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FRC publishes thematic review on business combinations
Publication date: 11 Oct 2022
uk In brief 2022-55
What is the issue?
Business combination transactions can be complex and often have a significant impact on an entity’s annual report and accounts. Given the complexity of such transactions and the reduced familiarity with the related accounting requirements due to their ‘one off’ nature, there is an increased risk of error in recording and disclosing these transactions. Issues related to business combination accounting are common in practice and have frequently featured in the FRC’s ‘top ten’ findings.
Review scope
This thematic review draws out the features of better reporting and disclosures, highlights common pitfalls and addresses areas for improvement with regards to the IFRS 3, ‘Business Combinations’ requirements, but also the disclosure requirements in the Companies Act 2006 (the ‘Act’) and the Disclosure Guidance and Transparency Rules (‘DTR’) that could apply. The review excludes business combinations under common control and reverse acquisitions.
Key observations
The FRC was generally pleased with the quality of reporting of business combinations but noted that there remains room for improvement. Particularly, the FRC raised the following key observations:
- Reasons and impact of the business combination – The best reports gave clear and consistent explanations of the reasons for, and the impact of, the combination throughout the annual report, with careful thought given as to how to convey the information in an understandable and concise way.
- Use of APMs in the context of a business combination – When alternative performance measures (‘APMs’) were used to explain the impact of the combination, the best examples followed recommendations from the FRC’s recent APM thematic review.
- Valuation techniques – The better disclosures provided an explanation of the valuation techniques applied to value acquired assets and liabilities, the key assumptions used and they disclosed this by significant class of asset and liability. They explained how fair value adjustments would unwind over time.
- Presentation of fair value adjustments – Some companies used a three-column approach to present fair value adjustments to the previous carrying values, which the FRC noted can in some instances be helpful in highlighting material adjustments.
- Factors giving rise to goodwill – Explanations of factors giving rise to goodwill were sometimes not provided or were boilerplate and of little benefit to readers.
- Share-based payments in the context of a business combination – The requirements to determine whether share-based payments form part of the consideration or are accounted for as a post- combination expense are complex, and companies could improve their explanations of how such payments have been treated.
- Contingent consideration disclosures – Disclosures related to contingent consideration could be enhanced. Explanations of the arrangements were often boilerplate, and the FRC noted it was hard to understand the potential variability in the amounts.
- Cash flow classification – Some companies incorrectly reported cash flows for acquisition costs as investing cash flows. These should be classified as operating cash flows within the consolidated accounts.
- Significant judgements and critical estimates disclosures – Accounting for business combinations often requires significant judgements and estimates to be made. When companies disclosed that there was significant estimation uncertainty, sensitivity disclosures could be improved.
- Deferred taxes – The relevant provisions of IAS 12, ‘Income Taxes’ should be applied. Business combinations can give rise to additional deferred tax balances, for example when revaluing assets to fair value or reassessing the recoverability of assets.
Other matters were addressed in the review in the context of a business combination, such as:
- Management commentary, including the impacts on liquidity and funding.
- Puts over non-controlling interests.
- Transactions not included in the business combination.
- Business combinations after the end of the reporting period.
- Merger relief (section 612 of the Companies Act 2006).
- Multiple business combinations.
- Indemnification assets.
- Accounting policies.
- Impairment testing.
- Changes in segmentation.
What is the impact?
The FRC encourages companies to take note of the key findings in the thematic review when they undertake a business combination and has set out the following key expectations:
- Clearly explain the impact of the business combination on the group’s strategy, resources, operations and performance. Explanations should be clear and concise, highlighting the reasons for any significant changes.
- Provide a comprehensive understanding of the effects of the business combination supported by consistent information throughout the annual report, allowing the reader to follow ‘the full story’.
- Avoid boilerplate disclosures, making sure explanations reflect specific circumstances.
- Provide meaningful sensitivities and/or ranges of reasonably possible outcomes for significant estimates made in accounting for the business combination.
- Clearly disclose the potential variability in future amounts payable for contingent consideration.
- Make sure business combination related cash flows are correctly classified, with cash flows for acquisition-related costs within operating cash flows in the consolidated accounts.
- Carefully consider what deferred tax balances should be recognised as a result of the combination.
- Explain how transactions not accounted for as part of the business combination have been treated and the line item(s) in the financial statements in which they have been recognised. When contingent payments are linked to continuing employment of personnel they should be excluded from consideration for the business combination and accounted for as post-combination employment expense.
When does it apply?
Going forward, where a business combination is undertaken, the FRC expects entities to consider the key findings from this review in their reporting and disclosures where relevant.
Where do I get more details?
Refer to this link for the FRC’s report.
Please reach out to your usual PwC contact if you have any queries with regard to the guidance contained within this In brief.
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