Re: Exposure Draft ED/2016/01 Definition of a Business and Accounting for Previously Held Interests

Transcription

1 International Accounting Standards Board 30 Cannon Street London EC4M 6XH United Kingdom Paris, October 28, 2016 Dear Mr Hoogervorst, Re: Exposure Draft ED/2016/01 Definition of a Business and Accounting for Previously Held Interests We welcome the opportunity to comment on the section Definition of a Business of Exposure Draft ED/2016/01 Definition of a Business and Accounting for Previously Held Interests, issued by the IASB on 28 June 2016 (the ED ). We appreciate the IASB s objective of trying to address concerns expressed that the definition of a business in IFRS 3 Business Combinations is difficult to apply, results in variations in the understanding of the guidance and in the exercise of judgment, lacks guidance on what should not be considered a business, resulting in characterizations that some believe are counterintuitive. Question 1 The Board is proposing to amend IFRS 3 to clarify the guidance on the definition of a business (see paragraphs B7 B12C and BC5 BC31). Do you agree with these proposed amendments to IFRS 3? In particular, do you agree with the Board s conclusion that if substantially all the fair value of the gross assets acquired (i.e. the identifiable assets and non-identifiable assets) is concentrated in a single identifiable asset or group of similar identifiable assets, then the set of activities and assets is not a business (see paragraphs B11A B11C)? Why or why not? If not, what alternative would you propose, if any, and why? NO. We do not agree with the proposed amendments. Origin of the significance of the characterization: A. The significance of the characterization as an asset or business acquisition is mainly caused by a limited set of differences in accounting. Those originate in the standards without, we believe, an underlying reasoning to explain the differences: i.e. acquisition costs (capitalization vs expensing), book to tax difference upon recognition of assets (first time recognition exemption or not), recognition of gain on disposal (full or partial if an asset sold to an ias28 affiliate), variable

2 consideration accounting. We believe it is worth exploring whether the sources of the differences may be characterized differently 1. B. We are aware that the Board has repeatedly decided not to reconsider those questions, but we note that the FASB has made a first step towards eliminating some of the differences (gains and losses). To continue not addressing the basis for differences will lead to continuing referral of issues to the IFRS IC 2. We therefore respectfully encourage the Board to reconsider its past decisions prior to finalizing the ED: the Board should analyze the relevance of those accounting differences in terms of informational value to external stakeholders, examine if the definition of a business vs an asset is needed to justify the accounting differences, explain its findings and conclusions. We are convinced that such a process may deliver more benefits than the proposed ED. Proposed ED : With respect to the ED, we initially had a very positive perception of the project and specifically of the identification of a business with the presence of a process as a way of emphasizing that as an integrated set of activities and assets, a business is characterized by a value exceeding that of its individual components. Ultimately however, we have reached the conclusion that the proposed ED will not deliver the expected benefits, neither through the proposed revised definition of what constitutes a business nor through the proposed approach to identify a business. The main reasons for our conclusion are presented hereafter: The definition of a business and outputs is still in need of improvements C. B7-B8 needs to be restructured to provide clarity: B7 should be dedicated to the usual elements present in an operating business and B8 to the accounting characterization as a business on the basis of a subset of elements (an input + a substantive process). With respect to ability to contribute to the creation of outputs vs ability to create : we understand the rationale for the change in BC10 that the acquired set need not be sufficient to create outputs and that not all the inputs and processes needed to create outputs need to be acquired to qualify the acquisition as a business. If so, this is however an element for the accounting characterization of the acquired set (B8), not an intrinsic characteristic of an [operating] business (B7). Similarly, the first sentence of B8 ( which together are or will be used to create outputs ) echoes probably the second sentence of B7 ( Although businesses usually have outputs, outputs are not 1 e.g.: Are acquisition costs of an asset and a business really of a similar nature beyond their common labelling as acquisition costs? Are the sources of book to tax differences really similar (are they linked or not to the carryover of a predecessor tax bases without needing to call for the definition of business?)? Do all natures of variable/contingent consideration warrant the same treatment? 2 e.g.: Recurrent difficulties about deferred taxes upon acquisition have recently been illustrated by the IFRS IC tentative decision on IAS12 income taxes- recognition of deferred taxes when acquiring a single asset entity that is not a business.

3 required ), and both would be best placed in B7 (c). In fact the assertion that no outputs are required questions the characterization of what are the outputs (see hereunder D). With respect to processes vs substantive processes in B7-B8: B7 mentions generically processes while B8 introduces the vocabulary of substantive processes but both are described as having the ability to contribute to the creation of outputs. D. With respect to the revised definition of outputs in B7: this is certainly the area where clarifications and focus was needed in response to the call in BC and therefore agree with BC15. However, - retaining investment income (such as dividends or income) among the possible outputs maintains the confusion between motivations for the acquisition with an assessment of the characteristics of the set acquired as well as confusion about what is acquired (a non controlling interest in a business is not an acquisition of a set of activities and assets). It should be removed. - describing outputs as goods and services to customers may be read as unduly restrictive in that a development stage company may be building bricks (IP, tools, processes in process) that could themselves be sold (be the output rather than the ultimate good or service that could be produced from the bricks ). This should be explained and clarified. The amendments do not alleviate the questions about the composition of the set of activities and assets E. We agree with the Board s decisions that the assessment should be based on what has been acquired, rather than considering whether a market participant could replace missing elements for continuing to produce outputs or could integrate the acquired activities assets (BC8 and 12) and consequently to with the related modification of B8. In parallel, this puts pressure on the composition of the set of activities and assets that drives the assessment (i.e. following the ED approach, the determination of the perimeter of inputs and processes). F. This is why we disagree with the decision to keep virtually unchanged B11, as we do not think there is such a thing as a fact driven assessment independent of the business rationale of the parties to the transaction (BC14): - It deprives preparers, auditors, regulators and users from information and understanding necessary in the exercise of judgment. 3,4 3 At least B50 determining what is part of the BC transaction recognizes the value of the insight provided by the reasons for a transaction 4 For example, a retail chain may decide to give up a hypermarket it owns and operates. The acquirer may be a real estate developer which plans to build office buildings or a competitor who wish to secure its hold over a population area or a REIT that will rent the premises to the seller or to another lessee. Everybody would agree that in the first case, there is an acquisition of land, but in the second case that is basically a swap of brand (ie a form of continuation of an activity), what are the missing key elements for it not to be a business acquisition? The third case raises the question of the valuation practice in B42.

4 - It appears in contradiction with the proposed analysis as explained in the Basis for Conclusions: Once the decision is made not all of the inputs and processes needed to create outputs need to be acquired for the set of activities to be a business (BC10), identifying what are those inputs and substantive process required to contribute to the ability to create outputs is key; as stated in BC22 about what processes are substantive, that determination could vary from industry to industry and from transaction from transaction. G. Similarly, while we understand the reasoning for focusing on the set of items acquired, we are unconvinced by the fact that acquired contracts (like purchasing contracts or contracts with customers) should not be part of the judgment leading to the characterization as stated in B12C 5. We also would have expected a link with IFRS3 51 and B50 about determining what is part of the business combination transaction. H. In fact, although a substantive process needs to be applied to an input, beyond the organized workforce, there is no guidance about the scope of inputs that are a differentiator. I. We agree with the Board that the presence in a transaction of an organized workforce (ie an input embedding a critical process) is an indicator of a business 6 but that it is not in itself sufficient to form a business for which another input is necessary (BC24). Considering the workforce in the assessment has the benefit of being aligned with the traditional view that associates the workforce as one of the factors generating an added value from the inputs. It is also, in many jurisdictions, what is differentiating a pure asset transfer from a business transfer from a legal or tax perspective. However, some jurisdictions may allow transaction structure achieving the same economic outcome without transferring the workforce. J. We regret that two terminologies are used within IFRS3 for the workforce: how is to be read the distinction between an organized workforce (B7, B12 A, B12 B: an organized workforce with the necessary skills, knowledge, or experience to perform an acquired [substantive] process ) and an assembled workforce (B37: permits to continue to operate an acquired business )? K. The key question is therefore whether absent an organized workforce there can be a business transfer. This question is also becoming more and more relevant as there already are a number of assets which generate outputs without an organized workforce (wind power generator, solar plant, algorithms, etc.) and as in the future it is not unlikely more activities will require little or no organized workforce. The ED rightly envisages a business without a workforce but only in the presence of outputs. These two items are further discussed under L (and foll.) and O (and foll.). 5 Example F is particularly illustrative of the curiosity of the ED s reasoning or at least how B12C has been applied to the fact pattern, given that the contracted access to the supply of product X achieves the same result as the acquisition of the manufacturing set in example G and is certainly critical to the distributor s activity. 6 Although it is difficult not to view it preempting B11 in some way.

5 The identification of a substantive process remains, notwithstanding the guidance, an uncertain outcome L. The ED s answer to the previous question is to rest the determination on the identification of a substantive process. After a careful evaluation, we conclude, the practical ability to identify a substantive process in a fact pattern is, notwithstanding the guidance, highly uncertain or blurred. Hence, the ED does not alleviate the concern raised in BC5 (a). M. As indicated in BC22, the ability to correctly circumscribe the notion of a substantive process through a single definition is difficult. This has resulted in the ED depicting a process by an attribute ( when applied to an acquired input or inputs, contributes to the ability to [continue] producing outputs ) that could characterize any input. This raises the question of the artificiality of the distinction between them (taking the example of a wind power generator). After all, when acquisitions of assets are made, it is likely that many will be contributing to the ability to produce outputs and that they embed some form of process. N. To distinguish further a process from a substantive process, other attributes are introduced in B12A (criticity) and B12B (uniqueness, scarcity or difficult to replace). They bring their own difficulty. For example, BC26 indicates that an organized workforce is not required in order to conclude that a set of acquired activities and assets is a business only in some limited circumstances (emphasis added). It goes on saying some critical processes may not be unique or scarce but widely available; consequently it is necessary that an organized workforce is also acquired in order to conclude that the transaction is a business combination. However the wording used in the standard appears to widen significantly the scope of situations envisaged in the BC i.a. B12B(a) that process.cannot be replaced without significant cost, effort or delay in the ability to continue producing outputs. Example J-acquisition of oil and gas operations is particularly illustrative of the drift towards extension. The dual set of circumstances (outputs/no ouputs at acquisition date) puts ongoing pressure on the determination of the presence of outputs O. We remain unconvinced of the choice made in favor of two different sets of criteria depending on whether the set of activities and assets has or has no outputs. This is because the duality of model (combination of the workforce and another input required only when there is no output, presence of workforce or process when there are outputs) puts pressure on the determination of the presence of outputs, with the related questions about: 1. the nature of the output: as indicated here above (ref. to definition of a business and outputs), in the circumstance of an early-stage entity that has not yet started generating revenues from customers, the developing IPRD, IP etc. can be the precursors (inputs) of a production of other goods and services as stated in B12A, but can also be the outputs in progress to be sold as in example B;

6 2. the generation of outputs at acquisition date: it introduces a subset of inputs, processes/ activities and assets in the ability to contribute to the creation of outputs. One can wonder whether introducing such an acquisition date bright line is relevant for applying B12A or B12B 7 ; 3. the set of activities and assets considered : the set of activities and assets to consider the presence or absence of outputs is unclear: it seems to refer to the set of the seller (not strictly equate the acquired set), an approach that would be in contradiction with the statement in B11 that it is not relevant whether a seller operated the set as a business or whether the acquirer intends to operate the set as business ; 4. the different wording: there are variations between the two circumstances in the ED s depiction of what forms an organized workforce ( necessary skills, knowledge, or experience to perform an acquired substantive process vs necessary skills, knowledge, or experience to perform an acquired process and criticity) or a substantive process (criticity vs uniqueness, scarcity, difficult to replace), that are difficult to substantiate; 5. the limited set of circumstances without a workforce: the only difference is that when there are outputs, the presence of a process in the set of acquired activities and assets may eliminate the requirement of an organized workforce. The reasoning in BC26 seems to rest upon the fact that the set having outputs, there is more evidence that the set is a business (as stated in BC25 to explain that it is less important to consider the type of inputs), but it does not tell much about the limited circumstances or characteristics of the process. Downgrading goodwill to a mere indicator is a move away from IFRS3 and the required discipline in separating what assets are or are not to be individually identified and separately recognized P. We disagree with B12 downgrading the presence of goodwill to an indicator rather than a presumption that the acquired set of activities and assets is a business and with the rationale expressed in BC28. We understand the Board is working on what goodwill should encompass and how it can be described as an asset (conceptual framework, PIR IFRS3, identification or subsuming of workforce, customer relationships etc.) and that it may create an incentive to dissociate in that context goodwill from the characterization of a business. Generating a return in excess of the individual assets through their integration and their combination with other inputs (other assets, supply contracts, sales contracts, workforce, regulation, etc.) is a key indicator of the value creation expected of activities conducted in a business (the acquired set has a value that exceeds the individual values). There is an immediate proximity with goodwill. An acquisition of a business without goodwill (if any) should economically be extremely rare if accounting avoid distorting significantly the scope of identified assets and liabilities. An acquisition of a business with badwill is therefore an economic anomaly, and most likely either an accounting creation (triggered by expected negative outflows inadequately recognized in accounting or the 7 E.g., in Example B without that bright line, the drug candidate could have been analyzed under B12B rather than B12A.

7 requirement to recognize differed tax), or a valuation artefact (originating in conditions inadequately reflected in the acquired assets fair valuation ) (see hereafter alternative). The need to downgrade the presumption because it may results in conflicts with parts of the analysis required by the proposed amendments highlights in our view the inadequacy of the proposed analysis. We believe that the approach should be to reconcile rather than disconnect the concept of substantive process with the value creation of such a process. We further discuss this in under the heading Alternative hereunder. The concentration test is unconvincing Q. We remain unconvinced about the usefulness of the proposed test applicable only to a limited subset of assets ( single assets or portfolios of similar assets) and have the following doubts: - Is the concentration test not simply reintroducing that without goodwill, there is no business while at the same time restricting this to a limited population of transactions because of the decision not to use goodwill as a presumption of a business? We think this restriction will generate new difficulties about what is a single asset as already evidenced by the questions addressed to the FASB 8 and by excluding from its scope complex assets purchases that may under various circumstances be or not be capable of generating outputs 9. - Is there not a risk of indirectly an involuntarily of endorsing valuation practices that do not distinguish between the value of the underlying asset and the goodwill (excess return over of the individual assets) as indicated here above? 10 R. To make the outcome of the concentration test mandatory rather than a presumption may be viewed as eliminating the possibility of having an accounting free choice or making the determination less challengeable. We however disagree with this as we believe a mandatory outcome will downgrade the use of judgment by incorporating into an accounting standard a way to alleviate the documentation burden induced by certain jurisdictions audit or regulatory requirements when confronted to the exercise of judgment. An evolution of practices in that respect, if any, should rest on a dialog of the accounting standard setter with the relevant stakeholders. 8 Basing guidance on an accounting class is unlikely to provide much relevance or relief: the next question being the level of homogeneity of the assets or the appropriate unit for complex assets. 9 Ref. the reasoning about the manufacturing facility in example D. Why is the manufacturing facility split in various components while a shopping mall would be viewed like an office building as a single asset? 10 Taking again the previous examples: in real estate, the price paid for land must be compatible with a return for its development, or the price paid for a building must be compatible with the risks associated with its leasing, but a contrario in a windfarm, the wind generators have a building cost that is measurable; if the transaction price of the windfarm exceeds this cost, it is likely that other elements characteristic of a business are present (or all equipment suppliers would turn into a power company) like for example the guaranteed purchase of the output at a given price.

8 S. We are also wary of the questions that will arise about the modus operandi of the test (notion of substantially all, single asset, scope of assumed liabilities when determining the fair value of the gross assets, working capital, etc.). Evidence based standard activity requires evidence of the resolution of the concerns that motivate the activity T. We believe educational materials are needed to illustrate how those fact patterns that under the current guidance were believed to result in counterintuitive outcomes or significant diversity in application are to be analyzed under the ED guidance. As a strong proponent of evidence based standard, this would provide evidence of the achievement, if any, of the intended benefits of the revised guidance. U. If examples are often useful in illustrating the application of the principles, we are wary of those in the proposed ED: uncertain articulation with the guidance 11, reliance for the concentration test on some of the weakest area of valuation like that of a workforce 12 with a potential confusion with goodwill, and ultimately for examples almost twice the number of pages for the standard 13. The need for numerous examples is often the sign either that the principles are not so clear or that the level of judgement remains irreducibly significant. We recommend that as a minimum the examples be screened to eliminate those that appear to have been built either to accommodate existing specific practices or to illustrate the guidance articulation on artificial or uncertain fact patterns. Overall, the accounting characterization based on the presence of an input + a substantive process is, in our opinion, non-operative. We respectfully suggest the following alternative if the Board concludes it should pursue its revision of the existing guidance on business. Possible Alternative: looking for a way to reconcile the substantive process approach with the expected value creation of a business V. One of the key difficulty of the proposed approach is the ability to identify (or not) a substantive process when there is no organized workforce (that is an input that embed a substantive process), as it is highly difficult to generically characterize what a substantive process may be. 11 e.g. example D-acquisition of a manufacturing facility : there is an organized workforce i.e. capable of performing a substantive process and an input (the manufacturing facility with the related equipment) but the example concludes to the absence of a business disqualifying the input on an unknown basis. 12 e.g. in examples E- acquisition of a biotech entity, I-acquisition of investment properties, K-acquisition of mortgage loan portfolio:; IAS38.15 clearly states that an entity usually has insufficient control over the expected future economic benefits arising from a team of skilled staff, specific management or technical talent; even if such control was protected by legal rights, it is difficult to arrive at situation where the remuneration would significantly differ from current market price and therefore result in a significant fair value. 13 in the proposed ED : 7 pages of examples vs 4 pages.

9 One could link the presence of the substantive process to its transformative nature that turns individual inputs into value creation. Such an approach would be built upon (a) the purpose of a business (generating a return in excess of the values of the acquired individual assets by the virtue of their integration/combination) and (b) the two key requirements of IFRS 3 (identification of the consideration transferred for the acquired set -or its fair valuation if no consideration is transferred - and fair valuation of the acquired individual assets). W. In a certain way, it is not unlike the concentration test proposed by the ED but independent from the nature or number of acquired items. It should be recognized that valuation methodologies (single point estimate or level 3 methods) have their limits and that where the presence or absence of goodwill is within the range of error of the methodologies, judgment is needed with its related transparency obligation toward users (i.e. when material disclose the accounting differences of the alternate characterization) 14. As in the proposed ED, the question of the perimeter of the assets would need clarification (see notion of gross assets that is, the identifiable assets and unidentifiable assets acquired BC8 (d) when the ED introduces the workforce). X. The approach is similar but not identical to the accounting goodwill 15. After all, it captures the consideration paid for the value added by the integration of various assets and processes (the acquired set on its own or through its integration in the acquirers operations). However, accounting goodwill is tainted by accounting rules prescribing specific recognition or measurement rules (IFRS esp. employee benefits, income tax or IFRS bargain purchases) that (may) differ from the underlying economic valuation of assets and liabilities. Y. We recognize that to adopt this approach for the characterization of a business requires confidence that the fair valuation of the assets does not subsume elements of business value creation (in accounting term goodwill). The Board may have to identify the situations of such valuation practices 16, understand the reasons for such situations and eventually provide additional guidance for the fair valuation of identified assets separately from the value added by its operation. Z. The alternative approach would at least build on the economic rationale of an acquisition and on the use of known approaches (determination of acquisition price, valuation of identified assets and liabilities). As today, it would enable to capture most transactions commonly viewed as business acquisitions. For those transactions, it would eliminate the need for differentiators like input, process, existing or future outputs, assembled vs organized workforce, etc. which we are convinced generate their own new difficulties without guaranteeing the expected improvements in consistency in and economic relevance of the characterization as asset or business acquisition. Accordingly, it 14 A similar question arises about the notion of substantially all in the ED s concentration test. Making an appreciation only in proportion to the identified assets may not be relevant for certain industries that are highly leveraged. 15 This is why there is no circularity. 16 The practice for valuing real estate assets subject to operating leases (B42) may be illustrative of such a situation. Another case that could warrant a review is the TAB practice in the valuation of individual assets.

10 would limit the burden associated with the introduction of any new approach to only a limited subset of well identified circumstances. Question 2 The Board and the FASB reached substantially converged tentative conclusions on how to clarify and amend the definition of a business. However, the wording of the Board s proposals is not fully aligned with the FASB s proposals. Do you have any comments regarding the differences in the proposals, including any differences in practice that could emerge as a result of the different wording? YES. We have the following observations: AA. Converged solutions by the IASB and the FASB are theoretically desirable, especially as a certain level of convergence (albeit incomplete) has been reached for business combinations. However, in the present case, we remain unconvinced that an alignment is necessary nor desirable, esp. if this would prevent the IASB either from cross examining the relevance of the accounting differences between asset and business acquisitions, or review the determination of what is a business and an asset. BB. With respect to BC7 and BC31 that emphasize the Board s conviction that the Boards have reached substantially converged conclusions and that the ED aligns the Board s and the FASB amendments, - we are wary that such statements are made without reference to the continued importance of judgment notwithstanding any guidance proposed in the ED; - we also fear that with such statements the IASB relinquishes its capacity to appreciate independently how its standards are applied and to decide in due time of its course of action, while IFRS preparers will be submitted to decisions not screened by the IASB or the IFRS IC. * * * Transition requirements Question 4 The Board is proposing the amendments to IFRS 3 [and IFRS 11] to clarify the guidance on the definition of a business and the accounting for previously held interests be applied prospectively with early application permitted. Do you agree with these proposed transition requirements? Why or why not?

11 YES. Requiring retrospective application would be costly and impracticable in most situations, and also be disruptive in terms of communication for very limited informational value, if any. We support the Board s decision for a prospective application and a possible earlier application. * * * If you would like to discuss our comments further, please do not hesitate to contact us. Yours sincerely, /s/ Nicolas de Paillerets Director of Accounting Principles nicolas.depaillerets@orange.com Orange is a European communication services provider that is reporting in accordance with IFRS as adopted by the E.U. and is listed on EuroNext and NYSE.