IFRS 3: Amended definition of a business - Ep 7

Transcript

Dipthi (Interviewer): Welcome to this episode of the Telco Talks podcast series focusing on topical issues in the telecommunications industry. I’m Dipthi Govind, a technical accounting manager in the PwC South African practice and I will be your host. Our aim is to keep you up to date on key accounting issues in the telecommunications industry.

Joining me on this podcast is Renitha Dwarika, a technical accounting partner specialising in the telecommunications industry in our PwC South African practice.

Welcome Renitha!

Renitha: Thanks Dipthi, it's great to be back to chat about my favourite accounting topic.

Dipthi: Yes, that’s right. For the listeners, today we will be shifting gears from IFRS 16 to IFRS 3 which is the standard that deals with business combinations. I understand that there has been an amendment to the standard.

Renitha can you highlight what has changed?

Renitha: Sure. IFRS 3 sets the accounting for business combinations and defines what constitutes a business. Now historically determining whether something acquired met the definition of a business or was merely an asset acquisition was very judgemental.

The amendment revises the definition of a business and hopefully removes the judgement from the assessment.

Dipthi: I have heard about a concentration test? Can you elaborate on that?

Renitha: Yes, you’ve heard right. An entity can apply an optional ‘concentration test’. If the test is met this removes the need for any further assessment under IFRS 3. In other words, the acquisition will be treated as an asset acquisition.

Dipthi: That sounds intriguing, so how does it work?

Renitha: The amendment says that the test is met if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or group of similar identifiable assets. Therefore the term “concentration test”

There are various detailed principles in the amendment which I will not bore you and our listeners with. I will rather highlight a few things.

The first thing is that the standard does not define what constitutes ‘substantially all’, there is no bright line and some might interpret it to mean at least 90%.

The next thing is that, a single asset in terms of the concentration test includes any individual asset or group of assets that could be recognised and measured as a single asset in a business combination. So if a Telco acquires a portfolio of 10 telco towers, the portfolio would be considered a group of similar assets because they are all similar in nature. They have the same risk profile.

Dipthi: Could you perhaps illustrate the principle of the concentration test through an example?

Renitha: Let's assume a simplistic example where we have Telco A who purchases another entity, Entity B from a third party.

All Entity B has are legal contracts with lets say 50,000 mobile subscriber contracts. Entity B has two employees who have before the acquisition acted on direction from the sellers group management. No other assets, contracts or other activities are transferred, just the subscriber contracts.

If Telco A as the acquirer elects to apply the optional concentration test to this scenario, it would result in this not being a business combination.

No other assets, contracts or other activities are transferred and substantially all of the fair value would be contained within the subscriber base. The two employees would not be considered to be a substantive workforce as they could be replaced at no significant cost (and I am sure I will touch on this concept of substantive a bit later) .

Hence if the optional concentration test was applied,Telco A would account for this as an asset acquisition.

Dipthi: That’s a very interesting way of looking at it. The example definitely helps. So what would happen if the test is failed or if the acquirer chooses not to apply the optional test?

Renitha: In that case, the entity would need to assess if the acquired activities meet the definition of a business which includes assessing if there are inputs, processes or outputs.

Dipthi: Could you unpack this in a bit more detail?

Renitha: Yes, for sure

The amendment says that in order to be a business, an acquired set needs to have an input and not just any process but a substantive process that together significantly contribute to the ability to create outputs.

In relation to processes, these do not need to be documented for example in the context of an organised workforce. An organised workforce could be an input, a process, or both. For example, a consulting firm might include employees (inputs) that use their intellectual capacity (a process) to generate outputs

The amendment also narrows the definition of ‘outputs’ to the result of inputs and processes applied to those inputs that provide goods or services to customers, generate investment income (such as dividends or interest) or generate other income from ordinary activities.

Lastly, the framework distinguishes between:

Where an acquired set does not have outputs and
Where the set does have outputs

Dipthi: Could we start with a set that does not have output?

Renitha: Certainly. Where a set does not have outputs, an acquired process is considered substantive only if:

it is critical to the ability to generate outputs; and
the inputs acquired include both an organised workforce that is skilled, knowledgeable or has experience to perform that process as well as other inputs in order to generate outputs.

Dipthi: Okay so in a nutshell one would need a critical process, an organised workforce and other inputs. And what about when the set does have output?

Renitha: If a set has outputs ,then an acquired process is substantive if either, it:

Is critical to producing outputs, and an organised workforce is part of the inputs acquired ; or
the process is unique, cannot be replace easily and significantly contributes to producing the outputs
So, if we think back to our earlier example of the customer base acquisition, the two employees do not represent a substantive process as they could be replaced without significant cost and they were certainly not critical.

Dipthi: Perfect. This still seems complex. Any chance you could bring this to life for us with an example?

Renitha: Sure. I have come prepared.

Let's assume Telco A purchases an entity, Entity B, from a third party, Telco C and elects to apply the concentration test.

Entity B owns a portfolio of telco towers in Western Africa and manages co-location agreements with other telcos

Let's assume that Entity B employs highly skilled engineers to maintain and further expand the tower network and has its own development management and customer relationship managers. The reason for Telco A acquiring Entity B is not only for the tower assets but for the whole tower network and customer relationships.

In this example, the concentration test is not satisfied. All of the fair value is not concentrated in a single identifiable asset or similar assets.

This is because the tower assets and customer relationships are separate assets.

Furthermore, there is an organised workforce that is critical to maintain and expand the tower network as well as managing customer relations.

Based on the above, this would be accounted for as a business combination as there are inputs (tower assets, customer relationships, an organised workforce) and substantive processes in the form of the critical highly skilled workforce.

Dipthi: Ok, That is actually quite helpful. Thank you very much for that.

Last question to wrap up this podcast, when is the amendment effective?

Renitha: The amendment is effective for business combinations for which the acquisition date is on or after 1 January 2020 and to asset acquisitions that occur on or after the beginning of that period.

Dipthi: Thanks Renitha. This has been insightful

Renitha: You’re welcome Dipthi.

Dipthi: This brings us to the end of this episode of Telco Talks.

Stay tuned for the next episode.