Share via

Consolidation in an industry is a rite of passage for industries and economies as they mature. More prominent players acquire smaller players in their quest to capture market share and aid growth. The structure of such acquisitions varies according to circumstances, but their impact on the financial statements needs to be accounted for. This newsletter talks about the valuation aspects of accounting for a business combination per Ind AS 103: Business Combinations (“the accounting standard”).

What is a business combination?

A business combination is defined as “a transaction or other event in which an acquirer obtains control of one or more businesses.”

While the standard definition of a business combination may indicate an acquisition, it is pertinent to note that a business combination can be effectuated via multiple means such as:

• Through the execution of a contract
• Due to an action by the acquiree
• Without the exchange of consideration
• Through transactions that combine multiple companies to form a single company

Let’s assume that an investor holds a 48% stake in Company A. The remaining 52% is held by minority investors, with no one owning more than 2%. Company A repurchases the various stakes held by the minority investors. This results in the investor obtaining control of Company A. This is a classic example of a business combination without the exchange of consideration.

Scope exceptions under the accounting standards

Following are the scope exceptions under Ind AS 103:

• The accounting for the formation of a joint arrangement in the financial statements of the joint arrangement itself.
• The acquisition of an asset or a group of assets that does not constitute a business.
• Business combinations of entities under common control (Guidance provided in Appendix C of Ind AS 103)
• Acquisition by an investment entity as defined in Ind AS 110, Consolidated Financial Statements, of an investment in a subsidiary that is required to be measured at fair value through profit or loss.

Distinguishing between an asset purchase vs stock purchase

Transactions are often structured as asset purchases or stock/share purchases. These nuances in structure often affect the tax treatment of such transactions. However, either of these transactions would still be accounted for as a business combination if the target being acquired qualifies as a business.

Acquisition method of accounting

The accounting standards prescribe the acquisition method of accounting for business combinations. Following are the steps involved in the method:

• Identifying the acquirer: While the standards provide detailed guidance to help determine the acquirer, it is generally the entity that transfers cash or other assets, incurs liabilities or issues equity interests.
• Determining the acquisition date: The acquisition date is the date on which the acquirer obtains control of the acquiree. The acquisition date is a key determination in the accounting for a business combination. The assets acquired, liabilities assumed, and any non-controlling/minority interest are measured at fair value as of the acquisition date.
• Recognizing and measuring the identifiable assets acquired, the liabilities assumed, and any minority/non-controlling interest in the acquiree. The assets acquired, liabilities assumed and any minority/non-controlling interest in the acquiree are measured at the acquisition date at fair value. Fair value is based on the definition in Ind AS 113: Fair value measurements as follows: “The price that would be received from the sale of an asset or paid to transfer a liability in an orderly transaction between market participants.”
• Recognizing and measuring goodwill or gain from a bargain purchase: The last and final step of the acquisition method of accounting is to recognize the goodwill or the gain from bargain purchase, if applicable. It is calculated as the difference between the fair value of the purchase consideration, fair value of the non-controlling interest and the fair value of the net assets acquired. In case of a bargain purchase (or negative goodwill in laymen’s terms), the acquirer is required to reassess whether all assets acquired and liabilities assumed have been identified and recognized. The acquirer is also required to review the procedures used to measure the assets and liabilities taken over, non-controlling/minority interest, acquirer’s previously held equity interest and the consideration transferred.

The purchase price allocation exercise

 The process of assigning fair values to the consideration involved, the liabilities assumed, and the assets acquired is known as the purchase price allocation (“PPA”) exercise. It is achieved by following the acquisition method of accounting.

The Process

A change of control transaction, be it in the form of a merger, amalgamation or acquisition entails several processes that need to be completed. Financial reporting is one such pre-dominant process. While accounting for a business combination requires an in-depth understanding of the accounting guidelines, it helps to understand the practicalities involved in the purchase price allocation exercise.

• Analysis of the purchase agreement to identify the assets acquired, the components of the purchase consideration and other key matters.
• Discussions with management to identify the rationale for the acquisition and drivers which in turn assist in identifying the intangible assets.
• Fair valuation of consideration. When the consideration consists of only cash, the fair value is simply the face value. However, consideration for acquisitions often involves multiple components such as cash, equity interests in the acquirer or some other entity related to the acquirer, deferred consideration and earnout consideration. The various non-cash components need to be fair valued. The equity interest will be valued using a single or a combination of valuation methods applied to derive the value of the issuing entity. Based on the structure of the earnout, it may be valued using an option pricing model such as Black Scholes option pricing model, Binomial Lattice model or Monte Carlo Simulation.
• Fair valuation of intangible assets identified. The intangible assets in a PPA exercise vary according to industry, specific characteristics of the target acquired etc. Commonly identified intangible assets include:
• • Existing customer relationships
  • Tradename/Trademark/Brand name
  • Intellectual property
  • Internally developed technology
  • Know-how
  • Non-compete agreements
  • Favorable/Unfavorable lease terms

Intangible assets are valued using methods under the income, market or cost approaches. Commonly used methods to value the intangible assets include:

• Multi-period excess earnings methods
• Relief from royalty method
• Replacement cost method
• With or without method
• Lost profits method

The methods mentioned above are variations of business valuation methods such as the discounted cash flow method.  These methods are adapted to the unique features of the intangible assets being valued.

• Reasonableness check: The standard of value for a PPA exercise, fair value, entails adherence to market participant The technical definition of market participant is buyers and sellers in the principal (or most advantageous) market for the asset or liability. In the context of a PPA, use of the market participant assumption implies that the projections relied on reflect the growth and margin expectations of the market. This assumption also extends to the discount rate used in the exercise which must reflect return expectations of a market participant.

As an appraiser, the test of reasonableness for a PPA exercise is the alignment of the internal rate of return (discount rate that equates the present value of the projections to the fair value of the consideration) and the weighted average cost of capital. This alignment also serves to assess that the projections are aligned with market participant levels.

There also certain rules of thumbs that an appraiser looks at such as:

• Profit split method – To assess the reasonableness of the royalty rate applied in the relief from royalty method.
• Common size – Analysis of the value of the intangible assets relative to the purchase consideration.
• Market parameters – Benchmarking the economic life of the intangible assets to that of intangible assets identified in comparable company financials.

How KNAV can help?

A business combination is a time-consuming process requiring an interplay of multiple factors. KNAV’s valuation team is well equipped with the knowledge of the relevant accounting requirements as well as the technicalities involved in the valuation process. As a consultant, we believe in asking the right questions and helping our clients in navigating towards the .