On 22 October, the IASB published amendments to IFRS 3 – Business Combinations, which applies to business combinations carried out during financial periods commencing on or after 1 January 2020 (early application is permitted).
The Board decided to review the definition of a business following the Post-implementation Review (PiR) of IFRS 3 and the subsequent discussions by the IFRS IC in November 2015 and the IASB in March 2016. (For more details on the findings of the PiR, see our ‘A Closer Look’ feature in Beyond the GAAP no. 91, July-August 2015.) First of all, we must remember that a business involves inputs, processes and, usually, outputs.
1. New Approach to Identifying a Business
In addition to the changes to the definitions of the various elements necessary to a business, the amendments also propose a new approach that can be used in practice to determine whether or not a set of assets is a business.
The first, optional, step is to determine whether substantially all of the fair value of the assets acquired is concentrated in a single asset (or a group of similar assets).
If the fair value of the assets acquired is not concentrated in a single asset, the amendments provide guidance on how to assess whether or not an acquired process (or processes) is (are) substantive. The guidance covers situations in which the activities and assets acquired have the ability to generate outputs, and situations in which they do not.
2. Clarifications to the Definitions of the Elements of a Business
The new definition of outputs focuses more on the provision of goods and services to customers (to align the definition more closely with the concept of an output in IFRS 15). Moreover, the new definition no longer refers to the ability of the assets and activities acquired to reduce costs (or generate other economic benefits).
The amendments specify that the process(es) acquired must be substantive/significant and must contribute to the ability to create outputs.
They also remove the reference to market participants, which was previously used in situations in which not all of the inputs and processes used by the seller were transferred to the buyer (to assess the buyer’s capacity to replace the missing elements).
In contrast, the assessment of the activities and assets acquired is still based on a hypothetical market participant (i.e. the aim is to carry out an objective assessment of the acquisition, without taking account of the buyer’s intentions or the previous use by the seller).
Finally, there is no longer a presumption that a more than insignificant amount of goodwill signifies the existence of a business. In fact, although goodwill was included as an “indicator” in the draft amendment, it has been removed from the final amendment.
The existing IFRS 3 already mentioned an organized workforce as a potential indicator of the existence of a process (or processes), but the amendments add a reference to the intellectual capacity of the workforce in question.
3. Step 1 of the Assessment: Test to Identify Concentration of Fair Value
This new step is intended to simplify the assessment, by allowing an entity to identify immediately that a business does not exist if certain conditions are met, without needing to progress any further through the decision tree.
In practice, the introduction of this new optional step involves determining whether substantially all of the fair value of the gross assets acquired is concentrated in a single asset (or a group of similar assets), in which case the transaction does not involve a business.
The concept of a “single asset” is based on the unit of account that would be used in a business combination.
Thus, in practice, a property leased to a third party under an operating lease would not be broken down into a property asset and an intangible asset (the lease), but would be considered as a single identifiable asset.
When assessing the concentration of the fair value of the assets acquired, an entity may not treat the following as similar assets:
- tangible and intangible assets;
- different types of intangible assets (brand names, patents, contractual relationships, etc.);
- different types of tangible assets (such as inventory and equipment, with the exception of situations in which the assets cannot be physically separated from one another without incurring significant costs or resulting in a significant loss of value);
- financial and non-financial assets;
- different types of financial assets (receivables, securities, cash, etc.).
The fair value of the gross assets differs from the transaction price as it also includes the fair value of any liabilities, the fair value of any non-controlling interests and the fair value of any previously held interest in the entity.
If the fair value of the gross assets is concentrated in a single asset (or a group of similar assets), the Board concludes that the transaction does not involve a business (and the entity does not need to continue with the assessment).
4. Step 2: Assessing whether or not an Acquired Process (or processes) is (are) Substantive
If the fair value concentration test does not resolve the issue, the entity must assess whether or not the acquired processes are significant. The criteria for this second step differ depending on whether or the activities and assets acquired have the ability to generate outputs.
If they do not have the ability to generate outputs, the amendments state that the acquired processes are only substantive if the inputs include an organized workforce that can generate outputs from the other acquired inputs.
In other words, the presence of a workforce that performs an ancillary support function is not sufficient to conclude that the activities and assets acquired constitute a business.
If the activities and assets acquired have the ability to generate outputs, one or more substantive processes exists if:
- the acquired inputs include an organized workforce (i.e. one that is capable of generating outputs); or
- the acquired activities and assets include one or more processes capable of generating outputs, and these processes are “unique” or “scarce” or cannot be replaced without significant cost or delay.
The amendments to IFRS 3 also include numerous illustrative examples.
5. In Summary
In summary, given the key importance of the organized workforce, we felt it would be clearer to base our decision tree around this element, rather than replicating the structure used in the amendment (see diagram hereafter).