Background
Banana is the parent of a listed group of companies which have a year end of 30 June 20X7. Banana has made a number of acquisitions and disposals of investments during the current financial year and the directors require advice as to the correct accounting treatment of these acquisitions and disposals.
The acquisition of Grape
On 1 January 20X7, Banana acquired an 80% equity interest in Grape. The following is a summary of Grape’s equity at the acquisition date.
The purchase consideration comprised 10 million of Banana’s shares which had a nominal value of $1 each and a market price of $6·80 each. Additionally, cash of $18 million was due to be paid on 1 January 20X9 if the net profit after tax of Grape grew by 5% in each of the two years following acquisition. The present value of the total contingent consideration at 1 January 20X7 was $16 million. It was felt that there was a 25% chance of the profit target being met. At acquisition, the only adjustment required to the identifiable net assets of Grape was for land which had a fair value $5 million higher than its carrying amount. This is not included within the $70 million equity of Grape at 1 January 20X7.
Goodwill for the consolidated financial statements has been incorrectly calculated as follows:
Draft an explanatory note to the directors of Banana, discussing the following:
(i) how goodwill should have been calculated on the acquisition of Grape and show the accounting entry which is required to amend the financial director’s error;
(ii) why equity accounting was the appropriate treatment for Strawberry in the consolidated financial statements up to the date of its disposal showing the carrying amount of the investment in Strawberry just prior to disposal;
(iii) how the gain or loss on disposal of Strawberry should have been recorded in the consolidated financial statements and how the investment in Strawberry should be accounted for after the part disposal.
Note: Any workings can either be shown in the main body of the explanatory note or in an appendix to the explanatory note.
Explanatory note to: Directors of Banana
Subject: Consolidation of Grape and Strawberry
(i) Goodwill should be calculated by comparing the fair value of the consideration with the fair value of the identifiable net assets at acquisition. The shares have been correctly valued using the market price of Banana at acquisition. Contingent consideration should be included at its fair value which should be assessed taking into account the probability of the targets being achieved as well as being discounted to present value. It would appear reasonable to measure the consideration at a value of $4 million ($16 million x 25%). A corresponding liability should be included within the consolidated financial statements with subsequent remeasurement. This would be adjusted prospectively to profit or loss rather than adjusting the consideration and goodwill.
The finance director has erroneously measured non-controlling interest using the proportional method rather than at fair value. Although either method is permitted on an acquisition by acquisition basis, the accounting policy of the Banana group is to measure non-controlling interest at fair value. The fair value of the non-controlling interest at acquisition is (20% x $20 million x $4·25) = $17 million.
Net assets at acquisition were incorrectly included at their carrying amount of $70 million. This should be adjusted to fair value of $75 million with a corresponding $5 million increase to land in the consolidated statement of financial position. Goodwill should have been calculated as follows:
The correcting entry required to the consolidated financial statements is:
Dr Goodwill $2 million
Dr Land $5 million
Cr Non-controlling interest $3 million
Cr Liabilities $4 million
(ii) If an entity holds 20% or more of the voting power of the investee, it is presumed that the entity has significant influence unless it can be clearly demonstrated that this is not the case. The existence of significant influence by an entity is usually evidenced by representation on the board of directors or participation in key policy making processes. Banana has 40% of the equity of Strawberry and can appoint one director to the board. It would appear that Banana has significant influence but not control. Strawberry should be classified as an associate and be equity accounted for within the consolidated financial statements.
The equity method is a method of accounting whereby the investment is initially recognised at cost and adjusted thereafter for the post-acquisition change in the investor’s share of the investee’s net assets. The investor’s profit or loss includes its share of the investee’s profit or loss and the investor’s other comprehensive income includes its share of the investee’s other comprehensive income. At 1 October 20X7, Strawberry should have been included in the consolidated financial statements at a value of $20·4 million ($18 million + 40% x $50 million – $44 million).
(iii) On disposal of 75% of the shares, Banana no longer exercises significant influence over Strawberry and a profit on disposal of $3·1 million should have been calculated.
Discuss whether the directors are correct to treat Melon as a financial asset acquisition and whether the International Accounting Standards Board’s proposed amendments to the definition of a business would revise your conclusions.
Melon should only be treated as an asset acquisition where the acquisition fails the definition of a business combination. In accordance with IFRS® 3 Business Combinations, an entity should determine whether a transaction is a business combination by applying the definition of a business in IFRS 3. A business is an integrated set of activities and assets which are capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants. A business will typically have inputs and processes applied to the ability to create outputs. Outputs are the result of inputs and processes and are usually present within a business but are not a necessary requirement for a set of integrated activities and assets to be defined as a business at acquisition.
It is clear that Melon has both inputs and processes. The licence is an input as it is an economic resource within the control of Melon which is capable of providing outputs once one or more processes are applied to it. Additionally, the seller does not have to be operating the activities as a business for the acquisition to be classified as a business. It is not relevant therefore that Melon does not have staff and outsources its activities. The definition of a business requires just that the activities could have been operated as a business. Processes are in place through the research activities, integration with the management company and supervisory and administrative functions performed. The research activities are still at an early stage, so no output is yet obtainable but, as identified, this is not a necessary prerequisite for the acquisition to be treated as a business. It can be concluded that Melon is a business and it is incorrect to treat Melon as an asset acquisition.
The International Accounting Standards Board has sought to give greater clarity to the definition of a business since the definition has proven difficult to apply in practice. Consequently, an exposure draft has been issued so that no business acquisition occurs where substantially all of the fair value of the gross assets acquired is concentrated in a single asset or group of similar assets. This is sometimes referred to as a screening test. The fair value of the gross assets acquired includes the fair value of any acquired input, contract, process, workforce and any other intangible asset which is not identifiable. In the case of Banana, they are not intending to use the services of the management company and are not looking to take on any of the employees. It is unclear therefore as to the extent of ‘know how’ from research activities which would be obtainable. Research activities appear to be at a very early stage and, whilst in substance are very different in nature to the licence itself and would be treated as separate assets, are likely to be of relatively low value. It is perfectly plausible that substantially all of the fair value is concentrated in the licence itself and the acquisition would not be treated as a business combination. Should it be determined that the research activities obtainable are of sufficient value so that not all the fair value is concentrated in a single asset, the acquisition would be treated as a business combination since the activities and processes are substantive.
Discuss how the derecognition requirements of IFRS 9 Financial Instruments should be applied to the sale of the bond including calculations to show the impact on the consolidated financial statements for the year ended 30 June 20X7.
IFRS 9 Financial Instruments requires that a financial asset only qualifies for derecognition once the entity has transferred the contractual rights to receive the cash flows from the asset or where the entity has retained the contractual rights but has an unavoidable obligation to pass on the cash flows to a third party. The substance of the disposal of the bonds needs to be assessed by a consideration of the risks and rewards of ownership.
Banana has not transferred the contractual rights to receive the cash flows from the bonds. The third party is obliged to return the coupon interest to Banana and to pay additional amounts should the fair values of the bonds increase. Consequently, Banana still has the rights associated with the interest and will also benefit from any appreciation in the value of the bonds. Banana still retains the risks of ownership as it has to compensate the third party should the fair value of the bonds depreciate in value.
It would be expected that, if the sale were a genuine transfer of risks and rewards of ownership, then the sales price would be approximate to the fair value of the bonds. It would only be in unusual circumstances such as a forced sale of Banana’s assets arising from severe financial difficulties that this would not be the case. The sales price of $8 million is well below the current fair value of the bonds of $10·5 million. Additionally, Banana is likely to exercise their option to repurchase the bonds.
It can be concluded that no transfer of rights has taken place and therefore the asset should not be derecognised. To measure the asset at amortised cost, the entity must have a business model where they intend to collect the contractual cash flows over the life of the asset. Banana maintains these rights and therefore the sale does not contradict their business model. The bonds should continue to be measured at amortised cost in the consolidated financial statements of Banana. The value of the bonds at 30 June 20X6 would have been $10·2 million ($10 million + 7% x $10 million – 5% x $10 million). Amortised cost prohibits a restatement to fair value. The value of the bonds at 30 June 20X7 should be $10·414 million ($10·2 million + 7% x $10·2 million – 5% x $10 million). The proceeds of $8 million should be treated as a financial liability and would also be measured at amortised cost. An interest charge of $0·8 million would accrue between 1 July 20X6 and 1 July 20X8, being the difference between the sale and repurchase price of the bonds.