The Joint Business Combinations Project IFRS 3 and the Project’s Impact on Convergence with U.S. GAAP

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By Christoph Watrin, Christiane Strohm, and Ralf Struffert

JANUARY 2006 – Starting in 2005, the public corporations in all 25 European Union nations must comply with International Financial Reporting Standards (IFRS)/International Accounting Standards (IAS). The motivation to converge IFRS/IAS and U.S. Generally Accepted Accounting Principles (GAAP) as part of the ongoing internationalization of accounting is stronger than. Every effort is being made to keep joint projects on a “similar” time schedule at each standards-setting body. The main goal is to achieve greater comparability among consolidated financial statements, which are still prepared using different accounting concepts.

One of the most important subjects of the convergence project is the accounting for business combinations, because of the number of these transactions. FASB and the International Accounting Standards Board (IASB) started to work on a common business-combinations project to achieve a reconciliation of the accounting for business combinations using IFRS and U.S. GAAP (see and During the last few years, the accounting for consolidated financial statements has been very controversial, as evidenced by the reception of SFAS 141, Business Combinations, and SFAS 142, Goodwill and Other Intangible Assets.

Since July 2001, the business combinations project has been one of the IASB’s main issues. The work process was originally separated into two phases, whereas forthcoming phases can be expected. As a result of Phase I, Exposure Draft (ED) 3, Business Combinations, was published on December 5, 2002, and comments were accepted until April 4, 2003. In addition, major changes to the accounting for intangible assets and the application of the impairment test for goodwill were planned, which led to published drafts of relevant standards (ED-IAS 36 and ED-IAS 38). National standards setters all over Europe criticized the proposed changes in the EDs. Phase I ended on March 31, 2004, with the publishing of IFRS 3, Business Combinations, and the refined IAS 36, Impairment of Assets, and IAS 38, Intangible Assets. The new standards, including additional notes, comprise more than 490 pages, showing the complexity of this project. The new IFRS 3 will replace IAS 22, as well as the interpretations SIC-9, SIC-22, and SIC-28 (Introduction 1, IFRS 3, and IFRS 3, Appendix C). The IASB incorporated some of the main aspects of American standards, but also decided deliberately against the American approach in certain areas.

IFRS 3 applies to all business combinations with an agreement date after March 31, 2004. For goodwill remaining from previous transactions, IFRS 3 applies prospectively for business years beginning on or after March 31, 2004 (IFRS 3.78-81). Following IFRS 3.85, an entity is permitted to retrospectively apply IFRS 3, IAS 36, and IAS 38, if it meets certain requirements. Relevant information required for a successful application of IFRS 3 must be available when the business combination was initially accounted for. In addition, the refined IAS 36 and IAS 38 need to be applied.

Application of IFRS 3

IFRS 3 applies to all business combinations. The result of nearly all business combinations is that one entity obtains control over one or more other businesses. Obtaining control over one or more entities that are not businesses is not considered a business combination. While economic entities are subject to IAS 22.8, IFRS 3 pertains to reporting entities. IFRS 3 does not apply to joint ventures, business combinations involving entities or businesses under common control, mutual entities, and reporting entities without the obtaining of an ownership interest.

The exclusion of mutual entities and reporting entities by contract alone without the obtaining of an ownership interest was motivated by problems with applying the purchase method. Therefore, the ED of proposed amendments to IFRS 3, “Combinations by Contract Alone or Involving Mutual Entities,” was published on April 29, 2004, as an interim solution. Several European standards setters criticized the proposal (see The criticism mostly pertained to the plan for the interim solution to be replaced shortly, the inconsistency with IFRS 3, the proposed modified purchase method, and the amendment being so close to the 2005 deadline for the adoption of IFRS in Europe. The IASB noted the disagreement and decided not to proceed with the ED. With respect to practical benefits, no support for an interim solution exists.

By now, in the wake of the ED of proposed amendments to IFRS 3’s June to October 2005 comment period, formations of joint ventures and combinations involving only entities and businesses under common control have been proposed to be excluded from IFRS 3. The amendments to IFRS 3 will be effective prospectively for business combinations with an acquisition date on or after January 2007. Because the IASB recently received comments on the proposed amendments, changes are still possible. Therefore, the authors will focus on the currently effective provisions of IFRS 3, as issued in March 2004.

One major change in IFRS 3, as compared to IAS 22, is the prohibition of the pooling-of-interests method, which previously could have been used when several conditions were present. From now on, all business combinations will be accounted for using the full-purchase method. Almost all standards setters had a positive reaction to this change, because the sphere of influence was deleted. The allowance of just one method has increased the comparability of financial statements. This is a step in the direction of convergence, given that the pooling-of-interests method has already been prohibited in Australia, Canada, and the United States. The information provided in consolidated financial statements will be improved through more comparability.

Treatment of Business Combinations

The application of the purchase method is based on the assumption that the acquiring business can be identified. Following IFRS 3, the acquirer is the combining entity that obtains control of the other combining entities or businesses. All pertinent facts and circumstances should be considered, including the possibility of “reverse acquisitions” (IFRS 3.21). A business is assumed to obtain control when it has the power to govern the financial and operating policies of an entity or business in order to benefit from its activities. This term in IFRS 3.19 was carried over from IAS 22.8 and ensures convergence with IAS 27. A control relationship is assumed when the acquirer owns more than one-half of the voting rights, unless it can be demonstrated that such ownership does not constitute control. A control relationship might be present when more than one-half of the voting rights are owned by virtue of an agreement with other investors. In addition, a control relationship might be present if the acquirer is able to govern the financial and operating policies under a statute or an agreement, to appoint or remove the majority of the board of directors or equivalent governing body, or, finally, to cast the majority of votes on the board of directors or equivalent body.

The costs of a business combination at the date of exchange are measured as an aggregate of the fair values of assets received, liabilities incurred or assumed, and equity instruments issued by the acquirer. There is an exception for noncurrent assets held for sale, as mentioned in IFRS 5, where the costs of the disposal are subtracted. In addition, any costs directly attributable to the business combination are included. These fees are defined as professional fees paid to accountants, legal advisors, appraisers, and other consultants to execute the business combination. Explicitly excluded are general administrative costs, such as emission costs for financial liabilities and costs for the registration or issue of equity instruments.

After the costs of the business combination have been determined, these costs must be allocated to the assets acquired and the liabilities and contingent liabilities assumed. The previous option between the benchmark treatment and the alternative treatment has been dropped in favor of the full fair value approach. This decision means that identifiable assets, liabilities, and contingent liabilities are measured initially by the acquirer at their fair value, irrespective of the extent of any minority interest. Any minority interest in the aquiree is measured as the minority proportion of the net fair values of those items; the minority proportion of the goodwill is not recorded.

Prohibiting the option to choose between treatments will lead to more comparability between consolidated financial statements. Allowing only the full fair value approach is a consequence of the growing importance of fair value accounting in the IFRS (e.g., IAS 39 and ED IAS 39), which in also reflected in U.S. GAAP.

Accounting for Goodwill

The goodwill recognized as an asset is measured initially as the excess of the cost of the business combination over the acquirer’s interest in the net fair values of the identifiable assets, liabilities, and contingent liabilities. It can include the following components: the fair value of the going-concern element of the acquiree; the fair value of the expected synergies; overpayments by the acquirer; errors in measuring and recognizing the fair value of either the cost of the business combination or the acquiree’s identifiable assets, liabilities, and contingent liabilities; or a requirement in an accounting standard to measure those identifiable items at an amount that is not fair value. It is questionable whether the latter two components could lead to goodwill; the IASB assumed that most goodwill would come from the first two components. Therefore, this core goodwill complies with the requirements of the IASB Framework. The IASB later said that components of core goodwill have to be specified in line with SFAS 141’s treatment.

A major change, compared to IAS 22, is IFRS 3’s prohibition of amortization, which follows the treatment in SFAS 142. From now on, goodwill is reviewed at least annually in accordance with IAS 36. If goodwill is impaired, an impairment loss must be recognized. This treatment eliminates previous problems with estimating an amortization schedule, but it leads to problems with respect to measuring fair value.

Under IAS 36, goodwill is allocated to each of the acquirer’s cash-generating units or groups that are expected to benefit from the synergies of the combination. A cash-generating unit is the smallest group of assets that includes the asset and generated cash inflows that are largely independent of the cash inflows from other assets or groups of assets. Each unit or group of units to which goodwill is allocated will represent the lowest level within the entity at which goodwill is monitored for internal management purposes and shall not be larger than a segment based on either the entity’s primary or the entity’s secondary reporting format, in accordance with IAS 14.

The annual impairment testing may be performed at any time during an annual period, provided it is performed at the same time every year. In addition, whenever an indication exists that the unit may be impaired, impairment testing is necessary.

Impairment testing requires the comparison of the carrying amount of the unit, including goodwill, with the recoverable amount of the unit. No impairment exists when the recoverable amount exceeds the carrying amount. In the opposite case, the impairment will be recognized as a loss. Therefore, the carrying amount of any goodwill allocated to the cash-generating unit will be reduced. Then, the loss will be allocated to the other assets of the unit pro rata on the basis of the carrying amount of each asset in the unit under IAS 36. However, the reduction of the carrying amount will not be lower than the highest of its fair value less costs to sell, its value in use, and zero. The amount of the loss that would have been allocated without this limitation will be added back pro rata to the other assets of the unit.

ED-IAS 36 suggested two steps for impairment testing. The first step was meant to identify goodwill impairment. If indicators suggested impairment, the implied value of the goodwill would be compared with its carrying amount. The IASB rejected this treatment and followed the one-step impairment-only approach because the benefits of the two-step approach did not seem to justify the effort. The current structure was maintained, which differs greatly from the U.S. GAAP approach embodied by SFAS 142. The impairment-only approach, does, however, treat goodwill the same as other intangible assets.

European standards setters generally supported the U.S. GAAP approach, but recognized the implementation problems. Some standards setters suggested an interim solution, which would give companies the option between annual amortization and an impairment-only approach. Others were against an impairment-only approach, believing that goodwill should not have an infinite useful life and should be amortized the same way as other noncurrent, wasting assets.

If a minority interest exists in a cash-generating unit to which goodwill has been allocated, the carrying amount of those units comprises both the parent’s interest and the minority interest in the identifiable net assets of the unit and the parent’s interest in goodwill. However, part of the recoverable amount of the cash-generating unit is attributable to the minority interest in goodwill.

Impairment testing cash-generating units with goodwill and minority interest can be illustrated as follows (see IAS 36, illustrative example 7). Entity D acquires a 70% ownership in entity B for $1,000 on January 1, 2005. At that date, B’s identifiable net assets have a carrying amount of $1,900 and a fair value of $2,300. The carrying amount for liabilities ($900) and contingent liabilities ($100) is equal to the fair value. Therefore, D recognizes in its consolidated financial statements identifiable net assets at their fair value of $1,300 ($2,300 – $900 – $100) and goodwill as follows:

Cost of business combination $1,000
70% of $1,300 – $910
Goodwill $90

Entity B is the cash-generating unit expecting to benefit from the synergies of the combination, so the goodwill has been allocated to it. This cash-generating unit is tested for impairment at the end of 2005, and the recoverable amount is $1,000. D uses straight-line depreciation over a 10-year useful life for net assets. A portion of B’s recoverable amount of $1,000 is attributable to the unrecognized minority interest in goodwill. The carrying amount of B must be notionally adjusted to include goodwill attributable to the minority interest ($90 x 30%/ 70% = $39), as follows:

Goodwill Indentifiable net assets Total
Gross carrying amount
Accumulated depreciation
Carrying amount
minority interest
Nationally adjusted
carrying amount
$ 299

The impairment loss of the $299 is allocated to the assets in the unit by first reducing the carrying amount of goodwill to zero, which requires an allocation of $129. Because the goodwill is recognized only to the extent of D’s 70% ownership interest in B, D recognizes only 70% of that goodwill impairment loss ($90). The remaining impairment loss ($299 – $129 = $170) is recognized by reducing the carrying amounts of B’s identifiable net assets, as shown below:

Goodwill Indentifiable net assets Total
Gross carrying amount
Accumulated depreciation
Carrying amount
Impairment loss
$ 170
Carrying amount after
impairment loss

An impairment loss recognized for goodwill cannot be reversed in a subsequent period under IAS 36. This provision is in accordance with the prohibition of internally generated goodwill under IAS 38. European standards setters criticized the prohibition of a reversal of an impairment loss. Some supported a reversal only when the primary external reason for the impairment no longer exists, thus avoiding a reversal for internally generated goodwill. The prohibition of a reversal is in line with SFAS 142.

The effects of the prohibition of the annual amortization of goodwill must be examined in practice. Companies that have amortized large amounts of goodwill in the past, will, assuming no impairment is necessary, have higher net profits but without qualitative improvements. On the other hand, these companies will have higher losses resulting from impairments if the acquired unit does not develop as successfully as first assumed.

Future Prospects

The issuance of the ED of amendments to IFRS 3 in June 2005 as a result of phase two indicates that the business combinations project will help achieve convergence between U.S. GAAP and IFRS.

In one major change to IFRS 3, the ED proposes that an acquirer measure the fair value of the acquiree, as a whole, as of the acquisition date. This full goodwill method recognizes not only the purchased goodwill attributable to an acquirer as a result of the purchase transaction, but also the goodwill attributable to a noncontrolling interest in the subsidiary. The IASB believes that this method is appropriate because it is consistent with the control and completeness concepts underlying the preparation of consolidated financial statements.

Other results of the second phase are the EDs of proposed amendments to IAS 27, Consolidated and Separate Financial Statements, and to IAS 37, Provisions, Contingent Liabilities and Contingent Assets, both issued for comment over June to October 2005.

Although FASB and the IASB reached the same conclusions on fundamental issues, they reached different conclusions on a few limited matters. Most of the differences arise because of each board’s decision to produce guidance for accounting for business combinations that is consistent with other existing SFAS or IFRS (ED-IFRS 3 part N).

In addition, the second phase of the business combinations project still needs to consider the accounting for business combinations in which separate businesses or entities are brought together to form a joint venture (see ED to IFRS 3.2). Furthermore, the accounting for business combinations involving entities under common control has to be considered (see ED to IFRS 3.2). Common control can be assumed when the same party or parties control all of the combining entities or businesses and the control is not transitory. These business combinations are highly relevant when consolidated businesses are restructured.

The advantages and disadvantages of the fresh-start accounting method should be taken into account. If the combination of businesses cannot be characterized as a purchase but rather as the creation of a new business, the fresh-start method might be the relevant accounting method. If so, the fair values of the net property, and possibly the original goodwill of the combined businesses, would be represented in the consolidated financial statement.

In addition to the outstanding developments of the business combinations project, other changes are expected. The IFRS “Consolidation Including Special Purpose Entities” (SPE) has been on the IASB’s agenda since April 2002. Part of this project will determine when a company has to consolidate its interest. Particularly, the control concept will be refined as one main element. However, the IASB will not change the recent definition, but the term “power” as part of the control definition needs to be clarified. During a meeting in September 2003, the IASB announced that control can be assumed when an investor has the power to govern the financial and operating policies of an entity or business so as to obtain benefits from its activities. The expected consolidation standard, which will replace both IAS 27 and SIC-12, will apply to the consolidation of SPEs and non-SPEs. The illustration of asset-backed securities transactions is fraught with difficulty. The general criteria of IAS 27were not, however, addressed in the ED of amendments to IAS 27, which focuses on accounting for ownership interests after control is obtained. Furthermore, the interpretation of SIC-12 regarding this topic is linked with application problems. The revision of these standards and the planned assimilation, with the illustration of ABS transactions after IAS 39, is welcomed.


IFRS 3, Accounting for Business Combinations, closely resembles U.S. GAAP accounting. However, it is not an exact copy, because the final IFRS 3 differs in key aspects—like the impairment test for goodwill—from the U.S. standard.

IFRS 3 and the revisions to IAS 36 and 38 have been welcomed by most. Through this movement toward convergence, the quality of accounting will increase. The elimination of the pooling-of-interests method can be seen as a major advance in the comparability of financial statements and a major restriction of the ability of companies to select among different accounting treatments to achieve their desired results.

Even if the convergence of consolidated accounting is achieved, it must be discussed whether and how IFRS 3 and the changes of IAS 36 and 38 will actually improve the conditions for applying companies. It remains to be seen whether the new regulations—particularly the prohibition of the annual goodwill amortization—will prove successful. In the end, IFRS 3 is only an interim solution to the persistent challenge of accounting for business combinations as shown by the issued ED of amendments to IFRS 3.

Christoph Watrin, PhD, is a professor of business taxation and chair of the department of accounting and business taxation at the University of Muenster, Germany.
Christiane Strohm is currently a visiting scholar at the Marshall School of Business at the University of Southern California, supported by the German Academic Exchange Service. She is enrolled in the PhD program at the University of Muenster.
Ralf Struffert is enrolled in the PhD program at the University of Muenster.

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