This episode is sequel to our previous discussion under the topic “Understanding Group Account” where we discussed extensively the term “inter-corporate investment” and the rationales for one company to invest in another company. We also understood that inter-corporate investment could arise through debt or equity participation in an investee. This time, we will look at various categories of inter-corporate equity investment and which one of them gives rise to a business combination. The categories generally include minority passive, minority active, controlling interest and joint venture/joint arrangement.        

• Minority passive: When an investor owns less than 20% interest in the investee’s equity share capital, this scenario is regarded as minority passive. In this case, the investor can only benefit from the investee’s variable returns and has no influence whatsoever on the investee’s operation and financial policies. This form of investment is treated in line with IFRS 9 financial instruments.  
• Minority active is a situation that arises when an investor owns more than 20% but less than 50% of the equity share capital of the investee. This scenario is otherwise called investment in an associate. By this percentage holding, the investor can exercise significant influence on the investee’s operation and financial policies. This is usually accounted for using the equity method under IAS 28 Investment in Associate and Joint Ventures. 
• Joint venture/joint arrangement is a situation whereby two companies put resources together to acquire another company. This gives rise to joint control over the investee. In this situation, both investors own equal voting right, i.e. 50% equity share capital each in the investee. Like the minority active, this arrangement is also accounted for using the equity method in line with IAS 28 Investment in Associate and Joint Ventures. A joint venture does not give rise to a business combination. 
• Controlling interest is a situation where an investor acquires more than 50% of the equity share capital of an investee. In this case, the investor is presumed to have control over the investee, giving rise to a parent and subsidiary relationship. This is accounted for in line with IFRS 10 consolidated financial statements whereby the Parent must prepare a group account (or consolidated financial statements). Note, it only this form of inter-corporate investment that gives rise to business combination. 

What is Business Combination?

Business combination entails a situation where a business obtains control of one or more other businesses or where two or more businesses come together to form a new and enlarged business. Business combinations are a common way for companies to grow in size rather than growing through organic (internal) activities. Business combination can be in the form of a merger or acquisition. 

1. Merger: A merger is an arrangement whereby two or more companies combine by either closing the old entities into one new entity or by one company absorbing the other. In other words, the other company or companies are subsumed into the company that possesses the control. An example is a merger between two Nigerian companies, Access Bank Plc and Diamond Bank Plc, to form a bigger Access Bank Plc. Here, Diamond Bank Plc was subsumed into Access Bank Plc. In a merger scenario, one entity emerges, and the entity that has control prepares a combined account only at the point of acquisition.  
2. Acquisition: This is an arrangement whereby one company acquires another company or companies without the intention to subsume them. In this scenario, the company or companies acquired continue to exist as separate legal entities. Still, the acquirer controls their financial and operational activities. An example is Mobil Plc’s acquisition by the Nigerian Independent Petroleum Company (NIPCO). Both companies still maintain their legal status. In an acquisition scenario, the company with the control, otherwise called the Parent, must prepare a group account (or consolidated financial statements) at every year-end. 

It is important to stress that from a financial reporting perspective, business combination can only happen between businesses and it is not every company that qualifies as a business. Therefore, if not every company qualifies as a business, what then is a business? IFRS 3, as amended in October 2018, defines a business as “an integrated set of activities and assets that is capable of being conducted and managed to provide goods or services to customers, generating investment income (such as dividends or interest) or generating other income from ordinary activities.” The set of activities or asset acquired can be assessed under two approaches: the normal and fair value concentration test approaches. 

1. The normal test requires that the set of activities or asset to be acquired must have the three elements of a business, i.e. input, process and output.  

• Input: These are the economic resources that create an output upon applying one or two processes (e.g. technology, in-process research and development projects, real estate and mineral interests).
• Process: A system, standard, protocol, convention or rules that, when applied on inputs, create an output. An example includes strategic management process, operational process, resource management process etc. Please note that the accounting or IT process cannot be considered as a process for a business combination.
• Output: Results of inputs and process applied to the input. 

 The amended standard also acknowledged that an output is not entirely necessary for a set of activity or assets to qualify as a business. If, as of the acquisition date, there is a high probability of output in the nearest future, such a set of activity and assets would still be recognised as a business. However, there must be an organised workforce with the skills, knowledge, or experience to perform the process and the inputs that the organised workforce could convert into an output. 

2. The optional fair value concentration test: This approach was proposed in the amended standard to address the concerns that stakeholders had about interpreting and applying the definition of a business. The fair value concentration test is a quick and simplified approach to assessing whether an activity or assets qualifies as a business for a business combination. This approach is optional.  

In simple terms, the concentration test is met if substantially all the fair value of the gross assets acquired is concentrated in a single identifiable asset or group of a similar identifiable asset. If the test is met, the acquisition will not qualify as a business combination, and no further assessment is required. However, suppose the test is not met, or an entity elects not to use the concentration test approach, a detailed assessment must be performed by applying the normal test approach, according to IFRS 3. 

Let me use this illustration to explain what I stated above, if Company A acquires company B for $1 million and the balance sheet of Company B contains a Patent right with a fair value of $950 thousand. It is reasonable to conclude that substantially all the fair value of the gross assets is concentrated in the Patent right. In this case, the concentration test is met. This acquisition would, therefore, be regarded as an asset acquisition and not a business combination. 

We will pause here for now. I hope you understand the different forms of inter-corporate investments that exist by the percentage equity interest that an investor has in an investee. Remember that we also said that merger and acquisition are both forms of business combination but the former results in the emergence of a single entity while both entities’ legal status is preserved in the later. We also stated that not all company qualifies as a business, and we explained the two approaches for assessing whether the set of activities and assets acquired qualify as a business or not. In our next discussion, we would talk about the concept of control in a business combination, types of control and what gives rise to control. We are gradually getting close to discussing to crux of the matter which is preparation of a group account. See you soon!

This episode is sequel to our previous discussion under the topic “Understanding Group Account” where we discussed extensively the term “inter-corporate investment” and the rationales for one company to invest in another company. We also understood that inter-corporate investment could arise through debt or equity participation in an investee. This time, we will look at various categories of inter-corporate equity investment and which one of them gives rise to a business combination. The categories generally include minority passive, minority active, controlling interest and joint venture/joint arrangement.        

• Minority passive: When an investor owns less than 20% interest in the investee’s equity share capital, this scenario is regarded as minority passive. In this case, the investor can only benefit from the investee’s variable returns and has no influence whatsoever on the investee’s operation and financial policies. This form of investment is treated in line with IFRS 9 financial instruments.  
• Minority active is a situation that arises when an investor owns more than 20% but less than 50% of the equity share capital of the investee. This scenario is otherwise called investment in an associate. By this percentage holding, the investor can exercise significant influence on the investee’s operation and financial policies. This is usually accounted for using the equity method under IAS 28 Investment in Associate and Joint Ventures. 
• Joint venture/joint arrangement is a situation whereby two companies put resources together to acquire another company. This gives rise to joint control over the investee. In this situation, both investors own equal voting right, i.e. 50% equity share capital each in the investee. Like the minority active, this arrangement is also accounted for using the equity method in line with IAS 28 Investment in Associate and Joint Ventures. A joint venture does not give rise to a business combination. 
• Controlling interest is a situation where an investor acquires more than 50% of the equity share capital of an investee. In this case, the investor is presumed to have control over the investee, giving rise to a parent and subsidiary relationship. This is accounted for in line with IFRS 10 consolidated financial statements whereby the Parent must prepare a group account (or consolidated financial statements). Note, it only this form of inter-corporate investment that gives rise to business combination. 

What is Business Combination?

Business combination entails a situation where a business obtains control of one or more other businesses or where two or more businesses come together to form a new and enlarged business. Business combinations are a common way for companies to grow in size rather than growing through organic (internal) activities. Business combination can be in the form of a merger or acquisition. 

1. Merger: A merger is an arrangement whereby two or more companies combine by either closing the old entities into one new entity or by one company absorbing the other. In other words, the other company or companies are subsumed into the company that possesses the control. An example is a merger between two Nigerian companies, Access Bank Plc and Diamond Bank Plc, to form a bigger Access Bank Plc. Here, Diamond Bank Plc was subsumed into Access Bank Plc. In a merger scenario, one entity emerges, and the entity that has control prepares a combined account only at the point of acquisition.  
2. Acquisition: This is an arrangement whereby one company acquires another company or companies without the intention to subsume them. In this scenario, the company or companies acquired continue to exist as separate legal entities. Still, the acquirer controls their financial and operational activities. An example is Mobil Plc’s acquisition by the Nigerian Independent Petroleum Company (NIPCO). Both companies still maintain their legal status. In an acquisition scenario, the company with the control, otherwise called the Parent, must prepare a group account (or consolidated financial statements) at every year-end. 

It is important to stress that from a financial reporting perspective, business combination can only happen between businesses and it is not every company that qualifies as a business. Therefore, if not every company qualifies as a business, what then is a business? IFRS 3, as amended in October 2018, defines a business as “an integrated set of activities and assets that is capable of being conducted and managed to provide goods or services to customers, generating investment income (such as dividends or interest) or generating other income from ordinary activities.” The set of activities or asset acquired can be assessed under two approaches: the normal and fair value concentration test approaches. 

1. The normal test requires that the set of activities or asset to be acquired must have the three elements of a business, i.e. input, process and output.  

• Input: These are the economic resources that create an output upon applying one or two processes (e.g. technology, in-process research and development projects, real estate and mineral interests).
• Process: A system, standard, protocol, convention or rules that, when applied on inputs, create an output. An example includes strategic management process, operational process, resource management process etc. Please note that the accounting or IT process cannot be considered as a process for a business combination.
• Output: Results of inputs and process applied to the input. 

 The amended standard also acknowledged that an output is not entirely necessary for a set of activity or assets to qualify as a business. If, as of the acquisition date, there is a high probability of output in the nearest future, such a set of activity and assets would still be recognised as a business. However, there must be an organised workforce with the skills, knowledge, or experience to perform the process and the inputs that the organised workforce could convert into an output. 

2. The optional fair value concentration test: This approach was proposed in the amended standard to address the concerns that stakeholders had about interpreting and applying the definition of a business. The fair value concentration test is a quick and simplified approach to assessing whether an activity or assets qualifies as a business for a business combination. This approach is optional.  

In simple terms, the concentration test is met if substantially all the fair value of the gross assets acquired is concentrated in a single identifiable asset or group of a similar identifiable asset. If the test is met, the acquisition will not qualify as a business combination, and no further assessment is required. However, suppose the test is not met, or an entity elects not to use the concentration test approach, a detailed assessment must be performed by applying the normal test approach, according to IFRS 3. 

Let me use this illustration to explain what I stated above, if Company A acquires company B for $1 million and the balance sheet of Company B contains a Patent right with a fair value of $950 thousand. It is reasonable to conclude that substantially all the fair value of the gross assets is concentrated in the Patent right. In this case, the concentration test is met. This acquisition would, therefore, be regarded as an asset acquisition and not a business combination. 

We will pause here for now. I hope you understand the different forms of inter-corporate investments that exist by the percentage equity interest that an investor has in an investee. Remember that we also said that merger and acquisition are both forms of business combination but the former results in the emergence of a single entity while both entities’ legal status is preserved in the later. We also stated that not all company qualifies as a business, and we explained the two approaches for assessing whether the set of activities and assets acquired qualify as a business or not. In our next discussion, we would talk about the concept of control in a business combination, types of control and what gives rise to control. We are gradually getting close to discussing to crux of the matter which is preparation of a group account. See you soon!