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Non-current assets

Property, plant and equipment

Stand-alone asset

1/1/X1, XYZ bought a production machine #123 for 60,000.

For simplicity, this example does not discuss any additional costs such as agent's fees, transportation, installation, break-in, development, disposal, interest, etc.

The following (self-manufactured asset) example does.

It estimated the machine would be useful for 12 years and could be sold for 9,000.

It elected to depreciate the machine using a straight-line method.

An asset's "useful life" is the time over which it is expected to serve its purpose (a purpose).

Assets acquired for a particular purpose may or may not be reassigned to a different purpose.

For example, if a company acquired a machine to manufacture a particular product for a three-year production run, the machine's useful life would be 3 years.

If, on the other hand, the company intended to transition the machine to successive products, the machine's useful life would be longer.

As US GAAP does not specify how to determine useful life, entities may use judgment or refer to IFRS.

While ASC 360-10-35-4 requires entities to depreciate assets over their useful life, ASC 360-10 fails to specify how useful life should be determined leaving companies free to exercise judgment in setting depreciation periods.

Being able to use judgment does not, however, imply that companies are free to use any depreciation period they like.

If a period proves to be materially inaccurate, as this is generally apparent only at or near its end, it will trigger a restatement as outlined in ASC 250-10-50-12.

Caveat: intentionally failing to establishing realistic depreciation periods can have serious consequences because this is a method occasionally used to manage earnings, something the SEC takes especially seriously.

ASC 250-10-S99-1: “...the staff believes that a registrant and the auditors of its financial statements should not assume that even small intentional misstatements in financial statements, for example those pursuant to actions to "manage" earnings, are immaterial.”

Note: the only way to correct errors is retrospectively, in this case going back to the period the asset was acquired.

Also note: even if the correction of an intentional error is not sufficiently material to warrant a restatement of the financial statements, the error would still need to be disclosed and reported to the SEC.

While both ASC 360-10-35-4 and IAS 16.50 require useful life, only IAS 16.56 outlines criteria.

IAS 16.56 outlines four criteria ("factors") for determining useful life.

The first should be used if possible, while the remaining three should be applied as appropriate.

  1. expected usage (a.k.a. units of production)
  2. physical wear and tear
  3. technical or commercial obsolescence
  4. legal or similar limits

Units or production not only yields better results, it can also reduce accounting complexity.

IAS 16.55 (edited emphasis added) states: ...depreciation does not cease when the asset becomes idle or is retired from active use unless the asset is fully depreciated. However, under usage methods of depreciation the depreciation charge can be zero while there is no production.

While the difference between depreciation that has ceased and a zero depreciation charge is minimal (the former implies depreciation will not be restarted in the future), being able to stop/start depreciation can bring practical benefits.

For example, assume a company estimates it will be able to manufacture and sell 10,000 units of a product per year for 10 years. To manufacture the product, it purchases a machine for 10,000.

To save effort, it assigns a fixed 10-year useful life to the asset and elects straight-line depreciation (and ignores residual value).

If production hits the target, a depreciation charge of 0.10 will accrue to year unit. However, if production falls short, say 5,000 units, a depreciation charge of 0.20 would accrue to year unit, increasing cost of sales (relative to production volume) and decreasing gross profit.

While it is possible to adjust depreciation periods on the basis of an annual review (IAS 16.51), if a units of production method is used, the adjustment occurs automatically.

For example, a production die can have a 10,000 unit limit until exceeds engineering tolerance.

Each time a unit is product, a depreciation charge of 1/10,000 would be recognized.

The drawback of this method: relatively few assets have precisely definable usage parameters.

The disadvantage of this method: the asset will need to be disposed of when the limit is reached.

This criterion is similar expected usage because it reflects the physical attributes of an asset.

It would be used in situations where units of production cannot be determined.

For example, a press utilizing a production die would most likely not, unlike the die, have a precise technical limit on the number of units it could produce.

Nevertheless, the press would eventually deteriorate physically, so would eventually need to be replaced for this reason.

In contrast to the previous two, this criterion is external.

Instead of examining how the entity uses the asset, it looks at how the asset deteriorates due to changes in technology or market conditions, both of which are generally external to the entity (and often beyond its control).

For example, an entity acquires a machine that can print 12nm circuits. Subsequently, a competitor develops a machine that can print 8nm circuits. This change in technological means the 12nm machine is now (at least partially) technologically obsolete.

Commercial obsolescence is the other side of the same coin.

Before 8nm chips were available, 12nm chips (almost certainly) sold for more than after 8nm chips became available.

Note: while commercial obsolescence can be used to determine depreciation periods, IAS 16.62A prohibits a "depreciation method that is based on revenue that is generated by an activity that includes the use of an asset" in effect disallowing its use in determining deprecation methods.

Also note: as US GAAP does not provide similarly detained guidance, "contribution to earnings" can be used to determine both depreciation periods and depreciation methods.

In practice, this criteria usually applies to intangible assets such as patents or licensing agreements.

It would also apply to right of use assets under IFRS 16, though these are also (technically) intangible assets.

When it comes to property plant and equipment, this criterion would most often apply to assets like leasehold improvements, if the lease term is shorter than the useful life of the improvement.

As no authoritative generally accepted accounting principles (ASC 105-10-05-1) specifically address useful life, nonauthoritative accounting guidance such as IFRS (ASC 105-10-05-3.d) may be considered (ASC 105-10-05-2), implying the criteria outlined in IAS 16.56 could be used to determine accounting policy in a US GAAP context.

Most items of property, plant and equipment have some remaining value at the end of their useful lives.

If this residual | salvage value is material, the asset should be depreciated to it, not zero.

IAS 16.6 defines residual value while ASC 360-10-35-4 refers to salvage value.

Since both reflect an estimate of the value an asset will have at the end of its useful life, the terms are interchangeable.

To establish residual | salvage value in practice, a company will generally use its historical experience.

For example, if it commonly sells class A machines for an average of 10% or their acquisition cost and class B machines for 20%, it would set residual | salvage values of 10% and 20% respectively.

It is also possible to estimate using observable inputs in a manner consistent with IFRS 13.67 | ASC 820-10-35-36.

For example, a company could determine the average price comparable assets bring at auction (although a quick and dirty internet search is often good enough).

However, in practice, sticking to the 10% to 20% rule of thumb is often the best option.

Depreciating PP&E to zero is common practice under many national GAAPs.

However, under IFRS | US GAAP, if the asset has residual | salvage value, not recognizing it would be an error.

Although not setting a residual | salvage for assets that are eventually sold (demonstrating that they had residual | salvage value) would be an error, if would rarely be sufficiently material to trigger a restatement as outlined in IAS 8.42 | ASC 250-10-50-12.

Caveat: intentionally failing to establish residual | salvage in situations where residual | salvage demonstrably exists to achieve a particular end would always be material as outlined in IAS 8.41 | ASC 250-10-S99-1.2

Note: the only way to correct errors is retrospectively, in this case going back to the period the asset was acquired.

Also note: even if the correction of an intentional error is not sufficiently material to warrant a restatement of the financial statements, the error would still need to be disclosed and reported to the pertinent market regulator.

This example uses a straight-line depreciation method because it is both simple and commonly used.

This should not be taken as a suggestion to use this method in all circumstances.

Instead, companies should elect a method suitable to the circumstances.

IFRS and US GAAP provide additional guidance including both suggested and prohibited methods.

A discussion of depreciation methods is provided as a standalone section of this page.

IAS 16.62A prohibits methods based on revenue (a.k.a. contribution to earnings).

ASC 360-10-35-9 prohibits tax deprecation (specifically ACRS) unless it reflects a reasonable range of the asset's useful life and ASC 360-10-35-10 prohibits the annuity method (a.k.a. decelerated depreciation).

It sold the machine for 9,500 on 12/31/X12.

1/1/X1 | 1.1.X1

 

 

Machine #123

60,000

 

 

Accounts payable

 

60,000


12/31/X1 to X12 | 31.12.X1 to X12

 

 

Depreciation expense

4,250

 

 

Accumulated depreciation: Machine #123

 

4,250

12/31/X12 | 31.12.X12

 

 

Accumulated depreciation: Machine #123

51,000

 

Cash

9,500

 

 

Machine #123

 

60,000

 

Gain on asset disposal

 

500


When a company disposes of an item of PP&E, it recognizes the difference between its net book value (carrying amount) and the sales price (if any) as a gain/loss.

Both IFRS and US GAAP prohibit recognizing revenue/expense, common practice in many national GAAPs.

IAS 16.68 (edited, emphasis added): The gain or loss arising from the derecognition of an item of property, plant and equipment shall be included in profit or loss... Gains shall not be classified as revenue.

While the paragraph is not similarly explicit with respect to losses, this is not because the guidance is asymmetrical. Instead, it is because in IFRS Expenses (the aggregated item) comprise expenses and losses (the disaggregated items).

An additional discussion of revenue vs gains and expenses vs losses is provided on the accounting elements page.

As outlined in ASC 610-20-32-2, when a company derecognizes a non-financial asset, it recognizes a gain or loss equal to the difference between amount received for the asset (ASC 610-20-32-3 to 6) and the asset's carrying amount.

Many national GAAPs do not distinguish between revenue/expenses gains/losses. The result is that when a company applying such a GAAP derecognizes an asset, it recognizes revenue/expense, which can have a dramatic impact on its reported results.

For example, some time ago a Czech company decided to list on a US exchange.

After retaining an underwriter, the underwriter retained us to draft a report consistent with US GAAP.

As, unlike CZ GAAP, US GAAP distinguishes revenue/gains and expenses/losses, this was one the first adjustments.

After reviewing our preliminary results, the underwater decided against pursuing a listing.

Our first step was to eliminate the major differences and draft a preliminary report.

Up to then, the company had only applied CZ GAAP.

As CZ GAAP does not distinguish between revenue and gains, when a company disposes of its fixed assets, it recognizes revenue in the amount received and an expense in the asset's book value.

Eliminating this difference caused a significant portion of its previously reported revenue to disappear.

In and of itself, this may have been enough to dissuade a listing, but there was more:

  • As the sale of receivables is recognized similarly by CZ GAAP, a similar adjustment had to be made to factored receivables.
  • As CZ GAAP (at the time) required increases in inventory and self-manufactured asset costs to be capitalized with a credit to revenue, this also had to be adjusted.

Eliminating the differences caused over half of the company’s previously reported revenue to disappear.

But there was more:

  • The company did not recognize the full value of its lease assets nor any associated liabilities because CZ GAAP does not require leased assets to capitalized nor liabilities to be recognized. It only requires the capitalization of advance payments, which are amortized over the lease term.
  • The company also did not recognize all of its leased assets because CZ GAAP does not require capitalization of operating leases even if their term is for substantially all the underlying asset's economic life.
  • The company also did not recognize all its contingent liabilities because CZ GAAP does not generally require recognition of constructive obligations.
  • The company also failed to distinguish between cost of sales, selling and administrative expenses as this distinction is not required by CZ GAAP.
  • The company also capitalized both development and some research as well as employee training which, at the time, was consistent with CZ GAAP.
  • The company also misapplied CZ GAAP guidance, for example by using tax depreciation periods for financial reporting purposes, but an examination of these issues was beyond the scope of our engagement.

What a mess.

A second step was not necessary.

After reviewing our preliminary report, the underwater decided to terminate its relationship with the company, which eventually wound up in receivership.

Loss on disposal

Same facts as above, except XYZ sold the machine for 8,500.

12/31/X12 | 31.12.X12

 

 

Accumulated depreciation: Machine #123

51,000

 

Cash

8,500

 

Loss

500

 

 

Machine #123

 

60,000


Intangible assets

Stand-alone asset

1/1/X1, XYZ bought a patent for 10,000.

The patent was acquired on its grant date in an orderly transaction. Its term of 20 years was nonrenewable.

1/1/X1 | 1.1.X1

 

 

Patent

10,000

 

 

Cash

 

10,000


12/31/X1 | 31.12.X1

 

 

Amortization expense

500

 

 

Accumulated amortization: Patent

 

500


Unlike PP&E, a "rebuttable presumption" of zero residual | salvage value applies to intangible assets.

As outlined in IFRS 38.100 | ASC 350-30-35-8, companies should assume intangible assets will have no value at the end of their useful lives unless (a) a third party has committed to buy them or (b) there is an active | existing market, which is expected to still exist, for them.

Useful life ≠ legal life

Same facts except XYZ planned to use the patent to manufacture a product it expected sell for 10 years.

1/1/X1 | 1.1.X1

 

 

Patent

10,000

 

 

Cash

 

10,000


12/31/X1 | 31.12.X1

 

 

Amortization expense

1,000

 

 

Accumulated amortization: Patent

 

1,000


Developed asset

Same facts except XYZ spent 9,500 from 1/1/X1 to 12/31/X1 to develop the patent and 500 to register the patent.

1/1/X1 to 12/31/X1 | 1.1.X1 to 31/12/X1

 

 

Research and development expense

9,500

 

Patent (intangible asset)

500

 

 

Cash, Payables, Enplyee benefits, etc.

 

10,000


As outlined in ASC 730-10-25-1, no research or development costs may ever be capitalized.

While not as categorical as US GAAP, the criteria outlined in IAS 38 practically eliminate any possibility of capitalizing the costs of internally generating a patent unless it will be used in existing operations.

As outlined in IAS 38.54, research costs may never be capitalized.

As outlined in IAS 38.57, development may be capitalized but only if the resulting asset can be sold or used.

IAS 38.57 (edited, emphasis added): An intangible asset arising from development ... shall be recognised if, and only if, an entity can demonstrate ...:
     (c) its ability to use or sell the intangible asset.
     (d) how the intangible asset will generate probable future economic benefits. Among other things,
            the entity can demonstrate the existence of a market for the output of the intangible asset or
            the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset...

As patents are unique, it is difficult to demonstrate that a market for the patent or the output of the patent (the product or service) exists.

It is also risky.

If a company capitalizes development of a patent for a new product or service which it later cannot sell, this inability demonstrates it misapplied IAS 38.57.c and d, so it will most likely need to correct its error as outlined in IAS 8.42 (by restating its previously issued financial reports).

In contrast, if the patent covers improved technology for an existing product or service (or some other useful internal purpose), capitalizing its development is fairly straightforward.

As outlined in IAS 38.59, development comprises (a) designing, producing and testing pre-production prototypes, (b) designing new tools, (c) designing, constructing and operating pilot plants and (d) designing, producing and testing alternative materials, devices or processes.

IAS 38 does not specify what a pilot plant is, only that it is “not of a scale economically feasible for commercial production.”

In practice, to be safe, this is generally interpreted to mean a production facility whose potential production volume will never be sufficient to cover its overhead (fixed and variable).

Note: if a pilot plant is later used for commercial production, the previously recognized development costs would be reversed and financial statements restated as outlined in IAS 8.42.

Also note: as US GAAP does not allow R&D to be capitalized, it does not refer to pilot plants. Instead, it requires any costs associated with facilities without an alternative use (apart from the particular research project) to be expensed as incurred.

The most effective development focuses on improving existing processes, not creating new products or services.

At the risk of stating the obvious, the downside of effective R&D is that innovation suffers.

This is one reason why older, well-established companies with well-developed internal cost control systems generally lag behind younger companies willing to take a risk on an unproven idea.

The flip side of the coin, well established companies with well-developed internal cost control systems generally go bankrupt less often than younger companies willing to take a risk on an unproven idea.

If a company is already selling a product or service, developing technology to improve its quality / reduce production costs not only involves less risk, but makes jumping the IAS 38.57.(c) and (d) hurdle much easier.

As outlined in IFRS 38.66, costs to develop an intangible asset may be capitalized once the asset meets the capitalization criteria outlined in paragraphs 21, 22 and (especially) 57.

These include (subparagraph c) fees to register the legal right.

In this example, as the costs to develop the patent did not meet IAS 38.57 criteria, XYZ only capitalized the costs to register.

While US GAAP does not provide similarly detailed guidance, ASC 350-30-25-3 does specify that costs of internally developing, maintaining, or restoring intangible assets that are not specifically identifiable, that have indeterminate lives, or that are inherent in a continuing business are expensed as incurred.

In general, this guidance is interpreted to mean that only registration costs and fees associated with developed patents are capitalized.

Note, it has been common practice in US GAAP to capitalize costs associated with a legal defense of a intangible asset such as a patent.

However, this practice was based on CON 6, which has since been superseded, and not standard level guidance. As the AICPA still considers this approach to be acceptable, one should consult with one’s CPA regarding this issue before making a decision.

For its part, IFRS (IAS 38.20) does not allow costs to defend an intangible asset such as a patent to be capitalized, as these costs maintain the asset instead of being part of its acquisition.

Indefinite useful life

1/1/X1, XYZ bought a customer list for 10,000. It could not determine how long the list would be useful.

1/1/X1 | 1.1.X1

 

 

Customer list

10,000

 

 

Cash

 

10,000


12/31/X1 | 31.12.X1

 

 

Amortization expense

N/A

 

 

Accumulated amortization: Customer list

 

N/A


As outlined in IAS 38.107 | ASC 350-30-35-15, intangible assets with indefinite lives are not amortized.

As outlined in IAS 38.107 | ASC 350-30-35-15, intangible assets with indefinite lives are not amortized.

Because indefinite is transitory, indefinite should not be confused with infinite, unlimited, indeterminate or undeterminable (IAS 38.91 | ASC 350-30-35-4).

From a practical, accounting perspective this means assets with indefinite lives, while not amortized or depreciated, are tested for impairment at least every period.

In contrast, assets with unlimited lives, for example land, while also not depreciated or amortized, do not need to be regularly tested for impairment (IAS 38.108 | ASC 350-30-35-16).

Instead, they are tested for impairment (at minimum annually).

Both IAS 38.108 and provide ASC 350-30-35-16 relatively straight forward guidance, requiring assets with indefinite lives (not being amortized) to be tested for impairment annually (sooner if there is an indication they are impaired).

In a minor difference, ASC 350-30-35-17A prohibits acquired in-process R&D from being amortized until the project is completed (and useful life is determined) or the project is abandoned (and the asset is written off). Neither IFRS 3 nor IAS 38 provides similar guidance.

Additional guidance (IAS 38.108 | ASC 350-30-35-18A) stipulates that a review | qualitative assessment should be performed.

Note: the qualitative assessment in US GAAP is relatively involved. Paragraphs 350-30-35-18B through 35-18F outline how exactly it should be performed.

For its part, IAS 38 does not provide similarly detailed guidance. IAS 38.110 simply refers to IAS 36.

Goodwill

1/1/X1, XYZ acquired ABC for 10,000,000 in cash.

1/1/X1 / 1.1.X1

 

 

Assets

9,000,000

 

Goodwill

1,000,000

 

 

Cash

 

10,000,000


The Assets acquired in business combination illustration examines this in more detail.

In its simplest form, goodwill results from this calculation:

+

Cash paid to the (previous) owners of the business

10,000,000

-

The fair value that business's net assets

(9,000,000)

=

Goodwill

1,000,000


In addition to cash, IFRS 3.37 | ASC 805-30-30-7 outline various other forms the consideration that can be paid (transferred) including, for example, the acquiring company’s shares (next example).

Interestingly, while both US GAAP and IFRS use the term consideration, neither define it.

This is not because its general meaning is unclear: it is the cash (or something of value like shares) paid in a transaction for something else of value (a product, service or, in this case, a company).

It is because its precise meaning is surprisingly difficult to pin down.

For example, entering "consideration" into Black's online law dictionary (link: thelawdictionary.org) brings up a blank page while Britannica (link: britannica.com), although it does define it, quickly goes off on a tangent about, among other things, love and affection.

... This definition, however, leaves unanswered the question of what is sufficient consideration. During certain periods of history, nominal consideration was held to be sufficient—even a cent or a peppercorn. Gradually, the courts came to require that the consideration be valuable, although not necessarily equal in value to what is received. The courts have had to decide specifically whether acts of forbearance on the faith of a promise, the giving of a counterpromise, money payments, preexisting duties to the promisor, preexisting duties to third parties, moral obligations, love and affection, surrender of another legal claim, or performance of a legal duty were sufficient, and the answer has varied considerably over time...

Fortunately, a quick google search (link: google.com) quickly brings up perhaps the best definition (link: law.cornell.edu).

In addition to consideration, IFRS 3.32 | ASC 805-30-30-1 also specifies the purchase price should include noncontrolling (minority) interest (if any) and any previously held equity (if the acquisition was done in stages).

It also specifies liabilities should be deducted from assets before the calculation is made.

A "business" may be a company (legal entity, or group of consolidated or combined legal entities) but it may also be an operating unit, division or segment.

What is important is that it could be a viable company if it were a stand-alone company.

To make this point, IFRS 13.B5–B12D | ASC 805-10-55-3A to 6 and 805-10-55-8 and 9 stipulate what an acquisition must have in order to be a “business.”

As outlined in IFRS 3.3 | ASC 805-10-25-1, goodwill may only be recognized if the acquired entity is a business. Otherwise, the acquisition is treated as an asset acquisition.

In general, as outlined in IFRS 3.B7 | ASC 805-10-55-4, a business is an entity with 1. inputs, 2. processes and 3. outputs.

Put simply:

Inputs are suppliers, employees, machinery, equipment, furniture, fixtures, patents, copyrights, etc.

A process is the factory (or office) where the material, parts or services supplied by the suppliers are combined or transformed into products (consumed providing services) by the employees using the machinery, equipment, furniture, fixtures, patents, copyrights, etc.

Outputs are the product or services produced in the processes. These are then sold to customers, who can be external (unrelated companies) or internal (operating units, divisions, segments or other related entities).

While inputs and a process are essential elements of a business, "outputs are not required for an integrated set to qualify as a business" (IFRS 3.B7 | ASC 805-10-55-4).

"However, to be considered a business, the set must include, at a minimum, an input and a substantive process that together significantly contribute to the ability to create output" (IFRS 3.B8 | ASC 805-10-55-5).

This implies, if an acquired operating unit only produced goods for other operating units, whether or not it had actual outputs (goods sold to unrelated, third parties) is beside the point. Whether it is capable of having these outputs is the point.

Note: IFRS 3.7A to C outline a simplified "concentration test" to assess if the assets acquired/liabilities assumed constitute a business. ASC 805-10-55 does not outline a similar test.

Also note: while both IFRS (IFRS 3.IE73 to IE123) and US GAAP (ASC 805-10-55-51 to 96) include various illustrative examples of how to determine if a business is a business, they do not use the same examples.

Net assets = assets - liabilities. An illustration of how liabilities are treated is presented below.

Cash and shares

1/1/X1, XYZ acquired ABC for 5,000,000 in cash and issued shares with a market value of 5,000,000.

IFRS 3.33 | ASC 805-30-30-2 specifies that acquisition-date fair value should be used to measure consideration transferred.

If the consideration includes shares traded on a liquid market, fair value would equal their market price.

While the guidance does not explicitly require it to be used, IFRS 3.IE72 | ASC 805-10-55-42 suggests that this market price be the closing market price on the day the acquisition closes.

Note: while acquisition announcements generally cause significant swings in share price, by the time the acquisition closes, the market has priced in its impact, giving a fair representation of fair value.

The guidance does however specify that, if acquiree’s equity interests are more reliably measurable, their fair value should be used.

This would likely occur only if the acquiree’s shares were publicly traded while the acquirer’s was not.

In situations where one public company acquires another public company, applying this guidance means the market price of the more liquid shares (higher trading volumes) should be used.

1/1/X1 / 1.1.X1

 

 

Assets

9,000,000

 

Goodwill

1,000,000

 

 

Cash

 

5,000,000

 

Equity

 

5,000,000


As outlined in IFRS 3.37 | ASC 805-30-30-7, consideration comprises:

  1. Cash
  2. Other assets (including, for example, shares in companies other than the acquirer)
  3. Contingent consideration
  4. Common or preferred equity instruments
  5. Options
  6. Warrants
  7. Member interests of mutual entities

IFRS 3 | ASC 805 defines continent consideration: Usually an obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are met. However, contingent consideration also may give the acquirer the right to the return of previously transferred consideration if specified conditions are met.

Additional guidance is provided in IFRS 3.39 and 40 | ASC 805-30-25-5 to 7.

In the past, if shares instead of cash were used to fund the acquisition, goodwill was not recognized.

Under current guidance, it makes no difference if the acquirer paid with cash, its own shares, or a combination.

Options and warrants are similar in that they convey the right the purchase equity instruments.

They differ in that options are generally issued by an investor that holds the company’s shares, while warrants are issued by the company itself.

As a result, funding an acquisition with options does not create new equity for the acquirer.

Warrants and options and are similar in that they convey the right the purchase equity instruments.

They differ in that warrants are issued by the company itself, while options are generally issued by an investor that holds the company’s shares.

As a result, funding an acquisition with warrants creates new equity for the acquirer.

Note: consideration also includes liabilities incurred by the acquirer to former owners of the acquiree.

Also note: the fair value of noncontrolling interest and the acquirer's previously held equity interest (for business combinations achieved in stages) are also included.

Assumed liabilities

1/1/X1, XYZ acquired ABC for 5,000,000 in cash and assumed 5,000,000 liabilities.

1/1/X1 / 1.1.X1

 

 

Assets

9,000,000

 

Goodwill

1,000,000

 

 

Cash

 

5,000,000

 

Liabilities

 

5,000,000


Net asset = total assets - liabilities assumed.

In contrast to recognizing assets, identifying liabilities is rarely the task of accountants.

Instead, it is better left to experts who specialize in due diligence.

Identifying, recognizing and measuring previously unrecognized assets (previous illustration) is not (usually) particularly difficult.

In contrast, identifying liabilities, especially those the acquired company's management may have gone out of its way to not disclose, is better left to experts (such as former FBI agents who left the agency due to its strict retirement policies) skilled wielding instruments not generally found in any accountant’s toolbox.

Obviously, once all the potential liabilities have been identified, the accounting department is still responsible for their recognition, measurement and disclosure but, assuming the due diligence was performed rigorously, relying on it should be sufficient .

It is important to note that responsibility is jurisdictional.

In the United States, section 302 of the Sarbanes Oxley act specifies the CEO and CFO are responsible for the company’s financial reports.

Obviously, they can rely on additional individuals, for example a chief accountant or controller who certifies the company’s accounts are SOX compliant. However, to “pass down” SOX responsibility, the CEO and CFO must be sure they are relying on individuals with sufficient professional expertise to understand the repercussions of certifying the company’s SOX compliance.

This implies, even if a chief accountant did certify that the acquiring company has recognized, measured and disclosed all the acquired company's liabilities, unless his skill set includes forensic audit, it is unlikely this certification will be sufficient to absolve the CEO and CFO of their SOX responsibility.

In contrast, IFRS is applied in various jurisdictions with varying requirements.

For example, in some EU member states, if a company employs the services of a court certified valuer, the valuer, not company’s officers, bear the responsibility for the content of the valuer’s report.

In such a jurisdiction, if the court certified valuer’s report outlines the assets acquired and liabilities assumed in a business combination, this report, not the judgment of the company’s accounting department, serves as the basis for recognition and measurement of those assets and liabilities.

When IFRS it applied in such a jurisdiction, that jurisdiction's rules and regulations may determine how IFRS is applied.

In a real-world example, company A acquired company B. Company B was domiciled in a jurisdiction where the acquisition price needed to be certified by a court appointed valuer.

Company B then used this valuer’s report to draft an "IFRS compliant" financial report. This report was certified by a statutory auditor licensed to express its opinion in this jurisdiction because, from the perspective of that jurisdiction’s legislation, the report was consistent with IFRS.

In an attempt to save time and effort, company A simply took this IFRS report and, with no significant adjustments (and in the belief IFRS and US GAAP were comparable), recognized the assets and liabilities it included.

However, as company A's shares were listed on a US exchange, its financial report was then reviewed by a US certified public accountant.

Rather than accept a qualified auditor's report (and risk a possible SOX compliance review), company A discarded company B's IFRS report and spent the next three months creating a report consistent with US GAAP.

The result?

What had been originally been bargain purchase, was magically transformed into an acquisition with goodwill (not in the same amount).

While some of the difference was due to inadequately measured assets, most was caused by liabilities not fully captured in the original valuer’s report.

Bargain purchase

Negative goodwill (a.k.a. badwill) is the opposite of goodwill.

It would be calculated thusly:

+

Consideration transferred to the (previous) owners of the business

9,000,000

-

The fair value of business's net assets

(10,000,000)

=

Badwill

(1,000,000)


Negative goodwill may not be reported on the balance sheet. It is recognized as a gain in the P&L | income statement.

No illustration given.

While IFRS 3.34 to 36 | ASC 805-30-25-2 to 4 specify that a bargain purchase is possible, in practice it generally means the acquirer did not correctly measure the acquiree's assets and, much more likely, failed to identify and measure all the acquiree's liabilities, especially provisions and contingent liabilities.

For this reason, as outlined in IFRS 3.36 | ASC 805-30-25-4, before recognizing any bargain purchase gain, it is imperative the acquirer repeat due diligence (this time thoroughly).

As recognizing a bargain purchase gain is practically never justifiable no illustrate is provided.

The only time we have ever encountered a company that considered recognizing a bargain purchase, on further review, it was determined the company had simply misapplied the guidance.

Fortunately, the company corrected its error before a whistle was blown (also see link: sec.gov).

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