Chapter 3

CONSOLIDATED FINANCIAL
STATEMENTS

LEARNING OBJECTIVES
x Recognize the three-part US GAAP consolidation model.
x Identify variable interest entities (VIE).
x Recognize similarities in the consolidation models under US GAAP and IFRS.
x Recognize how the rights and obligations of investors determine eligibility for consolidation.

US GAAP CONSOLIDATION MODEL

FASB ASC 810, Consolidation, employs three mutually-exclusive models for determining if an entity must
be consolidated into a parent entity. This is in contrast to the single model employed by IFRS 10,
Consolidated Financial Statements.
Under FASB ASC 810, a reporting entity must apply the following ASC subsections in the following order:
1. VIE guidance
2. Consolidation by contract
3. General

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A VIE is an entity in which either

x the voting interests of the equity holders are disproportionate to effective control of the entity and
exposure to expected returns and losses, or
x there is insufficient equity at risk from any one equity holder.

If control is straightforward in that a voting equity unit controls the entity in proportion to their voting
interests, the third and final option of general guidance is used. However, as is indicated by the order of
precedence in the previous paragraph, for an entity to not be subject to VIE guidance, all of the three
following conditions must not exist. In other words, if any of these circumstances exist, the entity is
subject to the VIE guidance:

x The equity investment is not sufficient to finance the activities of the entity without additional
subordinated financial support provided by any parties.
x As a group, holders of equity investment at risk lack
± WKHSRZHUWRGLUHFWWKHDFWLYLWLHVWKDWPRVWVLJQLILFDQWO\DIIHFWDQHQWLW\·VHFRQRPLFSHUIRUPDQFH
± the obligation to absorb expected losses, or
± the right expected residual returns.
x 7KHHTXLW\LQYHVWRUV·YRWLQJULJKWVDUHQRWSURSRUWLRQDOWRWKHHFRQRPLFVDQGVXEVWDQWLDOO\DOORIWKH
activities of the entity either involve, or are conducted on behalf of, an investor that has
disproportionately few voting rights.

,QVXPPDU\DQLQYHVWHHPXVWEHDVVHVVHGXQGHUWKH9,(JXLGDQFHLIHTXLW\KROGHUV·YRWLQJULJKWVDUH
not controlling and lack fundamental equity characteristics. The determination of whether an investor
must consolidate such an investee is subject to specific guidance in FASB ASC 810 (covered in the
remainder of the section). The ultimate decision to consolidate a VIE is a matter of judgment based on
the facts.
The condition of sufficiency of equity at risk includes a rebuttable presumption that 10 percent of total
equity is not sufficient to finance the activities of the potential VIE without subordinated help. FASB
ASC 810 articulates the meaning of these conditions, which will be covered later in this section.

The nature of the variability (the risk that returns or losses are higher or lower than expected), as well as
WKHLQFRQVLVWHQF\RIHDFKLQYHVWRU·V RUFODVVRILQYHVWRUV LQFLGHQFHRIORVVRUJDLQDUHERWKIXQGDPHQWDO
to understanding VIEs.

The date at which a determination must be made of whether an entity is a VIE is the date on which the
entity acquired ownership, contractual, or pecuniary interests.

THE VIE MODEL: RISKS

There are two steps to analyze the variability of a potential VIE:
1. Analyze the nature of the risks
2. Determine the purpose for which the entity was designed and the variability the entity is designed to
pass along to interest holders.

Interest holders include all potential holders (for example, owners or counterparties of derivatives,
options, and other instruments as well as contractual, debt, or other pecuniary interests).

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Subject Variability
The risks that can cause variability of returns on a potential VIE include, but are not limited to

x credit,
x interest rate,
x foreign currency exchange,
x commodity price,
x equity price, and
x operations.

The factors to consider for determining the purpose of the legal entity include, but are not limited to the
following:

x The activities
x Terms of the contracts entered into
x Nature of the interests issued
x How the interests were negotiated or marketed
x Which parties participated significantly in the design

If the terms of the interests transfer all or a portion of the risk or return of certain assets or operations,
this is a strong indicator that the variability caused by those risks is designed to create and pass them
along to interest holders.

A subordinated interest absorbs losses and returns before more senior interests. The greater the
proportion of losses absorbed by subordinated interests in relation to total overall expected losses and
residual returns expected by the entity, the greater the likelihood that an entity is a VIE. This is because
disproportionate exposure to losses and gains is a characteristic of equity, and therefore increases the
likelihood that the subordinate interest will consolidate the entity.

Periodic interest receipts and payments under US GAAP are excluded from the variability to consider
unless it was designed to pass along those risks.

Implicit interests must also be considered. Implicit interests are treated the same way as explicit interests
in assessing whether an investee must consolidate a VIE. An investor or interest holder with an implicit
variable interest receives or absorbs its gains or losses indirectly and, like those interest holders with
direct variable interests, the effects of those rights and obligations must be considered using judgment.
An assessment of implicit variable interest can result in the holder being a primary beneficiary.

KNOWLEDGE CHECK
1. A variable interest entity is

a. An entity in which there are different classes of equity.

b. An entity that is financed exclusively with variable interest rate debt.
c. An entity where voting interests are disproportionate to control, as well as exposure to gains
and losses.
d. Not reclassified based on future developments.

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2. These risks should all be evaluated in a VIE except for

a. Operations risks.
b. Interest rate.
c. Commodity risk.
d. Dissolution risk.

DETERMINING CONSOLIDATION OF INVESTEES UNDER US GAAP

An entity must consolidate a VIE in which it has a controlling financial interest, which means it is the
primary beneficiary. A reporting entity has a controlling financial interest in a VIE if it has the

x power to direct the activities that most significanWO\DIIHFWWKH9,(·VHFRQRPLFSHUIRUPDQFHDQG

x the obligation to absorb losses or the right to receive returns that could potentially be significant to
the VIE. The quantitative approach described in the definitions of FASBASC 810 is not required and
must not be the sole determinant of these obligations or rights of the reporting entity.

Rights of Other Interest Holders

An interest holder must consider its power and obligations regarding the VIE in relation to other interest
holders. If a single interest holder other than the entity with the power to direct the activities that most
significantly affects the economic performance has unilateral participating or kick-out rights (the ability to
dissolve the entity, usually associated with non-corporate entities), then that other entity may preclude the
entity from being the primary beneficiary. In fact, the other party may be the primary beneficiary.

If rights that convey power to an interest holder are shared with others, the interest holder with the most
significant power is the primary beneficiary.

Agents and Related Parties

A reporting entity must consider the power and rights and obligations of other parties that are deemed to
be effectively part of itself. These parties include its related parties (as defined in FASB ASC 850, Related
Party Disclosures) and its agents. Related parties are defined similarly to IFRS and include entities under
common control, members of immediate family, shared executives, and other factors. A group of agents,
called de facto agents, include

x a party that receives subordinated financial support from the reporting entity, without which it could
not finance its operations.
x an interest holder that received a loan or contribution from the reporting entity.
x an officer, employee, or member of the governing board of the reporting entity.
x under certain circumstances, an interest holder that cannot sell, transfer, or encumber its interests
without prior approval of the reporting entity.
x a party with a close business relationship, such as in the capacity of an advisor.

If after considering the power and rights and obligations of itself and its related parties, an entity
determines itself, its related parties, and agents together qualify as a primary beneficiary of the VIE, then
the related party that is most closely associated with the VIE is the primary beneficiary. This judgment is
made considering the relative rights and obligations among the group.

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VARIABLE INTEREST IN SPECIFIC ASSETS OF A VIE
A reporting entity with a variable interest (as determined by applying FASB ASC 810) in specified assets
of the VIE must consolidate the specified asset(s) only if

x the assets are more than 50 percent of the total assets of the VIE or the holder has another interest
in the VIE as a whole,
x the legal entity qualifies as a VIE, and
x the specified assets are essentially the only source of payment for specified liabilities or other
interests.

Primary beneficiaries of the VIE as a whole (that is, excluding the specific assets) must not consider the
specific assets in their measure of sufficiency of equity nor consolidate the specified assets and liabilities.
In essence, the specified assets and associated liabilities are treated as a separate entity.

KNOWLEDGE CHECK
3. Which statement is accurate regarding an inWHUHVWKROGHU·VDVVHVVPHQWRILWVSRZHURYHUD9,("

a. Rights and obligations that convey power are considered in isolation from other interest
holders.
b. A holder of debt does not need to assess power over an investee.
c. An interest holder must include related parties in its assessment.
d. If related parties are included in the assessment, the most senior entity in the ownership
chain consolidates the VIE.

US GAAP GENERAL CONSOLIDATION MODEL

When an investee does not fall under the VIE guidance, voting interests determine whether an investee is
consolidated. If a reporting entity has a majority of the voting interests, the investee is consolidated if
circumstances or rights of noncontrolling equity holders do not impinge upon control.

Rights of Noncontrolling Equity Holder

Under FASB ASC 810, rights of noncontrolled equity holders are either participating or protective rights.
Protective rights do not give the holders the ability to block or affect actions of the majority holder in the
ordinary course of business. Protective rights include amendments to articles of incorporation or similar
documents, pricing on self-dealing transactions, issuance or repurchase of equity interests, and
acquisitions or disposals of assets not expected to be undertaken in the ordinary course of business.
Protective rights are not sufficient to prevent consolidation of a majority vote holder.

Participating rights, conversely, give noncontrolling equity holders the ability to block or veto activities
expected to be taken by the majority vote holder in the ordinary course of business; however
participating rights can only prevent consolidation by the majority vote holder if they are substantive.

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Judgment is applied to the facts and circumstances of noncontrolling equity holder rights to determine if
the rights are protective or participating, and whether participating rights are substantive. Participating
rights are not substantive if

x the noncontrolling equity holders are widely dispersed (the next largest holder of interests is relatively
minor compared to the majority vote holder),
x the possibility of the activities over which noncontrolling holders can participate is remote, or
x a significant portion of the noncontrolling holders are in the same family as the majority vote holder.

In summary, the more disparate the connection among noncontrolling holders and the less likely to occur
the activities over which noncontrolling interest holders have participating rights, the less likely that
judgment will overcome the requirement for the majority vote holder to consolidate the investee.

For limited partnerships with kick-out rights, which can be participating rights, the limited partners must
have the ability to exercise those rights without significant barriers. Barriers include, but are not limited to

x limited time for exercise,

x financial penalties,
x absence of a qualified number of replacement general partners,
x absence of a reasonable mechanism to exercise the rights, and
x lack of ability to obtain information.

Withdrawal rights from the partnership are not substantive unless they would result in dissolution of the
entity. On the other hand, the right to cause a dissolution by withdrawal does not need to be contractual.

Not-for-Profits
US GAAP contains specific guidance on consolidation of not-for-profit (NFP) entities that overrides the
general guidance. However, many of the general concepts of control remain the same. Like the general
FRQVROLGDWLRQJXLGDQFHLID´SDUHQWµ1)3WKDWZRXOGRWKHUZLVHEHUHTXLUHGWRconsolidate another NFP,
EXWFRQWUROGRHVQRWUHVWZLWKWKH´SDUHQWµ1)3GXHWRH[WHQXDWLQJFLUFXPVWDQFHVWKHQWKH1)3FDQQRW
FRQVROLGDWH$QH[DPSOHRIH[WHQXDWLQJFLUFXPVWDQFHVPD\H[LVWZKHQWKH´SDUHQWµ1)3GRHVQRW
effectively control the other NFP (for example, the subject NFP is in bankruptcy proceedings or subject
to severe contractual limitations on power).
Majority Voting Interest
An NFP that owns a majority of the votes of the ownership units or is the sole corporate member must
consolidate the NFP.
Majority Voting Interest in the Board
If an NFP has the ability to appoint individuals to the board of another NFP that together form a
majority of the votes of a fully-constituted board, it must consolidate the controlled NFP. The fully-
constituted requirement means that board vacancies cannot give an NFP control temporarily while board
positions are open if those vacancies cause an NFP to have a majority voting interest in their absence.
Special Leasing Special Purpose Entity
An NFP must consolidate a special purpose entity (SPE) that leases assets to the NFP under the
following conditions:

x Substantially all the activities of the SPE involve assets that are leased to the NFP.
x Substantially all the risks and rewards of the leased assets and obligations of the SPE reside with the
NFP.

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x The nominal owners of the SPE are related to the NFP or have not made a substantive residual
equity capital investment that is at risk during the entire lease term.

The following circumstances presume that risks and rewards reside with the NFP:

x The lease agreement states as such through its terms.

x There is a residual value guarantee.
x Guarantee of the SPE's debt exists.
x There is an option granting the lessee a right to either purchase the assets at a price other than fair
value at the time of exercise or the NFP receives the sales proceeds of the assets in excess of a set
amount.

Consolidation begins at the start of the lease term, unless it involves construction of the assets to be
leased; in this case, consolidation starts at lease inception.

If an NFP has interests in an NFP structured as a partnership, the general rules concerning consolidation
of partnerships apply.

KNOWLEDGE CHECK
4. Which rights when held by a noncontrolling shareholder can prevent a majority equity holder from
consolidating an investee?
a. Protective rights.
b. Substantive rights.
c. Pecuniary rights.
d. Participating rights.

COMPARISON OF US GAAP CONSOLIDATION MODEL TO IFRS

Although IFRS 10 uses a single model to determine if an investee must be consolidated, all of the
elements in US GAAP are represented.

Under IFRS 10, an investor controls and consolidates an investee if and only if the investor has all the
following:

x Power over the investee

x Exposure, or rights, to variable returns from its involvement with the investee
x 7KHDELOLW\WRXVHLWVSRZHURYHUWKHLQYHVWHHWRDIIHFWWKHDPRXQWRIWKHLQYHVWRU·VUHWXUQV

An investor has power over an investee when the investor has existing rights to direct the relevant
DFWLYLWLHV WKRVHWKDWVLJQLILFDQWO\DIIHFWWKHLQYHVWHH·VUHWXUQV 6HPDQWLFDOO\WKLVLVWKHVDPHDVWKH
activities under the US GAAP assessment of a VIE.

In accordance with appendix B of IFRS 10, when voting equity interests do not make substantive
decisions regarding the relevant activities of the entity, holders of other interests must be assessed for
power. This language is analogous to the guidance in FASB ASC 810.

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Appendix B of IFRS 10 also requires that the rights of interest holders not only must affect the relevant
activities, but must be substantive. To be substantive, the interest holder needs to be able to exercise the
rights. If other interest holders can block the power over the relevant activities, the blocked interest
holders do not have power, regardless of the structure of the entity. Under FASB ASC 810, these other
interest holders are said to have participating rights. FASB ASC 810 addresses participating rights
specifically with kick-out rights in limited partnerships.

Also like FASB ASC 810, appendix B of IFRS 10 distinguishes between protective rights and
participating rights. Protective rights do not affect the execution of relevant activities and include
changing the articles of incorporation, diluting interests, and other matters not directly related to the
HQWLW\·VPDLQEXVLQHVVRSHUDWLRQV

The concept of agents under IFRS in the assessment of control of an entity is nearly identical to the
description in FASB ASC 810. De facto agents include related parties, companies under common
control, family members, and those with special relationships, such as advisors.

Similar to FASB ASC 810, when more than one investor or decision maker has the capability to direct
relevant activities and affect returns, IFRS 10 includes a requirement to assess which investor or decision
maker has the most relative influence to decide which investor consolidates the entity. Like FASB ASC
810, under IFRS 10, the more dispersed the other holders of interests that can block or alter the decisions
of an investor with significant power, the less likely that noncontrolling interest holders can prevent
consolidation of the investee.
'HHPHGVHSDUDWHHQWLWLHVDUHVLPLODUWR86*$$3·VJXLGDQFHIRUYDULDEOHLQWHUHVWLQVSHFLfic assets of a
VIE. Like FASB ASC 810, the certain liabilities must be serviced entirely by certain assets. The key
difference is that under IFRS 10, there is no requirement that the entity with the specific assets and
liabilities is itself a legal entity and that the assets comprise over 50 percent of the total assets of the VIE.
Overall, under IFRS 10, there is no mention that an investee must be a legal entity. That is, one that is
legally separate under the laws of the jurisdiction in which it operations. Under FASB ASC 810, an
investee must be a legal entity to be subject to the consolidation requirements.
Example: Assessment of Power
A SPE is created to manage the leasing of equipment for several investors in similar lines of business.
The SPE is intended to secure favorable leasing for its investors through purchasing power and
economies of scale, and leverages expertise in leasing, licensing, and permitting.
Each investor and the operator have votes equal to their shareholdings, but the votes relate only to
administrative matters such as selection of auditors and hiring of administrative service outsource
contracts. No one investor owns more than 10 percent of shares, which were all established at the
founding of the entity for the same amount of investment. However, each investor appoints a board
member. The operator takes requisitions from the other investors for equipment and bids for equipment
based on specifications supplied by the interest holders. The operator is reimbursed for personnel it uses
to operate the VIE based on its costs.

The gains or losses on the dispositions of returned equipment are shared among the investors, but the
operator receives a bonus of 10 percent of gains over a threshold. One investor (investor A) leases more
than 30 percent of the equipment and can exert significant influence over the specifications of common
equipment that is purchased on behalf of all investors.

Under FASB ASC 810, shareholders in this SPE lack the ability through votes to affect the decisions that
relate to operations, and thus the significant activities, because the votes only determine the course of

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administrative decisions. Therefore, the SPE must be considered for consolidation under the VIE
guidance. Even though no one shareholder holds 10 percent of the equity, this matter does not,
according to the facts given, require subordinate financial help. Also, even though the entity involves
leasing, the special leasing provisions of FASB ASC 810 are not relevant because the lessee is not
primarily one entity.

$QRSHUDWLRQ·VYDULDELOLW\LVRQHRIWKHIDFWRUVRIZKLFK)$6%$6&UHTXLUHVFRQVLGHUDWLRQXQGHUWKH
VIE guidance. Consequently, the gain and loss on sale of leased assets must be considered in the
assessment of the primary beneficiary of the SPE.
It is not clear from the facts whether the operator or investor A directs the activities that most
VLJQLILFDQWO\DIIHFWWKH63(·VHFRQRPLFSHUIRUPDQFH2QRQHKDQGWKHRSHUDWRUUHFHLYHVDERQXVWKDWLV
dependent on gains on sale on the leased assets. Such gains can come about under at least two
circumstances: a) the lease terms limit use of the equipment or require costly maintenance to give rise to
equipment with higher secondary-market value, or b) the lease payments were higher than market value
and thus the buyout value is low compared to market value. Both circumstances could be detrimental to
the non-operator investors-lessees and favorable to the operator, although because 70 percent of the
gains would be shared among all the investors, the assessment is one of degree.

Conversely, investor A has a strong influence over the requirements of common equipment (for example,
passenger vehicles) which could drive down the leasing rates and result in losses on the sale of
equipment.
There is no clear answer based on the facts given. Both investor A and the operator would need to
determine which activity, the gain or loss on sale of leased assets, or the influence over the common
equipment most significantly affects the returns of the SPE. FASB ASC 810 does not require a
quantitative analysis, but one should be performed to measure residual returns and variability if
qualitative assessments alone are not sufficient to determine the primary beneficiary. FASB ASC 810
prohibits quantitative assessments from being the sole determinant of primary beneficiary status;
quantitative assessments must be used in conjunction with qualitative assessments of power.

Each reporting period, each entity would need to consider if circumstances or the profitability of the
entity has changed, which may alter the balance of which interest holder has the power to most
significantly direct the activities that cause variability in returns. The reassessment may cause a change in
which entity, if any, consolidates the SPE.

Under IFRS 10, the analysis would be very similar. However, because IFRS 10 does not have separate
guidance regarding VIEs and equity at risk, it would not need to consider those factors (even though
these were not factors in this example). Equity at risk is not an explicit consideration under IFRS 10, but
if a small proportion of equity raised questions about the power of the interest holder, it would be
considered.

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KNOWLEDGE CHECK
5. A characteristic of a primary beneficiary of a variable interest entity is

a. The obligation to absorb all losses of a VIE.

b. The right to receive all residual returns from a VIE.
c. The right to direct significant administrative activities.
d. Power over activities most significantly affects the economic performance of the VIE.

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 Chapter 4

INTANGIBLE ASSETS AND

GOODWILL

LEARNING OBJECTIVES
x Compare how the effect on goodwill of noncontrolling interest can differ between US GAAP and IFRS.
x Distinguish the method in calculating impairment of goodwill under US GAAP versus IFRS.
x Apply the US GAAP qualitative test on goodwill.
x Identify the differences in capitalization of internally-generated intangible assets.

SUMMARY OF GOODWILL DIFFERENCES

Under both FASB ASC 805, Business Combinations, and IFRS 3, Business Combinations, goodwill is only
recognized under business combination accounting. Both standards require goodwill to be calculated as
the excess of consideration paid for the business(s) over the fair value of identifiable assets and liabilities
acquired. Lastly, the definition of fair value is identical under both standards.

However, US GAAP does not have an option regarding the measurement of noncontrolling interests in a
business combination, which gives rise to potential differences of the total amount of goodwill
recognized in an acquisition of a business when comparing the accounting treatment under both
standards. Under FASB ASC 805 and IAS 36, Impairment of Assets, the testing of goodwill can occur on a
different grouping of assets, meaning goodwill can be allocated to a different number of components of
DQHQWLW\7KLVFKDQJHVWKHQXPEHUDQGDPRXQWRI´XQLWVµRIJRRGZLOOWHVWHGIRULPSDLUPHQWLQRWKHUZLVH
identical business combinations. The value assigned to the component of an entity that is used to
measure goodwill impairment can also be different because IAS 36 requires that the component of the

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entity being tested is valued at the higher of value in use or fair value less costs to sell. Conversely, FASB
ASC 805 states that the value of the component of the entity carrying goodwill should be measured at fair
YDOXH/DVWO\UHJDUGLQJLPSDLUPHQWFXUUHQW86*$$3UHTXLUHVWKHFDOFXODWLRQRIWKH´LPSOLHGYDOXHRI
JRRGZLOOµZKLFKLVHVVHQWLDOO\DSURIRUPDEXVLQHVs combination at the date of testing.

Refer to the following table for a summary of differences when accounting for goodwill under IFRS and
US GAAP.
Summary of Major Differences Regarding Goodwill

Item IFRS US GAAP

Value of goodwill on Noncontrolling interests are Noncontrolling interests are
recognition measured at either the fair value measured only at the fair value
of interests not held by the of interests not held by
company or at a percentage of company.
the fair value of net assets
acquired.

Impairment testing Level of Cash-generating unit or groups of Reporting unit

testing cash generating units

Value Greater of value in use or fair Fair value

assigned value less cost to sell

Calculation Carrying amount of cash Step 1: Determine whether the

generating unit less value of cash fair value of the reporting unit is
generating unit higher than carrying value.
Step 2: Calculate the implied
value of goodwill. Write down
goodwill for any excess of
carrying value over implied
value.

Testing
incidence Annual testing is at the same Annual testing is at the same
period each year. With one period each year. Qualitative
narrow exception, quantitative screening is optional before the
testing occurs at each incidence. quantitative test.

Testing is at any reporting period Testing is at any reporting

in the fiscal year, if external or period if an event occurs or
internal conditions indicate an circumstances change that
intangible asset may be impaired. would more likely than not
reduce the fair value of a
reporting unit below its carrying
amount.

Testing occurs if the carrying

value of a reporting unit is zero
or below or if an event occurs
or circumstances change that
would more likely than not
mean that goodwill is impaired.

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NONCONTROLLING INTERESTS· EFFECT ON GOODWILL
The value of goodwill in a business combination is affected by the valuation of noncontrolling interests.
Under US GAAP, the value of noncontrolling interests is only determined using the fair value of the
interest using either the price in an active market if available, or another valuation technique. In other
words, the value of the interests is based on the value of the financial instrument that conveys the
QRQFRQWUROOLQJKROGHUV·ULJKWV

US GAAP does not permit the second option under IFRS to measure the noncontrolling interest at the
share of the acquisition-date fair values of assets acquired and liabilities assumed.
Example of Measurement Non-&RQWUROOLQJ,QWHUHVWV¶(IIHFWRQ*RRGZLOO
Goliath Company acquires 90 percent RIWKHVKDUHVRI'DYLG&RPSDQ\%RWKFRPSDQLHV·VKDUHVDUH
publicly traded in high-volume markets. The fair value of the identifiable assets less liabilities is less than
the consideration tendered by Goliath. Consequently, goodwill must be recognized.
Under FASB ASC 805, Goliath would value the minority interest at 10 percent of the market value of
David Company shares on the date of acquisition. Assuming no discounts for minority shareholding, if
shares were trading on the date of acquisition for USD 50, and the total number of shares outstanding
was 10,000,000, the value of the minority interest must be recognized at USD 50 million (10% ×
10,000,000 shares × USD 50). Goliath would debit goodwill and credit noncontrolling interest for USD
50 million each.

Under IFRS 3, Goliath would have a choice of recognizing noncontrolling interests at USD 50 million or
10 percent of the fair value of identifiable assets acquired less liabilities assumed (net assets). If the fair
value of net assets acquired was USD 450,000,000, noncontrolling interests under IFRS 10 could be
recognized for USD 45,000,000 (10% × USD 450,000,000). This would result in a debit to goodwill and a
credit to noncontrolling interest of USD 45,000,000 each.

UNIT OF ACCOUNT FOR GOODWILL IMPAIRMENT

Under FASB ASC 805, goodwill resulting from a business combination is allocated to a component of an
entity called a reporting unit. A reporting unit is a component of an entity that is expected to benefit
from the acquisition that constitutes a business or a not-for-profit activity for which discrete financial
information is available and is reviewed regularly by segment management. Benefits from an acquisition
may include increased market share or economies of scale, regardless of whether the reporting unit was
involved in the acquisition. A reporting unit cannot be larger than an operating segment as defined in
FASB ASC 280, Segment Reporting. Additionally, a reporting unit cannot be larger than one level below an
operating segment.

Under IAS 36, goodwill is allocated to cash-generating units or groups of cash-generating units that
represent the lowest level within the entity at which the goodwill is monitored for internal management
purposes but cannot not be larger than an operating segment as defined IFRS 8, Operating Segments. Like
under FASB ASC 350, under IAS 36, the goodwill is allocated to cash-generating unit(s) that are expected
to benefit from the acquisition. Cash-generating units are the lowest level of grouping of assets for which
specific cash inflows are identifiable.

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FASB ASC 280 and IFRS 8 contain identical definitions of operating segments. Therefore, under IFRS
and US GAAP, the largest component of an entity to which goodwill can be assigned for impairment
testing is the same. However, under IAS 36, the lowest level component of an entity to which goodwill is
assigned for impairment testing can be smaller than under FASC ASC 280, which can only be one level
below an operating segment. Consequently, IFRS can result in goodwill allocated to a greater number of
components of an entity than for US GAAP.
Example of Allocating Goodwill
Zeta Company acquires Alpha Corporation, a publicly held company that supplies equipment and parts
to the recycling industry. Alpha will be an operating segment under Zeta. There are two businesses under
Alpha that will be monitored separately by business unit management. Both are standalone businesses for
which cash inflows are separately identifiable. However, one of those units operates as a sub-unit of the
other because some customers of Delta can also purchase products of Epsilon; Delta supplies equipment
that processes recycling equipment and Epsilon supplies parts to repair the recycling equipment. The
structure of Zeta both before and after the acquisition, are as follows:
Alpha Corporation

Delta Corporation
Epsilon Company

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goodwill from the Alpha acquisition will not be allocated tR=HWD·VSUH-acquisition businesses.

Under FASB ASC 350, the goodwill is allocated entirely to Delta because it is the business which will
benefit from the acquisition and is not smaller than one unit below Zeta, which is an operating segment.
Under IAS 36, goodwill must be allocated to both Delta and Epsilon because each is expected to benefit
from the acquisition and each has identifiable cash inflows.

VALUE OF COMPONENT OF ENTITY FOR GOODWILL IMPAIRMENT TESTING

Paragraph 20 of FASB ASC 350 states that the value used in computing impairment of assets, including
goodwill, is fair value. Fair value under US GAAP is nearly identical to IFRS 13 because the standards
were developed in concert between FASB and the IASB.

IAS 36, in contrast, measures the value used in impairment at the higher of value-in-use or fair value less
costs of disposal. Value-in-use is an entity-specific value that is the present value of future cash flows
expected to be derived from using the asset or cash-generating unit.

Under both standards, the impairment test must be done at the same time each year. In addition, FASB
ASC 350 and IAS 36 require reporting entities to consider whether goodwill has been impaired at a
reporting date other than the annual, recurring date used to test for impairment. FASB ASC 350 and IAS
36 use very similar external and internal indicators of potential impairment triggers such as decreases in
profits or cash flows, changes in technology that could adversely affect the cash flows for assets, or
significant changes in company plans for assets in the operations of a reporting unit.

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Example of Value Used to Impair Goodwill
Apex Company is conducting its annual assessment for goodwill impairment. The unit to which goodwill
is assigned and tested can be sold for USD 900 million. Apex determines that the present value of cash
from continuing to use the unit as is would be USD 950 million.

Under IAS 36, the entity uses USD 950 for the impairment test, the higher of value in use or fair value
less cost to sell. Cost to sell is irrelevant in this case because value in use is higher. Under FASB ASC 350,
USD 900 million is used for impairment testing of the unit.

KNOWLEDGE CHECK
1. The value used to test impairment of goodwill under FASB ASC 350 is

a. The value in use of the reporting unit.

b. The fair value of the reporting unit without goodwill.
c. The fair value of the reporting unit.
d. The fair value of the primary asset.

2. Fair value

a. Differs under US GAAP and IFRS.

b. Is defined the same under US GAAP and IFRS.
c. Is based on market value for IFRS and is entity-specific under US GAAP.
d. Is not used in impairment testing.

INCIDENCE OF GOODWILL QUALITATIVE IMPAIRMENT TESTING

PROCEDURES

Step 0 in Goodwill Impairment Assessment

Under US GAAP, reporting entities have an option to make a qualitative assessment of whether goodwill
has been impaired before performing quantitative procedures. If the entity determines that it is more
likely than not that the reporting unit to which goodwill is allocated is impaired, then it performs the
quantitative procedures. Otherwise, the reporting entity can forego the quantitative tests.

FASB ASC 350-20 requires that the entity consider all relevant events and circumstances and apply
judgment to determine if it is more likely than not that a reporting unit is impaired. The following are
examples of the factors to be considered:

x Macroeconomic conditions
x Industry and market considerations
x Cost factors
x Overall financial performance
x Changes in ley personnel, strategy, customers, litigation, potential liquidation, or reorganization
x Strategic plans concerning the composition of the reporting unit

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x Goodwill impairments in the subsidiary of which the reporting unit is a part
x Sustained decrease in share price

These factors are not to be considered in isolation and are not all-inclusive. A reporting entity must
consider weight of evidence, including any mitigating events or circumstances of assessing the likelihood
that the carrying value of the unit is less than the fair value.

The reporting entity has an unconditional option to bypass this qualitative assessment for any reporting
unit in any period and proceed to the quantitative procedures.

Paragraph 99 of IAS 36 permits bypassing current-year testing for goodwill impairment if prior
impairment results exceeded the carrying value by a substantial margin and the composition of the cash-
generating unit has not changed significantly. However, the likelihood that the recoverable amount is less
than the current carrying amount must be remote. This last condition is in contrast to the more-likely-
than-not threshold used under the qualitative test in FASB ASC 350-20 (greater than 50 percent).

CASE: Nadir Company

Nadir Company is preparing for its annual goodwill impairment test. The unit to which goodwill is
assigned that it is currently analyzing has stayed intact. There have not been any significant disposals or
additions to locations, and only slight changes its product. The economic forecasts from major banks
show a stable business environment. Sales of product have increased from prior years, but less than
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Impairment testing from the prior year indicated that the carrying value was substantially below the value
of the unit. However, a competitor has reduced its selling price for similar products by 40 percent. If
Nadir were to match the price, it estimates within a confidence level of 60 percent that it would still be
SURILWDEOHEXWRSHUDWLQJLQFRPHIURPWKHXQLWZRXOGGHFUHDVHVLJQLILFDQWO\1DGLU·VPDQDJHPHnt thinks
there is a 70²80 percent chance that competitors cannot sustain the price cuts indefinitely and that
market share loss from lost sales will be manageable.

If Nadir reported its financial statements using IFRS, the following factors would be considered, in
accordance with paragraph 99 of IAS 36:

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x 7KHUHFRYHUDEOHDPRXQWH[FHHGHGWKHFDUU\LQJYDOXHE\DVXEVWDQWLDOPDUJLQLQODVW\HDU·VWHVWLQJ
x However, the judgement of management concerning the 1) ability for the competitor to sustain its
price cuts, and 2) loss in market share, do not lead to a remote possibility that the recoverable value
of the unit will not drop below recoverable value.

Based on this analysis, the company concludes that it must calculate the recoverable amount for this
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If Nadir reported its financial statements using US GAAP, the following factors would be considered, in
accordance with FASB ASC 350-20-35-3C:

x The general economy is doing well.

x The industry is relatively stable and there have not been any major technological changes for the
product of the unit.
x Revenues, costs of supplies, and labor are within budget and are expected to remain that way for the
foreseeable future.

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x Personnel turnover in the unit and company have been in line with historical data, the same
management team is in place as last year, and no changes are expected. Customer diversification
remains good, and the company is in good financial shape.
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Although management considers the FRPSHWLWRU·Vprice cuts to be of concern to the reporting unit, its
analysis of the chances that its competitor would maintain the price cuts and its loss of market share
show that there is a greater than 50 percent chance that the unit will continue to be profitable for some
time. Nadir concludes it does not have to perform the quantitative goodwill impairment tests. However,
if Nadir chooses to, it could perform the test regardless of its conclusions on the qualitative evaluations.

MEASURING GOODWILL IMPAIRMENT

Under current US GAAP, an entity performing the quantitative part of a goodwill impairment test
determines the fair value of the reporting unit to which goodwill is assigned using quoted market prices
where applicable, or using multiples of earnings if appropriate. If the fair value of the reporting unit is
less than its carrying value (step 1), it must calculate the implied value of goodwill.
To calculate the implied value of goodwill (step 2), the entity calculates the fair values of the reporting
XQLW·V assets and liabilities as if the reporting unit was being acquired in a business combination under
FASC 805. The fair value of the assets and liabilities of the reporting unit are then subtracted from the
fair value of the reporting unit. The result is the implied value of goodwill. If the implied value of
goodwill of the reporting unit is less than the carrying value of goodwill, an impairment loss is recognized
for the difference, but not more than an amount that would reduce the carrying value of the reporting
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An additional requirement of goodwill impairment under FASB ASC 350-20 takes effect when the
carrying value of the reporting unit is zero or negative. Under this circumstance, an entity must perform
the second step of the impairment test if it is more likely than not (greater than 50 percent chance) that a
goodwill impairment exists. The entity must consider whether there are significant differences between
the carrying amount and estimated fair values of its assets and liabilities, as well as the existence of
significant unrecognized intangible assets.

Example of Goodwill Quantitative Impairment Test

Wonder Company is conducting its annual goodwill impairment test. Its Raptor Division has goodwill
assigned to it. The coPSDQ\GHWHUPLQHVWKHGLYLVLRQ·VIDLUYDOXHLV86'PLOOLRQ7KHFDUU\LQJYDOXHRI
this division is USD 850 million. Because the fair value of the division is less than the carrying value, it
must calculate the fair value of the assets and liabilities at the testing date under FASB ASC 350. Raptor
division determines this figure is USD 770 million and, therefore, the implied value of goodwill is USD
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million. Wonder must recognize an impairment in profit and loss of USD 20 million (USD 50 million
carrying less implied value of goodwill of USD 30 million).

Using the same facts as the previous example, if Raptor division determined that the fair value of its
assets and liabilities were USD 740 million, the implied value of goodwill would be USD 60 million
(USD 800 million less USD 740 million). Under this scenario, goodwill is not impaired.

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Using IAS 36, if USD 800 million was the recoverable amount of the Raptor division (the higher of fair
value less cost to sell of value in use, an impairment of US 50 million would be recognized.

CHANGES TO US GAAP MEASUREMENT OF GOODWILL IMPAIRMENT

Effective for financial statements of public companies (as defined in US GAAP) issued after December
16, 2019, or non-public companies after December 16, 2021, goodwill impairment will be measured by
simply subtracting the carrying value at the reporting date from the fair value and reducing goodwill
accordingly. This is the same calculation as is currently used under IAS 36.

KNOWLEDGE CHECK
3. Under current US GAAP, which statement is accurate when calculating goodwill impairment?

a. An entity must always perform a quantitative test.

b. The implied value of goodwill must be calculated.
c. An entity must always perform a qualitative test.
d. The steps to calculate impairment are the same as under IAS 36.

INTERNALLY GENERATED INTANGIBLES

US GAAP does not permit the recognition of internally generated intangible assets. All such costs are
expensed. This is in contrast to IAS 38, Intangible Assets, which permits recognition of an intangible asset
for the costs incurred in the development stage of research and development activities under certain
circumstances.

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 Chapter 6

BUSINESS COMBINATIONS

LEARNING OBJECTIVES
x Compare the definition of a business under US GAAP and IFRS.
x Distinguish between US GAAP and IFRS the treatment of business acquisition measurement period
adjustments.

INTRODUCTION
Business combinations was one of the first convergence projects undertaken by the IASB and FASB. In
2003, the boards released nearly identical standards for business combinations with only some minor
differences as a consequence of some fundamental differences in definitions for IFRS and US GAAP.

IFRS 3, Business Combinations, and FASB ASC 805, Business Combinations, require that when an acquired set
of assets meets the definition of a business, the identifiable assets acquired and liabilities assumed are
recognized at fair value, with the excess of consideration recognized as goodwill.

Since the 2003 issuance of these standards, there have been changes to FASB ASC 805 that are not
aligned with IFRS 3.

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DEFINITION OF A BUSINESS UNDER US GAAP
In 2017, FASB issued ASU No. 2017-01, Business Combinations (Topic 805): Clarifying the definition of a
business. This update changed what constituted a business for the purposes of distinguishing between the
acquisition of a business and the acquisition of assets. This is a crucial definition because the acquisition of
assets does not involve the complex process of accounting under a business combination, such as
recognition of goodwill, valuation of liabilities, determination of acquisition date, and segregation of
transactions that are not part of a business combination (such as share-based compensation issued in
conjunction with the acquisition).

To clarify whether to account for an acquisition as one of assets or a business, ASU No. 2017-01
provides the following:

x A screen, or set of circumstances, that should be considered before rendering the transaction as an
acquisition of assets instead of a business
x Clarification of processes that are considered substantive and therefore meet one of two elements
necessary for the acquisition to be considered a business combination
x Elimination of the necessity for an acquisition target to have outputs in order to qualify as a business,
although it must be capable of producing outputs

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integrated set of activities and assets that is capable of being conducted and managed for the purpose of
providing a return in the form of dividends, lower costs, or other economic benefits directly to investors
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The screen referred to in the bulleted list is applied as follows: An acquisition will not be considered a
business combination 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. Gross assets, for the purpose of this criterion,
exclude cash, deferred tax assets, and goodwill resulting from the effect of deferred tax liabilities. To
determine if assets are similar, an acquirer must consider the characteristics of the assets and their
relationship to producing outputs. The following are not considered similar assets for this definition:

x Tangible and intangible assets

x Identifiable intangible assets in different major classes, such as customer-related intangibles,
trademarks, and in-process research and development.
x Financial and nonfinancial assets
x Major classes of financial assets
x Major classes of tangible assets
x Identifiable assets within the same major class that have differentiating risk characteristics

If an acquired set of assets is not concentrated, then the next step when differentiating between assets
and a business is to consider the processes and outputs.

When the acquired assets do not include outputs, processes are considered substantive, and therefore
meet the criterion of a business process only if they include employees that form an organized labor
force. Furthermore, the work force must have the necessary skills, knowledge, or experience to perform
an acquired process that when applied to inputs is critical to the ability to produce the outputs.

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When the assets include outputs, the employees that form the organized workforce must have the
necessary skills, knowledge, or experience that are considered scarce and enable the workforce to
perform the process(es) that is(are) critical to producing the output without significant delay. In other
words, continuity of output from before to after the acquisition of the set is necessary to be considered a
business.

DEFINITION OF A BUSINESS UNDER IFRS 3

The definition of a business in IFRS 3 is very similar to that of FASB ASC 805. To be considered a
business under IFRS 3, the acquired assets and resources must include processes that are capable of
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of FASB ASC 805. Therefore, it is possible that an acquisition of an identical set of assets, people, and
processes could be considered an asset purchase under FASB ASC 805, but a business combination
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Additionally, although IFRS 3 includes language about the importance of an assembled workforce in the
definition of a business, unlike FASB ASC 805, it does not require the existence of a workforce to qualify
as a business.

MEASUREMENT PERIOD ADJUSTMENTS

The measurement period under both IFRS 3 and FASB ASC 805 allows an acquirer in a business
combination one year to finalize the measurements required for an acquired business. Converged
standards required comparative financial statement figures to be restated for the effects of changes that
occurred during the measurement period. Current US GAAP retains this retrospective treatment.

However, ASU No. 2015-16, Business Combinations (Topic 805): Simplifying the Accounting for Measurement-
period Adjustments, requires that measurement period adjustments are recognized in the period in which
they arise. Entities, must, however, disclose the effect of the acquisition on the prior period.

The ASU is effective for financial statements issued after December 15, 2017, for public business entities,
and after December 15, 2018, for non-public business entities.

Example: Measurement Period Adjustments

Kappa Corp. acquired Lamda Corporation in 2017. In 2018, measurement period adjustments totaled 50
units of currency for cost of goods sold. Under IFRS 3, the 2017 comparative statement of income is
revised. Under FASB ASC 805, the changes are accounted for prospectively in 2018. See the following
for the effect on financial statements under IFRS and US GAAP:

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 Pre-Adjusted IFRS 3 ASC 805

2017 2018 2017 Variance 2018 Variance 2017 Variance 2018 Variance

Revenue 5,000 2,400 5,000 - 2,400 - 5,000 - 2,400 -

Cost of Sales 2,500 1,200 2,550 50 1,200 - 2,500 - 1,250 50

Gross Profit 2,500 1,200 2,450 (50) 1,200 - 2,500 - 1,150 (50)

Administrative 500 260 500 - 260 - 500 - 260 -

Expenses

Operating 2,000 940 1,950 (50) 940 - 2,000 - 890 (50)

Income

Interest 50 25 50 - 25 - 50 - 25 -
Expense, Net

Income Before 1,950 915 1,900 (50) 915 - 1,950 - 865 (50)
Taxes

Income Taxes 702 329 702 - 329 - 702 - 329 -

Net Income 1,248 586 1,198 (50) 586 - 1,248 - 536 (50)

KNOWLEDGE CHECK
1. Which statement is a requirement of an acquisition arrangement to be accounted for under IFRS 3
and FASB ASC 805?

a. The acquired resources must be accompanied by an in-place workforce.

b. The acquired resources must meet the definition of a business.
c. There can be no adjustments after the year of acquisition.
d. An established process is not required to be part of acquired resources.

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