Business combinations are infrequent transactions that are unique for each occurrence. IFRS 3 ‘Business Combinations’ contains the requirements and despite being fairly stable in the ten years since its been released, still provides challenges when accounting for these transactions in practice.

Our ‘Insights into IFRS 3’ series summarises the key areas of the Standard, highlighting aspects that are challenging to interpret and apply in practice. This article sets out the definition and underlying principles of fair value, gives a brief overview of permissible valuation techniques and presents IFRS 3’s specific guidance on fair value measurement.

IFRS 3’s measurement principle

The identifiable assets acquired and liabilities assumed in a business combination are measured in accordance with the general measurement principle in IFRS 3 which states they should be measured at their acquisition-date fair values. However, there are a few exceptions to this measurement principle, which are discussed in our article ‘Insights into IFRS 3 – Specific recognition and measurement provisions’.

IFRS 3 - Specific recognition and measurement provisions
IFRS 3 - Specific recognition and measurement provisions
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Fair value
  • The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

If an identifiable asset or liability has a quoted price in an active market (for example, listed shares), this price should be used as fair value. However, few assets and even fewer liabilities have such quoted prices. So in many cases, fair value then needs to be estimated using a valuation technique. As a result estimating fair values can be a complex exercise requiring considerable management judgement and many acquirers engage professional valuation specialists to assist in this stage of the process.

A number of concepts are embodied in this definition. Firstly, it clarifies fair value is an ‘exit’ price – for example it refers to the transfer of a liability rather than settlement. Secondly, it assumes an orderly sale or transfer (ie not a forced transaction or a distressed sale). Thirdly, there is an explicit reference to ‘market participants’, emphasising fair value is a market-based concept and not an entity specific value. Finally, IFRS 13 clarifies fair value is a current price at the measurement date (eg the acquisition date in a business combination).

Fair value estimates have a pervasive effect on business combination accounting. Aside from measuring identifiable assets acquired and liabilities assumed, the acquisition method uses fair value to measure:

  • consideration transferred
  • any previously held interest in the acquiree
  • any present ownership interests in the acquiree retained by non-selling shareholders, referred to in IFRS 3 as noncontrolling interests (NCI), but only if that measurement method (ie fair value) is elected for those interests that entitle their holders to a proportionate share of the entity’s net assets in the event of liquidation. Refer to our article ‘Insights into IFRS 3 – Recognising and measuring noncontrolling interest’ for more details.

IFRS 3 defines fair value (consistently with IFRS 13) but does not provide detailed guidance on the valuation methodology and instead refers to IFRS 13 for valuation models and techniques. IFRS 3 does however include limited guidance on some specific situations.

With respect to IFRS 13, the Standard notes there are three widely used ‘families’ of valuation techniques that can be grouped into three broad approaches and states entities should use valuation techniques

Approach Valuation technique
Market approach Uses prices and other relevant information generated by market transactions
involving identical or comparable (ie similar) assets, liabilities or a group of assets
and liabilities, such as a business.
Income approach

Converts future amounts (eg cash flows or income and expenses) to a single
current (ie discounted) amount. The fair value measurement reflects current market
expectations about those future amounts.

For example, present value techniques, option pricing models or the multi-period
excess earnings method.

Cost approach Reflects the amount that would be required currently to replace the service
capacity of an asset (often referred to as current replacement cost).

The complexity of the valuation depends on the asset or liability in question and management judgement is required to not only select the most appropriate valuation technique but also to determine all relevant inputs and material assumptions. Some valuations require specialist expertise and may need to engage a valuation professional. Whether or not a valuation professional is engaged, management’s involvement in the process and in developing assumptions should be commensurate with its overall responsibility for preparing the financial statements.

Whichever technique is used, the resulting valuation should be consistent with the definition and underlying concepts of fair value. The acquirer should ensure the valuation:

  • has an objective to estimate the price that would be paid or received in a hypothetical sale or transfer to other market participants (ie potential buyers and sellers)
  • uses techniques and assumptions that are consistent with how other market participants would determine fair value
  • does not take account of factors that are specific to the actual acquirer, such as the acquirer’s intended use of an asset or synergies that would not be available to other market participants
  • reflects conditions at the acquisition date
  • prioritises observable market inputs when available, and
  • incorporates IFRS 3’s specific guidance, as applicable.
Insights into IFRS 13 - Fair value measurement
Insights into IFRS 13 - Fair value measurement
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IFRS 3’s specific guidance on fair value measurement

IFRS 3 provides guidance on the determination of fair value in specific situations, as follows:

Assets with uncertain cash flows(valuation allowances)

The acquisition-date fair value of assets such as receivables and loans should reflect the effects of uncertainty about future cash flows. A separate valuation allowance should not be recognised.

Assets subject to operating leases – acquiree is the lessor

If the acquiree is the lessor (of say a building), when measuring the acquisition date fair value of the lessor’s underlying asset, the terms of the operating lease are taken into account. No separate asset or liability is recognised on acquisition even if the operating lease terms are either favourable or unfavourable when compared with market terms.

Assets that the acquirer intends not to use or to use in a way that is different from the way other market participants would use them

Fair value should be determined in accordance with the asset’s expected use by market participants (highest and best use) and should not be affected by the acquirer’s intended use of the asset.

Guidance on fair value measurement of specific items

Fair value of inventory acquired in a business combination is often different from the carrying amount of the same inventory in the acquiree’s books at the date of acquisition. This is because fair value represents an exit price, ie a price that a market participant would receive to sell the inventory in its principal (or most advantageous) market, instead of a ‘historical cost’ concept.

The complexity of the calculation of the amount of the adjustment to make to the carrying amount of the inventory usually depends on the nature of the inventory acquired and the industry in which the acquiree operates:

Nature of inventory Fair value measurement
Raw materials Usually determined using current replacement cost.

Usually determined as the estimated selling price of the related finished goods in the ordinary course of business, less:

  • the estimated costs of completion
  • the estimated costs necessary to make the sale, and
  • a reasonable profit allowance for the completing and selling effort, based on the profit for similar finished goods.
Finished goods

Usually determined as the estimated selling price of the finished goods in the ordinary course of business less:

  • the estimated costs necessary to make the sale, and
  • a reasonable profit allowance for the acquirer’s selling effort, based on the profit for similar finished goods.

The methods described above for measuring fair value of work-in-progress and finished goods aim to ensure that the fair value of the inventory acquired includes the profit generated by the selling and other efforts (manufacturing) of the acquiree before the date of acquisition as this profit does not belong to the acquirer and as such the acquirer cannot recognise it.

Deferred revenue
Deferred revenue is an obligation to transfer products or services to a customer because a payment has already been obtained (or an amount is due) from the customer. As part of a business combination transaction, an acquirer recognises deferred revenue as a part of the liabilities they assumed if the acquiree still has an obligation to provide goods or services after the date of acquisition.

As fair value is defined as an exit price, fair value of deferred revenue represents a price a market participant is willing to pay to assume the obligation to which the deferred revenue relates. As such fair value of deferred revenue is usually different from the acquiree’s carrying value. Measurement of this amount can be complex and may require a significant use of judgement in certain circumstances.

A method frequently seen in practice to measure fair value of deferred revenue is called the ‘build-up’ or ‘bottom-up’ approach. Under this method, an acquirer determines the fair value of deferred revenue based on an estimate of the direct and incremental costs a market participant must incur to fulfil the performance obligation after the date of acquisition, plus a ‘reasonable’ profit margin for the products or services provided and a premium for any risks assumed. The ‘reasonable’ profit margin should consider the different types of work that a market participant would need to perform to complete any remaining performance obligation.

How we can help

We hope you find the information in this article helpful in giving you some insight into IFRS 3. If you would like to discuss any of the points raised, please speak to your usual Grant Thornton contact or your local member firm.