Category: non-GAAP measures

A Question Not to be Underestimated: Asset or Business Acquisition?

A transaction is either accounted for as a business acquisition under IFRS 3, Business Combinations, or, if it is not a business combination, in accordance with the appropriate standard for an asset purchase (for example: IAS 16 Property, Plant and Equipment; IAS 38 Intangible Assets; or IAS 40 Investment Property).

The question is important (and there are significant consequences to getting the answer wrong or not considering the question at all!), because in a business combination:

  • Goodwill or a gain on bargain purchase is accounted for;
  • Assets acquired and liabilities assumed are accounted for at their fair values rather than being recognized at their relative fair values in an asset purchase;
  • Directly attributable acquisition costs are expensed versus capitalized as part of the asset purchased;
  • Deferred tax assets and liabilities are recognized in a business combination;
  • IFRS® Standards provides guidance on recognizing contingent consideration but there is no guidance in the standards applicable to asset purchases;
  • The disclosure requirements are considerable in the financial statements for a period in which a business combination is completed, and the same disclosure applies in any year where an acquisition is made subsequent to the report date but before the financial statements are issued; and
  • Also note that some of these differences continue in future periods, such as impairment and depreciation/amortization.

An entity first needs to determine whether the assets acquired and liabilities assumed constitute a business (IFRS 3.3). If they do not meet the definition of a business, then the default is to account for the transaction an asset purchase.

Appendix A to IFRS 3 defines a business as, ‘an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return…to investors or other owners, members or participants.’  A business therefore consists of inputs and processes applied to those inputs that have the ability to generate outputs. Therefore, outputs themselves are not required.

Input: are economic resources, such as intellectual property, access to necessary materials, employees and non-current assets such as intangible assets or the rights to use non-current assets.

Process: is any system, standard, protocol, convention or rule, such as strategic management processes, operational or resource management processes. Administrative processes are specifically excluded.

Output: is a return in the form of dividends, lower costs or other economic benefits

You should note the following in applying the definition:

  • If the transaction does not include both inputs and processes then it is not a business combination.
  • Some processes must be included in the transaction, but all processes used by the vendor need not be included. Some necessary processes may be provided by the acquirer on integrating the business with their own operations.
  • A business need not have liabilities.
  • The set of assets and activities must be capable of being conducted and managed as a business by a market participant. Whether the seller operated the set as a business and whether the acquirer intends to operate it as a business is not relevant.
  • There is a rebuttable presumption that an asset that includes goodwill is a business.
  • The elements of a business vary by both industry and structure of an entity.
  • New businesses often have few inputs and processes and only one (or no) outputs. In this situation, other factors must be considered, including whether the set:
    • Has begun planned principal activities;
    • Is pursuing a plan to produce outputs; and
    • Is expected to obtain access to customers to purchase those outputs.

The determination of whether a transaction is a business acquisition or an asset purchase is a judgement call that must be disclosed.

The Application Guidance provides more detail that is useful in applying IFRS 3, including the following.

The definition of a business includes inputs and processes and may also result in outputs, although outputs are not necessary for a business to exist. A process is defined as, ‘any system, standard, protocol, convention or rule’ (IFRS 3.B7) that when applied to inputs creates, or has the ability to create, outputs. Examples of processes include strategic management, operational and resource management. Inputs are economic resources that create, or have the ability to create, outputs when one or more processes are applied, and include intangible assets or the rights to use non-current assets.

‘To be capable of being conducted and managed for the purposes defined, an integrated set of activities and assets requires two essential elements – inputs and processes’. Therefore both assets and processes must be included in the acquisition, even though all necessary processes need not be acquired (some processes may be contributed by the acquirer) (IFRS 3.B8). If no processes are included, then the transaction is an asset purchase; if this was not the case, then any asset purchased for use in an existing business would meet the definition of a business, which would be non-sense.

Furthermore, processes are described as ‘activities’ in IFRS 3.B8, which is consistent with the English language definitions of the word: (i) as a noun, ‘a series of actions or steps taken’ and (ii) as a verb, ‘perform a series of mechanical or chemical operations on something in order to change or preserve it.’ The purchase of in-place leases, for example, represents economic inputs and not a process; the leases represent a right to benefit from non-current assets. There are no activities inherent in a rent-roll, instead leasing and other management processes are applied to it.

Where the acquisition includes both inputs and some level of process (over and above administrative functions, which are specifically excluded by the definition) the determination can involve significant judgement. The IFRS® Interpretations Committee White Paper of May 2013 addressed the application of this principle in practice by different sectors, including the real estate sector, and in different jurisdictions.

One view in practice is that the processes acquired must have a level of sophistication that involves a degree of knowledge unique to the assets being acquired for a business to exist. Common themes in the responses received include:

(a)    Examples of significant management processes that management views as being integral for a business to exist, include marketing, tenancy management, financing, development operations and other functions that are typically undertaken by the parent company or external management.

(b)    The acquisition of an investment property together with the employment of key management personnel of the vendor is a strong indicator of a business.

(c)     Other processes such as cleaning, security and maintenance are generally not considered to be significant processes. Therefore, a transaction that only includes those or similar processes is generally treated as an asset purchase.

Note that these necessary processes meet both the definition in IFRS 3 and the English language definition, while in-place leases acquired do not.

The view that a level of sophistication is required is predominant in Europe and Australia and is consistent with the requirement that processes be at a more supervisory or management level (as per the definition: strategic management, operational and resource management).

The view from respondents using US GAAP (which is nearly identical to the guidance in IFRS Standards) is that ‘any process that, when applied to an input or inputs, create or have the ability to create outputs, gives rise to a business.’  Therefore, transactions are more likely to result in business acquisitions than asset purchases in the US GAAP world.

Under Canadian Accounting Standards for Private Enterprises (ASPE) the relevant standard is 1582 Business Combinations, which is a copy of IFRS 3 Business Combinations. Therefore, the guidance surrounding IFRS Standards can also be applied to the same asset or business combination question under ASPE. In applying the GAAP hierarchy in ASPE (standard 1100 Generally Accepted Accounting Principles), the first consideration would be IFRS Standards and not US GAAP. This is logical given the fact that 1582 and IFRS 3 are identical.

The International Accounting Standards Board (the Board) carried out a Post Implementation Review (PIR) of IFRS 3 in 2014/2015. The review found that stakeholders find it difficult to apply the definition of a business in practice. The Board issued an exposure draft in June 2016 which proposes: amending the language used in the standard, adding illustrative examples and simplifying the application of the standard in some situations. The comment period closed on October 31, 2016. Watch this space for a piece on the final amendments to the standard.

Neutrality, relevance and comparability of non-GAAP and additional GAAP measures

In the first of a two-part article, originally published by Wiley, Paul Rhodes, partner at Crowe Soberman, Ontario, examines the use of non-GAAP and additional GAAP measures in Canada and highlights how the relevance, comparability and understandability of a company’s financial statements can be compromised.

Since the adoption of IFRS® Standards by Canadian publicly accountable entities with effect from 2011, there has been an increase in the use of non-GAAP and additional GAAP measures. In some cases this is a necessary side effect of the IFRS Standards financial reporting framework objective of ‘general purpose’ financial statements, as a one-size-fits-all approach is unlikely to do just that.

Non-GAAP financial measures

These have been defined by the Ontario Securities Commission (OSC) in Staff Notice 52-722 as a “numerical measure of an issuer’s historical or future financial performance, financial position or cash flow, that does not meet one or more of the criteria of an issuer’s GAAP for presentation in financial statements, and either:

  1. excludes amounts that are included in the most directly comparable measure calculated and presented in accordance with the issuer’s GAAP, or
  2. includes amounts that are excluded from the most directly comparable measure calculated and presented in accordance with the issuer’s GAAP.”

In some jurisdictions, non-GAAP financial measures are also referred to as alternative performance measures.

Additional GAAP measures

IAS 1 defines additional GAAP measures presented in financial statements as:

  1. a line item, heading or subtotal that is relevant to an understanding of the financial statements and is not a minimum line item mandated by IFRS Standards (paragraphs 55 & 85), or
  2. a financial measure provided in the notes to the financial statements that is relevant to an understanding of the financial statements and is a measure not presented elsewhere in the financial statements (paragraph 112c).

Qualities desirable of the MD&A

Neutrality is required for a faithful representation of economic events in financial statements. Management’s Discussion & Analysis (MD&A) should complement and supplement financial statements. The objective of MD&A is to provide a narrative explanation, through the eyes of management, of how an entity has performed in the past, its financial condition, and its future prospects. Therefore some qualities desirable of the MD&A are the same as those for financial statements. These include, in particular, the requirements that the financial and narrative information presented should be fair, balanced, understandable, relevant and comparable.

The risk posed by the increasing use of non-GAAP and additional GAAP financial measures is that these desirable qualities may be jeopardised. For example, there may be a lack of comparability of financial information between entities, or for the same entity for different periods, meaning that users are potentially unable to identify and understand similarities in, and differences between, items. In a worst case scenario information may not be neutral due to a biased presentation.

To put the issue into context: a study was conducted by the OSC, the results of which were published in 2013, in which the disclosures made by 50 reporting issuers with head offices in Ontario were reviewed. The study revealed that 82 per cent of those reviewed committed to enhancing their disclosures. 

Problems with additional GAAP measures

Operating income

The 1997 vintage of IAS 1 required the income statement to present the results of operating activities as a line item in the income statement. Even though that requirement was subsequently dropped because operating income is not a defined concept in IFRS Standards, it still has a well understood meaning. Some issuers present operating income as an additional GAAP measure but exclude components that would be considered part of operating results. Examples include the exclusion of amortization of acquired intangible assets that are used in operating activities and the exclusion of inventory write-downs.

Gross profit

Other financial statement line items with well understood meanings can also be incorrectly reported (a common example being gross profit), by excluding components that are typically a part of the measure, and conversely, including components that are not part of the measure. 

“Income before the undernoted”

Using terminology that is neither descriptive nor relevant to understanding the financial performance or position, such as ”income before the undernoted” or “income before operating expenses”. Similarly, the inclusion of unlabeled subtotals in the financial statements is unlikely to contribute to an investors’ understanding.

Boilerplate language

The use of boilerplate language, instead of explaining why the additional GAAP or non-GAAP measure is relevant to investors’ understanding of the financial statements, is problematic. A reporting issuer often makes no reference to the measure in either the notes to the financial statements or in MD&A, which casts doubt on the relevance of the measure to understanding financial position and performance.

Problems with non-GAAP measures

”Weighted average yield”

The use of undefined or ambiguous performance measures can be confusing and potentially misleading to investors. For example, disclosing, in MD&A or press release, undefined measures of performance, such as a “weighted average yield” applied to financial instrument receivables accounted for as loans and receivables at amortized cost using the effective interest method.

Furthermore, the inclusion of such a measure in the financial statements may reasonably lead investors to conclude that the measure is a standard GAAP measure that is required to be disclosed, especially in other public documents when there is inadequate disclosure and no reconciliation is provided between the measure and the entity’s GAAP financial statements.

Reconciliation issues

Not providing a clear quantitative reconciliation between the non-GAAP financial measure and the most directly comparable GAAP measure. Such omissions leave investors having to make assumptions about the composition of the non-GAAP measure.

Management bias

Clear management bias in presenting non-GAAP measures, such as including one-time gains but excluding one-time losses in other periods, or by describing measures as excluding non-recurring items when those items are seen to recur within a short timeframe. When items are removed from the GAAP measure of performance to arrive at the non-GAAP measure the nature of the item removed and why it is not expected to recur is rarely provided.

Management bias can also occur where the non-GAAP earnings measure is presented more prominently than the equivalent GAAP measure, or where the GAAP measure is excluded entirely. Earnings releases often include a level of analysis applied to non-GAAP measures that is not applied to the equivalent GAAP measure.

Sheer volume

Investor confusion may be increased by issuers including many non-GAAP measures of performance in a public document with only slight differences between each.

The problems identified above are not new to the IFRS Standards world in Canada. Clearly, there is a need for reporting issuers to be allowed to present measures of financial performance or position suitable to their respective business. However, the Canadian market regulators have had issues with the use of non-GAAP and additional GAAP measures for many years. A subsequent white paper will review in detail the IFRS Standards and Canadian regulatory rules on the use of these measures, and also position that guidance within the global context.