Mergers and acquisitions (business combinations) can have a fundamental impact on the acquirer’s operations, resources and strategies. For most entities such transactions are infrequent, and each is unique. IFRS 3 ‘Business Combinations’ contains the requirements for these transactions, which can be challenging in practice. The Standard itself has now been in place for more than ten years and has undergone a comprehensive post implementation review by the International Accounting Standards Board (IASB).

Our ‘Insights into IFRS 3’ series summarises the key areas of the Standard, highlighting aspects that are more difficult to interpret and revisiting the most relevant features that could impact your business. This article explains the recognition principles set out in IFRS 3.

Overview of IFRS 3’s recognition and measurement principles

The acquisition method requires the acquirer, to recognise and measure the acquiree’s identifiable assets acquired and liabilities assumed at their acquisition-date fair values, subject to some exceptions. These assets and liabilities usually include assets and liabilities already reported in the acquiree’s financial statements.

Applying the acquisition method may, however, also result in recognising assets and liabilities that were not previously reported in the acquiree’s financial statements for instance a brand name, a patent or a customer relationship, as the acquiree developed them internally. IFRS 3’s recognition and measurement principles should be applied to determine which assets and liabilities to recognise and how they should be measured.

The identifiable assets acquired and liabilities assumed should consist of those that:

  • belong to the acquiree at the date of acquisition, and
  • form part of what has been acquired by the acquirer.

Most, but not quite all, of these assets and liabilities are measured at fair value at the acquisition date – the so called ‘fair value exercise’. (The term ‘purchase price allocation’ is still frequently used to describe this process although it does not perfectly align with the IFRS 3 accounting model).

This fair value exercise is usually a complex and timeconsuming step in accounting for a business combination.

Many entities engage outside specialists in the valuation area to provide assistance. In most cases this step requires a good knowledge of the business acquired, careful analysis, extensive use of estimates and management judgement in a number of areas.

The identification exercise
  • The objective of this exercise is to identify the main items for which the acquirer made the decision to purchase the business. Establishing the core reasons for making the purchase should help to identify the intangible assets acquired, that is, what did the acquirer get in return for the consideration paid and what they were willing to pay for? For example, was it to gain access to a specific technology, to acquire a trademark with a market share (this is usually associated with a technology, a know-how or a process)?

Refer to our article ‘Insights into IFRS 3 – How should the identifiable assets and liabilities be measured?’ for more details on the fair value exercise.

In an acknowledgement of these challenges, IFRS 3 allows a ‘measurement period’ of up to twelve months from the date of acquisition for the acquirer to complete the initial accounting for the business combination. This is discussed in more detail in our article ‘Insights into IFRS 3 – Accounting after the acquisition date’.

Applying IFRS 3’s recognition principle

Identifiable assets acquired and liabilities assumed in a business combination are recognised (separately from goodwill) if, and only if, they meet IFRS 3’s recognition principle at the acquisition date. These assets and liabilities may not be the same as those recognised in the acquiree’s own financial statements.

Asset and Liability
  • Asset - Present economic resource controlled by the entity as a result of past events

  • Liability - Present obligation of the entity to transfer an economic resource as a result of past events

IFRS 3’s recognition conditions:
IFRS 3 states from 1 January 2022 at the latest, identifiable assets acquired and liabilities assumed are recognised at the acquisition date if they meet the definitions of an asset or a liability included in the ‘Conceptual Framework for Financial Reporting’ issued in 2018.

Prior to 1 January 2022, IFRS 3 referred to the IASB’s previous conceptual framework. Acquirers were therefore required to apply the definitions of an asset and a liability and supporting guidance in the ‘Framework for the Preparation and Presentation of Financial Statements’ adopted by the IASB in 2001.

In addition, to qualify for recognition in applying the acquisition method, the identifiable assets acquired and liabilities assumed should be part of what is exchanged between the acquirer and the acquiree (or its former owners) in the business combination (rather than being part of a separate transaction or arrangement).

This requires identifying separate transactions that were negotiated at the same time as the business combinations occurred as they should be accounted for separately from the business combination. For example, payments made or expected to be made to the selling shareholders but in consideration of future services that they are committed to render post combination.

In practice, most of the assets and liabilities to be recognised should fall within familiar IFRS categories, such as:

  • cash and cash equivalents
  • inventories including work in progress
  • financial assets and liabilities, including trade receivables and payables
  • prepayments and other assets
  • property, plant and equipment
  • intangible assets
  • income tax payable or receivable
  • deferred tax assets and liabilities
  • accruals and provisions.

The following two step process can be helpful when identifying the assets and liabilities to recognise:

  • determine the population of ‘potential’ identifiable assets and liabilities from sources such as the acquiree’s most recent financial statements, internal management reports and underlying accounting records, due diligence reports and the purchase agreement itself, and
  • evaluate these potential identifiable assets and liabilities against IFRS 3’s recognition conditions. This determination can be straightforward or may require a detailed analysis depending on the nature of each item. The next section presents some assets and liabilities for which more detailed analysis is often needed.

IFRS 3’s identifable assets and liabilities requiring specific

The identifiable assets and liabilities to be recognised are unique to each business combination and may differ extensively depending on the industry. However, specific considerations apply to some types of assets and liabilities because of one or more of the following factors:

  • IFRS 3 includes specific guidance that is, in some cases, an exception to the general recognition principle discussed above
  • these items were not recognised in the acquiree’s own financial statements.
IFRS 3 - Specific recognition and measurement provisions
IFRS 3 - Specific recognition and measurement provisions
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Recognising identifiable intangible assets: what IFRS 3 permits

It is important to identify intangible assets separately because, in most cases, their useful lives will be finite, which means an amortisation expense should be recognised by the acquirer to comply with the requirements set out in IAS 38 ‘Intangible Assets’. Separate recognition therefore affects post-combination earnings and the more intangibles with finite useful lives that are recognised separately from goodwill, the more their identification will affect the earnings of the acquirer. Partly for this reason, IFRS 3’s approach places a strong emphasis on separate recognition rather than subsuming intangibles within goodwill.

However, identifying intangible assets is inherently more difficult and subjective than identifying physical assets such as inventory and property. In addition, many intangibles recognised in a business combination may not have been recognised in the acquiree’s own financial statements. The IASB has started looking at a solution to the separation recognition of intangibles as part of its project entitled ‘Business Combinations – Disclosures, Goodwill and Impairment’. A Discussion Paper was issued in 2020 and at the time of writing the IASB is deciding if further changes to the existing standard are required.

Specific recognition requirements
Intangible assets acquired in a business combination are recognised separately from goodwill if they:

  • meet IFRS 3’s general recognition principle (see above), and
  • are identifiable.

Applying the specific recognition requirements
The identifiable intangible assets acquired will depend on the nature of the business, its industry and other specific facts and circumstances of the combination. It is useful to divide the identification process into two steps:

  1. Identify the population of ‘potential’ intangibles
  2. Assess each against IFRS 3’s specific criteria

Potential intangible assets
Potential intangible assets, items that are non-monetary without physical substance, arising from contractual or legal rights, such as trademarks and licences, may be detected based on analysis of applicable contracts or agreements. Non-contractual intangible assets, such as customer relationships and in-process research and development, can require more analysis.

Determining whether a potential intangible asset is identifiable

Each potential intangible asset (ie a non-monetary item without physical substance) should be assessed to determine if it is ‘identifiable’. As noted, intangible assets arising from contracts or agreements will always meet this test.

For other potential intangible assets an assessment of ‘separability’ is required. This is based on whether the item can be sold or otherwise transferred, without selling the entire business. Examples of these considerations are as follows:

  • it is a hypothetical assessment and is not dependent on any intention to sell (although a sale plan, if one exists, demonstrates separability)
  • actual exchange transactions for the type of potential intangible assets being analysed or a similar type indicate separability, even if those transactions are infrequent and regardless of whether the acquirer is involved in them
  • in order to be separable, the potential intangible asset need not be saleable on its own. It could be transferred in combination with a related contract, identifiable asset or liability. However, if separation is only possible as part of a larger transaction, judgement is required to determine whether the potential sale is of the entire business or only part of it
  • the terms of the purchase agreement or related agreements may prohibit the transfer of certain intangible assets (eg confidentiality agreements prohibiting transfer of customer information), and
  • the legal and regulatory environment may prevent the transfer of intangible assets without underlying contractual or legal rights.
How should the identifiable assets and liabilities be measured?
How should the identifiable assets and liabilities be measured?
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IFRS 3’s guidance on recognising restructuring plans

An acquirer recognises liabilities for restructuring or exit activities acquired in a business combination only if they meet the definition of a liability at the acquisition date, as follows:

  • recognising a restructuring provision as part of the acquiree’s liabilities requires that the acquiree has a constructive obligation to restructure at the acquisition date. This may only arise when the acquiree has developed a detailed formal plan for the restructuring and either raised a valid expectation with those affected that it will carry out the restructuring by publicly announcing details of the plan or demonstrating that it has begun implementing the plan. Such a liability is recognised when it becomes probable that an outflow of resources embodying economic benefits will be required to settle the obligation
  • a restructuring plan that is contingent on the business combination being consummated is not a liability of the acquiree at the acquisition date
  • similarly, a restructuring that the acquirer arranges to be implemented by the acquiree within the context of the business combination is not a liability of the acquiree at the acquisition date.

Although the standard no longer contains the explicit requirements relating to restructuring plans, the Basis for Conclusions clearly indicates that the requirements for recognising liabilities associated with restructuring or exit activities remain the same.

Classify or designate identifiable assets acquired and liabilities assumed

The accounting for identifiable assets and liabilities depends on how they are classified and designated. The acquisition method requires the acquirer to classify and designate acquired assets and liabilities based on contractual terms and economic conditions at the acquisition date. This also takes into account:

  • the acquirer’s operating or accounting policies
  • the intentions of the business going forward, and
  • other pertinent conditions.

Therefore, the acquirer’s classifications and designations may differ from those of the acquiree before the combination. IFRS 3 provides a non-exhaustive list of examples of the classification or designation of acquired assets and liabilities, as follows:

  • classification of particular financial assets and liabilities in accordance with IFRS 9 ‘Financial Instruments’
  • designation of a derivative instrument as a hedging instrument in accordance with IFRS 9, and
  • assessment of whether an embedded derivative should be separated from the host contract, which will be dependent on the classification of the host contract in accordance with IFRS 9.

The scope of this requirement is potentially broad and a large number of items may need to be assessed. In practice, the most significant area is often financial instruments, including classification in accordance with IAS 39 or IFRS 9, assessment of embedded derivatives and hedge accounting. Particular attention may need to be paid to the acquiree’s hedge accounting designations (if any).

The acquiree’s original designations cannot be continued in the acquirer’s post-combination financial statements. New designations are therefore required if the acquirer wishes to apply hedge accounting. These new designations may be susceptible to greater hedge ineffectiveness because the acquired hedging instruments (derivatives in most cases) are probably no longer ‘at market’.

IFRS 3 provides an exception to this general principle concerning leases, this is for the classification of a lease contract in which the acquiree is the lessor as either an operating lease or a finance lease in accordance with IFRS 16 ‘Leases’. In this situation, the acquirer classifies leases on the basis of the contractual terms and other factors that existed at the inception of the contracts.

IFRS 3 also currently provides this same exception for the classification of contracts as insurance contracts (under IFRS 4 ‘Insurance Contracts’). Similar to leases the acquirer classifies these contracts on the basis of the contractual terms and other factors that existed at the inception of the contracts. When IFRS 4 is replaced by IFRS 17 ‘Insurance Contracts’ this exception on classification will be removed and a new measurement exception will have to be applied. This new measurement exception is presented in our article ‘Insights into IFRS 3 – Specific recognition and measurement provisions’.

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.