Acquisitions of new businesses are quite common strategies for any business to leverage its exisiting competencies or to achieve an economy of scale. Apart from various valuation analysis that are being done while finalizing any new business acquisition decisions, a quick look towards its financial reporting aspects should also be done specially after the applicability of new accounting standards that are comprised with lot more specific detailings and guidances that are required to account for such transactions and possibly will be crucial for stakeholders perspective also.
As readers will be aware that after the introduction of new accounting standard on business acquisition, all assets & liabilities that are proposed to be taken over will be FAIR VALUED and if the acquisition meets the criteria of Business (definition of Business as per Ind-As- 103), then only fair value accounting is permitted.
While acquiring any Business, there could be some existing OPERATING LEASES within the business and that will probably be come together as part of this Business Combination. As per current accounting (Indian GAAPs) there is nothing specific available to deal with such instances.
Let’ look at first the relevant guidance which specifically detailed out the treatment of such existing operating leases –
As per – Ind-As 103 – “Business Combinations” Appendix B
Para – B 28– The acquirer shall recognise no assets or liabilities related to an operating lease in which the acquiree is the lessee except as required by paragraphs B29 and B30.
Para –B 29– The acquirer shall determine whether the terms of each operating lease in which the acquiree is the lessee are favourable or unfavourable. The acquirer shall recognise an intangible asset if the terms of an operating lease are favourable relative to market terms and a liability if the terms are unfavourable relative to market terms. Paragraph B42 provides guidance on measuring the acquisition-date fair value of assets subject to operating leases in which the acquiree is the lessor.
Para –B 30– An identifiable intangible asset may be associated with an operating lease, which may be evidenced by market participants’ willingness to pay a price for the lease even if it is at market terms. For example, a lease of gates at an airport or of retail space in a prime shopping area might provide entry into a market or other future economic benefits that qualify as identifiable intangible assets, for example, as a customer relationship. In that situation, the acquirer shall recognise the associated identifiable intangible asset(s) in accordance with paragraph B31.
Let’ s take an example to understand what essentially the standard is trying to explain-
Company A is acquiring Company T, apart from other assets &liabilities which are being taken over by Company A, there is a lease agreement between Company T and some other party in which they agreed for some rent for next one year (approx) and in between this acquisition is happening. Now, the rent which was agreed between Company T and other party was more/ less than (substantially) any normal market rate currently available for such leases. How to account for this situation under Business Combination transactions?
As one can refer para B 28 which completely denies to create any asset or liability related to such operating lease agreements where an acquiree (i.e. Company T in our example) is leasee except para B 29 & B 30.
Now, coming to our example scenario, suppose the rate of the lease agreed for one year is much more than currently available market lease rates then that difference may be eligible to create a liability (i.e. unfavorable as defined in above para of the standards) or if the situation is reverse i.e agreed rate is less than the available market rate then acquier can create an Intangible assets (i.e. favourable as defined in above para of the standards) as per Ind-As 38- Intangible Assets (subject to recognition criteria).
Here the Intangible assets so created will be made separately from Goodwill and hence will be considered while calculating Goodwill amounts.
Such Intangibles so created will not be re-measured subsequent to initial re-measurement and will be eligible for amortization based on its useful life.
Other than that there is nothing specific which is allowed to be created as assets or liability related to Operating leases. Let’s take another example where one can understand what could be other example where some assets or liabilities are related to an Operating Lease other than the situation explained above.
A company is having an operating lease contract which is of 5 years (assumed) subject to some rent-free period/ rent increase clauses etc. and hence a lease equalization reserve (which is commonly made to ensure straight lining of rental expenses) is made and that’s how lease rent is being deferred to amortise/ charge equal amount to PL. Now at the time of acquisition, such balances lying as liability (being deferred amounts) will NOT be an eligible liability (as mentioned in B-28 above) and the company who is acquiring the business will RE-CALCULATE such amount for the period falls after the acquisition date and hence all such liability exists at acquisition date will not be taken into account.
In case acquiree (i.e. Company T in our example) is a lessor and has given its assets on operating leases than the scenario where lease rental is less/ more than market rate will be considered as part of fair value of these assets and will be depreciated accordingly.
The whole idea to bring these provision to create kind of awareness among readers so that one can consider the concepts while dealing with such business combination workings and in a way can reduce (in case liability) some Goodwill (as the Goodwill is calculated based on fair value of all assets minus fair value of all liabilities, hence if one is able to create liability then probably it can reduce some Goodwill) amount expected to be arisen.
A reader will appreciate about the main objective of the standard and an approach which one can follow while keeping in mind the basis of origin of such requirements. There could possibly be some specific situations or circumstances where the interpretation of any standard will be different as we should always keep in mind that IND-AS is principle based standards and lot more areas need management judgment in line with the standards relevant interpretation and best practices.
One has to look into all related facts and patterns before concluding this type of assessment based on this concept. Readers are requested not to take this article as any kind of advice (it is not exhaustive in nature) and should evaluate all relevant factors of each individual cases separately.
(Author of this article is an experienced chartered accountant who has specialization on various GAAP conversions assignments covering different industries around different part of the world including acting as an Independent IFRS Advisor & Corporate Trainer. He can be reached via email at firstname.lastname@example.org or Whatsapp +91-9634706933)