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Journal number 1 ∘ Levan SabauriNadezhda Kvatashidze
Some As Aspects of Identification of Enterprises Association

https://doi.org/10.56079/20221/3

 

Topic: The article deals with the criteria of identification of business combinations and its  importance for providing relevant and fair information to users of financial statements.  

Objective and Tasks: Sharing the changes made by the International Accounting Standards Board in the criteria of identification of the business combinations and their implementation in the practice. A  novelty of the identification criteria is clarification of the criteria for businesses and introduction of the “Asset fair Value Concentration Test” 

Methodology: Relevant standards, guidelines, recommendations, scientific articles, monographs, systematization and comparison methods approved by the International  Accounting  Standards Board were used in this study.

Results: Businesses identification elements (resources, processes, products) and criteria (enterprise and control) are established; Characteristics of the essential processes, in particular,  a “principal importance" of the processes for manufacturing the  products and the organized labor resources, are discussed; Significance of the  “Asset fair Value Concentration Test” is analyzed. 

Refinement of the criteria of business combinations simplifies the process of such identification with limiting its scope of recognition, which affects a quality of financial information  

 Keywords: Business Combinations; enterprise; control; concentration test; essential processes; organizational labor forces.  

JEL Codes:  L50, L51, L53

 

Introduction

 

        In the context of globalization, the number of enterprises is decreasing, but their size is increasing. This trend has become more relevant in the context of the economic crisis caused by the pandemic, which is accompanied by different types of combinations of enterprises -   business combinations associations. As a result of business combinations,  separate economic entities or enterprises are combined  into one accountable economic entity.  A motivation of business combinations is to find a new market for sales, new perfect technologies, new competitive products, increase profits, reduce competition. The business combination  increases the scales of a single enterprise and its competitiveness, with making it possible to invest free money  and manage company’s capital.  

      It is important for investors to know what they have acquired - the enterprise (business) or a group of assets, since s their accounting methods and financial reporting rules are different. In case an economic event is not identified as a business combination, it should be recognized as an acquisition of assets. The economic events that will be identified as “business - combinations” must be accounted and recorded in the financial statements in accordance with International Standard IFRS 3  - “Business Combinations”. According to this Standard,  acquisition of a business is reflected by the “acquisition method" and a full consolidation of reporting, while in  case of “acquisition of assets”, the reporting is not consolidated, but new assets are recognized in their own financial statements. It is obvious that the accounting method affects the financial performance of a company, such as goodwill, its impairment loss, non-controlling interest, group’s profit, etc.  Goodwill is not recognized with the “acquisition of assets”, instead, it is recognized (included) in the assets (but should not exceed their fair value).

     Thus, it is important to find out in which cases events and operations can be identified as business combinations and what is  “business combinations”  - which economic events can be identified as acquisition of an enterprise (business)  and what criteria should be met for recognition of business combinations (Levan Sabauri, Nadezhda Kvatashidze, 2020). 

       According to thea new interpretation of the IFRS 3, Business Combination is a transaction or other event in which an acquirer obtains control of one or more businesses. (IFRS Foundation, 2021).   

          Thus, the criteria for identifying the business combinations are business and  acquisition of control of such business  by  the acquiring business. Therefore it is important to clarify the categories of enterprise and control.  

     

 

Business Identification Criteria

 

The International Accounting Standards Board  (IASB)  has made changes to the concept of business combinations, thus simplifying the criteria and process for its identification.   According to IFRS 3, business is an integrated set of activities and assets that is capable of being conducted and managed for: 

  • Providing goods and services to   clients; 

  • Earning  investment income (such as dividends or interest);

  • or earning other types of income from ordinary activities.

According to IFRS 3, any business must consist of the following three elements  

a) Input:   Any economic resource, that creates or has the ability to create, outputs when one or more processes are applied to it. Examples include non-current assets (including intangible assets or rights to use non-current assets), intellectual property, the ability to obtain access to necessary materials or rights and employees.

b) Process: Any system, standard, protocol, convention or rule that when applied to an input or inputs, creates or has the ability to create outputs. Examples include strategic management processes, operational processes and resource management processes.  It includes also an organized workforce having the necessary skills and experience following rules and conventions may provide the necessary processes that are capable of being applied to inputs to create outputs.  

c) Output: The result of inputs and processes applied to those inputs that provide or have the ability to provide goods and services to clients; to receive investment income (such as dividends or interest); or, to receive other types of income from ordinary activities. 

      It should be noted that according to the amendments to IDRS 3, output  is not mandatory for the identification of  business. It is deemed that any business needs to have two main elements – input and processes applied to input. It is not necessary for a business to integrate all the inputs and processes that a seller used in operating that business s used to operate it. In order for an integrated set of activities and assets to belong to a business,  it must, at a minimum, include inputs and any substantive process that together may contribute significantly to the ability to create output (IFRS Foundation, 2021)  

      IFRS introduces and defines a concept of “Essential Processes”. If the acquired set  of activities and assets does not have the output at the acquisition date, the acquired process (or group of processes) should only be considered essential, if:

a) It has a substantive importance for the ability of processing the acquired input or inputs  or transforming them into output; and  

b) Acquired inputs include both the organized workforce having the necessary skills, knoweledge, and praqtical experience to activate/implement this process (or group of processes), and other inputs  that could be processed or transformed into organized workforce  

Changes are made in the definition of output (production), as well. Earlier,  the outputs were defined as income in the form of dividends, cost reductions, or other economic benefits directly attributable to investors or other owners. Through the changes made in IFRS 3, the IASB certainly limited the above definition andб shifted еhe focus to goods or services provided to consumers, investment income (such as dividends or interest), and other income from ordinary activities.

According to the explanation given by the Board, the previous reference - to equate the outputs (production with the reduction of costs and other economic benefits provided directly to investors, did not reflect the difference between assets and the enterprise. For example, the acquisition of various  assets may be motivated by cost reduction, but may not involve the acquisition of a substantial process. This formulation was therefore excluded from the definition of  outputs and businesses. 

Assets Fair Value Concentration Test

 

    The business characteristics (input, essential processes, organized workforce) assessment process can be simplified  through the so called “Assets Fair Value Concentration Test”  offered by IFRS 3 for identification of a business (business combinations). The main question of the test is: whether the fair value of the total acquired assets is concentrated in a single asset or group of assets (PWC, 2021).   If the answer is yes, the acquisition is not a business, so,  there is no need to continue its further analysis. If the answer on concentration test is negative, or the business decides  not to use the given test, then it should conduct the following  analysis (Grant Thornton, 2020):

  • Analysis of the structure of acquired assets – whether one asset or a group of assets is acquired; 

  • Whether a practically total  fair value of the acquired assets is concentrated in a single identifiable asset or a group of similar identifiable assets;    

  • Whether the acquired processes are essential 

 

The fair value concentration test is required to determine the fair value of all acquired assets (and not of the net assets), since, for example, accounts payable and loans are of particular importance in assessing whether a business has been acquired; Cash, deferred taxes and goodwill are not taken into account. The fair value of total assets can be determined by primary (direct) and indirect (indirect) methods (Deloitte, 2020): 

By Direct method: fair value of acquired assets + goodwill - cash and cash equivalents - deferred tax asset;

By Indirect method: Paid remuneration  + fair value of the assumed liabilities  (excluding deferred tax liabilities) - cash and cash equivalents - deferred tax asset.

 

Identify Control of Economic Input

 

     An investor, regardless of the nature of its involvement with an entity (the investee), shall determine whether it is a parent by assessing whether it controls the investee.   

Control links economic input to a business. . According to the conceptual basis of financial reporting, an economic input  is a right that has the potential to generate economic benefits (IFRS Foundation, 2021). 

      A business controls an economic input if it already has the current (effective) ability to determine how to use the economic input and to receive the economic benefits that can be derived from that economic input.  Control also includes the current (effective) ability to prevent other parties from determining how to use an economic input and from obtaining the economic benefits that can be derived from that economic input.  This means that if one party controls the economic input,  no other party can control that resource.

      The guidelines of IFRS 10 “Consolidated Financial Statements” should be used to identify the acquiring business i.e. the entity  that controls the acquired business 

According to IFRS 10, An investor controls an investee when it is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee (IFRS Foundation, 2021).   

 Thus, an investor controls an investee if and only if the investor has all the following: 

a) Power over the investee (see paragraphs 10–14); 

b) Exposure to risks;  and

(c) The ability to use its power over the investee to affect the amount of the investor’s returns.

When the business combination is implemented, but, with using the IFRS 10 guidelines it is not clear which of the combined businesses  is the acquiring entity, then the business  should consider the factors described in IFRS 10.  

 

Conclusion

  • Business Combinationsis a common way of increasing the size of companies and a transaction in which the acquiring entity takes control of another (acquired)  entity(acquisition). The combinations criteria are control and the existence of an  enterprise. According to IFRS, a business is an integrated set of activities and assets that can provide investors with income through the supply of products, services, dividends, interest or other economic benefits.  

  • A business  consists of three components:  input, processes, and output  (products). At the same time, the two components of an integrated set of activities and assets, such as inputs  and processes, are sufficient for recognition as a business, as they have the ability to facilitate the manufacturing of products, that is sufficient to be considered a business. In particular, when an integrated set of activities and assets does not have output at the acquisition date, it must include substantive processes to identify it as a business.  The essential characteristics of processes are their fundamental importance in the transformation of inputs into  outputs and the existence of organized workforce  that have the appropriate intellectual potential - skills, knowledge and practical experience to transform inputs  into outputs.  

  • Outputs of the business are no longer abstract, and it is clear and specific what is meant by the outputs. These are the supply of goods or services to consumers, the receipt of investment income in the form of dividends or interest, and other types of income from ordinary activities; 

  • Changes in the definition of a business combination will lead to the recognition of a large proportion of transactions as an acquisition of assets (especially in the real estate, pharmaceutical, oil and gas businesses).

References:

  • Deloitte. (2020). New in IFRS –Review of Issued Amendments and Current Projects of the IASB . November 19, 2020.

  • Grant Thornton. (2020).Insights into IFRS 3. Definition of a Business (Amendments to IFRS 3). 2020. December 3, 

  • IFRS Foundation. Conceptual Framework for Financial Reporting. IFRS Foundation. 4.20. London, December 4, 2021.

  • IFRS Foundation. IFRS 10 Consolidated Financial Statements. IFRS Foundation, 6-7. London, 2021.

  • IFRS Foundation. IFRS 3 - Business Combinations. London, December 22, 2021.

  • IFRS Foundation. IFRS 3-Business Combinations, b8. London, December 22, 2021.

  • Levan Sabauri, Nadezhda Kvatashidze. (2020). "Some Aspects of loan and Capital Financial Instruments." ECONOMICS AND BUSINESS, 108-116.

  • PWC. IFRS Bulletin, 30 June 2019. December 24, 2021.