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Business Combinations Accounting:Gap Between GAAPs

Published on Tue, Nov 05,2013 | 13:48, Updated at Wed, Nov 06 at 14:57Source : 

By: Ashish Gupta, Head-Financial Reporting Advisory Services, Walker, Chandiok & Co

Globalisation – a phenomenon that opened the doors to growth and wealth for corporates across the world. The resulting potential has not remained untapped by Indian Corporates too whose activities have been gaining momentum ever since to seize all business opportunities– inbound and outbound, creating synergies and rising through the corporate ladder using the ‘inorganic’ growth model.Esther Dyson quotes the ushering thought as -"It may not always be profitable at first for businesses to be online, but it is certainly going to be unprofitable not to be online."

As the business transforms corporates into dynamic organisations, coping with uncertain global developments and asserting immense economic value to stakeholders, an important question that financial experts often seek an answer to is - whether accounting reflects the underlying economics of complex business relationships that corporates enter into and provides relevant &reliable information to its users for informed decision making. Criticism of absence of robust financial reporting frameworks further echoed every time a fraudulent corporate activity is unearthed.

The consequent modifications in financial reporting frameworks evolved over more than two decades in developed world to promulgate amongst other changes a paradigm shift in fundamental accounting principles from historical cost basis to fair value basis. ‘Fair value’ reflects the amount at which two knowledgeable parties are willing to transact and purports to reflect the true economics of the transaction. The classic showcase of fair value accounting principles is evident in two most popular accounting frameworks– IFRS and USGAAP, disseminating across several accounting branches, such as tangible assets, financial instruments, hedging relationships, business combinations to name a few. One of the revolutionary changes that indeed resulted in dawn of new era has been induction of Accounting Standard “IFRS 3 - Business Combinations” by International Accounting Standards Board.

These developments have brought radical changes in global accounting world; however does the Indian financial reporting framework built on historical cost principles also provide information that is relevant &reliable for synonymous transactions in India? Let’s glimpse through some of the inherent intricacies of business combinations and how accounting deviating under Indian GAAP from the international standards results in gloomy picture, enwrapping the desirable information from stakeholders –

(a)     What is the value of acquired assets and liabilities;

(b)     How it would contribute to future group earnings; and

(c)     Gain or loss arising on such business combination.

Taking an example to illustrate this, an Indian Company (“ABC Ltd”) acquires another Company (“XYZ Ltd”) having net assets at book value of $1,500 for purchase consideration of $ 1,000. In addition to the tangible assets, there were certain intangible benefits acquired in form of customer relationships, in house research& development and technological know-how. The accounting differences between IGAAP and IFRS will have significantly different ramifications on the accounting results for the transaction, as explained below.

IFRS 3 evaluates all business combinations as ‘acquisitions’, resulting in acquired assets and liabilities being measured at fair values. The pervasive change in acquisition accounting considers purpose &design of the combination to attribute value to assets based on their expected contribution to future business earnings and risks to which the business is exposed, through a purchase price allocation exercise (“PPA”).Business acquisitions effected for operational & strategic empowerment and consolidating market positions often assimilate value for several intangible benefits that the buyers expects to derive from the transactions. These evolving business relationships resulted in introduction of accounting concepts and valuation techniques to recognize such intangibles like brand name, technology, know-how, etc.

Accordingly, in our example, ABC Ltd. shall perform a PPA exercise to determine the fair value of assets acquired & liabilities assumed and in the process, recognize even previously un-recognized intangibles at a total value of say $ 2,000 ($ 1,500 of tangible assets and $ 500 of intangible assets). The resultant gain, representing difference between purchase consideration and fair value of net assets of $ 1,000 shall be recognized in income statement at par with any other gain on bargain purchase part of ‘owners’ equity’ and free for distribution to stakeholders.

In contrast, Indian GAAP stresses on historical cost basis of accounting, consolidating the subsidiary’s net assets at existing carrying amounts with difference between purchase consideration & net assets’ book value accounted as ‘goodwill’ or ‘capital reserve’. Replicating this accounting approach in our example, net assets shall be recognized at book value of $ 1,500, with resultant difference of $ 500 between purchase consideration and net assets being recognized as ‘capital reserve’ that has restricted use. A further deviating accounting result is achieved, if the acquisition is ‘an amalgamated entity’ as compared to ‘subsidiary’, recognizing net assets at fair value and difference between purchase consideration & fair value of net assets being booked as ‘capital reserve’. While the economic substance of the underlying acquisition transaction remains unchanged, the accounting variance significantly hampers comparability and also results in companies structuring transaction for desired accounting results.

Another sparkling distinction in accounting and measurement of goodwill& other intangible assets arising on acquisition cannot be overlooked. While IFRS permits separate recognition of identifiable intangible assets and goodwill is the residual value often paid for acquiring control of the acquiree, however Indian GAAP projects goodwill as the excess consideration paid by buyer above carrying book values. The amortization of segregated intangible assets under IFRS in income statement in proportion to the related economic benefits earned sustains the matching principle of revenues with costs. However, under Indian GAAP, goodwill often representing a heterogeneous mix of intangible assets transacted by the buyer is not amortized, thereby impairing comparability of financial statements with global peers.

In today’s economic scenario, where lot of capital or financing transactions are made in international markets, elaborate disclosures describing the transaction activities help decision users make informed decisions, removing the fear of unknown. Indian GAAP on other hand provides simplified accounting means, but orthodox reporting layout does not always portray real value of underlying transactions and may significantly impair credibility of financial information, resulting in situational disadvantage and leading to higher costs and efforts to meet requirements of acceptable standards.

With the global economy still recovering, the relevance of financial performance remains immense and more critical than ever. The need of the hour is to critically evaluate present financial reporting framework to plug the “Gap between GAAPs” and raise the curtain that presently obliterates true economics underlying business transactions. The advantages of such change resulting in better comparability of financial performance with companies globally as well as delivering more transparent & ‘real’ information cannot be undermined in enabling investors' and regulators' to make informed decisions.


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