. The nature of the consideration exchanged does not affect the recognition or measurement of the assets acquired and liabilities and contingent liabilities assumed. Because the exchange transaction is assumed to result from arm's length bargaining between independent parties, the values exchanged are presumed to be equal. The measurement of the acquirer's assets and liabilities is not affected by the transaction, nor are any additional assets or liabilities of the acquirer recognised as a result of the transaction, because they are not involved in the transaction. Therefore, the purchase method faithfully represents the underlying economics of business combinations in which one entity obtains control of another entity or business.
BC45 The Framework notes that one of the objectives of financial statements is to show the accountability of management for the resources entrusted to it. Because the purchase method recognises the values exchanged in a business combination, it provides users of an entity's financial statements with more useful information for assessing the investment made by management and the subsequent performance of that investment. In addition, by recognising at their fair values all of the assets acquired and liabilities and contingent liabilities assumed, the purchase method impounds information from the current transaction about the expected future cash flows associated with the assets acquired and liabilities and contingent liabilities assumed, thereby providing greater predictive value.
BC46 The Board considered the assertion that identifying the fair values of assets acquired and liabilities and contingent liabilities assumed in such business combinations is too costly or too difficult, particularly when the assets and liabilities are not traded regularly. The Board concluded that the benefits of obtaining more useful financial information by applying the purchase method outweigh the costs to obtain fair values, and that an understanding by the acquirer of the fair values of the assets acquired and the liabilities and contingent liabilities assumed would be necessary to arrive at an acceptable exchange value for the combination. Therefore, any additional costs or difficulties associated with recognising those assets, liabilities and contingent liabilities at their fair values are unlikely to be significant.
Business combinations in which none of the combining entities obtains control
BC47 As noted above, the Board decided that it should not, in the first phase of its Business Combinations project, rule out the possibility of a combination occurring (other than a combination involving the formation of a joint venture) in which one of the combining entities does not obtain control of the other combining entity or entities. Such combinations are sometimes referred to as 'true mergers' or 'mergers of equals'.
BC48 The Board concluded that even if 'true mergers' exist and were to be accounted for using a method other than the purchase method, suitable non-arbitrary and unambiguous criteria would be needed to distinguish those transactions from business combinations in which one entity obtains control of another entity (or entities). The Board observed that such criteria do not exist at present and, based on the history of the pooling of interests method, would be likely to take considerable time, and be extremely difficult, to develop. The Board also noted that:
(a) one of its primary aims in the first phase of the project is to seek international convergence on the method(s) of accounting for business combinations.
(b) permitting more than one method of accounting for combinations would create incentives for structuring transactions to achieve a desired accounting result, particularly given that the different methods (ie the purchase method and the pooling of interests method) produce significantly different accounting results.
(c) true mergers, assuming they exist, are likely to be rare.
(d) it does not follow that the pooling of interests method is the appropriate method of accounting for true mergers, assuming they exist. For the reasons outlined in paragraphs BC50-BC53, the Board concluded that in no circumstances does the pooling of interests method provide information superior to that provided by the purchase method, and that if true mergers were to be accounted for using a method other than the purchase method, the 'fresh start’ method was likely to be more appropriate than the pooling of interests method.
BC49 Therefore, the Board concluded that the IFRS arising from the first phase of the project should require all business combinations to be accounted for by applying the purchase method. However, as discussed in paragraph BC42, the Board committed itself to exploring in a future phase of its Business Combinations project whether the 'fresh start’ method might be applied to some combinations.
Reasons for rejecting the pooling of interests method
BC50 IAS 22 permitted business combinations to be accounted for using one of two methods: the pooling of interests method or the purchase method. These methods were not regarded as alternatives for the same form of business combination either in IAS 22 or the equivalent accounting standards in other jurisdictions that permitted the use of the two methods. Rather, each method applied to a specific form of business combination: the purchase method to those that were acquisitions (ie business combinations in which one entity obtains control of another entity or business), and the pooling of interests method to those that were 'true mergers' or 'unitings of interest’. Standard-setters disagree about the precise meaning of the term 'true merger’. However, the Board's deliberations on applying the pooling of interests method to true mergers focused on combinations in which one of the combining entities does not obtain control of the other combining entity or entities. The Board concluded that the pooling of interests method should not be applied to such transactions because in no circumstances does it provide information superior to that provided by the purchase method.
BC51 Use of the pooling of interests method was limited to business combinations in which equity was the predominant form of consideration. Assets and liabilities of the combining entities were carried forward at their pre-combination book values, and no additional assets or liabilities were recognised as a result of the combination. The Board considered the assertion that the pooling of interests method is appropriate for true mergers because, in such transactions, ownership interests are completely or substantially continued, no new equity is invested and no assets are distributed, post-combination ownership interests are proportional to those before the combination, and the intention is to have a uniting of commercial strategies. The Board rejected these arguments, noting that although a combination effected by an exchange of equity instruments results in the continuation of ownership interests, those interests change as a result of the combination. The owners of the combining entities have, as a result of the combination, a residual interest in the net assets of the combined entity. The information provided by applying the pooling of interests method would fail to reflect this and would therefore lack relevance. Because the assets and liabilities of all the combining entities would be recognised at their pre-combination book values rather than at their fair values at the date of the combination, users of the combined entity's financial statements would be unable to assess reasonably the nature, timing and extent of future cash flows expected to arise from the combined entity as a result of a combination. Furthermore, the Board does not accept that the nature of the consideration tendered (equity interests in the case of true mergers) should dictate how the assets and liabilities of the combining entities are recognised.
BC52 The Board also considered the assertion that the pooling of interests method properly portrays true mergers as a transaction between the owners of the combining entities rather than between the combining entities. The Board rejected this assertion, noting that business combinations are initiated by, and take place as a result of, a transaction between the entities themselves. It is the entities, and not their owners, that engage in the negotiations necessary to cany out the combination, although obviously the owners must eventually participate in and approve the transaction.
BC53 The Framework notes that one of the objectives of financial statements is to show the accountability of management for the resources entrusted to it. The Board observed that the pooling of interests method is an exception to the general principle that exchange transactions are accounted for at the fair values of the items exchanged. Because it ignores the values exchanged in the business combination, the information provided by applying the pooling of interests method does not hold management accountable for the investment made and its subsequent performance.
Business combinations in which it is difficult to identify an acquirer
BC54 The Board observed that in some business combinations, domestic legal, taxation or economic factors can make it extremely difficult to identify an acquirer. This can occur, for example, when entities of similar sizes or capitalisations come together through industry restructurings, with existing managements and staff retained and integrated. The Board considered arguments about whether such factors could make it impossible to identify an acquirer in a business combination and, if so, whether the pooling of interests method should be permitted in such circumstances. The Board also considered whether applying the purchase method to combinations for which identifying the acquirer is difficult could result in an arbitrary selection of an acquirer and therefore be detrimental to the comparability of accounting information. As part of its deliberations, the Board considered case studies that related to situations encountered in practice.
BC55 Whilst acknowledging that it could be difficult to identify an acquirer in some rare circumstances, the Board did not agree that exceptions to applying the purchase method should be permitted. The Board concluded that in no circumstances does the pooling of interests method provide superior information to that provided by the purchase method, even if identifying the acquirer is problematic.
Application of the purchase method
Identifying an acquirer (paragraphs 17-23)
BC56 As proposed in ED 3, the IFRS carries forward from IAS 22 the principle that, in a business combination accounted for using the purchase method, the acquirer is the combining entity that obtains control of the other combining entities or businesses. In developing ED 3 and the IFRS, the Board observed that the use of the control concept as the basis for identifying the acquirer is consistent with the use of the control concept in IAS 27 Consolidated and Separate Financial Statements to define the boundaries of the reporting entity and provide the basis for establishing the existence of a parent-subsidiary relationship. The IFRS also carries forward the guidance in paragraphs 10 and 11 of IAS 22 on control and identifying an acquirer.
Identifying an acquirer in a business combination effected through an exchange of equity interests (paragraph 21)
BC57 In developing ED 3 and the IFRS, the Board decided not to cany forward paragraph 12 of IAS 22, which provided guidance on identifying which of the combining entities is the acquirer when one entity (say entity A) obtains ownership of the equity instruments of another entity (entity B) but, as part of the exchange transaction, issues enough of its own voting equity instruments as purchase consideration for control of the combined entity to pass to the owners of entity B. IAS 22 described such a situation as a reverse acquisition and required the entity whose owners control the combined entity to be treated as the acquirer. The Board observed that such an approach to identifying the acquirer presumed that for any business combination effected through an exchange of equity interests, the entity whose owners control the combined entity is always the entity with the power to govern the financial and operating policies of the other entity so as to obtain benefits from its activities. The Board observed that this is not always the case and that carrying forward such a presumption to the IFRS would in effect override the control concept for identifying the acquirer.
BC58 The Board noted that the control concept focuses on the relationship between two entities, in particular, whether one entity has the power to govern the financial and operating policies of another so as to obtain benefits from its activities. Therefore, the Board concluded that fundamental to identifying the acquirer in a business combination is a consideration of the relationship between the combining entities to determine which of them has, as a consequence of the combination, the power to govern the financial and operating policies of the other so as to obtain benefits from its activities. The Board concluded that this should be the case irrespective of the form of the purchase consideration.
BC59 The Board also observed that there might be instances in which the acquirer is the entity whose equity interests have been acquired and the issuing entity is the acquiree. This might occur, for example, when a private entity arranges to have itself'acquired’ by a smaller public entity through an exchange of equity interests as a means of obtaining a stock exchange listing and, as part of the agreement, the directors of the public entity resign and are replaced with directors appointed by the private entity and its former owners. The Board observed that in such circumstances, the private entity (ie the legal subsidiary) has the power to govern the financial and operating policies of the combined entity so as to obtain benefits from its activities. Therefore, treating the legal subsidiary as the acquirer in such circumstances is consistent with applying the control concept for identifying the acquirer.
BC60 As a result, the Board concluded that the IFRS should require the acquirer in a business combination effected through an issue of equity interests to be identified on the basis of a consideration of all pertinent facts and circumstances, including but not limited to the relative ownership interests of the owners of the combining entities, to determine which of those entities has the power to govern the financial and operating policies of the other so as to obtain benefits from its activities. Respondents to ED 3 generally supported this conclusion.
BC61 The Board also considered the assertion that, although consistent with the control concept, treating the legal subsidiary as the acquirer in the circumstances described in paragraph BC59 produces an accounting result that:
